Principle Of Economics Chapter 9 (PDF)

PRINCIPLE OF ECONOMICS NOOR SA'ADAH SABUDIN SEFB CHAPTER 9 Introduction to Macroeconomics Part II INTHISLECT URE After studying this chapter, you will be able: After studying this chapter, you will be able: Will the Malaysia’s economy expand more rapidly next year or will it sink back...

PRINCIPLE OF ECONOMICS NOOR SA'ADAH SABUDIN SEFB CHAPTER 9 Introduction to Macroeconomics Part II INTHISLECT URE After studying this chapter, you will be able: After studying this chapter, you will be able: Will the Malaysia’s economy expand more rapidly next year or will it sink back into another recession? To assess the state of the economy and to make big decisions about business expansion, firms use forecasts of GDP. What exactly is GDP? How do we use GDP to tell us how rapidly our economy is expanding or whether our economy is in a recession? How do we take the effects of inflation out of GDP to reveal the growth rate of our economic well-being? And how do we compare economic well-being across countries? DEFINITION OF NATIONAL INCOME What is National Income Accounting? National income accounting is a measurement of aggregate economic activities. We are able to know how much output is being produced and how well the economy is performing, whether the economy is growing or contracting. Gross Domestic Product (GDP) and Gross National Product (GNP) are two important measures in the national income accounting. DEFINITION OF NATIONAL INCOME National income also refers to the flow of goods and services by a nation over a period of time, usually a year. OR National Income is the total payment received by the factors of production in a country during a year. DEFINITION OF NATIONAL INCOME Gross Domestic Product (GDP) GDP is the total market value of a country’s output. It is the market value of all final goods and services produced within a given period of time by factors of production located within a country. OR The total market value of all final goods and services produced annually within a country’s borders. DEFINITION OF NATIONAL INCOME Gross National Product (GNP) GNP is the total market value of all final goods and services produced within a given period by factors of production owned by a country’s citizen, regardless of where the output is produced.  DEFINITION OF NATIONAL INCOME GDP excludes the output produced abroad by domestically owned factors of production while includes the output produced domestically by foreign owned factors of production. Thus, the formula to calculate GDP is given as below: GDP = GNP + (output produced domestically by foreign owned factors of production) - (output produced abroad by domestically owned factors of production) GNP = GDP + net factor income from abroad. GROSS DOMESTIC PRODUCT GDP Defined GDP or gross domestic product is the market value of all final goods and services produced in a country in a given time period. This definition has four parts: Market value Final goods and services Produced within a country In a given time period GROSS DOMESTIC PRODUCT Market Value GDP is a market value—goods and services are valued at their market prices. To add apples and oranges, computers and popcorn, we add the market values so we have a total value of output in RM. GROSS DOMESTIC PRODUCT Final Goods and Services Final goods and services are referred to goods and services produced for final use / Goods in the hands of their final users. Do not count intermediate goods to avoid double counting problem. Intermediate goods are goods that are inputs for the production of final goods. Double counting would overestimate the value of final output. GROSS DOMESTIC PRODUCT Final Goods and Services In calculating GDP, we can either sum up the value added at each stage of production or take the value of final sales to avoid double counting. Value added is the difference between the values of goods as they leave the stage of production and the cost of the goods as they enter that stage.  GROSS DOMESTIC PRODUCT Final Goods and Services In calculating GDP, we can sum up the value added at each stage of production or we can take the value of final sales. We do not use the value of total sales in an economy to measure how much output has been produced. TABLE 21.1 Value Added in the Production of a Gallon of Gasoline (Hypothetical Numbers) Stage of Production Value of Sales Value Added (1) Oil drilling $3.00 $3.00 (2) Refining 3.30 0.30 (3) Shipping 3.60 0.30 (4) Retail sale 4.00 0.40 Total value added $4.00 GROSS DOMESTIC PRODUCT Final Goods and Services GROSS DOMESTIC PRODUCT Final Goods and Services From Table 11.1, the final sales value is equivalent to total value added along those five processes. The value of final sales is RM1.10, which is equivalent to the total value added from the first stage (extraction from natural source) to the last stage (retail sales). Adding the values of sales for each stage of production will give a total value of sales of RM3.30 which significantly overestimates the value of a liter of mineral water. The example illustrated that GDP is not the market value of total final sales within a given period. GDP is the market value of total production. GROSS DOMESTIC PRODUCT Produced Within a Country GDP measures production within a country—domestic production. In a Given Time Period GDP measures production during a specific time period, normally a year or a quarter of a year. GROSS DOMESTIC PRODUCT The circular flow diagram shows the transactions among households (C), firms (I), governments (G), and the rest of the world (X-M). GROSS DOMESTIC PRODUCT Households (C) and Firms (I) Households sell and firms buy the services of labor, capital, and land in factor markets. For these factor services, firms pay income to households: wages for labor services, interest for the use of capital, and rent for the use of land. A fourth factor of production, entrepreneurship, receives profit. In the figure, the blue flow, Y, shows total income paid by firms to households. GROSS DOMESTIC PRODUCT GROSS DOMESTIC PRODUCT Households (C) and Firms (I) Firms sell and households buy consumer goods and services in the goods market. Consumption expenditure is the total payment for consumer goods and services, shown by the red flow labeled C. Firms buy and sell new capital equipment in the goods market and put unsold output into inventory. The purchase of new plant, equipment, and buildings and the additions to inventories are investment, shown by the red flow labeled I. GROSS DOMESTIC PRODUCT GROSS DOMESTIC PRODUCT Governments (G) Governments buy goods and services from firms and their expenditure on goods and services is called government expenditure. Government expenditure is shown as the red flow G. Governments finance their expenditure with taxes and pay financial transfers to households, such as unemployment benefits, and pay subsidies to firms. These financial transfers are not part of the circular flow of expenditure and income. GROSS DOMESTIC PRODUCT GROSS DOMESTIC PRODUCT Rest of the World (X – M) Firms in the Malaysia sell goods and services to the rest of the world—exports—and buy goods and services from the rest of the world—imports. The value of exports (X ) minus the value of imports (M) is called net exports, the red flow (X – M). If net exports are positive, the net flow of goods and services is from Malaysia’s firms to the rest of the world. If net exports are negative, the net flow of goods and services is from the rest of the world to Malaysia’s firms. GROSS DOMESTIC PRODUCT GROSS DOMESTIC PRODUCT The blue and red flows are the circular flow of expenditure and income. GROSS DOMESTIC PRODUCT The sum of the red flows equals the blue flow. GROSS DOMESTIC PRODUCT That is: Y = C + I + G + X – M GROSS DOMESTIC PRODUCT The circular flow shows two ways of measuring GDP. GDP Equals Expenditure Equals Income Total expenditure on final goods and services equals GDP. GDP = C + I + G + X – M. Aggregate income equals the total amount paid for the use of factors of production: wages, interest, rent, and profit. Firms pay out all their receipts from the sale of final goods, so income equals expenditure, Y = C + I + G + (X – M). GROSS DOMESTIC PRODUCT Why “Domestic” and Why “Gross”? Domestic Domestic product is production within a country. It contrasts with national product, which is the value of goods and services produced anywhere in the world by the residents of a nation. Gross Gross means before deducting the depreciation of capital. The opposite of gross is net, which means after deducting the depreciation of capital. GROSS DOMESTIC PRODUCT Depreciation is the decrease in the value of a firm’s capital that results from wear and tear and obsolescence. Gross investment is the total amount spent on purchases of new capital and on replacing depreciated capital. Net investment is the increase in the value of the firm’s capital. Net investment = Gross investment  Depreciation. GROSS DOMESTIC PRODUCT Gross investment is one of the expenditures included in the expenditure approach to measuring GDP. So total product is a gross measure. Gross profit, which is a firm’s profit before subtracting depreciation, is one of the incomes included in the income approach to measuring GDP. So total product is a gross measure. WHAT’S NOT INCLUDED IN GDP GDP ignores all transactions in which money or goods change hands but no new goods or services are produced. 1.Certain non-market goods and services such as chores performed at home by family members. 2.Underground activities, both legal and illegal. 3.Sales of used goods. 4.Financial transactions such as trading of stocks and bonds. 5.Government transfer payments such as social security. 6.Leisure time. WHAT’S NOT INCLUDED IN GDP GDP calculation does not include output that have been produced in the previous period and sold in the current GDP calculation period. The relationship between total production and total sales is represented by the following equation: GDP = final sales + change in business inventories MEASURING GDP AND NATIONAL INCOME There are three approaches to measure GDP:  The expenditure approach  The income approach  The production approach/value added The three approaches lead to the same value of GDP because every payment (expenditure) by a buyer is a receipt (income) for the seller at the same time. MEASURING GDP AND NATIONAL INCOME The Expenditure Approach The expenditure approach measures GDP as the sum of consumption expenditure, investment, government expenditure on goods and services, and net exports. GDP = C + I + G + (X  M)  TABLE 21.2 Components of U.S. GDP, 2012: The Expenditure Approach Billions of Dollars Percentage of GDP Personal consumption expenditures (C) 11,119.5 70.9 Durable goods 1,218.8 7.8 Nondurable goods 2,563.0 16.3 Services 7,337.7 46.8 Gross private domestic investment (l) 2,059.5 13.1 Nonresidential 1,616.6 10.3 Residential 382.4 2.4 Change in business inventories 60.6 0.4 Government consumption and gross 3,063.6 19.5 investment (G) Federal 1,214.2 7.7 State and local 1,849.4 11.8 Net exports (EX – IM) −566.7 −3.6 Exports (EX) 2,179.7 13.9 Imports (IM) 2,746.3 17.5 Gross domestic product 15,676.0 100.0 Note: Numbers may not add exactly because of rounding. MEASURING GDP AND NATIONAL INCOME The Expenditure Approach Personal consumption expenditure (C) Personal consumption expenditures (C) consist of household spending on consumer goods. Personal consumption expenditure is usually the largest part of GDP. It consists of three main categories: durable goods, non-durable goods and payment for services. Durable goods are goods that are expected to last for more than three years, such as refrigerators, ovens, or cars. MEASURING GDP AND NATIONAL INCOME The Expenditure Approach Personal consumption expenditure (C) Nondurable goods are goods that are not expected to last for more than three years, such as food. Services are intangible items such as lawn care, car repair, and entertainment. MEASURING GDP AND NATIONAL INCOME The Expenditure Approach Gross private domestic investment expenditure (I) “Investment” generally refers to the purchase of new capital. Gross private domestic investment (I) refers to the total investment spent by the private sector. It includes the purchase of new housing, plant, equipment, and inventory by the private sector. There are three components of this category, which are non- residential investment, residential investment, and changes in business inventories. MEASURING GDP AND NATIONAL INCOME The Expenditure Approach Gross private domestic investment expenditure (I) Nonresidential investment - Expenditures by firms for machines, tools, plants, and so on. Residential investment - Expenditures by households and firms on new houses and apartment buildings. Changes in business inventories - Changes in the stock of unsold goods.  MEASURING GDP AND NATIONAL INCOME The Expenditure Approach Gross private domestic investment expenditure (I) Goods could depreciate in value over time. To take depreciation into consideration, depreciation is subtracted from gross domestic investment to get net domestic investment. Net domestic investment is a measure on how much stock of capital changes during a period. Positive (negative) net domestic investment refers to the amount of new capital produced exceeds (less than) the amount that wore out. The net domestic investment equation can be expressed as below: MEASURING GDP AND NATIONAL INCOME The Expenditure Approach Gross private domestic investment expenditure (I) Net domestic investment = Gross domestic investment – Depreciation or Capital at the end of the period – Capital at the beginning of the period Notes = capitalend of period = capitalbeginning of period + net investment MEASURING GDP AND NATIONAL INCOME The Expenditure Approach Government spending (G) Government spending (G) refers to its consumption and gross investment. It included expenditures by federal, state and local government for final goods (school buildings, fighting jets, table) and services (military salaries, teacher’s salaries, experts’ consultancy fees). Besides, government could invest in private institution through its various agencies, for instance Employees Provident Fund (EPF), Ministry of Finance and so forth. All these expenses are included in the GDP calculation. MEASURING GDP AND NATIONAL INCOME The Expenditure Approach Government spending (G) Excludes: Government transfer payments to persons that are not made in return for goods and services currently supplied. MEASURING GDP AND NATIONAL INCOME The Expenditure Approach Net export (X – M) Net export (X – M) is the sum of spending by the rest of the world on domestic produced goods (exports, X) minus the sum of spending by domestic economic groups on foreign produced goods (imports, M). In short, it is the difference between exports and imports. MEASURING GDP AND NATIONAL INCOME The Expenditure Approach Net export (X – M) The reason for including the net export in the calculation of GDP is because of personal consumption, gross domestic investment and government spending include expenditures on goods produced both domestically and foreign countries. Therefore, it needs to minus expenditures on goods produced in foreign countries to prevent overestimating the domestic production (GDP). MEASURING GDP AND NATIONAL INCOME The Expenditure Approach Net export (X – M) Meanwhile, some of the domestically produced goods sold abroad (exported). Thus, the value of those exports should be added into the calculation of GDP to prevent underestimating the domestic production (GDP). MEASURING GDP AND NATIONAL INCOME Market Price (MP) Market price refers to the current price in the market through the forces of demand and supply. Market prices are the actual price paid by the consumers. Factor Cost (FC) Factor cost is the real prices that is earned by the producers or sellers. GDP (FC)= GDP (MP) – Indirect taxes + Subsidies OR GDP(FC)= GDP (MP) – Indirect taxes + Subsidies MEASURING GDP AND NATIONAL INCOME GNP at Factor Cost vs GNP at the Market Price GNP at market prices means national output is calculated using the prices in the market. GNP at factor cost means national output is calculated using prices paid by manufacturers to owners of the factors of production. The difference between the two is caused by government intervention in the form of indirect taxes and subsidies. MEASURING GDP AND NATIONAL INCOME GNP at Cost Factor vs GNP at the Market Price Indirect taxes included in the market price of an item but not included in the factor cost of an item. Thus the national income at market prices have a greater value than national income at factor cost. Subsidies are included in the factor cost of an item but not included in the market price of an item. Thus national income at market prices have a smaller value of the national income at factor cost. MEASURING GDP AND NATIONAL INCOME GNP at Cost Factor vs GNP at the Market Price Therefore: GNP MP = GNP FC + indirect taxes - subsidies GNP FC = GNP MP - indirect taxes + subsidies MEASURING GDP AND NATIONAL INCOME Net National Product (NNP) NNP is GNP minus the value of capital consumption or depreciation during the year. NNP is also referred as National Income at market prices. National Income (NI) National income at factor cost (NI) is defined as the total of all income payments made to factor of production. NI = GNPFC–Depreciation value OR NI = NNPMP + Subsidies–Indirect Taxes MEASURING GDP AND NATIONAL INCOME GNP Vs Net National Product (NNP) Gross national product is the total market value of all goods and services produced by a country’s citizens in a year which is calculated at market / current prices. Prices of goods sold include depreciation of capital goods. Depreciation will be deducted from gross national product to get the net national product. MEASURING GDP AND NATIONAL INCOME The Expenditure Approach 1. GDPMP = C + I + G + X – M + changes in inventories 2. GDPFC = GDPMP– indirect taxes + subsidies 3. GNPFC = GDPFC + Net factor payment from the rest of the world 4. NI = GNPFC - depreciation MEASURING GDP AND NATIONAL INCOME RM millions 1 Personal consumption expenditure/C (+) 2,500 2 Government spending/G (+) 350 3 Gross private domestic investment /I (+) 350 4 Changes in inventories (+) 100 5 Export (+) 600 6 Import (-) 500 GDP AT MARKET PRICE 3,400 7 Indirect taxes (-) 300 8 Subsidies (+) 150 GDP AT FACTOR COST 3,250 9 Factor payment from the rest of the world(+) 800 Factor payment to the rest of the world(-) 700 Net factor payment from the rest of the world=100 GNP AT FACTOR COST 3,350 4 Depreciation (-) 50 NI 3,300 MEASURING GDP AND NATIONAL INCOME The Income Approach GDP is the summation of total income, which includes wages, rents, interest and profits received by all production factors in producing final goods or services during a given period. Based on this approach, GDP is divided into five components: national income, depreciation, indirect taxes minus subsidies, net factor payment to the rest of the world and “others”. The equation for calculating GDP can be expressed as follows: GDP = National income + Depreciation + (Indirect taxes – subsidies) + Net factor payments to the rest of the world + others MEASURING GDP AND NATIONAL INCOME The Income Approach Components of GDP: Income Approach “National income” refers to the total income earned by factors of production owned by a country’s citizens. This component is the sum of five items. 1.“Compensation of employees”. This is the largest component of the total income. Compensation of employees includes wages, salaries (excluding the self-employed), social insurance, private pension and welfare funds paid to households by firms and the government. MEASURING GDP AND NATIONAL INCOME The Income Approach Components of GDP: Income Approach 2.“Proprietors’ income” which is the income of unincorporated businesses (e.g. sole proprietorships or partnership). Proprietors’ income includes all forms of income earned by self-employed individuals and the owners of unincorporated businesses, including unincorporated farmers. MEASURING GDP AND NATIONAL INCOME The Income Approach Components of GDP: Income Approach 3.“Corporate profits”. The income earned by incorporated businesses. Corporate profits include all the income earned by the stockholders of corporations. 4.“Net interest”. The interest earned by individuals from businesses and foreign sources minus interest paid by individuals. MEASURING GDP AND NATIONAL INCOME The Income Approach Components of GDP: Income Approach 5.“Rental income” is the income received by individuals for the use of their non-monetary assets (land, houses, offices). It also includes returns to individuals who hold copyrights and patents. Finally, it includes an imputed value to owner-occupied houses. MEASURING GDP AND NATIONAL INCOME From National Income to GDP: The Income Approach GDP = National income(five components) - Income earned from the rest of the world + Income earned by the rest of the world + Indirect business taxes + Capital consumption allowance (depreciation) + Statistical discrepancy MEASURING GDP AND NATIONAL INCOME From National Income to GDP: The Income Approach MEASURING GDP AND NATIONAL INCOME The Income Approach The sum of all factor incomes is net domestic income at factor cost. Two adjustments must be made to get GDP: 1. Indirect taxes less subsidies are added to get from factor cost to market prices. 2. Depreciation is added to get from net domestic income to gross domestic income. Table 21.2 on the next slide shows the income approach with data for 2012 in US. MEASURING GDP AND NATIONAL INCOME The Income Approach NDP measures the total value of new goods available in the economy in a given year after worn-out capital goods have been replaced. Net domestic product (NDP) = GDP – Capital consumption allowance/depreciation* *The estimated amount of capital goods used up in production through natural wear, obsolescence, and accidental destruction. MEASURING GDP AND NATIONAL INCOME The Production / Value Added Approach Calculate GDP by measuring the output of each sector in a country. The main advantage of this approach is that it enables the comparison of the performance among the sectors. GDP equals to sum of the value added created by the various sectors in the economy or the value of final goods. Sectors of the economy are usually divided into three main sectors, namely agriculture and mining sectors, the service sector and the manufacturing sector @ industry. But in the calculation of national income, the sector is detailed into many sub sectors MEASURING GDP AND NATIONAL INCOME The Production / Value Added Approach MEASURING GDP AND NATIONAL INCOME The Production / Value Added Approach GDP BY SECTORS 123,722 Minus: Estimated bank service charges - 8,503 Plus: import tax/duties 5,090 GDP AT MARKET PRICE 120,309 11 Indirect Taxes(-) - 1,000 12 Subsidies (+) +1,000 GDP AT FACTOR COST 120,309 13 Net factor payment from abroad(+) - 6,714 THE CONCEPT OF NATIONAL INCOME Personal Income (PI) Personal income is the income that is actually received by individuals and households in a nation during a year. Disposable Personal Income (DPI) DPI is the part of the personal income that is left after the payment of personal direct taxes. DPI = PI – Personal income tax THE CONCEPT OF NATIONAL INCOME Personal Income (PI) Personal income = National income – Undistributed corporate profits – Social insurance taxes/EPF – Corporate profits taxes + Transfer payments Disposable Income (DPI) Personal income – Personal income taxes THE CONCEPT OF NATIONAL INCOME Personal Income (PI) Personal income is different from net national product as part of the NNP is not received by the individual, for example EPF deductions, insurance, income tax and company profit tax. Therefore, it should be excluded from the NNP to get the personal income. Transfer payments such as scholarships, pensions and welfare assistance are not included in the calculation of national income as they do not engage in economic activity, but it is income received by individuals. Therefore, it must be added to get the value of personal income. THE CONCEPT OF NATIONAL INCOME Personal Saving (PS) The amount of disposable income that is left after total personal spending in a given period. Personal Saving Rate The percentage of disposable personal income that is saved. If the personal saving rate is low, households are spending a large amount relative to their incomes; if it is high, households are spending cautiously. THE CONCEPT OF NATIONAL INCOME TABLE 21.5 National Income, Personal Income, Disposable Personal Income, and Personal Saving, 2012 Dollars (Billions) National income 13,833.2 Less: Amount of national income not going to households −43 0.8 Equals: Personal income 13,402.4 Less: Personal income taxes −1,471.9 Equals: Disposable personal income 11,930.6 Less: Personal consumption expenditures −11,119.5 Personal interest payments −172.3 Transfer payments made by households −168.1 Equals: Personal saving 470.8 Personal saving as a percentage of disposable personal income: 3.9% NOMINAL GDP VS REAL GDP 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 which adjusted for price changes is called real GDP Nominal GDP is the value of goods and services produced during a given year valued at their current prices. Nominal GDP is just a more precise name for GDP. THE CONCEPT OF NATIONAL INCOME Calculating Real GDP THE CONCEPT OF NATIONAL INCOME Calculating Real GDP TABLE 21.6 A Three-Good Economy (1) (2) (3) (4) (5) (6) (7) (8) GDP in GDP in GDP in GDP in Year 1 in Year 2 in Year 1 in Year 2 in Production Price per Unit Year 1 Year 1 Year 2 Year 2 Year Year 2 Year 1 Year 2 Prices Prices Prices Prices 1 Q1 Q2 P1 P2 P1 × Q1 P1 × Q2 P2 × Q1 P2 × Q2 Good A 6 11 $0.50 $0.40 $3.00 $5.50 $2.40 $4.40 Good B 7 4 0.30 1.00 2.10 1.20 7.00 4.00 Good C 10 12 0.70 0.90 7.00 8.40 9.00 10.80 Total $12.10 $15.10 $18.40 $19.20 Nominal Nominal GDP in GDP in year 1 year 2 THE CONCEPT OF NATIONAL INCOME Calculating Economic Growth from Real GDP THE LIMITATION OF NATIONAL INCOME ACCOUNTING Goods and services that are not marketed. If many people use their own products such as crops and livestock, national income will be undervalued. This is because if the crops and livestock is marketed or sold, it will contribute to the national income. Productive activities that are not recorded whether that activity is legal or illegal, such as the underground economy. The continues growing underground economic activities such as the black market, prostitution, unlicensed gambling, drug dealing and so on lead to undervalued in national income. This is because the activity is productive activity and generate so much money. THE LIMITATION OF NATIONAL INCOME ACCOUNTING Sale of used goods. If the sale of used goods such as cars and clothing included in the calculation national income, the national income would be overvalued. This is because it has been calculated during the year they are produced. Activities that are not paid in money. Bonuses in the form of a holiday trip and so on are not included in the calculation national income. This causes national income probably undervalued. THE LIMITATION OF NATIONAL INCOME ACCOUNTING The problem of double counting. The problem of government spending in the form of transfer payments (unproductive) The problem of determining depreciation. Too difficult to determine the depreciation of an item, this causes the national income would be overvalued or undervalued. The problem of information gathering. If economic activities are not reported, national income is likely to be undervalued. National income is not an appropriate measurement of social welfare the country.