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ECON 352D1 Lecture Notes - Lecture 1: Final Good, Money Supply, Opportunity CostExam


Department
Economics
Course Code
ECON 352D1
Professor
Alvarez-Cuadrado
Study Guide
Final

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Econ 352 2018
1
1. Measuring the Economy
Economists are in a better position than most social scientists as far as their
sources of information are concerned. Many goods are priced and sold in markets. This
produces a wealth of data that can be used to motivate theories, test their predictions,
and to guide policy. Our goal is to develop theories that are consistent with this data.
The data suggests which factors we need to include in our theory and which factors do
not seem to be relevant. We use these theories to make qualitative and quantitative
forecasts and to evaluate the effects of different policies. With data we can test
competing theories, comparing what actually happens to what different theories predict
it should happen.
For example, surveys of consumer prices, conducted on a monthly basis, provide
information on the evolution of prices through time. Combining this information with
observations on other economic variables allows the development of theories that explain
why prices change over time.
The goal of National Income accounting is to provide a systematic method for
aggregating the output of diverse sectors producing different goods and services into a
single measure of overall economic activity. Like accounting for a firm, it allows us to
analyze the state of an economy at a given point in time, the changes over time, and
differences across countries. We will pay special attention to the distinction between
real (expressed in terms of goods) and nominal variables (expressed in terms of money).
1.1 Gross Domestic Product
We will denote gross domestic product as
Y
. Gross Domestic Product (GDP) is
the market value of the final goods and services produced in a country over a period of
time. GDP is the basic measure of economic activity. GDP is a flow variable since it is
measured per unit of time.1
There are three approaches to measuring GDP: the product (value-added)
approach, the expenditure approach, and the income approach.
The production (value-added) measure of GDP adds the value of (final) goods
and services produced in the economy.
The expenditure measure of GDP adds the value of total purchases of (final)
goods and services in the economy.
The income measure of GDP counts all the income generated in the production
process in the economy.
All three approaches will give the same measure of GDP.
Production Income Expenditure Y≡≡ ≡
1 We will discuss many macroeconomic variables, some of which are stocks and the other flows. Flows are
measured as an amount per unit of time, in contrast stocks are measured as the amount at a given point
in time. Consider a bathtub and open the faucet. After 2 minutes there is a stock of water in the bathtub of
120 liters and each second a flow of 1 additional liter of water adds to that stock. As you can see stocks and
flows are clearly related. A stock is often an accumulation of flows over time. For instance, your monthly
saving is a flow and the balance of your savings account is its associated stock.

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Econ 352 2018
2
Let’s illustrate it with an example. Consider a simplified economy consisting of
two firms. Firm 1 produces steel using workers as the only input. It sells the steel for
$100 to a second firm that produces cars. The steel firm pays its workers $80, pays $10
dollars of taxes to the government and keeps the rest as profits. Firm 2, the car producer,
buys $100 worth of steel and hires workers for $50 to produce cars. The market value of
the cars produced is $210, $200 are sold to families and the remaining $10 remains
unsold and are kept in the form of inventories. The car producer pays $40 worth of taxes.
Firms
Steel co.
Car co.
100
210
100
200
0
10
80
150
80
50
0
100
10
40
10
20
The government hires $50 worth of workers to monitor the traffic (police).
Government
50
50
Finally, the consumers work for the firms and for the government earning total wages of
$180. Since the consumers are also the ultimate owners of the firms they receive an after-
tax profit of $30.
Consumers
Wage Income
180
Profits distributed by firms
30
Let’s use this simple economy to illustrate the three approaches to calculating GDP.
1.1.a The product (value-added) approach to GDP
Gross Domestic Product (GDP) is the market value of the final goods and
services produced in a country over a period of time.
In the value-added (or product) approach, GDP is calculated as the sum of
value added to goods and services in production across all productive units in the
economy. We would like to add the value of all goods produced in the economy, and
then subtract the value of the intermediate goods used in the production of other goods to
avoid double-counting, i.e. in the previous example the steel company produces an
input, steel, that is used by the car company. The market value of the cars obviously

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Econ 352 2018
3
includes the value of the steel used to produce them, so if we simply added the values of
steel and cars we will be overestimating the true amount of (new) goods produced.
To compute GDP following the value-added approach in our example, we
proceed as follows. The economy produces $360 worth of goods and services (steel, cars
and police services), of which $100 are intermediate goods so our value-added measure
of GDP would be $260.
We can look at this example in a different way. Suppose that both firms merge so
that the sale of steel took place inside the new firm and is no longer recorded. All we
would see would be one firm producing $210 worth of cars, paying workers $130, $50
worth of taxes and making a profit of $30. Our measure of GDP remains unchanged.
Note 1: Intermediate goods and services are excluded to avoid double counting (a
tire bought by BMW to incorporate to a car is an intermediate good but a tire bought by a
family to replace a flat one in their car is a final good).
Note 2: Goods that are produced and not sold are considered as purchased by the firm
that produces them, i.e. as an increase in its inventories. In a sense everything that is
produced is recorded as sold (either to customers or to the own firm).
Note 3: Only new (current-year) production of goods and services is counted in GDP.
If next year the firm sells the $10 inventory of cars that transaction will not be part of
next year’s GDP, since it was already counted this year when the cars were actually
produced. The same applies to second-hand goods.
Note 4: Since government services (police) are not sold (usually) at market prices, the
standard practice is to value them at the cost of inputs of production.
Finally, notice that the flow of labor (for instance the $80 of wages of the steel company)
is not treated as an intermediate good. If, in our example, one of the employees in the
steel company who was a lawyer quits her job and starts an independent firm that
provides legal advice to the steel company. Then, the market value of this legal advice
would be considered as an intermediate input, but GDP would remain unchanged (since
the increase in value added from the new firm, the small legal company, is compensated
by a decrease in value added of the steel firm).
1.1.b The income-approach to GDP
A second way of computing GDP is from the income side, i.e. how is the
revenue obtained through production divided among the factors of production. Or
alternatively how much is paid to workers and how much is paid to the owners of capital
(the government will collect some of this income, taxes, from workers and firms) for their
contribution to production. Every dollar that is produced is a dollar of income earned
by someone.
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