Download Gross Domestic Product How Is The GDP Calculated?

Chapter 23:
Measuring GDP, Inflation and Economic Growth
Two macroeconomic flows change the stock of capital:
Investment and Depreciation
< Investment is the purchase of new plant, equipment, and buildings
and the additions to inventories.
Investment increases the stock of capital.
Gross Domestic Product

Gross Domestic Product (GDP) is the value of aggregate or total
production of goods and services in a country during a given time
period usually a year.
< Depreciation is the decrease in the stock of capital that results
from wear and tear and the passage of time. (Also
referred to as capital consumption.)
•The GDP of Canada measure the value of aggregate production in
Canada during a year.
•The
total amount spent on adding to the stock of capital and on
replacing depreciated capital is called gross investment.
(Why do we care about the GDP?)
•The
amount by which the stock of capital increases is called net
investment.
How Is The GDP Calculated?
Stocks and Flows:
•A stock is a quantity that exists at a point in time.
•A
Net investment equals gross investment minus depreciation.
flow is a quantity per unit of time.
Wealth and Saving
•GDP
is a flow: It is the value of production in a country in a given
time period.
Capital and Investment
•The
Another macroeconomic stock is wealth, which is the value of all the
things that people own. What people own, a stock, is related to what
they earn, a flow.
key macroeconomic stock is capital:
=the plant =equipment
=buildings
=inventories of raw materials =semi-finished goods
People earn an income, which is the amount they receive during a
given time period from supplying the services of factors of production.
Income can be either consumed or saved.
that are used to produce other goods and services.
Consumption expenditure is the amount spent on consumption goods
and services.
•The
amount of capital in the economy is a crucial factor that
influences GDP.
1
2
Saving is the amount of income left over after meeting consumption
expenditures.
The Equality of Income, Expenditure, and the Value of Production
To understand why for the economy as a whole, income equals
expenditure and also equals the value of production, we study the
circular flow of income and expenditure. (See figure 23.2.)
The wealth of a nation at the start of a year equals its wealth at the
start of the previous year plus its saving during the year. And its
saving equals its income minus its consumption.
The economy consists of four sectors:
1. households
2. firms
3. governments
4. the rest of the world
The Short Term Meets the Long Term
•Potential GDP grows incessantly, year after year.
•Actual real GDP grows and fluctuates around potential
GDP.
Both the long-term growth in potential GDP and the short-term
fluctuations in actual real GDP are influenced by the stocks and flows.
One of the reasons why potential GDP grows is that the capital stock
grows.
And one of the reasons that real GDP fluctuates is that investment
fluctuates.
The figure has three aggregate markets:
1. factor markets
2. goods and services markets
3. financial markets
Households and Firms
•Households
sell and firms buy the services of labour, capital, land
and entrepreneurship in factor markets.
So capital and investment, as well as wealth and savings, are part of
the key to understanding the fluctuations and long-term growth of
GDP.
•For
these factor services, firms pay income to households.
•The
total income received by all households in payment for the
services of factors of production is aggregate income.
T he flows of i nves tment and sav ing together
w it h t he fl ows of i ncome and c ons umpti on
ex pendit ure int erac t in a c irc ular f l ow of
incom e and expen ditu re. Here, a ggre gate
income equ als a ggregat e expe nditure wh ich
equals the value of total production.
•Firms
sell and households buy consumer goods and services in the
markets for goods and services. The aggregate payment that
households make for these goods and services is consumption
expenditure.
•Firms buy and sell new capital equipment in the goods market.
3
4
•Some
of what firms produce might not be sold at all and is added to
inventory. The purchase of new plant, equipment, and buildings
and the additions to inventories are investment.
of exports is less than the value of imports, net exports are negative
and flow from firms to the rest of the world.
When net exports are positive, the rest of the world either borrows
from the domestic economy or sells domestic assets that it has bought
previously. These transactions take place in financial markets.
•In
the figure investment flows from firms through the goods
markets and back to firms.
•Households
place their savings in financial markets, and firms
borrow to finance their investment in the financial markets.
(Note these flows are neither income nor expenditure. Income is a
payment for the services of a factor of production and expenditure is a
payment for goods or services.)
Flows:
•The expenditure flows are consumption expenditure, investment,
government expenditures and net exports.
•The income flow is aggregate income.
•The financial transfers are savings, net taxes, government borrowing,
foreign borrowing and firms borrowing.
Governments: buy goods and services, called government
expenditures, from firms.
•Governments
Alternatively, when net exports are negative, the domestic economy
either borrows from the rest of the world or sells foreign assets that it
has previously acquired. Again these transactions takes place in
financial markets.
use taxes to pay for their expenditures.
•Net
taxes are equal to taxes paid to governments minus transfer
payments received from governments.
•Aggregate income and expenditure flows in aggregate
are equal.
•When
government expenditures exceed net taxes, the government
sector has a budget deficit, which if finances by borrowing in
financial markets.
Gross Domestic Product
Gross Domestic Product (GDP) is the value of aggregate production in
a country during a year. The circular flow of income and expenditure
illustrate two ways of measuring GDP.
Production can be valued in two ways:
1. By what buyers pay for the goods and services produced.
2. By what it costs producers to make the goods and services.
The Rest of the World Sector:
Firms in Canada export goods and services to the rest of the world and
import goods and services from the rest of the world. The value of
exports to the rest of the world minus the value of imports from the
rest of the world is called net exports.
If the value of exports exceeds the value of imports, net exports are
positive and flow from the rest of the world to firms. But if the value
These two concepts of value always give the same answer.
Expenditure Equals Income
5
6
The total amount that buyers pay for the goods and services produced
is aggregate expenditure.
Injections and Leakages
Firms revenues from the sale of goods and services equal
consumption (C) plus investment (I) plus government expenditures (G)
plus net exports (NX).
The sum of these four flows (C+I+G+NX) is equal to aggregate
expenditure on goods and services.
A leakage from the circular flow of income and expenditure is income
that is not spent on domestically produced goods and services.
•Saving, net taxes and imports are leakages.
An injection into the circular flow of income and expenditure is an
expenditure that does not originate with households.
•Investment, government expenditures, and exports are injections.
Start with the equality of aggregate income and the aggregate
expenditure:
Y= C + I + G + NX.
Net exports (NX) equals exports (X) minus imports (M).
We can write the above expression as
Y= C + I + G + X - M.
The total amount it costs producers to make goods and services is
equal to the incomes paid for the services of factors of production:
aggregate income (Y).
The sum of expenditure flows equals the income flow. The reason is
that everything a firm receives from the sale of its output, it pays out
as incomes to owners of the factors of production that it employs and
to the households that have a claim on its profits:
Focusing on Households in the diagram, aggregate income (Y) flows
in and consumption expenditure (C), savings (S), and net taxes (T)
flow out. Everything received by households is either spent on
consumption goods and services, saved or paid in net taxes, so
Y= C + S + T.
Y= C + I + G + NX
The buyers of aggregate production pay an amount equal to aggregate
expenditure, and the sellers aggregate production pay an amount equal
to aggregate income. But because aggregate expenditure equals
aggregate income, these two methods of valuing aggregate production
give the same answer.
Thus, GDP equals aggregate expenditure or aggregate income.
7
Subtract the second equation from the first equation and you get
I + G + X - M - S - T = 0.
Add saving (S) , net taxes (T) and imports (M) to both sides of this
equation and you get
I + G + X = S + T + M.
This left side is injections into the circular flow of income and
expenditure and the right side is leakages from the circular flow. So:
Injections always equal leakages.
8
How Investment Is Financed
Measuring Canadian GDP
Investment is financed by:
•National saving
•Borrowing from the rest of the world
To measure GDP, Statistics Canada use two approaches:
•Expenditure approach
•Factor incomes approach
National Saving: Saving plus government saving is called national
saving.
(I) The Expenditure Approach
The Expenditure Approach measure GDP by collecting data on
consumption expenditure (C), investment (I), government expenditure
(G), exports (X) and imports (M).
•Government saving equal net taxes minus government
expenditures: (T - G).
•If the government has a budget surplus, (T - G) is positive and
this surplus is a source of finance for investment.
To measure GDP using the expenditure approach, we add together
personal expenditure on consumer goods and services (C), business
investment (I), government expenditures (G), and exports of goods and
services (X) and subtract imports of goods and services (M).
•But if the government has a budget deficit, (T - G) is negative and
part of saving is used to finance the government deficit.
Personal expenditure on consumer goods and services is the
expenditure by households on goods and services. They do not include
the purchase of new residential houses, which is counted as part of
investment.
•Hence, National saving = S + (T - G).
Borrowing From the Rest of the World
Business investment is expenditure on capital equipment and
buildings by firms and expenditure on new residential houses by
households. It also includes the change in firms inventoriesstocks
of raw materials, semi-finished products and unsold final product held
by firms.
•If the value of imports (M) exceeds Canadian exports (X), we must
borrow from the rest of the world an amount equal to (M - X).
•Part of the worlds saving finances our negative net exports and
frees up an equal amount of national saving to finance investment
in Canada.
•If foreigners spend more on Canadian goods and services than we
spend on theirs, foreigners must borrow from us to pay the
difference.
•That is, part of Canadian national saving flows to the rest of the
world and is not available to finance Canadian investment.
Government expenditures on goods and services are expenditures on
goods and services by all levels of government. It does not include
transfer payments.
•Exports of goods and services are the value of goods and services
sold to foreign countries.
9
10
•Imports of goods and services are the value of goods and services
bought from foreign countries.
(See Table 23.1: the largest component is personal expenditure on
consumer goods and services and the smallest is business investment.)
produced goods is part of GDP, but the expenditure on financial
securities is not. GDP included the amount spent on new capital, not
the amount spent on pieces of paper.
Expenditure Not In GDP
•Aggregate expenditure which equals GDP, does not include
everything that people and businesses buy.
•Refer to the expenditure included in GDP as final expenditure.
•Items not part of final expenditure and not part of GDP include the
purchase of :
1. intermediate goods and services
2. used goods
3. financial securities
Intermediate goods and services are those goods and services that
firms buy from each other and use as inputs in the goods and services
that they eventually produce and sell to final users.
•Whether a good is intermediate or final depends on what it is used
for, and not on what it is.
Expenditure on used goods is not part of GDP because these goods
were counted as part of GDP in the period in which they were
produced and which they were new goods.
Firms often sell financial securities such as bonds and stock to finance
purchases of newly produced capital goods. The expenditure on newly
11
12
(II) Factor Incomes Approach
The factor incomes approach measures GDP by adding together all the
incomes paid by firms to households for the services of the factors of
production they hire wages for labour, interest for capital, rent for
land and profits paid for entrepreneurship.
The National Income and Expenditure Accounts divide factor incomes
into five categories:
1. Wages, salaries and supplementary labour income: are the
total payments by firms for labour services.
•This item includes the net wages and salaries (called takehome-pay) that workers receive plus taxes withheld on
earnings plus fringe benefits such as social security and
pension fund contributions.
4. Farmers income and 5. Income from non-farm incorporated
businesses are a mixture of the elements that we have just
mentioned.
•A farmer or the proprietor of an owner-operated business supplies
labour, capital, and land and buildings to the business.
•It is difficult to split up the income earned by an owner-operator
into its component parts: •compensation for labour
•payment for the use of capital
•rent payments for the use of land
or buildings &
•profit
so the national income accounts lump all these separate
incomes into a single category.
See Table 23.2.
2. Corporate profits: are the total profits made by corporations.
Some of these profits are paid to households in the form of
dividends, and some are retained by corporations as
undistributed profits.
•Wages, salaries and supplementary labour income is the
largest factor income.
3. Interest and miscellaneous investment income: is the total
interest payments received by households on loans made by
them minus the interest payments made by households on
their own borrowing. This item also includes payments for the
use of land and other rented inputs. It includes payments for
rented housing and imputed rent for owner-occupied housing.
(Imputed rent is an estimate of what homeowners would pay
to rent the housing they own and use themselves. By
including this item in the national income accounts, we
measure the total value of housing services, whether they are
owned or rented.)
13
•The sum of these five components of factor incomes is called net
domestic income at factor cost.
•It is not GDP.
•Two further adjustments are needed to get to GDP, one from
factor cost to market price and another from net to gross.
14
Factor Cost to Market Price
Net Domestic Product to Gross Domestic Product
•When we add up all the final expenditures on goods and services,
we arrive at a total called gross domestic product at market price.
•These expenditures are valued at the market prices that people pay
for the various goods and services.
•If we total all the factor incomes and then add indirect taxes and
subtract subsidies, we arrive at net domestic product at market
prices.
•The word gross means before subtracting depreciation.
•The word net means after subtracting depreciation.
•Another way of valuing goods and services is at factor cost.
•Factor cost is the value of a good or service measured by adding
together the costs of all the factors of production used to produce
it.
•If the only economic transactions were between households and
firms if there were no government taxes or subsidies the
market price and factor cost values would be the same.
•A component of aggregate expenditure is gross investment. So
when we total all the expenditure on final goods and services, we
arrive at a number that includes depreciation, a gross measure.
•A component of aggregate factor incomes is the net profit of
business. So when we total all the factor incomes, we arrive at a
number that excludes depreciation, a net measure.
•But indirect taxes and subsidies make these two method of
valuation differ.
•An indirect tax is a tax paid by consumers when they buy goods
and services. (Direct tax is a tax on income.)
•Because of indirect taxes, consumers pay more for some goods and
services than producers receive.
ŁThe market price is greater than the factor cost.
•To reconcile the factor incomes and expenditure approaches we
must add depreciation to net domestic product.
Valuing the Output of Industries
To measure the value of production of an individual industry, we must
be careful to count only the value added by that industry.
•A subsidy is a payment by the government to a producer.
•Because of subsides, consumers pay less for some goods and
services than producers receive.
ŁThe market price is less than the factor cost.
To use the factor incomes approach to measure GDP, we must add
indirect taxes to total factor incomes and subtract subsidies. This
adjustment gets us closer to GDP, but it does not quite get us
there. One more adjustment is needed:
15
•Value added is the value of a firms production minus the value of
the intermediate goods bought from other firms. (i.e. it is the sum of
the incomes including profits, paid to the factors of production used by
the firm to produce its output.)
•A consumers expenditure on an item is equal to the sum of the
value added at each stage in its production.
16
Final Goods and Intermediate Goods
•The price level is the average level of prices measured by a price
index.
•To construct a price index we take a basket of goods and services
and calculate its value in the current period and its value in a base
period.
•To value output, we count only value added because the sum of the
value added at each stage of production equals expenditure on the
final good.
ŁBy using value added we avoid double counting.
[ ∑Pit / ∑Pi0 ] * 100
Aggregate Expenditure, Income and GDP
•You have seen that aggregate expenditure equals aggregate
income.
•And you have seen that Stats Canada uses both aggregate
expenditure and aggregate income to measure GDP.
•Pit represents the price of the ith item in year t.
•Pi0 represents the price of the ith item in the base year.
•The price index is the value of the basket in the current period
expressed as a percentage or the value of the same basket in the
base period.
Why does it use both approaches when they are supposed to
be the same?
The two main price indices that are used to measure the price level
in Canada are:
k
k
ŁAlthough the two concepts of value of aggregate production are
identical, the actual measurements, give slightly different answers.
The Consumer Price Index
The GDP Deflator
The Consumer Price Index
¸⁄The expenditure approach uses data from surveys of retail sales,
house building, and business investment, the accounts of the
federal, provincial, and local governments, customs records and
other sources.
•The Consumer Price Index (CPI) measures the average level of
prices of the goods and services that a typical urban Canadian
family consume.
kThe factor incomes approach uses data supplied by Revenue
•
Measures changes over time in the price of a bundle of
consumption goods and services in Canada.
•
Only based on price changes in cities over 30,000 people, so
not fully representative.
Canada.
None of these sources gives a complete coverage of all the items
that make up aggregate expenditure and aggregate income.
Stats Canada can check one aggregate against the other.
• Based on the Laspeyres formula: a weighted aggregative index,
The Price Level and Inflation
17
18
•To construct the CPI, Statistics Canada first selects a base year
(1986).
with base-period quantities as the weights; or equivalently, a
weighted average of price relatives, with base-period expenditures
as the weights.
• Not just one index: an index for each of seven major consumption
groups, such as food, footwear, transportation, etc.. These are then
combined, in a weighted-average manner, into the all-groups index.
• Then during the base period, it surveys consumer spending to
determine the typical or average basket of goods and services that
people buy in the base period.
• The CPI is calculated by valuing the basket of goods and services at
the current months prices. The value is expressed as a percentage
of the value of the same basket in the base period.:
• In each case, there are provincial and local city indices. For
example, a food price index for Victoria.
• The indices are published monthly. In general, prices are surveyed
across the country, and at several sites in each city, every month.
In some cases they are surveyed more frequently (e.g., food), and
in some case less frequently (e.g., haircuts).
CPI =[(Current periods value of the basket) / (Base periods value of the basket)] *100
• To calculate the price index for the current period, we need only to
discover the prices of the goods in the basket in the current period.
We do not need to know the quantities bought. (Uses base period
quantities as weights).
• The CPI does not measure changes in the true "cost of living"
• The current index has a base value of 100, averaged over the
1986 calendar year, but the weights that are used are based on
household survey data in 1992.
• The weights get out of date over time, as a Laspeyres formula is
being used. Thus, there is a need to revise the weights
periodically. Traditionally, this was done every four years in
Canada. In recent times, it has been done less frequently than
this.
•
Unless the weights are revised, and the index re-based, changes in
the CPI will not be representative of changes in individual prices
in terms of their importance to consumers.
Text:
19
20
The GDP Deflator
Substitution Bias:
•The GDP deflator measures the average level of prices of all the
goods and services that are included in GDP.
•A change in the CPI measures the percentage change in the price
of a fixed basket of goods and services.
•But changes in relative prices lead consumers to seek less costly
items.
•Substitution of cheaper items for more costly items is not picked
up by the CPI.
•Because consumers make such substitutions, a price index based
on fixed basket overstates the effects of a given price change on
the inflation rate.
¸To calculate the GDP deflator, we use the formula:
GDP =[(Nominal GDP)/(Real GDP)] * 100
•Nominal GDP is GDP valued in the current years prices .
•It is the dollar value of GDP.
•Real GDP is GDP valued in the prices of the base year.
•Currently, the base year for the GDP deflator is 1986.
New Goods Bias:
What the Inflation Numbers Mean
•New goods keep replacing old goods.
•Because some new goods are more expensive than old goods, the
arrival of these new goods puts an upward bias into the estimate of
the price level.
•A major purpose of the CPI and GDP deflator is to measure
inflation.
Quality Change Bias:
•Despite the importance of getting the numbers right, the CPI and
the GDP deflator give different views of the inflation rate, and
neither index is a perfect measure.
•Most goods undergo constant quality improvement.
•Improvements in quality often mean increases in price.
But such price increases are not inflation.
Both measure overstate the inflation rate.
The main sources of bias are:
< Substitution bias.
< New Goods bias.
< Quality change bias.
21
22
How Real GDP Is Used
•An enormous amount of production takes place in our home, but it
does not involve market transactions and is not counted as part of
GDP.
•Household production has become much more capital intensive
over the years. As a result, less labour is used in household
production than in earlier periods.
•Because we use less labour and more capital in household
production, it is not easy to work out whether household
production has increased or decreased over time.
Estimates of real GDP and the real GDP growth rate are used for may
purposes. But the two main uses are to:
•
•
Make international comparisons of GDP
Assess changes in economic welfare over time
International Comparisons of GDP
•To make international comparisons, the real GDP of one country
must be converted into the same currency as the real GDP of the
other country.
3) The Underground Economy:
Economic Welfare
Economic welfare is a comprehensive measure of the general state of
well-being. Improvements in economic welfare depend on the growth
of real GDP. But, they also depend on many other factors not
measured by GDP.
The Underground Economy is part of the economy that is purposely
hidden from the view of the government so as to avoid taxes and
regulations or because the goods and services being produced are
illegal.
•Because underground economic activity is unreported, it is
omitted from GDP.
4) Health and Life Expectancy:
Ø
Some of the factors are:
•Good health and long life do not show up in real GDP. A higher
real GDP does enable us to spend more on medical research, health
care, healthy food and exercise equipment. As real GDP increased,
life expectancy increased.
-But we face new health and life expectancy problems every year.
•When we take these negative influences into account, we see that
real GDP growth overstates the improvements in economic
welfare.
1) Quality Improvements:
The price indices that we use to measure inflation give a
downward-biased estimate of the growth rate of real GDP. So
what is really an increase in production is counted as an increase in
price rather than an increase in real GDP The increase in real GDP
is deflated away by the incorrectly measured higher price level.
5) Leisure Time: o
2) Household Production: H
23
b
24
•Leisure time is an economic good that adds to our economic
welfare. OTRS, the more leisure we have, the better off we are.
•Our time spent working is valued as part of GDP, but our leisure
time is not.
•The improvements in economic well-being are not reflected in
GDP, so real GDP growth understates the improvement in
economic welfare.
6) The Environment:
N
Resources used to protect the environment are valued as part of GDP.
•But if we did not include these resources to protect the
environment and instead polluted the atmosphere, we would not
count the deteriorating air that we were breathing as a negative part
of GDP.
7) Political Freedom and Social Justice: Z
A country might have a very large real GDP per person but have
limited political freedom and equity.
•Such an economy would generally be regarded as having less
economic welfare than one that had the same amount of real GDP
but in which political freedoms were enjoyed by everyone.
8) The Net Outcome:
•The influences omitted from real GDP are probably important and
could be large.
•The measurement error could overstate the rate of economic
growth and the improvement in economic welfare.
25