# 14 GDP and the Standard of Living

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14 GDP and the Standard of Living
CHAPTER Notes and teaching tips: 4, 15, 18, 23, 51, 54, and 57. To view a full-screen figure during a class, click the red “expand” button. To return to the previous slide, click the red “shrink” button. To advance to the next slide, click anywhere on the full screen figure.

C H A P T E R C H E C K L I S T When you have completed your study of this chapter, you will be able to 1 Define GDP and explain why the value of production, income, and expenditure are the same for an economy. 2 Describe how economic statisticians measure GDP an distinguish between nominal GDP and real GDP. 3 Describe and explain the limitations of real GDP as a measure of the standard of living.

14.1 GDP, INCOME, AND EXPENDITURE
GDP Defined Gross domestic product or GDP The market value of all the final goods and services produced within a country in a given time period. Value Produced Use market prices to value production. Focus your students on the definition of GDP--the market value of all the final goods and services produced within a country in a given time period. Ask your students to go through the definition and pull out the essential parts. You will get this list: market value, final goods and services, produced, within a country, and time period. Explain that the words chosen in this definition were selected carefully. First, if the phrase “market value” had been left out, there would be room for lots of problems. Notice that when the government reports this figure, it doesn’t announce how many trains, planes, and automobiles the country has produced but rather it announces a monetary value. Using monetary values affords us the opportunity to be able to get around the problem of aggregation when the items in question are markedly different. We solve it by allowing the marketplace to determine the weights. The second item on the list is “final goods and services.” The explanation here is straightforward: We are distinguishing between final products and intermediate products. Intermediate goods are goods that are bought by one firm to be used in the production of another good that will be ultimately consumed. If we include these intermediate goods, then we would double count the nation’s output. Now we come to the word “produced.” This word is to make clear that sales are not important. If we only counted sales, then the GDP figures would understate production because not all output is sold. Some of it becomes inventory. Next is the phrase “within a country.” This phrase is to make clear that we don’t count output that wasn’t produced on a nation’s soil regardless of who was responsible for producing it. Lastly, is the phrase “time period.” Here we want to make unambiguous that we are only talking about production that occurred in a certain period. This phrase leaves no doubt that production of a good or service produced in a previous time period (even if perhaps sold in the present time period) does not count in this period’s GDP.

14.1 GDP, INCOME, AND EXPENDITURE
What Produced Final good or service is a good or service that is produced for its final user and not as a component of another good or service. Intermediate good or service is a good or service that is produced by one firm, bought by another firm, and used as a component of a final good or service. GDP includes only those items that are traded in markets.

14.1 GDP, INCOME, AND EXPENDITURE
Where Produced Within a country When Produced During a given time period.

14.1 GDP, INCOME, AND EXPENDITURE
Circular Flows in the U.S. Economy Consumption expenditure is the expenditure by households on consumption goods and services. Investment is the purchase of new capital goods (tools, instruments, machines, buildings, and other constructions) and additions to inventories.

14.1 GDP, INCOME, AND EXPENDITURE
Government expenditure on goods and services is the expenditure by all levels of government on goods and services. Net exports of goods and services is the value of exports of goods and services minus the value of imports of goods and services.

14.1 GDP, INCOME, AND EXPENDITURE
Exports of goods and services are the items that firms in in the United States produce and sell to the rest of the world. Imports of goods and services are the items that households, firms, and governments in the United States buy from the rest of the world.

14.1 GDP, INCOME, AND EXPENDITURE
Total expenditure is the total amount received by producers of final goods and services. Consumption expenditure: C Investment: I Government expenditure on goods and services: G Net exports: NX Total expenditure = C + I + G + NX

14.1 GDP, INCOME, AND EXPENDITURE
Labor earns wages. Capital earns interest. Land earns rent. Entrepreneurship earns profits. Households receive these incomes.

14.1 GDP, INCOME, AND EXPENDITURE
Expenditure Equals Income Because firms pay out everything they receive as incomes to the factors of production, total expenditure equals total income. That is: Y = C + I + G + NX The value of production equals income equals expenditure.

14.1 GDP, INCOME, AND EXPENDITURE
Figure 14.1 shows the circular flow of income and expenditure. The table shows the U.S. data for 2007.

The Expenditure Approach
14.2 MEASURING U.S. GDP The Expenditure Approach Measures GDP by using data on consumption expenditure, investment, government expenditure on goods and services, and net exports. Table 14.1 on the next slide shows the calculation for 2007. You might like to tell your students that measuring real GDP is actually very cheap. The BEA (in the Department of Commerce) employs fewer than 500 economists, accountants, statisticians, and IT specialists at an annual cost of less that \$70 million. It costs each American less than 0.25¢ (a quarter of a cent) to measure the value of the nation’s production. For some further perspective, the National Oceanic and Atmospheric Administration (also in the Department of Commerce), whose mission is to “describe and predict changes in the Earth’s environment, and conserve and manage wisely the nation’s coastal and marine resources so as to ensure sustainable economic opportunities,” employs more than 11,000 scientists and support personnel at an annual cost of \$3.2 billion!

14.2 MEASURING U.S. GDP Expenditures Not in GDP Used Goods
Expenditure on used goods is not part of GDP because these goods were part of GDP in the period in which they were produced and during which time they were new goods. Financial Assets When households buy financial assets such as bonds and stocks, they are making loans, not buying goods and services.

The Income Approach 14.2 MEASURING U.S. GDP
Measures GDP by summing the incomes that firms pay households for the factors of production they hire. The U.S. National Income and Product Account divide incomes into two big categories: Wages Interest, rent, and profits Most of the income data used by the BEA comes from the IRS. Expenditure data comes from a variety of sources. In recent years, the first estimates of GDP, which are based on companies reported profits, have been revised downward when data on company profits as reported to the IRS became available. Enron-style accounting has contaminated the initial estimates of GDP but not the final estimates. You can make a nice point with one example of creative accounting. For some years, in its reports to shareholders AOL recorded its advertising expenditure as investment and amortized it over a number of years. First, you can explain that the correct treatment of this item is as an expenditure on intermediate goods and services by AOL and as a charge against AOL profit. The expenditure on AOL services is the value of AOL’s production. And AOL’s expenditure on advertising is part of the value of the production of the advertising agencies used by AOL. You can go on to explain that AOL accounting practice would misleadingly swell GDP by causing some double counting. On the expenditure approach, AOL’s advertising expenditure shows up as investment in the national accounts. On the income approach, because the expenditure is not a cost, it swells profit, so AOL’s corporate profit increases by the same amount as its “investment.” If AOL filed its income tax return in this same way, the national income accounts wouldn’t get corrected. But when AOL files its tax returns, it calls its advertising a cost and lowers its profits by that amount, the BEA picks up these numbers from the IRS and the national accounts get adjusted appropriately.

14.2 MEASURING U.S. GDP Wages Wages, called compensation of employees in the national accounts, is the payment for labor services. It includes net wages and salaries plus fringe benefits paid by employers such health care insurance, social security contributions, and pension fund contributions.

14.2 MEASURING U.S. GDP Interest, Rent, and Profit
Interest, rent, and profit, called net operating surplus in the national account, is the sum of the incomes earned by capital, land, and entrepreneurship. Interest is the income households receive on loans they make minus the interest they pay on their borrowing. Rent includes payments for the use of land and other rented inputs. Profit includes the profits of corporations and small businesses.

14.2 MEASURING U.S. GDP

14.2 MEASURING U.S. GDP Net domestic product at factor cost is the sum of wages, interest, rent, and profit. Net domestic product at factor cost is not GDP. We need to make two adjustments to arrive at GDP: One from factor cost to market prices One from net product to gross product At an intuitive level, the equality between income and expenditure is not a difficult concept to get across. It makes sense to students that whatever someone spends must ultimately end up as income to someone else. The problem comes when we put this into practice. The reason has to do with the fact that there are two non-income charges against GDP (depreciation and indirect taxes less subsidies). If they are ignored, then when using the income approach the figure obtained will be less than the figure obtained using the expenditure approach. As always we are faced with a tradeoff. You can proceed immediately to introduce depreciation and indirect taxes less subsidies and do a comprehensive job. It will be accurate, but your simple and powerful point that income equals expenditure will be lost. The second alternative is to wait and let the intuitive equality sink in. This procedure has the benefit of preserving the expenditure/income equality without prematurely exhausting your students. The downside is that you delay the inevitable. You will eventually have to explain the discrepancy sometime.

14.2 MEASURING U.S. GDP From Factor Cost to Market Price
The expenditure approach values goods at market prices; the income approach values them at factor cost. Indirect taxes (such as sales taxes) make market prices exceed factor cost. Subsidies (payments by government to firms) make factor cost exceed market prices. To convert the value at factor cost to the value at market prices, we must: Add indirect taxes and subtract subsidies

14.2 MEASURING U.S. GDP

14.2 MEASURING U.S. GDP From Gross to Net The expenditure approach measures gross product; the income approach measures net product. Gross profit is a firm’s profit before subtracting the depreciation of capital. Net profit is a firm’s profit after subtracting the depreciation of capital. Depreciation is the decrease in the value of capital that results from its use and from obsolescence.

14.2 MEASURING U.S. GDP Income includes net profit, so the income approach gives a net measure. Expenditure includes investment. Because some new capital is purchased to replace depreciated capital, the expenditure approach gives a gross measure. To get gross domestic product from the income approach, we must add depreciation to total income. After making these two adjustments the income approach almost gives the same estimate of GDP as the expenditure approach.

14.2 MEASURING U.S. GDP

14.2 MEASURING U.S. GDP Statistical Discrepancy The income approach and the expenditure approach do not deliver exactly the same estimate of GDP—there is a statistical discrepancy. Statistical discrepancy is the discrepancy between the expenditure approach and income approach estimates of GDP, calculated as the GDP expenditure total minus the GDP income total.

14.2 MEASURING U.S. GDP

GDP and Related Measures of Production and Income
14.2 MEASURING U.S. GDP GDP and Related Measures of Production and Income Gross national product or GNP is the market value of all the final goods and services produced anywhere in the world in a given time period by the factors of production supplied by residents of the country. U.S. GNP = U.S. GDP + Net factor income from abroad

Disposable Personal Income
14.2 MEASURING U.S. GDP Disposable Personal Income Consumption expenditure is one of the largest components of aggregate expenditure and one of the main influences on it is disposable personal income. Disposable personal income is the income received by households minus personal income taxes paid.

14.2 MEASURING U.S. GDP Figure 14.2 shows the relationship between GDP, GNP, and disposable personal income.

Real GDP and Nominal GDP
14.2 MEASURING U.S. GDP Real GDP and Nominal GDP Real GDP is the value of the final goods and services produced in a given year expressed in the prices of the base year. Nominal GDP is the value of the final goods and services produced in a given year expressed in the prices of that same year. The method of calculating real GDP changed in recent years. Here we describe the essence of the calculation. The appendix gives the technical details.

Calculating Real GDP 14.2 MEASURING U.S. GDP
The goal of calculating real GDP is to measure the extent to which total production has increased Real GDP removes the influence of price changes from the nominal GDP numbers. To focus on the principles and keep the numbers easy to work with, we’ll calculate real GDP for an economy that produces only one consumption good, one capital good, and one government service.

14.2 MEASURING U.S. GDP Table 14.3 shows the calculation with 2000 (base year) and 2008. To find the total expenditure in 2000 multiply the quantity of each item produced in 2000 by its price in 2000. Then sum the expenditures to find nominal GDP in 2000. The next slide shows the data.

Nominal GDP in 2000 is \$100 million.
Because 2000 is the base year, real GDP in 2000 is also \$100 million.

14.2 MEASURING U.S. GDP In part (b) of Table 14.3, we calculate nominal GDP in 2008. Again, we calculate nominal GDP by multiplying the quantity of each item produced by its price and then sum the expenditures to find nominal GDP in 2008.

Nominal GDP in 2000 is \$100 million.

14.2 MEASURING U.S. GDP Nominal GDP in 2000 is \$100 million and in 2008 it is \$300 million. Nominal GDP in 2008 is three times its value in 2000. But by how much has the quantity of final goods and services produced increased?

14.2 MEASURING U.S. GDP The increase in real GDP will tell by how much the quantity of good and services has increased. Real GDP in 2008 is what the total expenditure would have been in 2008 if prices had remained the same as they were in 2000. To calculate real GDP in 2008 multiply the quantities produced in 2008 by the price in 2000 and the sum these expenditures to find real GDP in 2008. Part (c) of Table 14.3 shows the details.

Real GDP in 2000 is \$100 million. Real GDP in 2008 is \$160 million—only 1.6 times real GDP in 2000.

14.3 THE USE AND LIMITATIONS OF REAL GDP
We use estimates of real GDP for two main purposes: To compare the standard of living over time To compare the standard of living among countries The Standard of Living Over Time To compare living standards we calculate real GDP per person—real GDP divided by the population. Table 14.4 shows two calculations

14.3 THE USE AND LIMITATIONS OF REAL GDP
In 1967, real GDP in the United States was \$3,485 billion and the population of the United States was million. Real GDP per person = \$3,485 billion ÷ million Real GDP per person = \$17,536 In most years, real GDP per person increases, but sometimes it doesn’t change.

14.3 THE USE AND LIMITATIONS OF REAL GDP
Long-Term Trend Figure 14.3 shows the long-term trend in U.S. real GDP per person. Real GDP per person doubled in the 36 years from 1967 to 2002.

14.3 THE USE AND LIMITATIONS OF REAL GDP
Short-Term Fluctuations Fluctuations in the pace of expansion of real GDP is called the business cycle. The business cycle is a periodic irregular up-and down movement of total production and other measure of economic activity. The four stages of a business cycle are expansion, peak, recession, and trough.

14.3 THE USE AND LIMITATIONS OF REAL GDP
The shaded periods show the recessions—periods of falling production that lasts for at least six months.

14.3 THE USE AND LIMITATIONS OF REAL GDP

14.3 THE USE AND LIMITATIONS OF REAL GDP
Household Production Real GDP omits household production, it underestimates the value of the production of many people, most of them women. Underground Production Hidden from government to avoid taxes and regulations or illegal. Because underground economic activity is unreported, it is omitted from GDP.

14.3 THE USE AND LIMITATIONS OF REAL GDP
Leisure Time Our working time is valued as part of GDP, but our leisure time is not. Environment Quality Pollution is not subtracted from GDP. We do not count the deteriorating atmosphere as a negative part of GDP. If our standard of living is adversely affected by pollution, our GDP measure does not show this fact.

14.3 THE USE AND LIMITATIONS OF REAL GDP
Other Influences on the Standard of Living Health and Life Expectancy Good health and a long life do not show up directly in real GDP. Political Freedom and Social Justice A country might have a very large real GDP per person but have limited political freedom and social justice. A lower standard of living than one that had the same amount of real GDP but in which everyone enjoyed political freedom. You can generate a productive classroom discussion on the topic of this slide.

APPENDIX: MEASURING REAL GDP
The Problem with Base-Year Prices We’ll calculate real GDP in 2008 using 2000 as the base year and found that real GDP in 2008 was 1.6 percent greater than in 2000—an increase of 60%. But if we had used 2008 prices rather than 2000, real GDP would have increased from \$150 million (2008 dollars) in 2000 to \$300 million in 2008—an increase of 100%. So did real GDP increase by 60% or 100%?

APPENDIX: MEASURING REAL GDP
The BEA method uses the prices of both years. The three steps in the method are Value production in the prices of adjacent years. Find the average of the two percentage changes. Link (chain) back to the base year.

APPENDIX: MEASURING REAL GDP
Value Production in the Prices of Adjacent Years Let’s take as the two adjacent years 2008 and its preceding year 2007. Value the quantities produced in 2007 and 2008 at both the prices of 2007 and the prices of 2008. Table A14.1 shows the calculations. We’ve included this material on the chained-dollar method because it is the method actually used today. But it might be too technical for your students. Not much is lost by sticking with the traditional method.

APPENDIX: MEASURING REAL GDP
The table gives Value of production in 2007 at 2007 prices is \$145. Value of production in 2008 at 2007 prices is \$160. Value of production in 2007 at 2008 prices is \$158. Value of production in 2008 at 2008 prices is \$172. The next step is the find the percentage increases using 2007 prices and 2008 prices and then average these two percentages.

APPENDIX: MEASURING REAL GDP
Find the Average of Two Percentage Changes Table A14.1 sets out the calculation: Value of production in 2007 at 2007 prices is \$145. Value of production in 2008 at 2007 prices is \$160. Using 2007 prices, production increased by 10.3%. Value of production in 2007 at 2008 prices is \$158. Value of production in 2008 at 2008 prices is \$172. Using 2008 prices, production increased by 8.9%. The average percentage increase in production is 9.6%.

APPENDIX: MEASURING REAL GDP

APPENDIX: MEASURING REAL GDP
Link (Chain) Back to the Base Year Starting in the base year, apply the calculated average percentage increase each year to obtain the chained-dollar real GDP. Figure A14.1 illustrates the calculation with assumed data.