Fall Semester 10-11 Akila Weerapana

Lecture 2: Gross Domestic Product and its Variants

I. INTRODUCTION
The goal of the next four lectures is to understand what measures are commonly used to measure price and quantity (output) for the entire economy, understand how these aggregate measures of price and quantity are constructed and identify some of their shortcomings. A comprehensive set of accounts for the entire economy is available in the National Income and Product Accounts (NIPA), published by the Department of Commerce. We will not try to study the NIPA in great deal, instead we will focus on understanding how a few key measures of output are constructed and in doing so, learn more about what these measures fail to capture. Even though the study of National Income Accounts seems boring, it is important for us to have a good overview of the strengths and weaknesses of the process. Similarly it is important for countries to have good national income accounts; a country that has bad national income accounts opens the door to questionable and potentially harmful policy recommendations from those who study the data.

II. MEASURING THE SIZE OF THE ECONOMY

Gross Domestic Product (GDP) GDP is a measure of the value of new goods and services produced in the domestic economy during a particular time period. GDP is generally accepted by economists as the best measure of an economys production in a particular year. Note that GDP only counts goods and services that are newly produced during a specic time period within the countrys borders; used goods do not count towards GDP, nor do goods produced in foreign countries. How can we obtain a dollar value for goods and services? We use market prices to calculate the value of goods and services. GDP computed using market prices is often referred to as Nominal GDP. Consider an economy with only 2 goods: chocolate bars and pints of ice cream. Ice Price $3.50 $4.25 Cream Quantity 3000 3000 Chocolate Price Quantity $1.00 1500 $1.25 1000

Year 2008 2009

So we have GDP for 2008 = $3.50 3000 + $1 1500 = $12, 000 GDP for 2009 = $4.25 3000 + $1.25 1000 = $14, 000 Gross National Product (GNP) Some countries use Gross National Product as the measure of output. The U.S. also used GNP as its measure of output for a substantial period of time. GNP is the dollar value of new goods and services produced by domestic nationals and rms. So GNP for the U.S. would include all goods and services produced in other countries by U.S. citizens and companies but would exclude goods and services produced within the U.S. economy by foreign nationals and rms. GNP = GDP value of new goods produced in the U.S. by foreign entities +value of new goods produced abroad by U.S. entities For the U.S. presently GNP exceeds GDP; foreign individuals and rms produce less in the U.S. economy than U.S. citizens and rms produce in foreign countries. Since GDP is the more widely used measure of output, we will use GDP exclusively in this class to talk about output. Real Gross Domestic Product (Real GDP) In 1999 U.S. GDP was $9354 billion while in 2009 U.S. GDP was $14,119 billion. We can conclude that GDP increased by 51% over those 10 years. Does this mean that production of goods and services increased by 51% over that 10-year period? The answer is no. Remember that we value output using the market prices of goods. So changes in the price of goods will aect the value of GDP without any underlying change in production. Since there is a tendency for prices to rise in the economy: ination, we need to correct for ination to best compare changes in production over time. The measure of output that corrects for ination is known as Real GDP. Instead of using current market prices to calculate current GDP, we use some base years prices to calculate the dollar value of goods and services produced in the economy in a given year. If we compared Real GDP in 1999 and 2009 for the U.S. economy (in 2005 dollars, i.e. using 2005 as a base year) we nd that 1999 GDP in 2005 dollars (i.e. real GDP for 1999 calculated using prices from the base year of 2005) was $10,780 billion while the value of 2009 GDP in 2005 dollars (i.e. real GDP for 2009 calculated using prices from the base year of 2005) was $12,881 billion (This is only a 19.5% increase in real GDP which is smaller than the previously calculated 51% increase in nominal GDP.) Since nominal GDP allows both price and quantity to vary over time, it is inferior to Real GDP for measuring how output has changed over time. Real GDP is the best measure of the output of an economy over a period of time. Notice that real GDP requires the choice of a base year in which prices are stated. The choice of the base year is arbitrary, what is important is that prices for a base year be used for the calculations. Also note that by denition in the base year, real GDP=nominal GDP.

 We can get an idea about how to calculate Real GDP using our chocolate/ice cream economy. Ice Price $3.50 $4.25 Cream Quantity 3000 3000 Chocolate Price Quantity $1.00 1500 $1.25 1000

Year 2008 2009

Real GDP for 2008 (base year 2008) = $3.50 3000 + $1 1500 = $12, 000 Real GDP for 2009 (base year 2008) = $3.50 3000 + $1 1000 = $11, 500 Notice that even though GDP rose from $12,000 to $14,000 during this period, real GDP actually fell. Notice also that it is real GDP which accurately reects the fact that output fell - clearly since the quantity of ice cream is unchanged and the quantity of chocolate fallen, it must be the case that output has decreased in the economy. Per Capita GDP Even though GDP increased by 51% over the 10 years between 1999 and 2009, the number of people living in the United States also increased over that time period. So to get a better understanding about the well being of individuals in the country, we look at GDP percapita. GDP per capita (also referred to as GDP per person) is the value of all goods and services produced per person in the economy. It is calculated as GDP per capita = GDP Population

GDP per capita is also a better measure of comparing countries with dierent populations. For example, Indias GDP is 11 times higher than Norways but GDP per capita in Norway is about 70 times as high as Indias. People living in a country with high GDP per capita are likely to have more material possessions; food, clothing, cars, electronics etc. Since real GDP is superior to nominal GDP for comparing the value of output over time, we will in fact use real GDP per capita to measure the well-being of individuals in a country over time. Real GDP Real GDP per capita = Population Potential GDP In the last lecture we looked at a graph of real GDP for the United States and commented on two salient features, the rising trend and the uctuations around the trend. It will be useful to give a name to the upward trend line in real GDP which we will call potential GDP. Potential GDP represents the long-run tendency of the economy to grow.

 Note that potential GDP is not the maximum amount of real GDP. As we saw in the data series shown in class, sometimes real GDP goes above potential GDP. Instead, think of potential GDP as more like the average or trend level of real GDP. Unlike real GDP, potential GDP is not something we calculate explicitly. We also do not know the exact value of potential output at a point in time. Why? Because if we have a sustained period of time where GDP is higher than trend, it could be the case that potential output itself has changed - much like what we saw happened in China and India. There are also dierent ways in which one can estimate a trend line for an economy, each of these methods will generate a slightly dierent estimate of potential GDP. The following diagram illustrates the relationship between real GDP and potential GDP, as calculated by the Congressional Budget Oce.
15000

Real GDP and Potential GDP

0
1950q1

billions of 2005 dollars 5000 10000

1960q1

1970q1 Real GDP

1980q1 quarter

1990q1

2000q1

2010q1

Potential GDP

GDP at PPP We showed earlier how changes in price over time complicate our ability to compare how the size of an economy grows over time, and how we had to come up with a concept known as real GDP to correct for this. Similar problems arise when we are trying to compare GDP (or GDP per capita) across countries at a given point in time. Such comparisons are complicated by two factors - the large uctuations in the market exchange rates that we typically use to convert something denominated in one currency into another currency, and the substantial price dierences (especially in non-tradeables) in mostly identical goods and services across countries. Both the problems and the solution are best illustrated with an illustrative example. Consider the comparison of Japan and Sri Lanka given in the table.1 Japan 450,000 billion yen 150 million 3 million yen Sri Lanka 2,500 billion rupees 20 million 125,000 rupees

GDP Population GDP per capita

Comparing across countries is obviously a challenge since each countrys GDP is calculated in their own currency. One alternative is to convert the GDP of the countries in question
The numbers dont really correspond to a particular year, I have chosen them so that the rough magnitudes are correct and that things divide easily
1

into dollars using the market exchange rate, which is simply how many units of one currency can be bought with another currency. So we could, for example, convert everything into U.S. dollars and compare across countries. Suppose the market exchange rates were 75 yen per $ and 100 rupees per $. We can then convert everything into dollars; the results are below. We would then conclude that Japan has an economy that is about 300 times as large as Sri Lankas economy and that an average Japanese income is about 40 times as much as the average Sri Lankan income. Japan 450,000 billion yen 3 million yen 75 yen per $ $6,000 billion $40,000 Sri Lanka 2,500 billion rupees 125,000 rupees 100 rupees per $ $25 billion $1,000

GDP GDP per capita Exchange Rate GDP GDP per capita

This conversion, while allowing us to compare across countries by converting everything into dollars, is fraught with its own problems. First, market exchange rates are very volatile. So if tomorrow, the market exchange rate for the yen changed to 100 yen to 1 U.S. dollar, we would then calculate that GDP in Japan is $4,500 billion. In other words we would be claiming that the value of goods and services produced in the economy fell by about 25% overnight. This clearly is not the case. Second, the purchasing power of a dollar varies greatly across countries. Consider a collection of goods and services that I can buy for $100 in the United States. It is very likely that that collection of goods will cost much less in a country like Sri Lanka. and cost much more in a country like the U.K. or Japan. For example, it costs me $20 to get a haircut in Wellesley but a comparable haircut may cost (the equivalent of) $40 in Japan and $5 in Sri Lanka. But if we allow the same good to contribute much more to GDP in some countries and much less to GDP in other countries, then we will not be able to compare accurately across countries. Put another way, Japans GDP may not be as high as what we calculated above if we take into account the fact that goods typically cost more there, and Sri Lankas GDP may not be as low as what we calculated above if we take into account the fact that goods typically cost less there. The solution is to convert GDP into a common currency (so that it is comparable) but use something other than the market exchange rate. Instead, we use something called the Purchasing Power Parity exchange rate (PPP). The PPP exchange rate is one that equalizes the price of a collection (basket) of goods in country to the price of that basket in a base country in a base year. Typically the base year is 2000 and the base country is the United States. An example will help clarify matters. Suppose the PPP basket consists of goods that cost $1000 to buy in the United States in 2000. At market exchange rates, that $1000 is the equivalent of 100,000 Sri Lankan rupees. However, since the items in the basket are typically cheaper in Sri Lanka than in the U.S. you may only need 50,000 rupees to buy the basket. In this case, the PPP exchange rate would be 50 rupees to the dollar (Price of basket = 50,000 rupees in Sri Lanka =1000 dollars in the U.S.).

 Conversely, $1000 is the equivalent of 75,000 Japanese yen at the market exchange rate. However, since the items in the basket are typically more expensive in Japan than in the U.S. you may need as much as 100,000 yen to buy the basket. In this case, the PPP exchange rate would be 100 yen to the dollar (Price of basket = 100,000 yen in Japan =1000 dollars in the U.S.). We can then convert everything using PPP exchange rates as shown below. Sri Lankas GDP in PPP terms is now $ 40 billion (much higher than when we expressed it using market exchange rates) and Japans GDP in PPP terms is $ 4.5 trillion (lower than when we expressed it using market exchange rates). Japan 450,000 billion yen 3 million yen 100 yen per $ $4,500 billion $30,000 Sri Lanka 2,000 billion rupees 100,000 rupees 50 rupees per $ $40 billion $2,000

GDP GDP per capita PPP Exchange Rate GDP in PPP terms GDP per capita in PPP terms

Another way of describing the numbers above is as follows. We calculated GDP per capita of $1,000 for Sri Lanka and $40,000 for Japan; and GDP per capita in PPP terms of $2,000 for Sri Lanka and $30,000 for Japan. Since the PPP numbers are calculated relative to the United States, what this says is that Sri Lankans on average earn about $1,000 but that is equivalent to earning about $2,000 in the United States. Japanese on the other hand earn about $40,000 but that is equivalent to earning about $30,000 in the United States. Overall, we would conclude that Japanese are about 30 times as well o than Sri Lankans (compared to the 40 times gure we would get from market exchange rates). So GDP measured using PPP exchange rates (GDP in PPP terms) is the best way to compare output across countries both to avoid undue uctuations of market interest rates and to correct for dierential prices for similar goods across countries.