sysra insert home num Ik pgup serik pgdn ene CHAPTER 25 Measuring Domestic Output and National Income 559 be the same. And yet it is the quantity of goods and services that get produced and distributed to households that af- and services. For instance, the McDonald's hamburger fects our standard of living, not the price of those goods that sold for 95 cents in 2013 yields the same satisfaction as a nearly identical McDonald's hamburger that sold for In the actual economy, a price index is a measure of the price of a specified collection of goods and services, called a “market basket," in a given year as compared to the price of an identical (or highly similar) collection of goods and services in a reference year. That point of refer- ence, or benchmark, is known as the base period, base year, or, simply, the reference year. More formally, Price price of market basket index in specific year x 100 (1) in given price of same market year basket in base year 18 cents in 1967. The way around this problem is to deflate GDP when prices rise and to inflate GDP when prices fall. These ad- justments give us a measure of GDP for various years as if the value of the dollar had always been the same as it was in some reference year. A GDP based on the prices that prevailed when the output was produced is called unad- justed GDP, or nominal GDP. A GDP that has been de- flated or inflated to reflect changes in the price level is called adjusted GDP, or real GDP. By convention, the price ratio between a given year and the base year is multiplied by 100 to facilitate computa- tion. For example, a price ratio of 2/1 (= 2) is expressed as a price index of 200. A price ratio of 1/3 (= 0.33) is ex- pressed as a price index of 33. In our pizza-only example, of course, our market bas- ket consists of only one product. Column 2 of Table 25.5 reveals that the price of pizza was $10 in year 1, $20 in year 2, $25 in year 3, and so on. Let's select year 1 as our base year. Now we can express the successive prices of the contents of our market basket in, say, years 2 and 3 as com- pared to the price of the market basket in year 1: Price index, year 2 = $20 x 100 = 200 $10 - Adjustment Process in a One-Product Economy There are two ways we can adjust nominal GDP to reflect price changes. For simplicity, let's assume that the econ- omy produces only one good, pizza, in the amounts indi- cated in Table 25.5 for years 1, 2, and 3. Suppose that we gather revenue data directly from the financial reports of the economy's pizza businesses to measure nominal GDP in various years. After completing our effort, we will have determined nominal GDP for each year, as shown in col- umn 4 of Table 25.5. We will have no way of knowing to extent changes in price and/or changes in quantity of output have accounted for the increases or decreases in nominal GDP that we observe. GDP Price Index How can we determine real GDP in our pizza economy? One way is to assemble data on the price changes that occurred over various years (column 2) and use them to establish an overall price index for the entire period. Then we can use the index in each year to adjust nominal GDP to real GDP for that year. Price index, year 3 $25 x 100 = 250 $10 what rose from For year 1 the index has to be 100, since that year and the base year are identical. The index numbers tell us that the price of pizza year 1 to year 2 by 100 percent {= [(200 100)/100] x 100} and from year 1 to year 3 by 150 per- cent {= [(250 - 100)/100] X 100). Dividing Nominal GDP by the Price Index We can now use the index numbers shown in column 3 to deflate TABLE 25.5 Calculating Real GDP (Base Year = Year 1) (2) Price of Pizza (3) Price Index (Year 1 = 100) 100 200 (4) Unadjusted, or Nominal, GDP (1) X (2) $ 50 140 200 per Unit Year (5) Adjusted, or Real, GDP $50 70 80 (1) Units of Output 5 7 8 10 11 $10 20 250 2 3 4 25 30 28 1 1 sysra insert home num Ik pgup serik pgdn ene CHAPTER 25 Measuring Domestic Output and National Income 559 be the same. And yet it is the quantity of goods and services that get produced and distributed to households that af- and services. For instance, the McDonald's hamburger fects our standard of living, not the price of those goods that sold for 95 cents in 2013 yields the same satisfaction as a nearly identical McDonald's hamburger that sold for In the actual economy, a price index is a measure of the price of a specified collection of goods and services, called a “market basket," in a given year as compared to the price of an identical (or highly similar) collection of goods and services in a reference year. That point of refer- ence, or benchmark, is known as the base period, base year, or, simply, the reference year. More formally, Price price of market basket index in specific year x 100 (1) in given price of same market year basket in base year 18 cents in 1967. The way around this problem is to deflate GDP when prices rise and to inflate GDP when prices fall. These ad- justments give us a measure of GDP for various years as if the value of the dollar had always been the same as it was in some reference year. A GDP based on the prices that prevailed when the output was produced is called unad- justed GDP, or nominal GDP. A GDP that has been de- flated or inflated to reflect changes in the price level is called adjusted GDP, or real GDP. By convention, the price ratio between a given year and the base year is multiplied by 100 to facilitate computa- tion. For example, a price ratio of 2/1 (= 2) is expressed as a price index of 200. A price ratio of 1/3 (= 0.33) is ex- pressed as a price index of 33. In our pizza-only example, of course, our market bas- ket consists of only one product. Column 2 of Table 25.5 reveals that the price of pizza was $10 in year 1, $20 in year 2, $25 in year 3, and so on. Let's select year 1 as our base year. Now we can express the successive prices of the contents of our market basket in, say, years 2 and 3 as com- pared to the price of the market basket in year 1: Price index, year 2 = $20 x 100 = 200 $10 - Adjustment Process in a One-Product Economy There are two ways we can adjust nominal GDP to reflect price changes. For simplicity, let's assume that the econ- omy produces only one good, pizza, in the amounts indi- cated in Table 25.5 for years 1, 2, and 3. Suppose that we gather revenue data directly from the financial reports of the economy's pizza businesses to measure nominal GDP in various years. After completing our effort, we will have determined nominal GDP for each year, as shown in col- umn 4 of Table 25.5. We will have no way of knowing to extent changes in price and/or changes in quantity of output have accounted for the increases or decreases in nominal GDP that we observe. GDP Price Index How can we determine real GDP in our pizza economy? One way is to assemble data on the price changes that occurred over various years (column 2) and use them to establish an overall price index for the entire period. Then we can use the index in each year to adjust nominal GDP to real GDP for that year. Price index, year 3 $25 x 100 = 250 $10 what rose from For year 1 the index has to be 100, since that year and the base year are identical. The index numbers tell us that the price of pizza year 1 to year 2 by 100 percent {= [(200 100)/100] x 100} and from year 1 to year 3 by 150 per- cent {= [(250 - 100)/100] X 100). Dividing Nominal GDP by the Price Index We can now use the index numbers shown in column 3 to deflate TABLE 25.5 Calculating Real GDP (Base Year = Year 1) (2) Price of Pizza (3) Price Index (Year 1 = 100) 100 200 (4) Unadjusted, or Nominal, GDP (1) X (2) $ 50 140 200 per Unit Year (5) Adjusted, or Real, GDP $50 70 80 (1) Units of Output 5 7 8 10 11 $10 20 250 2 3 4 25 30 28 1 1 Billions e $16,245 2,543 $13,702 GALE 25.4 The Relationship between P, NDP, NI, PI, and Dl in the anded States, 2012* CHAPTER 25 Measuring Domestic Output and National Income 557 Boss domestic product (GDP) Lees: Consumption of fixed capitat adds to U.S. GDP, but some of U.S. consumption, govern- Luas Net domestic product Ne domestic product (NDP) Less: Statistical discrepancy Equa's National income (NI) PUs. Net foreign factor income National income (NI) Lass: Taxes on production and imports Less: Social Security contributions Less: Corporate income taxes LASS Undistributed corporate profits $13,702 -17 253 $13,972 Also, take a look at the foreign sector (all other countries) in the flow diagram. Spending by foreigners on U.S. exports ment, and investment expenditures buy imported products . The flow from foreign markets shows that we handle this complication by calculating net exports (U.S. exports minus U.S. imports). The net export flow may be a positive or nega- tive amount, adding to or subtracting from U.S. GDP. Finally, you need to be aware that the flows shown in Figure 25.3 are dynamic entities and generally expand in size over time as the economy grows. But not always! Case in point: The Great Recession of 2007–2009—first dis- cussed in the Consider This box on page 539–produced a pronounced slowing of the main spending and income flows. Specifically, U.S. businesses greatly reduced invest- ment expenditures and households initially reduced per- sonal consumption expenditures. Consequently, GDP, NDP, NI, and PI all significantly declined. 3 $13,972 1.066 951 435 542 2,766 $13,744 Plus: Transfer payments Equals: Personal income (PI) QUICK REVIEW 25.2 Personal income (Pl) Less: Personal taxes $13,744 1,498 $12,246 Equals: Disposable income (DI) Some of the items combine categories that appear in the more detailed accounts. Source: Bureau of Economic Analysis, www.bea.gov. Net domestic product (NDP) is the market value of GDP minus consumption of fixed capital (depreciation). National income (NI) is all income earned through the use of American-owned resources, whether located at home or abroad. NI also includes taxes on production and imports. Personal income (PI) is all income received by house- holds, whether earned or not. Disposable income (DI) is all income received by households minus personal taxes. The Circular Flow Revisited Figure 25.3 is an elaborate flow diagram that shows the economy's four main sectors along with the flows of ex- penditures and allocations that determine GDP, NDP, NI, and PI. The orange arrows represent the spending flows- C+1 + G + X,—that together measure gross domestic product . To the right of the GDP rectangle are green arrows that show first the allocations of GDP and then the adjustments needed to derive NDP, NI, PI, and DI. The diagram illustrates the adjustments necessary to determine each of the national income accounts. For ex- mple, net domestic product is smaller than GDP because consumption of fixed capital flows away from GDP in de- termining NDP. Also, disposable income is smaller than personal income because personal taxes flow away from PI o government) in deriving DI. Note the three domestic sectors of the economy: households, government, and businesses. The household sector has an inflow of disposable income and outflows of consumption spending and savings. The government sector has an inflow of revenue in the form of types of taxes and m outflow of government disbursements in the form of purchases and transfers. The business sector has inflows Nominal GDP versus Real GDP LO25.5 Discuss the nature and function of a GDP price index, and describe the difference between nominal GDP and real GDP. Recall that GDP is a measure of the market or money value of all final goods and services produced by the econ- omy in a given year. We use money or nominal values as a common denominator to sum that heterogeneous output into a meaningful total. But, as alluded to in Chapter 24, that creates a problem: How can we compare the market values of GDP from year to year if the value of money it- self changes in response to inflation (rising prices) or de- flation (falling prices)? After all, we determine the value of GDP by multiplying total output by market prices. Whether there is a 5 percent increase in output with no change in prices or a 5 percent increase in prices with no change in output, the change in the value of GDP will and an outflow of investment expenditures. sources of funds for business investment 560 PART SEVEN GDP, Growth, and Instability TABLE 25.6 Steps for Deriving Real GDP from Nominal GDP U.S the nominal GDP figures in column 4. The simplest and most direct method of deflating is to express the index numbers as hundredths—in decimal form—and then to divide them into corresponding nominal GDP. That gives us real GDP: Method 1 1. Find nominal GDP for each year. 2. Compute a GDP price index. 3. Divide each year's nominal GDP by that year's price index (in hundredths) to determine real GDP. Method 2 of th bee GD GD acki 200 of t1 and prices for each year. 1. Break down nominal GDP into physical quantities of output 2. Find real GDP for each year by determining the dollar amount that each year's physical output would have sold for if base- year prices had prevailed. (The GDP price index can then be the W25.2 found by dividing nominal GDP by real GDP.) year state to d year real nominal GDP Real GDP = (2) price index (in hundredths) Column 5 shows the re- WORKED PROBLEMS sults. These figures for real GDP measure the market value of the output of pizza Real GDP and price indexes in years 1, 2, and 3 as if the price of pizza had been a constant $10 throughout the 3-year period. In short, real GDP reveals the market value of each year's output measured in terms of dollars that have the same purchasing power as dollars had in the base year. To test your understanding, extend Table 25.5 to years 4 and 5, using equations 1 and 2. Then run through the entire deflating procedure, ORIGIN OF THE IDEA using year 3 as the base pe- riod. This time you will have to inflate some of the GDP price nominal GDP data, using index the same procedure as we used in the examples. $140 divided by the real GDP of $70. Note that equation 3 is simply a rearrangement of equation 2. Table 256 summarizes the two methods of determining real GDP in our single-good economy. 1 flati min the the with 025.1 Real-World Considerations and Data In the real world of many goods and services, of course, determining GDP and constructing a reliable price index are far more complex matters than in our pizza-only econ- omy. The government accountants must assign a "weight" to each of several categories of goods and services based on the relative proportion of each category in total output. They update the weights annually as expenditure patterns change and roll the base year forward year by year using a moving average of expenditure patterns. The GDP price index used in the United States is called the chain-type annual-weights price index—which hints at its complexity . We spare you the details. Table 25.7 shows some of the relationships between nominal GDP, real GDP, and the GDP price index for the GD dete cula $16. the X 10 nom real $15 dred An Alternative Method Another way to calculate real GDP is to gather separate data on physical outputs (as in column 1) and their prices (as in column 2) of Table 25.5. We could then determine the market value of outputs in successive years if the base- year price ($10) had prevailed. In year 2, the 7 units of pizza would have a value of $70 (= 7 units X $10). As column 5 confirms, that $70 worth of output is year 2's real GDP. Similarly, we could determine the real GDP for year 3 by multiplying the 8 units of output that year by the $10 price in the base year. Once we have determined real GDP through this method, we can identify the price index for a given year simply by dividing the nominal GDP by the real GDP for twee min and thos TABLE 25.7 Nominal GDP, Real GDP, and GDP Price Index for the United States, Selected Years (1) Year (2) Nominal GDP, Billions (3) Real GDP, Billions (4) GDP Price Index (2009 = 100) 1995 that year: $10,167.3 2000 2005 81.9 92.0 $ 7,664.0 10,289.7 13,095.4 14,417.9 14,958.3 16,244.6 14,235.6 2009 100.0 Price index nominal GDP (in hundredths) real GDP (3) Example: In year 2 we get a price index of 200-or, in hundredths, 2.00—which equals the nominal GDP of 2010 2012 14,779.4 15,547.0 101.2 104.5 government revision. Source: Bureau of Economic Analysis, www.bea.gov. All data are subject to
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