2 Theme: Gross Domestic Product

and Product Accounts

Plan:
1. Gross Domestic Product (GDP).
2. From GDP to Disposable Income
3. Nominal and Real GDP. Real GDP and the Price Level
4. Limitations of the GDP Concept
 What shows GDP?
 • GDP is used to evaluate the state of the economy at a given
time
 • Dynamics of GDP determines the dynamics of the economic
system
 • On the basis of the GDP a comparative analysis of the
countries can be made
 • GDP shows the effectiveness of economic policy
 1. Gross Domestic Product.

 1.1. Gross domestic product (GDP) is the total market value of all
final goods and services produced within a given period by factors of
production located within a country.

 This definition has four parts:

 • Market value
 • Final goods and services
 • Produced within a country
 • In a given time period
 Market value
 GDP is a market value—goods and services are valued at their market
prices.

 To add apples and oranges, computers and popcorn, we add the market
values so we have a total value of output in national currency.
 Final goods and services
 GDP is the value of the final goods and services produced.
 The term final goods and services refers to goods and services
produced for final use.
 Intermediate goods are goods produced by one firm for use in further
processing by another firm.

 When calculating GDP intermediate value of intermediate goods is not

included.
 Produced within a country
 GDP measures production within a country—domestic production.

 In a given time period

 GDP measures production during a specific time period, normally a
year or a quarter of a year.
 In calculating GDP, we can either sum up the value added at each stage of
production, or we can take the value of final sales. We do not use the value
of total sales in an economy to measure how much output has been produced.
 Value added is the difference between the value of goods as they leave a stage
of production and the cost of the goods as they entered that stage.
 For example:
 Sugar is an intermediate good when it is used for making sweets. However, if
it is used by the consumers, then it becomes a final good.
 Similarly, milk is an intermediate good when it used in dairy shops for resale.
However, it becomes a final good when it is used by the households.
 GDP ignores all transactions in which money or goods
change hands but in which no new goods and services are
produced.
 1.2. Calculating GDP
 GDP can be computed in two ways:
 • The expenditure approach is a method of computing GDP that
measures the amount spent on all final goods during a given period.

 • The income approach is a method of computing GDP that

measures the income—wages, rents, interest, and profits—received by
all factors of production in producing final goods.
 1.2.1. The Expenditure Approach

 If we calculate GDP with expenditure method, we use the following

categories.
 Personal consumption expenditures (C) are household spending on
consumer goods.
 Gross private domestic investment (I) are spending by firms and
households on new capital: plant, equipment, inventory, and new
residential structures.
 Government consumption and gross investment (G)
 Net exports (NX = EX – IM) are net spending by the rest of the world,
or exports (EX) minus imports (IM)
 The expenditure approach calculates GDP by adding
together these four components of spending in equation
form:

 GDP = C + I + G + NX
 Personal Consumption Expenditures
 Personal consumption expenditures (C) are expenditures by
consumers on the following:

 Durable goods are goods that last a relatively long time, such as
cars and household appliances.
 Nondurable goods are goods that are used up fairly quickly, such as
food and clothing.
 Services are the things that we buy that do not involve the
production of physical things, such as legal and medical services
and education.
 Gross Private Domestic Investment

 Investment refers to the purchase of new capital.

 Total investment by the private sector is called gross private domestic

investment. It includes the purchase of new housing, plants, equipment,
and inventory by the private (or non-government) sector.

 Nonresidential investment includes expenditures by firms for machines,

tools, plants, and so on.
 Residential investment includes expenditures by households and
firms on new houses and apartment buildings.

 Change in inventories computes the amount by which firms’

inventories change during a given period.
 Inventories are the goods that firms produce now but intend to
sell later.
 Gross Investment versus Net Investment

 Gross investment is the total value of all newly produced capital goods
(plant, equipment, housing, and inventory) produced in a given period.

 Depreciation is the amount by which an asset’s value falls in a given

period.

 Net investment equals gross investment minus depreciation.

 NI = I - D
 Capital end of period = capital beginning of period + net investment

 Investment plays a central role in the economy. Increases in

capital are one source of growth in potential real GDP.

 Fluctuations in investment are one source of fluctuations in real

GDP.
 Government consumption and gross investment (G) counts
expenditures by federal, state, and local governments for final goods
and services.

 Net exports (EX – IM) is the difference between exports (sales to

foreigners of country - produced goods and services) and imports
(country purchases of goods and services from abroad).

 Net exports can be positive or negative.

 1.2.2. The Income Approach

 The income approach measures GDP by summing the incomes that

firms pay households for the factors of production they hire.
 GDP = national income + depreciation + indirect taxes less subsidies

 Indirect taxes (such as sales taxes) make market prices exceed factor
cost.
 Subsidies (payments by government to firms) make factor cost exceed
market prices.
 A direct tax will refer to any levy that is both imposed and collected on a
specific group of people or organizations. An example of direct taxation
would be income taxes that are collected from the people who actually
earn their income.

 Indirect taxes are collected from someone or some organization other

than the person or entity that would normally be responsible for the taxes.
 A sales tax, for instance, would not be considered a direct tax because the
money is collected from merchants, not from the people who actually pay
the tax (the consumers).
 National income is the total income earned by the factors of
production owned by a country’s citizens.

 The National Income and Product Accounts divide incomes into

five categories:
 Compensation of employees
 Net interest
 Rental income
 Corporate profits
 Proprietors’ income
 Wages, called compensation of employees in the national accounts, is
the payment for labor services.

 It includes net wages and salaries plus fringe benefits paid by

employers such as health care insurance, social security contributions,
and pension fund contributions.

 Interest, rent, and profit, called net operating surplus in the national
account, is the sum of the incomes earned by capital, land, and
entrepreneurship.
 Interest is the income households receive on loans they make
minus the interest they pay on their borrowing.

 Rent includes payments for the use of land and other rented inputs.
 Profit includes the profits of corporations and small businesses
(Proprietors’ income).

 The sum of these five income components is net domestic income

at factor cost.
 Statistical Discrepancy
 The income approach and the expenditure approach do not deliver
exactly the same estimate of GDP—there is a statistical discrepancy.

 Statistical discrepancy is the discrepancy between the

expenditure approach and income approach estimates of GDP,
calculated as the GDP expenditure total minus the GDP income
total.
 Gross national product (GNP) is the market value of all the final goods
and services produced anywhere in the world in a given time period by
the factors of production supplied by residents of the country.
 GNP = GDP + Net factor income from abroad

 For example:
 1. Latvian citizens working temporarily in Germany, but planning to
return, so pay social tax in Latvia. We take his income into account in the
calculation of GNP, but not in GDP.
 2. A German citizen is working in Latvia. We take his income into
account in the calculation of GDP, but not in the calculation of GNP.
 GDP is the value of output produced by factors of
production located within a country.

 Output produced by a country’s citizens, regardless of

where the output is produced, is measured by gross
national product (GNP).
 2. From GDP to Disposable Income

 Net domestic product equals gross domestic product minus

depreciation.
 A nation’s total product minus what is required to maintain the
value of its capital stock.

 The National Income and Product Accounts divide incomes into

five categories
 or
 National Income = Net Domestic Product - indirect taxes less
subsidies

 Personal income is the total income of households.
 Personal income equals National income
 minus (corporate profits minus dividends)
 minus (social insurance payments)
 plus (interest income received from the government and
households).
 Personal income is the income received by households after paying
social insurance taxes but before paying personal income taxes.

 Disposable Personal Income

 Disposable personal income is the income received by households
minus personal income taxes paid.

 Consumption expenditure is one of the largest components of

aggregate expenditure and one of the main influences on it is
disposable personal income.
 Disposable Personal Income and Personal Saving

 The personal saving rate is the percentage of disposable

personal income that is saved.
 If the personal saving rate is low, households are
spending a large amount relative to their incomes; if it is
high, households are spending cautiously.
 3. Nominal and Real GDP. Real GDP and
the Price Level
 Real GDP is the value of the final goods and services produced in a given
year expressed in the prices of the base year.
 Nominal GDP is the value of the final goods and services produced in a
given year expressed in the prices of that same year.
 Calculating Real GDP
 The goal of calculating real GDP is to measure the extent to which total
production has increased.
 Real GDP removes the influence of price changes from the nominal GDP
numbers.
 3.2. Real GDP and the Price Level

 Real GDP is the value of final goods and services produced in a given
year when valued at constant prices.
 The first step in calculating real GDP is to calculate nominal GDP,
which is the value of goods and services produced during a given year
valued at the prices that prevailed in that same year.
 Calculating the Price Level
 The average level of prices is called the price level.
One measure of the price level is the GDP deflator, which is an average of
the prices of the goods in GDP in the current year expressed as a percentage
of the base year prices.
 Example:

Year Nominal GDP Real GDP GDP deflator

2012 $200 $200 100

2013 $575 $250 230

Deflating the GDP Balloon
Nominal GDP increases because production—real GDP– increases.
Nominal GDP also increases because prices rise.
We use the GDP deflator to let the air out of the nominal GDP balloon and reveal
real GDP.
Consumer Price Index (CPI)
 The composition of the CPI’s “basket”

Food and bev. 6.2%

17.4% 5.6%
Housing
3.0%
Apparel 3.1%
3.8%
Transportation 3.5%

Medical care

Recreation

Education 15.1%

Communication

Other goods 42.4%

and services
Example
 The Underground Economy
 The underground economy is the part of an economy in which transactions
take place and in which income is generated that is unreported and
therefore not counted in GDP.

 Per Capita GDP/GNP

 Per capita GDP or GNP measures a country’s GDP or GNP divided by its
population.
 Per capita GDP is a better measure of well-being for the average person
that its total GDP or GNP.
 We use real GDP to calculate the economic growth rate.
 The economic growth rate is the percentage change in the quantity
of goods and services produced from one year to the next.

 We measure economic growth so we can make:

 • Economic welfare comparisons

 • International welfare comparisons
 • Business cycle forecasts
The Annual Rate of Growth of GDP
 4. Limitations of the GDP Concept

 Society is better off when crime decreases, but a decrease

in crime is not reflected in GDP.

 An increase in leisure is an increase in social welfare, not

counted in GDP.

 Nonmarket and domestic activities are not counted

even though they amount to real production.
 GDP accounting rules do not adjust for production that
pollutes the environment.

 GDP has nothing to say about the distribution of output.

Redistributive income policies have no direct impact on
GDP.

 GDP is neutral to the kinds of goods an economy

produces.