chapter five: measuring the economy's performance

Chapter Five:Measuring The Economy's

Performance

5.1 Economic Activity and the Circular-Flow

A measure of economic activity is called National Income Accounting The circular-flow diagram is a model that represents the transactions in an economy by flows around a circle.

Seller produces = Buyer spendsFlow is in one direction

Circular-Flow of Economic Activities

A household is a person or a group of people that share their income.

A firm is an organization that produces goods and services for sale.

Firms sell goods and services they produce to households in markets made for goods and services.

Firms buy the resources they need to produce—factors of production—in factor markets.

The Circular-Flow DiagramThe Circular-Flow Diagram

The Circular FlowThe Circular Flow

Goods & Services Firms (production)Household

Factor Services

Total Income = wages, rents,

interest, profits

Personal Consumption

$Value of all G&S = $Value of output$Value of all G&S = $Value of output

Total Income = $Value of output??

1. Spending by one is income for another

2. Profit is a cost of production it is residual

The Enhanced Circular FlowThe Enhanced Circular Flow

Goods

Other countriesOther countries

Financial marketsFinancial markets

GovernmentGovernmentFirms

(production)HouseholdTaxes

Factor services

SavingsImports

Government

Spending

Wages, rents, interest, profits

Exports

Investment

Personal consumption

The Enhanced Circular FlowThe Enhanced Circular Flow

Other countries-trade and FDI

Other countries-trade and FDI

Financial Markets –show saving and borrowing

Financial Markets –show saving and borrowing

Government -collect taxes and use money to purchase G&S, transfers

Government -collect taxes and use money to purchase G&S, transfers

Total (Aggregate) Expenditure = Consumer + Foreign + Government + Business

• GDP is the nation’s expenditures on all FINAL goods and services produced during the year at market prices.

5.1 Measuring GDP

Avoid Double Counting

1. Intermediate goods• $Value Added at each production stage

2. Transfer Payments

Two Things to Avoid when Compiling GDP

• Multiple counting

– Only expenditures on final products – what consumers, businesses, and government units buy for their own use belong in GDP

• Intermediate goods are not counted

• Used goods are not counted

Two Things to Avoid when Compiling GDP

• Transfer payments– Transfer payments are not payments

for currently produced goods and services• When they are spent for final goods

and services they will go into GDP as consumer spending

• Financial transactions don’t go into GDP

Why only Final Goods

• Counting the sale of final goods and intermediate products would result in double and triple counting.

What is counted? What is not?

Only the value of the final sale is counted.

The cost of the parts is included in the

final sale price

So they are not counted when the manufacturer buys them.

This is confusing!

• The tires that come with the car is not counted as a final good

• However if you get a flat and buy the same tire it is counted as a final good

No Problem!

• To correct for this problem economist have created the Value Added approach.

Value Added Approach Eliminates Double Counting

5.3 Calculating GDP

GDP can be calculated two ways:

Expenditure: add up all spending on domestically produced final goods and services, leading to the equation:

GDP = C+I+G+(X-M)

Income: add up the all income paid to factors of production

Calculating GDP

Expenditure Approach Consumer – on G&S

++

Investment – creation of capital goods

++

Government – buying G&S and pays wages

++

(X-M) – net exports, what we buy from other nations

The Flow, Not Stock

• With GDP we are measuring a Flow or a movement NOT a Stock

– The store of wealth is a stock concept.

How GDP Is Measured?

HouseholdsFirms

Income (wages, salary, rent, interest, profits)

Expenditures by Consumers, Investors, Government, and Net Exports


HouseholdsFirms



Same As


HouseholdsFirms



Same As

Value of what is produced

Value of what is spent


HouseholdsFirms



Same As



Flow of Income Flow of Income ApproachApproach

Expenditures Expenditures ApproachApproach


HouseholdsFirms



Same As



Flow of Income Approach

Expenditures Approach

(GDP = C + I + G + NX )

• Consumption– Durable goods …………$ 820

– Nondurable goods …….. 2,010

– Services ……………….. 3,929

– Total C …………………………….$6,759

• Investment– Plant & Equipment …….$ 1,361

– Residential Housing …… 416

– Inventory change ………. 57

– Total I ……………………………….1,834

• Government Purchases– Federal ………………….$ 595

– State and Local …………. .1,148

– Total G ……………………………..$1,743

• Net Exports (Xn)– Exports ………………….$ 1,099

– Imports …………………..- 1,466

– NX …………………………………$ - 370

• GDP …… …………………………$9,966

The Components of GDP, 2000 (in $ billions)

• Consumption– Durable goods …………$ 820

– Nondurable goods …….. 2,010

– Services ……………….. 3,929

– Total C …………………………….$6,759

• Investment– Plant & Equipment …….$ 1,361

– Residential Housing …… 416

– Inventory change ………. 57

– Total I ……………………………….1,834

• Government Purchases– Federal ………………….$ 595

– State and Local …………. .1,148

– Total G ……………………………..$1,743

• Net Exports (Xn)– Exports ………………….$ 1,099

– Imports …………………..- 1,466

– Xn …………………………………$ - 370

• GDP …… …………………………$9,966

The Components of GDP, 2000 (in $billions)

GDP = C + I + G + NX

GDP =6,759+1,834+1,743+(-370)

GDP = 9,966

What’s measured on the income side?

Income received Income received by Householdsby Households

• Wages for use of

• Rent

• Interest

• Profit

Factors of Factors of ProductionProduction

• Labor

• Land

• Financial Capital

• Physical Capital

Net Domestic Income

Payments to Owners of Factors of Production

Wages

+

Rent

+

Interest

+

Profit

5.4 Other Components of GDP and National Income Accounting

GDP = NDI + Nonincome Expense Items (ind. Bus. taxes – (dep. + subs.))

NDP = GDP – Dep.

Dep: amount of capital stock that has been used (to repair)

Therefore,

NDP = C + I + G + (X-M) – Dep

Net I = I – Dep, changes in Cap Stock over time

Net National Income Accounting

If, GDP = NDI + Nonincome Expense Items (ind. Bus. taxes– (dep + subs))

Then,

NDP does not rep. income available to ppl. in that economy because of income paid to foreigners (NX)

Therefore,

Net National Income = all factor income of Canadian resource owners

Nominal Vs. Real

• Nominal GDP is GDP calculated at existing prices.

• Real GDP is nominal GDP adjusted for inflation.

• Real GDP is important to society because it measures what is really produced

Nominal GDP

• nominal GDP, is the value of all final output produced in an economy during a given year, calculated using the prices current in the year which the output is produced

Keeping it Real

Comparing output over time is best done with real output which is nominal output adjusted for inflation

• Real GDP is the value of the final goods and services produced calculated using the prices of some base year

Real vs. Nominal GDP

GDP Versus Real GDP (RGDP)

$8 $9 $10 $11

1998 1999 2000 2001

GDP is measured in current dollars. Therefore it appears as if GDP was larger in 2001 than in previous years. To make year-to-year GDP comparisons, we have to get rid of inflation

Deflating GDP to Get RGDP

RGDPcy = GDPcy X --------------------------GDP DEFLATORcy

GDP DEFLATORby

Nominal GPDcy = GDPcy X



GDP DEFLATORby

RGDP 86 = 4422.2 X ------------------------------------ 100

80.6



GDP DEFLATORby

RGDP 86 = 4422.2 X ------------------------------------ 100

80.6RGDP 86 = 4422.2 X 1.2406948



GDP DEFLATORby

RGDP 86 = 4422.2 X ------------------------------------ 100

80.6RGDP 86 = 4422.2 X 1.2406948

RGDP 86 = 5486.6


RGDP97 = GDP97 X --------------------------GDP DEFLATOR by

GDP DEFLATOR 97



GDP DEFLATOR 97

RGDP 97 = 8083.4 X ----------------------------------------`100

115.2



GDP DEFLATOR 97

RGDP 97 = 8083.4 X ----------------------------------------`100

115.2

RGDP 97 = 8083.4 X .8680556



GDP DEFLATOR 97

RGDP 97 = 8083.4 X ----------------------------------------`100

115.2

RGDP 97 = 8083.4 X 8680556

RGDP 97 = 7016.8

Calculating Percentage Changes

% change = ------------------------------------Change

Original Number


% change = ------------------------------------Change

Original Number

1980 GDP = 2784.2

1979 GDP = 2557.5


% change = ------------------------------------Change

Original Number

1980 GDP = 2784.2

1979 GDP = 2557.5

Change -----> 226.7


% change = ------------------------------------Change

Original Number

1980 GDP = 2784.2

1979 GDP = 2557.5

Change -----> 226.7

% change = --------------------226.7

2557.5


% change = ------------------------------------Change

Original Number

1980 GDP = 2784.2

1979 GDP = 2557.5

Change -----> 226.7

% change = --------------------226.7

2557.5

% change = .0886413 = 8.8%


% change = ------------------------------------Change

Original Number

1980 GDP = 2784.2

1979 GDP = 2557.5

Change -----> 226.7

% change = ---------------------226.7

2557.5

% change = .0886413 = 8.8%

1980 RGDP = 4611.9

1979 RGDP = 4624.0


% change = ------------------------------------Change

Original Number

1980 GDP = 2784.2

1979 GDP = 2557.5

Change -----> 226.7

% change = ---------------------226.7

2557.5

% change = .0886413 = 8.8%

1980 RGDP = 4611.9

1979 RGDP = 4624.0

Change ------> 12.9


% change = ------------------------------------Change

Original Number

1980 GDP = 2784.2

1979 GDP = 2557.5

Change -----> 226.7

% change = ---------------------226.7

2557.5

% change = .0886413 = 8.8%

1980 RGDP = 4611.9

1979 RGDP = 4624.0

Change ------> 12.9

% change = -------------------------12.9

4624.0


% change = ------------------------------------Change

Original Number

1980 GDP = 2784.2

1979 GDP = 2557.5

Change -----> 226.7

% change = -------------------226.7

2557.5

% change = .0886413 = 8.8%

1980 RGDP = 4611.9

1979 RGDP = 4624.0

Change ------> 12.9

% change = -------------------------12.1

4624.0

% change = .0026168 = .26 %

GDP Measures Market Activity, Not Welfare

• GDP does not measure happiness, nor does it measure economic welfare.

• Welfare is a complicated idea, very difficult to measure.

5.5 Limitations of GDP

• Production that is excluded– Household production– Illegal production– The underground economy

• Treatment of leisure time• Human cost and benefits• GDP gives us a ballpark idea of how

much we produce, not necessarily how well off we are

GDP Per Capita

• GDP Per Capita is GDP divided by the size of the population: it is equal to the average GDP per person.

• Not an end in itself does not address how a country uses that output to affect living standards.

Per Capita GDP

Per capita GDP = ---------------------------------GDP

Population

Per Capita GDP

Per capita GDP = --------------------------------GDP

Population20000

2000

2000

Per capita GDP = --------------------------------$9,966,000,000,000

281,000,000

Per capita GDP = $35,466

20000

20000

Foreign Exchange Rates: the price we pay for another country's currency

Eg. 0.98CAD : 1.00USD

Purchasing Power of Parity is an exchange rate where currency would have the same value

Eg. Baseball Bats

PPP Eg. Baseball Bats

1.00USD : 10.00MXN

United States wooden baseball bats sell for $40

Mexico they sell for 150 pesos

then, the bat costs $40 USD if we buy it in the U.S. but only 15 USD if we buy it in Mexico

*advantage to buying the bat in Mexico!

PPP Eg. Baseball Bats 1.00USD : 10.00MXN



-Need Mexico Pesos in order to buy baseball bats in Mexico.

-Sell American Dollars and buy Mexican Pesos

-Mexican Peso to become more valuable relative to the USD.

-The demand for baseball bats sold in the United States decreases, so the price American retailers charge goes down.

-The demand for baseball bats sold in Mexico increases, so the price Mexican retailers charge goes up.

PPP Eg. Baseball Bats 1.00USD : 10.00MXN



-The exchange rates and the prices in the two countries to change such that we have purchasing power parity.

-If 1USD = 8MXN, the price of baseball bats in the United States goes down to $30 each and the price of baseball bats in Mexico goes up to 240 pesos each, we will have PPP

-This is because a consumer can spend $30 in the United States for a baseball bat, or he can take his $30, exchange it for 240 pesos (since 1 USD = 8 MXN) and buy a baseball bat in Mexico and be no better off.

chapter five: measuring the economy's performance

Documents

sale of final goods

produced goods

countedused goods

gdpintermediate goods

final products

final goodscounting

final goodhowever

final sale priceso