taking the nation’s pulse

Copyright (c) 2000 by Harcourt Inc.All rights reserved.

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Slides to Accompany “Economics: Public and Private Choice 9th ed.” James Gwartney, Richard Stroup, and Russell Sobel

Taking the Nation’s Pulse

Chapter 7

Jump to first page Copyright (c) 2000 by Harcourt Inc.All rights reserved.

1. GDP – A Measure of Output


Stageof Production

Amount Added To the Value of the product (equals income created)

(2)

Sales Receiptsat each stage of production

(1)

GDP – A Measure of Output Gross Domestic Product (GDP) is the market value

of final goods and services produced within a country during a specific time period, usually a year.

Total consumer expenditure = $1

Stage 1: Farmer’s wheat

Stage 2: Miller’s flour

Stage 3: Baker’s bread

(wholesale)

Stage 4: Grocer’s bread (retail)

Value added by grocer

Value added by baker

Value addedby miller

Value addedby farmer

$.30

$.65

$.90

$1

$.30

Total value added = $1

$.10

$.35

$.25

What Counts Toward GDP? Only Final Goods and Services Count:

Sales at intermediate stages of production are not counted as their value is embodied within the final-user good. Their inclusion would result in double counting.


GDP – A Measure of Output What Counts Toward GDP? (cont.)

Financial transactions and income transfers are excluded because they do not involve production.

Only production within the geographicborders of the country is counted.

Only goods produced during the current period are counted.

Dollars -- The Common Denominator for GDP Each good produced increases output by the

amount the purchaser pays for the good. GDP is equal the sum of the total spending on

all goods and services produced during the year.


1. Indicate how each of the following activities will affect this year’s GDP:

Questions for Thought:

a. Sale of a used economics textbook to the college bookstore.

b. Smith’s $500 doctor bill for setting her son’s broken arm.

c. Family lawn services provided by Smith’s 16-year-old child.

d. Lawn services purchased by Smith from the neighbor’s 16-year-old child who has a lawn mowing business.

e. A $5,250 purchase of 100 shares of stock at $50 per share plus the sales commission of $250.

f. A multi-billion dollar discovery of natural gas in Oklahoma.

g. A hurricane that causes $10 billion of damage in Florida.

h. $50,000 of income earned by an American college professor teaching in England.


2. Two Ways of Measuring GDP


GDP

Two Ways of Measuring GDP

Deriving GDP by the Expenditure Approach: GDP is the sum of expenditures on final user

goods and services purchased by households, investors, governments, and foreigners.

There are four components of GDP: personal consumption purchases, gross private investment (including inventories), government purchases (both consumptions and

investment), and, net exports ( exports - imports )

Dollar Flow ofExpenditures

on Final Goods=

Dollar Flow ofIncome (and indirect cost)

of Final Goods=


Two Ways of Measuring GDP Deriving GDP by the

Resource Cost - Income Approach:

GDP is the sum of the costs incurred and income (including profits) generated producing goods and services during the period.

The direct cost income components of GDP are: employee compensation, self-employment income, rents, interest, and, corporate profit.

Sum of these = National Income


Two Ways of Measuring GDP The Resource Cost - Income Approach: (cont).

Not all cost components of GDP result in an income payment to a resource supplier. In order to get to GDP, we need to account also for three other factors:

Indirect business taxes: Taxes that increase the business firm’s costs of production and therefore the prices charged to consumers.

Depreciation: The cost of the wear and tear on the machines and other capital assets used to produce goods and services during the period.

Net Income of Foreigners The income that foreigners earn producing goods within the borders of a country minus the income Americans earn abroad.


Two Ways of Measuring GDP When derived by Resource Cost - Income Approach

GDP is equal to: national income

(employee compensation, self-employment income, rents, interest, corporate profit),

indirect business taxes, depreciation, and, the net income of foreigners.


There are two methods of calculating GDP:

Expenditure Approach Resource Cost-Income Approach

Personal Consumption Expenditures

+ Gross Private Domestic Investment

+Government Consumption and Gross Investment

+Net exports of goods and Services

Aggregate Income:

Compensation of employees (Wages and salaries)

Income of self-employed Proprietors

Rents Profits Interest

+

Non-Income Cost Items:

=

GDP

Indirect business taxes Depreciation

Net Income of Foreigners

+ =

GDP

Two Ways of Measuring GDP

It can be calculated either by summing the expenditures on the “final user” goods and services purchased by consumers, investors, governments, and foreigners (net exports), or,

by summing the income payments and direct cost items that accompany the production of goods and services.


The relative sizes of the major components of GDP usually fluctuate within a fairly narrow range.

Relative Size ofU.S. GDP Components: 1996-1998

The average proportion of each U.S. component during 1996-1998 is demonstrated here for both

The expenditure approach, and, The resource cost-income approach.

Personal consumption

68%

Net exports minus 1%

Private investment

14%

Government 19%

Rental income less than 1%

Net interest

7%

Indirect taxes 8%

Corporate profits

7%

Self-employed proprietor income 7%

a

Compensation to employees

60%

Depreciation 11%

(a) Expenditure approach (b) Resource cost-income approach

Source: Economic Report of the President, 1999. a The net income of foreigners was negligible.


3. Real and Nominal GDP


Real and Nominal GDP The term "real" means adjusted for inflation. Price indexes are use to adjust income and

output data for the effects of inflation. A price index measures the cost of purchasing

a market basket (or “bundle”) of goods at a point in time relative to the cost of purchasing the identical market basket during an earlier reference (or base) period.


4. Two Key Price Indexes: -- The Consumer Price Index

and the GDP Deflator


Two Key Price Indexes: -- The Consumer Price Index and the GDP Deflator

Consumer Price Index (CPI): -- measures the impact of price changes on the cost of the typical bundle of goods and services purchased by households.

GDP Deflator: -- is a broader price index than the CPI. It is designed to measure the change in the average price of the market basket of goods included in GDP.


CPI & GDP Deflator: 1981-1997

Even though the CPI and the GDP deflator are based on different market baskets and procedures, the rate of inflation as measured by each indicates that the differences between these two alternative measures have been small, usually only a few tenths of a % point.

YearCPI

(1982 – 84 = 100)

19811982198319841985198619871988198919901991199219931994199519961997

90.996.599.6

103.9107.6109.6113.6118.3124.0130.7136.2140.3144.5148.2152.4156.9160.5

10.36.23.24.33.61.93.64.14.85.44.23.03.02.62.83.02.3

10.06.24.13.73.62.53.13.64.24.34.02.82.62.42.31.91.9

GDP Deflator

(1992 = 100)

66.170.273.275.978.680.683.186.189.793.697.3

100.0102.6105.1107.5109.6111.6

Inflation Rate (Percent)

Inflation Rate (Percent)

Source: Economic Report of the President, 1999.

1998 163.0 1.5 1.0112.7


5. Using the GDP Deflator to Derive Real GDP


Real GDP2 =

Using the GDP Deflator to Derive Real GDP

Data on both money GDP and price changes are essential for meaningful output comparisons between two time periods.

Nominal GDP2 * GDP Deflator1

GDP Deflator2


1. What do price indexes measure?


2. What is the difference between the consumer price index (CPI) and the GDP deflator. Which would be better to use if you want to measure whether your hourly earnings this year were higher than they were last year. Why?

3. Consider an economy with the following data: Nominal GDP

(in Trillions) GDP deflator 1998 $8.5 120 1999 8.8 125

What was GDP in 1999 in constant 1998 dollars? What was the growth rate of real GDP between 1998

and 1999? What was the inflation rate between 1998 and 1999?


1992

1998

% Increase

Source: U.S. Department of Commerce.

NOMINAL GDP(BILLIONS OF DOLLARS)

REAL GDP (BILLIONS OF 1992 DOLLARS)

$6,244

$8,511

36.3%

PRICE INDEX (GDP DEFLATOR, 1992 = 100)

100.0

112.7

12.7%

$6,244

$7,552

20.9%

Using the GDP Deflator to Derive Real GDP

Between 1992 and 1998, nominal GDP increased by 36.3 percent.

But when the 1998 GDP is deflated to account for price increases, we see that real GDP increased by only 20.9 percent.


6. The Shortcomings and Strength of GDP

as a Measuring Rod


Shortcomings of GDP as a Measuring Rod It does not count non-market production. It does not count the underground economy. It makes no adjustment for leisure. It probably understates output increases

because of the problem of estimating improvements in the quality of products.

It does not adjust for harmful side effects.


The Great Contribution of GDP In spite of its shortcomings, real GDP is a

reasonably accurate measure of short-term fluctuations in output.


7. Related Income Measures


Related Income Measures Gross National Product (GNP):

Output produced by the "nationals"-- the citizens of the country, regardless of whether that output is produced domestically or abroad.

National income: Total income earned by the nationals (citizens) during a period. It is the sum of employee compensation, self-employment income, rents, interest, and corporate profits.

Personal income: Total income received by domestic households and non-corporate businesses. It is available for consumption, saving, and payment of personal taxes.

Disposable income: Income available to individuals after personal taxes. It can either be spent on consumption or saved.


1998 ($ billions)

Net exportsDepreciation

Personal consumer

expenditures

Gross Private Domestic

Investment

Government consumption & investment

Employee compensation

Proprietors’ income

Interest

Rents

Corporate profits

Personal taxes

Indirect business taxes minus net income earned

abroad

Plus

Transfer payments net interest, and

dividends

MinusCorporate profits & Social insurance

taxes

Gross Domestic Product

$8,511

Gross National Product

$8,491

National Income

$6,995

Personal Income

$6,102

Disposable Income

$5,307

Net income of foreigners

5 Alternative Measures of Income

The bars above illustrate the 5 alternative measures of national income. The alternatives range from GDP (the broadest measure of output) to

Disposable Income (which indicates the funds available to households for either consumption or saving).


The Link Between Output and Income

As the alternative ways of measuring of GDP highlight, output and income are linked.

Increases in output are the source of higher income levels.


2. GDP does not count productive services such as child care, food preparation, cleaning, and laundry provided within the household. Why are these things excluded? Is GDP a sexist measure? Does it understate the productive contributions of women relative to men?

1. Why might even real GDP be a misleading index of changes in output between 1950 and 1999 in the United States? Of differences in output between the United States and Mexico?


3. What are the components of GDP when it is derived by the expenditure approach?


EndChapter 7

taking the nation’s pulse

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