Ch 5 Macro

© 2015 Pearson Education, Inc

Chapter 5The Wealth of

Nations:Defining and Measuring

Macroeconomic Aggregates


5 The Wealth of Nations: Defining and Measuring Macroeconomic Aggregates

Chapter Outline

5.1 Macroeconomic Questions5.2 National Income Accounts: Production = Expenditure = IncomeEBE In the United States, what is the total market value of annual economic production?5.3 What Isn’t Measured by GDP?5.4 Real vs. Nominal


Key Ideas

1. Macroeconomics is the study of aggregate economic activity.

2. National income accounting is a framework for calculating gross domestic product (GDP), which is a measure of aggregate economic output.

3. GDP can be measured in three different ways, and in principle these three methods should all yield the same answer: Production = Expenditure = Income.



Key Ideas

4. GDP has limitations as a measure of economic activity and as a measure of economic well-being.

5. Economists use price indexes to measure the rate of inflation and to distinguish nominal GDP from real GDP (which holds prices fixed).



5.1 Macroeconomic Questions

Macroeconomics is the study of economic aggregates and economy-wide phenomena like the annual growth rate of a country’s total economic output or the annual percentage increase in the total cost of living.


In particular, macroeconomics asks the following questions:

• What is income per capita?• How do we measure differences in income per

capita?• How large are differences in income per capita?• What causes differences in income per capita?• How long will differences in income per capita

persist?



Income per capita The average income per person.

Income per capita Calculated by dividing a nation’s aggregate (or total) income by the number of people in that country.

Income per capita in the United States is more than 2 times the level in Portugal, 7 times the level in China, and 100 times the level in Zimbabwe!



Differences in income per capita are caused by institutional differences (so-called economic rules of the games) and political policies that impact them.

Differences in income per capita can either narrow over time (e.g., China) or widen over time (e.g., Argentina).



Why does economic growth sometimes slow down or even turn negative?

What is a recession?



In the short run, economic growth slows down or even becomes negative when aggregate spending decreases.

A recession is defined as two straight quarters in which aggregate income falls.



What is the unemployment rate, and why does it rise during recessions?

Why were the Great Recession of 2007–2009 and the Great Depression of 1929–1932 so severe?



The unemployment rate is defined as the ratio of workers without a job who are actively seeking one divided by the labor force.

There are a multitude of reasons behind the severity of the Great Depression and the Great Recession that we will examine later.



National income accounts A measure of the level of aggregate economic activity in a country.

National Income and Product Accounts (NIPA) The system of national income accounts used in the United States.



Aggregate economic activity in a country can be measured in three different ways:

• The production approach• The expenditure approach • The income approach

5.2 National Income Accounts: Production = Expenditure = Income


5.2 National Income Accounts: Production = Expenditure = Income The Production Approach in Penville

Penville is a small country with one employer, Bic Pen, which produces 10 million pens a year. The market price of a pen is $2.

Penville has 100,000 citizens who are the workers in the factories.

Bic Pen owns the inputs and its own machines so only needs to hire workers.


To determine the market value of production, we multiply the quantity of pens produced by the market price of each pen:

Production = (10 million pens) × ($2.00 / pen) = $20 million

5.2 National Income Accounts: Production = Expenditure = Income The Production Approach in Penville


We add up the sales of pens to households, firms, government, and the foreign sector, including unsold inventories:

Expenditure = (10 million pens) × ($2.00 / pen) = $20 million

5.2 National Income Accounts: Production = Expenditure = Income The Expenditure Approach in Penville


We add up payments to labor and payments to capital:

Income = $X + ($20 million ‒ $X) = $20 million

where X is payments to labor

5.2 National Income Accounts: Production = Expenditure = Income The Income Approach in Penville


Production = Expenditure = Income

$20 million = $20 million = $20 million

5.2 National Income Accounts: Production = Expenditure = Income Aggregate Accounting Identity for Penville



Exhibit 5.1 Circular Flow Diagram


Each of these approaches is used to measure gross domestic product, or GDP.

GDP The market value of the final goods and services produced within the borders of a country during a particular time period.



Production Approach

Production-based accounting sums up each firm’s value added, which is the firm’s sales revenue minus the firm’s purchases of intermediate products from other firms.



Expenditure Approach

Expenditure-based accounting sums up the purchases of goods and services by different groups or categories.

There are five main categories.



1. Consumption goods and consumption services bought by domestic households (C)



2. New physical capital (investment) bought by domestic households and domestic firms (I)



3. Government expenditures on goods and services (G)



4. Exports of goods and services produced domestically and sold abroad (X)



5. Imports of goods and services produced abroad and sold domestically (M)



Income Approach

Income-based accounting sums up payments (or income) received by labor and the owners of physical or financial capital.



Aggregate Accounting Identity

National Income Accounting Identity

Prod Exp IncomeY = GDP + GDP + GDP

Y = C + I + G + X - M



Evidence-Based Economics Example:

Question: In the United States, what is the total market value of annual economic production?

Answer: The Bureau of Economic Activity estimated in 2013 that U.S. GDP was $16.8 trillion, or $53,100 per resident.



Question: In 2013, how was GDP divided into the expenditure components?



Answer:


Exhibit 5.3 U.S. 2013 GDP and GDP Shares (Expenditure-based Accounting)


Evidence-Based Economics Example:

Question: Have U.S. expenditure shares fluctuated or remained constant over time?

Answer: The U.S. expenditure shares have been relatively constant over time.



Exhibit 5.4 U.S. GDP Shares (1929–2013)



Question: What fraction of income is paid to labor, and what fraction is paid to capital?

Answer: In the United States, labor receives about two-thirds of total income, and capital receives about one-third of total income.



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1.00Payments to U.S. Labor (% of total income)

Wages and Salaries Labor benefits

(%)

average payments to labor = 0.70



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Payments to Capital (% of total income)

Rental income Corporate profits Interest payments Tax payments

average payments to capital = 0.30



GDP and national income accounting is a useful system for taking the temperature of the economy. However, it is not perfect, and it necessarily leaves out a lot of details.

5.3 What Isn’t Measured by GDP?


GDP omits depreciation of the physical capital stock and resources.



GDP excludes home production of cleaning, cooking, and child care done in the household.



GDP does not capture transactions conducted in the underground economy.



GDP does not count negative externalities such as pollution, noise, and crime.



GDP does not record leisure.



GDP does not include production by U.S. workers and U.S. capital abroad.

19.3 What Isn’t Measured in GDP?5.3 What Isn’t Measured by GDP?


Gross domestic product, or GDP, records production in the United States regardless of whose labor and capital (domestic or foreign) is used.

Gross national product, or GNP, records production of domestically owned labor and capital in the United States and abroad.



Why is this distinction important?

• U.S. GDP was $16.8 trillion in 2013.

• U.S. GNP was $17.1 trillion in 2013.



Do all these limitations mean that GDP is a poor measure of well-being of an economy?

Why don’t we ask people how happy or satisfied they are and compare these responses to GDP?




Exhibit 5.6 GDP per Capita and Life Satisfaction


An increase in GDP will record both increases in actual production (and income) and increases in prices of those goods and services.

We therefore need to distinguish between nominal GDP and real GDP.

5.4 Real vs. Nominal


Nominal GDP The total value of production using current market prices to determine the value of each unit that is produced.

Real GDP The total value of production using market prices from a specific base year to determine the value of each unit that is produced.



Nominal GDP for 2009:




Real GDP for 2009 (base year 2009):

Nominal GDP for 2013 (base year 2009):



5.4 Real vs. Nominal The Nation of Barney

Example: The Nation of Barney


Calculate nominal GDP for 2012 and 2013.

Calculate real GDP for 2012 and 2013.

Peanut Butter Jelly

Year Quantity Price Quantity Price

2012 20 $4.00 50 $2.00

2013 30 $5.00 100 $2.00





$80 $100 $180

$150 $200 $350



Real GDP for 2012:

Real GDP for 2013:

$80 $100 $180

$120 $200 $320



$350GDP deflator = ×100 = 1.09

$320



GDP deflator The price level of the overall economy.

GDP deflator The ratio of nominal GDP to real GDP:

Nominal GDPGDP deflator = ×100

Real GDP



Consumer Price Index (CPI) The price level of a particular basket of consumer goods and services:

cost of consumer basket in current yearCPI =

cost of consumer basket in base year



The GDP deflator and the CPI formula look nearly identical.

Question: What are the differences?

Hint: Think about what is in each “basket” of goods and services.



1. The GDP deflator includes things not purchased by households, like trains, subways, and submarines.

2. The CPI includes imports like Chinese laptops.

3. Housing-related expenditures like shelter and utility bills have a large weight in the CPI.



GDP and the price level are more often quoted in growth rates.

A growth rate is defined as a percentage change:

(GDP in 2013) (GDP in 2012)

(GDP in 2012)



Inflation rate in 2013 =

Inflation rateThe percentage change in a price index.

(Price index in 2013) (Price index in 2012)100

(Price index in 2012)




Exhibit 5.5 The Relationship Between the Saving Rate and the Investment Rate (1929–2013)


We can use a price index to make meaningful comparisons across time:

In 1909, then U.S. President William Howard Taft was paid $75,000.

In 2013, current U.S. President Barack Obama was paid $400,000.



We can convert Taft’s salary to 2013 dollars by applying this formula:

(Price index in 2013) Value in 2013 dollars = Value in 1909 dollars

(Price index in 1909)

233 = × $75,000

9

= $1.9 million



Question: Which president earned more?

Taft did since his salary in 1909 could buy $1.9 million of goods and services, while Obama’s salary would buy only $400,000 of goods and services.

You can go to http://www.measuringworth.com to see the CPI and other relative calculations.


http://www.measuringworth.com/

http://www.measuringworth.com/