Download LECTURE 2 Measuring Economic Activity

Measuring Economic Activity
The most comprehensive measure of economic activity is the gross domestic product (GDP).
It is the value of final goods and services produced in the economy within a year.
 Final goods and services – produced during the current period and not used in the
production of other goods and services
 Intermediate goods are goods, produced during the current period, but used in the
production of other goods and services during the same period.
If we include intermediate goods in the assessment of output, we will count one and the
same value several times. For example, bread is produced from flour, and flour is made
from wheat. The value of wheat is part of the value of flour and part of the value of bread.
The value of flour is part of the value of bread, as well.
Stages of the production process of 1/2 kilo of bread:
1. Wheat from the farmer – € 0.15
2. Flour from the miller – € 0.43
3. Bread from the backer – € 0.84
Total : 15 + 43 + 84 = €1.42
This total, however, counts the value of wheat three times and the value of flour twice. Hence,
we have a double counting problem. It can be avoided if we eliminate the value of
intermediate products and take into account only the contribution of every producer at each
stage of production – value added by every producer.
Value added
1. €0.15 - by the farmer
2. €0.28 – by the millet
3. €0.41 – by the backer
Total Value added = = 15 + 28 + 41 = 84
GDP could be calculated by putting together all value added in the economy, whish equals the
value of final goods and services. This approach to GDP calculation is the flow of product
approach. At the same time, these goods and services are part of GDP only because they are
sold to final buyers. Therefore, the money spent on purchases of final goods and services,
equals the sum of value added in the economy = GDP.
We come to the expenditure approach of calculating GDP.
Who spends in the economy? - Economic Agents – households, firms, and government. Here,
however, we have to take into account the expenditures made by foreigners, because we are
interested in a particular country’s GDP.
GDP = AE (aggregate expenditures) = C (expenditures of households on consumer goods and
services) + I (expenditures of firms on final investment goods and services) + G (expenditures
of government on final goods and services) + X (expenditures of foreigners on final local
consumer and investment goods and services) – M (expenditures of households, firms and
government on foreign final consumer and investment goods and services).
We have to subtract expenditures on foreign goods and services, since they are part of
someone else’s GDP.
It is important to know, that G does not include transfer payments (that are not made in
exchange for goods and services supplied), because this money is spend by the people, who
have received it and, thus, it has been already included in C or I.
Economic agents spend their money on GDP. They got this money in exchange for their
resources – labor, land, and capital. Therefore, income generated from labor, land and capital,
equals aggregate expenditures and GDP. We come to the third approach of calculating GDP –
the earnings, or cost approach. Since this income is earned by the owners of production
factors (resources) before taxes and redistribution, it is called primary income.
GDP = ∑ primary income = wages and salaries + proprietors’ income + interests from
productive use of capital + rents + dividends+ retained earnings + depreciation.
To summarize: GDP could be calculated according to the value-added (or the flow-ofproduct) approach, the expenditure approach, and the income (or the earnings) approach. The
value of GDP calculated should be the same. However, it is not. Why?
Expenditure vs. income approach
The expenditure approach to GDP calculation takes into consideration the market prices of
final goods and services. Market prices, however, include something that is spent but that is
no one’s income. This are the indirect taxes – like the value added tax – sellers include the tax
in the price, buyers pay higher prices, but do not get higher value. Sellers charge higher
prices, but they do not get higher income, because they pay the tax to the government.
Therefore, the expenditure approach will give a greater value for GDP. On the other hand,
government pays subsidies to some producers, in order to motivate them to produce more.
These subsidies are income for the producers, but they are not included in the prices of goods
and services and buyers do not pay this money. Therefore, the income approach will give a
greater value for GDP. The two approaches will fit if we subtract indirect taxes from
aggregate expenditures and add subsidies.
Primary income = aggregate expenditures – indirect taxes + subsidies.
This is why economists talk of GDP at market prices (GDP according to the expenditures
approach) and GDP at factor prices (according to the income approach).
GDP vs. GNP
GDP includes the value of all final goods and services, created in the country no matter by
whom. Many foreign citizens work in the domestic economy and they contribute to its GDP.
If we are interested in the value, created by national citizens, no matter where, we will get
gross national product (GNP).
GDP vs. NDP
GDP is gross because it includes all investment goods produced. Some of them, however are
produced just to replace the used up equipment. A better measure of the economic activity in
the country would not include the depreciation of investment goods. Thus, the accurate
measure of economic activity will be net domestic product (NDP). NDP = GDP –
depreciation. Since, however, depreciation allowances are made according to standards set by
government, it might not reflect the real depreciation of capital. This is why GDP is preferred
to NDP in national and international accounts.
From GDP to Disposable Income
The basic GDP accounts are of interest not only for themselves but also because of their
importance for understanding how consumers and businesses behave.
To help us understand the division of total income among the different factors of production,
we construct data on national income (NI). It represents the total incomes received by labor,
land and capital. Since depreciation reflects just the replacement of capital that is warn out,
national income = GDP – depreciation. Note, that GDP here should be taken at factor prices
(according to the income approach). Therefore, national income = net national product –
indirect taxes + subsidies.
The concept of national income was developed in economics when GNP was accepted as a
measure of economic activity. Today, GDP is preferred to GNP, and therefore the measure of
income is derived from GDP. This is why, European countries call it domestic income, and
not national income.
The measure of national (domestic) income does not tell anything about actual money that
household can dispose with. First, national income includes some income, which is not
personal and does not go to households. These are. If we subtract from NI retained earnings,
corporate taxes, and social security, and add transfer payments, we will get personal income.
Unfortunately, households cannot dispose of all personal income, because they have to pay
income taxes to the government. Thus, personal income - households’ income taxes =
disposable income (DI). DI is what actually gets into the hands of consumers to dispose of as
they please. DI is what people divide between consumption spending and personal saving.
GDP shortcomings
GDP is the best measure of economic activity and welfare. Nevertheless, it has a few
shortcomings as such a measure.
a) nominal vs. real GDP
GDP is the euro value of final goods and services. Therefore, if the euro value of final
goods and services has increased in 2007 as compared to this value in 2006, this does not
always mean, that GDP has really increased. It might just reflect the fact that prices have
risen. Economists overcome this problem with the concepts of nominal GDP and real
GDP.
Nominal GDP is the value of final goods and services, measures in current prices. For
GDP in 2007, these are the prices in 2007.
Nominal GDP2007 = quantity of good A2007 x price of good A2007 + quantity of good B2007
x price of good B2007 + ……
In order to eliminate the impact of inflation, we can take the prices from a previous
period, say 2006, and calculate real GDP.
Real GDP2007 = quantity of good A2007 x price of good A2006 + quantity of good B2007 x
price of good B2006 + ……
If real GDP = €100, but nominal GDP is €109, this means that prices have risen by 5%, or
that there is a 9% inflation.
Easy to calculate inflation, isn’t it? Unfortunately, nominal GDP is never €100. It is
usually a more complicated number like, for example €3578, while real GDP could be
€3265. How can we then calculate inflation? We take the data for real GDP to be 100:
€3265 = 100
€3578 = X
Then X = {(€3578 x 100) : €3765] x 100
X ≈ 109
X is therefore a measure of the inflation. It is GDP deflator.
GDP deflator = (nominal GDP : real GDP) x 100
Nominal GDP is measured in the current period prices, hence – GDP at current prices
Real GDP is measures in the previous (base) period prices, hence – GDP at base year
prices, or GDP at constant prices.
b) underground activities
GDP measures the value of goods and services that are produced for the market. There are
however many goods, whose value is not reported in the market and therefore, it is not
included in GDP. All economic activities that are not reported in GDP calculations, are
included in the underground economy. The underground economy has three parts:
-
goods and services, produced not for sale, like home made food
-
goods and services, whose value is not reported, or not fully reported in order to avoid
taxes
-
goods and services, that are not officially sold, because their production is abolished
by the government – like drugs
c) income per capita and income distribution
GDP is a measure of welfare. GDP of Brazil is greater than GDP of Luxemburg, but this
does not mean that people in Brazil have higher living standards, because what matters for
the living standards is GDP per capita.
On the other hand, GDP per capita presents the average income earned in the country. It
does not reflect income distribution.
d) leisure time
GDP of a country might have risen just because people have increase their work time at
the expense of their leisure, which could mean a reduction in the welfare.
e) demerit activities
GDP can increase due to the increase in the production and consumption of demerit goods
(like cigarettes) which might reduce the quality of life.
f) market prices
GDP is measured usually at market prices. There are, however a range of activities, that
do not have market prices (like education in government owned schools, the services
offered by the police, army, etc.). The value of these goods is reported at factor prices.
g) quantity vs. quality
GDP is a measure of the quantity of goods and services, but it does not reflect properly
changes in the quality of goods and services and the quality of life. It does not reflect the
changes in the environment. If GDP increases significantly at the expense of the pollution
of the environment, the quality of life might be reduced.
h) net exports
The increase in exports might not contribute to the growth of welfare in the country. On
the other hand, a faster increase in imports (negative net exports) might reflect and
increase in consumption and welfare, even though this means a lower GDP.