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ECONOMICS FOR MANAGERS University of Management and Technology 1901 North Fort Myer Drive Arlington, VA 22209 Voice: (703) 516-0035 Fax: (703) 516-0985 Website: www.umtweb.edu © Prentice Hall 2003 Economics: Principles and Tools, 3/e Visit UMT online at www.umtweb.edu 1 of 40 Chapter 20, ECON125 CHAPTER 20 Measuring a Nation’s Production and Income © Prentice Hall 2003 Economics: Principles and Tools, 3/e Visit UMT online at www.umtweb.edu 2 of 40 Chapter 20, ECON125 Macroeconomics Macroeconomics is the branch of economics that deals with any nation’s economy as a whole. Macroeconomics focuses on issues such as unemployment, inflation, growth, trade, and the gross domestic product. © Prentice Hall 2003 Economics: Principles and Tools, 3/e Visit UMT online at www.umtweb.edu 3 of 40 Chapter 20, ECON125 Macroeconomics Macroeconomics focuses on two basic issues: Understanding economic growth in the long run and the factors behind the rise in living standards in modern economies. Understanding economic fluctuations—the ups and downs of the economy over time. © Prentice Hall 2003 Economics: Principles and Tools, 3/e Visit UMT online at www.umtweb.edu 4 of 40 Chapter 20, ECON125 Production, Income, and the Circular Flow The most fundamental concepts in macroeconomics are production and income. The circular flow diagram makes a simple but fundamental point: Production generates income. © Prentice Hall 2003 Economics: Principles and Tools, 3/e Visit UMT online at www.umtweb.edu 5 of 40 Chapter 20, ECON125 Production, Income, and the Circular Flow The circular flow diagram shows how production of goods and services generates income for households and how households purchase goods and services produced by firms. © Prentice Hall 2003 Economics: Principles and Tools, 3/e Visit UMT online at www.umtweb.edu 6 of 40 Chapter 20, ECON125 Production, Income, and the Circular Flow In factor markets, households supply inputs to production. Households are paid wages for their work, and interest, dividends and rents for supplying capital. © Prentice Hall 2003 Economics: Principles and Tools, 3/e Visit UMT online at www.umtweb.edu 7 of 40 Chapter 20, ECON125 Production, Income, and the Circular Flow Households use their income to purchase goods and services in product markets. The payments received by firms are used to pay for factors of production. © Prentice Hall 2003 Economics: Principles and Tools, 3/e Visit UMT online at www.umtweb.edu 8 of 40 Chapter 20, ECON125 Production, Income, and the Circular Flow In sum, corresponding to the production of goods and services in the economy are flows of income to households. © Prentice Hall 2003 Economics: Principles and Tools, 3/e Visit UMT online at www.umtweb.edu 9 of 40 Chapter 20, ECON125 Measuring Gross Domestic Product The most common measure of the total output of an economy is gross domestic product (GDP), the total market value of all the final goods and services produced within an economy in a given year. © Prentice Hall 2003 Economics: Principles and Tools, 3/e Visit UMT online at www.umtweb.edu 10 of 40 Chapter 20, ECON125 Measuring Gross Domestic Product “Total market value” refers to the quantity of goods multiplied by their respective prices. Using prices allows us to express the value of everything in a common unit of measurement. © Prentice Hall 2003 Economics: Principles and Tools, 3/e Visit UMT online at www.umtweb.edu 11 of 40 Chapter 20, ECON125 Measuring Gross Domestic Product “Final goods and services” refers to the goods and services that are sold to the ultimate, or final, purchasers. In order to avoid double counting, we do not count intermediate goods, or goods used in the production process that are not final goods or services. The value of the final good already reflects the price of the intermediate goods contained in it. © Prentice Hall 2003 Economics: Principles and Tools, 3/e Visit UMT online at www.umtweb.edu 12 of 40 Chapter 20, ECON125 Measuring Gross Domestic Product “In a given year” means that the sale of goods produced in prior years, for example, used cars, are not included in GDP this year. Since we use the prices times the quantities of goods to measure the value of GDP, GDP will increase when prices increase, even if the physical quantities of the goods produced remain the same. © Prentice Hall 2003 Economics: Principles and Tools, 3/e Visit UMT online at www.umtweb.edu 13 of 40 Chapter 20, ECON125 Measuring Gross Domestic Product Reality PRINCIPLE What matters to people is the real value of money or income–its purchasing power–not the face value of money or income. A measure of total output that does not increase just because prices increase is called real GDP. Real GDP takes into account price changes by using the same prices for both years. © Prentice Hall 2003 Economics: Principles and Tools, 3/e Visit UMT online at www.umtweb.edu 14 of 40 Chapter 20, ECON125 Measuring Gross Domestic Product Nominal GDP is the value of GDP in current dollars. Nominal GDP can increase for one of two reasons: The production of goods and services has increased, or The prices of those goods and services has increased. © Prentice Hall 2003 Economics: Principles and Tools, 3/e Visit UMT online at www.umtweb.edu 15 of 40 Chapter 20, ECON125 U.S. Real GDP 1930-2000 Real GDP has grown substantially over this period. © Prentice Hall 2003 Economics: Principles and Tools, 3/e Visit UMT online at www.umtweb.edu 16 of 40 Chapter 20, ECON125 U.S. Real GDP 1930-2000 Sustained increases in the real production of an economy over a period of time is what economists call economic growth. © Prentice Hall 2003 Economics: Principles and Tools, 3/e Visit UMT online at www.umtweb.edu 17 of 40 Chapter 20, ECON125 Who Purchases GDP? Economists divide GDP into four broad expenditure categories: Consumption expenditures: purchases by consumers. Private investment expenditures: purchases by firms. Government purchases: purchases by federal, state, and local governments. Net exports: net purchases by the foreign sector, or domestic exports minus domestic imports. © Prentice Hall 2003 Economics: Principles and Tools, 3/e Visit UMT online at www.umtweb.edu 18 of 40 Chapter 20, ECON125 Who Purchases GDP? Composition of U.S. GDP, Second Quarter 2000 (billions of dollars expressed at annual rates) GDP Consumption Expenditures Private Investment Expenditures Government Purchases Net Exports 9,945 6,706 1,852 1,742 -355 A quarter is a 3-month period with the second quarter running from April through June. GDP was approximately $9.9 trillion. U.S. population is approximately 281 million people, making GDP per person about $35,342. © Prentice Hall 2003 Economics: Principles and Tools, 3/e Visit UMT online at www.umtweb.edu 19 of 40 Chapter 20, ECON125 Consumption Expenditures Consumption expenditures are purchases of newly produced goods and services by households. Consumption is broken down into: Durable goods that last for a long time. Nondurable goods that last for a short time. Services that reflect work done in which people play a prominent role in the delivery. Consumption comprises 67% of total purchases. © Prentice Hall 2003 Economics: Principles and Tools, 3/e Visit UMT online at www.umtweb.edu 20 of 40 Chapter 20, ECON125 Private Investment Expenditures Private investment expenditures include: Spending on new plants and equipment. Newly produced housing. Increase in inventories during the current year. © Prentice Hall 2003 Economics: Principles and Tools, 3/e Visit UMT online at www.umtweb.edu 21 of 40 Chapter 20, ECON125 Private Investment Expenditures New investment expenditures are called gross investment. The true addition to the stock of capital of the economy is net investment. Net investment equals gross investment minus depreciation. Depreciation is the deterioration of plants, equipment, and housing in a given year. © Prentice Hall 2003 Economics: Principles and Tools, 3/e Visit UMT online at www.umtweb.edu 22 of 40 Chapter 20, ECON125 Private Investment Expenditures Note: Investment in everyday talk refers to the purchase of an existing financial asset. Investment in GDP accounts refers to the purchase of new final goods and services by firms. Don’t confuse the two. © Prentice Hall 2003 Economics: Principles and Tools, 3/e Visit UMT online at www.umtweb.edu 23 of 40 Chapter 20, ECON125 Government Purchases Government purchases refer to purchases of newly produced goods and services by all levels of government. Transfer payments are funds paid to individuals from governments (for example, Social Security, welfare, interest on government debt) and are not associated with the production of goods and services. A large part of the federal government budget is not part of GDP. © Prentice Hall 2003 Economics: Principles and Tools, 3/e Visit UMT online at www.umtweb.edu 24 of 40 Chapter 20, ECON125 Net Exports Net exports are total exports minus total imports. Net exports are included in GDP to correctly measure U.S. production. When we buy more goods from abroad than we sell, we have a trade deficit. A trade surplus occurs when our exports exceed our imports. © Prentice Hall 2003 Economics: Principles and Tools, 3/e Visit UMT online at www.umtweb.edu 25 of 40 Chapter 20, ECON125 U.S. Trade Balance as a Share of GDP, 1960 - 2000 © Prentice Hall 2003 Economics: Principles and Tools, 3/e Visit UMT online at www.umtweb.edu 26 of 40 Chapter 20, ECON125 Net Exports When the U.S. runs a trade deficit, we are forced to sell some of our assets to individuals or governments in foreign countries. We give up more dollars from exports than we receive from imports. Excess dollars in the hands of foreigners are used to buy U.S. assets. If a country runs a trade surplus with one country and an equally large deficit with another, it does not add to its stock of foreign assets. © Prentice Hall 2003 Economics: Principles and Tools, 3/e Visit UMT online at www.umtweb.edu 27 of 40 Chapter 20, ECON125 Trade Balance as a Percent of GDP, 2000 © Prentice Hall 2003 Economics: Principles and Tools, 3/e Visit UMT online at www.umtweb.edu 28 of 40 Chapter 20, ECON125 Who Gets the Income? The income that flows to the private sector is the national income which is the net national product less indirect taxes. To measure national income, economists must make three adjustments to gross domestic product (GDP). © Prentice Hall 2003 Economics: Principles and Tools, 3/e Visit UMT online at www.umtweb.edu 29 of 40 Chapter 20, ECON125 Who Gets the Income? The three adjustments to GDP are as follows: Add the net income earned by U.S. firms and residents abroad; subtract income earned in the U.S. by foreign firms to arrive at gross national product (GNP). Subtract depreciation from GNP to arrive at net national product (NNP). Subtract indirect taxes, which are sales taxes or excise taxes on products. © Prentice Hall 2003 Economics: Principles and Tools, 3/e Visit UMT online at www.umtweb.edu 30 of 40 Chapter 20, ECON125 Who Gets the Income? From GDP From to National GDP to National Income, Income, Second Quarter Second 2000 Quarter (billions 2000 of dollars) (billions of dollars) Gross domestic product plus net income from abroad = 9,945 Gross national product minus depreciation = 9,937 Net national product minus indirect taxes (and other adjustments) = 8,693 National income 7,983 After making all three adjustments, we reach national income. © Prentice Hall 2003 Economics: Principles and Tools, 3/e Visit UMT online at www.umtweb.edu 31 of 40 Chapter 20, ECON125 Who Gets the Income? Composition of U.S. National Income, Second Quarter 2000 (billions of dollars) National income 7,983 Compensation of employees 5,603 Corporate profits 964 Rental income 141 Proprietor’s income 709 Net interest 566 Approximately 70% of all national income goes to workers in the form of wages and benefits. © Prentice Hall 2003 Economics: Principles and Tools, 3/e Visit UMT online at www.umtweb.edu 32 of 40 Chapter 20, ECON125 Who Gets the Income? The sum of all the income (wages, interest, profits, and rent) generated by an organization is value added. National income is calculated by adding the value added for all the firms, plus nonprofit and government organizations. Personal income is income received by households (including transfer payments). Personal disposable income is the income that households keep after paying taxes. © Prentice Hall 2003 Economics: Principles and Tools, 3/e Visit UMT online at www.umtweb.edu 33 of 40 Chapter 20, ECON125 Real Versus Nominal GDP GDP Data for a Simple Economy Quantity Produced Price Year Cars Computers Cars Computers Nominal GDP 2004 4 1 $10,000 $5,000 $45,000 2005 5 3 $12,000 $5,000 $75,000 Differences between nominal GDP and real GDP arise only because of changes in prices. © Prentice Hall 2003 Economics: Principles and Tools, 3/e Visit UMT online at www.umtweb.edu 34 of 40 Chapter 20, ECON125 Real Versus Nominal GDP GDP Data for a Simple Economy Quantity Produced Price Year Cars Computers Cars Computers Nominal GDP 2004 4 1 $10,000 $5,000 $45,000 2005 5 3 $12,000 $5,000 $75,000 To calculate real GDP we use constant prices. Quantity Produced Price Year Cars Computers Cars Computers Real GDP 2004 4 1 $10,000 $5,000 $45,000 2005 5 3 $10,000 $5,000 $65,000 © Prentice Hall 2003 Economics: Principles and Tools, 3/e Visit UMT online at www.umtweb.edu 35 of 40 Chapter 20, ECON125 Real Versus Nominal GDP Quantity Produced Price Year Cars Computers Cars Computers Real GDP 2004 4 1 $10,000 $5,000 $45,000 2005 5 3 $10,000 $5,000 $65,000 Using the information on the table, we can calculate the growth of real GDP: We can also measure the change in prices over time using an index number called the GDP deflator. © Prentice Hall 2003 Economics: Principles and Tools, 3/e Visit UMT online at www.umtweb.edu 36 of 40 Chapter 20, ECON125 Real Versus Nominal GDP An index is set at 100 in a given year, say the year 2004, called the base year. Prices in other years are compared to prices in 2004: The value 115 means that prices rose by 15% ([115100)/100] between the two years. © Prentice Hall 2003 Economics: Principles and Tools, 3/e Visit UMT online at www.umtweb.edu 37 of 40 Chapter 20, ECON125 Real Versus Nominal GDP The Commerce Department uses a chain index to calculate changes in prices that includes an average of price changes using base years from neighboring years. Data produced by the Commerce Department measures real GDP in chained-dollars and a chain-type price index for GDP. © Prentice Hall 2003 Economics: Principles and Tools, 3/e Visit UMT online at www.umtweb.edu 38 of 40 Chapter 20, ECON125 GDP as a Measure of Welfare GDP is our best measure of the value of output produced, but not a perfect measure. There are several recognized flaws in the construction of GDP: 1. GDP ignores transactions that do not take place in organized markets, such as the work we perform at home. 2. GDP ignores leisure time, along with other non-market activities. © Prentice Hall 2003 Economics: Principles and Tools, 3/e Visit UMT online at www.umtweb.edu 39 of 40 Chapter 20, ECON125 GDP as a Measure of Welfare GDP is our best measure of the value of output produced, but not a perfect measure. There are several recognized flaws in the construction of GDP: 3. GDP ignores the underground economy, where transactions are not reported to official authorities. 4. Finally, GDP does not value changes in the environment that arise from the production of output. © Prentice Hall 2003 Economics: Principles and Tools, 3/e Visit UMT online at www.umtweb.edu 40 of 40 Chapter 20, ECON125