Chapter 2
Measuring the Economy
Introduction
•
•
•
•
•
•
Closed and Open Economies
Sectors of a Economy
Stocks and Flows
GDP and its components
National Wealth
Wealth Accounting
2
Dividing Up the World Economy
• Open and Closed Economies
- We call the economy of the country that we are
interested the domestic economy.
- The collection of all other economies is referred
as the “rest of the world”.
3
Dividing Up the World Economy
• Open and Closed Economies
- When a domestic economy is studies in
isolation from the rest of the world, it is called
a closed economy.
- When we explicitly consider interactions with
other countries, it is called a open economy.
- There are no real closed economies in the
modern world.
- BOX 2-1
4
Dividing Up the World Economy
• Sectors of the Domestic Economy
- The domestic economy is divided into different
sectors for different research purposes.
When we want to know
- how the economy allocates its resources
between consumption and investment  single
decision maker.
- how the government policy affects the
allocations  public and private sectors
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Dividing Up the World Economy
• Sectors of the Domestic Economy
- The private sector is usually divided into
households and firms income determination
- Firms are owned by Households.
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Measuring Gross Domestic Product
• Income, Expenditure, and Product
- A comprehensive set of data on GDP and its
components is recorded in the system of
National Income and Product Account (NIPA).
- Three approaches to measure GDP
1. the income method
2. the expenditure method
3. the product (value-added) method
7
Measuring Gross Domestic Product
• Income, Expenditure, and Product
- Three concepts need to introduced first
- GDP is the value of all final goods and services
produced within the domestic economy in a year.
- Final goods are those sold directly to end users.
- Intermediate goods are used as input by firms
which may be produced by other firms.
- The value added is the difference between the
value of the output that a firm sells and the value
of the intermediate goods used to produce it. 8
Measuring Gross Domestic Product
• The Circular Flow of Income
- See Figure 2-1
- For simplicity, we divide all the production
factors into two type: labor and capital.
- The income earned by labor and capital are
labor income (wage) and rent, respectively.
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The Circular Flow of Income
expenditure
method
income
method
Figure 2.1
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Measuring Gross Domestic Product
• Income method: adding up all of the income
earned by the factors of production.
• Expenditure: adding up all the expenditure on
final goods and services.
• Product (Value-added): sum up the values
added over all firms in the economy.
• Example: BOX 2-2
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Measuring Gross Domestic Product
• Consumption and Investment
- Closed economy :
GDP (Y)
= private consumption expenditure (C)
+ private investment expenditure (I)
+ government expenditure (G)
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Measuring Gross Domestic Product
• Consumption and Investment
- Open economy :
GDP (Y)
= private consumption expenditure (C)
+ private investment expenditure (I)
+ government expenditure (G)
+ the value of exports (X)
- the value of imports (M)
13
Measuring Gross Domestic Product
• Consumption and Investment
- Consumption goods are commodities like beer,
pizza, movies and etc., which meet our
immediate needs.
- Capital goods are commodities like tractors,
power plants, and etc., which help us to
produce more goods in the future.
- Trade off relationship
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Measuring Gross Domestic Product
• The Capital Market
- Financial institutions that channel savings from
households to firms are collectively referred to
as the “capital market”.
- banks, the stock market, pension fund, saving
and loan institutions.
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Measuring Gross Domestic Product
• Saving
- Saving is the act of abstaining from
consumption.
- Households save by putting money in the bank
or by lend it to the government or firms.
- Saving does not constitute investment.
16
Measuring Gross Domestic Product
• Investment
- Investment is the result of purchasing a new
capital good.
Example:
- A household buys a new house.
- A company buy a machine, a factory, a building.
- The government builds a new school or a
hospital.
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Saving and Investment in the
Circular Flow
Figure 2.2
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Measuring Gross Domestic Product
• Wage and Rent
- In a closed economy, the GDP is equal to the
income earned by its residents.
The income earned by the factor of production
is broken into several components:
- the largest component represents payments to
the services of labor.
- Other categories include net interest, rent,
corporate profit and proprietor’s income.
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Measuring Gross Domestic Product
• Wage and Rent
- For simplicity, we distinguish only two types
of income: labor income (wage) and capital
income (rent).
- In U.S., labor share of GDP is approximately
60% and capital share is approximately 40%.
- BOX 2-3
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FOCUS ON THE FACTS How Big are the
Components of the U.S. Economy?
Box 2.3
21
The Components of GDP
• In a closed economy, saving and investment
are always equal.
• In open economies, the idea extends to
relationships among the government budget
deficit, the trade surplus and private saving.
22
Saving and Investment in a Closed Economy
• Expenditure can be divided into three
categories:
private consumption expenditure
private investment expenditure
government expenditure
Y  C  I G
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Saving and Investment in a Closed Economy
GC
Y  C C
C
S
NAT
NAT
S
I
GOV
GOV
I
GOV
I I
NAT
Y C
NAT
GOV
I
NAT
NAT
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Saving and Investment in an Open Economy
• Countries can invest more than they save by
borrowing from abroad.
• When a Gov. spends more than it earns, the
excess expenditure is the Gov.’s budget deficit.
• When a nation as a whole spends more on
foreign goods and services than it earns by
selling exports, the excess of expenditures over
income is the nation’s trade deficit.
• Budget deficit has a significant impact on trade
deficit.
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26
Saving and Investment in an Open Economy
Y C
 S
S
NAT
NAT
NAT
I
I
NAT
 NX
I
NAT
 NX
NAT
 NX  0
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Government and the Private Sector
• Disposal income (YD) is the income that is
available to the private sector after the
government takes out taxes and put back
transfer payments to individuals and firms.
YD  Y  TR  T
S  YD  C
( S  I )  (T  TR  G )  NX
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Government and the Private Sector
( S  I )  (T  TR  G )  NX
Budget surplus
Trade Surplus
• Two sources of government deficit
- S-I
- NX
(G  TR  T )  ( S  I )  NX
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Government and the Foreign
Sector in the Circular Flow
Figure 2.3
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The Twin Deficits
Figure 2.4
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Measuring Wealth
• The concepts used to measure GDP and its
component parts are examples of flows.
• Wealth is a stock and is measured by a system
of balance sheet accounting.
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Stocks and Flows with an Individual Example
• A stock is a variable measured at a point in time.
- Ex. Government debt, capital
• A flow is a variable measured per unit of time.
• A flow is often the rate of change of a stock.
- Ex. Government budget deficit, investment
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34
U.S. Government Debt Since 1890 - Stock
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Real and Financial Assets
• The wealth of an individual can consist of real
assets (capital goods) and financial assets.
• Real asset: the capital owned by an individual
or firm.
- house, car, land, etc.
• Financial assets: promises to deliver resources
in the future.
- a mortgage on a house, bank account, etc.
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Real and Financial Assets
• In a closed economy, every financial asset is
someone else’s financial liability  the sum
total of all financial assets and liabilities is
zero.
• In a open economy, financial assets and
liabilities may not equal zero since individuals
and firms can borrow or lend abroad.
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Balance Sheet Accounting
• The total wealth (net worth) of an agent is the
sum total of his assets (both real and financial)
minus the sum of his financial liabilities
- This is called “balance sheet accounting”.
• TABLE 2.3
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Table 2.3
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The Link between GDP and Wealth
• Wealth accounting measures stocks and
income accounting measures flows.
• The NIPA can be used to show how the
stocks of real and financial assets for
different sectors of the economy change
from one year to the next.
40
Gross versus Net Domestic Product
Gross Investment = Net Investment + Depreciation
• Not all investment creates new capital;
Some investment is necessary each year to
offset the deterioration through normal wear
and tear of the existing stock of capitaldepreciation.
• The portion of gross investment that
contributes to increases in the stock of capital
is called “net investment”.
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Stocks and Flows
Figure 2.6
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Gross versus Domestic Product
• Net domestic product (NDP) is a measure of
the maximum output of the economy that is
available for consumption without running
down the stock of capital.
• GDP = NDP + depreciation
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Table 2.4
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45
Growth Rates and Percentage Changes
• Growth rate of GDP in year t :
 yt  yt 1 
g 
  100%
 yt 1 
y
t
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Table 2.6
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Homework
Question 3, 5, 6, 9
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END