Chap 20

1
20
CHAPTER
Measuring GDP and Economic Growth Ratna K.
Shrestha
2
An Economic Barometer

• What exactly is GDP?
• How do we use it to tell 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?

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An Economic Barometer

• What and for whom goods and services are produced
  affect the standard of livinga central concern
  of Macroeconomics
• The standard of living depends on the value of
  total productionthe gross domestic product or
  GDP and population. In other words, it depends
  on the per capita GDP.

4
Gross Domestic Product

• GDP Defined
• GDP or gross domestic product, is the market
  value of all final goods and services produced in
  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

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Gross Domestic Product

• Market Value
• Use market prices to value production. Both
  quantity and price together determine the total
  value of production.
• GDP includes only those items that are traded in
  markets. For example, If you wash your own car,
  it is not accounted in GDP calculation. However,
  if you buy a car wash, it is a part of GDP.
• Exception market value of home that people own.
  GDP puts a rental value on such homes as if the
  owners pay rents for their homes.

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Gross Domestic Product

• Final Goods and Services
• A good or service that is produced for its final
  user and not as a component of another good or
  service (i.e., intermediate good).
• Intermediate good or service
• A good or service that is produced by one firm,
  bought by another firm, and used as a component
  of a final good or service. For example, Goodyear
  tire used by Ford SUVs. Intermediate goods are
  not included in GDP calculation to avoid double
  counting.
• GDP is the value of the final goods and services
  produced.

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Gross Domestic Product

• Produced Within a Country
• GDP measures production within a countrydomestic
  production.
• In a Given Time Period
• GDP measures production during a specific time
  period, normally a year or a quarter of a year.

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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.
• Four types of expenditures on final goods.
• 1. Consumption expenditure (C)
• The expenditure by households on consumption
  goods and services, including owner occupied
  housing.
• 2. Investment (I)
• The purchase of new capital goods (tools,
  instruments, machines, buildings) and additions
  to inventories (unsold goods).

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Gross Domestic Product

• 3. Government expenditures (G)
• The expenditure by all levels of government on
  goods and services.
• For example, federal govt. buys submarines and
  defense equipment provincial govt. buys health
  care and education.
• 4. Net exports (Export, X Imports, M)
• The value of exports of goods and services minus
  the value of imports of goods and services.
• Expenditures Not in GDP
• Expenditure on used goods is not part of GDP
  because these goods were part of GDP in the
  period in which they were produced.

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Gross Domestic Product
11
Gross Domestic Product

• The circular flow demonstrates how GDP can be
  measured in two ways.
• 1. Aggregate expenditure
• Total expenditure on final goods and services,
  equals the market value of final goods and
  services, which is GDP.
• Total expenditure C I G (X M).
• 2. Aggregate income
• Firms pay out all their receipts from the sale of
  final goods as aggregate income to factor of
  production (such as wage, interest income, rent,
  and profits), so income equals expenditure, Y C
  I G (X M).

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Gross Domestic Product

• Financial Flows
• Financial markets finance deficits and
  investment.
• Total income is either consumed (C), saved (S),
  or paid in taxes (NT). That is,
• Y C S NT.
• Household saving S Y C NT and saving flows
  to the financial markets.
• Net taxes (NT) is governments tax revenue.

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Gross Domestic Product

• If G exceeds NT, the government has a budget
  deficit(G NT) and the government borrows from
  the financial markets.
• If NT exceeds G, the government has a budget
  surplus (NT G) and this surplus flows to the
  financial markets.
• If imports exceed exports, then the trade deficit
  with the rest of the world (M X) is borrowing
  from the rest of the world. Rest of world saving
  finances some investment in Canada.
• If exports exceed imports, the surplus with the
  rest of the world (X M) is lent to the rest of
  the world. Canadian saving finances some
  investment in the rest of the world.

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Gross Domestic Product

• How Investment Is Financed
• Investment is financed from three sources
• Private saving, S
• Government budget surplus, (NT G)
• Borrowing from the rest of the world (M X).

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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 NT C I G (X M).
• Then rearrange to obtain
• I S (NT G) (M X)
• Private saving S plus government saving (NT G)
  is called national saving.

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Gross Domestic Product

• Gross and Net Domestic Product
• Gross means before accounting for the
  depreciation of capital. Net value means
  therefore gross value minus depreciation.
• To understand this distinction, we need to
  distinguish between flows and stocks in
  macroeconomics.
• Flows and Stocks in Macroeconomics
• A flow is a quantity per unit of time a stock is
  the quantity that exists at a point in time.

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Gross Domestic Product

• Wealth and Saving
• Wealth, the value of all the things that people
  own, is a stock. Saving is the flow that changes
  the stock of wealth.
• Wealth at the start of this year equals wealth at
  the start of last year plus saving during last
  year.
• Capital and Investment
• Capital, the plant, equipment, and inventories of
  raw and semi-finished materials that are used to
  produce other goods, is a stock.
• Investment is the flow that changes the stock of
  capital.

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Gross Domestic Product

• Depreciation is the decrease in the capital stock
  that results from wear and tear and obsolescence.
• Gross investment is the total amount spent on
  purchases of new capital and on replacing
  depreciated capital.
• Net investment is the change in the stock of
  capital.
• Net investment Gross investment ? Depreciation.

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Gross Domestic Product

• Figure 20.2 illustrates the relationships among
  capital, gross investment, depreciation, and net
  investment.

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Gross Domestic Product

• Back to Gross in GDP
• Gross profits, and GDP, include depreciation.
  Similarly, gross investment includes that amount
  of purchases of new capital goods that replace
  depreciation.
• Net profits, net domestic product, and net
  investment subtract depreciation from the gross
  concepts.
• The Short-Run Meets the Long-Run
• Investment plays a central role in the economy.
  Increases in capital are one source of growth in
  potential real GDP fluctuations in investment
  are one source of fluctuations in real GDP.

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Measuring Canadas GDP

• The Statistics Canada uses two approaches to
  measure GDP
• The expenditure approach
• The income approach
• 1. The Expenditure Approach
• The expenditure approach measures GDP as the sum
  of consumption expenditure (C), investment (I),
  government expenditures on goods and services
  (G), and net exports (X M).
• GDP C I G X ? M

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MEASURING CANADAS GDP
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Measuring Canadas GDP

• The Income Approach
• The income approach measures GDP by summing the
  incomes that firms pay households for the factors
  of production they hire.
• Wages and salaries
• Corporate profits
• Interest and miscellaneous investment income
• Farmers income
• Income from non-farm unincorporated businesses
• The sum of these five income components is net
  domestic income at factor cost.

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Measuring Canadas GDP

• GDP is measured in market price and includes
  depreciation but the aggregate income is measured
  in factor prices and excludes depreciation.
• So two adjustments must be made to get GDP from
  aggregate income
• Indirect taxes minus subsidies are added to get
  from factor cost to market prices.
• Depreciation (or capital consumption) is added to
  get from net domestic product to gross domestic
  product.

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MEASURING CANADAS GDP
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Real GDP and the Price Level

• In 2003, Canadas (nominal) GDP was 1207
  billion in 2004 it was 1290 billion. This
  increase must be due to
• 1. Production of more goods and services and/or
• 2. Increase in the market prices of goods and
  services.
• The production of more goods and services adds
  to the standard of living but higher prices do
  not. That means change in (nominal) GDP is not a
  good measure of changes in standard of living.
• We measure the increase in production by real
  GDP.

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Real GDP and the Price Level

• Real GDP is the value of final goods and services
  produced in a given year when valued at constant
  prices.
• Nominal GDP
• 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
• The first step in calculating real GDP is to
  calculate nominal GDP.

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Real GDP and the Price Level

• Nominal GDP Calculations
• The table provides data for 2005 and 2006.
• In 2005,
• Expenditure on balls 100
• Expenditure on bats 100
• Nominal GDP 200

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Real GDP and the Price Level

• In 2006,
• Expenditure on balls 80
• Expenditure on bats 495
• Nominal GDP 575

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Real GDP and the Price Level

• Base-Year Prices Value of Real GDP
• This method of calculating real GDP (the
  traditional method) was to value each years
  output at the prices of a base year.
• In the base year, real GDP equals nominal GDP.
• Suppose 2005 is the base year, then real GDP in
  2005 is 200.

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Real GDP and the Price Level

• Using the traditional method real GDP in 2006
• Expenditure on balls in 2006 valued at 2005
  prices is 160.
• Expenditure on bats in 2006 valued at 2005 prices
  is 110.
• So real GDP in 2006 would be recorded as 270.

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Real GDP and the Price Level

• The New Method
• The new method of calculating real GDP, which is
  called the chain-weighted output index method,
  uses the prices of two adjacent years to
  calculate the real GDP growth rate.
• This calculation has four steps described on the
  next slide.

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Real GDP and the Price Level

• Step 1 Value last years production and this
  years production at last years prices and then
  calculate the growth rate of this number from
  last year to this year.
• Step 2 Value last years production and this
  years production at this years 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 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
  years prices.

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Real GDP and the Price Level

• Weve done step 1.
• Value of 2005 quantities at 2005 prices (GDP in
  2005) is 200.
• Value of 2006 quantities at 2005 prices is 270.
• At 2005 prices, the value of production increased
  from 200 to 270an increase of 35 percent.

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Real GDP and the Price Level

• Step 2.
• Value of 2005 quantities at 2006 prices is 500.
• Value of 2006 quantities at 2006 prices (GDP in
  2006) is 575.
• At 2006 prices, the value of production increased
  from 500 to 575an increase of 15 percent.

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Real GDP and the Price Level

• Step 3.
• At 2005 prices, the 2006 growth rate 35 .
• At 2006 prices, the 2006 growth rate 15 .
• The average growth rates 25 .
• So with 2005 as the base year, real GDP in 2006
  1.25 x 200 250 (25 more that in 2005).

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Real GDP and the Price Level

• Step 4.
• Real GDP in 2005 200
• Real GDP in 2006 250.
• We can repeat Steps 1, 2 and 3 for 2006 and 2007
  and so forth.
• Thus each years real GDP is linked to base
  years real GDP a chain linking.

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Real GDP and the Price Level

• Chain Linking
• Each pair of years is like a link in a chain.
• The entire chain links the current year back to
  the base year, 2003 in this example (on the
  right).

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Real GDP and the Price Level

• Calculating the Price Level
• The average level of prices is called the price
  level.
• GDP deflator
• One measure of the price level is the GDP
  deflator, which is average of current prices
  expressed as a percentage of base-year prices
• GDP deflator (Nominal GDP Real GDP) x 100

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Real GDP and the Price Level

• In 2005, the GDP deflator is (200/200) ? 100
  100.
• The GDP deflator in base year 100.
• In 2006, the GDP deflator is (575/250) ? 100
  230.

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Real GDP and the Price Level

• Deflating the GDP Balloon
• Nominal GDP increases because productionreal
  GDP increases.

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Real GDP and the Price Level

• Nominal GDP also increases because prices rise.

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Real GDP and the Price Level

• We use the GDP deflator to let the air out of the
  nominal GDP balloon and reveal real GDP.

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Measuring Economic Growth

• We use real GDP to calculate the economic growth
  rate.
• The economic growth rate is the percentage change
  in the quantity of goods and services produced
  from one year to the next.
• Econ growth (real GDP07 real GDP06)x100/ Real
  GDP06
• We measure economic growth so we can make
• Economic welfare comparisons
• International comparisons
• Business cycle forecasts

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Measuring Economic Growth

• Economic Welfare Comparisons
• Economic welfare measures the nations overall
  state of economic well-being.
• Real GDP is not a perfect measure of economic
  welfare for seven main reasons
• Quality improvements tend to be neglected in
  calculating real GDP, so the inflation rate is
  overestimated and real GDP is underestimated.
• E.g., when car prices rise because cars have
  become safer and more fuel efficient, GDP
  deflator counts it as inflation (rather than
  increase in real GDP).

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Measuring Economic Growth

• 2. Real GDP does not include household production
  such as cooking, cleaning, etc (which are not
  paid).
• 3. Real GDP, as measured, omits the underground
  economy, which is 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.
• 5. Leisure time, a valuable component of an
  individuals welfare, is not included in real
  GDP.
• 6. Environmental damage is not deducted from real
  GDP.
• 7. Political freedom and social justice are not
  included in real GDP.

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Measuring Economic Growth

• International Comparisons
• Real GDP is used to compare economic welfare 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.

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Measuring Economic Growth

• 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.
• In 2003, US per capita real GDP 39,000 and
  Chinas per capita real GDP 9,500 Yuan. So if
  we use the prevailing exchange rate of 1 8.27
  Yuan, U.S. real GDP per person was 34 times
  Chinese real GDP per person.
• Another alternative is to value all the goods and
  services produced in China at the prices
  prevailing in the US. That means if a haircut in
  the US costs 15, then a haircut in China is also
  valued at US 15.

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Measuring Economic Growth

• Using purchasing power parity prices leads to an
  estimate that U.S. GDP per person is (only) 12
  times that in Chinasee Figure 20.4.

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Measuring Economic Growth

• Business Cycle Forecasts
• Real GDP is used to measure business cycle
  fluctuations. Although there are biases in real
  GDP measurement (for the seven reason mentioned),
  it does not necessarily cause a wrong assessment
  of the phases of the business cycle.
• These fluctuations are probably accurately timed,
  but the changes in real GDP probably overstate
  the changes in total production caused by
  business cycles. This is because when business
  activity slows in a recession household
  production and leisure time increase so total
  production does not slow as shown by real GDP
  measurement. The same applies during an
  expansion.