Measuring a Nation’s

Income

Chapter 5
 Learning Objectives

 Describethe origins of macroeconomics

and the problems it deals with

 Describethe long-term trends and short-

terms fluctuations in economic growth,
unemployment, inflation, and
government and international deficits
 Learning Objectives (con't.)

 Explain
why economic growth,
unemployment, inflation, and deficits
matter

 Identify
the macroeconomic policy
challenges and describe the tools
available for meeting them
 Learning Objectives

 Distinguish betweenthe stocks of capital

and wealth and the flows of production,
income, investment and saving

 Explainwhy aggregate income,

expenditure, and product are equal

 Explain how GDP is measured

 Learning Objectives

 Describethe origins of macroeconomics

and the problems it deals with

 Describethe long-term trends and short-

terms fluctuations in economic growth,
unemployment, inflation, and
government and international deficits
 Microeconomics

Microeconomics is the study of how

individual households and firms make
decisions and how they interact with
one another in markets.
 Macroeconomics

Macroeconomics is the study of the

economy as a whole.
 Itsgoal is to explain the economic changes
that affect many households, firms, and
markets at once.
 Macroeconomics

Macroeconomics answers questions like

the following:
 Why is average income high in some countries
and low in others?
 Why do prices rise rapidly in some time periods
while they are more stable in others?
 Why do production and employment expand in
some years and contract in others?
 Origins and Issues of
Macroeconomics
 Modern macroeconomics emerged
during the Great Depression.

 People
began to doubt the free market
economy.

 JohnMaynard Keynes, in 1936,

published The General Theory of
Employment, Interest, and Money.
 Origins and Issues of
Macroeconomics
 Macroeconomic Problems

1) Economic Growth

2) Unemployment

3) Inflation

4) Deficits
 Origins and Issues of
Macroeconomics
 Short-Term Versus Long-Term Goals
Keynes focused on the short-term primarily
• He felt the depression was caused by insufficient
private spending
• Government should increase its spending
 Origins and Issues of
Macroeconomics
 Short-Term Versus Long-Term Goals
Long-term consequences were virtually
disregarded
• “In the long run, we’re all dead”
 Origins and Issues of
Macroeconomics
 Short-Term Versus Long-Term Goals
Today, macroeconomics is concerned with:
• Long-term economic growth and inflation
• Short-term business fluctuations and
unemployment
 Origins and Issues of
Macroeconomics

 The Road Ahead

The focus of macroeconomics has
shifted:
• Depression
• Inflation of the 1970’s
• International economics of today
 Economic Growth in the
United States
 Fluctuations Around Potential GDP
The business cycle is the periodic but
irregular up-and-down movement in
production.
 Economic Growth in the
United States
 Phases
of the Business Cycle
Recession
• Period during which real GDP decreases for two
successive quarters
Expansion
• Period during which real GDP increases
 Economic Growth in the
United States
 Turning Points
Peak
• Expansion ends, recession begins
Trough
• Recession ends, expansion begins
Long-Term Economic Growth
in the United States
 Economic Growth Around
the World
 Real GDP per person
The growth rate of real GDP divided by the
population is used to compare growth rates over
time and across countries.
 Benefits and Costs of
Economic Growth
 Benefits
Expanded production possibilities
• health care
• medical research
• space exploration
• roads
• environmental improvements (if resources are
devoted to solving environmental problems)
 Benefits and Costs of
Economic Growth
 Costs

1) Foregone consumption

2) Depletion of natural resources

3) Increased pollution

4) More frequent job and location

changes
 Macroeconomic Policy
Challenges and Tools
 Policy Challenges
1) Boost economic growth
2) Stabilize the business cycle
3) Reduce unemployment
4) Keep inflation low
5) Reduce the government and
international deficits
 Macroeconomic Policy
Challenges and Tools
 Policy Tools
1) Fiscal policy
• Making changes in taxes and government
spending
– Long term growth
– Smooth the business cycle
 Macroeconomic Policy
Challenges and Tools
 Policy Tools
2) Monetary policy
• Changing interest rates and the amount of money
in the economy
– Control inflation
– Smooth business cycle
 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.
 The Economy’s
Income and Expenditure

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.
 Gross Domestic Product

 Gross domestic product (GDP) is a

measure of the income and
expenditures of an economy.
 It is the total market value of all
final goods and services produced
within a country in a given period of
time.
The Circular-Flow Diagram

The equality of income and

expenditure can be illustrated
with the circular-flow diagram.
 The Circular-Flow Diagram
Revenue Spending
Market for
Goods
Goods & Goods &
Services sold and Services
Services
bought

Firms
Households

Inputs for Labor, land,

production Market for and capital
Factors
Wages, rent, of Production Income
and profit
The Measurement of GDP

GDP is the market value of all

final goods and services
produced within a country in a
given period of time.
 The Measurement of GDP

 Output is valued at market prices.

 It records only the value of final goods,
not intermediate goods (the value is
counted only once).
 It includes both tangible goods (food,
clothing, cars) and intangible services
(haircuts, housecleaning, doctor visits).
 The Measurement of GDP

 It includes goods and services currently

produced, not transactions involving
goods produced in the past.
 It measures the value of production
within the geographic confines of a
country.
 The Measurement of GDP

 Itmeasures the value of production

that takes place within a specific
interval of time, usually a year or a
quarter (three months).
What Is Counted in 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.
 Other Measures of Income

 Gross National Product (GNP)

 Net National Product (NNP)

 National Income

 Personal Income

 Disposable Personal Income

 Gross National Product

 Gross national product (GNP) is the total

income earned by a nation’s permanent
residents (called nationals).
 It differs from GDP by including income
that our citizens earn abroad and
excluding income that foreigners earn
here.
 Net National Product (NNP)

 Net National Product (NNP) is the total

income of the nation’s residents (GNP)
minus losses from depreciation.
 Depreciation is the wear and tear on
the economy’s stock of equipment and
structures.
 National Income

 National Income is the total income

earned by a nation’s residents in the
production of goods and services.
 It differs from NNP by excluding indirect
business taxes (such as sales taxes) and
including business subsidies.
 Personal Income
 Personal income is the income that
households and noncorporate businesses
receive.
 Unlike national income, it excludes retained
earnings, which is income that corporations
have earned but have not paid out to their
owners.
 In addition, it includes household’s interest
income and government transfers.
 Disposable Personal Income

 Disposable personal income is the income

that household and noncorporate
businesses have left after satisfying all
their obligations to the government.
 It equals personal income minus personal
taxes and certain nontax payments.
 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
 The Components of GDP

 Consumption (C):
 The spending by households on goods and
services, with the exception of purchases of
new housing.
 Investment (I):
 The spending on capital equipment,
inventories, and structures, including
new housing.
 Gross Domestic Product

 Gross Investment
The total amount spent on adding to the
stock of capital and on replacing depreciated
capital

 Net Investment
The amount spent on adding to the stock of
capital
• Gross Investment minus Depreciation
Capital and Investment

Initial
capital
 The Components of GDP

 Government Purchases (G):

 The spending on goods and services by local,
state, and federal governments.
 Does not include transfer payments because
they are not made in exchange for currently
produced goods or services.
 Net Exports (NX):
 Exports minus imports.
 GDP and Its Components (1998)

Total Per Person

(in billions of dollars) (in dollars) % of Total
Gross domestic product, Y $8,511 $31,522 100 percent
Consumption, C 5,808 21,511 68
Investment, I 1,367 5,063 16
Government purchases, G 1,487 5,507 18
Net exports, NX -151 -559 -2
GDP: The Income Approach

Amount in 1996 Percentage

Item (billions of dollars of GDP
Compensation of
employees 4,449 58.7
Net Interest 405 5.4
Rental Income 127 1.7
Corporate Profits 650 8.6
Proprietors’ income 518 6.8
Indirect taxes
less subsidies 569 7.5
Capital consumption
(depreciation) 858 11.3
Gross domestic 7,576 100.0
product
GDP and Its Components (1998)
 GDP and Its Components (1998)

Consumption
68 %
 GDP and Its Components (1998)

Investment
16%

Consumption
68 %
 GDP and Its Components (1998)
Government
Investment Purchases
16% 18%

Consumption
68 %
 GDP and Its Components (1998)

Government Purchases
Investment 18% Net Exports
16% -2 %

Consumption
68 %
 Aggregate Expenditure,
Output, and Income
100 NX Depreciation
G GDP
Indirect taxes
less subsidies
80 I Proprietor’s
incomes
Interest
C Profits
Rent
60
Percentage of GDP

Wages and other

labor income

40

20

0
Aggregate GDP Aggregate
expenditure income
 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.
 Real versus Nominal GDP

An accurate view of the economy

requires adjusting nominal to real
GDP by using the GDP deflator.
 GDP Deflator

 The GDP deflator measures the current

level of prices relative to the level of
prices in the base year.
 It tells us the rise in nominal GDP that is
attributable to a rise in prices rather than
a rise in the quantities produced.
 GDP Deflator

The GDP deflator is calculated as follows:

Nominal GDP
GDP deflator =  100
Real GDP
 Converting Nominal GDP to Real
GDP

Nominal GDP is converted to real

GDP as follows:
(Nominal GDP20xx )
Real GDP20xx = X 100
(GDP deflator20xx )
 Real and Nominal GDP

Price of Quantity of Price of Quantity of

Year Hot dogs Hot dogs Hamburgers Hamburgers
2001 $1 100 $2 50
2002 $2 150 $3 100
2003 $3 200 $4 150
 Real and Nominal GDP

Calculating Nominal GDP:

2001 ($1 per hot dog x 100 hot dogs) + ($2 per hamburger x 50 hamburgers) = $200
2002 ($2 per hot dog x 150 hot dogs) + ($3 per hamburger x 100 hamburgers) = $600
2003 ($3 per hot dog x 200 hot dogs) + ($4 per hamburger x 150 hamburgers) = $1200
 Real and Nominal GDP

Calculating Real GDP (base year 2001):

2001 ($1 per hot dog x 100 hot dogs) + ($2 per hamburger x 50 hamburgers) = $200
2002 ($1 per hot dog x 150 hot dogs) + ($2 per hamburger x 100 hamburgers) = $350
2003 ($1 per hot dog x 200 hot dogs) + ($2 per hamburger x 150 hamburgers) = $500
 Real and Nominal GDP

Calculating the GDP Deflator:

2001 ($200/$200) x 100 = 100
2002 ($600/$350) x 100 = 171
2003 ($1200/$500) x 100 = 240
 Real GDP in the United States

Billions of
1992 Dollars
8,000
(Periods of falling real GDP)

7,000

6,000

5,000

4,000

3,000
1970 1975 1980 1985 1990 1995 2000
 GDP and 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.
 GDP and Economic
Well-Being

 Higher GDP per person indicates a

higher standard of living.
 GDP is not a perfect measure of the
happiness or quality of life, however.
 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.
GDP, Life Expectancy, and Literacy
Country Real GDP per Life Adult
Person (1997) Expectancy Literacy
United States $29,010 77 years 99%
Japan 24,070 80 99
Germany 21,260 77 99
Mexico 8,370 72 90
Brazil 6,480 67 84
Russia 4,370 67 99
Indonesia 3,490 65 85
China 3,130 70 83
India 1,670 63 53
Pakistan 1,560 64 41
Bangladesh 1,050 58 39
Nigeria 920 50 59
 Summary

 Because every transaction has a buyer and

a seller, the total expenditure in the
economy must equal the total income in
the economy.
 Gross Domestic Product (GDP) measures
an economy’s total expenditure on newly
produced goods and services and the total
income earned from the production of
these goods and services.
 Summary

 GDP is the market value of all final goods

and services produced within a country
in a given period of time.
 GDP is divided among four components
of expenditure: consumption, investment,
government purchases, and net exports.
 Summary

 Nominal GDP uses current prices to

value the economy’s production. Real
GDP uses constant base-year prices to
value the economy’s production of goods
and services.
 The GDP deflator--calculated from the
ratio of nominal to real GDP--measures
the level of prices in the economy.
 Summary

 GDP is a good measure of economic well-

being because people prefer higher to
lower incomes.
 It is not a perfect measure of well-being
because some things, such as leisure time
and a clean environment, aren’t
measured by GDP.
Graphical
Review
 The Circular-Flow Diagram
Revenue Spending
Market for
Goods
Goods & Goods &
Services sold and Services
Services
bought

Firms
Households

Inputs for Labor, land,

production Market for and capital
Factors
Wages, rent, of Production Income
and profit
 GDP and Its Components (1998)

Government Purchases
Investment 18% Net Exports
16% -2 %

Consumption
68 %
 Real GDP in the United States

Billions of
1992 Dollars
8,000
(Periods of falling real GDP)

7,000

6,000

5,000

4,000

3,000
1970 1975 1980 1985 1990 1995 2000