Macroeconomics: Measuring GDP & Circular Flow

• Lecture 2 is about fundamental macro concepts

Australian GDP Growth

• GDP Growth can be measured quarterly or year-ended
• Data for growth figures is sourced from the ABS (Australian Bureau of Statistics)

Lecture Topics

• Fundamental macro concepts are introduced
• Examination of aggregate economic activity includes:
  • Measuring GDP
  • Circular flow of income
  • National income accounting
  • Nominal vs. real GDP
  • GDP levels vs. GDP growth
• Material covered in BOFAH chapters 1 and 2

Measuring GDP

• Measuring GDP through the circular flow of income concept

Three Sector Circular Flow Model

• Factors of production flow from households to firms
• Wages/rents/interest payments flow from firms to households
• Taxes & transfers flow between households, firms, and the government
• Supply of labor, land, capital flows from households to the government
• Government expenditure flows from the government to the goods & services sector
• Supply of goods & services flow from firms and government to households
• Revenue flows from goods & services to firms
• Consumption expenditure flows from households to the goods & services sector

Aggregate Economic Activity

• The aim is to find a summary measure of aggregate economic activity
• The most common measure is gross domestic product (GDP)
• Gross means depreciation is not subtracted
• Domestic means activity in an economy, regardless of ownership
• Product refers to one way to measure GDP as the value of production of final goods and services

Market Value

• Market prices are used to add up goods and services
• Non-market economic activities are not included in GDP like:
  • Home production: childcare, cleaning, cooking
  • Black market economy
• Government production often has no market price, so it is valued at cost such as:
  • Defense
  • Public education
  • Public health

Final Goods and Services

• GDP is the sum of final goods and services
• Measure avoids double-counting of intermediate goods used in production
  • For example: wheat (farmer) → flour (miller) → bread (baker)
• Measures economic activity per period, such as annually or quarterly
• Purchases of goods produced in previous periods are not counted
  • E.g., second-hand cars, second-hand houses
• Purchases of things that are not goods or services are not counted
  • E.g., financial assets like stocks and bonds

National Income Accounting

• Looks at measuring GDP, recorded in each country's national income accounts

National Income Accounts

• There are three approaches to measuring GDP per period:
  • Market value of production of all final goods and services (production approach)
  • Sum of all domestic expenditures (expenditure approach)
  • Sum of all domestic income (income approach)
• All three approaches should yield the same answer, by accounting construction
• Output that is produced and sold at market prices must equal expenditure
• Expenditure on output becomes income to producers
  • This can be either capital income or labor income
• Goods produced but not sold are treated as inventory accumulation, which is a form of expenditure

Circular Flow of Income

• Households own factors of production, such as labor and capital
• Households receive income from supplying labor and capital to firms
• Firms use factors of production to produce goods and services
• Firms receive revenue from selling goods and services to households

Aggregate Income

• The symbol Y is traditionally used to represent aggregate income
• The income approach to GDP is expressed as Y = wL + rK
  • wL denotes labour income
  • rK denotes capital income
• Every final good purchase transfers money from household to firm
• Firm revenues are paid to factors of production (labor and capital)

Example: Production and Income

• Steel Company (Firm #1) has revenue of $100
  • Inputs are labor ($80) and capital ($20)
• Car Company (Firm #2) has revenue of $210
  • Inputs are labor ($70), capital ($40), and steel ($100)
• GDP can be calculated in this example by using the value of production of all final goods and services
  • Steel is used to produce cars and is an intermediate good
  • The market value of final goods (just cars) is $210
• Calculate the sum of all value-added:
  • Value-added of steel production is $100
  • Value-added of cars is $210 – $100 = $110
  • Total value-added is $100 (steel) + $110 (cars) = $210
• Calculate the sum of all income:
  • Labor is $80 (steel) + $70 (cars) = $150
  • Capital is $20 (steel) + $40 (cars) = $60
  • Gross operating surplus is gross output minus prod. costs
  • Total income is $150 (labor) + $60 (capital) = $210

Aggregate Expenditure

• Expenditure approach to GDP is written as Y = C + I + G + (X – M)
  • Y = aggregate income (= GDP)
  • C = private consumption
  • I = private investment
  • G = government purchases
  • X - M = net exports = exports - imports
• Consumption: spending by households on goods and services
  • Durables are long lived goods like cars, white goods, and furniture
  • Non-Durables are services and short lived goods like food and clothing
• Investment: spending by firms on final goods and services
  • Business Fixed Investment: capital goods like computers/factories that are not used up in production (unlike intermediate goods)
  • Changes in Inventories: goods not sold in year of production
  • Residential Investment includes newly constructed homes
• Government Expenditure excludes transfers and interest
• Exports are foreign purchases of domestic-produced goods/services
• Imports are domestic purchases of foreign-produced goods/services

National Income Accounting Identity

• National income accounting says Y = C + I + G + X - M
• Note that this is an accounting identity that is always true because of how its components are defined
• It does not mean that an increase in C causes GDP to increase
• It does not mean that an increase in M causes GDP to decrease
• M is subtracted to avoid double-counting imported goods and services

GDP Caveats

• GDP is a measure of average income at market prices
  • But it leaves out non-market activity
  • And it may be desirable to value things at other than market prices
• GDP doesn't account for the depletion of natural resources and the impact from pollution or environmental degradation
• GDP per person tells us nothing about income distribution
  • Two countries may have very similar GDP per person but very different amounts of inequality
• GDP is not a measure of national well-being
  • Treating it like it's the only thing worth caring about is not advised

Nominal vs. Real GDP

• We have looked at GDP for one time period and one country so far
• It can be expressed in dollars (or some other currency)
• This is known as nominal GDP
• Make comparisons:
  • Over time, we need to adjust for the changing purchasing power of current units
• Across countries, we need to adjust for changing value of domestic currency relative to foreign currency

Nominal GDP vs. Real GDP

• Goal: separate nominal GDP into quantity index and price index
  • This gives nominal GDP = (real GDP) × (GDP deflator)
• Refer to:
  • The quantity index as real GDP
  • The price index as the GDP deflator
• Indexes summarise complex distributions of quantities and prices
• Real GDP measures aggregate quantity, controlling for changing purchasing power of currency

Constructing Real GDP Index

• There are two approaches: traditional and modern
• The traditional approach uses base year prices to calculate the value of output in a given year:
  • It is simple and captures changes in economic activity over time
  • Base year prices may not reflect changing economies since:
    • Innovation leads to new types of goods
    • Innovation leads to new quantities or varieties of existing goods
    • Changing tastes and demographics
• The modern approach uses a chain-weighting index to prevent prices being too outdated

Real GDP Index (Traditional Approach)

• Construct a measure of real GDP using prices fixed to the base year from a chosen base year
  • Multiply the base-year price by the target-year quantities and sum the results for each good
• If the target year is the base year then this real GDP measure is the same as nominal/current GDP in the base year
• Real and current GDP are scaled in currency units
• A real GDP index is often constructed by dividing real GDP by current GDP in the base year
  • The index is scaled as a ratio and not in currency units
  • Often multiplied by 100, where real GDP in the base year will be 100

Example: Real GDP Index (Trad. Approach)

• Cars (Year 0): $2,000 price, 10 quantity
• Phones (Year 0): $1,000 price, 4 quantity
• Bananas (Year 0): $1 price, 1,000 quantity
• Cars (Year 1): $3,000 Price, 12 Quantity
• Phones (Year 1): $500 Price, 6 Quantity
• Bananas (Year 1): $1 Price, 1,000 Quantity
• Cars (Year 2): $2,500 Price, 11 Quantity
• Phones (Year 2): $750 Price, 5 Quantity
• Bananas (Year 2): $1 Price, 1,000 Quantity
• If base year is 0, then real GDP for target year t (RealGDPFixedPo,t) is:
  • RealGDPFixedP0,0 = $2000 × 10 + $1000 × 4 + $1 × 1000 = $25,000
  • RealGDPFixedP0,1 = $2000 × 12 + $1000 × 6 + $1 × 1000 = $31,000
  • RealGDPFixedP0,2 = = $2000 × 11 + $1000 × 5 + $1 × 1000 = $28,000
• RealGDP Fixed P0,0 is also current GDP for year 0 (GDPo)
• A real GDP index JFixed,t = RealGDPFixedPo,t/GDPo:
  • JFixedP0,0 = 25,000/25,000 = 1.00
  • JFixedPo,1 = 31,000/25,000 = 1.24
  • JFixedPo,2 = 28,000/25,000 = 1.12
• The index is scaled as a ratio and not in currency units

Example: Real GDP Index (Modern Approach)

• Calculate the real GDP index for each year after the starting year to the target year, as if the base year is the year before the target year
  • JFixed Po, 1 = 1.24 (from above)
  • GDP1 = $3000 × 12 + $500 × 6 + $1 × 1000 = $40,000
  • RealGDP FixedP1,2 = $3000 × 11 + $500 × 5 + $1 × 1000 = $36,500 JFixedP1,2 = $36,500/$40,000 = 0.9125
• Multiply the results for the chain-weighted index: JChained,2 = 1.24 × 0.9125 = 1.1315
• Multiply this by current GDP in the reference year to recover real GDP:
  • RealGDP Chained,2 = JChained,2 × GDP◦= 1.1315 × $25,000 = $28,287.50
• Scaled in currency units of the reference year

Learning Outcomes

• Understand national accounting including the three approaches to measuring GDP
• Reflect on the merits and demerits of GDP as a measure
• Understand the difference between nominal and real GDP
• Understand how to calculate real GDP using the Traditional Approach and the Modern (Chain-Weighting) Approach
• Understand the difference between GDP levels and GDP growth

New Formula(s) and Notation

• Y = C + I + G + (X – M)
• Y = aggregate income
• C = private consumption
• I = private investment
• G = government purchases
• X - M = net exports = exports - imports

Next Lecture

• More fundamental macro concepts will be covered
• Inflation and interest rates will be covered:
  • Measurement and costs of inflation
  • Nominal vs. real interest rates
• Information available in BOFAH Chapters 3 and 5