Measures of Economic Activity By Michael Donnelly Matt

Measures of Economic Activity By Michael Donnelly, Matt Bundas, Andrew Wong and Neraj Bakshi

Chapter Focus ü Gross Domestic Product (GDP), and the two approaches to calculating it ü The components of GDP ü Per capita GDP, and how it may be used to compare GDPs of different years or different countries

Chapter Focus Cont. ü Some limitations of GDP as an economic indicator ü Other economic measures developed from the national income accounts

Recall ü Recall that businesses track revenues and expenditures in their accounts thereby allowing managers and owners to pinpoint ways improving a businesses performance ü Statistics Canada keeps track of the Canadian economy via national income accounts

National Income Accounts Ø Accounts showing the levels of total income and spending in the Canadian economy ü Allow us to evaluate the performance of the Canadian economy and to compare it with other nations’ economies ü Help government policymakers find ways to improve the economy

Gross Domestic Product (GDP) Ø The total dollar value at current prices of all final goods and services produced in Canada over a given period (usually a year) ü Used to measure economic activity and can be developed from the national income accounts ü The dollar value is used when calculating GDP because it simplifies the calculations ü Also because the dollar value is a way to quantify and combine a wide range of goods and services

How to Calculate GDP… ü There are 2 ways to calculate GDP: 1. Income Approach: a method calculating GDP by adding together incomes in the economy 2. Expenditure Approach: a method calculation GDP by adding together spending in the economy of all

The GDP Identity ü GDP calculated as total income is identical to GDP calculated as total spending GDP expressed as total income ≡ GDP expressed as total spending ü This applies to the entire Canadian economy, not just the simplified economy shown in Figure 10. 2

Breakdown of Figure 10. 2 ü In short, because all spending on final consumer products ends up as some form of household income, annual income equals annual spending ü This explains the GDP Identity

Breakdown Approach of the Income ü Made up of 7 categories 1. Wages and Salaries 2. Corporate Profits 3. Interest Income 4. Proprietors’ Incomes and Rents Ø These form the basis of GDP calculated using the income approach

Breakdown of Approach Cont. 1. 2. 3. Ø the Income Indirect Taxes Depreciation Statistical Discrepancy These are added on by Statistics Canada in order to balance GDP calculated by the income approach with GDP calculated by the expenditure approach Ø Using the income approach, GDP is the sum of all 7 categories

Wages and Salaries ü Largest income category ü Represents close to 60% of GDP ü Includes direct payments to workers in both businesses and government as well as employee benefits such as contributions to employee pension funds

Corporate Profits ü Includes all of the profits declared to the government by corporate businesses such as the profits paid as corporate income tax, the profits paid out to corporate shareholders as dividends and retained earnings ü Retained Earnings: profits kept by businesses for new investment

Interest Income ü Includes interest paid on business loans and bonds and income such as royalty payments (the latter occurring less frequently) ü Includes adjustments to the value of businesses’ unsold products ü Does not include interest payments made by consumers and government because these are viewed as transfers of purchasing power

Proprietors’ Incomes and Rents ü This includes the earnings made by sole proprietorships, partnerships, self-employed professionals, farmers as well as the income to landlords from renting property ü Recall that incomes are received by owners of proprietorships for supplying various types of resources to their business

Indirect Taxes ü Taxes that are charged on products rather then be applied to households or businesses (i. e. : P. S. T) ü Not included in the GDP with the income approach, but rather with the expenditure approach ü To balance the results from the 2 approaches, taxes -- subsidies that businesses receive are added to income-based GDP

Depreciation ü Like indirect taxes, must also be added to the income approach ü Includes durable assets such as buildings, equipment and tools that eventually wear out and need to be replaced ü Considered a cost of business and shows up in the expenditure approach

Statistical Discrepancy ü GDP figures are actually estimates due to businesses/persons records being faulty or missing ü The discrepancy between the two approaches is known as the statistical discrepancy ü This can be seen in Figure 10. 3

Breakdown of Figure 10. 3 Ø To balance the two figures, Statistics Canada divides the difference between the two approaches Ø Discrepancy was $4. 8 billion. Half the amount ($2. 4 billion) is added to the lower figure (income-based estimate of GDP), and half is deducted from the higher figure (expenditurebased estimate of GDP)

The Expenditure Approach ü GDP found using this approach is the sum of purchases in the product markets

Categories of Products ü Final Products: products that will not be processed further and will not be resold ü Intermediate Products: products that will be processed further or will be resold Ø Ex: Flour that is bought by a household for home baking is a final product. Flour that is bought by a bakery to make bread to be sold is an intermediate product

Double Counting ü This occurs when the values of all products, both final and intermediate are included in the GDP calculations ü Would cause estimates to be too high & not reflect the real activity in the economy

End of Day 1 Thanks for your time!

Value Added ü In order to prevent double counting, the concept of value added is applied to the GDP ü Value Added: the extra worth of product at each stage in its production; a concept used to avoid double counting in calculating GDP ü Figure 10. 4 uses a pad of paper at each level of production, the results of double counting and how the concept of vales added deals with it

Categories of Purchases ü Recall that expenditure -based GDP is calculated on the basis of almost all purchases in the Canadian economy ü Few products are excluded ü Those that are included, fall under 4 distinct categories

Excluded Purchases ü There are two types of excluded purchases: financial exchanges and second-hand purchases ü These are excluded because they are not related to current production

Financial Exchanges ü This includes a gift of money between family members and is not included in the GDP ü This is a transfer of of purchasing power from one party to another ü Also excluded are bank deposits and purchases of stock

Second-Hand Purchases ü A. K. A, used goods ü Excluded from GDP because they have been accounted for previously in their very first transaction to their original owner (first consumer) ü In brief, if they were included, GDP would double count and thus overestimate

Included Purchases ü Included in the GDP calculations 1. Personal consumption (C) 2. Gross investment (I) 3. Government purchases (G) 4. Net exports (X-M) ü Each contribute to the economy

Expenditure Equation GDP = C + I + G + ( X - M )

Personal Consumption ü Household spending on goods and services. ü Make up 60% of the GDP ü Goods include: nondurable and durable ü Nondurable: goods that are consumed just once. Ex: food ü Durable: goods that are consumed repeatedly over time. Ex: bikes and CD’s

Gross Investment ü Purchases of assets that are intended to produce revenue. ü Makes up 15 -25% of the GDP year-year ü Most important spending in this category is on capital goods (machines etc) used by businesses ü Also included are expenditures by government agencies into capital goods

Gross Investment Cont. ü Related to the economy’s capital stock ü The total value of productive assets that provide a flow of revenue ü Recall that capital such as machinery depreciate in value ü Net investment is the gross investment minus depreciation ü Represents the yearly change in the economy’s stock of capital ü Capital stock is the total value of productive assets that provide a flow of revenue

Breakdown of Fig. 10. 5 ü An economy has $200 billion of capital stock at the beginning of the year ü It depreciates by $40 billion during the year ü Gross investment during the same period is $100 billion thus the net investment is $60 billion (100 -40) ü The $60 billion represents the amount that the capital stock expanded during the year ü Thus by the end of the year, the economy’s capital stock is $260 billion (200+60)

Gross Investment Cont. Ø Also includes: ü inventories of different companies stocks of unsold goods and materials ü Building construction with owner-occupied housing ü Included here instead of personal consumption because the owner could rent it out for a profit

Government Purchases ü Include current spending by all levels of government on goods and services ü Make up 20% of GDP ü Ex: The federal government buying a battleship for the Navy, or a municipality hiring a paving company to repair roads ü Fig. 10. 7 shows the role of government in the economy’s circular flow of money

Net Exports ü Final category of purchase and includes the purchases of Canadian goods and services by foreigners, or exports Ø This is calculated via the exports -- imports ü This is done because while exports include an American furniture store buying Canadian softwood, imports include a Canadian paintball player buying an American paintball gun ü Represented as net exports, they make up a small % of GDP, yet viewed independently of each other, they each make up about 25% of the GDP

Breakdown of Fig. 10. 8 ü Shows the roles of exports and imports in the economy ü Foreigners also play a part in the economy by lending/borrowing from financial markets ü Foreign involvement tends to create a net increase in the economy ü Foreign loans to the Canadian economy > Canadian loans to foreigners

GDP and Living Standards ü GDP can be used to determine our standard of living via per capita GDP ü This is the GDP person and is calculated as GDP/population Ø In short, per capita GDP is the total $ value of output person Ø Ex: in 1993 our GDP was $710 723 million and our population was 28. 753 million. our per capita GDP was $24, 718 person

Adjustments to Per Capita GDP ü Adjusted depending on how it is to be used Ø Inflation adjustments Ø Exchange-Rate Adjustments

Inflation Adjustments ü Takes into account the effects of inflation when analyzing the economic well-being within a country ü Done by using real GDP ü GDP expressed in constant $ from a given year ü Per capita real GDP is calculated the same way as per capita GDP but using the real GDP

End of Day 2 Thanks for your time!

Exchange Rate Adjustments ü Used to help better compare per capita GDP between countries where currencies differ ü To counter this, all countries GDP’s are expressed in one currency; American $

Limitations of GDP ü Recall: GDP is a measure of the total $ value of all final goods and services produced in an economy over a given period ü Indicates economic activity and living standards (to some extent) ü Has quantitative and qualitative limitations ü Does not tell us about what is purchased or produced

Excluded Activities ü GDP does not include some types of productive activities meaning that the GDP can actually understate economic activity and living standards ü Non-market activities: productive activities that take place outside the market place such as housework, unpaid child care and the work of “do-it-yourselfers” ü Have vital impact on our living standards

Excluded Activities Cont. ü Underground economy: all the productive transactions that go unreported ü Include things such as smuggling or “under-the -table” transactions ü These are transactions paid for in cash so as to avoid applicable taxes

Product Quality ü With the introduction of new technology and an increase of living standards, the quality of our goods has increased dramatically over the years ü GDP can only add up selling prices, cannot fully capture these quality improvements

Composition of Output ü Refers to the different uses of GDP between countries ü A country that dedicates its GDP towards to health care and education would have a much higher standard of living than a country that dedicated its GDP towards military uses

Income Distribution üRecall that incomes may be distributed differently throughout the population ü “the richest 1 per cent alone owned 40 per cent of global assets in the year 2000. ”

Income Distribution Cont. ü “The world's total household wealth amounted to $125 trillion in the year 2000, a sum which, averaged out, should give every adult $20, 500. But in some countries, average per capita wealth was below $2, 000, while the richest ranked many times higher. ” Source: World's assets tightly held: Study by Olivia Ward. Excerpt from the Toronto Star

Leisure ü Many people consider this important to living standards ü Despite the fact that we are able to work every hour of the day, people do not ü The hours worked per week has decreased dramatically over the past century

Leisure Cont. ü GDP has no way of representing this change in working hours per week ü This would indicate in increase in the standard of living ü Furthermore, leisure is not a commodity and thus cannot be bought or sold on the market

The Environment ü GDP does not differ between economic activities that harm the environment, and those that don’t ü May not accurately represent spillover costs and benefits ü Ex: the cleaning up of an oil spill would be added to GDP, the creation of a new nature preserve would likely not be added

Gross National Product (GNP) ü The total income acquired by Canadians both within Canada and elsewhere ü Recall that GDP focuses on the incomes made in Canada while GNP focuses on earnings of Canadians ü In order to calculate GNP, 2 adjustments must be made to GDP

Calculating GNP 1. Income earned from Canadian investments by foreigners is deducted from GDP i. e. : interest payments on a Canadian government bond held in Japan 2. Income earned from foreign investments by Canadians is added to GDP i. e. : a stock dividend from an American company paid to a Canadian sharholder

Calculating GNP Cont. ü The 2 adjustments can be made in an investment income account ü Foreign investment in Canada is higher than Canadian investment in foreign countries ü GDP -- the account shows net investment income to foreigners = GNP

Net Domestic Income (NDI) ü Recall from CH. 8 that NDI represents what is earned by households supplying resources in Canada ü NDI = GDP -- amounts that are not earning from current production i. e. : indirect taxes, depreciation allowances, statistical discrepancy

Personal Income ü The income households actually received by ü Calculated via adjustments made to net domestic income (Refer to 10. 10)

Transfer Payments ü Government payments to net domestic income ü Unrelated to earned income ü Received by households ü Excluded from net domestic income, but are part of households’ personal income

Other Payments to Persons ü Primarily from governments to households ü Most important of which are interest payments paid by governments on the debt they owe ü Not part of resource earnings but are received by households ü they must be included in personal income

Earnings Not Paid Out to Persons ü Include taxes on corporate profits and retained earnings ü These items must be subtracted from net domestic income to find personal income because they are earned, not received by households

Net Investment Foreigners Income to ü Recall how foreigners invest into Canada and is represented by a net investment account ü This net investment income must subtracted to give personal income be ü The income payments are post of GDP and net domestic income ü They are not received by households

Disposable Income and Discretionary ü Disposable Income: household income minus personal taxes and other personal transfers to government ü Used to buy necessities such as food, housing and clothing ü Discretionary Income: disposable income -- purchases of necessities

End of Day 3 Thank you and we hope you enjoyed our presentation!