Chapter 2: The Data of Macroeconomics

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Gross Domestic Product (GDP)

the Consumer Price Index (CPI

Unemployment rate

National Income Accounting- measure the economy’s overall performance

Business firms- measures its flows of income and expenditures regularly

Usually every 3 months or annually

National Income Accounting- operates in much the same way as the economy as a whole.

NSO NSCB NEDA

This accounting enables the economists and policymakers to:

A. Assess the health of the economy by comparing levels of production at regular intervals.

Track the long-run course of the economy whether it has grown, been constant, or declined.

Formulate policies that will safeguard and improve the economy’s health.

Gross Domestic Product

Definition: Value of total final goods and services produced in an economy in a given period of time (measure of economic activity)

There are two ways to compute it:

Total income of everyone in the economy

Total expenditures on the economy’s goods and services

These two measures must be equal:Expenditure of buyers = Income of sellers

Why expenditure = income

In every transaction, In every transaction, the buyerthe buyer’’s expenditure s expenditure

becomes the sellerbecomes the seller’’s income.s income.

Thus, the sum of all Thus, the sum of all expenditure equals expenditure equals

the sum of all income.the sum of all income.

In every transaction, In every transaction, the buyerthe buyer’’s expenditure s expenditure

becomes the sellerbecomes the seller’’s income.s income.

Thus, the sum of all Thus, the sum of all expenditure equals expenditure equals

the sum of all income.the sum of all income.

The Circular FlowIncome ($)

Goods (bread)

Expenditure ($)

Households Firms

Gross Domestic Product (GDP) Example: an economy with two goods,

apples and oranges

GDP = (papples×qapples) + (poranges×qoranges)

= ($0.50 × 4) + ($1.00 × 3) = $5.00

Quantity produced Market Price

Apples 4 $0.50

Oranges 3 $1.00

Intermediate Goods

Value Added = value of firm’s output minus value of intermediate inputs

Rancher Sells Meat to McDonald’s

$0.50 Value added =

$0.50 – $0.00 = $0.50

McDonald’s sells hamburger

$1.50 Value added =

$1.50 – $0.50 = $1.00

GDP is the value of all FINAL goods and services produced and sold in the economy = $1.50

GDP is also equal to the sum of value added in all stages on production = $0.50 + $1.00 = $1.50

The expenditure components of GDP

• consumption

• investment

• government spending

• net exports

An important identity

Y = C + I + G + NX

where Y = GDP = the value of total output

C + I + G + NX = aggregate expenditure

Consumption (C)• durable goods

last a long time ex: cars, home appliances

• non-durable goodslast a short time ex: food, clothing

• serviceswork done for consumers ex: dry cleaning, air travel.

def: the value of all final goods and services bought by households. Includes:

U.S. Consumption, 2005

$ billions

% of GDP

Consumption 8,746.2 70%

Durables 1026.5 8.2%

Nondurables 2,564.6 20.5%

Services 5,155.1 41.2%

$ billions

% of GDP

Consumption 8,746.2 70%

Durables 1026.5 8.2%

Nondurables 2,564.6 20.5%

Services 5,155.1 41.2%

Investment (I)

def1: spending on [the factor of production] capital.def2: spending on goods bought for future use.

Includes: business fixed investment

spending on plant and equipment that firms will use to produce other goods & services

residential fixed investmentspending on housing units by consumers and landlords

inventory investmentthe change in the value of all firms’ inventories

U.S. Investment, 2005

$ billions

% of GDP

Investment $2,103.1 16.8%

Business fixed 1,330.6 10.6

Residential fixed 755.8 6

Inventory 16.6 0.01

$ billions

% of GDP

Investment $2,103.1 16.8%

Business fixed 1,330.6 10.6

Residential fixed 755.8 6

Inventory 16.6 0.01

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.

Investment vs. Capital

Example (assumes no depreciation): 1/1/2002:

economy has $500b worth of capital

during 2002:investment = $37b

1/1/2003: economy will have $537b worth of capital

Stocks vs. Flows

stock flow

a person’s wealth a person’s saving

# of people with # of new collegecollege degrees graduates

Flow Stock

More examples:

Government spending (G)

G includes all government spending on goods and services.

G excludes transfer payments (e.g. unemployment insurance payments), because they do not represent spending on goods and services.

Government spending, 2005

$ billions

% of GDP

Gov spending $2,363.4 18.9%

Federal 877.8 7.0

Non-defense 290.6 2.3

Defense 587.2 4.7

State & local 1,485.6 11.8

$ billions

% of GDP

Gov spending $2,363.4 18.9%

Federal 877.8 7.0

Non-defense 290.6 2.3

Defense 587.2 4.7

State & local 1,485.6 11.8

Net exports (NX = EX - IM)

def: the value of total exports (EX) minus the value of total imports (IM)

U.S. Net Exports, 1960-2000

1960 1965 1970 1975 1980 1985 1990 1995 2000

U.S. Net Exports, 1960-2000

1960 1965 1970 1975 1980 1985 1990 1995 2000

GDP: An important and versatile concept

We have now seen that GDP measures total income total output total expenditure the sum of value-added at all stages

in the production of final goods

Some Issues of GDP

Home production Illegal activities Underground economy Environment Quality

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)

(GNP – GDP) as a percentage of GDP for selected countries, 1997.

U.S.A. 0.1% Bangladesh 3.3 Brazil -2.0 Canada -3.2 Chile -8.8 Ireland -16.2 Kuwait 20.8 Mexico -3.2 Saudi Arabia 3.3 Singapore 4.2

Real GDP Is GDP a good measure of well-being/economic

activity?

Recall that: GDP = (papples×qapples) + (poranges×qoranges)

Higher GDP does NOT imply higher well-being GDP can increase if prices increase, with no change in quantities

Real GDP = measure of output keeping prices constant

Real GDP

In the previous example:

Quantity 2002

Price 2002

Quantity 2003

Price 2003

Apples 4 $0.50 7 $0.40

Oranges 3 $1.00 2 $1.20

Real GDP

Let 2002 be the base-year, i.e., real GDP will be calculated using 2002 prices

$5.502) ($1.00 7) ($0.50

) () ( Real20032002200320022003

orangesorangesapplesapples qpqpGDP

$5.003) ($1.00 4) ($0.50

) () ( Real20022002200220022002

Real GDP

Now with 2003 as base-year:

Notice that, at the base-year: Real GDP = Nominal GDP

$5.202) ($1.20 7) ($0.40

) () ( Real20032003200320032003

$5.203) ($1.20 4) ($0.40

) () ( Real20022003200220032002

Real GDP

Issue: results are sensitive to the choice of base yearBase year 2002, Real GDP goes from

$5.00 to $5.50 (growth rate = 10%)Base year 2003, Real GDP is the same

in both years (growth rate = 0) Solution: Chain-weighting

Take the average of the growth rates = 5%

Real GDP

Then use this growth rate to calculate Real GDP in 2003:RGDP2003 = $5.00*(1 + .05) = $5.25

RGDP2002 = $5.00

Advantages:It does not depend on the base yearPrices are updated as time passes

GDP Deflator

Reflects changes in the overall price level how price changes between current year and the base year

GDP RealGDP NominalDeflator GDP

Deflator GDPGDP Nominal GDP Real

GDP Deflator

In our example, using 2002 as base year:

= $5.20/$5.50 = 0.945

) () (

GDP RealGDP Nominal

Deflator GDP

2003200220032002

2003200320032003

20032003

orangesorangesapplesapples

GDP Deflator

Price level decreased 5.5% from 2002 to 2003

1GDP Real

GDP NominalDeflator GDP

20022002

Consumer Price Index (CPI)

Measures changes in the price level, i.e., inflation

More specifically, measures how the cost of a given consumption basket evolves over time (cost of living)

The bundle includes goods and services consumed by a typical consumer

Consumer Price Index (CPI)

For example, suppose a typical consumer buys 5 apples and 2 oranges:

In other words, the cost of this basket is 2% lower in 2003 relative to 2002 (the base year)

98.05.4/4.42)(5)(2)(5)(

2003CPI

20022002

20032003

orangesapples

CPI vs. GDP Deflator

CPI GDP Deflator

Includes only goods and services bought by consumers

Includes all final goods and services produced by country

Includes imports bought by consumers

Includes only goods generated domestically

CPI vs. GDP Deflator

CPI GDP Deflator

Fixed weights (Laspeyres index)

Changing weights (Paasche index)

Tends to overstate the increase in cost of living when prices rise

Tends to understate the increase in cost of living when prices rise

Two measures of inflation16

Percentagechange

1948 1953 1958 1963 1968 1973Year

1978 1983 1988 1993 1998

GDP deflator

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.

CPI vs. GDP deflator

prices of capital goods• included in GDP deflator (if produced domestically)

• excluded from CPI

prices of imported consumer goods• included in CPI• excluded from GDP deflator

the basket of goods• CPI: fixed• GDP deflator: changes every year

Chapter 2: The Data of Macroeconomics

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