I. Introduction
A. Objectives
1. Describe flows of expenditure and income
2. Explain why aggregate expenditure equals aggregate income
3. Explain how GDP and GNP are measured.
4. Describe the CPI and the GDP deflator
5. Explain how real GDP is measured
6. Explain why real GDP is not a good measure of economic well being
B. Topics to be covered in the Lecture
1. The Basic Circular Flow of Expenditure and Income
2. Government, the Foreign Sector and the Circular Flow
3. Disposable Income, Consumption, Saving and Taxes
4. Income and Expenditure Accounts
5. US National Income and Product Accounts
6. The Price Level and Inflation
7. Real Gross Domestic Product and Economic Well-Being
II. The Basic Circular Flow of Expenditure and Income
(Begg 20-3)
A. The circular flow of expenditure and income provides the needed framework to measure Gross Domestic Product (GDP).
B. Gives an intuitive feel for the accounting identities
a. Income = Output = Expenditures
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A. The simplest case:
1. Households and firms (no government)
2. Households
a. supply factor services to firms
b. Receive incomes from firms
c. Spend incomes on goods and services provided by firms
3. Firms:
a. use factors supplied by households to produce goods and services
b. pay households for factor services
c. Sell goods and services to households
4. Hence are three ways of measuring economic activity:
a: value of goods and services produced
b: the level of factor incomes (value of factor services supplied)
c: value of spending on goods and services
5. All three must be equal since profits are part of factor incomes.
Profits = sales of goods and services less other factor incomes.
6. Incomes equal spending since assuming nothing saved.
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A. In a more complex case
1. Two economic agents (households and firms)
2. Three economic markets (goods market, factor market and financial market)
3. Households engage in three actions.
a. In the factor market,
i. they sell their factors to firms and
ii. receive incomes.
b. In the goods markets,
i. they make expenditures and
ii. receive goods and services from firms.
c. In financial markets,
i. They save some of their incomes and
ii. purchase financial assets from financial firms (they lend to financial firms e.g. banks)
4. Firms engage in five economic activities
a. In the factor market,
i. firms pay incomes to households and
ii. acquire their factors of production.
b. In the goods market,
i. firms receive revenues and
ii. sell their products to households.
c. In the financial market,
i. firms sell financial assets (borrow)
ii. in order to purchase investment goods from other firms.
d. In the goods markets,
i. firms make investment expenditures by purchasing capital goods from other firms
ii. firms receive revenues from the sale of capital goods to other firms.
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A. Aggregate income (AY) is the total amount of income received by households in exchange for the use of factors of production.
1. Aggregate income (AY) includes
a. wages paid to workers (WAGES)
b. interest for the use of capital (INTEREST)
c. rent for the use of land (RENT)
d. and profits paid to owners of firms. (PROFIT)
AY = (WAGES) + (INTEREST) + (RENT) + (PROFIT)
B. aggregate expenditure (AE) is the sum of
1. consumption expenditure (C) and
2. Investment (I).
AE = C + I
C. Consumption expenditure (C) is the total amount spent by households on goods and services.
D. Investment (I) is the purchase of new plants, equipment, buildings, and additions to inventory.
E. All funds received by firms from the sale of their output (C + I) (Aggregate expenditure) (AE) must be paid to households to purchase the factors of production (Aggregate income)(AY).
1. Aggregate expenditure (AE) must equal aggregate incomes (AY).
AE = AY
2. This follows from the definition of profits
a. Profits equal total sales (total expenditures) less total costs (wages, rents and interest)
b. PROFITS = SALES - COSTS
PROFITS = AE - (WAGES + INTEREST + RENT)
Hence:
c. PROFIT + WAGES + INTEREST + RENT = AE
Hence:
d. AY = AE
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(B 20-4)
A. Gross domestic product (GDP) or (Y) is the value of all final goods and services produced in an economy over a period of time.
1. GDP (Y) equals the sum of consumption expenditure,(C), plus investment expenditure, (I).
2. Since aggregate expenditure (AE) equals C plus I,
a. GDP (Y) equals aggregate expenditure (AE)
b. which equals aggregate income (AY).
C + I = GDP = Y = AE = AY
3. Hence GDP (Y) can be measured by:
a. What was paid for production (AE) or
b. What the owners of the factors received for their inputs (AY).
III. Government, the Foreign Sector and the Circular Flow
A. Adding government and the Rest of the World to the circular flow model makes it more realistic.
1. It makes the model more complex
2. However AE = AY = GDP = Y still holds
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A. The government undertakes three economic activities:
1. It buys goods and Services (G)
2. It receives taxes and makes transfer payments
3. It sells financial assets (Borrows money))
B. In the goods market,
1. the government makes expenditures (buys) goods and services produced by firms (G).
AE = AE = GDP = Y = C + I + G
C. The government receives taxes (T) from households and firms and makes transfers (TR) of income to households and firms (or pays benefits (B)).
1. The difference between taxes received (T) and benefits paid (B) is net taxes (NT).
NT = T - B = T - TR
2. Net taxes (NT) are equal to the difference between:
a. taxes paid to the government (T) and
b. transfers (TR) or benefits (B) paid by the government.
D. In financial markets, the government sells assets (borrows) to help finance its spending.
a. Government sells government bonds. (promises to pay)
b. If less than one year called Treasury bills
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A. The rest of the world interacts in two markets
1. In the goods market, foreigners:
a. Buy goods and services from domestic firms, imports (Z)
b. Sell foreign goods to domestic households, firms and government, exports (X).
2. In the financial markets, foreigners
a. lend to domestic households, firms and government.
b. borrow from domestic households, firms and government.
B. Net Exports (NX) equal:
1. the value of exports (X) to the rest of the world minus
2. the value of imports (Z) from the rest of the world.
a. NX = X - Z
C. Net Foreign Borrowing (NFB) from a country would be equal to its net Exports (NX).
1. NFB = NX = X - Z
D. Just as before, aggregate expenditure (AE) equals aggregate income (AY), which equals GDP (Y).
1. AE = AY = Y
2. Because every dollar received by a firm ("aggregate expenditure") must be paid as:
a. income to the factors of production it employs or
b. profits to the firm's owners ("aggregate income").
1. AE = AY = GDP = Y = C + I + G + NX
III. Disposable Income, Consumption Expenditure, Saving and Taxes
A. Disposable income, YD. is equal to Aggregate income, AY, minus net taxes, NT,
1. YD = AY - NT Hence, AY = YD + NT
B. Disposable income, YD, can either be spent on consumption or saved.
1. YD = C + S
C. Saving is thus the portion of disposable that was not spent on consumption.
1. S = YD - C
2. Saving is a residual. Consumption spending is a positive act.
a. example of newly paid economic professor in US
i. S = YD
ii. S = YD - C
2. Hence AY = YD + NT can be written
AY = C + S + NT
IV. Income and Expenditure Accounts
A. Firm and household income and expenditure accounts
1. Firms' accounts:
a. Income = C + I + G + NX = AE
b. Expenses = WAGES + INTEREST + RENTS + PROFITS =
AY
c. Income = Expenses
2. Households' accounts
a. Incomes = WAGES + INTEREST + RENTS + PROFITS = AY
b. Expenses = C + NT + S
c. Income = Expenses
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A. Injections into the circular flow of expenditure and income include:
1. Investment (I),
2. Government purchases of goods and services (G), and
3. Exports (EX)
B. leakages from the circular flow of expenditure and income include:
1. Net taxes (NT),
2. Saving (S) and
3. Imports (Z)
C. Aggregate expenditure, (AE), is comprised of:
1. consumption expenditure, (C),
2. investment expenditure, (I),
3. government expenditure, (G) and
4. net exports, (NX).
1. AE = C + I + G + NX
D. If we dissaggregate net exports (NX), we get
NX = X - Z
E. Substitute in EQN. 1
1. AE = C + I + G + X - Z
F. Recall from households accounts
1. AY = C + S + NT
G. Hence
1. AY = C + S + NT = C + I + X - Z = AE
H. If Consumption (C) is subtracted from both aggregate expenditure (AE) and aggregate income (AY), we would get:
1. AY - C = I + G + X - Z = S + NT = AE - C, or
or
2. I + G + X - Z = S + NT
I. If Imports (Z) are added to both sides of the equation
1.(Injections) = I + G + X = S + NT + Z = (Leakages)
J. Injections and leakages to the circular flow are as follows:
1. I, G, X are injections.
2. S, NT and Z are leakages
3. They must be equal
IV. The US National Income and Product Accounts
A. GDP can be measured in two ways:
1. The expenditure approach
2. The factor incomes approach.
B. This is based on the national income accounting identity:
1. Total output = Total income
2. Follows from the definition of profits
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A. The expenditure approach measures GDP by collecting data on, then summing,
1. consumption expenditure (C),
2. investment (I),
3. government purchases of goods and services (G) and
4. net exports (NX).
Y = C + I + G + NX
B. These expenditures are valued using the prices paid for the goods and services.
1. It is called GDP at market price.
B. Personal consumption expenditures (C) are household's expenditures on goods and services that they use for their consumption.
1. Personal consumption is the largest component of aggregate expenditures.
a. In US is 2/3 of Y
2. Personal consumption only counts the purchases of new goods.
a. Purchases of used goods is not included.
b. (e.g. a used bicycle)
3. The purchase of a house is treated as investment.
4. Consumption normally broken down into 3 categories:
a. Durable goods (last more than 1 year)
i. e.g. automobiles
b. Non durable goods (last less than 1 year)
ii. e.g. bread
c. Services
i. e.g. bus transportation
C. Gross private domestic investment (I) is:
1. firms' expenditures on
a. plant (buildings)
b. capital equipment,
c. additions to their inventories and
2. households purchases of new homes.
3. The capital stock (K) is the total amount of:
a. plant,
b. equipment,
c. residential buildings and
d. inventory.
4. Inventories are the stocks of
a. raw materials,
b. semi-finished products and
c. unsold final products owned by firms.
5. Inventory investment is highly volatile.
a. It is the key element in the macroeconomic adjustment process.
5. Investment in the macroeconomic sense does not include the purchase of financial assets such as
a. stocks (equity shares) and
b. bonds
c. Nothing has been produced.
i. It is just an exchange of one type of financial asset (bonds) for another (money)
6. Depreciation (DEP) is deducted from gross investment (I) to get net investment (IN)
IN = IG - DEP
D. Government purchases of goods and services (G) is the expenditures on goods and services by all levels of government.
1. Government purchases of goods and services (G) does not include transfer payments (TR), or benefits (B).
a. Transfer payments do not represent any production
2. The US makes no distinction between:
a. government purchases for current consumption. (e.g. pencils)
b. government purchases of capital goods (e.g. computers)
E. Net exports of goods and services (NX) equals:
1. the value of exports (X) minus
2. the value of imports (Z).
F. Y = C + I + G + NX
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A. The factor incomes approach to measuring GDP (Y) involves two steps.
1. It starts by adding all the incomes paid to households by firms for the use of factors of production,
a. to get net domestic income at factor cost (NDI at FC).
2. Then the factor incomes approach makes some adjustments to yield GDP (Y).
B. The US national income accounts divide factor incomes into five categories.
1. Compensation of employees,
2. rental incomes,
3. corporate profits,
4, net interest and
5. proprietor's income.
C. Compensation of employees is wages and salaries.
1. This is the largest component of factor incomes.
D. Rental income includes payments for all rented inputs.
1. Includes imputed rent on owner occupied houses
E. Corporate profits is the total profits earned by corporations, regardless of whether the profits were:
1. paid out to households or
2. retained by the business.
3. It includes both distributed profits and retained earnings.
4. Whether paid out or retained all corporate profits belong to the stock holders (owners).
5. Corporate retained earnings is a type of forced savings.
F. Net interest equals:
1. all interest received by households (except interest on government debt)
2. less all interest paid by households.
3. In the US interest on government bonds is not included
a. Considered a transfer payment not a return on capital
G. Proprietor's income includes all income received by the owners of owner-operated businesses.
1. Includes wages, interest, rents of owners factors of production.
2. Also includes profits (which may be positive or negative).
3. Too complicated to sort out how much is wages, how much is rent how much is interest and how much is profit.
H. Net domestic income at factor cost (NDI at FC) is the sum of the five factor income components.
1. This values the output at factor cost, rather than at market price.
1. NDI at FC = Sum of factor payments
E. Two adjustments must be made to Net Domestic Income at Factor Cost to make it equal to GDP at Market Prices (Y).
1. Indirect taxes, (TI) [sometimes referred to as excise taxes] must be added and subsidies (SUB) must be subtracted.
a. The difference between indirect taxes (TI) paid into government and subsidies (SUB) paid out of government can be referred to as Net Excise Taxes (NTE)
NTE = TI - SUB
i. Indirect taxes include
Tariffs
Value Added Taxes
Turnover taxes
ii. Indirect taxes are called indirect because they are ultimately a tax on the households income.
b. Net Domestic Product at Market Prices (NDP) is equal to Net Domestic Income at Factor Prices plus Net Excise Taxes (NTE).
1. NDP = NDI at FC + NTE
c. Conversely Net Domestic Income at Factor Prices is equal to Net Domestic Product at Market Prices less Net Excise Taxes (NTE)
1. NDI at FP = NDP - NTE
2. Depreciation (DEP) must be added to Net Domestic Product (NDP) to equal Gross Domestic Product (Y).
a. Y = NDP + DEP
F. The steps to produce Net Domestic Product (NDP) are as follows:
1. An indirect tax (TI) is a tax paid by consumers when they purchase a good.
a. The tax raises the market price above factor cost.
b. The owners of the factors get less than the market price,
i. the difference goes to government in the form of excise taxes.
2. A subsidy (SUB) is a payment by the government to producers.
a. A subsidy lowers the market price below factor cost.
b. The owners of the factors get more than the market price,
i. the extra income comes from the government subsidy.
3. To get Net Domestic Product (NDP) at Market Prices, you must add Net Excise Taxes (TEN)
a. Indirect taxes (TI) must be added to factor incomes and
b. Subsidies (SUB) must be subtracted .
c. NDP at MP = Factor Incomes + (TI - SUB), or
b. NDP at MP = Factor Incomes + TEN
G. For convenience in notation and discussion, GDP and NDP are always assumed to be at market prices.
a. GDP at MP = GDP = Y
b. NDP at MP = NDP
H. The step to go from Net Domestic Product (NDP) to Gross Domestic Product (Y)
1. Depreciation (DEP) is the decrease in the value of the capital stock (K) resulting from its use.
a. Depreciation is often referred to as capital consumption (CC).
b. Depreciation (DEP) is an expense that contributes to the product's price,
i. but it is not paid to any factor owner.
c. Therefore, depreciation (DEP) must be added to the net domestic product (NDP) to get GDP (Y).
Y = GDP = NDP + DEP
d. Depreciation (DEP) was deducted in computing corporate profits and proprietor's income.
i. You are just putting it back in to get gross income.
2. Gross investment (I) is the total amount spent on investment.
a. Gross investment (I) is made up of two components,
i. Replacement of worn out capital (DEP)
ii. Net additions to capital stock, Net investment (NI).
iii. Gross investment (I) is equal to net investment (NI) plus depreciation (DEP)
I = NI + DEP
3. Net investment (NI) is equal to gross investment (I) minus depreciation (D).
a. NI = I - DEP
b. Net investment (NI) represents net additions to the capital stock (DELTA K).
a. NI = DELTA K
4. Net Domestic Product (NDP) does not include depreciation (DEP) because it was deducted from corporate profits and proprietor's income.
5. In the factor incomes approach, GDP (Y) equals NDP plus Depreciation (DEP).
i. Y = GDP = NDP + DEP
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A. To calculate the final output of a firm or sector:
1. we calculate its value added (VA).
B. Value added (VA) equals:
1. the value of a firm's output (Total Revenue) less
2. the value of the intermediate goods used by the firm.
C. In valuing output, only value added is counted;
1. Intermediate goods are excluded.
i. An intermediate good is a good used in the production process.
(e.g. electricity used in the home is a final good, electricity used in the National Economics University is an intermediate good.)
D. VA = V of OUTPUT - V of INTERMEDIATE GOODS
E. The value added (VA) in a firm or sector is the sum of the incomes (including profits) paid to the owners of the factors of production used by a firm or sector to produce its output.
1. PROFIT = V of OUTPUT - V of INTERMEDIATE GOODS - (WAGES + INTEREST + RENTS)
2. Add input costs to both sides
PROFIT + WAGES + INTEREST + RENTS = (V of OUTPUT - V of INTERMEDIATE GOODS) = VA
F. By summing the value added (VA) in one sector, you will get the value of the final product (FP) in that sector.
1. example of the producers of a loaf of bread
Price VA
Farmer 10 10
Miller 20 10
Baker 30 10
Grocer 40 10
G. By summing the value added (VA) of all sectors, you will get the total value of final product (FP) or the total of factor incomes (AY).
SUM of VA = Aggregate Income = AY
H. To get Gross Domestic Product you must add Net Excise Taxes (NTE) plus Depreciation (DEP)
GDP = NFI at FC + DEP + NTE
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A. The Government of Vietnam has kept its national production accounts using the Material Product System (MPS)
B. The basic difference between the Material Product System and the United Nations System of national Accounts (SNA) is:
1. The Material Product System does not include:
a. Services
b. Depreciation (DEP)
2. Material Product would equal Net Domestic Product (NDP) less Services.
MAT PROD = NDP - SERVICES
C. GDP would equal Material Product + Depreciation (DEP) + Services
GDP = MAT PROD + DEP + SERVICES
(B of dong at 1982 Prices)
YEAR MAT PROD DEP + SERV = GDP
1984 155 + 56 = 211
1985 164 + 60 = 224
1986 170 + 61 = 231
1987 179 + 61 = 240
1988 190 + 62 = 252
1989 194 + 78 = 272
1990 200 + 87 = 287
1991 206 + 95 = 301
(WB p. 235)
D. Material Product is Dissaggregated by Industry:
1. e.g. Agriculture, Forestry Industry, Commerce, Transport and Communications, Construction, Other
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A. The Gross National Product (GNP), is different from the Gross Domestic Product (GDP) or (Y).
i. Key is the middle word (national vs domestic)
B. The Gross National Product (GNP) (Y) is the total value of output owned by the residents of a country.
1. GNP measures the total income earned by domestic citizens regardless of the country in which their factor services were supplied.
a. GNP equals GDP (Y) plus net property income from abroad (NPIA).
GNP = GDP + NPIA
C. The Gross Domestic Product (GDP) is the total value of product produced in a country.
D. The difference between GDP and GNP is:
1. the net investment income received by residents of the country from residents of the rest of the world (NPIA).
GNP = GDP + NPIA
E. Net property income from abroad (NPIA) is:
1. the total payments of interest and dividends to residents of a country on their foreign investments less
2. the payments of interest and dividends to foreigners.
NPIA = Payments to residents - Payments to foreigners
F. In most countries NPIA is very small and GDP is approximately equal to GNP.
1. In the UK, NPIA is about 1 billion pounds,
a. Therefore in the UK, GNP is slightly larger than GDP (Y).
2. In the US, NPIA is very small
a. so GDP and GNP almost equal.
V. Price Level and Inflation
A. The price level (P) is the "average" level of prices
1. The price level (P) is measured using a price index.
2. The price index is the ratio of its value in the current period to its value in the base period.
B. In the US, there are two main price indexes,:
1. the Consumer Price Index (CPI) and
2. the GDP deflator.
3. The US also prepares a Wholesale Price Index (WPI)
a. WPI gives warning of future changes in Consumer Price Index (CPI)
C. In the UK, there are also two main price indexes,:
1. the Retail Price Index (RPI) and
2. the GDP deflator.
D. Viet Nam also prepares:
1. a Retail Price Index and
2. an Implicit GDP deflator
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A. In the US, The Consumer Price Index (CPI) measures the average level of prices of goods and services consumed by an urban family.
1. The CPI is calculated by
a. dividing the current cost of a market basket of goods by the cost of the same market basket in a base year and
b. multiplying by 100.
2. CPI = (Current cost of market basket) * 100
(Cost of basket in base period)
3. If the current period is the base period, the index is 100.
B. The CPI may fail to measure the true cost of living for three reasons.
1. substitution effects,
2. new goods and
3. quality changes
C. The market basket used in the CPI is fixed and does not take into account the fact that consumers will:
1. Substitute away from goods whose prices increase faster than average. (relative prices have risen)
2. Substitute towards goods whose prices increase slower than average. (relative prices have fallen)
3. Because consumers make substitutions, a price index based on a fixed basket will overstate the effects of a given price change on the consumer's cost of living.
DELTA CPI > DELTA true cost of living
D. New goods that were not available in the base year are not included in the market basket that is being priced.
1. Often new goods experience rapid price declines shortly after their introduction due to:
a. economies of scale
b. entry of competitors
2. Old goods may remain in market basket even after they have gone out of use.
E. The goods available today may be of a higher (or lower) quality than the corresponding goods in the base period.
1. In many cases the price has increased because the quality has improved.
a. e.g. economics textbooks are longer, better illustrated
b. The CPI treats this as inflation
F. The CPI is a better measure of inflation, the shorter the difference in time between the index numbers being compared.
1. Good for year to year and month to month changes
2. (except for sampling error)
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(B 2-2)
A. In the UK, the consumer price index is called the retail price index. (RPI)
B. It is constructed in two stages
1. First an index is constructed for each of 13 commodity groups
(e.g. housing, food, clothing)
a. Each index is a weighted average of prices.
(e.g. food includes coffee, bread and milk)
2. Then a weighted average of the indexes of the 13 commodity groups is formed. That is the RPI
b. e.g. food has a weight of .144
C. In Vietnam, the General Retail Price Index is dissaggregated into three sub indexes;
1. Food grain and foodstuffs
2. Other Consumer Goods
3. Agri-Production Materials
D. Prior to 1989, the General Retail Price Index was the weighted Sum of:
1. The Official Price Index
2. The Free Market Price Index
(WB p 248)
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(B 20-5)
A. the GDP deflator measures the average level of prices of all the goods and services included in GDP.
1. Nominal GDP (YN) is GDP where goods and services are valued using current year prices.
a. Nominal GDP (YN) can be deflated using the GDP deflator to calculate real GDP (Y).
2. Real GDP (Y) is calculated by valuing the goods and services produced in a given year at base year prices.
a. Changes in real GDP (Y) better reveal changes in the production of goods and services over time.
B. The GDP deflator is the ratio of nominal GDP (YN) to real GDP (Y) expressed as an index
1. The GDP deflator is calculated by:
a. Dividing the real GDP (Y) by the nominal GDP (YN) and multiplying by 100.
a. GDP Deflator = Real GDP * 100
Nominal GDP
2. If the current period is the base period, the GDP deflator is 100.
C. The GDP deflator is much more inclusive than the CPI or RPI, it also includes:
1. Investment expenditures (I)
2. Government expenditures (G), and
3. Net exports (NX)
D In Vietnam these are the values of the Nominal GDP (Billions of Dong), the Implicit GDP Deflator (1982 = 100) and GDP at 1982 prices
GDP GDP
at Current Prices Implicit GDP Deflator at 1982 Prices
1984 64.8 307 211.2
1985 131.1 587 223.2
1986 636.0 2,757 230.7
1987 3,099.0 12,929 239.7
1988 13,266.0 52,664 251.9
1989 25,557.8 93,963 272.0
1990 38,167.0 133,172 286.6
1991 69,959.0 232,422 301.0
(WB p. 235)
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A. A relative price is the ratio of the price of one product to the price of another good.
1. RP = P1 / P2
B. The percentage change in a relative price is the percentage change in the price of one good minus the percentage change in another good.
1. % CHANGE in RP = % CHANGE in P1 - % CHANGE in P2
C. Inflation is not caused by changes in relative prices.
1. Any inflation rate can occur with any behavior of relative prices.
VI. Real GDP, Aggregate Economic Activity and Economic Well-being
(B- 20-5)
A. Economic welfare measures the nation's overall state of well being, that is, its standard of living.
B. Economic welfare depends on:
1. The quality and quantity of goods available.
2. The amount of leisure time;
3. The degree of equality among individuals.
C. Real GDP (Y) is not a perfect measure of economic well- being for the following reasons:
Real GDP (Y) does not include:
1. Production in the underground economy,
a. Underground economy includes economic activities that is legal but is not reported to the authorities.
b. Usually not reported to evade taxes or regulations
2. Subsistence (nonmarket) household production refers to productive activities done in and around the house by the homeowner or the family.
a. These activities are excluded because they are hard to measure.
b. Household production is countercyclical. When people lose jobs, they do more household work.
(e.g. home repairs and expansion)
c. Due to specialization, there is a long run declining trend in subsistence household production
d. Growth rates of developing countries can be inflated by shift of production from household to the market.
(e.g. making clothing)
3. Environmental damage.
a. Resources used to control damage of production are treated as part of GDP.
(e.g. water treatment plants)
b. Damage to environment would not be deducted.
(e.g. noise pollution, water pollution)
4. Leisure time
a. Leisure time is the opportunity cost of working
b. Not counted in GDP.
c. Does provide great welfare
i. Often complementary to GDP (you need time to enjoy your books, boat, TV etc
D. Real GDP does not take into account:
1. Inequality of distribution of income
a. The same income distributed more equally may give higher welfare. (diminishing marginal utility of money)
2. The composition of output
a. An economy producing mainly consumer goods may have a higher level of well being than a country producing mainly military goods.
3. Non-economic factors
a. Personal security (crime, ethnic violence)
b. Income security (Secure jobs or social safety net)
c. Family solidarity
d. Freedom, human rights and participation
4. Size of the population
a. Per capita real GDP is a better measure of average welfare.
b. Per capita real GDP (YPC) is Real GDP (Y) divided by the total population
YPC = Income/ Population = Y / POP
c. For a given level of real GDP (Y),
i. a larger population (POP) means
ii. a smaller quantity of goods and services available to each individual.
d. The per capita GDP in Viet Nam (in 1991) was equal to
70 trillion Dong
70 million people
1 million dong / person = $200 in 1991
d. The rate of growth of real GDP per capita (YPC) is equal to:
i. the rate of growth of GDP (Y) minus
ii. the rate of growth of the population (POP).
% Change YPC = % Change in Y - % Change in POP
iii. Rates of Growth in Vietnam
GDP = 8%
POP = 2%
GNP/POP = 8% - 2% = 6%
Doubling time increased from 9 to 12 years
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A. The validity of inferences about changes in welfare from changes in Real GDP depend on whether you are concerned with:
1. changes over the business cycle or
2. Changes over the long term or
3. Inter country comparisons of living standards and welfare.
B. Business cycle fluctuations probably overstate:
1. the changes in total production and
a. Increase in non-market production
2. Changes in people's welfare.
a. Inventories of durables
C. For comparing living standards between countries or within one country over an extended period of time,
1. the GDP's shortcomings are probably quite important.
a. Changes in composition of output
b. Changes in quality of output
c. Changes in distribution of output
d. Changes in leisure time
e. Changes in the size of the population
VII. Summary of the lecture
The circular flow of expenditure and income
All economic decision makers-households, firms, governments, and the rest of the world-interact in the circular flow of income and expenditure. Households sell factors of production to firms and buy consumption goods and services from firms. Firms hire factors of production from households and pay incomes to households in exchange for factor services. Firms sell sell consumption goods and services to households and capital goods to other firms. Government collects taxes from households and firms, makes transfer payments under various social programs to households, and buys goods and services from firms. Foreigners buy buy goods and services from domestic firms and sell goods to them.
The flow of expenditures on final goods and services winds up as somebody's income. Therefore,
Aggregate income = Aggregate expenditure
Furthermore, expenditure on final goods and services is a method of valuing the output of the economy. Therefore,
GDP = Aggregate expenditure = Aggregate income
From the firms accounts we know that
Y = C + I + G + EX - IM
and from the household's accounts we know that
Y = C + S + T.
Combining these two equations, we obtain
I + G + EX = S + T + IM
This equation tells us that injections into the circular flow (left side) equal the leakages from the circular flow (right side).
U.S. National Income and Product Accounts
Because aggregate expenditure, aggregate income, and the value of output are equal, national income accountants can measure GDP using one of two approaches: the expenditures approach and the factor incomes approach.
The expenditure approach adds together consumption expenditure, investment, government purchases of goods and services, and net exports to arrive at an estimate of GDP.
The factor incomes approach adds the incomes paid to the various factors of production plus profits paid to the owners of firms. To use the factor incomes approach, it is necessary to make an adjustment from the factor cost value of GDP to the market price value by adding indirect taxes and subtracting subsidies. It is also necessary to add capital consumption in order to arrive at at GDP.
To value the output of a firm or sector in the economy, we measure value added. The use of value added avoids double counting.
Price level and inflation
There are two major price indexes that measure the price level and inflation: the Consumer Price Index and the GDP deflator.
The CPI measures the average level of prices of goods and services typically consumed by an urban family in the United States. The CPI is the ratio of the base period basket of commodities at current-period prices to the value of the same basket at base-period prices, multiplied by 100.
The GDP deflator is nominal GDP divided by real GDP, multiplied by 100. Nominal GDP is calculated by valuing current period quantities by current-period prices. Real GDP is calculated by valuing the quantities produced in the current period at the prices that prevailed in the base period.
In interpreting changes in prices, we need to distinguish between inflation and changes in relative prices. A relative price is the price of one good in terms of another goods. Relative prices are constantly changing. We cannot tell anything about the sources of inflation by studying which prices have changed most. Any relative price changes can occur with any rate of inflation.
Because relative prices are constantly changing and causing consumers to substitute less expensive items for more expensive items, because of the disappearance of some goods and the arrival of new goods, and because of quality changes, the CPI is an imperfect measure of the cost of living, especially when comparisons are made across a long time span.
Real GDP, Aggregate Economic Activity, and Economic Well-being
Real GDP is not a perfect measure of aggregate economic activity or of economic welfare. It excludes production in the underground economy, household production, environmental damage, and the contribution to economic welfare of equality and leisure.
Key concepts
1. Aggregate expenditure (AY)
2. Aggregate income (AY)
3. Benefits (B)
4. Capital stock (K)
5. Circular Flow of payments (Dong luan chuyen thanh toan)
6. Consumer Price Index (CPI)
7. Consumption expenditure (C)
8. Depreciation (DEP) (khau hao)
9. Direct taxes (Thue truc thu)
10. Disposable income (YD)
11. Double counting
12. Durable goods
13. Economic welfare
14. Expenditure approach
15. Exports (xuat khau )
16. Factor cost
17. Factor incomes approach
18. Final goods (Hang hoa cuoi cung)
19. GDP Deflator (He so giam phat GDP)
20. Government Spending on (Chi tieu cua chinh phu vao Goods and services (G) hang hoa va dich vu)
21. Gross investment (GI)
22. Gross Domestic Product (Y) (GDP)
23. Gross National Product (GNP) (GNP)
24. Gross National Product (GNP) (GNP theo gia thi truong)
at Market Prices
25. Gross National Product (GNP) (GNP theo chi phi cho yeu at Factor prices to san xuat)
26. Imports (nhap khau)
27. Indirect tax (TI) (Gian thu)
28. Injections (bom vao)
29. Intermediate goods (hang hoa trung gian)
30. Inventories
31. Investment (I)
32. Leakages (cac khoan ro ri)
33. Market price
34. National Income (thu nhap quoc dan)
35. National income accounting (hach toan thu nhap quoc dan)
36. National income accounting identity
37. Net domestic income at factor cost
38. Net domestic product (NDP) (NDP)
39. Net economic welfare (Phuc loi kinh te rong)
40. Net Excise taxes (TE)
41. Net exports (NX) (xuat khau rong)
42. Net investment (NI)
43. Net property income abroad (NPIA) (thu nhap tai san rong tu nuoc ngoi)
44. Nominal GDP (YN) (GDP danh ngia)
45. Nondurable goods
46. Per capita real GDP (GDP thuc te tinh theo dau ngoi)
47. Real GDP (Y) (GDP thuc te)
48. Relative price
49. Retail Price Index (RPI)
50. Saving (S)
51. Subsidy (SUB)
52. Transfer payments (TR) (Thanh toanh toan chuyen nhuong)
53. Underground economy
54. Value added (VA) (Gia tri gia tang)
Questions for Review
1. What are the components of Aggregate Expenditure (AE)?
2. What are the components of Aggregate Income (AY)?
3. Why does Aggregate Income (AY) equal Aggregate Expenditure (AE)?
4. In what way are government purchases of goods and services (G) different from transfer payments (or benefits) (B) ?
5. What are the injections to the circular flow of income?
6. What are the leakages from the circular flow of income?
7. Why do injections from the circular flow just equal leakages?
8. Why does total value added (VA) equal GDP (Y)?
9. What are the two main types of indexes used for measuring inflation?
10. How is the CPI calculated?
11. How is the RPI calculated?
12. How is the GDP deflator calculated?
13. What are the weaknesses of real GDP (Y) as a measure of welfare?
Questions based on lecture 5
1. Would the Gross Domestic Product System of Accounting be as useful to economic planners as the system of Material Product Accounts?
2. Would the Gross Domestic Product System of Accounting be as useful to the makers of macroeconomic policy in Viet Nam as the system of Material Product Accounts?
3. Would we get a more accurate picture of the productivity of the economy of Viet Nam if we counted the total product of each firm and enterprise instead of counting only the "value added" by the firm or enterprise?
4. In some countries a significant portion of the total consumption comes from illegal sources. For the sake of accuracy and completeness should estimates of this consumption be included in the GDP figures of these countries?
5. Ba Phuong earned 50,000 dong selling vegetables at a market in Ha Noi and she put all that money under her bed, how much has she saved? Unfortunately, there was a fire in her house and the money was totally destroyed, how much has Ba Phuong saved?
6. Mr. Tam, a young man in Ho Chi Minh City, needed money. So he sold his bicycle to a friend for 220,000 dong. How much has Mr. Tam added to the GDP of Viet Nam by selling his bicycle?
7. The TRACIMEX Company in Ha Noi bought a Japanese Panasonic Video Cassette Recorder (VCR) for 2 million dong and sold it to Miss Ha for 3 million dong. How much has the TRACIMEX Company added to the GDP of Viet Nam by selling that VCR to Miss Ha?
8. The per capita real GDP of Singapore is reported to be 60 times higher than the real per capita GDP in Viet Nam. Does that
mean that people living in Singapore are 60 times happier than people living in Viet Nam?
9. Can one single price index measure the changes in the cost of living for all the people in Vietnam whether they live in the North or the South and whether they live in cities or in rural areas?
10. The economy of Viet Nam is growing rapidly, at about 8% per year, while the economy of the United States is growing at only about 3% per year. Why does that make it more difficult to measure changes in the price level in Viet Nam than in the United States?
Problem based on lecture 5
1. Last year, Middlebury, Vermont declared itself an independent nation and this year, for the first time, the new nation of Middlebury published its national accounts data. The report shows all the important data but the economists in Middlebury do not know how to calculate the important aggregates. Can you help them?
2. The data: (in U.S. dollars)
Material Production 60,000
Consumer expenditures 80,000
Subsidies 6,000
Rents 2,000
Net income from abroad -4,000
Government purchases 15,000
Indirect Taxes 2,000
Profits 18,000
Capital Consumption 6,000
Investment spending 12,000
Exports 30,000
Wages 70,000
Imports 35,000
Interest 10,000
Direct taxes 10,000
Services 42,000
Agriculture 30,000
3. Can you calculate the following Aggregates for Middlebury?
a. Gross Domestic Product ________________.
b. Gross National Product ________________.
c. Net Domestic Income at Factor Cost _______________.
d. Net Domestic
Product an Market Price _______________.
e. Disposable Income _________________.
f. Saving __________________.
4. The economy of Middlebury in 1993 was much smaller than the economy of Viet Nam. But were the relative sizes of the components of the GDP of Middlebury similar to the relative sizes of the components of the GDP of Viet Nam?