GDP – Measuring Total Production and Income Taking the Nation’s Pulse Chapter 8

Gross Domestic Product (GDP): The market value of final goods and services produced within a country during a specific time period, usually a year. GDP vs GNP?? GDP: production within a country’s borders (domestic) GNP: production by people of a country (national)

Stage of production Value added to the product (equals income created) Sales Receipts (at each stage of production) Stage 1: farmer’s wheat Stage 2: miller’s flour Stage 3: baker’s bread (wholesale) Stage 4: grocer’s bread (retail) $.30 $.65$.90 $1 by farmer $.30 by grocer $.10 by miller $.35 by baker $.25 What Does Not Count Toward GDP? Sales at intermediate stages of production. Their value is already counted in the final-user good. Including them would result in double counting. Total consumer expenditure = $1 Total value added = $1 Only final goods and services count

What Else? Financial transactions and income transfers. They do not reflect production. Production outside the geographic borders of the country is not counted. Goods not produced during the current period are not counted. Stocks 1955 Chevy

Which are included in this year's GDP ? : 1. Interest on an AT&T bond - 2. Social Security payments to retirees - 3. Services of a painter in painting a house - 4. Income of a dentist - 5. Money received from the sale of a 1990 model car- 6. Monthly allowance of a college student - 7. Rent for a 2 bedroom apartment - 8. Money received for selling this year's model car - 9. Interest on a government bond - YES NO YES NO

Which? 10. A two hour decline in the work week Purchase of the AT&T bond A $ 2 billion increase in business investments Purchasing 100 shares of GM common stock Purchase of an insurance policy Wages paid to your butler Market value of a homemaker's services Purchase of the Mona Lisa - NO YES NO

GDP is measured in dollars Each good produced increases output by the amount the purchaser pays for the good. GDP is the sum of total spending on all goods and services produced during the year.

Two Ways of Measuring GDP Three ncomes xpenditures O I utput (Value Added) E

1. Expenditure Approach: GDP is the sum of expenditures on final user goods and services purchased by households, investors, governments, and foreigners. There are four components of GDP: personal consumption purchases C gross private investment I g (including inventories) government purchases G (consumption and investment) net exports ( exports minus imports ) X n GDP Dollar flow of expenditures on final goods = Dollar flow of income (and indirect cost) of final goods = Measuring GDP

10 of 37 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Figure 8.2 Components of GDP in 2010 Consumption accounts for 70.5 percent of GDP, far more than any of the other components. In recent years, net exports typically have been negative, which reduces GDP..

11 of 37 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Will U.S. Consumers Be Spending Less? Although it can be good news for the economy in the long run, the determination of U.S. households to cut back on spending and increase saving in 2011 may partly explain the slow recovery from the 2007– 2009 recession. Consumption is a larger fraction of GDP in the United States than in most other high-income countries or in rapidly growing countries such as China and India. Over time, consumption in the United States has increased as a fraction of GDP.

2. Resource Cost - Income Approach Sum of these = national income GDP is the sum of costs incurred and income (including profits) generated by production of goods and services during the period. a. The direct cost income components of GDP: employee compensation Labor self-employment income labor/entrepreneur rents land Interest capital corporate profit entrepreneur

2. Resource Cost - Income Approach: (cont.) Not covered

+ national income (employee compensation, self-employment income, rents, interest, corporate profit) + indirect business taxes + depreciation + net income of foreigners When derived by Resource Cost - Income Approach, GDP is equal to:

3. Output – by Industry (Value Added) Add up output by each industrial sector Chemicals + Agriculture + … Stage of production Value added to the product (equals income created) Sales Receipts (at each stage of production) Stage 1: farmer’s wheat Stage 2: miller’s flour Stage 3: baker’s bread (wholesale) Stage 4: grocer’s bread (retail) $.30 $.65$.90 $1 by farmer $.30 by grocer $.10 by miller $.35 by baker $.25 Total consumer expenditure = $1 Total value added = $1

16 of 37 © 2013 Pearson Education, Inc. Publishing as Prentice Hall FirmValue of ProductValue Added Cotton farmerValue of raw cotton = $1Value 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 Measuring GDP Using the Value-Added Method Value added The market value a firm adds to a product. Calculating Value Added The price of the shirt on L.L.Bean’s Web site is exactly equal to the sum of the value added by each firm involved in the production of the shirt.

Shortcomings of GDP: It does not count non-market production. It does not count the underground economy. It makes no adjustment for leisure. It probably understates output increases because of the problem of estimating improvements in the quality of products. It does not adjust for harmful side effects. It does not consider standard of living – GDP per person Great contribution of GDP: In spite of its shortcomings, real GDP is a reasonably accurate measure of short-term fluctuations in output.

The term "real" means adjusted for inflation. Price indexes are use to adjust data for inflation. A price index measures the cost of purchasing a good (or goods) at a point in time relative to the cost of purchasing the identical good during an earlier (or base) period.

Year$ SpendingIndex 1170_____ 2180_____ 3 Base year 200_____ 4200_____ 5224_____ 6250_____ 7280_____ Year$ SpendingIndex 1170_____ 2180_____ 3 Base year 200_____ 4200_____ 5224_____ 6250_____ 7280_____ Current year spending Base year spending x 100 Creating a price index

measures the impact of price changes on the cost of a typical bundle of goods and services purchased by households. designed to measure the change in the average price of the market basket of goods included in GDP (a broader price index than the CPI).

2. WPI 2. WPI 1. PPI 1. PPI 3. MPI 3. MPI

Real GDP 2 = Nominal GDP 2 * GDP Deflator 1 GDP Deflator 2 Data on both money GDP and price changes are essential for meaningful comparisons of output between two time periods. The formula for converting the nominal GDP into real GDP is:

Converting Earlier Figures to Current Dollars For comparisons across time periods, we must use current dollars. Done by “inflating” the earlier data for the increase in the price level. The formula: Figure current $ = Figure earlier $ * price index current year price index earlier year This will “inflate” the data for earlier years into line with the current purchasing power of the $.

Gross Domestic Product Complete the following table assuming that Year 1 is the base year. YearOutputPriceMoney GDP GDP Index Real GDP 1100$

Gross Domestic Product Complete the following table assuming that Year 1 is the base year. YearOutputPriceMoney GDP GDP Index Real GDP 1100$4.00 $400100$

Gross National Product (GNP): Output by the “nationals” – citizens of the country, regardless of whether that output is produced domestically or abroad. National income: Income earned by the nationals (citizens) during a period. It is the sum of employee compensation, self-employment income, rents, interest, and corporate profits. Minus depreciation and taxes Personal income: Income received by domestic households and non- corporate businesses. It is available for consumption, saving, and personal taxes. Includes transfers. Disposable income: Income available to individuals after personal taxes. Can be spent on consumption or saved.

Source: U.S. Department of Commerce % increase Nominal GDP (billions of U.S. $) Real GDP (billions of 1996 $) $7,813 $10, % Price index (GDP deflator, 1996 = 100) % $7,813 $9, % Deriving Real GDP Like “Deflating” the $ Source: % increase Nominal GDP (billions of U.S. $) Real GDP (billions of 1998 $) $8,747 $11, % Price index (GDP deflator, 2000 = 100) % $8,747 $10, % Source: % increase Nominal GDP (billions of U.S. $) Real GDP (billions of 2000 $) $9,817 $13, % Price index (GDP deflator, 2000 = 100) % $9,817 $11, %

Interesting Questions 1. The CPI was 177 in 2001 compared to 100 in Suppose that the price of a ticket at a local movie theater rose from $4 to $8 between 1983 and Did the real ticket price increase or decrease? Calculate the 1983 ticket price measured in 2001 dollars. 2. The CPI was 210 in 2007 compared to 100 in Suppose that the price of a ticket at a local movie theater rose from $4 to $8 between 1983 and Did the real ticket price increase or decrease? Calculate the 1983 ticket price measured in 2007 dollars.

GDP Comparisons Across Time Periods and Across Countries

1.Which of the following activities will affect GDP: a. You pay $600 per month to lease an apartment. b. You pay $8,000 to purchase a four-year-old car. c. You have car trouble and have to pay a repair shop $1,500 to fix the transmission of your car. d. You pay $5,100 to purchase 100 shares of Microsoft stock ($50 per share for the stock plus a $100 fee). e. You sell your 100 shares of Microsoft stock (purchased for $5,000) for $6,000 minus a $100 brokerage fee. f. Your aunt sends you $500 to help with your expenses. g. You earn $500 providing computer services for a faculty member. h. You win $500 playing cards with classmates.