Econ Ch21 Lecture Presentation PDF

2 MEASURING THE VALUE OF PRODUCTION: GDP After studying this chapter, you will be able to:  Define GDP and explain why GDP equals aggregate expenditure and aggregate income  Explain how the Bureau of Economic Analysis measures U.S. GDP  Explain the uses and limitations...

2 MEASURING THE VALUE OF PRODUCTION: GDP After studying this chapter, you will be able to:  Define GDP and explain why GDP equals aggregate expenditure and aggregate income  Explain how the Bureau of Economic Analysis measures U.S. GDP  Explain the uses and limitations of GDP as a measure of economic well-being Copyright © 2023 Pearson Education, Ltd.  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 Copyright © 2023 Pearson Education, Ltd.  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 dollars. Copyright © 2023 Pearson Education, Ltd.  Gross Domestic Product Final Goods and Services GDP is the value of the final goods and services produced. A final good (or service) is an item bought by its final user during a specified time period. A final good 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. Excluding the value of intermediate goods and services avoids counting the same value more than once. Copyright © 2023 Pearson Education, Ltd.  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. Copyright © 2023 Pearson Education, Ltd.  Gross Domestic Product GDP and the Circular Flow of Expenditure and Income GDP measures the value of production, which also equals total expenditure on final goods and total income. The equality of income and value of production shows the link between productivity and living standards. The circular flow diagram in Figure 21.1 illustrates the equality of income and expenditure. Copyright © 2023 Pearson Education, Ltd.  Gross Domestic Product The circular flow diagram shows the transactions among households, firms, governments, and the rest of the world. Copyright © 2023 Pearson Education, Ltd.  Gross Domestic Product Households and Firms Households sell and firms buy the services of labor, capital, and land in factor markets. Firms pay 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. Copyright © 2023 Pearson Education, Ltd.  Gross Domestic Product The blue flow, Y, from firms to households through factor markets shows total income paid by firms to households. Copyright © 2023 Pearson Education, Ltd.  Gross Domestic Product Firms sell and households buy consumer goods and services in the goods market. Consumption expenditure is the total payment for consumer goods and services. Firms buy and sell new capital equipment in the goods market and put unsold output into inventory. These purchases od new capital equipment and the additions to inventories are investment. Copyright © 2023 Pearson Education, Ltd.  Gross Domestic Product Consumption expenditure is the red flow C from households to firms through goods markets. Investment is the red flow I from firms to firms through goods markets. Copyright © 2023 Pearson Education, Ltd.  Gross Domestic Product Governments Governments buy goods and services from firms and their expenditure on goods and services is called government expenditure. 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. Copyright © 2023 Pearson Education, Ltd.  Gross Domestic Product Government expenditure is the red flow G from governments to firms through goods markets. Copyright © 2023 Pearson Education, Ltd.  Gross Domestic Product Rest of the World Firms in the United States 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 U.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 U.S. firms. Copyright © 2023 Pearson Education, Ltd.  Gross Domestic Product Net exports is the red flow (X – M) from the rest of the world to U.S. firms through goods markets. Copyright © 2023 Pearson Education, Ltd.  Gross Domestic Product The blue and red flows are the circular flow of expenditure and income. Copyright © 2023 Pearson Education, Ltd.  Gross Domestic Product The sum of the red flows equals the blue flow. Copyright © 2023 Pearson Education, Ltd.  Gross Domestic Product That is: Y = C + I + G + (X – M) Copyright © 2023 Pearson Education, Ltd.  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). Copyright © 2023 Pearson Education, Ltd.  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. Copyright © 2023 Pearson Education, Ltd.  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. Copyright © 2023 Pearson Education, Ltd.  Gross Domestic Product Gross investment is one of the expenditures included in the expenditure approach to measuring GDP. So total product measured by the expenditure approach 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 measured by the income approach is a gross measure. Copyright © 2023 Pearson Education, Ltd.  Measuring U.S. GDP The Bureau of Economic Analysis uses two approaches to measure GDP: The expenditure approach The income approach Copyright © 2023 Pearson Education, Ltd.  Measuring U.S. GDP 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) Figure 21.2 illustrates the expenditure approach. Copyright © 2023 Pearson Education, Ltd.  Measuring U.S. GDP The expenditure approach measures GDP as the sum of the red flows. GDP = C + I + G + (X  M) Table 21.1 on the next slide shows the expenditure approach with 2020 data. Copyright © 2023 Pearson Education, Ltd. Copyright © 2023 Pearson Education, Ltd.  Measuring U.S. GDP The Income Approach The income approach measures GDP by summing the incomes that firms pay households for the factors of production they hire—wages for labor, interest for capital, rent for land, and profit for entrepreneurship. Figure 21.3 illustrates the income approach. Copyright © 2023 Pearson Education, Ltd.  Measuring U.S. GDP The payment for labor services is the sum of net wages plus benefits and is shown by the blue flow W. Other factor incomes include interest, rent, and profit and some labor income from self- employment. They are included in the blue flow OFI. Copyright © 2023 Pearson Education, Ltd.  Measuring U.S. GDP The National Income and Expenditure Accounts divide incomes into two broad categories: Compensation of employees is the payments for labor services. It is the sum of net wages plus taxes withheld plus Social Security and pension fund contributions. Net interest, rental income, corporate profits, and proprietors' income earned by capital and land. Copyright © 2023 Pearson Education, Ltd.  Measuring U.S. GDP The sum of all factor incomes is net domestic income at factor cost. The expenditure on final goods is valued at market prices. Two adjustments must be made to the net domestic income 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 2020. Copyright © 2023 Pearson Education, Ltd. Copyright © 2023 Pearson Education, Ltd.  Measuring U.S. GDP Nominal GDP and 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. Currently, the reference base year is 2012 and we describe real GDP as measured in 2012 dollars. Nominal GDP is the value of goods and services produced during a given year valued at the prices that prevailed in that same year. Nominal GDP is just a more precise name for GDP. Copyright © 2023 Pearson Education, Ltd.  Measuring U.S. GDP Calculating Real GDP Table 21.3(a) shows the quantities produced and the prices in 2012 (the base year). Nominal GDP in 2012 is $100 million. Because 2012 is the base year, real GDP equals nominal GDP and is $100 million. Copyright © 2023 Pearson Education, Ltd.  Measuring U.S. GDP Table 21.3(b) shows the quantities produced and the prices in 2021. Nominal GDP in 2021 is $300 million. Nominal GDP in 2021 is three times its value in 2012. Copyright © 2023 Pearson Education, Ltd.  Measuring U.S. GDP In Table 21.3(c), we calculate real GDP in 2021. The quantities are those of 2021, as in part (b). The prices are those in the base year (2012), as in part (a). The sum of these expenditures is real GDP in 2021, which equals $160 million. Copyright © 2023 Pearson Education, Ltd.  The Uses and Limitations of Real GDP Economists use estimates of real GDP for two main purposes: To compare the standard of living over time To compare the standard of living across countries Copyright © 2023 Pearson Education, Ltd.  The Uses and Limitations of Real GDP The Standard of Living Over Time Real GDP per person is real GDP divided by the population. Real GDP per person tells us the value of goods and services that the average person can enjoy. By using real GDP, we remove any influence that rising prices and a rising cost of living might have had on our comparison. Copyright © 2023 Pearson Education, Ltd.  The Uses and Limitations of Real GDP Long-Term Trend A handy way of comparing real GDP per person over time is to express it as a ratio of some reference year. For example, in 1960, real GDP per person was $18,047 and in 2020, it was $55,822. So real GDP per person in 2020 was 3.1 times its 1960 level—that is, $55,822 ÷ $18,047 = 3.1. Copyright © 2023 Pearson Education, Ltd.  The Uses and Limitations of Real GDP Two features of our expanding living standard are The growth of potential GDP per person Fluctuations of real GDP around potential GDP Potential GDP is the maximum value of real GDP that can be produced while avoiding shortages of labor, capital, land, and entrepreneurial ability that would bring rising inflation. Copyright © 2023 Pearson Education, Ltd.  The Uses and Limitations of Real GDP Figure 21.4 shows U.S. potential GDP per person. Potential GDP per person grows at a steady pace because the quantities of the factors of production and their productivity grow at a steady pace. U.S. real GDP per person fluctuates around potential GDP per person. Copyright © 2023 Pearson Education, Ltd.  The Uses and Limitations of Real GDP Potential GDP per person growth rate is not constant. It slowed from 2.8 percent per year in the 1960s to 2.3 percent per year in the 1970s. Real GDP per person: Doubled between 1960 and 1988. Tripled between 1960 and 2020. Copyright © 2023 Pearson Education, Ltd.  The Uses and Limitations of Real GDP Productivity Growth Slowdown The growth rate of real GDP per person slowed after 1970. How costly was that slowdown? The answer is provided by a number that we’ll call the Lucas wedge. The Lucas wedge is the dollar value of the accumulated gap between what real GDP per person would have been if the 1960s growth rate had persisted and what real GDP per person turned out to be. Copyright © 2023 Pearson Education, Ltd.  The Uses and Limitations of Real GDP Figure 21.5 illustrates the Lucas wedge. The red line is actual real GDP per person. The black line is the trend that real GDP per person would have followed if the 1960s growth rate of potential GDP had persisted. The shaded area is the Lucas wedge. Copyright © 2023 Pearson Education, Ltd.  The Uses and Limitations of Real GDP Real GDP Fluctuations—The Business Cycle A business cycle is a periodic but irregular up-and-down movement of total production and other measures of economic activity. Every cycle has two phases: 1. Expansion 2. Recession and two turning points: 1. Peak 2. Trough Copyright © 2023 Pearson Education, Ltd.  The Uses and Limitations of Real GDP Figure 21.6 illustrates the business cycle. A recession is a period during which real GDP decreases—its growth rate is negative for at least two successive quarters. An expansion is a period during which real GDP increases—from a trough to a peak. Copyright © 2023 Pearson Education, Ltd.  The Uses and Limitations of Real GDP The Standard of Living Across Countries Two problems arise in using real GDP to compare living standards across countries: 1. The real GDP of one country must be converted into the same currency units as the real GDP of the other country. 2. The goods and services in both countries must be valued at the same prices. Copyright © 2023 Pearson Education, Ltd.  The Uses and Limitations of Real GDP Using the exchange rate to compare GDP in one country with GDP in another country is problematic because … prices of particular products in one country may be higher or lower more than in the other country. For example, using the market exchange rate to value China’s GDP in U.S. dollars leads to an estimate that in 2020, GDP per person in the United States was 6.1 times GDP per person in China. Figure 21.7 shows China’s real GDP per person and illustrates the problem. Copyright © 2023 Pearson Education, Ltd.  The Uses and Limitations of Real GDP Using the market exchange rate and domestic prices, the green line shows China’s growth rate. But using purchasing power parity prices, the red line shows China’s growth rate was much faster. Using PPP prices, U.S real GDP per person in 2020 is only 4 times China’s Copyright © 2023 Pearson Education, Ltd.  The Uses and Limitations of Real GDP Limitations of Real GDP Real GDP measures the value of goods and services that are bought in markets. Some of the factors that influence the standard of living and that are not part of GDP are Household production Underground economic activity Leisure time Environmental quality Copyright © 2023 Pearson Education, Ltd.  The Uses and Limitations of Real GDP The Bottom Line Do we get the wrong message about the level and growth of economic well-being and the standard of living by looking at the growth of real GDP? The influences that are omitted from real GDP are probably large. It is possible to construct broader measures that combine the many influences that contribute to human happiness. Despite all the alternatives, real GDP per person remains the most widely used indicator of economic well-being. Copyright © 2023 Pearson Education, Ltd.  Mathematical Note: Chained-Dollar Real GDP The BLS uses a measure of real GDP called chained-dollar real GDP. Three steps are needed to calculate this measure: Value production in the prices of adjacent years Find the average of two percentage changes Link (chain) back to the reference year Copyright © 2023 Pearson Education, Ltd.  Mathematical Note: Chained-Dollar Real GDP Value Production in Prices of Adjacent Years Part (a) shows the quantities and prices in 2020. Part (b) shows the quantities and prices in 2021. Part (c) the quantities of 2021 valued at 2020 prices. Part (d) the quantities of 2020 valued at prices of 2021. Copyright © 2023 Pearson Education, Ltd.  Mathematical Note: Chained-Dollar Real GDP Parts (a) and (c) value the quantities of both years at 2020 prices. That is, in 2020 prices, real GDP increased from $168 million to $172 million. Copyright © 2023 Pearson Education, Ltd.  Mathematical Note: Chained-Dollar Real GDP Parts (d) and (b) value the quantities in both years at 2021 prices. That is, in 2021 prices, real GDP increased from $295 million to $300 million. Copyright © 2023 Pearson Education, Ltd.  Mathematical Note: Chained-Dollar Real GDP Find the Average of Two Percentage Changes Part (a) shows that at 2020 prices, production increased by 2.4%. Part (b) shows that at 2021 prices, production increased by 1.7%. The average increase in production is 2.0%. Copyright © 2023 Pearson Education, Ltd.  Mathematical Note: Chained-Dollar Real GDP Link (Chain) to the Base Year To find real GDP in 2021 in base-year prices (2012), we need to know 1. Real GDP in 2012 2. Average growth rate each year from 2012 to 2021. The BEA must calculate the percentage change of the growth rate in real GDP for each pair of years from the base year to the most recent year. To find real GDP for years before the base year, the BEA must calculate the growth rates for each pair of years back to the earliest one available. Copyright © 2023 Pearson Education, Ltd.  Mathematical Note: Chained-Dollar Real GDP Finally, using the average growth rates that it has calculated, the BEA finds the real GDP in each year in 2012 prices by linking them to the real GDP in 2012. The figure shows an example. Copyright © 2023 Pearson Education, Ltd. Graphs in Macroeconomics After studying this chapter, you will be able to:  Make and interpret a times-series graph  Make and interpret a graph that uses a ratio scale Copyright © 2023 Pearson Education, Ltd.  The Time-Series Graph Making a Time-Series Graph A time-series graph measures  Time on the x-axis  The variable in which we are interested on the y-axis. Copyright © 2023 Pearson Education, Ltd.  The Time-Series Graph Reading a Time-Series Graph A time-series graph shows the  Level of the variable  Change in the variable  Speed of change in the variable Copyright © 2023 Pearson Education, Ltd.  The Time-Series Graph Ratio Scale Reveals Trend A time-series graph also reveals whether a variable has a  Cycle—a tendency for a variable to alternate between upward and downward movements  Trend—a tendency for a variable to move in one general direction Copyright © 2023 Pearson Education, Ltd.  The Time-Series Graph A Time-Series with a Trend Figure A21.2(a) shows the average prices paid by consumers from1975 to 2020. In 1975, the price is set at 100. The price in other years is measured as a percentage of the 1975 level. Prices look as if they rose at a fairly constant rate. Copyright © 2023 Pearson Education, Ltd.  The Time-Series Graph Using a Ratio Scale On the y-axis of a normal graph, the gap between 100 and 200 is the same as that between 300 and 400. On a graph with a ratio scale, the gap between 100 and 200 is same as that between 200 and 400. The ratio of 200 to 100 equals the ratio of 400 to 200—a constant ratio gap. Copyright © 2023 Pearson Education, Ltd.  The Time-Series Graph Graphing data on a ratio scale reveals the trend. The steeper the line, the faster is the rate at which prices are rising. Prices rose rapidly in the 1970s and early 1980s and more slowly in the late 1980s, 1990s, and 2000s. Copyright © 2023 Pearson Education, Ltd.