Chapter 8 Powerpoint

Chapter 8
Measuring the
Economy’s
Performance

Copyright ©2014 Pearson Education, Inc. All rights reserved. 8-2
Introduction
Some commentators are already referring to the twenty-
first century as the “Asian century.” It has been
suggested that China’s economy will be larger than the
U.S. economy by 2020.
How do we go about measuring the size of an economy?
And how do we make international comparisons with
regard to this measure?
The concept of gross domestic product, which is a key
concept of Chapter 8, is the starting point for
contemplating these questions.

Learning Objectives
• Describe the circular flow of income and
output
• Define gross domestic product (GDP)
• Understand the limitations of using GDP as
a measure of national welfare

Learning Objectives (cont'd)
• Explain the expenditure approach to
tabulating GDP
• Explain the income approach to computing
GDP
• Distinguish between nominal GDP and real
GDP

Chapter Outline
• The Simple Circular Flow
• National Income Accounting
• Two Main Methods of Measuring GDP
• Other Components of National Income
Accounting
• Distinguishing Between Nominal and Real
Values
• Comparing GDP Throughout the World

Did You Know That ...
• The flow of U.S. economic activity since
2009 has been more dampened than during
any other comparable post-recession period
since the Great Depression of the 1930’s?
• To measure the nation’s overall economic
performance, the government utilizes the
concept of national income accounting.

The Simple Circular Flow
The concept of the circular flow of income
involves two principles:
1. In every economic exchange, the seller receives
exactly the same amount that the buyer spends
2. Goods and services flow in one direction and
money payments flow in the other

The Simple Circular Flow (cont'd)
• Profits explained
– Question
• Why is profit a cost of production?
– Answer
• Profits are the return entrepreneurs receive for the risk
they incur when organizing productive activities

Figure 8-1 The Circular Flow of Income
and Product

• Product Markets
– Transactions in which households buy goods
• Factor Markets
– Transactions in which businesses buy resources

• Total Income
– The yearly amount earned by the nation’s
resources (factors of production)
– Includes wages, rent, interest payments, and
profits received by workers, landowners, capital
owners, and entrepreneurs, respectively

• Final Goods and Services
– Goods and services that are at their final stage
of production and will not be transformed into
yet other goods or services

• Question
– Why must the dollar value of total output equal
total income?
• Answer
– Every transaction simultaneously involves an
expenditure and a business receipt

National Income Accounting
• National Income Accounting
– A measurement system used to estimate
national income and its components
• Gross Domestic Product (GDP)
– The total market value of all final goods and
services produced by factors of production
located within a nation’s borders

National Income Accounting (cont'd)
• Observations
– GDP measures the dollar value of final output
– GDP measures the dollar value of final goods
and services produced per year by factors of
production located within a nation’s borders

• Stress on final output
– What is a final good?
• Wheat?
• Steel?
• Crude oil?
• Bread?
• Automobile?
• Gasoline?

• Intermediate Goods
– Goods used up entirely in the production of final
goods
• Value Added
– The dollar value of an industry’s sales minus the
value of intermediate goods (for example, raw
materials and parts) used in production

Table 8-1 Sales Value and Value Added at
Each Stage of Donut Production

• Numerous transactions occur that have
nothing to do with final goods and services
being produced:
– Financial transactions
– Transfer of secondhand goods
– Others excluded transactions

What If . . . Market prices of house cleaning, child
care, and lawn care services were valued for
inclusion in GDP?
• Even if market prices of household services
were used to place a value on household
production, national income accountants
still would not know the volume of such
activity.
• Therefore, they would have to estimate the
amount of household activity, and this
would introduce measurement errors into
the calculation of GDP.

• Financial transactions
– Securities
• Stocks and bonds
– Government transfer payments
• Social Security
• Unemployment compensation
– Private transfer payments
• Individual gifts
• Corporate gifts

• Transfer of secondhand goods
– Why not count the sale of a used computer,
guitar, or snowboard as part of GDP?
• Other excluded transactions
– Household production
– Legal and illegal underground transactions

• GDP’s limitations
– Excludes non-market production
– It is not necessarily a good measure of the well-
being of a nation

• GDP:
– Is a measure of the value of production in terms
of market prices, and an indicator of economic
activity
– Is not a measure of a nation’s overall welfare

Policy Example: Developed Nations Look for a
“Happier” Alternative to GDP
• The 34 member nations of the Organization for
Economic Cooperation and Development are aiming
to supplement or even replace GDP with a measure
called the “Your Better Life Index.”
• This measure of well-being includes scores in 11
areas such as community, education, health,
housing, life satisfaction, and safety.
• Initial results of the Your Better Life Index yield
high rankings for Denmark, Canada, and Norway,
with Hungary, Portugal, and Estonia ranking lowest
among the OECD nations.

Two Main Methods of Measuring GDP
• Expenditure Approach
– Computing GDP by adding up the dollar value at
current market prices of all final goods and
services

(cont'd)
• Income Approach
– Measuring GDP by adding up all components of
national income, including wages, interest, rent,
and profits

(cont'd)
• Deriving GDP by the expenditure approach
– Consumption Expenditure (C)
• Durable Consumer Goods
– Items that last more than three years (automobiles,
furniture)
• Nondurable Consumer Goods
– Goods that are used up in three years (gasoline, food)
• Services
– Mental or physical help

(cont'd)
– Gross Private Domestic Investment (I)
• The creation of capital goods, such as factories and
machines, that can yield production and hence
consumption in the future
– Also includes changes in business inventories and repairs
made to machines, buildings

(cont'd)
– Gross Private Domestic Investment (I)
• Producer Durables or Capital Goods
– Life span of more than three years
• Fixed Investment
– Purchases by business of newly produced producer
durables or capital goods
• Inventory Investment
– Changes in stocks of finished goods and goods in
process, as well as changes in raw materials

Example: Imputing Part of the
Government’s Contribution to GDP
• Some items included in GDP do not have explicit
market prices.
– Examples include public education, fire protection, and
national defense.
• National income accountants have reasoned that
government expenditures on these items
understate the market prices that would prevail if
they were provided by private firms.
• Therefore, the values are determined by using
prices for education, fire protection, and security
services provided in private markets.

(cont'd)
• Deriving GDP by the Expenditure Approach
– Government Expenditures (G)
• State, local, and federal
• Valued at cost

(cont'd)
• Deriving GDP by the Expenditure Approach
– Net Exports (Foreign Expenditures)
Net exports (X) = Total exports – Total imports

(cont'd)
• Presenting the expenditure approach
where
C = consumption expenditures
I = investment expenditures
G= government expenditures
X = net exports
GDP = C + I + G + X

Figure 8-2 GDP and Its Components

NDP = GDP – Depreciation
(cont'd)
• Net Domestic Product (NDP)
– Allowing for depreciation (capital consumption
allowance)
• The amount that businesses would have to save in
order to take care of deteriorating machines and other
equipment

(cont'd)
• Because NDP = GDP – Depreciation, and
GDP = C + I + G + X
• NDP = C + I + G + X – Depreciation
• NDP = C + net I + G + X
where net I (net investment ) = I – Depreciation
– Domestic investment minus an estimate of the wear and
tear on the existing capital stock
– The change in the capital stock over a one-year period

(cont’d)
• Deriving GDP by the Income Approach
– Gross Domestic Income (GDI)
• The sum of all income (wages, interest, rent, and
profits) paid to the four factors of production

(cont'd)
– Gross Domestic Income (GDI)
• Wages: salaries and labor income
• Rent: farms, houses, stores
• Interest: savings accounts
• Profits: sole proprietorships, partnerships, corporations

(cont'd)
– Gross domestic product equals gross domestic
income plus indirect business taxes and
depreciation
– These last items are called non-income expense
items

(cont'd)
– Indirect business taxes
• All business taxes except the tax on corporate profits
• Include sales and business property taxes

Figure 8-3 Gross Domestic Product and Gross
Domestic Income, 2013
(in billions of 2005 dollars per year)

Figure 8-3 Gross Domestic Product and Gross
Domestic Income, 2013
(in billions of 2005 dollars per year) (cont’d)

Other Components of National
Income Accounting
• National Income (NI)
– The total of all factor payments to resource
owners
• Personal Income (PI)
– The amount of income that households actually
receive before they pay personal income taxes

Example: Sources of U.S. Personal
Income Exhibit Unsustainable Trends
• Since early 2010, the share of personal
income derived from private payrolls has
dropped to levels that are the lowest in U.S.
history.
• At the same time, the portion of personal
income derived from government-provided
benefits has risen to its highest level.
• These trends are unsustainable because
government benefits are financed through
taxes on private income.

Other Components of National
Income Accounting (cont'd)
• Disposable Personal Income (DPI)
– Personal income after personal income taxes
have been paid

Table 8-2 Going from GDP to
Disposable Income, 2013

Distinguishing Between Nominal and
Real Values
• Nominal Values
– Measurements in terms of the actual market
prices at which goods are sold; expressed in
current dollars, also called money values
• Real Values
– Measurements after adjustments have been
made for changes in the average of prices
between years; expressed in constant dollars

Real Values (cont'd)
• Constant Dollars
– Dollars expressed in terms of real purchasing
power
– This price-corrected GDP is the real GDP

Example: Correcting GDP for Price
Index Changes, 2003 - 2013
• Let’s use a numerical example to show how
we can adjust GDP for changes in the price
index.
• In this example shown on the next slide, the
GDP deflator is used to calculate values for
real GDP from 2003 to 2013.

Table 8-3 Correcting GDP for Price
Index Changes

Figure 8-4 Nominal and Real GDP
Source: U.S. Department of Commerce.

Per capita real GDP =
Real GDP
Population
Real Values (cont'd)
• Per capita real GDP
– Real GDP divided by total population

Comparing GDP Throughout the
World
• Foreign Exchange Rate
– The price of one currency in terms of another
• Example:
– $1.25 = 1 euro, or $1 = .80 euros
– French income per capita = 28,944 euros
– French per capita income in terms of dollars
equals 28,944 euros x $1.25 = $36,180

Comparing GDP Throughout the
World (cont'd)
• Purchasing Power Parity
– Adjustment in exchange rate conversions that
takes into account differences in the true cost of
living across countries

International Example: Purchasing Power Parity
Comparisons of World Incomes
• The International Monetary Fund accepted the
purchasing power parity approach a few years ago
• It started presenting the statistics on each country’s
GDP relative to others and based on the purchasing
power parity relative to the dollar
• Why is China’s per capita GDP higher based on
purchasing power parity?

Table 8-4 Comparing GDP
Internationally

You Are There: Has the Economy Grown More
than Official GDP Data Suggest?
• Economists Bart Hobijin and Charles Steindel at the
Federal Reserve Bank of New York are considering
how to include three additional items in GDP:
– Intangible investment
– Real capital investment undertaken by government
– Shift away from non-market home production as more
women enter the labor force.
• Hobijin and Steindel conclude that the net effect of
these three items is to boost the GDP growth rate
by about 0.5 percentage points per year.

Issues & Applications: Asia’s “Economic Size”
Depends on How It Is Measured
• The figure on the next slide shows the combined
real GDP of Asia as a percentage of real GDP of the
entire world.
• The calculation was done according to two different
measures.
• One used prevailing exchange rates in foreign
currency markets.
• The other used purchasing power parity
adjustments.

Figure 8-5 Asia’s Share of Global Real
GDP
Source: International Monetary Fund.

Issues & Applications: Asia’s “Economic Size”
Depends on How It Is Measured (cont’d)
• Of the two methods, the purchasing power
parity measure gives a larger estimate for
Asia’s share of the world economy.
• Another measure of Asia’s economic
presence is per capita real GDP.
– When comparisons are based on foreign
exchange rates, Asian per capita real GDP is 11
percent of global per capita real GDP.
– Using a purchasing power parity comparison, the
figure rises to 26 percent.

Summary Discussion of Learning
Objectives
• The circular flow of income and output
– In every economic transaction, receipts exactly
equal expenditures
– Goods and services flow in one direction and
money payments flow in the other
• Gross domestic product (GDP)
– The total market value of a nation’s final output
of goods and services produced in a year using
factors of production located within its borders

Objectives (cont'd)
• The limitations of using GDP as a measure
of national welfare
– Excludes non-market transactions
– Does not measure national well-being
• The expenditure approach to tabulating
GDP
– GDP = C + I + G + X

Objectives (cont'd)
• The income approach to computing GDP
– The sum of wages, rent, interest, profits
• Distinguishing between nominal GDP and
real GDP
– Nominal GDP is the value of newly produced
final output measured in current market prices.
– Real GDP adjusts nominal GDP into constant
dollars by correcting for price level changes

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