Chapter 2 - Measuring The Economy PDF

L2 Measuring the Economy Marco Fongoni Introduction Today we will talk about the most important type of economic data: Gross Domestic Product We will learn what it is and how we measure it What things we need to take into account when comparing countri...

L2 Measuring the Economy Marco Fongoni Introduction Today we will talk about the most important type of economic data: Gross Domestic Product We will learn what it is and how we measure it What things we need to take into account when comparing countries How do countries differ on GDP How these differences have evolved over time Outline of Lecture I. Measuring GDP II. GDP as Expenditures III. Interpreting GDP a. Comparing GDP over time b. Comparing GDP across countries IV. Economic Growth V. Quiz Measuring GDP Gross Domestic Product How much does the economy produce in a given period? Estimates of a country’s aggregate output date back at least to the work of a seventeenth-century English medical doctor and professor of music, William Petty. Nowadays the calculations are the specialized task of a huge group of statisticians following internationally agreed guidelines for the compilation of National Accounts: the system used for measuring overall output and expenditure in a country – Like an accountant auditing a firm, but the firm is a whole country. The measure of aggregate output that is used is called Gross Domestic Product (GDP): A measure of the total output of goods and services in the economy in a given period. Remember the circular flow? Fundamental Principle: Income = Expenditures = Revenues = Value of Output Today we explain why GDP is also a measure of aggregate expenditure, and of the total incomes of the country’s residents. Three ways to measure GDP There are three ways of constructing GDP from data, according to measurements taken at three different points in the circular flow of macroeconomic life: 1. the production of output in the form of goods and services (aka value added) 2. generates incomes for the producers as wages, salaries, and profits 3. these incomes finance expenditure on goods and services Finally, expenditures purchase output. Simple Example Very simple economy comprising just three industries: The economy produces a single good, a cotton shirt. The shirt industry buys cloth for $80 from the cloth industry, The cloth industry buys cotton from the raw cotton industry for $50. Finally, the shirt is sold to a consumer for $100. GDP as Value Added The sum of the outputs of the different sectors of the economy. the cost of goods and services used as inputs to production is subtracted from the value of output. these inputs will be measured in the value added of other industries, which prevents double-counting when measuring production in the economy as a whole. Example: GDP as value added = 50+30+20 = 100 GDP as Income The sum of the incomes paid to the various factors of production such as labour and capital. This includes wages, profits, the incomes of the self-employed, and taxes received by the government. In the example: each industry makes profits that are equal to the price minus cost. Example: GDP as sum of profits of each industry = 50+30+20 = 100 GDP as Expenditure The sum of expenditures on total production in the home economy by its final users: households, firms, the government, and residents of other countries. The expenditure approach shows that the final product or GDP of this economy is equal to 100, because that is the value of the sale to the final consumer. Example: GDP as expenditures: 100 Back again to the circular flow model In reality, if completely accurate measurement were possible, the total of expenditure, output, and incomes in a year would be the same—so the point at which the measurement occurs would not matter. GDP: the Government And what about the government? Treat it as another producer – public services are “bought” by the government, using tax revenues (or borrowing) to finance their spending. The consumption and production of public goods and services can be thought as Households to government: Households pay taxes. Government to households: taxes pay for the production of public services used by households. Example: citizens on average pay $15,000 per year in taxes (the equivalent to ‘expenditure’), that is $15,000 of revenues to the government (the income), which uses it to produce $15,000 worth of public goods and services (the value added). GDP: the rest of the world What do we do with international transactions? foreign production is domestic consumption (imports); domestic production is foreign consumption (exports); We include exports and exclude imports – net exports! So that GDP includes value added, income from, or consumption of, domestic production. If someone in France buys mozzarella directly from someone in Italy: the expenditure is French the income is Italian France: this counts as an import and it is subtracted from domestic production. GDP, Expenditures, and Recessions The fact that expenditure, output, and incomes are all equal means that we can use any one of these perspectives to help us understand the others. For example, recessions are periods of falling output in the economy as a whole. From the model of the circular flow, this means they must also be periods of falling expenditure (if output is declining, people must be buying less). Often, we can even say that output declines because people are buying less. This is useful because we know a lot about what determines expenditure, which in turn helps us to understand recessions. This is the subject of the next part. GDP as Expenditures GDP Components Thinking of GDP as total expenditure, we consider it as the sum of expenditures by households and the government on goods and services; firms and the government on aggregate fixed investment in machinery and buildings, and new housing; by people from other countries (we need to subtract domestic expenditures on other countries). We think about 4 major components: Consumption (C) Investment (I) Government Spending (G) Net Exports (NX) Consumption: C Consumption includes the goods and services purchased by households. Goods are normally tangible things: durable goods: cars, household appliances, and furniture that last for three years or more non-durable goods: those that last less than three years, like food. Services are things that households buy that are normally intangible: transportation, housing (payment of rent), gym membership, and medical treatment. Household spending on durable goods like cars and household equipment is counted as consumption in the national accounts. Investment: I Investment spending : by firms and government on new equipment and new commercial buildings; and on new residential dwellings, also by households. This is termed gross fixed capital formation. residential: purchase of houses and apartments; non-residential: purchase of machines, equipment, business buildings, Inventories: changes in inventories, output produced but not sold. “Investment” does not mean the purchase of financial assets like stocks and bonds!!! Government Spending: G This represents the consumption and investment purchases by the government. Government consumption purchases: goods (such as office equipment, software, and cars) services (such as wages of civil servants, armed services, police, teachers, and scientists). Much of government spending on goods and services is for health and education. Government Spending: Expenditure by the government to purchase goods and services. When used as a component of aggregate demand, this does not include spending on transfers such as pensions and unemployment benefits. Government Transfers: NOT counted Spending by the government in the form of benefits and pensions (Medicare in the US or social security benefits in Europe). Government transfers are not considered spending because households receive them as income: They are recorded as consumption or investment when households spend them; Otherwise it will be double counting. Government Transfers: Spending by the government in the form of payments to households or individuals. Unemployment benefits and pensions are examples. Transfers are not included in government spending in the national accounts. The “size of a government”: spending + transfers Net Exports: (X – M) Exports: X domestically produced goods and services that are purchased by households, firms, and governments in other countries. Imports: M goods and services purchased by households, firms, and governments in the home economy that are produced in other countries. The difference is called Net Exports, or the Trade Balance. Components of GDP (2010–2019 average) Accounting Identity: 𝑮𝑫𝑷 ≡ 𝑪 + 𝑰 + 𝑮 + (𝑿 − 𝑴) Components of GDP over time Accounting Identity: 𝑮𝑫𝑷 ≡ 𝑪 + 𝑰 + 𝑮 + (𝑿 − 𝑴)  What is not included in the GDP?  Environmental health: air and water quality, biodiversity, etc.  Human health and quality of life: Life expectancy and quality of lived years.  Security and community: How safe and social people are.  Household production: Goods and services produced by the households that are not traded in a market, like cooking, cleaning and caring for other people (the elderly, or the children). So while GDP is incredibly useful, it is important to remember it has its shortcomings. Interpreting GDP GDP per capita The total output of an economy, GDP, provides a measure of the economy’s capacity to produce the goods and services that we need or enjoy, such as food, education, and government services. Dividing GDP by a country’s population gives us GDP per capita—that is, average income: 𝑮𝑫𝑷 𝑮𝑫𝑷 𝒑𝒆𝒓 𝒄𝒂𝒑𝒊𝒕𝒂 = 𝑷𝒐𝒑𝒖𝒍𝒂𝒕𝒊𝒐𝒏 GDP per capita: a widely used measure of the average living standards in a country. highly correlated with other measures of living standards, such as life expectancy. Can we compare GDP across countries? Suppose we want to know: Are Italians poorer (lower GPD per capita) today relative to Italians in the 70s? Are people in France richer (higher GDP per capita) than people in China? To be able to answer these questions we need to separate between What we want to measure: changes or differences in living standards From things that are not relevant to the comparison: changes or differences in prices of goods and services Accounting for Prices Comparing Output Over Time (One Country): If the price of Champagne is 20% higher today relative to the 70s, does it mean France has got 20% richer? Goal: Focus on changes in the quantity of output, excluding price effects. Comparing Output Across Countries (Same Time): If the price of pizza is higher in France than in Italy, does it imply France is richer? Goal: Focus on differences in the quantity of output, excluding price level variations. Challenge: Identify changes or differences in real output: without capturing price changes.  GDP: Over-Time Comparison Start with: Nominal GDP When estimating GDP for a given period, such as a year, statisticians use the prices at which goods and services are sold in the market, referred to as “current prices”. By multiplying the quantities of the vast array of different goods and services by their prices, they can be converted into money, or nominal terms. With everything in the common unit of nominal (or money) terms, they can be added together, giving us nominal GDP: Comparing Output Over Time: Real GDP If we compare the economy in two different years, and if all the quantities stay the same but the prices increase by, say, 2% from one year to the next, then nominal GDP rises by 2%. However, the economy has not grown! Only prices have increased. To gauge whether the economy is growing or shrinking, we need a measure of the total quantity of goods and services sold. We refer to this total quantity as real GDP. Estimating Real GDP We cannot directly measure real GDP, as we cannot add together the number of computers, shoes, restaurant meals, flights, etc. without using prices (to determined their value). 1. We need to calculate nominal GDP. 2. We pick a “base year” and define real GDP using Nominal GDP in this year. 3. Next, we use the quantities of goods and services in any other year and multiply them by the prices in the base year to get a comparable measure across years. Example: Two Goods Economy Year 2020 (Base Year): Has the economy grown between 2020 and Computers: 100 units at €1,000 each → €100,000 2021? Flights: 200 units at €500 each → €100,000 Calculate real GDP for 2021, Nominal GDP (2020) = €100,000 + €100,000 = we use 2020 prices: €200,000 Computers (100 units): 100 × €1,000 = €100,000 Year 2021: Flights (200 units): 200 × €500 = €100,000 Computers: 100 units at €1,200 each → €120,000 Real GDP (2021, using 2020 prices) = Flights: 200 units at €600 each → €120,000 €100,000 + €100,000 = €200,000 Nominal GDP (2021) = €120,000 + €120,000 = €240,000 We can do this for every other year… Example: UK GDP 1980-2022  GDP: Cross-Country Comparison Comparing Output Across Countries Here we are interested in comparing living standards: GDP per capita. To compare GDP per capita across countries, we need to choose a set of prices and apply it to both countries… why? Consider two countries at very different levels of development: France and India Because prices are so much lower in India than in France, you would need around 1.763€ in Delhi (per month) to maintain the same standard of life that you can have with 4.700€ in Marseille But focusing Euros comparison would suggest that living standard is more than half less in Delhi…this is not true. Purchasing Power Parity (PPP) Prices This is why when comparing living standards across countries, we use estimates of GDP per capita in a common set of prices. Purchasing Power Parity (PPP): PPPs are price indices that measure how much it costs to purchase a basket of goods and services compared to how much it costs to purchase the same basket in a reference country in a particular year. Comparisons between the value of output in two countries are generally performed by converting the value of GDP of each country into US dollars and then comparing them. Can be done either using purchasing power parity (PPP) or exchange rates: the rate at which the currency of one country would have to be converted into that of another to purchase the same amount of goods and services in each country. Using a single good: Big Mac Evolution of GDP per capita 2009–2023 relative to the US (=100) Cross-Country Comparison: GDP Cross-Country Comparison: Living Standards A map of the world Description automatically generated  Inequality across and over time As you can see, GDP is very different across countries… … but it wasn’t always like this! GDP was fairly constant since the middle ages until the 19th century, when the UK started diverging, with other countries following well into the 20th century.  How did this happen? Explaining these differences is one of the key motivations for studying Long-Run Macroeconomics. It requires that we understand what are the determinants of economic growth  Why does GDP increase in some countries but not others?  Can we (or the government) do something about it? While this class does not focus on these sorts of questions, we will nevertheless look at the concept of economic growth and how to measure it. Economic Growth Measurement (1) We calculate the relative increase of GDP from one period to the next: GDP growth The percentage change of GDP from period to period Example: 𝑅𝑒𝑎𝑙 𝐴𝑛𝑛𝑢𝑎𝑙 𝐺𝐷𝑃 𝐺𝑟𝑜𝑤𝑡ℎ 𝑖𝑛 2024 = % 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑟𝑒𝑎𝑙 𝐺𝐷𝑃 𝑏𝑒𝑡𝑤𝑒𝑒𝑛 2023 𝑎𝑛𝑑 2024 Measurement (2) The ‘ratio scale’, example: 𝑟𝑒𝑎𝑙 𝐺𝐷𝑃2024 − 𝑟𝑒𝑎𝑙 𝐺𝐷𝑃2023 𝑅𝑒𝑎𝑙 𝐴𝑛𝑛𝑢𝑎𝑙 𝐺𝐷𝑃 𝐺𝑟𝑜𝑤𝑡ℎ 𝑖𝑛 2024 = × 100 𝑟𝑒𝑎𝑙 𝐺𝐷𝑃2023 Numerator: the absolute change in real GDP between the 2 years Denominator: the base year, that is, the previous year In this way, we can compare GDP growth across countries with very different levels of GDP. Measurement (3) Fictitious Example: UK real annual GDP Fictitious Example: Japan real annual GDP 2024 = 1600 Billion Pounds 2024 = 240 Trillion Yen 2023 = 1500 Billion Pounds 2023 = 220 Trillion Yen 𝑟𝑒𝑎𝑙 𝐺𝐷𝑃2024 − 𝑟𝑒𝑎𝑙 𝐺𝐷𝑃2023 𝑟𝑒𝑎𝑙 𝐺𝐷𝑃2024 − 𝑟𝑒𝑎𝑙 𝐺𝐷𝑃2023 × 100 × 100 𝑟𝑒𝑎𝑙 𝐺𝐷𝑃2023 𝑟𝑒𝑎𝑙 𝐺𝐷𝑃2023 240 − 220 1600 − 1500 = × 100 = 9,1% = × 100 = 6,6% 220 1500 Economic Growth: UK vs Japan The Ratio Scale: Cross Countries The ‘Hockey Stick’ Growth take-off occurred at different points in time for different countries:  Britain was the first country to experience sustained economic growth, since 1650.  In Japan, it occurred around 1870.  The kink for China and India happened in the second half of the 20th century. In some economies, substantial improvements in people’s living standards did not occur until they gained independence from colonial rule or interference by European nations.  Not in all of them though: Neither Spanish colonial rule, nor its aftermath following the independence of most Latin American nations early in the nineteenth century, saw spectacular growth (nor did Spain itself!). It took to the second half of the 20th century. Technological Improvements The main reason behind economic take-off was a succession of rapid technological improvements. Technology: The description of a process using a set of materials and other inputs, including the work of people and machines, to produce an output – like a recipe. An improve in technology can be a new, improved machine. But it can also be changes in the ways we organise production – like the division of labour. By reducing the amount of work-time it takes to produce the things we need, technological changes allowed significant increases in living standards. Industrial Revolution Remarkable scientific and technological advances occurred more or less at the same time as the upward kink in the hockey stick in Britain in the middle of the 18th century. We refer to the changes as the Industrial Revolution. It transformed an agrarian and craft-based economy into a commercial and industrial economy. For example, today the productivity of labour in producing light is half a million times greater than it was among our ancestors around their campfire. How? What made the industrial revolution possible?  New ideas on what is best for the economy (accumulating gold vs production)  Comparative advantage  Access to raw materials and scientific discoveries  New ways of organizing society But , there is also a dark side of economic growth… The ‘Dark Side’  The Economy and the Environment The rapid expansion of production (particularly in the 20 th century) had a toll in the environment, in terms of atmospheric temperature, temperature of the oceans, great loss of biodiversity. Most economic activity requires natural resources, like energy, land and raw minerals. Extracting an using these resources impacts the environment, and can have effects on economic growth itself (if people become sick from air pollution, for example) and on the wider planet (destruction of ecosystems). But the technological revolution, which brought about dependence on fossil fuels and factory farming, may also be part of the solution to today’s environmental problems. We will not talk much about this in this class, but it is important to keep it in mind. Wrapping Up Today we have looked at how to measure the output produced in a country. We broke down the calculation of GDP as expenditures into its key components. We’ve gained an understanding of how to interpret GDP data, both over time, and across countries. We’ve introduced the meaning of economic growth and analysed some trends. In the next lecture, we will begin developing our model of the macroeconomy, starting with a model of aggregate demand that can explain changes in GDP in the short run. Quiz Key References The Economy 2.0: Macroeconomics Unit 3 – 3.5