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7
C HAPTE R
Measuring Domestic Output,
and National Income
Assessing the Economy’s Performance
National income accounts enable us to:
A. Measure the economy’s overall performance by measuring
the flows of income and expenditures over a period of time
(Assess the health of the economy)
B. Track the long run course of the economy: growing,
declining, or constant (compare conditions over time and
across countries)
C. Provide a basis for appropriate public policies to improve
economic performance (improve the economy’s health)
D. Compare the relatives sizes of different economies
GROSS DOMESTIC PRODUCT
• The total market value of all final goods and services
produced within the national borders of a country in
a given year produced by residents (nationals or
foreigners) in the economy
Note:
• GDP is a monetary measure:
Quantities x prices
• Money valuation allows the summing of apples and
oranges; money acts as the common denominator
• GDP includes only final products (goods and services
purchased for final use, not for resale or reprocessing
or manufacturing) and services.
• Avoiding Multiple Counting: Most products are
bought and sold many times before they reach the
market. To avoid multiple counting, GDP includes
only the value of final goods and ignores
intermediate goods.
• Intermediate goods: goods purchased for resale or
further processing or manufacturing.
• GDP: is the value of what has been produced in the
economy over the year, not what was actually sold.
To avoid multiple counting
1. Only consider the value of final products. Or
2. Measure and cumulate the value added at
each stage of production
Value added = market value of the product – the
value of inputs (i.e. wages, rent, interest and
profits).
Example
Stages of production Sales value of Materials Value added
Sheep ranch
Wool processor
Suit manufacturer
Clothing wholesaler
Retail clothier
Value added
120
180
220
270
350
120 (120-0)
60 (180-120)
40 (220-180)
50 (270-220)
80 (350-270)
350
GDP Excludes Non-production Transactions
1- Purely financial transactions are excluded:
a. Public transfer payments, like social
security payments and welfare payments.
These contribute nothing to current
production in return.
b. Private transfer payments, like student
allowances or money given by parents to
children. They produce no output.
c. The sale of stocks and bonds represent a
transfer of existing assets (just swap of
papers).
2 - Secondhand sales are excluded; they do not
represent current output. (However, any
value added between purchase and resale is
included, e.g., used car dealers).
Two Ways to Look at GDP:
Spending and Income
•
Expenditures Approach:
GDP is divided into the categories of buyers in the
market; household consumers, businesses,
government, and foreign buyers.
•
Add up all the spending on final goods and services
took place throughout the year. These are:
1. Personal Consumption Expenditures (C):
On durable goods (goods lasting 3 years or more),
non-durable goods and services.
2. Gross Private Domestic Investment (Ig):
Includes:
a. All final purchases of machinery,
equipment, and tools by businesses.
b. All construction (including residential).
c. Changes in business inventory.
•
Positive and negative changes in inventories
A. If total output exceeds current sales, inventories
build up. When inventory increases, output
produced by the economy will be greater than what
purchased. We need to calculate unsold output
(inventory accumulation) as part of this year’s
GDP (add it).
B. If businesses are able to sell more than they
currently produce, changes in inventory will be a
negative number. when inventory decreases, output
produced will be less than what is purchased. Since
this inventory depletion had been counted in GDP
of previous years, we need to subtract it from this
year’s GDP.
•
Net Private Domestic Investment (In)
includes only investment in the form of
added capital. Each year as current output is
being produced, existing capital equipments
are wearing out and buildings are
deteriorating; this is called depreciation or
consumption of fixed capital.
Net investment = gross investment (consumption of fixed capital) depreciation
Note:
• If Gross investment > depreciation Positive
net investment. the productive capacity of the
economy will expand
• If Gross investment < depreciation 
Negative net investment (disinvestment). The
economy’s production capacity will decline.
• If Gross investment = depreciation  Net
investment equals zero. The nation’s
productive capacity will be static.
Expenditure Approach
-
Gross Investment
Depreciation
= Net Investment
Gross
Investment
Net
Investment
Depreciation
Increase
Stock of
Capital
January 1
Consumption
& Government
Spending
Year’s GDP
Stock of
Capital
December 31
24-
• Non-investment transactions.
- Transfer of paper assets (stocks and bonds)
- Transfer of tangible assets (e.g., houses)
• These transactions do not create new capital
Definition:
Investment is the creation of
new capital assets, that create
jobs and income.
3. Government Purchases (G):
They include two components:
a) Expenditures for goods and services that the
government consumes in providing public services
b) Expenditures on social capital such as schools or
highways.
Remember, This entry excludes government
transfer payments because they generate no
production of any sort.
4 - Net Exports (Xn):
All spending on final goods produced in Kuwait
must be included in GDP, whether the purchase is
made here or abroad.
These include spending on domestic output by
foreigners (Exports X). However, expenditures by
residents on foreign made goods (Imports M) must
be excluded (they appear in the foreign country’s
GDP).
Instead of adding exports and subtracting imports
we only add “net exports”
Xn = X - M
Now adding all things together
GDP = C + Ig + G + Xn(X-M)
The Income Approach to GDP
•
Demonstrates how the expenditures on final
products are allocated to resource suppliers.
Items that make up national income are:
1.
•
•
•
Compensation of employees includes:
wages,
salaries,
payments made on behalf of workers like
social security and other health and pension
plans.
2. Rents: payments to households and
businesses for supplying property resources
(if adjusted for depreciation it will be the net
rent).
3. Interest: payments from private businesses
to suppliers of money capital. It also
includes interest the households receive on
their savings deposits, CDs (certificates of
deposits), and corporate bonds
4. Profits:
A. Proprietors’ income: income of incorporated
businesses: sole proprietorships, partnerships,
and cooperatives.
B. Corporate profits: Are the earnings of owners of
corporations. After corporate income taxes(1)
are paid to government, dividends(2) are
distributed to the shareholders, and the
remainder is left as undistributed corporate
profits(3).
•
The sum of the above entries equals national
income: all income earned by Kuwaitisupplied resources, whether here or abroad
From National Income to GDP
National income is all income that flows to nationals,
whether resident in the country or abroad.
Adjustments required to balance expenditures and
income. To get GDP we have to add three items:
1- indirect business taxes:
These include general sales taxes, excise taxes,
business property taxes and customs duties. (the
seller treats these taxes as a cost of production, hence,
they are part of the market value of output, but not of
income).
2. Depreciation/Consumption of Fixed Capital:
The firm also regards the decline of its
capital stock as a cost of production. In
addition to the depreciation of private
capital, depreciation public capital
(government buildings, port facilities, etc.),
must be included in this entry.
•
This is a cost of production and should be
included in the gross value of output. Since
this does add to income it must be added to
national income to balance with the
economy’s expenditures
3. Net foreign factor income:
National income measures the income of
Kuwaitis both here and abroad. To make
this final adjustment, the income of foreign
nationals must be added and Kuwaiti
income earned abroad must be subtracted.
Sometimes this entry is a negative number.
OTHER NATIONAL ACCOUNTS (USA EXAMPLE)
U.S. GDP, NDP, NI, PI, & DI, 2002
•Gross Domestic Product (GDP)
Consumption of fixed capital
•Net Domestic Product (NDP)
Net foreign factor income earned
in the U.S.
Indirect business taxes
•National Income (NI)
Social security contributions
Corporate income taxes
Undistributed corporate profits
Transfer payments
•Personal Income (PI)
Personal Taxes
•Disposable Income (DI)
$10,446
-1,393
$9,053
- 10
- 695
$8,348
-748
-213
-141
+1,683
$8,929
-1,113
$7,816
GROSS DOMESTIC PRODUCT
Expenditures Approach
Consumption
by Households
Income Approach
Wages
+
Expenditures
+
Rents
+
Interest
+
Profits
+
Statistical
by Foreigners
Adjustments
+
Investment
G
by Businesses
=
=
D
+
Government
P
Purchases
U.S. Economy 2007
in Billions
Receipts
Expenditures Approach
Personal Consumption (C)
$ 9734
Gross Private Domestic
Allocations
Income Approach
Compensation
Rents
$ 7874
65
Investment (Ig)
2125
Interest
603
Government Purchases (G)
2690
Proprietor’s Income
1043
Net Exports (Xn)
-708
Corporate Profits
1627
Taxes on Production and
Imports
National Income
1009
$12,221
Net Foreign Factor Income (-)
96
Statistical Discrepancy (+)
29
Consumption of Fixed Capital
(+)
Gross Domestic Product
$ 13,841
Gross Domestic Product
1687
$ 13,841
29
Definitions:
A. Net domestic product (NDP) is equal to GDP
minus depreciation allowance (consumption
of fixed capital).
B. National income (NI) is income earned by
Kuwaiti-owned resources here or abroad.
Adjust NDP by subtracting indirect business
taxes and adding net Kuwaiti income earned
abroad. (Note: This may be a negative
number if foreigners earned more in Kuwait
than Kuwaiti resources earned abroad.)
C. Personal income (PI) is income received by
households. To calculate, take NI minus
payroll taxes (social security contributions),
minus corporate profits taxes, minus
undistributed corporate profits, and add
transfer payments.
D. Disposable income (DI) is personal income
less personal taxes.
Nominal versus Real GDP
•
Nominal GDP is the market value of all final
goods and services produced in a year. This
creates problems when we compare GDP
over time.
•
If GDP increases, this may be due to rises in
quantities or in prices or both. But it is only
the quantity of goods we produce that
affects our standards of living not the price.
• To measure changes in the quantity of output,
we need a yardstick that stays the same size.
• To make comparisons of real output, a K.D.
must keep the same purchasing power over
time.
• Unadjusted (nominal) GDP: is based on
current prices
•
To overcome this problem we deflate GDP
when prices rise, or inflate GDP when prices
fall. Adjusted (real) GDP is deflated or
inflated to reflect changes in prices.
Adjustment process in one product economy.
Valid comparisons cannot be made with
nominal GDP alone, since both prices and
quantities are subject to change. Some
methods to separate the two effects must be
devised.
Adjustment Process:
• First Method: GDP Price Index: first determine a price
index, then adjust the nominal GDP figures by dividing by
this price index
• Price index = (price of market basket in a specific year/
price of the same basket in base year) x 100.
• Real GDP = (Nominal GDP/Price index) x 100
Price Index: is a measure of the price of a specified collection
of goods and services called a “market basket” in a given
year (e.g. current year) compared to the price of an identical
collection of goods and services in a reference (base) year.
NOMINAL GDP vs. REAL GDP: GDP Output of Pizza
(4)
(5)
(3)
(2)
(1)
Adjusted,
Price Price Index Unadjusted,
Units of
or Nominal, Or Real,
Year 1 =
Pizza
Output
GDP,
GDP
100
Year Of Pizza Per Unit
(1)x(2)
1
2
3
4
5
5
7
8
10
11
$ 10
20
25
30
28
100
200
250
$ 50
140
200
$ 50
70
80
Note:
- The market basket is composed of pizzas only
- Year 1 is the base year
- Real GDP can be calculated by multiplying units of output by base
year prices
Adjustment Process:
An alternative method
• Multiply current quantities of goods and services by
prices of the base year to calculate real GDP
• Multiply current quantities of goods and services by
current year prices to calculate nominal GDP
• Calculate the price index (Multiply by 100 to put it in
standard index form) by:
Price index = (nominal GDP/real GDP) x 100
• Consumer Price Index
Reports the price of a market basket of some
consumer goods and services purchased by a
typical urban consumer
• CPI = (price of a market basket in any given year / price of
the same market basket in base year) x 100
SHORTCOMINGS OF GDP
• Non-market Transactions
GDP doesn’t measure some very useful
output because it is unpaid (homemakers’
services, parental child care, volunteer efforts,
home improvement projects), e.g., the services
of a carpenter who repairs his own home are
not included in GDP.
One exception: output that farmers consume
themselves is estimated and added.
• Improved Product Quality:
Over time product quality improves though
prices may be the same. Quality affects our
welfare. GDP doesn’t measure improvements
in product quality
• Leisure (GDP ignores leisure value):
We spend more leisure time. GDP doesn’t
measure improved living conditions as a
result of more leisure. This affects our
welfare, but this is not reflected in GDP.
•
Composition and Distribution of Output:
GDP makes no value adjustments for
changes in the composition of output or the
distribution of income.
Nominal GDP simply adds the dollar value
of what is produced; it makes no difference
if the products are guns or food.
GDP figures do not provide information
about how the income is distributed.
•
The Underground Economy:
Illegal activities are not counted in GDP (estimated to be
around 8% of U.S. GDP).
Legal economic activity may also be part of the
“underground,” usually in an effort to avoid taxation
•
GDP and the environment:
The harmful effects of pollution are not deducted from
GDP (e.g., oil spills, increased incidence of cancer,
destruction of habitat for wildlife, the loss of a clear
unobstructed view).
Note that GDP does include payments made for cleaning
up oil spills and the cost of health care for cancer victims.
•
Non-economic Sources of well-being like courtesy, crime
reduction, etc., are not covered in GDP.