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Chapter 7
Taking the
Nation’s Pulse
Slides to Accompany “Economics: Public and Private Choice 9th ed.”
James Gwartney, Richard Stroup, and Russell Sobel
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1. GDP –
A Measure of Output
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GDP – A Measure of Output


Gross Domestic Product (GDP) is the market value
of final goods and services produced within a country
during a specific time period, usually a year.
What Counts Toward GDP?

Only Final Goods and Services Count:
Sales at intermediate stages of production are not
counted as their value is embodied within the final-user
good. Their inclusion would result in double counting.
Amount Added To the
Sales Receipts
Stage
of Production
Value of the product
at each stage
of production
(equals income created)
(1)
(2)
Stage 1: Farmer’s
wheat
$.30
$.30
Value added
by farmer
Stage 2: Miller’s
flour
Value added
by miller
$.65
$.35
Value added
by baker
Stage 3: Baker’s
bread
(wholesale)
$.90
$.25
Stage 4: Grocer’s
Value added
by grocer
bread
(retail)
$1
Total consumer expenditure = $1
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$.10
Total value added = $1
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GDP – A Measure of Output

What Counts Toward GDP? (cont.)




Financial transactions and income
transfers are excluded because they do not
involve production.
Only production within the geographic
borders of the country is counted.
Only goods produced during the current
period are counted.
Dollars -- The Common Denominator for GDP


Each good produced increases output by the
amount the purchaser pays for the good.
GDP is equal the sum of the total spending on
all goods and services produced during the year.
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Questions for Thought:
1. Indicate how each of the following activities will
affect this year’s GDP:
a.
b.
c.
d.
Sale of a used economics textbook to the college bookstore.
Smith’s $500 doctor bill for setting her son’s broken arm.
Family lawn services provided by Smith’s 16-year-old child.
Lawn services purchased by Smith from the neighbor’s
16-year-old child who has a lawn mowing business.
e. A $5,250 purchase of 100 shares of stock at $50 per share
plus the sales commission of $250.
f. A multi-billion dollar discovery of natural gas in Oklahoma.
g. A hurricane that causes $10 billion of damage in Florida.
h. $50,000 of income earned by an American college professor
teaching in England.
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2. Two Ways of
Measuring GDP
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Two Ways of Measuring GDP
Dollar Flow of
Expenditures
on Final Goods

= GDP =
Dollar Flow of
Income (and indirect cost)
of Final Goods
Deriving GDP by the Expenditure Approach:


GDP is the sum of expenditures on final user
goods and services purchased by households,
investors, governments, and foreigners.
There are four components of GDP:




personal consumption purchases,
gross private investment (including inventories),
government purchases (both consumptions and
investment), and,
net exports ( exports - imports )
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Two Ways of Measuring GDP

Deriving GDP by the
Resource Cost - Income Approach:


GDP is the sum of the costs incurred and income
(including profits) generated producing goods and
services during the period.
The direct cost income components of GDP are:
employee compensation,
 self-employment income,
 rents,
 interest, and,
 corporate profit.
Sum of these = National Income

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Two Ways of Measuring GDP

The Resource Cost - Income Approach: (cont).

Not all cost components of GDP result in an
income payment to a resource supplier. In order
to get to GDP, we need to account also for three
other factors:



Indirect business taxes:
Taxes that increase the business firm’s costs of
production and therefore the prices charged to
consumers.
Depreciation:
The cost of the wear and tear on the machines
and other capital assets used to produce goods
and services during the period.
Net Income of Foreigners
The income that foreigners earn producing
goods within the borders of a country minus the
income Americans earn abroad.
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Two Ways of Measuring GDP

When derived by Resource Cost - Income Approach
GDP is equal to:
 national income
(employee compensation, self-employment
income, rents, interest, corporate profit),



indirect business taxes,
depreciation, and,
the net income of foreigners.
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Two Ways of Measuring GDP
Expenditure Approach
Resource Cost-Income Approach
Personal Consumption
Expenditures
Aggregate Income:
Compensation of employees
(Wages and salaries)
Income of self-employed
Proprietors
Rents
Profits
Interest
+
Gross Private Domestic
Investment
+
Government Consumption and
Gross Investment
+
Net exports of goods and
Services
+
Non-Income Cost Items:
Indirect business taxes
Depreciation
=
GDP
+
Net Income of Foreigners
=
GDP

There are two methods of calculating GDP:


It can be calculated either by summing the expenditures on
the “final user” goods and services purchased by consumers,
investors, governments, and foreigners (net exports), or,
by summing the income payments and direct cost items that
accompany the production of goods and services.
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Relative Size of
U.S. GDP Components: 1996-1998
(a) Expenditure approach
(b) Resource cost-income approach a
Net exports
minus 1%
Rental income
less than 1%
Indirect
taxes
8%
Private
investment
14%
Government
19%
Net
interest
7%
Personal
consumption
68%
Depreciation
11%
Corporate
profits
7%
Compensation
to employees
60%
Self-employed
proprietor income 7%
a The net income of foreigners was negligible.
Source: Economic Report of the President, 1999.


The relative sizes of the major components of GDP usually
fluctuate within a fairly narrow range.
The average proportion of each U.S. component during
1996-1998 is demonstrated here for both
 The expenditure approach, and,
 The resource cost-income approach.
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3. Real and
Nominal GDP
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Real and Nominal GDP



The term "real" means adjusted for inflation.
Price indexes are use to adjust income and
output data for the effects of inflation.
A price index measures the cost of purchasing
a market basket (or “bundle”) of goods at a point
in time relative to the cost of purchasing the
identical market basket during an earlier
reference (or base) period.
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4. Two Key Price Indexes:
-- The Consumer Price Index
and the GDP Deflator
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Two Key Price Indexes:
-- The Consumer Price Index
and the GDP Deflator


Consumer Price Index (CPI):
-- measures the impact of price changes
on the cost of the typical bundle of goods
and services purchased by households.
GDP Deflator:
-- is a broader price index than the CPI.
It is designed to measure the change in
the average price of the market basket
of goods included in GDP.
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CPI & GDP Deflator: 1981-1997
Year
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
CPI
Inflation Rate
(1982 – 84 = 100)
GDP
Deflator
(Percent)
(1992 = 100)
90.9
96.5
99.6
103.9
107.6
109.6
113.6
118.3
124.0
130.7
136.2
140.3
144.5
148.2
152.4
156.9
160.5
163.0
10.3
6.2
3.2
4.3
3.6
1.9
3.6
4.1
4.8
5.4
4.2
3.0
3.0
2.6
2.8
3.0
2.3
1.5
66.1
70.2
73.2
75.9
78.6
80.6
83.1
86.1
89.7
93.6
97.3
100.0
102.6
105.1
107.5
109.6
111.6
112.7
Inflation Rate
(Percent)
10.0
6.2
4.1
3.7
3.6
2.5
3.1
3.6
4.2
4.3
4.0
2.8
2.6
2.4
2.3
1.9
1.9
1.0
Source: Economic Report of the President, 1999.

Even though the CPI and the GDP deflator are based on different
market baskets and procedures, the rate of inflation as measured by
each indicates that the differences between these two alternative
measures have been small, usually only a few tenths of a % point.
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5. Using the
GDP Deflator to
Derive Real GDP
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Using the GDP Deflator
to Derive Real GDP
GDP Deflator1
Real GDP2 = Nominal GDP2 *
GDP Deflator2

Data on both money GDP and price changes
are essential for meaningful output
comparisons between two time periods.
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Questions for Thought:
1. What do price indexes measure?
2. What is the difference between the consumer price
index (CPI) and the GDP deflator. Which would be
better to use if you want to measure whether your
hourly earnings this year were higher than they were
last year. Why?
3. Consider an economy with the following data:
Nominal GDP
(in Trillions)
1998
1999



$8.5
8.8
GDP deflator
120
125
What was GDP in 1999 in constant 1998 dollars?
What was the growth rate of real GDP between 1998
and 1999?
What was the inflation rate between 1998 and 1999?
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Using the GDP Deflator
to Derive Real GDP
NOMINAL GDP
(BILLIONS OF DOLLARS)
PRICE INDEX
(GDP DEFLATOR, 1992 = 100)
REAL GDP
(BILLIONS OF 1992 DOLLARS)
1992
$6,244
100.0
$6,244
1998
$8,511
112.7
$7,552
% Increase
36.3%
12.7%
20.9%
Source: U.S. Department of Commerce.


Between 1992 and 1998, nominal GDP increased
by 36.3 percent.
But when the 1998 GDP is deflated to account for
price increases, we see that real GDP increased by
only 20.9 percent.
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6. The Shortcomings
and Strength of GDP
as a Measuring Rod
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Shortcomings of GDP
as a Measuring Rod





It does not count non-market production.
It does not count the underground economy.
It makes no adjustment for leisure.
It probably understates output increases
because of the problem of estimating
improvements in the quality of products.
It does not adjust for harmful side effects.
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The Great
Contribution of GDP

In spite of its shortcomings, real GDP is a
reasonably accurate measure of short-term
fluctuations in output.
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7. Related
Income Measures
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Related Income Measures

Gross National Product (GNP):
Output produced by the "nationals"-- the citizens
of the country, regardless of whether that output is
produced domestically or abroad.

National income:
Total income earned by the nationals (citizens)
during a period. It is the sum of employee
compensation, self-employment income, rents,
interest, and corporate profits.


Personal income:
Total income received by domestic households and
non-corporate businesses. It is available for
consumption, saving, and payment of personal taxes.
Disposable income:
Income available to individuals after personal taxes.
It can either be spent on consumption or saved.
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5 Alternative Measures of Income
Net income of foreigners
Net exports
Depreciation
Indirect business
taxes minus net
income earned
abroad
Personal
taxes
Personal
consumer
expenditures
Minus
Employee
compensation
Corporate profits
& Social insurance
taxes
Plus
Transfer payments
net interest, and
dividends
Gross
Private
Domestic
Investment
Proprietors’
income
Interest
Government
consumption
& investment
Gross Domestic
Product
1998
($ billions)


$8,511
Rents
Corporate
profits
Gross National National Income
Product
$8,491
$6,995
Personal Income Disposable Income
$6,102
$5,307
The bars above illustrate the 5 alternative measures of national income.
The alternatives range from GDP (the broadest measure of output) to
Disposable Income (which indicates the funds available to households
for either consumption or saving).
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The Link Between
Output and Income


As the alternative ways of measuring of
GDP highlight, output and income are linked.
Increases in output are the source of higher
income levels.
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Questions for Thought:
1. Why might even real GDP be a misleading index of
changes in output between 1950 and 1999 in the
United States? Of differences in output between the
United States and Mexico?
2. GDP does not count productive services such as
child care, food preparation, cleaning, and laundry
provided within the household. Why are these
things excluded? Is GDP a sexist measure? Does it
understate the productive contributions of women
relative to men?
3. What are the components of GDP when it is derived
by the expenditure approach?
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End
Chapter 7
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