Part V: Introduction to Macroeconomics 19. The Wealth of Nations: Defining and

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1 Part V: Introduction to s Aggregate Incomes 1 / 56

2 Chapter 19 Defining and / 56

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4 Chapter 19 Q: In the United States, what is the total market value of annual economic production? 4 / 56

5 s is the study of aggregate economic activity. National income accounting is a framework for calculating gross domestic product (GDP), which is a measure of aggregate economic output. GDP can be measured in three different ways, and in principle these three methods should all yield the same answer: Production = Expenditure = Income 5 / 56

6 GDP has limitations as a measure of economic activity and as a measure of economic well-being. Economists use price indexes to measure the rate of inflation and to distinguish nominal GDP from real GDP (which holds prices fixed). 6 / 56

7 19.1 s is the study of economic aggregates and economy-wide phenomena like the annual growth rate of a country s total economic output or the annual percentage increase in the total cost of living. 7 / 56

8 In particular, macroeconomics asks the following questions: What is income per capita (i.e. income per person)? How do we measure differences in income per capita? How large are differences in income per capita? What causes differences in income per capita? How long will differences in income per capita persist? 8 / 56

9 Income per capita the average income per person is calculated by dividing a nation s aggregate (or total) income by the number of people in that country. Income per capita in the United States is more than 2 times the level in Portugal, 7 times the level in China, and 100 times the level in Zimbabwe. Differences in income per capita are caused by institutional differences (so-called economic rules of the games) and political policies that impact them. 9 / 56

10 Differences in income per capita can either narrow over time (e.g., China) or widen over time (e.g., Argentina). Macroeconomists also study the year-to-year, or short-run, fluctuations in economic activity. In the short run, economic growth slows down or even becomes negative when aggregate spending decreases. A recession is defined as two straight quarters in which aggregate income falls. 10 / 56

11 During recessions the unemployment rate rises. A person is officially unemployed if he or she (1) does not have a job, (2) has actively looked for work in the prior fours weeks, (3) is currently available for work. The unemployment rate is defined as the ratio of workers who are unemployed. 11 / 56

12 Why were the Great Recession of and the Great Depression of so severe? U.S economy shrank by 4.3% and the unemployment rate rose from 5% to 10% in From 1929 to 1933, production fell by nearly 30% and the unemployment rate rose from 3% to 25%. 12 / 56

13 Are there policies that will enable us to avoid such disasters in the future? Or are we only able to respond after the fact? Could the financial crisis have turned into another Great Depression? To answer these questions, the first thing we must do is to measure the thing we are studying: a country s aggregate economy. 13 / 56

14 19.2 : Production = Expenditure= Income National income accounts is a measure of the level of aggregate economic activity in a country. and Product (NIPA) is the system of national income accounts used in the United States. 14 / 56

15 Aggregate economic activity in a country can be measured in three different ways: The production approach The expenditure approach The income approach 15 / 56

16 Production Fordica is a small country with only one employer, the Ford Motor Company. Suppose we want to measure the total market value of annual production in the nation of Fordica. Ford only needs its own machines and the labor of Fordica s citizens to build cars. The market price of a Ford is $30,000, then the market value per year of production in Fordica is: (5 million cars) ($30, 000/car) = $150 billion 16 / 56

17 Expenditure We add up the sales of cars to households, firms, government, and the foreign sector, including unsold inventories: Expenditure = (5 million cars) ($30, 000/car) = $150 billion 17 / 56

18 Income We add up payments to labor and payments to capital: Income = $X + ($150 billion $X) = $150 billion Therefore, we have the following aggregate accounting identity: Production = Expenditure= Income 18 / 56

19 Circular Flows Exhibit 19.1 Circular Flow Diagram 19 / 56

20 The circular flow diagram presents two main decision makers firms and households and it shows the four types of flows in Exhibit Production represents the goods and services that are produced by firms. Expenditure represents the payments made by households to firms for goods and services. Income represents the payments made from firms to households for the use of their physical capital and labor. 20 / 56

21 Factors of production represent the productive resources owned by households and used by firms in the production process. Each of these approaches is used to measure gross domestic product, or GDP, which is the market value of the final goods and services produced within the borders of a country during a particular time period. 21 / 56

22 Account: Production Production-based accounting sums up each firm s value added, which is the firm s sales revenue minus the firm s purchases of intermediate products from other firms. Exhibit 19.2 Dell s Value Added 22 / 56

23 Total sales of Dell computers to retail customers: $15 billion (retailers) + $35 billion (direct) =$50 billion. Revenue received by Dell: $10 billion (retailers) + $35 billion (direct)= $45 billion. Dell s value added: $45 billion - $30 billion for intermediate products =$15 billion. Third-party retailers value added: $15 billion (sales) -$10 billion paid to Dell =$5 billion. 23 / 56

24 Account: Expenditure Expenditure-based accounting sums up the purchases of goods and services by different groups or categories. These expenditures can be assigned to five categories. 1. Consumption (C) Consumption goods and consumption services bought by domestic households. 2. Investment(I ) New physical capital (not financial investment ) bought by domestic households and domestic firms. 24 / 56

25 3. Government expenditures (G) The market value of government purchases of goods and services. Transfer payment and interest paid on government debt are excluded. 4. Exports (X) The market value of all domestically produced goods and services sold to foreign countries. 5. Imports (M) The market value of all foreign produced goods and services sold to domestic households, domestic firms, and the domestic government. Account Identity: Y = C + I + G + X M 25 / 56

26 Account: Income Income-based accounting sums up payments (or income) received by labor (labor income) and the owners of physical or financial capital (capital income). Most people in the economy receive both labor and capital income. Firms are owned by households, firms can not own themselves. In the United States and other developed economies, nearly two-thirds of income payment goes to labor (labor share of GDP) and one-third goes to capital. 26 / 56

27 Chapter 19 Q: In the United States, what is the total market value of annual economic production? 27 / 56

28 Exhibit 19.3 U.S GDP and GDP Shares (Expenditure-based Accounting) 28 / 56

29 台灣的 GDP 組成, 2013 年 總額 比例 NT$ 百萬元 % GDP, Y 15,221, % Consumption, C 8,249, % Investment, I 3,359, % Government purchases, G 2,226, % Net exports, NX 1,385, % Exports, X 10,580, % Imports, M 9,194, % 29 / 56

30 Have U.S. expenditure shares fluctuated or remained constant over time? Exhibit 19.4 U.S. GDP Shares ( ) 30 / 56

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35 Saving vs. Investment Saving = Y C G = (C + I + G + X M) C G = I + X M = Investment + Exports Imports In a closed economy, exports and import are both equal to zero, then and Saving = Investment Saving = Investment GDP GDP 35 / 56

36 Exhibit 19.5 The Relationship Between the Saving Rate and the Investment Rate ( ) The red line is a 45 degree line. The green circle represents the last year of data, / 56

37 19.3 GDP and national income accounting is a useful system for taking the temperature of the economy. However, it is not perfect, and it necessarily leaves out a lot of details. 37 / 56

38 Physical Capital Depreciation GDP omits depreciation of the physical capital stock and resources. Depreciation analyses tend to find that depreciation is equal to 10-15% of GDP. If we take account of physical capital depreciation, should we also try to calculate depreciation of health and human capital? 38 / 56

39 Home Production GDP excludes home production of cleaning, cooking, and child care done in the household. All economists agree that excluding home production is a flaw in the GDP accounts, but we do not have a way to measure home production. Home-produced childcare? 39 / 56

40 The Underground Economy GDP does not capture transactions conducted in the underground economy transactions that are intentionally hidden from government statisticians. The underground economy also include markets in illegal professions. Some countries, including Ireland, Italy and the U.K have recently started to include underground activity, such as illicit drug purchases and prostitution, in their GDP calculations. 40 / 56

41 Negative Externality GDP does not count negative externalities such as pollution, noise, and crime. Sometimes negative externality get counted as positive contributors to economic output. For example, property crimes, like theft, led people to purchase locks and other security devices. 41 / 56

42 Gross Domestic Product vs. Gross National Product GDP does not include production by U.S. workers and U.S. capital abroad. Gross domestic product, or GDP, records production in the United States regardless of whose labor and capital (domestic or foreign) is used. Gross national product, or GNP, records production of domestically owned labor and capital in the United States and abroad. In 2013, U.S. GDP was $16.8 trillion, U.S. GNP was $17.1 trillion, very close. 42 / 56

43 Leisure GDP does not record leisure. When we think about GDP comparisons across countries, we need to remember that different countries are working at different levels of intensity. 43 / 56

44 Does GDP Buy Hapiness? Do all these limitations mean that GDP is a poor measure of well-being of an economy? Why don t we ask people how happy or satisfied (10-point scale) they are and compare these responses to GDP per capita turns out to be an excellent predictor of life satisfaction. Exhibit 19.6 GDP per Capita and Life Satisfaction 44 / 56

45 19.4 An increase in GDP will record both increases in actual production (and income) and increases in prices of those goods and services. We therefore need to distinguish between nominal GDP and real GDP. 45 / 56

46 GDP is the total value of production using current market prices to determine the value of each unit that is produced. Real GDP is the total value of production using market prices from a specific base year to determine the value of each unit that is produced. 46 / 56

47 Exhibit 19.7 Quantities (Q) and Prices (P) is an Economy with Two Goods By holding prices constant as the prices from 2012, economists say that the analysis uses constant 2012 dollars. Real GDP growth is 2013 is $700, 000 $400, 000 $400, 000 = 3 4 = 0.75 = 75% 47 / 56

48 The GDP Deflator GDP deflator is the price level of the overall economy which is the ratio of nominal GDP and real GDP. GDP deflator = GDP deflator(2012) = GDP deflator(2013) = GDP 100 Real GDP $400, = 100 $400, 000 $900, = $700, 000 Percentage change in GDP deflator in 2013 is = 28.6% 48 / 56

49 Exhibit 19.8 The Value of the GDP Deflator from 1929 to 2013, Using 2009 as the Base Year The GDP deflator is less than 100 before 2009 and greater than 100 after From 2009 to 2013 the GDP deflator increased on average 2.9% per year. 49 / 56

50 The Consumer Price Index Consumer Price Index (CPI) is the price level of a particular basket of consumer goods and services. CPI(2013) = Cost of consumer basket in 2013 Cost of consumer basket in base year The rate of increase in prices is the inflation rate. Inflation rate in 2013 is (Price Index in 2013) (Price Index in 2012) Price Index in / 56

51 The GDP deflator and the CPI formula look nearly identical, with three key differences. 1. The GDP basket includes things that households don t purchase. 2. The consumer basket includes things that households purchase but are not counted in GDP. (e.g. foreign-produced goods) 3. Even if a product is included in both baskets, it is likely to have a different weight in the two baskets. 51 / 56

52 Exhibit 19.9 The Annual U.S. Inflation Rate from 1930 to 2013 Percentage change in GDP deflator is plotted in blue, percentage change in the CPI is plotted in dashed red. 52 / 56

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56 Adjusting Variables We can use a price index to make meaningful comparisons across time. In 1909, then U.S. President William Howard Taft was paid $75,000. In 2013, current U.S. President Barack Obama was paid $400,000. We can convert Taft s salary to 2013 dollars. CPI in 2013 Value in 2013 dollars = $75, 000 CPI in 1909 = 233 $75, = $1.9 million 56 / 56