ch05

Economics

THIRD EDITION

By John B. Taylor

Stanford University

Copyright © 2001 by Houghton

Mifflin Company. All rights reserved.

1

Chapter 18

(Macro 5)

Measuring the

Production, Income, and Spending of

Nations



2

Overview

This chapter introduces GDP and its components from the perspective of spending, income, and production. After a brief introduction to price indexes, nominal and real GDP are contrasted, and the limitations of GDP accounting are discussed. The chapter concludes with international comparisons of GDP and the role of exchange rates and purchasing power parity in making these comparisons.



3

Teaching Objectives

• 1. Define and introduce the three approaches to determining GDP.

2. Discuss the relationship among saving, investment, and net exports.

3. Distinguish between nominal and real GDP and the role of price indexes.

4. Provide an introductory discussion of international comparisons of GDP.



4

1. Measuring GDP

• It is most commonly used measure of economic activity.

• It indicates the dollar value of FINAL goods and services PRODUCED within the borders of the DOMESTIC economy during a period (quarter or year)

• Intermediate goods are excluded to avoid double counting.



5

How to measure GDP?

There are three approaches to the measurement of GDP:

• spending,

• income,

• and production.



6

Spending Approach

• The spending approach divides GDP into four areas: households (consumption), businesses (investment), government, and foreigners (net exports).



7

Consumption (C)

• Consumption reflects the spending by households or individuals for final goods and services. The numbers are given in

Table 18.2, and the percentage of GDP represented by consumption is given in

Figure 18.1.



8

Figure 18.1

(Macro 5)

Consumption as a Share of

GDP



9

Investment (I)

• Investment reflects the spending of businesses and includes fixed business investment, inventory investment, and residential investment. The numbers are given in Table 18.2, and the percentage of

GDP represented by consumption and investment is given in Figure 18.2.



10

Figure 18.2

(Macro 5)

Investment and

Consumption as a

Share of GDP



11

Government purchases (G)

• Government purchases of goods and services but not transfer payments make up over $1 trillion of

GDP. Transfer payments are excluded because they do not reflect current production. The numbers are given in Table 18.3, and the percentage of GDP represented by consumption, investment, and government purchases is given in

Figure 18.3.



12

Figure 18.3

(Macro 5)

Government

Purchases,

Investment, and

Consumption as a

Share of GDP



13

Net exports (X)

• Net exports (exports and imports), or the trade balance, is included to account for imported consumption and investment items and for items exported from the United

States that are not counted in the consumption, investment, or government spending parts of GDP.



14

Expression for GDP

•

The relation between GDP and its spending components is the familiar

Y = C + I + G + X equation.

•

What is the share of net exports, if the share of C, I, and G are 68, 18, 18 percent, respectively?



15

Figure 18.4

(Macro 5)

The Circular Flow of Income and Expenditure



16

The income approach

• The income approach divides GDP according to who receives the income from the spending flow. In addition to aggregate income, national income and personal income are also used as measures of income.



17

Labor, Capital Income and Depreciation

• Labor income includes wages, salary, and fringe benefits, as given in Table 18.3.

• Capital income (profits, rents, and interest payments) is also given in Table 18.3.

• Depreciation is included as a reduction in the flow of income to account for the wearing out of capital, allowing for a distinction between gross and net investment. Depreciation is used to get net

GDP.



18

Taxes and Foreign Income

• Indirect business taxes are taxes that are included in the selling price of the good or service and so are removed as a part of income flow from the production of GDP.

• Net income of foreigners balances out the net effect of income earned in the United States by citizens of other countries and income earned by

U.S. citizens abroad. The details are given in Table

20.3. Also included in this table is the statistical discrepancy between income and spending that occurs in data collection.



19

2. Saving, Investment, and Net Exports

• National saving is defined as income minus consumption minus government purchases, or S = Y - C G .

• In the absence of a change in net exports, for a country to increase its investment, it has to increase its saving: S = I + X .

• Saving varies over time for a variety of reasons, including the age composition of society.



20

Government Dis(saving)

• The government saves or dissaves, as do individuals, with a resulting budget surplus or deficit. When the government dissaves, households and businesses must save more to obtain the same level of national saving.



21

The production approach

• The production approach looks at GDP from the standpoint of value added by each input in the production process.

• The three approaches--spending, income, and production– (should) result in equivalent values for GDP.



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Figure 18.5 (Macro 5)

Value Added in Coffee: From Beans to Espresso



23

3. Real GDP and Nominal GDP

• Since GDP is the dollar value of goods and services measured in price units, as prices change,

GDP changes without any change in the underlying production, income, or spending of an economy. A method must be used to hold the effect of price increases constant, particularly when inflation is present to any degree.



24

Real GDP

• The adjustment of nominal GDP for the effects of changes in the price level, or inflation, results in real GDP. Real GDP then provides a basis of comparison of changes in production between points in time.



25

Computing real GDP growth rate

• The text illustrates how real GDP growth is computed between two years for two goods. First, growth is computed using prices of the first year.

Then, growth is computed using prices of the second year. An average of the two percentages is then computed in order to state the increase in real

GDP between the two years.

• Economists do a series of two-year corrections and chain them together to find the growth rate for any number of years and any number of goods.



26

Trends in GDP

• The behavior of nominal and real GDP is portrayed in Figure 18.6, which uses a base year of 1992.

• The difference between nominal and real

GDP in Figure 18.6 reflects inflation over the last 15 years. The basic relation is GDP deflator = nominal GDP/real GDP.



27


Real GDP versus Nominal GDP



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CPI is used as another tool compute inflation

• The CPI provides an alternative price index and an index based on a fixed quantity of consumption goods. The chain weighted price index is based on a changing quantity of goods and services and includes investment and government as well as consumption purchases. The GDP deflator and the

CPI are portrayed in Figure 18.7.



29


Comparison of Measures of Inflation



30

Stocks versus flow variables

• GDP, Income, and inflation rate are flow variables

• Unemployment, Wealth, and Savings are stock variables.



31

Distinguishing Between Stocks and Flows



32

4. Shortcomings of the GDP Measure

4a. Revisions in GDP occur periodically because of the unevenness of data collection. Also, changes in the base year occur at about 5-year intervals.

4b. Omissions from GDP occur because of difficulty in measurement or the absence of price information on the good or service.

4b1. Home production is not included because these activities are simply not reported. Market values of these activities are in most cases available but because no spending occurs, GDP tends to understate the value of production.



33

Shortcomings of the GDP Measure

4b.2 Leisure activity is similarly valuable, but no attempt is made to account for it in GDP.

4b.3 The underground economy is estimated to be about 10 percent of GDP in the United States and even larger in other countries. Because it is believed to be fairly constant over time, its consequences for growth are probably minor.

4b.4 As products improve, GDP should reflect the quality improvements. This has occurred in the case of some but not all goods and services.



34

Shortcomings of the GDP Measure

• 4c. It is important to understand that even a perfect measure of GDP, although essential to the well-being of individuals, is not a sole measure of other aspects of the well-being of a society.

• 4c.1 Although vital statistics have improved along with increases in real GDP per capita in the United States, there remain serious areas of concern that are to some extent related to the rise in real GDP. These include, for example, increases in the death rates from AIDS, suicide, and murder among young people.

• 4c.2 Similarly, although there have been improvements in environmental quality, and these improvements account for about $100 billion of GDP, the level of GDP is not itself an

35


5. International Comparisons of GDP

• 5a. In any attempt to compare GDP between countries, some account must be taken of differences in prices. Adjustment for GDP based on exchange rates makes some improvement in the comparison of GDP figures. However, if we wish to determine the value of GDP in another country, some information on the price differences of goods is needed.



36


• 5b. Purchasing power parity exchange rates attempt to adjust exchange rates for differences in the prices of goods across borders through the use of a ratio of price indexes. The exchange rate is adjusted to reflect this ratio.



37


• 5c. Once this adjustment is made, international rankings of countries based on GDP or per capita

GDP tend to fluctuate as exchange rates vary, while the corresponding prices do not. Despite their variability due to exchange rate fluctuations, purchasing power parity exchange rates provide a better basis for international comparisons than an adjustment based solely on exchange rates.



38

ch05

Economics

By John B. Taylor

Stanford University

Chapter 18

Measuring the

Production, Income, and Spending of

Nations

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ch05

Economics

By John B. Taylor

Stanford University

Chapter 18

Measuring the

Production, Income, and Spending of

Nations

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