The Measure of Economic Health

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5 The Measure of Output, Income, and Economic Growth

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Learning Outcomes

After reading this chapter, you should be able to

• Expand the circular flow model as a basis for examining GDP.

• Explain how GDP, net national product, national income, and personal income are calculated.

• Learn how to compute real GDP and growth rates of real GDP and to evaluate the costs and benefits of economic growth.

116

Section 5.1 Revisiting the Circular Flow Model

Introduction Liechtenstein is a country many people have never heard of. However, this little country in Europe has the highest gross domestic product (GDP) per capita in the world! When we study macroeconomics, one of the biggest indicators of strength in an economy is GDP, or the mea- surement of the final value of all goods and services produced in a country over a certain period of time.

But GDP is only one piece of the picture. When we break GDP down per person, we have what economists call GDP per capita. Some countries have a high GDP simply because they have a higher population. Countries like India show a high GDP, but that is primarily because there are over a billion people living there. When we measure GDP per person, we can see that the individual person doesn’t fare so well.

So, how does Liechtenstein lead the world in this important category? The answer is bank- ing—33% of the GDP in Liechtenstein comes from financial services. Despite a population of only 37,000, Liechtenstein has a GDP of over 6.6 billion.1 A tax haven for many because of the secretive policies and pro-business foundations, even Ikea founder Ingvar Kamprad chose Liechtenstein as the home of his foundation to avoid the high tax rate of Sweden. Liechten- stein is the sixth smallest country in the world, yet its banking center in the capital of Vaduz would rival that of any thriving metropolis. Who knew that such a small country could be a place of such great prosperity? Well, now you do.

1 Office of Statistics, Principality of Liechtenstein. (2016, November). Liechtenstein in figures: 2017. Retrieved from https://www.llv.li /files/as/fliz-englisch-2017.pdf

5.1 Revisiting the Circular Flow Model In Chapter 2 we introduced the circular flow model as a way to see the interrelationships in a market economy. The individual markets and decision makers that make up the circular flow constitute microeconomics. The sums of their actions constitute macroeconomics. This chap- ter focuses on the circular flow model from a macroeconomic perspective.

A simple two-sector circular flow model shows the flow of goods and services from firms to households as well as a return flow of payments from households for their purchases. Firms purchase the services of productive inputs from households, creating a flow of income back to households. Even in this very simple two-sector world, it is possible to identify some impor- tant macroeconomic relationships. The upper part of the diagram, the product market, repre- sents the aggregate of the individual markets in which final goods and services are bought and sold. The lower half, the resource market, is the aggregate of the individual markets in which the services of productive inputs are bought and sold. These markets represent the total of thousands of individual markets for steelwork, bread, rental housing, cars, machine tools, and other inputs and outputs. That is, the product market and the resource market are both macroeconomic markets.

https://www.llv.li/files/as/fliz-englisch-2017.pdf

117

Section 5.1 Revisiting the Circular Flow Model

Another important macroeconomic concept that is suggested by the circular flow diagram is the view of domestic income and output as a flow. The flow of resource income from firms to households becomes a flow back to firms to pay for purchases of goods and services. The upper flow is total output, and the lower flow is total income. The two flows are the same size in the simple circular flow model because all of the income received by households is spent to purchase goods and services from the firms.

Saving, Investment, and the Credit Market

Figure 5.1 is a simplified circular flow model (with just one flow through each market) with the addition of saving and investment. Saving is a flow from households that occurs because people (both as individuals and as owners of firms) refrain from spending part of their income flow on consumer goods and services. You save money when you deposit it in your account at your bank. These funds flow into the credit market instead of the product market. The credit market consists of financial institutions channeling household savings to firms that want to invest. Investment is a flow between firms. That is, firms use the borrowed funds to purchase new capital goods from other firms or to finance the “purchase” of their own output in the form of increased inventories. It is important to make a distinction between financial invest- ment and physical investment. Physical investment is investing in physical or capital goods such as machinery or equipment (see Figure 5.2). Financial investment is investing in finan- cial assets such as shares, Treasury bills, and so on. The credit market is a very important market, since it creates opportunities for households and firms to lend and borrow funds.

Figure 5.1: The circular flow with saving, investment, and a credit market

When there are leakages, not all household income is spent on consumption. A credit market allows saving by households to be converted into investment funds for firms. These investment funds are then spent by firms on capital goods and additional production.

Con su

mer spending for goods and services

Payments to resources

Business borrowing

to invest

Saving

Investment

118

Section 5.1 Revisiting the Circular Flow Model

Another important set of macroeconomic concepts are leakages out of the income stream and injections into the income stream. Leakages are flows out of the system that occur when resource income is received but not spent directly on purchases from domestic firms. Exam- ples of leakages are saving, taxes, and purchases of goods from other countries. Injections are flows added into the circular pattern that represent spending not paid for out of resource income. Examples of injections are business investment, government expenditures, and sales of domestic goods. If leakages are greater than injections, the size of the income flow will shrink. If injections are larger than leakages, the size of the income flow will increase. Because the level of output and income (that is, the sizes of the flows) is a central macroeconomic con- cern, leakages and injections play an important role in macroeconomic models.

Adding Government to Circular Flow

As we continue to increase the complexity of the circular flow model, we can now add the government, making the picture of the macroeconomy become more realistic. In Figure 5.2 governments (federal, state, and local) interact with firms and households in several ways. The government buys goods and services produced by firms. It is a third customer in addition to households, which buy goods for consumption, and firms, which purchase goods for invest- ment. Government purchases of goods and services are another injection into spending in the product market. The government also employs resources, mainly labor services. Wages paid by government increase the flow of income to households.

Figure 5.2: The circular flow with a credit market and government

Government subtracts from the circular flow by taxing households (leakage). It adds to the upper flow (expenditures) by buying goods and services from firms and to the income flow by purchasing the services of labor from households. Governments, like businesses, also borrow in the credit market.

Con su

mer spending for goods and services

Payments to resources

Business borrowing

to invest

Saving

Investment

Government purchases

TaxesTaxes

Wages—

Government borrowing

government workers

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Section 5.1 Revisiting the Circular Flow Model

Taxes collected by governments are a leakage from household income. Taxes paid by house- holds and firms finance the services governments provide, such as defense, police, fire protec- tion, streets, and education. If the government spends more than it collects in taxes, it must borrow funds in the credit market. A government that spends more than the revenue it takes in is running a deficit. A government that collects more in taxes than it spends on wages and purchases is showing a surplus. The government, then, enters the circular flow model at a number of points.

The Foreign Sector: Exports and Imports

Now we can add the rest of the world to the circular flow model. As Figure 5.3 shows, the rest of the world is not only another customer for firms’ output but also another supplier of goods and services besides the domestic business sector. Buying from foreign countries and selling to other countries adds a new source of leakages and a new source of injections. Purchases from foreign firms are imports. Goods and services sold to foreign buyers are exports. Pur- chases of imports are flows out of the stream (leakages). Sales of exports are flows into the stream (injections). Thus, if a country increases its purchases from foreigners, ceteris paribus, the size of the flow will shrink. If the same country increases its sales to foreigners, ceteris paribus, the size of the flow will increase. The difference between exports and imports for a given country for a given year is called the balance on goods and services. A surplus in the balance on goods and services means that injections from the foreign market exceed the leak- ages. A deficit in the balance on goods and services means that foreign market leakages are greater than injections.

Figure 5.3: The circular flow with a credit market, government, and

foreign sector

Purchases from foreign sellers represent an additional leakage from the flow when households buy imports. Sales of exports to foreign buyers are an additional injection into the expenditure stream.

C on

su mer spending for goods and services

Payments to resources

Business borrowing

to invest

Saving

Spending for imports

Foreign spending

on exports

Investment

Government purchases

Taxes

Wages—

Government borrowing

government workers

Taxes

120

Section 5.2 Measuring GDP and National Income

5.2 Measuring GDP and National Income The most important flow variables in the economy as a whole are the total flow of output through the product market, in the upper half of the circular flow, and the total flow of income through the resource market, in the lower half of the circular flow. The most widely used measure of total output is GDP, which is the total market value of all final products produced within a country during a given time period. It measures the size of the spending flow in the upper half of the circular flow diagram that takes place within a nation’s borders. GDP is most often reported quarterly and annually.

You might also hear about a related measure, gross national product (GNP), which was the standard measure of output used until 1991. Both GDP and GNP figures are calculated on a per capita basis to give a snapshot of a country’s economic development. GNP differs from GDP in counting all production by the resources owned by a nation’s citizens rather than all production that takes place inside its borders. GDP defines its scope according to location; GNP defines its scope according to ownership. GDP includes, for example, the value of out- put produced by a foreign-owned plant or a resident alien in the United States but does not count the value of output of a U.S. firm in Europe or Latin America or of a U.S. citizen working abroad. The difference between the two is relatively small (about an 8% difference in 2016) for the United States, although it can be quite large for countries that are hosts to a large number of foreign firms. In Ireland the difference between GDP and GNP in 2016 was 17%.

GDP by Producing Sector

Figure 5.4 shows GDP by producing sector for the United States in 2015, 2016, and 2017. The business sector’s $11,778.9 billion consists of net sales of all firms. These figures are obtained from sales figures reported in connection with state sales taxes, corporate income taxes, and

Key Ideas: The Components of the Circular Flow Diagram

Four markets Four decision makers Three leakages Three injections

Product Households Saving Investment

Resource Firms Taxes Government purchases

Credit Government Imports Exports

Foreign Exports and imports

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Section 5.2 Measuring GDP and National Income

reports to stockholders. Domestic-income accountants try to determine net sales, eliminating double counting by subtracting sales to other firms that use the goods in further production. The accounts are supposed to consist of only final goods or final sales, not any intermediate goods. Intermediate goods are those that will be further processed into final goods. Final goods are those that will not be further processed or resold. For example, flour sold to consumers in supermarkets is counted in GDP, but flour sold to bakers is not, because the bakers will use the flour to make bread. That sale of flour will be counted in GDP as part of the value of bread pro- duced. The goal is to have all goods and services be counted—but only once.

Figure 5.4: U.S. GDP by producing sector, 2015, 2016, and 2017

These pie charts show the portion of GDP produced by each sector of the economy.

From “Table 1.3.5. Gross Value Added by Sector,” by Bureau of Economic Analysis, 2018, Retrieved March 19, 2018, from https://bea.gov /iTable/iTable.cfm?reqid=19&step=2#reqid=19&step=3&isuri=1&1921=survey&1903=24.

2015 2016 2017

Business 75.65%

Business 75.55%

Business 75.71%

State and local government

8.02%

State and local government

8.13%

Household and nonprofit sector

12.48%

Federal government

3.73%

State and local government

8.14%

Household and nonprofit sector

12.64%

Federal government

3.68%

Household and nonprofit sector

12.64%

Federal government

3.63%

The output of the business sector reflects sales of final products, measured in dollars. Most U.S. output is produced by the business sector, as you would expect in a market economy. Gov- ernments—federal, state, and local—also produce services such as public education, police protection, and domestic defense. Data for the public sector are easy to find because all gov- ernments must report to their citizens each year how much money was received and how it was spent. Although the data are easy to come by, the market value of government output is difficult to measure because these services are not sold. Government agencies hire employees to produce these services, so national income accounts measure the value of government out- put by the compensation paid to employees. The services may actually be worth more or less than this amount. In the absence of a market price, however, labor cost is the only available measure of the value of government output.

A relatively small part of the GDP is produced in the household and nonprofit sector. The household and nonprofit sector includes the value of goods and services produced by non- profit, nongovernmental agencies, such as private schools, museums, charitable organiza- tions, and social clubs, as well as some small in-home businesses, such as family day-care centers. These data are assembled primarily from income tax returns and other sources.

https://bea.gov/iTable/iTable.cfm?reqid=19&step=2#reqid=19&step=3&isuri=1&1921=survey&1903=24

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Section 5.2 Measuring GDP and National Income

GDP by Buying Sector

The more common way of reporting GDP is by the buyers rather than the sellers. The upper half of the circular flow diagram sorts out the components of GDP by buying sectors. A basic assumption behind this approach to measuring GDP is that everything that is produced is also sold to someone. If the busi- ness sector produces goods that are not sold, these goods must be added to inventories. Business inventories are stocks of goods held by firms from which they can make sales to meet demand. Changes in these inventories are counted as sales of output to the business sector.

Table 5.1 shows how U.S. GDP for 2017 was divided among the four groups of buyers to which it could be sold: households, firms, government, and the foreign sector. These four groups cor- respond to the four components of the circular flow model.

AP Photo/Matthew Mead

Business inventories are an important consideration in economic forecasting.

Table 5.1: U.S. GDP by buying sector, 2017 (in billions of dollars)

GDP $19,386.2 total 100.0%

Personal consumption expenditures 13,393.4 69.1%

Consumer durables 1,474 7.6%

Consumer nondurables 2,820.7 14.6%

Consumer services 9,098.8 46.9%

Gross private domestic investment 3,210.4 16.6%

Fixed investment (plants and equipment) 2,449.1 12.6%

Residential construction 747.8 3.9%

Change in inventories 13.5 0.1%

Government purchases of goods and services 3,353.5 17.3%

Federal government 1,260.7 6.5%

State and local governments 2,092.8 10.8%

Net exports of goods and services –571.1 –3.0%

Exports 2,344.3 12.1%

Imports 2,915.3 15.04%

From “Table 1.1.5. Gross Domestic Product,” by Bureau of Economic Analysis, 2018, Retrieved March 26, 2018, from https://bea.gov /iTable/iTable.cfm?reqid=19&step=2#reqid=19&step=3&isuri=1&1910=x&0=-9&1921=survey&1903=5&1904=2017&1905=2017 &1906=a&1911=0.

https://bea.gov/iTable/iTable.cfm?reqid=19&step=2#reqid=19&step=3&isuri=1&1910=x&0=-9&1921=survey&1903=53&1904=2012&1905=2018&1906=a&1911=0

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Section 5.2 Measuring GDP and National Income

The Household Sector Sales to the household sector are called consumption expenditures. Consumer purchases are final sales, so they are all counted as part of GDP. Consumption expenditures in turn can be divided into various categories, which are useful because each one may respond differ- ently to changes in economic conditions. Consumer durables are long-lasting items such as refrigerators and washing machines or other appliances. Consumer nondurables are items that have a very short life, like a loaf of bread or a shirt. Consumer services are that part of household consumption composed of nontangible activities. Examples of services are getting a massage, attending a concert, using personal delivery, or hiring someone to assemble your furniture. Services make up a large and growing portion of total personal consumption, as Table 5.1 indicates. Consumption of services in the United States increased by $400 billion from 2016 to 2017, a 4.5% increase in 1 year!

The Business Sector Purchases of final output by the business sector are called gross private domestic investment. Gross investment is measured before subtracting capital goods that have worn out or become so obsolete that they are no longer useful. Thus, if the business sector buys 10,000 tablets dur- ing one year but has to scrap 1,000 old tablets that year, the net change in the number of tablets is 9,000. The word gross in gross private domestic investment means that this figure is calculated before subtracting the value of equipment that is worn out or used up. In this example, gross investment is 10,000 tablets, and net investment is 9,000 units.

The word private means investment by firms, rather than by the government. The word domestic means that the investment was made in the United States, not in another country. Finally, in GDP accounting the term investment means the purchase of some real, tangible asset, such as a machine, factory, or stock of inventories. To an economist, buying bonds and making deposits in banks are actually forms of lending. When firms use those borrowed funds to purchase new plants or equipment or expand their inventories, they are investing in the economic sense, but not in a physical way.

The components of gross private domestic investment are given in Table 5.1. The largest com- ponent of investment consists of fixed investment, which is new plants or equipment, such as factories, office buildings, machine tools, and computers. A second major component of gross private domestic investment is residential construction. If you think of investment as something that will be used to provide goods and services in the future, the idea that housing should be classed as investment rather than consumption makes a great deal of sense.

The last component of gross private domestic investment is changes in business inventories. Whatever a firm produces that is not sold to other sectors becomes part of that firm’s invest- ment in inventories. Inventories are counted in GDP for the year in which they are produced, not the year sold. This method of accounting for inventories assures that the GDP accounts balance. Every dollar of output produced has a buyer. If any goods remain unsold, the accounts show that the firm that produced them has bought them to add to its own inventories. Busi- ness inventory is an important category to watch, because it can be a signal of economic out- look. For example, when firms deliberately invest in inventories, it means they expect sales to be high enough to deplete the current stock, which is a positive economic sign.

124

Section 5.2 Measuring GDP and National Income

The Government Sector A large part of a nation’s income is claimed by government—federal, state, and local—and a substantial share of output is produced by or for government. Total government expenditures are much higher than the figures that appear in the GDP accounts. The federal government alone spent more than $6,177.5 billion in 2017. State and local governments added another $2,756.3 billion. Some of these government expenditures were for transfer payments, which are income payments to individuals who provide no goods or services in exchange. Veterans’ benefits, welfare payments, unemployment compensation, and Social Security benefits are all examples of transfer payments. Transfer payments are not counted in GDP, because they are not related to production. Only spending by government to produce or to purchase goods and services, such as national defense, health care, or highways, is counted in GDP.

Even with this narrower definition, purchase of goods and services by governments at all levels is still a major component of GDP—almost 1 dollar in 5. The largest part of govern- ment expenditures is for salaries and wages for government employees. Governments also purchase goods and services produced by other sectors, mainly the business sector. State and local governments actually purchase more goods and services than the federal government does. Some government purchases are used up almost immediately, such as food for army mess halls. Other government expenditures, such as those for dams or highways, result in goods that will last for years. These can be regarded as a form of government investment. The NI accounts, however, do not distinguish between government consumption and government investment but treat all government expenditures alike.

The Foreign Sector The final group of buyers is the foreign sector. The foreign sector consists of firms that buy from and sell to other countries, as well as the relatively small amount of household pur- chases abroad. Consumption, investment, and government expenditures all include some imported goods, which must be subtracted from the GDP because they are produced else-

where. Exports are part of domestic production, so they need to be included in GDP. Thus, exports are added and imports are subtracted to arrive at GDP. For convenience, GDP accounts usually group these exports and imports together and report the differ- ence between them, called the net exports of goods and services.

The use of net exports makes the foreign sector look less significant than it really is. Exports accounted for 12.1% and imports for 15% of the foreign sec- tor in 2017. The balance on goods and services (another name for net exports) can be either posi- tive or negative. When it is negative, there is often concern about the effects of the flood of imports on competing U.S. firms and of reduced export sales by U.S. exporting industries.

Max W. Hunn/SuperStock

Ecuador is the largest exporter of bananas in the world, selling $2.7 billion of bananas in 2016, 23.3% of the world total. The next largest exporter, Guatemala, sells less than half as much ($1.2 billion).

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Section 5.2 Measuring GDP and National Income

Total Spending and GDP The sum of spending by the four buying sectors is GDP. Adding consumption spending by households (C), investment spending by business (I), purchases of goods and services by government (G), and spending by the foreign sector, or net exports (X – M), gives this formula for GDP:

GDP = C + I + G + (X – M)

This formula states that everything that is produced in a year must be purchased by one of the four buying sectors.

National Income

The top half of the circular flow diagram measures the flow of output, or GDP. In the process of producing GDP, income is generated. This income is paid to the resources and corresponds to the accounting concept of domestic income. National income (NI) is income earned by the resources—land, labor, capital, and entrepreneurship. It consists of wages, rent, interest, profit, and proprietors’ net income, and it is shown on the bottom half of the circular flow.

Policy Focus: What Are the Limitations of Using GDP?

Although GDP has been used since 1944 to measure the general health of the U.S. economy, there are distinct drawbacks to using only GDP when determining the state of a country’s economic well-being.

First, GDP only counts the goods and services produced within a country’s borders during the year, regardless of whether they were produced by citizens or resident aliens. National GDP figures actually hide significant variations in output, employment, and incomes across a population. GDP calculations also exclude financial transactions and transfer payments because they do not represent current production.

Second, environmental quality is not included in GDP. The costs associated with pollution— like cleaning up, reverting over, or changing a method of production—cannot currently be quantified and added to the GDP equation.

Information has to be collected after a specified time period—today’s GDP would only be an estimate. After the data are collected and compared, only then can economists decipher the business cycles and ascertain information about a country’s economy.

Finally, GDP figures alone do not show the distribution of income and inequality of financial wealth, which can be distributed very unequally among the population, even in more advanced economies.

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Section 5.2 Measuring GDP and National Income

Global Outlook: Making International Comparisons

Once statistics are compiled, they are almost always used for comparisons. Is GDP higher than last year? Is GDP in the United States growing faster than GDP in other countries? How does the unemployment rate or inflation rate in the United States compare with that in other developed countries? It is possible to make those comparisons, but they must be done with caution. GDP, unemployment, and price indexes are not computed exactly the same way in all countries. The share of economic activity going through the market is much different in less developed countries. This difference affects all three indicators, but especially GDP and unemployment.

Comparisons of the United States, Canada, Japan, Australia, and the countries of western Europe are a little more reliable, because these countries are all at similar levels of economic development. The share of economic activity passing through the market is roughly the same, and the ways statistics are collected and presented are similar, but differences still remain. For example, unemployment figures for some countries may only include long-duration unemployment (13 weeks or longer), people aged 25 or over, or full-time workers only. Others may count as unemployed those workers who hold part-time jobs but would prefer to be full- time (Sorrentino, 2000). Similar differences exist for GDP figures and for price indexes.

In addition, even in industrial countries, the data are not always very accurate. The preliminary figures for GDP are often very different from the final figures, which do not appear until 3 years later (Bureau of Labor Statistics, 2018a). With these qualifications, how do the major industrial economies compare on the three principal measures—GDP growth, inflation (measured by the consumer price index), and unemployment rate? The Economist, a British weekly newsmagazine, reports comparative data for 13 industrial countries on a regular basis. Table 5.2 gives the figures for GDP growth, unemployment, and the inflation rate for 2018.

These figures tell an interesting story. Growth is low but positive in all the major industrial countries, but it is highest in India (with China being a close second). Unemployment varies across countries, but Mexico, for example, has a lower unemployment rate than the United States. However, Mexico also has the highest inflation among the countries shown here (5.3%). France has the lowest inflation, at 1.2%.

Table 5.2: GDP growth, unemployment, and inflation rate, 2017

Country GDP growth

rate Unemployment

rate Date of unem- ployment data Inflation rate

United States 2.5% 4.1% February 2018 2.2%

Australia 2.4% 5.5% January 2018 1.9%

Brazil 2.1% 12.2% January 2018 2.8%

Britain 1.4% 4.4% November 2017 3.0%

Canada 2.9% 5.8% February 2018 1.7%

China 6.8% 3.9% February 2018 2.9%

France 2.5% 9.0% January 2018 1.2%

Germany 2.9% 3.6% January 2018 1.2%

India 7.2% 6.1% February 2018 4.4%

Japan 2.0% 2.4% January 2018 1.3%

Mexico 1.5% 3.4% January 2018 5.3%

From “Economic and Financial Indicators,” by The Economist, 2018, Retrieved from https://www.economist.com /indicators. Reprinted with permission.

https://www.economist.com/indicators

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Section 5.2 Measuring GDP and National Income

The key to understanding NI is that all of the income generated in producing GDP must be accounted for in some way or another. Most of it is paid to the four resources. Thus, NI is the sum of rent, wages and salaries, interest, and profits. In a very simple economy, all of the value of final goods and services produced (GDP) would become payments to resources. GDP, which measures the flow in the product market of the circular flow diagram, and NI, which measures the flow in the resource market, would be identical. The actual economy is not so simple, however, and requires some adjustments to convert GDP to NI.

From GDP to NI The first adjustment in the process of getting from GDP to NI is to make a small correction for the difference between what is produced by U.S. residents (GDP) and what is produced by U.S. citizens (GNP). The value of payments to foreign-owned resources within the U.S. national boundaries is subtracted, and the value of the payments to U.S. resources located outside the country is added. In 2016 GDP was $18,624.48 billion, compared to a GNP of $17,352.84 (Bureau of Economic Analysis, 2018).

Depreciation and Net National Product The next adjustment is to reduce GNP to account for the fact that part of the capital stock is used up in the production process. Depreciation is a cost of production that is not received as income by any resource. For example, if a firm builds a new industrial production line to create the latest trend in athletic sportswear, the machinery will not be worth the same as it was originally. Each year, the market value of the machinery must be estimated; the difference between this estimate and the value from the prior year is the amount of depreciation.

GNP minus depreciation is equal to net national product (NNP). NNP is determined by the following formula:

NNP = C + In + G + (X – M)

where In represents net, rather than gross, investment. The only difference between GNP and NNP is that GNP includes gross private domestic investment, but the investment term in NNP is net private domestic investment.

NNP is a more meaningful measure of production than GDP or GNP because it excludes all intermediate products, including capital used up in the course of the year’s production. GDP is more widely used, however, for two reasons. First, GDP figures are more precise than NNP figures because depreciation is difficult to measure or even estimate accurately. Second, GDP is more closely related to the behavior of employment and prices.

Omissions From GDP

A number of kinds of productive activity are not counted in GDP. For instance, nonmarket production is not included in GDP. If you fix your own car, only the parts that you purchase are counted. If you take your car to a service station, all of the repairs enter into GDP. Excluding nonmarket transactions understates economic well-being and also distorts the comparative

128

Section 5.2 Measuring GDP and National Income

use of GDP figures. This omission of nonmarket production may not make a big difference in year-to-year comparisons within a country or comparisons of similar countries such as the United States and Canada. It does, however, distort comparisons between 1950 and 2020 or between the United States and India. As a country gets wealthier, more people eat meals pre- pared outside of the home, for example. The number of restaurants and total spending on eat- ing out both increase as income increases. This change says nothing about how well fed the population may be. Since the mid-1960s, when women entered the workforce in the United States in increasing numbers, a larger share of household services (including laundry, meals, and child care) has been purchased in the market. The change in GDP overstates the actual increase in economic well-being.

On the other hand, activities paid for “under the table” or by barter are difficult to track, so GDP accountants are not able to include such transactions. This omission understates eco- nomic welfare. Some transactions are excluded on purpose. Because the GDP is limited to legal markets, domestic-income accountants exclude illegal activities such as drugs, prostitu- tion, and gambling. An important aspect of well-being also not reflected in GDP is change in leisure time. If producing more output and rising GDP come at the expense of leisure time, this reduction in quality of life does not appear in GDP.

Finally, in many cases, what appear to be price increases are actually quality improvements. Products may be safer, more durable, or more useful. However, unless a specific feature can be separated out and assigned a price tag, GDP accountants have no good way of correcting for quality improvements.

Personal Income and Disposable Income

Personal income (PI) is the income received by households. It is different from NI, which is the income earned by the household sector. One major difference between NI and PI is that corporate income taxes and undistributed corporate profits are earned by households (stock- holders) but are not actually paid to them. A second difference is that payments by workers and their employers into the Social Security system are earned by workers but not received. Finally, transfer payments are added because they are received but not earned. Transfer pay- ments are not a part of NI because they represent only a movement of spending power from one sector to another. They are not related to any current production in the top half of the circular flow model.

As Table 5.3 indicates, the household sector can use its PI in three ways: (a) to pay personal taxes to various levels of government, (b) to spend on consumption goods, or (c) to save. The income the household sector has left after taxes is called disposable income. Disposable income can be spent on consumption or saved. It is very useful in forecasting household con- sumption, the largest component of GDP.

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Section 5.2 Measuring GDP and National Income

Table 5.3: Relation of NI and PI, 2012–2017 (in billions of dollars)

2012 2013 2014 2015 2016 2017

National income 14,061.9 14,444.8 15,144 15,739.6 16,052 16,607.7

Less: Corporate profits, taxes, interest, and gov- ernment social insurance

2,270.6 2,427.2 2,570.9 2,573.7 2,501.1 2,622.8

Plus: Personal income receipts and current transfer receipts

2,123.8 2,056.1 2,245.1 2,387.1 2,377.8 2,442.4

Equals: Personal income

13,915.1 14,073.7 14,818.2 15,553 15,928.7 16,427.3

Personal income 13,915.1 14,073.7 14,818.2 15,553 15,928.7 16,427.3

Compensation of employees

8,609.9 8,842.4 9,256.5 9,708.3 9,978.6 10,307.2

Wages and salaries 6,930.3 7,116.7 7,476.8 7,858.9 8,085.2 8,351.2

Private industries 5,732 5,908.7 6,239.9 6,583.3 6,777.8 7,010

Government 1,198.2 1,208 1,236.9 1,275.6 1,307.5 1,341.2

Supplements to wages and salaries

1,679.6 1,725.8 1,779.7 1,849.4 1,893.4 1,955.9

Employer contribu- tions for employee pension and insur- ance funds

1,165.3 1,199 1,231.7 1,278 1,309.8 1,345.8

Employer contribu- tions for government social insurance

514.3 526.8 548 571.4 583.6 610.2

Less: Personal current taxes

1,511.4 1,677.8 1,785.6 1,937.9 1,960.1 2,048.3

Equals: Disposable personal income

12,403.7 12,395.8 13,032.6 13,615 13,968.6 14,379

Less: Personal outlays 11,457 11,775.7 12,293.8 12,786.7 13,288 13,893

Equals: Personal saving 946.7 620.1 738.8 828.4 680.6 485.9

Personal saving as a percentage of dispos- able personal income

7.6 5 5.7 6.1 4.9 3.4

From “Table 2.1. Personal Income and Its Disposition” and “Table 1.7.5. Relation of Gross Domestic Product, Gross National Product, Net National Product, National Income, and Personal Income,” by U.S. Department of Commerce, Bureau of Economic Analysis, 2018, Retrieved from https://bea.gov/iTable/iTable.cfm?reqid=19&step=2#reqid=19&step=3&isuri=1&1910=x&0 =-9&1921=survey&1903=53&1904=2012&1905=2018&1906=a&1911=0.

https://bea.gov/iTable/iTable.cfm?reqid=19&step=2#reqid=19&step=3&isuri=1&1910=x&0=-9&1921=survey&1903=53&1904=2012&1905=2018&1906=a&1911=0

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Section 5.3 Real GDP, the GDP Deflator, and Economic Growth

5.3 Real GDP, the GDP Deflator, and Economic Growth The most important correction to GDP and other measures of output is to adjust for changes in the price level in order to measure real economic growth. Economic growth is defined as an increase in real output per capita. An increase in real output per capita means that the average person has more goods and services and a higher standard of living than before. The values of GDP, GNP, NNP, and NI in Tables 5.1, 5.2, and 5.4 are all nominal values. Nominal GDP (in current dollars, uncorrected for inflation) and real GDP can give very different pictures of economic performance. For example, as the U.S. economy slowed during 2007–2008, nominal GDP rose from $14,028 billion to $14,291 billion, an increase of 1.87%. However, after correc- tion for inflation, real GDP actually fell from $13,206 billion to $13,162 billion, a decrease of 0.33% (Bureau of Economic Analysis, 2012). Thus, in order to use GDP to measure economic growth or to forecast output or employment, economists need to know what is happening to real, physical production. The price index used to correct GDP figures for changes in the price level is the GDP deflator introduced in Chapter 4.

Computing Real GDP and Growth Rates

The GDP deflator is a price index using the current output mix as the basket of goods and services. Instead of fixing a market basket and remeasuring the cost of that basket each year, as the consumer price index does, the GDP deflator is computed by working backward. The current year’s output is valued at current prices; then the value of that output is recalculated using last year’s prices, and so forth. In order to understand how GDP deflators, real GDP, and growth rates are calculated, consider the hypothetical data in Table 5.4.

Key Ideas: Components of GDP

• Consumption expenditures (C) are the final sales of goods and services bought by households.

• Gross private domestic investment (I) is the purchases made by businesses. • Government expenditures (G) are the sum of federal, state, and local spending. • Exports (X) are domestic goods and services purchased by the foreign sector. • Imports (M) are goods and services produced abroad and imported. • GDP = C + I + G + (X – M)

Table 5.4: Hypothetical data for real GDP computations (in billions of dollars)

GDP at current prices: $16,500 2018 GDP at prices of earlier years

2018 $16,200

2017 $15,800

2016 $15,400

2015 $15,200

2014 $15,000

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Section 5.3 Real GDP, the GDP Deflator, and Economic Growth

How were these numbers computed? The same items that were actually produced in 2018 were entered at the prices of 2014, 2015, 2016, and 2017 to develop a series of values that is called 2018 GDP at 2014 prices, 2015 prices, and so on. These figures can now be used to compute a GDP deflator and an inflation rate.

Suppose, for example, that we set the GDP deflator for 2014 equal to 100. By holding the quantity of real output constant at the 2014 level, as in Table 5.5, we can measure the change in the average price level from year to year. The price index for 2015 is given by

(15,200/15,000) × 100 = 101.3

and for 2016 by

($15,400/15,000) × 100 = 102.7

Table 5.5: Computing GDP deflators and inflation rates

Year GDP deflator Inflation rate

2015 101.3 1.3%

2016 102.7 1.32%

2017 105.3 2.5%

2018 108 2.7%

The GDP deflators for each of the 4 years are shown in Table 5.5. The inflation rates in the table are calculated by dividing each index by the previous year’s index and subtracting 1. For example, the inflation rate in 2017 is

(105.3/102.7) – 1 = 2.6%

While price indexes are useful for calculating inflation rates, they are at least equally impor- tant in making it possible to measure changes in real output, or economic growth. For exam- ple, 2018 real GDP, measured in 2014 prices, is $16,500/1.08 = $15,278. Suppose that actual GDP in 2014, the base year, was $14,750. Then the growth of real GDP from 2014 to 2018 was

($15,278/$14,750) – 1 = 3.6%

Actual and Desirable Rates of Growth

The rate of real economic growth for 1976–2016 is shown in Figure 5.5. As this figure sug- gests, the United States has experienced periods of rapid growth alternating with stretches of slow growth or even decline in output. The 1970s were a period of very slow growth. The rate of growth picked up again by the mid-1980s but slowed at the end of the decade. After a brief recession in 1990–1991, the economy began growing again until 2001 and the dot-com reces- sion. This 10-year period of consistent and steady growth is often referred to as the Golden Era. The economy quickly recovered before the Great Recession of 2007–2009. As seen in

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Section 5.3 Real GDP, the GDP Deflator, and Economic Growth

Figure 5.4, this recession resulted in a slowed and then negative growth rate in 2009 before rebounding in 2010 and staying low and positive through 2016. The overall (compounded) rate of growth from 1950 to 2017 has been about 3.4% per year (Bureau of Economic Analy- sis, 2018).

Figure 5.5: Real GDP annual growth rate, 1976–2016

Growth rates of real GDP (in constant dollars) show much variation over time. It is easy to identify recessions in this diagram as periods when real output fell (i.e., growth rates were negative).

From “GDP growth (annual %),” by World Bank, n.d., Retrieved from https://data.worldbank.org/indicator/NY.GDP.MKTP.KD.ZG?end =2016&locations=US&start=1976. Licensed under CC-BY 4.0.

1976

-4%

-2%

GDP growth rate

1981 1991 2001 2011 201620061986 1996

It is generally believed that a growth rate of 3%–4% per year is the highest that can be sus- tained for any length of time. Producing more output requires more productive resources or improvements in technology. A rate of growth of 3%–4% corresponds to an attainable com- bined rate of change in these two important sources of economic growth.

One measure of a nation’s standard of living is calculated as GDP per capita, or average income per person. Economic growth is a critical component in this measure. As a nation’s population grows, output has to grow just to keep per capita output and income from falling. Generally, people want economic growth to provide some improvements in the standard of living as well. Additional capacity to produce means that more of those wants can be fulfilled, whether they are private wants such as better housing or collective wants such as better roads. Growth creates new jobs to absorb new workers into the labor force, which helps maintain low levels of unemployment.

https://data.worldbank.org/indicator/NY.GDP.MKTP.KD.ZG?end=2016&locations=US&start=1976

https://creativecommons.org/licenses/by/4.0/

133

Conclusion

Conclusion This chapter did not solve the problem of creating economic growth, but it did build an important foundation by demonstrating how we can measure it. Before governments can identify ways to encourage growth, they need to be able to measure output and income and how fast they are growing. Economic growth is more abstract than price stability and full employment, but it is an equally important goal.

Key Ideas

1. The circular flow model represents the aggregate level of economic activity. Adding a credit market, the government, and a foreign sector provides a more realistic picture of the components of the macroeconomy.

2. GDP measures final output produced in a country over a given time period. It can be measured by producing sector or by buying sector. Its value should be the same whether it measures output produced or income created in the production process. Other measures of output and income are national income (NI), net national product (NNP), personal income (PI), and disposable income. NI corresponds to the flow in the lower half of the circular flow diagram.

3. The primary components of GDP by buying sector are households (consumption), firms (investment), government, and the foreign sector (imports and exports).

4. Economic growth is measured by changes in real output. Economic growth of about 3%–4% a year is generally regarded as feasible and desirable because it raises the standard of living and reduces unemployment.

Critical-Thinking Questions

1. What are the costs and benefits of rapid economic growth? 2. Suppose that during a certain period, GDP rises from $13,000 billion to

$13,500 billion, while the GDP deflator goes from 100 to 125. What has happened to real GDP?

3. What is a leakage? What is an injection? Identify three kinds of leakages and three kinds of injections.

Key Ideas: Considering Economic Growth

• In order to measure real economic growth, GDP must be adjusted to account for changes in the price level.

• The GDP deflator is a price index that uses current output to calculate real GDP. • A target rate for economic growth is about 3%–4% per year.

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Conclusion

4. Why is GDP not entirely satisfactory as a measure of economic well-being? Why is it better for comparisons over short time periods or between countries that are similar in economic and social conditions?

5. Why is it unlikely that a rate of economic growth in excess of 3% or 4% can be sus- tained for a long period?

6. How would an increase in Social Security taxes affect GDP, NNP, domestic income, and PI?

7. Use the following data to compute GDP, NNP, and NI. If NI computed at resource cost is $3,387 billion, what is the statistical discrepancy? (All figures are in billions of dol- lars; any omitted items are zero.)

Consumption 2,762

Government purchases 865

Gross investment 675

Depreciation 455

Indirect business taxes 349

Net exports –106

8. Use the data in Question 7 to compute the percentage of GDP going to each buying sector. Present the results as a bar chart or pie chart.

9. Use the following data to compute NI, PI, and disposable income for the year. (All figures are in billions of dollars; any omitted items are zero.)

Wages and salaries 2,499

Personal taxes 513

Government transfers 491

Social insurance taxes 376

Corporate profits 300

Net interest 295

Proprietors’ income 279

Corporate profits taxes 103

Dividends 88

Undistributed profits 46

Business transfers 23

Rental income 16

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Conclusion

10. Suppose a hurricane struck the coast of New England, destroying millions of dollars’ worth of housing. What would be the immediate effect on GDP, NNP, NI, and PI?

11. Suppose the government decided not to tax corporate profits, and as a result corpo- rations decide to pay out all the extra funds as dividends to stockholders. How would this change affect GDP, NNP, NI, and PI?

12. Suppose the government is considering deficit reduction by cutting spending and is trying to choose between cutting spending for defense (soldiers, weapons, etc.) and cutting spending for transfer programs such as farm price supports and Social Security. For equal dollar amounts, which kind of cuts will have a more direct effect on GDP? NI? PI?

Key Terms balance on goods and services The differ- ence between the value of exports and the value of imports for a country in any given year.

business inventories Stocks of goods held by businesses from which they can make sales to meet demand.

consumer durables Goods that last, on average, a substantial length of time.

consumer nondurables Goods that last, on average, only a short length of time.

consumer services That part of house- hold consumption composed of nontangible activities.

consumption expenditures Sales to the household sector.

credit market The aggregate market con- sisting of financial institutions that channel household savings to business firms that want to invest.

disposable income Income received by households and available to spend or save; equals PI less personal taxes.

economic growth An increase in the level of real per capita output.

exports Goods and services sold to foreign buyers.

final goods Goods that do not have to be further processed or resold before final sale.

fixed investment The part of investment that does not add to inventories; consists of business plants and equipment and residen- tial construction.

gross private domestic investment Busi- ness sector purchases of final output in the GDP.

imports Purchases of goods and services from foreign sellers.

injections Spending added to the circu- lar flow that is not paid for out of resource income, such as business investment, gov- ernment expenditures, and exports.

intermediate goods Goods sold to be fur- ther processed into final goods.

investment The purchase of real tangible assets, such as machines, factories, or inven- tories, that are used to produce goods and services.

leakages Flows out of the circular flow that occur when resource income is not spent directly on purchases from domestic firms but goes to savings, taxes, and imports.

national income (NI) Income earned by the resources; consists of wages, rent, inter- est, profit, and proprietors’ net income.

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Conclusion

net exports The calculation of exports minus imports, which can be positive or negative.

net national product (NNP) A value that is equal to GNP less adjustments (depreciation).

saving The part of an income flow not spent on purchases of goods and services.

transfer payments Income payments to individuals who do not have to provide any goods or services in exchange.

5.1 Revisiting the Circular Flow Model
5.2 Measuring GDP and National Income
5.3 Real GDP, the GDP Deflator, and Economic Growth