Learning Objectives 05-01. Know what GDP measures – and what it doesn’t. 05-02. Know the difference between real and nominal GDP. 05-03. Know why aggregate income equals aggregate output. 05-04. Know the major submeasures of output and income. We will use these to summarize the chapter.

Measures of Output Each good and service produced and brought to market has a price, which serves as a measure of its value. Gross domestic product (GDP): the total dollar value of all final output produced within a nation’s borders in a given time period, usually one year. Product: the goods and services being produced. Domestic: within the borders of the country. Gross: all of it – that is, final goods.

Why “Final Output”? GDP measurements exclude intermediate goods. Intermediate goods: goods or services purchased for use as an input in the production of final goods or in services. Value added: the increase in the market value of a product that takes place at each stage of production. The value added by each intermediate good is captured in the market price of the final good produced. Seed is transformed into wheat, which is milled into flour, which is baked into bread, which is made into a sandwich, which is bought and eaten by you. You paid for the sandwich. Your payment includes all the value added by the farmer, the miller, the baker, the store, and the sandwich maker.

International Comparisons GDP is geographically focused: output produced within a nation’s borders. This makes it easier to make international comparisons of economic activity. For more vivid comparisons, we construct GDP per capita: average GDP, or the total GDP divided by total population. Remember, we are measuring production of goods and services and measuring them in the value-changing dollar. Therefore, we have two problems in cross-border comparisons: the relative purchasing power of each currency and the attitudes of the people in each country concerning their desire for material (vs. nonmaterial) possessions.

GDP per Capita GDP divided by population. Average output per person. Used as a measure of a country’s standard of living. Does not indicate the disparity of output distributed to high-income earners and low-income earners in that country. Low GDP per capita reflects a lot of deprivation in that country. The average grade in your class might be a C+ and the spread of grades goes from A+ to D-. Similarly, GDP per capita is the average. It does not adequately describe those getting more or those getting less, just as C+ doesn’t describe the A+ or the D-.

Measurement Problems Nonmarket activities: GDP measures exclude most goods and services produced but not sold in the market. Production not included: Unpaid production done at home or by volunteer workers. Unreported production done “off the books” or in the underground economy. The official GDP measurement significantly understates actual production in the country. Not included: under-the-table transactions, volunteer production, work done by family members, illegal transactions. That is a whole lot of production not accounted for. You could ask your students why these are not included in GDP.

Real GDP and Nominal GDP A significant use of GDP is to measure how production changes from year to year. Price changes from year to year make it difficult to compare one year’s GDP with the next year’s GDP. Both output levels and prices can change. We want to see only the change in output levels. Because of this, we must remove the effects of price changes from the GDP measurements. We now lead into the need to “correct” nominal GDP (as measured) to real GDP (with inflation’s effects removed).

Real GDP and Nominal GDP Nominal GDP: the value of final output produced in a given period, measured in the prices of that period (current prices). The effects of price changes are included. Real GDP: the value of final output produced in a given period, adjusted for changing prices. The effects of price changes are removed. The current year market values are recalculated in base year dollars. Using base year dollar values for every year means we recalculate GDP as if the prices in the base year still existed in every other year. 9

Computing Real GDP Base year: the year used for comparative analysis; the basis for indexing price changes. We arbitrarily set a price index in the base year to equal 100. The GDP for any other year is recalculated into base year dollars, using the price index for that year. When talking about prices, we use a price index. An index has a base number of 100. If the index goes to 110, that’s a 10% increase (% increase = 110-100/100 = 10%). Since inflation typically occurs, a price index in the years before the base year is below 100 and in the years after is above 100.

Computing Real GDP The general formula for computing real GDP is The price index represents a price level percentage change from the base of 100. Nominal GDP in year t Real GDP in year t = Price index Two exercises are coming up. 100 + Percentage change Price index = 100

Exercise 1 Convert nominal GDP to real GDP: Where (for 1991) Nominal GDP = $5,677.5 billion Price index = 117.8/100 or 1.178 Real GDP (1991) = $5,677.5/1.178 = $4,819.9 billion Nominal GDP in year t Real GDP in year t = Price index If base year prices were in effect in 1991, the total value of GDP would be $4,819.9B, not the $5,677.5B we had to pay because of inflation’s erosion of the dollar’s value.

Exercise 2 Convert nominal GDP to real GDP: Where (for year t) Nominal GDP = $15 trillion Price index = 150/100 or 1.5 Real GDP in year t =$15/1.5 =$10 trillion Nominal GDP in year t Real GDP in year t = Price index Prices jumped 50% since the base year. So nominal GDP is 50% higher than real GDP to reflect this.

NDP = GDP - Depreciation Net Domestic Product Net domestic product (NDP): GDP less depreciation. When we produce, we wear out some of our capital, which must be replaced. Depreciation measures the value of capital we use up. NDP is the amount of output we could consume without reducing our stock of capital. NDP = GDP - Depreciation NDP recognizes that some equipment wears out during production. So some current production must go to replace the worn-out equipment. Otherwise we reduce the stock of capital. To achieve growth, therefore, this year’s NDP should exceed last year’s NDP.

Net Domestic Product The distinction between GDP and NDP is mirrored in the difference between gross investment and net investment: Gross investment: total investment expenditure in a given time period. Net investment: gross investment less depreciation. When net investment is positive, the economy grows. When net investment is negative, the economy declines. This is simply another way of stating what we said for NDP.

The Uses of Output The users of output indicate what mix of output has been selected (answering WHAT to produce): Consumption (C): goods and services used by households (about two-thirds of GDP). Investment (I): plant, machinery, and equipment produced (about 15% of GDP). Government spending (G): resources purchased by the public sector (about one-fifth of GDP). Net exports (X - M): the value of exports (X) minus the value of imports (M). It might be worthwhile to identify that for the rest of the course, the abbreviations C, I, G, X, and M will be used for these measurements.

Net Exports Imports (M): goods and services made in foreign lands but purchased in the United States. Exports (X): goods and services produced in the United States but purchased in foreign lands. We add exports to our GDP, but subtract imports from our GDP. The difference between exports and imports is called net exports (X – M). Since the United States produces the goods exported, they count as GDP. Since other countries produce goods imported into the United States and purchased here (by consumers, say), they are subtracted from GDP.

GDP Components The value of GDP can be computed by adding up these expenditures: where: C = consumption expenditure I = investment expenditure G = government expenditure X = exports M = imports GDP = C + I + G + ( X – M ) This is called the expenditures method of computing GDP.

Measures of Income There are two ways to measure GDP: Measure expenditures (demand side). Measure income (supply side). The total value of market incomes must equal the total value of final output, or GDP. By tracking income in the economy, we see FOR WHOM the output is produced. The other way is the income method. Ignoring some variation and time problems in measurement, the expenditures method and the income methods should give equal results.

The Equivalence of Expenditure and Income On the left is the expenditures method. On the right is the income method. The statistical discrepancy is an indication of measurement and time problems in the collection of the data.

Measures of Income Output = Income. The spending that establishes the value of output also determines the value of incomes. We can track the distribution of funds from GDP to disposable income. A brief return to the circular flow might be useful. We buy from firms (their revenues). This is GDP by the expenditures method. They pay for resources used (their costs and our income). This leads to the income method. We use our income to buy from firms, and we are back to the beginning.

From GDP to Disposable Income GDP – Depreciation = Net domestic product (NDP) NDP + Net foreign factor income = National income (NI) National income (NI) is the total income earned by U.S. factors of production. Net foreign factor income is income earned by foreigners producing American goods minus income earned by Americans producing foreign goods.

From GDP to Disposable Income There are several adjustments that have to be made to national income in order to get to personal income. Subtract Indirect business taxes. Corporate profits. Interest and miscellaneous payments. Social Security taxes. Add Transfer payments. Capital income. This yields personal income (PI). Some payments for goods go to taxes and do not flow back as income. Some corporate profits go to pay taxes and do not go to income. Some corporate profits are retained by the firm (retained earnings) and not paid out as dividends. Payments that go to other than resource providers (for example, bond holders) are excluded. The firm’s part of Social Security taxes does not go to the income earner. The government does issue transfer payments to people. Those who own bonds and other income-earning assets receive payments.

From GDP to Disposable Income Personal income (PI) is pretax income received by households. Disposable income (DI) is what remains of personal income after taxes are paid. PI – Personal taxes (T) = DI. We can do two things with our DI: spend it or save it. DI = Consumption (C) + Saving (S). Saving: that part of DI not spent on C. Not done yet. Income has made it into our personal hands, but there are taxes to be paid. Once the taxes are paid, we have finally reached disposable income. It is up to us to decide how we dispose of this income. We spend or we save. It might be useful to explain that any nonspending is called saving by economists.

Personal income (PI) = C + S + T Income Summary Households receive personal income (PI) as payment for the resources they own and provide. How do households dispose of their Income? They spend: consumption (C). They save: saving (S). They pay taxes: taxes (T). To get a full picture of mandatory and voluntary decisions the income earner has, go back to PI. Then PI = C + S + T. Here is a good time to tell the students that the abbreviations C, S, and T will mean spending, saving, and taxes for the rest of the course. Personal income (PI) = C + S + T

The Flow of Income GDP, on the income side, ends up distributed in this way: To households, in the form of disposable income. Returned to GDP as consumer spending. To businesses, in the form of retained earnings and depreciation allowances. Returned to GDP as business investment spending. To government, in the form of taxes. Returned to GDP as government spending. This completes the domestic circular flow. Outflows going to businesses are reinvested as I. Outflows going to government are returned as G. Also, you could add that outflows going to buy imports come back as payments for exports (and lending to business and government).