Chapter 5
Public Spending
and Public Choice
Introduction
The U.S. Postal Service (USPS) delivers nearly 40
percent of the world’s mail. Yet, its annual mail volume
has declined by more than 20 percent since 2006.
Continuation of USPS operations is dependent on the
more than $15 billion in loans provided by the federal
government.
Why does government sponsor the provision of certain
items, rather than allowing private firms to supply
them? We will explore this question in Chapter 5.
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5-2
Learning Objectives
• Explain how market failures, such as
externalities, might justify economic
functions of government
• Distinguish between private and public
goods and explain the nature of the freerider problem
• Describe the political functions of
government that entail its involvement in
the economy
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5-3
Learning Objectives (cont'd)
• Analyze how Medicare affects the incentives
to consume medical services
• Explain why increases in government
spending on public education have not been
associated with improvements in measures
of student performance
• Discuss the central elements of the theory
of public choice
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5-4
Chapter Outline
• What a Price System Can and Cannot Do
• Correcting for Externalities
• The Other Economic Functions of
Government
• The Political Functions of Government
• Public Spending and Transfer Programs
• Collective Decision Making: The Theory of
Public Choice
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5-5
Did You Know That ...
• A woman searching for scrap metal in the Eastern
European nation of Georgia accidentally halted all
Internet communication to Armenia?
• In shoveling below ground to find unused wires
containing copper, the woman sliced through a
fiber optic cable.
• In her defense, the woman claimed that she was
pursuing her own self-interest by looking for scrap
metal that could be sold for a profit.
• This event is an example of how the market
system may cause negative spillovers for third
parties.
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5-6
What a Price System Can and Cannot
Do
• In its most ideal form, a price system
allows resources to move from lower-valued
to higher-valued uses through voluntary
exchange
– Economic efficiency arises when all mutually
advantageous trades have taken place
• There are, however, situations when a price
system does not generate the desired
results
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5-7
What a Price System Can and Cannot
Do (cont'd)
• Market Failure
– A situation in which the unrestrained market
economy leads to too few or too many resources
going to a specific economic activity
• Prevents economic efficiency and individual freedom
• Is addressed by public policy (government)
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5-8
Correcting for Externalities
• In a pure market system, economic
efficiency occurs when individuals know and
must bear the true opportunity cost of their
actions
– In some cases, the price that someone actually
pays for a resource, good, or service is higher or
lower than the opportunity cost that all society
pays
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5-9
Correcting for Externalities (cont'd)
• Market failure: an example
– Assume
• No government regulation against pollution
• A town with clean air
• A steel mill opens and emits smoke that causes
– More respiratory diseases
– Dirtier clothes, houses, cars
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5-10
Correcting for Externalities (cont'd)
• Market failure: an example
– Market failure occurs
• Steel mill does not pay for the clean air
• Costs of production have “spilled over” to the residents
(third parties)
• Lower production cost
– More steel is produced than would otherwise be the case
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5-11
Correcting for Externalities (cont'd)
• Externalities
– Occur when the consequences of an economic
activity spill over to affect third parties
• Third Parties
– Parties who are not directly involved in a given
activity or transaction
• Property Rights
– Rights of an owner to use and exchange
property
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5-12
Correcting for Externalities (cont'd)
• Externalities are examples of market
failures
• Pollution is an example of a negative
externality
• Inoculations generate external benefits
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5-13
Figure 5-1 External Costs and Benefits,
Panel (a)
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5-14
Figure 5-1 External Costs and Benefits,
Panel (b)
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5-15
Correcting for Externalities (cont’d)
• Resource misallocations of externalities
– External costs—market overallocates
– External benefits—market underallocates
• Government can correct negative
externalities
– Special taxes (a pollution tax or “effluent fee”)
– Regulation
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5-16
Example: Hungary’s Tax on
Prepackaged Snacks
• The Hungarian government has determined
that there are external spillovers on the
nation’s health care system from the snack
food market.
• The government wants to discourage
production of sweets, salted snacks, and
energy drinks.
• Therefore, it has imposed a tax on foods
with a high content of sugar, salt,
carbohydrates, or caffeine.
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5-17
Correcting for Externalities (cont'd)
• How the government can correct positive
externalities
– Government financing and production
– Subsidies
– Regulation
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5-18
Policy Example: Stop the Presses for
Subsidies!
• As newspaper readership has declined over
the past decade, some government officials
have argued that local newspapers provide
positive externalities.
• They reason that the information provided
by newspapers may save lives.
• As a consequence, some state governments
provide subsidies for local newspapers.
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5-19
The Other Economic Functions of
Government
• Providing a legal system
• Promoting competition
• Providing public goods
• Ensuring economy-wide stability
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5-20
The Other Economic Functions of
Government (cont'd)
• Providing a legal system
– Enforcing contracts
– Defining and protecting property rights
– Establishing legal rules of behavior
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5-21
The Other Economic Functions of
Government (cont'd)
• Promoting competition
– Market failure may occur if markets are not
competitive.
• Antitrust legislation
• Monopoly power
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5-22
The Other Economic Functions of
Government (cont'd)
• Antitrust Legislation
– Laws that restrict the formation of monopolies
and regulate certain anticompetitive business
practices
• Monopoly
– A firm that can determine the market price, in
the extreme case is the only seller of a good or
service
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5-23
The Other Economic Functions of
Government (cont'd)
• Providing public goods
– Goods to which the principle of rival
consumption does not apply
• These are goods that may be consumed jointly by
many individuals at the same time.
– In contrast, private goods can be consumed by
one individual at a time
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5-24
The Other Economic Functions of
Government (cont'd)
• What truly distinguishes public goods from
all private goods is that the costs incurred
in excluding nonpayers from consuming a
public good are prohibitive
• Individuals in the private sector have little
incentive to provide public goods
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5-25
The Other Economic Functions of
Government (cont'd)
• Characteristics of public goods
1. Can be used by more and more people at no
additional opportunity cost
2. Difficult to charge for a public good based on
consumption—the exclusion principle
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5-26
Example: Private Companies Look to Place
Humans in Orbit – and Beyond
• Bigelow Aerospace, a private firm, has
designed and tested low-cost inflatable
space stations in which humans can reside.
• Another firm, Moon Express, offers a lowcost method of landing people on the moon.
• Other firms are working on the technology
to get humans into orbit.
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5-27
The Other Economic Functions of
Government (cont'd)
• Free-Rider Problem
– Arises when some individuals take advantage of
the fact that others will take on the burden of
paying for public goods
– The free-rider problem often emerges in
connection with sharing the burden of
international defense
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5-28
The Other Economic Functions of
Government (cont'd)
• Ensuring economy-wide stability
– Smooth ups and downs in overall business
activity
– Full Employment Act 1946
• Full employment
• Price stability
• Economic growth
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5-29
The Political Functions of
Government
• Government-Sponsored Goods
– Goods deemed socially desirable through the
political process
• Museums
• Government-Inhibited Goods
– Goods deemed socially undesirable
• Certain psychoactive drugs
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5-30
The Political Functions of
Government (cont'd)
• Income redistribution: includes progressive
income tax system and transfers
– Transfer payments
– Transfers in kind
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5-31
The Political Functions of
Government (cont'd)
• Transfer Payments
– Money payments made by governments to
individuals for which in return no services or
goods are rendered
– Examples are Social Security old age and
disability benefits and unemployment insurance
benefits
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5-32
The Political Functions of
Government
• Transfers in Kind
– Payments that are in the form of goods and
services
– Include food stamps, subsidized public housing,
medical care
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5-33
Public Spending and Transfer
Programs
• Government Outlays
– All federal, state and local spending
– Examples
• Defense, income security, Social Security—at the
federal level
• Education, health and hospitals, public welfare—at the
state level
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5-34
Figure 5-2 Total Government Outlays
over Time
Sources: Facts and Figures on Government Finance, various issues; Economic Indicators, various issues.
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5-35
Public Spending and Transfer
Programs (cont'd)
• Publicly subsidized healthcare
– Medicare
• Began in 1965
• Pays hospital and physicians’ bills for U.S. residents
over 65 with public monies
• 2.9% of earnings taxed
• Second biggest domestic program in existence
– Medicaid
• Subsidizes people with lower incomes
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5-36
Figure 5-3 Federal Government Spending
Compared to State and Local Spending
Sources: Economic Report of the President, Economic Indicators.
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5-37
Figure 5-4 The Economic Effects of
Medicare Subsidies
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5-38
Public Spending and Transfer
Programs (cont’d)
• To increase the quantity of medical care,
the government pays a subsidy
– The price per unit paid to medical service
providers increases
– The price per unit paid by consumers falls
– More medical services are consumed
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5-39
Policy Example: The Great Underestimates of
Health Care Expenses
• In 1965, officials estimated the 1990 cost of
Medicare to be $12 billion, but the actual program
cost in 1990 was $110 billion.
• Similarly, the actual $45 billion cost of Medicaid in
1990 far exceeded the initial estimate of $7 billion.
• Why were the initial estimates inaccurate?
– Congress expanded the number of people eligible for both
programs.
– Officials did not take into account the fact that the use of
medical services would increase once these subsidies were
provided.
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5-40
Public Spending and Transfer
Programs (cont’d)
• Health Care Subsidies Continue to Grow
– The cost of Medicare is now $550 billion per
year, and unfunded guarantees of future
spending exceed $25 trillion.
– In addition, the federal government pays the
expenses of Medicaid, a program that provides
health care for low-income citizens.
– The current cost of Medicaid is more than $400
billion per year.
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5-41
What If . . . the federal government reduces outof-pocket prices consumers pay for health care
services?
• If out-of-pocket prices continue to fall, more
health care services will be demanded by
consumers.
• Yet, providers would require higher prices in
order to expand the volume of care.
• Therefore, higher subsidies would be
required, thereby raising the total
government outlay.
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5-42
Public Spending and Transfer
Programs (cont’d)
• Economic Issues of Public Education
– State and local governments provide primary,
secondary, and post-secondary education at
prices well below those that would otherwise
prevail in the marketplace
– Publicly subsidized, similar to government
subsidized healthcare
– Education priced below market
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5-43
Public Spending and Transfer
Programs (cont’d)
• The Incentive Problems of Public Education
– Various measures of performance show no
increase or decline in performance
– Many economists argue failure to improve relies
on incentive effects
– Higher subsidies may translate to services
unrelated to learning
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5-44
Example: A Weak Relationship Between
Spending and Schooling Results
• Alaska, New Jersey, New York, Vermont,
and Washington are the states with the
highest levels of per-pupil spending in
public schools.
• The five lowest per-pupil spending states
are Arizona, Idaho, Oklahoma, Tennessee,
and Utah.
• Yet, the educational outcomes do not differ
much between these two groups of states.
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5-45
Collective Decision Making: The
Theory of Public Choice
• Collective Decision Making
– How voters, politicians, and other interested
parties act and how these actions influence nonmarket decisions
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5-46
Collective Decision Making: The Theory of
Public Choice (cont'd)
• Theory of Public Choice
– The study of collective decision making
– Assumes that individuals will act within the
political process to maximize their individual
(not collective) well-being
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5-47
Collective Decision Making: The Theory of
Public Choice (cont'd)
• Similarities in market and public-sector
decision making
– Self-interest
– Opportunity cost
– Competition
– Similarity of individuals, but different incentive
structures
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5-48
Collective Decision Making: The Theory of
Public Choice (cont'd)
• Incentive Structure
– The system of rewards and punishments
individuals face with respect to their
actions
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5-49
Collective Decision Making: The Theory of
Public Choice (cont'd)
• Differences between market and collective
decision making
– Government goods at zero price
– Use of force
– Voting versus spending
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5-50
Collective Decision Making: The Theory of
Public Choice (cont'd)
• Differences between market and collective
decision making
– Voting versus spending
• Political system versus market system
– Political system run by majority rule
– Market system run by proportional rule
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5-51
Collective Decision Making: The Theory of
Public Choice (cont'd)
• Government or Political Goods
– Goods (and services) provided by the public
sector
• Majority Rule
– Collective decision making, decisions based on
more than 50%
• Proportional Rule
– If 10% of “dollar votes” cast for blue cars, 10%
of output is blue
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5-52
Collective Decision Making: The Theory of
Public Choice (cont'd)
• Differences between market and collective
decision making
– Voting versus spending
• Spending of dollars can indicate intensity of want
• Votes cannot; each vote counts with the same intensity
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5-53
You Are There: The U.S. Government Ensures
That an Airport is “Convenient”
• The free parking, short security lines, and
spacious baggage claim areas of the
Hagerstown Regional Airport in Maryland
make it much more convenient than any
major airport.
• But this convenience comes at an expense
to U.S. taxpayers, who provide a subsidy to
finance the operations of Cape Air in
providing its daily flights to Baltimore.
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5-54
Issues & Applications: The GovernmentSponsored U.S. Postal Service
• Operating as a government-sponsored
enterprise, the U.S. Postal Service (USPS)
receives an implicit subsidy in the form of
protection from competition.
• As mail volumes have declined, postal
revenues have fallen short of operating
expenses, and federally-provided loans are
making up the difference.
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5-55
Summary Discussion of Learning
Objectives
• How market failures such as externalities might
justify economic functions of government
– Market failure is a situation in which an unhindered free
market allocates too many or too few resources to a
specific economic activity
• Private goods versus public goods and the freerider problem
– Private goods are subject to rival consumption
– Public goods are not subject to rival consumption
– Free-riders anticipate others will pay
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5-56
Summary Discussion of Learning
Objectives (cont'd)
• Political functions of government that lead
to its involvement in the economy
– Merit goods deemed socially desirable
– Demerit goods deemed socially undesirable
– Redistributing income
• Transfer payments
• In kind transfers
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5-57
Summary Discussion of Learning
Objectives (cont'd)
• The effect of Medicare on incentives to
consume medical services
– Subsidies lead to a higher quantity of medical
services consumed
– Medicare encourages people to consume medical
services that are low in per-unit value relative to
the cost
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5-58
Summary Discussion of Learning
Objectives (cont'd)
• Why bigger subsidies for public schools do
not necessarily translate into improved
student performance
– Last unit of educational services provided likely
to cost more than its valuation by parents and
students
– Services provided in excess of those best suited
to promoting student learning
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5-59
Summary Discussion of Learning
Objectives (cont'd)
• Central elements of the theory of public choice
– Collective decision making
• Voters, politicians, other participants influence nonmarket
choices
– Incentive structures
• Rewards and punishments affect provision of government
goods
– Similarities and differences with market system structures
• Scarcity, competition—similarities
• Legal coercion, majority rule—differences
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5-60
Chapter 7
The Macroeconomy:
Unemployment,
Inflation, and
Deflation
Introduction
In 2009, Congress used general taxpayer funds to
extend the length of unemployment benefits from 26
weeks to 52 weeks.
A number of economists have suggested that this
policy change has caused an increase in the number of
people unemployed.
In this chapter, you will learn how unemployment is
defined as well as how extending unemployment
benefits many have contributed to the number of
people counted as unemployed.
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7-2
Learning Objectives
• Explain how the U.S. government calculates
the official unemployment rate
• Discuss the types of unemployment
• Describe how price indexes are calculated
and define the key types of price indexes
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7-3
Learning Objectives (cont'd)
• Distinguish between nominal and real
interest rates
• Evaluate who looses and who gains from
inflation
• Understand key features of business
fluctuations
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7-4
Chapter Outline
• Unemployment
• The Major Types of Unemployment
• Full Employment and the Natural Rate of
Unemployment
• Inflation and Deflation
• Anticipated versus Unanticipated Inflation
• Changing Inflation and Unemployment:
Business Fluctuations
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7-5
Did You Know That ...
• Between 2008 and 2010, the number of people
gainfully employed in the U.S. declined by nearly 9
million?
• Since then, more than 2 million of these people
have regained positions in the workplace.
• Of the remainder, most are still classified as
unemployed, which means that they are looking
for work but have not yet found employment.
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7-6
Unemployment
• Unemployment
– Total number of adults (aged 16 years or older)
willing and able to work and who are actively
looking for work but have not found a job
– Unemployment creates a cost to the entire
economy in terms of lost output – often ranging
in the billions of dollars
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7-7
Unemployment (cont'd)
• Labor Force
– Individuals aged 16 years or older who either
have jobs or who are looking and available for
jobs; the number of employed plus the number
of unemployed
• The unemployment rate is the percentage
of the measured labor force that is
unemployed
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7-8
Figure 7-1 More Than a Century of
Unemployment
Source: U.S. Department of Labor, Bureau of Labor Statistics.
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7-9
Figure 7-2 Adult Population
Source: U.S. Department of Labor, Bureau of Labor Statistics.
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7-10
Unemployment (cont'd)
• Stock
– The quantity of something, measured at a given
point in time—for example, an inventory of
goods
• Flow
– A quantity measured over time, such as the
income you make per year, or the number of
individuals fired every month
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7-11
Figure 7-3 The Logic of the
Unemployment Rate
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7-12
Unemployment (cont'd)
• Categories of individuals without work
– Job loser
– Reentrant
– Job leaver
– New entrant
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7-13
Unemployment (cont'd)
• Job Loser
– An individual whose employment was
involuntarily terminated or who was laid off
• 40–60% of the unemployed
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7-14
Unemployment (cont'd)
• Reentrant
– An individual who has worked a full-time job
before but left the labor force and has now
reentered it looking for a job
• 20–30% of the unemployed
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7-15
Unemployment (cont'd)
• Job Leaver
– An individual who voluntarily quit
• 10 to 15% of the unemployed
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7-16
Unemployment (cont'd)
• New Entrant
– An individual who has never worked a full-time
job for two weeks or longer
• 10 to 15% of the unemployed
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7-17
Unemployment (cont’d)
• Duration of unemployment
– More than a third of job seekers find work within
one month
– Approximately another third find employment
within a second month
– About a sixth are still unemployed after six
months
– Average duration varied between 10 and 20
weeks since the mid-1960s
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7-18
Unemployment (cont'd)
• Discouraged Workers
– Individuals who have stopped looking for a job
because they are convinced they will not find a
suitable one
• Question
– How does the existence of discouraged workers
bias the unemployment rate?
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7-19
Unemployment (cont'd)
• Labor Force Participation Rate
– The proportion of non-institutionalized workingage individuals who are employed or seeking
employment
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7-20
The Major Types of Unemployment
• The major types of unemployment
– Frictional
– Structural
– Cyclical
– Seasonal
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7-21
Example: Fewer Men at Work – Or
Even Looking for It
• Since the beginning of 2008, the U.S. labor force
participation rate has decreased by 2 full
percentage points.
• This translates into a departure of 5 million people
from the labor force.
• Men are heavily represented in this group of
discouraged workers.
• During the 2008 – 2009 recession, occupations
dominated by male workers, such as construction
and manufacturing, experienced the largest job
losses.
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7-22
The Major Types of Unemployment
(cont'd)
• Frictional Unemployment
– Results from the fact that workers must search
for appropriate job offers
– This takes time, so they remain temporarily
unemployed
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7-23
The Major Types of Unemployment
(cont'd)
• Structural Unemployment
– Unemployment of workers over lengthy intervals
resulting from skill mismatches with position
requirements of employers and from fewer jobs
being offered by employers constrained by
governmental business regulations and labormarket policies.
– Considerable evidence shows that government
labor market policies influence how many jobs
businesses wish to create, thereby affecting
structural unemployment.
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7-24
Policy Example: Warning: WARN May
Boost the Natural Unemployment Rate
• In 1989, Congress passed the Worker
Adjustment and Retraining Notification
(WARN) Act.
• The law requires firms to notify employees
and provide benefits when 50 or more fulltime workers are laid off.
• The law rarely applied until the 2008–2009
recession, when many firms initiated large
layoffs just to stay in business.
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7-25
Policy Example: Warning: WARN May
Boost the Natural Unemployment Rate
• As the number of WARN-related court cases
tripled, managers became more reluctant to
hire new workers, wanting to avoid future
layoffs.
• As a consequence, the unemployment rate
has remained high even as many companies
are experiencing improved performance and
profitability.
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7-26
The Major Types of Unemployment
(cont'd)
• Cyclical Unemployment
– Results from business recessions that occur
when aggregate (total) demand is insufficient to
create full employment
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7-27
The Major Types of Unemployment
(cont'd)
• Seasonal Unemployment
– Results from the seasonal pattern of work in
specific industries
– Due to seasonal fluctuations in demand or
changing weather conditions that affect
agriculture, construction, tourism industries and
so on
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7-28
Full Employment and the Natural
Rate of Unemployment (cont'd)
• Full Employment
– An arbitrary level of unemployment that
corresponds to “normal” friction in the labor
market
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7-29
Full Employment and the Natural
Rate of Unemployment (cont'd)
• Natural Rate of Unemployment
– The unemployment rate that is estimated to
prevail in the long-run macroeconomic
equilibrium
– Should not reflect cyclical unemployment
– When seasonally adjusted, the natural rate
should include only frictional and structural
unemployment
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7-30
Full Employment and the Natural
Rate of Unemployment (cont'd)
• Until the late 2000’s, most economists had
considered the natural rate of unemployment to be
about 5 percent.
• Since the end of the 2008-2009 recession,
however, the actual unemployment rate has been
considerably in excess of 5 percent.
• It has been suggested that higher structural
unemployment arises from two sources:
– The loss of jobs in construction, finance, and real estate
– Government regulations that raise the costs of hiring new
employees
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7-31
Inflation and Deflation
• Inflation
– A sustained increase in the average of all prices
of goods and services in an economy
• Deflation
– A sustained decrease in the average of all prices
of goods and services in an economy
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7-32
Inflation and Deflation (cont'd)
• Purchasing Power
– The value of money for buying goods and
services
– Varies with prices and income, e.g., if your
money income stays the same but the price of
one good goes up, your effective purchasing
power falls
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7-33
Inflation and Deflation (cont'd)
• Nominal value
– Price expressed in today’s dollars
• Real value
– Value expressed in purchasing power, adjusted
for inflation
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7-34
What If . . . City Governments Pass More Laws to
Benefit All Employees?
• Beginning in 2013, a new health care law went into
effect that is expected to raise the cost of
businesses providing health insurance coverage to
their employees.
• In addition, new laws are increasing the number of
days that firms must allow employees to take off
from work when they have a new child.
• These regulations reduce the incentive for firms to
hire new workers, thereby adding to structural
unemployment.
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7-35
Inflation and Deflation (cont'd)
Measuring the Rate of Inflation
• Market Basket
– Representative bundle of goods and services
• Base Year
– The point of reference for comparison of prices in
other years
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7-36
Inflation and Deflation (cont'd)
• Price Index
– The cost of today’s market basket of goods
expressed as a percentage of the cost of the
same market basket during a base year
cost of market basket today
Price index =
100
cost of market basket in base year
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7-37
Table 7-1 Calculating a Price Index for a
Two-Good Market Basket
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7-38
Inflation and Deflation (cont'd)
• Real-world price indexes
– Consumer Price Index (CPI)
– Producer Price Index (PPI)
– GDP deflator
– Personal Consumption Expenditure (PCE)
Copyright ©2014 Pearson Education, Inc. All rights reserved.
7-39
Inflation and Deflation (cont'd)
• Consumer Price Index (CPI)
– A statistical measure of a weighted average of
prices of a specified set of goods and services
purchased by wage earners in urban areas
– Market basket of goods and services of typical
consumer
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7-40
International Example: Why the Value of
China’s Consumer Price Index Is Rising
• In China, food accounts for about 35
percent of items in the consumer price
index.
• Food prices have been increasing so rapidly,
however, that they account for most of the
increase in China’s annual inflation rate.
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7-41
Inflation and Deflation (cont'd)
• Producer Price Index (PPI)
– A statistical measure of a weighted average of prices of
goods and services that firms produce and sell
– Used as a short-run leading indicator (before CPI)
– Producer Price Indexes for:
• Foodstuffs
• Intermediate goods
• Finished goods
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7-42
Inflation and Deflation (cont'd)
• GDP Deflator
– A price index measuring the changes in prices of
all new goods and services produced in the
economy
– Broadest measure of prices; reflects both price
changes and the public’s market responses to
those price changes
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7-43
Inflation and Deflation (cont'd)
• Personal Consumption Expenditure (PCE)
Index
– A statistical measure of average price using
annually updated weights based on consumer
spending
– Primary inflation indicator used by the Federal
Reserve
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7-44
Figure 7-4 Inflation and Deflation in
U.S. History
Source: U.S.
Department of
Labor, Bureau of
Labor Statistics.
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7-45
International Policy Example: Argentina
Penalizes Inflation Estimates That Are
“Too High”
• The official government measure of inflation
reported in Argentina is typically lower than the
inflation rate calculated by private firms.
• The Argentine government has criticized the
estimates of private firms and has imposed fines
on inflation estimates that differ substantially from
the inflation forecast.
• Consequently, private firms that provide
independent estimates do so only under the
condition of confidentiality.
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7-46
Anticipated versus Unanticipated
Inflation
• Anticipated versus unanticipated inflation
– To determine who is hurt by inflation we
distinguish between the two types
– The effects of inflation on individuals depend
upon which type of inflation exists
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7-47
Anticipated versus Unanticipated
Inflation (cont'd)
• Anticipated Inflation
– The inflation rate that we believe will occur
• Unanticipated Inflation
– Inflation at a rate that comes as a surprise
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7-48
Anticipated versus Unanticipated
Inflation (cont'd)
• Inflation and interest rates
– Nominal Rate of Interest
• The market rate of interest expressed in today’s dollars
– Real Rate of Interest
• The nominal rate of interest minus the anticipated rate
of inflation
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7-49
Anticipated versus Unanticipated
Inflation (cont'd)
• Real interest rate
– Nominal interest rate = 5%
– Expected inflation rate = 3%
– Real rate = 5% – 3% = 2%
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7-50
Anticipated versus Unanticipated
Inflation (cont'd)
• Does inflation necessarily hurt everyone?
– Inflation affects people differently
• Unanticipated inflation
– Creditors lose
– Debtors gain
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7-51
Anticipated versus Unanticipated
Inflation (cont'd)
• Protecting against inflation
– Cost-Of-Living Adjustments (COLAs)
• Clauses in contracts that allow for increases in specified
nominal values to take account of changes in the cost
of living
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7-52
Anticipated versus Unanticipated
Inflation (cont'd)
• The resource cost of inflation
– Repricing or Menu Cost of Inflation
• The cost associated with recalculating prices and
printing new price lists when there is inflation
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7-53
Changing Inflation and Unemployment:
Business Fluctuations
• Business Fluctuations
– The ups and downs in business activity
throughout the economy
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7-54
Changing Inflation and Unemployment:
Business Fluctuations (cont'd)
• Expansion
– A business fluctuation in which the pace of
national economic activity is speeding up
• Contraction
– A business fluctuation during which the pace of
national economic activity is slowing down
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7-55
Changing Inflation and Unemployment:
Business Fluctuations (cont'd)
• Recession
– A period of time during which the rate of growth
of business activity is consistently less than its
long-term trend or is negative
• Depression
– An extremely severe recession
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7-56
Figure 7-5 The Idealized Course of Business
Fluctuations
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7-57
Figure 7-6 National Business Activity,
1880 to the Present
Sources: American Business Activity from 1790 to Today, 67th ed., AmeriTrust Co., January 1996,
plus author’s estimates.
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7-58
Changing Inflation and Unemployment:
Business Fluctuations (cont'd)
• Leading Indicators
– Events that have been found to occur before
changes in business activity
• Economic downturns often follow
– Reduction in the average workweek
– Rise in unemployment insurance claims
– Decrease in prices of raw materials
– Drop in the quantity of money circulating
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7-59
International Policy Example: Internet Search
Activity as a Leading Indicator
• Economists at the Bank of England are studying the
volume of Internet searches as a leading indicator
of economic activity.
• This measure exhibits desirable properties of a
leading indicator:
– The data are available daily
– 60 percent of the adult population in the U.K. engages in
Web searches every day
– The volume of online searches appears to be related to key
measures of economic activity.
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7-60
You Are There: Struggling to Hire with the
Unemployment Rate Above 9 Percent
• Jack Kelly, CEO of Hamill Manufacturing, is having
a difficult time finding skilled workers to fill open
positions for operators of computer-controlled
metal-shaping equipment.
• A high-school graduate with knowledge of
trigonometry and basic science has the
fundamentals required for these jobs.
• Yet, students with these skills typically go on to
college rather than prepare for a career as a skilled
manufacturing laborer.
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7-61
Issues & Applications: Have Unemployment
Benefits Boosted Unemployment?
• Following the end of the recession in 2009, the
unemployment rate remained elevated above its
prior level by more than 2 percentage points for at
least three years.
• Some economists argue that this higher level of
structural unemployment is the result of the
significant extension of the length of
unemployment benefits to 99 weeks.
• Unemployed workers now have a greater incentive
to keep looking for jobs that are a good fit for their
preferences.
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7-62
Summary Discussion of Learning
Objectives
• How the U.S. government calculates the
official unemployment rate
– Percentage of the total number of adults willing
and able to work who are actively looking for
work but have not found a job
• The major types of unemployment
–
–
–
–
Frictional
Structural
Cyclical
Seasonal
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7-63
Summary Discussion of Learning
Objectives (cont'd)
• Full employment
– Arbitrary level of unemployment
• Corresponds to “normal” friction in labor market
• Natural rate of unemployment
– Estimated to prevail in the long-run
macroeconomic equilibrium
• All workers and employers adjust to any changes in
economy
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7-64
Summary Discussion of Learning
Objectives (cont'd)
• How price indexes are calculated and key
price indexes
– Multiply 100 times the ratio of the cost of a
market basket of goods in the current year to
the cost of the same basket in a base year
– Key price indexes
•
•
•
•
CPI
PPI
GDP deflator
PCE
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7-65
Summary Discussion of Learning
Objectives (cont'd)
• Nominal versus real interest rates
– Nominal rate is the market rate expressed in
current dollars
– Real rate is net of inflation
– Hence the real interest rate equals the nominal
interest rate minus the expected inflation rate
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7-66
Summary Discussion of Learning
Objectives (cont'd)
• Losers and gainers from inflation
– Creditors lose as a result of unanticipated
inflation
– Borrowers gain
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7-67
Summary Discussion of Learning
Objectives (cont'd)
• Key features of business fluctuations
– Increases and decreases in business activity
• Expansion from previous trough to new peak
• Contraction from previous peak to new trough
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7-68
Chapter 8
Measuring the
Economy’s
Performance
Introduction
Some commentators are already referring to the twentyfirst century as the “Asian century.” It has been
suggested that China’s economy will be larger than the
U.S. economy by 2020.
How do we go about measuring the size of an economy?
And how do we make international comparisons with
regard to this measure?
The concept of gross domestic product, which is a key
concept of Chapter 8, is the starting point for
contemplating these questions.
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8-2
Learning Objectives
• Describe the circular flow of income and
output
• Define gross domestic product (GDP)
• Understand the limitations of using GDP as
a measure of national welfare
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8-3
Learning Objectives (cont'd)
• Explain the expenditure approach to
tabulating GDP
• Explain the income approach to computing
GDP
• Distinguish between nominal GDP and real
GDP
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8-4
Chapter Outline
•
•
•
•
The Simple Circular Flow
National Income Accounting
Two Main Methods of Measuring GDP
Other Components of National Income
Accounting
• Distinguishing Between Nominal and Real
Values
• Comparing GDP Throughout the World
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8-5
Did You Know That ...
• The flow of U.S. economic activity since
2009 has been more dampened than during
any other comparable post-recession period
since the Great Depression of the 1930’s?
• To measure the nation’s overall economic
performance, the government utilizes the
concept of national income accounting.
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8-6
The Simple Circular Flow
The concept of the circular flow of income
involves two principles:
1. In every economic exchange, the seller receives
exactly the same amount that the buyer spends
2. Goods and services flow in one direction and
money payments flow in the other
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8-7
The Simple Circular Flow (cont'd)
• Profits explained
– Question
• Why is profit a cost of production?
– Answer
• Profits are the return entrepreneurs receive for the risk
they incur when organizing productive activities
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8-8
Figure 8-1 The Circular Flow of Income
and Product
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8-9
The Simple Circular Flow (cont'd)
• Product Markets
– Transactions in which households buy goods
• Factor Markets
– Transactions in which businesses buy resources
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8-10
The Simple Circular Flow (cont'd)
• Total Income
– The yearly amount earned by the nation’s
resources (factors of production)
– Includes wages, rent, interest payments, and
profits received by workers, landowners, capital
owners, and entrepreneurs, respectively
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8-11
The Simple Circular Flow (cont'd)
• Final Goods and Services
– Goods and services that are at their final stage
of production and will not be transformed into
yet other goods or services
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8-12
The Simple Circular Flow (cont'd)
• Question
– Why must the dollar value of total output equal
total income?
• Answer
– Every transaction simultaneously involves an
expenditure and a business receipt
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8-13
National Income Accounting
• National Income Accounting
– A measurement system used to estimate
national income and its components
• Gross Domestic Product (GDP)
– The total market value of all final goods and
services produced by factors of production
located within a nation’s borders
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8-14
National Income Accounting (cont'd)
• Observations
– GDP measures the dollar value of final output
– GDP measures the dollar value of final goods
and services produced per year by factors of
production located within a nation’s borders
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8-15
National Income Accounting (cont'd)
• Stress on final output
– What is a final good?
• Wheat?
• Steel?
• Crude oil?
• Bread?
• Automobile?
• Gasoline?
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8-16
National Income Accounting (cont'd)
• Intermediate Goods
– Goods used up entirely in the production of final
goods
• Value Added
– The dollar value of an industry’s sales minus the
value of intermediate goods (for example, raw
materials and parts) used in production
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8-17
Table 8-1 Sales Value and Value Added at
Each Stage of Donut Production
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8-18
National Income Accounting (cont'd)
• Numerous transactions occur that have
nothing to do with final goods and services
being produced:
– Financial transactions
– Transfer of secondhand goods
– Others excluded transactions
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8-19
What If . . . Market prices of house cleaning, child
care, and lawn care services were valued for
inclusion in GDP?
• Even if market prices of household services
were used to place a value on household
production, national income accountants
still would not know the volume of such
activity.
• Therefore, they would have to estimate the
amount of household activity, and this
would introduce measurement errors into
the calculation of GDP.
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8-20
National Income Accounting (cont'd)
• Financial transactions
– Securities
• Stocks and bonds
– Government transfer payments
• Social Security
• Unemployment compensation
– Private transfer payments
• Individual gifts
• Corporate gifts
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8-21
National Income Accounting (cont'd)
• Transfer of secondhand goods
– Why not count the sale of a used computer,
guitar, or snowboard as part of GDP?
• Other excluded transactions
– Household production
– Legal and illegal underground transactions
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8-22
National Income Accounting (cont'd)
• GDP’s limitations
– Excludes non-market production
– It is not necessarily a good measure of the wellbeing of a nation
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8-23
National Income Accounting (cont'd)
• GDP:
– Is a measure of the value of production in terms
of market prices, and an indicator of economic
activity
– Is not a measure of a nation’s overall welfare
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8-24
Policy Example: Developed Nations Look for a
“Happier” Alternative to GDP
• The 34 member nations of the Organization for
Economic Cooperation and Development are aiming
to supplement or even replace GDP with a measure
called the “Your Better Life Index.”
• This measure of well-being includes scores in 11
areas such as community, education, health,
housing, life satisfaction, and safety.
• Initial results of the Your Better Life Index yield
high rankings for Denmark, Canada, and Norway,
with Hungary, Portugal, and Estonia ranking lowest
among the OECD nations.
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8-25
Two Main Methods of Measuring GDP
• Expenditure Approach
– Computing GDP by adding up the dollar value at
current market prices of all final goods and
services
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8-26
Two Main Methods of Measuring GDP
(cont'd)
• Income Approach
– Measuring GDP by adding up all components of
national income, including wages, interest, rent,
and profits
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8-27
Two Main Methods of Measuring GDP
(cont'd)
• Deriving GDP by the expenditure approach
– Consumption Expenditure (C)
• Durable Consumer Goods
– Items that last more than three years (automobiles,
furniture)
• Nondurable Consumer Goods
– Goods that are used up in three years (gasoline, food)
• Services
– Mental or physical help
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8-28
Two Main Methods of Measuring GDP
(cont'd)
• Deriving GDP by the expenditure approach
– Gross Private Domestic Investment (I)
• The creation of capital goods, such as factories and
machines, that can yield production and hence
consumption in the future
– Also includes changes in business inventories and repairs
made to machines, buildings
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8-29
Two Main Methods of Measuring GDP
(cont'd)
• Deriving GDP by the expenditure approach
– Gross Private Domestic Investment (I)
• Producer Durables or Capital Goods
– Life span of more than three years
• Fixed Investment
– Purchases by business of newly produced producer
durables or capital goods
• Inventory Investment
– Changes in stocks of finished goods and goods in
process, as well as changes in raw materials
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8-30
Example: Imputing Part of the
Government’s Contribution to GDP
• Some items included in GDP do not have explicit
market prices.
– Examples include public education, fire protection, and
national defense.
• National income accountants have reasoned that
government expenditures on these items
understate the market prices that would prevail if
they were provided by private firms.
• Therefore, the values are determined by using
prices for education, fire protection, and security
services provided in private markets.
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8-31
Two Main Methods of Measuring GDP
(cont'd)
• Deriving GDP by the Expenditure Approach
– Government Expenditures (G)
• State, local, and federal
• Valued at cost
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8-32
Two Main Methods of Measuring GDP
(cont'd)
• Deriving GDP by the Expenditure Approach
– Net Exports (Foreign Expenditures)
Net exports (X) = Total exports – Total imports
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8-33
Two Main Methods of Measuring GDP
(cont'd)
• Presenting the expenditure approach
GDP = C + I + G + X
where
C=
consumption expenditures
I =
investment expenditures
G=
government expenditures
X=
net exports
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8-34
Figure 8-2 GDP and Its Components
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8-35
Two Main Methods of Measuring GDP
(cont'd)
• Net Domestic Product (NDP)
– Allowing for depreciation (capital consumption
allowance)
• The amount that businesses would have to save in
order to take care of deteriorating machines and other
equipment
NDP = GDP – Depreciation
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8-36
Two Main Methods of Measuring GDP
(cont'd)
• Because NDP = GDP – Depreciation, and
GDP = C + I + G + X
• NDP = C + I + G + X – Depreciation
• NDP = C + net I + G + X
where net I (net investment ) = I – Depreciation
– Domestic investment minus an estimate of the wear and
tear on the existing capital stock
– The change in the capital stock over a one-year period
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8-37
Two Main Methods of Measuring GDP
(cont’d)
• Deriving GDP by the Income Approach
– Gross Domestic Income (GDI)
• The sum of all income (wages, interest, rent, and
profits) paid to the four factors of production
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8-38
Two Main Methods of Measuring GDP
(cont'd)
• Deriving GDP by the Income Approach
– Gross Domestic Income (GDI)
• Wages: salaries and labor income
• Rent: farms, houses, stores
• Interest: savings accounts
• Profits: sole proprietorships, partnerships, corporations
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8-39
Two Main Methods of Measuring GDP
(cont'd)
• Deriving GDP by the Income Approach
– Gross domestic product equals gross domestic
income plus indirect business taxes and
depreciation
– These last items are called non-income expense
items
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8-40
Two Main Methods of Measuring GDP
(cont'd)
• Deriving GDP by the Income Approach
– Indirect business taxes
• All business taxes except the tax on corporate profits
• Include sales and business property taxes
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8-41
Figure 8-3 Gross Domestic Product and Gross
Domestic Income, 2013
(in billions of 2005 dollars per year)
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8-42
Figure 8-3 Gross Domestic Product and Gross
Domestic Income, 2013
(in billions of 2005 dollars per year) (cont’d)
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8-43
Other Components of National
Income Accounting
• National Income (NI)
– The total of all factor payments to resource
owners
• Personal Income (PI)
– The amount of income that households actually
receive before they pay personal income taxes
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8-44
Example: Sources of U.S. Personal
Income Exhibit Unsustainable Trends
• Since early 2010, the share of personal
income derived from private payrolls has
dropped to levels that are the lowest in U.S.
history.
• At the same time, the portion of personal
income derived from government-provided
benefits has risen to its highest level.
• These trends are unsustainable because
government benefits are financed through
taxes on private income.
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8-45
Other Components of National
Income Accounting (cont'd)
• Disposable Personal Income (DPI)
– Personal income after personal income taxes
have been paid
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8-46
Table 8-2 Going from GDP to
Disposable Income, 2013
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8-47
Distinguishing Between Nominal and
Real Values
• Nominal Values
– Measurements in terms of the actual market
prices at which goods are sold; expressed in
current dollars, also called money values
• Real Values
– Measurements after adjustments have been
made for changes in the average of prices
between years; expressed in constant dollars
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8-48
Distinguishing Between Nominal and
Real Values (cont'd)
• Constant Dollars
– Dollars expressed in terms of real purchasing
power
– This price-corrected GDP is the real GDP
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8-49
Example: Correcting GDP for Price
Index Changes, 2003 - 2013
• Let’s use a numerical example to show how
we can adjust GDP for changes in the price
index.
• In this example shown on the next slide, the
GDP deflator is used to calculate values for
real GDP from 2003 to 2013.
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8-50
Table 8-3 Correcting GDP for Price
Index Changes
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8-51
Figure 8-4 Nominal and Real GDP
Source: U.S. Department of Commerce.
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8-52
Distinguishing Between Nominal and
Real Values (cont'd)
• Per capita real GDP
– Real GDP divided by total population
Real GDP
Per capita real GDP =
Population
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8-53
Comparing GDP Throughout the
World
• Foreign Exchange Rate
– The price of one currency in terms of another
• Example:
– $1.25 = 1 euro, or $1 = .80 euros
– French income per capita = 28,944 euros
– French per capita income in terms of dollars
equals 28,944 euros x $1.25 = $36,180
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8-54
Comparing GDP Throughout the
World (cont'd)
• Purchasing Power Parity
– Adjustment in exchange rate conversions that
takes into account differences in the true cost of
living across countries
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8-55
International Example: Purchasing Power Parity
Comparisons of World Incomes
• The International Monetary Fund accepted the
purchasing power parity approach a few years ago
• It started presenting the statistics on each
country’s GDP relative to others and based on the
purchasing power parity relative to the dollar
• Why is China’s per capita GDP higher based on
purchasing power parity?
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8-56
Table 8-4 Comparing GDP
Internationally
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8-57
You Are There: Has the Economy Grown More
than Official GDP Data Suggest?
• Economists Bart Hobijin and Charles Steindel at
the Federal Reserve Bank of New York are
considering how to include three additional items
in GDP:
– Intangible investment
– Real capital investment undertaken by government
– Shift away from non-market home production as more
women enter the labor force.
• Hobijin and Steindel conclude that the net effect of
these three items is to boost the GDP growth rate
by about 0.5 percentage points per year.
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8-58
Issues & Applications: Asia’s “Economic Size”
Depends on How It Is Measured
• The figure on the next slide shows the combined
real GDP of Asia as a percentage of real GDP of the
entire world.
• The calculation was done according to two different
measures.
• One used prevailing exchange rates in foreign
currency markets.
• The other used purchasing power parity
adjustments.
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8-59
Figure 8-5
GDP
Asia’s Share of Global Real
Source: International Monetary Fund.
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8-60
Issues & Applications: Asia’s “Economic Size”
Depends on How It Is Measured (cont’d)
• Of the two methods, the purchasing power
parity measure gives a larger estimate for
Asia’s share of the world economy.
• Another measure of Asia’s economic
presence is per capita real GDP.
– When comparisons are based on foreign
exchange rates, Asian per capita real GDP is 11
percent of global per capita real GDP.
– Using a purchasing power parity comparison, the
figure rises to 26 percent.
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8-61
Summary Discussion of Learning
Objectives
• The circular flow of income and output
– In every economic transaction, receipts exactly
equal expenditures
– Goods and services flow in one direction and
money payments flow in the other
• Gross domestic product (GDP)
– The total market value of a nation’s final output
of goods and services produced in a year using
factors of production located within its borders
Copyright ©2014 Pearson Education, Inc. All rights reserved.
8-62
Summary Discussion of Learning
Objectives (cont'd)
• The limitations of using GDP as a measure
of national welfare
– Excludes non-market transactions
– Does not measure national well-being
• The expenditure approach to tabulating
GDP
– GDP = C + I + G + X
Copyright ©2014 Pearson Education, Inc. All rights reserved.
8-63
Summary Discussion of Learning
Objectives (cont'd)
• The income approach to computing GDP
– The sum of wages, rent, interest, profits
• Distinguishing between nominal GDP and
real GDP
– Nominal GDP is the value of newly produced
final output measured in current market prices.
– Real GDP adjusts nominal GDP into constant
dollars by correcting for price level changes
Copyright ©2014 Pearson Education, Inc. All rights reserved.
8-64
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