EC 102

1. EC 102 Lecture 2

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.

3. An Expanded Circular-Flow Diagram: The Flows of Money Through the Economy

4. 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

5. 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.

6. 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

7. 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

8. 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

9. 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

10. Calculating GDP

11. U.S. GDP in 2004: Two Methods of Calculating GDP

12. 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)

13. 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. • RealGDP per capita is a measure of average output per person, but is not by itself an appropriate policy goal.

14. 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!

15. Calculating GDP and Real GDP in a Simple Economy

16. Real vs. Nominal GDP

17. Real vs. Nominal GDP

18. The Relationship between Real GDP and Unemployment, 1949-2004

19. Issues with GDP • Black market • Unregistered works • Not marketed services • Quality of life

20. 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

21. 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

22. 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

23. 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.

24. 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

25. Calculating the Cost of a Market Basket

26. The Makeup of the Consumer Price Index in 2004

28. The CPI, 1913–2004

29. CPI-PPI: 1982-2004

30. CPI-PPI: 2003-2008

31. The CPI, the PPI, and the GDP Deflator

32. 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.

33. 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

34. Comparing Economies Across Time and Space

35. 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 since1820,” The Journal of Economic History 66: 809-28.

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

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

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

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

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

41. U.S. Real GDP per Capita

42. Income Around the World

43. 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.

44. Average Annual Growth Rates of Real GDP per Capita, 1975–2003

45. The Sources of Long-Run Growth- Definitions: • Labor productivity • Physical capital • Human capital • Technology

46. 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.

47. Physical Capital and Productivity

48. Technological Progress and Productivity Growth

49. 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.

50. Poor Countries Regulate Business the Most… Source: Doing Business database of the World Bank, 2004.