Chapter 8 - wps.aw.comwps.aw.com/wps/media/objects/3847/3940260/studynotes/notes08.pdf · anticipate the latest measure of total ... All rights reserved. 8-5 Chapter Outline • The

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Chapter 8

Measuring the Economy’s Performance

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 8-2

Introduction

Economists and financial news media anticipate the latest measure of total output by the Bureau of Economic Analysis (BEA).

How does the BEA attempt to gauge the economy’s performance?

You will find out in this chapter.


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 (cont'd)

• Explain the expenditure approach to tabulating GDP

• Explain the income approach to computing GDP

• Distinguish between nominal GDP and real GDP


Chapter Outline

• The Simple Circular Flow

• National Income Accounting

• Two Main Methods of Measuring GDP

• Other Components of National Income Accounting

• Distinguishing Between Nominal and Real Values

• Comparing GDP Throughout the World


Did You Know That...

• Decisions on how to categorize business expenses will affect the relative size of an increase or a decrease in economic activity?

• Statisticians measuring our national economic performance strive for consistency in constructing their measures across time?

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The Simple Circular Flow

• Two observations

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.


The Simple Circular Flow (cont'd)

• Profits explained

QuestionWhy is profit a cost of production?

AnswerProfits are the return entrepreneurs receive for the risk they incur when organizing productive activities.



• Final Goods and ServicesGoods 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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Figure 8-1 The Circular Flow of Income and Product



• Product MarketsTransactions in which households buy goods



• Factor MarketsTransactions in which businesses buy resources

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• Total Income Wages, rent, interest, profits



• QuestionWhy must total income be identical to the dollar value of total output?

• AnswerEvery transaction simultaneously involves an expenditure and a receipt.


National Income Accounting

• National Income AccountingA measurement system used to estimate national income and its components

• Total IncomeThe yearly amount earned by the nation’s resources (factors of production)

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National Income Accounting (cont'd)

• 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



• ObservationsGDP 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.



• Stress on final output

What is a final good?Wheat?Steel?Oil?Bread?Automobile?Gasoline?

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• Intermediate GoodsGoods used up entirely in the production of final goods

• Value AddedThe dollar value of an industry’s sales minus the value of intermediate goods(for example, raw materials and parts) used in production


Table 8-1 Sales Value and Value Added at Each Stage of Donut Production



• Exclusion of financial transactions, transfer payments, and secondhand goods

Numerous transactions occur that have nothing to do with final goods and services being produced.

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• Exclusion of financial transactionsSecurities

Stocks and bonds

Government transfer paymentsSocial SecurityUnemployment compensation

Private transfer paymentsIndividual giftsCorporate gifts



• Transfer of secondhand goods excluded

Why not count the sale of a used computer, guitar, or snowboard as part of GDP?

• Other excluded transactionsHousehold productionLegal and illegal underground transactions



• GDP’s limitations

Excludes non-market production

It is not necessarily a good measure of the well-being of a nation.

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• 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.


Two Main Methods of Measuring GDP

• Expenditure Approach

Computing GDP by adding up the dollar value at current market prices of all final goods and services


Two Main Methods of Measuring GDP (cont'd)

Expenditure Approach

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• Income Approach

Measuring GDP by adding up all components of national income, including wages, interest, rent, and profits



Income Approach



• Deriving GDP by the expenditure approach

Consumption Expenditure (C)Durable Consumer Goods

Life span of more than three years

Nondurable Consumer GoodsGoods that are used up in three years

ServicesMental or physical help

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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




Gross Private Domestic Investment (I) Producer Durables or Capital Goods

Life span of more than three years

Fixed InvestmentPurchases by business of newly produced producer durables or capital goods

Inventory InvestmentChanges in stocks of finished goods and goods in process, as well as changes in raw materials




Government Expenditures (G)State, local, and federal

Valued at cost

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Net Exports (Foreign Expenditures)

Net exports (X) = Total exports – Total imports



• Presenting the expenditure approachWhere

C = consumption expendituresI = investment expendituresG = government expendituresX = net exports

GDP = C + I + G + X


Figure 8-2 GDP and Its Components

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NDP = GDP – Depreciation


• 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• 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



• 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



• Gross Domestic Income (GDI)

Wages: salaries and labor income

Rent: farms, houses, stores

Interest: savings accounts

Profits: sole proprietorships, partnerships, corporations



• 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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• Indirect business taxes

All business taxes except the tax on corporate profits

Include sales and business property taxes


Figure 8-3 Gross Domestic Product and Gross Domestic Income, 2007 (in billions of 2007 dollars per year)

Source: U.S. Department of Commerce. First quarter preliminary data annualized.


Figure 8-3 Gross Domestic Product and Gross Domestic Income, 2007 (in billions of 2007 dollars per year)

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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


Other Components of National Income Accounting (cont'd)

• Disposable Personal Income (DPI)

Personal income after personal income taxes have been paid


Table 8-2 Going from GDP to Disposable Income, 2007

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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


Distinguishing Between Nominal and Real Values (cont'd)

• Real ValuesMeasurements after adjustments have been made for changes in the average of prices between years; expressed in constant dollars

• Constant DollarsDollars expressed in terms of real purchasing power


*Price level: measured by the GDP deflator

Real GDP = x 100Nominal GDPPrice level*

Example: Correcting GDP for Price Index Changes

• Correcting GDP for price index changesNominal (current) dollars GDP

Real (constant) dollars GDP

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Table 8-3 Correcting GDP for Price Index Changes


Per capita real GDP =Real GDPPopulation

Distinguishing Between Nominal and Real Values (cont'd)

• Per capita GDP

Adjusting for population growth


Source: U.S. Department of Commerce

Figure 8-4 Nominal and Real GDP

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Comparing GDPThroughout the World

• Foreign Exchange Rate

The price of one currency in terms of another


Comparing GDPThroughout the World (cont'd)

• Foreign exchange rate$1.25 = 1 euro, or $1 = 0.80 euros

French per capita income = 23,168.80 euros

French per capita income in terms of dollars equals 23,168.80 euros x $1.25 = $28,961


Comparing GDPThroughout the World (cont'd)

• Purchasing Power Parity

Adjustments in exchange rate conversions that takes into account differences in the true cost of living across countries

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Table 8-4 Comparing GDP Internationally


Issues and Applications: The Art of Estimating GDP Often Requires Touch-Ups• The Bureau of Economic Analysis gives an

advance estimate of quarterly GDP.

• The estimate receives considerable attention from the news media.

• Nevertheless, the estimate is updated at least two times.

• How different is the final result?


Figure 8-5 Effects of Revisions in GDP Estimates on Measured GDP Growth Rates

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Summary Discussion of Learning Objectives

• The circular flow of income and outputIn every economic transaction, receipts exactly equal expendituresGoods 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


Summary Discussion of Learning Objectives (cont'd)

• 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


Summary Discussion of Learning Objectives (cont'd)

• 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.

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End of Chapter 8Measuring the Economy’s Performance

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Chapter 8 - wps.aw.comwps.aw.com/wps/media/objects/3847/3940260/studynotes/notes08.pdf · anticipate the latest measure of total ... All rights reserved. 8-5 Chapter Outline • The