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GDP and the Standard of living
Outline:
1. Functions of National Income Accounting
2. Gross Domestic Product (GDP)
3. The Expenditure Approach to GDP
4. The Income Approach to GDP
5. Value added
6. Real versus Nominal GDP
7. Limitations of GDP as a measure of the standard of living
National income accounting (NIA) is the measurement of aggregate or total economic activity.
NIA is useful for assessing the performance of the
macroeconomy. NIA is also helpful in evaluating the
effectiveness of policy initiatives such as the Bush tax cuts.
We measure stockvariables at a
specific point intime; whereas
flows are measuredper unit of time.
Flows include:
•Income
•Sales revenue
•Output
Stocks include:
•Checking account balance
•Balance owed on student loans
•Inventories
We measure economic
activity as aflow.
Stocks vs. Flows
GDP is the market value final goods and services produced within a country in a given time period.
Gross Domestic Product (GDP)
GDP is our basicmeasure of economic
activity
Three approaches to measuring GDP
The value-added approach
The expenditure approach
The income approach
Value-added is the increasein the market value of a good
that takes place at each stage of the production
-distribution process.
$1.00Wood Chips
$1.50Raw Paper
$2.25Notebook
Paper
$3.50Notebook
Paper
$5.00Notebook
Paper
Lumber Mill
Paper Mill
Office SuppliesManufacturer
Wholesaler Retailer
Summing the value-added at each stage
Stage Value Added
Lumber milling $1.00
Paper processing .50
Office Supply Manufacturing
.75
Wholesaling 1.25
Retailing 1.50
Total $5.00
To count the notebook in GDP, we count the final transaction only. Otherwise, we would be counting value added twice.
We count only final goods—that is, a good or service produced for a final user—in GDP. The value
of intermediate goods and services are automatically
included when the count the value of the final good or service.
Here we simplyadd up all
expenditures forfinal goods
and services in oneyear
Total Expenditure = C + I + G + NX
Where,
C is personal consumption expenditure;I is gross private domestic investment;G is government expenditure (local, state, and federal); andNX is net exports, or Exports minus Imports
The expenditure approach
ConsumptionHousehold spending for newly-produced goods and services is defined as consumption. We distinguish between 3 categories or types:
Spending for consumer durables
Spending for consumer non-durables
Spending for consumer services.
Category
Spending in 2002
(billions)
Percent of Total
Durables $872.4 12
Nondurables 2,113.9 29
Services 4,314.5 59
Source:Bureau of Economic Analysis
Consumer Spending by Type, 2002 (in billions)
Total consumptionby U.S. households
in 2002 was $7.3
trillion
All spending by business firms for newly built equipment and business structures.
All changes in business inventories of raw materials, semifinished articles, and finished goods.
All spending by households for newly constructed residential housing
What is investment?
Components of Business Fixed Investment, 2002
(billions/percent of total)
Source: www.bea.gov
470.90 / 29.7%
847.60 / 53.4%
269.30 / 17.0%Equip. & Software
Business Structures
Housing
Investment does NOT include
•The purchase of stocks, bonds, or other financial assets.
•Secondhand salesRemember that
investment only happens when there is production of new tangible capital
goods
Business investment has been slumping lately
Amount in 2002 Percentage
Item Symbol (billions) of GDP
Consumption expenditure C 7,255 69.9
Investment I 1,588 15.3
Government purchases G 1960 18.9
Net exports NX -426 -4.1
GDP Y 10,377 100
GDP: The Expenditure Approach
Source: U.S. Bureau of Commerce, Bureau of Economic Analysis
GDP =
Employee compensation
+ net interest
+ rent
+ profits
+ proprietors’ income
+ Capital consumption
+ (indirect business taxes – subsidies)
The income Approach
This mainly involves summing up income
earned in factor markets
Definitions
Capital consumption (CC):A monetary measure of the depreciation of the capital stock in a year due to normal wear and tear, fires, or other accidents.
Net Investment: Gross Investment minus CC.
Indirect business taxes: taxes collected by businesses for government units, such as taxes on entertainment, motels, groceries, liquor, cigarettes, or gasoline taxes. Also called excise taxes.
Amount in 2002 Percentage
Item (billions) of GDP
Compensation of employees 5,964 57.5
Rental income of persons 153 1.5
Net interest 678 6.5
Corporate profits 785 7.6Proprietors' income 747 7.2
Net domestic product at factor cost 8,327 80.3
Indirect taxes less subsidies 660 6.4
Capital Consumption 1,390 13.3
GDP 10,377 100
GDP: The Income Approach
Source: U.S. Bureau of Commerce, Bureau of Economic Analysis
Real versus Nominal GDP
•We use money to measure the market value of new goods and services produced produced in the economy.
•The value (or purchasing power) of money is subject to change over time.
•Hence we need to adjust nominal GDP (that is, GDP measured at current prices) for changes in the value of money.
•GDP adjusted for changes in the value of money is called real GDP.
Nominal GDP Calculation
To calculate nominal GDP in 2002, sum the expenditures on apples and oranges in 2002 as follows:
Expenditure on apples = 100 × $1 = $100Expenditure on oranges = 200 × $0.50 = $100
Nominal GDP = $100 + $200 = $200
Now we will calculate nominal GDP for 2003 and compare
Expenditure on apples = 160 × $0.50 = $80Expenditure on oranges = 220 × $2.25 = $495
Nominal GDP = $80 + $495 = $575
Our problem is that the nominal GDP figures do not give us an
accurate read of period-to-period changes in actual production.
Notice that a part of the change in nominal GDP from 2002 to 2003 resulted from a change in prices.
To correct for changes in the value of money , we will establish 2002 as our base
year. That is, we will measure 2003 output at
2002 prices.
“Traditional” Real GDP calculationThe traditional method converts nominal GDP to real GDP
by measuring GDP in all periods at “base period prices”
Traditional method: measuring 2003 GDP at 2002 prices
Expenditure on apples = 160 × $1.00 = $160
Expenditure on oranges = 220 × $0.50 = $110Nominal GDP = $80 + $495 = $270
Thus, real GDP increased from 2002 to 2003—but not by as much as nominal GDP
Real GDPNominal GDP GDP Deflator (billions of
Year (billions) 1996 = 100 1996 dollars)1990 $5,748.30 86.51 $6,644.671991 5,916.70 89.66 $6,599.04
To compute Real GDP (GDP expressed in constant dollars):
100min
Re rGDPDeflato
alGDPNoalGDP
New Method of Calculating Real GDP
Item Quantity Price
Apples 160 $1.00
Oranges 220 $0.50
To use this method, we must value 2002 output at 2003 prices and 2003 output at 2002 prices.
2003 Quantities and 2002 Prices
Item Quantity Price
Apples 100 $0.50
Oranges 200 $2.25
2002Quantities and 2003 Prices
•Measured at 2002 prices, Real GDP increased by 35% from 2002 to 2003 [($70/$200) × 100]
•Measured at 2003 prices, real GDP increased by 15% from 2002 to 2003 [($75/$500) × 100]
The next step is to average together the percentage increases for 2002 and 2003. Thus we have:
%252
%15%35Re
alGDP
Therefore, since real GDP in 2002 is $200, this chain-weighted method of converting nominal to real GDP gives us real GDP in 2003 of $250.
0
2000
4000
6000
8000
60 65 70 75 80 85 90 95
Nominal GDP Chained 1996 dollars
GDP in the United States (in millions)
www.bea.gov
0
5000
10000
15000
20000
25000
30000
35000
60 65 70 75 80 85 90 95
Nominal Chained 1996 dollars
GDP per Person in the United States
www.economagic.com
2000
3000
4000
5000
6000
7000
70 75 80 85 90 95
Notice that real GDP decreased in 1991
Recessions are shaded
GDP in the U.S. (millions of chained 1996 dollars)
www.bea.gov
•Household production
•The underground economy
•Leisure time
•Environment quality
Limitations of (real) GDP as a measure of the standard of living