Download EPS Session2 2011

Gross Domestic Product (GDP)
and Business Fluctuations
MSc EPS
Hilary term 2011 (S2)
Professor Dermot McAleese
OUTLINE
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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
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
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Business forecasts
Monetary and fiscal policy
Political significance
International comparisons
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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:
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GDP vs GNP
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 of a country.
For most countries the difference is very small
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(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)
WDI 2007 World Bank CDRom
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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
GNP-GDP (% of GDP)
Memo:
China
US
0.5%
0.3%
World Bank Indicators 2007
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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)
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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
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Nominal GDP by Expenditure
(% share of GDP)
2003
2007
Private Consumption
42
35
Investment
41
42
Government Consumption
15
13
Exports of Goods and Services
29
39
Imports of Goods and Services
27
30
2
9
Net Exports
Source: China Statistical Yearbook 2008
Note: Consumption still at 35% of GDP in 2009, compared with 50% in S Korea at similar stage of development.
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Economist Oct 23 2010
Which sectors contribute most to GDP?
Agriculture
Fishing
Industry Services
Euro Area
2.2
26.6
71.1
4
China
(2006)
12.5
47.3
40.3
42
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
Source: WTO Trade Policy Review “European Communities” 22 Jan 2007; EIU China
Country Report March 2007
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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 22,64 yuan per head = $5,962 at PPP (3.8 yuan per dollar].
Comparison between GDP per capita at current exchange rates
and at PPP
Country
GDP per capita ($)
(current prices and exchange rates)
India
GDP per capita ($)
(PPP)
736
3452
Morocco
1711
4555
Argentina
4728
14,280
Mexico
7454
10,751
China
1713
6757
UK
36,509
33,238
France
34,936
30,386
Canada
34,484
33,375
US
41,890
41,890
Source: UN HDR Report 2007-2008
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 GDP calculated from nominal exchange rates
underestimates the living standards of
developing countries
This happens because non traded goods
(services) are much cheaper in developing
countries
 Divergences in prices of traded goods are much
less because of the law of one price
 The gap between GDP measured at current
exchange rate and GDP measured at PPP can be
substantial
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Exercise/ Review Question
In UN HDR 2010 (table16), GDP is higher in PPP
than in current exchange rates for most
countries.
a) For which countries is the opposite true?
b) Are there any developing countries in this
category? Can you explain why?
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Share of world production -- PPP vs
current exchange rates (%)
PPP weight US$ 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
17
Source: The Economist Feb 27, 2010
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Source: The Economist Feb 27, 2010
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.
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Human societies are based on the human tendency to
want things, and are geared to satisfying those wants:
possessions or facilities that bring ease and personal
satisfaction. The results are frequently disappointing,
and always terminate in the embarrassing non-sequitur
of death.
Diarmaid MacCulloch A History of Christianity: the first
three thousand years. Allen Lane London 2009 p 200
Classwork
pp 273-274
• E1, E2, E3
• Q1 (p 273)
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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
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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 under the
mattress and buys shares on the stock market.
Would this be recorded in GDP?
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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
1995 was Q1 = 20, Q2 = 25 and Q3 = 10.
(a) What is the value of nominal GDP?
(b) Assume that in 1996 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
GNP, using 1995 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 1996 prices as the base
year. Explain why your answer is different to that in
(b).
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1. Considerable resources are spent by the statistical
authorities in deriving estimates of GDP. From a
business perspective, would you say that this
exercise is a worthwhile and valuable one?
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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
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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
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Size of the shadow economy (%
GDP)
Country
Austria
Belgium
Canada
Denmark
Germany
Greece
France
Ireland
Italy
Netherlands
Norway
Spain
Sweden
Switzerland
UK
USA
1990
2002
5
20
14
11
12
27
9
12
23
14
15
21
16
7
10
7
11
22
16
18
16
28
15
16
27
13
19
23
19
9
13
9
Source: F. Schneider, ‘The shadow economies of Western Europe’,
Economic Affairs, September 1997; 2002 from F Schneider IMF paper
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Note: China 13.1%!
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QUESTIONS
Does the existence of a shadow economy imply that the
market system is not working?
Is its existence
consistent with the laws of demand and supply?
Estimation of the shadow economy activities has been
described by Schneider as a scientific passion for
knowing the unknown. Discuss
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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 is the difference between actual
GDP and potential GDP, as a percentage of
potential GDP.
[(actual GDP - potential GDP)/ potential GDP] x 100
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
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time
Output gaps for 2009 and 2010
Notes: Output gap = [(actual GDP - potential GDP)/ potential GDP]
Source: OECD, Economic Outlook, June 2010
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Question for class
Output gaps have declined in 2010 relative to 2009.
Can you suggest reasons why this has happened?
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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
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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
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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
38
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
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A MORE UPBEAT VIEW ….
It is not enough to assert that since there
have always been business cycles there
always will be business cycles.
Understanding what causes business cycles
and how these causes have changed
suggests that business cycles will not be as
important in the future as they were in the
past.
S. Weber “The end of the business cycle” Foreign Affairs July 1997
40
Average growth
rate 2.93%
41
Source: The Economist Jan 2009
42
UNITED KINGDOM Real GDP Growth 1964-2010
Av growth 2.3% p.a.
GERMANY: Real GDP annual % growth
Average 3.2% p.a.
World Output: Growth rate (% pa) 1960-2010
Source: IMF Weo april 2009
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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)
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Two Strong Forces at work in advanced country
macro economy
a) Downward Force due to adverse deflation dynamic effect
b) Upward Force due to:
Automatic Stabilisers
Demand stimulation policies (countercyclical)
48
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.
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Source: The Economist Nov 2008 *Based on calendar year data
'No one was responsible for the great Wall Street
crash. No one engineered the speculation that
preceded it. Both were the product of the free choice
and decisions of thousands of individuals. The latter
were not led to the slaughter. They were impelled to
it by the seminal lunacy which has always seized
people who are seized in turn with the notion that
they can become very rich.'
John Kenneth Galbraith The Great Crash 1929
(1954)
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Class exercise: define headings and interpret statistics in this table
OECD Economic Outlook
Dec 2011
52
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Question for Class
(for a country of your choice)
What are the main factors likely to constrain economic
growth over the next 5 years?
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