Measuring a Nation's Income

Chapter 10: Measuring a Nation’s Income

Chapter 10: Measuring a Nation’s IncomeAGEC 217

Patrick S. Ward

Purdue University

June 28, 2010


Overview

1 Overview

2 Income and Expenditure

3 The Measurement of GDP

4 Components of GDP

5 Real vs. Nominal GDP

6 Is GDP a Good Measure of Economic Well-Being?

7 Conclusion


Overview

Moving from Microeconomics to Macroeconomics

Up till now, our study of economics has focused onmicroeconomics

Studying how individual households and firms make decisionsand how they interact with one another in marketsThe focus is on individual decision-making units

We now move to study macroeconomicsStudying the economy as a wholeThe focus is on aggregated decision-making unitsStudying economy-wide phenomena including inflation,unemployment and economic growth

Macroeconomics is intimately linked with microeconomics:

Changes in the overall economy arise from the decisions ofindividual households and firms


Overview

Macroeconomics

Why study macroeconomics?

The health of the overall economy affects us all

We see reports of macroeconomic indicators and statistics allover the place Examples

We want to be able to interpret these reports and statisticsand understand how they will affect the economy


Overview

The Goal of Macroeconomics

We want to be able to explain changes that affect manyhouseholds, firms and market simultaneously

How does a tax change affect productivity?

How does productivity affect GDP?

How does GDP growth affect inflation?

How does inflation affect the exchange rate?

What effect do exchange rates have on GDP?


Income and Expenditure

1 Overview



4 Components of GDP



7 Conclusion



National Income and Expenditure

When judging economic well-being, it is natural to look at theeconomy’s total income

Gross Domestic Product: the market value of all final goodsand services produced within the borders of a country in agiven period of time.

Measures the country’s total overall economic output



Gross Domestic Product (GDP)

GDP measures two things at once

1 The total income of everyone in the economy

2 The total expenditure on the economy’s goods and services

These two values are really the same because for the economy as awhole, income must equal expenditure

Every dollar spent by consumers is income for the sellers





The Measurement of GDP

1 Overview



4 Components of GDP



7 Conclusion



“GDP is the market value...”

GDP adds together many different kinds of products

Uses market prices to determine the value of good and services

Allows us to add apples and oranges



“...of all...”

GDP is a very comprehensive measure

Includes all items produced in the economy and sold legally inmarkets

ApplesOrangesPearsGrapefruitBooksMoviesHealthcareetc.

Excludes items produced or sold illicitly

Excludes items produced and consumed at home (that neverenter the marketplace)



“...final...”

GDP only accounts for final goods—not intermediategoods

This eliminates the problem of double counting

Important exception:

If an intermediate good is held in inventory for use or sale at alater time, these goods are counted in GDPAdditions to inventory add to GDPWhen the goods in inventory are later used or sold, they aresubtracted from inventory and then subtracted from GDP



“...goods and services...”

GDP includes both tangible goods and intangible services



“...produced...”

GDP counts those goods and services that are currentlyproduced

Excludes anything produced in the past



“...within the borders of a country...”

The items that are counted in GDP are confined to limitedgeographic areas

Example: Foreign companies producing goods in the US

Subaru is a Japanese automobile manufacturing companySubaru has a large manufacturing facility in LafayetteThe value of all of the cars produced in Lafayette are countedin GDP

Example: US companies with overseas operations

IBM is a US companyHalf of IBM’s employees work outside the US producingvaluable outputsNone of the value of this output is counted in US GDP

It is instead counted in the GDP of the other countries wherethe goods are produced



“...in a given period of time.”

Just as GDP is limited by geographic confines (borders), it isalso limited by temporal constraints

Usually a year or quarter

Data are usually seasonally adjusted to remove any seasonalpatterns


Components of GDP

1 Overview



4 Components of GDP



7 Conclusion


Components of GDP

Components of GDP

Y = C + I + G + NX

Y = GDP

C = Consumption

G = Government purchases

I = Investment

NX = Net exports (exports - imports)

Memorize this!!!!


Components of GDP

Consumption

Spending by households on goods and services

Excludes purchases of new housing

Goods: tangible itemsDurable goods: goods that continue to be serviceable for atleast 3 years

Cars, refrigerators, washing machines, circular saw etc.

Nondurable goods: goods that are used up when used once, orthat have a lifespan of less than 3 years

Food, clothing, pencils, etc.

Services: Nontangible items

Economics classes, doctor visits, haircuts


Components of GDP

Investment

The purchase of good that will be used in the future toproduce more goods and services

Investment does not include things we normally think of asinvestments, like stocks and bonds

Capital equipment:

Machines, computers, bulldozers, printing presses, etc.

Structures:

Factories, houses, warehouses, etc.

Inventories of goods produced but not yet sold

Investment goods such as structures and vehicles used inproduction are not intermediate goods


Components of GDP

Government Purchases

Spending on goods and services by local, state, and federalgovernments

Salaries of government workers

Expenditures on public works

Does not include government transfers (like Social Securitypayments, welfare payments, or stimulus payments) becausethese are ultimately used either for consumption or investment


Components of GDP

Net Exports

Foreign purchases of domestically produced goods minusdomestic purchase of foreign-produced goods

Exports minus imports

Increasing exports adds to GDP

Increasing imports subtracts from GDP


Components of GDP

Test Your Understanding

In each of the following cases, determine how much GDP and eachof its components is affected (if at all)

1 Debbie spends $200 to buy her husband dinner at the finest restaurant inBoston.

2 Sarah spends $1,800 to purchase a new laptop to use in her publishingbusiness. The laptop was built in China.

3 Jane spends $1,200 on a computer to use in her editing business. She gotlast year’s model on sale for a great price from a local manufacturer.

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


Components of GDP

Components of GDP in 2009

Total Per Person Percent(in billions of dollars) (in dollars) of Total

Gross Domestic Product, Y $14,256.30 $46,226.59 100%Consumption, C 10,089.10 32,714.29 71%Investment, I 1,628.80 5,281.45 11%Government Purchases, G 2,930.70 9,502.91 21%Net Exports, NX -392.40 -1,272.37 -3%

Note: per person figures were derived by dividing the total dollaramount by the population (308.4 million at the end of 2009)


Components of GDP

Components of GDP in 2009


Real vs. Nominal GDP

1 Overview



4 Components of GDP



7 Conclusion



Nominal vs. Real GDP

There are two possible reasons for total spending to rise from oneyear to the next:

1 The economy may be producing a larger output of goods andservices

2 Goods and services could be selling at higher prices

Economists want to separate these two effects

Economists want to know if output has changed—not prices



Nominal GDP

Nominal GDP is simply a measure of the value of goods andservices produced in an economy during a period of time when thegoods and services are valued using current market prices



Real GDP

Real GDP answers the hypothetical question: What would be thevalue of the goods and services produced in an economy during aperiod of time if the goods and services were valued using theprices that prevailed in some specific year in the past?

Real GDP adjusts the current value of output for inflation

Real GDP shows how the economy’s overall production ofgoods and services changes over time



GDP Deflator

GDP Deflator: a measure of the price level calculated as theratio of the nominal GDP to real GDP times 100

GDP Deflator =Nominal GDP

Real GDP× 100

The GDP deflator measures the current level of prices relativeto the level of the base year

The GDP deflator will be exactly 100 in the base year, sinceReal GDP and Nominal GDP will be the same in that year

With the GDP deflator, we can calculate the rate of inflationin the economy



GDP Deflator and Inflation

Inflation: the situation in which the economy’s overall pricelevel is rising

We can calculate a measure of inflation using the GDPdeflator

Inflation Rate =GDP Deflator in year 2 - GDP Deflator in year 1

GDP Deflator in year 1



Calculating Nominal and Real GDP

Consider an economy that produces only two goods, pizza andlattes. The table below shows the prices and quantities producedof the two goods in 2008, 2009, and 2010.

Pizza Latte

Year P Q P Q2008 $10.00 400 $2.00 1,0002009 $11.00 500 $2.50 1,1002010 $12.00 600 $3.00 1,200

What is the nominal GDP in each year?



Calculating Nominal GDP

Nominal GDP is the value of the economy’s output valued atcurrent prices

2008: $10.00 × 400 + $2.00 × 1, 000 = $6, 000

2009: $11.00 × 500 + $2.50 × 1, 100 = $8, 250

2010: $12.00 × 600 + $3.00 × 1, 200 = $10, 800



Calculating Nominal GDP Growth

By what percent did the economy grow from 2008 to 2009? From2009 to 2010?

%∆Y =Y2 − Y1

Y1× 100%

GDP Growth from 2008 to 2009:%∆Y = Y2009−Y2008

Y2008× 100% = 8,250−6,000

6,000 × 100% =0.375 × 100% = 37.5%

GDP Growth from 2009 to 2010:%∆Y = Y2010−Y2009

Y2009× 100% = 10,800−8,250

8,250 × 100% =0.309 × 100% = 30.9%



Calculating Real GDP

To calculate Real GDP, we first have to choose the base year. Wethen use the prices from this base year to value the output of allyears.

The prices in the base year provide the basis for comparingquantities in different years

Let’s use 2008 as the base year

Real GDP is the value of output measured at constant prices (inthis case, 2008 prices)

2008: $10.00 × 400 + $2.00 × 1, 000 = $6, 000

2009: $10.00 × 500 + $2.00 × 1, 100 = $7, 200

2010: $10.00 × 600 + $2.00 × 1, 200 = $8, 400



Calculating Real GDP Growth

By what percent did the economy grow from 2008 to 2009 in realterms? From 2009 to 2010?

Real GDP Growth from 2008 to 2009:%∆Y = Y2009−Y2008

Y2008× 100% = 7,200−6,000

6,000 × 100% =0.200 × 100% = 20.0%

Real GDP Growth from 2009 to 2010:%∆Y = Y2010−Y2009

Y2009× 100% = 8,400−7,200

7,200 × 100% =0.167 × 100% = 16.7%



Calculating the GDP Deflator and Rates of Inflation

Recall the formula for calculating the GDP deflator is:

GDP Deflator =Nominal GDP

Real GDP× 100

GDP Deflator for 2008 = 6,0006,000 × 100 = 100

GDP Deflator for 2009 = 8,2507,200 × 100 = 114.58

GDP Deflator for 2010 = 10,8008,400 × 100 = 128.57



Nominal vs. Real GDP

Figure: Nominal GDP and Real GDP (2005 Dollars)


Is GDP a Good Measure of Economic Well-Being?

1 Overview



4 Components of GDP



7 Conclusion



GDP and Well-Being

GDP is considered the best single measure of the economicwell-being of a society

...but there are a lot of things that are left out of GDP that maybe more indicative of quality of life.

Health

Education

Leisure

So how can GDP be a good measure of well-being if it omits theseimportant factors?



GDP and Well-Being

Countries with large GDP can afford

Better healthcare

Better education

More leisure time

GDP also says nothing about the distribution of income

GDP per capita is the income of the average person

Nor does it say anything about the degradation of the environment


Conclusion

1 Overview



4 Components of GDP



7 Conclusion


Conclusion

Conclusion I

GDP is the best single measure we have for the well-being ofa society

...but it is not a perfect measure

GDP measures an economy’s total expenditures on newlyproduced goods and services and the total income earnedfrom the production of these goods and services

GDP is the market value of all final goods and servicesproduced within the borders of a country in a givenperiod of time

GDP = C + I + G + NX


Conclusion

Conclusion II

Because every transaction has a buyer and a seller, the totalexpenditure in the economy must equal the total income inthe economy

Nominal GDP uses current prices to value economic output

Real GDP uses constant prices or the prices from apre-determined base year to value economic output


Conclusion

Examples

Examples of macroeconomic indicators in the news

“U.S. Jobless Claims Drop but Remain at Elevated Levels”(New York Times)

“U.S. economy’s growth revised lower” (CNN)

“Housing Market: Falling again” (The Economist)

“Fed Grows More Wary on Economy” (Wall Street Journal)

Return

http://www.nytimes.com/aponline/2010/06/24/business/economy/AP-US-Economy.html?_r=1&ref=economy

http://www.nytimes.com/aponline/2010/06/24/business/economy/AP-US-Economy.html?_r=1&ref=economy

http://money.cnn.com/2010/05/27/news/economy/gdp/index.htm

http://www.economist.com/blogs/freeexchange/2010/06/housing_markets_2

http://online.wsj.com/article/SB10001424052748704629804575324962215305750.html?mod=WSJ_economy_LeftTopHighlights

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Measuring a Nation's Income