# Chapter 14: Spending, Income, and GDP

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Chapter 14: Spending, Income, and GDP

Learning Objectives Explain how economist define and measure an economy's output Use the expenditure method for measuring GDP to analyze economic activity Define and compute nominal GDP and real GDP Discuss the relationships between GDP and economic well-being

Data on output, employment, prices
Macroeconomics Data on output, employment, prices Vital signs of the economy Employment, unemployment, average work hours Stock values and trends Prices and inflation Reported often in the news Systematic measurement of economic output developed during World War II Common systems and measured used virtually worldwide

Measuring Output Gross Domestic Product (GDP) is The market value of
Final goods and services Produced in a country in a given period of time

Market Value A modern economy produces many different goods and services Macroeconomists’ goal is to understand the behavior of the economy as a whole This is done through answers to the following questions: Has the overall capacity of the economy to produce goods and services increased over time? If so, by how much? Economists aggregate the quantities of the many different goods and services into a single number

Market Value Aggregate measure of quantities produced
Weighs more expensive items more Willingness to pay is an indication of benefit from the good Orchardia's GDP = (4 apples\$0.25/apple) + (6 bananas\$0.50/banana) + (3 pairs of shoes\$20.00/pair) = \$64 Orchardia Apples Bananas Shoes Price \$0.25 \$0.50 \$20.00 Quantity 4 6 3 GDP contribution \$1.00 \$3.00 \$60.00

Market Value Suppose now:
Orchardia's GDP (3 apples\$0.25/apple) + (3 bananas\$0.50/banana) + (4 pairs of shoes\$20.00/pair) = \$82.25 > \$64 The good whose production has increased (shoes) is much more valuable than the goods whose production has decreased (apples and bananas) Orchardia Apples Bananas Shoes Price \$0.25 \$0.50 \$20.00 Quantity 3 4 GDP contribution \$0.75 \$1.50 \$80.00

Female Labor Force Participation
The percentage of adult women working outside the home has increased dramatically over the past three decades in the Middle East and North Africa Women’s labor force participation: Egypt: 7% in 1980 to about 26% in 2005 Morocco: 15% in 1982 to about 30% in 2007 Still it remains very low relative to other industrialized nations such as the US and the UK (60% and 70%) If more women join the workforce, how is this change expected to affect measured GDP?

Female Labor Force Participation
The entry of more women into the labor market can raise measured GDP in two ways: The goods and services that women produce in their new jobs contribute directly to increasing GDP Represents a genuine increase in economic activity The fact that paid workers take over previously unpaid housework and childcare duties increases measured GDP by the amount paid to those workers Reflects a transfer of existing economic activities from the unpaid sector to the market sector Measured change in GDP overstates actual change

Increasing Efficiency
Principle of Comparative Advantage applies to household tasks Produce at lowest opportunity cost Women with high opportunity cost of household tasks find other ways to get the tasks completed Feminist movement, civil rights concerns, increasing educational attainment, and loosening social constraints moved women into the work force Household tasks performed by paid specialists

Some Non-Market Goods Included
Government goods and services are not sold in the market Protection by the army / transportation / education These goods have value Increase overall output Quantities are known Prices cannot be established Government production is valued at cost Overstates GDP if there is waste and inefficiency

Final Goods and Services
Final goods are consumed by the ultimate user End products of production Included in GDP Intermediate goods are used up in the production of final goods Not included in GDP Avoids double counting A barber's assistant earns \$2 per haircut for providing services such as shampooing and sweeping up Barber charges \$10 per haircut Haircut's contribution to GDP is \$10

Goods Can Be Final and Intermediate
Milk can be sold as: A final product: milk in the grocery store sold to households An intermediate good: milk sold to restaurants Count only the final goods A capital good, difficult to classify, is a long-lived good used in the production of other goods and services Houses, apartments, and motels Stoves in restaurants, cooking schools Delivery vehicles and taxis Money is not a capital good

Produced in a Country in a Period of Time
"Domestic" in GDP means the activity is measured within a country's borders Nationality of owners or company is not relevant Value must be produced in the year considered Sell a 20-year old house for \$200,000 House was not produced in the period of time studied Pay \$12,000 commission  value added is \$12,000 Since the service was provided during the current year, the agent’s fee is counted in current-year GDP

The Value Added Method for Measuring GDP
Value added is the market value of the product minus the cost of inputs purchased from other firms Count value added in the year it is produced Suppose that the bread is the ultimate product of three corporations Company Revenues - Cost of Purchased Inputs = Value Added ABC Grain \$0.50 \$0.00 General Flour \$1.20 \$0.70 Hot'n'Fresh \$2.00 \$0.80 Total Sum of value added is equal to the sum of the value of final goods and services

The Expenditure Method for Measuring GDP
Users of final goods can be divided into 4 groups Households(C) ■ Firms (I) Government (G) ■ Foreigners (NX) All goods produced are purchased by one of these groups in a given year Amount spent = market value GDP can be measured two ways Market value Total spending for final goods less value of imports

The Expenditure Method for Measuring GDP
GDP per capita was roughly \$45,000

Consumption Expenditure
Spending by households for goods and services is divided into three subcategories Consumer durables are long-lived consumer goods Consumer non-durable goods are shorter-lived goods Services are the largest component of consumer spending Cars Furniture Appliances Clothing Food Bedding Education Taxi rides Haircuts

Investment Investment can be divided into three subcategories
Business fixed investment is purchases of new capital goods Residential investment is construction of new homes and apartment buildings Inventory investment is the change in unsold goods to the company's inventory These goods are produced but not yet sold This entry can be positive or negative Negative inventory investment means less in inventory at year-end than at the beginning Plant Property Equipment

Economic Investment and Financial Investment
The purchase of stocks and bonds do not represent an investment, as defined in this chapter. Rather, they are referred to as financial investments. Financial investments include purchases of stocks, bonds, and other financial assets Purchase generally transfers ownership of a portion of the firm's existing capital stock Does not correspond to any increase in physical capital or production capacity, in most cases New stock issues can be an exception Economic investment refers to the increase in the capital goods used to produce other goods This value is based on purchase price of the capital goods, not on stock value

Government Purchases Federal, state, and local government purchase final goods and services Excludes transfer payments Transfer payments are made by government but the government receives no current goods or services Pension benefits, unemployment No purchases of final goods and services involved in transfer payments Spending by recipients is included in GDP Excludes interest paid on government debt Fighter jets Teaching Office supplies

Net Exports Net exports are exports (X) minus imports (M)
Exports are goods and services produced domestically and sold abroad Exports reduce the amount available to the domestic economy Imports are purchases of goods and services produced abroad Imports can be consumption, investment, or government spending Imports increase the amount available to the domestic economy A tourist's haircut in the US is an exported service

GDP Expenditures Equation
Terminology Expenditure approach to measuring GDP Y = C + I + G + NX Y Gross Domestic Product or output C Consumption Expenditure I Investment G Government Purchases NX Net Exports

GDP Example Total production is 1 million cars valued at \$15,000 each
Total Production value is 1 million × \$15,000 = \$15 billion 25,000 cars are unsold Investment in inventories increases by \$0.375 billion Sector # Cars Purchased Consumers 700,000 Businesses 200,000 Government 50,000 Net exports 25,000 Total 975,000 GDP Contribution \$ billion \$3.000 billion \$0.750 billion \$0.375 billion \$ billion Investment 225,000 \$3.375 billion Total 1,000,000 \$ billion

Expenditure Components of GDP

The Income Method for Measuring GDP
There are three ways to measure GDP Measure of total production Measure of total expenditure Measure of incomes of capital and labor All three methods should give the same final answer

The Income Method for Measuring GDP
When a good is sold, its proceeds are distributed to workers or business owners GDP = labor income + capital income Labor income is wages, salaries, benefits, and incomes of the self-employed About 71 percent of GDP in the UAE (2008) Capital income pays for physical capital and intangibles Measured before taxes Profits for business owners Rent for land Interest for bond holders Royalties

The Three GDP Approaches
Production Market Value of Final Goods and Services Expenditure Investment Consumption Government purchases Net exports Income Capital Income Labor Income

Nominal GDP versus Real GDP
Compare GDP for different years to see how much output has changed GDP changes over time because Prices change AND / OR Quantity of output changes To see how much output has grown, use only the changes in quantities Hold prices constant

The Shirts and Skirts Economy
GDP in 2009 is \$175; GDP in 2013 is \$420 Only twice as many goods were produced in 2013 Comparing the GDP for the year 2009 to the GDP for the year 2013, we might conclude that it is 2.4 times greater: 2.4 = (\$420/\$175) Because of the increase in prices, the market value of production grew more than the physical volume of production Number of Shirts Price of Shirts Number of Skirts Price of Skirts Nominal GDP 2009 10 \$10 15 \$5 \$175 2013 20 \$12 30 \$6 \$420

Real GDP and Nominal GDP
Real GDP (RGDP) values output in the current year using the prices from the base year The base year is a reference year that changes infrequently Real GDP measures the physical volume of production Nominal GDP (NGDP) values output in the current year using prices from the current year Nominal GDP is the current dollar value of production

Calculating Real GDP for 2013
Use 2009 as the base year Nominal GDP for 2009 is \$175 and for 2013, \$420 Calculate real GDP using current year quantities and base year prices Number of Shirt Price of Shirts Number of Skirts Price of Skirts 2009 10 \$10 15 \$5 2013 20 \$12 30 \$6

Calculating Real GDP for 2013
Now we can determine how much real production has actually grown over the four-year period By using RGDP, we have eliminated the effects of price changes and obtained a reasonable measure of the actual change in physical production over the four-year span

Chain Weighting Another method to calculate RGDP
RGDP from a chain weighting approach is Less sensitive to the choice of the base year Chain weighting is similar to the simpler process Geometric average (where the subscript is the price year) Consistent with the income method, RGDP doubles between 2009 and 2013.

Observations on Real and Nominal GDP
Usually, nominal and real GDP increase each year Nominal GDP can go up and real GDP go down Fewer goods and services produced AND Prices increase faster than output decreased Nominal GDP will be smaller than real GDP if the prices in the current year are less than in the base year Usually true for years before the base year Real GDP could rise and nominal GDP fall, but this is rare Prices are falling faster than output is increasing

Calculating the Price Level
RGDP measures the change in output by constant prices. In a world of rising prices, nominal GDP is deflated by a factor, that we call GDP Deflator. The GDP deflator captures output prices in a particular year relative to a selected base year.

GDP Deflator The GDP deflator represents a measure of the overall price level of produced goods and services. The GDP deflator is equal to 100 in the base year. It is greater than 100 when the current year’s prices exceed the base year’s prices. It is less than 100 when the current year’s prices are lower than the base year’s prices.

Calculating Inflation
Following the previous example we have The percent change column shows that prices have increased by 20%

Real GDP and Economic Well-Being
Real GDP is a flawed measure of well-being It values only market transactions Omits illegal transactions, volunteer work, and household production Maximizing GDP will not necessarily maximize national well-being Whether increases in output increase welfare is a case-by-case issue

GDP Does Not Value Leisure
Amount of leisure time has increased in the past 100 years Work weeks are shorter People enter the labor force at an older age People retire earlier Leisure produces no goods for market GDP places a value of zero on all leisure time Opportunity cost of an hour of leisure is your hourly wage Omission of the value of leisure time makes GDP seem smaller

Nonmarket Economic Activities
GDP omits services that are not traded in markets Household production This is of particular importance to developing countries where services are commonly traded for others Volunteer services Valuing these services would be difficult Nonmarket activities are important in poor countries Self-sufficient households and bartered goods and services

Underground economy Underground economy is all unreported transactions, legal and illegal Casual labor is often paid in cash Failure to report transaction reduces taxes Includes baby sitters, lawn care, home repair, etc. Some underground activity is illegal A service of value is provided Drug dealers, etc Estimates suggest the underground economy is large regardless of national income level

Environmental Quality
Suppose a factory is built in your town People are employed and output is produced Productive activity is included in GDP Suppose further that the factory creates pollution Your city hires a company to restore the environment to its initial condition Clean-up activities are included in GDP Gets environment back to its starting point, not better

Environmental quality and resource depletion are difficult to value
No adjustment is made for the decline in resource availability when mining or other harvesting is done One more barrel of oil on the market means one less barrel for future use Environmental quality and resource depletion are difficult to value They have value and that value is omitted from GDP

Other Quality of Life Considerations
GDP does not account for intangibles people value Crime rates Traffic congestion Civic organizations Open space Sense of community

Poverty and Economic Inequality
GDP measures the total quantity of goods and services produced and sold in an economy, but it conveys no information about who gets to enjoy those goods and services Two countries may have identical GDPs but differ radically in the distribution of economic welfare across the population GDP does not capture the effects of income inequality Most would prefer living in a relatively equal society to one with a few wealthy and many poor

GDP as a Welfare Measure
GDP omits and undervalues some goods and services GDP per capita is positively associated with several measures of well-being Material standard of living: more goods and services Health and life expectancy Residents of industrialized countries fare better than residents of developing countries in a range of health measures Education Literacy and school enrollment rates are higher in high-income countries

GDP as a Welfare Measure