College of Business – Rabigh HBC608HBC608 ECON582 HBC608 FINA 353 Principles of Macroeconomics Lecture 3 Topic: Related Measures & GDP uses and limitations College of Business – Rabigh Dr. Mazharul Islam Finance NotesFinance notes Finance notes 1

After studying these topics you should be able to: HBC608HBC608 HBC608 ECON582 Lesson Objectives To learn about After studying these topics you should be able to: Distinguish between nominal and real GDP Calculation Real GDP The Uses and Limitations of Real GDP GNP Dr. Mazharul Islam Finance NotesFinance notes Finance notes 2

HBC608HBC608 HBC608 ECON582 NOMINAL vs REAL GDP Nominal GDP is GDP measured in current Saudi Riyal, or the current prices we pay for final goods and services. When a variable is measured in current prices, it is described in nominal terms. Real GDP is the value of a nation's total final goods and services, adjusted for price changes. It valued at the prices of a reference base year. A base year is the year we choose against which to compare all other years. Real GDP is also called gross domestic product in constant prices (Riyals). Note that real GDP is also known as constant-price GDP and inflation-corrected GDP. Dr. Mazharul Islam Finance NotesFinance notes Finance notes 3

ECON582 HBC608 HBC608HBC608 Calculating Real GDP To get real GDP we multiply the quantity of the final good or the service produced in the year by its price in the reference base year. Example: A Three-Good Economy (1) (2) (3) (4) (5) (6) (7) (8) GDP IN 2010 2012 IN PRODUCTION PRICE PER UNIT PRICES Q1 Q2 P1 P2 P1 x Q1 P1 x Q2 P2 x Q1 P2 X Q2 Good A 6 11 $.50 $ .40 $3.00 $5.50 $2.40 $4.40 Good B 7 4 .30 1.00 2.10 1.20 7.00 4.00 Good C 10 12 .70 .90 8.40 9.00 10.80 Total $12.10 $15.10 $18.40 $19.20 Nominal GDP in 2010 Real GDP in 2012 Real GDP in 2010 Nominal GDP in 2012 Dr. Mazharul Islam Finance notes Finance NotesFinance notes 4

Mathematical Note: Chained-Dollar Real GDP Starting with real GDP in 2005 of $125 million and the growth rates in Table 3, real GDP in each year since 2005 is calculated as follows: Real GDP in 2006 is 8 percent higher than the $125 million in 2005, which is $135 million. The figure illustrates the linking back to the base year. Dr. Mazharul Islam

HBC608HBC608 HBC608 ECON582 Calculating Real GDP Test: Let say Saudi Arabia produced only one good which is Dates. The nominal GDP in 2010 was SAR 100 million with SAR0.50 per kg. The nominal GDP in 2012 was SAR 120 million with SAR0.55 per kg. How many % nominal GDP increased in 2012? Calculate the quantity dates produced in 2012. Calculate the real GDP in 2012. Calculate actual/real growth. Why not use two consecutive year’s nominal GDP to calculate economic growth? Dr. Mazharul Islam Finance NotesFinance notes Finance notes 6

The General Formula for Calculating a Growth Rate ECON582 HBC608 HBC608HBC608 The General Formula for Calculating a Growth Rate 4W/9/2013 Dr. Mazharul Islam Finance NotesFinance notes Finance notes 7

HBC608HBC608 HBC608 ECON582 Importance of Real GDP Real GDP is important mainly for the following reasons: To know that how much the economy is actually producing. It means to compute economic growth, known as the GDP growth rate. The computed growth rate is using to compare the standard of living over time. To compare the size of economies throughout the world. That means to compare the standard of living among countries. The GDP growth rate is critical for investors countries with strong growth attract more investors for their corporate stocks, bonds and even their own independent debt. To track the course of the business cycle that means you can tell where the economy is in the business cycle. Dr. Mazharul Islam Finance NotesFinance notes Finance notes 8

ECON582 HBC608 HBC608HBC608 The Business Cycle The business cycle is the periodic but irregular up-and-down movement in production. Every cycle has two phases: 1. Expansion 2. Recession and two turning points: 1. Peak 2. Trough Dr. Mazharul Islam Finance NotesFinance notes Finance notes 9

ECON582 HBC608 HBC608HBC608 The Business Cycle Definitions of Four phases of Business Cycle : An expansion is a period during which real GDP increases—A speedup in the pace of economic activity – movement from a trough to a peak. A severe contraction, in which real GDP decreases for at least two quarters, is called a recession - A slowdown in the pace of economic activity - movement from a peak to trough. Through point is the lower turning point of a business cycle, where a recession turns into an expansion. Peak is the upper turning of a business cycle, where an expansion turns into a recession. Dr. Mazharul Islam Finance NotesFinance notes Finance notes 10

Real GDP Time Dr. Mazharul Islam ECON582 HBC608 HBC608HBC608 Finance NotesFinance notes Finance notes 11

ECON582 HBC608 HBC608HBC608 The GDP Deflator GDP price deflator measures the general price level i.e. the average price level of all final goods and services. It is an index of the prices of all goods and services included in GDP. It is calculated from the ratio of nominal GDP to real GDP. the GDP deflator is a measure of price inflation/deflation with respect to a specific base year. Dr. Mazharul Islam Finance NotesFinance notes Finance notes 12

ECON582 HBC608 HBC608HBC608 The Inflation Rate Inflation Rate is The percentage increase in the price level from one year to the next. We can use the growth rate formula to calculate the Inflation Rate. Inflation Rate Between two years = [(GDP Deflatort – GDP Deflatort-1)/GDP Deflatort-1] x 100 Dr. Mazharul Islam Finance NotesFinance notes Finance notes 13

ECON582 HBC608 HBC608HBC608 The Inflation Rate Inflation Rate is also calculate by using Consumer Price Index (CPI). The percentage change in CPI from one year to the next. Calculation formula as follows. Inflation Rate Between two years = [(CPIt – CPIt-1)/CPIt-1] x 100 Dr. Mazharul Islam Finance NotesFinance notes Finance notes 14

Consumer Price Index (CPI) ECON582 HBC608 HBC608HBC608 Consumer Price Index (CPI) A CPI is a measure of the average change over time in the prices paid by households consumers who are resident in the municipal city for a fixed basket of goods and services. It is an index of the prices of a fixed basket of final goods and services included in GDP. Dr. Mazharul Islam Finance NotesFinance notes Finance notes 15

Inflation Rate by Using CPI ECON582 HBC608 HBC608HBC608 Inflation Rate by Using CPI The CPI in Saudi Arabia was 172.1 (June 2010) and 178.3 (June 2012). Calculate Saudi’s annual inflation rate. What does the result mean? What are the difference between GDP deflator and CPI? Dr. Mazharul Islam Finance NotesFinance notes Finance notes 16

Gross National Product (GNP) ECON582 HBC608 HBC608HBC608 Gross National Product (GNP) Gross National Product is the market value of all final goods and services produced anywhere in the world by the factors of productions supplied by the residents of that country in a given period of time. Examples : Nikes’ income from the capital that it supplies to its Saudi Arabia shoe factory is part of US GNP but not part of US GDP. Dr. Mazharul Islam Finance NotesFinance notes Finance notes 17

GNP= GDP+ net factor income received from abroad HBC608 ECON582 HBC608HBC608 GNP= GDP+ net factor income received from abroad Net factor income received from abroad = factor income received from abroad - factor income paid to other countries Dr. Mazharul Islam Finance NotesFinance notes Finance notes 18

Dr. Mazharul Islam ECON582 HBC608 HBC608HBC608 Finance notes Finance NotesFinance notes 19

Limitations of GDP as a measure of Standard of Living HBC608HBC608 ECON582 HBC608 GDP excludes : Household production of goods and services , because these are not bought or sold in the market. Examples: So GDP underestimates the value of production. Dr. Mazharul Islam Finance NotesFinance notes Finance notes 20

Limitations of GDP as a measure of Standard of Living HBC608HBC608 ECON582 HBC608 Underground Production: it is the production of goods and services hidden from the view of government because people want to avoid taxes and regulations or their actions are illegal. Underground Production is unreported so it is omitted from GDP Dr. Mazharul Islam Finance NotesFinance notes Finance notes 21

Limitations of GDP as a measure of Standard of Living HBC608HBC608 ECON582 HBC608 Leisure Time: It is an economic good . You must choose between work or leisure time. When leisure time increases that means our standard of living increases. The improvements of our standard of living are not measured in real GDP. Dr. Mazharul Islam Finance NotesFinance notes Finance notes 22

Limitations of GDP as a measure of Standard of Living HBC608HBC608 ECON582 HBC608 Environment quality: Pollution is an economic evil. The more we pollute our environment, the lower is our standard of living(other things being the same). This lowering of our standard of living is not measured in GDP. Dr. Mazharul Islam Finance NotesFinance notes Finance notes 23

Other influences on the Standard of Living HBC608HBC608 ECON582 HBC608 Health and life expectancy: Good health and long life do not show up directly in GDP. On the other side we do not take into account the negative effect of bad diseases. Political freedom and social justice: A country might have a very large GDP per person but have limited political freedom and social justice. Such a country would be regarded as having lower standard of living Dr. Mazharul Islam Finance NotesFinance notes Finance notes 24

Limitations and inaccuracies of GDP measures HBC608HBC608 ECON582 HBC608 Some questions on limitations and inaccuracies of GDP measures Household production Examples? Why is this activity not included in GDP? Environmental quality Examples? How can this problem be addressed? Underground economic activity Examples? Do you think this is a larger/smaller issue in Greece or Vietnam? Political freedom and social justice Examples of high growth economies with limited freedom? Dr. Mazharul Islam Finance NotesFinance notes Finance notes 25

Now it’s over for today. Do you have any question? HBC608 ECON582 HBC608HBC608 Now it’s over for today. Do you have any question? Dr. Mazharul Islam Finance NotesFinance notes Finance notes 26