A. GDP, Economic Growth, and Business Cycles

ECON 3023 Hany Fahmy FAll, 2009 Lecture Note: Introduction and Basic Concepts A. GDP, Economic Growth, and Business Cycles A.1. Gross Domestic Product (GDP) de nition and measurement The Gross Domestic Product (GDP) is a measure of aggregate economic activity. It is de ned as the dollar (market) value of all nal goods and services produced within the borders of an economy during a speci c period of time (usually one year). There are three approaches to measuring GDP: namely (1) The product approach, (2) The expenditure approach, and (3) The income approach. 1. The Product Approach (Value Added Approach) According to this approach, the GDP is the sum of all value added to goods and services in production. To calculate GDP using this approach, compute the nal value of all goods and services used in production and then, to ensure that there is no double counting, subtract the value of all intermediate goods used in production of nal goods. The value added of good i, V A i ; is the value of the output of that good, O i ; minus the value of inputs used in production of the same good, I i ; that is V A i = O i I i : Assuming that we have n goods in an economy, the GDP can be found by summing the value added over n as nx GDP = V A i : 2. The Expenditure Approach According to this approach, the GDP is the sum of all expenditures in the economy as i=1 GDP = C + I + G + X M; where C is consumption expenditure, I is spending on machines and equipment for business purposes, G is government spending, X is spending by foreigners on domestic products (exports), and M is spending by domestic residents on foreign goods (imports). 3. The Income Approach According to this approach, the GDP is calculated by adding up all incomes received by economic agents contributing to production. The incomes include: Pro ts made by rms. Compensation to employees (salaries, wages and bene ts). Net interest (interest income of consumers). Taxes by producers to government (government income). 1

Depreciation. GDP = W age Income + After T ax profits + interest income + T axes: A.2. GDP versus GNP Gross National Product (GNP) measures the value of output produced by domestic factors of production, whether or not the production takes place within the national boundaries. By contrast, gross domestic product (GDP) is the value of output produced inside the national boundaries. A.3. Why GDP is an inaccurate measure of economic welfare? Because: 1. GDP does not account for how income is distributed across individuals. A better measure is percapita GDP; that is GDP=population: 2. GDP does not include non-market activities such as work in the home. A.4. Why GDP is an inaccurate measure of output? Because: 1. It does not include economic activities in the underground economy. 2. There are di culties in valuing government expenditures. Problem 1 Reference: Chapter 2, problem #2 (textbook). Assume an economy with a coal producer, a steel producer, and some consumers (there is no government). In a given year, the coal producer produces 15 million tones of coal and sells it for $5 per tonne. The coal producer pays $50 millions in wages to consumers. The steel producer uses 25 million tons of coal as an input into steel production, all purchased as $5 per tonne. Of this, 15 million tones of coal comes from the domestic coal producer, and 10 million tones is imported. The steel producer produces 10 million tons of steel and sells it for $20 per tonne. Domestic consumers buy 8 million tons of steel, and 2 million tones are exported. The steel producer pays consumers $40 in wages. All pro ts made by domestic producers are distributed to domestic consumers. Find the following: (a) GDP using (i) the product approach, (ii) the expenditure approach, and (iii) the income approach (b) Determine the current account surplus (c) What is GNP in this economy? Determine GNP and GDP in the case where the coal producer is owned by foreigners, so that the pro ts of the domestic coal producer go to foreigners and are not distributed to domestic consumers? (a) GDP using the three approaches 2

i. Output Approach V A(Coal) = O I = (15 5) 0 = $75 V A(Steel) = O I = (10 20) (25 5) = $75 GDP = X V A = 150 ii. Expenditure Approach iii. Income Approach C = 8 20 = 160 I = 0 G = 0 X = 2 20 = 40 M = 10 5 = 50 GDP = C + I + G + X M = 150 W age Income(after tax) = (50 + 40) 0 = 90 (b) CA = X M = 40 50 = 10 After T ax profits = T R coal + T R Steel T C coal T C steel T axes interest income = 0 T axes = 0 GDP = 150 = 75 + 200 50 (125 + 40) = 60 (c) As originally formulated, GNP is equal to GDP, which is equal to $150 million. Alternatively, if foreigners receive $25 million in coal industry pro ts as income, then net factor payments from abroad are - $25 million, so GNP is equal to $125 million. B. Real GDP and the Price Level B.1. De nition and Calculations Real GDP is the value of nal goods and services produced in a given year when valued at constant prices. = Def lator Remark 2 The growth rate of real GDP, g, is found using the percentage change formula as where y t is real GDP at time t: g = y t y t 1 y t 1 100%; There are two ways to calculate real GDP: (1) The base year method and (2) The chain-weighted output index method. Both methods are illustrated in the following subsections. 3

i. The Base year method Choose a base year rst and then multiply the quantities produced in a given year by base year prices. ii. The chain-weighted output index method. The chain-weighted output method involves three steps: 1. Calculate real GDP ratios using prices of two adjacent years 2. Calculate the chain-weighted real GDP ratios 3. Use the chain-weighted real GDP ratio to create a chain linking the base year real GDP to the real GDP in future years. Example 3 Imagine an economy with two goods, apples and oranges. Last year (2008), 50 apples were sold for $1 each and 100 units of orange at $0.8 each. This year (2009), 80 apples were sold for $1.25 each and 120 units of orange at $1.60 each. (a) Calculate nominal GDP in 2008 and 2009 (b) Calculate real GDP in each year, and the percentage increase in real GDP from year 2008 to year 2009 using year 2008 as the base year. (c) Do the same calculation as in part (b) using year 2009 as the base year (d) Compare your answers in part (b) and (c). Why does the choice of a base year matters in calculating real GDP? (e) Explain what chain weighting is. Explain the problem in measuring the real GDP. (f) Do the same calculation as in (b) using the chain-weighting method. Answer (a) Year 2008 Apples 50 $1 Oranges 100 $0.8 Total (50 1) + (100 $0:8) = $130 Year 2009 80 $1.25 120 $1.60 (80 1:25)+(120 1:6) = $292 (b) Year 2008 (base year) Year 2008 Apples 50 $1 $1 Oranges 100 $0.8 $0.8 Total = $130 = $130 The percentage change in real GDP is Year 2009 80 $1.25 $1 120 $1.60 $0.8 = $292 = (80 1)+(120 0:8) = 176 g = y t y t 1 176 130 100% = 100% = 35:4%: y t 1 130 4

(c) Year 2009 (base year) Year 2008 Apples 50 $1 $1.25 Oranges 100 $0.8 $1.60 Total = $130 (50 1:25) + (100 $1:6) = $222:5 Year 2009 80 $1.25 $1.25 120 $1.60 $1.60 = $292 = $292 (d) Real GDP growth rates are not the same. GDP values production at market prices. Real GDP compares di erent years production at a speci c set of prices. These prices are those that prevailed in the base year. Real GDP is therefore a weighted average of individual production levels. The weights are determined according to prevailing relative prices in the base year. Because relative prices change over time, comparisons of real GDP across time can di er according to the chosen base year. (e) Chain weighting directly compares production levels only in adjacent years. The price weights are determined by averaging the prices of the individual goods and services over the two adjacent years. Real GDP is di cult to measure due to changes over time in relative prices, di culties in estimating the extent of quality changes, and how one estimates the value of newly introduced goods. (f) At year 2008 prices, the ratio of year 2009 real GDP to 2008 real GDP is g 1 = RGDP 2009 RGDP 2008 = 176 130 = 1:354: At year 2009 prices, the ratio of year 2009 real GDP to 2008 real GDP is g 2 = RGDP 2009 RGDP 2008 = 292 222:5 = 1:312: The chain-weighted ratio of real GDP in the two years therefore is equal to g c = p g 1 g 2 = p 1:354 1:312 = 1:33: The percentage change chain-weighted real GDP from year 1 to year 2 is therefore approximately 33%. If we (arbitrarily) designate year 2008 as the base year, then year 2008 chainweighted GDP equals nominal GDP equals $130. Year 2009 chain-weighted real GDP is equal to (g c = 1:33 $130 = 173:29). C. Measures of the Price Level There are two commonly used measures of the price level. The implicit GDP price de ator which is obtained from the real GDP formula as Deflator = 100: and the consumer price index (CPI) which a weighted average of the prices of a set of goods and services produced in an economy over a period of time and is calculated as CP I current year = Cost of base year quantities at current prices Cost of base year quantities at base year prices 100: The In ation rate,, is the percentage change in the price level from one period to another and is calculates as t = CP I t CP I t 1 CP I t 1 100%: 5

D. Saving, Wealth, and Capital There are two types of savings: private savings S P and government saving S G : These can be found from the following formulas. The Private disposable income Y d Y d = Y + NF P + T R + INT T where also note that The Private Saving S P is Y = GDP N F P = net factor payments from abroad T R = government transfers to the private sector IN T = interest on government debt T = Taxes GNP = GDP + NF P S P = Y d As for the government saving S G, it is calculated as C S G = T T R INT G The government saving is the government surplus, and the government surplus is equal to the negative of the government de cit, D; i.e., D = S G Finally, national saving is the sum of government saving and private saving or, using Y = C + I + G + NX; we can write S = S P + S G = Y + NF P C G S = (C + I + G + NX) + NF P C G = I + NX + NF P {z } CA surplus The quantity NX + NF P is current account (CA) surplus E. Labour Market Measurement The employed, E;are those who worked part-time or full-time during the past week; the unemployed, UN;are those who were not employed during the past week but actively searched for work at some time during the last four weeks. The labor force, L; is L = E + UN: The total population consists of those who are in the labor force and those who are not in the labor force. The unemployment rate, U, is U = UN L 100%: and the participation rate is the labor force divided by the working age population. 6

F. Business Cycle Measurement F.1. De nitions Business cycle activity is represented graphically as deviations of real GDP from trend in GDP The trend is that smooth part of the GDP that can be explained by long-run growth factors Deviations are persistent in that if GDP is below (above) trend in one quarter it is most likely to stay below (above) trend the next quarter A peak is a relatively large positive deviation from trend in real GDP A trough is a relatively large negative deviation from trend in real GDP Amplitude is the maximum deviation from trend in an economic time series Frequency is the number of peaks in an economic time series that occur per year Comovement describes how aggregate economic variables move together over the business cycle Procyclical: Descirbes an economic variable that tends to be above (below) trend when real GDP is above (below) trend Countercyclical: Describes an economic variable that tends to be below (above) trend when real GDP is above (below) trend Acyclical: Describes an economic variable that is neither procyclical nor countercyclical A leading variable is a macroeconomic variable that tends to aid in predicting the future path of real GDP, whereas if real GDP helps to predict the future path of a particular macroeconomic variable, that variable is said to be a lagging variable. A coincident variable is one that neither leads nor lags real GDP The average labour productivity is measured as GDP per worker The real wage is the nominal wage rate divided by a price level Correlation coe cients do not indicate cyclicality Leading and lagging variables can have either positive or negative correlations F.2. Summary of Business Cycle Facts Variable Cyclicality Lead/Lag Variability relative to GDP Consumption Procyclical Coincident smaller Investment Procyclical Coincident larger Price Level Countercyclical Coincident larger Money Supply Procyclical leading larger Employment Procyclical lagging smaller Average Labor Productivity Procyclical? - 7

F.3. Short Answer Questions 1. In what ways are business cycles irregular, and in what ways are they regular? They are irregular in that economists have di culty predicting upturns and downturns. They are regular in the sense that many macroeconomic variables move together over the business cycle in predictable ways. 2. What evidence is there that the Canadian price-level deviation from trend is procyclical and what evidence is there that the Canadian price-level deviation from trend is countercyclical? The price level deviations appear countercyclical over the 1961-2005 period in Canada and procyclical over smaller periods such as between the world wars. 3. Explain what is meant by procyclical, a countercyclical, and an acyclical variable? An economic variable is said to be procyclical if its deviations from trend are positively correlated with the deviations from trend in real GDP, countercyclical if its deviations from trend are negatively correlated with the deviations from trend in real GDP, and acyclical if it is neither procyclial nor countercyclical. 4. Why forecasting business cycle is di cult? The idea of forecasting is coming from the persistence in GDP, which implies that if GDP is below trend in one quarter, it is most likely to stay below trend the next quarter. In real life, choppy behavior of GDP, varying amplitude, and frequency uctuations indicate why long-term forecasting is di cult. 8