The big picture marcoeconomics 12e parkin chapter 04

The fact that aggregate expenditure equals aggregate income equals the value of production is the key to understanding why changes in aggregate expenditure change aggregate income, which

T h e B i g P i c t u r e

Where we have been:

Chapter 4 does not directly use the material developed in the previous

chapters

Where we are going:

Chapter 4 is the first of the macroeconomic chapters It provides some basic definitions (GDP, real GDP, aggregate expenditure, potential GDP, and business cycles) that are used in virtually all the remaining chapters The circular flow model and the national income accounting explained in this chapter serve as a general framework for macroeconomic analysis The fact that aggregate expenditure equals aggregate income equals the value of production is the key to understanding why changes in aggregate expenditure change aggregate income, which then changes aggregate expenditure The components of aggregate expenditure provide an underpinning for the theory

of aggregate demand in Chapter 10 and the aggregate expenditure model and multiplier in Chapter 11

N e w i n t h e Tw e l f t h E d i t i o n

The content within the chapter is substantially the same as the 11th edition but there are special icons indicating problems that use real-time data All of the data within the chapter have been updated to use 2014 data The current event topic is under the ‘Economics in the News’ section and discusses the continuing expansion

in the United States during 2014 The Worked Problem presents some national accounts and then asks the students to calculate GDP using both the expenditure and income approaches, net domestic income at factor cost, and net domestic income at market prices The solutions show step-by-step how to calculate the required answers To include the new Worked Problem without lengthening the

4 MEASURING GDP AND ECONOMIC

C h a p t e r

34

chapter, some problems have been removed from the Study Plan Problem and Applications These problems are in the MyEconLab and are called Extra Problems

35

Measuring GDP and Economic Growth

I Gross Domestic Product

 GDP or gross domestic product is the market value of all the final goods and services produced within a country in a given time period

How do you add apples and oranges? You can pick any goods you like but I think it is

helpful to show GDP as an equation early on You can start with real goods and then

generalize to “n goods”:

GDP = PAQA + POQO + …

GDP = P1Q1 + P2Q2 + P3Q3 + … + PNQN

GDP = ∑ PiQi

You may find it useful to add slang while you discuss GDP, “GDP is the dollar value of all

‘stuff’ made over one year.” Be sure to repeat the definition as you move through all the chapters rather than assuming the your students always remember what is in GDP and how it is measured A solid understanding of GDP is crucial for other material to make sense

 The items in GDP are valued at their market values, that is, at their prices So if 100,000,000 slices of pizza are sold for $3 each, slices of pizza contribute

$300,000,000 to GDP Using market values means that the total value of output, that is, GDP will be in the dollars (or whatever the country’s currency unit might be)

 A final good is an item that is bought by its final user It contrasts with an

intermediate good, which is an item that is produced by one firm, bought by

another firm, and used as a component of a final good or service

intermediate goods and services are directly counted)

produced in North Carolina is counted in U.S GDP

 GDP is measured over a period of time, typically a quarter of a year or a year

Gross Domestic Product The main challenge in teaching this topic is generating

interest in it Many teachers are bored by it and not surprisingly, they bore their students

If you are one of the many who lean toward boredom, start by recalling just how vital it is that we measure the value of production with reasonable accuracy Working through issues with GDP is vital since it serves as the basis of measurement of the standard of living, economic welfare, and making international comparisons

Final goods versus intermediate goods The distinction between final and intermediate

goods is one of the key points in this first section Use some standard examples to make the key point—tires and autos, chips and computers, and so on Also, if you want to spend

a bit of time on this topic, tell your students about the Bureau of Economic Analysis (BEA) revision in the treatment of business spending on software The BEA began a major

revision in 1998 and published the first revisions to reclassify software from intermediate

to final good status in 1999 When the 1996 GDP was recalculated to include software as a final good, GDP increased by $115 billion, or 1.5 percent

GDP and the Circular Flow of Expenditure and Income

 The circular flow illustrates the equality of income, expenditure, and the value of

production The circular flow diagram shows the transactions among four economic agents—households, firms, governments, and the rest of the world—in two

aggregate markets—goods markets and factor markets

services For analytical purposes, we can categorize spending by these four agents

in the calculation of GDP:

consumption expenditure, C.

inventories are investment, I.

from firms

 Firms sell goods and services to the rest of the world, exports or X, and buy

goods and services from the rest of the world, imports or M Exports minus

imports are called net exports, X  M.

Government transfer payments, such as Social Security payments, are not part of

government expenditures because government expenditures include only funds used by

the government to buy goods and services Transfer payments are not buying a good or

service for the government and so are not included in government expenditures

 In factor markets households receive income from selling the services of resources to firms The total income received is aggregate income It includes wages paid to

workers, interest for the use of capital, rent for the use of land and natural resources, and profits paid to entrepreneurs; retained profits can be viewed as part of

household income, lent back to firms

The Circular Flow Model Start with a simpler picture than Figure 4.1—just households

and firms, and just income and consumption Explain that you are starting from the basics,

in which all goods and services produced are sold to consumers Explain that even beyond the assumption that all goods and services are consumption goods and services, we’re

simplifying things in the picture but are not omitting anything that leads us into a

misleading conclusion For instance the picture envisages all the income being paid to

households Nothing is lost and clarity is gained by this device Emphasize that the blue

flows are incomes and the red flows are expenditures on final goods and services Clearly

in this simplest case aggregate income equals aggregate expenditure Then add

investment It is still the case that aggregate expenditure (which is now C + I) equals

aggregate income Next add the government and the flow of government expenditure

Finally add the rest of the world and the flow of net exports In both cases you can continue

to make the crucial point at aggregate expenditure equals aggregate income

GDP Equals Expenditure Equals Income

GDP because all the goods and services that are produced are sold to households,

firms, governments, or foreigners (Goods and services not sold are included in

investment as inventories and hence are “sold” to the producing firm.)

goods and services, aggregate income equals aggregate expenditure equals GDP

Why “Domestic” and Why “Gross”?

 Depreciation is the decrease in the stock of capital that results from wear and tear

and obsolescence The total amount spent on purchases of new capital and on

replacing depreciated capital is called gross investment The amount by which the stock of capital increases is net investment Net investment = Gross

investment  Depreciation

 The “Gross” in gross domestic product reflects the fact that the investment in GDP is gross investment and so part of it goes to replace depreciating capital Net domestic product subtracts depreciation from GDP

II Measuring U.S GDP

Most of the income data used by the BEA to measure GDP come from the IRS Expenditure data come from a variety of sources

The Expenditure Approach

investment, I, government expenditure on goods and services, G, and net exports of goods and services, (X  M) So GDP = C + I + G + (X  M) or, in 2014 and in billions

The Income Approach

interest, rental income, corporate profits, and proprietors’ income This sum equals net domestic income at factor costs To obtain GDP, indirect taxes (which are taxes

paid by consumers when they buy goods and services) minus subsidies plus

depreciation are included Finally any discrepancy between the expenditure

approach and income approach is included in the income approach as “statistical

discrepancy.”

Measuring U.S GDP, the low cost of economic data You might like to tell your

students that measuring real GDP is actually very cheap The BEA (in the Department of

Commerce) employs fewer than 500 economists, accountants, statisticians, and IT

specialists at an annual cost of less that $70 million It costs each American less than

0.25¢ (a quarter of a cent) to measure the value of the nation’s production For some

further perspective, the National Oceanic and Atmospheric Administration (also in the

Department of Commerce), whose mission is to “describe and predict changes in the

Earth’s environment, and conserve and manage wisely the nation’s coastal and marine

resources so as to ensure sustainable economic opportunities,” employs more than 11,000 scientists and support personnel at an annual cost of $3.2 billion!

Creative accounting and GDP measurement In recent years, the first estimates of

GDP, which are based on companies’ reported profits, have been revised downward when

data on company profits as reported to the IRS became available Enron-style accounting

has contaminated the initial estimates of GDP but not the final estimates You can make a

nice point with one example of creative accounting For some years, in its reports to stock

holders AOL recorded its advertising expenditure as investment and amortized it over a

number of years First, you can explain that the correct treatment of this item is as an

expenditure on intermediate goods and services by AOL and as a charge against AOL

profit The expenditure on AOL services is the value of AOL’s production And AOL’s

expenditure on advertising is part of the value of the production of the advertising

agencies used by AOL You can go on to explain that AOL accounting practice would

misleadingly swell GDP by causing some double counting On the expenditure approach,

AOL’s advertising expenditure shows up as investment in the national accounts On the

income approach, because the expenditure is not a cost, it swells profit, so AOL’s corporate profit increases by the same amount as its “investment.” If AOL filed its income tax return

in this same way, the national income accounts wouldn’t get corrected But if, when AOL

files its tax returns, it calls its advertising a cost and lowers its profits by that amount, the

BEA picks up these numbers from the IRS and the national accounts are adjusted

appropriately

Nominal GDP and Real GDP

production of goods and services are higher or because the prices of goods and

services are higher

 Real GDP allows the quantities of production to be compared across time Real GDP

is the value of final goods and services produced in a given year when valued at the prices of a reference base year

 Nominal GDP is the value of the final goods and services produced in a given year

valued at the prices that prevailed in that same year

Calculating Real GDP

 Traditionally, real GDP is calculated

using prices of the reference base

year (the year in which real

GDP=nominal GDP)

 The tables to the right show this

method of calculating real GDP for

an economy that produces only

books and coffee If 2014 is the

reference base year, nominal GDP

in 2014 in the top table equals real

GDP in 2014 Real GDP in 2014 is

$3,000

calculation for nominal GDP in

2015

table It values 2015 production

using the prices from the reference

base year, 2014 Real GDP in 2015

is $4,250

You may want to mention the GDP deflator at this point even though coverage of it is in

next chapter Stress the separation of the “quantity effect,” measured by real GDP, and the

“price effect,” measured by the price level Real GDP will be used to compute the economic growth rate while the price level will be used to compute the inflation rate

REQUIRES MATHEMATICAL NOTE: Chained-Dollar Real GDP

for 2014 for an economy that

produces only books and coffee In

2014, nominal GDP is $3,000 The

second table to the right has the

same data for 2015 (These tables

are the same as used above to

calculate real GDP using the

standard method.) In 2015,

nominal GDP is $6,000

much has real GDP changed

between these years?

changes, suppose that 2014 is the

base year Then we need to determine the growth rate between 2014 and 2015 by

Data for 2014

ty

Pric e

Market Value

Nominal GDP

$3,000

Data for 2015

ty

Pric e

Market Value

Nominal GDP

$6,000

2015 Quantities and 2014 Prices

ty

Pric e

Market Value

GDP Data for 2014

ty

Pric e

Market Value

Nominal GDP

$3,000

GDP Data for 2015

ty

Pric e

Market Value

calculating the value of production in both years using 2014 prices and also

calculating it in both years using 2015 prices

 Using 2014 prices, the value of production increases from $3,000 (the first table) to

$4,250 (the third table) Using 2014 prices, the value of production has grown by

100  ($4,250  $3,000)/$3,000 = 41.7 percent

 Using 2015 prices, real GDP increases from $4,200 (the fourth table) to $6,000 (the second table) Using 2015 prices, the value of production has grown by

100  ($6,000  $4,200)/$4,200 = 42.9 percent

to (41.7 percent + 42.9

percent)/2 = 42.3 percent So real

GDP between these years has

grown by 42.3 percent If 2014 is

the base year, real GDP in 2011 is

$3,000  1.423 = $4,269

each pair of adjacent years from

the reference base year onwards

This procedure chains real GDP

back to the reference base year

III The Uses and Limitations of

Real GDP

The Standard of Living Over Time

living over time is real GDP per

person, or real GDP divided by the population Real GDP per person tells us the value

of goods and services that the average person can enjoy

 The value of real GDP when all the economy’s labor, capital, land, and

entrepreneurial ability are fully employed is called potential GDP Potential GDP

grows at a steady pace because the quantities of the factors of production and their productivity grow at a steady pace

This slowdown created a Lucas wedge A Lucas wedge is the dollar value of the

accumulated gap between what real GDP per person would have been if the growth rate had persisted and what real GDP per person actually turned out to be

The Importance of the Lucas Wedge It is usually straightforward to interest students

in the business cycle But it is perhaps a bit more difficult to motivate interest in economic growth and the Lucas wedge Yet economic growth and the Lucas wedge should be of immense importance to young students because they help determine the long-run living standard of their lives One way to make this point clear is to ask the students whether the difference between, say, 3 percent annual growth in income versus 4 percent annual growth is important This difference probably does not sound important But, suppose that the initial income was $35,000 After 10 years with 3 percent growth, the income would be

$47,037 and with 4 percent growth the income would be $51,809 This difference of about

$4,500 might not seem like much But point out to the students that this difference is for

only ten years and that the annual difference will continue to enlarge: After 30 years with 3

percent growth, the income would be $84,954 and with 4 percent growth the income would

be $113,519, a one year difference of about $40,000 And, over a 30-year working career, the total differences in income, which is the analog to the Lucas wedge, is approximately

$420,000 Over a 40-year working career, the Lucas wedge difference is over $1,000,000! Viewed from this perspective, the seemingly slight 1 percentage point difference in growth

2015 Quantities and 2014 Prices

y

Pric e

Market Value

Value of production (2010 dollars)

$4,250

2014 Quantities and 2015 Prices

y

Pric e

Market Value

Value of production

$4,200

rates makes for an incredibly major difference in incomes, which should easily capture

your students’ attention

periodic but irregular increases and decreases in the total production and other

measures of economic activity Each cycle is categorized by: trough, expansion,

peak, recession

The Business Cycle Students generally are interested in the topic of business cycles,

particularly if the economy happens to be in a recession when this chapter is covered

Often it is very difficult to tell the future path of the economy Stress to the students that it

is not stupidity on the part of economists that prevents us from knowing where the

economy is heading Rather it is the fact that forecasting is difficult for at least two

reasons First, different sectors of the economy frequently send different signals For

instance, retail sales may be down, signaling a start to a recession, but housing starts may

be up, indicating that an expansion will continue for a while Second, the data that must be used always are at least a bit out-of-date For example, the preliminary estimate of GDP is

not made until approximately six weeks after the end of the quarter, and the final revision

of GDP doesn’t appear until years later Although economists’ forecasts are much better

than those of others, forecasting GDP with complete accuracy is unlikely Conclude by

mentioning that this fact is important in later chapters when we discuss implementation of counter-cyclical policies

The Business Cycle, Part 2: The business cycle and its dating are interesting to

students, especially when the economy is in or near a recession If you have the capacity to show or assign Web pages, look at the NBER Business Cycle Dating Committee’s page at

http://www.nber.org/cycles/recessions.html

You might like to look at the dating of the cycle in other countries This dating is done by

the Economic Cycle Research Institute (ECRI) You can find their Web site at

http://www.businesscycle.com/ Another page on the ECRI Web site shows the cycle peak

and trough dates for 18 countries from 1948 nicely aligned in a table

You can compare the timing of cycles internationally You can also compare the severity of

U.S cycles over time Note that the recession that the NBER dates as beginning in March

2001 and ending in November 2001 was incredibly mild on all criteria except the labor

market The “Great Recession” that started in 2007, however, is one of the worst since the

great depression

The Standard of Living Across Countries

problems arise in using real GDP to compare living standards:

 First, the real GDP of one country must be converted into the same currency unit

as the real GDP of the other country

Relative prices in countries will differ, so goods and services should be weighted

accordingly For example, if more prices are lower in China than in the United States, China’s prices put a lower value on China’s production than would U.S prices If all

the goods and services produced in China are valued using U.S prices, than a more valid comparison can be made of real GDP in the two countries This comparison

using the same prices is called purchasing power parity (PPP) prices.

Big Mac Index (http://www.economist.com/content/big-mac-index): This is an impressive

and interactive site for measuring PPP of the Big Mac Students will immediately relate to

this example and you can ask them what country they want to check on