Chapter 24 - Measuring the Wealth of Nations
CHAPTER 24
Measuring the Wealth of Nations
Chapter Overview
GDP is a powerful and versatile metric. There are good reasons that it is one of the most commonly used tools in macroeconomics. It gives a simple measure of the size of an economy and the average income of its participants. It also allows us to make comparisons over time or across countries. The system of national income accounts gives us a picture of how output, expenditure, and income are linked, and a framework for adding up the billions of daily transactions that occur in an economy. Comparing nominal and real GDP allows us to disentangle the role of increasing prices versus increasing output in a growing economy. The GDP deflator and the inflation rate track changes in overall price levels over time—which, as we’ll see in the next chapter, is a major task in macroeconomics. GDP per capita gives us a sense of the average income within a country, although it doesn’t tell us about the distribution of income or quality of life. Finally, calculating real GDP growth rates shows us which direction the economy is moving, and is an important indicator of recession or depression.
In the next chapter, we’ll dig deeper into the tools that economists use to measure price changes and the cost of living. When we combine these tools with GDP, we have a menu of macroeconomic metrics that will allow us to describe and analyze national and international economies.
Learning Objectives
LO 24.1 Justify the importance of using the market value of final goods and services to calculate GDP, and explain why each component of GDP is important.
LO 24.2 Explain the equivalence of the expenditure and income approaches to valuing an economy.
LO 24.3 Explain the three approaches that are used to calculate GDP, and list the categories of spending that are included in the expenditure approach.
LO 24.4 Explain the difference between real and nominal GDP, and calculate the GDP deflator.
LO 24.5 Calculate and explain the meanings of GDP per capita and the real GDP annual growth rate.
LO 24.6 Discuss some limitations to GDP, including its measurement of home production, the underground economy, environmental degradation, and well-being.
Chapter Outline
IT’S MORE THAN COUNTING PEANUTS
Valuing an Economy
Unpacking the Definition of GDP (LO 24.1)
Production Equals Expenditure Equals Income (LO 24.2)
Approaches to Measuring GDP (LO 24.3)
The Expenditure Approach
The Income Approach
The "Value-Added” Approach
Using GDP to Compare Economies
Real versus Nominal GDP (LO 24.4)
The GDP Deflator
Using GDP to Assess Economic Health (LO 24.5)
Limitations of GDP Measures
Data Challenges (LO 24.6)
BOX FEATURE: FROM ANOTHER ANGLE – VALUING HOMEMAKERS
BOX FEATURE: FROM ANOTHER ANGLE – THE POLITICS OF GREEN GDP
GDP vs. Well-Being
BOX FEATURE: REAL LIFE – CAN MONEY BUY YOU HAPPINESS?
Beyond the Lecture
Reading Assignment: Unpacking the Definition of GDP (LO 24.1)
Have students examine the current news release of Gross Domestic Product from the Bureau of Economic Analysis. This is a great way to introduce students to the calculation of GDP and its significance.
Writing Assignment: Unpacking the Definition of GDP (LO 24.1)
Have students review the National Income Accounts entry in The Concise Encyclopedia of Economics. In the article, Mack Ott underscores the importance of GDP for policy purposes. Then, ask students to write a short essay about the following:
1. Why is GDP and national income accounting important?
2. How is GDP calculated? How is GDP useful for policy decisions?
Team Assignment/Class Discussion: Using GDP to Assess Economic Health (LO 24.5)
Have students use this data on the World Bank site to examine GDP per capita for a specific country. You may want to assign each student (or group of students) a country to examine. Ask the students to research their country outside of class before the in-class discussion. In class, have students discuss the following:
1. What is GDP per capita for your country?
2. How has GDP per capita changed over time for your country?
3. Can you determine why GDP per capita has changed in this fashion?
4. How does GDP per capita for your country compare to other countries?
Class Discussion: Data Challenges (LO 24.6)
Have students view this brief clip from The Colbert Report. In the clip, Colbert discusses individuals who live off of the garbage of others. Discuss the following:
1. How would the consumption of another person’s garbage impact GDP?
2. How well does GDP measure well-being? What issues does GDP miss?
Reading/Writing Assignment: Data Challenges (LO 24.6)
Have students read Hiding in the Shadows by Friedrich Schneider, a publication about the impact of the shadow economy. This is also a great piece for a writing assignment or to stimulate class discussion.
Solutions to End-of-Chapter Questions and Problems
Review Questions
1. U.S. car dealers sell both used cars and new cars each year. However, only the sales of the new carscount toward GDP. Why does the sale of used cars not count? [LO 24.1]
Answer: The production of the car was already included in GDP when it was first manufactured. To include the sale of the used car would serve to double-count the car, once as a new car, once as a used car.
2. There is an old saying, “You can’t compare apples and oranges.” When economists calculate GDP, are they able to compare apples and oranges? Explain. [LO 24.1]
Answer: When economists calculate GDP, they are able to make this comparison by converting production to its dollar value. If the economy produces 10 apples selling at $1.50 each and 5 oranges selling at $1 each, the economy has produced (10 x 1.50) + (5 x 1) = $20 of economic production. The economist has now compared apples and oranges.
3. When Americans buy goods produced in Canada, Canadians earn income from American expenditures. Does the value of this Canadian output and American expenditure get counted under the GDP of Canada or the United States? Why? [LO 24.2]
Answer: GDP is the total sum of goods and services produced within a country’s borders. Goods produced in Canada count in Canada’s GDP even if they are consumed in the U.S.
4. Economists sometimes describe the economy as having a “circular flow.” In the most basic form of the circular flow model, companies hire workers and pay them wages. Workers then use these wages to buy goods and services from companies. How does the circular flow model explain the equivalence of the expenditure and income methods of valuing an economy? [LO 24.2]
Answer: In this basic model all firm revenues are turned into wages, and all wages are spent on the firms’ products. Thus, total production in the economy can either be measured by summing up all of the firms’ sales (expenditure method) or all of the workers’ wages (income method).
5. In 2011, the average baseball player earned $3 million per year. Suppose that these baseball players spend all of their income on goods and services each year, and they save nothing. Argue why the sum of the incomes of all baseball players must equal the sum of expenditures made by the baseball players. [LO 24.2]
Answer: If nothing from income is left over after spending, then spending must exactly equal income.
6. Determine whether each of the following counts as consumption, investment, government purchases, net exports, or none of these, under the expenditure approach to calculating GDP. Explain your answer. [LO 24.3]
a. The construction of a court house.
b. A taxicab ride.
c. The purchase of a taxicab by a taxicab company.
d. A student buying a textbook.
e. The trading of municipal bonds (a type of financial investment offered by city or state governments).
f. A company’s purchase of foreign minerals.
Answer:
a. Courthouses are public institutions and are thus counted as part of government expenditure. In this case, the expenditure is technically an investment by the government.
b. A taxicab ride is a service, so it is counted as consumption.
c. The purchase of a taxicab by the company is an investment.
d. The purchase of a textbook counts as consumption.
e. Neither: Trading financial investments is considered a transfer, which does not go into the calculation of GDP.
f. The purchase of raw materials from a foreign country is considered an import and is therefore counted as part of net exports.
7. If car companies produce a lot of cars this year but hold the new models back in warehouses until they release them in the new-model year, will this year’s GDP be higher, lower, or the same as it would have been if the cars had been sold right away? Why? Does the choice to reserve the cars for a year change which category of expenditures they fall under? [LO 24.3]
Answer: If the cars are produced this year, they count in this year’s GDP even if they aren’t sold until next year. If the cars are sold right away, they count as consumption (or as government purchases if they are sold to the government, or as investment if they are sold to a firm). If the cars are not sold but instead put into inventory, then the production is counted as investment.
8. The value-added method involves taking the price of intermediate outputs (i.e., outputs that will in turn be used in the production of another good) and subtracting the cost of producing each one. In this way, only the value that is added at each step (the sale value minus the value that went into producing it) is summed up. Explain why this method gives us the same result as the standard method of counting only the value of final goods and services. [LO 24.3]
Answer: The only difference between the valued-added method and the final-goods method is that the production of the economy is added up along the way instead of being totaled at the end. For example, the height of a staircase is the same whether one measures each individual stair and adds them up as one climbs the stairs, or whether one simply climbs all of the way to the top and then measures the total height traveled.
9. Imagine a painter is trying to determine the value she adds when she paints a picture. Assume that after spending $200 on materials, she sells one copy of her painting for $500. She then spends $50 to make 10 copies of her painting, each of which sells for $100. What is the value added of her painting? What if a company then spends $10 per copy to sell 100 more copies, each for $50? What is the value the painter adds then? If it’s unknown how many copies the painting will sell in the future, can we today determine the value added? Why or why not? [LO 24.3]
Answer: The value-added approach determines the value of a good or service by subtracting the value of the inputs from the value of the outputs. In this case, the painter originally sold $1,500 worth of paintings, at a cost of $700, which implies that she added $800 in value by painting. After the company sells another $5,000 worth of paintings at a cost of $1,000, we can add $4,000 to the original $1,500. If we can’t know how many copies the painting will sell in the future and at what price, we cannot today know the final value the painter adds through painting.
10. In a press conference, the president of a small country displays a chart showing that GDP has risen by 10 percent every year for five years. He argues that this growth shows the brilliance of his economic policy. However, his chart uses nominal GDP numbers. What might be wrong with this chart? If you were a reporter at the press conference, what questions could you ask to get a more accurate picture of the country’s economic growth? [LO 24.4]
Answer: There are many potential problems here. The biggest is that the president is talking only about nominal GDP and not real GDP. If prices are rising 10 percent per year, then the country is not experiencing any real growth; GDP is getting bigger only because prices are rising.
11. Suppose that the GDP deflator grew by 10 percent from last year to this year. That is, the inflation rate this year was 10 percent. In words, what does this mean happened in the economy? What does this inflation rate imply about the growth rate in real GDP? [LO 24.4]
Answer: A 10 percent growth rate in the GDP deflator means that, overall, prices in the economy have risen by 10 percent. This inflation rate implies the growth rate in real GDP is essentially 10 percent less than the growth rate in nominal GDP.
12. An inexperienced researcher wants to examine the average standard of living in two countries. In order to do so, he compares the GDPs in those two countries. What are two reasons why this comparison does not lead to an accurate measure of the countries’ average standards of living? [LO 24.4, 24.5]
Answer: Two obvious problems are price levels and population. First, if one country has higher price levels than the other, then the nominal GDPs of the two countries are not directly comparable. The country with higher price levels will have a comparably lower real GDP than a country with low price levels. Second, standard of living is better reflected by GDP per capita, not simply total GDP. For example, India’s GDP is 15 times larger than Norway’s, but the average Indian person is quite poor compared with the average Norwegian since there are 1.2 billion Indians and only about 5 million Norwegians. The average Norwegian earns almost 15 times that of the average Indian.