1. EC 204 Slides to Accompany Chapters 1 and 2
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5. Gross Domestic Product
Two Perspectives:
1. Total Expenditure on domestically-produced final goods and services.
2. Total Income earned by domestically-located factors of production.
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6. Gross Domestic Product
Precise Definition: “Market value of all final goods and services produced within an economy in a given period of time.”
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7. Issues in Measuring GDP
Adding apples and oranges
Used goods
Inventories
Intermediate goods and value added
Housing and other imputations
Real versus Nominal
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Nominal and Real GDP
NGDPt = SPitQit
RGDPt = SPioQit
where summation is over i.
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9. Fixed Base-Year Weighting
RGDPt = SPioQit
1+gt = RGDPt/RGDPo
= S[PioQit]/S[PioQio]
= Swi[Qit/Qio]
where
wi = PioQio/ S[PioQio]
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10. Computer Prices and Problems Measuring Real GDP
Price of Computers Declined Sharply in 1980s to 1990s
Implying That Base Year Price of Computers Is Much Higher Than Current Year Price
Leads to Bias Upward in Real GDP for Recent Years
Leads to Bias Downward in Real GDP for Earlier Years
New Chain-weighted Measure of Real GDP Allows for More Frequent Updating of Prices
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11. Chain-weighted Real GDP
Over time, relative prices change, so the base year should be updated periodically.
In essence, “chain-weighted Real GDP” updates the base year every year.
This makes chain-weighted GDP more accurate than constant-price GDP.
See Supplements 2.1, 2.2, 2.4, and 2.6 for more information on GDP.
See Supplements 1.2 and 1.3 for a discussion of using GDP growth to predict the outcome of Presidential elections and a discussion of how to tell when we are in a recession.
Since constant-price GDP is easier to understand and compute, and because the two measures of real GDP are so highly correlated, the chapter (and indeed the textbook) emphasizes the constant-price version of real GDP.
However, if this topic is important to you and your students, you should have them carefully read page 23, and give them one or two exercises requiring students to computer or compare constant-price and chain-weighted real GDP.
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12. Chain-Weighted Real GDP
Example: Two goods: Apples (A) and Oranges (O).
Growth Rate Using a Fixed Base-Year Measure:
Growth Rate Using a Chain-Weighted Measure:
“Chain” the Growth Rates to get the Level (Index) of Real GDP:
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GDP Price Index
Similar approach allows measurement of the overall rate of change for the prices of goods and services in GDP:
“Chain” the Inflation Rates to get the GDP Price Index:
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14. Real GDP, Nominal GDP and the GDP Price Index
And, if one chooses a base year where in which to set real and nominal GDP equal:
Thus, the simple rule for approximating percent change continues to hold:
Change in Price = Percent Change in Nominal GDP minus Percent Change in Real GDP
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16. GDP and the Components of Expenditure, 2004
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Consumption, 2004
source: Bureau of Economic Analysis, U.S. Department of Commerce
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Investment, 2004
source: Bureau of Economic Analysis, U.S. Department of Commerce
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Investment vs. Capital
Capital is one of the factors of production. At any given moment, the economy has a certain overall stock of capital.
Investment is spending on new capital.
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Stocks vs. Flows
Flow
Stock
More examples:
stock flow
a person’s wealth a person’s saving
# of people with # of new college college degrees graduates
the govt. debt the govt. budget deficit
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Government spending, 2004
source: Bureau of Economic Analysis, U.S. Department of Commerce
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23. Net exports (NX = EX - IM)
source: FRED Database, The Federal Reserve Bank of St. Louis,
Before showing the data graph, the following explanation might be helpful:
Remember, GDP is the value of spending on our country’s output of goods & services.
Exports represent foreign spending on our country’s output, so we include exports.
Imports represent the portion of domestic spending (C, I, and G) that goes to foreign goods and services, so we subtract off imports.
NX, therefore, equals net spending by the foreign sector on domestically produced goods & services.
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An important identity
Y = C + I + G + NX
where: Y = GDP = the value of total output
C + I + G + NX = aggregate expenditure
A few slides ago, we defined GDP as the total expenditure on the economy’s output of goods and services (as well as total income). We can also define GDP as (the value of) aggregate output, not just spending on output.
An identity is an equation that always holds because of the way the variables are defined.
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25. Why does output = expenditure?
Unsold output goes into inventory, and is counted as “inventory investment”…
…whether the inventory buildup was intentional or not.
In effect, we are assuming that firms purchase their unsold output.
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GNP vs. GDP
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) = (factor payments from abroad) – (factor payments to abroad)
Emphasize that the difference b/w GDP and GNP boils down to two things:
location of the economic activity, and ownership (domestic vs. foreign) of the factors of production.
From the perspective of the U.S., factor payments from abroad includes things like
wages earned by U.S. citizens working abroad
profits earned by U.S.-owned businesses located abroad
income (interest, dividends, rent, etc) generated from the foreign assets owned by U.S. citizens
Factor payments to abroad includes things like
wages earned by foreign workers in the U.S.
profits earned by foreign-owned businesses located in the U.S.
income (interest, dividends, rent, etc) that foreigners earn on U.S. assets
Chapter 3 introduces factor markets and factor prices. Unless you’ve already covered that material, it might be worth mentioning to your students that factor payments are simply payments to the factors of production, for example, the wages earned by labor.
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27. (GNP – GDP) as a percentage of GDP (selected countries, 1997)
Data is from Source: World Development Indicators 2000 CD-ROM, World Bank.
For the U.S., GDP and GNP are very close. Thus, students may not realize why we bother teaching them the difference. But the data on this slide make clear that the difference is very important for some countries.
In Brazil, the number is –2.0%, which may seem tiny. But consider: it means that 2% of the income generated in Brazil is taken away and paid to foreigners. Almost 9% of the value of Chile’s production is paid to foreigners.
In some countries, GNP > GDP. Ask your students if they can think of a couple possible reasons for this. In other countries, GDP > GNP. Ask if anyone can think of possible reasons for this.
Reasons why GNP may exceed GDP:
Country has done a lot of lending or investment overseas and is earning lots of income from these foreign investments (income on nationally-owned capital located abroad). Take Kuwait. This tiny country earns (from oil revenue) more than it spends; the difference is invested (in the layperson’s sense of the term investment) in foreign assets, such as stocks and real estate. Thus, Kuwait has a lot of foreign-owned capital that generates income. This income comes back to Kuwait, making its GNP bigger than its GDP.
A significant number of citizens have left the country to work overseas (their income is counted in GNP, not GDP). I’d guess this is why GNP > GDP in Bangledesh; there unfortunately is not an abundance of economic opportunity for skilled workers in Bangledesh.
…continued on the “notes” portion of the next slide (the slide itself is “hidden”)
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Some Useful Identities
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Other Measures of Income
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32. Consumer Price Index (CPI)
A measure of the overall level of prices
Published by the Bureau of Labor Statistics (BLS)
Used to
track changes in the typical household’s cost of living
adjust many contracts for inflation (i.e. “COLAs”)
allow comparisons of dollar figures from different years
Regarding the comparison of dollar figures from different years:
If we want to know whether the average college graduate today is better off than the average college graduate of 1975, we can’t simply compare the nominal salaries, because the cost of living is so much higher now than in We can use the CPI to express the 1975 in “current dollars”, i.e. see what it would be worth at today’s prices.
Also: when the price of oil (and hence gasoline) shot up in 2000, some in the news reported that oil prices were even higher than in the 1970s. This was true, but only in nominal terms. If you use the CPI to adjust for inflation, the highest oil price in 2000 is still substantially less than the highest oil prices of the 1970s.
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33. How the BLS constructs the CPI
Surveys consumers to determine composition of the typical consumer’s “basket” of goods.
Every month, collect data on prices of all items in the basket; compute cost of basket
CPI in any month equals the cost of this basket divided by its cost in the “base” year multiplied by 100.
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The Composition of the CPI’s “Basket”
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Understanding the CPI
For good i = 1, 2, 3, ….
Cio = the amount of good i in the CPI’s basket
Pit = the price of good i in month t
Et = the cost of the CPI basket in month t
Eo = cost of the basket in the base period
The next slide uses simple algebra to show that the CPI is a weighted average of prices; the weight on each price reflects that good’s relative importance in the CPI basket. The algebra is very similar to that of an earlier slide that showed that the GDP deflator is a weighted average of prices.
I chose “E” to represent the cost of the basket because “E” stands for “Expenditure”, and using “B” or “C” for the cost of the basket didn’t feel right to me. (You can, of course, edit the slides to substitute whatever other letter or symbol you think would make more sense here.)
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36. Understanding the CPI CPIt = [Et/Eo] = SPitCio/ SPioCio
= Swi [Pit/Pio]
where wi = PioCio/ SPioCio and all summations are over i.
Note: Because the weights don’t all sum to 1, the CPI is a weighted sum, not a weighted average.
The CPI is a weighted average of prices.
The weight on each price reflects that good’s relative importance in the CPI’s basket.
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37. Reasons why the CPI may overstate inflation
Substitution bias: The CPI uses fixed weights, so it cannot reflect consumers’ ability to substitute toward goods whose relative prices have fallen.
Introduction of new goods: The introduction of new goods makes consumers better off and, in effect, increases the real value of the dollar. But it does not reduce the CPI, because the CPI uses fixed weights.
Unmeasured changes in quality: Quality improvements increase the value of the dollar, but are often not fully measured.
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The CPI’s bias
The Boskin Panel’s “best estimate”: The CPI overstates the true increase in the cost of living by 1.1% per year.
Result: the BLS has refined the way it calculates the CPI to reduce the bias.
It is now believed that the CPI’s bias is slightly less than 1% per year.
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39. GDP Deflator (Price Index) versus CPI
GDP Price Index measures prices of all goods and services produced, CPI only measures prices of goods and services bought by consumers.
GDP Price Index includes only goods produced domestically, CPI includes imports.
Weighting used to compute indexes differs: GDP Price Index uses changing weights, CPI uses fixed weights.
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41. Categories of the population
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
not in the labor force not employed, not looking for work.
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42. Two important labor force concepts
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
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Okun’s Law
Okun’s Law states that a one-percent decrease in unemployment is associated with two percentage points of additional growth in real GDP
Percentage change in real GDP 10 -3 -2 -1 1 2 4 3 8 6
1951
1984
2000
1999
1993
1975
1982
Change in unemployment rate
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