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Measuring a Nation’s Income
Chapter 5
Learning ObjectivesLearning Objectives
Describe the origins of macroeconomics and the problems it deals with
Describe the long-term trends and short-terms fluctuations in economic growth, unemployment, inflation, and government and international deficits
Learning Objectives (con't.)Learning Objectives (con't.)
Explain why economic growth, unemployment, inflation, and deficits matter
Identify the macroeconomic policy challenges and describe the tools available for meeting them
Learning ObjectivesLearning Objectives
Distinguish between the stocks of capital and wealth and the flows of production, income, investment and saving
Explain why aggregate income, expenditure, and product are equal
Explain how GDP is measured
Learning ObjectivesLearning Objectives
Describe the origins of macroeconomics and the problems it deals with
Describe the long-term trends and short-terms fluctuations in economic growth, unemployment, inflation, and government and international deficits
Microeconomics
Microeconomics is the study of how individual households and firms make decisions and how they interact with one another in markets.
Macroeconomics
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.
Macroeconomics
Macroeconomics answers questions like the following: 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?
Origins and Issues of Origins and Issues of MacroeconomicsMacroeconomics
Modern macroeconomics emerged during the Great Depression.
People began to doubt the free market economy.
John Maynard Keynes, in 1936, published The General Theory of Employment, Interest, and Money.
Origins and Issues of Origins and Issues of MacroeconomicsMacroeconomics
Macroeconomic Problems
1) Economic Growth
2) Unemployment
3) Inflation
4) Deficits
Origins and Issues of Origins and Issues of MacroeconomicsMacroeconomics
Short-Term Versus Long-Term GoalsKeynes focused on the short-term primarily
• He felt the depression was caused by insufficient private spending
• Government should increase its spending
Origins and Issues of Origins and Issues of MacroeconomicsMacroeconomics
Short-Term Versus Long-Term GoalsLong-term consequences were virtually
disregarded• “In the long run, we’re all dead”
Origins and Issues of Origins and Issues of MacroeconomicsMacroeconomics
Short-Term Versus Long-Term GoalsToday, macroeconomics is concerned with:
• Long-term economic growth and inflation
• Short-term business fluctuations and unemployment
Origins and Issues of Origins and Issues of MacroeconomicsMacroeconomics
The Road AheadThe focus of macroeconomics has
shifted:• Depression• Inflation of the 1970’s• International economics of today
Economic Growth in theEconomic Growth in theUnited StatesUnited States
Fluctuations Around Potential GDPThe business cycle is the periodic but
irregular up-and-down movement in production.
Economic Growth in theEconomic Growth in theUnited StatesUnited States
Phases of the Business CycleRecession
• Period during which real GDP decreases for two successive quarters
Expansion• Period during which real GDP increases
Economic Growth in theEconomic Growth in theUnited StatesUnited States
Turning PointsPeak
• Expansion ends, recession begins
Trough• Recession ends, expansion begins
Long-Term Economic GrowthLong-Term Economic Growthin the United Statesin the United States
Economic Growth AroundEconomic Growth Aroundthe Worldthe World
Real GDP per personThe growth rate of real GDP divided by the
population is used to compare growth rates over time and across countries.
Benefits and Costs ofBenefits and Costs ofEconomic GrowthEconomic Growth
BenefitsExpanded production possibilities
• health care
• medical research
• space exploration
• roads
• environmental improvements (if resources are devoted to solving environmental problems)
Benefits and Costs ofBenefits and Costs ofEconomic GrowthEconomic Growth
Costs
1) Foregone consumption
2) Depletion of natural resources
3) Increased pollution
4) More frequent job and location changes
Macroeconomic Policy Macroeconomic Policy Challenges and ToolsChallenges and Tools
Policy Challenges
1) Boost economic growth
2) Stabilize the business cycle
3) Reduce unemployment
4) Keep inflation low
5) Reduce the government and international deficits
Macroeconomic Policy Macroeconomic Policy Challenges and ToolsChallenges and Tools
Policy Tools
1) Fiscal policy• Making changes in taxes and government
spending– Long term growth– Smooth the business cycle
Macroeconomic Policy Macroeconomic Policy Challenges and ToolsChallenges and Tools
Policy Tools
2) Monetary policy• Changing interest rates and the amount of money
in the economy– Control inflation– Smooth business cycle
The Economy’s Income and Expenditure
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.
The Economy’s Income and Expenditure
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.
Gross domestic product (GDP) is a measure of the income and expenditures of an economy.
It is the total market value of all final goods and services produced within a country in a given period of time.
Gross Domestic Product
The Circular-Flow Diagram
The equality of income and expenditure can be illustrated with the circular-flow diagram.
The Circular-Flow Diagram
Firms Households
Market for Factors
of Production
Market for Goods
and Services
SpendingRevenue
Wages, rent, and
profit
Income
Goods & Services
sold
Goods & Services bought
Labor, land, and capital
Inputs for production
The Measurement of GDP
GDP is the market value of all final goods and services
produced within a country in a given period of time.
The Measurement of GDP
Output is valued at market prices. It records only the value of final goods,
not intermediate goods (the value is counted only once).
It includes both tangible goods (food, clothing, cars) and intangible services (haircuts, housecleaning, doctor visits).
The Measurement of GDP
It includes goods and services currently produced, not transactions involving goods produced in the past.
It measures the value of production within the geographic confines of a country.
It measures the value of production that takes place within a specific interval of time, usually a year or a quarter (three months).
The Measurement of GDP
What Is Counted in GDP?
GDP includes all items produced in the economy and sold legally in markets.
What Is Not Counted in GDP?
GDP excludes most items that are produced and consumed at home and that never enter the marketplace.
It excludes items produced and sold illicitly, such as illegal drugs.
Other Measures of Income
Gross National Product (GNP) Net National Product (NNP) National Income Personal Income Disposable Personal Income
Gross National Product
Gross national product (GNP) is the total income earned by a nation’s permanent residents (called nationals).
It differs from GDP by including income that our citizens earn abroad and excluding income that foreigners earn here.
Net National Product (NNP)
Net National Product (NNP) is the total income of the nation’s residents (GNP) minus losses from depreciation.
Depreciation is the wear and tear on the economy’s stock of equipment and structures.
National Income
National Income is the total income earned by a nation’s residents in the production of goods and services.
It differs from NNP by excluding indirect business taxes (such as sales taxes) and including business subsidies.
Personal Income
Personal income is the income that households and noncorporate businesses receive.
Unlike national income, it excludes retained earnings, which is income that corporations have earned but have not paid out to their owners.
In addition, it includes household’s interest income and government transfers.
Disposable Personal Income
Disposable personal income is the income that household and noncorporate businesses have left after satisfying all their obligations to the government.
It equals personal income minus personal taxes and certain nontax payments.
The Components of GDP
GDP (Y ) is the sum of the following: Consumption (C) Investment (I) Government Purchases (G) Net Exports (NX)
Y = C + I + G + NX
The Components of GDP
Consumption (C): The spending by households on goods and
services, with the exception of purchases of new housing.
Investment (I): The spending on capital equipment,
inventories, and structures, including new housing.
Gross Domestic ProductGross Domestic Product
Gross InvestmentThe total amount spent on adding to the
stock of capital and on replacing depreciated capital
Net InvestmentThe amount spent on adding to the stock of
capital• Gross Investment minus Depreciation
Capital and InvestmentCapital and Investment
Initialcapital
The Components of GDP
Government Purchases (G): The spending on goods and services by local,
state, and federal governments. Does not include transfer payments because
they are not made in exchange for currently produced goods or services.
Net Exports (NX): Exports minus imports.
GDP and Its Components (1998)
Total(in billions of dollars)
Per Person(in dollars) % of Total
Gross domestic product, Y $8,511 $31,522 100 percent
Consumption, C 5,808 21,511 68
Investment, I 1,367 5,063 16
Government purchases, G 1,487 5,507 18
Net exports, NX -151 -559 -2
GDP: The Income ApproachGDP: The Income Approach
Compensation ofemployees 4,449 58.7
Net Interest 405 5.4
Rental Income 127 1.7
Corporate Profits 650 8.6
Proprietors’ income 518 6.8Indirect taxesless subsidies 569 7.5
Capital consumption(depreciation) 858 11.3
Gross domestic 7,576 100.0product
Amount in 1996 Percentage
Item (billions of dollars of GDP
GDP and Its Components (1998)
GDP and Its Components (1998)
Consumption 68 %
Investment16%
GDP and Its Components (1998)
Consumption 68 %
Consumption 68 %
Government Purchases
18%
GDP and Its Components (1998)
Investment16%
Net Exports -2 %
GDP and Its Components (1998)
Consumption 68 %
Investment16%
Government Purchases
18%
Aggregate Expenditure,Aggregate Expenditure,Output, and IncomeOutput, and Income
0
40
60
80
100P
erce
nta
ge o
f G
DP
Aggregateexpenditure
20
NX G
I
C
GDP
GDP
Depreciation
Indirect taxesless subsidiesProprietor’sincomesInterestProfitsRent
Wages and otherlabor income
Aggregateincome
Real versus Nominal GDP
Nominal GDP values the production of goods and services at current prices.
Real GDP values the production of goods and services at constant prices.
Real versus Nominal GDP
An accurate view of the economy requires adjusting nominal to real GDP by using the GDP deflator.
GDP Deflator
The GDP deflator measures the current level of prices relative to the level of prices in the base year.
It tells us the rise in nominal GDP that is attributable to a rise in prices rather than a rise in the quantities produced.
GDP Deflator
100GDP Real
GDP Nominal=deflator GDP
The GDP deflator is calculated as follows:
100X )deflator (GDP) GDP (Nominal
=GDP Real20xx
20xx20xx
Converting Nominal GDP to Real GDP
Nominal GDP is converted to real GDP as follows:
Real and Nominal GDP
YearPrice ofHot dogs
Quantity ofHot dogs
Price of Hamburgers
Quantity ofHamburgers
2001 $1 100 $2 50
2002 $2 150 $3 100
2003 $3 200 $4 150
Real and Nominal GDP
Calculating Nominal GDP:
2001 ($1 per hot dog x 100 hot dogs) + ($2 per hamburger x 50 hamburgers) = $200
2002 ($2 per hot dog x 150 hot dogs) + ($3 per hamburger x 100 hamburgers) = $600
2003 ($3 per hot dog x 200 hot dogs) + ($4 per hamburger x 150 hamburgers) = $1200
Real and Nominal GDP
Calculating Real GDP (base year 2001):
2001 ($1 per hot dog x 100 hot dogs) + ($2 per hamburger x 50 hamburgers) = $200
2002 ($1 per hot dog x 150 hot dogs) + ($2 per hamburger x 100 hamburgers) = $350
2003 ($1 per hot dog x 200 hot dogs) + ($2 per hamburger x 150 hamburgers) = $500
Real and Nominal GDP
Calculating the GDP Deflator:
2001 ($200/$200) x 100 = 100
2002 ($600/$350) x 100 = 171
2003 ($1200/$500) x 100 = 240
(Periods of falling real GDP)
Real GDP in the United States
1970 1975 1980 1985 1990 19953,000
4,000
5,000
6,000
7,000
Billions of 1992 Dollars
2000
8,000
GDP and Economic Well-Being
GDP is the best single measure of the economic well-being of a society.
GDP per person tells us the income and expenditure of the average person in the economy.
GDP and Economic Well-Being
Higher GDP per person indicates a higher standard of living.
GDP is not a perfect measure of the happiness or quality of life, however.
GDP and Economic Well-Being
Some things that contribute to well-being are not included in GDP. The value of leisure. The value of a clean environment. The value of almost all activity that takes place
outside of markets, such as the value of the time parents spend with their children and the value of volunteer work.
GDP, Life Expectancy, and Literacy
Country Real GDP perPerson (1997)
LifeExpectancy
AdultLiteracy
United States $29,010 77 years 99%
Japan 24,070 80 99
Germany 21,260 77 99
Mexico 8,370 72 90
Brazil 6,480 67 84
Russia 4,370 67 99
Indonesia 3,490 65 85
China 3,130 70 83
India 1,670 63 53
Pakistan 1,560 64 41
Bangladesh 1,050 58 39
Nigeria 920 50 59
Summary
Because every transaction has a buyer and a seller, the total expenditure in the economy must equal the total income in the economy.
Gross Domestic Product (GDP) measures an economy’s total expenditure on newly produced goods and services and the total income earned from the production of these goods and services.
Summary
GDP is the market value of all final goods and services produced within a country in a given period of time.
GDP is divided among four components of expenditure: consumption, investment, government purchases, and net exports.
Summary
Nominal GDP uses current prices to value the economy’s production. Real GDP uses constant base-year prices to value the economy’s production of goods and services.
The GDP deflator--calculated from the ratio of nominal to real GDP--measures the level of prices in the economy.
Summary
GDP is a good measure of economic well-being because people prefer higher to lower incomes.
It is not a perfect measure of well-being because some things, such as leisure time and a clean environment, aren’t measured by GDP.
Graphical Review
The Circular-Flow Diagram
Firms Households
Market for Factors
of Production
Market for Goods
and Services
SpendingRevenue
Wages, rent, and
profit
Income
Goods & Services
sold
Goods & Services bought
Labor, land, and capital
Inputs for production
GDP and Its Components (1998)
Net Exports -2 %
Consumption 68 %
Investment16%
Government Purchases
18%
Real GDP in the United States
(Periods of falling real GDP)
1970 1975 1980 1985 1990 19953,000
4,000
5,000
6,000
7,000
Billions of 1992 Dollars
2000
8,000
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