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Unit 4

John Maynard

Keynes

and

Fiscal Policy

Lesson 3Krugman, Module 10 pp. 101-110

Module 11 pp. 112-116

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Module Objectives• What is GDP?• How is GDP Measured?• The Income Method • The Expenditures Method.• Limitations of the GDP Measure

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KEYNE’S THREE QUESTIONS

• WHERE ARE WE NOW?

• WHERE WERE WE?

• WHERE SHOULD WE BE?

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THE CIRCULAR FLOW

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THE CIRCULAR FLOW

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ExpenditureApproach

IncomeApproach

GDP

= =

+

HouseholdConsumption

BusinessInvestment

GovernmentPurchases

ExpendituresBy Foreigners

+

+

+

+

+

Wages

Rents

Interest

Profits

National Income Accounting

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Gross Domestic Product GDP

• National Income Accounting– A Monetary Measure

– Exclude • Previous year transactions

• Intermediate Goods

• Non-productive transactions

• Non-recorded transactions

• Other countries goods (imports)

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Expenditure Approach

Who Buys Our Stuff?

• Four components:

– Consumption (C)

– Investment (I)

– Government Purchases (G)

– Exports (X)

• These components add up to GDP:

Y = C + I + G + XNY = C + I + G + XN

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Expenditure ApproachPutting It All Together:

GDP = C + Ig + G + Xn

Gross Investment

Ig = Net Investment + Depreciation

(KCA)

Net Exports

Xn = Exports (X) – Imports (M)

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Expenditure Approach

January 1 Year’s GDP December 31

Consumption& Government

Spending

Depreciation

NetInvestment

GrossInvestment

Stock ofCapital

Increased

Stock ofCapital

Gross InvestmentDepreciation

Net Investment

-=

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Income Approach• National Income (NY)

– wages

– rent

– interest

– profits

• Kapital Consumption Allowance

• Indirect Business Taxes

Putting It All Together:

GDP = NY + KCA + IBT

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GDP Approaches Compared

Wages

Rent

Interest

Individual Profit

Corporate Profit

National Income

Indirect Business Taxes

Depreciation

Gross Domestic Product $625

$ 300

25

50

75

95

$545

30

50

Personal Consumption (C)

Gross Private Domestic

Investment (Ig)

Government Purchases (G)

Net Exports (Xn)

Gross Domestic Product

Accounting Statement for the U.S. Economy, 2005in Billions

ReceiptsExpenditures Approach

AllocationsIncome Approach

$ 300

200

150

-25

$ 625

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Then Why Do We Care About GDP?

• Having a large GDP enables a country to afford better schools, a cleaner environment, health care, etc.

• Many indicators of the quality of life are positively correlated with GDP. For example…

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GDP and Life Expectancy in 12 Countries

50

55

60

65

70

75

80

85

90

$0 $10,000 $20,000 $30,000 $40,000

Life expectancy

(in years)

Real GDP per capita, 2002

U.S.

Germany

Japan

Nigeria

Mexico

Russia

Brazil

China

Pakistan

Bangladesh

India

Indonesia

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GDP and Economic Well-Being

• Real GDP per capita is the main indicator of the average person’s standard of living.

• But GDP is not a perfect measure of well-being.

• Robert Kennedy issued a very eloquent yet harsh criticism of GDP:

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Gross Domestic Product…

“… does not allow for the health of

our children, the quality of their

education, or the joy of their play. It

does not include the beauty of our

poetry or the strength of our faith, the

intelligence of our public debate or the

integrity of our public officials. It

measures neither our courage, nor our wisdom, nor our

devotion to our country. It measures everything, in short,

except that which makes life worthwhile, and it can tell us

everything about America except why we are proud that

we are Americans.”- Senator Robert Kennedy, 1968

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GDP Does Not Value:

• the quality of the environment

• leisure time

• non-market activity, such as the child care a parent provides his or her child at home

• an equitable distribution of income

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Shortcomings of GDP

• Nonmarket Activities

• Leisure

• Improved Product Quality

• The Underground Economy

• GDP and the Environment

• Composition and Distribution of the Output

• Noneconomic Sources of Well-Being

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Shortcomings of GDP

Source: Journal of Economic Literature

Underground Economy as a Percentage of GDP - Select Nations

Greece

Italy

Spain

Portugal

Belgium

Sweden

Germany

France

Holland

United Kingdom

Japan

United States

Switzerland

0 5 10 15 20 25 30 Percentage of GDP

GLOBAL PERSPECTIVE