Download Chapter 1 MEASURING GDP AND PRICE LEVEL

ECON 141: Macroeconomics
Dr. Mohammed Alwosabi
MEASURING EONOMIC ACTIVITY
Macroeconomics studies the aggregate
(or total) concept of economic activity.
activity.
Its focus is on the aggregate output, the
aggregate income, the general price level
of goods and services, the total jobs in the
entire economy, etc.
It also discusses the issues and policies
concerning economic growth,
unemployment, inflation, the government
budget deficit, and the international trade
balance.
Chapter 1
MEASURING
GDP AND PRICE LEVEL
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Economic activity is measured by
calculating gross domestic product
(GDP).
This measurement is sometimes called
national Income accounts
accounts..
There are three ways to measure
economic activity or GDP:
1.
Approach:
1 Product (or Value Added) Approach:
output produced by all firms to be sold
2. Expenditure Approach:
Approach: amount spent by
ultimate buyers
3. Income Approach:
Approach: income received by
producers from the sale of the total
output
The three approaches are equivalent.
Any output produced (product approach)
is purchased by someone (expenditure
approach) which results in income to
someone (income approach) ⇒
total production = total expenditure = total
income.
GDP is important because it provides a
measure of total production, total
expenditures, and total income.
It can be used to make comparisons over
time and across countries.
So, what’s GDP?
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2. Final Goods and Services
Services::
GDP DEFINED (THE PRODUCT APPROACH)
Gross Domestic Product (GDP) is the
market value of all final goods and
services produced within the border of a
country in a given time period.
This definition contains four parts:
1. Market value
value::
Market value of a good = The sum of
Price of each good or service multiplied
by its Quantity = ∑ (Pi)(
)(Q
Qi)
To calculate GDP we count only the
value of the final goods and
services produced.
We do not count intermediate goods
to avoid double counting .
3. Produced within the border of a country
country::
4. In a given time period
period::
GDP includes only goods and services
that are newly produced within the
current year.
The year of production not the year of
sale determines the allocation of GDP 6
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ECON 141: Macroeconomics
Dr. Mohammed Alwosabi
EXPENDITURE APPROACH:
The expenditures on all final goods and
services made by all sectors of the
economy are added to calculate GDP.
Expenditures are divided into 4 different
categories:
1. consumption expenditure (C),
(C),
2. investment (I),
(I),
3. government expenditure (Purchase)
Using expenditure approach, the largest
component of GDP is usually personal
consumption expenditures.
GDP = Y = aggregate expenditure
=C+I+G+X–M
= C + I + G + NX
Consumption (C)
Firms sell and households buy
consumers’ goods and services in the
goods markets. The total payments for
these goods and services are called
consumption expenditure.
expenditure.
(G),, and
(G)
4. net exports,
exports, which is exports minus
imports (NX = X – M).
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Investment (I)
Investment (also called gross private
domestic investment) (I) as used in
macroeconomics refers to
1. The purchase of new capital.
capital. These new
capital goods are used to produce other
goods and services.
2.
Inventories,, which include a firm
s stock
2 Inventories
firm’s
of unsold goods, goods in process, and
raw materials.
3. Purchases of all new residential
buildings are also part of investment.
(Personal) consumption expenditure (C)
includes expenditures spent on goods
and services produced inside the country
and the rest of the world.
Buildings and houses are not included in
the consumption expenditure. They are
partt off th
the investment.
i
t
t
Purchased of stocks and bonds are not
part of consumption expenditure.
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Note - Investment does not include stocks
or bonds or other financial assets.
Why?
These assets only involve transfers of
ownership - no physical asset is directly
created because of these assets
Example:
Goods that are produced this year, stored
in inventories, and then sold to
consumers next year count in __________
this year’s GDP
Example:
If a Bahraini firm buys new machines from
Japan, Bahrain’s investment would_______
increase..
increase
Exercise:
A computer manufacturer makes a computer
this year to be sold next year
year. This computer will
be counted in
a. next year ‘s GDP
b. next year’s investment
c. this year’s investment and this year’s GDP
d. next year’s investment and next year’s GDP
C
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ECON 141: Macroeconomics
Dr. Mohammed Alwosabi
Government Expenditure (G)
Government expenditure on goods and
services (also called government
purchase) (G) may include
1. buying goods and services from firms,
2. building roads and bridges,
3 purchase
3.
h
off military
ilit
equipment,
i
t
4. purchase of furniture for offices, etc
etc..
Government collects taxes and uses tax
revenue to pay for its purchase
purchase..
Net tax = tax paid to government –
transfer payments – interest payments on
government debt.
debt.
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Transfer payments are cash transfers
from government to households such as
social security, unemployment
compensation, and to firms such as
subsidies.
Transfer payments are government
expenditures
p
that do not represent
p
purchase of final goods or services and
they are not related to current production
so they are not included in G and
therefore not included in GDP.
Exercise:
Which of the following is not included in
2004 GDP?
a. A landlord rents an apartment for BD400
per month during 2004
p
b. Bahraini g
government purchase
of new
tanks for its defense force in 2004
c. Bahraini government pays money for a
student to attend college in 2004
d. A company buys new machines in 2004
for its production line.
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C
Net Export:
Countries trade with each other.
Our country sells goods and services to
the rest of the world. This is called the
value of exports (X).
(X).
p
y are
Exports
are added because they
produced domestically but not measured
as part of C, I, or G.
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Example:
If a Bahraini firm buys new machines
from Japan, Bahrain’s net export would
_______.
decrease
Exercise:
If a furniture company
p y makes 300 dining
g
tables in 2003 and sold 200 of them in the
same year, using expenditure approach,
how to count the unsold dining tables?
inventories Ö part of investment Ö part of
GDP of n003
Our country buys goods and services
from the rest of the world. This is called
the value of imports (M).
(M).
Imports subtracted because they are
typically included in C, I, or G, but they are
not domestic production.
Total adjustment results in adding net
export (NX)
NX = Exports – Imports = X – M
If X > M ⇒ NX > 0 ⇒ trade surplus
If X < M ⇒ NX < 0 ⇒ trade deficit
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ECON 141: Macroeconomics
Dr. Mohammed Alwosabi
Exercise:
Bahrain Aluminum Company (BAC)
produces and sells aluminum products.
Place each of the following transaction in
one of the four components of
expenditure
a. BAC sells its product to the Bahrain
Defense Force
b. BAC sells its product to a private
company
c. BAC sells its product to a housewife
d. BAC sells its product to a company in
Saudi Arabia
e. Some of BAC products are unsold this
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year
INCOME APPROACH:
The income approach of calculating GDP
is the sum of incomes paid to resources
of production.
Income is divided into 5 categories
2. Rental income: The income earned by
5. Proprietor’s income: The income of
1. Compensation to employees. It is
the labor Income, which includes all
wages, salaries, and benefits paid to
labor, plus social security
contributions.
This is the largest component of GDP,
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using income approach.
approach.
self employed small businesses
such as private doctor’s clinics,
attorney’s office, mini
mini--mart stores,
small farms and so on.
the owners of land, and any other rented
resources.
3. Net interest: The income earned by the
owners of machines and equipments.
= the interest the domestic owners of the
capital receive - the interest they pay
4. Corporate profit: What is left to the firm
after all payments.
It includes both of profits distributed as
dividend plus undistributed profits.
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Proprietors' income might be a mix of
i
incomes
from
f
labor,
l b
capital
it l and
d land.
l d
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The sum of these five incomes results in
national income or net domestic income at
factor cost (NDI).
Net Domestic Income (NDI) =
compensation of employees + rental
income + net interest + corporate profit +
i t ' income.
i
proprietor's
Factor cost is the cost of factors of
production used to produce final goods
and services.
To calculate GDP using market value we
must add:
1. Net indirect tax (NIT), which is indirect
taxes minus subsidies.
This must be added to get from factor
cost to market prices. This gives net
domestic product at market prices.
2. Depreciation (D) (or capital
consumption).
Thus, GDP = NDI + (IT – subsidies) + D
= NDI + NIT + D
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ECON 141: Macroeconomics
Dr. Mohammed Alwosabi
Exercise:
Government purchase
Gross private domestic investment
Personal consumption expenditure
Personal income taxes
Depreciation
Net taxes
Net exports
Net interest
Gross and Net Domestic Product
“Gross”
Gross” means before accounting for the
depreciation of capital.
“Net”
Net” means after accounting for the
depreciation of capital.
Net domestic product = GDP – depreciation
$400
$500
$700
$150
$200
$
$100
$200
$130
Calculate GDP
Calculate Net domestic product
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Exercise:
Net interest
Net indirect tax
Corporate profits
Proprietors’ income
Compensation of employees
p
Depreciation
Rental income
Personal consumption expenditure
Net exports
Government purchase
a. Calculate GDP
b. Calculate net domestic product
c. Calculate gross investment
Exercise:
Item
Billions of dollars
C
80
G
30
T
35
I
20
M
10
X
20
D
10
Calculate:
a. GDP
b. Net domestic product
c. the value of net exports
d. the value of private saving
e. the value of government saving. Is there
government budget deficit or surplus?
$200
$300
$400
$150
$1200
$
$350
$100
$1500
$50
$600
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GROSS NATIONAL PRODUCT (GNP)
GNP is the market value of all final goods and
services newly produced by the citizens
(nationals) of a country whether they are inside
or outside the country in a given period time.
While GDP allocates product (income)
according to the location of the owners of
factors of production regardless of who produce
it whether they are nationals or foreigners,
GNP allocates product (income) according to
the nationality of the owners of the factor
whether they are inside the country or abroad.
Example:
The income of an Indian working in Bahrain is
part of Bahrain's GDP as well as India's GNP
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NOMINAL GDP vs. REAL GDP:
Recall that GDP is calculated by adding
the market value of all final goods
produced.
Thus, the market value of production and
hence GDP can increase either :
1. because of the increase in production of
goods and services,
2. because of the increase in the prices of
goods and services, or
3. because of the increase in both.
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ECON 141: Macroeconomics
Dr. Mohammed Alwosabi
To determine whether the increase is only
due to the increase in real production
rather than in the price level, economists
distinguish real from nominal GDP.
Thus, using nominal GDP to compare
among different years does not give us
the actual picture of the performance of
the economy.
Using nominal GDP
GDP,, we can measure the
changes in the cost of living due to the
changes
g in the price
p
level.
Cost of living is the amount of money it
takes to buy goods and services.
Nominal GDP is the value of GDP
measured at the prices that prevailed in
that same year (current
(current prices)
prices
prices).
)
).
Nominal GDP increases when the prices
and / or quantities of goods and services
increase.
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Real GDP is the value of GDP measured at
constant prices (base year prices).
It is a measure of a country's actual
production.
Real GDP allows the quantities of
production to be compared across time.
We use constant prices to remove the
effects of inflation
inflation..
Comparing RGDP of different years allows
us to say for sure that a country produces
more (or less) goods and services in one
particular year than any other year if the
RGDP of that year is higher (or lower) than
the other years.
The first step to calculate real GDP is to
choose a base year.
The base
base--year method is to choose a
reference year (a bench mark year if you
like) and then use that year prices of
goods and services for all other years.
The base year is the year in which
real GDP = nominal GDP
The base year is roughly revised every 5 to
10 years
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Example
Suppose a country produces two final
goods. Quantities and prices of each
good for three different years are given in
the table below. Suppose 2002 is the base
year.
a. Calculate nominal GDP
b. Calculate real GDP
c. Calculate GDP deflator
RGDP shows the change in production.
RGDP is used to measure:
1. the size of the economy, and
2. the growth in the economy
If RGDP > NGDP then prices were higher
in the base period than the current period
period.
If RGDP < NGDP, current prices are higher
than base period prices.
RGDP = NGDP for the base period.
In years with inflation, nominal GDP
increases faster than real GDP.
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ECON 141: Macroeconomics
Dr. Mohammed Alwosabi
Good 1
Year
Q
P
$/ unit
MEASURING ECONOMIC GROWTH:
Economic Growth is an increase in a
country’s output (real GDP). In other
words, it is an expansion of production
possibilities in a country.
It is represented by an outward shift of the
production possibility frontier (PPF) of the
country.
RGDP is a good measure with which we
compare the economy at two points in
time. That comparison can then be used
to formulate the growth rate of total output
within a country.
Good 2
Q
P
$/unit
2001
2500
15
600
20
2002
2300
20
500
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2003
2800
23
700
30
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Example:
If real GDP in 2003 is $9 billion and real
GDP in 2004 is $9.27 billion, what is the
economic growth rate in 2004?
Answer: 3.0 percent
Example
Real GDP in 2002 is $100. Between 2002
and
d 2003,
2003 using
i 2002 prices
i
GDP grew 8
percent and using 2003 prices real GDP
grew 4 percent. What does real GDP in
2003 equal?
Answer: $106
The economic growth rate is the
percentage change in the quantity of
goods and services produced from one
year to the next.
EconomicGrowthRate =
RGDP this year - RGDP last year
RGDP last year
× 100
The new method of calculating real GDP
GDP,
which is called the chainchain-weighted output
index method.
chain--weighted output index uses the
chain
prices of two adjacent years (or of several
years) to calculate the RGDP growth rate
and.
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We use the economic growth rate to
make:
1. economic welfare comparisons
2. international comparison
3. business cycle forecasts
Economic Welfare Comparisons (Measuring
Living Standards)
Economic welfare is a measure of
economic well being. It improves when
production increases.
RGDP is a useful number when describing
the size and the growth of a country
country's
s
economy.
To measure the standard of living we use
the RGDP per person (RGDP per head, per
capita).
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ECON 141: Macroeconomics
Dr. Mohammed Alwosabi
A standard of living is the level of
consumption that people enjoy, on the
average, and is measured by the average
income per person.
RGDP per person is the GDP divided by
the size of the population.
This measure gives the amount of GDP
that each individual can get, on average,
and thereby provides a fairly good
measure of the standard of living of the
people within an economy.
RGDP per person = (RGDP/population)
RGDP per person is a more useful
measure than RGDP for determining
standard of living because of differences
in population across countries.
If a country has a large RGDP and a very
large population, each person in the
country
y may
y have a low income and thus
may live in poor conditions. On the other
hand, a country may have a moderate
RGDP but a very small population and
thus a high individual income.
When the increase in RGDP is greater
than the increase in population RGDP per
person increases.
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3. GDP per person is only a measure of the
Shortcomings of Using GDP to Measure
Output and WellWell-being
While GDP measures are informative and
are widely used in many countries to
summarize the state of the economy, it is
important to realize that they are by no
means perfect.
be criticized
f t RGDP can b
iti i d as
a measure of economic welfare because:
1. It does not include nonnon-market activities.
2. It does not include underground
economy transactions
average level of output per person in the
economy.
4. degradation of environmental quality
5. Government services (not sold in
markets) are measured by their cost of
production
6. RGDP focuses only on income but there
are other important things that make life
better such as faith, security, freedom,
justice, education, health, the sense of
belongings, etc.
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7. Does not include leisure time
International Comparisons and
Purchasing Power Parity (PPP)
8. Governments overstate or understate
GDP for different political, economic, or
social reasons.
9. Over
Over--adjustment for inflation:
10. New g
goods create problems
p
in
calculating Real GDP.
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ECON 141: Macroeconomics
Dr. Mohammed Alwosabi
Investment is the flow that changes the
stock of capital.
Depreciation (D) is the decrease in the
capital stock that results from wear and
tear, and obsolescence. Capital
consumption is another name for
depreciation.
Gross investment is the purchases of new
capital.
Net investment is the change in the stock
of capital .
Net Investment = gross investment - D
APPENDIX:
A flow is a quantity per unit of time such
as GDP, saving, income, investment
A stock is the quantity that exists at a
point in time such as wealth, capital.
Capital and Investment
The term capital
capital,, as used in
macroeconomics, refers to the plant,
equipment, buildings, manufactured input,
and inventories of raw materials and semisemifinished goods, etc.
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How Investment Is Financed?
Financial markets are used to finance
deficits, pay for investment, and save.
Investment is financed from three
sources::
sources
1. Private saving (S), is the amount that
households have left after they have paid
their taxes and bought their consumption
goods and services
2. Public Saving which is the government
budget surplus (T – G)
3. Borrowing from the rest of the world (M –
X).
We can see these three sources of
investment finance by using the fact that
aggregate expenditure equals aggregate
income.
Households’ income is consumed,
saved, or paid in taxes: Y = C + S + T
Therefore, RGDP can be written as;
Y = C + I + G + X - M (reflecting
( fl ti its
it
aggregate expenditure), or
Y = C + S + T (reflecting the use of RGDP,
income)
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So we have C + I + G + (X –M) = C + S + T
Cancel the C's and move X - M to the
financing side you get
I + G = S + T + (M – X)
This equation shows us that financing for
I and G come from private saving, taxes,
sources
and foreign sources.
Move G to the financing side and you have
I = S + (T – G) + (M – X)
This formula shows that investment is
financed using saving, a government
budget surplus, (T
(T − G) and borrowing
from the rest of the world, (X
(X − M)
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Private saving (S) = Y – T – C
= disposable income – consumption =
income – tax – consumption
Government (Public) saving = T – G
If (T – G) > 0 ⇒ surplus
If (T
– G) < 0 ⇒ deficit
National saving = private saving +
government saving = (Y – T – C) + (T – G)
=Y–C–G
Private investment = National Saving +
borrowing from the rest of the world
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ECON 141: Macroeconomics
Dr. Mohammed Alwosabi
Example:
Suppose an economy has the following
data (in million of dollars)
Y = 200, C = 130, T = 30, and G = 20, then
S = Y – C – T = 200 – 130 – 30 = 40
Public saving = T – G = 30 – 20 = 10
National saving
g = Y – C – G = 200 – 130 –
20 = 50,or
50,or
= private saving + public saving = 40 + 10
= 50
Exercise:
If you have the following data:
government saving = 0, RGDP = $2500
million, private consumption = $1300
million, tax = $350 million;
calculate the country’s national saving
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PRICE LEVEL (PRICE INDEX)
To see how the change in prices changes
the cost of living we should analyze the
changes in price level.
Price level (also called price index) is a
weighted average of prices of goods and
services in a given year relative to the
prices in a specified base year.
Price level is a unit
unit--free measure.
There are many types of price level
measurements but the most popular two:
1. The GDP Deflator
2. The Consumer Price Index (CPI)
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Exercise:
If national saving is $200,000, net taxes
equal $100,000 and government
purchases of goods and services are
$50,000, how much are households and
businesses saving?
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GDP DEFLATOR:
Nominal GDP captures both changes in
quantity and changes in prices.
Real GDP, on the other hand, captures
only changes in quantity.
Because of this difference, after
computing nominal GDP and real GDP, a
third useful statistic can be computed -the GDP deflator, which captures the
changes in the price level.
GDP deflator is a general indicator of
inflation because it measures changes in
prices of goods and services included in
GDP.
It takes the contribution of rising prices
(inflation) out of nominal GDP so that we
h t happen
h
t RGDP.
RGDP
can see what
to
It is equal to 100 times nominal GDP
divided by real GDP.
GDP Deflator =
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10
Nominal GDP
× 100
Real GDP
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ECON 141: Macroeconomics
Dr. Mohammed Alwosabi
Real GDP = (Nominal GDP*100)/GDP
deflator
Nominal GDP = (Real GDP * GDP
deflator)/100
The larger the nominal GDP for a given
RGDP the higher is the price level and the
larger is the GDP deflator
Example:
Find GDP Deflator for the above example
Example:
Suppose the nominal GDP per person is
$10,000 in 2004, the 2004 GDP deflator is
110 th
then the
th reall GDP per person is
i $9091
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Shortcomings of Using GDP Deflator to
Measure Price Level
1. It is unable to fully incorporate the increased
purchasing power that comes with
improvements in quality so this tends to push
the deflator to overestimate inflation.
2. The introduction of new goods poses a
problem when calculating Real GDP; therefore,
it poses a problem in calculating the GDP
deflator because the deflator is the ratio of
nominal to Real GDP.
3. If prices of imported goods fall but prices of
domestic goods are high, consumer’s
purchasing power may not fall by much even if
the GDP deflator indicates a high price level.
THE CONSUMER PRICE INDEX (CPI):
The consumer price index (CPI) is a
measure of the average of the prices paid
by urban consumer for a fixed “basket” of
consumer goods and services.
CPI compares the cost in the current
period to the cost in a base period of a
basket of goods typically consumed in the
base period.
CPI =
Cost of the CPI basket at the current year prices
× 100
Cost of the CPI basket at the base year prices
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The CPI is defined to equal 100 for the
reference base period.
Example:
Suppose a typical family consumes three
goods: breads, gasoline and haircut.
Quantities and prices of the three goods
in three different years are given in the
table below (assuming no weights given
to any item). Suppose the base year is
2001
Good
Quantities P in P in P in
bought
Bread
2001 2002 2003
2000 bread $0.50 $0.55 $0.60
Gasoline 1000 liter
$1.00 $1.20 $1.30
Haircut 600 times
$1.5 $2.00 $2.50
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ECON 141: Macroeconomics
Dr. Mohammed Alwosabi
Cost of the CPI basket at 2001 prices =
($0.50)(2000) + ($1)(1000) + ($1.5)(600) =
$2900
Cost of the CPI basket at 2002 prices =
($0.55)(2000) + ($1.2)(1000) +($2)(600) =
$3700
Cost of the CPI basket at 2003 prices =
($0.60)(2000) + ($1.30)(1000) + ($2.5)(600) =
$4000
CPI in 2001 (the base year) =
(2900/2900)x100 = 100 (always)
CPI in 2002 = (3700/2900) x 100 = 128 Ö
the cost of living has increased from 2001
to 2002 by 28%
CPI in 2003 = (4000/2900) x 100 = 138 Ö
the cost of living has increased from 2001
to 2003 by 38%
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2. It does not account for changes in
Shortcomings of CPI
CPI is not a perfect measure of the price
level. It overstates the true inflation
because:
quality which improve purchasing
power-- the average computer today is
power
much faster and more powerful than
computers two years ago and price may
be the same if not falling. This causes
the CPI to overestimate inflation; the
price of computing has decreased even
th
though
h the
th price
i off the
th computer
t is
i
unchanged.
3. The introduction of new goods that
render old goods obsolete may pose a
problem because the old goods still
remain in the CPI basket until the basket
is revised again.
1. It does not reflect the substitution by
consumers as price change. For example,
suppose that
in
h chicken
hi k is
i an item
i
i the
h CPI
basket. If chicken becomes more expensive
than beef then some consumers may stop
eating chicken altogether and start eating
beef, however, the same quantity of chicken
remains part of the CPI basket even though
people are consuming less.
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2. The GDP deflator includes only those
The Differences between the GDP Deflator
and the CPI
There are three differences between the
GDP deflator and the CPI:
1. The GDP deflator measures the prices of
all goods and services produced
whereas the CPI measures the prices of
only the goods and services bought by
consumers. Thus, an increase in the
price of goods bought by the firms or
government will be included in the GDP
deflator but not in the CPI.
goods and services produced domestically.
Imported goods are not part of the GDP and
not included in the GDP deflator; but they
are included in the CPI because consumers
buy imported goods as well.
3 GDP deflator is not based on a fixed market
3.
basket of goods and services. The basket is
allowed to change with people’s
consumption and investment patterns. CPI
quantity is the same for different years. It is
based on a fixed basket of goods and
services.
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ECON 141: Macroeconomics
Dr. Mohammed Alwosabi
Exercise
The average price of the imported food
in Bahrain has increased in recent years.
This increase must show up
a. in Bahrain’s GDP deflator
b. in Bahrain’s CPI
c. both in Bahrain’s CPI and Bahrain’s
GDP deflator
d. neither in Bahrain’s CPI nor in
Bahrain’s GDP deflator
To measure changes in the cost of living
and in the value of money we need to
calculate the inflation rate using price
indexes.
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INFLATION RATE:
The inflation rate is the percentage
change in the price level from one year to
the next.
InflationRate =
PriceLevel (this year)- PriceLe vel (last year)
× 100
P -iPrice Le
Price
L vel (lastl (last
Level
(l
)
Price Level (this year)
year) t year)
× 100
Inflation Rate =
Price Level (last year)
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