Chapter 6 - Taking the Nation's Economic
See graphs on pages 137-138 and the questions posed.
In this chapter we look at how the economy's output is measured. We use the national income accounting system developed during the 1920s and 1930s to measure national income or national output. Just like a firm needs accounting to measure income to calculate profits or losses, the entire economy needs an income statement.
GDP is the most widely used measure of economic performance around the world. We currently have about $8T of annual GDP and we measure GDP in dollars. 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.
Dept of Commerce tracks the economy and releases the figures on GDP on a quarterly basis. Time frame - we just ended the fourth quarter of 1997 (October, Nov, Dec). The first estimate of fourth quarter GDP will be released around Feb 1, second estimate on March 1 and the final estimate around April 1. It takes three months after the EOQ to finalize data.
What GDP Counts and Doesn't Count:
1. Only final goods and services purchased by final users. Retail sales. GM buys steel or tires or transmissions, that doesn't count because it would be double-counting. For example, suppose GM spends $15,000 for a car and sells it to a deal 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+16+17.
Example, page 142. 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 sales would get counted, because they are current services.
Since GDP only counts durable goods like cars when they are produced, it may not accurately reflect economic activity. Example, during a recession, there may be fewer durable goods produced in the current period, but people will still have the use of goods produced in previous periods. More active secondhand market for resale. GDP would understate actual consumption during a recession.
And during expansion, production of new goods will increase in the current period even though they will last for many years. In this case, the current GDP may overstate consumption during an expansion.
3. Financial transactions and income transfers are excluded. Example: stock or bond purchase is just a transfer of money from one ind to another. Commission would count. Or if you get a gift, it doesn't count. Income transfers (Soc Security, welfare, veterans' pmts, etc) don't count.
Dollars are the common denominator for GDP. GDP = total spending on all goods and services produced during the year, or quarter, measured in dollars.
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", US citizens regardless of where they are working. See equation on page 143.
Canadian citizen crosses the border to work in Detroit. That counts in US GDP but not in US GNP. US citizen crosses the border to work in Canada, that counts in US GNP but not in US GDP.
When will GDP and GNP differ? The difference is usually quite small, about 1% in US, Germany, Japan, UK, because usually domestic production is produced by the countries' own citizens using domestic labor and capital. See page 151.
But if a country has a large number of foreign workers or foreign investment, the country's GDP could be larger than GNP. Examples: Canada, Indonesia, Malaysia and Australia have all attracted foreign capital and foreign labor, so that GDP > GNP.
If a country makes substantial investment abroad, or has large number of citizens working abroad, then the GNP > GDP. Example, Kuwait and Switzerland, the ratio of GDP to GNP is 86 and 96 percent.
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 145-146, Exhibit 6-2 and 6-3 - Two Ways of Measuring GDP
EXPENDITURE APPROACH: C + I + G + Net Exports
How was money spent during the year by consumers, businesses and governments?
1. Personal consumption expenditures - largest percentage of GDP - almost 70% - over $4T in 1993. Breakdown of PCE - durable, nondurables and services.
a. Durables - lasts longer than a year. Autos, furniture, appliances, etc.
b. Non-durables - 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 - fixed investment and inventories.
a. Fixed investment - business investment in property, plant and equipment. Spending on capital equipment. 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 $1100B was spent on gross investment in 1995, about $700B to replace worn-out equipment and $400B was Net Investment.
Future econ growth depends on Net Investment, because NI enhances future productive potential. Investment is for the future. Shifts out PPF by increasing capital stock.
b. Inventory investment. Change in Inventory. GDP measures current production, regardless of whether it has sold during the year. If inventories have increased over the year, inventory investment will be positive. If inventories decrease, inv investment will be negative. 1995 - US invested $37B in inventory.
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 gov spending on everything except transfer payments. Includes both consumption and investment goods. Includes spending on highways, gov buildings, education, FBI, FDA, DEA, ATF, Dept of Commerce, FDA, EPA, defense, etc.
4. Net Exports = Exports - Imports. 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. Means Y > C. When M > X, we have a trade deficit. Means C > Y.
We had a trade deficit in 1995 of -$102B.
See page 150 for a graph of Expenditure Approach and
Resource Cost-Income Approach.
In panel b, we see a graph of the RESOURCE-INCOME APPROACH to GDP. $8T spent on final goods and services goes somewhere. It goes to resources and the owners of resources. One persons spending is another person's income. $1500 spent on tuition goes to - salaries, buildings, books, etc.
$8T in spending by households, business and governments
1. Labor - employee compensation - 60%
2. Self-employment income - 7% Together, employees and self-employed persons account for 2/3 of GDP.
3. Rents, corporate profits, and interest are payments to people who supply either physical capital or financial capital to business.
Rent - lease payments to the owner of a shopping
Profits - money paid to shareholders for providing capital to a corporation.
Interest - money paid on loans to businesses. Bonds, bank loans, etc.
Indirect Business Taxes - taxes on goods which get passed along to consumers. Examples: sales, excise or 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.
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. In 1995, depreciation was $826B.
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.
Example: US citizen earns $100,000 working in Canada. We want to subtract that from GNP to get GDP.
Example: Canadian citizen earns $50,000 in US.
That counts for GDP.
Net income (NI): = Inc Americans earned abroad - Inc foreigners earned in US.
If NI > 0, Americans earned more abroad than foreigners earned here. The net income is pos, and contributes to GNP, but not GDP. When pos, we subtract NI from GNP to get GDP.
In the example above, the net inc would be $100,000-50,000= $50,000. We would subtract $50,000 to get to GDP.
In 1995, foreigners contributed $8B more to US output than US citizens contributed to foreign output. So that was added to the Resource Cost-Income approach (p 146). GDP was $8B more than GDP.
DEPRECIATION AND NET DOMESTIC PRODUCT -
Page 163. If we adjust Gross Domestic Product for depreciation of capital assets (property, plant and equipment), we have NDP, net domestic product. GDP doesn't allow for the wearing out of capital goods, so it can overstate the net output of an economy. GDP counts gross investment, NDP counts only net investment, or net additions to the capital stock. By counting gross investment, part of which is the replacement of worn out equipment, GDP OVERSTATES actual production. By subtracting off depreciation from GDP, we factor out the amount in GDP that was not really spent on new production, but is spent on replacing or fixing old equipment.
Example: GM spends $1 to replace worn out equipment, tools, or machinery, it is not really new production, it is just substituting new equipment for old equipment.
REAL VS. NOMINAL GDP -
In econ we always have to distinguish between real and nominal econ values or variables. Reason: we measure econ variables in dollars and the value of dollars is constantly changing. Inflation erodes the purchasing power of money over time. One dollar today is worth more than one dollar ten years from now, worth less than one dollar ten years ago. "Money's Gettin' Cheaper"
Nominal values, or money values are expressed in current dollars, or dollars during the current period. Over time, nominal values of income, asset values, economic variables in general get bigger for two reasons: 1) changes in the real size 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 concerned with real income, real GDP, real output, real values, real growth...
Example: Nominal GDP = Sigma(i=1 to n) Pi Qi
Over time, nominal GDP will increase as prices rise, and as 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 growth rate = % Nominal GDP - Inflation
Example: 1995, nominal GDP growth was 4.5%, inflation was about 2%, so real growth was about 2.5%.
We need a measure of inflation to make the adjustment for price level changes. There are two measures: CPI and GDP deflator. CPI is a consumer price index, measures the price level changes that affect consumer purchases, comes out monthly.
GDP deflator is a much broader, more comprehensive price
index that is used in GDP accounting, comes out quarterly.
Choosing a price index depends on the application. CPI measures consumer prices, cost of living increases. GDP Deflator is an ecnomy-wide price index, appropriate for adjusting national income data.
There is also the PPI (producer price index).
See p. 156 for a comparison of GDP Deflator and CPI. Some years, inflation from one is higher, other years the other, some years the same. Average inflation over 15 years is about the same, 4.2% for CPI and 4% for GDP Deflator.
To establish the price index in a given period, a typical basket of goods is determined. The basket of goods is priced in one period and in the next period and the index is calculated. The base year is established and the price index in that year is 100.
See example on page 154. Market basket of goods for college students might be:
60 hamburgers at McDonalds 4 T-shirts in university bookstore 2 pairs of Levi jeans 1 compact disc
Cost in 1985 = $200, base year, so Index = 100
Cost in 1994 = $324
Price Index in 1996 = 324/200 x 100 = 162
Inflation is just the percentage change in the price index from one period to another. Example: assume that in 1995 the price index was 150, and in 1996 it was 162. Rate of inflation is the percentage change in the index:
162-150/150 = .08 x 100 = 8% rate of inflation.
Actual CPI actually has 364 items typical of what urban consumers buy, established by a Consumer Survey in 1982-1984. Each month, prices are checked at 21,000 stores across the US, and the CPI uses 125,000 prices to establish average prices.
Why might CPI overstate the TRUE rate of inflation?
1) Substitution - 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 "substitution bias."
2) Quality improvements. Suppose one of the products in CPI is an average computer. What if the average price goes from $1500 to $1650 over a few year period, a 10% price increase, but they are comparing a 386 vs a Pentium II(586), possibly a computer with twice as much power. The real cost has fallen, even though the nominal price increase indicates inflation.
The current 3% inflation from CPI may actually overstate inflation by several percent? Boskin report, page. 157. Conclusion: CPI overstates inflation by 1.5%
The GDP deflator includes consumer items plus goods and services purchased by businesses and governments. The GDP deflator also does NOT use a fixed basket but allows the goods and services to change. In fact, it uses the current goods purchased this year and compares what the goods cost today vs last year.
GDP Deflator (current basket) =Cost of 1996 market basket/Cost of 1996 market basket at 1995 prices x 100
CPI (fixed basket) =Cost of base yr mkt basket(1985) in 1996/Cost of base year mkt basket in base year x 100
PROBLEMS WITH GDP -
1. Nonmarket production - nonmarket production is excluded from GDP because there is no way to accurately measure it. Nonmarket production includes household production like fixing your own car, repairing, fixing, painting your house, working on your garden, growing your own food, the work of a housewife/househusband, etc. Estimated to be 10-15% of GDP, or about $1T/year.
Might understate the output of developing countries compared to developed. Example, in Mexico there is more household production that is not counted compared to US. Mexican families are more likely than American families to grow their own food, prepare their own food, provide their own child care, build their own houses.
Comparison over time would also be distorted. More women are involved in market workforce now compared to 30 years ago. Increase in labor force.
2. Underground economy - could also easily be $1T, or 10-15% of GDP. Prostitution, drug trafficking, gambling, smuggling, illegal gun sales, etc. Also unreported income from cash business - taxi drivers, waiters/waitresses, bars, craftspeople, carnivals, farmer's market, illegal immigrants, etc.
Underground economy is even higher in S.America (heavy regulations) and Europe (heavy taxes).
$1200 cash outstanding per person x 4 = almost $5000/family of 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, but doesn't show up in GDP. Also, most jobs are safer, less strenuous, and more comfortable now. Even up to 1900, about 50% of the population was involved in agriculture. GDP is strictly a measurement in dollars, doesn't factor in non-monetary factors very well.
4. Quality Improvements and Introduction of New Products - Economists try to adjust for quality improvements, but it is hard to really measure quality improvements. Example, cars are much better and safer (airbags, ABS, fuel injection, etc.), dental services have improved and are now almost painless, computers have improved, all electronics have improved, etc.
And new products are introduced all the time. Faxes, cellular phones, computers, CD players, VCRs, etc. all didn't exist 25 years ago.
Failing to adjust for quality improvements and new products may overstate inflation by 1-2% annually.
For example, in 1930 real GDP per capita was $7000, in 1995 it was over $25,000 or more than 3x the level in 1930. Are we three 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.
Quality improvements are hard to measure. GDP is strictly 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. Air and water pollution are not considered in the calculation of GDP. In fact, money spent to clean up pollution will actually add to GDP. "Green" GDP.
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 from an act of nature.
CONTRIBUTION OF GDP - GDP cannot really measure economic welfare or economic well-being because it omits leisure and household production, etc. It does measure the value of output in the market sector, and shows us how that output changes over time. Allows us to have a measure of our economic performance, and gives policy makers and business owners information that helps them make decisions.
RELATED INCOME MEASURES -
see page 163. We sometimes hear about national income or personal 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.
Income = Taxes + Consumption + Savings
Income - Taxes = Disposable Income = Consume + Save.
Problems 1, 7-9, 11, 14, 20