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Econ606 chapter 27 2020
- 1. CHAPTER 27 Measuring DomesticOutput and National Income
- 2. Assessing the Economy’sPerformance The Expenditures Approach The Income Approach Other National Accounts Nominal GDP versus Real GDP Shortcomings of GDP 27-2 Chapter Contents
- 3. Assessing the Economy’sPerformance • 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 LO27.1 27-3
- 4. 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 • Market price reflects value of products for consumers. • More valuable goods a country produces, higher the GDP. • GDP includes only those items that are traded in markets. 13-4
- 5. Total Market Value YearAnnual Output Market Value 1 3 sofas and 2 computers 3 at $500 + 2 at $2,000 = $5,500 2 2 sofas and 3 computers 2 at $500 + 3 at $2,000 = $7,000 LO27.1 27-5 • Suppose a country produces only two products: sofa and computer. • Market price of sofa is $500 and market price of computer is $2,000. • In Year 1, the country produces three sofas and two computers. Then, total market value of five goods produced in Year 1 is $5,500. • In Year 2, the country produces two sofas and three computers. Then, total market value of five goods produced in Year 2 is $7,000. • Even though the country produces five products in total in both years, its total market value is higher in Year 2 when it produces more products whose market value is high.
- 6. Final Goods vs.Intermediate Goods • GDP only includes Final good or service: • 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 13-6
- 7. 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. 13-7
- 8. GDP as ValueAdded • 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. 13-8
- 9. Value Added ina Five-Stage Production Process • Firm A produces wool whose market value is $120 from scratch, so Firm A creates $120 value. • Firm B uses $120 wool and produces Wool yarn whose market value is $180, so Firm B added $60 value. • Firm A, B, C, D, and E contribute to produce the wool coat and add values at each stage. The sum of added values is $120 + $60 + $40 + $50 + $80 = $350, which is the price of final good paid by a consumer. LO27.1 (1) Stage of Production (2) Sales Value of Materials or Product (3) Value Added $ 0 Firm A, sheep ranch 120 Firm B, wool processor 180 Firm C, coat manufacturer 220 Firm D, clothing wholesaler 270 Firm E, retail clothier 350 Total sales values $1,140 Value added (total income) $120 (= $120 − $ 0) 60 (= 180 − 120) 40 (= 220 − 180) 50 (= 270 − 220) 80 (= 350 − 270) $350 27-9
- 10. Expenditure Not Countedin GDP • Exclude financial transactions • When households buy financial assets such as bonds and stocks, they are making loans or transferring ownerships, but do not involve production of goods or services. • Any monetary payments from the government (e.g. social security) or monetary gifts (e.g. charity donation) are not included, since it does not involve production of goods or services. • Exclude second hand (used good) sales • Used goods were counted in GDP in the past year when they were produced and they were new goods. LO27.1 27-10
- 11. Two Approaches toGDP • Expenditure approach • Summing up spending on the final goods • Spending by households, firms, governments, and foreigners • Example: Papa John produces $20 worth of pizza (added values of all stages of production) and sell it to customer at $20. • Income approach • Summing up incomes received by providers of factors of production • Wages (labor), rental income (land), interest income (capital), profit (entrepreneurship) • Example: Out of $20 revenue, Papa John pays $8 of wage to its employees and $6 to farmers (who provide food supply), $1 rent for building, $1 to pay interest on loans (used to purchase oven), and $2 profits to owners.LO27.1 27-11
- 12. Expenditure Approach • Aggregateexpenditure (AE) is the total amount received by producers of final goods and services. AE = C + I + G + NX • C: Consumption by households • I: Investment by businesses • G: Government purchases • NX: Net exports by foreigners 13-12
- 13. Personal Consumption Expenditures •Consumption (C) is the expenditure by households on consumption goods and services. • Consumption includes household spending on • Durable goods and Nondurable goods • Goods and Services • Domestic plus foreign goods produced • Consumption does not include spending on • Financial assets or transactions (e.g. bond, student loan payment) • Residential property for rent 13-13
- 14. Gross Private DomesticInvestment • Investment (I) is the purchase of capital goods and additions to inventories. • Gross Investment = Net Investment + Depreciation • Net investment: new capital assets. • Depreciation: Repairment or replacement of existing capital • Investment includes • Plant, machinery, and equipment. • Residential construction. • Research and development. • Changes in inventories. • Investment does not include • Financial investment (e.g. stocks). • Purchase or creation of capital by the government 13-14
- 15. Government Purchase • Governmentpurchase (G) on goods and services is the expenditure by all levels of government on goods and services. • Government purchase includes • Expenditures for goods and services (e.g. teachers’ salary) • Expenditures for publicly owned capital (e.g. construction of road, aircraft career) • Government purchase does not include • Transfer payments (e.g. social security, welfare benefits) 13-15
- 16. Net Exports • Netexports (NX) of goods and services is the value of exports of goods and services minus the value of imports of goods and services. • Exports (EX) of goods and services are the items that firms in the United States produce and sell to the rest of the world. • Imports (IM) of goods and services are the items that households, firms, and governments in the United States buy from the rest of the world. • NX = Exports (EX) - Imports (IM) • Trade deficit: Imports exceed exports (negative net exports). 13-16
- 17. Accounting Statement forthe U.S. Economy Using the Expenditures (Receipts) Approach, 2018 Billions Sum of: Personal consumption expenditures (C) $14,051 Gross private domestic investment (ig) 3,711 Government purchases (G) 3,550 Net exports (Xn) –654 Equals: Gross domestic product $20,658 Source: U.S. Bureau of Economic Analysis. LO27.1 27-17
- 18. Circular Flow Revisited •Circular Flow diagram presents flows of payments among economic sectors. • Goods and services produced in the U.S. are sold to U.S. households, U.S. business firms (through Financial market), U.S. governments, and foreigners. Their payments (C, I, G, NX) flow to Goods market and made to producers of goods (Firm). • Firms must pay to factor owners (wage, rent, interest, profit) for their contribution in production of goods. 13-18 C $14,051 I $3,711 G $3,550 NX -$654 GDP $20,658 GDP in 2018 AE
- 19. Income Approach • Nationalincome (NI) is sum of • Compensation of employees (wages, salary, benefits) • Rents • Interest income • Proprietor’s income • Corporate profits • Taxes on production and imports • From National Income to GDP • Subtract net foreign factor income • Statistical discrepancy • Consumption of fixed capital LO27.3 27-19
- 20. Accounting Statement forthe U.S. Economy, Using the Income (Allocations) Approach, 2018 Billions Sum of: Compensation of employees $10,908 Rents 767 Interest 563 Proprietors’ income 1,580 Corporate profits 2,321 Taxes on production and imports 1,535 Equals: National income $17,674 Less: Net foreign factor income 255 Plus: Consumption of fixed capital 3,298 Plus: Statistical discrepancy –59 Equals: Gross domestic product $20,658 LO27.1 Source: U.S. Bureau of Economic Analysis. 27-20
- 21. Other National Accounts •Net domestic product (NDP): GDP minus Consumption of fixed capital • National income (NI) • Personal income (PI): Earned and unearned income available to resources suppliers and others before the payment of personal taxes, but including transfer payments. • Disposable income (DI): Personal income less personal taxes, Income available for consumption expenditures and savings. LO27.4 27-21
- 22. U.S. Income Relationships,2018 Billions Gross domestic product (GDP) $20,658 Less: Consumption of fixed capital 3,298 Equals: Net domestic product $17,360 Net domestic product (NDP) $17,360 Less: Statistical discrepancy −59 Plus: Net foreign factor income 255 Equals: National income (NI) $17,674 National income (NI) $17,674 Less: Taxes on production and imports 1,375 Less: Corporate income taxes 244 Less: Social Security contributions 1,367 Less: Undistributed corporate profits 825 Plus: Transfer payments 3,720 Equals: Personal income (PI) $17,581 Personal income (PI) $17,581 Less: Personal taxes 2,050 Equals: Disposable income (DI) $15,531 Source: Bureau of Economic Analysis. www.bea.gov. LO27.4 * *Some of the items combine categories that appear in the more detailed accounts. 27-22
- 23. The Expenditures andIncome Approaches to GDP What we spent = What we produced = What we earned (paid for production)LO27.1 27-23
- 24. Expenditure, Production, Income •Total income (Y): Sum of incomes earned by labor, capital owners, land resource owners, and entrepreneurship. • Total Value of production (GDP) • Aggregate Expenditure (AE) AE = GDP = Y 13-24
- 25. Global Perspective 27.1 •Size of country’s economy is often measured by GDP. • By far, the U.S. is the largest economy in the world. Source: The World Bank Group. LO27.2 COMPARATIVE GDPs IN TRILLIONS OF U.S. DOLLARS, SELECTED NATIONS, 2017 27-25
- 26. GDP as Measureof Total Value • GDP is a dollar measure of production GDP = 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 • When prices change, GDP measure changes even if an economy produces exactly same amount of goods and services. 13-26
- 27. 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 LO27.5 27-27
- 28. GDP and RisingPrices • Part of the increase in nominal GDP reflects increased production and part reflects rising prices. 13-28
- 29. Calculating Nominal GDP •Assume only two goods in economy. 13-29 Year 2010 Price Quantity Expenditure Pizza $2 50 $100 Coke $1 100 $100 Total $200 • Nominal GDP in 2010 is $200. • $2 x 50 = $100 worth of Pizza • $1 x 100 = $100 worth of Coke • $100 + $100 =$200 in total value • GDP increased from $200 to $600 by threefold. Did an economy produce in 2011 three times as much as in 2010? Year 2011 Price Quantity Expenditure Pizza $3 100 $300 Coke $2 150 $300 Total $600 • Nominal GDP in 2011 is $600. • $3 x 100 = $300 worth of Pizza • $2 x 150 = $300 worth of Coke • $300 + $300 =$600 in total value
- 30. Calculating Real GDP •Use Base year prices (2010) to compute Real GDP 13-30 Year 2010 Price 2010 Quantity Expenditure Pizza $2 50 $100 Coke $1 100 $100 Total $200 • Real GDP in 2010 is $200. • $2 x 50 = $100 worth of Pizza • $1 x 100 = $100 worth of Coke • $100 + $100 =$200 in total value • Real GDP in 2010 is same as Nominal GDP in 2010, since it is base year. • Real GDP in 2011 is significantly less than Nominal GDP in 2011. • Real GDP in 2011 is $350. • $2 x 100 = $200 worth of Pizza • $1 x 150 = $150 worth of Coke • $200 + $150 =$350 in total value in 2010 prices (dollar) Year 2011 Price 2010 Quantity Expenditure Pizza $2 100 $200 Coke $1 150 $150 Total $350
- 31. GDP Deflator • GDPdeflator: price index based on all goods and services in GDP (basket) • Price index is a weighted average of prices of goods and services in basket. GDP deflator includes all goods and services produced in the U.S. • Index number is a number used to indicate change in magnitude as compared with the reference point when it is 100. No unit. • GDP deflator = 100 in base year since Real GDP = Nominal GDP. 13-31 GDP deflator = x 100 Nominal GDP Real GDP
- 32. GDP in theU.S. • Nominal GDP in 2019 = $21,427.7 billion • Real GDP in 2019 = $19,073.1 billion • GDP deflator in 2019 = 112.348 where 2012 is base year • GDP deflator = $21,427.7/$19,0731 x 100 = 112.35 • Overall price level in 2019 is 12.35% higher than the price level in 2012. 13-32
- 33. Potential GDP • PotentialGDP: 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 more or less than potential GDP, depending on how much the economy actually employs its available resources. • Actual real GDP is less than potential GDP when there are some unemployed resources like unemployed labor. • Actual GDP is more than potential GDP when resources are used more intensively than normally. 13-33
- 34. Shortcomings of GDP GDPmay omit some production of goods and services that should be counted for. • Nonmarket activities: Most household productions are not reported. • Home-cooking, home childcare, DIY home maintenance. • The underground economy: Most illegal activities are not reported. • Illegal drug sales, any cash transactions including tips. • Leisure: Value of many leisure activities are not counted. • Public park, beach, sports 13-34
- 35. Shortcomings of GDP GDPcalculation does not take into account of many factors which affect our quality of life. • 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 • Noneconomic sources of well-being: Freedom, democracy, health, safety • Income inequality: High GDP does not necessary mean everyone has high standard of living. 13-35
- 36. Global Perspective 27.2 •In some countries the size of underground economy is so large that the official report of GDP significantly underestimates the actual economic activity. • Example: In 2017, the underground economic activities amount to $104 billion, or 35% of GDP of Columbia. What economic activities are not counted? Source: Medina, Leandro, and Friedrich Schneider. Shadow Economies Around the World: What Did We Learn Over the Last 20 Years? International Monetary Fund (IMF). 2018. LO27.6 THE UNDERGROUND ECONOMY AS A PERCENTAGE OF GDP, SELECTED NATIONS, 2015 27-36
- 37. Gross Output • Sumof: • Resource extraction • Production • Distribution • Final output (GDP) • Larger than GDP. • Better reflection of productive side of economy. LO27.6 27-37
- 38. Last Word: MeasuringQuality to Price the Priceless • GDP more difficult to measure in digital age. • How do you: • Account for quality improvements? • Internet products that are free of charge? • Hedonic adjustment. • Dollar value on time. 27-38
Editor's Notes
- #2 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. Then, 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. The Last Word explores the difficulty of measuring GDP and inflation in the digital age.
- #3 Learning Objectives LO27.1 Define and measure gross domestic product (GDP). LO27.2 Determine GDP by summing all expenditures on final goods and services. LO27.3 Determine GDP by summing all incomes received for providing resources. LO27.4 Describe the relationships among GDP, net domestic product, national income, personal income, and disposable income. LO27.5 Distinguish between nominal GDP and real GDP. LO27.6 Explain some limitations of the GDP measure.
- #4 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.
- #5 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.
- #6 GDP is a monetary measure because we would not otherwise be able to determine if total output has changed from year to year if the mix of goods and services changes.
- #10 This table illustrates the value added in a five-stage production process. The value added is calculated as the difference between the sales value of the materials and the value of the good at the previous production stage value. Using this method will avoid multiple counting.
- #11 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 (e.g., Christmas gifts), and stock market transactions. Secondhand sales contribute nothing to current production, so they are ignored in calculating GDP.
- #12 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 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.
- #14 Personal consumption expenditures, indicated by a “C” notation, covers all expenditures by households on final goods and services during a year. In any given year, approximately 10 percent of those expenditures are for durable consumer goods, which are defined as having a life of three years or more. Another 30 percent go to nondurable goods such as food, clothing, and gasoline. The other 60 percent are for services, leading to the U.S. economy frequently being referred to as a service economy.
- #15 The second component of the expenditures approach is gross private investment, which includes all final purchases of plants, machinery, and equipment, businesses, residential construction, research-and-development activities, the creation of new works of art or music, and changes in inventories. All of these items represent ways businesses invest in themselves. The first two types of items are sometimes referred to as “tools” as they are the physical, tangible objects that help to produce goods and services. The next two items can be thought of as “recipes” as they are the intangible methods, techniques, and management practices necessary to produce goods and services. Inventories are another matter. They can either increase or decrease over some period, and only the change is factored into the GDP calculation. When gross investment exceeds depreciation during a year, net investment occurs. This net investment expands the stock of private capital from the beginning of the year to the end of the year, allowing the economy’s production capacity to expand, all other things equal.
- #16 The last two components of the expenditures approach are government purchases and net exports. Government purchases are officially labeled “government consumption expenditures and gross investment.” It includes expenditures for goods and services that the government uses in providing public services and expenditures for publicly owned capital such as for schools or roads. It excludes government transfer payments such as Social Security because they simply transfer government receipts to certain households and do not generate any sort of production.
- #17 Net exports are calculated by subtracting the value of imported goods from the value of exported goods. Adding up all four components provides a measure of GDP, a measure of the market value of a specific year’s total output.
- #18 This table calculates GDP for 2018 in the United States by the expenditures approach.
- #19 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.
- #20 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, which is income Americans gain from supplying resources abroad. It would be taken out and then income that foreigners gain from supplying resources to the United States 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 it was produced. The cost of the equipment must be allocated over its useful life.
- #21 This table calculates GDP in the United States for 2018 using the income approach. Note that the GDP total for both the expenditures and income approach is the same.
- #22 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.
- #23 This table illustrates the relationship between GDP, NDP, NI, PI, and DI in the United States for 2018.
- #24 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.
- #26 In this table comparing GDPs for selected nations for 2017, the United States, China, and Japan have the world’s highest GDP. Note that all data have been converted to U.S. dollars via international exchange rates.
- #27 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 from what it is today.
- #28 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 from what 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.
- #30 This is the method similar to the alternative method described in the textbook, but involving two goods rather than one good.
- #34 Se Chapter 29 for how to measure potential GDP
- #35 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.
- #37 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.
- #38 Gross output (GO) is a statistic that sums together the dollar value of the economic activity that takes place at each stage into which all economic activity can be grouped. In 2015, GO was $31.5 trillion, while GDP was $17.9 trillion. GO is particularly useful when attempting to gauge the magnitude of business cycle fluctuations. During the 2007–2009 recession, real GDP fell 4.2 percent, while real GO fell 8.6 percent. That means total economic activity fell by more than twice as much as final output, which helps to explain why employment fell so dramatically during and after the Great Recession.
- #39 The Bureau of Economic Analysis, the government agency charged with measuring GDP, has faced challenges in recent years with factoring in the changes caused by the digital age. How do you value services that do not have a price, such as a Google search or the incremental quality improvements in products like an iPhone? New ways have to be developed along with a new thought process in order to get a true value of our modern economic output.