Chapter 8 Measuring the Economy s Performance Introduction For a number of years, measured U.S. business investment spending on capital goods has declined relative to total national expenditures on goods and services. Some economists argue that perhaps U.S. capital investment is not correctly measured. How are capital investment and other aggregate economic quantities measured in the United States? 8-2 Learning Objectives Describe the circular flow of income and output Define gross domestic product (GDP) Understand the limitations of using GDP as a measure of national welfare 8-3
Learning Objectives Explain the expenditure approach to tabulating GDP Explain the income approach to computing GDP Distinguish between nominal GDP and real GDP 8-4 Chapter Outline The Simple Circular Flow National Income Accounting GDP Other Components of National Income Accounting Distinguishing Between Nominal and Real Values Comparing GDP Throughout the World 8-5 Did You Know That... During the past half-century, manufactured goods share of total U.S. output of goods and services has declined by more than one-half? The value of manufactured goods as a percentage of gross domestic product (GDP) has fallen from 28% in 1955 to >12% today. The government conducts what has become known as national income accounting. 8-6
The Simple Circular Flow The concept of the circular flow of income involves two principles: 1. In every economic exchange, the seller receives exactly the same amount that the buyer spends. 2. Goods and services flow in one direction and money payments flow in the other. 8-7 The Simple Circular Flow Profits explained Question Why is profit a cost of production? Answer Profits are the return entrepreneurs receive for the risk they incur when organizing productive activities. 8-8 The Simple Circular Flow Final Goods and Services Goods and services that are at their final stage of production and will not be transformed into yet other goods or services 8-9
Figure 8-1 The Circular Flow of Income and Product 8-10 The Simple Circular Flow Product Markets Transactions in which households buy goods 8-11 The Simple Circular Flow Factor Markets Transactions in which businesses buy resources 8-12
The Simple Circular Flow Total Income Wages, rent, interest, profits 8-13 The Simple Circular Flow Question Why must total income be identical to the dollar value of total output? Answer Every transaction simultaneously involves an expenditure and a receipt. 8-14 National Income Accounting National Income Accounting A measurement system used to estimate national income and its components Total Income The yearly amount earned by the nation s resources (factors of production) 8-15
National Income Accounting Gross Domestic Product (GDP) The total market value of all final goods and services produced by factors of production located within a nation s borders 8-16 National Income Accounting Observations GDP measures the dollar value of final output. GDP measures the dollar value of final goods and services produced per year by factors of production located within a nation s borders. 8-17 National Income Accounting Stress on final output What is a final good? Wheat? Steel? Oil? Bread? Automobile? Gasoline? 8-18
National Income Accounting Intermediate Goods Goods used up entirely in the production of final goods Value Added The dollar value of an industry s sales minus the value of intermediate goods (for example, raw materials and parts) used in production 8-19 Table 8-1 Sales Value and Value Added at Each Stage of Donut Production 8-20 National Income Accounting Numerous transactions occur that have nothing to do with final goods and services being produced: Financial transactions Transfer Payments Secondhand Goods 8-21
National Income Accounting Exclusion of financial transactions Securities Stocks and bonds Government transfer payments Social Security Unemployment compensation Private transfer payments Individual gifts Corporate gifts 8-22 National Income Accounting Transfer of secondhand goods excluded Why not count the sale of a used computer, guitar, or snowboard as part of GDP? Other excluded transactions Household production Legal and illegal underground transactions 8-23 National Income Accounting GDP s limitations Excludes non-market production It is not necessarily a good measure of the wellbeing of a nation. 8-24
National Income Accounting GDP is a measure of the value of production in terms of market prices, and an indicator of economic activity. GDP is not a measure of a nation s overall welfare. 8-25 International Example: Greece Pays a Price for Broadening Its GDP Definition Greece s government recently announced that its official tabulation of GDP would include production in black market industries. Consequently, GDP rose by about 25% for every year since 2000, which reduces the amount of EU payments Greece is eligible for by almost $600 million annually. Why is it harder now to compare Greek GDP to the levels of other nations? 8-26 GDP Expenditure Approach Computing GDP by adding up the dollar value at current market prices of all final goods and services 8-27
Expenditure Approach 8-28 Income Approach Measuring GDP by adding up all components of national income, including wages, interest, rent, and profits 8-29 Income Approach 8-30
Deriving GDP by the Expenditure Approach Consumption Expenditure (C) Durable Consumer Goods Life span of more than three years Nondurable Consumer Goods Goods that are used up in three years Services Mental or physical help 8-31 Deriving GDP by the Expenditure Approach Gross Private Domestic Investment (I) The creation of capital goods, such as factories and machines, that can yield production and hence consumption in the future Also included: changes in business inventories and repairs made to machines, buildings 8-32 Deriving GDP by the Expenditure Approach Gross Private Domestic Investment (I) Producer Durables or Capital Goods Life span of more than three years Fixed Investment Purchases by business of newly produced producer durables or capital goods Inventory Investment Changes in stocks of finished goods and goods in process, as well as changes in raw materials 8-33
Deriving GDP by the Expenditure Approach Government Expenditures (G) State, local, and federal Valued at cost 8-34 Deriving GDP by the Expenditure Approach Net Exports (Foreign Expenditures) Net exports (X) = Total exports Total imports 8-35 Presenting the Expenditure Approach Where C = consumption expenditures I = investment expenditures G = government expenditures X = net exports GDP = C + I + G + X 8-36
Figure 8-2 GDP and Its Components 8-37 Presenting the Expenditure Approach Depreciation and net domestic product Deducting for depreciation (capital consumption allowance) Reduction in the value of capital goods over a one-year period due to physical wear and tear, and also to obsolescence NDP = GDP Depreciation 8-38 NDP = GDP Depreciation GDP = C + I + G + X NDP = C + I + G + X Depreciation Net Investment = I Depreciation Domestic investment minus an estimate of the wear and tear on the existing capital stock NDP = C + Net I + G + X 8-39
Deriving GDP by the Income Approach 8-40 GDP (cont d) Deriving GDP by the Income Approach Gross Domestic Income (GDI) The sum of all income (wages, interest, rent, and profits) paid to the four factors of production. 8-41 Deriving GDP by the Income Approach Gross Domestic Income (GDI) Wages: salaries and labor income Rent: farms, houses, stores Interest: savings accounts Profits: sole proprietorships, partnerships, corporations 8-42
Deriving GDP by the Income Approach Gross domestic product equals gross domestic income plus indirect business taxes and depreciation These last items are called nonincome expense items 8-43 Deriving GDP by the Income Approach Indirect business taxes All business taxes except the tax on corporate profits Include sales and business property taxes 8-44 Figure 8-3 Gross Domestic Product and Gross Domestic Income, 2009 (in billions of 2009 dollars per year) Sources: U.S. Department of Commerce and author s estimates. 8-45
Figure 8-3 Gross Domestic Product and Gross Domestic Income, 2009 (in billions of 2009 dollars per year) Sources: U.S. Department of Commerce and author s estimates. 8-46 Other Components of National Income Accounting National Income (NI) The total of all factor payments to resource owners Personal Income (PI) The amount of income that households actually receive before they pay personal income taxes 8-47 Other Components of National Income Accounting Disposable Personal Income (DPI) Personal income after personal income taxes have been paid 8-48
Table 8-2 Going from GDP to Disposable Income, 2009 8-49 Distinguishing Between Nominal and Real Values Nominal Values Measurements in terms of the actual market prices at which goods are sold; expressed in current dollars, also called money values Real Values Measurements after adjustments have been made for changes in the average of prices between years; expressed in constant dollars 8-50 Distinguishing Between Nominal and Real Values Constant Dollars Dollars expressed in terms of real purchasing power This price-corrected GDP is the real GDP. 8-51
Example: Correcting GDP for Price Index Changes Correcting GDP for price index changes Nominal (current) dollars GDP Real (constant) dollars GDP Nominal GDP Real GDP = x 100 Price index* *Price index: measured by the GDP deflator 8-52 Table 8-3 Correcting GDP for Price Index Changes 8-53 Distinguishing Between Nominal and Real Values Per capita GDP Adjusting for population growth Per capita real GDP = Real GDP Population 8-54
Figure 8-4 Nominal and Real GDP Source: U.S. Department of Commerce 8-55 Comparing GDP Throughout the World Foreign Exchange Rate The price of one currency in terms of another 8-56 Comparing GDP Throughout the World Foreign exchange rate $1.50 = 1 euro, or $1 =.67 euros French income per capita = 24,120 euros French per capita income in terms of dollars equals 24,120 euros x $1.50 = $36,180 8-57
Comparing GDP Throughout the World Purchasing Power Parity Adjustments in exchange rate conversions that takes into account differences in the true cost of living across countries 8-58 Table 8-4 Comparing GDP Internationally 8-59 International Example: Purchasing Power Parity Comparisons of World Incomes The International Monetary Fund accepted the purchasing power parity approach a few years ago. It started presenting the statistics on each country s GDP relative to others and based on the purchasing power parity relative to the dollar. Why is China s per capita GDP higher based on purchasing power parity? 8-60
Issues and Applications: Is U.S. Fixed Investment Understated? Some economists argue that limiting business fix investment only to tangible items is inappropriate. These economists contend that several other types of business expenditures are forms of intangible that should also be included as forms of business fixed investment. Figure 8-5 illustrates how altering the present definition of business fixed investment by adding intangible forms of investment would change business fixed investment s share of GDP since 1950. 8-61 Issues and Applications: Is U.S. Fixed Investment Understated? (cont d) If intangibles were included today, business fixed investment s share of GDP would more than double, from just over 8% to more than 17%. What would happen to the level of GDP if intangible forms of investment were included within the current official definition of business fixed investment? 8-62 Figure 8-5 U.S. Business Fixed Investment as a Percentage of GDP Since 1950, Excluding and Including Intangible Forms of Investment Source: Carol Corrado, Dan Sickel, and Charles Hulten, Intangible Capital and Economic Growth, Finance and Economics Discussion Series, Board of Governors of the Federal Reserve System, 2006; author s estimates. 8-63
Summary Discussion of Learning Objectives The circular flow of income and output In every economic transaction, receipts exactly equal expenditures Goods and services flow in one direction and money payments flow in the other Gross domestic product (GDP) The total market value of a nation s final output of goods and services produced in a year using factors of production located within its borders 8-64 Summary Discussion of Learning Objectives The limitations of using GDP as a measure of national welfare Excludes non-market transactions Does not measure national well-being The expenditure approach to tabulating GDP GDP = C + I + G + X 8-65 Summary Discussion of Learning Objectives The income approach to computing GDP The sum of wages, rent, interest, profits Distinguishing between nominal GDP and real GDP Nominal GDP is the value of newly produced final output measured in current market prices. Real GDP adjusts nominal GDP into constant dollars by correcting for price level changes. 8-66