Gross Domestic Product (GDP) What is Gross Domestic Product and how we measure it? Why is this measure important? What are the definitions of the major expenditure components? What are the trends in these components over time? 2. Inflation What is the difference between ‘Real’ and ‘Nominal’ variables? How is inflation measured? 3. Unemployment How is Unemployment measured? Why do we care about Unemployment?

GDP is the best single measure of the economic well-being of a society. Three ways of measuring GDP Production Method: Measure the Value Added summed across all firms (value added = sale price less cost of raw materials) Income Method: Labor Income (wages/salary) + Capital Income (rent, interest, dividends, profits)+ Government Income (taxes) Expenditure Method: Spending by consumers (C) + Spending by businesses (I) + Spending by government (G) + Net Spending by foreign sector (NX) Fundamental identity of national income account: Total production = total income = total expenditure

To see how all these approaches work we consider a simple example. Consider a very simple economy where there is a coconut producer, a restaurant, some consumers and a government.

In this approach, to calculate the GDP: we add the value of all goods and services produced and then subtract intermediate goods the value of all intermediate goods used in production. intermediate goods Goods that are produced by one firm for use in further processing by another firm. We subtract the value of the intermediate goods to avoid double counting in the calculation. value added Using this approach the GDP is simply defined as the sum of value added to goods and services across all productive units in the economy.

In this approach, GDP is defined as: the total spending on all final goods and services produced in the economy in a given period of time. we do not count Notice: the word final in the definition implies that we do not count spending on intermediate goods. Y = GDP = the value of total output C + I + G + NX = aggregate expenditure

The spending by households on goods and services. Consumption (C): The purchase of goods and services to be used in future. The spending on capital equipment, inventories, and structures etc. Investment (I): The spending on goods and services by local, state, and federal governments. Government Purchases (G): Is the difference between the monetary value of exports and imports. In simple terms, it refers to exports minus imports. Net Exports (NX):

I produce apples and I can potentially: Sell them to some domestic customer (Consumption) Sell them to some business (Investment) Keep them in my stock room as inventory (Investment) Sell them to the other city for their shelters (Government spending) Sell them to some foreign customer (Net Export)

From our example, using the expenditure approach we have that I = 0 and NX = 0. There is no investment in our example and no international trade. The GDP is then given by: C + G

Components of the income approach: Wages, salaries, and supplements Net interest Rental income of persons Income of unincorporated enterprises Corporate profits before taxes Indirect taxes Depreciation

In this approach, GDP is defined as the sum of all income received by economic agents contributing to production. Income includes the profits of firms.

The difference between exports exports (sales to foreigners of country-produced goods and services) and imports imports (country purchases of goods and services from abroad). The figure can be positive or negative.

Gross National Product (GNP): total income earned by the nation’s factors of production, regardless of where located Gross Domestic Product (GDP): total income earned by domestically-located factors of production, regardless of nationality. GNP = GDP + Net Factor Income from Abroad (NFIA) NFIA = Receipts of factor income from the rest of the World – Payments of factor income to the rest of the World

net national product (NNP) Gross national product minus depreciation; a nation’s total product minus what is required to maintain the value of its capital stock. NNP = GNP – Depreciation personal income The total income of households.

GDP, GNP, NNP, National Income, Personal Income, and Disposable Personal Income (example) DOLLARS (BILLIONS) GDP10,205.6 Plus: receipts of factor income from the rest of the world Less: payments of factor income to the rest of the world Equals: GNP10,194.5 Less: depreciation- 1,351.3 Equals: net national product (NNP)8,843.2 Less: indirect taxes minus subsidies plus other Equals: national income8,199.9 Less: corporate profits minus dividends Less: social insurance payments Plus: personal interest income received from the government and consumers Plus: transfer payments to persons+1,148.7 Equals: personal income8,723.9 Less: personal taxes- 1,306.2 Equals: disposable personal income7,417.7

GDP is the value of all final goods and services produced. Nominal GDP measures these values using current prices. Real GDP measure these values using the prices of a base year. base year The year chosen for the weights in a fixed-weight procedure. fixed-weight procedure A procedure that uses weights from a given base year. Nominal GDP = Current year Quantities x Current year Prices Real GDP = Current year Quantities x Base year Prices Real GDP = Nominal GDP / price index

Changes in nominal GDP can be due to: changes in prices changes in quantities of output produced Changes in real GDP can only be due to changes in quantities, because real GDP is constructed using constant base-year prices.

Compute nominal GDP in 2012 and 2013 Compute real GDP in each year using 2012 as the base year.

Nominal GDP multiply Ps & Qs from same year 2012: $1 x 10 + $10 x 3 = $ : $2 x 15 + $15 x 4 = $90 Real GDP multiply each year’s Qs by 2012 Ps 2012: as above: $ : $1 x 15 + $10 x 4 = $55 (2012$) So in real terms, GDP did not rise as much as it would seem from nominal terms.

The inflation rate is the percentage increase in the overall level of prices. One measure of the price level is the GDP Deflator, defined as GDP deflator identifies an index that measures the overall price level in a given year. Inflation rate is the rate of change of that index from one year to the following.

Example with 3 goods: For good i = 1, 2, 3 P it = the market price of good i in month t Q it = the quantity of good i produced in month t NGDP t = Nominal GDP in month t RGDP t = Real GDP in month t The GDP deflator is a weighted average of prices. The weight on each price reflects that good’s relative importance in GDP. Note that the weights change over time.

Example with 3 goods: For good i = 1, 2, 3 C i = the amount of good i in the CPI’s basket P it = the price of good i in month t E t = the cost of the CPI basket in month t E b = cost of the basket in the base period The CPI is a weighted average of prices. The weight on each price reflects that good’s relative importance in the CPI’s basket. Weights remain fixed over time.

prices of capital goods included in GDP deflator (if produced domestically) excluded from CPI prices of imported consumer goods included in CPI excluded from GDP deflator the basket of goods CPI: fixed GDP deflator: changes every year

employed working at a paid job unemployed not employed but looking for a job labor force the amount of labor available for producing goods and services; all employed plus unemployed persons Labor Force = Employed +Unemployed not in the labor force not employed, not looking for work. Not in The Labor Force = Population – Labor Force

unemployment rate percentage of the labor force that is unemployed labor force participation rate the fraction of the adult population that ‘participates’ in the labor force Unemployment Rate = Number of Unemployed Labor Force  100 Labor Force Participation Rate = Labor Force Adult Population  100

Number employed = million Number unemployed = 6.9 million Adult population = million Labor Force = = Not in The Labor Force = – 153 = 78.7 Unemployment Rate = (6.9/153) x 100% = 4.5 % Labor Force Participation Rate = (153.0/231.7)x100 %= 66 %

A stock is a quantity measured at a point in time. A flow is a quantity measured per unit of time. Stock Flow a person’s wealth a person’s annual saving # of people with college degrees # of new college graduates this year the government debt the government budget deficit

Gross domestic product (GDP) Consumer Price Index (CPI) Unemployment rate National income accounting Stocks and flows Value added Imputed value Nominal versus real GDP GDP deflator National income accounts identity Consumption Investment Government purchases Net exports Labor force Labor-force participation rate

Measuring GDP using the Income Approach and the Expenditure Approach - watch the video -