Prepared by:
Fernando & Yvonn Quijano
© 2007 Worth Publishers Essentials of Economics Krugman • Wells • Olney
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With accurate economic data,
Portugal was able to make the
transition from revolution in 1975 to
a prosperous democracy today.
What you will learn in
this chapter:
➤ How economists use aggregate
measures to track the performance of
the economy
➤ What gross domestic product, or
GDP, is and the three ways of
calculating it
➤ The difference between real GDP and
nominal GDP and why real GDP is the
appropriate measure of real economic
activity
➤ The significance of the unemployment
rate and how it moves over the
business cycle
➤ What a price index is and how it is
used to calculate the inflation rate
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The National Accounts
The national income and product
accounts, or national accounts, keep
track of the flows of money between
different sectors of the economy.
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The National Accounts
The Circular-Flow Diagram, Revisited and Expanded
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The National Accounts
The Circular-Flow Diagram, Revisited and Expanded
Consumer spending is household
spending on goods and services.
A stock is a share in the ownership of a
company held by a shareholder.
A bond is borrowing in the form of an
IOU that pays interest.
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The National Accounts
The Circular-Flow Diagram, Revisited and Expanded
Government transfers are payments by the
government to individuals for which no good or service is
provided in return.
Disposable income, equal to income plus government
transfers minus taxes, is the total amount of household
income available to spend on consumption and to save.
Private savings, equal to disposable income minus
consumer spending, is disposable income that is not
spent on consumption.
The banking, stock, and bond markets, which channel
private savings and foreign lending into investment
spending, government borrowing, and foreign borrowing
are known as the financial markets.
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The National Accounts
The Circular-Flow Diagram, Revisited and Expanded
Government borrowing is the amount of
funds borrowed by the government in the
financial markets.
Government purchases of goods and
services are government expenditures on
goods and services.
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The National Accounts
The Circular-Flow Diagram, Revisited and Expanded
Goods and services sold to residents of
other countries are exports; goods and
services purchased from residents of other
countries are imports.
Investment spending is spending on
productive physical capital, such as
machinery and construction of structures,
and on changes to inventories.
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The National Accounts
Gross Domestic Product
Final goods and services are goods and services
sold to the final, or end, user.
Intermediate goods and services are goods and
services—bought from one firm by another firm—
that are inputs for production of final goods and
services.
Gross domestic product, or GDP, is the total
value of all final goods and services produced in
the economy during a given year.
Aggregate spending, the sum of consumer
spending, investment spending, government
purchases, and exports minus imports, is the total
spending on domestically produced final goods and
services in the economy.
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The National Accounts
Calculating GDP
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The National Accounts
Calculating GDP
Measuring GDP as the Value of Production of Final
Goods and Services
The value added of a producer is the value
of its sales minus the value of its purchases
of inputs.
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The National Accounts
Calculating GDP
Measuring GDP as Spending on Domestically
Produced Final Goods and Services
Another way to calculate GDP is by adding
up aggregate spending on domestically
produced final goods and services. That is,
GDP can be measured by the flow of funds
into firms.
The following equation breaks GDP down
by the four sources of aggregate spending:
(15-1)
GDP = C + I + G + X - IM
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The National Accounts
Calculating GDP
Measuring GDP as Factor Income Earned from
Firms in the Economy
Another way to calculate GDP is to add up
all the income earned by factors of
production from firms in the economy—the
wages earned by labor; the interest earned
by those who lend their savings to firms and
the government; the rent earned by those
who lease their land or structures to firms;
and the profit earned by the shareholders,
the owners of the firms’ physical capital.
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The National Accounts
Calculating GDP
The Components of GDP
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The National Accounts
Calculating GDP
The Components of GDP
Net exports are the difference between the
value of exports and the value of imports.
What GDP Tells Us
The most important use of GDP is as a
measure of the size of the economy,
providing us a scale against which to
measure the economic performance of other
years, or compare the economic performance
of other countries.
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Real GDP and Aggregate Output
Calculating Real GDP
TABLE 15-1
Calculating GDP and Real GDP in a Simple Economy
Year 1
Year 2
Quantity of apples (billions)
2,000
2,200
Price of apple
$0.25
$0.30
Quantity of oranges (billions)
1,000
1,200
Price of orange
$0.50
$0.70
GDP (billions of dollars)
$1,000
$1,500
Real GDP (billions of year 1 dollars)
$1,000
$1,150
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Real GDP and Aggregate Output
Calculating Real GDP
Real GDP is the total value of all final goods
and services produced in the economy
during a given year, calculated using the
prices of a selected base year.
Nominal GDP is the value of all final goods
and services produced in the economy
during a given year, calculated using the
prices current in the year in which the output
is produced.
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Real GDP and Aggregate Output
Calculating Real GDP
TABLE 15-2
Nominal versus Real GDP in 1996, 2000, and 2004
Nominal GDP (billions of
current dollars)
Real GDP (billions of
2000 dollars)
1996
$7,817
$8,329
2000
9,817
9,817
2004
11,734
10,842
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Real GDP and Aggregate Output
What Real GDP Doesn’t Measure
GDP per capita is GDP divided by the size
of the population; it is equivalent to the
average GDP per person.
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economics in action
Good Decades, Bad Decades
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The Unemployment Rate
Understanding the Unemployment Rate
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The Unemployment Rate
Growth and Unemployment
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Price Indexes and the Aggregate Price Level
Market Baskets and Price Indexes
A market basket is a hypothetical set of
consumer purchases of goods and services.
TABLE 15-3
Calculating the Cost of a Market Basket
Pre-frost
Post-frost
Price of orange
$0.20
$0.40
Price of grapefruit
$0.60
$1.00
Price of lemon
$0.25
$0.45
Cost of market basket
(200 oranges, 50 grapefruit,
100 lemons)
(200 × $0.20) +
(50 × $0.60) +
(100 × $0.25) = $95.00
(200 × $0.40) +
(50 × $1.00) +
(100 × $0.45) = $175.00
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Price Indexes and the Aggregate Price Level
Market Baskets and Price Indexes
A price index measures the cost of
purchasing a given market basket in a given
year, where that cost is normalized so that it
is equal to 100 in the selected base year.
(15-2) Price index in a given year 
Cost of market basket in a given year
x 100
Cost of market basket in base year
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Price Indexes and the Aggregate Price Level
Market Baskets and Price Indexes
The inflation rate is the percent change per
year in a price index—typically the
consumer price index.
(15-3) Inflation rate 
Price index in year 2 - Price index in year 1
x 100
Price index in year 1
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Price Indexes and the Aggregate Price Level
The Consumer Price Index
The consumer price index, or CPI,
measures the cost of the market basket of a
typical urban American family.
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Price Indexes and the Aggregate Price Level
The Consumer Price Index
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Price Indexes and the Aggregate Price Level
The Consumer Price Index
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Price Indexes and the Aggregate Price Level
Other Price Measures
The producer price index, or PPI,
measures changes in the prices of goods
purchased by producers.
The GDP deflator for a given year is 100
times the ratio of nominal GDP to real GDP
in that year.
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Price Indexes and the Aggregate Price Level
Other Price Measures
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KEY TERMS
National income and product
accounts (national accounts)
Consumer spending
Stock
Bond
Government transfers
Disposable income
Private savings
Financial markets
Government borrowing
Government purchases of goods
and services
Exports
Imports
Investment spending
Final goods and services
Intermediate goods and services
Gross domestic product (GDP)
Aggregate spending
Value added
Net exports
Real GDP
Nominal GDP
GDP per capita
Market basket
Price index
Inflation rate
Consumer price index (CPI)
Producer price index (PPI)
GDP deflator
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