CH 6 - A Precise Definition of GDP GDP a measure of the...

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Unformatted text preview: A Precise Definition of GDP GDP: a measure of the value of all newly produced1 goods and services in a country2 during some period of time3. A Precise Definition of GDP If you buy a 10yearold baby stroller from a garage sale this year, none of the value of that stroller is included in the calculation of this year's GDP. 2.Only goods and services produced within the borders of a country are included. The MiniCooper that your parents bought this year (made and assembled in Germany) is not part of the U.S. GDP; it is part of the German GDP. 3. Only new goods and services produced in a specified period of time are included. For example, if Ford produced a model 2008 Mustang in December 2007 but the car was not sold until January 2008, then that Mustang will be included in the GDP of the period in which it was produced--that is, 2007. 1.Only newly produced goods and services are included. A Precise Definition of GDP We cannot add 10 apples with 20 oranges. We can combine different goods only by multiplying the quantity of each good produced by its price. Table 1 illustrates how to calculate the GDP with two goods, CDs and DVDs. Intermediate Goods vs. Final Goods Intermediate good: a good that undergoes further processing before it is sold to consumers; a good that is an input to the production of other goods or services. Examples of intermediate goods: A bicycle tire that is sold to a bicycle manufacturing company Crude oil Intermediate Goods vs. Final Goods Final good: a new good that undergoes no further processing before it is sold to consumers; a good that is not an input to the production of other goods or services. Examples of final goods: Bicycles sold at a bicycle shop Gasoline sold at a gas station Three Ways to Measure GDP 1. 2. 3. The spending approach: measures the total amount that people spend on goods and services made in the United States. The income approach: measures the total income earned by all factors of production (workers, businesses, capital) that produce goods and services in the United States. The production approach: measures the total value of all goods and services as they are shipped out of the factory. The Spending Approach Total spending in the economy is divided into four components: Consumption spending: The purchases of final goods and services by individuals (70%). Investment spending: The purchases of final goods and services by firms plus the purchases of newly produced residences by households (17%). Government purchases: Purchases by federal, state, and local governments of new goods and services (19%). Net exports (exports minus imports. AKA Trade Balance) The Spending Approach The three components of investment spending: Business fixed investment: firm spending on new factories, machines, and other equipment. Inventory investment: the change in inventories (i.e., the difference between inventories at the end of the period and inventories at the start of the period). Residential investment: the purchase of new houses and apartment buildings. The Spending Approach Government purchases: purchases by federal, state, and local governments of new goods and services. Not all items in the government's budget are counted as part of government purchases. Welfare and retirement payments made by the government are not counted as part of these purchases. The Spending Approach Exports: the total value of goods and services that people in one country sell to people in other countries. Imports: the total value of goods and services that people in one country buy from people in other countries. The Spending Approach If net exports are positive, the country has a trade surplus. If net exports are negative, the country has a trade deficit.` For the United States in 2006, exports equaled $1,466 billion and imports equaled $2,229 billion. The U.S. trade deficit for 2006 was $763 billion. The Spending Approach A trade deficit for the United States is not uncommon. In fact, the last time the United States experienced a trade surplus was in the third quarter of 1980.* *Source: the Bureau of Economic Analysis The Spending Approach Algebraic summary: Y = C + I + G + X For the United States in 2006 (billions of dollars): 13,245 = 9,269 + 2212 + 2527 + (763) The Income Approach Components of aggregate income in the economy: Labor income Capital income Depreciation Indirect business taxes Net income of foreigners Labor Income Labor income: the sum of all wages, salaries, and fringe benefits paid to all workers in the country in a given period of time. Wages: payments to workers paid by the hour. Salaries: payments to workers paid by the month or year. Fringe benefits: retirement, health, and other benefits paid by firms on behalf of workers. Capital Income Capital income: the sum of profits, rental payments, and interest payments. Profits: include profits of both large and small businesses. Rental payments: incomes to persons who own buildings and rent them out. Interest payments: incomes received from lending to business firms. Depreciation Depreciation: the decrease in an asset's value over time. For capital, it is the amount by which physical capital (factories and machines) wears out over a given period of time. Why include depreciation in GDP? When profits and capital income are reported to government statisticians, depreciation has already been subtracted out. However, the new equipment that is used to replace old equipment is produced by someone who earns income. Hence, depreciation must be added back to calculate GDP via the income approach. Depreciation Net investment: the difference between the firm's purchases of final goods and the depreciation. Gross investment: the firm's purchases of final goods, including depreciation. Taxes, Subsidies, and Transfers When we tabulate production by adding up the incomes of consumers and the profits of firms, sales taxes are not included in firms' profits. Hence, we must add these sales taxes back to labor and capital income. Similarly, subsidies must be removed from calculations, because they do not represent income from production. Net Income of Foreigners Incomes of foreigners working in the United States are not included in U.S. labor income, but should be included in U.S. GDP. Incomes of Americans working outside the United States are included in U.S. labor income, but should be not included in U.S. GDP. To get GDP, we must add net income earned by foreigners in the United States and subtract net income by Americans outside the United States. If net income of foreigners > 0, then the value of income of foreigners working in the United States is larger than the value of American income outside the United States. If net income of foreigners < 0, then the value of income of foreigners working in the United States is smaller than the value of American income outside the United States. Statistical Discrepancy When we add up the components of aggregate income, the computed value is very close to GDP but is not exactly the same. The difference arises from errors in the collection of data on income and spending. The difference between aggregate income and GDP (less than 1 percent of GDP) is called statistical discrepancy. The Circular Flow Diagram The circular flow diagram in Figure 4 illustrates the link between aggregate production and aggregate spending. People earn income from producing goods and services, and then use this income (Y) to buy goods and services (C, I, G, X). The Circular Flow of Income and Expenditure The Production Approach When we measure GDP via the production approach, we count only the value added by each manufacturer. Value added: the value of a firm's production minus the value of the intermediate inputs used in production. Value Added in Coffee: From Beans to Espresso The Production Approach As shown in Figure 5, the cup of espresso that you buy from an espresso bar is produced in multiple stages. 1. The coffee beans are grown and harvested by a coffee farmer. 2. A roaster buys, roasts, and packages the beans. 3. A wholesaler buys the packaged beans and sells them to an espresso bar. 4. The espresso bar sells you the espresso for $3.00. Saving For an individual, saving is income earned by that person less taxes and expenditures. Total amount of saving: a measure of the amount of resources that a country has available for investment, either domestically or abroad. Note: In economics "saving" is not the same as "savings." National Saving National saving: aggregate income minus consumption spending minus government purchases. National saving = incomeconsumption government purchases National Saving Equation for national saving: S = Y C G where S = national saving Y = GDP C = consumption G = government spending Private and Government Saving National saving results from the saving of the private sector (individuals) and the public sector (the government). Private and Government Saving Public/government saving = T G If T G > 0: the government is experiencing positive saving (a budget surplus). The government is saving. If T G < 0: the government is experiencing negative saving (a budget deficit). The government is dissaving. Private and Government Saving Algebraically: S = Y C G S = (Y C T) + (T G) S = private saving + government/public saving Measuring Real GDP Nominal GDP: gross domestic product without any correction for inflation; the value of all newly goods and services produced in a country during some period of time, usually a year. Real GDP: the value of all newly goods and services produced in a country during some period of time, adjusted for changes in prices over time. Example on Board Calculating Real GDP Growth Suppose that total production consists entirely of the production of audio CDs and DVDs and we want to compare production in two different years: 2006 and 2007. Calculating Real GDP Growth Nominal GDP in 2006 = ($15 1,000) + ($10 2,000) = $35,000 Nominal GDP in 2007 = ($20 1,200) + ($15 2,200) = $57,000 Calculating Real GDP Growth Nominal GDP growth rate (percentage change) $57,000 - $35,000 $22,000 100 = 100 = 63% = $35,000 $35,000 Nominal GDP grows by 63 percent between 2006 and 2007. Calculating Real GDP Growth Nominal GDP is not a good measure for the increase in production. Nominal GDP increases by 63 percent, a much greater increase than the 20 percent increase in the production of DVDs and the 10 percent increase in the production of CDs. To calculate GDP, we must use the same price for both years, effectively adjusting for inflation. Example using 2006 and 2007 prices Calculating Real GDP Growth Real GDP using 2006 prices: Real GDP in 2006, using 2006 prices = ($15 1,000) + ($10 2,000) = $35,000 Real GDP in 2007, using 2006 prices = ($15 1,200) + ($10 2,200) = $40,000 Calculating Real GDP Growth Using 2006 prices, growth in real GDP between 2006 and 2007 $40,000 - $35,000 $5,000 = 100 = 100 = 14.3% $35,000 $35,000 Calculating Real GDP Growth Real GDP using 2007 prices: Real GDP in 2006, using 2007 prices = ($20 1,000) + ($15 2,000) = $50,000 Real GDP in 2007, using 2007 prices = ($20 1,200) + ($15 2,200) = $57,000 Calculating Real GDP Growth Using 2007 prices, growth in real GDP between 2006 and 2007 $57,000 - $50,000 $7,000 = 100 = 100 = 14.0% $50,000 $50,000 Calculating Real GDP Growth Using 2006 as the base year, we find a slightly different growth rate for real GDP than if we use 2007 as the base year. Different growth rates using different base years are inevitable. Economists usually use the average of the two growth rates. In our example, the economy achieved a growth rate of 14.15 percent (the average of 14.3 percent and 14 percent). Calculating Real GDP Growth Notes on the example: When using 2006 prices, real GDP in 2006 equals nominal GDP in 2006 (in both variables, the value is $35,000). When using 2007 prices, real GDP in 2007 equals nominal GDP in 2007 (in both variables, the value is $57,000). Real GDP vs. Nominal GDP over Time Figure 6 compares real GDP between 1996 and 2006. The base year is 2000, so real GDP equals nominal GDP in 2000. Before 2000, real GDP is larger than nominal GDP. After 2000, nominal GDP is larger than real GDP. Real GDP versus Nominal GDP The GDP Deflator GDP deflator: the nominal GDP divided by the real GDP. It measures the price level of goods and services included in real GDP relative to the given base year. GDP Deflator = nominal GDP/real GDP The GDP Deflator Price level: the average level of prices in the economy. The growth rate in the real GDP deflator, from period to period, is a measure of inflation. Alternative Inflation Measures Consumer price index (CPI): a price index equal to the current price of a fixed market basket of consumer goods and services relative to a base year. Alternative Inflation Measures Suppose that a market basket contains 1 DVD and 2 CDs. The CPI for 2007 relative to 2006 would be CPI 2007 (2006 is the base year) = ($20 1) + ($15 2) ($15 1) + ($10 2) = 50/35 = 1.43 Alternative Inflation Measures The growth rate (or percentage change) of the CPI is another measure of inflation. Inflation rates computed via the CPI and via the GDP deflator behave in a similar way, although CPI inflation is more volatile (i.e., it exhibits more fluctuations), as seen in Figure 7. Comparison of Measures of Inflation CPI vs. GDP Deflator Differences Between the CPI and the GDP Deflator 1. 2. The GDP deflator includes all domestically produced goods and services, whereas the CPI includes only goods bought by consumers. For example, the GDP deflator includes the price of heavy machinery and truck engines. The CPI measures the price of a fixed collection of goods and services, whereas the GDP basket varies with the GDP. The CPI may include foreignmade goods, whereas the GDP deflator includes only domestically produced goods. 1. Omissions from GDP 1. Shortcomings of the GDP Measure 2. 3. 1. Home work and production. Nonmarket activities such as cleaning the house and growing your own vegetables are not included in GDP, because these activities--though productive--are not recorded in markets where statisticians measure spending. Leisure activity. Activities such as going to the beach and hiking in the mountains are not included in GDP because these activities-- though enjoyable--are not recorded in markets where government statisticians measure spending. The underground economy. Illegal activities are not included in the calculation of GDP, because these activities are purposefully hidden from the government. Estimated size of the underground economy: Approximately 10 percent of GDP in the United States Approximately 25 percent of GDP in Italy More than 40 percent of GDP in Peru Quality improvements. The measure for GDP does not include improvements in the quality of goods and services. For example, a $1,500 notebook computer sold in 2005 was of substantially better quality than a $2,000 notebook computer sold in 2003. While the price fell, the qualityadjusted price declined even more. Shortcomings of the GDP Measure Other measures of wellbeing: Life expectancy Child mortality rates Crime rates Clean environments Percentage of children living in poverty Key Terms intermediate good final good consumption investment government purchases net exports exports imports trade balance labor income capital income value added total amount of saving national saving nominal GDP GDP deflator price level consumer price index (CPI) ...
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