Chapter Four: Notes -- Output and National Income

• Gross Domestic Product (GDP)
• Measuring GDP
• Gross National Product (GNP)
• The Business Cycle
• Useful Web Resources

Gross Domestic Product (GDP)

In Adam Smith's day, economies that stock-piled the most gold were thought to be the wealthiest. The U.S. today runs a large trade deficit; it imports more than it exports. If economies were on the gold standard, the U.S. would be shipping large amounts of gold to other countries to support the trade deficit. Yet, the U.S. is by most measures the wealthiest nation in the world. Adam Smith pointed out in The Wealth of Nations that material wealth is determined by a nation's ability to consume, which in turn is determined by its output. A nation's citizens in the long run can consume additional goods and services only by producing additional goods and services.

The U.S. government's Bureau of Economic Analysis has a whole system of accounting that tracks and classifies economic activity. This system is called National Income and Product Accounting (NIPA). It tracks everything from the level of output to the level of private investment, an essential task to have an accurate picture of the performance of the macroeconomy. For reasons discussed above, one of the most important statistics is a measure of the nation's output, Gross Domestic Product.

Gross Domestic Product (GDP) is the money value of all final goods and services produced in a country's borders in a given year. This statistic measures the size of the economy by its production level. The figure titled "U.S. GDP" plots the level of GDP between 1971 and the first quarter of 2006. As of the first quarter of 2006, (nominal) GDP in the United States was $13.0 trillion. The consistent upward trend in U.S. production reflects a combination of real output growth and inflation. The Federal Reserve Bank of St. Louis lists GDP data by quarter from 1947 to the present. The Bureau of Economic Analysis also has updated statistics on the components of GDP.

Because Gross Domestic Product is such an essential measure for describing an economy's performance, it is important to elaborate on the economic activity that GDP does not include. These exceptions are:

1. Sale of used goods: Because used goods are not newly produced, they are excluded from GDP. The sale of a used car, for example, is not counted because the good was already counted in the year of production. Likewise, the sale of an existing home is not counted in GDP. The home was counted in the year it was produced.

2. Production of intermediate goods: GDP measures only the production of final goods and services. These are goods and services sold to the end user. Suppose that we counted all production all the way through the production process. Let's take production of an automobile as an example. Suppose we add all the production that comes from glass factories, all the production from producers of rubber, and all the production from plastic and steel firms. Then we add into GDP the value of an automobile as it rolls off the assembly line. What have we done? Because the automobile contains glass for the windows, rubber in the tires, plastic on the interior, and steel on the exterior, we have double counted. By counting production of all goods and services, we overstate true GDP. To avoid double counting, we must count only production of goods and services produced for the end user. In other words, the car is counted in GDP but the intermediate goods that went into producing the car are not counted. What about a final good that is produced in the current year but not sold until the next year? That good is counted in GDP as inventory investment. Remember that GDP counts the production, not the sale of goods and services.

3. The underground economy: Underground economic transactions are not counted in GDP. The illicit drug and gambling trades, for example, are not included. The main reason for these exclusions is that--for obvious reasons--we have poor data on the amount of production in the underground economy. If the government could reliably count this production, economists would like to add it to GDP to better reflect the economy's production activity.

4. Purely financial transactions: Purely financial transactions, such as the purchase of stocks, bonds, or certificates of deposit, are not counted. We exclude these items because they are not examples of production of goods and services. These transactions simply involve the transfer of assets from one entity to another. If someone purchases stock, that person lends funds to the company who issued the stock. If stock sales are not recorded in GDP, should broker services for trading stocks be included? Sure. Broker services are newly produced services, part of a nation's GDP.

5. Non-market transactions: Non-market transactions are not included in GDP because the production activity is not recorded. If a homeowner has his kitchen remodeled and hires a remodeling company to do the job, the exchange is recorded and shows up in GDP. On the other hand, if the homeowner does the remodeling himself, only the value of the materials sold to the end user appears in GDP. The labor spent on the remodeling is not recorded because it was not traded through a market. Likewise, the services of homemakers who raise their children are not recorded. But if a child is in an official day care, that service is recorded in GDP.

6. Imports: Finally, because GDP counts production in the nation's domestic borders, it does not count imports, where imports are defined as production that occurs outside of the economy's borders. Imported clothing or watches, for example, do not contribute to GDP.

Unfortunately, Gross Domestic Product is not a perfect measure of the health of a nation's economy. Ideally, we would like a measure that increases when people's well-being rises, and falls when well-being declines. GDP generally works this way, but the correlation between production and people's well-being is imperfect for a few reasons.

First, GDP does not measure directly many quality-of-life issues such as the environment and public safety. GDP does not, for example, take into account air and water quality, though it does include the production activity that pollutes the air and water, and it accounts for the production activity to clean the air and water. In addition, GDP increases with the number of jails that a society builds and with the number of correctional officers it employs; however, a society that has to build more jails is not necessarily better off than a low-crime society with fewer jails. In sum, two nations may have equal levels of GDP, even though one nation has much dirtier air and water and higher crime rates than the other nation.

A second shortcoming of GDP is that it fails to account for the leisure time we enjoy. Wealthier societies tend to enjoy more leisure time as income increases. If people take more leisure time, all else equal, GDP falls with the level of recorded production.

Third, GDP does not decrease with the destruction of goods and services. If we have an earthquake, for example, GDP may actually rise due to the reconstruction and clean-up that follows. GDP does not decline, however, by the amount of the damage done.

Fourth, GDP weights all production by its market value regardless of the impact that it has on consumers. It doesn't matter, for example, if our society produces $1 billion worth of missiles or $1 billion worth of bread. GDP increases by $1 billion either way.

Finally, GDP says nothing about how the wealth and consumption in the nation is distributed. It may be the case that most of the wealth is concentrated in just a few hands. We have to examine income distribution independently to see how the wealth is being shared among the nation's citizens.

Despite these flaws, GDP is an excellent indicator of the size and health of an economy. When GDP declines, the economy is contracting and it is likely that it is in recession. When GDP grows quickly, the economy is vibrant with an abundance of new jobs being created.

Gross Domestic Product measures the size of an economy, but an economy with more people, other things equal, will have a larger GDP. If China with a population 1.2 billion had the same level of GDP as the U.S. with a population of 300 million, then U.S. citizens would be on average four times as wealthy as Chinese citizens. (In reality, the average U.S. citizen is about eight times as wealthy as the average Chinese citizen.) To measure the average wealth of people in the nation, it is appropriate to scale GDP by the size of the population. GDP per capita is GDP divided by the population. This statistic is a good indicator of the average standard of living in the economy. It represents the average amount of production that each person produces in the economy. If GDP per capita is high, the average standard of living is high.

Measuring GDP

The expenditure approach involves adding up the expenditures on all final goods and services. Expenditures fall into one of four categories: consumption, investment, government expenditures, and net exports. (We deal with these terms in detail in Chapter 8). By counting the value of all domestic production for the end user, we arrive at GDP. Newly produced consumption goods and services such as clothing, food, cars, haircuts, and tax consulting are included in GDP. Newly produced investment goods like computers, office buildings and tractors are also counted. We count government purchases of goods and services such as spending for education and defense, as well as production of exports--goods and services produced domestically but sold in other countries.

The income approach involves adding up all the income earned by individuals in the domestic country. This approach is in theory equal to the expenditure approach because the revenue from production has to be distributed to somebody in the economy. Most of the revenue goes to workers in the form of wages and salaries. Portions of the revenue go to owners of capital in the form of rent and interest income. What is not distributed in wages, salaries, rent, or interest, goes to profits. Owners of the firms receive this income. Therefore, the value of production (GDP) equals national income.

The income approach helps us to value the production of some goods and services that do not have explicit market prices. Public grade schools, for example, provide education services but they do not "sell" their services by charging tuition the way that private schools do. What is the appropriate value to place on grade school services? The expenditure approach makes this valuation difficult. The income approach, however, estimates the value of a public grade school by adding all the incomes from the teachers, staff, and administrators.

The final method to measure GDP is the value added approach. This method involves counting the production of all goods and services, whether they are produced for the end user or not. To avoid double counting, however, we count only the value that each firm adds to the production process. The value added is calculated as the revenue generated from production less the cost of raw materials. If at a tire factory $8,000 worth of rubber comes in one door, and $20,000 worth of tires goes out the other door, value added is $12,000--the value of the tires less the cost of the rubber inputs.

Any of these three approaches conceptually results in the same value for GDP. In practice the Bureau of Economic Analysis relies on survey data from firms to estimate production and income. If production numbers give different results than the income numbers, the BEA makes a judgment call and calculates GDP based on some weighted average of the two data sources.

Gross National Product (GNP) was the primary production statistic in the United States before 1991, when the government switched to GDP. (Nominal) Gross National Product is the money value of all final goods and services produced by a country's residents in a given year. GNP is identical to GDP except that the qualification for counting production changes from physical location to ownership of resources. Using GNP, production from a Japanese-owned Toyota plant located in Ohio would not be counted. Conversely, the Ford plant in Mexico would be counted in GNP but not GDP. GNP as of the first quarter of 2006 was $13.0 trillion. The Federal Reserve Bank of St. Louis lists quarterly GNP data from 1959 to the present. The figure titled "U.S. GNP" graphs this data series between 1971 and 2006.

There were two reasons for the switch from GNP to GDP. First, many other countries used GDP as their primary measure of output. This change brought the U.S. in line with international conventions. Second, increased international ownership of resources made the ownership of production activities less important than the physical location. The primary measure of output is supposed to reflect the health of the economy. If a U.S.-owned firm located in Taiwan is doing well, most people in the United States are entirely unaffected. Conversely, a foreign-owned firm located in the United States hires and pays workers just like domestically owned firms.

The difference between GDP and GNP from the U.S. perspective is summarized by the following equation:

Beginning with GNP, we arrive at GDP by adding production of foreign-owned firms located in the U.S., and we subtract production of U.S.-owned firms located abroad.

Suppose that the Toyota plant in Ohio is jointly owned by Japanese and U.S. investors. By simply excluding the production from GNP, we understate "true" GNP. Because firms are often jointly owned, in practice the difference between GDP and GNP is made up by net factor payments. To go from GNP to GDP, we subtract income earned by U.S. citizens on investments abroad, and add income earned by foreigners on investments located in the U.S. The figure titled "GDP vs. GNP" illustrates that as of the first quarter of 2006, U.S. GDP and GNP were nearly identical. This equality suggests that income earned by U.S. citizens abroad is just about equal to income earned by foreigners in the U.S. In many developing countries, GDP exceeds GNP by a wide margin because foreign investment in the country exceeds investment abroad by the domestic citizens.

The Business Cycle

In all capitalistic economies, production through time tends to move in a cyclical fashion. This cyclical behavior of the economy's output is known as the business cycle. The downward periods of negative real growth in GDP are called recessions. A recession is loosely defined as six or more consecutive months of decline in real GDP. More specifically, the National Bureau of Economic Research (NBER)Business Cycle Dating Committee has the responsibility of dating business cycles. They use several criteria including manufacturing production and employment. The committee dated the beginning of the most recent recession as March 2001; the end of the recession officially ended in November 2001, making the latest recession just eight months long. In the post-war era, U.S. expansions typically last 52 months while contractions last 10 months.

When the economy goes into recession, unemployment rises and inflation (usually) falls. The upward growth periods imply that the economy is experiencing economic growth. In these periods, unemployment falls while inflation tends to rise. The figure titled "Growth Rate of Real GDP" plots inflation-adjusted GDP growth from 1980 through the first quarter of 2006. Note the shaded areas that depict the recessions of 1980, 1982, 1990-91 and 2001. In each of those time periods, the growth rate of real GDP was negative.

Economists have studied business cycles for many years, but we still do not completely understand why nations experience these cycles. We have made good progress, however, in combating business cycles. The attempt to flatten out the business cycle is called stabilization policy. We deal next with two results of business cycles--inflation and unemployment.

Useful Web Resources

• See what economists are forecasting for economic growth rates over the next few years. Get a glimpse into these crystal balls at the Philadelphia Fed's Economic forecasting site.

• Read this Updated Summary NIPA Methodologies for more detail than you ever wanted to know about how the Bureau of Economic Analysis estimates Gross Domestic Product.

• Observe the different levels of GDP per capita across OECD countries (search for 'GDP per capita'). Notice that Mexico's GDP per capita is about one-fourth the level of that in the U.S.