Measuring the Economy

The Economy as a Circular Flow

Resources

Firms Households

Goods and Services

Expenditures

Income

Saving and Investment

Firms Households

Income

Expenditures

Financial Markets SavingsBorrowings

Real and Nominal Rates

Nominal interest rates are rates unadjusted for the effect of inflation or deflation.

Real rates are adjusted for price level changes.

Interest Rates: Facts

Interest rates serve many roles:Interest rates are a premium paid to forego

consumption.Interest rates are the price of credit.Interest rates are the return to capital as a

factor of production.

Inflation and Interest Rates

Nominal variables are not adjusted to reflect changes in the price level.They are the percentage by which the

money a borrower pays back exceeds the money he borrowed, making no adjustment for any change in purchasing power.

Inflation and Interest Rates

Real interest rates are the percentage increase in purchasing power that the borrower pays to the lender for the privilege of borrowing.Real interest rates are nominal interest

rates minus the rate of inflation.Real interest rates may be positive, zero,

or negative.

Nominal Rates: The Fisher Effect

THE FISHER EFFECT:

NOMINAL RATE = REAL RATE + EXPECTED INFLATION

Circular Flow with Government

SavingsBorrowing

Investment

Government

HouseholdsFirms

Financial Markets

Income

Expenditures

Government Salaries and Transfers

Government Purchases ofGoods and Services Subsidies

Taxes Taxes

Government BorrowingGovernment Saving

Saving and Investment

Economists make a clear distinction between saving and investment.Saving is the act of abstaining from

consumption.Investment is the result of purchasing a

new capital good.

Saving and Investment: Closed Economy

Y = C + I + GG = IG + CG

Y = CN + IN

CN = C + CG

IN = I + IG

Y – CN = IN

SN = IN

Savings = Investment: Closed Economy

In a closed economy, savings must just equal investment.If S > I, interest rates will fall and I will

rise.If S < I, interest rates will rise and I will

fall.

Circular Flow with Government and the Rest of the World

SavingsBorrowing

Investment

Foreign Borrowing Foreign Savings

Foreign Countries

Government

HouseholdsFirms

Financial Markets

Income

Expenditures

ExportsImports

Government Salaries and Transfers

Government Purchases ofGoods and Services Subsidies

Taxes Taxes

Government BorrowingGovernment Saving

The Rest of the World

An economy has two basic kinds of economic interactions with the rest of the world.Buying and selling goods and servicesBuying and selling assets.

Exports are those goods we produce for sale in the rest of the world. Imports are those goods we buy from the rest of the world.

We also lend to the rest of the world and borrow from them.

The Rest of the World

Saving and Investment: Open Economy

Y = CN + IN + NXNX = Exports – Imports

Y – CN – IN = NX SN – IN = NX

If SN = IN, NX =0, trade balanceIf SN > IN, NX >0, trade surplusIf SN < IN, NX <0, trade deficit

Looking at X - M

X represents the exports of a country.X is the income a country receives from

the rest of the world through exporting goods and services.

M represents the imports of a country.M is a country’s consumption of goods

and services produced by the rest of the world.

Looking at X - M

X – M then is income minus consumption vis a vis the rest of the world.If X > M, a country has excess funds to

lend to the ROW, or S > I.If X < M, the country’s trading partner has

excess funds to lend to it or domestically S < I.

S – I = NX

Net foreign investment (S – I) always equals the trade balance (NX).The international flow of funds to finance

capital accumulation and the international flow of goods and services are two sides of the same coin.

Government and the Private Sector YD = Y + TR – T S = YD – C

YD = C + I + G + NX + TR – TYD = S + C

Set YD = YD and solve for NXS + C = C + I + G + NX + TR – TS + C – C – I – G – TR + T = NX

(S – I) + (T – TR – G) = NX

Government and the Private Sector

(S – I) + (T – TR – G) = NX(S – I) = Private saving(T – TR – G) = Government saving

There are two sources from which the government can raise funds if G + TR > T.It can borrow at home, if S > I orIt can borrow from the ROW if NX < 0.

Government Budget Surplus

(S – I) + (T – TR – G) = NX Rearrange the equation: T – G – TR = (I + NX ) – S

There are three ways a government budget surplus can be used:

• Private saving can decline without requiring a decrease in private investment

• The surplus can stimulate domestic investment through lower interest rates.

• Dependence on foreign investment can be reduced.

Measuring GDP

What Is GDP?

GDP, Gross Domestic Product, is the total dollar value of all final goods and services produced in a country during a year.Current market prices are used to aggregate

different outputs to a dollar total. Government purchases, many of which do not

occur in markets, are valued at their cost of production.

Only final goods and services are included. Intermediate goods are not included to avoid double counting.

The measure is an annual flow, a rate of production. A GDP of $10 trillion implies that the economy is producing $10 trillion worth of goods and services per year.

GDP measures production by U.S. citizens and foreigners alike inside the geographic borders of the USA and thus unequivocally reflects economic activity in the USA.

What Is GDP?

Real and Nominal GDP Nominal GDP

The market value of a nation’s final output based on current prices for the goods and services produced during the year.

• Nominal GDP in 2003 = the sum of all the goods and services produced in 2003 multiplied by their 2003 prices

Real GDPAn estimate of the value of a nation’s final

products adjusted for changes in prices since a certain base year.

Calculating Changes in Real GDP GDP = PQ We are interested in measuring Q when

we measure GDP. Therefore, changes in P must be eliminated.

This is accomplished by using a price index to deflate nominal GDP.

Price Indexes: Use

GDP in 2000 = P2000 times Q2000

GDP in 2002 = P2002 times Q2002

If we wish to compare GDP in 2002 with GDP in 2000, we must remove any price changes that have occurred.

Why?

Price Indexes: Use

GDP 2002 = P2002 x Q2002

Divide by a price index = P2002/P2000

P2002Q2002 P2002 = P2002Q2002 x P2000 = Q2002P2000

P2000 P2002

Components of GDP: Expenditure and Income Expenditure

GDP = C + I + G + (X-M) Income

NI (Y) = W + i + R + profits Since NI and GDP measure aggregate

production, they must be equal.

GDP = NI 2001

Consumption 6,987.1 Durable Goods 835.9 Nondurables 2,041.3 Services 4,109.9

Investment 1,586.0 Nonresidential 1,201.6 Residential 444.7

Inventory Change -60.3 Government 1,858.0 Federal 628.1 State & Local 1,229.9

Net Exports -348.9 Exports 1,034.1 Imports 1,383.0

GDP 10,082.2

Employee Compensation 5874.9Corporate Profits 731.6 Proprietors’ Income 727.9Net Interest 649.8Rental Income 137.9National Income 8,122.1+ CCA 1329.3+ Indirect Business Taxes 774.8+ Business Transfers 42.5 - Subsidies 47.3+Statistical Discrepancy -117.3 GNP 10,104.1+Net Foreign Payments -21.9GDP 10,082.2

GDP Components

Concept Leakage/Saving Leakage/Taxes Government Transfers

GDPLess Depreciation= NDPLess Indirect business taxes=Domestic IncomeLess Undistributed Social Security

profits taxesPlus Transfer Payments and

interest=PILess Personal income

taxes=PYDDivided among Personal savingPersonal consumptionInterest payments

Components of GDP: Expenditure Viewpoint

ConsumptionNon-durable Goods (last less than 3 years)Durable Goods (last more than 3 years)Services

Gross Domestic InvestmentNon-residential lnvestment (plant and

equipment)Inventory ChangeResidential Investment

Government SpendingLocal and StateFederal

Net ExportsExports Minus Imports

Components of GDP: Expenditure Viewpoint

Components of GDP: Income Viewpoint Employee Compensation

Income from the sale of labor services during the year.

It includes wages, salaries, and fringe benefits such as employer provided insurance and employer contributions to pension funds.

Net InterestThe portion of business receipts used to

pay for borrowed funds that finance investment purchases.

Components of GDP: Income Viewpoint

Components of GDP: Income Viewpoint Rental Income

Rental income is earned by those who supply the services of land, mineral rights, and buildings for use by others.

Also included in rental income is an estimate of the imputed rent earned by homeowners who live in their own homes less the expenses of maintaining their homes.

Profits.Profits of corporations and unincorporated

business• Profits = Total revenues – Indirect business

taxes – Capital consumption allowance – Labor costs – Net interest – Rents paid

Components of GDP: Income Viewpoint