Chapter 8 Measuring the Economy’s Performance

1. Chapter 8Measuring the Economy’s Performance

2. Introduction Some commentators are already referring to the twenty-first century as the “Asian century.” It has been suggested that China’s economy will be larger than the U.S. economy by 2020. How do we go about measuring the size of an economy? And how do we make international comparisons with regard to this measure? The concept of gross domestic product, which is a key concept of Chapter 8, is the starting point for contemplating these questions.

3. 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

4. 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

5. 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

6. Did You Know That ... • The flow of U.S. economic activity since 2009 has been more dampened than during any other comparable post-recession period since the Great Depression of the 1930’s? • To measure the nation’s overall economic performance, the government utilizes the concept of national income accounting.

7. The Simple Circular Flow The concept of the circular flow of income involves two principles: • 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

8. The Simple Circular Flow (cont'd) • 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

9. Figure 8-1 The Circular Flow of Income and Product

10. The Simple Circular Flow (cont'd) • Product Markets • Transactions in which households buy goods • Factor Markets • Transactions in which businesses buy resources

11. The Simple Circular Flow (cont'd) • Total Income • The yearly amount earned by the nation’s resources (factors of production) • Includes wages, rent, interest payments, and profits received by workers, landowners, capital owners, and entrepreneurs, respectively

12. The Simple Circular Flow (cont'd) • 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

13. The Simple Circular Flow (cont'd) • Question • Why must the dollar value of total output equal total income? • Answer • Every transaction simultaneously involves an expenditure and a business receipt

14. National Income Accounting • National Income Accounting • A measurement system used to estimate national income and its components • 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

15. National Income Accounting (cont'd) • Observations • GDP 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

16. National Income Accounting (cont'd) • Stress on final output • What is a final good? • Wheat? • Steel? • Crude oil? • Bread? • Automobile? • Gasoline?

17. National Income Accounting (cont'd) • Intermediate Goods • Goods used up entirely in the production of final goods • Value Added • The dollar value of an industry’s sales minus the value of intermediate goods (for example, raw materials and parts) used in production

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

19. National Income Accounting (cont'd) • Numerous transactions occur that have nothing to do with final goods and services being produced: • Financial transactions • Transfer of secondhand goods • Others excluded transactions

20. What If . . . Market prices of house cleaning, child care, and lawn care services were valued for inclusion in GDP? • Even if market prices of household services were used to place a value on household production, national income accountants still would not know the volume of such activity. • Therefore, they would have to estimate the amount of household activity, and this would introduce measurement errors into the calculation of GDP.

21. National Income Accounting (cont'd) • Financial transactions • Securities • Stocks and bonds • Government transfer payments • Social Security • Unemployment compensation • Private transfer payments • Individual gifts • Corporate gifts

22. National Income Accounting (cont'd) • Transfer of secondhand goods • Why not count the sale of a used computer, guitar, or snowboard as part of GDP? • Other excluded transactions • Household production • Legal and illegal underground transactions

23. National Income Accounting (cont'd) • GDP’s limitations • Excludes non-market production • It is not necessarily a good measure of the well-being of a nation

24. National Income Accounting (cont'd) • GDP: • Is a measure of the value of production in terms of market prices, and an indicator of economic activity • Is not a measure of a nation’s overall welfare

25. Policy Example: Developed Nations Look for a “Happier” Alternative to GDP • The 34 member nations of the Organization for Economic Cooperation and Development are aiming to supplement or even replace GDP with a measure called the “Your Better Life Index.” • This measure of well-being includes scores in 11 areas such as community, education, health, housing, life satisfaction, and safety. • Initial results of the Your Better Life Index yield high rankings for Denmark, Canada, and Norway, with Hungary, Portugal, and Estonia ranking lowest among the OECD nations.

26. 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

27. Two Main Methods of Measuring GDP (cont'd) • Income Approach • Measuring GDP by adding up all components of national income, including wages, interest, rent, and profits

28. Two Main Methods of Measuring GDP (cont'd) • Deriving GDP by the expenditure approach • Consumption Expenditure (C) • Durable Consumer Goods • Items that last more than three years (automobiles, furniture) • Nondurable Consumer Goods • Goods that are used up in three years (gasoline, food) • Services • Mental or physical help

29. Two Main Methods of Measuring GDP (cont'd) • Deriving GDP by the expenditure approach • 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 includes changes in business inventories and repairs made to machines, buildings

30. Two Main Methods of Measuring GDP (cont'd) • Deriving GDP by the expenditure approach • Gross Private Domestic Investment (I) • Producer Durables or Capital Goods • Life span of more than three years • Fixed Investment • Purchases by business of newly produced producer durables or capital goods • Inventory Investment • Changes in stocks of finished goods and goods in process, as well as changes in raw materials

31. Example: Imputing Part of the Government’s Contribution to GDP • Some items included in GDP do not have explicit market prices. • Examples include public education, fire protection, and national defense. • National income accountants have reasoned that government expenditures on these items understate the market prices that would prevail if they were provided by private firms. • Therefore, the values are determined by using prices for education, fire protection, and security services provided in private markets.

32. Two Main Methods of Measuring GDP (cont'd) • Deriving GDP by the Expenditure Approach • Government Expenditures (G) • State, local, and federal • Valued at cost

33. Two Main Methods of Measuring GDP (cont'd) • Deriving GDP by the Expenditure Approach • Net Exports (Foreign Expenditures) Net exports (X) = Total exports – Total imports

34. Two Main Methods of Measuring GDP (cont'd) • Presenting the expenditure approach where C = consumption expenditures I = investment expenditures G = government expenditures X = net exports GDP = C + I + G + X

35. Figure 8-2 GDP and Its Components

36. Two Main Methods of Measuring GDP (cont'd) • Net Domestic Product (NDP) • Allowing for depreciation (capital consumption allowance) • The amount that businesses would have to save in order to take care of deteriorating machines and other equipment NDP = GDP – Depreciation

37. Two Main Methods of Measuring GDP (cont'd) • Because NDP = GDP – Depreciation, and GDP = C + I + G + X • NDP = C + I + G + X – Depreciation • NDP = C + net I + G + X where net I (net investment ) = I – Depreciation • Domestic investment minus an estimate of the wear and tear on the existing capital stock • The change in the capital stock over a one-year period

38. Two Main Methods of Measuring GDP (cont’d) • 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

39. Two Main Methods of Measuring GDP (cont'd) • Deriving GDP by the Income Approach • Gross Domestic Income (GDI) • Wages: salaries and labor income • Rent: farms, houses, stores • Interest: savings accounts • Profits: sole proprietorships, partnerships, corporations

40. Two Main Methods of Measuring GDP (cont'd) • Deriving GDP by the Income Approach • Gross domestic product equals gross domestic income plus indirect business taxes and depreciation • These last items are called non-income expense items

41. Two Main Methods of Measuring GDP (cont'd) • Deriving GDP by the Income Approach • Indirect business taxes • All business taxes except the tax on corporate profits • Include sales and business property taxes

42. Figure 8-3 Gross Domestic Product and Gross Domestic Income, 2013(in billions of 2005 dollars per year)

43. Figure 8-3 Gross Domestic Product and Gross Domestic Income, 2013 (in billions of 2005 dollars per year) (cont’d)

44. 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

45. Example: Sources of U.S. Personal Income Exhibit Unsustainable Trends • Since early 2010, the share of personal income derived from private payrolls has dropped to levels that are the lowest in U.S. history. • At the same time, the portion of personal income derived from government-provided benefits has risen to its highest level. • These trends are unsustainable because government benefits are financed through taxes on private income.

46. Other Components of National Income Accounting (cont'd) • Disposable Personal Income (DPI) • Personal income after personal income taxes have been paid

47. Table 8-2 Going from GDP to Disposable Income, 2013

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

49. Distinguishing Between Nominal and Real Values (cont'd) • Constant Dollars • Dollars expressed in terms of real purchasing power • This price-corrected GDP is the real GDP

50. Example: Correcting GDP for Price Index Changes, 2003 - 2013 • Let’s use a numerical example to show how we can adjust GDP for changes in the price index. • In this example shown on the next slide, the GDP deflator is used to calculate values for real GDP from 2003 to 2013.