Chapter 18- Measuring the Income, Production, and Spending of Nations
Today, there are two revisions after the initial real GDP (Y) (also called real output or output of production) report is released every three months. This example illustrates the immense complexity of making the appropriate fiscal (government spending, taxing, and transfer payments) and monetary policy (money supply and controlling inflation) decisions in an economy. We will examine how economists measure our nation’s real GDP.
Remember that real GDP (Y) is a measure of the value of all the final goods and services newly produced within a country’s borders during some period of time, taking into account changes in the price level (inflation or deflation). One of the greatest problems of measuring GDP in centrally planned economies, such as China and the former Soviet Union, is that the prices of goods and services are set by the government, not the market. Without markets determining prices, measuring real GDP is difficult.
How unemployment, inflation, and interest rates impact in real GDP/AD
*an ↑ in aggregate demand (AD)/real GDP (Y) the price level
(PL)/inflation ↑ aggregate supply (AS) ↑ unemployment ↓ and
eventually interest rates ↑ in order to ↓ aggregate demand (AD)/realGDP (Y)
*a ↓ in aggregate demand (AD)/real GDP (Y) the price level
(PL)/inflation ↓ aggregate supply (AS) ↓ unemployment ↑ and
eventually interest rates ↓ in order to ↑ aggregate demand (AD)/realGDP (Y)
When measuring GDP, it is important to not count the same item more than once. Consider bicycle tires. When you buy a $150 bicycle, the tires are considered part of the bicycle. Supposed the tires are worth $20. It would be a mistake to count both the $20 value of the tires and the $150 value of the bicycle. That would count the tires twice, which is called double counting.When a tire is part of a new bicycle, it is an example of an intermediate good. Intermediate goods are part of final goods, which by definition are goods that undergo no further processing. Only final goods are part of the GDP. The tires would not be counted as part of GDP until the bike is sold. But, if someone were to purchase a new tire or new seat, each would be considered a final good and counted.
Economists measure GDP in three ways. The first way measures the total income that is earned by all the workers and businesses that produce American goods and services. This is the income approach (aggregate (total) income). The second way measures the total of all the goods and services as they are produced. This is the production approach (aggregate production.) But by far the most used and important way measures the total amount that people spend on goods and services made in America. This is the spending approach(aggregate spending/expenditures). All of the approaches are part of an open economy. An open economy is an economy in which there are economic activities between the domestic community and outside. People and businesses trade goods and services with other people and businesses in the international community, and funds flow across the border.
The income that people are earning in a country provides a measure of GDP. Suppose you start a new driver’s education company, sales in the first year are $50,000, and you have two driving teachers earning $20,000 each. Your profit equals $10,000. But, if you add the total amount of income earned in the production of your driver’s education service (the amount earned by the two teachers plus the profits), you get $20,000 + $20,000 + $10,000, which equals $50,000, the true measure of output. In other words, the owner earned $10,000 and each driver earned $20,000, so the $50,000 is taken into account as income. Anything that decreases the gain of income among C, I, G, or X will ultimately decrease aggregate (total) income (AD), and vice versa.
Economists classify wages, salaries, and fringe benefits paid to workers as labor income, or payments to people for their labor.Wages refers to payments to workers paid by the hour and salaries refer to payments to workers paid by the month or year. A decrease in wages will cause an increase in real output (real GDP (Y)) in the short-run because firms will then have more money on hand; their costs have been cut.Fringe benefits refer to retirement, health, and other benefits paid by firms on behalf of workers.
Sticky wages occur when workers' earnings don't adjust quickly to changes in labor market conditions. Because workers' wages remain higher for longer than they should considering the contraction (decline) in the economy, the economy's recovery from a recession might take longer. Typically, when demand for a good drops, the price falls too. When sticky wages occur, the best way to raise GDP is to increase government spending (G). Wages also go up when aggregate supply (AS) is quickly shifted left (decreased), like during a natural disaster.
Economists classify business profits, rental payments, and interest payments as capital income. Profits include the profits of large corporations like GM or Exxon and also the income of small businesses and farms. Rental payments are income to people who own buildings and rent them out. Interest payments are income received from lending to business firms.
The second measure of GDP adds up the production of each firm or industry in the economy. In order to make this method work, we must avoid double counting. When we measure GDP by production, it is necessary to count only the value added by each manufacturer. Value added is the value of a firm’s production less the value of the intermediate goods used in the production. It is the value the firm adds to the intermediate inputs to get the final output. When we measure GDP by production, we count only the value added at each level of production of goods made in the U.S, regardless of where the goods are sold.
America uses the spending approach as our main way to measure GDP. The spending allocation model determines how GDP is allocated among the four major components of spending: consumption by consumers (C), business investment (I), government purchases (G), and net exports (X) (exports - imports). Because each share of spending must compete for the scarce resources in society, an increase in the share of one of the components will lead to a reduction in the share of at least one other component. By doing this, all four shares or components will always add up to 100% of GDP.
Y = C + I + G + X
where Y = GDP, C = consumption, I = business investment, G = government purchases, and X = net exports.
Interest rates are a key factor that both influence and are influenced by spending. This applies more to the long-run (LR- 4-5 years) than to the short-run (SR- up to one year out) because it takes time for consumers (C) and businesses (I) to completely respond to changes in interest rates (the proportion of a loan that is charged as interest to the borrower; it is either fixed or flexible, typically expressed as an annual percentage of the loan outstanding). What can determine how the shares of GDP are allocated amongst the four components? To answer this question, we need to consider the interest rate. Interest rates affect the three shares of spending by the private sector: consumption (C), business investment (I), and net exports (X). Government (G) purchases are part of the public sector and are not impacted by interest rates.
Especially in today's world, government surpluses and deficits have to also be considered. In the rare case of a government surplus, interest rates would go down because of the decreased lack of demand (D) of loanable funds in a country. The demand would decrease because of the surplus of money (more of something equals less value for each separately). C, I, and X would increase. In the almost typical case of a deficit, the amount of loanable funds in a country would be less and therefore more expensive. In the short-run (SR), the funds would be desired because of their value and need. C, I, and X would also decline.
Consumption (C) refers to the purchase of final goods and services by individuals. Government statisticians collect the data by surveying department stores, discount stores, car dealers, and other sellers, even if the goods were made in another country, to see how much consumers purchase each year. If consumer's wealth increases, so will consumption share of GDP. Consumption makes up about 2/3 of all GDP. The consumption share of GDP (Y) is the proportion of GDP that is used for consumption by individuals. For example, if consumption (C) = $6 trillion and GDP = $10 trillion, then the consumption share is C/Y = 60%.
A person's choice between consuming today and consuming tomorrow depends on a relative price (the price one day vs. another day), just like any other economic decision. This relative price is the price of consumption today relative to the price of consumption tomorrow. Changes in the interest rate will change the relative price. For instance, a higher interest rate today will raise the price of consumption (cost) today relative to that of consumption tomorrow. Why? If the interest rate is higher today, then any saving will deliver more funds in the future because of the interest earned from saving, which can then be used for future consumption (a larger home or more college education, for example). By spending today when interest rates are higher, you are losing what you might have gained by saving; your opportunity cost is higher.
When it comes down to it, you want to get the biggest bang for your buck. Higher interest rates give people more incentive to consume less and save for the future, whereas a lower interest rate gives people more incentive to consume today instead of saving for the future. We can conclude that consumption (C) is negatively related to the interest rate. When rates are high, we consume less, when low, we consume more. An increase in the interest rate or taxes leads to a decline in consumption and aggregate demand (AD). Less would be consumed relative to GDP at every higher interest rate because the cost of the sales tax would be at least partially passed along to the consumers. Conversely, a decrease in the interest rate and taxes on consumption would shift the consumption share line and AD to the right because consumption would increase since the price would be less.
Business investment (I)consists of new purchases of final goods by business firms. Included in investment are all the investments in human capital (which also increases workers' output productivity and wages), workers stock (value), capital goods (new machines), new factories, and other tools used to produce goods and services and to change their inventories, purchased in our country or not. Investment is sometimes called business fixed investment. If companies from anywhere build their goods in America then sell it here, it increases America's GDP. The more the investment, the more aggregate demand (AD) and GDP increase. If the investment (I) = $2 trillion and GDP = $10 trillion, then the investment share is I/Y = 20%. Sometimes the investment share is called the investment rate.
There is a negative relationship between the interest rate and investment (I) share. Remember, investment is used to communicate purchases by businesses and not to communicate putting away money in order to grow it, like in the stock market. Economists have observed that business investment is more sensitive to interest rates than consumption (C). Higher interest rates lead to less borrowing, fewer purchases, and fewer new factories built by firms. Higher interest rates also impact investment (I), including loans and house purchases.
When inventory investment is positive, inventories are rising, when inventories are negative, inventories are falling. Inventory investment is defined as the change in inventories, which are the goods on store shelves, on showroom floors, or in the warehouses that have not yet been sold or assembled into a final form for sale. They represent intermediate or final products that have not been sold during the time period that GDP is being calculated.
Depreciation is the amount by which factories and machines decrease in worth each year and need to be replaced.The difference between investment (the purchases of final goods by firms) and depreciation is called net investment, a measure of how much new investment there is each year after depreciation is subtracted. In 2001, net investment was $97 billion: $100 billioninvested minus $3 billion worth of depreciation. Sometimes the $100 billion of investment is called gross investment (the total amount invested by firms without taking into account any depreciation). As always though, educating their human capital is the most important investment for companies to make.
The third part of spending, government purchases (G), is the spending or expenditures by federal, state, and local governments on new goods and services, such as the military. At the state and local level, education dominates purchases. Not all government outlays are included in government purchases. For example, welfare payments are a transfer payment of income and not a government purchase and thus excluded from GDP. During a recession, government spending is critical as it leads to an increase in the money supply. This leads to decreased unemployment and increased real GDP (Y), but ultimately inflation. At the same time, a decrease of taxes frees up money in the economy to be spent.
Net exports (X) is the difference between exports and imports. Three other terms for net exports are trade balance, balance of payments, and current account. Net exports can be either favorable/positive (if exports increase) or unfavorable/negative (if exports decrease). The U.S. has had a negative trade balance in modern times. If net exports are positive (more exports than imports), there is a trade surplus, if negative (less exports than imports), a trade deficit. The more a country exports the better the GDP; the more it imports the lower the GDP. X/Y is the net exports share.
The value of a country's currency has a huge impact on its trade balance. If it's economy is doing well and its money is highly valued, goods will be more expensive to purchase in that country, like America, and exports will decrease. Since America's currency is currently strong, we can afford to import more from other countries than they do from us. Importing more than we export actually hurts America's GDP though; it decreases the amount of goods purchased in the U.S. and lowers our AD/GDP. When the amount of exports decreases, the most effective fiscal policy (Congress) is to transfer money to those who need it (government transfer payments) in order to help those negatively impacted by the decrease.
The U.S. sells cars to Mexico. Mexico buys tractors from Canada. Japan buys fireworks from Mexico. This is the foreign exchange market, or FOREX (the global market for the trading of currencies from different countries). For all these transactions, there are different national currencies, and each country must be paid in their own currency. The buyer (importer) must exchangetheir currency for that of the seller (exporter). Changes in preferences/tastes, relative incomes between countries, relative price levels between countries, and changes in relative interest rates can impact foreign exchange. On the foreign exchange market, the dollar exchange rate against the Russian ruble was weak in Feb., 2011, about 28.88 rubles per dollar: 1 to 28.88 ($ to ). As of Jan., 2018, the dollar is much stronger: $1 to 56.71 . In 2011, when the exchange rate between the dollar and the ruble was 28.88 rubles per dollar, you could buy a McDonald's Big Mac in Russia for 115.52 rubles, or $4. This was much more expensive in dollars than it is in 2018. The current exchange rate is 56.71 rubles per dollar and the same Big Mac costs $2.05. From 2011 to 2018, the dollar appreciated and the ruble depreciated.
A higher dollar exchange rate (stronger value/purchasing power of U.S. currency compared to another country's currency) brought about by a higher interest rate would tend to make goods imported into the U.S. more attractive because it makes foreign goods cheaper with the stronger U.S. dollar. If the Federal Reserve (monetary policy) sells bonds to banks and thus the nominal interest rate rises while other countries' central banks maintain or even lower their interest rates, then the return on savings is more attractive in the U.S. than in other countries. Given this higher rate in the U.S., international capital (money) will flow from other countries into the U.S. to earn higher interest rates, resulting in the dollar's appreciation (increase in value) and an increase in aggregate demand (AD). A loss of funds from a country, like when interest rates go down, depreciates (decreases) a country's currency value and decreases its AD.
In a country, a higher exchange rate (either fixed or flexible/floating, the value of one currency for the purpose of conversion to another) will increase the quantity demanded (Qd) of imported goods. This is because in the country where there are higher exchange rates, their money is valued more. The people in that country will buy less of their own country's goods and will then buy more imports. The higher the exchange rate, the better the bargain for the buyer. A fixed or pegged rate is a country's exchange rate fixed completely by its own country. A country fixes its exchange rate by keeping a large supply of their money by buying other currencies. A flexible or floating rate is an exchange rate between countries that changes depending on the supply (S) and demand (D) in the international community. Some governments attempt to depreciate their country’s currency in order to promote exports.