Measuring Domestic Output & National Income Chapter 6 4/22/2017

In this chapter, you will learn: How gross domestic product (GDP) is defined and measured. The relationships among GDP, net domestic product, national income, personal income, and disposable income The nature & function of a GDP price index The difference between nominal GDP & real GDP Some limitations of the GDP measure 4/22/2017

National Income Accounting (7.1) Measures the economy’s overall performance Enables economists & policymakers to Assess the health of the economy by comparing levels of production at regular intervals Track the long-run course of the economy to see whether it has grown, been constant, or declined Formulate policies that will safeguard & improve the economy’s health First…it does for the economy as a whole what private accounting does for the individual firm or for the individual household. 4/22/2017

Gross Domestic Product Total market value of all final goods & services produced within a country’s borders in a given year Primary measure of the economy’s performance Ex. Value of cars produced at a Toyota factory in Ohio count as U.S. GDP but not McDonald’s cheeseburgers produced in Canada. After #1…includes the market value of Fords produced by an American-owned factory in Michigan and the market value of Hondas produced by a Japanese-owned factory in Ohio. 3) To measure output accurately, all g&s must be counted only once. Because most products go through a series of production stages before they reach the market, some of their components are bought & sold many times. To avoid counting those components each time, GDP includes only the mkt value of final goods. Intermediate goods are g&s that are purchased for resale or for further processing or manufacturing. Final Goods- are g&s that are purchased for final use by the consumer, not for resale or for further processing or manufacturing…the value of the intermediate good is already included in the price of the final good. Including the value of intermediate goods would amount to multiple counting and would distort the value of GDP 4a) public transfer pymts (I.e. social security/welfare), private transfer payments (I.e. cash gifts given at Christmas time or money parents give to kids), & stock market transaction…4b) contribute nothing to current production and for that reason are excluded from GDP. 4/22/2017

Avoid multiple counting To measure aggregate output accurately, all goods & services produced in a particular year must be counted one time only To avoid multiple counting, GDP includes only final goods & ignores intermediate goods Intermediate Goods & services purchased for resale or further processing Final Consumption & capital goods that are purchased by their final users. 4/22/2017

GDP Excludes nonproduction transactions Must be excluded because they have nothing to do with the generation of final goods Public transfer payments Social security payments, welfare, veterans’ payments are excluded because they don’t contribute current production Private transfer payments Ex. Cash gifts Stock market transactions Swapping stock for money doesn’t create new production either First…although many monetary transactions in the economy involve final goods & services, many others do not. These nonproduction transactions must be excluded from GDP because they have nothing to do with the generation of final goods. 4/22/2017

Secondhand sales (used goods) Contribute nothing to current production and are excluded from GDP 4/22/2017

Two ways of looking at GDP How is the market value measured? How much did the final user pay for it? Another way to measure market value: Add up wage, rental, interest, & profit incomes that were created in producing the product 1a) Covers all expenditures by households on durable goods, non durable goods, & services 1b) includes the following: all final purchases of machinery, equipment, & tools for business, all construction, & changes in inventories (represents unconsumed output) 1c) includes the following: expenditures for g&s that govt consumes in providing public services and 2) expenditures for social capital such as schools & highways. 1d) exports-imports 4/22/2017

The Expenditures Approach Add up all spending on final goods & services that has taken place throughout the year Personal consumption (C) Gross Private Domestic Investment (I) Positive & Negative Changes in Inventories Noninvestment Transactions Net private domestic investment = gross investment-depreciation 2. Consumption expenditures by households on durable goods, nondurable goods, & consumer expenditures for services…accountants use the symbol C to designate this component of GDP. 3. Under the heading gross private domestic investment, accountants include the following items: all final purchases of machinery, equipment, & tools by business enterprises…all construction, changes in inventories 3a. Inventories can either increase or decrease over some period of time. 3b. Investment does not include the transfer of paper assets (stocks, bonds) 3c. Gross private domestic includes (1) all final purchases or machinery, equipment, & tools; (2) all construction; and (3) changes in inventories…the words “private” and “domestic” mean that we are speaking of spending by private businesses, not by government (public) agencies and that the investment is taking place inside the country, not abroad. Net private domestic investment includes only investment in the form of added capital. The amount of capital that is used up over the course of a year is called depreciation 4/22/2017

Expenditures (cont) Government Purchases (G) Net Exports (x) Expenditures for goods and services that government consumes in providing public services Expenditures for publicly owned capital such as schools and highways Does not include government transfer payments (ex. Social security) Net Exports (x) Exports - Imports 4/22/2017

Putting it all together Taken together, the four categories of expenditures provide a measure of the market value of a given year’s total output – its GDP GDP = C + I + G + (X-M) 4/22/2017

Income Items that make up national income Compensation of employees Wages & salaries paid by business and government to their employees Rent Income received by households & businesses that supply property resources Include monthly payments tenants make to landlords & lease payments corporations pay for the use of office space Interest Money paid by private businesses to the suppliers of loans used to purchase capital Interest households receive on savings, CD’s, & corporate bonds 1. By far the largest share of national income 4/22/2017

Income Approach (cont.) Proprietor’s income Net income of sole proprietorships & partnerships Corporate profits Earnings of corporations Corporate income taxes Dividends Undistributed corporate profits 2a. Taxes levied on corporations’ profits 2b. After-tax profits that corporations choose to pay out to their stockholders 2c. Any after-tax profits that are not distributed to shareholders are retained by corporations to be invested later in new plants & equipment 4/22/2017

Income Approach (cont.) Taxes on production & imports Includes the following: General sales taxes Excise taxes Business property taxes License fees Customs duties These are included in national income because it accounts for expenditures that are diverted to government 4/22/2017

From National Income to GDP National income is the total of all sources of private income plus government revenue All income that flows to American-supplied resources, whether here or abroad 4/22/2017

Net Foreign Factor Income When moving from national income to GDP, we must consider the income Americans gain from supplying resources abroad Income foreigners gain by supplying resources in the U.S. Difference is net foreign factor income 4/22/2017

Consumption of fixed capital Huge depreciation charge made against private & publicly owned capital each year Allowance for capital that has been “consumed” in producing this year’s GDP Portion of GDP that is set aside to pay for the ultimate replacement of those capital goods 4/22/2017

Other National Accounts (7.2) Net domestic product (NDP) NDP=GDP-consumption of fixed capital (depreciation) National income (NI) Includes all income earned through the use of American-owned resources, (home or abroad) Also includes taxes on production of imports Personal income (PI)- includes all income received (earned or unearned) Disposable income (DI)-personal income less personal taxes First…other national accounts provide additional useful information about the economy’s performance. GDP doesn’t make allowances for replacing the capital goods used up in each year’s production. NDP is simply GDP adjusted for depreciation. We can also calculate national income through the income approach by simply adding up employee compensation, rent, interest, proprietor’s income, corporate profit, & taxes of production & imports Likely to differ from NI because some income earned is not received by households (I.e. taxes on production, payroll taxes, & corporate income taxes). Conversely, some income received-such as social security payments, unemployment compensation, & welfare payments are not earned. In moving from NI to PI, we must subtract the income earned but not received & add income that is received but not earned. Personal taxes include: personal income taxes, personal property taxes, & inheritance taxes. Amount left over after paying personal taxes. 4/22/2017

Nominal GDP vs. Real GDP (7.3) START HERE Nominal GDP based on prices that prevailed when output was produced Real GDP that has been deflated or inflated to reflect changes in the price level These adjustments give us a measure of GDP for various years as if the value of the dollar had always been the same as it was in a reference year How can we compare the market values of GDP from year to year if the value of money itself changes in response to inflation or deflation? 4/22/2017

GDP Price Index Price index Measure of the price of a specified collection of goods & services (market basket) in a given year This # will be compared to the price of an identical collection of goods & services in a reference year (base year) First…how can we determine real GDP in our economy? One way is to assemble data on the price changes that occurred over various years (column #2) and use them to establish an overall price index for the entire period. Then we can use the index in each year to adjust nominal GDP to real GDP for that year. Formula…Price index in a given year = price of market basket in specific year/price of same market basket in base year x (100) 4/22/2017

Calculating Real GDP (Base year=year 1) (Table 7.5) Units of output Price of pizza/unit Price index (year 1=100) Unadjusted or Nominal GDP (2)x(3) Adjusted or real, GDP 1 5 $10 100 $50 50 2 7 20 200 140 70 3 8 25 250 80 4 10 30 11 28 First…there are two ways we can adjust nominal GDP to reflect price changes. #1 is column #1x#2…using this method, we have no way of knowing to what extent changes in price and/or changes in quantity of output have accounted for the increases or decreases in nominal GDP that we observe. Price index=price in specific year/price of same market basket in base year Real GDP=nom gdp/price index x 100 4/22/2017

Shortcomings of GDP Nonmarket activities Leisure Improved product quality Underground economy GDP & environment First…gdp is a reasonable accurate & highly useful measure of how well or how poorly the economy is performing. But is has several shortcomings. Certain productive activities do not take place in any market-services of homemakers, labor of carpenters who repair their own homes. These activities never show up in GDP so the figure is understated. Average workweek has declined from 53 hours (1900) to 35 hours. This increase in leisure time has had a positive effect on overall well-being. Because gdp is a quantitative measure rather than a qualitative measure, it fails to capture the full value of improvements in product quality. I.E. there is a real difference in the quality of a $200 cell phone today versus ten years ago. The value of underground transactions is estimated to be about 8% of the recorded gdp in the U.S. That would mean that gdp is understated by about $1 trillion. See Global Perspective 6.2 p. 119. Gdp growth is accompanied by dirty air, pollution, noise, & polluted water. These social costs reduce our economic well-being. 4/22/2017