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MONITORING THE MACROECONOMY
GDP and the
Standard of Living
PART 7
CHAPTER
20
CHAPTER CHECKLIST
When you have completed your study of this
chapter, you will be able to
1
Define GDP and explain why the value of production,
income, and expenditure are the same for an
economy.
2
Describe how economic statisticians measure GDP
in the United States.
3
Distinguish between nominal GDP and real GDP and
define the GDP deflator.
4
Explain and describe the limitations of real GDP as a
measure of the standard of living.
20.1 GDP, INCOME, AND EXPENDITURE
GDP Defined
Gross domestic product or GDP
The market value of all the final goods and services
produced within a country in a given time period.
Value Produced
• Use market prices to value production.
20.1 GDP, INCOME, AND EXPENDITURE
What Produced
Final good or service
A good or service that is produced for its final user and
not as a component of another good or service.
Intermediate good or service
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.
GDP includes only those items that are traded in
markets.
20.1 GDP, INCOME, AND EXPENDITURE
Where Produced
• Within a country
When Produced
• During a given time period.
20.1 GDP, INCOME, AND EXPENDITURE
Circular Flows in the U.S. Economy
Consumption expenditure
The expenditure by households on consumption goods
and services.
Investment
The purchase of new capital goods (tools, instruments,
machines, buildings, and other constructions) and
additions to inventories.
20.1 GDP, INCOME, AND EXPENDITURE
Government expenditure on goods and services
The expenditure by all levels of government on goods
and services.
Net exports of goods and services
The value of exports of goods and services minus the
value of imports of goods and services.
20.1 GDP, INCOME, AND EXPENDITURE
Exports of goods and services
Items that firms in in the United States produce and sell
to the rest of the world.
Imports of goods and services
Items that households, firms, and governments in the
United States buy from the rest of the world.
20.1 GDP, INCOME, AND EXPENDITURE
Total expenditure is the total amount received by
producers of final goods and services.
Consumption expenditure: C
Investment: I
Government expenditure on goods and services: G
Net exports: NX
Total expenditure = C + I + G + NX
20.1 GDP, INCOME, AND EXPENDITURE
Income
Labor earns wages, capital earns interest, land earns
rent, and entrepreneurship earns profits.
20.1 GDP, INCOME, AND EXPENDITURE
Expenditure Equals Income
Because firms pay out everything they receive as
incomes to the factors of production, total expenditure
equals total income.
That is:
Y = C + I + G + NX
The value of production equals income equals
expenditure.
20.1 GDP, INCOME, AND EXPENDITURE
Figure 20.1
shows the
circular flow
of income
and
expenditure.
20.2 MEASURING U.S. GDP
The Expenditure Approach
Measures GDP by using data on consumption
expenditure, investment, government expenditure on
goods and services, and net exports.
20.2 MEASURING U.S. GDP
Expenditures Not in GDP
Used Goods
Expenditure on used goods is not part of GDP because
these goods were part of GDP in the period in which
they were produced and during which time they were
new goods.
Financial Assets
When households buy financial assets such as bonds
and stocks, they are making loans, not buying goods
and services.
20.2 MEASURING U.S. GDP
The Income Approach
Measures GDP by summing the incomes that firms pay
households for the factors of production they hire.
The U.S. National Income and Product Account divide
incomes into two big categories:
• Wages
• Interest, rent, and profits
20.2 MEASURING U.S. GDP
Wages
Wages, called compensation of employees in the
national accounts, is the payment for labor services.
It includes net wages and salaries plus fringe
benefits paid by employers such health care
insurance, social security contributions, and pension
fund contributions.
20.2 MEASURING U.S. GDP
Interest, Rent, and Profit
Interest, rent, and profit, called net operating surplus in
the national account, is the sum of the incomes earned
by capital, land, and entrepreneurship.
Interest is the income households receive on loans they
make minus the interest they pay on their borrowing.
Rent includes payments for the use of land and other
rented inputs.
Profit includes the profits of corporations and small
businesses.
20.2 MEASURING U.S. GDP
Net domestic product at factor cost
The sum of wages, interest, rent, and profit.
Net domestic product at factor cost is not GDP.
We need to make two adjustments to arrive at GDP:
• One from factor cost to market prices
• One from net product to gross product
20.2 MEASURING U.S. GDP
From Factor Cost to Market Price
The expenditure approach values goods at market
prices; the income approach values them at factor cost.
Indirect taxes (such as sales taxes) make market prices
exceed factor cost.
Subsidies (payments by government to firms) make
factor cost exceed market prices.
To convert the value at factor cost to the value at
market prices, we must:
• Add indirect taxes and subtract subsidies
20.2 MEASURING U.S. GDP
From Gross to Net
The expenditure approach measures gross product; the
income approach measures net product.
Gross profit is a firm’s profit before subtracting the
depreciation of capital.
Net profit is a firm’s profit after subtracting the
depreciation of capital.
Depreciation is the decrease in the value of capital
that results from its use and from obsolescence.
20.2 MEASURING U.S. GDP
Income includes net profit, so the income approach
gives a net measure.
Expenditure includes investment. Because some new
capital is purchased to replace depreciated capital, the
expenditure approach gives a gross measure.
To get gross domestic product from the income
approach, we must add depreciation to total income.
After making these two adjustments the income
approach almost gives the same estimate of GDP as
the expenditure approach.
20.2 MEASURING U.S. GDP
20.2 MEASURING U.S. GDP
Statistical Discrepancy
The income approach and the expenditure approach do
not deliver exactly the same estimate of GDP—there is
a statistical discrepancy.
Statistical discrepancy
The discrepancy between the expenditure approach
and income approach estimates of GDP, calculated as
the GDP expenditure total minus the GDP income total.
20.2 MEASURING U.S. GDP
GDP and Related Measure of Production and
Income
Gross national product or GNP
The market value of all the final goods and services
produced anywhere in the world in a given time period
by the factors of production supplied by residents of the
country.
U.S. GNP = U.S. GDP + Net factor income from abroad
20.2 MEASURING U.S. GDP
Disposable Personal Income
Consumption expenditure is one of the largest
components of aggregate expenditure and one of the
main influences on it is disposable personal income.
Disposable personal income
Income received by households minus personal income
taxes paid.
20.2 MEASURING U.S. GDP
Figure 20.2 shows the
relationship between
GDP, GNP, and
disposable personal
income.
20.3 NOMINAL GDP VERSUS REAL GDP
Calculating Real GDP
Real GDP
The value of the final goods and services produced in a
given year expressed in the prices of the base year.
Nominal GDP
The value of the final goods and services produced in a
given year expressed in the prices of that same year.
The method of calculating real GDP changed in recent
years, we describe the two methods.
20.3 NOMINAL GDP VERSUS REAL GDP
Traditional Method of Calculating Real GDP
We’ll calculate real GDP in an economy that produces
only apples and oranges. The current year is 2006, and
the base year is 2000.
Because 2000 is the base year, real GDP and nominal
GDP are the same in 2000.
Let’s use the traditional method to calculate real GDP in
2000 and 2006.
20.3 NOMINAL GDP VERSUS REAL GDP
GDP Data for 2000:
To calculate real GDP in 2000, sum the values of apples
and oranges produced in 2000 using prices in 2000.
Value of apples = 60 apples x $0.50 = $30
Value of oranges = 80 oranges x $0.25 = $20
Nominal GDP in 2000 = $30 + $20 = $50
20.3 NOMINAL GDP VERSUS REAL GDP
GDP Data for 2006:
To calculate real GDP in 2006, sum the values of apples
and oranges produced in 2006 using prices in 2000.
Value of apples = 160 apples x $0.50 = $80
Value of oranges = 220 oranges x $0.25 = $55
Real GDP in 2006 = $80 + $55 = $135
20.3 NOMINAL GDP VERSUS REAL GDP
Chained-Dollar Method of Calculating Real
GDP
The chained-dollar method does not use the base-year
prices.
The chained-dollar method uses the prices of current
year and the preceding year.
We show the calculation in fives steps.
20.3 NOMINAL GDP VERSUS REAL GDP
Step 1:Calculate the
value of production in
both 2005 and 2006
using the prices of
2005.
In 2005:
Value of apples = 100 apples x $1.50 = $150
Value of oranges = 200 oranges x $0.75 = $150
Nominal GDP in 2005 = $150 + $150 = $300
20.3 NOMINAL GDP VERSUS REAL GDP
In 2006:
Value of apples = 160 apples x $1.50 = $240
Value of oranges = 220 oranges x $0.75 = $165
2006 Quantities at 2005 prices = $240 + $165 = $405
20.3 NOMINAL GDP VERSUS REAL GDP
Using 2005 prices:
• Value of production in 2005 is $300.
• Value of production in 2006 is $405.
So using 2005 prices, the value of production increased
by $105 or 35 percent in 2006.
20.3 NOMINAL GDP VERSUS REAL GDP
Step 2:Calculate the
value of production in
both 2005 and 2006
using the prices of
2006.
In 2005:
Value of apples = 100 apples x $1.00 = $100
Value of oranges = 200 oranges x $2.00 = $400
2005 Quantities at 2006 Prices = $100 + $400 = $500
20.3 NOMINAL GDP VERSUS REAL GDP
In 2006:
Value of apples = 160 apples x $1.00 = $160
Value of oranges = 220 oranges x $2.00 = $440
Nominal GDP in 2006 = $160 + $440 = $600
20.3 NOMINAL GDP VERSUS REAL GDP
Using 2006 prices:
• Value of production in 2005 is $500.
• Value of production in 2006 is $600.
So using 2006 prices, the value of production increased
by $100 or 20 percent in 2006.
20.3 NOMINAL GDP VERSUS REAL GDP
Step 3: Calculate the average of these increases in
production:
• 35 percent with 2005 prices
• 20 percent with 2006 prices
The average of 35 percent and 20 percent is 27.5
percent—our estimate of the real GDP growth rate
between 2005 and 2006.
Table 20.6(a) summarizes this calculation.
20.3 NOMINAL GDP VERSUS REAL GDP
20.3 NOMINAL GDP VERSUS REAL GDP
Step 4
Repeat the calculations for each year going back to the
base year, so we have an estimate of the real GDP
growth rate from the base year of 2000.
Step 5
Starting from real GDP (nominal GDP) in the base year
use the real GDP growth rates to calculate real GDP
each through to 2006.
Table 20.6(b) this calculation.
20.3 NOMINAL GDP VERSUS REAL GDP
20.3 NOMINAL GDP VERSUS REAL GDP
Calculating the GDP Deflator
GDP deflator
An average of current prices expressed as a
percentage of base-year prices.
GDP deflator measure the price level.
GDP deflator = (Nominal GDP  Real GDP)  100.
20.3 NOMINAL GDP VERSUS REAL GDP
We calculated the in 2006:
Nominal GDP = $600 and real GDP = $145
GDP deflator = (Nominal GDP ÷ Real GDP) x 100
So in 2006:
GDP deflator = ($600 ÷ $145) x 100 = 414.
20.4 THE USE AND LIMITATIONS OF REAL GDP
We use estimates of real GDP for two main purposes:
• To compare the standard of living over time
• To compare the standard of living among countries
The Standard of Living Over Time
To compare living standards we calculate real GDP per
person—real GDP divided by the population.
Table 20.8 shows two calculations
20.4 THE USE AND LIMITATIONS OF REAL GDP
20.4 THE USE AND LIMITATIONS OF REAL GDP
Long-Term Trend
Figure 20.3 shows
the long-term trend
in U.S. real GDP
per person.
Real GDP per
person doubled on
the 33 years from
1965 to 1998.
20.4 THE USE AND LIMITATIONS OF REAL GDP
Short-Term Fluctuations
Fluctuations in the pace of expansion of real GDP is
called the business cycle.
The business cycle is a periodic irregular up-and down
movement of total production and other measure of
economic activity.
The four stages of a business cycle are expansion,
peak, recession, and trough.
20.4 THE USE AND LIMITATIONS OF REAL GDP
The shaded periods
show the
recessions–
periods of falling
production that
lasts for at least six
months.
20.4 THE USE AND LIMITATIONS OF REAL GDP
Standard of Living Across Countries
To compare living standards across countries, we must
convert real GDP into a common currency and common
set of prices, called purchasing power parity.
Goods and Services Omitted from GDP
•
•
•
•
Household production
Underground production
Leisure time
Environment quality
20.4 THE USE AND LIMITATIONS OF REAL GDP
Household Production
• Real GDP omits household production, it
underestimates the value of the production of
many people, most of them women.
Underground Production
• Hidden from government to avoid taxes and
regulations or illegal.
• Because underground economic activity is
unreported, it is omitted from GDP.
20.4 THE USE AND LIMITATIONS OF REAL GDP
Leisure Time
• Our working time is valued as part of GDP, but our
leisure time is not.
Environment Quality
• Pollution is not subtracted from GDP.
• We do not count the deteriorating atmosphere as a
negative part of GDP.
• If our standard of living is adversely affected by
pollution, our GDP measure does not show this
fact.
20.4 THE USE AND LIMITATIONS OF REAL GDP
Other Influences on the Standard of Living
Health and Life Expectancy
• Good health and a long life do not show up directly
in real GDP.
Political Freedom and Social Justice
• A country might have a very large real GDP per
person but have limited political freedom and
social justice.
• A lower standard of living than one that had the
same amount of real GDP but in which everyone
enjoyed political freedom.
GDP in YOUR Life
As you listen to the news, look for references to GDP. How
is GDP used in daily life?
Is the news about nominal GDP or real GDP? Is the term
used correctly?
Using U.S.GDP person, how does your income compare to
the average income?
How do you think your standard of living compares with
that of a student in France or China?
Do you produce more market goods than nonmarket
good? How can you value your nonmarket production?
Is your production counted in the nation’s output?