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© 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster

21

Gross Domestic ProductFinal Goods and Services

Exclusion of Used Goods and PaperTransactions

Exclusion of Output Produced Abroad byDomestically Owned Factors ofProduction

Calculating GDPThe Expenditure ApproachThe Income Approach

Nominal versus Real GDPCalculating Real GDPCalculating the GDP DeflatorThe Problems of Fixed Weights

Limitations of the GDP ConceptGDP and Social WelfareThe Underground Economy

Gross National Income per Capita

CHAPTER OUTLINE

Measuring NationalOutput and

NationalIncome

PART IV CONCEPTS AND PROBLEMSIN MACROECONOMICS

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Gross Domestic Product

gross domestic product (GDP) The total market value of all final goods and services produced within a given period by factors of production located within a country.

GDP is the total market value of a country’s output. It is the market value of all final goods and services produced within a given period of time by factors of production located within a country.

Turkey’s GDP in 2009 was 615.3 billion US$ and the GDP of Northern Cyprus was 3.6 billion US$.

GDP is one of the key parameters that is used to evaluate the success or failure of an economy.

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final goods and services Goods and services produced for final use.

Final Goods and Services

intermediate goods Goods that are produced by one firm for use in further processing by another firm.Ex: tires sold to automobile manufacturers are intermediate goods.

Why are intermediate goods not counted in GDP? Suppose that Fiat pays 300$ to Pirelli for tires. Fiat uses this tires to assemble a car which it sells for 25000$. The value of the car is 25000$ not (25000+300)$. The final price already reflects the value of all its components.To count in GDP both the value of tires sold to Fiat and the value of the cars sold to consumers would result in double counting.

Another way of avoiding double counting is counting only the value added to a product by each firm in its production process.value added The difference between the value of goods as they leave a stage of production and the cost of the goods as they entered that stage.

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Final Goods and Services

In calculating GDP, we can sum up the value added at each stage of production or we can take the value of final sales. We do not use the value of total sales in an economy to measure how much output has been produced.

TABLE 21.1 Value Added in the Production of a Liter of Gasoline (Hypothetical Numbers)

Stage Of Production Value Of Sales Value Added

(1) Oil drilling $3.00 $3.00

(2) Refining 3.30 0.30

(3) Shipping 3.60 0.30

(4) Retail sale 4.00 0.40

Total value added $4.00

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Exclusion of Used Goods and Paper Transactions

GDP is concerned only with new, or current, production. Old output is not counted in current GDP because it was already counted when it was produced.

Ex: If you buy a used car, the transaction is not counted in GDP because no new production has taken place.Similarly, a house is counted in GDP only at the time it is built not at each time it is resold.

GDP does not count transactions in which money or goods changes hands but in which no new goods and services are produced.

Sales of stocks and bonds are not counted in GDP as they are exchanges of ownerships of assets and do not correspond to current production.

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Exclusion of Output Produced Abroad by Domestically Owned Factors of Production

GDP is the value of output produced by factors of production located within a country.

The three basic factors of production are land, labor and capital. The output produced by citizens of a country abroad, is not counted in that country’s GDP.

Profit earned abroad by companies of a country are not counted in that country’s GDP:

Output produced by foreigners working for ex. in Germany is counted in Germany’s GDP as the output is produced in Germany.

Also profits earned in for ex. Turkey by foreign owned companies are counted in Turkey’s GDP.

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Gross National Product

7 of 35

gross national product (GNP) The total market value of all final goods and

services produced within a given period by factors of production owned by a

country’s citizens, regardless of where the output is produced.

Generally, the difference between GDP and GNP is small.

Sometimes the distinction between GDPand GNP can be tricky:

Example: Consider the Honda plant in Ohio. The plant is owned by a Japanese

firm, but most of the workers are US workers. Although all the output is included

in US GDP, only part of it is included in US GNP. The wages paid to US citizens

are part of US GNP but the profits from the firm are not. They are counted in

Japanese GNP.

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Calculating GDP

expenditure approach A method of computing GDP that measures the total amount spent on all final goods and services during a given period.

income approach A method of computing GDP that measures the income—wages, rents, interest, and profits—received by all factors of production in producing final goods and services.

These two approaches lead to the same value:Every payment (expenditure) by a buyer is at the same time a receipt (income) for the seller.

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Calculating GDP

The Expenditure Approach

There are four main categories of expenditure:

Personal consumption expenditures (C): household spending on consumer goods

Gross private domestic investment (I): spending by firms and households on new capital, that is, plant, equipment, inventory, and new residential structures

Government consumption and gross investment (G)

Net exports (X - M): net spending by the rest of the world, or exports (X) minus imports (M)

GDP = C + I + G + (X - M)

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Calculating GDP


TABLE 21.2 Components of U.S. GDP, 2007: The Expenditure Approach

Billions Of Dollars Percentage of GDP

Personal consumption expenditures (C) 9,734.2 70.3

Durable goods 1,078.2 7.8Nondurable goods 2,833.2 20.5Services 5,822.8 42.1

Gross private domestic investment (l) 2,125.4 15.4Nonresidential 1,481.8 10.7Residential 640.7 4.6Change in business inventories 2.9 0.0

Government consumption and gross investment (G)

2,689.8 19.4

Federal 976.0 7.1State and local 1,713.8 12.4

Net exports (X – M) 708.0 5.1Exports (X) 1,643.0 11.9

Imports (M) 2,351.0 17.0Gross domestic product 13,841.3 100.0

Note: Numbers may not add exactly because of rounding.Source: U.S. Department of Commerce, Bureau of Economic Analysis.

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Calculating GDP


Personal Consumption Expenditures (C)

personal consumption expenditures (C) Expenditures by consumers on goods and services. Three main categories of consumer expenditures:

durable goods Goods that last a relatively long time, such as cars and household appliances.

nondurable goods Goods that are used up fairlyquickly, such as food, gasoline and clothing.

services The things we buy that do not involve the production of physical things, such as legal and medical services, and education.

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Calculating GDP


Gross Private Domestic Investment (I)

gross private domestic investment (I) Totalinvestment in capital—that is, the purchase of new housing, plants, equipment, and inventory by the private (or nongovernment) sector. It has three components. nonresidential investment Expenditures by firms for machines, tools, plants, and so on. Because these are goods that firms buy for their own final use, they are part of “final sales” and counted in GDP.

residential investment Expenditures by households and firms on new houses and apartment buildings.

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Calculating GDP



change in business inventories The amount by which firms’ inventories change during a period. Inventories are the goods that firms produce now but intend to sell later.

GDP = Final sales + Change in business inventories

(Remember that GDP is not the market value of total final sales during a period, it is the market value of total production)

Change in Business Inventories

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Calculating GDP



depreciation The amount by which an asset’s value falls in a given period.Ex: A PC purchased by a business today may be expected to have a useful life of 4 years before becoming worn out or obsolete. Over that period the PC steadily depreciates.

Gross Investment versus Net Investment

gross investment The total value of all newly produced capital goods (plant, equipment, housing, and inventory) produced in a given period.

net investment Gross investment minus depreciation.It is a measure of how much the stock of capital changes during a period.

capitalend of period = capitalbeginning of period + net investment

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Calculating GDP


Government Consumption and Gross Investment (G)

government consumption and gross investment (G) Expenditures by federal, state, and local governments for final goods (school buildings, PCs) and services (school teachers’ and military salaries).

Government transfer payments (such as social security benefits, etc.) are not included in GDP because these transfers are not purchases of anything currently produced.

Because interest payments on the government debt are also counted as transfers, they are excluded form GDP.

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Calculating GDP


Net Exports (X - M)

net exports (X - M) The difference between exports (sales to foreigners of home produced goods and services) and imports (purchases of goods and services from abroad). The figure can be positive or negative.

• Why are net exports included in the definition of GDP?• C, I, and G include expenditures on goods produced at home and abroad. Therefore, C+I+G overstates domestic production because it contains expenditures on foreign-produced goods, that is, imports.• At the same time, C+I+G understates domestic production because some of what a nation produces is sold abroad and therefore is not included in C, I or G. That is, exports have to be added in.

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Calculating GDP

The Income Approach

national income The total income earned by the factors of production owned by a country’s citizens. It is the sum of 8 items.

TABLE 21.3 National Income of US, 2007Billions of

DollarsPercentage of

National Income

National Income 12,221.1 100.0Compensation of employees 7,874.2 64.4Proprietors’ income 1,042.6 8.5Rental income 65.4 0.5Corporate profits 1,598.2 13.1Net interest 602.6 4.9

Indirect taxes minus subsidies 961.4 7.9Net business transfer payments 94.2 0.8Surplus of government enterprises 14.5 0.1

Source: See Table 6.2.

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Calculating GDP

The Income Approach

compensation of employees Includes wages, salaries, and various supplements—employer contributions to social insurance and pension funds, for example—paid to households by firms and by the government.

proprietors’ income The income of unincorporated businesses.

rental income The income received by property owners in the form of rent.

corporate profits The income of corporations.

net interest The interest paid by business.

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Calculating GDP

The Income Approach

indirect taxes minus subsidies Taxes such assales taxes, customs duties, and license fees less subsidies that the government pays for which it receives no goods or services in return.Thus, the value of indirect taxes minus subsidies is the net income received by governments.

net business transfer payments Net transferpayments by businesses to others.

surplus of government enterprises Income ofgovernment enterprises.

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Calculating GDP

The Income Approach

TABLE 21.4 GDP, GNP, NNP and National Income of US, 2007

Dollars(Billions)

GDP 13,841.3Plus: Receipts of factor income from the rest of the world + 817.5

Less: Payments of factor income to the rest of the world 721.8Equals: GNP 13,937.1

Less: Depreciation 1,686.6Equals: Net national product (NNP) 12,250.5

Less: Statistical discrepancy 29.4Equals: National income 12,221.1


Note that the national income is the income of the country’s citizens,

not the income of the residents of the country. So we first need to move

form GDP to GNP.

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Calculating GDP

The Income Approach

net national product (NNP) Gross national product minus depreciation; a nation’s total product minus what is required to maintain the value of its capital stock.

statistical discrepancy Data measurement error.

personal income The total income of households before they pay income taxes.

As the following table shows, almost all of national income is personal income.

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Calculating GDP

The Income Approach

TABLE 21.5 National Income, Personal Income, Disposable Personal Income, and Personal Saving of US, 2007

Dollars(Billions)

National income 12,221.1Less: Amount of national income not going to households 561.6

Equals: Personal income 11,659.5Less: Personal income taxes 1,482.5

Equals: Disposable personal income 10,177.0

Less: Personal consumption expenditures 9,734.2 Personal interest payments 262.8 Transfer payments made by households 137.1

Equals: Personal saving 42.9Personal saving as a percentage of disposable personal income: 0.4%


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Calculating GDP

The Income Approach

disposable personal income or after-tax income Personal income minus personal income taxes. The amount that households have to spend or save.As it can be seen on the previous table there are three categories of spending: (1) personal consumption expenditures, (2) personal interest payments, (3) transfer payments made by households

personal saving The amount of disposable income that is left after total personal spending in a given period.

personal saving rate The percentage of disposable personal income that is saved. If the personal saving rate is low, households are spending a large amount relative to their incomes; if it is high, households are spending cautiously.

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Problem 1

In a simple economy suppose that all income is either compensation of employees or profits. Suppose also there are no indirect taxes. Calculate GDP from the following set of numbers. Show that the expenditure approach and the income approach add up to the same number.

Consumption 5000

Investment 1000

Depreciation 600

Profits 900

Exports 500

Compensation of Employees 5300

Government purchases 1000

Direct taxes 800

Saving 1100

Imports 700

24 of 35

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Nominal versus Real GDP

nominal GDP Gross domestic product measured in current prices.

In most applications in macroeconomics, however, nominal GDP is not what we are after.Ex: an economy produces just pizza. It produces 100 units in year 1 and 2. Price in year 1 is 1 and in year 2 is 1.1. Although production does not grow the GDP increases.

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Calculating Real GDP

TABLE 21.6 A Three-Good Economy

(1) (2) (3) (4) (5) (6) (7) (8)

GDP in GDP in GDP in GDP inYear 1 Year 2 Year 1 Year 2

in in in inProduction Price Per Unit Year 1 Year 1 Year 2 Year 2

Year 1 Year 2 Year 1 Year 2 Prices Prices Prices PricesQ1 Q2 P1 P2 P1 x Q1 P1 x Q2 P2 x Q1 P2 X Q2

Good A 6 11 $0.50 $0.40 $3.00 $5.50 $2.40 $4.40

Good B 7 4 0.30 1.00 2.10 1.20 7.00 4.00

Good C 10 12 0.70 0.90 7.00 8.40 9.00 10.80

Total $12.10 $15.10 $18.40 $19.20

Nominal GDPin year 1

NominalGDP

in year 2

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base year The year chosen for the weights in a fixed-weight procedure.

fixed-weight procedure A procedure that uses weights from a given base year.

weight The importance attached to an item within a group of items.

If we use the fixed-weight procedure and year 1 as the base year column 5 gives us the real GDP in year 1 and column 6 gives as the real GDP in year 2. Thus, the real GDP has grown 24.8%.If we use year 2 as the base year the GDP growth is 4.3%.

Nominal GDP adjusted for price changes is called real GDP.We will see two methods to calculate the real GDP.

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New method (two changes): Take the geometric average between the two growth rates. The geometric average is the square of the product of the two numbers. In our case, the square of 24.8 *4.3 is 14.09.

When calculating the percentage change between years 1 and 2 use years 1 and 2 as base years, then use years 2 and 3 as the base years when computing the percentage changes between years 2 and 3, and so on.

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Calculating the GDP Deflator

The GDP deflator is one measure of the overall price level.

Overall price increases can be sensitive to the choice of the base year. For this reason, using fixed-price weights to compute real GDP has some problems.

Ex. Table 21.6.Let’s use year 1 as the base year. Thus, we use year 1’s quantities as weight. Then, the bundle price in year 1 is 12.10 (column 5) and the bundle price in year 2 is 18.40 (column 7). Thus, the bundle price has increased 52.1%.If we use year 2 as the base year, then the bundle price in year 1 is 15.10 (column 6) and in year 2 is 19.20 (column 8). The increase is 27.2%.If we use the newer method (taking the geometric mean of the two numbers) the increase would be 39.1%

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Exercise 1: If nominal GDP is $8 trillion and real GDP is $6 trillion, the GDP deflator is…

Exercise 2:

The GDP deflator in year 2 is 110 using year 1 as a base year. This means that, on average, the price of goods and services is A) 110% higher in year 2 than in year 1. B) 10% higher in year 2 than in year 1. C) 5% higher in year 1 than in year 2.

D) 10% higher in year 1 than in year 2.

Exercise 3:

The GDP deflator in year 2 is 110 and the GDP deflator in year 3 is 118. The rate of inflation between years 2 and 3 is …

Exercise 4:

Is the following statement true or false? “If in the same period output doubles and the price level remains the same, nominal GDP doubles.”

30 of 35

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The Problems of Fixed Weights

The use of fixed-price weights to estimate real GDP leads to problems because it ignores:

• Structural changes in the economy.

• Supply shifts, which cause large decreases in price and large increases in quantity supplied or the other way around.

• The substitution effect of price increases.

• There is no “right” way of computing real GDP.

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Limitations of the GDP Concept

GDP and Social WelfareSociety is better off when crime decreases; however, a decrease in crime is not reflected in GDP.

An increase in leisure is an increase in social welfare, but not counted in GDP.

Most nonmarket and domestic activities, such as housework and child care, are not counted in GDP even though they amount to real production.

GDP has nothing to say about the distribution of output among the individuals of the society. It does not distinguish for example, between the case in which most output goes to a few people and the case in which output is evenly distributed among all people.

We cannot use it to measure the effects of redistributive policies. (policies that take income from some people and give it to others)

It is neutral about the type of goods produced. Ex: guns vs. medicines

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The Underground Economy

underground economy The part of the economy in which transactions take place and in which income is generated that is unreported and therefore not counted in GDP.

Tax evasion is usually thought to be the major incentive for people to participate in the underground economy.

Estimates for Switzerland’s underground economy range from 3 to 5% and estimates for Italy range from 10 to 35%.

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gross national income (GNI) GNP converted into dollars using an average of currency exchange rates over several years adjusted for rates of inflation.

GNI is used to be able to make better comparisons between countries.

Gross national income per capita is GNI divided by population.

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FIGURE 21.1 Per Capita Gross National Income for Selected Countries, 2006

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base yearchange in business inventoriescompensation of employeescorporate profitscurrent dollarsdepreciationdisposable personal income, or after-tax incomedurable goodsexpenditure approachfinal goods and servicesfixed-weight proceduregovernment consumption and gross investment (G)gross domestic product (GDP)gross investmentgross national income (GNI)gross national product (GNP) gross private domestic investment (I)income approachindirect taxes minus subsidiesintermediate goodsnational incomenational income and product accountsnet business transfer paymentsnet exports (EX - IM)

net interestnet investmentnet national product (NNP)nominal GDPnondurable goodsnonresidential investmentpersonal consumption expenditures

(C)personal incomepersonal savingpersonal saving rateproprietors’ incomerental incomeresidential investmentservicesstatistical discrepancysurplus of government enterprisesunderground economyvalue addedweightExpenditure approach to GDP: GDP =

C + I + G + (EX - IM)GDP = Final sales - Change in

business inventoriesNet investment = Capital end of period

- Capital beginning of period

REVIEW TERMS AND CONCEPTS

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Exercise

Use the table above to answer the following questions:

1.Personal consumption expenditures in billions of dollars are ….$

2.The value for gross private domestic investment in billions of dollars is …. $

3.The value for net exports in billions of dollars is ….$

4.The value of government spending in billions of dollars is …$

5.value for gross domestic product in billions of dollars is …$

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Exercise 1:

If a Swiss dealer sells a newly produced Swiss watch on eBay to a

U.S. customer, the value of the watch is

A) counted in U.S. GDP.

B) counted in U.S. GDP and Swiss GDP.

C) counted in Swiss GDP.

D) not counted in either U.S. or Swiss GDP.

Exercise 2: True or False?

a.If nominal GDP rises, then so must real GDP.

b.If real GDP rises, then so must nominal GDP.

c.Disposable personal income is personal income minus personal taxes

d.All economic activities in the economy are included in the GDP.

Exercise 3:

A company produced 8 dishwasher machines in 2005. The company sold 6

in 2005 and added 2 to its inventories. The market value of the dishwasher

machines in 2005 was $200 per unit. What is the value of this company's

output that will be included in the 2005 GDP?

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© 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 39 of 35

Exercise 4:

Consider an economy that produces only three goods. In the year 2007 the prices of each good where p1=5, p2=10 and p3=15 and the quantities produced where q1=20, q2=25 and q3=10. In 2008, the prices increased to p1=6, p2=12 and p3=16 respectively. On the other hand, the production increased to q1=21, q2=27 and q3=11. How much did the economy grow?

Ch21

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