7/31/2019 Lecture 102 02

1/6

Fall Semester 10-11Akila Weerapana

Lecture 2: Gross Domestic Product and its Variants

I. INTRODUCTION

The goal of the next four lectures is to understand what measures are commonly used tomeasure price and quantity (output) for the entire economy, understand how these aggregatemeasures of price and quantity are constructed and identify some of their shortcomings.

A comprehensive set of accounts for the entire economy is available in the National Incomeand Product Accounts (NIPA), published by the Department of Commerce. We will nottry to study the NIPA in great deal, instead we will focus on understanding how a few keymeasures of output are constructed and in doing so, learn more about what these measuresfail to capture.

Even though the study of National Income Accounts seems boring, it is important for us tohave a good overview of the strengths and weaknesses of the process. Similarly it is importantfor countries to have good national income accounts; a country that has bad national incomeaccounts opens the door to questionable and potentially harmful policy recommendationsfrom those who study the data.

II. MEASURING THE SIZE OF THE ECONOMY

Gross Domestic Product (GDP)

GDP is a measure of the value of new goods and services produced in the domestic economyduring a particular time period. GDP is generally accepted by economists as the best measureof an economys production in a particular year.

Note that GDP only counts goods and services that are newly produced during a specic timeperiod within the countrys borders; used goods do not count towards GDP, nor do goodsproduced in foreign countries.

How can we obtain a dollar value for goods and services? We use market prices to calculatethe value of goods and services. GDP computed using market prices is often referred to asNominal GDP.

Consider an economy with only 2 goods: chocolate bars and pints of ice cream.

Ice Cream ChocolateYear Price Quantity Price Quantity2008 $3.50 3000 $1.00 15002009 $4.25 3000 $1.25 1000

7/31/2019 Lecture 102 02

2/6

So we have

GDP for 2008 = $3 . 50 3000 + $1 1500 = $12 , 000GDP for 2009 = $4 . 25 3000 + $1 . 25 1000 = $14 , 000

Gross National Product (GNP)

Some countries use Gross National Product as the measure of output. The U.S. also usedGNP as its measure of output for a substantial period of time. GNP is the dollar value of new goods and services produced by domestic nationals and rms.

So GNP for the U.S. would include all goods and services produced in other countries byU.S. citizens and companies but would exclude goods and services produced within the U.S.economy by foreign nationals and rms.

GNP = GDP value of new goods produced in the U.S. by foreign entities+value of new goods produced abroad by U.S. entities

For the U.S. presently GNP exceeds GDP; foreign individuals and rms produce less in theU.S. economy than U.S. citizens and rms produce in foreign countries. Since GDP is themore widely used measure of output, we will use GDP exclusively in this class to talk aboutoutput.

Real Gross Domestic Product (Real GDP)

In 1999 U.S. GDP was $9354 billion while in 2009 U.S. GDP was $14,119 billion. We canconclude that GDP increased by 51% over those 10 years. Does this mean that productionof goods and services increased by 51% over that 10-year period?

The answer is no. Remember that we value output using the market prices of goods. Sochanges in the price of goods will affect the value of GDP without any underlying change in

production. Since there is a tendency for prices to rise in the economy: ination, we need tocorrect for ination to best compare changes in production over time.

The measure of output that corrects for ination is known as Real GDP. Instead of usingcurrent market prices to calculate current GDP, we use some base years prices to calculatethe dollar value of goods and services produced in the economy in a given year.

If we compared Real GDP in 1999 and 2009 for the U.S. economy (in 2005 dollars, i.e. using2005 as a base year) we nd that 1999 GDP in 2005 dollars (i.e. real GDP for 1999 calculatedusing prices from the base year of 2005) was $10,780 billion while the value of 2009 GDP in2005 dollars (i.e. real GDP for 2009 calculated using prices from the base year of 2005) was$12,881 billion (This is only a 19.5% increase in real GDP which is smaller than the previously

calculated 51% increase in nominal GDP.) Since nominal GDP allows both price and quantity to vary over time, it is inferior to Real

GDP for measuring how output has changed over time. Real GDP is the best measure of theoutput of an economy over a period of time.

Notice that real GDP requires the choice of a base year in which prices are stated. The choiceof the base year is arbitrary, what is important is that prices for a base year be used for thecalculations. Also note that by denition in the base year, real GDP=nominal GDP.

7/31/2019 Lecture 102 02

3/6

We can get an idea about how to calculate Real GDP using our chocolate/ice cream economy.

Ice Cream ChocolateYear Price Quantity Price Quantity2008 $3.50 3000 $1.00 15002009 $4.25 3000 $1.25 1000

Real GDP for 2008 (base year 2008) = $3 . 50 3000 + $1 1500 = $12 , 000Real GDP for 2009 (base year 2008) = $3 . 50 3000 + $1 1000 = $11 , 500

Notice that even though GDP rose from $12,000 to $14,000 during this period, real GDPactually fell. Notice also that it is real GDP which accurately reects the fact that outputfell - clearly since the quantity of ice cream is unchanged and the quantity of chocolate fallen,it must be the case that output has decreased in the economy.

Per Capita GDP

Even though GDP increased by 51% over the 10 years between 1999 and 2009, the numberof people living in the United States also increased over that time period. So to get a betterunderstanding about the well being of individuals in the country, we look at GDP per-capita .

GDP per capita (also referred to as GDP per person) is the value of all goods and servicesproduced per person in the economy. It is calculated as

GDP per capita =GDP

Population

GDP per capita is also a better measure of comparing countries with different populations.For example, Indias GDP is 11 times higher than Norways but GDP per capita in Norwayis about 70 times as high as Indias. People living in a country with high GDP per capita arelikely to have more material possessions; food, clothing, cars, electronics etc.

Since real GDP is superior to nominal GDP for comparing the value of output over time, wewill in fact use real GDP per capita to measure the well-being of individuals in a country overtime.

Real GDP per capita =Real GDPPopulation

Potential GDP In the last lecture we looked at a graph of real GDP for the United States and commented

on two salient features, the rising trend and the uctuations around the trend.

It will be useful to give a name to the upward trend line in real GDP which we will callpotential GDP . Potential GDP represents the long-run tendency of the economy to grow.

7/31/2019 Lecture 102 02

4/6

Note that potential GDP is not the maximum amount of real GDP. As we saw in the data se-ries shown in class, sometimes real GDP goes above potential GDP. Instead, think of potentialGDP as more like the average or trend level of real GDP.

Unlike real GDP, potential GDP is not something we calculate explicitly. We also do not knowthe exact value of potential output at a point in time. Why? Because if we have a sustainedperiod of time where GDP is higher than trend, it could be the case that potential output

itself has changed - much like what we saw happened in China and India. There are alsodifferent ways in which one can estimate a trend line for an economy, each of these methodswill generate a slightly different estimate of potential GDP. The following diagram illustratesthe relationship between real GDP and potential GDP, as calculated by the CongressionalBudget Office.

0

5 0 0 0

1 0 0 0 0

1 5 0 0 0

b i l l i o n s o f 2 0 0 5

d o l l a r s

1950q1 1960q1 1970q1 1980q1 1990q1 2000q1 2010q1quarter

Real GDP Potential GDP

Real GDP and Potential GDP

GDP at PPP

We showed earlier how changes in price over time complicate our ability to compare how thesize of an economy grows over time, and how we had to come up with a concept known asreal GDP to correct for this. Similar problems arise when we are trying to compare GDP (orGDP per capita) across countries at a given point in time.

Such comparisons are complicated by two factors - the large uctuations in the market ex-change rates that we typically use to convert something denominated in one currency intoanother currency, and the substantial price differences (especially in non-tradeables) in mostlyidentical goods and services across countries. Both the problems and the solution are bestillustrated with an illustrative example.

Consider the comparison of Japan and Sri Lanka given in the table. 1

Japan Sri LankaGDP 450,000 billion yen 2,500 billion rupees

Population 150 million 20 millionGDP per capita 3 million yen 125,000 rupees

Comparing across countries is obviously a challenge since each countrys GDP is calculatedin their own currency. One alternative is to convert the GDP of the countries in question

1 The numbers dont really correspond to a particular year, I have chosen them so that the rough magnitudes arecorrect and that things divide easily

7/31/2019 Lecture 102 02

5/6

into dollars using the market exchange rate, which is simply how many units of one currencycan be bought with another currency. So we could, for example, convert everything into U.S.dollars and compare across countries.

Suppose the market exchange rates were 75 yen per $ and 100 rupees per $. We can thenconvert everything into dollars; the results are below. We would then conclude that Japanhas an economy that is about 300 times as large as Sri Lankas economy and that an average

Japanese income is about 40 times as much as the average Sri Lankan income.

Japan Sri LankaGDP 450,000 billion yen 2,500 billion rupeesGDP per capita 3 million yen 125,000 rupeesExchange Rate 75 yen per $ 100 rupees per $GDP $6,000 billion $25 billionGDP per capita $40,000 $1,000

This conversion, while allowing us to compare across countries by converting everything into

dollars, is fraught with its own problems. First, market exchange rates are very volatile. So if tomorrow, the market exchange rate for the yen changed to 100 yen to 1 U.S. dollar, we wouldthen calculate that GDP in Japan is $4,500 billion. In other words we would be claiming thatthe value of goods and services produced in the economy fell by about 25% overnight. Thisclearly is not the case.

Second, the purchasing power of a dollar varies greatly across countries. Consider a collectionof goods and services that I can buy for $100 in the United States. It is very likely that thatcollection of goods will cost much less in a country like Sri Lanka. and cost much more in acountry like the U.K. or Japan. For example, it costs me $20 to get a haircut in Wellesleybut a comparable haircut may cost (the equivalent of ) $40 in Japan and $5 in Sri Lanka. Butif we allow the same good to contribute much more to GDP in some countries and much lessto GDP in other countries, then we will not be able to compare accurately across countries.

Put another way, Japans GDP may not be as high as what we calculated above if we takeinto account the fact that goods typically cost more there, and Sri Lankas GDP may not beas low as what we calculated above if we take into account the fact that goods typically costless there.

The solution is to convert GDP into a common currency (so that it is comparable) butuse something other than the market exchange rate. Instead, we use something called thePurchasing Power Parity exchange rate (PPP). The PPP exchange rate is one that equalizesthe price of a collection (basket) of goods in country to the price of that basket in a basecountry in a base year. Typically the base year is 2000 and the base country is the UnitedStates.

An example will help clarify matters. Suppose the PPP basket consists of goods that cost$1000 to buy in the United States in 2000. At market exchange rates, that $1000 is theequivalent of 100,000 Sri Lankan rupees. However, since the items in the basket are typicallycheaper in Sri Lanka than in the U.S. you may only need 50,000 rupees to buy the basket. Inthis case, the PPP exchange rate would be 50 rupees to the dollar (Price of basket = 50,000rupees in Sri Lanka =1000 dollars in the U.S.).

7/31/2019 Lecture 102 02

6/6

Conversely, $1000 is the equivalent of 75,000 Japanese yen at the market exchange rate.However, since the items in the basket are typically more expensive in Japan than in the U.S.you may need as much as 100,000 yen to buy the basket. In this case, the PPP exchange ratewould be 100 yen to the dollar (Price of basket = 100,000 yen in Japan =1000 dollars in theU.S.).

We can then convert everything using PPP exchange rates as shown below. Sri LankasGDP in PPP terms is now $ 40 billion (much higher than when we expressed it using marketexchange rates) and Japans GDP in PPP terms is $ 4.5 trillion (lower than when we expressedit using market exchange rates).

Japan Sri LankaGDP 450,000 billion yen 2,000 billion rupeesGDP per capita 3 million yen 100,000 rupeesPPP Exchange Rate 100 yen per $ 50 rupees per $GDP in PPP terms $4,500 billion $40 billionGDP per capita in PPP terms $30,000 $2,000

Another way of describing the numbers above is as follows. We calculated GDP per capitaof $1,000 for Sri Lanka and $40,000 for Japan; and GDP per capita in PPP terms of $2,000for Sri Lanka and $30,000 for Japan. Since the PPP numbers are calculated relative to theUnited States, what this says is that Sri Lankans on average earn about $1,000 but that isequivalent to earning about $2,000 in the United States. Japanese on the other hand earnabout $40,000 but that is equivalent to earning about $30,000 in the United States. Overall,we would conclude that Japanese are about 30 times as well off than Sri Lankans (comparedto the 40 times gure we would get from market exchange rates).

So GDP measured using PPP exchange rates (GDP in PPP terms) is the best way to compareoutput across countries both to avoid undue uctuations of market interest rates and to correctfor differential prices for similar goods across countries.