Gross Domestic Product

Introduction to Macroeconomics

Content
History of Macroeconomics
Measuring Size of Economy
Two Ways to Measure GDP
Other Income Accounts
Nominal versus Real
Problems with GDP

History of Macroeconomics
Classical Economists
Free markets always clear
Market prices adjust to always clear markets
Government has limited role in economy

Mints coins
Encourages commerce
Finance a military to protect the nation
Protect private property rights

History of Macroeconomics
Great Depression struck the world between 1929 and
1939
Unemployment rate peaked at 26% in the United States
Germany experienced hyperinflation and an unemployment rate
of 50%
Soviet Union isolated itself from the world and the Great
Depression

John Maynard Keynes - wrote The General Theory of

Employment, Interest and Money in 1936

History of Macroeconomics
Paradox of Thrift
A crisis strikes a society and businesses lay off some of their
workers
Workers become fearful and boost their savings
Society contracts furthers from the negative multiplier effect
They buy fewer cars, houses, clothes, etc.
Businesses experience declining sales and layoff more workers
Remaining workers save even more, and the cycle continues

History of Macroeconomics
Keynesian Economics
World leaders thought free markets and economics had failed
Leaders thought about converting economies to socialistic
systems
Irony - Keynes saved capitalism by writing his book
Government leaders can intervene in a market economy to keep the
economy growing
Government uses taxes and government spending to influence the
economy
Central bank uses the money supply and interest rates to influence the
economy

Measuring Size of Economy

National Income Accounting measure incomes for
whole economy
U.S. government measures economy's size
Similar to a business
Businesses compile a variety of financial statements to gauge
performance of the business
Balance sheet, cash flow statement, income statement, and changes in
owners equity

Measuring Size of Economy

Gross Domestic Product (GDP) total market value of all
goods and services produced in one year
An aggregate (whole country)
Monetary measure
U.S. is measured in dollars

Example:
2011 U.S. Economy produced
2 million pizzas
10 million sodas
15 million bread sticks

2012 U.S. Economy produced

1 million pizzas
12 million sodas
20 million bread sticks

Measuring Size of Economy

Which year did the U.S. produce more?
We cannot say
Pizza production went down, but breadsticks and soda
production went up

Multiply the production levels by its price

Converts all production to dollars
Then add the value of production to yield one measure

Measuring Size of Economy

2011 GDP
Item
Pizza
Soda
Breadsticks

Production
2 million
10 million
15 million

Price
$10
$1
$5
Total

Value
$20 million
$10 million
$75 million
$105 million

2012 GDP
Item
Pizza
Soda
Breadsticks

Production
1 million
12 million
20 million

Price
$10
$1
$5
Total

Value
$10 million
$12 million
$100 million
$122 million

Measuring Size of Economy

The value of production is higher in 2012
Prices did not change
United States produced more products

The economy is so large, we would like to avoid multiple

accounting
Economists include and exclude items from GDP

Gross Domestic Product (GDP) is the value of all currently produced

goods and services produced within the borders of an economy
sold on the market during a particular time interval.
GDP includes final goods
Final goods - have no further processing and ready to be sold to customers
Excludes items that are re-sold; thus they are counted once
Soviet Union production managers doubled and tripled counted in order to
meet production quotas as resources became scarce

Measuring Size of Economy

GDP excludes
Intermediate goods goods require further processing and
manufacturing
When a good is finished and sold to a customer, the price already contains the
value of production from intermediate processing
We want to avoid multiple accounting
Multiple counting - where the same object is counted more than once

Secondhand sales do not contribute to new production such as used

houses, cars, furniture, etc. We are just transferring assets and not
creating new ones
Remove financial transactions do not contribute to production
Public welfare payments
Private transfer payments inheritances, gifts, etc.
Stock market transactions selling and buying bonds and stocks is transferring
financial instruments; not creating new ones

Measuring Size of Economy

GDP includes production within the borders of an
economy
Does not distinguish between U.S. or foreign businesses
Japanese companies, Honda, Nissan, and Toyota produce within
the U.S.
Examples Sentra, Altima, Accord, CR-V, Acura RD-X, Camry, etc.

GDP is goods and services are valued at their market

prices
GDP excludes housework and volunteer work because
government cannot measure quantity and prices accurately

Measuring Size of Economy

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2013 Ranking of GDP per capita

Qatar
$103,900
Liechtenstein
$89,400
Bermuda
$86,000
Macau
$82,400
Luxembourg
$81,100
Monaco
$70,700
Singapore
$61,400
Jersey
$57,000
Norway
$55,900
Falkland Islands (Islas
Malvinas)
$55,400
Brunei
$55,300
Isle of Man
$53,800
Hong Kong
$52,300
United States
$50,700
United Arab Emirates
$49,800
Malaysia
$17,200

Two Ways to Measure GDP

1. Definitions
Expenditure Approach - we aggregate the value of all
goods and services that consumers and businesses buy
Income Approach - we aggregate all incomes that
were generated from production of goods and services
Circular Flow is simplified without government and
international sector

Two Ways to Measure GDP

Two Ways to Measure GDP

2. Expenditure Approach use the equation:
GDP = C + Ig + G + Xn
Consumption expenditures (C) consumers purchase nondurable goods,
durable goods, and services
Gross investment (Ig) includes

Investment in machinery, equipment, and tools

New construction in factories, warehouses, and retail space
New construction in private homes
Owners could rent house for income
Change in inventory
If inventory increases include in GDP because production had increased
If inventory decreases deduct from GDP because inventory was produced in previous years and avoid
double counting

Does not include financial instruments like stocks and bonds

Two Ways to Measure GDP

Investment decomposed into several types
Net investment removes the impact of depreciation
As capital is being used, it depreciates
Buildings get old
Tools wear out
Equipment breaks down and becomes old

Depreciation is the amount the capital degraded

Thus, businesses replace worn-out capital depreciation and invest
in new equipment
Gross investment includes all investment
Net investment is

Net investment = Ig depreciation

Two Ways to Measure GDP

Why this distinction?
If gross investment is growing at 5% per year and capital is depreciating at
6% per year, then net investment falls by 1%
Country is using up its stock of capital?

Government purchases (G) include all government purchases

Gov. buys goods and services
Gov. invests in schools, highways, airports, etc.
Includes all three levels: Federal, state, and local

Net Exports (Xn) is exports minus imports

Exports produced inside country and sold abroad
Imports produced outside the country and sold inside country
Net exports add directly to GDP
The net impact on production
If net exports > 0, net increase in production here in U.S.
If net exports < 0 , net decrease in production here in U.S.

Two Ways to Measure GDP

3. Income Approach - aggregate income from producing

goods and services
Employee Compensation - wages and salaries paid to
workers
Includes wages paid by businesses and government
Largest source

Interest - earnings
households save money in financial institutions; financial
institutions lend money to businesses for capital
In turn, businesses pay interest to the financial institutions and
financial institutions pay the savers for their investments
households earn interest from savings deposits, certificates of
deposits (CDs), and corporate bonds

Two Ways to Measure GDP

Profits
Proprietor's profits - as a proprietor earns profits, he can pay
himself some of the profits and invest the rest into more capital
for his business
Partnerships are similar; the profits is divided among partners as
income and the rest is invested back into capital for the business
Corporations - are more complicated
Corporations pay taxes on its income
Corporations divide their capital into two accounts
contributed capital - corporation directly sells stocks to investors
provides funding so corporation can acquire buildings, machines, and equipment

retained earnings - a corporation's profits (minus taxes) are placed in this account
if board of directors approve dividends, then dividends are paid from this account and
funds left over can be used to invest more into corporation

Two Ways to Measure GDP

Rents - income earned from renting or leasing property
Includes leasing office space and rent paid to landlords
Government looks at net rent
Net rent = gross rent - depreciation
gross rent is cash received for rental income
depreciation - rental property wears out and degrades over time

Taxes - increase the price of goods and services

if you bought a can of Pepsi for $1 and the store charges 6% sales tax, you pay a
total of $1.06
The $1 only includes income for producing that can of Pepsi, but $0.06 reflects the
tax and the higher price.
Add these taxes to the income accounts

sales taxes
excise taxes
business property taxes
license fees
customs duties

Two Ways to Measure GDP

Adjustments - several adjustments are made creating GDP
from national income accounts
Foreign income - GDP is production within the borders of the U.S.
Deduct foreign income earned by Americans
Add foreigners income that they earned within the United States

Depreciation - buildings, machines, and equipment depreciated over

time
Businesses can claim depreciation expenses on their income statements, thus
lowering their profits and income
Add depreciation expenses back in

Statistical discrepancy - the income approach and expenditure

approach are never equal, thus add a number to the national
income account, so it equals total expenditures
Income approach always yields a smaller estimate of GDP than the
expenditure approach

Other Income Accounts

1. Net Domestic Product (NDP) - remove the impact of depreciation of

capital
Determine how the economy is doing and growing, even though
businesses and government are replacing worn out equipment.
Example - GDP can be growing, but NDP could be falling
Economy is using up its capital stock and not replacing it
Hinders future growth in the economy

2. National Income - how much households are earning from

supplying resources like land, labor, capital, and entrepreneurs.
Aggregate all forms of income
salaries, wages, rent, interest, profits from all businesses, and taxes on
production
We can get National Income from adjusting GDP from expenditures or income
approaches

Other Income Accounts

3. Personal Income - includes all household income

Earned income - salaries, wages, interest, rent, and profits from all
businesses
Some taxes are not included

Unearned income - transfer payments

Social Security retirement plan for U.S. citizens

Unemployment insurance
Food stamps
Medicare medical care for the elderly
Medicaid medical care for the poor

4. Disposable Income (DI) - income households have remaining after

they pay their taxes
Households choose how much to consume (C) and save (S)
DI = C + S

Nominal versus Real

1. Definitions
Nominal GDP - has no adjustment for inflation
If nominal GDP increases:

Country could produce more goods and services

And/or inflation raises all prices, increasing GDP
Note GDP could decrease by decreasing production and/or deflation
Deflation - prices in the economy on average decrease
Occurred in the United States when country was on the gold standard

Real GDP - removes the effect of inflation

If real GDP increases, economy has produced more goods and services
Example - Shows the calculation of GDP for an economy with 3 products
Pizza
Breadsticks
Sodas

Nominal versus Real

Nominal versus Real

Nominal GDP increases but economy does not expand production

2. How is inflation measured?

Inflation - continuously rise in prices over time
Measured as a percentage

Economists create a basket of goods

Basket contains goods like bread, milk, and many other products and services
Consumer Price Index (CPI)
Includes thousands of consumer products
Products are grouped into 224 categories

Producer Price Index (PPI)

Similar to CPI but a price index for producers

GDP Deflator
Index of all prices for final goods and services
The actual price index to deflate nominal GDP

Nominal versus Real

Economists chose one year to be the base year
Each year, economists calculate the average price of each
good in the basket
price index - the average price for the basket
It is not a simple average
Notice - pizzas, sodas, and breadsticks are produced in different
levels

Calculating the price index

Nominal versus Real

3. Calculate a price level
I define my base year,
which is 1980
I define my basket of
goods

1980 Items
Cookies
Sugar
Coffee
Unleaded
Gasoline
Basket Value

Units
20
pounds
10
pounds
10
pounds
30
gallons

Prices
$1.49
$0.27
$3.21
$1.13
$98.56

Nominal versus Real

I change the prices in the
basket but keep the
original quantities for
every year
I calculate the CPI for
2013

2013 Items

Units

Prices

Cookies

20 pounds

$3.73

Sugar

10 pounds

$0.68

Coffee

10 pounds

$5.90

Unleaded
Gasoline

30 gallons

$3.35

Basket
Value

$240.94

Nominal versus Real

I defined 1980 as my base year, so CPI1980 = 1

CPI2013 = 240.94 98.56 = 2.44

Workers earned average wages of $12,513 in 1980

Workers earned average wages of $43,000 in 2013.

Convert wages into real
1980, average real wage was $12,513
2013, average real wage was $43,000 / 2.44 = $17,662.95

Nominal versus Real

Problems of CPI
CPI is biased for residents living in large cities
City residents pay greater prices

Products' quality changes over time

In 1980, most people drove cars and trucks that used leaded gasoline
Gov. phased out leaded gasoline

CPI includes prices of medical services

Medical service prices have soared in the United States
U.S. residents with few medical problems experience less inflation

Prices for electronics are falling so young people experiences

less inflation

Nominal versus Real

4. GDP Deflator:
If prices for the base year
are 2,000 while the prices
for Year t is 3,000, then
the price index is 1.50
Calculating real GDP is
simple, use the formula:

Nominal versus Real

Using the same price index
If nominal GDP in Year t is $14 trillion, then take nominal GDP
and divide by the price index of 1.5, which yields $9.333 trillion.

Calculating inflation - take two price indices that are

adjacent to each other in time and calculate the
percentage change.
For example, in 2011 the price index is 1.78 and in 2012 it is
1.90, then the inflation rate is:

Nominal versus Real

Nominal versus Real

2009 is the base year.
Real and nominal GDP are equal.
Also nominal GDP is lower than real before 2000 and
higher after 2000.

Problems with GDP

GDP is not a perfect measure of economic well-being
Problems with GDP
GDP does not include volunteer work and housework
GDP does not include leisure
During 1900s, Americans worked 53 hours per week
Currently Americans work 40 hours per week
Under President Obama's Healthcare Law, employers may work their employees
less than 30 hours per week to avoid paying health insurance

Does not include quality improvements

All electronic devices are better than predecessors
T.V. Now they are digital; during 1950s, TVs used vacuum tubes
Cell phones Small and have many features; during 1980s they were big as a tool
box

Problems with GDP

GDP does not include underground economy
Also called hidden economy or black markets
Markets for illegal products and services
Hide income from tax authorities
Avoid regulations and price controls
Declining civic loyalty to government

Economists estimated size of underground economy

Economists are guessing (estimating)

Problems with GDP

Estimated Size of Underground Economy
Country
% of Real GDP % of Real GDP
1999
2007
China
13.2
11.9
Hong Kong
17
16
Japan
11.4
11
Nigeria
58
53
Malaysia
32.2
29.6
Mexico
30.8
28.8
Russia
47
40.6
United States
8.8
8.4

Problems with GDP

Source: Schneider, Friedrich and Collin C. Williams. 2013.
"The Shadow Economy." The Institute of Economic Affairs.
Available at http://www.iea.org.uk/publications/research/theshadow-economy (accessed on 10/29/2013).

Note - Participants in the underground economy are not

honest about their activities.
Furthermore, some activities may be crimes in one country
but not another. Hong Kong is lax on copyright laws.

Problems with GDP

GDP does not contain changes in the:

Environment
Noise
Congestion
Waste
Example - Asian countries like China and Kazakhstan are lax on
environmental laws

GDP does not specify who earns the income

Example - what if a countrys leader get 99% of the GDP while
everyone else gets the 1%

Problems with GDP

The government publishes statistics
The top leaders in the federal government are elected
May be some biases to appease the public and voters
Example - U.S. government published the Gross National Product
(GNP), which is a slightly different definition
GDP had a better growth rate than GNP and the federal government
dropped the GNP series in the early 1990s.
Not the first the federal government did this