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Gross Domestic Product (GDP) and Business Fluctuations MSc EPS Hilary term 2013 (S2) Professor Dermot McAleese OUTLINE Definition of GDP Real vs. nominal GDP GDP vs. GNP GDP estimation Shadow vs Official Economy PPP vs. current exchange rate Potential GDP and the output gap Business Fluctuations 2 GROSS DOMESTIC PRODUCT (GDP) GDP refers to the output of goods and services produced in an economy during a specific period of time. The importance of GDP statistic Business forecasts Monetary and fiscal policy Political significance International comparisons 3 Real vs. Nominal GDP Nominal GDP is the current value of output (goods and services) produced in an economy. Real GDP measures volume of output. computed by valuing the quantities of goods and services produced in 2 periods with the same set of prices. P1 x X 1 + P1 y Y 1 (5, 10) (8, 12) €146 Year 2: P2x X2 + P2y Y2 (6, 11) (9, 14) €192 (+31%) To compute real GDP: (1) Calculate value of Year 2 quantities at Year 1 prices P1x X2 + P1y Y2 = 5 x 11 + 8 x 14 = 55+112= 167 (2) Express this as % of base year GDP. Real GDP increased by 14%. Year 1: 4 GDP vs GNP (GNI) GDP is output produced by productive factors located in the country, regardless of their owners’ nationality. GNP refers to output produced by productive factors owned by permanent residents (‘citizens’) of a country. For most countries the difference is very small 5 (GDP – GNP)/GNP for 181 countries 40% 20% 0% -20% -40% -60% -80% -100% 6 Countries with GDP > GNP -- Top 16 Congo, Rep. Liberia Chad Ireland St. Kitts and Nevis Suriname Azerbaijan 29.4 25.7 23.1 18.2 15.6 15.4 14.6 Angola Nigeria Yemen, Rep. Belize Gabon Lao PDR Kazakhstan Chile Dominica 14.2 14.1 12.5 11.2 10.8 10.4 10.4 10.1 9.1 GDP-GNP (% of GDP) 7 WDI 2007 World Bank CDRom Countries with GNP > GDP -- Top 16 % gap Timor-Leste 36.8 Marshall Islands 19.8 Lesotho 18.3 Moldova 11.0 Kuwait 9.9 West Bank and Gaza 9.0 Djibouti 8.7 Philippines 7.8 Switzerland 7.7 Bangladesh 4.9 Bosnia and Herzegovina 4.5 Micronesia, Fed. Sts. 4.4 Mauritania 3.4 Jordan 2.9 Palau 2.8 Japan 2.3 Memo: China US 0.5% 0.3% World Bank Indicators 2007 (GNP-GDP)/GDP 8* 100 HOW TO COMPUTE GDP Production Value added = Gross Domestic Product ___________ Income Disposal income of households + Non distributed profits + Net direct taxes = National Income ______ Net Indirect Taxes ____________ Depreciation Expenditure Private consumption + Gross Investment (incl. inventories) + Public Consumption + Exports Imports (including income flows) 9 GDP = C + I + G + X - M C = private sector consumption I = investment (capital formation) G = government current spending X = exports of goods and services M = imports of goods and services 10 Composition of EU GDP Source: European Economy 2011 11 12 GDP by sector Agriculture Fishing Industry Services Euro Area 2.2 26.6 71.1 China (2010) 10 47 44 France 2.5 21.3 76.3 4 Poland 5.1 31.0 64.0 18 Germany 1.1 29.1 69.8 2 (incl Cons) % of workforce in agric 4 40 Source: WTO Trade Policy Review “European Communities” 22 Jan 2012 13 Real US after-tax income (% increase 1979-2007) Average income increase 1979-2007 62% Median income increase 1979-2007 35% Martin Wolf “Romney would be a backward step” FT Wed Oct 31st 2012 14 CBO = Congressional Budget Congressional Budget Office, Washington DC Office, Washington DC 15 Real US after-tax income By percentile, % increase, 1979-2007 300 Average income increase 62% 250 200 150 100 50 0 Top 1% 81-99 61-80 41-60 21-40 Source: Congressional Budget office Report November 2011 0-20 16 17 18 CBO Report Oct 2011 Ref to OECD study 2008 19 Purchasing Power Parity (PPP) 1. Nominal exchange rate in 2008 was 6.9 Yuan = US$1 . Hence $1000 = 6,900 yuan. 2. Buy a representative basket of goods and services in Washington DC. A representative basket might, for example, contain 2 kilos of rice 1 kilo beef 5 inner city bus rides one month’s rent of a two-bed apartment 1 personal computer 2 visits to doctor etc. (the list could run into hundreds of items) 3. Suppose this representative basket costs $1,000 to buy in Washington. Now buy exactly the same basket in China. Suppose it costs 3,800 yuan. Purchasing Power Parity (PPP) rate of exchange = 3,800 yuan divided by $1000 PPP exchange rate: 3.8 yuan = $1 4. GDP per head in China (2008) = 22,640 Yuan = $3,260 at nominal exchange rate. [6.9 yuan per dollar]. China’s GDP per head of 22,640 yuan per head = $5,962 at PPP (3.8 yuan per dollar]. 20 Comparison between GDP per capita at current exchange rates and at PPP Country GDP per capita ($) (current prices and exchange rates) India GDP per capita ($) (PPP) 736 3452 Morocco 1711 4555 Argentina 4728 14,280 Mexico 7454 10,751 China 1713 6757 UK 36,509 33,238 France 34,936 30,386 Canada 34,484 33,375 US 41,890 41,890 Source: UN HDR Report 2007-2008 21 GDP calculated from nominal exchange rates underestimates the living standards of developing countries This happens because non traded goods (services) are much cheaper in developing countries Divergences in prices of traded goods are much less because of the law of one price The gap between GDP measured at current exchange rate and GDP measured at PPP can be substantial 22 Review Questions In HDR 2011 table, most countries’ GDP per capita is higher in PPP than in current exchange rates. For some countries GDP at current exchange rates is higher than in PPP terms. What is the reason for this difference? 23 Shares of world production -- PPP vs current exchange rates (%) PPP weight US$ weight China 13.2 4.1 Japan 6.9 11.4 US 21.0 28.7 EU 21.4 32.7 Source: Bank of America 2006 24 Source: The Economist Feb 27, 2010 25 Source: The Economist Feb 27,262010 ‘The Gross National Product does not allow for the health of our children, the quality of their education or the joy of their play. It does not include the beauty of our poetry or the strength of our marriages; the intelligence of our public debate or the integrity of our public officials. It measures neither our wisdom nor our learning neither our compassion nor our devotion to our country; it measures everything, in short, except that which makes life worthwhile.’ Robert F. Kennedy (1968) quoted in Finance and Development, December 1993, p. 20 27 The basic purpose of development is to enlarge people’s choices. People often value achievements that do not show up at all, or not immediately, in income or growth figures: greater access to knowledge, better nutrition and health services, more secure livelihoods, security against crime and physical violence, satisfying leisure hours, political and cultural freedoms and sense of participation in community activities. The objective of development is to create an enabling environment for people to enjoy long, healthy and creative lives. Mahbub ul Haq, Founder of the Human Development Report. 28 Classwork pp 273-274 • E1, E2, E3 • Q1 (p 273) 29 Which of the following transactions should be included as part of GDP? (a) A consumer pays €10 for a meal at the restaurant (b) A company buys a plant from another firm for €1 million. (c) A supplier sells computer chips to another firm that makes personal computers. (d) A person buys a second-hand car from a dealer for €5,000. (e) A person buys a new car for €15,000. (f) A factory exports €2m worth of PCs and sells €5m on the domestic market. It imports €2m component parts for the PCs. (g) Chinese residents abroad send €5m to their relatives in China; China gives €5m aid to UN; Chinese temporary workers earn €5m in foreign countries 30 2. A person saves €10,000 of this year's income and spends it on new machinery. Explain how this would be recorded in the national accounts. Another person takes €10,000 from a deposit account and buys shares on the stock market. Would this be recorded in GDP? 31 Ex 3 p 274 Consider an economy with only three goods. Their market prices are P1 = 5, P2 = 10 and P3 = 15. The production (and consumption) of each good during 2002 was Q1 = 20, Q2 = 25 and Q3 = 10. (a) What is the value of nominal GDP? (b) Assume that in 2003 prices rise to P1 = 6, P2 = 12 and P3 = 17, and quantities produced (and consumed) go to Q1 = 21, Q2 = 27 and Q3 = 11. Calculate the value of nominal GDP. Compute real GDP, using 2002 prices as the base year. What is the real rate of growth of the economy? What is the rate of inflation? (c) Calculate the change in real GDP using 2003 prices as the base year. Explain why your answer is different to that in (b). 32 Shadow vs Official Economy (DMcA p.150) TOTAL ECONOMIC ACTIVITY FORMAL ECONOMY Nonmarketed economic activity SHADOW ECONOMY Marketed economic activity Marketed economic activity TOTAL MARKET ECONOMY Nonmarketed economic activity 33 Estimates of size of shadow economy March 2002 study shows from sample of 85 countries • 35-44% average range in developing countries (Nigeria and Egypt 77 and 69%, Thailand 70%, while only 14% in HK and Singapore, 19% in Chile) • 21-30% in transition countries Georgia 64%, Russia 44% • 14-16% in developed countries (US 10%) Source: F Schneider and D. Enste “Hiding in the Shadows: the Growth of the Underground Economy” IMF Economic Issues 30, Washington DC 2002 34 Size of the shadow economy (% GDP) Country 1990 2002 2008 2010 Austria 5 11 8.1 8.7 Belgium 20 22 17.5 17.9 Canada 14 16 12.0 12.7 Denmark 11 18 13.9 14.4 Germany 12 16 14.2 14.7 Greece 27 28 24.3 25.2 France 9 15 11.1 11.7 Ireland 12 16 12.2 13.2 Italy 23 27 21.4 22.2 Netherlands 14 13 9.6 10.3 Norway 15 19 14.7 15.4 Spain 21 23 18.7 19.8 Sweden 16 19 14.9 15.6 7 9 7.9 8.3 10 12 10.1 11.1 7 9 7.0 7.8 Switzerland UK USA Source: DMcA Economics for Business; F Schneider “The influence of the economic crisis on the underground economy” University of Linz, Austria Jan 2010 35 36 POTENTIAL GDP and the OUTPUT GAP Potential GDP is the maximum output that an economy can produce if capital, labour and other factors of production are fully utilised, consistent over the medium term with price stability. The Output Gap = [(actual GDP - potential GDP)/ potential GDP] x 100 37 POTENTIAL VS. ACTUAL GDP Actual GDP > Potential GDP price stability in jeopardy, indicators point to inflation Actual GDP < Potential GDP resources being wasted, unemployment, indicators point to recession Actual > Potential Real GDP Actual < Potential Actual Potential 38 time Source: Goldman Sachs “The long good buy” 21 March 2012 39 Output gaps for 2012 and 2013 0 -2 2012 2013 -4 -6 -8 -10 -12 Notes: Output gap = [(actual GDP - potential GDP)/ potential GDP] Source: OECD, Economic Outlook, May 2012 40 ESTIMATION OF POTENTIAL GDP Trend extrapolation Production function approach Growth in potential output Growth in government sector Growth in the business sector Growth in employment Growth in capital stock Growth in TFP Advances in technology Enterprise-friendly economic policies 41 OECD June 2012 42 Class exercise: define headings and interpret statistics in this table Source: OECD Nov43 2011 Class exercise: define headings and interpret statistics in this table OECD June 2012 44 Business Fluctuations (ch 16) What are business fluctuations? Why do they matter? What causes them? What can be done about them? --- next sessions – MONETARY AND FISCAL POLICY 45 What are business fluctuations? Business fluctuations are fluctuations in aggregate economic activity that are widely diffused throughout the economy and have identifiable “peaks” and “troughs” FLUCTUATIONS CYCLES 46 THE BUSINESS CYCLE WILL NOT DISAPPEAR …. The inevitability of the business cycle, as it used to be called, I take for granted. Good times bring into existence: first, incompetent business executives; second, wrongful government policies; and, third, speculators. Working together, they ensure the eventual bust. J K Galbraith “Challenges of the New Millennium” Finance and Development December 1999 p 5 47 2011 2010 2008 2006 2004 2002 2000 1998 1996 1994 1992 1990 1988 1986 1984 1982 1980 1978 1976 1974 1972 1970 1968 1966 1964 United States: GDP growth (% p.a.) Average growth rate 2.93% 8 6 4 2 0 -2 -4 -6 48 Source: The Economist Jan 2009 49 JAPAN Real GDP growth 1961-2011 (% p.a.) 15 10 Average 4.47% pa 5 0 -5 -10 50 UNITED KINGDOM Real GDP Growth 1964-2010 10 Av growth 2.3% p.a. 8 6 4 2 0 -2 -4 -6 2011 1.8 2012 0.9 51 GERMANY: Real GDP annual % growth Average 3.2% p.a. 52 China 1977-2010 (real GDP growth % p.a.) 16.00 14.00 12.00 10.00 Trend line 8.00 6.00 4.00 2.00 2007 2005 2003 2001 1999 1997 1995 1993 1991 1989 1987 1985 1983 1981 1979 1977 0.00 53 Facts About Fluctuations Negative growth infrequent Irregular periodicity No evidence of systematic long run cycles Sustained period of growth followed by relative or absolute downturn Industrial countries stay 3 times longer in the expansion phase of the cycle than in recession Strong synchronisation (contagion) effects – few cycles “made at home” Expanding role of emerging countries (now account for 2/3rds of world economy growth) 54 Two Strong Forces at work in macro economy 2009-12 a) Downward Force due to adverse deflation dynamic – multiplier effect b) Upward Force due to: Automatic Stabilisers Demand stimulation policies (countercyclical) 55 56 Why Do Business Fluctuations Matter? Long term economic growth is higher when stability is greater. Volatility not independent of trend. Fluctuations affect trend growth rate negatively. Most people prefer stability to an unstable, boom-and-bust growth path. 57 What can be done to achieve long term growth and to moderate macroeconomic fluctuations? 58