# Chapter 5: GDP and Economic Growth

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1 Chapter 5: GDP and Economic Growth Be Mean Green! Please consider the environment before printing this Chapter Outline. It ll be available online throughout the semester. For Firms private accounting measures the firms overall performance, e.g., profits or losses, costs, output, etc. Similarly, for Nations National Income Accounting, measures the economy s overall performance, in terms of: - Assess level of production/ output (overall health of economy) - Economy growth, de-growth or stagnant - Formulate policies to safeguard & improve economy s health The Bureau of Economic Analysis (BEA compiles the details of the level of total output, total income and total spending in the U.S. economy, in the form of National Income and Product Accounts (NIPAs). The primary measure of the economy s performance is given by Gross Domestic Product or GDP. GDP the total market value of all final goods & services produced in a country in a given period of time (e.g., yearly, six monthly, quarterly, monthly). GDP is a monetary measure, i.e., it gives the dollar value of goods/services produced. Ex: Say in 2006, the U.S. economy produced 100 cars oranges Hamburgers. Let the price of each car be \$10,000, oranges \$1 each, and hamburgers be \$2 each. Then GDP = (100* \$10,000) + (200* \$1) + (500* \$2) = \$1,000,000 + \$200 + \$1,000 = \$1,001,200 So, GDP = \$1,001,200 for the U.S. in

2 Intermediate goods: goods which are used to produce Final goods. (Final goods determined by the end use of the product.) Intermediate goods are NOT counted in GDP. Excluding intermediate goods when calculating GDP, helps avoid multiple counting. So, only FINAL use of the good is taken to avoid multiple counting in GDP. Ex: Milk - Intermediate good for an Ice cream factory Final good when you buy milk at the supermarket Measuring GDP Two ways of approaching GDP: Expenditure (or output) approach Income (or allocations) approach C = Personal consumption expenditures (67% or 2/3) on durable/non-durable goods + services Wages & salaries (71%) I = Investment in machinery, equipment, construction, inventories (can be written as I g as given in the book) Rents (1%) G = Government purchases (Federal, State, Local) Goods and services the govt. purchases, e.g., Hummvees, helicopters, paper shredding machines, paper, etc. Interest (5%) NX = Net Exports (Exports Imports) [or X n as given in the book) Proprietor s Income (9%) Corporate Profits (14%) GDP = C + I + G + NX (can be tallied with IRS records) 2

3 Refer to the Circular flow diagram: EXPENDITURE = INCOME or, GDP (Expenditure approach) = Y (Income approach) Nominal GDP = GDP at current prices (GDP that is unadjusted for inflation) Real GDP = GDP calculated at BASE year prices (GDP that is adjusted for inflation) Nominal GDP Real GDP = Consumer Price Index (CPI), Where, CPI = Price of a market basket in a specific year Price of the same basket in a base year *100 For CPI, BLS.gov, current Base Year is Ex: 2005 (base year) 100 \$2 each, and 100 \$3 each Nominal GDP = 100 * \$ * \$3 = \$200 + \$300 = \$ \$3 each, and 200 \$4 each Nominal GDP = 200 * \$ * \$4 = \$600 + \$800 = \$1,400 Nominal GDP growth = Final - Initial 1400 = 500 *100= 180% Initial 500 Real GDP (2006): 200 \$2 each (base year prices) \$3 each (base year prices) Real GDP = \$400 + \$600 = \$1,000 Real GDP growth = 1, * 100= 100% 500 3

4 Shortcomings of GDP: Non-market activities are not taken into account, e.g., home-maker services (housewives/ stay at home dads, though they contribute significantly to the economy, their contributions are not accounted for) Unpaid/ voluntary services provided, do not show up in GDP Net result of this GDP is UNDERSTATED Leisure the value of leisure (non-work) is not counted in GDP Improved Product Quality Better products cannot be accounted for in GDP Ex: Comparing a Personal Computer 10 years ago to a PC now: Intel chips (non Pentium) more expensive, less efficient) vs. Pentium 4 chips today- less expensive, more efficient The underground economy The black market, e.g., illegal drug sales, illegal monetary transactions, etc. Economic Growth: Economists define & measure economic growth as either: 1. An increase in Real GDP over a period of time or 2. An increase in Real GDP per capita over a period of time. Real GDP per capita Real GDP per person, given by Real GDP per capita = Real GDP Population 4

5 For comparing living standards, the second definition, i.e., RGDP per capita growth is more important. Why? Ex: In 2001, China s GDP was \$1,131 billion, compared to Denmark s \$166 billion. Does that mean that the living standards of China were better than that of Denmark s? - Denmark s RGDP per capita was \$31,090 - China s RGDP per capita was \$890 (divide RGDP by over 1 billion population) Growth is desirable economic goal. The expansion of total output, relative to population, results in rising real wages and incomes, and thus higher standards of living. Arithmetic of Growth (Rule of 70) A mathematical expression that provides an approximation of the effects of economic growth. Approx. number of years required to double Real GDP = 70 Annual Percentage rate of growth Ex: Assume, that the U.S and China have identical Real GDPs, but China s RGDP grows at 10%, while the U.S. RGDP grows at 3%. So, China s GDP will double in 7 years (70/10), and The U.S. GDP will double in 23 years (70/3) Ingredients of Growth Supply Factors: Society can increase its real output / income in two fundamental ways: 1. By increasing its input of Resources (Access to newer or better sources of Land, Labor, Capital & Entrepreneurship, to yield additional output.) 2. By increasing the productivity of the existing inputs (i.e., increasing the present inputs more efficiently, avoiding wastage, increases in productivity through specialization and enhancement of skills) 5

6 Demand Factors: Households, businesses and government should purchase the expanding/higher levels of output. Efficiency Factor: For reaching full production potential, economic efficiency and full employment must be achieved. Growth in the United States: Real GDP growth in the U.S. between 1950 and 2005 was around five (5) times. But in the same period the population of the U.S. also increased. So, RGDP per capita increased more than three (3) times over 1950 to

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