Production, Income, and Employment Chapter 6 Part 1

Aggregate Production is Measured by Gross Domestic Product (GDP) Gross Domestic Product (GDP) is the: total value of all final goods and services produced for the marketplace during a given period, within the nation’s borders. Total value… GDP is measured in dollar values (P x Q)

Production and GDP side note- Intermediate goods …of all final… final means goods and services sold to their final user side note- Intermediate goods Goods that are inputs for the production of final goods Value of intermediate goods is included in the value of final products …goods and services… Goods: tangibles Services: intangibles

Production and GDP …produced… …for the marketplace… Not included: land, stocks and bonds used goods … are not produced …for the marketplace… With the intention of being sold …during a given period… A specific period of time (annual/quarter) …within a nation’s borders Regardless of who owns the resources

Intermediate and Final Good Tires taken from that pile and mounted on the wheels of the new car before it is sold are considered intermediate goods. Tires taken from that pile to replace tires on your old car are considered final goods. If we included the value of the tires (an intermediate good) on new cars and the value of new cars (including the tires), we would be double counting.

Example: Production of Notebook Paper Stages of Production – Intermediate Goods Intermediate Goods Example: Production of Notebook Paper $5.00 is the final sale included in GDP

Tracking and Reporting GDP GDP is a flow variable Flow variable: measures a rate of production $40 billion worth of output each day $1.2 trillion each month $14.5 trillion for the year In general, flow variables are measured per unit of time

Tracking and Reporting GDP Annualization The government reports GDP as an annual rate But, it is measured and reported (as an annual rate) each quarter

Tracking and Reporting GDP Nominal variable A variable measured without adjustment for price changes Nominal GDP Real variable A variable adjusted for changes in prices Real GDP

Tracking and Reporting GDP Comparing variables measured in dollars over time It is important to translate nominal values to real values Annual growth rate of real GDP Reported quarterly Annualized

Annualized data for GDP, real GDP, and growth rate, by quarters Self test - How do we calculate the 3.8% real GDP growth rate for 2010-II?

What’s Not Included in GDP Non-market goods and services such as chores performed at home by family members. Underground activities, both legal and illegal such as legal unrecorded activities paid for in cash or illegal gambling Sales of used goods (no production) Financial transactions such as trading of stocks and bonds (no production) Government transfer payments: a payment to a person that is not for goods and services currently supplied such as social security (no production)

How to Calculate GDP The Expenditure Approach Four types of final users in the economy: Household Sector – Consumption (C) Business Sector – Investment (I) Government Sector – Government Purchases (G) Foreign Sector – Net Exports (NX) Expenditure approach: GDP = C+I+G+NX Adding the value of goods and services purchased by each type of final user

The Expenditure Approach to GDP Consumption spending (C) Part of GDP purchased by households as final users represents about 70% of total GDP Items not included: Imported consumption goods and components New home construction

The Expenditure Approach to GDP Consumption spending (C) Items included even though households don’t actually buy them Total value of food products produced on farms that are consumed by the farmers and their families themselves Total value of housing services provided by owner-occupied homes

The Expenditure Approach to GDP Private investment (I) Business purchases of plant, equipment, and software New home construction Changes in inventories

The Expenditure Approach to GDP Private investment (I) Adds to the nation’s capital stock Excludes Government investment Consumer durables Human capital Ignores depreciation Net investment Investment minus depreciation

The Expenditure Approach to GDP Government purchases (G ) Spending by federal, state, and local governments on goods and services and government investment in bridges, highways, etc.

The Expenditure Approach to GDP Government outlays Government purchases plus transfer payments Transfer payments Money redistributed from one group of citizens (taxpayers) to another (the poor, the unemployed, the elderly) not associated with production of goods and services included in government budgets as outlays not included in the government purchase component of GDP

The Expenditure Approach to GDP Net exports (NX) Total exports minus total imports Total exports (EX) U.S. production that is purchased by foreigners Total imports (IM) Americans’ purchases of goods produced outside of the United States

GDP in 2010: The Expenditure Approach 2013: C + I + G + (EX - IM) GDP = 11,662 + 2766 + 3118 + (2321 – 2778) GDP = 17,089

Factor Payment (Income) Approach to GDP Factor payments Payments to the owners of resources that are used in production Factor payments approach: Called The Income Approach GDP = sum the factor payments earned by all households in the economy (wages and salaries, rent, interest, and profit) Total output of the economy (GDP) = total income earned in the economy Total expenditure (GDP) = total income earned in the economy

Why does expenditure = income In every transaction, the buyer’s expenditure becomes the seller’s income. Thus, the sum of all expenditure equals the sum of all income.

Simple Circular Flow The circular flow diagram shows the income received and payments made by each sector of the economy.

Value Added Approache to GDP Revenue a firm receives Minus the cost of the intermediate goods it buys Value-added approach GDP = sum the values added by all firms in the economy

Back to the notebook example Value Added at Different Stages of Production Back to the notebook example

Value Added goes to the factors of production The Factor Payments Approach – Using the Notebook Paper Example Value Added goes to the factors of production

Exercise A farmer grows a bushel of wheat and sells it to a miller for $1.00. The miller turns the wheat into flour and sells it to a baker for $3.00. The baker uses the flour to make a loaf of bread and sells it to an engineer for $6.00. The engineer eats the bread. Compute: value added at each stage of production GDP

Exercise Value added - farmer = ? Value added - miller = ? Value added - baker = ? Total Value added = ? = GDP

Measuring GDP: A Summary

Calculating Real GDP Nominal GDP measures the value of all final goods and services using current prices. Real GDP measures the value of all final goods and services using the prices of a base year.

Real GDP controls for inflation Changes in nominal GDP can be due to: changes in prices (P) changes in quantities of output produced (Q) Remember: total sales = P x Q Changes in real GDP can only be due to changes in quantities (Q), because real GDP is constructed using constant base-year prices. P is held constant

Example - Calculation of Real GDP (NOTE: Numerical Calculation of Real GDP presented in this and the next 4 slides is not covered in the text) 2011 2010 2009 205 $100 200 $102 192 good B 1,050 $36 1,000 $31 900 $30 good A Q P Nominal GDP multiply Ps & Qs from same year 2009: $46,200 = $30  900 + $100  192 2010: $51,400 = $31 x 1000 + $102 x 200 2011: $58,300 = $36 x 1050 + $100 x 205 Real GDP multiply each year’s Qs by 2009 Ps 2009: $46,200 = $30 x 900 + $100 x 192 2010: $50,000 = $30 x 1000 + $100 x 200 2011: $52,000 = $30  1050 + $100  205 Compute nominal GDP in each year Compute real GDP in each year using 2009 as the base year.

Example - Calculation of Real GDP Nominal GDP multiply P & Q from same year 2009: $46,200 = $30  900 + $100  192 2010: $51,400 = $31 x 1000 + $102 x 200 2011: $58,300 = $36 x 1050 + $100 x 205 Real GDP multiply each year’s Q by 2009 P 2009: $46,200 = $30 x 900 + $100 x 192 2010: $50,000 = $30 x 1000 + $100 x 200 2011: $52,000 = $30  1050 + $100  205

GDP Deflator The inflation rate is the percentage increase in the overall level of prices. One measure of the price level is the GDP Deflator, defined as

Self Test 52,000 50,000 $46,200 Real GDP GDP deflator 58,300 2011 51,400 2010 n.a. 2009 inflation rate Nominal GDP Use your previous answers to compute the GDP deflator in each year. Use GDP deflator to compute the inflation rate from 2009 to 2010, and from 2010 to 2011.

Calculate the growth rate in NGDP for 2011. Answers 52,000 50,000 $46,200 Real GDP 112.1 102.8 100.0 GDP deflator 9.05% 58,300 2011 2.8% 51,400 2010 n.a. 2009 inflation rate Nom. GDP Calculate the growth rate in NGDP for 2011. Calculate the Growth rate in RGDP for 2011.

Inflation rate and growth rate is a percent change 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃= 𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃 𝐿𝑎𝑡𝑒𝑟 𝑌𝑒𝑎𝑟 − 𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃 𝐸𝑎𝑟𝑙𝑖𝑒𝑟 𝑌𝑒𝑎𝑟 𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃 𝐸𝑎𝑟𝑙𝑖𝑒𝑟 𝑌𝑒𝑎𝑟 𝑋 100 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑅𝑒𝑎𝑙 𝐺𝐷𝑃= 𝑅𝑒𝑎𝑙 𝐺𝐷𝑃 𝐿𝑎𝑡𝑒𝑟 𝑌𝑒𝑎𝑟 − 𝑅𝑒𝑎𝑙 𝐺𝐷𝑃 𝐸𝑎𝑟𝑙𝑖𝑒𝑟 𝑌𝑒𝑎𝑟 𝑅𝑒𝑎𝑙 𝐺𝐷𝑃 𝐸𝑎𝑟𝑙𝑖𝑒𝑟 𝑌𝑒𝑎𝑟 𝑋 100 Inflation Rate = 𝑃𝑟𝑖𝑐𝑒 𝑖𝑛𝑑𝑒𝑥 𝐿𝑎𝑡𝑒𝑟 𝑌𝑒𝑎𝑟 − 𝑃𝑟𝑖𝑐𝑒 𝐼𝑛𝑑𝑒𝑥 𝐸𝑎𝑟𝑙𝑖𝑒𝑟 𝑌𝑒𝑎𝑟 𝑃𝑟𝑖𝑐𝑒 𝐼𝑛𝑑𝑒𝑥 𝐸𝑎𝑟𝑙𝑖𝑒𝑟 𝑌𝑒𝑎𝑟 𝑋 100

Inflation rate and growth rate in 2011 - 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃 = 58,300 2011 − 51,400 2010 51,400 2011 𝑋 100 = 13.4% 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑅𝑒𝑎𝑙 𝐺𝐷𝑃 = 52,000 2011 − 50,000 2010 50,000 2011 𝑋 100 = 4.0% Inflation Rate = 112.1 2011 − 102.8 2010 102.8 2010 𝑋 100 = 9.05%

How GDP Is Used Short-run – Business cycle Long-run – Trend growth recession expansion Long-run – Trend growth Measure the long-run growth rate of the economy’s output

The Business Cycle peak trough +3% -2% +4% Over time, real GDP fluctuates around an overall long-run upward trend. Such fluctuations are called business cycles. When output rises, we are in the expansion phase of the cycle; when output falls, we are in a recession.

How GDP Is Used Real GDP needs to grow by about 3% per year to provide enough jobs for a workforce that is growing in number and becoming more productive every year This is a big concern now because the economy have not been growing at 3% per year.

Real GDP Growth Rate, 1970–2011 http://bea.gov/newsreleases/national/gdp/gdp_glance.htm

Real GDP Growth Rate, 1970–2011 Things to note: Although the growth rate of real GDP has fluctuated over time, it has been well above the 1 percent rate needed to maintain output per person, so real GDP per capita has risen over time. For most of the period, the average growth rate was high enough to create the jobs needed by a growing and more productive workforce. During some years (e.g., 2008– 2011), growth slowed, and an insufficient number of jobs were created

LIMITATIONS OF THE GDP CONCEPT GDP AND SOCIAL WELFARE If crime levels went down, society would be better off, but a decrease in crime is not an increase in output and is not reflected in GDP. An increase in leisure is also an increase in social welfare, but sometimes associated with a decrease in GDP. Most nonmarket and domestic activities, such as housework and child care, are not counted in GDP even though they amount to real production.

LIMITATIONS OF THE GDP CONCEPT underground economy - the part of the economy in which transactions take place and in which income is generated that is unreported and therefore not counted in GDP. distribution of income - GDP also has nothing to say about the distribution of output among individuals in a society. pollution – environmental deterioration is not subtracted out.