Measuring Domestic Output

Real GDP

"It is not only the quantity of growth that is important, but its quality"

-European Commission, 2007

Slide 1 of 26

In the last module, we learned that GDP is a broad measure of economic activity

In this module, we’ll add to our understanding:

First, we’ll differentiate between Real GDP and Real GDP Per Capita

Finally, we’ll look at some shortcomings of using Real

GDP to measure an economy.

Second, we’ll explore the four components of GDP.

Slide 2 of 26

To begin…we want economic growth

However, there are two ways to measure economic growth:

Why do we care:

Because growth lessens the burdens of scarcity

I think we can all agree…we want more guns AND butter.

An increase in real GDP per person

occurring over some time period

An increase in real GDP for the overall economy occurring

over some time periodSlide 3 of 26

In some cases, economic growth is best measured using Real GDP

For example, when measuring the economic power of a country

and its ability to wage war, economists would be more

interested in Real GDP.

Think of it in these terms- if a country were to transform its

production into wartime equipment such as tanks and planes, how much could they

produce?

Slide 4 of 26

In other cases, economic growth is best measured using Real GDP per Capita

For example, when measuring the likelihood that people in a

country would buy a new expensive product, economists

might look to Real GDP per capita.

Think of it in these terms- if a store like Tiffany’s, which sells

expensive jewelry- were to consider entry in a new country- they might consider Real GDP per person as opposed to total

Real GDP.

It is important to note however that in both cases, we are discussing REAL GDP.As we have already learned, we must control for changing prices in order to fairly

compare GDP from one period to the next!Slide 5 of 26

Let’s turn our attention to the components of GDP

• C = Personal Consumption

• I = Investment

• G = Government

• Xn = Exports (net)

GDP = C + I + G + Xn

This consists of U.S. residents spending money at the cash register, online or on

services such as haircuts.

This consists of spending on houses, buildings, equipment, and software.

This consists of federal, state, and local spending on goods and services.

This consists of the value of goods and services we sell to other countries minus

that which we buy from them.

The next slide will show the size of each component. After that we’ll look at each component in depth.

GDP can be broken into four components:

Slide 6 of 26

Consumption is the largest component of an economy

Note that the U.S. economy is on pace to produce about $16 trillion in goods and services

in 2013.

Picture the U.S. economy as a 4 piston engine. Unlike other engines, this one has one big piston and three little pistons. If something goes wrong with the big piston, what do you think happens to

the engine?

Slide 7 of 26

Let’s explore the 4 pistons

Slide 8 of 26

Piston #1: Consumption

Consumption is the largest component of economic activity in the U.S.

It includes spending on goods and services by us, the American consumer. In 2011, we’ll spend

$10 trillion in consumption!

Anytime you are at a cash register, swipe your credit card, click “buy now” or get a service such

as a haircut or a tree trimmed, that is consumption.

1

Slide 9 of 26

Consumption can be broken down into three parts

Consumption includes services such as a haircut, durable

goods, and non durable goods- explained on the next slide.

Slide 10 of 26

What are in those categories?

Durable goods- they have a useful life of 3+ years…like this washing

machine

Nondurable goods- they have a useful life of less than 3

years…like food or medicine.

Services include haircuts, doctors appts, lawyers,

architects, lawn care and many others

Slide 11 of 26

Piston #2: Investment

Investment is typically the third largest component of economic activity in the U.S.

It includes spending on office buildings, malls, houses, apartment complexes, malls, software,

and equipment. In 2012, we spent $2.1 trillion in investment!

For the definition of GDP, Investment does not include purchases of stocks. If companies take

invested money and build buildings, that is included.

3

Stocks

Slide 12 of 26

Investment (I)Investment is divided into four sections:

commercial equipment and software, Nonresidential structures (like malls or offices) ,

residential structures, and inventoriesWith the housing market turmoil, this section has gotten al lot of attention

(Note: when a new home is built and sold its value

is captured here)

Slide 13 of 26

Piston #3: Net Exports

Net Exports are the smallest component of economic activity in the U.S.

It is calculated by taking the total value of all goods and services we sell to other nations and subtracting the value of all goods and services

that we buy from other nations.

For at least 30 years, net exports have been negative meaning that we buy more from other

countries than they buy from us.

4

Slide 14 of 26

Net Exports (Xn)

Net Exports = Exports - Imports

Since GDP = C+I+G+NX

Exports add to GDP while imports take away from it.

Slide 15 of 26

Recent growth in imports has far outpaced growth in exports

You might also notice the huge disruption in trading activity that occurred during the last

recession!

At some point in the 1980s, we started to see a trade deficit develop. That means we are buying more from other countries than they

are buying from us.

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The U.S. balance of trade has deteriorated

Slide 17 of 26

Recent trends in international trade show that over a long period the U.S. has a growing Trade imbalance. That is a Key Learning Outcome.

Interestingly, economists are not in agreement as to whether or not a growing trade imbalance is a

problem. What do you think?

Piston #4: Government Spending

Government Spending is typically the second largest component of economic activity in the

U.S.

It is the sum of purchases of goods and services by all levels of government in the U.S. including federal, state, and local. It exceeded $3 trillion in

2012.

It only includes purchases. Transfers (where money is provided to a person and is not

exchanged for a good or service such as Social Security, or Medicare) is not included when

calculating GDP.

2

Slide 18 of 26

Government Expenditures

Government Expenditures includes government consumption expenditures and investments

Federal State

Local

Slide 19 of 26

Government Expenditures

Note: These figures exclude transfer payments, interest, and other subsidies that account for approximately 70% of federal government spending. That spending is not accounted for in GDP because it does not involve the purchase of a final good or service.

Government expenditures are divided into three sections: Federal, State, and Local

Slide 20 of 26

Be sure you understand the four components of GDP

We will spend a lot of time reflecting on these components in the future.

As you can imagine, understanding them can be critical to figuring out what is wrong

with an economy.

For example, if you see that GDP is falling and your economy is headed for a recession, you might then explore these to see which component has dropped.

Doing so can allow elected leaders to tailor economic policy to address those

specific areas.

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Let’s talk about one other aspect of GDP

GDP is a useful tool.

It allows us to measure and compare the size of different economies and determine if

they are growing or not.

It does however, have its shortcomings. Let’s explore some of those.

GDP

Slide 22 of 26

GDP is great but…

Economists use it to measure the size of a country, but also use it to measure “quality of life”…or even “happiness” assuming that greater income =

happiness.

GDP is a GREAT measure of an economy.

In fact, if told that they could only have one statistic describing an economy, most economists would

probably pick GDP.

Slide 23 of 26

Shortcomings of GDP

• Excludes nonmarket transactions

• Excludes amount of leisure the citizens of the economy are able to have

• Does not record the improvements in quality of products

• Doesn’t include underground (black market) economy (8% in U.S)

These are “under the table” transactions

Time off has value but isn’t counted in GDP

TV’s have gotten much better, right!

These are transactions where nothing is purchased. Examples include a social security payment.

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Shortcomings of GDP (Cont.)

• Does not record the pollution costs to the environment

• Does not account for changes in population

• Does not fully measure quality of life or well-beingGDP is criticized for not measuring happiness well. Tibet’s answer to this

problem is to measure GDH-Gross Domestic Happiness! Slide 25 of 26

In summary

A nation’s total output can be measured by adding the value of all products produced or all income

earned. That will equal Gross Domestic Product.

Using the expenditure approach, GDP is broken into four parts…Consumption, Investment, Net Exports,

and Government Spending.

It can also be used to measure a total Economy (Real GDP) or individual wealth (Real GDP per

Capita)

Understanding these four pieces can help when assessing the health of an economy

It is also important to remember that GDP has some shortcomings. Economists use it as a proxy for

happiness…perhaps we should not!Slide 26 of 26