Chapter 8 Measuring the Economy*s Performance

The Gross Domestic Product
When considering the health of a human being you might look to such
health measures as temperature, blood pressure, and pulse. When the
whole national economy is studied some measures of economic
“health” are collected in what are called the national income and
product accounts – the NIPA. “To get a gripa, look at the NIPA.”
One of the main economic measures observed is the Gross Domestic
Product. The GDP is total market value of all final goods and services
produced in the economy during a certain period of time.
GDP is a measure of production or aggregate output!
Some examples of production in the US are: Cars, beer, pop,
houses, hair cuts, books, movies, music, hotdogs, cheese,…
what do you want to include on the list – oh, snicker bars and
ice cream, apples and oranges, cookies and milk…peanuts and
greeting cards….
If you made a list of all the items produced in the US in a year I
think the list would stretch from here to the MOON. A lot of
stuff is made in the US each year.
Example of GDP calculation
In a very simple example of calculating GDP say we
only produce bread in the US. We might have
Year Quantity (loaves) Price per loaf
So to get the GDP, the quantity of goods produced is
multiplied by the price.
Another example of GDP calc
Say bread and cheese are produced. We might have
Bread in loaves
Cheese in pounds
$0.50 10+7.50=$17.50
2006 20
GDP Calc
The list of items produced in the US economy would
stretch from here to the moon - a long list of
heterogeneous goods and services - and would be hard to
make sense of so we multiply the units produced by
market price and talk about production in dollar terms – a
monetary measure.
So the GDP is 1 number that we look to as an indicator of
economic health. Changes in the number are studied.
GDP is in the neighborhood of $16,000,000,000,000, or 16
trillion dollars, in the US in the year 2009.
Expenditure Approach
There are many ways to take your temperature, right?
Under the tongue, or in your ear, or up your, uh,…, uh,…,
up your,…., sleeve, yea sleeve to get at your underarm.
We have the same thing with GDP. One approach is the
Expenditure approach and here we look at the 4 basic sectors
of the economy and group the goods and services by the
sector that takes them (by buying them).
Remember the sectors are households, businesses,
governments and the rest of the world.
Expenditure approach to GDP
The spending, or expenditure, approach to measuring GDP
organizes the goods and services into 4 groups, by type of
1) C - Personal Consumption expenditure on goods and
services, stuff bought by households,
2) Ig – Gross private domestic Investment goods like
equipment, buildings - stuff bought by businesses, and it also
includes production not sold – changes in inventory.
3) G - Government expenditure on goods and services like
roads and teachers and police and,
4) Xn - exports minus imports - stuff traded with foreigners
Be careful with government!
In the GDP measure government expenditure only
includes payments when the government buys a good
or service - the government budget is larger than this
because the government does more than just buy goods
and services.
When the government builds a bridge we get a good.
When the government sends aid to victims of a typhoon
in Asia it is a good thing, but not a payment for a good
or service.
Why subtract imports
We include exports because the stuff is produced here, even
though it is sold elsewhere. BUT, we subtract imports for a
good reason as well. When C, I and G are measured it is
easier to ignore at that point if the item is domestic or
foreign and then subtract later in a lump sum the amount of
imports. Consumption, for example, as measured includes
imports, so we subtract it out later and talk of NET
Our production measure – GDP – just looks at what is
produced here. Our measurement initially includes
production elsewhere for expediency, so we subtract it out
Notes about GDP
So, GDP = C + I + G + Xn.
On the following few screens we will point out some of
the details about what GDP does and does not include.
Specially, we mention
1) intermediate goods are not included, 2) Financial
transactions are not included, 3) sale of used items not
included, 4) household production not included, and 5)
illegal production or legal production not reported is not
GDP is only final goods and
As an example say General Motors buys $2000 worth of
steel to put in a car. Then GM sells the car for $15,000.
GDP is not 17,000 here. The steel sale is called an
intermediate sale because the item, steel, is used in the
production of another item. The value of the steel is
reflected in the value of the car.
Counting the steel sale would mean we have double
counted the value of steel. GM has taken steel (and
other inputs) and has ADDED VALUE by transforming
the inputs into an output.
Financial transactions
Financial transactions like buying stocks or the government
giving social security to recipients is not part of GDP. These
transactions are transfers from one individual to another.
Nothing has been created.
The difference here is that if you buy a car from GM, for
example, you transfer them money as well, but you do so
because the car was created. Financial transactions merely
shuffle around to new players the existing funds.
NOTE: the transfer is not directly part of GDP. But
households, for example, that get social security payments
buy newly produced products. This would be an influence
on GDP, BUT NOT part of the direct measurement. Here our
focus is measurement.
GDP is a measure of
Although it may seem we are looking at sales to get
the GDP, we really want to focus on the production.
Much of what is produced this year is sold, and if it
isn’t we add it to inventory and call it an addition to
inventory under investment.
But not all sales are for things that were produced this
year. You may have bought a used car that was
produced in 2000. Including the sale in 2009 GDP
would not be good because the car wasn’t made in
2009. So, the sale of used items is not included.
Household production
Say you go to the store and buy bread, peanut butter
and jelly. Then you go home and produce a PBJ. Your
production here is not included in GDP. But if you buy
all the same stuff and illegally hire a housemaid, it won’t
be counted either. Only if the hire is legal and reported
will the production of the PBJ sandwich at your home be
counted in GDP because it was part of what the maid
did on the job.
Illegal production
Items that are illegal in the US, but still produced, are not
counted as part of the GDP. During prohibition all the
alcohol produced was not counted as part of the GDP.
Income approach to GDP
The other side of the spending coin is that someone collects
the funds spent by others. The income approach to GDP
would have us focus on the income generated and this
amount has to equal the GDP from the expenditure
The functional distribution of income is made up of wage
and salary of labor, rent of land owners, interest of capital
owners , and entrepreneurs getting corporate profit and
proprietor’s income. If we add to this taxes on production
and imports we have a measure called national income. The
payment to labor is called Compensation of Employees in
the NIPA.
Income approach
In Major League Baseball there is a team called the
Washington Nationals. What is a National? In economics a
national is a person who is a citizen of a nation. US citizens
are US nationals.
US nationals may use some of their resources inside the
borders of other countries. In the functional distribution of
income, where the resource is used has been ignored. These
measures actually include income earned by nationals
working in another country and ignores “domestic” work
done by foreigners. This functional distribution of income
(plus the taxes on production and imports) thus needs to be
adjusted before we have the GDP.
Net Foreign Factor income- NFFI
Net foreign factor income = US citizens income earned abroad
minus foreign citizens income earned in US.
Similar to how we included imports in C, I and G in the
expenditure approach and subtracted it out later, when wages,
rent, interest and profit are earned it includes those values for
all nationals, whether the funds are earned in the US or
abroad. BUT, GDP is a measure of production within the
borders. National income was income of nationals in and out
of the border. SOOOOO, we have to subtract out the income
of US citizens that was earned abroad. Plus income earned by
foreigners working here must be added because they worked
in the domestic economy. This means we have national
income minus NFFI so far in our income approach to GDP.
Consumption of Fixed Capital depreciation
Capital goods are things like large machines, pieces of
equipment, and other tools we made to help us make other
stuff. These goods do not wear out totally each year, but they
wear out gradually over time. But, part of the income
generated by production this year is set aside to ultimately
replace the worn out equipment. This must be added into
national income so income = production value.
Finally, we have income approach to GDP = national income
– NFFI + depreciation + a fudge factor or statistical
Expenditure approach equal
income approach to GDP
So, GDP = C + I + G + Xn = national income – NFFI +
depreciation + a fudge factor or statistical discrepancy.
Corporate profit
Let’s note that corporate profits usually gets broken up into 3
categories at the national level: Some of the profit is paid in
tax, some is given to corporate owners in the form of
dividends and the rest is retained, or undistributed by the
Other NIPA accounts
Net domestic product = NDP = GDP – depreciation.
National income = NDP – statistical discrepancy + NFFI.
Personal income = national income - taxes on production and
imports – social security contributions – corporate profits tax
and undistributed profits + transfer payments (like social
security income).
Disposable income = personal income – personal taxes and
can be either consumed or saved.
Note from definition of disposable income that disposable
income + personal Taxes = personal income.
Here we look at why and how the
GDP is converted to RGPD.
Potential problem of the GDP
Let’s start with a very simple example here. Say in our
economy only computers are made. Say in year 1 that
10 computers are made and each is sold for $1000.
GDP year 1, GDP1 = $1000(10) = $10,000.
In year 2 say 12 computers are made and each sells for
$1100 for a GDP = GDP2 = $1100(12) = $13200.
Potential problem of the GDP
Now on the previous screen we could take the
percentage change in GDP to see the growth in
production. To get the percentage change in anything
(later value - earlier value) and divide by
earlier value.
So the % change in GDP = (13200 - 10000)/10000 = .32
or 32%.
But wait, we went from 10 to 12 computers or a
(12-10)/10 = .2 or 20% increase.
Potential problem of the GDP
By looking at the % change in GDP it appears output
went up 32%. But we know in this simple example
output only went up 20%. The reason the GDP went
up more than 20% in our example is because the price
level also went up.
The price level increasing makes it look like GDP went
up more than it did. So the price level change can
confuse us about the size of the change in the GDP. In
fact it is possible that output falls and prices go up so
much that GDP increases, while in fact output fell.
Real GDP or RGDP
Remember that we take market value in GDP because
the list of products is too long. But now using prices
may distort the GDP as a measure of production – this is
a problem of measurement.
Let’s return to the example we had with computers but
always use base year prices. The GDP we calculate is
called RGDP (say the base year price is $500).
RGDP1 = $500(10) = $5,000
RGDP2 = $500(12) = $6,000.
The % change in RGDP = (6000 - 5000)/5000 = .2 or 20%.
So by using the same prices in both years we only see
the % change in output.
Nominal GDP in year t, or GDP in current dollars, uses
the prices in year t. RGDP in year t, or GDP in constant
dollars, uses the prices in the base year.
Even tough in our simple example we show how RGDP
is calculated, when we look at the whole economy a
different way is used. Here is how RGDP is calculated
RGDPt = (GDPt/price index in year t)100.
The price index we use in this calculation is called the
GDP deflator.
I want you to remember both calculations for getting
RGDP is the real gross domestic product and is a broad measure
of production or income in a national economy. RGDP is the
total value of all goods and services produced in an economy
over a period of time and expressed in terms of value that has
been adjusted for the general increase in prices.
RGDP in trillions
This graph of
RGDP is not totally
accurate, but has a
few features that
reflect the true
historical record.
Let’s note two things about the graph on the previous screen.
1) Over the long haul, or long term, RGDP has moved
upward and this is called economic growth. At this time let’s
not concern ourselves with why this is so, let’s just note that it
is so.
2) In the short term there are economic fluctuations - ups and
downs in the level of RGDP. This shorter term pattern is often
called the business cycle.
Remember the long term shows RDGP grow, but in the short
term RGDP goes up and down along the long term trend.
Again, the short term fluctuations make a pattern called the
business cycle.
A recession is a fall in RGDP and as a rule of thumb the decline
must occur for at least six months in row to be called a
recession. The level of RGDP right before the recession is
called the peak and when the recession has stopped the RGDP
level is at its trough. From that point the economy expands to
the next peak and the cycle begins again.
Note that each cycle is not of the same length.
During the year 2000 the economy experienced a record in that
the longest time had passed by without a recession - something
like 9 years. We did have a recession since 2000.
When is a recession a depression? When you are the person
out of work. :) No, really though, a depression is just a severe
or huge recession.
The 1929-1933 recession is called the Great Depression, and
another severe recession hit around 1937. So the 1930’s
where a pretty tough time in the US from the point of view of
RGDP declines. Recessions since this time have been much
less severe. The 1990-1991 recession was considered tame or
mild compared to the experience of the 1930’s. Of course it
was hard for some, but we are looking at the big picture here.

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