Chapter 7: GDP: Measuring Total Production and Income © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 1 of 30 Gross Domestic Product Measures Total Production Gross domestic product (GDP) The market value of all final goods and services produced in a country during a period of time, typically one year. GDP Is Measured Using Market Values, Not Quantities The worth of a thing is the price it will bring. Final good or service A good or service purchased by a final user: Household consumption Business investment, including all residential construction Government purchases Exports to foreigners vs Intermediate good or service A good or service that is an input into another good or service, such as a tire on a truck. GDP Includes Only Current Production

Chapter 7: GDP: Measuring Total Production and Income © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 2 of 30 PRODUCTION AND PRICE STATISTICS FOR 2007 (1) PRODUCT (2) QUANTITY (3) PRICE PER UNIT Eye examinations 100$50.00 Pizzas Textbooks Paper (for textbooks) 2, PRODUCT (1) QUANTITY (2) PRICE PER UNIT (3) VALUE Eye examinations100$50$5,000 Pizzas Textbooks201002,000 Total GDP = $7,800

Chapter 7: GDP: Measuring Total Production and Income © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 3 of 30 Production, Income, and the Circular Flow Diagram

Chapter 7: GDP: Measuring Total Production and Income © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 4 of 30 Components of GDP Consumption Spending by households on goods and services, not including spending on new houses. Personal Consumption Expenditures, or “Consumption” Investment Spending by firms on new factories, office buildings, machinery, and additions to inventories, and spending by households on new houses. Gross Private Domestic Investment, or “Investment” Government Consumption and Gross Investment, or “Government Purchases” Government purchases Spending by federal, state, and local governments on goods and services. Net Exports of Goods and Services, or “Net Exports”

Chapter 7: GDP: Measuring Total Production and Income © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 5 of 30 Transfer payments are not included in GDP : Payments by the government to individuals for which the government does not receive a new good or service in return. Unemployment benefits paid to someone not working. Social security benefits paid to someone who is retired. Interest income paid to a government bondholder Since the government doesn’t produce anything for the market, the interest payment can’t be for any productive service. “Underground economy” activities are not included in GDP Production “off-the-books” Illegal activities Household production is not included in GDP

Chapter 7: GDP: Measuring Total Production and Income © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 6 of 30 Does GDP Measure What We Want It to Measure? Shortcomings of GDP as a Measure of Well-Being The Value of Leisure Is Not Included in GDP GDP Is Not Adjusted for Pollution or Other Negative Effects of Production GDP Is Not Adjusted for Changes in Crime and Other Social Problems GDP Measures the Size of the Pie but Not How the Pie Is Divided Up

Chapter 7: GDP: Measuring Total Production and Income © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 7 of 30 An Equation for GDP and Some Actual Values Components of GDP in 2006

Chapter 7: GDP: Measuring Total Production and Income © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 8 of 30 Consumer spending on services is greater than the sum of spending on durable and nondurable goods. Business fixed investment is the largest component of investment. Gross private domestic investment includes New plant and equipment New residential construction Net additions to business inventories Purchases made by state and local governments are greater than purchases made by the federal government. Imports are greater than exports  net exports are negative.

Chapter 7: GDP: Measuring Total Production and Income © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 9 of 30 Measuring GDP by the Value-Added Method Value added The market value a firm adds to a product. FIRMVALUE OF PRODUCTVALUE ADDED Cotton FarmerValue of raw cotton = $1 Value added by cotton farmer= 1 Textile Mill Value of raw cotton woven into cotton fabric = $3 Value added by cotton textile mill = ($3 – $1)= 2 Shirt Company Value of cotton fabric made into a shirt = $15 Value added by shirt manufacturer = ($15 –$3)= 12 L.L. Bean Value of shirt for sale on L.L. Bean’s Web site = $35 Value added by L.L. Bean = ($35 – $15)= 20 Total Value Added= $35

Chapter 7: GDP: Measuring Total Production and Income © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 10 of 30 PRODUCT 2009 QUANTITY 2000 PRICEVALUE Eye examinations100$40$4,000 Pizzas Textbooks20901, PRODUCTQUANTITYPRICEQUANTITYPRICE Eye examinations80$40100$50 Pizzas Textbooks Real GDP versus Nominal GDP Real GDP The value of this year’s final goods and services evaluated at base-year prices. Nominal GDP The value of this year’s final goods and services evaluated at this year’s prices. vs

Chapter 7: GDP: Measuring Total Production and Income © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 11 of 30 Comparing Real GDP and Nominal GDP Nominal GDP and Real GDP, 1990–2006

Chapter 7: GDP: Measuring Total Production and Income © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 12 of 30 The GDP Deflator GDP deflator A measure of the price level, calculated by dividing nominal GDP by real GDP and multiplying by 100. $ GDP = Price Level x Real Output $Y = P x Y P = $Y/Y

Chapter 7: GDP: Measuring Total Production and Income © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 13 of 30 Real GDP versus Nominal GDP FORMULAAPPLIED TO 2005APPLIED TO 2006 GDP Deflator NOMINAL GDP$12,456 billion$13,247 billion REAL GDP$11,049 billion$11,415 billion The GDP Deflator

Chapter 7: GDP: Measuring Total Production and Income © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 14 of 30 Other Measures of Total Production and Total Income Gross National Product (GNP) =GDP + Net Foreign Earnings of US Residents Compensation of employees earned abroad Interest and profits earned abroad Net National Product (NNP) = GNP - Capital Consumption Allowance (depreciation) National Income (NI) = NNP - Indirect Business Taxes Personal Income (PI) = NI + Net Transfer Payments = Income earned from production of national product Disposable Income (DI) = PI - Income Taxes Disposable Income is split between consumption and saving

Chapter 7: GDP: Measuring Total Production and Income © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 15 of 30 Other Measures of Total Production and Total Income FIGURE 7-4 Measures of Total Production and Total Income, 2006

Chapter 7: GDP: Measuring Total Production and Income © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 16 of 30 Other Measures of Total Production and Total Income The Division of Income FIGURE 7-5 The Division of Income

Chapter 7: GDP: Measuring Total Production and Income © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 17 of 30 An Inside LOOK Trucking Industry Depends on the Goods—Not Services—Component of GDP Economic Slowdown Slams Breaks on Trucking Sector As goods decline as a percentage of GDP, so does the demand for ground-freight transportation services. (The goods and services shares of GDP do not sum to 100 percent because GDP is composed of goods, services, and structures.)

Chapter 7: GDP: Measuring Total Production and Income © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 18 of 30 Business cycle Consumption Economic growth Expansion Final good or service GDP deflator Government purchases Gross domestic product (GDP) Inflation rate Intermediate good or service Investment K e y T e r m s Macroeconomics Microeconomics Net exports Nominal GDP Price level Real GDP Recession Transfer payments Underground economy Value added