1. 24 Measuring Domestic Output and National Income McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Prof. Mohammad El-Sakka – Kuwait University Objectives: 1.What gross domestic product (GDP) is defined and measured. 2.The relationships between GDP, net domestic product, national income, personal income, and disposable income. 3.Discuss the GDP price index 4.Describing the difference between nominal GDP & real GDP. 5.Some limitations of the GDP measure. Measuring Domestic Output and National Income 24-2

3. Prof. Mohammad El-Sakka – Kuwait University National income accounts:National income accounts: -Measure the economy’s performance by measuring the flows of income and expenditures over a period of time. -They serve a similar purpose for the economy, as do income statements for business firms. -Consistent definition of terms and measurement techniques allows us to use the national accounts in comparing conditions over time and across countries. -The national income accounts provide a basis for of appropriate public policies to improve economic performance. Assessing the Economy’s Performance 24-3

4. Prof. Mohammad El-Sakka – Kuwait University Gross Domestic Product First: GDP is the monetary measure of the total market value of all final goods and services produced within a country in one year. Note: 1. Money valuation allows the summing of apples and oranges; money acts as the common denominator. 2. GDP includes only final products and services; it avoids double or multiple counting, by eliminating any intermediate goods used in production of these final goods or services. 24-4

5. Gross Domestic Product (1) Stage of Production (2) Sales Value Of Materials Or Product $ 0 Firm A, sheep ranch120 Firm B, wool producer180 Firm C, coat manufacturer220 Firm D, clothing manufacturer270 Firm E, retail clothier (market value)350 Total Sales Value$1140 Value Added (total income) (3) Value Added ]--------$120 (= $120 - $ 0) ]-------- 60 (= 180 - 120) ]-------- 40 (= 220 - 180) ]-------- 50 (= 270- 220) ]-------- 80 (= 350 – 270) $350 24-5 Two ways to calculate GDP

6. Prof. Mohammad El-Sakka – Kuwait University Gross Domestic Product 3. GDP is the value of what has been produced in the economy over the year, not what was actually sold. Second; GDP Excludes Nonproduction Transactions 1. GDP is designed to measure what is produced or created over the current time period. Existing assets or property that sold or transferred, including used items, are not counted. 2. Purely financial transactions are excluded. a. Public transfer payments, like social security or cash welfare benefits. b. Private transfer payments, like student allowances or alimony payments. 24-6

7. Prof. Mohammad El-Sakka – Kuwait University Gross Domestic Product c. The sale of stocks and bonds represent a transfer of existing assets. (However, the brokers’ fees are included for services rendered.) 3. Secondhand sales are excluded; they do not represent current output. (However, any value added between purchase and resale is included, e.g. used car dealers.) 24-7

8. Prof. Mohammad El-Sakka – Kuwait University Two Approaches to GDP There are two Ways to Look at GDP: Spending approach and Income approach: Remember from last chapter:  What is spent on a product is income to those who helped to produce and sell it. As a result, this is an important identity and the foundation of the national accounting process. 24-8

9. Prof. Mohammad El-Sakka – Kuwait University First : Spending (Expenditures) Approach: 1.GDP is divided into the categories of buyers in the market; household consumers, businesses, government, and foreign buyers. 2.Personal Consumption Expenditures(C) includes durable goods (lasting 3 years or more), nondurable goods and services. 3.Gross Private Domestic Investment-(Ig) All final purchases of machinery, equipment, and tools by businesses. All construction (including residential). 24-9

10. Prof. Mohammad El-Sakka – Kuwait University First : Spending (Expenditures) Approach: Changes in business inventory. - If total output exceeds current sales, inventories build up. - If businesses are able to sell more than they currently produce, this entry will be a negative number. Noninvestment transactions – despite how the term “investment” is used by the general public, investment does not include transfers of ownership of paper assets (stocks and bonds) or real assets (houses, jewelry, art). Only newly created capital is counted as investment. Net Private Domestic Investment—(In). -Each year as current output is being produced, existing capital equipment is wearing out and buildings are deteriorating; this is called depreciation or consumption of fixed capital 24-10

11. Prof. Mohammad El-Sakka – Kuwait University First : Spending (Expenditures) Approach: - Gross Investment minus depreciation (consumption of fixed capital) is called net investment. - If more new structures and capital equipment are produced in a given year than are used up, the productive capacity of the economy will expand. - When gross investment and depreciation are equal, a nation’s productive capacity is static. - When gross investment is less than depreciation, an economy’s production capacity declines. 24-11

12. Prof. Mohammad El-Sakka – Kuwait University First : Spending (Expenditures) Approach: January 1Year’s GDPDecember 31 Consumption & Government Spending Depreciation Net Investment Gross Investment Stock of Capital Increase Stock of Capital Gross Investment Depreciation Net Investment - = 24-12

13. Prof. Mohammad El-Sakka – Kuwait University First : Spending (Expenditures) Approach: 4. Government Purchases (of consumption goods and capital goods)-(G) - Includes spending by all levels of government (federal, state and local). - Includes all direct purchases of resources (labor in particular). - This entry excludes transfer payments since these outlays do not reflect current production. 24-13

14. Prof. Mohammad El-Sakka – Kuwait University First : Spending (Expenditures) Approach: 5. Net Exports-(Xn) - All spending on final goods produced in the U.S. must be included in GDP, whether the purchase is made here or abroad. - Often goods purchased and measured in the U.S. are produced elsewhere (Imports). - Therefore, net exports, (Xn) is the difference: (exports minus imports) and can be either a positive or negative number depending on which is the larger amount. Final Result Based on the Spending(expenditures) Approah : GDP = C + I g + G + X n 24-14

15. Prof. Mohammad El-Sakka – Kuwait University Second : Income Approach Second: Income Approach to GDP: Demonstrates how the expenditures on final products are allocated to resource suppliers as income: 1.Compensation of employees includes wages, salaries, fringe benefits, salary and supplements, and payments made on behalf of workers like social security and other health and pension plans. 2.Rents: payments for supplying property resources (adjusted for depreciation it is net rent). 3.Interest: payments from private business to suppliers of money capital. 4.Proprietors’ income: income of incorporated businesses, sole proprietorships, partnerships, and cooperatives. 24-15

16. Prof. Mohammad El-Sakka – Kuwait University Second : Income Approach 5.Corporate profits: After corporate income taxes are paid to government, dividends are distributed to the shareholders, and the remainder is left as undistributed corporate profits (also referred to as retained earnings). 6.Taxes on production and imports: general sales taxes, excise taxes, business property taxes, license fees, and customs duties. National Income = Compensation of employees + Rents + Interest + Proprietors’ income + Corporate profits + Taxes on production and imports 24-16

17. Prof. Mohammad El-Sakka – Kuwait University Second : Income Approach Some important remarks: -Adjustments between National Income & GDP: Net foreign factor income: (nationals’ income earned abroad - the income of foreigners earned in the country) 24-17

18. Prof. Mohammad El-Sakka – Kuwait University Second : Income Approach Statistical discrepancy: a statistical discrepancy added to national income to equalize the income and expenditures approaches (calculated GDP by Income or expenditures approaches should yield same number of GDP) Depreciation/Consumption of Fixed Capital: The firm also regards the decline of its capital stock as a cost of production. The depreciation allowance is set aside to replace the machinery and equipment used up. In addition to the depreciation of private capital, public capital (government buildings, port facilities, etc.), must be included in this entry. Therefore, GDP - Depreciation of Fixed Capital = Net domestic product (NDP) - Statistical discrepancy + Net foreign factor income = National Income 24-18

19. Prof. Mohammad El-Sakka – Kuwait University Other National Accounts Other National Accounts: A.Net domestic product (NDP) is equal to GDP minus depreciation allowance (consumption of fixed capital). B.National income (NI) is income earned by American ‑ owned resources here or abroad. Adjust (NDP) by adding net foreign factor income. (Note: This may be a negative number if foreigners earned more in U.S. than American resources earned abroad.) C.Personal income (PI) is income received by households: = (NI) - payroll taxes (social security contributions), - corporate profits taxes - undistributed corporate profits + transfer payments D.Disposable income (DI) = (personal income - personal taxes) 24-19

20. Prof. Mohammad El-Sakka – Kuwait University Example: U.S. Income Relationships 2009 Gross Domestic Product (GDP) Less: Consumption of Fixed Capital Equals: Net Domestic Product (NDP) Less: Statistical Discrepancy Plus: Net Foreign Factor Income Equals: National Income (NI) Less: Taxes on Production and Imports Less: Social Security Contributions Less: Corporate Income Taxes Less: Undistributed Corporate Profits Plus: Transfer Payments Equals: Personal Income (PI) Less: Personal Taxes Equals: Disposable Income (DI) $ 14,256 1864 $ 12,392 209 105 $ 12,288 1090 967 315 418 2528 $ 12,026 1102 $ 10,924 24-20

21. Prof. Mohammad El-Sakka – Kuwait University GDPGDP == + Consumption by Households Investment by Businesses Government Purchases Expenditures By Foreigners + + + + + Wages Rents Interest Profits Statistical Adjustments + Summary: Two Approaches to GDP Expenditures or Output Approach Income or Allocations Approach 24-21

22. Prof. Mohammad El-Sakka – Kuwait University Compensation Rents Interest Proprietor’s Income Corporate Profits Taxes on Production and Imports National Income Net Foreign Factor Income (-) Statistical Discrepancy (+) Consumption of Fixed Capital (+) Gross Domestic Product $ 7792 268 788 1041 1309 1090 $12,288 105 209 1864 $ 14,256 Personal Consumption (C) Gross Private Domestic Investment (I g ) Government Purchases (G) Net Exports (X n ) Gross Domestic Product In Billions Receipts Expenditures Approach Allocations Income Approach $10,089 1628 2931 -392 $ 14,256 Example of both approaches; U.S. Economy 2009 24-22

23. Prof. Mohammad El-Sakka – Kuwait University Comparative GDP 24-23

24. Prof. Mohammad El-Sakka – Kuwait University Circular Flow Revisited Circular Flow Revisited (Read the book) A. Compare to the simpler model presented in earlier chapters. Now both government and foreign trade sectors are added. B. Note that the inside covers of the text contain a useful historical summary of national income accounts and related statistics. 24-24

25. Prof. Mohammad El-Sakka – Kuwait University The Circular Flow Revisited 24-25

26. Prof. Mohammad El-Sakka – Kuwait University Other issues regarding National Accounts Nominal versus Real GDP A.Nominal GDP is the market value of all final goods and services produced in a year. 1.GDP is a (P x Q) figure including every item produced in the economy. Money is the common denominator that allows us to sum the total output. 2.Nominal GDP is calculated using the current prices prevailing when the output was produced but real GDP is a figure that has been adjusted for price level changes. 24-26

27. Prof. Mohammad El-Sakka – Kuwait University Other issues regarding National Accounts B.The adjustment process in a one-good economy. Valid comparisons cannot be made with nominal GDP alone, since both prices and quantities are subject to change. Some method to separate the two effects must be devised: One method is to first determine a price index, (see equation 1) and then adjust the nominal GDP figures by dividing by the price index (in hundredths) (see equation 2). 24-27

28. Prof. Mohammad El-Sakka – Kuwait University GDP Price Index Use price index to determine real GDP - Equation One Price Index: - Equation Two Real GDP: Price Index In Given Year =x100 Price of Market Basket In Specific Year Price of Same Basket In Base Year Real GDP = Nominal GDP Price Index (in hundredths) 24-28

29. GDP Price Index Calculating Real GDP (Base Year = Yr 1) Year (1) Units of Output (2) Price of Pizza Per Unit (3) Price Index (Year 1 = 100) (4) Unadjusted, or Nominal, GDP (1) X (2) (5) Adjusted, or Real, GDP 15$10100$ 50 2720200 14070 3825250 20080 41030--- 51128--- 24-29

30. Prof. Mohammad El-Sakka – Kuwait University Other issues regarding National Accounts Shortcomings of GDP 1- GDP doesn’t measure some very useful output because it is unpaid (homemakers’ services, parental child care, volunteer efforts, and home improvement projects). 2- GDP doesn’t measure improved living conditions as a result of more leisure. 3- GDP does not measure improvements in product quality or make allowances for increased leisure time. 4- Illegal activities are not counted in GDP (estimated to be around 8% of U.S. GDP). This is referred to the Underground Economy. Note: Legal economic activity may also be part of the “underground Economy” usually in an effort to avoid taxation. 24-30

31. Prof. Mohammad El-Sakka – Kuwait University Underground Economy 24-31

32. Prof. Mohammad El-Sakka – Kuwait University Other issues regarding National Accounts 4 - GDP and the environment: -The harmful effects of pollution are not deducted from GDP (oil spills, increased incidence of cancer, destruction of habitat for wildlife, the loss of a clear unobstructed view). -GDP does include payments made for cleaning up the oil spills, and the cost of health care for the cancer victim. 5- GDP makes no value adjustments for changes in the composition of output or the distribution of income: Nominal GDP simply adds the dollar value of what is produced; it makes no difference if the product is a semi-automatic rifle or a jar of baby food. Note: Per capita GDP may give some hint as to the relative standard of living in the economy; but GDP figures do not provide information about how the income is distributed. 24-32

33. Prof. Mohammad El-Sakka – Kuwait University Other issues regarding National Accounts 6- Noneconomic Sources of Well-Being like courtesy, crime reduction, etc., are not covered in GDP. 24-33