Macroeconomics and GDP

Introduction to Macroeconomics & GDP

Learning Objectives

  • LO1: Explain why economists use GDP, inflation, and unemployment to assess the economy’s health.
  • LO2: Discuss why sustained increases in living standards are historically recent.
  • LO3: Identify why saving and investment promote higher living standards.
  • LO4: Define and measure gross domestic product (GDP).
  • LO5: Determine GDP by summing all expenditures on final goods and services.
  • LO6: Determine GDP by summing all incomes received for providing resources.
  • LO7: Describe the relationships among GDP, net domestic product, national income, personal income, and disposable income.
  • LO8: Distinguish between nominal GDP and real GDP.
  • LO9: Explain some limitations of the GDP measure.

Key Economic Indicators

  • Real GDP: Corrects for price changes.
  • Nominal GDP: Uses current prices.
  • Unemployment: Measures the percentage of the workforce that is jobless and actively seeking employment.
  • Inflation: Increase in the overall level of prices in an economy.

Performance and Policy

  • Economists collect and analyze economic data to understand how economies operate and how to improve their performance.
  • Key data includes constructions made, ships landed in ports, etc.
  • Macroeconomics focuses on three main statistics: GDP, Inflation, and Unemployment.

Modern Economic Growth

  • Standard of living is measured by output per person.
  • No growth in living standards prior to the Industrial Revolution.
  • Modern economic growth:
    • Output per person rises (LO2).
    • Not experienced by all countries.

Saving and Investment

  • Saving: Trade-off current consumption for future consumption (LO3).
  • Investment:
    • Financial Investment: Purchase of assets for financial gain.
    • Economic Investment: Creation of new capital assets (e.g., machinery, factories).
  • Banks and financial institutions play a crucial role in facilitating saving and investment.

Economic Growth Equation

  • Saving+Investment=Economic Growth\text{Saving} + \text{Investment} = \text{Economic Growth}

Assessing Economic Performance

  • National income accounting measures the economy’s overall performance.
  • Bureau of Economic Analysis (BEA) compiles National Income and Product Accounts (NIPA):
    • Assess health of economy.
    • Track long-run course.
    • Formulate policy (LO4).

Gross Domestic Product (GDP)

  • The market value of all finished goods and services produced within a country in a year.
  • Measure of aggregate output (LO4).
  • Avoid multiple counting:
    • Market value of final goods.
    • Ignore intermediate goods.
    • Count value added.
  • Domestic output only.

Comparing Heterogeneous Output

  • Using Money Prices
  • Example:
    • Year 1: 3 sofas at $500 + 2 computers at $2,000 = $5,500
    • Year 2: 2 sofas at $500 + 3 computers at $2,000 = $7,000

Value Added in Production Process

  • A five-stage production process illustrates the concept of value added (LO4).
  • Example:
    • Firm A (Sheep Ranch): Sales Value $120, Value Added $120
    • Firm B (Wool Processor): Sales Value $180, Value Added $60
    • Firm C (Coat Manufacturer): Sales Value $220, Value Added $40
    • Firm D (Clothing Wholesaler): Sales Value $270, Value Added $50
    • Firm E (Retail Clothier): Sales Value $350, Value Added $80
    • Total Sales Values: $1,140
    • Value Added (Total Income): $350

GDP: Excluded Transactions

  • Exclude financial transactions (LO4):
    • Public transfer payments (e.g., welfare, social security).
    • Private transfer payments (e.g., gifts).
    • Stock market transactions.
  • Exclude secondhand sales:
    • Example: selling a used car to a friend.

GDP Measures

  • GDP measures the monetary value and must be converted to $ for GDP to work.

Approaches to GDP Calculation

  • Income approach: Count income derived from production (LO4).
    • Wages, rental income, interest income, profit.
  • Expenditure approach: Count sum of money spent buying the final goods (LO4).
    • Who buys the goods?

Expenditures and Income Approaches Compared

  • Expenditures (Output) Approach:
    • Consumption expenditures by households + Investment expenditures by businesses + Government purchases of goods and services + Expenditures by foreigners
  • Income (Allocations) Approach:
    • Wages + Rents + Interest + Profits + Statistical adjustments
  • Both approaches should equal GDP.

Accounting Statement (Expenditures Approach)

  • Example for 2018 (in billions):
    • Personal consumption expenditures (C): $14,051
    • Gross private domestic investment (Ig): $3,711
    • Government purchases (G): $3,550
    • Net exports (Xn): -$654
    • Gross domestic product: $20,658
    • Source: U.S. Bureau of Economic Analysis.

Personal Consumption Expenditures

  • (C) (LO5)
    • Durable goods
    • Nondurable goods
    • Consumer expenditures for services
    • Domestic plus foreign goods produced

Gross Private Domestic Investment

  • (Ig) (LO5)
    • Plant, machinery, and equipment.
    • Residential construction.
    • Research and development.
    • Creation of new works of art, music, etc.
    • Changes in inventories.
    • Creation of new capital assets.
    • Noninvestment transactions excluded.

Investment: Gross vs. Net

  • Gross investment, depreciation, net investment, and the stock of capital (LO5)
  • Net Investment=Gross Investment−Depreciation\text{Net Investment} = \text{Gross Investment} - \text{Depreciation}

Government Purchases

  • (G) (LO5)
    • Expenditures for goods and services
    • Expenditures for publicly owned capital
    • Excludes transfer payments

Net Exports

  • (Xn) (LO5)
    • Add exported goods
    • Subtract imported goods
    • Xn=exports (X)−imports (M)\text{Xn} = \text{exports (X)} - \text{imports (M)}

GDP Equation (Expenditures Approach)

  • GDP=C+Ig+G+Xn\text{GDP} = \text{C} + \text{Ig} + \text{G} + \text{Xn}

Example: GDP Calculation

  • Given:
    • Government Purchases: $15
    • Consumption: $90
    • Gross Investment: $20
    • Consumption of Fixed Capital (depreciation): $5
    • Exports: $8
    • Imports: $12

The Income Approach

  • (LO6)
    • Compensation of employees
    • Rents
    • Interest
    • Proprietor’s income
    • Corporate profits:
    • Corporate income taxes
    • Dividends
    • Undistributed corporate profits
    • Taxes on production and imports

From National Income to GDP

  • (LO6)
    • Subtract net foreign factor income
    • Statistical discrepancy
    • Consumption of fixed capital

Other National Accounts

  • (LO7)
    • Net domestic product (NDP)
    • National income (NI)
    • Personal income (PI)
    • Disposable income (DI)

Example: National Income Data

  • Gross domestic product is
    • Personal consumption expenditures $245
    • Net foreign factor income 4
    • Transfer payments 12
    • Rents 14
    • Consumption of fixed capital (depreciation) 27
    • Statistical discrepancy 8
    • Social Security contributions 20
    • Interest 13
    • Proprietors' income 33
    • Net exports 11
    • Dividends 16
    • Compensation of employees 223
    • Taxes on production and imports 18
    • Undistributed corporate profits 21
    • Personal taxes 26
    • Corporate income taxes 19
    • Corporate profits 56
    • Government purchases 72
    • Net private domestic investment 33
    • Personal saving 20

Nominal GDP vs. Real GDP

  • GDP is a dollar measure of production.
  • Using dollar values creates problems.
  • Nominal GDP: Based on prices that prevailed when output was produced (LO8).
  • Real GDP: Reflects changes in the price level; uses base year price (LO8).

GDP Price Index

  • Use price index to determine real GDP (LO8).
  • Price index in given year=Price of market basket in specific yearPrice of same basket in base year×100\text{Price index in given year} = \frac{\text{Price of market basket in specific year}}{\text{Price of same basket in base year}} \times 100
  • Real GDP=Nominal GDPPrice index (in hundredths)\text{Real GDP} = \frac{\text{Nominal GDP}}{\text{Price index (in hundredths)}}

Calculating Real GDP

  • (Base Year = Year 1) (LO8)
    • Year 1: Units of Output 5, Price/Unit $10, Price Index 100, Nominal GDP $50, Real GDP $50
    • Year 2: Units of Output 7, Price/Unit $20, Price Index 200, Nominal GDP $140, Real GDP $70
    • Year 3: Units of Output 8, Price/Unit $25, Price Index 250, Nominal GDP $200, Real GDP $80

Steps for Deriving Real GDP from Nominal GDP

  • Method 1:
    1. Find nominal GDP for each year.
    2. Compute a GDP price index.
    3. Divide each year’s nominal GDP by that year’s price index (in hundredths) to determine real GDP.
  • Method 2:
    1. Break down nominal GDP into physical quantities of output and prices for each year.
    2. Find real GDP for each year by determining the dollar amount that each year’s physical output would have sold for if base-year prices had prevailed.
    3. The GDP price index can then be found by dividing nominal GDP by real GDP.

Example: Real GDP Calculation

  • In 1994, 7,000 buckets of chicken were produced, priced at $10 each.
  • In 2015, 22,000 buckets were produced, priced at $16 each.
    • What is the GDP price index for 1994, using 2015 as the base year?
    • By what percentage did the price level rise between 1994 and 2015?
    • What were the amounts of real GDP in 1994 and 2015?

Real GDP Computation

  • Nominal GDP and Price Index for Selected Years:
    • 1978: Nominal GDP $2293.8, Price Index 40.40, Real GDP = 2293.8 / (40.40/100) = $5677.72
    • 1988: Nominal GDP $5100.4, Price Index 66.98, Real GDP = 5100.4 / (66.98/100) = $7614.81
    • 1998: Nominal GDP $8793.5, Price Index 85.51, Real GDP = 8793.5 / (85.51/100) = $10283.59
    • 2008: Nominal GDP $14441.4, Price Index 108.48, Real GDP = 14441.4 / (108.48/100) = $13312.41
    • 2018: Nominal GDP $20501, Price Index 128.59, Real GDP = 20501 / (128.59/100) = $15942.92

Shortcomings of GDP

  • (LO9)
    • Nonmarket activities
    • Leisure and psychic income
    • Improved product quality
    • The underground economy
    • GDP and the environment
    • Composition and distribution of output
    • Noneconomic sources of well-being