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4.4: Measuring GDP

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    11805
  • Nominal GDP is measured using market prices and a specific time period. It is not possible to add up the final physical outputs of many different businesses and arrive at a meaningful result. Instead, because we have a ‘money economy’, we let current market prices determine the money values of these different outputs. Then the total market value can be found by adding up the money values. Nominal GDP is the market value at current prices of all final goods and services.

    Furthermore, the outputs of goods and services occur over time, not all at once. They flow over time and must be measured relative to time. GDP measured over three-month and one-year time periods are reported as quarterly GDP and annual GDP. Annual nominal GDP for any year is the value of the final goods and services produced in that year at the prices of that year.

    Final goods and services: goods and services are purchased by the ultimate users.

    In Canada, Statistics Canada uses the Canadian System of National Accounts (CSNA) to measure GDP. This framework is based on the circular flow concept we have discussed, but is applied to the complexity of the actual economy.

    Although we defined and discussed real GDP, measured at prices of a base year, earlier in this chapter, national accounting measures nominal GDP at current prices. The CSNA produces three measurements of nominal GDP:

    1. Output-based GDP is the sum of value added (output less the cost of goods and services purchased from other business) by all industries in Canada;

    2. Income-based GDP records the earnings generated by the production of goods and services; and

    3. Expenditure-based GDP is equal to expenditure on final goods and services produced.

    Nominal GDP: the output of final goods and services, the money incomes generated by the production of that output, and expenditure on the sale of that output in a specific time period.

    These three alternative measures of GDP provide importantly different perspectives on the level of national economic activity. The output and income measures describe the supply side of the economy in terms of goods and services produced, and cost of production. The expenditure measure of GDP describes the demand side of the economy.

    Output-Based GDP

    To measure output in the economy, and the contribution of particular businesses or industries to that output, we use the value-added approach to GDP. Value added measures the net output of each industry. To find the value added (net output) of a particular business or industry, the costs of the goods and services purchased from other businesses and industries are deducted from the value of the final product. National, or all-industry GDP, is then the sum of GDP by industry.

    Value added: the difference between the market value of the output of the business and the cost of inputs purchased from other businesses.

    This method recognizes that businesses buy inputs to production from other businesses as well as from households. Automakers like General Motors and Honda buy parts and components like tires and windshields from other businesses, and include the costs of those inputs in the prices of the finished cars they sell. They also buy services like accounting, advertising, and transportation from service producers. Similarly, pizza makers buy cheese and pepperoni from cheese factories and meat processors. If we were to add up the outputs of auto parts manufacturers, cheese makers, meat processors, pizza makers, General Motors, and Honda in our measurement of nominal GDP, we would overstate GDP by double counting. The cheese would be counted once at the cheese factory and again in the pizza. The same applies to the tires and windshields of the new cars. To avoid double counting, we use value added, the increase in the value of goods and services as measured by the difference between market value of output and the cost of intermediate inputs bought from other businesses. Or we could count only the outputs sold to final users. Notice that total GDP by our definition measures the output of final goods and services.

    Intermediate inputs: services, materials, and components purchased from other businesses and used in the production of final goods.

    Consider a simple example. A coffee shop sells 100 cups of coffee an hour at a price, before tax, of $1.50. To make 100 cups of coffee the shop uses 2 kilos of ground coffee costing $10.00 per kilo, 25 litres of pure spring water costing $0.40 a litre, and electricity and dairy products costing, in total $20. The coffee shop’s sales per hour are $150 using inputs costing $50. Its value added is $150−$50 = $100. As we will see shortly, this value added, or $100, covers the labour costs, rent, interest expenses, and management costs of the business, for producing 100 cups of coffee an hour.

    Table 4.4 shows the industrial structure of output in Canada in 2013, based on the percentage shares of selected industries in Canadian GDP. Industry outputs are measured by value added. The data illustrate the importance of service-producing industries to economic activity in Canada. This industrial structure is typical of today’s high-income economies and raises many interesting questions about the relationship between economic structure, performance, and growth. However, when our main interest is in the total level of economic activity rather than its industrial structure, the expenditure-based and income-based measures of GDP are used.

    Screenshot 2019-03-04 at 19.45.04.png

    Table 4.4: Outputs of Selected Industries in GDP, Canada 2013 (Percent Shares)
    Source: Statistics Canada, CANSIM Table 379-0031 and author's calculations.

    Expenditure-Based GDP

    The expenditure-based measurement of nominal GDP adds up the market value of all the final goods and services produced and bought in a given time period, say one year. The national accounts classify this final expenditure into five main categories: consumption, investment, government expenditure, exports, and imports. This classification system is essential for our study of macroeconomic activity for two reasons. First, the classification scheme covers final expenditure in the economy completely; nothing is omitted. Second, the categories represent expenditure decisions made for different reasons in different parts of the economy. Understanding expenditure decisions is critical to the work that lies ahead. Defining the expenditure categories is the first step.

    Consumption expenditure is expenditure by the household sector on currently produced final goods and services in one year. It includes expenditures on food, clothing, housing, home appliances, transportation, entertainment, personal services, financial services, and so forth. The total of these expenditures is aggregate consumption. We will use C to indicate these household expenditures.

    Consumption expenditure (C): spending by households on currently produced final goods and services.

    Investment is expenditure by the business sector on currently produced final goods and services to be used in the future production of goods and services. Investment adds to the buildings, machinery, and inventories that business uses for the production of goods and services. This is the country’s capital stock. It was included in our discussion of the factors of production and factor incomes. By national accounts conventions, investment also includes expenditure on newly constructed residential housing, another component of the nation’s capital stock, one that produces housing services.

    Investment (I): spending by business on currently produced final goods and services.

    The investment defined here is gross investment. It does not take account of the decline or depreciation of the capital stock through wear and tear and obsolescence. Net investment is gross investment minus depreciation. Net investment measures the change in capital stock from one year to the next. Notice that net investment will be smaller than gross investment and could even be negative if the current level of investment expenditure is not enough to cover the depreciation of the capital stock. The key concept for our work is gross investment expenditure by business on currently produced final goods and services. We will use I to indicate this expenditure.

    Government expenditure is the purchase of currently produced final goods and services by the government sector of the economy. It includes the wages and salaries of government employees and the military, and thus the government-provided services like health care, education, the courts, foreign embassies, and national defense. Governments also spend on office equipment, buildings, roads, and military equipment. This public sector capital stock is also used to provide government services to the economy. We use G to indicate government expenditure on final goods and services.

    Government expenditure (G): spending by government on currently produced final goods and services.

    Governments also make payments to households and business that are not expenditure directly on current final output. These include payments made under government programs like Old Age Security, Employment Insurance Benefits, and Social Assistance, as well as the interest payments the government makes to holders of government bonds. These are transfer payments that do not require the provision of any goods or services in return. They are not included in GDP because there is no corresponding output. We will see in later chapters that government taxes and transfer payments redistribute existing income and spending power away from those taxed and towards those receiving transfer payments.

    Exports and Imports measure the expenditures arising from international trade in goods and services. Our exports are the result of expenditures by residents of other countries on the final goods and services produced in this country. These expenditures provide incomes to domestic factors of production. Our imports are our expenditures on goods and services produced in other countries. They do not give rise to incomes for domestic factors of production. However, some part of household consumption expenditures, business investment expenditures, and government expenditures are for goods and services produced in other countries. Furthermore, many of our exports of goods and services have imports included in them; for example, the new cars we assemble in Ontario and sell in the United States have components made in other countries. We could subtract the import component separately from the other expenditure categories and measure only expenditure on domestically produced final goods and services, but it is easier to continue to measure that final expenditure in total and then subtract imports from that total.

    Exports (X): purchases of our domestic goods and services by residents of other countries.

    Imports (IM): purchases of goods and services produced by other countries.

    The effect of international trade on domestic incomes is the result of the difference between exports and imports. Net exports, exports minus imports, measure this effect even though they are not directly related. We will use X to represent exports, IM to represent imports, and NX (= X −IM) to represent net exports.

    Net exports (NX): the difference between exports and imports.

    Gross domestic product measured by the expenditure approach is the sum of expenditures by households, businesses, governments, and residents of other countries on domestically produced final goods and services. Using the expenditure categories and notation we have discussed gives:

    \(\text{GDP} = \text{consumption + investment + government expenditure + exports - imports}\)

    or

    \[\text{GDP} = C + I + G + X - IM\]

    This approach to the measurement of GDP corresponds to the output and expenditure in the upper part of Figure 4.5. The left-hand columns of Table 4.5 show Canadian GDP in 2013 measured by the expenditure approach, in terms of the absolute values of expenditure categories and the percent share of each category in GDP measured by expenditure. Shares of consumption and exports are important structural aspects of the Canadian economy that are important for the model of the economy developed in later chapters.

    Screenshot 2019-03-04 at 19.58.35.png
    1. Includes expenditure by non-profit institutions serving households
    2. Includes investment in inventories

    Table 4.5: Canadian National Accounts 2013 ($ Billions at Current Prices and % GDP)
    Source: Based on Statistics Canada CANSIM Tables 380-0063 and 380-
    0064 and author's calculations.

    Income-Based GDP

    The income-based measurement of nominal GDP follows from the lower part of the circular flow diagram in Figure 4.5. By the national accounts definition, the income-based approach to measuring GDP must give the same value as the expenditure approach. A comparison of the left hand and right hand columns of Table 4.5 illustrates this accounting identity.

    National accounts classify incomes roughly in terms of the factors of production used to produce the goods and services in the economy in a year or a quarter of a year. The income categories in Table 4.5 are based on the latest Statistics Canada revisions to the national accounts. Other costs and taxes are then added to include all the things that enter into the final market prices of goods and services. We begin our measurement of the income-based GDP by defining each of these income sources and components of price.

    Employment compensation is the income earned by labour from its contribution to the production of goods and services. It includes the wages and salaries paid by businesses to employees. It also includes supplementary income, the costs of benefits like pensions, employment insurance premiums, supplemental health care, and dental insurance plans. This is the total cost of the labour services supplied by households to businesses. It reflects the money wage rates and salaries multiplied by total employment. We will use the W to represent total employment income.

    Employee compensation (W): the sum of all wages, salaries, and benefits paid to labour.

    Net corporate surplus is the sum of the profits of corporations before tax.

    Net corporate surplus (NCS): corporate profits before tax.

    Net mixed income is in part the sum of the incomes and rents earned by unincorporated business, which include many small owner-operated businesses, professional practices, and farm operations. It measures the costs of management and entrepreneurship, and the cost of owners’ labour and capital used in the production of goods and services. Net mixed income also includes interest and investment income earned on bank deposits, holdings of corporate bonds, and other incomes from financial assets, excluding government bonds.

    Net mixed income (NMI): unincorporated business income plus investment income.

    We will sum up net corporate surplus and net mixed income and use BI, for business income, to represent this type of income.

    Business income (BI): the sum of net corporate surplus and net mixed income.

    Adding together the incomes earned by labour, by businesses, and by holders of investment assets gives the total of incomes earned by the factor inputs to the production of goods and services in the domestic economy. This total is called Domestic Income (DI) at factor cost.

    Domestic Income: total income earned by factors of production.

    Domestic Income=employee compensation+net corporate surplus+net mixed income:

    \[DI = W + BI\]

    Canadian Domestic Income for the year 2013 is reported in the right-hand side of Table 4.5. It is the sum of the first three factor incomes reported in the lines recording income by source, namely, $1,364.0 billion. Employee compensation was the largest component of this domestic income at about 70 percent, and accounted for about 51 percent of GDP at market price. This income distribution and cost structure is important for the modeling the short run fluctuations in aggregate output and prices, and for later work on models of economic growth.

    Factor incomes are the largest part of the income flow resulting from the production of goods and services, but they do not cover all the components of the market prices by which expenditures are measured. Two things are missing. The first is an allowance for the depreciation of the capital stock used for production. The second is the effect of taxes and government subsidies. We include both of these to measure GDP by the income approach.

    Even with expenditures on repair and maintenance, the reliability and productive capacity of the capital stock declines over time. The ability of business to produce goods and services declines with it. A car or a bicycle or a computer depreciates and loses its reliability in the same way. Business recognizes “consumption” of the capital stock as a cost of production over and above the factor cost. As with factor costs, businesses cover depreciation and the replacement costs of capital with part of the revenue received from sales of goods and services. National accounts capture depreciation by including a Capital Consumption Allowance (CCA) in the measurement of the income.

    Capital Consumption Allowance (CCA) measures depreciation of the capital stock.

    Adding the Capital Consumption Allowance to Domestic Income gives GDP at basic price. That is the price before indirect tax or subsidy.

    GDP at basic price = Domestic Income + Capital Consumption Allowance.

    \[\text{GDP at basic price} = DI + CCA\]

    Net indirect taxes (TIN) are the sales and excise taxes imposed by government on products and services, or on expenditure more generally, minus the subsidies governments give to some production. The GST, the HST, provincial retail sales taxes, taxes on liquor and tobacco products, and gasoline taxes are all indirect taxes. You pay if you buy. Sellers of these products collect the tax revenue for the government and remit it to the government. As a result, the expenditures on goods and services at market price exceed production cost and generate a flow of income to the government in addition to the flow of income going to business and households.

    Net indirect taxes (TIN): sales and excise taxes minus subsidies.

    Subsidies are payments made by governments to producers to cover some of the costs of production. A producer who receives such a payment does not have to recover all factor and depreciation costs from the market price of the product. As a result, the market price is less than the full cost. Subsidies are subtracted from indirect taxes to give the net effect. GDP at basic price plus net indirect tax equals GDP at market price, measured by the income approach.

    GDP at market price: Domestic Income + Capital Consumption Allowance + Net Indirect Tax.

    \[\text{GDP at market price} = DI + CCA + T_{IN}\]

    The economy as described by the concepts of national accounts is more complex than the simple economy of the circular flow in Figure 4.5. But the basic principle remains. The final output of the economy is, by definition, equal to the sum of expenditures on final goods and services at market price or by the flows of income to households, business, and government. GDP is the same by either approach if we measure correctly.

    There are two important concepts we have not yet discussed. The household and business sectors may save some of their incomes or borrow to finance expenditure. The government sector may also save or borrow, and operate with either a budget deficit or a budget surplus. These are topics we will examine carefully as we explain the determinants of expenditure decisions in Chapter 6 and government budgets in Chapter 7.

    To construct a macroeconomic theory and model the economy we must explain the linkages, feedbacks and interactions among the elements of the economy defined by national accounting conventions. These linkages, feedbacks and interactions are the important relationships that work together to explain how this economic system determines GDP, business cycle fluctuations in GDP, inflation, and employment.