ECON 201

1. ECON 201 Chapter 5 GDP & Economic Growth

2. Learning Objectives • How GDP is Defined and Measured. • How economists distinguish between nominal GDP & real GDP. • Long-term trend of U.S. economic growth. • General ingredients of economic growth & how they relate to production possibilities analysis. • “Growth Accounting” & the specific sources of U.S. economic growth. • Why U.S. productivity growth has accelerated since the mid-1990’s. • About differing perspectives on whether growth is desirable & sustainable.

3. Gross Domestic Product (GDP) The total market value of all final goods and services produced in a given year. This includes all goods and services provided by citizens or foreigners working in the U.S. It is a monetary measure and one way for us to determine how our economy is doing compared to previous years. The more goods and services we produce the ‘healthier’ we are.

4. Avoiding multiple counting • If GDP is going to be effective, we must avoid counting goods and services multiple times. • Therefore, only final goods are counted, and not intermediate goods. • Example : wool suits • Instead of adding up the sales value of each transaction in the making of the suit, we only count the final cost of the suit. • Another term for this: value added

5. Other exclusions • Non-production transactions: Financial & second-hand sales • Financial: • Public transfer payments: Social security, veteran’s benefits, welfare • Private transfer payments: Christmas gifts from grandma, allowance • Stock market transactions: buying and selling of stocks • Second-hand sales: yard sales, person-to-person sales of stuff

6. 2 ways to compute GDP Expenditures Approach – the sum of all money spent to buy GDP Income Approach – the sum of all the income created from producing GDP Technically, both approaches should give you the same answer.

7. Expenditure Approach Income Approach Consumption by Households Wages + + Rents Investment by Businesses + G D P + = = Interest + Government Purchases + Profits + Expenditures By Foreigners Statistical Adjustments

8. Household/personal consumption (C) This includes everything…. Durable goods (cars, fridge – lives of more than 3 yrs) non-durable goods (food, clothes, gas – lives of less than 3 yrs) services (haircuts, doctor bills, lawyers, etc.)

9. Investment by businesses (Ig) This is also called Gross private domestic investment. Includes: Purchases of machinery, tools, etc Construction costs (including residential) Changes in inventories (unsold goods) Noninvestment transactions

10. Constructions costs (incl. residential) Why include owner-occupied residential construction in the ‘investment by businesses’ category???? Because the house/apartment could be rented or leased

11. Changes in inventories It is hard to sell everything that was produced in a year by the end of the year. You almost always have some left over that was produced in this year but didn’t sell. Before we can compute how this affects GDP, we need to figure out how the level of inventories at the end of last year compare to the inventories at the end of this year.

12. Changes in inventories, cont. If there are more inventories now than last year, then inventories increased. So when this happens, what is left over is considered ‘investment’ for that year and must be added to the ‘investment’ figure If there are less inventories, then that means we sold inventories this year that were counted in last year’s GDP, so we subtract them from the ‘investment’ figure

13. Noninvestment transactions Investment DOES NOT include the transfer of paper assets (stocks, etc) Investment DOES NOT include the sale of existing tangible assets (houses, boats, etc.)

14. Gross vs Net Investment Gross investment means we are referring to ‘all’ investment during the year When an asset gets ‘worn out’ during the year, that is called ‘depreciation’. To find Net investment, you subtract depreciation from Gross investment If more stuff ‘depreciates’ during the year than you produce new stuff, that is ‘disinvesting’.

15. So far… Household/personal consumption (C) Investment by businesses (Ig)

16. Government purchases (G) The goods and services that it consumes in providing public services Expenditures for social capital like schools, highways It DOES NOT include transfer payments, which only transfer assets from one to another and don’t generate any new assets.

17. Net Exports (Xn) GDP includes the spending on goods and services produced in this country, and that doesn’t matter if American’s buy them or foreigners buy them. So products that are exported get counted Money that we spend on products that are imported are included in the GDP of other countries

18. Net Exports (Xn) , cont. To figure it, we simply take exports – imports, which gives us Net Exports.

19. Expenditures Approach summary: GDP = C + Ig + G + Xn

20. GDP in Trillions of Dollars, 2005 0 1 2 3 4 5 6 7 8 9 10 12 United States Japan Germany China United Kingdom France Italy Spain Canada Brazil Korea, Rep. India Mexico Russian Fed. Australia $12.4 $4.5 $2.8 $2.2 $2.2 $2.1 $1.7 $1.1 $1.1 $.79 $.79 $.78 $.77 $.76 $.70

21. Expenditure Approach Income Approach Consumption by Households Wages + + Rents Investment by Businesses + G D P + = = Interest + Government Purchases + Profits + Expenditures By Foreigners Statistical Adjustments

22. Measuring GDPGDP = C + Ig + G + Xn The simplest way to measure GDP is to add up all that was spent to buy total output in a certain year. Four categories of spending are added up: LO: 5-1

23. #2: Income Approach • To compute the National Income, we add up: • Wages of Employees • Rents • Interest • Profits (Proprietor’s & corporate)

24. Adjustments • Taxes on production and imports • Why would we add taxes that are paid on products? • Example: you buy a $1 item, and pay $.08 in taxes. • In the Expenditures approach, that tax was included in the cost of the item, so we have to add that same amount of tax to the Income approach to balance everything out.

25. Adjustments….cont. GDP is a measure of total ‘domestic’ output produced in the U.S. regardless of the nationality of those who provide the resources Some Americans earn income by supplying resources in other countries, but that activity is not ‘domestic’ activity. However, the money they make is included in their income. Some foreigners earn income by supplying resources here.

26. Adjustments….cont. So if we take the difference between what Americans earn abroad and subtract what foreigners make here, we call that…. Net Foreign Factor Income We add that figure to the total of all the incomes that we just added.

27. Adjustments….cont. Consumption of Fixed Capital – also known as ‘depreciation’. This amount of capital that is ‘used up’ during the year must be added to the income figures because depreciation was added to the cost of Expenditures in the other approach. We must balance the equation.

28. Adjustments….cont. Statistical Discrepancy – oops, we didn’t exactly come out the same in both approaches, so let’s just call this a ‘statistical discrepancy! The government can do this in figuring GDP, but you better not try this on your taxes!

29. Other national accounts Net Domestic Product (NDP) – simply take GDP and remove depreciation. National Income – take the NDP, add the Net Foreign Factor Income, and subtract the Statistical discrepancy

30. Other national accounts…cont. • Personal Income – includes all income received, whether earned or unearned • Simply remove income items that don’t apply to households (SS contributions, corp. income taxes) • Disposable Income – personal income minus personal taxes.

31. Nominal GDP vs Real GDP The market value of money changes every year because of inflation or deflation. So how can realistically compare dollar amounts from year to year? We deflate GDP when prices are rising and inflate GDP when prices are falling Whenever we adjust it, we call it Real GDP

32. Nominal and Real GDP • It is difficult to compare values over time without correcting them for inflation or deflation. • The monetary value of GDP changes from year to year due to changes in prices and output. • To distinguish the two, economists compute nominal GDP and real GDP. Nominal GDPis measured in terms of the price level at the time of measurement (i.e., GDP that is unadjusted for inflation). Real GDPis measured in terms of the price level in a base period (i.e., GDP that is adjusted for inflation). LO: 5-2

33. How we adjust it • Price of item in specific year • -------------------------------------- • Price of item in base year • We use a ‘price index’. • It is a measure of the price of a specific collection of goods & services called a ‘market basket’ in a given year as compared to that same thing in a previous year. • Formula: • Price indexin a givenyear • X 100 • =

34. Price index computation Remember: in the real world it is much harder to figure GDP and reliable price indexes

35. Shortcomings of GDP Nonmarket activities – plumber fixing his own house, activity of homemakers Leisure – we work shorter weeks than 100 yrs ago and we have vacations, holidays, etc. We are happier and GDP doesn’t reflect that Improved product quality – the same money today can buy a much better product

36. Shortcomings of GDP…cont. 0 5 10 15 20 25 30 Greece Italy Spain Portugal Belgium Sweden Germany France Holland United Kingdom Japan United States Switzerland The underground economy – not reporting tips, trading labor with your neighbor, etc Percentage of GDP

37. Shortcomings of GDP…cont. Environmental damage – the cost to cleanup pollution and waste is not considered Composition of output - To GDP, there’s no difference between books and hand grenades Non-economic sources of well-being – a household’s income doesn’t measure happiness, and GDP won’t either!

39. Two Definitions of Economics Growth • Economic Growth 1. An increase in real GDP occurring over some time period. 2. An increase in real GDP per capita occurring over some time period (takes into account the size of the population). (growth is calculated as a % rate of growth per quarter (3 month) or per year)

40. Growth – An Economic Goal Growth is an important economic goal because it means more material abundance and ability to meet the economizing problem. Growth lessens the burden of scarcity. An economy that is experiencing economic growth is better able to meet people’s wants and resolve socioeconomic problems

41. The Rule of 70 Example: A 3 % annual rate of growth will double real GDP in about 23 years (70/3 = 23).

42. Main Sources of Growth – 2 ways Increasing inputs of resources. (About one-third of U.S. growth comes from more inputs) 2. Increasing productivity of existing inputs. (About two-thirds of growth comes from improved productivity)

43. Economic Growth • An increase in real GDP occurring over time. or • An increase in real GDP per capita occurring over time. (both calculate economic growth as a percentage rate of growth per 3-month period or year) • Real GDP per capita (output per person) • Divide real GDP by the size of the population

44. Economic Growth • Economic growth is an economic goal of government • it raises the standards of living in society • lessens the burden of scarcity. • Two fundamental ways society can increase its real output and income are: • by increasing its inputs of resources • by increasing the productivity of those inputs Economic growth is the expansion of real GDP (or real GDP per capita) over time. LO: 5-3

45. Rule of 70 Shows the effect of compounding of economic growth rates over time. Number of years it will take for some measure to double, given its annual % increase. Calculate by dividing the percentage increase into the # 70.

46. Rule of 70 • Examples: • A 3 % annual rate of growth will double real GDP in appx. 23 (= 70/3) years. • Growth of 8 % per year will double it in appx. 9 (=70/8) years

47. Ingredients of Economic Growth Six main ingredients of economic growth: • Supply factors: • Increases in the quantity and quality of natural resources • Increases in the quantity and quality of human resources • Increases in the supply or stock of capital goods • Improvements in technology • Demand factor: households, businesses, and government must purchase the expanding output • Efficiency factor: the economy must achieve economic efficiency and full employment LO: 5-4

48. Economic Growth and Production Possibilities Economic growth is an expansion of production possibilities. A Economic Growth Capital Goods b a B D LO: 5-4 Consumer Goods

49. Growth Accounting Growth accounting measures the relative importance of supply factors contributing to growth: • Increases in hours of work (small factor in the U.S.) • Increases in labor productivity due to • Technological advance (40% of productivity growth) • Quantity of capital (30% of productivity growth) • Education and training (15% of productivity growth) • Economies of scale and resource allocation (15% of productivity growth) LO: 5-5

50. Labor Productivity Accelerated Since the Mid-90s LO: 5-6