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Chapter 5

Chapter 5 Summary.pdf

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McMaster University
Bridget O' Shaughnessy

Summary of Notes from Chapter 5 and Practice Questions KEY POINTS: 1. Every transaction has a buyer and a seller, the total expenditure in the economy must equal the total income in the economy. 2. Gross domestic product (GDP) measures an economy’s total expenditure on newly produced goods and services and the total income earned from the production of these goods and services. More precisely, GDP is the market value of all final goods and services produced within a country in a given period of time. 3. GDP is divided among four components of expenditure: consumption, investment, government purchases, and net exports. Consumption includes spending on goods and services by households, with the exception of purchases of new housing. Investment includes spending on new equipment and structures, including households’ purchases of new housing. Government purchases include spending on goods and services by local, provincial, and federal governments. Net exports equal the value of goods and services produced domestically and sold abroad (exports) minus the value of goods and services produced abroad and sold domestically (imports). 4. Nominal GDP uses current prices to value the economy’s production of goods and services. Real GDP uses constant base▯year prices to value the economy’s production of goods and services. The GDP deflator―calculated from the ratio of nominal to real GDP―measures the level of prices in the economy. 5. GDP is a good measure of economic well▯being because people prefer higher incomes to lower incomes. But it is not a perfect measure of well▯being. For example, GDP excludes the value of leisure and the value of a clean environment. I. Review of the Definitions of Microeconomics and Macroeconomics A. Definition of microeconomics : the study of how households and firms make decisions and how they interact in markets. B. Definition of macroeconomics: the study of economy-wide phenomena, including inflation, unemployment, and economic growth. II. The Economy’s Income and Expenditure A. To judge whether or not an economy is doing well, it is useful to look at Gross Domestic Product (GDP). 1. GDP measures the total income of everyone in the economy. 1 2 ☞ Chapter 5/Measuring A Nation’s Income 2. GDP measures total expenditure on an economy’s output of goods and services. B. For an economy as a whole, total income must equal total expenditure. 1. If someone pays someone else $100 to mow a lawn, the expenditure on the lawn service ($100) is exactly equal to the income earned from the production of the lawn service ($100). 2. We can also use the circular flow diagram from Chapter 2 to show why total income and total expenditure must be equal. Figure 5.1 Chapter 5/Measuring A Nation’s Income ☞ 3 . Households buy goods and services from firms; firms use their revenue from sales to pay wages to workers, rent to landowners, and profit to firm owners. b. In the simple economy described by this circular flow diagram, calculating GDP could be done by adding up the total purchases of households or summing total income paid by firms. c. Note that this simple diagram is somewhat unrealistic as it omits saving, taxes, government purchases and investment purchases by firms. Regardless, each transaction always has a buyer and a seller, therefore, total expenditure in the economy must be equal to total income. III. The Measurement of Gross Domestic Product A. Definition of gross domestic product (GDP) : the market value of all final goods and services produced within a country in a given period of time. B. “GDP is the Market Value . . .” 1. To add together different items produced, market values are used. 2. Market values are calculated by using market prices. C. “. . . of All . . .” 1. GDP includes all items produced and sold legally in the economy. 2. The value of housing services is somewhat difficult to measure. a. If housing is rented, the value of the rent is used to measure the value of the housing services. b. For housing that is owned (or mortgaged), the government estimates the rental value and uses this figure to value the housing services. 3. GDP does not include illegal goods or services that are sold in markets, nor items produced and consumed at home. 4 ☞ Chapter 5/Measuring A Nation’s Income a. When you hire someone to mow your lawn, that production is included in GDP. b. If you mow your own lawn, that production is not included in GDP. D. “. . . Final . . .” 1. Intermediate goods are not included in GDP. 2. The value of intermediate goods is already included as part of the value of the final good. 3. Goods that are placed into inventory are considered to be “final” and included in GDP as a firm’s inventory investment. a. Goods that are sold out of inventory are counted as a decrease in inventory investment. b. The goal is to count the production when the good is finished, which is not necessarily the same time that the product is sold. E. “. . . Goods and Services . . .” 1. GDP includes both tangible goods and intangible services. F. “. . . Produced . . .” 1. As mentioned above, current production is counted. 2. Used goods that are sold do not count as part of GDP. G. “. . . Within a Country . . .” 1. GDP measures the production that takes place within the geographical boundaries of a particular country. 2. If a British citizen works temporarily in Canada, the value of his output is included in GDP for Canada. If a Canadian owns a firm in Haiti, the value of the production of that firm is not included in Canadian GDP. Chapter 5/Measuring A Nation’s Income ☞ 5 H. “. . . in a Given Period of Time.” 1. The usual interval of time used to measure GDP is a year or a quarter (three
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