Chapter 2: Measuring the Economy1
2
Measuring the Economy
Overview
- The goal of macroeconomics is to understand how real world economies operate. In this chapter, we learn how to measure stocks and flows. We begin by breaking down the world economy into parts and show how they are related to each other. We also look at different ways of calculating the gross domestic product. We then distinguish the measurement of wealth (a stock) from the measurement of income (a flow). Finally, investment, which represents additions to the capital stock, links together the measurement of wealth and income.
- The country that we are interested in is called the domestic economy, and we refer the collection of all other economies as the rest of the world. The domestic economy is a closed economy if it is studied in isolation from the rest of the world. If we explicitly consider the interactions that arise with other countries, then this is called the study of an open economy.
- Macroeconomists often treat the entire domestic economy “as if” aggregate variables were chosen by a single decision maker. Depending on the issues that are under investigation, we break down the economy further into its component parts. The most important division is between the government and the private sector. A further useful division is to break the private sector into the households and firms. This distinction between households and firms play an important role in models of income determination.
- The gross domestic product (GDP) is the value of all final goods and services produced within the United States in a year. Final goods are those that are sold directly to final users as opposed to intermediate goods that are produced by one firm and used as an input by another. The valued added of a firm is the difference between the value of the output that it sells and the value of the intermediate goods used in the production process. The Commerce Department measures GDP using three methods: (1) the income method, (2) the expenditure method and (3) the product (or value added) method.
- Figure 12-1 presents the circular flow of income that shows the flow of income and output around the economy. Households spend money on goods and services (called domestic expenditure) produced by firms. Firms pay money for the services of factors of production, labor and capital. The income that is earned by the supply of labor services is called labor income and the income that is earned from supplying the capital services is called profits. By adding up all of the income earned by the factors of production, we arrive at the income method of measuring GDP.
- Final goods are commodities that are sold to final users; these include consumption goods sold to households, investment goods sold to firms and consumption and investment goods sold to the government. By adding up all of the expenditures on final goods and services, we arrive at the expenditure method of measuring GDP.
- The income and expenditure methods of computing GDP corresponds to measuring this flow at different points in the water pipe. The product (value added) method requires a diagram that keeps track of the flows between firms at different stages in the production process. Box 2-2 constructs an example to illustrate this third method and shows how it is connected with the other two approaches.
- The components of GDP in a closed economy are consumption, investment and government expenditure. In an open economy, GDP also includes exports but excludes imports. Consumption goods are commodities that meet our immediate needs. Investment goods are commodities that help us to produce more goods in the future. Households save money by abstaining from consumption and these savings are channeled to firms through the capital market. Firms carry out investment when they purchase new factories and machines. To raise money for investment, firms either borrow directly from the banks or other financial institutions in the capital market. Alternatively, firms may finance investment from retained earnings, which are profits that are used to purchase new capital instead of being returned to shareholders as dividends.
- GDP in a closed economy is identically equal to the income earned by its residents. The largest component of income represents payments to the services of labor; this is called compensation to employees. Other categories include net interests, rent, corporateprofit and proprietor’s income. In our discussion, we will distinguish only two types of income, labor income that we call wages and capital income that we call profits. In the U.S., the labor’s share of income is approximately 2/3 and the capital’s share is 1/3.
- The GDP accounting identity for a closed economy as in (2-1) says that GDP is equal to private consumption plus private investment and government purchases of goods and services. Total consumption is equal to the sum of private consumption expenditure and government spending on consumption goods. Total investment is equal to private investment expenditure plus government spending on investment goods.
- Saving is defined as the part of income that is not consumed and investment refers to additions to the stock of capital goods. Therefore, total saving is equal to GDP minus total consumption. It follows that in a closed economy, saving and investment must be equal. This is not true in an open economy since countries may invest more than they save by borrowing from abroad.
- The word deficit means an excess of expenditure over income. When a government spends more than it earns, we call the excess the government’s budget deficit. This results in an accumulation of government debt. By contrast, when the government revenues exceed expenditure, we say the government budget is in surplus. This results in an accumulation of government assets, and we also refer to a budget surplus as government saving.
- When the nation as a whole spends more on foreign goods and services than it earns by selling exports to foreigners, we call the excess the nation’s trade deficit. If exports exceed imports, then the nation enjoys a trade surplus with the rest of the world. Since the trade surplus is equal to the difference of exports over imports, we also call this difference net exports or balance of trade. With these definitions, the GDP accounting identity for an open economy as in (2-5) says that GDP is equal to total consumption plus total investment and net exports. This implies that net exports is equal to total saving minus total investment.
- Disposable income is defined as total income plus transfer payments minus taxes. Private saving is equal to disposable income minus private consumption. It follows that private saving plus government saving is equal to the net exports, as described in (2-9). When the government runs a budget deficit, it can finance the deficit by borrowing from its residents (this happens when private saving is greater than private investment) or it can borrow from the rest of the world (this happens when imports is greater than exports.)
- A flow is the rate of change of a stock. An important economic example is the relationship of government debt, a stock, to the government budget deficit, a flow. Table 2-2 illustrates this relationship using the example of an individual. It shows that a constant deficit every month leads to an accumulation of debt.
- Physical capital is a real asset and promises to deliver resources in the future are financial assets. An individual who promises to deliver goods in the future incurs a financial liability. In a closed economy, every financial asset is someone else’s financial liability. That is, the sum of total financial assets and liabilities is identically equal to zero.
- The total wealth (called net worth) of an agent is the sum of his assets (both real and financial) minus the sum of his financial liabilities. The method used to keep track of assets and liabilities of the households and firms in an economy is called balance sheet accounting. Table 2-3 presents an example for an individual and Table 2-4 applies the balance sheet accounting to the nation.
- The portion of gross investment that contributes to increases in the stock of capital is called net investment. The portion that is devoted to replacing worn out capital is called depreciation. The net domestic product (NDP), which equals GDP minus depreciation, is the maximum output of an economy that is available for consumption without running down the stock of capital.
- Table 2-5 shows how the flows recorded in the National Income and Product Accounts show up as changes of stocks in the balance sheets of the U.S. economy from one year to the next. The increase in net worth is less than the increase in real assets because part of the increased capital was purchased with borrowed funds.
- MULTIPLE CHOICE QUESTIONS
1.Which of the following is a stock variable?
a)Rate of unemployment.
b)Government budget deficit.
c)Depreciation cost of capital.
d)None of the above.
Answer: D
1.The GDP of an economy is
a)The total value of goods and services produced in that year.
b)The total value of goods (excluding services) produced domestically in that year.
c)The total profits earned in that year.
d)The total value of goods and services produced only by citizens in that year.
Answer: A
1.The value added of a firm is the value of
a)It's output minus the value of all inputs.
b)It's output plus the value of all inputs.
c)It's output minus the value of intermediate inputs.
d)It's output sold to the firms.
Answer: C
1.Which of the following helps economists avoid double counting in their computation of GDP?
a)Include only goods and services produced in a certain time period only.
b)Do not include intermediate goods in the computation of total production.
c)Do not include transfer payments in the computation of total income.
d)All of the above.
Answer: D
1.Which of the following would not be included in computing GDP using the income method?
a)Corporate profit and proprietor's income.
b)Compensation to employees.
c)Rent.
d)Depreciation allowances.
Answer: D
1.The total GDP in the U.S. in 1997 was approximately (in billions of $)
a)10,050.
b)8,083.
c)6,000.
d)4,560.
Answer: B
1.National Income of an economy is obtained from it's Net National Product by
a)Subtracting net exports.
b)Adding net factor incomes earned from abroad.
c)Adding depreciation costs.
d)Adding income earned abroad by U.S. citizens.
Answer: B
1.Total (government plus private) consumption accounts for roughly
a)45% of GDP.
b)60% of GDP.
c)80% of GDP.
d)93% of GDP.
Answer: C
1.The share of GDP going to labor in the U.S. is approximately
a)1/3.
b)2/3.
c)3/4.
d)5/6.
Answer: B
1.Government expenditure makes up roughly
a)30% of GDP.
b)50% of GDP.
c)75% of GDP.
d)80% of GDP.
Answer: A
1.Government savings is
a)The negative of the government budget deficit.
b)The negative of private saving.
c)The difference between GDP and total consumption and investment expenditure.
d)Always zero because GDP is always equal to the sum of total income earned.
Answer: A
1.The balance of trade is measured by
a)Total exports.
b)The sum of total exports and imports.
c)Total borrowing and lending among households.
d)Exports net of imports.
Answer: D
1.Suppose that a bakery produces cakes worth $1,000 using $500 for labor, $250 for flour and $100 for sugar. Its value added is
a)Zero.
b)$ 150.
c)$ 650.
d)$ 500.
Answer: C
1.Suppose the capital stock at the end of 1996 was $5,000 in Xanadu. If the gross investment figure for 1997 was $1,500, and the capital stock at the end of 1997 was $5,500, then the depreciation rate in 1997 must have been
a)20%.
b)25%.
c)18%.
d)10%.
Answer: A
1.If government expenditure is $5,000, taxes net of transfer payments is $3,500, then the government budget surplus is
a)- $1,500.
b)+ $1,500.
c)+ $8,500.
d)+ $4,250.
Answer: A
1.Which of the following will not be counted as a liability for John Doe
a)$56,700 in mortgage.
b)$3,500 in auto loan.
c)$1,000 owed to the credit card company.
d)$9,470 loaned to his friend.
Answer: D
1.Disposable income is defined as personal income minus taxes
a)Plus savings.
b)Plus transfer payments.
c)Plus net exports.
d)Minus imports.
Answer: B
1.Which of the following statements about the U.S. budget deficit is true?
a)It has been steadily declining in recent years.
b)It increased sharply during the 1980's under the Reagan admininstration.
c)It was associated with a trade deficit in the 1980's.
d)All of the above.
Answer: D
Problems
1.The following table represents GDP and population for Africa, Asia, U.S. and Canada, Europe and Latin America in 1988. Fill in the missing regional names at the head of each column.
(a) / (b) / (c) / (d) / (e)GDP (% of World) / 30 / 23 / 36 / 3 / 7
Population (% of World) / 57 / 5 / 15 / 11 / 12
2.An economy has two firms. Households own all of the labor services and all of the capital which they rent out to the firms. Firm A produces sugar using labor services worth $10 and capital services worth $20. It sells $15 worth of sugar to households and $15 of sugar to firm B; a bakery. The bakery produces cakes worth $60 that it sells directly to households. Households earn $30 in wages from firm A and B combined.
(a)What is the value of GDP in this economy?
(b)What is the value added by firm A?
(c)What is the value added by firm B?
(d) How much does the household earn in profit from firms A and B combined?
(e)What is the total value of intermediate goods produced in this economy?
3.What do economists mean by investment? What is saving? What is the relationship between saving and investment in a closed economy?
4.What is a closed economy? In an open economy, is it identically true that Y = C + I + EX - IM, where C is private plus government consumption, I is private plus government investment, EX is exports, IM is imports and Y is the value of GDP? Show that if exports is equal to imports, then investment must equal saving. [HINT: you will need to define saving.]
5.Briefly explain the difference between a stock and a flow. Give two examples of each.
6.Which of the following are stocks and which are flows -- a house, rent, mortgage payments, a bank account, a dollar bill, saving, investment, depreciation, a loan from a bank, interest on a loan from a bank, GDP, income, the money supply, employment in 1997?
7.What percentage of GDP in the U.S. is accounted for by private plus government consumption since 1930? Private plus government investment?
8.What percentage of GDP in the U.S. has been earned by labor and capital, respectively?
9.Write down an equation that describes the breakdown of saving and investment between public and private sectors.
10.If government consumption increases, will the trade balance increase or decrease? Explain your answer.
11.Explain why a country with a budget deficit tends to import more than it exports?
12.Why did the trade balance of the U.S. deteriorate in the 1980’s? Explain your answer.
13.The following data shows the balance sheet of the average resident of Econoland in 1996 and 1997, where capital is measured in 1996 dollars. Assume that the only way of storing wealth in Econoland is to accumulate capital.
January 1996 / January 1997Assets / Liabilities / Assets / Liabilities
Capital / Net Worth / Capital / Net Worth
$16,000 / $18,000
(a)Fill in the values of net worth in 1996 and 1997.
(b)What was the net investment in 1996?
(c)Assuming that capital depreciates at a rate of 10%, what was the gross investment in 1996?
14.The following figures represent gross investment in Liliput during the 1990’s. All figures are in 1990 dollars, i.e., Liliput uses 1990 as the base year for its GDP calculations.
1990 1,200
1991 900
1992 1,500
1993 600
1994 800
At the end of 1989, the stock of capital was equal to $5,000. Assuming that the capital depreciation rate is 10% per year, calculate the capital stock in 1995.
15.GDP of a closed economy in 1997 was equal to $20,200, depreciation was $2,900 and total gross investment (public and private) was $3,800 (all in per capita magnitudes). What was the value of
(a)Total (public plus private) consumption?
(b)Net Investment?
(c)Net Domestic Product?
16.Explain the relationship between the Gross Domestic Product and the Net Domestic Product. Your answer should explain how the two concepts differ.
Answer Key to Problems
1.(a) Asia (b) U.S. and Canada (c) Europe (d) Africa (e) Latin America.
2.(a) $75 (b) $30 (c) $45 (d) $45 (e) $15.
3.Investment refers to additions to the stock of capital goods and saving is defined as the part of income that is not consumed. In a closed economy, saving and investment are equal to each other.
4.A closed economy is one that is isolated from the rest of the world. Yes, Y = C + I + EX - IM in an open economy. When exports is equal to imports, Y = C + I. In addition, S = Y - C, where S is total saving. Hence, investment equals saving in this case.
5.A stock is used to measure wealth at a particular point in time and a flow is the rate of change of a stock. Government debt and wealth are stocks whereas government deficit and disposable income are flows.
6.Stocks -- a house, a bank account, a dollar bill, a loan from a bank, the money supply. Flows -- rent, mortgage payment, saving, investment, depreciation, interest on a loan from a bank, GDP, income, employment in 1997.
7.80%. 20%.
8.2/3 for labor and 1/3 for capital.
9.(S - I) + (T - TR -G) = NX.
10.A higher government consumption reduces government saving. As a result, the trade balance falls.
11.A country with a budget deficit will borrow funds from the world capital market in order to finance its deficits. This leads to a reduction in trade balance.
12.In the 1980’s, the Reagan administration cut taxes and increased defense expenditures thereby raising the budget deficit. See Figure 2-3.
13.(a) $16,000 for 1996 and $18,000 for 1997 (b) $2,000 (c) $3,600.
14.$6,950.87.
15.(a) $16,400 (b) $900 (c) $17,300.
16.Net Domestic Product (NDP) is equal to Gross Domestic Product (GDP) minus depreciation. While GDP measures the value of all final goods and services produced within an economy, NDP measures the maximum output of an economy that is available for consumption.