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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. Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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. Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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) Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 5-13 Figure 5-1 External Costs and Benefits, Panel (a) Copyright ©2014 Pearson Education, Inc. All rights reserved. 5-14 Figure 5-1 External Costs and Benefits, Panel (b) Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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. Copyright ©2014 Pearson Education, Inc. All rights reserved. 5-17 Correcting for Externalities (cont'd) • How the government can correct positive externalities – Government financing and production – Subsidies – Regulation Copyright ©2014 Pearson Education, Inc. All rights reserved. 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. Copyright ©2014 Pearson Education, Inc. All rights reserved. 5-19 The Other Economic Functions of Government • Providing a legal system • Promoting competition • Providing public goods • Ensuring economy-wide stability Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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. Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 5-30 The Political Functions of Government (cont'd) • Income redistribution: includes progressive income tax system and transfers – Transfer payments – Transfers in kind Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 5-34 Figure 5-2 Total Government Outlays over Time Sources: Facts and Figures on Government Finance, various issues; Economic Indicators, various issues. Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 5-36 Figure 5-3 Federal Government Spending Compared to State and Local Spending Sources: Economic Report of the President, Economic Indicators. Copyright ©2014 Pearson Education, Inc. All rights reserved. 5-37 Figure 5-4 The Economic Effects of Medicare Subsidies Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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. Copyright ©2014 Pearson Education, Inc. All rights reserved. 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. Copyright ©2014 Pearson Education, Inc. All rights reserved. 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. Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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. Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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. Copyright ©2014 Pearson Education, Inc. All rights reserved. 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. Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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. Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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. Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 7-8 Figure 7-1 More Than a Century of Unemployment Source: U.S. Department of Labor, Bureau of Labor Statistics. Copyright ©2014 Pearson Education, Inc. All rights reserved. 7-9 Figure 7-2 Adult Population Source: U.S. Department of Labor, Bureau of Labor Statistics. Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 7-11 Figure 7-3 The Logic of the Unemployment Rate Copyright ©2014 Pearson Education, Inc. All rights reserved. 7-12 Unemployment (cont'd) • Categories of individuals without work – Job loser – Reentrant – Job leaver – New entrant Copyright ©2014 Pearson Education, Inc. All rights reserved. 7-13 Unemployment (cont'd) • Job Loser – An individual whose employment was involuntarily terminated or who was laid off • 40–60% of the unemployed Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 7-15 Unemployment (cont'd) • Job Leaver – An individual who voluntarily quit • 10 to 15% of the unemployed Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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? Copyright ©2014 Pearson Education, Inc. All rights reserved. 7-19 Unemployment (cont'd) • Labor Force Participation Rate – The proportion of non-institutionalized workingage individuals who are employed or seeking employment Copyright ©2014 Pearson Education, Inc. All rights reserved. 7-20 The Major Types of Unemployment • The major types of unemployment – Frictional – Structural – Cyclical – Seasonal Copyright ©2014 Pearson Education, Inc. All rights reserved. 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. Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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. Copyright ©2014 Pearson Education, Inc. All rights reserved. 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. Copyright ©2014 Pearson Education, Inc. All rights reserved. 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. Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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. Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 7-37 Table 7-1 Calculating a Price Index for a Two-Good Market Basket Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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. Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 7-44 Figure 7-4 Inflation and Deflation in U.S. History Source: U.S. Department of Labor, Bureau of Labor Statistics. Copyright ©2014 Pearson Education, Inc. All rights reserved. 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. Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 7-49 Anticipated versus Unanticipated Inflation (cont'd) • Real interest rate – Nominal interest rate = 5% – Expected inflation rate = 3% – Real rate = 5% – 3% = 2% Copyright ©2014 Pearson Education, Inc. All rights reserved. 7-50 Anticipated versus Unanticipated Inflation (cont'd) • Does inflation necessarily hurt everyone? – Inflation affects people differently • Unanticipated inflation – Creditors lose – Debtors gain Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 7-53 Changing Inflation and Unemployment: Business Fluctuations • Business Fluctuations – The ups and downs in business activity throughout the economy Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 7-56 Figure 7-5 The Idealized Course of Business Fluctuations Copyright ©2014 Pearson Education, Inc. All rights reserved. 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. Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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. Copyright ©2014 Pearson Education, Inc. All rights reserved. 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. Copyright ©2014 Pearson Education, Inc. All rights reserved. 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. Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 7-66 Summary Discussion of Learning Objectives (cont'd) • Losers and gainers from inflation – Creditors lose as a result of unanticipated inflation – Borrowers gain Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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. Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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. Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 8-8 Figure 8-1 The Circular Flow of Income and Product Copyright ©2014 Pearson Education, Inc. All rights reserved. 8-9 The Simple Circular Flow (cont'd) • Product Markets – Transactions in which households buy goods • Factor Markets – Transactions in which businesses buy resources Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 8-15 National Income Accounting (cont'd) • Stress on final output – What is a final good? • Wheat? • Steel? • Crude oil? • Bread? • Automobile? • Gasoline? Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 8-17 Table 8-1 Sales Value and Value Added at Each Stage of Donut Production Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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. Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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. Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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. Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 8-34 Figure 8-2 GDP and Its Components Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 8-41 Figure 8-3 Gross Domestic Product and Gross Domestic Income, 2013 (in billions of 2005 dollars per year) Copyright ©2014 Pearson Education, Inc. All rights reserved. 8-42 Figure 8-3 Gross Domestic Product and Gross Domestic Income, 2013 (in billions of 2005 dollars per year) (cont’d) Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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. Copyright ©2014 Pearson Education, Inc. All rights reserved. 8-45 Other Components of National Income Accounting (cont'd) • Disposable Personal Income (DPI) – Personal income after personal income taxes have been paid Copyright ©2014 Pearson Education, Inc. All rights reserved. 8-46 Table 8-2 Going from GDP to Disposable Income, 2013 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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. Copyright ©2014 Pearson Education, Inc. All rights reserved. 8-50 Table 8-3 Correcting GDP for Price Index Changes Copyright ©2014 Pearson Education, Inc. All rights reserved. 8-51 Figure 8-4 Nominal and Real GDP Source: U.S. Department of Commerce. Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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 Copyright ©2014 Pearson Education, Inc. All rights reserved. 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? Copyright ©2014 Pearson Education, Inc. All rights reserved. 8-56 Table 8-4 Comparing GDP Internationally Copyright ©2014 Pearson Education, Inc. All rights reserved. 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. Copyright ©2014 Pearson Education, Inc. All rights reserved. 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. Copyright ©2014 Pearson Education, Inc. All rights reserved. 8-59 Figure 8-5 GDP Asia’s Share of Global Real Source: International Monetary Fund. Copyright ©2014 Pearson Education, Inc. All rights reserved. 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. Copyright ©2014 Pearson Education, Inc. All rights reserved. 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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Running head: ECONOMICS

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ECONOMICS

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One of the things that I found interesting is the difficulty the government may have in
charging companies that use public goods. The government is known to sometimes overcharge
taxes to companies and organizations in a bid to collect the tax. Companies are after profit
maximization, and...


Anonymous
Excellent resource! Really helped me get the gist of things.

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