Ch. 5 : MEASURING GDP AND ECONOMIC GROWTH

–Define GDP–Circular flow model–Relationship between aggregate expenditure

and aggregate income. –Measurement of real GDP and the GDP

deflator–Real GDP as a measure of economic growth

and the limitations of our measure

Gross Domestic Product

• GDP: gross domestic product– the market value of all final goods and

services produced in a country in a given time period.

– This definition has four parts:• Market value• Final goods and services• Produced within a country• In a given time period

Gross Domestic Product

• GDP and the Circular Flow of Expenditure and Income– GDP measures the value of production

• equals total expenditure on final goods• equals total income from production.

– The circular flow diagram illustrates the equality of income, expenditure, and the value of production.

Gross Domestic Product – Red=expenditures Blue=income

Green=borrowing/lending/taxes

Gross Domestic Product

– Two ways to measure GDP:– Expenditure Approach:

• Aggregate expenditure = C + I + G + (X-M)

– Income Approach• Aggregate income = Y = Wages + Rent + Interest +

Profit

– Because Income and expenditure approach both measure GDP:

Y = C + I + G + (X-M)

Gross Domestic Product • Financial Flows

– Y = C + S + T– Y = C + I + G + (X-M)

•S+T = I+G+(X-M)(G-T) = (S-I)-(X-M)

• According to last equality, what are the possible consequences of a larger government budget deficit?

Gross Domestic Product

• How Investment Is Financed– The last equation could also be reorganized

as:

I = S + (T-G) + (M-X)

• Investment is financed from three sources:– Private saving, S– Government budget surplus, (T – G)

• S + (T-G) is “national saving”

– Borrowing from the rest of the world (M – X).

Gross Domestic Product

• Gross vs. Net Domestic Product

• “Gross” means before accounting for the depreciation of capital.

• Net Domestic Product = GDP – Capital Consumption Allowance.

Gross Domestic Product Stocks versus flows

– Wealth• a stock representing the value of all the things that people

own– Saving

• A flow that is the source of changes in the stock of wealth.– Capital

• A stock representing the plant, equipment, and inventories of raw and semi-finished materials that are used to produce other goods

– Investment • A flow representing the purchases of new capital

– Depreciation (capital consumption)• A flow representing the decrease in the capital stock that

results from wear and tear, and obsolescence.

Gross Domestic Product – The relationships among capital, gross

investment, depreciation, and net investment.

Gross Domestic Product

• Depreciation is included in:– GDP– Gross profits – Gross Investment

• Depreciation is removed from– Net National Product– Net profits– Net investment

• Investment plays a central role in the economy. – Increases in capital are one source of growth in potential real GDP;– Fluctuations in investment are one source of fluctuations in real

GDP.

Measuring U.S. GDP

• The National Income and Product Accounts divide incomes into five categories– Compensation of employees– Net interest (paid by business) – Rental income– Corporate profits.– Proprietors’ income.

• The sum of these five income components is net domestic income at factor cost.

Measuring U.S. GDP

• Two items must be added to get GDP–Indirect taxes minus subsidies are added to

get from factor cost to market prices.–Depreciation (or capital consumption) is added

to get from net domestic product to gross domestic product.

Expenditure Components of US GDP: 2004

-2,000

0

2,000

4,000

6,000

8,000

10,000

12,000

2004

GDP

Consumption

Investment

Government

Net exports

Real GDP and the Price Level

– Nominal GDP is the value of final goods and services produced in a given year when valued at the same year’s prices

– Real GDP is the value of final goods and services produced in a given year when valued at constant (base year) prices.

Real GDP and the Price Level• 2002 NGDP ________• 2003 NGDP ________• Growth rate ________

• Base year of 2002• 2002 RDGP ________• 2003 RGDP ________• Growth rate ________

• Base year of 2003• 2002 RDGP ________• 2003 RGDP ________• Growth rate ________

Item Quant. Price

2002

Balls 100 $1.00

Bats 20 $5.00

2003

Balls 160 $1.00

Bats 22 $10.00

Chain-weighted method for real GDP1. Calculate growth rate in real GDP using last year’s

prices. ______

2. Calculate growth rate in real GDP using this year’s prices. ______

3. Calculate the average of the two growth rates. This average growth rate is the growth rate of real GDP from last year to this year.

average growth rate _______

RGDP (using 2002 as base) _________

4. Repeat steps 1, 2, and 3 for each pair of adjacent years to link real GDP back to the base year’s prices.

Real GDP and the Price Level

• GDP deflator• Avg. of the prices of the goods in GDP in

the current year expressed as a % of the base year prices.

t

tt GDPR

GDPNdeflGDP

*100

Interpreting the GDP-deflator

– The GDP-deflator provides a comparison of current year prices with base year prices.

– If deflator =100, prices are, on average, the same.

– If deflator=150, current year prices are, on average, 1.5 times those in base year (50 percent higher)

– If deflator=75, current year prices are, on average .75 times those in base year. (25 percent lower)

U.S. GDP-deflator (2000=100)

0.00020.00040.00060.00080.000

100.000120.000

1970

1973

1976

1979

1982

1985

1988

1991

1994

1997

2000

2003

Year

Measuring Economic Growth

– We use real GDP to calculate the economic growth rate.

– The economic growth rate is the percentage change in real GDP from one year to the next.

R-GDP as a measure of economic welfare.

1. Quality improvements

2. Household production

3. Underground economy

4. Health and life expectancy

5. Leisure time

6. Environment

7. Political freedom and social justice

8. Exchange rate in comparing across countries.

• Exchange rates and comparisons across countries.– Using actual exchange rate, U.S. real GDP

per capita = 69* Chinese real GDP per capita– Using PPP exchange rate, U.S. real GDP =

12*Chinese real GDP per capita.

• What does this say about actual versus PPP exchange rate?