Chapter 1

Measuring Domestic Output, National Income and the Price Level

Learning Outcomes

On completion of the chapter, the student will be able to:Define and compute an economy’s output and national incomeDefine economic growthDefine the concept of business cycle and identify the five phases of the business cycleIdentify the shortcomings of GDP as measure of a nation’s economic well-being

2

Gross Domestic Product

GDP is the total market value of all final goods and services produced annually within a country’s borders.

Expenditure Approach: compute GDP by adding the money spent by buyers on final goods and services. What are final goods? What are intermediate goods? What’s the difference?

Income Approach: compute GDP by adding the sum of all incomes earned (wages, interest, rents, and profits) in producing goods and services.

Value-Added Approach: compute GDP by adding the value added at each stage of production of all goods and services.

Total Market Value

Total Market Value is the monetary value of goods and services at today’s prices.

Only final goods are counted to protect against the error of over-counting.

Expenditure Approach Final Good -- a good in the hands of the final

user or consumer (no final buyer comes after)

intermediate good -- an input in the production of a final good

Example: Bob finds a seed and plants it. Some time later an orange tree appears. He pays Harry RM 5 to pick and box the oranges. Bob sells the oranges to Jim for RM 8. Jim make the orange juice and sells to Jenny for RM 10.

GDP = RM 10 ( spent by Jenny and no buyer comes after her)

Expenditure approach only add the amount of money spent by buyers on final goods and services because if we count expenditures on both final goods and intermediate goods, we would be double counting ( counting the good more than once), GDP = RM 23

Another example:

Intermediate goods used to make a book are glue, ink & paper.

In one sense, a book is simply another name for glue, ink, and paper together.

Book = glue + ink + paper Now, when computing GDP, if we count the

purchase of the book & the purchase of glue, ink and paper “Double-counting” problem., i.e., 3 = 1 + 1 + 1. Counting the “3” is enough; adding the “3” and the “1 +1 + 1” is double counting.

Income Approach

1. Harry earns RM 5 in wages 2. Bob’s profits= RM 8-RM 5 = RM 3 3. Jim’s profits = RM 10 - RM 8 = RM 2 GDP = Harry’s wages + Bob’s profits + Jim’s profits

= RM 10

Value- added approach

Value added: the dollar value contributed to a final good at each stage of production.

Difference between the dollar value of the output the producer sells and the dollar value of the intermediate goods the producer buys

Bob has no intermediate goods, but he sells the oranges to Jim for RM 8 ( value added is RM 8), Jim sells the orange juice for RM 10 ( value added is RM 2), GDP = RM 10

GDP? GNP? What’s different?

Gross National Product is the total market value of all final goods and services provided annually by the citizens of a country

GDP measures all final goods produced in a country, whether by citizens or not. GNP measures all final goods produced by citizens whether physically in that country or not.

What’s Not Included in GDP Certain Nonmarket Goods and services-- dinner prepared by mum or chores

performed at home by family members. (not transacted over market)

Sale of Used Goods--GDP measure current production. Used car

was counted when it was originally produced.

Financial Transactions-- e.g. trading of stocks and bonds is not

counted because it does not represent the production of new assets. (i.e., swapping bits of paper)

Government Transfer Payments.--payment to a person that is not made in

return for goods and services currently supply, e.g.: Social Security benefits, private transfer payments (cash gifts, angpau)

Leisure--too difficult to quantify

Underground Activities, both legal and illegal--because no record exists. Examples: illegal gambling, prostitution, drug sales)

GDP and Bads

GDP counts the goods and services, but it does not net out the air and water pollution.

• Thus, some economists argue that GDP overstates our overall economic welfare.

• GDP figures are useful for obtaining an estimate of the productive capabilities of an economy but they do not necessarily measure happiness or well being.

GDP and Per Capita GDP

Per Capita GDP is the GDP divided

by the population.

GDP - Expenditure Approach 4 SectorsExpenditures: Consumption (C) - the

sum of household spending on durable goods, non-durable goods, and services.

---Durable goods are goods that are expected to last for more than three years, such as refrigerators, ovens, or cars.

---Nondurable goods are goods that are not expected to last for more than three years, such as food.

---Services are intangible items such as lawn care, car repair, and entertainment.

Economists often talk about 4 sectors of the economy: H/hold sector, Biz sector, G sector and foreign sector. These economic actors buy goods and services

GDP - Expenditure Approach4 Sectors

Investment (I) is the sum of all purchases of :---newly produced capital goods. Business purchases of capital goods, such as machinery and factories, ---changes in business inventories (i.e., the stock of unsold goods), ---purchases of new residential housing.

Government Purchases (G) Includes:

Federal, state, and local government purchases of goods and services and gross investment in highways, bridges, and so on.

Excludes:Government transfer payments to persons that are not made in return for goods and services currently supplied.

GDP - Expenditure Approach4 Sectors

Net Exports (X – M) Exports (X) - Total foreign spending on

domestic (Malaysian) goods Less Imports (M) - Total domestic (Malaysian)

spending on foreign goods

GDP - Expenditure Approach4 Sectors

Arnold Economics, 6e / Ch. 6 Macroeconomics Measurements, Part II : GDP and Real GDP©2004 South-Western, a division of Thomson Learning™ 72

Exhibit 2 The Expenditure Approach to Computing GDP

GDP = C + I + G + (X – M)

Computing GDP using the Expenditure Approach

Anything that is not sold is “bought” by the firm that produced it. [Eg. If a car is produced but not sold, it goes into business inventory (Ig) & is considered to be “purchased” by the firm that produces it.]

GDP=Consumption + Investment + Government Purchases + Net Exports

Expenditure Approach

Example: RM (million)Consumers’ expenditure 717 Federal government purchases of goods And Services 40.5Exports of goods and services 450Imports of goods and services 550State and local government’s purchases 216.5Gross private domestic investment 77.7Income earned by the rest of the world 240Indirect business taxes (IBT) 40.6Income earned from the rest of the world 340Consumption of fixed capital 120

Expenditure Approach

Calculate the following from the above data.

(i) Gross Domestic product (GDP)

(ii) Gross National Product (GNP)

(iii) National Income (Net National Product)

Expenditure ApproachAnswer:(i) GDP = C + Ig + G + Xn

= RM717m + RM77.7m + (RM40.5m + RM216.5m) + (RM450m –

RM550m)= RM951.7m

(ii) GNP = GDP – Income earned by the rest of the world + Income earned from the rest of the world

= RM951.7m – RM240m + RM340m = RM1051.7m

(iii) NNP = GNP – Consumption of fixed capital - IBT = RM1051.7m – RM120m – RM40.6m = RM891.1m Note: IBT usually consist of excise taxes, sales taxes, and property taxes,

which are not part of national income as they’re not the payments to any resource.

GDP – Income Approach

1. Purchases (expenditures) made in product markets flow to business firms.

2. Business firms then use these monies to buy resources in resource markets.

3. These monies flow to the owners (suppliers) of land, labor, capital, and entrepreneurship.

4. The sum of these resource payments is total income, which flows to households. In this simple economy total purchases (expenditures) equal total income.

5. Because total purchases (expenditures) equal GDP and total purchases equal total income, it follows that GDP equals total income.

National Income

Total income earned by Malaysian citizens and businesses, no matter where they reside or are located.

National income is the sum of the payments to resources (land, labor, capital, and entrepreneurship).

Computing National Income

National income (NNP) = Compensation of employees + Proprietors’ income+ Corporate profits+ Rental income+ Net interest

Computing National Income

Compensation of Employees: Wages, salaries paid to employees plus employers’ contributions to Social Security and employee benefit plans plus the monetary value of fringe benefits, tips, and paid vacations.

Proprietors’ Income is all forms of income earned by self-employed individuals and the owners of unincorporated business, including unincorporated farmers.

Corporate Profits include all income earned by the stockholders of corporations. (some profits are paid to stockholders in the form of dividends, some are kept within the firm to finance investments, called undistributed profits, and some are used to pay corporate profits taxes)

Rental Income (of Persons) is the income received by individuals for the use of their non-monetary (non-financial) assets, such as houses, land. It also includes returns to individuals who hold copyrights and patents. Finally, it includes an imputed value to owner-occupied houses.

Net Interest: interest income received by Malaysian households and government minus the interest they paid out.

Part 2

National Income (NNP) = Compensation of employees

+ Proprietors’ Income + Corporate Profits + Rental Income + Net Interest

From National Income to GDP

GDP=National Income – Income earned (by the residents) from the rest of the world +Income earned by the rest of the world. (non-residents/ foreigners) + Indirect business taxes (IBT)+ Capital consumption allowance + Statistical discrepancy

National GDP Making Some Adjustments

Remember that the National income excludes foreign nationals and includes citizens abroad, but the GDP has to adjust for both of these incomes.

(Subtracting) income earned from the rest of the world (income Malaysian living abroad earned by producing and selling goods)

(adding) income earned by the rest of the world ( income non-Malaysian earned by producing and selling goods in Malaysia)

(Adding) Indirect Business Taxes usually comprise excise taxes, sales taxes, and property taxes. ( these taxes are not part of national income because they are NOT considered a payment to any resource, but should be included in GDP because these taxes are paid when we purchase goods and services)

(Adding) Capital Consumption Allowance or depreciation is the cost to replace capital goods that break or wear down

(Adding) Statistical discrepancies or pure computational errors often occur

Other National Income Accounting Measurements

Net Domestic Product (NDP) measures the total value of new goods available in the economy in a given year after worn-out capital goods have been replaced.

Net domestic product (NDP) = GDP – Capital consumption allowance*

*The estimated amount of capital goods used up in production through natural wear, obsolescence, and accidental destruction.

Other National Income Accounting Measurements

Personal Income = National income – Undistributed Corporate Profits – Social Security Taxes – Corporate Profits Taxes + Transfer Payments

Disposable Income = Personal Income – Personal Taxes

Per Capita Macroeconomic Measurements Divides these factors by the population.

Real GDP

Real GDP is the value of the entire output produced annually within a country’s borders, adjusted for price changes (inflation).

In other words, GDP adjusted for price changes.

Real GDP is equal to the sum of of all current year quantities times their base-year prices (in constant dollars/RM).

Real GDP = (Base-year prices X Current- year quantities)

Suppose 10 units of goods are produced and P = RM 10

GDP = RM 10 X 10 = RM 100

Suppose in year 2, GDP rises to RM 250, it can be:

GDP = RM 25 X 10 = RM 250 GDP = RM 10 X 25 = RM 250 GDP = RM 12.50 X 20 = RM 250

What Does It Mean If Real GDP is Higher In One Year than in Another Year?

GDP can rise from one year to the next if: Prices rise and output

remains constant; Output rises and prices

remain constant; Or prices and output rise.

Year Price

(1)

Qty

(2)

GDP

(1)x(2)

Real GDP

Base-year price x (2)

1 (Base Year)

RM 10 100 RM 1000 RM 1000

2 RM 12 120 RM 1440 RM 1200

3 RM 14 140 RM 1960 RM 1400

If You Know the Price Index and GDP For A Year, Can You Compute Real GDP?

Real GDP = GDP x 100 Chain Weighted Price Index

E.g. GDP was RM 9872, Price Index was 107,

Real GDP = RM 9872 x 100 = RM 9226 107

Real GDP, Economic Growth, and Business Cycles

Annual economic growth has occurred if the Real GDP in one year is higher than the previous year.

% Change in Real GDP

= Real GDP2 – Real GDP1 X 100

Real GDP 1

Economic Growth is measured by increases in Real GDP.

The Business Cycle

Recurrent swings (up and down) in Real GDP.

Five Phases of the Business Cycle

Peak: at the peak of the business cycle, Real GDP is at a temporary high.

Contraction: A decline in the real GDP. If it falls for two consecutive quarters, it is said to be in a recession.

Trough: The Low Point of the GDP, just before it begins to turn up.

Recovery: When the GDP is rising from the trough and ends at the initial peak

Expansion: when the real GDP expands beyond the recovery

An entire business cycle is measured by peak to peak

Recession

The National Bureau of Economic Research (NBER) definition of a recession is “ a significant decline in activity spread across the economy, lasting more than a few months, visible in industrial production, employment, real income, and wholesale-retail trade”.Recessions occur when Real GDP declines for TWO OR MORE consecutive quarters.

Shortcomings of GDP as a measure of a nation’s economic well-being. (McConnell Brue, pg.125 to pg.126) GDP doesn’t measure some very useful

output because it is unpaid (homemakers’ services, parental child care, volunteer efforts, home improvement projects).

GDP does not measure improvements in product quality or make allowances for increased leisure time.

GDP doesn’t measure improved living conditions as a result of more leisure.

Shortcomings of GDP

GDP makes no value adjustments for changes in the composition of output or the distribution of income.1. Nominal GDP simply adds the RM value of what is produced; it makes no difference if the product is a semi- automatic rifle or a jar of baby food.2. Per capital GDP [GDP/ population] may give some hint as to the relative standard of living in the economy; but GDP figures do not provide information about how the income is distributed.

Shortcomings of GDP The Underground Economy (no records exist)

1. Illegal activities are not counted in GDP.2. Legal economic activity may also be part of the “underground,” usually in an effort to avoid taxation.

GDP and the environment.1. The harmful effects of pollution are not deducted from GDP (oil spills, increased incidence of cancer, destruction of habitat for wildlife, the loss of a clear unobstructed view – this by-products our economic well-being).2. However, GDP does include payments (as part of expenditure) made for cleaning up the oil spills, and the cost of health care for the cancer victim.Result: GDP is overestimated!

Shortcomings of GDP Noneconomic Sources of Well-Being like

courtesy, crime reduction, etc., are not covered in GDP but they are useful to reflect the civilization of human race in a country!

Note: Per Capita GDP (GDP per person) is a better measure of standard of living than total GDP.