Introduction to Macroeconomics

Unit 5

Circular Flow and GDPMeasuring a Nation’s Product and Income

Macroeconomics = The study of the nation’s economy as a whole.

Focuses on a few key issues:1. Gross Domestic

Product (GDP)2. Inflation3. Unemployment4. Economic Growth

Macroeconomics

Every day people go to work, where they produce or sell goods/services, and return home with a paycheck

They use their income to purchase all of the things necessary to conduct a modern life

We have investigated the specifics that determine how individual producers or firms decide how much to produce/consume Now we step back and look at the entire economy as a whole

In order to understand the relationship between production of goods/services and income for the consumers for an entire economy, we must return to the circular flow diagram

Production and Income

The important point to remember is that production generates income Firms pay for

inputs, generating income for workers, land owners, other firms, etc

Any profit is income for the owners of the firm

Production and Income

Example: Your taxes pay for a school district to hire principals, teachers, and other staff

Your taxes also pay for the school to rent buildings or property, and to pay interest on any money borrowed The income

These individuals provide education for the students in the district The production

Circular Flow

How do we measure the production of an entire economy? GDP = the total market value of all final goods and services

produced in an economy in a given year “Total market value” = take the quantity of each good produced

and multiply it by the $ value of each “Final goods and services” = goods that are sold to final

consumers, as opposed to goods that are used in the production process Example: the steel used to manufacture cars.

Steel = intermediate good, car = final good “In a given year” = we do not keep a running total of all goods

produced by an economy…why? Allows us to measure growth of an economy

Measuring Production

How is GDP affected by price and quantity? If the price of goods and services increases, GDP will

increase, even if the quantity produced stys the same If the quantity produced increases, GDP will increase,

even if price stays the same And vise-versa

So…if only the prices increase, is this economy growing? Is it a stronger economy?

Economists apply the Reality Principle to GDP Consider real GDP

GDP

Reality Principle = what matters to people is the real value of money or income – its purchasing power – not its the face value

Real GDP = a measure of GDP that accounts for changes in the price of goods

Nominal GDP = a measure of GDP using current prices only (i.e. does not account for price changes from year to year)

Real GDP

Example: Consider the computers produced by an economy In year 1: 10 computers sold at $1,000 each In year 2: 12 computers sold at $1,100 each

Nominal GDP for year 1 and 2 is? $10,000; $13,200 Is this economic growth?

To calculate real GDP we simply use the year 1 prices for both years Real GDP for year 1 and 2 is?

$10,000; $12,000 The real GDP has grown by a factor of 1.2

Real GDP

Economic growth = sustained increased in the real production of an economy over a period of time

Real GDP & Economic Growth

There are four main components to GDP:1. Consumption of Expenditures; Purchases by

consumers2. Private Investment expenditures; purchases

by firms3. Government purchases; Purchases by

federal, state, and local government4. Net exports; net purchases by the foreign

sector, or domestic exports minus domestic imports

Components of GDP

Consumption Expenditures = Purchasers by consumers of currently produced goods and services, either domestic or foreign

Examples: TV sets, DVD players, cars, clothing, hair-styling services, movie tickets, food, and all other consumer items

Can be sub-divided into 3 categories: Durable goods (last for a long time – cars) Non-Durable Goods (last a short time – food) Services (fastest growing category)

Overall, consumption expenditures account for a large % of GDP (%67 – USA)

1. Consumption Expenditures

1. Consumption Expenditures

Private investment expenditures = Purchases of newly produced goods and services by firms

There are three components to private investment expenditures:

1. Spending on new equipment and facilities within a year

2. Spending on a newly produced home3. An increase in inventories

2. Private Investment Expenditures

Gross investment = the total of all NEW investments within the year

BUT, in order to determine the true investment by the private sector, we also have to consider the deterioration of previous investments (machines, facilities, etc)

Depreciation = the wear and tear of capital as it is used in production Example: a mold used to shape a plastic product cracks and

must be replaced The net investment = total investment – depreciation Net investment (not gross investment) is used to calculate

GDP

2. Private Investment Expenditures

Government purchases = purchases of newly produced goods and services by all levels of government Example: increase in wages associated with hiring more

government workers This component does NOT include transfers. Why?

This is money that is simply moved around It does not represent production when we are discussing

the entire economy However, transfers do make up large % of a

governments annual budget, and contribute to deficit

3. Government Purchases

For open economies, or economies that trade with other nations, exports and imports must be factored into GDP

Net exports = total exports – total imports If a good/service is not produced in a nation’s

economy, then it can not be included in the GDP Therefore we must subtract imports

Net exports can be negative if more goods/services are imported into a country then exported

4. Net Exports

4. Net Exports