1. Lecture 3
Chapter 7: Taking the Nation’s Economic Pulse

2. GDP
– A Measure of Output
– A Flow

3. GDP – A Measure of Output
Gross Domestic Product (GDP): The market value of final goods and services produced within a country’s borders during a specific time period, usually a year, quarter, or month.
GDP is the most widely used indicator of economic performance.
Measures the flow of exchange
Like a paycheck, rather than your bank account
GNP or “Gross National Product” is similar to GDP, but refers to the market value of goods produced by a nation’s citizens

4. What Counts Toward GDP? Only final goods and services count.
Sales at intermediate stages of production are not counted as their value is embodied within the final-user good.
Including goods at intermediate stages of production would result in double counting.
Stage of production
Value added to the product
(equals income created)
Sales Receipts
(at each stage of production)
Stage 1: farmer’s wheat
Stage 2: miller’s flour
Stage 3: baker’s bread
(wholesale)
Stage 4: grocer’s bread
(retail)
$.30
$.65
$.90 $1
by farmer
by grocer
$.10
by miller
$.35
by baker
$.25
Total consumer expenditure = $1
Total value added = $1

5. What Counts Toward GDP? What Counts Toward GDP?
Only transactions involving production count.
Financial transactions & income transfers are excluded because they do not reflect actual production.
Black market transactions are excluded, so you may consider them financial transactions or income transfers
Only production within the geographic borders of the country is counted.
(This is the DOMESTIC part)
Only those goods produced during the current period are counted.
Thus, the purchase and sale of goods produced during earlier years are not counted in this year’s GDP.

6. Dollars are the Common Denominator for GDP GDP is measured in dollars.
Each good produced increases output by the amount the purchaser pays for the good.
The total spending on all final-user goods and services produced during the year is summed, in dollar terms, to obtain the annual GDP.

7. Two Ways
of Measuring GDP

8. Two Ways of Measuring GDP
Dollar flow of expenditures on final goods =
Dollar flow of income (and indirect cost) of final goods =
GDP (Typically denoted “Y”) is a measure of both output and income. They SHOULD BE EQUAL.
Total expenditures on final-user goods and services produced during the year. This is called the expenditure approach.
Summing the income payments to the resource suppliers and the indirect cost of producing the goods and services. This is called the resource cost-income approach.

9. Expenditure Approach:
GDP is the sum of expenditures on final-user goods and services purchased by households, investors, governments, and foreigners.
There are four components of GDP:
personal consumption purchases (“C”)
gross private investment (“I”) (including inventories)
government purchases (“G”) (consumption and investment)
net exports (“X”)(exports minus imports) (“EX-IM”)
Y=C+I+G+X
You will see and use this repeatedly…

10. Y=C+I+G+X The National Income Identity
Also known as the National Product Identity
Sometimes written Y=C+I+G+EX-IM
We subtract imports because we don’t produce them, but we do consume them
If Exports exceed Imports we have a trade surplus
IM<EX
If Imports exceed Exports we have a trade deficit
IM>EX

11. Resource Cost - Income Approach
GDP is the sum of costs incurred and income (including profits) generated by the production of goods and services during the period.
The direct cost income components of GDP:
employee compensation
self-employment income
rents
interest
corporate profits
Sum of these = national income

12. Resource Cost - Income Approach: (cont.)
Not all cost components of GDP result in an income payment to a resource supplier. To get GDP, we need to account for 3 other factors:
Indirect business taxes: Taxes that increase the firm’s production costs and therefore final prices.
Depreciation: The cost of wear and tear on the machines and other capital assets used to produce goods and services.
Net Income of Foreigners: The income that foreigners earn producing goods within the borders of the U.S. minus the income Americans earn abroad.

13. Method of Measuring GDP
Resource Cost-Income
Method of Measuring GDP
When derived by the Resource Cost - Income Approach, GDP is equal to the sum of
national income, (employee compensation, self-employment income, rents, interest, corporate profits)
indirect business taxes,
depreciation, and,
net income of foreigners.

14. Two Ways of Measuring GDP: A Summary
The two methods of calculating GDP are summarized below:
Expenditure Approach
Resource Cost-Income Approach
Personal consumption expenditures
Aggregate income:
Employee Compensation
Income of self-employed
Rents
Profits
Interest +
Gross private domestic investment +
Government consumption
and gross investment +
Non-income cost items:
Indirect business taxes and depreciation +
Net exports of goods and services
= GDP
Net income of foreigners +
= GDP

15. Employee compensation
Relative Size of U.S. GDP Components:
Personal
consumption
70%
Net exports
- 4%
Private
investment
16%
Gov’t
18%
Rental income 1%
Net
interest 5%
Indirect
taxes 8%
Corporate
profits
Self-employed
proprietor income 7%
Employee compensation
58%
Depreciation
12%
(a) Expenditure approach
(b) Resource cost-income approach a
Source:
a The net income of foreigners was negligible.
-5.8%
2006
The relative sizes of the major components of GDP usually fluctuate within a fairly narrow range.

16. The Major Macroeconomic Issues
National economies are becoming increasingly interdependent:
In 2004 the U.S.:
Exported 10.0% of all goods and services produced. (11.1% in 2006)
Imported 14.4% of the goods and services used by Americans. (16.9% in 2006)
In 2006, U.S. had a trade deficit of $762 Billion, or 5.8% of GDP
Wal-Mart alone imported $18B worth of goods from China alone in 2004

17. The Major Macroeconomic Issues
The international flows create political and economic issues:
The impact of trade on jobs
The steel and textile industries
Trade agreements (NAFTA)
Trade imbalances
When exports and imports differ significantly
Trade deficits or surpluses
Money to pay for goods must come from somewhere

18. Exports and Imports as a Share of U.S. Output, 1900-2004.

19. Macroeconomic Policy Monetary Policy Fiscal Policy
Determination of the nation’s money supply
Controlled by the central bank or, in the U.S., the Federal Reserve System (Fed)
Fiscal Policy
Decisions that determine the government’s budget, including the amount and composition of government expenditures and government revenues
Think of taxes like government income or revenue

20. Macroeconomic Policy
Fiscal policy influences the balance between government spending and taxes:
A budget deficit occurs when government spending is greater than tax revenue.
Government spending > Taxes (G>T)
A budget surplus occurs when government spending is less than tax revenue.
Government spending < Taxes (G<T)
As deficits or surpluses add up, we get our National Debt (or Surplus).
The national debt is the source of the interest payments our country makes
Structural Policy
Government policies aimed at changing the underlying structure, or institutions, of the nation’s economy

21. Government Expenditures as a percent of GDP (Federal Only)
Source: Congressional Budget Office

22. Federal Revenues, Outlays, Deficits, and Surpluses, 1950 to 2075
Source: Congressional Budget Office

24. Aggregation
The adding up of the individual economic variables to obtain economywide totals
Used to take a “bird’s-eye view” of the economy
Aggregate measurements in dollar values allow economists to compare broad categories of goods and services, such as exports and imports.
Aggregation often obscures the fine detail of an economic situation.
“Fallacy of Composition” is the idea that something good for an individual is therfore good for the whole.
Keynes “Paradox of Thrift” shows that additional savings for one, may be good for that person, however if EVERYONE decided to suddenly save more, demand would fall, and we may experience a recession.

25. Why study aggregate output?
The Great Depression as a case study
In the U.S.:
Factories cut production 31%
Number of people without jobs nearly tripled by 1933 when the unemployment rate hit 25%
Stocks lost a third of their value in 3 weeks

26. The U.S. Unemployment Rate, 1900-2004
1933: Approximately 1 in 4 who wanted a job were NOT able to find one at ANY wage. Note that the minimum wage did not yet exist.
The unemployment rate: (UR = Unemployed/Labor Force)
% of the labor force that is out of work
Observations:
Typically rises during recessions
Always greater than zero
Saratoga Springs 2007 UR is 3.30%
U.S. avg. UR is 4.60%

27. Output per Person and per Worker in the U.S. Economy, 1900-2004
Output/person was 8 times the 1900 level
Output/worker was 6 times the 1900 level

28. Output of the U.S. Economy, 1900-2004
In 2004 output of the U.S. economy was:
33 times the 1900 level
6 times the 1950 level

29. Why study aggregate output?
The Great Depression
In Germany:
Nearly a third of all workers were without jobs
Banking system collapsed
Result of reparations from WWI a cause?
Withdrawal of credit due to stock market collapse to blame?

30. Why study aggregate output?
The Great Depression
The response:
Macroeconomic policies
Government and independent agency actions designed to affect the performance of the economy as a whole
Fiscal and Monetary Policy
Banking and stock market regulation
Economic Stabilizers
Transfer Programs

31. The Major Macroeconomic Issues
Standard of Living
The degree to which people have access to goods and services that make their lives easier, healthier, safer, and more enjoyable
This is the quantity of goods and services you consume over a certain period (like a year or a month)

32. The Major Macroeconomic Issues
Economic Growth
A process of steady increases in the quantity and quality of the goods and services the economy can produce in a given period
Growth
Positive or Negative
Measures the change in the FLOW

33. The Major Macroeconomic Issues
In the U.S.:
1.9 automobiles per U.S. household.
In 2004, a typical U.S. resident consumed over eight times the quantity of goods and services consumed in 1900.
In 1960, 8% of the adult population had a college degree compared to 25% in 2004.

34. Consumption Patterns around the World

35. The Major Macroeconomic Issues
Productivity
In 2004 the average U.S. worker could produce six times more than in 1900.
Average labor productivity:

36. The Major Macroeconomic Issues
Productivity
U.S. trends in output per employed worker
: increased 2.3%/yr
: increased by only 1.1%/yr
present: increased by 2.1%/yr

37. The Major Macroeconomic Issues
Productivity and Living Standards in China and the United States
2004 United States China
Output $11,375 billion $7,291 billion (U.S.)
Population 294 million 1,300 million
Employed 139 million 752 million
Output/person $39,915 $5,608
Average labor
productivity $84,424 $9,695

38. Output of the U.S. Economy, 1900-2004
Expansions: periods of rapid economic growth
1945-’48; 1961-’69; 1975-’80; 1982-’90;
Recessions: slowdowns in economic growth
1930s (depression); 1941-’45; 1973-’75; 1981-’82; 1990-’91; 2001

39. Periods of negative growth typically coincide with recessions

40. Increases In Unemployment During Recessions
Unemployment rate at beginning of recession (%)
Peak unemployment rate (%)
Increase in unemployment rate (%)
4.8 (Nov. 1973) 9.0 (May 1975) + 4.2
6.3 (Jan. 1980) 10.8 (Nov./Dec. 1982) + 4.5
5.5 (July 1990) 7.8 (June 1992) + 2.3
4.3 (March 2001) 6.3 (June 2003) +2.0

41. The Major Macroeconomic Issues
Unemployment rates differ from country to country:
For the past 20 years, about 10% of the European workforce has been unemployed.
European unemployment is double the rate in the U.S.
During the 1950s & ‘60s, the European unemployment rate was generally lower than in the U.S.

42. The U.S. Inflation Rate,1900-2004 Inflation
The rate prices in general are increasing over time
Varies over time -- high in the ‘70s and low in the ‘90’s and today
Varies between countries -- in % in U.S. & 400%/yr in Ukraine in the 90’s

43. The Major Macroeconomic Issues
The Major Economic Issues
Economic growth and living standards
Productivity
Recessions and expansions (Business Cycles)
Unemployment
Inflation
Economic interdependence among nations
Trade and Fiscal Policy

44. Real and Nominal GDP

45. Real and Nominal GDP The term "real" means adjusted for inflation.
Price indexes are use to adjust income and output data for the effects of inflation.
A price index measures the cost of purchasing a market basket (or “bundle”) of goods at a point in time relative to the cost of purchasing the same market basket during an earlier reference (or base) period.

46. Two Key Price Indexes: (1) Consumer Price Index (2) GDP Deflator

47. Two Key Price Indexes:
Consumer Price Index (CPI): measures the impact of price changes on the cost of a typical bundle of goods and services purchased by households.
GDP Deflator: designed to measure the change in the average price of the market basket of goods included in GDP.
The GDP deflator is a broader price index than the CPI.
CPI typically thought to overstate inflation

48. CPI and GDP Deflator:
CPI
Inflation rate
GDP deflator
Inflation rate
Year
( = 100)
(percent)
(2000 = 100)
(percent)
1993
144.5
3.0
88.4
2.3
1994
148.2
2.6
90.3
2.1
1995
152.4
2.8
92.1
2.0
1996
156.9
3.0
93.9
1.9
1997
160.5
2.3
95.4
1.7
1998
163.0
1.5
96.5
1.1
1999
166.6
2.2
97.9
1.4
2000
172.2
3.4
100.0
2.2
2001
177.1
2.8
102.4
2.4
2002
179.9
1.6
104.1
1.7
2003
184.0
2.3
106.0
1.8
Source:
Even though the CPI and the GDP deflator are based on different market baskets and procedures, they yield similar estimates of the rate of inflation.

49. Using the GDP Deflator
to Derive Real GDP

50. Using the GDP Deflator to Derive Real GDP
The formula for converting nominal GDP into real GDP (in period 1 prices) is:
Real GDP2 =
GDP Deflator1
GDP Deflator2
Nominal GDP2 x
Data on both money GDP and price changes are essential for meaningful comparisons of output between two time periods.

51. Between 1998 and 2003, nominal GDP increased by 25.8%.
Using the GDP Deflator to Derive Real GDP
Between 1998 and 2003, nominal GDP increased by 25.8%.
But, when the 2003 GDP is deflated to account for price increases …we can see that real GDP increased by only 14.5%.
Source:
Nominal GDP
(billions of U.S. $)
Price index
(GDP deflator, 2000 = 100)
96.5
106.0
9.8%
Real GDP
(billions of 1998 $)
1998
$8,747
$8,747
2003
$11,004
$10,018
% increase
25.8%
14.5%
2006, GDP Deflator is 116.6, thus, to compare 2003 GDP
11004 * 116.6/106 = Thus 2006 GDP is 9% larger in real terms vs

52. Converting Earlier Figures into Current Dollars
Sometimes we will want to make real data (e.g. income) comparisons in terms of the purchasing power of the dollar during the current year.
This can be done by “inflating” the data for earlier years for increases in the price level.
The formula for converting the figures for an earlier year into current dollars is:
Figurecurrent $ =
price indexcurrent year
price indexearlier year x
Figureearlier $
If prices have risen, this will “inflate” the data for earlier years and bring it into line with the current purchasing power of the dollar.

53. Shortcomings of GDP as a Measuring Rod Shortcomings of GDP:
It does not count non-market production.
It does not count the underground economy.
It makes no adjustment for leisure.
It probably understates output increases because of the problem of estimating improvements in the quality of products.
It does not adjust for harmful side effects.

54. U.S. Per Capita GDP (in 2000 U.S. dollars)
Differences in GDP Over Time
U.S. Per Capita GDP (in 2000 U.S. dollars)
$35,664
$28,429
$22,666
$18,391
$13,840
$11,717
$7,827
$6,418
1930
1940
1950
1960
1970
1980
1990
2003
Source: derived from U.S. Department of Commerce data.
Per capita GDP is GDP divided by population.
As shown here, the real 2003 GDP per capita of the U.S. was more than five times the figure for 1930.
How meaningful are these figures?

55. Per Capita GDP Comparisons Across Time Periods
As was shown in the previous exhibit, real U.S. per capita GDP has increased substantially over the past 70 years.
Compared to earlier periods, current GDP is probably biased upward because more output now takes place in the market sector and less in the household sector.
However, it is also probably biased downward because of failure to adjust for increased leisure, improvements in the work environment, and the introduction of improved products and new technologies.
The direction of the overall bias is uncertain.

56. The Great Contribution of GDP
In spite of its shortcomings, the evidence indicates that real GDP per person is a broad indicator of living standards.
As real per capita GDP in the United States has increased through time, the quality of most goods has increased while the amount of work time required for their purchase has declined.
Similarly, as real per capita GDP has risen in the United States and other countries, life expectancy and leisure time have gone up, while literacy and infant mortality rates have gone down.

57. The Great Contribution of GDP
However, the “great contribution” of GDP is its ability to measure short-term fluctuations in output.
Year-to-year (and quarter-to-quarter) changes in real GDP provide a reasonably precise measure of what is happening to the rate of output.