Chapter 8. GDP : Measuring Total Production and Income

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1 Chapter 8. GDP : Measuring Total Production and Income Instructor: JINKOOK LEE Department of Economics / Texas A&M University ECON Principles of Macroeconomics

2 Related Economic Terms Macroeconomics: The study of the economy as a whole, including topics such as inflation, unemployment, and economic growth. Business cycle: Alternating periods of economic expansion and economic recession. Expansion (Recession): The period of a business cycle during which total production and total employment are increasing (decreasing). Economic growth: The ability of an economy to produce increasing quantities of goods and services. Inflation rate: The percentage increase in the price level from one year to the next.

3 Gross Domestic Product (GDP) GDP: The market value of all final goods and services produced in a country during a period of time, typically one year. GDP is measured using market values, not just quantities market values: the value, in dollar terms, of all the goods and services produced. GDP includes only the market value of final goods. Final good: A good purchased by a final user. Intermediate good: A good that is an input into another good or service. GDP includes only current production that takes place during the indicated time period. We can measure GDP either by calculating the total value of expenditures on final goods, or by calculating the value of total income.

4 Components of GDP The BEA (Bureau of Economic Analysis) divides its statistics on GDP into four major categories of expenditures: 1 Consumption 2 Investment 3 Government purchases 4 Net exports

5 Components of GDP: (1)Consumption Consumption: Spending by households on goods and services, not including spending on new houses. Consumption expenditures are made by households and are divided into expenditures on... services: medical care, education, and haircuts. nondurable goods: food and clothing. durable goods: automobiles and furniture.

6 Components of GDP: (2)Investment Investment: Spending by firms on new factories, office buildings, machinery, and additions to inventories, plus spending by households and firms on new houses. Spending on Investment is divided into three categories: Business fixed investment: spending (by firms) on new factories, office buildings, and machinery used to produce other goods. Residential investment: spending (by households and firms) on new single-family and multi-unit houses. Changes in business inventories are also included in investment.

7 Components of GDP: (3-4)Government Purchases and Net Exports Government purchases: Spending by federal, state, and local governments on goods and services. Net exports: Exports minus imports. Exports are goods and services produced in the U.S. and purchased by foreign firms, households, and governments. We add exports to expenditures to include all spending on new goods and services domestically produced We subtract imports from total expenditures to exclude spending that does not result in this production.

8 An Equation for GDP and Some Actual Values A simple equation sums up the components of GDP: Y = C + I + G + NX The equation tells us that GDP (denoted as Y) equals consumption (C) plus investment (I) plus government purchases (G) plus net exports (NX).

9 Components of GDP in 2010

10 Components of GDP in 2010 The table shows several interesting points: Consumer spending on services is greater than the sum of spending on durable and nondurable goods. Business fixed investment is the largest component of investment. Purchases made by state and local governments are greater than purchases made by the federal government. Imports are greater than exports, so net exports are negative.

11 Measuring GDP Using the Value-Added Method Value added: The market value a firm adds to a product. The price of the shirt on L.L.Bean s Web site is exactly equal to the sum of the value added by each firm involved in the production of the shirt.

12 Shortcomings in GDP as a Measure of Total Production When the BEA calculates GDP, it does not include two types of production: 1 Production in the home Household production: Goods and services people produce for themselves that are not bought and sold in markets. 2 Production in the underground economy Underground economy: Buying and selling of goods and services that is concealed from the government to avoid taxes or regulations or because the goods and services are illegal.

13 Shortcomings of GDP as a Measure of Well-Being GDP per capita is calculated by dividing the value of GDP for a country by the country s population. 1 The Value of Leisure Is Not Included in GDP If Americans still worked 60-hour weeks as they typically did in 1890, GDP would be much higher than it is, but the well-being of the typical person would be lower because less time would be available for leisure activities. 2 GDP Is Not Adjusted for Pollution or Other Negative Effects of Production GDP is not adjusted to compensate for the costs of the pollution. Although GDP does not take into account negative effects of production, countries are known to devote more resources to reducing these effects as GDP increases.

14 Shortcomings of GDP as a Measure of Well-Being 3 GDP Is Not Adjusted for Changes in Crime and Other Social Problems An increase in crime reduces well-being but may actually increase GDP if it leads to greater spending on police, security guards, and alarm systems. 4 GDP Measures the Size of the Pie but Not How the Pie Is Divided Up GDP may not provide good information about the goods and services consumed by the typical person.

15 Did World War II Bring Prosperity? World War II was a period of extraordinary sacrifice and achievement by the greatest generation. But statistics on GDP may give a misleading indication of whether it was also a period of prosperity.

16 Calculating Real GDP Nominal GDP: The value of final goods and services evaluated at current-year prices. Real GDP: The value of final goods and services evaluated at base-year prices. One drawback to calculating real GDP using base-year prices is that, over time, prices may change relative to each other, distorting real GDP estimates more the further away the current year is from the base year.

17 Calculating Real GDP Use the information in the table below to compute real GDP for the year Assume that the base year is 2005.

18 Comparing Real GDP and Nominal GDP Nominal GDP and Real GDP ( )

19 The GDP Deflator Price level: A measure of the average prices of goods and services in the economy. GDP deflator: A measure of the price level, calculated by dividing nominal GDP by real GDP and multiplying by 100. Nominal GDP is equal to real GDP in the base year, so the value of the GDP price deflator will always be 100 in the base year.

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