National Income. Sherif Khalifa. Sherif Khalifa () National Income 1 / 44

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1 National Income Sherif Khalifa Sherif Khalifa () National Income 1 / 44

2 People with higher incomes enjoy higher standards of living. To judge how the economy is doing, we look at the total income of everyone in the economy. Gross Domestic Product GDP is the best measure of the national income. Gross Domestic Product GDP is the best measure of economic well being. Gross Domestic product GDP is the best measure of economic performance. GDP provides a single number for the dollar value of economic activity in a given period of time. Sherif Khalifa () National Income 2 / 44

3 Definition Gross Domestic Product is the market value of all final goods and services produced within a country in a given period of time. Sherif Khalifa () National Income 3 / 44

4 Definition Gross Domestic Product is the market value of all final goods and services produced within a country in a given period of time. The diversity of products in the economy complicates the calculation of GDP because different products have different values. GDP adds together different kinds of products into a single measure of the value of economic activity using market prices. Market prices measure the amount people are willing to pay for different goods, and reflect the value of those goods. Sherif Khalifa () National Income 4 / 44

5 Definition Gross Domestic Product is the market value of all final goods and services produced within a country in a given period of time. GDP includes all items produced in the economy and sold legally in markets. GDP excludes items produced and sold illicitly. GDP excludes all items produced and consumed at home. Sherif Khalifa () National Income 5 / 44

6 Definition Gross Domestic Product is the market value of all final goods and services produced within a country in a given period of time. GDP includes the value of final goods and not intermediate goods, to avoid double counting. Final goods are those intended for the end user. Intermediate goods are ingredients in the production of other goods. The value of intermediate goods is included in the prices of the final goods. An exception is when an intermediate good is produced and, rather than being used, is added to a firm s inventory. Sherif Khalifa () National Income 6 / 44

7 Definition Gross Domestic Product is the market value of all final goods and services produced within a country in a given period of time. GDP includes tangible goods and intangible services. Tangible goods include durable and non-durable goods. Durable goods are goods that last for a long time. Non-durable goods are goods that do not last for a long time. Sherif Khalifa () National Income 7 / 44

8 Definition Gross Domestic Product is the market value of all final goods and services produced within a country in a given period of time. GDP includes goods and services currently produced. GDP does not include items produced in the past. GDP does not include the sale of used goods. Sherif Khalifa () National Income 8 / 44

9 Definition Gross Domestic Product is the market value of all final goods and services produced within a country in a given period of time. GDP measures the value of production within the geographic confines of a country. The items are included in a nation s GDP if they are produced domestically, regardless of the nationality of the producer. The production of citizens abroad is not included in the GDP of the citizen s country. Sherif Khalifa () National Income 9 / 44

10 Definition Gross Domestic Product is the market value of all final goods and services produced within a country in a given period of time. GDP measures the value of production that takes place within a specific interval of time. The interval of time is usually a quarter or a year. When GDP is reported for a quarter, it usually represents GDP at an annual rate. Which is the amount of income and expenditure during a quarter multiplied by 4. Sherif Khalifa () National Income 10 / 44

11 GDP increases from one year to another because: 1 The economy is producing a larger output of goods and services. 2 Goods and services are being sold at higher prices. Sherif Khalifa () National Income 11 / 44

12 Definition Nominal GDP is the value of goods and services measured at current prices. Nominal GDP uses current prices to place a value on the economy s production of goods and services. Definition Real GDP is the value of goods and services measured using a constant set of prices. Real GDP uses constant base year prices to place a value on the economy s production of goods and services. Because real GDP is not affected by changes in prices, changes in real GDP reflect only changes in the quantities produced. Sherif Khalifa () National Income 12 / 44

13 Billions $12,000 Nominal and Real GDP in the U.S., $10,000 $8,000 $6,000 Real GDP (base year 2000) $4,000 $2,000 Nominal GDP $ Sherif Khalifa () National Income 13 / 44

14 Year Hot Dog Hot Dog Hamburger Hamburger Price Quantity Price Quantity 2013 $1 100 $ $2 150 $ $3 200 $4 150 Sherif Khalifa () National Income 14 / 44

15 Year Hot Dog Hamburger Nominal GDP 2013 $1x100=$100 $2x50=$100 $ $2x150=$300 $3x100=$300 $ $3x200=$600 $4x150=$600 $1200 Sherif Khalifa () National Income 15 / 44

16 Year Hot Dogs Hamburgers Real GDP 2013 $1x100=$100 $2x50=$100 $ $1x150=$150 $2x100=$200 $ $1x200=$200 $2x150=$300 $500 Sherif Khalifa () National Income 16 / 44

17 Definition The GDP deflator is the price of output relative to its price in the base year. GDP Deflator = Nominal GDP Real GDP x100 Sherif Khalifa () National Income 17 / 44

18 Year Nominal GDP Real GDP ( GDP Deflator ) ( 200 x100 = ) 350 ) x100 = x100 =240 ( Sherif Khalifa () National Income 18 / 44

19 GDP is the total income of everyone in the economy. GDP is the total expenditure on the economy s output of goods and services. For an economy as a whole, income equals expenditure. Every transaction has a buyer and a seller. Every dollar of expenditure by a buyer is a dollar of income for a seller. Sherif Khalifa () National Income 19 / 44

20 Revenue (=GDP) G & S sold Markets for Goods & Services Spending (=GDP) G & S bought Firms Households Factors of production Wages, rent, profit (=GDP) Markets for Factors of Production Labor, land, capital Income (=GDP) Sherif Khalifa () National Income 20 / 44

21 Y : Gross Domestic Product C: Consumption spending I : Investment spending G: Government spending NX : Net exports Y = C + I + G + NX Sherif Khalifa () National Income 21 / 44

22 Definition Consumption spending is spending by households on goods and services, with the exception of purchases of new housing. Goods include household spending on durable goods and non-durable goods Services include household spending on intangible items. Non-durable goods are goods that last only a short time. Durable goods are goods that last a long time. For renters, consumption includes rent payments. For homeowners, consumption includes the imputed rental value of the house but not the purchase price or mortgage payments. Sherif Khalifa () National Income 22 / 44

23 Definitions The relationship between consumption and disposable income is called the consumption function. C = C (Y T ) Definition The marginal propensity to consume is the amount by which consumption changes when disposable income increases by one dollar. Sherif Khalifa () National Income 23 / 44

24 C = C(Y T) depends on consumption spending by households C disposable income C C = = C( C( Y T) Y T) Y T The slope of the consumption function is the MPC. Sherif Khalifa () National Income 24 / 44

25 Definition Investment spending is the purchase of goods that will be used in the future to produce more goods and services. Divided into: business fixed investment, residential investment, and inventory investment. Business fixed investment is the purchase of new plant and equipment by firms. Residential investment is the purchase of new housing by households and landlords. Inventory investment is the increase in firm s inventories of goods. Sherif Khalifa () National Income 25 / 44

26 Definition The relationship between investment spending and the interest rate is called the investment function. I = I (r) The quantity of investment goods demanded depends on the interest rate. The interest rate measures the cost of the funds used to finance investment. Sherif Khalifa () National Income 26 / 44

27 Investment spending I = I(r) depends on real interest rate Real interest rate, r Investment function, I(r) Quantity of investment, I Sherif Khalifa () National Income 27 / 44

28 Definition Government spending is spending on goods and services by local, state and federal governments. Includes the salaries of government workers, spending on public works, and defense spending. Excludes transfer payments, such as social security or unemployment benefits. Because it is not made in exchange for a currently produced good or service. Government spending depends on the government ideology and the budget deficit. Sherif Khalifa () National Income 28 / 44

29 Definition Net Exports equal the purchases of domestically produced goods by foreigners minus the domestic purchases of foreign goods. Net Exports = Exports Imports Exports are domestically produced goods purchased by foreigners. Imports are foreign goods purchased by domestic residents. When a household, a firm or the government buys a good or a service from abroad. It decreases net exports but it also increases C, I, and G, and does not affect GDP. Sherif Khalifa () National Income 29 / 44

30 Example Drug Lords increase their production of cocaine. Sherif Khalifa () National Income 30 / 44

31 Example Drug Lords increase their production of cocaine. Sherif Khalifa () National Income 30 / 44

32 Example Drug Lords increase their production of cocaine. A cattle rancher sells meat to McDonald s to prepare Big Macs. Sherif Khalifa () National Income 30 / 44

33 Example Drug Lords increase their production of cocaine. A cattle rancher sells meat to McDonald s to prepare Big Macs. Sherif Khalifa () National Income 30 / 44

34 Example Drug Lords increase their production of cocaine. A cattle rancher sells meat to McDonald s to prepare Big Macs. A company increases its production of paper that is used in Hallmark cards. Sherif Khalifa () National Income 30 / 44

35 Example Drug Lords increase their production of cocaine. A cattle rancher sells meat to McDonald s to prepare Big Macs. A company increases its production of paper that is used in Hallmark cards. Sherif Khalifa () National Income 30 / 44

36 Example Drug Lords increase their production of cocaine. A cattle rancher sells meat to McDonald s to prepare Big Macs. A company increases its production of paper that is used in Hallmark cards. A chef cooks a gourmet meal to his family. Sherif Khalifa () National Income 30 / 44

37 Example Drug Lords increase their production of cocaine. A cattle rancher sells meat to McDonald s to prepare Big Macs. A company increases its production of paper that is used in Hallmark cards. A chef cooks a gourmet meal to his family. Sherif Khalifa () National Income 30 / 44

38 Example Drug Lords increase their production of cocaine. A cattle rancher sells meat to McDonald s to prepare Big Macs. A company increases its production of paper that is used in Hallmark cards. A chef cooks a gourmet meal to his family. You grow oranges in your garden that your kids eat. Sherif Khalifa () National Income 30 / 44

39 Example Drug Lords increase their production of cocaine. A cattle rancher sells meat to McDonald s to prepare Big Macs. A company increases its production of paper that is used in Hallmark cards. A chef cooks a gourmet meal to his family. You grow oranges in your garden that your kids eat. Sherif Khalifa () National Income 30 / 44

40 Example A collector sells a Mickey Mantle card to another collector. Sherif Khalifa () National Income 31 / 44

41 Example A collector sells a Mickey Mantle card to another collector. Sherif Khalifa () National Income 31 / 44

42 Example A collector sells a Mickey Mantle card to another collector. Ford produces cars in France. Sherif Khalifa () National Income 31 / 44

43 Example A collector sells a Mickey Mantle card to another collector. Ford produces cars in France. Sherif Khalifa () National Income 31 / 44

44 Example A collector sells a Mickey Mantle card to another collector. Ford produces cars in France. A family buys a new refrigerator. Sherif Khalifa () National Income 31 / 44

45 Example A collector sells a Mickey Mantle card to another collector. Ford produces cars in France. A family buys a new refrigerator. Consumption. Sherif Khalifa () National Income 31 / 44

46 Example A collector sells a Mickey Mantle card to another collector. Ford produces cars in France. A family buys a new refrigerator. Consumption. Aunt Jane buys a new house. Sherif Khalifa () National Income 31 / 44

47 Example A collector sells a Mickey Mantle card to another collector. Ford produces cars in France. A family buys a new refrigerator. Consumption. Aunt Jane buys a new house. Investment. Sherif Khalifa () National Income 31 / 44

48 Example Ford adds some of its Mustang cars to its inventory. Sherif Khalifa () National Income 32 / 44

49 Example Ford adds some of its Mustang cars to its inventory. Investment. Sherif Khalifa () National Income 32 / 44

50 Example Ford adds some of its Mustang cars to its inventory. Investment. Ford sells a Mustang car from its inventory. Sherif Khalifa () National Income 32 / 44

51 Example Ford adds some of its Mustang cars to its inventory. Investment. Ford sells a Mustang car from its inventory. Investment & Consumption. Sherif Khalifa () National Income 32 / 44

52 Example Ford adds some of its Mustang cars to its inventory. Investment. Ford sells a Mustang car from its inventory. Investment & Consumption. California paves highway 101. Sherif Khalifa () National Income 32 / 44

53 Example Ford adds some of its Mustang cars to its inventory. Investment. Ford sells a Mustang car from its inventory. Investment & Consumption. California paves highway 101. Government Expenditure. Sherif Khalifa () National Income 32 / 44

54 Example Ford adds some of its Mustang cars to its inventory. Investment. Ford sells a Mustang car from its inventory. Investment & Consumption. California paves highway 101. Government Expenditure. Federal Government increases unemployment benefits. Sherif Khalifa () National Income 32 / 44

55 Example Ford adds some of its Mustang cars to its inventory. Investment. Ford sells a Mustang car from its inventory. Investment & Consumption. California paves highway 101. Government Expenditure. Federal Government increases unemployment benefits. Sherif Khalifa () National Income 32 / 44

56 Example Ford adds some of its Mustang cars to its inventory. Investment. Ford sells a Mustang car from its inventory. Investment & Consumption. California paves highway 101. Government Expenditure. Federal Government increases unemployment benefits. Your parents buy a bottle of French wine. Sherif Khalifa () National Income 32 / 44

57 Example Ford adds some of its Mustang cars to its inventory. Investment. Ford sells a Mustang car from its inventory. Investment & Consumption. California paves highway 101. Government Expenditure. Federal Government increases unemployment benefits. Your parents buy a bottle of French wine. Imports, & Consumption. Sherif Khalifa () National Income 32 / 44

58 Income Markets for factors of Production Factor Payments Private Saving Financial Markets Households Taxes Government Public Saving Firms Government Purchases Investment Consumption Markets for Goods and Services Firm Revenue Sherif Khalifa () National Income 33 / 44

59 Definition Factors of production are the inputs used to produce goods and services. The two most important factors of production are capital and labor. Capital is the set of tools that workers use. Labor is the time people spend working. Factors of production are fully utilized. K = K L = L Sherif Khalifa () National Income 34 / 44

60 Definition The production technology determines how much output is produced from given amounts of capital and labor. Y = F (K, L) Y = F ( K, L ) Definition A production function has constant returns to scale if an increase of an equal percentage in all factors of production cause an increase in output of the same percentage. zy = F (zk, zl) Sherif Khalifa () National Income 35 / 44

61 The kitchen and its equipment are the Bakery capital. The workers hired to make the bread are its labor. The loaves of bread are its output. Sherif Khalifa () National Income 36 / 44

62 To make a product, the firm needs two factors of production, capital and labor. Let s represent the firm s technology by the usual production function: Y = F (K, L) Sherif Khalifa () National Income 37 / 44

63 A competitive firm is small relative to the markets in which it trades. The competitive firm has no influence on market prices. The competitive firm has no influence on the wages of the workers. The competitive firm has no influence on the rents of the capital. Sherif Khalifa () National Income 38 / 44

64 The firm sells output at a price P, hires workers at wage W, and rents capital at a rate R. The goal of the firm is to choose L and K to maximize profit. Firm profits equal sales revenues minus production costs. Profit = Revenue Labor Costs Capital Costs = PY WL RK = PF (K, L) WL RK Sherif Khalifa () National Income 39 / 44

65 Definition The marginal product of labor is the extra amount of output the firm gets from one extra unit of labor, holding the amount of capital constant. Definition Diminishing marginal productivity means that, holding capital fixed, the marginal product of labor decreases as the amount of labor increases. Profit = Revenue Cost (P) (MPL) = W 0 = (P) (MPL) W Sherif Khalifa () National Income 40 / 44

66 Definition The marginal product of capital is the amount of extra output the firm gets from an extra unit of capital, holding the amount of labor constant. Definition Diminishing marginal productivity means that, holding labor fixed, the marginal product of capital decreases as the amount of capital increases. Profit = Revenue Cost (P) (MPK ) = R 0 = (P) (MPK ) R Sherif Khalifa () National Income 41 / 44

67 Y = F (K, L) = AK α L 1 α MPL = AK α (1 α) L 1 α 1 MPK = AL 1 α αk α 1 W = (P) (MPL) = PAK α (1 α) L 1 α 1 R = (P) (MPK ) = PAL 1 α αk α 1 Sherif Khalifa () National Income 42 / 44

68 Y = F (K, L) = AK 1 2 L 1 2 A = 100, K = 100, L = 100, P = 10 MPL = 1 2 AK 1 2 L 1 2 = 1 2 (100) (100) 1 2 (100) 1 2 = 50 MPK = 1 2 AK 1 2 L 1 2 = 1 2 (100) (100) 1 2 (100) 1 2 = 50 W = P (MPL) = 50P = 500 R = P (MPK ) = 50P = 500 Sherif Khalifa () National Income 43 / 44

69 Y C G = I Y = C + I + G Y C G + T T = I Y } {{ T C } + T }{{ G } = I Private Saving Public Saving S = I Sherif Khalifa () National Income 44 / 44