UNIT TWO

1. UNIT TWO Measurement of Economic Performance

2. P.S. Supply and Demand: Four events that will shift demand (determinants): (Fads, population, change of income levels across society, price of other goods) Four events that will shift supply (determinants): (New technology, weather, price of inputs, and government regulation)

3. Government Regulation • Subsidies • A payment from the government to a producer for each unit of good produced • Lowers costs of production • Increases supply • Subsidies for farmers in United States • Taxes • Mandatory payment from the producer to the government for each unit produced • Adds to costs of production • Lowers supply

4. Unit Outline: Key Measures of Economic Performance • A. National Income Accounts • Circular Flow • Gross Domestic Product • Components of Gross Domestic Product • Real vs. Nominal GDP • B. Inflation Measurement and Adjustment • Price Indices • Nominal and real values • Costs of Inflation • C. Unemployment • Definition and Measurement • Types of Unemployment • Natural Rate of Employment

5. National Income Accounts • I. The Circular Flow of the Economy • Significance of the circular flow • Illustrates the interactions of the modern market economy

6. National Income Accounts • The Five Contributors to the economic activity of a nation • Households • Firms • Government Sector • Foreign Sector • Banking Sector • The Two Markets • Product Market • Resource Market

7. National Income Accounts • Households • Demand goods and services in the product market • Supply land, labor, capital in the resource market • Pay taxes to the government • Receive transfer payments and the provision of public goods from the government • Demand imported goods from foreign nations

8. National Income Accounts • Firms • Produce many goods and services to households in the product market • Demand productive resources from households in the factor (resource) market • Pay taxes to the government • Enjoy public goods and services provided by the government • Sell output to foreign markets • Demand resources from foreign households

9. National Income Accounts • Government Sector • Collects taxes from households and firms • Redistributes income through transfer payments and the provision of public goods • Transfer Payments • Welfare • Social Security • Subsidies • Provides infrastructure and legal structure to protect private property rights (which creates an environment for the economy to function)

10. National Income Accounts • The Foreign Sector • Domestic households and firms demand goods, services, and productive resources from foreign markets • Foreigners demand output from domestic markets • Imports from abroad are LEAKAGES because money leaves the domestic economy in order to purchase foreign goods • Exports to foreign markets are INJECTIONS into the domestic economy since money enters the economy for exports.

11. National Income Accounts • The Banking Sector • Facilitates the flow of capital from households to firms • Money saved by households in banks is a LEAKAGE from the circular flow because it is not money being spent on goods and services • Money lent to firms or households for investment is an injection into the circular flow because firms are spending on new capital which equals more employment and output • Bank as intermediary

12. The Five Sector Model

13. National Income Accounts • Injections • Government – government spending more than collecting: education, infrastructure, legal system, judicial system • Foreign – Exports • Banking – Money borrowed from banks by households and firms • Leakages • Government - Taxes paid by households and firms • Foreign – Imports • Banking – Savings – not spent on output

14. National Income Accounts • The Five Sector Model • More realistic • Illustrates leakages and injections

15. There are three key measures of economic performance: • GDP • Inflation • Unemployment

16. GDP • How it is measured • What are its components • Real vs. Nominal GDP

17. Measuring GDP • GDP is the international standard for measuring the economic output and growth of countries. • It is the market value of all final goods and services produced within a nation in a year • “Final goods and services” are goods and services ready for consumption • Intermediate goods – require further processing before they are counted as a final good • You count a car (final good), not steel (intermediate good) • You count a house (final good), not lumber (intermediate good)

18. NOT COUNTED IN GDP • Second-hand sales • You buy a new x-box from GameStop (YES) • You buy a used x-box from GameStop (NO) • Nonmarket Transactions • Clogged drain • Call a plumber (YES) • Get a neighbor to help (NO) • Underground Economy • Pharmaceutical sales (YES) • Drug trafficking (NO)

19. THREE METHODS FOR CALCULATING GDP • The Expenditure Approach • Adds up spending by households, firms, government, and foreign trade • The Income Approach • Expenditures on GDP ultimately become income and can thus be used to figure out the GDP • Output Approach • Measures value of total output

20. The Expenditure Approach GDP = Aggregate Spending, spending across the economy on output Spending on production is done in four sectors: Consumer Spending (C) Investment Spending (I) Government Spending (G) Net Exports (X – M) Exports minus imports AGGREGATE SPENDING (GDP)= C + I + G + (X-M)

21. Consumer Spending (C) • Largest component of GDP • Spending done by consumers • Purchase services • Lawn mowing companies • College degrees • Haircuts • Purchase goods • Durable – Boat (Expected to last a year or more) • Non-durable – Pasta (Goods consumed in under a year)

22. Investment Spending (I) • Current spending in order to increase output or productivity later • Three kinds • New capital machinery purchased by firms • Fleet of U-Haul trucks • New construction for firms or consumers • A new Banana Republic store • New residential houses • Market value of the change in unsold inventories • New FORD in 2012, not bought by 2012 – appear in I as unsold inventory. • If it is sold in 2014, it is added into C and deducted from I

23. Government Spending (G) • At all levels, the government purchases final goods and services and invests in infrastructure • Police cars • Social workers • Computers for the Pentagon • Interpreters for visiting diplomats • Government cash transfers do not count toward GDP

24. Net Exports (X-M) • Add all domestically produced goods purchased by foreign consumers (exports –X) but subtract any spending by our citizens on purchases of goods made within other nations (imports – M) • Include dollars flowing into our economy minus dollars flowing out

25. The Second Approach: The Income Approach • Measures GDP by recording the income of households on the resource side of the circular flow. • If all spending on goods and services creates revenue to the firms providing products, and the revenue earned goes toward paying households for the land, labor, and capital employed in production, then you can arrive at an accurate measurement of GDP by counting the income received by households during one year.

26. The Income Approach • Makes use of the fact that expenditures on GDP ultimately become income • National Income: Sum of the income earned by the factors of production owned by a country’s citizens. • Includes • Wages, salaries, and fringe benefits paid for labor services (largest component) • Rent paid for the use of land and buildings • Interest paid for the use of money • Profits received for the use of capital resources. • W + R + I + P = GDP

27. The Output Approach • Measures total value of all final goods and services by calculating the value of the total output produced in different sectors of the economy • The sectors include: • Agriculture, forest, fishing, mining, utilities, construction, manufacturing, transportation, warehousing, wholesale, retail, information, education, professional and business services, healthcare, arts and entertainment, government, other services plus rest of the world plus national income plus capital consumption plus statistical adjustment = GDP

28. Before we move on . . . • Personal Income (PI) • Money income received by households before personal income taxes are subtracted • Disposable Income (DI) • Personal income less personal income taxes • National income = National output

29. Other measurements . . . • Gross National Product (GNP) • which is a measure of the final output of the citizens and businesses of a country, regardless of where in the world the output is produced. • GDP = GNP + net foreign factor income (the income from foreign sources located domestically minus the income of domestic sources located internationally) • Net Domestic Product (NDP) • GDP – depreciation; where depreciation accounts for the gradual wearing out of factories and equipment

30. Components of GDP 1. Consumer Spending (C) 2. Investment Spending (I) 3. Government Spending (G) 4. Net Exports (X – M) Exports minus imports

31. Components of GDP

32. GDP and its Components

33. Quick Review • A. National Income Accounts • Circular Flow • Gross Domestic Product • FINAL goods and services • Expenditure Approach C+I+G+ (X-M) = GDP • Income Approach W + R + I + P = GDP • Output Approach • Components of Gross Domestic Product • Real vs. Nominal GDP

34. Real vs. Nominal GDP • Nominal: Values the production of goods and services at current prices • Real: Values the production of goods and services at constant prices

35. Real vs. Nominal • Nominal GDP measures the value of a nation’s output produced in a year, expressed in the value of the prices charged for that year. • If the average price level of a nation’s output increases in a year, the nominal GDP could increase even if the actual amount of output does not change. • It would appear that GDP has increased when, in fact, the same number of goods and services were produced.

36. Nominal • Price increases from inflation could cause GDP to be overestimated, causing us to think the economy is doing better than it actually is. • How do economists fix this?

37. Measuring Real GDP • To determine the change in the real GDP, economists must adjust the nominal value of the nation’s output in a year based on any changes in the average price level of goods and services during that year. • In the case of price level increasing (inflation): nominal GDP exaggerates the value of output compared to actual output. • In the case of the price level decreasing (deflation): nominal GDP underestimates the value of real output.

38. Nominal becoming Real GDP GDP deflator (Price Index): Price of selected goods in current year/Price of selected goods in base year X 100 This measures the average price of a good. It is also known as the GDP Price Index. Real GDP = nominal GDP/deflator or price index X 100 Called “deflator” because the nominal GDP is usually overstated because of inflation.

39. Converting Nominal to Real • Real GDP = nominal 20xx/GDP deflator x 100

40. Converting nominal to real

41. GDP Application • GDP is 10 million, consumer spending is 6 million, government spending is 3 million, exports are 2 million, and imports are 3 million. How much was spent for investments? • 0 million • 1 million • 2 million • 3 million • 4 million • 5 million

42. GDP Application • If Real GDP = 200 billion and the price index = 200, Nominal GDP is • 4 billion • 400 billion • 200 billion • 2 billion • Impossible to determine since the base year is not given Real GDP = nominal GDP/price index X 100

43. Per Capita GDP • Real GDP adjusts for price changes, what adjusts for population changes? • To account for the average income of a nation, real GDP is divided by the population to find the per capita GDP. • Per capita GDP = real GDP/population

44. GDP does not Equal the Standard of Living • GDP 2011 • US 15,090,000 • China 7,298, 000 • Italy 2,199, 000 • What is the population? • US 311,800,000 • China 1,347,350,000 • Italy 59,464,000

45. Real GDP per capita • Gives us a better picture of how productive a nation is on a per capita basis. • But it does not tell us anything about the income distribution within a nation.

46. How do we measure growth? • You calculate the rate of change . . . • Growth rate = • Real GDP in period 2 – Real GDP in period 1/Real GDP in period 1 X 100

47. The Economic Downturn: The Final Number Illustrates Stagnation (2008) and Recession (2009)

48. Before we leave GDP • National economies suffer leakages and enjoy injections • Tally of FINAL goods and services produced in a nation in a year • GNP = Tally of all final goods and services produced by a nation’s citizens in a year. • GDP = C + I + G + (x-m) • GDP deflator = price of good current year/ price of good base year X 100 • Real GDP = Nominal GDP/Price Index X 100 • GDP Growth = REAL GDP P2 – REAL GDP P1/Real GDP P1 X 100 • You must focus on real, not nominal, GDP • GDP does not necessarily determine the standard of living.

49. Unit Outline: Key Measures of Economic Performance • A. National Income Accounts • Circular Flow • Gross Domestic Product • Components of Gross Domestic Product • Real vs. Nominal GDP • B. Inflation Measurement and Adjustment • Price Indices • Nominal and real values • Costs of Inflation • C. Unemployment • Definition and Measurement • Types of Unemployment • Natural Rate of Employment

50. Inflation Measurement and Adjustment • Inflation – an increase in the average price level of a nation’s output over time. • Inflation rate can be determined using a price index • Deflation – a decrease in the average price level of a nation’s output over time