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Gross Domestic Product
Lesson 15


History of Macroeconomics

  • Classical Economists
    • Free markets always clear
    • Market prices adjust to always clear markets
    • Government has limited role in economy
      • Mints coins
      • Encourages commerce
      • Finance a military to protect the nation
      • Protect private property rights
  • Great Depression struck the world between 1929 and 1939
    • Unemployment rate peaked at 26% in the United States
    • Germany experienced hyperinflation and an unemployment rate of 50%
    • Soviet Union isolated itself from the world and the Great Depression
  • John Maynard Keynes - wrote The General Theory of Employment, Interest and Money in 1936
    • Paradox of Thrift
      • A crisis strikes a society and businesses lay off some of their workers
      • Workers become fearful and boost their savings
      • Society contracts furthers from the negative multiplier effect
      • They buy fewers cars, houses, clothes, etc.
      • Businesses experience declining sales and layoff more workers
      • Remaining workers save even more, and the cycle continues
  • Keynesian Economics
    • World leaders thought free markets and economics had failed
    • Leaders thought about converting economies to socialistic systems
    • Irony - Keynes saved capitalism by writing his book
    • Government leaders can intervene in a market economy to keep the economy growing
      • Government uses taxes and government spending to influence the economy
      • Central bank uses the money supply and interest rates to influence the economy

Measuring Size of Economy

  • National Income Accounting – measure incomes for whole economy
    • U.S. government measures economy's size
    • Bureau of Economic Analysis (BEA) compiles national income accounts
      • Part of the U.S. Department of Commerce
    • Similar to a business
      • Businesses compile a variety of financial statements to gauge performance of the business
        • Balance sheet, cash flow statement, income statement, and changes in owner’s equity
  • Gross Domestic Product (GDP) – total market value of all goods and services produced in one year
    • An aggregate (whole country)
    • Monetary measure
    • U.S. is measured in dollars
  • Example:
    • 2011 U.S. Economy produced
      • 2 million pizzas
      • 10 million sodas
      • 15 million bread sticks
    • 2012 U.S. Economy produced
      • 1 million pizzas
      • 12 million sodas
      • 20 million bread sticks
    • Which year did the U.S. produce more?
  • We cannot say
    • Pizza production went down, but breadsticks and soda production went up
    • Multiply the production levels by its price
    • Converts all production to dollars
    • Then add the value of production to yield one measure
2011 GDP
Item Production Price Value
Pizza 2 million $10 $20 million
Soda 10 million $1 $10 million
Breadsticks 15 million $5 $75 million
  Total $105 million
2012 GDP
Item Production Price Value
Pizza 1 million $10 $10 million
Soda 12 million $1 $12 million
Breadsticks 20 million $5 $100 million
  Total $122 million
  • The value of production is higher in 2012
    • Prices did not change
    • United States produced more products
  • The economy is so large, we would like to avoid multiple accounting
    • Economists include and exclude items from GDP
  • Gross Domestic Product (GDP) is the value of all currently produced goods and services produced within the borders of an economy sold on the market during a particular time interval.
  • GDP includes final goods
    • Final goods - have no further processing and ready to be sold to customers
      • Excludes items that are re-sold; thus they are counted once
      • Soviet Union – production managers doubled and tripled counted in order to meet production quotas as resources became scarce
  • GDP excludes
    • Intermediate goods – goods require further processing and manufacturing
      • When a good is finished and sold to a customer, the price already contains the value of production from intermediate processing
      • We want to avoid multiple accounting
        • Multiple counting - where the same object is counted more than once
    • Secondhand sales – do not contribute to new production such as used houses, cars, furniture, etc. We are just transferring assets and not creating new ones
    • Stock market transactions – selling and buying bonds and stocks is transferring financial instruments, not creating new ones
      • do not contribute to production
    • Transfer payments
      • Public welfare payments – social security, Medicaid, etc.
      • Private transfer payments – inheritances, gifts, etc.
  • GDP – includes production within the borders of an economy
    • Does not distinguish between U.S. or foreign businesses
      • Japanese companies, Honda, Nissan, and Toyota produce within the U.S.
      • Examples – Sentra, Altima, Accord, CR-V, Acura RD-X, Camry, etc.
  • GDP is goods and services are valued at their market prices
    • GDP excludes housework and volunteer work because government cannot measure quantity and prices accurately


Two Ways to Measure GDP

1. Definitions

  • Expenditure Approach - we aggregate the value of all goods and services that consumers and businesses buy
  • Income Approach - we aggregate all incomes that were generated from production of goods and services
  • Circular Flow is simplified without government and international sector

The circular flow for an economy

2. Expenditure Approach – use the equation:  GDP = C + Ig + G + Xn

  • Consumption expenditures (C) – consumers purchase nondurable goods, durable goods, and services
  • Gross investment (Ig) – includes
    • Investment in machinery, equipment, and tools
    • New construction in factories, warehouses, and retail space
      • New construction in private homes
      • Owners could rent house for income
    • Change in inventory
      • If inventory increases – include in GDP because production had increased
      • If inventory decreases – deduct from GDP because inventory was produced in previous years and avoid double counting
    • Does not include financial instruments like stocks and bonds
  • Investment – decomposed into several types
    • Net investment – removes the impact of depreciation
    • As capital is being used, it depreciates
      • Buildings get old
      • Tools wear out
      • Equipment breaks down and becomes old
    • Depreciation is the amount the capital degraded
    • Thus, businesses replace worn-out capital depreciation and invest in new equipment
    • Gross investment includes all investment
    • Net investment is

Net investment = Ig – depreciation

  • Why this distinction?
    • If gross investment is growing at 5% per year and capital is depreciating at 6% per year, then net investment falls by 1%
    • Country is using up its stock of capital?
  • Government purchases (G) – include all government purchases
    • Gov. buys goods and services
    • Gov. invests in schools, highways, airports, etc.
    • Includes all three levels: Federal, state, and local
  • Net Exports (Xn) – is exports minus imports
    • Exports – produced inside country and sold abroad
    • Imports – produced outside the country and sold inside country
    • Net exports – add directly to GDP
    • The net impact on production
      • If net exports > 0, net increase in production here in U.S.
      • If net exports < 0 , net decrease in production here in U.S.

3. Income Approach - aggregate income from producing goods and services

  • Employee Compensation - workers receive wages and salaries paid
    • Businesses and government pay wages
    • Largest source
  • Interest - earnings
    • households save money in financial institutions, and financial institutions lend money to businesses for capital
    • In turn, businesses pay interest to the financial institutions and financial institutions pay the savers for their investments
      • households earn interest from savings deposits, certificates of deposits (CDs), and corporate bonds
  • Profits
    • Proprietor's profits - as a proprietor earns profits, he can pay himself some of the profits and invest the rest into more capital for his business
    • Partnerships are similar; the profits is divided among partners as income and the rest is invested back into capital for the business
    • Corporations - are more complicated
      • Corporations pay taxes on its income
      • Corporations divide their capital into two accounts
        • contributed capital - corporation directly sells stocks to investors
          • provides funding so corporation can acquire buildings, machines, and equipment
        • retained earnings - a corporation's profits (minus taxes) are placed in this account
          • if board of directors approve dividends, then dividends are paid from this account and funds left over can be used to invest more into corporation
  • Rents - income earned from renting or leasing property
    • Includes leasing office space and rent paid to landlords
    • Government looks at net rent
      • Net rent = gross rent - depreciation
      • gross rent is cash received for rental income
      • depreciation - rental property wears out and degrades over time
  • Taxes - increase the price of goods and services
    • if you bought a can of Pepsi for $1 and the store charges 6% sales tax, you pay a total of $1.06
      • The $1 only includes income for producing that can of Pepsi, but $0.06 reflects the tax and the higher price.
    • Add these taxes to the income accounts
      • sales taxes
      • excise taxes
      • business property taxes
      • license fees
      • customs duties
  • Adjustments - several adjustments are made creating GDP from national income accounts
    • Foreign income - GDP is production within the borders of the U.S.
      • Deduct foreign income earned by Americans
      • Add foreigners' income that they earned within the United States
    • Depreciation - buildings, machines, and equipment depreciated over time
      • Businesses can claim depreciation expenses on their income statements, thus lowering their profits and income
      • Add depreciation expenses back in
    • Statistical discrepancy - the income approach and expenditure approach are never equal, thus add a number to the national income account, so it equals total expenditures
      • Income approach always yields a smaller estimate of GDP than the expenditure approach

Other Income Accounts

1. Net Domestic Product (NDP) - remove the impact of depreciation of capital

  • Determine how the economy is doing and growing, even though businesses and government are replacing worn out equipment.
  • Example - GDP can be growing, but NDP could be falling
    • Economy is using up its capital stock and not replacing it
    • Hinders future growth in the economy

2. National Income - how much households are earning from supplying resources like land, labor, capital, and entrepreneurs.

  • Aggregate all forms of income
    • Salaries, wages, rent, interest, profits from all businesses, and taxes on production
    • We can get National Income from adjusting GDP from expenditures or income approaches

3. Personal Income - includes all household income

  • Earned income - salaries, wages, interest, rent, and profits from all businesses
    • Some taxes are not included
  • Unearned income - transfer payments
    • Social Security
    • Unemployment insurance
    • Food stamps
    • Medicare/Medicaid

4. Disposable Income (DI) - income households have remaining after they pay their taxes

  • Households choose how much to consume (C) and save (S)
  • DI = C + S

Nominal versus Real

1. Definitions

  • Nominal GDP - has no adjustment for inflation
    • If nominal GDP increases:
      • Country could produce more goods and services
      • And/or inflation raises all prices, increasing GDP
  • Note – GDP could decrease by decreasing production and/or deflation
    • Deflation - prices in the economy on average decrease
      • Occurred in the United States when country was on the gold standard
      • Severe economic contractions
  • Real GDP - removes the effect of inflation
    • If real GDP increases, economy has produced more goods and services
  • Example - Shows the calculation of GDP for an economy with 3 products
    • Pizza
    • Breadsticks
    • Soda

Calculating real GDP

Blue arrow Nominal GDP increases but economy does not expand production

Below is the Nominal and Real GDP for the United States

The real and nominal GDP growth rates


Blue arrow Did you notice during the 1930s that GDP was constantly negative. That was the Great Depression. During the 1940s, the U.S. economy was geared for World War II. The 2008 Financial Crisis is prominent on the graph. Finally the more vertical distance between nominal and real GDPs indicate times of high inflation.

2. How is inflation measured?

  • Inflation - continuously rise in prices over time
    • Measured as a percentage
  • Economists create a basket of goods
    • Basket contains goods like bread, milk, and many other products and services
      1. Consumer Price Index (CPI)
        • Includes thousands of consumer products
        • Products are grouped into 224 categories
      2. Producer Price Index (PPI)
        • Similar to CPI but a price index for producers
      3. GDP Deflator
        • Index of all prices for final goods and services
        • The actual price index to deflate nominal GDP
    • Economists chose one year to be the base year
    • Each year, economists calculate the average price of each good in the basket
    • price index - the average price for the basket
      • It is not a simple average
      • Notice - pizzas, sodas, and breadsticks are produced in different levels

Calculation of price index

The price index

3. Calculate a price level

  • I define my base year, which is 1980
  • I define my basket of goods
  • Calculate the Consumer Price Index (CPI)
    • CPI is most common
    • CPI includes thousands of products
1980 Items Units Prices
Cookies 20 pounds $1.491
Sugar 10 pounds $0.273
Coffee 10 pounds $3.208
Unleaded Gasoline 30 gallons $1.131
Basket Value   $98.56
  • I change the prices in the basket but keep the original quantities for every year
  • I calculate the CPI for 2013
2013 Items Units Prices
Cookies 20 pounds $3.728
Sugar 10 pounds $0.683
Coffee 10 pounds $5.902
Unleaded Gasoline 30 gallons $3.351
Basket Value   $240.94
  • I defined 1980 as my base year, so CPI1980 = 1
  • CPI2013 = 240.94 ÷ 98.56 = 2.44
  • Workers earned average wages of $12,513 in 1980
  • Workers earned average wages of $43,000 in 2013.
  • Convert wages into real
    • 1980, average real wage was $12,513
    • 2013, average real wage was $43,000 / 2.44 = $17,662.95
  • Problems of CPI
    • CPI is biased for residents living in large cities
      • City residents pay greater prices
    • Products' quality changes over time
      • In 1980, most people drove cars and trucks that used leaded gasoline
      • Gov. phased out leaded gasoline
    • CPI includes prices of medical services
      • Medical service prices have soared in the United States
      • U.S. residents with few medical problems experience less inflation
    • Prices for electronics are falling so young people experiences less inflation

4. GDP Deflator:

  • If prices for the base year are 2,000 while the prices for Year t is 3,000, then the price index is 1.50
  • Calculating real GDP is simple, use the formula:

Calculating real GDP

Using the same price index, if nominal GDP in Year t is $14 trillion, then take nominal GDP and divide by the price index of 1.5, which yields $9.333 trillion.

Calculating inflation - take two price indices that are adjacent to each other in time and calculate the percentage change. For example, in 2011 the price index is 1.78 and in 2012 it is 1.90, then the inflation rate is:

Calculating the inflation rate

Below is GDP for the United States since 1929

A graph of real versus nominal GDP

Blue arrow 2009 is the base year. Real and nominal GDP are equal. Also nominal GDP is lower than real before 2000 and higher after 2000.

Problems with GDP

GDP is not a perfect measure of economic well-being

  • Problems with GDP
    • GDP does not include volunteer work and housework
    • GDP does not include leisure
      • During 1900s, Americans worked 53 hours per week
      • Currently Americans work 40 hours per week
      • Under President Obama's Healthcare Law, employers may work their employees less than 30 hours per week to avoid paying health insurance
    • Does not include quality improvements
      • All electronic devices are better than predecessors
      • T.V. – Now they are digital; during 1950s, TVs used vacuum tubes
      • Cell phones – Small and have many features; during 1980s they were big as a tool box
  • GDP does not include underground economy
    • Also called hidden economy or black markets
    • Markets for illegal products and services such as gambling, prostitution, and drugs
    • Hide income from tax authorities - some businesses want customers to pay in cash
    • Employer may pay workers wages "under the table"
    • Avoid regulations and price controls
    • Declining civic loyalty to government
  • Economists estimated size of underground economy
    • Economists are guessing (estimating)
Estimated Size of Underground Economy
Country % of Real GDP
% of Real GDP
China 13.2 11.9
Hong Kong 17 16
Japan 11.4 11
Nigeria 58 53
Malaysia 32.2 29.6
Mexico 30.8 28.8
Russia 47 40.6
United States 8.8 8.4

Source: Schneider, Friedrich and Collin C. Williams. 2013. "The Shadow Economy." The Institute of Economic Affairs. Available at http://www.iea.org.uk/publications/research/the-shadow-economy (accessed on 10/29/2013).

Note - Participants in the underground economy are not honest about their activities. Furthermore, some activities may be crimes in one country but not another. Hong Kong is lax on copyright laws.

  • GDP does not contain changes in the:
    • Environment
    • Noise
    • Congestion
    • Waste
    • Example - Asian countries like China and Kazakhstan are lax on environmental laws
  • GDP does not specify who earns the income
    • Example - what if a country’s leader get 99% of the GDP while everyone else gets the 1%
  • The government publishes statistics
    • The top leaders in the federal government are elected
    • May be some biases to appease the public and voters
    • Example - U.S. government published the Gross National Product (GNP), which is a slightly different definition
      • GDP had a better growth rate than GNP and the federal government dropped the GNP series in the early 1990s.
      • Not the first the federal government did this



  • national income accounting
  • gross domestic product
  • intermediate goods
  • final goods
  • multiple counting
  • expenditures approach
  • income approach
  • consumption expenditures (C)
  • gross investment (Ig)
  • net investment
  • government purchases
  • net exports (Xn)
  • national income
  • net domestic product (NDP)
  • personal income (PI)
  • disposable income (DI)
  • nominal GDP
  • real GDP
  • deflation
  • price index
  • inflation
  • consumer price index
  • producer price index
  • GDP deflator

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