5 GDP – Economics (INCOMPLETE)

5.1 Gross Domestic Product (GDP)

William D. Nordhaus (2002): “While the GDP and the rest of the National Income and Product Accounts (NIPA) may seem to be arcane concepts, they are truly among the great inventions of the twentieth century. Much like a satellite in space can survey the weather across an entire continent, GDP provides an overall picture of the state of the economy. Since its initial construction by Simon Kuznets, who won the Nobel Prize in Economics for his contributions to national income accounting, significant strides have been made in developing and improving indexes of economic welfare.”

Nordhaus, W. D. (2002). The health of nations: The contribution of improved health to living standards (Working Paper 8818). National Bureau of Economic Research (NBER).

The Gross Domestic Product (GDP) “is the market value of all final goods and services produced within a country in a given period of time” (Mankiw, 2024, ch. 24).

Mankiw, N. G. (2024). Principles of economics (10th ed.). Cengage Learning.

This definition consists of four parts:

Market value: The items in GDP are valued at their market prices.
Final goods and services: A final good is an item purchased by its final user. It contrasts with an intermediate good, which is produced by one firm, bought by another firm, and used as a component of a final good or service. To avoid double counting, GDP includes only final goods and services.
Produced within a country: Only goods and services produced within a country are counted.
In a given period of time: GDP is measured over a specified time frame, typically a quarter or a year.

5.2 Three equivalent ways to measure the GDP

GDP can be quantified through three methods, each expected to yield equivalent outcomes. The circular flow diagrams of Figure 5.2 visualize the concept.

Total spending on domestic products and services (expenditure approach)
Total domestic income (income approach)
Total domestic production (production approach)

All three approaches theoretically should arrive at the same result, that is, measuring the value that was added within an economy over the course of time.

Figure 5.2: The circular flow in a closed economy
*Note: The diagram was taken from Suranovic (2016), p. 54.*

Watch the videos of Figure 5.3.

Figure 5.3: What is Gross Domestic Product (GDP)?

Source: Youtube

5.2.1 The expenditure approach

The expenditure approach measures GDP as the sum of consumption expenditure, $C$, investment, $I$, government expenditure on goods and services, $G$, and net exports of goods and services, $(X - M)$. Therefore, the equation - which is often called the GDP decomposition - is:

\[GDP = C + I + G + (X - M),\]

where

$C$ denote the expenditure on all consumer goods,
$I$ denotes the expenditure on newly produced capital goods,
$G$ denotes government expenditure on goods and services (excluding transfers),
$X$ denotes the exports, and $M$ the imports. The difference $X-M$ stands for the net exports, also known as the trade balance. For example, for the USA in 2020, this amounts to: \[\$14,145 + \$3,605 + \$3,831 + (-\$645) = \$20,936.\] Aggregate expenditure equals GDP because all goods and services produced are sold to households, firms, governments, or foreigners. Please note, goods and services that are not sold are included in investment as inventories and thus are “sold” to the producing firm.

Please consider Figures Figure 5.4, Figure 5.5, and Figure 5.6. They illustrate various aspects of GDP composition.

Figure 5.4: Decomposition of GDP in 2013 for the US, the Eurozone, and China.

Figure 5.5: Composition of US GDP, 1929-2005

Figure 5.6: Expenditure Shares of U.S. GDP, 1970-2005

5.2.2 The income approach

The income approach measures GDP as the sum of compensation of employees, net interest, rental income, corporate profits, and proprietors’ income. This sum equals net domestic income at factor costs. To obtain GDP, indirect taxes (taxes paid by consumers when they buy goods and services) minus subsidies are included along with depreciation. Finally, any discrepancy between the expenditure approach and the income approach is included in the income approach as a statistical discrepancy.

5.3 Limitations of the nominal GDP

The GDP as a single measure for economic activity and production, respectively, was pioneered and developed by a Russian-born American economist, Simon Kuznets (1901-1985), see Figure 5.7. He received the Nobel Prize in economics in 1971 for his contributions. While he was convinced about the valuable uses of national income measurements, he was very much aware of the limitations and the risks of the measures to be abused. In an report to the U.S. Senate where he explains the possibilities of a national income measure, he warns in the section “Uses and Abuses of National Income Measurements” (Kuznets, 1934, pp. 5–8) that the GDP needs to be “interpreted with a full realization of the definition of national income assumed”Kuznets (1934, p. 6). Otherwise it is abused. Please read here his carefull warning:

Kuznets, S. (1934). National income, 1929-32: Letter from the acting secretary of commerce transmitting in response to senate resolution no. 220 (72D cong.) a report on national income, 1929-32 (124). Senate, 73rd Congress, 2d session. https://fraser.stlouisfed.org/title/national-income-1929-1932-971

“The valuable capacity of the human mind to simplify a complex situation in a compact characterization becomes dangerous when not controlled in terms of definitely stated criteria. With quantitative measurements especially, the definiteness of the result suggests, often misleadingly, a precision and simplicity in the outlines of the object measured. Measurements of national income are subject to this type of illusion and resulting abuse, especially since they deal with matters that are the center of conflict of opposing social groups where the effectiveness of an argument is often contingent upon oversimplification.

From the definition of national income presented and discussed above it is obvious that a measure of income produced sheds a good deal of light on the productivity of the nation; that income received measures the same productivity as reflected in the flow of means of purchase to the nation’s members; and that when total income paid out is adjusted for changes in the value of money and apportioned per capita, the result is illuminating of movements in the nation’s economic welfare. Comparison of such income measurements for different nations, or for the same nation for different years, yields valuable indications of spatial and temporal differences in national productivity and economic welfare. Moreover, various single groups of services or drafts may be compared with the country’s total to indicate their relative weight in or draft upon the latter.

These constitute highly valuable uses of national income measurements, but only if the results are interpreted with a full realization of the definition of national income assumed, either explicitly or implicitly, by the measurement. Thus, the estimates submitted in the present study define income in such a way as to cover primarily only efforts whose results appear on the market place of our economy. A student of social affairs who is interested in the total productivity of the nation, including those efforts which, like housewives’ services, do not appear on the market, can therefore use our measures only with some qualifications. Secondly, the present study’s measures of national income, like all such studies, estimates the value of commodities and direct services at their market price. But market valuation of commodities and especially of direct services depends upon the personal distribution of income within the nation. Thus in a nation with a rich upper class, the personal services to the rich are likely to be valued at a much higher level than the very same services in another nation, characterized by a more equitable personal distribution of income. A student of social affairs who conceives of a nation’s end-product as undistorted by the existing distribution of income, yould again have to qualify and change our estimates, possibly in a marked fashion. Thirdly, the present study’s estimate of national income produced is based in part, like most existing estimates, upon the prevalent legal and accounting distinction between gross and net income of business enterprises. To a student of social affairs whose concept of net productivity does not agree with the prevailing practices of separating net from gross income, especially by corporations, our estimates will obviously present a somewhat distorted picture of the nation’s net product.

All these qualifications upon estimates of national income as an index of productivity are just as important when income measurements are interpreted from the point of view of economic welfare. But in the latter case additional difficulties will be suggested to anyone who wants to penetrate below the surface of total figures and market values. Economic welfare cannot be adequately measured unless the personal distribution of income is known. And no income measurement undertakes to estimate the reverse side of income, that is, the intensity and unpleasantness of effort going into the earning of income. The welfare of a nation can, therefore, scarcely be inferred from a measurement of national income as defined above.

The abuses of national income estimates arise largely from a failure to take into account the precise definition of income and the methods of its evaluation which the estimator assumes in arriving at his final figures. Notions of productivity or welfare as understood by the user of the estimates are often read by him into the income measurement, regardless of the assumptions made by the income estimator in arriving at the figures. As a result we find all too commonly such inferences that a decline of 30 percent in the national income (in terms of “constant” dollars) means a 30 percent decline in the total productivity of the nation, and a corresponding decline in its welfare. Or that a nation whose total income is twice the size of the national income of another country is twice “as well off”, can sustain payments abroad twice as large or can carry a debt burden double in size. Such statements can obviously be true only when gualified by a host of “ifs.”

A similar failure to take into account the investigator’s basic assumptions underlies another widely prevalent abuse of national income measures, involved in estimating the draft or “burden” which this or that particular type of expenses (e.g., government expenses, payments on bonded debt, etc.) constitutes ot the country’s total end-product. Every payment included in the national income is ipso facto a draft or a “burden” upon national income. For example, net receipts by physicians from medical practice, are both an addition to national income and a draft upon individual incomes from which such receipts originate. Since we estimate the value of personal services or commodities at their market value it follows that any payment for productive services contributes just as much to the national income total as it takes away from it. No items included in national income can, therefore, be conceived as “pure” draft.

The full meaning of a statement that such payments as interest on bonds or taxes for government services are a ” burden” or draft upon national income is that actually no services are being rendered in return for these payments. That an increasing weight in the national income of payments on fixed debt or of salaries of government officials is not hailed as an increased contribution to national income lies in the implicit assumption, not always true, that the services contributed by creditors or government officials have not increased proportionately, and that, therefore, a heavier burden was added upon other income recipients without an increased benefit.

Such assumptions are accepted all too easily because they are based upon a natural but erroneous identification of national income with business or personal income. From the standpoint of a business firm or person, the income of employees, private or public, is likely to appear as a draft. But from the vantage point of national economy as a whole, which is used by a national income investigator, no payment that is included in national income can be considered as a pure draft upon the country’s end-product. This can be true only of payments not included, such as charity, earnings from illegal pursuits, and the like. All that the national income estimator can say is that this or the other part of the national total has increased or declined more than the others. That this rise or decline implies a larger or smaller burden upon the national economy can be established only on the basis of such additional assumptions as have been formulated above, assumptions which arc not a proper part of the national income estimate and which are far from being self-evident.”

In a nutshell, GDP is an imperfect measure of production as it overlooks significant parts of economic activity. For example, it does not account for black market activity, private production, and production that occurs outside formal markets. While GDP is often used to gauge a country’s welfare or the well-being and happiness of its citizens, it neglects factors considered essential to these concepts, which are inherently difficult to define.

Exercise 5.3 GDP as an imperfect measure

Watch the video Robert F. Kennedy challenges Gross Domestic Product or read the speech of Robert Kennedy below and discuss what factors influencing the standard of living are not included in GDP and how that may impact GDP:

“Gross National Product counts air pollution and cigarette advertising, and ambulances to clear our highways of carnage. It counts special locks for our doors and the jails for the people who break them. It counts the destruction of the redwood and the loss of our natural wonder in chaotic sprawl. It counts napalm and counts nuclear warheads and armored cars for the police to fight the riots in our cities. It counts Whitman’s rifle and Speck’s knife, and the television programs which glorify violence in order to sell toys to our children. Yet the gross national product does not allow for the health of our children, the quality of their education or the joy of their play. It does not include the beauty of our poetry or the strength of our marriages, the intelligence of our public debate or the integrity of our public officials. […] it measures everything in short, except that which makes life worthwhile.”
– Senator Robert F. Kennedy (1925-1968) (see Kennedy, 1968)

Solution: Factors omitted from GDP

Some aspects that influence the standard of living are not part of GDP. These include:

Non-market transactions: Household production, such as childcare services, is excluded from GDP. As more services, including childcare, are provided in the marketplace, the measured growth rate might overstate the development of overall economic activity.
Black-market activities: Although the level of GDP may be underestimated if the underground economy is a stable proportion of total economic activity, the growth rate itself should remain accurate.
Leisure Time: An increase in leisure time may lower the economic growth rate, but individuals may value their leisure and feel better off as a result.
Environmental Quality: Pollution does not directly diminish the economic growth rate, even though it may lower living standards.
Inequality: GDP fails to account for income inequality within society.
Sustainability: GDP does not reflect the sustainability of economic growth.
Health and environment: GDP overlooks the health of individuals and the environment in general.
Depreciation replacement: GDP does not consider how much capital (tangible goods) has depreciated. For example, while GDP measures the construction of new bridges, it does not account for bridges that have been decommissioned. It is not a balance sheet of prosperity but a measure of the inflow of new production.

Kennedy, R. F. (1968). Remarks at the University of Kansas, march 18, 1968 (Miscellaneous Recordings MR 89-34). John F. Kennedy Presidential Library.

5.4 Nominal and real GDP

Please watch the video of Figure 5.8.

Figure 5.8: Nominal vs. Real GDP

Source: Youtube

Nominal GDP reflects the value of final goods and services produced in a specific year, valued at the prices prevalent during that year. The overall market value of production and thus GDP can rise either through increased output of goods and services or through higher prices. In contrast, the real GDP enables the comparison of production quantities across different time periods, as it represents the value of final goods and services produced in a year, valued at the prices of a reference base year. This relationship is expressed as:

\[GDP^{\text{real}}=\frac{GDP^{\text{nominal}}}{P}\]

While nominal GDP is the commonly reported figure and does not account for price adjustments, real GDP provides somehow a more accurate reflection of the actual quantity of goods and services produced. The real GDP is an inflation-adjusted measure that captures the value of all goods and services produced by an economy in a given year, expressed in base-year prices. It is often referred to as constant-price GDP, inflation-corrected GDP, or constant dollar GDP. A clear definition can be found on Wikipedia (2020):

Wikipedia. (2020). Wikipedia, the free encyclopedia: Real gross domestic product. https://en.wikipedia.org/wiki/Real_gross_domestic_product

“Real gross domestic product (real gdp for short) is a macroeconomic measure of the value of economic output adjusted for price changes (i.e., inflation or deflation). This adjustment transforms the money-value measure, nominal GDP, into an index for quantity of total output.”

To clarify the concept of the real GDP, consider the two following examples where we suppose the economy produces only one product.

Example A: Prices change

Production and prices are as shown in Table 5.1:

Table 5.1: No quantity changes

Year	Number	Price in Euro
2010	500	1
2011	500	1.1
2012	500	1.2

Nominal GDP:

\[\begin{align} GDP_{2010}^{nominal} &= 500 \cdot 1 \text{€} = 500\text{€}\\ GDP_{2011}^{nominal} &= 500 \cdot 1.1 \text{€} = 550\text{€}\\ GDP_{2012}^{nominal} &= 500 \cdot 1.2 \text{€}= 600\text{€} \end{align}\]

Real GDP with a base year 2010:

\[\begin{align} GDP_{2010}^{real, base=2010} = 500 \cdot 1\text{€} = 500 \text{€} \\ GDP_{2011}^{real, base=2010} = 500 \cdot 1\text{€} = 500 \text{€} \\ GDP_{2012}^{real, base=2010} = 500 \cdot 1\text{€} = 500 \text{€} \end{align}\]

Example B: Prices and quantity change

The production and prices are as shown in Table 5.2:

Table 5.2: Price and quantity changes

Year	Number	Price in Euro
2010	500	1
2011	600	1.1
2012	700	1.2

Nominal GDP: \[\begin{align} GDP_{2010} = 500 \cdot 1\text{€} = 500 \text{€} \\ GDP_{2011} = 600 \cdot 1.1\text{€} = 660 \text{€} \\ GDP_{2012} = 700 \cdot 1.2\text{€} = 840 \text{€} \end{align}\] Real GDP with a base year of 2010: \[\begin{align} GDP_{2010}^{base=2010} = 500 \cdot 1\text{€} = 500 \text{€} \\ GDP_{2011}^{base=2010} = 600 \cdot 1\text{€} = 600 \text{€} \\ GDP_{2012}^{base=2010} = 700 \cdot 1\text{€} = 700 \text{€} \end{align}\]

The examples above simplify reality by assuming that only one item is being produced in the economy, while, in fact, many goods and services are produced. Despite this limitation, the examples illustrate two important points. First, it is crucial to identify a representative basket of goods produced in an economy. Second, it is essential to measure the prices of this basket accurately. Both of these aspects will be discussed in Chapter 6. Afterward, we will return to evaluating GDP as a measure of welfare in Chapter 7.

Exercise 5.4 Various GDP

To estimate GDP, you add the value of all goods and services produced, both final and intermediate goods. Is this procedure correct? Why?
What is the relationship between aggregate income and aggregate production? Why does this relationship exist?
Does my purchase of a domestically produced Ford automobile that was manufactured in 2020 add to the current U.S. GDP? Why? How about my purchase of a domestically produced, newly produced Ford? Why?
Does my purchase of 100 shares of stock in Meta add to the nation’s GDP? Why?
If a homeowner cuts their lawn, is the value of this work included in real GDP? Suppose the homeowner hires a neighborhood kid to cut the lawn. Is this activity included in real GDP? Comment on your answers.
In 1900, the average work week was 65 hours; today it is approximately 35 hours. How did this change affect real GDP within the United States? How did it affect the standard of living within the United States? Comment on your answers.
In the United States, many children receive daycare from commercial providers. In Africa, this is uncommon; children are almost all cared for by relatives. How would this difference affect comparisons of GDP per person?

Solution

Adding the value of all goods and services produced is incorrect because it leads to significant double counting. Intermediate goods and services will be counted multiple times; for example, a CPU produced by Intel and then used in a Dell computer could be counted as both a CPU from Intel and as part of the computer from Dell.
Aggregate income equals aggregate production. The circular flow shows this result: the flow of production out of business firms equals the flow of expenditure into business firms, which equals the flow of costs out of business firms, which is the same as the flow of aggregate income to households.
The purchase of the used Ford does not add to current U.S. GDP as it was not produced in the current year; however, a new Ford automobile is counted in current U.S. GDP because it was produced during the current year.
Purchasing shares of stock does not add to the nation’s GDP, as GDP measures production. Shares of stock are not the production of a good or service and, therefore, are not included in GDP.
The homeowner’s work around their home is not included in GDP because home production is excluded. Hiring a neighborhood kid to cut the lawn is included in GDP because it is a service that has been sold in a market. This illustrates a flaw in GDP computation; the same lawn is mowed regardless of payment, yet GDP is unaffected in one case and increases in the other.
The decrease in the average work week will likely decrease real GDP, as less time is spent producing goods and services. This could imply a lower standard of living. However, the increase in leisure time can lead to a higher standard of living for many individuals who value their leisure more than the goods and services they could produce. Thus, relying solely on changes in real GDP to measure standard of living is inadequate.
This difference suggests that U.S. GDP per person is biased higher than GDP per person in African countries, as the same service—childcare—produced in both regions is included in GDP in the U.S. due to market transactions, while in Africa it is omitted due to being performed as household production.

Exercise 5.5 What counts as GDP?

By how much does GDP rise in each of the following scenarios? Explain.

You spend 8000 € on college tuition this semester.
You buy a used computer from a friend for 500€.
The government spends 300€ million to build a bridge.
Foreign graduate students work as teaching assistants at the local university and earn 2000€ each.