Measuring the Macroeconomy

Gross Domestic Product (GDP)

Measures

• What? Newly produced final goods and services.

• Where? Goods and services produced within the country’s borders.

• When? Within the specific period of time.

Remember GDP measures the value of all final goods and services produced in a country during a specific period of time.

Intermediate vs. final goods

Intermediate goods:

• Goods that are processed further before being sold to the consumer.

• Example: Chocolate

Final goods:

• The total product sold to the consumer.

• Example: The Hershey candy bar.

The chocolate that Hershey produces is not counted in the country’s GDP. It is an intermediate good. The chocolate is further processed and made into a Hershey candy bar, which is sold to the consumer and is counted in the country’s GDP.

Intermediate vs. final goodsContinued

Three Approaches to Measuring GDP

* Spending Approach

* Income Approach

* Production Approach

SPENDING APPROACH

The economy’s total spending is divided into four categories.

* Consumption (C)

* Investment (I)

* Government Purchases (G)

* Net Exports (X)

Consumption:The total of all final

goods and services purchased by individuals.

Consumption represents 68% of the U.S. GDP.

Investment:

The total of all final goods and services purchased by firms plus newly produced homes by households.

Investment represents 14.7% of the U. S. GDP.

Government Purchases:

The total of all final goods and services purchased by federal, state, and local governments.

Gov’t purchases

represents 18.6% of the U.S. GDP.

Net Exports:

The value of exports minus imports.

Net Exports is also called a trade balance.

Net Exports represent -1.3% of the U.S. GDP.

Exports:

The total value of the final goods and services that the domestic country sells to foreign countries.

Imports:

The total value of final goods and services that the domestic country purchases from foreign countries.

Net Exports = Exports - Imports

GDP Equation

GDP= C + I + G + X

Gross Domestic Product = Consumption + Investments + Government Purchases + (Exports - Imports)

INCOME APPROACH

The economy’s aggregate income is divided into five categories.

* Labor Income

* Capital Income

* Depreciation

* Indirect Business Taxes

*Net Income of Foreigners

Labor Income:

The total of all wages, salaries, and fringe benefits paid to workers.

Capital Income:The total of all profits, rental payments, and interest payments.

Depreciation:The value that an asset decreases over time.

Indirect Business Taxes:

Taxes that are placed on products when they are sold.

Net Income of Foreigners:

Income received by foreigners while producing in the domestic country, but the income is not included in labor or capital incomes.

Production

GDP = or = Income

Output

GDP = C + I + G + X = Y

PRODUCTION APPROACH

Measures the value added by each manufacturer to the final product.

Value added: the value of the firm’s production minus the value of the intermediate goods.

Households Businesses

Financial Intermediaries

Foreign Countries

Labor

Wages

Goods and Services

Purhcases of Goods and Services

Savings Investment

Net Exports

Payments for Net Exports

Government$$

Goods & Services

$$Goods

& Services

Circular Flow of Income and Expenditures

Households provide labor for business.

In return, Businesses provide wages for Households.

Businesses produce goods and services for Households to buy.

Households use part of their wages to purchase goods and services.

Households save part of their wages in financial institutions.

Financial institutions loan part of their funds to businesses for investments.

The Government provides services to both the household and the business sectors.

In return, households and businesses pay taxes to the Government.

Households provide labor resources to the Government, while Businesses provides goods and services to the Government.

In return, the Government provides wages to the Households and payments to the Businesses for the goods and services.

National Saving

Is the total aggregate income minus consumption minus government purchases.

Saving equation:

S = Y - C - G

Equation Manipulation:

If Y = C + I + G + X and

S = Y - C - G then

Y - C - G = I + X and

S = I + X

Therefore savings equals investment plus net exports.

What does this mean?

National Savings can be used to:

(a) invest into new factories, equipment, and housing or

(b) provide funds to foreigners equal the exports they purchase above what they import.

• Well, when more is saved than invested, then exports will exceed imports (net exports will be positive) and the country will experience a trade surplus.

• And, when less is saved than invested, then imports will exceed exports (net exports will be negative) and the country will experience a trade deficit.

So?

Remember the distinction between Real and Nominal GDP?

Real GDP has been adjusted for inflation.

Assume a three good world.

1995 1996 1997P Q Q QP PGood

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30 4000 25 8000 15 15000

20 5000 15 7000 15 9000

15 6000 12 5000 12 4000

With this information, we can now calculate nominal GDP.

To calculate each year’s nominal GDP, you must multiple each goods price times its respective quantity.

Then, you must add the totals for each good together. This sum represents the nominal GDP for the year.

Still using a three good world.

1995 1996 1997P Q Q QP PGood

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30 4000 25 8000 15 15000

20 5000 15 7000 15 9000

15 6000 12 5000 12 4000

Nominal GDP $ 310,000 $ 365,000 $ 408,000

Nominally, GDP rose by:

• 17.74% from 1995 to 1996

and

• 11.78% from 1996 to 1997

365/310=1.1774

408/365=1.1178

Remember when you divide the 1 represents 100 because you divided a smaller number into a larger number. You do not utilize the whole number 1 in your percentage in this calculation.

As you know, this increase is not a true representation of this examples output and GDP. An adjustment for inflation must be made.

Therefore, we will use 1995 as the base year to make the adjustment for inflation.

Using 1995 Prices

1995 1996 1997P Q Q QP PGood

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30 4000 30 8000 30 15000

20 5000 20 7000 20 9000

15 6000 15 5000 15 4000

Real GDP $ 310,000 $ 455,000 $ 690,000

Real GDP based on 1995 prices rose by:

• 46.77% from 1995 to 1996

and

• 51.65% from 1996 to 1997

or

• 122.58% from 1995 to 1997

455/310=1.4677

690/455=1.5165

690/310=2.2258

Now, use 1996 as the base year to make the adjustment for inflation.

1995 1996 1997P Q Q QP PGood

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25 4000 25 8000 25 15000

15 5000 15 7000 15 9000

12 6000 12 5000 12 4000

Real GDP $ 247,000 $ 365,000 $ 558,000

Using 1996 Prices

Real GDP based on 1996 prices rose by:

• 47.77% from 1995 to 1996

and

• 52.88% from 1996 to 1997

or

• 125.91% from 1995 to 1997

365/247=1.4777

558/365=1.5288

558/247=2.2591

In the textbook example, nominal GDP was greater than real GDP.

However, this example presented real GDP being greater than nominal

GDP.

WHY? What was the differnece in the two examples?

Prices made the difference.

In the textbook example, the prices were higher in the year 1998 than in the year 1997. This will make nominal GDP greater than real GDP (assuming total output increased).

In the presentation example, prices decreased over the three year period while output rose. Thiss will make the nominal GDP less than the real GDP.

GDP deflatorThe GDP deflator measures the level of prices of goods and services included in real GDP relative to a given base year.

Example: 1997 GDP deflator based on 1995 Prices.

Nominal GDP = $365,000

Real GDP = $455,000

GDP Deflator: 365,000/455,000 = .8022

Weaknesses of the GDP Measurement

• Revisions in GDP• Omissions from GDP

• Housework and upkeep• Preparing of your own tax returns• Leisure Activity• Underground economy

• Measures of Well-Being

• Quality of Life• Quality of the Environment

Complete the assignment for unit 2.

Then move on to unit 3. This ends the specific chapter presentations. You have the basics, now you will apply

them throughout the rest of the course.

Keep on Moving on