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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
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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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