Understanding Macroeconomic Concepts: Measuring a Nation's Income

1. III THE DATA OF MACROECONOMICS

2. 5 Measuring a Nation’s Income

3. Microeconomics and Macroeconomics • Microeconomics is the study of how individual households and firms make decisions and how they interact with one another in markets • Macroeconomics is the study of the economy as a whole • Its goal is to explain the economic changes that affect many households, firms, and markets at once CHAPTER 5 MEASURING A NATION’S INCOME

4. Microeconomics and Macroeconomics • Because the economy as a whole is just a collection of many households and many firms interacting in many markets, microeconomics and macroeconomics are closely linked. • The basic tools of supply and demand, for instance, are as central to macroeconomic analysis as they are to microeconomic analysis. Yet studying the economy in its entirety raises some new and intriguing challenges. CHAPTER 5 MEASURING A NATION’S INCOME

5. Macroeconomics • Macroeconomics answers questions like these: • Why is average income high in some countries and low in others? • Why do prices rise rapidly in some time periods while they are more stable in others? • Why do production and employment expand in some years and contract in others? CHAPTER 5 MEASURING A NATION’S INCOME

6. The Role of Data • To see whether there’s a problem, you first need data

7. The Role of Data • In macroeconomics, data are crucial • Data help policy makers see what problems, if any, need to be addressed • Data help macroeconomists identify the theories that make correct predictions and the theories that make incorrect predictions CHAPTER 5 MEASURING A NATION’S INCOME

8. THE ECONOMY’S INCOME AND EXPENDITURE • If you were to judge how a person is doing economically, you might first look at his or her income. • A person with a high income can more easily afford life’s necessities and luxuries. • It is no surprise that people with higher incomes enjoy higher standards of living—better housing, better health care, fancier cars, more opulent vacations, and so on. • The same logic applies to a nation’s overall economy. When judging whether the economy is doing well or poorly, it is natural to look at the total income that everyone in the economy is earning. • That is the task of gross domestic product (GDP). CHAPTER 5 MEASURING A NATION’S INCOME

9. Total Income • Recall that we need to measure the health of an economy • When judging whether an economy is doing well or poorly, it is natural to look at the total income that everyone in the economy is earning CHAPTER 5 MEASURING A NATION’S INCOME

10. Total Income • We can temporarily boost our standard of living by borrowing from others. • But we can’t keep borrowing forever • This is why a nation’s standard of living depends heavily on its own total income CHAPTER 5 MEASURING A NATION’S INCOME

11. Income = Expenditure • We could measure either total income or total expenditure • We would get the same number either way • For an economy as a whole, income must equal expenditure because: • Every transaction has a buyer and a seller. • Every dollar of spending by some buyer is a dollar of income for some seller. CHAPTER 5 MEASURING A NATION’S INCOME

12. Income = Expenditure • Why is this true? The reason that an economy’s income is the same as its expenditure is simply that every transaction has two parties: a buyer and a seller. • Everydollar of spending by some buyer is a dollar of income for some seller. • Suppose, for instance, that Mr.Kpays Mr.D$100 to mow her lawn. In this case, Mr. Dis a seller of a service, and Mr.Kis a buyer. Mr.Dearns $100, and Mr. Kspends $100. CHAPTER 5 MEASURING A NATION’S INCOME

13. Income = Expenditure CHAPTER 5 MEASURING A NATION’S INCOME

14. Income = Expenditure • This diagram describes all the transactions between households and firms in a simple economy. • In this economy, households buy goods and services from firms; these expenditures flow through the markets for goods and services. • The firms in turn use the money they receive from sales to pay workers’ wages, landowners’ rent, and firm owners’ profit; this income flows through the markets for the factors of production. • In this economy, money continuously flows from households to firms and then back to households CHAPTER 5 MEASURING A NATION’S INCOME

15. Methods of measuring GDP • We can compute GDP for this economy in one of two ways: by adding up the total expenditure by households or by adding up the total income (wages, rent, and profit) paid by firms. • Because all expenditure in the economy ends up as someone’s income, GDP is the same regardless of how we compute it. CHAPTER 5 MEASURING A NATION’S INCOME

16. But what about saving? • Q: People typically save part of what they earn. How then is income equal to expenditure for the economy as a whole? • A: What people save tends to get loaned to businesses who then spend the money they borrowed. So, for the economy as a whole, income must still equal expenditure. CHAPTER 5 MEASURING A NATION’S INCOME

17. International Trade • We buy foreign-made goods and foreigners buy goods made by us • Q: In that case, how can our total income be equal to our total expenditure? • A: Very good point! It is better to say that total income equals the total expenditure on domestically produced goods CHAPTER 5 MEASURING A NATION’S INCOME

18. Gross Domestic Product CHAPTER 5 MEASURING A NATION’S INCOME

19. Gross Domestic Product • Gross Domestic Product (GDP) is one measure of a country’s total income • There are other measures of total income, but GDP is the most popular measure CHAPTER 5 MEASURING A NATION’S INCOME

20. Gross Domestic Product • GDP is the total market value of all final goods and services produced within a country in a given period of time. • For example, the GDP of the United States in 2017 was $19,390.6 billion, according to the U.S. Department of Commerce • Given a mid-year population of 325,983,000 (est.) the per capita GDP was $59,484

21. Gross Domestic Product • GDP is the total market value of all final goods and services produced within a country in a given period of time. • GDP is also the total expenditure on all final goods and services produced within a country in a given period of time. • It is also the total income of all domestically located resources

22. GDP is the Market Value … • In GDP, all output is valued at market prices. • The market value of all sandwiches produced is both the total expenditure of the buyers of those sandwiches and the total income of the makers of those sandwiches • As our goal is to measure total income, it therefore makes sense to measure the market values of the various produced goods and add them up CHAPTER 5 MEASURING A NATION’S INCOME

23. … Of All Final Goods … • Final goods are those goods sold to their final users • A pencil is a final good because, once produced, it is ready for use by its final users • The wood, the graphite, and other materials that disappeared in the pencil are not final goods • Their market value is already counted when the market value of the pencil is counted • So, counting them in GDP would count them twice

24. … Of All Final Goods … • GDP records only the value of final goods, not intermediate goods • Intermediate goods are those goods that disappear inside other goods that are produced for sale • Final goods are goods that are not intermediate goods. These are goods sold to their final users • GDP is defined so that the value of intermediate goods is counted only once, not twice or thrice. CHAPTER 5 MEASURING A NATION’S INCOME

25. … Of All Final Goods … • Intermediate goods are sold by their producers to producers of other goods • Examples: milk sold by a dairy to an ice-cream company, grapes sold by a vineyard to a winemaker, printer paper sold to Kinko’s • Final goods are goods that are sold to the final users of those goods • Examples: milk you buy at the supermarket, table grapes you buy at the farmer’s market, printer paper you buy for your computer printer • All goods made this year but not sold by year’s end are regarded as final goods (inventories) CHAPTER 5 MEASURING A NATION’S INCOME

26. … Of All Final Goods … • Suppose a dairy farmer sells milk worth $50,000 to an ice-cream company. • The farmer does not buy anything from any other firm. • The total income of the dairy farmer and her employees is, therefore, $50,000 • The ice-cream company uses the milk to produce ice-cream which it sells for $75,000. • The ice-cream company does not buy anything from any firm other than the dairy. • Therefore, the total income of the owners and employees of the ice-cream firm is $25,000. • Therefore, the total income of this country is $75,000 • This is accurately measured by the value of the ice-cream (the final good) alone • Had we also counted milk, the intermediate good, we would have calculated total income to be $125,000, which would have been an exaggeration. CHAPTER 5 MEASURING A NATION’S INCOME

27. … and Services … • GDP includes both • tangible goods (food, clothing, cars) and • intangible services (haircuts, housecleaning, doctor visits, legal consultations). • Trade in assets does not affect GDP. • Such trade does not require new productive activity, it is merely the transfer of ownership of an asset from one person to another CHAPTER 5 MEASURING A NATION’S INCOME

28. … Produced Within a Country … • GDP measures the value of all production within the geographic boundaries of a country. • The citizenship of the owners of the resources used in production is not the key issue • Production by foreigners living in a country is counted in the country’s GDP • Production by a country’s citizens working in other countries is not counted CHAPTER 5 MEASURING A NATION’S INCOME

29. … In a given period of time • GDP measures the value of production that takes place within a specific interval of time, usually a year or a quarter (three months). • GDP includes goods and services currently produced, not transactions involving goods produced in the past. • Transactions involving used cars or buildings that were constructed in the past are not counted CHAPTER 5 MEASURING A NATION’S INCOME

30. What’s not counted in GDP? • GDP includes all items produced in the economy and sold legally in markets. • It excludes items produced and sold illicitly, such as illegal drugs. • GDP excludes most items that are produced and consumed at home and that never enter the marketplace. CHAPTER 5 MEASURING A NATION’S INCOME

31. What is Gross Domestic Product (GDP)? • Video: https://youtu.be/mjJmo5mN5yA CHAPTER 5 MEASURING A NATION’S INCOME

32. Nominal and real GDP How can we measure a nation’s productive activity so that the numbers can be compared across time?

33. GDP: nominal and real • The GDP we saw earlier is more precisely called Nominal GDP • GDP comes in two flavors: • Nominal GDP (also called GDP at current prices), and • Real GDP (also called GDP at constant prices) • So, when you see or hear a discussion of GDP, be sure to ask, “Nominal or real?”

34. Gross Domestic Product • GDP is the total market value of all final goods and services produced within a country in a given period of time. • For example, the GDP of the United States in 2017 was $19,390.6 billion, according to the U.S. Department of Commerce • Given a mid-year population of 325,983,000 (est.) the per capita GDP was $59,484 We saw this slide earlier. This is nominal GDP or current-prices GDP.

35. Gross Domestic Product, Nominal • Nominal GDP is the total market value of all final goods and services produced within a country in a given period of time. • The market value is calculated using current prices, the prices that prevailed when the production took place. • For example, the nominal GDP of the United States in 2017 was $19,390.6 billion, according to the U.S. Department of Commerce • Given a mid-year population of 325,983,000 (est.) the per capita nominal GDP was $59,484

36. Gross Domestic Product, Real • Real GDP is the total market value of all final goods and services produced within a country in a given period of time. • The market value is calculated using constant prices, the prices that prevailed in a benchmark year called the base year. • For example, the real GDP of the United States in 2017 was $17,096.2 billion in 2009 dollars, according to the U.S. Department of Commerce • Given a mid-year population of 325,983,000 (est.) the per capita nominal GDP was $52,445 in 2009 dollars

37. Nominal and Real GDP Note that the base year’s nominal and real GDP must be the same.

38. Nominal and Real GDP

39. Real and Nominal GDP of USA Nominal GDP: https://fred.stlouisfed.org/series/GDPA Real GDP: https://fred.stlouisfed.org/series/GDPCA

40. Growth Rate of Real GDP, USA Source: https://fred.stlouisfed.org/series/A191RL1A225NBEA

41. Table 2: Real and Nominal GDP This table shows how to calculate real GDP, nominal GDP, and the GDP deflator for a hypothetical economy that produces only hot dogs and hamburgers.

42. The GDP Deflator • The GDP deflator is a measure of the overall level of the prices of the final goods and services produced within a country during a given period of time CHAPTER 5 MEASURING A NATION’S INCOME

43. The GDP Deflator • The GDP Deflator tells us how the overall level of prices in a particular year compare to the overall level of prices in the base year. • USA data: https://fred.stlouisfed.org/series/A191RD3A086NBEA • The GDP Deflator for 2017 compared to base year 2012 was 107.948. • This means that, for domestically produced final goods and services, prices in 2017 were, on average, 7.948 percent higher than in 2012. • In this way, the overall level of prices for various years can be compared (by comparing each year’s prices to the base year). CHAPTER 5 MEASURING A NATION’S INCOME

44. The GDP Deflator • The GDP Deflator is calculated as follows: CHAPTER 5 MEASURING A NATION’S INCOME

45. Market value of all domestically produced final goods and services produced in 2017 at 2017 prices GDP Deflator for 2017 with base year 2009 × 100 = Market value of all domestically produced final goods and services produced in 2017 at 2009 prices $600 × 100 = $200 = 300

46. Market value of all domestically produced final goods and services produced in 2017 at 2017 prices GDP Deflator for 2017 with base year 2009 × 100 = Market value of all domestically produced final goods and services produced in 2017 at 2009 prices Why are the goods produced in 2017 worth 3 times as much at 2017 prices as at 2009 prices? It must be that 2017 prices are, on average, 3 times as high as 2009 prices. $600 × 100 = $200 This is what the GDP Deflator is saying. = 300

47. Market value of all domestically produced final goods and services produced in 2017 at 2017 prices GDP Deflator for 2017 with base year 2009 × 100 = Market value of all domestically produced final goods and services produced in 2017 at 2009 prices The GDP Deflator is 300. This indicates that the 2017 prices of domestically produced final goods and services were on average 300 percent of the corresponding prices in 2009, the base year. $600 × 100 = $200 = 300

48. Example: 2017 • US Nominal GDP was $19,485.394 billion • US Real GDP was $18,050.693 billion (chained 2012 dollars) • US GDP Deflator = (19,485.394 / 18,050.693) × 100 = 107.948 • This means that the final goods and services domestically produced in 2017 had a market value in 2017 prices that was 107.948 percent of their market value in 2012 prices • This means that, domestically produced final goods and services were on average 7.948% higherrin 2017 compared to 2012 CHAPTER 5 MEASURING A NATION’S INCOME

49. GDP Deflator: USA (Price Level) Source: https://fred.stlouisfed.org/series/A191RD3A086NBEA

50. GDP Deflator: USA (Inflation) Source: https://fred.stlouisfed.org/series/A191RI1A225NBEA