Measuring the State of the Economy

• Gross domestic product (GDP)
  • The market value of the final goods and services produced in an economy over a certain period.

• Production measure of GDP
  • The number of goods produced in the economy.
• Expenditure measure
  • The total purchases in the economy.
• Income measure
  • All the income earned in the economy.
• All three approaches give identical measures of GDP.

Thus:
Production = Expenditure = Income

Economy of Eden

• The economy of Eden only produces apples
• To make apples, you need land, a tractor, and someone to pick the apples
• GDP=Income=Expenditure=$3

Production
Each year, Eden produces 3 apples, and apples sell for $1 each

Income
The landowner makes $1 per year, the worker of the tractor gets $1 per year, and the worker makes $1 per year

Expenditure
The workers, the landowner, and the owner of the tractor all purchase 1 apple per year, for $1 each

• When calculating income, we need to distinguish between “profits” and “economic profits”
• Profits
  • Normal competitive return on inputs.
• Economic profits
  • Above-normal returns associated with prices that exceed those that prevail under perfect competition.

The Expenditure Approach to GDP

The national income accounting identity states:

Y = C + I + G + NX

Where
Y = GDP (in dollars)
C = consumption
I = investment
G = government purchases
NX = net exports = exports – imports

Other important identities

• C+I+G+(X-M)=Y (Expenditure=GDP)
• C+S+T=Y (Income=GDP)
• I=S+(G-T)+(M-X)
• Savings/Investment Equation

• Net exports (trade balance) for the United States is negative.
• The recent trade deficit indicates that the United States is borrowing goods from the rest of the world.
• As the trade balance has turned negative, consumption has increased as a share of GDP recently.

The Income Approach to GDP

• The income approach
  • Measures the sum of all income earned in the economy.

• Capital
  • Inputs into production other than labor that are not used up in the production process.
  • Firms increase capital through investment.

• Depreciation
  • The deterioration of the capital stock due to wear and tear.

GDP – depreciation = net domestic product.

• Total shares of GDP to inputs:
  • Share of GDP to Labor: two-thirds
  • Share of GDP to Capital: one-third.
  • Labor’s share of GDP has remained approximately constant over time.

The Production Approach to GDP

• There is no “double counting” in GDP; only the final sale of goods and services count.
• Value added
  • The amount each producer contributes to GDP.
  • The revenue generated by each producer minus the value of intermediate products.
• Only new production of goods and services counts toward GDP.

What Is Included in GDP and What’s Not?

• Only goods and services that are transacted through markets are included in GDP.
• GDP does not include:
  • Government transfer payments to individuals.
    • Social Security, Medicare, unemployment insurance
  • A measure of the health of a nation’s people.
  • Changes in environmental resources.