Economics: Income & Expenditure

Economics

• Microeconomics studies how households and firms make decisions and interact in markets
• Macroeconomics studies economy-wide phenomena, including inflation, unemployment, and economic growth

The Economy's Income & Expenditure

• Gross Domestic Product (GDP) measures the total income of everyone in the economy
• GDP measures the total expenditure on the economy’s output of goods and services
• For an economy as a whole, income must equal expenditure

Circular-Flow Diagram Assumptions

• Markets exist for goods/services and factors of production
• Households spend all income and buy all goods/services
• Households own the factors of production, selling or renting them to firms for income
• Firms buy/hire factors of production to produce goods/services
• Firms pay wages, rent, and profit to resource owners

What The Circular-Flow Diagram Omits

• The government collects taxes and buys goods/services
• The financial system matches savers' supply of funds with borrowers' demand for loans
• The foreign sector trades goods/services, financial assets, and currencies with the country's residents

Gross Domestic Product (GDP)

• Is the market value of all final goods and services
• GDP is produced within a country during a specific period
• Market prices reflect the value of goods incorporated in GDP
• Final goods are intended for the end user, while intermediate goods are components in the production of other goods
• The value of intermediate goods is already included in the prices of final goods
• GDP includes tangible goods and intangible services currently produced
• GDP includes solely goods/services produced domestically, regardless of the producer's nationality
• GDP measures the goods/services in a year or quarter

Components of GDP

• The GDP identity is Y = C + I + G + NX
  • Y = GDP
  • C = Consumption
  • I = Investment
  • G = Government Purchases
  • NX = Net Exports
• Consumption (C) is household spending on goods/services, including durable, non-durable goods, and intangible services like education
• The exception to this is purchases of new housing

Consumption and Housing

• Renters' consumption includes rent payments
• Homeowners' consumption includes the imputed rental value, but not the purchase price or mortgage payments

Investment (I)

• Investment constitutes purchases of capital goods used to produce other goods/services in the future
  • Categories include business capital (structures, equipment, intellectual property), residential capital (landlord's buildings, personal residences)
  • Plus inventory accumulation (goods produced but not yet sold)

Government Purchases (G)

• Government purchases includes government consumption expenditure and gross investment
• This measures spending on goods/services by local, state, and federal entities
• Transfer payments (e.g., social security, unemployment) are not included

Net Exports (NX)

• Net Exports = Exports - Imports
• Exports include Spending on domestically produced goods by foreigners
• Imports are the portion of C, I, and G spent on foreign goods by domestic residents

Real vs. Nominal GDP

• Total spending rises due to larger output and/or higher prices
• Nominal GDP
  • Production of goods/services valued at current prices
• Real GDP
  • Production of goods/services valued at constant prices
  • Designates one year as a base year

GDP Deflator

• Real GDP is unaffected by price changes and nominal = real
• The GDP deflator calculates as:
  • 100 * (Nominal GDP / Real GDP)
• The deflator equals 100 in the base year
• Measures the current level of prices relative to the base year
• It takes inflation out of nominal GDP

Inflation

• The economy's overall price level is rising
• Inflation Rate formula:
  • ((GDP Deflator in Year 2 - GDP Deflator in Year 1) / GDP Deflator in Year 1) * 100

GDP Data

• Real GDP has grown over time
  • In the US average growth is 3% per year since 1965
• Growth is not steady and is interrupted by recessions
• Recession entails two consecutive quarters of falling GDP
  • Entails lower incomes and rising unemployment
  • Plus falling profits and increased bankruptcies

GDP and Well-Being

• The single best measure of a society's economic well-being
• Real GDP per capita indicates a person's standard of living
• Larger GDP indicates a good life, better healthcare, and better educational systems
• GDP measures the obtaining of inputs into a worthwhile life

GDP Limitations

• GDP does not include leisure, the value of activities outside the market, or environmental quality
• Nothing is noted about the distribution of income in GDP

Consumer Price Index (CPI)

• The CPI Measures the overall level of prices and the overall cost of goods/services bought by customers
• It is computed every month by the Bureau of Labor Statistics

Calculating CPI

• Fix the basket, finding most important prices to consumers
• Find prices at each point in time
• Compute the basket’s cost, using the same basket to isolate price changes
• Choose a base year and compute the CPI
  • (Price of basket of goods/services in current year / Price of basket in base year) * 100
• Compute the inflation rate
  • (CPI in year 2 - CPI in year 1) / CPI in year 1 * 100

The Consumer Price Index

• Inflation Rate is the percentage change in the price index from the preceding period
• Core CPI measures the overall cost of goods excluding food and energy
• Producer Price Index (PPI) measures the cost of goods bought by firms and predicts changes in CPI

Problems Measuring Cost of Living

• Substitution Bias
  • Prices do not change proportionately
  • Consumer substitution toward goods that have become relatively less expensive
• Introduction of New Goods
  • More variety of goods
  • Money becomes more valuable
• Unmeasured Quality Change
  • Changes in quality

GDP Deflator vs. CPI

• GDP Deflator
  • The ratio of Nominal GDP to Real GDP
  • Reflects prices of all goods/services produced domestically
  • Compares the price of currently produced items to the price of the same goods/services in the base year
• CPI
  • Reflects prices of goods/services bought by consumers
  • Compares the price of a fixed basket of goods/services to the price of that basket in the base year

Correcting Economic Variables

• The dollar figures from different times must be corrected to account for inflation

Indexation

• Measures the price level and determines the amount of inflation correction
• Indexation is automatic correction by law or contract to adjust effects of inflation
• This entails Cost of Living Allowance (COLA)

Real and Nominal Interest Rates

• Nominal interest rate is the reported rate without correction for inflation
• The real interest rate is corrected for the effects of inflation and is = nominal interest rate - inflation rate

Economic Growth and Productivity

• Real GDP per person measures the living standard and varies across countries
• Growth rate indicates how rapidly real GDP per person grew during a typical year
• Productivity indicates the quantity of goods/services produced from each unit of labor input
• Productivity is important because it is a key determinant of living standards, reflecting an economy's output

Production Function

• Y = A x F(L, K, H, N)
• The graph/equation relates outputs to inputs
• The F() determines inputs
• "A" measures level of technology, so improvements in technology increase the potential output

Constant Returns to Scale

• Changes all inputs by same percentage, causing output to change by a constant percentage
• Doubling all inputs doubles output, i.e. 2Y = A x F(2L, 2K, 2H, 2N)

Productivity Determinants

• Physical Capital
  • The stock of equipment and structures used to produce goods and services
  • An increase in physical capital per worker (K/L) causes an increase in output per worker (Y/L)
• Human Capital
  • Knowledge and skills workers acquire through education, training, and experience
  • An increase in human capital per worker (H/L) causes an increase in output per worker (Y/L)
• Natural Resources
  • Inputs into the production of goods/services that are provided by nature
  • An increase in natural resources per worker (N/L) leads to increased output per worker (Y/L)
• Technological Knowledge
  • Society's understanding of the best ways to produce goods and services
  • Technological knowledge is common knowledge everyone becomes aware of it

The Production Function and Inputs

• Productivity (Y/L, or output per worker) depends on the level of technology (A)
• It also relates to physical capital per worker (K/L), human capital worker (H/L), natural resources per worker (N/L),

Saving & Investment

• Raising future productivity requires investment or trade-offs
• Invest more current capital and devote fewer resources to consume

Diminishing Returns

• Higher savings means fewer resources used to make consumption goods and more resources used to make capital goods
• In the long run, a higher savings rate means higher level of productivity & incomes and no higher growth
• The benefit from an extra unit of input declines as the quantity of the input increases

Catch Up Effect

• Catch up entails countries starting off poor tend to grow more rapidly than countries that start off rich
• Poor countries have low productivity
• Rich countries increase workers' productivity substantially with even small amounts of investment

Investment From Abroad

• Way for a country to invest in new capital, raising future productivity
• Foreign Direct Investment (FDI) is capital investment owned/operated by a foreign entity
• Foreign Portfolio Investment (FPI) is investment financed by foreign money operated by domestic residents

World Bank

• The world bank encourages capital flows to poor countries and uses funds from advanced countries
• It makes loans to less developed countries to improve infrastructure
• Plus advice about how funds might best be used

World Bank & IMF

• World Bank and the International Monetary Fund (IMF) promote global economic prosperity
• They were set up after World War II because economic distress leads to political turmoil and military conflict

Education

• Human Capital
• The gap between wages of educated versus uneducated workers reflects the opportunity cost of wages forgone
• Education entails positive externalities
• Public education involves large subsidies
• Brain drain challenges poorer countries

Health

• Investments in health and education raise the standard of living
• Better nutrition from more expenditures leads to taller workers and wages

Property Rights and Stable Politics

• Property rights allow people to exercise authority over resources
• Courts enforce property rights and promote political stability
• To foster economic growth, protect property rights

The Trouble with Lack of Property Rights

1. Contracts are hard to enforce and fraud goes unpunished
2. Corruption discourages investment

Free Trade

• There are inward and outward oriented policies on trade
• Inward
  • Inward policies avoid interaction with the rest of the world using tariffs
  • These have adverse effects on economic growth
• Outward
  • Outward policies integrate into the world by allowing international trade and economic growth
• Levels of trade are determined by government policy and geography
  • Natural seaports ease trade

Research and Development

• Entails tax breaks and a patent system
• Government promotes research methods, aerospace research, research grants, and population growth

Population Growth

• A larger population can lead to more workers & consumers and may stretch resources
• There are theories correlating workforce vs poverty

Financial System

• Channels savings to investors

Financial Institutions Functions

• The financial system matches savings with investments
• The system moves scarce resources to borrowers
• It contains financial market and intermediaries

Bonds

• Savers provide funds to borrowers with bonds
• Bonds involve a certificate of debt (IOUS) with maturity dates, interest rates, and the amount borrowed
• Bonds differ in terms of bond length, credit risk, and tax treatment

Equity Finance

• Stock reflects ownership and future profits
• Greater risk, carries potentially higher rewards
• Stock Exchanges organize trades and equity
• Demand influences prices of stock on stock exchanges