Measuring a Nation’s Income Copyright © 2004 South-Western Measuring a Nation’s Income • Microeconomics • Microeconomics is the study of how individual households and firms make decisions and how they interact with one another in markets • Macroeconomics • Macroeconomics is the study of the economy as a whole • Its goal is to explain the economic changes that affect many households, firms, and markets at once Copyright © 2004 South-Western Measuring a Nation’s Income • Macroeconomics answers questions like the following: • Why is average income high in some countries and low in others? • Why prices rise rapidly in some time periods while they are more stable in others? • Why production and employment expand in some years and contract in others? Copyright © 2004 South-Western THE ECONOMY’S INCOME AND EXPENDITURE • When judging whether the economy is doing well or poorly, it is natural to look at the total income that everyone in the economy is earning Copyright © 2004 South-Western THE ECONOMY’S INCOME AND EXPENDITURE • For an economy as a whole, income must equal expenditure because: • Every transaction has a buyer and a seller • Every dollar of spending by some buyer is a dollar of income for some seller Copyright © 2004 South-Western THE MEASUREMENT OF GROSS DOMESTIC PRODUCT • Gross domestic product (GDP) is a measure of the income and expenditures of an economy • It is the total market value of all final goods and services produced within a country in a given period of time Copyright © 2004 South-Western THE MEASUREMENT OF GROSS DOMESTIC PRODUCT • The equality of income and expenditure can be illustrated with the circular-flow diagram Copyright © 2004 South-Western Figure The Circular-Flow Diagram MARKETS FOR GOODS AND SERVICES •Firms sell Goods •Households buy and services sold Revenue Wages, rent, and profit Goods and services bought HOUSEHOLDS •Buy and consume goods and services •Own and sell factors of production FIRMS •Produce and sell goods and services •Hire and use factors of production Factors of production Spending MARKETS FOR FACTORS OF PRODUCTION •Households sell •Firms buy Labor, land, and capital Income = Flow of inputs and outputs = Flow of dollars Copyright © 2004 South-Western THE MEASUREMENT OF GROSS DOMESTIC PRODUCT • GDP is the market value of all final goods and services produced within a country in a given period of time Copyright © 2004 South-Western THE MEASUREMENT OF GROSS DOMESTIC PRODUCT • “GDP is the Market Value ” • Output is valued at market prices • “ Of All Final ” • It records only the value of final goods, not intermediate goods (the value is counted only once) • “ Goods and Services “ • It includes both tangible goods (food, clothing, cars) and intangible services (haircuts, housecleaning, doctor visits) Copyright â 2004 South-Western GDP AND ECONOMIC WELLBEING Higher GDP per person indicates a higher standard of living • GDP is not a perfect measure of the happiness or quality of life, however Copyright © 2004 South-Western GDP AND ECONOMIC WELL-BEING • Some things that contribute to well-being are not included in GDP • The value of leisure • The value of a clean environment • The value of almost all activity that takes place outside of markets, such as the value of the time parents spend with their children and the value of volunteer work Copyright © 2004 South-Western GDP, Life Expectancy Copyrightâ2004 South-Western GDP (PPP) Purchasing Power Parity (PPP) is an economic theory that compares different countries' currencies through a market "basket of goods" approach According to this concept, two currencies are in equilibrium or at par when a market basket of goods (taking into account the exchange rate) is priced the same in both countries Copyright © 2004 South-Western GDP Nominal vs GDP (PPP) Copyright © 2004 South-Western Why not GDP (PPP)? • • • • • • Transport Costs Taxes Government Intervention Non-Traded Services Market Competition Inflation Copyright © 2004 South-Western GNP: An Alternative Measure of Output GNP = GDP + Net income received from abroad by residents of a nation Copyright © 2004 South-Western Case in Point: The Spread of the Value Added Tax • VAT- a sales tax on final goods and services but is collected at each stage of production • In 1948, France became the first country in the world to use the VAT • In 1967, Brazil became the first country in the Western Hemisphere to so • The VAT spread to other western European and Latin American countries in the 1970s and 1980s • And to countries in the Asia/Pacific region, central European and former Soviet Union area, and Africa in the 1990s and early 2000s Copyright © 2004 South-Western Case in Point: The Spread of the Value Added Tax Why bother to tax in stages instead of just on final sales? − Tax Tax Already Collected Paid $1,200 − $0 = Value Added Tax = $1,200 $2,500 − $1,200 = $1,300 Good Logs Price $12,000 Value Added $12,000 Lumber $25,000 $13,000 House $125,000 $100,000 $12,500 − $2,500 = $10,000 $16,200 −$3,700 = $12,500 Total Copyright © 2004 South-Western Question Suppose you are given the following data for an economy: Identify to which each of these items corresponds What is the economy’s GDP Personal consumption Home construction Increase in inventories Equipment purchases by firms Government purchases Social Security payments to households Government welfare payments Exports Imports $1,000 100 40 60 100 40 100 50 150 Copyright © 2004 South-Western Question Suppose a dairy farm produces raw milk, which it sells for $1,000 to a dairy The dairy produces cream, which it sells for $3,000 to an ice cream manufacturer The ice cream manufacturer uses the cream to make ice cream, which it sells for $7,000 to a grocery store The grocery store sells the ice cream to consumers for $10,000 Compute the value added at each stage of production, and compare this figure to the final value of the product produced Report your results in a table “Final Value and Value Added” Copyright © 2004 South-Western Summary • Because every transaction has a buyer and a seller, the total expenditure in the economy must equal the total income in the economy • 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 Copyright © 2004 South-Western Summary • GDP is the market value of all final 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 Copyright © 2004 South-Western Summary • Nominal GDP uses current prices to value the economy’s production Real GDP uses constant base-year prices to value the economy’s production of goods and services • The GDP deflator—calculated from the ratio of nominal to real GDP—measures the level of prices in the economy Copyright © 2004 South-Western Summary • GDP is a good measure of economic well-being because people prefer higher to lower incomes • It is not a perfect measure of well-being because some things, such as leisure time and a clean environment, aren’t measured by GDP Copyright © 2004 South-Western ... South-Western The GDP Deflator • The GDP deflator is calculated as follows: Nominal GDP GDP deflator =  10 0 Real GDP Copyright â 2004 South-Western The GDP Deflator Converting Nominal GDP to Real GDP •... to Real GDP • Nominal GDP is converted to real GDP as follows: Real GDP2 0XX Nominal GDP2 0XX   10 0 GDP deflator20XX Copyright © 2004 South-Western Table Real and Nominal GDP Copyright©2004 South-Western... $12 5,000 $10 0,000 firm Final Value $12 5,000 House Sum of Values Added Price $12 ,000 Value Added $12 ,000 $12 5,000 Copyright © 2004 South-Western THE COMPONENTS OF GDP • GDP (Y) is the sum of the following: