CHAPTER 24: MEASURING DOMESTIC OUTPUT AND NATIONAL INCOME

Introduction . Ii f t · 's macroeconomic per ormance.

Gross domestic product (GDP) is the primary measure 0 a na IOn . ' . S . . . . I I d d to address cautions In Its use. o It IS Important to understand how GDP IS ca cu ate an f

. . DP II as several other measures 0 Chapter 24 explainS the details of the calculatIOn ofG , as we Ii d . . d' . feconomic per ormance an natIOnal accounts. These measures underhe the ISCUSSlOns 0 24 .

economic theories throughout the macroeconomics course. Material from Chapter ~ very likely to appear in a few multiple-choice questions and has occasionally appeared as a ree­response question on the AP macroeconomics exam.

Nat.ional.lncome Accou~ti~g . . A v . NatIOnal Income accounting IS a way to measure how well the economy IS ~erformlng. ar~ety of statistics are used to evaluate production and income, as well as t~e relatl~~ growth o.r .dechne of the economy. Those statistics are then used to determine appropnate pohcles to stabilize the economy and promote long-run economic growth.

Gross Domestic Product and Gross National Product GDP is the dollar value of all final goods and services produced in a country in one year. T~is statistic includes all final products produced in the United States, regardless of the home nation of the company. To calculate GDP, the output of a Honda plant in Indiana would be counted in U.S. GDP, but the output of a Coca-Cola plant in Belgium would not.

Factors Not Counted in GDP In order to accurately measure production, certain economic activities are not included in GDP. Intermediate goods are used in other goods, such as tires sold to an auto producer. Intermediate goods are not counted, because if the tires were counted when sold to the auto manufacturer, and then the value of the completed car was counted, the value of the tires would have been counted twice. So while sales of final products to consumers, firms , and government are counted in GDP, sales of intermediate products are not.

Purely financial transactions are also not counted as part of GDP. Government transfer payments such as Social Security or unemployment benefits are not counted because households create no production in return for the checks. Further, if transfer payments were counted in GDP, and then households used those checks to purchase consumer goods which were counted as part ofGDP, the value of those transfer payments would be counted twice. Private transfer payments such as monetary gifts or sales of stock are also not counted as part of GDP because no output was created as a part of the transaction.

Second-hand sales, or used goods, are also not counted as part of current GDP. The sale of used goods creates no new output in the economy. Further, the product was counted when it was originally produced. By not counting intermediate goods, purely financial transactio s d

dh d I " n , an

secon -. an sa es, economists attempt to Increase the accuracy ofGDP as a measure of productIOn that can be compared from year to year.

Measuring GDP: Expenditure and Income Approaches Production in the economy can be measured by spending or income appro h Th d' ac es. e expen lture approach adds all of the money spent to purchase final goods in the econ Th'

h dd II f h . d . omy. e mcome approac a sao t e Incomes earne III the economy Were we abl t b '

I d b . e 0 0 tam completely accurate numbers, GDP calcu ate y the two approaches would be e lb '

qua, ecause spendmg by

160 Chapter 24' Measuring 0 . . omestlc Output and National Income

one person is income to another. I f you bought $20 of gasoline from a gas station, it would contribute $20 toward GDP, whether we counted it from your perspective as spending or from the gas station's perspective as income.

The Expenditure Approach Calculation ofGDP using the expenditure approach calls for adding the spending by the four sectors of the economy with the formula GDP = C + I + G + X, where

• C is personal consumption expenditures, • I is gross private domestic investment, • G is government purchases, and • X is net exports.

Personal consumption expenditures include the spending for consumer items by households. This includes spending for durable goods which last years (such as cars and furniture), nondurable goods (such as food and medicine), and services. Personal consumption is the largest part of the economy, constituting about 70 percent ofGDP.

Gross private domestic investment primarily measures spending by firms. It includes firms' purchases of machinery and equipment, construction of homes and businesses, and changes in inventories. Inventories are products produced but not yet sold; because we are measuring total production and not just product sales, we need to include inventories.

Another way to measure investment sector spending is net private domestic investment. Net private domestic investment is gross private domestic investment minus depreciation, or the amount of capital that is used up during a year. Net private domestic investment tries to compensate for the value of capital that is used up and whose replacement does not increase the amount of capital stock. Gross investment is generally greater than depreciation, and the amount of capital increases from year to year. But when the economy is in strong decline, firms may significantly reduce their investment in capital, resulting in negative investment. We will come back to this discussion, but remember that gross private domestic investment is the numb4!r used to calculate gross domestic product. Gross private domestic investment accounts for approximately 15 percent ofGDP.

Government purchases are the third sector ofGDP. Government purchases include spending for goods and services needed to produce public goods, as well as publicly owned capital such as highways. Remember that transfer payments are not counted in the government sector. Government purchases constitute about 19 percent of GDP.

Net exports is spending for exports minus spending for imports. Because we want to measure production within the United States, we must include products that were produced in the U.S. and then exported, while subtracting U.S. spending for products produced elsewhere. Because the U.S. imports significantly more than it exports, the foreign sector actually produces a negative number, reducing the GDP from what it would have been if trade were balanced by approximately 5 percent.

The Income Approach National income measures incomes distributed to owners of the factors of production. The largest proportion of income is paid to labor in wages and salaries. Rent is the income households and firms receive for supplying property to renters. Interest is the income received

Chapter 24: Measuring Domestic Output and National Income 161

for the use of borrowed money. Proprietors' income is the net income of sole propriet~rships ~nd partnerships. Although corporate profits are initially earned by firms, the flow of that m~ome IS divided among income taxes paid to government, dividends paid to households, .an~ retame~ earnings held by the corporation. Taxes on production and imports (also called mdlrect ?usmess taxes) account for the tax revenues that are paid to governments through sales ta~es, e~~lse taxes, property taxes, and import tariffs. Income earned via wages, rent, interest, prop~letors m.come, corporate profits, and taxes together are national income. To equate the expenditure a~d mcome approaches, economists make additional adjustments to the national income, the .most Importa~t of which is the consumption of fixed capital, which accounts for the capital that IS used up dunng a year and will eventually have to be replaced (the same idea as depreciation).

Bear in Mind The relationships between the various types of income and expenditure can be mind-boggling, especially when viewing a flow chart like the one given below. Questions about the calculation of GDP on the AP macroeconomics exam have been much more straightforward. Questions have focused primarily on the expenditure model, such as identifYing the sectors or specific types of spending that would be included in the calculation. A multiple-choice question about the income approach is likely to focus on wages, rent, interest, proprietors' income, corporate profit, and taxes.

Other National Accounts Net domestic product measures new production in the economy minus depreciation. Net domestic product uses the same formula as GDP, except that net private domestic investment is used for the investment sector to include the depreciation. This statistic tells us how much is available for consumption without detracting from our ability to produce more in the future.

Disposable income is the personal income of households minus personal taxes. When we consider all of the kinds of income a household could receive (wages, dividends, interest, government and private transfer payments) and subtract the many personal taxes households pay (income,..property, and Social Security taxes), we find the amount households have available for the purchase of goods and services in the economy.

The Circular Market Flow Model Receipts: Expendilu ... Approach Allocations: Income Apptoach'

Sumo!: Sumo!: f'enoNI ~ expenditum (e) $9734 Compen"tion rJ ernpiorees Gross privale domeltit irMStment (IJ 212l Rents Go>emmer< I"'rdwes (GI 2690 ,-Net export> (X,I -708 1Toprie<on' incorro

Corponte profItS T"", on production .nd imports

EqucI< NatioM/lncome

National income less; Net I<niJn bctor income PIa: SaIiUial discrepanq PIa: ConsOO'f>lion rJ fiX2d apit>I

£qu<;t £qu<;t G ...... metlicptodu<t J/3,141 Grou cIomostk fI'Oduct

'Some 01 the ittmI in de (cUM (cwr*It rtbtld U..., WI &ppar in the mm dtahd KCOI.I'II1

.......,110",,, cI&onomo<~ ---....

Accounting statement for the U.S. economy, 2007 (in billions)

$7874 6S

603 1043 1627 1009

$/2,11/

$12.221 96 19

1687

$13,141

162 Chapter 24: Measuring D . omestlc Output and National Income

Revisiting the circular flow model, you can see that it has grown much more complicated than the basic model introduced in the early chapters of this book. Note that two new sectors­govenUllent and foreign- have been added to represent all four sectors of the expenditure model. This model again reinforces the idea that the income and expenditure models of GOP must be equal, because one sector's spending is another sector's income.

Bear in Mind Questions about the circular flow model on previous AP macroeconomics exams have asked about the basic flow model with households and firms, product and factor markets, not flows as complex as those represented in this model.

Nominal and Real GDP Nominal GOP is calculated using the current prices of products. In order to compare production over time without the inflation distortion, we must calculate real GOP. In order to do that, we must construct a price index to measure the prices of a market basket of goods and services. The price index used to convert nominal GOP to real GOP is called the GOP price deflator.

Price of Market Basket This Year Price Index x 100

Price of Market Basket in Base Year

If the total price of a market basket of goods last year was $1,000, and this year that same market basket price total is $1 ,200, the calculation would be $1,200 / $1 ,000 = 1.2 x 100 = 120. This number tells us that the price of the market basket this year is 120% of the price of the market basket last year-a 20% increase in prices.

In order to convert nominal GOP to real GOP, we divide inflation out of the equation.

Nominal GOP Real GOP

Price Index (as a Oecimal)

Using this equation, if nominal GOP for this year is $12,000 and you want to compare this year's GOP to last year's GOP, you must remove the inflation for that time period. Thus, $12,000 / 1.2 = $10,000 is this year's real GOP.

When calculating the percentage change in nominal GOP, it is important to remember that the statistic includes changes in both output and prices.

% Change in Nominal GOP = % Change in Real GOP + % Change in Prices

Ifreal GOP increased by 3% and prices rose by 2% this year, nominal GOP would increase by 5%. By converting the formula, we can also determine that if the nominal GOP for this year increased by 5% and prices rose 2%, real GOP must have risen by 3%.

Chapter 24: Measuring Domestic Output and National Income 163

Taking the EEK! Out of Economics SOIllt:tilllt:S it can be confusing to remember how to remove inflation from nominal GOP. A quick trick oftht: trade is to look at whether you're converting a raw number, such as a total GOP amount , or a percentagc. such as a change in GOP. When working with the dollar amount of GOP. divide inflation out of the GOP using the price index. When working with a percentage change in GOP, subtract the intlation percentage from GOP.

Bear in Mind You may need to calculate a price index or real GOP from data on either the multiple-choice or free-response sections of the AP macroeconomics exam. These basic formulas wIll repeat through the rest of the course in a variety of measures.

Shortcomings of GDP A measure as broad as GOP, while providing important information about our economy, still has its shortcomings. Nonmarket activities (or home production), such as cooking your own dinner or painting your own house, is also excluded from GOP calculation. It is difficult to get an accurate measure of such production, and money was not exchanged for this economic activity, so official GOP misses a great deal of economic activity.

GOP also cannot measure the value of leisure people have gained as the result of shorter workweeks and labor-saving appliances and services. Further, GOP cannot adequately measure improvements in the quality of life due to higher quality products.

The underground economy is specifically left out of GOP calculations. Although illegal activity is significant, it is very difficult to find reliable figures to quantify the level of activity, so it is left out. In addition, people who work for cash "under the table" or who under-report tips or business incomes in order to avoid taxes also contribute to a lower level of official GOP than the actual level of economic activity.

Further, the GOP cannot measure negative externalities such as pollution and other negative effects of production on the quality oflife. GOP says nothing about the mix of goods, making no judgment about whether most of the spending in the country is for government goods or consumer goods. GOP also does not note the distribution of incomes; if 90 percent of national income went to the top 1 percent of citizens, the standard of living for most citizens would be quite low. And while GOP gives us an idea about the economic well-being of a nation's citizens, it cannot measure their feelings of safety and peace, the quality of education, the limitations on government power, or the protection of the nation's natural resources.

The gross domestic product is the most important statistic economists use to measure the state of the economy. But it is important to recognize the limitations on GOP so that you can interpret the data with the understanding that the well-being ofa nation's people is based on far more than simply the officially reported GOP.

Multiple-Choice Questions I. All of the following products would be included in the calculation of the U.S. GDP

EXCEPT (A) Toyota cars produced in Kentucky. (B) haircuts. (C) Starbuck ' s coffee produced and sold in Canada.

164 Chapter 24: Measuring Domestic Output and National Income

(D) a finn's purchase of capital equipment produced in Arizona. (E) government spending on highways.

2. Which of the following would be included in the calculation of U.S. GOP? (A) a girl mowing her family's yard. (8) a student buying a used car. (C) a neighbor paying a babysitter with homemade cookies. (D) a senior citizen receiving a Social Security check. (E) a family buying dinner at a restaurant.

3. Why are intennediate goods not included in the calculation of GOP? (A) They cannot be used by consumers in their unfinished state . (8) They are not subject to sales taxes. (C) They are imported. (D) They would be double-counted when the finished product is counted. (E) They require multiple steps of production.

4. Why are transfer payments not included in the calculation of GOP? (A) Recipients have not produced any output in return for the payment. (8) The payments generally are made to those with the lowest incomes. (C) Government spending is not included in the calculation ofGDP. (D) Transfer payments are intended to promote economic activity. (E) Transfer payments have no impact on the economy.

5. The largest sector in the expenditure model of GOP is the (A) consumer sector. (8) investment sector. (C) government sector. (D) import sector. (E) export sector.

6. The calculation of gross private domestic investment includes I. finns' spending for equipment and machinery. II. all construction. III. depreciation. IV. changes in inventories.

(A) I only (8) II and III only (C) III and IV only (D) I, II, and IV only (E) I, III, III, and IV

7. Net exports as a factor in U.S. GOP have been negative since the 1980s because (A) the federal government has experienced consistent budget deficits. (8) the value of imports has exceeded the value of exports. (C) the real GOP has been declining throughout this period. (D) inflation has reduced the value of the dollar. (E) trade barriers have effectively limited the number of imports.

Chapter 24: Measuring Domestic Output and National Income 165

8. Why must GOP calculated using the expenditure approach equal GOP calculated using the income approach? (A) Income and spending are both reported to government agencies. (B) Spending in the economy must equal the incomes earned in the economy. (C) Taxes must be paid on both income and sales. (0) Both approaches use product sales as their base. (E) Economists add a statistical correction to the expenditure approach C + I + G +

X (X as the correction) to ensure that it equals the income approach.

9. The measure of consumer income after payment of personal taxes is (A) national income. (B) personal income. (C) disposable income. (0) gross domestic product. (E) net domestic product.

10. Real GOP rather than nominal GOP is used to compare changes in national output over time, because real GOP removes the effects of (A) imports. (B) unemployment. (C) taxes. (D) interest. (E) inflation.

I I. Ifreal GDP increased 2% this year and the price level increased 4% this year, how much did nominal GDP increase this year? (A) -2% (B) 2% (C) 4% (D) 6% (E) 8%

12. The shortcomings of gross domestic product as a measure of all economic activity in a country include all of the following EXCEPT that it (A) does not include home production such as repairing one' s own car. (B) cannot measure improvements in the quality of products. (C) does not take into consideration negative externalities such as pollution. (0) does not take into account increased leisure time or quality of life. (E) does not count government spending for public goods.

Free-Response Questions Econ Island is a very small island that produces a limited amount of products each year. The table below shows this year's prices and purchases of products on the island.

This Year' s Output This Year's Prices 1,000 pounds of hambuIRer $2 per pound 2 cars bought from the used car lot $ 1O,000~r car 10 clothing outfits imported from another island $20 per outfit 10,000 pounds of rice (8,000 used on the island, 2,000 exported) $1 per pound

166 Chapter 24: MeaSuring Domestic Output and National Income

Gllvemment spending fm workers to clean the beach $5,000 I meat processing machine bought from a local producer $250 Illegal dmgs produced and sold on the island $1 ,000

(a) Using the data. calculate this year's nominal GOP for Econ Island. (b) If the price index is 110, calculate this year's real GOP for Econ Island. (c) Identify the factors in the table that would not be included in GOP using the expenditure

model. For each factor. complete the following: (i) Identify the factor that would not be included in GOP (ii) Explain why that factor would not be included in the GDP calculation

(d) Explain one shortcoming of using GOP as an accurate measure of the standard ofliving for residents of a country .

Multiple-Choice Explanations 1. (C) Products produced and sold in other countries are counted in that nation ' s GOP,

not ours. even if it is an American company producing the product. 2. (E) (A) and (C) are examples of home production, (B) is the purchase ofa used good,

and (D) is a purely financial transaction, none of which are counted in GDP. 3. (0) Intermediate goods are sold to other firms to be included in the final product of

the other firm. Counting it once when sold to the other firm, and then counting it again in the final product double-counts the product.

4. (A) Because recipients provide no goods or services in return for the transfer payment, GDP does not change as a direct result of the payment. Once households use the transfer payment to buy products in the economy, those purchases would be counted in the consumer sector.

5. (A) Consumers account for more than two-thirds of spending in the U.S. economy. 6. (D) Depreciation is subtracted from gross private domestic investment to calculate

net private domestic investment. 7. (B) Net exports are the value of exports minus the value of imports. Because U.S.

imports have been greater than U.S. exports since the 1980s, the net exports component of the GDP calculation is negative.

8. (B) As can be seen in the circular market flow, money spent by one market participant is income to another. So if the numbers are accurately compiled, GDP should be the same using either method of calculation.

9. (C) National income is the total income of all resource suppliers plus taxes. Personal income is income before taxes are paid. Gross domestic product is the total economic output. Net domestic product is GOP minus depreciation.

10. (E) Because nominal GDP is calculated using the current value of money, nominal GOP would increase when prices rise. even if the same quantity of products is produced. Real GDP removes that distortion.

II. (0) % Change in Nominal GOP = % Change in Real GOP + % Change in Prices 12. (E) Government spending for public goods is a part of the expenditure formula for

GOP: C + I + G + X (G is the government sector).

Free-Response Explanations 7 points (I + I + 4 + I) (a) 1 point :

• I point is earned for stating that this year's nominal GOP for Econ Island is $17,050: (1,000 x $2) - ( lOx $20) + (10,000 x $1) + $5.000 + $250 = $17.050.

Chapter 24: Measuring Domestic Output and National Income 167

(b) •

(c)

• •

• •

(d)

•

168

1 point:

1 point is earned for stating that this year's real GDP for Econ Island is $15,500: ($17,050 / 1.10) = $15.500. 4 points:

I point is earned for stating that the used cars are not counted in GOP. I point is earned for explaining that GOP only measures new output for the year, not used goods. I point is earned for stating that illegal drug production is not counted in GOP. I point is earned for stating that illegal activity is not counted because reliable numbers are difficult to calculate. I point: I point is earned for identifying a shortcoming of GOP. Potential answers include the fOllowing:

o Population (needing to use per capita GDP) o NOllmarket activities o Bartered goods and services o Leisure o Quality of life o Negative externalities o The mix of consumer and government goods o Oistribution of incomes

Chapter 24: Measuring Domestic Output and National Income