2. 5 GDP: A Measure of Total Production and Income
CHAPTER CHECKLIST
“Their policies produced 1.2% growth, the weakest so-called recovery since the Great Depression, and a doubling of the national debt.”
(Presidential Candidate Donald Trump, Detroit, August 08, 2016).
Q: How do we know if the economy is “good” or “bad”?
A: Need to measure things. In this chapter, measuring the economy’s output and standard of living (taking the economy’s pulse).

4. The gap between actual and trend in 2017-Q1 is 20.9% or $10,889.
Growth trend based
on pre-recession
The gap between actual and trend in 2017-Q1 is 20.9% or $10,889.

5. 5 GDP: A Measure of Total Production and Income
CHAPTER CHECKLIST
When you have completed your study of this chapter, you will be able to
1 Define GDP and explain why the value of production, income, and expenditure are the same for an economy.
2 Describe how economic statisticians measure GDP and distinguish between nominal GDP and real GDP.
3 Describe the uses of real GDP and explain its limitations as a measure of the standard of living.
Notes and teaching tips: 4, 16, 19, 24, 53, 56, and 62.
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6. 5.1 GDP, INCOME, AND EXPENDITURE
GDP Defined
Gross domestic product or GDP
The market value of all the final goods and services produced within a country in a given time period.
Market value - means that goods traded in illegal markets, and home production, are not counted in GDP.
Focus your students on the definition of GDP--the market value of all the final goods and services produced within a country in a given time period. Ask your students to go through the definition and pull out the essential parts. You will get this list: market value, final goods and services, produced, within a country, and time period. Explain that the words chosen in this definition were selected carefully. First, if the phrase “market value” had been left out, there would be room for lots of problems. Notice that when the government reports this figure, it doesn’t announce how many trains, planes, and automobiles the country has produced but rather it announces a monetary value. Using monetary values affords us the opportunity to be able to get around the problem of aggregation when the items in question are markedly different. We solve it by allowing the marketplace to determine the weights. The second item on the list is “final goods and services.” The explanation here is straightforward: We are distinguishing between final products and intermediate products. Intermediate goods are goods that are bought by one firm to be used in the production of another good that will be ultimately consumed. If we include these intermediate goods, then we would double count the nation’s output. Now we come to the word “produced.” This word is to make clear that sales are not important. If we only counted sales, then the GDP figures would understate production because not all output is sold. Some of it becomes inventory. Next is the phrase “within a country.” This phrase is to make clear that we don’t count output that wasn’t produced on a nation’s soil regardless of who was responsible for producing it. Lastly, is the phrase “time period.” Here we want to make unambiguous that we are only talking about production that occurred in a certain period. This phrase leaves no doubt that production of a good or service produced in a previous time period (even if perhaps sold in the present time period) does not count in this period’s GDP.

7. 5.1 GDP, INCOME, AND EXPENDITURE
What Produced
Final good or service is a good or service that is produced for its final user and not as a component of another good or service.
Intermediate good or service is a good or service that is produced by one firm, bought by another firm, and used as a component of a final good or service.
GDP includes only those items that are traded in markets.

8. 5.1 GDP, INCOME, AND EXPENDITURE
Where Produced
Within a country
When Produced
During a given time period

9. 5.1 Defining GNP
Gross Domestic Product (GDP) – the market value of all the final goods and services produced within a country in a given time period.
Gross National Product (GNP) – the market value of all the final goods and services produced by country's residents in a given time period.
GNP = GDP + NFP
NFP = Net Factor Payments from abroad to domestic residents = payments to domestic residents from abroad – payments to foreign factors in the U.S.

10. (1) Expenditure Approach 𝐺𝐷𝑃 = 𝐶 + 𝐼 + 𝐺 + 𝑁𝑋
5.2 Measuring Nominal GDP
(1) Expenditure Approach
𝐺𝐷𝑃 = 𝐶 + 𝐼 + 𝐺 + 𝑁𝑋
𝐶 - Personal Consumption Expenditures: Goods and services purchased by persons resident in the United States, except for new housing.

11. (1) Expenditure Approach 𝐺𝐷𝑃 = 𝐶 + 𝐼 + 𝐺 + 𝑁𝑋
5.2 Measuring Nominal GDP
(1) Expenditure Approach
𝐺𝐷𝑃 = 𝐶 + 𝐼 + 𝐺 + 𝑁𝑋
𝐼 - Gross private domestic investment: the spending of firms on plant, equipment and inventories, and the spending of households on new houses.

12. (1) Expenditure Approach 𝐺𝐷𝑃 = 𝐶 + 𝐼 + 𝐺 + 𝑁𝑋
5.2 Measuring Nominal GDP
(1) Expenditure Approach
𝐺𝐷𝑃 = 𝐶 + 𝐼 + 𝐺 + 𝑁𝑋
𝐺 - Government consumption expenditures and gross investment. Government consumption expenditures consists of spending by government to produce and provide services to the public, such as public school education. Gross investment consists of spending by government on fixed assets that directly benefit the public, such as highway construction, or that assist government agencies in their production activities, such as purchases of military hardware (e.g. tanks, missiles).

13. (1) Expenditure Approach 𝐺𝐷𝑃 = 𝐶 + 𝐼 + 𝐺 + 𝑁𝑋
5.2 Measuring Nominal GDP
(1) Expenditure Approach
𝐺𝐷𝑃 = 𝐶 + 𝐼 + 𝐺 + 𝑁𝑋
𝑁𝑋 - Net Exports of goods and services: exports less imports of goods and services
(𝑁𝑋 = 𝑋 – 𝐼𝑀).
The formula in (1) gives the nominal GDP (measured in current prices), using the expenditure approach.

14. 5.2 MEASURING U.S. GDP Expenditures Not in GDP Used Goods
Expenditure on used goods is not part of GDP because these goods were part of GDP in the period in which they were produced and during which time they were new goods.
Financial Assets
When households buy financial assets such as bonds and stocks, they are making loans, not buying goods and services.

15. 5.2 MEASURING U.S. GDP

16. The Income Approach 5.2 MEASURING U.S. GDP
Measures GDP by summing the incomes that firms pay households for the factors of production they hire.
The U.S. National Income and Product Account divide incomes into two big categories:
Wage income
Interest, rent, and profit income
Most of the income data used by the BEA comes from the IRS. Expenditure data comes from a variety of sources. In recent years, the first estimates of GDP, which are based on companies reported profits, have been revised downward when data on company profits as reported to the IRS became available. Enron-style accounting has contaminated the initial estimates of GDP but not the final estimates. You can make a nice point with one example of creative accounting. For some years, in its reports to shareholders AOL recorded its advertising expenditure as investment and amortized it over a number of years. First, you can explain that the correct treatment of this item is as an expenditure on intermediate goods and services by AOL and as a charge against AOL profit. The expenditure on AOL services is the value of AOL’s production. And AOL’s expenditure on advertising is part of the value of the production of the advertising agencies used by AOL. You can go on to explain that AOL accounting practice would misleadingly swell GDP by causing some double counting. On the expenditure approach, AOL’s advertising expenditure shows up as investment in the national accounts. On the income approach, because the expenditure is not a cost, it swells profit, so AOL’s corporate profit increases by the same amount as its “investment.” If AOL filed its income tax return in this same way, the national income accounts wouldn’t get corrected. But when AOL files its tax returns, it calls its advertising a cost and lowers its profits by that amount, the BEA picks up these numbers from the IRS and the national accounts get adjusted appropriately.

17. 𝑁𝐷 𝑃 𝑓 =𝑊+ 𝐼𝑛𝑡+𝑅𝑒𝑛𝑡+𝜋 𝑁𝑒𝑡 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑆𝑢𝑟𝑝𝑙𝑢𝑠
5.2 Measuring Nominal GDP
(2) Income Approach
𝑁𝐷 𝑃 𝑓 =𝑊+ 𝐼𝑛𝑡+𝑅𝑒𝑛𝑡+𝜋 𝑁𝑒𝑡 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑆𝑢𝑟𝑝𝑙𝑢𝑠
𝑁𝐷 𝑃 𝑓 – Net Domestic Product at factor cost
𝑊 – Compensation of employees: wages, salaries and fringe benefits earned by workers.
𝐼𝑛𝑡 – Interest is the income households receive on loans they make minus the interest they pay on their borrowing.

18. (2) Income Approach 𝑁𝐷 𝑃 𝑓 =𝑊+𝐼𝑛𝑡+𝑅𝑒𝑛𝑡+𝜋
5.2 Measuring Nominal GDP
(2) Income Approach
𝑁𝐷 𝑃 𝑓 =𝑊+𝐼𝑛𝑡+𝑅𝑒𝑛𝑡+𝜋
𝑅𝑒𝑛𝑡 – income that landlords receive from renting, including the “imputed” rent that homeowners pay themselves, less expenses on the house such as depreciation.
𝜋 – profit of corporations and incomes of proprietors who run their own business.

19. 𝐺𝐷𝐼 – Gross Domestic Income
5.2 Measuring Nominal GDP
(2) Income Approach
𝐺𝐷𝐼=𝑁𝐷 𝑃 𝑓 + 𝑇 𝑖 +𝐷𝑒𝑝
𝐺𝐷𝐼 – Gross Domestic Income
𝑇 𝑖 – indirect taxes (such as sales tax), net of subsidies.
𝐷𝑒𝑝 – depreciation (consumption of fixed capital).

20. 𝐺𝐷𝑃=𝐺𝐷𝐼+𝑆𝐷 5.2 Measuring Nominal GDP 𝑆𝐷 – Statistical Discrepancy.

21. 5.2 MEASURING U.S. GDP

22. GDP and Related Measures of Production and Income
5.2 MEASURING U.S. GDP
GDP and Related Measures of Production and Income
Gross national product or GNP is the market value of all the final goods and services produced anywhere in the world in a given time period by the factors of production supplied by residents of the country.
𝐺𝑁𝑃 = 𝐺𝐷𝑃 +𝑁𝐹𝑃

23. Disposable Personal Income
5.2 MEASURING U.S. GDP
Disposable Personal Income
Consumption expenditure is one of the largest components of aggregate expenditure and one of the main influences on it is disposable personal income.
Disposable personal income is the income received by households minus personal income taxes paid.

24. 5.2 MEASURING U.S. GDP
Figure 5.2 shows the relationship between GDP, GNP, and disposable personal income.

26. 5.2 MEASURING U.S. GDP The above can be written as formulas:
Gross National Product: 𝐺𝑁𝑃=𝐺𝐷𝑃+𝑁𝐹𝑃 Net Netional Product: 𝑁𝑁𝑃=𝐺𝑁𝑃−𝐷𝑒𝑝 National Inocme: 𝑁𝐼=𝑁𝑁𝑃−𝑆𝐷=𝐺𝐷𝐼−𝑁𝐹𝑃−𝐷𝑒𝑝 Personal Income: 𝑃𝐼=𝑁𝐼+𝑇𝑅− 𝑆 𝐵
In the last formula, 𝑆 𝐵 is business saving, i.e. retained profit. Business profit is 𝜋 𝐵 = 𝑇 𝐵 +𝐷𝑖𝑣+ 𝑆 𝐵 , i.e. business tax + dividends (distributed profit) + retained profit.
Disposable income: 𝐷𝐼=𝑃𝐼− 𝑇 𝑃
Disposable income is used for consumption and personal saving: 𝐷𝐼=𝐶+ 𝑆 𝑃

27. Real GDP and Nominal GDP
5.2 MEASURING U.S. GDP
Real GDP and Nominal GDP
Nominal GDP is the value of the final goods and services produced in a given year expressed in the prices of that same year.
Real GDP is the value of the final goods and services produced in a given year expressed in the prices of the base year.
The method of calculating real GDP changed in recent years.

28. Calculating Real GDP 5.2 MEASURING U.S. GDP
The goal of calculating real GDP is to distinguish between growth in productive capacity of the economy, and growth in prices (inflation):
𝐺𝐷𝑃=𝑃∙𝑅𝐺𝐷𝑃
Where GDP is the nominal GDP, 𝑃 is price level (called GDP deflator), and RGDP is the real GDP.

29. Calculating Real GDP 5.2 MEASURING U.S. GDP If we have: 𝐺𝐷𝑃=𝑃∙𝑅𝐺𝐷𝑃
Then, we can show, that for small growth rates:
𝐺𝐷𝑃 ≈ 𝑃 + 𝑅𝐺𝐷𝑃
The variable with the hat represents the growth rate of the variable.

30. Example: real vs. nominal GDP 𝐺𝐷𝑃 ≈ 𝑃 + 𝑅𝐺𝐷𝑃 Consider two cases.
5.2 MEASURING U.S. GDP
Example: real vs. nominal GDP
𝐺𝐷𝑃 ≈ 𝑃 + 𝑅𝐺𝐷𝑃
Consider two cases.
In the first case, most of the nominal growth comes from inflation. In the second case, most of the growth in nominal GDP is real.
𝑮𝑫𝑷 𝑷
𝑹𝑮𝑫𝑷
Case 1 4%
3.5%
0.5%
Case 2 1% 3%

31. 5.2 Nominal vs. Real GDP 𝐺𝐷𝑃2000 = 0.5∗60 + 0.25∗80 = 50
Year P1 Q1 P2 Q2
GDP
RGDP P
2000
0.5 60
0.25 80 50
100
2006 1
160 2
220
600
135
444.44
𝐺𝐷𝑃2000 = 0.5∗ ∗80 = 50
𝐺𝐷𝑃2006 = 1∗ ∗220 = 600
Suppose the base year is The real GDP is:
𝑅𝐺𝐷𝑃2000 = 0.5∗ ∗80 = 50
𝑅𝐺𝐷𝑃2006 = 0.5∗ ∗220 = 135
The GDP deflator is:
𝑃2000 = (𝐺𝐷𝑃2000/ 𝑅𝐺𝐷𝑃2000)∗100 = 100
𝑃2006 = (𝐺𝐷𝑃2006/ 𝑅𝐺𝐷𝑃2006)∗100 =

32. Nominal GDP in 2009 is $100 million.

33. 5.2 MEASURING U.S. GDP
Nominal GDP in 2009 is $100 million and in 2013 it is $300 million.
Nominal GDP in 2013 is three times its value in 2009.
But by how much has the quantity of final goods and services produced increased?

34. 5.2 MEASURING U.S. GDP
The increase in real GDP will tell by how much the quantity of good and services has increased.
Real GDP in 2013 is what the total expenditure would have been in 2013 if prices had remained the same as they were in 2009.
To calculate real GDP in 2013 multiply the quantities produced in 2013 by the price in 2009 and the sum these expenditures to find real GDP in 2013.
Part (c) of Table 5.3 shows the details.

35. Real GDP in 2009 is $100 million.
Real GDP in 2013 is $160 million—only 1.6 times real GDP in 2009.

36. 5.3 THE USE AND LIMITATIONS OF REAL GDP
We use estimates of real GDP for three main purposes:
To compare the standard of living over time
To track the course of the business cycle
To compare the standard of living among countries
The Standard of Living Over Time
To compare living standards we calculate real GDP per person (per capita)—real GDP divided by the population.

37. The gap between actual and trend in 2017-Q1 is 20.9% or $10,889.
Growth trend based
on pre-recession
The gap between actual and trend in 2017-Q1 is 20.9% or $10,889.

38. 5.3 THE USE AND LIMITATIONS OF REAL GDP
Year
𝑹𝑮𝑫𝑷
𝑷𝑶𝑷
𝑹𝑮𝑫𝑷 𝑷𝑶𝑷
1960
3,108.7b
180.76m
$17,198
2016
16,660b m
$51,517
Growth factor
5.36
1.79 3
We say that the standard of living in the U.S. (defined as real GDP per capita), increased by a factor of 3 since 1960.

39. 5.3 THE USE AND LIMITATIONS OF REAL GDP
Two features of our changing standard of living are
The growth of potential GDP per person
Fluctuations of real GDP per person around potential GDP
Potential GDP is the value of real GDP when all the economy’s factors of production —labor, capital, land, and entrepreneurial ability—are fully employed.

40. Source for Real Potential GDP is Congressional Budget Office,

41. 5.3 THE USE AND LIMITATIONS OF REAL GDP
The Standard of Living Among Countries
To compare living standards across countries, we must convert real GDP into a common currency and common set of prices, called purchasing power parity.
A discussion of omissions from GDP can arouse students’ interest. For example, you might point out that if one of your students mows her/his own lawn, the value of the student’s production doesn’t show up in GDP. But if you hire the student to mow your lawn (and if your student reports the income earned correctly to the IRS), the value of the student’s production does show up in GDP. Why don’t we measure all lawn mowing as part of GDP? Some reasons are cost of collecting data and the degree of intrusiveness we’d be willing to tolerate. But note how little we spend on collecting the GDP data and how relatively inexpensive it would be to add some questions about domestic production to either the Labor Force Survey or the Family Expenditure Survey. You might like to explain how the omission of illegal goods and services also leads to some misleading comparisons. For instance, the day before prohibition ended, the production of illegal beer was not counted as part of GDP. But the day after prohibition ended, the production of now legal beer counted. Ask your students to suggest two good reasons why illegal goods and services are omitted. First, the data are hard but not impossible to obtain. Second, there may be the moral position that illegal activities should not be included in GDP. This latter observation can lead to an interesting discussion. Ask the students if they think that the production of, say, marijuana should be included in GDP. Some, maybe even many, of them will see no problem with this. Then ask about the production of murder-for-hire. The response, we hope, will be significantly different. Does such a good have any value?

42. Country
GDP per Capita (PPP $, 2016)
Somalia
$400
Liberia
$900
Madagascar
$1,500
North Korea
$1,800
U.S.A.
$57,300
Norway
$69,300
Singapore
$87,100
Qatar
$129,700

43. 5.3 THE USE AND LIMITATIONS OF REAL GDP
Goods and Services Omitted from GDP
Household production
Underground production
Leisure time
Environment quality
Health
A discussion of omissions from GDP can arouse students’ interest. For example, you might point out that if one of your students mows her/his own lawn, the value of the student’s production doesn’t show up in GDP. But if you hire the student to mow your lawn (and if your student reports the income earned correctly to the IRS), the value of the student’s production does show up in GDP. Why don’t we measure all lawn mowing as part of GDP? Some reasons are cost of collecting data and the degree of intrusiveness we’d be willing to tolerate. But note how little we spend on collecting the GDP data and how relatively inexpensive it would be to add some questions about domestic production to either the Labor Force Survey or the Family Expenditure Survey. You might like to explain how the omission of illegal goods and services also leads to some misleading comparisons. For instance, the day before prohibition ended, the production of illegal beer was not counted as part of GDP. But the day after prohibition ended, the production of now legal beer counted. Ask your students to suggest two good reasons why illegal goods and services are omitted. First, the data are hard but not impossible to obtain. Second, there may be the moral position that illegal activities should not be included in GDP. This latter observation can lead to an interesting discussion. Ask the students if they think that the production of, say, marijuana should be included in GDP. Some, maybe even many, of them will see no problem with this. Then ask about the production of murder-for-hire. The response, we hope, will be significantly different. Does such a good have any value?

44. 5.3 THE USE AND LIMITATIONS OF REAL GDP
Household Production
Real GDP omits household production and it underestimates the value of the production of many people, most of them women.
Underground Production
Economic activity hidden from government to avoid taxes and regulations or production that is illegal.
Because underground economic activity is unreported, it is omitted from GDP.

45. 5.3 THE USE AND LIMITATIONS OF REAL GDP
Leisure Time
Our working time is valued as part of GDP, but our leisure time is not.
Environment Quality
Pollution is not subtracted from GDP.
We do not count the deteriorating atmosphere as a negative part of GDP.
If our standard of living is adversely affected by pollution, our GDP measure does not show this fact.

46. 5.3 THE USE AND LIMITATIONS OF REAL GDP
Other Influences on the Standard of Living
Health and Life Expectancy
Good health and a long life do not show up directly in real GDP.
Political Freedom and Social Justice
A country with a large real GDP per person might have limited political freedom and social justice.
A country with a lower standard of living might be one in which everyone enjoys political freedom.
You can generate a productive classroom discussion on the topic of this slide.

47. GDP and the Standard of Living
Questions – Ch. 5
GDP and the Standard of Living

48. A person buys a new VW Jetta (Made in Mexico) In C In IM In I
Question 1
How will the following transactions be recorded in the U.S. NIPA of the current year?
A person buys a new VW Jetta (Made in Mexico)
In C
In IM
In I
In C and IM
In X

49. Enterprise car rental company buys a new VW Jetta (Made in Mexico)
Question 2
How will the following transactions be recorded in the U.S. NIPA of the current year?
Enterprise car rental company buys a new VW Jetta (Made in Mexico)
In I
In I and C
In I and IM
In X
In IM

50. A person buys a new house In C In I In G In X
Question 3
How will the following transactions be recorded in the U.S. NIPA of the current year?
A person buys a new house
In C
In I
In G
In X

51. Question 4
In order to compare standard of living across time and across countries, economists use
Nominal GDP
Real GDP
Nominal GDP per capita
Real GDP per capita
Ask people: “from 1 to 10, how happy are you? where 1 is  and 10 is .

52. Question 5
The relative size of home production and underground activity is larger in poor countries than in rich countries. The official measures of GDP then
Understate the standard of living in poor countries relative to rich countries
Overstates the standard of living in poor countries relative to rich countries
Understates the standard of living in rich countries relative to poor countries

53. Question 6
Economists believe that the real GDP per capita is the ideal measure of quality of living in a country.
True
False

54. Gross domestic product (GDP) also measures A nation’s exports
Question 7
Gross domestic product (GDP) also measures
A nation’s exports
A nation’s debt
A nation’s income
A nation’s consumption

55. Why doesn’t GDP count expenditures on intermediate goods?
Question 8
Why doesn’t GDP count expenditures on intermediate goods?
To make GDP calculations easier
Because intermediate goods are used by firms instead of consumers
To avoid double counting
Intermediate goods have no market value

56. Why doesn’t GDP count expenditures on intermediate goods?
Question 9
Why doesn’t GDP count expenditures on intermediate goods?
To make GDP calculations easier
Because intermediate goods are used by firms instead of consumers
To avoid double counting
Intermediate goods have no market value

57. What is the biggest component of GDP? Consumption [C] Investment [I]
Question 10
What is the biggest component of GDP?
Consumption [C]
Investment [I]
Government Purchases [G]
Net Exports [NX]

58. How is real GDP different from nominal GDP?
Question 11
How is real GDP different from nominal GDP?
Real GDP is adjusted for inflation, and nominal GDP is just measured in current prices
Real GDP includes goods and services, and nominal GDP only includes goods
Real GDP averages income over time, and nominal GDP is just for this year

59. Which of the following would not be included in GDP?
Question 12
Which of the following would not be included in GDP?
Bob hires a construction company to build his home
Michael pays the neighbor kid to mow his yard
Alex buys some cheese and dough to bake a pizza at home
Elyse buys new shoes

60. Question 13
Suppose that in some country the nominal GDP grows at 3% and real GDP grows at 2%. What is the approximate inflation rate in that country, based on the GDP deflator? Show your calculations.

61. Question 14
Suppose that in some country the real GDP grows at 5% and population grows at 3%. What is the approximate growth rate of real GDP per capita in this country? Show your calculations.