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Chapter 2
The Measurement
of Income,
Prices, and
Unemployment
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The Circular Flow of Income and
Expenditure
• The circular flow of income and expenditure model
is a simple representation of the macro economy
• In the following graph, convince yourself that:
– The value of output produced by firms equals the value of
expenditures by participants in the economy
– The value of output produced by firms equals the total
income generated in the economy
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Figure 2-1 The Circular Flow of Income
and Consumption Expenditures
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Defining GDP
• GDP (Y) is the value of all final goods
and services that are currently produced
and sold (but not resold) through the
market during the current time period
– The GDP of a country is often referred to as
the country’s output and/or income
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Table 2-1 What’s In and What’s Out of
GDP
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Keeping Track of GDP and other
U.S. Data
• The National Income and Product Accounts
(NIPA) is the official U.S. government accounting of
all the U.S. flows of income and expenditures.
• The “Big Three” agencies for U.S. economic data
– The Bureau of Economic Analysis (BEA)
– The Bureau of Labor Statistics (BLS)
– The Federal Reserve Board (Fed)
• Other sources of data
– The Bureau of the Census
– International data: OECD, the World Bank and the IMF
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Types of Investment (I)
• Inventory Investment is the change in the
stock of raw materials, parts and finished
products held by businesses.
– Any goods that are unsold automatically are counted as
part of unplanned inventory investment.
• Fixed Investment includes all final goods
(mainly structures and equipment) purchased
by businesses not intended for resale.
– Houses and condominiums owned by households are also
counted as fixed investment.
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Relation of Investment and Saving
• Personal Saving (S) is that part of personal
income that is not consumed or paid out in taxes
– Also referred to as Private Saving
– Algebraically: S = (Y-T) - C (where T = Net Taxes)
• Funds from savings are channeled to firms in two
basis ways:
– Households buy bonds and stocks issued by firms
– Households deposit savings in banks and other financial
institutions that in turn lend money to firms
• Firms use the money channeled from savings to
buy investment goods
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Figure 2-2 Introduction of Saving and
Investment to the Circular Flow Diagram
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Net Exports and Net Foreign
Investment
• Exports are goods produced within one country
and shipped to another
• Imports are goods consumed within one country
but produced in another country
• Net Exports (NX) are equal to the excess of
exports over imports
• Net Foreign Investment (NFI) is equal to U.S.
purchases of foreign financial assets minus foreign
purchases of U.S. financial assets
– Interesting connection: NX = NFI !
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The Government Sector
•
•
Government Purchases (G) is the value of
goods and services purchased by the government
at the federal, state and local levels
Transfer Payments (F) are payments from the
government to households that do not require the
recipient to provide a service in return
– Examples: Social Security, Medicare and Food Stamps
•
•
•
•
Government Spending = G + F
The Government pays for its spending by collecting
Taxes (R) or by borrowing and/or printing money
Net Taxes (T) = R – F
Budget Surplus = T – G
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Figure 2-3 Introduction of Taxation,
Government Spending, and the Foreign Sector
to the Circular Flow Diagram
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Global Economic Crisis and GDP
• How long did the crisis last?
– Business Cycle Peak: 2007:Q4
– Business Cycle Trough: 2009:Q2
• How did the components of GDP behave over this
time?
–
–
–
–
Real consumption by 0.8%
Real government spending by 6.6%
NX became significantly less negative
But real investment by 31.7%!
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Deriving the “Magic” Equation
• The income accounting identity states that an
economy’s income must equal its expenditures:
Y ≡ E  Y = C + I + G + NX
(1)
• Now, use the fact that household income must
equal household outlays (and recall that T = R - F):
Y+F=C+S+R
(2)
Y=C+S+T
• Equating (1) and (2) yields the “Magic Equation”
C + S + T = C + I + G + NX
 S + T = I + G + NX
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Interpreting the “Magic Equation”
Recall the “Magic Equation:” S + T = I + G + NX
• Leakages (S + T) describe the portion of total
income that is not available for consumption
• Injections (I + G + NX) is a term for nonconsumption expenditures
• The “Magic Equation” shows how leakages and
injections are connected by definition!
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“Magic Equation” Application:
Twin Deficits
Recall the “Magic Equation:” S + T = I + G + NX
• Rearranging (1) yields  T - G = (I + NX) – S
(1)
– If T - G < 0  possibly NX < 0
– This suggests that a budget deficit and trade deficit
might be observed at the same time!
– Note that the “magic equation” only suggests the
possible connections that may be observed in these
variables.
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The “Magic Equation” in Recent
Years (as % of GDP)
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Table 2-2 Households Get
What Remains After All the Leakages
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Nominal GDP, Real GDP and the
GDP Deflator
• Nominal GDP is the value of gross domestic
product in current (actual) prices.
• Real GDP is the measure of gross domestic
product using prices of an arbitrarily chosen base
year.
• The GDP deflator is a price index that measures
the aggregate economy’s price level.
– Algebraically: GDP Def = Nominal GDP / Real GDP * 100
– The percentage change in the GDP deflator gives a
measure of the economy’s inflation rate.
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Figure 2-4 Nominal GDP, Real GDP,
and the GDP Deflator, 1900–2010
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Source: Appendix
Table A-1. See
explanation in
Appendix C-4.
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How to Calculate Growth Rates
• The general formula for the percentage annual
growth rate of any variable X at time t beginning
from time s:
(where LN is the natural log function)
• Inflation and GDP growth rates are just two
applications of this formula!
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Measuring Unemployment
• The unemployed are those without who either are on
temporary layoff or have taken specific action to look for work
• The total labor force is total of the civilian employed, the
armed forces and the unemployed
• The actual unemployment rate (U) is defined below:
• Each month 1,500 census workers interview a random sample
of 60,000 households to estimate unemployment
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Flaws in the Definition of
Unemployment
• U is not a measure of social distress
– Much worse for the head of a household to be
unemployed compared to a 16-year old teenage
– Other common situations:
• College graduates looking for first jobs
• Women reentering the labor market after maternity leave
• People who voluntarily quit jobs and are now looking again
• U misses “forced part time workers”
• U misses “discouraged workers” who are not
actively seeking jobs and therefore are not in the
labor force
– See chart on next slide!
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Millions Impacted by Recessions
but Not Counted as Unemployed
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