measuring a nation’s income: nominal vs. real gdp, applications and implications introduction to...

Measuring a Nation’s Income:Measuring a Nation’s Income:Nominal vs. Real GDP, Nominal vs. Real GDP,

Applications and Implications Applications and Implications

Introduction to Political Economy: Introduction to Political Economy: MacroeconomicsMacroeconomicsWashington University – St. LouisWashington University – St. Louis

Mark VaughanMark VaughanFall 2008Fall 2008

2 - 38Updated: 11/16/200811/16/2008

Vaughan – 104 / Fall 2008Measuring National IncomeMeasuring National Income

Lecture OutlineLecture Outline

• Transition from micro to macro economics

• Define gross domestic product (GDP)

• Differentiate real and nominal GDP

• Break GDP into component parts

• Outline stylized GDP facts

• Evaluate GDP as measure of well-being

• Use GDP data to prediction elections

• Examine misuse of income statistics

3 - 38Updated: 11/16/200811/16/2008


From Micro to MacroeconomicsFrom Micro to Macroeconomics

Goals in Part II of Course:• Master basic “stylized facts” of macroeconomics.

• Build simple models to account for these facts.

• Develop a framework for assessing macroeconomic policy interventions. Identity key institutional features for explaining facts and

assessing policy.

4 - 38Updated: 11/16/200811/16/2008


Gross Domestic Product (GDP)Gross Domestic Product (GDP)

• Definition: Total market value of all final goods and services produced within a country in a given period of time.

• Valuable as tool for measuring long-run economic growth and short-run economic fluctuations.

• Measures income and expenditures in the economy. GDP can be measured by summing income received or

expenditures on goods/services.

5 - 38Updated: 11/16/200811/16/2008


The Circular-Flow DiagramThe Circular-Flow Diagram

Spending

Goods andservicesbought

Revenue

Goodsand servicessold

Labor, land,and capital

Income

= Flow of inputs and outputs

= Flow of dollars

Factors ofproduction

Wages, rent,and profit

FIRMS•Produce and sellgoods and services

•Hire and use factorsof production

•Buy and consumegoods and services

•Own and sell factorsof production

HOUSEHOLDS

•Households sell•Firms buy

MARKETSFOR

FACTORS OF PRODUCTION

•Firms sell•Households buy

MARKETSFOR

GOODS AND SERVICES

For the economy as a whole, income

must equal expenditure!

6 - 38Updated: 11/16/200811/16/2008


What is GDP?What is GDP?

Gross domestic product is:

• “the market value . . .” Output is valued at market prices.

• “of all. . .” GDP includes all items produced / sold legally in markets.

Anomaly: Legalize marijuana and GDP rises. Sometimes values are imputed:

Rental housing counted. Rental values for owner-occupied housing imputed.

GDP does not count non-market transactions Restaurant meals – YES! Value-added by home-cooked meals – NO! Anomaly: Marry your cook and GDP falls.

7 - 38Updated: 11/16/200811/16/2008



Gross domestic product is the market value of all…

• “final . . .” GDP excludes intermediate goods to avoid double counting.

Inventory investment only exception.

• “goods and services . . .” GDP includes both tangible goods (food, clothing, cars) and

intangible services (haircuts, housecleaning, doctor visits).

8 - 38Updated: 11/16/200811/16/2008



Gross domestic product is the market value of all final goods and services:

• “produced . . .” GDP does not include goods produced in the past.

Example: Valued-added by used-car salesman – YES! Value of used car – NO!

• “within a country . . .” GDP measures production taking place inside border of a nation.

Example:

Wash U. student from PRC shelving books in Olin Library on work-study program – Counted in U.S. GDP!

9 - 38Updated: 11/16/200811/16/2008



Gross domestic product is the market value of all final goods and services produced within a country…

• “in a given period of time.” GDP measures production taking place during a given interval,

generally a quarter or year.

Quarterly GDP is generally adjusted in two ways (SAAR): Annualized (multiplied by 4)

Seasonally adjusted

10 - 38Updated: 11/16/200811/16/2008


Real vs. Nominal GDPReal vs. Nominal GDP

Nominal GDP values production of goods and services at current prices.

Nominal GDP can rise because physical output of goods/ services rises (c.p.), prices of goods/services rise (c.p.), or both.

To gauge growth of physical output (and incomes derived from), prices must be “deflated.”

SOLUTION: Real GDP!

11 - 38Updated: 11/16/200811/16/2008



Real GDP values production of goods and services at constant prices.

Conceptual Experiment: Values GDP in any given year at prices obtaining in some base year. Changes in GDP then represent changes in physical production only.

12 - 38Updated: 11/16/200811/16/2008



Example:

Note: Between 2005 and 2007, •Price of hot dogs triples and price of hamburgers doubles.•Production of hot dogs doubles and production of hamburgers triples.

13 - 38Updated: 11/16/200811/16/2008



Note:•Nominal GDP values current production at current prices.•Nominal GDP rises six-fold between 2005 and 2007.

Example:

14 - 38Updated: 11/16/200811/16/2008



Example:

Note:•Real GDP values current production at constant prices.•Real GDP rises 2.5 times between 2005 and 2007.

15 - 38Updated: 11/16/200811/16/2008


What if quantities are not observable? What if quantities are not observable?

Use GDP deflator to “deflate” nominal GDP(i.e., revalue in prices obtaining in base year).

Notes on GDP Deflator: Value of GDP deflator is 100 for base year. “General price level” is another name for GDP deflator. Percentage change in GDP deflator is a measure of inflation.

Formally, GDP Deflator = (Nominal GDP / Real GDP) x 100

16 - 38Updated: 11/16/200811/16/2008



Example:

Note:•General price level rises 71% from 2005 to 2006. •General price level rises 40.4% from 2006 to 2007.

17 - 38Updated: 11/16/200811/16/2008


Real vs. Nominal GDPReal vs. Nominal GDPHow to “DeflateHow to “Deflate””

GDP deflator formula can be manipulated to express nominal GDP in base-year prices:

If… GDP Deflator = (Nominal GDP / Real GDP) x 100,

Then… Real GDP = Nominal GDP / [GDP Deflator / 100]

18 - 38Updated: 11/16/200811/16/2008


Real vs. Nominal GDPReal vs. Nominal GDPExample of “Deflating”Example of “Deflating”

Example: Mankiw, “Problems/Applications,” p. 222, #5

a. Growth of nominal GDP, 1999-2000?

($9,873 – $9,269) / $9,269 = 6.5%

b. Growth of GDP deflator, 1999-2000?

(118 -113) / 113 = 4.4%

c. What was real GDP in 1999, measured in 1996 prices?

$9,269 / [113 / 100] = $8,203

d. What was real GDP in 2000, measured in 1996 prices?

$9,873 / [118 / 100] = $8,367

e. What was real GDP growth, 1999-2000?

($8,367 - $8,203) / $8,203 = 2.0%

f. Was the growth rate of nominal GDP higher or lower than the growth rate of real GDP? Explain.

Higher, b/c prices rose as well as physical output.

YearNominal

GDP($ billions)

GDP Deflator

(100 = 1996)

2000 $9,873 118

1999 $9,269 113

19 - 38Updated: 11/16/200811/16/2008


GDP ComponentsGDP Components

GDP (Y) is the sum of the following:Consumption (C) Investment (I) Government Purchases (G) Net Exports (NX)

Y = C + I + G + NXY = C + I + G + NX

Note: Equation is an identity.

20 - 38Updated: 11/16/200811/16/2008


GDP Components (2007)GDP Components (2007)

Consumption (C) 70.3%

Government Purchases (G)19.5%

Net Exports (NX) -5.1%

Investment (I)15.4%

GDP = $13,807.5

C = $9,710.2

I = $2,130.4

G = $2,674.8

NX = $707.8

Billions of 2007 Dollars

21 - 38Updated: 11/16/200811/16/2008


GDP Components:GDP Components:Consumption (C)Consumption (C)

• Spending by households: Consumer durables (examples: cars, appliances) Consumer non-durables (examples: food, clothing) Services (examples: haircuts, medical care)

• Stable component Fluctuates less than GDP

22 - 38Updated: 11/16/200811/16/2008


GDP Components:GDP Components:Investment (I)Investment (I)

• Spending by firms on: Capital equipment (example: new computers) Structures (example: new plants)

Note: Spending on capital equipment and structures equals fixed private investment.

Inventories

• Spending by households on: Residential housing

• Volatile component Fluctuates far more than GDP

23 - 38Updated: 11/16/200811/16/2008


GDP ComponentsGDP Components(G, NX)(G, NX)

• Government Purchases (G): Spending on goods/services by local, state, and

federal governments. Does not include transfer payments.

• Net Exports (NX): Exports minus imports Imports subtracted to avoid double counting

(already included in other GDP components)

24 - 38Updated: 11/16/200811/16/2008


Stylized Facts: Stylized Facts: Real GDP in the United StatesReal GDP in the United States

Rule of 70=(70/growth rate)=Years to Double=70/3.26=21.5 Rule of 70=(70/growth rate)=Years to Double=70/3.26=21.5

25 - 38Updated: 11/16/200811/16/2008


What is a recession?What is a recession?

• DefinitionDefinition:: General period of macroeconomic decline, characterized by falling production, employment and income.

• Rule of Thumb:Rule of Thumb: Two consecutive quarters of declining real GDP (i.e., negative real GDP growth).

• Determining Body:Determining Body: Business Cycle Dating Committee of the National Bureau of Economic Research (NBER)

ContractionContraction (recession): period from business-cycle peak to trough

Expansion:Expansion: period from business-cycle trough to peak

26 - 38Updated: 11/16/200811/16/2008


What is a recession?What is a recession?

Business Cycle DatingBusiness Cycle Dating::

NBER Business Cycle Dating Committee (BCDC) considers real GDP the single best measure of aggregate economic activity.

Because real GDP is reported quarterly, the BCDC also looks at key monthly series when calling peaks and troughs.

1. Personal income less transfer payments, in real terms

2. Employment

3. Industrial production

4. Sales volume in manufacturing & wholesale-retail sectors, adjusted for price changes.

Sometimes NBER calls a recession using (1)-(4) even though “2-quarter rule” does not hold.

27 - 38Updated: 11/16/200811/16/2008


Stylized Facts: Stylized Facts: Per Capita Real GDP in the United StatesPer Capita Real GDP in the United States

28 - 38Updated: 11/16/200811/16/2008


Stylized Facts: Stylized Facts: Investment more Volatile than ConsumptionInvestment more Volatile than Consumption

29 - 38Updated: 11/16/200811/16/2008


How Good is GDP?How Good is GDP?

• GDP is best measure of societal economic well-being.

• GDP per capita is best measure of income / expenditureof average person. Higher GDP per person implies higher living standard (c.p.) Stylized facts:

U.S. real GDP per capita, 2008:Q3 (2000 $) == $38,387$38,387 U.S. real GDP per capita growth, 1870-2003 = = 1.82%1.82% U.S. real GDP per capita growth, 1959:Q1-2008:Q3 = = 2.11%2.11%

30 - 38Updated: 11/16/200811/16/2008


How Good is GDP?How Good is GDP?

GDP is not perfect measure of happiness/quality of life.

Not captured: Value of leisure Value of a clean environment Value of most activity taking place outside of markets

Example: Value of time spent with children Value of volunteer work

Maldistribution of income

Potential BiasBeware careful with cross-country comparisons. Differences in extent of legal

markets can affect real per capita GDP.

31 - 38Updated: 11/16/200811/16/2008


GDP and Quality of LifeGDP and Quality of Life

12 of the world’s most populous countries, ranked by real GDP per personNote: Positive correlation between per capita real GDP and various quality of life

measures.

Source: Human Development Report 2004, U.N.

32 - 38Updated: 11/16/200811/16/2008


Ray Fair (Yale) – built most well-respected econometric forecasting model for predicting popular vote shares in presidential elections.

Fair (1978): Model predicting presidential elections, based on 1916-76 sample.

Model updated every four years (only one substantive revision – post 1992)

2008 equation is:

FORECAST VARIABLE VOTEP: Republican share of two-party presidential vote in 2008

EXPLANATORY VARIABLES GROWTH: Growth rate of real per capita GDP in first 3 quarters of 2008 (annual rate)

INFLATION: Growth rate of GDP deflator in first 15 quarters of 2nd Bush term[i.e., 2005:1-2008:3 (seasonally adjusted, annual rate)]

GOODNEWS: Number of quarters in first 15 quarters of 2nd Bush term in which real per capita GDP growth > 3.2 percent (annual rate)

CONTROLS: Party occupying White House, Incumbent running for re-election, Duration of incumbent party occupancy of White House, and “War” Elections

Forecasting Elections:Forecasting Elections:An Econometric ApproachAn Econometric Approach

33 - 38Updated: 11/16/200811/16/2008


VOTEP = 46.61 + 0.680*GROWTH - 0.657*INFLATION + 1.075*GOODNEWS

EXPLANATORY VARIABLES • CONTROLS: Captured by constant term

• GROWTH: Growth of real GDP per capita, 2008:Q1-2008:Q3 = 0.22%0.22%

• INFLATION: Growth rate of GDP deflator, 2008:Q1-2008:Q3 = 2.88%2.88%

• GOODNEWS: # of quarters, 2005:q1-2008:q3, growth of real GDP per capita> 3.2% (annual rate) = 3 3

FORECAST VARIABLE

• VOTEP: Republican share of 2008 two-party vote = 48.09% McCain (51.91% Obama)48.09% McCain (51.91% Obama)

Results: •McCain’s prospects do not look good (spread = 3.82 percentage points)•Republican share of two-party House vote even worse (44.24%, spread = 11.52 percentage points)

Irony:•Presidents do not have much impact on the economy in the short run.

Forecasting Elections:Forecasting Elections:An Econometric ApproachAn Econometric Approach

34 - 38Updated: 11/16/200811/16/2008


Presidential Economics:Presidential Economics:Economic Performance by PartyEconomic Performance by Party

Since 1961, under Democratic Administrations:

• Real GDP growth has been faster.

• Employment growth has been faster.

• Inflation has been lower.

• The DJIA has risen faster.

SourceSource: www.currencythoughts.com, August 19, 2008

Interpretation: Causation or correlation?

35 - 38Updated: 11/16/200811/16/2008


Misuse of Income StatisticsMisuse of Income Statistics

FallacyFallacy::

Except for rich, U.S. incomes have stagnated

FactFact:: Growth of U.S. real GDP per capita 1959:Q1-2008:Q3 (2.11%)(2.11%) above 1870-2003 average (1.82%)(1.82%)

36 - 38Updated: 11/16/200811/16/2008



FallacyFallacy::

Except for rich, U.S. incomes have stagnated

Reasons for Specious AnalysisReasons for Specious Analysis:: • Focus on wage growth – increasing % of working income from fringe benefits

• Focus on household income – more year-round full-time workers in upper 20% households than lower %; rising living standards lead to more upper 20% households

• Focus on incomes rather than wealth – many low income people are not poor

• Focus on income “snapshot” rather than income migration – people in upper/lower quintiles do not stay put

• Focus on earnings rather than “all in” income – rich pay taxes / poor receive transfers

37 - 38Updated: 11/16/200811/16/2008


Misuse of Income StatisticsMisuse of Income StatisticsFallacyFallacy:: Corporate CEOs are overpaid at the expense of stockholders/consumers

FactFact:: • Professional athletes / movie stars earn as much.

• “Greed” only works if someone gives in. No evidence corporate boards of directors captured by senior management.

Economic Justification for High SalariesEconomic Justification for High Salaries::• Small set of people with requisite skills.

• Value created (destroyed) by good (bad) decisions immense. Lehman Bros. had assets of $639 billion at bankruptcy (1% = $6.39 billion)

• Golden parachutes needed to boot failed executives.

• Caps ineffective – lead to payment in benefits / perks.

38 - 38Updated: 11/16/200811/16/2008



FallacyFallacy:: Corporate CEOs are overpaid at the expense of stockholders/consumers

Caution about Caps on Wall Street SalariesCaution about Caps on Wall Street Salaries::• Just discovered job is harder than expected.

• Politics will make it harder still.

• Good idea to weaken incentive to work in financial services?

Measuring a Nation’s Income:Measuring a Nation’s Income:Nominal vs. Real GDP, Nominal vs. Real GDP,

Applications and Implications? Applications and Implications?

Introduction to Political Economy: Introduction to Political Economy: MacroeconomicsMacroeconomicsWashington University – St. LouisWashington University – St. Louis

Mark VaughanMark VaughanFall 2008Fall 2008

Questions over:Questions over:

measuring a nation’s income: nominal vs. real gdp, applications and implications introduction to...

Documents

real gdp

nominal gdp break gdp

gdp falls

stylized gdp facts

capital income

nations income

measures income

final goods