Measurement of Economic Performance: Gross Domestic Product

1. Measurement of Economic Performance:Gross Domestic Product AP Economics Mr. Bordelon

2. National Income and Product Accounts • National accounts. These accounts keep track of flows of money between different sectors of the economy. • Keeps track of spending of consumers, sales of producers, business investment spending, government purchases, and a variety of other flows of money between different sectors of the economy. • National income accounting is a method of measuring the flows of income and expenditures in the economy over a period of time. • National income accounts serve the same purpose for the economy as a whole as does the income statement of a business firm.

3. Simple Circular Flow Diagram Look at this awesome market economy CFD. We’ve got two different decision-makers in a market economy: households and businesses. Product market. Where goods and services (g/s) are bought and sold. Households buy g/s—demand/monetary flow. Businesses sell g/s—supply/physical flow. Price determined by free market. Consumer expenditures constitute sales receipts for businesses. Factor market. Where resources are bought and sold. Businesses buy factors—demand/monetary flow. Households sell factors—supply/physical flow. Price determined by free market. Businesses’ payments for resources constitute business costs and resource owners’ income.

4. Expanded CFD This CFD looks at a mixed economy, and there’s a lot of info here. First, notice that we’ve added two more actors: government and the rest of the world. Second, notice that there’s a third market, the financial market.

5. Expanded CFD Product market Household consumer spending goes straight to the product market. Firms g/s constitute investment spending. Government buys g/s—government spending. • Rest of the world buys and sells g/s through exports and imports (net exports).

6. Expanded CFD Factor Market Firms buy resources from households, revenue from which comes in the form of wages, profits, interest and rent. In short, no real difference between simple and expanded CFD. • Notice that households take part of their income and put it towards private savings in the financial market. • Also notice that government takes a chunk of revenue in taxes.

7. Expanded CFD Financial Market Banks loan government money. Banks will also issue stock and bonds to firms. For the rest of the world, banks continue lending and issuing stock and bonds. This covers the three market, but let’s take a look at the actors a little bit further. If you haven’t noticed, at least according to this CFD, GDP is found only as part of the product market? Why? Because some of this stuff doesn’t count.

8. Expanded CFD What doesn’t count? Taxes and government transfers do not count. They are not products. Any lending done or financial instrument issued by banks in the financial market. They are not products. Okay, but why does GDP only stand out in the product market? Well, it’s time to take a look at what GDP means.

9. Gross Domestic Product • Gross Domestic Product (GDP). Total value of all final g/s produced in the economy in a given year. • total value—value, not sales • final g/s—g/s sold to the end user • produced in an economy (country)—territory • in a given year—calendar year • AP Note: This is one of the few definitions you actually have to have down by heart. On the macro exam, on virtually every graph, it can help save your life and score points.

10. Measuring GDP • Value-Added Approach. Add the value of all final g/s produced in an economy, excluding the value of intermediate goods. • Why intermediate goods? They are not final.

11. Measuring GDP This table shows the value added at each step of production of a car sold at American Motors, Inc. American Ore produces $4,200 worth of value, based on wages, interest, rent and profits. That ore will be sent on to American Steel. American Steel will also add value in wages, interest, rent and profits, but notice that their expenditure are more than double of American Ore. That’s because it bought the iron ore at $4,200. However, the value added is only $4,800. This is because the ore is an intermediate good and not counted. So to find the value added by American Steel, we subtract the value added from the iron ore from the value added by the steel.$9,000 - $4,200 = $4,800 3. The final step is when the steel goes to American Motors, which makes the final product of the car, sold at $21,500. Total expenditures are $21,500, which we would expect given the factor payments used to make the car with the additional of $9,000 worth of steel. But we’re only interested in the value added. So we subtract the total expenditure (sale) from the value of the intermediate goods.$21,500 - $9,000 = $12,500

12. Measuring GDP Why do it this way? Because if we simply go by aggregate spending (value of sales), then we end up counting the value added twice (three times for the ore). This is called double counting, and leads to an inaccurate accounting of GDP. Going after value-added only, however, is a more accurate reflection of GDP. Sum of value added is $21,500, which is also the amount of the final product sold…which would count as part of GDP. We can also look at this through the factor income. Summing those up, we get the same result of $21,500. This is representative of another made called the factor income approach, which we’ll discuss shortly. For now, notice that sums between the value-added and factor-income approaches are equal. That’s not a coincidence. All three methods would calculate GDP as the same amount.

13. Measuring GDP • Expenditure Approach. Add up aggregate spending on domestically produced final g/s. In other words, the flow of cash money baby into businesses. • Go back to the expanded CFD. Notice that the black arrow goes into firms. This is demonstrative of the expenditure approach.

14. Measuring GDP • Four Elements to the Expenditure Approach • Consumer spending (C). Household spending on g/s. • Investment spending (I). Spending on new productive physical capital, such as machinery and structures and on changes in inventory. • Government spending (G). Government spending on g/s done at federal, state, and local levels. • Net exports (X – IM). The difference between the value of exports and imports. We don’t count imports because those are products that are produced outside the economy. • GDP = C + I + G + (X – IM)

15. Measuring GDP • Factor-Income Approach. Add all the income earned by factors of production earned in the economy—wages, interest, rent, and profit. • The money must go somewhere. It’s a good bet that the households and firms who receive the income will spend it. • NI = Wages + Rents + Interest + Profits

16. What’s In and What’s Out? • In. Domestically produced final g/s, including capital goods, new construction of structures, and changes to inventories. • U.S. final goods • U.S. final services • Out • intermediate g/s • inputs • used goods • financial assets • imports

17. What’s In and What’s Out? • Two AP favorites for exclusion from GDP • Second Hand Sales. Especially houses. Do not count it when it’s sold because its value has already been accounted for in the year produced. • Purely Financial Transactions • Public: social security, welfare, unemployment, any kind of government transfer payment • Private: stocks, bonds, allowance, and alimony • What about the broker’s fee for stocks? • COUNT IT! It’s a final g/s!

18. Special Note on Inventories • Inventory. Stocks of goods and raw materials held to facilitate business operations. • Businesses will build up inventories in anticipation of future sales, and this will count as investment spending in GDP. But why isn’t counted when it’s sold? • Because we’re focused on the value, not it’s sale price. • Additional inventory is an investment in future sales. • When good is released from the inventories, its value is subtracted from the value of inventories and so from GDP.

19. What does GDP mean? • GDP gives us the value of current production at current prices. We could be more specific and call this nominal GDP. • Nominal GDP. Total value of all final g/s produced in the economy during a given year, calculated with the price current in the year in which the output is produced. • Using nominal GDP to compare production across years is misleading, and can often lead to exaggerated results.

20. Calculating GDP • Basic multiplication and addition here: (P x Q) + (P x Q) + … = GDP • As a matter of math, if P increases, but Q stays the same, GDP increases. • MISLEADING: This does not mean that the economy has increased—it just got more expensive! • Solution: calculate real GDP. • Real GDP. Total value of all final g/s produced in the economy during a given year, calculated using the prices of a selected base year.

21. Calculating Real GDP • Now, if we compare nominal GDP, we find that we have a percentage growth between 2007 and 2008 of 43.6%. • NOOO! Equation: [(New number – Old number)/Old Number] x 100% • This number is crap. By the way, this is also how politicians lie with numbers. All of them. Satan’s little minions each and every one. • Solution: Use 2007 prices as a base year and multiply 2008 quantity by those prices.

22. Calculating Real GDP Now this is more like it. If we look at a percentage change from year to year, we have 7.1% change. Why do this? Because we need numbers that we can understand and recognize. 2007, in this example, is a year we understand, but future years not so much. The base year’s prices give us a frame of reference to judge from. One other note, notice that the nominal and real GDP for 2007 is the same. This is because we are using 2007 prices and quantity. This will always be the case for the base year, that nominal and real GDP will be equal.

23. What Real GDPDoesn’t Measure • Happiness doesn’t count: volunteer work, hobbies, raising children, chores, work around the house, etc. • All of these are things that hurt the economy. So stop doing it. You don’t hate America, do you? • Unhappiness, however, does: divorce lawyers, security systems, choosing an assault rifle over butter, natural disasters, plagues, locusts, the Apocalypse. • All of these are things that contribute to the economy. So…when do we start firing off the nukes?

24. Exercise • Calculate nominal GDP for: • 2010 • 2011 • Compute the percentage change in nominal GDP from 2010 to 2011. • Using 2010 as the base year, calculate the real GDP for 2011. • Compute the percentage change in real GDP from 2010 to 2011.