Ch. 5 : MEASURING GDP AND ECONOMIC GROWTH

1. Ch. 5 : MEASURING GDP AND ECONOMIC GROWTH • Define GDP • Circular flow model • Relationship between aggregate expenditure and aggregate income. • Measurement of real GDP and the GDP deflator • Real GDP as a measure of economic growth and the limitations of our measure

2. Gross Domestic Product • GDP: gross domestic product • 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

3. Gross Domestic Product • GDP and the Circular Flow of Expenditure and Income • GDP measures the value of production • equals total expenditure on final goods • equals total income from production. • The circular flow diagram illustrates the equality of income, expenditure, and the value of production.

4. Gross Domestic Product • Red=expenditures Blue=income Green=borrowing/lending/taxes

5. Gross Domestic Product • Two ways to measure GDP: • Expenditure Approach: • Aggregate expenditure = C + I + G + (X-M) • Income Approach • Aggregate income = Y = Wages + Rent + Interest + Profit • Because Income and expenditure approach both measure GDP: Y = C + I + G + (X-M)

6. Gross Domestic Product • Financial Flows • Y = C + S + T • Y = C + I + G + (X-M) • S+T = I+G+(X-M) • (G-T) = (S-I)-(X-M) • According to last equality, what are the possible consequences of a larger government budget deficit?

7. Gross Domestic Product • How Investment Is Financed • The last equation could also be reorganized as: • I = S + (T-G) + (M-X) • Investment is financed from three sources: • Private saving, S • Government budget surplus, (T – G) • S + (T-G) is “national saving” • Borrowing from the rest of the world (M – X).

8. Gross Domestic Product • Gross vs. Net Domestic Product • “Gross” means before accounting for the depreciation of capital. • Net Domestic Product = GDP – Capital Consumption Allowance.

9. Gross Domestic Product Stocks versus flows • Wealth • a stock representing the value of all the things that people own • Saving • A flow that is the source of changes in the stock of wealth. • Capital • A stock representing the plant, equipment, and inventories of raw and semi-finished materials that are used to produce other goods • Investment • A flow representing the purchases of new capital • Depreciation (capital consumption) • A flow representing the decrease in the capital stock that results from wear and tear, and obsolescence.

10. Gross Domestic Product The relationships among capital, gross investment, depreciation, and net investment.

11. Gross Domestic Product • Depreciation is included in: • GDP • Gross profits • Gross Investment • Depreciation is removed from • Net National Product • Net profits • Net investment • Investment plays a central role in the economy. • Increases in capital are one source of growth in potential real GDP; • Fluctuations in investment are one source of fluctuations in real GDP.

12. Measuring U.S. GDP • The National Income and Product Accounts divide incomes into five categories • Compensation of employees • Net interest (paid by business) • Rental income • Corporate profits. • Proprietors’ income. • The sum of these five income components is net domestic income at factor cost.

13. Measuring U.S. GDP • Two items must be added to get GDP • Indirect taxes minus subsidies are added to get from factor cost to market prices. • Depreciation (or capital consumption) is added to get from net domestic product to gross domestic product.

14. Expenditure Components of US GDP: 2004

15. Real GDP and the Price Level • Nominal GDP is the value of final goods and services produced in a given year when valued at the same year’s prices • Real GDP is the value of final goods and services produced in a given year when valued at constant (base year) prices.

16. Real GDP and the Price Level • 2002 NGDP ________ • 2003 NGDP ________ • Growth rate ________ • Base year of 2002 • 2002 RDGP ________ • 2003 RGDP ________ • Growth rate ________ • Base year of 2003 • 2002 RDGP ________ • 2003 RGDP ________ • Growth rate ________

17. Chain-weighted method for real GDP • Calculate growth rate in real GDP using last year’s prices. ______ • Calculate growth rate in real GDP using this year’s prices. ______ • Calculate the average of the two growth rates. This average growth rate is the growth rate of real GDP from last year to this year. average growth rate _______ RGDP (using 2002 as base) _________ 4. Repeat steps 1, 2, and 3 for each pair of adjacent years to link real GDP back to the base year’s prices.

18. Real GDP and the Price Level • GDP deflator • Avg. of the prices of the goods in GDP in the current year expressed as a % of the base year prices.

19. Interpreting the GDP-deflator • The GDP-deflator provides a comparison of current year prices with base year prices. • If deflator =100, prices are, on average, the same. • If deflator=150, current year prices are, on average, 1.5 times those in base year (50 percent higher) • If deflator=75, current year prices are, on average .75 times those in base year. (25 percent lower)

21. Measuring Economic Growth • We use real GDP to calculate the economic growth rate. • The economic growth rate is the percentage change in real GDP from one year to the next.

22. R-GDP as a measure of economic welfare. • Quality improvements • Household production • Underground economy • Health and life expectancy • Leisure time • Environment • Political freedom and social justice • Exchange rate in comparing across countries.

23. Exchange rates and comparisons across countries. • Using actual exchange rate, U.S. real GDP per capita = 69* Chinese real GDP per capita • Using PPP exchange rate, U.S. real GDP = 12*Chinese real GDP per capita. • What does this say about actual versus PPP exchange rate?