Spending,

Income and GDP

Instructor: Xi Wang

UMSL, Summer 2015

Learning Objectives

1. What is Macroeconomics? Why study it

separately?

2. How do economists define and measure an

economy’s output?

3. Expenditure Approach for measuring GDP

4. Nominal GDP and Real GDP

5. Relationship between Real GDP and

economic well-being/standard of living

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Where in the World is this?

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Great Depression

During the Great Depression (1929-33) in the US

Factories cut production 31%

Number of people without jobs nearly tripled by

1933 when the unemployment rate hit 25%

Stocks lost a third of their value in 3 weeks

All across America shantytowns named

“Hoovervilles” sprang up.

President Herbert Hoover (1929-33) and his

economic advisors were clueless as to how to

help. He lost to Franklin D. Roosevelt in 1933 (4

terms, 1933-45). Slide

4

Why Macroeconomics?

President’s Hoover’s cluelessness was understandable.

Microeconomics - study of production and consumption decisions of individual producers and consumers; allocation of scarce resources among industries was well established.

Macroeconomics – study of the behavior of the economy as a whole – was in a state of infancy.

The study of Macroeconomics, as a separate branch of economics, was established during the Great depression.

It includes the study of economic recessions and how to avoid them; long run economic growth; inflation; open economy macroeconomics, etc.

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Macroeconomics – Not Just a Simple

Addition of Microeconomics

Can Macroeconomics be understood by

simply adding up the answers to corresponding

Microeconomic problems?

No. Examples:

Paradox of Thrift – individually responsible thrifty

behavior during hard times is bad for the overall

economy. Conversely, seemingly profligate

behavior leads to good times for all.

Cash Circulation – An individual with more cash on

hand is richer. But if everyone has more cash on

hand, that simply raises the price level, leaving the

overall purchasing power the same as before. Slide

6

Macroeconomic Data

To understand economic developments and

to give useful advice to policymakers,

businesspeople and financial investors,

economists need up-to-date accurate data.

Attempts at measuring the economy dates

back to the early 1600s in Ireland. However

WWII provided the catalyst for the

development of accurate economic statistics

– Simon Kuznets of the US and Richard Stone of

UK developed comprehensive systems for

measuring a nation’s output.Slide

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Measuring Output: GDP

Slide

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Gross Domestic Product (GDP) is

The market value of

Final goods and services

Produced in a country in a given period of time (typically a year)

Real GDP: 1900-2007

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2007 output of the U.S. economy was more than 33 times the 1900

level. Recessions: 1929-33; 1973-’75; 1981-’82; 1990-’91; Mar–Nov 01;

Dec 07-Jun 09. Expansions: 33-37; 41-’45; 61-’69; 75-’80; 82-’90; 91-

2001; Nov 01 – Nov 07; July 09 till date.

Per Capita Real GDP: 1900-2007

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Except for the Great Depression, recessions are almost invisible

Fruits of Long term Growth in the US

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Gross Domestic Product: A

Detailed Look: Market Value GDP is a weighted average:

Market value of the final goods and

services is used to add up the

quantities of different goods and

services into one measurement

Calculating GDP for Nation A

producing three goods: X, Y and Z

with prices PX, PY, and PZ, respectively

is

GDP = (XPX) + (YPY) + (ZPZ)Slide

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Gross Domestic Product: A

Detailed Look: Market Value

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Aggregate measure of quantities produced

Weighs more expensive items more

Logic: willingness to pay is an indication of

benefit derived from the good.

Orchardia’s GDP = $64.

GDP: Market Value

Observation about Market Value

A good or service that is not bought

and sold in the market is not a part of

GDP

An unpaid work of a homemaker is not

counted in GDP

But paid housekeeping and paid child

care services are added to GDP

How About used good transaction?Slide

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Female labor Force Participation

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Labor Force Participation

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The labor force participation rate (LFPR) is

determined by comparing the actual labor

force with the potential labor force.

The potential labor force includes persons

16 years of age and older who are non-

institutionalized (i.e., not prison, mental

institution, etc.) – also called the working-

age population.

The actual labor force includes those

employed and unemployed (i.e., actively

looking for a job).

Participation Rates

LFPR =

actual labor force

potential labor force

* 100

LFPR = Employed + Unemployed

Non-institutional population 16 yrs. and older

* 100

For February 2007:

LFPR = 152,784,000

230,834,000* 100 = 63.6%

Female labor Force Participation

Slide

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Women's labor force participation increased

since 1960 and peaked in 1999

Measured GDP increased for two reasons:

Working women's output measured and

counted

This output is a real addition to GDP

Paid workers provide previously unpaid

childcare - this increase in measured GDP

corrects a measurement problem

Not a net addition to goods and services

produced

Measured change in GDP due to increased female LFPR

probably overstates actual change

Some Non market Goods Are

Included Some non-market items are included:

wages in kind (health benefits etc.)

agricultural output for self-consumption

imputed rent from owner occupied housing; imputed values of renovations

Services (like checking account services) provided by financial

intermediaries free or for a nominal fee are given an imputed

value using differences in interest rates

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Some Non market Goods Are

Included

Government (public) goods and services are not sold in the

market but included because

These goods have value

Increase overall output

Quantities are known

However, prices cannot be easily established

So, Government production is valued at cost

Overstates GDP if there is waste and inefficiency

Slide

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Some Goods Are Excluded

Nonproduction transactions

public transfer payments (unemployment benefits, social security,

etc.)

private transfer payments, such as gifts

Capital Gains and Losses

Unpaid volunteer work for charities

Illegal market activities

Financial Market Transactions(i.e Capital Gain,

Defiition?)

Slide

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Some Goods Are Excluded

Financial market transactions are excluded since securities

represent either ownership, such as with stocks, or they represent

loans, such as bonds. Financial securities do not represent real

production, but simply represent the means to finance

production.

Interest paid by Government or Consumers (except mortgages because a house provides housing services).

Slide

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GDP: Final Vs. Intermediate

Goods and Services Final goods are consumed by the ultimate user

End products of production

Included in GDP

Intermediate goods are used up in the production

of final goods

Not included in GDP

Avoids double counting

A barber charges $10 for a haircut. He hires an assistant

who provides services such as shampooing and sweeping

Barber’s assistant is paid $2 for his services

Haircut's contribution to GDP is $10Slide

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Final Vs. Intermediate Goods and

Services

Example of Final and Intermediate Goods

Bread - final good; Wheat and flour - intermediate goods

Milling Co. (produces flour) pays $0.50 for wheat

Bakery (produces bread) pays $1.20 for flour

Bakery sells bread for $2.00

Contribution to GDP = $2.00

The same good may be intermediate or final

Farmer B produces $100 worth of milk of which he sells $40 worth to his neighbor and uses the rest to feed his pigs, which he eventually sells to Farmer A for $120

GDP = $40 + $120 = $160Slide

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Final Vs. Intermediate: Treatment of

Capital Goods

Capital Goods may be potentially difficult to classify as

intermediate or final:

A capital good is a long-lived good used in the production of other goods and services

Houses, apartments, hotels, etc

Stoves in restaurants and cooking

schools, but not homes

Delivery vehicles and taxis

Slide

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Final Vs. Intermediate: Treatment of

Capital Goods

Capital Goods are not final goods as they are inputs in the production of final goods

not intermediate goods as they are not immediately used up during the production of other goods

Solution? Newly produced capital goods are classified as final goods & added

to GDP.

Money is NOT a capital good. Money is a means of payment and a unit of account – it is neither a good nor a service.(By the way, What is Money?)

) Slide

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Final Vs. Intermediate: Treatment of

the Government Sector All Government spending is valued arbitrarily as there are no

markets for government services.

So they are valued at Cost.

For simplicity all government expenditure is considered to be on final goods and services although some are really on intermediate goods and services.

Slide

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The Value Added Method of

Calculating GDP

Recall the bread example: Suppose that the grain and flour were produced in late 2008, but the bread was produced in 2009.

Should we add $2 to the GDP of 2008 or 2009 or both?

Solution? Value Added Method

Value added for any firm is the market value of its product or service minus the cost of inputs purchased from other firms

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Value Added in Bread Production

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Company Revenues – Cost of purchased inputs = Value added

ABC Grain(2008) $0.50 $0.00 $0.50

General Flour(2008) $1.20 $0.50 $0.70

Hot’n’Fresh(2009) $2.00 $1.20 $0.80

Total $2.00

The grain and flour are produced in 2008

Bread is produced in 2009

$1.20 is added to 2008 GDP

$0.80 is added to 2009 GDP

GDP: Production Within a Country

(domestic)

What do we mean by “domestic product”?

Domestic - production that takes

place within a country’s border

Nationality of the owners or company

is irrelevant.

Cars produced in the U.S. by foreign

owned companies are counted.

Car produced in Mexico by U.S.

owned companies are not counted.Slide

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GDP: Production Within a Year

Value must be produced in the year

considered

A 20-year old house is sold in 2008 for $200,000

Commission is 6% = $12,000

Value added is $12,000

House was not produced in the period of

time studied

Amount included in 2008 GDP = $12,000

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GDP vs. GNP

Gross national product – GNP – is the total factor income that is

earned by the citizens of a country.(Now it is very hard to

identify the citizenship of a company)

Includes factor incomes earned abroad by Americans

Profits from IBMs European operations accruing to American

shareholders and wages of Americans working abroad

Excludes factor incomes earned by foreigners

Dividends (profits) paid to foreign holders of US stocks and

wages of foreign workers who temporarily work in the US

In 2007, US GNP was about 0.7% larger than GDP because of

overseas profits of US companies.

For smaller countries GNP and GDP can diverge significantly.Slide

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The Expenditure Approach for

Measuring GDP

There are 4 groups that buy final goods and

services:

Households, Firms, Government and Foreign buyers

Total Expenditure = Total Market Value of goods and services = GDP

www.bea.gov

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Consumption

Expenditure Household spending on goods and services,

such as food, clothing, and entertainment is called Consumption Expenditure, or simply Consumption

Three categories of consumption expenditure Consumer durables - long lived, e.g., cars, refrigerators etc.

Consumer non-durables - short lived, e.g., food, clothing, etc.

Services - legal, financial, educational, domestic, services

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Investment Expenditure

Spending by firms on final goods and services, primarily capital goods and by households on housing, is called Investment expenditure, or simply, Investment

Three categories of Investment expenditures:

Business fixed investment includes sum of non-residential and residential investment.

Non-residential Investment - purchase of new capital goods like factories, machinery etc. (now includes R&D)

Residential investment - construction of new housing, this number decreases 80% during the Great Recession 2008-2009

Inventory investment - goods that a firm produces but doesn’t sell during the accounting period

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Government Expenditure

Government expenditure includes

Purchases by federal, state, and local governments of final goods and services like buying fighter planes, paying public school teachers, etc.

Government expenditure does not include transfer payments or the interest paid on government debt.

Transfer payments are payments by the govt. for which no current goods or services are received in exchange.

Examples: Unemployment benefits, Social Security payments, Pensions, Other Welfare payments, etc. And we can avoid double counting problem, Why? Slide

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Government Expenditure

Government expenditure does not include the interest paid on

government debt.

Interest paid on government bonds is NOT

counted as part of GDP; the argument is that

the interest is not usually on a loan for

purchasing capital equipment, and therefore

is not connected to production; whereas net

business interest paid is typically for a loan

used to purchase capital equipment and is

counted as part of GDP since it is related to

production.

Slide

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Expenditure by Domestic and

Foreign Buyers

Add Exports - these are domestically

produced goods that are sold abroad

Subtract imports - these are foreign

made goods that are purchased by

domestic buyers

Net Exports = Exports - Imports

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The Expenditure Approach for

Measuring GDP

Y = gross domestic product, or output

C = consumption expenditure

I = investment expenditure

G = government purchases

NX = net exports

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NXGICY

GDP Example Total production is 1 million cars, $15,000 each.

700K sold to consumers; 200K sold to

businesses; 50K to Govt., and 25K to foreign

countries.

25,000 cars are unsold

Investment in inventories increases by $0.375 billion

GDP Contribution

$10.500 billion

$3.000 billion

$0.750 billion

$0.375 billion

$14.625 billion

Sector # Cars Purchased

Consumers 700,000

Businesses 200,000

Government 50,000

Net exports 25,000

Total 975,000

Businesses 225,000 $3.375 billion

Total 1,000,000 $15.000 billion

GDP Data

Expenditure Approach for calculating GDP

from the Bureau of Economic Analysis (US Dept

. of Commerce):

http://www.bea.gov/iTable/iTable.cfm?ReqID

=9&step=1#reqid=9&step=3&isuri=1&903=6

From the Economic report of the President:

http://www.gpoaccess.gov/eop/tables08.htm

l

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Income Approach to GDP When a good is sold, its proceeds are distributed to workers or

business owners

GDP = labor income + capital income

Labor income is wages, salaries, benefits, and incomes of the self-

employed

About ⅔ of GDP

Capital income pays for physical capital and intangibles

All income is measured before taxes

▪ Profits for business owners incl

dividends

▪ Rent for land

▪ Interest includes the total sums paid

by private businesses for loans,

including the interest paid on

savings, certificates of deposits, and

corporate bonds.

▪ Royalties

The Three Faces of GDP

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= =

Market

value of

final

goods

and

services

Production Expenditure Income

Investment =

20% of GDP

Consumption =

60% of GDP

Government

purchases =

20% of GDP

Net exports

Capital Income

= 25% of GDP

Labor Income =

75% of GDP

Nominal GDP versus Real

GDP Nominal GDP = GDP valued at current prices

Nominal GDP measures the current dollar value of

production

Real GDP = GDP valued at some base year prices rather than current prices

Real GDP measures the actual physical volume of

production

Slide

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Prices and Quantities in 2000 and 2004

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Quantity of

pizzas

2000 10 $10 15 $5

2004 20 $12 30 $6

Price of

pizzas

Quantity of

calzones

Price of

calzones

Nominal GDP

2000 = (10)($10) + (15)($5) = $175

2004 = (20)($12) + (30)($6) = $420

Real GDP, Base year = 2000

2004 Real GDP = (20)($10) + (30)($5) = $350

Nominal GDP overstates Economic Growth

Nominal GDP versus Real

GDP

Slide

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Usually, nominal and real GDP increase each year

Nominal GDP can go up and real GDP go down (happens

during recessions and stagflations; happened in the US

during 1990-91 recession)

Fewer goods and services produced AND

Prices increase faster than output decreases

Nominal GDP will be smaller than real GDP if the prices in

the current year are less than in the base year

Usually true for years before the base year

Although rare, Real GDP could rise and nominal GDP

could fall

Prices are falling faster than output is increasing

(happened in Japan during several years in the 1990s)

Real GDP and Economic Well-Being

- Leisure

Is Real GDP a good measure of economic well being? It is an imperfect measure because many things that determine

economic well being are not bought and sold in markets

Leisure Time - We enjoy shorter work week, start working much later in life and often retire earlier than our forefathers did. However these extra leisure hours are not priced in markets and hence don’t get reflected in a higher GDP.

Real GDP understates the true extent of well being.

Slide

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Real GDP and Economic Well-Being

– Non Market Activities

Real GDP does not include Non-market

Economic Activities

Unpaid household activities

Volunteer services - fire service

Underground economy - legal and illegal from

informal babysitting to organized crime

Non-market activities can be quite significant

in poor countries(So why do they poor?)

Real GDP will understate true economic well-

being.Slide

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Real GDP and Economic Well-Being –

Environment and Resource Depletion

Real GDP numbers typically do not reflect :

the cost of lower environmental quality and greater resource

depletion that occurs with growth; e.g., China, India

Quality of Life - Crime rates, Traffic congestion, Civic organizations,

Open space

Poverty and Economic Inequality - GDP does not capture the effects

of income inequality.

Real GDP overstates the true well-being

Slide

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GDP and the Well-being

of Life

Slide

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GDP and the Meaning of Life

The Life Satisfaction Index was from a Gallup

World Survey that asked people to rate how

they feel about their lives on a scale of 0 to

10.

Rich is better

However money is neither necessary (Brazil,

Venezuela) nor sufficient (Hong Kong, Kuwait,

etc.)

Money matters less as you get richer

Slide

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Spending, Income and GDP Slide 52

Real GDP: Is It Related to Economic

Well Being

Robert Kennedy in 1968:

“[GDP] 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…, 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.”

Real GDP Is Related to Economic

Well Being

While Real GDP can be useful when

comparing labor productivity between

countries, it has, as we have seen, serious

limitations as a measure of a country’s living

standards.

An increase in Real GDP implies an expansion

of a nation’s PPF. With increased productive

capacity a nation can achieve more.

A larger GDP affords us a better chance at

enjoying a better life; it does not guarantee it.

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End of

Section

Let’s Summarize what we have learnt