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Measuring the Economy
The Economy as a Circular
Flow
Resources
Income
Firms
Households
Expenditures
Goods and Services
Saving and Investment
Income
Firms
Households
Expenditures
Borrowings
Financial Markets
Savings
Real and Nominal Rates
Nominal interest rates are rates
unadjusted for the effect of inflation or
deflation.
 Real rates are adjusted for price level
changes.

Interest Rates: Facts

Interest rates serve many roles:
Interest rates are a premium paid to forego
consumption.
 Interest rates are the price of credit.
 Interest rates are the return to capital as a
factor of production.

Inflation and Interest Rates

Nominal variables are not adjusted to
reflect changes in the price level.

They are the percentage by which the
money a borrower pays back exceeds the
money he borrowed, making no
adjustment for any change in purchasing
power.
Inflation and Interest Rates

Real interest rates are the percentage
increase in purchasing power that the
borrower pays to the lender for the
privilege of borrowing.
Real interest rates are nominal interest
rates minus the rate of inflation.
 Real interest rates may be positive, zero,
or negative.

Nominal Rates: The Fisher
Effect
THE FISHER EFFECT:
NOMINAL RATE
=
REAL RATE +
EXPECTED INFLATION
Circular Flow with
Government
Income
Firms
Households
Investment
Taxes
Government
Purchases of
Goods and Services
Subsidies
Borrowing
Expenditures
Taxes
Government
Government
Government
Government Salaries
and Transfers
Borrowing
Saving
Financial Markets
Savings
Saving and Investment

Economists make a clear distinction
between saving and investment.
Saving is the act of abstaining from
consumption.
 Investment is the result of purchasing a
new capital good.

Saving and Investment: Closed
Economy

Y=C+I+G


G = IG + CG
Y = CN + IN
CN = C + CG
 IN = I + I G

Y – CN = IN
 SN = IN

Savings = Investment: Closed
Economy

In a closed economy, savings must just
equal investment.
If S > I, interest rates will fall and I will
rise.
 If S < I, interest rates will rise and I will
fall.

Circular Flow with Government and
the Rest of the World
Foreign Countries
Foreign Borrowing
Foreign Savings
Exports
Investment
Imports
Income
Households
Firms
Taxes
Taxes
Expenditures
Government
Purchases of
Goods and Services
Subsidies
Borrowing
Government
Government
Government
Borrowing
Saving
Financial Markets
Government Salaries
and Transfers
Savings
The Rest of the World

An economy has two basic kinds of
economic interactions with the rest of
the world.
Buying and selling goods and services
 Buying and selling assets.

The Rest of the World
Exports are those goods we produce for
sale in the rest of the world. Imports
are those goods we buy from the rest of
the world.
 We also lend to the rest of the world
and borrow from them.

Saving and Investment: Open
Economy

Y = CN + IN + NX

NX = Exports – Imports
Y – CN – IN = NX
 SN – IN = NX

If SN = IN, NX =0, trade balance
 If SN > IN, NX >0, trade surplus
 If SN < IN, NX <0, trade deficit

Looking at X - M

X represents the exports of a country.


X is the income a country receives from
the rest of the world through exporting
goods and services.
M represents the imports of a country.

M is a country’s consumption of goods
and services produced by the rest of the
world.
Looking at X - M

X – M then is income minus consumption
vis a vis the rest of the world.
If X > M, a country has excess funds to
lend to the ROW, or S > I.
 If X < M, the country’s trading partner has
excess funds to lend to it or domestically
S < I.

S – I = NX

Net foreign investment (S – I) always
equals the trade balance (NX).

The international flow of funds to finance
capital accumulation and the international
flow of goods and services are two sides
of the same coin.
Government and the Private
Sector
YD = Y + TR – T
 S = YD – C

YD = C + I + G + NX + TR – T
 YD = S + C


Set YD = YD and solve for NX
S + C = C + I + G + NX + TR – T
 S + C – C – I – G – TR + T = NX


(S – I) + (T – TR – G) = NX
Government and the Private
Sector

(S – I) + (T – TR – G) = NX
(S – I) = Private saving
 (T – TR – G) = Government saving


There are two sources from which the
government can raise funds if G + TR >
T.
It can borrow at home, if S > I or
 It can borrow from the ROW if NX < 0.

Government Budget Surplus



(S – I) + (T – TR – G) = NX
Rearrange the equation:
T – G – TR = (I + NX ) – S

There are three ways a government budget
surplus can be used:
• Private saving can decline without requiring a decrease
in private investment
• The surplus can stimulate domestic investment through
lower interest rates.
• Dependence on foreign investment can be reduced.
Measuring GDP
What Is GDP?

GDP, Gross Domestic Product, is the
total dollar value of all final goods and
services produced in a country during a
year.
Current market prices are used to
aggregate different outputs to a dollar
total.
 Government purchases, many of which do
not occur in markets, are valued at their
cost of production.

What Is GDP?
Only final goods and services are included.
Intermediate goods are not included to
avoid double counting.
 The measure is an annual flow, a rate of
production. A GDP of $10 trillion implies
that the economy is producing $10 trillion
worth of goods and services per year.
 GDP measures production by U.S. citizens
and foreigners alike inside the geographic
borders of the USA and thus unequivocally
reflects economic activity in the USA.

Real and Nominal GDP

Nominal GDP

The market value of a nation’s final output
based on current prices for the goods and
services produced during the year.
• Nominal GDP in 2003 = the sum of all the
goods and services produced in 2003 multiplied
by their 2003 prices

Real GDP

An estimate of the value of a nation’s final
products adjusted for changes in prices
since a certain base year.
Calculating Changes in Real
GDP
GDP = S PQ
 We are interested in measuring Q when
we measure GDP. Therefore, changes in
P must be eliminated.
 This is accomplished by using a price
index to deflate nominal GDP.

Price Indexes: Use
GDP in 2000 = P2000 times Q2000
 GDP in 2002 = P2002 times Q2002
 If we wish to compare GDP in 2002 with
GDP in 2000, we must remove any price
changes that have occurred.
 Why?

Price Indexes: Use
GDP 2002 = P2002 x Q2002
 Divide by a price index = P2002/P2000

P2002Q2002
P2002
= P2002Q2002 x P2000 = Q2002P2000
P2000
P2002
Components of GDP:
Expenditure and Income

Expenditure


Income


GDP = C + I + G + (X-M)
NI (Y) = W + i + R + profits
Since NI and GDP measure aggregate
production, they must be equal.
GDP = NI 2001
Consumption
6,987.1
Durable Goods
Nondurables
Services
835.9
2,041.3
4,109.9
Investment
Nonresidential
Residential
Inventory Change
Government
Federal
State & Local
Net Exports
Exports
Imports
GDP
1,586.0
1,201.6
444.7
-60.3
1,858.0
628.1
1,229.9
-348.9
1,034.1
1,383.0
10,082.2
Employee Compensation
5874.9
Corporate Profits
731.6
Proprietors’ Income
727.9
Net Interest
649.8
Rental Income
137.9
National Income
8,122.1
+ CCA
1329.3
+ Indirect Business Taxes
774.8
+ Business Transfers
42.5
- Subsidies
47.3
+Statistical Discrepancy
-117.3
GNP
10,104.1
+Net Foreign Payments
-21.9
GDP
10,082.2
GDP Components
Concept
Leakage/Saving Leakage/Taxes
GDP
Less
Depreciation
= NDP
Less
=Domestic Income
Less
Undistributed
profits
Plus
=PI
Less
=PYD
Divided among
Personal saving
Personal consumption
Interest payments
Government Transfers
Indirect business taxes
Social Security
taxes
Transfer Payments and
interest
Personal income
taxes
Components of GDP:
Expenditure Viewpoint

Consumption
Non-durable Goods (last less than 3 years)
 Durable Goods (last more than 3 years)
 Services


Gross Domestic Investment
Non-residential lnvestment (plant and
equipment)
 Inventory Change
 Residential Investment

Components of GDP:
Expenditure Viewpoint

Government Spending
Local and State
 Federal


Net Exports

Exports Minus Imports
Components of GDP: Income
Viewpoint

Employee Compensation
Income from the sale of labor services
during the year.
 It includes wages, salaries, and fringe
benefits such as employer provided
insurance and employer contributions to
pension funds.

Components of GDP: Income
Viewpoint

Net Interest

The portion of business receipts used to
pay for borrowed funds that finance
investment purchases.
Components of GDP: Income
Viewpoint

Rental Income
Rental income is earned by those who
supply the services of land, mineral rights,
and buildings for use by others.
 Also included in rental income is an
estimate of the imputed rent earned by
homeowners who live in their own homes
less the expenses of maintaining their
homes.

Components of GDP: Income
Viewpoint

Profits.

Profits of corporations and unincorporated
business
•
Profits = Total revenues – Indirect business
taxes – Capital consumption allowance –
Labor costs – Net interest – Rents paid