Taking the Nations Pulse

To Accompany “Economics: Private and Public Choice 10th ed.” James Gwartney, Richard Stroup, Russell Sobel, & David Macpherson

Slides authored and animated by: James Gwartney, David Macpherson, & Charles Skipton

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Taking the Nations Pulse3 73 7

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GDP– A Measure of Output


• Gross Domestic Product (GDP): The market value of final goods and services produced within a country during a specific time period, usually a year.

GDP – A Measure of Output


Stage of productionValue added to the product (equals income created)

Sales Receipts(at each stage of production)

Stage 1: farmer’s wheat

Stage 2: miller’s flour

Stage 3: baker’s bread(wholesale)

Stage 4: grocer’s bread (retail)

$.30

$.65

$.90

$1

by farmer$.30

by grocer$.10

by miller$.35

by baker$.25

GDP – A Measure of Output• What Counts Toward GDP?

• Only final goods and services count • Sales at intermediate stages of production

are not counted as their value is embodied within the final-user good. Including them would result in double counting.

Total consumer expenditure = $1 Total value added = $1


• What Counts Toward GDP? (cont.)

• Financial transactions and income transfers are excluded as they do reflect production.

• Only production within the geographicborders of the country is counted.

• Only those goods produced during the current period are counted.

• GDP is measured in dollars• Each good produced increases output by the

amount the purchaser pays for the good. • GDP is the sum of total spending on all

goods and services produced during the year.

GDP – A Measure of Output


Questions for Thought:1. Indicate how each of the following activities

will affect GDP:a. You pay $600 per month to lease an apartment

while attending school.b. You pay $8,000 to purchase a four-year-old car.c. You have car trouble and have to pay a repair

shop $1,500 to fix the transmission of your car.d. You pay $5,100 to purchase 100 shares of

Microsoft stock ($50 per share for the stock plus a $100 brokerage fee).

e. You sell your 100 shares of Microsoft stock (purchased for $5,000) for $6000 minus a $100 brokerage fee.

(continued on next slide)


Questions for Thought:1. Indicate how each of the following activities

will affect GDP: (cont.)f. Your aunt sends you $500 to help with your

college expenses.g. You earn $500 providing computer services

for a faculty member.h. You win $500 playing cards with classmates

in the dormitory.

2. Why aren’t the purchases of intermediate goods like steel and automobile motors and the purchase of final market goods like new automobiles both included in GDP?


Two Ways of Measuring GDP


• Expenditure Approach:• GDP is the sum of expenditures on final user

goods and services purchased by households, investors, governments, and foreigners.

• There are four components of GDP: • personal consumption purchases • gross private investment

(including inventories) • government purchases

(consumption and investment)• net exports ( exports minus imports )

GDPDollar flow ofexpenditureson final goods

=Dollar flow of

income (and indirect cost) of final goods

=



• Resource Cost - Income Approach

Sum of these = national income


• GDP is the sum of costs incurred and income (including profits) generated by production of goods and services during the period.

• The direct cost income components of GDP:• employee compensation• self-employment income • rents • interest• corporate profit


Two Ways of Measuring GDP• Resource Cost - Income Approach: (cont.)

• Not all cost components of GDP result in an income payment to a resource supplier. To get GDP, we need to account for 3 other factors:

• Indirect business taxes: Taxes that increase the firm’s production costs and therefore final prices.

• Depreciation: The cost of wear and tear on the machines and other capital assets used to produce goods and services.

• Net Income of Foreigners: The income that foreigners earn producing goods within the borders of a country minus the income Americans earn abroad.


• national income (employee compensation, self-employment income, rents, interest, corporate profit)

• indirect business taxes • depreciation • net income of foreigners

Two Ways of Measuring GDP• When derived by Resource Cost - Income

Approach, GDP is equal to:


Resource Cost-Income ApproachExpenditure Approach

• There are two methods of calculating GDP:

Personal consumption expenditures

+ Gross private domestic investment

+

Government consumptionand gross investment

+Net exports of goods and services

Aggregate income:Employee CompensationIncome of self-employedRents Profits Interest

+Non-income cost items:

Indirect business taxesand depreciation

Net income of foreigners+= GDP


• Summing the expenditures of “final user” goods and services of consumers, investors, governments, and foreigners (net exports), or,

• Summing income payments and indirect cost items that accompany the production of goods and services.

= GDP


Personal consumption

68%

Net exports - 3%

Privateinvestment

17%

Gov’t

18%

Rental income < 1%

Net interest

6%

Indirect taxes

7%

Corporate profits 9%

Self-employed proprietor income

7% Employeecompensation

58%

Depreciation

13%

(a) Expenditure approach (b) Resource cost-income approach a

Source: Economic Report of the President, 2002. a The net income of foreigners was negligible.

Relative Size of U.S. GDP Components: 1998-2001

• The relative sizes of the major components of GDP usually fluctuate within a fairly narrow range.

• The average proportion of each U.S. component during 1998-2001 period is shown above for both the expenditure and resource cost-income approach.


Questions for Thought:1. What is the difference between Gross Domestic

Product (GDP) and Gross National Product (GNP)?

2. Can net investment ever be negative? What would negative net investment imply?

3. What is the largest component of GDP when it is derived by the expenditure approach? What is the largest component of GDP when it is derived by the income-cost approach?


Real and Nominal GDP


Real and Nominal GDP

• The term "real" means adjusted for inflation. • Price indexes are use to adjust income and

output data for the effects of inflation. • A price index measures the cost of purchasing

a market basket (or “bundle”) of goods at a point in time relative to the cost of purchasing the identical market basket during an earlier reference (or base) period.


Two Key Price Indexes: - Consumer Price Index - GDP Deflator


Two Key Price Indexes:• Consumer Price Index (CPI):

measures the impact of price changes on the cost of a typical bundle of goods and services purchased by households.

• GDP Deflator: designed to measure the change in the average price of the market basket of goods included in GDP (a broader price index than the CPI).


YearCPI

(1982-84 = 100)

1991199219931994199519961997199819992000

136.2140.3144.5148.2152.4156.9160.5163.0166.6172.2

4.23.03.02.62.83.02.31.52.23.4

3.62.42.42.12.21.92.01.21.52.2

GDP deflator (1996 = 100)

89.791.894.196.0

98.1100.0102.0103.2104.7107.0

Inflation rate(percent)

Inflation rate (percent)

Source: Economic Report of the President, 2001.

2001 177.1 2.8 2.2109.4

CPI and GDP Deflator: 1991-2001

• Even though the CPI and the GDP deflator are based on different market baskets and procedures, they yield similar estimates of the rate of inflation.


Using the GDP Deflator to Derive Real GDP


Real GDP2 = Nominal GDP2 * GDP Deflator1

GDP Deflator2


• Data on both money GDP and price changes are essential for meaningful comparisons of output between two time periods.

• The formula for converting the nominal GDP into real GDP is:


Source: U.S. Department of Commerce.

1996 2001 % increase

Nominal GDP(billions of U.S. $)

Real GDP(billions of 1996 $)

$7,813 $10,208 30.7%

Price index (GDP deflator, 1996 = 100)

100.0 109.4 9.4%

$7,813 $9,331 19.4%


• Between 1996 and 2001, nominal GDP increased by 30.7%.

• But, when the 2001 GDP is deflated to account for price increases, we see that real GDP increased by only 19.4%.


Converting Earlier Figures to Current Dollars

• In order to make comparisons across time periods, we must use current dollars.

• This can be done by “inflating” the earlier data for the increase in the price level.

• The formula for converting the figures for the earlier year into current dollars is:

Figurecurrent $ = Figureearlier $ * price indexcurrent year

price indexearlier year

• If prices have risen, this will “inflate” the data for earlier years and bring it into line with the current purchasing power of the dollar.


Questions for Thought:1. What do price indexes measure?

2. What is the difference between the CPI and the GDP deflator? Which would you use if you wanted to measure whether your own earnings this year were higher than they were last year?

3. The CPI was 177 in 2001 compared to 100 in 1983. Suppose that the price of a ticket at a local movie theater rose from $4 to $8 between 1983 and 2001. Did the real ticket price increase or decrease? Calculate the 1983 ticket price measured in 2001 dollars.


Questions for Thought:4. Use the following data to answer this question.

a. Calculate the real GDP in 1999, 2000, and 2001 measured in 1996 dollars.

b. What was the percent change in real GDP between 1999 and 2000? What was the percent change between 2000 and 2001?

c. What was the inflation rate as measured by the GDP deflator in 2000 and 2001?

Nominal GDP(trillions of $)

GDP deflator(1996=100)

199920002001

9.279.87

10.21

104.7107.0109.4


Shortcomings and Strengths of GDP as a Measuring Rod


Shortcomings and Strengths of GDP as a Measuring Rod

• Shortcomings of GDP:• It does not count non-market production. • It does not count the underground economy.• It makes no adjustment for leisure.• It probably understates output increases

because of the problem of estimating improvements in the quality of products.

• It does not adjust for harmful side effects.• Great contribution of GDP:

• In spite of its shortcomings, real GDP is a reasonably accurate measure of short-term fluctuations in output.


GDP ComparisonsAcross Time Periods and Across Countries


Per capita GDP Across Time Periods

• Per capita GDP has steadily risen. In 2000, per capita GDP was 4.6 times the 1940 figure. What does this mean?

$7,423

$13,148

$21,521

$6,101

$11,119

$17,446

$33,833

$26,834

1930 1950 1970 1990 2000

U.S. Per Capita GDP

1940 1960 1980

Source: derived from U.S. Department of Commerce data.


Per Capita GDP ComparisonsAcross Time Periods

• As was seen in the previous exhibit, U.S. per capita GDP has increased substantially over the past 70 years.

• Compared to earlier periods, current GDP is probably biased upward because more output now takes place in the market sector and less in the household sector.

• However, it is also probably biased downward because of failure to adjust for increased leisure, improvements in the work environment, and the introduction of improved products and new technologies.

• The direction of the overall bias is uncertain.


Per Capita GDP ComparisonsAcross Countries

• GDP comparisons across countries may be biased because of differences in • leisure versus time worked, • size of the underground economy, • the share of output in the household rather

than the business sector. • Small differences in per capita GDP should be

interpreted with caution. • However, there is a strong relation between

per capita GDP across countries and indicators of living standards such as life expectancy, infant mortality, and literacy. (see exhibit 8 of this chapter for evidence)


Related Income Measures


• Gross National Product (GNP): Output produced by the “nationals” – citizens of the country, regardless of whether that output is produced domestically or abroad.

• National income: Income earned by the nationals (citizens) during a period. It is the sum of employee compensation, self-employment income, rents, interest, and corporate profits.

• Personal income: Income received by domestic households and non-corporate businesses. It is available for consumption, saving, and personal taxes.

• Disposable income: Income available to individuals after personal taxes. Can be spent on consumption or saved.

Related Income Measures


2001 U.S. Income Measures(in billions of $)

Net exports

Personal consumer

expenditures

Gross private domestic

investment

Government consumption

and investment

Proprietors’ incomeInterestRents

Corporate profits

– Minus –Corporate profits andsocialinsurance taxes

GDP $10,208 $10,203

National Income $8,218

Personal income $8,724

Disposable income $7,417

• Above are 5 alternative measures of national income.

• These range from GDP (broadest) to Disposable Income (that available to households for saving or consumption).

5 Measures of National Income

Personaltaxes

GNP

Net income of foreigners

Employee compensation

Depreciation

Indirect businesstaxes

– Plus –Transferpayments,net interest,anddividends


• GDP is a measure of both output & income. • This highlights a very important point:

Expansion in output (additional production of goods and services that people value) is the source of higher income levels.

• If we want to achieve higher income levels and living standards, we must figure out how to expand output (productivity) per person. We cannot have one without the other.

Link Between Output and Income


Questions for Thought:1. When making income and GDP comparisons

across time periods, why is it important to adjust for changes in the level of prices?

2. If nominal GDP during a year increased by 7% while the GDP deflator rose by 10 %, what happened to real GDP?

3. Why might per capita GDP be a misleading indicator of living standards across countries?

4. GDP does not count services such as child care, food preparation, cleaning, and laundry within the household. Why not? Is GDP a sexist measure? Does it understate the productive contributions of women relative to men?


Questions for Thought:5. Which of the following are included in GDP?

a. the value of goods produced in the underground economy

b. the value of leisurec. increases in the value of housing and

financial assetsd.depreciation in the value of real assets

such as equipment and buildingse. the value of services such as food

preparation and house cleaning that we provide for ourselves


EndChapter 7

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Taking the Nations Pulse