Download Macro Lecture 2: Gross Domestic Product

Macro Lecture 2: Gross Domestic Product
Motivating Macroeconomics
Thus far, we have been studying microeconomics. In micro, we try to understand how one particular
market or one particular firm behaves. It appears that applying microeconomics to the labor market
does not allow us to explain persistent unemployment, however. Consequently, we shall now take a
different approach by exploiting the relationship between unemployment and production in the
economy as a whole:
Unemployment Up

Employment Down

Production Down
Unemployment Down

Employment Up

Production Up
Macroeconomics focuses on aggregate production, production in our economy as a whole, growth in
the economy as a whole, unemployment in the economy as a whole, inflation in the economy as a
whole, etc. We begin by introducing some basic concepts that we use to measure how much our
economy is producing, how fast it is growing, etc. You hear these statistics cited frequently on the
evening news, in newspapers, magazines, etc. We suspect that you do not know precisely what they
mean. So, this appears to be a good place to start.
Gross Domestic Product: How many goods and services does the economy produce?
Gross Domestic Product (GDP) is designed to measure how many goods and services an economy
produces. In the U.S., the Department of Commerce releases GDP figures every quarter. So, four
times a year, the evening news reports on the GDP. Exactly what do GDP figures represent?
Nominal GDP
Nominal GDP for 2014
= Sum of the market values of all final goods and services produced
in the United States during 2014
2014
2014
2014
= P2014
Auto  QAuto + P Beer  Q Beer + . . .
Let us parse the definition:
 Sum: It should be clear what a “sum” means.
 Market value: The market value is just the price of the good times the quantity
produced.
 Produced in the U.S.: We only consider production in the U.S.
 Final goods and services: The term “final goods and services” requires some
explanation.
Final goods and services
When the Department of Commerce calculates GDP, it makes a distinction between final and
intermediate goods. Intermediate goods are those goods that produced in 2014 which were then
used to produce other goods in the same year. For example, wheat is typically an intermediate
good because wheat is used to produce flour. Most of the flour produced is also an intermediate
good because most of the flour produced in the U.S. is used to produce bread. The bread is a final
good. If the Department of Commerce were to count not only the bread, but also the flour that is
used to make the bread, and the wheat that is used to make the flour, it would be double (or more
accurately triple) counting. It would be counting the wheat in the flour and the flour in the bread
twice. To avoid double counting only the value of final goods is included in GDP calculations.
2
Calculating GDP
To calculate GDP, the Department of Commerce divides the users of final goods into three
categories:
 households;
 firms;
 governments.
It then measures how many final goods each category purchases. Households purchase food,
clothing, entertainment, etc. for the purpose of consumption; that is, households purchase
consumption goods. Firms purchase machines, tools, factories, etc. for the purpose of investment;
that is, firms purchase investment goods. We call the purchases that federal, state, and local
governments make government purchases.
Now, let us consider the data for 2014 reported in table 2.1 (all figures are in billions of dollars):
U.S. Household Purchases of Final Goods and Services (Consumption)
11,930
U.S. Firm Purchases of Final Goods and Services (Investment)
2,850
U.S. Government Purchases of Final Goods and Services
3,180
Federal
1,220
National defense
760
Nondefense
460
State and local
1,960
Total
17,960
Table 2.1: Household, firm, and government purchasing data – 2014
Now, let us use the information from the table 2.1 to calculate GDP in the U.S. during 2014:
Nominal
U.S. Household
U.S. Firm
U.S. Government
GDP
=
Purchases of
+
Purchases of
+
Purchases of
for 2014
Final G&S (C)
Final G&S (I)
Final G&S (G)
=
11,930
+
2,850
+
3,180
=
17,960
It looks like GDP equals $16,790 billion. But wait. The goal of GDP is to measure how many
final goods and services are produced in the U.S.
 Some of the purchases that U.S. households, firms, and governments make are for goods
that are produced abroad, our imports: American households purchase BMW’s produced
in Germany, Volvos produced in Sweden, wine produced in France, etc. Shouldn’t we
subtract our imports?
 Also, some of the goods that are produced in the U.S. are shipped abroad and are not
consumed in the U.S., our exports: American wheat is shipped abroad, American
computers are shipped abroad, etc. Therefore, shouldn’t we add exports?
To obtain an accurate measure of U.S. production, we must add exports and subtract imports for
the figure we just calculate. We call the difference between exports and imports net exports. The
2014 figures for exports and imports are:
U.S. Exports of Final Goods and Services
2,340
U.S. Imports of Final Goods and Services
2,880
Therefore,
U.S. Net Exports of Final Goods and Services = 2,880  2,340 = 540
Nominal
U.S. Household
U.S. Firm
U.S. Government
U.S. Net
GDP
=
Purchases of
+ Purchases of +
Purchases of
+
Exports of
for 2014
Final G&S (C)
Final G&S (I)
Final G&S (G)
Final G&S (NX)
=
11,930
+
2,850
+
3,180
+
540
=
17,420
In 2014, nominal GDP was $17,420 billion.
3
Two Roles of the Government in the Macro Economy
 Purchasing of final goods and services. The Federal government purchases rifles, bullets, etc. for the military; state
government purchase asphalt to build and maintain highways; local governments purchase the services of teachers
for public schools.
 Affecting the disposable income of households. Disposable income refers to the amount of income household
have available to spend. Federal, state, and local governments affect this in two ways:
o Governments decrease the disposable income of households by collecting taxes: Income taxes, property
taxes, etc.
o Governments increase the disposable income of households by distributing transfer payments: Social
Security benefits, unemployment insurance, welfare payments, etc.
The Role of Federal, State, and Local Governments
Before moving on, let us reconsider the government’s role in the economy. First, table 2.2 reports that
state and local governments purchase more final goods and services than does the federal government.
U.S. Government Purchases of Final Goods and Services
3,180
Federal
1,220
National defense
760
Nondefense
460
State and local
1,960
Table 2.2: U.S. government purchases of final goods and services
Also, note that most of the federal government’s purchases go for defense; that is, most of the federal
government’s purchases are spent on military personnel, guns, munitions, aircraft, ships, etc. But wait
a second. According to table 1.5 the federal government is spending $1,230 billion, yet isn’t the
federal budget well over two trillion dollars? What is going on here? All federal government’s outlays
can be divided into two broad categories:
 Purchase of final goods and services;
 Transfer payments.
The federal government not only purchases final goods and services, it also administers transfer
programs. These programs transfer income from one group of Americans to another. The largest
transfer program is Social Security which transfers income from those who are working primarily to
those who are retired. The federal budget figure that is cited on the evening news includes not only the
purchase of goods and services, but also transfer payments, total Federal outlays. The Federal deficit
equals all federal outlays less Federal receipts:
Total Federal
Total Federal

Government Receipts
Government Outlays
ã 3,600 é
2,775
Federal Purchase of
Federal Transfer
+
Final G&S
Payments
1,220
2,380
Federal Deficit
=
We shall return to this later in the semester.
= 825
4
Great Depression: Unemployment and Nominal GDP
Now, recall how we motivated macroeconomics. Since applying microeconomics to the labor market
does not allow us to explain persistent unemployment, we took a different approach by exploiting the
relationship between unemployment and production in the economy as a whole:
Unemployment Up

Employment Down

Production Down
Unemployment Down

Employment Up

Production Up
Let us now see how well that approach works. By considering the Great Depression as reported in
table 2.3:
Nominal GDP
Unemployment
Year
(billions of dollars)
Rate (%)
1933
57
20.9
1934
67
16.2
1935
74
14.4
1936
85
10.0
1937
93
9.2
1938
87
12.5
1939
94
11.3
1940
103
9.5
1941
129
6.0
1942
166
3.1
1943
203
1.8
1944
225
1.2
Table 2.3: Unemployment and nominal GDP data –
1933-1944
Based on these years, it appears that the new approach works:
 Between 1933 and 1937 the unemployment consistently fell and nominal GDP consistently
rose.
 In 1938, the unemployment rate rose and nominal GDP fell from 87 to 94 billion dollars.
 Between 1938 and 1944 the unemployment consistently fell and nominal GDP consistently
rose.
But now we will consider a more recent case in which it does not work which prompts us to introduce
a modified notion of gross domestic product.
5
Nominal GDP and Unemployment: A Puzzle
A Puzzle: 2007-2008
Table 2.4 reports a puzzle.
Year
Nominal GDP
Unem Rate (%)
2007
14,480
4.6
2008
14,720
5.8
Table 2.4: Nominal GDP and the unemployment rate
for 2007 and 2008
GDP increased but the unemployment rate increased also. How could this occur? Let us review the
definition of nominal GDP:
Nominal GDP for 2007 = Sum of the market values of all final goods and services
produced in the United States during 2007
2007
2007
2007
= P2007
Auto  QAuto + P Beer  Q Beer + . . . = 14,480
Nominal GDP for 2008 = Sum of the market values of all final goods and services
produced in the United States during 2008
2008
2008
2008
= P2008
Auto  QAuto + P Beer  Q Beer + . . . = 14,720
Nominal GDP can increase for two reasons:
 the Q’s can rise.
 the P’s can rise.
Why did we introduce the notion of GDP in the first place? We wanted a way to measure how
many goods and services the economy as a whole was producing. But a rising nominal GDP need
not necessarily indicate that the economy is producing more. We have a problem don’t we.
Real GDP
Real GDP solves our problem. It modifies the definition of nominal GDP so that changes in real GDP
reflect only the changes in the Q’s, the quantity of goods and services produce. To see how, we begin
with the definition of nominal GDP:
Nominal GDP for 2014
= Sum of the market values of all final goods and services
produced in the United States during 2014
2014
2014
2014
= P2014
Auto  QAuto + P Beer  Q Beer + . . .
= $17,420
If nominal GDP rises because the Q’s increase, then the rising nominal GDP would indeed indicate
that the economy was producing more goods and services. But GDP could rise as a consequence of
rising prices, P’s, with the Q’s remaining the same or even falling. In this latter case, a rising GDP
would not indicate a robust, growing economy. Since both an increase in the Q’s and an increase in
the P’s can cause a rise in nominal GDP, nominal GDP itself cannot tell us what is happening to the
Q’s, the production of goods and services.
For this reason, we shall now introduce a new concept, real GDP, which can only rise when the Q’s
increase. Consequently, when real GDP increase we can conclude confidently that our economy is
producing more goods. Real GDP is what nominal GDP would have equaled if prices had not changed
from their base year values. Currently, the base year used by the Department of Commerce is 2009:
Real GDP for 2014
= Sum of the market values of all final goods and services
produced in the United States during 2014 evaluated at
base year (2009) prices
2014
2009
2014
= P2009
Auto  QAuto + P Beer  Q Beer + . . .
= $16,090
6
Now, calculate real GDP for 2007 and 2008
Real GDP for 2007
2007
2009
2009
= P2009
Auto  QAuto + P Beer  Q Beer + . . .
= $14,875
Real GDP for 2008
2008
2009
2008
= P2009
Auto  QAuto + P Beer  Q Beer + . . .
= $14,835
The Q’s, production, had to fall because the P’s the prices were the same.
Year
Nominal GDP
Real GDP
Unem Rate (%)
2007
14,480
14,875
4.6
2008
14,720
14,835
5.8
Table 2.5: Nominal GDP, real GDP, and the unemployment rate for
2007 and 2008
As table 2.5 reports nominal GDP rose and the fact that real GDP fell in 2008; that is, nominal GDP
rose while the production of goods and services in the economy actually fell. This resolves our puzzle;
production fell in 2008 and unemployment rose.
7
Figure 1.11 illustrates real GDP and its components since 1930:
Figure 2.1: Real GDP and its components: 1920-2014
Of course some of this growth is attributable to population growth; accordingly, the per capita figures
are illustrated in figure 1.12:
Figure 2.2: Real per capita GDP and its components: 1920-2014
Terminology: Henceforth, whenever we refer to GDP, consumption, etc. we will be referring to real
GDP, real consumption, etc. unless we explicitly say otherwise.
8
Measuring the Health of the Economy – Some Complications
Table 2.6 reports labor market statistics issued by the Bureau of Labor Statistics for December 2014
and January 2015:
Dec 2014 Jan 2015 Difference
249,000
249,700
700
Noninstutitional Population
156,130
157,180
1,050
Labor Force
92,900
92,550
-350
Not in Labor Force
147,440
148,200
760
Employed
8,690
8,980
290
Unemployed
5.6
5.7
Unemployment Rate (%)
62.7
62.9
Labor Force Participation Rate (%)
Table 2.6: Labor market statistics December 2014 and January 2015
(thousands)
Economists React to the January Jobs Report: ‘Astonishingly Strong’
Wall Street Journal – February 6, 2015
“The report earned a 10 out of 10 in our eyes and suggests that labor markets remain extremely
strong as fears of an early-year slowdown prove unfounded…..” –Gennadiy Goldberg, TD
Securities
“Employment growth is astonishingly strong; ….Ignore the increase in the unemployment rate;
month-to-month, it is just noise. What matters is payroll growth, and the numbers are huge….
With every indicator we follow screaming that payrolls will be very strong for the foreseeable
future...” –Ian Shepherdson, Pantheon Macroeconomics
“Before long, the U.S. economy is going to run into a problem that was unimaginable just six
months ago: we might run out of people to employ.” –Guy LeBas, Janney Montgomery Scott
“January was another strong month across a breadth of industries confirming that our economic
recovery is becoming robust. Job growth is
strong and the labor force participation rate
Noninstitution Population Up 700,000
ticked up slightly, indicating that people who
have given up looking for work are beginning
Labor Force Up 1,050,000
to start looking again...” –Bill Spriggs, AFLCIO
Question: How can we explain the
enthusiastically positive comments about the
economy when the unemployment rate rose?
Answer: The reason for the optimism was the
decline in those Americans not in the labor
force which declined by more than a quarter
of a million individuals as illusted in figure
2.3. Apparently, more of those who in
December were not seeking a job decided to
do so. The belief is that they did those was the
fact that the prospects of getting a job had
improved. In other words, workers who
previously had given up on finding a job,
discouraged workers, we now encouraged by
the improving economy and rejoined the labor
force.
Employed
Up 760,000
Not in Labor Force
Down 350,000
entrants
Unemployed
Up 290,000
Figure 2.3: Labor market changes – December 2014 to January
2015