MONITORING THE MACROECONOMY

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PART 2
MONITORING THE MACROECONOMY
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GDP and the Standard of Living
CHAPTER
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C H A P T E R C H E C K L I S T

• When you have completed your study of this
  chapter, you will be able to

Define GDP and explain why the value of
production, income, and expenditure are the same
for an economy.
Describe how economic statisticians measure GDP
in the United States.
Distinguish between nominal GDP and real GDP and
define the GDP deflator.
Explain and describe the limitations of real GDP
as a measure of the standard of living.
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5.1 GDP, INCOME, AND EXPENDITURE

• GDP Defined
• Gross domestic product or GDP
• The market value of all the final goods and
  services produced within a country in a given
  time period.
• Value Produced
• Use market prices to value production.

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5.1 GDP, INCOME, AND EXPENDITURE

• What Produced
• Final good or service
• A good or service that is produced for its final
  user and not as a component of another good or
  service.
• Intermediate good or service
• A good or service that is produced by one firm,
  bought by another firm, and used as a component
  of a final good or service.
• GDP includes only those items that are traded in
  markets.

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5.1 GDP, INCOME, AND EXPENDITURE

• Where Produced
• Within a country
• When Produced
• During a given time period.

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5.1 GDP, INCOME, AND EXPENDITURE

• Circular Flows in the U.S. Economy
• Consumption expenditure
• The expenditure by households on consumption
  goods and services.
• Investment
• The purchase of new capital goods (tools,
  instruments, machines, buildings, and other
  constructions) and additions to inventories.

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5.1 GDP, INCOME, AND EXPENDITURE

• Government expenditure on goods and services
• The expenditure by all levels of government on
  goods and services.
• Net exports of goods and services
• The value of exports of goods and services minus
  the value of imports of goods and services.

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5.1 GDP, INCOME, AND EXPENDITURE

• Exports of goods and services
• Items that firms in in the United States produce
  and sell to the rest of the world.
• Imports of goods and services
• Items that households, firms, and governments in
  the United States buy from the rest of the world.

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5.1 GDP, INCOME, AND EXPENDITURE

• Total expenditure is the total amount received by
  producers of final goods and services.
• Consumption expenditure C
• Investment I
• Government expenditure on goods and services G
• Net exports NX
• Total expenditure C I G NX

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5.1 GDP, INCOME, AND EXPENDITURE

• Income
• Labor earns wages, capital earns interest, land
  earns rent, and entrepreneurship earns profits.

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5.1 GDP, INCOME, AND EXPENDITURE

• Expenditure Equals Income
• Because firms pay out everything they receive as
  incomes to the factors of production, total
  expenditure equals total income.
• That is
• Y C I G NX
• The value of production equals income equals
  expenditure.

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5.1 GDP, INCOME, AND EXPENDITURE

• Figure 5.1 shows the circular flow of income and
  expenditure.

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5.2 MEASURING U.S. GDP

• The Expenditure Approach
• Measures GDP by using data on consumption
  expenditure, investment, government expenditure
  on goods and services, and net exports.

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5.2 MEASURING U.S. GDP

• Expenditures Not in GDP
• Used Goods
• Expenditure on used goods is not part of GDP
  because these goods were part of GDP in the
  period in which they were produced and during
  which time they were new goods.
• Financial Assets
• When households buy financial assets such as
  bonds and stocks, they are making loans, not
  buying goods and services.

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5.2 MEASURING U.S. GDP

• The Income Approach
• Measures GDP by summing the incomes that firms
  pay households for the factors of production they
  hire.
• The U.S. National Income and Product Account
  divide incomes into two big categories
• Wages
• Interest, rent, and profits

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5.2 MEASURING U.S. GDP

• Wages
• Wages, called compensation of employees in the
  national accounts, is the payment for labor
  services.
• It includes net wages and salaries plus fringe
  benefits paid by employers such health care
  insurance, social security contributions, and
  pension fund contributions.

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5.2 MEASURING U.S. GDP

• Interest, Rent, and Profit
• Interest, rent, and profit, called net operating
  surplus in the national account, is the sum of
  the incomes earned by capital, land, and
  entrepreneurship.
• Interest is the income households receive on
  loans they make minus the interest they pay on
  their borrowing.
• Rent includes payments for the use of land and
  other rented inputs.
• Profit includes the profits of corporations and
  small businesses.

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5.2 MEASURING U.S. GDP

• Net domestic product at factor cost
• The sum of wages, interest, rent, and profit.
• Net domestic product at factor cost is not GDP.
• We need to make two adjustments to arrive at GDP
• One from factor cost to market prices
• One from net product to gross product

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5.2 MEASURING U.S. GDP

• From Factor Cost to Market Price
• The expenditure approach values goods at market
  prices the income approach values them at factor
  cost.
• Indirect taxes (such as sales taxes) make market
  prices exceed factor cost.
• Subsidies (payments by government to firms) make
  factor cost exceed market prices.
• To convert the value at factor cost to the value
  at market prices, we must
• Add indirect taxes and subtract subsidies

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5.2 MEASURING U.S. GDP

• From Gross to Net
• The expenditure approach measures gross product
  the income approach measures net product.
• Gross profit is a firms profit before
  subtracting the depreciation of capital.
• Net profit is a firms profit after subtracting
  the depreciation of capital.
• Depreciation is the decrease in the value of
  capital that results from its use and from
  obsolescence.

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5.2 MEASURING U.S. GDP

• Income includes net profit, so the income
  approach gives a net measure.
• Expenditure includes investment. Because some new
  capital is purchased to replace depreciated
  capital, the expenditure approach gives a gross
  measure.
• To get gross domestic product from the income
  approach, we must add depreciation to total
  income.
• After making these two adjustments the income
  approach almost gives the same estimate of GDP as
  the expenditure approach.

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5.2 MEASURING U.S. GDP
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5.2 MEASURING U.S. GDP

• Statistical Discrepancy
• The income approach and the expenditure approach
  do not deliver exactly the same estimate of
  GDPthere is a statistical discrepancy.
• Statistical discrepancy
• The discrepancy between the expenditure approach
  and income approach estimates of GDP, calculated
  as the GDP expenditure total minus the GDP income
  total.

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5.2 MEASURING U.S. GDP

• GDP and Related Measure of Production and Income
• Gross national product or GNP
• The market value of all the final goods and
  services produced anywhere in the world in a
  given time period by the factors of production
  supplied by residents of the country.
• U.S. GNP U.S. GDP Net factor income from
  abroad

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5.2 MEASURING U.S. GDP

• Disposable Personal Income
• Consumption expenditure is one of the largest
  components of aggregate expenditure and one of
  the main influences on it is disposable personal
  income.
• Disposable personal income
• Income received by households minus personal
  income taxes paid.

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5.2 MEASURING U.S. GDP

• Figure 5.2 shows the relationship between GDP,
  GNP, and disposable personal income.

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5.3 NOMINAL GDP VERSUS REAL GDP

• Calculating Real GDP
• Real GDP
• The value of the final goods and services
  produced in a given year expressed in the prices
  of the base year.
• Nominal GDP
• The value of the final goods and services
  produced in a given year expressed in the prices
  of that same year.
• The method of calculating real GDP changed in
  recent years, we describe the two methods.

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5.3 NOMINAL GDP VERSUS REAL GDP

• Traditional Method of Calculating Real GDP
• Well calculate real GDP in an economy that
  produces only apples and oranges. The current
  year is 2006, and the base year is 2000.
• Because 2000 is the base year, real GDP and
  nominal GDP are the same in 2000.
• Lets use the traditional method to calculate
  real GDP in 2000 and 2006.

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5.3 NOMINAL GDP VERSUS REAL GDP

• GDP Data for 2000

To calculate real GDP in 2000, sum the values of
apples and oranges produced in 2000 using prices
in 2000. Value of apples 60 apples x 0.50
30 Value of oranges 80 oranges x 0.25
20 Nominal GDP in 2000 30 20 50
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5.3 NOMINAL GDP VERSUS REAL GDP
GDP Data for 2006

• To calculate real GDP in 2006, sum the values of
  apples and oranges produced in 2006 using prices
  in 2000.
• Value of apples 160 apples x 0.50 80
• Value of oranges 220 oranges x 0.25 55
• Real GDP in 2006 80 55 135

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5.3 NOMINAL GDP VERSUS REAL GDP

• Chained-Dollar Method of Calculating Real GDP
• The chained-dollar method does not use the
  base-year prices.
• The chained-dollar method uses the prices of
  current year and the preceding year.
• We show the calculation in fives steps.

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5.3 NOMINAL GDP VERSUS REAL GDP

• Step 1Calculate the value of production in both
  2005 and 2006 using the prices of 2005.

In 2005 Value of apples 100 apples x 1.50
150 Value of oranges 200 oranges x 0.75
150 Nominal GDP in 2005 150 150 300
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5.3 NOMINAL GDP VERSUS REAL GDP

• In 2006
• Value of apples 160 apples x 1.50 240
• Value of oranges 220 oranges x 0.75 165
• 2006 Quantities at 2005 prices 240 165
  405

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5.3 NOMINAL GDP VERSUS REAL GDP

• Using 2005 prices
• Value of production in 2005 is 300.
• Value of production in 2006 is 405.
• So using 2005 prices, the value of production
  increased by 105 or 35 percent in 2006.

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5.3 NOMINAL GDP VERSUS REAL GDP

• Step 2Calculate the value of production in both
  2005 and 2006 using the prices of 2006.

In 2005 Value of apples 100 apples x 1.00
100 Value of oranges 200 oranges x 2.00
400 2005 Quantities at 2006 Prices 100 400
500
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5.3 NOMINAL GDP VERSUS REAL GDP

• In 2006
• Value of apples 160 apples x 1.00 160
• Value of oranges 220 oranges x 2.00 440
• Nominal GDP in 2006 160 440 600

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5.3 NOMINAL GDP VERSUS REAL GDP

• Using 2006 prices
• Value of production in 2005 is 500.
• Value of production in 2006 is 600.
• So using 2006 prices, the value of production
  increased by 100 or 20 percent in 2006.

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5.3 NOMINAL GDP VERSUS REAL GDP

• Step 3 Calculate the average of these increases
  in production
• 35 percent with 2005 prices
• 20 percent with 2006 prices
• The average of 35 percent and 20 percent is 27.5
  percentour estimate of the real GDP growth rate
  between 2005 and 2006.
• Table 5.6(a) summarizes this calculation.

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5.3 NOMINAL GDP VERSUS REAL GDP
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5.3 NOMINAL GDP VERSUS REAL GDP

• Step 4
• Repeat the calculations for each year going back
  to the base year, so we have an estimate of the
  real GDP growth rate from the base year of 2000.
• Step 5
• Starting from real GDP (nominal GDP) in the base
  year use the real GDP growth rates to calculate
  real GDP each through to 2006.
• Table 5.6(b) this calculation.

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5.3 NOMINAL GDP VERSUS REAL GDP
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5.3 NOMINAL GDP VERSUS REAL GDP

• Calculating the GDP Deflator
• GDP deflator
• An average of current prices expressed as a
  percentage of base-year prices.
• GDP deflator measure the price level.
• GDP deflator (Nominal GDP ? Real GDP) ? 100.

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5.3 NOMINAL GDP VERSUS REAL GDP
We calculated the in 2006 Nominal GDP 600 and
real GDP 145 GDP deflator (Nominal GDP
Real GDP) x 100 So in 2006 GDP deflator (600
145) x 100 414.
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5.4 THE USE AND LIMITATIONS OF REAL GDP

• We use estimates of real GDP for two main
  purposes
• To compare the standard of living over time
• To compare the standard of living among countries
• The Standard of Living Over Time
• To compare living standards we calculate real GDP
  per personreal GDP divided by the population.
• Table 5.8 shows two calculations

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5.4 THE USE AND LIMITATIONS OF REAL GDP
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5.4 THE USE AND LIMITATIONS OF REAL GDP

• Long-Term Trend
• Figure 5.3 shows the long-term trend in U.S. real
  GDP per person.

Real GDP per person doubled on the 33 years from
1965 to 1998.
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5.4 THE USE AND LIMITATIONS OF REAL GDP

• Short-Term Fluctuations
• Fluctuations in the pace of expansion of real GDP
  is called the business cycle.
• The business cycle is a periodic irregular up-and
  down movement of total production and other
  measure of economic activity.
• The four stages of a business cycle are
  expansion, peak, recession, and trough.

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5.4 THE USE AND LIMITATIONS OF REAL GDP

• The shaded periods show the recessions periods
  of falling production that lasts for at least six
  months.

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5.4 THE USE AND LIMITATIONS OF REAL GDP

• Standard of Living Across Countries
• To compare living standards across countries, we
  must convert real GDP into a common currency and
  common set of prices, called purchasing power
  parity.
• Goods and Services Omitted from GDP
• Household production
• Underground production
• Leisure time
• Environment quality

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5.4 THE USE AND LIMITATIONS OF REAL GDP

• Household Production
• Real GDP omits household production, it
  underestimates the value of the production of
  many people, most of them women.
• Underground Production
• Hidden from government to avoid taxes and
  regulations or illegal.
• Because underground economic activity is
  unreported, it is omitted from GDP.

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5.4 THE USE AND LIMITATIONS OF REAL GDP

• Leisure Time
• Our working time is valued as part of GDP, but
  our leisure time is not.
• Environment Quality
• Pollution is not subtracted from GDP.
• We do not count the deteriorating atmosphere as a
  negative part of GDP.
• If our standard of living is adversely affected
  by pollution, our GDP measure does not show this
  fact.

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5.4 THE USE AND LIMITATIONS OF REAL GDP

• Other Influences on the Standard of Living
• Health and Life Expectancy
• Good health and a long life do not show up
  directly in real GDP.
• Political Freedom and Social Justice
• A country might have a very large real GDP per
  person but have limited political freedom and
  social justice.
• A lower standard of living than one that had the
  same amount of real GDP but in which everyone
  enjoyed political freedom.

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GDP in YOUR Life

• As you listen to the news, look for references to
  GDP. How is GDP used in daily life?

Is the news about nominal GDP or real GDP? Is the
term used correctly?
Using U.S.GDP person, how does your income
compare to the average income?
How do you think your standard of living compares
with that of a student in France or China?
Do you produce more market goods than nonmarket
good? How can you value your nonmarket production?
Is your production counted in the nations output?