How do we track the booms and busts of the business cycle? How do we measure a nation’s production and income? How do we determine when a recession begins? 1

GDP, INCOME, AND EXPENDITURE GDP Defined Gross domestic product or GDP The market value of all the final goods and services produced within a country in a given time period. Value Produced Use market prices to value production. Focus your students on the definition of GDP--the market value of all the final goods and services produced within a country in a given time period. Ask your students to go through the definition and pull out the essential parts. You will get this list: market value, final goods and services, produced, within a country, and time period. Explain that the words chosen in this definition were selected carefully. First, if the phrase “market value” had been left out, there would be room for lots of problems. Notice that when the government reports this figure, it doesn’t announce how many trains, planes, and automobiles the country has produced but rather it announces a monetary value. Using monetary values affords us the opportunity to be able to get around the problem of aggregation when the items in question are markedly different. We solve it by allowing the marketplace to determine the weights. The second item on the list is “final goods and services.” The explanation here is straightforward: We are distinguishing between final products and intermediate products. Intermediate goods are goods that are bought by one firm to be used in the production of another good that will be ultimately consumed. If we include these intermediate goods, then we would double count the nation’s output. Now we come to the word “produced.” This word is to make clear that sales are not important. If we only counted sales, then the GDP figures would understate production because not all output is sold. Some of it becomes inventory. Next is the phrase “within a country.” This phrase is to make clear that we don’t count output that wasn’t produced on a nation’s soil regardless of who was responsible for producing it. Lastly, is the phrase “time period.” Here we want to make unambiguous that we are only talking about production that occurred in a certain period. This phrase leaves no doubt that production of a good or service produced in a previous time period (even if perhaps sold in the present time period) does not count in this period’s GDP.

GDP, INCOME, AND EXPENDITURE What Produced Final good or service is a good or service that is produced for its final user and not as a component of another good or service. Intermediate good or service is a good or service that is produced by one firm, bought by another firm, and used as a component of a final good or service. GDP includes only those items that are traded in markets.

GDP, INCOME, AND EXPENDITURE Where Produced Within a country When Produced During a given time period.

GDP, INCOME, AND EXPENDITURE Circular Flows in the U.S. Economy Consumption expenditure is the expenditure by households on consumption goods and services. Investment is the purchase of new capital goods (tools, instruments, machines, buildings, and other constructions) and additions to inventories.

GDP, INCOME, AND EXPENDITURE Government expenditure on goods and services is the expenditure by all levels of government on goods and services. Net exports of goods and services is the value of exports of goods and services minus the value of imports of goods and services.

5.1 GDP, INCOME, AND EXPENDITURE Exports of goods and services are the items that firms in in the United States produce and sell to the rest of the world. Imports of goods and services are the items that households, firms, and governments buy from the rest of the world.

5.1 GDP, INCOME, AND EXPENDITURE Total expenditure is the total amount received by producers of final goods and services. Consumption expenditure: C Investment: I Government expenditure on goods and services: G Net exports: NX Total expenditure = C + I + G + NX

GDP, INCOME, AND EXPENDITURE Labor earns wages. Capital earns interest. Land earns rent. Entrepreneurship earns profits. Households receive these incomes.

GDP, INCOME, AND EXPENDITURE Expenditure Equals Income Because firms pay out everything they receive as incomes to the factors of production, total expenditure equals total income. That is: Y = C + I + G + NX The value of production equals income equals expenditure.

GDP, INCOME, AND EXPENDITURE Figure 1 shows the circular flow of income and expenditure. The table shows the U.S. data for 2009.

The Expenditure Approach MEASURING U.S. GDP The Expenditure Approach Measures GDP by using data on consumption expenditure, investment, government expenditure on goods and services, and net exports. Table 1 on the next slide shows the calculation for 2009. You might like to tell your students that measuring real GDP is actually very cheap. The BEA (in the Department of Commerce) employs fewer than 500 economists, accountants, statisticians, and IT specialists at an annual cost of less that $70 million. It costs each American less than 0.25¢ (a quarter of a cent) to measure the value of the nation’s production. For some further perspective, the National Oceanic and Atmospheric Administration (also in the Department of Commerce), whose mission is to “describe and predict changes in the Earth’s environment, and conserve and manage wisely the nation’s coastal and marine resources so as to ensure sustainable economic opportunities,” employs more than 11,000 scientists and support personnel at an annual cost of $3.2 billion!

MEASURING U.S. GDP

MEASURING GDP Expenditures Not in GDP Used Goods Expenditure on used goods is not part of GDP because these goods were part of GDP in the period in which they were produced and during which time they were new goods. Financial Assets When households buy financial assets such as bonds and stocks, they are making loans, not buying goods and services.

GDP and Related Measures of Production and Income MEASURING GDP GDP and Related Measures of Production and Income Gross national product or GNP is the market value of all the final goods and services produced anywhere in the world in a given time period by the factors of production supplied by residents of the country. U.S. GNP = U.S. GDP + Net factor income from abroad

Disposable Personal Income MEASURING GDP Disposable Personal Income Consumption expenditure is one of the largest components of aggregate expenditure and one of the main influences on it is disposable personal income. Disposable personal income is the income received by households minus personal income taxes paid.

Real GDP and Nominal GDP MEASURING GDP Real GDP and Nominal GDP Real GDP is the value of the final goods and services produced in a given year expressed in the prices of the base year. Nominal GDP is the value of the final goods and services produced in a given year expressed in the prices of that same year. The method of calculating real GDP changed in recent years. Here we describe the essence of the calculation. The appendix gives the technical details.

Calculating Real GDP MEASURING GDP The goal of calculating real GDP is to measure the extent to which total production has increased Real GDP removes the influence of price changes from the nominal GDP numbers. To focus on the principles and keep the numbers easy to work with, we’ll calculate real GDP for an economy that produces only one consumption good, one capital good, and one government service.

MEASURING U.S. GDP Table 3 shows the calculation with 2005 (base year) and 2010. To find the total expenditure in 2005 multiply the quantity of each item produced in 2005 by its price in 2005. Then sum the expenditures to find nominal GDP in 2005. The next slide shows the data.

Nominal GDP in 2005 is $100 million. Because 2005 is the base year, real GDP in 2005 is also $100 million.

MEASURING U.S. GDP In part (b) of Table 3, we calculate nominal GDP in 2010. Again, we calculate nominal GDP by multiplying the quantity of each item produced by its price and then sum the expenditures to find nominal GDP in 2010.

Nominal GDP in 2005 is $100 million.

MEASURING U.S. GDP Nominal GDP in 2005 is $100 million and in 2010 it is $300 million. Nominal GDP in 2010 is three times its value in 2005. But by how much has the quantity of final goods and services produced increased?

MEASURING U.S. GDP The increase in real GDP will tell by how much the quantity of good and services has increased. Real GDP in 2010 is what the total expenditure would have been in 2010 if prices had remained the same as they were in 2005. To calculate real GDP in 2010 multiply the quantities produced in 2010 by the price in 2005 and the sum these expenditures to find real GDP in 2010. Part (c) of Table 3 shows the details.

Real GDP in 2005 is $100 million. Real GDP in 2010 is $160 million—only 1.6 times real GDP in 2005.

THE USE AND LIMITATIONS OF REAL GDP We use estimates of real GDP for three main purposes: To compare the standard of living over time To track the course of the business cycle To compare the standard of living among countries The Standard of Living Over Time To compare living standards we calculate real GDP per person—real GDP divided by the population.

THE USE AND LIMITATIONS OF REAL GDP In 2009, U.S. real GDP was $12,893 billion and the U.S. population was 306.2 million. Real GDP per person = $12,893 billion ÷ 306.2 million Real GDP per person = $42,106. In 1959, real GDP per person was $15,540. The standard of living in 2009 was 2.7 times the standard of living in 1959.

THE USE AND LIMITATIONS OF REAL GDP Two features of our changing standard of living are The growth of potential GDP per person Fluctuations of real GDP per person around potential GDP Potential GDP is the value of real GDP when all the economy’s factors of production —labor, capital, land, and entrepreneurial ability—are fully employed.

THE USE AND LIMITATIONS OF REAL GDP When some factors of production are unemployed, real GDP is less than potential GDP. When some factors of production are over-employed and working hard, real GDP exceeds potential GDP. In the short term, real GDP fluctuates around potential GDP. To measure the trend in the standard of living, we remove the influence of short-term fluctuations and focus on potential GDP. Figure 3 on next slide shows these two features.

THE USE AND LIMITATIONS OF REAL GDP Real GDP per person grows and fluctuates around the path of potential GDP. Potential GDP per person grew at 2.8 percent in the 1960s and slowed during the 1970s.

THE USE AND LIMITATIONS OF REAL GDP Tracking the Course of the Business Cycle Fluctuations in the pace of expansion of real GDP is called the business cycle. The business cycle is a periodic irregular up-and down movement of total production and other measure of economic activity. The four stages of a business cycle are expansion, peak, recession, and trough.

THE USE AND LIMITATIONS OF REAL GDP The shaded periods show the recessions—periods of falling production that lasts for at least six months.

EYE on the BUSINESS CYCLE How Do We Track the Booms and Busts of the Business Cycle? The National Bureau of Economic Research (NBER) Business Cycle Dating Committee determines the dates of U.S. business cycle turning points. To identify the date of a business cycle peak, the NBER committee looks at data on industrial production, total employment, real GDP, and wholesale and retail sales. The two most reliable measures of aggregate domestic production are real GDP measured using the expenditure approach and the income approach. 36

EYE on the BUSINESS CYCLE How Do We Track the Booms and Busts of the Business Cycle? The NBER committee met in November 2008 to determine when the economy went into recession. Because of a statistical discrepancy, the two estimates of real GDP differ and for a few quarters in 2007 and 2008 they told conflicting stories. The NBER examined other data on real personal income, real manufacturing, wholesale and retail sales, industrial production, and employment. 37

EYE on the BUSINESS CYCLE How Do We Track the Booms and Busts of the Business Cycle? All of these data peaked between November 2007 and June 2008. The committee decided that November 2007 was the peak. But as the figure shows, real GDP didn’t begin a sustained fall until two quarters later. 38

THE USE AND LIMITATIONS OF REAL GDP Standard of Living Across Countries To compare living standards across countries, we must convert real GDP into a common currency and common set of prices, called purchasing power parity. Goods and Services Omitted from GDP Household production Underground production Leisure time Environment quality A discussion of omissions from GDP can arouse students’ interest. For example, you might point out that if one of your students mows her/his own lawn, the value of the student’s production doesn’t show up in GDP. But if you hire the student to mow your lawn (and if your student reports the income earned correctly to the IRS), the value of the student’s production does show up in GDP. Why don’t we measure all lawn mowing as part of GDP? Some reasons are cost of collecting data and the degree of intrusiveness we’d be willing to tolerate. But note how little we spend on collecting the GDP data and how relatively inexpensive it would be to add some questions about domestic production to either the Labor Force Survey or the Family Expenditure Survey. You might like to explain how the omission of illegal goods and services also leads to some misleading comparisons. For instance, the day before prohibition ended, the production of illegal beer was not counted as part of GDP. But the day after prohibition ended, the production of now legal beer counted. Ask your students to suggest two good reasons why illegal goods and services are omitted. First, the data are hard but not impossible to obtain. Second, there may be the moral position that illegal activities should not be included in GDP. This latter observation can lead to an interesting discussion. Ask the students if they think that the production of, say, marijuana should be included in GDP. Some, maybe even many, of them will see no problem with this. Then ask about the production of murder-for-hire. The response, we hope, will be significantly different. Does such a good have any value?

THE USE AND LIMITATIONS OF REAL GDP Household Production Real GDP omits household production and it underestimates the value of the production of many people, most of them women. Underground Production Hidden from government to avoid taxes and regulations or illegal. Because underground economic activity is unreported, it is omitted from GDP.

THE USE AND LIMITATIONS OF REAL GDP Leisure Time Our working time is valued as part of GDP, but our leisure time is not. Environment Quality Pollution is not subtracted from GDP. We do not count the deteriorating atmosphere as a negative part of GDP. If our standard of living is adversely affected by pollution, our GDP measure does not show this fact.

THE USE AND LIMITATIONS OF REAL GDP Other Influences on the Standard of Living Health and Life Expectancy Good health and a long life do not show up directly in real GDP. Political Freedom and Social Justice A country with a large real GDP per person might have limited political freedom and social justice. A country with a lower standard of living might be one in which everyone enjoys political freedom. You can generate a productive classroom discussion on the topic of this slide.

APPENDIX: MEASURING REAL GDP The Problem with Base-Year Prices We calculated real GDP in 2010 using 2005 as the base year and found that real GDP in 2010 was 1.6 percent greater than in 2005—an increase of 60%. But if we had used 2010 prices rather than 2005, real GDP would have increased from $150 million (2010 dollars) in 2005 to $300 million in 2010—an increase of 100%. So did real GDP increase by 60% or 100%?

APPENDIX: MEASURING REAL GDP The BEA method uses the prices of both years. The three steps in the method are Value production in the prices of adjacent years. Find the average of the two percentage changes. Link (chain) to the base year.

APPENDIX: MEASURING REAL GDP By applying the average percentage change between each pair of years, we find the chained-dollar real GDP for each year, expressed in terms of 2005 dollars. We can do this for years after the base year, And for years earlier than the base year.