1. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Chapter 19 Measuring National Output and National Income

2. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Chapter Outline Gross Domestic ProductGross Domestic Product Calculating GDPCalculating GDP Nominal Versus Real GDPNominal Versus Real GDP Limitations of GDP conceptLimitations of GDP concept

3. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Gross Domestic Product Gross domestic product (GDP) is the total market value of all final goods and services produced within a given period by factors of production located within a country.Gross domestic product (GDP) is the total market value of all final goods and services produced within a given period by factors of production located within a country. Just as individual firm needs to evaluate its success, similarly GDP, as a measure of total production of an economy, provides a country’s economic report card.Just as individual firm needs to evaluate its success, similarly GDP, as a measure of total production of an economy, provides a country’s economic report card.

4. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Final Goods and Services The term final goods and services refers to goods and services produced for final use.The term final goods and services refers to goods and services produced for final use. Intermediate goods are goods produced by one firm for use in further processing by another firm.Intermediate goods are goods produced by one firm for use in further processing by another firm. Intermediate goods are NOT counted in GDP to avoid DOUBLE COUNTINGIntermediate goods are NOT counted in GDP to avoid DOUBLE COUNTING Double counting can also be avoided by counting only the VALUE ADDED to a product by each firm in its production processDouble counting can also be avoided by counting only the VALUE ADDED to a product by each firm in its production process

5. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Value Added Value added is the difference between the value of goods as they leave a stage of production and the cost of the goods as they entered that stage.Value added is the difference between the value of goods as they leave a stage of production and the cost of the goods as they entered that stage. In calculating GDP, we can either: In calculating GDP, we can either: sum up the value added at each stage of production, sum up the value added at each stage of production, OR OR we can take the value of final sales. we can take the value of final sales. We do not use the value of total sales in an economy to measure how much output has been produced. We do not use the value of total sales in an economy to measure how much output has been produced.

6. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Value Added Value Added in the Production of a Gallon of Gasoline (Hypothetical Numbers) STAGE OF PRODUCTION VALUE OF SALES VALUE ADDED (1) Oil drilling $.50$.50 (2)Refining.65.15 (3)Shipping.80.15 (4) Retail sale 1.00.20 Total value added $1.00

7. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Exclusions from GDP: Used Goods and Paper Transactions GDP is concerned with only new or current production; old output is not counted in current GDP.GDP is concerned with only new or current production; old output is not counted in current GDP. Also sales of used goods is not a part of current GDPAlso sales of used goods is not a part of current GDP GDP ignores all transactions in which money or goods change hands but in which no new goods and services are produced.GDP ignores all transactions in which money or goods change hands but in which no new goods and services are produced. Sales of stock and bonds are not counted in GDP because they are only transfer of ownership of assets, that do not correspond to current production.Sales of stock and bonds are not counted in GDP because they are only transfer of ownership of assets, that do not correspond to current production.

8. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Exclusions from GDP: Used Goods and Paper Transactions Also profit from sale of stock and bonds is not a part of GDPAlso profit from sale of stock and bonds is not a part of GDP But if a broker is paid a fee for selling a stock or bond, then it will be a part of GDP as the broker is performing a service, which is a part of current production.But if a broker is paid a fee for selling a stock or bond, then it will be a part of GDP as the broker is performing a service, which is a part of current production.

9. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Exclusion of output produced abroad by domestically owned factors of production: GDP Versus GNP GDP is the value of output produced by factors of production located within a country.GDP is the value of output produced by factors of production located within a country. Hence output produced by Indian citizen working in Dubai is not a part of Indian GDPHence output produced by Indian citizen working in Dubai is not a part of Indian GDP Similarly, profits earned by Indian Companies abroad is not counted in Indian GDP.Similarly, profits earned by Indian Companies abroad is not counted in Indian GDP. However, outputs produced by foreigners in India is included in GDP as it is produced in India.However, outputs produced by foreigners in India is included in GDP as it is produced in India. Also, profits earned by foreign owned companies in India is counted in Indian GDP.Also, profits earned by foreign owned companies in India is counted in Indian GDP.

10. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Exclusion of output produced abroad by domestically owned factors of production: GDP Versus GNP… Hence the concept of GNP…Hence the concept of GNP… Gross National Product (GNP) is the total market value of all final goods and services produced within a given period by factors of production owned by a country’s citizen, regardless of where the output is produced.Gross National Product (GNP) is the total market value of all final goods and services produced within a given period by factors of production owned by a country’s citizen, regardless of where the output is produced. Distinction between GDP and GNP can be tricky!!!!!Distinction between GDP and GNP can be tricky!!!!!

11. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Calculating GDP GDP can be computed in two ways: The expenditure approach: A method of computing GDP that measures the amount spent on all final goods during a given period.The expenditure approach: A method of computing GDP that measures the amount spent on all final goods during a given period. The income approach: A method of computing GDP that measures the income—wages, rents, interest, and profits—received by all factors of production in producing final goods.The income approach: A method of computing GDP that measures the income—wages, rents, interest, and profits—received by all factors of production in producing final goods. Both the methods lead to the same value of GDP because every payment (expenditure) by a buyer is at the same time a receipt (income) for the seller.Both the methods lead to the same value of GDP because every payment (expenditure) by a buyer is at the same time a receipt (income) for the seller.

12. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair 1. The Expenditure Approach There are 4 main groups in the economy: There are 4 main groups in the economy: 1.Households, 2.Firms, 3.Government and 4.The Rest of the World

13. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Expenditure categories: 1.Personal consumption expenditures (C)— household spending on consumer goods. 2.Gross private domestic investment (I)— spending by firms and households on new capital: plant, equipment, inventory, and new residential structures. 3.Government consumption and gross investment (G) 4.Net exports (EX – IM)—net spending by the rest of the world, or exports (EX) minus imports (IM)

14. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Expenditure Approach The expenditure approach calculates GDP by adding together these four components of spending. In equation form:The expenditure approach calculates GDP by adding together these four components of spending. In equation form:

15. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair 1. Personal Consumption Expenditures (C) Personal consumption expenditures (C) are expenditures by consumers on the following:Personal consumption expenditures (C) are expenditures by consumers on the following: 1. Durable goods: Goods that last a relatively long time, such as cars and household appliances. 2. Nondurable goods: Goods that are used up fairly quickly, such as food and clothing. 3. Services: The things that we buy that do not involve the production of physical things, such as legal and medical services and education. This category comprises the largest part of GDP This category comprises the largest part of GDP

16. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Components of GDP, 1999: The Expenditure Approach BILLIONS OF DOLLARS PERCENTAGE OF GDP Total gross domestic product 9,299.2100.0 Personal consumption expenditures (C) 6,268.767.4 Durable goods 761.38.2 Nondurable goods 1,845.519.8 Services3,661.939.4 Gross private domestic investment (l) 1,650.117.7 Nonresidential1,203.112.9 Residential403.84.3 Change in business inventories 43.30.5 Government consumption and gross investment (G) 1,634.417.6 Federal568.66.1 State and local 1,065.811.5 Net exports (EX – IM)  254.0  2.7 Exports (EX) 990.210.6 Imports (IM) 1,244.213.4 Note: Numbers may not add exactly because of rounding. Source: U.S. Department of Commerce, Bureau of Economic Analysis.

17. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair 2. Gross Private Domestic Investment (I) Investment, in economics refers to the purchase of new capital like housing, plant, equipment, inventory, etc.Investment, in economics refers to the purchase of new capital like housing, plant, equipment, inventory, etc. Total investment in capital by the private sector is called gross private domestic investment. It includes the purchase of new housing, plants, equipment, and inventory by the private (or non-government) sector.Total investment in capital by the private sector is called gross private domestic investment. It includes the purchase of new housing, plants, equipment, and inventory by the private (or non-government) sector.

18. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Gross Private Domestic Investment includes: 1.Nonresidential investment includes expenditures by firms for machines, tools, plants, and so on. 2.Residential investment includes expenditures by households and firms on new houses and apartment buildings. 3.Change in business inventories computes the amount by which firms’ inventories change during a given period. Inventories are the goods that firms produce now but intend to sell later.

19. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Change in business inventory Inventory is counted as capital whereas change in inventory counted as gross private domestic investment????Inventory is counted as capital whereas change in inventory counted as gross private domestic investment???? Inventory of a firm has a value and it also renders services- to meet unforeseen demand and maintain goodwill of clients, convenienceInventory of a firm has a value and it also renders services- to meet unforeseen demand and maintain goodwill of clients, convenience To provide these services like of a retail shop, the shop needs counters, building, cash registers and lots of inventory.To provide these services like of a retail shop, the shop needs counters, building, cash registers and lots of inventory. Hence capital stock is made up of plant, equipment, inventory; but change in inventory or inventory accumulation is a part of change in capital stock or investment.Hence capital stock is made up of plant, equipment, inventory; but change in inventory or inventory accumulation is a part of change in capital stock or investment.

20. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Cont… Remember that GDP is not the market value of total final sales during a period- it is the market value of total production:Remember that GDP is not the market value of total final sales during a period- it is the market value of total production: GDP= Final sales + change in businessGDP= Final sales + change in business inventory, inventory, I.e., Total Production (GDP) equals final sales of domestic goods plus change in business inventory

21. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Gross Investment Vs Net Investment Gross investment is the total value of all newly produced capital goods (plant, equipment, housing, and inventory) produced in a given period.Gross investment is the total value of all newly produced capital goods (plant, equipment, housing, and inventory) produced in a given period. Depreciation is the amount by which an asset’s value falls in a given period.Depreciation is the amount by which an asset’s value falls in a given period. Net investment = gross investment -depreciation.Net investment = gross investment -depreciation. capital end of period = capital beginning of period + net investment

22. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair 3. Government Consumption and Gross Investment (G) Government consumption and gross investment (G) counts expenditures by central, state, and local governments for final goods and services ( like school buildings, bombs, military, school teachers salary)Government consumption and gross investment (G) counts expenditures by central, state, and local governments for final goods and services ( like school buildings, bombs, military, school teachers salary) Some of these expenditures are counted as government consumption and some as government investmentsSome of these expenditures are counted as government consumption and some as government investments Government transfer payments like disability benefits, social security benefits, interest on government debt are not included in GDP because they are not purchase of anything currently producedGovernment transfer payments like disability benefits, social security benefits, interest on government debt are not included in GDP because they are not purchase of anything currently produced

23. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair 4. Net Exports (EX-IM) Net exports (EX – IM) is the difference between exports (sales to foreigners of India’s produced goods and services) and imports ( India’s purchases of goods and services from abroad).Net exports (EX – IM) is the difference between exports (sales to foreigners of India’s produced goods and services) and imports ( India’s purchases of goods and services from abroad). The figure can be positive or negative.The figure can be positive or negative. Why to include net exports in GDP????Why to include net exports in GDP???? C, I, and G include expenditures on goods produced both domestically and by foreigners hence it overstates domestic production because it contains expenditure on foreign produced goods- ie, imports, that have to be subtracted from GDP to find correct figure.C, I, and G include expenditures on goods produced both domestically and by foreigners hence it overstates domestic production because it contains expenditure on foreign produced goods- ie, imports, that have to be subtracted from GDP to find correct figure. And exports have to be added back as they understate GDP.And exports have to be added back as they understate GDP.

24. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Income Approach This approach looks at GDP in terms of income earned and not in terms expenditure. The income approach to GDP breaks down GDP into four components:The income approach to GDP breaks down GDP into four components: GDP = national income + depreciation + (indirect taxes – subsidies) + net factor payments to the rest of the world + others

25. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair National Income National Income is the total income earned by the factors of production owned by a country’s citizens. It is the sum of eight income items:

26. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Components of National Income 1. Compensation of employees= includes wages and salaries paid to households by firms and by government, as well other supplements to salary that employers make 2. Proprietors Income= is the income of unincorporated business 3.Rental Income = income received by property owners in the form of rent 4. Corporate profits= is the income of corporations 5. Net Interest=interest paid by business 6. Indirect taxes –subsidies=includes taxes such as sales tax, custom duties, license fees minus government subsidies 7. Net business transfer payments= net transfer payments by business to others and are thus income of others, such as student scholarship 8. Surplus of government enterprises= income of government enterprises

27. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Calculating National Income (NI)…. Calculating National Income (NI)…. NI is not equal to GDP. NI is the income of the country’s citizens, not the income of residents of the country, hence we need to move from GDP to Gross National Product (GNP)NI is not equal to GDP. NI is the income of the country’s citizens, not the income of residents of the country, hence we need to move from GDP to Gross National Product (GNP) Step 1: Calculating GNPStep 1: Calculating GNP GNP = GDP + receipts of factor income from rest of the world – payments of factor income to the rest of the world Step 2: Calculating Net National Product (NNP)Step 2: Calculating Net National Product (NNP) NNP = GNP – Depreciation Step 3: Calculating National Income (NI)Step 3: Calculating National Income (NI) NI = NNP –Statistical discrepancy

28. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair National Income….. GDP, GNP and National Income Amount GDP Plus Receipts of factor income from rest of the world Less Payments of factor income to rest of the world Equals Gross National Product (GNP) LessDepreciation Equals Net National Product (NNP) Less Statistical discrepancy Equals National Income

29. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Relation between NI, Personal Income, Disposable Personal Income and Personal Savings Personal Income- the total income of households before paying personal income taxPersonal Income- the total income of households before paying personal income tax Disposable Personal Income / after tax income= personal income – personal taxesDisposable Personal Income / after tax income= personal income – personal taxes Personal Savings = Disposable Personal Income – personal consumption expenditure- personal interest payments- transfer payments made by householdsPersonal Savings = Disposable Personal Income – personal consumption expenditure- personal interest payments- transfer payments made by households The personal saving rate is the percentage of disposable personal income that is saved. If the personal saving rate is low, households are spending a large amount relative to their incomes; if it is high, households are spending cautiouslyThe personal saving rate is the percentage of disposable personal income that is saved. If the personal saving rate is low, households are spending a large amount relative to their incomes; if it is high, households are spending cautiously

30. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Relation between NI, Personal Income, Disposable Personal Income and Personal Savings National Income Amt.(RS) Less Amount of NI not going to households Equals Personal Income Less Personal Income Tax Equals Disposable Personal Income Less Personal Consumption expenditure Personal Interest Payment Transfer Payments made by households Equals Personal Savings xxx Personal Savings/Disposable Personal Income %

31. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Nominal versus Real GDP Nominal GDP is GDP measured in current rupee (i.e. the current price that one pays for goods and services).Nominal GDP is GDP measured in current rupee (i.e. the current price that one pays for goods and services). Nominal GDP includes all the components of GDP valued at their current prices.Nominal GDP includes all the components of GDP valued at their current prices. When a variable is measured in current monetary terms, it is described in nominal terms.When a variable is measured in current monetary terms, it is described in nominal terms.

32. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Calculating Real GDP The nominal GDP adjusted for price changes is called real GDP.The nominal GDP adjusted for price changes is called real GDP. A weight is the importance attached to an item within a group of items.A weight is the importance attached to an item within a group of items. A base year is the year chosen for the weights in a fixed-weight procedure.A base year is the year chosen for the weights in a fixed-weight procedure. A fixed-weight procedure uses weights from a given base year.A fixed-weight procedure uses weights from a given base year.

33. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Calculating Real GDP A Three-Good Economy (1)(2)(3)(4)(5)(6)(7)(8) GDP IN YEAR 1 YEAR 2 YEAR 1 YEAR 2 ININININ PRODUCTION PRICE PER UNIT YEAR 1 YEAR 2 YEAR 1 YEAR 2 YEAR 1 YEAR 2 PRICESPRICESPRICESPRICES Q1Q1Q1Q1 Q2Q2Q2Q2 P1P1P1P1 P2P2P2P2 P 1 x Q 1 P 1 x Q 2 P 2 x Q 1 P 2 X Q 2 Good A 611$.50 $.40 $3.00$5.50$2.40$4.40 Good B 74.301.002.101.207.004.00 Good C 1012.70.907.008.409.0010.80 Total$12.10$15.10$18.40$19.20 Nominal GDP in year 1 Nominal GDP in year 2

34. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Calculating the GDP Deflator The GDP Deflator is one measure of the overall price level- also called GDP Price IndexThe GDP Deflator is one measure of the overall price level- also called GDP Price Index

35. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Problems of Fixed Weights 1.Structural changes in the economy. 2.Supply shifts, which cause large decreases in price and large increases in quantity supplied. 3.The substitution effect of price increases. The use of fixed price weights to estimate real GDP leads to problems because it ignores:

36. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Limitations of the GDP Concept Society is better off when crime decreases, but a decrease in crime is not reflected in GDP.Society is better off when crime decreases, but a decrease in crime is not reflected in GDP. An increase in leisure is an increase in social welfare, not counted in GDP.An increase in leisure is an increase in social welfare, not counted in GDP. Nonmarket and domestic activities are not counted even though they amount to real production.Nonmarket and domestic activities are not counted even though they amount to real production.

37. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Limitations of the GDP Concept GDP accounting rules do not adjust for production that pollutes the environment.GDP accounting rules do not adjust for production that pollutes the environment. GDP has nothing to say about the distribution of output. Redistributive income policies have no direct impact on GDP.GDP has nothing to say about the distribution of output. Redistributive income policies have no direct impact on GDP. GDP is neutral to the kinds of goods an economy produces.GDP is neutral to the kinds of goods an economy produces.

38. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Underground Economy The underground economy is the part of an economy in which transactions take place and in which income is generated that is unreported and therefore not counted in GDP.The underground economy is the part of an economy in which transactions take place and in which income is generated that is unreported and therefore not counted in GDP. E.g.- Tax evasion (income that is earned but not reported), most illegal transactionsE.g.- Tax evasion (income that is earned but not reported), most illegal transactions

39. © 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Per Capita GDP/GNP Comparison across countries is difficult as it needs to be made in different currencies.Comparison across countries is difficult as it needs to be made in different currencies. Per capita GDP or GNP measures a country’s GDP or GNP divided by its population.Per capita GDP or GNP measures a country’s GDP or GNP divided by its population. Per capita GDP is a better measure of well-being for the average person that its total GDP or GNP.Per capita GDP is a better measure of well-being for the average person that its total GDP or GNP. Gross National Income (GNI)- GNP converted into dollars using an average of currency exchange rates over several years adjusted for rates of inflation.Gross National Income (GNI)- GNP converted into dollars using an average of currency exchange rates over several years adjusted for rates of inflation. GNI per capita= GNI divided by Total populationGNI per capita= GNI divided by Total population