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Chapter 7

Measuring Domestic Output and National Income

McGraw-Hill/Irwin

We will be calculating how economists estimate a country’s output and income for a year. The importance of these figures will be discussed, as well as the differences between the various ways that we can measure income. Lastly we will discuss how we can adjust the figures that we have calculated for inflation 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

Bureau of Economic Analysis compiles National Income and Product Accounts

Assess health of economy

Track long run course

Formulate policy

LO1

National income accounting does for the economy what private accounting would do for an individual household or business. The Bureau of Economic Analysis, an agency of the Department of Commerce, compiles the data and reports it in National Income and Product Accounts. This information is used by economists and policymakers in formulating decisions for the best interest of the nation.

Gross Domestic Product

Measure of aggregate output

Monetary measure

Avoid multiple counting

Market value final goods

Ignore intermediate goods

Count value added

LO1

The primary measure of the economy’s performance as a whole is its aggregate output. This is most commonly calculated as Gross Domestic Product, or GDP. GDP is a monetary measure in that everything is valued in dollars. All goods and services produced must be converted into dollar values for GDP to work. To avoid multiple counting of goods, GDP includes only the market value of final goods and ignores intermediate goods, which are goods either purchased for resale or for further processing into final goods. GDP could also avoid multiple counting by counting only the value added at each stage. Value added is the market value of a firm’s output less the value of the inputs that the firm purchased from others.

Gross Domestic Product

LO1

(1) Stage of Production	(2) Sales Value Of Materials Or Product
$ 0
Firm A, sheep ranch	120
Firm B, wool producer	180
Firm C, coat manufacturer	220
Firm D, clothing manufacturer	270
Firm E, retail clothier	350
Total Sales Value	$1140
Value Added (total income)

(3) Value Added

]--------$120 (= $120 - $ 0)

]-------- 60 (= 180 - 120)

]-------- 40 (= 220 - 180)

]-------- 50 (= 270- 220)

]-------- 80 (= 350 – 270)

$350

This table illustrates the value-added in a five-stage production process. The value added is calculated as the difference between the sales value of the materials and the value of the good at the previous production stage value. Using this method will avoid multiple counting.

Gross Domestic Product

Exclude financial transactions

Public transfer payments

Private transfer payments

Stock market transactions

Exclude second hand sales

Sell used car to a friend

LO1

Nonproduction transactions must be excluded from GDP since they have nothing to do with the production of final goods. There are two types: purely financial transactions and secondhand sales. Purely financial transactions include such items as public transfer payments like Social Security, private transfer payments (Christmas gifts), and stock market transactions. Secondhand sales contribute nothing to current production so they are ignored in calculating GDP.

Two Approaches to GDP

Income approach

Count income derived from production

Wages, rental income, interest income, profit

Expenditure approach

Count sum of money spent buying the final goods

Who buys the goods?

LO1

GDP can be viewed from two different perspectives. The income approach looks at GDP in terms of the income derived, or created, from producing goods and services. The expenditures approach measures GDP as the sum of all of the money spent in buying the output. In theory, either method should yield equal results. The expenditures and income approaches are two different ways to look at the same thing. You could look at a quarter from the heads side or the tails side, but it is still worth the same amount. This is the same as the expenditures and income approaches for calculating GDP.

Consumption by

Households

Investment by

Businesses

Government

Purchases

Expenditures

By Foreigners

Wages

Rents

Interest

Profits

Statistical

Adjustments

Two Approaches to GDP

Expenditures or Output Approach

Income or

Allocations Approach

LO1

Here the two different approaches to measuring GDP are illustrated. On the left, the expenditures approach measures GDP as the sum of four items: (1) consumption by households, (2) investment by businesses, (3) government purchases, and (4) expenditures by foreigners. On the right, the income approach uses different inputs: (1) wages, (2) rents, (3) interest, (4) profits, and (5) statistical adjustments. Each of these items will be further discussed next.

Expenditures Approach

Personal consumption expenditures (C)

Durable goods

Nondurable goods

Consumer expenditures for services

Domestic plus foreign goods produced

LO2

Personal consumption expenditures, indicated by a “C” notation, covers all expenditures by households on 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 for services leading to the U.S. economy, frequently being referred to as a service economy.

Expenditures Approach

Gross private domestic investment (Ig)

Machinery, equipment, and tools

All construction

Positive and negative changes in inventories

Creation of new capital assets

Noninvestment transactions excluded

LO2

The second component of the expenditures approach is gross private investment, which includes all final purchases of machinery, equipment, and tools by businesses, all construction, and changes in inventories. All of these items represent ways businesses invest in themselves. Construction also includes residential construction because homes could be rented to produce income.

Expenditures Approach

January 1

Year’s GDP

December 31

Consumption,

government

expenditures,

and net exports

Depreciation

Net

Investment

Gross

Investment

Stock of

Capital

Stock

Capital

Gross Investment

Depreciation

Net Investment

LO2

When gross investment exceeds depreciation during a year, net investment occurs. This net investment expands the stock of private capital from the beginning of the year to the end of the year, allowing the economy’s production capacity to expand, all other things equal.

Expenditures Approach

Government purchases (G)

Expenditures for goods and services

Expenditures for publicly owned capital

Excludes transfer payments

Net exports (Xn)

Add exported goods

Subtract imported goods

Xn= exports (X) – imports (M)

GDP = C + Ig + G + Xn

LO2

The last two components of the expenditures approach are government purchases and net exports. Government purchases are officially labeled “government consumption expenditures and gross investment.” 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 it merely transfers government receipts to certain households and does not generate any sort of production.

Net exports are calculated by subtracting the value of imported goods from the value of exported goods.

Adding up all four components provides a measure of GDP, a measure of the market value of a specific year’s total output.

Accounting Statement for
the U.S. Economy, 2012 (in Billions)

LO2

This table calculates GDP for 2012 in the United States by both the expenditures approach and the income approaches. Note that both methods come to the same conclusion for the year.

Comparative GDP

LO2

In this table comparing GDPs for selected nations, the United States, Japan, and China have the world’s highest GDP. Note that all data have been converted to U.S. dollars via international exchange rates.

The Income Approach

Compensation of employees

Rents

Interest

Proprietor’s income

Corporate profits

Corporate income taxes

Dividends

Undistributed corporate profits

Taxes on production and imports

LO3

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 as well as supplements such as benefits paid by employers on behalf of employees.

The Income Approach

From national income to GDP

Subtract net foreign factor income

Statistical discrepancy

Consumption of fixed capital

Other national accounts

Net domestic product (NDP)

National income (NI)

Personal income (PI)

Disposable income (DI)

LO3

Under the income approach, all expenditures on final goods and services flow as income to either private citizens or the government. To move from national income to GDP, several adjustments must be made. The first adjustment is for net foreign factor income. This is income Americans gain from supplying resources abroad, which would be taken out, and then income that foreigners gain from supplying resources to the U.S. would be added.

The next adjustment comes from what is called a statistical discrepancy, which basically is just a balancing amount. The final adjustment factor is the useful life of private capital equipment that extends well beyond the year in which they were produced. The cost of the equipment must be allocated over its useful life. The other national accounts provide useful information about the economy’s performance.

NDP is GDP less consumption of fixed capital. National income is NDP less the statistical discrepancy and plus the net foreign factor income. Personal income includes all income received, regardless of whether it is earned or unearned. Finally, disposable income is PI less personal taxes.

U.S. Income Relationships 2012

LO4

These tables illustrate the relationship between GDP, NDP, NI, PI, and DI in the United States for 2012.

Circular Flow Revisited

LO4

Here is the updated circular flow that was introduced in a much simpler form in a previous chapter. However, from this diagram, we can see that even when we account for more transactions in the economy, income and expenditures are equal.

Nominal GDP vs. Real GDP

GDP is a dollar measure of production

Using dollar values creates problems

Nominal GDP

Based on prices that prevailed when output was produced

Real GDP

Reflect changes in the price level

Use base year price

LO5

GDP measures production at current dollar values which creates problems because the value of a dollar changes over time. One hundred years ago, the purchasing power of one dollar was much different than it is today. To get around that problem, there are two different GDPs. Nominal GDP is based upon the prices that were in effect when the output was produced. A GDP that has been deflated or inflated to reflect changes in price levels is referred to as real GDP. In order to calculate real GDP, a base year must be selected and then the current year’s prices adjusted accordingly.

GDP Price Index

Use price index to determine real GDP

LO5

Price

Index

In Given

Year

100

Price of Market Basket

In Specific Year

Price of Same Basket

In Base Year

Real

GDP

Nominal GDP

Price Index (in hundredths)

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 divided by 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 determine real GDP.

GDP Price Index

Calculating Real GDP (Base Year = Year 1)

LO5

Year	(1) Units of Output	(2) Price of Pizza Per Unit	(3) Price Index (Year 1 = 100)	(4) Unadjusted, or Nominal, GDP (1) X (2)	(5) Adjusted, or Real, GDP
1	5	$10	100	$ 50	$50
2	7	20	200	140	70
3	8	25	250	200	80
4	10	30	---	---	---
5	11	28	---	---	---

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 the output

Noneconomic sources of well-being

LO6

While GDP is a reasonably accurate and highly useful measure of how the economy is performing, 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 face it, a $200 cell phone purchased today is of very different quality than a cell phone that cost $200 just a decade ago. There is also a huge underground economy, mainly comprised of illegal activities, that produces income that is not measured through traditional GDP methods. Included in this underground economy are legal activities that provide income that the recipients do not wish to report to the I.R.S. and pay taxes on. Environmental issues and noneconomic sources of well-being are also problematic in that GDP does not really have a way to accurately value and report the issues.

Underground Economy

LO6

This table shows the underground economy as a percentage of GDP in several nations. Three factors that help explain the variation in size are (1) the extent and complexity of regulation, (2) the type and degree of taxation, and (3) the effectiveness of law enforcement.

Sources of BEA Data

Consumption

Census Bureau’s Retail Trade Survey

Census Bureau’s Survey of Manufacturers

Census Bureau’s Service Survey

Industry Trade Sources

LO4

The Bureau of Economic Analysis, an agency of the Department of Commerce, is responsible for compiling the NIPA tables. The BEA gets its data from a variety of sources. The consumption data comes from four primary sources, three of which are provided by the Census Bureau. The Retail Trade Survey gathers sales data from a sample of 22,000 firms, the Survey of Manufacturers collects information on shipments of consumer goods from 50,000 establishments, and the Service Survey collects sales data from 30,000 service businesses. The BEA also collects information from a variety of industry trade sources.

Sources of BEA Data

Investment

All consumption data sources

Census Bureau’s Housing Starts Survey and Housing Sales Survey

Retail Trade Survey

Wholesale Trade Survey

Survey of Manufacturing

LO4

For investment data, the BEA looks at the consumption sources as well as the Housing Starts Survey and Housing Sales Survey produced by the Census Bureau.

Sources of BEA Data

Government Purchases

Office of Personnel Management

Construction Surveys

Census Bureau’s Survey of Government Finance

Net Exports

U.S. Customs Service

BEA Surveys and Analysis

LO4

The data for government purchases comes from the Office of Personnel Management, OPM, which collects data on wages and benefits of both public and private sectors, and the Construction Survey and the Census Bureau’s Survey of Government Finance, which provide data on government consumption and investment expenditures. The Net Exports data comes from U.S. Customs Service reports and the BEA surveys of domestic exporters and importers of services.