Chapter Five
Economic Measures
Economic measures and reasons for changes in the economy, such as inflation, deflation, and interest rate changes.
National income accounting is an attempt to measure the economic performance and production of a nation. The accounting results in a hierarchy of measures that are related to each other. We start with Gross Domestic Product (GDP). GDP is the total market value of all final goods and services produced within a nation’s borders during a specified year. GDP even includes the goods that are produced in local factories owned by foreign companies. The value of the good or service is determined by the price paid by the final consumer. By only counting the value paid by the “final consumer,” it helps to avoid the multiple counting of the value of the good as it moves from one stage of production to another.
There are some transactions that are excluded from GDP. GDP excludes all financial and monetary transactions because they are not related to the production of the final good or service. A second-hand sale is one such transaction (example, resale of home). Second-hand sales contribute nothing to the production of goods in the current year. Similarly, financial transactions is the other type of transaction that is excluded. Financial transactions such as veterans benefits, social security benefits, welfare benefits, gifts from one individual to another, and the buying and selling of stocks and bonds are not included in GDP. They are not included because they too are not associated with the payment for something that was produced in the current year.
Even though GDP should include “all” goods and services within an economy, GDP fails to include some items of production that should be included. Homemakers who repair their own roof or who use their own labor to build a garage are producing something, but the value of their labor is not captured in GDP. Likewise, the production of the
“underground economy” is not included in GDP. The underground economy, which produces goods like illegal drugs and illegal labor, along with unreported tips by waiters and waitresses, would actually add to the GDP of the economy but are omitted.
There are two basic ways of determining GDP, the expenditures approach and the income approach. The expenditures approach focuses on totaling the expenditures on goods and services produced while the income approach focuses on totaling all of the income generated by the production of final goods and services. Even though the two approaches yield the same GDP amount, their component parts are very different. The two approaches to calculating GDP are contrasted below:
Expenditures Approach Income Approach
Per1Personal Consumption Expenditures
+
Gross Private Domestic Investment
+
Government Purchases +
Net Exports
Total Aggregate Income Wages and Salaries Profits
Interest Rents
+
Indirect Business Taxes +
Depreciation +
Net Foreign Factor Income (N.F.F.I)
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For the expenditures approach, the various elements are defined as follows:
x Personal Consumption Expenditures – the amount households spend on consumer goods and services during the year.
x Gross Private Domestic Investment – the amount businesses spend on adding and replacing fixed assets (capital goods) and improvements plus additions to business inventories. Gross Private Domestic Investment does not include the sale of stocks, bonds, or the resale of business assets.
x Government Purchases – the amount that the government spends on goods (office supplies), services (law enforcement), and infrastructure (roads and schools). Government Purchases exclude transfer payments such as social security payments or welfare payments.
x Net Exports – the amount equal to total exports minus total imports. Total exports are all the goods and services produced domestically, but sold abroad. Total imports are all goods and services produced abroad but sold domestically.
For the income approach, the various elements are defined as follows:
x Wages and Salaries – compensation of employees including salaries, wages, and fringe benefits.
x Profits – net income of sole proprietors, partners, and other unincorporated businesses. Additionally, profits include the dividends, income taxes, and undistributed profits of corporations.
x Interest – earnings from bonds, savings deposits, certificates of deposit, and other debt instruments.
x Rents – rent and lease payments less the year’s depreciation on the asset being rented or leased.
The sum of the four income elements listed above (Wages and Salaries, Rents, Interest, and Profits) constitute the National Income (NI). NI is discussed more fully later.
x Indirect Business Taxes – Taxes that include excise taxes, sales taxes, business property taxes, and license fees. These taxes are regarded as part of the cost of producing goods and services and are passed on (in whole or in part) to consumers through higher prices.
x Depreciation – Depreciation is the capital consumption allowance related to capital goods. This includes the depreciation on business assets and public assets such as bridges and government buildings.
x Net Foreign Factor Income – The income earned by foreigners in the domestic economy for their contribution of labor and capital in the production of goods and service minus the income earned by domestic nationals working , or employing their capital , abroad. The Net Foreign Factor Income can be either + or -.
x Net Domestic Product (NDP) is the market value of all final goods and services within an economy (GDP) less depreciation (consumption of fixed assets).
x National Income (NI), which has already been discussed, may be determined in another way. NI can be calculated by starting with NDP and subtracting two elements of GDP. Those two elements are indirect business taxes and Net Foreign Factor Income (NFFI). The following illustrates that approach:
Net Domestic Product (NDP) – GDP less Depreciation XXX,XXX
Subtract Indirect Business Taxes XXX
Subtract Net Foreign Factor Income XXX
National Income XXX,XXX
x Personal Income (PI) is the total income received by individuals or households. PI includes amounts that are currently received but not earned (transfer payments such as, social security benefits and pension benefits) and excludes amounts earned but not received (social security contributions, corporate income taxes, and undistributed corporate profits). PI is available for use in consuming goods and services, increasing savings, and paying personal taxes. Starting with NI, PI is calculated as follows:
National Income (NI) XXX,XXX
Subtract Social Security Contributions XXX
Subtract Undistributed Corporate Profits XXX
Subtract Corporate Income Taxes XXX
Add transfer payments XXX
Personal Income (PI) XXX, XXX
x Disposable Income (DI) is PI minus personal taxes (income taxes, personal property taxes, and inheritance taxes). DI is the amount of income left after paying personal taxes. DI is available for use in consuming goods and services and increasing savings.
Personal Income (PI) XXX,XXX
Less Personal Taxes XXX
Disposable Income (DI) XXX,XXX
The following summarizes the relationships among GDP, NDP, NI, PI, and DI:
Billions of some currency
GDP 10,000
Depreciation - 1,500
NDP 8,500
Indirect Business Taxes - 500
Net Foreign Factor Income - 100
NI 7,900
Social Security Contributions - 800
Corporate Income Taxes - 400
Undistributed Corporate Profits - 600
Transfer Payments + 1,800
PI 7,900
Personal Taxes - 1,400
DI 6,500
The general level of product prices tends to change from year to year because of inflation or deflation. GDP that has not been adjusted for price level changes is called the “Nominal GDP.” Nominal GDP is based on the “current”
price for each final good or service. A GDP amount that has been adjusted for inflation or deflation is called “Real GDP.” Real GDP is the sum of final goods and services measured in constant prices (eliminating the influence of price level changes from year to year). Real GDP is the proper measure of actual production changes from year to year because the impact of price level changes has been removed.
In adjusting Nominal GDP to Real GDP, one must divide each year’s Nominal GDP by that year’s price index. Real GDP amounts are comparable from one year to another because they are based on an index that reflects a stable currency from year-to-year. In the United States of America, the price index used to convert Nominal GDP to Real GDP is the GDP deflator, a specialized index designed for use with GDP amounts. This specialized GDP index is a very broad index that measures not only consumer goods but also capital goods, goods and services purchased by the government, and goods and services in world trade.
Another pricing index that is used to measure the change in price levels is the Consumer Price Index (CPI). The CPI index is different from the index used with GDP amounts because the GDP index is based upon the actual goods and services produced each year. The CPI index is based on the prices of 364 consumer goods and services
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(often called a “basket of goods”). The CPI is a weighted price index such that the proportion of the various goods and services in the basket does not change from year-to-year. Therefore, if 20% of the basket of goods were food items during the period 1993-1995, then food items are considered to make up 20% of the basket of goods in all other years. For example, the CPI was 166.6 in the year 1999 and increased to 172.2 in the year 2000. This means that there was an increase in the cost of the basket of goods from 1999 to 2000, hence inflation. The inflation rate between 1999 and 2000 was 3.4% ((172.2 – 166.6) / 166.6). The CPI index is used in the United States of America as a basis for adjusting social security benefits, federal income tax brackets, and selected other contractual payments.
Price indices are used to measure price level changes within an economy. Inflation is the increase in the general level of prices in an economy. There are two basic types of inflation – cost-push inflation and demand-pull inflation. Cost-push inflation is an increase in the price level caused by an increase in the cost of the resources used in production. As a result of the increasing cost of resources, the firm has to charge higher prices to offer the same quantity supplied and cover the increased production costs, thus resulting in price level increases. Demand-pull inflation is an increase in the price level caused by an increase in demand during a period when supply is limited by capacity. In general, this means that consumers are demanding more goods than the suppliers are supplying. Or in other words, there are “too many dollars chasing too few goods.” This results in the consumer’s bidding higher prices for the limited supply of goods. The end result is that consumers “pull” the price levels up.
The index of leading economic indicators is used to foresee changes in GDP. This index includes ten economic variables that, together, provide clues about the future direction of the economy. Because it takes time for economic policies to work, the index provides insight to policy makers about the future direction of the economy. This allows policy makers the opportunity to act before it is too late. The ten economic variables are commented on below:
1. Initial weekly claims for unemployment insurance – an increase in the claims for unemployment insurance suggests that firms are letting people go. An increase signals that there is diminishing demand for labor because production, as measured by GDP, is declining.
2. New orders for consumer goods – new orders with manufacturers usually result in increased production and an additional boost to an economy’s production (GDP). However, if there is a decrease in the number of new orders, it usually means the economy is slowing.
3. Average workweek – a lengthening workweek suggests more production and higher GDP. However, a shortening of the average workweek suggests production is slowing and that GDP is likely to decline.
4. New orders for capital goods – an increase in new orders for capital goods suggests firms are expanding, which could result in increased production. A decline in new orders for capital goods means that firms do not have a need to increase their production capacities by acquiring land, buildings, and equipment.
5. Vendor on-time delivery – Slower on-time deliveries suggest increased demand for good as a result of firms’ inability to keep up with the increased demand. On the other hand, more on-time deliveries suggest that there is not an increasing demand for goods or services because firms are able to keep up with orders.
6. Building permits for houses – An increase in permits means more production and greater output for the economy.
7. Stock prices – Increasing stock prices reflect expected increases in corporate profits based on higher production and thus greater productive output. A decrease in the stock prices means investors are skeptical about productive output and profits. Thus, the investors withhold their investments as production slows.
8. Money Supply – Increases in the money supply cause lower interest rates, higher aggregate demand, and higher GDP.
9. Long-term vs. term interest rate differential – A small difference between long-term and short-term interest rates suggests that the Fed is causing higher short-short-term rates (the rates that the Fed has the most control over) to slow the economy. Higher short-term interest rates are associated with lower GDP.
10. Consumer expectations – Such expectations measured by the index of consumer expectations are subtle reflections of future consumption by consumers. A decline in the index may predict a future decline in aggregate demand and lower GDP.
Now that we have examined the elements that are included in GDP and the items that are useful in predicting GDP, let’s analyze GDP from an aggregate supply and aggregate demand perspective. Aggregate supply is a curve that represents the Real GDP that all firms will produce at each price level. The graph below depicts the shape of the aggregate supply curve.
Aggregate Supply
Price Level
Intermediate Range
Vertical Range
Horizontal Range
Real GDP
The horizontal range of the aggregate supply curve represents the aggregate supply during the recession phase of the business cycle. In the horizontal range, firms can employ resources that have been idle without putting upward pressure on price levels. In the intermediate range of the aggregate supply curve, expansion of real output will be accompanied by an increasing price level. In the vertical range of the aggregate supply curve, the economy is operating at full capacity and increases in price level will not be accompanied by increases in production because of the lack of unused capacity. In the vertical range there is a strong tendency toward increases in the price level. The vertical range occurs during the latter stages of the expansion phase of the business cycle.
Aggregate demand (AD) is equal to the total (aggregate) real expenditures on final goods and services within an economy for a given time period. The aggregate demand curve is a curve that shows the demand relationship between Real GDP and the general price level. As the general price level decreases, Real GDP increases, and vice versa. The graph below illustrates the aggregate demand curve. Notice that it is downward sloping to the right. There are three reasons why the aggregate demand curve is downward sloping. Those reasons are as follows:
a. A change in price level, or the wealth effect – a change in the price level changes the
power of financial assets (money). So, if the price level falls, consumers can buy more goods with the same fixed quantity of money. Hence, real GDP increases.
b. An interest rate effect – If the price level falls, the lower price level causes a
reduction in the demand for money. That reduction in the demand for money lowers the real interest rate and spurs additional demand. That will cause GDP to increase.
c. An international trade effect – With everything else remaining constant, a decrease in
price level will make the goods that are produced domestically cheaper. When domestic goods are cheaper than foreign goods, net exports will increase, consumers will tend to buy more domestic goods and fewer foreign goods, and real GDP will increase.
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Aggregate Demand
P1
Price Level P2
AD1 AD
Y1 Y2
Real GDP
A decline in the price level from P1 to P2 will result in the real GDP increasing from Y1 to Y2 given the aggregate demand curve AD.
Notice that the Aggregate Demand graph shows two parallel downward sloping aggregate demand curves. The one representing the current state of the aggregate demand curve is labeled AD and the aggregate demand curve representing the alternate state is labeled AD1. The AD1curve has shifted outward and to the right indicating that at every price level GDP will be greater than with the original AD curve. The aggregate demand curve shifts from AD to AD1 for various reasons.
The factors that cause a shift in the aggregate demand curve include the following:
1. Change in consumer spending 2. Change in investment spending 3. Change in government spending 4. Change in net export spending
The outward shift to the right of the AD1curve could have been caused by the following positive consumer spending factors:
1. Consumers having more wealth (e.g., increase in stock prices) 2. Consumers having higher expectations concerning the economy
3. Consumers having lower household debt. Thus, they have borrowing power.
4. Consumers having lower taxes
The outward shift to the right of the AD1curve could have been caused by the following positive investment spending factors:
1. Lower interest rates
2. Higher expected business profits 3. Lower business taxes
Fiscal policies are actions that are implemented by government through spending and taxation. The impact that these actions have on the aggregate demand are illustrated below:
1. An increase in government spending will cause the aggregate demand curve to shift outward and to the right. The curve will shift out and to the right because the government will increase the consumption of goods and services, which stimulates aggregate demand and increases GDP. On the other hand, a decrease in government spending will have the opposite effect.
2. A change in taxation legislation will also impact the aggregate demand curve. As noted above, a decrease in personal taxes and business taxes will cause the aggregate demand curve to shift outward and to the right. This is so because consumers will now have more disposable income to spend in
demand curve to shift outward and to the right. On the contrary, an increase in taxes will have the opposite effect.
Another reason the aggregate demand curve would shift outward and to the right is because of the impact of net exports. The impact that net exports have on the aggregate demand curve is illustrated below:
1. A higher level of exports causes an increase in production. Higher incomes abroad will cause increased exports.
2. Depreciation of the domestic currency in relation to other currencies causes domestic exports to be cheaper in the world market. The result is increased exports and higher aggregate demand.
Another economic measure is the size of the money supply. The money supply is best considered in the context of the market for money (money market) where both the demand for money and the money supply are considered in terms of their combined impact on interest rates.
Market for Money
Real Interest
Rate %
Amount of Money Supplied and Demanded
D S
Market Equilibrium Determines Interest Rates
Demand for Money
Supply of Money
Amount of Money
The interest rate is the price paid for money and just like any market for commodities, the price of money (the interest rate) is determined by the forces of money supply and money demand. The graph shown above illustrates the intersection of the supply and demand curves for money and how that intersection (the market equilibrium of supply and demand) determines the real interest rate.
Money is needed (demanded) for two basic reasons – for transactions and for a store of value (an asset). Thus, the demand for money is the combination of these two sub-demands. The transactional demand for money varies directly with Nominal GDP. As Nominal GDP increases, the transactional demand for money increases because the higher level of economic activity increases the number of economic transactions and thus increases the need for money. The demand for money that originates from money as a store of value is a demand that is inversely related to the interest rate. When the interest rate is high, people are less likely to hold money as an asset because it is costly to hold money assets. When interest rates are low, the opportunity cost of holding money assets is low and thus people are more likely to want the security of liquid money assets.
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Transactional Demand Asset Demand
Interest Interest
Rate % Rate %
D
D
Amount of Money Amount of Money
Demanded Demanded
The demand curve in the “Market for Money” graph is the combination of the two demand curves shown immediately above. Thus, the demand curve in the “Market for Money” graph is steeper than the demand curve for
“Asset Demand” but not as steep as the demand curve for “Transactional Demand.”
Notice that the demand curve for Transactional Demand is inelastic (a straight vertical line) in relation to interest rates. That means the transactional demand is not influenced by interest rates. As stated earlier, transactional demand is influenced by Nominal GDP. On the other hand, the asset demand is influenced by the interest rate and thus it is shown with a gently slanting line indicating that it tends to be elastic demand. Elastic demand means that a small percentage change in the interest rate percentage will result in a greater percentage change in the amount of money demanded.
Referring to the “Market for Money” graph, it should be clear that an increase in the Nominal GDP will shift the demand curve up and to the right. With no change in money supply, such a shift would cause interest rates to increase because the market equilibrium point will shift upwards. On the other hand, a decline in Nominal GDP will cause the demand curve to shift down and to the left. Such a shift, with no change in money supply, would cause the market equilibrium to shift downwards and interest rates will decline.
Now that we have examined the sources of change in the demand for money, let’s discuss the measures of money supply. There are three components of the money supply, M1, M2, and M3. In general the M1 money supply contains the most liquid of the financial assets, then M2, and finally M3. The various components (M1, M2, and M3) of the money supply are described and related to each other below:
M1 includes the following:
Currency (counts and paper money Travelers checks
Demand deposits and other checkable deposits M2 includes all that is included in M1 plus the following:
Savings deposits and money market deposits Certificates of deposit of less than $100,000 Money Market mutual funds
Small denomination time deposits
M3 includes all that is included in M2 plus the following:
Certificates of deposit and time deposits of $100,000 or more
With regard to the money supply, economists typically focus on the M1 level. The other levels of money supply (M2 and M3) are measures used for other more specialized purposes. For example, M3 is used as a trend variable in