Chapter 7 - Taking the Nation's Economic Pulse

In this chapter we look at how the economy's output is measured. We use the National Income and Products Accounts (NIPA), a system of national-income accounting developed during the 1920s and 1930s to measure national income or national output (see p. 157, economist Simon Kuznets). Just like a firm needs accounting to measure income to calculate profits or losses, the entire economy needs an income statement.

Gross Domestic Product (GDP) is the most widely used measure of economic performance around the world. We currently have almost \$11T of annual GDP in the U.S. GDP measures the total market value or total spending on all final goods and services produced domestically during a specific period, usually quarters or years.

Bureau of Economic Analysis at Dept of Commerce tracks the economy and releases the figures on GDP on a quarterly basis. Time frame - we are now in the second quarter (as the notes are updated) of 2003 (April, May, June). The first estimate of QII 2003 GDP will be released around Aug. 1, second estimate on Sept. 1 and the final estimate around Oct. 1.  It takes three months after the end of quarter and six months after the start of the quarter to finalize data.  This time frame for the release of GDP will become very important later in the course when we discuss policy (fiscal and monetary).

WHAT COUNTS IN GDP?:

1. Only FINAL goods and services purchased by final users.  Only retail sales count, not intermediate (wholesale) goods or transactions.  When GM buys steel, tires or transmissions, those transactions don't count because it would be double counting since those expenditures will be accounted for in the final retail price of the car.  For example, suppose GM spends \$15,000 for a car and sells it to a dealer for \$16,000 and the dealer sells it for \$17,000. We only count the \$17,000 for the final retail sale. We can't count \$15,000 + 16,000 + 17,000 = \$48,000. Only the value of the final output is counted, and the value of the inputs are not directly counted since their value is reflected in the final purchase price.

See Example, page 158. Bread example.

2. Only goods and services produced during the time period are counted. Only new production is counted, not secondhand sales. Example: sales of used cars and used houses don't count. They were already counted as new production in the year built. Resale doesn't get counted in current GDP. Commissions on used cars or houses would get counted, because they are current services.

3. Financial transactions and income transfers are excluded.  Example: stock or bond purchase is just a transfer of money from one individual to another, it does not involve current production of a good or service.  Commissions would count, as a current service (income) provided by the broker.  Gifts and income transfers (Social Security, welfare, veterans' pmts, etc.) also don't count, since no current production of goods or services is involved.

4. ONLY Domestic Production is Counted, regardless of who provided the labor.  Foreign citizens working in the U.S. count toward U.S. GDP, since their labor contributed to "domestic production."  U.S. citizens working temporarily overseas does NOT count in U.S. GDP, since their labor does not contribute to "domestic production."

GDP vs. GNP  - GDP measures domestic production within the 50 states, regardless of who provided the labor or capital, US citizens or foreigners. GNP measures the production of US "nationals," U.S. citizens regardless of where they are working.

Example:
Canadian citizen crosses the border to work in Detroit. That counts in U.S. GDP but not in U.S. GNP. US citizen crosses the border to work in Canada, that counts in U.S. GNP but not in U.S. GDP.

NOTE: GDP is measured in U.S. dollars, all market transactions for final goods and services are measured and summed in dollars to calculate quarterly or annual nominal GDP.

TWO WAYS OF MEASURING GDP

Expenditure Approach vs. Resource Cost-Income Approach.

\$ spent on final goods by consumers = GDP = \$ spent by producers to produce final products

Example: New house sells for \$100,000 = Expenditure approach.

Resource Cost-Income approach = \$50,000 spent on materials and supplies (lumber, appliances, siding, windows, etc.), \$40,000 spent on labor (carpenters, plumbers, electricians, architect, etc.) and \$10,000 profit to developer. = Total \$100,000.

See page 160-161, Exhibits 7-2 and 7-3: "Two Ways of Measuring GDP."

EXPENDITURE APPROACH: C + I + G + Net Exports (X - M)

How was money spent during the year by consumers, businesses and governments?

1. Personal Consumption Expenditures (PCE) - largest percentage of GDP - almost 70% or \$7T in 2001. Breakdown of PCE - Durable goods, Nondurables and Services (almost 60% of PCE).

a. Durable Goods - Goods that last longer than one year. Autos, furniture, appliances, etc.

b. Nondurable Goods - Food, clothing, fuel, shampoo, toothpaste, medicine, prescriptions, office supplies, etc.

c. Services - Insurance, education, medical services, legal services, consulting, accounting, recreation, entertainment, etc.

Non-durables and services make up almost 90% of PCE.

2. Gross Private Investment - Two components: a) Fixed Investment and b) Inventories.

a. Fixed Investment - Business investment in property, plant and equipment. Business spending on capital equipment (durable assets), and Household Investment in housing.

Gross Investment includes two components: a) Replacing worn out equipment and b) New additions to capital stock.

Net Investment = Gross Investment - Amount Spent on Replacement

Example: in US, about \$1634B was spent on gross investment in 2001, about \$1100B to replace worn-out equipment and about \$500B was Net Investment.

Future economic growth depends on Net Investment (NI), because NI enhances future productive potential. Investment is for the future. Shifts out PPF by increasing capital stock of the economy.

b. Inventory investment. Change in Inventory. GDP measures current production, regardless of whether it has necessarily sold during the year. If inventories have increased over the year, Inventory Investment will be positive. If inventories decrease, inventory investment will be negative in that period. In 2001, U.S. "disinvested" \$60B in inventory.  Why??

Note: NIPA arbitrarily assumes: All household spending is PCE except spending on housing. All business spending on final goods is considered Investment.

Example: Company buys office supplies or toothpaste or car, INVESTMENT. You buy a lawnmower or chain saw or car, CONSUMPTION.

3. Government Purchases of goods and services. State, local and federal govt. spending on everything except transfer payments. Includes both consumption (paperwork, office supplies) and investment goods (highways, buildings, dams, etc.). Includes spending on highways, govt. buildings, education, FBI, FDA, DEA, ATF, Dept. of Commerce, FDA, EPA, defense, etc.

4. Net Exports = Exports (X) - Imports (M). We add exports because they are domestically produced goods sold to foreigners, contributes to domestic production. We subtract imports, because they are foreign produced goods and services purchased domestically by consumers, businesses or government.

Part of C, I and G are purchases of imports, so we subtract these expenditures out.

When X > M, we have a trade surplus. When M > X, we have a trade deficit.

See page 164 for a graph of Expenditure Approach and Resource Cost - Income Approach.

In panel b, we see a graph of the RESOURCE COST - INCOME APPROACH to GDP (or Gross Domestic Income-"GDI"). \$11T spent on final goods and services goes to pay: for Resources (inputs) and the owners of resources. One persons spending is another person's income. \$1500 spent on tuition goes to - salaries, buildings, books, etc.  \$100 spent at Target goes to: salaries, rents, interest, taxes, depreciation, profits, etc.

\$11T in spending by households, business and governments goes to:

1. Employee Compensation -- 58%

2. Self-employment income -- 7%

Together, compensation to employees and self-employment income account for almost 2/3 of GDP.

3. Rents, corporate profits, and interest are payments (income) to people who supply either physical capital or financial capital to businesses.

Rent - lease payments to the owners of real estate -  shopping mall, office buildings, etc.
Profits - money paid to shareholders for providing capital to a corporation.
Interest - money paid on loans to businesses. Bonds, bank loans, etc.

4. Indirect Business Taxes - taxes on goods which get passed along to consumers. Examples: sales, excise and property taxes. Part of PCE doesn't go as income to a resource owner, it goes to the government. Indirect cost of supplying goods.

Example: Gas, alcohol have excise taxes hidden in the price, doesn't go the producer as income, it goes to the state and federal govt. as taxes.

5. Depreciation - wear and tear on machines and capital equipment is a cost of producing goods, but it doesn't involve a direct payment to a resource owner.  Also called the "capital consumption allowance."  In 2001, depreciation was \$1350B.  Think of UPS or Northwest Airlines - every year their trucks and airplanes are depreciating from daily use.

6. Net Income of Foreigners (GNP-GDP adjustment) - When we use the Resource Cost-Income method we have to adjust for income that Americans earned from abroad and for the domestic income that foreigners earned here. We want only Domestic production, so we want to exclude income that Americans earned abroad, and count income that foreigners earned in U.S.

Example: U.S. citizen earns \$50,000 working in Canada. We exclude that from GDP.

Example: Canadian citizen earns \$100,000 in US. That counts for U.S. GDP.

Net income of foreigners (NI): = Income foreigners earned in U.S. - income Americans earned abroad.
If NI > 0, it means that foreigners earned more here than Americans earned abroad.

In the example above, the Net Income would be \$100,000 - 50,000= \$50,000. We would add \$50,000 to GDP.

In 2001, foreigners contributed \$5B more to U.S. output than U.S. citizens contributed to foreign output, so that amount was added to GDP using the Resource Cost - Income approach (p. 161).  GDP = GDI = \$10.2T

REAL vs. NOMINAL GDP -

In economics, we always have to distinguish between real and nominal economic values or variables when comparing economic data in two different years measured in dollars. Reason: we measure economic variables in U.S. dollars and the value of the dollar is constantly changing over time. Inflation erodes the purchasing power of money over time. One dollar today is worth less than one dollar ten years ago, worth more than one dollar ten years from now. "Money's Gettin' Cheaper"  A \$100 bill in 2003 is not the same as a \$100 bill in 1950 or 1960 or even 2002, in terms of its real value or purchasing power.

Nominal values, or money values are expressed in current dollars, or dollars during the current period when they are measured. Over time, nominal values of income, asset values, economic variables in general get bigger for two reasons: 1) changes in the real value of a variable and 2) inflation - changes in the general price level.

Real values, or real variables, measure the real change of the variable, with the effects of inflation factored out. We are usually ultimately concerned with real income, real wages, real GDP, real output, real values, real returns, real growth...

Example: Nominal GDP = Σ Pi Qi, where P represents nominal prices and Q represents the physical quantities of real goods and services.  Average Price per car X number of vehicles produced = contribution of auto sales to nominal GDP.

Over time, nominal GDP increases as a) prices rise, and as b) the real quantity of output rises. We are more concerned with the real increase in output. Just like we are concerned with our real income which better measures our real standard of living.

Money Illusion - confusing real and nominal variables.

It is usually easier to deal with percentage changes, or growth rates, of a variable.

Nominal % GDP = % Prices + % Real output

Nominal % GDP = Inflation (%) + Real growth rate (%)

Real GDP growth rate = % Nominal GDP - Inflation (%)

Example: 2002, nominal GDP growth was 4.25%, inflation was about 1.25%, so real growth (real GDP) was about 3%.  The 4.25% growth in nominal GDP was caused by a 1.25% increase in all prices, and a 3% increase in the real quantity of goods and services.  We want to factor out the 1% increase in prices to isolate the 3% increase in real GDP (inflation-adjusted growth), which is a better indicator of economic growth, our standard of living, etc.

We need a measure of inflation to make the adjustment for price level changes. There are several measures of prices: Consumer Price Index (CPI) and GDP deflator, see pages 165-166. There is also the Producer Price Index (PPI), which measures wholesale prices that producers pay for inputs.  CPI is a consumer price index, measures the price level changes that affect us as consumers.  CPI comes out monthly from the Dept. of Labor, based on an actual survey of average prices in 21,000 stores (125,000 prices) of a 364-item market basket of goods and services, which reflects the purchases of a typical household.  The market basket of 364 goods is priced monthly to construct the CPI, from which the inflation rate is calculated (Inflation rate = Percentage Change in the price index).  If the CPI goes from 100 to 105, inflation is 5%.

GDP Deflator is a much broader, more comprehensive price index reflecting ALL goods and services in GDP (thousands of items) including consumer, business and government spending.  In addition to being more comprehensive than the CPI, the GDP Deflator is also different from CPI because it is not based on a fixed basket of goods - it updates the typical bundle each year to reflect what people, businesses and government actually buy.  GDP Deflator is calculated by comparing cost of the actual goods bought this year TO the cost of purchasing those same goods last year.  If the cost this year is \$102 and the cost of those goods purchased last year would have been \$100, then inflation is 2%.

SUMMARY: CPI is less comprehensive and assumes a fixed basket of goods from year to year, compared to the GDP Deflator, which is more comprehensive and uses a changing basket of goods based on what is actually purchased.  Therefore, GDP Deflator is considered a more accurate measure of prices.

Choosing a price index depends on the application. CPI measures consumer prices, is appropriate for cost of living increases in wage contracts and Social Security. GDP Deflator is an economy-wide price index, appropriate for adjusting national income data.

See p. 166 for a comparison of GDP Deflator and CPI, and inflation rates from each.  In most years, CPI inflation is higher.  Average over 20 years, CPI inflation = 3.72%, GDP Deflator inflation = 3.16%.

Why does the CPI overstate the TRUE rate of inflation (cost of living)?

1) Substitution - CPI uses fixed basket of goods and doesn't allow for substitution. If price of beef rises and the price of turkey falls, people will buy more turkey and less beef. The CPI assumes a constant basket of goods and services, leading to upward "substitution bias."  CPI measures what people used to buy, now what they buy now.

2) Quality improvements. Suppose one of the products in CPI is an average computer. What if the average price doesn't change from one year to the next, but they are comparing a 386 in 1990 vs a Pentium III in 2000, possibly a computer with twenty times as much power. The real cost has fallen, even though the nominal price doesn't show any change.

Conclusion of recent presidential study (Boskin Report): CPI overstates true cost-of-living inflation by approximately .5 to 1.5%.

USING A PRICE INDEX TO CALCULATE REAL VALUES

We typically have easy access to both: a) nominal (current) values for national income, personal income, consumption, salaries, wages, housing prices, gas prices, stock prices, etc. and b) price indexes.  From nominal values and a price index, we can then calculate real (constant) values, to make a valid comparison of economic variables over time.  We use the following formula (p. 166) to convert nominal (current) values to real (constant) values, using GDP as an example (t = year, or time period):

REAL GDPt = NOMINAL GDPt  X  GDP DEFLATOR IN BASE YEAR
GDP DEFLATORt

This formula will convert the nominal GDP value in year t into real GDP in year t, measured in the constant, or real dollars of the BASE YEAR.

If we have Nominal GDP in two different years and the GDP Deflator in those two years, we can then calculate Real GDP.  For example (page 166), we know that Nominal GDP was \$7813B in 1996 and by 2001 had grown to \$10,208B.  Remember that part of that increase is because prices in general rose over the 5 year period, and also because real output rose during that period.  And we can't accurately compare \$7813B and \$10,208B because they are measured in different years and in different units (the 1995 \$ is not equal to the 2001 \$ - which one has more value/purchasing power?)

We can convert nominal GDP in 2001 into real, inflation-adjusted 1996 dollars using the formula:

\$9,331B = \$10,208B  x (100 / 109.4)

We have now "deflated" the higher nominal value into a real value, by factoring out the amount of the nominal increase that came about due to prices rising (inflation).  We NOW can compare \$7813B and \$9331B, because they are both expressed in constant, inflation-adjusted, real 1996 dollars.  We can say that nominal GDP increased by almost 31% over this period, but that real GDP increased by only 19.4%. POINT: To make valid cross-year comparisons for anything measured with money, we have to convert from nominal dollars to real dollars.

Do problem #7 on page 177.

PROBLEMS WITH GDP -

1. Nonmarket production - Nonmarket production is excluded from GDP because there is no way to accurately measure it. Only actual "market transactions" get counted in GDP.  Nonmarket production includes household production like fixing your own car, repairing, fixing, painting your house, working on your garden, growing your own food, cooking, the work of a housewife/househusband, etc. Estimated to be 10-15% of GDP, or about \$1T/year.

Example: If you eat out a restaurant, the value of the meal counts in GDP since it was a market transaction.  If you eat the same food at home, only the value of the food counts and your "nonmarket production" (cooking) is NOT counted in GDP.  If you hire someone to clean your house, it adds to GDP.  If you clean your own house, it doesn't count for GDP.

Official GDP might understate the output of developing countries compared to developed economies. Example, in Mexico there is more household production that is not counted compared to the U.S. Mexican families are more likely than American families to grow their own food, prepare their own food, do their own laundry, provide their own child care, build their own houses, fix their own cars, etc..

A comparison of official GDP over time would also be distorted, since many households have gradually substituted market transactions for household production, which would overstate GDP in the later years compared to the earlier period.  Households are more likely now than 30 years ago to eat out (increase in fast food), use dry cleaning services, hire a lawn service, get oil changed at Rapid Oil, hire house cleaning service, etc.

2. Underground economy - could also easily be another \$1T, or 10-15% of GDP from prostitution, drug trafficking, gambling, smuggling, illegal gun sales, tax evasion, etc. Also unreported cash income from cash business - taxi drivers, waiters/waitresses, bars, craftspeople, carnivals, fleas markets, illegal immigrants, etc.

Underground economy is even higher in S. America (heavy regulations) and Europe (heavy taxes).

Evidence: There is about \$500B of currency in circulation, for about 250m people, that means there is \$2000 currency outstanding per person x 4  persons per average household = almost \$8000/family in CASH!!

3. GDP doesn't account for amount of time worked, or the improved conditions in the workplace. On average, the workweek has declined over time - 40 hours in 1947 to 34.5 today. This has raised our standard of living because leisure has increased (and we highly value leisure), but this doesn't show up in GDP. Also, most jobs are now safer, less strenuous, and more comfortable. Even up to 1900, about 50% of the population was involved in agriculture, very demanding physical work. GDP is strictly a measurement in dollars, doesn't factor in non-monetary factors like leisure, working conditions, life expectancy, etc. very well.

4. Quality Improvements and Introduction of New Products - Economists try to adjust for quality improvements, but it is hard to accurately measure quality improvements. Example: cars are much better, more durable, safer (airbags, ABS, fuel injection, etc.), dental services have improved and are now almost painless, computers have improved, all electronics have improved, there have been many medical advancements and breakthroughs, etc.  Also, new products are introduced all the time: Faxes, cellular phones, Internet, email, computers, CD, DVD and VHS players, etc. didn't exist 25 years ago..

Example: In 1930 real GDP per capita was \$7000, in 1998 it was almost \$28,000, about 4x the level in 1930. Are we four times better off?

Depends - there are products available now that even a millionaire couldn't buy in 1930 - TV, VCR, antibiotics, computers, jet planes, CDs, etc. Even a millionaire couldn't purchase the typical bundle consumed by an average consumer.

POINT: Quality improvements and the introduction of new products are hard to measure accurately and therefore don't get reflected in GDP. GDP is strictly a somewhat crude, monetary measure of output, doesn't necessarily measure standard of living.

5. Harmful Side Effects / Externalities- GDP makes no allowance for negative externalities such as pollution. The economic costs to society from air and water pollution are not subtracted from GDP. In fact, money spent to clean up pollution will actually add to GDP.

Also, GDP doesn't account for the damage from natural disasters like hurricanes, earthquakes, tornados, etc. because it is outside the area of market activity. The subsequent construction would be counted. Since the destruction is not counted but the rebuilding is counted, GDP would overstate the change in living standards (GDP) from an act of nature.

DIFFERENCES IN GDP OVER TIME AND ACROSS DIFFERENT COUNTRIES

1. Changes Over Time in GDP: Although not perfect, GDP/capita gives us a starting point to measure and compare changes in the standard of living over time.  See p. 171 - Real GDP/capita has increased from \$6,000 in 1930 to \$34,000 in 2000, an increase of 5.55 times over 70 years in GDP/capita.  Is the average person 5.5 times better off?  Depends on the bias.

Upward bias: The amount of nonmarket activity over time has increased, which would artificially bias GDP/capita upwards in recent years (as a measure of our standard of living), meaning that we might not be 5.5 times better off.

Downward bias: There has been significant progress over time in medicine, technology, new products, safer products, longer life expectancy, shorter work week, more pleasant work envirornments, etc., meaning that we might be more than 5.5 times better off!

In general, we can say that our standard of living has increased significantly over time, regardless of whether it is more or less the 5.5 time increase in Real GDP/capita.   For example, see the application "The Time Cost of Goods" on p. 173-174.  Comparing wages and prices measured in dollars over time is complicated because of the changing value of the dollar.  Another way to adjust for inflation in prices and wages is to calculate prices for consumer goods in minutes or hours worked (at the average wage) instead of dollars.  See Chart 1 on p. 174.  Real prices have fallen and/or real wages have risen over time, resulting in an increase in our standard of living.

2. International Comparison of GDP: See Exhibit 8 on p. 172 for a comparison of GNP/capita.  U.S. is the highest.  Caveats: 1) Underground economy in Europe is much greater than, so official GNP statistics understate actual production/output in Europe.  U.S. standard of living might not actually be 50% greater than U.K. as the GNP data suggest.  2) There is more household production of goods/services in Mexico than in U.S., so official GNP stats in Mexico understate the actual production.  U.S. standard of living might not actually be 4x greater than Mexico as the GNP data suggest.

Main Point: There is link between GNP/Income/Output and "Quality of Life."  People in higher income economies live longer, have higher literacy, and lower infant mortality.  Therefore, even with some shortcomings, GNP/GDP is a useful and fairly accurate indicator of economic well-being, quality of life and standard of living.

CONTRIBUTION OF GDP - Even if GDP cannot perfectly and precisely measure economic welfare or economic well-being because it omits leisure, household production, quality improvements, side effects, etc., it does measure the value of output in the market sector, and shows us how that output changes over time.  GDP allows us to have a measure of economic performance, and gives policy makers and business owners information that helps them make decisions.  We can also do cross country comparisons. Conclusion: Despite shortcomings, GDP is a valuable measure of economic performance, and allows us to track the economy over time, and make international comparisons.

RELATED INCOME MEASURES -

See page 175. We sometimes hear about other measure of income like GNP, National Income, Personal Income or Disposable Income. Personal income is the total of all income received by all Americans, adjusted for taxes like Social Security. It also includes transfer payments. After personal income is adjusted for federal and state income taxes, we are left with disposable income.  For example, which measure of income do you think GM and Target are most interested in?

POINT: Income and Output are the same: GDP = GDI (gross domestic income).  Expansion in output and higher income levels are the same.  Increases in productivity are the ultimate source of higher income.  How to achieve greater productivity?  Central question of economics going back to Adam Smith ("An Inquiry into the Nature and Causes of the Wealth of Nations.").

Problems 1, 7-9, 14, 17