Chapters 6 and 7

1. Chapters 6 and 7 Introduction to Macroeconomics Measuring Domestic Output and National Income

2. Intro to Macroeconomics Macroeconomics: Study of the economy as a whole • Concerned with variables such as unemployment, inflation and measures of total production 3 Macroeconomic Goals 1) Modern Economic Growth -- ability of economy to produce increasing quantities of goods and services (economic growth) above the increase in population  rise in output per person -- variable used to measure economic growth is known as real GDP or real Gross Domestic Product (a.k.a aggregate or total output) -- leads to increase in avg standard of living

3. 3 Macroeconomic Goals 2) High Employment Unemployment: % of workforce that would like to work but can not find jobs -- some level of unemployment is actually healthy for the economy 3) Stable Prices -- When we refer to changes in the price level, we are referring to inflation Inflation: rise in the general level of prices in economy -- Inflation has an affect on the purchasing power of a currency (i.e. if prices increase from one year to next, $1 today buys less than it did a year ago)

4. Relationship Between Economic Growth and Employment -- High levels of Output = High levels of employment -- Low levels of Output = Low levels of employment Business Cycle -- Periodic fluctuations in output (real GDP) around the long term growth trend. -- Periods of economic expansion and economic recession

5. Real GDP Trend For a Hypothetical Economy

6. Real GDP Trend For a Hypothetical Economy

7. Business Cycles a) Expansion: a period of increasing production or output (i.e. increase in real GDP) -- continues until there is a peak (point where GDP reaches its highest level during an expansion) or pt A -- increase in real GDP is above normal levels b) Recession: a period of declining production or output (i.e. decline in real GDP)  most explicit sign -- continues until there is a trough (point where GDP reaches its lowest level during a recession) or pt B -- recessions can also occur when real GDP is growing at below normal rates Depression: long lasting recession More on this topic in later chapters

8. Measuring GDP Gross Domestic Product (GDP) -- simple definition: measure of total production or output in the economy (aggregate output) -- standard definition: market value of all final goods and services produced for the marketplace during a period of time, within the nation’s borders. Breakdown of definition: a) “market value”: GDP is measured by the dollar value of all final good and services

9. Advantages of using the value of good/service vs. some other measure: 1) gives us a common unit of measurement w/out common measurement  5 bushels of wheat + 5 lbs of apples = ? w/common measurement ($)  $25.00 for wheat + $5.00 for apples = $30.00 -- as stated in the business world  this is now an apples to apples comparison 2) Accounts for the value of higher price goods

10. b) “of all final”: focuses exclusively on the value of the final good or the good sold to the final user. -- excluding the value of intermediate goods used to make the final good Intermediate Goods -- goods used up in producing the final good or goods used as inputs for other goods

11. Example: Truckload of gasoline -- For GDP, we only count the value of the product sold to the final user (step 3) or $28,000 -- value of intermediate goods (i.e. petroleum) are already included in the value of the final good Note: Capital Goods (long-lived goods used in the production of other goods/services) such as buildings, machines, etc are not classified as final goods (they’re used to produce other goods) or intermediate goods (they’re not used up in the production process)  included in GDP when they are initially produced or new.

12. c) “goods and services”: GDP includes both goods and services. -- Services such as lawn care and medical exams -- Goods such as toys, new cars and electronics d) “produced”: GDP includes only goods and services produced Examples of items not produced: 1) Sale of Land – natural resource 2) Financial Assets (stocks/bonds) – right to receive future payments 3) Transfer Payments (Public and Private) – social security payments, welfare payments, birthday money

13. e) “for the marketplace”: GDP only includes goods and services intending to be sold. • does not include goods/services that you provide for yourself but don’t receive payment e.g.) mowing own lawn, washing own car, watching neighbor’s children • does not include volunteer work Note: -- goods/services provided by the Federal/State/Local Govt’s such as education and national defense although not sold in the marketplace are included in GDP

14. f) “during a period of time”: GDP includes goods and services produced during a specific time frame being analyzed -- does not include the value of used goods -- part of GDP in earlier yr when they were new g) “within the nation’s borders”: GDP includes only those goods/services produced within a nation’s borders -- relating to the U.S., goods and services must be “Born in the USA”

15. 2 Approaches to Measuring GDP I) Expenditure Approach -- measure GDP by adding the value of goods and services purchased by each type of final user (Households, Firms, Gov’t and Foreign Sector) -- sum of the money spent to buy the output -- 4 Categories 1) Personal Consumption Expenditure or simply Consumption (C) 2) Gross Private Domestic Investment or simply Investment (Ig) 3) Gov’t Consumption and Gross Investment or simply Gov’t Purchases (G) 4) Net Exports (Xn) GDP = C + Ig + G + Xn

16. 1) Consumption Expenditure or simply Consumption (C) -- largest component of GDP (about 70%) -- part of GDP purchased by households -- subdivided into the following: a) Services (e.g. medical care, education, lawn care)  largest component of C category b) Nondurable goods (e.g. food and clothing) -- Goods with expected lifespan of less than 3 yrs c) Durable Goods (e.g. automobiles, furniture, appliances -- Goods with expected lifespan of 3 or more yrs -- items not part of GDP 1) Used Goods 3) Do it yourself projects 2) Land 4) Financial Securities

17. -- special items included in GDP but are estimated values 1) total value of all food products that farm families produce and consume themselves 2) Value of shelter from owner occupied homes -- New home construction (which normally would fall into this category) is included elsewhere

18. 2) Gross Private Domestic Investment (Ig) -- spending by firms on final goods/services, including new home or residential construction -- purchasing capital stock (goods that will provide useful services in the future) Subdivided into the following: i) Business Fixed Investment -- business purchase of new plant and equipment (e.g. telephone, machinery, buildings & computers) -- largest component of Ig category ii) Residential Investment -- New Home construction is considered an investment because it could be translated into a business venture (rental property) -- not part of C since Gov’t considers it to be capital stock

19. iii) Change in Inventories -- inventories are goods that have been produced but not yet sold. -- require special attention depending on whether we are accumulating inventories or depleting them. a) Increase in inventories (a.k.a capital formation) e.g.) • $2 billion in unsold boats go into inventory • $18 billion in boats sold are accounted for in Consumption (C) and $2 billion needs to be accounted for in Ig category or GDP = $18 billion + $2 billion or $20 billion. • not accounting for ↑ in inventories would underestimate GDP

20. b) Decrease in inventories e.g. • $2 billion over production must have come from inventories • $2 billion is then deducted from GDP as part of inventory changes • GDP = $22 billion (Consumption) - $2 billion (Investment) or $20 billion • Not accounting for ↓ in inventories would overestimate GDP

21. 3) Government Purchases (G) -- spending by Federal, State and Local Gov’t on final goods and services • goods such as police cars, buildings, etc • services such as military, police, agencies, education Transfer Payments: type of gov’t spending involving the redistribution of funds from one group in society to another (e.g. social security, welfare & unemployment) -- since they do not involve the purchase of goods and services, they are not included in GDP

22. 4) Net Exports (Xn) a) Imports: goods produced outside the U.S. but sold in the U.S. -- in GDP, we must subtract their value from the calculation since they’re accounted for in Consumption but were not produced within the country (i.e. must be “Born in the USA”) b) Exports: goods produced within the U.S. but sold to foreign firms, gov’t or households -- in GDP, we must add their value in the calculation since they’re not accounted for anywhere else Net Exports (Xn) = Exports – Imports -- indicator of the balance of trade

23. Example

24. 2006 GDP (Current $)

25. 2 Approaches to Measuring GDP • Income Approach to Calculating GDP -- GDP as measured by the Income derived from producing it -- Whenever a good or service is sold, revenue from the sale is used for factor payments. -- Factor Payments are payments made to the owners of the resources used in producing a good (factors of production) GDP = National Income - Net Foreign Factor Income + Statistical Discrepancy + Consumption of Fixed Capital National Income -- income that flows to domestic or foreign American- owned resources + taxes on production & imports a) Private income (employee compensation, rents, interest, proprietor’s income and corporate profits) b) Govt revenue from taxes on production & imports

26. 2 Approaches to Measuring GDP Net Foreign Factor Income - deduct income Americans gain from supplying resources abroad and adding in income that foreigners gain from supplying resources in the U.S. Statistical Discrepancy -- added to national income to bring into alignment with Expenditure approach to calculating GDP Consumption of Fixed Capital -- allowance made for depreciation of capital -- allowance for capital that is consumed in producing the given year’s GDP -- included in the value of output but not included in national income so we have to add it back in

27. 2 Approaches to Measuring GDP National Income 1) Wages, salaries and incomes of employees - largest component of national income 2) Rents: income received by households and businesses that supply property resource 3) Interest: money paid by private businesses to suppliers of loans to purchase capital 4) Proprietor’s Profit: profit earned by sole proprietorships, partnerships and other unincorporated businesses 5) Corporate Profit: Earnings of Corporation a) Corporate Income Taxes: corporate taxes b) Dividends: after tax profits distributed to shareholders c) Retained Earnings: after tax profits retained by corporations 6) Taxes on Production and Imports: general sales tax, excise taxes, business property taxes, license fees and customs duties - income for Gov’t

28. Example

29. Measuring GDP Summary: GDP = Sum of all final goods and services produced in the economy (some exceptions) GDP = C + Ig + G + NX GDP = National Income - Net Foreign Factor Income + Statistical Discrepancy + Consumption of Fixed Capital

30. GDP: Real versus Nominal • GDP, measured in $ value, can be influenced by changes in quantity, changes in price or both Revenue = price x quantity • Given this influence, it’s important to mitigate changes in price and allow quantity to the sole determinant of changes in GDP. 2 Types of GDP Nominal GDP: GDP as measured by the value of final goods and services at current year prices Real GDP: GDP adjusted for changes in the dollar value or changes in the price level (adjusted for inflation) -- uses base year price levels to measure value of current production -- measure of the actual physical volume of production by mitigating the influence of price changes

31. Index Numbers: way of measuring variable over time by using base period values Index Number = Current Period Value Base Period Value -- Index # in base period is 100 -- base periods are chosen because they represent a “normal” year for the variable in question and therefore is a good benchmark x 100

32. Price Index • Price Index Yr A = Cost of Market Basket in Yr A____ • Cost of Market Basket in Base Year • ratio of the dollar amt necessary to buy the market basket of goods in given year divided by the dollar amt necessary to buy the market basket in base year • Market basket is a collection of goods • Example: Assume the following • -- 1983 is the base year / 1983 Market Basket = $200 billion • -- 1990 Market Basket = $261.4 billion • Price Index1990 = • = • Interpretation: It costs _____% more for the basket of goods in 1990 versus 1983 or prices rose by _____%  • _____% derived as follows x 100 Price Index1983 = = _____in base Yr

33. Using Price Index to Calculate Real GDP • Deflating nominal GDP or adjusting for inflation • Real GDP Yr A = Nominal GDP Yr A • _________________ • Price Index (hundredths) Yr A • Example: Find 1995 Real GDP • Nominal GDP = $350 billion Price Index = 150.00 • Real GDP = 350 / 1.50 • = 233.33 billion • Note: Gov’t uses a price index called chain-type annual-weights, • which is more complex than the price index illustrated here Converting back to decimal

34. Using Base Year Price Levels to calculate Real GDP • Using Base Year price levels (in lieu of current) and the current year quantities to calculate GDP • Price levels in base year are used to calculate the value of the goods and services • Normally real GDP is less than Nominal GDP for years following the base year Example: Find Real and Nominal GDP for 2006 (2000 is base year) Nominal GDP = Real GDP =

35. Notes relating to GDP data on Bureau of Economic Analysis website: • www.bea.gov provides historical and current nominal and real GDP for both quarterly and yearly time frames • Includes GDP info within sectors as discussed via Expenditure approach (i.e. Personal Consumption, Gross Private Domestic Investment, etc) • Includes GDP info by industry • Quarterly info is seasonally and annually adjusted including percent change values. • In order to match quarterly % change values using seasonally annual adjusted values, you need to multiply by 4. • Reference to “chained” values corresponds to Gov’t measure of real GDP using the chained-weighted approach

36. GDP May Not Reflect True Economic Well-Being -- Certain factors associated with societies’ true economic well- being are not part of GDP such as: • Benefits of Leisure Time • Both Individuals and Society benefit from some level of leisurely activities • Non-Market Economic Activities • Volunteer services, unpaid services, underground economies, “under the table” or cash compensations, bartering, etc are all part of society and may understate level of economic activity • Degree of understatement depends on whether you are a developing or industrialized nation  developing nations probably have higher rates of non-market activities

37. 3) Environmental Effects • Both positive and negative 4) Degree of Economic Inequality • Is 90% of the economy controlled by a handful of people or is it more evenly distributed? • Two economies with similar levels of GDP may have different distributions of wealth Importance of GDP • Used to monitor business fluctuations (recessions & expansions) – Not sole indicator of a recession • Makes assumptions about the overall health of the economy • Strong correlation to economic well-being of a country (although not perfect)