This chapter include objectives: Explain how the Consumer Price Index is constructed and use it to calculate the inflation rate; show how the CPI is used to adjust economic data to eliminate the effects of inflation; discuss the two most important biases in the CPI; distinguish between inflation and relative price changes to find the true cost of inflation; summarize the connections among inflation, nominal interest rates, and real interest rates.
Spending, Income, and GDP Chapter 15 McGrawHill/Irwin Copyright © 2015 by McGrawHill Education (Asia). All rights reserved 151 Learning Objectives Explain how economists define and measure an economy's output Apply the expenditure method for measuring GDP to analyze economic activity Define and compute nominal GDP and real GDP Discuss the relationships between GDP and economic well-being 152 Macroeconomics • Data on output, employment, prices – Vital signs of the economy • • • – • Employment, unemployment, average work hours Stock values and trends Prices and inflation Reported often in the news Systematic measurement of economic output developed during World War II – Common systems and measures used virtually worldwide 153 Measuring Output 154 Market Value • • Aggregate measure of quantities produced More expensive items receive a higher weighting – Willingness to pay is an indication of benefit received from the good Orchardia Price Quantity GDP contribution • Apples Bananas Shoes $0.25 $0.50 $20.00 $1.00 $3.00 $60.00 Orchardia's GDP is $64 155 Some Non-Market Goods Included • Government goods and services are not sold in the market – – – – • These goods have value Increase overall output Quantities are known Prices cannot be established Government production is valued at cost – Overstates GDP if there is waste and inefficiency 156 Final Goods and Services • Final goods and services are consumed by the ultimate user – – • Intermediate goods and services are used up in the production of final goods – • End products of production Included in GDP Not included in GDP to avoid double counting A barber's assistant earns $2 per haircut for providing services such as shampooing and sweeping up – – Barber charges $10 per haircut Haircut's contribution to GDP is $10 157 Goods Can Be Final and Intermediate • Milk can be sold as a final product or used as an intermediate good – – – • A capital good is a long-lived good used in the production of other goods and services – – – • Liters of milk in the store Liters of milk sold to restaurants Count only the final goods Houses, apartments, and motels Stoves in restaurants, cooking schools Delivery vehicles and taxis Money is not a capital good 158 Value Added • Value added is the market value of the product minus the cost of inputs purchased from other firms – – Count value added in the year it is produced Hot ‘n’ Fresh buys flour and other inputs to make bread that sells for $2.00 Revenues Cost of Purchased Inputs Value Added ABC Grain $0.50 $0.00 $0.50 General Flour $1.20 $0.50 $0.70 Hot'n'Fresh $2.00 $1.20 $0.80 Company Total $2.00 159 Produced in a Country in a Period of Time • "Domestic" in GDP means the activity is measured within a country's borders – • Nationality of owners or company is not relevant Value must be produced in the year considered – Sell a 20-year old house for $200,000 • • • • Pay $12,000 commission Value added is $12,000 House was not produced in the period of time studied Count income generated from the sale of used goods 1510 Adjusting for Price Changes • • Compare GDP for different years to see how much output has changed GDP changes over time because – – • Prices change AND Quantity of output changes To see how much output has grown, use only the changes in quantities – Hold prices constant 1522 The Donut and Cupcake Economy • GDP in 2009 is $175; GDP in 2013 is $420 – • GDP in 2013 is 2.4 times the GDP in 2009 Only twice as many donuts and cupcakes were produced in 2013 – Market value of output grew faster than the physical volume of output Number of Donuts Price of Donut Number of Cupcakes Price of Cupcake 2009 10 $10 15 $5 2013 20 $12 30 $6 1523 Real GDP and Nominal GDP • Real GDP values output in the current year using the prices from the base year – – • The base year is a reference year that changes infrequently Real GDP measures the physical volume of production Nominal GDP values output in the current year using prices from the current year – Nominal GDP is the current dollar value of production 1524 Calculating Real GDP for 2013 • • • Use 2009 as the base year Nominal GDP for 2009 is $175 and for 2013, $420 Calculate real GDP using current year quantities and base year prices Real GDP in 2013 is (20 donuts) ($10) + (30 cupcakes) (5) = $350 – • Real GDP doubled between 2009 and 2013 Number of Donuts Price of Donut Number of Cupcakes Price of Cupcake 2009 10 $10 15 $5 2013 20 $12 30 $6 1525 Observations on Real and Nominal GDP • • Usually, nominal and real GDP increase each year Nominal GDP can go up and real GDP go down – – • Nominal GDP will be smaller than real GDP if the prices in the current year are less than in the base year – • Fewer goods and services produced AND Prices increase faster than output decreased Usually true for years before the base year Real GDP could rise and nominal GDP fall, but this is rare – Prices are falling faster than output is increasing 1526 Real GDP and Economic Well-Being • Real GDP is a flawed measure of well-being – It values only market transactions • • Omits illegal transactions, volunteer work, and household production Maximizing GDP will not necessarily maximize national well-being – Whether increases in output increase welfare is a case-by-case issue 1527 GDP Does Not Value Leisure • Amount of leisure time has increased in the past 100 years – – – • Work weeks are shorter People enter the labor force at an older age People retire earlier Leisure produces no goods for market – – – GDP places a value of zero on all leisure time Opportunity cost of an hour of leisure is your hourly wage Omission of the value of leisure time makes GDP seem smaller 1528 Nonmarket Economic Activities • GDP omits services that are not traded in markets – – • • Household production Volunteer services Valuing these services would be difficult Nonmarket activities are important in poor countries – Self-sufficient households and bartered goods and services 1529 Underground Economy • • Underground economy is all unreported transactions, legal and illegal Casual labor is often paid in cash – – • Some underground activity is illegal – – • Failure to report transaction reduces taxes Includes baby sitters, tutoring, home repair, etc A service of value is provided Drug dealers, bookies, fences, prostitution, etc Estimates suggest the underground economy is large regardless of national income level 1530 Environmental Quality • Suppose a factory is built in your town – People are employed and output is produced • • Productive activity is included in GDP Suppose further that the factory creates pollution – – Your city hires a company to restore the environment to its initial condition Clean-up activities are included in GDP • Gets environment back to its starting point, not better 1531 Resource Depletion • No adjustment is made for the decline in resource availability when mining or other harvesting is done – • One more barrel of oil on the market means one less barrel for future use Environmental quality and resource depletion are difficult to value – They have value and that value is omitted from GDP 1532 Other Quality of Life Considerations • GDP does not account for intangibles people value – – – – – Crime rates Traffic congestion Civic organizations Open space Sense of community 1533 Poverty and Economic Inequality • GDP does not capture the effects of income inequality – • US uses an absolute standard of poverty – • Most would prefer living in a relatively equal society to one with a few wealthy and many poor In 2011, a family of four was poor if their income was less than $22,350 Inequality matters and it is increasing in the US – The case of the beat-up car 1534 GDP as a Welfare Measure • • GDP omits and undervalues some goods and services GDP per capita is positively associated with several measures of well-being – Material standard of living: more goods and services – Health and life expectancy • Residents of industrialized countries fare better than residents of developing countries in a range of health measures – Education • Literacy and school enrollment rates are higher in high-income countries 1535 Spending, Income, and GDP Gross Domestic Product Production Method Expenditure Method Real and Nominal Values Income Method GDP and Well-Being 1536 ... – Market value of output grew faster than the physical volume of output Number of Donuts Price of Donut Number of Cupcakes Price of Cupcake 2009 10 $10 15 $5 2013 20 $12 30 $6 15 23 Real GDP... • Real GDP doubled between 2009 and 2013 Number of Donuts Price of Donut Number of Cupcakes Price of Cupcake 2009 10 $10 15 $5 2013 20 $12 30 $6 15 25 Observations on Real and Nominal GDP • •... – GDP places a value of zero on all leisure time Opportunity cost of an hour of leisure is your hourly wage Omission of the value of leisure time makes GDP seem smaller 15 28 Nonmarket Economic