Measuring the Economy's Performance (CH 07) PDF

Chapter 7 Economics Today Measuring the A Canadian Perspective: Economy’s Macroeconomics Performance  Learning Objectives 7.1 Describe economic activity and the circular flow of income and output. 7.2 Explain the measurement of gross domestic produc...

Chapter 7 Economics Today Measuring the A Canadian Perspective: Economy’s Macroeconomics Performance  Learning Objectives 7.1 Describe economic activity and the circular flow of income and output. 7.2 Explain the measurement of gross domestic product (GDP). Why do we care about GDP and what is it used for? 7.3 Explain the two methods of computing GDP: the expenditure and income approaches. 7-2  Learning Objectives 7.4 Explain how various subcomponents of GDP are calculated. 7.5 Understand the limitations of GDP. 7-3 The Importance of Macroeconomics Macroeconomics is the study of “big picture” economic issues. Governments look backwards to measure the past, and look forward through models The macroeconomy affects personal and professional lives – it is closely tied to the stock market and how the market varies/fluctuates over time. 5-4  The Importance of Macroeconomics Macroeconomics has many questions that are only partially answered – many aspects of economic growth can be understood from multiple perspectives. For example – why are some countries rich and others are poor? Why is it that some countries have barely progressed in 100+ years? Why are northern countries richer than southern ones (generalization). 5-5  Measuring GDP National Income Accounting  A measurement system used to estimate national income and its components.  Income vs Expenditure Approach. Gross Domestic Product (GDP)  The total market value of all final goods and services produced in the economy during the year 5-6  The Circular Flow of Income and Output Businesses Households 5-7  The Circular Flow of Income and Output Businesses Households 5-8  The Circular Flow of Income and Output Businesses Households 5-9  The Simple Circular Flow Product Markets  Transactions in which households buy goods. Businesses Households 5-10  The Simple Circular Flow Final Goods and Services  Goods and services that are at their final Businesses Households stage of production and will not be transformed into yet other goods or services. 5-11  The Simple Circular Flow Total Income  The yearly amount earned by the country’s factors of Businesses Households production. 5-12  The Simple Circular Flow Factor Markets  Transactions in which business buy resources. Businesses Households 5-13  The Circular Flow of Income and Output Businesses Households 5-14  The Circular Flow of Income and Output Businesses Households 5-15  The Simple Circular Flow Result  Total income earned must be identical to the dollar value of Businesses Households total output! 5-16  Measuring GDP Why Measure GDP? Provides a useful measure of economic performance. Groups that use this information: - Central banks to know when to apply their policy levers (implement changes to interest rates) - Businesses to know the health of the economy – as part of demand planning - Governments to know when to make changes to fiscal policies. - Investors want to have some ability to forecast future demand – GDP provides some details on growth trends in the economy. 5-17  Measuring GDP Intermediate Goods  Goods used up entirely in the production of final goods.  Not included in the calculation of GDP. Value Added  The dollar value of an industry’s sales minus the value of intermediate goods used in production. 5-18 Intermediate Good & Value-Added Which of the following is a final good? a) Seed used for corn b) Wheat used for bread c) Electricity used to produce automobiles d) A lawn mower purchased by a household Intermediate goods adds value to the final product, and its cost is included in the final product. GDP doesn’t include Intermediate goods to avoid double counting. E.g. Tire sale. To Ford; Intermediate good to add to the price of a car in its final value. To consumer; after replacing a flat tire – Final good. 5-19  Measuring GDP Exclude: Financial Transactions: stocks & bonds Transfer Payments, and Second-hand Goods  Numerous transactions occur that have nothing to do with final goods and services being currently produced. 5-20  Measuring GDP Fails to account for: Size of the population – per capita GDP Distribution of output Household production – non marketed goods and services Underground production Leisure time Environmental quality Health and Life expectancy 5-21  Limitations of GDP Per Capita GDP  Adjusting for population growth Real GDP Per Capita Real GDP  population 5-22  Limitations of GDP GDP does not measure social and economic well-being. It only measures the value of production in terms of market prices and is an indicator of economic activity. 5-23  Limitations of GDP Comparing standards of living throughout the world must be done through true purchasing power, using an appropriate comparison of prices and exchange rates. 5-24  Economic Growth – our living standards North America 100 years ago: - Life expectancy at birth is under 50 years. - One in every ten infants dies before reaching their first birthday. - Fewer than 10% of young adults have graduated from high school. - More than 90% of households have no electricity, refrigerator, telephone, or car. 5-25  Two Main Methods of Measuring GDP Expenditure Approach  A way of computing national income by adding up the dollar value at current market prices of all final goods and services. 5-26  Two Main Methods of Measuring GDP Businesses Households Expenditure Approach 5-27  Two Main Methods of Measuring GDP The Expenditure Approach has 4 categories: Consumption Expenditures (C)  Durable consumer goods, nondurable consumer goods, and services Gross Private Domestic Investment (I)  Additions to productive capacity  Construction, equipment and inventory 5-28  Two Main Methods of Measuring GDP Government Expenditures (G)  Government purchases of goods and services  Valued at cost Net Exports (X-M)  Total Exports – Total Imports 5-29 Expenditure Approach Method of Measuring GDP GDP C  I  G  ( X  M ) Consumption Expenditures (C) Gross Private Domestic Investment (I) Government Expenditures (G) Net Exports (X-M) 5-30 GDP Expenditure Approach: Example Expenditure Approach C Personal Expenditure on Consumer goods and services 1000 I + Business Investment 450 G + Gov’t Exp on Goods & Services 500 Xn + Net Exports of Goods and Services 50 GDP = Gross Domestic Product (GDP) (Expenditure Approach) 2000 1-31  Two Main Methods of Measuring GDP Income Approach  A way of measuring national income by adding up components of national income including wages, interest, rent, and profits. 5-32  Two Main Methods of Measuring GDP Income Approach Businesses Households 5-33  Two Main Methods of Measuring GDP Gross Domestic Product: Income Approach. Income paid to households providing factors of production:  The sum of all income paid to households for the four factors of production. –  wages, corporate profits before taxes, interest, farmers income, and non- incorporated non-farm income, and inventory valuation adjustment. 5-34  Income Approach example Income Approach + Wages, Salaries and Supplementary Labour Income 1000 + Corporate Profits 350 + Interest and Miscellaneous Investment income 70 + Farmer's Income 10 + Income from Non-farm unincorporated businesses 170 = Net Domestic (National) Income at factor cost (Income Approach). 1600 Net Domestic Income at factor cost (Income Approach). 1600 + Indirect taxes less subsidies 300 = Net Domestic Product (NDP). 1900 Net Domestic Product (NDP). 1900 + Capital Consumption (depreciation) 100 = Gross Domestic Product (Income Approach) 2000 1-35 Other Components of GDP From GDP to Net Domestic Product  Deducting for depreciation (capital consumption allowance) Reduction in the value of capital goods over a one-year period due to physical wear and tear and to obsolescence. NDP GDP - depreciation 5-36 Other Components of GDP National Income (NNI) at Basic Costs  Net Domestic Product less indirect business taxes and subsidies and net investment income (which represents the income earned by the factors of production.) Indirect Business Taxes less Subsidies 5-37 Other Components of GDP Personal Income (PI)  The amount of income that households receive before they pay personal income taxes. Disposable Personal Income (DPI)  Personal income after personal income taxes have been paid. Personal Savings (S)  The amount that is left over from disposable income after consumption. 5-38  GDP Personal Income Personal Income Personal Expenditure on Consumer goods and services 1000 + Savings 400 + Net Taxes (Taxes - Transfer Payments) 600 = National Income (Y) = GDP 2000 1-39  Real and Nominal GDP Correcting GDP for Price Changes  Nominal (current) dollars GDP  Real (constant) dollars GDP nominal GDP Real GDP = x 100 GDP Deflator 5-40 Real and Nominal GDP Source: Adapted from the Statistics Canada CANSIM database, Table 380-0002 5-41 Real & Nominal GDP- Demonstration Problem 2016 2021 Quantit Good Price Quantity Price y Pizza $ 2 25 $ 4 18 Cola 3 20 4 25 Assume Base Year is 2016 Consider the table above for the economy of a nation whose residents produce two final goods. Answer the following questions…… 1-42 Real & Nominal GDP- Demonstration Problem continued Assuming a 2016 base year: Calculate the following: a) Nominal GDP 2016 b) Nominal GDP 2021 c) Real GDP 2016 d) Real GDP 2021 e) GDP Deflator 2016 f) GDP Deflator 2021 g) Growth rate in Real GDP h) Inflation rate (Price Level Change) 1-43  Real & Nominal GDP- Demonstration Problem continued Assuming a 2016 base year: Formulas a) Nominal GDP 2016 = P16 x Q16 b) Nominal GDP 2021 = P21 x Q 21 c) Real GDP 2016 = P16 x Q16 d) Real GDP 2021 = P16 x Q21 e) GDP Deflator 2016 = (Nominal GDP2016 / Real GDP2016) x 100 f) GDP Deflator 2021 = (Nominal GDP2021 / Real GDP2021) x 100 g) Growth rate in Real GDP = [(Real GDP2021 – Real GDP 2016)/ Real GDP 2016] x 100 h) Price Level change = [(GDP Defl21 – GDP Defl16) / GDP Defl16] x 100 Note: To measure production changes, measure changes in Q, and set P to the base year. We assume prices do not change. 1-44  Real & Nominal GDP- Demonstration Problem continued Base Year 2016 2021 2016 P16 x Q16 P21 x Q21 P16 x Q21 Good P16 Q16 P21 Q21 Pizza $ 2 25 $ 4 21 50 84 42 Cola 3 20 4 25 60 100 75 Total 110 184 117 Solution: a) Nominal GDP 2016 = P16 x Q16 = 110 b) Nominal GDP 2021 = P21 x Q 21 = 184 c) Real GDP 2016 = P16 x Q16 = 110 d) Real GDP 2021 = P16 x Q21 = 117 1-45  Real & Nominal GDP- Demonstration Problem continued e) GDP Deflator 2016 = (Nominal GDP2016 / Real GDP2016) x 100 = (110 / 110) x 100 = 100 (Base Year) f) GDP Deflator 2021 = (Nominal GDP2021 / Real GDP2021) x 100 = (184 / 117) x 100 = 157.26 g) Growth rate in Real GDP = [(Real GDP2021–Real GDP 2016)/Real GDP 2016] x 100 = [(117 – 110)/ 110] x 100 = 6.36% h) Price Level change = [(GDP Defl21 – GDP Defl16) / GDP Defl16] x 100 = [(157.26 – 100) / 100] x 100 = 57.26% 1-46 Real & Nominal GDP- Demonstration Problem Conclusion In nominal terms it appears that GDP rose by 67.3% from $110 in 2016 to $184 in 2021. In reality, once we remove the price level increase and measure production changes only, the real GDP change between 2016 and 2021 is 6.36% shown in (h). The majority of the increase in nominal GDP amounted to a 57.26% increase in the average price level between 2016 and 2021. What appeared to be tremendous growth was in reality only a 6.36% increase in production. 1-47 GDP over time 5-48  Something to think about What Henry Ford understood about wages Every time Ford increased the productivity of car production (in one three- year period, he lowered labor costs by 66% per car), he also raised wages. Not merely because it's the right thing to do. He did it because well-paid workers had more to spend. On houses, on clothes, and of course, on cars. There's a positive ratchet here. You can't shrink your way to greatness. When you enable your workers (and your customers) to do more, connect more, produce more and get paid more, you create a positive system. The goal isn't to clear the table, the goal is to set the table. 5-49  Key Terms Gross Domestic Product (GDP) Personal Income Income Approach Disposable Personal Income Product Markets Savings Factor Markets Intermediate Goods Nominal GDP Final Goods Real GDP Expenditure Approach  Consumption Expenditure (C) GDP Deflator  Gross Private Domestic Investment (I)  Government Expenditures (G)  Net Exports (X-M) Per Capita GDP Net Domestic Product (NDP) 5-50 Expenditure Approach Method of Measuring GDP GDP C  I  G  ( X  M ) Consumption Expenditures (C) Gross Private Domestic Investment (I) Government Expenditures (G) Net Exports (X-M) 5-51  Real and Nominal GDP Correcting GDP for Price Changes  Nominal GDP: Price (P) x Quantity (Q) in the SAME year  Real GDP: Price (P) in BASE year x Quantity (Q) in CURRENT year  GDP Deflator: Nominal GDP ÷ Real GDP in the SAME year x 100  Real GDP Growth Rate: (Real GDP in Current year - Real GDP in Base year) ÷ Real GDP in base year x 100 5-52