GROSS DOMESTIC

PRODUCT AND GROWTHChapter 12

GROSS DOMESTIC PRODUCT &

GROWTH

Section 1

NATIONAL INCOME ACCOUTNING Economists use a system called national

income accounting to monitor the U.S. economy.They collect macroeconomic statistics, which

the government uses to determine economic policies.

The most important data economists

analyze is gross domestic product (GDP), which is the dollar value of all final goods and services produced within a country’s borders in a given year.

WHAT IS GDP? Basically, gross

domestic product tracks exchanges of money.

To understand GDP, you need to understand which exchanges are included in the final calculations—and which ones are not.

EXPENDITURE APPROACH One method used to

calculate GDP is to estimate the annual expenditures on four categories of final goods and services:Consumer goodsBusiness goods and

servicesGovernment goods

and servicesNet exports

INCOME APPROACH Another method

calculates GDP by adding up all the incomes in the economy. The rationale for this

approach is that when a firm sells a product or service, the selling price minus the dollar value of goods service purchased from other firms represents income from the firm’s owners and employees.

NOMINAL VS REAL GDP Nominal GDP is measured in current

prices.To calculate nominal GDP, we use the current

year’s prices to calculate the value of the current year’s output.

The problem with nominal GDP is that it does not account for the rise in prices. Even though your output might be the same from year to year, the prices won’t be and nominal GDP would be different.

To solve this problem, economists determine real GDP, which is GDP expressed in constant, or unchanging, prices.

LIMITATIONS OF GDP Nonmarket Activities—GDP does not

measure goods and services that people make or do themselves.

The Underground Economy—GDP does not account for black market activities or people paid “under the table” without being taxed

Negative Externalities—unintended economic side effects, like pollution, are not subtracted from GDP

Quality of Life—a high GDP does not necessarily mean people are happier

OTHER MEASURES In addition to GDP, economists use other

ways to measure the economy. The equations below summarize the formulas for

calculating these other economic measurements.

INFLUENCES ON GDP Aggregate Supply

Aggregate supply is the total amount of goods and services in the economy available at all possible price levels.

In a nation’s economy, as the prices of most goods and services change, the price level changes and firms respond by changing their output.

As the price level rises, real GDP, or aggregate supply rises. As the price level falls, real GDP falls.

INFLUENCES ON GDP, CONT. Aggregate Demand

Aggregate demand is the amount of goods and services that will be purchased at all possible price levels.

As price levels in the economy move up and down, individuals and firms change how much they buy—in the opposite direction that aggregate supply changes.

Any shift in aggregate supply or aggregate demand will have an impact on real GDP and the price level.

AGGREGATE SUPPLY & DEMAND Aggregate supply and demand represent

supply and demand on a nationwide level. The far right-hand chart shows what happens to GDP and price levels when aggregate demand shifts.

BUSINESS CYCLESSection 2

PHASES OF A BUSINESS CYCLE Business cycles are made up of major

changes in real GDP above or below normal levels.

The business cycle consists of four phases:

Expansion Peak Contraction Trough

FACTORS THAT AFFECT A BUSINESS CYCLE

Periods of economic growth

Periods of economic decline

Business investments Interest rates and

credit Consumer

expectations External shocks

CONTRACTIONS There are three types of contractions,

each with different characteristics.A recession is a prolonged economic

contraction that generally lasts from 6 to 18 months and is marked by a high unemployment rate.

A depression is a recession that is especially long and severe characterized by high unemployment and low economic output.

Stagflation is a decline in real GDP combined with a rise in price level, or inflation.

BUSINESS INVESTMENT Business cycles are

affected by four main economic variables.

Business Investment When the economy is

expanding, business investment increases, which in turn increases GDP and helps maintain the expansion.

When firms decide to decrease spending, the result is a decrease in GDP and the price level.

INTEREST RATES & CREDIT Consumers often use credit to buy new cars,

home, electronics, and vacations. If the interest rates on these goods rise, consumers are less likely to buy them.

The same principle holds true for businesses who are deciding whether or not to buy new equipment or make large investments.

CONSUMER EXPECTATIONS

If people expect that the economy is going to start to contract, they may reduce spending.

High consumer confidence, though, will lead to people buying more goods, pushing up GDP.

EXTERNAL SHOCKS Negative external shocks, like war breaking

out in a country where U.S. banks and businesses have invested heavily, can have a great effect on business, causing GDP to decline.

Positive external shocks, like the discovery of large oil deposits, can lead to an increase in a nation’s wealth.

BUSINESS CYCLE FORECASTING To predict the next phase of a business

cycle, forecasters must anticipate movements in real GDP before they occur.

Economists use leading indicators to help them make these predictions.The stock market is a leading indicator.Today, the stock market turns sharply

downward before a recession.

THE GREAT DEPRESSION Before the 1930s, many economists

believed that when an economy declined, it would recover quickly on its own.

The Great Depression changed this belief and led economists to consider the idea that modern market economies could fall into long-lasting contractions.

Not until World War II, more than a decade later, did the economy achieve full recovery.

THE GREAT DEPRESSION, CONT. Declining GDP and high unemployment

were two major signs of the Great Depression, the longest recession in U.S. history. In what year did the Great Depression

hit its trough?How long

did it take GDP to return to its pre-Depression peak?

LATER RECESSIONS OPEC Embargo

In the 1970s, the United States experienced an external shock when the price of gasoline and heating fuels skyrocketed as a result of the OPEC embargo on oil shipped to the United States.

The U.S. economy also experienced a recession in the early 1980s and another brief one in 1991, followed by a period of steady economic growth.

The attacks of 9/11 led to another sharp drop in consumer spending in many service industries.

THE BUSINESS CYCLE TODAY The economy began to grow slowly in

2001 and was surging by late 2003 with GDP growing at a rate of 7.5 percent over three months.

However, growth slowed again as a result of high gas prices in 2006. The sub-prime mortgage crisis caused further

decline in 2007.2008 and 2009 marked a recession in the

economy, but by the end of 2009, a rebound occurred.

ECONOMIC GROWTHSection 3

HOW DOES THE ECONOMY GROW? The economy grows through

An increase in capital deepeningA higher savings rateA population that grows along with capital

growthGovernment interventionTechnological progress

MEASURING ECONOMIC GROWTH The basic measure of

a nation’s economic growth rate is the percentage of change in real GDP over a period of time.

Economists prefer a measuring system that takes population growth into account. For this, they rely on real GDP per capita.

GDP AND QUALITY OF LIFE GDP measures the standard of living but

it cannot be used to measure people’s quality of life.

In addition, GDP tells us nothing about how output is distributed across the population. While real GDP per capita tells us little about

individuals it does give us a starting point for measuring a nation’s quality of life.

In general, though, nations with a high GDP per capita experience a greater quality of life.

CAPITAL DEEPENING A nation with a large

amount of physical capital will experience economic growth.

The process of increasing the amount of capital per worker, known as capital deepening, is one of the most important sources of growth in modern economies.

SAVING AND INVESTMENT If the amount of money

people save increases, then more investment funds are available to businesses.

These funds can then be used for capital investment and expand the stock of capital in the business sector.

POPULATION GROWTH If the population grows while the supply

of capital remains constant, the amount of capital per worker will shrink, which is the opposite of capital deepening. This process leads to lower standards of

living.

On the other hand, a nation with low population growth and expanding capital stock will experience significant capital deepening.

GOVERNMENT If government raises taxes, households

will have less money. People will reduce saving, thus reducing the money available to businesses for investment.

However, if government invests the extra tax revenues in public goods, like infrastructure, this will increase investment, resulting in capital deepening.

FOREIGN TRADE Foreign trade can result in a trade deficit,

a situation in which the value of goods a country imports is higher than the value of goods it exports. If these imports consist of investment goods,

running a trade deficit can foster capital deepening.

When the funds are used for long-term investment, capital deepening can offset the negatives of a trade deficit by helping generate economic growth, helping a country pay back the money it borrowed in the first place.

TECHNOLOGICAL PROGRESS Technological progress is a key source of

economic growth. It can result from new scientific

knowledge, new inventions, and new production methods

Measuring technological progress can be done by determining how much growth in output comes from increases in capital and how much comes from increases in labor. Any remaining growth in output must come

from technological progress.

TECHNOLOGICAL PROGRESS, CONT. Causes of technological progress

include:Scientific research Innovation

New products increase output and boost GDP and profits

Scale of the market Larger markets provide more incentives for

innovationEducation and experience

Increases human capitalNatural resources

Increased natural resources use can create a need for new technology