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Chapter 6 Measure Domestic Output, National Income, and the price level Table 1. GCC Countries: Selected Economic Indicators, 2002 Nominal Central Nominal GDP Overall Total Bank Current GDP (Per Fiscal Government Proven Foreign Account Assets (Millions of capita Balance Gross Debt Oil Balance U.S. in U.S. Population (Percent (Percentof Reserves (Months of (Percent of dollars) dollars)1 (Millions)1 of GDP)2 GDP) (Years)3 Imports)4 GDP) Country Bahrain 8,506 Kuwait 33,215 Oman 20,290 Qatar 17,321 Saudi 188,960 Arabia U.A.E. 71,187 GCC 339,479 11,619 15,098 7,515 28,362 0.7 2.2 2.7 0.6 0.8 20.6 3.7 5.1 30.3 32.9 16.0 58.2 15.0 134.0 16.0 15.0 2.7 10.7 4.8 2.7 0.3 20.9 10.0 13.8 8,567 22.1 –5.3 93.8 85.0 12.9 4.7 19,613 11,9795 3.6 31.9 –9.3 –2.75 4.5 66.65 124.0 83.75 4.7 7.6 5.5 6.95 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) a. Track the long run course of the economy: growing, declining, or constant (compare conditions over time and across countries) b. Provide a basis for appropriate public policies to improve economic performance (improve the economy’s health) GROSS DOMESTIC PRODUCT • The total market value of all final goods and services produced within 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 Gross Domestic Product Measures Total Production Measuring Total Production: Gross Domestic Product Gross domestic product (GDP) The market value of all final goods and services produced in a country during a period of time, typically one year. GDP Is Measured Using Market Values, Not Quantities The word value is important in the definition of GDP. Gross Domestic Product Measures Total Production Measuring Total Production: Gross Domestic Product GDP Includes Only the Market Value of Final Goods Final good or service A good or service purchased by a final user. Intermediate good or service A good or service that is an input into another good or service, such as a tire on a truck. NOT ICLUDED IN GDP GDP Includes Only Current Production GDP includes only production that takes place during the indicated time period. Calculating GDP PRODUCTION AND PRICE STATISTICS FOR 2007 (1) PRODUCT (2) QUANTITY (3) PRICE PER UNIT 100 $50.00 Pizzas 80 10.00 Textbooks 20 100.00 2,000 0.10 Eye examinations Paper (1) QUANTITY (2) PRICE PER UNIT 100 $50 $5,000 Pizzas 80 10 800 Textbooks 20 100 2,000 PRODUCT Eye examinations (3) VALUE Gross Domestic Product Measures Total Production Production, Income, and the Circular Flow Diagram Gross Domestic Product Measures Total Production Components of GDP Personal Consumption Expenditures, or “Consumption” Consumption Spending by households on goods and services, not including spending on new houses. Gross Private Domestic Investment, or “Investment” Investment Spending by firms on new factories, office buildings, machinery, and additions to inventories, and spending by households on new houses. Don’t Let This Happen to YOU! Remember What Economists Mean by Investment Gross Domestic Product Measures Total Production Components of GDP Government Consumption and Gross Investment, or “Government Purchases” Government purchases Spending by federal, state, and local governments on goods and services. Transfer payments Payments by the government to individuals for which the government does not receive a new good or service in return. !!! NOT A PART OF GDP !!! Gross Domestic Product Measures Total Production Production, Income, and the Circular Flow Diagram Transfer payments Payments by the government to individuals for which the government does not receive a new good or service in return. !!! NOT A PART OF GDP !!! GDP Excludes Non-production Transactions These are: 1- Purely financial transactions are excluded: a. Public transfer payments, like social security payments, welfare payments, and veteran’s 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). Note: the brokers’ fees are included in GDP for services rendered. 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). 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. This is paid as wages, rent, interest and profits. 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 Gross Domestic Product Measures Total Production Components of GDP Net Exports of Goods and Services, or “Net Exports” Net exports Exports minus imports. An Equation for GDP and Some Actual Values Y C I G NX Gross Domestic Product Measures Total Production An Equation for GDP and Some Actual Values Kuwait GDP Sector Oil & Gas 2003 2004 2005 2006 5797.8 7822.0 12832.8 16214.9 Mining and Quarrying 17.0 22.5 32.4 41.3 Agriculture and Fishing 64.9 70.9 71.1 74.4 Manufacturing of which : 1127.0 1455.9 1712.9 1973.4 Refined Products Industry : 572.4 795.5 970.2 1159.2 Electricity, Gas and Water 299.4 306.9 319.1 336.6 Construction 349.3 401.9 437.1 479.3 Wholesale and Retail Trade 890.2 950.2 1017.8 1088.8 Restaurants and Hotels 174.2 170.5 168.0 Transport, Storage and Communications 799.9 1048.0 1230.7 1397.4 Financial Instituitions 1171.7 1496.5 2776.6 3813.4 Insurance 64.9 62.1 78.8 171.2 97.7 Real Estate 1062.0 1094.8 1208.4 1295.8 Business Services 186.6 Community, Social and Personal Services 2726.4 2950.0 3228.3 3478.7 GDP at Producer's Price 14731.3 18079.4 25356.3 30716.3 227.2 242.3 253.4 Imputed Bank & insurance Service Charges -612.9 -724.2 -1052.1 -1318.1 Imports Duties 161.5 GDP at Purchaser's Price Value 135.1 173.6 174.6 14253.5 17516.7 24477.8 29572.8 Real GDP versus Nominal GDP Calculating Real GDP Real GDP The value of final goods and services evaluated at base-year prices. Nominal GDP The value of final goods and services evaluated at current-year prices. Solved Problem 7-3 Calculating Real GDP 2000 PRODUCT QUANTITY PRICE 2009 Value QUANTITY PRICE Value Eye examinations 80 $40 3200 100 $50 5000 Pizzas 90 11 990 80 10 800 Textbooks 15 90 1350 20 100 2000 GDP 5540 PRODUCT Eye examinations 2009 QUANTITY 7800 2000 PRICE VALUE 100 $40 $4,000 Pizzas 80 11 880 Textbooks 20 90 1,800 Real GDP 6680 Real GDP versus Nominal GDP Comparing Real GDP and Nominal GDP FIGURE 7-3 Nominal GDP and Real GDP, 1990–2006 Real GDP versus Nominal GDP The GDP Deflator Price level A measure of the average prices of goods and services in the economy. GDP deflator A measure of the price level, calculated by dividing nominal GDP by real GDP and multiplying by 100. Nominal GDP GDP deflator 100 Real GDP Nominal GDP Real GDP 100 GDP deflator Real GDP versus Nominal GDP The GDP Deflator 2005 2006 NOMINAL GDP $12,456 billion $13,247 billion REAL GDP $11,049 billion $11,415 billion FORMULA APPLIED TO 2005 APPLIED TO 2006 GDP Nominal GDP 100 Deflator Real GDP $12,456 billion 100 113 $11,049 billion $13,247 billion 100 116 $11,415 billion 116 113 2.7% 113 GDP vs GDP per capita WHICH economy has enjoyed the best economic performance over the past five years: America's or Japan's? Most people will pick America. The popular perception is that America's vibrant economy was sprinting ahead. And it is true that America's average annual real GDP growth of 2.9% was much faster than Japan's 2.1%. However, the single best gauge of economic performance is not growth in GDP, but GDP per person, which is a rough guide to average living standards. It tells a completely different story. Source: “Grossly distorted picture” The Economist, March 13th, 2008. URL: http://www.economist.com/finance/displaystory.cfm?story_id=10852462 GDP vs GDP per capita Does GDP Measure What We Want It to Measure? Shortcomings in GDP as a Measure of Total Production Household Production Household production refers to goods and services people produce for themselves. The Underground Economy Underground economy Buying and selling of goods and services that is concealed from the government to avoid taxes or regulations or because the goods and services are illegal. Does GDP Measure What We Want It to Measure? Shortcomings of GDP as a Measure of Well-Being The Value of Leisure Is Not Included in GDP GDP Is Not Adjusted for Pollution or Other Negative Effects of Production GDP Is Not Adjusted for Changes in Crime and Other Social Problems GDP Measures the Size of the Pie but Not How the Pie Is Divided Up Gross Domestic Product Measures Total Production Measuring GDP by the Value-Added Method Value added The market value a firm adds to a product. Table 7-1 Calculating Value Added FIRM VALUE OF PRODUCT VALUE ADDED Cotton Farmer Value of raw cotton = $1 Value added by cotton farmer =1 Textile Mill Value of raw cotton woven into cotton fabric = $3 Value added by cotton textile mill = ($3 – $1) =2 Value of cotton fabric made into a shirt = $15 Value added by shirt manufacturer = ($15 –$3) = 12 Value of shirt for sale on L.L. Bean’s Web site = $35 Value added by L.L. Bean = ($35 – $15) = 20 Shirt Company L.L. Bean Total Value Added = $35 Other Measures of Total Production and Total Income The Division of Income FIGURE 7-5 The Division of Income An Inside LOOK Trucking Industry Depends on the Goods—Not Services—Component of GDP Economic Slowdown Slams Breaks on Trucking Sector As goods decline as a percentage of GDP, so does the demand for ground-freight transportation services. (The goods and services shares of GDP do not sum to 100 percent because GDP is composed of goods, services, and structures.) 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. • Non-investment transactions. 1. Transfer of paper assets (stocks and bonds) 2. 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 (of consumption goods and capital goods) – (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). They also include expenditures by residents on foreign made goods (Imports M). 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) GLOBAL PERSPECTIVE Comparative GDPs in Trillions, 2001 0 United States Japan Germany United Kingdom France China Italy Canada Mexico Spain Brazil India Korea, Rep. Netherlands Australia 1 2 3 4 5 6 7 8 9 10 Source: World Bank Kuwait’s GDP Sector Oil & Gas 2003 2004 2005 2006 5797.8 7822.0 12832.8 16214.9 Mining and Quarrying 17.0 22.5 32.4 41.3 Agriculture and Fishing 64.9 70.9 71.1 74.4 Manufacturing of which : 1127.0 1455.9 1712.9 1973.4 Refined Products Industry : 572.4 795.5 970.2 1159.2 Electricity, Gas and Water 299.4 306.9 319.1 336.6 Construction 349.3 401.9 437.1 479.3 Wholesale and Retail Trade 890.2 950.2 1017.8 1088.8 Restaurants and Hotels 174.2 170.5 168.0 Transport, Storage and Communications 799.9 1048.0 1230.7 1397.4 Financial Instituitions 1171.7 1496.5 2776.6 3813.4 Insurance 64.9 62.1 78.8 171.2 97.7 Real Estate 1062.0 1094.8 1208.4 1295.8 Business Services 186.6 Community, Social and Personal Services 2726.4 2950.0 3228.3 3478.7 GDP at Producer's Price 14731.3 18079.4 25356.3 30716.3 227.2 242.3 253.4 Imputed Bank & insurance Service Charges -612.9 -724.2 -1052.1 -1318.1 Imports Duties 161.5 GDP at Purchaser's Price Value 135.1 173.6 174.6 14253.5 17516.7 24477.8 29572.8 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 for supplying property resources (if adjusted for depreciation it will be the net rent). 3. Interest: payments from private business 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. A. Corporate profits: 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 Kuwaiti-supplied 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. 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 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 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. GLOBAL PERSPECTIVE The Underground Economy as a Percent of GDP Greece Italy Spain Portugal Belgium Sweden Germany France Holland United Kingdom Japan United States Switzerland 0 5 10 15 20 25 30 Source: The Journal of Economic Literature, 2000