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