Measuring a Nation's Income - Macroeconomics Vocabulary

Microeconomics and Macroeconomics

  • Microeconomics:

    • The study of how households and firms make decisions and how they interact in specific markets.
    • Focuses on individual decision-making, market equilibrium for specific goods, and price mechanisms.

  • Macroeconomics:

    • The study of economy-wide phenomena across national or global scales.
    • Focuses on aggregate variables including inflation, unemployment, economic growth, and national income.

The Economy's Income and Expenditure

  • Gross Domestic Product (GDP):

    • Measures the total income of everyone in the economy.
    • Measures the total expenditure on the economy's output of goods and services.

  • Equivalence of Income and Expenditure:

    • For an economy as a whole, total income must equal total expenditure.
    • Every transaction has a buyer and a seller: every dollar spent by a buyer becomes a dollar of income for a seller.

The Circular-Flow Diagram

Circular-Flow Diagram

  • Overview and Structure:

    • A visual model of the economy showing how dollars flow through markets among households and firms.

  • Assumptions of the Model:

    • Two Types of Economic Decision-Makers: Households and Firms.
    • Two Types of Markets: Markets for Goods and Services, and Markets for Factors of Production.
    • Households:
    • Own and sell/rent all factors of production (labor, land, and capital).
    • Spend all of their income to buy all goods and services produced by firms.
    • Firms:
    • Hire or buy factors of production in factor markets to produce output.
    • Sell goods and services in product markets.
    • Pay out revenue as wages to workers, rent to landowners, and profit to firm owners.

  • Dual Flows in the Model:

    • Flow of Inputs and Outputs (Real Flow):
    • Households provide labor, land, and capital to the Markets for Factors of Production.
    • Factors of production flow from factor markets to Firms.
    • Firms produce goods and services sold in the Markets for Goods and Services.
    • Goods and services flow from product markets to Households.
    • Flow of Dollars (Monetary Flow):
    • Households spend dollars in the Markets for Goods and Services.
    • Spending flows into Firms as Revenue.
    • Firms use revenue to pay wages, rent, and profit in the Markets for Factors of Production.
    • Payments flow to Households as Income.

  • Macroeconomic Equality in the Model:

    • Spending (=GDP= \text{GDP}) in goods and services markets equals Revenue (=GDP= \text{GDP}) received by firms.
    • Factor payments (wages, rent, profit =GDP= \text{GDP}) equal Income (=GDP= \text{GDP}) received by households.

Definition and Measurement of Gross Domestic Product

  • Formal Definition:

    • Gross Domestic Product (GDP) is defined as the market value of all final goods and services produced within a country in a given period of time.

  • Detailed Analysis of Definition Components:

    • "Market Value":
    • Aggregates diverse goods and services using prevailing market prices.
    • Market prices reflect the monetary value consumers place on different items.
    • "Of All":
    • Includes all goods and services produced in the economy and sold legally in markets.
    • Excludes illegal items produced and sold illicitly (black market activity).
    • Excludes items produced and consumed at home without entering formal markets (e.g., home gardening, unpaid childcare).
    • "Final":
    • Counts only final goods and services to avoid double counting.
    • Excludes intermediate goods because their value is already included in the market price of final goods.
    • "Goods and Services":
    • Includes tangible physical goods (e.g., food, clothing, automobiles).
    • Includes intangible services (e.g., medical care, haircuts, house cleaning, education).
    • "Produced":
    • Includes only goods and services produced in the current period.
    • Excludes transactions of items produced in past periods (e.g., sales of used items).
    • "Within a Country":
    • Measures economic output generated within geographic borders of a nation.
    • Includes production by foreign citizens working locally, while excluding production by citizens located abroad.
    • "In a Given Period of Time":
    • Measures output over a designated timeframe, typically a year or a quarter (3 months).

Components of Gross Domestic Product

GDP and Its Components (2015)

  • The Expenditure Identity:

    • Y=C+I+G+NXY = C + I + G + NX
    • YY = Gross Domestic Product (GDP)
    • CC = Consumption
    • II = Investment
    • GG = Government Purchases
    • NXNX = Net Exports

  • Consumption (CC):

    • Total spending by households on goods and services.
    • Includes tangible goods divided into durable goods and nondurable goods.
    • Includes intangible services, such as education and healthcare.
    • Specific Exception: Purchases of new residential housing are excluded from consumption and classified under investment.

  • Investment (II):

    • Purchase of capital goods used to produce other goods and services in the future.
    • Business Capital: Business structures, equipment, machinery, and intellectual property products.
    • Residential Capital: Landlord apartment structures and homeowner personal residences.
    • Inventory Accumulation: Changes in business inventories over the period.

  • Government Purchases (GG):

    • Spending on goods and services by local, state, and federal governments.
    • Consists of government consumption expenditure and gross investment.
    • Excludes Transfer Payments: Payments such as Social Security benefits or unemployment insurance are excluded because they are not made in exchange for a currently produced good or service.

  • Net Exports (NXNX):

    • NX=Exports−ImportsNX = \text{Exports} - \text{Imports}
    • Exports: Spending by foreign consumers on domestically produced goods and services.
    • Imports: Spending by domestic residents on foreign-produced goods and services (subtracted to offset their inclusion in CC, II, or GG).

  • U.S. GDP Breakdown (2015 Data):

    • Total GDP (YY): Almost $18 trillion\$18\text{ trillion} ($17,938 billion\$17,938\text{ billion}), equal to $55,882\$55,882 per person (100%100\% of total GDP).
    • Consumption (CC): $12,268 billion\$12,268\text{ billion} total, equal to $38,218\$38,218 per person (68%68\% of total GDP).
    • Investment (II): $3,018 billion\$3,018\text{ billion} total, equal to $9,402\$9,402 per person (17%17\% of total GDP).
    • Government Purchases (GG): $3,184 billion\$3,184\text{ billion} total, equal to $9,919\$9,919 per person (18%18\% of total GDP).
    • Net Exports (NXNX): −$532 billion-\$532\text{ billion} total, equal to −$1,657-\$1,657 per person (−3%-3\% of total GDP), indicating Americans spent more on foreign goods than foreign residents spent on domestic exports.

Real versus Nominal Gross Domestic Product

Real and Nominal GDP Calculation Example

  • Conceptual Difference:

    • Total expenditure can increase due to expanding output quantities or rising price levels.
    • Nominal GDP: Evaluates current production of goods and services at current prices; influenced by price changes.
    • Real GDP: Evaluates current production of goods and services at constant base-year prices; removes price changes to reflect actual volume of output.
    • Base Year Rule: For the selected base year, Real GDP always equals Nominal GDP.

  • Numerical Example (Hot Dogs and Hamburgers Economy):

    • Raw Price and Quantity Data:
    • 2016: Hot Dogs price = $1\$1, quantity = 100100; Hamburgers price = $2\$2, quantity = 5050.
    • 2017: Hot Dogs price = $2\$2, quantity = 150150; Hamburgers price = $3\$3, quantity = 100100.
    • 2018: Hot Dogs price = $3\$3, quantity = 200200; Hamburgers price = $4\$4, quantity = 150150.
    • Calculating Nominal GDP:
    • 2016 Nominal GDP:       (\1 \times 100) + (\2×50)=$2002 \times 50) = \$200
    • 2017 Nominal GDP:       (\2 \times 150) + (\3×100)=$6003 \times 100) = \$600
    • 2018 Nominal GDP:       (\3 \times 200) + (\4×150)=$1,2004 \times 150) = \$1,200
    • Calculating Real GDP (Base Year 2016):
    • 2016 Real GDP:       (\1 \times 100) + (\2×50)=$2002 \times 50) = \$200
    • 2017 Real GDP:       (\1 \times 150) + (\2×100)=$3502 \times 100) = \$350
    • 2018 Real GDP:       (\1 \times 200) + (\2×150)=$5002 \times 150) = \$500

The GDP Deflator and Inflation Rate

  • Definition and Calculation of the GDP Deflator:

    • The GDP deflator measures the price level relative to the base year:     GDP Deflator=Nominal GDPReal GDP×100\text{GDP Deflator} = \frac{\text{Nominal GDP}}{\text{Real GDP}} \times 100
    • The base year GDP deflator always equals 100100.
    • Used by economists to "deflate" nominal GDP and extract inflation.

  • Calculating the GDP Deflator (Hot Dogs and Hamburgers Example):

    • 2016 GDP Deflator:     ($200$200)×100=100\left(\frac{\$200}{\$200}\right) \times 100 = 100
    • 2017 GDP Deflator:     ($600$350)×100=171\left(\frac{\$600}{\$350}\right) \times 100 = 171
    • 2018 GDP Deflator:     ($1,200$500)×100=240\left(\frac{\$1,200}{\$500}\right) \times 100 = 240

  • Inflation and Inflation Rate:

    • Inflation: A rise in the economy's overall price level over time.
    • Inflation Rate: Percentage change in the price measure (GDP deflator) from one period to the next.
    • Formula for Year 2:     Inflation Rate in Year 2=GDP Deflator in Year 2−GDP Deflator in Year 1GDP Deflator in Year 1×100\text{Inflation Rate in Year 2} = \frac{\text{GDP Deflator in Year 2} - \text{GDP Deflator in Year 1}}{\text{GDP Deflator in Year 1}} \times 100

Historical Trends and Recessions

U.S. Real GDP from 1965 to 2015

  • Long-Term Real GDP Growth:

    • U.S. real GDP grows substantially over long horizons.
    • Real GDP in 2015 was more than four times its 1965 level.
    • Average real GDP growth rate in the U.S. has been approximately 3%3\% per year since 1965.

  • Economic Recessions:

    • Definition: A recession is defined as two consecutive quarters of falling real GDP.
    • Impact of Recessions: Recessions involve declines in real GDP, falling national income, reduced corporate profits, rising unemployment, and increased rates of bankruptcy.
    • Growth Instability: Economic growth is not steady, but characterized by cyclical fluctuations and recessions.

GDP and Economic Well-Being

GDP and the Quality of Life Across Nations

  • Role as a Measure of Well-Being:

    • Recognized as the single best measure of society's economic well-being.
    • Captures total national income and total national expenditure.
    • Higher GDP enables societies to afford superior medical care, advanced education systems, and expanded public services.

  • Omissions and Limitations of GDP:

    • Excludes Leisure: Does not factor in working hours or personal leisure time.
    • Excludes Non-Market Production: Ignores household work, unpaid caregiving, and volunteer services.
    • Excludes Environmental Quality: Does not deduct degradation or pollution caused by industrial output.
    • Ignores Income Distribution: Ignores how national income is distributed across income groups.

  • International Evidence on GDP and Quality of Life (2015 Data):

    • Rich Nations (High Real GDP per Person): Feature longer life expectancies, higher adult literacy, higher average years of schooling, higher internet adoption, and higher overall life satisfaction.
    • Poor Nations (Low Real GDP per Person): Feature higher infant and maternal mortality, lower birth weights, higher rates of child malnutrition, reduced access to safe drinking water, fewer children in school, fewer teachers per student, fewer televisions and telephones, fewer paved roads, and reduced access to electricity.
    • Country Summary Data Table:
    • United States: Real GDP per person = $52,947\$52,947; Life Expectancy = 79 years79\text{ years}; Average Schooling = 13 years13\text{ years}; Life Satisfaction = 7.27.2 / 1010.
    • Germany: Real GDP per person = $43,919\$43,919; Life Expectancy = 81 years81\text{ years}; Average Schooling = 13 years13\text{ years}; Life Satisfaction = 7.07.0 / 1010.
    • Japan: Real GDP per person = $36,927\$36,927; Life Expectancy = 83 years83\text{ years}; Average Schooling = 12 years12\text{ years}; Life Satisfaction = 5.95.9 / 1010.
    • Russia: Real GDP per person = $22,352\$22,352; Life Expectancy = 70 years70\text{ years}; Average Schooling = 12 years12\text{ years}; Life Satisfaction = 6.06.0 / 1010.
    • Mexico: Real GDP per person = $16,056\$16,056; Life Expectancy = 77 years77\text{ years}; Average Schooling = 9 years9\text{ years}; Life Satisfaction = 6.76.7 / 1010.
    • Brazil: Real GDP per person = $15,175\$15,175; Life Expectancy = 74 years74\text{ years}; Average Schooling = 8 years8\text{ years}; Life Satisfaction = 7.07.0 / 1010.
    • China: Real GDP per person = $12,547\$12,547; Life Expectancy = 76 years76\text{ years}; Average Schooling = 8 years8\text{ years}; Life Satisfaction = 5.25.2 / 1010.
    • Indonesia: Real GDP per person = $9,788\$9,788; Life Expectancy = 69 years69\text{ years}; Average Schooling = 8 years8\text{ years}; Life Satisfaction = 5.65.6 / 1010.
    • India: Real GDP per person = $5,497\$5,497; Life Expectancy = 68 years68\text{ years}; Average Schooling = 5 years5\text{ years}; Life Satisfaction = 4.44.4 / 1010.
    • Nigeria: Real GDP per person = $5,341\$5,341; Life Expectancy = 53 years53\text{ years}; Average Schooling = 6 years6\text{ years}; Life Satisfaction = 4.84.8 / 1010.
    • Pakistan: Real GDP per person = $4,866\$4,866; Life Expectancy = 66 years66\text{ years}; Average Schooling = 5 years5\text{ years}; Life Satisfaction = 5.45.4 / 1010.
    • Bangladesh: Real GDP per person = $3,191\$3,191; Life Expectancy = 72 years72\text{ years}; Average Schooling = 5 years5\text{ years}; Life Satisfaction = 4.64.6 / 1010.