Chapter 4 Lecture

MEASURING GDP AND

ECONOMIC GROWTH
 Stocks and Flows
 The distinction between a stock and a flow is very
important.
 A stock is a position at a moment of time, for example, the
stock of inventories in the economy at year end 2005.
(Balance sheets report stocks.)
 A flow is the rate of change in a stock, for example, the
change in the stock of inventories in the economy in 2005.
(Profit and loss statements report flows.)
 If the bath tub is filling up, the stock is rising.

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 Gross Domestic Product
GDP Defined

◦ GDP or gross domestic product is the market value of all final

goods and services produced in a country in a given time period.
◦ This definition has four parts:
Market value
Final goods and services
Produced within a country
In a given time period
Excludes financial transactions and income transfers since these do
not reflect production.
Net additions to inventory are current period output so are also
included.

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 Gross Domestic Product
Market Value
◦ GDP is a market value—goods and services are valued at their market
prices.
◦ To add apples and oranges, computers and popcorn, we add the market
values so we have a total value of output in dollars.
Final Goods and Services
◦ GDP is the value of the final goods and services produced.
◦ A final good (or service) is an item bought by its final user during a
specified time period.
◦ A final good contrasts with an intermediate good, which is an item that is
produced by one firm, bought by another firm, and used as a component of
a final good or service.
◦ Excluding the value of intermediate goods and services avoids counting
the same value more than once.

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 Gross Domestic Product
Produced Within a Country
◦GDP measures production within a country—domestic
production.
In a Given Time Period
◦GDP measures production during a specific time period,
normally a year or a quarter of a year.

Gross National Product (GNP) is the total market value of

final goods and services produced during a given period by the
citizens of a country no matter where they live. The goods and
services are produced by the “nationals” of the country.

GDP is the preferred measure these days. Why? 5

 Gross Domestic Product
GDP and the Circular Flow of Expenditure and
Income
◦GDP measures the value of production, which also
equals total expenditure on final goods and total
income.
◦The equality of income and value of production shows
the link between productivity and living standards.
◦The circular flow diagram on the next slide illustrates
the equality of income and expenditure.

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 Gross Domestic Product
The sum of the red flows equals the blue flow.
The blue and red flows are the circular flow of expenditure and
income.
That is: Y = C + I + G + X – M

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 Gross Domestic Product
The circular flow shows two ways of measuring GDP.
GDP Equals Expenditure Equals Income
Total expenditure on final goods and services equals GDP.
 GDP = C + I + G + X – M.
Aggregate income equals the total amount paid for the use
of factors of production: wages, interest, rent, and profit.
Firms pay out all their receipts from the sale of final
goods, so income equals expenditure,
◦ Y = C + I + G + (X – M).

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 Measuring National Income

3 ways of measuring national income :

GDP by value added

GDP on the expenditure side
GDP on the income side

All methods should result give similar

answers when adjusted for market prices
versus factor costs.

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VALUE ADDED in a Five-Stage Production Process

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Expenditure vs. Income Approach

Consumption by Wages

+
Households

+
Investment by Rents
Businesses G +
+ = D= Interest
Government
Purchases P +
Profits
+
Expenditures
+
Statistical
By Foreigners Adjustments
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 GDP as Expenditures
GDP is the sum of the amount each sector
(households, investors, governments, and foreigners)
spends on final user goods and services.
There are four components of GDP:

• personal consumption expenditures (C),

• gross private domestic investment (I),
• government purchases (G) of goods and services, and,
• net exports (NX) = ( exports - imports )

GDP = C + I + G + NX

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 Personal Consumption
Consumer Durables
Durable has a life of over 3 years: cars, furniture,
etc
Consumer Non-Durables
Goods with a life of less than three years: food,
utilities, clothing
Services
Housing, healthcare, recreation, education

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 Investment: Adding to
the Capital Stock
 Flows and Stocks
◦ A stock is a quantity: capital, inventories and wealth are
stock variables
◦ A flow is an addition to or a subtraction from a stock:
Investment and income are flow variables
 Investment in National Stocks
◦ Residential Investment (homes)
◦ Non-residential Investment (business investments in
structures and equipment)
◦ Changes in Inventories (changes get registered)

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 Net Investment
Gross Investment
- Depreciation or Capital Consumption Allowance

= Net Investment
Net
Investment
Gross
Investment
Depreciation

Increase

Consumption
Stock of & Government Stock of
Capital Spending Capital

January 1 Year’s GDP December 31

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 Government
 Government Expenditures reflect direct consumption, not transfers

Defense, Government investments in roads and other infrastructure, government services such as Department of Motor
Vehicles. Police and Congress are all expenditures.

Transfer payments represent money redistributed from one group of citizens (taxpayers) to another (poor, unemployed,
elderly).
While transfers are included in government budgets as outlays they are not purchases of currently produced goods and
services.
Does not result in production of new goods and services
Does not included in government purchases or in GDP

◦ Examples: Social Security, Medicare and Medicaid and Interest payments on national debt

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 External Accounts
 Imports (M): Product Accounts: Goods and Services
 Exports (X): Product Accounts: Goods and Services

 Net Exports = NX = X – M
 If NX = X – M > 0 Trade Surplus
 If NX = X – M < 0 Trade Deficit

 Here are some examples of exports of services

 Spending of foreign tourists in USA
 transportation services
 insurance / banking services
 medical services
 retail services (souvenirs)
 hotel accommodation services
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http://www.bea.gov/iTable/iTable.cfm?ReqID=9&step=1 18
 Measuring U.S. GDP
The Income Approach
◦The income approach measures GDP by summing the incomes
that firms pay households for the factors of production they hire.
The National Income and Expenditure Accounts divide incomes into two
broad categories:
1. Compensation of employees
2. Net operating surplus
Compensation of employees is the payments for labor services. The sum
of net wages plus taxes withheld plus social security and pension fund
contributions.
Net operating surplus is the sum of other factor incomes. It includes net
interest, rental income, corporate profits, and proprietor’s income.

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 Measuring U.S. GDP
The sum of all factor incomes is net domestic
income at factor cost.
Two adjustments must be made to get GDP:

1. Indirect taxes less subsidies are added to get from

factor cost to market prices.
2. Depreciation is added to get from net domestic
income to gross domestic income.

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 Measuring U.S. GDP
Nominal GDP and Real GDP
◦Real GDP is the value of final goods and services
produced in a given year when valued at valued at
the prices of a reference base year.
◦Currently, the reference base year is 2005 and we
describe real GDP as measured in 2005 dollars.
◦Nominal GDP is the value of goods and services
produced during a given year valued at the prices that
prevailed in that same year.
◦Nominal GDP is just a more precise name for GDP.

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 Measuring U.S. GDP
Calculating Real GDP
• Table 4.3 (a) shows the quantities
produced and the prices in 2009 (the
base year).
• Nominal GDP in 2009 is $100
million.
• Because 2009 is the base year, real
GDP equals nominal GDP and is $100
million.
•Table 4.3(b) shows the quantities
produced and the prices in 2014.

•Nominal GDP in 2014 is $300 million.

•Nominal GDP in 2014 is three times its
value in 2009.

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 Measuring U.S. GDP

In Table 4.3(c), we calculate

real GDP in 2014.
The quantities are those of
2014, as in part (b).
The prices are those in the
base year (2009) as in part (a).
The sum of these
expenditures is real GDP in
2014, which is $160 million.

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 The Uses and Limitations of Real GDP
TheStandard of Living Over Time
◦Real GDP per person is real GDP divided by the population.
◦Real GDP per person tells us the value of goods and services
that the average person can enjoy.
◦By using real GDP, we remove any influence that rising
prices and a rising cost of living might have had on our
comparison. Long-Term Trend
◦A handy way of comparing real GDP per person over time is
to express it as a ratio of some reference year.
◦For example, in 1960, real GDP per person was $15,850 and
in 2012, it was $42,800.
◦So real GDP per person in 2012 was 2.7 times its 1960 level
—that is, $42,800 ÷ $15,850 = 2.7.
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The Uses and Limitations of Real GDP
◦Two features of our expanding living standard are
 The growth of potential GDP per person
 Fluctuations of real GDP around potential GDP
◦The value of real GDP when all the economy’s
labor, capital, land, and entrepreneurial ability are
fully employed is called potential GDP.

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 Real and Potential GDP

http://www.washingtonpost.com/wp-srv/business/the-output-gap/index.html
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The Uses and Limitations of Real GDP

◦Productivity Growth Slowdown

◦The growth rate of real GDP per person slowed
after 1970. How costly was that slowdown?
◦The answer is provided by a number that we’ll
call the Lucas wedge.
◦Lucas wedge is the dollar value of the
accumulated gap between what real GDP per
person would have been if the 1960s growth rate
had persisted and what real GDP per person turned
out to be.
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 Lucas Wedge
◦The red line is actual real
GDP per person.
◦The thin black line is the
trend that real GDP per
person would have
followed
if the 1960s growth rate of
potential GDP had
persisted.
◦The shaded area is the
Lucas wedge.

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The Uses and Limitations of Real GDP
Limitations of Real GDP
◦Real GDP measures the value of goods and services
that are bought in markets.
◦Some of the factors that influence the standard of
living and that are not part of GDP are
 Household production
 Underground economic activity
 Health and life expectancy
 Leisure time
 Environmental quality
 Political freedom and social justice
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What GDP Does and Does Not Capture
Can you think of other activities not captured by GDP
that ought to be included?
Genuine Progress Indicator (GPI)*
Adjust GDP for welfare-reducing activities such as
resource depletion; environmental damage; crime;
and quality of life.
http://www.green.maryland.gov/mdgpi

GDP can also be a poor measure of the living standards in

various nations.
To get around the problem, economists use purchasing
power parity (PPP), which adjusts for different relative
prices among nations before making comparisons.

http://www.indexmundi.com/g/r.aspx?c=mr&v=67

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 Business Cycles
Real GDP Fluctuations— The Business Cycle
A business cycle is a periodic but irregular up-and-down movement of total
production and other measures of economic activity.
Every cycle has two phases:
1. Expansion
2. Recession
and two turning points:
1. Peak
2. Trough

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 Business Cycles

An expansion is a
period during which real
GDP increases—from a
trough to a peak.
Recession is a period
during which real GDP
decreases—its growth
rate is negative for at least
two successive quarters.

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