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How do we track our economy’s
booms and busts?
© 2013 Pearson
21
GDP: A Measure of Total
Production and Income
CHAPTER CHECKLIST
When you have completed your
study of this chapter, you will be able to
1 Define GDP and explain why the value of production,
income, and expenditure are the same for an economy.
2 Describe how economic statisticians measure GDP
and distinguish between nominal GDP and real GDP.
3 Describe the uses of real GDP and explain its limitations
as a measure of the standard of living.
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21.1 GDP, INCOME, AND EXPENDITURE
GDP Defined
Gross domestic product or GDP
The market value of all the final goods and services
produced within a country in a given time period.
Value Produced
• Use market prices to value production.
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21.1 GDP, INCOME, AND EXPENDITURE
What Produced
Final good or service is a good or service that is
produced for its final user and not as a component of
another good or service.
Intermediate good or service is a good or service
that is produced by one firm, bought by another firm,
and used as a component of a final good or service.
GDP includes only those items that are traded in
markets.
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21.1 GDP, INCOME, AND EXPENDITURE
Where Produced
• Within a country
When Produced
• During a given time period.
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21.1 GDP, INCOME, AND EXPENDITURE
Circular Flows in the U.S. Economy
Consumption expenditure is the expenditure by
households on consumption goods and services.
Investment is the purchase of new capital goods
(tools, instruments, machines, buildings, and other
constructions) and additions to inventories.
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21.1 GDP, INCOME, AND EXPENDITURE
Government expenditure on goods and services
is the expenditure by all levels of government on goods
and services.
Net exports of goods and services is the value of
exports of goods and services minus the value of
imports of goods and services.
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21.1 GDP, INCOME, AND EXPENDITURE
Exports of goods and services are the items that
firms in the United States produce and sell to the rest of
the world.
Imports of goods and services are the items that
households, firms, and governments in the United
States buy from the rest of the world.
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21.1 GDP, INCOME, AND EXPENDITURE
Total expenditure is the total amount received by
producers of final goods and services.
Consumption expenditure: C
Investment: I
Government expenditure on goods and services: G
Net exports: NX
Total expenditure = C + I + G + NX
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21.1 GDP, INCOME, AND EXPENDITURE
Income
• Labor earns wages.
• Capital earns interest.
• Land earns rent.
• Entrepreneurship earns profits.
Households receive these incomes.
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21.1 GDP, INCOME, AND EXPENDITURE
Expenditure Equals Income
Because firms pay out everything they receive as
incomes to the factors of production, total expenditure
equals total income.
That is:
Y = C + I + G + NX
The value of production equals income equals
expenditure.
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21.1 GDP, INCOME, AND EXPENDITURE
Figure 21.1
shows the
circular flow
of income
and
expenditure.
The table
shows the
U.S. data
for 2011.
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21.2 MEASURING U.S. GDP
The Expenditure Approach
Measures GDP by using data on consumption
expenditure, investment, government expenditure on
goods and services, and net exports.
Table 21.1 on the next slide shows the calculation for
2011.
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21.2 MEASURING U.S. GDP
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21.2 MEASURING U.S. GDP
Expenditures Not in GDP
Used Goods
Expenditure on used goods is not part of GDP because
these goods were part of GDP in the period in which
they were produced and during which time they were
new goods.
Financial Assets
When households buy financial assets such as bonds
and stocks, they are making loans, not buying goods
and services.
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21.2 MEASURING U.S. GDP
The Income Approach
Measures GDP by summing the incomes that firms pay
households for the factors of production they hire.
The U.S. National Income and Product Account divide
incomes into two big categories:
• Wage income
• Interest, rent, and profit income
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21.2 MEASURING U.S. GDP
Wage Income
Wage income, called compensation of employees in
the national accounts, is the payment for labor
services.
It includes net wages and salaries plus fringe
benefits paid by employers such health-care
insurance, Social Security contributions, and
pension fund contributions.
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21.2 MEASURING U.S. GDP
Interest, Rent, and Profit income
Interest, rent, and profit income, called net operating
surplus in the national account, is the sum of the
incomes earned by capital, land, and entrepreneurship.
Interest is the income households receive on loans they
make minus the interest they pay on their borrowing.
Rent includes payments for the use of land and other
rented inputs.
Profit includes the profits of corporations and small
businesses.
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21.2 MEASURING U.S. GDP
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21.2 MEASURING U.S. GDP
Net domestic product at factor cost is the sum of
wages, interest, rent, and profit.
Net domestic product at factor cost is not GDP.
We need to make two adjustments to arrive at GDP:
• One from factor cost to market prices
• One from net product to gross product
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21.2 MEASURING U.S. GDP
From Factor Cost to Market Price
The expenditure approach values goods at market
prices; the income approach values them at factor cost.
Indirect taxes (such as sales taxes) make market prices
exceed factor cost.
Subsidies (payments by government to firms) make
factor cost exceed market prices.
To convert the value at factor cost to the value at
market prices, we must:
• Add indirect taxes and subtract subsidies
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21.2 MEASURING U.S. GDP
From Net to Gross
The income approach measures net product.
The expenditure approach measures gross product.
Gross profit is a firm’s profit before subtracting the
depreciation of capital.
Net profit is a firm’s profit after subtracting the
depreciation of capital.
Depreciation is the decrease in the value of capital
that results from its use and from obsolescence.
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21.2 MEASURING U.S. GDP
Income includes net profit, so the income approach
gives a net measure.
Expenditure includes investment. Because some new
capital is purchased to replace depreciated capital, the
expenditure approach gives a gross measure.
To get gross domestic product from the income
approach, we must add depreciation to total income.
After making these two adjustments the income
approach almost gives the same estimate of GDP as
the expenditure approach.
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21.2 MEASURING U.S. GDP
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21.2 MEASURING U.S. GDP
Statistical Discrepancy
The income approach and the expenditure approach do
not deliver exactly the same estimate of GDP—there is
a statistical discrepancy.
Statistical discrepancy is the discrepancy between
the expenditure approach and income approach
estimates of GDP, calculated as the GDP expenditure
total minus the GDP income total.
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21.2 MEASURING U.S. GDP
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21.2 MEASURING U.S. GDP
GDP and Related Measures of Production
and Income
Gross national product or GNP is the market value
of all the final goods and services produced anywhere
in the world in a given time period by the factors of
production supplied by residents of the country.
U.S. GNP = U.S. GDP + Net factor income from abroad
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21.2 MEASURING U.S. GDP
Disposable Personal Income
Consumption expenditure is one of the largest
components of aggregate expenditure and one of the
main influences on it is disposable personal income.
Disposable personal income is the income received
by households minus personal income taxes paid.
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21.2 MEASURING U.S. GDP
Figure 21.2
shows the
relationship
between GDP,
GNP, and
disposable
personal income.
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21.2 MEASURING U.S. GDP
Real GDP and Nominal GDP
Real GDP is the value of the final goods and services
produced in a given year expressed in the prices of the
base year.
Nominal GDP is the value of the final goods and
services produced in a given year expressed in the
prices of that same year.
The method of calculating real GDP changed in recent
years. Here we describe the essence of the calculation.
The appendix gives the technical details.
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21.2 MEASURING U.S. GDP
Calculating Real GDP
The goal of calculating real GDP is to measure the
extent to which total production has increased.
Real GDP removes the influence of price changes from
the nominal GDP numbers.
To focus on the principles and keep the numbers easy
to work with, we’ll calculate real GDP for an economy
that produces only one consumption good, one capital
good, and one government service.
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21.2 MEASURING U.S. GDP
Table 21.3 shows the calculation with 2005 (base year)
and 2011.
To find the total expenditure in 2005 multiply the
quantity of each item produced in 2005 by its price in
2005.
Then sum the expenditures to find nominal GDP in
2005.
The next slide shows the data.
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Nominal
GDP in 2005
is $100
million.
Because
2005 is the
base year,
real GDP in
2005 is
also $100
million.
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21.2 MEASURING U.S. GDP
In part (b) of Table 21.3, we calculate nominal GDP in
2011.
Again, we calculate nominal GDP by multiplying the
quantity of each item produced by its price and then
sum the expenditures to find nominal GDP in 2011.
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Nominal
GDP in
2005 is
$100
million.
Nominal
GDP in
2011 is
$300
million.
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21.2 MEASURING U.S. GDP
Nominal GDP in 2005 is $100 million and in 2011 it is
$300 million.
Nominal GDP in 2011 is three times its value in 2005.
But by how much has the quantity of final goods and
services produced increased?
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21.2 MEASURING U.S. GDP
The increase in real GDP will tell by how much the
quantity of good and services has increased.
Real GDP in 2011 is what the total expenditure would
have been in 2011 if prices had remained the same as
they were in 2005.
To calculate real GDP in 2011 multiply the quantities
produced in 2011 by the price in 2005 and the sum
these expenditures to find real GDP in 2011.
Part (c) of Table 21.3 shows the details.
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Real GDP
in 2005 is
$100
million.
Real GDP
in 2011 is
$160
million—
only 1.6
times real
GDP in
2005.
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21.3 THE USE AND LIMITATIONS OF REAL GDP
We use estimates of real GDP for three main purposes:
• To compare the standard of living over time
• To track the course of the business cycle
• To compare the standard of living among countries
The Standard of Living Over Time
To compare living standards we calculate real GDP per
person—real GDP divided by the population.
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21.3 THE USE AND LIMITATIONS OF REAL GDP
In 2011, U.S. real GDP was $13,088 billion and the U.S.
population was 310.1 million.
Real GDP per person = $13,088 billion ÷ 310.1 million
Real GDP per person = $42,206.
In 1961, real GDP per person was $15,754.
The standard of living in 2011 was 2.7 times the
standard of living in 1961.
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21.3 THE USE AND LIMITATIONS OF REAL GDP
Two features of our changing standard of living are
1. The growth of potential GDP per person
2. Fluctuations of real GDP per person around potential
GDP
Potential GDP is the value of real GDP when all the
economy’s factors of production —labor, capital, land, and
entrepreneurial ability—are fully employed.
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21.3 THE USE AND LIMITATIONS OF REAL GDP
When some factors of production are unemployed, real GDP
is less than potential GDP.
When some factors of production are over-employed and
working hard, real GDP exceeds potential GDP.
In the short term, real GDP fluctuates around potential GDP.
To measure the trend in the standard of living, we remove
the influence of short-term fluctuations and focus on potential
GDP.
Figure 21.3 on next slide shows these two features.
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21.3 THE USE AND LIMITATIONS OF REAL GDP
Real GDP per
person grows and
fluctuates around
the path of
potential GDP.
Potential GDP
per person grew
at 2.8 percent in
the 1960s and
slowed during the
1970s.
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21.3 THE USE AND LIMITATIONS OF REAL GDP
Tracking the Course of the Business Cycle
Fluctuations in the pace of expansion of real GDP is
called the business cycle.
The business cycle is a periodic, but irregular, up- and
down-movement of total production and other measures
of economic activity.
The four stages of a business cycle are
expansion, peak, recession, and trough.
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21.3 THE USE AND LIMITATIONS OF REAL GDP
The shaded
periods show the
recessions—
periods of falling
production that
lasts for at least
six months.
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21.3 THE USE AND LIMITATIONS OF REAL GDP
Standard of Living Among Countries
To compare living standards across countries, we must
convert real GDP into a common currency and common
set of prices, called purchasing power parity.
Goods and Services Omitted from GDP
• Household production
• Underground production
• Leisure time
• Environment quality
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21.3 THE USE AND LIMITATIONS OF REAL GDP
Household Production
• Real GDP omits household production and it
underestimates the value of the production of
many people, most of them women.
Underground Production
• Economic activity hidden from government to avoid
taxes and regulations or production that is illegal.
• Because underground economic activity is
unreported, it is omitted from GDP.
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21.3 THE USE AND LIMITATIONS OF REAL GDP
Leisure Time
• Our working time is valued as part of GDP, but our
leisure time is not.
Environment Quality
• Pollution is not subtracted from GDP.
• We do not count the deteriorating atmosphere as a
negative part of GDP.
• If our standard of living is adversely affected by
pollution, our GDP measure does not show this
fact.
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21.3 THE USE AND LIMITATIONS OF REAL GDP
 Other Influences on the Standard of Living
Health and Life Expectancy
• Good health and a long life do not show up directly
in real GDP.
Political Freedom and Social Justice
• A country with a large real GDP per person might
have limited political freedom and social justice.
• A country with a lower standard of living might be
one in which everyone enjoys political freedom.
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How Do We Track the Booms and Busts of Our
Economy?
The National Bureau of Economic Research (NBER)
Business Cycle Dating Committee determines the dates of
U.S. business cycle turning points.
To identify the date of a business cycle peak, the NBER
committee looks at data on industrial production, total
employment, real GDP, and wholesale and retail sales.
The two most reliable measures of aggregate domestic
production are real GDP measured using the expenditure
approach and the income approach.
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How Do We Track the Booms and Busts of the
Our Economy?
The NBER committee met in November 2008 to determine
when the economy went into recession.
Because of a statistical discrepancy, the two estimates of
real GDP differ and for a few quarters in 2007 and 2008 they
told conflicting stories.
The NBER examined other data on real personal income,
real manufacturing, wholesale and retail sales, industrial
production, and employment.
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How Do We Track the Booms and Busts of Our
Economy?
All of these data peaked between November 2007 and June
2008.
The committee
decided that
November 2007
was the peak.
But as the figure
shows, real GDP
didn’t begin a
sustained fall until
two quarters later.
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APPENDIX: MEASURING REAL GDP
The Problem with Base-Year Prices
We calculated real GDP in 2011 using 2005 as the base
year and found that real GDP in 2011 was 1.6 percent
greater than in 2005—an increase of 60%.
But if we had used 2011 prices rather than 2005, real
GDP would have increased from $150 million (2011
dollars) in 2005 to $300 million in 2011—an increase of
100%.
So did real GDP increase by 60% or 100%?
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APPENDIX: MEASURING REAL GDP
The BEA method uses the prices of both years.
The three steps in the method are
• Value production in the prices of adjacent years.
• Find the average of the two percentage changes.
• Link (chain) to the base year.
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APPENDIX: MEASURING REAL GDP
Value Production in the Prices of Adjacent
Years
Let’s take as the two adjacent years 2012 and its
preceding year 2011.
Value the quantities produced in 2011 and 2012 at both
the prices of 2011 and the prices of 2012.
Table A21.1 shows the calculations.
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APPENDIX: MEASURING REAL GDP
The table gives
• Value of production in 2011 at 2011 prices is $145.
• Value of production in 2012 at 2011 prices is $160.
• Value of production in 2011 at 2012 prices is $158.
• Value of production in 2012 at 2012 prices is $172.
The next step is the find the percentage increases using
2011 prices and 2012 prices and then average these
two percentages.
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APPENDIX: MEASURING REAL GDP
Find the Average of Two Percentage Changes
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APPENDIX: MEASURING REAL GDP
Link (Chain) to the Base Year
Starting in the base year, apply the calculated average
percentage increase each year to obtain the chaineddollar real GDP.
Figure A21.1 illustrates the calculation with assumed
data. The base year is 2005. Suppose that in 2005, real
GDP is $60 million.
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APPENDIX: MEASURING REAL GDP
By applying the average percentage change between
each pair of years, we find the chained-dollar real GDP
for each year, expressed in terms of 2005 dollars.
We can do this for years after the base year, …
and for years earlier than the base year.
© 2013 Pearson