Download Slide 1

Chapter: 7
Tracking the
Macroeconomy
Krugman/Wells
©2009  Worth Publishers
The National Accounts






Almost all countries calculate a set of numbers known
as the national income and product accounts.
The national income and product accounts, or national
accounts, keep track of the flows of money between
different parts of the economy.
Gross domestic product or GDP measures the total
market value of all final goods and services newly
produced within a country during a given year.
It is a measure of output in an economy in it’s most
aggregated form.
Total market value means we count the monetary
value of goods & services. It is a common
denominator of apples & oranges.
Within a country means any good or service produce
inside a country is included in that countries GDP
regardless of ownership.
Gross Domestic Product



Newly produced means we exclude the value of
financial transactions or the sale of used goods.
The value of stocks bought & sold are not counted in
GDP, nor the sale of existing homes, nor the value of
social security payments.
Final goods and services are goods and services sold
to the final, or end, user.


Why bother with this distinction?


Intermediate goods and services are goods and
services—bought from one firm by another firm—that
are inputs used for production of other goods and
services or for resale.
To avoid double counting production of a good or
service since the cost of an intermediate good is
included in the price the firm sells it’s product.
How do government statisticians do this?
Calculating Gross Domestic Product

GDP can be calculated three ways (they are not
mutually exclusive, each way complements the other):
1. Add up the value added of all producers

This is how statisticians avoid double counting.
2. Add up all spending on domestically-produced
final goods and services from consumers,
business firms, governments, and foreigners.

This results in the equation:
GDP = C + I + G + X - IM
3. Add up all income paid to factors of production

Wages, interest, rent, and profit
Calculating Gross Domestic Product
Value Added…




Goods are produced in different stages of production.
Raw materials, making of parts, assembly of parts,
selling to consumers.
By not counting the value of the good produced when
it is sold, but only counting the value added at each
stage of production statisticians will count the
equivalent of only counting final goods & services.
Definition of value added:
 the value of a firms output minus the value of
intermediate goods purchased by the firm.
Calculating Gross Domestic Product
If you counted the sales of the good when they were sold ($4,200,
$9,000, $21,500) GDP would be $34,700, which would be a vast
exaggeration of actual production.
Calculating Gross Domestic Product
2. Adding up spending on all domestically produced
goods & services:
Consumption - done by Households
Investment - done by Business Firms
Government Purchases - done by governments
Net Exports = Exports – Imports : done by the rest of
the world
Consume:
Pay
Buy goods &
Households
taxes
services
Work:
Save:
Earn
Spend less
Income
than income
earned
Firms
Produce
goods & services
(GDP)
Invest:
Buy Capital
(investment)
goods (tools,
factories,etc)
Hire Resources:
To produce
goods & services
An Expanded Circular-Flow Diagram
Consumer spending
Households
Wages, profit, interest,
rent
Factor Markets
Wages, profit,
interest, rent
GDP
Firms
The National Accounts

Households earn income via the factor markets from
wages, interest on bonds, dividends on stocks, and
rent on land.




A stock is a share in the ownership of a company held
by a shareholder.
A bond is borrowing in the form of an IOU that pays
interest.
In addition, households receive government transfers
from the government.
Disposable income = total household income minus
taxes, is available to spend on consumption or to
save.
Percent of GDP (2009)
100
90
80
70
60
50
40
30
20
10
70.8%
Consumption
Households: Consumption (C)
Durable goods: goods that last a
relatively long time: Cars,
Refrigerators, T.V.’s, Radios
Non-durable goods: goods which
are perishable: Food, Clothing
Services: goods which do not
involve the production of physical
things: Banking, Medical care,
Legal services
Services make up the bulk of Consumption
Consumption spending is fairly steady over the
business cycle
Categories of GDP; 2009
Billions of $
Percent of GDP
Gross Domestic Product
14,119.0
100.0
Consumption
10,001.3
70.8
Durable
Non-durable
Services
1,026.5
2,204.2
6,770.6
7.3
15.6
47.9
Percent of GDP(2009)
100
90
80
70
60
50
40
30
20
10
11.2%
Investment
70.8%
Consumption
Business Firm spending:
Investment (I)
1) All final purchases of machines,
equipment, tools, etc.
2) All construction
Nonresidential: expenditures on,
factories, office buildings,
computers, software
Residential: expenditures by
households on new houses and
apartment buildings
3) Changes in inventories from previous year
Business inventories: goods that firms produce
now with the intent to sell later
The goods on shelves and warehouses.
Investment categories
1. Business Fixed Investment
a.Non-residental: The spending by business firms on
equipment, tools, factories, etc. so as to increase
future production and output.
b. Residential Investment: Newly purchased homes
are included here because they lead to a future
stream of output for consumers
2. Inventory investment: The change in business
inventories affects business firms ability for future
sales.
Categories of GDP; 2009
Investment
Non-residential
Residential
Changes in Business Inventories
1,589.2
1,364.4
352.1
-127.2
11.2
9.7
2.5
-0.9
An Expanded Circular-Flow Diagram
Consumer spending
Private savings
Households
Wages, profit, interest,
rent
Factor Markets
Wages, profit,
interest, rent
GDP
Firms
Investment spending
Borrowing
and stock
issues by
firms
Financial
Markets
Percent of GDP(2009)
Trade Deficit
100
90
80
70
60
50
40
30
20
10
Government Purchases (G)
20.6%
Government
11.2%
Investment
Expenditures by federal, state and
local governments on new final goods
such as military goods,roads,education,
police, etc.
Does not include transfer payments
(social security, unemployment benefits,
70.8%
Consumption welfare payments, etc.)
Government outlays(Spending) would
include both purchases & transfer payments
Notice that Total purchases from households, firms, and
governments is 102.6%. How is this possible?
Because of Net Exports!
Percent of GDP(2009)
Trade Deficit
100
90
80
70
60
50
40
30
20
10
20.6%
Government
11.2%
Investment
Net Exports (X - IM)
Goods produced by Americans and sold
to Foreigners (Exports) minus
Goods produced by Foreigners and
bought by Americans (Imports).
Net Exports = (Exports - Imports)
70.8%
Also called the Trade Balance
When the stacked bar from C, I, & G is
greater than 100% there is a Trade
deficit (Imports > Exports)
Consumption
Net exports are used to only count production in the U.S.
Imports are bought by consumers and would be in consumption
spending, but we don’t want to count those goods that are not
produced in the U.S.
Exports are not bought in the U.S. but produced here, which we
do want to count. Need to subtract Imports and add Exports
Categories of GDP; 2009
Government Purchases
2,914.9
20.6
Net Exports
-386.4
-2.6
exports
1578.4
imports
1964.7
Adding up all the expenditures using symbols:
GDP(Y) =
C
+
I
+
G
+ NX
14,119.0 = 10,001.3 + 1,589.2 + 2,914.9 - 386.4
An Expanded Circular-Flow Diagram
Government purchases
of goods and services
Government borrowing
Government
Government transfers
Taxes
Consumer spending
Private savings
Households
Wages, profit, interest,
rent
Factor Markets
Wages, profit,
interest, rent
GDP
Firms
Financial
Markets
Borrowing
and stock
issues by
firms
Investment spending
Foreign borrowing
and sales of stock
Exports
Rest of the world
Imports
Foreign lending and purchases of
stock
Source:BEA
Composition of Gross Domestic Product 1929-2007
Real vs. Nominal GDP


Does production increase when GDP increases?
Nominal GDP is the value of all final goods and
services produced in the economy during a given year,
calculated using the prices current in the year in
which the output is produced.


If Nominal GDP increases, output may or may not go up
since an increase in prices themselves could cause
Nominal GDP to increase.
Real GDP is the total value of the final goods and
services produced in the economy during a given year,
calculated using the prices of a selected base year.


Statisticians adjust for price changes, so that if real
GDP increases, we know for sure that output increases.
This is the measure that is often quoted in the media.
Real vs. Nominal GDP
Calculating GDP and Real GDP in a Simple Economy
Year 1
Year 2
Quantity of apples (billions)
2,000
2,200
Price of apple
$0.25
$0.30
Quantity of oranges (billions)
1,000
1,200
Price of orange
$0.50
$0.70
Nominal GDP (billions of dollars)
$1,000
$1,500
Real GDP (billions of year 1 dollars)
$1,000
$1,150
Nominal GDP = Price (in current year) x Quantity
Real GDP = Price (in a common year) x Quantity
For year 2: (2,200 x $0.25) + (1,200 x $0.50) = $1,150
Nominal GDP increases by 50% (($500/$1,000) x 100)
Real GDP increases by 15% (($150/$1,000) x 100)
Using Nominal GDP vastly exaggerates the change in the amount
of actual output produced, which is why calculating Real GDP is
necessary.
Real vs. Nominal GDP
►ECONOMICS IN ACTION
Miracle in Venezuela?


The South American nation of Venezuela has a distinction that
may surprise you: in recent years, it has had one of the world’s
fastest-growing nominal GDPs. Between 1997 and 2007,
Venezuelan nominal GDP grew by an average of 28% each
year—much faster than nominal GDP in the United States or
even in booming economies like China.
So is Venezuela experiencing an economic miracle?
►ECONOMICS IN ACTION
Miracle in Venezuela?

No, it’s just suffering from unusually high inflation.
Nominal GDP
(billions of bolivars),
Real GDP (billions of 1997
bolivars)
VEB500,000
400,000
300,000
200,000
100,000
1997
1999
2001
2003
2005
2007
Year
Real vs. Nominal GDP
Calculating GDP and Real GDP in a Simple Economy
Year 1
Year 2
Quantity of apples (billions)
2,000
2,200
Price of apple
$0.25
$0.30
Quantity of oranges (billions)
1,000
1,200
Price of orange
$0.50
$0.70
Nominal GDP (billions of dollars)
$1,000
$1,500
Real GDP (billions of year 1 dollars)
$1,000
$1,150
Real GDP (billions of year 2 dollars)
$1,300
$1,500
Choosing a base year is arbitrary, so we could use Year 2 prices if we
wished.
Using Year 2 prices, Real GDP increases by 15.4%. Remember,
using Year 1 prices Real GDP increases by 15%. Both are correct!
The BEA uses both numbers and averages them to get the
percentage actually used.
This is called Chained dollars. Calculate changes in real GDP
using the average between the growth rate calculated using an early
base year and the growth rate calculated using a late base year.
Real vs. Nominal GDP
Except in the base year, real GDP is not the same as
nominal GDP, output valued at current prices.
What makes Nominal GDP different than Real
GDP is the change in prices from year to year
(inflation rate).
Real GDP in 2005
chained dollars
Nominal GDP
(Current dollars)
By definition,
Nominal GDP &
Real GDP are
the same in the
base year (2005)
Real vs. Nominal GDP
Nominal versus Real GDP in 1993, 2000, and 2007
Nominal GDP (billions
of current dollars)
Real GDP (billions of 2000
dollars)
1993
$6,657
$7,533
2000
9,817
9,817
2007
13,808
11,524
By dividing Nominal GDP by Real GDP for each year we can construct an
implicit price index, which is called the GDP Deflator.
 A price index is the ratio of the current cost of that market basket to the cost
in a base year, multiplied by 100.
 In this case the market basket is goods & services in GDP
1993: $6,657 / $7,533 = 88.4
2000: $9,817 / $9,817 = 100
2007: $13,808 / $11,524 = 119.8
A price index can be use to
measure the aggregate price
level (overall level of prices in
the economy).
Inflation Rate, CPI, and other Indexes



By changing the market basket of goods & services
different price indexes can be calculated.
The inflation rate is the yearly percentage change in
a price index, typically based upon Consumer Price
Index, or CPI, the most common measure of the
aggregate price level.
The consumer price index, or CPI, measures the
cost of the market basket of a typical urban American
family.
Consumer Price Index
Market Basket composition for the Consumer Price Index
Motor fuel
7%
Apparel
4%
Transportation
13%
Medical care
5%
Housing
40%
Recreation
5%
Education and
communication
6%
Other goods
and services
4%
Food and
beverages
16%
Inflation Rate, CPI, and other Indexes






CPI number
2005 – 195.3
2006 – 201.6
2007 – 207.3
2008 – 215.3
2009 – 214.5
Inflation Rates
2006: ((201.6 – 195.3) / 195.3) x 100 = 3.22%
2007: ((207.3 – 201.6) / 201.6) x 100 = 2.83%
2008: ((215.3 – 207.3) / 207.3) x 100 = 3.86%
2009: ((214.5 – 215.3) / 215.3) x 100 = -0.37%
Example: An RCA 23” Color TV cost $495 in 1956. Was
this cheap or expensive compared to today’s HDTV’s?
 Use the CPI to find out.
Price in 2009 = Price in 1956 x CPI in 2009 / CPI in 1956
Price in 2009 =
$495
x
214.5 / 27.2
$3,903 =
$495
x
7.886

►ECONOMICS IN ACTION
Indexing to the CPI

The CPI has a direct and immediate impact on millions
of Americans.





The reason is that many payments are tied, or
“indexed,” to the CPI—the amount paid rises or falls
when the CPI rises or falls.
Today, 48 million people receive checks from Social
Security.
The amount of an individual’s check is determined by a
formula that reflects his or her previous payments into
the system as well as other factors.
In addition, all Social Security payments are adjusted
each year to offset any increase in consumer prices
over the previous year.
The CPI is used to calculate the official estimate of the
inflation rate used to adjust these payments yearly.
FOR INQUIRING MINDS
Is the CPI biased?


The U.S. government takes considerable care in
measuring consumer prices. Nonetheless, many
economists believe that the consumer price index
systematically overstates the actual rate of inflation.
One reason is the fact that the CPI measures the cost
of buying a given market basket.


Yet, consumers typically alter the mix of goods and
services they buy, reducing purchases of products that
have become relatively more expensive and increasing
purchases of products that have become relatively
cheaper.
The second reason arises from innovation.

By widening the range of consumer choice, innovation
makes a given amount of money worth more.
The CPI, the PPI, and the GDP Deflator
Percent change in
CPI, PPI, GDP
deflator
25%
20
15
10
5
0
-5
-10
-15
-20
1930
1940
1950
1960
1970
1980
1990
2000 2007 Year
These three different measures of inflation usually move closely
together. Each reveals a drastic acceleration of inflation during the
1970s and a return to relative price stability in the 1990s.
Problems with GDP
1. GDP cannot count all production done in an economy.
GDP does not count Non-Market Transactions:
a. Household production
Example: Instead of hiring someone to cut your grass you
do it yourself
b. Underground Economy
Legal or Illegal activity that is paid for by cash or goods.
Much of it to avoid taxes and regulations
Will cause GDP to understate economic activity
Possibly by as much as 10% of GDP in the U.S.
Makes it difficult to compare across countries
2. GDP cannot deal with quality improvements in goods
& services, which will cause us to understate our
actual standard of living if we use GDP as a measure
of standard of living.
Example: Suppose you had this place setting for a dinner
table: There are 4 items, which can be considered GDP
GDP only measures
quantity.
Now consider the place setting below for dinner:
There are still only 4 items
so GDP will be the same as
the place setting above.
Since you now have a fork
and knife the quality of your
dining experience will be
better.
You are better off with the bottom place setting,
but GDP is unchanged!
Problems with GDP
3. GDP does not consider distribution of output
How much of GDP goes to poor, middle class, rich
Can measure GDP/Person, but that only gives an average
4. GDP does not subtract the byproducts of production:
Pollution or Waste
These could even cause GDP to increase!
Because of the hiring of workers to clean up.
If crime is high, GDP increases because more police and
security persons are hired.
GLOBAL COMPARISON
GDP and the meaning of life



Rich is better, all other things equal
Money matters less as you grow richer beyond some level
Money isn’t everything. Leisure time, etc also important.
SUMMARY
1. Economists keep track of the flows of money
between sectors with the national income and
product accounts, or national accounts.
Households earn income via the factor markets from
wages. Disposable income is allocated to
consumer spending (C) and private savings. Via
the financial markets, private savings and foreign
lending are channeled to investment spending (I),
government borrowing, and foreign borrowing.
Government purchases of goods and services
(G) are paid for by tax revenues and any
government borrowing. Exports (X) generate an
inflow of funds into the country from the rest of the
world, but imports (IM) lead to an outflow of funds to
the rest of the world.
SUMMARY
2. Gross domestic product, or GDP, measures the value of all
final goods and services produced in the economy. It does
not include the value of intermediate goods and services,
but it does include inventories and net exports (X − IM). It
can be calculated in three ways: add up the value added by
all producers; add up all spending on domestically produced
final goods and services (GDP = C + I + G + X − IM); or add
up all the income paid by domestic firms to factors of
production. These three methods are equivalent.
SUMMARY
3. Real GDP is the value of the final goods and services
produced calculated using the prices of a selected base year.
Except in the base year, real GDP is not the same as nominal
GDP, the value of aggregate output calculated using current
prices. Analysis of the growth rate of aggregate output must
use real GDP. Real GDP per capita is a measure of average
aggregate output per person but is not in itself an appropriate
policy goal. U.S. statistics on real GDP are always expressed
in chained dollars.
SUMMARY
4. To measure the aggregate price level, economists calculate
the cost of purchasing a market basket. A price index is the
ratio of the current cost of that market basket to the cost in a
selected base year, multiplied by 100.
5. The inflation rate is the yearly percent change in a price
index, typically based on the consumer price index, or CPI,
the most common measure of the aggregate price level. A
similar index for goods and services purchased by firms is the
producer price index, or PPI. Finally, economists also use
the GDP deflator, which measures the price level by
calculating the ratio of nominal to real GDP times 100.