1. 18 Prepared by: Fernando Quijano and Yvonn Quijano © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair Measuring National Output and National Income

2. C H A P T E R 18: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 2 of 38 Gross Domestic Product Gross domestic product (GDP) is the total market value of all final goods and services produced within a given period by factors of production located within a country.

3. C H A P T E R 18: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 3 of 38 National Income and Product Accounts National income and product accounts are data collected and published by the government describing the various components of national income and output in the economy. The U.S. Department of Commerce is responsible for producing and maintaining the “National Income and Product Accounts” that keep track of GDP.

4. C H A P T E R 18: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 4 of 38 Final Goods and Services The term final goods and services in GDP refers to goods and services produced for final use. Intermediate goods are goods produced by one firm for use in further processing by another firm.

5. C H A P T E R 18: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 5 of 38 Value Added Value added is the difference between the value of goods as they leave a stage of production and the cost of the goods as they entered that stage. In calculating GDP, we can either sum up the value added at each stage of production, or we can take the value of final sales.

6. C H A P T E R 18: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 6 of 38 Value Added Value Added in the Production of a Gallon of Gasoline (Hypothetical Numbers) STAGE OF PRODUCTIONVALUE OF SALESVALUE ADDED (1)Oil drilling$.50$ (2)Refining.65.15 (3)Shipping.80.15 (4)Retail sale1.00.20 Total value added$1.00

7. C H A P T E R 18: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 7 of 38 Exclusions of Used Goods and Paper Transactions GDP ignores all transactions in which money or goods change hands but in which no new goods and services are produced.

8. C H A P T E R 18: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 8 of 38 Exclusion of Output Produced Abroad by Domestically Owned Factors of Production GDP is the value of output produced by factors of production located within a country. Output produced by a country’s citizens, regardless of where the output is produced, is measured by gross national product (GNP).

9. C H A P T E R 18: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 9 of 38 Calculating GDP GDP can be computed in two ways: The expenditure approach: A method of computing GDP that measures the total amount spent on all final goods during a given period. The income approach: A method of computing GDP that measures the income—wages, rents, interest, and profits—received by all factors of production in producing final goods.

10. C H A P T E R 18: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 10 of 38 The Expenditure Approach Expenditure categories: Personal consumption expenditures (C)—household spending on consumer goods. Gross private domestic investment (I)—spending by firms and households on new capital: plant, equipment, inventory, and new residential structures.

11. C H A P T E R 18: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 11 of 38 The Expenditure Approach Government consumption and gross investment (G) Expenditure categories: Net exports (EX – IM)—net spending by the rest of the world, or exports (EX) minus imports (IM)

12. C H A P T E R 18: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 12 of 38 The Expenditure Approach The expenditure approach calculates GDP by adding together the four components of spending. In equation form:

13. C H A P T E R 18: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 13 of 38 Components of GDP, 1999: The Expenditure Approach Components of GDP, 2002: The Expenditure Approach BILLIONS OF DOLLARS PERCENTAGE OF GDP Personal consumption expenditures (C)7303.769.9 Durable goods871.98.3 Nondurable goods2115.020.2 Services4316.841.3 Gross private domestic investment (l)1543.214.8 Nonresidential1117.410.7 Residential471.94.5 Change in business inventories3.90 Government consumption and gross investment (G)1972.918.9 Federal693.76.6 State and local1279.212.2 Net exports (EX – IM)  423.6  4.1 Exports (EX)1014.99.8 Imports (IM)1438.513.8 Total gross domestic product (GDP)10446.2100.0 Note: Numbers may not add exactly because of rounding. Source: U.S. Department of Commerce, Bureau of Economic Analysis.

14. C H A P T E R 18: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 14 of 38 Personal Consumption Expenditures Personal consumption expenditures (C) are expenditures by consumers on the following: Durable goods: Goods that last a relatively long time, such as cars and appliances. Nondurable goods: Goods that are used up fairly quickly, such as food and clothing. Services: Things that do not involve the production of physical things, such as legal services, medical services, and education.

15. C H A P T E R 18: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 15 of 38 Gross Private Domestic Investment Investment refers to the purchase of new capital. Total investment by the private sector is called gross private domestic investment. It includes the purchase of new housing, plants, equipment, and inventory by the private sector.

16. C H A P T E R 18: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 16 of 38 Gross Private Domestic Investment Nonresidential investment includes expenditures by firms for machines, tools, plants, and so on. Residential investment includes expenditures by households and firms on new houses and apartment buildings. Change in inventories computes the amount by which firms’ inventories change during a given period. Inventories are the goods that firms produce now but intend to sell later.

17. C H A P T E R 18: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 17 of 38 Gross Private Domestic Investment Remember that GDP is not the market value of total sales during a period—it is the market value of total production. The relationship between total production and total sales is: GDP = final sales + change in business inventories

18. C H A P T E R 18: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 18 of 38 Gross Investment versus Net Investment Gross investment is the total value of all newly produced capital goods (plant, equipment, housing, and inventory) produced in a given period. Depreciation is the amount by which an asset’s value falls in a given period. Net investment equals gross investment minus depreciation. capital end of period = capital beginning of period + net investment

19. C H A P T E R 18: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 19 of 38 Government Consumption and Gross Investment Government consumption and gross investment (G) counts expenditures by federal, state, and local governments for final goods and services.

20. C H A P T E R 18: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 20 of 38 Net Exports Net exports (EX – IM) is the difference between exports and imports. The figure can be positive or negative. Exports (EX) are sales to foreigners of U.S.-produced goods and services. Imports (IM) are U.S. purchases of goods and services from abroad).

21. C H A P T E R 18: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 21 of 38 The Income Approach National income is the total income earned by the factors of production owned by a country’s citizens. The income approach to GDP breaks down GDP into four components: GDP = national income + depreciation + (indirect taxes – subsidies) + net factor payments to the rest of the world + other

22. C H A P T E R 18: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 22 of 38 The Income Approach Components of GDP, 2002: The Income Approach BILLIONS OF DOLLARS PERCENTAGE OF GDP National income8,199.980.3 Compensation of employees6,010.058.9 Proprietors’ income943.57.3 Corporate profits748.97.3 Net interest554.85.4 Rental income142.71.4 Depreciation1,351.313.2 Indirect taxes minus subsidies739.47.2 Net factor payments to the rest of the world11.10.1 Other  96.1  0.9 Gross domestic product10,205.6100.0 Source: See Table 18.2.

23. C H A P T E R 18: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 23 of 38 From GDP to Disposable Personal Income GDP, GNP, NNP, National Income, Personal Income, and Disposable Personal Income, 2002 DOLLARS (BILLIONS) GDP 10,205.6 Plus: receipts of factor income from the rest of the world+ 342.1 Less: payments of factor income to the rest of the world  353.2 Equals: GNP 10,194.5 Less: depreciation  1,351.3 Equals: net national product (NNP) 8,843.2 Less: indirect taxes minus subsidies plus other  643.3 Equals: national income 8,199.9 Less: corporate profits minus dividends  332.6 Less: social insurance payments  731.2 Plus: personal interest income received from the government and consumers+ 439.1 Plus: transfer payments to persons+1,148.7 Equals: personal income 8,723.9 Less: personal taxes  1,306.2 Equals: disposable personal income 7,417.7 Source: See Table 18.2.

24. C H A P T E R 18: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 24 of 38 From GDP to Disposable Personal Income Net national product equals gross national product minus depreciation; a nation’s total product minus what is required to maintain the value of its capital stock. Personal income is the income received by households after paying social insurance taxes but before paying personal income taxes.

25. C H A P T E R 18: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 25 of 38 Disposable Personal Income and Personal Saving Disposable Personal Income and Personal Saving, 2002 DOLLARS (BILLIONS) Disposable personal income 7,417.7 Less: Personal consumption expenditures  7063.5 Interest paid by consumers to business  204.3 Personal transfer payments to foreigners  31.3 Equals: personal saving 118.6 Personal savings as a percentage of disposable personal income: 1.6% Source: See Table 18.2.

26. C H A P T E R 18: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 26 of 38 Disposable Personal Income and Personal Saving The personal saving rate is the percentage of disposable personal income that is saved. If the personal saving rate is low, households are spending a large amount relative to their incomes; if it is high, households are spending cautiously.

27. C H A P T E R 18: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 27 of 38 Nominal Versus Real GDP Nominal GDP is GDP measured in current dollars, or the current prices we pay for things. Nominal GDP includes all the components of GDP valued at their current prices. When a variable is measured in current dollars, it is described in nominal terms.

28. C H A P T E R 18: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 28 of 38 Calculating Real GDP A weight is the importance attached to an item within a group of items. A base year is the year chosen for the weights in a fixed-weight procedure. A fixed-weight procedure uses weights from a given base year.

29. C H A P T E R 18: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 29 of 38 Calculating Real GDP A Three-Good Economy (1)(2)(3)(4)(5)(6)(7)(8) GDP IN YEAR 1YEAR 2YEAR 1YEAR 2 IN PRODUCTIONPRICE PER UNITYEAR 1 YEAR 2 YEAR 1YEAR 2YEAR 1YEAR 2PRICES Q1Q1 Q2Q2 P1P1 P2P2 P 1 x Q 1 P 1 x Q 2 P 2 x Q 1 P 2 X Q 2 Good A611$.50$.40$3.00$5.50$2.40$4.40 Good B74.301.002.101.207.004.00 Good C1012.70.907.008.409.0010.80 Total$12.10$15.10$18.40$19.20 Nominal GDP in year 1 Nominal GDP in year 2

30. C H A P T E R 18: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 30 of 38 Calculating the GDP Deflator The GDP deflator is one measure of the overall price level. The GDP deflator is computed by the Bureau of Economic Analysis (BEA). Overall price increases can be sensitive to the choice of the base year. For this reason, using fixed- price weights to compute real GDP has some problems.

31. C H A P T E R 18: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 31 of 38 The Problems of Fixed Weights 1.Structural changes in the economy. 2.Supply shifts, which cause large decreases in price and large increases in quantity supplied. 3.The substitution effect of price increases. The use of fixed price weights to estimate real GDP leads to problems because it ignores:

32. C H A P T E R 18: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 32 of 38 GDP and Social Welfare Society is better off when crime decreases, however, a decrease in crime is not reflected in GDP. An increase in leisure is an increase in social welfare, but not counted in GDP. Nonmarket and household activities are not counted in GDP even though they amount to real production.

33. C H A P T E R 18: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 33 of 38 GDP and Social Welfare GDP accounting rules do not adjust for production that pollutes the environment. GDP has nothing to say about the distribution of output. Redistributive income policies have no direct impact on GDP. GDP is neutral to the kinds of goods an economy produces.

34. C H A P T E R 18: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 34 of 38 The Underground Economy The underground economy is the part of an economy in which transactions take place and in which income is generated that is unreported and therefore not counted in GDP.

35. C H A P T E R 18: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 35 of 38 Gross National Income per Capita To make comparisons of GNP between countries, currency exchange rates must be taken into account. Gross National Income (GNI) is a measure used to make international comparisons of output. GNI is GNP converted into dollars using an average of currency exchange rates over several years adjusted for rates of inflation. GNI divided by population equals gross national income per capita.

36. C H A P T E R 18: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 36 of 38 Gross National Income per Capita Per Capita Gross National Income for Selected Countries, 2002 COUNTRYU.S. DOLLARSCOUNTRYU.S. DOLLARS Switzerland36,970Portugal10,670 Japan35,990South Korea9,400 Norway35,530Argentina6,860 United States34,870Mexico5,540 Denmark31,090Czech Republic5,270 Ireland28,880Brazil3,060 Sweden25,400South Africa2,900 United Kingdom24,230Turkey2,540 Netherlands24,040Colombia1,910 Austria23,940Jordan1,750 Finland23,840Romania1,710 Germany23,700Philippines1,050 Belgium23,340China890 France22,640Indonesia680 Canada21,340India460 Australia18,770Pakistan420 Italy18,470Nepal250 Spain14,860Rwanda220 Greece11,780Ethiopia100 Source: The World Bank Atlas, 2002.

37. C H A P T E R 18: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 37 of 38 Review Terms and Concepts base year base year change in business inventories change in business inventories compensation of employees compensation of employees corporate profits corporate profits current dollars current dollars depreciation disposable personal income, or after-tax income disposable personal income, or after-tax income durable goods durable goods expenditure approach expenditure approach final goods and services final goods and services fixed-weight procedure fixed-weight procedure government consumption and gross investment (G) government consumption and gross investment (G) gross domestic product (GDP) gross domestic product (GDP) gross investment gross investment gross national income (GNI) gross national income (GNI) gross national product (GNP) gross national product (GNP) gross private domestic investment (I) gross private domestic investment (I) income approach income approach indirect taxes indirect taxes intermediate goods intermediate goods national income national income national income and product accounts national income and product accounts

38. C H A P T E R 18: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 38 of 38 Review Terms and Concepts personal saving personal saving personal saving rate personal saving rate proprietors’ income proprietors’ income rental income rental income residential investment residential investment services subsidies underground economy underground economy value added value added weight net exports (EX – IM) net exports (EX – IM) net factor payments to the rest of the world net factor payments to the rest of the world net interest net interest net investment net investment net national product (NNP) net national product (NNP) nominal GDP nominal GDP nondurable goods nondurable goods nonresidential investment nonresidential investment personal consumption expenditures (C) personal consumption expenditures (C) personal income personal income