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Chapter 20 - Measuring GDP and Economic Growth.docx

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ECON 1010
Steven Edwards

Chapter Twenty – Measuring GDP and Economic Growth Intro Will our economy expand more rapidly next year or will it sink into a “double-dip” recession? To assess the state of the economy and to make big decisions about business expansion, firms use forecasts of GDP. What exactly is GDP? How do we use GDP to tell us how rapidly our economy is expanding or whether our economy is in a recession? How do we take the effects of inflation out of GDP to reveal the growth rate of our economic well-being? And how do we compare economic well-being across countries? Gross domestic product GDP or gross domestic product is the market value of all final goods and services produced in a country in a given time period. This definition has four parts: Market value, final goods and services, produced within a country and in a given time period. Market value - GDP is a market value which is when goods and services are valued at their market prices. To add apples and oranges, computers and popcorn, we add the market values so we have a total value of output in dollars. Final goods and services - GDP is the value of the final goods and services produced. A final good (or service) is an item bought by its final user during a specified time period. A final good contrasts with an intermediate good, which is an item that is produced by one firm, bought by another firm, and used as a component of a final good or service. Excluding the value of intermediate goods and services avoids double counting. Produced within a country - GDP measures production within a country, in other words, domestic production. In a given time period - GDP measures production during a specific time period, normally a year or a quarter of a year. GDP measures the value of production, which also equals total expenditure on final goods and total income. The equality of income and value of production shows the link between productivity and living standards. The circular flow diagram illustrates the equality of income and expenditure. The circular flow diagram shows the transactions among households, firms, governments, and the rest of the world. Households sell and firms buy the services of labour, capital, and land in factor markets. For these factor services, firms pay income to households: wages for labour services, interest for the use of capital, and rent for the use of land. A fourth factor of production, entrepreneurship, receives profit. In the figure, the blue flow, Y, shows total income paid by firms to households. Firms sell and households buy consumer goods and services in the goods market. Consumption expenditure is the total payment for consumer goods and services, shown by the red flow labelled C . Firms buy and sell new capital equipment in the goods market and put unsold output into inventory. The purchase of new plant, equipment, and buildings and the additions to inventories are investment, shown by the red flow labelled I. Governments buy goods and services from firms and their expenditure on goods and services is called government expenditure. Government expenditure is shown as the red flow G. Governments finance their expenditure with taxes and pay financial transfers to households, such as unemployment benefits, and pay subsidies to firms. These financial transfers are not part of the circular flow of expenditure and income. Firms in Canada sell goods and services to the rest of the world called exports and buy goods and services from the rest of the world called imports. The value of exports (X ) minus the value of imports (M) is called net exports, the red flow X – M. If net exports are positive, the net flow of goods and services is from Canadian firms to the rest of the world. If net exports are negative, the net flow of goods and services is from the rest of the world to Canadian firms. The blue and red flows are the circular flow of expenditure and income. The sum of the red flows equals the blue flow. That is: Y = C + I + G + X – M The circular flow shows two ways of measuring GDP. By aggregate expenditure or aggregate income. GDP = C + I + G + X – M. Aggregate income equals the total amount paid for the use of factors of production: wages, interest, rent, and profit. Firms pay out all their receipts from the sale of final goods, so income equals expenditure, Y = C + I + G + (X – M). “Gross” means before deducting the depreciation of capital. The opposite of gross is net. “Net” means after deducting the depreciation of capital. Depreciation is the decrease in the value of a firm’s capital that results from wear and tear and obsolescence. Gross investment is the total amount spent on purchases of new capital and on replacing depreciated capital. Net investment is the increase in the value of the firm’s capital. Net investment = Gross investment  Depreciation. Gross investment is one of the expenditures included in the expenditure approach to measuring GDP, so total product is a gross measure. Gross profit, which is a firm’s profit before subtracting depreciation, is one of the incomes included in the income approach to measuring GDP, so total product is a gross measure. Measuring Canada’s GDP The Bureau of Economic Analysis uses two approaches to measure GDP: The expenditure approach and the income approach. Expenditure approach - The expenditure approach measures GDP as the sum of the red flow: consumption expenditure, investment, government expenditure on goods and services and net exports. GDP = C + I + G + (X  M) Income approach - The income approach measures GDP by summing the incomes that firms pay households for the factors of production they hire. Two broad categories are: Wages, salaries, other labour income and all other factor incomes. The payment for labour services is the sum of gross
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