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2. How do we track our economy’s booms and busts?

3. © 2013 Pearson 5 When you have completed your study of this chapter, you will be able to 1 Define GDP and explain why the value of production, income, and expenditure are the same for an economy. 2Describe how economic statisticians measure GDP and distinguish between nominal GDP and real GDP. 3Describe the uses of real GDP and explain its limitations as a measure of the standard of living. CHAPTER CHECKLIST GDP: A Measure of Total Production and Income

4. © 2013 Pearson 5.1 GDP, INCOME, AND EXPENDITURE  GDP Defined Gross domestic product or GDP The market value of all the final goods and services produced within a country in a given time period. Value Produced Use market prices to value production.

5. © 2013 Pearson 5.1 GDP, INCOME, AND EXPENDITURE What Produced Final good or service is a good or service that is produced for its final user and not as a component of another good or service. Intermediate good or service is a 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. © 2013 Pearson 5.1 GDP, INCOME, AND EXPENDITURE Where Produced Within a country When Produced During a given time period.

7. © 2013 Pearson 5.1 GDP, INCOME, AND EXPENDITURE  Circular Flows in the U.S. Economy Consumption expenditure is the expenditure by households on consumption goods and services. Investment is the purchase of new capital goods (tools, instruments, machines, buildings, and other constructions) and additions to inventories.

8. © 2013 Pearson 5.1 GDP, INCOME, AND EXPENDITURE Government expenditure on goods and services is the expenditure by all levels of government on goods and services. Net exports of goods and services is the value of exports of goods and services minus the value of imports of goods and services.

9. © 2013 Pearson 5.1 GDP, INCOME, AND EXPENDITURE Exports of goods and services are the items that firms in the United States produce and sell to the rest of the world. Imports of goods and services are the items that households, firms, and governments in the United States buy from the rest of the world.

10. © 2013 Pearson 5.1 GDP, INCOME, AND EXPENDITURE Total expenditure is the total amount received by producers of final goods and services. Consumption expenditure: C Investment: I Government expenditure on goods and services: G Net exports: NX Total expenditure = C + I + G + NX

11. © 2013 Pearson 5.1 GDP, INCOME, AND EXPENDITURE Income Labor earns wages. Capital earns interest. Land earns rent. Entrepreneurship earns profits. Households receive these incomes.

12. © 2013 Pearson 5.1 GDP, INCOME, AND EXPENDITURE  Expenditure Equals Income Because firms pay out everything they receive as incomes to the factors of production, total expenditure equals total income. That is: Y = C + I + G + NX The value of production equals income equals expenditure.

13. © 2013 Pearson 5.1 GDP, INCOME, AND EXPENDITURE Figure 5.1 shows the circular flow of income and expenditure. The table shows the U.S. data for 2011.

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15. 5.2 MEASURING U.S. GDP  The Expenditure Approach Measures GDP by using data on consumption expenditure, investment, government expenditure on goods and services, and net exports. Table 5.1 on the next slide shows the calculation for 2011.

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17. © 2013 Pearson 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 Assets When households buy financial assets such as bonds and stocks, they are making loans, not buying goods and services.

18. © 2013 Pearson 5.2 MEASURING U.S. GDP  The Income Approach 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: Wage income Interest, rent, and profit income

19. © 2013 Pearson 5.2 MEASURING U.S. GDP Wage Income Wage income, 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.

20. © 2013 Pearson 5.2 MEASURING U.S. GDP Interest, Rent, and Profit income Interest, rent, and profit income, 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.

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23. 5.2 MEASURING U.S. GDP Net domestic product at factor cost is the 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 prices One from net product to gross product

24. © 2013 Pearson 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

25. © 2013 Pearson 5.2 MEASURING U.S. GDP From Net to Gross The income approach measures net product. The expenditure approach measures gross 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 t he decrease in the value of capital that results from its use and from obsolescence.

26. © 2013 Pearson 5.2 MEASURING U.S. GDP Income 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.

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28. © 2013 Pearson 5.2 MEASURING U.S. GDP Statistical Discrepancy The income approach and the expenditure approach do not deliver exactly the same estimate of GDP—there is a statistical discrepancy. Statistical discrepancy is the discrepancy between the expenditure approach and income approach estimates of GDP, calculated as the GDP expenditure total minus the GDP income total.

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30. © 2013 Pearson 5.2 MEASURING U.S. GDP  GDP and Related Measures of Production and Income Gross national product or GNP is the 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

31. © 2013 Pearson 5.2 MEASURING U.S. GDP Disposable Personal Income Consumption expenditure is one of the largest components of aggregate expenditure and one of the main influences on it is disposable personal income. Disposable personal income is the income received by households minus personal income taxes paid.

32. © 2013 Pearson 5.2 MEASURING U.S. GDP Figure 5.2 shows the relationship between GDP, GNP, and disposable personal income.

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34. 5.2 MEASURING U.S. GDP  Real GDP and Nominal GDP Real GDP is the value of the final goods and services produced in a given year expressed in the prices of the base year. Nominal GDP is the 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. Here we describe the essence of the calculation. The appendix gives the technical details.

35. © 2013 Pearson 5.2 MEASURING U.S. GDP  Calculating Real GDP The goal of calculating real GDP is to measure the extent to which total production has increased. Real GDP removes the influence of price changes from the nominal GDP numbers. To focus on the principles and keep the numbers easy to work with, we’ll calculate real GDP for an economy that produces only one consumption good, one capital good, and one government service.

36. © 2013 Pearson 5.2 MEASURING U.S. GDP Table 5.3 shows the calculation with 2005 (base year) and 2011. To find the total expenditure in 2005 multiply the quantity of each item produced in 2005 by its price in 2005. Then sum the expenditures to find nominal GDP in 2005. The next slide shows the data.

37. © 2013 Pearson Nominal GDP in 2005 is $100 million. Because 2005 is the base year, real GDP in 2005 is also $100 million.

38. © 2013 Pearson 5.2 MEASURING U.S. GDP In part (b) of Table 5.3, we calculate nominal GDP in 2011. Again, we calculate nominal GDP by multiplying the quantity of each item produced by its price and then sum the expenditures to find nominal GDP in 2011.

39. © 2013 Pearson Nominal GDP in 2005 is $100 million. Nominal GDP in 2011 is $300 million.

40. © 2013 Pearson 5.2 MEASURING U.S. GDP Nominal GDP in 2011 is three times its value in 2005. But by how much has the quantity of final goods and services produced increased? Nominal GDP in 2005 is $100 million and in 2011 it is $300 million.

41. © 2013 Pearson 5.2 MEASURING U.S. GDP The increase in real GDP will tell by how much the quantity of good and services has increased. Real GDP in 2011 is what the total expenditure would have been in 2011 if prices had remained the same as they were in 2005. To calculate real GDP in 2011 multiply the quantities produced in 2011 by the price in 2005 and the sum these expenditures to find real GDP in 2011. Part (c) of Table 5.3 shows the details.

42. © 2013 Pearson Real GDP in 2005 is $100 million. Real GDP in 2011 is $160 million— only 1.6 times real GDP in 2005.

43. © 2013 Pearson 5.3 THE USE AND LIMITATIONS OF REAL GDP We use estimates of real GDP for three main purposes: To compare the standard of living over time To track the course of the business cycle To compare the standard of living among countries  The Standard of Living Over Time To compare living standards we calculate real GDP per person—real GDP divided by the population.

44. © 2013 Pearson 5.3 THE USE AND LIMITATIONS OF REAL GDP In 2011, U.S. real GDP was $13,088 billion and the U.S. population was 310.1 million. Real GDP per person = $13,088 billion ÷ 310.1 million Real GDP per person = $42,206. In 1961, real GDP per person was $15,754. The standard of living in 2011 was 2.7 times the standard of living in 1961.

45. © 2013 Pearson 5.3 THE USE AND LIMITATIONS OF REAL GDP Two features of our changing standard of living are 1. The growth of potential GDP per person 2. Fluctuations of real GDP per person around potential GDP Potential GDP is the value of real GDP when all the economy’s factors of production —labor, capital, land, and entrepreneurial ability—are fully employed.

46. © 2013 Pearson 5.3 THE USE AND LIMITATIONS OF REAL GDP When some factors of production are unemployed, real GDP is less than potential GDP. When some factors of production are over-employed and working hard, real GDP exceeds potential GDP. In the short term, real GDP fluctuates around potential GDP. To measure the trend in the standard of living, we remove the influence of short-term fluctuations and focus on potential GDP. Figure 5.3 on next slide shows these two features.

47. © 2013 Pearson 5.3 THE USE AND LIMITATIONS OF REAL GDP Real GDP per person grows and fluctuates around the path of potential GDP. Potential GDP per person grew at 2.8 percent in the 1960s and slowed during the 1970s.

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49. 5.3 THE USE AND LIMITATIONS OF REAL GDP  Tracking the Course of the Business Cycle Fluctuations in the pace of expansion of real GDP is called the business cycle. The business cycle is a periodic, but irregular, up- and down-movement of total production and other measures of economic activity. The four stages of a business cycle are expansion, peak, recession, and trough.

50. © 2013 Pearson 5.3 THE USE AND LIMITATIONS OF REAL GDP The shaded periods show the recessions— periods of falling production that lasts for at least six months.

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52. 5.3 THE USE AND LIMITATIONS OF REAL GDP  Standard of Living Among Countries To 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 GDP Household production Underground production Leisure time Environment quality

53. © 2013 Pearson 5.3 THE USE AND LIMITATIONS OF REAL GDP Household Production Real GDP omits household production and it underestimates the value of the production of many people, most of them women. Underground Production Economic activity hidden from government to avoid taxes and regulations or production that is illegal. Because underground economic activity is unreported, it is omitted from GDP.

54. © 2013 Pearson 5.3 THE USE AND LIMITATIONS OF REAL GDP Leisure Time Our working time is valued as part of GDP, but our leisure time is not. Environment Quality Pollution 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.

55. © 2013 Pearson 5.3 THE USE AND LIMITATIONS OF REAL GDP  Other Influences on the Standard of Living Health and Life Expectancy Good health and a long life do not show up directly in real GDP. Political Freedom and Social Justice A country with a large real GDP per person might have limited political freedom and social justice. A country with a lower standard of living might be one in which everyone enjoys political freedom.

56. © 2013 Pearson The National Bureau of Economic Research (NBER) Business Cycle Dating Committee determines the dates of U.S. business cycle turning points. To identify the date of a business cycle peak, the NBER committee looks at data on industrial production, total employment, real GDP, and wholesale and retail sales. The two most reliable measures of aggregate domestic production are real GDP measured using the expenditure approach and the income approach. How Do We Track the Booms and Busts of Our Economy?

57. © 2013 Pearson The NBER committee met in November 2008 to determine when the economy went into recession. Because of a statistical discrepancy, the two estimates of real GDP differ and for a few quarters in 2007 and 2008 they told conflicting stories. The NBER examined other data on real personal income, real manufacturing, wholesale and retail sales, industrial production, and employment. How Do We Track the Booms and Busts of the Our Economy?

58. © 2013 Pearson All of these data peaked between November 2007 and June 2008. How Do We Track the Booms and Busts of Our Economy? The committee decided that November 2007 was the peak. But as the figure shows, real GDP didn’t begin a sustained fall until two quarters later.

59. © 2013 Pearson APPENDIX: MEASURING REAL GDP  The Problem with Base-Year Prices We calculated real GDP in 2011 using 2005 as the base year and found that real GDP in 2011 was 1.6 percent greater than in 2005—an increase of 60%. But if we had used 2011 prices rather than 2005, real GDP would have increased from $150 million (2011 dollars) in 2005 to $300 million in 2011—an increase of 100%. So did real GDP increase by 60% or 100%?

60. © 2013 Pearson APPENDIX: MEASURING REAL GDP The BEA method uses the prices of both years. The three steps in the method are Value production in the prices of adjacent years. Find the average of the two percentage changes. Link (chain) to the base year.

61. © 2013 Pearson APPENDIX: MEASURING REAL GDP  Value Production in the Prices of Adjacent Years Let’s take as the two adjacent years 2012 and its preceding year 2011. Value the quantities produced in 2011 and 2012 at both the prices of 2011 and the prices of 2012. Table A5.1 shows the calculations.

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63. APPENDIX: MEASURING REAL GDP The table gives Value of production in 2011 at 2011 prices is $145. Value of production in 2012 at 2011 prices is $160. Value of production in 2011 at 2012 prices is $158. Value of production in 2012 at 2012 prices is $172. The next step is the find the percentage increases using 2011 prices and 2012 prices and then average these two percentages.

64. © 2013 Pearson APPENDIX: MEASURING REAL GDP Find the Average of Two Percentage Changes

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66. APPENDIX: MEASURING REAL GDP Link (Chain) to the Base Year Starting in the base year, apply the calculated average percentage increase each year to obtain the chained- dollar real GDP. Figure A5.1 illustrates the calculation with assumed data. The base year is 2005. Suppose that in 2005, real GDP is $60 million.

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68. APPENDIX: MEASURING REAL GDP By applying the average percentage change between each pair of years, we find the chained-dollar real GDP for each year, expressed in terms of 2005 dollars. We can do this for years after the base year, … and for years earlier than the base year.