Lecture 5 – The Macroeconomic Perspective II School of Natural and Social Sciences Department of Economics and Business, Lehman College Lecture 5 – The Macroeconomic Perspective II "Quarterly gross domestic product compared to Federal Funds Rate" by Wikideas1 is in the Public Domain, CC0 Alexander Núñez Torres, PhD Assistant Professor, Department of Economics and Business These slides are based on Principles of Macroeconomics by Steven A. Greenlaw and Timothy Taylor - OpenStax (2017). Unless otherwise noted, they are licensed under an Attribution-NonCommercial-ShareAlike 4.0 International.

Schedule Concepts related to Gross Domestic Product Calculating GDP Expenditure approach Income approach Nominal versus Real GDP Contrast nominal GDP and real GDP Explain GDP deflator Calculate real GDP based on nominal GDP values Limitations of the GDP Concept GDP and Social Welfare The Informal Economy

Concepts related to Gross Domestic Product National Income and product accounts (NIPA) Data Collected and published by the government describing the various components of national income and output in the economy. Data are complied by the Bureau of Economic Analysis (BEA) of the U.S. Department of Commerce We are going to discuss some of the variables of the national income and product accounts NIPA do not explain how the economy works, but they do show the key parts and how they are connected. Gross Domestic Product The total market value of all final goods and services produced within a given period by factors of production located within a country. Is the total market value of a country’s output.

Concepts related to Gross Domestic Product What is the difference between intermediate goods and final goods? Any examples?

Concepts related to Gross Domestic Product Exclusion of Used Goods and Paper Transactions GDP is concerned only with new, or current production. Old output is not counted in current GDP because it was already counted when it was produced. GDP does not count transactions in which money or goods change hands or in which no new goods and services are produced. For example: 1) Selling a car to a friend does not add value to the GDP 2) Selling the same car to a dealer, GDP will increase by the amount of the dealer’s markup over what they pay for it

Concepts related to Gross Domestic Product Exclusion of Output produced abroad by domestically owned factors of production GDP is the value of output produced by factors of production located within a country Gross National Product (GNP). GDP includes only what the country produces within its borders. GNP adds what domestic business and labor abroad produces, and substracts any payments that foreign labor and business located in the United States send home to other countries. In other words, GNP is based on what a country’s citizens and firms produces, wherever they are located, GDP is based on what happens within a certain country’s geographic boundaries

Calculating GDP Expenditure approach: A method of computing GDP that measures the total amount spent on all final goods and services during a given period. Income approach: A method of computing GDP that measures the income – wages, rents, interest, and profits – received by all factors of production in producing final good and services

Calculating GDP: Expenditure approach 𝐺𝐷𝑃=𝐶+𝐼+𝐺+(𝐸𝑋 −𝐼𝑀) There are four main categories of expenditure: Personal consumption expenditures (C): household spending on consumer goods. Gross private domestic investment (I): spending by firms and households on new capital – that is, plant, equipment, inventory, and new residential structures Government purchases/consumption and gross investment (G) Net exports (EX – IM): net spending by the rest of the world, or export (EX) minus imports (IM)

Macroeconomic Concerns: GDP Gross Domestic Product (GDP) For the following table with the components of Gross Domestic Product. What is the value of GDP? What is the value of net exports? Concept Amount Government Purchases $ 120 Billion Depreciation $ 40 Billion Consumption $ 400 Billion Business Investment $ 60 Billion Exports $ 100 Billion Imports

Macroeconomic Concerns: GDP Concept Amount Government Purchases $ 120 Billion Depreciation $ 40 Billion Consumption $ 400 Billion Business Investment $ 60 Billion Exports $ 100 Billion Imports Gross Domestic Product (GDP) For the following table with the components of Gross Domestic Product. What is the value of GDP? What is the value of net exports? 𝑮𝑫𝑷=𝑪+𝑰+𝑮+ 𝑬𝑿 −𝑰𝑴 𝑮𝑫𝑷=$𝟒𝟎𝟎+$𝟔𝟎+$𝟏𝟐𝟎+ $𝟏𝟎𝟎−$𝟏𝟐𝟎 𝑮𝑫𝑷=$𝟓𝟔𝟎 𝑵𝒆𝒕 𝑬𝒙𝒑𝒐𝒓𝒕𝒔=−𝟐𝟎 𝑩

Calculating GDP: Expenditure approach Personal Consumption Expenditures (C) Expenditures by consumers on goods and services 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: Are the things we buy that do not involve the production of physical things, such as legal and medical services and education.

Billions of Dollars ($) Calculating GDP: Table 6.2 Components of U.S. GDP Billions of Dollars ($) Percentage of GDP (%) Personal consumption expenditures (C) 12,820.7 68.84 Durable goods 1,411.0 7.58 Nondurable goods 2,710.4 14.55 Services 8,699.3 46.71 Gross private domestic investment (l) 2,094.4 16.42 Nonresidential 2,316.3 12.44 Residential 705.8 3.79 Change in business inventories 35.1 0.19 Government consumption and gross investment (G) 3,267.8 17.55 Federal 1,231.5 6.61 State and local 2,036.3 10.93 Net exports (EX – IM) −521.2 −2.80 Exports (EX) 2,214.6 11.89 Imports (IM) 2,735.8 14.69 Gross domestic product 18,624.5 100.0

Calculating GDP: Expenditure approach 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: Inventories are the goods that firms produce now but intend to sell later. 𝐺𝐷𝑃=𝐹𝑖𝑛𝑎𝑙 𝑆𝑎𝑙𝑒𝑠+𝐶ℎ𝑎𝑛𝑔𝑒𝑠 𝑖𝑛 𝑏𝑢𝑠𝑖𝑛𝑒𝑠𝑠 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑖𝑒𝑠 Depreciation: the amount by which an asset’s value falls in a given period. Net investment: equals gross investment (total value of all newly produced capital goods: plant equipment, inventory) minus depreciation

Billions of Dollars ($) Calculating GDP: Table 6.2 Components of U.S. GDP Billions of Dollars ($) Percentage of GDP (%) Personal consumption expenditures (C) 12,820.7 68.84 Durable goods 1,411.0 7.58 Nondurable goods 2,710.4 14.55 Services 8,699.3 46.71 Gross private domestic investment (l) 2,094.4 16.42 Nonresidential 2,316.3 12.44 Residential 705.8 3.79 Change in business inventories 35.1 0.19 Government consumption and gross investment (G) 3,267.8 17.55 Federal 1,231.5 6.61 State and local 2,036.3 10.93 Net exports (EX – IM) −521.2 −2.80 Exports (EX) 2,214.6 11.89 Imports (IM) 2,735.8 14.69 Gross domestic product 18,624.5 100.0

Calculating GDP: Expenditure approach Government Consumption and Gross Investment (G) Includes expenditures by federal, state, and local governments for final goods and services. It does not includes government transfer payments or interest payments on the national debt, because neither is a payment for any final goods or services Net Export (EX-IM) The difference between exports (sales to foreigners of U.S. –produced goods and services) and imports (U.S. purchases of goods and services from abroad)

Billions of Dollars ($) Calculating GDP: Table 6.2 Components of U.S. GDP Billions of Dollars ($) Percentage of GDP (%) Personal consumption expenditures (C) 12,820.7 68.84 Durable goods 1,411.0 7.58 Nondurable goods 2,710.4 14.55 Services 8,699.3 46.71 Gross private domestic investment (l) 2,094.4 16.42 Nonresidential 2,316.3 12.44 Residential 705.8 3.79 Change in business inventories 35.1 0.19 Government consumption and gross investment (G) 3,267.8 17.55 Federal 1,231.5 6.61 State and local 2,036.3 10.93 Net exports (EX – IM) −521.2 −2.80 Exports (EX) 2,214.6 11.89 Imports (IM) 2,735.8 14.69 Gross domestic product 18,624.5 100.0

Calculating GDP: Income approach National Income Is the total income earned by factors of production owned by a country’s citizens. Is the sum of compensation of employees, proprietor’s income, rental income, corporate profits, net interest, indirect taxes minus subsidies, net business transfer payments, and the surplus of the government enterprises GDP is not exactly National Income!!: GDP measures total production within a country. National Income measures income received by the citizens of the country (regardless where they live)

Nominal vs Real GDP Nominal GDP Is gross domestic product measured in current dollars, the current prices that we pay for goods and services. The nominal value of any economic statistic means that we measure the statistic in terms of actual prices that exist at the time. The real value refers to the same statistic after it has been adjusted for inflation (What is inflation!?!?!?) This is not a desirable measure of production. Nominal GDP can increase because the price level has increased with no change in output. Example: Suppose that in Year 1 a firm produces 5 cars valued at $10,000 each. It has contributed $50,000 to GDP. In Year 2 its contribution is $60,000. Has the firm produced more cars?

Nominal vs Real GDP Nominal GDP The BEA creates an index of the average price level to adjust nominal GDP for inflation. Base year is the year chosen for the weights in a fixed-weight procedure Fixed-weight procedure A procedure that uses weights from a given base year. The weight is the importance attached to an item within a group of items.

Nominal vs Real GDP: Table 6.5 U.S. Nominal GDP and the GDP Deflator Year Nominal GDP GDP Deflator (2005 = 100) 1960 543.3 19.0 1965 743.7 20.3 1970 1,075.9 24.8 1975 1,688.9 34.1 1980 2,862.5 48.3 1985 4,346.7 62.3 1990 5,979.6 72.7 1995 7,664.0 81.7 2000 10,289.7 89.0 2005 13,095.4 100.0 2010 14,958.3 110.0

Nominal vs Real GDP: Calculating the GDP Deflator Policy makers need not only good measures of how real output is changing but also good measures of how the overall price level is changing. If an unwary analyst compared nominal GDP in 1960 to nominal GDP in 2010, it might appear that national output had risen by a factor of more than twenty-seven over this time. This conclusion would be highly misleading. GDP deflator is one measure of the overall price level. Is a price index measuring the average prices of all goods and services included in the economy.

Nominal vs Real GDP: Calculating the GDP Deflator Much like nominal GDP (left), the GDP deflator (right) has risen exponentially from 1960 through 2010 (source: BEA)

Nominal vs Real GDP: Calculating the GDP Deflator 𝑽𝒂𝒍𝒖𝒆=𝑷𝒓𝒊𝒄𝒆 𝒙 𝑸𝒖𝒂𝒏𝒕𝒊𝒕𝒚 𝑵𝒐𝒎𝒊𝒏𝒂𝒍 𝑮𝑫𝑷=𝑷𝒓𝒊𝒄𝒆 𝑰𝒏𝒅𝒆𝒙 𝒙 𝑹𝒆𝒂𝒍 𝑮𝑫𝑷 𝑹𝒆𝒂𝒍 𝑮𝑫𝑷= 𝑵𝒐𝒎𝒊𝒏𝒂𝒍 𝑮𝑫𝑷 𝑷𝒓𝒊𝒄𝒆 𝑰𝒏𝒅𝒆𝒙 𝑹𝒆𝒂𝒍 𝑮𝑫𝑷= 𝑵𝒐𝒎𝒊𝒏𝒂𝒍 𝑮𝑫𝑷 𝑮𝑫𝑷 𝑫𝒆𝒇𝒍𝒂𝒕𝒐𝒓/𝟏𝟎𝟎

Nominal vs Real GDP: Example: Computing GDP From Table 6.5, in 1960, Nominal GDP was $543.3 B and the price index (GDP deflator) was 19.0 To calculate the real GDP in 1960, using the formula: 𝑹𝒆𝒂𝒍 𝑮𝑫𝑷= 𝑵𝒐𝒎𝒊𝒏𝒂𝒍 𝑮𝑫𝑷 𝑮𝑫𝑷 𝑫𝒆𝒇𝒍𝒂𝒕𝒐𝒓/𝟏𝟎𝟎 𝑹𝒆𝒂𝒍 𝑮𝑫𝑷= $𝟓𝟒𝟑.𝟑𝑩 𝟏𝟗/𝟏𝟎𝟎 𝑹𝒆𝒂𝒍 𝑮𝑫𝑷= $𝟓𝟒𝟑.𝟑𝑩 𝟎.𝟏𝟗 𝑹𝒆𝒂𝒍 𝑮𝑫𝑷=$𝟐,𝟖𝟓𝟗.𝟓 𝐁

GDP Deflator: Calculating GDP Deflator (1) (2) (3) (4) (5) (6) (7) (8) Production Price per Unit GDP in Year 1 in Year 1 Prices GDP in Year 2 in Year 1 Prices GDP in Year 1 in Year 2 Prices GDP in Year 2 in Year 2 Prices Q1 Q2 P1 P2 P1 × Q1 P1 × Q2 P2 × Q1 P2 × Q2 Good A 7 4 $ 3.00 $ 5.00 Good B 5 12 $ 4.00 $ 6.00 Good C 6 10 Total

GDP Deflator: Calculating GDP Deflator (1) (2) (3) (4) (5) (6) (7) (8) Production Price per Unit GDP in Year 1 in Year 1 Prices GDP in Year 2 in Year 1 Prices GDP in Year 1 in Year 2 Prices GDP in Year 2 in Year 2 Prices Q1 Q2 P1 P2 P1 × Q1 P1 × Q2 P2 × Q1 P2 × Q2 Good A 7 4 $ 3.00 $ 5.00 $ 21.00 Good B 5 12 $ 4.00 $ 6.00 $ 20.00 Good C 6 10 $ 36.00 Total $ 77.00 Nominal GDP in year 1

GDP Deflator: Calculating GDP Deflator (1) (2) (3) (4) (5) (6) Production Price per Unit GDP in Year 1 in Year 1 Prices GDP in Year 2 in Year 1 Prices Q1 Q2 P1 P2 P1 × Q1 P1 × Q2 Good A 7 4 $ 3.00 $ 5.00 $ 21.00 $ 12.00 Good B 5 12 $ 4.00 $ 6.00 $ 20.00 $ 48.00 Good C 6 10 $ 36.00 $ 60.00 Total $ 77.00 $ 120.00 Nominal GDP in year 1

GDP Deflator: Calculating GDP Deflator (1) (2) (3) (4) (5) (6) (7) (8) Production Price per Unit GDP in Year 1 in Year 1 Prices GDP in Year 2 in Year 1 Prices GDP in Year 1 in Year 2 Prices GDP in Year 2 in Year 2 Prices Q1 Q2 P1 P2 P1 × Q1 P1 × Q2 P2 × Q1 P2 × Q2 Good A 7 4 $ 3.00 $ 5.00 $ 21.00 $ 12.00 $ 35.00 $ 20.00 Good B 5 12 $ 4.00 $ 6.00 $ 48.00 $ 30.00 $ 72.00 Good C 6 10 $ 36.00 $ 60.00 $ 24.00 $ 40.00 Total $ 77.00 $ 120.00 $ 89.00 $ 132.00 Nominal GDP in year 1 Nominal GDP in year 2 GDP in Year 1 with Year 1 Prices  $ 77.00 (Nominal GDP Year 1) GDP in Year 1 with Year 2 Prices  $ 89.00 GDP in Year 2 with Year 2 Prices  $ 132.00 (Nominal GDP Year 2) GDP in Year 2 with Year 1 Prices  $ 120.00

GDP Deflator: Calculating GDP Deflator (1) (2) (3) (4) (5) (6) (7) (8) Production Price per Unit GDP in Year 1 in Year 1 Prices GDP in Year 2 in Year 1 Prices GDP in Year 1 in Year 2 Prices GDP in Year 2 in Year 2 Prices Q1 Q2 P1 P2 P1 × Q1 P1 × Q2 P2 × Q1 P2 × Q2 Good A 7 4 $ 3.00 $ 5.00 $ 21.00 $ 12.00 $ 35.00 $ 20.00 Good B 5 12 $ 4.00 $ 6.00 $ 48.00 $ 30.00 $ 72.00 Good C 6 10 $ 36.00 $ 60.00 $ 24.00 $ 40.00 Total $ 77.00 $ 120.00 $ 89.00 $ 132.00 1.1558 1.1000 𝐺𝑒𝑜𝑚𝑒𝑡𝑟𝑖𝑐 𝐺𝐷𝑃 𝑑𝑒𝑓𝑙𝑎𝑡𝑜𝑟= 1.1558 𝑥 1.1000 = 1.1276

Limitations of the GDP Concept: GDP and Social Welfare If crime levels went down, society would be better off, but a decrease in crime is not an increase in output and is not reflected in GDP. An increase in leisure is also an increase in social welfare, sometimes associated with a decrease in GDP. Most nonmarket and domestic activities, such as housework and child care, are not counted in GDP. GDP also has nothing to say about the distribution of output among individuals in a society. GDP is also neutral about the kinds of goods an economy produces

Limitations of the GDP Concept: GDP and Social Welfare “Standard of living” is a broader term than GDP. While GDP focuses on production that is bought and sold in markets, standard of living includes all elements that affect people’s well-being.

Limitations of the GDP Concept: The Informal Economy Is the part of the economy in which transactions take place and in which income is generated that is unreported and therefore not counted in GDP. These transactions may be missed because they are illegal activities or tax evasions. This causes two problems: The size of the GDP will be underreported. Since countries differ in the relative sizes of their underground economies, inter-country comparisons based on GDP or any GDP-related measurement are suspect

Lecture 5 – The Macroeconomic Perspective II School of Natural and Social Sciences Department of Economics and Business, Lehman College Lecture 5 – The Macroeconomic Perspective II "Quarterly gross domestic product compared to Federal Funds Rate" by Wikideas1 is in the Public Domain, CC0 Alexander Núñez Torres, PhD Assistant Professor, Department of Economics and Business