Download + = GDP

Lecture 3
Chapter 7: Taking the
Nation’s Economic Pulse
GDP
– A Measure of Output
– A Flow
GDP – A Measure of Output

Gross Domestic Product (GDP):
The market value of final goods and services
produced within a country’s borders during a
specific time period, usually a year, quarter, or
month.


GDP is the most widely used indicator of
economic performance.
Measures the flow of exchange
 Like

a paycheck, rather than your bank account
GNP or “Gross National Product” is similar to
GDP, but refers to the market value of goods
produced by a nation’s citizens
What Counts Toward GDP?

Only final goods and services count.
 Sales
at intermediate stages of production are
not counted as their value is embodied within
the final-user good.
 Including goods at intermediate stages of
production would result in double counting.
Stage of production
Sales Receipts
Value added to the product
(at each stage of production)
(equals income created)
Stage 1: farmer’s wheat
by farmer
$.30
$.30
Stage 2: miller’s flour
by miller
$.65
$.35
Stage 3: baker’s bread
(wholesale)
by baker
$.90
$.25
Stage 4: grocer’s bread
(retail)
by grocer
$1
Total consumer expenditure = $1
$.10
Total value added = $1
What Counts Toward GDP?

What Counts Toward GDP?
 Only
transactions involving production count.
Financial transactions & income transfers are
excluded because they do not reflect actual production.
 Black market transactions are excluded, so you may
consider them financial transactions or income transfers

 Only
production within the geographic
borders of the country is counted.

(This is the DOMESTIC part)
 Only
those goods produced during the
current period are counted.

Thus, the purchase and sale of goods produced during
earlier years are not counted in this year’s GDP.
Dollars are the Common
Denominator for GDP

GDP is measured in dollars.
 Each
good produced increases output
by the amount the purchaser pays for
the good.
 The total spending on all final-user
goods and services produced during
the year is summed, in dollar terms, to
obtain the annual GDP.
Two Ways
of Measuring GDP
Two Ways of Measuring GDP
Dollar flow of
expenditures
on final goods

= GDP =
Dollar flow of
income (and indirect
cost) of final goods
GDP (Typically denoted “Y”) is a measure
of both output and income. They SHOULD
BE EQUAL.
 Total
expenditures on final-user goods and
services produced during the year. This is called
the expenditure approach.
 Summing the income payments to the resource
suppliers and the indirect cost of producing the
goods and services. This is called the resource
cost-income approach.

Expenditure Approach:
 GDP
is the sum of expenditures on final-user
goods and services purchased by households,
investors, governments, and foreigners.
 There are four components of GDP:
personal consumption purchases (“C”)
 gross private investment
(“I”) (including inventories)
 government purchases (“G”)
(consumption and investment)
 net exports (“X”)(exports minus imports) (“EX-IM”)

 Y=C+I+G+X

You will see and use this repeatedly…
Y=C+I+G+X
The National Income Identity


Also known as the National Product Identity
Sometimes written Y=C+I+G+EX-IM
 We
subtract imports because we don’t produce them,
but we do consume them
 If Exports exceed Imports we have a trade surplus

 If
IM<EX
Imports exceed Exports we have a trade deficit

IM>EX
Resource Cost - Income Approach
 GDP is the sum of costs incurred and
income (including profits) generated by
the production of goods and services
during the period.
 The direct cost income components of
GDP:

employee compensation
 self-employment income
 rents
 interest
 corporate profits

Sum of these = national income

Resource Cost - Income Approach:
(cont.)
 Not
all cost components of GDP result in an
income payment to a resource supplier. To get
GDP, we need to account for 3 other factors:



Indirect business taxes:
Taxes that increase the firm’s production costs and
therefore final prices.
Depreciation:
The cost of wear and tear on the machines and
other capital assets used to produce goods and
services.
Net Income of Foreigners:
The income that foreigners earn producing goods
within the borders of the U.S. minus the income
Americans earn abroad.
Resource Cost-Income
Method of Measuring GDP

When derived by the Resource Cost Income Approach, GDP is equal to the
sum of
 national
income,
(employee compensation, selfemployment income, rents, interest,
corporate profits)
 indirect business taxes,
 depreciation, and,
 net income of foreigners.
Two Ways of Measuring GDP: A Summary

The two methods of calculating GDP are
summarized below:
Expenditure Approach
Resource Cost-Income Approach
Personal consumption expenditures
Aggregate income:
Employee Compensation
Income of self-employed
Rents
Profits
Interest
+
Gross private domestic investment
+
Government consumption
and gross investment
+
Net exports of goods and services
= GDP
+
Non-income cost items:
Indirect business taxes
and depreciation
+
Net income of foreigners
= GDP
Relative Size of U.S. GDP Components: 2000-2003
(a) Expenditure approach
Private
investment
Net exports
- 4%
-5.8% (b) Resource cost-income approach a
2006
Indirect
taxes
Rental income
1%
Net
interest
5%
16%
Depreciation
8%
Gov’t
12%
58%
18%
Corporate
profits
7%
70%
Self-employed
proprietor income
Personal
consumption
Source: http://www.economagic.com.

8%
Employee
compensation
a The net income of foreigners was negligible.
The relative sizes of the major components of GDP
usually fluctuate within a fairly narrow range.
The Major Macroeconomic Issues

National economies are becoming
increasingly interdependent:
 In
2004 the U.S.:
Exported 10.0% of all goods and services
produced. (11.1% in 2006)
 Imported 14.4% of the goods and services
used by Americans. (16.9% in 2006)

 In
2006, U.S. had a trade deficit of $762
Billion, or 5.8% of GDP
 Wal-Mart alone imported $18B worth of
goods from China alone in 2004
The Major Macroeconomic Issues

The international flows create political
and economic issues:
 The
impact of trade on jobs
The steel and textile industries
 Trade agreements (NAFTA)

 Trade
imbalances
When exports and imports differ significantly
 Trade deficits or surpluses
 Money to pay for goods must come from
somewhere

Exports and Imports as a Share
of U.S. Output, 1900-2004.
Macroeconomic Policy

Monetary Policy
 Determination
of the nation’s money supply
 Controlled by the central bank or, in the U.S., the
Federal Reserve System (Fed)

Fiscal Policy
 Decisions
that determine the government’s budget,
including the amount and composition of government
expenditures and government revenues
 Think of taxes like government income or revenue
Macroeconomic Policy

Fiscal policy influences the balance between
government spending and taxes:
 A budget
deficit occurs when government spending
is greater than tax revenue.

Government spending > Taxes (G>T)
 A budget
surplus occurs when government spending
is less than tax revenue.

Government spending < Taxes (G<T)
 As
deficits or surpluses add up, we get our National
Debt (or Surplus).


The national debt is the source of the interest payments our
country makes
Structural Policy
 Government
policies aimed at changing the
underlying structure, or institutions, of the nation’s
economy
Government Expenditures as a
percent of GDP (Federal Only)
Source: Congressional Budget Office
Federal Revenues, Outlays, Deficits, and Surpluses, 1950
to 2075
Source: Congressional Budget Office
Aggregation



The adding up of the individual economic variables to
obtain economywide totals
Used to take a “bird’s-eye view” of the economy
Aggregate measurements in dollar values allow
economists to compare broad categories of goods and
services, such as exports and imports.


Aggregation often obscures the fine detail of an economic
situation.
“Fallacy of Composition” is the idea that something good
for an individual is therfore good for the whole.

Keynes “Paradox of Thrift” shows that additional savings for one,
may be good for that person, however if EVERYONE decided to
suddenly save more, demand would fall, and we may experience
a recession.
Why study aggregate output?

The Great Depression as a case study
 In
the U.S.:
Factories cut production 31%
 Number of people without jobs nearly tripled by
1933 when the unemployment rate hit 25%
 Stocks lost a third of their value in 3 weeks

The U.S. Unemployment Rate,
1900-2004
1933: Approximately 1 in 4 who
wanted a job were NOT able to find
one at ANY wage. Note that the
minimum wage did not yet exist.
The unemployment rate: (UR = Unemployed/Labor Force)
•% of the labor force that is out of work
Observations:
•Typically rises during recessions
•Always greater than zero
•Saratoga Springs 2007 UR is 3.30%
•U.S. avg. UR is 4.60%
Output per Person and per Worker
in the U.S. Economy, 1900-2004
In 2004:
•Output/person was 8 times the 1900 level
•Output/worker was 6 times the 1900 level
Output of the U.S. Economy,
1900-2004
In 2004 output of the U.S. economy was:
•33 times the 1900 level
•6 times the 1950 level
Why study aggregate output?

The Great Depression
 In
Germany:
Nearly a third of all workers were without jobs
 Banking system collapsed
 Result of reparations from WWI a cause?
 Withdrawal of credit due to stock market collapse
to blame?

Why study aggregate output?
 The
Great Depression
The
response:
 Macroeconomic
 Government
policies
and independent agency actions
designed to affect the performance of the
economy as a whole
 Fiscal and Monetary Policy
 Banking and stock market regulation
 Economic Stabilizers
 Transfer Programs
The Major Macroeconomic Issues

Standard of Living
 The
degree to which people have access to
goods and services that make their lives
easier, healthier, safer, and more enjoyable
 This is the quantity of goods and services you
consume over a certain period (like a year or
a month)
The Major Macroeconomic Issues

Economic Growth
 A process
of steady increases in the quantity
and quality of the goods and services the
economy can produce in a given period
 Growth
Positive or Negative
 Measures the change in the FLOW

The Major Macroeconomic Issues

In the U.S.:
 1.9
automobiles per U.S. household.
 In 2004, a typical U.S. resident consumed
over eight times the quantity of goods and
services consumed in 1900.
 In 1960, 8% of the adult population had a
college degree compared to 25% in 2004.
Consumption Patterns around the World
The Major Macroeconomic Issues

Productivity
 In
2004 the average U.S. worker could
produce six times more than in 1900.
 Average labor productivity:
Total output
 output per employed worker
Number of people employed
The Major Macroeconomic Issues

Productivity
 U.S.
trends in output per employed worker
1950 - 1973: increased 2.3%/yr
 1973 - 1995: increased by only 1.1%/yr
 1995 - present: increased by 2.1%/yr

The Major Macroeconomic Issues

Productivity and Living Standards in China
and the United States
2004
Output
Population
Employed
Output/person
Average labor
productivity
United States
China
$11,375 billion
294 million
139 million
$39,915
$7,291 billion (U.S.)
1,300 million
752 million
$5,608
$84,424
$9,695
Output of the U.S. Economy,
1900-2004
Expansions: periods of rapid economic growth
•1945-’48; 1961-’69; 1975-’80; 1982-’90; 1991-2001
Recessions: slowdowns in economic growth
•1930s (depression); 1941-’45; 1973-’75; 1981-’82; 1990-’91; 2001
Periods of
negative
growth typically
coincide with
recessions
Increases In Unemployment
During Recessions
Unemployment
rate at beginning
of recession (%)
4.8 (Nov. 1973)
6.3 (Jan. 1980)
Peak
unemployment
rate (%)
9.0 (May 1975)
10.8 (Nov./Dec. 1982)
Increase in
unemployment
rate (%)
+ 4.2
+ 4.5
5.5 (July 1990)
7.8 (June 1992)
+ 2.3
4.3 (March 2001)
6.3 (June 2003)
+2.0
The Major Macroeconomic Issues

Unemployment rates differ from country
to country:
 For
the past 20 years, about 10% of the European
workforce has been unemployed.
 European unemployment is double the rate in the
U.S.
 During the 1950s & ‘60s, the European
unemployment rate was generally lower than in
the U.S.
The U.S. Inflation Rate,1900-2004
Inflation
• The rate prices in general are increasing over time
• Varies over time -- high in the ‘70s and low in the ‘90’s and today
• Varies between countries -- in 2004 3% in U.S. & 400%/yr in Ukraine in
the 90’s
The Major Macroeconomic Issues

The Major Economic Issues
 Economic
growth and living standards
 Productivity
 Recessions and expansions (Business
Cycles)
 Unemployment
 Inflation
 Economic interdependence among nations
 Trade and Fiscal Policy
Real and Nominal GDP
Real and Nominal GDP
The term "real" means adjusted for
inflation.
 Price indexes are use to adjust
income and
output data for the effects of
inflation.

 A price
index measures the cost of
purchasing a market basket (or “bundle”)
of goods at a point in time relative to
the cost of purchasing the same market
basket during an earlier reference (or
base) period.
Two Key Price Indexes:
(1) Consumer Price Index
(2) GDP Deflator
Two Key Price Indexes:

Consumer Price Index (CPI):
measures the impact of price changes on the
cost of a typical bundle of goods and services
purchased by households.

GDP Deflator:
designed to measure the change in the
average price of the market basket of goods
included in GDP.
 The
GDP deflator is a broader price index
than the CPI.

CPI typically thought to overstate inflation
CPI and GDP Deflator: 1993-2003
CPI
Year
(1982-84 = 100)
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
144.5
148.2
152.4
156.9
160.5
163.0
166.6
172.2
177.1
179.9
184.0
Inflation rate
GDP deflator
Inflation rate
(percent)
(2000 = 100)
(percent)
3.0
2.6
2.8
3.0
2.3
1.5
2.2
3.4
2.8
1.6
2.3
88.4
90.3
92.1
93.9
95.4
96.5
97.9
100.0
102.4
104.1
106.0
2.3
2.1
2.0
1.9
1.7
1.1
1.4
2.2
2.4
1.7
1.8
Source: http://www.economagic.com.
 Even
though the CPI and the GDP deflator
are based on different market baskets and
procedures, they yield similar estimates of
the rate of inflation.
Using the GDP Deflator
to Derive Real GDP
Using the GDP Deflator to Derive Real GDP

The formula for converting nominal GDP
into real GDP (in period 1 prices) is:
Real GDP2 =

Nominal GDP2
x
GDP Deflator1
GDP Deflator2
Data on both money GDP and price
changes are essential for meaningful
comparisons of output between two time
periods.
Using the GDP Deflator to Derive Real GDP
Between 1998 and 2003, nominal
GDP increased by 25.8%.
 But, when the 2003 GDP is deflated
to account for price increases …we
can see that real GDP increased by
only 14.5%.

1998
2003
% increase
Nominal GDP
Price index
Real GDP
(billions of U.S. $)
(GDP deflator, 2000 = 100)
(billions of 1998 $)
$8,747
$11,004
25.8%
96.5
106.0
9.8%
$8,747
$10,018
14.5%
Source: http://www.economagic.com.
2006, GDP Deflator is 116.6, thus, to compare 2003 GDP
11004 * 116.6/106 = 12104.4. Thus 2006 GDP is 9% larger in real terms vs. 2003.
Converting Earlier Figures into Current Dollars



Sometimes we will want to make real data (e.g.
income) comparisons in terms of the purchasing
power of the dollar during the current year.
This can be done by “inflating” the data for earlier
years for increases in the price level.
The formula for converting the figures for an
earlier year into current dollars is:
Figurecurrent $ = Figureearlier $ x

price indexcurrent year
price indexearlier year
If prices have risen, this will “inflate” the data for
earlier years and bring it into line with the current
purchasing power of the dollar.
Shortcomings of GDP
as a Measuring Rod

Shortcomings of GDP:
 It
 It
does not count non-market production.
does not count the underground
economy.
 It makes no adjustment for leisure.
 It probably understates output increases
because of the problem of estimating
improvements in the quality of products.
 It does not adjust for harmful side effects.
Differences in GDP Over Time
U.S. Per Capita GDP
$35,664
(in 2000 U.S. dollars)
$28,429
$22,666
$18,391
$11,717
$6,418
1930
$13,840
$7,827
1940
1950
1960
1970
1980
1990
2003
Source: derived from U.S. Department of Commerce data.



Per capita GDP is GDP divided by population.
As shown here, the real 2003 GDP per capita of the
U.S. was more than five times the figure for 1930.
How meaningful are these figures?
Per Capita GDP Comparisons
Across Time Periods




As was shown in the previous exhibit, real
U.S. per capita GDP has increased
substantially over the past 70 years.
Compared to earlier periods, current GDP
is probably biased upward because more
output now takes place in the market
sector and less in the household sector.
However, it is also probably biased
downward because of failure to adjust for
increased leisure, improvements in the
work environment, and the introduction of
improved products and new technologies.
The direction of the overall bias is
uncertain.
The Great Contribution of GDP

In spite of its shortcomings, the evidence
indicates that real GDP per person is a
broad indicator of living standards.
 As
real per capita GDP in the United States
has increased through time, the quality of
most goods has increased while the amount
of work time required for their purchase has
declined.
 Similarly, as real per capita GDP has risen in
the United States and other countries, life
expectancy and leisure time have gone up,
while literacy and infant mortality rates have
gone down.
The Great Contribution of GDP

However, the “great contribution” of GDP
is its ability to measure short-term
fluctuations in output.
 Year-to-year (and quarter-to-quarter)
changes
in real GDP provide a reasonably precise
measure of what is happening to the rate
of output.