Chapter 24

1. Chapter 24 Measuring Domestic Output and National Income

2. Objectives • Define and measure GDP • GDP and income relationships • The nature and function of a GDP price index • The difference between nominal GDP and real GDP • Some limitations of the GDP measure

3. Assessing the Economy’s Performance • National income accounting measures the economy’s performance by measuring the flows of income and expenditures over a period of time. • National income accounts serve a similar purpose for the economy, as do income statements for business firms.

4. Assessing the Economy’s Performance • Consistent definition of terms and measurement techniques allows us to use the national accounts in comparing conditions over time and across countries. • The national income accounts provide a basis for appropriate public policies to improve economic performance.

5. Gross Domestic Product (GDP) • Gross Domestic Product: • Measures total production in an economy. • Is the market value of all the final goods and services produced within a country in a given time period (usually one year). • The US Department of Commerce is in charge of measuring U.S. GDP, and measures it quarterly.

6. Gross Domestic Product Four things to note about the definition of GDP: • Value Produced: GDP is measured using market values, not quantities. • To measure total production, we must add together the production of apples and oranges, for example. • Which is the greater total production:100 apples and 50 oranges or 50 apples and 100 oranges? • To answer that question, we need to value items at their market value-at the prices at which the items are traded in markets. • By using market prices to value production, we can add the apples and oranges together.

7. Gross Domestic Product • What produced: GDP includes only the market value of final goods or services. • Final good or service: A good or service purchased by a final user. • Intermediate good or service: A good or service that is used as a component of a final good or service. • The same good can be either final or intermediate depending on how it is used. For example, a Ford car is a final good, but a Firestone tire that Ford buys and installs on the car is an intermediate good. But if you by a replacement Firestone tire for your car, the tire is then a final good.

8. Gross Domestic Product • Where produced: Only goods and services that are produced within a country count as part of that country’s GDP. For example, Nike Corporation, a US firm, produces sneakers in China; the market value of those shoes is part of China’s GDP, not part of US GDP. • When produced: GDP measures the value of production during a given time period. This time period is either a quarter or a year. The Federal Reserve and others use the quarterly GDP data to keep track of the short-term evolution of the economy, and economists use the annual GDP data to examine long-term trends.

9. Measuring GDP • Two ways of looking at GDP: Spending and Income. • What is spent on a product is income to those who helped to produce and sell it. • This is an important identity and the foundation of the national accounting process.

10. Measuring GDP: Expenditures Approach GDP is divided into the categories of buyers in the market: household consumers, businesses, government, and foreign buyers. The four components of GDP are: • Personal Consumption Expenditures: Consumption • Consumption (C): Spending by households on goods and services, not including spending on new houses. • In particular, it includes durable goods (lasting 3 years or more), nondurable goods and services.

11. Measuring GDP: Expenditures Approach • Gross Private Domestic Investment: Investment • Investment (I): Spending by firms on new factories, office buildings, machinery, and inventories, and spending by households on new houses. • Changes in business inventory. • If total output exceeds current sales, inventories build up. • If businesses are able to sell more than they currently produce, this entry will be a negative number.

12. Measuring GDP: Expenditures Approach • Gross Private Domestic Investment: Investment • Net Private Domestic Investment • Each year as current output is being produced, existing capital equipment is wearing out and buildings are deteriorating; this is called depreciation or consumption of fixed capital. • Gross Investment minus depreciation (consumption of fixed capital) is called net investment.

13. Measuring GDP: Expenditures Approach • Government Consumption and Gross Investment: Government Purchases • Government purchases (G): Spending by federal, state, and local governments on goods and services. • This entry excludes transfer payments since these outlays do not reflect current production. • Net Exports of Goods and Services: Net Exports • Net exports (NX): Exports minus imports. • Exports (X): Expenditures by foreigners for U.S. goods produced domestically • Imports (M): Dollar amount of our purchases of foreign products

14. Measuring GDP: Expenditures Approach Putting all the components together, we have the following identity: GDP = Y = C + I + G + NX

15. Shortcomings in GDP as a Measure of Total Production • Household Production is not included. • Household production: Goods and services people produce for themselves. • The Underground Economy is not accounted for • Underground economy: Buying and selling of goods and services that is concealed from the government to avoid taxes or regulations or because the goods and services are illegal.

16. Shortcomings of GDP as a Measure of Well-Being • The value of leisure is not included in GDP • GDP is not adjusted for negative effects of production such as pollution • GDP is not adjusted for other social indicators such as crime, illiteracy, life expectancy • Equity: A large GDP per capita does not mean that the wealth of a nation is shared equally.

17. Other National Accounts • Net domestic product (NDP) is equal to GDP minus depreciation (consumption of fixed capital). • National income (NI) is income earned by American‑owned resources here or abroad. Adjust NDP by adding net foreign factor income. (Note: This may be a negative number if foreigners earned more in U.S. than American resources earned abroad.)

18. Other National Accounts • Personal income (PI) is income received by households. To calculate, take NI minus payroll taxes (social security contributions), minus corporate profits taxes, minus undistributed corporate profits, and add transfer payments. • Disposable income (DI) is personal income less personal taxes (personal Income taxes, personal property taxes, and inheritance taxes) • Households divide their disposable income between consumption and saving

19. Nominal versus Real GDP What matters to people is the real value of money or income - its purchasing power-not the “face” value of money or income. • Nominal GDP: The value of final goods and services evaluated at current year prices. • Nominal GDP is the dollar value of an economy’s final output measured at current market prices. • Real GDP The value of final goods and services evaluated at base year prices. • Real GDP is an estimate of the value of an economy’s final output, adjusting for changes in the overall price level.

20. Nominal versus Real GDP • Valid comparisons cannot be made with nominal GDP alone, since both prices and quantities are subject to change. Some method to separate the two effects must be devised. • The adjustment process in a one-good economy (1st method) • One method is to first determine a price index, and then adjust the nominal GDP figures by dividing by the price index (in hundredths)

21. Price of Market Basket In Specific Year Price Index In Given Year = x 100 Price of Same Basket In Base Year Nominal versus Real GDP • It measures the average level of prices for some specified set of goods and services, relative to the prices in a specified base year. First, determine the GDP Price Index Note that the price index = 100 at the base year.

22. Nominal GDP Real GDP = Price Index (in hundredths) Nominal versus Real GDP Then, use the price index to determine real GDP We inflate when prices fall We deflate when prices rise

23. Nominal versus Real GDP • The adjustment process in a one-good economy (2nd method) • An alternative method is to gather separate data on the quantity of physical output and determine what it would sell for in the base year. The result is Real GDP. The price index is implied in the ratio: Nominal GDP/Real GDP. Multiply by 100 to put it in standard index form.

24. U.S. GDP Over Time Real vs. Nominal GDP (Base = 2000) 1990-2004

25. Comparative GDP Selected Nations GDPs, 2007 GDP in Trillions of Dollars 0 1 2 3 4 5 6 7 8 9 10 12 13 United States Japan Germany China United Kingdom France Italy Canada Spain Brazil Russia India South Korea Mexico Australia Source: World Bank