Macroeconomics: GDP, Income and Expenditure

• Macroeconomics is the study of the economy as a whole, as opposed to microeconomics which examines individual markets.
• This chapter addresses questions such as:
  • What is Gross Domestic Product (GDP)?
  • How does GDP relate to a nation's total income and spending?
  • What are the components of GDP?
  • How is GDP corrected for inflation?
  • Does GDP measure society's well-being?

Income and Expenditure

• Gross Domestic Product (GDP) measures the total income of everyone in the economy.
• GDP also measures the total expenditure on the economy's output of goods and services.
• Income equals expenditure for the economy as a whole because every dollar a buyer spends is a dollar of income for the seller.

Circular-Flow Diagram

• It is a simple depiction of the macroeconomy that illustrates GDP as spending, revenue, factor payments, and income.
• Factors of production are inputs like labor, land, capital, and natural resources.
• Factor payments are payments to the factors of production (e.g., wages, rent).
• Households own the factors of production then sell/rent factors to firms for income and buy/consume goods & services
• Firms buy/hire factors of production and use them to produce goods and services and sell the goods & services.
• The circular flow omits the government, the financial system, and the foreign sector.
  • The government collects taxes and buys goods and services.
  • The financial system matches savers' supply of funds with borrowers' demand for loans.
  • The foreign sector trades goods and services, financial assets, and currencies with a country's residents.

Gross Domestic Product (GDP)

• It is the market value of all final goods and services produced within a country in a given period of time.
• Goods are valued at their market prices, and all goods are measured in the same units (e.g., dollars in the U.S.).
• Things that don't have a market value are excluded, e.g., housework.
• Final goods are intended for the end user, while intermediate goods are used as components or ingredients in the production of other goods.
• GDP only includes final goods because they already embody the value of the intermediate goods used in their production.
• GDP includes tangible goods (like DVDs, mountain bikes, beer) and intangible services (dry cleaning, concerts, cell phone service).
• GDP includes currently produced goods, not goods produced in the past.
• GDP measures the value of production that occurs within a country's borders, whether done by citizens or foreigners.
• GDP is usually measured in a year or a quarter (3 months)

Components of GDP

• GDP is total spending.
• GDP (denoted Y) is the sum of four components: Consumption (C), Investment (I), Government Purchases (G), and Net Exports (NX)
  • Y = C + I + G + NX
• Consumption (C) is total spending by households on goods and services.
  • For renters, consumption includes rent payments.
  • For homeowners, consumption includes the imputed rental value of the house.
• Investment (I) includes spending on goods that will be used in the future to produce more goods.
  • Includes spending on capital equipment (e.g., machines, tools), structures (factories, office buildings, houses), and inventories (goods produced but not yet sold).
  • Investment does NOT mean the purchase of financial assets like stocks and bonds.
• Government Purchases (G) is all spending on the goods and services purchased by the government at the federal, state, and local levels, and excludes transfer payments, like Social Security or unemployment insurance benefits.
• Net Exports (NX) = exports – imports
  • Exports represent foreign spending on the economy's goods and services.
  • Imports are the portions of C, I, and G that are spent on goods and services produced abroad.

Active Learning Example

• Debbie spends $200 to buy her husband dinner at the finest restaurant in Boston.
  • Consumption and GDP rise by $200.
• Sarah spends $1800 on a new laptop for her publishing business. The laptop was built in China.
  • Investment rises by $1800, net exports fall by $1800, and GDP is unchanged.
• Jane spends $1200 on a computer for her editing business. It was last year's model on sale from a local manufacturer.
  • GDP and investment do not change because the computer was built last year.
• General Motors builds $500 million worth of cars, but consumers only buy $470 million worth of them.
  • Consumption rises by $470 million, inventory investment rises by $30 million, and GDP rises by $500 million.

Real vs. Nominal GDP

• If output doubles and prices stay the same, GDP doubles.
• If output stays the same and prices double, GDP doubles.
• Inflation can distort economic variables like GDP, so real and nominal GDP is calculated
  • Nominal GDP values output using current prices and is not corrected for inflation
  • Real GDP values output using the prices of a base year and is corrected for inflation.
• The change in nominal GDP reflects both prices and quantities whereas the change in real GDP is the amount that GDP would change if prices were constant, therefore real GDP is corrected for inflation

EXAMPLE:

• Consider an economy that only produces pizza and latte.
• Year 2011: Pizza (P=$10, Q=400), Latte (P=$2.00, Q=1000)
• Year 2012: Pizza (P=$11, Q=500), Latte (P=$2.50, Q=1100)
• Year 2013: Pizza (P=$12, Q=600), Latte (P=$3.00, Q=1200)
• Nominal GDP in each year:
  • 2011: ($10 x 400) + ($2 x 1000) = $6,000
  • 2012: ($11 x 500) + ($2.50 x 1100) = $8,250
  • 2013: ($12 x 600) + ($3 x 1200) = $10,800
• Increase:
  • $6,000 to $8,250 increase is 37.5%
  • $8,250 to $10,800 increase is 30.9%
• Real GDP in each year using 2011 as the base year:
  • 2011: ($10 x 400) + ($2 x 1000) = $6,000
  • 2012: ($10 x 500) + ($2 x 1100) = $7,200
  • 2013: ($10 x 600) + ($2 x 1200) = $8,400
• Increase:
  • $6,000 to $7,200 increase is 20.0%
  • $7,200 to $8,400 increase is 16.7%

GDP Deflator

• A measure of the overall level of prices.
• GDP deflator = 100 x (nominal GDP/real GDP)
• Inflation rate is the percentage increase in the GDP deflator from one year to the next.

EXAMPLE:

• Year | Nominal GDP | Real GDP | GDP Deflator
  • 2011: $6000, $6000, 100.0
  • 2012: $8250, $7200, 114.6
  • 2013: $10,800, $8400, 128.6
• GDP deflator computation for each year:
  • 2011: 100 x (6000/6000) = 100.0
  • 2012: 100 x (8250/7200) = 114.6
  • 2013: 100 x (10,800/8400) =128.6
• Inflation computation for each year:
  • 2011 to 2012: 14.6%
  • 2012 to 2013: 12.2%

Active Learning - Computing GDP

• Given the following data for goods A and B:

• Nominal GDP in 2011: ($30 x 900) + ($100 x 192) = $46,200
• Real GDP in 2012: ($30 x 1000) + ($100 x 200) = $50,000
• GDP deflator in 2013:
  • Nominal GDP = ($36 x 1050) + ($100 x 205) = $58,300
  • Real GDP = ($30 x 1050) + ($100 x 205) = $52,000
  • GDP deflator = 100 x (Nom GDP)/(Real GDP) = 100 x ($58,300)/($52,000) = 112.1

GDP and Economic Well-Being

• Nominal GDP is discussed often but is not very useful.
• Real GDP per capita is much more important.
• Chinese GDP became greater than Japanese GDP for the first time, but GDP per capita in Japan is still more than 10 times GDP per capita in China.
• Real GDP per capita is the main indicator of the average person's standard of living, however, is not a perfect measure of well-being.
• GDP doesn't value:
  • The quality of the environment because degradation of the environment is like depreciation (the cost of repairing the environment should be a reduction in GDP)
  • Leisure time.
  • Non-market activity, such as child care at home.
  • An equitable distribution of income.
• A large GDP enables a country to afford better schools, a cleaner environment, health care, etc.
• Many indicators of the quality of life are positively correlated with GDP.
• Recession is two consecutive quarters of falling GDP, real GDP declines, lower income, rising unemployment, falling profits, and increased bankruptcies

This section covers Gross Domestic Product (GDP), its relation to national income and spending, and its components. It explains how GDP is corrected for inflation and whether it accurately measures societal well-being. It also describes the circular-flow diagram.