Gross Domestic Product Measures Total Production

Gross domestic product (GDP) The market value of all final goods and services produced in a country during a period of time, typically one year.GDP Is Measured Using Market Values, Not Quantities

The worth of a thing is the price it will bring.Final good or service A good or service purchased by a final user:

•Household consumption—C

•Business investment, including all residential construction—I

•Government purchases—G

•Exports to foreigners—X

vs

Intermediate good or service A good or service that is an input into another good or service, such as a tire on a truck.

GDP Includes Only Current Production

Production, Income, and the Circular Flow Diagram

PRODUCTION AND PRICE STATISTICS FOR 2007

(1)PRODUCT

(2)QUANTITY

(3)PRICE PER UNIT

Eye examinations 100 $50.00

Pizzas 80 10.00

Textbooks 20 100.00

Paper (for textbooks) 2,000 0.10

PRODUCT(1)

QUANTITY(2)

PRICE PER UNIT(3)

VALUE

Eye examinations 100 $50 $5,000

Pizzas 80 10 800

Textbooks 20 100 2,000

Total GDP = $7,800

Measuring GDP by the Value-Added Method

Value added The market value a firm adds to a product.

FIRM VALUE OF PRODUCT VALUE ADDED

Cotton Farmer Value of raw cotton = $1

Value added by cotton farmer = 1

Textile Mill

Value of raw cotton woven into cotton fabric = $3

Value added by cotton textile mill = ($3 – $1) = 2

Shirt Company

Value of cotton fabric made into a shirt = $15

Value added by shirt manufacturer = ($15 –$3) = 12

L.L. Bean Value of shirt for sale on L.L. Bean’s Web site = $35

Value added by L.L. Bean = ($35 – $15) = 20

Total Value Added = $35

Components of GDP

Consumption (C) Spending by households on goods and services, not including spending on new houses.

Personal Consumption Expenditures, or “Consumption”

Investment (I) Spending by firms on new factories, office buildings, machinery, and additions to inventories, and spending by households on new houses.

Gross Private Domestic Investment, or “Investment”

Government Consumption and Gross Investment, or “Government Purchases”

Government purchases (G)Spending by federal, state, and local governments on goods and services.

Net Exports of Goods and Services, or “Net Exports” (NX)

The mantra: Y = C + I + G + NX

Components of GDP in 2006

NXGICY

GDP Facts

Consumer spending on services is greater than the sum of spending on durable and nondurable goods.

• Business fixed investment is the largest component of investment. Gross private domestic investment includes

New plant and equipment

New residential construction

Net additions to business inventories

• Purchases made by state and local governments are greater than purchases made by the federal government.

• Imports are greater than exports net exports are negative.

Transfer payments are not included in GDP: Payments by the government to individuals for which the government does not receive a new good or service in return.

•Unemployment benefits paid to someone not working.

•Social security benefits paid to someone who is retired.

•Interest income paid to a government bondholder

Since the government doesn’t produce anything for

the market, the interest payment can’t be for any

productive service.

“Underground economy” activities are not included in GDP

•Production “off-the-books”•Illegal activities…a matter of the law

•Legalize prostitution GDP up

Household production is not included in GDP•Marry your gardener GDP down

Does GDP Measure What We Want It to Measure?

GDP Not a Measure of Well-Being…but pretty close

The Value of Leisure Is Not Included in GDP

GDP Is Not Adjusted for Pollution or Other Negative Effects of Production

GDP Is Not Adjusted for Changes in Crime and Other Social Problems

GDP Measures the Size of the Pie but Not How the Pie Is Divided Up

GDP Accounting Conventions•Which component of GDP will be affected by each of these transaction?

•You buy a ticket to fly to Seattle.

•American Airlines buys a new jetliner from Boeing.

•AA buys new seats for a jetliner it already owns.

•AA buys 100 million gallons of jet fuel.

•A resident of France buys a ticket to fly from Paris to NY.

•Clark County extends a runway at McCarran so AA can land larger jets.

•In recent years, the BEA has classified government purchases into gov’t consumption and gross gov’t investment expenditures. How would you classify Homeland Security expenditures?•Which of the following would increase measured GDP and which would reduce it?

•The fraction of women working outside the home increases.

•There is a sharp increase in the crime rate.

•Higher tax rates cause some people to hide more of the income they earn.

•What would you expect to happen to household production as unemployment rises during a recession?

•Would you therefore expect fluctuation in actual production—GDP plus household production—to be greater or less than fluctuation in GDP?

PRODUCT2009

QUANTITY2000

PRICE VALUE

Eye examinations 100 $40 $4,000

Pizzas 80 11 880

Textbooks 20 90 1,800

2000 2009

PRODUCT QUANTITY PRICE QUANTITY PRICE

Eye examinations 80 $40 100 $50

Pizzas 90 11 80 10

Textbooks 15 90 20 100

Real GDP versus Nominal GDPReal GDP The value of this year’s final goods and services evaluated at base-year prices.

Nominal GDP The value of this year’s final goods and services evaluated at this year’s prices.

vs

$6,680Y2009 = Real GDP = GDP in base year prices =

$Y2009 = Nominal GDP = GDP in current year prices = $7,800

Comparing Real GDP and Nominal GDPNominal GDP and Real GDP, 1990–2006

Base year prices >

Current year prices

Y > $Y

Base year prices <

Current year prices

Y < $Y

The GDP Deflator GDP deflator A measure of the price level, calculated by dividing nominal GDP by real GDP and multiplying by 100.

100Nominal GDP

GDP deflatorReal GDP

$ GDP = Price Level x Real Output

$Y = P x YP = $Y/Y

In practice,, the GDP deflator is estimated first:

Deflatorthis yr = (Cost of outputthis yr /Cost of same stufflast yr) x Deflatorlast yr

Then,

Real GDPthis yr = $GDPthis yr/(GDP Deflator)this yr

Other Measures of Total Production and Total Income

Gross National Product (GNP)

=GDP + Net Foreign Earnings of US Residents

•Compensation of employees earned abroad

•Interest and profits earned abroad

Net National Product (NNP) = GNP - Capital Consumption Allowance (depreciation)

National Income (NI) = NNP - Indirect Business Taxes

+ Statistical discrepancy

Personal Income (PI) = NI + Net Transfer Payments – Corporate Retained Earnings

= Income earned from production of national product

Disposable Income (DI) = PI - Income Taxes

Disposable Income is split between consumption and saving

YD = C + S

Other Measures of Total Production and Total Income

FIGURE 7-4

Measures of Total Production and Total Income, 2006

Other Measures of Total Production and Total Income

FIGURE 7-5

The Division of Income

Real GDP—NI/PI/DI

• If the quantity of final goods and services produced decreased, • Could real GDP increase?• Could nominal GDP increase?

• Suppose the amount the federal government collects in personal income taxes increases, while the level of GDP remains the same. What will happen to the values of

• National income• Personal income• Personal disposable income

Business cycle

Consumption

Economic growth

Expansion

Final good or service

GDP deflator

Government purchases

Gross domestic product (GDP)

Inflation rate

Intermediate good or service

Investment

K e y T e r m s

Macroeconomics

Microeconomics

Net exports

Nominal GDP

Price level

Real GDP

Recession

Transfer payments

Underground economy

Value added