Economic Performance. Sherif Khalifa. Sherif Khalifa () Economic Performance 1 / 55

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1 Sherif Khalifa Sherif Khalifa () Economic Performance 1 / 55

2 People earning higher income levels also enjoy higher living standards. To judge economic well being, we consider the total income of an economy. Economies with a larger output satisfy the demands of their inhabitants. Gross Domestic Product measures the total income and output of a nation. Gross Domestic product is the best assessment of economic performance. Provides a number for the dollar value of economic activity in a period of time. Sherif Khalifa () Economic Performance 2 / 55

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 () Economic Performance 3 / 55

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. GDP adds together diverse products into one value of economic activity. The value of economic activity is calculated using market prices. Market prices is the amount people are willing to pay for products. Market prices reflect the value of those products to people. Sherif Khalifa () Economic Performance 4 / 55

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 items produced and sold in markets legally. GDP excludes items produced and sold illicitly. GDP excludes items produced and consumed at home. GDP excludes items sold in black markets or informal markets. Sherif Khalifa () Economic Performance 5 / 55

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. Final goods are ready for consumption and 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. GDP includes only the value of final goods to avoid double counting. An exception when an intermediate good is added to a firm s inventory for sale at a later date. Sherif Khalifa () Economic Performance 6 / 55

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 period of time. Non-durable goods are goods that do not last for a long period of time. Services include work done for consumers by individuals and by firms. Sherif Khalifa () Economic Performance 7 / 55

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 old and used items. Sherif Khalifa () Economic Performance 8 / 55

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 is the value of production within the geographic confines of a country. GDP includes items that are produced domestically by nationals and foreigners. The production of citizens abroad is not included in the GDP of the citizen s country. Sherif Khalifa () Economic Performance 9 / 55

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 is the value of production that takes place within a specific interval of time, a year or a quarter. When GDP is reported for a quarter, it represents GDP at an annual rate. This is the amount of income and expenditure during a quarter multiplied by 4. Sherif Khalifa () Economic Performance 10 / 55

11 The performance of the economy reflects the ability to produce more products. Gross Domestic Product increases from one year to another either because: 1 The economy is producing a larger quantity of goods and services. 2 Goods and services are being sold at higher prices. Sherif Khalifa () Economic Performance 11 / 55

12 Definition Nominal GDP is the production of goods and services valued at current prices. Definition Nominal GDP uses current prices to place a value on the economy s production of goods and services. Nominal GDP 2017 = [(P 2017 Q 2017 ) Item1 + (P 2017 Q 2017 ) Item2 +...] Nominal GDP 2018 = [(P 2018 Q 2018 ) Item1 + (P 2018 Q 2018 ) Item2 +...] Sherif Khalifa () Economic Performance 12 / 55

13 Definition Real GDP is the production of goods and services valued at constant prices. Definition Real GDP uses constant base year prices to place a value on the economy s production of goods and services. Real GDP 2017 = [(P base Q 2017 ) Item1 + (P base Q 2017 ) Item2 +...] Real GDP 2018 = [(P base Q 2018 ) Item1 + (P base Q 2018 ) Item2 +...] Sherif Khalifa () Economic Performance 13 / 55

14 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 () Economic Performance 14 / 55

15 Example Assume an economy produces hot dogs and burgers only. Calculate Nominal GDP and Real GDP. Year Hot Dogs Burgers Price Quantity Price Quantity 2015 $1 100 $ $2 150 $ $3 200 $4 150 Sherif Khalifa () Economic Performance 15 / 55

16 Year Hot Dogs Burgers Nominal GDP 2015 $1x100=$100 $2x50=$100 $ $2x150=$300 $3x100=$300 $ $3x200=$600 $4x150=$600 $1200 Sherif Khalifa () Economic Performance 16 / 55

17 Year Hot Dogs Burgers Real GDP 2015 $1x100=$100 $2x50=$100 $ $1x150=$150 $2x100=$200 $ $1x200=$200 $2x150=$300 $500 Sherif Khalifa () Economic Performance 17 / 55

18 Definition The GDP Deflator measures the current level of prices relative to the level of prices in the base year. [ ] Nominal GDP GDP Deflator = X 100 Real GDP [ ] (P2018 Q 2018 ) GDP Deflator 2018 = Item1 + (P 2018 Q 2018 ) Item X 100 (P base Q 2018 ) Item1 + (P base Q 2018 ) Item Sherif Khalifa () Economic Performance 18 / 55

19 Year Nominal GDP Real GDP ( GDP Deflator 2015 $200 $ ) 200 x100 = $600 $ $1200 $500 ( 600 ) 350 x100 =171 ( 1200 ) 500 x100 =240 Sherif Khalifa () Economic Performance 19 / 55

20 GDP does not take into account activity in black markets or informal markets. GDP does not take into account the effect of production on the environment. GDP does not take into account subsistence production and volunteer work. GDP does not take into account human happiness and life satisfaction. GDP does not take into account the impact of leisure on the quality of life. GDP does not take into account income inequality between rich and poor. Sherif Khalifa () Economic Performance 20 / 55

21 GDP is the income of everyone in the economy and the total expenditure on the economy s output. Total expenditure has to equal total income because every transaction has a buyer and a seller. Every dollar of spending on a product by some buyer is a dollar of income for some seller. The expenditure of buyers on purchasing a product is income to the sellers of the product. Sherif Khalifa () Economic Performance 21 / 55

22 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 () Economic Performance 22 / 55

23 Economists care not only about the economy s total output but also about the allocation of this output among alternative uses. GDP is allocated among four categories: consumption spending, investment spending, government spending and net exports. These categories consider expenditure by domestic and foreign households, firms and governments on goods and services. This equation is an identity that holds at all times, and is called the national income accounts identity. Sherif Khalifa () Economic Performance 23 / 55

24 Y : Gross Domestic Product C: Consumption Spending I : Investment Spending G: Government Spending NX : Net exports Y = C + I + G + NX Sherif Khalifa () Economic Performance 24 / 55

25 Definition Consumption Spending is spending by households on goods and services, with the exception of purchases of new housing. Goods include durable goods and non-durable goods. Durable goods are goods that last for a long period of time. Non-durable goods are goods that do not last a long period of time. A service is the non material equivalent of a good. A service is an economic activity that does not result in ownership. For renters, consumption includes rent payments. For homeowners, consumption includes the imputed rental value of the house. Sherif Khalifa () Economic Performance 25 / 55

26 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 () Economic Performance 26 / 55

27 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 () Economic Performance 27 / 55

28 Definition Investment Spending is spending on capital equipment, structures, and inventories, and household purchases of new housing. Investment spending is divided into business fixed investment, residential investment, and changes in inventory. Business fixed investment is spending on new plant, factories, machines, equipment and tools by firms. Residential investment is the purchase of new housing by households and landlords. Residential investment includes the purchase price, down payment and mortgage payments. Inventory includes items produced in a given year, but may be sold in a later year. Sherif Khalifa () Economic Performance 28 / 55

29 Definition The relationship between investment spending and the interest rate is called the investment function. I = I (r) Definition The interest rate measures the cost of the funds used to finance investment. Sherif Khalifa () Economic Performance 29 / 55

30 Investment spending I = I(r) depends on real interest rate Real interest rate, r Investment function, I(r) Quantity of investment, I Sherif Khalifa () Economic Performance 30 / 55

31 Definition Government Spending is spending by local, state and federal governments on goods and services. Federal government spending includes defense and non-defense spending. State and local government spending includes only non-defense spending. Non defense includes the salaries of government workers and spending on public works. Excludes transfer payments, such as social security or unemployment benefits. Transfer payments are not made in exchange for a currently produced good or service. Government spending depends on the government ideology and the budget deficit. Sherif Khalifa () Economic Performance 31 / 55

32 Definition Net Exports equal the purchases of domestically produced goods by foreigners minus the domestic purchases of foreign goods. Net Exports = Exports Imports The purchases of domestically produced goods by foreigners is a country s exports. The domestic purchases of foreign goods is a country s imports. When a household, a firm or the government buys a good or a service from abroad, it increases imports. This also increases either consumption, investment, or government spending, and does not affect GDP. The trade balance depends on trade policy, the exchange rate and transportation costs. Sherif Khalifa () Economic Performance 32 / 55

33 Gross Domestic Product Personal Consumption Expenditures Durable Goods (Cars, Household Durables, Computers) Nondurable Goods (Food & Clothes) Services (Travel, Entertainment, Imputed Costs Of Home Ownership) Gross Private Domestic Investment Fixed Investment Nonresidential Structures Equipment & Software Residential Change In Private Inventories (End Of Period To End Of Period) Government Consumption Expenditures & Gross Investment Federal National Defense Nondefense State & Local Net Exports Of Goods & Services Exports Goods Services Imports Goods Services Sherif Khalifa () Economic Performance 33 / 55

34 Sherif Khalifa () Economic Performance 34 / 55

35 Y = Wage + Rent + Interest + Profit Compensation of employees or wages and fringe benefits earned by workers. Proprietor s income which is the income of non-corporate businesses. Rental income include the imputed rent that homeowners pay to themselves less depreciation. Corporate profits is the income of corporations after payments to their workers and creditors. Net interest is the interest businesses pay less the interest they receive, plus interest earned from foreigners. Sherif Khalifa () Economic Performance 35 / 55

36 GDP exclusively measures the market value of finished goods and services. GDP completely captures the net contributions or the value added of intermediate producers. Total dollars spent on finished goods and services equals the total dollars collected by economic entities involved in the production of economic output. Sherif Khalifa () Economic Performance 36 / 55

37 An economy solely in the business of the production and sale of rocking chairs. Value Price Income Wage Rent Interest Profits Added Alpha $10 $10 $10 $8 $1 $1 Lumber Beta $60 $70 $60 $55 $5 Furniture Gamma $30 $100 $30 $20 $2 $3 $5 Retailer Total $100 $100 $83 $3 $3 $11 Sherif Khalifa () Economic Performance 37 / 55

38 Example Drug Lords increase their production and sale of cocaine. Sherif Khalifa () Economic Performance 38 / 55

39 Example Drug Lords increase their production and sale of cocaine. Sherif Khalifa () Economic Performance 38 / 55

40 Example Drug Lords increase their production and sale of cocaine. A cattle rancher sells beef to McDonald s to prepare Big Macs. Sherif Khalifa () Economic Performance 38 / 55

41 Example Drug Lords increase their production and sale of cocaine. A cattle rancher sells beef to McDonald s to prepare Big Macs. Sherif Khalifa () Economic Performance 38 / 55

42 Example Drug Lords increase their production and sale of cocaine. A cattle rancher sells beef to McDonald s to prepare Big Macs. A company increases production of paper used in Hallmark cards. Sherif Khalifa () Economic Performance 38 / 55

43 Example Drug Lords increase their production and sale of cocaine. A cattle rancher sells beef to McDonald s to prepare Big Macs. A company increases production of paper used in Hallmark cards. Sherif Khalifa () Economic Performance 38 / 55

44 Example Drug Lords increase their production and sale of cocaine. A cattle rancher sells beef to McDonald s to prepare Big Macs. A company increases production of paper used in Hallmark cards. A chef cooks a gourmet meal to his family. Sherif Khalifa () Economic Performance 38 / 55

45 Example Drug Lords increase their production and sale of cocaine. A cattle rancher sells beef to McDonald s to prepare Big Macs. A company increases production of paper used in Hallmark cards. A chef cooks a gourmet meal to his family. Sherif Khalifa () Economic Performance 38 / 55

46 Example Drug Lords increase their production and sale of cocaine. A cattle rancher sells beef to McDonald s to prepare Big Macs. A company increases production of paper 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 () Economic Performance 38 / 55

47 Example Drug Lords increase their production and sale of cocaine. A cattle rancher sells beef to McDonald s to prepare Big Macs. A company increases production of paper 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 () Economic Performance 38 / 55

48 Example A collector sells a Mickey Mantle card to another collector. Sherif Khalifa () Economic Performance 39 / 55

49 Example A collector sells a Mickey Mantle card to another collector. Sherif Khalifa () Economic Performance 39 / 55

50 Example A collector sells a Mickey Mantle card to another collector. Ford produces cars in France. Sherif Khalifa () Economic Performance 39 / 55

51 Example A collector sells a Mickey Mantle card to another collector. Ford produces cars in France. Sherif Khalifa () Economic Performance 39 / 55

52 Example A collector sells a Mickey Mantle card to another collector. Ford produces cars in France. A family buys a new car. Sherif Khalifa () Economic Performance 39 / 55

53 Example A collector sells a Mickey Mantle card to another collector. Ford produces cars in France. A family buys a new car. Consumption. Sherif Khalifa () Economic Performance 39 / 55

54 Example A collector sells a Mickey Mantle card to another collector. Ford produces cars in France. A family buys a new car. Consumption. A family buys a new house. Sherif Khalifa () Economic Performance 39 / 55

55 Example A collector sells a Mickey Mantle card to another collector. Ford produces cars in France. A family buys a new car. Consumption. A family buys a new house. Investment. Sherif Khalifa () Economic Performance 39 / 55

56 Example A collector sells a Mickey Mantle card to another collector. Ford produces cars in France. A family buys a new car. Consumption. A family buys a new house. Investment. Ford expands its factory. Sherif Khalifa () Economic Performance 39 / 55

57 Example A collector sells a Mickey Mantle card to another collector. Ford produces cars in France. A family buys a new car. Consumption. A family buys a new house. Investment. Ford expands its factory. Investment. Sherif Khalifa () Economic Performance 39 / 55

58 Example Ford adds some Mustang cars to its inventory. Sherif Khalifa () Economic Performance 40 / 55

59 Example Ford adds some Mustang cars to its inventory. Investment. Sherif Khalifa () Economic Performance 40 / 55

60 Example Ford adds some Mustang cars to its inventory. Investment. Ford sells a Mustang car from its inventory. Sherif Khalifa () Economic Performance 40 / 55

61 Example Ford adds some Mustang cars to its inventory. Investment. Ford sells a Mustang car from its inventory. Investment & Consumption. Sherif Khalifa () Economic Performance 40 / 55

62 Example Ford adds some Mustang cars to its inventory. Investment. Ford sells a Mustang car from its inventory. Investment & Consumption. California paves Highway 101. Sherif Khalifa () Economic Performance 40 / 55

63 Example Ford adds some Mustang cars to its inventory. Investment. Ford sells a Mustang car from its inventory. Investment & Consumption. California paves Highway 101. Government Expenditure. Sherif Khalifa () Economic Performance 40 / 55

64 Example Ford adds some Mustang cars to its inventory. Investment. Ford sells a Mustang car from its inventory. Investment & Consumption. California paves Highway 101. Government Expenditure. You buy a bottle of French wine. Sherif Khalifa () Economic Performance 40 / 55

65 Example Ford adds some Mustang cars to its inventory. Investment. Ford sells a Mustang car from its inventory. Investment & Consumption. California paves Highway 101. Government Expenditure. You buy a bottle of French wine. Imports & Consumption. Sherif Khalifa () Economic Performance 40 / 55

66 Example Ford adds some Mustang cars to its inventory. Investment. Ford sells a Mustang car from its inventory. Investment & Consumption. California paves Highway 101. Government Expenditure. You buy a bottle of French wine. Imports & Consumption. Federal Government increases unemployment benefits. Sherif Khalifa () Economic Performance 40 / 55

67 Example Ford adds some Mustang cars to its inventory. Investment. Ford sells a Mustang car from its inventory. Investment & Consumption. California paves Highway 101. Government Expenditure. You buy a bottle of French wine. Imports & Consumption. Federal Government increases unemployment benefits. Sherif Khalifa () Economic Performance 40 / 55

68 Definition Gross Domestic Product GDP is total income earned domestically. GDP includes income earned domestically by foreigners, but it does not include income earned by nationals abroad. Definition Gross National Product GNP is the market value of all final goods and services produced by factors of production owned by a country s citizens. Definition Gross National Product GNP is total income earned by nationals. GNP includes the income that nationals earn abroad, but it does not include the income earned by foreigners within a country. Sherif Khalifa () Economic Performance 41 / 55

69 Definition Net National Product NNP is the market value of all final goods and services produced by factors of production owned by a country s citizens, after depreciation of capital has been allowed for. Definition Depreciation is the amount of the economy s stock of plants, equipment and residential structures that wears out during the year. NNP = GNP Depreciation Sherif Khalifa () Economic Performance 42 / 55

70 Gross Domestic Product (Flow Of Output On U.S. Soil) Plus: Income Receipts From The Rest Of World (e.i. IBM Profits Earned In Europe) Less: Income Payments To The Rest Of World (e.i. U.S. Government Interest Payment To Japanese Owners Of Treasuries) Equals: Gross National Product (Flow Of Output To U.S. Citizens/U.S. Companies) Less: Consumption Of Fixed Capital (Depreciation) Private Domestic Business Capital Consumption Allowances Less: Capital Consumption Adjustment Households And Institutions Government General Government Government Enterprises Equals: Net National Product Less: Statistical Discrepancy Equal: National Income Sherif Khalifa () Economic Performance 43 / 55

71 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 () Economic Performance 44 / 55

72 Definition Factors of production are the inputs used to produce goods and services. The two critical 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 () Economic Performance 45 / 55

73 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 () Economic Performance 46 / 55

74 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 () Economic Performance 47 / 55

75 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 () Economic Performance 48 / 55

76 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 () Economic Performance 49 / 55

77 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 () Economic Performance 50 / 55

78 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 () Economic Performance 51 / 55

79 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 () Economic Performance 52 / 55

80 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 () Economic Performance 53 / 55

81 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 () Economic Performance 54 / 55

82 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 () Economic Performance 55 / 55