Understanding Economics 4th edition by Mark Lovewell, Khoa Nguyen and Brennan Thompson
Understanding Economics 4 th edition by Mark Lovewell, Khoa Nguyen and Brennan Thompson Chapter 8 Measures of Economic Activity
Learning Objectives In this chapter you will: 1. learn about Gross Domestic Product (GDP) and the two approaches to calculating it 2. consider real GDP and per capita GDP and their possible uses and limitations when comparing living standards in different years or different countries 3. analyze other economic measures developed from the national income accounts
Definitions Macroeconomics: the study of the economy as a whole (looks at the forest) Microeconomics: the study of individual parts of the economy such as businesses, households and prices (looks at the trees)
National Income Accounts Canada s national income accounts show the levels of total income and spending in the Canadian economy. Among other measures, these accounts highlight Gross Domestic Product (GDP).
Gross Domestic Product GDP is the total dollar value of all final goods and services produced in an economy during a particular period. http://www.investopedia.com/video/play/what-is-gdp#axzz1ivjnicvw GDP is calculated using two approaches: the income approach the expenditure approach The GDP identity states that GDP expressed as total income = GDP expressed as total spending.
GDP Includes: http://www.reffonomics.com/textbook2/m acroeconomics2/introtomacro/gdp.swf Only final goods and services; it does not count intermediate goods and services Profits earned by foreign-owned businesses and income earned by foreigners in Canada
GDP Does NOT Count: Second hand goods Buying and selling of stocks and bonds Transfer payments such as welfare, C.P.P and Old Age Unemployment compensation Certain interest payments Profits earned by Canadian-owned companies overseas and income earned by Canadian citizens who work abroad
Calculating Gross Domestic Product Figure 8.1, Page 207 Product Current Price (P) Annual Product (Q) Total Dollar Value (P x Q) Surgical lasers $1000 3 $3000 Milkshakes 2 1000 2000 GDP = $5000
Households and businesses meet in both resource and product markets. The inner (clockwise) loop represents the flow of money. The outer (counterclockwise) loop represents the flow of products and resources. The income approach to GDP measures the flow of incomes in the upper portion; the expenditure approach measures the flow of spending in the lower portion. Circular Flow in a Simple Economy Figure 8.2, Page 208 Businesses Income Approach Economic Resources Resource Markets Household Incomes Consumer Spending Product Markets Consumer Products Expenditure Approach Households
The Income Approach The income approach: adds the five types of incomes that flow from the business sector to the household sector: Wages and salaries: includes all benefits received and is expressed as gross earnings before taxes or deductions Interest and investment income: includes business interest only and not interest on consumer loans or on loans to government (considered a form of transfer payment)
The Income Approach Gross profits: the earnings of corporations before any distribution of dividends or payment of taxes Farmers Income: singled out because it is difficult to know what portion of their total income comes from wages, what portion is profits and what portion is from crop retention
The Income Approach Self-Employed Income: includes the incomes of all businesses other than corporations (e.g. sole proprietors and partners) and also includes some rent as well as the profits of Crown corporations
The Income Approach The income approach also includes three other categories to balance GDP calculated with the expenditure approach: indirect taxes--sales taxes and GST firms are required to collect these on behalf of government Depreciation (or capital consumption allowance) is not available for distribution the statistical discrepancy, which is the difference between the GDP estimates using the two approaches, with half added to the lower estimate and half deducted from the higher estimate
The Expenditure Approach The expenditure approach: C consumption (includes spending on consumer goods and services and is subdivided into various components, such as: Consumer durables (e.g. cars and household appliances) Semidurables (clothes) Nondurables (food and beverages) Consumer services (educational, financial, health care and legal)
The Expenditure Approach I investment spending--composed of: spending on machinery and equipment Changes in the value of inventories Spending on all construction (including residential construction)
The Expenditure Approach G government spending on goods and services Health services Education military spending security services (including police, emergency services, courts and prisons) Subsidies to firms Highway construction Salaries to bureaucrats and government administrators
The Expenditure Approach X exports (net exports: total exports minus total imports of goods and services) Net exports is the total value of all exports (whether of consumer goods, capital goods, or government services) less the total value of all imports Actual figures (in $ billions) for Canada in 2006 C I G (X-IM) 804 286 319 37 (525-488)
Flow of Income and Total Expenditures Expenditures Incomes Consumption $804 Wages $737 Gross Investment 286 Interest 65 Government Spending 319 Gross Profits 197 Net Exports +37 Farmers Income 1 Self-Employed Income 100 Gross Domestic Product +/-Net Foreign F. Income Gross National Product $1446 Net Domestic Income -11 +/-Net Foreign F. Income 1435 Less Depreciation 185 $1100-11 Net national Product 1250 Less Indirect Taxes 161 NNP at Factor Costs $1089 Equals National income $1089
Value Added in Making Paper Figure 8.4, Page 211 Production Stage Total Value Paid/Received Value Added Business That Adds Value 1. Wood is cut and transported to paper mill $1.00 $1.00 logging company 2. Paper is processed and sold to retailer 2.75 1.75 (2.75 1.00) paper company 3. Paper is sold by retailer to consumer 4.00 $7.75 1.25 (4.00 2.75) $4.00 retailer
Canada s Gross Domestic Product (2005) Figure 8.3, Page 210 Income Approach ($ billions) Wages and salaries 678.9 Corporate profits 193.9 Interest Income 61.3 Proprietors incomes and rents 99.2 Indirect taxes 154.7 Depreciation 181.4 Statistical discrepancy -0.7 Gross Domestic Product 1368.7 Expenditure Approach ($ billions) Personal consumption (C) 761.9 Gross investment (I) 254.4 Government purchases (G) 297.5 Net exports (X M) 54.2 Statistical Discrepancy 0.7 Gross Domestic Product 1368.7
Gross and Net Investment Net investment: is the annual change in an economy s capital stock equals gross investment - depreciation is positive in a growing economy with an increasing capital stock is negative in a declining economy with a decreasing capital stock
Net Investment and Capital Stock Figure 8.5, Page 213 Capital Stock at Start of Year Depreciation Gross Investment Capital Stock at End of Year $200 billion $40 billion $100 billion $260 billion
Financial Market Flows The sources of funds for investment come from: businesses retained earnings personal saving (S) These are inflows into financial markets, while investment is an outflow.
Financial Markets and the Circular flow Figure 8.6, Page 213 Income Resource Markets Income Investment Funds Financial Markets Saving (S) Businesses Retained Earnings Households Investment (I) Spending Product Markets Consumption (C)
Government Flows Financial inflows to government include: household taxes minus transfer payments business taxes minus subsidies government borrowing Government purchases are a financial outflow from government.
Government and the Circular Flow Figure 8.7, Page 214 Income Resource Markets Income Government Borrowing Financial Markets Businesses Business Taxes (-Subsidies) Government Household Taxes (- Transfer Payments) Households Government Purchases (G) Spending Product Markets Consumption (C)
Connections with the Rest of the World Net exports represent a net inflow into Canadian product markets. Lending by foreigners represents an inflow into Canadian financial markets. Borrowing by foreigners represents an outflow from Canadian financial markets.
The Rest of the World and the Circular Flow Figure 8.8, Page 215 Income Resource Markets Income Foreign Lending (-Foreign Borrowing) Financial Markets Businesses Rest of the World Households Export (X) Imports (M) Spending Product Markets Consumption (C)
8.2 GDP and Living Standards http://www.reffonomics.com/trb/chapter21 /GDP/realgdp4.swf Per capita GDP is GDP per person and equals GDP divided by population. Per capita real GDP is: per capita GDP expressed in constant dollars from a given year used to compare living standards in a given country over time Per capita GDP = GDP / population
Constant Dollar An adjusted value of currency used to compare dollar values from one period to another. Due to inflation, the purchasing power of the dollar changes over time, so in order to compare dollar values from one year to another they need to be converted to constant dollar values. Calculated as: http://www.investopedia.com/terms/c/constantdollar.asp#ixzz1t48 0rZkA
Adjustments to Per Capita GDP Inflation Adjustment Because prices change over the years, per capita GDP needs to be adjusted when comparing economic wellbeing in the same country in different years Real GDP = GDP expressed in constant dollars from a given year Per capita real GDP = real GDP / population Exchange-Rate Adjustment: to compare various countries per capital GDP for a given year, an adjustment needs to be made for different currencies all countries GDP is expressed in one currency: the American $
Limitations of GDP GDP has limitations as an indicator of living standards because it does not: include nonmarket activities and those that take place in the underground economy (estimated at between 1 and 5 percent of GDP) fully capture improvements in product quality (shows price changes not quality changes e.g. technology) indicate the composition of output (doesn t tell what is produced e.g. military spending, health care, education) indicate the distribution of income
Limitations of GDP indicate how much leisure is enjoyed by a country s citizens (GDP doesn t show the shortened work week Canadians have seen) distinguish between activities that are and are not harmful to the environment (does not differentiate between activities that are harmful to the environment and those that are not)
Purchasing Power Parity http://www.investopedia.com/terms/p/ppp.asp http://www.investopedia.com/terms/b/big macppp.asp http://www.travelex.ca/big-mac-indexexplained/ http://www.economist.com/content/bigmac-index
Other Economic Measures Gross National Product (GNP) this term has recently been changed to Gross National Income: is the total market value of all final goods and services produced by the citizens of a country, regardless of the location of production The total income acquired by Canadians both within Canada and elsewhere While GDP focuses on incomes made in Canada, GNP focuses on the earnings of Canadians GNI = GDP minus net investment income to the rest of the world http://www.gfmag.com/tools/glossary/gdp-gni-definitions.html#axzz2nenm0k68 http://video.about.com/useconomy/what-is-the-gross-national-product-.htm
Deriving Gross National Product (2005) Figure 8.9, Page 220 ($ billions) Gross Domestic Product (GDP) 1368.7 Deduct: Net investment income to the rest of the world (-) 24.5 Gross National Product (GNP) 1344.2 To calculate GNP two adjustments to GDP must be made: Income earned from Canadian financial investments by the rest of the world interest payments on a Canadian government bond help in Japan, for example is deducted from GDP to find GNP Although included in GDP, such earning are not part of the earnings of Canadian Income earned from financial investments by Canadians in the rest of the world a stock dividend from an American company paid to a Canadian shareholder, for example is added to GDP to find GNP While not included in GDP, this income is part of Canadians earnings
GNP (GNI) continued The two adjustments can be made in an investment income account because: Traditionally financial investment by the rest of the world in Canada has been higher than financial investment by Canadians in the rest of the world, the account gives net investment income to the rest of the world and is subtracted from GDP to give GNP This is the case in all countries in which large parts of the nations financial assets are owned by foreigners so that each year there is a net outflow of financial investment income (e.g. Canada)
GNP (GNI) continued In countries where the nation s citizens foreign financial investments are greater than the amounts of the nation s assets owned by foreigners (e.g. United Kingdom) For these countries, GNP is greater than GDP In Canada, GNP is now used only when comparisons are being made with countries that stress GNP rather than GDP in their national accounts
Other Economic Measures (b) Disposable Income (DI): Income, after the payment of income taxes, that households can either consume or save is personal income minus personal taxes and other personal transfers to government
Other Income Measures (2005) Figure 8.10, Page 221 GDP 1368.7 GNP 1344.2 1000 DI 777.7 750 $ billions 500 250
8.3 Practice Question 1. In a given year, a country s GDP in terms of the country s own dollars is $235 billion. 1. If the country s population is 6 million, then what is per capita GDP? 2. If each of the country s own dollars is worth US $0.56, then what is the country s per capita GDP in terms of US dollars? 3. If each of the country s dollars is worth US $0.60, after adjusting for purchasing power parity, then what is the country s per capita GDP in PPP-adjusted US dollars? 4. Explain why the country s per capita GDP in PPPadjusted US dollars is higher than its per capita GDP in unadjusted US dollars.
Adding the Human Dimension (a) Mahbub ul Haq was instrumental in devising the Human Development Index (HDI) published annually for various countries by the United Nations Development Programme. This index is based on per capita GDP adjusted for purchasing power parity, the rate of adult literacy, the percentage of youth enrolled in school and life expectancy at birth. http://economicseducationhs.blogspot.com/2011/ 03/freakonomics-radio-health-of-nations.html
The Debate Over the HDI (a) There are four issues with the HDI that its critics highlight: The HDI rankings for rich countries are numerically very close, making it difficult to use these rankings in any meaningful way. Literacy figures for many countries (such as Canada s figure of 99 percent) are open to dispute.
The Debate Over the HDI (b) Increases in per capita GDP for rich countries are discounted at higher and higher rates, a method criticized by some observers. Life expectancy statistics change very gradually and are difficult to estimate.
Refining the HDI Haq was aware of these suggestions, and realized that the HDI would be modified over time. Each year, the UNDP (United Nations Development Program) has been including adjusted HDIs that highlight income disparities within countries and disparities between men and women. Such extensions are certain to continue.
Other Indicators http://hdr.undp.org/en/statistics/hdi/ Human Development Index Combines indicators of life expectancy, educational attainment and income into a composite human development index The HDI sets a minimum and a maximum for each dimension, called goalposts, and then shows where each country stands in relation to these goalposts, expressed as a value between 0 and 1 life expectancy at birth component of the HDI is calculated using a minimum value of 20 years and maximum value of 83.57 years the education component of the HDI is now measured by mean of years of schooling for adults aged 25 years and expected years of schooling for children of school entering age Expected years of schooling is capped at 18 years For the wealth component, the goalpost for minimum income is $100 (PPP) and the maximum is $87,478 (PPP)
Economic Freedom Index http://www.heritage.org/index/ Economic freedom is the fundamental right of every human to control his or her own labor and property. In an economically free society, individuals are free to work, produce, consume, and invest in any way they please, with that freedom both protected by the state and unconstrained by the state. In economically free societies, governments allow labor, capital and goods to move freely, and refrain from coercion or constraint of liberty beyond the extent necessary to protect and maintain liberty itself Rule of Law Limited Gov t Regulatory Efficiency Open Markets Property Rights Gov t Spending Business Freedom Trade Freedom Freedom from Corruption Fiscal Freedom Labour Freedom Investment Freedom Monetary Freedom Financial Freedom
Prosperity Index http://www.prosperity.com/ The Prosperity Index is the only global measurement of national success based on both income and wellbeing The econometric analysis has identified 89 variables, which are spread across eight sub-indices By measuring prosperity holistically we are able to identify and analyse the specific factors that contribute to the success of a country
Understanding Economics 4 th edition by Mark Lovewell, Khoa Nguyen and Brennan Thompson Chapter 8 The End