Chapter 6 GDP and the Measurement of Progress 1 Chapter Outline What is GDP? Growth Rates Cyclical and Short-Run Changes in GDP The Many Ways of Splitting GDP Problems with GDP as a Measure of Output and Welfare 2 Introduction A Visitor to India will be struck by the dramatic difference in living standards. 75% of the population live on less than $2 a day (2007). Over 100 million Indians live at an American or European standard living. 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. 3 Introduction 4 India is now growing rapidly Introduction 5 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. 6 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 countrys population. Lets look more closely at the definition of GDP. 7 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. 8 GDP is the Market Value Lets use an example to illustrate our point 9 GDP Is Calculated by Multiplying the Price of Final Goods and Services by Their Quantities and Adding the Market Values Final Good Price x Quantity = Market Value Cars $28,000 x 12 million = $336 billion Computers $1,000 x 20 million = $20 Billion $356 billion Total Added to GDP Of All Final Of All Final Goods and Services 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. 10 Goods and Services Goods are tangible. e.g. cars, food 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. 11 Goods and Services 12 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. 13 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. 14 In a Year GDP is a flow which means it measures the rate of production during a given time period. This contrasts to a nations wealth which is the value of a nations assets at a point in time and has no time dimension. 15 Check Yourself 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 Pokmon 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 United States or Colombia? 16 Growth Rates The growth rate of GDP tells us how rapidly the countrys production is rising or falling over time. 17 Example: Using actual data (numbers are in billions) Check Yourself If GDP in 1990 was $5,803 billion and GDP in 1991 was $5,995 billion, what was the growth rate of (nominal) GDP? 18 Nominal vs. Real GDP Nominal variables, such as nominal GDP, have not been adjusted for changes in prices. Real variables, such as real GDP, have been adjusted for changes in prices. Economists usually are more interested in real GDP because increases in real GDP reflect increases in the standard of living. 19 Nominal vs. Real GDP It is important to distinguish between nominal and real GDP Example: Calculating nominal GDP Problem: The growth of nominal GDP includes price increases as well as increases in output. 20 Lets see how we can fix this. Nominal vs. Real GDP It is important to distinguish between nominal and real GDP(cont.) Solution: Calculate GDP in each year using the same years prices. 21 Nominal vs. Real GDP Real GDP Growth Most economists would choose real GDP growth as the best single indicator of economic performance. Media usually report growth in nominal GDP. If we want to compare GDP over time, we should always use real GDP. It doesnt matter which years prices we use to calculate real GDP. 22 Real GDP Growth 23 Real GDP Growth What do we learn from the previous slide? Normally, real growth is positive. Growth in the 50s and 60s was high. Rising inflation and oil price shocks resulted in low growth in the 70s. The economy has done better since the 70s. 24 The GDP Deflator A price index that can be used to measure inflation: Data from The U.S. Bureau of Economic Analysis (http://www.bea.gov/ ) :http://www.bea.gov/ 25 YearNominal GDP ($ trillions) Real GDP ($ trillions, 2005 prices) Real GDP Growth per Capita Example: Annual growth of per capita real GDP = 4% Growth rate of the population growth rate = 2% Growth rate of per capita real GDP = 4% 2% = 2%. 26 Where: g is the growth rate of each variable Real GDP Growth Per Capita There can be large differences for countries with rapidly growing populations. 27 Country% annual growth real GDP % annual growth population % annual growth per capita real GDP Guatemala3.6%2.8%0.8% United States 3.6%1.2%2.4% Conclusion: Even though the U.S. and Guatemala had the same growth rate of real GDP, the standard of living in the U.S. grew much faster. Source: Bureau of Economic Analysis, and the U.S. Census Bureau Real GDP Growth Per Capita Real Growth per Capita (cont.) 28 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 Name a country with a high GDP but a low GDP per capita. Name a country with a low GDP but a high GDP per capita. Why do we often convert nominal variables into real variables? 29 Cyclical and Short-Run Changes in GDP Recession 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. National Bureau of Economic Research (NBER) Most authoritative source of identifying recessions. 30 Cyclical and Short-Run Changes in GDP How often do recession occur? There have been 10 recessions since There have been 3 recession since 1990 Business fluctuations or business cycles Short-run movements in real GDP around its long-run trend. 31 Cyclical and Short-Run Changes in GDP Real GDP Growth Rate (%) Year Source: Bureau of Economic Analysis Note: Shaded areas indicate recessions. All Recessions Since 1948 Cyclical and Short-Run Changes in GDP Defining when a recession begins and ends is not always easy. Quarterly data is not available until almost a month after the quarter is over. Data is often revised. Updates can even occur years after the first estimates are released. 33 Cyclical and Short-Run Changes in GDP Example: Dating the 2001 recession Official NBER starting date is March Data revisions have led many analysts to conclude that the recession began late Who cares? Presidency changed at the beginning of Democrats: Recession was a result of the new administration policies. Republicans: Recession began during President Clintons term. 34 Check Yourself What are business fluctuations? Why is it sometimes difficult to determine if an economy is in a recession? 35 The Many Ways of Splitting GDP Two common ways of splitting GDP: National Spending Approach: Add up all the components of spending. GDP = C + I + G + NX Factor Income Approach: Add up all of the income generated by producing goods and services: GDP = Wages + Rent + Interest + Profit Both approaches help us understand the business cycle. 36 The National Spending Approach We begin with Y = C + I + G + NX Y = Nominal GDP, market value of all final goods and services 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) 37 Lets look at each of the components in turn. The National Spending Approach Consumption spending (C) sometimes referred to as spending by households. Investment Spending (I) Private spending on tools, plant, and equipment used to produce future output. Government spending (G) Includes all levels of government Does not include government transfers. 38 The National Spending Approach 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 The National Spending Approach 40 The Factor Income Approach The Other Side of the Expenditure Coin When money is spent it ends up as someones 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. 41 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. 42 Check Yourself Which is the largest of the national spending 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 spending approach? (In practice, the answers are close but differ because of accounting errors and data omissions.) 43 Problems With GDP as a Measure of Output There are many goods and services for which we do not know the market value. GDP does not count the underground economy Illegal activities Off-the-books activities GDP does not count non-priced production Example: Work done in the home by household members. 44 GDP Does Not Count the Underground Economy Results in two biases Biases over time Example: Number of women in the labor forces has almost doubled since When they were at home unpaid work was not counted. Now much of the same work is paid for and therefore counted. Result: growth in real GDP is exaggerated Biases across nations Example: Nonmarket activity is more prevalent in less developed countries. Exaggerate differences in GDP 45 GDP Noes Not Count Non-Priced Production We do not know the market value of many goods and services GDP does not add value of leisure In the U.S. the average workweek has fallen. The workweek is longer in poor countries Implication: GDP differences are exaggerated. GDP does not subtract the value of bads. Pollution Depletion of resources Crime 46 GDP Does Not Count The Value of Leisure 47 GDP Does Not Reflect the Distribution of Income Growth in GDP per capita does not mean that everyones 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. 48 Check Yourself 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 off inequality? If GDP does not account for everything, does that make the GDP statistic useless? 49 Take Away 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. 50 Take Away There are two ways to measure GDP 1.National Income Approach 2.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 subtracted 3.Do not tell us anything about the distribution of income or who benefits from growth. 51 Second Edition End of Chapter 6 52