Chapter 5 â Measuring a Nation's Income
Chapter 5 – Measuring a Nation’s Income •
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In some years, firms throughout the economy are expanding their production of goods and services, employment is rising o In other years, firms are cutting back on production, employment is declining The condition of the overall economy profoundly affects all of us, therefore changes in economic conditions are widely reported by the media The statistic might measure: o The total income of everyone on the economy (GDP) o The rate at which average prices are rising (inflation) o The percentage of the labor force that is out of work (unemployment) o Total spending at stores (retail sales) o The imbalance of trade between Canada and the rest of the world (the trade deficit) o All of these statistics are macroeconomic – rather than telling us about a particular household or firm, they tell us something about the entire economy Economics is divided into two branches: microeconomics and macroeconomics Microeconomics is the study of how individual households and firms make decisions and how they interact with one another in markets Microeconomics is the study of the economy as a whole o The study of economywide phenomena, including inflation, unemployment, and economic growth o Why is average income high in some countries while it is low in others? o Why do price rise rapidly in some periods of time while they are more stable in other periods? o Why do production and employment expand in some years and contract in others? o What can the government do to promote rapid growth in incomes, low inflation, and stable employment? This chapter considers gross domestic product, or simply GDP, which measures the total income of a nation o Best single measure of a society’s economic wellbeing
The Economy’s Income and Expenditure • When judging whether the economy is doing well or poorly, it is natural to look at the total income that everyone in the economy is earning – that is the task of gross domestic product • GDP measures two things at once: o The total income of everyone in the economy o The total expenditure on the economy’s output of goods and services o These two things are really the same o For an economy as a whole, income must equal expenditure
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An economy’s income is the same as its expenditure because every transaction has two parties: a buyer and a seller Another way to see the equality of income and expenditure is with the circular flow diagram o The diagram describes all the transactions between households and firms in a simple economy o Households buy goods and services from firms; these expenditures flow through the markets for goods and services o Firms in turn use the money they receive from sales to pay worker’s wages, landowners’ rent, and firm owners’ profit; this income flow through the markets for the factors of production We can compute GDP for this economy in one of two ways: by adding up the total expenditure by households or by adding up the total income (wages, rent, and profit) paid by firms Actual economy is more complicated: o Households do not spend all of their income – some is paid to government in taxes, and they save some for use in the future o They don’t buy all the goods and services produced in the economy – some goods and services are bought by governments, and some are bought by firms that plan to use them in the future to produce their own output
The Measurement of Gross Domestic Product • Gross domestic product (GDP) is the market value of all final goods and services produced within a country in a given period of time “GDP is the market value …” • GDP adds together many different kinds of products into a single measure of the value of economic activity o It uses market prices o Because market prices measure the amount of people are willing to pay for different goods, they reflect the value of those goods “… Of all …” • GDP tries to be comprehensive • It includes all items produced in the economy and sold legally in markets • GDP also includes the market value of the housing services provided by the economy’s stock of housing o If the individual owns the place where they live, they do not pay rent o GDP is based on the assumption that the owner, in effect, pays rent to himself, so the rent is included both in his expenditure and in his income • GDP excludes most items produces and sold illicitly, such as illegal drugs • It also excludes most items that are produced and consumed at home and, therefore, never enter the marketplace o Exclusions sometimes lead to paradoxical results “… Final …” • There are intermediate goods, and there are final goods
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GDP includes only the value of final goods o The reason is that the value of intermediate goods is already included in the prices of the final goods • An important exception arises when an intermediate good is produced and, rather than being used, is added to a firm’s inventory of goods to be used or sold at a later date o In this case, the intermediate good is taken to be “final” for the moment, and its value as inventory investment is added to GDP o When the inventory of the intermediate good is later used or sold, the firm’s inventory investment is negative, and GDP for the later period is reduced accordingly “… Goods and Services …” • Both tangible goods and intangible services “… Produced …” • Goods and services currently produced • New car vs. Used car “… Within a Country …” • Measures the value of production within the geographic confines of a country • Items are included in a nation’s GDP if they are produced domestically, regardless of the nationality of the producer “… In a Given Period of Time …” • Within a specific interval of time o Usually that interval is a year or a quarter (three months) o When the government reports the GDP for a quarter, it usually presents GDP “at an annual rate” o Government uses this convention so that quarterly and annual figures on GDP can be compared more easily • When the government reports quarterly GDP, it presents the data after they have been modified by a statistical procedure called seasonal adjustment • The unadjusted data show clearly that the economy produces more goods and services during some times of year than others – December for example The Components of GDP • GDP (which we denote as Y) is divided into four components: consumption (C), investment (I), government purchases (G), and net exports (NX): • Y = C + I + G + NX • This equation is an identity – an equation that must be true by the way the variables in the equation are defines Consumption • Consumption is spending by households on goods and services, with the exception of purchases of new housing Investment • Investment is the purchase of goods that will be used in the future to produce more goods and services
o It is the sum of purchases of capital equipment, inventories, and structures o Investment in structures includes expenditure on new housing • The treatment of inventory accumulation is noteworthy o Inventories are treated this way becomes one aim of GDP is to measure the value of the economy’s production, and goods added to inventory are part of that period’s production • When you hear the word investment, you might think of financial investments, such as stocks, bonds, and mutual funds – topics that we study later in the book • By contrast, because GDP measures expenditures on goods and services, here the word investment means purchases of goods used to produce other goods Government Purchases • Government purchases include spending on goods and services by local, territorial, provincial, and federal governments o It includes the salaries of government workers and spending on public works • Transfer payment – it is not made in exchange for a currently produced good or service o These alter household income, but they do not reflect the economy’s production o Not counted as part of government purchases Net Exports • Net exports equal the purchases of domestically produced goods by foreigners (exports) minus the domestic purchases of foreign goods (imports) • Net exports include goods and services produced abroad because these goods and services are included in consumption, investment, and government purchases Case Study – The Components of Canadian GDP • The annual GDP of Canada was about 1600 billion dollars in 2008 • If we divide this number by the 2008 Canadian population of approx. 33.3 million, we find that GDP per person – the amount of expenditure for the average Canadian – was about $48 009 in that year • Look at Tables 5.1 and 5.2 Real Versus Nominal GDP • If total spending rises from one year to the next, one of two things must be true: o (1) The economy is producing a larger output of goods and services o (2) Goods and services are being sold at higher prices • In particular, they want a measure of the total quantity of goods and services the economy is producing that is not affected by changes in the prices of those goods and services o To do this, economists use a measure called real GDP: What would be the value of the goods and services produced this year if we valued these goods and services at the prices that prevailed in some specific year in the past
A Numerical Example • Nominal GDP – the production of goods and services valued at current prices • Real GDP – the production of goods and services valued at constant prices o We calculate real GDP by first choosing one year as a base year o We then use the prices of hot dogs and hamburgers in the base year to compute the value of goods and services in the base year to compute the value of goods and services in all of the years o For the base year, real GDP always equals nominal GDP • Nominal GDP uses current prices to place a value on the economy’s production of goods and services • Real GDP uses constant base year prices to place a value on the economy’s production of goods and service o Real GDP is not affected by changes in prices, changes in real GDP reflect only changes in the amounts being produced • Real GDP is a better gauge of economic wellbeing than is normal GDP The GDP Deflator • Reflects the prices of goods and services but not the quantities • GDP deflator – a measure of the price level calculated as the ratio of nominal GDP to real GDP times 100 • The GDP deflator for the base year always equals 100 • For subsequent years, it measures the change in nominal GDP from the base year that cannot be attributable to a change in real GDP • Economists use the term inflation to describe a situation in which the economy’s overall price level is rising o The inflation rate is the percentage change in some measure of the price level from one period to the next o (GDP deflator in year 2 – GDP deflator in year 1 / GDP deflator in year 1) X 100 Case Study – Real GDP Over Recent History • The output of goods and services produced in Canada has grown on average about 3 percent per year since 1970 • Growth is not steady o The upward climb of real GDP is occasionally interrupted by periods during which GDP declines, called recessions o Recessions are associated not only with lower incomes but also with other forms of economic distress: rising unemployment, falling profits, increased bankruptcies, and so on Case Study – Measuring Economic WellBeing In Canada • GDP as just one of a long list of indicators of wellbeing
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Measures of poverty, human capital, income inequality, natural resource consumption, environmental degradation Figure 5.3 o A higher value for the index indicates that the average person in that jurisdiction enjoyed a higher level of well being o Over this period, the economic well being of Canadians increased and this is true regardless of province of residence
Case Study – GDP, GNP, And Foreign Ownership • GNP measures the value of all income earned by Canadians, regardless of whether the income is earned in Canada or in foreign countries • GDP measures the value of all income earned in Canada, regardless of nationality • If we calculate GDP minus GNP, we obtain a measure of the difference between the value of output produced by foreigners in Canada and the value of output produced by Canadians in foreign countries o This grows as foreigners purchase more of Canada’s productive capacity and as Canadians purchase less of the productivity capacity of other countries • The Foreign Investment Review Act (FIRA), passed in 1974, was designed to monitor and regulate the purchase of Canada’s productive capacity by foreigners – the act was repealed in 1985 • The height of bars indicate the size of the difference between GDP and GNP as upwardsloping lines • The gap between GDP and GNP reflects in part the relative attractiveness of Canada as a place to produce goods and services GDP and Economic WellBeing • GDP per person tells us the income an expenditure of the average person in the economy • GDP does not the health of our children, but nations with larger GDP can afford better health care for their children • GDP does not measure the quality of their education, but nations with larger GDP can afford better educational systems • Etc. • Some things that contribute to a good life are left out of GDP such as leisure • Because GDP uses market prices to value goods and services, it excludes the value of almost all activity that takes place outside of markets • Another thing that GDP excludes is the quality of the environment • GDP also says nothing about the distribution of income o GDP per person tells us what happens to the average person, but behind the average lies a large variety of personal experiences Case Study – International Differences in GDP and the Quality of Life
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Table 5.4 shows Canada and 12 of the world’s most populous countries ranked in order of GDP per person o Also shows life expectancy and literacy These data show a clear pattern o In rich countries, people can expect to live into their eighties, and almost all of the population can read Countries with low GDP per person tend to have more infants with low birth weight, higher rates of infant mortality, higher rates of maternal mortality, malnutrition, and less common access to safe drinking water
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In some years, firms throughout the economy are expanding their production of goods and services, employment is rising o In other years, firms are cutting back on production, employment is declining The condition of the overall economy profoundly affects all of us, therefore changes in economic conditions are widely reported by the media The statistic might measure: o The total income of everyone on the economy (GDP) o The rate at which average prices are rising (inflation) o The percentage of the labor force that is out of work (unemployment) o Total spending at stores (retail sales) o The imbalance of trade between Canada and the rest of the world (the trade deficit) o All of these statistics are macroeconomic – rather than telling us about a particular household or firm, they tell us something about the entire economy Economics is divided into two branches: microeconomics and macroeconomics Microeconomics is the study of how individual households and firms make decisions and how they interact with one another in markets Microeconomics is the study of the economy as a whole o The study of economywide phenomena, including inflation, unemployment, and economic growth o Why is average income high in some countries while it is low in others? o Why do price rise rapidly in some periods of time while they are more stable in other periods? o Why do production and employment expand in some years and contract in others? o What can the government do to promote rapid growth in incomes, low inflation, and stable employment? This chapter considers gross domestic product, or simply GDP, which measures the total income of a nation o Best single measure of a society’s economic wellbeing
The Economy’s Income and Expenditure • When judging whether the economy is doing well or poorly, it is natural to look at the total income that everyone in the economy is earning – that is the task of gross domestic product • GDP measures two things at once: o The total income of everyone in the economy o The total expenditure on the economy’s output of goods and services o These two things are really the same o For an economy as a whole, income must equal expenditure
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An economy’s income is the same as its expenditure because every transaction has two parties: a buyer and a seller Another way to see the equality of income and expenditure is with the circular flow diagram o The diagram describes all the transactions between households and firms in a simple economy o Households buy goods and services from firms; these expenditures flow through the markets for goods and services o Firms in turn use the money they receive from sales to pay worker’s wages, landowners’ rent, and firm owners’ profit; this income flow through the markets for the factors of production We can compute GDP for this economy in one of two ways: by adding up the total expenditure by households or by adding up the total income (wages, rent, and profit) paid by firms Actual economy is more complicated: o Households do not spend all of their income – some is paid to government in taxes, and they save some for use in the future o They don’t buy all the goods and services produced in the economy – some goods and services are bought by governments, and some are bought by firms that plan to use them in the future to produce their own output
The Measurement of Gross Domestic Product • Gross domestic product (GDP) is the market value of all final goods and services produced within a country in a given period of time “GDP is the market value …” • GDP adds together many different kinds of products into a single measure of the value of economic activity o It uses market prices o Because market prices measure the amount of people are willing to pay for different goods, they reflect the value of those goods “… Of all …” • GDP tries to be comprehensive • It includes all items produced in the economy and sold legally in markets • GDP also includes the market value of the housing services provided by the economy’s stock of housing o If the individual owns the place where they live, they do not pay rent o GDP is based on the assumption that the owner, in effect, pays rent to himself, so the rent is included both in his expenditure and in his income • GDP excludes most items produces and sold illicitly, such as illegal drugs • It also excludes most items that are produced and consumed at home and, therefore, never enter the marketplace o Exclusions sometimes lead to paradoxical results “… Final …” • There are intermediate goods, and there are final goods
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GDP includes only the value of final goods o The reason is that the value of intermediate goods is already included in the prices of the final goods • An important exception arises when an intermediate good is produced and, rather than being used, is added to a firm’s inventory of goods to be used or sold at a later date o In this case, the intermediate good is taken to be “final” for the moment, and its value as inventory investment is added to GDP o When the inventory of the intermediate good is later used or sold, the firm’s inventory investment is negative, and GDP for the later period is reduced accordingly “… Goods and Services …” • Both tangible goods and intangible services “… Produced …” • Goods and services currently produced • New car vs. Used car “… Within a Country …” • Measures the value of production within the geographic confines of a country • Items are included in a nation’s GDP if they are produced domestically, regardless of the nationality of the producer “… In a Given Period of Time …” • Within a specific interval of time o Usually that interval is a year or a quarter (three months) o When the government reports the GDP for a quarter, it usually presents GDP “at an annual rate” o Government uses this convention so that quarterly and annual figures on GDP can be compared more easily • When the government reports quarterly GDP, it presents the data after they have been modified by a statistical procedure called seasonal adjustment • The unadjusted data show clearly that the economy produces more goods and services during some times of year than others – December for example The Components of GDP • GDP (which we denote as Y) is divided into four components: consumption (C), investment (I), government purchases (G), and net exports (NX): • Y = C + I + G + NX • This equation is an identity – an equation that must be true by the way the variables in the equation are defines Consumption • Consumption is spending by households on goods and services, with the exception of purchases of new housing Investment • Investment is the purchase of goods that will be used in the future to produce more goods and services
o It is the sum of purchases of capital equipment, inventories, and structures o Investment in structures includes expenditure on new housing • The treatment of inventory accumulation is noteworthy o Inventories are treated this way becomes one aim of GDP is to measure the value of the economy’s production, and goods added to inventory are part of that period’s production • When you hear the word investment, you might think of financial investments, such as stocks, bonds, and mutual funds – topics that we study later in the book • By contrast, because GDP measures expenditures on goods and services, here the word investment means purchases of goods used to produce other goods Government Purchases • Government purchases include spending on goods and services by local, territorial, provincial, and federal governments o It includes the salaries of government workers and spending on public works • Transfer payment – it is not made in exchange for a currently produced good or service o These alter household income, but they do not reflect the economy’s production o Not counted as part of government purchases Net Exports • Net exports equal the purchases of domestically produced goods by foreigners (exports) minus the domestic purchases of foreign goods (imports) • Net exports include goods and services produced abroad because these goods and services are included in consumption, investment, and government purchases Case Study – The Components of Canadian GDP • The annual GDP of Canada was about 1600 billion dollars in 2008 • If we divide this number by the 2008 Canadian population of approx. 33.3 million, we find that GDP per person – the amount of expenditure for the average Canadian – was about $48 009 in that year • Look at Tables 5.1 and 5.2 Real Versus Nominal GDP • If total spending rises from one year to the next, one of two things must be true: o (1) The economy is producing a larger output of goods and services o (2) Goods and services are being sold at higher prices • In particular, they want a measure of the total quantity of goods and services the economy is producing that is not affected by changes in the prices of those goods and services o To do this, economists use a measure called real GDP: What would be the value of the goods and services produced this year if we valued these goods and services at the prices that prevailed in some specific year in the past
A Numerical Example • Nominal GDP – the production of goods and services valued at current prices • Real GDP – the production of goods and services valued at constant prices o We calculate real GDP by first choosing one year as a base year o We then use the prices of hot dogs and hamburgers in the base year to compute the value of goods and services in the base year to compute the value of goods and services in all of the years o For the base year, real GDP always equals nominal GDP • Nominal GDP uses current prices to place a value on the economy’s production of goods and services • Real GDP uses constant base year prices to place a value on the economy’s production of goods and service o Real GDP is not affected by changes in prices, changes in real GDP reflect only changes in the amounts being produced • Real GDP is a better gauge of economic wellbeing than is normal GDP The GDP Deflator • Reflects the prices of goods and services but not the quantities • GDP deflator – a measure of the price level calculated as the ratio of nominal GDP to real GDP times 100 • The GDP deflator for the base year always equals 100 • For subsequent years, it measures the change in nominal GDP from the base year that cannot be attributable to a change in real GDP • Economists use the term inflation to describe a situation in which the economy’s overall price level is rising o The inflation rate is the percentage change in some measure of the price level from one period to the next o (GDP deflator in year 2 – GDP deflator in year 1 / GDP deflator in year 1) X 100 Case Study – Real GDP Over Recent History • The output of goods and services produced in Canada has grown on average about 3 percent per year since 1970 • Growth is not steady o The upward climb of real GDP is occasionally interrupted by periods during which GDP declines, called recessions o Recessions are associated not only with lower incomes but also with other forms of economic distress: rising unemployment, falling profits, increased bankruptcies, and so on Case Study – Measuring Economic WellBeing In Canada • GDP as just one of a long list of indicators of wellbeing
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Measures of poverty, human capital, income inequality, natural resource consumption, environmental degradation Figure 5.3 o A higher value for the index indicates that the average person in that jurisdiction enjoyed a higher level of well being o Over this period, the economic well being of Canadians increased and this is true regardless of province of residence
Case Study – GDP, GNP, And Foreign Ownership • GNP measures the value of all income earned by Canadians, regardless of whether the income is earned in Canada or in foreign countries • GDP measures the value of all income earned in Canada, regardless of nationality • If we calculate GDP minus GNP, we obtain a measure of the difference between the value of output produced by foreigners in Canada and the value of output produced by Canadians in foreign countries o This grows as foreigners purchase more of Canada’s productive capacity and as Canadians purchase less of the productivity capacity of other countries • The Foreign Investment Review Act (FIRA), passed in 1974, was designed to monitor and regulate the purchase of Canada’s productive capacity by foreigners – the act was repealed in 1985 • The height of bars indicate the size of the difference between GDP and GNP as upwardsloping lines • The gap between GDP and GNP reflects in part the relative attractiveness of Canada as a place to produce goods and services GDP and Economic WellBeing • GDP per person tells us the income an expenditure of the average person in the economy • GDP does not the health of our children, but nations with larger GDP can afford better health care for their children • GDP does not measure the quality of their education, but nations with larger GDP can afford better educational systems • Etc. • Some things that contribute to a good life are left out of GDP such as leisure • Because GDP uses market prices to value goods and services, it excludes the value of almost all activity that takes place outside of markets • Another thing that GDP excludes is the quality of the environment • GDP also says nothing about the distribution of income o GDP per person tells us what happens to the average person, but behind the average lies a large variety of personal experiences Case Study – International Differences in GDP and the Quality of Life
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Table 5.4 shows Canada and 12 of the world’s most populous countries ranked in order of GDP per person o Also shows life expectancy and literacy These data show a clear pattern o In rich countries, people can expect to live into their eighties, and almost all of the population can read Countries with low GDP per person tend to have more infants with low birth weight, higher rates of infant mortality, higher rates of maternal mortality, malnutrition, and less common access to safe drinking water
