Gross Domestic Product. How Is The GDP Calculated? Net investment equals gross investment minus depreciation.

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1 Chapter 23: Measuring GDP, Inflation and Economic Growth Gross Domestic Product applegross Domestic Product (GDP) is the value of aggregate or total production of goods and services in a country during a given time period usually a year. The GDP of Canada measure the value of aggregate production in Canada during a year. (Why do we care about the GDP?) How Is The GDP Calculated? Stocks and Flows: A stock is a quantity that exists at a point in time. A flow is a quantity per unit of time. GDP is a flow: It is the value of production in a country in a given time period. Capital and Investment The key macroeconomic stock is capital: =the plant =equipment =buildings =inventories of raw materials =semi-finished goods that are used to produce other goods and services. The amount of capital in the economy is a crucial factor that influences GDP. Two macroeconomic flows change the stock of capital: Investment and Depreciation <Investment is the purchase of new plant, equipment, and buildings and the additions to inventories. Investment increases the stock of capital. <Depreciation is the decrease in the stock of capital that results from wear and tear and the passage of time. (Also referred to as capital consumption.) The total amount spent on adding to the stock of capital and on replacing depreciated capital is called gross investment. The amount by which the stock of capital increases is called net investment. Net investment equals gross investment minus depreciation. Wealth and Saving Another macroeconomic stock is wealth, which is the value of all the things that people own. What people own, a stock, is related to what they earn, a flow. People earn an income, which is the amount they receive during a given time period from supplying the services of factors of production. Income can be either consumed or saved. Consumption expenditure is the amount spent on consumption goods and services. 1 2

2 Saving is the amount of income left over after meeting consumption expenditures. The wealth of a nation at the start of a year equals its wealth at the start of the previous year plus its saving during the year. And its saving equals its income minus its consumption. The Short Term Meets the Long Term Potential GDP grows incessantly, year after year. Actual real GDP grows and fluctuates around potential GDP. Both the long-term growth in potential GDP and the short-term fluctuations in actual real GDP are influenced by the stocks and flows. One of the reasons why potential GDP grows is that the capital stock grows. And one of the reasons that real GDP fluctuates is that investment fluctuates. So capital and investment, as well as wealth and savings, are part of the key to understanding the fluctuations and long-term growth of GDP. The flows of investment and saving together with the flows of income and consumption expenditure interact in a circular flow of income and expenditure. Here, aggregate income equals aggregate expenditure which equals the value of total production. The Equality of Income, Expenditure, and the Value of Production To understand why for the economy as a whole, income equals expenditure and also equals the value of production, we study the circular flow of income and expenditure. (See figure 23.2.) The economy consists of four sectors: 1. households 2. firms 3. governments 4. the rest of the world The figure has three aggregate markets: 1. factor markets 2. goods and services markets 3. financial markets Households and Firms Households sell and firms buy the services of labour, capital, land and entrepreneurship in factor markets. For these factor services, firms pay income to households. The total income received by all households in payment for the services of factors of production is aggregate income. Firms sell and households buy consumer goods and services in the markets for goods and services. The aggregate payment that households make for these goods and services is consumption expenditure. Firms buy and sell new capital equipment in the goods market. 3 4

3 Some of what firms produce might not be sold at all and is added to inventory. The purchase of new plant, equipment, and buildings and the additions to inventories are investment. In the figure investment flows from firms through the goods markets and back to firms. Households place their savings in financial markets, and firms borrow to finance their investment in the financial markets. (Note these flows are neither income nor expenditure. Income is a payment for the services of a factor of production and expenditure is a payment for goods or services.) Governments: buy goods and services, called government expenditures, from firms. Governments use taxes to pay for their expenditures. Net taxes are equal to taxes paid to governments minus transfer payments received from governments. When government expenditures exceed net taxes, the government sector has a budget deficit, which if finances by borrowing in financial markets. The Rest of the World Sector: Firms in Canada export goods and services to the rest of the world and import goods and services from the rest of the world. The value of exports to the rest of the world minus the value of imports from the rest of the world is called net exports. If the value of exports exceeds the value of imports, net exports are positive and flow from the rest of the world to firms. But if the value of exports is less than the value of imports, net exports are negative and flow from firms to the rest of the world. When net exports are positive, the rest of the world either borrows from the domestic economy or sells domestic assets that it has bought previously. These transactions take place in financial markets. Alternatively, when net exports are negative, the domestic economy either borrows from the rest of the world or sells foreign assets that it has previously acquired. Again these transactions takes place in financial markets. Flows: The expenditure flows are consumption expenditure, investment, government expenditures and net exports. The income flow is aggregate income. The financial transfers are savings, net taxes, government borrowing, foreign borrowing and firms borrowing. Aggregate income and expenditure flows in aggregate are equal. Gross Domestic Product Gross Domestic Product (GDP) is the value of aggregate production in a country during a year. The circular flow of income and expenditure illustrate two ways of measuring GDP. Production can be valued in two ways: 1. By what buyers pay for the goods and services produced. 2. By what it costs producers to make the goods and services. These two concepts of value always give the same answer. Expenditure Equals Income 5 6

4 The total amount that buyers pay for the goods and services produced is aggregate expenditure. Firms revenues from the sale of goods and services equal consumption (C) plus investment (I) plus government expenditures (G) plus net exports (NX). The sum of these four flows (C+I+G+NX) is equal to aggregate expenditure on goods and services. The total amount it costs producers to make goods and services is equal to the incomes paid for the services of factors of production: aggregate income (Y). The sum of expenditure flows equals the income flow. The reason is that everything a firm receives from the sale of its output, it pays out as incomes to owners of the factors of production that it employs and to the households that have a claim on its profits: Y= C + I + G + NX The buyers of aggregate production pay an amount equal to aggregate expenditure, and the sellers aggregate production pay an amount equal to aggregate income. But because aggregate expenditure equals aggregate income, these two methods of valuing aggregate production give the same answer. Thus, GDP equals aggregate expenditure or aggregate income. Injections and Leakages A leakage from the circular flow of income and expenditure is income that is not spent on domestically produced goods and services. Saving, net taxes and imports are leakages. An injection into the circular flow of income and expenditure is an expenditure that does not originate with households. Investment, government expenditures, and exports are injections. Start with the equality of aggregate income and the aggregate expenditure: Y= C + I + G + NX. Net exports (NX) equals exports (X) minus imports (M). We can write the above expression as Y= C + I + G + X - M. Focusing on Households in the diagram, aggregate income (Y) flows in and consumption expenditure (C), savings (S), and net taxes (T) flow out. Everything received by households is either spent on consumption goods and services, saved or paid in net taxes, so Y= C + S + T. Subtract the second equation from the first equation and you get I + G + X - M - S - T = 0. Add saving (S), net taxes (T) and imports (M) to both sides of this equation and you get I + G + X = S + T + M. This left side is injections into the circular flow of income and expenditure and the right side is leakages from the circular flow. So: Injections always equal leakages. 7 8

5 How Investment Is Financed Investment is financed by: National saving Borrowing from the rest of the world National Saving: Saving plus government saving is called national saving. Government saving equal net taxes minus government expenditures: (T - G). If the government has a budget surplus, (T - G) is positive and this surplus is a source of finance for investment. But if the government has a budget deficit, (T - G) is negative and part of saving is used to finance the government deficit. Hence, National saving = S + (T - G). Borrowing From the Rest of the World If the value of imports (M) exceeds Canadian exports (X), we must borrow from the rest of the world an amount equal to (M - X). Part of the world s saving finances our negative net exports and frees up an equal amount of national saving to finance investment in Canada. If foreigners spend more on Canadian goods and services than we spend on theirs, foreigners must borrow from us to pay the difference. That is, part of Canadian national saving flows to the rest of the world and is not available to finance Canadian investment. 9 Measuring Canadian GDP To measure GDP, Statistics Canada use two approaches: Expenditure approach Factor incomes approach (I) The Expenditure Approach The Expenditure Approach measure GDP by collecting data on consumption expenditure (C), investment (I), government expenditure (G), exports (X) and imports (M). To measure GDP using the expenditure approach, we add together personal expenditure on consumer goods and services (C), business investment (I), government expenditures (G), and exports of goods and services (X) and subtract imports of goods and services (M). Personal expenditure on consumer goods and services is the expenditure by households on goods and services. They do not include the purchase of new residential houses, which is counted as part of investment. Business investment is expenditure on capital equipment and buildings by firms and expenditure on new residential houses by households. It also includes the change in firms inventories stocks of raw materials, semi-finished products and unsold final product held by firms. Government expenditures on goods and services are expenditures on goods and services by all levels of government. It does not include transfer payments. Exports of goods and services are the value of goods and services sold to foreign countries. 10

6 Imports of goods and services are the value of goods and services bought from foreign countries. (See Table 23.1: the largest component is personal expenditure on consumer goods and services and the smallest is business investment.) produced goods is part of GDP, but the expenditure on financial securities is not. GDP included the amount spent on new capital, not the amount spent on pieces of paper. Expenditure Not In GDP Aggregate expenditure which equals GDP, does not include everything that people and businesses buy. Refer to the expenditure included in GDP as final expenditure. Items not part of final expenditure and not part of GDP include the purchase of : 1. intermediate goods and services 2. used goods 3. financial securities Intermediate goods and services are those goods and services that firms buy from each other and use as inputs in the goods and services that they eventually produce and sell to final users. Whether a good is intermediate or final depends on what it is used for, and not on what it is. Expenditure on used goods is not part of GDP because these goods were counted as part of GDP in the period in which they were produced and which they were new goods. Firms often sell financial securities such as bonds and stock to finance purchases of newly produced capital goods. The expenditure on newly 11 12

7 (II) Factor Incomes Approach The factor incomes approach measures GDP by adding together all the incomes paid by firms to households for the services of the factors of production they hire wages for labour, interest for capital, rent for land and profits paid for entrepreneurship. The National Income and Expenditure Accounts divide factor incomes into five categories: 1. Wages, salaries and supplementary labour income: are the total payments by firms for labour services. This item includes the net wages and salaries (called takehome-pay) that workers receive plus taxes withheld on earnings plus fringe benefits such as social security and pension fund contributions. 2. Corporate profits: are the total profits made by corporations. Some of these profits are paid to households in the form of dividends, and some are retained by corporations as undistributed profits. 3. Interest and miscellaneous investment income: is the total interest payments received by households on loans made by them minus the interest payments made by households on their own borrowing. This item also includes payments for the use of land and other rented inputs. It includes payments for rented housing and imputed rent for owner-occupied housing. (Imputed rent is an estimate of what homeowners would pay to rent the housing they own and use themselves. By including this item in the national income accounts, we measure the total value of housing services, whether they are owned or rented.) Farmers income and 5. Income from non-farm incorporated businesses are a mixture of the elements that we have just mentioned. A farmer or the proprietor of an owner-operated business supplies labour, capital, and land and buildings to the business. It is difficult to split up the income earned by an owner-operator into its component parts: compensation for labour payment for the use of capital rent payments for the use of land or buildings & profit so the national income accounts lump all these separate incomes into a single category. See Table Wages, salaries and supplementary labour income is the largest factor income. The sum of these five components of factor incomes is called net domestic income at factor cost. It is not GDP. Two further adjustments are needed to get to GDP, one from factor cost to market price and another from net to gross. 14

8 Factor Cost to Market Price When we add up all the final expenditures on goods and services, we arrive at a total called gross domestic product at market price. These expenditures are valued at the market prices that people pay for the various goods and services. Another way of valuing goods and services is at factor cost. Factor cost is the value of a good or service measured by adding together the costs of all the factors of production used to produce it. If the only economic transactions were between households and firms if there were no government taxes or subsidies the market price and factor cost values would be the same. But indirect taxes and subsidies make these two method of valuation differ. An indirect tax is a tax paid by consumers when they buy goods and services. (Direct tax is a tax on income.) Because of indirect taxes, consumers pay more for some goods and services than producers receive. ŁThe market price is greater than the factor cost. A subsidy is a payment by the government to a producer. Because of subsides, consumers pay less for some goods and services than producers receive. ŁThe market price is less than the factor cost. To use the factor incomes approach to measure GDP, we must add indirect taxes to total factor incomes and subtract subsidies. This adjustment gets us closer to GDP, but it does not quite get us there. One more adjustment is needed: 15 Net Domestic Product to Gross Domestic Product If we total all the factor incomes and then add indirect taxes and subtract subsidies, we arrive at net domestic product at market prices. The word gross means before subtracting depreciation. The word net means after subtracting depreciation. A component of aggregate expenditure is gross investment. So when we total all the expenditure on final goods and services, we arrive at a number that includes depreciation, a gross measure. A component of aggregate factor incomes is the net profit of business. So when we total all the factor incomes, we arrive at a number that excludes depreciation, a net measure. To reconcile the factor incomes and expenditure approaches we must add depreciation to net domestic product. Valuing the Output of Industries To measure the value of production of an individual industry, we must be careful to count only the value added by that industry. Value added is the value of a firm s production minus the value of the intermediate goods bought from other firms. (i.e. it is the sum of the incomes including profits, paid to the factors of production used by the firm to produce its output.) A consumer s expenditure on an item is equal to the sum of the value added at each stage in its production. 16

9 Final Goods and Intermediate Goods To value output, we count only value added because the sum of the value added at each stage of production equals expenditure on the final good. ŁBy using value added we avoid double counting. Aggregate Expenditure, Income and GDP You have seen that aggregate expenditure equals aggregate income. And you have seen that Stats Canada uses both aggregate expenditure and aggregate income to measure GDP. Why does it use both approaches when they are supposed to be the same? ŁAlthough the two concepts of value of aggregate production are identical, the actual measurements, give slightly different answers. The expenditure approach uses data from surveys of retail sales, house building, and business investment, the accounts of the federal, provincial, and local governments, customs records and other sources. kthe factor incomes approach uses data supplied by Revenue Canada. The price level is the average level of prices measured by a price index. To construct a price index we take a basket of goods and services and calculate its value in the current period and its value in a base period. [ P it / P i0 ] * 100 Pit represents the price of the ith item in year t. Pi0 represents the price of the ith item in the base year. The price index is the value of the basket in the current period expressed as a percentage or the value of the same basket in the base period. The two main price indices that are used to measure the price level in Canada are: k The Consumer Price Index k The GDP Deflator The Consumer Price Index The Consumer Price Index (CPI) measures the average level of prices of the goods and services that a typical urban Canadian family consume. Measures changes over time in the price of a bundle of consumption goods and services in Canada. None of these sources gives a complete coverage of all the items that make up aggregate expenditure and aggregate income. Stats Canada can check one aggregate against the other. The Price Level and Inflation 17 Only based on price changes in cities over 30,000 people, so not fully representative. Based on the Laspeyres formula: a weighted aggregative index, 18

10 with base-period quantities as the weights; or equivalently, a weighted average of price relatives, with base-period expenditures as the weights. Not just one index: an index for each of seven major consumption groups, such as food, footwear, transportation, etc.. These are then combined, in a weighted-average manner, into the all-groups index. In each case, there are provincial and local city indices. For example, a food price index for Victoria. The indices are published monthly. In general, prices are surveyed across the country, and at several sites in each city, every month. In some cases they are surveyed more frequently (e.g., food), and in some case less frequently (e.g., haircuts). The CPI does not measure changes in the true "cost of living" The current index has a base value of 100, averaged over the 1986 calendar year, but the weights that are used are based on household survey data in To construct the CPI, Statistics Canada first selects a base year (1986). Then during the base period, it surveys consumer spending to determine the typical or average basket of goods and services that people buy in the base period. The CPI is calculated by valuing the basket of goods and services at the current month s prices. The value is expressed as a percentage of the value of the same basket in the base period.: CPI =[(Current period s value of the basket) / (Base period s value of the basket)] *100 To calculate the price index for the current period, we need only to discover the prices of the goods in the basket in the current period. We do not need to know the quantities bought. (Uses base period quantities as weights). The weights get out of date over time, as a Laspeyres formula is being used. Thus, there is a need to revise the weights periodically. Traditionally, this was done every four years in Canada. In recent times, it has been done less frequently than this. Unless the weights are revised, and the index re-based, changes in the CPI will not be representative of changes in individual prices in terms of their importance to consumers. Text: 19 20

11 The GDP Deflator The GDP deflator measures the average level of prices of all the goods and services that are included in GDP. To calculate the GDP deflator, we use the formula: GDP =[(Nominal GDP)/(Real GDP)] * 100 Nominal GDP is GDP valued in the current year s prices. It is the dollar value of GDP. Real GDP is GDP valued in the prices of the base year. Currently, the base year for the GDP deflator is What the Inflation Numbers Mean A major purpose of the CPI and GDP deflator is to measure inflation. Despite the importance of getting the numbers right, the CPI and the GDP deflator give different views of the inflation rate, and neither index is a perfect measure. Substitution Bias: A change in the CPI measures the percentage change in the price of a fixed basket of goods and services. But changes in relative prices lead consumers to seek less costly items. Substitution of cheaper items for more costly items is not picked up by the CPI. Because consumers make such substitutions, a price index based on fixed basket overstates the effects of a given price change on the inflation rate. New Goods Bias: New goods keep replacing old goods. Because some new goods are more expensive than old goods, the arrival of these new goods puts an upward bias into the estimate of the price level. Quality Change Bias: Most goods undergo constant quality improvement. Improvements in quality often mean increases in price. But such price increases are not inflation. Both measure overstate the inflation rate. The main sources of bias are: < Substitution bias. < New Goods bias. < Quality change bias

12 How Real GDP Is Used Estimates of real GDP and the real GDP growth rate are used for may purposes. But the two main uses are to: Make international comparisons of GDP Assess changes in economic welfare over time International Comparisons of GDP To make international comparisons, the real GDP of one country must be converted into the same currency as the real GDP of the other country. Economic Welfare Economic welfare is a comprehensive measure of the general state of well-being. Improvements in economic welfare depend on the growth of real GDP. But, they also depend on many other factors not measured by GDP. Some of the factors are: 1) Quality Improvements: The price indices that we use to measure inflation give a downward-biased estimate of the growth rate of real GDP. So what is really an increase in production is counted as an increase in price rather than an increase in real GDP The increase in real GDP is deflated away by the incorrectly measured higher price level. 2) Household Production: H 23 An enormous amount of production takes place in our home, but it does not involve market transactions and is not counted as part of GDP. Household production has become much more capital intensive over the years. As a result, less labour is used in household production than in earlier periods. Because we use less labour and more capital in household production, it is not easy to work out whether household production has increased or decreased over time. 3) The Underground Economy: The Underground Economy is part of the economy that is purposely hidden from the view of the government so as to avoid taxes and regulations or because the goods and services being produced are illegal. Because underground economic activity is unreported, it is omitted from GDP. 4) Health and Life Expectancy: Ø Good health and long life do not show up in real GDP. A higher real GDP does enable us to spend more on medical research, health care, healthy food and exercise equipment. As real GDP increased, life expectancy increased. -But we face new health and life expectancy problems every year. When we take these negative influences into account, we see that real GDP growth overstates the improvements in economic welfare. 5) Leisure Time: o b 24

13 Leisure time is an economic good that adds to our economic welfare. OTRS, the more leisure we have, the better off we are. Our time spent working is valued as part of GDP, but our leisure time is not. The improvements in economic well-being are not reflected in GDP, so real GDP growth understates the improvement in economic welfare. 6) The Environment: N Resources used to protect the environment are valued as part of GDP. But if we did not include these resources to protect the environment and instead polluted the atmosphere, we would not count the deteriorating air that we were breathing as a negative part of GDP. 7) Political Freedom and Social Justice: Z A country might have a very large real GDP per person but have limited political freedom and equity. Such an economy would generally be regarded as having less economic welfare than one that had the same amount of real GDP but in which political freedoms were enjoyed by everyone. 8) The Net Outcome: The influences omitted from real GDP are probably important and could be large. The measurement error could overstate the rate of economic growth and the improvement in economic welfare. 25