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2.2 Measuring the State of the Economy
Chapter 2
Measuring the
Macroeconomy
By Charles I. Jones
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• Gross domestic product (GDP)
– The market value of the final goods and
services produced in an economy over a
certain period.
• United States GDP
– $12.5 trillion in 2005
– $15.7 trillion in 2012 ($50,000 per person)
Dave Brown
Penn State University
2.1 Introduction
• In this chapter, we learn:
– The importance of gross domestic product (GDP)
– The composition of GDP, and how it has
changed over time.
– How to use GDP to examine
• the evolution of living standards
• differences in living standards across countries.
• Production measure of GDP
– The number of goods produced in the
economy.
• Expenditure measure
– The total purchases in the economy.
• Income measure
– All the income earned in the economy.
• All three approaches give identical
measures of GDP.
Thus:
Production = Expenditure = Income
• National income accounting
– Method of aggregating the production of
diverse goods into a single measure of
overall economic activity.
• National accounting
– State of an economy at a given time.
– Changes to an economy over time.
– Differences across countries.
• When calculating income, we need to
distinguish between “profits” and
“economic profits”
• Profits
– Normal competitive return on inputs.
• Economic profits
– Above-normal returns associated with prices
that exceed those that prevail under perfect
competition.
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The Expenditure Approach to GDP
• The national income accounting identity
states:
• Where
Y = GDP (in dollars)
C = consumption
I = investment
G = government purchases
NX = net exports = exports – imports
• Net exports (trade balance) for the United
States is negative.
• The recent trade deficit indicates that the
United States is borrowing goods from the
rest of the world.
• As the trade balance has turned negative,
consumption has increased as a share of
GDP recently.
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The Income Approach to GDP
• The income approach
– Measures the sum of all income earned in the
economy.
• Capital
– Inputs into production other than labor that are
not used up in the production process.
• Total shares of GDP to inputs:
– Share of GDP to Labor: two-thirds
– Share of GDP to Capital: one-third.
– Labor’s share of GDP has remained
approximately constant over time.
– Firms increase capital through investment.
The Income Approach to GDP
• Depreciation
– The deterioration of the capital stock due to
wear and tear.
GDP – depreciation = net domestic product.
The Production Approach to GDP
• There is no “double counting” in GDP;
only the final sale of goods and services
count.
• Value added
– The amount each producer contributes to
GDP.
– The revenue generated by each producer
minus the value of intermediate products.
• Only new production of goods and
services counts toward GDP.
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What Is Included in GDP and What’s Not?
• Only goods and services that are
transacted through markets are included in
GDP.
• GDP does not include:
– Government transfer payments to individuals.
• Social Security, Medicare, unemployment
insurance
– A measure of the health of a nation’s people.
– Changes in environmental resources.
A Simple Example: Where Real GDP
Doesn’t Change
• To compute GDP across time, we must use
one year’s price.
– Real GDP will be measured in a certain year’s
dollars
– Nominal GDP is measured in current dollars.
• Consider Apples and Computers:
A Simple Example: Where Real GDP
Doesn’t Change
• If the quantity of goods and services
produced does not change, but prices do
change
– Nominal GDP will change.
– Real GDP will not change.
2.3 Measuring Changes
over Time
• Nominal GDP
– A measure of GDP when prices and
quantities have not been separated.
• Real GDP
– Actual quantity of goods and services.
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A Second Example: Where Real GDP Changes
• The magnitude of the change in real
GDP will depend on the year’s prices
we select to calculate real GDP.
Quantity Indexes: Laspeyres, Paasche, and
Chain Weighting
• Calculating real GDP changes over time:
• The Laspeyres index
– Calculates changes in real GDP using the
initial prices.
• The Paasche index
• Indexes
• Laspeyres (L), Paasche (P), Fisher (F)
Price Indexes and Inflation
• Recall the formula for nominal GDP:
• The GDP deflator is the price level that satisfies
the equation.
• We could compute this formula for two different
years to calculate a price change.
• We could also use the following math trick:
– Calculates changes in real GDP using the final
year prices.
• Over long-time intervals the two indexes
can result in substantial differences.
• The Fisher index (chain weighting) is the
preferred approach to calculating real GDP.
– Average of the Laspeyres and Paasche index.
– Preferred because new goods are invented
while others become obsolete —making early
or recent prices inaccurate.
– Can be applied on a year-by-year basis if we
compute real GDP each year.
• The inflation rate is the percentage change in
the price level.
Using Chain-Weighted Data
• Main reason for using chain-weighted data:
– Prices of computers rapidly changing in 1990s.
• Main disadvantage:
– The sum of real C, I, G, NX will not equal real
chain-weighted GDP because the prices used
in constructing the components are different.
• General rule to follow:
– For particular components of GDP, we look at
the ratio of nominal variables.
– When you want real rates of economic growth,
use the chain-weighted real measures.
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2.4 Comparing Economic
Performance across Countries
• The exchange rate:
– Price at which different currencies are traded.
• To make comparisons of GDP across
countries we must take the following steps:
– GDP must be expressed in a common currency
by first adjusting it by the exchange rate.
– This value of nominal GDP must be multiplied
by the ratio of prices in the countries.
• Example: China and United States
• First, use the exchange rate to turn
Chinese yuan into U.S. dollars.
• Adjust for relative price level of goods.
Summary
• National income accounting provides systematic
measures of aggregate economic activity.
• Gross domestic product (GDP) is the key overall
measure of economic activity in an economy.
– Can be viewed as total expenditure, total income, or total
production in an economy.
• The expenditure approach to GDP makes use of a
fundamental national income identity:
Y = C + I + G + NX
which says that total spending is the sum of
spending on consumption, investment, government
purchases, and net exports.
• The income approach shows that labor’s
share of GDP is relatively stable over time
at about two-thirds.
• In the production approach, it is only the
value of final production that counts.
– Equivalently, GDP is the sum of value added
at each stage of production.
• Price level ratio is about (1/0.3), so the
real GDP of China is $11.7 trillion.
• Comparison of countries:
– In general, rich countries tend to have higher
price levels than poor countries.
– This is mainly because poor countries have
lower wages.
• Nominal GDP refers to the value of GDP
measured in current prices in a given year.
• Real GDP involves computing GDP in two
different years using the same set of prices.
– Think about real GDP as being adjusted for
inflation.
• Changes in real GDP therefore reflect
changes in actual production rather than
changes in prices.
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• Chain weighting allows us to compare
changes in real GDP over time by
gradually updating prices.
• By linking the chain of comparisons in
this way, we construct a more
accurate measure of real GDP.
• International comparisons of GDP involve
two conversions.
– First, we need exchange rates to convert the
measures into a common currency.
– Second, just as we need to use common
prices to measure real GDP over time, we
also need to use common prices to compare
real GDP across countries.
This concludes the Lecture
Slide Set for Chapter 2
Macroeconomics
Third Edition
by
Charles I. Jones
W. W. Norton & Company
Independent Publishers Since 1923
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