HE9091

Principles of Economics

Lecture 7

Gross Domestic Product

(GDP) and Inflation

Tan Khay Boon

Email: khayboon@ntu.edu.sg

Office: HSS-04-25

Topics

• Gross Domestic Product (GDP)

• The Expenditure Method

• Nominal and Real GDP

• Real GDP and Economic Well-Being

• The Consumer Price Index

• Adjusting for Inflation

• Costs of Inflation

• Reference: FBLC, chapters 15 & 16

Macroeconomics

• Study the economy as a whole

• Focus on issues such as national output, growth,

inflation, unemployment, government policies,

international trade and exchange rates

• Analyse data on output, employment, prices

– Vital signs of the economy

• Employment, unemployment, productivity

• Savings & Investment, Stock and finance

• Prices and inflation

Measuring Output

Gross Domestic Product (GDP) is

The market value of

Final goods and services

Produced in a country in a given period of time

Market Value

• Aggregate measure of quantities produced

• More expensive items receive a higher

weighting

– Willingness to pay is an indication of benefit

received from the good

• Orchardia's GDP is $64

Orchardia Apples Bananas Shoes

Price $0.25 $0.50 $20.00

Quantity 4 6 3

GDP contribution $1.00 $3.00 $60.00

Final Goods and Services• Final goods and services are consumed by the

ultimate user

– End products of production

– Included in GDP

• Intermediate goods and services are used up in

the production of final goods

– Not included in GDP to avoid double counting

• A barber's assistant earns $2 per haircut for

providing services such as shampooing and

sweeping up

– Barber charges $10 per haircut

– Haircut's contribution to GDP is $10

Final, Intermediate & Capital Goods

• Milk can be sold as a final product or used as an

intermediate good

– Milk in the store (Final Good)

– Milk sold to restaurants (Intermediate Good)

– Count only the final goods

• A capital good is a long-lived good used in the

production of other goods and services

– Houses, apartments, and motels

– Machines used in production (computers)

– Delivery vehicles and taxis

Value Added

• Value added is the market value of the product

minus the cost of inputs purchased from other

firms

– Count value added in the year it is produced

– Hot ‘n’ Fresh buys flour and other inputs to make

bread that sells for $2.00

Company RevenuesCost of Purchased

Inputs

Value

Added

ABC Grain $0.50 $0.00 $0.50

General Flour $1.20 $0.50 $0.70

Hot'n'Fresh $2.00 $1.20 $0.80

Total $2.00

Produced in a Country in a

Period of Time

• "Domestic" in GDP means the activity is

measured within a country's borders

– Nationality of owners or company is not relevant

• Value must be produced in the year considered

– Sell a 20-year old house for $200,000

• Pay $12,000 commission

• Value added is $12,000

• House was not produced in the period of time studied

• Count income generated from the sale of used goods

Expenditure Method for

Measuring GDP

• Four users of final goods

Households ■ Firms

Government ■ Foreigners

• All goods produced are purchased by one of

these groups in a given year

• Amount spent = market value

• GDP can be measured two ways

– Market value of output

– Total spending for final goods less value of imports

Consumption $10,350.6

Durable Goods $1,089.3

Non-durable Goods 2,337.4

Services 6,923.9

Government Purchases 3,000.3

Investment 1,822.5

Business Fixed Investment 1,413.2

Residential 340.4

Inventory 68.9

Net Exports – 515.7

Exports 1,838.5

Imports 2,354.1

GDP $14,657.8

US GDP, 2010 (billions of dollars)

Consumption Expenditure

• Consumption expenditure is spending by

households for goods and services

– Consumer durables are long-lived consumer goods

– Consumer non-durable goods are shorter-lived

goods

– Services are the largest component of consumer

spending

• Cars • Furniture • Appliances

• Clothing • Food • Drinks

• Education • Taxi rides • Haircuts

Investment

• Investment is spending by firms on final goods

and services

• Business fixed investment is purchases of new

capital goods

• Residential investment is construction of new

homes and apartment buildings

• Inventory investment is the change in unsold

goods to the company's inventory

– These goods are produced but not yet sold

– This entry can be positive or negative

• Plant • Property • Equipment

Economic Investment and

Financial Investment

• Financial investment includes purchases of

stocks, bonds, and other financial assets

– Purchase generally transfers ownership of a portion

of the firm's existing capital stock

– Does not correspond to any increase in physical

capital or production capacity, in most cases

– Financial investment is not included in the

calculation of GDP

• Economic investment refers to the increase in

the capital goods used to produce other goods

Government Purchases

• Government purchases are final goods and services

bought by central, state, and local governments

• Excludes transfer payments

– Transfer payments are made by government but the

government receives no current goods or services

– No purchases of final goods and services involved

in transfer payments

– Spending by recipients is included in GDP

• Fighter jets • Teaching • Office supplies

• Social Security • Vouchers

Net Exports

• Net exports equal exports minus imports

– Exports are goods and services produced

domestically and sold abroad

• Exports reduce the amount available to the domestic

economy

– Imports are purchases in the domestic economy of

goods and services produced abroad

• Imports can be consumption, investment, or

government spending

• Imports increase the amount available to the

domestic economy

• Needs to be excluded from the calculation of GDP

GDP Expenditures Equation

Terminology

• Expenditure approach to measuring GDP

Y = C + I + G + NX

Y Gross Domestic Product or output

C Consumption Expenditure

I Investment

G Government Purchases

NX Net Exports

GDP Example• Total production is 1 million cars, $15,000 each

• Production value is 1 million times $15,000 =

$15 billion

– 25,000 cars are unsold

– Incorporate in the inventory investment

GDP Contribution

$10.500 billion

$3.000 billion

$0.750 billion

$0.375 billion

$14.625 billion

Sector # Cars Purchased

Consumers 700,000

Businesses 200,000

Government 50,000

Net exports 25,000

Total 975,000

GDP Example• Total production is 1 million cars, $15,000 each

• Production value is 1 million times $15,000 =

$15 billion

– 25,000 cars are unsold

• Investment in inventories increases by $0.375 billion

GDP Contribution

$10.500 billion

$3.000 billion

$0.750 billion

$0.375 billion

$14.625 billion

Sector # Cars Purchased

Consumers 700,000

Businesses 200,000

Government 50,000

Net exports 25,000

Total 975,000

Businesses 225,000 $3.375 billion

Total 1,000,000 $15.000

billion

Income Approach to GDP

• When a good is sold, its proceeds are distributed to

workers or business owners

• GDP = labor income + capital income

• Labor income is wages, salaries, benefits, and

incomes of the self-employed

– About ⅔ of GDP

• Capital income pays for physical capital and

intangibles

• Add up all incomes = GDP in the economy

• Profits for business owners • Rent for land

• Interest for bond holders • Royalties

Three GDP Approaches

Expenditure

Investment

Consumption

Government

purchases

Net exports

Income

Capital

Income

Labor

Income

Production

Market

Value of

Final Goods

and

Services

Adjusting for Price Changes

• Compare GDP for different years to see how

much output has changed

• GDP changes over time because

– Prices change AND

– Quantity of output changes

• To see how much output has grown, use only

the changes in quantities

– Hold prices constant

The Donut and Cupcake

Economy• GDP in 2009 is $175; GDP in 2013 is $420

– GDP in 2013 is 2.4 times the GDP in 2009

• Only twice as many donuts and cupcakes were

produced in 2013

– Market value of output grew faster than the physical

volume of output

Number of

Donuts

Price of

Donut

Number of

Cupcakes

Price of

Cupcake

2009 10 $10 15 $5

2013 20 $12 30 $6

Real GDP and Nominal GDP

• Real GDP values output in the current year using

the prices from the base year

– The base year is a reference year that changes

infrequently

– Real GDP measures the physical volume of

production

• Nominal GDP values output in the current year

using prices from the current year

– Nominal GDP is the current dollar value of production

Calculating Real GDP for 2013

• Use 2009 as the base year

• Nominal GDP for 2009 is $175 and for 2013, $420

• Calculate real GDP using current year quantities and

base year prices

Real GDP in 2013=(20 donuts)($10)+(30 cupcakes)(5) =$350

– Real GDP doubled between 2009 and 2013

Number of

Donuts

Price of

Donut

Number of

Cupcakes

Price of

Cupcake

2009 10 $10 15 $5

2013 20 $12 30 $6

Real and Nominal GDP

• Usually, nominal and real GDP increase each year

• When prices increase (inflation), Nominal GDP

exceeds real GDP

• Nominal GDP exceeds Real GDP even if fewer

goods and services produced but prices increase faster

than output decreased

• Nominal GDP will be smaller than real GDP if the

prices in the current year are less than in the base

year (deflation)

Real GDP and Economic

Well-Being• Real GDP is a flawed measure of well-being

– It values only market transactions

• Omits illegal transactions, volunteer work, and

household production

• Maximizing GDP will not necessarily maximize

national well-being

• GDP does not account for intangibles people

value, such as crime rates, traffic congestion,

open space and sense of community

GDP Does Not Value Leisure

• Over time people consume more leisure time

– Work weeks are shorter

– People enter the labor force at an older age

– People retire earlier

• Leisure produces no goods for market

– GDP places a value of zero on all leisure time

– Opportunity cost of an hour of leisure is your hourly

wage

– Omission of the value of leisure time makes GDP

seem smaller

• Leisure contributes to well being of people

Nonmarket Economic Activities

• GDP omits services that are not traded in

markets

– Household production

– Volunteer services

• Valuing these services would be difficult

• Nonmarket activities are important in poor

countries

– Self-sufficient households and bartered goods and

services

Underground Economy

• Underground economy is all unreported

transactions, legal and illegal

• Casual labor is often paid in cash

– Failure to report transaction reduces taxes

– Includes baby sitters, tutoring, home repair, etc.

• Some underground activity is illegal

– Goods and services are being produced and

consumed but not included in GDP

• Estimates suggest the underground economy is

large regardless of national income level

Environmental Quality

• Produce more output requires more factories,

and extraction of mineral resources

• Contributes to degrading of environmental

quality such as pollution, greenhouse effect,

congestion

• Depletion of resources may also damage the

environment permanently

• Reduce well being of people

Poverty and Economic Inequality

• GDP does not capture the effects of income

inequality

• Income distribution can be very unequal

although the GDO value is high

• Most would prefer living in a relatively equal

society to one with a few wealthy and many poor

GDP as a Welfare Measure• GDP omits and undervalues some goods and services

• GDP per capita is positively associated with several

measures of well-being

– Material standard of living: more goods and

services

– Health and life expectancy

• Residents of industrialized countries fare better

than residents of developing countries in a range

of health measures

– Education

• Literacy and school enrollment rates are higher

in high-income countries

Inflation

• Prices of goods change over time, creates

inflation and erodes the purchasing power of

money

• Income needs to increase over time to maintain

the standard of living

• Adjust values, incomes, or spending for change

in prices for constant purchasing power

• Inflation increases uncertainty when planning for

the future and is costly to the society

Measuring the Price Level

• The Consumer Price Index (CPI) is a measure

of the cost of living during a particular period

• The CPI measures

– The cost of a standard basket of goods and

services in a given year

– relative to the cost of the same basket of goods and

services in the base year

• Base year for the CPI changes periodically,

normally it changes every five years

Calculating the CPI

2013 Spending Monthly Cost in 2013

Rent (2 bedroom apartment) $500

Hamburgers (60 at $2 each) 120

Movie tickets (10 at $6 each) 60

Monthly expenditures $680

2014 Spending Monthly Cost in 2014

Rent (2 bedroom apartment) $630

Hamburgers (60 at $2.50 each) 150

Movie tickets (10 at $7 each) 70

Monthly expenditures $850

Calculating the CPI

• CPI is the ratio of the cost of the basket of goods

in the current year to the cost in the base year

– Base year cost $680

– 2014 cost $850

CPI = (850 / 680) (100) = 1.25

• Cost of living in 2014 is 25% higher than in 2013

– CPI for the base year is always 1

– CPI for a given period is the cost of living in that

period relative to what it was in the base year

– Some countries use CPI as a percentage – the

ratio times 100

Price Index

• A price index measures the average price of a

given class of goods and services relative to the

price of the same goods and services in a base

year

• CPI measures the change in consumer prices

• Other indices

– Producer price index measures price of resources

– Import / export price index measures price of goods

and services traded internationally

– GDP deflator measures the prices of goods and

services included in the GDP

Inflation• The rate of inflation is the annual percentage

change in the price level

• Inflation of China in 2012 = (2.68–2.61)/2.61 = 0.0268 = 2.7%

• When inflation rates are negative there is deflation

Year China Japan Singapore Thailand United

States

2008 2.41 1.02 0.99 0.94 2.15

2009 2.40 1.01 1.00 0.93 2.15

2010 2.48 1.00 1.03 0.96 2.18

2011 2.61 1.00 1.08 1.00 2.25

2012 2.68 1.00 1.13 1.03 2.30

CPI of Selected Countries

Adjusting for Inflation

• A nominal quantity is measured in terms of its

current dollar value

• A real quantity is measured in physical terms

– Quantities of goods and services

• To compare values over time, use real quantities

– Deflating a nominal quantity converts it to a real

quantity

• Divide a nominal quantity by its price index to

express the quantity in real terms

Family Income in 2013 and 2018

• Can a family buy more with $40,000 in income in

2013 or with $44,000 in 2018?

– 2010 is the base year for the CPI

– Deflate nominal income in both years to get real income

– Compare real income

– $40,000 in 2013 has the greater purchasing power

Year Nominal Income

2013 $40,000

2018 $44,000

CPI

1.00

1.25

Real Income

$40,000/1.00 = $40,000

$44,000/1.25 = $35,200

Real Wages

• The real wage is the wage paid to the worker

measured in terms of purchasing power

– The real wage for any given period is calculated by

dividing the nominal wage by the CPI for that period

• US production worker wages

– CPI uses 1982 – 1984 as base year

– Real wages stayed the same between 1970 and 2010

despite the fact that the nominal wage in 2010 was 5.5

times the nominal wage in 1970

Year Average Wage

1970 $3.40

2010 $19.00

CPI

0.39

2.18

Real Average Wage

$3.40 / 0.39 = $8.72

$19.00 / 2.18 = $8.72

Indexing• Indexing increases a nominal quantity each

period by the percentage increase in a specified

price index

– Indexing prevents the purchasing power of the

nominal quantity from being eroded by inflation

• Indexing automatically adjusts certain values,

such as Social Security payments, by the

amount of inflation

– If prices increase 3% in a given year, the Social

Security recipients receive 3% more

• No action by the government

– Indexing is sometimes included in labor contracts

Adjusting for Inflation

• An indexed labor contract

– First year wage is $12 per hour

• Real wages rise by 2% per year for next 2 years

– Relevant price index is 1.00 in first year, 1.05 in the

second, and 1.10 in the third

• Nominal wage is real wage times the price index

Year Real Wage

1 $12.00

2 $12.24

3 $12.48

Price Index

1.00

1.05

1.10

Nominal Wage

$12.00

$12.85

$13.73

CPI and Inflation

• CPI and other indexes influence policy decisions

and wage increases

• Wage adjustment is usually based in CPI and

labour productivity changes

• CPI tend to overstates inflation by 1 to 2

percentage points a year

– Unnecessarily increases government spending

– Underestimates increase in the standard of living

CPI Quality Adjustment Bias• One important bias in the CPI is its measurement

of price changes but not quality changes

– PC with 20% more memory has 20% higher price

• Not the same PC as the one with less memory

– If no adjustment is made for quality, PC's

contribution to the CPI will be 20%

• Adjusting for quality is difficult

– Large numbers of goods

– Subjective differences

• Incorporating new goods is difficult

– No base year price for this year's new goods

CPI Substitution Biases

• CPI uses a fixed basket of goods and services

– When the price of a good increases, consumers buy

less and substitute other goods

– Failing to account for substitution overstates inflation

• Example: base year cost of market basket

Item 2013 price 2013 Spending

Coffee (50 cups) $1.00 $50.00

Tea (50 cups) $1.00 $50.00

Donuts (100) $1.00 $100.00

Total $200.00

CPI Substitution Bias

• In 2014, coffee and scones are more expensive

– Buying exactly the same basket of goods costs

$300, compared to $200 in 2013

– CPI = 300 / 200 = 1.50

Item 2014 price 2014 Spending

Coffee (50 cups) $2.00 $100.00

Tea (50 cups) $1.00 $50.00

Donuts (100) $1.50 $150.00

Total $300.00

CPI Substitution Bias

• Actually, consumer substitutes tea for coffee

– Scone purchases constant

• True CPI for consumer is 250 / 200 = 1.25

• CPI estimate of 1.50 is 20% higher than the

consumer's experience

Item 2014 price 2014 Spending

Coffee (00 cups) $2.00 $0.00

Tea (100 cups) $1.00 $100.00

Donuts (100) $1.50 $150.00

Total $250.00

The Costs of Inflation

• Prices transmit information about

– The cost of production and

– The value buyers place on buying an additional unit

• The price level is a measure of the overall level

of prices at a particular point in time

– Measured by a price index such as the CPI

• The relative price of a specific good is a

comparison of its price to the prices of other

goods and services

Noisy Prices

• Inflation creates static in the communication

– Buyers and sellers can't easily tell whether

• The relative price of this good is increasing OR

• Inflation is increasing the price of this good and all

others

– Deciding these issues requires market participants

gather information – at a cost

– Response to changing prices is tentative and slow

Indexing Avoids Distortions

• Index Income taxes to avoid bracket creep

– Bracket creep occurs when a household is moved into

a higher tax bracket due to increases in nominal but

not real income

• Higher tax brackets have a higher tax rate

• Indexing income taxes matches tax rates to the

real income level

– Suppose the tax rate on $50,000 is 25% in 2010

– CPI is 1 for 2010, 1.25 for 2014

– Nominal income of $62,500 is taxed 25% in 2014

• Not all taxes are indexed

Distortions Caused by Taxes• Capital depreciation allowance encourages

purchase of capital goods

– Allows firms to deduct a share of the purchase price

as a business expense

– Machine cost is $1,000 and its useful life is 10 years

• Capital depreciation allowance of $100 per year

• $100 in year 1 is worth more than $100 in year 10

because of inflation

• High inflation decreases investment in plant and

equipment. Taxes that are not indexed distort

the tax incentives for work, save, and invest

– Lower savings and investment means lower

economic growth – a real cost of inflation

Shoe Leather and Menu Cost

• If there is no inflation, cash holds its value over time

– Some cash will be held for convenience

• When inflation is high, cash loses value over time

• Manage cash balances to limit losses

– More frequent, smaller withdrawals cost consumers and

businesses time, travel – a real cost of inflation

– Banks process more transactions, increasing costs –

another real cost of inflation

– Cost of frequent trips to the bank - "shoe leather" costs,

• Sellers have adjust price list (menu) frequently

– Menu cost - Resources consumed in updating the prices

Unexpected Redistribution of

Wealth• Unexpected inflation redistributes wealth

• Suppose workers' salaries are not indexed and

inflation is higher than anticipated

– Salaries lose purchasing power

– Employers gain at the expense of workers

• Similarly, unexpectedly high inflation benefits

borrowers at the expense of lenders

– Borrowers repay with dollars worth less than

anticipated

• Unexpected inflation confuses incentives

Interference with Long-Term

Planning• Some decisions have a long time horizon

– Erratic inflation makes planning risky

• Retirement planning requires an estimated cost

for your desired life-style

– Save too little and you live less well in the future

– Save too much and you live less well now

• Given the costs of inflation, most economists

agree that low and stable inflation promotes a

healthy economy

Inflation and Interest Rates

• Unanticipated inflation helps borrowers and

hurts lenders

• The real interest rate is the annual percentage

increase in the purchasing power of financial

assets

– Real interest rate = nominal interest rate – inflation

r = i -

• The nominal interest rate is the annual

percentage increase in the dollar value of an

asset

– Nominal interest rates are the most commonly

stated rates

Inflation and Interest Rates

• Nominal interest rates

and inflation vary

• Nominal interest rate range

is 3.2% to 11.4%

• Inflation rate range is 1.6%

to 13.5%

– Real interest rate is nominal

interest rate minus inflation

• Real interest rate was

highest in 1985, 7.0%

• Real interest rate was

lowest in 1980, – 2.1%

YearInterest

Rate (%)

Inflation

Rate (%)

1975 8.0% 9.1

1980 11.4 13.5

1985 10.6 3.6

1990 8.6 5.4

1995 6.6 2.8

2000 6.0 3.4

2005 4.3 3.4

2010 3.2 1.6

2012 1.8 2.1

Inflation and Interest Rates

• Unexpected inflation benefits borrowers and

hurts lenders

– For a given nominal interest rate, the higher the

inflation rate, the lower the real interest rate

• Expected inflation may not hurt lenders if they

can adjust the nominal interest rates

– Inflation-protected bonds pay a real rate of interest

plus the inflation rate

• The Fisher effect is the tendency for nominal

interest rates to be high when inflation is high

and low when inflation is low

US Inflation and Interest Rates,

1960 - 2012

-2

0

2

4

6

8

10

12

14

19

70

19

75

19

80

19

85

19

90

19

95

20

00

20

05

20

10

Infl

ati

on

an

d i

nte

rest

rate

s

(%/y

ear)

Year

Nominal interest rate

Inflation rate