The Measurement and Structure of the National Economy

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					The Measurement and Structure of
     the National Economy
         ECON 202 – Fall 2012
Chapter Outline
 Microeconomics vs. Macroeconomics
 National Income Accounting: The Measurement of
  Production, Income, and Expenditure
 Gross Domestic Product
 Real GDP, Price Indexes, and Inflation
Microeconomics vs. Macro
 Microeconomics focuses on how decisions are made by
  individuals and firms and the consequences of those decisions.
 Macroeconomics, in contrast, examines the aggregate
  behavior of the economy – how the actions of all the
  individuals and firms in the economy interact to produce a
  particular economy-wide level of economic performance.
   Microeconomics vs. Macro
         Microeconomic Questions                        Macroeconomic Questions
Should I go to business school or take a job   How many people are employed in the
right now?                                     economy as a whole this year?
What determines the salary offered by          What determines the overall salary levels
Citibank to Jane Doe, a new Columbia MBA?      paid to workers in a given year?
What determines the cost to a university or    What determines the overall level of prices
college of offering a new course?              in the economy as a whole?
What government policies should be             What government policies should be
adopted to make it easier for low-income       adopted to promote employment and
students to attend college?                    growth in the economy as a whole?
What determines whether Citibank opens a       What determines the overall trade in goods,
new office in Shanghai?                        services, and financial assets between the U.S.
                                               and the rest of the world?
Microeconomics vs. Macro
 A key insight into macroeconomics is that in the short run –
  a time period consisting of several years but typically less
  than a decade – the combined effect of individual decisions
  can have effects that are very different from what any one
  individual intended, effects that are sometimes perverse.
  The behavior of the macroeconomy is greater than the sum
  of individual actions and market outcomes.
   Non-econ example: “rubber-necking”.
   Macro example: the “Paradox of Thrift”
Microeconomics vs. Macro
 Careful study of how markets work has led microeconomists to
  the conclusion that government should typically leave markets
  alone. Except in certain well-defined cases, government
  intervention in markets usually leaves society as a whole worse off.
 In contrast, economists generally believe there is a much wider
  role for government to play in macroeconomics – most
  importantly, to manage short-term fluctuations and adverse
  events in the economy.
   The origins of this view that the government should take an active
    role in the management of the macroeconomy lie in the Great
    Depression of the 1930s.
   The modern macroeconomic toolkit consists of fiscal policy, control of
    government spending and taxation, and monetary policy, control over
    interest rates and the quantity of money in circulation.
Microeconomics vs. Macro
 Microeconomics focuses on problems that take the amount
  of output the economy is capable of producing as given.
 Macroeconomics examines the longer-run problem of how a
  society can increase the total amount of productive resources
  so that it can achieve higher rates of growth and a higher
  standard of living. Moreover, what governments should or
  shouldn’t do to promote long-run growth is also an
  important area of study.
Microeconomics vs. Macro
 A distinctive feature of modern macroeconomics is that both
  its theory and policy implementation focus on economic
  aggregates – economic measures that summarize data
  across many different markets for goods, services, workers,
  and assets.
National Income Accounting
 National income and product accounts: an accounting
  framework used in measuring current economic activity
   In the U.S., calculated by the Bureau of Economic Analysis, a
    division of the Commerce Department
   Keep track of the spending of consumers, sales of producers,
    business investment spending, government purchases, and a
    variety of other flows of money between different sectors of the
National Income Accounting
 To judge whether or not an economy is doing well, it is
  useful to look at Gross Domestic Product (GDP)
 Three alternative approaches give the same measurements
   Product approach: the amount of output produced
   Income approach: the incomes generated by production
   Expenditure approach: the amount of spending by purchasers
 Juice business example shows that all three approaches are
National Income Accounting
 Why are the three approaches equivalent?
   They must be, by definition
   Any output produced (product approach) is purchased by
    someone (expenditure approach) and results in income to
    someone (income approach)
     Production generates income, which in turn results in the purchasing
      power that generates the demand for products. If I pay you $100 to
      prune my apple trees, the expenditure on the orchard service ($100) is
      exactly equal to the income earned from the production of the garden
      service ($100).
     You can see this from the circular flow diagram.
   The fundamental identity of national income accounting:
       total production = total income = total expenditure
Gross Domestic Product
 The product approach to measuring GDP
   GDP (gross domestic product) is the market value of all final
    goods and services produced within a country in a given period
    of time
Gross Domestic Product
 “GDP is the market value…”
   Allows adding together unlike items by valuing them at their
    market prices
   Government services (that aren’t sold in markets) are valued at
    their cost of production
Gross Domestic Product
 Example: The country of Ellensburgistan produces two goods:
  footballs and basketballs. Below is a table showing prices and
  quantities of output for three years:
                  Price of   Quantity of    Price of     Quantity of
                 Footballs    Footballs    Basketballs   Basketballs
       Year 1      $10          120           $12           200

       Year 2       12          200            15           300

       Year 3       14          180            18           275

 Nominal GDP in Year 1 = ($10 × 120) + ($12 × 200) = $3,600
 Nominal GDP in Year 2 = ($12 × 200) + ($15 × 300) = $6,900
 Nominal GDP in Year 3 = ($14 × 180) + ($18 × 275) = $7,470
Gross Domestic Product
 “…of All…”
  GDP includes all items produced and sold legally in the
    There is some adjustment to reflect the underground economy
  The value of housing services is somewhat difficult to measure.
    If housing is rented, the value of the rent is used to measure the value of
     the housing services.
    For housing that is owned (or mortgaged), the government estimates the
     rental value and uses this figure to value the housing services.
Gross Domestic Product
 “…Final…”
   Don’t count intermediate goods and services (those used up in
    the production of other goods and services in the same period
    that they themselves were produced)
   Final goods & services are those that are not intermediate
   Capital goods (goods used to produce other goods) are final
    goods since they aren’t used up in the same period that they are
Gross Domestic Product
 “…Final…”
   Inventory investment (the amount that inventories of unsold
    finished goods, goods in process, and raw materials have
    changed during the period) is also treated as a final good
     Goods that are sold out of inventory are counted as a decrease in
      inventory investment.
     The goal is to count the production when the good is finished, which is
      not necessarily the same time that the product is sold.
   Adding up value added works well, since it automatically
    excludes intermediate goods
Gross Domestic Product
 “…Goods and Services…”
   GDP includes both tangible goods and intangible services.
Gross Domestic Product
 “…Produced…”
  As mentioned above, only current production is counted
  Used goods that are sold do not count as part of GDP
Gross Domestic Product
 “…Within a Country…”
   GDP measures the production that takes place within the
    geographical boundaries of a particular country.
   If a Canadian citizen works temporarily in the U.S., the value of
    his output is included in GDP for the U.S. If an American owns
    a firm in Nicaragua, the value of the production of that firm is
    not included in U.S. GDP.
Gross Domestic Product
 “…in a Given Period of Time.”
   The usual interval of time used to measure GDP is a quarter
    (three months).
   When the government reports GDP growth, the data is
    generally reported on an annual basis.
   In addition, data are generally adjusted for regular seasonal
    changes (such as Christmas).
Gross Domestic Product
 The expenditure approach to measuring GDP
   Measures total spending on final goods and services produced
    within a nation during a specified period of time
   Four main categories of spending: consumption (C), investment
    (I), government purchases of goods and services (G), and net
    exports (NX)
   Y = C + I + G + NX
     the income-expenditure identity
Gross Domestic Product
 The expenditure approach to measuring GDP
   Consumption: spending by domestic households on final goods
    and services (including those produced abroad)
     About 2/3 of U.S. GDP
     Three categories
       Consumer durables (examples: cars, TV sets, furniture, major
       Nondurable goods (examples: food, clothing, fuel)
       Services (examples: education, health care, financial services,
Gross Domestic Product
 The expenditure approach to measuring GDP
   Investment: spending for new capital goods (fixed investment)
    plus inventory investment
     Not to be confused with purchases of stocks, bonds, etc. – these are
      purchases of financial instruments, and are simply exchanges of money…
      not associated with production of output
     About 1/6 of U.S. GDP
     Business (or nonresidential) fixed investment: spending by businesses on
      structures and equipment and software
     Residential fixed investment: spending on the construction of houses and
      apartment buildings
     Inventory investment: increases in firms’ inventory holdings
Gross Domestic Product
 The expenditure approach to measuring GDP
   Government purchases of goods and services: spending by the
    government on goods or services
     About 1/5 of U.S. GDP
     Most by state and local governments, not federal government
     Not all government expenditures are purchases of goods and services
        Some are payments that are not made in exchange for current goods
         and services
        One type is transfers, including Social Security payments, welfare, and
         unemployment benefits
        Another type is interest payments on the government debt
     Some government spending is for capital goods that add to the nation’s
      capital stock, such as highways, airports, bridges, and water and sewer
Gross Domestic Product
 The expenditure approach to measuring GDP
   Net exports: exports minus imports
     Exports: goods produced in the country that are purchased by foreigners
     Imports: goods produced abroad that are purchased by residents in the
     Imports are subtracted from GDP, as they represent goods produced
      abroad, and were included in consumption, investment, and government
Expenditure Approach to Measuring
GDP in the United States, 2011:2
                                                                 Billions of Dollars % of GDP
  Personal consumption expenditures (C)                               10667           71.1%
   Goods                                                              3624.4          24.2%
    Durable goods                                                     1144.3           7.6%
    Nondurable goods                                                   2480           16.5%
   Services                                                           7042.6          47.0%
  Gross private domestic investment (I)                               1895.7          12.6%
   Fixed investment                                                    1840           12.3%
    Nonresidential                                                    1504.9          10.0%
     Structures                                                        400.2           2.7%
     Equipment and software                                           1104.8           7.4%
    Residential                                                        335.1           2.2%
   Change in private inventories                                        55.6           0.4%
  Net exports of goods and services (NX)                              -604.2          -4.0%
   Exports                                                            2082.2          13.9%
    Goods                                                             1474.1           9.8%
    Services                                                            608            4.1%
   Imports                                                            2686.4          17.9%
    Goods                                                             2260.1          15.1%
    Services                                                           426.2           2.8%
  Government consumption expenditures and gross investment (G)        3038.3          20.3%
   Federal                                                            1237.1           8.2%
    National defense                                                   830.6           5.5%
    Nondefense                                                         406.5           2.7%
   State and local                                                    1801.2          12.0%
  Gross domestic product (Y)                                         14996.8         100.0%
  Note: Numbers may not add up due to rounding.
  Source: BEA web site, Table 1.1.5
Gross Domestic Product
 GNP vs. GDP
   GNP (gross national product) = output produced by
    domestically owned factors of production
   GDP = output produced within a nation
   GDP = GNP – NFP
     NFP = net factor payments from abroad
      = payments to domestically owned factors located abroad minus
      payments to foreign factors located domestically
Gross Domestic Product
 GNP vs. GDP
   Example: Engineering revenues for a road built by a U.S.
    company in Saudi Arabia is part of U.S. GNP (built by a U.S.
    factor of production), not U.S. GDP, and is part of Saudi GDP
    (built in Saudi Arabia), not Saudi GNP
   Difference between GNP and GDP is small for the United States,
    about 0.2%, but higher for countries that have many citizens
    working abroad
Gross Domestic Product
 The income approach to measuring GDP
   Adds up income generated by production (including profits and
    taxes paid to the government)
     National income = compensation of employees (including benefits) +
      proprietors’ income + rental income of persons + corporate profits +
      net interest + taxes on production and imports + business current
      transfer payments + current surplus of government enterprises
     National income + statistical discrepancy = net national product
     Net national product + depreciation (the value of capital that wears out
      in the period) = gross national product (GNP)
     GNP – net factor payments (NFP) = GDP
Gross Domestic Product
 The income approach to measuring GDP
   Private sector and government sector income
     Private disposable income = income of the private sector = private sector
      income earned at home (Y or GDP) and abroad (NFP) + payments from
      the government sector (transfers, TR, and interest on government debt,
      INT) – taxes paid to government (T) = Y + NFP + TR + INT – T
     Government’s net income = taxes – transfers – interest payments = T –
      TR – INT
     Private disposable income + government’s net income = GDP + NFP =
Income Approach to Measuring GDP in
the United States, 2005
Real GDP, Price Indexes, and Inflation
 Real GDP
   Nominal variables are those in dollar terms
   Problem: Do changes in nominal values reflect changes in prices
    or quantities?
   Real variables: adjust for price changes; reflect only quantity
Production and Price Data
Real GDP, Price Indexes, and Inflation
 Real GDP
   Nominal GDP is the dollar value of an economy’s final output
    measured at current market prices
   Real GDP is an estimate of the value of an economy’s final
    output, adjusting for changes in the overall price level
   We are going to use real GDP as a proxy for aggregate
    production throughout the course.
Calculation of Real Output with
Alternative Base Years
Real GDP, Price Indexes, and Inflation
 Price Indexes
   A price index measures the average level of prices for some
    specified set of goods and services, relative to the prices in a
    specified base year
   GDP deflator = 100  nominal GDP/real GDP
   Note that base year GDP deflator = 100
Real GDP, Price Indexes, and Inflation
 Price Indexes
   Choice of expenditure base period matters for GDP when
    prices and quantities of a good, such as computers, are changing
   BEA compromised by developing chain-weighted GDP
   Now, however, components of real GDP don’t add up to real
    GDP, but discrepancy is usually small
Real GDP, Price Indexes, and Inflation
 Price Indexes
   Inflation
     Calculate inflation rate:
                 t+1 = (Pt+1 – Pt)/Pt = Pt+1/Pt
     Following Figure shows the quarterly U.S. inflation rate since 1989 for
      the GDP deflator
The Inflation Rate in the United States,
Is GDP a Good Measure of Economic
 GDP per capita (i.e., GDP per person) tells us the income
  and expenditure level of the average person in the economy
 GDP, however, may not be a very good measure of the
  economic well-being of an individual.
   Omits important factors in the quality of life including leisure, the
    quality of the environment, and the value of goods produced but not
    sold in formal markets
   Says nothing about the distribution of income
   GDP tends to measure disasters and other waste as gains
 However, a higher GDP does help us achieve a good life.
  Nations with larger GDP generally have better education and
  better health care, among other things.

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