CHAPTER 5
The Wealth of Nations
1
5.1: Defining and Measuring Macroeconomic
Aggregates
What is Economics? Two broad fields:
Microeconomics
Macroeconomics
Macroeconomics: economywide phenomena, explaining
historical data and making forecasts, and comparing
between economies.
2
Defining and Measuring Macroeconomic
Aggregates
Some general macroeconomics questions:
i. Why are some countries poor and others rich? Some grow rapidly,
others slowly, and some not at all.
ii. Will China catch-up with the US.?
iii. What can be done to speed up the economic growth of poor countries
such as Haiti, Rwanda, Uganda?
iv. What causes recessions and how can recessions be quickly overcome?
v. What were the COVID-19 pandemic macroeconomic effects?
3
Defining and Measuring Macroeconomic
Aggregates
 What were the macroeconomic effects COVID-19 pandemic in the
US?
• The COVID-19 pandemic created a global economic recession that
started in 1st quarter of 2020.
• In the U.S., output fell by 10.2% in the 1st and 2nd quarter of 2020.
• The unemployment rate skyrocketed from 3.5% in February 2020
to 14.7% in just two months.
• The stock market fell by about 30% in March 2020 but rebounded
quickly after that.
4
5.2 National Income Accounts
Qn. What is National Income Accounting?
• Three Approaches:
A Production approach
An Expenditure approach
An Income approach
-The three approaches yield identical results.
5
(A) Production Approach
𝑇𝑜𝑡𝑎𝑙 𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒
𝑜𝑓 𝑁𝑒𝑤 𝑃𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛
=
𝑛
𝑖=1
𝑄𝑖𝑡 ∗ 𝑃𝑖𝑡
where:
i≡1,2,3,4,5......, 𝑛𝑡ℎ item (goods and services)
t ≡ time period, usually a year
𝑄𝑖𝑡 ≡ quantity of a given item (i) produced in year (t).
𝑃𝑖𝑡 ≡ price per unit of item (i) produced in year (t)
Multiply 𝑄𝑖𝑡 the quantity of each item produced in a
country by 𝑃𝑖𝑡 its market price, and then sum up the
products all the items.
-The sum ≡ “Gross Domestic Product” (GDP).
6
Definition of GDP
GDP: the total market value of the new final goods and services
produced within a country, during a particular period of time,
usually one year (or quarter).
What gets counted into GDP?
 Total
 Market value
 Goods and Services
 New
 Final goods and services vs. Intermediate
 Produced that year, whether sold or not, i.e., inventory
 Within a country
 In a particular year: New
Definition of GDP vs. GNP
2017
2018
2019
GDP (in $billions)
19.54
20.61
21.43
Plus: income
receipts from the
rest of the world
1.03
1.14
1.17
Minus: income
payments to the
rest of the world
0.74
0.86
0.90
Equals GNP
19.83
20.89
21.70
8
Value Added Approach
•
𝐹𝑖𝑟𝑚′ 𝑠 𝑅𝑒𝑣𝑒𝑛𝑢𝑒
𝑉𝑎𝑙𝑢𝑒
=
−
𝑓𝑟𝑜𝑚 𝑆𝑎𝑙𝑒𝑠
𝐴𝑑𝑑𝑒𝑑
𝐹𝑖𝑟𝑚’𝑠 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠 𝑓𝑜𝑟 𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠 𝑜𝑓
𝑖𝑛𝑡𝑒𝑟𝑚𝑒𝑑𝑖𝑎𝑡𝑒 𝑝𝑟𝑜𝑑𝑢𝑐𝑡𝑠
𝑓𝑟𝑜𝑚 𝑜𝑡ℎ𝑒𝑟 𝑓𝑖𝑟𝑚𝑠
• 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 𝑓𝑟𝑜𝑚 𝑆𝑎𝑙𝑒𝑠 = 𝑖𝑛𝑡𝑒𝑟𝑛𝑎𝑙 𝑐𝑜𝑠𝑡𝑠 + 𝑒𝑥𝑡𝑒𝑟𝑛𝑎𝑙 𝑐𝑜𝑠𝑡𝑠 +
𝑝𝑟𝑜𝑓𝑖𝑡
• 𝐼𝑛𝑡𝑒𝑟𝑛𝑎𝑙 𝐶𝑜𝑠𝑡𝑠 = 𝑤𝑎𝑔𝑒𝑠 + 𝑟𝑒𝑛𝑡 + 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡
• 𝐸𝑥𝑡𝑒𝑟𝑛𝑎𝑙 𝐶𝑜𝑠𝑡𝑠 =
𝑃𝑎𝑦𝑚𝑒𝑛𝑡𝑠 𝑡𝑜 𝑜𝑡ℎ𝑒𝑟 𝑓𝑖𝑟𝑚𝑠 𝑓𝑜𝑟 𝑡ℎ𝑒 𝑖𝑛𝑡𝑒𝑚𝑒𝑑𝑖𝑎𝑡𝑒 𝑔𝑜𝑜𝑑𝑠
•
𝑉𝑎𝑙𝑢𝑒
= 𝑤𝑎𝑔𝑒𝑠 + 𝑟𝑒𝑛𝑡 + 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 +
𝐴𝑑𝑑𝑒𝑑
Value Added Approach
Item
Seller
Bushel of soybeans
Price
Value Added
Farmer Miller
$3
$3
Bag of Soymeal
Miller
$4
$1
Gallon of Soy Sauce
Factory H.E.B
$8
$4
Gallon of Soy Sauce
H.E.B
$10
$2
$25
$10
Total
Buyer
Factory
Ssozi
• The value-added method avoids double counting.
• The value-added method avoids including foreign value (imported
intermediate goods) into GDP.
• The $10 of total value-added is same as the final price of soy sauce at H.E.B
which is what is counted in the expenditure approach.
 Hence, National Expenditure ≡ National Output (production)or value
added ≡ National income. It is an identity
Value Added Approach
• Example 2: Dell Computers
• Let Dell buy intermediate goods from foreign manufacturers in Asia, and Dell
pays $600 to foreign suppliers per laptop. A third-party retailer, such as
BestBuy, purchases a laptop at $900 from Dell and sell it to their clients at
$1000. Direct Purchases of laptops from Dell by users are also at $1000.
• Q1: What is the value-added by Dell?
 Case 1: When a laptop is sold to BestBuy, the value-added by Dell is: VA=$900$600=$300
 Case 2: When a laptop is sold directly to users, the value-added by Dell is:
VA=$1000-$600=$400
• Q2: What is the value added by BestBuy?
VA= $1000-$900= $100
Value Added Approach
• Scenario: Infi Corp. is a leading manufacturer of
smart phones. Every year, customers spend $31
billion on smart phones manufactured by Infi Corp. A
leading retailer generates $10 billion worth of total
sales, while the remaining is generated directly from
consumers. The retailer pays 70 percent of its revenue
to Infi Corp., and Infi Corp. pays $19 billion to its
suppliers.
• Qn.1. Refer to the scenario above. Infi Corp. adds a
value of ________ to the production process.
• Qn.2. Refer to the scenario above. The retailer adds a
value of ________ to the production process.
(B) Expenditure Approach
• The expenditure approach computes GDP (Y) in terms of
purchases of the new final goods and services. It uses four
categories:
• Household consumers (C),
• Private Business Investment (I),
• Government Consumption and Investment(G),
• Foreign residents who buy our Exports (X) minus (-) our
Imports (M).
 Hence, Y(GDP)=C+I+G+(X-M)
US Household consumers (C)
US Private Business Investment (I)
US Government Consumption and
Investment(G)
US Exports (X)
US Imports (M)
U.S. 2019 GDP shares: Expenditure based
Accounting
Blank
Trillion of Dollars
Share of GDP
Gross Domestic Product
$21.4
100%
Consumption
$14.6
68.0%
+ Investment
$3.7
17.5%
+ Government Exp.
$3.8
17.5%
+ Exports
$2.5
11.7%
− Imports
$3.1
14.6%
U.S. GDP shares (1929-2019): Expenditure
based Accounting
Trade Balance: Exports minus Imports
How do we explain the huge post-2020 trade deficit?
The collapse in European GDP in 2020 was nearly twice as large as ours; and our
expected rebound in 2021 is much larger than in Europe. It appears that a big part of
the story was the big decline in our exports to a collapsing European economy (our largest
trading partner).
https://www.census.gov/foreign-trade/statistics/country/index.html
Net Exports (X-M)
Trade Balance (TB): also known as Net Export
• 𝑁𝑒𝑡 𝐸𝑥𝑝𝑜𝑟𝑡𝑠 (𝑇𝐵) = 𝐸𝑥𝑝𝑜𝑟𝑡𝑠(𝑋) − 𝐼𝑚𝑝𝑜𝑟𝑡𝑠(𝑀) = (𝑋 − 𝑀). It
can be positive or negative.
 If X-M>0, we have a trade surplus, and C+I+G would
understate GDP
 ü If X-M<0, we have a trade deficit, and C+I+G would
overstate GDP
• National Expenditure=C+I+G+ X-M =Y = GDP which is
the National Income Accounting identity.
• Therefore, Earnings= market value of output (price of
output)=expenditure to buy them
(C) Income Approach
• This approach sums up all the earnings of
the factors of production, that is, wages
(from labor), rent (from land), interest
(from capital) and profits
(entrepreneurship).
• 𝐺𝐷𝑃 𝑖𝑛𝑐𝑜𝑚𝑒 𝑎𝑝𝑝𝑟𝑜𝑎𝑐ℎ) = 𝑤𝑎𝑔𝑒𝑠 +
𝑟𝑒𝑛𝑡 + 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 + 𝑝𝑟𝑜𝑓𝑖𝑡
• There are two main categories of income
payments:
• labor income
• capital income.
(D) Circular Flows of Income and expenditure
model
Assumptions:
Two sector economy: Households and firms: It
leaves out governments, banks, and foreign
countries
Households own the factors of productions: land,
labor, capital, entrepreneurship.
Firms buy the factors of production from
households and use them to produce goods and
service
There is no savings by both firms and households.
Circular Flows of Income and expenditure
model
(E) Saving versus Investment
• Savings =Y-C-G (Income minus Consumption)
=(C+I+G+X-M)-C-G=I+X-M in an open economy
• If X and M are close in magnitude, then saving=
investment (approximately).
• Closed Economy: X=0; M=0. Hence, S=I
• Dividing both sides of the equation by GDP:
Saving/GDP=Investment/GDP
The Relationship Between the Saving Rate and
the Investment Rate (1929–2015)
5.3 What isn’t measured by GDP?
GDP is a good but imperfect measure of economic activity
because it leaves out a number of details.
i. Physical Capital Depreciation
ii. Home Production
iii. The Underground Economy or shadow economy or
black market
iv. Negative externalities
v. GDP versus GNP
vi. Increase in Income Inequality
vii. Leisure
viii.Does GDP buy happiness?
GDP per capita and Life Satisfaction
As income per
capita increases,
average life
satisfaction
increases at a
decreasing rate.
Hence, the
diminishing
marginal life
satisfaction of
income.
5.4 Real versus Nominal GDP
• 𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃 =
• 𝑅𝑒𝑎𝑙 𝐺𝐷𝑃 =
𝑄𝑖𝑡 ∗ 𝑃𝑖𝑡
𝑄𝑖𝑡 ∗ 𝑃𝑖 𝑏𝑎𝑠𝑒 𝑦𝑒𝑎𝑟
• 𝑅𝑒𝑎𝑙 𝐺𝐷𝑃 𝑝𝑒𝑟 𝑐𝑎𝑝𝑖𝑡𝑎 =
𝑅𝐺𝐷𝑃
𝑇𝑜𝑡𝑎𝑙 𝑃𝑜𝑝𝑢𝑙𝑎𝑡𝑖𝑜𝑛
• Economic growth:
𝑅𝐺𝐷𝑃𝑝𝑐2013 − 𝑅𝐺𝐷𝑃𝑝𝑐2012
∗ 100
𝑅𝐺𝐷𝑃𝑝𝑐2012
Real GDP vs. Real GDP per Capita
Country Name
United States
United States
United States
Series Name
2018 [YR2018]
GDP (constant 2010 US$)
GDP per capita (constant 2010 US$)
Population, total
China
China
China
Germany
Germany
Germany
India
India
India
GDP (constant 2010 US$)
GDP per capita (constant 2010 US$)
Population, total
GDP (constant 2010 US$)
GDP per capita (constant 2010 US$)
Population, total
GDP (constant 2010 US$)
GDP per capita (constant 2010 US$)
Population, total
**Compare Germany with China
1.785648E+13
54659.19827
326687501
1.0873E+13
7806.953095
1392730000
3.93724E+12
47490.51712
82905782
2.82217E+12
2086.45075
1352617328
Real GDP per Capita
Advantages of Real GDP per capita
 Assuming a low degree of income inequality, Real GDP per capita is a good
indicator about the standard of living (income per person) of a country.
 Real GDP per capita enables us to compare the economic performance of two or
more countries with significantly different sizes of population, e.g. China, The US,
and Germany.
 Real GDP per capita provides better information about the economic growth of
a country than Nominal GDP because it adjusts for both inflation (price changes)
and population changes (size/number of residents).
 Hence, we can Real GDP per capita compare economic performance over
time and across countries.
Real GDP per Capita
Limitations of Real GDP per capita
 It is a measure of average income but does not tell us how that income is
distributed.
 It doesn’t tell us what one can buy with a given amount of money in a given
country. The cost of living differs from country to country, even between
countries with equal Real GDP per capita.
 People not only care about income and consumption but also other values
e.g. self-esteem, social status, freedom and rights, safety, etc. which are not
measured/included in GDP per capita.
Price Indexes
Price Indexes:
- GDP Deflator
- Consumer Price Index
- Producer Price index
a) The GDP deflator
• Q: What if it is the price increases in the overall economy
that we are interested in, instead of the change in
output?
• 𝐺𝐷𝑃 𝐷𝑒𝑓𝑙𝑎𝑡𝑜𝑟 =
𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃
𝑅𝑒𝑎𝑙 𝐺𝐷𝑃
∗ 100
b) Consumer Price Index
• 𝐶𝑃𝐼 =
𝑐𝑜𝑠𝑡 𝑜𝑓 𝑎 𝑓𝑖𝑥𝑒𝑑 𝑏𝑎𝑠𝑘𝑒𝑡 𝑎𝑡 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑝𝑟𝑖𝑐𝑒𝑠
𝑐𝑜𝑠𝑡 𝑜𝑓 𝑎 𝑓𝑖𝑥𝑒𝑑 𝑏𝑎𝑠𝑘𝑒𝑡 𝑎𝑡 𝑏𝑎𝑠𝑒 𝑦𝑒𝑎𝑟 𝑝𝑟𝑖𝑐𝑒𝑠
• 𝐶𝑜𝑠𝑡 𝑎𝑡 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑝𝑟𝑖𝑐𝑒𝑠
= 𝑄𝑖 𝑏𝑎𝑠𝑒 𝑦𝑒𝑎𝑟 ∗ 𝑃𝑖 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑦𝑒𝑎𝑟 )
• 𝐶𝑜𝑠𝑡 𝑎𝑡 𝑏𝑎𝑠𝑒 𝑦𝑒𝑎𝑟 𝑝𝑟𝑖𝑐𝑒𝑠
= 𝑄𝑖 𝑏𝑎𝑠𝑒 𝑦𝑒𝑎𝑟 ∗ 𝑃𝑖 𝑏𝑎𝑠𝑒 𝑦𝑒𝑎𝑟 )
• 𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒 =
𝐶𝑃𝐼𝑡+1 −𝐶𝑃𝐼𝑡
𝐶𝑃𝐼𝑡
∗ 100
Consumer Price Index
Goods
Price in 2003
$
Hamburgers 2
Jeans
30
Gasoline
1
Quantity
purchased
in 2003
20
15
150
Price in 2004
$
1
35
2
Quantity
purchased
in 2004
30
10
150
i. Compute the Consumer Price Index (CPI) for 2004 using 2003 as the base period.
What is the CPI for 2003?
ii. Interpret the CPI you have got for 2004 in (i) above. Compute the inflation rate.
iii. Compute the real spending in 2003 and 2004.
𝑅𝑒𝑎𝑙 𝑆𝑝𝑒𝑛𝑑𝑖𝑛𝑔𝑔𝑖𝑣𝑒𝑛 𝑦𝑒𝑎𝑟 =
𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝑆𝑝𝑒𝑛𝑑𝑖𝑛𝑔𝑔𝑖𝑣𝑒𝑛 𝑦𝑒𝑎𝑟 =
𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝑆𝑝𝑒𝑛𝑑𝑖𝑛𝑔𝑔𝑖𝑣𝑒𝑛 𝑦𝑒𝑎𝑟
∗ 100
𝐶𝑃𝐼𝑔𝑖𝑣𝑒𝑛 𝑦𝑒𝑎𝑟
𝑄𝑖 𝑔𝑖𝑣𝑒𝑛 𝑦𝑒𝑎𝑟 ∗ 𝑃𝑖 𝑔𝑖𝑣𝑒𝑛 𝑦𝑒𝑎𝑟
GDP deflator and CPI
Key differences between GDP deflator and CPI: key difference is in the types
of “baskets”
i. The CPI measures expenditures by consumes only, while the GDP deflator
includes everything that is produced in the economy even things such as
submarines and aircraft carriers, that households do not buy.
 The GDP deflator includes things not purchased by households, like trains, subways, and submarines
ii. The CPI includes imported goods, but the GPD deflator does not. GDP
counts only domestic production.
iii. The CPI uses a fixed weight (quantity of the base year) basket of goods and
services, but the GDP deflator does not. Even if a product is considered by
both CPI and deflator, it is likely to have different weights(quantities) in the
two measures.
GDP deflator and CPI
Criticisms/Limitations of the CPI:
i. Which goods to include? Who is a typical consumer?
ii. Does not account for changes in patterns of consumption: these are mainly
due to substitution and innovation (new products and quality change)
c) Inflation
• Inflation: is the rate of increase in the
general (average) price level. It is computed
as the year-over-year (month-over-month)
percentage increase in the price index.
• 𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒 =
𝐶𝑃𝐼𝑡+1 −𝐶𝑃𝐼𝑡
𝐶𝑃𝐼𝑡
Measures of inflation for the
United States from 1960-2010
CPI
GDP Deflator
PPI
0
Year
d) Producer Price Index (PPI): measures changes in the prices of goods and services
purchased by firms e.g. industrial machinery, inputs etc. The PPI is a good predictor
of the CPI because increases in input prices eventually make it to the consumers.
The annual U.S. inflation rates (1930-2019)
Inflation rates:
 using the GDP
deflator (plotted in
blue);
 using CPI (plotted
in red)
 The two have a
similar historical
pattern
15
10
5
0
-5
-10
-15
1930
1934
1938
1942
1946
1950
1954
1958
1962
1966
1970
1974
1978
1982
1986
1990
1994
1998
2002
2006
2010
2014
2018
Inflation: % change in prices
20
Year
(e) Adjusting nominal variables
•
𝑉𝑎𝑙𝑢𝑒 𝑖𝑛 2009 𝑑𝑜𝑙𝑙𝑎𝑟𝑠
𝑃𝑟𝑖𝑐𝑒 𝑖𝑛𝑑𝑒𝑥 𝑖𝑛 2009
=
𝑉𝑎𝑙𝑢𝑒 𝑖𝑛 1969 𝑑𝑜𝑙𝑙𝑎𝑟𝑠
𝑃𝑟𝑖𝑐𝑒 𝑖𝑛𝑑𝑒𝑥 𝑖𝑛 1969
• 𝑉𝑎𝑙𝑢𝑒 𝑖𝑛 2009 𝑑𝑜𝑙𝑙𝑎𝑟𝑠 =
𝑃𝑟𝑖𝑐𝑒 𝐼𝑛𝑑𝑒𝑥 𝑖𝑛 2009
𝑃𝑟𝑖𝑐𝑒 𝑖𝑛𝑑𝑒𝑥 𝑖𝑛 1969
∗ 𝑉𝑎𝑙𝑢𝑒 𝑖𝑛 1969 𝑑𝑜𝑙𝑙𝑎𝑟𝑠
• Example: What is the real value in 2009 dollars of a salary of $20,520
in 1969?
• Real value in 2009=(214.5/26.7)*20520=$119,933
• Hence the $20,520 salary in 1969 has equivalent purchasing power
to $119,933 in 2009