Chapter 7 Summary

private savings

disposable income minus consumer spending; disposable income that is not spent on consumption but rather goes into financial markets.

inventories

stocks of goods and raw materials held to satisfy future sales.

value added

(of a producer) the value of a producer's sales minus the value of input purchases.

Tip #2.

A primary focus of this chapter is the topic of economic aggregation. Discussion of macroeconomic issues requires the construction and development of different measures that can be used to describe the macroeconomy. Economic aggregation addresses this issue. In this chapter, you need to fully understand the process of economic aggregation and how it relates to the measurement of economic production and the overall price level.

Objective #10.

Economists measure changes in the aggregate price level by tracking changes in the cost of buying a given market basket. A price index measures the cost of purchasing a given market basket in a given year, where that cost is normalized so that it is equal to 100 in the base year. To calculate the cost of the market basket, multiply the quantities of each good in the market basket times its price and then sum these products. Then use this information to calculate a price index by dividing the cost of the market basket for a particular time period by the cost of the market basket in the base year and then multiplying this ratio by 100. The price index for the base year is always equal to 100. An example of a price index is the consumer price index, or the CPI. The producer price index (also known as the wholesale price index), or the PPI, is another price index that measures the cost of a basket of goods typically purchased by producers. The inflation rate between two years can be calculated using this formula: Inflation rate = [(price index in year 2) − (price index in year 1)/(price index in year 1)] × 100.

Objective #8.

GDP can change over time because the economy is producing more or because the prices of the goods and services it produces have increased. Real GDP calculates the value of aggregate production during a given time period, using prices from some given base year. In effect, real GDP uses constant prices. In contrast, nominal GDP is the calculation of GDP using current prices. Real GDP measures allow one to compare the growth in aggregate production in an economy over time.

GDP per capita

GDP divided by the size of the population; equivalent to the average GDP per person.

Objective #1.

Good macroeconomic policy depends on good measurement of key economic variables that provide information about how the aggregate economy is performing. These key variables include the level of aggregate income and aggregate output, the level of employment and unemployment, and the level and rate of change of prices in the economy.

Objective #5.

Gross domestic product, or GDP, is the sum of consumer spending on goods and services, investment spending, government spending, and the difference between spending on exports and imports. GDP is the total value of all final goods and services produced in an economy during a given time period. Final goods and services are goods and services sold to the final user. Intermediate goods and services are those items that are used as inputs for the production of final goods and services.

Objective #7.

Gross national product, or GNP, is the total factor income earned by citizens of a country irrespective of where they reside. GDP, in contrast, is the total factor income earned in a country without regard to the citizenship of the owners of those factors of production.

Objective #9.

In comparing GDP across countries or over time, we can eliminate differences in population size by dividing each country's GDP by its population to get GDP per capita, or the average GDP per person. Real GDP per capita is one of many important determinants of human welfare: it measures what a country can do, but it does not address how that country uses that output to affect living standards.

Tip #1.

It is important that you understand thoroughly the concepts underlying the more complicated circular-flow diagram presented in this chapter. The circular-flow diagram tracks the flows of money into and out of different markets and sectors in the economy. The flows into a market or sector must equal the flows out of that market or sector. Review this material and practice working with some numerical examples until you are very comfortable with the concepts and relationships.

Objective #11.

Many payments are tied or "indexed" to the CPI: that is, many payments are adjusted up or down when the CPI rises or falls. For example, Social Security checks are indexed to the CPI as are income tax brackets and some wage settlements. Due to this indexing there is concern as to whether the CPI accurately reflects changes in the aggregate price level. Some economists believe that the CPI overstates the rate of inflation due to the fact that the CPI calculation uses a fixed market basket and does not allow for the fact that consumers substitute away from relatively more expensive goods and toward relatively cheaper goods when prices change. In addition, the CPI may be biased due to the presence of innovation. Innovation, by widening the range of consumer choice, makes a given amount of money worth more and this is like a fall in consumer prices.

net exports

the difference between the value of exports and the value of imports. A positive value for net exports indicates that a country is a net exporter of goods and services; a negative value indicates that a country is a net importer of goods and services.

Objective #12.

The GDP deflator is not a price index, but it does provide a measure of prices. The GDP deflator is calculated as the ratio of nominal GDP for that year to real GDP for that year times 100: GDP deflator = [(nominal GDP for year n)/(real GDP for year n)] × 100. The value of the GDP deflator for the base year is always equal to 100.

Objective #3.

The circular-flow diagram provides a simplified illustration of national income and national spending. Here is a brief summary of each sector's activity. • Households receive income from selling factors of production to firms. Households receive income from wages earned by selling their labor; income, in the form of dividends and interest, from their indirect ownership (their stock and bond ownership) of physical capital used by firms; and income, in the form of rent, earned by selling the use of their land. Households gain the income they earn from selling factors of production and then use this income to purchase goods and services, to pay their taxes, and to provide private savings to financial markets. Household income net of taxes and government transfers is called disposable income. Private saving is that part of disposable income that is not spent on goods and services. • The government collects tax revenue and then returns part of this money as transfer payments. Government transfer payments are payments made by the government to individuals for which no good or service is provided in return; for example, Social Security payments and unemployment insurance payments are government transfer payments. The sum of tax revenue net of transfer payments plus funds the government borrows from the financial markets is then used by the government to purchase goods and services. • Firms hire factors of production to produce goods and services but they also expend funds to buy goods and services. This investment spending on productive physical capital and on inventories is included in the national accounts as part of total spending on goods and services. Investment spending includes expenditure on inventories, since these inventories will contribute to greater future sales of a firm. Construction of new homes is also included in investment spending since a new home produces a future stream of housing services for the people who live in the house. • The rest of the world participates in the domestic economy by purchasing goods and services produced in the domestic economy (the domestic economy's exports), by selling goods and services to the domestic economy (the domestic economy's imports), and by making transactions in the domestic economy's financial markets.

Tip #5.

The distinction between real and nominal variables is important in macroeconomics. Prices are used to measure the relative value of goods and services, but because prices do not stay constant over time in an economy it is important to measure economic variables over time using methods that correct for these price changes. Real economic variables are variables measured using prices from a designated base year. In contrast, nominal economic variables are measured with current prices and therefore are measures that do not correct for price level fluctuations. It is important to realize that if there is inflation the national income and product accounts may indicate nominal GDP is increasing, even though real GDP may be decreasing, increasing, or staying constant.

Objective #4.

The financial markets receive funds from households, as well as from the rest of the world. These funds provide the basis for loans to the government, firms, and the rest of the world.

Tip #3.

The national income accounts provide measures about the aggregate or overall economy; understanding the concept of economic aggregation is essential in the study of macroeconomics. The national income accounts are data collected and provided by the government about aggregate economic performance. The national income accounts break down the components of total spending so the behavior of households, firms, the government, and the foreign sector can be studied. The national income accounts also break down national income into wages, interest, rent, and other factor payments so factor income can be analyzed.

Objective #6.

There are different ways to calculate GDP. One method is to add up the total value of final goods and services produced in an economy during a given time period. This method requires that the value of intermediate goods be excluded from the calculation in order to avoid double counting. An alternative method is to add up total spending on domestically produced final goods and services in an economy during a given time period. A third method of computing GDP is to sum the total value of factor income paid by firms in the economy to households. All three of these methods will yield identical values of GDP for an economy during a given time period. • In calculating GDP care must be taken to avoid double counting. For example, in measuring GDP as the value of total spending on final goods and services in an economy, we count only each producer's value added in the calculation. Or, if we calculate GDP as the value of total spending on final goods and services on domestically produced final goods and services, we avoid double counting by counting only the value of sales to final purchasers. When estimating GDP using spending data, we omit sales of inputs from one business to another, unless that spending represents investment spending by firms. Investment spending by firms represents a purchase that will last for a considerable time. • GDP for an economy can be expressed as an equation: GDP = C + I + G + X − IM, where C is consumer spending, I is investment spending, G is government spending, X is spending on domestically produced goods and services by foreigners (the domestic economy's exports), and IM is spending on imports, or the spending on goods and services produced by foreign economies. The difference between exports and imports, or X − IM, is referred to as net exports. • GDP can also be measured as the sum of all the income earned by factors of production in the economy: this is the sum of wages, interest, rent, and profit.

Tip #4.

There are three methods for calculating GDP, but each method yields the same measure of GDP for a given time period. GDP calculation for an economy can be done using three methods: (1) multiply the price of final goods and services produced in an economy during a given time period by the quantities produced in that time period and then sum together these products; (2) add up the total expenditures in the domestic economy on final goods and services during a given time period by the sectors of the economy, or in other words, by households, government, firms, and the rest of the world; and (3) sum the value of factor payments in the domestic economy over the given time period. Each method yields the same value of GDP for a given time period. It is important for you to thoroughly understand the concepts underlying each of these approaches.

market basket

a hypothetical consumption bundle of consumer purchases of goods and services, used to measure changes in overall price level.

bond

a legal document based on borrowing in the form of an IOU that pays interest.

consumer price index (CPI)

a measure of prices; calculated by surveying market prices for a market basket intended to represent the consumption of a typical urban American family of four. The CPI is the most commonly used measure of prices in the United States.

producer price index (PPI)

a measure of the cost of a typical basket of goods and services purchased by producers. Because these commodity prices respond quickly to changes in demand, the PPI is often regarded as a leading indicator of changes in the inflation rate.

price index

a measure of the cost of purchasing a given market basket in a given year, where that cost is normalized so that it is equal to 100 in the selected base year; a measure of overall price level.

GDP deflator

a price measure for a given year that is equal to 100 times the ratio of nominal GDP to real GDP in that year.

stock

a share in the ownership of a company held by a shareholder.

aggregate price level

a single number that represents the overall price level for final goods and services in the economy.

imports

goods and services purchased from other countries.

exports

goods and services sold to other countries.

final goods and services

goods and services sold to the final, or end, user.

intermediate goods and services

goods and services, bought from one firm by another firm, that are inputs for production of final goods and services.

consumer spending

household spending on goods and services from domestic and foreign firms.

disposable income

income plus government transfers minus taxes; the total amount of household income available to spend on consumption and saving.

national income and product accounts

method of calculating and keeping track of consumer spending, sales of producers, business investment spending, government purchases, and a variety of other flows of money among different sectors of the economy; also referred to as national accounts.

chained dollars

method of calculating real GDP that splits the difference between growth rates calculated using early base years and the growth rates calculated using late base years.

government transfers

payments by the government to individuals for which no good or service is provided in return.

investment spending

spending on productive physical capital, such as machinery and construction of structures, and on changes to inventories.

government borrowing

the amount of funds borrowed by the government in financial markets to buy goods and services.

inflation rate

the annual percentage change in a price index—typically the consumer price index. The inflation rate is positive when the aggregate price level is rising (inflation) and negative when the aggregate price level is falling (deflation).

financial markets

the banking, stock, and bond markets, which channel private savings and foreign lending into investment spending, government borrowing, and foreign borrowing.

aggregate spending

the total flow of funds into markets for domestically produced final goods and services; the sum of consumer spending, investment spending, government purchases of goods and services, and exports minus imports.

aggregate output

the total quantity of final goods and services the economy produces for a given time period, usually a year. Real GDP is the numerical measure of aggregate output typically used by economists.

gross domestic product (GDP)

the total value of all final goods and services produced in the economy during a given period, usually a year.

real GDP

the total value of all final goods and services produced in the economy during a given year, calculated using the prices of a selected base year.

nominal GDP

the value of all final goods and services produced in the economy during a given year, calculated using the prices current in the year in which the output is produced.

government purchases of goods and services

total purchases by federal, state, and local governments on goods and services.