For Sheryl Hogan Economics-2

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MBA 530 ECONOMICS

Unit 11: An Introduction to Measures of Macroeconomic Performance Part 1: Measuring National Income and National Output

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These lecture notes contain links to further reading or data, highlighted in blue.

Topics in this lecture:

1. Economic growth 2. Gross Domestic Product (GDP) 3. Gross National Product (GNP)

The final units of content pertain to basic concepts and issues in macroeconomics.

Recall that macroeconomics is the study of the performance of the overall economy. The concepts and measures we’ll examine are much larger in scope than those in microeconomics, and include total national output (total production), total consumption, the overall price level and total employment.

How is the economy doing?

How will the economy perform in the coming months and years?

These are questions that I get asked a lot when people learn that I’m an economist. Unfortunately the answers are not straightforward. The overall health of an economy can be measured many ways, including measures of output, income, employment (or unemployment), the price level (inflation), consumer spending or the balance of trade with other nations. We will cover the basics of all of these ways to measure the performance of the macro economy.

One of the most common ways to assess the performance of an overall economy is to measure economic growth.

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Economic Growth typically refers to positive changes in the ability of an economy to produce goods and services. Economic growth is most often measured as the change in per capita income or output (we’ll soon see that these are the same) over time.

When a country’s production of output is increasing faster than population is increasing, per capita income will be rising over time, and we state that that nation is experiencing economic growth.

In order to discuss the causes and consequences of economic growth we have to first understand the ways that income and output can be measured.

Measures of aggregate income and output: GDP and GNP

Gross Domestic Product (GDP) is the total market value of final goods and services that are produced within the geographical boundaries of a country within a given period of time (e.g., quarter, year).

Gross National Product (GNP) is the total market value of the final goods and services produced by the citizens of a nation within a given period of time (e.g., quarter, year). GNP is also known as Gross National Income (GNI).

GDP and GNP are standard measures of the economic wellbeing of a nation.

Before we expand on these definitions, let’s illustrate the difference between GDP and GNP with an example... Suppose that I engage in consulting work for the government of Barbados, and I do this work while physically located in Barbados. In which nation’s GDP is the value of this service included? In which nation’s GNP is the value of this service included?

Hopefully you see that the value of this service would be included in Barbados GDP (the physical location of the production) and U.S. GNP (the citizenship of the producer).

Something to consider: Which measure, GDP or GNP do you think is easier to measure and keep track of? GDP is probably easier for a particular nation to keep track of because the economic activity is within their own defined borders. Hence,

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GDP is the more commonly used measure of the two, especially when it comes to international comparisons. We will therefore focus primarily on GDP.

Let’s break down the concepts in the definitions of these two measures:

“Market value”: GDP and GNP are measures of the value of production in an economy. This value is calculated using the quantities of final goods and services produced multiplied by their market prices. Calculating GDP therefore involves counting up all of the goods and services produced (e.g. 2 million tons of coal, plus 60 million passenger automobiles, plus….) and multiplying each by the appropriate price (e.g. $45/ton of coal, $30,000/car….), and adding them all together. This idea means that the size of GDP and GNP can depend on the quantity of output and the value placed on that output by the market forces of supply and demand. We’ll explore this more below when we examine the difference between “real” and “nominal” GDP and GNP.

“Final goods and services”: To avoid double counting, GDP and GNP calculations include only the value of final goods and services - those purchased by the final user of the product. For example, suppose the market value (price) of a framed photograph sold in a retail outlet is $100. In order to bring this product to market, the retailer paid for the associated inputs, including paying a photographer $30 for their labor and the digital image, $30 to a frame builder for their labor and materials, and $10 to a printer. The frame builder used $10 worth of wood (paid to a lumber seller), $3 worth of glass (paid to a glass manufacturer) and $2 worth of screws, nails and glue. Each producer in the supply chain combined inputs from other sellers and added value from their own labor and skills. If we also included the value of the raw materials and intermediate goods and services used to produce the final product we would ascribe a value of $185 to the photograph. Because the market value of the framed photograph is $100, this would be an overestimate of its contribution to GDP.

GDP and GNP are measures of both aggregate income and aggregate output

To understand why GDP and GNP represent both the value of income and output, it is important to note that spending by one party is income to another party. The basic idea behind this is illustrated by the simple “circular flow” diagram shown below. The market value paid for goods and services by consumers is returned to the owners of the factors of production (land, labor, capital) as income. Hence,

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GDP and GNP are measures of both the value of total spending on goods and services (i.e. the value of output) and the value of total national income.

Real vs. Nominal GDP or GNP

Changes in prices may affect the value of GDP or GNP from year to year, even if the quantities of goods and services produced does not change. To understand why the value of output is changing, it is therefore important to distinguish changes in GDP that represent real changes in production from changes in GDP that are the result of changes in prices.

Nominal GDP is the value of goods and services produced in a particular year measured using current prices (i.e. the prices that existed during that year). Changes in nominal GDP may be the result of changes in output, changes in prices or both. Hence, increases in nominal GDP do not necessarily mean that an economy is growing. In fact, nominal GDP can increase if prices rise from year to year even if total output is declining. Likewise, nominal GDP can decrease from year to year if prices are falling and output is rising. Real GDP is the value of goods and services produced in a given year valued using prices from a specific year in the past. Measuring the value of output using a constant set of prices from a "base year" allows us to understand whether incomes and production are actually changing over time. Changes in real GDP from year to year are a more accurate way of understanding whether the quantity of output

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produced in a country has actually changed over time. If real GDP is increasing, we can accurately state that an economy is growing.

Calculating GDP

Because GDP and GNP are measures of both aggregate income and aggregate output, they can be calculated using the “expenditure approach” (adding up total spending on goods and services) or by using the “income approach” (adding up payments to different factors of production).

Using the expenditure approach to calculate GDP involves summing four major categories of spending in an economy: spending by consumers (C), spending by investors (I), spending by government (G) and spending by foreign countries. This last category of spending is known as "net exports" and is calculated as the value of a country's exports (x) less the value of its imports (m). Hence, net exports is often represented as x-m. Each of these components is detailed below.

The expenditure approach to calculating GDP yields a common formula:

GDP = C + I + G + (x-m)

C: Spending by Consumers (Personal Consumption Expenditures) are purchases of final goods and services by households and individuals. This spending includes spending on durable goods (items that last for many years like computers, furniture, refrigerators and automobiles), non-durable goods (items that are used up quickly like groceries and gasoline) and nonmaterial items or services (things like insurance, haircuts, doctors’ visits, hotel stays and education). Purchases of new homes are not included as part of consumption spending. These are treated as investment. Historically, personal consumption expenditures have accounted for more than 50 percent of GDP, and currently make up more than 70 percent of GDP. Reductions in consumer spending are therefore problematic for an economy. We’ll discuss this more in Unit 12.

I: Spending by Investors (Gross Private Domestic Investment) includes purchases of capital equipment and buildings by businesses, the change in business inventories during the year, and purchases of new homes by consumers. These goods are seen as investments because they are expected to contribute to the production of goods and services in the future. It is important to note that it is net

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additions to inventory in a year that are considered investment spending. The logic is as follows: Initially the business purchases goods in inventory for itself. This value must be included in GDP to properly account for the value of production. Once that inventory is sold to a final consumer, to avoid double counting it is subtracted from investment and added to consumption. For example, if a retailer purchases a lamp for $100 and adds it to sellable inventory 2014, $100 would be included in 2014 GDP as investment spending. If the retailer sells the lamp for $150 in 2015, $100 would be deducted from the investment spending component of GDP in 2015 and $150 would be added to the consumption spending component of GDP in 2015. In the U.S. Investment spending comprised approximately 15 percent of GDP in 2015.

G: Spending by Government (Government Consumption Expenditure and Gross Investment) includes spending on final goods and services (including labor) by local, state and federal governments in a nation. This includes things like office supplies, fuel for government vehicles, materials and labor for public works projects, salaries and wages to government employees, and military equipment. It is important to note that while payments to government employees like University Professors and Navy Seals (see how I lumped those together?) are included in the Government spending component of GDP, spending on transfer payments like Social Security payments to the elderly, welfare payments to the poor, unemployment benefits and subsidies to the agricultural sector are not included in GDP because they do not represent production. In recent years, government expenditure has accounted for approximately 20 percent of GDP, and reached upwards of 40 percent during World War 2.

(X-M): Net Exports (NE) are comprised of two components. Exports (X) are expenditures on U.S. final goods and services that are sold abroad. Imports (M) are expenditures on final goods and services produced abroad and purchased by U.S. citizens, businesses and governments. Net exports is therefore the amount by which exports exceeds imports. If the value of goods and services that are exported exceeds the value of goods and services that are imported, then NE will be positive and international trade adds to GDP. If the value of imports exceeds the value of exports, then NE will be negative and trade subtracts from GDP. Net exports in the U.S. have been negative since the 1970s.

It is important to note that imports (M) are subtracted from GDP because all the other components of GDP (C, I and G) all have imports built in. That is, consumption

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expenditure, Investment expenditure and Government expenditure all include spending on goods and services produced abroad. We could calculate each of these components net of imports, but it is easier to simply subtract one big number at the end.

You may have figured this out if you were paying attention to the percentages of GDP that I quoted for the other components of GDP. In recent years, C = 68% of GDP, I = 15% of GDP and G = 20% of GDP. This is 103% !! Yet this is correct because each of those components includes spending on imports which are subtracted at the end. Indeed, NE has recently been around -3% of GDP. Yes, this is a weird statistic.

The income approach to calculating GDP recognizes the fact that the production of goods and services in an economy generates income. The income approach to calculating GDP involves adding up the incomes received by the major factors of production in an economy and adjusting the value for things like taxes, depreciation and interest earnings by US citizens from capital held abroad. Incomes include compensation paid to employees (payments to labor, including the value of wages, salaries and benefits), rents (payments to property owners), interest (payments to the suppliers of financial capital), proprietors' income (profits to business owners), and corporate profits (payments to stock holders). Each of these components is detailed below.

The expenditure approach to calculating GDP yields a net income formula for GDP:

GDP = Net Income

= Labor Income + Rental Income + Interest Income + Business Profit

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Labor Income (Compensation of Employees) is income earned from the sale of labor services during the year, and includes wages, salaries, tips and fringe benefits such as employer-funded insurance and employer-funded contributions to retirement accounts. This component of income has amounted to approximately 42 percent of GDP in recent years and has been on a downward trend since around 1970.

Rental Income is earned by the owners of land, buildings and mineral rights, and includes an estimate of the value of the rent “earned” by homeowners who live in their homes. This component of national income has historically been small (around 1 percent through 1990) but it did rise to around 3 percent during the housing bubble.

Interest Income (net interest) is income to those who supply loanable funds to businesses and households, including the interest earned in household savings accounts. Importantly, interest paid by governments is not included in this component of national income (GDP) because those payments are funded through tax revenues, not the sale of final goods and services.

Business Profit is the sum of profits to (unincorporated) business owners and corporate profits. These profits are calculated net of business expenses, business taxes (sales taxes and excise taxes, which are treated as costs) and net of the fixed costs of capital (capital that is “used up” during the production process during the year).

Calculating GNP

GNP is calculated by making adjustments to the value of GDP.

Using the expenditure approach, GNP is calculated by taking GDP (the sum of personal consumption expenditures, private domestic investment spending, government expenditure and net exports), and adding the value of final products produced overseas by domestic companies or citizens, and subtracting the value of production created by non-citizens and foreign-owned companies located within domestic borders.

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Using the income approach, GNP is calculated by taking GDP and adding in net income from labor and other factor inputs working abroad and subtracting income earned by citizens of foreign countries working in the US.

Per capita GDP

Per capita GDP is calculated as total GDP divided by population, and represents the average income of a nation’s residents. Note that an average can be influenced by outliers. If there are a handful of very rich people in a nation, per capita GDP may overstate the income of the “typical” citizen.

What is not included in GDP?

GDP does not include the value of many goods and services that are produced in an economy. For example, goods and services exchanged through barter, “under- the-table” cash transactions or illegal transactions are not counted as part of GDP.

If previously purchased goods increase in value, the appreciation is not included in GDP. For example suppose you purchased a new 50th anniversary edition Corvette in 2003 for $50,000. Between the time of purchase and the present day the car increased in value by $10,000 per year and now has a market value of over $60,000. The only contribution to GDP that would be recorded would be the $50,000 worth of spending that took place in 2003. The subsequent appreciation in value would not be included in any year’s GDP.

The value volunteer work and the value of goods and services produced and consumed within households are also not included in GDP. Such household production might include the value of childcare services provided by a stay-at- home parent, the value of vegetables grown in a home garden, or the value of household cleaning and maintenance services performed by household members.

GDP does not include the production of goods and services by the natural environment, unless those goods and services are sold in a formal market. For example, the value of petroleum extracted from the ground would be included in GDP, but the value of clean air produced by plant life or the shoreline protection services offered by healthy coastal ecosystems would not be included in GDP. If the coastal ecosystem erodes and a man-made replacement such as a breakwater or groin is installed, that value would be included in GDP. Further, while the value of "economic bads" like pollution are not deducted from GDP, the value of

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pollution clean-up services are included as long as they are bought and sold in a market.

Because GDP includes only the value of final goods and services produced and consumed in a nation, the sale of used goods is not included in GDP. Financial transactions such as the purchase of stocks and bonds are also not included in GDP. This is because the purchase of stocks represents ownership in a company and bond purchases are equivalent to loans. These financial transactions therefore do not represent real production (Spaulding, 2016).

Other transactions not associated with production such as government transfer payments associated with social security, welfare programs and unemployment compensation programs are also not included in GDP.

Is GDP an accurate measure of wellbeing?

Because GDP is a measure of national production and national income, GDP per person (total GDP divided by population) can be used as a measure of the average income in a nation. However, whether or not this is an accurate or useful indicator of wellbeing is a matter of debate.

An average measure such as GDP per person does not provide information regarding the distribution of income. A high GDP per person can be achieved in a society where a few people have very large incomes while most people have low incomes. Further, as noted above, GDP does not include the value of many things that contribute to or detract from the wellbeing of a nation's citizens. In addition to excluding the value of household production and environmental goods and services, GDP does not include the value of human health, the value of leisure time, or the value of scenic beauty. However, higher incomes do allow a nation's citizens to obtain better health care, afford more leisure time and fund environmental conservation. Hence, while GDP is clearly an inaccurate measure of wellbeing, it is nonetheless useful and despite its flaws and omissions, is considered a good proxy for wellbeing.

How much is current US GDP?

How much is current US GDP per capita?