GDP : Gross Domestic Product MACROECONOMICS By Dr. Nimantha Manamperi Chapter 7 GDP : Gross Domestic Product

WHAT YOU WILL LEARN IN THIS CHAPTER How economists use aggregate measures to track the performance of the economy. The Gross Domestic Product (GDP) Three Ways of calculating GDP. The difference between real GDP and nominal GDP and why real GDP is the appropriate measure of real economic activity. What are some shortcomings of GDP calculations? WHAT YOU WILL LEARN IN THIS CHAPTER

An Expanded Circular-Flow Diagram Government purchases of goods and services Government borrowing Government Consumer spending Government transfers Taxes Private savings Households Wages, profit, interest, rent Markets for goods and services Financial Markets Factor Markets Wages, profit, interest, rent Figure Caption: Figure 7(22)-1: An Expanded Circular-Flow Diagram: The Flows of Money Through the Economy A circular flow of funds connects the four sectors of the economy—households, firms, government, and the rest of the world—via three types of markets: the factor markets, the markets for goods and services, and the financial markets. Funds flow from firms to households in the form of wages, profit, interest, and rent through the factor markets. After paying taxes to the government and receiving government transfers, households allocate the remaining income— disposable income—to private savings and consumer spending. Via the financial markets, private savings and funds from the rest of the world are channeled into investment spending by firms, government borrowing, foreign borrowing and lending, and foreign transactions of stocks. In turn, funds flow from the government and households to firms to pay for purchases of goods and services. Finally, exports to the rest of the world generate a flow of funds into the economy and imports lead to a flow of funds out of the economy. If we add up consumer spending on goods and services, investment spending by firms, government purchases of goods and services, and exports, then subtract the value of imports, the total flow of funds represented by this calculation is total spending on final goods and services produced in the United States. Equivalently, it’s the value of all the final goods and services produced in the United States—that is, the gross domestic product of the economy. GDP Borrowing and stock issues by firms Investment Firms Foreign borrowing and sales of stock Exports Rest of the world Foreign lending and purchases of stock Imports

Terms to Know … Households earn income via the factor markets from wages, interest on bonds, dividends on stocks, and rent on land. A stock is a share in the ownership of a company held by a shareholder. A bond is borrowing in the form of an IOU that pays interest. In addition, households receive government transfers from the government. (Social security benefits, Medicaid, etc…) Disposable income, total household income minus taxes, is available to spend on consumption or to save.

Terms to Know … Inventories are stocks of goods and raw materials held to facilitate business operations. Investment spending is spending on productive physical capital, such as machinery and construction of structures, and on changes to inventories. Final goods and services are goods and services sold to the final, or end, users. Intermediate goods and services are goods and services—bought from one firm by another firm—that are inputs for production of final goods and services. E.g.

Terms to Know … Private savings, equal to disposable income minus consumer spending, is disposable income that is not spent on consumption. Government purchases of goods and services (G) is paid for by tax receipts, as well as by government borrowing. Exports (X) generate an inflow of funds into the country from the rest of the world, while Imports (M) lead to an outflow of funds to the rest of the world.

Gross Domestic Product Gross domestic product or GDP : The market value of all the final goods and services produced in a country in a given period of time.

Gross Domestic Product Market Value: The value of the final goods and services in the market Final Goods and Services: The goods and services are sold to final consumers. In a given country If we calculate the GDP of the United States, then we should only count the goods and services produced in the united states.

Gross Domestic Product In a given period of time If we calculate the GDP for year 2012, Then we should only consider the Final goods and services produced in year 2012. Eg. Calculate the GDP for United States in 2012 given the following economic transactions. 1. Toyota manufacturer in Alabama produced a 2012 Toyota Yaris for $20000 and sold in Texas at that price to Mr. Taylor for private use. 2. Mr. X sold his 2008 produced Nissan Altima through a dealer for $8000 to Mr. Y in Berea. Dealer fees were $200.

Uses of GDP Data Measuring the Living Standards of a Country.

Uses of GDP Data Measuring Economic Growth. Measuring Business Cycles.

Important Relationship …. Aggregate Expenditure : the sum of all the spending in the economy. Aggregate Income : The sum of all the income earned by the factors of production. Aggregate Income = Aggregate Expenditure Aggregate Expenditure = GDP So, Aggregate Income = Aggregate Expenditure = GDP

Calculating Gross Domestic Product GDP can be calculated three ways: (1). Counting Market Values. (2). Adding Up all the Spending on domestically produced goods and services. (Expenditure Method) (3). Adding Up the total factor income given to households. (Income Method)

Market Value Method: Country A produces 200 Apples at $1 market price and 100 Oranges for $3 market price and both will be sold to final consumers . Calculate the GDP for country A. Country B produces $100 worth of milk which will be used in $300 Ice cream production. Ice creams will be consumed by the school children. Also country B produces $900 worth clothing. Calculate the GDP for Country B.

Expenditure Method GDP = C + I + G + NX Add all the expenditures on domestic produced goods by; Consumers > Consumption ( C ) Durable Goods Non – Durable Goods Services Firms > Investment ( I ) Investment Spending Government ( G ) Federal Government State and Local Rest of the World > Net Exports ( NX ) Net Exports ( i.e. Exports – Imports) GDP = C + I + G + NX

Income Method Add all the income received by the factors of Domestic Production; Wages for labor Interest Payments received for Capital Rent Income received for Land Profits for Entrepreneurship. Etc …..

Calculating Gross Domestic Product Figure Caption: Figure 7(22)-2: Calculating GDP In this hypothetical economy consisting of three firms, GDP can be calculated in three different ways: measuring GDP as the value of production of final goods and services, by summing each firm’s value added; measuring GDP as aggregate spending on domestically produced final goods and services; and measuring GDP as factor income earned by households from firms in the economy.

Real versus Nominal GDP Real GDP is the total value of the final goods and services produced in the economy during a given year, calculated using the prices of a selected base year. Nominal GDP is the value of all final goods and services produced in the economy during a given year, calculated using the prices current in the year in which the output is produced.

Real versus Nominal GDP Calculating GDP and Real GDP in a Simple Economy

Real GDP Vs. Nominal GDP Real GDP t = ( Nominal GDP t / Price Level t ) * 100

Shortcomings of GDP Data GDP does not count all the goods and services produced in an economy. Non market Goods and Services : Doing Dishes at home, Doing your laundry, Washing your Car , Making a burger for lunch …. Underground Economy : Black Market activities Quality of the Environment : A clean environment is not counted in GDP. Leisure Time : The value of the leisure time is not counted.

Price Indexes and the Aggregate Price Level The aggregate price level is a measure of the overall level of prices in the economy. To measure the aggregate price level, economists calculate the cost of purchasing a market basket. A price index is the ratio of the current cost of that market basket to the cost in a base year, multiplied by 100. The consumer price index measures the cost of the market basket of a typical urban American family.

Market Baskets and Price Indexes Calculating Price Index in a Simple Economy

Inflation Rate, CPI, and other Indexes The inflation rate is the yearly percentage change in a price index, typically based on the Consumer Price Index, or CPI, the most common measure of the aggregate price level.

Inflation Rate, CPI, and other Indexes Producer Price Index (PPI) : Measures the changes in the prices of goods purchased by the producers. (i.e. Coal, Steel, electricity, raw materials etc …) GDP Deflator : GDP Deflator = ( Nominal GDP / Real GDP ) * 100

Measures of Inflation: Trend