Measuring Domestic Output, 7 C H A P T E R Measuring Domestic Output, and National Income

Assessing the Economy’s Performance National income accounts enable us to: Measure the economy’s overall performance by measuring the flows of income and expenditures over a period of time (Assess the health of the economy) Track the long run course of the economy: growing, declining, or constant (compare conditions over time and across countries) Provide a basis for appropriate public policies to improve economic performance (improve the economy’s health) Compare the relatives sizes of different economies

GROSS DOMESTIC PRODUCT The total market value of all final goods and services produced within the national borders of a country in a given year produced by residents (nationals or foreigners) in the economy Note: GDP is a monetary measure: Quantities x prices Money valuation allows the summing of apples and oranges; money acts as the common denominator

GDP includes only final products (goods and services purchased for final use, not for resale or reprocessing or manufacturing) and services. Avoiding Multiple Counting: Most products are bought and sold many times before they reach the market. To avoid multiple counting, GDP includes only the value of final goods and ignores intermediate goods. Intermediate goods: goods purchased for resale or further processing or manufacturing. GDP: is the value of what has been produced in the economy over the year, not what was actually sold.

To avoid multiple counting Only consider the value of final products. Or Measure and cumulate the value added at each stage of production Value added = market value of the product – the value of inputs (i.e. wages, rent, interest and profits).

Example

GDP Excludes Non-production Transactions 1- Purely financial transactions are excluded: Public transfer payments, like social security payments and welfare payments. These contribute nothing to current production in return. Private transfer payments, like student allowances or money given by parents to children. They produce no output.

c. The sale of stocks and bonds represent a transfer of existing assets (just swap of papers). 2 - Secondhand sales are excluded; they do not represent current output. (However, any value added between purchase and resale is included, e.g., used car dealers).

Two Ways to Look at GDP: Spending and Income Expenditures Approach: GDP is divided into the categories of buyers in the market; household consumers, businesses, government, and foreign buyers. Add up all the spending on final goods and services took place throughout the year. These are: Personal Consumption Expenditures (C): On durable goods (goods lasting 3 years or more), non-durable goods and services.

All final purchases of machinery, equipment, and tools by businesses. 2. Gross Private Domestic Investment (Ig): Includes: All final purchases of machinery, equipment, and tools by businesses. All construction (including residential). c. Changes in business inventory.

Positive and negative changes in inventories If total output exceeds current sales, inventories build up. When inventory increases, output produced by the economy will be greater than what purchased. We need to calculate unsold output (inventory accumulation) as part of this year’s GDP (add it). If businesses are able to sell more than they currently produce, changes in inventory will be a negative number. when inventory decreases, output produced will be less than what is purchased. Since this inventory depletion had been counted in GDP of previous years, we need to subtract it from this year’s GDP.

Net Private Domestic Investment (In) includes only investment in the form of added capital. Each year as current output is being produced, existing capital equipments are wearing out and buildings are deteriorating; this is called depreciation or consumption of fixed capital. Net investment = gross investment - (consumption of fixed capital) depreciation

Note: If Gross investment > depreciation Positive net investment. the productive capacity of the economy will expand If Gross investment < depreciation  Negative net investment (disinvestment). The economy’s production capacity will decline. If Gross investment = depreciation  Net investment equals zero. The nation’s productive capacity will be static.

- Expenditure Approach = Gross Investment Depreciation Net Investment Increase Consumption & Government Spending Stock of Capital Stock of Capital January 1 Year’s GDP December 31

Non-investment transactions. Transfer of paper assets (stocks and bonds) Transfer of tangible assets (e.g., houses) These transactions do not create new capital Definition: Investment is the creation of new capital assets, that create jobs and income.

3. Government Purchases (G): They include two components: Expenditures for goods and services that the government consumes in providing public services Expenditures on social capital such as schools or highways. Remember, This entry excludes government transfer payments because they generate no production of any sort.

4 - Net Exports (Xn): All spending on final goods produced in Kuwait must be included in GDP, whether the purchase is made here or abroad. These include spending on domestic output by foreigners (Exports X). However, expenditures by residents on foreign made goods (Imports M) must be excluded (they appear in the foreign country’s GDP). Instead of adding exports and subtracting imports we only add “net exports” Xn = X - M

Now adding all things together GDP = C + Ig + G + Xn(X-M)

The Income Approach to GDP Demonstrates how the expenditures on final products are allocated to resource suppliers. Items that make up national income are: Compensation of employees includes: wages, salaries, payments made on behalf of workers like social security and other health and pension plans.

Rents: payments to households and businesses for supplying property resources (if adjusted for depreciation it will be the net rent). Interest: payments from private businesses to suppliers of money capital. It also includes interest the households receive on their savings deposits, CDs (certificates of deposits), and corporate bonds

Profits: Proprietors’ income: income of incorporated businesses: sole proprietorships, partnerships, and cooperatives. Corporate profits: Are the earnings of owners of corporations. After corporate income taxes(1) are paid to government, dividends(2) are distributed to the shareholders, and the remainder is left as undistributed corporate profits(3). The sum of the above entries equals national income: all income earned by Kuwaiti-supplied resources, whether here or abroad

From National Income to GDP National income is all income that flows to nationals, whether resident in the country or abroad. Adjustments required to balance expenditures and income. To get GDP we have to add three items: 1- indirect business taxes: These include general sales taxes, excise taxes, business property taxes and customs duties. (the seller treats these taxes as a cost of production, hence, they are part of the market value of output, but not of income).

Depreciation/Consumption of Fixed Capital: The firm also regards the decline of its capital stock as a cost of production. In addition to the depreciation of private capital, depreciation public capital (government buildings, port facilities, etc.), must be included in this entry. This is a cost of production and should be included in the gross value of output. Since this does add to income it must be added to national income to balance with the economy’s expenditures

Net foreign factor income: National income measures the income of Kuwaitis both here and abroad. To make this final adjustment, the income of foreign nationals must be added and Kuwaiti income earned abroad must be subtracted. Sometimes this entry is a negative number.

OTHER NATIONAL ACCOUNTS (USA EXAMPLE) U.S. GDP, NDP, NI, PI, & DI, 2002 Gross Domestic Product (GDP) $10,446 Consumption of fixed capital -1,393 Net Domestic Product (NDP) $9,053 Net foreign factor income earned in the U.S. - 10 Indirect business taxes - 695 National Income (NI) $8,348 Social security contributions -748 Corporate income taxes -213 Undistributed corporate profits -141 Transfer payments +1,683 Personal Income (PI) $8,929 Personal Taxes -1,113 Disposable Income (DI) $7,816

GROSS DOMESTIC PRODUCT Expenditures Approach Income Approach Consumption by Households Wages + + Rents G D P + Investment by Businesses = + = Interest + Government Purchases Profits + + Expenditures by Foreigners Statistical Adjustments

Expenditures Approach U.S. Economy 2007 in Billions Receipts Expenditures Approach Allocations Income Approach Personal Consumption (C) Gross Private Domestic Investment (Ig) Government Purchases (G) Net Exports (Xn) Gross Domestic Product $ 9734 2125 2690 -708 $ 13,841 Compensation Rents Interest Proprietor’s Income Corporate Profits Taxes on Production and Imports National Income Net Foreign Factor Income (-) Statistical Discrepancy (+) Consumption of Fixed Capital (+) Gross Domestic Product $ 7874 65 603 1043 1627 1009 $12,221 96 29 1687 $ 13,841

Definitions: A. Net domestic product (NDP) is equal to GDP minus depreciation allowance (consumption of fixed capital). National income (NI) is income earned by Kuwaiti‑owned resources here or abroad. Adjust NDP by subtracting indirect business taxes and adding net Kuwaiti income earned abroad. (Note: This may be a negative number if foreigners earned more in Kuwait than Kuwaiti resources earned abroad.)

Personal income (PI) is income received by households Personal income (PI) is income received by households. To calculate, take NI minus payroll taxes (social security contributions), minus corporate profits taxes, minus undistributed corporate profits, and add transfer payments. D. Disposable income (DI) is personal income less personal taxes.

Nominal versus Real GDP Nominal GDP is the market value of all final goods and services produced in a year. This creates problems when we compare GDP over time. If GDP increases, this may be due to rises in quantities or in prices or both. But it is only the quantity of goods we produce that affects our standards of living not the price.

To measure changes in the quantity of output, we need a yardstick that stays the same size. To make comparisons of real output, a K.D. must keep the same purchasing power over time. Unadjusted (nominal) GDP: is based on current prices

To overcome this problem we deflate GDP when prices rise, or inflate GDP when prices fall. Adjusted (real) GDP is deflated or inflated to reflect changes in prices. Adjustment process in one product economy. Valid comparisons cannot be made with nominal GDP alone, since both prices and quantities are subject to change. Some methods to separate the two effects must be devised.

Adjustment Process: First Method: GDP Price Index: first determine a price index, then adjust the nominal GDP figures by dividing by this price index Price index = (price of market basket in a specific year/ price of the same basket in base year) x 100. Real GDP = (Nominal GDP/Price index) x 100 Price Index: is a measure of the price of a specified collection of goods and services called a “market basket” in a given year (e.g. current year) compared to the price of an identical collection of goods and services in a reference (base) year.

NOMINAL GDP vs. REAL GDP: GDP Output of Pizza (4) Unadjusted, or Nominal, GDP, (1)x(2) (3) Price Index Year 1 = 100 (5) Adjusted, Or Real, GDP (1) Units of Output Of Pizza (2) Price Pizza Per Unit Year 1 2 3 4 5 5 7 8 10 11 $ 10 20 25 30 28 100 200 250 $ 50 140 200 $ 50 70 80 Note: - The market basket is composed of pizzas only - Year 1 is the base year - Real GDP can be calculated by multiplying units of output by base year prices

Adjustment Process: An alternative method Multiply current quantities of goods and services by prices of the base year to calculate real GDP Multiply current quantities of goods and services by current year prices to calculate nominal GDP Calculate the price index (Multiply by 100 to put it in standard index form) by: Price index = (nominal GDP/real GDP) x 100

Consumer Price Index Reports the price of a market basket of some consumer goods and services purchased by a typical urban consumer CPI = (price of a market basket in any given year / price of the same market basket in base year) x 100

SHORTCOMINGS OF GDP Non-market Transactions GDP doesn’t measure some very useful output because it is unpaid (homemakers’ services, parental child care, volunteer efforts, home improvement projects), e.g., the services of a carpenter who repairs his own home are not included in GDP. One exception: output that farmers consume themselves is estimated and added.

Improved Product Quality: Over time product quality improves though prices may be the same. Quality affects our welfare. GDP doesn’t measure improvements in product quality Leisure (GDP ignores leisure value): We spend more leisure time. GDP doesn’t measure improved living conditions as a result of more leisure. This affects our welfare, but this is not reflected in GDP.

Composition and Distribution of Output: GDP makes no value adjustments for changes in the composition of output or the distribution of income. Nominal GDP simply adds the dollar value of what is produced; it makes no difference if the products are guns or food. GDP figures do not provide information about how the income is distributed.

The Underground Economy: Illegal activities are not counted in GDP (estimated to be around 8% of U.S. GDP). Legal economic activity may also be part of the “underground,” usually in an effort to avoid taxation GDP and the environment: The harmful effects of pollution are not deducted from GDP (e.g., oil spills, increased incidence of cancer, destruction of habitat for wildlife, the loss of a clear unobstructed view). Note that GDP does include payments made for cleaning up oil spills and the cost of health care for cancer victims. Non-economic Sources of well-being like courtesy, crime reduction, etc., are not covered in GDP.