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6 Measuring Domestic Output and National Income 6-1 Copyright 2008 The McGraw-Hill Companies Learning objectives • In this chapter you will learn: A. How gross domestic product (GDP) is defined and measured. B. The relationships between GDP, net domestic product, national income, personal income, and disposable income. C. The nature and function of a GDP price index. D. The difference between nominal GDP and real GDP. E. Some limitations of the GDP measure. 6-2 Copyright 2008 The McGraw-Hill Companies Assessing the Economy’s Performance • National income accounting measures the economy’s performance by measuring the flows of income and expenditures over a period of time. 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) 6-3 Copyright 2008 The McGraw-Hill Companies Gross Domestic Product GDP is the monetary measure of the total market value of all final goods and services produced within a country in one year. Note GDP is a monetary measure i.e., GDP=Quantities of goods and sericves x prices 1. Money valuation allows the summing of apples and oranges; money acts as the common denominator. (See Table 6.1.) 2. GDP includes only final products and services (goods and services purchased for final use, not for resale or reprocessing or manufacturing); it avoids double or multiple counting, by eliminating any intermediate goods used in production of these final goods or services. (Table 6.2 illustrates how including sales of intermediate goods would overstate GDP.) 3. GDP is the value of what has been produced in the economy over the year, not what was actually sold. 6-4 Copyright 2008 The McGraw-Hill Companies Example Suit production stages of production firm A: sheep ranch firm B: wool processor firm C: suit manufacturer firm D: Clothing wholesaler firm E: Retail Clothier Total Sales value Value Added sales value of materials or product 0 120 180 220 270 350 1140 Value added 120 (=120-0) 60 (=180-120) 40 (=220-180) 50 (=270-220) 80 (=350-270) 350 Two ways to calculate GDP 6-5 Copyright 2008 The McGraw-Hill Companies GDP Excludes Non-production Transactions GDP is designed to measure what is produced or created over the current time period. 1. Existing assets or property that are sold or transferred, including used items, are not counted. 2. Purely financial transactions are excluded. a. Public transfer payments, like social security or cash welfare benefits. b. Private transfer payments, like student allowances or alimony payments. c. The sale of stocks and bonds represent a transfer of existing assets. (However, the brokers’ fees are included for services rendered.) 3. 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.) 6-6 Copyright 2008 The McGraw-Hill Companies Two Ways to Look at GDP: Spending and Income. What is spent on a product is income to those who helped to produce and sell it. This is an important identity and the foundation of the national accounting process. Expenditures Approach (See Figure 6.1 and Table 6.3) • GDP is divided into the categories of buyers in the market; household consumers, businesses, government, and foreign buyers. 1. Personal Consumption Expenditures (C) includes durable goods (lasting 3 years or more), nondurable goods and services. 2. a. b. c. Gross Private Domestic Investment-(Ig) All final purchases of machinery, equipment, and tools by businesses. All construction (including residential). Changes in business inventory (±). i. ii. 6-7 If total output exceeds current sales, inventories build up. If businesses are able to sell more than they currently produce, this entry will be a negative number. Copyright 2008 The McGraw-Hill Companies Non-investment transactions – despite how the term “investment” is used by the general public, investment does not include transfers of ownership of paper assets (stocks and bonds) or real assets (houses, jewelry, art). Only newly created capital is counted as investment. Net Private Domestic Investment -(In). i. Each year as current output is being produced, existing capital equipment is wearing out and buildings are deteriorating; this is called depreciation or consumption of fixed capital. ii. Gross Investment minus depreciation (consumption of fixed capital) is called net investment. iii. If more new structures and capital equipment are produced in a given year than what are used up, the productive capacity of the economy will expand. (Figure 6.2) iv. When gross investment and depreciation are equal, a nation’s productive capacity is static. v. When gross investment is less than depreciation, an economy’s production capacity declines. 6-8 Copyright 2008 The McGraw-Hill Companies 3. • • • 4. a. b. c. • Government Purchases (of consumption goods and capital goods) – (G) Includes spending by all levels of government (federal, state and local). Includes all direct purchases of resources (labor in particular). This entry excludes transfer payments since these outlays do not reflect current production. Net Exports-(Xn) All spending on final goods produced in Kuwait must be included in GDP, whether the purchase is made here or abroad. Often goods purchased and measured in Kuwait are produced elsewhere (Imports). Therefore, net exports, (Xn) is the difference: (exports minus imports) and can be either a positive or negative number depending on which is the larger amount. Summary: GDP = C + Ig + G + Xn 6-9 Copyright 2008 The McGraw-Hill Companies Expenditure Approach 1. Personal Consumption Expenditures • Durable Consumer Goods • Nondurable Consumer Goods • Consumer Expenditures for Services 2. Gross Private Domestic Investment • Machinery, Equipment, and Tools • All Construction • Changes in Inventories 6-10 Copyright 2008 The McGraw-Hill Companies C Ig Expenditure Approach G 3. Government Purchases • Expenditures for Goods and Services • Expenditures for Social Capital 4. Net Exports Xn = Exports (X) – Imports (M) Xn Putting It All Together: GDP = C + I + G + Xn GDP= $8,746 + 2,105 + 2,363 - 727 = $12,487 in 2005 6-11 Copyright 2008 The McGraw-Hill Companies Income Approach to GDP (See Table 6.3): Demonstrates how the expenditures on final products are allocated to resource suppliers. 1. Compensation of employees includes: • wages, • salaries, • fringe benefits, • supplements, • and payments made on behalf of workers like social security and other health and pension plans. 2. Rents: payments for supplying property resources (adjusted for depreciation it is net rent). 3. Interest: payments from private business to suppliers of money capital. 6-12 Copyright 2008 The McGraw-Hill Companies 4. Proprietors’ income: income of incorporated businesses, sole proprietorships, partnerships, and cooperatives. 5. Corporate profits, include: • corporate income taxes paid to government, • dividends distributed to the shareholders, • the remainder is left as undistributed corporate profits (also referred to as retained earnings). 6. Taxes on production and imports: general sales taxes, excise taxes, business property taxes, license fees, and customs duties. • The sum of the above entries equals national income: all income earned by Kuwaiti supplied resources, whether here or abroad, plus taxes on production and imports. 6-13 Copyright 2008 The McGraw-Hill Companies • Adjustments required to balance both sides of the account: a. Net foreign factor income: National income measures the income of Kuwaitis both here and abroad. GDP measures the output of the geographical Kuwait regardless of the nationality of the contributors. 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. (Without this adjustment you have GNP.) b. Statistical discrepancy: NIPA accountants add a statistical discrepancy to national income to equalize the income and expenditures approaches ($43 billion in USA in 2005). c. Depreciation/Consumption of Fixed Capital: The firm also regards the decline of its capital stock as a cost of production. The depreciation allowance is set aside to replace the machinery and equipment used up. In addition to the depreciation of private capital, public capital (government buildings, port facilities, etc.), must be included in this entry. 6-14 Copyright 2008 The McGraw-Hill Companies GDP Approaches Compared Accounting Statement for the U.S. Economy, 2005 in Billions Receipts Expenditures Approach Allocations Income Approach Personal Consumption (C) $ 8746 Compensation Gross Private Domestic Rents $ 7125 73 Investment (Ig) 2105 Interest 498 Government Purchases (G) 2363 Proprietor’s Income 939 Net Exports (Xn) -727 Corporate Profits Taxes on Production and 1352 917 Imports National Income Net Foreign Factor Income Statistical Discrepancy $10,904 -34 43 Consumption of Fixed Capital Gross Domestic Product $ 12,487 Gross Domestic Product 6-15 Copyright 2008 The McGraw-Hill Companies 1574 $ 12,487 Comparative GDPs GLOBAL PERSPECTIVE Select Nations GDPs - 2005 GDP in Trillions of Dollars 0 United States Japan Germany China United Kingdom France Italy Spain Canada Brazil Korea, Rep. India Mexico Russian Fed. Australia 1 2 3 4 5 6 7 8 9 10 12 $12.4 $4.5 $2.8 $2.2 $2.2 $2.1 $1.7 $1.1 $1.1 $.79 $.79 $.78 $.77 $.76 $.70 Source: World Bank 6-16 Copyright 2008 The McGraw-Hill Companies Two Approaches to GDP Expenditure Approach Income Approach Consumption by Households Wages Investment by Businesses Rents + + Government Purchases + Expenditures By Foreigners 6-17 Copyright 2008 The McGraw-Hill Companies G = D= P + + + + Interest Profits Statistical Adjustments IV. 1. 2. 3. 4. Other National Accounts (see Table 6.4) Net domestic product (NDP) is equal to GDP minus depreciation allowance (consumption of fixed capital). National income (NI) is income earned by American-owned resources here or abroad. Adjust NDP by adding net foreign factor income. (Note: This may be a negative number if foreigners earned more in Kuwait than Kuwaiti resources earned abroad.) Personal income (PI) is income received by households. To calculate PI, take NI minus taxes on production and imports, minus payroll taxes (social security contributions), minus corporate profits taxes, minus undistributed corporate profits, and add transfer payments. Disposable income (DI) is personal income less personal taxes. 6-18 Copyright 2008 The McGraw-Hill Companies The Income Approach • From National Income to GDP: add the following items to NI: – Net Foreign Factor Income – Statistical Discrepancy – Consumption of Fixed Capital • Other National Accounts – Net Domestic Product (NDP) • Subtract consumption of fixed capital from GDP – National Income (NI). Subtract the following from NDP: • Statistical discrepancy • Net foreign factor income – Personal Income (PI) subtract the following 4 items and add the 5th item • • • • • Taxes on Production and Imports Social Security Contributions Corporate Income Taxes Undistributed Corporate Profits Transfer Payments – Disposable Income (DI) • subtract personal tax – Note that DI = C (consumption) + S (saving) 6-19 Copyright 2008 The McGraw-Hill Companies W 6.1 The Income Approach Income Relationships – United States, 2005 Gross Domestic Product (GDP) Consumption of Fixed Capital Net Domestic Profit (NDP) - Statistical Discrepancy - Net Foreign Factor Income (-(-34)) National Income (NI) 1. Taxes on Production and Imports 2. Social Security Contributions 3. Corporate Income Taxes 4. Undistributed Corporate Profits 5. Transfer Payments Personal Income (PI) Personal Taxes Disposable Income (DI) 6-20 Copyright 2008 The McGraw-Hill Companies $ 12,487 -1,574 $ 10,913 -43 34 $ 10,904 -917 -871 -378 -460 +1,970 $ 10,248 -1,210 $ 9,038 V. Circular Flow Revisited (see Figure 6.3) A. Compare to the simpler model presented in earlier chapters. Now both government and foreign trade sectors are added. B. Note that the inside covers of the text contain a useful historical summary of national income accounts and related statistics. 6-21 Copyright 2008 The McGraw-Hill Companies Circular Flow Revisited 6-22 Copyright 2008 The McGraw-Hill Companies 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. 6-23 Copyright 2008 The McGraw-Hill Companies • • • Unadjusted (nominal) GDP: is based on current year prices Adjusted (nominal) GDP: is based on base year prices To overcome the 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. 6-24 Copyright 2008 The McGraw-Hill Companies NOMINAL GDP vs. REAL GDP: GDP Output of Pizza (4) (5) (3) (2) (1) Adjusted, Base year Units of Price of Price Index Unadjusted, 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 - =(20/10)*100 $ 50 70 80 =(140/20)*100 Or =Q*base year price 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 6-25 Copyright 2008 The McGraw-Hill Companies • Adjustment Process: • First Method: GDP Price Index: 1. first determine a price index, 2. 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. 6-26 Copyright 2008 The McGraw-Hill Companies 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 6-27 Copyright 2008 The McGraw-Hill Companies VII. Shortcomings of GDP • GDP doesn’t measure some very useful output because it is unpaid (homemakers’ services, parental child care, volunteer efforts, home improvement projects), these are non-market transactions. GDP doesn’t measure improved living conditions as a result of more leisure. GDP does not measure improvements in product quality or make allowances for increased leisure time. 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. 6-28 Copyright 2008 The McGraw-Hill Companies • GDP and the environment. 1. The harmful effects of pollution are not deducted from GDP (oil spills, increased incidence of cancer, destruction of habitat for wildlife, the loss of a clear unobstructed view). 2. GDP does include payments made for cleaning up the oil spills, and the cost of health care for the cancer victim. • 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 product is a semiautomatic rifle or a jar of baby food. – Per capita GDP may give some hint as to the relative standard of living in the economy; but GDP figures do not provide information about how the income is distributed. • Noneconomic Sources of Well-Being like courtesy, crime reduction, etc., are not covered in GDP. 6-29 Copyright 2008 The McGraw-Hill Companies Shortcomings of GDP GLOBAL PERSPECTIVE Underground Economy as a Percentage of GDP - Select Nations Percentage of GDP 0 Greece Italy Spain Portugal Belgium Sweden Germany France Holland United Kingdom Japan United States Switzerland 6-30 Copyright 2008 The McGraw-Hill Companies 5 10 15 20 25 30 Source: Journal of Economic Literature VIII. LAST WORD: Magical Mystery Tour • • • • • • • • GDP is compiled by the Bureau of Economic Analysis (BEA) in U.S. Commerce Department. Where does it get its data? Explanation follows. Consumption data comes from: Census Bureau’s “Retain Trade Survey” from sample of 22,000 firms. Census Bureau’s “Survey of Manufacturers,” which gets information on consumer goods shipments from 50,000 firms. Census Bureau’s “Service Survey” of 30,000 service businesses. Industry trade sources like auto and aircraft sales. Investment data comes from: All the consumption sources listed above. 6-31 Copyright 2008 The McGraw-Hill Companies • Census construction surveys. • Government purchase data is obtained from: • U.S. Office of Personnel Management, which collects data on wages and benefits. • Census construction surveys of public projects. • Census Bureau’s “Survey of Government Finance.” • Net export information comes from: • U.S. Customs Service data on exports and imports. • BEA surveys on service exports and imports. 6-32 Copyright 2008 The McGraw-Hill Companies 6-33 Copyright 2008 The McGraw-Hill Companies