Chapter 2

The
Measurement of
Income, Prices,
and
Unemployment

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 The Circular Flow of Income and
Expenditure

•  The circular flow of income and expenditure model

is a simple representation of the macro economy
•  In the following graphs, convince yourself that:
–  The value of output produced by firms equals the value
of expenditures by participants in the economy
–  The value of output produced by firms equals the total
income generated in the economy

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 Figure 2-1 The Circular Flow of Income and
Consumption Expenditures

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 Defining GDP

•  GDP (Y) is the value of all final goods and

services that are currently produced and
sold (but not resold) through the market
during the current time period
–  The GDP of a country is often referred to as the
country’s output and/or income

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 Keeping Track of GDP and other U.S.
Data

•  The National Income and Product Accounts (NIPA) is

the official U.S. government accounting of all the U.S. flows
of income and expenditures.
•  The “Big Three” agencies for U.S. economic data
–  The Bureau of Economic Analysis (BEA)
–  The Bureau of Labor Statistics (BLS)
–  The Federal Reserve Board (Fed)
•  Other sources of data
–  The Bureau of the Census
–  International data: OECD, the World Bank, and the IMF

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 Types of Investment (I)

•  Inventory Investment is the change in the

stock of raw materials, parts, and finished
products held by businesses.
–  Any goods that are unsold automatically are counted as
part of unplanned inventory investment.
•  Fixed Investment includes all final goods
(mainly structures and equipment) purchased
by businesses not intended for resale.
–  Houses and condominiums owned by households are
also counted as fixed investment.
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 Relation of Investment and Saving

•  Personal Saving (S) is that part of personal income that is

not consumed or paid out in taxes
–  Also referred to as Private Saving
–  Algebraically: S = (Y-T) - C (where T = Net Taxes)
•  Funds from savings are channeled to firms in two basis
ways:
–  Households buy bonds and stocks issued by firms
–  Households deposit savings in banks and other financial
institutions that in turn lend money to firms
•  Firms use the money channeled from savings to buy
investment goods

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 Figure 2-2 Introduction of Saving and
Investment to the Circular Flow Diagram

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 Net Exports and Net Foreign
Investment

•  Exports are goods produced within one country

and shipped to another
•  Imports are goods consumed within one country
but produced in another country
•  Net Exports (NX) are equal to the excess of
exports over imports
•  Net Foreign Investment (NFI) is equal to U.S.
purchases of foreign financial assets minus foreign
purchases of U.S. financial assets
–  Interesting connection: NX = NFI

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 The Government Sector

•  Government Purchases (G) is the value of

goods and services purchased by the government
at the federal, state and local levels
•  Transfer Payments (F) are payments from the
government to households that do not require the
recipient to provide a service in return
–  Examples: Social Security, Medicare, and Food Stamps
•  Government Spending = G + F
•  The Government pays for its spending by collecting
Taxes (R) or by borrowing and/or printing money
•  Net Taxes (T) = R – F
•  Budget Surplus = T – G
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 Figure 2-3 Introduction of Taxation, Government
Spending, and the Foreign Sector to the Circular Flow
Diagram

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 Deriving the “Magic” Equation

•  The income accounting identity states that an economy’s

(1)
income must equal its expenditures:
Y ≡ E è Y = C + I + G + NX
•  Now, use the fact that household income must equal (2)
household outlays (and recall that T = R - F):
Y+F=C+S+Rè Y=C+S+T
•  Equating (1) and (2) yields the “Magic Equation”
C + S + T = C + I + G + NX
è S + T = I + G + NX

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 Interpreting the “Magic Equation”

Recall the “Magic Equation:” S + T = I + G + NX

•  Leakages (S + T) describe the portion of total
income that is not available for consumption
•  Injections (I + G + NX) is a term for
nonconsumption expenditures
•  The “Magic Equation” shows how leakages and
injections are connected by definition!

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 Table 2-1 Households Get
What Remains After All the Leakages

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 “Magic Equation” Application: Twin
Deficits

Recall the “Magic Equation”: S + T = I + G + NX (1)

•  Rearranging (1) yields è T - G = (I + NX) – S
–  If T - G < 0 è possibly NX < 0
–  This suggests that a budget deficit and trade deficit
might be observed at the same time!
–  Note that the “magic equation” only suggests the
possible connections that may be observed in these
variables.

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 Nominal GDP, Real GDP, and the
GDP Deflator

•  Nominal GDP is the value of gross domestic product

in current (actual) prices.
•  Real GDP is the measure of gross domestic product
using prices of an arbitrarily chosen base year.
•  The GDP deflator is a price index that measures the
aggregate economy’s price level.
–  Algebraically: GDP Def = Nominal GDP / Real GDP * 100
–  The percentage change in the GDP deflator gives a measure of the
economy’s inflation rate.

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 Figure 2-4 Nominal GDP, Real GDP, and
the Implicit GDP Deflator, 1900–2007

Source: Appendix Table A-1.

See explanation in Appendix
C-4

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 Figure 2-5 Employment from the Household and
Payroll Survey, 1990–2007

Source: Bureau of Labor Statistics

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