Chapter 8

Measuring the Economy’s Performance

8-2

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

8-3

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

8-4

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.

8-5

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.

8-6

The Simple Circular Flow (cont'd)

• 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

8-7

Figure 8-1 The Circular Flow of Income and Product

8-8

The Simple Circular Flow (cont'd)

• Product Markets

– Transactions in which households buy goods

8-9

The Simple Circular Flow (cont'd)

• Factor Markets

– Transactions in which businesses buy resources

8-10

The Simple Circular Flow (cont'd)

• Total Income

– Wages, rent, interest, profits

8-11

The Simple Circular Flow (cont'd)

• Question

– Why must total income be identical to the dollar value of total output?

• Answer

– Every transaction simultaneously involves an expenditure and a receipt.

8-12

National Income Accounting

• National Income Accounting– A measurement system used to estimate

national income and its components

• Total Income– The yearly amount earned by the nation’s

resources (factors of production)

8-13

National Income Accounting (cont'd)

• 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

8-14

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.

8-15

National Income Accounting (cont'd)

• 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

8-16

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

8-17

National Income Accounting (cont'd)

Numerous transactions occur that have nothing to do with final goods and services being produced:

• Financial transactions

• Transfer Payments

• Secondhand Goods

8-18

National Income Accounting (cont'd)

• Exclusion of financial transactions

– Securities• Stocks and bonds

– Government transfer payments• Social Security

• Unemployment compensation

– Private transfer payments• Individual gifts

• Corporate gifts

8-19

National Income Accounting (cont'd)

• Transfer of secondhand goods excluded– 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

8-20

National Income Accounting (cont'd)

• GDP’s limitations

– Excludes non-market production

– It is not necessarily a good measure of the well-being of a nation.

8-21

National Income Accounting (cont'd)

• GDP is a measure of the value of production in terms of market prices, and an indicator of economic activity.

• GDP is not a measure of a nation’s overall welfare.

8-22

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

8-23

Two Main Methods of Measuring GDP (cont'd)

Expenditure Approach

8-24

Two Main Methods of Measuring GDP (cont'd)

• Income Approach

– Measuring GDP by adding up all components of national income, including wages, interest, rent, and profits

8-25

Two Main Methods of Measuring GDP (cont'd)

Income Approach

8-26

Two Main Methods of Measuring GDP (cont'd)

Deriving GDP by the Expenditure Approach

– Consumption Expenditure (C)

• Durable Consumer Goods

– Life span of more than three years

• Nondurable Consumer Goods

– Goods that are used up in three years

• Services

– Mental or physical help

8-27

Two Main Methods of Measuring GDP (cont'd)

Deriving GDP by the Expenditure Approach

– 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 included: changes in business inventories and repairs made to machines, buildings

8-28

Two Main Methods of Measuring GDP (cont'd)

Deriving GDP by the Expenditure Approach

– 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

8-29

Two Main Methods of Measuring GDP (cont'd)

Deriving GDP by the Expenditure Approach

– Government Expenditures (G)• State, local, and federal

• Valued at cost

8-30

Two Main Methods of Measuring GDP (cont'd)

Deriving GDP by the Expenditure Approach

– Net Exports (Foreign Expenditures)

Net exports (X) = Total exports – Total imports

8-31

Two Main Methods of Measuring GDP (cont'd)

Presenting the Expenditure Approach

– Where• C = consumption expenditures

• I = investment expenditures

• G = government expenditures

• X = net exports

GDP = C + I + G + X

8-32

Figure 8-2 GDP and Its Components

8-33

Two Main Methods of Measuring GDP (cont'd)

Deriving GDP by the Income Approach

8-34

Figure 8-3 Gross Domestic Product and Gross Domestic Income, 2009 (in billions of 2009 dollars per year)

Sources: U.S. Department of Commerce and author’s estimates.

8-35

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

8-36

Other Components of National Income Accounting (cont'd)

• Disposable Personal Income (DPI)

– Personal income after personal income taxes have been paid

8-37

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

8-38

Distinguishing Between Nominal and Real Values (cont'd)

• Constant Dollars– Dollars expressed in terms of real purchasing

power

– This price-corrected GDP is the real GDP.

8-39

*Price index: measured by the GDP deflator

Real GDP = x 100Nominal GDP

Price index*

Example: Correcting GDP for Price Index Changes

• Correcting GDP for price index changes

– Nominal (current) dollars GDP

– Real (constant) dollars GDP

8-40

Table 8-3 Correcting GDP for Price Index Changes

8-41

Per capita real GDP =Real GDP

Population

Distinguishing Between Nominal and Real Values (cont'd)

• Per capita GDP

– Adjusting for population growth

8-42

Source: U.S. Department of Commerce

Figure 8-4 Nominal and Real GDP

8-43

Comparing GDP Throughout the World

• Foreign Exchange Rate

– The price of one currency in terms of another

8-44

Comparing GDP Throughout the World (cont'd)

• Foreign exchange rate• $1.50 = 1 euro, or $1 = .67 euros

• French income per capita = 24,120 euros

• French per capita income in terms of dollars equals 24,120 euros x $1.50 = $36,180

8-45

Comparing GDP Throughout the World (cont'd)

• Purchasing Power Parity

– Adjustments in exchange rate conversions that takes into account differences in the true cost of living across countries

8-46

Table 8-4 Comparing GDP Internationally

8-47

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

8-48

Summary Discussion of Learning 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

8-49

Summary Discussion of Learning 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.