Download Some Definitions and Preliminaries

Unit Code: 11102
Handout #2/01
Some Definitions and Preliminaries
A. Measuring aggregate or total output: Gross Domestic Product
Gross Domestic Product or GDP is a measure of the total output of an economy during a particular
period, such as a year. Blanchard explains it and related ideas in Chs. 2&3 and appendix 2, but a little
briefly and in a US setting. Here I explain it a little more.
Imagine firm A produces 1,000 units of steel priced at £1 per unit, i.e. £1,000 worth of steel. It stores
250 units and sells the remainder to firm B which converts it into 12,000 nails worth 10p each, i.e.
£1,200 worth of nails. How is the value of the total output of the economy affected by these
transactions? It might seem that output has gone up by £1000 + £1,200 = £2,200; but this doublecounts the £750 worth of steel used by the nail manufacturers; the nail manufacturers have only really
added £450 worth of value to the steel they bought. The value added by each firm is £1,000 by firm A
and £450 by firm B. (Of course, this assumes that firm A produced the steel from nothing; but, in an
example, you have to start somewhere.) So the total value added is £1,450. GDP sums the value
added by each firm, individual, government organisation: the sum of all values added in an economy is
a measure of the economy's total output. It is known as gross domestic product or GDP Alternatively,
this same measure can be calculated as the value of the output of final goods and services produced. In
the example, this will equal the value of the output of nails, £1,200, plus the value of the output of steel
which was not used to produce anything else, that is £250. The other £750 worth of steel is known as
an intermediate good.
Let the amount of the ith final good produced (or service provided) in the economy during period t be
denoted by q it . So, for example, q 1t might denote the number of Mars bars produced in 1997, q 2 t the
number of Jaguar cars, and q 3t pairs of Dr. Martens. Let the price of the ith final good or service in
period t be denoted by p it . And let the number of types of final goods and services produced in the
economy be denoted by N. Then the economy's GDP can be measured as:
iN
 q
it . p it

This sum is known as nominal aggregate output, or nominal GDP, in period t
and we shall denote it by PY t or £ Yt .
i 1
In the next period, period t+1, the value of nominal aggregate output, or nominal GDP, will be:
iN
 q
it  1 . p it  1
 or
PYt 1
i 1
Clearly, changes in nominal GDP from period t to period t+1 can occur for two reasons: changes in the
quantities of output produced, the q i s; and changes in the prices of those goods and services, the p i s.
Often we want to separate these two types of change. To do so, we select one particular period, say
ho2.doc
Unit Code: 11102
Handout #2/01
1990, as the base year. And we multiply the quantity of each good produced in period t, q it , by its
price in that base year, p i1990 . Summing over all N goods and services gives,
iN
 q
it . p i1990

This quantity is known as real aggregate output, or real GDP, in
period t, and we shall denote it by Yt
i 1
Real GDP in period
iN
t+1 will be
 q
it 1 . p i1990

or Yt 1 .
i 1
Changes in real GDP can only occur because of changes in the quantities of goods and services; prices
are, by construction, constant.
700000
600000
The graph shows UK aggregate nominal and
real GDP for 1950-1995. The base year for
the calculation of real output is 1990. Hence
the two graphs intersect in year 1990.
Aggregate Real Output
500000
400000
Notice that, over the period, nominal GDP has
grown faster than real GDP. Another way of
putting this is that prices have risen over the
period.
300000
200000
Aggregate Nominal Output
100000
1995
1990
1985
1980
1975
1970
1965
1960
1955
1950
Source: Economic Trends
0
B. Measuring the General Level of Prices
There are two commonly used ways of calculating the general, or average, level of prices. The first,
known as the GDP deflator, simply divides nominal GDP in period t by real GDP in period t, giving,
iN
PtGDP  {
 (q
i 1
iN
it . p it )
}/{
 (q
it . p i1990 )
} or PYt / Yt
i 1
It measures the average price of the goods/services produced in the economy, weighting the price of
each by its importance in total output. The GDP deflator is an index number: its level is quite arbitrary.
As written above, it equals 1 in 1990, the base year. We could multiply it by 100 so that is 100 rather
than 1 in the base year. This is, in fact, the usual practice.
The second and more commonly quoted measure of the general level of prices in the UK is the Retail
Price Index or RPI. This works as follows: each month the Office of National Statistics uses 300 price
checkers who visit 147 retail outlets, logging the price of more than 120,000 goods in a month. The
selection of goods they look at varies from year to year but is supposed to be representative of
consumers' purchases. The price of each good is weighted by the good's importance in a typical
ho2.doc
Unit Code: 11102
Handout #2/01
consumer's expenditure. The current basket contains 600 items, and includes goods such as bread,
cheese, burgers, fromage frais, and services such as medical insurance and private school fees. In 1947,
when the RPI first appeared, there were only 80 items including wild rabbits, lamp oil, tram fares,
rubber roller table mangles, and distemper.

The two measures of the
general price level have moved very
closely together over the last 40
years. [For clarity I have rebased the
GDP deflator so that it starts off at
the same value as the RPI.]

The GDP deflator has
increased slightly more quickly than
the RPI.
180
160
GDP Deflator
Index Number
140
120
100
80
RPI
60
40
20
1995
1990
1985
1980
1975
1970
1965
1960
1955
Source: Economic Trends
1950
0
A problem for all price indices is how to deal with goods that didn't exist in previous years or whose
quality has improved. E.g. 50 years ago the first microwave oven was marketed in the US - it weighed
about 350 kilos and was 5 feet 6 inches tall. Today, they are much commoner and more efficient.
Recently it has been suggested that, in the US and possibly in other countries too, the imperfect
treatment of this problem has led to the rate of increase in prices being overestimated by about 1
percentage point. So the "true" inflation rate may be closer to 2% than the 3% currently reported.
C. The Components of Expenditure on GDP
The goods and services a country produces, its GDP, can be split into two broad groups:

Goods and services for immediate consumption. Examples are food, cinema tickets, car
insurance, the hiring of skips for rubbish removal. Strictly, this type of good or service is one which is
consumed almost as it is purchased, but, in practice, "consumer durables", e.g. new cars, fridges,
videos, are also classified as consumption goods.

Investment goods. Goods which are not for immediate consumption but rather for use over a
significant period. There are three sub-categories usually identified: (i) fixed capital formation machinery, computers, factory buildings etc. which help firms produce goods; (ii) residential
investment - the construction of new houses; (iii) stockbuilding - goods/raw materials which firms hold
as inventories to meet demand in the future for their final products.
Corresponding to these categories of total output there are similar categories of total expenditure, but
the picture is slightly more complicated here, especially if the economy we are dealing with is "open" -
ho2.doc
Unit Code: 11102
Handout #2/01
that is, if it trades with other countries. For any such economy - call it the domestic economy - there are
five categories of expenditure we can identify:

Consumption expenditure. The total amount which the private consumers in the domestic
economy spend on consumption goods and services produced both in the domestic economy and
abroad.

Investment expenditure. The total amount which the private sector of the domestic economy
spends on investment goods produced both in the domestic economy and abroad.

Government expenditure. The total amount which the government sector of the domestic
economy spends on goods and services produced both in the domestic economy and abroad.

Exports. The total amount which the rest of the world spends on goods and services produced
in the domestic economy.

Imports. The sub-total of the first three categories which consists of expenditure on goods and
services produced abroad.
Total expenditure on goods and services produced in this particular economy is then the sum of the
first four categories minus the fifth. These 5 categories of expenditure can be measured either in
nominal terms, that is quantities times current prices, or in real terms, that is quantities times base year
prices. When measured in the first of these ways the sum of the first four categories minus the fifth
provides a measure of nominal aggregate expenditure; when measured in the second way it provides a
measure of real aggregate expenditure.
Let CA , I A , G A , XA , and QA represent actual, real consumption, investment, government
expenditure, exports and imports, respectively. Then total, actual, real expenditure, Z A , will be
ZA  C A  I A  G A  ( X A  Q A )
0.7
The graph shoes the fraction each component has
contributed to aggregate spending in the UK from
1950-1995. A similar picture would emerge for
other industrialised countries.
0.6
0.5
Consumption
0.4
Note:
 Consumption expenditure is the most important
component of Z A .
 The contribution of "net exports", ( XA  QA )
can be positive or negative.
 Investment expenditure appears to be the most
volatile component
Government
0.3
0.2
Net Exports
0.1
Investment
-0.1
ho2.doc
1995
1990
1985
1980
1975
1970
1965
1960
1955
1950
0
Source: Economic Trends
Unit Code: 11102
Handout #2/01
D. National Income Accounting: the three measures of GDP
(a) The output measure of GDP.
On the first page of this handout, when explaining how GDP is the total value of the final goods and
services produced in the economy during a period, I gave an example involving two firms producing
steels and nails. The total value of final goods and services in that example was £1,450. That method
of measuring GDP - the sum of the output of final goods and services - is known as the output measure
of GDP. It is possible to measure it in two different ways and, in principle get exactly the same
answer.
(b) The expenditure measure of GDP.
The first other method begins by asking what happens to this final output - the £250 worth of steel and
the £1,200 worth of nails - in the previous example. By national income conventions, any final good or
service must have been bought by someone, whether they wanted to or not. We assumed that firm A
stored £250 worth of its output. In national income account terms, firm A bought £250 of its own
output, and this would be classified, in the national income accounts, as an act of investment
expenditure - under the sub-heading of stockbuilding. As for the £1,200 worth of nails: if they were all
sold to consumers or the government, they would be classified as an item of consumption or
government expenditure and the two would sum to £1,200. If firm A only managed to sell £1,000
worth of nails in this way, consumption and government expenditure would rise by only £1,000. But
the remaining £200 worth of nails would be deemed as having been bought by firm B; firm B has,
unwillingly perhaps, bought £200 worth of its own output; again, this would be classified as an item of
investment expenditure. In total then, consumption and government expenditure would have risen by
£1,000; and investment expenditure would have risen by £200+£250, so total actual expenditure, as
measured in the national income accounts, would have risen by £1,450, exactly the amount by which
the value of actual output has risen. GDP, therefore, can be measured by adding up all the categories of
expenditure on final goods and services. The resultant GDP measure is known as the expenditure
measure of GDP. Notice the stress on the word 'actual' in the explanation above. The identity of
output and expenditure only holds if we are considering the actual value of output and expenditure or its
components. As the example illustrates, it may be that some of this actual expenditure was not intended
or desired. The distinction between actual and desired quantities will be crucial later on.
(c) The income measure of GDP
If actual expenditure has increased by £1,450, who has received it? The idea behind the third way of
measuring the value of output is that for every act of expenditure there must, in principle, be a recipient,
ho2.doc
Unit Code: 11102
Handout #2/01
someone who receives as income, in one form or another, the final expenditure on the steel and the
nails. To see how this might work out, assume that firm A pays its workers wages of £600; and that
firm B pays its workers wages of £300. So, income from employment is £900. What has happened to
the other £550? The answer is that it appears as income under the sub-heading profits. To see why
profits will equal exactly £550, look first of all at firm B. It has earned £1,200 from selling its nails; it
has paid out £750 to firm A for its steel; and it has paid its workers £300. Its profits are £150. Firm A
has obtained £750 from firm B; the value of its holdings of its own product has increased by £250,
which is counted as an asset item in its balance sheet; and it has paid out £600 to its workers. So firm
A's profits are £400. The total profits of the two firms are therefore £550. So total actual income has
gone up by £1,450.
Putting this all together we have the three measures of GDP giving the following:
________________________________________________________________________
GDP
Output-based
GDP
Expenditure-based
GDP
Income-based
Value added:
Firm A
£1000
C
£600
Income type:
Firm B
£450
I
£250
Employment
£900
G
£600
Profits
£550
Total
____
____
____
£1450
£1450
£1450
________________________________________________________________________
E. Minor technicalities.
There are three other complications which are not very important for the course but which you should
be aware of.
(a) GDP at factor cost and GDP at market prices
The prices used to value output in the accounts (whether current or base year) are the prices paid by the
purchaser - the market price. These prices include the effects of indirect taxes such as VAT and of
subsidies paid to the producers by the government to keep prices down. When these effects are
removed, by subtracting the indirect taxes and adding subsidies, the measure of GDP is referred to as
being at factor cost. When they are not removed the measure of GDP is referred to as being at market
prices.
(b) GNP and GDP
While GDP measures the output produced in a particular country, GNP, or gross national product,
measures the income that is received by a country. To convert GDP into GNP, it is necessary to add
ho2.doc
Unit Code: 11102
Handout #2/01
income received by domestic resident from assets owned abroad and to subtract income paid out to
non-residents who own assets in the country, or what is called net property income from abroad. For
example, all the profits generated by a Japanese car manufacturer operating in the UK will be included
in GDP, even though a large part of the profits may be paid back to Japan. This is because the profits
have been earned in the UK. A UK company operating abroad may earn profits in its overseas
subsidiary and some of these profits will come to the UK: these will be excluded from GDP since they
were not earned in the UK.
(c) GDP and NDP, or GNP and NNP
The word "gross" in gross domestic product means that no allowance has been made for the fact that
during the period the value of capital such as factories and machinery, will have to some extent worn
out or depreciated. Subtracting some estimate of the extent of this depreciation from GDP or GNP
gives N(et)DP or N(et)NP.
F. Problems/Peculiarities with GDP
GDP or GDP per capita is often used as a measure of a country's well-being or success: the higher it is,
or the faster it grows, the better. And league tables of countries' per capita GDPs often appear.
Although, undoubtedly, this has some validity there are several problems with treating GDP in this way.
1.
Production where no money changes hands does not appear in GDP. Thus, unpaid domestic
work and child care are not included. Since most of this is done by women, conventional measures of
GDP seriously understate the contribution of women to total output. To put this differently, if all
women who currently look after their own families were each to swap and do the domestic work of their
neighbour and get paid for it, GDP would increase sharply, even though exactly the same amount of
work is being done.
2.
Unpaid charity work and activity in voluntary organisations is also excluded from conventional
GDP.
3.
People living in Norway probably have to spend more on heating than do people in Italy, just
to stay as warm. Production of heating in Norway will be greater than in Italy, and GDP might, as a
result, be higher. But Norway does not for that reason have a higher standard of living than Italy.
Similarly, expenditure on, and output of, burglar alarms has increased sharply in the UK in recent years
as a response to the increase in crime. As a result GDP is higher; but we were better off without the
burglar alarms and without the crime.
4.
Comparing GDP in different countries requires converting all countries' GDPs to a common
currency, say the US dollar. And this requires an exchange rate. But exchange rates fluctuate quite
widely at times and so comparisons can be erratic. For example, from July - October 1997 the currency
of Thailand, the baht, depreciated by about 25% against the US dollar; and the Malaysian currency, the
ho2.doc
Unit Code: 11102
Handout #2/01
ringgit, depreciated by 13 or 14%. Although students from those countries over here were made worse
off than they would have been, it's not the case that people in Thailand or Malaysia were generally 25%
or 15% worse off than they were two or three months before: more or less the same goods and services
were being produced and consumed there as before.
For a non-technical discussion of issues such as these see Victor Anderson, Alternative Economic
Indicators (Routledge 1991).
ho2.doc