Principles of Macroeconomics ECON203, Lecture 6: GDP and Related Measures of Production and Income Instructor: Turki Abalala

Recap of Last Lecture  GDP and other related measures  Nominal GDP and Real GDP  GDP Deflator  Inflation Rate and Consumer Price Index ECON nd Semester 20143

Class Outline  The Use of Real GDP  The business Cycle and Potential GDP  The Limitations of GDP ECON nd Semester 20144

The Use (importance) of Real GDP  We use estimates of real GDP for three main purposes: To compare the standard of living over time To track the course of the business cycle To compare the standard of living among countries  The Standard of Living Over Time To compare living standards we calculate real GDP per person—real GDP divided by the population. ECON nd Semester 20145

The Business Cycle  The business cycle is the periodic but irregular up-and-down movement of total production and measures of economic activities. Every business cycle has two phases: 1.Expansion (Increase in R.GDP and positive economic growth) 2.Recession (Decrease in R.GDP and negative economic growth) And two turning points: 1.Peak (where expansion ends and recession begins) 2.Trough (where recession ends and expansion begins) ECON nd Semester 20146

7 Real GDP Peak Expansion Recession Trough Time The Business Cycle ECON nd Semester 2014

The Use and Limitations of Real GDP  Two features of our changing standard of living are 1. The growth of potential GDP per person 2. Fluctuations of real GDP per person around potential GDP  Potential GDP is the value of real GDP when all the economy’s factors of production —labor, capital, land, and entrepreneurial ability—are fully employed. ECON nd Semester 20148

The Use and Limitations of Real GDP  When some factors of production are unemployed, real GDP is less than potential GDP.  When some factors of production are over-employed and working hard, real GDP exceeds potential GDP.  In the short term, real GDP fluctuates around potential GDP.  To measure the trend in the standard of living, we remove the influence of short-term fluctuations and focus on potential GDP.  The figure on next slide shows these two features. ECON nd Semester 20149

The Use and Limitations of Real GDP Real GDP per person grows and fluctuates around the path of potential GDP. Potential GDP per person grew at 2.8 percent in the 1960s and slowed during the 1970s. ECON nd Semester

The Use and Limitations of Real GDP  Goods and Services Omitted from GDP Household production Underground production Leisure time Environment quality ECON nd Semester

12 1.Household production of goods and services: Because these are not bought or sold in the market. So, GDP underestimates the value of production. 2.Underground Production: it is the production of goods and services hidden from government to avoid taxes and regulations or their actions are illegal. Underground Production is unreported so it is omitted from GDP 3.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. The Use and Limitations of Real GDP ECON nd Semester 2014

13 4.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. The Use and Limitations of Real GDP ECON nd Semester 2014

14  Other Influences on the Standard of Living : 1.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. 2.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 The Use and Limitations of Real GDP ECON nd Semester 2014

Reference Chapter 5 of “Foundations of Macroeconomics” Pages ECON nd Semester

16 Now it’s over for today. Any question? ECON nd Semester 2014