1 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 7: GDP: Measuring Total Production and Income CHAPTER 7 7 GDP: Measuring Total Production and Income In the more than 100 years that Ford Motor Company has been in business, its experiences have often mirrored those of the U.S economy.

2 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 7: GDP: Measuring Total Production and Income 7.1Gross Domestic Product Measures Total Production Explain how total production is measured. 7.2Does GDP Measure What We Want It to Measure? Discuss whether GDP is a good measure of well-being. 7.3Real GDP versus Nominal GDP Discuss the difference between real GDP and nominal GDP Other Measures of Total Production and Total Income Become familiar with other measures of total production and total income. GDP: Measuring Total Production and Income Chapter Outline and Learning Objectives CHAPTER 7 7

3 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 7: GDP: Measuring Total Production and Income GDP: Measuring Total Production and Income Microeconomics The study of how households and firms make choices, how they interact in markets, and how the government attempts to influence their choices. Macroeconomics The study of the economy as a whole, including topics such as inflation, unemployment, and economic growth. Business cycle Alternating periods of economic expansion and economic recession.

4 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 7: GDP: Measuring Total Production and Income GDP: Measuring Total Production and Income Recession The period of a business cycle during which total production and total employment are decreasing. Economic growth The ability of an economy to produce increasing quantities of goods and services. Inflation rate The percentage increase in the price level from one year to the next. Expansion The period of a business cycle during which total production and total employment are increasing.

5 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 7: GDP: Measuring Total Production and Income Gross Domestic Product Measures Total Production Gross domestic product (GDP) The market value of all final goods and services produced in a country during a period of time, typically one year. Measuring Total Production: Gross Domestic Product GDP Is Measured Using Market Values, Not Quantities The word value is important in the definition of GDP. 7.1 LEARNING OBJECTIVE Explain how total production is measured.

6 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 7: GDP: Measuring Total Production and Income Gross Domestic Product Measures Total Production Final good or service A good or service purchased by a final user. Measuring Total Production: Gross Domestic Product Intermediate good or service A good or service that is an input into another good or service, such as a tire on a truck. GDP Includes Only Current Production GDP Includes Only the Market Value of Final Goods GDP includes only production that takes place during the indicated time period. 7.1 LEARNING OBJECTIVE Explain how total production is measured.

7 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 7: GDP: Measuring Total Production and Income Calculating GDP Solved Problem 7-1 PRODUCTION AND PRICE STATISTICS FOR 2011 (1) PRODUCT (2) QUANTITY (3) PRICE PER UNIT Medical services 100$50.00 Pizzas Textbooks Paper 2, PRODUCT (1) QUANTITY (2) PRICE PER UNIT (3) VALUE Medical services100$50$5,000 Pizzas Textbooks201002,000 YOUR TURN: For more practice, do related problem 1.12 at the end of this chapter. 7.1 LEARNING OBJECTIVE Explain how total production is measured.

8 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 7: GDP: Measuring Total Production and Income Gross Domestic Product Measures Total Production Production, Income, and the Circular-Flow Diagram FIGURE 7-1 The Circular Flow and the Measurement of GDP The circular-flow diagram illustrates the flow of spending and money in the economy. Firms sell goods and services to three groups: domestic households, foreign firms and households, and the government. To produce goods and services, firms use factors of production: labor, capital, natural resources, and entrepreneurship. Households supply the factors of production to firms in exchange for income in the form of wages, interest, profit, and rent. Firms make payments of wages and interest to households in exchange for hiring workers and other factors of production. The sum of wages, interest, rent, and profit is total income in the economy. We can measure GDP as the total income received by households. 7.1 LEARNING OBJECTIVE Explain how total production is measured.

9 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 7: GDP: Measuring Total Production and Income Gross Domestic Product Measures Total Production Production, Income, and the Circular-Flow Diagram FIGURE 7-1 (continued) The diagram also shows that households use their income to purchase goods and services, pay taxes, and save. Firms and the government borrow the funds that flow from households into the financial system. We can measure GDP either by calculating the total value of expenditures on final goods and services or by calculating the value of total income. The Circular Flow and the Measurement of GDP 7.1 LEARNING OBJECTIVE Explain how total production is measured.

10 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 7: GDP: Measuring Total Production and Income Gross Domestic Product Measures Total Production Transfer payments Payments by the government to individuals for which the government does not receive a new good or service in return. Production, Income, and the Circular-Flow Diagram 7.1 LEARNING OBJECTIVE Explain how total production is measured.

11 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 7: GDP: Measuring Total Production and Income Gross Domestic Product Measures Total Production Components of GDP Consumption Spending by households on goods and services, not including spending on new houses. Personal Consumption Expenditures, or “Consumption” Investment Spending by firms on new factories, office buildings, machinery, and additions to inventories, and spending by households and firms on new houses. Gross Private Domestic Investment, or “Investment” Don’t Let This Happen to YOU! Remember What Economists Mean by Investment 7.1 LEARNING OBJECTIVE Explain how total production is measured. YOUR TURN: Test your understanding by doing related problem 1.8 at the end of this chapter.

12 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 7: GDP: Measuring Total Production and Income Gross Domestic Product Measures Total Production Components of GDP Government purchases Spending by federal, state, and local governments on goods and services. Government Consumption and Gross Investment, or “Government Purchases” 7.1 LEARNING OBJECTIVE Explain how total production is measured.

13 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 7: GDP: Measuring Total Production and Income Gross Domestic Product Measures Total Production Components of GDP Net exports Exports minus imports. Net Exports of Goods and Services, or “Net Exports” An Equation for GDP and Some Actual Values 7.1 LEARNING OBJECTIVE Explain how total production is measured.

14 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 7: GDP: Measuring Total Production and Income Gross Domestic Product Measures Total Production An Equation for GDP and Some Actual Values FIGURE 7-2 Components of GDP in 2008 Consumption accounts for 70 percent of GDP, far more than any of the other components. In recent years, net exports typically have been negative, which reduces GDP. 7.1 LEARNING OBJECTIVE Explain how total production is measured.

15 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 7: GDP: Measuring Total Production and Income Gross Domestic Product Measures Total Production An Equation for GDP and Some Actual Values Consumer spending on services is greater than the sum of spending on durable and nondurable goods. Business fixed investment is the largest component of investment. Purchases made by state and local governments are greater than purchases made by the federal government. Imports are greater than exports, so net exports are negative. 7.1 LEARNING OBJECTIVE Explain how total production is measured.

16 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 7: GDP: Measuring Total Production and Income Components of Malaysian GDP (in RM million) Data Source: Bank Negara Malaysia 2009 Annual Report Demand Aggregates Current prices (RM million) Consumption Investment62547 Government purchases Changes in stock Exports Imports GDP (purchasers’ prices) Net factor payments abroad GNI661845

17 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 7: GDP: Measuring Total Production and Income Malaysian GDP by sectors (in RM million) Data Source:Bank Negara Malaysia 2009 Annual Report

18 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 7: GDP: Measuring Total Production and Income GDP ranking by countries (Top 50) 1.European Union $ 14,510,000,000,000 2.United States $ 14,260,000,000,000 3.China $ 8,789,000,000,000 4.Japan $ 4,137,000,000,000 5.India $ 3,560,000,000,000 6.Germany $ 2,811,000,000,000 7.United Kingdom $ 2,149,000,000,000 8.Russia $ 2,116,000,000,000 9.France $ 2,110,000,000, Brazil $ 2,025,000,000, Italy $ 1,760,000,000, Mexico $ 1,482,000,000, Spain $ 1,368,000,000, Korea, South $ 1,356,000,000, Canada $ 1,285,000,000, Indonesia $ 969,200,000, Iran $ 876,000,000, Turkey $ 863,300,000, Australia $ 824,300,000, Taiwan $ 717,700,000, Poland $ 690,100,000, Netherlands $ 654,900,000, Saudi Arabia $ 585,800,000, Argentina $ 558,000,000, Thailand $ 538,600,000,000

19 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 7: GDP: Measuring Total Production and Income 26.South Africa $ 495,100,000, Egypt$ 471,200,000, Pakistan$ 449,300,000, Colombia $ 401,000,000, Malaysia $ 381,100,000, Belgium$ 381,000,000, Nigeria $ 357,200,000, Venezuela $ 350,100,000, Greece $ 341,000,000, Sweden $ 333,500,000, Philippines $ 324,800,000, Austria $ 323,100,000, Switzerland $ 317,000,000, Hong Kong $ 301,600,000, Ukraine $ 294,300,000, Norway $ 273,100,000, Vietnam $ 258,100,000, Czech Republic $ 256,600,000, Romania$ 255,400,000, Peru $ 253,000,000, Chile $ 243,700,000, Bangladesh $ 242,400,000, Algeria $ 239,600,000, Singapore$ 235,700,000, Portugal $ 233,400,000,000 (Source: World Factbook, Central Intelligence Agency factbook/rankorder/2001rank.html?countryName=Malaysia&countryCode=my&regionCode=eas&rank=30#my) GDP ranking by countries (Top 50)

20 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 7: GDP: Measuring Total Production and Income Gross Domestic Product Measures Total Production FIRMVALUE OF PRODUCTVALUE ADDED Cotton farmerValue of raw cotton = $1Value added by cotton farmer= 1 Textile mill Value of raw cotton woven into cotton fabric = $3 Value added by cotton textile mill = ($3 – $1)= 2 Shirt company Value of cotton fabric made into a shirt = $15 Value added by shirt manufacturer = ($15 –$3)= 12 Benetton Value of shirt for sale on Benetton’s Web site = $35 Value added by Benetton = ($35 – $15)= 20 Total Value Added= $35 Measuring GDP by the Value-Added Method Value added The market value a firm adds to a product. Table 7-1 Calculating Value Added 7.1 LEARNING OBJECTIVE Explain how total production is measured.

21 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 7: GDP: Measuring Total Production and Income Does GDP Measure What We Want It to Measure? Household production refers to goods and services people produce for themselves. Shortcomings in GDP as a Measure of Total Production Household Production The Underground Economy Underground economy Buying and selling of goods and services that is concealed from the government to avoid taxes or regulations or because the goods and services are illegal. 7.2 LEARNING OBJECTIVE Discuss whether GDP is a good measure of well-being.

22 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 7: GDP: Measuring Total Production and Income Why Do Many Developing Countries Have Such Large Underground Economies? Making the Connection In some developing countries, more than half the workers may be in the underground economy. YOUR TURN: Test your understanding by doing related problem 2.6 at the end of this chapter. 7.2 LEARNING OBJECTIVE Discuss whether GDP is a good measure of well-being. A large informal sector can be a sign of government policies that are retarding economic growth.

23 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 7: GDP: Measuring Total Production and Income Does GDP Measure What We Want It to Measure? Shortcomings of GDP as a Measure of Well-Being The Value of Leisure Is Not Included in GDP GDP Is Not Adjusted for Pollution or Other Negative Effects of Production GDP Is Not Adjusted for Changes in Crime and Other Social Problems GDP Measures the Size of the Pie but Not How the Pie Is Divided Up 7.2 LEARNING OBJECTIVE Discuss whether GDP is a good measure of well-being.

24 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 7: GDP: Measuring Total Production and Income Did World War II Bring Prosperity? Making the Connection World War II was a period of extraordinary sacrifice and achievement by the “greatest generation.” But statistics on GDP may give a misleading indication of whether it was also a period of prosperity. YOUR TURN: Test your understanding by doing related problem 2.8 at the end of this chapter. 7.2 LEARNING OBJECTIVE Discuss whether GDP is a good measure of well-being.

25 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 7: GDP: Measuring Total Production and Income Real GDP versus Nominal GDP Real GDP The value of final goods and services evaluated at base-year prices. Calculating Real GDP Nominal GDP The value of final goods and services evaluated at current-year prices. 7.3 LEARNING OBJECTIVE Discuss the difference between real GDP and nominal GDP.

26 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 7: GDP: Measuring Total Production and Income Solved Problem 7-3 Calculating Real GDP PRODUCT 2011 QUANTITY 2005 PRICEVALUE Medical services100$40$4,000 Bread Textbooks20901, PRODUCTQUANTITYPRICEQUANTITYPRICE Medical services80$40100$50 Bread Textbooks YOUR TURN: For more practice, do related problem 3.3 at the end of this chapter. 7.3 LEARNING OBJECTIVE Discuss the difference between real GDP and nominal GDP.

27 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 7: GDP: Measuring Total Production and Income Real GDP versus Nominal GDP Comparing Real GDP and Nominal GDP FIGURE 7-3 Nominal GDP and Real GDP, 1990–2008 Currently, the base year for calculating GDP is In the years before 2005, prices were, on average, lower than in 2005, so nominal GDP was lower than real GDP. In 2005, nominal and real GDP were equal. After 2005, prices have been, on average, higher than in 2005, so nominal GDP is higher than real GDP. 7.3 LEARNING OBJECTIVE Discuss the difference between real GDP and nominal GDP.

28 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 7: GDP: Measuring Total Production and Income Real GDP versus Nominal GDP Price level A measure of the average prices of goods and services in the economy. The GDP Deflator GDP deflator A measure of the price level, calculated by dividing nominal GDP by real GDP and multiplying by LEARNING OBJECTIVE Discuss the difference between real GDP and nominal GDP.

29 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 7: GDP: Measuring Total Production and Income Real GDP versus Nominal GDP FORMULAAPPLIED TO 2007APPLIED TO 2008 GDP Deflator NOMINAL GDP$14,078 billion$14,441 billion REAL GDP$13,254 billion$13,312 billion The GDP Deflator From these values for the deflator, we can calculate that the price level increased by 1.9 percent between 2007 and 2008: 7.3 LEARNING OBJECTIVE Discuss the difference between real GDP and nominal GDP.

30 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 7: GDP: Measuring Total Production and Income Other Measures of Total Production and Total Income Gross National Product (GNP) Disposable Personal Income National Income Personal Income Become familiar with other measures of total production and total income. 7.4 LEARNING OBJECTIVE Gross national product (GNP) is the value of final goods and services produced by residents of a certain country, even if the production takes place outside the country. National income is calculated as GDP minus the consumption of fixed capital, or depreciation. Disposable personal income is equal to personal income minus personal tax payments. Personal income is income received by households.

31 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 7: GDP: Measuring Total Production and Income Other Measures of Total Production and Total Income (U.S. example) FIGURE 7-4 Measures of Total Production and Total Income, 2008 The most important measure of total production and total income is gross domestic product (GDP). As we will see in later chapters, for some purposes, the other measures of total production and total income shown in the figure turn out to be more useful than GDP. Become familiar with other measures of total production and total income. 7.4 LEARNING OBJECTIVE

32 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 7: GDP: Measuring Total Production and Income Other Measures of Total Production and Total Income The Division of Income FIGURE 7-5 The Division of Income We can measure GDP in terms of total expenditure or as the total income received by households. The largest component of income received by households is wages, which are more than three times as large as the profits received by sole proprietors and the profits received by corporations combined. Become familiar with other measures of total production and total income. 7.4 LEARNING OBJECTIVE

33 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 7: GDP: Measuring Total Production and Income A Slowing Descent: Auto Sales Fell 37Percent, but Improved Slightly Real GDP declined for three consecutive quarters beginning in the third quarter of Falling Auto Purchases Lead to Lower GDP >> AN INSIDE LOOK

34 of 33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 7: GDP: Measuring Total Production and Income Business cycle Consumption Economic growth Expansion Final good or service GDP deflator Government purchases Gross domestic product (GDP) Inflation rate Intermediate good or service Investment Macroeconomics Microeconomics Net exports Nominal GDP Price level Real GDP Recession Transfer payments Underground economy Value added KEY TERMS