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  • 1. Chapter 2 The Measurement and Structure of the National Economy
  • 2. National Income Accounting
    • National income accounts : an accounting framework used in measuring current economic activity.
    • These accounts are set up in a way that mirrors the structure of the economy, so they help us understand how the macroeconomy works.
  • 3. How to measure economic activity ? Producers Consumers $ Output Produced Incomes received Expenditures
  • 4. How to measure economic activity ?
    • Product Approach : measure the amount of output produced , excluding output used up in intermediate stages of production.
    • Income Approach : measure the incomes received by the producers of output.
    • Expenditure Approach : measure the amount of spending by the ultimate purchasers of output.
  • 5. How to measure economic activity ?
    • In principle, the 3 approaches should yield the same measurement of current economic activity.
    • In practice, there might be some discrepancies due to incomplete or misreported data.
  • 6. An Example OrangeInc JuiceInc Consumers $ orange orange $ juice
  • 7. An Example
    • OrangeInc Transactions
    • Wage bill $15,000
    • Tax payment $ 5,000
    • Revenue
    • Orange sold to public $10,000
    • Orange sold to JuiceInc $ 25,000
    • Total $ 35,000
    • JuiceInc Transactions
    • Wage bill $ 10,000
    • Tax payment $ 2,000
    • Oranges purchased
    • from OrangeInc $ 25,000
    • Revenue $ 40,000
  • 8. An Example : Income Approach
    • The income approach measures economic activity by adding all income generated by production, including
      • wages received by workers
      • (after-tax) profits received by owners of firms
      • tax revenues received by the government
  • 9. An Example: Income Approach
    • OrangeInc Transactions
    • Wage bill $15,000
    • Tax payment $ 5,000
    • Revenue
    • Orange sold to public $10,000
    • Orange sold to JuiceInc $ 25,000
    • Total $ 35,000
    • Profits = Revenue - wage - tax
    • = $ 35,000 - $15,000 - $5,000
    • = $ 15,000
    • JuiceInc Transactions
    • Wage bill $ 10,000
    • Tax payment $ 2,000
    • Oranges purchased
    • from OrangeInc $ 25,000
    • Revenue $ 40,000
    • Profits = Revenue – wage – inputs
    • - tax
    • = $ 3,000
  • 10. An Example : Income Approach
    • Total Income:
    • Profits for OrangeInc $ 15,000
    • Profits for JuiceInc $ 3,000
    • Wage received by
    • OrangeInc Employees $ 15,000
    • Wage received by
    • JuiceInc Employees $ 10,000
    • Taxes from OrangeInc $ 5,000
    • Taxes from JuiceInc $ 2,000
    • Total $ 50,000
  • 11. An Example: Expenditure Approach
    • The expenditure approach measures activity by adding the amount spent by all ultimate users of output.
    • In this example, the ultimate users are the consumers.
    • Total Expenditures
      • Buy oranges from OrangeInc $ 10,000
      • Buy juices from JuiceInc $ 40,000
      • Total $ 50,000
  • 12. An Example : Product Approach
    • The product approach measures the amount of output produced, excluding output used up in intermediate stages of production.
    • Q: In this example, is this the same as adding up the revenues of the OrangeInc and JuiceInc ?
    • A: NO.
  • 13. An Example : Product Approach
    • For JuiceInc,
    Revenue / Output $40,000 Oranges $25,000 Value-added $15,000
  • 14. An Example : Product Approach
    • The value added of any producer is the value of its output minus the value of the inputs it purchases from other producers ( intermediate goods ).
    • The product approach computes economic activity by summing the value added by all producers.
  • 15. An Example: Product Approach
    • OrangeInc Transactions
    • Wage bill $15,000
    • Tax payment $ 5,000
    • Revenue
    • Orange sold to public $10,000
    • Orange sold to JuiceInc $ 25,000
    • Total $ 35,000
    • Value-added $ 35,000
    • JuiceInc Transactions
    • Wage bill $ 10,000
    • Tax payment $ 2,000
    • Oranges purchased
    • from OrangeInc $ 25,000
    • Revenue $ 40,000
    • Value-added $40,000-$25,000
    • = $15,000
    Total value added = $50,000
  • 16. Gross Domestic Product (GDP)
    • GDP is the most commonly used measure of aggregate economic activity.
    • GDP data can be obtained from the following website:
      • http:// www.bea.gov/national/index.htm#gdp
  • 17. Nominal GDP of the U.S., 1930-2006
  • 18. GDP: Income Approach
      • The income approach calculates GDP by adding the incomes received by producers, including profits, and taxes paid to the government.
      • 8 categories of income
  • 19. GDP: Income Approach
      • Compensation of employees is the before-tax income of workers (excluding the self-employed). [57% of GDP in 2005.]
      • Corporate Profits represent the remainder of the corporate revenue after wages, interest, rents and other costs have been paid but before taxes have been paid. [10.8% of GDP in 2005.]
      • Proprietor’s income is the income of the non-incorporated self-employed. [7.5% of GDP in 2005.]
  • 20. GDP: Income Approach
      • Taxes on production and imports include indirect business taxes (such as sales taxes) as well as custom duties and taxes on residential real estate. [6.8% of GDP in 2005.]
      • Net interest is interest earned by individuals from businesses and foreign sources minus interest paid by individuals. [4.0% of GDP in 2005.]
  • 21. GDP: Income Approach
      • Rental income of persons
      • Business current transfer payments
      • Current surplus of government enterprises.
      • (See Chapter 2 for details)
  • 22. GDP: Expenditure Approach
    • The expenditure approach measures GDP as total spending on final goods and services produced within a nation during a specified period of time.
    • 4 major categories of spending:
      • Consumption (C)
      • Investment (I)
      • Government purchases of goods and services (G)
      • Net exports (NX)
    • Income-expenditure identity:
    • Y = C + I + G + NX
  • 23. Table 2.1 Expenditure Approach to Measuring GDP in the United States, 2005
  • 24. GDP: Expenditure Approach
    • Consumption: spending by domestic households on final goods and services , including those produced abroad (i.e. imports).
    • 3 categories of consumption spending:
      • Consumer durables , e.g. cars, DVD players, ipod.
      • Nondurable goods , e.g. food, clothing.
      • Services , e.g. education, health care, transportation.
  • 25. GDP: Expenditure Approach
    • Q: In the definition, you said we only count the spending on final goods and services produced within a nation . But now you said we also include imports in the consumption component.
    • A: We include imports in Consumption (C) but we take these out in Net Exports (NX). So imports are cancelled out in C + NX.
  • 26. GDP: Expenditure Approach Domestic Producers Foreign Producers Domestic Households Foreign Households (1) (2) (3) (4) Import = (2) Export = (3) Consumption (C) = (1) + (2) Net Export (NX) = (3) – (2) C + NX = (1) + (3)
  • 27. GDP: Expenditure Approach
    • Investment:
      • Fixed investment: spending for new capital goods
        • Business fixed investment : spending by businesses on structures, equipment and software etc..
        • Residential investment : spending on the construction of new houses and apartment buildings.
        • How about investment made by the government ?
      • Inventory investment: increases in firm’s inventory holdings.
  • 28. GDP: Expenditure Approach
    • Government purchases of goods and services : any expenditure by the government for a currently produced good or service, foreign or domestic.
    • Not all government spending is included in here
      • Transfers (such as Social Security and Medicare benefits, welfare payments) are excluded.
      • Interest payments on the national debt are also excluded.
  • 29. GDP: Product Approach
    • Product Approach :
      • The product approach defines a nation’s GDP as the market value of final goods and services newly produced within a nation during a fixed period to time.
  • 30. GDP: Product Approach
    • Market value (or current value):
      • the value of goods and services at the prices at which they are sold ( market prices ).
      • If we think of market-determined prices as measures of relative economic values , then using market value to measure production will take into account differences in the relative economic importance of different items.
  • 31. GDP: Product Approach
    • Market value:
      • Q: What if some commodities are not sold in formal markets ?
      • A: They are either not included or only partially included in GDP.
      • Examples:
      • Child care performed within the family without pay.
      • Activities that improve the environment.
      • Activities in the underground economy.
  • 32. GDP: Product Approach
    • Final goods and services:
      • Intermediate goods are those used up in the production of other goods in the same period that they themselves were produced.
      • Capital good : good that is itself produced, used to produce other goods but is not used up in the same period that it is produced. Examples: buildings, machinery, software.
      • Capital goods are classified as final goods in the national income accounts.
  • 33. GDP: Product Approach
    • Final goods and services:
      • Inventories are stock of unsold finished goods and raw materials held by firms.
      • Inventory investment is the amount by which inventories increase during the year.
      • Inventory investment is treated as final good.
  • 34. GDP: Product Approach
    • Q: Which of the following is included in the GDP of 2006 ?
      • The sale of a car produced in 2006.
      • The sale of a used car in 2006.
      • The sale of an unused car from a
      • manufacturer’s inventory.
      • The sale of a machine used to produce
      • cars.
      • Services provided by private day-care
      • center.
    YES NO NO YES YES
  • 35. Real vs Nominal GDP
      • So far, all the components in GDP are measured in terms of current market values (current prices).
      • Such variables are called nominal variables .
      • Changes in nominal GDP over time can be due to
        • Changes in the prices of goods and services
        • Changes in the quantities
      • How can we remove the effects of price changes ?
  • 36. Real GDP: An Example
      • 2005 2006
    • Quantity
    • Computers 5 10
    • Bicycles 200 250
    • Price
    • Computers $1,200@ $600@
    • Bicycles $200@ $240@
    • Value
    • Computers 5 x $1200 = $6,000 10 x $600 = $6,000
    • Bicycles 200 x $200 = $40,000 250 x $240 = $60,000
    • Nominal GDP $6,000 + $40,000 $6,000 + $ 60,000
    • = $46,000 = $ 66,000
  • 37. Real GDP: An Example
    • Percentage change of Nominal GDP
      • from 2005 to 2006
      • New Value – Old Value
      • Old Value
      • $ 66,000 - $ 46,000
      • $ 46,000
      • = 43.5%
    x 100% = = x 100%
  • 38. Real GDP & Price Indices
      • To remove the effects of price changes:
        • Pick one year as the base year
        • Calculate the value of production in each year by using the prices from the base year.
  • 39. Real GDP: An Example
      • 2005 (Base Year) 2006
    • Quantity
    • Computers 5 10
    • Bicycles 200 250
    • Price
    • Computers $1,200@ $1,200@
    • Bicycles $200@ $200@
    • Value
    • Computers 5 x $1200 = $6,000 10 x $1,200 = $12,000
    • Bicycles 200 x $200 = $40,000 250 x $200 = $50,000
    • Real GDP $6,000 + $40,000 $12,000 + $ 50,000
    • = $46,000 = $ 62,000
    • (No change)
  • 40. Real GDP: An Example
      • 2005 2006 (Base Year)
    • Quantity
    • Computers 5 10
    • Bicycles 200 250
    • Price
    • Computers $600@ $600@
    • Bicycles $240@ $240@
    • Value
    • Computers 5 x $600 = $3,000 10 x $600 = $6,000
    • Bicycles 200 x $240 = $48,000 250 x $240 = $60,000
    • Real GDP $3,000 + $48,000 $12,000 + $ 50,000
    • = $51,000 = $ 62,000
    • (No change)
  • 41. Real GDP: An Example
      • 2005 2006 % change
    • Nominal GDP $ 46,000 $ 66,000 43.5%
    • Real GDP $ 46,000 $ 62,000 34.8%
    • (Base year = 2005)
    • Real GDP $ 51,000 $ 66,000 29.4%
    • (Base year = 2006)
  • 42. Real GDP: An Example
    • % change of Nominal GDP = 43.5%
    • % change of Real GDP using 2005 as base year
      • $ 62,000 - $ 46,000
      • $ 46,000
    • % change of Real GDP using 2006 as base year
    • $ 66,000 - $ 51,000
    • $ 51,000
    x 100% = 34.8 % = = x 100% = 29.4 %
  • 43. Real and Nominal GDP in the U.S., 1930-2006 . Real GDP Nominal GDP
  • 44. Real vs Nominal GDP
    • To summarize:
      • Real GDP measures the physical volume of an economy’s final production using the prices of a base year.
      • Nominal GDP is the dollar value of an economy’s final output measured at current market prices.
      • Nominal GDP = Real GDP for the base year.
  • 45. Price Indexes & Inflation
    • A price index is a measure of the average level of prices for some specified set of goods and services , relative to the prices in a specified base year.
    • Inflation is the percentage change in the price index per period.
    • Two most common price indexes:
      • GDP Deflator
      • Consumer Price Index (CPI)
  • 46. GDP Deflator
    • The GDP deflator is a price index that measures the overall level of prices of goods and services included in GDP.
    • Like real GDP, the measurement of the GDP deflator depends on the choice of a base year.
    GDP Deflator = Nominal GDP Real GDP x 100
  • 47. GDP Deflator: An Example
      • 2005 2006 % change
    • Nominal GDP $ 46,000 $ 66,000 43.5%
    • Real GDP $ 46,000 $ 62,000 34.8%
    • (Base year = 2005)
    • GDP Deflator 100 106.5 6.5%
    • (Inflation)
  • 48. Consumer Price Index (CPI)
    • CPI measures the prices of consumer goods .
    • Every month the Bureau of Labor Statistics collect the current prices of a fixed basket of consumer goods an services such as food, housing and fuel.
    • The BLS also collects information on consumers’ expenditure patterns.
    • This information is used to weight the prices.
  • 49. Consumer Price Index (CPI)
    • The CPI is intended to reflect the costs of living.
    • Many government payments and taxes are tied, or indexed, to the CPI. For example, social security benefits are raised every year by the same % as the CPI.
    • But there are reasons to believe that increases in the CPI might overstate the actual rate at which the cost of living rises.
  • 50. Consumer Price Index (CPI)
    • This can arise when the CPI fails to account for quality improvements in goods and services.
    • Example:
      • The processing speed of computer is increased by 10% and the price of computer increases accordingly.
      • The price increase should not be considered as an increase in the cost of living.
      • If the BLS fail to account for the improved quality of computer but simply note the price increase, then the price change will be incorrectly interpreted as inflation.
  • 51. Consumer Price Index (CPI)
    • Monthly data on the CPI can be obtained from the following website:
    • http:// www.bls.gov
  • 52. What we have learned in this chapter ?
    • The 3 approaches to measure economic activity, namely the product approach, the income approach and the expenditure approach.
    • How to use these approaches to measure GDP.
    • Real vs Nominal GDP
  • 53. Preparing for the Quiz
    • Be familiar with the following concepts:
      • Product, income and expenditure approach
      • Value added of producers
      • Intermediate goods
      • Capital goods
      • Inventory and inventory investment
      • Consumption, investment, government purchases and net export (GDP = C + I + G + NX)
      • Market value of final goods and services
      • Real and nominal variables
      • Price index
  • 54. Preparing for the Quiz
    • Know the differences between
      • Intermediate goods vs Capital goods
      • GDP vs GNP
      • GDP deflator vs Consumer Price Index
    • Know how to compute
      • Nominal GDP
      • Real GDP
      • GDP deflator
      • % Changes in these variables