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Modern Principles:
Macroeconomics
Tyler Cowen
and Alex Tabarrok
Chapter 5
GDP and the
Measurement of
Progress
Copyright © 2010 Worth Publishers • Modern Principles: Macroeconomics • Cowen/Tabbarrok
Introduction
• A visitor to India today will be struck by the
dramatic difference in living standards.
 80% of the population live on less than $2 a day.
 Over 100 million Indians live at an American or
European standard of living.
 The latter is a relatively recent change.
•
•
GDP and GDP per capita are measures used
to reflect changes and differences in
standards of living.
The following figure and table show how GDP
is used to measure growth and differences
between countries.
Slide 2 of 50
Introduction
Slide 3 of 50
Introduction
Slide 4 of 50
Introduction
• What Will We Learn in This Chapter?
 What the GDP statistic means and how it is
measured.
 The difference between the level of GDP and the
growth rate of GDP.
 The difference between nominal GDP and real
GDP.
 How growth in per capita real GDP is a standard
measure of economic progress.
 The use of GDP in business cycle
measurement.
 Problems with GDP as a measure of output and
welfare.
Slide 5 of 50
What is GDP?
• Gross domestic product (GDP)— the
•
•
market value of all final goods and
services produced within a country in a
year.
GDP per capita is GDP divided by a
country’s population.
Let’s look more closely at the definition of
GDP.
Slide 6 of 50
What is GDP?
• GDP is the Market Value…
 Two problems:
• How do you add up different goods and
services and get a number that makes
sense?
• Some goods are more important than others;
e.g., producing two houses is more important
than producing two packs of gum.
 Solution: Multiply the quantities of final goods
and services by their market prices and add up
these values.
Slide 7 of 50
What is GDP?
• GDP is the Market Value…(cont.)
 Let’s use an example to illustrate our point:
Slide 8 of 50
What is GDP?
• …Of All Final…
 Intermediate goods are sold to firms and
then bundled or processed with other
goods or services for sale at a later stage.
 Final goods are the finished goods sold to
final users and then consumed or held in
personal inventories.
 To avoid double-counting, only final goods
are included in GDP.
Slide 9 of 50
What is GDP?
• …Goods and Services…
 Goods are tangible. i.e., cars, food,
clothes.
 Services are intangible. Transportation,
haircuts, medical care.
 Both are included in GDP
 Since 1950 the portion of U.S. GDP created
by the production of services has doubled
from 21% to 42%.
 We see this in the next figure.
Slide 10 of 50
What is GDP?
Slide 11 of 50
What is GDP?
• …Produced…
 GDP measures production.
 Sale of used goods are NOT included.
 The sale of financial assets such as stocks
and bonds are not included.
 The services of realtors, stock brokers,
used car salesmen ARE included because
their services represent current economic
activity.
Slide 12 of 50
What is GDP?
• …Within a Country…
 Only production that takes place within the
borders of a country is included in GDP.
 Examples:
• Cars produced in Mexico by American firms
are NOT included.
• Cars produced in the U.S. by Japanese firms
ARE included.
 GNP (Gross National Product) The value of
goods and services produced by U.S.
residents no matter where they live.
Slide 13 of 50
What is GDP?
• …in a year.
 GDP is a flow:
• it measures a rate of production during
a given time period
 In contrast to a nation’s wealth:
• the value of a nation’s assets at a point
in time
• has no time dimension
Slide 14 of 50
CHECK YOURSELF
The Interstate Bakeries Corporation buys
wheat flour to make into Wonder Bread.
Does the purchase of wheat flour add to
GDP?
On eBay you sell your collection of
Pokemon cards. Does your sale add to
GDP?
An immigrant from Colombia works as a
cook in a New York restaurant. Is the money
he earns considered part of the GDP of the
U.S. or Colombia?
Slide15 of 50
Growth Rates
• The growth rate of GDP tells us how
rapidly the country’s production is rising or
falling over time.
GDP2005  GDP2004
 100  GDP growth rate for 2005
GDP2004
Example: Using actual data (numbers are in billions)
$12,455  $11,712
100  6.34%
$11,712
Slide 16 of 50
CHECK YOURSELF
If GDP in 1990 was $5,803 billion
and GDP in 1991 was
$5,995 billion, what was the
growth rate of (nominal) GDP?
Slide17 of 50
Nominal vs. Real GDP
• Definitions
 Nominal variables, such as nominal GDP,
have not been adjusted for changes in prices.
 Real variables, such as real GDP, have been
adjusted for changes in prices.
• Economists usually are more interested in
real GDP because increases in real GDP
reflect increases in the standard of living.
Slide 18 of 50
Nominal vs. Real GDP
• Importance of distinguishing between
nominal and real GDP
 Given the following calculations for nominal GDP:
2005 GDP in 2005 Dollars  2005 Prices  2005 Quantities  $12.4 trillion
1995 GDP in 19955 Dollars  1995 Prices 1995 Quantities  $7.4 trillion
Growth of nominal GDP 1995- 2005
12 .4  7.4

100 
7.4
67 .6%
Slide 19 of 50
Nominal vs. Real GDP
•
•
Problem: The growth of nominal GDP between
1995 and 2005 includes price increases as well
as increases in output.
Solution: calculate GDP in each year using the
same year’s prices.
2005 GDP in 2005 Dollars  2005 Prices  2005 Quantities  $12.4 trillion
1995 GDP in 2005 Dollars  2005 Prices 1995 Quantities  $9.0 trillion
Growth rate of real GDP 1995- 2005
•
12 .4  9.0

100  37 .8%
9.0
This eliminates the effect of price changes on
GDP.
Slide 20 of 50
Nominal vs. Real GDP
• Real GDP Growth
 Most economists would choose real
GDP growth as the best single indicator
of economic performance.
 Media usually report growth in nominal
GDP.
 If we want to compare GDP over time,
we should always compare real GDP.
• It doesn’t matter which year’s prices we use
to calculate real GDP.
Slide 21 of 50
Nominal vs. Real GDP
Slide 22 of 50
Nominal vs. Real GDP
• Real Growth per Capita
 Best reflection of changing living standards.
 Per capita real GDP is real GDP divided by
the population.
 Growth of per capita real GDP = growth of
real GDP minus growth of the population.
 Example: If growth of per capita real GDP =
3% and the population growth rate = 2%,
then growth of per capita real GDP = 3% –
2% = 1%.
Slide 23 of 50
Nominal vs. Real GDP
• Real Growth per Capita (cont.)
The Extremes:
1. Taiwan had the highest growth rate = 6% per year.
2. Nigeria even though a member of OPEC had close to negative growth.
Slide 24 of 50
CHECK YOURSELF
Name a country with a low GDP but a
high GDP per capita.
Name a country with a high GDP but a
low GDP per capita.
Why do we often convert nominal
variables into real variables?
Slide25 of 50
Cyclical and Short-Run Changes in GDP
• Recessions
 National Bureau of Economic Research
(NBER)
• Research organization based in Cambridge,
Massachusetts.
• Most authoritative source of identifying
recessions.
 Official definition – “…a significant, widespread
decline in economic activity spread across the
economy, lasting for more than a few months,
normally visible [as a decline] in real GDP, real
income, employment, industrial production,
and wholesale-retail sales.”
Slide 26 of 50
Cyclical and Short-Run Changes in GDP
• Recessions (cont.)
 How often do recessions occur?
• There have been 11 recessions since
1948.
• There have been 3 recessions since
1990 (including the recession beginning
in Dec. 2007)
Slide 27 of 50
Cyclical and Short-Run Changes in GDP
Slide 28 of 50
Cyclical and Short-Run Changes in GDP
• Recessions (cont.)
 Defining when a recession begins and ends is
not always easy.
• Quarterly data are not available until almost a
month after the quarter is over.
• The government often makes significant
changes in the GDP estimates between the
initial and final estimates.
• Updates can even occur years after the first
estimates are released.
• It is normal for real GDP to fluctuate around
its long-term trend or “normal” growth rate
(business fluctuations).
Slide 29 of 50
Cyclical and Short-Run Changes in GDP
• Recessions (cont.)
 Example: Dating the 2001 recession
• Official NBER starting date is March 2001.
• Data revisions have led many analysts to
conclude that the recession began late 2000.
 Who cares?
• U.S. Presidency changed at the beginning of
2001.
 Democrats: Recession was a result of the
new administration policies.
 Republicans: Recession began during
President Clinton’s term.
Slide 30 of 50
CHECK YOURSELF
What are business fluctuations?
Why is it sometimes difficult to
determine if an economy is in a
recession?
Slide31 of 50
The Many Ways of Splitting GDP
• Another way to understand GDP is to
study its components and how they fit
together.
 There are two common ways of splitting GDP
1. National spending approach:
Y = C + I + G + NX
2. Factor income approach:
Y = Wages + Rent + Interest + Profit
 Both approaches are useful for understanding
business cycles and economic growth.
Slide 32 of 50
The Many Ways of Splitting GDP
• The National Spending Approach
 We begin with the national spending identity:
• Y = C + I + G + NX
 Y = Nominal GDP
 C = The market value of consumption goods
and services
 I = The market value of investment goods
 G = The market value of government
purchases
 NX = Net exports (market value of exports
minus market value of imports)
 Let’s look at each of the components in turn.
Slide 33 of 50
The Many Ways of Splitting GDP
• The National Spending Approach (cont.)
 Consumption spending (C)
• Private (household) spending on goods and
services.
 Investment spending (I)
• Private spending on tools, plant, and
equipment used to produce future output.
 Government spending (G)
• Spending by all levels of government on final
goods and services
 Note: this does NOT include government
transfers.
Slide 34 of 50
The Many Ways of Splitting GDP
• The National Spending Approach (cont.)
 Net exports (NX)
• The value of exports minus the value of
imports
 Exports: Market value of goods and
services sold to residents of other
countries.
 Imports: Market value of goods and
services purchased by U.S. residents from
other nations.
 The next figure shows the composition of U.S.
GDP for 2007.
Slide 35 of 50
The Many Ways of Splitting GDP
Slide 36 of 50
The Many Ways of Splitting GDP
• The Factor Income Approach: The Other
Side of the Expenditure Coin
 When money is spent, it ends up as someone’s
income.
 Adding up the types of income will result in the
value of total spending, or, GDP.
Y = Wages + Rent + Interest + Profit
 Caveat: Not every dollar that is spent is income
because of such factors as sales taxes.
• Adjustments must be made to get the two
approaches to “balance”.
Slide 37 of 50
The Many Ways of Splitting GDP
• Why Split GDP?
 Both ways throw a different light on the
economy.
• The different components of spending behave
differently over time and it is important to
understand why.
• The factor income approach is useful in
determining the relative size and growth of
the income shares.
 The two approaches provide a check for
errors.
Slide 38 of 50
CHECK YOURSELF
Which is the largest of the national
expenditure components: C, I, G, or NX?
Which is more stable, consumption
spending or investment spending?
Why does the income approach to GDP
give the same answer (in theory!) as the
expenditure approach? (In practice, the
answers are close but differ due to
accounting errors and data omissions.)
Slide39 of 50
Problems with GDP as a Measure of Output and Welfare
• There are many goods and services for
which we do not know the market value.
 GDP does NOT count the underground
economy
• Illegal activity
• Off-the-books activity
 GDP does NOT count nonmarket production
• Occurs when goods and services are
produced but no explicit payment is made.
 Example: Work done in the home by
household members.
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Problems with GDP as a Measure of Output and Welfare
•
Results in two biases in GDP statistics:
1. Biases over time
• Example: women in the labor force has
almost doubled since 1950
 When they were at home, unpaid work was
not counted
 Now much of the same work is paid for and
therefore counted (e.g., use of paid nannies
and housekeepers)
• Result: the growth of GDP between 1950
and now is exaggerated.
Slide 41 of 50
Problems with GDP as a Measure of Output and Welfare
•
Results in two biases in GDP
statistics (cont.):
2. Biases across nations
• Example: nonmarket activity is more
prevalent in less developed countries
 Implication: the differences in GDP
between developed and less
developed countries are exaggerated.
Slide 42 of 50
Problems with GDP as a Measure of Output and Welfare
• We do not know the market value of many
goods and services
 GDP does not count leisure.
• People value leisure.
• In the U.S. the average workweek has fallen.
 This growth in leisure is not counted in
GDP.
• The workweek is longer in poor countries.
 Implication: The gap in GDP between rich
and poor countries is understated to the
extent of differences in leisure.
Slide 43 of 50
Problems with GDP as a Measure of Output and Welfare
• We do not know the market value of many
goods and services (cont.)
 GDP does not count “bads”
• GDP does not subtract the value of “bads”
 Pollution
 Depletion of resources
 Loss of animal or plant species
 Crime
 Most economists agree “bads” should be
subtracted, but agreement on how to value
them has not been attained.
Slide 44 of 50
Problems with GDP as a Measure of Output and Welfare
• We do not know the market value of many
goods and services (cont.)
 GDP does not measure distribution of
income.
• Growth in GDP per capita does not mean
that everyone’s income grows at the same
rate.
• Implication: While growth in GDP per capita
is necessary for improvements in standards
of living, it may not be sufficient for large
numbers of the population.
Slide 45 of 50
CHECK YOURSELF
 Why does GDP not account for or try to
measure certain things? What is the
common thread throughout all of the
uncounted variables?
 If two countries have the same GDP per
capita, do they necessarily have the
same level of inequality?
 If GDP does not account for everything,
does that make the GDP statistic
useless?
Slide46 of 50
Takeaway
• The concept of GDP was developed to
•
•
quantify economic growth and fluctuations.
When we say the economy is growing, we
mean that real GDP or real GDP per
capita is growing.
When we say that an economy is booming
or contracting, we mean that growth in real
GDP is above or below its long-run trend.
Slide 47 of 50
Takeaway
• There are two ways to measure GDP
•
•
1. National Spending Approach
2. Factor Income Approach
GDP per capita is a rough measure of the
standard of living.
GDP statistics are imperfect.
1. Many goods are not included.
2. “Bads” are not subtracted
3. Do not tell us anything about the distribution
of income or who benefits from growth
Slide 48 of 50