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Measuring Domestic Output and National Income

“...I mean just these sixteen accomplishments or whatever: I mean, we've got a major rapport - relationship of economics, major in the security, and all of that, we should not lose sight of.” George W. Bush. Measuring Domestic Output and National Income.

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Measuring Domestic Output and National Income

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  1. “...I mean just these sixteen accomplishments or whatever: I mean, we've got a major rapport - relationship of economics, major in the security, and all of that, we should not lose sight of.” George W. Bush Measuring Domestic Output and National Income

  2. Chapter Objectives How GDP is Defined and Measured Circular Flow The Nature and Function of a GDP Price Index The Difference Between Nominal GDP and Real GDP Some Limitations of the GDP Measure

  3. Gross Domestic Product • GDP, or gross domestic product, is the market value of all final goods and services produced in a country in a given time period. • US GDP, 2nd quarter 2008 ($ billions) : (Chg from previous period) Nominal GDP $14,497.8 (+3.5%) Real GDP (2005 dollars) $13,415.3 (+1.5%) • US GDP, 2nd quarter 2009 ($ billions) : Nominal GDP $14,143.3 (- 1.0%) Real GDP (2005 dollars) $12,892.5 (- 1.0%) Source: www.BEA.gov

  4. Gross Domestic ProductMarket Value GDP is a market value -- goods and services are valued at their market prices. To add sofas and computers, we add the market values so we have a total value of output in dollars. Output in 2009 is greater than output in 2008.

  5. Gross Domestic ProductFinal Goods and Services A final good (or service), is an item bought by its final user during a specified time period. Only value added is considered in GDP. Excluding intermediate goods and services avoids double counting.

  6. Gross Domestic ProductProduced Within a Country GDP measures production within a nation’s borders – domestic production – no matter who owns the resources. • Cars produced in a Japanese-owned factory in the US counts in US GDP. • Cars produced in a US-owned factory in Mexico counts in Mexico’s GDP. How is this different from GNP (Gross National Product)?

  7. Gross Domestic ProductIn a Given Time Period Nominal GDP Real GDP GDP measures production during a specific time period, normally a year or a quarter of a year.

  8. NOTCounted in GDPNon- Production Transactions Financial: • Public transfer payments (payments made by US government to households for which nothing is required in return): • Social Security/Medicare • Welfare benefits • Veteran’s benefits • Private transfer payments such as cash gifts

  9. NOTCounted in GDP Non- Production Transactions Financial: • Stock market transactions: • Buying/selling stock certificates or bonds transfers of pieces of paper; it is not producing goods or services. • Second-hand sales or sales of used goods • Count production in GDP for the year it is new. • Buying a used car or a house built in 1995 will NOT count in GDP for this year (counted in the year it was produced).

  10. Measuring GDPTwo Approaches The Expenditure Approach • Measures GDP as the sum of consumption expenditure, investment, government purchases of goods and services, and net exports. • Final-Product or Value-Added • The sum of the money spent to buy the output. The Income Approach • Measures GDP by summing the incomes that firms pay households for the factors of production they hire. • Wages (return to labor)  Interest (return to capital) • Rent (return to land)  Profits (return to enterprise)

  11. Expenditure ApproachC = Personal Consumption Personal Consumption Expenditures, C • Durable Consumer Goods (expected life of 3+ years): • Cars, Appliances, TV’s . . . • Nondurable Consumer Goods (expected life less than 3 years): • Groceries, pencils, toothpaste . . . • Consumer Expenditures for Services • Legal advice, healthcare, manicures, education . . .

  12. Expenditure ApproachGross Private Domestic Investment Gross Private Domestic Investment, I • Machinery, Equipment, and Tools • All Construction (commercial AND residential) • Changes in Inventories (unsold goods, unconsumed output) • NOT included - Noninvestment Transactions, such as transfer of ownership of assets (like houses, stocks, bonds)

  13. Expenditure ApproachGovernment Purchases Government Purchases, G • Expenditures for Goods and Services • Labor, office supplies, uniforms . . . • Expenditures for Social Capital • Highways, schools, museums . . . Remember: G does not include transfer payments

  14. Expenditure ApproachNet Exports Net Exports, Xn • Exports (X=goods sold to other countries) • Dell computers, haircuts for foreign tourists • Imports (M=goods bought from other countries) • Toyota Prius made in Japan, haircut you got in Paris • Xn = Exports (X) – Imports (M)

  15. Two Approaches to GDP Income Approach Expenditure Approach Wages Consumption by Households Rents G D P Investment by Businesses = = Interest Government Purchases Profits Statistical Adjustments Net Expenditures By Foreigners

  16. Expenditure Approach Putting It All Together: GDP = C + I + G + Xn Circular Flow of Expenditure and Income • GDP = production = income = expenditures • The equality of income and output shows the link between productivity and living standards.

  17. Circular Flow Diagram The circular flow diagram shows the transactions among households, firms, governments, and the rest of the world.

  18. Transactions take place in factor (resource) markets, goods markets, and financial markets.

  19. Y = income Firms hire factors of production from households. The blue flow, Y, shows total income paid by firms to households.

  20. Y = income C = consumption Households buy consumer goods and services. The red flow, C, shows consumption expenditures.

  21. Households save, S, and pay taxes, T. Firms borrow some of household savings to pay for investment.

  22. (I = investment = creation of capital) Firms buy capital goods from other firms. The red flow I represents this investment expenditure by firms.

  23. G = government purchases Governments buy goods and services, G, and borrow or repay debt if spending exceeds or is less than taxes.

  24. X = exports, M = imports, so X – M = net exports The rest of the world buys goods and services from us, X and sells us goods and services, M: net exports are X – M.

  25. And the rest of the world borrows from us or lends to us depending on whether net exports are positive or negative.

  26. The blue and red flows are the circular flow of expenditure and income. The green flows are borrowing and lending.

  27. Y = C + I + G + (X-M) The sum of the red flows (C + I + G +(X-M)) equals the blue flow (Y).

  28. Nominal Versus Real GDP Nominal GDP • GDP measured in terms of the price level at the time of measurement (NOT adjusted for inflation). Real GDP • GDP adjusted for inflation. • Nominal GDP is deflated (if prices increased) or inflated (if prices fell). • Only real GDP measures changes in output accurately, holding price constant.

  29. Nominal Versus Real GDP In 2006: Expenditure on hats $100 = (100 x $1.00) Expenditure on bats $100 = ( 20 x $5.00) Nominal GDP $200

  30. Nominal Versus Real GDP In 2007: Expenditure on hats $ 80 (160 x $0.50) Expenditure on bats $495(22 x $22.50) Nominal GDP $575

  31. Nominal Versus Real GDP Total spending: 2006 $200 2007 $575

  32. Price of Market Basket In Specific Year Price Index In Given Year = x 100 Price of Same Basket In Base Year Nominal Versus Real GDP • GDP Price Index Method • Price index = measure of price of a specific “market basket” of goods in a specific year compared to price of identical goods in a base, or reference, year. Two Methods for Calculating Real GDP • GDP Price Index Method • Base Year Prices Method

  33. Price of Market Basket In Specific Year Price Index In Given Year = x 100 Price of Same Basket In Base Year Nominal Versus Real GDPGDP Price Index Method Base year Note: Value of any index in the base year is ALWAYS 100. Do you see why?

  34. $23.50 Price Index In 2007 = x 100 = 195.8 $12.00 Nominal Versus Real GDPGDP Price Index Method Base year $15.00 Price Index In 2006 = x 100 = 125 $12.00

  35. Nominal Versus Real GDP Base Year Prices Method Base year Base year Nominal GDP = Real GDP GDP Price Index/100 GDP price index is also known as “GDP deflator”, because it “deflates” nominal to real (removes influence of inflation)

  36. $1,350 Real GDP In 2006 = = $1,08000 1.25 $2,585 Real GDP In 2007 $1,32022 = = 1.958 Nominal Versus Real GDP Base Year Prices Method Base year Base year

  37. Nominal Versus Real GDPBase Year Prices Method Determine market value of basket in successive years assuming the price has not changed from the base year. Current Prices Base-Year Price

  38. Nominal Versus Real GDPCalculating Percentage Change in GDP Reminder: To calculate % change in anything, (New – Old)/Old Percentage change in real GDP from 2006 to 2007: ($1,320 –$1,080) / $,1080 = 0.222 = 22.2% increase % change in real GDP from 2005 to 2006 = __________________ % change in real GDP from 2005 to 2007 = __________________

  39. Measuring Economic Growth • The economic growth rate is the percentage change in GDP from one year to the next. • We measure economic growth so we can make: • Economic welfare comparisons • International welfare comparisons • Business cycle forecasts

  40. Shortcomings of GDPEconomic Welfare Comparisons • Economic welfare measures the nation’s overall state of economic well-being. • Real GDP is not a perfect measure of economic welfare for seven reasons: • Real GDP does not include household production (nonmarket activities), that is, productive activities done in and around the house by members of the household. 2. The value of “leisure” (time spent NOT working) is not captured in real GDP.

  41. Shortcomings of GDPEconomic Welfare Comparisons • Economic welfare measures the nation’s overall state of economic well-being. • Real GDP is not a perfect measure of economic welfare for seven reasons: • Real GDP does not capture the value of improvements in quality. (ex, $200 cell phone today is of much higher quality than $200 cell phone 10 years ago). • Real GDP does not account for activity in the illegal underground economy, or legal activity with unreported income.

  42. Shortcomings of GDPEconomic Welfare Comparisons • Economic welfare measures the nation’s overall state of economic well-being. • Real GDP is not a perfect measure of economic welfare for seven reasons: 5. Environmental damage is not deducted from real GDP. • Composition and distribution of output is not accounted for in real GDP. (ex. an assault rifle and a set of encyclopedias is valued equally if prices are equal). • Noneconomic sources of well-being, such as peace time, justice, civility, reduced crime, are not included in real GDP.

  43. Key Terms • GDP (gross domestic product) • intermediate goods • final goods • value added • expenditures approach • income approach • government purchases (G) • domestic investment (I) • consumption expenditures (C) • net exports (Xn) • nominal GDP • real GDP • leisure • underground economy

  44. Measuring Output and IncomeWrap Up Gross Domestic Product (GDP) Definition Measure Real v. Nominal Evaluate Expenditure Definition Shortcomings Two Ways to Calculate Income Circular Flow Growth

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