GDP, Income and Economic Growth

GDP, Income and Economic Growth
Chapter 12 GDP, Income and Economic Growth

Learning Objectives Explain how total production in an economy is measured. Discuss whether GDP is a good measure of economic wellbeing. Discuss the difference between real and nominal variables.

Learning Objectives Understand how the economic growth rate is measured. Discuss the importance of long-run economic growth and its impact on living standards. Use the economic growth model to explain why economic growth rates differ between countries.

Growth and the business cycle at General Motors Holden
In the long run, the Australian economy has experienced economic growth and rising living standards, and in the short run the economy has experienced a series of business cycles. Companies such as General Motors Holden, while often experiencing long run growth, are greatly affected by business cycles.

GDP, income and economic growth
PRELIMINARY DEFINITIONS GDP, income and economic growth Microeconomics: The study of how households and firms make choices, how they interact in markets, and how the government attempts to influence their choices. Macroeconomics: The study of the economy as a whole, including topics such as inflation, unemployment, and economic growth.

PRELIMINARY DEFINITIONS GDP, income and economic growth Economic growth: The expansion of society’s productive potential. Economic growth is usually measured by the rate of growth in real GDP. Business cycle: Alternating periods of economic expansion and economic recession.

PRELIMINARY DEFINITIONS GDP, income and economic growth Expansion: The period of a business cycle during which total production and total employment are increasing. Recession: The period of a business cycle during which total production and total employment are decreasing. Inflation rate: The percentage increase in the price level from one year to the next.

Gross domestic product measures total production
LEARNING OBJECTIVE 1 Gross domestic product measures total production Measuring total production: Gross Domestic Product Gross Domestic Product (GDP): The market value of all final goods and services produced in a country during a period of time.

LEARNING OBJECTIVE 1 Gross domestic product measures total production GDP is measured using market values, not quantities. GDP includes only the market value of final goods and services. Final good or service: A new good or service which is the end product of the production process that is purchased by the final user. Intermediate good or service: A good or service that is an input into another good or service, such as a tyre on a truck.

LEARNING OBJECTIVE 1 Gross domestic product measures total production GDP includes only current production. Current production is that which takes place during the indicated time period; GDP does not include the value of used (second-hand) goods.

LEARNING OBJECTIVE 1 Gross domestic product measures total production Measuring GDP by the value-added method An alternative way to calculate GDP is the value-added method. Value added: The market value a firm adds to a product. GDP can be calculated by adding up the value added of every firm involved in the production process of goods and services.

LEARNING OBJECTIVE 1 Gross domestic product measures total production Other measures of total production and total income Net domestic product (NDP): Calculated by measuring GDP and subtracting the value of depreciation on capital equipment. Gross National Income (GNI): Australia’s GDP plus income generated overseas by Australian residents and firms, minus the income generated in Australia by non-residents and foreign firms.

LEARNING OBJECTIVE 1 Calculating GDP Examine a simple economy (Economy X) which produces only three goods; sunglasses, suntan lotion and swimming costumes. Use the information in the table below to calculate GDP for this economy. Production and Price Statistics for Economy X Product Quantity Price per unit ($) Sunglasses 1000 20 Suntan lotion 500 10 Swimmers 100 80 The text uses Solved Problem 12.1 to provide a simple introduction to calculating GDP. GDP is calculated as the price times the quantity of all goods and services produced in an economy.

LEARNING OBJECTIVE 1 Calculating GDP STEP 1: Review the chapter material. The problem provides a simple introduction to the calculation of GDP as the sum of the monetary value of the goods and services produced in an economy in a given period. You may like to review the section ‘Measuring total production: Gross Domestic Product’. STEP 2: Calculate GDP by multiplying the prices times the quantity of all three goods, and then summing the three values. (Note, all the goods in the example are final goods, and therefore all should be included in your calculation). .

Production and Price Statistics for Economy X
LEARNING OBJECTIVE 1 Calculating GDP STEP 3: Complete the table. Production and Price Statistics for Economy X Product Quantity Price per unit ($) Value ($) Sunglasses 1000 20 20 000 Suntan lotion 500 10 5 000 Swimmers 100 80 8 000 TOTAL (or GDP): $33 000

Methods of measuring GDP
LEARNING OBJECTIVE 1 Methods of measuring GDP The Australian Bureau of Statistics (ABS) uses three alternative methods to measure GDP: The production method: The sum of the value of all goods and services produced by industries in the economy in a year minus the cost of goods and services used in production – leaving the value added.

LEARNING OBJECTIVE 1 Methods of measuring GDP The expenditure method: The sum of the total expenditure on goods and services by households, investors, government and net exports (the value of exports minus the expenditure on imports). The income method: The sum of the income generated in the production of goods and services, including profits, wages and other employee payments, income from rent and interest earned.

LEARNING OBJECTIVE 1 Methods of measuring GDP Production, income and the circular-flow diagram The circular-flow diagram shows the flow of spending and money in the economy. It illustrates the equality between GDP measured from the income and expenditure methods. The income generated in the production of goods and services is equal to the value of expenditure on these goods and services.

LEARNING OBJECTIVE 1 Methods of measuring GDP Production, income and the circular-flow diagram Transfer payments: Payments by the government to individuals for which the government does not receive a good or service in return. Examples: age pensions, unemployment benefits, family benefit payments. Transfer payments are not included in GDP.

The circular flow and measurement of GDP: Figure 12.1
Figure 12.1: The circular flow and measurement of GDP: The circular-flow diagram illustrates the flow of spending and money in the economy. Firms sell goods and services to three groups: domestic households, foreign firms and households and the government. To produce goods and services, firms use factors of production: labour, capital, natural resources and entrepreneurship. Households supply the factors of production to firms in exchange for income in the form of wages, interest, profit and rent. Firms make payments of wages and interest to households in exchange for hiring workers and other factors of production. The sum of wages, interest, rent and profit is total income in the economy. We can measure GDP as the total income received by households. The diagram also shows that households use their income to purchase goods and services, pay taxes and save. Firms and the government borrow them funds that flow from households into the financial system. We can measure GDP either by calculating the total value of expenditures on final goods and services or by calculating the value of total income. Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

LEARNING OBJECTIVE 1 Components of GDP The ABS divides GDP into four major categories of expenditures. Consumption (C): Spending by households on goods and services, not including spending on new houses. Investment (I): Spending by firms on new factories, office buildings, machinery, and inventories, and spending by households on new houses.

Components of GDP Y = C + I + G + NX
LEARNING OBJECTIVE 1 Components of GDP Government purchases (G): Spending by federal, state, and local governments on goods and services. Net exports (NX): The value of exports minus expenditure on imports. An equation for GDP (where Y = GDP or total output): Y = C + I + G + NX

Components of GDP, 2008 (millions of dollars)
Table of components of GDP, 2008: Figure 12.2(a) Components of GDP, 2008 (millions of dollars) Consumption Investment Dwellings 71 019 Buildings and structures 85 690 Equipment 91 178 Other 36 679 Change in inventories -1 940 Government Net Exports -3 644 Exports Imports TOTAL GDP Figure 12.2 Table and graph of components of GDP, 2008. The table provides a more detailed breakdown and shows several interesting points: Consumption expenditure by households is the largest component of GDP. Investment in equipment was the largest component of investment in (This can fluctuate significantly). Investment in building structures was greater than investment in dwellings. Imports were greater than exports, so net exports were slightly negative. Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

Graph of components of GDP, 2008: Figure 12.2(b)
Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

Does GDP measure what we want it to measure?
LEARNING OBJECTIVE 2 Does GDP measure what we want it to measure? GDP does a good job at measuring production, and provides an indication of wellbeing, but it is not flawless.

LEARNING OBJECTIVE 2 Does GDP measure what we want it to measure? Shortcomings of GDP as a measure of total production. GDP does not include: Household production: Goods and services people produce for themselves. Examples: Home cooking, cleaning, child care, gardening, maintenance. The black economy: Buying and selling of goods and services that is concealed from the government to avoid taxes or regulations or because the goods and services are illegal.

How the underground economy hurts developing countries
MAKING THE CONNECTION 12.1 How the underground economy hurts developing countries In some developing countries, more than half the workers may be in the underground economy. Making the Connection 12.1. In developing countries, the underground economy is often referred to as the informal sector, as opposed to the formal sector in which output of goods and services is measured. Although it might not seem to matter whether production of goods and services is measured and included in GDP or unmeasured, a large informal sector can be a sign of government policies that are retarding economic growth. Because firms in the informal sector are acting illegally, they tend to be smaller and have less capital than firms acting legally. The entrepreneurs who start firms in the informal sector may be afraid their firms could someday be closed or confiscated by the government. Therefore, the entrepreneurs limit their investments in these firms. As a consequence, workers in these firms have less machinery and equipment to work with and so can produce fewer goods and services.

LEARNING OBJECTIVE 2 Does GDP measure what we want it to measure? Shortcomings of GDP as a measure of wellbeing. The distribution of GDP is not captured in GDP measures. The value of leisure is not included in GDP. The level, quality of, and access to health care is not measured in GDP.

LEARNING OBJECTIVE 2 Does GDP measure what we want it to measure? Shortcomings of GDP as a measure of wellbeing. GDP is not adjusted for pollution or other negative effects of production. GDP is not adjusted for changes in crime and other social problems.

Our Choice: Live Longer or Prosper
MAKING THE CONNECTION 12.2 Our Choice: Live Longer or Prosper Is there a trade-off between more income and longevity? ‘Making the Connection 12.2 ’of the text suggests that a possible reason for the comparatively low ranking of the US on the life expectancy score is that Americans have traded wealth for longevity. The text refers to research conducted by an expatriate American academic which shows a link between loss of control over life circumstances, particularly at work, and chronic stress, which in turn has a detrimental effect on health and life expectancy. The inference is that many Americans sacrifice control over their working lives in pursuit of higher incomes. The textbox also provides some detail on both the relatively large proportion of GDP devoted to health care in the US and the high cost of American health services. It may be useful to elaborate a little further on the latter point; that is, the resources devoted to health care do not always ensure universal access to same, and it may be that the lack of a universal health care system also contributes to low life expectancy among Americans.

Real GDP versus nominal GDP
LEARNING OBJECTIVE 3 Real GDP versus nominal GDP It is important to separate a measured rise in GDP that may be due only to price changes from real quantity changes. Calculating Real GDP Nominal GDP: The market value of final goods and services evaluated at current year prices. Real GDP: The market value of final goods and services evaluated at base year prices. GDP statisticians are attempting to measure the value of output from year to year. If current year prices are used from year to year, then the value of GDP may change either due to changes in output or due to changes in price. The statisticians therefore adjust nominal GDP figures to calculate real GDP by eliminating changes that can be attributed to price changes. This is illustrated through the use of a base year, although ABS has now moved to using chain weighted prices.

LEARNING OBJECTIVE 3 Real GDP versus nominal GDP Nominal GDP can change over time due to changes in either price or output. Real GDP shows changes in output only. The ABS (or GDP statisticians) select a base year and use this over a specified period. A simple rule: Real GDP equals the base year prices multiplied by current year quantities.

LEARNING OBJECTIVE 3 Real GDP versus nominal GDP A drawback of using base year prices is that prices may change relative to each other. The ABS uses chain-weighted prices and publishes statistics on real GDP in ‘chained dollars’. Prices in each year are ‘chained’ to prices in the previous year to minimise the distortion from changes in relative prices.

LEARNING OBJECTIVE 3 Calculating Real GDP Return to the example of the simplified economy (Economy X) which produces only three goods; sunglasses, suntan lotion and swimming costumes. Use the information in the table below to calculate real GDP for this economy in 2010, assuming 2009 is the base year. Production and Price Statistics for Economy X 2009 2010 Product Quantity Price per Unit ($) Sunglasses 1000 20 1500 25 Suntan Lotion 500 10 550 11 Swimmers 100 80 110 The text uses Solved Problem 12.2 to demonstrate the calculation of real GDP. The same approach is used in the power point slides using a different, but equally simple example.

LEARNING OBJECTIVE 3 Calculating Real GDP STEP 1: Review the chapter material in the section ‘Calculating real GDP’. Real GDP is found by holding prices constant at the base year and multiplying these prices by current year quantities. STEP 2: Calculate real GDP for 2010 by multiplying the prices of each item for 2009 times the quantity of all three goods for 2010, and then summing the three values.

LEARNING OBJECTIVE 3 Calculating Real GDP Production and Price Statistics for Economy X 2009 2010 Product Price per Unit ($) Quantity Value ($) Sunglasses 20 1500 30 000 Suntan Lotion 10 550 5 500 Swimmers 80 110 8 800 REAL GDP: $44 300

Calculating the economic growth rate
LEARNING OBJECTIVE 4 Calculating the economic growth rate Economic growth rate: The rate of change in real GDP from one year to the next. Note the terms current and previous are used to show we can measure growth over various periods, for example, year to year, quarter to quarter, month to month and so on.

Calculating the economic growth rate
LEARNING OBJECTIVE 4 Calculating the economic growth rate Example: Real GDP for Australia was: In 2006/07: $ million. In 2007/08: $ million. Calculate the economic growth as follows: $ million - $ million = $ million

LEARNING OBJECTIVE 4 The GDP deflator GDP also allows us to calculate changes in the price level over time. Price level: A measure of the average prices of goods and services in the economy. GDP deflator: A measure of the price level, calculated by dividing nominal GDP by real GDP and multiplying by 100.

LEARNING OBJECTIVE 4 The GDP deflator The formula:

LEARNING OBJECTIVE 4 Calculating the GDP deflator Returning again to the simplified economy (Economy X). The real GDP calculation from the previous problem is included below. Now use the table to calculate nominal GDP for this economy in 2010, and then calculate the GDP deflator. Production and Price Statistics for Economy X 2009 2010 Product Quantity Price per Unit ($) Sunglasses 1000 20 1500 25 Suntan Lotion 500 10 550 11 Swimmers 100 80 110 REAL GDP: $44 300

LEARNING OBJECTIVE 4 Calculating the GDP deflator STEP 1: Calculate nominal GDP for 2010 by multiplying the prices of each item for 2010 times the quantity of all three goods for 2010, and then summing the three values. Production and Price Statistics for Economy X 2010 Product Quantity Price per Unit ($) Value ($) Sunglasses 1500 25 37 500 Suntan Lotion 550 11 6 050 Swimmers 110 80 8 800 NOMINAL GDP: $52 350

Calculating the GDP deflator
LEARNING OBJECTIVE 4 Calculating the GDP deflator STEP 2: Calculate the GDP deflator by dividing nominal GDP by real GDP and multiplying by 100.

Calculating the price change
LEARNING OBJECTIVE 4 Calculating the price change The solved problem has derived the GDP deflator for 2010 for a simple economy. The GDP deflator for the base year will always equal 100, as nominal and real GDP are the same. The price change between 2009 and 2010 is calculated as follows:

Long-run economic growth is the key to rising living standards
LEARNING OBJECTIVE 5 Long-run economic growth is the key to rising living standards Long-run economic growth: The process by which rising productivity increases the average standard of living. Real GDP per capita is used to measure changing living standards over time.

Real GDP per capita, Australia, 1901-2007: Figure 12.3
Measured in prices, real GDP per capita in Australia grew from about $1150 in 1901 to about $6110 in The average Australian in the year 2007 could buy more than five times as many goods and services as the average Australia in the year 1901. Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

The connection between economic prosperity and health
MAKING THE CONNECTION 12.3 The connection between economic prosperity and health Because of technological advance, these children from a low-income country will live longer, be healthier and may work less than their parents and grandparents. Research has highlighted the close connection between economic growth, improvements in technology and improvements in human physiology. Many economists believe there is a link between health and economic growth. Today, economists studying economic development have put increasing emphasis on the need for low-income countries to reduce disease and increase nutrition if they are to experience economic growth. Many researchers believe that the state of human physiology will continue to improve as technology advances. In the high-income countries, life expectancy at birth is expected to rise from about 80 years today to about 90 years by the middle of the twenty-first century. 47

What determines the rate of long-run growth?
LEARNING OBJECTIVE 5 What determines the rate of long-run growth? Increases in real GDP per capita depend on increases in labour productivity. Labour productivity: The quantity of goods and services that can be produced by one worker or by one hour of work.

LEARNING OBJECTIVE 5 What determines the rate of long-run growth? Two key factors determine labour productivity. Increases in capital per hour worked Capital: Manufactured goods that are used to produce other goods and services; examples are computers, factory buildings, and machine tools. Human capital: The accumulated knowledge and skills that workers acquire from education and training, or from their life experiences.

LEARNING OBJECTIVE 5 What determines the rate of long-run growth? Technological Change Accumulating more inputs such as labour, capital, and raw materials will not ensure that an economy experiences economic growth unless technological change also occurs.

LEARNING OBJECTIVE 5 What determines the rate of long-run growth? Potential real GDP The concept of potential GDP is useful when taking a long-run perspective of economic growth. Potential GDP: The level of real GDP attained when all firms are producing at capacity. Growth in potential real GDP is estimated to be approximately 3.5% per year. Actual real GDP fluctuates around the long-run potential due to the business cycle.

Actual and potential quarterly real GDP, Australia, 1960 - 2008: Figure 12.4
Potential real GDP increases every year as the labour force and the capital stock grow and technological change occurs. The smooth orange line represents potential real GDP and the blue line represents actual real GDP. Because of the business cycle, actual real GDP has sometimes been greater than potential real GDP and sometimes less. Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

What determines how fast economies grow?
LEARNING OBJECTIVE 6 What determines how fast economies grow? Economic growth model: A model that explains changes in real GDP per capita in the long run. Technological Change: The change in the ability of a firm to produce a given level of output with a given quantity of inputs.

LEARNING OBJECTIVE 6 What determines how fast economies grow? Three main sources of technological change: Better machinery and equipment. Increases in human capital. Better means of organising and managing production.

LEARNING OBJECTIVE 6 What determines how fast economies grow? The economic growth model can be illustrated using the per-worker production function. The Per-Worker Production Function: The relationship between real GDP, or output, per hour worked and capital per hour worked, holding the level of technology constant. L = labour; K = capital Real GDP per hour = Y/L Capital per hour worked = K/L

The per-worker production function: Figure 12.5
Figure 12.5: The per-worker production function. The per-worker production function shows the relationship between capital per hour worked and real GDP per hour worked, holding technology constant. Increases in capital per hour worked increase output per hour worked, but at a diminishing rate. For example, an increase in capital per hour worked from $ to $ increases real GDP per hour worked from $200 to $350. An increase in capital per hour worked from $ to $ increases real GDP per hour worked from only $350 to $475. Each additional $ increase in capital per hour worked results in progressively smaller increases in output per hours worked. Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

LEARNING OBJECTIVE 6 What determines how fast economies grow? Which is more important for economic growth: More capital or technological change? Technological change is the key to sustaining economic growth.

Technological change increases output per hour worked: Figure 12.6
Figure 12.6: Technological change increases output per hour worked. Technological change shifts up the production function and allows more output per hour worked with the same amount of capital per hour worked. For example, along Production function1 with $ in capital per hour worked, the economy can produce $575 in real GDP per hour worked. However, an increase in technology that shifts the economy to Production function2 makes it possible to produce $675 in real GDP per hour worked with the same level of capital per hour worked. Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

What explains rapid economic growth in Botswana?
MAKING THE CONNECTION 12.4 Firms like the Botswana Meat Company benefit from the government policies that protect private property. Economic growth in much of sub-Saharan Africa has been very slow. As desperately poor as most of these countries were in 1960, some are even poorer today. Growth rates in one country in this region stand out, however, as being exceptionally rapid. What explains Botswana’s rapid growth rate? Several factors have been important. Botswana avoided the civil wars that plagued other African countries during these years. The country also benefited from earnings from diamond exports. But many economists believe the pro-growth policies of its government are the most important reason for the country’s success. These policies—protecting private property, avoiding political instability and corruption and allowing press freedom and democracy—may seem a straightforward recipe for providing an environment in which economic growth can occur. However, in practice these are policies many countries have difficulty implementing successfully.

LEARNING OBJECTIVE 6 What determines how fast economies grow? Endogenous growth theory: A model of long-run economic growth that emphasises that technological change is influenced by economic incentives, and so is determined by the working of the market system. Developed by economist Paul Romer. Romer argued that the accumulation of knowledge capital is a key determinant of economic growth.

LEARNING OBJECTIVE 6 What determines how fast economies grow? Is economic growth good or bad? Is undeniable that economic growth has reduced poverty and increased health, education and many other measures of welfare. Criticisms of economic growth include: Globalisation undermines distinctive cultures. Multi-national firms exploit low wages and poor health, safety and environmental regulations in the developing world. Economic growth contributes to global warming, deforestation and other environmental problems.

LEARNING OBJECTIVE 6 What determines how fast economies grow? Is economic growth good or bad? The search for economic growth that is sustainable has come to the forefront of economic policy in high income countries, and also in the rapidly developing countries such as China and India.

Key Terms Black economy Business cycle Capital Consumption
Economic growth Economic growth model Economic growth rate Endogenous growth theory Expansion Final good or service GDP deflator Government purchases Gross domestic product (GDP) Human capital Inflation rate Intermediate good or service Investment Labour productivity Long-run economic growth Macroeconomics Microeconomics Net Exports Nominal GDP Per-worker production function Potential GDP Price level Real GDP Recession Technological change Transfer payments Value Added

Get Thinking! The Australian Bureau of Statistics (ABS) is Australia’s main data collecting body. Go to the ABS website and find information on GDP for recent years. Has the Australian economy been growing over the past year? Has growth increased or slowed over the past five years? What factors are contributing positively to growth and what factors are having a negative impact?

Check Your Knowledge Q1. In the circular flow diagram, who supplies factors of production in exchange for income? Households. Firms. The government. All of the above.

Check Your Knowledge Q2. When accounting for exports and imports in GDP, which of the following is correct? Exports are added to the other categories of expenditures. Imports are added to the other categories of expenditures. Both exports and imports are added to the other categories of expenditures. Both exports and imports are subtracted from the other categories of expenditures.

Check Your Knowledge Q3. Household production and the underground economy: are fully accounted for in GDP figures gathered by the Commerce Department. are not considered formal production of goods and services, and therefore are not included in GDP accounting. are important but unaccounted for in the Commerce Department’s estimate of GDP. are irrelevant because they constitute only a very small fraction of GDP for most countries.

Check Your Knowledge Q3. Household production and the underground economy: are fully accounted for in GDP figures gathered by the Commerce Department. are not considered formal production of goods and services; therefore, are not included in GDP accounting. are important but unaccounted for in the Commerce Department’s estimate of GDP. are irrelevant because they constitute only a very small fraction of GDP for most countries.

Check Your Knowledge Q4. Which measure of GDP represents changes strictly in the quantity of goods and services produced in the economy, not the prices? Nominal GDP. Real GDP. The GDP measure that sums up the value of goods and services evaluated at current year prices. None of the above.

Check Your Knowledge Q5. Along the per-worker production function, what happens to real GDP per hour worked as the capital per hour worked increases? a. It increases at an increasing rate. b. It increases at a decreasing rate. c. It decreases at an increasing rate. d. It decreases at a decreasing rate.

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