GDP and the Standard of living Outline: 1.Functions of National Income Accounting 2.Gross Domestic Product (GDP) 3.The Expenditure Approach to GDP 4.The Income Approach to GDP 5.Value added 6.Real versus Nominal GDP 7.Limitations of GDP as a measure of the standard of living

National income accounting (NIA) is the measurement of aggregate or total economic activity. NIA is useful for assessing the performance of the macroeconomy. NIA is also helpful in evaluating the effectiveness of policy initiatives such as the Bush tax cuts.

We measure stock variables at a specific point in time; whereas flows are measured per unit of time. Flows include: Income Sales revenue Output Stocks include: Checking account balance Balance owed on student loans Inventories We measure economic activity as a flow. Stocks vs. Flows

GDP is the market value final goods and services produced within a country in a given time period. Gross Domestic Product (GDP) GDP is our basic measure of economic activity

Three approaches to measuring GDP The value-added approach The expenditure approach The income approach

Value-added is the increase in the market value of a good that takes place at each stage of the production -distribution process.

$1.00 Wood Chips $1.50 Raw Paper $2.25 Notebook Paper $3.50 Notebook Paper $5.00 Notebook Paper Lumber Mill Paper Mill Office Supplies Manufacturer Wholesaler Retailer

Summing the value-added at each stage StageValue Added Lumber milling$1.00 Paper processing.50 Office Supply Manufacturing.75 Wholesaling1.25 Retailing1.50 Total$5.00

To count the notebook in GDP, we count the final transaction only. Otherwise, we would be counting value added twice. We count only final goods—that is, a good or service produced for a final user—in GDP. The value of intermediate goods and services are automatically included when the count the value of the final good or service.

Here we simply add up all expenditures for final goods and services in one year Total Expenditure = C + I + G + NX Where, C is personal consumption expenditure; I is gross private domestic investment; G is government expenditure (local, state, and federal); and NX is net exports, or Exports minus Imports The expenditure approach

Consumption Household spending for newly- produced goods and services is defined as consumption. We distinguish between 3 categories or types: Spending for consumer durables Spending for consumer non- durables Spending for consumer services.

Source:Bureau of Economic AnalysisBureau of Economic Analysis Consumer Spending by Type, 2002 (in billions) Total consumption by U.S. households in 2002 was $7.3 trillion

ï All spending by business firms for newly built equipment and business structures. ï All changes in business inventories of raw materials, semifinished articles, and finished goods. ï All spending by households for newly constructed residential housing What is investment?

Investment does NOT include The purchase of stocks, bonds, or other financial assets. Secondhand sales Remember that investment only happens when there is production of new tangible capital goods

Business investment has been slumping lately

Amount in 2002Percentage ItemSymbol(billions)of GDP Consumption expenditureC7, InvestmentI1, Government purchasesG Net exportsNX GDPY10, GDP: The Expenditure Approach Source: U.S. Bureau of Commerce, Bureau of Economic Analysis

GDP = Employee compensation + net interest + rent + profits + proprietors’ income + Capital consumption + (indirect business taxes – subsidies) The income Approach This mainly involves summing up income earned in factor markets

Definitions áCapital consumption (CC):A monetary measure of the depreciation of the capital stock in a year due to normal wear and tear, fires, or other accidents. áNet Investment: Gross Investment minus CC. áIndirect business taxes: taxes collected by businesses for government units, such as taxes on entertainment, motels, groceries, liquor, cigarettes, or gasoline taxes. Also called excise taxes.

Amount in 2002Percentage Item(billions)of GDP Compensation of employees5, Rental income of persons Net interest Corporate profits Proprietors' income Net domestic product at factor cost8, Indirect taxes less subsidies Capital Consumption1, GDP10, GDP: The Income Approach Source: U.S. Bureau of Commerce, Bureau of Economic Analysis

Real versus Nominal GDP We use money to measure the market value of new goods and services produced produced in the economy. The value (or purchasing power) of money is subject to change over time. Hence we need to adjust nominal GDP (that is, GDP measured at current prices) for changes in the value of money. GDP adjusted for changes in the value of money is called real GDP.

Nominal GDP Calculation To calculate nominal GDP in 2002, sum the expenditures on apples and oranges in 2002 as follows: Expenditure on apples = 100 × $1 = $100 Expenditure on oranges = 200 × $0.50 = $100 Nominal GDP = $100 + $200 = $200

Now we will calculate nominal GDP for 2003 and compare Expenditure on apples = 160 × $0.50 = $80 Expenditure on oranges = 220 × $2.25 = $495 Nominal GDP = $80 + $495 = $575 Our problem is that the nominal GDP figures do not give us an accurate read of period-to-period changes in actual production. Notice that a part of the change in nominal GDP from 2002 to 2003 resulted from a change in prices.

To correct for changes in the value of money, we will establish 2002 as our base year. That is, we will measure 2003 output at 2002 prices. “Traditional” Real GDP calculation The traditional method converts nominal GDP to real GDP by measuring GDP in all periods at “base period prices”

Traditional method: measuring 2003 GDP at 2002 prices Expenditure on apples = 160 × $1.00 = $160 Expenditure on oranges = 220 × $0.50 = $110 Nominal GDP = $80 + $495 = $270 Thus, real GDP increased from 2002 to 2003—but not by as much as nominal GDP

To compute Real GDP (GDP expressed in constant dollars):

New Method of Calculating Real GDP ItemQuantityPrice Apples160$1.00 Oranges220$0.50 To use this method, we must value 2002 output at 2003 prices and 2003 output at 2002 prices Quantities and 2002 Prices ItemQuantityPrice Apples100$0.50 Oranges200$ Quantities and 2003 Prices Measured at 2002 prices, Real GDP increased by 35% from 2002 to 2003 [($70/$200) × 100] Measured at 2003 prices, real GDP increased by 15% from 2002 to 2003 [($75/$500) × 100]

The next step is to average together the percentage increases for 2002 and Thus we have: Therefore, since real GDP in 2002 is $200, this chain-weighted method of converting nominal to real GDP gives us real GDP in 2003 of $250.

GDP in the United States (in millions)

GDP per Person in the United States

Notice that real GDP decreased in 1991 Recessions are shaded GDP in the U.S. (millions of chained 1996 dollars)

Household production The underground economy Leisure time Environment quality Limitations of (real) GDP as a measure of the standard of living