© 2007 Thomson South-Western. Agenda Circular Flow Diagram GDP – Nominal and Real GDP Deflator.

48
© 2007 Thomson South-Western

Transcript of © 2007 Thomson South-Western. Agenda Circular Flow Diagram GDP – Nominal and Real GDP Deflator.

Page 1: © 2007 Thomson South-Western. Agenda Circular Flow Diagram GDP – Nominal and Real GDP Deflator.

© 2007 Thomson South-Western

Page 2: © 2007 Thomson South-Western. Agenda Circular Flow Diagram GDP – Nominal and Real GDP Deflator.

© 2007 Thomson South-Western

Agenda

• Circular Flow Diagram• GDP – Nominal and Real• GDP Deflator

Page 3: © 2007 Thomson South-Western. Agenda Circular Flow Diagram GDP – Nominal and Real GDP Deflator.

© 2007 Thomson South-Western

THE ECONOMY’S INCOME AND EXPENDITURE

• When judging whether the economy is doing well or poorly, it is natural to look at the total income that everyone in the economy is earning.

• For an economy as a whole, income must equal expenditure because:– Every transaction has a buyer and a seller.– Every dollar of spending by some buyer is a dollar

of income for some seller.

Page 4: © 2007 Thomson South-Western. Agenda Circular Flow Diagram GDP – Nominal and Real GDP Deflator.

© 2007 Thomson South-Western

Figure 1 The Circular-Flow Diagram

Spending

Goods andservicesbought

Revenue

Goodsand services

sold

Labor, land,and capital

Income

= Flow of inputs and outputs

= Flow of dollars

Factors ofproduction

Wages, rent,and profit

FIRMS•Produce and sell

goods and services•Hire and use factors

of production

•Buy and consumegoods and services

•Own and sell factorsof production

HOUSEHOLDS

•Households sell•Firms buy

MARKETSFOR

FACTORS OF PRODUCTION

•Firms sell•Households buy

MARKETSFOR

GOODS AND SERVICES

Page 5: © 2007 Thomson South-Western. Agenda Circular Flow Diagram GDP – Nominal and Real GDP Deflator.

© 2007 Thomson South-Western

MEASURING A NATION’S INCOME 5

What This Diagram Omits

• The government– collects taxes, buys g&s

• The financial system– matches savers’ supply of funds with borrowers’

demand for loans

• The foreign sector– trades g&s, financial assets, and currencies with

the country’s residents

Page 6: © 2007 Thomson South-Western. Agenda Circular Flow Diagram GDP – Nominal and Real GDP Deflator.

© 2007 Thomson South-Western

THE MEASUREMENT OF GROSS DOMESTIC PRODUCT• Gross domestic product (GDP) is a measure of

the income and expenditures of an economy.

• GDP is the total market value of all final goods and services produced within a country in a given period of time.

Page 7: © 2007 Thomson South-Western. Agenda Circular Flow Diagram GDP – Nominal and Real GDP Deflator.

© 2007 Thomson South-Western

THE MEASUREMENT OF GROSS DOMESTIC PRODUCT• “GDP is the Market Value . . .”

– Output is valued at market prices.

• “. . . Of All. . .”– Includes all items produced in the economy and legally sold in markets

(not counted within households or for illegal sales).

• “. . . Final . . .”– It records only the value of final goods, not intermediate goods (the

value is counted only once and inventory is temporary).

• “. . . Goods and Services . . .”– It includes both tangible goods (food, clothing, cars) and intangible

services (haircuts, housecleaning, doctor visits).

Page 8: © 2007 Thomson South-Western. Agenda Circular Flow Diagram GDP – Nominal and Real GDP Deflator.

© 2007 Thomson South-Western

THE MEASUREMENT OF GROSS DOMESTIC PRODUCT• “. . . Produced . . .”

– It includes goods and services currently produced, not transactions involving goods produced in the past.

• “ . . . Within a Country . . .”– It measures the value of production within the geographic

confines of a country.

• “. . . In a Given Period of Time.”– It measures the value of production that takes place within

a specific interval of time, usually a year or a quarter (three months).

Page 9: © 2007 Thomson South-Western. Agenda Circular Flow Diagram GDP – Nominal and Real GDP Deflator.

© 2007 Thomson South-Western

THE COMPONENTS OF GDP

• GDP includes all items produced in the economy and sold legally in markets.

• What Is Not Counted in GDP?– GDP excludes most items that are produced and

consumed at home and that never enter the marketplace.

– It excludes items produced and sold illicitly, such as illegal drugs, gambling or prostitution. (AKA Grey or Black economies)

Page 10: © 2007 Thomson South-Western. Agenda Circular Flow Diagram GDP – Nominal and Real GDP Deflator.

© 2007 Thomson South-Western

THE COMPONENTS OF GDP

• Question.– Which contributes more to GDP – the production of a pound

of hamburger or the production of a pound of caviar? Why?

Page 11: © 2007 Thomson South-Western. Agenda Circular Flow Diagram GDP – Nominal and Real GDP Deflator.

© 2007 Thomson South-Western

THE COMPONENTS OF GDP

GDP (Y) is the sum of the following: Consumption (C) Investment (I) Government Purchases (G) Net Exports (NX)

Y = C + I + G + NX

Page 12: © 2007 Thomson South-Western. Agenda Circular Flow Diagram GDP – Nominal and Real GDP Deflator.

© 2007 Thomson South-Western

THE COMPONENTS OF GDP

• Consumption (C):• The spending by households on goods and services,

with the exception of purchases of new housing. This includes education.

• Investment (I):• The spending on capital equipment (used in the

future to produce more goods/services), inventories, and structures, including new housing.

• Many people think education should be included here. What do you think?

Page 13: © 2007 Thomson South-Western. Agenda Circular Flow Diagram GDP – Nominal and Real GDP Deflator.

© 2007 Thomson South-Western

THE COMPONENTS OF GDP

• Government Purchases (G):– The spending on goods and services by local, state,

and federal governments. Example?– Does not include transfer payments because they

are not made in exchange for currently produced goods or services. Example?

• Net Exports (NX):– Exports minus imports. – Can this be negative?

Page 14: © 2007 Thomson South-Western. Agenda Circular Flow Diagram GDP – Nominal and Real GDP Deflator.

© 2007 Thomson South-Western

• 2007, GDP of the United States = $14 trillion

• GDP per person = $45,838– Consumption = $32,225 per person– Investment = $7,061 per person– Government purchases = $8,912 per person– Net exports = –$2,360 per person

The components of U.S. GDP

14

Page 15: © 2007 Thomson South-Western. Agenda Circular Flow Diagram GDP – Nominal and Real GDP Deflator.

© 2007 Thomson South-Western

In each of the following cases, determine how much GDP and each of its components is affected (if at all).

A. Debbie spends $200 to buy her husband dinner at the finest restaurant in Boston.

B. Sarah spends $1800 on a new laptop to use in her publishing business. The laptop was built in China.

C. Jane spends $1200 on a computer to use in her editing business. She got last year’s model on sale for a great price from a local manufacturer.

D. General Motors builds $500 million worth of cars, but consumers only buy $470 million worth of them.

A C T I V E L E A R N I N G A C T I V E L E A R N I N G 11

GDP and its componentsGDP and its components

Page 16: © 2007 Thomson South-Western. Agenda Circular Flow Diagram GDP – Nominal and Real GDP Deflator.

© 2007 Thomson South-Western

A. Debbie spends $200 to buy her husband dinner at the finest restaurant in Boston.

Consumption and GDP rise by $200.

B. Sarah spends $1800 on a new laptop to use in her publishing business. The laptop was built in China.

Investment rises by $1800, net exports fall by $1800, GDP is unchanged.

A C T I V E L E A R N I N G A C T I V E L E A R N I N G 11

AnswersAnswers

16

Page 17: © 2007 Thomson South-Western. Agenda Circular Flow Diagram GDP – Nominal and Real GDP Deflator.

© 2007 Thomson South-Western

C. Jane spends $1200 on a computer to use in her editing business. She got last year’s model on sale for a great price from a local manufacturer.

Current GDP and investment do not change, because the computer was built last year.

D. General Motors builds $500 million worth of cars, but consumers only buy $470 million of them.

Consumption rises by $470 million, inventory investment rises by $30 million, and GDP rises by $500 million.

A C T I V E L E A R N I N G A C T I V E L E A R N I N G 11

AnswersAnswers

17

Page 18: © 2007 Thomson South-Western. Agenda Circular Flow Diagram GDP – Nominal and Real GDP Deflator.

© 2007 Thomson South-Western

REAL VERSUS NOMINAL GDP

• Nominal GDP values the production of goods and services at current prices.

• Real GDP values the production of goods and services at constant prices.

Page 19: © 2007 Thomson South-Western. Agenda Circular Flow Diagram GDP – Nominal and Real GDP Deflator.

© 2007 Thomson South-Western

REAL VERSUS NOMINAL GDP

• An accurate view of the economy requires adjusting nominal to real GDP by using the GDP deflator.

Page 20: © 2007 Thomson South-Western. Agenda Circular Flow Diagram GDP – Nominal and Real GDP Deflator.

© 2007 Thomson South-Western

Table 2 Real and Nominal GDP

Page 21: © 2007 Thomson South-Western. Agenda Circular Flow Diagram GDP – Nominal and Real GDP Deflator.

© 2007 Thomson South-Western

Table 2 Real and Nominal GDP

Page 22: © 2007 Thomson South-Western. Agenda Circular Flow Diagram GDP – Nominal and Real GDP Deflator.

© 2007 Thomson South-Western

Table 2 Real and Nominal GDP

Again….what is the difference between the Real and the Nominal GDP?

Why is the Real GDP helpful to know?

Page 23: © 2007 Thomson South-Western. Agenda Circular Flow Diagram GDP – Nominal and Real GDP Deflator.

© 2007 Thomson South-Western

Real GDP

• Real GDP is a measure of the economy’s production of goods and services.

• This will reflect the economy’s ability to satisfy people’s needs and desires.

• Comparing different periods of Nominal GDP will show the growth/decline but how much of it was due to price changes will not be known.

• Comparing the same for Real GDP will show the change in actual production.

Page 24: © 2007 Thomson South-Western. Agenda Circular Flow Diagram GDP – Nominal and Real GDP Deflator.

© 2007 Thomson South-Western

Real vs. Nominal GDP

• In the Weimar years in Germany, when inflation went up thousands of percent, what was happening with Nominal GDP? Real GDP?

• Which measure is more useful?

Page 25: © 2007 Thomson South-Western. Agenda Circular Flow Diagram GDP – Nominal and Real GDP Deflator.

© 2007 Thomson South-Western

The GDP Deflator

• The GDP deflator is a measure of the price level calculated as the ratio of nominal GDP to real GDP times 100.

• It tells us what portion of the rise in nominal GDP that is attributable to a rise in prices rather than a rise in the quantities produced.

Page 26: © 2007 Thomson South-Western. Agenda Circular Flow Diagram GDP – Nominal and Real GDP Deflator.

© 2007 Thomson South-Western

The GDP Deflator

• So if the GDP Deflator was 171 in 2006, that means that the price level increased by 71 percent as compared to the base year of the index.

Page 27: © 2007 Thomson South-Western. Agenda Circular Flow Diagram GDP – Nominal and Real GDP Deflator.

© 2007 Thomson South-Western

Figure 2 Real GDP in the United States

Billions of

2000 Dollars

$10,000

9,000

8,000

7,000

6,000

5,000

4,000

3,000

1970 1975 1980 1985 1990 20001995 2005

2,000

Page 28: © 2007 Thomson South-Western. Agenda Circular Flow Diagram GDP – Nominal and Real GDP Deflator.

© 2007 Thomson South-Western

IS GDP A GOOD MEASURE OF ECONOMIC WELL-BEING?• GDP is the best single measure of the

economic well-being of a society. • GDP per person tells us the income and

expenditure of the average person in the economy.

• Higher GDP per person indicates a higher standard of living.

• GDP is not a perfect measure of the happiness or quality of life, however.

Page 29: © 2007 Thomson South-Western. Agenda Circular Flow Diagram GDP – Nominal and Real GDP Deflator.

© 2007 Thomson South-Western

GDP AND ECONOMIC WELL-BEING• Some things that contribute to well-being are

not included in GDP.– The value of leisure.– The value of a clean environment.– The value of almost all activity that takes place

outside of markets, such as the value of the time parents spend with their children and the value of volunteer work.

– Does these have value?

Page 30: © 2007 Thomson South-Western. Agenda Circular Flow Diagram GDP – Nominal and Real GDP Deflator.

© 2007 Thomson South-Western

More issues with GDP• GDP can vary depending upon the “market basket” used

to calculate prices. Ie. Prices of potatoes vs. eggs.• Black market, bartering, etc.• Externalities such as the environment, subsistence

production and domestic work • Volunteer work• Counts work that produces no net change or that results

from repairing harm, ie. Natural disasters• Sustainable growth…bubbles.• Economic surplus

Page 31: © 2007 Thomson South-Western. Agenda Circular Flow Diagram GDP – Nominal and Real GDP Deflator.

© 2007 Thomson South-Western

Alternatives• Gross National Product

• Net National Product

• Personal Income

• Genuine Progress Indicator

• Gross National Happiness (Bhutan)

Page 32: © 2007 Thomson South-Western. Agenda Circular Flow Diagram GDP – Nominal and Real GDP Deflator.

© 2007 Thomson South-Western

What is happening in Korea?• GDP (purchasing power parity):

$1.574 trillion (2011 est.) • GDP (official exchange rate):

$1.116 trillion (2011 est.) • GDP - real growth rate:

3.6% (2011 est.)• GDP - per capita (PPP):

$32,100 (2011 est.)

• GDP - composition by sector: agriculture: 2.6%

• industry: 39.2%

• services: 58.2% (2011 est.)

For Comparison – US

GDP - per capita (PPP): $49,000 (2011 est.)GDP - composition by sector: agriculture: 1.2%industry: 19.2%services: 79.6% (2011 est.)

Page 33: © 2007 Thomson South-Western. Agenda Circular Flow Diagram GDP – Nominal and Real GDP Deflator.

© 2007 Thomson South-Western

THE CONSUMER PRICE INDEX

• The consumer price index (CPI) is a measure of the overall cost of the goods and services bought by a typical consumer.

• The US Bureau of Labor Statistics reports the CPI each month.

• It is used to monitor changes in the cost of living over time.

Page 34: © 2007 Thomson South-Western. Agenda Circular Flow Diagram GDP – Nominal and Real GDP Deflator.

© 2007 Thomson South-Western

How the Consumer Price Index Is Calculated1. Fix the basket. Determine what prices are most

important to the typical consumer.– The Bureau of Labor Statistics (BLS) identifies a

market basket of goods and services the typical consumer buys.

•The BLS conducts monthly consumer surveys to set the weights for the prices of those goods and services.

Page 35: © 2007 Thomson South-Western. Agenda Circular Flow Diagram GDP – Nominal and Real GDP Deflator.

© 2007 Thomson South-Western

How the Consumer Price Index Is Calculated2. Find the prices. Find the prices of each of the

goods and services in the basket for each point in time.

3. Compute the basket’s cost. Use the data on prices to calculate the cost of the basket of goods and services at different times.

Page 36: © 2007 Thomson South-Western. Agenda Circular Flow Diagram GDP – Nominal and Real GDP Deflator.

© 2007 Thomson South-Western

How the Consumer Price Index Is Calculated4. Choose a base year and compute the index.

– Designate one year as the base year, making it the benchmark against which other years are compared.

– Compute the index by dividing the price of the basket in one year by the price in the base year and multiplying by 100. 100

year basein basket of Price

services and goods ofbasket of Priceindex priceConsumer

Page 37: © 2007 Thomson South-Western. Agenda Circular Flow Diagram GDP – Nominal and Real GDP Deflator.

© 2007 Thomson South-Western

How the Consumer Price Index Is Calculated5. Compute the inflation rate. The inflation rate

is the percentage change in the price index from the preceding period.

Page 38: © 2007 Thomson South-Western. Agenda Circular Flow Diagram GDP – Nominal and Real GDP Deflator.

© 2007 Thomson South-Western

MEASURING THE COST OF LIVING 38

What’s in the CPI’s Basket?

43%

17%

15%

6%

6%

6%4% 3% Housing

Transportation

Food & Beverages

Medical care

Recreation

Education andcommunicationApparel

Other

Page 39: © 2007 Thomson South-Western. Agenda Circular Flow Diagram GDP – Nominal and Real GDP Deflator.

© 2007 Thomson South-Western

MEASURING THE COST OF LIVING 39

Problems with the CPI: Substitution Bias• Over time, some prices rise faster than others.

• Consumers substitute toward goods that become relatively cheaper.

• The CPI misses this substitution because it uses a fixed basket of goods.

• Thus, the CPI overstates increases in the cost of living.

Page 40: © 2007 Thomson South-Western. Agenda Circular Flow Diagram GDP – Nominal and Real GDP Deflator.

© 2007 Thomson South-Western

MEASURING THE COST OF LIVING 40

Problems with the CPI: Introduction of New Goods• The introduction of new goods increases

variety, allows consumers to find products that more closely meet their needs.

• In effect, dollars become more valuable.

• The CPI misses this effect because it uses a fixed basket of goods.

• Thus, the CPI overstates increases in the cost of living.

Page 41: © 2007 Thomson South-Western. Agenda Circular Flow Diagram GDP – Nominal and Real GDP Deflator.

© 2007 Thomson South-Western

MEASURING THE COST OF LIVING 41

Problems with the CPI: Unmeasured Quality Change• Improvements in the quality of goods in the

basket increase the value of each dollar.

• The BLS tries to account for quality changes but probably misses some, as quality is hard to measure.

• Thus, the CPI overstates increases in the cost of living.

Page 42: © 2007 Thomson South-Western. Agenda Circular Flow Diagram GDP – Nominal and Real GDP Deflator.

© 2007 Thomson South-Western

Problems in Measuring the Cost of Living• The substitution bias, introduction of new

goods, and unmeasured quality changes cause the CPI to overstate the true cost of living.

• The issue is important because many government programs use the CPI to adjust for changes in the overall level of prices.

• The CPI overstates inflation by about 1 percentage point per year.

Page 43: © 2007 Thomson South-Western. Agenda Circular Flow Diagram GDP – Nominal and Real GDP Deflator.

© 2007 Thomson South-Western

The GDP Deflator versus the Consumer Price Index • Economists and policymakers monitor both

the GDP deflator and the consumer price index to gauge how quickly prices are rising.

• There are two important differences between the indexes that can cause them to diverge.

Page 44: © 2007 Thomson South-Western. Agenda Circular Flow Diagram GDP – Nominal and Real GDP Deflator.

© 2007 Thomson South-Western

MEASURING THE COST OF LIVING 44

Imported consumer goods:– included in CPI – excluded from GDP deflator

Imported consumer goods:– included in CPI – excluded from GDP deflator

The basket: CPI uses fixed basket GDP deflator uses basket of

currently produced goods & servicesThis matters if different prices are changing by different amounts.

The basket: CPI uses fixed basket GDP deflator uses basket of

currently produced goods & servicesThis matters if different prices are changing by different amounts.

Capital goods: excluded from CPI included in GDP deflator

(if produced domestically)

Capital goods: excluded from CPI included in GDP deflator

(if produced domestically)

Contrasting the CPI and GDP Deflator

Page 45: © 2007 Thomson South-Western. Agenda Circular Flow Diagram GDP – Nominal and Real GDP Deflator.

© 2007 Thomson South-Western

In each scenario, determine the effects on the CPI and the GDP deflator.

A. Starbucks raises the price of Frappuccinos.

B. Caterpillar raises the price of the industrial tractors it manufactures at its Illinois factory.

C. Armani raises the price of the Italian jeans it sells in the U.S.

A C T I V E L E A R N I N G A C T I V E L E A R N I N G 33 CPI vs. GDP deflatorCPI vs. GDP deflator

45

Page 46: © 2007 Thomson South-Western. Agenda Circular Flow Diagram GDP – Nominal and Real GDP Deflator.

© 2007 Thomson South-Western

A. Starbucks raises the price of Frappuccinos.

The CPI and GDP deflator both rise.

B. Caterpillar raises the price of the industrial tractors it manufactures at its Illinois factory.

The GDP deflator rises, the CPI does not.

C. Armani raises the price of the Italian jeans it sells in the U.S.

The CPI rises, the GDP deflator does not.

A C T I V E L E A R N I N G A C T I V E L E A R N I N G 33 AnswersAnswers

46

Page 47: © 2007 Thomson South-Western. Agenda Circular Flow Diagram GDP – Nominal and Real GDP Deflator.

© 2007 Thomson South-Western

What’s up in Korea with CPI?

• Korean CPI• (Sources: IMF-IFS and EconStats.) What is the base

year for the given CPI?

10,000 won in 2004 would have been worth how much in 1990?

Page 48: © 2007 Thomson South-Western. Agenda Circular Flow Diagram GDP – Nominal and Real GDP Deflator.

© 2007 Thomson South-Western

What’s up in Korea with CPI?• CPI Info… (2/08)– By the end of the year, the office will add items that account

for more than one-10,000th of monthly household expenditures; those falling short of the standard will be excluded.

– The statistics agency revises the index, currently comprising 516 items, every five years.

• New Additions This Year– Bidets, Olive oil, Saunas, Substitute drivers, Medical

expenses for pets• Items Removed This Year

– Briquettes, table clocks and artificial seasonings

• Source: www.seriworld.org