# Macroeconomic Measurements, Part II: GDP and Real GDP CHAPTER

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1 Macroeconomic Measurements, Part II: GDP and Real GDP 7 CHAPTER

2 An Economic Barometer What exactly is GDP? How do we use it to tell us whether our economy is in a recession or how rapidly our economy is expanding? How do we take the effects of inflation out of GDP to compare economic well-being over time? And how do we compare economic well-being across countries?

3 Gross Domestic Product GDP Defined GDP or gross domestic product is the market value of all final goods and services produced within a country in a given time period. This definition has four parts: Market value Final goods and services Produced within a country In a given time period

4 Gross Domestic Product Market value GDP is a market value goods and services are valued at their market prices. To add apples and oranges, computers and popcorn, we To add apples and oranges, computers and popcorn, we add the market values so we have a total value of output in terms of money, that is dollars, taka etc..

5 Gross Domestic Product Final goods and services GDP is the value of the final goods and services produced. A final good (or service) is an item bought by its final user during a specified time period. A final good contrasts with an intermediate good, which is an item that is produced by one firm, bought by another firm, and used as an input into the production of some other good or service. Excluding intermediate goods and services avoids double counting.

6 Gross Domestic Product Produced within a country GDP measures production within the territory of a country domestic production. The contrast is with GNP, Gross National Product, which is output that accrues to nationals of a country, wherever produced. In a given time period GDP measures production during a specific time period, normally a year or a quarter of a year.

7 Gross Domestic Product Flow and Stock A flow is a quantity per unit of time; a stock is the quantity that exists at a point in time. Wealth, the value of all the things that people own, is a stock. Saving is a flow that changes the stock of wealth. Capital, the plant, equipment, and inventories of raw and semi-finished materials that are used to produce other goods and services, is a stock. Investment is a flow that changes the stock of capital.

8 Gross Domestic Product GDP and the Circular Flow of Expenditure and Income GDP measures the value of production, which also equals total expenditure on final goods and total income. The equality of income and output shows the link between productivity and living standards. The circular flow diagram in the following Figure illustrates the equality of income, expenditure, and the value of production.

9 Gross Domestic Product The circular flow diagram shows the transactions among households, firms, governments, and the rest of the world.

10 Gross Domestic Product These transactions take place in factor markets, goods markets, and financial markets.

11 Gross Domestic Product Firms hire factors of production from households. The blue flow, Y, shows total income paid by firms to households.

12 Gross Domestic Product Households buy consumer goods and services. The red flow, C, shows consumption expenditures.

13 Gross Domestic Product Households save, S, and pay taxes, T. Firms borrow some of what households save to finance their investment.

14 Gross Domestic Product Firms buy capital goods from other firms. The red flow I represents this investment expenditure by firms.

15 Gross Domestic Product Governments buy goods and services, G, and borrow or repay debt if spending exceeds or is less than taxes.

16 Gross Domestic Product The rest of the world buys goods and services from us, X, and sells us goods and services, M net exports are X - M

17 Gross Domestic Product And the rest of the world borrows from us or lends to us depending on whether net exports are positive or negative.

18 Gross Domestic Product The blue and red flows are the circular flow of income and expenditure.

19 Gross Domestic Product The sum of the red flows equals the blue flow.

20 Gross Domestic Product That is: Y = C + I + G + X - M

21 Gross Domestic Product The circular flow demonstrates how GDP can be measured in two ways. Aggregate expenditure Total expenditure on final goods and services equals the value of output of final goods and services, which is GDP. Total expenditure = C + I + G + (X M).

22 Gross Domestic Product Aggregate income Aggregate income earned from production of final goods, Y, equals the total paid out for the use of resources: wages, interest, rent, and profit. Firms are thought of as paying out all their receipts from the sale of final goods, so income equals expenditure, Y = C + I + G + (X M). [In reality, firms often retain some profits in the business, but that retained profit belongs to the firms owners, so we pretend it is income they have received]

23 Gross Domestic Product Financial Flows Financial markets finance deficits and investment. Household saving, S, is income minus net taxes and consumption expenditure, and flows to the financial markets; Y = C + S + T, income equals the uses of income.

24 Gross Domestic Product If government purchases exceed net taxes, the deficit (G T) is borrowed from the financial markets (if T exceeds G, the government surplus flows to the markets). If imports exceed exports, the deficit with the rest of the world (M X) is borrowing from the rest of the world.

25 Gross Domestic Product How Investment Is Financed Investment is financed from three sources: Private saving, S Government budget surplus, (T G) Borrowing from the rest of the world (M X)

26 Gross Domestic Product We can see these three sources of investment finance by using the fact that aggregate expenditure equals aggregate income. Start with Y = C + S + T = C + I + G + (X M) Then rearrange to obtain I = S + (T G) + (M X) Private saving S plus government saving (T G) is called national saving.

27 Measuring GDP There are two standard approaches to measure GDP: The expenditure approach; this measures total expenditure during the time period on final goods. The income approach; the income approach measures The income approach; the income approach measures GDP by summing the incomes that firms pay households for the factors of production they hire.

28 Measuring GDP The Expenditure Approach The expenditure approach measures GDP as the sum of consumption expenditure, investment, government purchases of goods and services, and net exports. Why use expenditure? Because when many things are produced, we do not know for sure whether they will be final goods or intermediates it depends on who buys them and why.

29 Measuring GDP

30 Measuring GDP The Income Approach The National Income and Product Accounts divide incomes into five categories: Compensation of employees Net interest Rental income Corporate profits Proprietors income The sum of these five income components is net national income at factor cost.

31 Measuring GDP A few adjustments must be made to get from net national income at factor cost to GDP at market prices: Indirect taxes minus subsidies are added Net national income at market prices Capital consumption allowance (or Depreciation) is added Gross national income at market prices Income earned from the rest of the world is deducted and income earned by the rest of the world is added Gross domestic income at market prices Statistical discrepancies need to be reported in the national income accounts GDP at market prices

32 Real GDP and the Price Level Real GDP is the value of final goods and services produced in a given year when valued at an approximation to constant purchasing power. Calculating Real GDP The first step in calculating real GDP is to calculate nominal GDP, which is the value of goods and services produced during a given year valued at the prices that prevailed in that same year. This is also referred to as money GDP.

33 Real GDP and the Price Level The table provides data for 2011 and In 2011, nominal GDP is: Expenditure on balls \$100 Expenditure on bats \$100 Nominal GDP \$200 Item Quantity Price 2011 Balls 100 \$1.00 Bats 20 \$ Balls 160 \$0.50 Bats 22 \$22.50

34 Real GDP and the Price Level Item Quantity Price In 2012, nominal GDP is: Expenditure on balls \$80 Expenditure on bats \$495 Nominal GDP \$ Balls 100 \$1.00 Bats 20 \$ Balls 160 \$0.50 Bats 22 \$22.50

35 Real GDP and the Price Level The old method of calculating real GDP was to value each year s output at the prices of a base year the base year prices method. Suppose 2011 is the base year and 2012 is the current year. Item Quantity Price 2011 Balls 100 \$1.00 Bats 20 \$ Balls 160 \$0.50 Bats 22 \$22.50

36 Real GDP and the Price Level Expenditure on balls in 2012 valued at 2011 prices is \$160. Expenditure on bats in 2012 valued at 2011 prices is \$110. Real GDP in 2012 (baseyear prices method) is \$270. Item Quantity Price 2011 Balls 100 \$1.00 Bats 20 \$ Balls 160 \$0.50 Bats 22 \$22.50

37 Real GDP and the Price Level Using a base-year-constant-prices approach to estimating real GDP has some problems notably that the choice of base year strongly influences the results if relative prices change. Switching base year from 1970 to 1980 changed real GDP and growth markedly for oil-producers, for example. The new method of calculating real GDP, which is called the chain-weighted output index method, uses the prices of each pair of adjacent years to calculate the real GDP growth rate, so no one year s prices matter more than any other year s. This calculation has four steps described on the next slide.

38 Real GDP and the Price Level Step 1: Value last year s production and this year s production at last year s prices and then calculate the growth rate of this number from last year to this year. Step 2: Value last year s production and this year s production at this year s prices and then calculate the growth rate of this number from last year to this year. Step 3: Calculate the average of the two growth rates. This average growth rate is the estimate of the growth rate of real GDP from last year to this year. Step 4: Repeat steps 1, 2, and 3 for each pair of adjacent years to link real GDP back to the base year.

39 Real GDP and the Price Level We ve done step production at 2011 prices (money GDP in 2011) is \$ production at 2011 prices is \$270. The 2012 growth rate at 2011 prices is 35 percent. Item Quantity Price 2011 Balls 100 \$1.00 Bats 20 \$ Balls 160 \$0.50 Bats 22 \$22.50

40 Real GDP and the Price Level Step production at 2012 prices is \$ production at 2012 prices (money GDP in 2012) is \$575. The 2012 growth rate at 2012 prices is 15 percent. Item Quantity Price 2011 Balls 100 \$1.00 Bats 20 \$ Balls 160 \$0.50 Bats 22 \$22.50

41 Real GDP and the Price Level Step 3. The 2012 growth rate at 2011 prices is 35 percent. The 2012 growth rate at 2012 prices is 15 percent. The average of these two growth rates is 25 percent. Real GDP in 2012 with 2011 as the base year is \$250, that is \$200*(1.25). Item Quantity Price 2011 Balls 100 \$1.00 Bats 20 \$ Balls 160 \$0.50 Bats 22 \$22.50

42 Real GDP and the Price Level Step 4. Because we re calculating real GDP in 2012 at 2011 prices, step 4 is completed! Real GDP in 2011 is \$200. Real GDP in 2012 is \$250, using 2011 as the base year. Chain linking: In 2013, the calculations are repeated but using the prices and quantities of 2012 and Real GDP in 2013 equals real GDP in 2012 increased by the calculated percentage change in real GDP for 2013 Item Quantity Price 2011 Balls 100 \$1.00 Bats 20 \$ Balls 160 \$0.50 Bats 22 \$22.50

43 Real GDP and the Price Level Do in class: Assume 2011 is the base year. Calculate real GDP in 2013 using the 1. Base year prices method 2. Chain-weighted output index method Round up/down all figures up to 2 decimal points. Recall that under the Chainweighted output index method Real GDP in 2012: \$250 Item Quantity Price 2011 Balls 100 \$1.00 Bats 20 \$ Balls 160 \$0.50 Bats 22 \$ Balls 180 \$1.50 Bats 25 \$26.00

44 Real GDP and the Price Level Calculating the Price Level The average level of prices is called the price level. One measure of the price level is the GDP deflator, which is a broad measure of average prices of all goods and services in GDP in the current year expressed as a percentage of the base year prices. It is not a direct price index; it is derived as an implicit price index from the comparison of real and money GDP. The GDP deflator is calculated in the table on the next slide.

45 Real GDP and the Price Level Nominal GDP and real GDP are calculated in the way that you ve just seen. By definition, GDP Deflator = (Nominal GDP/Real GDP) 100. So, with 2011 as the base year, In 2011, the GDP deflator is (\$200/\$200) 100 = 100. In 2012, the GDP deflator is (\$575/\$250) 100 = 230. Year Nominal GDP Real GDP GDP deflator 2011 \$200 \$ \$575 \$

46 Real GDP and the Price Level Deflating the GDP Balloon Nominal GDP increases because production real GDP increases.

47 Real GDP and the Price Level Deflating the GDP Balloon Nominal GDP also increases because prices rise.

48 Real GDP and the Price Level Deflating the GDP Balloon We use the GDP deflator to let the air out of the nominal GDP balloon and reveal real GDP.

49 The Uses and Limitations of Real GDP We use real GDP to calculate the economic growth rate. The economic growth rate is the percentage change in real GDP from one year to the next. Both real GDP and economic growth are used for: Economic welfare comparisons International welfare comparisons Measuring business cycle fluctuations [Jargon note: welfare means potential well-being, how well-off output could allow people to be] Most often when making comparisons over time or across countries, economists care about growth rate of Per capita GDP.

50 The Uses and Limitations of Real GDP Economic Welfare Comparisons Long-Term Trend A handy way of comparing real GDP per person over time is to express it as a ratio of some reference year. For example, in 1960, real GDP per person was \$15,850 and in 2012, it was \$43,182. So real GDP per person in 2012 was 2.7 times its 1960 level that is, \$43,182 \$15,850 = 2.7. In Bangladesh, real GDP per person in 2014 was 2.9 times its 1972 level.

51 The Uses and Limitations of Real GDP Economic Welfare Comparisons Productivity Growth Slowdown The growth rate of real GDP per person slowed after How costly was that slowdown? The answer is provided by a number that we ll call the Lucas wedge. The Lucas wedge is the dollar value of the accumulated gap between what real GDP per person would have been if the 1960s growth rate had persisted and what real GDP per person turned out to be.

52 The Uses and Limitations of Real GDP This Figure illustrates the Lucas wedge. The red line is actual real GDP per person. The thin black line is the trend that real GDP per person would have followed if the 1960s growth rate of potential GDP had persisted. The shaded area is the Lucas wedge.

53 Nominal GDP per Capita Bangladesh:

54 Real GDP per Capita Bangladesh:

55 The Uses and Limitations of Real GDP Economic Welfare Comparisons Economic welfare measures the nation s overall state of economic well-being. Real GDP is not a perfect measure of economic welfare for at least seven reasons: 1. Quality improvements are hard to measure so tend to be undervalued in calculating real GDP so the inflation rate is overstated and real GDP understated. 2. Real GDP does not include most household production, that is, productive activities done in and around the house by members of the household with no market transaction.

56 The Uses and Limitations of Real GDP Welfare comparisons continued 3. Real GDP, as measured, omits the underground economy, illegal economic activity or legal economic activity that goes unreported for tax avoidance reasons. 4. Health and life expectancy are not directly included in real GDP, nor are they perfectly correlated with it. 5. Leisure time, a valuable component of an individual s well-being, is not measured by real GDP. 6. Environmental damage is not deducted from real GDP. 7. Political freedom and social justice are not measured in real GDP.

57 The Uses and Limitations of Real GDP International Comparisons Real GDP is used to compare output in one country with that in another. Two special problems arise in making these comparisons. Real GDP of one country must be converted into the same currency units as the real GDP of the other country, so an exchange rate must be used. The same prices should be used to value the goods and services in the countries being compared, but often are not.

58 The Uses and Limitations of Real GDP Using the exchange rate to compare GDP in one country with GDP in another country is problematic because prices of particular products in one country may be much less or much more than in the other country the relative prices vary between countries, particularly for things not traded internationally like services and low-value perishables. For example, using the market exchange rate to value Chinese GDP in US dollars leads to an estimate that U.S. real GDP per person in 1992 was 69 times Chinese real GDP per person. Whereas using a purchasing power parity estimate which approximates re-valuing both countries GDP at an average international price level -- leads to an estimate that per person GDP in the United States in 1992 was (only) 12 times that in China.

59 The Uses and Limitations of Real GDP 8 Economic Growth Rates Bangladesh India Pakistan Source: World Bank

60 The Uses and Limitations of Real GDP 8 Economic Growth Rates Bangladesh South Asia Developing Countries Source: World Bank

61 The Uses and Limitations of Real GDP Business Cycle Forecasts Real GDP is used to measure business cycle fluctuations.

62 The Uses and Limitations of Real GDP Business Cycle Forecasts These fluctuations are probably accurately timed but the changes in real GDP probably can not accurately measure people s welfare change caused by business cycles.

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