Inthischapterwelookathowtheeconomy'soutputismeasured.

Weusethe
NationalIncomeandProductsAccounts(NIPA),asystemofnationalincome
accountingdevelopedduringthe1920sand1930stomeasurenationalincome
ornationaloutput(seep.157,economistSimonKuznets).Justlikeafirm
needsaccountingtomeasureincometocalculateprofitsorlosses,theentire
economyneedsanincomestatement.
GrossDomesticProduct(GDP)isthemostwidelyusedmeasureofeconomic
performancearoundtheworld.Wecurrentlyhavealmost$11TofannualGDP
intheU.S.GDPmeasuresthetotalmarketvalueortotalspendingonallfinal
goodsandservicesproduceddomesticallyduringaspecificperiod,usually
quartersoryears.
BureauofEconomicAnalysisatDeptofCommercetrackstheeconomyand
releasesthefiguresonGDPonaquarterlybasis.Timeframewearenowin
thesecondquarter(asthenotesareupdated)of2003(April,May,June).The
firstestimateofQII2003GDPwillbereleasedaroundAug.1,secondestimate
onSept.1andthefinalestimatearoundOct.1.Ittakesthreemonthsafterthe
endofquarterandsixmonthsafterthestartofthequartertofinalizedata.This
timeframeforthereleaseofGDPwillbecomeveryimportantlaterinthe
coursewhenwediscusspolicy(fiscalandmonetary).

WHATCOUNTSINGDP?:
1.OnlyFINALgoodsandservicespurchasedbyfinalusers.Onlyretail
salescount,notintermediate(wholesale)goodsortransactions.WhenGM
buyssteel,tiresortransmissions,thosetransactionsdon'tcountbecauseit
wouldbedoublecountingsincethoseexpenditureswillbeaccountedforinthe
finalretailpriceofthecar.Forexample,supposeGMspends$15,000foracar
andsellsittoadealerfor$16,000andthedealersellsitfor$17,000.Weonly
countthe$17,000forthefinalretailsale.Wecan'tcount$15,000+16,000+
17,000=$48,000.Onlythevalueofthefinaloutputiscounted,andthevalue
oftheinputsarenotdirectlycountedsincetheirvalueisreflectedinthefinal
purchaseprice.
SeeExample,page158.Breadexample.

2.Onlygoodsandservicesproducedduringthetimeperiodare
counted.Onlynewproductioniscounted,notsecondhandsales.Example:
salesofusedcarsandusedhousesdon'tcount.Theywerealreadycountedas
newproductionintheyearbuilt.Resaledoesn'tgetcountedincurrentGDP.
Commissionsonusedcarsorhouseswouldgetcounted,becausetheyare
currentservices.
3.Financialtransactionsandincometransfersare
excluded.Example:stockorbondpurchaseisjustatransferofmoneyfrom
oneindividualtoanother,itdoesnotinvolvecurrentproductionofagoodor
service.Commissionswouldcount,asacurrentservice(income)providedby
thebroker.Giftsandincometransfers(SocialSecurity,welfare,veterans'
pmts,etc.)alsodon'tcount,sincenocurrentproductionofgoodsorservicesis
involved.
4.ONLYDomesticProductionisCounted,regardlessofwhoprovidedthe
labor.ForeigncitizensworkingintheU.S.counttowardU.S.GDP,sincetheir
laborcontributedto"domesticproduction."U.S.citizensworkingtemporarily
overseasdoesNOTcountinU.S.GDP,sincetheirlabordoesnotcontributeto
"domesticproduction."
GDPvs.GNPGDPmeasuresdomesticproductionwithinthe50states,
regardlessofwhoprovidedthelabororcapital,UScitizensorforeigners.GNP
measurestheproductionofUS"nationals,"U.S.citizensregardlessofwhere
theyareworking.
Example:
CanadiancitizencrossesthebordertoworkinDetroit.ThatcountsinU.S.
GDPbutnotinU.S.GNP.UScitizencrossesthebordertoworkinCanada,
thatcountsinU.S.GNPbutnotinU.S.GDP.
NOTE:GDPismeasuredinU.S.dollars,allmarkettransactionsforfinalgoods
andservicesaremeasuredandsummedindollarstocalculatequarterlyor
annualnominalGDP.

TWOWAYSOFMEASURINGGDP
ExpenditureApproachvs.ResourceCostIncomeApproach.

$spentonfinalgoodsbyconsumers=GDP=$spentbyproducerstoproduce
finalproducts
Example:Newhousesellsfor$100,000=Expenditureapproach.
ResourceCostIncomeapproach=$50,000spentonmaterialsandsupplies
(lumber,appliances,siding,windows,etc.),$40,000spentonlabor(carpenters,
plumbers,electricians,architect,etc.)and$10,000profittodeveloper.=Total
$100,000.
Seepage160161,Exhibits72and73:"TwoWaysofMeasuringGDP."

EXPENDITUREAPPROACH:C+I+G+NetExports(XM)
Howwasmoneyspentduringtheyearbyconsumers,businessesand
governments?
1.PersonalConsumptionExpenditures(PCE)largestpercentageofGDP
almost70%or$7Tin2001.BreakdownofPCEDurablegoods,Nondurables
andServices(almost60%ofPCE).
a.DurableGoodsGoodsthatlastlongerthanoneyear.Autos,furniture,
appliances,etc.
b.NondurableGoodsFood,clothing,fuel,shampoo,toothpaste,medicine,
prescriptions,officesupplies,etc.
c.ServicesInsurance,education,medicalservices,legalservices,consulting,
accounting,recreation,entertainment,etc.
Nondurablesandservicesmakeupalmost90%ofPCE.
2.GrossPrivateInvestmentTwocomponents:a)FixedInvestmentandb)
Inventories.
a.FixedInvestmentBusinessinvestmentinproperty,plantandequipment.
Businessspendingoncapitalequipment(durableassets),andHousehold
Investmentinhousing.

GrossInvestmentincludestwocomponents:a)Replacingwornoutequipment
andb)Newadditionstocapitalstock.
NetInvestment=GrossInvestmentAmountSpentonReplacement
Example:inUS,about$1634Bwasspentongrossinvestmentin2001,about
$1100Btoreplacewornoutequipmentandabout$500BwasNetInvestment.
FutureeconomicgrowthdependsonNetInvestment(NI),becauseNIenhances
futureproductivepotential.Investmentisforthefuture.ShiftsoutPPFby
increasingcapitalstockoftheeconomy.
b.Inventoryinvestment.ChangeinInventory.GDPmeasurescurrent
production,regardlessofwhetherithasnecessarilysoldduringtheyear.If
inventorieshaveincreasedovertheyear,InventoryInvestmentwillbepositive.
Ifinventoriesdecrease,inventoryinvestmentwillbenegativeinthatperiod.In
2001,U.S."disinvested"$60Bininventory.Why??
Note:NIPAarbitrarilyassumes:AllhouseholdspendingisPCEexcept
spendingonhousing.Allbusinessspendingonfinalgoodsisconsidered
Investment.
Example:Companybuysofficesuppliesortoothpasteorcar,INVESTMENT.
Youbuyalawnmowerorchainsaworcar,CONSUMPTION.
3.GovernmentPurchasesofgoodsandservices.State,localandfederal
govt.spendingoneverythingexcepttransferpayments.Includesboth
consumption(paperwork,officesupplies)andinvestmentgoods(highways,
buildings,dams,etc.).Includesspendingonhighways,govt.buildings,
education,FBI,FDA,DEA,ATF,Dept.ofCommerce,FDA,EPA,defense,
etc.
4.NetExports=Exports(X)Imports(M).Weaddexportsbecausethey
aredomesticallyproducedgoodssoldtoforeigners,contributestodomestic
production.Wesubtractimports,becausetheyareforeignproducedgoodsand
servicespurchaseddomesticallybyconsumers,businessesorgovernment.
PartofC,IandGarepurchasesofimports,sowesubtracttheseexpenditures
out.

WhenX>M,wehaveatradesurplus.WhenM>X,wehaveatradedeficit.
Wehadatradedeficitin2001of$330B,andabout$500Bin2002.

Seepage164foragraphofExpenditureApproachandResourceCostIncome
Approach.
Inpanelb,weseeagraphoftheRESOURCECOSTINCOME
APPROACHtoGDP(orGrossDomesticIncome"GDI").$11Tspentonfinal
goodsandservicesgoestopay:forResources(inputs)andtheownersof
resources.Onepersonsspendingisanotherperson'sincome.$1500spenton
tuitiongoestosalaries,buildings,books,etc.$100spentatTargetgoesto:
salaries,rents,interest,taxes,depreciation,profits,etc.
$11Tinspendingbyhouseholds,businessandgovernmentsgoesto:
1.EmployeeCompensation58%
2.Selfemploymentincome7%
Together,compensationtoemployeesandselfemploymentincomeaccountfor
almost2/3ofGDP.
3.Rents,corporateprofits,andinterestarepayments(income)topeople
whosupplyeitherphysicalcapitalorfinancialcapitaltobusinesses.
Rentleasepaymentstotheownersofrealestateshoppingmall,office
buildings,etc.
Profitsmoneypaidtoshareholdersforprovidingcapitaltoacorporation.
Interestmoneypaidonloanstobusinesses.Bonds,bankloans,etc.
4.IndirectBusinessTaxestaxesongoodswhichgetpassedalongto
consumers.Examples:sales,exciseandpropertytaxes.PartofPCEdoesn'tgo
asincometoaresourceowner,itgoestothegovernment.Indirectcostof
supplyinggoods.
Example:Gas,alcoholhaveexcisetaxeshiddenintheprice,doesn'tgothe
producerasincome,itgoestothestateandfederalgovt.astaxes.

5.Depreciationwearandtearonmachinesandcapitalequipmentisacostof
producinggoods,butitdoesn'tinvolveadirectpaymenttoaresourceowner.
Alsocalledthe"capitalconsumptionallowance."In2001,depreciationwas
$1350B.ThinkofUPSorNorthwestAirlineseveryyeartheirtrucksand
airplanesaredepreciatingfromdailyuse.
6.NetIncomeofForeigners(GNPGDPadjustment)Whenweusethe
ResourceCostIncomemethodwehavetoadjustforincomethatAmericans
earnedfromabroadandforthedomesticincomethatforeignersearnedhere.
WewantonlyDomesticproduction,sowewanttoexcludeincomethat
Americansearnedabroad,andcountincomethatforeignersearnedinU.S.
Example:U.S.citizenearns$50,000workinginCanada.Weexcludethatfrom
GDP.
Example:Canadiancitizenearns$100,000inUS.ThatcountsforU.S.GDP.
Netincomeofforeigners(NI):=IncomeforeignersearnedinU.S.income
Americansearnedabroad.
IfNI>0,itmeansthatforeignersearnedmoreherethanAmericansearned
abroad.
Intheexampleabove,theNetIncomewouldbe$100,00050,000=$50,000.
Wewouldadd$50,000toGDP.
In2001,foreignerscontributed$5BmoretoU.S.outputthanU.S.citizens
contributedtoforeignoutput,sothatamountwasaddedtoGDPusingthe
ResourceCostIncomeapproach(p.161).GDP=GDI=$10.2T

REALvs.NOMINALGDP
Ineconomics,wealwayshavetodistinguishbetweenrealandnominal
economicvaluesorvariableswhencomparingeconomicdataintwodifferent
yearsmeasuredindollars.Reason:wemeasureeconomicvariablesinU.S.
dollarsandthevalueofthedollarisconstantlychangingovertime.Inflation
erodesthepurchasingpowerofmoneyovertime.Onedollartodayisworth
lessthanonedollartenyearsago,worthmorethanonedollartenyearsfrom
now."Money'sGettin'Cheaper"A$100billin2003isnotthesameasa$100

billin1950or1960oreven2002,intermsofitsrealvalueorpurchasing
power.
Nominalvalues,ormoneyvaluesareexpressedincurrentdollars,ordollars
duringthecurrentperiodwhentheyaremeasured.Overtime,nominalvalues
ofincome,assetvalues,economicvariablesingeneralgetbiggerfortwo
reasons:1)changesintherealvalueofavariableand2)inflationchangesin
thegeneralpricelevel.
Realvalues,orrealvariables,measuretherealchangeofthevariable,withthe
effectsofinflationfactoredout.Weareusuallyultimatelyconcernedwithreal
income,realwages,realGDP,realoutput,realvalues,realreturns,real
growth...
Example:NominalGDP=PiQi,wherePrepresentsnominalpricesandQ
representsthephysicalquantitiesofrealgoodsandservices.AveragePriceper
carXnumberofvehiclesproduced=contributionofautosalestonominal
GDP.
Overtime,nominalGDPincreasesasa)pricesrise,andasb)therealquantity
ofoutputrises.Wearemoreconcernedwiththerealincreaseinoutput.Just
likeweareconcernedwithourrealincomewhichbettermeasuresourreal
standardofliving.
MoneyIllusionconfusingrealandnominalvariables.
Itisusuallyeasiertodealwithpercentagechanges,orgrowthrates,ofa
variable.
Nominal%GDP=%Prices+%Realoutput
Nominal%GDP=Inflation(%)+Realgrowthrate(%)
RealGDPgrowthrate=%NominalGDPInflation(%)
Example:2002,nominalGDPgrowthwas4.25%,inflationwasabout1.25%,
sorealgrowth(realGDP)wasabout3%.The4.25%growthinnominalGDP
wascausedbya1.25%increaseinallprices,anda3%increaseinthereal
quantityofgoodsandservices.Wewanttofactoroutthe1%increaseinprices

toisolatethe3%increaseinrealGDP(inflationadjustedgrowth),whichisa
betterindicatorofeconomicgrowth,ourstandardofliving,etc.
Weneedameasureofinflationtomaketheadjustmentforpricelevelchanges.
Thereareseveralmeasuresofprices:ConsumerPriceIndex(CPI)andGDP
deflator,seepages165166.ThereisalsotheProducerPriceIndex(PPI),
whichmeasureswholesalepricesthatproducerspayforinputs.CPIis
aconsumerpriceindex,measuresthepricelevelchangesthataffectusas
consumers.CPIcomesoutmonthlyfromtheDept.ofLabor,basedonan
actualsurveyofaveragepricesin21,000stores(125,000prices)ofa364item
marketbasketofgoodsandservices,whichreflectsthepurchasesofatypical
household.Themarketbasketof364goodsispricedmonthlytoconstructthe
CPI,fromwhichtheinflationrateiscalculated(Inflationrate=Percentage
Changeinthepriceindex).IftheCPIgoesfrom100to105,inflationis5%.
GDPDeflatorisamuchbroader,morecomprehensivepriceindexreflecting
ALLgoodsandservicesinGDP(thousandsofitems)includingconsumer,
businessandgovernmentspending.Inadditiontobeingmorecomprehensive
thantheCPI,theGDPDeflatorisalsodifferentfromCPIbecauseitisnot
basedonafixedbasketofgoodsitupdatesthetypicalbundleeachyearto
reflectwhatpeople,businessesandgovernmentactuallybuy.GDPDeflatoris
calculatedbycomparingcostoftheactualgoodsboughtthisyearTOthecost
ofpurchasingthosesamegoodslastyear.Ifthecostthisyearis$102andthe
costofthosegoodspurchasedlastyearwouldhavebeen$100,theninflationis
2%.
SUMMARY:CPIislesscomprehensiveandassumesafixedbasketofgoods
fromyeartoyear,comparedtotheGDPDeflator,whichismore
comprehensiveandusesachangingbasketofgoodsbasedonwhatisactually
purchased.Therefore,GDPDeflatorisconsideredamoreaccuratemeasureof
prices.
Choosingapriceindexdependsontheapplication.CPImeasuresconsumer
prices,isappropriateforcostoflivingincreasesinwagecontractsandSocial
Security.GDPDeflatorisaneconomywidepriceindex,appropriatefor
adjustingnationalincomedata.
Seep.166foracomparisonofGDPDeflatorandCPI,andinflationratesfrom
each.Inmostyears,CPIinflationishigher.Averageover20years,CPI
inflation=3.72%,GDPDeflatorinflation=3.16%.

WhydoestheCPIoverstatetheTRUErateofinflation(costofliving)?
1)SubstitutionCPIusesfixedbasketofgoodsanddoesn'tallowfor
substitution.Ifpriceofbeefrisesandthepriceofturkeyfalls,peoplewillbuy
moreturkeyandlessbeef.TheCPIassumesaconstantbasketofgoodsand
services,leadingtoupward"substitutionbias."CPImeasureswhatpeople
usedtobuy,nowwhattheybuynow.
2)Qualityimprovements.SupposeoneoftheproductsinCPIisanaverage
computer.Whatiftheaveragepricedoesn'tchangefromoneyeartothenext,
buttheyarecomparinga386in1990vsaPentiumIIIin2000,possiblya
computerwithtwentytimesasmuchpower.Therealcosthasfallen,even
thoughthenominalpricedoesn'tshowanychange.
Conclusionofrecentpresidentialstudy(BoskinReport):CPIoverstatestrue
costoflivinginflationbyapproximately.5to1.5%.

USINGAPRICEINDEXTOCALCULATEREALVALUES
Wetypicallyhaveeasyaccesstoboth:a)nominal(current)valuesfornational
income,personalincome,consumption,salaries,wages,housingprices,gas
prices,stockprices,etc.andb)priceindexes.Fromnominalvaluesandaprice
index,wecanthencalculatereal(constant)values,tomakeavalidcomparison
ofeconomicvariablesovertime.Weusethefollowingformula(p.166)to
convertnominal(current)valuestoreal(constant)values,usingGDPasan
example(t=year,ortimeperiod):
REALGDPt=NOMINALGDPtXGDPDEFLATORINBASE
YEAR
GDPDEFLATORt
ThisformulawillconvertthenominalGDPvalueinyeartintorealGDPin
yeart,measuredintheconstant,orrealdollarsoftheBASEYEAR.
IfwehaveNominalGDPintwodifferentyearsandtheGDPDeflatorinthose
twoyears,wecanthencalculateRealGDP.Forexample(page166),weknow
thatNominalGDPwas$7813Bin1996andby2001hadgrownto$10,208B.
Rememberthatpartofthatincreaseisbecausepricesingeneralroseoverthe5
yearperiod,andalsobecauserealoutputroseduringthatperiod.Andwecan't

accuratelycompare$7813Band$10,208Bbecausetheyaremeasuredin
differentyearsandindifferentunits(the1995$isnotequaltothe2001$
whichonehasmorevalue/purchasingpower?)
WecanconvertnominalGDPin2001intoreal,inflationadjusted1996dollars
usingtheformula:
$9,331B=$10,208Bx(100/109.4)
Wehavenow"deflated"thehighernominalvalueintoarealvalue,by
factoringouttheamountofthenominalincreasethatcameaboutduetoprices
rising(inflation).WeNOWcancompare$7813Band$9331B,becausethey
arebothexpressedinconstant,inflationadjusted,real1996dollars.Wecan
saythatnominalGDPincreasedbyalmost31%overthisperiod,butthatreal
GDPincreasedbyonly19.4%.POINT:Tomakevalidcrossyearcomparisons
foranythingmeasuredwithmoney,wehavetoconvertfromnominaldollarsto
realdollars.