Lecture 2

1. Lecture 2

2. Economy’s income and expenditure • For an economy as a whole, income must equal expenditurebecause: • Every transaction has a buyer and a seller. • Every dollar of spending by some buyer is a dollar of income for some seller.

3. Factor Income Approach • Factor Income Approach: If we want to measure GDP by income approach then we have to add all the incomes earned by households and firms. So GDP will become • GDP = W + R + I + P Where W= wage R= Rent I = Interest P= Profit

4. Expenditure Approach • Expenditure Approach: If we want to calculate GDP by expenditure approach then we need to add all the expenditure by Consumers, Investors, Government, and Traders . So the GDP becomes • GDP = C + I + G + NX where C= Consumption expenditure I = Investment expenditure G= Government expenditure NX= Net Export

5. (GDP) Investment spending by businesses and households Net exports or net foreign demand Government purchases of goods and services Consumption spending by households Components of Expenditure in GDP Y = C + I + G + NX

6. COMPONENTS OF GDP • Consumption (C): Spending by households • Durable goods: Goods that last a relatively long time, such as cars and appliances. • Nondurable goods: Goods that are used up fairly quickly, such as food and clothing. • Services: Things that do not involve the production of physical things, such as legal services, medical services, and education • Investment (I): • Nonresidential investment includes expenditures by firms for machines, tools, plants, and so on. • Residential investment includes expenditures by households and firms on new houses and apartment buildings. • Change in inventories computes the amount by which firms’ inventories change during a given period.

7. Government Purchases (G): • The spending on goods and services by local, state, and federal governments. • Does not include transfer payments • Net Exports (NX): • Exports minus imports.

8. Real GDP in current year Real GDP in previous year Growth of real GDP = – x 100 Real GDP in previous year Growth of real GDP = $8.4 trillion – $8.0 trillion x 100 = 5 percent. $8.0 trillion ECONOMIC GROWTH The economic growth measures how fast the economy is growing. Economic growth rate is the percentage change (increase or decrease ) of real GDP compared to the previous year. To calculate this growth rate, we use the formula: • For example, if real GDP in the current year is $8.4 trillion and if real GDP in the previous year was $8.0 trillion, then the growth rate of real GDP is

9. GDP AND ECONOMIC WELL-BEING • GDP is not a perfect measure of the happiness or quality of life, however it is the best single measure of the economic well-being of a society. • Per Capita GDP (measured by dividing real GDP by population) calculations may be a better measure of the standard of living. • For comparing standards of living between citizens of a country and citizens of different countries. • Higher per capita GDP indicates a higher standard of living. • However, the measurement of per capita GDP suffers from fallacious composition of income.

10. Shortcomings of the GDP to be a perfect measure the economic well-being. 1. Non-market Transactions: All productive activities do not pass through markets. Thus, GDP understates productive activity in the economy. 2. Leisure time is not considered by GDP, but additional leisure can easily be argued to increase well being. 3. Improved product quality does not directly enter GDP. Only quality enhancements that result in higher prices get into GDP. 4. Voluntary and social works do not enter in GDP. The value of the time parents spend with their children and the value of volunteer work takes place outside of markets and not included in GDP.

11. Gross national product (GNP): Gross national product (GNP): If weadd receipts of factor income (wages, profit, rent and interest) and grant/aid from the rest of the world and subtract payments of factor income and grant/aid to the rest of the world from GDP then we get GNP . GNP = GDP + Factor Payments from Abroad + aid received from Abroad - Factor Payments to Abroad - aid given to Abroad GDP VERSUS GNP Whereas GDP measures the total income produced domestically, GNP measures the total income earned by nationals. Question: What are the other differences between GDP and GNP?

12. Price Index: GDP Deflator and CPI • Price Index is a measure of the economy's price level or a cost of living. • Most popular price index: 1) GDP Deflator 2) Consumer Price Index (CPI)

13. GDP Deflator • It shows the state of overall level of prices in the economy. • It is also known as implicit price deflator. • The GDP deflator is calculated from the ratio of nominal GDP to real GDP for same year times 100. GDP Deflator= (Nominal GDP)/(Real GDP) X 100 So it is used to deflate ( by taking inflation out of) nominal GDP to yield real GDP. How ? Because Real GDP= (Nominal GDP)/( GDP Deflator) X 100

14. Exercise Given the following items produced in your economy for different years. • Find out the following • Nominal GDP for each year, • Real GDP for each year taking 2002 as base year, • GDP deflator for 2000 and 2003, • Growth rates of real GDP for 2003 and 2004, and • interpret your results.