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Production Income and Gross Domestic Product


									Macroeconomics tries to understand the economy to achieve three basic goals

1) Rapid Economic Growth
Economic growth is the ability of an economy to produce increasing quantities of goods and
2) High Employment
High employment is important, both because it helps us achieve our full productive potential,
and because it affects the distribution of economic well-being among our citizens.
3) Stable Prices (or low inflation rates)
Inflation rate is the percenage increase in a price level from one period (usally measured
annually) to the next.

Low inflation rates are important because coping with inflation uses up resources that could
otherwise be used to produce goods and services.

Inflation imposes costs on society and keeping the rate of inflation low helps to reduce these

The Macroeconomic Approach

Aggregation is the process of combining different things into a single category

The next two chapters examine three of the most important economic aggregates: output (chapter
7), employment (chapter 8), and the price level (chapter 8).

First though we will introduce the Business cycle and call our measure of aggreate output Gross
Domestic Product (GDP), which we will defined later.

                             1999Q1 - 2002Q4 Real GDP

                           Business cycles and economic fluctuations



                    Expansion          Recession    Expansion


The Business Cycle

   An Expansion is a period of increasing real GDP
   A Peak is the point at which real GDP reaches its highest level during an expansion.
   A Trough is the point at which real GDP reaches its lowest level during a recession.
   A Recession is the period of a business cycle during which total production and total
    employment are decreasing.

A recession is generally considered to be a period when real GDP falls for 6 or more consecutive
months. (This is only a ―rule of thumb‖)

A recession is also considered to exist during periods of abnormally low real GDP that are
considered to be significant in terms of depth, breadth, and duration.

For the U.S. the determination of an ―official‖ recession is made by the National Bureau of
Economic Research.

Depression is a severe recession

                                   Other terms associated with
                                       the business cycle

A Countercyclical variable is a variable that falls when real GDP rises. An example is

A Pro-cyclical variable is a variable that rises when real GDP rises. Examples are investment
spending and employment.

                 Chapter 7: GDP: Measuring Total Production and Income

Using the production possibility frontier we were able to conceptually answer questions of how
much an economy could produce.

But we need to move beyond the abstract to find a variable that we can use to measure the value
of actual output aggregated over the economy.

       How might this be useful to you in your personal life?

                     Production, Income, and the Circular Flow Diagram

    Gross Domestic Product (GDP) is the total market value of final goods and services
    produced within an economy in a given year.

       Calculation: Sum of all final goods and services produced in a given year multiplied by
        their respective prices

    For example suppose the economy produced the following with the listed prices-

                                  desks               apples              coats
            Price                 $ 100                 $1                 $50
            Qty                     10                 1000                 50

    GDP = $4500

                                 About the definition of GDP

Only final goods are used to eliminate double counting of intermediate goods

For example suppose we are trying to calculate the value of products sold and we have a loaf of
bread to count. Look at the below costs and price data for the loaf of bread that is made with
flour (we will assume no other ingredients).

             Goods bought                 Product Produced             Sold for
Farmer -----------                Wheat (1b)                           $.20
Miller 1b wheat                   Flour 1lbs                           $.50
Baker 1lbs flour                  bread                                $.90
Kroger bread                      service                              $1.10

What should be counted in GDP?
       Intermediate goods are goods used up in producing final goods.
       Final goods are goods sold to its final user.

   A good must be produced and not just represent a claim on ownership, such as stocks and
   Only goods and services produced for the market place are included.
   A time period is specified—in a given year. Thus, GDP is a flow variable
   GDP measures only final goods and services produced within a nation’s borders

           The expenditure Approach to Calculate Gross Domestic Product (GDP)

                                 GDP = C + I + G + (X – M)

Personal Consumption ( C ):

Purchases buy households of:
Durable goods: goods that lasts for long period of time. However, it does not include new
Non-durable goods: goods that lasts for short periods of time

Gross Private Domestic Investment (I)
Purchases by business of
 On new plants and equipment
 Newly produced housing (Spending by consumers on new houses)
 Inventory investment

Note: Depreciation is the wear and tear of capital as it is used in production

 Gross investment = net investment +

 Government Consumption Expenditures
 Government Gross Investment
Government purchases do not include transfer payments.
Transfer payments are payments by the government to individuals for which the government
does not receive a good or service in return

Net Exports: Exports (X) – Imports (M)

           Net exports > 0 is a trade surplus
           Net exports < 0 is a trade deficit

For example, use the data below to calculate the Nominal GDP via the Expenditure method.

                U.S. 2006 Third Quarter
                    National Accounts
                  in Current $ (billions)                          $$$$$         $$$$$
Personal consumption (C)                                                             9346.7
 Durable goods                                                        1075.5
 Nondurable goods                                                     2747.7
 Services                                                             5523.5
Gross private domestic
Investment (I)                                                                        2235.5
 Fixed investment                                                     2171.4
  Nonresidential (Business)                                           1420.8
  Residential                                                          750.5
 Change in private
 Inventories                                                             64.2

Net exports (NX)                                                                            -801.7
 Exports                                                      1488.3
  Goods                                                       1055.8
  Services                                                     432.5
 Imports                                                      2290.1
  Goods                                                       1938.8
  Services                                                     351.3
Government Purchases (G)                                                                    2542.1
 Federal                                                       927.2
   expenditures                                                809.1
   Gross investment                                            118.1
 State and local                                              1614.9
   expenditures                                               1300.0
   Gross investment                                            315.0
Gross Domestic Product (GDP) 9346.7+2235.5+2542.1-801.7=13322.6

The table shows several interesting points:

  G is 19%, I is 17%, C is 70%, and NX is -6% of GDP
  Consumer spending on services is greater than the sum of spending on durable and
   nondurable goods.
 Business fixed investment is the largest component of investment.
 Purchases by state and local governments are greater than purchases by the federal
 Imports are greater than exports, so net exports are negative.
Value Added Approach to Calculate GDP is measuring GDP by summing the market value
added to a product or service by all firms in the economy.
 Value added is the revenue a firm receives minus the cost of the intermediate goods and
   services it buys.

For example in our earlier example of the loaf of bread we had the following—

       Intermediate good Product Produced        Sold for
Farmer ---------------   Wheat (1b)              $.20
Miller 1B wheat          Flour 1lbs              $.50
Baker 1lbs flour         bread                   $.90
Marsh bread              service                 $1.10

Calculate the value added for each stage of production and the total value added.
            Cost of Intermediate goods              Revenue             Value added
                                                    From sale
Farmer                   $0                 .20                         .20
Miller                  $.20                .5-.2                       .3
Baker                   $.50                .9-.5                       .4
Marsh                   $.90                1.10-.9                     .2

Total---------------------------------- $1.10

The Factor Payments Approach to calculating GDP is measuring GDP by summing the factor
payment made by all firms in the economy.

   Factor payments are payments to the owners of resources that are used in production.

Remember from our circular flow diagram that production = income therefore;

GDP = wages and salaries + interest + rent + profit

Real versus Nominal GDP

Nominal variables are measured with out adjustment for the change in the value of currency
over time.

Real variables are measured with an adjustment for the change in the value of currency over

                            Inflation and the measurement of Real GDP

Price level is a measure of the average prices of goods and services in the economy.

GDP deflator is a price index calculated by dividing nominal GDP by real GDP, and
multiplying by 100. This produces an index that measures how the prices of goods included in
GDP change over time.

The GDP deflator uses a base year’s prices to calculate the real value of the goods.

                                   Calculation of a single base year
                                         GDP deflator index

Suppose we have the following and we want 2000 to be the base year.

                        2000                    apples                 coats
                        Price                     $1                   $100
                        Qty                      1000                   50

                     2007                    apples              coats
                     Price                     $2                $120
                     Qty                      1200                100

    NGDP2007 = 2400 + 12000 = 14400

    RGDP2007 = 1200 + 10000 = 11200

GDP deflator for 2007 =
                     (NGDP2007 / RGDP2007) * 100

From the above we see that

                                RGDP = (NGDP/GDPdef) * 100

A Chained index is a method for calculating changes in prices that includes an average of price
changes using base years from neighboring years.

   This is the primary way Commerce Department now reports price indexes.

U. S. system of national accounts provides us with data for calculating GDP and other variables.
Some other commonly used measured derived from the national accounts are:

Gross National Product (GNP) is the market value of all final goods and services produced by a
nation’s residents, no matter where they are located.

   GNP = GDP + net income earned abroad

   Net National Product (NNP) = GNP – depreciation

   National income = NNP - indirect business taxes

National income equal the sum of the below general categories

   Compensation to employees (wages plus benefits)
   Corporate profits
   Rental income
   Proprietor’s income (income of unincorporated businesses)
   Net interest (interest payments received by households from business and from abroad)

Personal Income (PI) is income including transfers received by households.

   PI = National income + Transfer payments + personal interest income ─ Corporate Retained
    profits – Social Security taxes

Disposable Income (DI) is personal income after income taxes.

   DI= Personal Income – Personal income Taxes

                         Account Relationships                                       2006:Q3
Gross domestic product (GDP)                                                                   13322.6
    + Income receipts from abroad                                                                  682.3
    - Income payments abroad                                                                       665.7
Gross national product (GNP)                                                                   13339.2
  - depreciation                                                                                  1582
Net National Product (NNP)                                                                     11757.2
  - indirect business taxes and
     Retained corporate profits                                                                   3151.3
  - Soc. Ins Tax                                                                                   948.9
  - statistical discrepancy                                                                         -5.3
  + Transfers                                                                                     1618.6
  + Personal interest                                                                             1683.6
Personal Income (PI)                                                                           10964.5
  -income taxes                                                                                 1366.2
Disposable Income DI)                                                                             9598.3

              Problems with GDP as a Measure of Value of Output or Well-being

   It ignores non-market transactions.

   GDP ignores leisure time

   It ignores the underground economy.

   Distribution and Quality of Products

   It ignores changes in the environment. or other negative effects of production

   GDP is not adjusted for changes in crime and other social problems

GDP is used to guide the economy in the short run and in the long run to give us an idea of the
growth of the economy. It is not used as a measure of well-being

However, per capita real GDP is used as a rough estimate of average economic well-being for
macroeconomic models.


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