Measuring Domestic Output and National Income

6 Measuring Domestic Output and National Income

Chapter Objectives • How GDP is Defined and Measured • Relationships Between GDP, Net Domestic Product, National Income, Personal Income, and Disposable Income • The Nature and Function of a GDP Price Index • The Difference Between Nominal GDP and Real GDP • Limitations of GDP

An Expanded Circular-Flow Diagram

National Income Accounting • Bureau of Economic Analysis compiles National Income and Product Accounts • Assess health of economy • Track long run course • Formulate policy

Assessing Economy’s Performance • Gross Domestic Product (GDP) • A Monetary Measure • Avoid Multiple Counting • Market value final goods • Ignore intermediate goods • Count value added • Exclude Nonproduction Transactions

Assessing Economy’s Performance • Financial Transactions Excluded • Public Transfer Payments • Private Transfer Payments • Stock (and Bond) Market Transactions • Second Hand Sales • Sell used car to a friend • Yard Sales

Two Approaches to GDP • Income approach • Count income derived from production • Wages, rental income, interest income, profit • Expenditure approach • Count sum of money spent buying the final goods • Who buys the goods? • Final-Product or Value-Added • Sum of the Money Spent to Buy the Output

Two Approaches to GDP Expenditure Approach Income Approach Consumption by Households Wages + + Rents Investment by Businesses + G D P + = = Interest + Government Purchases + Profits + Expenditures By Foreigners Statistical Adjustments

Expenditure Approach • Personal consumption expenditures (C) • Durable consumer goods • Nondurable consumer goods • Consumer expenditures for services • Domestic plus foreign produced

Expenditure Approach • Gross private domestic investment (I) • Machinery, equipment, and tools • All construction • Changes in inventories • Creation of new capital asset • Noninvestment transactions • Capital consumption • Capital transfers

Expenditure Approach Gross Investment - Depreciation = Net Investment Net Investment Gross Investment Depreciation Increased Consumption & Government Spending Stock of Capital Stock of Capital January 1 Year’s GDP December 31

Expenditure Approach • Government purchases (G) • Expenditures for goods and services • Expenditures for social capital • Excludes transfer payments

Expenditure Approach • Net exports (Xn) • Add exported goods • Subtract imported goods • NX = exports - imports

Expenditure Approach Putting It All Together: GDP = C + I + G + Xn GDP = $11,249 + 2,084 + 3,053 - 557 = $15,829 in 2012

$11,249 2,084 3,053 -557 $ 15,829 GDP Approaches Compared Accounting Statement for the U.S. Economy, 2012 in Billions Receipts Expenditures Approach Personal Consumption (C) Gross Private Domestic Investment (Ig) Government Purchases (G) Net Exports (Xn) Gross Domestic Product

GLOBAL PERSPECTIVE Comparative GDPs Select Nations GDPs - 2010 GDP in Trillions of Dollars 0 1 2 3 4 5 6 7 8 9 10 12 United States China Japan Germany France United Kingdom Brazil Italy India Canada Russia Spain Mexico South Korea Australia $14.58 $5.93 $5.48 $3.28 $2.56 $2.24 $2.09 $2.05 $1.84 $1.58 $1.48 $1.40 $1.03 $1.01 $.94 Source: World Bank

The Income Approach • Compensation of Employees • Rents • Interest • Proprietor’s Income • Corporate Profits • Corporate Income Taxes • Dividends • Undistributed Corporate Profits • Taxes on Production and Imports

The Income Approach • From National Income to GDP • Net Foreign Factor Income • Statistical Discrepancy • Consumption of Fixed Capital • Other National Accounts • Net Domestic Product (NDP) • National Income (NI) • Personal Income (PI) • Disposable Income (DI) DI = C + S

$ 15,829 2036 $ 13793 -50 165 $ 13,196 1098 924 513 344 2361 $ 13,936 1514 $ 12,422 U.S. Income Relationships 2012 Gross Domestic Product (GDP) Less: Consumption of Fixed Capital Equals: Net Domestic Product (NDP) Less: Statistical Discrepancy Plus: Net Foreign Factor Income Equals: National Income (NI) Less: Taxes on Production and Imports Less: Social Security Contributions Less: Corporate Income Taxes Less: Undistributed Corporate Profits Plus: Transfer Payments Equals: Personal Income (PI) Less: Personal Taxes Equals: Disposable Income (DI)

$10,858 2,000 3,018 -582 $ 15,294 GDP Approaches Compared Accounting Statement for the U.S. Economy, 2011 in Billions Receipts Expenditures Approach Allocations Income Approach Personal Consumption (C) Gross Private Domestic Investment (Ig) Government Purchases (G) Net Exports (Xn) Gross Domestic Product Compensation Rents Interest Proprietor’s Income Corporate Profits Taxes on Production and Imports National Income Net Foreign Factor Income Statistical Discrepancy Consumption of Fixed Capital Gross Domestic Product $ 8,242 404 536 1108 1870 1036 $13,196 165 -50 1983 $ 15,294

Circular Flow Revisited U.S. Domestic Output and the Flows of Expenditure and Income

Nominal vs. Real GDP • GDP is a dollar measure of production • Using dollar values creates problems • Nominal GDP • Use prevailing price • Real GDP • Reflect changes in price • Use base year price

Price of Market Basket In Specific Year Price Index In Given Year = x 100 Price of Same Basket In Base Year Nominal GDP Real GDP = Price Index (in hundredths) GDP Price Index Use price index to determine real GDP

Shortcomings of GDP • Nonmarket activities • Leisure • Improved product quality • The underground economy • GDP and the environment • Composition and distribution of the output • Noneconomic sources of well-being

GLOBAL PERSPECTIVE The Free Economy Underground Economy as a Percentage of GDP - Select Nations Percentage of GDP 0 5 10 15 20 25 30 Mexico South Korea India Italy Spain China Sweden Germany France United Kingdom Japan Switzerland US Source: Journal of Economic Literature

C+I+G=Baloney • Mainstreamers add government expenditures to Gross Domestic Product (GDP) • But it is really a drain depending on the weight of the fiscal extent of government activity in the economy • Government expenditure is theft not production • So we need to adjust GDP to arrive at Gross Private Product

GPP • Corrections to GDP • Transfer payments, because they are taken from producers and given to non-producers, should not be added • Any “goods or services” from government enterprises, need to be subtracted • Public employees’ salaries because it is gathered by means of taxation of the private sector need subtraction

C+I+G=Baloney X • Now from GPP, G must be subtracted, but… • If spending is larger than taxes, then the deficit is either financed by issuing new money or by borrowing private savings. • In either case, the deficit constitutes a drain of resources from the private sector. • If there is a surplus of taxes over spending, then the surplus taxes are drains on the private sector. • Subtract which ever larger

C+I+G=Baloney This subtracted from GPP yields the private product remaining in private hands: PPR (Private Output plus Costs of Government output) • GDP=C+I+G+(X-M) • GDP- GI (products or incomes from government=GPP • GPP- G (receipts or spending)=PPR

7 Introduction to Economic Growth and Instability

Chapter Objectives • How Economic Growth is Measured and Why is it Important • The General Ingredients of Economic Growth and How They Relate to Production Possibilities Analysis and Long-Run Aggregate Supply • “Growth Accounting” and the Specific Sources of U.S. Economic Growth • Differing Perspectives on Whether Growth is Desirable and Sustainable • The Business Cycle and its Primary Phases • The Types of Unemployment and Inflation and their Various Economic Impacts

Seven Major Sources of Economic Progress Common Sense Economics JamesGwartney, Richard L. Stroup, and Dwight R. Lee

Questions to Consider • Capital investments and new technology clearly contribute to economic growth and prosperity. What else is needed and what can governments add? • Why are sound institutions, governmental policies and money of stable value important? How can they advance economic progress? How can they stifle it? • Why do economic growth patterns and rates differ across countries and time?

Source #1 Legal System The foundation for economic progress is a legal system that protects the private use of land, natural resources, labor, capital, and entrepreneurial talent in an even-handed manner.

The Foundation for Economic Progress Private property rights grant the owner of property the right to buy, sell, or derive income from their land, natural resources, capital and entrepreneurial talent. Even-handed enforcement protects these rights to exclusive use, protection against abuse, and transfer rights, thus allowing property owners to focus on resource allocation, efficient production, investment, and technological advancement.

Property Rights Encourage people to use their property productively. Promote wise stewardship. Encourage people to develop their property in ways beneficial to others for possible exchange, transfer or sale. Promote the wise development and conservation of resources for the future.

The U.S. Will Run Out of Oil! Or Will It? • In which year(s) did experts predict that the U.S. would run out of oil in the near future? • 1914 • 1926 • 1970s • 2008 • All of the above

Why Have Doomsday Forecasts Been Wrong? • When the scarcity of a privately owned resource increases, the invisible hand of the market takes over and prices rise. • Buyers and sellers seek substitutes, discover ways to conserve, and innovate! • Historically, competitive markets and flexible prices spur conservation, substitution, and technological advancement. • And the “sky” never falls!

Source #2 Competitive Markets Competition promotes the efficient use of resources and provides a continuous stimulus for innovative improvements.

Consumers Rule! • Competition places pressure on producers to operate efficiently. • Competition forces businesses to cater to their customers’ preferences and provide goods and services for which they are willing to pay prices sufficient to cover their costs. • Consumers vote with dollars on which businesses stay and which must go. (e.g. Target vs. Wal-Mart vs. Sears vs. K-Mart) • They make sure that sole proprietors, partnerships and large corporations charge low prices, produce quality products and provide services of value relative to costs!

Source #3 Limits on Government Regulation Regulatory policies that reduce trade also retard economic progress.

Governments Limit Trade and Retard Progress By Limiting entry into some businesses and occupations • Licensing requirements, completing bureaucratic forms, etc. Substituting political authority for rule of law and freedom of contract • Imprecise, ambiguous and discriminatory laws invite people to spend resources on bribery and lobbying efforts rather than production. Imposing price controls • Price floors and ceilings interfere with trades between buyers and sellers, distort prices, and lead to inefficient levels of production and employment.

Source #4 An Efficient Capital Market To realize its potential, a nation must have a mechanism that channels capital into wealth-creating projects.

Capital Investment and Its Role in Growth • Capital is anything used to produce something else and helps us produce more goods and services in the future. • Machines, buildings, computers, tools • Capital investment requires consumption sacrifices today. It requires savings. The payoff is increased production and consumption in the future. • A mechanism is needed to channel savings into productive investments. Capital markets perform this function.

Capital Markets • Capital markets, broadly defined, include markets for: • Loanable funds, real estate, stock markets & financial markets • Institutions like banks, credit unions and investment firms bring savers and investors together. • Interest rates provide people with incentive to save. Productive investments will yield a return sufficient to cover all costs, including borrowing. • Not all investment projects are productive. In a world of uncertainty, investments can and do fail. But failures hold investors accountable and provide them the incentive to discover and undertake productive projects.

Capital Markets and Government Intervention • Governments can and do intervene in capital markets by restricting capital movements, setting interest rates, and using taxes and budgets to allocate capital. • These actions: • Distort market incentives. • Increase the importance of political rather than economic considerations. • Make unproductive investments more likely.

Source #5 Monetary Stability Inflationary monetary policies distort price signals, undermining a market economy.

Money, Money, Money! • “Money is to an economy what language is to communication.” • Money serves three functions • Medium of exchange • Unit of account • Store of value • When the value of money is stable, • Many potentially beneficial exchanges will take place. • Borrowers and lenders will face less uncertainty. • Gains from trade will be maximized.

Measuring Domestic Output and National Income