Lecture 2. Measuring GDP and economic growth

Measuring GDP and Economic Growth

• GDP is a measure of total production and total income.
• Real GDP measures production of goods and services.
• GDP can be used to make comparisons over time and across countries.

I. Gross Domestic Product

• GDP or gross domestic product is the market value of all the final goods and services produced within a country in a given time period.

· The items in GDP are valued at their market values, that is, at their prices. So if 100,000,000 slices of pizza are sold for $3 each, slices of pizza contribute $300,000,000 to GDP. Using market values means that the total value of output, that is, GDP will be in the dollars (or whatever the country’s currency unit might be).

· A final good is an item that is bought by its final user. It contrasts with an intermediate good, which is an item that is produced by one firm, bought by another firm, and used as a component of a final good or service.

· To avoid double counting, GDP includes only final goods and services (no intermediate goods and services are directly counted).

· Only the goods and services produced within a country are counted. A Honda produced in North Carolina is counted in U.S. GDP.

· GDP is measured over a period of time, typically a quarter of a year or a year.

GDP and the Circular Flow of Expenditure and Income

The circular flow illustrates the equality of income, expenditure, and the value of production. The circular flow diagram shows the transactions among four economic agents—households, firms, governments, and the rest of the world—in two aggregate markets—goods markets and factor markets.

In the goods market, households, firms, governments, and foreigners buy goods and services. For analytical purposes, we can categorize spending by these four agents in the calculation of GDP:

· The total payment for goods and services by households in the goods markets is consumption expenditure, C.

· The purchases of new plants, equipment, and buildings and the additions to inventories are investment, I.

· Governments buy goods and services, called government expenditure or G, from firms.

· Firms sell goods and services to the rest of the world, exports or X, and buy goods and services from the rest of the world, imports or M. Exports minus imports are called net exports, X - M.

In factor markets households receive income from selling the services of resources to firms. The total income received is aggregate income. It includes wages paid to workers, interest for the use of capital, rent for the use of land and natural resources, and profits paid to entrepreneurs; retained profits can be viewed as part of household income, lent back to firms.

GDP Equals Expenditure Equals Income

Aggregate expenditure equals C + I + G + (X - M). Aggregate expenditure equals GDP because all the goods and services that are produced are sold to households, firms, governments, or foreigners. (Goods and services not sold are included in investment as inventories and hence are “sold” to the producing firm.)

• Because firms pay out as income everything they receive as revenue from selling goods and services, aggregate income equals aggregate expenditure equals GDP.

Why is Domestic Product “Gross”?

Depreciation is the decrease in the stock of capital that results from wear and tear and obsolescence. The total amount spent on purchases of new capital and on replacing depreciated capital is called gross investment. The amount by which the stock of capital increases is net investment. Net investment = Gross investment - Depreciation.

The “Gross” in gross domestic product reflects the fact that the investment in GDP is gross investment and so part of it goes to replace depreciating capital. Net domestic product subtracts depreciation from GDP.

II. Measuring U.S. GDP

The Expenditure Approach

The expenditure approach measures GDP as the sum of consumption expenditure, C, investment, I, government expenditure on goods and services, G, and net exports of goods and services, (X - M). So GDP = C + I + G + (X - M) or, in 2010 and in billions of dollars, $10,285 + $1,842 + $2,991 + -$539 = $14,579.

The Income Approach

The income approach measures GDP as the sum of compensation of employees, net interest, rental income, corporate profits, and proprietors’ income. This sum equals net domestic income at factor costs. To obtain GDP, indirect taxes (which are taxes paid by consumers when they buy goods and services) minus subsidies plus depreciation are included. Finally any discrepancy between the expenditure approach and income approach is included in the income approach as “statistical discrepancy.”

Nominal GDP and Real GDP

The market value of production and hence GDP can increase either because the production of goods and services are higher or because the prices of goods and services are higher.

Real GDP allows the quantities of production to be compared across time. Real GDP is the value of final goods and services produced in a given year when valued at the prices of a reference base year.

Nominal GDP is the value of the final goods and services produced in a given year valued at the prices that prevailed in that same year.

Calculating Real GDP

Traditionally, real GDP is calculated using prices of the reference base year (the year in which real GDP=nominal GDP).

The tables to the right show this method of calculating real GDP for an economy that produces only books and coffee. If 2010 is the reference base year, nominal GDP in 2010 in the top table equals real GDP in 2010. Real GDP in 2010 is $3,000.

The second table shows the calculation for nominal GDP in 2011.

Real GDP in 2011 is in the bottom table. It values 2011 production using the prices from the reference base year, 2010. Real GDP in 2011 is $4,250.

REQUIRES MATHEMATICAL NOTE: Chained-Dollar Real GDP

The top table to the right has data for 2010 for an economy that produces only books and coffee. In 2010, nominal GDP is $3,000. The second table to the right has the same data for 2011. (These tables are the same as used above to calculate real GDP using the standard method.) In 2011, nominal GDP is $6,000.

Nominal GDP has doubled but how much has real GDP changed between these years?

To determine how real GDP changes, suppose that 2010 is the base year. Then we need to determine the growth rate between 2010 and 2011 by calculating the value of production in both years using 2010 prices and also calculating it in both years using 2011 prices.

Using 2010 prices, the value of production increases from $3,000 (the first table) to $4,250 (the third table). Using 2010 prices, the value of production has grown by

100 ´ ($4,250 - $3,000)/$3,000 = 41.7 percent.

Using 2011 prices, real GDP increases from $4,200 (the fourth table) to $6,000 (the second table). Using 2011 prices, the value of production has grown by

100 ´ ($6,000 - $4,200)/$4,200 = 42.9 percent.

The average growth rate is equal to (41.7 percent + 42.9 percent)/2 = 42.3 percent. So real GDP between these years has grown by 42.3 percent. If 2010 is the base year, real GDP in 2011 is $3,000 ´ 1.423 = $4,269.

Similar calculations are made for each pair of adjacent years from the reference base year onwards. This procedure chains real GDP back to the reference base year.

III. The Uses and Limitations of Real GDP

The Standard of Living Over Time

One measure of the standard of living over time is real GDP per person, or real GDP divided by the population. Real GDP per person tells us the value of goods and services that the average person can enjoy.

The value of real GDP when all the economy’s labor, capital, land, and entrepreneurial ability are fully employed is called potential GDP. Potential GDP grows at a steady pace because the quantities of the factors of production and their productivity grow at a steady pace.

The growth rate of real GDP slowed in the productivity growth slowdown after 1970. This slowdown created a Lucas wedge. A Lucas wedge is the dollar value of the accumulated gap between what real GDP per person would have been if the growth rate had persisted and what real GDP per person actually turned out to be.

Fluctuations in the pace of expansion of real GDP is denoted the business cycle, periodic but irregular increases and decreases in the total production and other measures of economic activity. Each cycle is categorized by: trough, expansion, peak, recession.

The Standard of Living Across Countries

Real GDP can be used to compare living standards across countries. But two problems arise in using real GDP to compare living standards:

· First, the real GDP of one country must be converted into the same currency unit as the real GDP of the other country.

• Second, the goods and services in both countries must be valued at the same prices. Relative prices in countries will differ, so goods and services should be weighted accordingly. For example, if more prices are lower in China than in the United States, China’s prices put a lower value on China’s production than would U.S. prices. If all the goods and services produced in China are valued using U.S. prices, than a more valid comparison can be made of real GDP in the two countries. This comparison using the same prices is called purchasing power parity (PPP) prices.

Limitations of Real GDP

Some of the factors that influence the standard of living are not part of real GDP. Omitted from GDP are:

· Household Production: As more services, such as childcare, are provided in the marketplace, the measured growth rate overstates development of all economic activity.

· Underground Economic Activity: If the underground economy is a reasonably stable proportion of all economic activity, though the level of GDP will be too low, the growth rate will be accurate.

· Health and Life Expectancy: Better health and long life are not directly included in real GDP.

· Leisure Time: Increases in leisure time lower the economic growth rate, but we value our leisure time and we are better off with it.

· Environmental Quality: Pollution does not directly lower the economic growth rate.

· Political Freedom and Social Justice: Political freedom and social justice are not measured by real GDP.

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