Chapter 4: Measuring GDP and Economic Growth Objectives: 1.Define GDP and use circular flow model to explain how GDP can be measured from income or expenditure side. 2.Measurement of GDP and its major components. 3.GDP as a measure of economic growth. 4.Limitations of GDP as a measure of economic growth or the standard of living.

Definition of GDP GDP (Gross Domestic Product) is the market value of all final goods and services produced in a country in a given time period. – Market value goods & services are valued at their market prices. GDP rises if prices rise (more on this later) – Final goods and services Bought by final user Intermediate goods are produced by one firm, bought by another, and used as a component of a final good or service. Exlude intermediate goods to avoid double counting.

Produced within a country – Any domestic production, regardless of who owns the resources In a given time period – Production during a specific year (sales of used items excluded, except value of service in sale) – Inventory adjustments account for goods produced in one year but sold in another if inventories rise by $10 million during 2010, $10 million is added to sales of final goods & services since it reflects goods produced but not sold during If inventories fall by $10 million during 2010, $10 million is subtracted from sales of final goods & services because $10 million was sold during 2010 that was produced prior to Definition of GDP

Households sell factors of production the firms in factor markets – Factors of production: land, labor, capital Wages for labor Interest for loans used to purchase capital Rent for the use of land Profit to owners of capital Total income paid to households=Y GDP and Circular Flow

Expenditure Components of GDP Consumption (C) – total payment for consumer goods and services Investment (I) – purchase of new plant, equipment, and buildings – additions to inventories Government spending (G): – government purchases ofgoods and services from firms – excludes “transfer payments” such as Social Security, Unemployment Insurance Net exports (X-M) – (exports-imports) – Imports subtracted because counted as part of C,I,G and are not part of domestic production.

Y=total income; C=consumption; I=investment; G=government purchases; X-M=exports-imports=net exports

GDP: Income & Expenditure Approach GDP can be measured by income or expenditure side Circular flow demonstrates that Y = C + I + G + (X-M)

Gross vs Net Domestic Product GDP is before subtracting depreciation (capital consumption allowance) NDP =GDP- CCA – NDP is “net of” depreciation. Net investment = Gross investment (I) – CCA

GDP: The Expenditure Side

GDP: The Income Side Income includes 1. Compensation of employees 2. Rental income 3. Net interest 4. Corporate profits 5. Proprietors’ income Two adjustments to income required: 1.Indirect taxes minus subsidies are added to get from factor cost to market prices. 2. Depreciation (or capital consumption) is added to get from net domestic product to gross domestic product

GDP: The Income Side

GDP: Adjusting for changes in prices Nominal GDP the value of goods and services produced during a given year valued at the prices that prevailed in that same year. Nominal GDP is a more precise name for GDP. Real GDP the value of final goods and services produced in a given year when valued at the prices of a reference base year.

ProductQuantityPriceQuantityPrice computers100$500120$600 refrigerators50$ $1500 Nominal GDP Real GDP (2000 base year) Real GDP (2010 base year) GDP-deflator (2000 base year) GDP-deflator (2010 base year)

GDP Deflator GDP deflator – Provides a comparison of current and base year prices

Uses of Real GDP Use Real GDP per capita to – compare the standard of living over time – compare the standard of living across countries In 1958, real GDP per person was $12,883 and in 2008, it was $38,422 Two sources of growth in standard of living – Growth of potential GDP per capita Potential GDP = GDP if economy is at full employment – Fluctuations of real GDP around potential GDP

Lucas Wedge dollar value of the accumulated gap between what real GDP per person would have been if the 1960s growth rate had persisted and what real GDP per person turned out to be.

Temporary fluctuations in GDP: The Business Cycle 4 stages to a business cycle – Peak – Recession – Trough – Expansion

Comparing Standard of Living Across Countries Use per capita real GDP Must make two adjustments – Convert into common currency – Goods and services must be valued at same prices Using the exchange rate to convert can be problematic because prices of some products may differ after conversion Purchasing Power Parity exchange rate is the exchange rate that would make the prices of goods and services equal across countries. Using actual exchange rate instead of PPP exchange rate causes underestimate of standard of living in less developed countries.

With actual exchange rates, China RGDP per capita is 5% of that in U.S. With PPP exchange rates, China RDDP per capita is 12.5% of that in U.S.

Real GDP per capita across the world Source:

Limitations of GDP as measure of standard of living Household production Underground economic activity Health and life expectancy Leisure time Environmental quality Political freedom and social justice