Download ECN 111 Chapter 5 Lecture Notes

ECN 111 Chapter 5 Lecture Notes
5.1. GDP, Income, and Expenditure
A. GDP Defined
Gross Domestic Product or GDP is the market value of all the final goods and services
produced within a country in a given time period.
1. Value Produced
The items are valued at their market value,—at the price at which each item is traded in
markets.
2. What Produced
A final good or service is a good or service that is produced for its final user and not as a
component of another good or service. To calculate GDP, we value all the final goods and
services.
a. An intermediate good or service is a good or service that is produced by one firm, bought
by another firm, and used as a component of a final good or service.
3. Where Produced
Goods and services produced within a country count as part of that country's GDP.
4. When Produced
GDP measures the value of production during a given time period.
B. Circular Flows in the U.S. Economy
Four groups buy the final goods and services produced: household, firms, governments, and the
rest of the world.
1. Consumption expenditure is the expenditure by households on goods and services.
2. Investment is the purchase of new capital goods (tools, instruments, machines, buildings, and
other constructions) and additions to inventories.
3. Government purchases of goods and services are the purchases by all levels of
government on goods and services.
4. Net exports of goods and services is the value of exports of goods and services minus the
value of imports of goods and services. Exports of goods and services are items that firms
in the United States produce and sell to the rest of the world. Imports of goods and services
are items that households, firms, and governments in the United States buy from the rest of
the world.
5. Total expenditure equals the sum of the four types of expenditure, C + I + G + NX.
6. Income is the sum of wages, interest, rent, and profit.
C. Expenditure Equals Income
The circular flow shows that income, Y, equals expenditure, C + I + G + NX. So the value of
production equals income equals expenditure.
5.2. Measuring U.S. GDP
A. The Expenditure Approach
The expenditure approach measures GDP by using data on consumption expenditure,
investment, government purchases, and net exports.
B. Expenditures Not in GDP
1. Used goods are not part of GDP because they already were part of GDP in the period in which
they were produced.
2. The expenditure on newly produced capital goods is part of GDP, but the purchase of financial
assets is not.
C. The Income Approach
The income approach measures GDP by summing the incomes that firms pay households for the
resources they hire–wages for labor, interest for the use of capital, rent for the use of land, and
profits for entrepreneurship.
1. Compensation of Employees—the payment for labor services.
2. Net Interest—the interest households receive on loans they make minus the interest
households pay on their own borrowing.
3. Rental Income of Persons—payments for the use of land and other rented inputs.
4. Corporate Profit—profits of corporations.
5. Proprietors’ Income—payments to people who run their own businesses. It is a mixture of the
previous four items.
6. From Factor Cost to Market Price
The sum of compensation of employees, net interest, rental income of persons, corporate
profit, and proprietor’s income is net domestic product at factor cost. To convert the value at
factor cost to the value at market prices, we add indirect taxes and subtract subsidies.
7. From Gross to Net
To convert this net domestic product at factor cost to GDP, depreciation, the decrease in the
value of capital that results from its use and from obsolescence (also call capital consumption),
must be added.
D. Valuing the Output of Industries
Value added, the value of a firm’s production minus the value of the intermediate goods it buys
from other firms, can be used to measure the contribution each industry makes to GDP.
5.3. Nominal GDP Versus Real GDP
A. Calculating Real GDP
Real GDP is the value of the final goods and services produced in a given year when valued at
constant prices. Nominal GDP is the value of the final goods and services produced in a given
year valued at the prices that prevailed in that same year.
1. Nominal GDP Calculation—value the products produced at the current price and then sum
these values.
2. Traditional Real GDP Calculation—the traditional method values the quantities produced in
each year at the prices of the base year.
3. New Method of Calculating GDP—this method uses the prices of two adjacent years to
calculate the real GDP growth rate.
a. Value last year’s production and this year’s production at last year’s prices and then
calculate the growth rate of this number from last year to this year.
b. Value last year’s production and this year’s production at this year’s prices and then
calculate the growth rate of this number from last year to this year.
c. Calculate the average of the two growth rates. This average growth rate is the growth rate of
real GDP from last year to this year.
4. Chain Linking
By applying the calculated percentage change to the real GDP of the preceding real GDP,
each year is linked back to the dollars of the base year like the links in a chain.
B. Calculating the GDP Deflator
The GDP deflator is an average of current prices as a percentage of base-year prices and
equals (Nominal GDP  Real GDP)  100.
5.4. Real GDP and the Standard of Living
A. Goods and Services Omitted from GDP
1. Household production
Household production is productive activities at the home that do not involve market
transactions.
2. Underground production
Underground production is the part of the economy that is hidden from the view of the
government either because people want to avoid taxes and regulations or because the goods
and services being produced are illegal.
3. Leisure time
Leisure time is an economic good that does not get measured in the official GDP figures.
Leisure time is a good that must be at least as valuable to us as the wage we earn for working.
4. Environment quality
If our standard of living is adversely affected by pollution, our GDP measure does not show
this fact. The reason is that the devices that we produce to mitigate pollution count as part of
GDP but the pollution itself is not subtracted.
B. Other Influences on the Standard of Living
1. Health and Life Expectancy
Health and life expectancy have improved as infant deaths and death in childbirth have almost
been eliminated. Life expectancy has increased from 70 years at the end of WWII to nearly 80
years today. These gains have been checked somewhat by AIDS and drug abuse, which take
away from our standard of living.
2. Political freedom and social justice
A country might enjoy a very large GDP but have limited political freedom and social justice.