Chapter 23: Measuring a Nation’s Income

  • Macroeconomics: the study of the economy as a whole; includes factors such as inflation, unemployment, etc.
  • Microeconomics: the study of how individual firms and households interact with each other in a free market
  • Following chapters will focus on macroeconomics and statistics that provide information about the well-being of the entire economy

23-1: The Economy’s Income and Expenditure

  • Can judge how a nation (or person) is doing based on the income of the people in that economy
  • Gross domestic product (GDP) allows economists to measure income; tracks the total income and total expenditure of an economy
    • Note that for an economy as a whole, income must equal expenditure
    • If someone pays $100 for a service, then one party gains $100 and one party spends $100; GDP raises by $100 as a whole
  • The circular flow diagram is a good representation of GDP
    • All of the green arrows in the figure below represent money and, therefore, changes in GDP
    • Diagram: image

23-2: The Measurement of GDP

  • Gross domestic product (GDP): the market value of all final goods and services produced within a country in a given period of time
    • Definition has many aspects

“GDP is the market value…“

  • The GDP measures market prices to reflect the value of goods sold and purchased

“…of all…“

  • The GDP attempts to measure the market value of every single good sold or purchased in an economy
    • Housing is measured by the rental price of the home or, if the house is not being rented, the estimated rental price of the home
  • The GDP does not measure illegal products, such as drugs, or products manufactured and consumed in homes, such as a backyard tomato garden
    • This can lead to situations where a marriage can lower a GDP if a consumer and producer get married

“…final…“

  • Goods can either be intermediate or final
    • Intermediate goods are used in the process of making a final good; think the corn used in making a tortilla
    • Final goods are the end product of a production process; the tortilla
    • GDP only measures the value of final, not intermediate goods
  • The GDP does measure intermediate goods if it is added to an inventory for use at a later time
    • Essentially, additions to an inventory add to the GDP, and when those additions are used at a later time, they are subtracted from the GDP

“…goods and services…“

  • Both goods (food, books, video games, etc) and services (haircuts, car wash, concerts, etc.) are included in a GDP

“…produced…“

  • GDP only includes goods and services currently produced, not ones produced in the past
    • If a car manufacturer creates a car, the value of that car is added to the GDP
    • If someone sells an old car to someone else, the valur of that car is not added to the GDP

“…within a country…“

  • The GDP measures the production inside of the geographical boundaries of a country, regardless of the citizenship or nationality of the producer

“…in a given period of time.”

  • The GDP measures the value of production in an interval of time, which is typically either a financial quarter or year
    • Reporting for a GDP for a quarter is typically multiplied by 4 to represent an “annual rate”
    • Quarterly GDP data is typically adjusted in order to account for seasonal changes, such as shopping sprees in December
  • With these clarifications, the definition of GDP has multiple layers
    • Theoretically, the GDP should be equal to the gross domestic income (GDI), but the difference in GDP and GDI can be chalked up to a statistical discrepancy

23-3: The Components of GDP

  • The GDP can be understood as a sum of four different types of spending
  • Y = C + I + G + NX
    • Y represents GDP
    • C represents consumption
    • I represents investment
    • G represents government purchases
    • NX represents net exports

Consumption

  • Consumption is spending by households (aka citizens/regular people) on goods and services
    • Does not include housing purchases, as those count as an investment
    • Services include haircuts and medical care, and goods include food, clothing, appliances, etc.

Investment

  • Investment includes the purchase of goods (known as capital goods) that will be used in the future to produce more goods and services
  • Includes business capital, residential capital, and inventories/stock
    • Business capital: business structures (like factories), equipment, and intellectual property products (software or recipes)
    • Residential capital: buildings for rent, personal residences
    • Inventory: components, ingredients, intermediate goods
  • Investment, in this case, does not refer to financial investments such as stocks and bonds; it refers to goods that will be used in the future to create more goods and services

Government Purchases

  • Government purchases includes spending on goods and services by all types of governments
    • Includes salaries of government workers and expenditure on public works
    • Known officially as government consumption expenditure and gross investment but known traditionally as government purchases
  • Social Security benefits or unemployment is not considered part of government purchases; they are instead defined as transfer payments
    • These are not specified as expenditures because no value is being extracted from the production of goods or services; thus, they are not part of the GDP

Net Exports

  • Net exports = exports - imports
  • Net refers to the subtraction of imports from exports in order to show the amount exported
    • Selling a domestic product to a foreign buyer increases GDP, while purchasing a foreign product domestically decreases it

23-4: Real versus Nominal GDP

  • If total spending rises from year to year, either a) more goods and services were produced or b) the price of goods increased
    • To measure quantity of goods instead of a change in price, economists use real GDP which uses a market price baseline of a set year

A Numerical Example

  • Example table of an economy which produces hot dogs and hamburgers: image
  • The total expenditure can be simply found by multiplying the current market price by the current quantity of goods sold
    • The production of goods and services valued at current prices is called the nominal GDP
    • In the table, the nominal GDP for hot dogs and hamburgers continually increases, but this increase can be attributed ot both the increase in price and the increase in production
  • Real GDP removes the issue of price changes by valuing goods and services at a set price based on a previous year
    • Using 2019 as the base year, we can calculate the value of goods and services using the 2019 market price in order to account for any changes in price
    • For the base year, the real GDP will always equal the nominal GDP
  • Nominal GDP uses current prices to value the economy’s production of goods and services. Real GDP uses constant base-year prices to value the economy’s production of goods and services.
  • Real GDP is a better measurement of economic well-being because it consistently tracks the level of production between years; real GDP is used to determine economy growth

The GDP Deflator

  • The GDP Deflator is calculated as follows:
    • ∣GDPDeflator=NominalGDPRealGDP∗100∣| { GDP Deflator = {Nominal GDP \over Real GDP} * 100 } |
  • This equation allows us to see how the prices of goods and services have changed compared to the base year
    • If the prices remain the same from the base to current year, then the GDP deflator remains constant
    • If the prices increase or decrease from the base year, then the GDP deflator will also increase or decrease accordingly

23-5: Is GDP a Good Measure of Economic Well-Being?

  • GDP tells us the income and expenditure of the average person in the economy, and in most cases, this tells us about the economic well-being of the average person (more expenditure = more money = happier)
  • Some disagree that GDP is a good measure of economic well-being, as it does not measure any intangibles such as happiness, bravery, creativity, etc.
    • GDP, though not directly connected, can indirectly measure these traits
    • More GDP = more education, better nutrition, more specialization for a country
  • GDP is not a perfect measure of well-being
    • Production can unnaturally increase (everyone begins working every day of the week), thus increasing GDP but decreasing well-being
    • Does not include goods and services produced at home, such as a chef’s home-cooked meals, volunteer work, or the work of stay-at-home parents
    • Does not measure environmental factors, such as pollution
    • Does not measure distribution of income; a nation with 100 people making 50k has the same GDP as a nation with 1 person making 5 million and 99 people making 0
  • In general, GDP is a good measure of well-being for most, but not all, purposes