MBA 505 ECONOMICS AND PUBLIC POLICY
Chapter 21 MEASURING ECONOMIC ACTIVITY
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Key Words
| national income accounting |
net national product (NNP) |
price index |
| gross domestic product (GDP) |
gross investment |
base year |
| intermediate good |
net income |
chain-type real GDP |
| value added |
national income (NI) |
implicit GDP deflator |
| inventory |
personal income (PI) |
consumer price index (CPI) |
| capital consumption allowance |
transfer payment |
cost of living adjustment (COLA) |
| depreciation |
disposable personal income (DPI) |
producer price index (PPI) |
| indirect business tax |
nominal GDP |
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| gross national product (GNP) |
real GDP |
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| I. GROSS DOMESTIC PRODUCT (GDP)
A. GDP - the value of all the final goods and services
produced in the economy (in a year.) This counts final output geographically
produced in the U.S. by foreigners, but not output produced by U.S. citizens
abroad. [Gross National Product (GNP) counts everything produced
by U.S. citizens, wherever located, and does not count output produced
by foreigners working in the U.S.]
1. Final goods and services (or final output)
are those delivered to the ultimate user or consumer.
2. Intermediate goods and services (or intermediate
inputs) are used to produce final output, but are not counted
in GDP.
B. Nominal or current dollar GDP measures the
value of the nation's output using the current prices of the goods
and services.
C. Real or constant dollar GDP measures
the value of the nation's output using prices that prevailed in a previous
base period (e.g., 1988 or 1992). The government currently uses 1992 as
the base year, but this is changed from time to time. Changes in real
GDP indicate changes in the "size" of national output, i.e., in the
nation's production of goods and services.
D. Over time real GDP has trended higher, but this movement is
not constant from one year to the next.
1. Trend real GDP rises because of increases in population,
increases in the nation's capital stock, and advances in technology.
2. Rapid GDP growth allows the nation to increase consumption and also
enables it to spend more on health care, research, and environmental protection.
3. Rapid GDP growth also has costs: it depletes natural resources rapidly,
causes more severe environmental problems, and forces rapid changes in
people's jobs and consumption patterns.
E. Some economists believe that fluctuations in real GDP are quite
costly and so we should strive to eliminate them; others suggest that the
fluctuations are the result of natural change and smoothing them would
harm society by delaying the implementation of new technologies.
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| II. THE CIRCULAR FLOW OF EXPENDITURE AND INCOME (aka
The Circular Flow of Payments)
A. In the simplest model there are two economic agents, households
and firms, and three economic markets, the goods market, factor market,
and financial markets.
1. Households engage in three activities:
a. In the factor market households receive income from firms
from the sale of factors to firms. The most important factor most households
can sell is their labor services. If a household owns natural resources,
e.g., an oil well, it can also sell the oil. (Think of Jed Clampett's household.)
b. In the goods market firms make expenditures by purchasing
the goods and services firms produce. E.g., you buy shampoo from Proctor
& Gamble.
c. In the financial market households save some of their income
(hopefully).
2. Firms engage in five economic activities:
a. In the factor market they pay households for the use of
factors of production, i.e., labor services, natural resources, agricultural
output.
b. In the goods market firms make investment expenditures by
purchasing capital goods (e.g., Nantahaila Power buys a gas turbine,) and
changing their inventories (e.g., Proctor & Gamble produces a stock
of Head & Shoulders shampoo to cover anticipated future demand by households.)
c. In the goods market firms receive revenue from the sale of
their (consumption) products to households.
d. In the goods market firms receive revenue from the sale of
their (investment) goods to other firms. E.g., Allis-Chalmers
sell a gas turbine to the power company.
e. In the financial market firms borrow to finance their investment
expenditures, e.g., the power company issues corporate bonds to pay for
the gas turbine, or gets a bank loan.
B. Aggregate income is the total amount of income received
by households in exchange for the use of the factors of production. This
includes wages paid to workers as well as profits paid to firms' owners.
(Remember, all firms are owned by households, either as proprietors or
stockholders.
C. Consumption expenditure is the total amount spent by
households on goods and services.
D. Investment is the purchase of new plants, equipment,
buildings, and additions to inventories.
E. All funds received by firms for the sale of their output (aggregate
expenditure = consumption expenditure + investment expenditure)
must be paid to the factors of production (aggregate income).
Thus aggregate expenditure = aggregate income.
F. Gross Domestic Product (GDP) is the value of all final
goods and services produced in the economy over a given time period. U.S.
GDP is measured quarterly.
1. GDP = consumption expenditure C + investment expenditure I.
2. GDP = C + I = aggregate expenditure = aggregate income. GDP
is often referred to as "national income," and it is currently
the most commonly used measure of national income. Alternative measures
include Gross National Product (GNP) and Net Value Added (NVA).
G. A More Realistic Model - Adding the government and the
rest of the world to the circular flow makes the model more realistic (also
more complicated).
H. The government undertakes three economic activities:
1. In the goods market, the government buys goods and services
produced by firms, e.g., the Town of Sylva buys new police cars, or the
Navy buys a new destroyer from Newport News.
2. The government receives tax revenue from households and firms,
and makes transfer payments of income to households and firms. Transfer
payments include Aid to Families with Dependent Children and Small Business
Administration Opportunity Grants.
3. In the financial market the government borrows to help finance
its spending, generally by issuing treasury bills and bonds.
I. The rest of the world interacts in two markets:
1. In the goods market, foreigners buy goods and services from
domestic firms (U.S. exports to other countries) and sell
foreign produced goods and services to U.S. households, firms, and the
government (imports from other countries).
2. In the financial market, foreigners lend to or borrow from
domestic households, firms, or governments.
J. Net taxes equal the difference between taxes paid to the
government and transfer payments received from the government.
1. Transfer payments are funds given to firms
or households.
2. Transfer payments are not given in exchange for a good or
a service, and so are not a part of the government's expenditure on goods
and services. "Government spending" is different from transfer
payments.
K. Net exports equal the value of exports to the rest of
the world minus the value of imports from the rest of the world. NX
= EX - IM.
L. Just as before, aggregate expenditure = aggregate income =
GDP.
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| III. GDP, CONSUMPTION EXPENDITURE, SAVING, AND TAXES
A. Aggregate income, Y, minus net taxes, T, equals disposable
income. Disposable income can be either spent on consumption or
saved. Thus, Y = GDP = C + S + T.
B. Aggregate expenditure, Y, is comprised of consumption expenditure,
C, investment expenditure, I, government purchases of goods and services,
G, and net exports, X. Thus, Y = GDP = C + I + G + X. [X
= EX - IM, and can be negative.]
C. Equating the expression for aggregate income with aggregate expenditure
gives I + G + EX = S + T + IM, where net exports X = EX -
IM. I, G, EX are injections (of money) into the circular flow; S,
T, and IM are leakages.
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| IV. U.S. NATIONAL INCOME AND PRODUCT ACCOUNTS (NIPA)
A. GDP can be measured three ways: the expenditure approach,
the factor income approach, and the output approach.
B. The expenditure approach measures GDP by collecting
data on and then summing consumption expenditure, investment, government
purchases of goods and services, and net exports. These expenditures are
valued using the prices paid for the goods and services and is called the
GDP
at market prices.
1. Personal consumption expenditures is households'
expenditures on the goods and services they use for their consumption.
This is the largest component of aggregate expenditures.
2. Gross private domestic investment is firms' expenditure
on capital equipment, additions to their inventories, and households' purchases
of new homes.
a. Inventories are the stocks of raw materials,
semifinished
products, and unsold final products owned by firms.
b. The capital stock is the total amount of plant,
equipment,
buildings,
and inventories.
3. Government purchases of goods and services (government spending)
are the expenditures on goods and services by all levels of government.
This does not include transfer payments.
C. The factor income approach starts to measure GDP by adding
all the incomes paid to households by firms for the use of factors of production.
The standard national income accounts divide factor income into five categories:
1. Compensation of employees is wages and salaries.
2. Rental income includes payments for all rented inputs,
(typically rented capital equipment and buildings in which production takes
place.)
3. Corporate profits are the total profits earned by corporations
regardless of whether the profits are paid to households (stockholders)
or retained by the business (in the form of capital improvements.)
4. Net interest equals all interest received by households
minus all interest paid by them. (This can be negative for individual households.)
5. Proprietors' income includes all income received by
owners of owner-operated businesses.
D. Summing the five factor income components gives net domestic income
at factor cost. This values the output at factor cost
rather than market price. Hence two adjustments must be made to
net
domestic income at factor cost to give an estimate of GDP: indirect
taxes must be added and government subsidies subtracted; and depreciation
of the capital stock must be added.
1. An indirect tax is a tax paid by consumers when they
purchase a good; a subsidy, is a payment made by the government
to producers. Taxes raise the market price of consumption and investment
goods relative to the factor cost; subsidies lower it.
a. Adding indirect taxes minus subsidies to net domestic income gives
net
domestic product at market prices.
2. Depreciation, the decrease in the value of the capital
stock resulting from its use (or non-use,) is an expense that contributes
to the product's market price but is not paid to any factor owner. Therefore
depreciation must be added to net domestic income at factor cost to estimate
GDP.
a. Gross investment is the total amount spent on investment;
net
investment is gross investment minus depreciation. Net investment
represents new additions to the nation's capital stock.
E. The Output approach measures the value of all final output
produced in the U.S. This includes both consumption goods and investment
goods, but not intermediate inputs which are processed further to produce
final output. E.g., if wood is processed into furniture, only the final
output (the furniture) is measured in GDP.
1. Value added equals the value of a firm's output less
the value of the intermediate goods used by the firm. In valuing output,
only value added is counted; that is, intermediate goods are excluded.
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F. Gross national product (GNP), is the value
of output produced by citizens of the country; gross domestic
product (GDP), is the value of output produced in the country.
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| V. THE PRICE LEVEL AND INFLATION
A. The price level is the "average" level of prices,
and is measured using a price index.
B. The consumer price index (CPI) measures the average
level of the prices of goods and services consumed by an urban family.
1. The CPI is calculated by taking the ratio of the current cost of
a market basket of goods to the cost of the same market basket in a base
year (1982, 1988) and multiplying by 100.
C. The CPI may mismeasure the true cost of living for three reasons: substitution
effects, arrival of new goods, and quality changes.
1. The market basket used in the CPI is fixed and does not take account
of consumers' substitution away from goods whose relative price increases.
2. New goods that were not available in the base year are not included
in the CPI, while goods that "disappear" continue to influence it.
3. Quality improvements in products are ignored by the CPI.
D. The GDP deflator measures the average level of prices
of the goods and services included in GDP.
1. Nominal GDP is GDP where the goods and services are
valued using current year prices. Nominal GDP can be deflated
using the GDP deflator to calculate real GDP.
2. Real GDP values the goods and services at base year
prices and hence changes in real GDP better reveal changes in the production
of goods and services over time.
E. A relative price is the ratio of the price of one product
to another good. Inflation is not caused by relative price changes.
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Example: Chain and constant-dollar GDP Growth Rates
| Year 1 |
Quantity |
Price |
Nominal Expenditures |
| Good A |
200 |
$1 |
$200 |
| Good B |
300 |
$2 |
$600 |
| Total Nominal Expenditures in year
1 |
$800 |
| Year 2 |
| Good A |
100 |
$4 |
$400 |
| Good B |
400 |
$3 |
$1200 |
| Total Nominal Expenditures in year
2 |
$1600 |
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| Constant Dollar Real GDP Growth Rate using
Year 1 as the base year:
(Year 2 expends at year 1 prices)/(Year 1 expends at year 1 prices)
- 1 =
[(100 x $1) + (400 x $2)]/[(200 x $1) + (300 x $2)] - 1
= 900/800 - 1 = 1.125 - 1 = 0.125 = 12.5%
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| Constant Dollar Real GDP Growth Rate using
Year 2 as the base year:
(Year 2 expends at year 2 prices)/(Year 1 expends at year 2 prices)
- 1 =
[(100 x $4) + (400 x $3)]/[(200 x $4) + (300 x $3)] - 1
= 1600/1700 - 1 = 0.941 - 1 = -0.059 = -5.9%
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| Chained Real GDP Growth Rate:
Square root of (expenditures ratio with base year 1 x expenditures ratio
with base year 2) - 1 =
(1.125 x 0.941)1/2 - 1 = (1.059)1/2 -1 = 1.029
- 1 = 0.029 = 2.9% |
