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2.

1 GDP and its Determinants


%ntroduction to Macroeconomics

Introduction to Macroeconomics

Throughout our studies of Microeconomics& 'e learned several key concepts& most for 'hich there is a similar concept 'hich 'e 'ill study in Macroeconomics. The ta"le "elo' sho's several of the Micro concepts 'e studied and their Macro e(uivalents. Micro Macro Concept Key Terms in Macroeconomics Concept
Market Demand !upply Price $uantity Decrease in Demand %ncrease in Demand Decrease in National Economy Aggregate Demand (AD) Aggregate Supply Average Price Level National utput Examines all the economic activity taking place in a country The total demand for a nation s output of goods and services The total supply of goods and services "y all the industries of a country #n index of the average prices of goods and services over time Total output of all the industries of a country # fall in total output resulting from a decrease in #D #n increase in the average price level resulting from an increase in #D #n increase in the price level and decrease in output from a fall

!ecession "n#lation Supply S$oc%

2.1 GDP and its Determinants


The Macroeconomic )ircular *lo'
%n the introduction to economics unit of the course& you learned a"out the circular flo' of income in a market economy. %n macroeconomics 'e have added several features to this model& including+
# government sector+ The government collects taxes from households and firms ,these are a leakage from the circular flo'and contri"utes government expenditures on pu"lic goods ,these are in.ections into the flo'-. # foreign sector+ # nation spends money on foreign goods ,imports& this is a leakage- and earns money "y selling goods to foreigners ,exports& an in.ection-. The "anking sector+ /ouseholds and firms

The Circular Flow Model

2.1 GDP and its Determinants

The Circular Flow Model

0eakage and %n.ections in the )ircular *lo' of the Macroeconomy


%n the circular flo' model on the previous slide there 'ere red arro's and green arro's& indicating leakages from and in.ections to the circular flo'.
Lea%ages( Taxes paid to the government& spending on imports from a"road& and money saved in "anks are all considered leakages from the circular flo' of income. #ny income earned "ut 12T spent on goods and services does not contri"ute to the nation s total output& and is therefore leaked from the nation s economy. /o'ever& these three leakages allo' for the three follo'ing in.ections. "n)ections( Government spending& export revenues and investments are all ena"led "y the three leakages a"ove.
3ecause households and firms pay taxes& government has money to provide the nation 'ith valua"le infrastructure& education& defense& support for health care and so on& all pu"lic or (uasi4pu"lic goods that 'ould "e under4provided "y the free market. These contribute to national output and are thus injections into the circular flo'. 3ecause domestic households "uy imports& foreigners have access to the money the need to "uy the nation s exports. The spending "y foreigners on domestically produced goods contri"utes to national output and is therefore an injection. 3ecause households save some percentage of their income& capital is availa"le for others to "orro' and spend. !pending on capital goods "y firms or on homes "y households ,"oth considered investmentscontri"utes to the nation s output and is thus an in.ection into the circular flo'.

2.1 GDP and its Determinants


Three #pproaches to Measuring 2utput

,0$

0ooking closely at the circular flo' model& 'e can see that there is a relationship "et'een the amount of income earned& the expenditures made and the total output. The economic activity of a nation can& in fact& "e measures using any of these three methods+
T$e "ncome approac$( Measures GDP "y recording the income of household in the resource market side of
the circular flo' of income. %ncome includes payments households receive in the resource market in exchange for providing firms 'ith the factors of production& including the total sum of each of the follo'ing earned "y a nation s households in a year+ !ages for labor" Interest for capital" #ent for land and $rofits for entrepreneurship%

&ational Income ' !(I(#($

T$e

utput approac$( Measures the value of the total output produced in the different sectors of the

economy. 5hen the total output of every sector of the nation s economy is summed& total output is found.

&ational output ' )utputs of the primary sector ( the secondary sector the tertiary sector

T$e E*penditure approac$( )ounts the total spending on final ne' goods and services in a given year.
6*inal6 goods are ready for consumption and do not includes goods that 'ill "e input goods or are ra' materials for other production. This approach distinguishes "et'een four types of spending on a nation s output. These

2.1 GDP and its Determinants


%ntroduction to Gross Domestic Product

,0$

The primary measure of the total economic activity of a nation is gross domestic product ,GDP-. GDP 7 the total value of a nation s output in a particular period of time. )an "e measured using the income approach" the output approach or the e-penditure approach% The measure of GDP 'e 'ill use throughout our study of Macroeconomics is the e-penditure approach" 'hich measures the output of a nation "y summing+ )+ The total spending "y households on goods and services %+ The investments firms make in ne' capital or that households make in real estate and homes G+ The spending government does on pu"lic goods 8n+ The spending of foreigners on goods produced "y our country ,exports- M%19! the spending our consumers do on goods produced a"road ,importsThe GDP of a particular nation in a particular year therefore e(uals the sum of )& %& G and 8n.

2.1 GDP and its Determinants


5hat is included in GDP:

,0$

GDP measures the value of the final output of goods and services in a nation in a year. 3ut there are some economic transactions 'hich are not included in GDP. &DP includes( GDP includes only final products and services GDP is the value of 'hat has "een produced 'ithin the "orders of a nation over one year& not 'hat 'as actually sold. &DP E*cludes +nonproduction transactions,( Purely #inancial transactions are excluded. Pu"lic transfer payments& like social security or cash 'elfare "enefits. Private transfer payments& like student allo'ances or alimony payments. The sale of stocks and "onds represent a transfer of existing assets ,/o'ever& the "rokers fees are included for services rendered. Second$and sales( %f % "uy a used car in 2;;<& that sale does not count to'ards 2;;<=s GDP& "ecause the car was not made in 1223 The price of the car 'as originally included in the year=s GDP 'hen it 'as produced.

2.1 GDP and its Determinants


The )omponents of GDP

,0$

The expenditure approach to measuring GDP measures the total spending on a nation s output "y households& firms& the government and foreigners. The four types of spending are outlined "elo'+ -ouse$old Consumption (C)( The purchase "y households of all goods and services& including+ 1on4dura"les+ "read& milk& toothpaste& t4shirts& socks& toys& etc... Dura"les+ T>s& computers& cars& refrigerators& etc... !ervices+ dentist visits& haircuts& taxi rides& accountants& la'yers& etc? &ross Private Domestic "nvestment. ("g) #ll final purchases of machinery& e(uipment& and tools "y "usinesses. #ll construction ,including residential-. )hanges in "usiness inventories %f total output exceeds current sales& inventories "uild up. %f "usinesses are a"le to sell more than they currently produce& this entry 'ill "e a negative num"er.

2.1 GDP and its Determinants


The )omponents of GDP

,0$

The expenditure approach to measuring GDP measures the total spending on a nation s output "y households& firms& the government and foreigners. The four types of spending are outlined "elo'+ &overnment Purc$ases (o# consumption goods and capital goods) . (&) %ncludes spending "y all levels of government ,federal& state and local-. %ncludes all direct purchases of resources ,la"or in particular-. This entry excludes transfer payments since these outlays do not reflect current production. Net E*ports. (/n) #ll spending on goods produced in the 9.!. must "e included in GDP& 'hether the purchase is made here or a"road. 2ften goods purchased and measured in the 9.!. are produced else'here ,%mports-. Therefore& net exports& ,8n- is the difference+ ,exports 4 imports- and can "e either a positive or negative num"er depending on 'hich is the larger amount.

2.1 GDP and its Determinants


1ominal GDP and @eal GDP

,0$

1ominal GDP measures the value of a nation s output produced in a year& expressed in the value of the prices charged for that year. 3ut if the average price level of a nation s output increases in a year& the nominal ,0$ could increase even if the actual amount of output does not change& since everything 'ill appear more expensive at higher prices. To determine the change in the real ,0$" ,the actual output of a nation ad.usted for changes in the price level-& economists must measure the value of a nation s output in one year using the price level from a "ase year. %n the case of the price level increasing ,inflation-+ real GDP 'ill "e lo'er than the nominal GDP %n the case of the price level decreasing ,deflation-+ real GDP 'ill "e higher than the nominal GDP Real GDP ' the value of a nations output in a particular year adjusted for changes in the price level from a base year% )ffers a more accurate measure of actual /uantity of goods and services a nations produces because it adjusts for price changes%

2.1 GDP and its Determinants


1ominal GDP and @eal GDP
To ad.ust a nation s nominal GDP in one year to its real GDP& 'e must measure the value of output using prices from a "ase year.
Consider the country seen here% If we want to know the 1242 real ,0$ with 1225 as a base year" we must find the value of 1242s output in 1225 prices% 41 cheeses at 61 ' 617 18 chocolates at 61 ' 682 8 watches at 642 ' 682 2010 real GDP = $124 For this country" the ,0$ deflator ' 5ith this 'e kno' that prices rose "y 2AB "et'een 2;;A and 2;1;. 3uantity

,0$

utput in Price produce 0112 in 0112 d in 0112 )heese )hocolate 5atches 1; 2; D 3uantity 2 2 1;

Total value o# output 0112 2; C; D; Total 441 value o# output 0141 2D FD

utput in NominalPrice &DP( produce 0141 in 0141 d in 0141 )heese )hocolate 5atches 12 2D 2.D; E

2.1 GDP and its Determinants


)alculating real GDP using a GDP Deflator

,0$

The GDP deflator is a price index that can "e used to ad.ust a nation s nomial GDP for change sin the price level. The deflator is an indicator of ho' much prices have changed "et'een t'o years. *or a "ase year& the deflator al'ays e(uals 1;;& since the real GDP 7 nominal GDP %f& in a later year& the index is 11;& this means that prices have risen "y 1;B "et'een those years. %f it is 12;& prices have risen "y 2;B. %f it is AD& then price fell "y DB& and so on? Consider 6elo'7 nominal!eal and&DP real &DP data #or t$e 8nited &otice that for each of the 9ear t$e ta6le Nominal &DP s$o'ing &DP De#lator years from 1229 on" real States(
2;;D 2;;G 2;;F 2;;< 2;;A 12&GE<.C 1E&EA<.A 1C&;G1.< 1C&EGA.1 1C&11A.; 1;; 12&GE<.C 12&AFG.2 1E&22<.A 1E&22<.< 12&<<;.G 1;E.2D 1;G.2A 1;<.G1 1;A.G1 ,0$ was lower than nominal because the deflator increased each year" indicating that there was inflation: therefore" nominal ,0$ would have over;stated the changes in real output from year to

2.1 GDP and its Determinants


@eal GDP and @eal GDP per capita

,0$

# nation s real GDP tells us the actual value of its output in a particular year& ad.usted for any changes in the price level "et'een that year and an earlier "ase year. /o'ever& real GDP does not tell us 'hether a nation is rich or poor. )onsider the ta"les "elo'+
Countries 'it$ largest &DP
(and per.capita ran%)

Total &DP7 (trillions :) 1C.2 D.; C.A E.E 2.G

Country 'it$ largest per capita &DP


(and total &DP ran%)

Per.capita &DP (: in 0112) 1;D&ED; FA&;<A DD&AA2 D1&;CA CF&A1F

1. 9nited !tates ,G2. Hapan ,1CE. )hina ,<GC. Germany ,1ED. *rance ,12-

1. 0uxem"ourg ,G<2. 1or'ay ,2CE. Denmark ,2AC. %reland ,EFD. 1etherlands ,1G-

Per capita &DP( Measures the total GDP of a nation divided "y the total population. Gives a more realistic measure of ho' rich a nation is. 1otice that none of the richest nations ,on the right- are even in the top 2; for total

2.1 GDP and its Determinants


5hy is GDP important:

,0$

GDP is considered "y economists to "e the most important measure of economic activity in nations for several reasons+ %t tells us something a"out the relative siIe of different countries= economies %t is a monetary measure& so it tells us how much income a country earns in a year ,assuming everything that is produced is sold-. 5hen 'e divide GDP "y the population& 'e get GDP per capita& 'hich tells us how many goods and services the average person consumes in a country. 5hen real GDP gro's more than the population& that tells us that people on average" have more stuff than they did "efore. %f you "elieve that having more stuff makes people "etter off& then GDP per capita tells us ho' 'ell off people in society are.

#eal ,0$ is better indicator of output than nominal ,0$


,0$ per capita is a better indicator of the well;being of a typical person in a nation than total ,0$

2.1 GDP and its Determinants


5hat are some shortcomings of GDP:

,0$

5hile GDP is a valua"le and 'idely used measure of economic activity& it does have several shortcomings that must "e ackno'ledged+
%t ignores all social aspects of human life& such as income distri"ution& access to health care and education& life expectancy& gender e(uality& religious freedom& human rights and so on. )ertain important 'ork is left out of accounting ,homemakers& la"or of carpenters 'ho make o'n homes "ecause GDP measures only the M#@JET >#09E of output. GDP therefore is understated. GDP does not reflect that people in most countries 'ork fe'er hours than in past years ,in 1A;; the average 'ork 'eek in the industrialiIed 'orld 'as DE hours& today it is around C;Does not reflect improved product (uality Does not include the underground economy GDP does not put a market valueKcost on the environment. /igher GDP may "e accompanied "y negative externalities& 'hich are 12T su"tracted from GDP. GDP does not tell us if the "est com"o of goods and services are producedL a machine gun and text"ooks are assigned e(ual 'eight. 1or does it measure ho' GDP is distri"uted in among the population GDP does not measure the total 'ell "eing& happiness& a reduction of crime or "etter relationships 'ith society& 'ith other countries& etc?

2.1 GDP and its Determinants


#lternative Measures to GDP

,0$

5hile gross domestic product is the primary measure of a nation s output in a particular year& economists have developed alternative measures of output 'hich are sometimes referred to instead of GDP. These include+ &ross National Product (&NP)( Measures the total value of output produced in a year "y the factors of production provided "y a nation.
Differs from GDP in that it includes output produced a"road "y domestically o'ned factories& "ut su"tracts output produced domestically "y foreign o'ned factories. Does not offer as accurate a measure of the actual economic activity within a nation as GDP does& and is therefore not considered as useful as GDP for measuring output of a nation.

&reen &DP( This is an under4used measure of economic activity 'hich su"tracts from real GDP the losses to the environment and "iodiversity resulting from economic gro'th.
Places a monetary value on environmental degradation and su"tracts this from the nation s GDP %s a measure preferred "y environmentalists 'ho "elieve that economic gro'th overstates increases in peoples 'ell4"eing due to the fact that it ignores the externalities that accompany gro'th.

2.1 GDP and its Determinants


The 3usiness )ycle

The <usiness Cycle

)hanges in a nation s GDP over time can "e illustrated in a simple economic model kno'n as the business cycle. There are four stages to a nation s "usiness cycle
# recession is a decline in total output& income& employment& and trade lasting six months or more. During recessions& unemployment increases and there is do'n'ard pressure on the price level # recovery is 'hen a recession has ended and national output "egins #n e*pansion occurs 'hen an to increase again economy is gro'ing at a rate "eyond its long4run gro'th trend.

Long-run Growth Trend: &otice that despite the short;tern fluctuations" the economy tends to grow over time

2.1 GDP and its Determinants


The 3usiness )ycle

The <usiness Cycle

1otice from the "usiness cycle model that economic gro'th ,an increase in GDP- occurs over time& "ut not al'ays at a steady rate. 2f course& each economy s "usiness cycle 'ill look uni(ue& "ut most economies 'ill experience the types of fluctuations the model sho's. Possi6le causes o# t$e 6usiness cycle( There are several theories regarding 5/M countries gro' at such volatile rates over time.
Ma.or innovations may trigger ne' investment andKor consumption spending. )hanges in productivity may "e a related cause. Most agree that the level of aggregate spending is important& especially changes in the purchase of capital goods and consumer dura"les. )yclical fluctuations+ Dura"le goods output is more unsta"le than non4dura"les and services "ecause spending on latter usually can not "e postponed.

Decrease in &DP versus a decrease in &DP gro't$ rate( The gro'th rate of an economy refers to the percentage change in ,0$ between two periods of time. 5hen an economy is approaching a peak in its "usiness cycle& the rate of growth has "egun to fall.

2.1 GDP and its Determinants


The Macroeconomic 2".ectives

The Macroeconomic )bjectives

%n our study of macroeconomics& 'e 'ill focus on ho' the tools of macro can help policymakers achieve several o".ectives& all meant to make the lives of a nation s people "etter over time. T$e #our 6)ectives o# Macroeconomic Policy( 1. ;ull employment( This means most of the nation s 'orkers are a"le to find a .o" and that the nation s resources are "eing put to'ards the production of goods and services 0< Price.level sta6ility( %nflation 'ill "e lo'& meaning households real incomes are high. 9nsta"le prices lead to uncertainty and unsta"le livelihoods for the nation s households =< Economic gro't$( This is defined simply as an increase in output and income over time. Economic gro'th is needed to sustain a gro'ing population and assure that the average person en.oys a higher standard of living over time. >< "mproved e?uality in t$e distri6ution o# income ( The free market tends to result in 'inners and losers. To some extent& the government must look after the losers in the market system& and implement policies that improve e(uality of income

2.1 GDP and its Determinants


The Macroeconomic 2".ectives

The Macroeconomic )bjectives

0ooking again at our "usiness cycle model& 'e can see the effect of an economy 'hich is successfully meeting its macroeconomic o".ectives. The "lue line represents a more sta"le& steadily gro'ing economy. @ecessions are less severe& peaks and troughs less extreme 9nemployment rises "y less during recessions& and inflation is lo'er during expansions. #n economy meeting its macroeconomic o".ectives 'ill achieve gro'th that is closer to the long4run trend line. There 'ill "e less volatility and uncertainty in the economy