1. Ch. 5 : MEASURING GDP AND ECONOMIC GROWTH
Define GDP
Circular flow model
Relationship between aggregate expenditure and aggregate income.
Measurement of real GDP and the GDP deflator
Real GDP as a measure of economic growth and the limitations of our measure

2. Gross Domestic Product
GDP: gross domestic product
the market value of all final goods and services produced in a country in a given time period.
This definition has four parts:
Market value
Final goods and services
Produced within a country
In a given time period
The main challenge in teaching this topic is generating interest in it. Many teachers are bored by it and not surprisingly, they bore their students. If you are one of the many who lean toward boredom, start by recalling just how vital it is that we measure the value of production with reasonable accuracy. For such a measure is the basis of measurement of the standard of living, economic welfare, and making international comparisons.
Final goods versus intermediate goods. The distinction between final and intermediate goods is one of the key points in this first section. Use some standard examples to make the key point—tires and autos, chips and computers, and so on. Also, if you want to spend a bit of time on this topic, tell your students about the Bureau of Economic Analysis (BEA) revision in the treatment of business spending on software. The BEA began a major revision in 1998 and published the first revisions to reclassify software from intermediate to final good status in 1999.
When the 1996 GDP was recalculated to include software, it increased by $115 billion, or 1.5 percent of GDP.

3. Gross Domestic Product
GDP and the Circular Flow of Expenditure and Income
GDP measures the value of production
equals total expenditure on final goods
equals total income from production.
The circular flow diagram illustrates the equality of income, expenditure, and the value of production.

4. Gross Domestic Product
Red=expenditures Blue=income Green=borrowing/lending/taxes

5. Gross Domestic Product
Two ways to measure GDP:
Expenditure Approach:
Aggregate expenditure = C + I + G + (X-M)
Income Approach
Aggregate income = Y = Wages + Rent + Interest + Profit
Because Income and expenditure approach both measure GDP:
Y = C + I + G + (X-M)

6. Gross Domestic Product
Financial Flows
Y = C + S + T
Y = C + I + G + (X-M)
S+T = I+G+(X-M)
(G-T) = (S-I)-(X-M)
According to last equality, what are the possible consequences of a larger government budget deficit?

7. Gross Domestic Product
How Investment Is Financed
The last equation could also be reorganized as:
I = S + (T-G) + (M-X)
Investment is financed from three sources:
Private saving, S
Government budget surplus, (T – G)
S + (T-G) is “national saving”
Borrowing from the rest of the world (M – X).
How investment is financed. Don’t skimp on this topic. It provides the foundation for what the student will meet in Chapter 23 (Chapter 8 in the macro text).

8. Gross Domestic Product
Gross vs. Net Domestic Product
“Gross” means before accounting for the depreciation of capital.
Net Domestic Product = GDP – Capital Consumption Allowance.

9. Gross Domestic Product
Stocks versus flows
Wealth
a stock representing the value of all the things that people own
Saving
A flow that is the source of changes in the stock of wealth.
Capital
A stock representing the plant, equipment, and inventories of raw and semi-finished materials that are used to produce other goods
Investment
A flow representing the purchases of new capital
Depreciation (capital consumption)
A flow representing the decrease in the capital stock that results from wear and tear, and obsolescence.

10. Gross Domestic Product
The relationships among capital, gross investment, depreciation, and net investment.

11. Gross Domestic Product
Depreciation is included in:
GDP
Gross profits
Gross Investment
Depreciation is removed from
Net National Product
Net profits
Net investment
Investment plays a central role in the economy.
Increases in capital are one source of growth in potential real GDP;
Fluctuations in investment are one source of fluctuations in real GDP.

12. Measuring U.S. GDP
The National Income and Product Accounts divide incomes into five categories
Compensation of employees
Net interest (paid by business)
Rental income
Corporate profits.
Proprietors’ income.
The sum of these five income components is net domestic income at factor cost.

13. Measuring U.S. GDP Two items must be added to get GDP
Indirect taxes minus subsidies are added to get from factor cost to market prices.
Depreciation (or capital consumption) is added to get from net domestic product to gross domestic product.

14. Expenditure Components of US GDP: 2004

15. Real GDP and the Price Level
Nominal GDP is the value of final goods and services produced in a given year when valued at the same year’s prices
Real GDP is the value of final goods and services produced in a given year when valued at constant (base year) prices.

16. Real GDP and the Price Level
Item
Quant.
Price
2002
Balls
100
$1.00
Bats 20
$5.00
2003
160 22
$10.00
2002 NGDP ________
2003 NGDP ________
Growth rate ________
Base year of 2002
2002 RDGP ________
2003 RGDP ________
Base year of 2003

17. Chain-weighted method for real GDP
Calculate growth rate in real GDP using last year’s prices. ______
Calculate growth rate in real GDP using this year’s prices. ______
Calculate the average of the two growth rates. This average growth rate is the growth rate of real GDP from last year to this year.
average growth rate _______
RGDP (using 2002 as base) _________
4. Repeat steps 1, 2, and 3 for each pair of adjacent years to link real GDP back to the base year’s prices.

18. Real GDP and the Price Level
GDP deflator
Avg. of the prices of the goods in GDP in the current year expressed as a % of the base year prices.

19. Interpreting the GDP-deflator
The GDP-deflator provides a comparison of current year prices with base year prices.
If deflator =100, prices are, on average, the same.
If deflator=150, current year prices are, on average, 1.5 times those in base year (50 percent higher)
If deflator=75, current year prices are, on average .75 times those in base year. (25 percent lower)

21. Measuring Economic Growth
We use real GDP to calculate the economic growth rate.
The economic growth rate is the percentage change in real GDP from one year to the next.

22. R-GDP as a measure of economic welfare. Quality improvements
Household production
Underground economy
Health and life expectancy
Leisure time
Environment
Political freedom and social justice
Exchange rate in comparing across countries.
Omissions from GDP. A discussion of omissions from GDP can arouse students’ interest. For example, you might point out that if one of your students mows her/his own lawn, the value of the student’s production doesn’t show up in GDP. But if you hire the student to mow your lawn (and if your student reports the income earned correctly to the IRS), the value of the student’s production does show up in GDP.
Why don’t we measure all lawn mowing as part of GDP? Some reasons are cost of collecting data and the degree of intrusiveness we’d be willing to tolerate. But note how little we spend on collecting the GDP data and how relatively inexpensive it would be to add some questions about domestic production to either the Labor Force Survey or the Family Expenditure Survey.
The inclusion of the imputed rental of owner-occupied houses, but not owner-used cars and other durables, is a good example.
You might like to explain how the omission of illegal goods and services also leads to some misleading comparisons. For instance, the day before prohibition ended, the production of (illegal) beer was not counted as part of GDP. But the day after prohibition ended, the production of (now legal) beer counted. Ask your students to suggest two good reasons why illegal goods and services are omitted. First, the data are hard (but not impossible) to obtain. Second, there may be the moral position that illegal activities should not be included in GDP. This latter observation can lead to an interesting discussion. Ask the students if they think that the production of, say, marijuana should be included in GDP. Some, maybe even many, of them will see no problem with this. Then ask about the production of murder-for-hire. The response, we hope, will be significantly different. Does such a good have any value?

23. Exchange rates and comparisons across countries.
Using actual exchange rate, U.S. real GDP per capita = 69* Chinese real GDP per capita
Using PPP exchange rate, U.S. real GDP = 12*Chinese real GDP per capita.
What does this say about actual versus PPP exchange rate?