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Chapter 8:
Measuring the Economy’s Performance
ECON 151 – PRINCIPLES OF MACROECONOMICS
Materials include content from Pearson Addison-Wesley which has been modified by the instructor and displayed with permission of the publisher. All rights reserved.
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
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Learning Objectives
Explain the expenditure approach to tabulating GDP
Explain the income approach to computing GDP
Distinguish between nominal GDP and real GDP
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National Income Accounting
National Income AccountingA measurement system used to estimate
national income and its components
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The Simple Circular Flow
Figure 8-1
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The Simple Circular Flow
Figure 8-1
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The Simple Circular Flow
Figure 8-1
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The Simple Circular Flow
Figure 8-1
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The Simple Circular Flow
Two observations In every economic exchange, the seller
receives exactly the same amount that the buyer spends.
Goods and services flow in one direction and money payments flow in the other.
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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
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The Simple Circular Flow
Product Markets Transactions in which
households buy goods
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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
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The Simple Circular Flow
Factor Markets Transactions in which
businesses buy resources
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The Simple Circular Flow
Total Income The yearly amount
earned by the nation’s factors of production
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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
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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
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National Income Accounting
ObservationsGDP measures the dollar value of final outputGDP measures the dollar value of final goods
and services produced per year by factors of production located within a nation’s borders
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National Income Accounting
Intermediate GoodsGoods used up entirely in the production of
final goods
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Stage 1: Fertilizer and Seed $.03
Stage 2: Growing .06
Stage 3: Milling .12
Stage 4: Baking .30
Stage 5: Retailing .45
Total value added $.45
Stage of Production Dollar Value of Sales Value Added
$.03
$.03
$.06
$.18
$.15
Sales Value and Value Added at Each Stage of Donut Production
Total dollar value of all sales $.96
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National Income Accounting
Exclusion of financial transactions, transfer payments, and secondhand goodsNumerous transactions occur that have
nothing to do with final goods and services being produced.
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National Income Accounting
Financial transactions Securities
Stocks and bonds
Government transfer payments Social Security Unemployment compensation
Private transfer payments Individual gifts Corporate gifts
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National Income Accounting
Transfer of secondhand goodsWhy not count the sale of a used car, stereo,
or snowboard as part of GDP? Other excluded transactions
Household productionLegal underground transactions Illegal underground transactions
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Recognizing GDP Limitations
GDP’s limitationsExcludes non-market productionDifferent countries have different legal versus
illegal activitiesQuality of life is not measuredGDP poorly measures a nation’s well-being
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Two Main Methodsof Measuring GDP
Expenditure ApproachA way of computing national income by
adding up the dollar value at current market prices of all final goods and services
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Two Main Methodsof Measuring GDP
Expenditure Approach
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Two Main Methods of Measuring GDP
Income ApproachA way of measuring national income by
adding up income received by all factors of production
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Two Main Methodsof Measuring GDP
Income Approach
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Two Main Methodsof Measuring GDP
Deriving GDP by the expenditure approachConsumption Expenditure (C)
Durables Life span of more than three years
Nondurables Life span of less than three years
Services Intangible commodities
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Two Main Methodsof Measuring GDP
Deriving GDP by the expenditure approachGross Private Domestic Investment (I)
The creation of capital goods, such as factories and machines, that can yield production and hence consumption in the future
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Two Main Methodsof Measuring GDP
Deriving GDP by the expenditure approachGovernment Expenditures (G)
State, local, and federal Valued at cost
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Two Main Methodsof Measuring GDP
Deriving GDP by the expenditure approachNet Exports (Foreign Expenditures)
Net exports (X) = total exports - total imports
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Two Main Methodsof Measuring GDP
Mathematical representation using the expenditure approach
GDP = C + I + G + X
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GDP and Its Components
Figure 8-4
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Two Main Methodsof Measuring GDP
Depreciation and net domestic productDeducting 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
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Two Main Methodsof Measuring GDP
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
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Two Main Methodsof Measuring GDP
Deriving GDP by the income approach
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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
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Two Main Methodsof Measuring GDP
Gross Domestic Income (GDI)Wages InterestRentProfits
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Two Main Methodsof Measuring GDP
Gross domestic product equals gross domestic income plus indirect business taxes and depreciation.
These last items are called nonincome expense items.
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Gross Domestic Product and Gross Domestic Income, 2005(in billions of 2005 dollars per year)
Figure 8-5 Source: U.S. Department of Commerce. First quarter preliminary data annualized.
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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
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Other Components of National Income Accounting
Disposable Personal Income (DPI)Personal income after personal income taxes
have been paid
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Source: U.S. Department of Commerce, and author’s estimates
Going from GDP to Disposable Income, 2005
Table 8-2
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Distinguishing Between Nominal and Real Values
Nominal ValuesMeasurements in terms of the actual market
prices at which goods are sold; expressed in current dollars
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Distinguishing Between Nominal and Real Values
Real ValuesMeasurements after adjustments have been
made for changes in the average of prices between years; expressed in constant dollars
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Example: Correcting GDP for Price Index Changes
Correcting GDP for price index changesNominal (current) dollars GDPReal (constant) dollars GDP
*Price level: measured by the GDP deflator
Real GDP = x 100nominal GDP
price level*
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Example: Correcting GDP for Price Index Changes
Source: U.S. Department of Commerce, Bureau of Economic Analysis, and author’s estimatesTable 8-3
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Nominal and Real GDP
Figure 8-6 Source: U.S. Department of Commerce
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Distinguishing Between Nominal and Real Values
Per capita GDPAdjusting for population growth
Per capita real GDP =real GDP
population
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Nominal and Real GDP
The Bureau of Economic Analysis now uses a chain-weighted measure of real GDP.
This means that changes in the prices and output levels of a certain good will contribute to overall changes in GDP to the extent that the good accounts for a significant share of overall economic activity.
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Distinguishing Between Nominal and Real Values
Some issuesThe distribution of outputChanges in leisure time Increased traffic congestionAir pollutionCrimeHousework
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Comparing GDPThroughout the World
ExampleFrance
$1.25 = 1 euro Per capita income = 23,168.80 euros
France per capita income in terms of dollars equals23,168.80 x 1.25 = $28,961.
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Comparing GDPThroughout the World
True purchasing powerAccounting for goods and services that are
not traded in the world marketPurchasing Power Parity
Adjustments in exchange rate conversions that takes into account differences in the true cost of living across countries
54Source: World Bank
International Example:Purchasing Power Parity Comparisons of Incomes
Table 8-4
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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
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Summary Discussion of Learning Objectives
The limitations of using GDP as a measure of national welfareExcludes non-market transactionsDoes not measure national well-being
The expenditure approach to tabulating GDPGDP = C + I + G + X
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Summary Discussion of Learning Objectives The income approach to computing GDP
The sum of wages, rent, interest, profit, depreciation, and indirect business taxes
Distinguishing between nominal GDP and real GDP Nominal GDP is the value of newly produced final
output in the current year measured in current market prices.
Real GDP adjusts nominal GDP into constant dollars by correcting for price level changes.
Chapter 8:
Measuring the Economy’s Performance
ECON 151 – PRINCIPLES OF MACROECONOMICS
Materials include content from Pearson Addison-Wesley which has been modified by the instructor and displayed with permission of the publisher. All rights reserved.