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77 5MEASURING GDP AND ECONOMIC GROWTH*Key Concepts  Gross Domestic Product Gross domestic product, GDP, is the market value of all the final goods and services produced within in a country in a given time period. ♦ A final good or service is an item that is bought by its final user during a specified time period. In con-trast, an intermediate good is an item produced by one firm, bought by another and used as a compo-nent of a final good or service. Intermediate goods are not directly included in real GDP. The circular flow of income and expenditure shows real and monetary flows in the economy. The circular flow involves: ♦ Four economic sectors — households, firms, gov-ernments, and the rest of the world. ♦ Three major markets — factor markets, goods mar-kets, and financial markets. In these markets people make their economic decisions by choosing the amounts of key economic variables: ♦ Consumption expenditures (C ) — total house-hold spending on consumption goods and services. ♦ Investment (I ) — firms’ purchase of new plants, equipment, buildings, and additions to inventories. ♦ Government purchases (G ) — government spending on goods and services. Net taxes (T ) are taxes paid to the government minus transfer pay-ments received from governments and minus inter-est payments on the government’s debt. * This is Chapter 21 in Economics. ♦ Net exports (NX ) — exports (X, sales of U.S. goods and services abroad) minus imports (M, pur-chases of foreign good and services). Aggregate expenditure, C + I + G + NX, equals aggre-gate production, GDP, and also equals aggregate in-come, Y. This equality is the basis for measuring GDP. ♦ National saving equals saving by households and businesses plus government saving: S + (T − G ). ♦ Borrowing from the rest of the world equals M − X. Investment is financed by national saving plus borrow-ing from the rest of world, I = S + (T − G ) + M − X. A flow is a quantity over a unit of time. A stock is a quantity that exists at a moment in time. Wealth and capital are stocks; saving and investment are flows. ♦ Wealth, the value of things that people own, is a stock; income, what people earn, is a flow. ♦ Saving is the amount of income remaining after spending on consumption. Saving is a flow that adds to wealth. ♦ Capital, the amount of plant, equipment, and in-ventories used to produce other goods, is a stock. ♦ Depreciation (also called capital consumption) is the decrease in the capital stock because of wear and tear and obsolescence. Gross investment is the total amount of investment. Net investment is gross in-vestment minus depreciation. Net investment is the flow that is the amount by which the capital stock changes. Gross domestic product includes depreciation and so on the income side includes firms’ gross profit (before subtracting depreciation) and on the expenditure side includes gross investment. Net domestic product ex-cludes (subtracts) depreciation so it includes firms’ net profits and net investment. ChapterCHAPTER 5 (21) 78 Measuring U.S. GDP In 2003, U.S. GDP equaled $10,847 billion. ♦ The expenditure approach measures GDP by adding final expenditures, C + I + G + NX. Of these expen-ditures, personal consumption expenditure is the largest, at about 71 percent. Gross private invest-ment is about 15 percent, government purchases of goods and services is about 19 percent, and net ex-ports is about –5 percent. ♦ The income approach adds the compensation of em-ployees, net interest, rental income, corporate prof-its and proprietors’ income to give net domestic in-come at factor cost. Indirect taxes and depreciation are added and subsidies subtracted to obtain GDP.  Real GDP and the Price Level Real GDP is the value of final goods and services pro-duced in a given year when valued at constant prices. Nominal GDP is the value of the final goods and ser-vices produced in a given year valued at the prices that prevailed in that same year. The base year prices method, which is the traditional method of calculating real GDP, values the quantities produced in each year using the prices of the base year. The chain-weighted output index method, which is the new method of calculating real GDP, uses the prices of two adjacent years to calculate the real GDP growth rate. ♦ The chain-weighted output index first calculates the value of GDP for this year and last year, using prices from last year and then calculates the growth rate of GDP between the two years. ♦ Next the chain-weighted index calculates the value of GDP for this year and last year, using prices from this year and again calculates the growth rate of GDP between the two years. ♦ The two growth rates are averaged. This average is used to scale up last year’s real GDP by multiplying last year’s real GDP by the average. The price level is the average level of prices. One measure is of the price level is the GDP deflator, which is an average of current year prices as a percent-age of base-year prices. The GDP deflator equals (Nominal GDP ÷ Real GDP) × 100.  Measuring Economic Growth The economic growth rate is the percentage change in the quantity of goods and services produced from one year to the next. It equals the growth rate of real GDP. Real GDP is used for economic welfare comparisons, for making international comparisons of output, and for business cycle forecasting. Economic welfare is a comprehensive measure of gen-eral economic well being. Real GDP is an imperfect measure of economic welfare because real GDP: ♦ Over adjusts for inflation — many quality im-provements that lead to higher prices are counted as only price hikes. ♦ Omits household production — all household pro-duction is omitted. ♦ Omits the underground economy — the under-ground economy (transactions hidden from the government) is not included. ♦ Omits health and life expectancy — neither peo-ple’s health nor life expectancy are indicated by real GDP. ♦ Omits leisure time — the value of leisure time is not included. ♦ Omits environmental quality — the consequences of adverse and beneficial environmental changes are omitted. ♦ Ignores political freedom and social justice — the extent of political freedom or social justice within a nation is not measured. Making international comparisons of real GDP can be tricky because the real GDP of one country must be


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UWW ECON 202 - MEASURING GDP AND ECONOMIC GROWTH

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