SPENDING, INCOME, & GDP

Chapter 4

GDP Accounting

GDP (Gross Domestic Product)—the market value of all final goods and services produced in a country during a given period of time.

GDP Breakdown

1) Only consider the market value 2) We wish to include only final goods and

services.3) Must avoid double accounting—

counting the same production twice.4) All output should be included in GDP.5) GDP includes only currently produced

goods and services.6) GDP includes only goods and services

produced within a nation’s border

1) Market Value Approach to GDP Measure in terms of market value, not in

terms of solely output or solely price

Market Value Example:

Suppose a country’s total production is 4 purses ($20 each), 2 cookies ($1 each), and 1 television ($600).

Three possibilities of measurement: Just in terms of output: 4+2+1 = 7 units of total

output Does this make sense?

In terms of price only: 20+1+600 = $621 Really?

Or in terms of market value: (4 purses*20)+(2 cookies*1)+(1 television *600)=$682 Allows for all goods to be on an equal playing field

2) We wish to include only final goods and services.

Final goods—consumed by the ultimate user.

Intermediate goods—used up in the production of final goods (not counted as part of GDP).

3) Must avoid double accounting—counting the same production twice. To avoid double accounting, we use value

added Value added, for any firm, is the market value of

its product minus the cost of inputs purchased. Example: Suppose the following market

values: Grain: $.50 Flour: $1.20 French Bread: $2.00

So GDP must be $3.70…WRONG! GDP is $2.00

4) All output should be included in GDP, but it’s not

Some output is not sold through markets and is difficult to value.

GDP does not include the volunteer services, housework, and do-it-yourself activities.

Underground economy

Drawback of Market Value

Non-market goods not counted in GDP Fails to account for household activities,

volunteer services, and do-it yourself activities Example is female labor force participation

Since 1960 female LFP has increased, so did GDP. However prior many females stay at home as

mothers, whose production was not counted in GDP

Note: some non-market goods are still included, e.g. defense spending

5) GDP includes only currently produced goods and services GDP only includes production that takes

place during the indicated time period. For example GDP in 2011 includes only

goods and services in 2011. Transactions in existing assets are not

included.

Eg. If you buy a DVD of star Trek from Amazon, the purchase is included in GDP. If 6 months later you resell the DVD on ebay, that transaction is not included in GDP.

6) Produced within a nation’s borders Key: GDP = Gross Domestic Product GDP includes any goods produced

within the nation’s borders regardless of a company’s home country

If Toyota (a Japanese Multinational Corp.) makes cars in Kentucky, is that part of U.S. GDP?

If Apple ( a California based Corp.) makes ipods in Canada, is that part of U.S. GDP?

GNP

GNP (Gross National Product)—the market value of all final goods and services produced by resources supplied by a country during a given period of time, regardless of where they are located.

Main Difference

GDP measures the production of resources located in the U.S., regardless of who owns them.

GNP measures the production of resources owned by U.S. residents, regardless of where the resources are located.

Nominal GDP

Expenditure Approach to GDP

GDP = consumption + investment + government purchases + net exports

Consumption

Consumption—spending by households on goods and services except the purchase of homes.

Types of Consumption

Consumer Durables – long-lived consumer goods

Consumer Nondurables – short-lived consumer goods

Services – Largest component of consumption

Consumption

Investment

Investment—spending by firms on final goods and services—primarily capital goods and housing.

Types of Investment

Business Fixed Investment – purchase by firms of new capital goods such as machinery factories, and office buildings

Residential Investment – construction of new homes and apartment buildings. (treated as investment by business sector)

Inventory Investment – addition of unsold goods to company inventories

CAUTION: Do not confuse with financial investment

Investment

Government Spending

Government purchases—government purchases of final goods and services.

Exclusions of Government Spending Government Spending does not include

transfer payments What are transfer payments?

Payments made by the government in return for which no current goods or services are received

Examples: Social Security benefits, unemployment benefits, pensions to government workers, and welfare payments

Why do we exclude them?

Government Purchases

Net Exports

Net exports = exports – imports

Why do we subtract imports?

Since imports are included in consumption, investment, and government purchases but do not represent spending on domestic production, they must be subtracted.

Net Exports

Formal Representation of GDP Y = C + I + G + NX

Recall NX = EX - IM What does each component represent?

Or more appropriately who?

How do we classify the following? A haircut A defense contractor buys a tank The U.S. Army buys a tank Financial services provided by domestic

residents to foreigners on U.S. soil

Income Approach to GDP

Three GDP Approaches

Expenditure

Investment

Consumption

Government purchasesNet exports

Income

Capital Income

Labor Income

Production

Adjusting for Price Changes

Compare GDP for different years to see how much output has changed

GDP changes over time because Prices change AND Quantity of output changes

To see how much output has grown, use only the changes in quantities Hold prices constant

The Pizza and Games Economy GDP in 2009 is $175; GDP in 2013 is

$420 GDP in 2013 is 2.4 times the GDP in 2009

Only twice as many pizzas and games were produced in 2013 Market value of output grew faster than the

physical volume of output

Number of Pizzas

Price of Pizza

Number of Games

Price of Game

2009 10 $10 15 $5

2013 20 $12 30 $6

Real GDP and Nominal GDP

Real GDP values output in the current year using the prices from the base year The base year is a reference year that

changes infrequently Real GDP measures the physical volume of

production Nominal GDP values output in the current

year using prices from the current year Nominal GDP is the current dollar value of

production

Calculating Real GDP for 2013

Use 2009 as the base year Nominal GDP for 2009 is $175 and for 2013,

$420 Calculate real GDP using current year quantities

and base year prices Real GDP in 2013 is

(20 pizzas) ($10) + (30 games) (5) = $350 Real GDP doubled between 2009 and 2013

Number of Pizzas

Price of Pizza

Number of Games

Price of game

2009 10 $10 15 $5

2013 20 $12 30 $6

Observations on Real and Nominal GDP Usually, nominal and real GDP increase each

year But can they move in opposite directions?

YES! Nominal GDP can go up and real GDP go down

Fewer goods and services produced AND Prices increase faster than output decreased

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

Real GDP could rise and nominal GDP fall, but this is rare Prices are falling faster than output is increasing

Real GDP and Economic Well-Being Real GDP is a flawed measure of well-

being It values only market transactions

Omits illegal transactions, volunteer work, and household production

Maximizing GDP will not necessarily maximize national well-being Whether increases in output increase

welfare is a case-by-case issue

Poverty and Economic Inequality GDP does not capture the effects of income

inequality Most would prefer living in a relatively equal

society to one with a few wealthy and many poor

US uses an absolute standard of poverty In 2005, a family of four was poor if their income

was less than $19,350 Inequality matters and it is increasing in the

US The case of the beat-up car

GDP as a Welfare Measure

GDP omits and undervalues some goods and services

GDP per capita is positively associated with several measures of well-being Material standard of living: more goods and services Health and life expectancy

Residents of industrialized countries fare better than residents of developing countries in a range of health measures

Education Literacy and school enrollment rates are higher in high-

income countries