ECON 1220 Principles of Macroeconomics

Semester 2, 2011/12

Measuring National output and Income

1. Measuring Production: Gross Domestic Product (GDP) Gross Domestic Product (GDP): The total market value of all final goods and services produced within an economy in a given period of time. market value o Goods and services are counted in GDP at their market values, i.e. their market prices. o It allows adding the production of different goods and services. o Exclusion of non-market goods and services and underground economy o A few exceptions that requires imputations: Government services, such as police services and national defense. Valuing at costs. Housing services enjoyed by people living in their own houses. Imputed rent: The estimates of what the market rent for a house would be if it were rented. Food produced on farms that are self-consumed. final goods and services o GDP only includes the final goods and services that are the end products of a production process. o Exclusion of Intermediate goods and services that are used up in the production of other goods and services to avoid double-counting (or multiple-counting). o The Value-added approach: add up the value-added, which is defined as the value of the firms output minus the amount paid for intermediate goods, at each stage of production. Example: Suppose a cattle rancher sells one-quarter pound of meat to McDonalds for $0.50, and then McDonalds sells a consumer a hamburger for $1.50. What are the valueadded of the rancher and that of McDonalds? What is the sum of the value-added? o How about capital goods? goods that are used to produce other goods in future (last for many years), but are not used up in the production process. are included as final goods.

produced o Transactions that involve no production are excluded from GDP. o Exclusion of purely financial transactions: Public and private transfer payments Transactions of financial assets How about the brokerage fees the buyers and sellers pay for the services provided by the brokers, dealers and so on? in a given period of time o GDP only includes goods and services that are newly produced within the current period. o Exclusion of purchases or sales of goods produced in pervious periods. o How about inventories? Stocks of unsold finished goods, goods in process, and raw materials held by firms.

ECON 1220 Principles of Macroeconomics

Semester 2, 2011/12

The inventories are treated as being purchased by the firms themselves and are included in current GDP. What happens later when the firm sells them out of inventory?

within an economy o GDP measures those output produced within a nation. o GNP measures those output produced by domestic factors of production. GNP = GDP + net factor payments from abroad

2. Three Approaches to Compute GDP The government statistical unit responsible for measuring national production use several different ways to calculate GDP o Because different approaches provide us with different insights into the structure of the economy. o As each method is subject measurement errors, it is more prudent and accurate to look at more than a single measure. GDP can be measured in terms of: o the amount of output produced The product (value-added) approach o the amount of spending by the ultimate purchasers of output The expenditure approach o the incomes received by the households (factor owners) The income (or the factor payment) approach Circular Flow Diagram o It depicts the operation of a very simple economy consisting of households and firms only. o Total Production (Output) = Total Expenditure = Total Income

Income Resource (Production Factors) Markets Labor, Capital, Land

Factor Payments

Households (Consumers)

Firms (Producers)

Goods and Services Goods Markets Expenditure Revenue

ECON 1220 Principles of Macroeconomics

Semester 2, 2011/12

3. The Expenditure Approach: Components of Expenditure Consumption expenditure (C) o Goods and services bought by households o Includes durable goods, nondurable goods and services. (Private) Investment expenditure (I) o Goods bought by firms for future production, which includes: Fixed investment (or fixed capital formation) Mainly production plants and equipment. Newly produced residential houses (why?) Inventory investment (or change in inventories) Unsold goods are treated as capital goods as they will provide service in the future when they are finally sold and used. How about unsold tires (supposed to be intermediate goods in car production)? Including this component guarantees that GDP equals total expenditure by definition. What would happen when a local consumer buys a digital camera imported from Japan? o Net Investment = Investment depreciation (What does net investment measure?) Government purchases (G) o All goods bought by government (including government investment) o How about transfer payment, such as social security, unemployment benefits? Net Exports (NX) o NX = Exports (X) Imports (M) o Exports are goods and services produced domestically but purchased by foreign countries. o Imports are goods and services produced in foreign countries but purchased domestically. o What would happen when a local consumer buys a digital camera imported from Japan? The expenditure approach to measuring GDP: GDP = C + I + G + NX

GDP (by Expenditure Components) in Hong Kong, 2008 - 2010. 2008 Millions of $ % of GDP Private Consumption Expenditure (C) 1,022,862 61% Gross Private Investment (I) 342,832 20% Gross Domestic Fixed Capital Formation 334,352 20% Changes in Inventory 8,480 1% Government Expenditure (G) 139,262 8% Net Exports (NX) 172,055 10% Exports of Goods 2,843,998 170% Exports of Services 718,630 43% Imports of Goods 3,024,089 180% Import of Services 366,484 22% GDP 1,677,011 100%

2009 Millions of $ % of GDP 1,012,790 62% 345,671 21% 322,772 20% 22,899 1% 142,853 9% 121,008 7% 2,494,746 154% 669,829 41% 2,702,966 167% 340,601 21% 1,622,322 100%

2010 Millions of $ % of GDP 1,085,268 62% 413,531 24% 374,586 21% 38,945 2% 147,209 8% 97,850 6% 3,061,252 176% 826,856 47% 3,395,057 195% 395,201 23% 1,743,858 100%

ECON 1220 Principles of Macroeconomics

Semester 2, 2011/12

4. The Income Approach To understand the income approach to measuring GDP, we need to understand how income transfers from businesses to households:

Gross Domestic Product (GDP)

Depreciation Net Domestic Product (NDP) Statistical discrepancy Net factor income from abroad National Income (NI)

Indirect business taxes Corporate taxes Social security contributions

Undistributed profits Transfer payments and interest received from government or households

Personal Income (PI)

Personal taxes Disposable Income (DI)

Private Savings

Consumption

The income approach to measuring GDP: o National Income (NI)

4

ECON 1220 Principles of Macroeconomics

Semester 2, 2011/12

Total of all sources of household income (wages for labor services, interest income for capital, rents for land and profits for entrepreneurship) and government income generated from taxes on production (indirect business taxes).

GDP = National Income Net income from abroad + depreciation + statistical discrepancy Depreciation are added back because it is deducted from the firms total sales (= total expenditure) to calculate the corporate profits. Net income from abroad are deducted because we are computing GDP instead of GNP. Statistical discrepancy is intentionally added to match the GDP computed by expenditure approach and income approach.

5. Nominal versus Real GDP

Nominal GDP o The values of the total current output measured at the current prices.
GDPNOMINAL

CURRENT

QiCURRENT

Real GDP o The values of the total current output measured at the constant (base-year) prices.
GDPREAL

BASE

QiCURRENT

Comparison based on real GDP eliminates the influence of changes in prices and reflect the true changes in the output level.

Example: Calculation of Nominal and Real GDP 2009 Price Quantity Apple $2.00 10 Orange $1.00 30 2009 $2 x 10 + $1 x 30 = $50 $2 x 10 + $1 x 30 = $50 $2.5 x 10 + $2 x 30 = $85

2010 Price $2.50 $2.00 Quantity 20 20 2010 $2.5 x 20 + $2 x 20 = $90 $2 x 20 + $1 x 20 = $60 $2.5 x 20 + $2 x 20 = $90

Nominal GDP Real GDP (Base year = 2009) Real GDP (Base year = 2010)

(Implicit) GDP Deflator o The ratio of nominal GDP to real GDP, which is a price index
ImplicitGDP Deflator NominalGDP Real GDP

ECON 1220 Principles of Macroeconomics

Semester 2, 2011/12

Nominal and Real GDP (in 2008 dollars) in Hong Kong, 1961 - 2009

1,800,000 1,600,000 1,400,000

Millions of dollars

1,200,000 1,000,000 800,000 600,000 400,000 200,000 0

140.0

120.0

Price Index (2008 = 100)

100.0

80.0

60.0

40.0

20.0

0.0

The Chain-Weighted Real GDP (optional) o The above example shows that the value of real GDP depends on the base year used. 2009 2010 $60 $90 Ratio of 2010 real GDP to 2009 real GDP, g 1.20 1.059

Real GDP (Base year = 2009) Real GDP (Base year = 2010) o

Chain-weighted real GDP, which was first adopted in U.S. in 1995 and is also currently used in HK, largely overcomes the problem.

19 61 19 63 19 65 19 67 19 69 19 71 19 73 19 75 19 77 19 79 19 81 19 83 19 85 19 87 19 89 19 91 19 93 19 95 19 97 19 99 20 01 20 03 20 05 20 07 20 09

19 61 19 63 19 65 19 67 19 69 19 71 19 73 19 75 19 77 19 79 19 81 19 83 19 85 19 87 19 89 19 91 19 93 19 95 19 97 19 99 20 01 20 03 20 05 20 07 20 09

Implicit GDP Deflator in Hong Kong, 1961 - 2009

$50 $85

ECON 1220 Principles of Macroeconomics

Semester 2, 2011/12

A reasonable solution to the above problem is to average the two ratios, by which economists use the geometric mean:
g g (base year1) g (base year 2)

If year 1 is chosen as the base year: Year 1 real GDP = Year 1 nominal GDP
Year 2 chain - weightedrealGDP Year1 nominalGDP g

Example: Calculation of Chain-Weighted Real GDP using 2009 as base year:

g 1.2 1.059 1.127

2010Chain - weightedrealGDP (base year 2009) $50 1.127 $56.35

Nominal GDP Real GDP (Base year = 2009) Chain-weighted real GDP (Base year = 2009) o

2009 $50 $50 $50

2010 $90 $60 $56.35

It is called chain-weighted real GDP because the weights move forward from year to year.

6. Limitations of GDP as a measure of total output and economic well-being GDP per capita (i.e. GDP per person) is often used as a measure of the average standard of living. However, there are some limitations of using GDP as a measure of total output and economic well-being: o Nonmarket activities o Underground economy o Quality changes o Income distribution o Other aspects of economic well-being, such as leisure, pollution, crime rate.

Readings: Chapter 18 (p.534 553)

Well-being and wealth: The pursuit of happiness | The Economist

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Well-being and wealth

May 24th 2011, 14:44 by The Economist online

A correlation between well-being and wealth FOR more than 70 years, economists have been fixated with measuring economic ouput. Their chosen measure, gross domestic product, has limitationsit takes no account of natural-resource depletion and excludes unpaid services such as volunteering. On May 24th the OECD launched its alternative measure of well-being which includes 20 different indicators across 11 sectors in its 34 member countries, from life satisfaction to air pollution. It has produced an interactive tool (http://www.oecdbetterlifeindex.org/) which allows users to change the weight of each sector according to their own view of its importance. The chart below shows the results of its headline Better Life index (which is equally weighted) plotted against GDP per person at purchasing-power parity (which adjusts GDP for differences in the cost of living across countries). Money may not buy you happiness. But it can buy a strong correlation with a fancy new index that aims to put a number on contentment.

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Controlling pollution: The greening of China | The Economist

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Controlling pollution

The greening of China

China is investigating whether its rigid system for assessing the performance of party leaders and civil servants can be used to tackle pollution
Oct 20th 2005 | BEIJING | from PRINT EDITION

AN ELABORATE points system that determines the careers of officials is often blamed for many of China's problems. In their drive to meet targets for economic growth, local mandarins squander money, ride roughshod over citizens and ravish the environment. So now China is trying to devise and embed into its assessment of officials a way of calculating a green GDPwhich allows for environmental costs in national accountsto help mitigate some of these excesses. President Hu Jintao first endorsed the idea in March 2004, in a speech about the need to foster a scientific concept of development, a slogan intended to suggest that in pursuing growth China should pay more heed to such issues as the environment and the depletion of natural resources. Last February, the government said that ten regions, including Beijing, were carrying out a pilot project in green GDP assessment. Pan Yue, the deputy director of the State Environmental Protection Administration, said a framework for a green GDP accounting system could be unfolded within three to five years. This would make China the pioneer of a statistical approach that no other country has adoptedand which many economists around the world eschew as an attempt to quantify the unquantifiable. So why bother? Mr Pan, a media-friendly 45-year-old with a reputation for talking tough on polluters, has highlighted the problem of how China evaluates the performance of local leaders. This has evolved in the last two decades into a system of fiendish complexity. In the days of Mao Zedong, loyalty to the Communist Party was pretty well all that counted. Nowadays, adhering to the party line is only one important test. Points are awarded for an array of targets, and the promotion and bonus prospects of an official who scores below par will suffer. Targets are usually set by the next-highest level of the party (for party leaders) or government (for government officials). To minimise the need for subjective judgments, they are often very precise. A leader is told that his area must achieve a certain rate of GDP growth, attract a certain sum of inward investment and increase government revenues by a specified amount. Some of these are designated as veto targets: failing to meet them will ensure that the cadre is rated as underperforming, even if he scores well in other areas. GDP growth, population control and social order are often among the veto categories. In an autocracy, officials often feel at liberty to pursue these targets at any cost. This is why, in order to limit births or prevent public protests, officialdom is guilty of widespread abuses of human rights. The same system causes colossal waste and environmental damage as officials doggedly pursue growth targets. China is littered with extravagant and often useless building projects with no purpose except to impress superiors. One egregious example is a vast $40m airport completed in 1998 in the remote city of Fuyang in Anhui province. It has been closed for several months because it was hardly used. Of China's 660 or so cities, no fewer than 183 have vowed to turn themselves into modern international metropolises. Mr Pan says that devising a green GDP target would help to focus official minds on the price of reckless development. Such a figure would be calculated by subtracting the cost of the natural resources used and the pollution caused from regular GDP. If only it were that simple. From calculating the market value of the extinction of a species, to the cost of soil erosion resulting from the felling of trees, to the health damage from pollution, the exercise is riddled with

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1/14/2011

Controlling pollution: The greening of China | The Economist

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complexity. China's normal GDP figures are often suspect enough, particularly those produced by local governments, without adding a whole new layer of numbers even more prone to manipulation and dispute. The lack of an agreed method has not deterred some experts from coming up with green figures. Niu Wenyuan, a government adviser and professor at the Chinese Academy of Sciences, says that the country's annual average GDP growth from 1980 to 2000 of 9.6% should be really be 6.8% if reckoned greenly. This difference, he says, would not be out of line with other fast-growing countries. Academics in the northern province of Shanxi, a centre of coal production, have calculated that environmental costs and naturalresource losses amounted to 33.4% of its GDP in 2002. However, the National Bureau of Statistics, which is running the pilot programmes jointly with the environmental-protection agency, is less enthusiastic about the project. In Anhui province, one of the pilot regions, the team responsible for devising a way to calculate green GDP consists mainly of environmentalists rather than economists. Some people say the scheme is a ploy by the environment agency to draw political attention to China's pollution problem, but one that is unlikely to produce practical results.

Even without a green GDP system, there is nothing to stop governments introducing green criteria into the way they rate the performance of officials. A few have done so already. Beijing's leaders have promised stringent targets for pollution control for the 2008 Olympic Games. With huge central-government assistancewhich other governments cannot count onthe city has succeeded in reducing its air pollution (see chart). But a recent upsurge of private car ownership is undermining these efforts; note the rise last year in inhalable particulate matter, average levels of which remain triple those of American and Chinese national standards. China's top leaders themselves may be getting cold feet. A draft of the national economicdevelopment plan for the next five years, published this week, stresses the need for an a resources-saving and environment-friendly society. But it makes no mention of a green GDP.
from PRINT EDITION | Asia

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http://www.economist.com/node/5061453/print

1/14/2011