ECON1002: Introduction to Economics IIyluo/teaching/Econ1002EF/chapter7.pdf · ECON1002:...

ECON1002: Introduction to Economics II

Yulei Luo

SEF of HKU

January 16, 2012

Luo, Y. (SEF of HKU) ECON1002 January 16, 2012 1 / 17

Learning Objectives

1 Explain how total production is measured.2 Discuss whether GDP is a good measure of economic well-being.3 Discuss the difference between real variables and nominal variables.4 Become familiar with other measures of total production and totalincome.


GDP: Measuring Total Production and Income

Macroeconomics: The study of the economy as a whole, includingtopics such as business cycle, economic growth, inflation, andunemployment.

Business cycle: Alternating periods of economic expansion andeconomic recession.

Expansion: The period of a business cycle during which totalproduction and total employment are increasing.Recession: The period of a business cycle during which totalproduction and total employment are decreasing.

Economic growth: The ability of an economy to produce increasingquantities of goods and services.

Inflation rate: The percentage increase in the price level from oneyear to the next.


Gross Domestic Product Measures Total Production

Gross domestic product (GDP): The market value of all final goodsand services produced in a country during a period of time, typicallyone quarter or one year.

GDP is measured using market values, not quantities.GDP includes only the market value of final goods.

Final good or service: A good or service (G&S) purchased by a finaluser.Intermediate good or service: A good or service (G&S) that is an inputinto another good or service, such as a tire on a truck.

GDP includes only current production.


Production, Income, and the Circular Flow Diagram

The value of total production = the value of total income.

Four factors of production:

LaborCapitalNatural resources (e.g. land)Entrepreneurship.

Four corresponding categories of income: wages, interest, rent, andprofit.


(continued.)

Governments also make payments for wages and interest tohouseholds in exchange for hiring workers and other factors.

Transfer payments: Payments by the government to individuals forwhich the government does not receive a G&S in return.

e.g., social security payments to retired an disabled people,unemployment insurance payments to unemployed workers.


10 of 33Copyright © 2010 Pearson Education, Inc. · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e.

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Gross Domestic Product Measures Total ProductionProduction, Income, and the Circular-Flow DiagramFIGURE 7-1 (continued)

The diagram also shows that households use their income to purchase goods and services, pay taxes, and save. Firms and the government borrow the funds that flow from households into the financial system. We can measure GDP either by calculating the total value of expenditures on final goods and services or by calculating the value of total income.

The Circular Flow and the Measurement of GDP

7.1 LEARNING OBJECTIVEExplain how total production is measured.


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Gross Domestic Product Measures Total ProductionProduction, Income, and the Circular-Flow DiagramFIGURE 7-1The Circular Flow and the Measurement of GDP

The circular-flow diagram illustrates the flow of spending and money in the economy. Firms sell goods and services to three groups: domestic households, foreign firms and households, and the government. To produce goods and services, firms use factors of production: labor, capital, natural resources, and entrepreneurship. Households supply the factors of production to firms in exchange for income in the form of wages, interest, profit, and rent. Firms make payments of wages and interest to households in exchange for hiring workers and other factors of production.The sum of wages, interest, rent, and profit is total income in the economy. We can measure GDP as the total income received by households.


Components of GDP

Consumption: Spending by households on goods and services, notincluding spending on new houses. Consumption expenditures include:

expenditures on services (medical care, education, etc.).expenditures on nondurable goods (food and clothing).expenditures on durable goods (automobiles and furniture).


(continued.)

Investment: Spending by1 firms on new factories, offi ce buildings, machinery, and inventories;2 households on new houses.

Investment is divided into three categories:

business fixed investment: spending of firms on new factories, offi cebuildings, etc.;residential investment: spending of households on new houses;changes in business inventories: goods that have been produced butnot yet sold.


Government purchases: Spending by federal, state, and localgovernments on G&S, e.g. teachers’salaries, highways, etc.


(continued.)

Net exports: Exports minus imports.

exports: The G&S produced in the U.S. that are purchased by foreignfirms, consumers, and governments.imports: G&S produced in foreign countries, but purchased by U.S.firms, consumers, and governments.

An Equation for GDP (or GDP identity):

Y = C + I + G +NX (1)



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Gross Domestic Product Measures Total ProductionAn Equation for GDP and Some Actual Values

FIGURE 7-2Components of GDP in 2008Consumption accounts for 70 percent of GDP, far more than any of the other components. In recent years, net exports typically have been negative, which reduces GDP.


(continued.)

The above table provides a more detailed breakdown and showsseveral interesting points:

Consumer spending on services is greater than the sum of spending ondurable and nondurable goods.Business fixed investment is the largest component of investment.Purchases by state and local governments are greater than purchasesby the federal government.Imports are greater than exports, so net exports are negative.



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Will U.S. Consumers Be Spending Less?

Making the

Connection

YOUR TURN: Test your understanding by doing related problem 1.11 at the end of this chapter.



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Gross Domestic Product Measures Total Production

FIRMVALUE OF PRODUCT VALUE ADDED

Cotton farmer Value of raw cotton = $1 Value added by cotton farmer = 1

Textile mill Value of raw cotton woven into cotton fabric = $3

Value added by cotton textile mill = ($3 – $1) = 2

Shirt company Value of cotton fabric made into a shirt = $15

Value added by shirt manufacturer = ($15 –$3) = 12

L.L. Bean Value of shirt for sale on L.L. Bean’s Web site = $35

Value added by L.L. Bean = ($35 – $15) = 20

Total Value Added = $35

Measuring GDP by the Value-Added Method

Value added The market value a firm adds to a product.

Table 7-1Calculating Value Added


Shortcomings in GDP as a Measure of Total Production

Household production: Goods and services people produce forthemselves.

e.g., If a person has been caring for children, cleaning house, andpreparing the family meals, the value of such services is not included inGDP.

Underground economy: Buying and selling of G&S that is concealedfrom the government to avoid taxes or regulations or because thegoods and services are illegal.

In some developing countries, more than half the workers may be in theunderground economy.


(continued.)

The value of leisure is not included in GDP, e.g., if an economicconsultant decides to retire, GDP will decline while his well-being willincrease if he values leisure more than the income he earns in thecompany.

GDP is not adjusted for pollution or other negative effects ofproduction.

GDP is not adjusted for changes in crime and other social problems.

Summary: A person’s well-being depends on many factors that arenot taken into account in calculating GDP.



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Did World War II Bring Prosperity?Making

the Connection

World War II was a period of extraordinary sacrifice and achievement by the “greatest generation.” But statistics on GDP may give a misleading indication of whether it was also a period of prosperity.

YOUR TURN: Test your understanding by doing related problem 2.8 at the end of this chapter.

7.2 LEARNING OBJECTIVEDiscuss whether GDP is a good measure of well-being.

Calculating Real GDP

Real GDP: The value of final goods and services evaluated at baseyear prices.

Nominal GDP: The value of final goods and services evaluated atcurrent year prices.

Real GDP holds prices constant: It is a better measure than nominalGDP for changes in the production of G&S from one year to the next.



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Solved Problem 7-3Calculating Real GDP

PRODUCT2011

QUANTITY2005

PRICE VALUEEye examinations 100 $40 $4,000

Pizzas 80 11 880

Textbooks 20 90 1,800

2005 2011

PRODUCT QUANTITY PRICE QUANTITY PRICE

Eye examinations 80 $40 100 $50

Pizzas 90 11 80 10 Textbooks 15 90 20 100

YOUR TURN: For more practice, do related problem 3.3 at the end of this chapter.

7.3 LEARNING OBJECTIVEDiscuss the difference between real GDP and nominal GDP.


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Real GDP versus Nominal GDP

Comparing Real GDP and Nominal GDP

FIGURE 7-3Nominal GDP and Real GDP, 1990–2008Currently, the base year for calculating GDP is 2005. In the years before 2005, prices were, on average, lower than in 2005, so nominal GDP was lower than real GDP. In 2005, nominal and real GDP were equal. After 2005, prices have been, on average, higher than in 2005, so nominal GDP is higher than real GDP.


The GDP Deflator

Price level: A measure of the average prices of goods and services inthe economy.

GDP deflator: A measure of the price level, calculated by dividingnominal GDP by real GDP, and multiplying by 100:

GDP deflator =Nominal GDPReal GDP

× 100. (2)



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Real GDP versus Nominal GDP

FORMULA APPLIED TO 2007 APPLIED TO 2008

GDPDeflator

2007 2008NOMINAL GDP $14,078 billion $14,441 billion

REAL GDP $13,254 billion $13,312 billion

100GDP Real

GDP Nominal×= 106100

billion $13,254billion 078,14$

=×⎟⎠

⎞⎜⎝

⎛

The GDP Deflator

108100billion $13,312billion 441,14$

=×⎟⎠

⎞⎜⎝

⎛

%9.1100106

106108=×⎟

⎠⎞

⎜⎝⎛ −

From these values for the deflator, we can calculate that the price level increased by 1.9 percent between 2007 and 2008:


Other Measures of Total Production and Total Income

Gross National Product (GNP): The value of final G&S produced byresidents of the US, even if the production takes place outside of theUS.

National Income: Calculated as GDP minus the consumption of fixedcapital, or depreciation.

Personal Income: Income received by households including transferpayments or interest on gov. bonds.

Disposable Personal Income: Personal income minus personal taxpayments.



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FIGURE 7-4Measures of Total Production and Total Income, 2008The most important measure of total production and total income is gross domestic product (GDP). As we will see in later chapters, for some purposes, the other measures of total production and total income shown in the figure turn out to be more useful than GDP.

Become familiar with other measures of total production and total income.

7.4 LEARNING OBJECTIVE


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The Division of Income

FIGURE 7-5The Division of IncomeWe can measure GDP in terms of total expenditure or as the total income received by households. The largest component of income received by households is wages, which are more than three times as large as the profits received by sole proprietors and the profits received by corporations combined.

Become familiar with other measures of total production and total income.

7.4 LEARNING OBJECTIVE

Key Terms in Chapter 7

Gross domestic product (GDP), Consumption, Investment,Government purchases, Net exports

Final good or service, Intermediate good or service, Value added

Nominal GDP, Real GDP, GDP deflator, Price level, Inflation rate

Business cycle , Expansion, Recession


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