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How do we track
the booms and
busts of the
business cycle?
How do we measure a
nation’s production and
income?
How do we determine
when a recession begins?
GDP, INCOME, AND EXPENDITURE
GDP Defined
Gross domestic product or GDP
The market value of all the final goods and services
produced within a country in a given time period.
Value Produced
• Use market prices to value production.
GDP, INCOME, AND EXPENDITURE
What Produced
Final good or service is a good or service that is
produced for its final user and not as a component of
another good or service.
Intermediate good or service is a good or service
that is produced by one firm, bought by another firm,
and used as a component of a final good or service.
GDP includes only those items that are traded in
markets.
GDP, INCOME, AND EXPENDITURE
Where Produced
• Within a country
When Produced
• During a given time period.
GDP, INCOME, AND EXPENDITURE
Circular Flows in the U.S. Economy
Consumption expenditure is the expenditure by
households on consumption goods and services.
Investment is the purchase of new capital goods
(tools, instruments, machines, buildings, and other
constructions) and additions to inventories.
GDP, INCOME, AND EXPENDITURE
Government expenditure on goods and services
is the expenditure by all levels of government on goods
and services.
Net exports of goods and services is the value of
exports of goods and services minus the value of
imports of goods and services.
5.1 GDP, INCOME, AND EXPENDITURE
Exports of goods and services are the items that
firms in in the United States produce and sell to the rest
of the world.
Imports of goods and services are the items that
households, firms, and governments buy from the rest
of the world.
5.1 GDP, INCOME, AND EXPENDITURE
Total expenditure is the total amount received by
producers of final goods and services.
Consumption expenditure: C
Investment: I
Government expenditure on goods and services: G
Net exports: NX
Total expenditure = C + I + G + NX
GDP, INCOME, AND EXPENDITURE
Income
• Labor earns wages.
• Capital earns interest.
• Land earns rent.
• Entrepreneurship earns profits.
Households receive these incomes.
GDP, INCOME, AND EXPENDITURE
Expenditure Equals Income
Because firms pay out everything they receive as
incomes to the factors of production, total expenditure
equals total income.
That is:
Y = C + I + G + NX
The value of production equals income equals
expenditure.
GDP, INCOME, AND EXPENDITURE
Figure 1
shows the
circular flow
of income
and
expenditure.
The table
shows the
U.S. data
for 2009.
MEASURING U.S. GDP
The Expenditure Approach
Measures GDP by using data on consumption
expenditure, investment, government expenditure on
goods and services, and net exports.
Table 1 on the next slide shows the calculation for
2009.
MEASURING U.S. GDP
MEASURING GDP
Expenditures Not in GDP
Used Goods
Expenditure on used goods is not part of GDP because
these goods were part of GDP in the period in which
they were produced and during which time they were
new goods.
Financial Assets
When households buy financial assets such as bonds
and stocks, they are making loans, not buying goods
and services.
MEASURING GDP
GDP and Related Measures of Production
and Income
Gross national product or GNP is the market value
of all the final goods and services produced anywhere
in the world in a given time period by the factors of
production supplied by residents of the country.
U.S. GNP = U.S. GDP + Net factor income from abroad
MEASURING GDP
Disposable Personal Income
Consumption expenditure is one of the largest
components of aggregate expenditure and one of the
main influences on it is disposable personal income.
Disposable personal income is the income received
by households minus personal income taxes paid.
MEASURING GDP
Real GDP and Nominal GDP
Real GDP is the value of the final goods and services
produced in a given year expressed in the prices of the
base year.
Nominal GDP is the value of the final goods and
services produced in a given year expressed in the
prices of that same year.
The method of calculating real GDP changed in recent
years. Here we describe the essence of the calculation.
The appendix gives the technical details.
MEASURING GDP
Calculating Real GDP
The goal of calculating real GDP is to measure the
extent to which total production has increased
Real GDP removes the influence of price changes from
the nominal GDP numbers.
To focus on the principles and keep the numbers easy
to work with, we’ll calculate real GDP for an economy
that produces only one consumption good, one capital
good, and one government service.
MEASURING U.S. GDP
Table 3 shows the calculation with 2005 (base year)
and 2010.
To find the total expenditure in 2005 multiply the
quantity of each item produced in 2005 by its price in
2005.
Then sum the expenditures to find nominal GDP in
2005.
The next slide shows the data.
Nominal
GDP in
2005 is
$100
million.
Because
2005 is the
base year,
real GDP
in 2005 is
also $100
million.
MEASURING U.S. GDP
In part (b) of Table 3, we calculate nominal GDP in
2010.
Again, we calculate nominal GDP by multiplying the
quantity of each item produced by its price and then
sum the expenditures to find nominal GDP in 2010.
Nominal
GDP in
2005 is
$100
million.
Nominal
GDP in
2010 is
$300
million.
MEASURING U.S. GDP
Nominal GDP in 2005 is $100 million and in 2010 it is $300
million.
Nominal GDP in 2010 is three times its value in 2005.
But by how much has the quantity of final goods and
services produced increased?
MEASURING U.S. GDP
The increase in real GDP will tell by how much the
quantity of good and services has increased.
Real GDP in 2010 is what the total expenditure would
have been in 2010 if prices had remained the same as
they were in 2005.
To calculate real GDP in 2010 multiply the quantities
produced in 2010 by the price in 2005 and the sum
these expenditures to find real GDP in 2010.
Part (c) of Table 3 shows the details.
Real GDP
in 2005 is
$100
million.
Real GDP
in 2010 is
$160
million—
only 1.6
times real
GDP in
2005.
THE USE AND LIMITATIONS OF REAL GDP
We use estimates of real GDP for three main purposes:
• To compare the standard of living over time
• To track the course of the business cycle
• To compare the standard of living among countries
The Standard of Living Over Time
To compare living standards we calculate real GDP per
person—real GDP divided by the population.
THE USE AND LIMITATIONS OF REAL GDP
In 2009, U.S. real GDP was $12,893 billion and the U.S.
population was 306.2 million.
Real GDP per person = $12,893 billion ÷ 306.2 million
Real GDP per person = $42,106.
In 1959, real GDP per person was $15,540.
The standard of living in 2009 was 2.7 times the
standard of living in 1959.
THE USE AND LIMITATIONS OF REAL GDP
Two features of our changing standard of living are
1. The growth of potential GDP per person
2. Fluctuations of real GDP per person around potential
GDP
Potential GDP is the value of real GDP when all the
economy’s factors of production —labor, capital, land, and
entrepreneurial ability—are fully employed.
THE USE AND LIMITATIONS OF REAL GDP
When some factors of production are unemployed, real GDP
is less than potential GDP.
When some factors of production are over-employed and
working hard, real GDP exceeds potential GDP.
In the short term, real GDP fluctuates around potential GDP.
To measure the trend in the standard of living, we remove
the influence of short-term fluctuations and focus on potential
GDP.
Figure 3 on next slide shows these two features.
THE USE AND LIMITATIONS OF REAL GDP
Real GDP per
person grows and
fluctuates around
the path of potential
GDP.
Potential GDP per
person grew at 2.8
percent in the
1960s and slowed
during the 1970s.
THE USE AND LIMITATIONS OF REAL GDP
Tracking the Course of the Business Cycle
Fluctuations in the pace of expansion of real GDP is
called the business cycle.
The business cycle is a periodic irregular up-and down
movement of total production and other measure of
economic activity.
The four stages of a business cycle are
expansion, peak, recession, and trough.
THE USE AND LIMITATIONS OF REAL GDP
The shaded periods
show the
recessions—
periods of falling
production that
lasts for at least six
months.
EYE on the BUSINESS CYCLE
How Do We Track the Booms and Busts of the
Business Cycle?
The National Bureau of Economic Research (NBER)
Business Cycle Dating Committee determines the dates of
U.S. business cycle turning points.
To identify the date of a business cycle peak, the NBER
committee looks at data on industrial production, total
employment, real GDP, and wholesale and retail sales.
The two most reliable measures of aggregate domestic
production are real GDP measured using the expenditure
approach and the income approach.
EYE on the BUSINESS CYCLE
How Do We Track the Booms and Busts of the
Business Cycle?
The NBER committee met in November 2008 to determine
when the economy went into recession.
Because of a statistical discrepancy, the two estimates of
real GDP differ and for a few quarters in 2007 and 2008 they
told conflicting stories.
The NBER examined other data on real personal income,
real manufacturing, wholesale and retail sales, industrial
production, and employment.
EYE on the BUSINESS CYCLE
How Do We Track the Booms and Busts of the
Business Cycle?
All of these data peaked between November 2007 and June
2008.
The committee
decided that
November 2007
was the peak.
But as the figure
shows, real GDP
didn’t begin a
sustained fall until
two quarters later.
THE USE AND LIMITATIONS OF REAL GDP
Standard of Living Across Countries
To compare living standards across countries, we must
convert real GDP into a common currency and common
set of prices, called purchasing power parity.
Goods and Services Omitted from GDP
• Household production
• Underground production
• Leisure time
• Environment quality
THE USE AND LIMITATIONS OF REAL GDP
Household Production
• Real GDP omits household production and it
underestimates the value of the production of
many people, most of them women.
Underground Production
• Hidden from government to avoid taxes and
regulations or illegal.
• Because underground economic activity is
unreported, it is omitted from GDP.
THE USE AND LIMITATIONS OF REAL GDP
Leisure Time
• Our working time is valued as part of GDP, but our
leisure time is not.
Environment Quality
• Pollution is not subtracted from GDP.
• We do not count the deteriorating atmosphere as a
negative part of GDP.
• If our standard of living is adversely affected by
pollution, our GDP measure does not show this
fact.
THE USE AND LIMITATIONS OF REAL GDP
 Other Influences on the Standard of Living
Health and Life Expectancy
• Good health and a long life do not show up directly
in real GDP.
Political Freedom and Social Justice
• A country with a large real GDP per person might
have limited political freedom and social justice.
• A country with a lower standard of living might be
one in which everyone enjoys political freedom.
APPENDIX: MEASURING REAL GDP
The Problem with Base-Year Prices
We calculated real GDP in 2010 using 2005 as the base
year and found that real GDP in 2010 was 1.6 percent
greater than in 2005—an increase of 60%.
But if we had used 2010 prices rather than 2005, real
GDP would have increased from $150 million (2010
dollars) in 2005 to $300 million in 2010—an increase of
100%.
So did real GDP increase by 60% or 100%?
APPENDIX: MEASURING REAL GDP
The BEA method uses the prices of both years.
The three steps in the method are
• Value production in the prices of adjacent years.
• Find the average of the two percentage changes.
• Link (chain) to the base year.
APPENDIX: MEASURING REAL GDP
By applying the average percentage change between
each pair of years, we find the chained-dollar real GDP
for each year, expressed in terms of 2005 dollars.
We can do this for years after the base year,
And for years earlier than the base year.