EE1900-Chapter 12 - GDP PDF

CHAPTER CHAPTER GDP: Measuring Total 12 Production and Income Chapter Outline and Learning Objectives 12.1 Gross Domestic Product Measures Total Production 12.2 Does GDP Measure What...

CHAPTER CHAPTER GDP: Measuring Total 12 Production and Income Chapter Outline and Learning Objectives 12.1 Gross Domestic Product Measures Total Production 12.2 Does GDP Measure What We Want it to Measure? 12.3 Real GDP versus Nominal GDP 12.4 Other Measures of Total Production and Total Income © 2015 Pearson Education, Inc. 1 Microeconomics and Macroeconomics Microeconomics is the study of how households and firms make choices, how they interact in markets, and how the government attempts to influence their choices. In contrast, macroeconomics is the study of the economy as a whole, including topics such as inflation, unemployment, and economic growth. When we want to study the overall economy-level actions of people and governments, the models and tools of macroeconomics become very useful. © 2015 Pearson Education, Inc. 2 Some Important Terms in Macroeconomics Business cycle: Alternating periods of economic expansion and economic recession. Expansion: The period of a business cycle during which the total production and total employment are increasing. Recession: The period of a business cycle during which total production and total employment are decreasing. Economic growth: The ability of an economy to produce increasing quantities of goods and services. Inflation rate: The percentage increase in the price level from one year to the next. © 2015 Pearson Education, Inc. 3 Goal of This Chapter Over the coming chapters, we will explore many aspects of the economy, including how all of the elements on the previous slide relate to one another. For this chapter, we have a less lofty goal: to figure out how to measure the total output of an economy. Being able to measure total output is incredibly important, since much of macroeconomics depends on our ability to measure and predict aggregate economic activity. © 2015 Pearson Education, Inc. 4 Measuring Total Production: Gross Domestic Product The most common measure used by economists of overall economic activity in an economy is Gross domestic product, or GDP. Gross domestic product: the market value of all final goods and services produced in a country during a period of time, typically one year. We will examine each of the parts of this definition. © 2015 Pearson Education, Inc. 5 “Market Values” Gross domestic product: the market value of all final goods and services produced in a country during a period of time, typically one year. GDP Is Measured Using Market Values, Not Quantities. Market Value GDP is a market value—goods and services are valued at their market prices. We cannot add together the number of cars, melons, haircuts, and all other goods and services without agreeing on a common way to measure them. The best practical way is to value each good and service in monetary terms; and the best measure of this that we have is the price that each good or service is sold for. © 2015 Pearson Education, Inc. 6 “Final Goods and Services” Gross domestic product: the market value of all final goods and services produced in a country during a period of time, typically one year. A final good or service is a good or service purchased by a final user. These are what are used to calculate GDP. Why? If we counted intermediate goods and services as well, ones that were inputs into another good or service, such as a tire on a truck, then we would end up double-counting. Example: if we counted the value of the ice cream bought by a store, and also counted the value of that ice cream when it was sold to a consumer, we would be double-counting the wholesale value of the ice cream. © 2015 Pearson Education, Inc. 7 “During a Period of Time” Gross domestic product: the market value of all final goods and services produced in a country during a period of time, typically one year. To measure total output in a given year, we measure the goods and services produced only in that given year. Again, this avoids double-counting: if you buy a DVD in 2011, that DVD counts in 2011’s GDP. If you resell it in 2012, it will not count again in 2012. So GDP counts only new goods and services. Used items were previously produced and counted, so don’t need to be counted again. © 2015 Pearson Education, Inc. 8 Production and Income There are two main conceptual ways to measure the total economic activity in an economy: total production or total income. When we measure one, we are also measuring the other. Why? Everything that is produced and sold constitutes income for someone; so we have the choice of measuring the value of products produced and sold, or the value of incomes, and each is a valid way of measuring economic activity. https://www.youtube.com/watch?v=mjJmo5mN5yA 5min GDP https://www.youtube.com/watch?v=Z0qHA93oOSc 5min Real GDP per capita and the standard of living https://www.youtube.com/watch?v=PzAr_mL0Qd8 4min Basic Facts of Wealth © 2015 Pearson Education, Inc. 9  Gross Domestic Product Why “Domestic” and Why “Gross”? Domestic Domestic product is production within a country. It contrasts with national product, which is the value of goods and services produced anywhere in the world by the residents of a nation. Gross Gross means before deducting the depreciation of capital. The opposite of gross is net, which means after deducting the depreciation of capital. Problem 1 Product Quantity Price Sweatshirts 50 $35.00 Dental Examination 40 75.00 Coffee drinks 1000 4.00 Coffee beans 2000 0.50 Suppose that a simple economy produces only four goods and services: sweatshirts, dental examinations, coffee drinks, and coffee beans. Assume all of the coffee beans are used in the production of the coffee drinks. Using the information in the above table, calculate the nominal GDP for this simple economy? © 2015 Pearson Education, Inc. 11 Problem 2 Product Quantity Price Shoes 60 $40.00 DVDs 100 18.00 Tomatoes 2000 1.00 Ketchup 300 4.00 Suppose that a simple economy produces only four goods and services: shoes, DVDs, tomatoes, and ketchup. Assume one half of the tomatoes are used in making the ketchup and the other half of the tomatoes are purchased by households. Using the information in the above table, calculate the nominal GDP for this simple economy? © 2015 Pearson Education, Inc. 12 The Circular Flow and the Measurement of GDP In a very simple model of the economy, we could start with households and firms. To measure overall economic activity, we could measure the amount of money that households spend on goods and services. Or we could measure income to households. Figure 12.1 The circular flow and the measurement of GDP © 2015 Pearson Education, Inc. 13 Adding Government to the Circular Flow Let’s add in some more layers. We’ll start with government. How does the government affect economic activity? It takes in taxes from households and firms. It uses those taxes to buy goods and services, and to make transfer payments—payments to households for which the government does not Figure 12.1 receive a good or service in return. The circular flow and the measurement of GDP © 2015 Pearson Education, Inc. 14 Adding the Rest of the World to the Circular Flow Some economic activity takes place between households, firms, and the rest of the world. Households buy goods and services from firms in other countries; these are known as imports. Firms sell goods and services to households in other countries; these are known as exports. Figure 12.1 The circular flow and the measurement of GDP © 2015 Pearson Education, Inc. 15 Adding the Financial System to the Circular Flow Finally, there are firms that deal specifically in flows of money; we label these firms the financial system. Households elect not to spend some of their income, and instead save it with financial system firms like banks. These financial system firms lend money to other firms and the government. Figure 12.1 The circular flow and the measurement of GDP © 2015 Pearson Education, Inc. 16 Follow the Spending to Measure GDP To measure GDP, the Bureau of Economic Analysis (BEA) in the Department of Commerce measures four major categories of expenditures: Personal Consumption Expenditures, or “Consumption” (C) Gross Private Domestic Investment, or “Investment” (I) Government Consumption and Gross Investment, or “Government Purchases” (G) Net Exports of Goods and Services, or “Net Exports” (NX) GDP can be expressed as the sum of these: Y = C + I + G + NX We will examine each component of GDP in turn. © 2015 Pearson Education, Inc. 17 Consumption Y = C + I + G + NX Consumption is spending by households on goods and services, not including spending on new houses (which are counted instead as investments). In BEA statistics, consumption is further divided into expenditure on services, durable goods, and nondurable goods. © 2015 Pearson Education, Inc. 18 Investment Y = C + I + G + NX Investment is spending by firms on new factories, office buildings, and additions to inventories, plus spending by households and firms on new houses. The BEA measures the following categories of investment: business fixed investment, residential investment, and changes in business inventories. This last category includes goods that have been produced but not yet sold. © 2015 Pearson Education, Inc. 19 Government Purchases Y = C + I + G + NX Government purchases are spending by federal, state, and local governments on goods and services, such as teachers’ salaries, highways, and military. This does not include transfer payments, since those do not result in immediate production of new goods and services. © 2015 Pearson Education, Inc. 20 Net Exports Y = C + I + G + NX Net exports are defined as the value of exports minus the value of imports. This difference might be positive or negative; in recent years, this has been negative in the United States. Since we want to count domestic production (production in the United States), we add up the value of the goods and services sold to foreigners, and subtract off the value of the goods and services sold to Americans by foreigners. © 2015 Pearson Education, Inc. 21 Components of GDP in 2012 Figure 12.2 Components of GDP in 2012 Consumption is the largest component of GDP; within that, services are the largest component—almost half of GDP. American net exports are negative, since the value of our imports exceeds the value of our exports. © 2015 Pearson Education, Inc. 22 Consumption and Investments In BEA statistics, consumption is further divided into expenditure on Services, such as medical care, education, and haircuts Nondurable goods, such as food and clothing, and Durable goods, such as automobiles and furniture. The BEA measures the following categories of investment: Business fixed investment, such as new factories, office buildings, machinery, and research and development. Residential investment, i.e. new single-family and multi-unit houses. Changes in business inventories, i.e. goods that have been produced but not yet sold… If Ford has $200 million worth of unsold cars at the beginning of the year and $350 million worth of unsold cars at the end of the year, then the firm has spent $150 million on inventory investment during the year. © 2015 Pearson Education, Inc. 23  Making the Adding More of Lady Gaga to GDP Connection The BEA (Bureau of Economic Analysis) continually studies ways to improve its measurement of GDP. In 2013, the BEA started counting R&D as investment, rather than an intermediate good, so as to emphasize the importance of intellectual property. A consequence is that money spent on development of, say, entertainment products, now gets counted as investment. So the money spent by Lady Gaga and her record company on writing and recording her songs is now included in the investment component of GDP. © 2015 Pearson Education, Inc. 24 Measuring GDP Using the Value-Added method An alternative method to measure GDP is to measure the value added: the market value a firm adds to a product. The final selling price of a product must equal the sum of the values added to the product at each stage of production. The table below illustrates this method for a shirt sold on L.L.Bean’s web site. Firm Value of Product Value Added Cotton farmer Value of raw cotton = $1 Value added by cotton farmer = 1 Textile mill Value of raw cotton woven Value added by cotton textile = 2 into cotton fabric = $3 mill = ($3 − $1) Shirt company Value of cotton fabric made Value added by shirt = 12 into a shirt = $15 manufacturer = ($15 − $3) L.L.Bean Value of shirt for sale on Value added by L.L.Bean = 20 L.L.Bean’s Web site = $35 = ($35 − $15) Total Value Added = $35 Table 12.1 Calculating value added © 2015 Pearson Education, Inc. 25 Shortcomings of GDP GDP can be a useful tool to measure total output in an economy. Many people go further than this, interpreting GDP as a measure of the well-being of citizens. However GDP has shortcomings, both in its measure of total production, and in its usefulness as a measure of well-being. © 2015 Pearson Education, Inc. 26 Shortcomings of GDP as a Measure of Total Production Two important types of production are omitted from the BEA’s measurement of GDP: Household Production Household production such as childcare, cleaning, and cooking is not typically paid for with money. However such contributions are real—if they were performed by a non-household-member, they would be paid for and counted in GDP. The Underground Economy Buying and selling of goods and services might be concealed from the government to avoid taxes or regulations, or because the goods and services are illegal. This constitutes the underground economy. This may be 10% or more of the economy in America, and substantially more in low-income households. © 2015 Pearson Education, Inc. 27 Shortcomings of GDP as a Measure of Total Production Individuals and firms sometimes conceal the buying and selling of goods and services, in which case their production isn’t counted in GDP. Individuals and firms conceal what they buy and sell for three main reasons: 1. They are dealing in illegal goods and services, such as drugs; 2. They want to avoid paying taxes on the income they earn; 3. They want to avoid government regulations. According to worldeconomics.com, the size of Morocco’s informal economy is estimated to be 36.6%. An informal economy (informal sector or shadow economy) is the part of any economy that is neither taxed nor monitored by any form of government. © 2015 Pearson Education, Inc. 28 How Important Are These Shortcomings? If we are comparing GDP from year to year, the size of household production and the underground economy is probably about the same from year to year, so GDP growth is a reasonable measure of the growth in total production. However over long periods of time, these shortcomings might be more serious. Example: As women have entered the workforce in larger numbers, some household production has been replaced by paid childcare and restaurant meals. So increases in GDP may exaggerate the increase in actual total production. © 2015 Pearson Education, Inc. 29  Making Underground Economies in Developing Countries the Connection In developing countries, the underground economy is often referred to as the informal sector, as opposed to the formal sector, in which output of goods and services is measured. In many developing countries, the informal sector is very large; often above 50% of total output. Economists studying economic development say this often reflects poor government policies: high taxes and regulations and low confidence in the security of private property from government seizure. © 2015 Pearson Education, Inc. 30 Shortcomings of GDP as a Measure of Well-Being GDP per capita (i.e. GDP divided by population) is often used to represent differences in standards of living from country to country. However, even if it accurately measured total production, it would not reflect: The value of leisure Pollution and other negative effects of production Crime and other social problems The distribution of income In fact, improvements in many of these will result in lower GDP per capita. Example: Lower crime would allow lower spending on police, prisons, and private security. This would decrease GDP, but surely result in improvements in economic well-being. © 2015 Pearson Education, Inc. 31  Making the Did World War II Bring Prosperity? Connection World War II was a period of extraordinary sacrifice and achievement by the “greatest generation.” But statistics on GDP may give a misleading indication of whether it was also a period of prosperity: Production was very high, but much of the production was of military goods—so people weren’t becoming more well-off. After the war, GDP fell; but the production of consumption goods rose rapidly. © 2015 Pearson Education, Inc. 32  Real GDP versus Nominal GDP 12.3 LEARNING OBJECTIVE Discuss the difference between real GDP and nominal GDP. © 2015 Pearson Education, Inc. 33 Calculating Real GDP Since GDP is measured in “value” terms, we might have problems interpreting changes over time if prices change. Is an increase in GDP due to production increasing, or due to prices increasing? To separate these effects, the BEA calculates both nominal GDP—the value of final goods and services evaluated at current- year prices—and real GDP—the value of final goods and services evaluated at base-year prices. The choice of a base-year is arbitrary; we might use any year’s prices to compare real GDP in each year. The current standard is 2009. Unfortunately, the relative prices also change from year to year, distorting real GDP calculations. Since 1996, the BEA has overcome this problem by using chain-weighted prices, using previous-year prices to adjust current-year production measure. © 2015 Pearson Education, Inc. 34 Calculating Real GDP: An Example 2009 2015 The table shows output and Product Quantity Price Quantity Price prices in 2009 and 2015. Eye examinations 80 $40 100 $50 Calculating the total value of Pizzas 90 11 80 10 output in 2009 gives: Textbooks 15 90 20 100 $3200 + $990 + $1350 = $5540. 2015 2009 Product Quantity Price Value To calculate real GDP in 2015, Eye examinations 100 $40 $4,000 we use the prices from 2009. Pizzas 80 11 880 This gives real 2015 GDP in Textbooks 20 90 1,800 2009 dollars of $6680. Most prices increased from 2009 to 2015, so using nominal GDP would have yielded a higher figure: $7800. This highlights the need to use real GDP to avoid exaggerating growth. https://www.youtube.com/watch?v=rGqhTQyY6g4 7min © 2015 Pearson Education, Inc. 35 Comparing Real GDP and Nominal GDP The current base year for calculating prices is 2009, so real and nominal GDP are equal in 2009. Growth figures reported in the media are the growth in real GDP. Since prices have generally increased since 2009, real GDP is less than nominal GDP, and the opposite is true Figure 12.3 Nominal GDP and real before 2009. GDP: 1990-2012 © 2015 Pearson Education, Inc. 36 The GDP Deflator Economists and policy-makers are interested in the price level: a measure of the average prices of goods and services in the economy. Why? Stable prices are desirable because they allow households and firms to plan for the future appropriately. In order to know whether we are achieving price stability, we need to measure the price level. One way to do this is using the GDP deflator: a measure of the price level, calculated by dividing nominal GDP by real GDP and multiplying by 100: Nominal GDP GDP deflator = ´100 Real GDP Since nominal and real GDP will be the same in the base year, the GDP deflator will be 100 in the base year. © 2015 Pearson Education, Inc. 37 Calculating the GDP Deflator The table on the right gives the 2011 2012 values of nominal and real GDP for 2011 and 2012. Nominal GDP $15,534 billion $16,245 billion Real GDP $15,052 billion $15,471 billion We can use this to calculate the GDP deflator in each year: Formula Applied to 2011 Applied to 2012 GDP Nominal GDP æ $15,534 billion ö æ $16,245 billion ö Deflator = ´ 100 ç ÷ ´ 100 = 103 ç ÷ ´100 = 105 Real GDP è $15,052 billion ø è $15,471 billion ø The GDP deflator increased from 103 to 105 between the two years. This is a 1.9% increase: æ 105 - 103 ö ç ÷ ´100 = 1.9% è 103 ø So we say the price level rose 1.9% over this period. © 2015 Pearson Education, Inc. 38 Problem 1. Suppose people only consume 3 different goods. The following table shows the prices and quantities of each good consumed in 2006, 2007, and 2008. Year Price of Quantity Price of Quantity of Price of Quantity Fish of Fish Chicken Chicken Beef of Beef 2006 $7 400 $8 225 $10 175 2007 8 550 7 250 12 275 2008 9 900 6 275 15 275 a- Calculate nominal GDP in each of the three years. b- Calculate Real GDP in each of the three years, using 2006 as the base year. c. Calculate the GDP deflator for each of the three years. d. Calculate inflation for 2006 to 2007 and for 2007 to 2008. © 2015 Pearson Education, Inc. 39 Solution Nominal GDP is simply equal to the sum of the current year price * current year quantity of all the goods. 2006: (7*400) + (8*225) + (10*175) = 2,800 + 1,800 + 1,750 = $6,350. 2007: (8*550) + (7*250) + (12*275) = 4,400 + 1,750 + 3,300 = $9,450. 2008: (9*900) + (6*275) + (15*275) = 8,100 + 1,650 + 4,125 = $13,875. Real GDP is equal to the sum of the base year price * current year quantity of all the goods. 2006: (7*400) + (8*225) + (10*175) = 2,800 + 1,800 + 1,750 = $6,350. 2007: (7*550) + (8*250) + (10*275) = 3,850 + 2,000 + 2,750 = $8,600. 2008: (7*900) + (8*275) + (10*275) = 6,300 + 2,200 + 2,750 = $11,250. The GDP deflator is equal to (Nominal GDP / Real GDP)*100. 2006: 100. Because 2006 is the base year we know the deflator has to equal 100 even without doing any calculations. 2007: (9,450 / 8,600)*100 = 109.9. 2008: (13,875 / 11,250)*100 = 123.3. © 2015 Pearson Education, Inc. 40 Solution Inflation is equal to the growth rate of the GDP deflator. The growth rate formula is: ((Year2 – Year1)/Year1) *100. 2007: ((109.9 – 100)/100)*100 = 9.9%. 2008: ((123.3 – 109.9)/109.9)*100 = 12.2%. © 2015 Pearson Education, Inc. 41 Real GDP Per Capita https://www.youtube.com/watch?v=Z0qHA93oOSc Real GDP per capital and the standard of living Wealth of Nations https://www.youtube.com/watch?v=9-4V3HR696k 9min How to make a country rich? https://www.youtube.com/watch?v=Y9zThcMJzQU 9min © 2015 Pearson Education, Inc. 42  The Uses and Limitations of Real GDP The Standard of Living Across Countries Two problems arise in using real GDP to compare living standards across countries: 1. The real GDP of one country must be converted into the same currency units as the real GDP of the other country. 2. The goods and services in both countries must be valued at the same prices.  The Uses and Limitations of Real GDP Using the exchange rate to compare GDP in one country with GDP in another country is problematic because … prices of particular products in one country may be higher or lower more than in the other country. For example, using the market exchange rate to value China’s GDP in U.S. dollars leads to an estimate that in 2016, GDP per person in the United States was 6.3 times GDP per person in China. International comparisons and PPP prices. People sometimes see estimates of GDP per person in developing nations. Most such estimates are extremely low, and people often ask: how people can live on such low incomes? We can Point out that the estimate is biased downward in two ways. First, in poor nations, more transactions do not go through a market than in rich nations. For example, transportation services in developing nations include a lot of walking, which is not counted as part of GDP. In richer nations, people ride a bus or subway and pay a fare, which is counted as part of GDP. Second, many locally produced and consumed goods and services have extremely low prices in poor nations. For example, a haircut that costs $20 in New York might cost $1 in Calcutta. (You might get a better haircut in New York, but probably not one that is 20 times better!) Converting Indian GDP into U.S. dollars at the market exchange rate leaves this bias in the data. Using purchasing power parity prices to convert India’s GDP into U.S. dollars avoids this bias.