CHAPTER

Measuring GDP and Economic Growth

21

Main Text followed for the course: Economics: Parkin, Powell and Matthews; seventh edition, Addison Wesley Macroeconomics starts from chapter 20
Other helpful reading: Principles of Economics: Gregory Mankiw; Dryden Press

Principles of Macroeconomics: Frank and Bernanke; McGraw Hill

After studying this chapter you will be able to:

Define GDP and use the circular flow model to explain why GDP equals aggregate expenditure and aggregate income Explain the two methods used by the Office for National Statistics to measure UK GDP Explain how the Office for National Statistics measures real GDP and the GDP deflator to separate economic growth from inflation Explain the uses and limitations of real GDP

Gross Domestic Product

GDP Defined

GDP or gross domestic product is 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

Market Value

GDP is a market value goods and services are valued at their market prices.
To add apples and oranges, computers and popcorn, we add the market values so we have a total value of output in pounds, taka,etc.

Gross Domestic Product

Final Goods and Services

GDP is the value of the final goods and services produced.

A final good (or service) is an item bought by its final user during a specified time period. A final good contrasts with an intermediate good, which is an item that is produced by one firm, bought by another firm, and used as a component of a final good or service. Excluding intermediate goods and services avoids double counting.

Gross Domestic Product

Produced Within a Country

GDP measures production within a country domestic production.

In a Given Time Period

GDP measures production during a specific time period, normally a year or a quarter of a year.

Gross Domestic Product

GDP and the Circular Flow of Expenditure and Income

GDP measures the value of production, which also equals total expenditure on final goods and total income.
GDP Output = Expenditure = Income

Gross Domestic Product

The circular flow diagram shows the transactions among households, firms, governments, and the rest of the world.

Gross Domestic Product

These transactions take place in factor markets, goods markets and financial markets.

Gross Domestic Product

Firms hire factors of production from households. The blue flow, Y, shows total income paid by firms to households.

Gross Domestic Product

Households buy consumer goods and services. The red flow, C, shows consumption expenditure.

Gross Domestic Product

Households save, S, and pay net taxes, T. Firms borrow some of what households save to finance their investment.

Gross Domestic Product

Firms buy capital goods from other firms. The red flow I represents this investment by firms.

Gross Domestic Product

Governments buy goods and services, G, and borrow or repay debt if spending exceeds or is less than net taxes.

Gross Domestic Product

Firms sell goods and services to the rest of the world, exports, and buy goods and services from the rest of the world, imports.

Gross Domestic Product

The value of exports, X, minus the value of imports, M, is net exports, X M.

Gross Domestic Product

And the rest of the world borrows from us or lends to us depending on whether net exports are positive or negative.

Gross Domestic Product

The blue and red flows are the circular flow of expenditure and income. The green flows are financial flows.

Gross Domestic Product

The sum of the red flows equals the blue flow.

Gross Domestic Product

That is: Y = C + I + G + X M

Measuring GDP
The Expenditure Approach The expenditure approach measures GDP as the sum of consumption expenditure, investment, government expenditure on goods and services, and net exports. GDP = C + I + G + (X M)

Measuring UKGDP
The Income Approach The income approach measures GDP by summing the incomes that firms pay households for the factors of production they hire. These are:

wages,
interest, rent, profit.

Gross Domestic Product

Financial Flows Household saving, S, is the income left after paying net taxes and making consumption expenditure.

That is,
S = Y (T + C). Saving flows into the financial markets.

Gross Domestic Product

If G exceeds T, the government has a budget deficit and the government borrows from the financial markets.

If T exceeds G, the government has a budget surplus and this surplus flows to the financial markets.

Gross Domestic Product

If imports exceed exports, the a country borrows an amount equal to (M X) from the rest of the world. Rest of world saving finances some investment in the domestic country.
If exports exceed imports, a country lends an amount equal to (X M) to the rest of the world. Domestic saving finances some investment in other countries.

Gross Domestic Product

How Investment Is Financed Investment is financed from three sources: 1 Private saving, S

2 Government budget surplus, (T G)

3 Borrowing from the rest of the world (M X)

Gross Domestic Product

Start with

Y = C + S + T = C + I + G + (X M)
Then rearrange to obtain C + I + G + (X M) = C + S + T I = S + (T G) + (M X) + C C I = S + (T G) + (M X)

Private saving S plus government saving (T G) is called national saving.

Gross Domestic Product

Gross and Net Domestic Product

Gross means before deducting the depreciation of capital. The opposite of gross is net.
To understand this distinction, we need to distinguish between flows and stocks. Flows and Stocks in Macroeconomics A flow is a quantity per unit of time.

A stock is the quantity that exists at a point in time.

Gross Domestic Product

Wealth and Saving

Wealth, the value of all the things that people own, is a stock.
Saving is the flow that changes the stock of wealth.

Wealth at the start of this year equals wealth at the start of last year plus saving during last year.

Gross Domestic Product

Capital and Investment

Capital is the plant, equipment, and inventories of raw and semi-finished materials that are used to produce other goods. Capital is a stock.
Investment is the flow that changes the stock of capital.

Gross Domestic Product

Depreciation is the decrease in the capital stock that results from wear and tear and obsolescence. Gross investment is the total amount spent on purchases of new capital and on replacing depreciated capital.

Net investment is the change in the capital stock.

Net investment = Gross investment Depreciation.

Gross Domestic Product

The Short Run Meets the Long Run

Capital and investment play a central role in the understanding of the growth and fluctuations in real GDP.
Investment adds to the capital stock, so investment is one source of real GDP growth. Investment fluctuates, so investment is one source of fluctuations in real GDP.

Measuring Economic Growth

Real GDP is the value of final goods and services produced in a given year when valued at constant prices. Calculating Real GDP The first step in calculating real GDP is to calculate nominal GDP. Nominal GDP is the value of goods and services produced during a given year valued at the prices that prevailed in that same year.

Measuring Economic Growth

Nominal GDP Calculations
The table provides data for 2005 and 2006. In 2005,
Bats 20 5.00

Item 2005 Balls

Quantity

Price

100

1.00

Expenditure on balls = 100 Expenditure on bats = 100

2006 Balls Bats 160 22 0.50 22.50

Nominal GDP = 200

Measuring Economic Growth

In 2006,
Expenditure on balls = 80 Expenditure on bats = 495 Nominal GDP = 575

Item 2005 Balls Bats 2006 Balls Bats

Quantity

Price

100 20

1.00 5.00

160 22

0.50 22.50

Measuring Economic Growth

Base-year Prices Value of Real GDP This method of calculating real GDP is to value each years output at the prices of a base year. In the base year, real GDP equals nominal GDP. Suppose 2005 is the base year, then real GDP in 2005 is 200. This method is the traditional method.

Item 2005 Balls Bats 2006 Balls Bats

Quantity

Price

100 20

1.00 5.00

160 22

0.50 22.50

Measuring Economic Growth

Using the traditional baseyear prices method to calculate real GDP in 2006: Expenditure on balls in 2006 valued at 2005 prices is 160. Expenditure on bats in 2006 valued at 2005 prices is 110. So real GDP in 2006 would be recorded as 270.

Item 2005 Balls Bats 2006 Balls Bats

Quantity

Price

100 20

1.00 5.00

160 22

0.50 22.50

Measuring Economic Growth

The new method of calculating real GDP, which is called the chained volume measure.

The chained volume measure method, uses the prices of two adjacent years to calculate the real GDP growth rate.
This calculation has four steps described on the next slide.

Measuring Economic Growth

Step 1: Value last years production and this years production at last years prices and then calculate the growth rate of this number from last year to this year. Step 2: Value last years production and this years production at this years prices and then calculate the growth rate of this number from last year to this year. Step 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. Step 4: Apply the growth rate this year to last years real GDP to calculate this years real GDP.

Measuring Economic Growth

Weve done step 1: Value of 2005 quantities at 2005 prices (GDP in 2005) is 200. Value of 2006 quantities at 2005 prices is 270. At 2005 prices, the value of production increased from 200 to 270 an increase of 35 percent.

Item 2005 Balls Bats 2006 Balls Bats

Quantity

Price

100 20

1.00 5.00

160 22

0.50 22.50

Measuring Economic Growth

Step 2: Value of 2005 quantities at 2006 prices is 500. Value of 2006 quantities at 2006 prices (GDP in 2006) is 575. At 2006 prices, the value of production increased from 500 to 575 an increase of 15 percent.

Item 2005 Balls Bats 2006 Balls Bats

Quantity

Price

100 20

1.00 5.00

160 22

0.50 22.50

Measuring Economic Growth

Step 3: At 2005 prices, the 2006 growth rate is 35 percent. At 2006 prices, the 2006 growth rate is 15 percent. The average of these two growth rates is 25 percent.
Item 2005 Balls Bats 2006 Balls Bats 160 22 0.50 22.50 100 20 1.00 5.00 Quantity Price

Measuring Economic Growth

Step 4: So with 2005 as the base year, real GDP in 2006 is 25 percent more than 200 in 2005. Real GDP in 2005 is 200 Real GDP in 2006 is 250

Item 2005 Balls Bats 2006 Balls Bats

Quantity

Price

100 20

1.00 5.00

160 22

0.50 22.50

Measuring Economic Growth

Calculating the Price Level

The average level of prices is called the price level.

One measure of the price level is the GDP deflator, which is an average of the prices of the goods and services in GDP in the current year expressed as a percentage of the base-year prices. The GDP deflator is calculated in the table on the next slide.

Measuring Economic Growth

Nominal GDP and real GDP are calculated in the way that youve just seen. GDP Deflator = (Nominal GDP Real GDP) 100. In 2005, the GDP deflator is (200 200) 100 = 100. In 2006, the GDP deflator is (575 250) 100 = 230.
Year Nominal GDP Real GDP GDP deflator

2005
2006

200
575

200
250

100
230

The Uses and Limitations of Real GDP

We use real GDP to calculate the economic growth rate.

The economic growth rate is the percentage change in the quantity of goods and services produced from one year to the next. We measure economic growth so we can make:
Economic welfare comparisons over time International comparisons across countries

Business cycle forecasts

The Uses and Limitations of Real GDP

Economic Welfare Comparisons Over Time

Economic welfare measures the nations overall state of economic well-being.

Real GDP is not a perfect measure of economic welfare for seven reasons: 1 Inflation rate tends to be overestimated because quality improvements are neglected, so real GDP is underestimated. 2 Real GDP does not include household production productive activities done in and around the house by members of the household.

The Uses and Limitations of Real GDP

3 Real GDP, as measured, omits the underground economy, which is illegal economic activity or legal economic activity that goes unreported for tax avoidance reasons. 4 Health and life expectancy are not directly included in real GDP. 5 Leisure time, a valuable component of an individuals welfare, is not included in real GDP. 6 Environmental damage is not deducted from real GDP. 7 Political freedom and social justice are not included in real GDP.

The Uses and Limitations of Real GDP

Economic Welfare Comparisons Across Countries

Real GDP is used to compare economic welfare in one country with that in another.
Two special problems arise in making these comparisons.

Real GDP of one country must be converted into the same currency units as the real GDP of the other country, so an exchange rate must be used.
The same prices should be used to value the goods and services in the countries being compared, but often are not.

The Uses and Limitations of Real GDP

Using the exchange rate to compare GDP in one country with GDP in another country is problematic because prices of particular products in one country may be much less or much more than in the other country. For example, using the market exchange rate to value of Chinese GDP in dollars leads to an estimate that in 2006, US real GDP per person was 28 times Chinese real GDP per person.

Using purchasing power parity prices leads to an estimate that, in 2006, US GDP per person is (only) 12 times that in China.

The Uses and Limitations of Real GDP

The purchasing power parity (PPP) exchange rate theory is based on the law of one price: the theory states that, in ideally efficient markets, identical goods should have only one price.
Exchange rate that is required to hold this law of one price is the PPP exchange rate.

The Uses and Limitations of Real GDP

Ex: A television costs 200.00 in the U.K. Same TV costs 20,000 Taka in Bangladesh. What should be exchange rate between pound sterling and Taka in order to Law of One Price to hold? If the Law of One Price holds 200 = 20,000 Taka. Therefore 1 = 20,000/200 = 100 taka In exchange of 1 we could get 100 taka. This is the exchange rate based on PPP.

The Uses and Limitations of Real GDP

There can be marked differences between PPP and market exchange rates. For example, the World Bank's World Development Indicators 2005 estimated that in 2003, one United States dollar was equivalent to about 1.8 Chinese yuan by purchasing power parity considerably different from the nominal exchange rate that put one dollar equal to 7.6 yuan. This discrepancy has large implications; for instance, GDP per capita in the People's Republic of China is about US$1,800 while on a PPP basis it is about US$7,204.