GDP and the Measurement of Progress

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1 Chapter 6 (Chapter 26) MODERN PRINCIPLES OF ECONOMICS Third Edition GDP and the Measurement of Progress

2 Outline What Is GDP? Growth Rates Nominal vs. Real GDP Cyclical and Short-Run Changes in GDP The Many Ways of Splitting GDP Problems with GDP as a Measure of Output and Welfare 2

3 Introduction India has both extreme poverty and rapid economic growth: Two-thirds of India s population lives on less than $2 a day. At the same time, at least 100 million people are at an American standard of living. a remarkable increase from just a few decades ago. Gross Domestic Product (GDP) and GDP per capita gives us a way to measure changes in economic output and the standard of living. 3

4 Introduction Real GDP per capita in India 4

5 Definition Gross Domestic Product (GDP): the market value of all final goods and services produced within a country in a year. GDP per capita: GDP divided by population. 5

6 Introduction In this chapter, we will explain: What the GDP statistic means and how it is measured. The difference between the level of GDP and the growth rate of GDP The difference between nominal GDP and real GDP How growth in per capita real GDP is a standard measure of economic progress The use of GDP in business cycle measurement Problems with GDP as a measure of output and welfare 6

7 Introduction 7

8 GDP GDP is the market value of all final goods and services produced within a country in a year. An economy s total output includes millions of different goods and services. Some goods are more valuable than others, so we can t just add up quantities. GDP uses market values to determine how much each good or service is worth and then sums the total. 8

9 GDP Final goods and services are sold to final users and then consumed or held in personal inventories. Intermediate goods are sold to firms and then bundled or processed with other goods or services for sale at a later stage. To avoid double counting, only final goods are included in GDP. However, machinery and equipment used to produce other goods are included in GDP. 9

10 GDP GDP measures production, so sales of old houses, used goods, and financial assets do not add to GDP. Sales of used goods: NOT included Sale of financial assets: NOT included Services of stockbrokers, realtors, used car salesmen ARE included Products produced by not sold in same year are included as inventory 10

11 Self-Check Which of the following is a final good: a. A book in Amazon s inventory. b. Tires purchased by a Toyota plant. c. Tires purchased by you for your car. Answer: c tires purchased by you are a final good because they are for your own use (consumption), not for resale. 11

12 GDP Services are increasing as a share of U.S. GDP. The output of an economy includes both goods and services. Haircuts, transportation, and medical care provide a benefit to individuals without a tangible output. Since 1950, the portion of U.S. GDP created by services has doubled from 21% to 42%. 12

13 GDP U.S. GDP includes goods and services produced by labor and capital located in the United States, regardless of the nationality of the workers or property owners. Gross national product (GNP) is similar to GDP but measures what is produced by the labor and property supplied by U.S. permanent residents. 13

14 Definition Gross National Produce (GNP): the market value of all final goods and services produced by a country s permanent residents, wherever located, within a year. 14

15 GDP GDP tells us how much the nation produced in a year, not how much it has accumulated in its entire history. GDP is like annual income, not wealth National wealth refers to the value of a nation s entire stock of assets. GDP is calculated by the Bureau of Economic Analysis (BEA), which is part of the Department of Commerce and based in Washington, D.C. 15

16 US GDP vs Rest of World (ROW) 16

17 GDP Growth = Job Growth 17

18 Growth Rates GDP tells us how much a country produced. The growth rate of GDP tells us how rapidly the country s production is rising or falling. GDP2013 GDP = GDP 2012 GDP growth rate for 2013 Using actual numbers (in billions): $16,798 $16,245 $16, = 3.4% 18

19 Self-Check If GDP in 1990 was $5,803 billion and GDP in 1991 was $5,995 billion, what was the growth rate of GDP? a. 1.92% b. 3.20% c. 3.31% Answer: c The growth rate was [( ) / 5803] x 100 = 3.31% 19

20 Nominal vs. Real GDP Nominal Growth Rate is the rate of growth just calculated did not adjust for price changes and is called the nominal growth rate. Nominal GDP is calculated using prices at the time of sale. GDP in 2013 is calculated using 2013 prices. GDP in 2000 is calculated using 2000 prices. If there is an increase in nominal GDP, we can t tell if it was due to greater production or increased prices. It is increases in production, not increases in prices, that improve the standard of living. 20

21 Definition Nominal variables: variables such as GDP that have not been adjusted for changes in price. 21

22 Nominal vs. Real GDP To remove the effect of price changes, we can calculate GDP in constant prices GDP in 2013 dollars: 2013 prices 2013 quantities = $16.8 trillion 2000 GDP in 2013 dollars: 2013 prices 2000 quantities = $13.8 trillion We can now find the increase in real GDP. 22

23 Definition Real variables: variables such as GDP that have been adjusted for changes in prices by using the same set of prices in all time periods. 23

24 Nominal vs. Real GDP 2013 nominal GDP 2013 prices 2013 quantities $16.8 trillion 2000 nominal GDP 2000 prices 2000 quantities $10.3 trillion Increase in nominal GDP = ( ) / = 63% 2013 real GDP 2013 prices 2013 quantities $16.8 trillion 2000 real GDP 2013 prices 2000 quantities = $13.8 trillion Increase in real GDP = ( ) / = 21.7% 24

25 Real GDP Growth per Capita Growth Rate in Nominal GDP = Inflation Rate (change in price level) + Growth Rate in Real GDP Real GDP growth = (Nominal GDP growth rate) (Inflation rate) where the growth rate in nominal GDP is the growth rate in spending (C + I + G + NX) So if Nominal GDP growth is 5%, it could be: 1% inflation + 4% growth in Real GDP or 2% inflation + 3% growth in Real GDP or 5% inflation + 0% growth in Real GDP 25

26 Real GDP Growth per Capita 26

27 Self-Check Real GDP is: a. Adjusted for changes in the price level. b. Not adjusted for changes in the price level. c. Adjusted for price increases but not decreases. Answer: a Real GDP is adjusted for changes in the price level. 27

28 GDP Deflator The GDP Deflator is a price index that can be used to measure inflation. It is the ratio of nominal to real GDP: Nominal GDP GDP Deflator = 100 Real GDP If 2013 nominal GDP = $16.79 trillion and 2013 real GDP = $15.76 trillion, 1 t G D tr D e = ri = P f 0 6 l. i. a 5 t 28

29 Real GDP Growth The Growth Rate of Real GDP in the U.S. 29

30 Real GDP Growth per Capita Growth in real GDP does not account for changes in population. Growth in real GDP per capita is usually the best reflection of changing living standards. There can be large differences for countries with rapidly growing populations. 30

31 Real GDP Growth per Capita Country %annual growth real GDP % annual growth population % annual growth real GDP per capita Guatemala 3.6% 2.8% 0.8% United States 3.6% 1.2% 2.1% Source: Bureau of Economic Analysis, and the U.S. Census Bureau Even though the U.S. and Guatemala had the same growth rate of real GDP, the standard of living in the U.S. grew much faster. 31

32 Real GDP Growth per Capita Fifty Years of Economic Growth 32

33 Cyclical and Short-run Changes GDP is used to compare economic output across countries and over long periods. GDP is also used to measure short-run fluctuations in an economy. According to the National Bureau of Economic Research (NBER), a recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale retail sales. 33

34 Definition Recession: a significant, widespread decline in real GDP and employment. (Unofficially two quarter of negative real GDP growth) 34

35 Cyclical and Short-run Changes U.S. Recessions Since 1948 Quarterly Growth Rates Expressed as Annualized Rates 35

36 Cyclical and Short-run Changes Defining when a recession begins and ends is not always easy. Quarterly data are not available until almost a month after the quarter is over. The government often makes significant changes in the GDP estimates between the initial and final estimates. Updates can even occur years after the first estimates are released. It is normal for real GDP to fluctuate around its long-term trend or normal growth rate (business fluctuations or cycles). 36

37 Cyclical and Short-run Changes Why is dating recessions so import? Dating the 2001 recession - Official NBER starting date is March Data revisions have led many analysts to conclude that the recession began late Who cares? U.S. Presidency changed at the beginning of Democrats: Recession was a result of the new administration policies. Republicans: Recession began during President Clinton s term. 37

38 Definition Business cycles: short-run movements in real GDP around its long-term trend. 38

39 Self-Check A widespread decline in real GDP and employment is called: a. Inflation. b. Recession. c. A business cycle. Answer: b a decline in real GDP and employment is called a recession. 39

40 Splitting GDP Economists split the production of goods and services in many different ways. Two common ways are: 1. National spending approach add up the components of spending: Y = C + I + G + NX 2. Factor income approach add up the income generated by producing goods and services: Y = Wages + Rent + Interest + Profit 40

41 National Spending Approach Y = C + I + G + NX Y C I G NX Nominal GDP The market value of all finalgoods and services. Consumption Privatespending on final goods and services. Investment Government purchases Net exports Private spending on tools, plant, and equipment used to produce future output. Spending by all levels of government on final goods and services. Transfers are not included in government purchases. The value of exports minus the value of imports. 41

42 National Spending Approach U.S. GDP and Its Components,

43 Factor Income Approach Y = Employee Compensation + Rent + Interest + Profit When a consumer spends money, the money is received by workers, landlords, owners of capital, and businesses. We can therefore calculate GDP by adding up all of the incomes received. When using the factor income approach, we need to make adjustments for things like sales taxes. 43

44 Factor Income Approach Employee Compensation: Salaries, wages, and fringe benefits such as health or retirement. This also includes unemployment insurance and government taxes for Social Security. Rent: Income received from property received by households. Royalties from patents, copyrights and assets as well as imputed rent are included. Interest: Income received by households through the lending of their money to corporations and business firms. Government and household interest payments are not included in the national income. Profits: The amount firms have left after paying their rent, interest on debt, and employee compensation. GDP calculation involves accounting profit and not economic profit. 44

45 Which Approach is the Right One? The answer depends on what you want to study. Want to understand business fluctuations? It s worthwhile to study the national spending approach. Want to study how the income from production is divided amongst people and resources? It s worthwhile to focus on the factor income approach. 45

46 Self-Check Which of the following splits GDP according to the national spending approach? a. C + I + G + NX. b. Revenues - expenses. c. Employee compensation + rent + interest + profit. Answer: a C + I + G + NX. 46

47 The BIG Question Consider the following two claims. The first would be a typical statement at the magazine The Nation: Europeans have strong labor unions, so their workers get a bigger share of the pie than American workers. The second would be a typical statement at the magazine National Review: Since European businesses are highly regulated, they have little incentive to make big profits. Therefore, they get a much smaller share of national product than American workers. Which statement is more correct/do you agree with more? a) The first b) The second 47

48 Problems With GDP Illegal or underground-market transactions are omitted from GDP. Underground transactions are especially significant in countries with higher levels of corruption and taxes. The informal sector in Latin America is estimated at 41% of officially measured GDP. In the U.S. or Western Europe, the underground economy is likely 10% - 20% of GDP. 48

49 Problems With GDP GDP does not count non priced production, when valuable goods and services are produced but no monetary payment is made. Housework, reading free blogs, volunteering This introduces two biases into GDP statistics: biases over time and biases across nations. As more women in the U.S. entered the workforce, housework shifted from unpaid to paid. Women s participation in the workforce varies across countries, changing the proportion of work included in GDP. 49

50 Avg Hours Worked by Country Tyler Cowen and Alex Tabarrok Modern Principles: Macroeconomics, Third Edition / Modern Principles of Economics, Third Edition Copyright 2015 by Worth Publishers

51 Problems With GDP GDP does not count leisure, although people value it. GDP does not count economic bads such as pollution, crime, or the extinction of species. Cleaning up pollution ADDS to GDP GDP does not measure the distribution of income. Endless arguments can ensue 51

52 GDP & Income Distribution Tyler Cowen and Alex Tabarrok Modern Principles: Macroeconomics, Third Edition / Modern Principles of Economics, Third Edition Copyright 2015 by Worth Publishers

53 Takeaway GDP is an estimate of the economic output of a nation over a year. GDP can be summed up in different ways. The national spending identity, Y = C + I + G + NX, splits GDP according to different classes of income spending. The factor income approach, Y = Employee compensation + Interest + Rent + Profit, splits GDP into different classes of income receiving. 53

54 Takeaway GDP per capita is a rough estimate of the standard of living in a nation. Real GDP is corrected for inflation by using the same set of prices in every year. GDP does not include: The value of leisure Goods in the underground economy The value of goods that are difficult to price. How equally income is distributed. 54

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