Chapter 20 : The Measurement of National Income Copyright © 2017 Pearson Canada Inc.

Chapter Outline/Learning Objectives Section Learning Objectives After studying this chapter, you will be able to 20.1 National Output and Value Added 1. see how the concept of value added solves the problem of " double counting when measuring national income. 20.2 National Income Accounting: The Basics 2. explain the income approach and the expenditure approach to measuring national income. 20.3 National Income Accounting: Some Further Issues 3. explain the difference between real and nominal GDP and understand the GDP deflator. 4. discuss the many important omissions from official measures of GDP. 5. understand why real per capital GDP is a good measure of average material living standards but an incomplete measure of overall well - being. Copyright © 2017 Pearson Canada Inc.

20.1 National Output and Value Added Production occurs in stages. Some firms produce outputs that are used as inputs by other firms, and these firms, in turn, produce outputs that are used as inputs by yet other firms. The error that would arise in estimating the nation’s output by adding all sales of all firms is called double counting. The problem of double counting could in principle be solved by distinguishing between two types of output. Copyright © 2017 Pearson Canada Inc.

All outputs that are used as inputs by other producers in a further stage of production are intermediate goods. Goods that are not used as inputs by other firms but are produced to be sold for consumption, investment, government, or export during the period under consideration are final goods. If the firms’ sales could be easily disaggregated into sales of final goods and sales of intermediate goods, then measuring total output would be straightforward. However, this is not the case. Copyright © 2017 Pearson Canada Inc.

To avoid the problem of double counting, economists use the concept of value added, which is the value of a firm’s output minus the value of the inputs that it purchases from other firms. Value added = Sales revenue – Cost of intermediate goods and Value added = Payments owed to the firm’s factors of production The sum of all values added in an economy is a measure of the economy’s total output. Copyright © 2017 Pearson Canada Inc.

20.2 National Income Accounting: The Basics The circular flow of income suggests three different ways of measuring national income. The first uses the concept of value added. A second approach is to add up the total flow of expenditure on final domestic output. A third approach is to add up the total flow of income generated by the flow of domestic production. All three measures yield the same total, gross domestic product (GDP), which is the total value of goods and services produced in the economy during a given period. Copyright © 2017 Pearson Canada Inc.

Fig. 20-1 The Circular Flow of Expenditure and Income Copyright © 2017 Pearson Canada Inc.

GDP from the Expenditure Side GDP for a given year is calculated from the expenditure side by adding up the expenditures needed to purchase the final output produced in that year. Consumption Expenditure Consumption expenditure is household expenditure on all goods and services. Investment Expenditure Investment expenditure is expenditure on the production of goods not for present consumption. Copyright © 2017 Pearson Canada Inc.

GDP from the Expenditure Side Investment expenditure also includes inventories. Inventories are stocks of raw materials, goods in process, and finished goods held by firms to mitigate the effect of short-term fluctuations in production or sales. Investment expenditure also includes capital goods and residential housing. The economy’s total quantity of capital goods is called the capital stock. Creating new capital goods is called fixed investment. Copyright © 2017 Pearson Canada Inc.

GDP from the Expenditure Side The total investment that occurs in the economy is called gross investment. Depreciation is the amount by which the capital stock is depleted through the production process. Net investment = Gross investment – Depreciation Government Purchases Government purchases are all government expenditure on currently produced goods and services, exclusive of government transfer payments. Transfer payments are payments to an individual or institution not made in exchange for a good or service. Copyright © 2017 Pearson Canada Inc.

GDP from the Expenditure Side Net Exports Imports is the value of all domestically produced goods and services purchased from firms, households, or governments in other countries. Exports is the value of all goods and services sold to firms, households, and governments in other countries. Net exports is the value of total exports minus the value of total imports. Copyright © 2017 Pearson Canada Inc.

GDP from the Expenditure Side Measured from the expenditure side, GDP is equal to the total expenditure on domestically produced output. GDP = Ca + Ia + Ga + NXa Copyright © 2017 Pearson Canada Inc.

Table 20-1 GDP from the Expenditure Side, 2014 Copyright © 2017 Pearson Canada Inc.

C I G S T X IM or N – not applicable Self-Test Identify the items for the Canadian economy according to the following code: C I G S T X IM or N – not applicable a) A student gets her haircut from self-employed hairdresser b) The hairdresser buys a pair of scissors from the Ace Beauty Supply Company c) Out of each day’s revenue, the hairdresser puts $5 in her piggy bank

GDP from the Income Side The calculation of GDP from the income side involves adding up factor incomes and other claims on the value of output until all of that value is accounted for. Factor Incomes National income accountants distinguish three main components of factor incomes: wages and salaries, interest, and business profits. Non-factor Payments Indirect taxes are taxes on the production and sale of goods and services. Subsidies act like negative taxes. They are payments from the government to firms. Copyright © 2017 Pearson Canada Inc.

Self-Test continued d) Each time she has enough set aside, the hairdresser buys a share of GM stock e) GM expands its computer facilities in its head office f) American tourists go skiing in the Canadian Rockies Two Canadians go to Tokyo and stay at the Hilton Hotel Russia buys beef from Alberta ranchers The Province of Saskatchewan pays for the building of a new highway

GDP from the Income Side Some portion of current output replaces worn out physical capital— depreciation. So from the income side, GDP is the sum of factor incomes plus indirect taxes (net of subsidies) plus depreciation. Copyright © 2017 Pearson Canada Inc.

GDP from the Income Side GDP is also the sum of factor incomes and other claims on the value of output. Factor incomes include: wages rent, interest, and profits Non-factor payments include: indirect taxes (net of subsidies) depreciation of existing physical capital net domestic income Copyright © 2014 Pearson Canada Inc. Chapter 20, Slide

GDP from the income side is therefore equal to: GDP = Net domestic income + Indirect taxes (less subsidies) + Depreciation Copyright © 2014 Pearson Canada Inc. Chapter 20, Slide

GDP from the Income Side When we calculate GDP from the income side, we include a “fudge factor”, called statistical discrepancy. Statistical discrepancy makes sure that the independent measures of income and expenditure come to the same total. Although national income and national expenditure are conceptually identical, in practice both are measured with slight error. Copyright © 2017 Pearson Canada Inc.

Table 20-2 GDP from the Income Side, 2014 Copyright © 2017 Pearson Canada Inc.

20.3 National Income Accounting: Some Further Issues Real and Nominal GDP Total GDP valued at current prices is called nominal GDP. GDP valued at base-period prices is called real GDP. The GDP Deflator If nominal and real GDP change by different amounts over a given time period, then prices must have changed over that period. Copyright © 2017 Pearson Canada Inc.

GDP from the Income Side We compare what has happened to nominal GDP and real GDP by calculating the GDP deflator. The GDP deflator is an index number derived by dividing nominal GDP by real GDP. Its change measures the average change in price of all the items in GDP. Nominal GDP GDP Deflator = x 100 Real GDP Copyright © 2017 Pearson Canada Inc.

Table 20-3 Nominal and Real GDP in Canada: Selected Years (billions of dollars) Copyright © 2017 Pearson Canada Inc.

GDP Deflator Versus the CPI The GDP deflator does not necessarily change in line with changes in the CPI. The two price indices are measuring different things. Movements in the CPI measure the change in the average price of consumer goods. Movements in the GDP deflator reflect the change in the average price of goods produced in Canada. Copyright © 2017 Pearson Canada Inc.

Omissions from GDP Gross domestic product is an excellent measure of the flow of economic activity in organized markets in a given year. But much economic activity takes place outside the markets that the national income accountants survey. These activities include: Illegal Activities The Underground Economy “Home Production” and Other Non-market Activities Economic “Bads” Copyright © 2017 Pearson Canada Inc.

Do the Omissions Matter? The current approach to measuring GDP is useful because: It would be difficult to correct the major omissions. The level of GDP may be inaccurate but the change in GDP is a good indication of the changes in economic activity. To design policies to control inflation it is necessary to know the flow of money payments made to produce and purchase Canadian output. Modified measures that included non- market activities would distort these figures and likely lead to policy errors. Copyright © 2017 Pearson Canada Inc.

GDP and Living Standards To what extent does GDP provide a useful measure of our living standards? Changes in real per capita income are a good measure of average material living standards. But material living standards are only part of what most people consider their overall well-being. Copyright © 2017 Pearson Canada Inc.

Review A) $3784 B)$3866 C) $3904 D) $3936 E)$3708 Wages and salaries Refer to Table 20-2. What is the value of GDP, as calculated from the expenditure side? A) $3784 B)$3866 C) $3904 D) $3936 E)$3708 Wages and salaries 3029 GST remittances 107 Exports 32 Gross investment 537 Depreciation 82 Consumption expenditure 2808 Government subsidies to firms 51 Business profit 423 Imports 35 Interest and investment income 276 Government purchases 524 © 2014 Pearson Education Canada Inc.

Review If a firm's depreciation exceeds its gross investment, then its A) net investment will be positive. B) capital stock will be shrinking. C) capital stock will be growing. D) gross investment will be negative. E) depreciation cannot exceed gross investment. © 2014 Pearson Education Canada Inc.