978-1305971509 Chapter 23_10 Lecture Notes

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WHAT’S NEW IN THE EIGHTH EDITION:

There are two new In the News features, “Sex, Drugs, and GDP” and “Gauging the High Tech

Economy.” The denition of investment has been changed. There are two new questions in

the Problems and Applications section and tables have been updated.

LEARNING OBJECTIVES:

By the end of this chapter, students should understand:

 why an economy’s total income equals its total expenditure.

 how gross domestic product (GDP) is dened and calculated.

 the breakdown of GDP into its four major components.

 the distinction between real GDP and nominal GDP.

 whether GDP is a good measure of economic well-being.

CONTEXT AND PURPOSE:

Chapter 23 is the rst chapter in the macroeconomic section of the text. It is the rst of a

two-chapter sequence that introduces students to two vital statistics that economists use to

monitor the macroeconomy—GDP and the consumer price index. Chapter 23 develops how

economists measure production and income in the macroeconomy. The following chapter

develops how economists measure the level of prices in the macroeconomy. Taken together,

Chapter 23 concentrates on the quantity of output in the macroeconomy while Chapter 24

concentrates on the price of output in the macroeconomy.

The purpose of this chapter is to provide students with an understanding of the

measurement and the use of gross domestic product (GDP). GDP is the single most

important measure of the health of the macroeconomy. Indeed, it is the most widely

reported statistic in every developed economy.

KEY POINTS:

 Because every transaction has a buyer and a seller, the total expenditure in the

economy must equal the total income in the economy.

384

in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise

on a password-protected website or school-approved learning management system for classroom use.

23 MEASURING A NATION’S

INCOME

385 ❖ Chapter 23/Measuring a Nation’s Income

 Gross domestic product (GDP) measures an economy’s total expenditure on newly

produced goods and services and the total income earned from the production of these

goods and services. More precisely, GDP is the market value of all nal goods and

services produced within a country in a given period of time.

 GDP is divided among four components of expenditure: consumption, investment,

government purchases, and net exports. Consumption includes spending on goods and

services by households, with the exception of purchases of new housing. Investment

includes spending on business capital, residential capital, and inventories. Government

purchases include spending on goods and services by local, state, and federal

governments. Net exports equal the value of goods and services produced domestically

and sold abroad (exports) minus the value of goods and services produced abroad and

sold domestically (imports).

 Nominal GDP uses current prices to value the economy’s production of goods and

services. Real GDP uses constant base-year prices to value the economy’s production of

goods and services. The GDP deDator―calculated from the ratio of nominal to real

GDP―measures the level of prices in the economy.

 GDP is a good measure of economic well-being because people prefer higher incomes to

lower incomes. But it is not a perfect measure of well-being. For example, GDP excludes

the value of leisure and the value of a clean environment.

CHAPTER OUTLINE:

I. Review of the Denitions of Microeconomics and Macroeconomics

A. Denition of microeconomics: the study of how households and -rms make

decisions and how they interact in markets.

B. Denition of macroeconomics: the study of economy-wide phenomena

including in1ation, unemployment, and economic growth.

II. The Economy’s Income and Expenditure

A. To judge whether an economy is doing well, it is useful to look at Gross Domestic

Product (GDP).

1. GDP measures the total income of everyone in the economy.

2. GDP measures total expenditure on an economy’s output of goods and services.

in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise

on a password-protected website or school-approved learning management system for classroom use.

Students have heard of GDP and they are often interested in learning

more about what it is. The basic point that you must get across is that

GDP is a measure of both

aggregate production and aggregate income in

a nation over a period of one year. You can demonstrate this by using the

circular-Dow diagram and explaining that production generates income,

which provides the purchasing power that generates the demand for the

products.

Regardless of whether microeconomics is taught before macroeconomics

or vice versa, students need to be reminded of the diHerences between

the two areas of study. Begin by dening the two terms and contrasting

and comparing their focus.

Chapter 23/Measuring a Nation’s Income ❖ 386

B. For an economy as a whole, total income must equal total expenditure.

1. If someone pays someone else $100 to mow a lawn, the expenditure on the lawn

service ($100) is exactly equal to the income earned from the production of the

lawn service ($100).

2. We can also use the circular-Dow diagram from Chapter 2 to show why total

income and total expenditure must be equal.

a. Households buy goods and services from rms; rms use this money to pay

for resources purchased from households.

b. In the simple economy described by this circular-Dow diagram, calculating

GDP could be done by adding up the total purchases of households or

summing total income paid by rms.

c. Note that this simple diagram is somewhat unrealistic as it omits saving,

taxes, government purchases, and investment purchases by rms. However,

because a transaction always has a buyer and a seller, total expenditure in

the economy must be equal to total income.

III. The Measurement of Gross Domestic Product

A. Denition of gross domestic product (GDP): the market value of all -nal

goods and services produced within a country in a given period of time.

in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise

on a password-protected website or school-approved learning management system for classroom use.

Students have heard of GDP and they are often interested in learning

more about what it is. The basic point that you must get across is that

GDP is a measure of both

aggregate production and aggregate income in

a nation over a period of one year. You can demonstrate this by using the

circular-Dow diagram and explaining that production generates income,

which provides the purchasing power that generates the demand for the

products.

Figure 1

387 ❖ Chapter 23/Measuring a Nation’s Income

B. “GDP Is the Market Value . . .”

1. To add together diHerent items, market values are used.

2. Market values are calculated by using market prices.

C. “. . . Of All . . .”

1. GDP includes all items produced and sold legally in the economy.

2. The value of housing services is somewhat diOcult to measure.

a. If housing is rented, the value of the rent is used to measure the value of the

housing services.

b. For housing that is owned (or mortgaged), the government estimates the

rental value and uses this gure to value the housing services.

3. GDP does not include illegal goods or services or items that are not sold in

markets.

a. When you hire someone to mow your lawn, that production is included in GDP.

b. If you mow your own lawn, that production is not included in GDP.

D. “. . . Final . . .”

1. Intermediate goods are not included in GDP.

2. The value of intermediate goods is already included as part of the value of the

nal good.

3. Goods that are placed into inventory are considered to be “nal” and included in

GDP as a rm’s inventory investment.

a. Goods that are sold out of inventory are counted as a decrease in inventory

investment.

b. The goal is to count the production when the good is nished, which is not

necessarily the same time that the product is sold.

E. “. . . Goods and Services . . .”

1. GDP includes both tangible goods and intangible services.

in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise

on a password-protected website or school-approved learning management system for classroom use.

Make sure that students realize that investment goods (such as structures

and vehicles used in production) are not intermediate goods. Investment

goods represent products purchased for nal use by business rms.

To put GDP in terms that students may understand better, explain to them

that GDP represents the amount of money one would need to purchase

one year’s worth of the economy’s production of all nal goods and

services.

Have a contest and see which student can come closest in guessing the

level of GDP for the United States last year.

Chapter 23/Measuring a Nation’s Income ❖ 388

F. “. . . Produced . . .”

1. Only current production is counted.

2. Used goods that are sold do not count as part of GDP.

G. “. . . Within a Country . . .”

1. GDP measures the production that takes place within the geographical boundaries

of a particular country.

2. If a Canadian citizen works temporarily in the United States, the value of her

output is included in GDP for the United States. If an American owns a factory in

Haiti, the value of the production of that factory is not included in U.S. GDP.

H. “. . . in a Given Period of Time.”

1. The usual interval of time used to measure GDP is a year or a quarter (three

months).

2. When the government reports GDP, the data are generally reported on an annual

basis.

3. In addition, data are generally adjusted for regular seasonal changes (such as

Christmas).

I. In addition to summing expenditure, the government also calculates GDP by adding

up total income in the economy.

1. The two ways of calculating GDP generate almost exactly the same answer.

2. The diHerence between the two calculations of GDP is called the statistical

discrepancy.

J. FYI: Other Measures of Income

A. Gross National Product (GNP) is the total income earned by a nation’s permanent

residents.

1. GNP includes income that American citizens earn abroad.

in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise

on a password-protected website or school-approved learning management system for classroom use.

Students sometimes have trouble understanding that the production of a

foreign rm operating in the United States is part of U.S. GDP. Help them

make the connection by using the circular-Dow diagram. Show them that,

even if it is a foreign rm, the rm’s workers are living in the United States

and buying clothes, groceries, and other goods in the United States. Thus,

the workers in the foreign rm operating in the United States are fueling

the domestic economy.

It can be a challenge to teach all of these denitions without putting your

students to sleep. Concentrate on the measures that will mean the most

to students as the semester progresses.

389 ❖ Chapter 23/Measuring a Nation’s Income

2. GNP excludes income that foreigners earn in the United States.

B. Net National Product (NNP) is the total income of a nation’s residents (GNP) minus

losses from depreciation (wear and tear on an economy’s stock of equipment and

structures).

C. National income is the total income earned by a nation’s residents in the production

of goods and services.

1. National income diHers from NNP by excluding indirect business taxes and

including business subsidies.

2. NNP and national income also diHer due to “statistical discrepancy.”

D. Personal income is the income that households and noncorporate businesses receive.

E. Disposable personal income is the income that households and noncorporate

businesses have left after taxes and other obligations to the government.

IV. The Components of GDP

A. GDP (Y ) can be divided into four components: consumption (C ), investment (I ),

government purchases (G ), and net exports (NX ).

B. Denition of consumption: spending by households on goods and services,

with the exception of purchases of new housing.

C. Denition of investment: spending on business capital, residential capital,

and inventories.

1. GDP accounting uses the word “investment” diHerently from how we use the term

in everyday conversation.

2. When a student hears the word “investment,” she thinks of nancial instruments

such as stocks and bonds.

3. In GDP accounting, investment means purchases of investment goods such as

business capital, residential structures, and inventories.

D. Denition of government purchases: spending on goods and services by

local, state, and federal governments.

1. Salaries of government workers are counted as part of the government purchases

component of GDP.

in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise

on a password-protected website or school-approved learning management system for classroom use.

Students will ask why GDP is called “Y.” Remind them that in equilibrium

GDP expenditures must be equal to income. The “Y ” stands for income

because the letter “I ” is used for investment.

= + + +Y C I G NX

Chapter 23/Measuring a Nation’s Income ❖ 390

2. Transfer payments are not included as part of the government purchases

component of GDP.

E. Denition of net exports: spending on domestically produced goods by

foreigners (exports) minus spending on foreign goods by domestic

residents (imports).

F. Case Study: The Components of U.S. GDP

1. Table 1 shows these four components of GDP for 2015.

2. The data for GDP come from the Bureau of Economic Analysis, which is part of the

Department of Commerce.

G. In the News: Sex, Drugs, and GDP

1. Countries are reconsidering what goods and services to include in GDP.

2. The inclusion of typically excluded goods and services like illegal drugs and

prostitution are considered in this Slate article.

V. Real Versus Nominal GDP

A. There are two possible reasons for total spending to rise from one year to the next.

1. The economy may be producing a larger output of goods and services.

2. Goods and services could be selling at higher prices.

B. When studying GDP over time, economists would like to know if output has changed

(not prices).

C. Thus, economists measure real GDP by valuing output using a xed set of prices.

D. A Numerical Example

1. Two goods are being produced: hot dogs and hamburgers.

in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise

on a password-protected website or school-approved learning management system for classroom use.

Make sure that you point out Table 1. Call attention to the importance of

consumption and the negative number in the net exports column.

Make sure that you do this example or a similar numerical example in

class. If you feel comfortable improvising, let the students pick two goods

and then make up an example with them.

Spend some time in class distinguishing between government purchases

and transfer payments. Point out that transfer payments are actually

negative taxes representing payments from the government to individuals

(with no good or service provided in return) rather than payments from

individuals to the government. Dene net taxes as the diHerence between

taxes and transfers.

Table 1

391 ❖ Chapter 23/Measuring a Nation’s Income

Year Price of

Hot Dogs

Quantity of

Hot Dogs

Price of

Hamburgers

Quantity of

Hamburgers

2016 $1 100 $2 50

2017 $2 150 $3 100

2018 $3 200 $4 150

2. Denition of nominal GDP: the production of goods and services valued at

current prices.

Nominal GDP for 2016 = ($1 × 100) + ($2 × 50) = $200.

Nominal GDP for 2017 = ($2 × 150) + ($3 × 100) = $600.

Nominal GDP for 2018 = ($3 × 200) + ($4 × 150) = $1,200.

3. Denition of real GDP: the production of goods and services valued at

constant prices.

Let’s assume that the base year is 2016.

Real GDP for 2016 = ($1 × 100) + ($2 × 50) = $200.

Real GDP for 2017 = ($1 × 150) + ($2 × 100) = $350.

Real GDP for 2018 = ($1 × 200) + ($2 × 150) = $500.

E. Because real GDP is unaHected by changes in prices over time, changes in real GDP

reDect changes in the amount of goods and services produced.

in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise

on a password-protected website or school-approved learning management system for classroom use.

Emphasize that when there is inDation, nominal GDP can increase while

real GDP actually declines. Make sure that students understand that real

GDP will be used as a proxy for aggregate production throughout the

course.

Make sure that it is clear to students how to calculate these numbers so

that they can compute nominal GDP and real GDP on their own.

Table 2

Chapter 23/Measuring a Nation’s Income ❖ 392

F. The GDP DeDator

1. Denition of GDP de1ator: a measure of the price level calculated as the

ratio of nominal GDP to real GDP times 100.

2. Example Calculations

GDP DeDator for 2016= ($200 / $200) × 100 = 100.

GDP DeDator for 2017 = ($600 / $350) × 100 = 171.

GDP DeDator for 2018 = ($1200 / $500) × 100 = 240.

G. Case Study: A Half Century of Real GDP

1. Figure 2 shows quarterly data on real GDP for the United States since 1965.

2. We can see that real GDP has increased over time.

3. We can also see that there are times when real GDP declines. These periods are

called recessions.

in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise

on a password-protected website or school-approved learning management system for classroom use.

Figure 2

ALTERNATIVE CLASSROOM EXAMPLE:

The country of ____________ (insert name based on school mascot such as

“Pantherville” or “Owlstown”) produces two goods: footballs and basketballs.

Below is a table showing prices and quantities of output for three years:

Year Price of

Footballs

Quantity of

Footballs

Price of

Basketballs

Quantity of

Basketballs

Year 1 $10 120 $12 200

Year 2 12 200 15 300

Year 3 14 180 18 275

Nominal GDP in Year 1 = ($10 × 120) + ($12 × 200) = $3,600

Nominal GDP in Year 2 = ($12 × 200) + ($15 × 300) = $6,900

Nominal GDP in Year 3 = ($14 × 180) + ($18 × 275) = $7,470

Using Year 1 as the Base Year:

Real GDP in Year 1 = ($10 × 120) + ($12 × 200) = $3,600

Real GDP in Year 2 = ($10 × 200) + ($12 × 300) = $5,600

Real GDP in Year 3 = ($10 × 180) + ($12 × 275) = $5,100

(Note that nominal GDP rises from Year 2 to Year 3, but real GDP falls.)

GDP deDator for Year 1 = ($3,600/$3,600) × 100 = 1 × 100 = 100

GDP deDator for Year 2 = ($6,900/$5,600) × 100 = 1.2321 × 100 = 123.21

GDP deDator for Year 3 = ($7,470/$5,100) × 100 = 1.4647 × 100 = 146.47

= ´

Nominal GDP

GDP deDator 100

Real GDP

Make sure that you point out that nominal GDP and real GDP will be equal

in the base year. This implies that the GDP deDator for the base year will

always be equal to 100.

393 ❖ Chapter 23/Measuring a Nation’s Income

H. In the News: Gauging the High-Tech Economy

1. Because GDP is used in the measurement of productivity, if GDP is incorrect, then

productivity is incorrect.

2. This Wall Street Journal article considers the diOculty in measuring and including

some high-tech goods and services in GDP and the repercussions for the measure

of productivity.

VI. Is GDP a Good Measure of Economic Well-Being?

A. GDP measures both an economy’s total income and its total expenditure on goods

and services.

B. GDP per person tells us the income and expenditure level of the average person in

the economy.

C. GDP, however, may not be a very good measure of the economic well-being of an

individual.

1. GDP omits important factors in the quality of life including leisure, the quality of

the environment, and the value of goods produced but not sold in formal markets.

2. GDP also says nothing about the distribution of income.

3. However, a higher GDP does help us achieve a good life. Nations with larger GDP

generally have better education and better health care.

D. Case Study: International Di0erences in GDP and the Quality of Life

1. Table 3 shows real GDP per person, life expectancy at birth, the average years of

schooling among adults, and an index of life satisfaction based on asking people

to gauge how they feel about their lives.

2. In rich countries, life expectancy is higher, adults have more years of schooling,

and people rate their life satisfaction higher.

3. In poor countries, people typically die about 10 years earlier, have less than half

as much schooling, and rate their satisfaction about 2 points lower on the

10-point scale.

in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise

on a password-protected website or school-approved learning management system for classroom use.

Get students involved in a discussion of the merits and problems involved

with using GDP as a measure of well-being. Students are often as

interested in what is not included in GDP as they are in what is included.

Have the students break into small groups and list the things that might

be missing if we use GDP as a measure of well-being. Then, have each

group report their results and summarize them on the board.

Table 3

Chapter 23/Measuring a Nation’s Income ❖ 394

Activity 1—GDP and Well-Being

Type: In-class demonstration

Topics: Per capita GDP

Materials needed: None

Time: 15 minutes

Class limitations: Works in any size class

Purpose

This activity examines the usefulness and limits of measures of GDP. Students

often have diOculty accepting the use of GDP as a proxy for well-being. Per capita

GDP does not directly measure well-being but it is highly correlated with direct

measures. Making this correlation explicit helps students understand the

emphasis on GDP in macroeconomics.

Instructions

Ask students the following questions. Discuss each before moving to the next

question.

1. If GDP is a good measure of well-being, why is Switzerland’s GDP so much

lower than India’s GDP or China’s GDP?

2. What measures would be better to compare the well-being of diHerent

countries?

3. How do you expect these direct measures to correlate with per capita GDP?

Common Answers and Points for Discussion

1. GDP itself tells very little; Switzerland’s GDP is much lower than that of India

or China, yet Swiss citizens have one of the highest standards of living in the

world. The diHerence, of course, is population. Switzerland is a small country,

so its GDP is relatively small, despite its wealth. The appropriate comparison

is per capita GDP.

A more interesting question is “Is per capita GDP a good measure of

well-being?” Or worded another way: “What constitutes well-being?”

2. Well-being can be measured directly in a variety of ways. Students often

suggest these:

Health care

Food

Education

These are certainly better measures than money income, but they can be

diOcult to collect and interpret.

E. In the News: Measuring Macroeconomic Well-Being

1. Some economists wonder if we need a better measure of economic well-being.

2. This article from The Wall Street Journal describes some attempts at creating a

better measure of well-being.

in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise

on a password-protected website or school-approved learning management system for classroom use.