Chapter 5  National Income Accounting (Measuring Output)

I.  Gross Domestic Product (GDP)

Macroeconomists are interested in total production in the economy, so it is essential that we create a measure of total output. This measure is called GDP. GDP is the total market value of all final goods and sevices produced in a country in a given year. Three things to note about this definition of GDP:

• total market value. We add up the dollar value of all the stuff produced in the United States. This is because producing a car is way different that producing a haircut or a can of soup, but by converting everything to its dollar value we have a uniform measure.
• final goods and services. We only count final products ready to be consumed, NOT products used to make other products. So a car will be counted in the GDP but the steel used to make the car is not counted separately. Why? Because the value of the car already reflects the value of the steel, rubber, plastic,etc. that goes into it.
• produced in a country. The U.S. GDP counts only those goods and services produced in the physical borders of the United States. So Toyotas made in Ohio are counted, even though Toyota is a Japanese company. However, minivans made by General Motors in Mexico do NOT count in GDP, even though GM is a U.S. company. Where the good or service is produced is important.

Example. Suppose our imaginary economy produces 3 goods: apples, computers, pizza. The table below shows production and prices for 1999:

 year apples computers pizza price quantity price quantity price quantity 1999 \$0.50 500 \$1000 100 \$9 400

To caluculate GDP, we simple multiply the price and quanitity of each good to get the dollar value, then add up all three values:

GDP = value of apples + value of computers + value of pizza
GDP = (\$.50)(500) + (\$1000)(100) + (\$9)(400) = \$250 + \$100,000 + \$3600 = \$103,850

With millions of goods and services in the United States, the process is a bit more complicated, but the principle is the same.

The measurement of GDP and its components is known as national income accounting. The U.S. Department of Commerce is in charge of measuring U.S. GDP and measures it quarterly, or 4 times per year.

II.  Nominal GDP vs. Real GDP

In measuring GDP, we use prices to measure the value of good and services produced. Using the current prices to value current production is known as nominal GDP. The problem with nominal GDP is that a change in nominal GDP can be due to either (1) a change in the production of goods and services, or (2) a change in the prices of those goods and services. So an increase in prices will cause nominal GDP to rise, even if production has not changed at all. This gives a misleading picture of how well our economy is doing. It also makes it difficult to compare production from year to year, since prices change every year.

To address the price problem, we also construct a measure of GDP that takes price changes into account. Real GDP values goods and services in any given year by using the prices of a set base period. By holding prices constant, real GDP measures only the changes in production from year to year. Changes in real GDP are used to measure economic growth.

Example. Lets continue our example above. The table below has the prices and production of apples, computers and pizza for three years:
 year apples computers pizza price quantity price quantity price quantity 1997 \$0.45 475 \$1100 70 \$7 380 1998 \$0.48 510 \$1050 85 \$8 390 1999 \$0.50 500 \$1000 100 \$9 400

First, let's calcuate nominal GDP for each year. This means we take the price for that year times the quantity for that year.

nominal GDP 1997 = (.45)(475) + (1100)(70) + (7)(380) = \$ 79,873.75
nominal GDP 1998 = (.48)(510) + (1050)(85) + (8)(390) = \$ 92,614.80
nominal GDP 1999 = (.50)(500) + (1000)(100) + (9)(400) = \$103,850

From 1997 to 1999 nominal GDP has increased by

but this increase includes changes in BOTH price and production

Now let's calculate real GDP, using 1998 as the base year. This means for each year we will value output using 1998 prices.

real GDP 1997 = (.48)(475) + (1050)(70) + (8)(380) = \$ 76,786
real GDP 1998 = (.48)(510) + (1050)(85) + (8)(390) = \$ 92,614.80
real GDP 1999 = (.48)(500) + (1050)(100) + (8)(400) = \$108,440

From 1997 to 1999 real GDP has increased by

but this increase includes ONLYchanges in production, because prices are held constant at their 1998 levels. Note how the real GDP increase is greater. This is because in calculating nominal GDP, computer prices are falling over time even though computer production is increasing.

Note that real GDP = nominal GDP in the base year, since both measures use the same prices and same production.

When the U.S. Department of Commerce calcuates real GDP they use an average of prices in previous years, not just the prices of a single year. This is known as a chain-weighted price adjustment.

Figure 5.1 (page 95) measures real vs. nominal GDP from 1975 to 1996, using 1992 as the base year. Given that prices on average increase over time in the U.S., the real GDP is greater than the nominal GDP before 1992, and less than nominal GDP after 1992.

Real and nominal GDP are used to form a price index, something we discuss in Chapter 7.

III.  U.S. GDP Over Time

The graph below shows the post WWII path of real and nominal GDP in the United States, using 1996 as a base year.

Given that prices on average increase over time in the U.S., the real GDP is greater than the nominal GDP before 1996, and less than nominal GDP after 1996.  Note that even after adjusting for inflation, production in the United States has risen dramatically in the past 50 years, from \$1.5 trillion to over \$9 trillion.

Typically economists are more interested in the CHANGE in real GDP rather than the LEVEL of real GDP:

The negative percent changes in real GDP indicate recessions.

Real and nominal GDP are used to form a price index, something we discuss in Chapter 7.

IV.  Measuring GDP: The Expenditure Approach

So how does the U.S. government go about measuring such a huge quantity? One approach is to add up expenditures on goods and services in each sector of the economy:

• Consumption (C). As mentioned in chapter two, this accounts for about 2/3 of GDP.
• Investment (I). Plants, equipment and inventory of businesses. This is one of the most volatile components of GDP.
• Government Spending (G): Federal, state, and local government purchases of goods and services are counted here. This does NOT count transfer payments, such as welfare, since this just transfers income and does not represent production of goods and services.
• Net Exports (X - IM). Net exports is exports minus imports. So we add in those goods and services produced in the U.S. and sold abroad but we substract the good and services purchased by consumers, businesses, and governments that were not made in the United States. Since the 1970s, the U.S. has imported more than it has exported, so net exports are negative.
Putting all of the expenditures together we have the identity

GDP = C + I + G + X - IM

V.  Measuring GDP: The Income Approach

The second approach to measuring GDP is to look at income instead of expenditures. If someone bought it, then someone is being paid to make it. The income components include

• Wages and salaries
• Corporate profits
• Proprietors income (the profits of partnerships and soley owned businesses, like a family restaurant)
• Farm income
• Rent
• Interest
• Sales taxes
• Depreciation (the amount of capital that has worn out during the year)
Tables 5.5 and 5.6 (pages 98, 99) show the relationship between the income and expenditure approaches.
The expenditure and income approaches should, in theory, give us the same answer. In reality they are slightly different due to some measurement error. But spending and income are related in a circular flow: spending by someone becomes income for someone else. For example, when my family goes out to eat, the meal we purchase represents income for the waiter, the restaurant owner, the suppliers, and the sales tax on the meal is income for the government. So to calculate GDP we can either add up expenditures or add up income. The flow between income and spending is demonstrated in figure 5.3 (page 101).

VI.  What does GDP NOT measure?

So GDP is an important measure of the economic power and health of a nation. But GDP does not tell the whole story in terms of the well being of a nation. Here are a few things GDP leaves out:

• Other social indicators. These include crime, illiteracy, life expectancy, infant mortality. Although these things are related to GDP, the connection is not perfect: The U.S. has a larger GDP per capita than Canada or Japan, but also has a higher rate of crime, illiteracy, and infant mortality.
• Equity. A large GDP per capita does not mean that the wealth of a nation is shared equally. In some nations, the GDP is distributed for the most part among a small elite class, leaving the rest of the nation in poverty.
• Environmental issues. A high rate of production may have disasterous environmental consequences. Brazil may increase its GDP by cutting down rain forests for the timber, but very few of us would say that is a good thing.
• The underground economy. The GDP actually measured will fail to capture any goods and services that are not reported to the government. These include illegal activities, like marijuana cultivation, cocaine sales, and tax evasion, such as under-reporting tip income, or cash-paid babysitting. The underground economy is estimated to be as large as 10% of the measured GDP in the United States(see page 91). The underground economy in Mexico is relatively larger due to drug smuggling. Canada's underground economy is estimated to be as high as 20% due to the higher taxes there.
• Nonmarket work. This includes transactions for which people are not paid. When I do my family's laundry, that is not counted in GDP. But if I paid someone to do my laundry, it would count in GDP. The exclusion of homemaking really understates the services produced in the United States.
So while GDP is a crucial measure of the size and health of an economy, keep in mind it is not the ONLY measure of well-being.