MEASURING DOMESTIC OUTPUT, AND NATIONAL INCOMEMeasuring the National Economy

Why do we measure the national economy?

We use “National Income Accounting” in order to: Assess the overall health of the national

economy Make comparisons of the economy over

different periods of time Assist public officials and analysts in

creating and maintaining public policy

National Income Accounting: History of …

The idea was created by Simon Kuznets (1901-1985) beginning in 1930 shortly after the beginning of the Great Depression. He received the Nobel Prize in Economics in 1971 for his efforts.

The tools of collection of the data were developed by the team led by Dr. Kuznets.

The Bureau of Economic Analysis (part of the Commerce Department) compiles the numbers (http://www.bea.gov/).

GDP Defined Gross Domestic Product, or GDP, is the

market value of the final goods and services produced within

the boundaries of the US, whether by Americans or foreigners, in one year.

GDP Explained

Monetary measure, or a “price tag” is attached to all goods and services produced.

Uses only the current value or sale of FINAL GOODS (goods and services ready for final use by consumers, firms, and governments).

This avoids the double counting INTERMEDIATE GOODS (goods and services usually sold between firms in order to produce final goods).

GDP: Transactions that are NOT Counted

Sale of intermediate goods (ex: lumber sold to a construction company for building a house)

Non-productive activities Public transfer payments (ex: veteran’s benefits

& public assistance payments) Private transfer payments (ex: money or property

gifts given to relatives) Sales of securities (ex: stocks, bonds,

government securities, etc.) Sale of secondhand goods

GDP Calculated: Two Methods

Adds up all the spending that occurs in the circular flow: Consumption by

households Investment by firms Purchases by the

government Spending overseas on

exports

Adds up all the ways that households earn income: Wages earned Rents collected Interest earned Profits made Statistical

adjustment

Expenditures Approach Income Approach

Expenditures Approach Examined

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

Recall that we are adding up all the spending that happens in a national economy Consumption spending by

consumers (C) Investment spending by firms (I) Government spending (G) Net export spending (NX or Xn or

“X-M”)

Consumption (C)

Since the 1980s, consumer spending has accounted for about 60 to 65 percent of US GDP.

In the US, consumption (C) represents the largest portion of GDP

Consumption is spending on: Consumer non-durable goods Consumer durable goods

(Lasting more than 3 years) Services

Investment (I)

Investment (I) happens when FIRMS spend, not households. Household investment is referred to as personal investment, and much of it is NOT counted as GDP.

Investment is FIRMS spending on: New home construction New commercial construction Machinery and tools Changes in their existing sales

inventories (the amount firms have stored up for immediate sales). Changes in inventories could be negative IF firms have sold more than they anticipated (a good problem to have)

Gross & Net Investment

Total (or gross) investment minus depreciation (the wear and tear on capital) equals net investment. Net investment can be negative.

Government Spending (G)

Although government spending is sometimes viewed as negative, it accounts for the provision of public goods and services like defense, police, fire fighting, and public education.

In the U.S., government spending occurs at the national (or federal) level, the state level, and the local level.

At the national level this spending provide for defense, the national pension plan (called “Social Security”) and medical assistance to the elderly (called “Medicare”).

At the state level this spending provides for roads and public education.

At the local level this spending provides for police and fire protection.

Net Exports

Net Exports represents spending on exports by people living overseas MINUS domestic spending on imports (X-M).

Exports are goods and services from one country purchased by citizens of other countries

Imports are goods and services from other countries purchased by one country’s citizens

To figure ‘net exports,’ the value of a nation’s exports are subtracted by the value of its imports (X-M)

Net exports can be abbreviated as either ‘NX’ or ‘Xn’

This is the simple-to-remember formula for calculating GDP using the expenditures approach.

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

Income Approach Explained

To calculate GDP using the income approach, we add up the factor payments that are earned in any national economy.

Recall that factor payments are wages, rent, interest, and profits Wages are the compensation paid to

employees Rent is the income earned from the sale or

lease of land Interest is the repayment for the use of

money Profits are revenues earned by firms in

excess of their total costs; the concept of accounting profits is used here

The result of adding factors up is called “National Income”

Special Note About Profit Accounting profit used in calculating GDP rather

that the concept of economic profit (so opportunity costs are NOT taken into consideration)

Profit includes: Proprietors’ (owners of firms) incomes Corporate profits (gross profits, not net)

Corporate income taxes Dividends (paid out to investors) Retained earnings (profits plowed back into the company

that need to be paid out as dividends at a later time

GDP to National Income (NI)

Begin with GDP Subtract depreciation of fixed (immovable)

sources of capital (recall that GDP factors depreciation into Investment)

Subtract foreigners earning income in the U.S. and add in Americans earning income abroad (this is called ‘Net Foreign Factor Income’ and in the U.S. it produces a negative number)

Subtract indirect business taxes (ex. sales taxes) that the GDP calculation did not take into account)

The resultant number is National Income (NI)

Beyond GDP & NI Net Domestic Product is the result of taking GDP and

subtracting Depreciation (sometimes called the ‘consumption of fixed capital’); this gives us a true figure for the amount of NEW goods and services produced

Personal Income is obtained by subtracting losses to income (like Social Security contributions and retained earnings) and adding in transfer payments to National Income; this shows the income available to the nation

Disposable Income is the result of taking Personal Income and subtracting the amount paid in taxes; this gives us the amount that can be consumed or saved

An Example from 2002Macroeconomic Variable Amount ($

billions)Abbrv.

Gross Domestic Product 10,446 GDP - Depreciation (consumption of capital) -1393Net Domestic Product 9053 NDP - Net Foreign Factor Income -10 - Indirect Business Taxes -695National Income 8348 NI - Social Security contributions -748 - Corporate income taxes - 213 - Retained earnings -141 + Transfer payments +1683Personal Income 8929 PI - Personal taxes -1113Disposable income 7816 DI

Nominal GDP versus Real GDP Nominal GDP

Reflects the current price level of goods and services and ignores the effect of inflation on the growth of GDP

This measure is called ‘Current Dollar GDP’ Real GDP

Measures the value of goods and services adjusted for change in the price level. It will reflect the real change in output

This measure is called the ‘Constant Dollar GDP’ Indicates what the GDP would be if the purchasing power of

the dollar has not changed from what it was in a base year

Problems with Nominal GDP Artificially inflates GDP when prices rise and

deflates GDP when prices fall The example on the following slide illustrates

this problem We assume a national economy only

produces pizza Notice that in Year 2, the output of pizza rises

by 2 pizzas, but the GDP almost triples! Now notice what happens when we use a

price index to arrive at a real value for GDP

Using a Price Index to Calculate Real GDP

Year

Units of Output

(1)

Per Unit Price of

Pizza(2)

Price Index

Year 1 = 100(3)

Nominal GDP

(1)x (2)(4)

Real GDP

(4)/(3) x 100(5)

1 5 $10 100 $50 $502 7 $20 200 $140 $703 8 $25 250 $200 $804 10 $30 300 $300 $1005 11 $28 280 $308 $110

The next slide will show you the calculations used to compile this chart. You must memorize these calculations.

How to Calculate Real GDP Nominal Price of a “Basket” of

GoodsPrice Index Calculation

Price of the Same “Basket” of Goods in

a Chosen Base Year Nominal GDPReal GDP Calculation

Price Index

Nominal GDPAnother Price Index Calculation

Real GDP

U.S. Nominal & Real GDP2000-2009

Year Nominal GDP(billions)

Real GDP in 2005 Dollars (billions)

2000 9951.5 11,226.02001 10,286.2 11,347.22002 10,642.3 11,553.02003 11,142.1 11,840.72004 11,867.8 12,263.82005 12,638.4 12,638.42006 13,398.9 12,976.22007 14,061.8 13,228.92008 14,369.1 13,228.82009 14,119.0 12,880.6

Source: Bureau of Economic Analysis (BEA): http://www.bea.gov.htm

Summary

GDP is the total amount of goods and services produced within a nation in a year

The two main methods of measuring GDP is by examining 1) income flows and 2) expenditures

Put simply, GDP = C + I + G + NX Nominal GDP is a measurement of current GDP,

while Real GDP is adjusted for inflation Price Indexes are used to adjust nominal

measurements for inflation Review this PPT several times before your AP

examinations!