1. of 34 Copyright © 2008 Pearson Education Canada 1 Chapter 20 The Measurement of National Income

2. of 34 Copyright © 2008 Pearson Education Canada 2 In this chapter you will learn 1. how the concept of value added solves the problem of “double counting” when measuring national income. 3. the difference between real and nominal GDP and the meaning of the GDP deflator. 2. the income approach and the expenditure approach to measuring national income.

3. of 34 Copyright © 2008 Pearson Education Canada 3 In this chapter you will learn 4. about the many important omissions from official measures of GDP. 5. why real per capita GDP is a good measure of average “material” living standards but an incomplete measure of overall “well-being.”

4. of 34 Copyright © 2008 Pearson Education Canada 4 Production occurs in stages — most firms produce outputs that are other firms’ inputs - intermediate products - final products 20.1 NATIONAL OUTPUT AND VALUE ADDED Each firm’s contribution to total output is its value added = revenues - non-labour costs

5. of 34 Copyright © 2008 Pearson Education Canada 5 Total value added in the economy is called Gross Domestic Product (GDP). Summing value added avoids the problem of double counting when measuring total output. APPLYING ECONOMIC CONCEPTS 20-1 Value Added Through Stages of Production

6. of 34 Copyright © 2008 Pearson Education Canada 6 20.2 NATIONAL INCOME ACCOUNTING: THE BASICS total value added from domestic production total expenditures on domestic output total income generated by domestic production Three methods for measuring national income (output): Because of the circular flow of income, these three measures yield the same total — GDP.

7. of 34 Copyright © 2008 Pearson Education Canada 7 Domestic Households Domestic Firms Factor income: wages, rents, profits Revenue from sales of final G & S Start with a very simple economy mfc2007mfc2007mfc2007mfc2007mfc2007mfc2007

8. of 34 Copyright © 2008 Pearson Education Canada 8 Domestic Households Domestic Firms Factor income: wages, rents, profits Revenue from sales of final G & S How does household income actually get used up? Taxes Savings Imports Consumption mfc2007mfc2007mfc2007mfc2007mfc2007mfc2007

9. of 34 Copyright © 2008 Pearson Education Canada 9 Domestic Households Domestic Firms Factor income: wages, rents, profits Revenue from sales of final G & S Do any other agents buy final G & S from Cdn firms? Governments Investment Foreigners (Exports) Consumption mfc2007mfc2007mfc2007mfc2007mfc2007mfc2007

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11. of 34 Copyright © 2008 Pearson Education Canada 11 GDP from the Expenditure Side Actual consumption expenditure (C a ) includes expenditure on all final goods during the year. Consider adding up the expenditures needed to purchase the final output produced in any given year. There are four broad expenditure categories: - consumption - investment - government purchases - net exports

12. of 34 Copyright © 2008 Pearson Education Canada 12 Actual investment expenditure (I a ) is expenditure on the production of goods not for present consumption, including: Actual government purchases (G a ) are the purchases of currently produced goods and services by the government - excluding transfer payments. inventories plant and equipment residential housing

13. of 34 Copyright © 2008 Pearson Education Canada 13 Actual net exports (NX a ) is the difference between exports and imports: NX a = (X a - IM a ) Exports are purchases of Canadian-produced goods and services by foreigners. We subtract imports because they are not produced in Canada. Since total domestic output must equal total expenditure on domestic output, we have: GDP = C a + I a + G a + NX a

14. of 34 Copyright © 2008 Pearson Education Canada 14 Ca + Ia + Ga + (Xa - IMa) = GDP mfc2007mfc2007mfc2007mfc2007mfc2007mfc2007

15. of 34 Copyright © 2008 Pearson Education Canada 15 Does the accounting identity GDP = Ca + Ia + Ga + (Xa - IMa) imply that everything that firms produce each year is automatically sold to customers? NO! INVENTORIES! INVENTORIES! mfc2007mfc2007mfc2007mfc2007mfc2007mfc2007

16. of 34 Copyright © 2008 Pearson Education Canada 16 Category$billion% of GDP Consumption Government purchases Investment Net exports Statistical discrepancy Total GDP from the Expenditure Side: 2005 $761.955.7 254.418.6 297.621.7 54.34.0 0.70.0 $1368.9100.0 Source: Statistics Canada website: www.statcan.ca. Go to “Canadian Statistics” and click on “Economic Conditions” and then “National accounts.”

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18. of 34 Copyright © 2008 Pearson Education Canada 18 GDP from the Income Side GDP is also the sum of factor incomes and other claims on the value of output. Factor incomes include: - wages - rent, interest, and profits Non-factor payments include: - indirect taxes (net of subsidies) - depreciation of existing physical capital net domestic income

19. of 34 Copyright © 2008 Pearson Education Canada 19 GDP from the income side is therefore equal to: GDP = Net domestic income + Indirect taxes (less subsidies) + Depreciation EXTENSIONS IN THEORY 20-1 Arbitrary Decisions in National Income Accounting

20. of 34 Copyright © 2008 Pearson Education Canada 20 GDP from the Income Side: 2005 Billions of $ % of GDP 61.2 4.5% 1033.2 75.5% Factor Incomes Wages, salaries and supplementary income Interest and miscellaneous investment income Business profits (including net income of farmers and unincorporated businesses) Net Domestic Income at factor cost Non Factor Payments Depreciation Indirect taxes less subsidies Statistical discrepancy Total 1368.9 100.0 % 678.949.6% 293.1 21.4% 181.413.3% 154.711.3% -0.4 -0.0% Source: Statistics Canada website: www.statcan.ca. Go to “Canadian Statistics” and click on “Economic Conditions” and then “National accounts.”

21. of 34 Copyright © 2008 Pearson Education Canada 21 Ca + Ia + Ga + (Xa - IMa) Wages + Rent + Interest + Profits + Indirect taxes + Depreciation mfc2007mfc2007mfc2007mfc2007mfc2007mfc2007

22. of 34 Copyright © 2008 Pearson Education Canada 22 What goes into the firm’s revenue must come out as wages, rent, interest, profits, indirect taxes or depreciation. The total revenue of all Canadian firms (the total expenditure on Canadian final goods and services) must equal the total value of factor payments plus indirect taxes and depreciation. Therefore as accounting identities it must be true that: Ca + Ia + Ga + (Xa - IMa) = Wages + Rent + Interest + Profits + Indirect taxes + Depreciation mfc2007mfc2007mfc2007mfc2007mfc2007mfc2007

23. of 34 Copyright © 2008 Pearson Education Canada 23 A measure of national output closely related to GDP is Gross National Product (GNP). The difference between GDP and GNP is the difference between income produced and income received. GDP and GNP 20.3 NATIONAL INCOME ACCOUNTING: SOME EXTRA ISSUES Income produced in Canada versus income received by Canadians mfc2007mfc2007mfc2007mfc2007mfc2007mfc2007

24. of 34 Copyright © 2008 Pearson Education Canada 24 GDP is superior as a measure of domestic economic activity. GNP is superior as a measure of living standards of residents. A more “refined” measure is disposable personal income: It equals GNP minus: - any part not actually paid to households - personal income taxes - plus transfer payments received by households

25. of 34 Copyright © 2008 Pearson Education Canada 25 Real and Nominal GDP GDP that is valued at constant base-period prices is real national income. GDP Deflator = Nominal GDP Real GDP x 100 The GDP deflator is a very comprehensive index of prices because it includes the prices of all goods and services produced in the country.

26. of 34 Copyright © 2008 Pearson Education Canada 26 Do the CPI and the GDP Deflator Move Together? Broadly, the two price indexes move together, due to underlying inflationary forces. But because one tracks consumer prices and the other tracks the prices of goods produced in Canada, there will be some differences. APPLYING ECONOMIC CONCEPTS 20-2 Calculating Nominal and Real GDP

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28. of 34 Copyright © 2008 Pearson Education Canada 28 Output and Well Being The rise in real GDP over the past century has had two main causes: 1. The increase in the amount of land, labour, and capital used in production, and 2. An increase in the amount of output produced per unit of input. Per capita output is the amount of output per person — it is computed by dividing GDP by total population. It measures the average output (and income) per person (but tells us nothing about how that income is distributed across people). GDP per capita in 2005 was $42,548 mfc2007mfc2007mfc2007mfc2007mfc2007mfc2007

29. of 34 Copyright © 2008 Pearson Education Canada 29 Changes in overall living standards are better reflected by changes in productivity than by changes in GDP per capita. A better way of assessing average living standards is to consider measures of productivity. For example, GDP divided by the number of employed persons tells us the average output per employed person. This is one measure of labour productivity. GDP and related measures of national income must be interpreted with their limitations in mind. What are these limitations? GDP divided by the total number of hours worked measures output per hour of labour input, and provides a second measure of labour productivity. GDP per worker in 2005 was $79,868 GDP per hour worked in 2005 was $45.99 mfc2007mfc2007mfc2007mfc2007mfc2007mfc2007

30. of 34 Copyright © 2008 Pearson Education Canada 30 Omissions from GDP National income accountants cannot measure economic activity that takes place outside of regular, legal markets: illegal activities Leisure (consumption of non-work time) the underground economy (tax & regulation avoidance) home production (non-market activity) economic “bads” (pollution) mfc2007mfc2007mfc2007mfc2007mfc2007mfc2007

31. of 34 Copyright © 2008 Pearson Education Canada 31 “Well-being” is a broader concept than material living standards: - GDP is not a complete measure of economic well- being - but income is a very important part of well-being and GDP is a good measure of income. GDP and Living Standards Unless the unmeasured economic activity changes rapidly, changes in GDP will do a reasonable job of measuring changes in material living standards.

32. of 34 Copyright © 2008 Pearson Education Canada 32 How useful are the various measures of GDP? They are very useful for tracking the year-to-year changes in the level of economic activity (market activity). They are useful in tracking changes in economic activity, productivity, etc. over the longer term in a given country. But remember, GDP measures only what goes through markets – what is bought and sold. mfc2007mfc2007mfc2007mfc2007mfc2007mfc2007

33. of 34 Copyright © 2008 Pearson Education Canada 33 How useful are the various measures of GDP? Are they good measures of the level of human wellbeing (happiness) in a society? Only in a limited sense – material, market activity, with no consideration of things like pollution. Are they good measures of the change in the level of material wellbeing over time? Maybe, but care must be taken in making such an interpretation. (war, more labour force participation, degree of marketization, etc.) Do they provide the basis for comparing the level of material wellbeing across different countries? Only if the counties are of very similar in a deeper structural sense (Canada and the US or France maybe ok but Canada and Nigeria or Bolivia probably not. mfc2007mfc2007mfc2007mfc2007mfc2007mfc2007

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