Measuring a Nation’s Income 10 Measuring a Nation’s Income

Measuring a Nation’s Income Microeconomics Microeconomics is the study of how individual households and firms make decisions and how they interact with one another in markets. Macroeconomics Macroeconomics is the study of the economy as a whole. Its goal is to explain the economic changes that affect many households, firms, and markets at once.

THE MEASUREMENT OF GROSS DOMESTIC PRODUCT GDP is the market value of all final goods and services produced within a country in a given period of time.

THE MEASUREMENT OF GROSS DOMESTIC PRODUCT “GDP is the Market Value . . .” Output is valued at market prices. “. . . Of All Final . . .” It records only the value of final goods, not intermediate goods (the value is counted only once). “. . . Goods and Services . . . “ It includes both tangible goods (food, clothing, cars) and intangible services (medical, legal, retail sales).

THE MEASUREMENT OF GROSS DOMESTIC PRODUCT “. . . Produced . . .” It includes goods and services currently produced, not transactions involving goods produced in the past. “ . . . Within a Country . . .” It measures the value of production within the geographic confines of a country.

THE MEASUREMENT OF GROSS DOMESTIC PRODUCT “. . . In a Given Period of Time.” It measures the value of production that takes place within a specific interval of time, usually a year or a quarter (three months).

GDP vs GNP Domestic Product – within a country National Product – owned by country’s citizens Example – Subaru plant – US GDP, Japan’s GNP GNP - the market value of all final goods and services produced by factors owned by a country’s citizens in a given period of time.

Figure 1 The Circular-Flow Diagram Firms sell Households buy MARKETS FOR GOODS AND SERVICES Revenue Spending Goods and services sold Goods and services bought FIRMS Produce and sell goods and services Hire and use factors of production Buy and consume goods and services Own and sell factors of production HOUSEHOLDS Households sell Firms buy MARKETS FOR FACTORS OF PRODUCTION Factors of production Labor, land, and capital Wages, rent, and profit Income = Flow of inputs and outputs = Flow of dollars

Calculating GDP Expenditure Approach Income Approach

THE COMPONENTS OF GDP GDP (Y) is the sum of the following: Consumption (C) Durable goods Non-durable Goods Investment (I) Non-residential Residential (Housing) Inventories Government Purchases (G) Net Exports (NX) = Exports - Imports Y = C + I + G + NX

Table 1 GDP and Its Components (Q2 2011) Total (B$) Percentage GDP (Y) 15018.1 100% Consumption (C) 10670.9 71% Investment (I) 1882.7 13% Government Purchases (G) 3027.0 20% Net Exports (NX) -562.5 -4%

GDP and Its Components Government Purchases 20% Net Exports Investment -4 % Investment 13% Consumption 71%

Income Approach National Income Depreciation 13% Compensation of employees 57% Proprietor’s income 7% Corporate profits 9% Interest and rental income 7% Depreciation 13% Indirect Taxes and Subsidies 7% Net Factor Payments to rest of the world

REAL VERSUS NOMINAL GDP Nominal GDP values the production of goods and services at current prices. Real GDP values the production of goods and services at constant prices.

Table 2 Real and Nominal GDP

The GDP Deflator The GDP deflator is a measure of the price level calculated as the ratio of nominal GDP to real GDP times 100. It measures the changes in the price level.

The GDP Deflator The GDP deflator is calculated as follows:

Converting Nominal GDP to Real GDP The GDP Deflator Converting Nominal GDP to Real GDP Nominal GDP is converted to real GDP as follows:

Nominal and Real GDP in the U.S., 1965–2011 Real GDP (base year 2005) billions The source I used: http://research.stlouisfed.org/fred2/ The original source: U.S. Department of Commerce: Bureau of Economic Analysis Since you have just finished covering real vs. nominal GDP, it might be worthwhile pointing out the following to your students: The graph shows that nominal GDP rises faster than real GDP. This should make sense, because growth in nominal GDP is driven by growth in output AND by inflation. Growth in real GDP is driven only by growth in output. The two lines cross in the year 2005 (the base year for the real GDP data in this graph). This should make sense because real GDP equals nominal GDP in the base year. (Better yet, ask your students whether there’s anything significant about the point where the two lines cross.) Before the base year, real GDP > nominal GDP. For example, in 1981, nominal GDP is about $3 trillion, while real GDP is about $6 trillion (in 2005 dollars). This should make sense because prices were so much higher in 2005 than in 1981, so using those high 2005 prices to value 1981 output would lead to a bigger result than valuing 1981 output using 1981 prices. Similarly, after 2005, nominal GDP is higher than real GDP because prices are higher in later years than they were in 2005. Nominal GDP 19

GDP AND ECONOMIC WELL-BEING GDP is the best single measure of the economic well-being of a society. GDP per person tells us the income and expenditure of the average person in the economy.

Limitations of GDP Measures only income – ignores quality of education, medical care, environment Excludes non-market production Excludes underground economy

Table 3 GDP, Life Expectancy, and Literacy

Summary Because every transaction has a buyer and a seller, the total expenditure in the economy must equal the total income in the economy. Gross Domestic Product (GDP) measures an economy’s total expenditure on newly produced goods and services and the total income earned from the production of these goods and services.

Summary GDP is the market value of all final goods and services produced within a country in a given period of time. GDP is calculated through four components of expenditure: consumption, investment, government purchases, and net exports.

Summary Nominal GDP uses current prices to value the economy’s production. Real GDP uses constant base-year prices to value the economy’s production of goods and services. The GDP deflator—calculated from the ratio of nominal to real GDP—measures the level of prices in the economy.