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					EC 102


Lecture 2
Transactions: The Circular-Flow Diagram




The circular-flow diagram is a model that represents
the transactions in an economy by flows around a circle.
An Expanded Circular-Flow Diagram: The Flows
of Money Through the Economy
Gross Domestic Product
Gross domestic product , or GDP, measures the value of all
final goods and services produced in the economy by the factors
of production located in that country. It does not include the value
of intermediate goods.
Gross national product , or GNP, measures the value of all
final goods and services produced in the economy by the factors
of production owned by the citizens of that country. It does not
include the value of intermediate goods.
GNP-Net Factor Income=GDP
Net Factor Income= Turkish factors abroad-Good produced in
Turkey by foreign factors
 Gross Domestic Product
Total value of final goods and services newly produced
  in the country over a specified period of time (1 year)
Final goods – avoid double counting
“Domestic” – within the borders of the country
Value of production = value of spending = value of
  income
Production – sum up value of all final goods and
  services produced in each sector
Spending – sum up value of spending by all sectors
Income – sum up compensation received by all
  involved in production and services.
Calculation of GDP
   Total expenditure
     Consumption   by households (C)
     Investment expenditures by firms (I) – on
      capital goods, not intermediate goods
     Government expenditures (G)
     Exports (X)
     Imports (Z)
    Y=C+I+G+X-Z
Calculating its Value – Three
Approaches
 Income Approach – adding up production-related
   domestic incomes (wages, rents, profits) earned
   by all individuals and organizations
 Closed vs. open economy
 Need to taken into account
 - Net income from RoW : to be deducted
 - Depreciation: consumption of fixed capital – to be
   added
 GDP = NI – Net income from RoW + Depreciation
Calculating its Value – Three
Approaches
 Product Approach – Rather than looking at the
   final sale, utilize a “value-added” approach
 Q: how much each industry contributes the the value
   of the final good or service?
 Start from the raw material and see how much
   market value is added at each stage
 Value of sold – value of intermediate inputs used
 Value added at each stage must sum up to the final
   value of the final product
 Input-Output tables
Calculating its Value – Three
Approaches
Use of imputation to estimate the value of some
  components
Esp. Government production is imputed by summing
  up the payments to workers, payments for
  intermediate goods and services, allowance for
  depreciation of assets
What about household production for own use? Not
  counted at all!
GDP = Business production + household and
  institutions production + government production
Calculating GDP
U.S. GDP in 2004: Two Methods of Calculating GDP
Growth, Price Changes and Real
GDP
Nominal vs. Real GDP
Nominal GDP – total production valued at current
   prices (current meaning the year in consideration)
!! Not only the level of output but also the price levels
   change from one year to another.
Real GDP – Actual value of goods and services
   produced which is net of price changes
GDP = Σ (P x Q)
Real vs. Nominal GDP

Real GDP: the value of the final goods and services produced
calculated using the prices of some base year.
Nominal GDP: output valued at current prices.
Real GDP per capita is a measure of average output per
person, but is not by itself an appropriate policy goal.
Growth, Price Changes and Real
GDP
Calculate Real GDP using constant prices from a base
  year/reference year
For the base year Nominal and Real GDP are same!
Calculating GDP and Real GDP in a
Simple Economy
Real vs. Nominal GDP
Real vs. Nominal GDP
The Relationship between Real GDP and
Unemployment, 1949-2004
Issues with GDP
 Black market
 Unregistered works
 Not marketed services
 Quality of life
Growth, Price Changes and Real
GDP
GDP Growth – changes in GDP over time, percentage
  change in the value of GDP from one year to another.
Percentage change = [(Value2-Value1)/Value1]*100
Annual growth and quarterly growth
Growth, Price Changes and Real
GDP
 Use of price indices – to measure the changes in
  prices as compared to another period.
 CPI – consumer price index: measuring changes
  in prices of goods and services bought by
  households.
 Weighted average of a bundle of goods and
  services
Inflation – growth rate of prices
When weights are constant, tend to
  overstate inflation – because people may
  look for cheaper substitutes!
Updating the market basket periodically
  using information from household
  budget/expenditure surveys
Growth, Price Changes and Real
GDP
 Other indices are used: e.g. PPI – using prices
   facing domestic producers
 Baskets are different, inflation rates differ!
 GDP Deflator – implicit price deflator
 GDP Deflator = (Nominal GDP / Real GDP) *100
 Reflects changes in all the prices of goods and
   services included in GDP.
Price Indexes and the Aggregate
Price Level
A price index is the ratio of the current cost of that market
basket to the cost in a base year, multiplied by 100. It allows to
track the change in price of a weighted average of many goods
Calculating the Cost of a Market
Basket
The Makeup of the Consumer Price
Index in 2004
TURKEY
                                                                     100.00




FOOD AND NON-ALCOHOLIC BEVERAGES                                      28.63


ALCOHOLIC BEVERAGES AND TOBACCO                                        5.00


CLOTHING AND FOOTWEAR                                                  8.07


HOUSING, WATER, ELECTRICITY, GAS AND OTHER FUELS                      16.60


FURNISHINGS, HOUSEHOLD EQUIPMENT, ROUTINE MAINTENANCE OF THE HOUSE     7.42


HEALTH                                                                 2.54


TRANSPORT                                                             12.59


COMMUNICATIONS                                                         4.30


RECREATION AND CULTURE                                                 2.81


EDUCATION                                                              2.24


HOTELS, CAFES AND RESTAURANTS                                          5.64


MISCELLANEOUS GOODS AND SERVICES                                       4.16
The CPI, 1913–2004
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                                             CPI-PPI: 1982-2004




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                  1.9
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                                                             CPI-PPI: 2003-2008




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The CPI, the PPI, and the GDP
Deflator
Growth, Price Changes and Real
GDP
 Other indices are used: e.g. PPI – using prices
   facing domestic producers
 Baskets are different, inflation rates differ!
 GDP Deflator – implicit price deflator
 GDP Deflator = (Nominal GDP / Real GDP) *100
 Reflects changes in all the prices of goods and
   services included in GDP.
Biases in price indices
   Bias = A consistent form of error (i.e. being usually too
    high)
   New Product Bias: CPI ignores new products until they
    become cheap enough to be popular
      Causes CPI to overestimate inflation
   Quality Improvement Bias: If the price of a product goes
    up because it's better, then it's no inflation
      Causes CPI to overestimate inflation
   Substitution Bias: People switch between substitutes in
    response to high or low prices
      Causes CPI to overestimate inflation
Comparing Economies Across Time
and Space
What about Turkey?
   Following graphs (Tablo 1 and Grafik 2-5) are from

    Pamuk, Sevket. 2007. “Dunyada ve Turkiye’de Iktisadi
    Buyume (1820-2005)”, Uluslararasi Ekonomi ve Dis
    Ticaret Politikalari, 1(2): 3-26

For a similar text in English:
  Pamuk, Ş., 2006. “Estimating Economic Growth in the
  Middle East since 1820,” The Journal of Economic
  History 66: 809-28.
Pamuk, Sevket. 2007. “Dunyada ve Turkiye’de Iktisadi Buyume (1820-2005)”, Uluslararasi Ekonomi ve Dis Ticaret Politikalari, 1(2): 3-26
Pamuk, Sevket. 2007. “Dunyada ve Turkiye’de Iktisadi Buyume (1820-2005)”, Uluslararasi Ekonomi ve Dis Ticaret Politikalari, 1(2): 3-26
Pamuk, Sevket. 2007. “Dunyada ve Turkiye’de Iktisadi Buyume (1820-2005)”, Uluslararasi Ekonomi ve Dis Ticaret Politikalari, 1(2): 3-26
Pamuk, Sevket. 2007. “Dunyada ve Turkiye’de Iktisadi Buyume (1820-2005)”, Uluslararasi Ekonomi ve Dis Ticaret Politikalari, 1(2): 3-26
Pamuk, Sevket. 2007. “Dunyada ve Turkiye’de Iktisadi Buyume (1820-2005)”, Uluslararasi Ekonomi ve Dis Ticaret Politikalari, 1(2): 3-26
U.S. Real GDP per Capita
Income Around the World
Rule of 70
The Rule of 70 tells us that the time it takes a variable that
grows gradually over time to double is approximately 70 divided
by that variable’s annual growth rate.
Average Annual Growth Rates of Real
GDP per Capita, 1975–2003
The Sources of Long-Run Growth
- Definitions:
Labor productivity
Physical capital
Human capital
Technology
Accounting for Growth: The
Aggregate Production Function

The aggregate production function is a
hypothetical function that shows how productivity
(real GDP per worker) depends on the quantities
of physical capital per worker and human capital
per worker as well as the state of technology.
Physical Capital and Productivity
Technological Progress and
Productivity Growth
Why Growth Rates Differ
A number of factors influence differences among
countries in their growth rates.
savings and investment spending,
foreign investment,
education,
infrastructure,
research and development,
as well as foster political stability, and
the protection of property rights.
Poor Countries Regulate Business the Most…




Source: Doing Business database of the World Bank, 2004.
Success, Disappointment, and Failure
Success, Disappointment, and
Failure
East Asian economies have done many things right and
achieved very high growth rates.
In Latin America, where some important conditions are
lacking, growth has generally been disappointing.
In Africa, real GDP per capita has declined for several decades,
although there are some signs of progress now.


The convergence hypothesis fits the data only when factors
that affect growth, such as education, infrastructure, and
favorable policies and institutions, are held equal across countries.
Economics in Action: Are
economies converging?

				
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