Measuring Domestic Output and National Income
Lecture 2
Chapter 7
Measuring Domestic Output and National Income
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
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.
Gross Domestic Product(GDP)
GDP is the dollar value of all final goods and services produced within the borders of a country during a specific period of time.
Measure of aggregate output
Monetary measure
Avoid multiple counting
One way to avoid multiple counting is to include market value of final goods and ignore intermediate goods
Another approach is to count value added
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.
Intermediate goods are products that are purchased for resale or further processing or manufacturing. Final goods are products that are purchased by their end users.e.g Lettuce, carrots and vinegar in restaurant salads are intermediate goods, restaurant salads are final goods.
Monetary Measure
LO1
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.
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Gross Domestic Product Continued
(1)
Stage of Production
(2)
Sales Value
of Materials
or Product
$ 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 Value
$1140
Value Added (total income)
(3)
Value
Added
]——–$120 (= $120 – $ 0)
]——– 60 (= 180 – 120)
]——– 40 (= 220 – 180)
]——– 50 (= 270 – 220)
]——– 80 (= 350 – 270)
$350
LO1
This table illustrates the value-added in a five-stage production process. The value added is the market value of a firm’s output less the value of the inputs the firm has bought from others. Using this method will avoid multiple counting.
Gross Domestic Product Concluded
Exclude financial transactions
Public transfer payments e.g social security payments, welfare payments etc
Private transfer payments e.g money that parents give to children
Stock market transactions
Exclude second hand sales
Sell used car to a friend
LO1
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.
Two Approaches to GDP
Income approach
Count income derived from production
Wages, rental income, interest income, profit
Expenditure approach
Count sum of money spent buying the final goods
Who buys the goods?
LO1
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.
Two Approaches to GDP Cont’d
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
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.
Expenditures Approach
Personal consumption expenditures (C)
Durable goods
Nondurable goods
Consumer expenditures for services
LO2
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% of those expenditures are for durable consumer goods, which are defined as having a life of three years or more. Another 30% go to nondurable goods such as food, clothing, and gasoline. The other 60% are for services leading to the U.S. economy frequently being referred to as a service economy.
Expenditures Approach Continued
Gross private domestic investment (Ig)
Machinery, equipment, and tools
All construction
Positive and negative changes in inventories
Expenditures on R&D as well as money spent to develop new works of writing,art,music and software
Noninvestment transactions excluded
LO2
The second component of the expenditures approach is gross private investment, which includes all final purchases of machinery, equipment, and tools by businesses, all construction, and changes in inventories. All of these items represent ways businesses invest in themselves. Construction also includes residential construction because homes could be rented to produce income.
Expenditures Approach: Investment
January 1
Year’s GDP
December 31
Consumption,
government
expenditures,
and net exports
Depreciation
Net
Investment
Gross
Investment
Stock of
Capital
Stock
of
Capital
Gross Investment
Depreciation
Net Investment
–
=
LO2
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.
Expenditures Approach Concluded
Government purchases (G)
Expenditures for goods and services
Expenditures for publicly owned capital
Excludes transfer payments
Net exports (Xn)
Add exported goods
Subtract imported goods
Xn= exports (X) – imports (M)
GDP = C + Ig + G + Xn
LO2
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 does not generate any sort of production.
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.
Accounting Statement for the U.S. Economy, 2015
LO2
This table calculates GDP for 2015 in the United States by both the expenditures approach and the income approach. Note that both methods come to the same total of GDP for the year.
Comparative GDP
LO2
In this table comparing GDPs for selected nations for 2014, 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.
GDP VS GNP
Government National Product(GNP) GNP measures the levels of production of all the citizens or corporations from a particular country working or producing in any country. For example, the United States’ GNP measures and includes the production levels of any American or American-owned entity, regardless of where in the world the actual production process is taking place, and defines the economy in terms of the private or corporate citizens’ output Government Domestic Product(GDP) refers to and measures the domestic levels of production in a country. It represents the monetary value of all goods and services produced within a nation’s geographic borders over a specified period of time
For example, the output of a Toyota plant in Kentucky isn’t included in America’s GNP, although it’s counted in America’.s GDP
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Discussion Question # 12
Which of the following are included or excluded in this year’s GDP? Explain your answer in each case.
a. Social Security payments received by a retired factory worker.
b. Unpaid services of a family member in painting the family home.
c. Income of a dentist from the dental services provided.
d. A monthly allowance a college student receives from home.
e. Money received by Josh when he resells his nearly brand-new Honda automobile to Kim.
f. The publication and sale of a new college textbook.
g. An increase in leisure resulting from a 2-hour decrease in the length of the workweek, with no reduction in pay.
h. A $2 billion increase in business inventories.
i. The purchase of 100 shares of Google common stock.
a. Excluded. A transfer payment from taxpayers for which no service is rendered (in this year).
b. Excluded. Nonmarket production.
c. Included. Payment for a final service. You cannot pass on a tooth extraction!
d. Excluded. A private transfer payment; simply a transfer of income from one private individual to another for which no transaction in the market occurs.
e. Excluded. The production of the car had already been counted at the time of the initial sale.
f. Included. It is a new good produced for final consumption.
g. Excluded. The effect of the decline will be counted, but the change in the workweek itself is not the production of a final good or service or a payment for work done.
h. Included. The increase in inventories could only occur as a result of increased production.
i. Excluded. Merely the transfer of ownership of existing financial assets
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Problem # 3
If in some country personal consumption expenditures in a specific year are $50 billion, purchases of stocks and bonds are $30 billion, net exports are -$10 billion, government purchases are $20 billion, sales of second-hand items are $8 billion, and gross investment is $25 billion, what is the country’s GDP for the year?
Answer: $85 billion
Nominal GDP vs. Real GDP
GDP is a dollar measure of production
Using dollar values creates problems
Nominal GDP
Based on prices that prevailed when output was produced
Real GDP
Reflect changes in the price level
Use base year price
LO5
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 Price Index
Use price index to determine real GDP
Price
Index
In Given
Year
=
×
100
Price of Market Basket
in Specific Year
Price of Same Basket
in Base Year
Real GDP in given year
=
Nominal GDP in given year
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.
GDP Growth rate
GDP Price Index Continued
Calculating Real GDP (Base Year = Year 1)
| Year | (1) Units of Output | (2) Price of Pizza Per Unit | (3) Price Index (Year 1 = 100) | (4) Unadjusted, or Nominal, GDP (1) × (2) | (5) Adjusted, or Real, GDP |
| 1 | 5 | $10 | 100 | $ 50 | $50 |
| 2 | 7 | 20 | 200 | 140 | 70 |
| 3 | 8 | 25 | 250 | 200 | 80 |
| 4 | 10 | 30 | — | — | — |
| 5 | 11 | 28 | — | — | — |
LO5
In this table, nominal GDP and real GDP are calculated based upon the formula. Years 1 to 3 have been calculated. Complete the table for years 4 and 5.
Extra Credit 2: Nominal GDP for Year 4=10×30=300 ; Price index for year 4=(30/10)x100=300; Real GDP for year 4=300/(300/100)=100
Question
Consider the production of fries and burger in an economy:
Where Q represents quantity and P represents prices; 2013 is the base year.
Find the nominal GDP for each year
Find the real GDP for each year
What is the nominal growth rate?
What is the real growth rate?
Note: Real GDP is calculated using base year’s prices.
Real World Considerations
This table shows some of the relationships between nominal GDP, real GDP and the GDP price index over the past decade. Here the base year is 2009 (note that is the year where the index is 100). To test your understanding of the relationships, determine the value of the price index for 1995 and real GDP for 2005 and 2009.
GDP price index for 1995= (7664/10167.3)x100=75.4
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Shortcomings of GDP
Nonmarket activities
Leisure
Improved product quality
The underground economy
GDP and the environment
Composition and distribution of output
Noneconomic sources of well-being
LO6
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 refuse 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.
Underground Economy
LO6
This table shows the underground economy as a percentage of GDP in several nations.