M.Sc. Economics E-566 Macroeconomic Theory-I

LECTURE 2

Instructor: Ms. Rafat Mahmood

The Data of Macroeconomics:

Topic 1: GDP

Outline

Gross Domestic Product (GDP)

• What is GDP?

• Approaches towards measurement of GDP

• National income accounting

• Real Vs Nominal GDP

• The GDP Deflator

Macroeconomic Theory-I

• GDP is a measure of output.

• Often considered the best measure of how well the economy is performing.

[Because output is thought to be highly correlated (at certain times) with things we care about (standard of living, wages, unemployment, inflation, budget and trade deficits, value of currency, etc…)]

• Any qualifications?

Formal Definition:

GDP is the Market Value of all Final Goods and Services Newly Produced on Domestic Soil During a Given Time Period (different than GNP)

Measuring the value of Economic Activity: The GDP

Macroeconomic Theory-I

National Income Accounting • Fundamental identity of national income account:

total production = total income = total expenditure

Illustration: Income, Expenditure and The Circular Flow

Macroeconomic Theory-I

Income (Rs.)

Labor

Goods (bread)

Expenditure (Rs.)

Households Firms

Approaches to Measure GDP

Macroeconomic Theory-I

GDP The Income Approach: Labor income (wages/salary) + Capital income (rents, interest, dividends, profits) + Government income (taxes)

The Expenditure Approach: Spending by consumers (C) + Spending by businesses (I) + Spending by government (G) + Net spending by foreign sector (NX)

The Product Approach: Amount of output produced excluding output used up in intermediate stages of production OR Value added summed across all firms. Value added=value of output-value of purchased input

Example

Macroeconomic Theory-I

What is the total value (in dollars) of the economic activity generated by these 2 firms?

• Product Approach (Value added=value of output-value of purchased input):

• 35K + (40K– 25K) = 50K

• Income Approach (Wages + Profits + Taxes) =

(15K + 10K) + (15K + 3K) + (5K + 2K )= 50K

• Expenditure approach (expenditure by final users):

10K + 40K = 50K

Thus,

total production = total income = total expenditure

Macroeconomic Theory-I

1. The Product Approach Market Value of Goods and Services newly produced within a country in a fixed period of time.

Practical Issues:

• Adding Apples and Oranges: GDP combines the values of all goods and services into a single measure. To compute the total values of different goods and services, the national income accounts use market prices (reflection of willingness to pay).

GDP = P1Q1 + P2Q2+ P3Q3+…..+PnQn

GDP = 𝑃𝑖𝑄𝑖𝑛𝑖=1

Problem: Exclusion of some useful non-market goods & services.

• Used Goods: GDP measures the value of currently produced goods and services. Thus, the sale of used goods is not included as part of GDP.

Macroeconomic Theory-I

• Intermediate goods and value added: Intermediate goods and services are those used up in production of other goods and services in the same period that they themselves were produced. GDP includes the value of only final goods and services because the market value of final goods include the value of intermediate goods (avoids double counting).

• Thus, GDP is also calculated as the sum of value added at each stage of production (Value added=value of firm’s output less value of intermediate goods that the firm purchases)

• Capital goods are considered final products.

• Imputations: Goods that are not sold at marketplace are counted at an estimated value which is referred to as imputed value.

Examples: Housing services

Not imputed: underground economy, domestic work

Macroeconomic Theory-I

The Product Approach (contd.)

• Inventories: i. Unsold stuff is spoiled:

Product and Expenditure approach: No new product thus no expenditure Income approach: wages rise, profits fall: Cancelled No increase in GDP

ii. Unsold stuff to be sold later: Product approach: New goods produced Expenditure approach: firms have purchased inventory (I) Income approach: wages rise GDP increases

iii. Sale of inventory: Good just changes hands. No increase in GDP

The Product Approach (contd.)

Macroeconomic Theory-I

Total spending on final goods and services produced within a country during a specified period of time.

• Four major categories of spending are added to get GDP i.e.

Y = C + I + G + NX (income-expenditure identity)

Practical Issues

• Consumption (C): Spending by domestic households on final goods and services including those produced abroad. Includes consumer durables, non-durables and services.

• Investment (I): Spending for new capital goods (fixed investment) and increases in firm’s inventory holdings (inventory investment)

• Components of fixed investments: Business fixed investment and residential fixed investment.

• Investment includes spending on foreign-produced goods.

Macroeconomic Theory-I

The Expenditure Approach

The Expenditure Approach (contd.)

• Government Purchases of Goods and Services (G): Expenditure by govt. on currently produced good or service, domestic or foreign. Transfers and interest payments on national debt are not included in GDP.

• Net Exports: Exports minus imports. Subtracting imports ensures that total spending Y=C+I+G+NX reflects spending only on output produced in the country.

Macroeconomic Theory-I

The Income Approach • Total income received by producers, including profits, and taxes

paid to government.

Practical Issues

• Either add all the before tax incomes or add after tax incomes plus the taxes paid to government.

National Income (NI) includes:

1. Compensation of Employees: wages, salaries, employee benefits, and employer’s contribution to social security.

2. Proprietor's income: Incomes of non-incorporated self-employed.

3. Rental income of persons: Income earned by individuals who own land or structures that they rent to others.

4. Corporate profits: Profits earned by corporations i.e. (corporate revenue)- (wages, interests, rents and other costs)

5. Net interest: Interests earned by individuals from businesses and foreign sources minus interest paid by individuals.

Macroeconomic Theory-I

The Income Approach (contd.)

From National Income to GDP

• NI + indirect business taxes Net National Product (NNP)

• NNP + Consumption of fixed capital (depreciation) Gross National Product (GNP)

• GNP + Payments of factor income to rest of the world – factor income received from rest of the world Gross Domestic Product (GDP)

Macroeconomic Theory-I

Private Sector and Government Sector Income

Private disposable income measures the amount of income the private sector has available to spend.

Private disposable income = Y + NFP+ TR + INT – T

Net Government income = T – TR - INT

Private disposable income + Net Government income = GNP

Macroeconomic Theory-I

Real vs Nominal GDP • Nominal GDP is value of goods and services produced at current

prices.

• Nominal GDP can increase either because prices rise or because quantities rise.

• Real GDP is the value of goods and services at a constant set of prices i.e. it shows expenditure on output if quantities had changed but prices had not.

• A base year is selected whose prices are taken as the reference point.

Suppose 2011 is the base year then

Real GDP in 2011 = (2011 Qa x 2011 Pa) + (2011 Qo x 2011Po)

Real GDP in 2012= (2012 Qa x 2011 Pa) + (2012 Qo x 2011Po)

Real GDP in 2013= (2013 Qa x 2011 Pa) + (2013 Qo x 2011Po)

• Real GDP varies from year to year only if quantities produced vary.

Macroeconomic Theory-I

The GDP Deflator

GDP deflator = Nominal GDP / Real GDP

• Also called implicit price deflator for GDP because it reflects on the overall level of prices in the economy.

• Nominal GDP can be imagined to consist of two parts: One part measures quantities (real GDP) and the other measures prices (the GDP deflator) i.e.

Nominal GDP = Real GDP x GDP deflator

• The GDP deflator is named so because it is used to deflate the nominal GDP to yield real GDP i.e.

Real GDP =Nominal GDP / GDP deflator

Macroeconomic Theory-I

Read: Mankiw Chapter 2

Macroeconomic Theory-I

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