Chapter 2

THE DATA OF MACROECONOMICS

Goals and Outline of Chapter 2:

Gross Domestic Product (GDP)

What is Gross Domestic Product and how we measure it?

Why is this measure important?

What are the definitions of the major expenditure components?

What are the trends in these components over time?

2. Inflation

What is the difference between ‘Real’ and ‘Nominal’ variables?

How is inflation measured?

3. Unemployment

How is Unemployment measured?

Why do we care about Unemployment?

GDP is a measure of output!

Why Do We Care?

Because output is highly correlated (at certain times) with things

we care about

(standard of living, wages, unemployment, inflation, budget and

trade deficits, value of currency, etc…)

Formal Definition:

GDP

is the market value of all final goods and services newly

produced on

domestic soil during a given time period

(different than GNP)

GDP

Gross Domestic ProductGDP is the best single measure of the economic well-

being of a society.

Three ways of

measuring GDP

Production Method: Measure the Value Added summed across

all firms (value added = sale price less cost of raw materials)

Income Method: Labor Income (wages/salary) +

Capital Income (rent, interest, dividends, profits)+

Government Income (taxes)

Expenditure Method: Spending by consumers (C)

+ Spending by businesses (I) + Spending by government (G)

+ Net Spending by foreign sector (NX)

Fundamental identity of national income account:Total production = total income = total expenditure

To see how all these approaches work we consider a simple example.

Consider a very simple economy where there is a coconut producer, a restaurant, some consumers and a government.

Calculating GDP (example)

Calculating GDP The product approach (or value

added)In this approach, to calculate the GDP:

we add the value of all goods and services produced and then

subtract

the value of all intermediate goods used in production.

intermediate goods

Goods that are produced by one firm for use in further processing

by another firm.

We subtract the value of the intermediate goods to avoid

double counting in the calculation.

Using this approach the GDP is simply defined as the sum of

value added to goods and services across all productive units in

the economy.

Calculating GDP The product approach (or value

added)

In this approach, GDP is defined as: the total spending on all final goods and services produced in

the economy in a given period of time.

Notice: the word final in the definition implies that we do not count spending on intermediate goods.

Y = GDP = the value of total outputC + I + G + NX = aggregate expenditure

Calculating GDP The expenditure approach

• The spending by households on goods and services.

Consumption (C):

• The purchase of goods and services to be used in future.

• The spending on capital equipment, inventories, and structures etc.

Investment (I):

• The spending on goods and services by local, state, and federal governments.

Government Purchases (G):

• Is the difference between the monetary value of exports and imports. In simple terms, it refers to exports minus imports.

Net Exports (NX):

Calculating GDP The expenditure approach

(components)

I produce apples and I can potentially:

Sell them to some domestic customer

(Consumption)

Sell them to some business (Investment)

Keep them in my stock room as inventory

(Investment)

Sell them to the other city for their shelters

(Government spending)

Sell them to some foreign customer (Net Export)

Simple example

From our example, using the expenditure approach we have that

I = 0 and NX = 0.There is no investment in our example and no international

trade.The GDP is then given by: C + G

Calculating GDP The expenditure approach

Calculating GDP The income approach

Components of the income approach:

Wages, salaries, and supplements

Net interest

Rental income of persons

Income of unincorporated enterprises

Corporate profits before taxes

Indirect taxes

Depreciation

In this approach, GDP is defined as the sum of all income received by economic agents contributing to production.

Income includes the profits of firms.

Calculating GDP The income approach

The different components of aggregate

expenditure:

Consumption (C)the value of all goods and services bought by households.

Includes:durable goods

Goods that last a relatively long time, such as cars and household appliances.

nondurable goods Goods that are used up fairly quickly, such as food and clothing.

services The things we buy that do not involve the production of physical

things, such as legal and medical services and education.

The different components of aggregate

expenditure: Investment (I)gross private domestic investment (I)

Total investment in capital — that is, the purchase of new housing, plants, equipment, and inventory by the private (or

nongovernment) sector.

nonresidential investment Expenditures by firms for machines, tools, plants, and so on.

residential investment Expenditures by households and firms on new houses and

apartment buildings.

change in business inventories The amount by which firms’ inventories change during a period. Inventories are the goods that firms produce now but intend to

sell later.

Land purchases are NOT counted as part of GDP (land is not produced!)

Stock purchases are NOT counted as part of GDP (stock transactions do NOT represent production – they

are saving!)

The different components of aggregate

expenditure:

Government spending (G)

Government spending

includes all government spending on goods and services.

Government spending

excludes transfer payments (e.g. unemployment insurance

payments),

because they do not represent spending on

goods and services.

The different components of aggregate

expenditure: Net exports (NX = EX - IM)

The difference between

exports (sales to foreigners of country-produced goods and

services) and

imports (country purchases of goods and services from

abroad).

The figure can be positive or negative.

Another Measure of Total IncomeGNP vs. GDP

Gross National Product (GNP):total income earned by the nation’s factors of production,

regardless of where located

Gross Domestic Product (GDP):total income earned by domestically-located factors of

production, regardless of nationality.

GNP = GDP + Net Factor Income from Abroad (NFIA) 

NFIA = Receipts of factor income from the rest of the World –

Payments of factor income to the rest of the World  

net national product (NNP) Gross national product minus depreciation; a nation’s total product minus what is required to maintain the

value of its capital stock.

NNP = GNP – Depreciation

personal income The total income of households.

Another Measure of Total IncomeNNP

GDP, GNP, NNP, National Income, Personal Income, and Disposable Personal Income (example)

DOLLARS(BILLIONS)

GDP 10,205.6Plus: receipts of factor income from the rest of the world

+ 342.1

Less: payments of factor income to the rest of the world

- 353.2

Equals: GNP 10,194.5Less: depreciation - 1,351.3

Equals: net national product (NNP) 8,843.2Less: indirect taxes minus subsidies plus other - 643.3

Equals: national income 8,199.9Less: corporate profits minus dividends - 332.6Less: social insurance payments - 731.2Plus: personal interest income received from the government and consumers

+ 439.1

Plus: transfer payments to persons +1,148.7Equals: personal income 8,723.9

Less: personal taxes - 1,306.2Equals: disposable personal income 7,417.7

Real vs. Nominal GDP

GDP is the value of all final goods and services

produced.

Nominal GDP measures these values using current

prices.

Real GDP measure these values using the prices of

a base year.

base year The year chosen for the weights in a fixed-weight

procedure.

fixed-weight procedure A procedure that uses weights from a given base year.

Nominal GDP = Current year Quantities x

Current year Prices

Real GDP = Current year Quantities x Base year

Prices

Real GDP = Nominal GDP / price index

Changes in nominal GDP can be due to:

changes in prices

changes in quantities of output produced

Changes in real GDP can only be due to changes in

quantities,

because real GDP is constructed using constant base-year

prices.

Real GDP controls for inflation

Compute nominal GDP in 2012 and 2013

Compute real GDP in each year using 2012 as the

base year.

Practice problem

Nominal GDP

multiply Ps & Qs from same year

2012: $1 x 10 + $10 x 3 = $40

2013: $2 x 15 + $15 x 4 = $90

Real GDP

multiply each year’s Qs by 2012 Ps

2012: as above: $40

2013: $1 x 15 + $10 x 4 = $55 (2012$)

So in real terms,

GDP did not rise as much as it would seem from nominal

terms.

Solutions :

The inflation rate

is the percentage increase in the overall level of prices.

One measure of the price level is the

GDP Deflator, defined as

GDP deflator identifies an index that measures the overall price level in a given year.

Inflation rate is the rate of change of that index from one year to the following.

Calculating the GDP Deflator

Example with 3 goods:

For good i = 1, 2, 3

Pit = the market price of good i in month t

Qit = the quantity of good i produced in month t

NGDPt = Nominal GDP in month t

RGDPt = Real GDP in month t

The GDP deflator is a weighted average of prices.The weight on each price reflects that good’s relative

importance in GDP.Note that the weights change over time.

Understanding the GDP deflator

The Consumer Price Index

CPI

A price index computed each month by the Statistical

institute using a bundle that is meant to represent the

“market basket” purchased monthly by the typical urban

consumer.

The CPI market basket shows how a typical consumer

divides his or her money among various goods and

services.

Most of a consumer’s money goes toward

housing, transportation, and food and beverages.

Contents of the CPI Market Basket

Understanding the CPI

Example with 3 goods:

For good i = 1, 2, 3

Ci = the amount of good i in the CPI’s basket

Pit = the price of good i in month t

Et = the cost of the CPI basket in month t

Eb = cost of the basket in the base period

The CPI is a weighted average of prices.The weight on each price reflects that good’s relative

importance in the CPI’s basket.Weights remain fixed over time.

prices of capital goods

included in GDP deflator (if produced

domestically)

excluded from CPI

prices of imported consumer goods

included in CPI

excluded from GDP deflator

the basket of goods

CPI: fixed

GDP deflator: changes every year

CPI vs. GDP deflator

Measures of inflation in TurkeyPercentage change

employedworking at a paid job

unemployednot employed but looking for a job

labor forcethe amount of labor available for producing goods and

services; all employed plus unemployed persons

Labor Force = Employed +Unemployed

not in the labor forcenot employed, not looking for work.

Not in The Labor Force = Population – Labor Force

Measuring Unemployment:Categories of the population

unemployment rate

percentage of the labor force that is unemployed

labor force participation rate

the fraction of the adult population that ‘participates’ in the

labor force

Two important labor force concepts

Unemployment Rate = Number of Unemployed

Labor Force

100

Labor Force Participation Rate = Labor Force Adult Population

100

Number employed = 146.1 million

Number unemployed = 6.9 million

Adult population = 231.7 million

Labor Force = 146.1 + 6.9 = 153.0

Not in The Labor Force = 231.7 – 153 = 78.7

Unemployment Rate = (6.9/153) x 100% = 4.5 %

Labor Force Participation Rate = (153.0/231.7)x100 %=

66 %

Practice problem

A stock is a quantity measured at a point in time.

A flow is a quantity measured per unit of time.

Stock Flow a person’s wealth a person’s annual saving# of people with college degrees # of new college graduates this year the government debt the government budget deficit

Stock Variables vs Flow variables

Gross domestic product (GDP)

Consumer Price Index (CPI)

Unemployment rate

National income accounting

Stocks and flows

Value added

Imputed value

Nominal versus real GDP

GDP deflator

National income accounts identity

Consumption

Investment

Government purchases

Net exports

Labor force

Labor-force participation rate

Key Concepts of Chapter 2

Measuring GDP using the Income Approach and the Expenditure Approach

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