# The Juice

### The Juice

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 1. State the purposes of national income accounting. 2. List the components of GDP in the output (expenditures) approach and in the income approach. 3. Compute GDP using either the expenditure or income approach when given national income data. 4. Differentiate between gross and net investment. . Explain why changes in inventories are investments. 6. Discuss the relationship between net investment and economic growth. 7. Compute NDP, NI, PI, and DI when given relevant data. 8. Describe the system represented by the circular flow in this chapter when given a copy of the diagram. 9. Calculate a GDP price index using simple hypothetical data. 10. Find real GDP by adjusting nominal GDP with use of a price index. 11. List seven shortcomings of GDP as an index of social welfare. 12. Explain what is meant by the underground economy and state its approximate size in the U.

S. and how that compares to other nations. 13. 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. 14. Define and identify terms and concepts listed at the end of the chapter. 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. . 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. . 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.

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 y 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. . 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. VII. LAST WORD: Feeding the GDP Accounts A. GDP is compiled by the Bureau of Economic Analysis (BEA) in the U. S. Commerce Department.

Where does it get its data? Explanation follows. B. Consumption data comes from 1. Census Bureau’s “Retain Trade Survey” from a sample of 22,000 firms. 2. Census Bureau’s “Survey of Manufacturers,” which gets information on consumer goods shipments from 50,000 firms. 3. Census Bureau’s “Service Survey” of 30,000 service businesses. 4. Industry trade sources like auto and aircraft sales. C. Investment data comes from 1. All the consumption sources listed above. 2. Census construction surveys. D. Government purchase data is obtained from 1. U. S.

Office of Personnel Management, which collects data on wages and benefits. 2. Census construction surveys of public projects. 3. Census Bureau’s “Survey of Government Finance. ” E. Net export information comes from 1. U. S. Customs Service data on exports and imports. 2. BEA surveys on service exports and imports. ANSWERS TO END-OF-CHAPTER QUESTIONS 7-1In what ways are national income statistics useful? National income accounting does for the economy as a whole what private accounting does for businesses. Firms measure income and expenditures to assess their economic health.

The national income accounting system measures the level of production in the economy at some particular time and helps explain the significance at that level. By comparing national accounts over a number of years, we can track the long-run course of the economy. Information supplied by national accounts provide a basis for designing and applying public policies to improve the performance of the economy. Without national accounts, economic policy would be guesswork. National income accounting allows us to assess the health of an economy and formulate policies to maintain and improve that health. -2Explain why an economy’s output is also its income? Everything that is produced is sold, even if the “selling,” in the case of inventory, is to the producing firm itself. Since the same amount of money paid out by the buyers of the economy’s output is received by the sellers as income (looking only at a private-sector economy at this point), “an economy’s output is also its income. ” 3. (Key Question) Why do national income accountants include only final goods in measuring GDP for a particular year? Why don’t they include the value of stocks and bonds sold?

Why don’t they include the value of used furniture bought and sold? The dollar value of final goods includes the dollar value of intermediate goods. If intermediate goods were counted, then multiple counting would occur. The value of steel (an intermediate good) used in autos is included in the price of the auto (a final product). This value is not included in GDP because such sales and purchases simply transfer the ownership of existing assets; such sales and purchases are not themselves (economic) investment and thus should not be counted as production of final goods and services.

Used furniture was produced in some previous year; it was counted as GDP then. Its resale does not measure new production. 7-4What is the difference between gross private domestic investment and net private domestic investment? If you were to determine net domestic product (NDP) through the expenditures approach, which of these two measures of investment spending would be appropriate? Explain. Gross private domestic investment less depreciation is net private domestic investment. Depreciation is the value of all the physical capital—machines, quipment, buildings—used up in producing the year’s output. Since net domestic product is gross domestic product less depreciation, in determining net domestic product through the expenditures approach it would be appropriate to use the net investment measure that excludes depreciation, that is, net private domestic investment. 7-5Why are changes in inventories included as part of investment spending? Suppose inventories declined by \$1 billion during 2003. How would this affect the size of gross private domestic investment and gross domestic product in 2003? Explain.

Anything produced by business that has not been sold during the accounting period is something in which business has invested—even if the “investment” is involuntary, as often is the case with inventories. But all inventories in the hands of business are expected eventually to be used by business—for instance, a pile of bricks for extending a factory building—or to be sold—for instance, a can of beans on the supermarket shelf. In the hands of business both the bricks and the beans are equally assets to the business, something in which the business has invested.

If inventories declined by \$1 billion in 2003, \$1 billion would be subtracted from both gross private domestic investment and gross domestic product. A decline in inventories indicates that goods produced in a previous year have been used up in this year’s production. If \$1 billion is not subtracted as stated, then \$1 billion of goods produced in a previous year would be counted as having been produced in 2003, leading to an overstatement of 2003’s production. 7-6Use the concepts of gross and net investment to distinguish between an economy that has a rising stock of capital and one that has a falling stock of capital. In 1933 net private domestic investment was minus \$6 billion. This means in that particular year the economy produced no capital goods at all. ” Do you agree? Why or why not? Explain: “Though net investment can be positive, negative, or zero, it is quite impossible for gross investment to be less than zero. ” When gross investment exceeds depreciation, net investment is positive and production capacity expands; the economy ends the year with more physical capital than it started with.

When gross investment equals depreciation, net investment is zero and production capacity is said to be static; the economy ends the year with the same amount of physical capital. When depreciation exceeds gross investment, net investment is negative and production capacity declines; the economy ends the year with less physical capital. The first statement in wrong. Just because net investment was a minus \$6 billion in 1933 does not mean the economy produced no new capital goods in that year. It simply means depreciation exceeded gross investment by \$6 billion.

So the economy ended the year with \$6 billion less capital. The second statement is correct. If only one \$20 spade is bought by a construction firm in the entire economy in a year and no other physical capital is bought, then gross investment is \$20—a positive amount. This is true even if net investment is highly negative because depreciation is well above \$20. If not even this \$20 spade has been bought, then gross investment would have been zero. But gross investment can never be less than zero. 7-7Define net exports.

Explain how the United States’ exports and imports each affect domestic production. Suppose foreigners spend \$7 billion on American exports in a given year and Americans spend \$5 billion on imports from abroad in the same year. What is the amount of America’s net exports? Explain how net exports might be a negative amount. Net exports are a country’s exports of goods and services less its imports of goods and services. The United States’ exports are as much a part of the nation’s production as are the expenditures of its own consumers on goods and services made in the United States.

Therefore, the United States’ exports must be counted as part of GDP. On the other hand, imports, being produced in foreign countries, are part of those countries’ GDPs. When Americans buy imports, these expenditures must be subtracted from the United States’ GDP, for these expenditures are not made on the United States’ production. If American exports are \$7 billion and imports are \$5 billion, then American net exports are +\$2 billion. If the figures are reversed, so that Americans export \$5 billion and import \$7 billion, then net exports are -\$2 billion—a negative amount.

Since oranges and computers have different values, the quantities of each commodity are multiplied by their values or prices. Adding together all the results of the price times quantity figures leads to the aggregate figure showing the total value of all the final goods and services produced in the economy. Thus, to return to oranges and computers, if the value of orange production increases by 100 percent from \$100 million to \$200 million, while that of computers increases 10 percent from \$2 billion to \$2. 2 billion, we can see that total production has increased from \$2. 1 billion (= \$100 million + \$2 billion) to \$2. 4 billion (= \$200 million + \$2. 2 billion).

This is an increase of 14. 29 percent [= (\$2. 4 billion – \$2. 1 billion)/\$2. 1 billion)]—and not the 55 percent incorrectly derived earlier. Comparing market values over time has the disadvantage that prices change. If the market value in year 2 is 10 percent greater than in year 1, we cannot say the economy’s production has increased 10 percent. It depends on what has been happening to prices; on whether the economy has been experiencing inflation or deflation. To resolve this problem, statisticians deflate (in the case of inflation) or inflate (in the case of deflation) the value figures for the total output so that only “real” changes in production are recorded.

To do this, each item is assigned a “weight” corresponding to its relative importance in the economy. Housing, for example, is given a high weight because of its importance in the average budget. A book of matches would be given a very low weight. Thus, the price of housing increasing by 5 percent has a much greater effect on the price index used to compare prices from one year to the next, than would the price of a book of matches increasing by 100 percent. 7-11(Key Question) Suppose that in 1984 the total output in a single-good economy was 7,000 buckets of chicken. Also suppose that in 1984 each bucket of chicken was priced at \$10. Finally, assume that in 1996 the price per bucket of chicken was \$16 and that 22,000 buckets were purchased.

Determine the GDP price index for 1984, using 1996 as the base year. By what percentage did the price level, as measured by this index, rise between 1984 and 1996? Use the two methods listed in Table 7-6 to determine real GDP for 1984 and 1996. X/100 = \$10/\$16 = . 625 or 62. 5 when put in percentage or index form (. 625 x 100) [pic] or 60%(Easily calculated [pic]) Method 1:1996 = (22,000 x \$16) ? 1. 0 = \$352,000 1984 = (7,000 x \$10) ? .625 = \$112,000 Method 2:1996 = 22,000 x \$16 = \$352,000 1984 = 7,000 x \$16 = \$112,000 12. (Key Question) The following table shows nominal GDP and an appropriate price index for a group of selected years. Compute real GDP.

Indicate in each calculation whether you are inflating or deflating the nominal GDP data. | | | | | | |Nominal GDP, |Price index |Real GDP, | |Year |Billions |(1996 = 100) |Billions | | | | | | | | | | | |1960 |\$527. 4 | |22. 9 | |\$ ______ | |1968 |911. 5 | |26. 29 | |\$ ______ | |1978 |2295. 9 | |48. 22 | |\$ ______ | |1988 |4742. 5 | |80. 22 | |\$ ______ | |1998 |8790. 2 | |103. 22 | |\$ ______ | | | | | | Values for real GDP, top to bottom of the column: \$2,376. 7 (inflating); \$3,467. (inflating); \$4,761. 3 (inflating); \$5,911. 9 (inflating); \$8,516 (deflating). 7-13Which 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. (a)Included. Income received by the bondholder for the services derived by the corporation for the loan of money. (b)Excluded. A transfer payment from taxpayers for which no service is rendered (in this year). (c)Excluded. Not a market transaction. If any payment is made, it will be within the family. (d)Included. Payment for a final service. You cannot pass on a tooth extraction! (e)Excluded.

Secondhand sales are not counted; the textbook is counted only when sold for the first time. (f)Excluded. A private transfer payment; simply a transfer of income from one private individual to another for which no transaction in the market occurs. (g)Included. Payment for the final service of housing. (h)Excluded. The production of the car had already been counted at the time of the initial sale. (i)Included. The income received by the bondholders is paid by the corporations for the current use of the “money capital” (the loan). (j)Excluded. The effect of the decline will be counted, but the change in the workweek itself is not the production of a final good or service or a payment for work done. (k) Excluded.

A noninvestment transaction; it is merely the transfer of ownership of financial assets. (If AT&T uses the money from the sale of a new bond to carry out an investment in real physical assets that will be counted. ) (l)Included. The increase in inventories could only occur as a result of increased production. (m)Excluded. Merely the transfer of ownership of existing financial assets. (n)Included. Insurance is a final service. If bought by a household, it will be shown as consumption; if bought by a business, as investment—as a cost added to its real investment in physical capital. 7-14(Last Word) What government agency compiles the U. S. NIPA tables? In what U. S. epartment is it located? Of the several specific sources of information, name one source for each of the four components of GDP: consumption, investment, government purchases, and net exports. The Bureau of Economic Analysis (BEA) in the Department of Commerce compiles GDP statistics. The Census Bureau provides survey data for consumption, investment, and government purchases. Consumption figures also come from industry trade sources as does some investment data. The U. S. Office of Personnel Management also provides data on government spending on services. Net export figures come from the U. S. Customs Service and BEA surveys on service exports and imports.