1. Econ 100 Measures of (real) output, price level and unemployment
Lecture 11
Introduction to macroeconomics and its data:
Measures of (real) output, price level and unemployment

2. With our last lecture, we have completed our study of microeconomics in this course.
In the remaining (little) time during the rest of the semester, we will look at macroeconomics.
Let us recall the difference between microeconomics and macroeconomics:
Microeconomics focuses on parts of the economy (such as consumers or households, producers or firms, workers, investors, markets for specific goods and services) and takes up one part at a time
in order to explain, for example, what happens in a market for a specific good...

3. … whereas macroeconomics looks at the economy from a bird's eye view and tries to see it as a whole consisting of all the parts
in order to answer questions like:
Why has production of goods and services increased more slowly this year than last year?
Why have prices of goods and services increased much faster this year than the year before?
Why has the total number of unemployed people increased and not decreased this year?
Why has the return on people's savings been relatively low this year?

4. In other words, macroeconomics focuses on economic variables such as
growth rate of (production and income)
inflation rate
rate of unemployment
interest rates
in an economy.
This implies, among several things, that...

5. … whereas microeconomics deals with the price and quantity produced and sold of this good or that good, or income earned by this type of labor or that type of labor etc, taken one at a time,
macroeconomics deals with the prices and production of all goods and services or income earned by all income-earners, taken all together.
This means that, in macroeconomics, we study the overall production of goods and services,
which implies that we need a measure of overall production.

6. Suppose that
N different final goods are being produced
within a given country
over a given period of time (such as a year)
of quantities Q1, Q2, ..., QN, and
sold at the prices P1, P2, ..., PN.
What could be a measure of overall production in this country for this period of time?

7. Obviously, taking the sum of quantities produced of all different goods as in
Q1 + Q2 + … + QN
would not do because quantities of things of different kinds
can not be added for the units are different
would not be meaningful
Consequently, economists use a different measure, and the measure they use is called the “Gross Domestic Product” (GDP).

8. GDP
GDP = total market value of all final goods and services produced within a given country over a given period of time or
GDP = P1 Q1 + P2 Q2 + … + PN QN
where P1 Q1 is the market value of good 1, P2 Q2 is the market value of good 2, …, PN QN is the market value of good N,
and market values of different goods can be added because they are all measured in the same (monetary) units.

9. Numerical example (GDP)
Consider an economy in which only 2 goods are produced.
Year Year t
P TL/kg TL/kg
Q kgs kgs
P TL/kg TL/kg
Q kgs kgs
P1 Q x500 TL x700 TL
P2 Q x200 TL x250 TL
GDP TL TL
GDP increases by ((5450 – 2300) / 2300) x 100 = 137%

10. Notice that if Q produced of any good increases, GDP will also increase, and GDP does reflect changes in overall production.
However, there are two main problems with GDP as a measure of overall production:
What if prices instead of quantities produced of goods or services change?
What if in this economy some goods are produced that are used as raw materials or parts in the production of other goods?
Now we will examine these questions in the order they are given above.

11. Real versus Nominal GDP
In order to remove the effect of prices on the measure of overall production, we calculate the GDP as if prices have not changed since a certain year in the past.
In other words, instead of the prices recorded in the present year, prices recorded in a past year are used in the GDP calculation.
If GDP is calculated this way, it will not change from one year to another if prices change, and it will change only if quantities change.
GDP calculated this way is called the “real GDP” whereas if you use present-year prices it is called “nominal GDP.”

12. Numerical example (real GDP)
Year Year t
P TL/kg TL/kg
Q kgs kgs
P TL/kg TL/kg
Q kgs kgs
P1 Q x500 TL x700 TL
P2 Q x200 TL x250 TL
Nom GDP TL TL
Real GDP TL TL
Real GDP increases by ((3100 – 2300) / 2300) x 100 = 34.8%

13. Year 0 which is the year from which the prices are taken and which is used as a(n arbitrary) beginning point when we observe the changes in overall production
is called the “base year.”
Note that, for the base year, the real GDP is equal to the nominal GDP by definition.

14. To sum up:
Nominal GDP
is the GDP calculated using the present-year prices,
is also called “GDP in current prices,” and
reflects changes in both prices and quantities
Real GDP
is the GDP calculated using the base-year prices,
is also called “GDP in constant prices,” and
reflects changes in quantities only

15. This suggests that a comparison of nominal and real GDPs will provide a measure of how quickly prices of goods and services have changed since the base year,
which is called the “GDP Deflator” and defined as:
GDP Deflator = (nom GDP / real GDP) x 100

16. In the example before,
Nom GDP in year t = 5450
Real GDP in year t = 3100
GDP Deflator for year t = (5450 / 3100) x 100 = 175.8%
Prices have increased on the average by 75.8% since year 0. Notice that
% increase in prices = 75.8%
% increase in real GDP = 34.8%
( )x( ) = 2.37, which corresponds to a 137% increase that is the % increase in nom GDP.

17. The purpose of the whole field of macroeconomics can be described at least to some extent by referring to the fluctuations of real GDP over time.
When we plot the real GDP of any country against time, we see that
real GDP fluctuates irregularly around some long run path of growth and
this long run path along which the year-to-year real GDP fluctuates grows at different rates for different countries.

18. The fluctuations of the actual real GDP around the long run real GDP are called “business cycles.” The business cycles pose some basic questions the macroeconomists try to answer:
Why does actual real GDP fluctuate? How can we explain business cycles? (business cycle theory)
What can we do to change the period and the magnitude of these cycles? Can we smoothen them out? (stabilization policy)
Why does the long run real GDP (or the so-called “potential output”) grow faster in some countries and slower in some other countries? (growth theory)

19. Now we will take up the second question that we posed above:
What if there are some goods produced in the economy that are used as raw materials or parts in the production of other goods?
That is, should we include these goods in the calculation of our measure of overall production?
Let us try to clarify this by examining an example.

20. Example (case a)
Consider an economy with two producers (Firm 1 and Firm 2) only.
Firm Firm 2
owns units of land units of land
produces oranges orange juice
sales / year
to consumers TL TL
GDP = = 160 TL ?

21. Example (case b) Firm 1 Firm 2
owns units of land units of land
produces oranges orange juice
sales / year
Total TL TL
to the other firm TL TL
to consumers TL TL
GDP = = 208 TL ?

22. Comparing these two alternative cases a and b, we see that
the quantity of oranges produced for consumers,
the quantity of oranges produced to be used as input in the production of orange juice, and
the quantity of orange juice production
are the same.
The only difference between cases a and b is that, in case b, the oranges used as input (intermediate good) by Firm 2 are not produced by Firm 2 itself but they are produced by Firm 1 and purchased by Firm 2.

23. If we calculate GDP as
GDP = = 208 TL
then the value of the oranges used as intermediate goods is counted twice, leading to an overestimation of total production. To avoid this, consider
either the total expenditure by final users only
GDP = = 160
or the total value added by all producers
GDP = (120 – 0) + (88 – 48) = = 160
regardless of whether the good produced is final or intermediate.

24. We see tat GDP can be calculated using two different methods that should in principle give exactly the same result.
The first one is called the “expenditure method”
and the second one is called the “production (or value added) method.”
There is even a third method.

25. Income accounting
Consider an income statement prepared to calculate the profits of a firm:
Profits = Sales – Cost of Intermediate Goods – Wages and Salaries – Interest – Rent
(simplified by disregarding (1) unsold goods added to the firm's inventories, (2) sales taxes or indirect taxes, and (3) depre- ciation of machinery, equipment and buildings)
Sales – Cost of Int. Goods = Profits + Wages and salaries + Interest + Rent
But this means
Value added (generated in the firm) = Profits + Wages and Salaries + Interest + Rent

26. The lefthand side is the value added generated in the firm and the righthand side is the income by all categories generated in the same firm.
Since, according to production method, GDP is the total sum of value added by all producers, it will also be equal to the total sum of income earned by all income- earners.
GDP = Profits + Wages + Interest + Rent
This is called the “income method” of calculating the GDP.

27. So it turns out that GDP, our measure of overall production, which can be calculated by looking at the total expenditure, is also a measure of total income generated or earned in the economy
which should be no surprise because
Production
Income
Expenditure
are different faces of the same process.

28. To summarize what we did so far in this lecture,
Macroeconomics is a study of the economy as a whole
To do this, we need a measure of overall production of goods and services
The measure used by economists is the so-called GDP...
which is the total market value of all final goods and services produced within a country over a given period of time.

29. We distinguish between nominal GDP and real GDP
Nominal GDP is obtained by evaluating the market values in present-year prices
whereas real GDP is obtained by evaluating the market values in base-year prices
Nominal GDP is affected by changes both in quantities produced and in prices whereas real GDP is affected only by changes in quantities produced
and that's why real GDP is taken to be the measure of overall production

30. But the distinction between nominal GDP and real GDP is useful also because it gives as the opportunity to define how high or low prices are in general compared to what they were in a previous year
This measure is called the GDP Deflator
The value of the GDP Deflator in a particular year is a measure of the general level of prices
whereas the percentage change in GDP Deflator gives the rate of inflation since the base year
We have also seen that there are three different methods to measure GDP

31. GDP = total value added generated by all firms
GDP = total market value of all final goods and services produced within a given country over a given period of time
(measured by the total expenditure made by the buyers of the final goods only)
GDP = total value added generated by all firms
(regardless of whether the firms produce final or intermediate goods)
GDP = total income generated in the country (plus some other items we neglected)

32. Suppose we want to measure now the GDP of a country for a certain year using the expenditure method.
We need
the market values of all final goods and services...
produced...
over the year chosen.
As we try to collect these data, we will see that measurement of GDP is not as straightforward as its definition and we will have to be careful about several issues and overcome some difficulties.
Let us see some of those difficulties (in fact, six of them).

33. Difficulties in measuring GDP
(1) Not everything produced goes through the markets
Examples:
Agricultural products produced by farmers but not sold in any market or to anyone else and used or consumed by the producers themselves
Household tasks (cleaning, cooking etc) performed by the members of the household who could ask professionals to provide such services in return for money

34. (2) Not everything produced and sold in a market is recorded
Examples:
Goods produced and sold by firms who try to avoid paying sales taxes or taxes out of profits
Labor spent by workers who are employed but not recorded in the accounts of the companies whose owners try to avoid paying payroll taxes or social security premiums
Goods or services that are illegal to be produced and sold

35. (3) Not everything produced and sold is sold at the market prices
Example:
High school teachers working in state schools and paid less than their colleagues employed in private schools

36. (4) Not everything produced in the year considered is sold in that year
Examples:
Goods produced by a producer but not sold due to, for example, insufficient demand, and added to the finished good inventories of the producer to be sold later, provided that it is a storable good
Q produced Q sold ∆inventory
1000 units units units
Expenditure made by the buyers on 800 units will not measure the production.

37. (5) Not everything sold in the year considered has been produced in that year
Examples:
Goods sold by a producer out of inventory because of, for example, unexpected demand in a given year, but produced in a previous year
Q produced Q sold ∆inventory
1000 units units –300 units
Expenditure made by the buyers on 1300 units will not measure the production.

38. Items sold secondhand (such as cars, clothing, books etc) or resold by the initial owner (such as old houses) that have not been produced in this year
But the services of the real estate agent, for example, who helps any houseowner to sell his house is a service produced in this year and should be included in the GDP of this year.
Notice that secondhand purchases of any items should not be included in the GDP even if those items have been produced in the year considered because their value has already been included in the GDP to record their production when they were sold for the first time within the year.

39. (6) Not everything sold in the markets is a good or service produced
Example:
Financial securities such as bonds or shares of stock
But the services provided by the investment bankers to the institutions selling those bonds or shares to issue and sell them is a service produced and should be included in the GDP.

40. Economists constantly work on developing better methods and procedures to provide more satisfactory solutions to the issues encountered in the measurement of GDP such as those above.
Let us now focus on an other way the GDP measured by the expenditure method can be described.
As we have seen already, the GDP as the total market value of all final goods and services will be measured by the total expenditure made by buyers on final goods and services, or the total expenditure made by the so- called “final users.”

41. There are four categories of final users and therefore four categories of expenditure:
Consumers – consumption expenditure
Firms – investment expenditure
Government – government purchases
Foreigners – exports
Since GDP is supposed to measure the domestic production, the expenditures mentioned above are those made by the final user on domestically produced goods.

42. Consumption
Expenditures made by consumers include expenditure on the following main categories of goods and services newly produced:
Nondurable goods (food, clothing...)
Durable goods (house appliances, cars...)
Services (cleaning, health, education, security...)
But not newly produced houses purchased by the consumers.

43. Goods and services purchased by consumers may be domestically produced or imported from abroad.
Therefore, if we denote total consumption expenditure by C, expenditure on domestically produced consumer goods by Cd and that on imported consumption goods by Cm,
Cd = C – Cm
It is Cd that contributes to GDP.

44. Investment
What is meant by “investment” is not investment in financial assets but in physical (capital) goods. The investment expenditure includes
Business fixed investment (expenditure on machinery, equipment, factory and office buildings) – by firms
New residential construction (expenditure on newly produced houses or apartment buildings) – by consumers
Inventory investment (changes in inventories of goods) – by firms

45. Just as goods and services purchased by consumers may be domestically produced or imported from abroad, investment expenditure can be made on domestically produced or imported machinery and equipment etc.
Therefore, if we denote total investment expenditure by I, expenditure on domestically produced capital goods by Id and that on imported capital goods by Im,
Id = I – Im
It is Id that contributes to GDP.

46. Government purchases
Government purchases of goods and services includes spending on
Salaries of government officials (such as those of teachers employed in state schools, army personnel)
Roads, highways, public buildings the government pays construction companies to build
Goods purchased to provide public services (such as guns for the army to provide national security)
But not pensions to people retired from the social security system, aid to the poor, unemployment insurance to unemployed because these are not paid in return for any good or service produced.

47. Goods and services purchased by the government may also be domestically produced or imported from abroad.
Therefore, if we denote total government purchases expenditure by G, purchases of domestically produced government goods by Gd and that on imported government goods by Gm,
Gd = G – Gm
It is Gd that contributes to GDP.

48. Exports
These are expenditure made by foreigners who buy goods and services domestically produced in the country we are considering (evaluated in the domestic currency)
Let the amount of exports be denoted by X,
whereas the total amount of imports made by consumers, firms and the government in the country will be denoted by M.

49. GDP GDP = Cd + Id + Gd + X GDP = C – Cm + I – Im + G – Gm + X
GDP = C + I + G + X – (Cm + Im + Gm)
GDP = C + I + G + X – M
Or, defining net exports NX = X – M,
GDP = C + I + G + NX

50. This completes our discussion of the measure of overall production
This completes our discussion of the measure of overall production. But there is more to say about the measure of general level of prices.
Again, the measure we developed so far for the general level of prices is the GDP Deflator.
It gives how high the prices of final goods and services are on the average.
There are other measures of the general price level. One of them, called the “Consumer Price Index” (CPI) focuses on the prices of consumer goods and services and therefore it also measures the cost of living.

51. CPI is calculated by first finding out a basket of goods and services consumed by the typical consumer,
then calculating the total price (or value) of this basket in the base year and in the present year,
and finally taking the ratio of those two values expressed in percentages:
CPI = (Vt / V0) x 100
The value of CPI for a particular year gives how high or low prices of consumer goods and services are in general compared to what they were in a previous year, or the level of those prices on the average.

52. Example (CPI) Good Quantity P in 0 P in t Pt / P0 %∆P
Value of basket in 0: V0 = 20x8 +70x x30 = 890
Value of basket in t: Vt = 20x10+70x x42 =
CPI = (Vt / V0) x 100 = ( / 890) x 100 =
% increase in prices = 27.55%

53. The percentage change in the CPI since the base year gives directly the inflation of prices of consumer goods and services since the base year.
It can be shown that the percentage change in the CPI is a weighted average of the percentage changes in the prices of consumer goods and services.
Similarly, it can be shown that the percentage change in the GDP Deflator is a weighted average of the percentage changes in the prices of final goods and services.

54. But in order to find the inflation for a year, you need to calculate the percentage change in the price level since last year:
Inflation rate in consumer prices
= (CPI this year – CPI last year) / CPI last year
Inflation rate in final goods and services
= (Deflator this year – Deflator last year) / Deflator last year
and both must be multiplied by 100 to give the inflation rate in percentages.

55. Problems with CPI as a measure of cost of living
Since CPI is calculated based on a fixed basket o goods, it may be under- or overestimating the true cost of living because
Consumers may have switched to cheaper goods over time (substitution bias)
Consumers may be buying new goods that did not exist at the time when the basket was fixed (introduction of new goods)
The goods in the basket may have existed before but their quality may have changed a lot (unmeasured quality change)

56. Differences between GDP Deflator and CPI as measures of general price level
Both GDP Deflator and CPI are measures of general level of prices and they tend to move together by similar magnitudes but they each measure inflation differently because
GDP Deflator is a weighted average with weights changing over time whereas CPI is a weighted average with weights fixed over time.
CPI measures the level of prices from the point of view of the consumer who (1) usually buy imported goods, (2) do not necessarily buy exported goods, and (3) do not buy machinery and equipment used in production (of these, 2 and 3 are taken into account by GDP Deflator but 1 is not).