Learning Objectives

Learning Objectives • 05-01. Know what GDP measures – and what it doesn’t. • 05-02. Know the difference between real and nominal GDP. • 05-03. Know why aggregate income equals aggregate output. • 05-04. Know the major submeasures of output and income.

Measures of Output Each good and service produced and brought to market has a price, which serves as a measure of its value. Gross domestic product (GDP):the total dollar value of all final output produced within a nation’s borders in a given time period, usually one year.

Why “Final Output”? • GDP measurements exclude intermediate goods. • Intermediate goods: goods or services purchased for use as an input in the production of final goods or in services. • Value added: the increase in the market value of a product that takes place at each stage of production. • The value added by each intermediate good is captured in the market price of the final good produced.

International Comparisons • GDP is geographically focused: output produced within a nation’s borders. • This makes it easier to make international comparisons of economic activity. • For more vivid comparisons, we construct GDP per capita: average GDP, or the total GDP divided by total population.

GDP per Capita • GDP divided by population. • Average output per person. • Used as a measure of a country’s standard of living. • Does not indicate the disparity of output distributed to high-income earners and low-income earners in that country. • Low GDP per capita reflects a lot of deprivation in that country.

Measurement Problems • Nonmarket activities: GDP measures exclude most goods and services produced but not sold in the market. • Production not included: • Unpaid production done at home or by volunteer workers. • Unreported production done “off the books” or in the underground economy. • The official GDP measurement significantly understates actual production in the country.

Real GDP and Nominal GDP • A significant use of GDP is to measure how production changes from year to year. • Price changes from year to year make it difficult to compare one year’s GDP with the next year’s GDP. • Both output levels and prices can change. • We want to see only the change in output levels. • Because of this, we must remove the effects of price changes from the GDP measurements.

Real GDP and Nominal GDP • Nominal GDP: the value of final output produced in a given period, measured in the prices of that period (current prices). • The effects of price changes are included. • Real GDP: the value of final output produced in a given period, adjusted for changing prices. • The effects of price changes are removed. • The current year market values are recalculated in base year dollars.

Computing Real GDP • Base year:the year used for comparative analysis; the basis for indexing price changes. • We arbitrarily set a price index in the base year to equal 100. • The GDP for any other year is recalculated into base year dollars, using the price index for that year.

Computing Real GDP Nominal GDP in year t Real GDP in year t = Price index 100 + Percentage change Price index = 100 The general formula for computing real GDP is The price index represents a price level percentage change from the base of 100.

Exercise 1 Convert nominal GDP to real GDP: Where (for 1991) Nominal GDP = $5,677.5 billion Price index = 117.8/100 or 1.178 Real GDP (1991) = $5,677.5/1.178 = $4,819.9 billion Nominal GDP in year t Real GDP in year t = Price index

Exercise 2 Convert nominal GDP to real GDP: Where (for year t) Nominal GDP = $15 trillion Price index = 150/100 or 1.5 Real GDP in year t =$15/1.5 =$10 trillion Nominal GDP in year t Real GDP in year t = Price index

Net Domestic Product NDP = GDP - Depreciation • Net domestic product(NDP):GDP less depreciation. • When we produce, we wear out some of our capital, which must be replaced. • Depreciation measures the value of capital we use up. • NDP is the amount of output we could consume without reducing our stock of capital.

Net Domestic Product • The distinction between GDP and NDP is mirrored in the difference between gross investment and net investment: • Gross investment: total investment expenditure in a given time period. • Net investment: gross investment less depreciation. • When net investment is positive, the economy grows. • When net investment is negative, the economy declines.

The Uses of Output The users of output indicate what mix of output has been selected (answering WHAT to produce): Consumption (C): goods and services used by households (about two-thirds of GDP). Investment (I): plant, machinery, and equipment produced (about 15% of GDP). Government spending (G): resources purchased by the public sector (about one-fifth of GDP). Net exports (X - M): the value of exports (X) minus the value of imports (M).

Net Exports • Imports (M): goods and services made in foreign lands but purchased in the United States. • Exports (X): goods and services produced in the United States but purchased in foreign lands. • We add exports to our GDP, but subtract imports from our GDP. • The difference between exports and imports is called net exports (X – M).

GDP Components GDP = C + I + G + ( X – M ) • The value of GDP can be computed by adding up these expenditures: where: C = consumption expenditure I= investment expenditure G = government expenditure X = exports M = imports

Measures of Income • There are two ways to measure GDP: • Measure expenditures (demand side). • Measure income (supply side). • The total value of market incomes must equal the total value of final output, or GDP. • By tracking income in the economy, we see FOR WHOM the output is produced.

The Equivalence of Expenditure and Income

Measures of Income • Output = Income. • The spending that establishes the value of output also determines the value of incomes. • We can track the distribution of funds from GDP to disposable income.

From GDP to Disposable Income • GDP – Depreciation = Net domestic product (NDP) • NDP + Net foreign factor income = National income (NI) • National income (NI) is the total income earned by U.S. factors of production.

From GDP to Disposable Income • There are several adjustments that have to be made to national income in order to get to personal income. • Subtract • Indirect business taxes. • Corporate profits. • Interest and miscellaneous payments. • Social Security taxes. • Add • Transfer payments. • Capital income. • This yields personal income (PI).

From GDP to Disposable Income • Personal income (PI) is pretax income received by households. • Disposable income (DI) is what remains of personal income after taxes are paid. • PI – Personal taxes (T) = DI. • We can do two things with our DI: spend it or save it. • DI = Consumption (C) + Saving (S). • Saving: that part of DI not spent on C.

Income Summary Households receive personal income (PI) as payment for the resources they own and provide. How do households dispose of their Income? They spend: consumption (C). They save: saving (S). They pay taxes: taxes (T). Personal income (PI) = C + S + T

The Flow of Income • GDP, on the income side, ends up distributed in this way: • To households, in the form of disposable income. • Returned to GDP as consumer spending. • To businesses, in the form of retained earnings and depreciation allowances. • Returned to GDP as business investment spending. • To government, in the form of taxes. • Returned to GDP as government spending.

Learning Objectives