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Gross Domestic Gross Domestic Product AccountingProduct Accounting

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Gottheil - Principles of Economics, 4e

Economic PrinciplesEconomic Principles

The circular flow of resources, goods, and services

The circular flow of money

The expenditure approach to measuring GDP

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Economic PrinciplesEconomic Principles

The income approach to measuring GDP

The relationship between GDP, NDP, and national income

The limitations of GDP as a measure of economic well-being

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Circular flow of goods, services, and resources• The movement of goods and services from firms to households, and of resources from households to firms.

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EXHIBIT 1 THE CIRCULAR FLOW OF GOODS, SERVICES, AND RESOURCES

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Exhibit 1: The Circular Exhibit 1: The Circular Flow of Goods, Flow of Goods, Services, and Services, and

ResourcesResources1. What do households supply to the resource market?• Households supply their resources—labor, capital, land, entrepreneurship—to the firms in the resource market.

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Exhibit 1: The Circular Exhibit 1: The Circular Flow of Goods, Flow of Goods, Services, and Services, and

ResourcesResources2. What do firms provide to households in the product market?• Firms provide households with goods and services in the product market.

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Circular flow of money

• The movement of income in the form of resource payments from firms to households, and of income in the form of revenue from households to firms.

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EXHIBIT 2 THE CIRCULAR FLOW OF MONEY

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Exhibit 2: The Exhibit 2: The Circular Flow of Circular Flow of

MoneyMoneyWhat do firms in the resource market pay to households for resources provided?• Firms pay money in the form of wages, interest, rent and profit to households for resources supplied.

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Two Approaches to Two Approaches to Calculating GDPCalculating GDP

• Economists calculate GDP in two ways: the expenditure approach to GDP and the income approach to GDP.

• Regardless of which method is used, the values should be equivalent.

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The Expenditure The Expenditure ApproachApproach

Expenditure approach

• A method of calculating GDP that adds all expenditures made for final goods and services by households, firms and government.

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When using the expenditure approach to GDP, one must be certain that only final goods and services are counted. Otherwise, goods may be double counted.

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Final goods

• Goods purchased for final use, not for resale.

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Intermediate goods

• Goods used to produce other goods.

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Value added

• The difference between the value of a good that a firm produces and the value of the goods the firm uses to produce it.

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EXHIBIT 3 MARKET VALUE AND VALUE ADDED OF GOODS PRODUCED

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Exhibit 3: Market Value Exhibit 3: Market Value and Value Added Goods and Value Added Goods

ProducedProduced1. What is the total market value of the wool sweater in Exhibit 3?

• The total market value is $94.

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ProducedProduced2. Why shouldn’t the total market value be used when calculating GDP?• The total market value counts the original resource multiple times.

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ProducedProduced2. Why shouldn’t the total market value be used when calculating GDP?• For example, the $4 value for wool on the sheep makes up part of the $13 value for wool fabric and $50 value for a wool sweater.

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There are four expenditure categories of GDP:

1. Personal consumption

2. Gross private domestic investment

3. Government purchases

4. Net exports

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1. Personal consumption expenditures (C)

• All goods and services bought by households. These expenditures are grouped into categories of durable goods, nondurable goods, and services.

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1a. Durable goods

• Goods expected to last at least a year. For example, refrigerators, automobiles, and washing machines.

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1a. Durable goods

• During recessions, consumers tend to hang on to their durable goods, so that sales of new durable goods are relatively weak. During times of prosperity, consumers are more likely to discard old durables, and sales of new durables are strong.

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1b. Nondurable goods

• Goods expected to last less than a year. For example, food, clothing, gasoline and toiletries. Households spend more on nondurables than on durables.

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1c. Services

• Productive activities that are instantaneously consumed. For example, medical care, a lecture, and appliance repair. Households spend more on services than durable and nondurable goods combined.

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2. Gross private domestic investment (I)• The purchase by firms of plant, equipment, and inventory goods.

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2. Gross private domestic investment (I)• Plant (or new structure) and equipment purchases may either replace worn out plants and equipment or increase the quantity of plants and equipment.

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2a. Inventory investment

• Stocks of finished goods and raw materials that firms keep in reserve to facilitate production and sales.

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3. Government purchases (G)

• All goods and services bought by government. For example, goods such as national defense materials, interstate highway, and post offices, and services such as justice and education.

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4. Net exports (X - M)

• An economy’s exports to other economies, minus its imports from other economies.

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All final goods and services that make up GDP, then, can be expressed in the form:

GDP = C + I + G + (X – M).

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EXHIBIT 4 EXPENDITURE APPROACH TO 2003 GDP ($ BILLIONS)

Source: Bureau of Economic Analysis, U.S. Department of Commerce, 2003.

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Exhibit 4: Expenditure Exhibit 4: Expenditure Approach to 2003 GDP Approach to 2003 GDP

($ billions)($ billions)1. What was the largest category of GDP expenditure in 2003? • The largest category was personal consumption expenditures at $7,598.6 billion.

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Exhibit 4: Expenditure Exhibit 4: Expenditure Approach to 2003 GDP Approach to 2003 GDP

($ billions)($ billions)2. Why was the net exports category of expenditure negative in 2003? • The category was negative (-$504.6 billion) because the value of U.S. imports was greater than the value of U.S. exports.

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The Income ApproachThe Income Approach

Income approach

• A method of calculating GDP that adds all the incomes earned in the production of final goods and services.

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National income

• The sum of all payments made to resource owners for the use of their resources.

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The income payments are arranged into five categories: (1) the compensation of employees, (2) interest, (3) corporate profit, (4) rental income, and (5) proprietors’ income.

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The compensation of employees is divided into two categories: wages and salaries and supplements. Supplements (or fringe benefits) include such things as bonuses, paid vacations, and contributions to employees’ Social Security.

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The Income ApproachThe Income ApproachCorporate profit represents the return to owners of incorporated firms. Corporate profit is divided into three categories—dividends, corporate reinvestment, and corporate taxes. All three are included in the income approach to GDP.

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The Income ApproachThe Income ApproachRent is the payment for use of property. Although most people don’t pay themselves rent for using their own property, the rent is still estimated in GDP accounting. Net rental income is total rental income minus depreciation.

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Proprietors’ income is the income earned by unincorporated firms for the goods and services they produce. Proprietors’ income is the net income after paying such expenses as rent, utilities, and supplies.

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EXHIBIT 5 2003 NATIONAL INCOME ($ BILLIONS)


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Exhibit 5: 2003 Exhibit 5: 2003 National Income ($ National Income ($

billions)billions)What was the largest category of income in the U.S. in 2003 according to Exhibit 5?• Compensation of employees was by far the largest category of income at $6,094.5 billion, or 70.7 percent of the national income.

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Bringing GDP and Bringing GDP and National Income into National Income into

AccordAccordGDP, according to Exhibit 4, was $10,802.7 billion in 2003. Yet national income, according to Exhibit 5, was only $8,618.0 billion.

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AccordAccordIn order to bring the two into accord, first gross domestic product is converted to gross national product. Then depreciation of capital and indirect business taxes are subtracted from gross national product.

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AccordAccordGross National Product (GNP)

• The market value of all final goods and services in an economy produced by resources owned by people of that economy, regardless of where the resources are located.

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AccordAccordWhile GDP measures location, GNP measures ownership. For example, the value of goods produced by a U.S.-owned firm in Spain are not counted in our GDP, but are counted in our GNP.

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AccordAccordCapital depreciation

• The value of existing capital stock used up in the process of producing goods and services.

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AccordAccordNet Domestic Product (NDP)

• GDP minus capital depreciation.

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Exhibit 6: Influence of Exhibit 6: Influence of Capital Depreciation on Capital Depreciation on the Growth Rate of NDP the Growth Rate of NDP

($ billions)($ billions)How does the rate of NDP growth compare to the rate of GDP growth as capital depreciation increases in Exhibit 6?• Regardless of the value of capital depreciation, the rate of GDP growth remains unchanged.

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Exhibit 6: Influence of Exhibit 6: Influence of Capital Depreciation on Capital Depreciation on the Growth Rate of NDP the Growth Rate of NDP

($ billions)($ billions)How does the rate of NDP growth compare to the rate of GDP growth as capital depreciation increases in Exhibit 6?• The rate of NDP growth declines, however, as capital depreciation increases from $900 to $1100 billion.

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AccordAccordIndirect business taxes include general sales taxes, excise taxes, customs duties and license fees. They are indirect because they are taxes levied not on the firms directly, but on the goods and services.

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EXHIBIT 7 THE RELATIONSHIP BETWEEN GROSS DOMESTIC PRODUCT, GROSS NATIONAL PRODUCT, NET NATIONAL PRODUCT, AND NATIONAL INCOME: 2003 ($ BILLIONS)

Note: Net domestic product = $8,767.7 billion. The use of NNP instead of NDP to derive national incomes conforms to the derivation of national income used by government sources. Note also that because GDP and GNP are almost identical, NDP and NNP are almost identical.


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Exhibit 7: The Relationship Exhibit 7: The Relationship Between GDP, GNP, Net Between GDP, GNP, Net National Product, and National Product, and National Income: 2003National Income: 2003How is national income derived from gross domestic product?• First, GDP is converted to GNP. This is done by subtracting factor payments to the rest of the world and adding factor payments from the rest of the world.

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Exhibit 7: The Relationship Exhibit 7: The Relationship Between GDP, GNP, Net Between GDP, GNP, Net National Product, and National Product, and National Income: 2003National Income: 2003How is national income derived from gross domestic product?• Second, capital depreciation is subtracted from GNP. The result is net national product.

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Exhibit 7: The Relationship Exhibit 7: The Relationship Between GDP, GNP, Net Between GDP, GNP, Net National Product, and National Product, and National Income: 2003National Income: 2003

How is national income derived from gross domestic product?• Third, indirect business taxes are subtracted from net national product. The result is national income.

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Personal Income and Personal Income and Personal Disposable Personal Disposable

IncomeIncomePersonal income

• National income, plus income received but not earned, minus income earned but not received.

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IncomeIncomeTransfer payments

• Income received but not earned. For example, government-supplied income from retirement benefits, veteran benefits, unemployment insurance benefits, disability payments and subsidies to farmers.

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IncomeIncomeTransfer payments

• The government transfers income from taxpayers (who earned the income in the first place) to those receiving benefits.

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How Comprehensive Is How Comprehensive Is GDP?GDP?

GDP tries to measure everything that appears on the market. Yet, not everything produced in the economy gets onto the market, and some things that contribute to our economic well-being aren’t even produced.

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The value of housework is one example of an important service that is usually not included in GDP. The work is only included if it is performed by someone outside the household, such as a housekeeper, nanny, or cook.

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Underground economy

• The unreported or illegal production of goods and services in the economy that is not counted in GDP.

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Illegal unreported activities may include drug trafficking, money laundering, bribery, prostitution, illegal gambling, fraud and burglary.

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Tax avoidance is the main reason why legal activities may go unreported. Swapping services or simply understating the value of income earned are two ways to avoid paying taxes.

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Finally, legal and illegal immigrants may work for less than minimum wage at off-the-books entry-level jobs.

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The quality of goods and services produced may not be included in GDP. For example, a good may be of higher quality, but cost less, than a similar good. The economic value of the improved quality good is not recorded.

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While the expense associated with cleaning up the pollution we create contributes to GDP, the actual pollution created is not subtracted from GDP.

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Many economists agree that despite the exclusion of some forms of economic value, our measure of GDP is sufficiently comprehensive to be a reliable indicator of changes in the overall performance of the economy.

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