Macro W3 Handout

8/6/2019 Macro W3 Handout

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Chapter 5

GROSS DOMESTIC

PRODUCT ACCOUNTING1

What is Gross Domestic Product (GDP)?

How is GDP related to a nations total income and

spending?

What are the components of GDP?

Does GDP measure societys well-being?

2

Look for the answers to these questions

3

Income and Expenditure

Gross Domestic Product (GDP) measures

total income of everyone in the economy.

GDP also measures total expenditure on the

economys output of g&s.

For the economy as a whole,

income equals expenditurebecause every dollar a buyer spends

is a dollar of income for the seller.

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The Circular-Flow Diagram

a simple depiction of the macroeconomy

illustrates GDP as spending, revenue,

factor payments, and income

Preliminaries:

Factors of production are inputs like labor,

land, capital, and natural resources.

Factor payments are payments to the factors

of production (e.g., wages, rent).


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The Circular-Flow DiagramHouseholds:

own the factors of production,sell/rent them to firms for income

buy and consume goods & services

HouseholdsFirms

Firms:

buy/hire factors of production,use them to produce goodsand services

sell goods & services

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The Circular-Flow Diagram

Markets forFactors ofProduction

HouseholdsFirms

Income (=GDP)Wages, rent,

profit (=GDP)

Factors ofproduction

Labor, land,capital

Spending (=GDP)

G & Sbought

G & Ssold

Revenue (=GDP)Markets forGoods &Services

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What This Diagram Omits

The government

collects taxes, buys g&s

The financial system

matches savers supply of funds with

borrowers demand for loans

The foreign sector

trades g&s, financial assets, and currencieswith the countrys residents

Production, Income, and the Circular-Flow Diagram

Transfer paymentsPayments by thegovernment toindividuals for which

the government doesnot receive a new goodor service in return.


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the market value of all final goods &

services produced within a country

in a given period of time.

Gross Domestic Product (GDP) Is

Goods are valued at their market prices, so:

All goods measured in the same units

(e.g., dollars in the U.S.)

Things that dont have a market value are

excluded, e.g., housework you do for yourself.

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Final goods:intended for the end user

Intermediate goods: used as components

or ingredients in the production of other goods

GDP only includes final goods they already

embody the value of the intermediate goods

used in their production.

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GDP includes tangible goods

(like DVDs, mountain bikes, beer)

and intangible services(dry cleaning, concerts, cell phone service).

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GDP includes currently produced goods,

not goods produced in the past.


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GDP measures the value of production that occurs

within a countrys borders, whether done by its own

citizens or by foreigners located there.

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Usually a year or a quarter (3 months)

National Income Accounting System

A system of accounts developed for each country, based

on the circular flow, whose purpose is to measure the level

of economic activity in that country.

The U.S. national income accounting system (National

Income and Product Accounts) is operated by the Bureau

of Economic Analysis (BEA) in the U.S. Department of

Commerce.

3 equivalent methods of calculating GDP: Value Added,Expenditure and Income Methods.

Note: In the book, the first two methods are combined into

one method. This is fine, but for this class, we will use 3

distinct methods, as is standard practice.

The Value-Added Approach

2010 Cengage Learning16

When using this approach to GDP, one must becertain that only finalgoods and services arecounted. Otherwise, goods may be doublecounted.


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Measuring GDP by the Value-Added Method

Value added: The market value a firm adds to a product.

FIRM VALUE OF PRODUCT VALUE ADDED

Cotton

Farmer Value of raw cotton = $1

Value added by cotton

farmer = ($1-$0) = 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

L.L. Bean Value of shirt for sale on

L.L. Beans Web site = $35

Value added by L.L. Bean

= ($35 $15) = 20

Total Value Added = $35

Another example

PRODUCTION AND PRICE STATISTICS FOR 2009

(1)

PRODUCT

(2)

QUANTITY

(3)

PRICE PER

UNIT

Eye examinations 100 $50.00

Pizzas 80 10.00

Textbooks 20 100.00

Paper 2,000 0.10

PRODUCT

(1)

QUANTITY

(2)

PRICE PER

UNIT

(3)

VALUE

Eye examinations 100 $50 $5,000

Pizzas 80 10 800

Textbooks 20 100 2,000

GDP =$7800

2010 Cengage Learning 19

EXHIBIT 3 Another example:

MARKET VALUE AND VALUE ADDED OFGOODS PRODUCED


1. What is the total market value of the woolsweater in Exhibit 3, including all thestages of production?

The total market value is $94.


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2. Why shouldnt the total market value of allthe goods used in production be used whencalculating GDP?

The total market value ($94) counts the originalresource multiple times.


2. Why shouldnt the total market value beused when calculating GDP?

For example, the $4 value for wool on thesheep makes up part of the $13 value forwool fabric and $50 value for a wool sweater.


3. What shouldbe used when calculatingGDP?

Only the market value of the final good beingproduced, which is the sweater worth $50.

Notice that the Market value of finalgood=$50=Total Value Added

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Recall: GDP is total spending.

Four components:

Consumption (C)

Investment (I)

Government Purchases (G)

Net Exports (NX)

These components add up to GDP (denotedY):

Y = C + I + G + NX

Measuring GDP by the Expenditure Method

The Components of GDP


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Personal Consumption (C) is total spending by households on durable

goods, nondurable goods, and services.

Note on housing costs:

For renters,

consumption includes rent payments.

For homeowners,

consumption includes the imputed rental value

of the house, but not the purchase price or

mortgage payments.

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Gross Private Domestic Investment (I) is total spending on goods that will be used in the

future to produce more goods.

includes spending on

capital equipment (e.g., machines, tools)

structures (factories, office buildings, houses)

inventories (goods produced but not yet sold)

Note:Investmentdoes not

mean the purchase of financial

assets like stocks and bonds.

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Government Purchases (G)

is all spending on the g&s purchased by govt

at the federal, state, and local levels.

G excludes transfer payments, such as

Social Security or unemployment insurance

benefits. They are not purchases of g&s.

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Net Exports (NX)

NX= exports imports

Exports represent foreign spending on the

economys g&s.

Imports are the portions of C, I, and G

that are spent on g&s produced abroad.

Adding up all the components of GDP gives:

Y = C + I + G + NX


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EXHIBIT 4 EXPENDITURE APPROACH TO 2008 GDP($ BILLIONS)

Source: Bureau of Economic Analysis, U.S. Department of Commerce, 2008. 2010 Cengage Learning 30

1. What was the largest category of GDPexpenditure in 2008?

The largest category was personal consumptionexpenditures at $10,053.7 billion.


2. Why was the net exports category ofexpenditure negative in 2008?

The category was negative ($717.9 billion)because the value of U.S. imports wasgreater than the value of U.S. exports.

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U.S. GDP and Its Components, 2009

1,307

9,608

5,059

32,940

$46,299

per capita

2.8

20.8

10.9

71.1

100.0

% of GDP

402

2,955

1,556

10,133

$14,242

billions

NX

G

I

C

Y


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In each of the following cases, determine how much

GDP and each of its components is affected (if at all).

A.Debbie spends $200 to buy her husband dinner

at the finest restaurant in Boston.

B.Sarah spends $1800 on a new laptop to use in her

publishing business. The laptop was built in China.

C.Jane spends $1200 on a computer to use in her

editing business. She got last years model on sale

for a great price from a local manufacturer.

D.General Motors builds $500 million worth of cars,

but consumers only buy $470 million worth ofthem.

GDP and its components

A. Debbie spends $200 to buy her husband dinner

at the finest restaurant in Boston.

Consumption and GDP rise by $200.

B.Sarah spends $1800 on a new laptop to use in

her publishing business. The laptop was built in

China.

Investment rises by $1800, net exports fall

by $1800, GDP is unchanged.

Answers

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C.Jane spends $1200 on a computer to use in her

editing business. She got last years model on

sale for a great price from a local manufacturer.

Current GDP and investment do not change,

because the computer was built last year.

D.General Motors builds $500 million worth of cars,but consumers only buy $470 million of them.

Consumption rises by $470 million, inventory

investment rises by $30 million, and GDP rises by

$500 million.

Answers

35 2010 Cengage Learning

36

We can measure GDP in terms the total incomereceived by households.

The income payments are arranged into five maincategories:

(1) the compensation of employees,

(2) interest,(3) corporate profit,

(4) rental income, and

(5) proprietors income.

Measuring GDP by the Income Method


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The Income Approach


The compensation of employees is divided intotwo categories:

wages and salaries and supplements.

Supplements (or fringe benefits) include suchthings as bonuses, paid vacations, andcontributions to employees Social Security.


Corporate profit represents the return to owners ofincorporated firms.

Corporate profit is divided into three categories-dividends, corporate reinvestment, and corporatetaxes.

All three are included in the income approach toGDP.

The Income Approach


Rent is the payment for use of property.

Although most people dont pay themselves rentfor using their own property, the rent is stillestimated in GDP accounting. Net rental incomeis total rental income minus depreciation.

The Income Approach


Proprietors income is the income earned byunincorporated firms for the goods andservices they produce.

Proprietors income is the net income afterpaying such expenses as rent, utilities, and

supplies.

The Income Approach


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EXPANDED CIRCULAR FLOW: INCOME ANDEXPENDITURE APPROACHES TO GDP Equivalence of Expenditure and Income Methods

Components of GDP in 2007

NXGICY Expenditure Method

Observations from the Expenditure method

Consumer spending on services is greater than thesum of spending on durable and non-durable goods.

Business fixed investment is the largest componentof investment.

Purchases made by state and local governments aregreater than purchases made by the federal

government (since education and law enforcementare usually funded at the state/local level).

Imports are greater than exports, so net exports arenegative.

The Division of Income in 2007

The largest component of income received by households is wages,which are about three times as large as the profits received by soleproprietors and the profits received by corporations combined.

Income MethodEquivalence of Expenditure and Income Methods


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Gross National Product (GNP)

The market value of all final goods and servicesin an economy produced by resources ownedby people of that economy, regardless of wherethe resources are located.


While GDP measures location, GNP measuresownership.

For example, the value of goods produced by aU.S.-owned firm in Spain are not counted in ourGDP, but are counted in our GNP.

Gross National Product (GNP)

National Income


The sum of all payments made to resource ownersfor the use of their resources.


EXHIBIT 5 2008 NATIONAL INCOME ($ BILLIONS)

Source: Bureau of Economic Analysis, U.S. Department of Commerce, 2008.


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What was the largest category of income inthe U.S. in 2008 according to Exhibit 5?

Compensation of employees was by far thelargest category of income at $8,110.7 billion,or 64.9 percent of the national income.

Bringing GDP and National Incomeinto Accord


GDP, according to Exhibit 4, was $14,201 billion in2008.

Yet national income, according to Exhibit 5, wasonly $12,481.3 billion.


How is national income derived from grossdomestic product?

First, GDP is converted to GNP.

This is done by subtracting factor payments tothe rest of the world and adding factor

payments from the rest of the world.



Second, capital depreciation is subtracted fromGNP. The result is Net National Product (NNP).

Capital depreciationThe value of existingcapital stock used up in the process ofproducing goods and services.


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Third, indirect business taxes are subtractedfrom NNP. The result is National Income.

Indirect business taxesinclude general salestaxes, excise taxes, customs duties and licensefees. They are indirect because they are taxeslevied not on the firms directly, but on thegoods and services.


EXHIBIT 6 THE RELATIONSHIP BETWEEN GROSSDOMESTIC PRODUCT, GROSS NATIONALPRODUCT, NET NATIONAL PRODUCT, ANDNATIONAL INCOME: 2008 ($ BILLIONS)

Source: Bureau of Economic Analysis, U.S. Department of Commerce, 2008.

Other Important Terms


Net Domestic Product (NDP)

GDP minus capital depreciation.

Personal Income andPersonal Disposable Income


Personal income

National income, plus income received butnot earned, minus income earned but notreceived.


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Transfer payments

Income received but not earned.

For example, government-supplied incomefrom retirement benefits, veteran benefits,unemployment insurance benefits, disabilitypayments and subsidies to farmers.



Transfer payments

The government transfers income fromtaxpayers (who earned the income in the firstplace) to those receiving benefits.



Disposable personal income

Personal income minus direct taxes.


EXHIBIT 7 U.S. ECONOMIC PERFORMANCE, 19982005(CURRENT AND CONSTANT $, BASE YEAR 2000; AND PERCENT)

Source:Economic Report of the President, Washington, D.C., 2006, Statistical Tables. Except for the per capita data, all otherdata are in billion of U.S. dollars.


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1. Looking at GDP, national income,personal income, or personal disposableincome, the annual rate of growth is?

Over 6 percent. Adjusting for price changesover the 25 years reduces GDP growth rate3.1 percent per year.


2. But does GDP really measure everythingproduced in the national economy?

It is a quite legitimate means of measurement.The point is knowing and understanding whatmeasure we are using and why we use it.

Does GDP MeasureWhat We Want It to Measure?

MEASURING A NATIONS INCOME 64

GDP and Economic Well-Being

Real GDP per capita is the main indicator of

the average persons standard of living.

But GDP is not a perfect measure of

well-being.

Robert Kennedy issued a very eloquent

yet harsh criticism of GDP:


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Gross Domestic Product

does not allow for the health of our

children, the quality of their education,

or the joy of their play. It does not

include the beauty of our poetry or

the strength of our marriages, the

intelligence of our public debate or

the integrity of our public officials.

It measures neither our courage, nor our wisdom,

nor our devotion to our country. It measures everything,

in short, except that which makes life worthwhile, and it

can tell us everything about America except why we are

proud that we are Americans.

- Senator Robert Kennedy, 196865

How Comprehensive Is GDP?


GDP tries to measure everything that appearson the market.

Yet, not everything produced in the economygets onto the market, and some things thatcontribute to our economic well-being arenteven produced.



The value of housework is one example of animportant service that is usually not included inGDP.

The work is only included if it is performed by

someone outside the household, such as ahousekeeper, nanny, or cook.



Underground economy

The unreported or illegal production ofgoods and services in the economy that isnot counted in GDP.


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EXHIBIT 8 UNDERGROUND ECONOMIES, SELECTEDCOUNTRIES (PERCENT OF GDP)

Source: The Tax Foundation,Washington, D.C., 2006. Datacompiled by Friedrich Schneider,Johannes Kelper University(Linz, Austria).


Why would socially conscious and law-abidingsocieties such as Sweden and Switzerland havelarger underground economies?

Taxes and other government regulation maycreate an irresistible temptation.



Illegal unreported activities may include drugtrafficking, money laundering, bribery,prostitution, illegal gambling, fraud andburglary.



Tax avoidance is the main reason why legalactivities may go unreported.

Swapping services or simply understating thevalue of income earned are two ways to avoidpaying taxes.

Finally, legal and illegal immigrants may workfor less than minimum wage at off-the-booksentry-level jobs.


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The quality of goods and services producedmay not be included in GDP.

For example, a good may be of higher quality,but cost less, than a similar good. Theeconomic value of the improved quality good isnot recorded.



The costs of environmental damage areanother factor not taken into account in GDP.

While the expense associated with cleaning upthe pollution we create contributes to GDP, theactual pollution created is not subtracted fromGDP.



Many economists agree that despite the exclusion ofsome forms of economic value, our measure of GDPis sufficiently comprehensive to be a reliable indicatorof changes in the overall performance of theeconomy.

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Recap: GDP Does Not Value:

the quality of the environment

leisure time

non-market activity, such as the child care

a parent provides his or her child at home

an equitable distribution of income


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Then Why Do We Care About GDP? Having a large GDP enables a country to afford

better schools, a cleaner environment,

health care, etc.

Many indicators of the quality of life are

positively correlated with GDP. For example

GDP and Life Expectancy in 12 countries

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Lifeexpectancy(years)

Real GDP per capita

U.S.Germany

Japan

Mexico

Russia

Brazil

China

India

Indonesia

Pakistan

Bangladesh

Nigeria

GDP and Literacy in 12 countries

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AdultLiteracy

(%o

fpopulation)

Real GDP per capita

U.S.Germany Japan

Mexico

Russia

Brazil

China

India

Indonesia

Nigeria

Pakistan

Bangladesh

GDP and Internet Usage in 12 countries

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InternetUsage

(

%o

fpopulation)

Real GDP per capita

U.S.

Germany

Japan

Mexico

Russia

Brazil

ChinaIndia

Indonesia

Nigeria

Bangladesh

Pakistan


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Gross Domestic Product (GDP) measures acountrys total income and expenditure.

The four spending components of GDP include:

Consumption, Investment, Government Purchases,

and Net Exports.

Nominal GDP is measured using current prices.

Real GDP is measured using the prices of a

constant base year and is corrected for inflation.

GDP is the main indicator of a countrys economic

well-being, even though it is not perfect.

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