# Measuring GDP. A Precise Definition of GDP

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4 134 Chapter 6 Measuring the Production, Income, and Spending of Nations income and product accounts, the official U.S. government tabulation of GDP put together by economists and statisticians at the U.S. Department of Commerce s BEA. The first way measures the total amount that people spend on goods and services made in the United States. This is the spending approach. The second 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. In this approach, your income is a measure of what you produce. The third way measures the total of all the goods and services as they are produced, or as they are shipped out of the factory. This is the production approach. Note that each of the approaches considers the whole economy, and thus we frequently refer to them as aggregate spending, aggregate income, and aggregate production, in which case the word aggregate means total. Let us consider each of the three approaches in turn. The Spending Approach Typically, total spending in the economy is divided into four components: consumption, investment, government purchases, and net exports, which equal exports minus imports. Each of the four components corresponds closely to one of four groups into which the economy is divided: consumers, businesses, governments, and foreigners. Before considering each component, look at Table 6-2, which shows how the \$14,660 billion of GDP in the United States in 2010 was divided into the four categories. consumption purchases of final goods and services by individuals. investment purchases of final goods by firms plus purchases of newly produced residences by households. Consumption The first component, consumption, is purchases of final goods and services by individuals. Government statisticians, who collect the data in most countries, survey department stores, discount stores, car dealers, and other sellers to see how much consumers purchase each year (\$10,349 billion in 2010, as given in Table 6-2). They count anything purchased by consumers as consumption. Consumption does not include spending by business or government. Consumer purchases may be big-ticket items, such as a new convertible, an operation to remove a cancerous tumor, a new stereo, a weekend vacation, or college tuition, or smaller-ticket items, such as an oil change, a medical checkup, a bus ride, or a driver s education class. Consumption accounts for a whopping 71 percent of GDP in the United States (see Figure 6-1). Investment The second component, investment, consists of purchases of final goods by business firms and of newly produced residences by households. When a business such as a pizza delivery firm buys a new car, economists consider that purchase as part of investment rather than as consumption. The firm uses the car to make deliveries, which contributes to its production of delivered pizzas. Included in investment are all the new machines, new factories, and other tools used to produce goods and services. Purchases of intermediate goods that go directly into a manufactured product such as a tire on a bicycle are not counted as investment. These items are part of the finished Table 6-2 Components of Spending in 2010 (billions of dollars) Gross domestic product (GDP) \$14,660 Consumption 10,349 Investment 1,827 Government purchases 3,000 Net exports 516 Source: U.S. Department of Commerce, Bureau of Economic Analysis.

12 142 Chapter 6 Measuring the Production, Income, and Spending of Nations total amount of saving a measure of the amount of resources that a country has for investment, either in its own country or abroad. Saving Another important macroeconomic measure is the total amount of saving undertaken by an economy. Investment and saving have an important symbiotic relationship. To see why this is, consider what would happen if you wanted to build a factory that makes shoes. To build the factory, you would have to either use your own (or a friend or family member s) saving or borrow money from a bank. But the money that a bank lends to you will be some other individual s saving. Therefore the total amount of saving is a measure of the amount of resources the country has available for investment, either in its own country or abroad. Similarly, the total amount of investment depends on how much saving is available from that country and from other countries. Countries with a high level of saving have a greater ability to undertake investment projects than countries with a low level of saving. A country with a low level of saving, however, can increase investment if people and firms in other nations are willing to lend to or invest their own saving in that country. The U.S. economy in recent years has been able to sustain a high level of investment even when U.S. saving was low. In this section, we will define the concept of national saving and show how it is calculated. Individual Saving For an individual, saving is defined as income less taxes and consumption. If you earn \$25,000 in income during the year and pay taxes of \$5,000 while spending \$18,000 on consumption food, rent, and movies, for example by definition, your saving for the year is \$2,000 (\$25,000 \$5,000 \$18,000). But if you instead spend \$23,000 on food, rent, and movies for the year, then your saving is \$3,000; you will have to either take \$3,000 out of the bank or borrow \$3,000. national saving aggregate income minus consumption minus government purchases. Algebraic definition of national saving. National Saving For a country, saving is defined in a similar manner: by subtracting from a country s economy what is consumed. We subtract government purchases of goods and services in addition to consumer purchases. National saving, the sum of all saving in the economy, is defined as income less consumption and government purchases. That is, National saving ¼ income consumption government purchases Using the symbol S for national saving and the symbols already introduced for income (Y), consumption (C), and government purchases (G), we define national saving as follows: S ¼ Y C G Using the numbers from Table 6-2, national saving in 2010 was \$1,311 billion (\$14,660 billion \$10,349 billion \$3,000 billion). The major component of national saving is private saving: the sum of all savings by individuals in the economy. Some people save a lot, some do not save at all, and some are dissaving that is, they have negative saving. For example, when people retire, they usually consume a lot more than their income they are dissaving. When people are middle aged, their income is usually greater than their consumption they are saving. Most young people either save very little or, if they are able to borrow, dissave. We define private savings using the symbol T for taxes, as follows: Private saving ¼ Y C T A country, however, also has a government, and so we need to include government saving in our calculation of national saving. What do we mean by saving by the

13 Measuring Real GDP 143 REVIEW National saving is an important macroeconomic variable because it is a measure of the resources that a country has available for investment, either in its own economy or abroad. A country with a high level of national saving can have a high level of investment if it desires. A country with a low level of national saving can have a high level of investment only if people in other countries are willing to lend their savings to or invest them in the low-saving country. National saving is defined as income minus consumption minus government purchases. It can be decomposed into the sum of private saving and government saving. Private saving equals income minus consumption minus taxes. Government saving is the difference between government tax receipts and government expenditures, also known as the budget balance. government? The difference between the government s receipts from taxes and the government s expenditures, the budget balance, is called government saving. When the balance is positive, a budget surplus results that is, the government is saving. When the balance is negative, a budget deficit results that is, the government is dissaving. Algebraically, we define government saving as follows: Government saving ¼ T G Combining private and government saving, we see that Private saving þ government saving ¼ðY C TÞþðT GÞ ¼ðY C GÞ Private saving þ government saving ¼ national saving Measuring Real GDP Economists also are interested in assessing how the economy is changing over time. For example, they might want to know how rapidly the production of goods and services in India has grown over the last decade, and how that increase compares with the change in China s economy. However, the value of goods and services in an economy, as measured by GDP, is determined by both the quantity of goods and services produced and the price of these goods and services. Thus, an increase in the prices of all goods and services will make measured GDP grow, even if the amount of production in the economy does not increase. Suppose, for example, that the prices of all goods in the economy double and that the number of items produced of every good remains the same. The dollar value of these items then will double even though physical production does not change. A \$10,000 car will become a \$20,000 car, a \$10 CD will become a \$20 CD, and so on. Thus, GDP will double as well. Clearly, GDP is not useful for comparing production at different dates when all prices increase. Although the example of doubling all prices is extreme, we do know from Chapter 5 that prices on the average tend to rise over time a tendency that we have called inflation. Thus, when inflation exists, GDP becomes an unreliable measure of the changes in production over time. Adjusting GDP for Inflation Real GDP is a measure of production that corrects for inflation. To emphasize the difference between GDP and real GDP, we will use the term nominal GDP to refer to what previously has been defined as GDP. real GDP ameasureofthevalueofallthe goods and services newly produced in a country during some period of time, adjusted for changes in prices over time. (Ch. 5) nominal GDP gross domestic product without any correction for inflation; the same as GDP; the value of all the goods and services newly produced in a country during some period of time, usually a year.

14 144 Chapter 6 Measuring the Production, Income, and Spending of Nations Calculating Real GDP Growth To see how real GDP is calculated, consider an example. Suppose that total production consists entirely of the production of audio CDs and DVDs and that we want to compare total production in two different years: 2008 and Price Quantity Price Quantity DVDs \$15 1,000 \$20 1,200 CDs \$10 2,000 \$15 2,200 Notice that the number of DVDs produced increases by 20 percent and the number of CDs produced increases by 10 percent from 2008 to Notice also that the price of DVDs is greater than the price of CDs, but both increase between the two years because of inflation. Nominal GDP is equal to the dollar amount spent on CDs plus the dollar amount spent on DVDs, which is \$35,000 in 2008 and \$57,000 in 2009, a substantial 63 percent increase. Nominal GDP in 2008 ¼ \$15 3 1,000 þ \$10 3 2,000 ¼ \$35,000 Nominal GDP in 2009 ¼ \$20 3 1,200 þ \$15 3 2,200 ¼ \$57,000 Clearly, nominal GDP is not a good measure of the increase in production: Nominal GDP increases by 63 percent, a much greater increase than the increase in either DVD production (20 percent) or CD production (10 percent). Thus, failing to correct for inflation gives a misleading estimate. To calculate real GDP, we must use the same price for both years and, thereby, adjust for inflation. That is, the number of CDs and DVDs produced in the two years must be evaluated at the same prices. For example, production could be calculated in both years using 2008 prices. That is, Using 2008 prices, production in 2008 ¼ \$15 3 1,000 þ \$10 3 2,000 ¼ \$35,000 Using 2008 prices, production in 2009 ¼ \$15 3 1,200 þ \$10 3 2,200 ¼ \$40,000 Keeping prices constant at 2008 levels, we see that the increase in production is from \$35,000 in 2008 to \$40,000 in 2009, an increase of 14.3 percent. Production, however, also can be calculated in both years using 2009 prices. That is, Using 2009 prices, production in 2008 ¼ \$20 3 1,000 þ \$15 3 2,000 ¼ \$50,000 Using 2009 prices, production in 2009 ¼ \$20 3 1,200 þ \$15 3 2,200 ¼ \$57,000 Keeping prices constant at 2009 levels, we see that the increase in production is from \$50,000 in 2008 to \$57,000 in 2009, an increase of 14.0 percent. Observe that the percentage increase in production varies (14.3 percent versus 14 percent) depending on whether 2008 or 2009 prices are used. Such differences are inevitable, because we have no reason to prefer the prices in one year to those of another year when controlling for inflation. Economists arrive at a single percentage by simply averaging the two percentages. 1 In this example, they would conclude that the increase in real GDP from 2008 to 2009 is percent, the average of 14.3 percent and 14 percent. This percent increase in real GDP is much lower than the 63 percent increase in nominal GDP and much closer to the actual increase in the number of CDs and tapes produced. By adjusting for inflation in this way, real GDP gives a better picture of the increase in actual production in the economy. 1 A geometric average is used. The geometric average of two numbers is the square root of the product of the two numbers.

16 146 Chapter 6 Measuring the Production, Income, and Spending of Nations Figure 6-6 Real GDP versus Nominal GDP Real GDP increases less than nominal GDP because real GDP takes out the effect of rising prices. The chart shows that for the 2005 base year, real GDP and nominal GDP are equal. Nominal GDP is below real GDP in earlier years because prices were generally lower before BILLIONS OF DOLLARS 16,000 14,000 12,000 Real GDP (2005 dollars) 10,000 8,000 6,000 4,000 Nominal GDP 2, Here the GDP deflator is defined so that its value in the base year, such as 2005, is (Sometimes it is scaled to equal 100 in the base year by multiplying by 100.) The reason for the term deflator is that to get real GDP, we can deflate nominal GDP by dividing it by the GDP deflator. That is, nominal GDP Real GDP ¼ GDP deflator The percentage change in the GDP deflator from one year to the next is a measure of the rate of inflation. consumer price index (CPI) a price index equivalent that calculates current price of a fixed market basket of consumer goods and services relative to a base year. Alternative Inflation Measures The percentage change in the GDP deflator is not the most widely used measure of inflation. A much more frequently cited measure of inflation is based on the percentage change in the consumer price index (CPI), which is the price of a fixed collection a market basket of consumer goods and services in a given year divided by the price of the same collection in some base year. For example, if the market basket consists of one DVD and two CDs, then the CPI for 2009 compared with the base year 2008 in the previous example would be \$ þ \$ \$ þ \$ ¼ ¼ 1:43 The CPI inflation rate is the percent change in the CPI; it measures how fast the prices of the items in the basket increase. What are the differences between inflation measured using the CPI and inflation measured using the GDP deflator? The first difference is that the GDP deflator is measuring the price level of all domestically produced goods and services. This includes goods that affect the day-to-day life of consumers, such as the price of milk, the price of orange juice, and the cost of airplane tickets, but it also includes goods that individuals never purchase directly, such as the price of heavy machinery and the price of truck engines. Thus the CPI, as its name suggests, may be a more relevant measure of the price level that consumers care about. The second difference is that CPI measures the price of a fixed collection of goods and services the price of the basket whereas the goods and services that make up

17 Measuring Real GDP 147 GDP, and hence are measured by the GDP deflator, change from year to year. The use of a fixed collection of goods and services in the CPI is one of the reasons economists think the CPI overstates inflation. When the price of goods rises, the quantity demanded should decline; when the price falls, the quantity demanded should rise. Thus, by not allowing the quantities to change when the price changes, the CPI puts too much weight on items with rising prices and too little weight on items with declining prices. The result is an overstatement of inflation; in other words, by assuming that people buy no less of the goods and services that have increased in price and buy no more of the goods and services that have decreased in price, the CPI tends to indicate that prices have gone up by more than they really have. During the 1990s, a group of economists appointed by the U.S. Senate and chaired by Michael Boskin of Stanford University found that the government, by adjusting expenditures according to this overstated CPI, was spending billions of dollars more than it would with a correct CPI. Hence, getting the economic statistics right makes a big difference. The third difference between the CPI and the GDP deflator is that the CPI market basket can include goods and services that are produced in other countries, whereas the GDP deflator, by definition, will measure the price of domestically produced goods and services. In countries where imported goods lack good domestic substitutes, inflation measured using the CPI may be a better measure of the difficulties that both people and businesses in the economy face. Figure 6-7 shows how measures of inflation using the GDP deflator and the CPI compare. The general inflation movements are similar, but the CPI is more volatile. The GDP deflator and the CPI each have strengths and weaknesses relative to the other. So you should think of them as alternative ways of measuring price levels and inflation rates, rather than as competing measurements. Yet another measure of inflation is the producer price index (PPI), which measures the prices of raw materials and intermediate goods as well as the prices of final goods sold by producers. Prices of raw materials oil, wheat, and copper sometimes are watched carefully because they give early warning signs of increases in inflation. Figure 6-7 INFLATION RATE (PERCENT PER YEAR) 16.00% 14.00% 12.00% 10.00% 8.00% 6.00% 4.00% 2.00% 0.00% 2.00% Deflator inflation CPI inflation Comparison of Measures of Inflation Measuring inflation with either the CPI or the GDP deflator shows the rise in inflation in the 1960s and 1970s and the lower inflation in the 1980s and 1990s. The CPI is more volatile: It bounces around more. (The inflation rate is based on yearly percent changes in the stated variable.)

18 148 Chapter 6 Measuring the Production, Income, and Spending of Nations REVIEW Nominal GDP changes when either the quantity of goods and services changes or the prices of those goods and services change. Therefore the change in nominal GDP is not a good measure of how the physical amount of production in the economy is changing over time. Economists use real GDP when they want to compare production over time. Real GDP corrects nominal GDP for inflation by measuring the production of goods and services in the dollars of a given base year, such as The GDP deflator is a measure of the price level in the economy. It is defined as the ratio of nominal GDP to real GDP. The percentage change in the GDP deflator from year to year is a measure of the inflation rate. The CPI is the most widely used measure of the price level in the economy. It is defined as the price of a representative market basket of goods and services, relative to the price of that basket in a base year. The percentage change in the CPI from year to year is the most widely used measure of the inflation rate. Some important differences exist between the CPI and the GDP deflator. Each has strengths and weaknesses compared with the other. You should think of them as alternative ways of measuring price levels and inflation rates. Shortcomings of the GDP Measure Although nominal GDP is the best measure of overall production that we have, it is deficient in several ways. You need to understand what these limitations are, so that you can make informed judgments about what is really happening in the economy. Nominal GDP has three main types of limitations: (1) revisions to GDP can change the assessment of the economy; (2) some types of production are omitted from GDP; and (3) the production of goods and services is only part of what affects the quality of life. When you compare two countries, the one with a higher level of GDP is not necessarily better off than the one with a lower level of GDP. Revisions to GDP Government statisticians obtain data on GDP from surveys of stores and businesses, and even from income tax data from the Internal Revenue Service. Not all of these data are collected quickly. Data on sales at stores and large firms come in within a month; however, data on exports and imports take several months. Some income tax data are reported only once a year. Information about small firms comes in even more slowly. For this reason, the statistics on GDP frequently are revised as new data come in. For those who use the GDP data to make decisions, either in business or in government, faulty data on GDP, which are apparent only when the data are revised, can lead to mistakes. Revisions of GDP are inevitable and occur in all countries. These revisions can be quite large in magnitude. For example, in January 2006, the first estimate for GDP for the fourth quarter of 2005 was given as \$ trillion. In March 2006, the final revision of that number was given as \$ trillion, a difference of almost \$30 billion. Omissions from GDP Given the description of how GDP is calculated, you will hardly be surprised to hear that production that does not occur in a formal market is difficult for government statisticians to measure. Examples include work done in the home and illegal commerce. The other principal difficulty in calculating GDP is how to deal with quality improvements in goods. Both of these problems are explained in more detail.

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