measuring the economy chapter 2. 2 introduction closed and open economies sectors of a economy...
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Measuring the Economy
Chapter 2
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2
Introduction
• Closed and Open Economies
• Sectors of a Economy
• Stocks and Flows
• GDP and its components
• National Wealth
• Wealth Accounting
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3
Dividing Up the World Economy
• Open and Closed Economies
- We call the economy of the country that we are interested the domestic economy.
- The collection of all other economies is referred as the “rest of the world”.
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4
Dividing Up the World Economy
• Open and Closed Economies
- When a domestic economy is studies in isolation from the rest of the world, it is called a closed economy.
- When we explicitly consider interactions with other countries, it is called a open economy.
- There are no real closed economies in the modern world.
- BOX 2-1
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Dividing Up the World Economy
• Sectors of the Domestic Economy
- The domestic economy is divided into different sectors for different research purposes.
When we want to know
- how the economy allocates its resources between consumption and investment single decision maker.
- how the government policy affects the allocations public and private sectors
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Dividing Up the World Economy
• Sectors of the Domestic Economy
- The private sector is usually divided into households and firms income determination
- Firms are owned by Households.
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7
Measuring Gross Domestic Product
• Income, Expenditure, and Product
- A comprehensive set of data on GDP and its components is recorded in the system of National Income and Product Account (NIPA).
- Three approaches to measure GDP
1. the income method
2. the expenditure method
3. the product (value-added) method
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8
Measuring Gross Domestic Product
• Income, Expenditure, and Product
- Three concepts need to introduced first
- GDP is the value of all final goods and services produced within the domestic economy in a year.
- Final goods are those sold directly to end users.
- Intermediate goods are used as input by firms which may be produced by other firms.
- The value added is the difference between the value of the output that a firm sells and the value of the intermediate goods used to produce it.
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Measuring Gross Domestic Product
• The Circular Flow of Income
- See Figure 2-1
- For simplicity, we divide all the production factors into two type: labor and capital.
- The income earned by labor and capital are labor income (wage) and rent, respectively.
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10
©2002 South-Western College Publishing
Figure 2.1
The Circular Flow of Income
income
method
expenditure
method
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11
Measuring Gross Domestic Product
• Income method: adding up all of the income earned by the factors of production.
• Expenditure: adding up all the expenditure on final goods and services.
• Product (Value-added): sum up the values added over all firms in the economy.
• Example: BOX 2-2
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12
Measuring Gross Domestic Product
• Consumption and Investment
- Closed economy :
GDP (Y)
= private consumption expenditure (C)
+ private investment expenditure (I)
+ government expenditure (G)
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Measuring Gross Domestic Product
• Consumption and Investment
- Open economy :
GDP (Y)
= private consumption expenditure (C)
+ private investment expenditure (I)
+ government expenditure (G)
+ the value of exports (X)
- the value of imports (M)
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Measuring Gross Domestic Product
• Consumption and Investment
- Consumption goods are commodities like beer, pizza, movies and etc., which meet our immediate needs.
- Capital goods are commodities like tractors, power plants, and etc., which help us to produce more goods in the future.
- Trade off relationship
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Measuring Gross Domestic Product
• The Capital Market
- Financial institutions that channel savings from households to firms are collectively referred to as the “capital market”.
- banks, the stock market, pension fund, saving and loan institutions.
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16
Measuring Gross Domestic Product
• Saving
- Saving is the act of abstaining from consumption.
- Households save by putting money in the bank or by lend it to the government or firms.
- Saving does not constitute investment.
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17
Measuring Gross Domestic Product
• Investment
- Investment is the result of purchasing a new capital good.
Example:
- A household buys a new house.
- A company buy a machine, a factory, a building.
- The government builds a new school or a hospital.
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18
©2002 South-Western College Publishing
Figure 2.2
Saving and Investment in the Circular Flow
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19
Measuring Gross Domestic Product
• Wage and Rent
- In a closed economy, the GDP is equal to the income earned by its residents.
The income earned by the factor of production is broken into several components:
- the largest component represents payments to the services of labor.
- Other categories include net interest, rent, corporate profit and proprietor’s income.
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20
Measuring Gross Domestic Product
• Wage and Rent
- For simplicity, we distinguish only two types of income: labor income (wage) and capital income (rent).
- In U.S., labor share of GDP is approximately 60% and capital share is approximately 40%.
- BOX 2-3
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21Box 2.3
FOCUS ON THE FACTS How Big are the Components of the U.S. Economy?
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22
The Components of GDP
• In a closed economy, saving and investment are always equal.
• In open economies, the idea extends to relationships among the government budget deficit, the trade surplus and private saving.
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23
Saving and Investment in a Closed Economy
• Expenditure can be divided into three categories:
private consumption expenditure
private investment expenditure
government expenditure
Y C I G
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Saving and Investment in a Closed Economy
GOV GOVG C I GOV GOV
NAT NAT
Y C C I I
C I
NAT NATS Y C
NAT NATS I
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Saving and Investment in an Open Economy
• Countries can invest more than they save by borrowing from abroad.
• When a Gov. spends more than it earns, the excess expenditure is the Gov.’s budget deficit.
• When a nation as a whole spends more on foreign goods and services than it earns by selling exports, the excess of expenditures over income is the nation’s trade deficit.
• Budget deficit has a significant impact on trade deficit.
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26
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Saving and Investment in an Open Economy
NAT NATY C I NX
NAT NATS I NX
0NAT NATS I NX
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28
Government and the Private Sector
• Disposal income (YD) is the income that is available to the private sector after the government takes out taxes and put back transfer payments to individuals and firms.
YD Y TR T
S YD C
( ) ( )S I T TR G NX
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Government and the Private Sector
• Two sources of government deficit
- S - I
- NX
( ) ( )S I T TR G NX
Budget surplus Trade Surplus
( ) ( )G TR T S I NX
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30©2002 South-Western College Publishing
Figure 2.3
Government and the Foreign Sector in the Circular Flow
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31©2002 South-Western College Publishing
Figure 2.4
The Twin Deficits
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Measuring Wealth
• The concepts used to measure GDP and its component parts are examples of flows.
• Wealth is a stock and is measured by a system of balance sheet accounting.
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Stocks and Flows with an Individual Example
• A stock is a variable measured at a point in time.
- Ex. Government debt, capital
• A flow is a variable measured per unit of time.
• A flow is often the rate of change of a stock.
- Ex. Government budget deficit, investment
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U.S. Government Debt Since 1890 - Stock
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Real and Financial Assets• The wealth of an individual can consist of real
assets (capital goods) and financial assets.
• Real asset: the capital owned by an individual or firm.
- house, car, land, etc.
• Financial assets: promises to deliver resources in the future.
- a mortgage on a house, bank account, etc.
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37
Real and Financial Assets
• In a closed economy, every financial asset is someone else’s financial liability the sum total of all financial assets and liabilities is zero.
• In a open economy, financial assets and liabilities may not equal zero since individuals and firms can borrow or lend abroad.
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Balance Sheet Accounting
• The total wealth (net worth) of an agent is the sum total of his assets (both real and financial) minus the sum of his financial liabilities
- This is called “balance sheet accounting”.
• TABLE 2.3
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39Table 2.3
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The Link between GDP and Wealth
• Wealth accounting measures stocks and income accounting measures flows.
• The NIPA can be used to show how the stocks of real and financial assets for different sectors of the economy change from one year to the next.
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41
Gross versus Net Domestic Product
• Not all investment creates new capital; Some investment is necessary each year to
offset the deterioration through normal wear and tear of the existing stock of capital-depreciation.
• The portion of gross investment that contributes to increases in the stock of capital is called “net investment”.
Gross Investment = Net Investment + Depreciation
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42Figure 2.6
Stocks and Flows
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43
Gross versus Domestic Product
• Net domestic product (NDP) is a measure of the maximum output of the economy that is available for consumption without running down the stock of capital.
• GDP = NDP + depreciation
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44Table 2.4
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45
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46
Growth Rates and Percentage Changes
• Growth rate of GDP in year t :
1
1
100%y t tt
t
y yg
y
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47Table 2.6
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48
Homework
Question 3, 5, 6, 9
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