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Chapter 8
Measuring
the Economy’s
Performance
Introduction
Economists and financial news media
anticipate the latest measure of total
output by the Bureau of Economic
Analysis (BEA).
How does the BEA attempt to gauge the
economy’s performance?
You will find out in this chapter.
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
8-2
Learning Objectives
• Describe the circular flow of income and
output
• Define gross domestic product (GDP)
• Understand the limitations of using
GDP as a measure of national welfare
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
8-3
Learning Objectives (cont'd)
• Explain the expenditure approach to
tabulating GDP
• Explain the income approach to
computing GDP
• Distinguish between nominal GDP and
real GDP
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
8-4
Chapter Outline
• The Simple Circular Flow
• National Income Accounting
• Two Main Methods of Measuring GDP
• Other Components of National
Income Accounting
• Distinguishing Between Nominal and
Real Values
• Comparing GDP Throughout the World
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
8-5
Did You Know That...
• Decisions on how to categorize
business expenses will affect the
relative size of an increase or a
decrease in economic activity?
• Statisticians measuring our national
economic performance strive for
consistency in constructing their
measures across time?
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
8-6
The Simple Circular Flow
• Two observations
1. In every economic exchange, the seller
receives exactly the same amount that the
buyer spends.
2. Goods and services flow in one direction
and money payments flow in the other.
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8-7
The Simple Circular Flow (cont'd)
• Profits explained
 Question
 Why
is profit a cost of production?
 Answer
 Profits
are the return entrepreneurs receive
for the risk they incur when organizing
productive activities.
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
8-8
The Simple Circular Flow (cont'd)
• Final Goods and Services
 Goods and services that are at their final stage of
production and will not be transformed into yet
other goods or services
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8-9
Figure 8-1 The Circular Flow
of Income and Product
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8-10
The Simple Circular Flow (cont'd)
• Product Markets
 Transactions in which households buy goods
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8-11
The Simple Circular Flow (cont'd)
• Factor Markets
 Transactions in which businesses buy resources
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8-12
The Simple Circular Flow (cont'd)
• Total Income
 Wages, rent, interest, profits
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8-13
The Simple Circular Flow (cont'd)
• Question
 Why must total income
be identical to the dollar
value of total output?
• Answer
 Every transaction
simultaneously involves
an expenditure and
a receipt.
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
8-14
National Income Accounting
• National Income Accounting
 A measurement system used to estimate
national income and its components
• Total Income
 The yearly amount earned by the nation’s
resources (factors of production)
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
8-15
National Income Accounting (cont'd)
• Gross Domestic Product (GDP)
 The total market value of all final
goods and services produced by
factors of production located within
a nation’s borders
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
8-16
National Income Accounting (cont'd)
• Observations
 GDP measures the dollar value of
final output.
 GDP measures the dollar value of final
goods and services produced per year
by factors of production located within
a nation’s borders.
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
8-17
National Income Accounting (cont'd)
• Stress on final output
 What is a final good?
 Wheat?
 Steel?
 Oil?
 Bread?
 Automobile?
 Gasoline?
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8-18
National Income Accounting (cont'd)
• Intermediate Goods
 Goods used up entirely in the production of
final goods
• Value Added
 The dollar value of an industry’s sales
minus the value of intermediate goods
(for example, raw materials and parts)
used in production
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8-19
Table 8-1 Sales Value and Value Added
at Each Stage of Donut Production
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8-20
National Income Accounting (cont'd)
• Exclusion of financial transactions,
transfer payments, and
secondhand goods
 Numerous transactions occur that have
nothing to do with final goods and services
being produced.
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8-21
National Income Accounting (cont'd)
• Exclusion of financial transactions
 Securities

Stocks and bonds
 Government transfer payments

Social Security

Unemployment compensation
 Private transfer payments

Individual gifts

Corporate gifts
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8-22
National Income Accounting (cont'd)
• Transfer of secondhand
goods excluded
 Why not count the sale of a used
computer, guitar, or snowboard as part
of GDP?
• Other excluded transactions
 Household production
 Legal and illegal underground transactions
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8-23
National Income Accounting (cont'd)
• GDP’s limitations
 Excludes non-market production
 It is not necessarily a good measure of the
well-being of a nation.
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8-24
National Income Accounting (cont'd)
• GDP is a measure of the value of
production in terms of market prices,
and an indicator of economic activity.
• GDP is not a measure of a nation’s
overall welfare.
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8-25
Two Main Methods
of Measuring GDP
• Expenditure Approach
 Computing GDP by adding up the dollar
value at current market prices of all final
goods and services
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8-26
Two Main Methods
of Measuring GDP (cont'd)
Expenditure Approach
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8-27
Two Main Methods
of Measuring GDP (cont'd)
• Income Approach
 Measuring GDP by adding up all
components of national income, including
wages, interest, rent, and profits
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8-28
Two Main Methods
of Measuring GDP (cont'd)
Income Approach
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8-29
Two Main Methods
of Measuring GDP (cont'd)
• Deriving GDP by the expenditure approach
 Consumption Expenditure (C)

Durable Consumer Goods


Nondurable Consumer Goods


Life span of more than three years
Goods that are used up in three years
Services

Mental or physical help
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
8-30
Two Main Methods
of Measuring GDP (cont'd)
• Deriving GDP by the
expenditure approach
 Gross Private Domestic Investment (I)
 The
creation of capital goods, such as factories
and machines, that can yield production and
hence consumption in the future

Also included: changes in business inventories and
repairs made to machines, buildings
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8-31
Two Main Methods
of Measuring GDP (cont'd)
• Deriving GDP by the expenditure approach
 Gross Private Domestic Investment (I)

Producer Durables or Capital Goods


Fixed Investment


Life span of more than three years
Purchases by business of newly produced producer
durables or capital goods
Inventory Investment

Changes in stocks of finished goods and goods in
process, as well as changes in raw materials
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8-32
Two Main Methods
of Measuring GDP (cont'd)
• Deriving GDP by the
expenditure approach
 Government Expenditures (G)
 State,
local, and federal
 Valued
at cost
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8-33
Two Main Methods
of Measuring GDP (cont'd)
• Deriving GDP by the
expenditure approach
 Net Exports (Foreign Expenditures)
Net exports (X) = Total exports – Total imports
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8-34
Two Main Methods
of Measuring GDP (cont'd)
• Presenting the expenditure approach
 Where
C
= consumption expenditures
I
= investment expenditures
G
= government expenditures
X
= net exports
GDP = C + I + G + X
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
8-35
Figure 8-2
GDP and Its Components
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8-36
Two Main Methods
of Measuring GDP (cont'd)
• Depreciation and net domestic product
 Deducting for depreciation (capital
consumption allowance)
 Reduction
in the value of capital goods over a
one-year period due to physical wear and tear,
and also to obsolescence
NDP = GDP – Depreciation
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8-37
Two Main Methods
of Measuring GDP (cont'd)
• NDP = GDP – Depreciation
• GDP = C + I + G + X
• NDP = C + I + G + X – Depreciation
• Net Investment = I – Depreciation
 Domestic investment minus an estimate
of the wear and tear on the existing
capital stock
• NDP = C + Net I + G + X
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
8-38
Two Main Methods
of Measuring GDP (cont'd)
• Deriving GDP by the income approach
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8-39
Deriving GDP
by the Income Approach
• Gross Domestic Income (GDI)
 The sum of all income—wages, interest,
rent, and profits—paid to the four factors
of production
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
8-40
Two Main Methods
of Measuring GDP (cont'd)
• Gross Domestic Income (GDI)
 Wages: salaries and labor income
 Rent: farms, houses, stores
 Interest: savings accounts
 Profits: sole proprietorships, partnerships,
corporations
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
8-41
Two Main Methods
of Measuring GDP (cont'd)
• Gross domestic product equals gross
domestic income plus indirect business
taxes and depreciation
• These last items are called nonincome
expense items
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8-42
Two Main Methods
of Measuring GDP (cont'd)
• Indirect business taxes
 All business taxes except the tax on
corporate profits
 Include sales and business property taxes
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8-43
Figure 8-3 Gross Domestic Product
and Gross Domestic Income, 2007
(in billions of 2007 dollars per year)
Source: U.S. Department of Commerce. First quarter preliminary data annualized.
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8-44
Figure 8-3 Gross Domestic Product
and Gross Domestic Income, 2007
(in billions of 2007 dollars per year)
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8-45
Other Components of
National Income Accounting
• National Income (NI)
 The total of all factor payments to resource
owners
• Personal Income (PI)
 The amount of income that households
actually receive before they pay personal
income taxes
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8-46
Other Components of
National Income Accounting (cont'd)
• Disposable Personal Income (DPI)
 Personal income after personal income
taxes have been paid
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8-47
Table 8-2 Going from GDP
to Disposable Income, 2007
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8-48
Distinguishing Between Nominal
and Real Values
• Nominal Values
 Measurements in terms of the actual
market prices at which goods are sold;
expressed in current dollars, also called
money values
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
8-49
Distinguishing Between Nominal
and Real Values (cont'd)
• Real Values
 Measurements after adjustments have
been made for changes in the average
of prices between years; expressed in
constant dollars
• Constant Dollars
 Dollars expressed in terms of real
purchasing power
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8-50
Example: Correcting GDP
for Price Index Changes
• Correcting GDP for price index changes
 Nominal (current) dollars GDP
 Real (constant) dollars GDP
Nominal GDP
x 100
Real GDP =
Price level*
*Price level: measured by the GDP deflator
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8-51
Table 8-3 Correcting GDP
for Price Index Changes
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8-52
Distinguishing Between Nominal
and Real Values (cont'd)
• Per capita GDP
 Adjusting for population growth
Real GDP
Per capita real GDP =
Population
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8-53
Figure 8-4 Nominal and Real GDP
Source: U.S. Department of Commerce
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8-54
Comparing GDP
Throughout the World
• Foreign Exchange Rate
 The price of one currency in terms
of another
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8-55
Comparing GDP
Throughout the World (cont'd)
• Foreign exchange rate
 $1.25
= 1 euro, or $1 = 0.80 euros
 French
per capita income = 23,168.80 euros
 French
per capita income in terms of dollars
equals 23,168.80 euros x $1.25 = $28,961
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8-56
Comparing GDP
Throughout the World (cont'd)
• Purchasing Power Parity
 Adjustments in exchange rate conversions
that takes into account differences in the
true cost of living across countries
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8-57
Table 8-4
Comparing GDP Internationally
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8-58
Issues and Applications:
The Art of Estimating GDP
Often Requires Touch-Ups
• The Bureau of Economic Analysis gives an
advance estimate of quarterly GDP.
• The estimate receives considerable attention
from the news media.
• Nevertheless, the estimate is updated at
least two times.
• How different is the final result?
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8-59
Figure 8-5 Effects of Revisions
in GDP Estimates on Measured
GDP Growth Rates
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8-60
Summary Discussion
of Learning Objectives
• The circular flow of income and output
 In every economic transaction, receipts exactly
equal expenditures
 Goods and services flow in one direction and
money payments flow in the other
• Gross domestic product (GDP)
 The total market value of a nation’s final output of
goods and services produced in a year using
factors of production located within its borders
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
8-61
Summary Discussion
of Learning Objectives (cont'd)
• The limitations of using GDP as
a measure of national welfare
 Excludes non-market transactions
 Does not measure national well-being
• The expenditure approach to
tabulating GDP
 GDP = C + I + G + X
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
8-62
Summary Discussion
of Learning Objectives (cont'd)
• The income approach to computing GDP
 The sum of wages, rent, interest, profits
• Distinguishing between nominal GDP and
real GDP
 Nominal GDP is the value of newly produced final
output measured in current market prices.
 Real GDP adjusts nominal GDP into constant
dollars by correcting for price level changes.
Copyright © 2008 Pearson Addison Wesley. All rights reserved.
8-63
End of
Chapter 8
Measuring
the Economy’s
Performance