Measuring Domestic Output, and National Income

1. Measuring Domestic Output, and National Income Measuring the National Economy

2. Why do we measure the national economy? • We use “National Income Accounting” in order to: • Assess the overall health of the national economy • Make comparisons of the economy over different periods of time • Assist public officials and analysts in creating and maintaining public policy

3. National Income Accounting: History of … • The idea was created by Simon Kuznets (1901-1985) beginning in 1930 shortly after the beginning of the Great Depression. He received the Nobel Prize in Economics in 1971 for his efforts. • The tools of collection of the data were developed by the team led by Dr. Kuznets. • The Bureau of Economic Analysis (part of the Commerce Department) compiles the numbers (http://www.bea.gov/).

4. GDP Defined • Gross Domestic Product, or GDP, is the market value of the final goods and services produced within the boundaries of the US, whether by Americans or foreigners, in one year.

5. GDP Explained • Monetary measure, or a “price tag” is attached to all goods and services produced. • Uses only the current value or sale of FINAL GOODS (goods and services ready for final use by consumers, firms, and governments). • This avoids the double counting INTERMEDIATE GOODS (goods and services usually sold between firms in order to produce final goods).

6. GDP: Transactions that are NOT Counted • Sale of intermediate goods (ex: lumber sold to a construction company for building a house) • Non-productive activities • Public transfer payments (ex: veteran’s benefits & public assistance payments) • Private transfer payments (ex: money or property gifts given to relatives) • Sales of securities (ex: stocks, bonds, government securities, etc.) • Sale of secondhand goods

7. GDP Calculated: Two Methods Expenditures Approach Income Approach • Adds up all the spending that occurs in the circular flow: • Consumption by households • Investment by firms • Purchases by the government • Spending overseas on exports • Adds up all the ways that households earn income: • Wages earned • Rents collected • Interest earned • Profits made • Statistical adjustment

8. Expenditures Approach Examined GDP = C + I + G + (X-M) • Recall that we are adding up all the spending that happens in a national economy • Consumption spending by consumers (C) • Investment spending by firms (I) • Government spending (G) • Net export spending (NX or Xn or “X-M”)

9. Consumption (C) Since the 1980s, consumer spending has accounted for about 60 to 65 percent of US GDP. • In the US, consumption (C) represents the largest portion of GDP • Consumption is spending on: • Consumer non-durable goods • Consumer durable goods (Lasting more than 3 years) • Services

10. Investment (I) Investment (I) happens when FIRMS spend, not households. Household investment is referred to as personal investment, and much of it is NOT counted as GDP. • Investment is FIRMS spending on: • New home construction • New commercial construction • Machinery and tools • Changes in their existing sales inventories (the amount firms have stored up for immediate sales). Changes in inventories could be negative IF firms have sold more than they anticipated (a good problem to have)

11. Gross & Net Investment Total (or gross) investment minus depreciation (the wear and tear on capital) equals net investment. Net investment can be negative.

12. Government Spending (G) Although government spending is sometimes viewed as negative, it accounts for the provision of public goods and services like defense, police, fire fighting, and public education. • In the U.S., government spending occurs at the national (or federal) level, the state level, and the local level. • At the national level this spending provide for defense, the national pension plan (called “Social Security”) and medical assistance to the elderly (called “Medicare”). • At the state level this spending provides for roads and public education. • At the local level this spending provides for police and fire protection.

13. Net Exports Net Exports represents spending on exports by people living overseas MINUS domestic spending on imports (X-M). • Exports are goods and services from one country purchased by citizens of other countries • Imports are goods and services from other countries purchased by one country’s citizens • To figure ‘net exports,’ the value of a nation’s exports are subtracted by the value of its imports (X-M) • Net exports can be abbreviated as either ‘NX’ or ‘Xn’

14. GDP = C + I + G + (X-M) This is the simple-to-remember formula for calculating GDP using the expenditures approach.

15. Income Approach Explained To calculate GDP using the income approach, we add up the factor payments that are earned in any national economy. • Recall that factor payments are wages, rent, interest, and profits • Wages are the compensation paid to employees • Rent is the income earned from the sale or lease of land • Interest is the repayment for the use of money • Profits are revenues earned by firms in excess of their total costs; the concept of accounting profits is used here • The result of adding factors up is called “National Income”

16. Special Note About Profit • Accounting profit used in calculating GDP rather that the concept of economic profit (so opportunity costs are NOT taken into consideration) • Profit includes: • Proprietors’ (owners of firms) incomes • Corporate profits (gross profits, not net) • Corporate income taxes • Dividends (paid out to investors) • Retained earnings (profits plowed back into the company that need to be paid out as dividends at a later time

17. GDP to National Income (NI) • Begin with GDP • Subtract depreciation of fixed (immovable) sources of capital (recall that GDP factors depreciation into Investment) • Subtract foreigners earning income in the U.S. and add in Americans earning income abroad (this is called ‘Net Foreign Factor Income’ and in the U.S. it produces a negative number) • Subtract indirect business taxes (ex. sales taxes) that the GDP calculation did not take into account) • The resultant number is National Income (NI)

18. Beyond GDP & NI • Net Domestic Product is the result of taking GDP and subtracting Depreciation (sometimes called the ‘consumption of fixed capital’); this gives us a true figure for the amount of NEW goods and services produced • Personal Income is obtained by subtracting losses to income (like Social Security contributions and retained earnings) and adding in transfer payments to National Income; this shows the income available to the nation • Disposable Income is the result of taking Personal Income and subtracting the amount paid in taxes; this gives us the amount that can be consumed or saved

19. An Example from 2002

20. Nominal GDP versus Real GDP • Nominal GDP • Reflects the current price level of goods and services and ignores the effect of inflation on the growth of GDP • This measure is called ‘Current Dollar GDP’ • Real GDP • Measures the value of goods and services adjusted for change in the price level. It will reflect the real change in output • This measure is called the ‘Constant Dollar GDP’ • Indicates what the GDP would be if the purchasing power of the dollar has not changed from what it was in a base year

21. Problems with Nominal GDP • Artificially inflates GDP when prices rise and deflates GDP when prices fall • The example on the following slide illustrates this problem • We assume a national economy only produces pizza • Notice that in Year 2, the output of pizza rises by 2 pizzas, but the GDP almost triples! • Now notice what happens when we use a price index to arrive at a real value for GDP

22. Using a Price Index to Calculate Real GDP The next slide will show you the calculations used to compile this chart. You must memorize these calculations.

23. How to Calculate Real GDP Nominal Price of a “Basket” of Goods Price Index Calculation Price of the Same “Basket” of Goods in a Chosen Base Year Nominal GDP Real GDP Calculation Price Index Nominal GDP Another Price Index Calculation Real GDP

24. U.S. Nominal & Real GDP2000-2009 Source: Bureau of Economic Analysis (BEA): http://www.bea.gov.htm

25. Summary • GDP is the total amount of goods and services produced within a nation in a year • The two main methods of measuring GDP is by examining 1) income flows and 2) expenditures • Put simply, GDP = C + I + G + NX • Nominal GDP is a measurement of current GDP, while Real GDP is adjusted for inflation • Price Indexes are used to adjust nominal measurements for inflation • Review this PPT several times before your AP examinations!