Introduction to Gross Domestic Product

Learning Objectives Define gross domestic product and explain how it is measured using the expenditure approach. Explain the difference between nominal and real GDP.

GDP Dating Exercise Describe the empirical facts before you (ie. GDP generally increases). Identify peaks, valleys what happened. Is there regularity in the frequency of changes?

Expansion and Contraction: The Business Cycle An expansion, or boom, is the period in the business cycle from a trough up to a peak, during which output and employment rise. A contraction, recession, or slump is the period in the business cycle from a peak down to a trough, during which output and employment fall.

Real GDP, 1900-2002

Real GDP, 1970 I-2003 II

Macroeconomic Concerns Three of the major concerns of macroeconomics are: Inflation Unemployment Output growth

Output Growth: Short Run and Long Run The business cycle is the cycle of short-term ups and downs in the economy. The main measure of how an economy is doing is aggregate output: Aggregate output is the total quantity of goods and services produced in an economy in a given period.

Output Growth: Short Run and Long Run A recession is a period during which aggregate output declines. Two consecutive quarters of decrease in output signal a recession. A prolonged and deep recession becomes a depression. Policy makers attempt not only to smooth fluctuations in output during a business cycle but also to increase the growth rate of output in the long-run.

The Components of the Macroeconomy Everyone’s expenditure is someone else’s receipt. Every transaction must have two sides.

An Overview of National Income and Product Accounting (NIPA) Detailed calculations were first worked out by Simon Kuznets during the Great Depression Large quantities of data collected and organized from a variety of sources around the country These data are summarized, assembled into a coherent framework, and reported by the government

Gross Domestic Product and Gross National Product GDP is the market value of all newly produced final goods and services produced by resources located in the United States, regardless of who owns those resources

Final and Intermediate Goods and Services Final goods and services sold to ultimate, users Cotton shirts are a final good Intermediate goods and services are purchased for further reprocessing and resale Cotton is intermediate good Keeping final goods and intermediate goods separate in our thinking allows us to avoid double counting Value added is the difference between the value of goods as they leave a stage of production and the cost of the goods as they entered that stage. In calculating GDP, we can either sum up the value added at each stage of production, or we can take the value of final sales.

Calculating GDP GDP can be computed in two ways: The expenditure approach: A method of computing GDP that measures the total amount spent on all final goods during a given period. The income approach:

The Expenditure Approach The expenditure approach calculates GDP by adding together the four components of spending. In equation form:

The Circular Flow of Income and Expenditure aggregate income = GDP transfer payments taxes Disposable income Financial markets consumption (C) S Investment (I) Gov’t (G) X-M C+I+G+X-M

Categories of Expenditures Consumption (C) All household purchases (blue jeans, twinkies, etc.) Investment (I) Purchases not used for current consumption (newly built homes,plant, new inventories) Government Purchases (G) Examples include missile systems and paper clips Net Exports (X - M) Net exports = exports (X) - imports (M)

Personal Consumption Expenditures Personal consumption expenditures (C) are expenditures by consumers on the following: Durable goods: Goods that last a relatively long time, such as cars and appliances. Nondurable goods: Goods that are used up fairly quickly, such as food and clothing. Services: Things that do not involve the production of physical things, such as legal services, medical services, and education.

Gross Private Domestic Investment Investment refers to the purchase of new capital. Total investment by the private sector is called gross private domestic investment. It includes the purchase of new housing, plants, equipment, and inventory by the private sector.

Gross Private Domestic Investment Nonresidential investment includes expenditures by firms for machines, tools, plants, and so on. Residential investment includes expenditures by households and firms on new houses and apartment buildings. Change in inventories computes the amount by which firms’ inventories change during a given period. Inventories are the goods that firms produce now but intend to sell later. The relationship between total production and total sales is: GDP = final sales + change in business inventories

Government Consumption and Gross Investment Government consumption and gross investment (G) counts expenditures by federal, state, and local governments for final goods and services.

Net Exports Net exports (EX – IM) is the difference between exports and imports. The figure can be positive or negative. Exports (EX) are sales to foreigners of U.S.-produced goods and services. Imports (IM) are U.S. purchases of goods and services from abroad).

Classify each of these scenarios You buy an old house You buy some marijuana from a friend You buy stock in GM A Japanese firm buys City Brewery The government makes a welfare payment You buy a used car A business fails to sell some of its inventory A business buys a new truck You buy an old house You buy some marijuana from a friend You buy stock in GM A Japanese firm buys City Brewery The government makes a welfare payment You buy a used car A business fails to sell some of its inventory A business buys a new truck

Components of GDP, 2002: The Expenditure Approach BILLIONS OF DOLLARS PERCENTAGE OF GDP Personal consumption expenditures (C) 7303.7 69.9 Durable goods 871.9 8.3 Nondurable goods 2115.0 20.2 Services 4316.8 41.3 Gross private domestic investment (l) 1543.2 14.8 Nonresidential 1117.4 10.7 Residential 471.9 4.5 Change in business inventories 3.9 Government consumption and gross investment (G) 1972.9 18.9 Federal 693.7 6.6 State and local 1279.2 12.2 Net exports (EX – IM) - 423.6 - 4.1 Exports (EX) 1014.9 9.8 Imports (IM) 1438.5 13.8 Total gross domestic product (GDP) 10446.2 100.0 Note: Numbers may not add exactly because of rounding. Source: U.S. Department of Commerce, Bureau of Economic Analysis.

Current and Historical Data US data (BEA) http://www.bea.doc.gov/bea/newsrel/gdp499p.htm Historical US Data http://eh.net/hmit/gdp/ International http://www.stls.frb.org/publications/iet/ http://www.odci.gov/cia/publications/factbook/

GDP and Social Welfare Society is better off when crime decreases, however, a decrease in crime is not reflected in GDP. An increase in leisure is an increase in social welfare, but not counted in GDP. Nonmarket and household activities are not counted in GDP even though they amount to real production.

GDP and Social Welfare GDP accounting rules do not adjust for production that pollutes the environment. GDP has nothing to say about the distribution of output. Redistributive income policies have no direct impact on GDP. GDP is neutral to the kinds of goods an economy produces.

The Underground Economy The underground economy is the part of an economy in which transactions take place and in which income is generated that is unreported and therefore not counted in GDP. About $1 trillion in US http://www.frontpagemag.com/Articles/ReadArticle.asp?ID=16532 Highest in Greece at 29% of GDP.

Gross National Income per Capita To make comparisons of GNP between countries, currency exchange rates must be taken into account. Gross National Income (GNI) is a measure used to make international comparisons of output. GNI is GNP converted into dollars using an average of currency exchange rates over several years adjusted for rates of inflation. GNI divided by population equals gross national income per capita.

Per Capita Gross National Income for Selected Countries, 2002 COUNTRY U.S. DOLLARS Switzerland 36,970 Portugal 10,670 Japan 35,990 South Korea 9,400 Norway 35,530 Argentina 6,860 United States 34,870 Mexico 5,540 Denmark 31,090 Czech Republic 5,270 Ireland 28,880 Brazil 3,060 Sweden 25,400 South Africa 2,900 United Kingdom 24,230 Turkey 2,540 Netherlands 24,040 Colombia 1,910 Austria 23,940 Jordan 1,750 Finland 23,840 Romania 1,710 Germany 23,700 Philippines 1,050 Belgium 23,340 China 890 France 22,640 Indonesia 680 Canada 21,340 India 460 Australia 18,770 Pakistan 420 Italy 18,470 Nepal 250 Spain 14,860 Rwanda 220 Greece 11,780 Ethiopia 100 Source: The World Bank Atlas, 2002.

Accounting for Price Changes

Nominal Versus Real GDP Nominal GDP is GDP measured in current dollars, or the current prices we pay for things. Nominal GDP includes all the components of GDP valued at their current prices. When a variable is measured in current dollars, it is described in nominal terms.

Real GDP Real GDP is the value of GDP measure in terms of dollars of fixed purchasing power Real GDP is measured in the dollars of the base year The base year is a reference year against which other years are measured

The Simplest Example of a Price Index (One Product)

The GDP Price Index, Nominal GDP, and Real GDP The GDP price index is a comprehensive price index of all goods and services included in the gross domestic product

Calculating Real GDP A weight is the importance attached to an item within a group of items. A base year is the year chosen for the weights in a fixed-weight procedure. A fixed-weight procedure uses weights from a given base year.

Calculating Real GDP A Three-Good Economy (1) (2) (3) (4) (5) (6) (7) (8) GDP IN YEAR 1 YEAR 2 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 year 1 Nominal GDP in year 2

The Problems of Fixed Weights The use of fixed price weights to estimate real GDP leads to problems because it ignores: Structural changes in the economy. Supply shifts, which cause large decreases in price and large increases in quantity supplied. The substitution effect of price increases.

Hypothetical Data Used to Develop Chain-Weighted Indexes

Calculating the GDP Deflator The GDP deflator is one measure of the overall price level. The GDP deflator is computed by the Bureau of Economic Analysis (BEA). Overall price increases can be sensitive to the choice of the base year. For this reason, using fixed-price weights to compute real GDP has some problems.

Appendix Slides after this point will most likely not be covered in class. However they may contain useful definitions, or further elaborate on important concepts, particularly materials covered in the text book. They may contain examples I’ve used in the past, or slides I just don’t want to delete as I may use them in the future.

Introduction to Macroeconomics Macroeconomists often reflect on the microeconomic principles underlying macroeconomic analysis, or the microeconomic foundations of macroeconomics.

Government in the Macroeconomy Fiscal policy refers to government policies concerning taxes and spending. Monetary policy consists of tools used by the Federal Reserve to control the quantity of money in the economy. Growth policies are government policies that focus on stimulating aggregate supply instead of aggregate demand.

The Components of the Macroeconomy The circular flow diagram shows the income received and payments made by each sector of the economy.

The Methodology of Macroeconomics Connections to microeconomics: Macroeconomic behavior is the sum of all the microeconomic decisions made by individual households and firms. We cannot understand the former without some knowledge of the factors that influence the latter.

Measuring Economic Aggregates

Gross Domestic Product and Gross National Product GDP is the market value of all final goods and services produced by resources located in the United States, regardless of who owns those resources GNP is the market value of all final goods and services produced by resources supplied by U.S. residents and firms, regardless of location

Calculating GDP GDP can be computed in two ways: The expenditure approach: A method of computing GDP that measures the total amount spent on all final goods during a given period. The 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 goods.

Gross Private Domestic Investment Remember that GDP is not the market value of total sales during a period—it is the market value of total production. The relationship between total production and total sales is: The relationship between total production and total sales is: GDP = final sales + change in business inventories GDP = final sales + change in business inventories

Consumer Price Index The consumer price index is a measure over time of the cost of a fixed “market basket” of consumer goods and services

Review Terms and Concepts base year change in business inventories compensation of employees corporate profits current dollars depreciation disposable personal income, or after-tax income durable goods expenditure approach final goods and services fixed-weight procedure government consumption and gross investment (G) gross domestic product (GDP) gross investment gross national income (GNI) gross national product (GNP) gross private domestic investment (I) income approach indirect taxes intermediate goods national income national income and product accounts

Review Terms and Concepts net exports (EX – IM) net factor payments to the rest of the world net interest net investment net national product (NNP) nominal GDP nondurable goods nonresidential investment personal consumption expenditures (C) personal income personal saving personal saving rate proprietors’ income rental income residential investment services subsidies underground economy value added weight

Skip The slides that follow We skipped some of the slides for time consideration and some because it is material I do not care to cover.

The Components of the Macroeconomy Transfer payments are payments made by the government to people who do not supply goods, services, or labor in exchange for these payments.

The Three Market Arenas Households, firms, the government, and the rest of the world all interact in three different market arenas: Goods-and-services market Labor market Money (financial) market

The Three Market Arenas Households and the government purchase goods and services (demand) from firms in the goods-and services market, and firms supply to the goods and services market. In the labor market, firms and government purchase (demand) labor from households (supply). The total supply of labor in the economy depends on the sum of decisions made by households.

The Three Market Arenas In the money market—sometimes called the financial market—households purchase stocks and bonds from firms. Households supply funds to this market in the expectation of earning income, and also demand (borrow) funds from this market. Firms, government, and the rest of the world also engage in borrowing and lending, coordinated by financial institutions.

Financial Instruments Treasury bonds, notes, and bills are promissory notes issued by the federal government when it borrows money. Corporate bonds are promissory notes issued by corporations when they borrow money.

Financial Instruments Shares of stock are financial instruments that give to the holder a share in the firm’s ownership and therefore the right to share in the firm’s profits. Dividends are the portion of a corporation’s profits that the firm pays out each period to its shareholders.

Review Terms and Concepts aggregate behavior aggregate demand aggregate output aggregate supply business cycle circular flow contraction, recession, or slump corporate bonds deflation depression dividends expansion or boom fine tuning fiscal policy Great Depression hyperinflation inflation macroeconomics microeconomic foundations of macroeconomics microeconomics monetary policy recession shares of stock stagflation sticky prices supply-side policies transfer payments Treasury bonds, notes, bills unemployment rate

Inflation and Deflation Inflation is an increase in the overall price level. Hyperinflation is a period of very rapid increases in the overall price level. Hyperinflations are rare, but have been used to study the costs and consequences of even moderate inflation. Deflation is a decrease in the overall price level. Prolonged periods of deflation can be just as damaging for the economy as sustained inflation.

Unemployment The unemployment rate is the percentage of the labor force that is unemployed. The unemployment rate is a key indicator of the economy’s health. The existence of unemployment seems to imply that the aggregate labor market is not in equilibrium. Why do labor markets not clear when other markets do?

Unemployment Rate, 1970 I-2003 II

Percentage Change in the GDP Deflator (Four-Quarter Average), 1970 I-2003 II

Introduction to Macroeconomics Microeconomics examines the behavior of individual decision-making units—business firms and households. Macroeconomics deals with the economy as a whole; it examines the behavior of economic aggregates such as aggregate income, consumption, investment, and the overall level of prices. Aggregate behavior refers to the behavior of all households and firms together.

Introduction to Macroeconomics Microeconomists generally conclude that markets work well. Macroeconomists, however, observe that some important prices often seem “sticky.” Sticky prices are prices that do not always adjust rapidly to maintain the equality between quantity supplied and quantity demanded.

The Roots of Macroeconomics The Great Depression was a period of severe economic contraction and high unemployment that began in 1929 and continued throughout the 1930s.

The Roots of Macroeconomics Classical economists applied microeconomic models, or “market clearing” models, to economy-wide problems. However, simple classical models failed to explain the prolonged existence of high unemployment during the Great Depression. This provided the impetus for the development of macroeconomics. And they often fail to explain any involuntary unemployment.

The Roots of Macroeconomics In 1936, John Maynard Keynes published The General Theory of Employment, Interest, and Money. Keynes believed governments could intervene in the economy and affect the level of output and employment. During periods of low private demand, the government can stimulate aggregate demand to lift the economy out of recession. This is a theory of insufficient aggregate demand. Keynes argued that govt should pay people to dig holes and others to fill them.

Recent Macroeconomic History Fine-tuning was the phrase used by Walter Heller to refer to the government’s role in regulating inflation and unemployment. The use of Keynesian policy to fine-tune the economy in the 1960s, led to disillusionment in the 1970s and early 1980s.

Recent Macroeconomic History Stagflation occurs when the overall price level rises rapidly (inflation) during periods of recession or high and persistent unemployment (stagnation). 70’s staglflation was not easily explainable by Keynesian models

Aggregate Supply and Aggregate Demand Aggregate demand is the total demand for goods and services in an economy. Aggregate supply is the total supply of goods and services in an economy. Very different then micro. AD does not increase as price falls due to the substitution effect (among goods anyway). There may be some substitution among financial assets, and there may be an income effect. While there is also some controversy on the supply side it can’t be upward slopping because the price of inputs is fixed, P represents the price of all goods and services including those that are inputs. Aggregate supply and demand curves are more complex than simple market supply and demand curves.

Government in the Macroeconomy There are three kinds of policy that the government has used to influence the macroeconomy: Fiscal policy Monetary policy Growth or supply-side policies