386 GROSS DOMESTIC PRODUCT: THE YARDSTICK OF AN ECONOMY’S PERFORMANCE What is the gross domestic product? GDP is the name we give to the total market value of the fi nal goods and services produced within a nation during a given year. It is the fi gure you get when you apply the measuring rod of money to the diverse goods and services—from apples to zithers—that a country produces with its land, labor, and capital resources. GDP equals the total production of consumption and investment goods, government purchases, and net exports to other lands. The gross domestic product (GDP) is the most comprehensive measure of a nation’s total output of goods and services. It is the sum of the dollar val-ues of consumption ( C ), gross investment ( I ), gov-ernment purchases of goods and services ( G ), and CHAPTER20 Of all the concepts in macroeconomics, the single most important one is the gross domestic product (GDP), which measures the total value of goods and services produced in a country. GDP is part of the national income and product accounts (or national accounts ), which are a body of statistics that enable policymakers to determine whether the economy is contracting or expanding and whether a severe reces-sion or infl ation threatens. When economists want to determine the level of economic development of a country, they look at its GDP per capita. While the GDP and the rest of the national accounts may seem to be arcane concepts, they are truly among the great inventions of the twen-tieth century. Much as a satellite in space can sur-vey the weather across an entire continent, so can the GDP give an overall picture of the state of the economy. In this chapter, we explain how econo-mists measure GDP and other major macroeco-nomic concepts. When you can measure what you are speaking about, and express it in numbers, you know something about it; when you cannot measure it, when you cannot express it in numbers, your knowledge is of a meager and unsatisfactory kind; it may be the beginning of knowledge, but you have scarcely, in your thoughts, advanced to the stage of science. Lord Kelvin Measuring Economic Activity sam11290_ch20.indd 386sam11290_ch20.indd 386 12/31/08 7:07:57 PM12/31/08 7:07:57 PMFirst PagesGROSS DOMESTIC PRODUCT: THE YARDSTICK OF AN ECONOMY’S PERFORMANCE 387net exports ( X ) produced within a nation during a given year. In symbols: GDP  C I G X GDP is used for many purposes, but the most important one is to measure the overall performance of an economy. If you were to ask an economic his-torian what happened during the Great Depression, the best short answer would be: Between 1929 and 1933, GDP fell from $104 billion to $56 billion. This sharp decline in the dollar value of goods and services produced by the American economy caused high unemployment, hardship, a steep stock market decline, bankruptcies, bank failures, riots, and political turmoil. Similarly, if you were to ask a macroeconomist about the second half of the twentieth century, she might reply: The second half of the twentieth century was a unique economic period. During those years, the affl uent regions of the North—consisting of Japan, the United States, and Western Europe—experienced the most rapid growth in output per capita in recorded his-tory. From the end of World War II until 2005, for example, real GDP per capita in the United States expanded by almost 250 percent. We now discuss the elements of the national income and product accounts. We start by showing different ways of measuring GDP and distinguishing real from nominal GDP. We then analyze the major components of GDP. We conclude with a discussion of the measurement of the general price level and the rate of infl ation. Two Measures of National Product: Goods Flow and Earnings Flow How do economists actually measure GDP? One of the major surprises is that we can measure GDP in two entirely independent ways. As Figure 20-1 shows, GDP can be measured either as a fl ow of products or as a sum of earnings. To demonstrate the different ways of measur-ing GDP, we begin by considering an oversimplifi ed world in which there is no government, foreign trade, or investment. For the moment, our little economy produces only consumption goods, which are items that are purchased by households to satisfy their wants. (Important note: Our fi rst example is oversimplifi ed to show the basic ideas. In the realistic examples that follow, we will add investment, government, and the foreign sector.) Flow-of-Product Approach. Each year the public consumes a wide variety of fi nal goods and services: goods such as apples, computer software, and blue jeans; services such as health care and haircuts. We include only fi nal goods —goods ultimately bought and used by consumers. Households spend their incomes for these consumer goods, as is shown in the upper loop of Figure 20-1. Add together all the consumption dollars spent on these fi nal goods, and you will arrive at this simplifi ed economy’s total GDP. Thus, in our simple economy, you can easily calculate national income or product as the sum of the annual flow of final goods and services: (price of blue jeans  number of blue jeans) plus (price of apples  number of apples) and so forth for all other final goods. The gross domestic product is defined as the total money value of the flow of final products produced by the nation. National accountants use market prices as weights in valuing different commodities because market prices refl ect the relative economic value of diverse goods and services. That is, the relative prices of different goods refl ect how much consum-ers value their last (or marginal) units of consump-tion of these goods. Earnings or Cost Approach. The second and equiv-alent way to calculate GDP is the earnings or cost approach. Go to the lower loop in Figure 20-1. Through it fl ow all the costs of doing business; these costs include the wages paid to labor, the rents paid to land, the profi ts paid to capital, and so forth. But these business costs are also the earnings that house-holds receive from fi rms. By measuring the annual fl ow of these earnings or incomes, statisticians will again arrive at the GDP. Hence, a second way to calculate GDP is as the total of factor earnings (wages, interest, rents, and sam11290_ch20.indd 387sam11290_ch20.indd 387 12/31/08 7:07:57 PM12/31/08