1 20 C H A P T E R © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Measuring a Nation’s Production and

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© 2001 Prentice Hall Business Publishing© 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/eEconomics: Principles and Tools, 2/e O’Sullivan & SheffrinO’Sullivan & Sheffrin

Measuring a Nation’s Production and Income


Macroeconomics

Macroeconomics is the branch of economics that deals with any nation’s economy as a whole.

Macroeconomics focuses on issues such as unemployment, inflation, growth, trade, and the gross domestic product.


Macroeconomics

Macroeconomics focuses on two key issues: Understanding economic growth in the

long run and the factors behind the rise in living standards in modern economies

Understanding economic fluctuations—the ups and downs of the economy over time


Production, Income and the Circular Flow

The most fundamental concepts in macroeconomics are production and income.

In factor markets, households supply inputs to production.

Households supply labor and capital to the firms.

Households are paid wages for their work, and interest, dividends and rents for supplying capital.


Production, Income and the Circular Flow

Households use their income to purchase goods and services in product markets.

The payments received by firms are used to pay for factors of production.

In sum, corresponding to the production of goods and services in the economy are flows of income to households.


Measuring Gross Domestic Product

The most common measure of the total output of an economy is gross domestic product, the total market value of all the final goods and services produced within an economy in a given year.



“Total market value” refers to the quantity of goods multiplied by their respective prices. Using prices allows us to express the value of everything in a common unit of measurement.

Quantity Price Value

2 cars $15,000 $30,000

3 computers $3,000 $9,000

Gross domestic product $39,000



“Final goods and services” refers to the goods and services that are sold to the ultimate, or final, purchasers.

In order to avoid double counting, we do not count intermediate goods, or goods used in the production process. The value of the final good already reflects the price of the intermediate goods contained in it.

“In a given year” means that the sale of goods produced in prior years, for example, used cars, are not included in GDP this year.



Since we use the prices times the quantities of goods to measure the value of GDP, GDP will increase when prices increase, even if the physical quantities of the goods produced remain the same.

Year 1 Year 2

Quantity Price Value Quantity Price Value

2 cars $15,000 $30,000 2 cars $30,000 $60,000

3 computers $3,000 $9,000 3 computers $6,000 $18,000

GDP = $39,000 GDP = $78,000



A measure of total output that does not increase just because prices increase is called real GDP. Real GDP takes into account price changes by using the same prices for both years.



Using year 1 prices to compute GDP in year 2:

Year 1 Year 2

Quantity Price Value Quantity Price Value10 computers $1,000 $10,000 12 computers $1,100 $11,000

Nominal GDP $10,000 Nominal GDP $11,000

Growth in nominal GDP ($13,200/$10,000) = 1.32

Quantity Price Value Quantity Price Value10 computers $1,000 $10,000 12 computers $1,000 $12,000

Real GDP $10,000 Real GDP $12,000

Growth in real GDP ($12,000/$10,000) = 1.20


U.S. Real GDP 1930-1998


Who Purchases GDP?

Economists divide GDP into four broad expenditure categories:1. Consumption expenditures: purchases

by consumers2. Private investment expenditures:

purchases by firms3. Government purchases: purchases by

federal, state, and local governments4. Net exports: net purchases by the foreign

sector, or domestic exports minus domestic imports


Composition of U.S. GDP

GDP figures are produced by the U.S. Department of Commerce.

Composition of U.S. GDP, Second Quarter 1999 (billions of dollars expressed at annual rates)

GDPConsumption Expenditures

PrivateInvestmentExpenditures

Government Purchases

NetExports

8,893 6,148 1,427 1,544 -226

In percentage terms:

100% = 69% + 16% + 17% - 2%


Consumption Expenditures

Consumption expenditures comprise purchases of currently produced, domestic or foreign, goods and services.

Consumption is broken down into: Durable goods. Nondurable goods. Services, the fastest growing component of

consumption. Consumption comprises 68% of total purchases.


Private Investment Expenditures

Private investment expenditures include: Spending on new plants and equipment. Newly produced housing. Increase in inventories during the current

year. Note: investment in everyday talk refers to the

purchase of an existing financial asset. Investment in GDP accounts refers to the purchase of new final goods and services by firms. Don’t confuse the two.


Private Investment Expenditures

New investment expenditures are called gross investment. The true addition to the stock of capital of the economy is net investment. Net investment equals gross investment minus depreciation.

Depreciation is the deterioration of plants, equipment, and housing in a given year.

Second Quarter 1999 (billions $)

Gross Investment

DepreciationNet

Investment$1,427 $943 $484

100% 66% 44%


Government Purchases

Includes any goods the government purchases plus the wages and benefits of all government employees; but does not include all the government spending.

Transfer payments, or government payments to individuals which are not associated with the production of any goods and services, are not included in government purchases.

This means that a large part of the federal government budget is not part of GDP.


Net Exports

Net exports are total exports minus total imports. By including net exports in GDP, we correctly measure U.S. production—by adding exports and subtracting imports.

Purchases of foreign goods (imports) are subtracted from GDP because these goods were not produced in the U.S.

Any goods that are produced in the U.S. and sold abroad (exports) are included in GDP.


Net Exports

Net exports for the U.S. in 1999 were -$226. This means that the U.S. bought $226 billion more goods and services from abroad than it sold abroad.

The balance of trade: Trade deficit: imports > exports Trade surplus: imports < exports Trade balance: imports = exports


U.S. Trade Balance As a Share of GDP 1950-1998


The Meaning of Continued Trade Deficits

When the U.S. runs a trade deficit, we are forced to sell some of our assets to individuals or governments in foreign countries.

We give up more dollars from exports than we receive from imports. Excess dollars in the hands of foreigners are used to buy U.S. assets such as stocks, bonds or real estate.

If a country runs a trade surplus with one country and an equally large deficit with another, it does not add to its stock of foreign assets.


Trade Balance For Various Countries As a Percent of GDP, 1997

Trade Balance as a Percent of GDP, 1997

-0.7

0.5

3.2

-3.4

2.5

-1.0

-3.4

-6

-4

-2

0

2

4

Argentina Australia Canada Chile Japan Korea Spain

Per

cent


Who Gets the Income?

Three adjustments must be made to GDP in order to arrive at national income:

1. Add the net income earned by U.S. firms and residents abroad; subtract income earned in the U.S. by foreign firms to arrive at GNP or gross national product.

2. Subtract depreciation from GNP to arrive at net national product, or NNP.

3. Subtract indirect taxes, which are sales taxes or excise taxes on products, because the part of sales revenue that goes to the government is not part of private sector income.


Who Gets the Income

From GDP to National Income, Second Quarter 1999 (billions)Gross domestic product $8,893

plus net income from abroad =

Gross national product 8,788

minus depreciation =

Net national product 7,846

minus indirect taxes (and otheradjustments)

National income 7,265

Composition of U.S. National Income, Second Quarter 1999 (billions)

National income 7,265

Compensationof employees

$5,166

Corporate profits 869

Rental Income 168

Proprietor’s income 598

Net interest 464


Measuring Income Through Value Added

The value added of a firm is the sum of all of the income it generates and distributes after paying for its inputs—wages, profits, rents, and interest.

Sale of GoodValue of Inputs

Purchased

Firm’s Value Added—Distributed as

Income$16,000 $6,000 $10,000

In calculating national income through value added, we include all the firms in the economy, even the firms that produce intermediate goods.


Real Versus Nominal GDP

Differences between nominal GDP and real GDP arise only because of changes in prices.

Quantity Produced PriceNominal

GDPYear Cars Computers Cars Computers

2004 4 1 $10,000 $5,000 $45,000

2005 5 3 12,000 5,000 $75,000 To calculate real GDP we use constant prices

Quantity Produced PriceReal GDP

Year Cars Computers Cars Computers2004 4 1 $10,000 $5,000 $45,000

2005 5 3 10,000 5,000 $65,000


Calculating the Growth of Real GDP

Using the information on the table, we can calculate the growth of real GDP for this economy:

($65,000 - $45,000)/$45,000 = .444, or 44.4%

We can also measure the change in prices over time using an index number called the GDP deflator.

Quantity Produced PriceReal GDP

Year Cars Computers Cars Computers2004 4 1 $10,000 $5,000 $45,000

2005 5 3 10,000 5,000 $65,000


The GDP Deflator

Value of GDP deflator in 2005 = 100 x [(Nominal GDP in 2005)/(Real GDP in 2005)]

100 x ($75,000/$65,000) = 100 x 1.15 = 115 The value 115 means that prices rose by 15% ([115-

100)/100] between the two years. The Commerce Department uses a chain index to

calculate price changes which is based on an average of price changes using base years from neighboring years.

An index is set at 100 in a given year, say the year 2004, called the base year. Prices in other years are compared to prices in 2004:


GDP As a Measure of Welfare

GDP is our best measure of the value of output produced, but not a perfect measure:

GDP ignores transactions that do not take place in organized markets, such as the work we perform at home.

GDP ignores the underground economy, where transactions are not reported to official authorities.


GDP As a Measure of Welfare

The Internal Revenue Service estimated that in the 1990s, about $100 billion in income from the underground economy escaped federal taxes each year.

If the average tax rate is 20%, about $500 billion ($100/0.20) escaped the GDP accountants, or 7% of GDP.

Finally, GDP does not value changes in the environment that arise from the production of output, such as pollution and depletion of nonrenewable resources.

Documents

1 20 C H A P T E R © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Measuring a Nation’s Production and