Chapters 6 & 7 – Introduction & The Measurement of GDP
Outline
• What is macroeconomics? (Chapter 6) • The national accounts. (Chapter 7)
What is Gross Domestic Product (GDP)? 3 approaches to measure GDP.
Nominal GDP vs. Real GDP
• Price indexes. (Chapter 7)
Consumer price index (CPI) vs. GDP deflator.
Chapter 6 – Macroeconomics: The Big Picture
• Macroeconomicsisaboutthebigpicture,i.e.,itisthestudyofthebehaviour of the economy as a whole.
• Macroeconomics look at things in a different way than microeconomics, we focus on:
The interactions of different sectors in an economy (instead of what happens in a specific market and we cannot just add things up).
Macro has a strong policy focus.
• Issues that macroeconomists will look at:
Causes of the business cycles – the short-run alternation between recessions and expansions.
Factors that affecting the unemployment rate.
What should policy makers (the government and the central bank) do to
smooth out the business cycles?
Causes and costs of inflation.
What determine the long-run economic growth?
Our interactions with the rest of the world (exchange rate, trade balance).
An Expanded Circular-Flow Diagram
Note:
• Total spending on final goods and services = consumer spending +
investment spending + government purchases of goods and services +
exports – imports
• Total spending on final goods and services = Total value of all final goods
and services produced within a country (Gross domestic product)
Chapter 7 – GDP and the CPI: Tracking the Macroeconomy
The National Account Gross Domestic Product
• Grossdomesticproduct(GDP)isthetotalvalueofallfinalgoodsandservices
produced in the economy during a given year.
It only includes goods and services sold to final/end users, i.e., intermediate
goods and services are not counted.
It looks at the value of products produced within the economy.
• There are 3 ways to measure GDP, and they are: 1) The value-added approach.
2) The expenditure approach.
3) The income approach.
The Value-Added Approach
• This approach focuses on the value added of each producer in the economy.
Value added = Value of the sales – Value of the purchases of intermediate goods and services.
Example: An economy consists of 3 firms only – Canadian Ore, Inc. (CO), Canadian Steel, Inc. (CS), and Canadian Motors, Inc. (CM).
Canadian Ore (ore – sold to CS)
Canadian Steel (steel – sold to CM)
$4200
$9000
$0
$4200
$2000
$3700
$1000
$600
$200
$300
$1000
$200
Sales
Canadian Motors (car – sold to consumers) $21500
Intermediate goods $9000
Wages
Interest payments Rent
Profit
• Using the value-added approach to find the GDP. Value-added of Canadian Ore =
Value-added of Canadian Steel = Value-added of Canadian Motors =
GDP =
$10000
$1000
$500
$1000
The Expenditure Approach
• Itaddsupexpenditureondomesticallyproducedfinalgoodsandservicesby
households, firms, governments, and foreign buyers.
• Total expenditure is the sum of 4 major categories:
1) Consumption (C) – spending by households on goods and services.
2) Investment (I) – spending on goods that are not for present consumption. It includes both private investment and public investment. There are 3
types of investment:
➢Business fixed investment – the purchases of capital equipment,
machinery and production plants.
➢ Residential investment – the building of new houses.
➢ Inventory investment – the change in the quantity of goods that firms
hold in storage, including materials and supplies, work in process, and
finished goods.
3) Government spending (G) – spending on goods and services by different
levels of government, exclusive of government transfer payments. 4) Net exports (NX), NX = Exports (X) – Imports (IM)
➢Consumption, investment, and government spending may include imported goods (goods made in foreign countries), and these imported goods should not be included in the country’s GDP; thus, we need to subtract imports.
• According to the expenditure approach, GDP is given by: GDP = C + I + G + X – IM = C + I + G + NX
Example (continued):
Sales
Canadian Motors (car – sold to consumers) $21500
Canadian Ore (ore – sold to CS)
Canadian Steel (steel – sold to CM)
$4200
$9000
$0
$4200
$2000
$3700
$1000
$600
$200
$300
$1000
$200
Intermediate goods $9000
Wages
Interest payments Rent
Profit
$10000
$1000
$500
$1000
• Using the expenditure approach to find the GDP.
GDP = Consumption + Investment + Gov’t spending + Net exports
The Income Approach
• It looks at income earned from production of goods and services.
• There are two sources of income:
1) Factor incomes – income earned by factors of production or inputs such as wages, salaries, interest, rent, business profits.
2) Non-factor payments – the difference between the prices paid for final goods and services and the amount received by production factors before income taxes are removed. Non-factor payments include net indirect taxes, capital depreciation.
Example (continued):
Canadian Motors
(car – sold to consumers)
Sales $21500
Canadian Ore (ore – sold to CS)
Canadian Steel (steel – sold to CM)
$4200
$9000
$0
$4200
$2000
$3700
$1000
$600
$200
$300
$1000
$200
Intermediate goods
$9000
Wages $10000
Interest payments
$1000
Rent $500
Profit
$1000
GDP = Wages + Interest payments + Rent + Profit + Non-factor payments
• Using the income approach to find the GDP.
• Both expenditure approach and the income approach gave the same GDP.
What GDP Tells Us
• GDP is the most commonly used measure of the size of an economy, which allows us to compare a country’s economic performance to other countries.
• However, the following items are not included in the GDP: Inputs and intermediate goods and services.
Used goods.
Financial assets such as bonds, stocks, mutual funds.
Foreign-produced goods and services.
Household production and volunteer work.
Underground economy transactions and illegal activities.
Harm done to the environment during the production or consumption of
goods.
• Gross domestic product (GDP) vs. Gross national product (GNP)
GDP measures the sum of all final goods and services produced within a country.
GNP measures the sum of all final goods and services produced by a country’s residents.
GNP = GDP + (Income earned by Canadians outside Canada – Income earned by foreigners in Canada)
GNP = GDP + Net factor income earned abroad
Real GDP: A Measure of Aggregate Output
• We have to be careful when using GDP to make comparisons over time because an increase in GDP might cause by increases in prices of goods and services, an increase in production, or a combination of both.
• To have an accurate measure of economic growth, we look at real GDP.
Calculating Real GDP
• Nominal GDP measures the value of all final goods and services produced in the economy during a given year, calculated using the prices in the year in which the output is produced (i.e., the current year prices).
Nominal GDPt (NGDPt) = P1,tQ1,t + P2,tQ2,t …+ Pn,tQn,t = ∑𝑛 𝑃 𝑄 𝑖=1 𝑖,𝑡 𝑖,𝑡
where Pi,t = price of good i in time t
Qi,t = quantity of good i produced in time t
• Real GDP measures the total value of all final goods and services produce in the economy during a given year, calculated using the prices of a selected base year.
Real GDPt (RGDPt) = P1,Base yearQ1,t + P2,Base yearQ2,t …+ Pn, Base yearQn,t
=∑𝑛𝑃 𝑄
𝑖=1 𝑖,𝐵𝑎𝑠𝑒 𝑦𝑒𝑎𝑟 𝑖,𝑡
Example: Let Year 1 be the base year.
Price
Good X
Good Y
Good X
$1
$2
10
$1.5
$3
20
$2
$4
20
Quantity
Year Good Y
1 15
2 30
3 30 • Find nominal GDP. (Use current year quantities & current year prices).
Nominal GDP1 (NGDP1) = NGDP2 =
NGDP3 =
• Compute the real GDP (Use current year quantities & base year prices). Real GDP (RGDP1) =
RGDP2 =
RGDP3 =
What Real GDP Doesn’t Measure
• Real GDP takes out the effect of price changes on the value of production. However, a country with a larger population tends to have a higher GDP.
• RealGDPpercapitalisusedtoeliminatetheeffectofdifferenceinpopulation size:
Real GDP per capita = Real GDP Population
• Real GDP per capita is a commonly used measure to compare labour productivity across countries. Some even use it to compare living standard across countries because countries with higher real GDP per capita tend to have higher living standard. But, we need to use it with caution because: It only gives us a measure of the economy’s average output per person; it
ignores the distribution of output.
It does not address how a country uses that output to affect living standards.
Price Indexes and the Aggregate Price Level
• In this section, we will learn how to measure the aggregate price level, the measure of the overall level of prices in the economy.
Market Baskets and Price Indexes
• Therearedifferentpriceindexessuchastheconsumerpriceindex(CPI),the producer price index (PPI), and the GDP deflator.
• The inflation rate is the percentage change of a price index.
The Consumer Price Index (CPI)
• It measures how fast the cost of a basket of goods and services bought by a typical Canadian household has changed over time, which is the most commonly used measure to compute inflation rate
• It uses a fixed basket of goods and services because the quantities in the basket, i.e., the weights of the basket, are held fixed at the base-year level.
• To construct the CPI, Statistics Canada will:
Choose a base year.
Determine the market basket of goods and services purchased by a typical
household.
Compute the cost of that basket (COB) in different years:
COBt=∑𝑛 𝑃𝑄
𝑖=1 𝑖,𝑡 𝑖,𝐵𝑎𝑠𝑒 𝑦𝑒𝑎𝑟
CPI in year t = Cost of (fixed) market basket in year t × 100 Cost of (fixed) market basket in base year
Figure 7-6 – The Makeup of the Consumer Price Index in 2015
Other Price Measures
• The other price measures that are widely used to track changes in prices are: 1) Industrial producer price index (IPPI)
It measures the wholesale cost of a typical fixed basket of good purchased
by producers, items enter IPPI include raw materials such as coal, steel, and
other inputs such as electricity.
The IPPI tends to respond to inflationary or deflationary pressure more
quickly than the CPI, it serves as a “leading indicator” of changes in the
inflation rate.
2) GDP deflator
It is a current weighted price index, i.e., it uses the currently quantities of all goods and services that enter into GDP as weights.
The GDP deflator for a year t is given as:
GDP deflator in year t = Nominal GDP in year t × 100 Real GDP in year t
Example: The economy only produces 2 goods & they are bought by households only.
Year 2 (Current year) Quantity
Good X 6
Good Y 1.5 Use the CPI to find the % change in Prices from Year 1 to Year 2
• Cost of base-year basket in year 1, COB1 =
• Cost of base-year basket in year 2, COB2 =
• CPI1 = COB1 × 100 = 100 (because year 1 is the base year) COBBase year
• CPI2 = COB2 × 100 = COBBase year
Year 1 (Base year)
Price
Quantity
Price
$3
4
$5
$10
2
$30
Year 1 (Base year)
Price
Quantity
Price
$3
4
$5
$10
2
$30
Year 2 (Current year) Quantity
Good X 6
Good Y 1.5 Use the GDP Deflator to find the % change in Prices from Year 1 to Year 2
• NGDP2 =
• RGDP2 =
• GDP deflator1 = 100 (because year 1 is the base year)1
• GDP deflator2 = NGDP2 × 100
RGDP2
1 Both nominal and real GDP in year 1 are equal to $32.
Differences between the GDP deflator and the CPI
1) The CPI uses the bundle purchased by a typical household; while the GDP
deflator uses the bundle produced within the country.
Changes in the prices of imported consumption goods.
GDP deflator: CPI:
Changes in the prices of domestically produced goods that are only bought by firms or government.
GDP deflator:
CPI:
2) The GDP deflator uses the bundle that is currently produced and the CPI uses a fixed bundle (the base-year bundle).
Nominal GDP t
Real GDP t
Cost of Basket Cost of BasketBase year
∑𝑛 𝑃 𝑖=1 𝑖,𝑡
𝑄 𝑖,𝑡
GDP deflatort =
× 100 =
∑𝑛 𝑖=1
× 100
𝑖=1 𝑖,𝑡 𝑖,𝐵𝑎𝑠𝑒𝑦𝑒𝑎𝑟 ×100
𝑃𝑖,𝐵𝑎𝑠𝑒 𝑦𝑒𝑎𝑟𝑄𝑖,𝐵𝑎𝑠𝑒 𝑦𝑒𝑎𝑟
∑𝑛 𝑃
𝑖=1 𝑖,𝐵𝑎𝑠𝑒 𝑦𝑒𝑎𝑟 𝑖,𝑡
𝑄
CPIt =
t ×100=
∑𝑛 𝑃 𝑄