economics ch 21 – Flashcards

• dominant economic policy in 17th and 18th centuries stating that economic prosperity was best measured by the stock of precious metals that a nation accumulated in the public treasury. It led to restrictions on international trade=reduced gains from comparative advantage.

o in 18th century the first to measure economic activity as a flow (probably because he know about the circular flow of blood-he was the court physician to King Louis XV of France). 1758 published Tableau Economique. o published in 1758 by Francois Quesnay; described the circular flow of output and income through different sectors of the economy.

o Rough measures of national income were developed in England two centuries ago.

o the result of detailed calculations built up from the microeconomic data which were refined in the US during the Great Depression. It organized huge quantities of data collected from a variety of sources across America; which were summarized, assembled into a coherent framework, and reported by the federal government. Was developed by Simon Kuznets. o Nobel Prize winner in 1971 for developing US national income accounts (one of the greatest achievements of 20th century, most widely copied and most highly regarded in the world). This gave quantitative precision to economic entities.

• measures the market values of all final goods and services produced during a year by resources located in the United States, regardless of who owns the resources (Ex: Toyota plant in Kentucky COUNTS vs. Ford plant in Mexico DOESN'T COUNT). Sales of intermediate goods and services are excluded from GDP to avoid the problem of double counting. It also ignores most of the secondhand value of used goods, such as existing homes, used cars and used textbooks because they were counted in GDP when they were produced.

• calculating GDP by adding up spending on all final goods and services produced in the nation during the year. The easiest way to understand the spending approach is to divide aggregate expenditure into its components:

o household purchases of final goods and services during a year (examples: services=haircut, nondurable goods=soap, durable goods=furniture); largest spending category, averaging about 2/3 of the US GDP during the last decade. Does not include new residences (which count as investment). goods expected to last at least three years goods expected to not last three or more years.

it consists of spending on current production that isn't used for current consumption. It's composed of the purchase of new plants (physical capital), new equipment (physical capital), new residences (residential construction), plus net addition to inventories (inventories). Although it fluctuates from year to year, investment averaged about 1/6 of US GDP during the last decade. NOT INVESTMENTS-existing buildings (including residences), machines and purchases of financial assets like stocks and bonds. Physical capital: the most important investment-manufactured items used to produce goods and services; includes new plants (new buildings) and new equipment (new machinery). Residential construction: building new homes of dwelling places. Inventories: counts as an investment b/c it represents current production not used for current consumption (help manufacturers cope with unexpected changes in the supply of their resources or in the demand for their products)-producer's stocks of finished and in-process goods (such as computer parts, and stocks of finished goods like new computers) awaiting sale. NOT INVESTMENTS: • Existing buildings (including residences), machines and purchases of financial assets like stocks and bonds are not investments. Why? • Existing buildings and machines: were counted in GDP when they were produced. • Stocks and bonds (and other financial assets): are not investments themselves but simply indications of ownership.

spending for goods and services by all levels of government on things like clearing snowy roads and paying librarians; government outlays(expenditure and spending) minus transfer payments (like Social security, welfare benefits, and unemployment insurance because such payments are not true purchases by the government or true earnings by the recipients).

net exports: the value of a country's exports(G&S that foreign countries purchase from US) minus the value of its imports(G&S that US purchases from foreign countries); goods (***merchandise*** traded) is the tangible stuff that can be put in a box like bananas while services (***invisibles***) are intangible things like European or American tours. Since 1960s, net export is negative (imports of G&S greater than exports); during last decade net export was negative 2% of GDP but in recent years it's not negative 5% or 6% of the GDP. The impact of the rest of the world on aggregate expenditure; (X -M) can be positive, negative, or zero.

o Aggregate expenditure: total spending on final goods and services in an economy during a given period, usually a year. C + I + G + (X - M)= Aggregate expenditure=GDP 1) C= sums Consumption 2) I= Investment 3) G=Government purchases 4)(X-M)= Net Exports; X=eXports minus M=iMports

• expenditure approach sums, or aggregates, spending on production while income approach sums, or aggregates, income arising from that production.

calculating GDP by adding up all earnings from resources used to produce output in the nation during the year.

o all earnings of resource suppliers in an economy during a given period, usually a year. Aggregate expenditure=GDP=?.

• used to track the economy; spending on the aggregate output is recorded on one side of the ledger and income from producing that aggregate output is recorded on the other side. It ensures that the value of aggregate output equals the aggregate income paid for resources used to produce that output: the wages, interest, rent, and profit arising from production. We avoid double counting either by including only the market value of G&S( like a desk)when it is sold to the final user or by summing the ***value added*** at each stage of production.

• goods and services sold to final, or end, users (ex: me buying a chicken COUNTS vs. KFC buying a chicken DOESN'T COUNT because KFC is gonna do a bunch of stuff to the chicken then sell to the final consumer).

• goods and services purchased by firms for further reprocessing and resale (ex: KFC's chicken). Its sales are excluded from GDP to avoid the problem of ***double counting.***

• the mistake of including both the value of intermediate products and the value of final products in calculating gross domestic product; counting the sme production more than once.

• GDP also ignores most of the secondhand value of ____ ____, such as existing homes, used cars, and used textbooks.

• at each stage of production, the selling price of a product minus the cost of intermediate goods purchased from other firms. More detailed definition: the value added by each firm equals that firm's selling price minus payments for inputs from other firms. The value added at each stage is the income earned by resource suppliers at that stage. The value added at all stages sums to the market value of the final good, and the value added for all final goods sums to GDP based on the income approach.

o Lessons learned from Exhibit 1: if all transactions were added up, the total would exceed the market value of the G&S. To avoid double counting, we include only the value added at each stage as the difference between the purchase price and the selling price at that stage. Again, the value added at each stage equals the income earned by those who supply their resources at that stage. Pretty straightforward.

Computation of value added for a new desk: the value added at each stage of production is the sale price at that stage minus the cost of intermediate goods, or column (1) minus column (2). The values added at each stage sum to the market value of the final good, shown at the bottom of column (3).

New section-circular flow of income and expenditure Unlike in ch. 1, Exhibit 2 shows circular flow of not only households and firms but of governments and the rest of the world as well. For each flow of $, there is an equal and opposite flow of products and resources. We're gonna following da mula here! • Assumptions when making a circular flow of income and spending: 1) Capital does not wear out (no capital deprecation) 2) Firms pay out all profits to firm owners (firms retain no earnings) 3) GDP equals aggregate income

• Most logical to begin where firms make production decisions b/c production must occur before output can be sold and income earned. Henry Ford-"it is not the employer who pays the wages-the employer only handles the money. It is the product that pays wages." Households supply their labor, capital, natural resources, and entrepreneurial ability to make products that sell to pay wages, interest, rent and profit. Production of aggregate output, or GDP, gives rise to an equal amount of aggregate income. Pg. 466 and 467 describe the circular flow of income and expenditure in a detailed manner-very good.

• Income half of circular flow: is at the bottom. Given that GDP=aggregate income, firms have produced output (Juncture 1) and have paid resource suppliers(part 1 of2 in j4) so now they wait to see how much consumers want to spend(any unsold production gets added to firm inventories) AFTER governments have collected taxes(j2) and made transfer payments(j3 and part 2 of 2 in j4). o Net Taxes (NT): taxes minus transfer payments. o Disposable income (DI): the income households have available to now spend or to save AFTER AFTER AFTER paying (think subtract) taxes and receiving (think adding) transfer payments & earnings from firms. In other words, DI= GDP - NT. o GDP= Aggregate Income= DI + NT

• Expenditure half of circular flow: is at the top half; four components: consumption (C), Investment (I), government purchases (G), and net exports (X-M). o DI=C + S. C=consumption; S=Saved o Spending on consumption remains in the circular flow and is the biggest aggregate expenditure, about 2/3 of the total.

o Financial markets: banks and other financial institutions that facilitate the flow from funds from savers to borrowers. o Firms borrow to finance purchases of physical capital plus any increases in their inventories b/c firms pay resource suppliers an amount equal to the entire value of output. Investment enters the circular flow at juncture 6, so aggregate spending at that point totals C+I. Governments also borrow whenever they incur deficits (when outlays exceed their revenues). Government purchases of goods and services enter the spending stream in the upper half of the circular flow at juncture 7 (excludes transfer payments because that already entered the stream at j3, plus it's not really government purchasing stuff anyway). Because spending on imports flows to foreign producers, spending on imports, M, leaks from the circular flow at j8. Rest of world buys US products, so foreign spend on US exports, X, enters spending flow at j9. Aggregate expenditure flows into firms at j10. C + I + G + (X- M)= Aggregate Expenditure= GDP

• First accounting identity: Aggregate expenditure (top half/total spending on US output/spending by each sector)... equals... Aggregate income (bottom half, income arising from that spending/DI + NT). In other words: C + I + G + (X -M)= DI+ NT o Given first accounting identity and this: DI= C + S....sub C+S in for DI o Therefore: C + I + G + (X -M) = C + S + NT.....subtract C and add M to both sides... o Second accounting identity: I + G + X = S + NT + M. injections(left)=leakages(right).

• any spending other than by households or any income other than from resource earnings; includes investment, government purchases, exports, and transfer payments. Left variables of the second accounting identity ( I, G, X). Injections=leakages.

• any diversion of income from the domestic spending stream; includes saving taxes, and imports. Right variables of second accounting identity ( S, NT, M). injections=leakages.

New section-limitations of national income accounting In this section, we examine some limitations of the national income accounting system, beginning with production not captured by GDP.

• GDP doesn't count/capture/reflect: o Do-it-yourself production: examples are child care and meal preparation. o Underground economy: market transactions that go unreported either because they are illegal or because people involved want to evade taxes (equals 7.5% of US GDP; $1tril in 2007). o Leisure time: ex-we retire earlier and live longer. o Changes in the quality of products: ex-MP3s getting better o Availability of new products: ex- people can afford cards. o Negative externalities: costs that fall on those not directly involved in the transactions are mostly ignored in GDP calculations even though they diminish the quality of life now and in the future (check out green GDP included later on in notes).

some economic production that does not involve market change like o Imputed income: the income assigned for some economic activity because market exchange does not occur. 1) Imputed rental income: homeowners receive from home ownership even though no rent is actually paid or received. 2) (wages paid)In kind : like in the form of employers' payments for employees' medical insurance 3) food by the farmers for the farmers: food farmers produce for their own consumption o Deprecation: the value of capital stock used up to produce GDP or that becomes obsolete during the year. Gross domestic product is called "gross" because it fails to take into account this depreciation (haha?). o Net Domestic product: equals Gross domestic product minus depreciation-it is NOT GDP and it accounts for depreciation.

• the value of all investment during a year and is used in computing GDP. If gross investment exceeds depreciation, net investment is positive which means that the economy's capital stock increases and so does its contribution to output. Reflects GDP.

• equals gross investment minus depreciation (accounts for depreciation). Reflects Net domestic product.

• National income accounts reflect depreciation of physical capital stock but not the natural capital stock.

• registers the impact of production on air pollution, water pollution, soil depletion, and loss of other natural resources (now in the process of being developed by US Commerce Department).

• tries to avoid making value judgments about HOW people spend their money because GDP, as a total provides no info about its composition, some economists question whether GDP is the best measure of the nation's economic welfare.

GDP based on prices prevailing at the time of production. It's composed of nominal dollars and nominal value-all just numbers but these numbers can fool us into thinking that the GDP is increasing when it's not because when we take the nominal GDP, we're only taking the face value of the GDP and completely being ignorant about inflation/deflating, or price change. Therefore, in order to truly know how GDP is doing, we need to take a look at the real GDP, which is adjusted for price level changes, inflation.

• the year with which other years and compared when constructing an index; the index equals 100 in the base year.

• compares the value of some variable in a particular year to the value in a base year, or reference year.

• a number that shows the average price of products; changes in a price index over time show changes in the economy's average price level. The price index equals the price in the current year divided by the price in the base year, all multiplied by 100. We construct a price index by dividing each year's price by the price in the base year and then multiplying by 100. If you're asked to find how happened to the price level between two years, you divide the price index of the later year by the earlier year and find the percent difference in price level between the two years. Btw, if base year price index is 100 and price index for a later year is 104, then price level rose 4%.

• a measure of inflation based on the cost of a fixed market basket of goods and services. Lessons from Example: the total cost of each product in the base year is found by multiplying price by quantity. To compute the consumer price index for the current year, we simply divide the cost in the current year by the cost of that same basket in the base year, and then multiply by 100.. We could say that between the base period and the current year, the "cost of living increased or decreased by (blank)%, although not all prices may have increased/decreased by the same percentage.

• Flaws of CPI: o Quality bias: assumes that the quality of the market basket remains relatively constant over time and because of this ignorance in quality improvements, it overstates the true extent of inflation. o Not allowing households to shift away from goods that have become more costly: in its calculations results in it overestimating the true extent of inflation experienced by the typical household. Overstates inflation because of this. o Shift toward discount stores: failed to keep up with them (ex: Wal-Mart). Government counts discounters as different from goods sold by regular retailers, thus the discounter's lower price does not translate into a reduction in the cost of living, simply as a different consumer purchase decision (FAAAIIILL!). Overstates inflation because of this. o Including an item in the market basket only after the product becomes widely used: by that time, the major price drops have already taken place and CPI doesn't capture them (cell phones started out as $1,000 then dropped and after widely used then CPI counted it). o CPI overestimates inflation by about 1% per year: it needs to be adjusted because a bunch of money is allocated incorrectly if that 1% is off (ex:fed budget can save $200bil annually by 2012). Tax brackets, wage agreement, social security benefits, welfare benefits, alimony affected by this stuff. In other words, GETTING IT RIGHT IS VERY VERY IMPORTANT.

• breaks down the item under consideration into its characteristics and then estimates the value of each characteristic. This is a way of capturing the impact of a change in product quality on any price change. Otherwise, price changes would not reflect the fact that consumers are getting more or less for their money as product features change over time. Helps with quality bias.

Price index is a weighted sum of various prices vs. • CPI focuses on just a sample of consumer purchases vs. • GDP price index: is a comprehensive inflation measure of all goods and services included in the gross domestic product. ***GDP price index= Nominal GDP(100)/Real GDP*** when nominal GDP is the $ value of GDP in a particular year measured in prices of that prices of that same year, and real GDP is the $ value of GDP in a particular year measured in base-year prices.

• bureau of economic analysis

• an inflation weights from year to year in calculating a price index, thereby reducing the bias caused by a fixed-price weighting system.

• captures all income earned by American-owned resources, whether located in the US or abroad. ?????= Net DP + American resources abroad.

• Personal income: find by adding to national income the income received but not earned and subtracting the income earned but not received by individuals. Personal income=national income + (income rec but not earn - income earn but not rec). o Earned but not received: employer's share of social security taxes, taxes on production (sales and property taxes) net of subsidies, corporate income taxes, and undistributed corporate profits, which are profits the firm retains rather than pays out as dividends. o Received but not earned: in the current period includes government transfer payments, receipts from private pension plans, and interest paid by government and by consumers.

• the amount available to spend or save-the amount that can be "disposed of" by the household. Take-home pay. DI=personal income - personal taxes and other government charges.

• includes both money wages and employer contributions to cover social security taxes, medical insurance, and other fringe benefits.

• includes the earnings of unincorporated businesses.

• the net revenues received by incorporated business but before subtracting corporate income taxes.

• the interested received by individuals, excluding interested paid by consumers to business and interest paid by government.

• Summary of national income accounts: let's summarize the income side of national income accounts. We begin with GDP, the market value of all final goods and services produced during the year by resources located in the US. We subtract depreciation from GDP to yield the Net DP. To Net DP, we add net earnings from American resources broad to yield national income. We obtain personal income by subtracting from national income all income earned this year but not received this year (ex: undistributed corporate profits) and by adding all income received this year but not earned this year (Ex: transfer payments). By subtracting personal taxes and other government charges from personal income, we arrive at the bottom line: DI, the amount people can either spend or save.