Measuring economic performance

Copyright © 2002 by Thomson Learning, Inc.

to accompanyto accompanyExploring EconomicsExploring Economics

3rd Edition3rd Editionby Robert L. Sextonby Robert L. SextonCopyright © 200Copyright © 20055 Thomson Learning, Inc. Thomson Learning, Inc.

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A Lecture PresentationA Lecture Presentation


Measuring Economic Measuring Economic PerformancePerformance

Chapter 18Chapter 18


18.1 National Income 18.1 National Income Accounting: Measuring Accounting: Measuring Economic Performance Economic Performance

The desire to measure the success, or The desire to measure the success, or performance, of our economy is performance, of our economy is important to private businesses and important to private businesses and to macroeconomic policy makers for to macroeconomic policy makers for setting goals and developing policy setting goals and developing policy recommendations.recommendations.


Why Do We Measure Our Why Do We Measure Our Economy’s Performance?Economy’s Performance?

Measurement of the economy’s Measurement of the economy’s performance is also important to performance is also important to private businesses because private businesses because inaccurate measurement can lead inaccurate measurement can lead to bad decision making.to bad decision making.

Traders in stocks and bonds are Traders in stocks and bonds are continually checking economic continually checking economic statistics—buying and selling in statistics—buying and selling in response to the latest economic data.response to the latest economic data.


What Is National Income Accounting?What Is National Income Accounting?

To achieve a reliable, uniform To achieve a reliable, uniform measurement of economic measurement of economic performance, performance, national income national income accountingaccounting was developed early in the was developed early in the 2020thth century. century.

Several measures of aggregate national Several measures of aggregate national income and output have been income and output have been developed, the most important of which developed, the most important of which is is gross domestic product (GDP)gross domestic product (GDP). .


What Is Gross Domestic Product?What Is Gross Domestic Product?

The measure of aggregate economic The measure of aggregate economic performance that gets the most performance that gets the most attention in the popular media is attention in the popular media is gross domestic product (GDP)gross domestic product (GDP), , which is defined as the value of all which is defined as the value of all final goods and services produced final goods and services produced within a country during a given within a country during a given period.period.


The value of a good or service is The value of a good or service is determined by the market prices determined by the market prices at which goods and services sell. at which goods and services sell.

Underlying GDP calculations are Underlying GDP calculations are the various equilibrium prices and the various equilibrium prices and quantities for the multitude of goods quantities for the multitude of goods and services produced. and services produced.


A final good or service A final good or service ready for its designated ultimate useready for its designated ultimate use intermediate goods or services are used intermediate goods or services are used

in the production of other goodsin the production of other goods If we counted the value of intermediate If we counted the value of intermediate

goods as well as the full value of the final goods as well as the full value of the final products in GDP, we would be products in GDP, we would be double double countingcounting by adding the value of an by adding the value of an intermediate good twice, first in its raw intermediate good twice, first in its raw form and second in its final form.form and second in its final form.


Measuring Gross Domestic ProductMeasuring Gross Domestic Product

There are two primary ways of There are two primary ways of calculating economic output: calculating economic output: the expenditure approach the expenditure approach the income approach the income approach

Although these methods differ, the Although these methods differ, the resulting GDP is the same, apart resulting GDP is the same, apart from minor “statistical from minor “statistical discrepancies.”discrepancies.”


18.2 The Expenditure Approach18.2 The Expenditure Approach to Measuring GDP to Measuring GDP

The The expenditure approachexpenditure approach to GDP to GDP GDP is calculated by adding up the GDP is calculated by adding up the

expenditures of market participants on expenditures of market participants on final goods and services over a period final goods and services over a period of time. of time.


Economists usually categorize Economists usually categorize expenditures into four categories:expenditures into four categories: consumption, consumption, CC investment, investment, II government purchases, government purchases, GG net exports [which equals exports (net exports [which equals exports (XX) )

minus imports (minus imports (MM), or ), or XX – – MM] ] Following the expenditure method, Following the expenditure method,

GDP = GDP = C C + + II + + GG + ( + (XX – – MM))


Consumption Consumption (C)(C)

ConsumptionConsumption—the purchase of —the purchase of consumer goods and services by consumer goods and services by households—does not include households—does not include purchases by business or purchases by business or government.government. A large percentage of GDP in a given A large percentage of GDP in a given

year goes for consumer goods and year goes for consumer goods and services. services.



Consumption spending is usually Consumption spending is usually broken down into three subcategoriesbroken down into three subcategories Nondurable GoodsNondurable Goods

tangible consumer items typically consumed tangible consumer items typically consumed or used up in a relatively short period of timeor used up in a relatively short period of time

Durable GoodsDurable Goods longer‑lived consumer goods; the most longer‑lived consumer goods; the most

important category is consumer vehiclesimportant category is consumer vehicles ServicesServices


On occasion, it is difficult to decide On occasion, it is difficult to decide whether a good is durable or whether a good is durable or nondurable, and the definitions are, nondurable, and the definitions are, therefore, somewhat arbitrary. therefore, somewhat arbitrary.

The distinction between durables The distinction between durables and nondurables is important and nondurables is important because consumer buying behavior because consumer buying behavior is somewhat different for each of is somewhat different for each of these categories of goods. these categories of goods.


In boom periods, when GDP is rising rapidly, In boom periods, when GDP is rising rapidly, expenditures on durables often increase expenditures on durables often increase dramatically. dramatically.

In years of stagnant or falling GDP, sales of In years of stagnant or falling GDP, sales of durable goods often plummet. durable goods often plummet.

By contrast, sales of nondurables tend By contrast, sales of nondurables tend to be more stable over time because to be more stable over time because purchases of such goods are more difficult purchases of such goods are more difficult to shift from one time period to shift from one time period to another.to another.


ServicesServices are intangible items of are intangible items of value, as opposed to physical goods. value, as opposed to physical goods.

As incomes have risen, service As incomes have risen, service expenditures have been growing expenditures have been growing faster than spending on goodsfaster than spending on goods The share of total consumption going for The share of total consumption going for

services increased from 35% in 1950 to services increased from 35% in 1950 to almost 60% by 2003.almost 60% by 2003.


Investment Investment (I)(I) InvestmentInvestment, as used by economists, , as used by economists,

refers to the creation of capital goods refers to the creation of capital goods whose purpose is to produce other whose purpose is to produce other goods.goods.

This definition of investment deviates This definition of investment deviates from the popular use of that term. from the popular use of that term.

For instance, purchases of stock are not For instance, purchases of stock are not an investment as defined by economists an investment as defined by economists (i.e., an increase in capital goods).(i.e., an increase in capital goods).


There are two categories of There are two categories of investment purchases measured investment purchases measured in the expenditure approach: in the expenditure approach: fixed investmentfixed investment inventory investmentinventory investment


Fixed investmentFixed investment, sometimes called , sometimes called producer goodsproducer goods, include all spending , include all spending on capital goods that increase our future on capital goods that increase our future production capabilities production capabilities

machinerymachinery toolstools factory buildingsfactory buildings as well as residential constructionas well as residential construction

Inventory investmentInventory investment all business purchases that add to inventories all business purchases that add to inventories

to meet customer demandsto meet customer demands


In recent years, investment In recent years, investment expenditures have generally been expenditures have generally been around 15 percent of GDP. around 15 percent of GDP.

Investment spending is the most Investment spending is the most volatile category of GDP, however, volatile category of GDP, however, and tends to fluctuate considerably and tends to fluctuate considerably with changing business conditions.with changing business conditions.


When the economy is booming, When the economy is booming, investment purchases tend to investment purchases tend to increase dramatically. In downturns, increase dramatically. In downturns, the reverse happens.the reverse happens.


Government Purchases In GDP Government Purchases In GDP (G)(G)

Government expenditures on goods Government expenditures on goods and services are included in GDP. and services are included in GDP.

Transfer payments are not included in Transfer payments are not included in government purchases because that government purchases because that spending does not go to purchase newly spending does not go to purchase newly produced goods or services. produced goods or services.

The government purchase proportion The government purchase proportion of GDP has grown rapidly over the last of GDP has grown rapidly over the last 30 years.30 years.


Exports Exports (X-M)(X-M) Some of the goods and services that Some of the goods and services that

are produced in the U.S. are exported are produced in the U.S. are exported for use in other countries.for use in other countries.

The fact that these goods and services The fact that these goods and services were made in the U.S. means that they were made in the U.S. means that they should be included in a measure of U.S. should be included in a measure of U.S. production.production.

Thus, we include the value of exports Thus, we include the value of exports when calculating GDP. when calculating GDP.


At the same time, however, some of At the same time, however, some of our expenditures in other categories our expenditures in other categories were for foreign‑produced goods and were for foreign‑produced goods and services. services.

These imports must be excluded from These imports must be excluded from GDP in order to obtain an accurate GDP in order to obtain an accurate measure of American production. measure of American production.


Thus, GDP calculations measure net Thus, GDP calculations measure net exports, which equals total exports exports, which equals total exports ((XX) minus total imports () minus total imports (MM). ).

Net exports are a small proportion of Net exports are a small proportion of GDP and are often negative for the GDP and are often negative for the United States.United States.


18.3 The Income Approach to 18.3 The Income Approach to Measuring GDP Measuring GDP

The The income approachincome approach to measuring to measuring GDP involves summing the incomes GDP involves summing the incomes received by producers of goods and received by producers of goods and services. services.


The Income Approach to Measuring GDPThe Income Approach to Measuring GDP

When someone makes an expenditure for When someone makes an expenditure for a good or service, that spending creates a good or service, that spending creates income for someone else. income for someone else.

Someone receives the money spent, and Someone receives the money spent, and that receipt of funds is called income. that receipt of funds is called income.

Therefore, by adding up all of the incomes Therefore, by adding up all of the incomes received by producers of goods and received by producers of goods and services, we can calculate the gross services, we can calculate the gross domestic product because output creates domestic product because output creates income of equal value.income of equal value.


Factor PaymentsFactor Payments

The incomes received by persons The incomes received by persons providing goods and services are providing goods and services are actually payments to the owners actually payments to the owners of productive resources. of productive resources.


Factor paymentsFactor payments include include wages for the use of labor serviceswages for the use of labor services rent for landrent for land payments for the use of capital goods in payments for the use of capital goods in

the form of interestthe form of interest profits for entrepreneurs who put labor, profits for entrepreneurs who put labor,

land, and capital togetherland, and capital together


Before we can measure income, we must Before we can measure income, we must make three adjustments to GDP.make three adjustments to GDP. The net income of foreigners must be The net income of foreigners must be

subtracted from GDP to get subtracted from GDP to get Gross National Gross National Product (GNP)Product (GNP)..

Then Then depreciationdepreciation—annual allowances set —annual allowances set aside for the replacement of worn-out plant and aside for the replacement of worn-out plant and equipment—must be subtracted to get equipment—must be subtracted to get Net Net National Product (NNP)National Product (NNP)..

Finally, Finally, indirect business taxesindirect business taxes, sent by , sent by businesses to government, must be subtracted businesses to government, must be subtracted to get to get National Income (NI)National Income (NI)..


National IncomeNational Income is a measure of the is a measure of the income earned by owners of resources income earned by owners of resources factor payments, including payments for factor payments, including payments for labor services (wages, salaries, and labor services (wages, salaries, and

fringe benefits)fringe benefits) use of land and buildings (rent)use of land and buildings (rent) money lent to finance economic money lent to finance economic

activity (interest)activity (interest) use of capital resources (profits) use of capital resources (profits)



Circular flow model of income and Circular flow model of income and output illustrates the continuous output illustrates the continuous flow of goods and payments flow of goods and payments between firms and households, between firms and households, with the product market on the with the product market on the top half and the factor or input top half and the factor or input markets on the bottom half.markets on the bottom half.


The main point is that buyers have The main point is that buyers have sellers. sellers.

That is, aggregate (or total) That is, aggregate (or total) expenditures is equal to aggregate expenditures is equal to aggregate (or total) income.(or total) income.



Personal Income And Personal Income And Disposable Personal IncomeDisposable Personal Income

Personal Income (PI)Personal Income (PI) measures the measures the amount of income received by amount of income received by individuals, rather than the income individuals, rather than the income earned, because the income received earned, because the income received reflects the amount available for reflects the amount available for spending after taxes and transfer spending after taxes and transfer payments. payments.


Personal Income measures the total Personal Income measures the total amount of income received by amount of income received by households and noncorporate households and noncorporate businesses.businesses.

Disposable Personal Income (DPI)Disposable Personal Income (DPI) is the personal income available to is the personal income available to individuals after taxes.individuals after taxes.


18.4 Problems in Calculating18.4 Problems in Calculating an Accurate GDP an Accurate GDP

The primary problem in calculating The primary problem in calculating accurate GDP statistics is that the accurate GDP statistics is that the "yardstick" used in adding together the "yardstick" used in adding together the values of different products, the U.S. dollar, values of different products, the U.S. dollar, also changes in value over time. also changes in value over time.

In order to compare GDP values over time, In order to compare GDP values over time, a common or standardized unit of a common or standardized unit of measure, which only money can provide, measure, which only money can provide, must be used in the calculations.must be used in the calculations.


We must adjust for the changing We must adjust for the changing purchasing power of the dollar by purchasing power of the dollar by constructing a price index, which attempts constructing a price index, which attempts to provide a measure of the trend in prices to provide a measure of the trend in prices paid for goods and services over time. paid for goods and services over time.

The The price indexprice index can be used to deflate can be used to deflate the nominal or current dollar GDP values to the nominal or current dollar GDP values to a real GDP expressed in dollars of constant a real GDP expressed in dollars of constant purchasing power.purchasing power.


Many different types of price indicesMany different types of price indices Consumer price index (CPI)Consumer price index (CPI)

most well-known indexmost well-known index provides a measure of the trend in the prices of provides a measure of the trend in the prices of

goods and services purchased for consumption goods and services purchased for consumption purposes. purposes.

GDP deflatorGDP deflator corrects GDP statistics for changing pricescorrects GDP statistics for changing prices measures average prices of all final goods and measures average prices of all final goods and

services produced in the economy. services produced in the economy.



The CPI is the price index that is most The CPI is the price index that is most relevant to households trying relevant to households trying to evaluate their changing financial to evaluate their changing financial position over time.position over time.


Constructing a price index is Constructing a price index is complicated. complicated.

To begin with, there are literally To begin with, there are literally thousands of goods and services thousands of goods and services in our economy. in our economy.

A "bundle" or "basket" of A "bundle" or "basket" of representative goods and services representative goods and services is selected by the index calculators. is selected by the index calculators.

How Is A Price Index Created?How Is A Price Index Created?


A price index that can be used to A price index that can be used to measure the inflation rate is equal measure the inflation rate is equal to the cost of the chosen market to the cost of the chosen market basket in the current year divided basket in the current year divided by the cost of the same market by the cost of the same market basket in the base year, times 100.basket in the base year, times 100.


Unfortunately for our ability to Unfortunately for our ability to calculate inflation not all prices move calculate inflation not all prices move by the same amount or in the same by the same amount or in the same direction, so an average of the many direction, so an average of the many price changes must be calculated. price changes must be calculated.


This is complicated by several factors, This is complicated by several factors, including including quality changes in goods and services quality changes in goods and services

over time over time the observed price change may, in reality, the observed price change may, in reality,

reflect a qualitative change in the product reflect a qualitative change in the product rather than the purchasing power of the dollar rather than the purchasing power of the dollar

the creation of new productsthe creation of new products the disappearance of some old productsthe disappearance of some old products


Real GDPReal GDP

The formula for converting any year’s The formula for converting any year’s nominal GDP into real GDP (in base nominal GDP into real GDP (in base year dollars) is: year dollars) is:

R eal G D P n o m in a l G D Pp rice lev e l in d ex

1 0 0

In modern times, inflation has been In modern times, inflation has been prevalent. prevalent.


Is Real GDP Always Less Than Is Real GDP Always Less Than Nominal GDP?Nominal GDP?

For most people, the price level (as For most people, the price level (as measured by the consumer price measured by the consumer price index) has risen in every single year of index) has risen in every single year of their lifetime because the last year of their lifetime because the last year of a declining price level was 1955. a declining price level was 1955.

Therefore, the adjustment of nominal Therefore, the adjustment of nominal (money) GDP to real GDP will tend to (money) GDP to real GDP will tend to reduce the growth in GDP suggested reduce the growth in GDP suggested by nominal GDP figures. by nominal GDP figures.


Real GDP Per CapitaReal GDP Per Capita The measure of economic welfare most The measure of economic welfare most

often cited is often cited is real gross domestic real gross domestic product per capitaproduct per capita..

To calculate real GDP per capita, we divide To calculate real GDP per capita, we divide the real GDP by the total population to get the real GDP by the total population to get the value of real output of final goods and the value of real output of final goods and services per person. services per person.

Ceteris paribus,Ceteris paribus, people prefer more goods people prefer more goods to fewer, so a higher GDP would seemingly to fewer, so a higher GDP would seemingly make people better off. make people better off.


Why Is The Measure Of Per Why Is The Measure Of Per Capita GDP So Important?Capita GDP So Important?

Because one purpose of using GDP Because one purpose of using GDP as a crude welfare measure is to as a crude welfare measure is to relate output to human desires, we relate output to human desires, we need to adjust for population change. need to adjust for population change.

If we do not take population growth If we do not take population growth into account, we can be misled by into account, we can be misled by changes in real GDP values. changes in real GDP values.



18.5 Problems with GDP as a18.5 Problems with GDP as a Measure of Economic Welfare Measure of Economic Welfare

Real GDP is often used as a measure Real GDP is often used as a measure of the economic welfare of a nation. of the economic welfare of a nation.


The accuracy of this measure for that The accuracy of this measure for that purpose is, however, questionable because purpose is, however, questionable because several important factors are excluded several important factors are excluded from its calculations, including from its calculations, including nonmarket transactionsnonmarket transactions the underground economythe underground economy leisureleisure externalitiesexternalities types of goods purchasedtypes of goods purchased distribution of incomedistribution of income expectationsexpectations


Nonmarket TransactionsNonmarket Transactions Nonmarket transactions include the Nonmarket transactions include the

provision of goods and services outside provision of goods and services outside of traditional markets for which no money of traditional markets for which no money is exchanged.is exchanged. We simply do not have reliable enough We simply do not have reliable enough

information to include it in the GDP. information to include it in the GDP. Most important nonmarket transaction omitted Most important nonmarket transaction omitted

from GDP are services provided directly in the from GDP are services provided directly in the home. home.

Marrying one’s housekeeper causes reported Marrying one’s housekeeper causes reported GDP to fall, although output does not change.GDP to fall, although output does not change.


In less-developed countries, where In less-developed countries, where a significant amount of food and a significant amount of food and clothing output is produced in the clothing output is produced in the home, the failure to include home, the failure to include nonmarket economic activity in nonmarket economic activity in GDP is a serious deficiency. GDP is a serious deficiency.


The Underground EconomyThe Underground Economy Underground economy includes unreported Underground economy includes unreported

income from both legal and illegal sources. income from both legal and illegal sources. It’s impossible to know for sure the magnitude. It’s impossible to know for sure the magnitude. Most payments for these services are neither Most payments for these services are neither

reported to governmental authorities nor go reported to governmental authorities nor go through normal credit channels. through normal credit channels.

Size estimates vary from less than 4% to more Size estimates vary from less than 4% to more than 20% of GDP.than 20% of GDP.

good portion of this unreported income from good portion of this unreported income from legal sources, such as self-employmentlegal sources, such as self-employment


Measuring The Value Of LeisureMeasuring The Value Of Leisure

Leisure Leisure This omission in GDP can be fairly This omission in GDP can be fairly

significant in international comparisons, significant in international comparisons, or when one looks at one nation over or when one looks at one nation over time, because the amount of work and time, because the amount of work and leisure varies considerably, usually leisure varies considerably, usually falling with rising GDP.falling with rising GDP.


GDP And ExternalitiesGDP And Externalities Positive and negative externalities Positive and negative externalities

can result from the production of can result from the production of some goods and services. some goods and services. Externalities that have not been Externalities that have not been

internalized result in equilibrium prices internalized result in equilibrium prices that do not reflect true social values. that do not reflect true social values.

GDP does not decrease to reflect GDP does not decrease to reflect pollution resulting from production, or pollution resulting from production, or increase to reflect external benefits to increase to reflect external benefits to others in society. others in society.


Conceptually, we would like to add positive Conceptually, we would like to add positive externalities to and subtract negative externalities to and subtract negative externalities from GDP. externalities from GDP. Two distinguished economists have Two distinguished economists have

developed a measure of economic welfare developed a measure of economic welfare or MEW.or MEW.

Broader‑based welfare measures that Broader‑based welfare measures that attempts to correct for the deficiencies in attempts to correct for the deficiencies in GDP, such as the failure to account for the GDP, such as the failure to account for the spillover effects of pollution or the value of spillover effects of pollution or the value of leisure. leisure.


Quality Of GoodsQuality Of Goods

Work in the direction of developing Work in the direction of developing a "quality of life" indicator may a "quality of life" indicator may ultimately reduce reliance on GDP ultimately reduce reliance on GDP as a measure of performance.as a measure of performance.

One difficulty is that construction of One difficulty is that construction of such indicators involves many such indicators involves many subjective judgments (e.g., what is subjective judgments (e.g., what is the value of leisure?).the value of leisure?).


Real GDP has severe defects as a Real GDP has severe defects as a welfare measure, but at the present welfare measure, but at the present time, there is no alternative measure time, there is no alternative measure that is generally accepted as better. that is generally accepted as better.

The GDP indicator is useful in making The GDP indicator is useful in making comparisons of the market values over comparisons of the market values over time and across countries, even if we time and across countries, even if we cannot be completely sure of the cannot be completely sure of the welfare implications of the comparisons. welfare implications of the comparisons.


Other Measures Of Economic Other Measures Of Economic Well BeingWell Being

We can probably even sometimes be We can probably even sometimes be fairly confident about the welfare fairly confident about the welfare implications of changing GDP.implications of changing GDP.

An unexpectedly fast increase in GDP An unexpectedly fast increase in GDP probably will lead to an increase in probably will lead to an increase in consumption relative to expectations, consumption relative to expectations, almost certainly increasing welfare. almost certainly increasing welfare.


Likewise, a sharp fall in GDP leads to Likewise, a sharp fall in GDP leads to reduced consumption—a decline in reduced consumption—a decline in the ratio of what people have to what the ratio of what people have to what they want—and therefore almost they want—and therefore almost certainly a decline in human welfare.certainly a decline in human welfare.

Education

Measuring economic performance