Chapter 8

Vocabulary
Business Cycle: Alternating periods of economic expansion and economic recession
Expansion: The period of a business cycle during which the total production and total
employment are increasing
Recession: The period of a business cycle during which total production and total employment
are decreasing
Economic Growth: The ability of an economy to produce increasing quantities of goods and
services
Inflation Rate: The percentage increase in the price lvl form one year to the next
Gross Domestic Product (GDP): The market value of all final goods and services produced in a
country during a period, typically one year
Final Good/Service: Good/service purchased by a final user
Intermediate Goods/Services: Inputs into another good or service
Double Counting: Counting intermediate goods/services at each transaction
Transfer Payments: Payments by the gov. to households for which the gov. doesn’t receive a new
good/service in return
Imports: Households buy goods and services from firms in other countries
Exports: Firms sell goods/services to households in other countries
Consumption: Spending by households on goods/services, not including spending on new houses
Investment: Spending by firms on new factories, office buildings, machinery, and additions to
inventories, plus spending by households and firms on new houses
Government Purchases: Spending by federal, state, and local governments on goods/services
Net Exports: Exports minus imports
Informal Sector: The underground economy in developing countries, as opposed to the formal
sector
GDP Per Capita: GDP divided by population
Nominal GDP: The value of final goods/services evaluated at current-year prices
Real GDP: The value of final goods and services evaluated at base-year prices
GDP Deflator: A measure of the price level
Price Level: A measure of the average prices of goods/services in the economy
Gross National Product (GNP): Production performed by citizens of a nation, including overseas
production
National Income: GDP minus the consumption of fixed capital, i.e. GDP minus depreciation
Personal Income: Income received by households; includes transfer payments but excludes firms’
retained earnings
Disposable Personal Income: Personal income minus personal tax payments; this measures the
amount that households can spend or save

Formulas
Measure GDP = Consumption + Investment + Government Purchases + Net Exports
Net Exports = Added up value of goods/services sold to foreigners – values of goods/services
sold to Americans by foreigners
GDP Deflator = (Nominal GDP / Real GDP) x 100

Final Goods and Services

 Double counting example
o Counted the value of the ice cream bout by a store, and counted the value of it
when it was sold = double counting the value of the ice cream
 GDP measures output produced within a country’s borders
o However, production overseas don’t count, even if it’s performed by a U.S. firm

During a Period of Time

 To measure total output each year => measure the goods/services produced only in that
given year
 o This avoids double counting
 Ex: If you buy a DVD in 2021, that DVD counts in 2021’s GDP. If you resell it in
2022, it will not count again in 2022
o GDP counts only new goods/services
 Used items were previously produced and counted, so don’t need to be
counted again

Calculating Value Added

 Alt. method to measure GDP:
Measure the valued added
(The market value a firm adds to a
product)
 The final selling price of a product must
equal the sum of the values added to the
product at each stage of production
o Ex: this table shows this method
for a shirt sold on L.L. Bean’s
website

Production and Income

 Two main conceptual ways to measure the total economic activity in an economy
o Total production
o Total income
 Everything that’s produced and sold constitutes income for someone => measuring the
value of products and sold or the value of incomes

The Circular Flow and the Measurement of GDP

 Households and firms
o To measure overall economic activity
 Measure amount of money that households spend
on goods/services
 Measure income to households
 Households, firms, and gov.
o Gov. takes taxes from households and firms
o Uses those taxes to buy goods/services, and to make
transfer payments
 Households, firms, and world
o Households buy goods/services from firms in other countries
o Firms sell goods/services to households in other countries
 Firms, households, government, and financial system
o Households elect not to spend some of their income and
instead save it with financial system firms
o Financial system firms lend money to other firms and government

Follow the Spending to Measure GDP

 To measure GDP
o Consumption (C)
 Services: Medical care, education, haircuts, etc.
 Nondurable goods: Food, clothing, etc.
 Durable goods: Automobiles, furniture, etc.
o Investment (I)
 Business fixed investment: New factories, office buildings, machinery,
research and development, etc.
 Residential investment: New single-family, multi-unit houses, etc.
  Changes in business inventories: Goods that have been produced but not yet
sold
o Government purchases (G)
 Government consumption: Teacher’s salaries, office supplied, etc.
 Government investment Highways, military bases, etc.
 Does NOT include transfer payments, since those don’t result in immediate
production of new goods/services
o Net exports (NX)
 Might be pos. or neg. (In the past it’s been neg.)
 An export is not counted otherwise (in C, I, or G), so we need to count it
somehow as production
 An import is counted (in C, usually) but we are trying to measure domestic
production, so don’t count it. Subtracting it achieves this goal
 Y = C + I + G + NX

Shortcomings of GDP as a Measure of Total Production

 Two types of production are omitted from the BEA’s measurement of GDP
o Households Production: Childcare, cleaning, cooking, etc. is not typically paid for
with money
 If they were performed by a non-household member, they would be paid for
and counted in GDP
o Underground economy: Buying and selling of goods/services that is concealed from
the gov. to avoid taxes or regulations, or b/c the goods/services are illegal
 May be 10% or more of the economy in the U.S. and substantially more in
low-income countries

How Important Are These Shortcomings?

 GDP from year to year => size of household production and the underground economy is
prob. about the same from year to year
o Meaning GDP growth is a reasonable measure of the growth in total production
 Over long periods of time, these shortcomings might be more serious

Shortcomings of GDP as a Measure of Well-Being

 It doesn’t reflect:
o The value of leisure
o Pollution and other negative effects of production
o Crime and other social problems
 Improvements in many of those would result in lower GDP per capita

Calculating Real GDP (EX)

 Calculating the total value of output in
2012: 3200 + 990 + 1350 = 5540
 To calc. real GDP in 2022, use the prices
 from 2012
o Gives real 2022 GDP in 2012
dollars of 6680
o Compare this to nominal GDP in 2022 of 7800

The GDP Deflator

 Allows households and firms to plan appropriately
 EX (Using table on right):
o GDP deflator increases from 112.3 to 113.6
o GDP deflator = [(113.6 – 112.3) / 112.3] x 100 = 1.2%
o Price level rose by 1.2% over this period
Other Measures of Total Production and Total Income
 Gross national product (GNP)
 National income
 Personal income
 Disposable personal income