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ECONOMICS 202 Notes I MEASURING THE ECONOMY

I. NATIONAL INCOME ACCOUNTING A. National income accounting provides a means to discover how the economy is operating and what, if anything, needs to be done to improve conditions. B. National income accounting provides government policy-makers a tool to formulate and evaluate economic policy. 1. In order to fight inflation, unemployment, or slow-growth problems, decision-makers need to learn the effects of instituting a policy how effective is the policy? C. National income accounting helps businesses and consumers make intelligent economic decisions. 1. Should you buy your house now or next year? This depends in part on the national economy. 2. Should I borrow to buy a new frozen yogurt machine or should I pay cash? This depends in part on the national economy. 3. Should I open more outlets of my espresso bar or should I sell out to Starbucks? This depends in part on the national economy. II. MEASUREMENT OF OUTPUT A. Gross Domestic Product (GDP) is the total market value of all final goods and services produced in the economy during one year. 1. GDP is a money measure of output in the circular flow, it measures the outside ring the money expenditures spent on goods and services. 2. GDP only measures final output of goods and services. a. Intermediate goods (unfinished goods) are excluded by subtracting the beginning year inventory from the end of the year inventory. b. This avoids double counting the counting of the same good twice. 3. Items excluded from GDP accounts: a. Nonproductive transactions i. Purely financial transactions such as public and private transfer payments and the purchase or sale of securities (stocks) because these items to not represent current production. ii. Second-hand sales used goods because production was counted when the good was first produced. b. Non-market transactions i. Homemakers services ii. Do-it-yourself labor ( but does include the cost of materials purchased) iii. Labor of children in your own household iv. Volunteer help to non-profit organizations v. Illegal purchases vi. Underground economy 4. Reporting of National Income Accounting a. Even though GDP is an annual rate of production in the economy, estimates are made quarterly and frequently revised. i. Preliminary estimates are made about three weeks following the end of the quarter (about January 25, April 25, July 25, and October 25). ii. Revisions are made in the estimates often for years iii. Sometime the preliminary estimates give false readings of the condition of the economy. B. Categorization of expenditures in determining GDP 1. Personal Consumption Expenditures (C) a. Durable goods (line a refrigerator or automobile) b. Non-durable goods (like food and clothing) c. Services (like telephone or transportation by airplane or bus) 2. Gross Private Domestic Investment (Ig or I) a. New plant and equipment spending capital equipment used to increase output b. New business and residential construction c. Increase in the stock of inventories

Government Purchases (G) all levels of government a. Only purchases on newly produced goods and services b. Does not include transfer payments a large portion of government budgets c. Government purchases may include some investment goods 4. Net Exports (Xn) a. Total exports less total imports i. If exports less imports are positive, a trade surplus exists. ii. If exports less imports are negative, a trade deficit exists. b. The United States is currently running a trade deficit of about 2% of GDP. C. Gross Domestic Product (GDP) computed by the expenditure approach, can be determined by adding together the four individual elements, as follows: 3.

GDP = C + Ig + G + Xn
D. Net Domestic Product (NDP) is the total value of all final goods and services produced in the economy during one year, after accounting for depreciation. 1. Some part of Gross Private Domestic Investment is made for replacement of worn out equipment and is not really a part of new production, so this portion of investment spending is subtracted from the total investment spending to obtain Net Private Domestic Investment (In). a. Net investment (In) is found by subtracting depreciation from gross investment (Ig) b. In = Ig depreciation 2. There are two ways to compute NDP:

NDP = C + In + G + Xn or NDP = GDP Depreciation


Net Domestic Product (NDP) is generally considered a better measure of economic conditions than is Gross Domestic Product (GDP); however, GDP is used more. III. ADJUSTMENT TO GDP FOR INFLATION AND FOR POPULATION CHANGES A. If you wish to make meaningful comparisons between different years of the performance of the national economy, you must make adjustments in the basic data, so the comparisons are relatively valid. B. Adjustment must be made for price changes and for population changes. 1. Real GDP is GDP adjusted for inflation. 2. Inflation-adjusted GDP or Real GDP a. Because GDP is measured in terms of current dollars, an increase in prices over time will appear the same as an increase in actual production. b. Prices over time may increase, decrease or stay the same. c. Prices may change for two reasons: i. The price of constant-quality products changes ii. The quality of constant-price products changes iii. In recent years, there have been greater changes in product quality (as a result of technological changes) than in pure prices, but this has not always been true. d. Two methods are used to adjust for price changes i. Fixed base year a) Obtain the base and current year price deflators (price index) b) Divide the nominal (current money) GDP by the current year price deflator and multiply by the base year price deflator to obtain what is referred to as REAL GDP, CONSTANT DOLLAR GDP, OR INFLATION-ADJUSTED GDP. c) If you are simply computing the real GDP for a year against a given base year, the formula is slightly simplified: Real GDP in current year Nominal GDP in current year GDP price deflator 3.

100

d) Currently, the base year for computing inflation-adjusted GDP is 1992. Chain-Weighted Price Adjustments a) In order to reduce the distortion of using a fixed year as the base year, GDP statistics are currently based on a moving average of price levels in consecutive years as an inflation adjustment. b) When using chain-weighted price adjustments, real GDP still refers to inflation adjusted GDP but is not expressed in any given base year. C. Per Capita GDP 1. Per Capita GDP is the GDP per person. 2. Since population changes, per capita GDP (GDP per person) is a better measure of how the economy is doing than total GDP. 3. To obtain per capita GDP, simply divide the appropriate GDP figure by the population. a. Be sure to watch out for dividing billions (or trillions) by GDP by millions of persons! b. The result is a figure expressed in dollars per person. 4. You may compute both real and nominal GDP per capita. 5. It is easier to compare per capita figures than total, because we can relate to per capita figures because they are in numbers we can comprehend, rather than large abstract numbers in the trillions. IV. MEASURES OF INCOME A. The above analysis discusses looking at who is spending money on what is produced; we can also examine who receives the income from the spent money. B. The results of the two approaches must be equal (at least in theory). C. In class, we will focus primarily on the expenditure approach, but you will need to know the definitions of the terms used in the income approach. D. Definitions 1. National Income (NI) is the total income earned by current factors of production. a. NI is computed by subtracting indirect business taxes from NDP. 2. Personal Income (PI) is the income received by households before payment of personal taxes. a. PI is computed by subtracting corporate taxes, retained earnings, and social security taxes from NI and adding transfer payments and net interest received. 3. Disposable Income (DI) is the after-tax income of households. a. DI is computed by subtracting personal taxes from PI. 4. Saving (S) is that portion of Disposable Income not spent on current consumption. a. S is computed by subtracting consumption spending from DI. V. THE QUALITY OF LIFE A. The National Income and Expenditure Accounts measure the production and income in an economy during a year; however, this does not necessarily imply that we are better off in all ways. 1. Higher incomes may mean a decrease in well being, as family and leisure time is more scarce and the environment deteriorates. 2. However, do lower incomes mean an increase in well being? B. The Index of Social Health is a measure that includes both economic and social variables. 1. Social welfare and economic welfare are not the same thing. C. Recent discussions raise serious questions whether society is better off as a result of more families where both parents are working and bringing home greater money income. 1. Some argue that many social problems, such as drugs, crime, breakdown of the family unit are a result of one of the parents not being present as a child grows up. 2. Dr. Laura Schlesinger, a popular radio talk show host makes a strong argument for the importance of a stay-at-home mom (or dad) and that such presence of a parent at home for a child is critical for family and society well being. ii.

Gross Domestic Product and Related Measures Billions of Billions of Current Dollars Chained (2000) dollars 2004 2005:Q1 2005:Q2\r\ 2004 2005:Q1 2005:Q2\r\ Gross domestic product....... $11,734.3 $12,198.8 $12,373.1 $10,755.7 $10,999.3 $11,088.6 Personal consumption expenditures. Durable goods................... Nondurable goods................ Services........................ Gross private domestic investment. Fixed investment................ Nonresidential................ Structures.................. Equipment and software...... Residential................... Change in private inventories... Net exports of goods and services. Exports......................... Imports......................... Government consumption expenditure and gross investment............. Federal......................... State and local................. Residual.......................... Gross domestic product.......... Plus: Income receipts from the rest of the world.......... Less: Income payments to the rest of the world.......... Equals: Gross national product.. Net domestic product............ 8214.3 987.8 2368.3 4858.2 $1,928.1 1872.6 1198.8 298.4 900.4 673.8 55.4 -$624.0 1173.8 1797.8 8535.8 1017.3 2476.6 5041.8 $2,058.5 1998.7 1280.1 315.9 964.3 718.5 59.9 -$697.5 1253.2 1950.6 8667.7 1035.0 2532.8 5099.9 $2,054.2 2053.7 1312.9 325.7 987.3 740.8 0.5 -$687.0 1304.2 1991.2 7588.6 1089.9 2200.4 4310.9 $1,809.8 1755.1 1186.7 248.4 947.6 561.8 52.0 -$601.3 1117.9 1719.2 7764.9 1122.3 2265.6 4392.0 $1,902.9 1842.2 1252.2 251.0 1014.2 584.1 58.2 -$645.4 1165.3 1810.7 7823.2 1143.3 2285.1 4412.7 $1,886.8 1882.1 1277.8 252.7 1039.6 597.9 2.6 -$611.2 1201.9 1813.1

$2,215.9 827.6 1388.3 ..... $11,734.3 415.4 361.7 11788.0 $10,299.0

$2,302.0 860.2 1441.7 ..... $12,198.8 462.3 422.9 12238.2 $10,750.4

$2,338.2 868.2 1470.1 ..... $12,373.1 487.3 454.3 12406.1 $10,917.4

$1,952.3 723.7 1228.4 -$26.8 $10,755.7 383.7 333.5 10805.7 $9,365.5

$1,971.9 731.8 1239.8 -$48.0 $10,999.3 420.4 383.3 11036.3 $9,608.3

$1,985.0 734.7 1250.1 -$60.2 $11,088.6 439.6 408.6 11119.4 $9,689.1

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