Measuring the Economy

  • Some of the links for this chapter are not working. instead I have added a chapter outline at the end of the lecture. All of the statements in bold print are important.

 

 

  • I know this is a bit messy, but it will have to do for now

OPTIONAL:

Introduction

We've been using the AS - AD model to understand the macroeconomy. The vertical axis measures the PRICE LEVEL which is the average level of prices in an economy. The horizontal axis measures REAL DOMESTIC OUTPUT which is all the goods and services produced in an economy.

But WHAT NUMBERS do we put on the axes? How do we measure the price level and real domestic output?

We measure real domestic output with REAL GDP and we measure the price level with a PRICE INDEX.

In this lesson we'll learn how to calculate real GDP and a price index.

Measuring Real Domestic Output: real GDP

GDP vs. GNP

"domestic" production vs. production by American "nationals" or citizen

Definition: GDP

Gross Domestic Product is the total market value of all final goods and services that are produced in the economy in one year.

This is one definition that should be memorized. As you can see it has three components.

(1) "total market value"
The unit of measure for real domestic output or real GDP is the market value or $$$

GDP = SUM P x Q = P this year x Q this year
(the sum of price times quantity for everything produced in a year)

(2) "final goods and services"

Only final goods and services are included to avoid double counting
Final goods are bought and used by the final consumer. When you buy a hamburger from McDonald's the value of the hamburger is included in GDP

Intermediate goods are bought so that they can be resold or further processes. When McDonald's buys buns, and burger and ketchup the value of these pruchases of intermediate goods are NOT added to GDP since they will be added when a consumer buys the hamburger (a final good).

If we included the value of the hamberger AND the value of the bun, burger, and ketchup then these would be counted twice.

Another way to avoid double counting is to use the value-added method.

(3) "produced in one year"

GDP is a measure of what is produced or made in one year, therefore:
a. secondhand sales are not included, and
b. financial transactions not included

A car produced in 1999 is included in 1999's GDP. Therefore, if a used 1999 vehicle is sold in the year 2001 we would NOT include its price in the GDP for 2001 since it was not produced then. We WOULD include the profits earned by the used car salesperson in 2001 since he or she did clean, advertise, and sell the used car in that year, but we would not include the value of the 1999 car itself.

Also, a lot of the "business news" that you hear concerning the billions of dollars spent on stocks and bonds each day does not affect the GDP directly.

When people buy stocks and bonds from whom do they buy them? If I buy $100 in IBM, from whom do I buy it? I may buy it through a stock broker, but whose stock do I buy? I probably didn't buy it from IBM (unless it was an IPO - Initial Public Offering), but rather I bought it from somebody who had bought it earlier. In other words, I bought :used" stock. But the main point is, when I buy $100 on IBM stock, nothing is being produced so the $100 is not added to GDP.

REVIEW: (Textbook Question 7-13)

Which of the following are actually included in this year’s GDP? Explain your answer in each case.

a. Interest on an AT&T bond.

b. Social security payments received by a retired factory worker.

c. The services of a family member in painting the family home.

d. The income of a dentist.

e. The money received by Smith when she sells her economics textbook to a book buyer.

f. The monthly allowance a college student receives from home.

g. Rent received on a two-bedroom apartment.

h. The money received by Josh when he resells his current-year-model Honda automobile to Kim.

i. Interest received on corporate bonds.

j. A 2-hour decrease in the length of the workweek.

k. The purchase of an AT&T corporate bond.

l. A $2 billion increase in business inventories.

m. The purchase of 100 shares of GM common stock.

n. The purchase of an insurance policy.

ANSWERS

Circular Flow Model

The circular flow model can help us to understand the two approaches used to measure GDP

1. expenditures approach
2. income approach

Arrow # 3 is real GDP. This is output produced by business and sold in the product markets to consumers (households). To measure this level of produced output we can measure arrow #4 which are the expenditures spent on this output. This is the EXPENDITURES APPROACH.

We can also measure arrow #1 which is the income earned by households when they sell their resources (arrow #2) to businesses. The value of output produced (GDP) is equal to the value of ALL the income earned by everyone who had anything to do with producing the output. If a $20,000 car is sold, then $20,000 was earned by everyone who was involved in producing and selling the car. So to measure GDP ( the value of the products produced) we can sum up all the income earned in producing that level of GDP. This is the INCOME APPROACH to calculating GDP.

 

Expenditures Approach

GDP = C + Ig + G + Xn

GDP = C + Ig + G + Xn

1. personal consumption expenditures (C)

2. gross private domestic investment (Ig)

a. includes:
1) all final purchases of machinery, equipment, and tools by businesses
2) all construction
3) changes in inventories

b. gross vs. net domestic investment (In)

c. net investment and economic growth

1) expanding economy

2) static economy

3) declining economy

3. government purchases (G)

4. net exports (Xn)

Practice Problem

Given the data below, use the EXPENDITURES APPROACH to calculate GDP.

Answer the next question(s) on the basis of the following national income data for the economy. All figures are in billions.

Personal consumption expenditures

$400

Government purchases

128

Gross private domestic investment

88

Net exports

7

Net foreign factor income earned in the U.S

0

Consumption of fixed capital

43

Indirect business taxes

50

Compensation of employees

369

Rents

12

Interest

15

Proprietors' income

52

Corporate income taxes

36

Dividends

24

Undistributed corporate profits

22

R-1 REF07059

ANSWER: Before scrolling down, pick up some paper and a pencil and actually calculate GDP. DOING it yourself is better than reading it.

.

.

.
GDP = C + I + G + Xn

.

.

From the table we get:

GDP
=
C
+
I
+

G

+

Xn

GDP
=
400
+
128
+
88
+
7

GDP = C + I + G + Xn = 400 + 128 + 88 + 7 = $ 623

Income Approach --calculating national income (NI)

1. circular flow: expenditures = income?

NI = Wages + Rents + Interest + Corp. Profits + Prop. Income

2. resource payments

a. compensation of employees (wages)
b. rent
c. interest
d. profit
1) proprietor's income
2) corporate profits

Practice Problem

Given the data below, use the INCOME APPROACH to calculate National Income (NI).

Answer the next question(s) on the basis of the following national income data for the economy. All figures are in billions.

Personal consumption expenditures

$400

Government purchases

128

Gross private domestic investment

88

Net exports

7

Net foreign factor income earned in the U.S

0

Consumption of fixed capital

43

Indirect business taxes

50

Compensation of employees

369

Rents

12

Interest

15

Proprietors' income

52

Corporate income taxes

36

Dividends

24

Undistributed corporate profits

22

R-1 REF07059

ANSWER: Before scrolling down, pick up some paper and a pencil and actually calculate GDP. DOING it yourself is better than reading it.

.

.

.

NI = Wages + Rents + Interest + Corp. Profits + Prop. Income

.

.

From the table we get:

NI
=
Wages
+
Rents
+
Interest
+
Corp. Profits
+
Proprietor's Income
NI
=
369
+
12
+
15
+
82
+
52

NI = Wages + Rents + Interest + Corp. Profits + Prop. Income

Corporate profits are used for three different purposes:

  1. Corporate income taxes = 36
  2. Dividends = 24
  3. Undistributed corporate profits = 22

Corporate profits then equal 36 + 24 + 22 = 82 . On the exam I will give you "corporate profits".

NI = 369 + 12 + 15 + 82 + 52 = $ 530

As you can see, National income does not equal GDP. there are some expenditures (that are included in the expenditures approach) that are not income (therefore not included in the income approach). they are indirect business taxes ( 50), depreciation (43), and net foreign income factor ( 0 )

GDP = C + I + G + Xn = 400 + 128 + 88 + 7 = $ 623

 

 

3. National Income to GDP

NI + IBT + Depreciation (CCA) = GDP

NI + IBT + Depreciation (CCA) = 530 + 50 + 43 = 623 = GDP

a. indirect business taxes (IBT)
b. depreciation

4. Other Social Accounts

a. Net Domestic Product (NDP)
GDP - Depreciation (CCA) = NDP

 

b. National Income (NI)
NI = Wages + Rents + Interest + Corporate Profits + Proprietor's Income

NI is income EARNED by the factors of production (resources)

c. Personal Income (PI)

PI is the income RECEIVED by the factors of production (resources)

d. Disposable Personal Income (DPI)

DPI is your SPENDABLE income

7-8 (Key Question) Below is a list of domestic output and national income figures for a given year. All figures are in billions. The ensuing questions ask you to determine the major national income measures by both the expenditure and income methods. Answers derived by each approach should be the same.

a. Using the above data, determine GDP and NDP by the expenditure method.

b. Calculate National Income (NI) by the income method.

Personal consumption expenditures..............
Net foreign factor income earned
Transfer payments...........................
Rents
Consumption of fixed capital (depreciation).......
Social security contributions
Interest.......
Proprietors’ income
Net exports..........................................
Dividends
(part of corporate profits)
Compensation of employees.............
Indirect business taxes
Undistributed corporate profits
(part of profits)....
Personal taxes
Corporate income taxes
(part of corporate profits)....
Corporate profits
Government purchases........
Net private domestic investment
Personal saving.......

....$245
4
....12
14
....27
20
....13
33
.....11
16
....223
18
....21
26
....19
56
......72
33
.......20

ANSWERS:

a. Using the above data, determine GDP and NDP by the expenditure method.

 

GDP = $388
GDP = C + Igross + G + Xnet
Igross = Inet + depreciation = 33 + 27 = 60
GDP = 245 + 60 + 72 + 11 = 388

NDP = $361
NDP + C + Inet + G + Xnet
NDP = 245 + 33 + 72 + 11 = 361

or

NDP = GDP - depreciation
NDP = 388 - 27 = 361

b. Calculate National Income (NI) by the income method.

NI = $339
NI = wages + rents + interest + profits
profits = corporate profits + proprietor's income
profits = 56 + 33 = 89
NI = 223 + 14 + 13 + 89 = 339

 

GDP and Economic Well-Being

GDP per capita is often used to measure a country's well being or standard of living. The higher the GDP per capita for a country the better off the country is. But there are some problems with using GDP per capita to measure a country's standard of living.

Problems with using GDP to Measure the Standard of Living:

1. non-market transactions are not included in GDP
2. leisure increases a standard of living but isn't counted
3. improved product quality often isn't accounted for in GDP
4. We must use per capita GDP
5. increases in GDP may harm the environment and decrease the standard of living
6. the underground economy is not included in GDP

 

Shortcomings of GDP (pp. 125-126)

GDP is often used a a meassure of Economic Well-Being in a country, but there are problems:

1. GDP doesn’t measure some very useful output because it is unpaid (homemakers’ services, parental child care, volunteer efforts, home improvement projects). Called non-market transactions

2. GDP doesn’t measure improvements in product quality unless they are incuded in the price.

3. GDP doesn’t measure improved living conditions as a result of more leisure.

4. GDP makes no value adjustments for changes in the composition of output. Nominal GDP simply adds the dollar value of what is produced; it makes no difference if the product is a semiautomatic rifle or a jar of baby food.

5. GDP makes no value adjustments for changes in the distribution of income. Per capita GDP may give some hint as to the relative standard of living in the economy; but GDP figures do not provide information about how the income is distributed.

6. GDP does not include output from the Underground Economy. Illegal activities are not counted in GDP (estimated to be around 8% of U.S. GDP). Legal economic activity may also be part of the “underground,” usually in an effort to avoid taxation.

7. GDP and the environment:

  • The harmful effects of pollution are not deducted from GDP (oil spills, increased incidence of cancer, destruction of habitat for wildlife, the loss of a clear unobstructed view).
  • GDP does include payments made for cleaning up oil spills and the cost of health care for cancer victims.
  • Resouce depletion could result in lower future output

8. Noneconomic Sources of well-being like courtesy, crime reduction, etc., are not covered in GDP.

9. GDP does not account for a possible future decline in output due to resource depletion.

10. Per-capita income should be used to compare the economic well-being of different countries.

Which country has a higher GDP, Switzerland or India? Which has a higher level of economic well-being:
  • Switzerland:
    • GDP: $239.3 billion (2003 est.)
    • Population: 7,450,867 (July 2004 est.)
    • GDP per capita: $32,700 (2003 est.)
  • India:
    • GDP: $3.033 trillion (2003 est.)
    • Population:1,065,070,607 (July 2004 est.)
    • GDP per capita: $2,900 (2003 est.)

 

GDP per capita = GDP / population

 

REVIEW:

Do each of the following cause GDP to OVERSTATE the economic well-being of a country or UNDERSTATE it?

1. non-market transactions (Does GDP OVERstate or UNDERstate economic well-being?)

 

not included so, GDP UNDERstates well-being.

2. improved product quality (Does GDP OVERstate or UNDERstate economic well-being?)

 

not accounted for, so GDP UNDERstates well-being.

3. more leisure (Does GDP OVERstate or UNDERstate economic well-being?)

 

not accounted for, so GDP UNDERstates well-being.

4. the composition of output (Does GDP OVERstate or UNDERstate economic well-being?)

 

if "bad" things are being produced, then GDP OVERstates well-being.

5. the distribution of income (Does GDP OVERstate or UNDERstate economic well-being?)

 

an unequal distributin of income would result in GDP OVERstating the well-being of most of a country's population

6. the underground economy (Does GDP OVERstate or UNDERstate economic well-being?)

 

not accounted for, so GDP UNDERstates well-being

7. GDP and the environment (Does GDP OVERstate or UNDERstate economic well-being?)

 

harmful effects of pollution and costs of pollution reduction are not deducted from GDP, so GDP OVERstates well-being.

8. Non-economic sources of well-being (Does GDP OVERstate or UNDERstate economic well-being?)

 

not accounted for, so GDP UNDERstates well-being

9. per-capita income (Does GDP OVERstate or UNDERstate economic well-being?)

 

GDP OVERstates well-being in countries with large populations and UNDERstates well-being in countries with small populations

 

Measuring the Price Level

Introduction

We've been using the AS - AD model to understand the macroeconomy. The vertical axis measures the PRICE LEVEL which is the average level of prices in an economy. The horizontal axis measures REAL DOMESTIC OUTPUT which is all the goods and services produced in an economy.

But WHAT NUMBERS do we put on the axes? How do we measure the price level and real domestic output?

We have seen that you measure real domestic output with REAL GDP and we have learned how to calculate GDP. Now we will learn how to measure the general price level. We measure the price level with a PRICE INDEX.

Definitions

nominal GDP and real GDP

Nominal GDP = SUM (this year's prices x this year's quantities) = P this year x Q this year

Therefore, if nominal GDP increases is it because we are producing more ( Q this year ) or is it because the Price Level increased ( P this year ) ?

In fact it is possible for nominal GDP to increase even though the quantity produced has DECREASED. How?

Nom. GDP = P this year x Q this year

 

Nom. GDP = P this year x Q this year

So if we know that nominal GDP has increased, we still do not know if we are producing more (and reducing scarcity) or if the price level has just increased.

Real GDP = SUM (base year's prices x this year's quantities) = P base year x Q this year

By using the same price level (base year prices) we remove the effects of a higher price level (inflation) and if REAL GDP increases we know that the economy is producing more and scarcity is being reduced..

 

real GDP
  • real GDP = SUM P base year x Q specific year
  • specific year's quantities x base years prices

Real GDP = SUM (base year's prices x this year's quantities) = P base year x Q this year

By using the same price level (base year prices) we remove the effects of a higher price level (inflation) and if REAL GDP increases we know that the economy is producing more and scarcity is being reduced..

Calculating a price index

To measure the price level we use a price index. A price index is a measure of the price level as a percent of the price level in a BASE year. This is different from inflation which is the rate of increase in the price level from the PREVIOUS year.

As you have read to calculate a price index a year is selected as a base year. the average level of prices for that year is assigned a value of 100. Then the price levels for all other years are calculated as a percent of the base year.

GDP Price Index (GDP deflator)
1. definition
a price index is a measure of the price of a specified collection of goods and services, called a "market basket", in a given year as compared to the price of an identicle (or highly similar) collection of goods and services in a reference year (called the "base year")

2. calculating a GDP price index

price index in a given year = (price of mkt basket inspecific year / price of same mkt basket in base year) x 100

3. calculating real GDP

 

 

REVIEW

The following data show nominal GDP and the appropriate price index for several years.

Compute real GDP for each year. In which year(s) was there a recession (decline in real GDP)?. All GDP are in billions.

                                   Nominal           Price level                                                  

                Year               GDP                  index                Real GDP

                   1                  $117                    120                       ___                       

                   2                    124                    104                       ___                       

                   3                    143                      85                       ___                       

                   4                    149                      96                       ___                       

                   5                    178                    112                       ___                       

                   6                    220                    143                       ___                       


The answers are below:

 

 

 

 

 

 

 

ANSWERS:

                                   Nominal           Price level                                                  

                Year               GDP                  index                Real GDP

                   1                  $117                    120                      $ 98                       

                   2                    124                    104                       119                       

                   3                    143                      85                       168                       

                   4                    149                      96                       155                       

                   5                    178                    112                       159                       

                   6                    220                    143                       154                       

 

 

 


Chapter Outline

Pay special attention to the statements in bold print.

chapter seven

measuring domestic output and national income

CHAPTER OVERVIEW

News headlines frequently report the status of the nation’s economic conditions, but to many citizens the information is confusing or incomprehensible.  This chapter acquaints students with the basic language of macroeconomics and national income accounting.  GDP is defined and explained.  Then, the differences between the expenditure and income approaches to determining GDP are discussed and analyzed in terms of their component parts.  The income and expenditure approaches are developed gradually from the basic expenditure‑income identity, through tables and figures.

The importance of investment is given considerable emphasis, including the nature of investment, the distinction between gross and net investment, the role of inventory changes, and the impact of net investment on economic growth.  On the income side, nonincome charges—depreciation and indirect business taxes—are covered in detail because these usually give students the most trouble.

Other measures of economic activity are defined and discussed, with special emphasis on using price indexes.  The purpose and procedure of deflating and inflating nominal GDP are carefully explained and illustrated.  Finally, the shortcomings of current GDP measurement techniques are examined.  Global comparisons are made with respect to size of national GDP and size of the underground economy.

The Last Word looks at the sources of data for the GDP accounts.

INSTRUCTIONAL OBJECTIVES

After completing this chapter, students should be able to

State the purposes of national income accounting.

List the components of GDP in the output (expenditures) approach and in the income approach.

Compute GDP using either the expenditure or income approach when given national income data.

Differentiate between gross and net investment.

Explain why changes in inventories are investments.

Discuss the relationship between net investment and economic growth.

Compute NDP, NI, PI, and DI when given relevant data.

Describe the system represented by the circular flow in this chapter when given a copy of the diagram.

Calculate a GDP price index using simple hypothetical data.

Find real GDP by adjusting nominal GDP with use of a price index.

List seven shortcomings of GDP as an index of social welfare.

Explain what is meant by the underground economy and state its approximate size in the U.S. and how that compares to other nations.

Give an estimate of actual 2002 (or later) U.S. GDP in trillions of dollars and be able to rank the U.S. relative to a few other countries.

Define and identify terms and concepts listed at the end of the chapter.

STUDENT STUMBLING BLOCKS

1.There is a lot of memorization required to learn the various measures used in the national accounts.  In the interest of time, you might choose to have your students focus on the expenditures approach to calculating GDP.  It will prove to be the most useful in understanding the analysis in subsequent chapters which use C + I + G + Xn formulation frequently.

2. Special Problems:  Investment is a word that all of the students in the class think they understand.  The meaning of the term in ordinary conversation interferes with their ability to acquire a new definition and use that new definition consistently.

3. Changes in business inventory is an entry that represents the difference between what has been produced and what is sold.  Although this entry is very small compared to total GDP, it is one of the most important indicators of future business activity.  It has an important role in the income determination models presented later in the text.

4. Many of the exclusions from the GDP accounts involve financial transactions that transfer the ownership of existing assets.  The sale of stock in a corporation is a transfer of part ownership of existing assets.  New stock issues only dilute the share of ownership and are excluded as well.  The sale of corporate bonds also represents a purely financial transaction.  Corporations that are seeking to expand use the proceeds of these sales to purchase capital equipment or engage in new construction, and this is included in GDP.  To also include the purchase of the securities would be an example of double counting.  However, services are provided when these transactions are processed, the value of which should be included in GDP. 

5. Sales of secondhand goods are also excluded; however parts of the transactions may need to be counted.  The used car dealership that buys a car for $1000 and resells it for $3000 has created $2000 worth of output, even if the entire sum is profit to the entrepreneur.

6. Remind the students that entries beginning with the word net could be negative and have been in the case of net exports for many years in U.S.

LECTURE NOTES

I.          Assessing the Economy’s Performance

A.  National income accounting measures the economy’s performance by measuring the flows of income and expenditures over a period of time.

B.   National income accounts serve a purpose for the economy similar to income statements for business firms.

C.   Consistent definition of terms and measurement techniques allows us to use the national accounts in comparing conditions over time and across countries.

D.  The national income accounts provide a basis for appropriate public policies to improve economic performance.

 

 

II.        Gross Domestic Product

A.  GDP is the monetary measure of the total market value of all final goods and services produced within a country in one year.
1.   Money valuation allows the summing of apples and oranges; money acts as the common denominator.  (See Table 7.1.)

2.   GDP includes only final products and services; it avoids double or multiple counting by eliminating any intermediate goods used in production of these final goods or services.  (Table 7.2 illustrates how including sales of intermediate goods would overstate GDP.)

3.   GDP is the value of what has been produced in the economy over the year, not what was actually sold.

B.  GDP Excludes Nonproduction Transactions

1.   GDP is designed to measure what is produced or created over the current time period.  Existing assets or property that was sold or transferred, including used items, are not counted.

2.   Purely financial transactions are excluded.

a.   Public transfer payments, like social security or cash welfare benefits.

b.   Private transfer payments, like student allowances or alimony payments.

c.   The sale of stocks and bonds represent a transfer of existing assets.  (However, the brokers’ fees are included for services rendered.)

3.   Secondhand sales are excluded; they do not represent current output.  (However, any value added between purchase and resale is included, e.g., used car dealers.)

C. Two Ways to Look at GDP: Spending and Income.

1.   What is spent on a product is income to those who helped to produce and sell it.

2.   This is an important identity and the foundation of the national accounting process.

D.  Expenditures Approach (See Figure 7.1 and Table 7.3.)

1.   GDP is divided into the categories of buyers in the market; household consumers, businesses, government, and foreign buyers.

2.   Personal Consumption Expenditures—(C)—includes durable goods (goods lasting 3 years or more), nondurable goods, and services.

3.   Gross Private Domestic Investment—(Ig)

a.   All final purchases of machinery, equipment, and tools by businesses.

b.   All construction (including residential).

c.   Changes in business inventory.

i.  If total output exceeds current sales, inventories build up.

ii. If businesses are able to sell more than they currently produce, this entry will be a negative number.

d.   Net Private Domestic Investment—(In).

i.    Each year as current output is being produced, existing capital equipment is wearing out and buildings are deteriorating; this is called depreciation or consumption of fixed capital.

ii.   Gross Investment minus depreciation (consumption of fixed capital) is called net investment.

iii.  If more new structures and capital equipment are produced in a given year than are used up, the productive capacity of the economy will expand. (Figure 7.2)

iv.  When gross investment and depreciation are equal, a nation’s productive capacity is static.

v.   When gross investment is less than depreciation, an economy’s production capacity declines.

vi.  CONSIDER THIS … Stock Answers about Flows

4.   Government Purchases (of consumption goods and capital goods) – (G)

a.   Includes spending by all levels of government (federal, state, and local).

b.   Includes all direct purchases of resources (labor in particular).

c.   This entry excludes transfer payments since these outlays do not reflect current production.

5.   Net Exports— (Xn)

a.   All spending on final goods produced in the U.S. must be included in GDP, whether the purchase is made here or abroad.

b.   Often goods purchased and measured in the U.S. are produced elsewhere (Imports).

c.   Therefore, net exports, (Xn) is the difference:  (exports minus imports) and can be either a positive or negative number depending on which is the larger amount.

6.   Summary:  GDP = C + Ig + G + Xn

E. Income Approach to GDP (See Table 7.3): Demonstrates how the expenditures on final products are allocated to resource suppliers.

1. Compensation of employees includes wages, salaries, fringe benefits, salary and supplements, and payments made on behalf of workers like social security and other health and pension plans.

2. Rents: payments for supplying property resources (adjusted for depreciation it is net rent).

3. Interest: payments from private business to suppliers of money capital.

4.   Proprietors’ income:  income of incorporated businesses, sole proprietorships, partnerships, and cooperatives.

5.   Corporate profits:  After corporate income taxes are paid to government, dividends are distributed to the shareholders, and the remainder is left as undistributed corporate profits.

6.   The sum of the above entries equals national income:  all income earned by American-supplied resources, whether here or abroad.

7.   Adjustments required to balance both sides of the account:

a.   Indirect business taxes:  general sales taxes, excise taxes, business property taxes, license fees and customs duties (the seller treats these taxes as a cost of production).

b.   Depreciation/Consumption of Fixed Capital:  The firm also regards the decline of its capital stock as a cost of production.  The depreciation allowance is set aside to replace the machinery and equipment used up.  In addition to the depreciation of private capital, public capital (government buildings, port facilities, etc.), must be included in this entry.

c.   Net foreign factor income:  National income measures the income of Americans both here and abroad.  GDP measures the output of the geographical U.S. regardless of the nationality of the contributors.  To make this final adjustment, the income of foreign nationals must be added and American income earned abroad must be subtracted.  Sometimes this entry is a negative number. (Without this adjustment you have GNP.)

III.       Other National Accounts (see Table 7.4)

A.  Net domestic product (NDP) is equal to GDP minus depreciation allowance (consumption of fixed capital).

B.  National income (NI) is income earned by American‑owned resources here or abroad.  Adjust NDP by subtracting indirect business taxes and adding net American income earned abroad.  (Note:  This may be a negative number if foreigners earned more in U.S. than American resources earned abroad.)

C.  Personal income (PI) is income received by households.  To calculate, take NI minus payroll taxes (social security contributions), minus corporate profits taxes, minus undistributed corporate profits, and add transfer payments.

D.  Disposable income (DI) is “spendable” income -  personal income less personal taxes.

IV.       Circular Flow Revisited (see Figure 7.3)

A.  Compare to the simpler model presented in earlier chapters.  Now both government and foreign trade sectors are added.

B.   Note that the inside covers of the text contain a useful historical summary of national income accounts and related statistics.

V.         Nominal versus Real GDP

A.  Nominal GDP is the market value of all final goods and services produced in a year.
1.   GDP is a (P x Q) figure including every item produced in the economy.  Money is the common denominator that allows us to sum the total output.

2.   To measure changes in the quantity of output, we need a yardstick that stays the same size.  To make comparisons of length, a yard must remain 36 inches.  To make comparisons of real output, a dollar must keep the same purchasing power.

3.   Nominal GDP is calculated using the current prices prevailing when the output was produced, but real GDP is a figure that has been adjusted for price level changes.

B.  The adjustment process in a one-good economy (Table 7.5).  Valid comparisons cannot be made with nominal GDP alone, since both prices and quantities are subject to change.  Some method to separate the two effects must be devised.

1.   One method is to first determine a price index, (see Equation 1) and then adjust the nominal GDP figures by dividing by the price index (in hundredths) (see Equation 2).

2.   An alternative method is to gather separate data on the quantity of physical output and determine what it would sell for in the base year.  The result is Real GDP.  The price index is implied in the ratio:  Nominal GDP/Real GDP.  Multiply by 100 to put it in standard index form (see Equation 3).

C.   Real World Considerations and Data

1.   The actual GDP price index in the U.S. is called the chain-type annual-weights price index, and is more complex than can be illustrated here.

2.   Once nominal GDP and the GDP price index are established, the relationship between them and real GDP is clear (see Table 7.7).

3.   The base year price index is always 100, since Nominal GDP and Real GDP use the same prices.  Because the long-term trend has been for prices to rise, adjusting Nominal GDP to Real GDP involves inflating the lower prices before the base year and deflating the higher prices after the base year.

4.   Real GDP values allow more direct comparison of physical output from one year to the next, because a “constant dollar” measuring device has been used.  (The purchasing power of the dollar has been standardized at the base-year level.)

VI. Shortcomings of GDP

A. GDP doesn’t measure some very useful output because it is unpaid (homemakers’ services, parental child care, volunteer efforts, home improvement projects).

B. GDP doesn’t measure improvements in product quality or make allowances for increased leisure time.

C. GDP doesn’t measure improved living conditions as a result of more leisure.

D. GDP makes no value adjustments for changes in the composition of output or the distribution of income.

1. Nominal GDP simply adds the dollar value of what is produced; it makes no difference if the product is a semiautomatic rifle or a jar of baby food.

2. Per capita GDP may give some hint as to the relative standard of living in the economy; but GDP figures do not provide information about how the income is distributed.

E. The Underground Economy

1. Illegal activities are not counted in GDP (estimated to be around 8% of U.S. GDP).

2. Legal economic activity may also be part of the “underground,” usually in an effort to avoid taxation.

F. GDP and the environment

1. The harmful effects of pollution are not deducted from GDP (oil spills, increased incidence of cancer, destruction of habitat for wildlife, the loss of a clear unobstructed view).

2. GDP does include payments made for cleaning up oil spills and the cost of health care for cancer victims.

G. Noneconomic Sources of well-being like courtesy, crime reduction, etc., are not covered in GDP.

also see:

http://www.harpercollege.edu/mhealy/eco212/lectures/measecon/measecon.htm