ANTHONY PATRICK O’BRIEN R. GLENN HUBBARD ANTHONY PATRICK O’BRIEN FIFTH EDITION © 2015 Pearson Education, Inc..

GDP: Measuring Total Production and Income

Microeconomics and Macroeconomics Microeconomics is the study of how households and firms make choices, how they interact in markets, and how the government attempts to influence their choices. In contrast, macroeconomics is the study of the economy as a whole, including topics such as inflation, unemployment, and economic growth. When we want to study the overall economy-level actions of people and governments, the models and tools of macroeconomics become very useful.

Some Important Terms in Macroeconomics Business cycle: Alternating periods of economic expansion and economic recession. Expansion: The period of a business cycle during which the total production and total employment are increasing. Recession: The period of a business cycle during which total production and total employment are decreasing. Economic growth: The ability of an economy to produce increasing quantities of goods and services. Inflation rate: The percentage increase in the price level from one year to the next.

Goal of This Chapter Over the coming chapters, we will explore many aspects of the economy, including how all of the elements on the previous slide relate to one another. For this chapter, we have a less lofty goal: to figure out how to measure the total output of an economy. Being able to measure total output is incredibly important, since much of macroeconomics depends on our ability to measure and predict aggregate economic activity.

Gross Domestic Product Measures Total Production 8.1 Explain how total production is measured.

Measuring Total Production: Gross Domestic Product The most common measure used by economists of overall economic activity in an economy is Gross domestic product, or GDP. Gross domestic product: the market value of all final goods and services produced in a country during a period of time, typically one year. We will examine each of the parts of this definition in turn.

“Market Values” Gross domestic product: the market value of all final goods and services produced in a country during a period of time, typically one year. We cannot add together the number of cars, melons, haircuts, and all other goods and services without agreeing on a common way to measure them. The best practical way is to value each good and service in monetary terms; and the best measure of this that we have is the price that each good or service is sold for.

“Final Goods and Services” Gross domestic product: the market value of all final goods and services produced in a country during a period of time, typically one year. A final good or service is a good or service purchased by a final user. These are what are used to calculate GDP. Why? If we counted intermediate goods and services as well, ones that were inputs into another good or service, such as a tire on a truck, then we would end up double-counting. Example: if we counted the value of the ice cream bought by a store, and also counted the value of that ice cream when it was sold to a consumer, we would be double-counting the wholesale value of the ice cream.

“During a Period of Time” Gross domestic product: the market value of all final goods and services produced in a country during a period of time, typically one year. To measure total output in a given year, we measure the goods and services produced only in that given year. Again, this avoids double-counting: if you buy a DVD in 2011, that DVD counts in 2011’s GDP. If you resell it in 2012, it will not count again in 2012. So GDP counts only new goods and services. Used items were previously produced and counted, so don’t need to be counted again.

Production and Income There are two main conceptual ways to measure the total economic activity in an economy: total production or total income. When we measure one, we are also measuring the other. Why? Everything that is produced and sold constitutes income for someone; so we have the choice of measuring the value of products produced and sold, or the value of incomes, and each is a valid way of measuring economic activity.

The Circular Flow and the Measurement of GDP In a very simple model of the economy, we could start with households and firms. To measure overall economic activity, we could measure the amount of money that households spend on goods and services. Or we could measure income to households. The circular-flow diagram illustrates the flow of spending and money in the economy. Firms sell goods and services to three groups: domestic households, foreign firms and households, and the government. To produce goods and services, firms use factors of production: labor, capital, natural resources, and entrepreneurship. Households supply the factors of production to firms in exchange for income in the form of wages, interest, profit, and rent. Firms make payments of wages and interest to households in exchange for hiring workers and other factors of production. The sum of wages, interest, rent, and profit is total income in the economy. We can measure GDP as the total income received by households. The diagram also shows that households use their income to purchase goods and services, pay taxes, and for savings. Firms and the government borrow the funds that flow from households into the financial system. We can measure GDP either by calculating the total value of expenditures on final goods and services or by calculating the value of total income. Figure 8.1 The circular flow and the measurement of GDP

Adding Government to the Circular Flow Let’s add in some more layers. We’ll start with government. How does the government affect economic activity? It takes in taxes from households and firms. It uses those taxes to buy goods and services, and to make transfer payments—payments to households for which the government does not receive a good or service in return. Figure 8.1 The circular flow and the measurement of GDP

Adding the Rest of the World to the Circular Flow Some economic activity takes place between households, firms, and the rest of the world. Households buy goods and services from firms in other countries; these are known as imports. Firms sell goods and services to households in other countries; these are known as exports. Figure 8.1 The circular flow and the measurement of GDP

Adding the Financial System to the Circular Flow Finally, there are firms that deal specifically in flows of money; we label these firms the financial system. Households elect not to spend some of their income, and instead save it with financial system firms like banks. These financial system firms lend money to other firms and the government. Figure 8.1 The circular flow and the measurement of GDP

Follow the Spending to Measure GDP To measure GDP, the Bureau of Economic Analysis (BEA) in the Department of Commerce measures four major categories of expenditures: Personal Consumption Expenditures, or “Consumption” (C) Gross Private Domestic Investment, or “Investment” (I) Government Consumption and Gross Investment, or “Government Purchases” (G) Net Exports of Goods and Services, or “Net Exports” (NX) GDP can be expressed as the sum of these: Y = C + I + G + NX We will examine each component of GDP in turn.

Consumption Y = C + I + G + NX Consumption is spending by households on goods and services, not including spending on new houses (which are counted instead in investment). In BEA statistics, consumption is further divided into expenditure on services, durable goods, and nondurable goods.

Investment Y = C + I + G + NX Investment is spending by firms on new factories, office buildings, and additions to inventories, plus spending by households and firms on new houses. The BEA measures the following categories of investment: business fixed investment, residential investment, and changes in business inventories. This last category includes goods that have been produced but not yet sold.

Government Purchases Y = C + I + G + NX Government purchases are spending by federal, state, and local governments on goods and services, such as teachers’ salaries, highways, and aircraft carriers. This does not include transfer payments, since those do not result in immediate production of new goods and services.

Net Exports Y = C + I + G + NX Net exports are defined as the value of exports minus the value of imports. This difference might be positive or negative; in recent years, this has been negative in the United States. Since we want to count domestic production (production in the United States), we add up the value of the goods and services sold to foreigners, and subtract off the value of the goods and services sold to Americans by foreigners.

Components of GDP in 2012 Consumption accounts for a much larger percentage of GDP than any of the other components. In recent years, net exports have typically been negative, which reduces GDP. Note that the subtotals may not sum to the totals for each category because of rounding. Source: U.S. Bureau of Economic Analysis. Figure 8.2 Components of GDP in 2012 Consumption is the largest component of GDP; within that, services are the largest component—almost half of GDP. American net exports are negative, since the value of our imports exceeds the value of our exports.

Adding More of Lady Gaga to GDP The BEA continually studies ways to improve its measurement of GDP. In 2013, the BEA started counting R&D as investment, rather than an intermediate good, so as to emphasize the importance of intellectual property. A consequence is that money spent on development of, say, entertainment products, now gets counted as investment. So the money spent by Lady Gaga and her record company on writing and recording her songs is now included in the investment component of GDP.

Measuring GDP Using the Value-Added method An alternative method to measure GDP is to measure the value added: the market value a firm adds to a product. The final selling price of a product must equal the sum of the values added to the product at each stage of production. The table below illustrates this method for a shirt sold on L.L.Bean’s web site. 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 Shirt company Value of cotton fabric made into a shirt = $15 Value added by shirt manufacturer = ($15 − $3) 12 L.L.Bean Value of shirt for sale on L.L.Bean’s Web site = $35 Value added by L.L.Bean = ($35 − $15) 20 Total Value Added $35 Table 8.1 Calculating value added

Does GDP Measure What We Want It to Measure? 8.2 Discuss whether GDP is a good measure of well-being.

Shortcomings of GDP GDP can be a useful tool to measure total output in an economy. Many people go further than this, interpreting GDP as a measure of the well-being of citizens. However GDP has shortcomings, both in its measure of total production, and in its usefulness as a measure of well-being.

Shortcomings of GDP as a Measure of Total Production Two important types of production are omitted from the BEA’s measurement of GDP: Household Production Household production such as childcare, cleaning, and cooking is not typically paid for with money. However such contributions are real—if they were performed by a non-household-member, they would be paid for and counted in GDP. The Underground Economy Buying and selling of goods and services might be concealed from the government to avoid taxes or regulations, or because the goods and services are illegal. This constitutes the underground economy. This may be 10% or more of the economy in America, and substantially more in low-income households.

How Important Are These Shortcomings? If we are comparing GDP from year to year, the size of household production and the underground economy is probably about the same from year to year, so GDP growth is a reasonable measure of the growth in total production. However over long periods of time, these shortcomings might be more serious. Example: As women have entered the workforce in larger numbers, some household production has been replaced by paid childcare and restaurant meals. So increases in GDP may exaggerate the increase in actual total production.

Underground Economies in Developing Countries In developing countries, the underground economy is often referred to as the informal sector, as opposed to the formal sector, in which output of goods and services is measured. In many developing countries, the informal sector is very large; often above 50% of total output. Economists studying economic development say this often reflects poor government policies: high taxes and regulations and low confidence in the security of private property from government seizure.

Shortcomings of GDP as a Measure of Well-Being GDP per capita (i.e. GDP divided by population) is often used to represent differences in standards of living from country to country. However, even if it accurately measured total production, it would not reflect: The value of leisure Pollution and other negative effects of production Crime and other social problems The distribution of income In fact, improvements in many of these will result in lower GDP per capita. Example: Lower crime would allow lower spending on police, prisons, and private security. This would decrease GDP, but surely result in improvements in economic well-being.

Did World War II Bring Prosperity? World War II was a period of extraordinary sacrifice and achievement by the “greatest generation.” But statistics on GDP may give a misleading indication of whether it was also a period of prosperity: Production was very high, but much of the production was of military goods—so people weren’t becoming more well-off. After the war, GDP fell; but the production of consumption goods rose rapidly.

Real GDP versus Nominal GDP 8.3 Discuss the difference between real GDP and nominal GDP.

Calculating Real GDP Since GDP is measured in “value” terms, we might have problems interpreting changes over time if prices change. Is an increase in GDP due to production increasing, or due to prices increasing? To separate these effects, the BEA calculates both nominal GDP—the value of final goods and services evaluated at current- year prices—and real GDP—the value of final goods and services evaluated at base-year prices. The choice of a base-year is arbitrary; we might use any year’s prices to compare real GDP in each year. The current standard is 2009. Unfortunately, the relative prices also change from year to year, distorting real GDP calculations. Since 1996, the BEA has overcome this problem by using chain-weighted prices, using previous-year prices to adjust current-year production measure.

Calculating Real GDP: An Example 2009 2015 Product Quantity Price Eye examinations 80 $40 100 $50 Pizzas 90 11 10 Textbooks 15 20 The table shows output and prices in 2009 and 2015. Calculating the total value of output in 2009 gives: $3200 + $990 + $1350 = $5540. To calculate real GDP in 2015, we use the prices from 2009. This gives real 2015 GDP in 2009 dollars of $6680. Product 2015 Quantity 2009 Price Value Eye examinations 100 $40 $4,000 Pizzas 80 11 880 Textbooks 20 90 1,800 Most prices increased from 2009 to 2015, so using nominal GDP would have yielded a higher figure: $7800. This highlights the need to use real GDP to avoid exaggerating growth.

Comparing Real GDP and Nominal GDP The current base year for calculating prices is 2009, so real and nominal GDP are equal in 2009. Growth figures reported in the media are the growth in real GDP. Since prices have generally increased since 2009, real GDP is less than nominal GDP, and the opposite is true before 2009. Currently, the base year for calculating GDP is 2009. In the years before 2009, prices were, on average, lower than in 2009, so nominal GDP was lower than real GDP. In 2009, nominal and real GDP were equal. Since 2009, prices have been, on average, higher than in 2009, so nominal GDP is higher than real GDP. Source: U.S. Bureau of Economic Analysis. Figure 8.3 Nominal GDP and real GDP: 1990-2012

The GDP Deflator Economists and policy-makers are interested in the price level: a measure of the average prices of goods and services in the economy. Why? Stable prices are desirable because they allow households and firms to plan for the future appropriately. In order to know whether we are achieving price stability, we need to measure the price level. One way to do this is using the GDP deflator: a measure of the price level, calculated by dividing nominal GDP by real GDP and multiplying by 100: Since nominal and real GDP will be the same in the base year, the GDP deflator will be 100 in the base year.

Calculating the GDP Deflator The table on the right gives the values of nominal and real GDP for 2011 and 2012. We can use this to calculate the GDP deflator in each year: 2011 2012 Nominal GDP $15,534 billion $16,245 billion Real GDP $15,052 billion $15,471 billion Formula Applied to 2011 Applied to 2012 GDP Deflator The GDP deflator increased from 103 to 105 between the two years. This is a 1.9% increase: So we say the price level rose 1.9% over this period.

Other Measures of Total Production and Total Income 8.4 Understand other measures of total production and total income.

National Income and Product Accounts (NIPA) The BEA is charged with performing national income accounting for the United States. Each quarter, it publishes the National Income and Product Accounts tables. These include GDP computations, but also: Gross National Product (GNP) Production performed by citizens of a nation, including overseas production (as opposed to GDP, which is performed within national borders) National Income GDP minus the consumption of fixed capital; i.e. GDP minus depreciation Personal Income Income received by households; includes transfer payments, but excludes firms’ retained earnings Disposable Personal Income Personal income minus personal tax payments; this measures the amount that households are able to spend or save

NIPA Measurements The table and graph show the various measures of the national income accounts for the United States in 2012. National income must be smaller than GDP, since it is just GDP minus depreciation. Similarly, disposable personal income must be less than personal income, since it is just personal income minus taxes. Each measure is useful in different contexts. The most important measure of total production and total income is gross domestic product (GDP). As we will see in later chapters, for some purposes, the other measures of total production and total income shown in the figure turn out to be more useful than GDP. Source: U.S. Bureau of Economic Analysis. Figure 8.4 Measures of total production and total income, 2012

Total Production = Total Income All production must be rewarded with income; so in theory, we could count either in order to calculate GDP. In practice, data limitations make us unlikely to come up with the same number; there will always be some statistical discrepancy. The figure illustrates the division of income as measured by the BEA in 2012. We can measure GDP in terms of total expenditure or as the total income received by households. The largest component of income received by households is wages, which are more than three times as large as the profits received by sole proprietors and the profits received by corporations combined. Note: The components in the figure do not sum to 100% because of rounding. Source: U.S. Bureau of Economic Analysis. Figure 8.5 The division of income, 2012

Common Misconceptions to Avoid “Investment” in reference to national income accounting has a very narrow definition: purchases of things like machines, factories, and houses. It refers only to the purchase of new items, not trades in financial instruments based on those items. We based statements about growth on GDP; but GDP has limitations, both as a measure of total production, and as a measure of well- being. In order to make useful comparisons, concentrate on real GDP rather than nominal GDP. In calculating real GDP, the choice of base year is largely arbitrary; there is no “correct” base year.