Production, Income, and Employment

Chapter 6Part 1

CHAPTER

1

Aggregate Production is Measured by Gross Domestic Product (GDP)

• Gross Domestic Product (GDP) is the: – total value of all final goods and services

produced for the marketplace during a given period, within the nation’s borders.

• Total value… – GDP is measured in dollar values (P x Q)

2

Production and GDP• …of all final…

– final means goods and services sold to their final user

side note- Intermediate goods– Goods that are inputs for the production

of final goods– Value of intermediate goods is included in

the value of final products• …goods and services…

• Goods: tangibles• Services: intangibles

3

Production and GDP• …produced…

– Not included: land, stocks and bonds used goods … are not produced

• …for the marketplace…– With the intention of being sold

• …during a given period…– A specific period of time (annual/quarter)

• …within a nation’s borders– Regardless of who owns the resources

4

Intermediate and Final Good

Tires taken from that pile and mounted on the wheels of the new car before it is sold are considered intermediate goods.Tires taken from that pile to replace tires on your old car are considered final goods.

If we included the value of the tires (an intermediate good) on new cars and the value of new cars (including the tires), we would be double counting.

Stages of Production – Intermediate Goods

6

Example: Production of Notebook Paper

$5.00 is the final sale included in GDP

Intermediate Goods

Tracking and Reporting GDP• GDP is a flow variable

– Flow variable: measures a rate of production• $40 billion worth of output each day• $1.2 trillion each month• $14.5 trillion for the year

• In general, flow variables are measured per unit of time

Tracking and Reporting GDP

• Annualization– The government reports GDP as an

annual rate– But, it is measured and reported (as an

annual rate) each quarter

Tracking and Reporting GDP

• Nominal variable – A variable measured without adjustment

for price changes– Nominal GDP

• Real variable – A variable adjusted for changes in prices– Real GDP

Tracking and Reporting GDP

• Comparing variables measured in dollars over time– It is important to translate nominal values

to real values• Annual growth rate of real GDP

– Reported quarterly– Annualized

Annualized data for GDP, real GDP, and growth rate, by quarters

Self test - How do we calculate the 3.8% real GDP growth rate for 2010-II?

What’s Not Included in GDP

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• Non-market goods and services such as chores performed at home by family members.

• Underground activities, both legal and illegal such as legal unrecorded activities paid for in cash or illegal gambling

• Sales of used goods (no production)• Financial transactions such as trading of stocks

and bonds (no production)• Government transfer payments: a payment to a

person that is not for goods and services currently supplied such as social security (no production)

How to Calculate GDPThe Expenditure Approach

• Four types of final users in the economy:Household Sector – Consumption (C)

Business Sector – Investment (I)

Government Sector – Government Purchases (G)

Foreign Sector – Net Exports (NX)

• Expenditure approach: GDP = C+I+G+NX– Adding the value of goods and services

purchased by each type of final user

The Expenditure Approach to GDP

• Consumption spending (C) – Part of GDP purchased by households as

final users– represents about 70% of total GDP– Items not included:

• Imported consumption goods and components

• New home construction

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The Expenditure Approach to GDP

• Consumption spending (C)

– Items included even though households don’t actually buy them• Total value of food products produced on

farms that are consumed by the farmers and their families themselves

• Total value of housing services provided by owner-occupied homes

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The Expenditure Approach to GDP

• Private investment (I) – Business purchases of plant,

equipment, and software

– New home construction

– Changes in inventories

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The Expenditure Approach to GDP• Private investment (I)

– Adds to the nation’s capital stock– Excludes

• Government investment • Consumer durables • Human capital

– Ignores depreciation• Net investment

– Investment minus depreciation

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The Expenditure Approach to GDP• Government purchases (G )

– Spending by federal, state, and local governments on goods and services and government investment in bridges, highways, etc.

•

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The Expenditure Approach to GDP• Government outlays

– Government purchases plus transfer payments

• Transfer payments– Money redistributed from one group of

citizens (taxpayers) to another (the poor, the unemployed, the elderly)

– not associated with production of goods and services

– included in government budgets as outlays – not included in the government purchase

component of GDP19

The Expenditure Approach to GDP• Net exports (NX)

– Total exports minus total imports• Total exports (EX)

– U.S. production that is purchased by foreigners

• Total imports (IM)– Americans’ purchases of goods produced

outside of the United States

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GDP in 2010: The Expenditure Approach

2013: C + I + G + (EX - IM)

GDP = 11,662 + 2766 + 3118 + (2321 – 2778)

GDP = 17,089

Factor Payment (Income) Approach to GDP• Factor payments

– Payments to the owners of resources that are used in production

• Factor payments approach: Called The Income ApproachGDP = sum the factor payments earned by all households in the economy (wages and salaries, rent, interest, and profit)

• Total output of the economy (GDP) = total income earned in the economy

• Total expenditure (GDP) = total income earned in the economy

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Why does expenditure = income

In every transaction, the buyer’s expenditure becomes the seller’s

income.

Thus, the sum of all expenditure equals the sum of all income.

In every transaction, the buyer’s expenditure becomes the seller’s

income.

Thus, the sum of all expenditure equals the sum of all income.

Simple Circular Flow

Income ($)

Labor

Goods (bread)

Expenditure ($)

Households Firms

The circular flow diagram shows the income received and payments made by each sector of the economy.

Value Added Approache to GDP

• Value added – Revenue a firm receives – Minus the cost of the intermediate goods it

buys• Value-added approach

– GDP = sum the values added by all firms in the economy

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Value Added at Different Stages of Production Back to the notebook example

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The Factor Payments Approach – Using the Notebook Paper Example

Value Added goes to the factors of production

Exercise

A farmer grows a bushel of wheat and sells it to a miller for $1.00.

The miller turns the wheat into flour and sells it to a baker for $3.00.

The baker uses the flour to make a loaf of bread and sells it to an engineer for $6.00.

The engineer eats the bread.

Compute:• value added at each stage of production• GDP

Exercise

Value added - farmer = ?

Value added - miller = ?

Value added - baker = ?

Total Value added = ? = GDP

Measuring GDP: A Summary

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Calculating Real GDP

Nominal GDP measures the value of all final goods and services using current prices.

Real GDP measures the value of all final goods and services using the prices of a base year.

Real GDP controls for inflation

Changes in nominal GDP can be due to: changes in prices (P) changes in quantities of output produced (Q) Remember: total sales = P x Q

Changes in real GDP can only be due to changes in quantities (Q), because real GDP is constructed using constant base-year prices. P is held constant

Example - Calculation of Real GDP(NOTE: Numerical Calculation of Real GDP presented in this and the next 4 slides is not covered in the text)

201120102009

205$100200$102192$100good B

1,050$361,000$31900$30good A

QPQPQP

Compute nominal GDP in each year

Compute real GDP in each year using 2009 as the base year.

Example - Calculation of Real GDP

Nominal GDP multiply P & Q from same year2009: $46,200 = $30 900 + $100 192 2010: $51,400 = $31 x 1000 + $102 x 2002011: $58,300 = $36 x 1050 + $100 x 205

Real GDP multiply each year’s Q by 2009 P2009: $46,200 = $30 x 900 + $100 x 192 2010: $50,000 = $30 x 1000 + $100 x 200 2011: $52,000 = $30 1050 + $100 205

GDP Deflator

The inflation rate is the percentage increase in the overall level of prices.

One measure of the price level is the GDP Deflator, defined as

Nominal GDPGDP deflator = 100

Real GDP

Self Test

52,000

50,000

$46,200

Real GDPGDP

deflator

58,3002011

51,4002010

n.a.$46,2002009

inflationrate

Nominal GDP

Use your previous answers to compute the GDP deflator in each year.

Use GDP deflator to compute the inflation rate from 2009 to 2010, and from 2010 to 2011.

Answers

52,000

50,000

$46,200

Real GDP

112.1

102.8

100.0

GDP deflator

9.05%58,3002011

2.8%51,4002010

n.a.$46,2002009

inflationrate

Nom. GDP

Calculate the growth rate in NGDP for 2011.Calculate the Growth rate in RGDP for 2011.

Inflation rate and growth rate is a percent change

𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 h𝐶 𝑎𝑛𝑔𝑒 𝑖𝑛𝑅𝑒𝑎𝑙𝐺𝐷𝑃=(𝑅𝑒𝑎𝑙𝐺𝐷𝑃𝐿𝑎𝑡𝑒𝑟 𝑌𝑒𝑎𝑟−𝑅𝑒𝑎𝑙𝐺𝐷𝑃𝐸𝑎𝑟𝑙𝑖𝑒𝑟 𝑌𝑒𝑎𝑟

𝑅𝑒𝑎𝑙𝐺𝐷𝑃𝐸𝑎𝑟𝑙𝑖𝑒𝑟 𝑌𝑒𝑎𝑟)𝑋 100

𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 h𝐶 𝑎𝑛𝑔𝑒 𝑖𝑛𝑁𝑜𝑚𝑖𝑛𝑎𝑙𝐺𝐷𝑃=(𝑁𝑜𝑚𝑖𝑛𝑎𝑙𝐺𝐷𝑃𝐿𝑎𝑡𝑒𝑟 𝑌𝑒𝑎𝑟 −𝑁𝑜𝑚𝑖𝑛𝑎𝑙𝐺𝐷𝑃𝐸𝑎𝑟𝑙𝑖𝑒𝑟 𝑌𝑒𝑎𝑟

𝑁𝑜𝑚𝑖𝑛𝑎𝑙𝐺𝐷𝑃𝐸𝑎𝑟𝑙𝑖𝑒𝑟 𝑌𝑒𝑎𝑟) 𝑋 100

Inflation Rate

Inflation rate and growth rate in 2011 -

= 13.4% = 4.0%

Inflation Rate = 9.05%

How GDP Is Used• Short-run – Business cycle

– recession – expansion

• Long-run – Trend growth– Measure the long-run growth rate of the

economy’s output

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The Business Cycle

peak

trough

+3%

+4%

-2%

Over time, real GDP fluctuates around an overall long-run upward trend. Such fluctuations are called business cycles. When output rises, we are in the expansion phase of the cycle; when output falls, we are in a recession.

How GDP Is Used

• Real GDP needs to grow by about 3% per year to provide enough jobs for a workforce that is growing in number and becoming more productive every year

• This is a big concern now because the economy have not been growing at 3% per year.

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Real GDP Growth Rate, 1970–2011

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http://bea.gov/newsreleases/national/gdp/gdp_glance.htm

• Although the growth rate of real GDP has fluctuated over time, it has been well above the 1 percent rate needed to maintain output per person, so real GDP per capita has risen over time.

• For most of the period, the average growth rate was high enough to create the jobs needed by a growing and more productive workforce. During some years (e.g., 2008– 2011), growth slowed, and an insufficient number of jobs were created

Real GDP Growth Rate, 1970–2011Things to note:

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LIMITATIONS OF THE GDP CONCEPTGDP AND SOCIAL WELFARE

If crime levels went down, society would be better off, but a decrease in crime is not an increase in output and is not reflected in GDP.

An increase in leisure is also an increase in social welfare, but sometimes associated with a decrease in GDP.

Most nonmarket and domestic activities, such as housework and child care, are not counted in GDP even though they amount to real production.

LIMITATIONS OF THE GDP CONCEPT

underground economy - the part of the economy in which transactions take place and in which income is generated that is unreported and therefore not counted in GDP.

distribution of income - GDP also has nothing to say about the distribution of output among individuals in a society.

pollution – environmental deterioration is not subtracted out.