Economics 1bb3, Mike Veall

National Accounting

Notes based on text Chapter 7. (omit pp. 139-142). Questions from text, pp. 151-152 # 2, 4-13 (answers to even numbered questions in text; answers to odd-numbered questions below).
Also read Case 2 on your own and do questions p. 172 #1, 2

Definitions of GDP and related concepts

"GDP is the market value of all final goods and services produced within a given period of time by factors of production located within a country."

The words market value indicate that the different products are added together by adding their dollar values on the market. Because of data limitations, illegal or underground economy production (e.g. drug production or undocumented work done "under the table" is not included.) Home production (e.g. making your own meals) does not go through a market and is not included. Government production (e.g. military, public health care) are valued at cost.

The word final indicates that only final, at "point of use" goods should be included. If we count both the $1.50 loaf of bread we eat and the $.60 worth of ingredients used to make the bread, we are double counting: the ingredients count twice. So we don't count intermediate goods such as the flour used by a commercial baker. (We would count flour used by a household because given we do not include home production in GDP, the point of use is the flour leaving the store.)

If we just want the contribution to GDP by the commercial bakery, we take its value added, that is sales minus the cost of purchased goods and services. For example if our $1.50 loaf of bread has been made from $.60 worth of materials and the rental of the building (including electricity) works out to $.20 per loaf, value added is $1.50 - $.60 - $.20 = $.70. Note value added is not the same as profits: in fact value added within an establishment is profit plus wages and salaries.

Note also that if we add up all the value addeds in the economy, that will be the same as the total value of final sales of goods and services. As an example, suppose that the supplier of materials to our bakery is a self-contained organic farm that purchases no goods and services and the building owner also purchases no goods and services (perhaps the building has a well and its own source of thermal energy. Then the value added of the farm on the materials sold to the bakery is $.60 (sales minus zero purchased goods and services) and the value added of the building owner per loaf is $.20 (sales minus zero purchased goods and services). Total value added per load is therefore $.60 from the farm, $.20 to building owner and $.70 to baker for a total of $1.50, which must necessarily be the same as the $1.50 final price. Even if the farmer had purchased some product, say fertilizer, we would just deduct the cost of the fertilizer from the farmer's value added but add in the fertilizer manufacturer's value added. If we make sure we include all producers along the chain, the sum of the value addeds is the final sale price.

GDP vs. GNP: GDP is prodcution by factors of production located within a country. GNP counts production due to Canadian factors of production outside Canada but subtracts production due to foreign factors of production within Canada. In practice, Statistics Canada does not make an adjustment for nonresident labour in Canada or Canadian residents working elsewhere, but only makes an adjustment for the return to capital owned by Canadian residents in other countries and the return to capital within Canada owned by nonresidents of Canada. So the component of production in the Alliston Ontario Honda plant that can be attributed to Japanese-owned capital counts in Canadian GDP but not in Canadian GNP, in Japanese GNP but not in Japanese GDP.

Two approaches to calculating GDP:

The expenditure approach to calculating GDP:

GDP: C+I+G+EX-IM

Consumption: Durables, semi-durables, nondurables and services

Investment: New capital: housing, plants, equipment, inventory (not stocks and bonds)

Gross investment: no adjustment for depreciation of capital

Net investment: gross investment minus an estimate of depreciation

Government Purchases: Goods and services purchased by government but not transfers or interest on government debt

EX-IM: Exports minus imports

The income approach to calculating GDP:

As every dollar spent must end up as someone's income: either wages, salaries, rent or gross profits. So if we add these components, we get GDP.

Personal disposable income: GNP less depreciation less indirect taxes plus subsidies less personal taxes plus transfer payments minus retained earnings (approximately: output less net taxes)
(retained earnings are corporate profits not distributed as dividends)

Nominal vs. Real GDP

	Production		Prices		GDP at 1998 Prices	GDP at 1999 Prices	GDP at 2000 Prices
Year	Sticks	Stones	Sticks	Stones
1998	12	15	$5	$8	$180
1999	16	15	$10	$12	$200	$340
2000	20	20	$11	$15	$260		$520

As an example, 1998 GDP is 12 × $5 + 15×$8 = $180. From 1998 to 1999, GDP has gone up from 180 to 340, which is 89%. But this includes some change simply because prices have gone up. To calculate "real GDP", we value everything at base year prices: say we use 1998 as the base year. Hence 1999 real GDP (at 1998 prices, or as we sometimes say, in 1998 dollars) is 16 ×$5+ 15×$8 = $200. Hence between 1998 and 1999, real GDP has only gone up 11%, from 180 to 200.

Measuring the Price Level

The GDP deflator (or GDP implicit price deflator or GDP price index) is a measure of the price level. It is calculated as the ratio of nominal GDP to real GDP, usually multiplied by 100 as we will see below. Nominal GDP is just another word for GDP when we want to emphasize that the ordinary calculation of GDP is at nominal (that is actual current) prices as opposed to constant (base year) prices for real GDP. The base year GDP deflator is normally set at 100. So for example using 1998 as the base year, the GDP price deflator will be (1998 nominal GDP/1998 real GDP) × 100 = ($180/$180) × 100. The 1999 GDP deflator using 1998 as a base year will be (1999 nominal GDP/1999 real GDP) × 100 = (340/200) × 100 = 170. The year 2000 GDP deflator will be (2000 nominal GDP/2000 real GDP) × 100 = (520/260) × 100 = 200, suggesting that the price level increased by 100% between 1998 and 2000. Note that all real GDP calculations in this have been done using the base year of 1998; we can only compare real GDPs of two years or the GDP deflators of two years if they are calculated with the same base year.

Note if we take nominal GDP for a year and "deflate" it by dividing by the GDP deflator and multiply by 100, we obtain real GDP. So dividing the year 2000 GDP of 520 by the year 2000 GDP deflator of 200 and multiplying by 100 we obtain 260, which is year 2000 real GDP.

Inflation is measured as the percentage change in the price level. The GDP deflator measure of price inflation from 1998 to 1999 is therefore ((170-100)/100) × 100 = 70%. The GDP deflator measure of price inflation from 1999 to 2000 is ((200-170)/170) × 100 = 17.6%. Note that prices of both sticks and stones did not increase by 70% between 1999 and 2000: the measure of inflation is in essence an average.

The text gives a three good example. Statistics Canada uses thousands of goods, although the principles are the same.

Fixed Weight Price Indices:

It is possible to get different measures of the price level using different weights just as in a course, the final grade depends on the weights assigned to tests, the exam etc. Hence using different weights will give you different measures of price inflation. There is no perfect way to do this (what economists call the index number problem) just as there is no perfect way to calculate grades for a course. Illustrations of this problem include the Maclean's comparison of Canadian universities. Different universities do better in different categories - the overall score depends on how these are weighted. The U.N. Index of Human Development that compares countries ranks Canada highly uses a set of weights for different attributes. Different weights would lead to different results.

The Consumer Price Index (CPI) is an alternative to the GDP deflator that can be used to estimate the price level. It is partly different because it includes only consumer goods, not all goods. But also the GDP deflator calculation uses the quantities of each year, so that the 1999 GDP deflator is calculated using 1999 quantities and the year 2000 GDP deflator is calculated using year 2000 quantities. The CPI uses the same quantities every year, the base year quantities (i.e. a fixed bundle of goods). So again using 1998 as the base year and assuming that sticks and stones are both consumer goods, we would use a fixed bundle of 12 sticks and 15 stones and price that every year. As shown in the table below, that bundle of goods would cost (12 × $10 + 15 × $12) = $300 in 1999 and $357 in 2000. If we want to make the CPI equal 100 in the base year, we divide all the bundle costs by the base year bundle cost of $180. Hence the 1998 value of the CPI is ($180/$180) × 100 = 100, the 1999 value of the CPI is ($300/$180) × 100 = 167 and the 2000 value of the CPI is ($357/$180) × 100 = 198. It is straightforward to calculate the percentage increase in the CPI as 67% between 1998 and 1999 and 19% between 1999 and 2000 and to note that these are not the same estimates of inflation as given by the GDP deflator. The CPI is based on a fixed bundle; the GDP deflator is based on a changing bundle.

Calculating the Consumer Price Index Using the Same Numbers as Above (Assuming Sticks and Stones are Consumer Goods and consumed as well as produced, 1998 is Base Year, Percentage Changes are from Previous Year)

One reason the CPI is more commonly used is it is more timely: it does not require new observations on quantities each period, only new observations on prices. Hence the CPI is published monthly with a lag of about a month while the GDO deflator is published monthly, has a lag of about threee months and is subsequently revised.

GDP is not a measure of social welfare!

No allowance for crime, leisure, pollution, resource depletion, distribution

Nonmarket activities not counted (home production, underground economy)

The danger in comparing per capita GDP across countries (the problems in converting to a common currency); the problem with comparability in the UN Index of Human Development

ANSWERS TO TEXT QUESTIONS

5. Double counting occurs when intermediate goods are counted directly in calculating GDP. This means these intermediate goods will be counted more than once because they are also counted as part of the value of the final product. Total sales includes sales of intermediate goods that firms sell to each other. GDP includes only the sale of final goods and services.

7. a. not counted financial transaction

b. counted investment spending

c. not counted financial transaction

d. not counted financial transfer

e. counted consumption spending

f. should be counted but unlikely a transaction in such an informal market will be recorded

g. not counted transfer payment

h. counted investment spending

i. counted consumption (the cheese is part of the value of the final good)

j. not counted nonmarket activity

k. not counted illegal goods

9. Imports are included with the final purchases of consumption, investment, and government goods. If they were not subtracted, they would be incorrectly included as domestic production.

11. Nortel shares would have to increase in value by 2% because (1/3)×2% + (2/3)×(-1%) = 0%.

13. Suppose two students agree that one university has smaller classes and the other has better student services. The students may still disagree as to which university is the better because one student puts more value on small classes and the other puts more value on student services. Maclean's index reflects one set of weights; others with different weights will draw different conclusions.

CASE STUDY 2, "Indexes of Economic Well-Being"

Case Study 2 is left for you to read but there are two main points. First, real GDP per capita is not a particularly good measure of economic well-being, because it leaves out (at least) considerations of inequality, poverty and health. Second, any index number that tries to address these issues can still be challenged on the weighting issue: how much weight should be assigned to each factor?

ANSWERS TO TEXT QUESTIONS

1. Travel to work is presumably a cost to working and not a productive activity itself. Including it may overvalue a society where people have long commutes. Similarly taking out the costs of law enforcement makes sense because most of us would rather live in a crime-free society where such expenditures were not necessary.

2. Of course answers will differ. Here is a sample. Someone might argue for putting the most weight on "ill health" because it can affect everyone and it is often beyond individual control but the next most weight on single-parent poverty, because along with ill health, being born to a single-parent, poor household is something that children have no control over. Then the third heaviest weight could be put on unemployment because at least some of the unemployed don't have jobs through no fault of their own while it could be argued that old age poverty could have the smallest weight because most people do have the opportunity to prepare for old age by saving. But this answer is just an opinion and not even my opinion. The key is to understand that different weights would lead to different indexes.