Chapter 6 Measuring Domestic Output And National Income ECON 201 Chapter 6 Measuring Domestic Output And National Income

Learning Objectives How GDP is Defined and Measured Relationships Between GDP, Net Domestic Product, National Income, Personal Income, and Disposable Income The Nature and Function of a GDP Price Index The Difference Between Nominal GDP and Real GDP Some Limitations of the GDP Measure

Gross Domestic Product (GDP) The total market value of all final goods and services produced in a given year. This includes all goods and services provided by citizens or foreigners working in the U.S. It is a monetary measure and one way for us to determine how our economy is doing compared to previous years. The more goods and services we produce the ‘healthier’ we are.

Avoiding multiple counting If GDP is going to be effective, we must avoid counting goods and services multiple times. Therefore, only final goods are counted, and not intermediate goods. Example in book: wool suits, pg. 107. Instead of adding up the sales value of each transaction in the making of the suit, we only count the final cost of the suit, $350. Another term for this: value added

Other exclusions Non-production transactions: Financial & second-hand sales Financial: Public transfer payments: Social security, veteran’s benefits, welfare Private transfer payments: Christmas gifts from grandma, allowance Stock market transactions: buying and selling of stocks Second-hand sales: yard sales, person-to-person sales of stuff

2 ways to compute GDP Expenditures Approach – the sum of all money spent to buy GDP Income Approach – the sum of all the income created from producing GDP Technically, both approaches should give you the same answer.

+ + + + + + + G D P = = Expenditure Approach Income Approach Page 108 Consumption by Households Wages + + Rents Investment by Businesses + G D P + = = Interest + Government Purchases + Profits + Expenditures By Foreigners Statistical Adjustments Page 108

Household/personal consumption (C) This includes everything…. Durable goods (cars, fridge), non-durable goods (food, clothes, gas), and services (haircuts, doctor bills)

Investment by businesses (Ig) This is also called Gross private domestic investment. Includes: Purchases of machinery, tools, etc Construction costs (including residential) Changes in inventories Noninvestment transactions

Constructions costs (incl. residential) Why include owner-occupied residential construction in the ‘investment by businesses’ category???? Because the house/apartment could be rented or leased

Changes in inventories It is hard to sell everything that was produced in a year by the end of the year. You almost always have some left over that was produced in this year but didn’t sell. Before we can compute how this affects GDP, we need to figure out how the level of inventories at the end of last year compare to the inventories at the end of this year.

Changes in inventories, cont. If there are more inventories now than last year, then inventories increased. So when this happens, what is left over is considered ‘investment’ for that year and must be added to the ‘investment’ figure If there are less inventories, then that means we sold inventories this year that were counted in last year’s GDP, so we subtract them from the ‘investment’ figure

Noninvestment transactions Investment DOES NOT include the transfer of paper assets (stocks, etc) Investment DOES NOT include the sale of existing tangible assets (houses, boats, etc.)

Gross vs Net Investment Gross investment means we are referring to ‘all’ investment during the year When an asset gets ‘worn out’ during the year, that is called ‘depreciation’. To find Net investment, you subtract depreciation from Gross investment If more stuff ‘depreciates’ during the year than you produce new stuff, that is ‘disinvesting’.

Household/personal consumption (C) Investment by businesses (Ig) So far… Household/personal consumption (C) Investment by businesses (Ig)

Government purchases (G) The goods and services that it consumes in providing public services Expenditures for social capital like schools, highways It DOES NOT include transfer payments, which only transfer assets from one to another and don’t generate any new assets.

Net Exports (Xn) GDP includes the spending on goods and services produced in this country, and that doesn’t matter if American’s buy them or foreigners buy them. So products that are exported get counted Money that we spend on products that are imported are included in the GDP of other countries

Net Exports (Xn) , cont. To figure it, we simply take exports – imports, which gives us Net Exports.

Expenditures Approach summary: GDP = C + Ig + G + Xn

GDP in Trillions of Dollars, 2005 0 1 2 3 4 5 6 7 8 9 10 12 United States Japan Germany China United Kingdom France Italy Spain Canada Brazil Korea, Rep. India Mexico Russian Fed. Australia $12.4 $4.5 $2.8 $2.2 $2.2 $2.1 $1.7 $1.1 $1.1 $.79 $.79 $.78 $.77 $.76 $.70

+ + + + + + + G D P = = Expenditure Approach Income Approach Page 108 Consumption by Households Wages + + Rents Investment by Businesses + G D P + = = Interest + Government Purchases + Profits + Expenditures By Foreigners Statistical Adjustments Page 108

#2: Income Approach To compute the National Income, we add up: Wages of Employees Rents Interest Profits (Proprietor’s & corporate)

Adjustments Taxes on production and imports Why would we add taxes that are paid on products? Example: you buy a $1 item, and pay $.08 in taxes. In the Expenditures approach, that tax was included in the cost of the item, so we have to add that same amount of tax to the Income approach to balance everything out.

Adjustments….cont. GDP is a measure of total ‘domestic’ output produced in the U.S. regardless of the nationality of those who provide the resources Some Americans earn income by supplying resources in other countries, but that activity is not ‘domestic’ activity. However, the money they make is included in their income. Some foreigners earn income by supplying resources here.

Net Foreign Factor Income Adjustments….cont. So if we take the difference between what Americans earn abroad and subtract what foreigners make here, we call that…. Net Foreign Factor Income We add that figure to the total of all the incomes that we just added.

Adjustments….cont. Consumption of Fixed Capital – also known as ‘depreciation’. This amount of capital that is ‘used up’ during the year must be added to the income figures because depreciation was added to the cost of Expenditures in the other approach. We must balance the equation.

Adjustments….cont. Statistical Discrepancy – oops, we didn’t exactly come out the same in both approaches, so let’s just call this a ‘statistical discrepancy! The government can do this in figuring GDP, but you better not try this on your taxes!

Other national accounts Net Domestic Product (NDP) – simply take GDP and remove depreciation. National Income – take the NDP, add the Net Foreign Factor Income, and subtract the Statistical discrepancy

Other national accounts…cont. Personal Income – includes all income received, whether earned or unearned Simply remove income items that don’t apply to households (SS contributions, corp. income taxes) Disposable Income – personal income minus personal taxes.

Nominal GDP vs Real GDP The market value of money changes every year because of inflation or deflation. So how can realistically compare dollar amounts from year to year? We deflate GDP when prices are rising and inflate GDP when prices are falling Whenever we adjust it, we call it Real GDP

How we adjust it We use a ‘price index’. Formula: = It is a measure of the price of a specific collection of goods & services called a ‘market basket’ in a given year as compared to that same thing in a previous year. Formula: Price of item in specific year -------------------------------------- Price of item in base year Price index in a given year = X 100

Price index computation Look at page 116 in the textbook Remember: in the real world it is much harder to figure GDP and reliable price indexes

Shortcomings of GDP Nonmarket activities – plumber fixing his own house, activity of homemakers Leisure – we work shorter weeks than 100 yrs ago and we have vacations, holidays, etc. We are happier and GDP doesn’t reflect that Improved product quality – the same money today can buy a much better product

Shortcomings of GDP…cont. The underground economy – not reporting tips, trading labor with your neighbor, etc 0 5 10 15 20 25 30 Greece Italy Spain Portugal Belgium Sweden Germany France Holland United Kingdom Japan United States Switzerland Percentage of GDP

Shortcomings of GDP…cont. Environmental damage – the cost to cleanup pollution and waste is not considered Composition of output - To GDP, there’s no difference between books and hand grenades Non-economic sources of well-being – a household’s income doesn’t measure happiness, and GDP won’t either!

Suggestions…. Make sure you know the GDP formulas for the 2 approaches (Expenditures & Income) Make sure you know how to compute a value-added figure (pg. 107) Make sure you know how to compute a price index (pg 117) Make sure you know the difference between Nominal and Real GDP

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