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ECONOMICS 5e
Michael Parkin
CHAPTER
6
Measuring GDP,
Economic Growth, and
Inflation
Chapter 23 in Economics
Learning Objectives
• Distinguish between the stocks of capital
and wealth and the flows of production,
income, investment and saving
• Explain why aggregate income,
expenditure, and product are equal
• Explain how GDP is measured
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 6-2
Learning Objectives (cont.)
• Explain how the Consumer Price Index
(CPI) and GDP deflator are measured
• Explain how the shortcomings of the CPI
and the GDP deflator as measures of
inflation
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 6-3
Learning Objectives (cont.)
• Explain how real GDP is measured
• Explain the shortcomings of real GDP
growth as a measure of improvements in
living standards
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 6-4
Learning Objectives
• Distinguish between the stocks of capital
and wealth and the flows of production,
income, investment and saving
• Explain why aggregate income,
expenditure, and product are equal
• Explain how GDP is measured
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 6-5
Gross Domestic Product
Gross domestic product (GDP) is the value
of the aggregate production of goods and
services in a country during a given time
period.
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 6-6
Gross Domestic Product
Flows and Stocks
1) A flow is the quantities per unit of time.
2) A stock is a quantity that exists at a point
in time.
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 6-7
Gross Domestic Product
Flows and Stocks (cont.)
Capital is the key macroeconomic stock.
Capital
The plant, equipment, buildings, and
inventories of raw materials and semifinished
goods that are used to produce other goods and
services.
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 6-8
Gross Domestic Product
Depreciation
The decrease in the stock of capital that results
from wear and tear and obsolescence.
Otherwise known as capital consumption.
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 6-9
Gross Domestic Product
Gross Investment
The total amount spent on adding to the stock
of capital and on replacing depreciated capital.
Net Investment
The amount spent on adding to the stock of
capital.
Gross Investment minus depreciation.
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 6-10
Capital and Investment
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Slide 6-11
Learning Objectives
• Distinguish between the stocks of capital
and wealth and the flows of production,
income, investment and saving
• Explain why aggregate income,
expenditure, and product are equal
• Explain how GDP is measured
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 6-12
Gross Domestic Product
Wealth
Another macroeconomic stock.
The value of all the things that people own.
Related to their earnings (a flow).
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 6-13
Gross Domestic Product
Consumption Expenditure
The amount spent on consumption goods and
services.
Saving
The amount of an income after meeting
consumption expenditures.
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 6-14
Gross Domestic Product
Income, Expenditure, and the Value of
Production
1) Households sell their labor, capital, land,
and entrepreneurship to firms.
2) Firms sell consumer goods and services.
3) Firms buy and sell capital goods.
4) Firms borrow to finance investment.
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 6-15
Gross Domestic Product
Government
Government purchases are purchases of goods
and services by governments.
• Paid for with tax revenue.
Net taxes are taxes paid to governments minus
transfer payments received from governments
and minus interest payments from the
government on its debt.
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 6-16
Gross Domestic Product
Rest of World Sector
Net exports is the value of exports minus the
value of imports.
Gross Domestic Product
Production can be valued by what:
• Buyers pay for it.
• It costs producers to make it.
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 6-17
The Circular Flow of
Income and Expenditure
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 6-18
Learning Objectives
• Distinguish between the stocks of capital
and wealth and the flows of production,
income, investment and saving
• Explain why aggregate income,
expenditure, and product are equal
• Explain how GDP is measured
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 6-19
Gross Domestic Product
Expenditure Equals Income:
Y = C + I + G + NX
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Slide 6-20
Gross Domestic Product
How Investment is Financed
1) National saving is the amount of saving
by households and businesses plus
government saving
National saving = S + (T – G)
2) Borrowing from the rest of the world
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Slide 6-21
Gross Domestic Product
Measuring U.S. GDP
1) Expenditure Approach
2) Income Approach
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Slide 6-22
Gross Domestic Product
Expenditure Approach
Uses data on consumption expenditure,
investment, government purchases, and net
exports
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 6-23
Gross Domestic Product
Expenditure Approach (cont.)
Personal consumption expenditures are the
expenditures by households on goods and
services produced in the United States and the
rest of the world
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 6-24
Gross Domestic Product
Expenditure Approach (cont.)
Gross domestic investment is expenditure on
capital equipment and buildings by firms and
expenditure on new homes by households.
Also, it includes the change in inventories.
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 6-25
Gross Domestic Product
Expenditure Approach (cont.)
Government purchases of goods and services
are the purchases of goods and services by all
levels of government.
Does not include transfer payments
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 6-26
Gross Domestic Product
Expenditure Approach (cont.)
Net exports of goods and services are the value
of exports minus the value of imports
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 6-27
GDP: The Expenditure Approach
Amount
in 1996
Item
Symbol
(billions of
dollars
Percentage
of GDP
Personal consumption
expenditures
C
5, 152
68.0
Gross private domestic
investment
I
1,116
14.7
Government purchase
of goods and services
G
1,407
18.6
NX
–99
– 1.3
Y
7,576
100.0
Net exports of good
and services
Gross domestic
product
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 6-28
Gross Domestic Product
Expenditures Not in GDP
1) Intermediate goods and services
2) Used goods
3) Financial assets
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 6-29
Gross Domestic Product
Income Approach
• Measures GDP by summing the incomes that
firms pay households for the resources they
hire.
• Compensation of employees is the payment for
labor services.
• Includes net wages and salaries plus taxes withheld
on earnings plus fringe benefits such as social
security and pension fund contributions.
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 6-30
Gross Domestic Product
Income Approach (cont.)
• Net interest is the interest households receive
on loans they make minus the interest
households pay on their own borrowing.
• Rental income is the payment for the use of
land and other rented inputs.
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 6-31
Gross Domestic Product
Income Approach (cont.)
• Corporate profits are the profits of corporations.
• Proprietors’ income is a combination of all of
these.
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Slide 6-32
Gross Domestic Product
Net Domestic Income at Factor Cost
The sum of the five categories of income
We must convert factor cost to
market prices.
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 6-33
Gross Domestic Product
Income Approach (cont.)
Indirect taxes are taxes paid by consumers
when they buy goods and services
Due to this additional cost, the market price
is greater than the factor cost value for
measuring GDP.
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 6-34
Gross Domestic Product
Income Approach (cont.)
Subsidies are payments by the government to a
producer.
• Due to this payment, the factor cost is
greater than the market price for measuring
GDP.
We must convert from Net Domestic
Product to Gross Domestic Product.
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 6-35
Gross Domestic Product
Income Approach (cont.)
• Net profit of businesses--profit after subtracting
depreciation—is a component of aggregate
incomes.
• To get gross domestic product, we must add
depreciation to aggregate income.
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 6-36
GDP: The Income Approach
(billions of dollars
Percentage
of GDP
4,449
58.7
Net Interest
405
5.4
Rental Income
127
1.7
Corporate Profits
650
8.6
Proprietors’ income
Indirect taxes
less subsidies
Capital consumption
(depreciation)
518
6.8
569
7.5
858
11.3
7,576
100.0
Item
Amount in 1996
Compensation of
employees
Gross domestic
product
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 6-37
Gross Domestic Product
Valuing the Output of Industries
Value added is the value of a firm's production
minus the value of the intermediate goods that
the firm buys from other firms.
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 6-38
Value Added and
Final Expenditure
Farmer
Farmer’s
value added
Miller
Value
of wheat
Value added
Baker
Value
of flour
Grocer
Wholesale
value of bread
Consumer
Retail value of bread;
Final Expenditure on bread
Copyright © 2000 Addison Wesley Longman, Inc.
Intermediate
expenditure
Miller’s
value added
Bakers
value added
Final
expenditure
Grocer’s
value added
Slide 6-39
Aggregate Expenditure,
Output, and Income
Percentage of GDP
100
80
NX
G
GDP
Depreciation
Indirect taxes
less subsidies
Proprietor’s
incomes
Interest
I
C
Profits
Rent
60
Wages and other
labor income
40
20
0
Copyright © 2000 Addison Wesley Longman, Inc.
Aggregate
expenditure
GDP
Aggregate
income
Slide 6-40
Learning Objectives (cont.)
• Explain how the Consumer Price Index
(CPI) and GDP deflator are measured
• Explain how the shortcomings of the CPI
and the GDP deflator as measures of
inflation
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 6-41
The Price Level and Inflation
The inflation rate is the percentage change
in the price level from one year to the next.
Two Main Price Indexes
• Consumer Price Index
• GDP Deflator
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 6-42
The Price Level and Inflation
Consumer Price Index
• Measures the average level of prices of the
goods and services that a typical urban family
buys.
• Published monthly by the Bureau of Labor
Statistics
• Must use a base period (1982-1984)
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 6-43
The CPI:
A Simplified Calculation
Base Period
Base-period basket
Price
5 pounds of oranges $0.80/pound
6 haircuts
100 bus rides
Total expenditure
CPI =
Copyright © 2000 Addison Wesley Longman, Inc.
Current period
Expenditure
Price
$4 $1.20/pound
$11.00 each
$66
$12.50 each
$1.40 each
$140
$1.50
$210
$210.00
 100 = 100
$210.00
Expenditure
$6
$75
$150
$231
$231.00
 100 = 110
$210.00
Slide 6-44
The Price Level and Inflation
The GDP Deflator
Measures the average level of prices of all the
goods and services that are included in GDP
Nominal GDP
 100
GDP deflator =
Real GDP
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 6-45
Learning Objectives (cont.)
• Explain how real GDP is measured
• Explain the shortcomings of real GDP
growth as a measure of improvements in
living standards
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 6-46
The Price Level and Inflation
Nominal GDP is GDP valued in the current
year’s prices.
Real GDP is GDP in a base year (1992)
scaled up by the growth rate of real GDP
since the base year.
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 6-47
The Price Level and Inflation
Real GDP Growth: A Chain-Weighted
Measure
The chain-weighted output index is an index
number that measures the growth rate of real
GDP.
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 6-48
Calculating a Chain-Weighted
Output Index
Item
1992 quantities
Oranges
Video games
1992 prices
1992 quantities
valued at 1992
prices
1993 prices
1992 quantities
valued at 1993
prices
50
$1.00
$50
$2.00
$100
5
$10.00
$50
$8.00
$40
A = $100
Copyright © 2000 Addison Wesley Longman, Inc.
D = $140
Slide 6-49
Calculating a Chain-Weighted
Output Index
Item
1993 quantities
Oranges
Video games
1992 prices
1993 quantities
valued at 1992
prices
1993 prices
1993 quantities
valued at 1993
prices
45
$1.00
$45
$2.00
$90
7
$10.00
$70
$8.00
$56
B = $115
Copyright © 2000 Addison Wesley Longman, Inc.
E = $146
Slide 6-50
Calculating a Chain-Weighted
Output Index
Item
1993 quantities
Oranges
1992 prices
1993 quantities
valued at 1992
prices
1993 prices
1993 quantities
valued at 1993
prices
45
$1.00
$45
$2.00
$90
7
$10.00
$70
$8.00
$56
Video games
B = $115
Output index
E = $146
F = E/D = 1.043
Chain-weighted output index (geometric mean of C and F = 1.150 x1.043) = 1.095
Copyright © 2000 Addison Wesley Longman, Inc.
C = B/A = 1.150
Slide 6-51
Calculating a Chain-Weighted
Output Index
Item
1993 quantities
Oranges
1992 prices
1993 quantities
valued at 1992
prices
1993 prices
1993 quantities
valued at 1993
prices
45
$1.00
$45
$2.00
$90
7
$10.00
$70
$8.00
$56
Video games
B = $115
Output index
E = $146
F = E/D = 1.043
Chain-weighted output index (geometric mean of C and F = 1.150 x1.043) = 1.095
Growth rate in 1993 using chain-weighted output index
9.5 percent
Copyright © 2000 Addison Wesley Longman, Inc.
C = B/A = 1.150
Slide 6-52
The Price Level and Inflation
The GDP Deflator can now be calculated.
$146  100 = 133.33
GDP deflator =
$109.5
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 6-53
The U.S. GDP Balloon
GDP
deflator
1992
Copyright © 2000 Addison Wesley Longman, Inc.
1998
Slide 6-54
Learning Objectives (cont.)
• Explain how the Consumer Price Index
(CPI) and GDP deflator are measured
• Explain how the shortcomings of the CPI
and the GDP deflator as measures of
inflation
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 6-55
The Biased CPI
The sources of bias are:
1) New goods bias.
2) Quality change bias.
3) Commodity substitution bias.
4) Outlet substitution bias.
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 6-56
The Biased CPI
In 1996, a Congressional Advisory
Commission on the CPI said the CPI
overstates inflation by 1.1 percentage
points.
The GDP deflator uses price indexes to
estimate quantities, so it too is somewhat
biased.
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 6-57
The Biased CPI
The three primary consequences of the bias
are:
1) It distorts private contracts
2) It increases government outlays
3) It biases estimates or real earnings
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 6-58
Two Measures of Inflation
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 6-59
Learning Objectives (cont.)
• Explain how real GDP is measured
• Explain the shortcomings of real GDP
growth as a measure of improvements in
living standards
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 6-60
The Limitations of Real GDP
Real GDP and growth rates of real GDP are
used for:
1) Economic welfare comparisons.
2) International comparisons of GDP.
3) Business cycle assessment and
forecasting.
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 6-61
The Limitations of Real GDP
Economic Welfare
A comprehensive measure of the general state
of economic well-being.
Economic welfare depends upon a variety of
other factors.
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 6-62
The Limitations of Real GDP
Factors Not Accounted for by Real GDP
1) Overadjustment for inflation.
2) Household production.
3) Underground economic activity.
4) Health and life expectancy.
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 6-63
The Limitations of Real GDP
Factors Not Accounted for by Real GDP
(cont.)
5) Leisure time.
6) Environmental quality.
7) Political freedom.
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 6-64
The Limitations of Real GDP
International Comparisons of GDP
• The real GDP of one country must be converted
into the same currency units as the real GDP of
the other.
• The same prices must be used to value the
goods and services in the countries being
compared.
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Slide 6-65
Two Views of
Real GDP in China
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Slide 6-66
The End
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Slide 6-67