prepared by: jamal husein c h a p t e r 10 © 2005 prentice hall business publishingsurvey of...

© 2005 Prentice Hall Business Publishing© 2005 Prentice Hall Business Publishing Survey of Economics, 2/eSurvey of Economics, 2/e O’Sullivan & SheffrinO’Sullivan & Sheffrin

Prepared by: Jamal Husein

C H A P T E R

1010Measuring a Nation’s Production and Income

© 2005 Prentice Hall Business Publishing Survey of Economics, 2/e O’Sullivan & Sheffrin 2

MacroeconomicsMacroeconomicsMacroeconomicsMacroeconomics

Macroeconomics is the branch of economics that deals with any nation’s economy as a whole.

Macroeconomics focuses on issues such as unemployment, inflation, growth, trade, and the gross domestic product.


MacroeconomicsMacroeconomicsMacroeconomicsMacroeconomics Macroeconomics focuses on two key

issues: Understanding economic growth in the

long run and the factors behind the rise in living standards in modern economies

Understanding economic fluctuations; the ups and downs of the economy over time


Production, Income and the Circular Production, Income and the Circular FlowFlowProduction, Income and the Circular Production, Income and the Circular FlowFlow

The most fundamental concepts in macroeconomics are production and income.

In factor markets, households supply inputs to production.

Households supply labor and capital to the firms.

Households are paid wages for their work, and interest, dividends and rents for supplying capital.


Production, Income and the Circular Production, Income and the Circular FlowFlowProduction, Income and the Circular Production, Income and the Circular FlowFlow

Households use their income to purchase goods and services in product markets.

The payments received by firms are used to pay for factors of production.

In sum, corresponding to the production of goods and services in the economy are flows of income to households.


Measuring Gross Domestic Product Measuring Gross Domestic Product (GDP)(GDP)Measuring Gross Domestic Product Measuring Gross Domestic Product (GDP)(GDP)

The most common measure of the total output of an economy is gross domestic product (GDP)

GDP is the total market value of all the final goods and services

produced within an economy in a given year.

GDP is the total market value of all the final goods and services

produced within an economy in a given year.


Measuring Gross Domestic ProductMeasuring Gross Domestic ProductMeasuring Gross Domestic ProductMeasuring Gross Domestic Product

“Total market value” refers to the quantity of goods multiplied by their respective prices. Using prices allows us to express the value of everything in a common unit of measurement.

Quantity Price Value

2 cars $15,000 $30,000

3 computers $3,000 $9,000

Gross domestic product $39,000



“Final goods and services” refers to the goods and services that are sold to the ultimate, or final, purchasers.

In order to avoid double counting, we do not count intermediate goods, or goods used in the production process. The value of the final good already reflects the price of the intermediate goods contained in it.

“In a given year” means that the sale of goods produced in prior years, for example, used cars, are not included in GDP this year.



Since we use the prices times the quantities of goods to measure the value of GDP, GDP will increase when prices increase, even if the physical quantities of the goods produced remain the same.

Year 1 Year 2

Quantity Price Value Quantity Price Value

2 cars $15,000 $30,000 2 cars $30,000 $60,000

3 computers $3,000 $9,000 3 computers $6,000 $18,000

GDP = $39,000 GDP = $78,000



A measure of total output that does not increase just because prices increase is called real GDP. Real GDP takes into account price changes by using the same prices for both years.

Nominal GDP is the value of GDP in current dollars



Using year 1 prices to compute GDP in year 2:

Year 1 Year 2

Quantity Price Value Quantity Price Value10 computers $1,000 $10,000 12 computers $1,100 $11,000

Nominal GDP $10,000 Nominal GDP $11,000

Growth in nominal GDP ($13,200/$10,000) = 1.32

Quantity Price Value Quantity Price Value10 computers $1,000 $10,000 12 computers $1,000 $12,000

Real GDP $10,000 Real GDP $12,000

Growth in real GDP ($12,000/$10,000) = 1.20


U.S. Real GDP 1930-2000U.S. Real GDP 1930-2000U.S. Real GDP 1930-2000U.S. Real GDP 1930-2000


Who Purchases GDP?Who Purchases GDP?Who Purchases GDP?Who Purchases GDP?

Economists divide GDP into four broad expenditure categories:

1. Consumption expenditures: purchases by consumers

2. Private investment expenditures: purchases by firms

3. Government purchases: purchases by federal, state, and local governments

4. Net exports: net purchases by the foreign sector, or domestic exports minus domestic imports


Composition of U.S. GDPComposition of U.S. GDPComposition of U.S. GDPComposition of U.S. GDP

GDP figures are produced by the U.S. Department of Commerce.

Composition of U.S. GDP, Third Quarter 2002 (billions of dollars expressed at annual rates)

GDPConsumption Expenditures

PrivateInvestmentExpenditures

Government Purchases

NetExports

10,506 7,361 1,597 1,981 -433

In percentage terms:

100% = 70.1% + 15.2% + 18.5% - 4.12%


Consumption ExpendituresConsumption ExpendituresConsumption ExpendituresConsumption Expenditures Consumption expenditures comprise

purchases of currently produced, domestic or foreign, goods and services.

Consumption is broken down into: Durable goods. Nondurable goods. Services, the fastest growing component

of consumption. Consumption comprises 70% of total

purchases.


Private Investment ExpendituresPrivate Investment ExpendituresPrivate Investment ExpendituresPrivate Investment Expenditures

Private investment expenditures include: Spending on new plants and equipment. Newly produced housing. Increase in inventories during the

current year. Note: investment in everyday talk refers to

the purchase of an existing financial asset. Investment in GDP accounts refers to the purchase of new final goods and services by firms. Don’t confuse the two.


Private Investment ExpendituresPrivate Investment ExpendituresPrivate Investment ExpendituresPrivate Investment Expenditures

New investment expenditures are called gross investment. The true addition to the stock of capital of the economy is net investment. Net investment equals gross investment minus depreciation.

Depreciation is the deterioration of plants, equipment, and housing in a given year.

Third Quarter 2002 (billions $)

Gross Investment

DepreciationNet

Investment$1,597 $1,175 $422

100% 74% 26%


Government PurchasesGovernment PurchasesGovernment PurchasesGovernment Purchases Includes any goods the government

purchases plus the wages and benefits of all government employees; but does not include all the government spending.

Transfer payments, or government payments to individuals which are not associated with the production of any goods and services, are not included in government purchases.

This means that a large part of the federal government budget is not part of GDP.


Net ExportsNet ExportsNet ExportsNet Exports

Net exports are total exports minus total imports. By including net exports in GDP, we correctly measure U.S. production—by adding exports and subtracting imports.

Purchases of foreign goods (imports) are subtracted from GDP because these goods were not produced in the U.S.

Any goods that are produced in the U.S. and sold abroad (exports) are included in GDP.


Net ExportsNet ExportsNet ExportsNet Exports

Net exports for the U.S. in 3rd quarter of 2002 were -$433. This means that the U.S. bought $433 billion more goods and services from abroad than it sold abroad.

The balance of trade: Trade deficit: imports > exports Trade surplus: imports < exports Trade balance: imports = exports


U.S. Trade Balance As a Share of GDP U.S. Trade Balance As a Share of GDP 1960-20001960-2000U.S. Trade Balance As a Share of GDP U.S. Trade Balance As a Share of GDP 1960-20001960-2000


The Meaning of Continued Trade The Meaning of Continued Trade DeficitsDeficitsThe Meaning of Continued Trade The Meaning of Continued Trade DeficitsDeficits

When the U.S. runs a trade deficit, we are forced to sell some of our assets to individuals or governments in foreign countries.

We give up more dollars from exports than we receive from imports. Excess dollars in the hands of foreigners are used to buy U.S. assets such as stocks, bonds or real estate.

If a country runs a trade surplus with one country and an equally large deficit with another, it does not add to its stock of foreign assets.


Who Gets the Income?Who Gets the Income?Who Gets the Income?Who Gets the Income? Three adjustments must be made to GDP in order

to arrive at national income:

1. Add the net income earned by U.S. firms and residents abroad; subtract income earned in the U.S. by foreign firms to arrive at GNP or gross national product.

2. Subtract depreciation from GNP to arrive at net national product, or NNP.

3. Subtract indirect taxes, which are sales taxes or excise taxes on products, because the part of sales revenue that goes to the government is not part of private sector income.


Who Gets the IncomeWho Gets the IncomeWho Gets the IncomeWho Gets the Income

From GDP to National Income, Third Quarter 2002 (billions)Gross domestic product $10.506

plus net income from abroad =

Gross national product

minus depreciation = 10,495

Net national product

minus indirect taxes (and otheradjustments) 9,090

National income 8,388

Composition of U.S. National Income, Third Quarter 2002 (billions)National income 8,388

Compensationof employees

$6,027

Corporate profits 771

Rental Income 144

Proprietor’s income 759

Net interest 687


Real Versus Nominal GDPReal Versus Nominal GDPReal Versus Nominal GDPReal Versus Nominal GDP

Differences between nominal GDP and real GDP arise only because of changes in prices.

Quantity Produced PriceNominal

GDPYear Cars Computers Cars Computers

2004 4 1 $10,000 $5,000 $45,000

2005 5 3 12,000 5,000 $75,000 To calculate real GDP we use constant prices

Quantity Produced PriceReal GDP

Year Cars Computers Cars Computers2004 4 1 $10,000 $5,000 $45,000

2005 5 3 10,000 5,000 $65,000


Calculating the Growth of Real GDPCalculating the Growth of Real GDPCalculating the Growth of Real GDPCalculating the Growth of Real GDP

Using the information on the table, we can calculate the growth of real GDP for this economy:

($65,000 - $45,000)/$45,000 = .444, or 44.4%

We can also measure the change in prices over time using an index number called the GDP deflator.

Quantity Produced PriceReal GDP

Year Cars Computers Cars Computers2004 4 1 $10,000 $5,000 $45,000

2005 5 3 10,000 5,000 $65,000


The GDP DeflatorThe GDP DeflatorThe GDP DeflatorThe GDP Deflator

Value of GDP deflator in 2005 = 100 x [(Nominal GDP in 2005)/(Real GDP in 2005)]

100 x ($75,000/$65,000) = 100 x 1.15 = 115

The value 115 means that prices rose by 15% ([115-100)/100] between the two years.

The Commerce Department uses a chain index to calculate price changes which is based on an average of price changes using base years from neighboring years.

An index is set at 100 in a given year, say the year 2004, called the base year. Prices in other years are compared to prices in 2004:


GDP As a Measure of WelfareGDP As a Measure of WelfareGDP As a Measure of WelfareGDP As a Measure of Welfare

GDP is our best measure of the value of output produced, but not a perfect measure:

GDP ignores transactions that do not take place in organized markets, such as the work we perform at home.

GDP ignores the underground economy, where transactions are not reported to official authorities.


GDP As a Measure of WelfareGDP As a Measure of WelfareGDP As a Measure of WelfareGDP As a Measure of Welfare

The Internal Revenue Service estimated that in the 1990s, about $100 billion in income from the underground economy escaped federal taxes each year.

If the average tax rate is 20%, about $500 billion ($100/0.20) escaped the GDP accountants, or 7% of GDP.

Finally, GDP does not value changes in the environment that arise from the production of output, such as pollution and depletion of nonrenewable resources.

prepared by: jamal husein c h a p t e r 10 © 2005 prentice hall business publishingsurvey of...

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