Chapter: 7

Krugman/Wells

©2009 Worth Publishers

Tracking the

Macroeconomy

The National Accounts Almost all countries calculate a set of numbers known

as the national income and product accounts. The national income and product accounts, or national

accounts, keep track of the flows of money between different parts of the economy.

Gross domestic product or GDP measures the total market value of all final goods and services newly produced within a country during a given year.

It is a measure of output in an economy in it’s most aggregated form.

Total market value means we count the monetary value of goods & services. It is a common denominator of apples & oranges.

Within a country means any good or service produce inside a country is included in that countries GDP regardless of ownership.

Gross Domestic Product Newly produced means we exclude the value of

financial transactions or the sale of used goods. The value of stocks bought & sold are not counted in

GDP, nor the sale of existing homes, nor the value of social security payments.

Final goods and services are goods and services sold to the final, or end, user. Intermediate goods and services are goods and

services—bought from one firm by another firm—that are inputs used for production of other goods and services or for resale.

Why bother with this distinction? To avoid double counting production of a good or

service since the cost of an intermediate good is included in the price the firm sells it’s product.

How do government statisticians do this?

Calculating Gross Domestic Product GDP can be calculated three ways (they are not

mutually exclusive, each way complements the other):

1. Add up the value added of all producers

This is how statisticians avoid double counting.

2. Add up all spending on domestically-produced final goods and services from consumers, business firms, governments, and foreigners.

This results in the equation: GDP = C + I + G + X - IM

3. Add up all income paid to factors of production

Wages, interest, rent, and profit

Calculating Gross Domestic ProductValue Added… Goods are produced in different stages of production. Raw materials, making of parts, assembly of parts,

selling to consumers. By not counting the value of the good produced when

it is sold, but only counting the value added at each stage of production statisticians will count the equivalent of only counting final goods & services.

Definition of value added: the value of a firms output minus the value of

intermediate goods purchased by the firm.

Calculating Gross Domestic Product

If you counted the sales of the good when they were sold ($4,200, $9,000, $21,500) GDP would be $34,700, which would be a vast exaggeration of actual production.

Calculating Gross Domestic Product2. Adding up spending on all domestically produced

goods & services:

Consumption - done by Households

Investment - done by Business Firms

Government Purchases - done by governments

Net Exports = Exports – Imports : done by the rest of the world

Consume:Buy goods & services

Save:Spend lessthan income earned

Work:Earn Income

PaytaxesHouseholds

Producegoods & services (GDP)

Firms

Invest:Buy Capital(investment)goods (tools,factories,etc)

Hire Resources:To producegoods & services

An Expanded Circular-Flow Diagram

Firms

Markets for goods and services

Households

Factor Markets

Wages, profit, interest, rent

Wages, profit, interest, rent

GDP

Consumer spending

The National Accounts Households earn income via the factor markets from

wages, interest on bonds, dividends on stocks, and rent on land. A stock is a share in the ownership of a company held

by a shareholder. A bond is borrowing in the form of an IOU that pays

interest. In addition, households receive government transfers

from the government. Disposable income = total household income minus

taxes, is available to spend on consumption or to save.

Percent of GDP (2009)

100908070605040302010

70.8%Consumption

Households: Consumption (C)

Durable goods: goods that last a relatively long time: Cars, Refrigerators, T.V.’s, RadiosNon-durable goods: goods which are perishable: Food, ClothingServices: goods which do not involve the production of physical things: Banking, Medical care, Legal services

Services make up the bulk of Consumption

Consumption spending is fairly steady over the business cycle

Categories of GDP; 2009 Billions of $ Percent of GDP Gross Domestic Product 14,119.0 100.0 Consumption 10,001.3 70.8 Durable 1,026.5 7.3 Non-durable 2,204.2 15.6 Services 6,770.6 47.9

1) All final purchases of machines, equipment, tools, etc.

2) All construction Nonresidential: expenditures on, factories, office buildings, computers, software Residential: expenditures by

households on new houses and apartment buildings

3) Changes in inventories from previous year Business inventories: goods that firms produce now with the intent to sell later The goods on shelves and warehouses.

Percent of GDP(2009)

100908070605040302010

11.2%Investment

Business Firm spending: Investment (I)

70.8%Consumption

Investment categories1. Business Fixed Investment

a.Non-residental: The spending by business firms on equipment, tools, factories, etc. so as to increase future production and output.

b. Residential Investment: Newly purchased homes are included here because they lead to a future stream of output for consumers

2. Inventory investment: The change in business inventories affects business firms ability for future sales.

Categories of GDP; 2009

Investment 1,589.2 11.2 Non-residential 1,364.4 9.7 Residential 352.1 2.5Changes in Business Inventories -127.2 -0.9

An Expanded Circular-Flow Diagram

Firms

Markets for goods and services

Households

Factor Markets

Wages, profit, interest, rent

Wages, profit, interest, rent

GDP

Consumer spending

Investment spending

Financial Markets

Private savings

Borrowing and stock issues by firms

Expenditures by federal, state and local governments on new final goods such as military goods,roads,education, police, etc. Does not include transfer payments (social security, unemployment benefits, welfare payments, etc.) Government outlays(Spending) would

include both purchases & transfer payments

Notice that Total purchases from households, firms, and governments is 102.6%. How is this possible?

Because of Net Exports!

Percent of GDP(2009) Government Purchases (G)100908070605040302010

20.6%Government

Trade Deficit

70.8%Consumption

11.2%Investment

Goods produced by Americans and sold to Foreigners (Exports) minus

Goods produced by Foreigners and bought by Americans (Imports).

Net Exports = (Exports - Imports)

Also called the Trade Balance When the stacked bar from C, I, & G is

greater than 100% there is a Trade deficit (Imports > Exports)

Net exports are used to only count production in the U.S.Imports are bought by consumers and would be in consumption spending, but we don’t want to count those goods that are not produced in the U.S.Exports are not bought in the U.S. but produced here, which we do want to count. Need to subtract Imports and add Exports

Net Exports (X - IM)Percent of GDP(2009)

100908070605040302010

20.6%Government

Trade Deficit

70.8%Consumption

11.2%Investment

Categories of GDP; 2009

Government Purchases 2,914.9 20.6 Net Exports -386.4 -2.6 exports 1578.4 imports 1964.7 Adding up all the expenditures using symbols: GDP(Y) = C + I + G +

NX 14,119.0 = 10,001.3 + 1,589.2 + 2,914.9 - 386.4

An Expanded Circular-Flow Diagram

Firms

Markets for goods and services

Households

Factor Markets

Wages, profit, interest, rent

Wages, profit, interest, rent

GDP

Consumer spending

Investment spending

Financial Markets

Private savings

Borrowing and stock issues by firms

Government

Government purchases of goods and services

Government borrowing

Government transfers

Taxes

Rest of the world

Foreign borrowing and sales of stock

Foreign lending and purchases of stock

Exports

Imports

Source:BEA

Composition of Gross Domestic Product 1929-2007

Real vs. Nominal GDP Does production increase when GDP increases? Nominal GDP is the value of all final goods and

services produced in the economy during a given year, calculated using the prices current in the year in which the output is produced. If Nominal GDP increases, output may or may not go up

since an increase in prices themselves could cause Nominal GDP to increase.

Real GDP is the total value of the final goods and services produced in the economy during a given year, calculated using the prices of a selected base year. Statisticians adjust for price changes, so that if real

GDP increases, we know for sure that output increases. This is the measure that is often quoted in the media.

Real vs. Nominal GDPCalculating GDP and Real GDP in a Simple Economy

Year 1 Year 2

Quantity of apples (billions) 2,000 2,200

Price of apple $0.25 $0.30

Quantity of oranges (billions) 1,000 1,200

Price of orange $0.50 $0.70

Nominal GDP (billions of dollars) $1,000 $1,500

Real GDP (billions of year 1 dollars) $1,000 $1,150

Nominal GDP = Price (in current year) x QuantityReal GDP = Price (in a common year) x QuantityFor year 2: (2,200 x $0.25) + (1,200 x $0.50) = $1,150

Nominal GDP increases by 50% (($500/$1,000) x 100)Real GDP increases by 15% (($150/$1,000) x 100)Using Nominal GDP vastly exaggerates the change in the amount of actual output produced, which is why calculating Real GDP is necessary.

Real vs. Nominal GDP

►ECONOMICS IN ACTIONMiracle in Venezuela? The South American nation of Venezuela has a distinction that

may surprise you: in recent years, it has had one of the world’s fastest-growing nominal GDPs. Between 1997 and 2007, Venezuelan nominal GDP grew by an average of 28% each year—much faster than nominal GDP in the United States or even in booming economies like China.

So is Venezuela experiencing an economic miracle?

►ECONOMICS IN ACTIONMiracle in Venezuela?

No, it’s just suffering from unusually high inflation. Nominal GDP

(billions of bolivars), Real GDP (billions of

1997 bolivars)

1997 1999 2001 2003 2005 2007

Year

VEB500,000

400,000

300,000

200,000

100,000

Real vs. Nominal GDPCalculating GDP and Real GDP in a Simple Economy

Year 1 Year 2

Quantity of apples (billions) 2,000 2,200

Price of apple $0.25 $0.30

Quantity of oranges (billions) 1,000 1,200

Price of orange $0.50 $0.70

Nominal GDP (billions of dollars) $1,000 $1,500

Real GDP (billions of year 1 dollars) $1,000 $1,150

Real GDP (billions of year 2 dollars) $1,300 $1,500

Choosing a base year is arbitrary, so we could use Year 2 prices if we wished.Using Year 2 prices, Real GDP increases by 15.4%. Remember, using Year 1 prices Real GDP increases by 15%. Both are correct!The BEA uses both numbers and averages them to get the percentage actually used. This is called Chained dollars. Calculate changes in real GDP using the average between the growth rate calculated using an early base year and the growth rate calculated using a late base year.

Real vs. Nominal GDP

Except in the base year, real GDP is not the same as nominal GDP, output valued at current prices.

Real GDP in 2005 chained dollars

Nominal GDP(Current dollars)

By definition, Nominal GDP &Real GDP are the same in thebase year (2005)

What makes Nominal GDP different than Real GDP is the change in prices from year to year (inflation rate).

Real vs. Nominal GDPNominal versus Real GDP in 1993, 2000, and 2007

Nominal GDP (billions of current dollars)

Real GDP (billions of 2000 dollars)

1993 $6,657 $7,533

2000 9,817 9,817

2007 13,808 11,524

By dividing Nominal GDP by Real GDP for each year we can construct an implicit price index, which is called the GDP Deflator. A price index is the ratio of the current cost of that market basket to the cost in a base year, multiplied by 100.

In this case the market basket is goods & services in GDP

1993: $6,657 / $7,533 = 88.4

2000: $9,817 / $9,817 = 100

2007: $13,808 / $11,524 = 119.8

A price index can be use to measure the aggregate price level (overall level of prices in the economy).

Inflation Rate, CPI, and other Indexes By changing the market basket of goods & services

different price indexes can be calculated. The inflation rate is the yearly percentage change in

a price index, typically based upon Consumer Price Index, or CPI, the most common measure of the aggregate price level.

The consumer price index, or CPI, measures the cost of the market basket of a typical urban American family.

Consumer Price Index

Recreation5%

Education and communication

6%Other goods and services

4%

Food and beverages

16%

Motor fuel7%

Housing40%

Apparel4%

Transportation13%

Medical care5%

Market Basket composition for the Consumer Price Index

Inflation Rate, CPI, and other Indexes

CPI number 2005 – 195.3 2006 – 201.6 2007 – 207.3 2008 – 215.3 2009 – 214.5

2006: ((201.6 – 195.3) / 195.3) x 100 = 3.22%

2007: ((207.3 – 201.6) / 201.6) x 100 = 2.83%

2008: ((215.3 – 207.3) / 207.3) x 100 = 3.86%

2009: ((214.5 – 215.3) / 215.3) x 100 = -0.37%

Inflation Rates

Example: An RCA 23” Color TV cost $495 in 1956. Was this cheap or expensive compared to today’s HDTV’s?

Use the CPI to find out.

Price in 2009 = Price in 1956 x CPI in 2009 / CPI in 1956

Price in 2009 = $495 x 214.5 / 27.2

$3,903 = $495 x 7.886

►ECONOMICS IN ACTIONIndexing to the CPI The CPI has a direct and immediate impact on millions

of Americans. The reason is that many payments are tied, or

“indexed,” to the CPI—the amount paid rises or falls when the CPI rises or falls.

Today, 48 million people receive checks from Social Security.

The amount of an individual’s check is determined by a formula that reflects his or her previous payments into the system as well as other factors.

In addition, all Social Security payments are adjusted each year to offset any increase in consumer prices over the previous year.

The CPI is used to calculate the official estimate of the inflation rate used to adjust these payments yearly.

FOR INQUIRING MINDS

Is the CPI biased? The U.S. government takes considerable care in

measuring consumer prices. Nonetheless, many economists believe that the consumer price index systematically overstates the actual rate of inflation.

One reason is the fact that the CPI measures the cost of buying a given market basket. Yet, consumers typically alter the mix of goods and

services they buy, reducing purchases of products that have become relatively more expensive and increasing purchases of products that have become relatively cheaper.

The second reason arises from innovation. By widening the range of consumer choice, innovation

makes a given amount of money worth more.

The CPI, the PPI, and the GDP DeflatorPercent change in CPI, PPI, GDP deflator

25%

20

15

10

5

0

-5

-10

-15

-20 1930 1940 1950 1960 1970 1980 1990 2000 2007

YearThese three different measures of inflation usually move closely together. Each reveals a drastic acceleration of inflation during the 1970s and a return to relative price stability in the 1990s.

Problems with GDP1. GDP cannot count all production done in an economy.

GDP does not count Non-Market Transactions:a. Household production Example: Instead of hiring someone to cut your grass you

do it yourself

b. Underground Economy Legal or Illegal activity that is paid for by cash or goods. Much of it to avoid taxes and regulations

Will cause GDP to understate economic activity Possibly by as much as 10% of GDP in the U.S. Makes it difficult to compare across countries2. GDP cannot deal with quality improvements in goods

& services, which will cause us to understate our actual standard of living if we use GDP as a measure of standard of living.

Example: Suppose you had this place setting for a dinner table: There are 4 items, which can be considered GDP

GDP only measures quantity.

Now consider the place setting below for dinner:There are still only 4 items so GDP will be the same as the place setting above.Since you now have a fork and knife the quality of your dining experience will be better.

You are better off with the bottom place setting, but GDP is unchanged!

Problems with GDP3. GDP does not consider distribution of output How much of GDP goes to poor, middle class, rich

Can measure GDP/Person, but that only gives an average

4. GDP does not subtract the byproducts of production: Pollution or Waste

These could even cause GDP to increase!

Because of the hiring of workers to clean up.

If crime is high, GDP increases because more police and security persons are hired.

GLOBAL COMPARISON

GDP and the meaning of life Rich is better, all other things equal Money matters less as you grow richer beyond some level Money isn’t everything. Leisure time, etc also important.

SUMMARY

1. Economists keep track of the flows of money between sectors with the national income and product accounts, or national accounts. Households earn income via the factor markets from wages. Disposable income is allocated to consumer spending (C) and private savings. Via the financial markets, private savings and foreign lending are channeled to investment spending (I), government borrowing, and foreign borrowing. Government purchases of goods and services (G) are paid for by tax revenues and any government borrowing. Exports (X) generate an inflow of funds into the country from the rest of the world, but imports (IM) lead to an outflow of funds to the rest of the world.

SUMMARY

2. Gross domestic product, or GDP, measures the value of all final goods and services produced in the economy. It does not include the value of intermediate goods and services, but it does include inventories and net exports (X − IM). It can be calculated in three ways: add up the value added by all producers; add up all spending on domestically produced final goods and services (GDP = C + I + G + X − IM); or add up all the income paid by domestic firms to factors of production. These three methods are equivalent.

SUMMARY

3. Real GDP is the value of the final goods and services produced calculated using the prices of a selected base year. Except in the base year, real GDP is not the same as nominal GDP, the value of aggregate output calculated using current prices. Analysis of the growth rate of aggregate output must use real GDP. Real GDP per capita is a measure of average aggregate output per person but is not in itself an appropriate policy goal. U.S. statistics on real GDP are always expressed in chained dollars.

SUMMARY

4. To measure the aggregate price level, economists calculate the cost of purchasing a market basket. A price index is the ratio of the current cost of that market basket to the cost in a selected base year, multiplied by 100.

5. The inflation rate is the yearly percent change in a price index, typically based on the consumer price index, or CPI, the most common measure of the aggregate price level. A similar index for goods and services purchased by firms is the producer price index, or PPI. Finally, economists also use the GDP deflator, which measures the price level by calculating the ratio of nominal to real GDP times 100.