Mehdi Arzandeh, University of Manitoba PowerPoint Presentation by

7-2 © 2016 McGraw ‐ Hill Education Limited LEARNING OBJECTIVES LO7.1Explain how gross domestic product (GDP) is defined and measured. LO7.2Describe how expenditures on goods and services can be summed to determine GDP. LO7.3Explain how GDP can be determined by summing all of the incomes that were derived from producing the economy’s output of goods and services. LO7.4Discuss the nature and function of a GDP price index, and describe the difference between nominal GDP and real GDP. LO7.5List and explain the shortcomings of GDP as a measure of domestic output and well-being. 7 Measuring the Economy’s Output

National Income Accounting measures economy’s overall performance Statistics Canada compiles National Income and Product Accounts Assess health of economy Track the long-run course of the economy Formulate policies LO1 © 2016 McGraw ‐ Hill Education Limited 7.1 Measuring the Economy’s Performance: GDP 7-3

Gross Domestic Product The main measure of the economy’s performance The total (aggregate) market value of all final goods and services produced within the borders of a country during a specific period of time A Monetary Measure LO1 © 2016 McGraw ‐ Hill Education Limited 7.1 Measuring the Economy’s Performance: GDP 7-4

© 2016 McGraw ‐ Hill Education Limited LO1 7-5 TABLE 7-1 Comparing Heterogeneous Outputs by Using Money Prices YearAnnual outputMarket value 13 sofas and 2 computers3($500) + 2($2000) = $ sofas and 3 computers2($500) + 3($2000) = $7000 Society is willing to pay $1500 more for the combination of goods produced in year 2 than for the combination of goods produced in year 1.

Avoiding Multiple Counting To avoid multiple counting, only final goods and services are counted Final goods: Goods and services purchased for final use and not for resale or further processing or manufacturing Intermediate goods: Products purchased for resale or further processing or manufacturing Value added LO1 © 2016 McGraw ‐ Hill Education Limited 7.1 Measuring the Economy’s Performance: GDP 7-6

© 2016 McGraw ‐ Hill Education Limited LO1 7-7 TABLE 7-2 Value Added in a Five-Stage Production Process (1) Stage of production (2) Sales value of materials or product (3) Value added 0 Firm A, sheep ranch$ 120$120 (= $120 – $0) Firm B, wool processor (= 180 – 120) Firm C, suit manufacturer (= 220 – 180) Firm D, clothing wholesaler (= 270 – 220) Firm E, retail clothier (= 350 – 270) Total sales value$1140 Value added (total income) $350

GDP Excludes Nonproduction Transactions Two types of nonproduction transactions: FINANCIAL TRANSACTIONS Public Transfer Payments Private Transfer Payments Stock-Market Transactions SECOND-HAND SALES LO1 © 2016 McGraw ‐ Hill Education Limited 7.1 Measuring the Economy’s Performance: GDP 7-8

Two Ways of Calculating GDP: Expenditures and Income The Expenditures Approach: The sum of all the money spent in buying final goods and services By households, businesses, government, and buyers abroad The Income Approach The income derived or created from producing final goods and services Payments to the suppliers of factors of production as wages, rent, interest, and profit LO1 © 2016 McGraw ‐ Hill Education Limited 7.1 Measuring the Economy’s Performance: GDP 7-9

The Expenditures Approach: adds up all the expenditures made for final goods and services. The Expenditures Approach adds up personal consumption expenditures (C) gross investment (I g ) government purchases (G) net exports (X n ) = exports (X) – imports (M) LO2 © 2016 McGraw ‐ Hill Education Limited 7.2 The Expenditure Approach 7-10

© 2016 McGraw ‐ Hill Education Limited LO TABLE 7-3 Value Added in a Five-Stage Production Process GDPPercent of GDP Personal consumption expenditures (C) Gross investment (I g ) Government current purchases of goods and services (G) Net exports (X n ) Gross domestic product at market prices* *Includes adjustments and statistical discrepancy. Source: Statistics Canada Gross Domestic Product, expenditure-based.

Gross investment (Ig) includes All final purchases of machinery, equipment, and tools by firms All construction Changes in inventories Intellectual property products (R&D) Net investment = Gross investment - depreciation LO2 © 2016 McGraw ‐ Hill Education Limited 7.2 The Expenditure Approach 7-12

© 2016 McGraw ‐ Hill Education Limited LO FIGURE 7-1 Gross Investment, Depreciation, Net Investment, and the Stock of Capital January 1 Net investment Stock of capital December 31 Depreciation Gross Investment Stock of capital

GDP as the sum of all the money spent in buying final goods and services. GDP = C + I g + G + X n For Canada in 2014 (in billions, from Table 7-3): GDP = $ $467 + $417 + $18 = $1975 LO2 © 2016 McGraw ‐ Hill Education Limited 7.2 The Expenditure Approach 7-14

7.1 GLOBAL PERSPECTIVE Comparative GDPs of Selected Nations, 2013 (trillions of dollars) © 2016 McGraw ‐ Hill Education Limited LO2 7-15

The Income Approach: adds up expenditures that are allocated as income to those producing the output Wages, salaries, and supplementary labour income Profits of corporations and government enterprises before taxes Interest and investment income Net income of farm and unincorporated businesses Indirect taxes less subsidies on products Depreciation: Capital consumption allowances LO3 © 2016 McGraw ‐ Hill Education Limited 7.3 The Income Approach 7-16

Net domestic income at factor cost All the income earned by Canadian-supplied factors of production as wages, interest, rent, and profit. Personal income (PI) The earned and unearned income available to resource suppliers and others before the payment of personal income taxes. Disposable income (DI) Personal income less personal taxes. LO3 © 2016 McGraw ‐ Hill Education Limited 7.3 The Income Approach 7-17

© 2016 McGraw ‐ Hill Education Limited LO TABLE 7-4 Calculating GDP in 2014: 1: The Income Approach (billions of dollars) GDPPercent of GDP Wages, salaries, and supplementary labour income$ Profits of corporations and government enterprises before taxes Interest and investment income Net income of farm and unincorporated businesses552.8 Taxes less subsidies on factors of production773.9 Indirect taxes less subsidies on products* Capital consumption allowances Statistical discrepancy10.3 Gross domestic product at market prices *Includes inventory valuation adjustment. Source: Statistics Canada Gross Domestic Product, expenditure-based.

Nominal GDP GDP measured in terms of the price level at the time of measurement (unadjusted for inflation) Real GDP Nominal GDP adjusted for inflation. LO4 © 2016 McGraw ‐ Hill Education Limited 7.4 Nominal GDP versus Real GDP 7-19

© 2016 McGraw ‐ Hill Education Limited LO TABLE 7-5 Calculating Real GDP (base year = year 1) Year (1) Units of output (Q) (2) Price of pizza per unit (P) (3) Price index (year 1 = 100) (4) Unadjusted, or nominal, GDP (Q) x (P) (5) Adjusted, or real, GDP 15$10100$ ??? 51128???

PRICE INDEX A measure of the price of a specified collection of goods and services, called a “market basket,” in a specific year as compared to the price of an identical (or highly similar) collection of goods and services in a reference year LO4 © 2016 McGraw ‐ Hill Education Limited 7.4 Nominal GDP versus Real GDP 7-21

PRICE INDEX Price index in specific year = price of market basket in specific year x 100 price of same market basket in base year For example, if in year 2, price of basket is $20 Price of same basket in base year is $10, then price index, year 2 = ($20/$10) x 100 = 200. LO4 © 2016 McGraw ‐ Hill Education Limited 7.4 Nominal GDP versus Real GDP 7-22

DIVIDING NOMINAL GDP BY THE PRICE INDEX For example, if in year 2, nominal GDP is $140 and price index is 200, then Real GDP = ($140/200) x 100 = $70. LO4 © 2016 McGraw ‐ Hill Education Limited 7.4 Nominal GDP versus Real GDP 7-23

© 2016 McGraw ‐ Hill Education Limited LO TABLE 7-5 Calculating Real GDP (base year = year 1) Year (1) Units of output (Q) (2) Price of pizza per unit (P) (3) Price index (year 1 = 100) (4) Unadjusted, or nominal, GDP (Q) x (P) (5) Adjusted, or real, GDP 15$10100$

An Alternative Method For example, if in year 2, nominal GDP is $140 and real GDP is $70, then GDP Deflator = ($140/$70) x 100 = 200. LO4 © 2016 McGraw ‐ Hill Education Limited 7.4 Nominal GDP versus Real GDP 7-25

© 2016 McGraw ‐ Hill Education Limited LO TABLE 7-6 Steps for Deriving Real GDP from Nominal GDP Method 1 1. Find nominal GDP for each year. 2. Compute a price index. 3. Divide each year’s nominal GDP by that year’s price index, then multiply by 100 to determine real GDP. Method 2 1. Break down nominal GDP into physical quantities of output and prices for each year. 2. Find real GDP for each year by determining the dollar amount that each year’s physical output would have sold for if base-year prices had prevailed.

Real-World Considerations and Data Chain-type annual-weights price index Links each year to the previous year through the use of both the prior-year prices and current-year prices. For example, the calculation of the chain-weighted index would use both 2011 and 2012 prices to calculate real GDP growth in Since the 2011 chain-weighted index was arrived at using both 2010 and 2011 prices, the year 2010 is linked back - as the links of a chain are - to 2009, 2008 and previous years as well. LO4 © 2016 McGraw ‐ Hill Education Limited 7.4 Nominal GDP versus Real GDP 7-27

© 2016 McGraw ‐ Hill Education Limited LO TABLE 7-7 Nominal GDP, Real GDP, and the GDP Deflator*, Selected Years (1) Year (2) Nominal GDP (3) Real GDP (4) GDP deflator 2002 = *Chain-type annual-weights price index. Source: Statistics Canada. Gross GDP.

Measurement Shortcomings NONMARKET ACTIVITIES THE UNDERGROUND ECONOMY IMPROVED QUALITY LO5 © 2016 McGraw ‐ Hill Education Limited 7.5 Shortcomings of GDP 7-29

7.2 GLOBAL PERSPECTIVE The Underground Economy as a Percentage of GDP, Selected Nations © 2016 McGraw ‐ Hill Education Limited LO5 7-30

Shortcomings of the Well-Being Measure GDP AND THE ENVIRONMENT LEISURE COMPOSITION AND DISTRIBUTAION OF OUTPUT NONMATERIAL SOURCES OF WELL-BEING LO5 © 2016 McGraw ‐ Hill Education Limited 7.5 Shortcomings of GDP 7-31

The LAST WORD Value Added and GDP © 2016 McGraw ‐ Hill Education Limited 7-32 The value added approach sums up the value of total output less the value of intermediate goods and services. The expenditure approach sums up the expenditure on final goods and services. The income approach tallies earnings of all factors of productions.

LO7.1 Explain how gross domestic product (GDP) is defined and measured. LO7.2 Describe how expenditures on goods and services can be summed to determine GDP. LO7.3 Explain how GDP can be determined by summing all of the incomes that were derived from producing the economy’s output of goods and services. LO7.4 Discuss the nature and function of a GDP price index, and describe the difference between nominal GDP and real GDP. LO7.5 List and explain the shortcomings of GDP as a measure of domestic output and well-being. Chapter Summary © 2016 McGraw ‐ Hill Education Limited 7-33