Chapter 7: Measuring Domestic Output, National Income, and the Price Level

National Income Accounting Measures the economy’s overall performance. Bureau of Economic Analysis compiles the national income accounts for the U.S. economy. http://www.bea.gov/

This accounting enables economist and policymakers to: Assess the health of the economy by comparing levels of production at regular intervals Track the long-run course of the economy to see whether it has grown, been constant, or declined. Formulate policies that will safe guard and improve the economy’s health.

Gross Domestic Product (GDP) The total market value of all final goods and services produced in a given year All goods & services produced by either citizen-supplied or foreign-supplied resources employed in the country Michigan Plant Japanese owned factory in Ohio

A Monetary Measure They have to apply a price tag to each product to figure GDP Have to have a monetary measure to compare GDP from one year to the next

Avoid multiple counting GDP includes only the market value of final goods and ignores intermediate goods altogether. Intermediate goods: goods & services that are purchased for resale or for further processing or manufacturing. Final goods: goods & services that are purchased for final use by the consumer, not resale or for further processing or manufacturing.

5 stages in developing a wool suit

GDP Excludes Nonproduction Transactions Financial Transactions such as: Public transfer payments: social security payments, welfare payments, and veteran’s payments that the government makes directly to the households. Recipients do nothing productive in return.

GDP Excludes Nonproduction Transactions 2. Private transfer payments: money that parents give children or cash gifts for Christmas or birthdays. They produce no output!!

GDP Excludes Nonproduction Transactions 3. Stock Market Transactions: The buying and selling of stocks (and bonds) is a matter of swapping bits of paper. Payments for the services of a stock broker ARE included….they produce a service.

Secondhand Sales They contribute nothing to current production and therefore are not included into GDP. They were counted the first time they were sold.

Two ways of looking at GDP: spending and income Expenditures Approach Income Approach GDP as the sum of all the money spent in buying goods and services. How much the final user paid for a good or service G & S bought by households, businesses, & government GDP = C + Ig + G + Xn GDP in terms of the income derived or created from producing a good or service. Earnings or allocations approach Wages + Rents + Interest + Profits = GDP

The Expenditures Approach Personal Consumption Expenditures (C) Covers all expenditures by households on durable consumer goods, nondurable consumer goods, and consumer expenditures for services. Durable consumer goods Nondurable consumer goods Consumer expenditures for services

Gross Domestic Investment (Ig) Includes the following: All final purchases of machinery, equipment, & tools by business enterprises All construction (residential & business) Changes in inventories Box making machinery

Positive and Negative Changes in Inventories Inventories can either increase or decrease over some period. Suppose they increased by $10 billion in a year. That means that the economy produced $10 billion more output than was purchased. We need to count all output that was produced in that year even though some of it remained unsold at the end of year. Suppose they decreased by $10 billion in a year. It means that the economy sold $10 billion more of output & it will overstate the GDP by $10 billion that year. So in that year we consider the $10 billion decline in inventories as “negative investment” and subtract it from total investment that year.

Noninvestment Transactions What is NOT investment?? Investment does not include: Transfer of paper assets (stocks and bonds) The resale of tangible assets (houses, jewelry, boats) These transfer ownership of existing assets; they do not create new capital assets– assets that create jobs & income. Gross Investment vs. Net Investment “domestic” means by private businesses “gross” means all investments those depreciated and new Net private domestic investment is ONLY investment in the form of added capital THUS Net investment= gross investment – depreciation

Government Purchases (G) Gov’t buying laptops for schools Government consumption expenditures Expenditures for goods & services that gov’t consumes in providing public services. Expenditures for social capital such as schools & highways

Net Exports (Xn) GDP records all spending on goods & services produced in the U.S., including spending on U.S. output by people abroad. At the same time we spend a great deal on imports. National Income accountants use “exports less imports” or net exports. Xn = exports (x) – imports (m)

Putting it all together!!! GDP = C + Ig + G + Xn Personal consumption expenditures ------------- $6759 Gross private domestic investment--------------- 1834 Government purchases------------------------------ 1743 Net exports--------------------------------------------- -370 6759 + 1834 + 1743 – 370 = $9966

The Income Approach Wages plus Rents Interest Profits Statistical adjustments

Rents Consist of the income received by the households and businesses that supply property resources. They include monthly payments by renters by private and business. Net rent is used----- gross rental income minus depreciation of the rental property

Interest Consists of the money paid by private businesses to the suppliers of money capital. Includes interest households receive on savings deposits, certificates of deposit, and corporate bonds.

Proprietors’ Income & Corporate Profits Proprietors Income consists of the net income of sole proprietorship, partnerships, and other unincorporated businesses. Corporate Profits include: Corporate income taxes Dividends: part of the corporate profits paid to stockholders Undistributed corporate profits: money saved by corporations to be invested later in new plants & equipment. Retained earnings

From National Income to GDP Indirect Business Taxes General sales taxes, excise taxes, business property taxes, license fees, & custom duties. Product sells for $1 but gov’t puts a $.05 tax. The retailer adds the tax to the price. Consumers pay $1.05. Gov’t has to add the .05 to the $1 of national income in calculating GDP Consumption of Fixed Capital Depreciation is the amount estimated of how much of the capital is being used up each year. The huge depreciation charge made vs. private & social capital each year is called consumption of fixed capital. This must be added to national income to achieve balance with the economy’s expenditures

From National Income to GDP Net Foreign Factor Income National income is the total income of American, whether it was earned in the U.S. or abroad. BUT GDP is a measure of domestic output. So, we must consider the income American gain from supplying resources abroad & the income foreigners gain by supplying resources in the U.S. In 2000, foreign-owned resources earned $9 billion more in the U.S. than American-owned resourced earned abroad. That difference is called net foreign factor income.

Other National Accounts Several other national accounts provide additional useful information about the economy’s performance. We can derive these accounts by making various adjustments to GDP. Net Domestic Product (NDP) National Income (NI) Personal Income (PI) Disposable Income (DI)

Net Domestic Product (NDP) GDP does not make allowances for replacing the capital goods used up in each year’s production. We need to subtract consumption of fixed capital (depreciation) from GDP. The result: Net domestic product NDP= GDP- depreciation OR NDP = GDP – consumption of fixed capital

National Income National income includes all income earned through the use of American-owned resources, whether they are located at home or abroad. Subtract net foreign factor income from NDP (income earned by foreigners in the U.S. minus income earned by Americans abroad) Subtract indirect business taxes from NDP.

Personal Income PI includes all income received whether earned or unearned. You have to add transfer payments since they are not earned by working. You have to subtract social security taxes, corporate income taxes & undistributed corporate profits. National Income---$8018 SS contributions - 706 Corporate income taxes - 286 Undistributed corp. profit - 274 Transfer payments +1530 Personal Income $8282

Disposable Income (DI) DI is personal income less personal taxes. DI is the amount of income that households have left over after paying their personal taxes. They are free to divide that income between consumption and saving DI = C + S

The Circular Flow Revisited

Nominal gdp versus real gdp We use money, or nominal, values as a common denominator in order to add that heterogeneous output (GDP) into a meaningful total. BUT how can we compare the market values of GDP when the value of money changes from year to year?????? It is the quantity of goods that get produced & distributed to households that affects our standard of living, not the price of the goods. To solve the problem ------- deflate GDP when prices rise & inflate GDP when prices fall. These adjustments give a measure of GDP for various years as if the value of the dollar had always been the same as it was in some reference year.

Nominal GDP Real GDP A GDP based on the prices that prevailed when the output was produced is called unadjusted GDP, or nominal GDP. A GDP that has been deflated or inflated to reflect changes in the price level is called adjusted GDP, or real GDP.

Adjustment process in a one-Product economy GDP price index is a measure of the price of a specified collection of goods & services, called a “market basket,” in a given year as compared to the price of an identical collection of goods & services in a reference year. That point of reference is known as the base period or base year. Price price of market basket index in in specific year X 100 given = price of same market Year basket in base year

Calculating real GDP Year (1) Units of output (2) Price of Pizza per unit (3) Price Index (year 1= 100 (4) Unadjusted or Nominal GDP (1) x (2) (5) Adjusted, or Real GDP 1 5 $10 100 $ 50 $50 2 7 20 200 140 70 3 8 25 250 80 4 10 30 11 28 Real GDP = nominal GDP price index (in hundredths)

An alternative method Price index nominal GDP (in hundredths) = real GDP

The consumer price index (CPI) Compiled by the Bureau of Labor Statistics (BLS) http://www.bls.gov/ This is the index that the gov’t uses to measure the rate of inflation from month to month. Reports the price of a market basket of some 300 consumer goods and services that presumably are purchased by a typical urban consumer.

Shortcomings of gdp Nonmarket Transactions Leisure The services of homemakers & the labor of carpenters that work on their own homes never show up in GDP. The portion of farmers output that they consume themselves is estimated & included in GDP Leisure U.S. work week has declined from 53 to about 36 hrs. a week. Increase in leisure time has a positive effect on our overall well-being Satisfaction that many people derive from their work is not included in GDP

Shortcomings of gdp Improved Product Quality The Underground Economy GDP fails to take into account the value of improvements in product quality. This has a great deal to do with our economic well-being. The Underground Economy Gamblers, smugglers, prostitutes, “fences,” drug growers, & drug dealers have good reason to hide their income and is not counted in GDP. Some do not report tips or portions of sales that may be in cash.

Shortcomings of gdp GDP & the environment Dirty air, polluted water, toxic waste, congestion, and noise are costs not included in GDP. We have some social costs of the negative by-products of our economy not counted in GDP Composition & distribution of output GDP assigns equal weight to an assault rifle and a set of encyclopedias as long as they both sell for the same price. GDP does not tell us whether the mix of goods & services is enriching or potentially detrimental to our society.

Shortcomings of gdp Noneconomic sources of well-being Just as a household’ s income does not measure its total happiness, a nation’s GDP does not measure its total well-being. Things that could make things better—reduction of crime & violence, peaceful relations with other countries, greater civility toward one another, reduction of drug & alcohol abuse, etc. Per capita output The most meaningful measure of economic performance. Found by dividing real GDP by population. Measures only the magnitude of total output, it conceals changes in the standard of living of individuals & households.