*Measuring Economic Aggregates and the Circular Flow of Income

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22 2003 South-Western/Thomson Learning

*The Product of a NationHow do we measure the economys performance?

Francois Quesnay became the first to measure economic activity as a flow, when he described the circular flow of output and income through different sectors of the economy in 1758

The resulting national income accounting system organizes huge quantities of data collected from a variety of sources

*National Income AccountsGross domestic productMeasures the market value of all final goods and services produced during a year by resources located in the United States, regardless of who owns those resources

National income accountsBased on the idea that one persons spending is another persons incomeDouble entry bookkeeping systemAggregate output is recorded on one side of the ledger and income created by that spending on the other side

*GDPGDP can be measured either by total spending on U.S. production or by total income received from that production

Expenditure approachAdds up the aggregate expenditure on all final goods and services produced during that year

Income approachAdds up the aggregate income earned during the year by those who produce that output

*GDPGross domestic product includes only final goods and servicesGoods that are sold to the final, or ultimate, userIgnores most of the secondhand value of used goods because these goods were counted in GDP the year they were produced

Intermediate goods and services are those purchased for additional processing and resaleExcluded to avoid the problem of double counting which is counting an items value more than once

*GDP: Expenditure ApproachEasiest way to understand the spending approach is to divide aggregate expenditure into its four components

Consumption

Investment

Government Purchases

Net Exports

*ConsumptionPersonal consumption expendituresConsists of purchases of final goods and services by households during the yearLargest spending category Accounting on average for about two-thirds of U.S. GDPThree componentsServicesDurable Goods: Goods that are expected to last at least three yearsNondurable Goods

*InvestmentGross private domestic investmentConsists of spending on new capital goods and additions to inventoriesMore generally, investment consists of spending on current production that is not used for current consumptionAccounts for about one-sixth of U.S. GDPCategoriesPhysical capital: new buildings and new machinery purchased by firms and used to produce goods and servicesPurchases of new residential constructionInventories

*InventoriesRefers to stocks of goods in process and stocks of finished goodsHelp firms deal with unexpected changes in the supply of their resources or in the demand for their productsNet changes in inventoriesNet increase in inventories counts as investment because it represents current production not used for current consumptionNet decrease in inventories counts as negative investment, or disinvestment, because it represents the sale of output already credited to a prior years GDP

*InvestmentExcludes Household purchases of durable goods

Purchases of existing buildings and machines

Purchases of financial assetsStocks and bondsAre not investments themselves, rather, they are simply an indication of ownership

*Government PurchasesSpecifically, government consumption and gross investmentIncludes spending by all levels of government for goods and servicesAveraged a little less than one-fifth of U.S. GDP during last decadeExcludes transfer payments because they are an outright grant from the government to the recipientAre not true purchases by government or true earnings by recipientsSocial security, welfare benefits, unemployment insurance

*Net ExportsNet ExportsResult from the interaction between the U.S. economy and the rest of the worldEqual the value of U.S. exports of goods and services minus the value of U.S. imports of goods and servicesInclude merchandise trade and and services invisiblesNet Exports equals Exports minus ImportsThe value of U.S. imports has exceeded the value of our exports nearly every year since the 1960s U.S. net exports have been negativeEqual an average of negative 1% over past decade

*GDP: Expenditure ApproachUsing the expenditure approach, the nations aggregate expenditure equals the sum of Consumption, C

Investment, I

Government Purchases, G

Net Exports, (Exports, X, minus Imports, I)

C + I + G + (X M) = Aggregate Expenditures = GDP

*GDP: Income ApproachIncome approach sums, or aggregates, income arising from that production

Recall that double-entry bookkeeping ensures that the value of aggregate output equals the aggregate income paid for resources used to produce that outputWagesInterestRentProfit arising from production

*GDP : Income ApproachAggregate income equals the sum of all the income earned by resource suppliers in the economy

Aggregate expenditure = GDP = aggregate income

We avoid double counting either byincluding only the market value of the goods and services, orcalculating the value added at each stage of production

*Exhibit 1: Computation of Value Added for a New DeskThe value added by each firm equals the firms selling price minus the amount paid for inputs from other firms. The value added at each stage represents income toindividual resource suppliers at that stateThe sum of the value added at all stages equals the market value of the final good and the value added for all final goods and services equals GDP based on the income approachCost ofSaleIntermediate ValueStage ofValueGoods Added Production (1) (2) (3)

Logger$ 20 $ 20Miller 50$ 20 30Manufacturer 120 50 70Retailer 200 120 80

Market Value of Final Good $200

*Exhibit 2: The Circular FlowThe main stream flows clockwise around the circle, first as income from firms to households the lower half of the circle then as spending from households to firms the upper half of the circle.For each flow of money there is an equal and opposite flow of goods or resources.

*Exhibit 2: The Circular FlowAt 1, firms make production decisions. All production must occur before output is sold and income is earned. Production of aggregate output, or GDP, gives rise to an equal amount of aggregate income.2. Not all income is available for households spending; governments collect taxes.3. Some of these tax dollars are returned to the income stream as transfer payments.4. By subtracting taxes and adding transfers, we obtain disposable income which flows to the households

*The Circular FlowAggregate income is the total income from producing GDP

Disposable income is the income remaining after taxes are subtracted and transfers addedNet taxesNTTaxes minus transfer paymentsTherefore, disposable income equals GDP minus net taxesGDP = Aggregate income = DI + NT

*The Circular FlowHouseholds, with disposable income in hand, must now decide how much to spend and how much to save

Since firms have already produced the output and have paid resource suppliers, firms wait and see how much consumers want to spend

Should any output go unsold, suppliers will be stuck with it in the form of unplanned additions to inventories

*Disposable income splits at 5 where part of it is spent on consumption, C, and the remainder saved, S, DI = C + S. Consumption spending remains in the circular flow.Household saving flows to financial markets. For simplicity, we have assumed that only households save.While the primary borrowers are firms and governments, in reality, financial markets are connected to all four economic decision-makers.Exhibit 2: Expenditure Half of the Circular Flow

*Exhibit 2: Circular Flow

Since firms in our simplified model pay resource suppliers an amount equal to the entire value of output, they have nothing left for investment.Thus, firms and households must borrow in order to finance their investments

6 investment spending enters the circular flow aggregate spending at this juncture equals C + I.Governments must also borrow to finance deficits. These purchases, G, enter the spending stream in the upper half at 7.

*Some spending by firms, households, and governments goes for imports, M. This flows to foreign producers it is a leakage from the circular flow at 8.However, the rest of the world buysU.S. products exports enters theCircular flow at point 9.The net impact of the rest of the world on aggregate expenditures equals exports minus imports, or net exports which can be positive, negative, or zeroAggregate spending flows into firms at 10.Exhibit 2: Circular Flow

*Circular Flow of Income and ExpenditureThe upper half of the circular flow is the expenditure half because it focuses on the components that make up aggregate expenditureConsumption, CInvestment, IGovernment Purchases, GNet Exports, X - M

Aggregate spending on U.S. output equals the market value of aggregate output GDPC + I + G + (X M) = aggregate expenditure = GDP

*Leakages Equal InjectionsIn the lower half of the circular flow, aggregate income equals disposable income plus net taxes

In the upper half, aggregate expenditures equals the total spending on U.S. output

The aggregate output arising from production equals the aggregate expenditure on that production

*Leakages Equal InjectionsThis first accounting identity leads toDI + NT = C + I + G + (X M)Since disposable income equals consumption plus saving, we can substitute C + S for DI in this equationC + S + NT = C + I + G + (X M)After subtracting C from both sides and adding M to both sides, the equation reduces toS + NT + M = I + G + XThus, the leakages (S, NT, and M) must equal the injections (I, G, and X) into the circular flow

*Planned versus Actual InvestmentPlanned InvestmentThe amount firms plan to invest before they know how much output they sellActual InvestmentIncludes both planned investment and any unplanned changes in inventoriesUnplanned increases in inventories cause firms to decrease their production next time aroundOnly when there are no unplanned changes in inventories will GDP be at an equilibrium level planned investment equals actual investment

*Limitations of National Income AccountingSome production is not included in GDPWith some minor exceptions, GDP includes only those products that are sold in marketsIgnores do-it-yourself household production an economy in which householders are largely self-sufficient will understate GDPIgnores the underground economyAll market activity that goes unreported because its illegal or those involved want to evade taxesFederal study suggests the equivalent of 7.5% of GDP or about $750 billion in 2001

*LimitationsFor some economic activity, income must be imputed, or estimated, because market exchange does not occurImputed rental income that homeowners receive from home ownershipImputed dollar amount for wages paid in kind, such as employers payments for employees medical insuranceImputed dollar amount for food produced by farm families for their own consumption

*Leisure, Quality and VarietyAverage U.S. workweek is much shorter now that it was a century ago people work less to produce todays output but this increase in leisure time is not reflected in GDP because it is not explicitly bought and sold in a market

People also retire at a much earlier age and they live longer after retirement quality of life has increased

*Leisure, Quality and VarietyThe quality and variety of products available have on average also improved over the years because of technological advances and competition

GDP does not reflect these improvements

*GDP Ignores DepreciationIn the process of producing GDP, some capital wears out or becomes obsolete

A truer picture of the net production that actually occurs during a year is found by subtracting this depreciation from GDP

Depreciation measures the value of the capital stock that is used up or becomes obsolete in the production process

*Net Domestic ProductNet domestic product equals gross domestic product minus depreciation

Two definitions of investmentGross investment measures the value of all investment during a yearUsed in computing GDPNet investment equals gross investment less depreciationWhen net investment is negative depreciation exceeds gross investment the capital stock declinesIf it is zero capital stock remains constantIf positive, the capital stock growsUsed in computing net domestic product

*GDP Does Not Reflect All CostsSome production and consumption degrades the quality of our environment

Negative externalities such as pollution are largely ignored in GDP accounting

GDP also ignores the depletion of natural resources ignores the natural capital stock

*GDP and Economic WelfareIn computing GDP, the market value of output is the measure of value

Because the level of GDP provides no information about its composition, some economists question whether GDP is a good measure of the nations economic welfare

*Accounting for Price ChangesGross domestic product measures the value of output in current dollars, e.g., in the dollar values at the time the output is produced

This technique of basing GDP on current dollars the national income accounts measure nominal GDP

This system allows for comparisons among income or expenditure components in a particular year

*Accounting for Price ChangesSince the economys average price level changes over time, current-dollar comparisons across years can be misleading

Specifically, nominal GDP can increase over time becauseOutput increasesPrices increaseBoth of these occur

*Real GDPReal GDP refers to GDP adjusted for changes in prices measures the changes which occurred in output or production

This process of adjusting nominal GDP for price changes is called deflating GDP

*Price IndexesAn index number compares the value of some variable in a particular year to its value in a base or reference year

The base year is a point of reference to which prices in other years can be compared prices in other years are expressed relative to the base-year price

We construct a price index by dividing each years price by the price in the base year and multiplying by 100

*Exhibit 3: A Price Index (base year = 2000)Price of BreadPrice of Bread in Current Yearin Base YearPrice Index Year(1)(2)(3) = (1)/(2)x1002000$1.25$1.25100

20011.301.25104

20021.401.25112For base year 2000, we divide the base price of bread by itself, $1.25 / $1.25 price index for 2000 equals 1 100 = 100 the price index in the base year is always 100. The price index for 2001 is $1.30 / $1.25 = 1.04, which when multiplied by 100 = 104, and for 2002 it is 112.Thus, the index is 4% higher in 2001 than in the base year, and 12% higher in 2002 than in the base year.

*Price IndexesThe price index permits comparisons between any two years

For example, if we use the information provided in Exhibit 3 and asked what happened to the price level between 2001 and 2002?

By dividing the 2002 price index by the 2001 price index, 112 / 104, you would find that the price level rose by 7.7%

*Consumer Price IndexThe consumer price index, CPI, measures changes over time in the cost of buying a market basket of goods and services purchased by a typical family

A simplified version of the process used in the CPI is presented in Exhibit 4

*Exhibit 4aQuantity inPrice inCost of Basket Good or Market BasketBase Yearin Base Year Service (1)(2)(3 ) = (1) x (2)Twinkies365 packages$0.84/pkg.$ 324.85Fuel Oil500 gallons1.00/gallon500.00Cable TV12 months30.00/month360.00$1,184.85Hypothetical Market Basket Used to Develop Consumer Price IndexPrices in the base year are listed in column (2) while the total cost found by multiplying price by quantity is in column (3). Thus, the cost of the typical market basket in the base year is $1,184.85.

*Exhibit 4 continuedPrices in Cost of Basket Good or Current Yearin Base Year Service (4)(5) = (1) x (4)Twinkies$0.79$ 288.35Fuel Oil1.50750.00Cable TV30.00360.00$1,398.35Notice in column (4) that not all prices have changed by the same percent since the base year. The cost of purchasing this same market basket in the current year is $1,398.35 as seen in column (5).To compute the price index for the current year, divide the total cost in the current year by the total cost of the same basket in the base year ($1,398.35 / $1,184.85) then multiply by 100, resulting in a price index of 118. Between the base year and the current year, the cost of living increased by 18%.

*Consumer Price IndexThe federal government uses the years 1982 1984 as the base period for calculating the CPI for a market basket of 400 goods and services in eight major categories

It is based on prices collected from about 23,000 sellers across the country

*Problems with the CPICPI tends to overstate inflation for the following reasonsThere is a quality bias because the CPI assumes the quality of the market basket remains relatively constant over timeBecause the CPI holds constant the kind and amount of goods and services in the typical market basket, it is slow to incorporate consumer responses to changes in relative prices the process used does not allow households to shift away from goods that have become relatively more costly

*Problems with the CPICPI has also failed to keep up with the consumer shift toward discount stores because the statisticians consider goods sold at discount retailers as distinct from similar or identical goods sold by traditional retailers

Researchers conclude the CPI has overestimated inflation by about 1 percent per year

*Impact of These ProblemsOverstatement of the rate of inflation causes a number of problemsChanges in the index determine changes in tax bracketsChanges in the index determine changes in an array of paymentsWage agreements that include a cost-of-living (COLA) allowanceSocial Security benefitsWelfare paymentsAbout 30% of federal outlays are tied to changes in the CPI and a 1% overstatement cost the federal government approximately $180 billion per yearDistorts other measures of the economy. For example, based on the official CPI, the average real wage fell by a total of about 2% between 1980 and 2000. However, if the CPI overstates inflation by 1% per year, the real wage increased by 20%

*GDP Price IndexThe GDP price index measures the average level of prices of all goods and services included in GDPGDP price index = (nominal GDP / real GDP) x 100Where nominal GDP is the dollar value of this years GDP measured in base-year pricesReal GDP is the dollar value of this years GDP measured in base year pricesIf we know both nominal GDP and real GDP, then finding the GDP price index is easy

*GDP Price IndexAny measure of real GDP is constructed as the weighted sum of thousands of different goods and servicesThe question is what weights, or prices, to useBetween World War II and 1995, the Bureau of Economic Analysis used prices of a particular base year, most recently, 1997, to estimate real GDPIn this case, the quantity of each output in a particular year was valued by using the 1987 price of each output

*GDP Price IndexSo long as the base year used is close to the year in question, the process of using prices from a base year yields an accurate measure of real GDP

In early 1996, the BEA switched from a fixed-price weighting system to a chain-weighted systemUses a complicated process that changes price weights from year to yearThat is, real GDP adjusts the weights in calculating a price index more or less continuously from year to year

*Exhibit 5: U.S. GDP in Current Dollars and Chained (1996) Dollars

*GDP Price IndexTo provide the reference point, BEA measures U.S. real GDP and its components in chained 1996 dollars

To summarizeCurrent-dollar GDP growth reflects growth in real GDP and in the price levelChained-dollar GDP growth reflects only growth in output or production

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