Chapter 8.

GDP: Measuring Total Production and Income

8.1. Gross Domestic Product Measures Total Production 8.2. Does GDP Measure What We Want It to Measure? 8.3. Real GDP versus Nominal GDP 8.4. Other Measures of Total Production and Total Income

Microeconomics. The study of how households and firms make choices, how they interact in markets, and how the government attempts to influence their choices. Macroeconomics. The study of the economy as a whole, including topics such as inflation, unemployment, and economic growth. Business cycle. Alternating periods of economic expansion and economic recession. Expansion. The period of a business cycle during which total production and total employment are increasing. Recession. The period of a business cycle during which total production and total employment are decreasing. Economic growth. The ability of an economy to produce increasing quantities of goods and services. Inflation rate. The percentage increase in the price level from one year to the next.

8.1. 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. 1. GDP is measured using market values, not quantities. We measure production by taking the value, in dollar terms, of all the goods and services produced. 2. GDP includes only the market value of final goods Final good or service. A good or service purchased by a final user. Intermediate good or service. A good or service that is an input into another good or service, such as a tire on a truck. To avoid double counting, we do not include the value of intermediate goods or services in calculating GDP. 3. GDP includes only current production. GDP includes only production that takes place during the indicated time period. 4. GDP includes only production within a country.

There are three methods for calculating GDP. 1. Expenditure Method 2. Income Method 3. Value-added Method

1. Expenditure Method Since GDP is the total market values of final goods and services, it is the total expenditure of households, firms and the government. But GDP includes only the production within a country; we need to add foreign expenditure on domestic production (export) and subtract domestic expenditure on foreign production (import).

Components of GDP The BEA divides its statistics on GDP into four major categories of expenditures: (1.) Consumption (C) (2.) Investment (I) (3.) Government purchases (G) (4.) Net exports (NX) = exports (E) imports (M)

Using the expenditure method, GDP (denoted as Y) is Y = C + I + G + NX.

(1.) Consumption (i.) Spending by households on goods and services, not including spending on new houses.

(ii.) Consumption expenditures are made by households and are divided into expenditures on services, such as medical care, education, and haircuts; expenditures on nondurable goods, such as food and clothing; and expenditures on durable goods, such as automobiles and furniture.

(2.) Investment (i.) Spending by firms on new factories, office buildings, machinery, and additions to inventories, plus spending by households and firms on new houses.

(ii.) Investment, is divided into three categories: 1. Business fixed investment is spending by firms on new factories, office buildings, and machinery used to produce other goods. 2. Residential investment is spending by households and firms on new single-family and multi-unit houses. 3. Changes in business inventories are also included in investment.

(iii.) Since the changes in inventories are included in investment, that is, unsold goods (that are currently produced) are purchased by the firms themselves, total expenditure is equal to GDP.

(iv.) Economists reserve the word investment for purchases of machinery, factories, and houses. Purchases of stock or rare coins or deposits in saving accounts are not included.

(4.) Government purchases (i.) Spending by federal, state, and local governments on goods and services. (ii.) Transfer payments. Payments by the government to households for which the government does not receive a new good or service in return. (ii.) Transfer payments are not included in GDP because they do not received in exchange for production of a new good and service.

(5.) Net exports Exports minus imports

Some facts about the GDP of the U.S. The table in Figure 8.2 provides a more detailed breakdown of the components of GDP and shows several interesting points: 1. Consumer spending on services is greater than the sum of spending on durable and nondurable goods. 2. Business fixed investment is the largest component of investment. 3. Purchases made by state and local governments are greater than purchases made by the federal government. 4. Imports are greater than exports, so net exports are negative.

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Consumption as a percentage of GDP

Consumption is a larger fraction of GDP in the United States than in most other highincome countries or in rapidly growing countries such as China and India. Over time, consumption in the United States has increased as a fraction of GDP.

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Consumption as a percentage of GDP

Although it can be good news for the economy in the long run, the determination of U.S. households to cut back on spending and increase saving in 2011 may partly explain the slow recovery from the 20072009 recession.

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2. Income Method We have seen that GDP is equal to the total expenditure. Total expenditure is the total revenue of firms. The total revenue of firms is the incomes of the factors of production.

Factors of production are divided into four categories (1.) labor, (2.) capital, (3.) natural resources, and (4.) entrepreneurship.

The income of these factors of production are respectively (1.) wage, (2.) interest, (3.) rent, and (4.) profit.

Using the income method, GDP (denoted as Y) is Y = wage + interest + rent + profit.

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Production, Income, and the Circular-Flow Diagram

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1. The circular-flow diagram illustrates the flow of spending and money in the economy. 2. Firms sell goods and services to four groups: domestic households, domestic firms, the government, and the rest of the world. 3. To produce goods and services, firms use factors of production: labor, capital, natural resources, and entrepreneurship. 4. Households supply the factors of production to firms in exchange for income in the form of wages, interest, profit, and rent. 5. The diagram also shows that households use their income to purchase goods and services, pay taxes, and save. 6. Firms and the government borrow the funds that flow from households into the financial system, which consists of banks and stock and bond markets.

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3. Value-Added Method Value-added. The market value a firm adds to a product. Precisely, the value-added of a firm is equal to the value of the firms products minus the value of the intermediate goods that the firm used.

GDP = the value-added of all firms

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Question 1. Suppose the table below shows the accounting information of all firms in an economy. Use expenditure method, value-added method and income method to calculate the GDP of this economy.

Values of Sales Intermediate goods Wages Interest payments Rent Profit Total expenditure Value added per firm = Value of Sales Cost of Intermediate goods

American Ore, Inc. 4200 (ore) 0 2000 1000 200 1000 4200 4200

American Steel, Inc. 9000 (steel) 4200 (ore) 3700 600 300 200 9000 4800

American Motors, Inc. 21500 (car) 9000 (steel) 10000 1000 500 1000 21500 12500

Total Factor Income

15700 2600 1000 2200

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Answer 1. Expenditure Approach: GDP = Consumption = 21500 Value Added Approach: GDP = Value added of Auto Producer + Value added of Steel Producer + Value added of Ore Producer = 4200 + 4800 + 12500 = 21500 Income Approach: GDP = Wages + Interest Payment + Rent + Profit = 15700 + 2600 +1000 + 2200 = 21500

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8.2. Does GDP Measure What We Want It to Measure?

Shortcomings in GDP as a Measure of Total Production

1. Household production. Goods and services people produce for themselves that are not bought and sold in markets. 2. Underground economy. Buying and selling of goods and services that is concealed from the government to avoid taxes or regulations or because the goods and services are illegal.

When the BEA calculates GDP, it does not include two types of production: home production and the production in the underground economy.

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Shortcomings of GDP as a Measure of Well-Being GDP per capita is calculated by dividing the value of GDP for a country by the countrys population.

1. The Value of Leisure Is Not Included in GDP. If Americans still worked 60-hour weeks as they typically did in 1890, GDP would be much higher than it is, but the wellbeing of the typical person would be lower because less time would be available for leisure activities.

2. GDP Is Not Adjusted for Pollution or Other Negative Effects of Production. Although GDP does not take into account negative effects of production, countries are known to devote more resources to reducing these effects as GDP increases.

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3. GDP Is Not Adjusted for Changes in Crime and Other Social Problems. An increase in crime reduces well-being but may actually increase GDP if it leads to greater spending on police, security guards, and alarm systems.

4. GDP Measures the Size of the Pie but Not How the Pie Is Divided Up. GDP may not provide good information about the goods and services consumed by the typical person.

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8.3. Real GDP versus Nominal GDP

Nominal GDP. The value of final goods and services evaluated at current-year prices.

Real GDP. The value of final goods and services evaluated at base-year prices.

One drawback to calculating real GDP using base-year prices is that, over time, prices may change relative to each other, distorting real GDP estimates more the further away the current year is from the base year.

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To make the calculation of real GDP more accurate, in 1996, the BEA switched to using chain-weighted prices, and it now publishes statistics on real GDP in chained (2005) dollars.

In this way, prices in each year are chained to prices from the previous year, and the distortion from changes in relative prices is minimized.

Holding prices constant means that the purchasing power of a dollar remains the same from one year to the next.

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Figure 8.3. Nominal GDP and Real GDP, 19902010.

Currently, the base year for calculating

GDP is 2005. In the years before 2005, prices were, on average, lower than in 2005, so nominal GDP was lower than real GDP. In 2005, nominal and real GDP were equal. Since 2005, prices have been, on average, higher than in 2005, so nominal GDP is higher than real GDP.

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The GDP Deflator

Price level. A measure of the average prices of goods and services in the economy. GDP deflator. A measure of the price level, calculated by dividing nominal GDP by real GDP and multiplying by 100.

Nominal GDP is equal to real GDP in the base year, so the value of the GDP price deflator will always be 100 in the base year.

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8.4. Other Measures of Total Production and Total Income

Gross national product (GNP) is the value of final goods and services produced by residents of the United States, even if the production takes place outside the United States.

National income is calculated as GDP minus the consumption of fixed capital, or depreciation. (NI = GDP - depreciation)

Personal income is income received by households. To calculate personal income, we subtract the earnings that corporations retain rather than pay to shareholders in the form of dividends. We also add in the payments received by households from the government in the form of transfer payments or interest on government bonds. (PI = NI retained earning + transfer payments + interest on government bond)

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Disposable personal income is equal to personal income minus personal tax payments and is the best measure of the income households actually have available to spend. (DPI = PI personal tax payments)

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GDP calculated as the sum of income payments to households is sometimes referred to as gross domestic income.

1. Wages include all compensation received by employees, including fringe benefits such as health insurance. 2. Interest is net interest received by households, or the difference between the interest received on savings accounts, government bonds, and other investments and the interest paid on car loans, home mortgages, and other debts. 3. Rent is rent received by households. 4. Profits include the profits of sole proprietorships, which are usually small businesses, and the profits of corporations.

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