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Econ789 chapter025
- 1. Chapter 25 Measuring Domestic Output and National Income Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
- 2. 25-2 Assessing the Economy’s Performance • National Income Accounting measures economy’s overall performance • Bureau of Economic Analysis compiles National Income and Product Accounts • Assess health of economy • Track long run course • Formulate policy LO1
- 3. 25-3 Gross Domestic Product • Gross Domestic Product (GDP): Total market value of all final goods and services produced during a given time period within the boundaries of a nation. • Measure of total output of national economy • Market value: Monetary measure ($) - Use market prices to value production • GDP includes only those items that are traded in markets. LO1
- 4. 25-4 Gross Domestic Product • What to produce: 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. • Ignore intermediate goods • 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. • Avoid multiple counting LO1
- 5. 25-5 Gross Domestic Product • Where Produced • Within a nation • It does not matter who produce – Americans or foreigners • Those produced by Americans or American firms oversea are not included • When Produced • During a given time period • Usually annually, but also quarterly.LO
- 6. 25-6 GDP as Value Added • GDP is also measure of total value added by all levels of production process. • A final price of product reflects value added to the product. LO
- 7. 25-7 GDP as Value Added • The value of the final good, bread, (the red bar) is equal to the sum of the values added at all stages in its production (the blue bars). LO Sum of added values = 20¢ + 50¢ + 80¢ = $1.50 = Price of final good
- 8. 25-8 Expenditure Not Counted in GDP • Exclude financial transactions • When households buy financial assets such as bonds and stocks, they are making loans, not buying goods and services. • Exclude second hand (used good) sales • Used goods were counted in GDP in the period in which they were produced and during which time they were new goods. LO1
- 9. 25-9 Two Approaches to GDP • Expenditure approach • Summing up spending on the final goods • households, firms, governments, and foreigners • Income approach • Summing up incomes received by providers of factors of production • Wages, rental income, interest income, profit LO1
- 10. 25-10 Expenditure Approach • Consumption 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. • Government purchase on goods and services is the expenditure by all levels of government on goods and services. • Exclude transfer paymentsLO
- 11. 25-11 Expenditure Approach • Net exports of goods and services is the value of exports of goods and services minus the value of imports of goods and services. • Exports of goods and services are the items that firms 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. LO
- 12. 25-12 Expenditure Approach • Total expenditure (TE) is the total amount received by producers of final goods and services. TE = C + I + G + NX •C: Consumption by households •I: Investment by businesses •G: Government purchases •NX: Net exports by foreigners LO
- 13. 25-13 Circular Flow Revisited LO4 C $11,150 I $2,475 G $3,167 NX -$547 GDP $16,245 GDP in 2012
- 14. 25-14 Income, Production, Expenditure • Total income (Y): Sum of incomes earned by labor, capital owners, land resource owners, and entrepreneurship. • Total Value of production (GDP) • Total Expenditure (TE) TE = GDP = Y LO
- 15. 25-15 Two Approaches to GDP G D P = = + Consumption by Households Investment by Businesses Government Purchases Expenditures By Foreigners + + + + + Wages Rents Interest Profits Statistical Adjustments + Expenditures or Output Approach Income or Allocations Approach LO1
- 16. 25-16 Accounting Statement for the U.S. Economy, 2012 (in Billions) LO2
- 18. 25-18 The Income Approach • Total income is sum of • Compensation of employees (wages) to labor • Rents to land • Interest to capital • Profits to entrepreneurship • Proprietor’s income • Corporate profits LO3
- 19. 25-19 The Income Approach • Some Income Measures • Personal income (PI): Earned and unearned income available to resources suppliers and others before the payment of personal taxes. • Disposable income (DI): Personal income less personal taxes, Income available for consumption expenditures and savings. LO3
- 20. 25-20 U.S. Income Relationships 2012 LO4
- 21. 25-21 Nominal GDP vs. Real GDP • GDP is a dollar measure of production GDP = Σ Pit x Qit Pit: Price of good i in year t Qit: Quantity produced of good i in year t • Using dollar values creates problems •Prices change over time LO5
- 22. 25-22 Nominal GDP vs. Real GDP • Nominal GDP • Based on prices that prevailed when output was produced (Current dollar) • Real GDP • GDP adjusted for price changes • Use base year price (constant dollar) • Intended to measure only quantity changes LO5
- 23. 25-23 Nominal GDP vs. Real GDP • Part of the increase in nominal GDP reflects increased production and part reflects rising prices. LO
- 24. 25-24 Year 2011 Price Quantity Expenditure Pizza $3 100 Coke $2 150 Total Year 2010 Price Quantity Expenditure Pizza $2 50 Coke $1 100 Total Calculating Nominal GDP • Nominal GDP in 2010 is $200. LO Year 2010 Price Quantity Expenditure Pizza $2 50 $100 Coke $1 100 $100 Total $200 Year 2011 Price Quantity Expenditure Pizza $3 100 $300 Coke $2 150 $300 Total $600 • Nominal GDP in 2011 is $600. • Did an economy produce three times in 2011?
- 25. 25-25 Year 2010 Price Quantity Expenditure Pizza $2 50 Coke $1 100 Total Year 2011 Price Quantity Expenditure Pizza $3 100 Coke $2 150 Total Year 2011 Price 2010 Quantity Expenditure Pizza $2 100 Coke $1 150 Total Calculating Real GDP • Real GDP in 2010 is $200. LO Year 2010 Price 2010 Quantity Expenditure Pizza $2 50 Coke $1 100 Total Year 2011 Price 2010 Quantity Expenditure Pizza $2 100 $200 Coke $1 150 $150 Total $350 • Real GDP in 2011 is $350. • Use Base year prices (2010) to compute Real GDP. Year 2010 Price 2010 Quantity Expenditure Pizza $2 50 $100 Coke $1 100 $100 Total $200
- 26. 25-26 GDP Deflator • GDP deflator: price index based on all goods and services in GDP (basket) GDP deflator = x100 Nominal GDP Real GDP LO5
- 27. 25-27 Potential GDP • Potential GDP: the value of real GDP when all the economy’s factors of production —labor, capital, land, and entrepreneurial ability—are fully employed. • Actual real GDP may be less than potential if there are some unemployed resources like unemployed labor. LO
- 28. 25-28 Shortcomings of GDP • GDP may omit some production of goods and services that should be counted for. • Nonmarket activities: Most household productions are not reported • The underground economy: Most illegal activities are not reported • Leisure: Value of many leisure activities are not counted. LO6
- 29. 25-29 Shortcomings of GDP • Improved product quality: GDP only counts quantity, not Improved quality value reflected on prices • GDP and the environment: Environmental hazard (negative externality) is not accurately counted LO6
- 31. 25-31 Shortcomings of GDP • GDP is not a perfect measure of standard of living • Composition and distribution of the output: Price of goods does not fully reflect actual value of product for the society, and extremely unequal distribution is not necessarily good for the society • Noneconomic sources of well-being: reduction in crime and disease improves standard of living, but not considered in GDP LO6
Editor's Notes
- We will be calculating how economists estimate a country’s output and income for a year. The importance of these figures will be discussed, as well as the differences between the various ways that we can measure income. Lastly we will discuss how we can adjust the figures that we have calculated for inflation effects and analyze some of the issues associated with the various accounts.
- National income accounting does for the economy what private accounting would do for an individual household or business. The Bureau of Economic Analysis, an agency of the Department of Commerce, compiles the data and reports it in National Income and Product Accounts. This information is used by economists and policymakers in formulating decisions for the best interest of the nation.
- The primary measure of the economy’s performance as a whole is its aggregate output. This is most commonly calculated as Gross Domestic Product, or GDP. GDP is a monetary measure in that everything is valued in dollars. All goods and services produced must be converted into dollar values for GDP to work. To avoid multiple counting of goods, GDP includes only the market value of final goods and ignores intermediate goods, which are goods either purchased for resale or for further processing into final goods. GDP could also avoid multiple counting by counting only the value added at each stage. Value added is the market value of a firm’s output less the value of the inputs that the firm purchased from others.
- The primary measure of the economy’s performance as a whole is its aggregate output. This is most commonly calculated as Gross Domestic Product, or GDP. GDP is a monetary measure in that everything is valued in dollars. All goods and services produced must be converted into dollar values for GDP to work. To avoid multiple counting of goods, GDP includes only the market value of final goods and ignores intermediate goods, which are goods either purchased for resale or for further processing into final goods. GDP could also avoid multiple counting by counting only the value added at each stage. Value added is the market value of a firm’s output less the value of the inputs that the firm purchased from others.
- Nonproduction transactions must be excluded from GDP since they have nothing to do with the production of final goods. There are two types: purely financial transactions and secondhand sales. Purely financial transactions include such items as public transfer payments like Social Security, private transfer payments (Christmas gifts), and stock market transactions. Secondhand sales contribute nothing to current production so they are ignored in calculating GDP.
- GDP can be viewed from two different perspectives. The income approach looks at GDP in terms of the income derived, or created, from producing goods and services. The expenditures approach measures GDP as the sum of all of the money spent in buying the output. In theory, either method should yield equal results. The expenditures and income approaches are two different ways to look at the same thing. You could look at a quarter from the heads side or the tails side, but it is still worth the same amount. This is the same as the expenditures and income approaches for calculating GDP.
- Here is the updated circular flow that was introduced in a much simpler form in a previous chapter. However, from this diagram, we can see that even when we account for more transactions in the economy, income and expenditures are equal.
- Here the two different approaches to measuring GDP are illustrated. On the left, the expenditures approach measures GDP as the sum of four items: (1) consumption by households, (2) investment by businesses, (3) government purchases, and (4) expenditures by foreigners. On the right, the income approach uses different inputs: (1) wages, (2) rents, (3) interest, (4) profits, and (5) statistical adjustments. Each of these items will be further discussed next.
- This table calculates GDP for 2012 in the United States by both the expenditures approach and the income approaches. Note that both methods come to the same conclusion for the year.
- In this table comparing GDPs for selected nations, the United States, Japan, and China have the world’s highest GDP. Note that all data have been converted to U.S. dollars via international exchange rates.
- This approach allocates expenditures as income to those responsible for producing the output. The major component is national income, which is made up of employee compensation, rents, interest, proprietor’s income, corporate profits, and taxes on production and imports. The largest share is employee compensation which includes wages and salaries paid by both businesses and government as well as supplements such as benefits paid by employers on behalf of employees.
- Under the income approach, all expenditures on final goods and services flow as income to either private citizens or the government. To move from national income to GDP, several adjustments must be made. The first adjustment is for net foreign factor income. This is income Americans gain from supplying resources abroad, which would be taken out, and then income that foreigners gain from supplying resources to the U.S. would be added. The next adjustment comes from what is called a statistical discrepancy, which basically is just a balancing amount. The final adjustment factor is the useful life of private capital equipment that extends well beyond the year in which they were produced. The cost of the equipment must be allocated over its useful life. The other national accounts provide useful information about the economy’s performance. NDP is GDP less consumption of fixed capital. National income is NDP less the statistical discrepancy and plus the net foreign factor income. Personal income includes all income received, regardless of whether it is earned or unearned. Finally, disposable income is PI less personal taxes.
- These tables illustrate the relationship between GDP, NDP, NI, PI, and DI in the United States for 2012.
- GDP measures production at current dollar values which creates problems because the value of a dollar changes over time. One hundred years ago, the purchasing power of one dollar was much different than it is today. To get around that problem, there are two different GDPs. Nominal GDP is based upon the prices that were in effect when the output was produced. A GDP that has been deflated or inflated to reflect changes in price levels is referred to as real GDP. In order to calculate real GDP, a base year must be selected and then the current year’s prices adjusted accordingly.
- GDP measures production at current dollar values which creates problems because the value of a dollar changes over time. One hundred years ago, the purchasing power of one dollar was much different than it is today. To get around that problem, there are two different GDPs. Nominal GDP is based upon the prices that were in effect when the output was produced. A GDP that has been deflated or inflated to reflect changes in price levels is referred to as real GDP. In order to calculate real GDP, a base year must be selected and then the current year’s prices adjusted accordingly.
- This is the formula used to calculate real GDP. We use a price index that is equal to the price of a collection of goods and services in the specific year divided by the price for the same goods and services in a base year multiplied by 100. Nominal GDP is then divided by the price index (in hundredths) to determine real GDP.
- While GDP is a reasonably accurate and highly useful measure of how the economy is performing, it does have several shortcomings. Certain productive activities occur outside of any market and therefore are not measured in the traditional way. The value of leisure time, weekends, holidays, etc., is also not included, but they certainly add value due to the added satisfaction they provide to workers. GDP fails to capture the full value of improvements in product quality. Let’s face it, a $200 cell phone purchased today is of very different quality than a cell phone that cost $200 just a decade ago. There is also a huge underground economy, mainly comprised of illegal activities, that produces income that is not measured through traditional GDP methods. Included in this underground economy are legal activities that provide income that the recipients do not wish to report to the I.R.S. and pay taxes on. Environmental issues and noneconomic sources of well-being are also problematic in that GDP does not really have a way to accurately value and report the issues.
- While GDP is a reasonably accurate and highly useful measure of how the economy is performing, it does have several shortcomings. Certain productive activities occur outside of any market and therefore are not measured in the traditional way. The value of leisure time, weekends, holidays, etc., is also not included, but they certainly add value due to the added satisfaction they provide to workers. GDP fails to capture the full value of improvements in product quality. Let’s face it, a $200 cell phone purchased today is of very different quality than a cell phone that cost $200 just a decade ago. There is also a huge underground economy, mainly comprised of illegal activities, that produces income that is not measured through traditional GDP methods. Included in this underground economy are legal activities that provide income that the recipients do not wish to report to the I.R.S. and pay taxes on. Environmental issues and noneconomic sources of well-being are also problematic in that GDP does not really have a way to accurately value and report the issues.
- This table shows the underground economy as a percentage of GDP in several nations. Three factors that help explain the variation in size are (1) the extent and complexity of regulation, (2) the type and degree of taxation, and (3) the effectiveness of law enforcement.
- While GDP is a reasonably accurate and highly useful measure of how the economy is performing, it does have several shortcomings. Certain productive activities occur outside of any market and therefore are not measured in the traditional way. The value of leisure time, weekends, holidays, etc., is also not included, but they certainly add value due to the added satisfaction they provide to workers. GDP fails to capture the full value of improvements in product quality. Let’s face it, a $200 cell phone purchased today is of very different quality than a cell phone that cost $200 just a decade ago. There is also a huge underground economy, mainly comprised of illegal activities, that produces income that is not measured through traditional GDP methods. Included in this underground economy are legal activities that provide income that the recipients do not wish to report to the I.R.S. and pay taxes on. Environmental issues and noneconomic sources of well-being are also problematic in that GDP does not really have a way to accurately value and report the issues.