CHAPTER

1. 8 GDP: Measuring Total Production and Income CHAPTER Chapter Outline and Learning Objectives

2. Microeconomics and macroeconomics Microeconomics is the study of how households and firms make choices, how they interact in markets, and how the government attempts to influence their choices. In contrast, macroeconomics is the study of the economy as a whole, including topics such as inflation, unemployment, and economic growth. When we want to study the overall economy-level actions of people and governments, the models and tools of macroeconomics become very useful.

3. Some important terms in macroeconomics Business cycle: Alternating periods of economic expansion and economic recession. Expansion: The period of a business cycle during which the total production and total employment are increasing Recession: The period of a business cycle during which total production and total employment are decreasing Economic growth: The ability of an economy to produce increasing quantities of goods and services Inflation rate: The percentage increase in the price level from one year to the next

4. Goal of this chapter Over the coming chapters, we will explore many aspects of the macroeconomy, including how all of the elements on the previous slide relate to one another. For this chapter, we have a less lofty goal: to figure out how to measure the total output of an economy. Being able to measure total output is incredibly important, since much of macroeconomics depends on our ability to measure and predict aggregate economic activity.

5. Gross Domestic Product Measures Total Production 8.1 LEARNING OBJECTIVE Explain how total production is measured.

6. Measuring total production: Gross Domestic Product The most common measure used by economists of overall economic activity in an economy is Gross Domestic Product, or GDP. We will examine each of the parts of this definition in turn. Gross Domestic Product: the market value of all final goods and services produced in a country during a period of time, typically one year.

7. GDP is measured using market values, not quantities We cannot add together the number of cars, melons, haircuts, and all other goods and services without agreeing on a common way to measure them. The best practical way is to value each good and service in monetary terms; and the best measure of this that we have is the price that each good or service is sold for. Gross Domestic Product: the market value of all final goods and services produced in a country during a period of time, typically one year.

8. GDP includes only the market value of final goods A final good or service is a good or service purchased by a final user. These are what are used to calculate GDP. Why? If we counted intermediate goods and services as well, ones that were inputs into another good or service, such as a tire on a truck, then we would end up double-counting. Example: if we counted the value of the ice cream bought by a store, and also counted the value of that ice cream when it was sold to a consumer, we would be double-counting the wholesale value of the ice cream. Gross Domestic Product: the market value of all final goods and services produced in a country during a period of time, typically one year.

9. GDP includes only current production To measure total output in a given year, we measure the goods and services produced only in that given year. Again, this avoids double-counting: if you buy a DVD in 2011, that DVD counts in 2011’s GDP. If you resell it in 2012, it will not count again in 2012. So GDP counts only new goods and services. Used items were previously produced and counted, so don’t need to be counted again. Gross Domestic Product: the market value of all final goods and services produced in a country during a period of time, typically one year.

10. Production and income There are two main conceptual ways to measure the total economic activity in an economy: total production or total income. When we measure one, we are also measuring the other. Everything that is produced and sold constitutes income for someone; so we have the choice of measuring the value of products produced and sold, or the value of incomes, and each is a valid way of measuring economic activity.

11. Follow the spending to measure GDP To measure GDP, the Bureau of Economic Analysis (BEA) in the Department of Commerce measures four major categories of expenditures: Personal Consumption Expenditures, orConsumption (C) Gross Private Domestic Investment, or Investment (I) Government Consumption and Gross Investment, or Government Purchases (G) Net Exports of Goods and Services, or Net Exports (NX) GDP can be expressed as the sum of these: Y = C + I + G + NX

12. Consumption Y = C + I + G + NX Consumption (C) Consumption is spending by households in goods and services, not including spending on new houses (which are counted instead in investment). In BEA statistics, consumption is further divided into expenditure on services, durable goods, and nondurable goods. Investment (I) Government Purchases (G) Net Exports (NX)

13. Investment Y = C + I + G + NX Consumption (C) Investment (I) Investment is spending by firms on new factories, office buildings, and additions to inventories, plus spending by households and firms on new houses. The BEA measures the following categories of investment: business fixed investment, residential investment, and changes in business inventories. This last category includes goods that have been produced but not yet sold. Government Purchases (G) Net Exports (NX)

14. Government purchases Y = C + I + G + NX Consumption (C) Investment (I) Government Purchases (G) These are spending by federal, state, and local governments on goods and services, such as teachers’ salaries, highways, and aircraft carriers. This does not include transfer payments, since those do not result in immediate production of new goods and services. Net Exports (NX)

15. Net exports Y = C + I + G + NX Consumption (C) Investment (I) Government Purchases (G) Net Exports (NX) Net exports are defined as the value of exports minus the value of imports. This difference might be positive or negative; in recent years, this has been negative in the United States. Since we want to count domestic production (production in the United States), we add up the value of the goods and services sold to foreigners, and subtract off the value of the goods and services sold to Americans by foreigners.

16. Components of GDP in 2010 Figure 8.2 Consumption is the largest component of GDP; within that, services are the largest component—almost half of GDP. American net exports are negative, since the value of our imports exceeds the value of our exports.

17. MakingtheConnection Will U.S. Consumers Be Spending Less? Recent decades have seen Americans consuming larger and larger fractions of what we produce. This has come in part due to increased borrowing, both by households and by governments.

18. MakingtheConnection Will U.S. Consumers Be Spending Less? American consumption as a fraction of production is higher than in other large countries. This leaves less production for investment, which inhibits long-term growth. However since the recent recession, households have been saving more—6% of income in 2009—which, while probably slowing down the recovery from the recession, will likely lead to more long-term growth as these savings finance firm investment.

19. Measuring GDP using the value-added method An alternative method to measure GDP is to measure the value added: the market value each firm adds to a product. The final selling price of a product must equal the sum of the values added to the product at each stage of production. The table below illustrates this method for a shirt sold on L.L.Bean’s web site. Table 8.1

20. Does GDP Measure What We Want It to Measure? 8.2 LEARNING OBJECTIVE Discuss whether GDP is a good measure of well-being.

21. Shortcomings of GDP GDP can be a useful tool to measure total output in an economy. Many people go further than this, interpreting GDP as a measure of the well-being of citizens. However GDP has shortcomings, both in its measure of total production, and in its usefulness as a measure of well-being.

22. Shortcomings of GDP as a measure of total production Two important types of production are omitted from the BEA’s measurement of GDP: Household Production Household production such as childcare, cleaning, and cooking is not typically paid for with money. However such contributions are real—if they were performed by a non-household-member, they would be paid for and counted in GDP. The Underground Economy Buying and selling of goods and services might be concealed from the government to avoid taxes or regulations, or because the goods and services are illegal. This constitutes the underground economy. This may be 10% or more of the economy in America, and substantially more in low-income households.

23. Shortcomings of GDP as a measure of total production How important are these shortcomings? It depends. If we are comparing GDP from year to year, the size of household production and the underground economy is probably about the same from year to year, so GDP growth is a reasonable measure of the growth in total production. However over long periods of time, these shortcomings might be more serious. Example: As women have entered the workforce in larger numbers, some household production has been replaced by paid childcare and restaurant meals. So increases in GDP may exaggerate the increase in actual total production.

24. MakingtheConnection Why Do Many Developing Countries Have Such Large Underground Economies? In developing countries, the underground economy is often referred to as the informal sector, as opposed to the formal sector, in which output of goods and services is measured. In many developing countries, the informal sector is very large; often above 50% of total output. Economists studying economic development say this often reflects poor government policies: high taxes and regulations, and low confidence in the security of private property from government seizure. In some developing countries, more than half the workers may be in the underground economy.

25. Shortcomings of GDP as a measure of well-being GDP per capita (i.e. GDP divided by population) is often used to represent differences in standards of living from country to country. However, even if it accurately measured total production, it would not reflect: The value of leisure Pollution and other negative effects of production Crime and other social problems The distribution of income In fact, improvements in many of these will result in lower GDP per capita. Example: Lower crime would allow lower spending on police, prisons, and private security. This would decrease GDP, but surely result in improvements in economic well-being.

26. MakingtheConnection Did World War II Bring Prosperity? World War II was a period of extraordinary sacrifice and achievement by the “greatest generation.” But statistics on GDP may give a misleading indication of whether it was also a period of prosperity.

27. Real GDP versus Nominal GDP 8.3 LEARNING OBJECTIVE Discuss the difference between real GDP and nominal GDP.

28. Calculating real GDP Since GDP is measured in “value” terms, we might have problems interpreting changes over time if prices change. Is an increase in GDP due to production increasing, or due to prices increasing? To separate these effects, the BEA calculates both Nominal GDP—the value of final goods and services evaluated at current-year prices—and Real GDP—the value of final goods and services evaluated at base-year prices. The choice of a base-year is arbitrary; we might use 2000, 2005, or 2012 prices to compare real GDP in each year. Unfortunately, the relative prices also change from year to year, distorting real GDP calculations. Since 1996, the BEA has overcome this problem by using chain-weighted prices, using previous-year prices to adjust current-year production measure.

29. Calculating real GDP: an example The table shows output and prices in 2005 and 2013. Calculating the total value of output in 2005 gives: $3200 + $990 + $1350 = $5540. To calculate real GDP in 2013, we use the prices from 2005. This gives real 2013 GDP in 2005 dollars of $6680. Most prices increased from 2005 to 2013, so using nominal GDP would have yielded a higher figure: $7800. This highlights the need to use real GDP to avoid exaggerating growth.

30. Comparing real GDP and nominal GDP Figure 8.3 The current baseyear for calculating prices is 2005, soreal and nominal GDP are equal in 2005. Growth figures reported in the media are the growth in real GDP. Since prices have generally increased since 2005, real GDP is less than nominal GDP, and the opposite is true before 2005.

31. The GDP deflator Economists and policy-makers are interested in the price level: a measure of the average prices of goods and services in the economy. Why? Stable prices are desirable because they allow households and firms to plan for the future appropriately. In order to know whether we are achieving price stability, we need to measure the price level. One way to do this is using the GDP deflator: Since nominal and real GDP will be the same in the base year, the GDP deflator will be 100 in the base year.

32. Calculating the GDP deflator The table on the right gives the values of nominal and real GDP for 2009 and 2010. We can use this to calculate the GDP deflator in each year: The GDP deflator increased from 110 to 111 between the two years. This is a 0.9% increase: So we say the price level rose 0.9% over this period.

33. Other Measures of Total Production and Total Income 8.4 LEARNING OBJECTIVE Understand other measures of total production and total income.

34. National Income and Product Accounts (NIPA) The BEA is charged with performing national income accountingfor the United States. Each quarter, it publishes the National Income and Product Accounts tables. These include GDP computations, but also:

35. National Income and Product Accounts measurements The table and graph show the various measures of the national income accounts for the United States in 2010. National income must be smaller than GDP, since it is just GDP minus depreciation. Similarly, disposable personal income must be less than personal income, since it is just personal income minus taxes. Each measure is useful in different contexts. Figure 8.4

36. Total production = total income All production must be rewarded with income; so in theory, we could count either in order to calculate GDP. In practice, data limitations make us unlikely to come up with the same number; there will always be some statistical discrepancy. The figure illustrates the division of income as measured by the BEA in 2010. Figure 8.5

37. Common misconceptions to avoid “Investment” in reference to national income accounting has a very narrow definition: purchases of things like machines, factories, and houses. It refers only to the purchase of new items, not trades in financial instruments based on those items. We based statements about growth on GDP; but GDP has limitations, both as a measure of total production, and as a measure of well-being. In order to make useful comparisons, concentrate on real GDP rather than nominal GDP. In calculating real GDP, the choice of base year is largely arbitrary; there is no “correct” base year.