fa Measuring GDP. It’s More than Counting Peanuts If we made a list of the economic changes that are most dramatically reshaping the world, the rapid growth of China's economy would likely top it. In 1978, when (China's leaders moved to open up its economic system, it was the world’s [Sthvlargest ‘economy. The size of China's economy doubled. Then it doubled, and doubled, and doubled again. By 2011, China's economy checked in at about $6 trillion, passing Japan's to become the second-largest economy in the world. This progress is about, ‘more than numbers. Rapid economic growth can ereate jobs, reduce poverty, and improve standards of living. In China, the fraction of the population living below the international poverty line ($1.90 per person per day) fell from 88 percent in 1981 to 6.5 pereent in 2012, and to just 0.7 percent in 2015.! Economic growth has increased living standards all over the world in recent decades, although typically in less dramatic fashion than in China. Over the same ‘ime of China’s explosive growth, the proportion of people worldwide living on less ‘than $1.90 fell from 42 percent to 10 percent in 2015, ‘The health of the national economy has a powerful effect on everydlay life in any country. When the economy is doing wel, jobs are plentiful and most people can live well and securely. When the economy does poorly, jobs are scarce, businesses lose down, and people struggle. It’s no wonder that politicians spend a lot of energy debating the best plan to expand the economy. Over the next few chapters, we'll discuss many of the ideas and terms used in those debates. But, frst, we need to answer a basic question: How do we measure the “size” of ‘an economy? If we can answer that, we can compare China's economy to economies of other nations. We also can determine whether an economy is growing or not over «Growl Eduction ite mages time, What does it really mea to say that China has a $12 trillion economy? The answers to these questions require some careful accounting. As a start, think about just ‘one of the many transactions that take place in the U.S. economy. Say you bought a jar of peanut butter when you went to the grocery store, Although small, your purchase contributed to the size of the economy.LEARNING OBJECTIVES 107.4 107.2 1073 107.4 1075 1076 1077 Consider some of the things that happened before that jar of peanut butter made it into your shopping cart: A farmer grew the peanuts, perhaps on a small farm in Georgia. The farmer sold his peanuts toa wholesaler in Atlanta, The wholesaler then sold the peanuts to 8 peanut butter factory in Ohio, which combined the peanuts with other ingredients to produce a jar of peanut butter. The factory then sold that jar toa grocery store chain, which delivered it to your neighborhood store. ‘Many people were employed to produce that peanut butter: farmers, accountants, truck drivers, custodians, and grocery-store cashiers. Many firms earned profits from the jar of peanut butter, too: the peanut farm, the wholesaler, the factory, the shipping company, and your local store, Clearty, the activities that went into making and buying the jar of peanut butter added value to the ‘economy, Can we measure how much? ‘The peanuts passed through many stages: from seed, to harvested nut, to peanut butter, co a jar on the grocery store shelf. At each stage, the peanuts were sold as an output of one firm and purchased as an input by another firm. Should we add up all of these sales individually to calculate the value the jar of peanut butter added to the economy? No-if we did that, we'd be evercounting the value of your purchase. All of the sales were just steps toward one end product: your peanut butter, How then do we calculate the total value of your jar of peanut butter to the economy? ne SESE TEETER SS ESSENSE Understand the importance of using the market value of final goods and services to calculate GOP, and explain why each ‘component of GDP is important. Explain the equivalence of the expenditure and income approaches to valuing an economy Explain the thtee approaci that are used to calculate GDP, and summarize the cat f spending that are Included inthe expenelture approact Explain the difference between real and nominal GDP. Calculate the GOP deflator. Use GDP per capita to compare economies and calculate the eal GOP annual growth rate Discuss some limitations to GDP, Including its measurement of well-being, home production, the underground economy, and environmental degradation, This is the problem that economists faced inthe 1920s and 1930s when they first attempted to calculate the value of the U:S, economy. How can you add up all economic activity to arrive at an overall value for the economy, witout doublecounting tems that ae resold more than once before they reach the consume? ‘The solution is a system called national income accounting, created by [Nobel Prize winners Simon Kuznets and Richard Stone. In this chapter, well see how to use this systom to caleulate the value of a national economy. We'll see why it’s so useful to measure a country’s total output and also why gross domestic product (GDP), the most commonly used measure, has some limitations. In later chapters, wel put these ideas to ‘work to explain economic growth, unemployment, and economic booms and slowdowns. Valuing an Economy Economies has traditionally been divided into two broad fields, micro- economics and macroeconomics. Microeconomics is the study of how individuals and firms manege resources. In microeconomics, we 2er0 in ona single person's budget, or one firm’s cost of production, or the price of a particular good. Macroeconomics, on the other hand, isthe study of the economy on a broad scale, focusing on issues such as economic growth, unemployment, and inflation. In macroeconomies, we talk about consumption, produc- tion, and prices in the aggregate, on a national level, and we look at the effects of those ageregate forces on the whole economy,‘Macroeconomics: Improve Your Worl, Third Eon Measuring GDP = Chapter 7 Compared to microeconomics, the concepts of macroeconomics may seem distant from deci sions we make and challenges we face. But macroeconomic issues can have profound impacts on ‘our daily lives. Periods with steady economic growth, stable prices, and low unemployment create solid platforms for progress. On the flip side, long periods of stagnation, inflation, and high unem ployment ean do great damage to family finances and communities. AL the start of the chapter, we introduced one of the most important macroeconomic phe- ‘nomena of our time: the ineredible growth of the Chinese economy. Thinking about the Chinese ‘economy raises some questions: ‘+ How do we know how big the Chinese economy is? ‘+ How do we know that it is larger than Japan's but smaller than the United States's? ‘+ What does it mean to say that the size of China's economy doubled? To talk about these critical issues, we need a tool for measuring the “size” or “value” of a national economy. ‘The most commonly used metric for measuring the value ofa national economy is gross domestic product, or GDP. Gross domestic product is the sum of the market values of al final goods and services produced within a country in a given period of time. Economists divide these goods and services into different categories, called consumption, investments, government purchases, and net exports, to make it clear wat is being produced in the economy. We'll cover these categories in. ‘more detail later. For now, we'll unpack the definition of GDP using examples of consumption, GDP is one of the most important and commonly used data points in macroeconomics. It ives us a sense of the wellbeing of the average person in a country. It also allows us to gauge the direction an economy is headed, by looking at changes over time. Before we look at how econo ‘ists calculate GDP, though, let's unpack the component pacts of the definition, Unpacking the definition of GDP ‘The definition of GDP has four important pieces: + the marker value + of final goods and services ‘produced wtihin a country + ina given period of ime. Let's take each piece one at a time and explain its importance. Market values If we measured the output of economies by simply listing every single good and service, we wouldn't learn much~680 million jars of peanut butter, 103 million copies of Microsoft Word, 421 million haircuts, and so on. The list would go on for thousands of pages. It wouldn't be very interesting. Nor would it be useful for comparing the overall size of different national economies, which tend to make different things. For example, how would we compare the size of the U.S. economy with the Mexican economy-wiich produces its own set of petro- chemicals, cars, crops, and other goods and services? Clearly, we need to translate the production of peanut butter, software, haircuts, and all the ‘other goods and services into a common unit so we can add them up. That common unit is their market value—which in the United States is measured in dollars (and pesos in Mexico). So we know from this part of the definition that GDP is going to be a number measured in the local eur reney. (Though for comparison across countries, these local currency calculations are then later ‘translated to a value in a common currency.) Final goods and services Consider the 800 or so peanuts that end up in your jar of pea- ‘ut butter. Suppose our Georgia peanut farmer sells them to the Atlanta wholesaler for 12 cents. The wholesaler sells them to the Ohio peanut butter factory for 25 cents. The peanut butter factory 167 the study ofthe economy asa whole, and how polymers menage the grout and behav ofthe overall economy ross domestic product (GDP) the sum othe matket values of al ral goods and senices produced win @courry ina ven period of tine 107.1. Understand the importance of sng the market ‘vale offal goods and services to calcu late GP, and explain ‘why each component of Ps important,Economic Environment 168 ‘9r0ss national product (enP) the sum ofthe matket ‘oles ofl fal goods and services produced by etaens ofa country ‘within a given peri of time Cinge var itotandse HoogeRedux Part 3 The Data of Macroeconom sells the 18-ounce jar of peanut butter to the grocery store for $1.85. Finally, the grocery store sells it to you for $3.40, How much does this process contribute to GDP? If we simply add up all the transactions, we might think that the Jar of peanut butter contributed $5.61, to GDP ($0.12 + $0.25 + $1.85 + $3.40). But, if that ‘were true, producing the jar of peanut butter would contribute more to GDP than its final selling price. ‘That can’t be right, [Pit were, we could grow the econ- ‘omy just by trading the same jar of peanut butter for the same dollar, over and over again, and adding up cach “transaction.” The problem here is that by adding each of the transactions, we are double-counting. giving us to big, a total, To avoid double-counting, we should ignore the price of intermediate goods and services—that is, goods and services used only to produce something else, like the raw peanuts that were sold to the peanut butter factory, Instead, we want (0 count only expenditures on “final goods and services-those that get sold to the consumer. In this case, the only final good was the jar of peanut butter you bought at the store. Its price was $3.40-so that is how much your purchase contributed to GDP. Produced within a country The goods and services that count toward GDP are defined in terms of the location of production, not the citizenship of the producer. So: + Ifa US. company owns factory in Mexico, the value of the goods produced in that fac- tory will count toward Mexican GDP, not U.S. GDP. = AUS. citizen working in France will contribute to French GDP. ‘+ Likewise, a French or Mexican citizen working in the United States will contribute to US. GDP. What if we want to measure the value of what is produced by all U.S. companies regardless of their location? In this ease, we use a different metric, called gross national product (GNP). GNP is the sum of the market values of all final goods and services produced by a country’s businesses within a given period of time, IL is similar to GDP except that it 1. includes the worldwide value of all final goods and services produced by a country's busi nesses and 2. excludes production by foreign businesses within the country. Given period of time Asa measure of income, GDP tracks production over the course of a year. Measuring production within a certain space of time allows for clear calculation, In theory, we could calculate the output of the economy over any time period~a day, a month, ‘year. When you hear people talking about GDP, they're often referring to an annual figure. How- ever, a year is a long time to wait for an update on how the economy is doing, so GDP is usually calculated on a quarterly basis-that is, four times a year, ‘Typically, what we really want to know is an estimate of annual GDP, using the most recent quarterly information, We can't just multiply this quarter's GDP by four, however, because the economy seldom rolls along at the same pace all year. For instance, December usually has more economic activity than other months due to people buying presents and traveling, ‘Therefore, we need to adjust quarterly GDP estimates to account for these seasonal patterns. “That's why quarterly GDP is typically shown as a seasonally adjusted estimate al an annual rate. BY‘Macroeconomics: Improve Your Wor Measuring GDP» Chapter? taking account of predictable seasonal patterns, we can have a good guess at what annual GDP will be ifthe economy continues at its current pace. Production equals expenditure equals income [Now that we have defined the tem grass domestic product, ow do we go about measuring example of peanut butter was jst a star the esonomy is dynamic, producing a whole range of “Smt” Tonomists Use (wo terms intechangebl)-outpu or production to refer o this “stu.” which includes both goods and services. Indeed, about treequarers of US. output is services, not foods. Inthe previous section, we Saw thatthe final vale of goods or services sld makes up GDP. However, there ae three ways to calulate that final vale. Weil look a the first two ways brie here (and ten look at ll three in more det inte net section) First, the exenure approac: The markt valve ofa good or service isthe price at which it is bought and sold. I'we add p al the money people spend buying final goods and services— tring care to omit spending on intermediate goods so as nt to daublecount-the sum will be the market valu of all ouput sold inthe economy. In other words, we can use the expenditure approach fo measure total output by measuring tal expenditure Seoond, the income approach; Every transiction, of cours, bas nt only a buy who spends con a good or service but also a slr who earns income from te sal, Tus, expenditures by one person translate direct into nome for someone else. So, we can also measure production ving the income approach by adding up everyone's income. “Tis approach may sound familiar if you remember the ctculr flow model of the economy that was presented in Chapter 1, “Eeonomics and Life” and is repeated here in Figure 7-1 Households buy things from firms in the market for goods and services. Firms then use some cf the money they cam in revenue to pay wages to workers and rent to landowners in the market forthe factor of production. In each ofthese transactions, expenitures by one party ae income foranothe. The circular flow model is a major simplification ofthe economy. (We're ignoring, for now, the rmoney pai in axes or te money that is saved instead of spent, for example) Yeti shows that we Should get to the same igre for GDP regardless of whether we measire expenditure or income in an economy. National production = National expenditure = National income This equality is a crucial idea in the study of macroeconomics. ee | want 0 X\, povont ¥ 0 ncome spending \ ee eer ops. ot ; peraes\X tee RN tna ter. \SS YY sermesto acpi Fs tesa > Flow ofdolins > Flow of goods | Third Eton 169 107.2 Bspainthe ‘equivalence ofthe expenciture and income approaches tovalurg an economy. FIGURE 7-1 Circular flow diagram10 Economic Environment 170 107.3 Expiainthe three approaches tat are usedto ‘aleulate GOP, and summarize the cat egoties ct spencing that are included Inthe expenditure approach consumption (C) spending on goods and services by private incwavals and households Part3 © The Data of Macroeconomics TEST YOURSELF O Why are only final goods and services counted under GDP? Why are sales of used goods not counted? [Lo 7.4] 1 Why is total income in a country equal to total expenditures on goods produced in that country? [Lo 7.2) Approaches to Measuring GDP We just saw that national production equals national expenditure equals national income. The ‘equality of production, expenditure, and income would hold true in a literal, straightforward way if'we lived in a clased economy—an economy in which all goods were produced and sold domest- cally and everything was consumed as soon as it was made. The actual economy is more compli- cated, but the basic equality still holds~as long as we're a litle more careful about how we define each part, We'll nced to consider two complications in particular: * One complication is international trade. Once we start to consider imports and exports, ‘we see that expenditure in one country can translate into income in another country. + The second complication is unsold inventories. What happens when goods are prociuced but not sold? In this section, we will consider three approaches to measuring GDP-the expenditure approach, ‘the income approach, and the value-added approach. Looking at the different approaches, we will see how economists deal with the complications of international trade and unsold inventories. Why are there three approaches? Each focuses on a different piece of GDP and so provides a slightly different look at how those different pieces make up the big picture. It turns out, though, that all three approaches end up with roughly the same GDP number. AMter reading the next three sections, you'll understand the details of how they differ. For now, it's enough to give this broad overview of the differences: + The expendinure approach highlights the importance of consumer spending versus govern: ‘ment purchases. + The income approach emphasizes information about the relative importance of different factors of production. + The valuesadded approach is especially useful for racking how goods are sold and resold. ‘Some countries use all three approaches to calculate GDP so that policy-makers and researchers can get a full picture of economie activity The expenditure approach To measure output using the expenditure mctiod, we start by breakog down expenditure into categories. Remember that we don't want to double coun, so we don include intermediate prod ut, ike raw peanuts andthe labor of peanut factory workers, which firms uy only to transrrmn into inl goods and services, I turns out that all expenitares can be casi in ne of of four categories fina goods and service, goods bougt as investment. government purchases, and net exports To find total expenditure, we ad together those four eaepores ‘Consumption (C) + Investment (I) + Government purchases (G) + Net exports (NX) =Total expenditure Let's look at each in more detail Consumption (C) The first category, consumption (C), measures spending on goods and services by private individuals and households. It includes almost anything you'd buy for yourself,Measuring GDP © Chapt 7 from basic, nondurable goods (like food and clothing), to durable goods (like computers and cars), to services (like haircuts, tutoring, and plumbing). Ifyou pay rent or college tuition, those expenses are also included in consumption. ‘Note that what is consumed has to be ev. This requirement avoids the illogical conclusion that we could grow the economy simply by reselling the same jar of peanut butter over and over, again, Ifyou buy a used camera on eBay, for example, the camera itselis not counted toward the size of the economy: the original purchase of the camera was already recorded in GDP when it ‘was sold new. However, the fee the seller pays to eBay is counted as consumption and so is the price the seller pays FedEx to deliver the camera to you. Investment (I) The second category, investment (1) includes spending on productive inputs, such as factories, machinery, and inventories. That means goods bought by people or firms who plan to use those purchases to produce other goods and services in the future, rather than con- suming them, Itincludes capital goods, which are items like machines or tools that will be used for production of other goods or services. It also includes buildings and structures, like warehouses, that will be involved in providing goods and services. it's worth noting that newly built houses are also counted as investment. In contrast, if you rent a house, that expenditure falls under consumption. Why the difference? A newly built house will provide a place to live (or to rent out) now and for years to come, just as a newly built factory will generate output now and in future years, But when you rent a house, you are paying its owner for the service of letting you live there. You are consuming “place-tolive” services, but you're not mak ing an investment because the house belongs to someone else and won't generate future revenues {or you. ‘Again, note that investment goods are counted only if they are new. We don't count buying an existing factory or secondhand tools as investment. Nor do we count an individual's purchase of tan existing house. The services of the real estate agent selling you the house, though, would be counted toward consumption. A CAUTION: COMMON MISTAKE You may have heard people talk about their “investments"~stocks, bonds, mutual funds, and ‘other products bought and sold in the financial markets. While it may seem as if these financial products should be counted under the “I” (investment) term in GDP, they do not get counted as a art of GDP, There are two reasons for that: + First, ifyou buy a share of General Motors stock through the New York Stock Exchange, ‘your money does not go to General Motors. Instead, you are buying stock from some other investor who has decided to sell her stock in General Motors, (We'll cover how economists think about buying stocks end making other financial “investments” in Chapter-14, “The Basics of Finance.”) ‘Second, including stock purchases in GDP calculations would be another type of double- counting. If we added to GDP every time someone bought shares, we could make the economy seem to be growing simply by having people resell the same shares aver and over, again—just like selling the same jar of peanut butter multiple times, Although sales of stocks do not count in GDP, the money raised in initial public offerings (IPOs) of stocks may still be counted in other ways. Since the money raised by stock offerings {oes to the company that sells stock, they may make investments or purchases with the money, increasing GDP, ‘Macroeconomics Improve Your Wor, Third Edition 1 m Invostment() spending on productive Inputs, suchas factories, machinery. and_— AZ Economic Environment 12 Past3 The Dala of Mactosconomics Finally, our definition of investment also includes a less-obvious type of “purchase”: spending ‘on inventories, Earlier in the chapter, when We equated production, income, and expenditure, Inventory ‘we raised the question of how to deal with goods that are produced but not sold. Inventory is the ‘restock goods iat answer: I's the stock of goods that a company produces now but keeps to sell ata future time. If compary prosuces Ford manufactures a car this year, but the car sits on the lot until next year, the car becomes part ow but doesnot sell of Ford's inventory. If Apple makes a batch of iPhones but keeps them in a warchouse until it’s Immeciately time to release the new model for public sale, they become part of Apple’s inventory. When a good is added to a company’s inventory, we treat it as if the producing company has “bought” that item to keep in stock for the future. The value of the company’s purchase is included. in our calculation of investment for the year. What happens next year when a consumer buys the new-model iPhone? We don’t want to count the same iPhone toward GDP in two different years, So, its value will be subtracted from Apple's inventory at the same time as itis counted as. ‘consumption. These two transactions cancel out, meaning the consumer's purchase of the phone results in no net increase in GDP. government Goverment purchases (G) The next category of spending, government purchases (G), purchases (6) represents goods and services bought by all levels of government, This includes both: spending on goods and services by all eves of government “onsumption” type purchases of goods (for instance, buying new bulbs to goin street- lights) and services (buying the labor of government workers who repair streetlights). + “Investment™-type purchases (for instance, buying a truck that government workers will use to repair streetlights in the future. In fact, the technical name for this category of spending is “government consumption expendi- tures and gross investment.” We'll stick with the term goverament purchases because it's less of a ‘mouthful, In the United States, government purchases were $4.4 trillion in 2018, or 21 percent of GDP, However, one important category of government spending does of count as a government pur- ‘chase: spending that simply mangférs resources to individuals, through Social Security or similar programs, For example, the Social Security payment from the government toa retired person does ‘not count toward government purchases. When that person spends money from his or her Social Security payment to buy groceries, the spending will then be counted 2s private consumption. Net exports (NX) The three categories of spending we've considered—consumption, invest- ‘ment, and government purchasesinclude spending on goods and services produced abroad as well as those produced domestically. Let’s think about the GDP of the United States, Our calcu lation of consumption will include instances when people in the United States buy goods made abroad~say, a sweater imported from Scotland. If we're trying to measure the value of the goods produced within the United States, we don't want to count this spending. On the flip side, we don’t ‘want to miss spending by people in other countries on goods or services made in the United States and exported for sale abroad—say, a Harley-Davidson motorcycle. ‘These two forces work in opposite directions: Domestic spending on imports should get sub- ‘tracted from our GDP calculations, while international spending on exports should get added. We net exports (4X) can simplify these international transactions by combining exports and imports into one term, roar: mins imports; called net exports (NX). Net exports represent the value of goods and services produced domesti- the value of goods cally and consumed abroad minus the value of goods and services produced abroad and con- and senices produced sumed domestically. If exports are higher than imports, NX wil be positive. If imports are higher domestically and than exports, NX will be negative. Figure 7-2 shows how we can think about the role of net exports consume abroad minus using a visual tool the ylue of goods and senices produced arses pecuce Summing spending categories When we add together spending in all four categories amestclly consumption, investment, government purchases, and net exports-the total will be equal toMacrozconomics:Improve Your World, Third Edition 13 Mensuring GDP = Chapter? 13 FIGURE 7-2 Adding up expencitures when there are Imports and exports Everything thats produced domestically 'S added to GDP, whether tis purchased for consumption, for investment, by the government, or by people abroad (exports) Goods that are produced international but Bought domestically, otherwise known as imports, are subtracted from GOP because they represent expenditures leaving the county. Trensactons between foreign producers and foreign buyers do not involve domestic production or expenditure and therefore donot, figure nto GDP calculations, Domestic transactions (erie \ % cor 7 pons (otic ot expenditure on all goods and services produced in a country. As we learned in the previous sec- tion, the total of those national expenditures is equal to the value of national production, This equation is represented as follows. EQUATION 741 Expenditure = C+1+G +NX= Production AAs you can seein Figure 7-3, consumption is by far the largest single category of expenditure in the United States, but investment and government purchases are also significant. ‘We can also see in Figure 7-3 that U.S. residents buy more goods from abroad than they sell to people abroad. That's why the value for net exports is a negative number, ~3.2 percent of {otal 2018 GDP. In other words, in 2018 U.S. consumers spent more abroad than U.S. produc- ers earned from foreigners buying U.S-made goods, and the size of that difference was equal to 3.2 percent of GDP. If exports had been higher than imports, this number would have been positive, Figuring out what goes into GDP and what isn’t counted in the expenditure method takes a Little practice. To help you keep track, Table 7-1 summarizes some of the examples presented in this chapter, The income approach A citfeent way to think about the value ofa national econony iso ad up the income eared by everyone tn the county. The income approach thus brings together information on the diferent factors of production ‘To value an economy using the income approach, we ad up all the types of income earned by people ina country. + wages earned by workers, * interest earned on capital investments, * rents earned on land and property, and * profits earned by firms (plus a couple of additional technical adjustments)Economic Evironment 174 Part. The Dats of Macroeconomics FicuRe 7S Tatlone of dt) US. 6DP breakdown Be Tis figure shows the expeneitue i _ mete of aleulating ceeuce aaa) GP, whieh adds 6 together consumption, investment, government purchases, and net exports exports minus imports) the United Sales, imports are Current higher than ‘exports, s0the value of not exports is negative ‘and is subtracted from the tia sec TABLE 7-1 Isitepp? Situation GDP Category Buying a new digital camera Consumption Buying a used camera on eBay Not counted Buying a new house Investment Renting an apartment Consumption ‘Apple makes anew batch of Phones but doesn't sell them until next year seer Buying shares of General Motors stock Not counted Government uys plastic bins for eiport secur TSA buys p We eae, Babysitting for your neighbor Not counted nl onc nes Dame Poe eae hppa gone ches op= 26 SpE Cee read) Netexports(-3.28) entasie Why? Purchasing @ new good or service always counts toward GDP. ‘Asa sed good, the camera does not count toward GDP as it was already counted when new. The fees paid to eBay for seling the ‘camera count as consumption, though. Since buying a house wil provide a place to lve for yeas into the future, it makes sense to think of itas an investment. ‘You are paying the over ofthe house fora service, so tis counted as consumption, Counted as apart of investment as Apple i holding these phones as «part ofits inventory. Shares of stock are a transfer of money from one owner ofthe stock to another. Including stocks would cause a double-counting problem, Any consumption or investment purchases made by the government ‘are counted in GDP as government spending In principle, it should be included in GDP, but such income is often not reported tothe IRS, and thus it can't be included in official statistics.Macroeconomics:Improve Your Word, Third Elion 15 Messuring GDP. Chapter 7 175 Under this approach, national income can be shown in an equation as EQUATION 722 ‘National income = Wages + Interest + Rental income + Profits In an economy without any imports and exports, this ineome approach will give us the same result as the expenditure approach. Why? Because in every transaction, there is not only a buyer wo spends but also a seller who carns the same amount in income. If you spend $20 on sasoline, that same $20 is both expenditure to you and income to the owner of the gas station, The expenditure approach added up everything on one side of this transaction. The income approach adds up everything on the other side of the transaction, which comes out to the same amount. ‘But what happens when there is foreign trade? When goods produced in the United States are exported, the transaction is expenditure by other countries and income for the United States ‘When people in the United States spend money on goods made in another country, the transac tion is expenditure in the United States and income for the other country. The “value-added” approach Finally, we come to the third approach that economists sometimes use to measure economic output: the value-added approach. We have seen that the expenditure approach solves the double-counting problem by considering only transactions that represent final, and not inter mediate, goods and services. For example, we count a consumer's purchase of a jar of peanut butter from a store but not a peanut butter factory's purchase of peanuts from 2 peanut whole- saler. What if, instead, we were to look at all transactions, but count only the vaue they add to the economy? "To see the reasoning behind this approach, It’s stick with peanut butter. At each stage of the peanut butter production process, let's look atthe difference between the sale value of the product ‘and the value of the inputs that went into it. This difference represents the “value added” at that stage of production, For instance: ‘+ ‘The farmer adds value to the economy by taking seeds, land, and water and growing pea ruts, Just for simplicity, imagine the farmer didn't pay anything for his inputs. The value ‘added to the economy is the $0.12 the farmer gets from selling his 800 or so peanuts to the ‘wholesaler, minus the value of the inputs, which we are imagining to be zero. ‘+ Ifthe wholesaler buys those $0.12 in peanuts and sells them to a peanut butter factory for $0.25, then the wholesaler has added $0.13 ($0.25 — $0.12) in value to the economy by helping to link up farmers and factories. + The peanut butter fuctory adds value by pressing the peanuts into butter and pouring it into jars. I'the factory is able to get $1.85 per jar, it has added $1.60 ($1.85 — $0.25) in value to the economy. + The grocery store adds value by transporting jars to a convenient location in your neigh borhood, where clerks are on hand to allow you to purchase it for the final price of $3.40 per jar, a value added of $1.55 ($3.40 ~ $1.85). ‘To see the final value added, simply sum up the value added at each stage of the process $0.12 + $0.13 +$1.60+ $1.55 3.40 You'll notice that this isthe same as the final price of the peanut butter in the store—which is the ‘amount that is counted in the expenditure method. The value-added approach is an alternative, ‘nd equally valid, way of avoiding the problem of double-counting the peanuts. It lets us break ‘down the total value paid and see how much value was ereated at each step of the production process.6 107.4 Expiainthe atference between teal and nominal or. real GDP GP calculation in which g008s and serces are valued at constant prices ‘nominal GDP. GDP calcation in hich goods and services are valued at curtent aces Part3 The Data of Macroeconomics ‘The valueadded approach is especially useful when thinking about services involved in the resale of existing goods. We've already seen, for example, t houses, and shares of company stock do not count toward GDP—but the related services provided by eBay, real estate agents, and stockbrokers do, The concept of added value helps us to think about why this isso. A stockbroker adds value by handling the paperwork associated with purchas- ing shares of stock. A real estate agent adds value by publicizing the fact that a house is forsale, showing potential purchasers around, and helping negotiate a sale. eBay adds value by connecting buyers with seers. ‘In general, any intermediary involved in the sale of used goods adds value by sourcing those goods and making them available for sale in a convenient way. resale of used cameras, existing TEST YOURSELI 1D What isthe difference between consumption to 7.3] 1 Under which category of expenditure do inventories fall? [LO 7.8], 11 Does the sale of intermediate goods count toward GDP in the expenditure approach? (LO 7.3] How do the expenditure approach and income approach capture two sides of the same transactions? (Lo 7.31 0 How do GDP calculations account for the value added in the sale of an existing house by a realtor? [Lo 7.3) spending and investment spending? Using GDP to Compare Economies US. GDP inereased from $12.5 trillion in 2005 to nearly $21 trillion in 2018, Does this mean that people in the United States produced more goods and services in 2018 than in 2005? Or does it ‘mean that we just paid more for the same things because prices were higher? The calculation of zeal and nominal GDP allows us to get to the heart of the question. Real versus nominal GDP GDP is a function of both the quantity of goods and services produced (output) and their market value (prices). For this reason, economists look at two different calculations of production: real GDP and nominal GDP. Both numbers are important, but economists are generally more interested in real GDP because it gives a sense of how the size of the economy moves over time. Tracking rea! GDP gives a clearer view of changes in the amount of “stuff” (goods and services) that the economy produces. The term rea! GDP refers to GDP measurement that focuses solely on output, controlling for price changes. Formally, real GDP is calculated based on goods and services valued at constant prices. Those constant prices are given for a specific year, We might, for example, measure real GDP by valuing output in 2018 at the prices that prevailed in 2010. If we report GDP without controlling for price changes, we are talking about nominal GDP. ‘Nominal GDP is calculated based on goods and services valued at current prices (current at the time they are produced). Thus, in nominal GDP measurement, output for 2018 would be valued in 2018 prices. Calculating nominal and real GDP To see the difference between real and nominal GDP measures in practice, let's imagine an economy with only two goods: pizza and spaghetti For ease of discussion, let’s call this fictional economy “Pizzetta."Macroeconomics Improve Your Worl, Third Edition Moesuring GDP.» Chapter 7 7 Suppose that in 2015, Pizzetta produced § million pizzas at a price of $10 each and 20 milion, plates of spaghetti at a price of $8. Table 7-2 shows this output. In 2016, the number of pizzas and plates of spaghetti increased to 6 million and 22 million, respectively; prices stayed the same. In 2017, Pizzetta produced the same number of pizzas and plates of spaghetti, but prices increased In 2018, both quantity and prices increased. In order to calculate nominal GDP, we simply multiply the quantity of each good produced in ‘given year by its price in that year. as shown in column 6 of Table 7-2. We can see that Pizzetta’s nominal GDP increased between 2015 and 2016 and again in 2017 and 2018, ‘What doesn’t nominal GDP tell us? If we looked just at nominal GDP, we couldn't tell the cause of the inerease, We wouldn't see that in 2016 the increase was due to larger output, or that in 2017 the increase was due only to an increase in prices with no increase in output, Instead, look- ing at real GDP helps us see the different causes of the changes in GDP in the two years, ‘To calculate real GDP (GDP valued at constant prices), we have to choose a base year. In the base year, nominal GDP and real GDP are equa. In every other year, we multiply the quantity of a good produced in that year by its price in the base year. In essence, we are holding prices constant while allowing quantities to rise and fll. This method isolates increases in output from increases in prices, Looking at the Pizzetta example, suppose we pick 2015 as our base year. We can see in ‘Table 72 that in 2016, the inerease in real GDP is actually the same as the increase in nominal TABLE 7-2 Caleulating real versus nominal GDP growth mina GP isthe su oft market vale ofl al goods and servics, which we cleat by multiplying the quantly of sch output ts marke price Inthe ure yea To cals eo/ GDP, we want ovale thse goods and series at tha pce nthe base year Whe pies stay he sae, nominal ‘SOP at tel GDP increase tthe same ret. I prceee, nominal GDP lb ge than el GDP. 0 @ @) ” ©). (6) a (8) Real GDP in Pizzas Priceof Spaghetti Priceof Nominal GDP eer te) pze) morn) soehet)fimomore) 215s Wiets hrprng tie et (5x $10) (5x $10) (Gentes 10 20 8 + (20x $8) + (20x $8) teal GDP are equal ores xsi xsi “nndpessty me 8k) Hct =$236 ‘and real GDP rise at xsi, xsi. amiouatsa 8k ast HS coment oxsiy asi “tae me 7st emitoned rates,18 Economic Environment 178 107.5 Calculate the GDP defator GP deflator ‘measure ofthe overs economy, using the tala between real and rominl GD? Part The Data of Macroeconomics GDP ($236 million). That makes sense: Prices didn't change between the two years, so baseyear prices are the same as currentyear prices. Between 2016 and 2017, however, the difference between nominal and real GDP shows up. Nominal GDP increases because prices increased. (Prices of pizza and spaghetti increased by $2 each.) But real GDP stays constant because output stayed constant. Between 2017 and 2018, boi nominal and real GDP increase because both prices and output increased, However, the increase in real GDP ($34 million) is smaller than the increase in nomi nial GDP (874 million). What does that tell us? It indicates that only $34 million of the $74 mil- lion growth in nominal GDP is due to rising output; the rest is due to rising prices. In summary: + Real GDP isolates changes in an economy's output. + Nominal GDP encompasses changes in both output and prices. As a result, because economists and policy-makers are often most interested in changes in output, they typically use real GDP numbers as a reference point ‘When economists and policy-makers do want to focus on changes in prices, they tun to another measure-the GDP deflator. The GDP deflator ‘We just saw that the difference between nominal and real GDP is the difference between current prices and base-year prices. If we want to know about how prices have changed, we could directly compare the price of each good in the current and base years. But that would be much lke listing every good and service instead of reporting total GDP: I's not incorrect, but its long and boring ‘and doesn't do much to summarize what's going on in the economy as a whole. The GDP deflator is one way of summarizing how prices have changed across the entire economy. ‘The GDP deflator is a measure of the overall change in prices in an economy, using the ratio between real and nominal GDP. To compute the index, we first need to have measures of nominal GDP and real GDP from the current year. Then, we calculate the GDP deflator as follows: Nominal GDP 199 EQUATION 73 GDP deflator = RSG GDP “The GDP deflator equation gives us the ratio between the baseyear value of current output (the real GDP number) and the current-year value of current output (the nominal GDP number). TThe equation has three direct implications: «Inthe base year, the GDP deflator is always equal (0 100 because current prices are base- year prices. Thus, in the base year, nominal GDP equals real GDP. «+ [Fprices have risen such that nominal GDP is now higher than real GDP, the deflator will bee areater than 100. So, for example, ifthe GDP deflator is 115 ina given year, we infer that the overall price level is 15 percent higher than it was in the base year. + IEprices have fallen such that nominal GDP is now lower than real GDP, the deflator will be less than 100. Similarly, if we are looking at a year before the base year, when prices were lower, the deflator will be less than 100. ‘Table 7-3 shows the GDP deflator for the imaginary country Pizzetta in 2015-2018, ‘The GDP deflator gets its name from its relationship to inflation. Inflation is an idea we'll discuss at length in future chapters; in fact, Chapter 16, “Inflation,” is entirely devoted to the topie. For now. it’s enough to note that inflation describes how fast the overall level of prices is changing. Inflation is defined in terms ofa year-to-year increase in prices, rather than an increase over a base yearMeasuring GDP = Chapter? Yeu fattonteS)—Getirs of) Dota sae. 20520 210 Bx 100= 100 = 2016 26 236 FRE x100=100 (100 1009100 0% 2017 22 236 2 x 100= 124 (124 100/100 =24% 2018 366 270 $8 x 100= 136 (136 = 124/124 = 9.7% We can calculate inflation by looking at the increase in the GDP deflator between any two ‘years using the equation below: Praesens = Delite] x 100 For instance, as shown in Table 7-3, the inflation rate in Pizzetta between 2017 and 2018 is: Det Dettor ‘The GDP deflator is one simple way of measuring changes in the price level, It allows us to “deflate” nominal GDP by controlling for price changes. In official government statistics, the GDP deflator is actually calculated using a somewhat more elaborate method called a chain-veighted index. The basic intuition is the same as the sim- pler approach we've described here.? We'll return to the idea of changes in the overall price level in Chapter 8, “The Cost of Living.” Using GDP to assess economic health How do we use GDP to compare economies? We could, of course, simply look at the GDPs of two countries side by side to see their relative sizes. High GDP means a big economy. Figure 7-4 shows, the GDPs of a number of countries around the world. As you can see, the United States has the Jargest economy by far, followed by China. However, if what we really want to know is the income of an average individual in these coun- ‘ties, GDP will paint a misleading picture. The reason is that the populations of the countries are Quite different sizes. For example: ‘+ China's GDP is just over one-half as high as that of the United States, but its population is more than four times as large. Indi has just under four times as many people as the United States but only about one-tenth the GDP. The total income earned in China and India is spread across far more people, $0 the average person has a lower income, Meanwhile, Norway has a much smaller economy than the United States, but because its Boplation is also much small, the average Norwegian i atually richer than the average smerican, ‘To compare average income across countries, we need to know GDP per capita 179 TABLE 7-3 Calculating the GDP deflator and Infation rates sng the values of poi andrea 6DP weean ‘aka the GDP deft, Smear of pie changes ‘rtina Nissetto 100 feratare year a pcs increao the value he defetorinceate sell Withthe GP defaterwe cancaeatinfaten, the orange change of pre. 107.6 Use GDP pe copia to compere economies and calculate the real {GDP annual growth rate.