Chapter 20. The Measurement of National Income. In this chapter you will learn to. National Output and Value Added

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1 Chapter 20 The Measurement of National Income In this chapter you will learn to 1. Use the concept of value added to solve the problem of double counting when measuring national income. 2. Describe the income approach and the expenditure approach to measuring national income. 3. Explain the difference between real and nominal GDP and the meaning of the GDP deflator. 4. Describe the important omissions from official measures of GDP. 5. Explain why real per capita GDP is a good measure of average material living standards but an incomplete measure of overall well-being National Output and Value Added Production occurs in stages most firms produce outputs that are other firms inputs - intermediate products -finalproducts Each firm s contribution to total output is its value added = revenues cost of intermediate goods = income to factors of production

2 National Output and Value Added Intermediate goods: Outputs that are used as inputs by other producers in a further stage of production. Final goods: Goods that are not used as inputs by other firms but are produced to be sold for consumption, investment, government, or exports. Value added: The value of a firm s output minus the value of the inputs that it purchases from other firms 20-4 Gross Domestic Product Summing value added avoids the problem of double counting when measuring total output. Total value added in the economy is called Gross Domestic Product (GDP). APPLYING ECONOMIC CONCEPTS 20.1 Value Added Through Stages of Production 20-5 National Income Accounting: The Basics Three methods for measuring national income (output): total value added from domestic production total expenditures on domestic output total income generated by domestic production Because of the circular flow of income, these three measures yield the same total GDP

3 Figure 20.1 The Circular Flow of Expenditure and Income 20-7 GDP from the Expenditure Side Consider adding up the expenditures needed to purchase the final output produced in any given year. There are four broad expenditure categories: - consumption - investment - government purchases - net exports 20-8 GDP from the Expenditure Side Actual consumption expenditure (C a ) includes expenditure on all final goods during the year. Actual investment expenditure (I a ) is expenditure on the production of goods not for present consumption, including: inventories plant and equipment residential housing

4 GDP from the Expenditure Side Actual government purchases (G a ) are the purchases of currently produced goods and services by the government only purchases of goods and services count, so that a great deal of government expenditure does not count excluding transfer payments Actual net exports (NX a ) is the difference between exports and imports: NX a = (X a -IM a ) exports are purchases of U.S.-produced goods and services by foreigners. imports are subtracted because they are not produced in the U.S Total Expenditures Since total domestic output must equal total expenditure on domestic output, we have: GDP = C a + I a + G a + NX a Table 20.1 GDP from the Expenditure Side,

5 GDP from the Income Side GDP is also the sum of factor incomes and other claims on the value of output. Factor incomes include: - wages - rent, interest, and profits net domestic income Nonfactor payments include: - indirect taxes (net of subsidies) - depreciation of existing physical capital GDP from the Income Side GDP from the income side is therefore equal to: GDP = Net domestic income + Indirect taxes (less subsidies) + Depreciation EXTENSIONS IN THEORY 20.1 Arbitrary Decisions in National Income Accounting Table 20.2 GDP from the Income Side,

6 National Income Accounting: Some Further Issues GDP and GNP A measure of national output closely related to GDP is Gross National Product (GNP). The difference between GDP and GNP is the difference between income produced and income received National Income Accounting: Some Further Issues GDP is superior as a measure of domestic economic activity. GNP is superior as a measure of living standards of residents. A more refined measure is disposable personal income: It equals GNP minus: - any part not actually paid to households - personal income taxes -plustransfer payments received by households Real and Nominal GDP GDP that is valued at constant (base-period) dollars is real national income. GDP Deflator = Nominal GDP Real GDP x 100 The GDP deflator is a very comprehensive index of prices because it includes the prices of all goods and services produced in the country

7 Real and Nominal GDP Do the CPI and the GDP Deflator Move Together? Broadly, the two price indexes move together, due to underlying inflationary forces. But because one tracks consumer prices and the other tracks the prices of goods produced in the country, there will be some differences. APPLYING ECONOMIC CONCEPTS 20.2 Calculating Nominal and Real GDP Table 20.3 Nominal and Real GDP: Selected Years (billions of dollars) Omissions from GDP National income accountants cannot measure economic activity that takes place outside of regular, legal markets: illegal activities leisure the underground economy Nonmarket activities economic bads

8 GDP and Living Standards Unless the unmeasured economic activity changes rapidly, changes in GDP will do a reasonable job of measuring changes in material living standards. Well-being is a broader concept than material living standards: -GDP is nota complete measure of economic wellbeing - but income is a very important part of well-being and GDP is a good measure of income Table 20.4 Data for a Hypothetical Economy Table 20.5 Value of Production Using Current Year Prices: Nominal GDP

9 Table 20.6 Value of Production Using Year 1 Prices: Traditional Real GDP Table 20.7 An Alternative Traditional Measure: Real GDP Based on Year 2 Prices Table 20.8 Real GDP Growth Using Year 1 or Year 2 Prices