1. 6 Prepared by: Fernando Quijano and Yvonn Quijano © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair Measuring National Output and National Income

2. C H A P T E R 6: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 2 of 38 Gross Domestic Product (GDP) Is the most important concept in macroeconomics, because it measure the total value of goods and services produced in the country. GDP is part of the national income and product accounts or national account. GDP is useful in determining whether the economy is expanding or contracting. GDP give an overall picture of the state of the economy.

3. C H A P T E R 6: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 3 of 38 Gross Domestic Product What is the GDP? (GDP) is the total market value of all final goods and services produced within a nation during a given year, by factors of production located within a country. Therefore GDP is very important in measuring the overall performance of the economy.

4. C H A P T E R 6: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 4 of 38 National Income and Product Accounts National income and product accounts are data collected and published by the government describing the various components of national income and output in the economy. The U.S. Department of Commerce is responsible for producing and maintaining the “National Income and Product Accounts” that keep track of GDP.

5. C H A P T E R 6: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 5 of 38 Tow measures of national product How do economist measure GDP? GDP can be measured in two entirely independent ways. The expenditure approach: A method of computing GDP that measures the total amount spent on all final goods during a given period. National accountants use market prices as weights in valuing different commodities because market prices reflect the relative economic of diverse goods and services.

6. C H A P T E R 6: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 6 of 38 The Expenditure Approach Expenditure categories: Personal consumption expenditures (C)—household spending on consumer goods. Gross private domestic investment (I)—spending by firms and households on new capital: plant, equipment, inventory, and new residential structures.

7. C H A P T E R 6: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 7 of 38 The Expenditure Approach Government consumption and gross investment (G) Expenditure categories: Net exports (EX – IM)—net spending by the rest of the world, or exports (EX) minus imports (IM)

8. C H A P T E R 6: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 8 of 38 The Expenditure Approach The expenditure approach calculates GDP by adding together the four components of spending. In equation form:

9. C H A P T E R 6: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 9 of 38 Components of GDP, 1999: The Expenditure Approach Components of GDP, 2002: The Expenditure Approach BILLIONS OF DOLLARS PERCENTAGE OF GDP Personal consumption expenditures (C)7303.769.9 Durable goods871.98.3 Nondurable goods2115.020.2 Services4316.841.3 Gross private domestic investment (l)1543.214.8 Nonresidential1117.410.7 Residential471.94.5 Change in business inventories3.90 Government consumption and gross investment (G)1972.918.9 Federal693.76.6 State and local1279.212.2 Net exports (EX – IM)  423.6  4.1 Exports (EX)1014.99.8 Imports (IM)1438.513.8 Total gross domestic product (GDP)10446.2100.0 Note: Numbers may not add exactly because of rounding. Source: U.S. Department of Commerce, Bureau of Economic Analysis.

10. C H A P T E R 6: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 10 of 38 Personal Consumption Expenditures Personal consumption expenditures (C) are expenditures by consumers on the following: Durable goods: Goods that last a relatively long time, such as cars and appliances. Nondurable goods: Goods that are used up fairly quickly, such as food and clothing. Services: Things that do not involve the production of physical things, such as legal services, medical services, and education.

11. C H A P T E R 6: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 11 of 38 Gross Private Domestic Investment Investment refers to the purchase of new capital. Total investment by the private sector is called gross private domestic investment. It includes the purchase of new housing, plants, equipment, and inventory by the private sector.

12. C H A P T E R 6: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 12 of 38 Gross Private Domestic Investment Nonresidential investment includes expenditures by firms for machines, tools, plants, and so on. Residential investment includes expenditures by households and firms on new houses and apartment buildings. Remember that GDP is not the market value of total sales during a period—it is the market value of total production.

13. C H A P T E R 6: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 13 of 38 Gross Investment versus Net Investment 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. Net investment equals gross investment minus depreciation. capital end of period = capital beginning of period + net investment

14. C H A P T E R 6: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 14 of 38 Government Consumption and Gross Investment Government consumption and gross investment (G) counts expenditures by federal, state, and local governments for final goods and services.

15. C H A P T E R 6: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 15 of 38 Net Exports Net exports (EX – IM) is the difference between exports and imports. The figure can be positive or negative. Exports (EX) are sales to foreigners of U.S.-produced goods and services. Imports (IM) are U.S. purchases of goods and services from abroad ).

16. C H A P T E R 6: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 16 of 38 The Income or cost Approach 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. National income is the total income earned by factors of production owned by a country's citizens. GDP = national income + depreciation + (indirect taxes – subsidies) + net factor payments to the rest of the world + other

17. C H A P T E R 6: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 17 of 38 Who Gets the Income? The income that flows to the private sector is the national income which is the net national product less indirect taxes.The income that flows to the private sector is the national income which is the net national product less indirect taxes. To measure national income, economists must make three adjustments to gross domestic product (GDP).To measure national income, economists must make three adjustments to gross domestic product (GDP).

18. C H A P T E R 6: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 18 of 38 Who Gets the Income? The three adjustments to GDP are as follows:The three adjustments to GDP are as follows: Add the net income earned by U.S. firms and residents abroad; subtract income earned in the U.S. by foreign firms to arrive at gross national product (GNP).Add the net income earned by U.S. firms and residents abroad; subtract income earned in the U.S. by foreign firms to arrive at gross national product (GNP). Subtract depreciation from GNP to arrive at net national product (NNP).Subtract depreciation from GNP to arrive at net national product (NNP). Subtract indirect taxes, which are sales taxes on products to arrive at national income (NI).Subtract indirect taxes, which are sales taxes on products to arrive at national income (NI).

19. C H A P T E R 6: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 19 of 38 The Income Approach Components of GDP, 2002: The Income Approach BILLIONS OF DOLLARS PERCENTAGE OF GDP National income8,199.980.3 Compensation of employees6,010.058.9 Proprietors’ income943.57.3 Corporate profits748.97.3 Net interest554.85.4 Rental income142.71.4 Depreciation1,351.313.2 Indirect taxes minus subsidies739.47.2 Net factor payments to the rest of the world11.10.1 Other  96.1  0.9 Gross domestic product10,205.6100.0 Source: See Table 18.2.

20. C H A P T E R 6: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 20 of 38 Final Goods and Services A final product is one that is sold for consumption purposes or is an investment good. The point here is that the product is not changed or modified and sold again to someone else. The product has reached its final stage and is now being used either as a consumption good or a piece of capital equipment.

21. C H A P T E R 6: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 21 of 38 Intermediate goods Intermediate goods are goods produced by one firm for use in further processing by another firm. Intermediate goods are not added separately in order to avoid double counting. Double counting can also be avoided by adding up national income using the value added approach.

22. C H A P T E R 6: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 22 of 38 Value Added Value added : Value added is the difference between a firm’s total revenue and what it pays other firms for intermediate goods. Value added includes wages and salaries, rent, interest, and profits. In calculating GDP, we can either sum up the value added at each stage of production, or we can take the value of final sales.

23. C H A P T E R 6: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 23 of 38 Value Added Value Added in the Production of a Gallon of Gasoline (Hypothetical Numbers) STAGE OF PRODUCTIONVALUE OF SALESVALUE ADDED (1)Oil drilling$.50$ (2)Refining.65.15 (3)Shipping.80.15 (4)Retail sale1.00.20 Total value added$1.00

24. C H A P T E R 6: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 24 of 38 Exclusions of Used Goods and Paper Transactions Old output is not counted in current GDP because it was already counted back at the time it was produced. It would be double counting to count sales of used goods in current GDP.

25. C H A P T E R 6: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 25 of 38 Paper Transactions Sales of stocks and bonds are not counted in GDP. These sales are exchanges of paper assets and do not correspond to current production. However, what if I sell the stock or bond for more than I originally paid for it? Profits from the stock or bond market have nothing to do with current production, so they are not counted in GDP. What about stock market dealers?

26. C H A P T E R 6: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 26 of 38 Exclusion of Output Produced Abroad by Domestically Owned Factors of Production GDP is the value of output produced by factors of production located within a country. Output produced by a country’s citizens, regardless of where the output is produced, is measured by gross national product (GNP). GNP =GDP + Net Factor Income From Abroad

27. C H A P T E R 6: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 27 of 38 From GDP to Disposable Personal Income Net national product equals gross national product minus depreciation; a nation’s total product minus what is required to maintain the value of its capital stock. NNP = GNP - Depreciation Personal income is the income received by households after paying social insurance taxes but before paying personal income taxes.

28. C H A P T E R 6: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 28 of 38 From GDP to Disposable Personal Income GDP, GNP, NNP, National Income, Personal Income, and Disposable Personal Income, 2002 DOLLARS (BILLIONS) GDP 10,205.6 Plus: receipts of factor income from the rest of the world+ 342.1 Less: payments of factor income to the rest of the world  353.2 Equals: GNP 10,194.5 Less: depreciation  1,351.3 Equals: net national product (NNP) 8,843.2 Less: indirect taxes minus subsidies plus other  643.3 Equals: national income 8,199.9 Less: corporate profits minus dividends  332.6 Less: social insurance payments  731.2 Plus: personal interest income received from the government and consumers+ 439.1 Plus: transfer payments to persons+1,148.7 Equals: personal income 8,723.9 Less: personal taxes  1,306.2 Equals: disposable personal income 7,417.7 Source: See Table 18.2.

29. C H A P T E R 6: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 29 of 38 Disposable Personal Income and Personal Saving.disposable personal income is the amount of income that households can spend or save. The personal saving rate is the percentage of disposable personal income that is saved, this is an important indicator of household behaviour. If the personal saving rate is low, households are spending a large amount relative to their incomes; if it is high, households are spending carefully.

30. C H A P T E R 6: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 30 of 38 Disposable Personal Income and Personal Saving Disposable Personal Income and Personal Saving, 2002 DOLLARS (BILLIONS) Disposable personal income 7,417.7 Less: Personal consumption expenditures  7063.5 Interest paid by consumers to business  204.3 Personal transfer payments to foreigners  31.3 Equals: personal saving 118.6 Personal savings as a percentage of disposable personal income: 1.6% Source: See Table 18.2.

31. C H A P T E R 6: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 31 of 38 Real versus Nominal GDP Because prices change over time, as inflation generally sends prices upward year after year. Economists have to solve the problem of changes prices by using a reliable measure. We can measure GDP for a particular year using the actual market prices of that year, this gives us the Nominal GDP, or GDP at Current prices. but we are usually more interested in determining what has happened to the Real GDP.

32. C H A P T E R 6: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 32 of 38 Real GDP is calculated by tracking the volume or quantity of production after removing the rate of inflation. Hence, Nominal GDP is calculated using changing prices, while Real GDP represent the change in the volume of total output after price changes are removed.

33. C H A P T E R 6: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 33 of 38 When we evaluate the nation’s current output at current market prices, we measure nominal GDP. This is equivalent to multiplying output by price, for all units of every commodity that is produced, and then adding all these numbers up. So, nominal GDP is a huge sum of prices times quantities. Therefore, if nominal GDP changes from one year to the next it could be due to a change in P, or Q, or both. Since we are very interested in the growth of the economy over time, we need to know which component of GDP is (are) changing.

34. C H A P T E R 6: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 34 of 38 Suppose, for example, that prices increase from one year to the next, and output decreases.In fact, this economy has a couple of new problems. Prices are higher, so there is an increase in inflation. Output is lower, so there is probably an increase in unemployment, too. When both inflation and unemployment increase together, economists refer to this situation as stagflation. (The economy slows down or stagnates at the same time that prices increase.)

35. C H A P T E R 6: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 35 of 38 Calculating Real GDP In order to accurately assess the real growth of the economy over time, we need to measure output with a constant set of prices. One year is chosen as the base year and then every year’s output is evaluated in terms of the prices in the base year. 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 fixed-weight procedure uses weights from a given base year.

36. C H A P T E R 6: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 36 of 38 Calculating Real GDP A Three-Good Economy (1)(2)(3)(4)(5)(6)(7)(8) GDP IN YEAR 1YEAR 2YEAR 1YEAR 2 IN PRODUCTIONPRICE PER UNITYEAR 1 YEAR 2 YEAR 1YEAR 2YEAR 1YEAR 2PRICES Q1Q1 Q2Q2 P1P1 P2P2 P 1 x Q 1 P 1 x Q 2 P 2 x Q 1 P 2 X Q 2 Good A611$.50$.40$3.00$5.50$2.40$4.40 Good B74.301.002.101.207.004.00 Good C1012.70.907.008.409.0010.80 Total$12.10$15.10$18.40$19.20 Nominal GDP in year 1 Nominal GDP in year 2

37. C H A P T E R 6: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 37 of 38 Calculating the CPI,GDP Deflator and PPI The most widely used measure of inflation is the consumer price index ( CPI). CPI is a measure of the average change over time in the prices paid by consumes for a market basket of consumer goods and services. If we divide nominal GDP by real GDP (and multiply by 100), we get the overall price index which we call the GDP Deflator. PPI measures the level of prices at the wholesale or producer stage.

38. C H A P T E R 6: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 38 of 38 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:

39. C H A P T E R 6: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 39 of 38 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. Tax evasion is usually thought to be the major incentive for people to participate in the underground economy

40. C H A P T E R 6: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 40 of 38 Gross National Income per Capita To make comparisons of GNP between countries, currency exchange rates must be taken into account. Gross National Income (GNI) is a measure used to make international comparisons of output. GNI is GNP converted into dollars using an average of currency exchange rates over several years adjusted for rates of inflation. GNI divided by population equals gross national income per capita.

41. C H A P T E R 6: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 41 of 38 Gross National Income per Capita Per Capita Gross National Income for Selected Countries, 2002 COUNTRYU.S. DOLLARSCOUNTRYU.S. DOLLARS Switzerland36,970Portugal10,670 Japan35,990South Korea9,400 Norway35,530Argentina6,860 United States34,870Mexico5,540 Denmark31,090Czech Republic5,270 Ireland28,880Brazil3,060 Sweden25,400South Africa2,900 United Kingdom24,230Turkey2,540 Netherlands24,040Colombia1,910 Austria23,940Jordan1,750 Finland23,840Romania1,710 Germany23,700Philippines1,050 Belgium23,340China890 France22,640Indonesia680 Canada21,340India460 Australia18,770Pakistan420 Italy18,470Nepal250 Spain14,860Rwanda220 Greece11,780Ethiopia100 Source: The World Bank Atlas, 2002.

42. C H A P T E R 6: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 42 of 38 Review Terms and Concepts base year base year change in business inventories change in business inventories compensation of employees compensation of employees corporate profits corporate profits current dollars current dollars depreciation disposable personal income, or after-tax income disposable personal income, or after-tax income durable goods durable goods expenditure approach expenditure approach final goods and services final goods and services fixed-weight procedure fixed-weight procedure government consumption and gross investment (G) government consumption and gross investment (G) gross domestic product (GDP) gross domestic product (GDP) gross investment gross investment gross national income (GNI) gross national income (GNI) gross national product (GNP) gross national product (GNP) gross private domestic investment (I) gross private domestic investment (I) income approach income approach indirect taxes indirect taxes intermediate goods intermediate goods national income national income national income and product accounts national income and product accounts

43. C H A P T E R 6: Measuring National Output and National Income © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 43 of 38 Review Terms and Concepts personal saving personal saving personal saving rate personal saving rate proprietors’ income proprietors’ income rental income rental income residential investment residential investment services subsidies underground economy underground economy value added value added weight net exports (EX – IM) net exports (EX – IM) net factor payments to the rest of the world net factor payments to the rest of the world net interest net interest net investment net investment net national product (NNP) net national product (NNP) nominal GDP nominal GDP nondurable goods nondurable goods nonresidential investment nonresidential investment personal consumption expenditures (C) personal consumption expenditures (C) personal income personal income