Chapter 5

Measuring GDP and Economic Growth

You will learn

• How GDP is measured

• The difference between real and nominal GDP

• Aggregate income and aggregate expenditures

• How real GDP is used to compute economic growth

• Problems with interpreting real GDP

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

1. Market value

2. Final goods

3. Produced domestically

4. In a given time period (usually a year or quarter)

Market value

1 2 3

1 1 2 2 3 3

But you can't add these things together.

You can add the dollar value of the items

GDP=P Q +P Q +P Q +

GDP Apples Oranges Cars Haircuts

GDP Q Q Q

Final goods

• The materials($8,000) used in producing a new car are included in the price to dealer

• The price to the dealer is $12,000

• The price to the customer is $20,000

• Should the value of the car be – $20,000+$12,000+$8,000=$40,000

• The value of the car is $20,000 (avoid double counting).

• Produced domestically – within a country

• In a given time period –usually a year or quarter

AE—aggregate expenditure

Who can buy output?– Consumers (C)– Businesses (I—investment spending)– Government (G)– Foreigners (X-M net exports)

( ) ( )

( )

US M

US M

US M

US M US M US M

US US US M M M

US US US

US US US

US US US

C C C

I I I

G G G

C I G C C I I G G

C I G C I G C I G

C I G C I G M

C I G X M C I G M X M

C I G X M C I G X

AE—one way to compute GDP

• AE=GDP

• AE=C+I+G+(X-M)

• C+I+G+(X-M)=GDP

Aggregate Income (Y)—another way to compute GDP

• GDP=what firms take in when they sell output. What do firms do with these funds.

1. Pay employees (wages)

2. Pay lenders (interest)

3. Pay owners of land and buildings (rent)

4. Pay stockholders (corporate profits--interest)

5. Profits—to entrepreneurs (sole proprietors and partnerships)

Recall these are payments to the factors of production

Y=factor income

• Y=Wages+Interest+Rent+Profits

Y=factor income

• What can you do with income– Pay taxes (T)– Consume some (C)– Save what is left (S)

Y=C+S+T

Two ways of computing GDP

• Aggregate expenditures approach– AE=GDP=C+I+G+(X-M)

• Factor income appoach– GDP=Y=wages+interest+rent+profits– Y=C+S+T

G 100 120 120 130

T 100 100 110 130

Deficit

G-T

0 20 10 0

National debt

0 20 30 30

Government deficit

• If the government runs a deficit it must borrow the money to finance the deficit.

• The Treasury borrows money by selling bonds in the bond market.

• Who buys the bonds? Anybody that wants to.

• Businesses also borrow by selling bonds.

International trade deficits

• (X-M)=current account=balance of trade

• X=what we sell to foreigners (exports)

• M=what we buy from them (imports)

• If M>X we buy more than we sell (a trade deficit)

• What do foreigners do with these dollars?– They buy government bonds and corporate

stocks and bonds.

Total U.S. borrowing

• U.S. government debt (G-T)

• Plus

• U.S. private debt—domestic + (X-M)

Two ways to estimate prices

• Directly by constructing price indexes– Consumer Price Index (CPI)

• Not in book

• Indirectly by computing the implicit price deflator

Price index for groceries

• Market basket (in base year of 1960)– 1 dozen eggs– 2 chickens– 3 pounds hamburger – Other things a typical family might buy

Price of basket =$100 in 1960

Price of basket = $200 in 1970

Price index

• The market basket does not change so any difference must be due to prices.

• Price indexes however miss– Substitution effect– New goods– Quality changes– Discount stores

Computing real GDP using price index

•

Nominal GDPReal GDP

P

Implicit price deflator

• Can get good estimate of Nominal GDP– Nominal GDP = Sum of Value Added

• Estimate real GDP by determining what people buy now using base year prices– If year 2000 is the base year compute real

GDP by determining what year 2003 GDP would have cost in 2000

Implicit price deflator

•

Nominal GDP

Real GDPP

See spreadsheet

• GDP calculations.xls

Economic growth

• Economic growth is the percent change in real GDP from one time period to the next time period

• If real GDP is 100 one year and 105 next year, the percent change is 5%. We would say that real GDP grew by 5%

Economic growth

• Using the numbers on the previous slide

1 100%

105 100100% 5%

100

t t

t

GDP GDPGrowth

GDP

Growth

Economic growth

We measure economic growth so we can make:

– Economic welfare comparisons– International welfare comparisons– Business cycle forecasts

Economic growth

• Rule of 72

72 Approximate time to double GDP

Growth rate in percent

Economic growth

Growth rate Time to double

10% 7.2 years

5% 14.4 years

3% 24 years

Economic welfare comparisons

• Compare GDP now with GDP in some other year to determine how much output has changed.

• Does GDP measure economic welfare?

GDP and economic welfare

• GDP computed using CPI overstates real GDP

• Computed GDP ignores non market activities– Household work– Underground economy 9—30% of real output

GDP and economic welfare

• GDP ignores changes in heath and life expectancy

• GDP ignores leisure time (early retirement)

• GDP ignores environmental quality

• GDP ignores political freedom and social justice

International comparisons

• You can compare GDP values between two countries.– Need to be careful– In 2003 US GDP per person = $39,000– In 2003 China’s GDP per person = Y9,500– Exchange rate $1=Y8.276– China GDP =Y9,500*($1/Y8.276)=$1147.90– US GDP per person 34 times greater than

China

International comparisons

• The US—China comparison is misleading

• The Chinese government keeps the exchange rate deliberately low to encourage exports

• Use purchasing power parity to make comparisons.

Purchasing power parity (PPP)

• The McDonald’s hamburger index– What does a McDonald’s hamburger cost in

the US.– What does it cost in China.– The real purchasing price parity index using a

number of goods– Adjusting for PPP indicates US GDP per

person is approximately 6 times that of China

GDP and business cycle forecasting

• Declining GDP for 2 quarters is a commonly used measure for recession.

• Compare GDP growth rates for time periods.