GDP and Economic Growth Notes

Gross Domestic Product (GDP) and Economic Growth

Gross Domestic Product (GDP) Defined

  • GDP is the market value of all final goods and services produced within a country in a given time period.

  • Four key parts to this definition:

    • Market value

    • Final goods and services

    • Produced within a country

    • In a given time period

Market Value

  • GDP uses market prices to value goods and services.

  • This allows for the aggregation of different items (apples, oranges, computers, ice cream) by summing their market values in a common currency (e.g., euros).

Final Goods and Services

  • GDP includes the value of final goods and services produced.

  • A final good (or service) is purchased by its final user during a specified time period.

  • An intermediate good is used as a component in the production of a final good or service (e.g., a laptop battery).

  • Excluding intermediate goods avoids double counting.

Produced Within a Country

  • GDP measures production within a country's borders (domestic production).

  • The nationality of the firms producing the goods or services is irrelevant.

In a Given Time Period

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

GDP and the Circular Flow of Expenditure and Income

  • GDP measures the value of production, which equals total expenditure on final goods and total income.

  • The circular flow illustrates transactions among households, firms, governments, and the rest of the world.

Circular Flow

  • Firms hire factors of production from households; the total income paid by firms to households is represented by YY.

  • Households buy consumer goods and services; consumption expenditure is represented by CC.

  • Households save (S) and pay taxes (T).

  • Firms buy capital goods from other firms; investment expenditure by firms is represented by II.

  • Governments buy goods and services (G) and may borrow or repay debt.

  • The rest of the world buys goods and services from us (exports, X) and sells us goods and services (imports, M); net exports are X–MX – M.

Equation

  • The sum of expenditures equals income:
    Y=C+I+G+(X−M)Y = C + I + G + (X - M)

GDP Equals Expenditure Equals Income

  • GDP can be measured by total expenditure or total income.

  • Total expenditure on final goods and services equals the value of final goods and services, which is GDP.

  • Total income earned from production of final goods equals the total amount paid for the use of resources (wages, interest, rent, and profit).

  • Firms pay out all their receipts from the sale of final goods and services.

Financial Flows

  • Financial markets finance deficits and investment.

  • Household saving (S) is income minus net taxes and consumption expenditure and flows from households to the financial markets.

  • If government expenditures exceed net taxes, the deficit (G–T)(G – T) is borrowed from the financial markets.

  • If imports exceed exports, the deficit with the rest of the world (M–X)(M – X) represents borrowing from the rest of the world.

How Investment Is Financed

  • Investment is financed from three sources:

    1. Private saving, SS

    2. Government budget surplus, (T–G)(T – G)

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

Economic Accounting Principles

  • The calculation of GDP requires understanding:

    • The difference between flows and stocks

    • The equality between income, expenditure, and value of production

  • A flow is a quantity per unit of time.

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

Flow Variable

  • A flow variable is measured over a specific period of time (e.g., income per hour, day, week, or month).

Stock Variable

  • A stock variable is independent of time (e.g., the balance in a current account).

Wealth, Capital, and Investment

  • Wealth is a stock; saving is the flow that increases wealth, and consumption is a flow that decreases wealth.

  • Capital is a stock (plant, equipment, and inventories).

  • Investment is the flow that changes the stock of capital.

  • Depreciation is a flow that decreases the stock of capital.

  • Gross investment is the total amount spent on purchases of new capital and on replacing depreciated capital.

  • Net investment is the change in the stock of capital.

Net Investment Formula

  • NetInvestment=GrossInvestment−DepreciationNet Investment = Gross Investment - Depreciation

Investment and GDP Growth

  • GDP grows as the capital stock grows.

  • Fluctuations in investment cause real GDP to fluctuate.

Measuring GDP: Two Approaches

  • National Statistical Authorities measure GDP using two approaches:

    1. The expenditure approach

    2. The income approach

Expenditure Approach

  • Measures GDP as the sum of consumption expenditure, investment, government expenditures, and net exports.

Components of Expenditure Approach

  • Personal consumption (labeled “C”) is the value of goods and services purchased by households.

  • Gross private domestic investment (labeled “I”) is the value of all goods produced for use in the production of other goods and services; it adds to the stock of capital.

  • Government purchases (labeled “G”) are government expenditures on goods and services; transfer payments are excluded.

  • Exports are sales of a country’s goods and services to buyers in the rest of the world.

  • Imports are purchases of foreign-produced goods and services by a country’s residents.

  • Net exports (labeled “NX”) are exports minus imports: NX=(X–M)NX = (X – M).

GDP 2014 (EUR-28) – Expenditure Approach (market prices)

  • Consumption (C): €7.9 trillion

  • Gross Investment (I): €2.9 trillion

  • Government Purchases (G): €2.7 trillion

  • Net Exports (X-M): €0.4 trillion

  • Gross Domestic Product (Y): €13.9 trillion

Income Approach

  • Measures GDP by summing the incomes paid by firms to households for the services of factors of production (wages, interest, rent, and profit).

Categories of Income

  • Compensation of employees: total payments by firms for labor services (wages, salaries, and benefits).

  • Gross operating surplus: total profit made by companies and surpluses generated by publicly owned firms.

  • Mixed income: rental income and income from self-employment.

GDP at Factor Cost vs. Market Prices

  • The sum of the income components is gross domestic income at factor cost.

  • GDP is gross domestic product at market prices.

  • To get from factor cost to market prices, add indirect taxes and subtract subsidies.

  • GDP calculated using the expenditure and income approaches is always the same.

GDP 2014 (EUR-28) – Income Approach (market prices)

  • Compensation of employees: €6.7 trillion

  • Gross operating surplus and gross mixed income: €5.6 trillion

  • Indirect taxes less subsidies: €1.3 trillion

  • GDP at factor cost: €12.3 trillion

  • Gross domestic product (market prices): €13.9 trillion

Measuring Economic Growth

  • When GDP increases, it could be due to increased production or higher prices.

  • Expansion of production is economic growth.

  • Paying higher prices is inflation.

  • Real GDP (or GDP at constant prices) values production at the prices of a base year.

  • Nominal GDP (or GDP at current prices) values production at current year prices.

Calculating Nominal and Real GDP

  • Nominal GDP is calculated by multiplying the quantity of each item produced in a given year by its price in that year and summing the expenditures.

  • Real GDP is calculated by multiplying the quantity of each item produced in a given year by its price in the base year and summing the expenditures.

GDP Example

  • Year 2012 (Base Year)

    • Clothes: Price €10, Quantity 20, Total Expenditure €200

    • National Defense: Price €20, Quantity 2, Total Expenditure €40

    • Nominal GDP: €240

  • Year 2013

    • Clothes: Price €10, Quantity 10, Total Expenditure €100

    • National Defense: Price €40, Quantity 10, Total Expenditure €400

    • Nominal GDP: €500

  • Year 2014

    • Clothes: Price €15, Quantity 15, Total Expenditure €225

    • National Defense: Price €50, Quantity 15, Total Expenditure €750

    • Nominal GDP: €975

  • Real GDP (2012 Prices) - 2013

    • Clothes: €100

    • National Defense: €200

    • Real GDP: €300

  • Real GDP (2012 Prices) - 2014

    • Clothes: €150

    • National Defense: €300

    • Real GDP: €450

Real vs. Nominal GDP

  • Nominal GDP uses current prices; real GDP uses constant prices.

  • Changes in real GDP reflect only changes in the amounts produced.

  • Real GDP is a better measure of economic well-being than nominal GDP.

  • Economic growth is measured as the percentage change in real GDP from one year to another.

Economic Growth Calculation

  • Economic Growth = RealGDP<em>current−RealGDP</em>previousRealGDPprevious×100\frac{Real GDP<em>{current} - Real GDP</em>{previous}}{Real GDP_{previous}} \times 100

  • Example: If real GDP is €300 in 2013 and €450 in 2014, economic growth is 450−300300×100=50%\frac{450-300}{300} \times 100 = 50\%.

Calculating the Price Level: GDP Deflator

  • The GDP deflator is an average of current-year prices expressed as a percentage of base-year prices.

GDP Deflator Formula

  • GDPDeflator=NominalGDPRealGDP×100GDP Deflator = \frac{Nominal GDP}{Real GDP} \times 100

  • The GDP deflator for the base year always equals 100.

Deflating

  • Deflating is the process of finding the real value of any nominal value.

Formula for Real GDP using GDP Deflator

  • RealGDP=NominalGDPGDPDeflator×100Real GDP = \frac{Nominal GDP}{GDP Deflator} \times 100

Inflating

  • Inflating is the process of finding the nominal value of any real value.

Formula for Nominal GDP using GDP Deflator

  • NominalGDP=RealGDP×GDPDeflator100Nominal GDP = \frac{Real GDP \times GDP Deflator}{100}

GDP Deflator Table Example

Nominal GDP

Real GDP

GDP Deflation

200

200

100

600

300

200

1200

400

300

Uses of Real GDP

  • We use real GDP for three main purposes:

    • Economic welfare comparisons

    • International welfare comparisons

    • Forecasts for stabilization policy

Limitations of Real GDP as a Measure of Economic Welfare

  • Real GDP measures market activity but is not a perfect measure of economic welfare.

  • Goods and services produced and exchanged in a market are counted; those not exchanged in markets are not.

Four Main Reasons Real GDP Is Limited

  1. Household Production

    • GDP omits the value added by household members who do housework themselves.

  2. Underground Economy

    • Some production goes unreported to evade taxes or the law and is not counted in GDP.

  3. Leisure

    • Leisure time, a valuable component of an individual’s welfare, is not included in real GDP.

  4. Environment

    • GDP accounts ignore the impact of pollution on the environment.

International Welfare Comparisons

  • Real GDP is used to compare economic welfare in one country with that in another.

  • Two special problems arise in making these comparisons:

    1. 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.

    2. The same prices should be used to value the goods and services in the countries being compared, but often are not.

Review Quiz

Question 1

  • Which of the following expenditures is an intermediate good?

  • Correct Answer: c. BMW buys new tires to put on the cars it’s building

Question 2

  • Which of the following is NOT a flow variable?

  • Correct Answer: b. The number of DVDs available at the library

Question 3

  • According to the table on the left, net investment is ___?

  • Correct Answer: b. €160
    *€b. Wages and salaries 800 Government expenditure 240 Depreciation 240 Gross investment 400 Gross operating surplus 80 Indirect taxes 120 Net exports 80 Consumption expenditure 640 Mixed income 50

Question 4

  • In the economy shown in the table, GDP is ___?

  • Correct Answer: d. €1,420
    *Item €b. Wages and salaries 800 Government expenditure 240 Depreciation 240 Gross investment 400 Gross operating surplus 80 Indirect taxes 120 Net exports 80 Consumption expenditure 640 Mixed income 50

Question 5

  • In the economy shown in the table, GDP is ___?

  • Correct Answer: a. £1,150
    *Item £b. Consumption expenditure 700 Government expenditure 250 Indirect taxes less subsidies 150 Net exports 50 Compensation of employees 600 Gross operating surplus 300 Mixed incomes 50

Question 6

  • The Office for National Statistics in Virtual Reality has had a hard drive crash and lost some data. The data remaining show that in 2003, real GDP was €55 billion and the GDP deflator was 120; and in 2004, nominal GDP was €80 billion and the GDP deflator was 125. From these numbers, we know that nominal GDP in 2003 was____ and real GDP in 2004 was.

  • Correct Answer: d. €66 billion; €64 billion