Chapter 8
Measuring the
Economy’s
Performance
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
Introduction
Does a general increase in the level of a nation’s
economic activity and the resulting rise in the capability
of a person to buy more goods and services tend to
make that person happier?
To answer this question, economists have to measure
not only the level of “happiness” but also the level of
the country’s economic activity
This chapter will help you understand the measurement
of a nation’s overall economic performance.
Learning Objectives
• Describe the circular flow of income and
output
• Define gross domestic product (GDP)
• Understand the limitations of using GDP as a
measure of national welfare
Learning Objectives (cont'd)
• Explain the expenditure approach to
tabulating GDP
• Explain the income approach to computing
GDP
• Distinguish between nominal GDP and real
GDP
Chapter Outline
•
•
•
•
The Simple Circular Flow
National Income Accounting
Two Main Methods of Measuring GDP
Other Components of National Income
Accounting
• Distinguishing Between Nominal and Real
Values
• Comparing GDP Throughout the World
Did You Know That ...
• U.S. economic activity declined by a greater percentage
during the first 18 months of the Great Recession of the late
2000s than during any other 18-month period since World
War II?
• To measure the nation’s overall economic performance, the
government utilizes the concept of national income
accounting.
The Simple Circular Flow
The concept of the circular flow of income
involves two principles:
1. In every economic exchange, the seller receives
exactly the same amount that the buyer spends
2. Goods and services flow in one direction and
money payments flow in the other
The Simple Circular Flow (cont'd)
• Profits explained
– Question
• Why is profit a cost of production?
– Answer
• Profits are the return entrepreneurs receive for the risk
they incur when organizing productive activities
Figure 8-1 The Circular Flow of Income
and Product
The Simple Circular Flow (cont'd)
• Product Markets
– Transactions in which households buy goods
• Factor Markets
– Transactions in which businesses buy resources
The Simple Circular Flow (cont'd)
• Total Income
– The yearly amount earned by the nation’s
resources (factors of production)
– Includes wages, rent, interest payments, and
profits received by workers, landowners, capital
owners, and entrepreneurs, respectively
The Simple Circular Flow (cont'd)
• Final Goods and Services
– Goods and services that are at their final stage of
production and will not be transformed into yet
other goods or services
The Simple Circular Flow (cont'd)
• Question
– Why must the dollar value of total output equal
total income?
• Answer
– Every transaction simultaneously involves an
expenditure and a business receipt
National Income Accounting
• National Income Accounting
– A measurement system used to estimate national
income and its components
• Gross Domestic Product (GDP)
– The total market value of all final goods and
services produced by factors of production
located within a nation’s borders
National Income Accounting (cont'd)
• Observations
– GDP measures the dollar value of final output
– GDP measures the dollar value of final goods and
services produced per year by factors of
production located within a nation’s borders
National Income Accounting (cont'd)
• Stress on final output
– What is a final good?
• Wheat?
• Steel?
• Crude oil?
• Bread?
• Automobile?
• Gasoline?
National Income Accounting (cont'd)
• Intermediate Goods
– Goods used up entirely in the production of final
goods
• Value Added
– The dollar value of an industry’s sales minus the
value of intermediate goods (for example, raw
materials and parts) used in production
Table 8-1 Sales Value and Value Added at Each Stage of
Donut Production
National Income Accounting (cont'd)
• Numerous transactions occur that have
nothing to do with final goods and services
being produced:
– Financial transactions
– Transfer of secondhand goods
– Others excluded transactions
National Income Accounting (cont'd)
• Financial transactions
– Securities
• Stocks and bonds
– Government transfer payments
• Social Security
• Unemployment compensation
– Private transfer payments
• Individual gifts
• Corporate gifts
National Income Accounting (cont'd)
• Transfer of secondhand goods
– Why not count the sale of a used computer, guitar,
or snowboard as part of GDP?
• Other excluded transactions
– Household production
– Legal and illegal underground transactions
National Income Accounting (cont'd)
• GDP’s limitations
– Excludes non-market production
– It is not necessarily a good measure of the wellbeing of a nation
National Income Accounting (cont'd)
• GDP:
– Is a measure of the value of production in terms of
market prices, and an indicator of economic
activity
– Is not a measure of a nation’s overall welfare
International Example: The French Government Seeks to Deemphasize GDP
• The president of France, Nicolas Sarkozy, endorsed a report
that proposes the development of an alternative measure of
economic performance.
• Similar to the United Nation’s Human Development Index,
that alternative measure considers GDP per person along with
measures of health and knowledge.
Two Main Methods of Measuring GDP
• Expenditure Approach
– Computing GDP by adding up the dollar value at
current market prices of all final goods and
services
Two Main Methods of Measuring GDP
(cont'd)
• Income Approach
– Measuring GDP by adding up all components of
national income, including wages, interest, rent,
and profits
Two Main Methods of Measuring GDP
(cont'd)
• Deriving GDP by the expenditure approach
– Consumption Expenditure (C)
• Durable Consumer Goods
– Items that last more than three years (automobiles, furniture)
• Nondurable Consumer Goods
– Goods that are used up in three years (gasoline, food)
• Services
– Mental or physical help
Two Main Methods of Measuring GDP
(cont'd)
• Deriving GDP by the expenditure approach
– Gross Private Domestic Investment (I)
• The creation of capital goods, such as factories and
machines, that can yield production and hence
consumption in the future
– Also includes changes in business inventories and repairs
made to machines, buildings
Two Main Methods of Measuring GDP
(cont'd)
• Deriving GDP by the expenditure approach
– Gross Private Domestic Investment (I)
• Producer Durables or Capital Goods
– Life span of more than three years
• Fixed Investment
– Purchases by business of newly produced producer durables
or capital goods
• Inventory Investment
– Changes in stocks of finished goods and goods in process, as
well as changes in raw materials
Example: Is Failing to Include Intangibles Depressing Measured
Business Fixed Investment?
• Some economists suggest that because investment is broadly
defined as the use of current resources to expand productive
capabilities, business fixed investment should also include
intangible investment, such as research and employee
education.
• Economist Leonard Nakamura has estimated that if intangible
investment had been counted as part of business fixed
investment, business fixed investment as a percentage of GDP
would have been nearly doubled in recent years.
Two Main Methods of Measuring GDP
(cont'd)
• Deriving GDP by the Expenditure Approach
– Government Expenditures (G)
• State, local, and federal
• Valued at cost
Two Main Methods of Measuring GDP
(cont'd)
• Deriving GDP by the Expenditure Approach
– Net Exports (Foreign Expenditures)
Net exports (X) = Total exports – Total imports
Two Main Methods of Measuring GDP
(cont'd)
• Presenting the expenditure approach
GDP = C + I + G + X
where
C=
consumption expenditures
I =
investment expenditures
G=
government expenditures
X=
net exports
Figure 8-2 GDP and Its Components
Two Main Methods of Measuring GDP
(cont'd)
• Net Domestic Product (NDP)
– Allowing for depreciation (capital consumption
allowance)
• The amount that businesses would have to save in order
to take care of deteriorating machines and other
equipment
NDP = GDP – Depreciation
Two Main Methods of Measuring GDP
(cont'd)
• Because NDP = GDP – Depreciation, and
GDP = C + I + G + X
• NDP = C + I + G + X – Depreciation
• NDP = C + net I + G + X
where net I (net investment ) = I – Depreciation
– Domestic investment minus an estimate of the wear and tear on the
existing capital stock
– The change in the capital stock over a one-year period
Two Main Methods of Measuring GDP
(cont’d)
• Deriving GDP by the Income Approach
– Gross Domestic Income (GDI)
• The sum of all income (wages, interest, rent, and
profits) paid to the four factors of production
Two Main Methods of Measuring GDP
(cont'd)
• Deriving GDP by the Income Approach
– Gross Domestic Income (GDI)
• Wages: salaries and labor income
• Rent: farms, houses, stores
• Interest: savings accounts
• Profits: sole proprietorships, partnerships, corporations
Two Main Methods of Measuring GDP
(cont'd)
• Deriving GDP by the Income Approach
– Gross domestic product equals gross domestic
income plus indirect business taxes and
depreciation
– These last items are called non-income expense
items
Two Main Methods of Measuring GDP
(cont'd)
• Deriving GDP by the Income Approach
– Indirect business taxes
• All business taxes except the tax on corporate profits
• Include sales and business property taxes
Figure 8-3 Gross Domestic Product and Gross Domestic Income,
2011 (in billions of 2005 dollars per year)
Figure 8-3 Gross Domestic Product and Gross Domestic Income,
2011 (in billions of 2005 dollars per year) (cont’d)
Other Components of National Income
Accounting
• National Income (NI)
– The total of all factor payments to resource
owners
• Personal Income (PI)
– The amount of income that households actually
receive before they pay personal income taxes
Other Components of National Income
Accounting (cont'd)
• Disposable Personal Income (DPI)
– Personal income after personal income taxes have
been paid
Table 8-2 Going from GDP to
Disposable Income, 2011
Distinguishing Between Nominal and
Real Values
• Nominal Values
– Measurements in terms of the actual market
prices at which goods are sold; expressed in
current dollars, also called money values
• Real Values
– Measurements after adjustments have been made
for changes in the average of prices between
years; expressed in constant dollars
Distinguishing Between Nominal and
Real Values (cont'd)
• Constant Dollars
– Dollars expressed in terms of real purchasing
power
– This price-corrected GDP is the real GDP
Example: Correcting GDP for Price Index Changes,
2001-2011
• Correcting GDP for price index changes
– Nominal (current) dollars GDP
– Real (constant) dollars GDP
Nominal GDP
Real GDP =
Price index*
*Price index: measured by the GDP deflator
x 100
Table 8-3 Correcting GDP for Price
Index Changes
Figure 8-4 Nominal and Real GDP
Why Not … always use the most recent completed calendar
year as the base year for computing real GDP?
• In principle, the government could update its base year every
year.
• However, the government’s national income accountants
typically revise the real GDP figure a number of times before
settling on a final amount.
• Thus, the government usually waits until those accountants
feel certain about the GDP measurement for a given year
before establishing that year as the base year.
Distinguishing Between Nominal and
Real Values (cont'd)
• Per capita real GDP
– Real GDP divided by total population
Real GDP
Per capita real GDP =
Population
Comparing GDP Throughout the World
• Foreign Exchange Rate
– The price of one currency in terms of another
• Example:
– $1.25 = 1 euro, or $1 = .80 euros
– French income per capita = 28,944 euros
– French per capita income in terms of dollars
equals 28,944 euros x $1.25 = $36,180
Comparing GDP Throughout the World
(cont'd)
• Purchasing Power Parity
– Adjustment in exchange rate conversions that
takes into account differences in the true cost of
living across countries
International Example: Purchasing Power Parity Comparisons of
World Incomes
• The International Monetary Fund accepted the purchasing
power parity approach a few years ago
• It started presenting the statistics on each country’s GDP
relative to others and based on the purchasing power parity
relative to the dollar
• Why is China’s per capita GDP higher based on purchasing
power parity?
Table 8-4 Comparing GDP
Internationally
You Are There: Questioning China’s Official Real GDP Statistics
• Some economists argue that China’s government has
overstated its real GDP growth rate since 2008 as electricity
production has indeed declined.
• Paul Cavey of Macquarie Securities notes, however, that the
decline in aluminum and steel production accounted for the
lower electricity usage, while production of other items might
have contributed to a net increase in real GDP.
Issues & Applications: Can More Per Capita Real GDP Buy
Additional Happiness?
• A 1974 study by economist Richard Easterlin suggests that
above a relatively low level of real GDP, further increases in
real GDP do not make people happier.
• A recent study by Betsey Stevenson and Justin Wolfers,
however, found that an increase in a person’s purchasing
power by itself does not necessarily make people happier, but
it enables the person to pay for activities that lead to greater
satisfaction.
Summary Discussion of Learning
Objectives
• The circular flow of income and output
– In every economic transaction, receipts exactly
equal expenditures
– Goods and services flow in one direction and
money payments flow in the other
• Gross domestic product (GDP)
– The total market value of a nation’s final output of
goods and services produced in a year using
factors of production located within its borders
Summary Discussion of Learning
Objectives (cont'd)
• The limitations of using GDP as a measure of
national welfare
– Excludes non-market transactions
– Does not measure national well-being
• The expenditure approach to tabulating GDP
– GDP = C + I + G + X
Summary Discussion of Learning
Objectives (cont'd)
• The income approach to computing GDP
– The sum of wages, rent, interest, profits
• Distinguishing between nominal GDP and real
GDP
– Nominal GDP is the value of newly produced final
output measured in current market prices.
– Real GDP adjusts nominal GDP into constant
dollars by correcting for price level changes