Lesson 4

Statistical discrepancy

A statistical discrepancy is added to national income to make the income approach match the expenditures approach In 2009, this was $209b

Inventory

A store of output that has been produced but not yet sold Firms maintain inventory to attempt to address the problem of fluctuating demand. When demand is low, the inventory stock would rise as unsold products are added; when demand is high, the inventory would fall as previously produced products are sold from the inventory stock However, using inventories to meet unexpected changes in demand only helps for a short period of time. If inventories become large and remain so for a long period of time, they are costly to maintain and end up hurting business profits.

Economic growth

Depends on devoting some current output to increase future output This process involves 1. saving: when current spending is less than current income / when current consumption is less than current output 2. investment: when resources are devoted to the production of future output The amount of economic investment is limited by the amount of saving available for such investment The only way that more output can be directed at investment activities is if saving increases (this means that individuals and society must make trade-offs between current and future consumption)

The amount spent to purchase this year's total output

Equals the money income derived from production of this year's output

Personal consumption expenditures (C)

Expenditures of households for durable (10%) and nondurable (30%) goods, and services (60%) Durable goods are products that have expected lives of years or more Nondurable goods are products with less than 3 years of expected life Economists often refer to the US economy as a service economy

Expenditures approach for calculating GDP

From the expenditures perspective, GDP is composed of total of 4 expenditure categories: 1. personal consumption expenditures (C): 2. gross private domestic investment (Ig): 3. government purchases (G) 4. net exports (Xn) GDP = C + Ig + G + Xn These expenditures become income for people or the government when they are paid out in the form of employee compensation, rents, interest, proprietor's income, corporate profits, and taxes on production and imports.

Income approach for calculating GDP

From the income perspective, GDP can be calculated by adding the income derived from the production and sales of final goods and services, and then adjusting. The 6 income items are: 1. Compensation of employees (largest share of national income) 2. Rents 3. Interest 4. Proprietors' income 5. Corporate profits 6. Taxes on production and imports The sum of all six categories equals national income To obtain GDP from national income, 3 adjustments must be made: 1. Net foreign factor income is subtracted 2. A statistical discrepancy is added 3. The consumption of fixed capital is added

GDP shortcomings

GDP has shortcomings as a measure of total output and economic well-being -Non-market activities: It excludes the value of non-market final goods and services that are not bought and sold in the markets, such as unpaid work done by people in their houses (one exception: the output that farmers consume themselves is included) -Leisure: It excludes the amount of increased leisure enjoyed by the participants in the economy -Improved product quality: It does not fully account for the value of improvements in the quality of products that occur over the years (although it does adjust GDP for quality improvement for selected items) -The underground economy: It does not measure the market value of the final goods and services produced in the underground sector of the economy because that income and activities is not reported (value of underground transactions estimated at 8% of GDP) -The environment: It does not record the pollution or environmental costs of producing final goods and services -Consumption and distribution of output: It does not measure changes in the consumption and the distribution of the domestic output -Non-economic sources of well-being: It does not measure non-macroeconomic sources of well-being such as a reduction in crime, drug or alcohol abuse, or better relationships among people and nations

Great recession

Great recession started in late 2017 and continues to 2008 and into 2009 It was triggered by a steep decline in housing prices and a crisis involving mortgage loans and the financial securities built on them Several key US financial institutions collapsed or nearly failed, and lending markets largely froze Despite government bailout efforts, the financial crisis eventually spread to the broader economy; employment fell by 8 million between 2007 and 2009, the unemployment rate rose from 4.7% to 10%. Economic growth slumped to .4% in 2008 and to negative 2.4% in 2009, compared with the 2.7% between 1995 and 2007.

Unemployment

Measures the degree to which labor resources are being fully used in the economy A condition that arises when a person who is willing to work seeks a job but does not find one High rates of unemployment mean that an economy is not fully employing its labor resources, which reduces potential production and leads to other social problems (higher crime rate, greater political unrest, higher rates of depression, higher rates of illnesses, etc.) Unemployment is a waste because we must count as a loss all the goods and services that unemployed workers could have produced if they had been working

Interest

Money paid by private businesses to the suppliers of loans used to purchase capital Only the interest payment made by financial institutions or business firms are included Interest payments made by government are excluded

National income accounting

National income accounting measures the economy's overall performance Consists of concepts that enable those who use them to measure the economy's output, to compare it with past outputs, to explain its size and the reasons for changes in its size, and to formulate policies designed to increase it The Bureau of Economic Analysis (BEA) is a unit of the Department of Commerce that is responsible for compiling the National Income and Product Accounts (NIPA). It obtains data from multiple sources to estimate consumption, investment, government purchases, and net exports for the calculation of GDP.

Demand shocks

Occur with unexpected changes in the demand for products Most short-run fluctuations in the economy are a result of demand shocks They represent a major macroeconomic problem for the economy because the prices of most products are inflexible or slow to change in the short run ("sticky")

Supply shocks

Occur with unexpected changes in the supply of products

Modern economic growth

Output per person and standards of living increased Before the industrial revolution in late 1700s, there was virtually no growth over hundreds of years (this was partly because their populations increased by similar proportion of the increase in output, so output per person remained the same) With the industrial revolution came factory production and automation and research and technology... output grew faster than the population, so living standards increased as output per person increased Those that experienced this were said to be experiencing modern economic growth; such growth explains the large differences in living standards today among nations Richer nations have a longer history of modern economic growth than poorer nations Citizens of the richest nations today have standards of living that are on average more than 50 times higher than those experienced by citizens of the poorest nations

Real gross domestic product (GDP)

Overall indicator of output or production in the economy Measure of the value (price) of final goods and services produced by the domestic economy during a time period, typically a year "Real" refers to the fact that in comparing the value of GDP (prices x quantities) from one year to the next, prices are held constant so only quantities of goods and services produced by the economy (or real output) changes Because more output means greater consumption possibilities, economists and policymakers are committed to encouraging a large and growing real GDP Non-production transactions are not included in GDP such as purely financial transactions or sales of secondhand or used goods There are two acceptable methods for determining GDP: expenditures or income approach

Macroeconomic models

Policymakers construct macroeconomic models to assess the short-run and long-run performance of the economy to seek to maximize economic growth and minimize the adverse effects of unemployment and inflation Such models can be useful for addressing important macroeconomic questions such as what can be done by government policies to control information or foster long-run economic growth

Purely financial transactions

Purely financial transactions are not included in GDP because they have nothing to do with the generation of final goods and services 1. public transfer payments: social security payments, welfare payments, and veterans' payments that the government makes directly to households 2. private transfer payments: include, for example, the money that parents give children or the cash gifts given during the holidays 3. stock market transactions: the buying and selling of stocks (and bonds) is just a matter of swapping bit of paper

Expectations

The future is uncertain, so the consumer and business participants in the economy have to act from expectations of what will happen Their expectations about the future will shape their economic decisions Expectations are important for 2 reasons: 1. expectations effect current behavior 2. when expectations are unmet, firms are forced to cope with shocks

Rents

The income received by property owners The rent is a net measure of the difference between gross rent and property depreciation

Corporate profits

The earnings of corporations They are allocated in 3 ways: 1. corporate income taxes paid to the government 2. dividends (from after tax profits) paid to stockholders, which are households, the ultimate owners of all corporations 3. undistributed corporate profits (from after tax profits that are not distributed to shareholders) retained/saved by corporations; retained earnings

Gross private domestic investment (Ig)

1. All final purchases of machinery, equipment, and tools by business enterprises 2. Spending by firms and households for new construction (buildings) - they could be rented to bring in income 3. changes in the inventories of business firms - Increases in inventories represent unconsumed output, which is an addition to stock of capital goods; Decreases in inventories much be subtracted from total investment Gross investment includes investment in replacement capital and in added capital; Gross investment exceeds net investment by the value of the capital goods worn out during the year (depreciation) An economy in which net investment is positive is one with an expanding production capacity

Key indicators of economic health and the development of the economy

1. Real GDP 2. Unemployment 3. Inflation

Government purchases (G)

1. expenditures for goods and services that the government consumes in providing public services 2. expenditures for publicly owned capital such as schools and highways, which have long lifetimes Government purchases (federal, state, and local) include all government expenditures on final goods from businesses, and for the direct purchases of resources, including labor Transfer payments made by the government to individuals, such as social security payments, are not included in government purchases because they simply transfer income to individuals and do not generate production

Consumption of fixed capital (depreciation)

Consumption of fixed capital (depreciation) is added to national income to get GDP because it is a cost of production that does not add to anyone's income It covers depreciation of private capital goods and publicly owned capital goods such as roads or bridges

Net domestic product (NDP)

Annual output of final goods and services over and above the privately and publicly owned capital goods warn out during the year NDP = GDP - depreciation (consumption of fixed capital)

Banks and other financial institutions

Banks and other financial institutions collect the savings of households (rewarding savers with interest and dividends, and sometimes capital gains - increases in asset values) They then lend the funds to businesses, which are the main economic investors (they invest in equipment, factories, and other capital goods)

Net exports (Xn)

Calculated as the difference between exports (X) and imports (M) It is equal to the expenditures made by foreigners for goods and services produced in the economy minus the expenditures made by the consumers, governments, and investors of the economy for goods and services produced in foreign nations

Net private domestic investment

Includes only investment in the form of added capital Net investment = gross investment - depreciation (the amount of capital that is used up over the course of the year) In typical years, gross investment exceeds depreciation, so net investment is positive and the nation's stock of capital rises by the amount of net investment The economy's stock of private capital expands when net investment is positive; stays constant when net investment is zero; and declines when net investment is negative

Taxes on production and imports

Initially income for households that later gets paid to government in the form of taxes; this is added to account for income to the government Includes general sales taxes, excise taxes, business property taxes, license fees, and custom duties

Business cycle

Long-run economic growth and short-run fluctuations in output and employment

Price "stickiness" and macroeconomic models

Macroeconomic models can be categorized based on price stickiness Short run macroeconomic models assume that prices are inflexible or sticky, and thus demand shocks change output and employment (extreme short run is first few weeks/months after demand shock) Long run macroeconomic models assume flexible prices, and thus demand shocks only have an effect on prices and not on output or employment (very long run is many months to several years after demand shock)

Flexible prices

Some markets for commodities and raw materials such as corn, oil, and natural gas feature extremely flexible prices that react within second to changes in supply and demand Some products like gasoline and airline tickets can change very rapidly too - like once a month or even less than once a month

Macroeconomics

Studies the behavior of the whole economy, or its major aggregates such as consumption and investment Focuses on 2 topics 1. Short-run changes in output and employment; fluctuations that create conditions giving rise to up-and-down business cycle 2. Long-run economic growth; trends for economic growth that bring rising living standards Long-run growth trend leads to higher output and standards of living for an economy, but along the way there can be short-run variability that produces a decline in output (recession)

Net foreign factor income

Subtracted from national income because it reflects income earned from production outside the US (we must take out income Americans gain from supplying resources abroad and add in the income that foreigners fain by supplying resources in the US) Net foreign factor income = income earned by American-owned resources abroad - income earned by foreign owned resources in the US

Compensation of employees

Sum of wages and salaries, and wage and salary supplements, such as social insurance and private pension or health funds for workers

Price index

The price index is a ratio of the price of a market basket (a specified collection of goods and services) in a given year to the price of the same market basket in a base year, with the ratio multiplied by 100 To obtain real GDP, divide nominal GDP by the price index expressed in hundredths (if nominal GD by $14,000b and the price index was 120, then the real GDP would be $14,000b/1.20) The price index number of a reference period is arbitrarily set at 100 For years when the price index is below 100, dividing nominal GDP by the price index (in hundredths) inflates nominal GDP to obtain real GDP For years when the price index is above 100, dividing nominal GDP by the price index (in hundredths) deflates nominal GDP to obtain real GDP

Proprietors' income

The profits or net income of sole proprietors or unincorporated business firms

Financial investment

The purchase of an asset such as a stock, bond, or real estate that is made for the purpose of financial fain Simply transfers ownership of an asset from one party to another

Economic investment

The purchase of newly created capital goods such as new tools, new machinery, or new buildings that are bought with the purpose of expanding a business (to be used for production of goods and services)

Inflexible ("sticky") prices

There are many inflexible prices for goods and services in the economy. For many final goods and services, there is a 4.3-month time lag before prices change. There are several reasons for this: 1. consumers prefer stable and predictable prices - so there is pressure on business to keep prices stable and not upset consumers 2. businesses may not want to cut prices because that may result in a price war with competing firms Help to explain how unexpected changes in demand lead to the fluctuations in GDP and employment that occur over the course of the business cycle Ex. haircuts and newspapers average more than 2 years between price changes. Coin operated laundry machines average nearly 4 years between price changes. Price stickiness moderates over time - firms that choose to use a fixed-price policy in the short run do not have to stick to that policy permanently (if unexpected changes in demand look permanent, many firms will allow their prices to change to help equalize quantities supplied with quantities demanded)

Computerized inventory tracking

This has increased how quickly firms can respond to changes in demand This change helped moderate business cycle fluctuations over the past 25 years

Disposable income (DI)

Total income available to households after the payment of personal taxes (include personal income taxes, personal property taxes, and inheritance taxes) DI = PI - personal taxes DI = personal consumption expenditures + personal saving

National income (NI)

Total income earned by US owners of land and capital and by the US suppliers of labor and entrepreneurial ability (whether they are located at home or abroad) during the year plus taxes on production and imports NI = NDP - a statistical discrepancy + net foreign factor income

Personal income (PI)

Total income received (whether it is earned or unearned) by the households of the economy before the payment of personal taxes It is found by taking NI and adding the income that is received but not earned, and subtracting the income that is earned but not received Take NI and adding transfer payments, and then subtracting taxes on production and imports, social security contributions, corporate income taxes, and undistributed corporate profits.

Nominal GDP

Total output of final goods and services produced by an economy in 1 year multiplied by the market prices when they were produced (based on the prices that prevailed when the output was produced) Prices, however change each year; to compare total output over time, GDP is converted to real GDP to account for these price changes (GDP that has been inflated or deflated to reflect changes in the price level) There are 2 methods for deriving real GDP from nominal GDP 1. Nominal GDP / price index (in hundredths) 2. Use base-year prices and multiply them by each year's physical quantities; GDP price index for a particular year is the ratio of nominal GDP to real GDP for that year (if nominal GDP was $14,000b and real GDP was $11,666b, then GDP index would be 1.2 ($14,000b/$11,666b))

Nominal GDP

Totals the dollar value of all goods and services produced within the borders of a country using their current prices during the year that they were produced The problem for measuring output this way is that prices and quantities change from one year to the next

Inflation

Tracks the overall increase in the level of prices in the economy Increase in the overall general level of prices Prices for individual products can rise or fall, but if there is a rise in prices overall, then the economy is experiencing inflation Inflation erodes purchasing power of incomes and reduces the value of savings

Economic shocks

When expectations differ significantly from reality (when the unexpected happens), then participants in the economy experience this Such shocks can be positive or negative depending on whether the surprising changes are beneficial or costly for a person or group

Recession

When output and living standards decline Great recession started in late 2017 and continues to 2008 and into 2009

When prices are flexible

When this is the case, when there is a change in demand for a product, the result will be a change in the price to achieve equilibrium at the set quantity of output; such a change in demand would not change the output, but only the price of the product (there would be no short-run fluctuations in output)

When prices are inflexible ("sticky")

When this is the case, when there is a change in the demand for a product, the result will be a change in output and employment. A demand shock will cause short-term fluctuations in output and employment. This is because if the demand for products fall, firms will cut production, causing output and economic growth to decrease and unemployment to increase.