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					Measuring GDP and   20

 Economic Growth

   ECON 311
Ratna K. Shrestha
An Economic Barometer

 What exactly is GDP?
How do we use it to tell whether our economy is in a
recession or how rapidly our economy is expanding?
How do we take the effects of inflation out of GDP to
compare economic well-being over time?
And how do we compare economic well-being across
An Economic Barometer

 What and for whom goods and services are
 produced affect the standard of living—a central
 concern of Macroeconomics
 The standard of living depends on the value of total
 production—the gross domestic product or GDP– and
 population. In other words, it depends on the per
 capita GDP.
Gross Domestic Product

 GDP Defined
  GDP or gross domestic product, is the market value
  of all final goods and services produced in a country in a
  given time period.
  This definition has four parts:
   Market value
   Final goods and services
   Produced within a country
   In a given time period
Gross Domestic Product

 Market Value
 Use market prices to value production. Both quantity
 and price together determine the total value of
 GDP includes only those items that are traded in
 markets. For example, If you wash your own car, it is
 not accounted in GDP calculation. However, if you buy
 a car wash, it is a part of GDP.
 Exception: market value of home that people own. GDP
 puts a rental value on such homes as if the owners pay
 rents for their homes.
Gross Domestic Product

 Final Goods and Services
 A good or service that is produced for its final user and
 not as a component of another good or service (i.e.,
 intermediate good).
 Intermediate good or service
 A good or service that is produced by one firm, bought
 by another firm, and used as a component of a final
 good or service. For example, Goodyear tire used by
 Ford SUVs. Intermediate goods are not included in GDP
 calculation to avoid double counting.
 GDP is the value of the final goods and services
Gross Domestic Product

Produced Within a Country
GDP measures production within a country—domestic
In a Given Time Period
GDP measures production during a specific time period,
normally a year or a quarter of a year.
Gross Domestic Product

GDP and the Circular Flow of Expenditure and Income
GDP measures the value of production, which also equals
total expenditure on final goods and total income.
Four types of expenditures on final goods.
1. Consumption expenditure (C)
The expenditure by households on consumption goods
and services, including owner occupied housing.
2. Investment (I)
The purchase of new capital goods (tools, instruments,
machines, buildings) and additions to inventories (unsold
Gross Domestic Product
 3. Government expenditures (G)
 The expenditure by all levels of government on goods and
 For example, federal govt. buys submarines and defense
 equipment; provincial govt. buys health care and education.
 4. Net exports (Export X – Imports M)
 The value of exports of goods and services minus the value
 of imports of goods and services.
Expenditures Not in GDP
 Expenditure on used goods is not part of GDP because
 these goods were part of GDP in the period in which they
 were produced.
Gross Domestic Product
Gross Domestic Product
The circular flow demonstrates how GDP can be
measured in two ways.
1. Aggregate expenditure
Total expenditure on final goods and services, equals the
market value of final goods and services, which is GDP.
        Total expenditure = C + I + G + (X – M).
2. Aggregate income
Firms pay out all their receipts from the sale of final
goods as aggregate income to factor of production (such
as wage, interest income, rent, and profits), so income
equals expenditure, Y = C + I + G + (X – M).
Gross Domestic Product

Financial Flows
Financial markets finance deficits and investment.
Total income is either consumed (C), saved (S), or paid in
taxes (NT). That is,
                     Y = C + S + NT.
Household saving S = Y – C – NT and saving flows to the
financial markets.
Net taxes (NT) is the revenue raised by the government.
Gross Domestic Product

If G exceeds NT, the government has a budget deficit
(G – NT) and the government borrows from the financial
If NT exceeds G, the government has a budget surplus
(NT – G) and this surplus flows to the financial markets.
If imports exceed exports, the deficit with the rest of the
world (M – X) is borrowing from the rest of the world. Rest
of world saving finances some investment in Canada.
If exports exceed imports, the surplus with the rest of the
world (X – M) is lent to the rest of the world. Canadian
saving finances some investment in the rest of the world.
Gross Domestic Product

How Investment Is Financed
Investment is financed from three sources:
 Private saving, S
 Government budget surplus, (NT – G)
 Borrowing from the rest of the world (M – X).
Gross Domestic Product

We can see these three sources of investment finance
by using the fact that aggregate expenditure equals
aggregate income.
Start with
             Y = C + S + NT = C + I + G + (X – M).
Then rearrange to obtain
                  I = S + (NT – G) + (M – X)
Private saving S plus government saving (NT – G) is
called national saving.
Gross Domestic Product

Gross and Net Domestic Product
―Gross‖ means before accounting for the depreciation of
capital. Net value means therefore gross value -
To understand this distinction, we need to distinguish
between flows and stocks in macroeconomics.
Flows and Stocks in Macroeconomics
A flow is a quantity per unit of time; a stock is the quantity
that exists at a point in time.
Gross Domestic Product
Wealth and Saving
Wealth, the value of all the things that people own, is a
stock. Saving is the flow that changes the stock of wealth.
Wealth at the start of this year equals wealth at the start of
last year plus saving during last year.
Capital and Investment
Capital, the plant, equipment, and inventories of raw and
semi-finished materials that are used to produce other
goods, is a stock.
Investment is the flow that changes the stock of capital.
Gross Domestic Product

Depreciation is the decrease in the capital stock that
results from wear and tear and obsolescence.
Gross investment is the total amount spent on purchases
of new capital and on replacing depreciated capital.
Net investment is the change in the stock of capital.
   Net investment = Gross investment  Depreciation.
Gross Domestic Product

Figure 20.2 illustrates the
relationships among
capital, gross
investment, depreciation,
and net investment.
Gross Domestic Product

Back to Gross in GDP
Gross profits, and GDP, include depreciation. Similarly,
gross investment includes that amount of purchases of
new capital goods that replace depreciation.
Net profits, net domestic product, and net investment
subtract depreciation from the gross concepts.
The Short-Run Meets the Long-Run
Investment plays a central role in the economy. Increases
in capital are one source of growth in potential real GDP;
fluctuations in investment are one source of fluctuations
in real GDP.
Measuring Canada’s GDP

The Statistics Canada uses two approaches to measure
 The expenditure approach
 The income approach
1. The Expenditure Approach
 The expenditure approach measures GDP as the sum of
 consumption expenditure, investment, government
 expenditures on goods and services, and net exports.
                GDP = C + I + G + X  M
Measuring Canada’s GDP
The Income Approach
   The income approach measures GDP by summing the
   incomes that firms pay households for the factors of
   production they hire.
1. Wages and salaries
2. Corporate profits
3. Interest and miscellaneous investment income
4. Farmers’ income
5. Income from non-farm unincorporated businesses
   The sum of these five income components is net
   domestic income at factor cost.
Measuring Canada’s GDP

   GDP is measured in market price and includes
   depreciation but the aggregate income is measured in
   factor prices and excludes depreciation.
So two adjustments must be made to get GDP from
   aggregate income:
1. Indirect taxes minus subsidies are added to get from
   factor cost to market prices.
2. Depreciation (or capital consumption) is added to get
   from net domestic product to gross domestic product.
Real GDP and the Price Level

    In 2003, Canada’s (nominal) GDP was $1207 billion;
    in 2004 it was $1290 billion. This increase must be
    due to
1. Production of more goods and services and/or
2. Increase in the market prices of goods and services.

   The production of more goods and services adds to
   the standard of living but higher prices do not. That
   means change in (nominal) GDP is not a good
   measure of changes in standard of living.
   We measure the increase in production by real GDP.
Real GDP and the Price Level

 Real GDP is the value of final goods and services
 produced in a given year when valued at constant prices.
 Nominal GDP
 The value of the final goods and services produced in a
 given year valued at the prices that prevailed in that
 same year.
Calculating Real GDP
 The first step in calculating real GDP is to calculate
 nominal GDP.
Real GDP and the Price Level

Nominal GDP Calculations      Item    Quantity   Price
The table provides data for   2005
2005 and 2006.
                              Balls       100       $1.00
In 2005,
                              Bats         20       $5.00
Expenditure on balls = $100
Expenditure on bats = $100
                              Balls       160       $0.50
Nominal GDP = $200
                              Bats         22      $22.50
Real GDP and the Price Level

In 2006,                     Item    Quantity   Price
Expenditure on balls = $80
                             Balls       100       $1.00
Expenditure on bats = $495
                             Bats         20       $5.00
Nominal GDP = $575

                             Balls       160       $0.50
                             Bats         22      $22.50
Real GDP and the Price Level

Base-Year Prices Value
of Real GDP
                              Item    Quantity   Price
This method of calculating
real GDP (the traditional     2005
method) was to value each     Balls       100       $1.00
year’s output at the prices
of a base year.               Bats         20       $5.00
In the base year, real GDP
equals nominal GDP.
Suppose 2005 is the base      Balls       160       $0.50
year, then real GDP in
                              Bats         22      $22.50
2005 is $200.
Real GDP and the Price Level

Using the traditional
method real GDP in 2006:     Item    Quantity   Price
Expenditure on balls in      2005
2006 valued at 2005 prices
                             Balls       100       $1.00
is $160.
Expenditure on bats in       Bats         20       $5.00
2006 valued at 2005 prices
is $110.
So real GDP in 2006 would    Balls       160       $0.50
be recorded as $270.         Bats         22      $22.50
Real GDP and the Price Level

The New Method
The new method of calculating real GDP, which is called
the chain-weighted output index method, uses the
prices of two adjacent years to calculate the real GDP
growth rate.
This calculation has four steps described on the next slide.
Real GDP and the Price Level
Step 1: Value last year’s production and this year’s
production at last year’s prices and then calculate the
growth rate of this number from last year to this year.
Step 2: Value last year’s production and this year’s
production at this year’s prices and then calculate the
growth rate of this number from last year to this year.
Step 3: Calculate the average of the two growth rates. This
average growth rate is the growth rate of real GDP from
last year to this year.
Step 4: Repeat steps 1, 2, and 3 for each pair of adjacent
years to link real GDP back to the base year’s prices.
Real GDP and the Price Level

We’ve done step 1.             Item    Quantity   Price
Value of 2005 quantities at    2005
2005 prices (GDP in 2005)
                               Balls       100       $1.00
is $200.
Value of 2006 quantities at    Bats         20       $5.00
2005 prices is $270.
At 2005 prices, the value of
production increased from      Balls       160       $0.50
$200 to 270—an increase
of 35 percent.                 Bats         22      $22.50
Real GDP and the Price Level

Step 2.                        Item    Quantity   Price
Value of 2005 quantities at    2005
2006 prices is $500.
                               Balls       100       $1.00
Value of 2006 quantities at
2006 prices (GDP in 2006)      Bats         20       $5.00
is $575.
At 2006 prices, the value of
production increased from      Balls       160       $0.50
$500 to $575—an increase
of 15 percent.                 Bats         22      $22.50
Real GDP and the Price Level

Step 3.
At 2005 prices, the 2006   Item    Quantity   Price
growth rate = 35 %.        2005
At 2006 prices, the 2006   Balls       100       $1.00
growth rate = 15 %.
The average growth rates   Bats         20       $5.00
= 25 %.
So with 2005 as the base
year, real GDP in 2006 =   Balls       160       $0.50
1.25 x $200 = $250 (25%
more that in 2005).        Bats         22      $22.50
Real GDP and the Price Level

Step 4.                         Item    Quantity   Price

Real GDP in 2005 = $200         2005
Real GDP in 2006 = $250.        Balls       100       $1.00
We can repeat Steps 1, 2        Bats         20       $5.00
and 3 for 2006 and 2007
and so forth.                   2006
Thus each year’s real GDP       Balls       160       $0.50
is linked to base year’s real
                                Bats         22      $22.50
GDP – a chain linking.
Real GDP and the Price Level

  Chain Linking
  Each pair of years is like
  a link in a chain.
  The entire chain links
  the current year back to
  the base year, 2003 in
  this example (on the
Real GDP and the Price Level

Calculating the Price Level
 The average level of prices is called the price level.
 GDP deflator
 One measure of the price level is the GDP deflator,
 which is average of current prices expressed as a
 percentage of base-year prices

       GDP deflator = (Nominal GDP ÷ Real GDP) x 100
Real GDP and the Price Level

In 2005, the GDP deflator is ($200/$200)  100 = 100.
The GDP deflator in base year = 100.
In 2006, the GDP deflator is ($575/$250)  100 = 230.

          Year    Nominal    Real       GDP
                   GDP       GDP       deflator
          2005     $200      $200        100

          2006     $575      $250        230
Real GDP and the Price Level

Deflating the GDP Balloon
 Nominal GDP increases because production—real GDP–
Real GDP and the Price Level

Nominal GDP also increases because prices rise.
Real GDP and the Price Level

 We use the GDP deflator to let the air out of the nominal
 GDP balloon and reveal real GDP.
Measuring Economic Growth

We use real GDP to calculate the economic growth rate.
The economic growth rate is the percentage change in
the quantity of goods and services produced from one year
to the next.
Econ growth = (real GDP07 – real GDP06)x100/ Real GDP06
We measure economic growth so we can make:
 Economic welfare comparisons
 International comparisons
 Business cycle forecasts
Measuring Economic Growth
Economic Welfare Comparisons
 Economic welfare measures the nation’s overall state of
    economic well-being.
Real GDP is not a perfect measure of economic welfare for
  seven main reasons:
1. Quality improvements tend to be neglected in
   calculating real GDP, so the inflation rate is
   overestimated and real GDP is underestimated.
    E.g., when car prices rise because cars have become
    safer and more fuel efficient, GDP deflator counts it as
    inflation (rather than increase in real GDP).
Measuring Economic Growth
2. Real GDP does not include household production such
   as cooking, cleaning, etc (which are not paid).
3. Real GDP, as measured, omits the underground
   economy, which is illegal economic activity or legal
   economic activity that goes unreported for tax
   avoidance reasons.
4. Health and life expectancy are not directly included in
   real GDP.
5. Leisure time, a valuable component of an individual’s
   welfare, is not included in real GDP.
6. Environmental damage is not deducted from real GDP.
7. Political freedom and social justice are not included in
   real GDP.
Measuring Economic Growth

International Comparisons
 Real GDP is used to compare economic welfare in one
 country with that in another.
 Two special problems arise in making these
 Real GDP of one country must be converted into the
 same currency units as the real GDP of the other country,
 so an exchange rate must be used.
 The same prices should be used to value the goods and
 services in the countries being compared, but often are
Measuring Economic Growth

Using the exchange rate to compare GDP in one country
with GDP in another country is problematic because prices
of particular products in one country may be much less or
much more than in the other country.
In 2003, US per capita real GDP = $39,000 and China’s
per capita real GDP = 9,500 Yuan. So if we use the
prevailing exchange rate of $ 1 = 8.27 Yuan, U.S. real
GDP per person was 34 times Chinese real GDP per
Another alternative is to value all the goods and services
produced in China at the prices prevailing in the US. That
means if a haircut in the US costs $15, then a haircut in
China is also valued at US $15.
Measuring Economic Growth

Using purchasing
power parity prices
leads to an estimate
that U.S. GDP per
person is (only) 12
times that in China—
see Figure 20.4.
Measuring Economic Growth
Business Cycle Forecasts
 Real GDP is used to measure business cycle fluctuations.
 Although there are biases in real GDP measurement (for
 the seven reason mentioned), it does not necessarily cause
 a wrong assessment of the phases of the business cycle.
These fluctuations are probably accurately timed, but the
changes in real GDP probably overstate the changes in
total production caused by business cycles. This is because
when business activity slows in a recession household
production and leisure time increase so total production
does not slow as shown by real GDP measurement. The
same applies during an expansion.