Robert J. Gordon, Macroeconomics, 10 th edition, 2006, Addison-Wesley

Robert J. Gordon, Macroeconomics, 10th edition, 2006, Addison-Wesley Chapter 2 The Measurement of Income, Prices, and Unemployment

The circular flow of income: a simple economy • Assume that households spend all their income, no savings and no government • There are two types of transactions between households and firms Figure 2-1 • Firms sell goods and services paid by households (consumption expenditures) • Households must work to earn income to pay for their consumption (income) • Income and consumption are equal.

Figure 2-1 The Circular Flow of Income and Consumption Expenditures

Income (Y) = labor services = consumption expenditures (C) = product • Each of the four elements in the figure is a flow magnitude. • What transactions should be included in income and expenditure • National income and product accounts is the official government accounting of all flows of income and expenditure in the country • Defining GDP • There are 3 major rules for including items in the total final product

Currently produced: a good must be currently produced, i.e., exclude all used items. It also excludes any transaction in which money is transferred without any accompanying good or a service; transfer payments (gifts from one person to another, gifts from the government to persons; social security, medical care and unemployment benefits), it also excludes capital gains accruing to persons as the price of their assets change. • Sold in the market. Goods must be sold in the market and valued at market prices. The value of personal time spent in activities that are not sold in the market are excluded (self consumption). Pollution cost allowances are excluded.

But not resold. A good must not be resold in the current time period. i.e., the good must be a final product not an intermediate product. • Components of Expenditure • Types of investment. Final goods that business firms keep for themselves are called private investments or capital formation. They add to nation’s stock of income-yielding assets. There are two types of private investments. • Inventory investment. Unsold products stay in inventories. By including change in inventories as part of expenditure GDP is guaranteed to equal total expenditure

Fixed investment. All final goods purchased by business firms other than additions to inventory. These are mainly structures (e.g., factories and houses), and equipments • Relation of investment and saving • The portion of household income that is not consumed is called personal saving. These funds are channeled to business firms in two ways: • They buy business bonds or stocks • They deposit savings in financial intermediaries to be lent to business firms • Saving is a leakage from the income used for consumption expenditures. This leakage must be balanced by an injection on non-consumption spending in the form of private investment. Figure 2-2

Figure 2-2 Introduction of Saving and Investment to the Circular Flow Diagram

Net exports • Exports creates income in the country, but not part of the consumption and investment spending of residents • Imports are expenditures of residents for goods and services produced abroad and thus do not create domestic income • If income created from exports is greater than income spent on imports, the net effect is a higher level of domestic production and income. Thus, net exports is a component of a final product and GDP • Another name of net exports is net foreign investment, since net foreign investment (net exports) creates claims on foreigners. If Japanese exports to USA is greater than its imports from USA, US payments of the net exports will enable Japan to buy US assets including bank accounts in USA

GNP versus GDP • These two terms differ in their geographical coverage of GDP. • GDP covers goods and services produced within the borders of the country • GNP covers goods and services produced by labor and capital supplied by the country residents, whether takes place within borders of the country or in a foreign country • To convert GDP in GNP we must add in elements such as the income of domestic residents earned abroad and dividends they receive from abroad, then subtract income that is paid to foreigners (net foreign factors income)

The government sector • collects taxes from the private sector • Makes two kinds of expenditures • Purchase of goods and services, • Generate production and create income • It can also make direct payments to households. Figure 2-3

Figure 2-3 Introduction of Taxation, Government Spending, and the Foreign Sector to the Circular Flow Diagram

The magic equation and the twin deficit • the magic equation helps us to understand the relationship among investment, private saving, the government surplus/deficit and the NX • Implications of equality between income and expenditures: Y ≡ E E ≡ C+I+G+NX (1) • Personal income the households receive is production (Y) and transfer payments from the government (F). This is available for (C), (S) and tax payments R. i.e., Y+F ≡ C + S + R • Or Y ≡ C + S + R – F (2) • Or Y ≡ C + S + T (3) • T (net taxes)

Leakages and Injections • Note that C + S + T = C + I +G +NX -C -C S + T ≡ I + G + NX (4) • Leakages (S+T) must be exactly balanced by injections of non consumption spending (I+G+NX) • Equation 4 is the magic equation. Its technical name “the leakages-injection) identity”. If there is a budget deficit (T-G) < 0 then, I + NX – S < 0 (T-G)

The government budget and the twin deficits • Rearrange eq. 4 to show the uses of a government budget surplus T – G = (I + NX) – S (5) • If T>G, there are 3 ways that a government budget surplus can be used • A budget surplus allows private savings to decline without a need for a decline of total investment (I+NX). • A budget surplus can stimulate domestic investment (I) • a budget surplus can boost foreign investment (NX) or if NX is negative, reduce borrowing from foreigners.

If T<G, the government is running a deficit, there are 3 implications • Budget deficit could make (I) smaller. • Budget deficit requires that (S) must rise to avoid any downward pressure on total investment (I+NX). • If S does not increase, to avoid a decline in (I+NX), there must be more borrowing from foreigners and a decline in lending to foreigners. • e.g., • T – G = (I + NX) - S • -1.8 = (17.8 – 1) – 18.4 (deficit financed by foreign borrowing (-NX), and S to be greater than I) • 4.4 = (20.8 – 4) – 12.4 (surplus with greater borrowing (-NX) allowed I to increase to 20.8 greater than S) • -4.6 = (15.9 – 4.9) – 15.6 (deficit with greater borrowing allowed I to be greater than S)

How much income flows from business to households • Income leakages and the circular flow Table 2-1 • Summarize the steps by which income travels from business firms to households. • Net Domestic Product = GDP – depreciation • Now you may notice that gross or net depends on whether depreciation is included or excluded • Domestic income = NDP – indirect business taxes • Personal income = DI – undistributed profits – corporate taxes + transfer payments • Personal disposable income = personal income – personal income taxes

Table 2-1 Households Get What Remains After All the Leakages

Nominal GDP, Real GDP and the GDP deflator • Real and Nominal Magnitudes • Nominal amounts are not very useful in economic analysis. They may rise because of a rise in Q or P. • When we spend more, it does not indicate that we consume more, if prices are rising. For this reason we eliminate the influence of price changes. • Real GDP and Real output • Real GDP is expressed in the prices of an arbitrary base year. Year 2005 real output at the 2000 prices represents the amount that actual 2005 production have cost it had been sold at its 2000 prices. Nominal GDP of 2005>2000, and nominal GPD of 1995<2000 Figure 2-4

Figure 2-4 Nominal GDP, Real GDP, and the Implicit GDP Deflator, 1900–2004

The ratio of nominal GDP to real GDP is a price index called Implicit GDP deflator. • How we measure real GDP and the inflation rate • We have to find someway to separate changes in nominal GDP caused by changes in real GPD and those caused by inflation. • Why we care about real GDP and inflation • Movements of real GDP indicate the changes in unemployment rate. It is also important to measure productivity. • Inflation is also important since very fast inflation can destroy a society; either because of the direct harm it causes, or because of the indirect harm done by measures to stop it (e.g., higher interest rates).

How we calculate changes in real GDP • Output can’t be added together. the only way to combine these products is to place a value on each component of GDP. But since prices are constantly changing, the measures of GDP and its changes will depend on which time period we choose to take the prices. Table 2-2 • The table shows a general tendency, that choosing the prices of a later year tends to give use of a lower increase in real GDP, since a lower valuation on the quantities that have increased most rapidly.

Table 2-2 Calculation of Fixed-weight and Chain-weighted Real GDP and GDP Deflators in an Imaginary Economy Producing Only Oranges and Apples

A chain weighted calculation of real GDP • In the table above we there are two rats of growth of real GDP. A reasonable compromise is to average these two answers using the geometric average. • The outcome is called chain-weighted real GDP, because the weights move forward from year to year. • Implicit deflator and the chain-weighted deflator • There are two different GDP deflators. The first, the implicit GDP deflator, is simply the ratio of nominal GDP to chain weighted real GDP. • Implicit GDP deflator = nominal GPD/real GDP

The second type of GDP deflator is calculated directly from the prices and quantities of goods and services in the economy, then calculate the chain weighted GDP deflator. • The implicit and chain weighted GDP deflator give very a close answer. • Measuring unemployment • The unemployment survey • to calculate unemployment rate, it is impossible to collect information every month. As a compromise, each month 60000 households are interviewed. Each month one-forth of the sample is replaced. • The questions asked in the survey some questions such as: • What you doing most of last week. Anyone who has done any work at all for pay during the past week, whether part of full time is counted as employed.

“did you have a job from which you were temporarily absent or on layoff last week”. Any person who is awaiting a recall from a layoff or has obtained a new job but waiting for it to begin is counted as unemployed. • “have you been looking for work in the last 4 weeks and if so what have you been doing in the last 4 weeks to find a work”. A person searching for a job by applying to an employer, registering with employment agency, checking with friends or other specified job search activities is counted as unemployed. • The remaining people are not in the labor force: homemakers who don’t seek work, students, disabled, and retired people

Total labor force = civilian employed + armed forces + unemployed • Actual unemployment rate = number of unemployed / civilian employed + unemployed • The labor force participation rate is the ratio of the labor force/population aged 16 or over. • Not in the labor force. • Those who do not participate in the labor force include those who are above 15 and in school, retired, homemakers, could not work because they are ill and disabled, those who have given up on finding jobs;

Flows in the definition • The unemployment rate by itself is not a measure of the social distress caused by the loss of a job. • The government concept misses some of the people hurt by a recession, e.g., cut in hours, enforcement to shift from full to part time. • “Discouraged workers” or “disguised unemployment • For these reasons, official statistics understate the total amount of unemployment.

Next Chapter # 3 Spending, Income, and Interest Rates

Figure 2-5 Employment From the Household and Payroll Survey, 1990–2004

Robert J. Gordon, Macroeconomics, 10 th edition, 2006, Addison-Wesley