chapter 5 gdp and the measurement of progress

Modern Principles: Macroeconomics

Tyler Cowen

and Alex Tabarrok

Copyright © 2010 Worth Publishers • Modern Principles: Macroeconomics • Cowen/Tabbarrok

Chapter 5

GDP and the Measurement of

Progress

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• A visitor to India today will be struck by the dramatic difference in living standards. 80% of the population live on less than $2 a day. Over 100 million Indians live at an American or

European standard of living. The latter is a relatively recent change.

• GDP and GDP per capita are measures used to reflect changes and differences in standards of living.

• The following figure and table show how GDP is used to measure growth and differences between countries.

Introduction

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Introduction

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Introduction• What Will We Learn in This Chapter?

What the GDP statistic means and how it is measured.

The difference between the level of GDP and the growth rate of GDP.

The difference between nominal GDP and real GDP.

How growth in per capita real GDP is a standard measure of economic progress.

The use of GDP in business cycle measurement. Problems with GDP as a measure of output and

welfare.

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What is GDP?• Gross domestic product (GDP)— the

market value of all final goods and services produced within a country in a year.

• GDP per capita is GDP divided by a country’s population.

• Let’s look more closely at the definition of GDP.

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What is GDP?

• GDP is the Market Value… Two problems:

• How do you add up different goods and services and get a number that makes sense?

• Some goods are more important than others; e.g., producing two houses is more important than producing two packs of gum.

Solution: Multiply the quantities of final goods and services by their market prices and add up these values.

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What is GDP?

• GDP is the Market Value…(cont.) Let’s use an example to illustrate our point:

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What is GDP?• …Of All Final…

Intermediate goods are sold to firms and then bundled or processed with other goods or services for sale at a later stage.

Final goods are the finished goods sold to final users and then consumed or held in personal inventories.

To avoid double-counting, only final goods are included in GDP.

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What is GDP?• …Goods and Services…

Goods are tangible. i.e., cars, food, clothes.

Services are intangible. Transportation, haircuts, medical care.

Both are included in GDP Since 1950 the portion of U.S. GDP created

by the production of services has doubled from 21% to 42%.

We see this in the next figure.

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What is GDP?

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What is GDP?• …Produced…

GDP measures production. Sale of used goods are NOT included. The sale of financial assets such as stocks

and bonds are not included. The services of realtors, stock brokers, used

car salesmen ARE included because their services represent current economic activity.

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What is GDP?• …Within a Country…

Only production that takes place within the borders of a country is included in GDP.

Examples:• Cars produced in Mexico by American firms

are NOT included.• Cars produced in the U.S. by Japanese firms

ARE included. GNP (Gross National Product) The value of

goods and services produced by U.S. residents no matter where they live.

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What is GDP?• …in a year.

GDP is a flow:• it measures a rate of production during

a given time period In contrast to a nation’s wealth:

• the value of a nation’s assets at a point in time

• has no time dimension

CHECK YOURSELF

Slide15 of 50

The Interstate Bakeries Corporation buys wheat flour to make into Wonder Bread. Does the purchase of wheat flour add to GDP?On eBay you sell your collection of Pokemon cards. Does your sale add to GDP? An immigrant from Colombia works as a cook in a New York restaurant. Is the money he earns considered part of the GDP of the U.S. or Colombia?

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Growth Rates• The growth rate of GDP tells us how

rapidly the country’s production is rising or falling over time.

2005for rate growth GDP100GDP

GDPGDP

2004

20042005

%34.6100712,11$

712,11$455,12$

Example: Using actual data (numbers are in billions)

CHECK YOURSELF

Slide17 of 50

If GDP in 1990 was $5,803 billionand GDP in 1991 was$5,995 billion, what was thegrowth rate of (nominal) GDP?

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Nominal vs. Real GDP• Definitions

Nominal variables, such as nominal GDP, have not been adjusted for changes in prices.

Real variables, such as real GDP, have been adjusted for changes in prices.

• Economists usually are more interested in real GDP because increases in real GDP reflect increases in the standard of living.

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Nominal vs. Real GDP• Importance of distinguishing between

nominal and real GDP

Given the following calculations for nominal GDP:

%6.67

1004.7

4.74.12GDP nominal ofGrowth 2005-1995

trillion$7.4Quantities 1995Prices 9951Dollars 19955in GDP 1995

trillion$12.4Quantities 2005 Prices 2005Dollars 2005in GDP 2005

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Nominal vs. Real GDP• Problem: The growth of nominal GDP between

1995 and 2005 includes price increases as well as increases in output.

• Solution: calculate GDP in each year using the same year’s prices.

• This eliminates the effect of price changes on GDP.

trillion$9.0Quantities 1995Prices 2005Dollars 2005in GDP 1995

trillion$12.4Quantities 2005 Prices 2005Dollars 2005in GDP 2005

%8.371000.9

0.94.12GDP real of rateGrowth 2005-1995

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Nominal vs. Real GDP• Real GDP Growth

Most economists would choose real GDP growth as the best single indicator of economic performance.

Media usually report growth in nominal GDP.

If we want to compare GDP over time, we should always compare real GDP.• It doesn’t matter which year’s prices we use

to calculate real GDP.

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Nominal vs. Real GDP

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Nominal vs. Real GDP• Real Growth per Capita

Best reflection of changing living standards. Per capita real GDP is real GDP divided by

the population. Growth of per capita real GDP = growth of

real GDP minus growth of the population. Example: If growth of per capita real GDP =

3% and the population growth rate = 2%, then growth of per capita real GDP = 3% – 2% = 1%.

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Nominal vs. Real GDP• Real Growth per Capita (cont.)

The Extremes:1. Taiwan had the highest growth rate = 6% per year.2. Nigeria even though a member of OPEC had close to negative growth.

CHECK YOURSELF

Slide25 of 50

Name a country with a low GDP but a high GDP per capita.Name a country with a high GDP but a low GDP per capita.Why do we often convert nominal variables into real variables?

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Cyclical and Short-Run Changes in GDP• Recessions

National Bureau of Economic Research (NBER)• Research organization based in Cambridge,

Massachusetts.• Most authoritative source of identifying

recessions. Official definition – “…a significant, widespread

decline in economic activity spread across the economy, lasting for more than a few months, normally visible [as a decline] in real GDP, real income, employment, industrial production, and wholesale-retail sales.”

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Cyclical and Short-Run Changes in GDP

• Recessions (cont.)

How often do recessions occur?• There have been 11 recessions since

1948.

• There have been 3 recessions since 1990 (including the recession beginning in Dec. 2007)

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Cyclical and Short-Run Changes in GDP

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Cyclical and Short-Run Changes in GDP• Recessions (cont.)

Defining when a recession begins and ends is not always easy.• Quarterly data are not available until almost a

month after the quarter is over.• The government often makes significant

changes in the GDP estimates between the initial and final estimates.

• Updates can even occur years after the first estimates are released.

• It is normal for real GDP to fluctuate around its long-term trend or “normal” growth rate (business fluctuations).

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Cyclical and Short-Run Changes in GDP• Recessions (cont.)

Example: Dating the 2001 recession• Official NBER starting date is March 2001.• Data revisions have led many analysts to

conclude that the recession began late 2000. Who cares?

• U.S. Presidency changed at the beginning of 2001. Democrats: Recession was a result of the

new administration policies. Republicans: Recession began during

President Clinton’s term.

CHECK YOURSELF

Slide31 of 50

What are business fluctuations?Why is it sometimes difficult to determine if an economy is in a recession?

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The Many Ways of Splitting GDP• Another way to understand GDP is to study

its components and how they fit together. There are two common ways of splitting GDP

1. National spending approach:

Y = C + I + G + NX

2. Factor income approach:

Y = Wages + Rent + Interest + Profit

Both approaches are useful for understanding business cycles and economic growth.

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The Many Ways of Splitting GDP• The National Spending Approach

We begin with the national spending identity:• Y = C + I + G + NX

Y = Nominal GDP C = The market value of consumption goods

and services I = The market value of investment goods G = The market value of government

purchases NX = Net exports (market value of exports

minus market value of imports) Let’s look at each of the components in turn.

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The Many Ways of Splitting GDP• The National Spending Approach (cont.)

Consumption spending (C) • Private (household) spending on goods and

services. Investment spending (I)

• Private spending on tools, plant, and equipment used to produce future output.

Government spending (G)• Spending by all levels of government on final

goods and services Note: this does NOT include government

transfers.

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The Many Ways of Splitting GDP• The National Spending Approach (cont.)

Net exports (NX)• The value of exports minus the value of

imports Exports: Market value of goods and

services sold to residents of other countries.

Imports: Market value of goods and services purchased by U.S. residents from other nations.

The next figure shows the composition of U.S. GDP for 2007.

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The Many Ways of Splitting GDP

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The Many Ways of Splitting GDP• The Factor Income Approach: The Other

Side of the Expenditure Coin When money is spent, it ends up as someone’s

income. Adding up the types of income will result in the

value of total spending, or, GDP.

Y = Wages + Rent + Interest + Profit Caveat: Not every dollar that is spent is income

because of such factors as sales taxes.• Adjustments must be made to get the two

approaches to “balance”.

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The Many Ways of Splitting GDP• Why Split GDP?

Both ways throw a different light on the economy.

• The different components of spending behave differently over time and it is important to understand why.

• The factor income approach is useful in determining the relative size and growth of the income shares.

The two approaches provide a check for errors.

CHECK YOURSELF

Slide39 of 50

Which is the largest of the national expenditure components: C, I, G, or NX?Which is more stable, consumption spending or investment spending?Why does the income approach to GDP give the same answer (in theory!) as the expenditure approach? (In practice, the answers are close but differ due to accounting errors and data omissions.)

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Problems with GDP as a Measure of Output and Welfare

• There are many goods and services for which we do not know the market value. GDP does NOT count the underground

economy• Illegal activity• Off-the-books activity

GDP does NOT count nonmarket production• Occurs when goods and services are produced

but no explicit payment is made. Example: Work done in the home by

household members.

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• Results in two biases in GDP statistics:1. Biases over time

• Example: women in the labor force has almost doubled since 1950

When they were at home, unpaid work was not counted

Now much of the same work is paid for and therefore counted (e.g., use of paid nannies and housekeepers)

• Result: the growth of GDP between 1950 and now is exaggerated.

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• Results in two biases in GDP statistics (cont.):

2. Biases across nations

• Example: nonmarket activity is more prevalent in less developed countries

Implication: the differences in GDP between developed and less developed countries are exaggerated.

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• We do not know the market value of many goods and services GDP does not count leisure.

• People value leisure.• In the U.S. the average workweek has fallen.

This growth in leisure is not counted in GDP.

• The workweek is longer in poor countries. Implication: The gap in GDP between rich

and poor countries is understated to the extent of differences in leisure.

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• We do not know the market value of many goods and services (cont.) GDP does not count “bads”

• GDP does not subtract the value of “bads” Pollution Depletion of resources Loss of animal or plant species Crime

Most economists agree “bads” should be subtracted, but agreement on how to value them has not been attained.

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• We do not know the market value of many goods and services (cont.) GDP does not measure distribution of

income.• Growth in GDP per capita does not mean

that everyone’s income grows at the same rate.

• Implication: While growth in GDP per capita is necessary for improvements in standards of living, it may not be sufficient for large numbers of the population.

CHECK YOURSELF

Slide46 of 50

Why does GDP not account for or try to measure certain things? What is the common thread throughout all of the uncounted variables?

If two countries have the same GDP per capita, do they necessarily have the same level of inequality?

If GDP does not account for everything, does that make the GDP statistic useless?

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Takeaway

• The concept of GDP was developed to quantify economic growth and fluctuations.

• When we say the economy is growing, we mean that real GDP or real GDP per capita is growing.

• When we say that an economy is booming or contracting, we mean that growth in real GDP is above or below its long-run trend.

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Takeaway• There are two ways to measure GDP

1. National Spending Approach2. Factor Income Approach

• GDP per capita is a rough measure of the standard of living.

• GDP statistics are imperfect.1. Many goods are not included.2. “Bads” are not subtracted3. Do not tell us anything about the distribution

of income or who benefits from growth

chapter 5 gdp and the measurement of progress

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