Chapter 2
THE MEASUREMENT AND STRUCTURE OF THE NATIONAL ECONOMY.
Introduction.
§ In this course we are going to be dealing with issues of inflation, unemployment and economic growth but before we can study how to fight inflation, reduce unemployment and promote long-run economic growth we have to properly define those terms.
§ Proper measurement of these variables is the unavoidable first step.
- Inflation (p) is measured through the evolution of the Consumer Price Index (CPI)
- Unemployment is measured through the evolution if the Unemployment Rate (u)
- National wealth is measured through the Gross Domestic Product (GDP)
§ There are international standards to follow so that these figures can be compared among countries. National and international agencies compile and publish this type of information.
2.1 National Income Accounting.
§ We need to be able to tell whether the economy is growing, stalling or contracting at any given moment in time. We need to estimate what is the level of economic activity.
§ How is that done? We can look at a number of macroeconomic indicators: unemployment rate, interest rates, inflation rate… but the bottom line is going to be determined by the GDP.
§ You are going to learn that there are three possible ways of estimating the level of economic activity (a.k.a.: GDP). We can follow any of these approaches:
- The product approach: measuring the value of all the goods and services produced.
- The income approach: measuring all the sources of income generated by production.
- The expenditure approach: measuring all the different types of expenditure.
§ The beauty of it is that each individual approach should give us the same estimate. Why?
§ Remember the concept of the circular flow diagram. According to it, for the economy as a whole it must be that at all times:
Total Output (Product) = Total Income = Total Expenditure
- The total amount of money spent in the economy (expenditure) cannot be larger than the total amount of money received by national producers (income) and the market value of goods and services (output or product) purchased will not be larger than the expenditure or income.
§ This is the fundamental identity of national income accounting.
§ The most basic measure of economic activity is the Gross Domestic Product (GDP)
Product approach to GDP calculation.
§ According to this approach, GDP is:
“The total market value of all final goods and services produced in a country during a year.”
§ GDP stands for:
The total market value; we multiply the volume of output produced times its unitary price to calculate the total market value. We use the wholesale price because that captures the value of the goods by themselves (without transportation costs, taxes, retailing, or other expenses.)
(Problem: inflation can distort the real value of things by affecting prices)
of all new; we are only interested in newly produced goods because if we were to account for second-hand goods we will be registering year after year the value of already produced goods. Not all goods and services are accounted for, though. The value of homemaking work (cooking, cleaning, childcare...), public goods (national defense, legal system...) and illegal activities (drugs, prostitution, extortion...) are not registered in the GDP.
(Problem: the economic impact of criminal activities can be very large in some countries)
final goods and services; some goods are produced as parts for more complex goods and if we were to register the value of both parts and the whole we will be incurring in double accounting. We are only interested in the value of final goods.
(Note: capital goods, as well as inventories, are considered final goods)
produced in a country; the GDP does not distinguish among goods based on the nationality of the producer, it just registers the production that takes place within the US borders. If we classified output by producer’s nationality we would obtain Gross National Output (GNP.)
(Note: for some countries the difference between GNP and GDP can be very significant)
Go to http://www.worldbank.org/ and compare Nigeria with Bangladesh.
The difference between GDP and GNP is defined as Net Factor Payments from abroad.
during a year; the GDP figures are released only once a year because their calculation is very time consuming. These figures are compiled through surveys, polls and estimates.
(Note: quarterly estimates are also available)
Expenditure approach to GDP calculation.
§ According to this approach, GDP is calculated as the sum of all the possible different ways of spending the incomes generated in the production process.
§ In the most basic national account identity, the income-expenditure identity, we can write:
Y = GDP = C + I + G + NX
where: Y = output = product = gross domestic product = GDP
C = consumption, expenditure by households
I = investment, expenditure by firms
G = government purchases of goods and services (not transfers)
NX = net exports (X - M, value of exports minus value of imports)
§ Consumption is the expenditure on final goods and services done by households (e.g.: food, clothing, transportation, education…) It does not include construction of new homes (that’s I.)
§ Investment is the expenditure on capital goods done by firms (e.g.: drilling and pressing machines –goods that are used to produce other goods and therefore are not final.)
- Total investment adds up private investment (by firms) and public investment (by the government –in the form of roads, dams, post offices, military equipment…)
- Because the existing capital stock deteriorates with use and becomes obsolete over time (this is called depreciation) it has to be replaced. Therefore when we talk about investment we will refer to Net Investment. (Net Investment = Gross Investment – Depreciation)
§ Government purchases is the expenditure on final goods and services done by the government for its day-to-day operations (e.g.: wages, paper clips, cigars…)
§ Net exports is the difference between the expenditure on American goods done by foreigners (X, exports) and the expenditure on foreign goods done by Americans (M, imports)
(See Table 2.1 for discussion of GDP components according to the expenditure approach)
Income approach to GDP calculation.
§ The income approach is based on measuring all the incomes received by all the producers involved the process of fabricating goods and providing services.
National Income =
Compensation of employees; wages, salaries, employee benefits and SS contributions.
+ Proprietors' income; income of the self-employed.
+ Rental Income of Persons; income from renting land, machines...
+ Corporate Profits; income left to firms after subtracting production costs from revenue.
+ Net Interest; interest earned from holding assets minus interest paid for borrowing money.
§ In order to calculate GDP from National Income we have to:
+ Indirect Business taxes; rendering Net National Product.
+ Depreciation of Physical Capital; rendering Gross National Product.
- Factor Income received from non-nationals;
+ Factor Income paid to non-nationals; rendering Gross Domestic Product.
(See Table 2.2 for discussion of GDP components according to the expenditure approach)
§ For some of our discussions it will be important to distinguish between the income of the private sector (private disposable income) and the income of the public sector (net government income.)
Private Disposable Income = Y + NFP + TR + INT - T
where: Y = output = product = gross domestic product = GDP
NFP = net factor payments from abroad
TR = transfers received from the government
INT = interest payment on the government's debt
T = taxes paid to the government
Net Government Income = T - TR - INT
2.3 Saving and Wealth
§ So far we have been talking about how much money the country "makes" per year. We have been measuring the activity level from year to year.
§ As it happens, not all the income generated in an economy during a year is spent in consumption (either private or public.) Some of it is saved for future expenditure.
§ Wealth will be the accumulated income over time. In order to increase the level of wealth we have to save. The volume of savings at the country-level is called national saving.
(note the distinction between income -a flow variable- and wealth -a stock variable)
The bucket example: income is water pouring in, expenditure is water leaking out.
§ Let's define some terms:
National Saving = Private Saving + Public Saving
S = SPVT + SGOVT
Since both private agents (firms and households) and the public sector (the government) can save
§ Private Saving is what is left of income (minus taxes) after we consume:
SPVT = private disposable income - consumption
or
SPVT = (Y + NFP - T + TR + INT) - C
Why don't we subtract I from Y? Because income invested is not spent in the sense that it is consumed. Investment implies buying capital goods that are used to produce more goods.
§ Public Saving is what is left of government revenue (taxes) after expenditures:
SGOVT = net government income - government purchases
or
SGOVT = (T - TR - INT) - G
The government can run a budget deficit (when expenditures are larger than income) or a budget surplus (when income is larger than expenditures.) SGOVT can be negative or positive.
§ National Saving is the saving of the economy:
S = SPVT + SGOVT = Y + NFP - C - G
§ What can we use national saving for? Let's replace Y with the income-expenditure identity:
S = (C + I + G + NX) + NFP - C - G
or
S = I + (NX + NFP) = I + CA
where: CA = Current Account Balance
decomposing S into SPVT and SGOVT we can write:
SPVT = I + (-SGOVT) + CA
This is the uses-of-savings identity.
§ So that private saving can be used to:
- Invest in physical capital (I)
- Finance the budget deficit (-SGOVT) by buying the government bonds issued as public debt.
- Lend money to foreigners (CA). If CA>0 it must be the case that we are selling goods on credit. Currently, CA<0, so we are buying on credit. We are using foreign funds to consume; we are becoming indebted to the rest of the world.
§ Let’s clarify the distinction between flow variables and stock variables (the bucket example):
- Income (Y), Savings (S) and Investment (I) are flow variables because they represent monetary amounts per unit of time. The same definition applies to Depreciation.
- Wealth (W) and the Capital Stock (K), on the other hand, are stock variables because they represent static measures of certain variables. They indicate accumulated values over time.
2.4 Real GDP, Price Indexes, and Inflation.
§ Inflation presents a problem when it comes to measuring the real value of the nation's income, consumption and saving. The presence of inflation can distort our analysis.
§ When the general price level rises, the market value of things increases, but that that does not mean that goods and services have a higher real value. It's just that prices are "inflated".
(See Table 2.3)
§ In order to know the real value of things we need to discount the value of inflation from their market value (nominal value)
Nominal GDP = Quantity produced x Selling price
Real GDP = Nominal GDP - Effect of inflation
§ How can we measure inflation? We can use two tools:
§ The GDP Deflator:
Real GDP = Nominal GDP / GDP Deflator
- The value of the Real GDP each year is calculated by choosing a base year and using the base year prices to compute the market value of all goods and services produced in following years
- This has a major drawback, choosing a base year becomes a critical factor that can change the results completely. To avoid that since 1995 we use a chain-weighted real GDP.
§ The Consumer Price Index (CPI):
Inflation = % change in the CPI
- The CPI is calculated by choosing a basket of goods and services consumed by the average American family and recording the change in their prices over time.
- It is more accurate than the GDP deflator in capturing inflation because it reflects the increase in the price of imported goods (like oil.)
- It also has some shortcomings that make it overestimate and underestimate inflation.
(See Figure 2.2 for the evolution of US cost of living measured through the CPI)
2.5 Interest Rates.
§ These are the returns that we obtain from holding financial assets (as when we lend our money to other people at a price.) They are also the cost of borrowing funds.
§ Inflation also affects the real value of interest rates because it undermines the use of money to buy goods and services. Economists say that with inflation money loses its value.
e.g.: when we deposit part of our income on a bank account our money grows in value because we collect an interest rate but at the same time inflation reduces its purchasing value.
§ In order to know the real interest rate that we obtain from a bank deposit we need to subtract from the nominal interest rate that we collect the inflation rate.
Real interest rate = Nominal interest rate - Inflation rate
or
r = i - P
(See Figure 2.3 for the evolution of the real and nominal interest rates)
§ What interest rate are we talking about? There are many interest rates in the economy (bank deposits, credit cards, bonds…) Since they all tend to move in the same direction over time we can simplify things by just talking about one representative interest rate at a time.