PART 2 MONITORING THE MACROECONOMY GDP and the Standard of Living CHAPTER 5

PART 2MONITORING THE MACROECONOMY

GDP and theStandard of Living

CHAPTER5

When you have completed your study of this chapter, you will be able to

C H A P T E R C H E C K L I S T

Define GDP and explain why the value of production, income, and expenditure are the same for an economy.

1

Describe how economic statisticians measure GDP in the United States.

Distinguish between nominal GDP and real GDP and define the GDP deflator.

2

3

Explain and describe the limitations of real GDP as a measure of the standard of living.

4

5.1 GDP, INCOME, AND EXPENDITURE

GDP Defined

Gross domestic product or GDP

The market value of all the final goods and services produced within a country in a given time period.

Value Produced• Use market prices to value production.


What Produced

Final good or service

A good or service that is produced for its final user and not as a component of another good or service.

Intermediate good or service

A good or service that is produced by one firm, bought by another firm, and used as a component of a final good or service.

GDP includes only those items that are traded in markets.


Where Produced• Within a country

When Produced• During a given time period.


Circular Flows in the U.S. Economy

Consumption expenditure

The expenditure by households on consumption goods and services.

Investment

The purchase of new capital goods (tools, instruments, machines, buildings, and other constructions) and additions to inventories.


Government expenditure on goods and services

The expenditure by all levels of government on goods and services.

Net exports of goods and services

The value of exports of goods and services minus the value of imports of goods and services.


Exports of goods and services

Items that firms in in the United States produce and sell to the rest of the world.

Imports of goods and services

Items that households, firms, and governments in the United States buy from the rest of the world.


Total expenditure is the total amount received by producers of final goods and services.

Consumption expenditure: C

Investment: I

Government expenditure on goods and services: G

Net exports: NX

Total expenditure = C + I + G + NX


Income

Labor earns wages, capital earns interest, land earns rent, and entrepreneurship earns profits.


Expenditure Equals Income

Because firms pay out everything they receive as incomes to the factors of production, total expenditure equals total income.

That is:

Y = C + I + G + NX

The value of production equals income equals expenditure.


Figure 5.1 shows the circular flow of income and expenditure.

5.2 MEASURING U.S. GDP

The Expenditure Approach

Measures GDP by using data on consumption expenditure, investment, government expenditure on goods and services, and net exports.


Expenditures Not in GDP

Used Goods

Expenditure on used goods is not part of GDP because these goods were part of GDP in the period in which they were produced and during which time they were new goods.

Financial Assets

When households buy financial assets such as bonds and stocks, they are making loans, not buying goods and services.


The Income Approach

Measures GDP by summing the incomes that firms pay households for the factors of production they hire.

The U.S. National Income and Product Account divide incomes into two big categories:

• Wages• Interest, rent, and profits


Wages

Wages, called compensation of employees in the national accounts, is the payment for labor services.

It includes net wages and salaries plus fringe benefits paid by employers such health care insurance, social security contributions, and pension fund contributions.


Interest, Rent, and Profit

Interest, rent, and profit, called net operating surplus in the national account, is the sum of the incomes earned by capital, land, and entrepreneurship.

Interest is the income households receive on loans they make minus the interest they pay on their borrowing.

Rent includes payments for the use of land and other rented inputs.

Profit includes the profits of corporations and small businesses.


Net domestic product at factor cost

The sum of wages, interest, rent, and profit.

Net domestic product at factor cost is not GDP.

We need to make two adjustments to arrive at GDP:• One from factor cost to market prices• One from net product to gross product


From Factor Cost to Market Price

The expenditure approach values goods at market prices; the income approach values them at factor cost.

Indirect taxes (such as sales taxes) make market prices exceed factor cost.

Subsidies (payments by government to firms) make factor cost exceed market prices.

To convert the value at factor cost to the value at market prices, we must:

• Add indirect taxes and subtract subsidies


From Gross to Net

The expenditure approach measures gross product; the income approach measures net product.

Gross profit is a firm’s profit before subtracting the depreciation of capital.

Net profit is a firm’s profit after subtracting the depreciation of capital.

Depreciation is the decrease in the value of capital that results from its use and from obsolescence.


Income includes net profit, so the income approach gives a net measure.

Expenditure includes investment. Because some new capital is purchased to replace depreciated capital, the expenditure approach gives a gross measure.

To get gross domestic product from the income approach, we must add depreciation to total income.

After making these two adjustments the income approach almost gives the same estimate of GDP as the expenditure approach.



Statistical Discrepancy

The income approach and the expenditure approach do not deliver exactly the same estimate of GDP—there is a statistical discrepancy.

Statistical discrepancy

The discrepancy between the expenditure approach and income approach estimates of GDP, calculated as the GDP expenditure total minus the GDP income total.


GDP and Related Measure of Production and Income

Gross national product or GNP

The market value of all the final goods and services produced anywhere in the world in a given time period by the factors of production supplied by residents of the country.

U.S. GNP = U.S. GDP + Net factor income from abroad


Disposable Personal Income

Consumption expenditure is one of the largest components of aggregate expenditure and one of the main influences on it is disposable personal income.

Disposable personal income

Income received by households minus personal income taxes paid.


Figure 5.2 shows the relationship between GDP, GNP, and disposable personal income.

5.3 NOMINAL GDP VERSUS REAL GDP

Calculating Real GDP

Real GDP

The value of the final goods and services produced in a given year expressed in the prices of the base year.

Nominal GDP

The value of the final goods and services produced in a given year expressed in the prices of that same year.

The method of calculating real GDP changed in recent years, we describe the two methods.


Traditional Method of Calculating Real GDP

We’ll calculate real GDP in an economy that produces only apples and oranges. The current year is 2006, and the base year is 2000.

Because 2000 is the base year, real GDP and nominal GDP are the same in 2000.

Let’s use the traditional method to calculate real GDP in 2000 and 2006.


GDP Data for 2000:

To calculate real GDP in 2000, sum the values of apples and oranges produced in 2000 using prices in 2000.

Value of apples = 60 apples x $0.50 = $30

Value of oranges = 80 oranges x $0.25 = $20

Nominal GDP in 2000 = $30 + $20 = $50


To calculate real GDP in 2006, sum the values of apples and oranges produced in 2006 using prices in 2000.



Real GDP in 2006 = $80 + $55 = $135

GDP Data for 2006:


Chained-Dollar Method of Calculating Real GDP

The chained-dollar method does not use the base-year prices.

The chained-dollar method uses the prices of current year and the preceding year.

We show the calculation in fives steps.


Step 1:Calculate the value of production in both 2005 and 2006 using the prices of 2005.

In 2005:



Nominal GDP in 2005 = $150 + $150 = $300


In 2006:



2006 Quantities at 2005 prices = $240 + $165 = $405


Using 2005 prices:• Value of production in 2005 is $300.• Value of production in 2006 is $405.

So using 2005 prices, the value of production increased by $105 or 35 percent in 2006.


Step 2:Calculate the value of production in both 2005 and 2006 using the prices of 2006.

In 2005:



2005 Quantities at 2006 Prices = $100 + $400 = $500


In 2006:



Nominal GDP in 2006 = $160 + $440 = $600


Using 2006 prices:• Value of production in 2005 is $500.• Value of production in 2006 is $600.

So using 2006 prices, the value of production increased by $100 or 20 percent in 2006.


Step 3: Calculate the average of these increases in production:

• 35 percent with 2005 prices• 20 percent with 2006 prices

The average of 35 percent and 20 percent is 27.5 percent—our estimate of the real GDP growth rate between 2005 and 2006.

Table 5.6(a) summarizes this calculation.



Step 4

Repeat the calculations for each year going back to the base year, so we have an estimate of the real GDP growth rate from the base year of 2000.

Step 5

Starting from real GDP (nominal GDP) in the base year use the real GDP growth rates to calculate real GDP each through to 2006.

Table 5.6(b) this calculation.



Calculating the GDP Deflator

GDP deflator

An average of current prices expressed as a percentage of base-year prices.

GDP deflator measure the price level.

GDP deflator = (Nominal GDP Real GDP) 100.


We calculated the in 2006:

Nominal GDP = $600 and real GDP = $145

GDP deflator = (Nominal GDP ÷ Real GDP) x 100

So in 2006:

GDP deflator = ($600 ÷ $145) x 100 = 414.

5.4 THE USE AND LIMITATIONS OF REAL GDP

We use estimates of real GDP for two main purposes:• To compare the standard of living over time• To compare the standard of living among countries

The Standard of Living Over Time

To compare living standards we calculate real GDP per person—real GDP divided by the population.

Table 5.8 shows two calculations



Long-Term Trend

Figure 5.3 shows the long-term trend in U.S. real GDP per person.

Real GDP per person doubled on the 33 years from 1965 to 1998.


Short-Term Fluctuations

Fluctuations in the pace of expansion of real GDP is called the business cycle.

The business cycle is a periodic irregular up-and down movement of total production and other measure of economic activity.

The four stages of a business cycle are expansion, peak, recession, and trough.


The shaded periods show the recessions– periods of falling production that lasts for at least six months.


Standard of Living Across Countries

To compare living standards across countries, we must convert real GDP into a common currency and common set of prices, called purchasing power parity.

Goods and Services Omitted from GDP• Household production• Underground production• Leisure time• Environment quality


Household Production• Real GDP omits household production, it

underestimates the value of the production of many people, most of them women.

Underground Production• Hidden from government to avoid taxes and

regulations or illegal. • Because underground economic activity is

unreported, it is omitted from GDP.


Leisure Time• Our working time is valued as part of GDP, but our

leisure time is not.

Environment Quality• Pollution is not subtracted from GDP. • We do not count the deteriorating atmosphere as a

negative part of GDP. • If our standard of living is adversely affected by

pollution, our GDP measure does not show this fact.


Other Influences on the Standard of Living

Health and Life Expectancy• Good health and a long life do not show up directly

in real GDP.

Political Freedom and Social Justice• A country might have a very large real GDP per

person but have limited political freedom and social justice.

• A lower standard of living than one that had the same amount of real GDP but in which everyone enjoyed political freedom.

GDP in YOUR LifeAs you listen to the news, look for references to GDP. How is GDP used in daily life?

Using U.S.GDP person, how does your income compare to the average income?

How do you think your standard of living compares with that of a student in France or China?

Do you produce more market goods than nonmarket good? How can you value your nonmarket production?

Is the news about nominal GDP or real GDP? Is the term used correctly?

Is your production counted in the nation’s output?

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PART 2 MONITORING THE MACROECONOMY GDP and the Standard of Living CHAPTER 5