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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 Copyright © 2000 Addison Wesley Longman, Inc. 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 Copyright © 2000 Addison Wesley Longman, Inc. 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 Copyright © 2000 Addison Wesley Longman, Inc. Slide 6-21 Gross Domestic Product Measuring U.S. GDP 1) Expenditure Approach 2) Income Approach Copyright © 2000 Addison Wesley Longman, Inc. 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. Copyright © 2000 Addison Wesley Longman, Inc. 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. Copyright © 2000 Addison Wesley Longman, Inc. Slide 6-65 Two Views of Real GDP in China Copyright © 2000 Addison Wesley Longman, Inc. Slide 6-66 The End Copyright © 2000 Addison Wesley Longman, Inc. Slide 6-67