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Chapter 4 Spending, Income, and GDP McGraw-Hill/Irwin ©2009 The McGraw-Hill Companies, All Rights Reserved Macroeconomics: Data and Issues Wages and Unemployment Spending, Income, and GDP Inflation and Price Level LO 16- All McGraw-Hill/Irwin 4-2 © The McGraw-Hill Companies, Inc., 2009 Learning Objectives 1. Explain how economist define and measure an economy's output 2. Use the expenditure method for measuring GDP to analyze economic activity 3. Define and compute nominal GDP and real GDP 4. Discuss the relationships between GDP and economic well-being LO 16- All McGraw-Hill/Irwin 4-3 © The McGraw-Hill Companies, Inc., 2009 Measuring Output Gross Domestic Product (GDP) is The market value of Final goods and services Produced in a country in a given period of time LO 16 - 1 McGraw-Hill/Irwin 4-4 © The McGraw-Hill Companies, Inc., 2009 Market Value Aggregate measure of quantities produced Weighs more expensive items more Willingness to pay is an indication of benefit from the good Orchardia Price Quantity GDP contribution Apples Bananas Shoes $0.25 $0.50 $20.00 4 6 3 $1.00 $3.00 $60.00 Orchardia's GDP is $64 LO 16 - 1 McGraw-Hill/Irwin 4-5 © The McGraw-Hill Companies, Inc., 2009 Market Value A convenient way to aggregate the many different goods and services produced in a modern economy. However, non-market activities are not counted in GDP Unpaid work of a homemaker paid house keeping and child care services LO 16 - 1 McGraw-Hill/Irwin 4-6 © The McGraw-Hill Companies, Inc., 2009 Women's labor force participation and GDP measurement Women's labor force participation increased since 1960 Measured GDP increased Working women's output measured and counted a real addition to GDP Paid workers provide previously unpaid childcare Not a real addition to goods and services produced Measured change in GDP overstates actual change LO 16 - 1 McGraw-Hill/Irwin 4-7 © The McGraw-Hill Companies, Inc., 2009 Final Goods and Services Final goods are consumed by the ultimate user End products of production Included in GDP Intermediate goods are used up in the production of final goods Not included in GDP Avoids double counting A barber's assistant earns $2 per haircut for providing services such as shampooing and sweeping up Barber charges $10 per haircut Haircut's contribution to GDP is $10, not $12. LO 16 - 1 McGraw-Hill/Irwin 4-8 © The McGraw-Hill Companies, Inc., 2009 Value-added Method Value added is the market value of the product minus the cost of inputs purchased from other firms Count value added in the year it is produced Hot'n'Fresh buys flour and other inputs to make bread that sells for $2.00 Revenues Cost of Purchased Inputs Value Added ABC Grain $0.50 $0.00 $0.50 General Flour $1.20 $0.50 $0.70 Hot'n'Fresh $2.00 $1.20 $0.80 Company Total LO 16 - 1 McGraw-Hill/Irwin $2.00 4-9 © The McGraw-Hill Companies, Inc., 2009 Produced in a Country in a Period of Time "Domestic" in GDP means the activity is measured within a country's borders Nationality of owners or company is not relevant Value must be produced in the year considered Sell a 20-year old house for $200,000 Pay $12,000 commission Value added is $12,000 House was not produced in the period of time studied LO 16 - 1 McGraw-Hill/Irwin 4-10 © The McGraw-Hill Companies, Inc., 2009 Expenditure Method for GDP Four users of final goods ■ Households Firms ■ Government Foreigners Assumes all goods produced are purchased by one of these groups in a given year Amount spent = market value GDP can be measured by: Total spending for final goods less value of imports LO 16 - 2 McGraw-Hill/Irwin 4-11 © The McGraw-Hill Companies, Inc., 2009 US GDP, 2007 (billions of dollars) Consumption Durable Goods $9,732.0 $1,079.6 Non-durable Goods 2,833.0 Services 5,819.4 Investment Business Fixed Investment Residential Inventory 2,132.3 1,483.2 641.5 7.6 Government Purchases 2,691.4 Net Exports – 712.7 Exports 1,640.3 Imports 2,353.0 GDP LO 16 - 2 McGraw-Hill/Irwin $13,843.0 4-12 © The McGraw-Hill Companies, Inc., 2009 Consumption Expenditure Spending by households for goods and services Consumer durables are long-lived consumer goods Cars Furniture Appliances Consumer non-durable goods are shorter-lived goods Clothing Food Bedding Services are the largest component of consumer spending Education Taxi rides Haircuts LO 16 - 2 McGraw-Hill/Irwin 4-13 © The McGraw-Hill Companies, Inc., 2009 Investment Business fixed investment is purchases of new capital goods machinery Business Buildings Residential investment is construction of new homes and apartment buildings Inventory investment is the change in unsold goods to the company's inventory These goods are produced but not yet sold This entry can be positive or negative Negative inventory investment means less in inventory at year-end than at the beginning LO 16 - 2 McGraw-Hill/Irwin 4-14 © The McGraw-Hill Companies, Inc., 2009 Economic Investment and Financial Investment Financial investments include purchases of stocks, bonds, and other financial assets Purchase generally transfers ownership of a portion of the firm's existing capital stock Does not correspond to any increase in physical capital or production capacity Economic investment refers to the increase in the capital goods used to produce other goods This value is based on purchase price of the capital goods, not on stock value LO 16 - 2 McGraw-Hill/Irwin 4-15 © The McGraw-Hill Companies, Inc., 2009 Government Purchases Federal, state, and local government purchase final goods and services Fighter jets Teaching Office supplies Excludes transfer payments Transfer payments are made by government but the government receives no current goods or services Food Stamps Spending by recipients is included in GDP Excludes interest paid on government debt LO 16 - 2 McGraw-Hill/Irwin 4-16 © The McGraw-Hill Companies, Inc., 2009 Net Exports Net exports are exports minus imports Exports are goods and services produced domestically and sold abroad Exports reduce the amount available to the domestic economy Imports are purchases in the US of goods and services produced abroad Imports increase the amount available to the domestic economy LO 16 - 2 McGraw-Hill/Irwin 4-17 © The McGraw-Hill Companies, Inc., 2009 GDP Expenditures Equation Terminology Y Gross Domestic Product or output C I G NX Consumption Expenditure Investment Government Purchases Net Exports Expenditure approach to measuring GDP Y = C + I + G + NX LO 16 - 2 McGraw-Hill/Irwin 4-18 © The McGraw-Hill Companies, Inc., 2009 GDP Example Total production is 1 million cars, $15,000 each Production value is 1 million times $15,000 = $15 billion Sector # Cars Purchased GDP Contribution Consumers 700,000 $10.500 billion Investment Businesses 225,000 200,000 $3.375 $3.000 billion Government 50,000 $0.750 billion Net exports 25,000 $0.375 billion Total 1,000,000 975,000 $15.000 $14.625 billion 25,000 cars are unsold Investment in inventories increases by $0.375 billion, In what category is this number included? LO 16 - 2 McGraw-Hill/Irwin 4-19 © The McGraw-Hill Companies, Inc., 2009 Income Approach to GDP When a good is sold, its proceeds are distributed to workers or business owners GDP = labor income + capital income Labor income is wages, salaries, benefits, and incomes of the self-employed About ⅔ of GDP Capital income pays for physical capital and intangibles Profits for business owners Rent for land Interest for bond holders Royalties Measured before taxes LO 16 - 2 McGraw-Hill/Irwin 4-20 © The McGraw-Hill Companies, Inc., 2009 Three GDP Approaches Production Expenditure Market Value of Final Goods and Services Consumption Labor Income Investment Government purchases Net exports LO 16 - 2 McGraw-Hill/Irwin Income Capital Income 4-21 © The McGraw-Hill Companies, Inc., 2009 Adjusting for Price Changes Compare GDP for different years to see how much output has changed GDP changes over time because Prices change AND Quantity of output changes To see how much output has grown, use only the changes in quantities Hold prices constant LO 16 - 3 McGraw-Hill/Irwin 4-22 © The McGraw-Hill Companies, Inc., 2009 The Pizza and Calzone Economy GDP in 2009 is $175; GDP in 2013 is $420 GDP in 2013 is 2.4 times the GDP in 2009 Only twice as many pizzas and calzones were produced in 2013 Market value of output grew faster than the physical volume of output Number of Pizzas Price of Pizza Number of Calzones Price of Calzones 2009 10 $10 15 $5 2013 20 $12 30 $6 LO 16 - 3 McGraw-Hill/Irwin 4-23 © The McGraw-Hill Companies, Inc., 2009 Real GDP and Nominal GDP Nominal GDP values output in the current year using prices from the current year Nominal GDP is the current dollar value of production Real GDP values output in the current year using the prices from the base year Real GDP measures the physical volume of production Nominal GDP adjusted for inflation Comparisons of economic activity at different times should always be done using real GDP. LO 16 - 3 McGraw-Hill/Irwin 4-24 © The McGraw-Hill Companies, Inc., 2009 Calculating Real GDP for 2013 Use 2009 as the base year Nominal GDP for 2009 is $175 and for 2013, $420 Calculate real GDP using current year quantities and base year prices Real GDP in 2013 is (20 pizzas) ($10) + (30 calzones) (5) = $350 Real GDP doubled between 2009 and 2013 Number of Pizzas Price of Pizza Number of Calzones Price of Calzones 2009 10 $10 15 $5 2013 20 $12 30 $6 LO 16 - 3 McGraw-Hill/Irwin 4-25 © The McGraw-Hill Companies, Inc., 2009 Real GDP and Economic Well-Being Real GDP is a flawed measure of well-being It values only market transactions Omits illegal transactions, volunteer work, and household production Maximizing GDP will not necessarily maximize national well-being Whether increases in output increase welfare is a case-by-case issue LO 16 - 4 McGraw-Hill/Irwin 4-26 © The McGraw-Hill Companies, Inc., 2009 GDP Does Not Value Leisure Amount of leisure time has increased in the past 100 years Work weeks are shorter People enter the labor force at an older age People retire earlier Leisure produces no goods for market GDP places a value of zero on all leisure time Opportunity cost of an hour of leisure is your hourly wage Omission of the value of leisure time makes GDP seem smaller LO 16 - 4 McGraw-Hill/Irwin 4-27 © The McGraw-Hill Companies, Inc., 2009 Environmental Quality and resource depletion Suppose a factory is built in your town People are employed and output is produced Productive activity is included in GDP the factory creates pollution No adjustment is made for the decline in resource availability when mining is done One more barrel of oil on the market means one less barrel for future use Environmental quality and resource depletion are difficult to value They have value and that value is omitted from GDP LO 16 - 4 McGraw-Hill/Irwin 4-28 © The McGraw-Hill Companies, Inc., 2009 Other Quality of Life Considerations GDP does not account for intangibles people value Crime rates Traffic congestion Civic organizations Open space Sense of community LO 16 - 4 McGraw-Hill/Irwin 4-29 © The McGraw-Hill Companies, Inc., 2009 Poverty and Economic Inequality GDP does not capture the effects of income inequality Most would prefer living in a relatively equal society to one with a few wealthy and many poor Inequality matters and it is increasing in the US LO 16 - 4 McGraw-Hill/Irwin 4-30 © The McGraw-Hill Companies, Inc., 2009 GDP as a Welfare Measure GDP per capita is positively associated with several measures of well-being Material standard of living: more goods and services Health and life expectancy Residents of industrialized countries fare better than residents of developing countries in a range of health measures Education Literacy and school enrollment rates are higher in high-income countries LO 16 - 4 McGraw-Hill/Irwin 4-31 © The McGraw-Hill Companies, Inc., 2009 Spending, Income, and GDP Gross Domestic Product Production Method Expenditure Method Real and Nominal Values LO 16 - All McGraw-Hill/Irwin Income Method GDP and Well-Being 4-32 © The McGraw-Hill Companies, Inc., 2009