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Chapter 07 – Measuring Domestic Output and National Income

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, nonincomes charges—consumption of fixed capital

(depreciation) and taxes on production and imports—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.

WHAT’S NEW

There are now six learning objectives in the chapter (previously there were four).

There is a more detailed discussion about the statistical discrepancy when calculating GDP.

There is a new Quick Review (QR 7.4) at the end of the chapter.

There are extensive data updates throughout but no major changes to content.

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.

5. Explain why changes in inventories are investments.

6. Discuss the relationship between net investment and economic growth.

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Chapter 07 – Measuring Domestic Output and National Income

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 20012 (or later) U.S. GDP in trillions of dollars and be able to rank U.S.

relative to a few other countries.

14. Define and identify terms and concepts listed at the end of the chapter.

COMMENTS AND TEACHING SUGGESTIONS

1. National income accounts are detailed and can be very time-consuming for students. Some

instructors choose to treat them selectively. For example, focus only on expenditures approach to

GDP. Decide what priorities are most important and plan accordingly.

2. Encourage students to look for news items on Chapter 7 concepts. Students could be asked to keep

a weekly journal summarizing reports or follow a particular measure like unemployment.

Political cartoons are often about macroeconomic issues. Keeping a collection of them; asking students

to contribute enlivens the classroom and builds understanding.

3. Use of circular flow diagrams in this section may be helpful. The national income accounts are

built on the identity of income and output. Once a good is produced it generates a like amount of

income; this is clearly demonstrated in the sum of the transactions in the product and resource

markets.

4. Discuss the difference between “stock” concepts and “flows.” The national accounts are measured

over a period of time, so GDP and the related aggregates are all flow concepts. A “stock” is a

measure of a variable at a point in time. Consider these pairs of terms: income and wealth; saving

and savings; deficit and debt. Contrast the income statement of a firm with the firm’s balance

sheet.

5. In the expenditures approach to GDP we subtract imports because they represent spending on

production outside the United States. Students may wonder why we don’t just ignore it as we do

other forms of spending (e.g. on used goods). It may be useful to point out the need to subtract

them because they were included positively in the other categories (the German-made car is

recorded as consumption expenditure) and now need to be removed.

6. For discussion: Why is a hurricane or an earthquake good for the economy? How does a divorce

add to GDP? How can the depletion of a natural resource add to GDP?

7. Ask students how they think a researcher might get information about the size of the underground

economy. Obviously a drug dealer is not going to include sales information on his 1040 tax return

(despite a line on the form to report illegal income). Discuss how the presence of the underground

economy might influence tax structure and policies.

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STUDENT STUMBLING BLOCKS

1. There is a lot of memorization required to learn the various measures used in the national accounts. In

the interest of time, you might choose to have your students focus on the expenditures approach to

calculating GDP. It will prove to be the most useful in understanding the analysis in subsequent

chapters which use C + I + G + Xn formulation frequently.

2. Special Problems: Investment is a word that all of the students in the class think they understand. The

meaning of the term in ordinary conversation interferes with their ability to acquire a new

definition and use that new definition consistently.

3. Changes in business inventory is an entry that represents the difference between what has been

produced and what is sold. Although this entry is very small compared to total GDP, it is one of the

most important indicators of future business activity. It has an important role in the income

determination models presented later in the text.

4. Many of the exclusions from the GDP accounts involve financial transactions that transfer the

ownership of existing assets. The sale of stock in a corporation is a transfer of part ownership of

existing assets. New stock issues only dilute the share of ownership and are excluded as well. The

sale of corporate bonds also represents a purely financial transaction. Corporations that are seeking

to expand use the proceeds of these sales to purchase capital equipment or engage in new

construction, and this is included in GDP. To also include the purchase of the securities would be

an example of double counting. However, services are provided when these transactions are

processed, the value of which should be included in GDP.

5. Sales of secondhand goods are also excluded; however parts of the transactions may need to be

counted. The used car dealership that buys a car for $1000 and resells it for $3000 has created

$2000 worth of output, even if the entire sum is profit to the entrepreneur.

6. Remind the students that entries beginning with the word net could be negative and have been for

many years in the case of U.S. net exports.

LECTURE NOTES

I. Learning objectives – After reading this chapter, students should be able to:

A. Explain how gross domestic product (GDP) is defined and measured.

B. Describe how expenditures on goods and services can be summed to determine GDP.

C. Explain how GDP can be determined by summing up all of the incomes that were derived

from producing the economy’s output of goods and services.

D. Describe the relationships between GDP, net domestic product, national income, personal

income, and disposable income.

E. Discuss the nature and function of a GDP price index, and describe the difference between

nominal GDP and real GDP.

F. List and explain some limitations of the GDP measure.

II. 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 similar purpose for the economy, as do income statements

for business firms.

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Chapter 07 – Measuring Domestic Output and National Income

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 of appropriate public policies to improve

economic performance.

III. 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 sold or transferred, including used items, are not counted.

2. 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 (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.

b. 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.

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d. Noninvestment transactions – despite how the term “investment” is used by the

general public, investment does not include transfers of ownership of paper assets

(stocks and bonds) or real assets (houses, jewelry, art). Only newly created capital is

counted as investment.

e. 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 … Stocks Versus 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. Income Approach to GDP (See Table 7.3): Demonstrates how the expenditures on final

products are allocated to resource suppliers as income.

1. Compensation of employees includes wages, salaries, fringe benefits, salary and

supplements, and payments made on behalf of workers like social security and other

health and pension plans.

2. Rents: payments for supplying property resources (adjusted for depreciation it is net

rent).

3. Interest: payments from private business to suppliers of money capital.

4. Proprietors’ income: income of incorporated businesses, sole proprietorships,

partnerships, and cooperatives.

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5. Corporate profits: After corporate income taxes are paid to government, dividends are

distributed to the shareholders, and the remainder is left as undistributed corporate

profits (also referred to as retained earnings).

6. Taxes on production and imports: general sales taxes, excise taxes, business property

taxes, license fees, and customs duties.

7. The sum of the above entries equals national income: all income earned by American

supplied resources, whether here or abroad, plus taxes on production and imports.

8. Adjustments required to balance both sides of the account:

a. Net foreign factor income: National income measures the income of Americans both

here and abroad. GDP measures the output of the geographical U.S. regardless of the

nationality of the contributors. Net foreign factor income measures American income

earned abroad minus the income of foreign nationals producing in the U.S. To make

the final adjustment from national income to GDP (thereby only measuring what is

produced within U.S. borders), net foreign factor income must be subtracted from

national income. This removes the income earned by Americans outside the borders,

but adds in what foreign workers produced on U.S. soil. Sometimes net foreign

factor income is negative, making the net contribution to GDP positive. (Without this

adjustment you have GNP.)

b. Statistical discrepancy: NIPA accountants add a statistical discrepancy to national

income to equalize the income and expenditures approaches ($67 billion in 2012).

c. Depreciation/Consumption of Fixed Capital: The firm also regards the decline of its

capital stock as a cost of production. The depreciation allowance is set aside to

replace the machinery and equipment used up. In addition to the depreciation of

private capital, public capital (government buildings, port facilities, etc.), must be

included in this entry.

IV. Other National Accounts (see Table 7.4)

A. Net domestic product (NDP) is equal to GDP minus depreciation allowance (consumption of

fixed capital).

B. National income (NI) is income earned by American-owned resources here or abroad. Adjust

NDP by adding net foreign factor income. (Note: This may be a negative number if

foreigners earned more in U.S. than American resources earned abroad.)

C. Personal income (PI) is income received by households. To calculate, take NI minus payroll

taxes (social security contributions), minus corporate profits taxes, minus undistributed

corporate profits, and add transfer payments.

D. Disposable income (DI) is personal income less personal taxes.

V. Circular Flow Revisited (see Figure 7.3)

A. Compare to the simpler model presented in earlier chapters. Now both government and

foreign trade sectors are added.

B. Note that the inside covers of the text contain a useful historical summary of national income

accounts and related statistics.

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VI. 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 by 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.

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 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 — currently 2005)

VII. Shortcomings of GDP

A. GDP doesn’t measure some very useful output because it is unpaid (homemakers’ services,

parental child care, volunteer efforts, and home improvement projects).

B. GDP doesn’t measure improved living conditions as a result of more leisure.

C. GDP does not measure improvements in product quality or make allowances for increased

leisure time.

D. 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.

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E. 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 the oil spills, and the cost of health

care for the cancer victim.

F. GDP makes no value adjustments for changes in the composition of output or the distribution

of income.

1. Nominal GDP simply adds the dollar value of what is produced; it makes no difference if

the product is a semi-automatic 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.

G. Noneconomic Sources of Well-Being like courtesy, crime reduction, etc., are not covered in

GDP.

VIII. LAST WORD: Magical Mystery Tour

A. GDP is compiled by the Bureau of Economic Analysis (BEA) in 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 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.

QUIZ

1. Suppose the total monetary value of all final goods and services produced in a particular country

in 2008 is $500 billion and the total monetary value of final goods and services sold is $450

billion. We can conclude that:

A. GDP in 2008 is $450 billion.

B. NDP in 2008 is $450 billion.

C. GDP in 2008 is $500 billion.

D. inventories in 2008 fell by $50 billion.

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2. If depreciation (consumption of fixed capital) exceeds domestic investment, we can conclude

that:

A. nominal GDP is rising but real GDP is declining.

B. net investment is negative.

C. the economy is importing more than it exports.

D. the economy’s production capacity is expanding.

3. Real GDP measures:

A. current output at current prices.

B. current output at base year prices.

C. base year output at current prices.

D. base year output at current exchange rates.

4. Real GDP and nominal GDP differ because the real GDP:

A. is adjusted for changes in the volume of intermediate transactions.

B. includes the economic effects of international trade.

C. has been adjusted for changes in the price level.

D. excludes depreciation charges.

5. The GDP tends to:

A. overstate economic welfare because it does not include certain nonmarket activities such as

the productive work of housewives.

B. understate economic welfare because it includes expenditures undertaken to offset or correct

pollution.

C. understate economic welfare because it does not take into account increases in leisure.

D. overstate economic welfare because it does not reflect improvements in product quality.

6. The monetary value of all final goods and services produced by the United States economy

during a year is:

A. NDP

B. GDP

C. NI

D. DI

7. Which would be considered an investment according to economists?

A. The purchase of newly-issued shares of stock in Microsoft

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B. The construction of a new computer chip factory by Intel

C. The purchase of shares of stock by Fidelity, a mutual fund company

D. The sale of government bonds by the nation’s central bank

8. The following are national income account data for a hypothetical economy in billions of dollars:

gross private domestic investment ($320); imports ($35); exports ($22); personal consumption

expenditures ($2,460); and, government purchases ($470). What is GDP in this economy?

A. $3,250 billion

B. $3,263 billion

C. $3,237 billion

D. $3,290 billion

9. GDP in an economy is $4,600 billion. Consumer expenditures are $3,500 billion, government

purchases are $900 billion, and gross private domestic investment is $400 billion. Net exports

are:

A. +$400 billion

B. -$400 billion

C. +$200 billion

D. -$200 billion

10. A consumer price index attempts to measure changes in:

A. The prices of all goods and services produced by the U.S. economy

B. The price of a select market basket of goods and services

C. The spending patterns of all consumers in the United States

D. The spending patterns of consumers worldwide

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