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1.DefiningGDP(GrossDomesticProduct)
GDPincludesthetotalvalueoffinalproductsthatareproducedandsold(andnotresold)withinthecurrent
year.In1947,percapitaGDPoftheUSwasonlyabout$1700,buthassincegrowntoabout$47,000in2008,
andhasnotbeenincreasinginrecentmonths,duetotheworstrecessionlastyear.Thegrowthratehasbeen
about5.5%peryear.Ofcourse,muchofthisreflectsinflation.Forthesameperiod,theinflationrate(GDP
deflator)hasbeenabout3.5%.Thus,thenetorrealpercapitaGDPgrowthratehasbeenabout2%intheUS.
DuringthepostWWIIperioduntilabout1980,businesscycleshadshortduration.Arecessionoccurred
abouteveryfiveyears.After1980,itoccurredonceadecade.
2.Whichproductsareexcluded?
1.Exclusionofnonmarket
products
Inafreemarketeconomy,GDPincludesonlythoseproductsthatare
soldthroughthemarket.Thatis,consumersarewillingtopayprices
fortheproductstheyconsume.Inprinciple,GDPdoesNOTinclude
thoseproductsconsumersdonotpayfor.Thisisakindof
chauvinisticmeasure,notcountingthevalueofoutputsthatare
producedandconsumedbymanyhouseholdssuchashomecooking,
babysitting,servingandhelpingothermembersofthehousehold.
Wedonotincludethevalueoftheseproducts,primarilybecauseitis
difficulttoputvaluesonsuchhouseholdservicesthatdonotgo
throughthemarketmechanism.
Inrecentyears,GDPofnorthernEuropeancountriesaremuch
higherduetotheinclusionofmanyservices(suchasbabysitting)
thataremutuallysoldbetweenhouseholds.
2.Nointermediategoods
Somegoodsareusedasingredientinputstoproduceothergoods.
Forinstance,assumethereareonlytwotypesoffarmers,one
producingcornandtheotherpork.Ifcornfarmersproduce$1billion
worthofcorn,whichareonlyusedasfeedtoproduce$2billion
worthofpork,weshouldnotaddthevalueofcornusedasinputto
obtainGDP.Likewise,GeneralMotorsbuyhighstrengthsteelto
makechassis.WeshouldnotaddthevalueofGMcarssoldandthat
ofsteel.Thisresultsindoublecounting.
GDPdoesnotincludethevalueofintermediateinputs(inthiscase,
corn)butonlythevalueoffinalproducts.Alternatively,wecan
sumthevalueaddedofeachindustrytoobtainGDP.
3.Badsandresource
depletionareexcluded
Environmentalpollution,watercontaminationandresourcedepletion
areexcluded.GDPisnotreducedbypollutionandbadsthatare
producedintheprocess.
Eventhoughresourcesaredepleted,theireconomicvalueorcosts
areexcludedintheGDPcalculation.
Outputsproducedbyillegalactivitiesareexcluded.
4.IllegalGoods
Undergroundeconomy:howbigitisisnotknown.Insome
countries,itcouldbeover10%ofGDP.
Illegaltrade(narcotics,etc.)
3.TheExpenditureApproach
Withthisapproach,GDPistheamountmarketparticipantsspendonfinalgoodsandservicesoveragiven
periodoftime,usually1year.
GDP=C+I+G+(XM)
Expendituresofthehouseholdsectortobuydomestically
producedgoods.
Consumption
Thisunderstatestotalconsumptionbecauseimportsarenot
included.In2009,C=$10,130billion(70%ofGDP)
Nondurables=foodandclothing.
durables=longlivedconsumergoodssuchashouses,cars,washing
machines,etc.
services=insurance,travelservices.Asincomeincreases,service
shareincreases.(about2/3ofconsumption)
Investmentisthecreationofcapitalgoods,whichareusedto
producegoods.(buyingstocksisNOTinvestmenthere.)
Fixedinvestment(machinery,buildings,housingconstruction)
InventoryInvestment
Planned
inventory
Everybusinessneedsinventorytoconduct
business.Someareplanned.
unintendedinventoryaccumulationunsold
productspilingup.
Unintended
inventory
Investment
unintendedinventorydecumulationinventory
isdepletingfasterthanplanned.
Actualinventory=plannedinventory
equilibriumoutput.
Investmentisabout15%ofGDP.
However,investmentisthemostvolatilecomponentofGDP.
Investmentvolatilityisthesourceofbusinesscycles.$1billion
investmentcausesalargerchangeinGDP(multipliereffect,as
shownlater)
Someportionisneededtomaintainproductioncapacity(about10%)
=replacementinvestment.
Anythingabovereplacementinvestmentisnetinvestment,which
increasestheproductioncapacityoftheeconomy.
Governmetpurchasesofgoodsandservices.
Thereisnomarketforpublicgoods.Outputsofthegovernment
sectorisevaluatedbythepurchasingprices.Forexample,theoutput
ofagovernmentofficialishis/hersalary.
Governmentspending
employeesalaries,costsofpublicgoodsandservices.
TransferpaymentsareNOTincludedingovernment
spending.Thisisatransferofincomebetweenindividualsandfirms,
i.e.,fromtherichtothepoor(orviceversa)andbetweenfirmsand
households.
XM
NetExports
ExportsImports=netexports.
Imports=consumptiononimportedgoods.
Importsareanincreasingfunctionofincome.
4.GNPvsGDP
GrossNationalProduct
GNP=GDP+factorpaymentsfromothercountriesfactor
paymentstoothercountries.
factorpayments=interestpaymentsforforeignborrowingand
lending+dividendincomesfromthesubsidiariesofmultinational
firmslocatedinothercountries.
foreignwageincomesarenegligible.
GNPDepreciation
Capitalgoodsaredurableandlastmanyyears.Eachyear,some
portionisconsideredtobewornout(wearandtear).
Depreciationaccountsforabout10%ofGDP.
NetNationalProduct
Infrastructurecapital(suchashighways,bridges,dams)lasts
longer.Forinstance,highwaysandbridgeslastabout50years.
(concreteconstruction).
UShighwayswerebuiltduringEisenhoweradministration(1953
1961),andneedtoberebuilt.(Inotherwords,theUSdoesnot
havemodernhighways,becauseofdepreciation.)
GDPdepreciation
NetDomesticProduct
thenetvalueofoutputsproducedinthedomesticmarket.
(annual)Investmentmustexceed10%ofGDPfortheeconomy's
productioncapacitytogrow.
ReplacementInvestment
Ifreplacementinvestment=10%,thecountry'sproductive
capacityremainsconstant.
Ifreplacementinvestment>10%,theproductivecapacitygrows.
Intheabsenceofforeigncapital,moneytoinvestcomesfrom
domesticsavings.
Savings
Ifsavingsfalllessthan10%ofGDP,theeconomyisintrouble.
5.FourSectorsinatypicaleconomy
Householdsector
Businesssector
buysconsumptiongoodsfromthebusinesssector,andsupplies
laborandcapitalinputs(throughsavings).
producesproductsusingcapitalandlaborinputsandsellsthemto
consumers.
FinancialSectorispartofthebusinesssector:Itreceivessavings
fromthehouseholdsectorandlendsmoneytobusinessfirms.
Thegovernmentcollectstaxesandspendstherevenue.
Governmentsector
Redistributesincome,supposedlyfromthepoortotorichto
stabilizethesociety.
Whenincomedistributionisunequal,thereisahigherchanceofa
revolutionoroverthrowofthegovernment.
Foreignsector
Theforeignsectorbuysdomesticproductsandsuppliesforeign
productstodomesticconsumers.
6.TwinDeficits
Inrecentyears,theUSaswellasmanyEuropeancountriesaresufferingfromtwindeficits.These
governmentsarerunninglargebudgetdeficits,i.e.,governmentspendingfarexceedstaxrevenue.
Budgetdeficit
Tradedeficit
TG<0budgetdeficit
TG>0budgetsurplus(=TG)
XM>0tradesurplus(=XM)=netexports
XM<0tradedeficit
Atthesametime,thesecountriesareimportingfarmorethantheyexport,thusincurringtradedeficits.These
situationsdescribecountriesthatarenotinequilibrium.
7.Greece'sproblem
amphitheaterinAthens.
OlympicstadiumsinmanycountriesaremodifiedversionsofGreekamphitheaters.
Greeks(specifically,Cretans)inventedplumbing.
Greece'sGDP
$340billion
population
11million
percapita
GDP
$32,000(approximate)
Exports
$18billion
Imports
$61billion(TradeDeficit=$43billion)in2008
workhours
1800hours/year.(Japan=1830hours,USA=1777,SouthKorea=2400hours.China:no
reliablestatistics,maybe10hoursperday,sixdaysaweek.)
Government
spending
about40%.socialisteconomy
problem
biggovernment,nomanufacturing,nohightechindustry,peopledependonpensionsfor
whichtheyhavenotworked.
Thegovernmentneedstocutpensions,butpeoplearerevolting.
8.Equilibriuminaclosedeconomy
Aggregateexpenditureisdefinedas:
EC+I+G+(XM).
Ontheotherhand,totalpersonalincomemay
bespentonconsumption,savingsandtax.
YC+S+T.
Sinceincome=expenditure,
or
C+I+G+(XM)=C+S+T,
I+G+(XM)=S+T.
Ifthecountryisaclosedeconomy(X=
M=0),
then
Ifthegovernmenthasabudgetsurplus
ordeficit,thesituationisnot
sustainable,anditisnotalongrun(LR)
equilibrium.
thenLRequilibriumrequires
I+G=S+T.
I=S.
Thatis,LRdomesticequilibriumrequires
LRequilibriumrequiresthatthe
governmentbudgetbebalanced
(G=T),
investmentsavingsequality.
ThisistheoriginoftheIScurve,tobestudied
later.
9.DisposablePersonalIncome
DisposableIncomeistheportionofGDPthatconsumerscanspend.
WhydepreciationshouldnotbeincludedinnetGDP?
depreciation
depreciationisconsumptionofthecapitalgoods.Eachyearsomefractionofthe
capitalinputisusedupthroughwearandtear,andmustbereplenishedinorderto
maintaintheproductivecapacity.
Depreciationcostsarenotcountedascorporateprofits,andhenceshouldnotbepart
ofnetincome.
Whendepreciationisincludedinincome,wecallit"Gross"domesticproduct.
Net
Domestic
Product
=GDPdepreciation.
=firmspaysalestaxesandpropertytaxes(whicharegenerallyusedbylocal
governmentstobuildschools,highways,etc.)
Indirect
Business
Taxes
HongKonghasnosalestax,butinothercitieshavehighsalestax.
NewYorkcityhasahighsalestax,especiallyongoodstouristsbuy(hotels,
restaurants).
Intent:letvisitorspay.
Domestic
Income
=NDPIndirectBusinessTaxes.
Undistributed Corporationsdonotgenerallydistributealltheprofitstostockholders.
Corporate
Thesearecalledretainedearnings,andusedforfutureinvestment.
profits
10.ProblemsinComparingGDPoverTime
1.pricesarenotheld
constant
WhencalculatingandcomparingGDPovertime,weshouldremember
thatpricesarenotheldconstant.Inthe1970s,theworldeconomywas
greatlyperturbedbytwooilpriceshocks.Oilpricemorethanquadrupled
duringthisdecade.Oilisalsousedasinputinmanyindustries,andthe
pricesoftheseproductsalsorosesignificantly.
Accordingly,between1970and1978,GDPintheUnitedStatesmorethan
doubled.However,dollartheyardstickalsochangedinvalueduring
thisperiod,becausethepricesofmostgoodincreased.
InsteadofGDP,canweusephysicalquantitieswhichdonotchangevalue
overtimeasameaureofoutput?
No.quantitiesareimpractical.
2.CanWeUseQuantities?
ThemainproblemisthattheUSproducesmillionsofdifferentproducts
eachyear.Wecannotaddapplesandoranges,steelandwheat,because
theyaremeasuredindifferentunitsofmeasurement.Thatisthereasonto
useGDPinthefirstplace.
Wehavetousesomesortofpriceindextoadjustforthechangingvalueor
purchasingpowerofthedollar.Apriceindexcanbeusedtodeflatethe
nominalGDP(GDPincurrentdollars).
First,atypicalbundleofgoodsconsumersbuyischosenanditscostinthe
baseyearisgivenanindexof100.
Second,computethecostofthesamebundleinotheryears.Next,
computehowmuchmoreinanygivenyearrelatvetothebaseyear.Ifthe
indexis120thisyear,itmeansitcosts20%morethanthebaseyearto
purchasethechosenbundleofgoods.
3.PriceIndicesareused.
Priceindicesareusefulforcomparingoutputsoverashortperiod
oftime,saylessthan510years.
Notusefulwhencomparingincomesoverlongperiodsoftime,sayover
10years.
Why?theconsumptionbundleschangesignificantly.
VeryfewpeoplebuyVHSvideotapes.EvenDVDswillsoonbecome
obsolete.
Outputsareoftenmeasuredquarterly.
Thereareseasonalfluctuations.(about8%intheUS)
Incoldregions,seasonalvariationsarehigher,duetolongwinter.
4.Seasonaladjustment
Goodclimateisconducivetoeconomicactivities.
(i)cropsareharvestedinthefall
(ii)lessoutdooractivitiesareheldinthewinter.
Insteadofreportingrawdata,economistsoftenreportseasonallyadjusted
outputsbyeliminatingexpectedseasonalchangesoraveragingthe
outputs.
11.RealvsNominalGDP
Ifthereisnoinflation
RealGDP=NominalGDP
Thesamenominalincomehasmorepurchasing
power.
Ifdeflationoccurs
DeflationoccurredinJapaninthe1990s.
DeflationoccurredinHongKongaftertheAsian
financialcrisisin1997andendedonlyin2004.
Duringthisperiod,assetpricesfell.
Ifinflationoccurs
Thesamenominalincomeisworthless,andits
purchasingpowerdeclines.Sometimes,inflationis
calledthesilenttax.
12.NominalGDP
NominalGDP=ipiyi=p1y1+p2y2+...
wherepiandyiarethepriceandoutputofgoodiduringthecurrentyear.
NominalGDPissimplythesumofexpendituresoneachandeverygoodconsumedatcurrentprices.
Example
2009price
2009quantity
2009expenditure
200
200
10
10
100
30
300
9000
NomilalGDP=200+100+9000
=9300.
Thenextyear,bothpricesandoutputschange.
2010price
2010quantity
2010expenditure
300
300
10
20
200
50
200
10000
NominalGDP=300+200+10000
=10500.
ThetwotablesshownominalGDPincreasedfrom$9300to10500.
Doesitmeanconsumersarebetteroff?SincenominalGDPoverstatesrealGDPduringperiodsofinflation,
theextentofoverstatmentcanbeestimatedbytheGDPdeflator.
13.RealGDP
Pricesin2010aredifferentfromthosein2009.TogetrealGDPin2010,instead
ofusing2010prices,weusethebaseyear(2009)pricestoevaluatetotaloutputs.
2009price
2010quantity
hypothetical2010expenditureifpriceswere
heldconstant
300
300
10
20
200
30
200
6000
RealGDP=300+200+6000=6500.(Real
incomedeclined)
Whenthebaseyear(2009)pricesareused,thevalueofoutputsactuallyshrankin2010.WhilenominalGDP
in2010is10230,realGDPactuallydeclinedto6500.Thus,
GDPdeflatorin2010is=$10500/6500.
Becausepriceschangeovertime.
WhyrealGDP?
WhencomparingGDPfiguresovertime,nominalGDPsometimes
overestimatesrealoutputs.Thisisbecausepricesgenerallytendto
rise.
Whenincomerises
fasterthanprice
level
Consumersarebetteroff.
Whenincomerises
pricelevelalsorises.
Whenincomeis
stagnant
Usually,thepricelevelstillrises.Itdependsontheeconomy.
Whenincomefalls
inarecession
priceleveldoesnotrisemuch.Sometimesthepricelevelfalls.
Whenone'sincomerisesby10%inagivenyear,pricesarenot
generallyheldconstant.
Ifpricesfall,asinrecession,a5%fallinincomemeansrealincome
usuallyfallslessthan5%becauseoffallingprices.
However,onaverageduringanormalyear,pricestendtorise.
Ifpricesrise4%,a10%increaseinnominalincomerepresentsonlya
6%increaseinrealincome.
Nominalamountsareexpressedusingcurrentdollarprices,i.e.,they
areactualamountspaidorreceived.Thus,economistssometimesare
interestedinfiguringoutthechangesinrealincome,excludingthe
paymentsforriseinprices.
Oncepriceindicesarecalculated,realGDPcanbecalculatedusingtheaboveformula.Usually,anindex
numberof100isassignedtosomebaseyear.
Forinstance,ifoneisinterestedinGDPgrowthduringthepostWWIIera,onecanassignanindexof100to
1945or1946,andthencomputethepriceindicesforotheryears.
Whichbaseyearshouldoneuse?Italldependsonthepurposeofcomparison.
ChainWeightedMeasureofRealGDP
Relativepriceschangeover
time.
Forinstance,priceofpersonalcomputerskeeps
fallingeachyear.
Foodpricehasbeenrisingfasterthanothers.
BurealofEconomicAnalysis
choosesbaseyeareveryfive
years.
GDPsarecomputedduringthenextfewyears,
assumingpricesareheldconstantwhentheyare
not.
Since1995,chainweighted
measuresofrealGDPare
computed.
Theaveragepricesin2009and2010areusedto
measuretheGDPgrowthfrom2009to2010.
14.GDPperCapita
AhigherGDPisbetter,butdoesnotalwaysmakepeoplebetteroff.SometimesahigherGDPisbrought
aboutbyanincreaseinpopulation.Thus,ahigherGDPdoesnotnecesarilymeaneconomicgrowth.When
comparingwelfareovertimeandbetweencountries,weoftnuseGDPpercapita.WedivideGDPbythetotal
population.ToobtainrealGDPpercapita,onealsodividesrealGDPbythepopulation.
WorldGDP(misnomer,GrossWorldProduct)in2010isestimatedtobeabout$73trillion.PercapitaGWP
isabout$12,000in2010.
IfGDPrisesby3%,andalsothepopulationgrowsatthesamerate,thereisnochangeinwelfareofthe
representativepersoninthatcountry.
15.OtherProblemswithGDP
(1)Nonmarket
Transactions
Thesearethetransactionsoutsidethemarket,andhencethereisnoreliable
priceinformationaboutthem.Themostimportanttransactionexcludedfrom
theGDPistheservicesofhouswives.Thesearenotsoldinthemarket,and
hencenotenteredintotheGDP.
InLDCs,asignificantamountoffoodandclothingisproducedinthehome,
butnotincludedintheGDP.Thus,welfareisoftenunderstatedinLDCs.On
theotherhand,insomeEuropeancountries,differentfamiliespayoneanother
forbabysittingexpendituresandgettaxcredit,andtheseexpendituresare
includedinGDP.Thus,GDPtendtooverstatewelfareinthesecountries.
Thereisnotmuchdataaboutthemagnitudeoftheundergroundeconomy,
whichincludesbothlegalandillegaleconomies.Incomefromillegalactivities
arenotincludedintheGDP,andhenceGDPunderstatesactualeconomic
activities.Theyarenotexcludedbecausetheyareimmoral,buttheamounts
arenotreported.Also,cashpayments"underthetable"tocorruptofficialsand
businessmenarenotreported.
(2)TheUnderground
Economy
Also,asignificantamountisunderreportedbyselfemployedpeoplewhoare
doingbusinesslegally.
AccordingtoastudyofOECD(OrganizationforEconomicCooperationand
Development)countries,about17%ofeconomicactivitiesareunreported.
Also,blackmarketsarelargeindevelopingcountries.Incountriessuchas
Spain,Portugal,Italy,BelgiumandGreece,thisundergroundeconomy
exceeds20%.
Mostpeoplecangetaparttimejob,inadditiontotheirregularjobs,by
workingintheeveningsandonweekends.However,theychoosenotto.
Why?Becausetheyvalueleisuremorethantheadditionalincometheycould
earn!
Youcannotgotoparties,watchTV,orgotothemovies.Ifsomehowthese
peopleareforcedtoworkextrahours,GDPwillgoup,butnottheirwelfare.
GDPdoesNOTincludethevalueofleisure,althoughitisanimportant
elementofwelfare.
Annualworkinghours:
Korea:2400
(3)ValueofLeisure
Japan:1828
US:1777
UK:1650
Germany:1360
Netherlands:1300
India:28003400hours
13thcenturyfarmer:1600hours(UK)
UKin1840:3600
(Aswageraterises,workinghoursdecline)
Manyindustriesproducepollutionintheproductionprocess.Forinstance,a
(4)Pollutionandother
Externalities
steelmillproducespollutionwhileproducingsteelproducts.Likewise,theoil
industrypollutestheocean.Onlythevalueofoutputsproducedisincludedin
GDP,butnotthepollution.
Ifweareinterestedinmeasuringwelfare,thecostofpollutionshouldbe
subtractedfromthevalueofoutputs.
Iftheindustryorgovermentcleansupthemess,resourcesareusedup,and
theirvalueisincludedinGDP.Thus,GDPoverstatestheactualvalueof
outputs,whetherthepollutedenvironmentiscleanedupornot.
(5)QualityofGoods
GDPmissesanimportantelementofwelfare.ThequalityofTVs,washing
machines,computersandclothingarenotincludedinGDP.Forexample,
everyotheryearthequalityofpersonalcomputersseemtodoublebuttheir
priceshalved.
Whiletechnologicaladvancesoftenimprovethequalityoftheproductsand
hencewelfare,theylowerpricesandhencedecreaseGDP.
Source:ThomasWalter(http://www.geography.hunter.cuny.edu/~tbw/wc.notes/13.air.pollution/notes_chap13.htm)
16.WhyGDP?
Thereareothermeasuresofsocialwellbeing.Lifeexpectancies,infantmortalityrates,crimerates,health
care,etc.However,despiteallitsproblems,GDPisasingleindexthatmeasuresthevalueofoutputsofa
nation.Ittendstobepositivelyrelatedtowellbeing,butnotaprecisemeasureofsocialwelfare.
17.UnemploymentReducesGDP
Eachmonththegovernmentannouncestheunemploymentrate,thatsomanylostjobs,etc.Toverifywhether
oneisunemployed,thegovernmentneedstocontacteverybody.IntheUnitedStatesthisisdoneoncea
decade(decennialCensusofPopulation)Itiscostlytointerviewallworkers.Accordingly,thegovernment
conductscensusonlyoncein10years.Also,eachmonththeCensusBureauinterviewsabout60,000
households(orabout110,000individuals).Forstabilityonly1/4ofthesesamplesarereplacedeachmonth.
OftenthesuccessofaPresident'seconomicpolicyismeasuredbythenumberofjobscreated.Thisisavery
dangerouscriterion.(Remember:Associationisnotcausation!)
Onecansystematicallyhirepeopletobreakglassesofbuildingsandfactories.Theyneedtobe
repairedorreplaced,whichcreatejobsandincreasesGDP.However,thewellbeingofthecitizensdoesnot
increase,butactuallywilldecline,despitetheincreaseinjobscreatedandGDP.
TotalLaborForce=ArmedForces+CivilianEmployed+Unemployed.
HowtheGovernmentMeasuresUnemployment