SPENDING, INCOME, & GDP Chapter 4

GDP Accounting GDP (Gross Domestic Product)—the market value of all final goods and services produced in a country during a given period of time.

GDP Breakdown 1) Only consider the market value 2) We wish to include only final goods and services. 3) Must avoid double accounting—counting the same production twice. 4) All output should be included in GDP. 5) GDP includes only currently produced goods and services. 6) GDP includes only goods and services produced within a nation’s border

1) Market Value Approach to GDP Measure in terms of market value, not in terms of solely output or solely price

Market Value Example: Suppose a country’s total production is 4 purses ($20 each), 2 cookies ($1 each), and 1 television ($600). Three possibilities of measurement: Just in terms of output: 4+2+1 = 7 units of total output Does this make sense? In terms of price only: 20+1+600 = $621 Really? Or in terms of market value: (4 purses*20)+(2 cookies*1)+(1 television *600)=$682 Allows for all goods to be on an equal playing field

2) We wish to include only final goods and services. Final goods—consumed by the ultimate user. Intermediate goods—used up in the production of final goods (not counted as part of GDP).

3) Must avoid double accounting—counting the same production twice. To avoid double accounting, we use value added Value added, for any firm, is the market value of its product minus the cost of inputs purchased. Example: Suppose the following market values: Grain: $.50 Flour: $1.20 French Bread: $2.00 So GDP must be $3.70…WRONG! GDP is $2.00

4) All output should be included in GDP, but it’s not Some output is not sold through markets and is difficult to value. GDP does not include the volunteer services, housework, and do-it-yourself activities. Underground economy

Drawback of Market Value Non-market goods not counted in GDP Fails to account for household activities, volunteer services, and do-it yourself activities Example is female labor force participation Since 1960 female LFP has increased, so did GDP. However prior many females stay at home as mothers, whose production was not counted in GDP Note: some non-market goods are still included, e.g. defense spending

5) GDP includes only currently produced goods and services GDP only includes production that takes place during the indicated time period. For example GDP in 2011 includes only goods and services in 2011. Transactions in existing assets are not included. Eg. If you buy a DVD of star Trek from Amazon, the purchase is included in GDP. If 6 months later you resell the DVD on ebay, that transaction is not included in GDP.

6) Produced within a nation’s borders Key: GDP = Gross Domestic Product GDP includes any goods produced within the nation’s borders regardless of a company’s home country If Toyota (a Japanese Multinational Corp.) makes cars in Kentucky, is that part of U.S. GDP? If Apple ( a California based Corp.) makes ipods in Canada, is that part of U.S. GDP?

GNP GNP (Gross National Product)—the market value of all final goods and services produced by resources supplied by a country during a given period of time, regardless of where they are located.

Main Difference GDP measures the production of resources located in the U.S., regardless of who owns them. GNP measures the production of resources owned by U.S. residents, regardless of where the resources are located.

Nominal GDP

Expenditure Approach to GDP GDP = consumption + investment + government purchases + net exports

Consumption Consumption—spending by households on goods and services except the purchase of homes.

Types of Consumption Consumer Durables – long-lived consumer goods Consumer Nondurables – short-lived consumer goods Services – Largest component of consumption

Consumption

Investment Investment—spending by firms on final goods and services—primarily capital goods and housing.

Types of Investment Business Fixed Investment – purchase by firms of new capital goods such as machinery factories, and office buildings Residential Investment – construction of new homes and apartment buildings. (treated as investment by business sector) Inventory Investment – addition of unsold goods to company inventories CAUTION: Do not confuse with financial investment

Investment

Government Spending Government purchases—government purchases of final goods and services.

Exclusions of Government Spending Government Spending does not include transfer payments What are transfer payments? Payments made by the government in return for which no current goods or services are received Examples: Social Security benefits, unemployment benefits, pensions to government workers, and welfare payments Why do we exclude them?

Government Purchases

Net Exports Net exports = exports – imports Why do we subtract imports?

Since imports are included in consumption, investment, and government purchases but do not represent spending on domestic production, they must be subtracted.

Net Exports

Formal Representation of GDP Y = C + I + G + NX Recall NX = EX - IM What does each component represent? Or more appropriately who?

How do we classify the following? A haircut A defense contractor buys a tank The U.S. Army buys a tank Financial services provided by domestic residents to foreigners on U.S. soil

Income Approach to GDP When a good is sold, its proceeds are distributed to workers or business owners Capital income pays for physical capital and intangibles Profits for business owners GDP = labor income + capital income Rent for land Interest for bond holders Labor income is wages, salaries, benefits, and incomes of the self- employed Royalties

Market Value of Final Goods and Services Three GDP Approaches Production Market Value of Final Goods and Services Expenditure Investment Consumption Government purchases Net exports Income Capital Income Labor Income

Adjusting for Price Changes Compare GDP for different years to see how much output has changed GDP changes over time because Prices change AND Quantity of output changes To see how much output has grown, use only the changes in quantities Hold prices constant

The Pizza and Games Economy GDP in 2009 is $175; GDP in 2013 is $420 GDP in 2013 is 2.4 times the GDP in 2009 Only twice as many pizzas and games were produced in 2013 Market value of output grew faster than the physical volume of output Number of Pizzas Price of Pizza Number of Games Price of Game 2009 10 $10 15 $5 2013 20 $12 30 $6

Real GDP and Nominal GDP Real GDP values output in the current year using the prices from the base year The base year is a reference year that changes infrequently Real GDP measures the physical volume of production Nominal GDP values output in the current year using prices from the current year Nominal GDP is the current dollar value of production

Calculating Real GDP for 2013 Use 2009 as the base year Nominal GDP for 2009 is $175 and for 2013, $420 Calculate real GDP using current year quantities and base year prices Real GDP in 2013 is (20 pizzas) ($10) + (30 games) (5) = $350 Real GDP doubled between 2009 and 2013 Number of Pizzas Price of Pizza Number of Games Price of game 2009 10 $10 15 $5 2013 20 $12 30 $6

Observations on Real and Nominal GDP Usually, nominal and real GDP increase each year But can they move in opposite directions? YES! Nominal GDP can go up and real GDP go down Fewer goods and services produced AND Prices increase faster than output decreased Nominal GDP will be smaller than real GDP if the prices in the current year are less than in the base year Usually true for years before the base year Real GDP could rise and nominal GDP fall, but this is rare Prices are falling faster than output is increasing

Real GDP and Economic Well-Being Real GDP is a flawed measure of well-being It values only market transactions Omits illegal transactions, volunteer work, and household production Maximizing GDP will not necessarily maximize national well-being Whether increases in output increase welfare is a case- by-case issue

Poverty and Economic Inequality GDP does not capture the effects of income inequality Most would prefer living in a relatively equal society to one with a few wealthy and many poor US uses an absolute standard of poverty In 2005, a family of four was poor if their income was less than $19,350 Inequality matters and it is increasing in the US The case of the beat-up car

GDP as a Welfare Measure GDP omits and undervalues some goods and services GDP per capita is positively associated with several measures of well-being Material standard of living: more goods and services Health and life expectancy Residents of industrialized countries fare better than residents of developing countries in a range of health measures Education Literacy and school enrollment rates are higher in high-income countries