Macro Measuring Domestic Output and National Income Lecture Notes 7

CHAPTER 7 Measuring Domestic Output and National Income We will be calculating how economists estimate a country’s output and income for ayear. The importance of these figures will be discussed, as well as thedifferences between the various ways that we can measure income. Lastly, wewill discuss how we can adjust the figures that we have calculated forinflation effects and analyze some of the issues associated with the various accounts. Assessing the Economy’s Performance -National income accounting measures economy’s overall performance. Nationalincome accounting does for the economy what private accounting would do for anindividual household or business. -Bureauof Economic Analysis compiles National Income and Product Accounts. TheBureau of Economic Analysis, an agency of the Department of Commerce, compilesthe data and reports it in National Income and Product Accounts. Thisinformation is used by economists and policymakers in formulating decisions forthe best interest of the nation. •Assess health of economy •Track long-run course •Formulate policy Gross Domestic Product -Measure of aggregate output: Theprimary measure of the economy’s performance as a whole is its aggregateoutput. This is most commonly calculated as Gross Domestic Product, or GDP. -Monetary measure: GDPis a monetary measure in that everything is valued in dollars. All goods andservices produced must be converted into dollar values for GDP to work. -Avoid multiple counting: Toavoid multiple counting of goods, GDP includes only the market value of finalgoods and ignores intermediate goods, which are goods either purchased forresale or for further processing into final goods. GDP could also avoidmultiple counting by counting only the value added at each stage. Value addedis the market value of a firm’s output less the value of the inputs that thefirm purchased from others. •Marketvalue final goods •Ignoreintermediate goods •Countvalue added GDP: C+I+G+NX Monetary Measure -GDPis a monetary measure because we would not otherwise be able to determine iftotal output has changed from year to year if the mix of goods and serviceschanges. Gross Domestic Product Continued Thistable illustrates the value-added in a five-stage production process. The valueadded is calculated as the difference between the sales value of the materialsand the value of the good at the previous production stage value. Using thismethod will avoid multiple counting. Gross Domestic Product Concluded -Exclude financial transactions: Nonproductiontransactions must be excluded from GDP since they have nothing to do with theproduction of final goods. There are two types: purely financial transactionsand secondhand sales. -Purelyfinancial transactions include such items as public transfer payments likeSocial Security, private transfer payments (Christmas gifts), and stock markettransactions. •Public transfer payments (medicare) •Private transfer payments •Stock market transactions -Exclude second hand sales: Secondhandsales contribute nothing to current production so they are ignored incalculating GDP. •Sell used car to a friend Two Approaches to GDP Income approach: Theincome approach looks at GDP in terms of the income derived, or created, fromproducing goods and services. •Countincome derived from production •Wages,rental income, interest income, profit Expenditure approach: The expenditures approach measures GDP as the sum of all of the money spent inbuying the output. In theory, either method should yield equal results. •Count sum of money spent buying the final goods •Who. buys the goods? *The expenditures and income approaches are two different ways to look at the samething. You could look at a quarter from the heads side or the tails side, butit is still worth the same amount. This is the same as the expenditures andincome approaches for calculating GDP.* Here. the two different approaches to measuring GDP are illustrated. On the left, theexpenditures approach measures GDP as the sum of four items: (1) consumption byhouseholds, (2) investment by businesses, (3) government purchases, and (4)expenditures by foreigners. On the right, the income approach uses differentinputs: (1) wages, (2) rents, (3) interest, (4) profits, and (5) statisticaladjustments. Each of these items will be further discussed next. Exp.A: 3.1 Inc.A: 3.999 Expenditures Approach *Personal consumption expenditures, indicated by a "C" notation, covers all expendituresby households on final goods and services during a year. In any given year,approximately 10% of those expenditures are for durable consumer goods, which are defined as having a life of three years or more. Another 30% go to nondurable goods such as food, clothing, and gasoline. The other 60% are forservices leading to the U.S. economy frequently being referred to as a serviceeconomy. *To determine GDP using the expenditures approach, we add up all the spending on final goods and services that has taken place throughout the year. -Personal consumption expenditures (C)= What we have called "consumption expenditures by households," the national income accountants call personal consumption expenditures. This term covers all expenditures by households on goods and services. •Durable goods: products that have expected lives of 3 years or more. Such goods include new automobiles, furniture, and refrigerators. •Nondurable goods: Another 30 percent are on nondurable goods—products with less than 3 years of expected life. Included are goods like food, clothing, and gasoline. •Consumer expenditures for services: About 60 percent of personal consumption expenditures are on services—the work done by lawyers, hair stylists, doctors, mechanics, and other service providers. •Domestic plus foreign goods produced -Gross private domestic investment (Ig) : The second component of the expenditures approach is gross private investment,which includes all final purchases of machinery, equipment, and tools bybusinesses, all construction, and changes in inventories. All of these itemsrepresent ways businesses invest in themselves. Construction also includes residential construction because homes could be rented to produce income. •Machinery,equipment, and tools •All construction •Positive and negative changes in inventories •Creation of new capital assets •Non investment transactions excluded •Money spent on research and development (R&D) or for the creation of new works of art, music, writing, film, and so on. *When gross investment exceeds depreciation during a year, net investment occurs.This net investment expands the stock of private capital from the beginning ofthe year to the end of the year, allowing the economy’s production capacity toexpand, all other things equal.* Gross investment includes investment in replacement capital and in added capital.In contrast, net private domestic investment includes only investment in the form of added capital. The amount of capital that is used up over the course of a year is called depreciation. * *Gross investment need not always exceed depreciation, however. When gross investment and depreciation are equal, net investment is zero and there is no change in the size of the capital stock. When gross investment is less than depreciation, net investment is negative. * Expenditures Approach Concluded *The last two components of the expenditures approach are government purchases and net exports.* -Government purchases (G)=Government purchases are officially labeled "government consumption expenditures and grossinvestment." It includes expenditures for goods and services that the government uses in providing public services and expenditures for publicly owned capital such as for schools or roads. It excludes government transfer payments such as Social Security because they simply transfer government receipts to certain households and does not generate any sort of production. *(1) expenditures for goods and services that government consumes in providing public services; (2) expenditures for publicly owned capital such as schools and highways, which have long lifetimes; and (3) government expenditures on R&D and other activities that increase the economy’s stock of know-how. Government purchases (federal, state, and local) include all government expenditures on final goods and all direct purchases of resources, including labor.It does not include government transfer payments because, as we have seen, they merely transfer government receipts to certain households and generate no production of any sort* •Expenditures for goods and services •Expenditures for publicly owned capital •Excludes transfer payments -Net exports (Xn)=Netexports are calculated by subtracting the value of imported goods from thevalue of exported goods. Adding up all four components provides a measure of GDP, a measure of the market valueof a specific year’s total output. •Add exported goods •Subtract imported goods •Xn= exports (X) -imports (M) Accounting Statement for the U.S. Economy, 2015 *This table calculates GDP for 2015 in the United States by both the expendituresapproach and the income approach. Note that both methods come to the same totalof GDP for the year.* The Income Approach *This approach allocates expenditures as income to those responsible for producing the output. The major component is national income, which is made up of employee compensation, rents, interest, proprietor’s income, corporate profits,and taxes on production and imports. The largest share is employee compensation which includes wages and salaries paid by both businesses and government aswell as supplements such as benefits paid by employers on behalf of employees.* •Compensation of employees= includes wage and salary supplements, in particular, payments by employers into social insurance and into a variety of private pension, health, and welfare funds for workers. •Rents=consist of the income received by the households and businesses that supply property resources. They include the monthly payments tenants make to landlords and the lease payments corporations pay for the use of office space. The figure used in the national accounts is netrent— gross rental income minus depreciation of the rental property. •Interest= consists of the money paid by private businesses to the suppliers of loans used to purchase capital. It also includes such items as the interest households receive on savings deposits, certificates of deposit (CDs), and corporate bonds. •Proprietor’s income •Corporate profits Corporate profits are the earnings of corporations. National income accountants subdivide corporate profits into three categories:    Corporate income taxes These taxes are levied on corporations’ profits. They flow to the government. Dividends These are the part of after-tax profits that corporations choose to pay out, or distribute, to their stockholders. They thus flow to households—the ultimate owners of all corporations. Undistributed corporate profits Any after-tax profits that are not distributed to shareholders are saved, or retained, by corporations to be invested later in new plants and equipment. Undistributed corporate profits are also called retained earnings. •Taxes on production and imports=includes general sales taxes, excise taxes, business property taxes, license fees, and customs duties *Under the income approach, all expenditures on final goods and services flow as income to either private citizens or the government. •From national income to GDP=To move from national income to GDP, several adjustments must be made. *national income is the total of all sources of private income (employee compensation, rents, interest, proprietors’ income, and corporate profits) plus government revenue from taxes on production and imports. * -Subtract net foreign factor income=. The first adjustment is fornet foreign factor income. This is income Americans gain from supplying resources abroad, which would be taken out, and then income that foreignersgain from supplying resources to the U.S. would be added. -Statistical discrepancy= The next adjustment comes from what is called a statistical discrepancy, which basically is just a balancing amount. -Consumptionof fixed capital= The final adjustment factor is the usefullife of private capital equipment that extends well beyond the year in whichthey were produced. The cost of the equipment must be allocated over its usefullife. The huge depreciation charge made against private and publicly owned capital each year is called consumption of fixed capital because it is the allowance for capital that has been "consumed" in producing the year’s GDP. It is the portion of GDP that is set aside to pay for the ultimate replacement of those capital goods. •Other national accounts=The other national accounts provide useful information about theeconomy’s performance. -Net domestic product (NDP)= NDP is GDP less consumption of fixed capital. -National income (NI)= National income is NDP less thestatistical discrepancy and plus the net foreign factor income. -Personal income (PI)= Personal income includes all income received, regardless of whether it is earned or unearned. -Disposable income (DI)= Finally, disposable income is PI less personal taxes. It is personal income less personal taxes. Personal taxes include personal income taxes, personal property taxes, and inheritance taxes. Disposable income is the amount of income that households have left over after paying their personal taxes. They are free to divide that income between consumption (C) and saving (S): U.S.Income Relationships 2015 *These tables illustrate the relationship between GDP, NDP, NI, PI, and DI in the United States for 2015.* Circular Flow Revisited *Here is the updated circular flow that was introduced in a much simpler form in aprevious chapter. However, from this diagram, we can see that even when weaccount for more transactions in the economy, income and expenditures are equal.* Nominal GDP vs. Real GDP •GDP is a dollar measure ofproduction •Using dollar values createsproblems  GDP measures production at current dollar values which creates problems because thevalue of a dollar changes over time. Nominal GDP •Based on prices that prevailed when output was produced Real GDP •Reflect changes in the price level •Usebase year price  . A. GDP that has been deflated or inflated to reflect changes in price levels isreferred to as real GDP. In order to calculate real GDP, a base year must beselected and then the current year’s prices adjusted accordingly. GDP Price Index  This is the formula used to calculate real GDP. We use a price index that is equal to the price of a collection of goods and services in the specific year dividedby the price for the same goods and services in a base year multiplied by 100.Nominal GDP is then divided by the price index (in hundredths) to determinereal GDP. *In this table, nominal GDP and real GDP are calculated based upon the formula.Years 1 to 3 have been calculated. Complete the table for years 4 and 5.* Shortcomings of GDP •Nonmarket activities •Leisure •Improved product quality •The underground economy •GDP and the environment •Composition and distribution of output •Non economic sources of well-being *While GDP is a reasonably accurate and highly useful measure of how the economy isperforming, it does have several shortcomings. Certain productive activities occur outside of any market and therefore are not measured in the traditional way. The value of leisure time, weekends, holidays, etc., is also not included,but they certainly add value due to the added satisfaction they provide to workers. GDP fails to capture the full value of improvements in product quality. Let’s faceit, a $200 cell phone purchased today is of very different quality than a cellphone that cost $200 just a decade ago. There is also a huge undergroundeconomy, mainly comprised of illegal activities, that produces income that isnot measured through traditional GDP methods. Included in this undergroundeconomy are legal activities that provide income that the recipients refuse toreport to the I.R.S. and pay taxes on. Environmental issues and noneconomicsources of well-being are also problematic in that GDP does not really have away to accurately value and report the issues.*