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Measuring GDP: What's Included and Omitted?

Learn about the circular flow of income and output, the concept of GDP, and its limitations as a measure of national welfare. Understand the expenditure and income approaches to measuring GDP, and the difference between nominal and real GDP.

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Measuring GDP: What's Included and Omitted?

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  1. Chapter 8 Measuring the Economy’s Performance

  2. Gross domestic product is the statistic most often used to indicate the economy’s overall performance. What is included and what is omitted from GDP? Introduction

  3. Learning Objectives • Describe the circular flow of income and output • Define gross domestic product (GDP) • Understand the limitations of using GDP as a measure of national welfare

  4. Learning Objectives • Explain the expenditure approach to tabulating GDP • Explain the income approach to computing GDP • Distinguish between nominal GDP and real GDP

  5. Chapter Outline • TheSimple Circular Flow • NationalIncome Accounting • Two Main Methods of Measuring GDP • OtherComponents of National Income Accounting

  6. Chapter Outline • Distinguishing Between Nominal and Real Values • Comparing GDP Throughout the World

  7. Did You Know That... • Decisions on how to categorize business expenses will affect the relative size of an increase or a decrease in economic activity? • Statisticians measuring our national economic performance strive for consistency in constructing their measures across time?

  8. National Income Accounting • National Income Accounting • A measurement system used to estimate national income and its components

  9. The Simple Circular Flow Figure 8-1

  10. The Simple Circular Flow Figure 8-1

  11. The Simple Circular Flow Figure 8-1

  12. The Simple Circular Flow Figure 8-1

  13. The Simple Circular Flow • Two observations • In every economic exchange, the seller receives exactly the same amount that the buyer spends. • Goods and services flow in one direction and money payments flow in the other.

  14. The Simple Circular Flow • Profits explained • Question • Why is profit a cost of production? • Answer • Profits are the return entrepreneurs receive for the risk they incur when organizing productive activities

  15. The Simple Circular Flow • Product Markets • Transactions in which households buy goods

  16. The Simple Circular Flow • Final Goods and Services • Goods and services that are at their final stage of production and will not be transformed into yet other goods or services

  17. The Simple Circular Flow • Factor Markets • Transactions in which businesses buy resources

  18. The Simple Circular Flow • Total Income • The yearly amount earned by the nation’s factors of production

  19. The Simple Circular Flow • Question • Why must total income be identical to the dollar value of total output? • Answer • Every transaction simultaneously involves an expenditure and a receipt

  20. National Income Accounting • Gross Domestic Product (GDP) • The total market value of all final goods and services produced by factors of production located within a nation’s borders

  21. National Income Accounting • Observations • GDP measures the dollar value of final output • GDP measures the dollar value of final goods and services produced per year by factors of production located within a nation’s borders

  22. National Income Accounting • Stress of final output • What is a final good? • Wheat? • Steel? • Oil? • Bread? • Automobile? • Gasoline?

  23. National Income Accounting • Intermediate Goods • Goods used up entirely in the production of final goods

  24. $.03 $.03 $.06 $.18 $.15 Sales Value and Value Added at Each Stage of Donut Production Stage of Production Dollar Value of Sales Value Added Stage 1: Fertilizer and Seed $.03 Stage 2: Growing .06 Stage 3: Milling .12 Stage 4: Baking .30 Stage 5: Retailing .45 Total dollar value of all sales $.96 Total value added $.45

  25. National Income Accounting • Exclusion of financial transactions, transfer payments, and secondhand goods • Numerous transactions occur that have nothing to do with final goods and services being produced.

  26. National Income Accounting • Financial transactions • Securities • Stocks and bonds • Government transfer payments • Social Security • Unemployment compensation • Private transfer payments • Individual gifts • Corporate gifts

  27. National Income Accounting • Transfer of secondhand goods • Why not count the sale of a used car, stereo, or snowboard as part of GDP? • Other excluded transactions • Household production • Legal underground transactions • Illegal underground transactions

  28. Recognizing GDP Limitations • GDP’s limitations • Excludes non-market production • Different countries have different legal versus illegal activities • Quality of life is not measured • GDP poorly measures a nation’s well-being

  29. Two Main Methodsof Measuring GDP • Expenditure Approach • A way of computing national income by adding up the dollar value at current market prices of all final goods and services

  30. Two Main Methodsof Measuring GDP Expenditure Approach

  31. E-Commerce Example:Using the Internet to Reduce Business Inventory Levels • With access to internet auctions, firms find it easier to follow a just-in-time inventory practice. • The ratio of inventories to sales in manufacturing has dropped since 1990. • How does this change affect the investment component of GDP?

  32. Two Main Methods of Measuring GDP • Income Approach • A way of measuring national income by adding up income received by all factors of production

  33. Two Main Methodsof Measuring GDP Income Approach

  34. Two Main Methodsof Measuring GDP • Deriving GDP by the expenditure approach • Consumption Expenditure (C) • Durables • Life span of more than three years • Nondurables • Life span of less than three years • Services • Intangible commodities

  35. Two Main Methodsof Measuring GDP • Deriving GDP by the expenditure approach • Gross Private Domestic Investment (I) • The creation of capital goods, such as factories and machines, that can yield production and hence consumption in the future

  36. Two Main Methodsof Measuring GDP • Deriving GDP by the expenditure approach • Government Expenditures (G) • State, local, and federal • Valued at cost

  37. Net exports (X) = total exports - total imports Two Main Methodsof Measuring GDP • Deriving GDP by the expenditure approach • Net Exports (Foreign Expenditures)

  38. GDP = C + I + G + X Two Main Methodsof Measuring GDP • Mathematical representation using the expenditure approach

  39. GDP and Its Components Figure 8-4

  40. NDP = GDP - depreciation Two Main Methodsof Measuring GDP • Depreciation and net domestic product • Deducting for depreciation (capital consumption allowance) • Reduction in the value of capital goods over a one-year period due to physical wear and tear, and also to obsolescence

  41. Two Main Methodsof Measuring GDP • GDP = C + I + G + X • NDP = C + I + G + X - depreciation • Net Investment = I - depreciation • Domestic investment minus an estimate of the wear and tear on the existing capital stock • NDP = C + net I + G + X

  42. Two Main Methodsof Measuring GDP • Deriving GDP by the income approach

  43. Deriving GDP by the Income Approach • Gross Domestic Income (GDI) • The sum of all income—wages, interest, rent, and profits—paid to the four factors of production

  44. Two Main Methodsof Measuring GDP • Gross Domestic Income (GDI) • Wages • Interest • Rent • Profits

  45. Two Main Methodsof Measuring GDP • Gross domestic product equals gross domestic income plus indirect business taxes and depreciation. • These last items are called nonincome expense items.

  46. Gross Domestic Product and Gross Domestic Income, 2005(in billions of 2005 dollars per year) Figure 8-5 Source: U.S. Department of Commerce. First quarter preliminary data annualized.

  47. Other Components of National Income Accounting • National Income (NI) • The total of all factor payments to resource owners • Personal Income (PI) • The amount of income that households actually receive before they pay personal income taxes

  48. Other Components of National Income Accounting • Disposable Personal Income (DPI) • Personal income after personal income taxes have been paid

  49. Going from GDP to Disposable Income, 2005 Source: U.S. Department of Commerce, and author’s estimates Table 8-2

  50. Distinguishing Between Nominal and Real Values • Nominal Values • Measurements in terms of the actual market prices at which goods are sold; expressed in current dollars

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