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Taking the Nation’s Pulse

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1 Taking the Nation’s Pulse
Chapter 7 Taking the Nation’s Pulse

2 1. GDP – A Measure of Output

3 GDP – A Measure of Output
Gross Domestic Product (GDP) is the market value of final goods and services produced within a country during a specific time period, usually a year. What Counts Toward GDP? Only Final Goods and Services Count: Sales at intermediate stages of production are not counted as their value is embodied within the final-user good. Their inclusion would result in double counting. Stage of Production Amount Added To the Value of the product (equals income created) (2) Sales Receipts at each stage of production (1) Stage 1: Farmer’s wheat $.30 $.30 Value added by farmer Stage 2: Miller’s flour $.65 $.35 Value added by miller Stage 3: Baker’s bread (wholesale) $.90 $.25 Value added by baker Stage 4: Grocer’s bread (retail) $1 $.10 Value added by grocer Total consumer expenditure = $1 Total value added = $1

4 GDP – A Measure of Output
What Counts Toward GDP? (cont.) Financial transactions and income transfers are excluded because they do not involve production. Only production within the geographic borders of the country is counted. Only goods produced during the current period are counted. Dollars -- The Common Denominator for GDP Each good produced increases output by the amount the purchaser pays for the good. GDP is equal the sum of the total spending on all goods and services produced during the year.

5 Questions for Thought:
1. Indicate how each of the following activities will affect this year’s GDP: a. Sale of a used economics textbook to the college bookstore. b. Smith’s $500 doctor bill for setting her son’s broken arm. c. Family lawn services provided by Smith’s 16-year-old child. d. Lawn services purchased by Smith from the neighbor’s year-old child who has a lawn mowing business. e. A $5,250 purchase of 100 shares of stock at $50 per share plus the sales commission of $ f. A multi-billion dollar discovery of natural gas in Oklahoma. g. A hurricane that causes $10 billion of damage in Florida. h. $50,000 of income earned by an American college professor teaching in England.

6 2. Two Ways of Measuring GDP

7 Two Ways of Measuring GDP
Dollar Flow of Expenditures on Final Goods = Dollar Flow of Income (and indirect cost) of Final Goods = Deriving GDP by the Expenditure Approach: GDP is the sum of expenditures on final user goods and services purchased by households, investors, governments, and foreigners. There are four components of GDP: personal consumption purchases, gross private investment (including inventories), government purchases (both consumptions and investment), and, net exports ( exports - imports )

8 Two Ways of Measuring GDP
Deriving GDP by the Resource Cost - Income Approach: GDP is the sum of the costs incurred and income (including profits) generated producing goods and services during the period. The direct cost income components of GDP are: employee compensation, self-employment income, rents, interest, and, corporate profit. Sum of these = National Income

9 Two Ways of Measuring GDP
The Resource Cost - Income Approach: (cont). Not all cost components of GDP result in an income payment to a resource supplier. In order to get to GDP, we need to account also for three other factors: Indirect business taxes: Taxes that increase the business firm’s costs of production and therefore the prices charged to consumers. Depreciation: The cost of the wear and tear on the machines and other capital assets used to produce goods and services during the period. Net Income of Foreigners The income that foreigners earn producing goods within the borders of a country minus the income Americans earn abroad.

10 Two Ways of Measuring GDP
When derived by Resource Cost - Income Approach GDP is equal to: national income (employee compensation, self-employment income, rents, interest, corporate profit), indirect business taxes, depreciation, and, the net income of foreigners.

11 Two Ways of Measuring GDP
Expenditure Approach Resource Cost-Income Approach Personal Consumption Expenditures Aggregate Income: Compensation of employees (Wages and salaries) + Gross Private Domestic Investment Income of self-employed Proprietors Rents + Government Consumption and Gross Investment Profits Interest + Non-Income Cost Items: + Net exports of goods and Services Indirect business taxes Depreciation = GDP Net Income of Foreigners + = GDP There are two methods of calculating GDP: It can be calculated either by summing the expenditures on the “final user” goods and services purchased by consumers, investors, governments, and foreigners (net exports), or, by summing the income payments and direct cost items that accompany the production of goods and services.

12 Relative Size of U.S. GDP Components: 1996-1998
Personal consumption 68% Net exports minus 1% Private investment 14% Government 19% Rental income less than 1% Net interest 7% Indirect taxes 8% Corporate profits Self-employed proprietor income 7% a Compensation to employees 60% Depreciation 11% (a) Expenditure approach (b) Resource cost-income approach Source: Economic Report of the President, 1999. a The net income of foreigners was negligible. The relative sizes of the major components of GDP usually fluctuate within a fairly narrow range. The average proportion of each U.S. component during is demonstrated here for both The expenditure approach, and, The resource cost-income approach.

13 3. Real and Nominal GDP

14 Real and Nominal GDP The term "real" means adjusted for inflation.
Price indexes are use to adjust income and output data for the effects of inflation. A price index measures the cost of purchasing a market basket (or “bundle”) of goods at a point in time relative to the cost of purchasing the identical market basket during an earlier reference (or base) period.

15 4. Two Key Price Indexes: -- The Consumer Price Index and the GDP Deflator

16 Two Key Price Indexes: -- The Consumer Price Index and the GDP Deflator
Consumer Price Index (CPI): -- measures the impact of price changes on the cost of the typical bundle of goods and services purchased by households. GDP Deflator: -- is a broader price index than the CPI It is designed to measure the change in the average price of the market basket of goods included in GDP.

17 CPI & GDP Deflator: 1981-1997 GDP CPI Deflator
Year CPI (1982 – 84 = 100) 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 90.9 96.5 99.6 103.9 107.6 109.6 113.6 118.3 124.0 130.7 136.2 140.3 144.5 148.2 152.4 156.9 160.5 10.3 6.2 3.2 4.3 3.6 1.9 4.1 4.8 5.4 4.2 3.0 2.6 2.8 2.3 10.0 3.7 2.5 3.1 4.0 2.4 GDP Deflator (1992 = 100) 66.1 70.2 73.2 75.9 78.6 80.6 83.1 86.1 89.7 93.6 97.3 100.0 102.6 105.1 107.5 111.6 Inflation Rate (Percent) Source: Economic Report of the President, 1999. 1998 163.0 1.5 1.0 112.7 Even though the CPI and the GDP deflator are based on different market baskets and procedures, the rate of inflation as measured by each indicates that the differences between these two alternative measures have been small, usually only a few tenths of a % point.

18 5. Using the GDP Deflator to Derive Real GDP

19 Using the GDP Deflator to Derive Real GDP
Nominal GDP2 * Data on both money GDP and price changes are essential for meaningful output comparisons between two time periods.

20 Questions for Thought:
1. What do price indexes measure? 2. What is the difference between the consumer price index (CPI) and the GDP deflator. Which would be better to use if you want to measure whether your hourly earnings this year were higher than they were last year. Why? 3. Consider an economy with the following data: Nominal GDP (in Trillions) GDP deflator $ What was GDP in 1999 in constant 1998 dollars? What was the growth rate of real GDP between 1998 and 1999? What was the inflation rate between 1998 and 1999?

21 Using the GDP Deflator to Derive Real GDP
1992 1998 % Increase Source: U.S. Department of Commerce. NOMINAL GDP (BILLIONS OF DOLLARS) PRICE INDEX (GDP DEFLATOR, 1992 = 100) 100.0 112.7 12.7% REAL GDP (BILLIONS OF 1992 DOLLARS) $6,244 $6,244 $8,511 $7,552 36.3% 20.9% Between 1992 and 1998, nominal GDP increased by 36.3 percent. But when the 1998 GDP is deflated to account for price increases, we see that real GDP increased by only 20.9 percent.

22 6. The Shortcomings and Strength of GDP as a Measuring Rod

23 Shortcomings of GDP as a Measuring Rod
It does not count non-market production. It does not count the underground economy. It makes no adjustment for leisure. It probably understates output increases because of the problem of estimating improvements in the quality of products. It does not adjust for harmful side effects.

24 The Great Contribution of GDP
In spite of its shortcomings, real GDP is a reasonably accurate measure of short-term fluctuations in output.

25 7. Related Income Measures

26 Related Income Measures
Gross National Product (GNP): Output produced by the "nationals"-- the citizens of the country, regardless of whether that output is produced domestically or abroad. National income: Total income earned by the nationals (citizens) during a period. It is the sum of employee compensation, self-employment income, rents, interest, and corporate profits. Personal income: Total income received by domestic households and non-corporate businesses. It is available for consumption, saving, and payment of personal taxes. Disposable income: Income available to individuals after personal taxes. It can either be spent on consumption or saved.

27 5 Alternative Measures of Income
1998 ($ billions) Net income of foreigners Net exports Depreciation Personal consumer expenditures Indirect business taxes minus net income earned abroad Personal taxes Employee compensation Minus Corporate profits & Social insurance taxes Plus Transfer payments net interest, and dividends Gross Private Domestic Investment Proprietors’ income Government consumption & investment Interest Rents Corporate profits Gross Domestic Product Gross National Product National Income Personal Income Disposable Income $8,511 $8,491 $6,995 $6,102 $5,307 The bars above illustrate the 5 alternative measures of national income. The alternatives range from GDP (the broadest measure of output) to Disposable Income (which indicates the funds available to households for either consumption or saving).

28 The Link Between Output and Income
As the alternative ways of measuring of GDP highlight, output and income are linked. Increases in output are the source of higher income levels.

29 Questions for Thought:
1. Why might even real GDP be a misleading index of changes in output between 1950 and 1999 in the United States? Of differences in output between the United States and Mexico? 2. GDP does not count productive services such as child care, food preparation, cleaning, and laundry provided within the household. Why are these things excluded? Is GDP a sexist measure? Does it understate the productive contributions of women relative to men? 3. What are the components of GDP when it is derived by the expenditure approach?

30 End Chapter 7


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