Download Chapter 5 In this chapter we will study how a nation`s standard of

Chapter 5
In this chapter we will study how a nation’s
standard of living is measured by GDP.
GDP (gross domestic product) is the
market value of all final goods and services
produced within a country in a given time
period.
To understand how GDP is measured,
we return to the circular flow model:
The circular flow model illustrates that:
Expenditure = Income
The left-hand side of the circle equals the
right-hand side.
When the firms produce output that is
purchased by the spenders in the economy,
the firms necessarily also generate factor
income equal in value to the output they
have produced.
Let Y = income = value of output. The
circular flow model shows that:
Y = C + I + G + NX.
It follows that there are two methods that
can be used to measure GDP:
1. The expenditure approach
2. The income approach
The Expenditure Approach
We simply add up all of the expenditures on
final goods and services on the right-hand
side of the circular flow diagram:
GDP = C + I + G + NX
This calculation will give us the value of
all output produced in the economy,
evaluated in terms of market prices.
The Income Approach
We start by adding up all of the different
forms of factor income paid in the economy:
Compensation of employees
+ Net interest
+ Rent
+ Profit
_______________________________
= Net domestic product at factor cost
“Net” because firms’ profits are net of depreciation.
“At factor cost” because goods are valued in terms
of the factors used to produce them.
The expenditure approach gives GDP, which
includes depreciation, evaluated at market prices.
Therefore, to make the income approach
consistent with the expenditure approach, we must:
Convert factor costs to market prices:
add indirect taxes
subtract subsidies
Convert net domestic product to gross:
add depreciation
Net domestic product at factor cost
+ indirect taxes
- subsidies
+ depreciation
_______________________________
= Gross domestic product at market prices
Real versus nominal GDP
GDP is measured at market prices, i.e., in dollars.
If this dollar amount increases, it could be
because
we produced more goods and services (our
standard of living increased), or
prices increased (our cost of living increased)
An increase in the current dollar value of
output produced is called an increase in
nominal GDP.
An increase in the amount of output
produced is called an increase in real GDP.
Nominal GDP could increase either because of an
increase in real GDP or because of an increase in
the average level of prices in the economy, or
because both happened. An increase in the price
level is measured by the GDP deflator.
Nominal GDP is the value of final goods and
services produced in a given year evaluated in
terms of the prices prevailing in that same year
Real GDP is the value of final goods and
services produced in a given year evaluated
in terms of the prices prevailing in a base
year, i.e., holding prices constant at baseyear levels.
Traditional, and simplest, method of
calculating real GDP:
Assume that the economy produces only two goods,
beer and pretzels. 2006 is the current year; 2005 is
the base year.
In the base year, nominal GDP and real GDP are
the same. Nominal GDP = real GDP in 2005 is
calculated by adding up the values of beer and
pretzels produced in 2005 in terms of 2005 prices:
2005
beer
pretzels
Total
Quantity
produced
90
170
Price per
unit
$1.20
$0.75
Value
$108
$127.50
$235.50
$235.50 is nominal GDP and real GDP in 2005.
Nominal GDP in 2006 is the value of beer and
pretzels produced in 2006 in terms of 2006 prices:
2006
beer
pretzels
Quantity
produced
150
200
Price per
unit
$1.30
$3.00
Total
$795 is nominal GDP in 2006.
Value
$195
$600
$795
Real GDP in 2006 is the value of beer and pretzels
produced in 2006 in terms of 2005 prices:
2006
beer
pretzels
Total
Quantity
produced
150
200
Price per
unit
$1.20
$0.75
Value
$180
$150
$330
$330 is real GDP in 2006, i.e., the value of output
produced in 2006 evaluated at base-year (2005)
prices.
Thus, in constant 2005 prices, real GDP increased
from $235.50 to $330, a 40% increase.
The traditional approach to calculating real GDP
uses base-year prices. The more modern approach,
also called the “chained-dollar method,” takes into
account what happens when changes in output are
evaluated at constant current-year prices.
To implement the modern approach, we calculate
the value of beer and pretzels produced in 2005 in
terms of 2006 prices:
2005
Quantity
produced
Price per
unit
Value
beer
90
$1.30
$117
pretzels
170
$3.00
$510
Total
$627
$627 is the value of output produced in 2005 in
terms of 2006 prices. This number may be
compared with $795, which is the value of output
produced in 2006 in terms of 2006 prices.
Thus, at constant 2006 prices, output increased
from $627 to $795, a growth rate of 27%.
The modern method of calculating real GDP takes the
geometric average of the 40% increase in the value of
output holding prices constant at 2005 prices and the
27% increase in the value of output holding prices
constant at 2006 prices:
40 X 27 = 32.86%.
Thus, real GDP, according to this approach, has
increased by 32.86% from 2005 to 2006. In 2005
real GDP was $235.50. Therefore real GDP in
2006 must be 32.86% greater than $235.50, or
$312.88.
The GDP deflator
The GDP deflator is a measure of the average
change in prices between the base year and a
current year.
It is calculated as an average of current
prices expressed as a percentage of baseyear prices:
GDP deflator = (Nominal GDP/Real GDP) x 100
In our example, the GDP deflator is given by:
GDP deflator in 2005 = ($235.50/$235.50) x 100
= 100
GDP deflator in 2006 = ($795/$312.88) x 100
= 254
Thus prices in our economy increased by 154%
between 2005 and 2006.