Chapter 24: Measuring Domestic Output & National Income

Chapter 24: Measuring Domestic Output & National Income

Assessing the Economy’s Performance

National Income Accounting measures the economy’s overall performance. The Bureau of Economic Analysis (BEA) compiles the National Income and Product Accounts (NIPA) for the U.S. economy.

These accounts enable economists and policymakers to do the following.

• Assess the health of the economy by comparing production levels from year to year.

• Track the long run course of the economy to check its progress.

• Formulate policies to maintain and improve that performance.

Gross Domestic Product(GDP) & Gross National Product(GNP)

Gross National Product: total output produced by land, labor, capital and entrepreneurship supplied by Americans, whether in the U.S. or abroad. We stopped using GNP in 1992. We now use GDP.

Gross Domestic Product: total output of goods and services produced within the nations borders of the U.S. whether American or foreign supplied resources.

1.Monetary Measure- GDP is measure in dollars and cents.

2.Avoiding Multiple Counting- To measure GDP accurately goods and services must be counted once and only once. Because most products go through a series of stages before they reach the market, some of their components are bought and sold many times. To avoid this double counting, GDP includes only the market value of final goods and ignores intermediate goods.

Intermediate goods are products that are purchased for resale or further processing.

Intermediate goods Final goods

• crude oil gas for personal use

• steel beams high rise apartments

• buttons, zippers pair of Levi’s jeans

The value of final goods already includes the value of the intermediate goods that were used in producing them. We can avoid multiple counting by measuring and adding only the value added at each stage of the production process.

Value added- is the market value of the firm’s output less the value of inputs the firm bought from others. Below is an example.

Stage of Production $ value of sales Value added

1. fertilizer and seed $0.01 $0.01

2. growing wheat $0.02 $0.01

3. flour milling $0.04 $0.02

4. donut baking $0.10 $0.06

5. donut retailing $0.15 $0.05

6. Total $0.32 $0.15

3.GDP Excludes Nonproduction Transactions- because no final good or service is created.

a) Financial transactions

§ Public transfer payments- social security and welfare.

§ Private transfer payments- gifts of money from relatives.

§ Security transactions- buying and selling of stocks and bonds. This is an exchange of paper assets.

b) Secondhand sales- involve no current production. These goods

have already been counted in a previous years GDP.

4. Non-market transactions- work done for which no money is paid such as mowing your own yard, house cleaning or other home improvements.

There are 2 approaches to looking at GDP like 2 sides of a coin. Think back to the circular flow model. The money that is spent in the product market becomes income to those in the resource market who contributed to the production of that output.

Expenditure Approach

1.Personal Consumption Expenditures (C)- This includes spending by households on all goods and services and represents about 70% of GDP.

• Durable goods- are tangible goods that have an expected life of 3 years or more.

• Nondurable goods- include goods with less than 3 years of expected life.

• Services- represent work that someone does for you and is intangible.

2.Gross Private Domestic Investment (Ig)- are purchases made by businesses and include the following items.

• All purchases of machinery, equipment and tools.

• All construction, both residential and commercial.

• Changes in inventories.

Inventories can either increase or decrease over some period. Suppose inventory increased by $10 billion between 12/31/2008 and 12/31/2009. This means the 2009 economy produced $10 billion more output than people purchased. We need to count all output produced in 2009 as part of that year’s GDP, even though some of it remained unsold at the end of the year. Conversely, suppose inventories decreased by $10 billion in 2009. This means the economy sold $10 billion more in 2009 than it produced that year. It did this by selling goods produced in prior years so we must consider the $10 billion as a decline in inventory and subtract it from total investment that year.

Gross Private Domestic Investment (Ig)- includes production of all investment goods, those which replace machinery, equipment, and buildings used up in the current years production plus any net additions to the economy’s stock of capital.

Net Private Domestic Investment (In)- refers only to the added investment in the current year.

Net investment(In) = Ig − depreciation

ü Growing economy: If gross investment(Ig) > depreciation

ü Static economy: If gross investment(Ig) = depreciation

ü Declining economy: If gross investment(Ig) < depreciation

3.Government Purchases (G)- this includes spending for goods and services that government consumes in providing public services and spending for publicly owned capital such as schools and highways at the federal, state, and local level. Government spending does not include transfer payments because no good or service is produced in return for the money received.

4.Net Exports (Xn)- We must add in the value of goods and services produced within the borders of the U.S. and subtract out the value of imports, or goods produced abroad and sold in the U.S. Therefore

Xn =X - M.

X- exports

M-imports

X > M → trade surplus

X < M → trade deficit

GDP = C + Ig + G + Xn

Income Approach

Now we focus on GDP by looking at how the spending we just examined is divided among the various people who had a part in the production of that output. Remember, that one person’s spending is another person’s income.

1.Compensation of Employees (W)- This is the share of income that goes to pay wages and salaries by business and government to their workers. It also includes wage and salary supplements for social insurance and a variety of private pension, health, and welfare funds for workers.

Here’s a breakdown of the costs considered by few but the boss. Let’s assume a base annual salary of $70,000.

· Social Security Tax: $4340, 6.2%

· Medicare Tax: $1015, 1.45%

· State Unemployment Insurance: $478, 2.8%

· Health Care Insurance Benefits: $10119

· 401(k) Benefits: $1750

2.Rent (R)- consists of the income received by the households and businesses that supply property resources. This could include the monthly payments tenants make to landlords and lease payments corporations pay for the use of office space.

3.Interest (I)- consists of the money paid by private businesses to the suppliers of loans used to purchase capital goods. It also includes interest households receive on savings deposits, certificates of deposit, and corporate bonds.

4.Proprietors’ Income (P)- this represents “profits” broken down into 2 accounts. This one consists of the net income of sole proprietorships, partnerships, and other unincorporated businesses.

5.Corporate Profits (CP)- are the earnings of corporations and are broken down into 3 categories.

· Corporate income taxes- are levied on corporations by the government.

• Dividends- are part of after tax profits that are paid out to the stockholders, who own the company.

• Undistributed corporate profits- also called retained earnings. These are the after tax profits which are put back into the corporation to finance future growth.

6.Taxes on Production & Imports (TOP)- includes general sales taxes, excise taxes, business property taxes, license fees, and custom duties.

These first 6 categories give us National Income (NI) which is income earned by American supplied resources, plus government revenue from taxes on production and imports.

There are now 3 non-income adjustments which must be accounted for before we get to GDP.

7.Net foreign Factor Income (NFFI)- National income includes the total income of Americans, whether here or abroad. But GDP is a measure of domestic output so in moving from national income to GDP, we must take out the income Americans earned abroad and add in the income that foreigners gained by supplying resources in the U.S.

Example: In 2009, NFFI was $105 billion, meaning that American owned resources earned $105 billion more in other countries than foreign resources earned in the U.S. Because this $105 billion is earnings of Americans, it is included in national income. But since it is not part of U.S. domestic income it reflects earnings from output produced in other nations and therefore must be subtracted.

8.Statistical Discrepancy- this is simply an adjustment to make the income approach match the expenditure approach.

9.Consumption of Fixed Capital- this is also referred to as depreciation or capital consumption allowance. This is the allowance for capital goods that have been consumed in producing the year’s GDP. It is the portion of GDP that is set aside to pay for the ultimate replacement of those capital goods.

GDP using the income approach includes the following;

GDP = Wages + Rent + Interest + Prop. Income + Corp. Profits + TOP − NFFI + statistical Discrepancy + Depreciation

Other National Income Accounts

We will now make several adjustments to GDP to derive other national income accounts by working backwards.

1.Net Domestic Product (NDP)- measures the total annual output that the economy can consume without impairing its capacity to produce in future years.

GDP = C + In + G + Xn

NDP = GDP − depreciation

2.National Income (NI)- measures income earned by American owned resources, whether here or abroad. It also includes taxes on production and imports.

NI = NDP − statistical disc + NFFI

3.Personal Income (PI)- represents income received, whether earned or unearned in the current period so we must recognize that some income is received, but not earned and some income is earned, but not received. We have to subtract income that was earned but not received and then add income that was received, but not earned.

PI = NI – Top − Social security contrib. − corp. inc. taxes − ret. Earnings + transfer payments

4.Disposable Income (DI)- is income you can spend or save so we must take out the personal taxes such as personal income taxes, property taxes, and inheritance taxes.

DI = PI − personal taxes (or) DI = C + S

See table 24.4 in the textbook for an example of these adjustments.

Nominal vs. Real GDP

How can we compare the market values of GDP from year to year if the value of money itself changes in response to inflation or deflation? After all, we determine the value of GDP by multiplying total output (Q) by market prices. It is the quantity of goods and services that get produced and distributed to households that affects our standard of living, not the price of those goods and services.

The way around this problem is to deflate GDP when prices rise and to inflate GDP when prices fall.

Nominal GDP: GDP based on the prices that existed when the output was produced is called unadjusted, current or nominal GDP. This is simply GDP measured in today’s dollars.

Real GDP: GDP that has been adjusted to reflect price level changes is called adjusted, or real GDP. This gives us the value of total output in various years as if the prices of the products had been constant from a reference or base year throughout all the years being considered.

Price Index- is a measure of the price of a specified collection of goods and services, called a market basket, in a given year divided by the price of an identical or highly similar market basket in a reference year.

PI = price of mb in given year ∕ price of mb in base year x 100

Base Year- is a point of reference or base period that allows us to compare various years. By convention, the price ratio is multiplied by 100 to facilitate computation. In the following example use year 1 as the base year.

Year output Price per unit price index nom. GDP real GDP

1 5 $10

2 7 $20

3 8 $25

4 10 $30

5 11 $28

Real GDP = nominal GDP ÷ Price index (in hundredths)

Price index = nominal GDP ÷ real GDP

Look at table 24.7 in the text and see if you can fill in the blanks.

Shortcomings of GDP

Real GDP is a reasonably accurate and useful measure of how well or how poorly the economy is performing, but it has several shortcomings as a measure of both total output and well-being.

1.Nonmarket Activities- Certain productive activities do not take place in any market such as services of stay-at-home parents and the labor of carpenters who repair their own homes. These activities never show up in GDP because no money changes hands. GDP understates a nation’s total output because it does not count unpaid work.

2.Leisure- The average workweek in the U.S. has declined from about 53 hours to about 40 + hours. This increase in leisure time has had a positive effect on overall well-being, but it is not counted in the GDP numbers.

3.Improved Product Quality- Because GDP is a quantitative measure rather than a qualitative measure, it fails to capture the full value of improvements in product quality. It also understates well-being and is not reflected in the GDP numbers.

4.The Underground Economy- represents illegal activity such as gambling, prostitution, and the drug trade, but most participants are engaged in legal activity but choose not to report their income to the IRS for tax purposes.

5.GDP and the Environment- The growth of GDP is accompanied by some negative side-effects including dirty air, polluted water, toxic waste and congestion. The social costs of the negative by-products reduce our economic well-being and since these costs are not deducted from GDP, it overstates our national well-being.

6.Composition & Distribution of Output- GDP doesn’t tell us whether the current mix of goods and services is enriching or potentially detrimental to society. Moreover, GDP reveals nothing about the way output is distributed.

VS.

7.Noneconomic Sources of Well-being- Some things can make society better off without necessarily raising GDP. Examples include a reduction in crime and violence, peaceful relations with other nations, greater civility toward one another and a reduction in drug and alcohol abuse.