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MEASURING GDP ANDECONOMIC GROWTH

Key Concepts



Gross Domestic Product

Gross domestic product

GDP

, is the market value of all the final goods and services produced within in acountry in a given time period.

♦

final good or service

is an item that is bought by its final user during a specified time period. In con-trast, an

intermediate good

is an item produced by one firm, bought by another and used as a compo-nent of a final good or service. Intermediate goodsare not directly included in real GDP. The circular flow of income and expenditure shows realand monetary flows in the economy. The circular flowinvolves:

♦

Four economic sectors — households, firms, gov-ernments, and the rest of the world.

♦

Three major markets — factor markets, goods mar-kets, and financial markets. In these markets people make their economic decisionsby choosing the amounts of key economic variables:

♦

Consumption expenditures

(

) — total house-hold spending on consumption goods and services.

♦

Investment

(

) — firms’ purchase of new plants,equipment, buildings, and additions to inventories.

♦

Government purchases

(

) — governmentspending on goods and services.

Net taxes

(

) aretaxes paid to the government minus transfer pay-ments received from governments and minus inter-est payments on the government’s debt. * This is Chapter 21 in

Economics

♦

Net exports

(

) —

exports

(

sales of U.S.goods and services abroad) minus

imports

(

pur-chases of foreign good and services). Aggregate expenditure,

, equals aggre-gate production, GDP, and also equals aggregate in-come,

This equality is the basis for measuring GDP.

♦

National saving

equals saving by households andbusinesses plus government saving:

+ (

−

♦

Borrowing from the rest of the world equals

−

.Investment is financed by national saving plus borrow-ing from the rest of world,

I = S +

(

−

)

+ M

−

flow

is a quantity over a unit of time. A

stock

is aquantity that exists at a moment in time. Wealth andcapital are stocks; saving and investment are flows.

♦

Wealth

, the value of things that people own, is astock;

income

, what people earn, is a flow.

♦

Saving is the amount of income remaining afterspending on consumption. Saving is a flow thatadds to wealth.

♦

Capital, the amount of plant, equipment, and in-ventories used to produce other goods, is a stock.

♦

Depreciation

(also called

capital consumption

) isthe decrease in the capital stock because of wear andtear and obsolescence.

Gross investment

is the totalamount of investment.

Net investment

is gross in-vestment minus depreciation. Net investment is theflow that is the amount by which the capital stock changes. Gross domestic product includes depreciation and soon the income side includes firms’ gross profit (beforesubtracting depreciation) and on the expenditure sideincludes gross investment. Net domestic product ex-cludes (subtracts) depreciation so it includes firms’ netprofits and net investment.

Chapter

CHAPTER 5 (21)



Measuring U.S. GDP

In 2003, U.S. GDP equaled $10,847 billion.

♦

The

expenditure approach

measures GDP by addingfinal expenditures,

. Of these expen-ditures, personal consumption expenditure is thelargest, at about 71 percent. Gross private invest-ment is about 15 percent, government purchases of goods and services is about 19 percent, and net ex-ports is about –5 percent.

♦

The

income approach

adds the compensation of em-ployees, net interest, rental income, corporate prof-its and proprietors’ income to give

net domestic in-come at factor cost

. Indirect taxes and depreciationare added and subsidies subtracted to obtain GDP.



Real GDP and the Price Level

Real GDP

is the value of final goods and services pro-duced in a given year when valued at constant prices.

Nominal GDP

is the value of the final goods and ser-vices produced in a given year valued at the prices thatprevailed in that same year.The base year prices method, which is the traditionalmethod of calculating real GDP, values the quantitiesproduced in each year using the prices of the base year.The

chain-weighted output index

method, which isthe new method of calculating real GDP, uses theprices of two adjacent years to calculate the real GDPgrowth rate.

♦

The chain-weighted output index first calculates thevalue of GDP for this year and last year, usingprices from last year and then calculates the growthrate of GDP between the two years.

♦

Next the chain-weighted index calculates the valueof GDP for this year and last year, using prices fromthis year and again calculates the growth rate of GDP between the two years.

♦

The two growth rates are averaged. This average isused to scale up last year’s real GDP by multiplyinglast year’s real GDP by the average.The

price level

is the average level of prices. Onemeasure is of the price level is the

GDP deflator,

which is an average of current year prices as a percent-age of base-year prices. The GDP deflator equals(Nominal GDP

Real GDP)

100.



Measuring Economic Growth

The

economic growth rate

is the percentage change inthe quantity of goods and services produced from oneyear to the next. It equals the growth rate of real GDP.Real GDP is used for economic welfare comparisons,for making international comparisons of output, andfor business cycle forecasting.

Economic welfare

is a comprehensive measure of gen-eral economic well being. Real GDP is an imperfectmeasure of economic welfare because real GDP:

♦

Over adjusts for inflation — many quality im-provements that lead to higher prices are counted asonly price hikes.

♦

Omits household production — all household pro-duction is omitted.

♦

Omits the underground economy — the under-ground economy (transactions hidden from thegovernment) is not included.

♦

Omits health and life expectancy — neither peo-ple’s health nor life expectancy are indicated by realGDP.

♦

Omits leisure time — the value of leisure time isnot included.

♦

Omits environmental quality — the consequencesof adverse and beneficial environmental changes areomitted.

♦

Ignores political freedom and social justice — theextent of political freedom or social justice within anation is not measured. Making international comparisons of real GDP can betricky because the real GDP of one country must beconverted into the other nation’s currency. Using ex-change rates for such conversions might understate thereal GDP in less developed nations. However, use of purchasing power parity prices might give a more accu-rate comparison.Though real GDP probably overstates the size of fluc-tuations in total production and economic welfare, it isa reasonably good indicator of the phase of the businesscycle, e.g., expansion, peak, and so on.

Helpful Hints

GDP, A

GGREGATE

XPENDITURE

AND

GGRE-GATE

NCOME

Some of the most important re-

MEASURING GDP AND ECONOMIC GROWTH

sults in this chapter show the equality betweenGDP, aggregate expenditure, and aggregate in-come. A key point about these equalities is thatGDP, aggregate expenditure, and aggregate incomeare linked. For instance, the production of output(GDP) creates income (aggregate income) as firmspay their workers and also creates expenditure (ag-gregate expenditure) as households use their in-comes to buy goods and services.

IFFERENCE

ETWEEN

OVERNMENT

UR-CHASES AND

OVERNMENT

RANSFER

AYMENTS

Government spending on goods and services (

)and government transfer payments are fundamen-tally different. Both involve payments by the gov-ernment, but transfer payments are not paymentsfor goods and services. Instead, they are simply aflow of money. Transfer payments are like gifts;they do not buy a good or service for the govern-ment in exchange. Transfer payments are not pay-ment for a good or service, so they are not part of the

component of aggregate expenditure,

, because aggregate expenditure measurespurchases of goods and services.

Questions



True/False and Explain

Gross Domestic Product

11. The market value of

all

the goods and services pro-duced within a country in a given time period areincluded in GDP.12. Wages paid to households for their labor is part of aggregate income.13. Transfer payments are included in the governmentpurchases component of aggregate expenditure.14. Aggregate income equals aggregate expenditure.15. Capital is a stock; investment is a flow.16. Gross domestic product is larger than net domesticproduct.

Measuring U.S. GDP

17. GDP can be measured only one way.18. The expenditure approach to measuring GDP addsfirms’ expenditures on wages, rent, interest, andprofit.

Real GDP and the Price Level

19. The chain-weighted output index method is howreal GDP is calculated.10. The GDP deflator is calculated as real GDP di-vided by nominal GDP, multiplied by 100.11. If prices rise, nominal GDP is smaller than realGDP.

Measuring Economic Growth

12. If two nations have the same GDP, economic wel-fare must be the same in each.13. Real GDP is a good measure of economic welfarein less developed nations, but is a bad measure indeveloped nations.14. Real GDP is a good measure of the phase of thebusiness cycle.



Multiple Choice

Gross Domestic Product

11.Which of the following is NOT a final good?a. a new computer sold to an NYU studentb. a new car sold to Avis for use in their fleet of rental carsc. a purse sold to a foreign visitord. a hot dog sold to a spectator at a Chicago Bearsfootball game12.GDP equalsa. aggregate expenditure.b. aggregate income.c. the value of the aggregate production in a coun-try during a given time period.d. all of the above.13.A nation’s investment must be financed by a. national saving only.b. the government’s budget deficit.c. borrowing from the rest of the world only.d. national saving plus borrowing from the rest of the world.14.Which of the following is a flow?a. GDPb. Wealthc. The amount of money in a savings accountd. Capital