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Measuring a Nation’s Income

10. Measuring a Nation’s Income. E conomics. P R I N C I P L E S O F. N. Gregory Mankiw. Premium PowerPoint Slides by Ron Cronovich. In this chapter, look for the answers to these questions:. What is Gross Domestic Product (GDP)?

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Measuring a Nation’s Income

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  1. 10 Measuring a Nation’s Income Economics P R I N C I P L E S O F N. Gregory Mankiw Premium PowerPoint Slides by Ron Cronovich

  2. In this chapter, look for the answers to these questions: • What is Gross Domestic Product (GDP)? • How is GDP related to a nation’s total income and spending? • What are the components of GDP? • How is GDP corrected for inflation? • Does GDP measure society’s well-being? 1

  3. Micro vs. Macro Microeconomics: The study of how individual households and firms make decisions, interact with one another in markets. Macroeconomics: The study of the economy as a whole. We begin our study of macroeconomics with the country’s total income and expenditure. ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME

  4. (1) Income and Expenditure Gross Domestic Product (GDP) measures total income of everyone in the economy. [later: more formal definition] GDP also measures total expenditure on the economy’s output of goods and services (g&s). For the economy as a whole, income equals expenditurebecause every dollar a buyer spends is a dollar of income for the seller. ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME

  5. The Circular-Flow Diagram a simple depiction of the macroeconomy illustrates GDP as spending, revenue, factor payments, and income Preliminaries: Factors of production are inputs like labor, land, capital, and natural resources. Factor payments are payments to the factors of production (e.g., wages, rent). ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME

  6. The Circular-Flow Diagram Firms Households Households: • own the factors of production, sell/rent them to firms for income • buy and consume goods & services Firms: • buy/hire factors of production, use them to produce goods and services • sell goods & services ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME

  7. The Circular-Flow Diagram Revenue (=GDP) Spending (=GDP) Markets for Goods & Services G & S sold G & S bought Firms Households Factors of production Labor, land, capital Markets for Factors of Production Income (=GDP) Wages, rent, profit (=GDP) ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME

  8. What This Diagram Omits The government collects taxes, buys g&s The financial system matches savers’ supply of funds with borrowers’ demand for loans The foreign sector trades g&s, financial assets, and currencies with the country’s residents ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME

  9. (2) Gross Domestic Product To understand macroeconomic issues, we first need information (data). One very important (may be most important) concept: Gross domestic product (GDP) Paul Samuelson and William Nordhaus: “GDP … among the great inventions of the twentieth century” (cited in Survey of Current Business, Jan 2000, 6-14) http://www.bea.gov/scb/pdf/BEAWIDE/2000/0100od.pdf ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME

  10. Gross Domestic Product Data USA: Bureau of Economic Analysis (BEA), Department of Commerce http://www.bea.gov/ (http://www.bea.gov/national/xls/gdplev.xls) HK: Census & Statistics Department http://www.censtatd.gov.hk/home/index.jsp (http://www.censtatd.gov.hk/FileManager/EN/Content_802/nat_account.pdf) releases the information every quarter ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME

  11. Gross Domestic Product Hong Kong nominal GDP (2007): HK$1,615.0 billions GDP per capita: HK$ 233,185 (US$29,896) USA nominal GDP (2007): US$14,077.6 billions population (est.): 301,290,332 (US Census Bureau) GDP per capita: US$ 46,724 nominal GDP: measured at current prices ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME

  12. …the market value of all final goods & services produced within a country in a given period of time. Gross Domestic Product (GDP) Is… Goods are valued at their market prices, so: • All goods measured in the same units (e.g., Hong Kong dollars, U.S. dollars) • Things that don’t have a market value are excluded, e.g., housework you do for yourself. ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME

  13. …the market value of all final goods & services produced within a country in a given period of time. Gross Domestic Product (GDP) Is… Final goods:intended for the end user Intermediate goods: used as components or ingredients in the production of other goods GDP only includes final goods – they already embody the value of the intermediate goods used in their production. e.g., General Motors (GM) does not produce tires for its cars; it buys them from tire companies (such as Goodyear) Tire: intermediate good; GM car: final good Prevent double counting ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME

  14. …the market value of all final goods & services produced within a country in a given period of time. Gross Domestic Product (GDP) Is… GDP includes tangible goods (like DVDs, mountain bikes, beer) and intangible services (dry cleaning, concerts, mobile phone service). ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME

  15. …the market value of all final goods & services produced within a country in a given period of time. Gross Domestic Product (GDP) Is… GDP includes currently produced goods, not goods produced in the past. e.g. If you bought a Toyota Prius on January 2005, the purchase (say, at $200,000) was included in GDP (of 2005). If you sold it on December 2010, that transaction was not included in GDP (of 2010). Why? ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME

  16. …the market value of all final goods & services produced within a country in a given period of time. Gross Domestic Product (GDP) Is… GDP measures the value of production that occurs within the borders of a country (an economy), whether done by its own citizens or by foreigners located there. ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME

  17. …the market value of all final goods & services produced within a country in a given period of time. Gross Domestic Product (GDP) Is… Usually a year or a quarter (3 months) ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME

  18. (3) The Components of GDP Recall: GDP is total spending. Four components: Consumption (C) Investment (I) Government Purchases (G) Net Exports (NX) These components add up to GDP (denoted Y): Y = C + I + G + NX ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME

  19. Consumption (C) is total spending by households on g&s. Note on housing costs: For renters, consumption includes rent payments. For homeowners, consumption includes the imputed rental value of the house, but not the purchase price or mortgage payments. ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME

  20. Investment (I) is total spending on goods that will be used in the future to produce more goods. includes spending on capital equipment (e.g., machines, tools) structures (factories, office buildings, houses) inventories (goods produced but not yet sold) Note: “Investment” does not mean the purchase of financial assets like stocks and bonds. ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME

  21. Government Purchases (G) is all spending on the g&s purchased by govt. at the federal, state, and local levels. G excludes transfer payments, such as Social Security or unemployment insurance benefits. They are not purchases of g&s. ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME

  22. Net Exports (NX) NX = exports – imports Exports represent foreign spending on the economy’s g&s. Imports are the portions of C, I, and Gthat are spent on g&s produced abroad. If HK consumers buy $10 million worth of watches made in Switzerland, that spending is included in consumption expenditure. However, the imports do not represent domestic production. Thus, the value of these imports is subtracted from GDP (see the next equation). ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME

  23. GDP and Its Components Adding up all the components of GDP gives: Y = C + I + G + NX ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME

  24. A C T I V E L E A R N I N G 1GDP and its components In each of the following cases, determine how much GDP and each of its components is affected (if at all). A.Debbie spends $200 to buy her husband dinner at the finest restaurant in the Central. B.Sarah spends $1800 on a new laptop to use in her publishing business. The laptop was built in Japan. C.Jane spends $1200 on a computer to use in her editing business. She got last year’s model on sale for a great price from a local manufacturer. D.A car company builds $500 million worth of cars, but consumers only buy $470 million worth of them.

  25. A C T I V E L E A R N I N G 1Answers A.Debbie spends $200 to buy her husband dinner at the finest restaurant in the Central. Consumption and GDP rise by $200. B.Sarah spends $1800 on a new laptop to use in her publishing business. The laptop was built in Japan. Investment rises by $1800, net exports fall by $1800, GDP is unchanged. 24

  26. A C T I V E L E A R N I N G 1Answers C.Jane spends $1200 on a computer to use in her editing business. She got last year’s model on sale for a great price from a local manufacturer. Current GDP and investment do not change, because the computer was built last year. D.A car company builds $500 million worth of cars, but consumers only buy $470 million of them. Consumption rises by $470 million, inventory investment rises by $30 million, and GDP rises by $500 million. 25

  27. U.S. GDP and Its Components, 2007 billions % of GDP per capita Y $13,841 100.0 $45,825 C 9,734 70.3 32,228 I 2,125 15.4 7,037 G 2,690 19.4 8,905 NX –708 –5.1 –2,344 ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME

  28. H.K. GDP and Its Components, 2007 Nominal GDP of Hong Kong, 2007 ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME

  29. GDP and Its Components USA vs. Hong Kong (2007) • • Consumption: 70.3% in USA; 60.2% in HK. • • Investment: 15.4% in USA; 20.9% in HK. • Government purchases: 19.4% in USA; 8.1% in HK. • Net exports: negative in USA; positive in HK. ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME

  30. (4) Real versus Nominal GDP Inflation can distort economic variables like GDP, so we have two versions of GDP: One is corrected for inflation, the other is not. Nominal GDPvalues output using current prices. It is not corrected for inflation. Real GDPvalues output using the prices of a base year. Real GDP is corrected for inflation. ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME

  31. Real versus Nominal GDP Nominal GDP of Hong Kong, 2006 and 2007 ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME

  32. Real versus Nominal GDP Reason for Introducing Real GDP When GDP increases from one year (2006) to the next (2007) by 9.4%, can we conclude that the quantity of production increases by 9.4%? Because GDP is measured in value terms, it can be changed by changes in prices, not quantities. We should be careful about interpreting changes over time. To separate price changes from quantity changes, we introduce a concept called real GDP. ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME

  33. Real versus Nominal GDP Calculating Real GDP Nominal GDP The value of final goods and services evaluated at current-year prices. = P1Q1+ P2Q2+…+PnQn Real GDP The value of final goods and services evaluated at base-year prices. ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME

  34. EXAMPLE: Compute nominal GDP in each year: 2005: $10 x 400 + $2 x 1000 = $6,000 2006: $11 x 500 + $2.50 x 1100 = $8,250 2007: $12 x 600 + $3 x 1200 = $10,800 37.5% 30.9% Increase: ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME

  35. EXAMPLE: Compute real GDP in each year, using 2005 as the base year: $10 $2.00 20.0% 16.7% Increase: 2005: $10 x 400 + $2 x 1000 = $6,000 2006: $10 x 500 + $2 x 1100 = $7,200 2007: $10 x 600 + $2 x 1200 = $8,400 ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME

  36. EXAMPLE: In each year, nominal GDP is measured using the (then) current prices. real GDP is measured using constant prices from the base year (2005 in this example). ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME

  37. EXAMPLE: The change in nominal GDP reflects both prices and quantities. 37.5% 20.0% 30.9% 16.7% • The change in real GDP is the amount that GDP would change if prices were constant (i.e., if zero inflation). Hence, real GDP is corrected for inflation. ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME

  38. Nominal and Real GDP in the U.S., 1965-2007 Real GDP (base year 2000) Nominal GDP 37

  39. Which measure of GDP represents changes strictly in the quantity of goods and services produced in the economy, not the prices? a. Nominal GDP. b. Real GDP. c. The GDP measure that sums up the value of goods and services evaluated at current year prices. d. None of the above. ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME

  40. Which measure of GDP represents changes strictly in the quantity of goods and services produced in the economy, not the prices? a. Nominal GDP. b. Real GDP. c. The GDP measure that sums up the value of goods and services evaluated at current year prices. d. None of the above. ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME

  41. The GDP Deflator One by-product of real GDP calculation is to compute the general price level. The GDP deflator is a measure of the overall level of prices. Definition: GDP deflator = 100 x nominal GDP real GDP • One way to measure the economy’s inflation rate is to compute the percentage increase in the GDP deflator from one year to the next. ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME

  42. EXAMPLE: Compute the GDP deflator in each year: 100.0 14.6% 114.6 12.2% 128.6 2005: 100 x (6000/6000) = 100.0 2006: 100 x (8250/7200) = 114.6 2007: 100 x (10,800/8400) = 128.6 ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME

  43. A C T I V E L E A R N I N G 2Computing GDP Use the above data to solve these problems: A. Compute nominal GDP in 2007. B. Compute real GDP in 2008. C. Compute the GDP deflator in 2009. 42

  44. A C T I V E L E A R N I N G 2Answers A. Compute nominal GDP in 2007. $30 x 900 + $100 x 192 = $46,200 B. Compute real GDP in 2008. $30 x 1000 + $100 x 200 = $50,000 43

  45. A C T I V E L E A R N I N G 2Answers C. Compute the GDP deflator in 2009. Nom GDP = $36 x 1050 + $100 x 205 = $58,300 Real GDP = $30 x 1050 + $100 x 205 = $52,000 GDP deflator = 100 x (Nom GDP)/(Real GDP) = 100 x ($58,300)/($52,000) = 112.1 44

  46. (5) GDP and Economic Well-Being Real GDP per capita is the main indicator of the average person’s standard of living. But GDP is not a perfect measure of well-being. Robert Kennedy issued a very eloquent yet harsh criticism of GDP: ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME

  47. Gross Domestic Product… “… does not allow for the health of our children, the quality of their education, or the joy of their play. It does not include the beauty of our poetry or the strength of our marriages, the intelligence of our public debate or the integrity of our public officials. It measures neither our courage, nor our wisdom, nor our devotion to our country. It measures everything, in short, except that which makes life worthwhile, and it can tell us everything about America except why we are proud that we are Americans.” - Senator Robert Kennedy, 1968 46

  48. GDP Does Not Value: the quality of the environment leisure time non-market activity, such as the child care a parent provides his or her child at home an equitable distribution of income ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME

  49. Then Why Do We Care About GDP? Having a large GDP enables a country to afford better schools, a cleaner environment, health care, etc. Many indicators of the quality of life are positively correlated with GDP. For example… ECON1002 C/D (2011) Chapter 10: MEASURING A NATION’S INCOME

  50. GDP and Life Expectancy in 12 countries Indonesia Japan China U.S. Mexico Germany Brazil Pakistan Life expectancy (years) Russia India Bangladesh Nigeria Real GDP per capita 49

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