Lecture 3Chapter 7: Taking the Nation’s Economic Pulse

Lecture 3Chapter 7: Taking the Nation’s Economic Pulse

GDP– A Measure of Output– A Flow

Gross Domestic Product (GDP): The market value of final goods and services produced within a country’s borders during a specific time period, usually a year, quarter, or month.

GDP is the most widely used indicator of economic performance.

Measures the flow of exchange Like a paycheck, rather than your bank account

GNP or “Gross National Product” is similar to GDP, but refers to the market value of goods produced by a nation’s citizens

GDP – A Measure of Output

What Counts Toward GDP? Only final goods and services count.

Sales at intermediate stages of production are not counted as their value is embodied within the final-user good.

Including goods at intermediate stages of production would result in double counting.

Stage of productionValue added to the product (equals income created)

Sales Receipts(at each stage of production)

Stage 1: farmer’s wheat

Stage 2: miller’s flour

Stage 3: baker’s bread(wholesale)

Stage 4: grocer’s bread (retail)

$.30

$.65

$.90

$1

by farmer$.30

by grocer$.10

by miller$.35

by baker$.25

Total consumer expenditure = $1 Total value added = $1

What Counts Toward GDP? Only transactions involving production count.

Financial transactions & income transfers are excluded because they do not reflect actual production.

Black market transactions are excluded, so you may consider them financial transactions or income transfers

Only production within the geographicborders of the country is counted.

(This is the DOMESTIC part)Only those goods produced during the

current period are counted. Thus, the purchase and sale of goods produced during

earlier years are not counted in this year’s GDP.

What Counts Toward GDP?

GDP is measured in dollars.Each good produced increases output

by the amount the purchaser pays for the good.

The total spending on all final-user goods and services produced during the year is summed, in dollar terms, to obtain the annual GDP.

Dollars are the CommonDenominator for GDP

Two Ways of Measuring GDP

GDP (Typically denoted “Y”) is a measure of both output and income. They SHOULD BE EQUAL.Total expenditures on final-user goods and

services produced during the year. This is called the expenditure approach.

Summing the income payments to the resource suppliers and the indirect cost of producing the goods and services. This is called the resource cost-income approach.

GDPDollar flow ofexpenditureson final goods

=Dollar flow of

income (and indirect cost) of final goods

=

Two Ways of Measuring GDP

Expenditure Approach:GDP is the sum of expenditures on final-user

goods and services purchased by households, investors, governments, and foreigners.

There are four components of GDP: personal consumption purchases (“C”) gross private investment

(“I”) (including inventories) government purchases (“G”)

(consumption and investment) net exports (“X”)(exports minus imports) (“EX-IM”)

Y=C+I+G+X You will see and use this repeatedly…

Y=C+I+G+XThe National Income Identity Also known as the National Product Identity Sometimes written Y=C+I+G+EX-IM

We subtract imports because we don’t produce them, but we do consume them

If Exports exceed Imports we have a trade surplus IM<EX

If Imports exceed Exports we have a trade deficit IM>EX

Resource Cost - Income Approach

Sum of these = national income

GDP is the sum of costs incurred and income (including profits) generated by the production of goods and services during the period.

The direct cost income components of GDP:

employee compensation self-employment income rents interest corporate profits

Resource Cost - Income Approach: (cont.)

Not all cost components of GDP result in an income payment to a resource supplier. To get GDP, we need to account for 3 other factors:

Indirect business taxes: Taxes that increase the firm’s production costs and therefore final prices.

Depreciation: The cost of wear and tear on the machines and other capital assets used to produce goods and services.

Net Income of Foreigners: The income that foreigners earn producing goods within the borders of the U.S. minus the income Americans earn abroad.

national income, (employee compensation, self-employment income, rents, interest, corporate profits)

indirect business taxes, depreciation, and, net income of foreigners.

When derived by the Resource Cost - Income Approach, GDP is equal to the sum of

Resource Cost-Income Method of Measuring GDP

Resource Cost-Income ApproachExpenditure Approach

The two methods of calculating GDP are summarized below:

Personal consumption expenditures

+ Gross private domestic investment

+

Government consumptionand gross investment

+Net exports of goods and services

Aggregate income:Employee CompensationIncome of self-employedRents Profits Interest

+Non-income cost items:

Indirect business taxesand depreciation

Net income of foreigners+= GDP

Two Ways of Measuring GDP: A Summary

= GDP

Relative Size of U.S. GDP Components: 2000-2003

Personal consumption

70%

Net exports

- 4%

Privateinvestment

16%

Gov’t

18%

Rental income

1%Net

interest

5%

Indirect taxes

8%

Corporate

profits 8%

Self-employed proprietor income

7% Employeecompensation

58%

Depreciation

12%

(a) Expenditure approach (b) Resource cost-income approach a

Source: http://www.economagic.com. a The net income of foreigners was negligible.

The relative sizes of the major components of GDP usually fluctuate within a fairly narrow range.

-5.8%2006

The Major Macroeconomic Issues National economies are becoming

increasingly interdependent: In 2004 the U.S.:

Exported 10.0% of all goods and services produced. (11.1% in 2006)

Imported 14.4% of the goods and services used by Americans. (16.9% in 2006)

In 2006, U.S. had a trade deficit of $762 Billion, or 5.8% of GDP

Wal-Mart alone imported $18B worth of goods from China alone in 2004

The Major Macroeconomic Issues The international flows create political

and economic issues:The impact of trade on jobs

The steel and textile industries Trade agreements (NAFTA)

Trade imbalances When exports and imports differ significantly Trade deficits or surpluses Money to pay for goods must come from

somewhere

Exports and Imports as a Share of U.S. Output, 1900-2004.

Macroeconomic Policy

Monetary Policy Determination of the nation’s money supply Controlled by the central bank or, in the U.S., the

Federal Reserve System (Fed)

Fiscal Policy Decisions that determine the government’s budget,

including the amount and composition of government expenditures and government revenues

Think of taxes like government income or revenue

Fiscal policy influences the balance between government spending and taxes: A budget deficit occurs when government spending

is greater than tax revenue. Government spending > Taxes (G>T)

A budget surplus occurs when government spending is less than tax revenue.

Government spending < Taxes (G<T) As deficits or surpluses add up, we get our National

Debt (or Surplus). The national debt is the source of the interest payments our

country makes Structural Policy

Government policies aimed at changing the underlying structure, or institutions, of the nation’s economy

Macroeconomic Policy

Government Expenditures as a percent of GDP (Federal Only)

Source: Congressional Budget Office

Federal Revenues, Outlays, Deficits, and Surpluses, 1950 to 2075

Source: Congressional Budget Office

Aggregation

The adding up of the individual economic variables to obtain economywide totals

Used to take a “bird’s-eye view” of the economy Aggregate measurements in dollar values allow

economists to compare broad categories of goods and services, such as exports and imports. Aggregation often obscures the fine detail of an economic

situation. “Fallacy of Composition” is the idea that something good

for an individual is therfore good for the whole. Keynes “Paradox of Thrift” shows that additional savings for one,

may be good for that person, however if EVERYONE decided to suddenly save more, demand would fall, and we may experience a recession.

Why study aggregate output?

The Great Depression as a case study In the U.S.:

Factories cut production 31% Number of people without jobs nearly tripled by

1933 when the unemployment rate hit 25% Stocks lost a third of their value in 3 weeks

The U.S. Unemployment Rate, 1900-2004

The unemployment rate: (UR = Unemployed/Labor Force)•% of the labor force that is out of workObservations:•Typically rises during recessions•Always greater than zero•Saratoga Springs 2007 UR is 3.30%•U.S. avg. UR is 4.60%

1933: Approximately 1 in 4 who wanted a job were NOT able to find one at ANY wage. Note that the minimum wage did not yet exist.

Output per Person and per Worker in the U.S. Economy, 1900-2004

In 2004:•Output/person was 8 times the 1900 level•Output/worker was 6 times the 1900 level

Output of the U.S. Economy, 1900-2004

In 2004 output of the U.S. economy was:•33 times the 1900 level•6 times the 1950 level

Why study aggregate output?

The Great Depression In Germany:

Nearly a third of all workers were without jobs Banking system collapsed Result of reparations from WWI a cause? Withdrawal of credit due to stock market collapse

to blame?

Why study aggregate output? The Great Depression

The response: Macroeconomic policies

Government and independent agency actions designed to affect the performance of the economy as a whole

Fiscal and Monetary PolicyBanking and stock market regulationEconomic StabilizersTransfer Programs

The Major Macroeconomic Issues

Standard of LivingThe degree to which people have access to

goods and services that make their lives easier, healthier, safer, and more enjoyable

This is the quantity of goods and services you consume over a certain period (like a year or a month)

The Major Macroeconomic Issues

Economic GrowthA process of steady increases in the quantity

and quality of the goods and services the economy can produce in a given period

Growth Positive or Negative Measures the change in the FLOW

The Major Macroeconomic Issues

In the U.S.:1.9 automobiles per U.S. household. In 2004, a typical U.S. resident consumed

over eight times the quantity of goods and services consumed in 1900.

In 1960, 8% of the adult population had a college degree compared to 25% in 2004.

Consumption Patterns around the World

The Major Macroeconomic Issues

Productivity In 2004 the average U.S. worker could

produce six times more than in 1900.Average labor productivity:

workeremployed per output employed people of Number

output Total

The Major Macroeconomic Issues

ProductivityU.S. trends in output per employed worker

1950 - 1973: increased 2.3%/yr 1973 - 1995: increased by only 1.1%/yr 1995 - present: increased by 2.1%/yr

The Major Macroeconomic Issues

Productivity and Living Standards in China and the United States2004 United States China

Output $11,375 billion $7,291 billion (U.S.)

Population 294 million 1,300 million

Employed 139 million 752 million

Output/person $39,915 $5,608

Average labor productivity $84,424 $9,695

Output of the U.S. Economy, 1900-2004

Expansions: periods of rapid economic growth•1945-’48; 1961-’69; 1975-’80; 1982-’90; 1991-2001

Recessions: slowdowns in economic growth•1930s (depression); 1941-’45; 1973-’75; 1981-’82; 1990-’91; 2001

Periods of negative growth typically coincide with recessions

Increases In Unemployment During Recessions

Unemployment rate at beginning of recession (%)

4.8 (Nov. 1973) 9.0 (May 1975) + 4.2

6.3 (Jan. 1980) 10.8 (Nov./Dec. 1982) + 4.5

5.5 (July 1990) 7.8 (June 1992) + 2.3

4.3 (March 2001) 6.3 (June 2003) +2.0

Peak unemployment

rate (%)

Increase in unemployment

rate (%)

The Major Macroeconomic Issues Unemployment rates differ from country

to country: For the past 20 years, about 10% of the European

workforce has been unemployed. European unemployment is double the rate in the

U.S. During the 1950s & ‘60s, the European

unemployment rate was generally lower than in the U.S.

The U.S. Inflation Rate,1900-2004

Inflation• The rate prices in general are increasing over time• Varies over time -- high in the ‘70s and low in the ‘90’s and today• Varies between countries -- in 2004 3% in U.S. & 400%/yr in Ukraine in

the 90’s

The Major Macroeconomic Issues The Major Economic Issues

Economic growth and living standardsProductivityRecessions and expansions (Business

Cycles)Unemployment InflationEconomic interdependence among nationsTrade and Fiscal Policy

Real and Nominal GDP

Real and Nominal GDP

The term "real" means adjusted for inflation. Price indexes are use to adjust income and

output data for the effects of inflation. A price index measures the cost of purchasing a

market basket (or “bundle”) of goods at a point in time relative to the cost of purchasing the same market basket during an earlier reference (or base) period.

Two Key Price Indexes:(1) Consumer Price Index (2) GDP Deflator

Two Key Price Indexes: Consumer Price Index (CPI):

measures the impact of price changes on the cost of a typical bundle of goods and services purchased by households.

GDP Deflator: designed to measure the change in the average price of the market basket of goods included in GDP.The GDP deflator is a broader price index than the

CPI. CPI typically thought to overstate inflation

YearCPI

(1982-84 = 100)

19931994199519961997199819992000

144.5148.2152.4156.9160.5163.0166.6172.2

3.02.62.83.02.31.52.23.4

2.32.12.01.91.71.11.42.2

GDP deflator (2000 = 100)

20022003

179.9184.0

1.62.3

1.71.8

104.1106.0

88.490.3

92.193.995.496.597.9

100.0

Inflation rate(percent)

Inflation rate (percent)

Source: http://www.economagic.com.

2001 177.1 2.8 2.4102.4

CPI and GDP Deflator: 1993-2003

Even though the CPI and the GDP deflator are based on different market baskets and procedures, they yield similar estimates of the rate of inflation.

Using the GDP Deflator to Derive Real GDP

Real GDP2 = Nominal GDP2 GDP Deflator1

GDP Deflator2

Using the GDP Deflator to Derive Real GDP

Data on both money GDP and price changes are essential for meaningful comparisons of output between two time periods.

The formula for converting nominal GDP into real GDP (in period 1 prices) is:

x

Source: http://www.economagic.com.

1998 2003 % increase

Nominal GDP(billions of U.S. $)

Real GDP(billions of 1998 $)

$8,747 $11,004 25.8%

Price index (GDP deflator, 2000 = 100)

96.5 106.0 9.8%

$8,747 $10,018 14.5%

Using the GDP Deflator to Derive Real GDP

Between 1998 and 2003, nominal GDP increased by 25.8%. But, when the 2003 GDP is deflated to account for price increases …

we can see that real GDP increased by only 14.5%.

2006, GDP Deflator is 116.6, thus, to compare 2003 GDP11004 * 116.6/106 = 12104.4. Thus 2006 GDP is 9% larger in real terms vs. 2003.

2006, GDP Deflator is 116.6, thus, to compare 2003 GDP11004 * 116.6/106 = 12104.4. Thus 2006 GDP is 9% larger in real terms vs. 2003.

Converting Earlier Figures into Current Dollars

Sometimes we will want to make real data (e.g. income) comparisons in terms of the purchasing power of the dollar during the current year.

This can be done by “inflating” the data for earlier years for increases in the price level.

The formula for converting the figures for an earlier year into current dollars is:

Figurecurrent $ = Figureearlier $ price indexcurrent year

price indexearlier year

If prices have risen, this will “inflate” the data for earlier years and bring it into line with the current purchasing power of the dollar.

x

Shortcomings of GDPas a Measuring Rod

Shortcomings of GDP: It does not count non-market production. It does not count the underground

economy. It makes no adjustment for leisure. It probably understates output increases

because of the problem of estimating improvements in the quality of products.

It does not adjust for harmful side effects.

Differences in GDP Over Time

Per capita GDP is GDP divided by population. As shown here, the real 2003 GDP per capita of the U.S.

was more than five times the figure for 1930. How meaningful are these figures?

$7,827

$13,840

$22,666

$6,418

$11,717

$18,391

$35,664

$28,429

1930 1950 1970 1990 2003

U.S. Per Capita GDP(in 2000 U.S. dollars)

1940 1960 1980

Source: derived from U.S. Department of Commerce data.

Per Capita GDP ComparisonsAcross Time Periods

As was shown in the previous exhibit, real U.S. per capita GDP has increased substantially over the past 70 years.

Compared to earlier periods, current GDP is probably biased upward because more output now takes place in the market sector and less in the household sector.

However, it is also probably biased downward because of failure to adjust for increased leisure, improvements in the work environment, and the introduction of improved products and new technologies.

The direction of the overall bias is uncertain.

The Great Contribution of GDP In spite of its shortcomings, the evidence

indicates that real GDP per person is a broad indicator of living standards. As real per capita GDP in the United States

has increased through time, the quality of most goods has increased while the amount of work time required for their purchase has declined.

Similarly, as real per capita GDP has risen in the United States and other countries, life expectancy and leisure time have gone up, while literacy and infant mortality rates have gone down.

The Great Contribution of GDP However, the “great contribution” of GDP

is its ability to measure short-term fluctuations in output. Year-to-year (and quarter-to-quarter) changes

in real GDP provide a reasonably precise measure of what is happening to the rate of output.