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Economics
THIRD EDITION
By John B. Taylor
Stanford University
Copyright © 2001 by Houghton
Mifflin Company. All rights reserved.
1
Chapter 18 (Macro 5)
Measuring the
Production, Income,
and Spending of
Nations
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2
Overview
This chapter introduces GDP and its
components from the perspective of
spending, income, and production. After a
brief introduction to price indexes, nominal
and real GDP are contrasted, and the
limitations of GDP accounting are
discussed. The chapter concludes with
international comparisons of GDP and the
role of exchange rates and purchasing
power parity in making these comparisons.
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Teaching Objectives
• 1. Define and introduce the three approaches to
determining GDP.
2. Discuss the relationship among saving,
investment, and net exports.
3. Distinguish between nominal and real GDP and
the role of price indexes.
4. Provide an introductory discussion of
international comparisons of GDP.
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1. Measuring GDP
• It is most commonly used measure of
economic activity.
• It indicates the dollar value of FINAL goods
and services PRODUCED within the
borders of the DOMESTIC economy during
a period (quarter or year)
• Intermediate goods are excluded to avoid
double counting.
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How to measure GDP?
There are three approaches to the
measurement of GDP:
• spending,
• income,
• and production.
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Spending Approach
• The spending approach divides GDP into
four areas: households (consumption),
businesses (investment), government, and
foreigners (net exports).
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Consumption (C)
• Consumption reflects the spending by
households or individuals for final goods
and services. The numbers are given in
Table 18.2, and the percentage of GDP
represented by consumption is given in
Figure 18.1.
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Figure 18.1
(Macro 5)
Consumption
as a Share of
GDP
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Investment (I)
• Investment reflects the spending of
businesses and includes fixed business
investment, inventory investment, and
residential investment. The numbers are
given in Table 18.2, and the percentage of
GDP represented by consumption and
investment is given in Figure 18.2.
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Figure 18.2
(Macro 5)
Investment and
Consumption as a
Share of GDP
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Government purchases (G)
• Government purchases of goods and services but
not transfer payments make up over $1 trillion of
GDP. Transfer payments are excluded because
they do not reflect current production. The
numbers are given in Table 18.3, and the
percentage of GDP represented by consumption,
investment, and government purchases is given in
Figure 18.3.
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Figure 18.3
(Macro 5)
Government
Purchases,
Investment, and
Consumption as a
Share of GDP
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Net exports (X)
• Net exports (exports and imports), or the
trade balance, is included to account for
imported consumption and investment items
and for items exported from the United
States that are not counted in the
consumption, investment, or government
spending parts of GDP.
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Expression for GDP
• The relation between GDP and its
spending components is the familiar
Y = C + I + G + X equation.
• What is the share of net exports, if the
share of C, I, and G are 68, 18, 18
percent, respectively?
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Figure 18.4
(Macro 5)
The Circular Flow of Income and Expenditure
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The income approach
• The income approach divides GDP
according to who receives the income from
the spending flow. In addition to aggregate
income, national income and personal
income are also used as measures of
income.
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Labor, Capital Income and Depreciation
• Labor income includes wages, salary, and fringe
benefits, as given in Table 18.3.
• Capital income (profits, rents, and interest
payments) is also given in Table 18.3.
• Depreciation is included as a reduction in the flow
of income to account for the wearing out of
capital, allowing for a distinction between gross
and net investment. Depreciation is used to get net
GDP.
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Taxes and Foreign Income
• Indirect business taxes are taxes that are included
in the selling price of the good or service and so
are removed as a part of income flow from the
production of GDP.
• Net income of foreigners balances out the net
effect of income earned in the United States by
citizens of other countries and income earned by
U.S. citizens abroad. The details are given in Table
20.3. Also included in this table is the statistical
discrepancy between income and spending that
occurs in data collection.
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2. Saving, Investment, and Net Exports
• National saving is defined as income minus
consumption minus government purchases,
or S = Y - C - G .
• In the absence of a change in net exports,
for a country to increase its investment, it
has to increase its saving: S = I + X .
• Saving varies over time for a variety of
reasons, including the age composition of
society.
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Government Dis(saving)
• The government saves or dissaves, as do
individuals, with a resulting budget surplus
or deficit. When the government dissaves,
households and businesses must save more
to obtain the same level of national saving.
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The production approach
• The production approach looks at GDP
from the standpoint of value added by each
input in the production process.
• The three approaches--spending, income,
and production– (should) result in
equivalent values for GDP.
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Figure 18.5 (Macro 5)
Value Added in Coffee: From Beans to Espresso
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3. Real GDP and Nominal GDP
• Since GDP is the dollar value of goods and
services measured in price units, as prices change,
GDP changes without any change in the
underlying production, income, or spending of an
economy. A method must be used to hold the
effect of price increases constant, particularly
when inflation is present to any degree.
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Real GDP
• The adjustment of nominal GDP for the
effects of changes in the price level, or
inflation, results in real GDP. Real GDP
then provides a basis of comparison of
changes in production between points in
time.
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Computing real GDP growth rate
• The text illustrates how real GDP growth is
computed between two years for two goods. First,
growth is computed using prices of the first year.
Then, growth is computed using prices of the
second year. An average of the two percentages is
then computed in order to state the increase in real
GDP between the two years.
• Economists do a series of two-year corrections
and chain them together to find the growth rate for
any number of years and any number of goods.
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Trends in GDP
• The behavior of nominal and real GDP is
portrayed in Figure 18.6, which uses a base
year of 1992.
• The difference between nominal and real
GDP in Figure 18.6 reflects inflation over
the last 15 years. The basic relation is GDP
deflator = nominal GDP/real GDP.
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Figure 18.6 (Macro 5)
Real GDP versus Nominal GDP
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CPI is used as another tool compute inflation
• The CPI provides an alternative price index and an
index based on a fixed quantity of consumption
goods. The chain weighted price index is based on
a changing quantity of goods and services and
includes investment and government as well as
consumption purchases. The GDP deflator and the
CPI are portrayed in Figure 18.7.
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Figure 18.7 (Macro 5)
Comparison of Measures of Inflation
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Stocks versus flow variables
• GDP, Income, and inflation rate are flow
variables
• Unemployment, Wealth, and Savings are
stock variables.
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Distinguishing Between Stocks and Flows
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4. Shortcomings of the GDP Measure
4a. Revisions in GDP occur periodically because
of the unevenness of data collection. Also,
changes in the base year occur at about 5-year
intervals.
4b. Omissions from GDP occur because of
difficulty in measurement or the absence of price
information on the good or service.
4b1. Home production is not included because
these activities are simply not reported. Market
values of these activities are in most cases
available but because no spending occurs, GDP
tends to understate the value of production.
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Shortcomings of the GDP Measure
4b.2 Leisure activity is similarly valuable, but no
attempt is made to account for it in GDP.
4b.3 The underground economy is estimated to be
about 10 percent of GDP in the United States and
even larger in other countries. Because it is
believed to be fairly constant over time, its
consequences for growth are probably minor.
4b.4 As products improve, GDP should reflect the
quality improvements. This has occurred in the
case of some but not all goods and services.
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Shortcomings of the GDP Measure
• 4c. It is important to understand that even a perfect
measure of GDP, although essential to the well-being of
individuals, is not a sole measure of other aspects of the
well-being of a society.
• 4c.1 Although vital statistics have improved along with
increases in real GDP per capita in the United States, there
remain serious areas of concern that are to some extent
related to the rise in real GDP. These include, for example,
increases in the death rates from AIDS, suicide, and
murder among young people.
• 4c.2 Similarly, although there have been improvements in
environmental quality, and these improvements account for
about $100 billion of GDP, the level of GDP is not itself an
indicator of environmental
quality.
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5. International Comparisons of GDP
• 5a. In any attempt to compare GDP between
countries, some account must be taken of
differences in prices. Adjustment for GDP based
on exchange rates makes some improvement in
the comparison of GDP figures. However, if we
wish to determine the value of GDP in another
country, some information on the price differences
of goods is needed.
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5. International Comparisons of GDP
• 5b. Purchasing power parity exchange rates
attempt to adjust exchange rates for
differences in the prices of goods across
borders through the use of a ratio of price
indexes. The exchange rate is adjusted to
reflect this ratio.
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5. International Comparisons of GDP
• 5c. Once this adjustment is made, international
rankings of countries based on GDP or per capita
GDP tend to fluctuate as exchange rates vary,
while the corresponding prices do not. Despite
their variability due to exchange rate fluctuations,
purchasing power parity exchange rates provide a
better basis for international comparisons than an
adjustment based solely on exchange rates.
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