CHAPTER 13Measuring the

Economy’s Performance

CHAPTER 13SECTION 1

National Income Accounting

National Income Accounting

National Income Accounting: the measurement of the national economy’s performance

Five major statistics measure the national economy: gross domestic product (GDP) net domestic product (NDP) national income (NI) personal income (PI) disposable personal income (DPI)

Measuring GDP

Gross Domestic Product (GDP): total dollar value of all final goods produced in a country during a year

This figure tells the amount of goods and services produced within the country’s borders and made available for purchase in that year.

Measuring Value

Simply adding up the quantities of different items produced would not mean much to measuring the economy.

It is important to know the value of items using some common metric.

The GDP value is always expressed in dollars.

Measuring Final Goods and Services

The GDP only accounts for final products so that parts are not double counted. For example: GDP does not add the price of

computers and motherboards and memory chips if those motherboards and memory chips are going to be installed in computers for sale.

Only new products are counted: used products are not because they are considered a transfer from one owner to another.

Computing GDP

GDP is computed by adding products purchased by consumers (C), by businesses (I), by the government (G), and net exports (X), which is the difference between exports and imports. GDP= (C)+(I)+(G)+(X)

Weaknesses of GDP

Some of the figures used to compute GDP are estimates.

It omits some areas of the economy.

It only measures quantity not quality.

Net Domestic Product

Accounts for fact that some production is only due to depreciation. Depreciation: loss of value because of wear and

tear to durable goods and capital goods

Net Domestic Product (NDP): value of the nation’s total output (GDP) minus the total value lost through depreciation on equipment

NDP is a better measure of productivity because it accounts for depreciation.

Measurement of Income

Three measurements look at income:

National Income

Personal Income

Disposable Personal Income

National Income

National Income (NI): the total income earned by everyone in the economy.

NI is equal to the sum of all income resulting from 5 areas of the economy: wages and salaries income of self-employed people rental income corporate profits interest on savings and other investments.

Personal Income

Personal income (PI): total income that individuals receive before paying personal taxes

PI is National Income minus transfer payments (assistance payments) and income that is not available to be spent. Transfer Payments: welfare and other

supplementary payments that a state or the federal government makes to individuals

Disposable Personal Income

Disposable personal income (DI): income left to purchase goods or put in savings after paying taxes.

DI is an important indicator of the economy’s health because it measures the actual amount of money income people have available to save and spend.

CHAPTER 13SECTION 2

Correcting Statistics for Inflation

The Purchasing Power of Money

When inflation occurs, the prices of goods and services rise, and the purchasing price of the dollar goes down. Inflation: prolonged rise in the general price

level of goods and services

Purchasing power of a dollar is equal to the real goods and services the dollar can buy. Inflation can also be defined as the decline in

the purchasing power of money.

The Purchasing Power of Money

Faster the rate of inflation, greater the drop in purchasing power.

Inflation must be taken into account when calculating the GDP.

Deflation: a prolonged decline in the general price level of goods and services Deflation rarely happens.

Measures of Inflation

The government measures inflation in several ways.

Three of the most commonly used measurements are: Consumer Price Index (CPI)

Producer Price Index (PPI)

GDP Price Deflator

Consumer Price Index

The consumer price index (CPI): measure of the change in price of a specific group of products and services used by the average household.

The group of items that are priced are referred to as a market basket. Market Basket: representative group of goods

and services used to compile the consumer price index

The list includes about 80,000 specific goods and services under general categories.

Consumer Price Index

The numbers are updated monthly and new items are added to the list every 10 years.

The Bureau of Labor Statistics is responsible for updating the list. They start with prices from a base year to

serve as a comparison.

Producer Price Index

The Producer Price Index (PPI): measures the average change in prices that companies charge the consumer for their goods and services

Most of the producer prices are in mining, manufacturing, and agriculture.

PPIs usually increase before the CPI and are used as an indicator that inflation is going to increase.

GDP Price Deflator

GDP Price Deflator: price index that removes the effect of inflation from GDP so that the overall economy in one year can be compared to another year

When the price deflator is applied to the GDP in any year, the new figure is called the real GDP. Real GDP: GDP that has been adjusted for

inflation by applying the price deflator

CHAPTER 13SECTION 3

Aggregate Demand and Supply

Aggregates

The laws of supply and demand can be applied to the economy as a whole as well as to individual consumer decisions.

Economist are interested in the demand by all consumers for all goods and services and the supply by all producers of all goods and services.

This requires the use of aggregates. Aggregate: summation of all the individual

parts in the economy

Aggregate Demand

Aggregate Demand: total quantity of goods and services in the entire economy that all citizens will demand at any single time

Where consumer demand is related to the price of one product, aggregate demand is related to the price level or the average of all prices as measured by a price index. Because there are millions of different prices for

all products, aggregate demand cannot be related to one price.

Aggregate Demand

If the price level goes down, a larger quantity of real domestic output is demanded per year.

There are two reasons for this inverse relationship: Purchasing power of money

Relative prices of goods and services sold to other countries.

Aggregate Demand

Purchasing Power Inflation causes the purchasing power to

decrease. Deflation causes purchasing power to

increase. Therefore, when price level goes down, the

purchasing power of any cash held will increase.

Relative Prices When price level goes down in the United

States, our goods become relatively better deals for foreigners who want to buy them.

Foreigners would them demand more of our goods and services.

Aggregate Demand

Aggregate Supply

Aggregate Supply: real domestic output of producers based on the rise and fall of the price level

If the price level goes up and wages do not, overall profits will rise and producers will want to supply more.

Aggregate Supply

Aggregate Demand and Aggregate Supply Together

If you combine the aggregate supply curve and the aggregate demand curve, you can find the equilibrium price and quantity (where two curves meet).

If price levels and output remain the same, there will be neither inflation nor deflation.

CHAPTER 13SECTION 4Business Fluctuations

The Business Cycle

Some years inflation, unemployment, world trade, or taxes are high; other years they are not.

There are fluctuations in virtually all aspects of our economy.

Business Fluctuations: ups and downs in an economy

Business Cycle: irregular changes in the level of total output measured by real GDP

Model of the Business Cycle

The Business Cycle

Begins with growth that leads to an economic peak, boom, or period of prosperity. Peak/Boom: period of prosperity in a business

cycle in which economic activity is at its highest point

Economies also experience contraction, where real GDP levels off and begins to decline, while business activity slows down. Contraction: part of the business cycle during

which economic activity is slowing down

The Business Cycle

If real GDP doesn’t grow for at least 6 months, economy is in a recession.

If recession continues to get worse, economy goes into a depression. Depression: major slowdown of economic

activity

The Business Cycle

The downward direction of economy levels off in a trough and real GDP stops going down. Trough: lowest part of the business cycle in

which the downward spiral of the economy levels off

Business activity increases and economy begins expansion or recovery.

Ups and Downs of a Business

In real world economy, business cycles are not regular.

The largest drop in the U.S. economy was following the stock market crash of 1929, which resulted in a severe depression.

The rise climaxed after World War II.

Ups and Downs of a Business

In the 1970s and 1980s the economy had small recessions.

The 1990s began with a recession but became a time of great economic growth.

CHAPTER 13SECTION 5Causes and Indicators

of Business Fluctuations

Causes of Business Fluctuations

For many years economists believed that business fluctuations occurred in regular cycles.

Today economists tend to link business fluctuations to 4 main forces: Business Investment Government Activity External Factors Psychological Fators

Business Investment

Some economists believe that business decisions are the key to business fluctuations.

Business investment involves companies expanding or scaling back, or companies using innovations in their business practices. Innovation: inventions and new production

techniques

When businesses anticipate a downturn in the economy, they cut back their investments and inventories.

Government Activity

A number of economists believe that the changing policies of the federal government are a major reason for business cycles.

Government activity involves taxing and spending policies, and control of money supply in economy.

External Factors

Factors outside a nation's economy also influence the business cycle.

External factors are non-economy related factors, such as wars or raw material costs.

The impact of wars results from the increase in government spending during wartime.

New sources of raw materials may lower operating costs for certain industries.

Psychological Factors

Psychological factors are people’s optimistic or pessimistic outlook on the future and the economy and can contribute to increased spending or more saving.

Economic Indicators

Business leaders are faced with the dilemma of trying to predict what will happen to the economy in the coming months or years.

Economists and the government create forecasts to try and aid in predicting the future of the economy.

They are usually too broad to be helpful.

Economic Indicators

Economists then turn to indicators to help predict the economy more accurately. Economic Indicators: statistics that measure

variables in the economy

Often different indicators within a group move in opposite directions.

It can take a long time before a change in an indicator is felt in the economy.

Economic Indicators

Economic indicators can be placed into 3 groups: Leading Indicators

Coincident Indicators

Lagging Indicators

Economic Indicators

Leading Indicators: statistics that point to what will happen in the economy They seem to lead to a change in overall

business activity- whether it is an upward or a downward trend.

The Commerce Department keeps track of numerous leading indicators.

Example: Weekly initial claims for unemployment

insurance New orders for consumer goods Stock prices

Economic Indicators

Coincident Indicators: economic indicators that usually change at the same time as changes in overall business activity They indicate a downswing or upswing has

begun.

Examples: Personal income minus transfer payments Rate of industrial production Sales of manufacturers, wholesalers, and

retailers

Economic Indicators

Lagging Indicators: indicators that seem to lag behind changes in overall business activity It could be months after the start of a

downturn before businesses begin to reduce borrowing.

Lagging indicators give economists clues as to the duration of the phase of the business cycles

Examples: Averate length of unemployment Size of manufacturing and trade inventories Change in CPI for services