Circular flow chart revisited: When firms and government buy resources (land, labor and capital) from households to produce goods and services, the prices of those resources (rents, wages, interest, and profits) paid to households constitute the households' incomes.

What firms and government pay (to households) for the resources they buy to produce goods and services will constitute their costs of production.

Firms' costs of production are reflected in the prices they put on the goods and services they produce, and these costs are recovered when those goods and services are sold in the product market.

Governments recover their costs of production (of services) by collecting taxes (or borrowing.)

Thus, households' incomes are spent on paying taxes, buying goods and services (produced by firms), or saving which would directly or indirectly lead to investment; investment is simply purchase of capital goods or inventory.

We can measure the value of the output of the economy either buy counting the income dollars received by households for their resources (an income approach) or we can measure it when they spent their incomes (an expenditures approach.) Money income from Amount spent to the sale of resources purchase the economy's used to produce the = output economy's output Rents +Wages + Interest + Profits + Adjustments =

Consumption + Investment + Government purchases of goods and services + Net export A formal measure of the value of the output of an economy is its gross national product, GDP. Gross National Product
An economy's annual aggregate output is measured by its GDP or gross domestic product: the total market value of all final goods and services produced within a country over a period of one year. GDP is a monetary measure of the economy's output. To be sure that GDP reflects society's valuation of the economy's output market prices are used as bases of output valuation. To avoid multiple counting, only the values of final goods are counted; the values of intermediate goods are contained in the value of final goods. Value Added: National income measures include only the value added by each firm. In fact, the value of an economy's output is the sum of all of its "added values." An example: Sales Value Value added A tree is cut form the forest and sold to a mill as timber for $50 $50 $50 The mill cuts the timber into lumber and sells it to a furniture company for $80 80 30 The furniture company makes a chair out the lumber and sells it to a retailer for $150 150 70 The retailer ( furniture store) sells the chair to a consumer for $200. $200 50 ======== ------------- $200 =========
Note that the sum of the added values is same as the price of the final product.
The last value added in the production process the chair in this simple example is $50 worth of retailing service provided by the retailer. Excluded from the estimations are: • Sales of intermediate goods • Secondhand transactions • Private or public transfer payments are not counted (e.g. government transfer to the unemployed – not made in exchange of a service, no new production) • Pure exchange transactions Note: Non-production transactions are excluded from GDP. Public transfers: social security and welfare payments Private transfers: gift payments Purchase of stocks and bonds Purchase of existing assets: secondhand sales Expenditures Approach to Measuring GDP
GDP = Personal consumption (C) + Gross domestic investment (Ig) + Government purchases (G) + Net exports (Xn) Personal consumption (C): Households' spending on durable and non-durable goods and on services.

Gross Private Domestic Investment (Ig): All final purchases of tools, equipment, and machinery by businesses, all (private)construction including new homes, and changes in inventory Net Investment versus Gross Investment Net investment = Gross investment minus depreciation When an economy's (annual) net investment is positive, its stock of capital is growing and, thus, its production capacity is expanding. If net investment is negative, the economy's production capacity is shrinking. Note 1: Purchase of stocks and bonds and depositing money in a bank are not considered investment. Note 2: Construction of new roads and new buildings by the government would not be included the gross private domestic investment. These expenditures are included in government expenditures. Government Expenditures(G)
Government purchases include spending by all levels of governments on finished goods and resources including labor. All government transfers are excluded.

Net Exports (Gn)
The difference between a country's sales to other countries (exports) and its purchases from other countries (imports) is called net exports. Since 1980 the U.S. annual net exports have been negative. The GDP equation: GDP = C + Ig + G + Xn

Statistical Discrepancy
Error term due to some unrecorded transactions
Data associated with a given transaction may come from different sources that differ in coverage, accuracy, and timing.

Components of Industrial Origin Agriculture Farming, fishing, livestock raising, forestry
Industry
Manufacturing, construction, mining, electricity, gas and water
Service
Transport and communication, finance, trade, real estate, personal, professional and recreational services
_________________________
Gross Domestic Product

Net Factor Income from Abroad earnings of Filipinos abroad less earnings of foreign residents GDP (+/-) NFYA ___________ GNP

Income Approach to Measuring GDP
An economy's national income consists of labor compensation
(wages, salaries and other benefits), rents, interest incomes, and profits.

Labor compensation includes wages and salaries paid by businesses and government to workers as well as all other benefit payments by employers such as payments towards social security, pension funds and health insurance.

Rent incomes are net rents received by landlords. Rents are paid by households, businesses and government.

Interest incomes include interest payments households receive on their bank deposits or bonds.

Profits can be classified into proprietors' income and corporate profits. Proprietors' incomes are their reported net profits. Corporate profits are corporations' net earnings after business expenses. Corporate profits are divided into three parts: Corporate income taxes Distributed dividends Retained(undistributed)profits

The sum of labor compensation, rents, interest, proprietors' income, and corporate profits would give us the national income; all incomes earned from U.S. supplied resources at home and abroad. To get the GNP we need to make three adjustments in this measure: 1. We need to add indirect business taxes. These taxes are paid by businesses and are included in their production costs. 2. We need to add capital consumption (depreciation).

To get the GDP we need to add the net foreign factor income; that is the difference between the income foreign investors earn from their assets in the U.S. and what U.S. investors earn from their (foreign) assets abroad. GDP = Labor compensation + rents + Interest + Proprietors' income + Corporate profits + Indirect business taxes + Depreciation + Net foreign factor income earned

Other National Accounts
GNP - Depreciation ( capital consumption) = Net National Product = NNP
NI - Corporate income - government income + Transfer payments= Personal Income = PI
PI - Personal taxes = Disposable Income = DI

Nominal GDP versus Real GDP
Consider a simple closed economy that produces only for categories of products: food, housing, clothes, and health care.
-------------------------------------------------------------------------
1995 output in
Products 1990 1995 1990 Price Quantity Value Prices Quantity Value Prices
Food $10 5 $ 50 $12 6 $72 $ 60
Housing 2 50 100 3 60 180 120
Clothes 5 4 20 6 5 30 25
Health Care 4 20 80 5 25 125 100 ------- -------- -------
GDP $250 $407 $305
==================================================
The value of the 1995 GDP in current (1995) prices is $407: nominal GDP
The value of the 1995 GDP in 1990 prices is $305: adjusted or real GDP
The difference between these two values reflects the price inflation between the two years.
We can measure the inflation rate between the two years by dividing the nominal GDP by the real GDP and multiplying it by 100: $407 (------ - 1 ) 100 = 33.44 % $305 Nominal GDP 407
GDP price index (or GDP deflator) = ---------------- x 100 = ------ x 100 =133.44 Real GDP 305
From this equation we can write: Nominal GDP
Real GDP = ------------------------- x 100 GDP price index
The GDP price index (or GDP deflator) allows us to adjust the nominal
GDP for inflation and determine the (real) GDP in terms of the
(constant) prices of a certain reference (base) year.
Price Index
A price index is simply a measure of the money value (combined price) of a basket of goods and services in a given year relative to the money value of the same basket of goods and services in another (reference or base) year.
In the above example the GDP price index for 1995 based on 1990 prices is 133.44; that indicates that 1995 price of our given basket of goods and services was 1.3344 times the 1990 price of the same basket.
Or, it was 33.44 percent higher. Price index price of a market basket in year t for year t = ------------------------------------------------- x 100 price of the same market basket in a base year Pt Or, Price Index = ---------- x 100 Pb

In the real world of many goods calculating the GDP price index is done through a rather complex accounting process. In this process in addition to prices, the weight of each category of goods is taken into account.
These weights change as the economy's expenditure patterns change.
In the U.S. these weights are annually updated and the base year is continuously rolled forward.

The Consumer Price Index (CPI)
Consumers do not directly buy all the goods and services produced in the economy.
Therefore, the GDP price index does not accurately reflect the prices of consumer goods.
The consumer price index measures the price of a market basket of goods and services purchased by a typical urban consumer. Price of a fixed market basket in year t CPIt = ---------------------------------- x 100 Price of the same market basket in a base year period

The weights in the CPI market basket remain fixed, the base year period is changed about every ten years.

Note: The CPI of the base year period is set equal to 100. An example: Base year period (1982-84) price of the consumer basket = 240 The price of the same consumer basket in 1990 = 420 420 CPI (1990) = --------- x 100 = 175 240
This means if we set the price of the consumer basket in 1982-84 base year period equal to 100, the price of the same basket in 1990 would be 175; that is, between the base year period and 1990 the price of the consumer basket increased by 75 percent. What GDP Does Not Reflect: GDP does not necessarily reflect society's well-being • Non-market production; e.g., services of a homemaker, output of a person fixing his own house • Leisure: Increases in the leisure time of individuals resulting from their ability to produce the same amount of output with less labor (work) are not reflected GDP • Product Quality : Quality improvements are not always reflected in GDP. • Composition of Output: A gun, a bottle of liquor, a book, a life-saving medicine and a computer all are included in the GDP the same way. • Distribution of Output: GDP does not tell us how the economy's output is distributed. • Costs of Environmental Damages: The costs of environmental damages are not deducted from GDP. Underground Economy: The output of the underground economy of which a large portion is from illegal activities remains unreported and, thus, is not included in GDP. One could argue that GDP understates the actual output of the economy because of this exclusion. Economic Well Being of Individual Households: Per Capita Output: Per capita output is simply the economy's output divided by the country's population. If the GDP growth does not keep up with the population growth, the economic well-being of the society may decline.

Uses • Use to compare economic performances • Shows the economic structure of a country • Shows relative participation and contributions of different sectors • Use as a basis for government and business planning

Alternative measures of well being: • Happy Planet Index (HPI) • Physical quality-of-life Index • Human Development Index • Genuine Progress Index (GPI)