2 5 PART 2 GDP and the Standard of Living MONITORING THE MACROECONOMY CHAPTER
3 C H A P T E R C H E C K L I S TWhen you have completed your study of this chapter, you will be able toDefine GDP and explain why the value of production, income, and expenditure are the same for an economy.1Describe how economic statisticians measure GDP in the United States.2Distinguish between nominal GDP and real GDP and define the GDP deflator.3Explain and describe the limitations of real GDP as a measure of the standard of living.4
4 5.1 GDP, INCOME, AND EXPENDITURE GDP DefinedGross domestic product or GDPThe market value of all the final goods and services produced within a country in a given time period.Value ProducedUse market prices to value production.
5 5.1 GDP, INCOME, AND EXPENDITURE What ProducedFinal good or serviceA good or service that is produced for its final user and not as a component of another good or service.Intermediate good or serviceA good or service that is produced by one firm, bought by another firm, and used as a component of a final good or service.GDP includes only those items that are traded in markets.
6 5.1 GDP, INCOME, AND EXPENDITURE Where ProducedWithin a countryWhen ProducedDuring a given time period.
7 5.1 GDP, INCOME, AND EXPENDITURE Circular Flows in the U.S. EconomyConsumption expenditureThe expenditure by households on consumption goods and services.InvestmentThe purchase of new capital goods (tools, instruments, machines, buildings, and other constructions) and additions to inventories.
8 5.1 GDP, INCOME, AND EXPENDITURE Government expenditure on goods and servicesThe expenditure by all levels of government on goods and services.Net exports of goods and servicesThe value of exports of goods and services minus the value of imports of goods and services.
9 5.1 GDP, INCOME, AND EXPENDITURE Exports of goods and servicesItems that firms in in the United States produce and sell to the rest of the world.Imports of goods and servicesItems that households, firms, and governments in the United States buy from the rest of the world.
10 5.1 GDP, INCOME, AND EXPENDITURE Total expenditure is the total amount received by producers of final goods and services.Consumption expenditure: CInvestment: IGovernment expenditure on goods and services: GNet exports: NXTotal expenditure = C + I + G + NX
11 5.1 GDP, INCOME, AND EXPENDITURE Labor earns wages, capital earns interest, land earns rent, and entrepreneurship earns profits.
12 5.1 GDP, INCOME, AND EXPENDITURE Expenditure Equals IncomeBecause firms pay out everything they receive as incomes to the factors of production, total expenditure equals total income.That is:Y = C + I + G + NXThe value of production equals income equals expenditure.
13 5.1 GDP, INCOME, AND EXPENDITURE Figure 5.1 shows the circular flow of income and expenditure.
14 The Expenditure Approach 5.2 MEASURING U.S. GDPThe Expenditure ApproachMeasures GDP by using data on consumption expenditure, investment, government expenditure on goods and services, and net exports.
15 5.2 MEASURING U.S. GDP Expenditures Not in GDP Used Goods Expenditure on used goods is not part of GDP because these goods were part of GDP in the period in which they were produced and during which time they were new goods.Financial AssetsWhen households buy financial assets such as bonds and stocks, they are making loans, not buying goods and services.
16 The Income Approach 5.2 MEASURING U.S. GDP Measures GDP by summing the incomes that firms pay households for the factors of production they hire.The U.S. National Income and Product Account divide incomes into two big categories:WagesInterest, rent, and profits
17 5.2 MEASURING U.S. GDPWagesWages, called compensation of employees in the national accounts, is the payment for labor services.It includes net wages and salaries plus fringe benefits paid by employers such health care insurance, social security contributions, and pension fund contributions.
18 5.2 MEASURING U.S. GDP Interest, Rent, and Profit Interest, rent, and profit, called net operating surplus in the national account, is the sum of the incomes earned by capital, land, and entrepreneurship.Interest is the income households receive on loans they make minus the interest they pay on their borrowing.Rent includes payments for the use of land and other rented inputs.Profit includes the profits of corporations and small businesses.
19 Net domestic product at factor cost 5.2 MEASURING U.S. GDPNet domestic product at factor costThe sum of wages, interest, rent, and profit.Net domestic product at factor cost is not GDP.We need to make two adjustments to arrive at GDP:One from factor cost to market pricesOne from net product to gross product
20 5.2 MEASURING U.S. GDP From Factor Cost to Market Price The expenditure approach values goods at market prices; the income approach values them at factor cost.Indirect taxes (such as sales taxes) make market prices exceed factor cost.Subsidies (payments by government to firms) make factor cost exceed market prices.To convert the value at factor cost to the value at market prices, we must:Add indirect taxes and subtract subsidies
21 5.2 MEASURING U.S. GDPFrom Gross to NetThe expenditure approach measures gross product; the income approach measures net product.Gross profit is a firm’s profit before subtracting the depreciation of capital.Net profit is a firm’s profit after subtracting the depreciation of capital.Depreciation is the decrease in the value of capital that results from its use and from obsolescence.
22 5.2 MEASURING U.S. GDPIncome includes net profit, so the income approach gives a net measure.Expenditure includes investment. Because some new capital is purchased to replace depreciated capital, the expenditure approach gives a gross measure.To get gross domestic product from the income approach, we must add depreciation to total income.After making these two adjustments the income approach almost gives the same estimate of GDP as the expenditure approach.
24 Statistical discrepancy 5.2 MEASURING U.S. GDPStatistical DiscrepancyThe income approach and the expenditure approach do not deliver exactly the same estimate of GDP—there is a statistical discrepancy.Statistical discrepancyThe discrepancy between the expenditure approach and income approach estimates of GDP, calculated as the GDP expenditure total minus the GDP income total.
25 GDP and Related Measure of Production and Income 5.2 MEASURING U.S. GDPGDP and Related Measure of Production and IncomeGross national product or GNPThe market value of all the final goods and services produced anywhere in the world in a given time period by the factors of production supplied by residents of the country.U.S. GNP = U.S. GDP + Net factor income from abroad
26 Disposable Personal Income 5.2 MEASURING U.S. GDPDisposable Personal IncomeConsumption expenditure is one of the largest components of aggregate expenditure and one of the main influences on it is disposable personal income.Disposable personal incomeIncome received by households minus personal income taxes paid.
27 5.2 MEASURING U.S. GDPFigure 5.2 shows the relationship between GDP, GNP, and disposable personal income.
28 5.3 NOMINAL GDP VERSUS REAL GDP Calculating Real GDPReal GDPThe value of the final goods and services produced in a given year expressed in the prices of the base year.Nominal GDPThe value of the final goods and services produced in a given year expressed in the prices of that same year.The method of calculating real GDP changed in recent years, we describe the two methods.
29 5.3 NOMINAL GDP VERSUS REAL GDP Traditional Method of Calculating Real GDPWe’ll calculate real GDP in an economy that produces only apples and oranges. The current year is 2006, and the base year is 2000.Because 2000 is the base year, real GDP and nominal GDP are the same in 2000.Let’s use the traditional method to calculate real GDP in 2000 and 2006.
30 5.3 NOMINAL GDP VERSUS REAL GDP GDP Data for 2000:To calculate real GDP in 2000, sum the values of apples and oranges produced in 2000 using prices in 2000.Value of apples = 60 apples x $0.50 = $30Value of oranges = 80 oranges x $0.25 = $20Nominal GDP in 2000 = $30 + $20 = $50
31 5.3 NOMINAL GDP VERSUS REAL GDP GDP Data for 2006:To calculate real GDP in 2006, sum the values of apples and oranges produced in 2006 using prices in 2000.Value of apples = 160 apples x $0.50 = $80Value of oranges = 220 oranges x $0.25 = $55Real GDP in 2006 = $80 + $55 = $135
32 5.3 NOMINAL GDP VERSUS REAL GDP Chained-Dollar Method of Calculating Real GDPThe chained-dollar method does not use the base-year prices.The chained-dollar method uses the prices of current year and the preceding year.We show the calculation in fives steps.
33 5.3 NOMINAL GDP VERSUS REAL GDP Step 1:Calculate the value of production in both 2005 and 2006 using the prices of 2005.In 2005:Value of apples = 100 apples x $1.50 = $150Value of oranges = 200 oranges x $0.75 = $150Nominal GDP in 2005 = $150 + $150 = $300
34 5.3 NOMINAL GDP VERSUS REAL GDP Value of apples = 160 apples x $1.50 = $240Value of oranges = 220 oranges x $0.75 = $1652006 Quantities at 2005 prices = $240 + $165 = $405
35 5.3 NOMINAL GDP VERSUS REAL GDP Using 2005 prices:Value of production in 2005 is $300.Value of production in 2006 is $405.So using 2005 prices, the value of production increased by $105 or 35 percent in 2006.
36 5.3 NOMINAL GDP VERSUS REAL GDP Step 2:Calculate the value of production in both 2005 and 2006 using the prices of 2006.In 2005:Value of apples = 100 apples x $1.00 = $100Value of oranges = 200 oranges x $2.00 = $4002005 Quantities at 2006 Prices = $100 + $400 = $500
37 5.3 NOMINAL GDP VERSUS REAL GDP Value of apples = 160 apples x $1.00 = $160Value of oranges = 220 oranges x $2.00 = $440Nominal GDP in 2006 = $160 + $440 = $600
38 5.3 NOMINAL GDP VERSUS REAL GDP Using 2006 prices:Value of production in 2005 is $500.Value of production in 2006 is $600.So using 2006 prices, the value of production increased by $100 or 20 percent in 2006.
39 5.3 NOMINAL GDP VERSUS REAL GDP Step 3: Calculate the average of these increases in production:35 percent with 2005 prices20 percent with 2006 pricesThe average of 35 percent and 20 percent is 27.5 percent—our estimate of the real GDP growth rate between 2005 and 2006.Table 5.6(a) summarizes this calculation.
41 5.3 NOMINAL GDP VERSUS REAL GDP Step 4Repeat the calculations for each year going back to the base year, so we have an estimate of the real GDP growth rate from the base year of 2000.Step 5Starting from real GDP (nominal GDP) in the base year use the real GDP growth rates to calculate real GDP each through to 2006.Table 5.6(b) this calculation.
43 5.3 NOMINAL GDP VERSUS REAL GDP Calculating the GDP DeflatorGDP deflatorAn average of current prices expressed as a percentage of base-year prices.GDP deflator measure the price level.GDP deflator = (Nominal GDP Real GDP) 100.
44 5.3 NOMINAL GDP VERSUS REAL GDP We calculated the in 2006:Nominal GDP = $600 and real GDP = $145GDP deflator = (Nominal GDP ÷ Real GDP) x 100So in 2006:GDP deflator = ($600 ÷ $145) x 100 = 414.
45 5.4 THE USE AND LIMITATIONS OF REAL GDP We use estimates of real GDP for two main purposes:To compare the standard of living over timeTo compare the standard of living among countriesThe Standard of Living Over TimeTo compare living standards we calculate real GDP per person—real GDP divided by the population.Table 5.8 shows two calculations
47 5.4 THE USE AND LIMITATIONS OF REAL GDP Long-Term TrendFigure 5.3 shows the long-term trend in U.S. real GDP per person.Real GDP per person doubled on the 33 years from 1965 to 1998.
48 5.4 THE USE AND LIMITATIONS OF REAL GDP Short-Term FluctuationsFluctuations in the pace of expansion of real GDP is called the business cycle.The business cycle is a periodic irregular up-and down movement of total production and other measure of economic activity.The four stages of a business cycle are expansion, peak, recession, and trough.
49 5.4 THE USE AND LIMITATIONS OF REAL GDP The shaded periods show the recessions– periods of falling production that lasts for at least six months.
50 5.4 THE USE AND LIMITATIONS OF REAL GDP Standard of Living Across CountriesTo compare living standards across countries, we must convert real GDP into a common currency and common set of prices, called purchasing power parity.Goods and Services Omitted from GDPHousehold productionUnderground productionLeisure timeEnvironment quality
51 5.4 THE USE AND LIMITATIONS OF REAL GDP Household ProductionReal GDP omits household production, it underestimates the value of the production of many people, most of them women.Underground ProductionHidden from government to avoid taxes and regulations or illegal.Because underground economic activity is unreported, it is omitted from GDP.
52 5.4 THE USE AND LIMITATIONS OF REAL GDP Leisure TimeOur working time is valued as part of GDP, but our leisure time is not.Environment QualityPollution is not subtracted from GDP.We do not count the deteriorating atmosphere as a negative part of GDP.If our standard of living is adversely affected by pollution, our GDP measure does not show this fact.
53 5.4 THE USE AND LIMITATIONS OF REAL GDP Other Influences on the Standard of LivingHealth and Life ExpectancyGood health and a long life do not show up directly in real GDP.Political Freedom and Social JusticeA country might have a very large real GDP per person but have limited political freedom and social justice.A lower standard of living than one that had the same amount of real GDP but in which everyone enjoyed political freedom.
54 GDP in YOUR LifeAs you listen to the news, look for references to GDP. How is GDP used in daily life?Is the news about nominal GDP or real GDP? Is the term used correctly?Using U.S.GDP person, how does your income compare to the average income?How do you think your standard of living compares with that of a student in France or China?Do you produce more market goods than nonmarket good? How can you value your nonmarket production?Is your production counted in the nation’s output?