# 6...I mean just these sixteen accomplishments or whatever: I mean, we've got a major rapport - relationship of economics, major in the security, and all.

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6...I mean just these sixteen accomplishments or whatever: I mean, we've got a major rapport - relationship of economics, major in the security, and all of that, we should not lose sight of. George W. Bush Measuring Domestic Output and National Income

Chapter Objectives How GDP is Defined and Measured Circular Flow The Nature and Function of a GDP Price Index The Difference Between Nominal GDP and Real GDP Some Limitations of the GDP Measure 2

Gross Domestic Product GDP, or gross domestic product, is the market value of all final goods and services produced in a country in a given time period. US GDP, 2 nd quarter 2008 (\$ billions) : (Chg from previous period) Nominal GDP \$14,497.8 (+3.5%) Real GDP (2005 dollars) \$13,415.3 (+1.5%) US GDP, 2 nd quarter 2009 (\$ billions) : Nominal GDP \$14,143.3 (- 1.0%) Real GDP (2005 dollars) \$12,892.5 (- 1.0%) Source: www.BEA.govwww.BEA.gov 3

Gross Domestic Product Market Value GDP is a market value -- goods and services are valued at their market prices. To add sofas and computers, we add the market values so we have a total value of output in dollars. Output in 2009 is greater than output in 2008. YearAnnual OutputMarket Value 2008 3 sofas 2 computers (3) (\$500) + (2) (\$2,000) = \$5,500 2009 2 sofas 3 computers (2) (\$500) + (3) (\$2,000) = \$7,000 4

Gross Domestic Product Final Goods and Services A final good (or service), is an item bought by its final user during a specified time period. Only value added is considered in GDP. Excluding intermediate goods and services avoids double counting. Sales ValueValue Added Sheep Ranch \$120 Wool \$180\$60 Suit Maker \$220\$40 Macy's Department Store \$350\$130 Total \$870\$350 Sales Value Sheep Ranch\$120 Wool\$180 Suit Maker\$220 Macy's Department Store\$350 Total\$870 5

Gross Domestic Product Produced Within a Country GDP measures production within a nations borders – domestic production – no matter who owns the resources. Cars produced in a Japanese-owned factory in the US counts in US GDP. Cars produced in a US-owned factory in Mexico counts in Mexicos GDP. How is this different from GNP (Gross National Product)? 6

Gross Domestic Product In a Given Time Period GDP measures production during a specific time period, normally a year or a quarter of a year. Nominal GDP Real GDP 7

NOT Counted in GDP Non- Production Transactions Financial: Public transfer payments (payments made by US government to households for which nothing is required in return): Social Security/Medicare Welfare benefits Veterans benefits Private transfer payments such as cash gifts 8

NOT Counted in GDP Non- Production Transactions Financial: Stock market transactions: Buying/selling stock certificates or bonds transfers of pieces of paper; it is not producing goods or services. Second-hand sales or sales of used goods Count production in GDP for the year it is new. Buying a used car or a house built in 1995 will NOT count in GDP for this year (counted in the year it was produced). 9

Measuring GDP Two Approaches The Expenditure Approach Measures GDP as the sum of consumption expenditure, investment, government purchases of goods and services, and net exports. Final-Product or Value-Added The sum of the money spent to buy the output. The Income Approach Measures GDP by summing the incomes that firms pay households for the factors of production they hire. Wages (return to labor) Interest (return to capital) Rent (return to land) Profits (return to enterprise) 10

Expenditure Approach C = Personal Consumption Personal Consumption Expenditures, C Durable Consumer Goods (expected life of 3+ years): Cars, Appliances, TVs... Nondurable Consumer Goods (expected life less than 3 years): Groceries, pencils, toothpaste... Consumer Expenditures for Services Legal advice, healthcare, manicures, education... 11

Expenditure Approach Gross Private Domestic Investment Gross Private Domestic Investment, I Machinery, Equipment, and Tools All Construction (commercial AND residential) Changes in Inventories (unsold goods, unconsumed output) NOT included - Noninvestment Transactions, such as transfer of ownership of assets (like houses, stocks, bonds) 12

Expenditure Approach Government Purchases Government Purchases, G Expenditures for Goods and Services Labor, office supplies, uniforms... Expenditures for Social Capital Highways, schools, museums... Remember: G does not include transfer payments 13

Expenditure Approach Net Exports Net Exports, X n Exports (X=goods sold to other countries) Dell computers, haircuts for foreign tourists Imports (M=goods bought from other countries) Toyota Prius made in Japan, haircut you got in Paris X n = Exports (X) – Imports (M) 14

Two Approaches to GDP GDPGDP == Consumption by Households Investment by Businesses Government Purchases Net Expenditures By Foreigners Expenditure Approach Wages Rents Interest Profits Statistical Adjustments Income Approach 15

Expenditure Approach Putting It All Together: GDP = C + I + G + X n Circular Flow of Expenditure and Income GDP = production = income = expenditures The equality of income and output shows the link between productivity and living standards. 16

Circular Flow Diagram The circular flow diagram shows the transactions among households, firms, governments, and the rest of the world. 17

Transactions take place in factor (resource) markets, goods markets, and financial markets. 18

Firms hire factors of production from households. The blue flow, Y, shows total income paid by firms to households. Y = income 19

Households buy consumer goods and services. The red flow, C, shows consumption expenditures. C = consumptionY = income 20

Households save, S, and pay taxes, T. Firms borrow some of household savings to pay for investment. 21

Firms buy capital goods from other firms. The red flow I represents this investment expenditure by firms. (I = investment = creation of capital) 22

Governments buy goods and services, G, and borrow or repay debt if spending exceeds or is less than taxes. G = government purchases 23

The rest of the world buys goods and services from us, X and sells us goods and services, M: net exports are X – M. X = exports, M = imports, so X – M = net exports 24

And the rest of the world borrows from us or lends to us depending on whether net exports are positive or negative. 25

The blue and red flows are the circular flow of expenditure and income. The green flows are borrowing and lending. 26

The sum of the red flows (C + I + G +(X-M)) equals the blue flow (Y). Y = C + I + G + (X-M) 27

Nominal Versus Real GDP Nominal GDP GDP measured in terms of the price level at the time of measurement (NOT adjusted for inflation). Real GDP GDP adjusted for inflation. Nominal GDP is deflated (if prices increased) or inflated (if prices fell). Only real GDP measures changes in output accurately, holding price constant. 28

Nominal Versus Real GDP In 2006: Expenditure on hats \$100 = (100 x \$1.00) Expenditure on bats \$100 = ( 20 x \$5.00) Nominal GDP \$200 YearItemQuantity Price 2006Hats 100\$1.00 Bats 20\$5.00 29

Nominal Versus Real GDP In 2007: Expenditure on hats \$ 80 (160 x \$0.50) Expenditure on bats \$495 (22 x \$22.50) Nominal GDP \$575 YearItemQuantity Price 2007Hats 160\$0.50 Bats 22\$22.50 30

Nominal Versus Real GDP YearItemQuantity Price 2006Hats 100\$1.00 Bats 20\$5.00 2007Hats 160\$0.50 Bats 22\$22.50 Total spending:2006\$200 2007\$575 31

Nominal Versus Real GDP Two Methods for Calculating Real GDP 1.GDP Price Index Method 2.Base Year Prices Method 1.GDP Price Index Method Price index = measure of price of a specific market basket of goods in a specific year compared to price of identical goods in a base, or reference, year. Price Index In Given Year =x100 Price of Market Basket In Specific Year Price of Same Basket In Base Year 32

Nominal Versus Real GDP GDP Price Index Method Price Index In Given Year =x100 Price of Market Basket In Specific Year Price of Same Basket In Base Year Pizzas Qty Price 200575\$12.00 200690\$15.00 2007110\$23.50 Base year Note: Value of any index in the base year is ALWAYS 100. Do you see why? 33

Nominal Versus Real GDP GDP Price Index Method Price Index In 2006 =x100 \$15.00 \$12.00 =125 Price Index In 2007 =x100 \$23.50 =195.8 \$12.00 Pizzas Qty Price 200575\$12.00 200690\$15.00 2007110\$23.50 Base year 34

Nominal Versus Real GDP Base Year Prices Method Base year Real GDP = Nominal GDP GDP Price Index/100 GDP price index is also known as GDP deflator, because it deflates nominal to real (removes influence of inflation) PizzasQtyPriceGDPGDP Price Index 200575\$12.00\$900100 200690\$15.00\$1,350125 2007110\$23.50\$2,585195.8 Base year 35

Nominal Versus Real GDP Base Year Prices Method Base year PizzasQtyPriceGDPGDP Price Index 200575\$12.00\$900100 200690\$15.00\$1,350125 2007110\$23.50\$2,585195.8 Base year 36 Real GDP In 2006 = \$1,350 1.25 = \$1,080 00 Real GDP In 2007 = \$2,585 = \$1,320 22 1.958

Nominal Versus Real GDP Base Year Prices Method 37 Determine market value of basket in successive years assuming the price has not changed from the base year. PizzaQuantityPriceNominal GDPReal GDP 200575\$12 00 75x\$12 00 =\$900 200690\$15 00 90x\$15 00 =\$1,35090x\$12 00 =\$1,080 2007110\$23 50 110x\$23 50 =\$2,585110x\$12 00 =\$1,320 Current Prices Base-Year Price

Nominal Versus Real GDP Calculating Percentage Change in GDP 38 Reminder: To calculate % change in anything, (New – Old)/Old Percentage change in real GDP from 2006 to 2007: (\$1,320 – \$1,080) / \$,1080 = 0.222 = 22.2% increase % change in real GDP from 2005 to 2006 = __________________ % change in real GDP from 2005 to 2007 = __________________ PizzaQuantityPriceNominal GDPReal GDP 200575\$12 00 75x\$12 00 =\$900 200690\$15 00 90x\$15 00 =\$1,35090x\$12 00 =\$1,080 2007110\$23 50 110x\$23 50 =\$2,585110x\$12 00 =\$1,320 2008122\$26 00 ____________________________

Measuring Economic Growth 39 The economic growth rate is the percentage change in GDP from one year to the next. We measure economic growth so we can make: Economic welfare comparisons International welfare comparisons Business cycle forecasts

Shortcomings of GDP Economic Welfare Comparisons 40 Economic welfare measures the nations overall state of economic well-being. Real GDP is not a perfect measure of economic welfare for seven reasons: 1.Real GDP does not include household production (nonmarket activities), that is, productive activities done in and around the house by members of the household. 2. The value of leisure (time spent NOT working) is not captured in real GDP.

Shortcomings of GDP Economic Welfare Comparisons 41 Economic welfare measures the nations overall state of economic well-being. Real GDP is not a perfect measure of economic welfare for seven reasons: 3.Real GDP does not capture the value of improvements in quality. (ex, \$200 cell phone today is of much higher quality than \$200 cell phone 10 years ago). 4.Real GDP does not account for activity in the illegal underground economy, or legal activity with unreported income.

Shortcomings of GDP Economic Welfare Comparisons 42 Economic welfare measures the nations overall state of economic well-being. Real GDP is not a perfect measure of economic welfare for seven reasons: 5. Environmental damage is not deducted from real GDP. 6.Composition and distribution of output is not accounted for in real GDP. (ex. an assault rifle and a set of encyclopedias is valued equally if prices are equal). 7.Noneconomic sources of well-being, such as peace time, justice, civility, reduced crime, are not included in real GDP.

Key Terms GDP (gross domestic product) intermediate goods final goods value added expenditures approach income approach government purchases (G) domestic investment (I) consumption expenditures (C) net exports (X n ) nominal GDP real GDP leisure underground economy 43

Measuring Output and Income Wrap Up 44 Gross Domestic Product (GDP) Definition Measure Real v. Nominal Evaluate Expenditure Income Circular Flow Definition Two Ways to Calculate Growth Shortcomings

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