AD

Chapter 5 Notes: GDP, Expenditure Approach, Nominal vs Real GDP, GDP Deflator, and Welfare Considerations

Gross Domestic Product (GDP)

  • GDP is the market value of all final goods and services produced within a country in a given period.
  • It is considered the best single measure of a society’s economic well‑being (aggregate performance) and is the most closely watched economic statistic.
  • GDP is studied in macroeconomics as an economy‑wide phenomenon (inflation, unemployment, growth).

What is GDP and why it matters

  • GDP = measures the total income of a nation; equal to the market value of all final goods and services produced within a country in a given period.
  • It links to overall living standards and policy decisions.
  • Final goods and services are counted; intermediate goods are not (to avoid double counting).
  • The circular flow diagram shows that spending by one entity is income to another; total income = total expenditure for an economy as a whole.

Expenditure Approach

  • GDP can be measured by summing expenditures on final goods and services:
    GDP = C + I + G + NX
  • Components:
    1. C: Consumption — all goods and services purchased by consumers.
    2. I: Investment — (i) business fixed investment (plant and equipment), (ii) new residential structure, (iii) inventory investment.
    3. G: Government purchases — government goods and services purchased; includes salaries but not transfer payments like unemployment insurance.
    4. NX: Net exports — NX = ext{Exports} - ext{Imports} (trade balance).
  • The approach emphasizes final expenditure on domestically produced goods and services.

Circular Flow and Income vs. Expenditure

  • For an economy as a whole, income must equal expenditure (circular flow).
  • Two ways to measure GDP:
    • Income approach: sum of all incomes earned by factors of production (wages, rents, profits, etc.).
    • Expenditure approach: sum of spending on final goods and services as above.
    • Value-added approach: sum of value added at each stage of production; avoids double counting.
  • The circular flow diagram illustrates why income and expenditure are equal in equilibrium: every expenditure by one agent is someone else’s income.

Nominal vs Real GDP

  • Nominal GDP: values of GDP expressed in current dollars (unadjusted for inflation).
  • Real GDP: GDP adjusted for changes in the price level (inflation); uses a base year for prices.
  • Why it matters: to compare economic performance over time, we must separate changes due to actual quantities from changes due to prices.
  • Real GDP reflects true changes in production, removing price effects.
  • Base year concept: Real GDP uses prices from a base year to value quantities in current year.

Real GDP vs Nominal GDP – Example (base year = 2000)

  • Data (from example):
    • Year 2000: X: price = $10, quantity = 100; Y: price = $2, quantity = 200; Z: price = $5, quantity = 100.
    • Year 2001: X: price = $15, quantity = 150; Y: price = $3, quantity = 220; Z: price = $6, quantity = 100.
  • Nominal GDP in 2000:
    ext{Nominal GDP}_{2000} = (10 imes 100) + (2 imes 200) + (5 imes 100) = 1900
  • Nominal GDP in 2001:
    ext{Nominal GDP}_{2001} = (15 imes 150) + (3 imes 220) + (6 imes 100) = 3510
  • Real GDP in 2001 (using 2000 prices):
    ext{Real GDP}_{2001} = (10 imes 150) + (2 imes 220) + (5 imes 100) = 2440
  • Observations:
    • Nominal GDP increased from 2000 to 2001 due to both higher quantities and higher prices.
    • Real GDP increased from 2000 to 2001 due to higher quantities, with prices kept at 2000 levels.

GDP Deflator

  • The GDP deflator is a price index that measures the level of prices of all new, domestically produced, final goods and services.
  • Definition:
    ext{Deflator} = rac{ ext{Nominal GDP}}{ ext{Real GDP}} imes 100
  • It reflects the current price level relative to the base year.
  • Usage: A first measure of inflation derived from GDP data.

Inflation via the GDP Deflator

  • Inflation rate using the GDP deflator:
    \pi_{GDP} = igg( \frac{\text{Nominal GDP}}{\text{Real GDP}} - 1\bigg) \times 100
  • Example (2001 using 2000 as base):
    \pi_{GDP,2001} = \bigg( \frac{3510}{2440} - 1\bigg) \times 100 \approx 43.85\%
  • Note: This is the inflation rate implied by the GDP deflator for the period, using the base year prices.

GDP Pitfalls and Limitations

  • GDP may mismeasure welfare and well-being in several ways; some items should be added or subtracted if GDP is used as a welfare measure.
  • Major categories of omissions and adjustments:
    • Unrecorded transactions (informal economy, non-market activity) could add to well-being if included.
    • Environmental damage reduces welfare but may not be captured in GDP.
    • Transfer payments (e.g., lump-sum transfers) do not reflect production; often excluded from GDP calculations.
    • Household production (e.g., producing own food, mowing own lawn) is difficult to record and is often omitted.
  • Inclusions and exclusions:
    • Securities purchases (e.g., IBM stock) are transfers and do not reflect production; often excluded from GDP.
    • Private and government transfers (e.g., parental tuition payments, unemployment insurance) typically do not directly reflect current production and may be excluded.
    • Second-hand goods trading is excluded because it does not reflect new production.
    • Household production is argued to be included in welfare calculations but is omitted from GDP due to lack of transaction records.
  • Other legal and illegal transactions can be problematic in measuring well-being.

Imports and Exports in GDP

  • Imports are subtracted in the NX term; they therefore reduce GDP in the expenditure approach.
  • An example consideration: If an Italian espresso machine is imported, the expenditure is counted, but NX becomes smaller (exports minus imports).
  • Question from slides: Would it have the same impact if the money was not originally spent versus money spent on a Canadian good?
    • If money is spent on an imported good, GDP is reduced via a larger import component (negative NX).
    • If the same money is spent on a Canadian (domestic) good, it increases C and does not reduce NX by imports; GDP rises with domestic production.
  • Implication: The source of spending matters for GDP composition, not just total spending.

Depreciation and Net vs Gross Measures

  • Depreciation (consumption of fixed capital) is used to move from GDP to net measures:
    • ext{Net Domestic Product (NDP)} = ext{GDP} - ext{Depreciation}
  • Depreciation accounts for wear and tear on the capital stock and affects measures of sustainable production.

Imports, Excluded Items, and the Value-Added Perspective

  • Intermediate goods should not be double-counted; the value-added approach sums the value added at each stage of production.
  • The expenditure approach counts final goods and services only, to avoid double counting.
  • The circular flow diagram complements understanding by showing that total spending equals total income.

Canadian Example and Real GDP over Time

  • There is a Canadian example illustrating GDP components and real vs nominal measures; the exact figures are used to demonstrate the calculation process and interpretation of deflators and inflation.

GDP per Capita and Welfare Considerations

  • GDP per capita is GDP divided by the population; commonly used to compare living standards across countries or over time.
  • GDP alone is not a complete measure of welfare; supplementary indicators are often used.

GDP and Welfare: What Should Be Added or Removed for Welfare Measurement?

  • What should be added to GDP if it is used as a welfare measure:
    1) Unrecorded transactions that do not go through the market
    2) Peace and stability
    3) Preservation of natural resources
    4) Sustainable agriculture
    5) Quality of life / leisure time
    6) Other welfare indicators
  • What should be removed from GDP when measuring welfare:
    1) Environmental damage (e.g., oil spills)
    2) Poverty and unequal distribution of income
    3) Killing and human harm caused by war
    4) Other negative welfare impacts
  • GDP can serve as a base for welfare accounting, but supplementing indicators are necessary.

Supplementary Methods and Alternatives to GDP

  • Use GDP as a base for welfare accounting but supplement with other measures:
    1) Time use surveys (to capture leisure and unpaid work)
    2) Qualitative indicators for environment and human welfare (e.g., HDI)
  • HDI (Human Development Index) as an alternative or complement to GDP in assessing welfare.
  • HDI provides a broader view of well-being, combining health, education, and standard of living.

Review and Summary (Chapter 5)

  • Key ideas: What is GDP; how to calculate GDP via the expenditure approach; the difference between nominal and real GDP; what the GDP deflator is and how it measures inflation; the main pitfalls of using GDP as a welfare measure; the importance of the circular flow, and alternative measures of welfare (HDI, time use, qualitative indicators).
  • Major equations:
    GDP = C + I + G + NX
    NX = Exports - Imports
    ext{Nominal GDP}{t} = \sum pt qt ext{Real GDP}{t} = \sum p{base} qt
    ext{Deflator} = \frac{\text{Nominal GDP}}{\text{Real GDP}} \times 100
    \pi_{GDP} = \left( \frac{\text{Nominal GDP}}{\text{Real GDP}} - 1 \right) \times 100
  • Important distinctions: understanding the difference between nominal and real GDP; recognising the main pitfalls of using GDP as welfare, and knowing when to supplement GDP with other indicators.