MEASURING A NATION'S INCOME

MEASURING  A  NATION'S INCOME

Monitoring the performance of the overall economy:

Microeconomics:

 The study of how households and firms make decisions and how they interact in markets.

Macroeconomics:

 The study of economy-wide phenomena, including inflation,  unemployment, and economic growth.

Because the condition of the overall economy profoundly affects all of us, changes in economic conditions are widely reported by the media.

The statistics might measure:

·        the total income of everyone in the economy  (GDP),

·        the rate at which average prices are rising (inflation),

·        the percentage of the labor force that is out of work (unemployment), total spending at stores (retail sales) or the trade deficit.

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. That is the task of gross domestic product (GDP).

GDP measures two things at once: the total income of everyone in the economy and the total expenditure on the economy’s output of goods and services.

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

Every transaction has two parties: a buyer and a seller.

THE CIRCULAR-FLOW DIAGRAM

Households buy goods and services from firms, and firms use their revenue from sales to pay wages to workers, rent to landowners, and profit to firm owners.

GDP equals the total amount spent by households in the market for goods and services. It also equals the total wages, rent, and profit paid by firms in the markets for the factors of production.

GDP is the market value of all final goods and services produced within a country in a given period of time.

GDP adds together many different kinds of products into a single measure of the value of economic activity. To do this, it uses market prices.

Because market prices measure the amount people are willing to pay for different goods, they reflect the value of those goods.

There are some products, however, that GDP excludes because measuring them is difficult.

GDP excludes items produced and sold illicitly. It also excludes most items that are produced and consumed at home and, therefore, never enter the market place.

GDP includes only the value of final goods.

 The reason is that the value of Intermediate goods is already included in the prices of the final goods.

• GDP includes both tangible goods (food, clothing, cars) and intangible services (doctor visits).
•  GDP includes goods and services currently produced. It does not include transactions involving items produced in the past.
•   GDP measures the value of production within the geographic confines of a country.

GDP measures the value of production that takes place within a specific interval of time. Usually that interval is a year or a quarter. GDP measures the economy’s flow of income and expenditure during that interval.

THE COMPONENTS OF GDP

GDP (Y) is divided into four components: consumption (C), investment (I), government purchases (G), and net exports (NX).

Y = C +  I  + G + NX

Consumption:

 Spending by households on goods and services, with the exception of purchases of new housing.

Investment:

Spending on capital equipment, inventories, and structures, including household purchases of new housing.

Government purchases: 

Spending on goods and services by the government. Transfer payments are not counted as part of government purchases.

Net exports:

spending on domestically produced goods by foreigners (exports) minus spending on foreign goods by domestic residents (imports).

REAL VERSUS NOMINAL GDP

If total spending rises from one year to the next, one of two things must be true: (1) the economy is producing a larger output or (2) goods and services are being sold at higher prices.

When studying changes in the economy over time, economists want to separate these two effects. In particular, they want a measure of the total quantity of goods and services the economy is producing that is not affected by changes in the prices of those goods and services.

Real GDP:

  Answers a hypothetical question: What would be the value of the goods and services produced this year if we valued these goods and services at the prices that prevailed in some specific year in the past?

Real GDP shows how the economy’s overall production of goods and services changes over time.

Nominal GDP:

The production of goods and services valued at current prices

THE GDP DEFLATOR

Nominal GDP reflects both the prices of goods and services and the quantities of goods and services the economy is producing.

By contrast, by holding prices constant at base-year levels, real GDP reflects only the quantities produced.

From these two statistics, we can compute a third, called the GDP deflator, this reflects the prices of goods and services but not the quantities produced.

GDP deflator = (Nominal GDP/Real GDP)*100.

Ø The GDP deflator measures the current level of prices relative to the level of prices in the base year.

GDP AND ECONOMIC WELL-BEING

GDP measures both the economy’s total income and the economy’s total expenditure on goods and services.

GDP per person tells us the income and expenditure of the average person in the economy. GDP per person seems a natural measure of the economic well-being of the average individual. Yet some people dispute the validity of GDP as a measure of well-being.

GDP measures everything, except that which makes life worthwhile. It does not allow for such things as the health of people, the quality of education, and the happiness of the family….

However, a large GDP does, in fact, help us to lead a good life.

GDP is not a perfect measure of well-being. Some things that contribute to a good life are left out of GDP.

Because GDP uses market prices to value goods and services, it excludes the

The value of almost all activity that takes place outside of markets.

Another thing that GDP excludes is the quality of the environment.

GDP also says nothing about the distribution of income.

Summary

Because every transaction has a buyer and a seller, the total expenditure in the economy must equal the total income in the economy.

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.

GDP is divided among four components of expenditure.

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.

GDP is a good measure of economic well-being because

People prefer higher to lower incomes. But it is not a perfect measure of well-being.