Dr. Mohammed Alwosabi Econ 141: Macroeconomics - Ch.

Chapter 1
MEASURING GDP AND PRICE LEVEL

MEASURING EONOMIC ACTIVITY

— Macroeconomics focuses on the economic activity of a country. Overall, economic
activity is the pattern of transactions in which things of real useful value--
resources, goods and services--are created, transformed, and exchanged.
— Macroeconomics studies the aggregate (or total) concept of economic activity. Its
focus is on the aggregate output, the aggregate income, the general price level of
goods and services, the total jobs in the entire economy, etc.
— Macroeconomics discusses the issues and policies concerning economic growth,
unemployment, inflation, the government budget deficit, and the international trade
balance.
— Economic activity is measured by calculating gross domestic product (GDP).
This measurement is sometimes called national Income accounts.
— There are three ways to measure economic activity or GDP:
o Product (or Value Added) Approach: output produced by all firms to be
sold
o Expenditure Approach: amount spent by ultimate buyers
o Income Approach: income received by producers from the sale of the total
output
— The three approaches are equivalent. Any output produced (product approach) is
purchased by someone (expenditure approach) which results in income to someone
(income approach) ⇒ total production = total expenditure = total income.
— GDP provides a measure of total production, total expenditures, and total income.
— It can be used to make comparisons over time and across countries.
— So, what’s GDP?

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Dr. Mohammed Alwosabi Econ 141: Macroeconomics - Ch.1

GDP DEFINED (THE PRODUCT APPROACH)

— Gross Domestic Product (GDP) is the market value of all final goods and
services produced within the border of a country in a given time period.
— This definition contains four parts:
1. Market value
2. Final goods and services produced
3. Within the border of a country
4. In a given period of time
1. Market value:
o To measure total production we must add together the production of all final
goods and services produced in a country. Since we cannot add fruits to
clothes, computers to rice, and since we cannot add tons to units to meters to
gallons, it is necessary to convert all output to the same unit of measurement.
Conversion is to calculate the market value (market price) of each good and
service and then add them together. Thus, market value means valuing
production according to market price.
o Market value of a good = (Price of the good) * (Quantity of the good) = P*Q
o Example:
Suppose a country produces only three final goods. Quantities and prices of
these goods for two different years are given in the table below:
Good 1 Good 2 Good 3
Year GDP
Q $P/unit Q $P/unit Q $P/unit
2005 2000 1 3500 3 500 10 $ 17500
2006 3000 2 4000 2.5 700 11 $ 23700
GDP in 2005 = P1 Q1 + P2 Q2 + P3 Q3
= ($1) (2000) + ($3) (3500) + ($10) (500) = $17500
GDP in 2006 = P1 Q1 + P2 Q2 + P3 Q3
= ($2) (3000) + ($2.5) (4000) + ($11) (700) = $23700

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Dr. Mohammed Alwosabi Econ 141: Macroeconomics - Ch.1

o Using market value allows us to add goods and services produced together,
and to compare the GDP of one year to that of another. We can see here that
GDP increases in 2006. This means the economy has grown from 2005 to
2006.

2. Final Goods and Services:

o To calculate GDP we count only the value of the final goods and services
produced. We do not count intermediate goods.
o A final good (or service) is the good that does not require any further
processing in the market and is available for immediate consumption or use.
In other words, it is an item bought by its final user during a specified time
period.
o The bread bought by a consumer is a final good but the flour bought by the
baker is not. The flour bought by the baker is an intermediate good.
o An intermediate good (or service) is an item that is produced by one firm, bought
by another firm, and used as a component of a final good or service in the same
period. In other words, it is the good that requires additional processing before it is
sold to consumers for final use.
o Examples of intermediate goods: flour used to produce bread, tires used on the
car, and Intel Pentium chip inside a computer.
o Some goods can be intermediate goods in some situations and final goods in
other situations. For example, eggs may be used as a final good or an
intermediate good.
o Consumption goods, capital goods, government purchases, and inventory
investment are treated as final goods
o GDP counts only final goods and does not directly include intermediate goods
to avoid double counting, counting the same intermediate goods twice.

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Dr. Mohammed Alwosabi Econ 141: Macroeconomics - Ch.1

o Exercise:
Which of the following expenditures of a country is an intermediate good?
a. The government of a country buys new batteries for its military trucks
b. You buy a new battery for your used car
c. A car producer in the country buys new batteries to install in the cars it is
producing
d. A battery company in the country sells new batteries to other countries
o Exercise:
Which of the following is not considered a final good?
a. The purchase of a car by a household
b. A tailor buys textiles to make shirts
c. The purchase of food by household
d. A company buys a new machine for its production of goods
o Exercise
Bahrain Aluminum Company (BAC) produces and sells aluminum products.
If BAC sold an oven to a bakery that used it to produce breads, do you
consider this oven as an intermediate good or a final good?

3. Produced within the border of a country:

o Only goods and services that are produced within the border of a country
counted as part of that country’s GDP, irrespective of who produces them.
o Examples:
a. The income received by a Bahraini worker working in Dubai is part of
UAE’s GDP.
b. The market value of the product provided by a Malaysian company working
in Bahrain is part of Bahrain’s GDP.
c. Profits generated by a U. S. bank in Bahrain are included in Bahrain’s GDP.

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Dr. Mohammed Alwosabi Econ 141: Macroeconomics - Ch.1

4. In a given time period:

o GDP includes only goods and services that are newly produced within the
current year.
o GDP does not include purchases or sales of goods and services that were
produced in previous years. All used goods traded during that year are
excluded.
o The year of production not the year of sale determines the allocation of GDP.
o Goods that are produced this year, kept in inventories, and then sold to
consumers next year count in this year’s GDP
o Example:
Suppose a house newly built in 2003 but sold in 2004. The market price of
the house counted in the GDP of 2003 not in the GDP of 2004.

EXPENDITURE APPROACH:
— In this approach of measuring GDP, the expenditures on all final goods and
services made by all sectors of the economy are added to calculate GDP.
— Expenditures are divided into 4 different categories: consumption expenditure (C),
investment (I), government expenditure on goods and services (G), and net exports
over a period of time, which is exports minus imports (NX = X – M).
— Using expenditure approach, the largest component of GDP is usually personal
consumption expenditures.
— GDP can be computed as the sum of total expenditures of personal consumption,
gross private investment, government purchase of goods and services, and net
export over a period of time.
— If GDP denoted by Y then,
GDP = Y = aggregate expenditure = C + I + G + X – M = C + I + G + NX

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Dr. Mohammed Alwosabi Econ 141: Macroeconomics - Ch.1

Consumption (C)
— Firms sell and households buy consumers’ goods and services in the goods
markets. The total payments for these goods and services are called consumption
expenditure.
— Personal consumption expenditure (C) includes expenditures spent on goods and
services produced inside the country and the rest of the world.
— Buildings and houses are not included in the consumption expenditure. They are
part of the investment.
— Purchased of stocks and bonds are not part of consumption expenditure.

Investment (I)
— Investment (also called gross private domestic investment) (I) as used in
macroeconomics refers to
1. The purchase of new capital. Firms buy from each other new capital goods
such as machines, tools, equipments and buildings in the goods markets.
These new capital goods are used to produce other goods and services.
2. Some of what firms produce is not sold but is added to inventory (can be
considered as if the firm is buying from itself). Inventories include a firm’s
stock of unsold goods, goods in process and raw materials.
3. Purchases of all new residential buildings are also part of investment.
— Both capital goods and inventory investment are treated as final goods and
included in the GDP.
— Note - Investment does not include stocks or bonds or other financial assets. These
assets only involve transfers of ownership - no physical asset is directly created
because of these assets
— Example:
Goods that are produced this year, stored in inventories, and then sold to
consumers next year count in this year’s GDP

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Dr. Mohammed Alwosabi Econ 141: Macroeconomics - Ch.1

— Example:
If a Bahraini firm buys new machines from Japan, Bahrain’s investment would
increase.
— Exercise:
True or False: An example of investment in calculating this year GDP using
expenditure approach is the purchase of one year old beautiful house by a newly
married couple.
— Exercise:
A computer manufacturer makes a computer this year to be sold next year. This
computer will be counted in
a. next year ‘s GDP
b. next year’s investment
c. this year’s investment and this year’s GDP
d. next year’s investment and next year’s GDP

Government Expenditure (Purchase) (G)

— Government expenditure on goods and services (also called government purchase)
(G) may include buying goods and services from firms, building roads and bridges,
purchase of military equipment, purchase of furniture for offices, etc.
— Government collects taxes and uses tax revenue to pay for its purchase.
— Net tax = tax paid to government – transfer payments – interest payments on
government debt.
— Transfer payments are cash transfers from government to households such as
social security, unemployment compensation, and to firms such as subsidies.
— Transfer payments are government expenditures that do not represent purchase of
final goods or services and they are not related to current production so they are
not included in G and therefore not included in GDP.
— Exercise:
Which of the following is not included in 2004 GDP?

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Dr. Mohammed Alwosabi Econ 141: Macroeconomics - Ch.1

a. A landlord rents an apartment for BD400 per month during 2004

b. Bahraini government purchase of new tanks for its defense force in 2004
c. Bahraini government pays money for a student to attend college in 2004
d. A company buys new machines in 2004 for its production line.

Net Export:
— Countries trade with each other.
— Our country sells goods and services to the rest of the world. This is called the
value of exports (X). Exports are added because they are produced domestically
but not measured as part of C, I, or G.
— Our country buys goods and services from the rest of the world. This is called the
value of imports (M). Imports subtracted because they are typically included in C,
I, or G, but they are not domestic production.
— Total adjustment results in adding net export (NX)
NX = Exports – Imports = X – M
If X > M ⇒ NX > 0 ⇒ trade surplus
If X < M ⇒ NX < 0 ⇒ trade deficit
— Example:
If a Bahraini firm buys new machines from Japan, Bahrain’s net export would
decrease.
— Exercise:
If a furniture company makes 300 dining tables in 2003 and sold 200 of them in
the same year, using expenditure approach, how to count the unsold dining tables?
— Exercise:
Bahrain Aluminum Company (BAC) produces and sells aluminum products. Place
each of the following transaction in one of the four components of expenditure
a. BAC sells its product to the Bahrain Defense Force
b. BAC sells its product to a private company
c. BAC sells its product to a housewife

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Dr. Mohammed Alwosabi Econ 141: Macroeconomics - Ch.1

d. BAC sells its product to a company in Saudi Arabia

e. Some of BAC products are unsold this year

INCOME APPROACH:
— Since total value of a product is equal to the amount of income generated by its
production, GDP can also be calculated by adding all the income generated in the
production of GDP.
— The income approach of calculating GDP is the sum of incomes paid to resources
of production.
— National Income and Product Accounts divide incomes into five categories:
compensation to employees, rental income, net interest, corporate profits, and
proprietors' income.
1. Compensation to employees. It is the labor Income, which includes all
wages, salaries, and benefits paid to labor, plus social security contributions.
This is the largest component of GDP, using income approach.
2. Rent for the use of land. It is the income earned by the owners of land,
and any other rented resources.
3. Net interest for the use of the capital. It is the income earned by the owners
of machines and equipments. It equals the interest the domestic owners of
the capital receive minus the interest they pay
4. Corporate profit. It refers to what is left to the firm after all payments. It
includes both of profits distributed as dividend plus undistributed profits.
5. Proprietor’s income. It is the income of self employed small businesses
such as private doctor’s clinics, Attorney’s office, mini-mart stores, small
farms and so on. Proprietors' income might be a mix of incomes from labor,
capital and land.
— The sum of these five incomes results in national income or net domestic income
at factor cost (NDI).

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Dr. Mohammed Alwosabi Econ 141: Macroeconomics - Ch.1

— Net Domestic Income (NDI) = compensation of employees + rental income + net

interest + corporate profit + proprietor's income.
— Factor cost is the cost of factors of production used to produce final goods and
services.
— To calculate GDP using market value we must make two adjustments:
1. Net indirect tax (NIT), which is indirect taxes minus subsidies, must be
added to get from factor cost to market prices. This gives net domestic product
at market prices.
2. Depreciation (D) (or capital consumption) must be added to get from net
domestic product to gross domestic product.
Thus, GDP = NDI + net indirect tax (NIT) + Depreciation (D), or
GDP = NDI + (indirect tax – subsidies) + Depreciation
o Indirect tax is a tax paid by consumers when they buy goods and services.
Because of indirect taxes consumers pay more for the goods and services
than producers receive ⇒ market price > factor cost.
o Subsidy is a payment made by a government to a producer. Because of
subsidies consumers pay less for some goods and services than producers
receive ⇒ factor cost > market price
o Depreciation (D) is the decrease in the capital stock because of the wearing
out of machines and equipments (is the consumption of the capital). It is
treated as a cost of production and is subtracted in calculation NDI. So it
must be added back to get the GDP.

— Gross and Net Domestic Product

o “Gross” means before accounting for the depreciation of capital.
o “Net” means after accounting for the depreciation of capital.
o Net domestic product = GDP – depreciation

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Dr. Mohammed Alwosabi Econ 141: Macroeconomics - Ch.1

— Exercise:
Government purchase $400
Gross private domestic investment $500
Personal consumption expenditure $700
Personal income taxes $150
Depreciation $200
Net taxes $100
Net exports $200
Net interest $130
a. Calculate GDP
b. Calculate Net domestic product

— Exercise:
Net interest $200
Net indirect tax $300
Corporate profits $400
Proprietors’ income $150
Compensation of employees $1200
Depreciation $350
Rental income $100
Personal consumption expenditure $1500
Net exports $50
Government purchase $600
a. Calculate GDP
b. Calculate net domestic product
c. Calculate gross private domestic investment

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Dr. Mohammed Alwosabi Econ 141: Macroeconomics - Ch.1

— Exercise:
Item Billions of dollars
C 80
G 30
T 35
I 20
M 10
X 20
D 10
Calculate:
a. GDP
b. Net domestic product
c. the value of net exports
d. the value of private saving
e. the value of government saving
f. Is there government budget deficit or surplus?

GROSS NATIONAL PRODUCT (GNP)

— GNP is the market value of all final goods and services newly produced by the
citizens (nationals) of a country whether they are inside or outside the country in a
given period time.
— While GDP allocates product (income) according to the location of the owners of
factors of production regardless of who produce it whether they are nationals or
foreigners, GNP allocates product (income) according to the nationality of the
owners of the factor whether they are inside the country or abroad.
— Example:
The income of an Indian working in Bahrain is part of Bahrain's GDP as well as
India's GNP

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Dr. Mohammed Alwosabi Econ 141: Macroeconomics - Ch.1

NOMINAL GDP vs. REAL GDP:

— Recall that GDP is calculated by adding the market value of all final goods
produced.
— The market value of production and hence GDP can increase either because the
increase in production of goods and services or because of the increase in the
prices of goods and services, or by the increase in both.
— To determine whether the increase in only due to the increase in production rather
than in the price level, economists distinguish real from nominal GDP to determine
whether real production has changed.
— Nominal GDP is the value of final goods and services produced in a given year
valued at the prices that prevailed in that same year (current prices).
— Nominal GDP increases when the prices and quantities of goods and services
increase.
— Real GDP is the value of GDP measured at constant (base year) prices.
— Real GDP is a measure of a country's actual production.
— Real GDP allows the quantities of production to be compared across time.
— We use constant prices to remove the effects of inflation. Thus, the first step to
calculate real GDP is to choose a base year.
— The base-year method of calculating GDP compared quantities produced in
different years using prices from a year chosen as a reference year. The base year
is like a benchmark year.
— The base year is the year in which real GDP=nominal GDP
— Example
Suppose a country produces two final goods. Quantities and prices of each good
for three different years are given in the table below. Suppose 2002 is the base
year.

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Dr. Mohammed Alwosabi Econ 141: Macroeconomics - Ch.1

Good 1 Good 2 Nominal Real

GDP
Year P P GDP GDP
Q Q Deflator
$/ unit $/unit in $ in $
2001 2500 15 600 20 49500 66200 75
2002 2300 20 500 27 59500 59500 100
2003 2800 23 700 30 85400 74900 114

Nominal GDP in 2001 = (P1, 2001) (Q1, 2001) + (P2, 2001) (Q2, 2001)
= ($15) (2500) + ($20) (600) = 49500
Nominal GDP in 2002 = (P1, 2002) (Q1, 2002) + (P2, 2002) (Q2, 2002)
= ($20) (2300) + ($27) (500) = 59500
Nominal GDP in 2003 = ((P1, 2003) (Q1, 2003) + (P2, 2003) (Q2, 2003)
= ($23) (2800) + ($30) (700) = 85400
— We can see that nominal GDP of 2002 is higher than that of 2001. This may be
because the country produced more in 2002 than 2001 or may be because the
prices in 2002 are higher than prices in 2001. (If producing more goods and
services the standard of living would increase. If paying higher prices the cost of
living would increase).
— We can see in our case that the country produces fewer goods and services in 2002
and prices were higher. People were worse off in 2002 than in 2001. But still
nominal GDP was higher in 2002.
— GDP in 2003 was the highest for the two reasons: higher production and higher
price level.
— Thus, using nominal GDP to compare among different years does not give us the
actual picture of the performance of the economy. We cannot say for sure that a
country produces more in a particular year than any other year. Nominal GDP tells
us the change in price level that affects our cost of living.
— Cost of living is the amount of money it takes to buy goods and services.

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Dr. Mohammed Alwosabi Econ 141: Macroeconomics - Ch.1

— To calculate real GDP (RGDP) we select a base year, and then we use the price of
that year (the constant price) to calculate GDP in different years. In our example,
the base year was 2002. Thus, goods will be added up using 2002 prices.
RGDP in 2001 = (P1, 2002) (Q1, 2001) + (P2, 2002) (Q2, 2001)
= ($20) (2500) + ($27) (600) = 66200
RGDP in 2002 = P1, 2002) (Q1, 2002) + (P2, 2002) (Q2, 2002)
= ($20) (2300) + ($27) (500) = 59500
RGDP in 2003 = P1, 2002) (Q1, 2003) + (P2, 2002) (Q2, 2003)
= ($20) (2800) + ($27) (700) = 74900
— Comparing RGDP of different years allows us to say for sure that a country
produces more (or less) goods and services in one particular year than any other
year if the RGDP of that year is higher (or lower) than the other years.
— RGDP tells us the change in production and it is used to measure the size of the
economy and the growth in the economy (the change in the quantities of goods and
services).
— If Real GDP > Nominal GDP then prices were higher in the base period than the
current period.
— If Real GDP < Nominal GDP, current prices are higher than base period prices.
— Real GDP = Nominal GDP for the base period.
— In years with inflation, nominal GDP increases faster than real GDP.

MEASURING ECONOMIC GROWTH:

— Economic Growth is an increase in a country’s output (real GDP). In other words,
it is an expansion of production possibilities in a country.
— It is represented by an outward shift of the production possibility frontier (PPF) of
the country.

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Dr. Mohammed Alwosabi Econ 141: Macroeconomics - Ch.1

— RGDP is a good measure with which we compare the economy at two points in
time. That comparison can then be used to formulate the growth rate of total output
within a country.
— The economic growth rate is the percentage change in the quantity of goods and
services produced from one year to the next.
RGDP this year - RGDP last year
Economic Growth Rate = × 100
RGDP last year

From the example above

The growth rate from 2001 to 2002 = -10.1%
The growth rate from 2002 to 2003 = 25.9%
The growth rate from 2001 to 2003 = 13.1%
— The new method of calculating real GDP, which is called the chain-weighted
output index method, uses the prices of two adjacent years (or the average of
several years) to calculate the real GDP growth rate and then uses the growth rates
to create a chain linking the base year real GDP to the real GDP in future years.
— Example
Real GDP in 2002 is $100. Between 2002 and 2003, using 2002 prices GDP grew
8 percent and using 2003 prices real GDP grew 4 percent. What does real GDP in
2003 equal? Answer: $106
Example:
If real GDP in 2003 is $9 billion and real GDP in 2004 is $9.27 billion, then the
economic growth rate in 2004 is 3.0 percent
— We use the economic growth rate to make:
o economic welfare comparisons
o international comparison
o business cycle forecasts

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Dr. Mohammed Alwosabi Econ 141: Macroeconomics - Ch.1

Economic Welfare Comparisons (Measuring Living Standards)

— Economic welfare is a measure of economic well being. It improves when
production increases.
— RGDP is a useful number when describing the size and the growth of a country's
economy. To measure the standard of living we use the RGDP per person (RGDP
per head, per capita).
— A standard of living is the level of consumption that people enjoy, on the average,
and is measured by the average income per person.
— RGDP per person is the GDP divided by the size of the population. This measure
gives the amount of GDP that each individual can get, on average, and thereby
provides a fairly good measure of the standard of living of the people within an
economy.
RGDP
RGDP per person =
Population
— RGDP per person is a more useful measure than RGDP for determining standard
of living because of differences in population across countries. If a country has a
large RGDP and a very large population, each person in the country may have a
low income and thus may live in poor conditions. On the other hand, a country
may have a moderate RGDP but a very small population and thus a high individual
income.
— When the increase in RGDP is greater than the increase in population RGDP per
person increases.
— Example:
If Bahrain’s GDP (using PPP) in 2005 was $15.83 billion at constant prices and the
population was 698,585 then
$15,830,000,000
GDP per person = = $22 ,660
698,585

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Dr. Mohammed Alwosabi Econ 141: Macroeconomics - Ch.1

Shortcomings of Using GDP to Measure Output and Well-being

— While GDP measures are informative and are widely used in many countries to
summarize the state of the economy, it is important to realize that they are by no
means perfect. RGDP can be criticized as a measure of economic welfare because:
1. It does not include non-market activities.
Because we use market prices to value the goods that are being sold, only
market activities are included in GDP. Goods and services that are not
marketed are not included in GDP. It excludes what we produce for ourselves
at home such as preparing meals, doing laundry, gardening, etc. It also
excludes any activity that has no price such as friends helping each other.
Most of agricultural production in less developed countries is not included in
the GDP because farmers consume what they produce (self-sufficient) so most
of their production does not reach the market.
2. It does not include underground economy transactions such as production of
illegal goods. It also excludes economic activity that people hide and do not
report to government to avoid taxes and other government regulation or
because the activity is illegal. Official statistics ignore this underground
economy, which is very substantial in some countries.
3. The quality of the environment. An increase in production will raise real GDP
and at the same time it may lead to an increase in pollution. So, RGDP does
not measure a clean environment and does not account for natural resource
depletion or degradation of environmental quality.
4. Leisure time, a valuable component of an individual’s welfare, is not included
in real GDP.
5. GDP per person is only a measure of the average level of output per person in
the economy. Economic well-being depends both on the size of the income as
well as the distribution of the income.
6. Health and life expectancy are not directly included in real GDP.

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Dr. Mohammed Alwosabi Econ 141: Macroeconomics - Ch.1

7. Over-adjustment for inflation: The measured growth rate is deflated by price

increases, but some price increases reflect quality improvements, which make
us better off.
8. Government services (not sold in markets) are measured by their cost of
production
9. RGDP per person focuses only on income but there are other important things
that make life better such as faith, security, freedom, justice, education, health,
the sense of belongings, etc. And even if we address only income it does not
show the real distribution of income.
10. Governments overstate or understate GDP for different political, economic, or
social reasons.
11. New goods create problems in calculating Real GDP. Recall that we used
some base year’s prices to calculate the value of Real GDP for a particular
year. But what if there are goods that were not around in the base year? What
is the appropriate price for those goods?

International Comparisons and Purchasing Power Parity (PPP)

— Real GDP comparisons among countries have two problems: first, the RGDP of
one country has to be converted into the same currency unit as the RGDP of the
other country. Second, the same prices must be used to value the goods and
services in the countries being compared.
— To avoid the problems of fluctuating currency exchange rate, and to account for
the differences in the cost of living, the international comparison project (ICP) of
the UN and University of Pennsylvania (Summer and Heston, Penn World Tables)
have calculated a purchasing power parity (PPP) index.
— The Purchasing Power Parity (PPP) between two countries is the rate at which
the currency of one country needs to be converted into that of a second country to
ensure that a given amount of the first country’s currency will purchase the same
volume of goods and services in the second country as it does in the first.

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Dr. Mohammed Alwosabi Econ 141: Macroeconomics - Ch.1

— As it is used by the international organizations, purchasing power parity (PPP) of a

country’s currency is the number of units of that currency required to purchase the
same representative basket of goods and services that a US dollar would buy in the
US. This index allows for a more direct comparison of living standards in different
countries.
— A simple example can illustrate the concept. GDP per person in Nigeria in 2003
was about $370 while GDP per person in U.S. in 2003 was about $37400.
However, this number is misleading because $370 in Nigeria can buy a lot more
goods and services than $370 in the U.S. would because prices are much lower in
Nigeria.
— GDP per capita measured at PPP, i.e. the per-capita value of Nigerian GDP using a
common set of prices (typically U.S. prices) is about $1000. In other words, the
average Nigerian earns about $370 a year, which because of the fact that prices are
lower there than in the U.S., is equivalent to earning $1000 in the U.S.
— So, PPP prices are used to construct GDP data that can be used to make more valid
comparison between one country and another.
— While using PPP exchange rates for comparison is an improvement over using
actual exchange rates, it is still imperfect, and comparisons using the PPP method
can still be misleading.
o Comparing standards of living using the PPP method implicitly assumes
that the real value placed on goods is the same in different countries. In
reality, what is considered a luxury in one culture could be considered a
necessity in another culture! The PPP method does not account for this.
o A PPP exchange rate varies depending on the choice of goods used for the
index. Hence, it is possible to deliberately or accidentally bias a PPP
exchange rate by the choice of the basket.
o PPP could also have difficulty accounting for differences in quality between
goods in one country and equivalent goods in another.

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Dr. Mohammed Alwosabi Econ 141: Macroeconomics - Ch.1

APPENDIX:

— Capital and Investment

o The term capital, as used in macroeconomics, refers to the plant,
equipment, buildings, manufactured input, and inventories of raw materials
and semi-finished goods, etc.
o Investment is the flow that changes the stock of capital.
o Depreciation is the decrease in the capital stock that results from wear and
tear, and obsolescence. Capital consumption is another name for
depreciation.
o Gross investment is the purchases of new capital.
o Net investment is the change in the stock of capital and equals gross
investment minus depreciation.
— A flow is a quantity per unit of time such as GDP, saving, income, investment
— A stock is the quantity that exists at a point in time such as wealth, capital
— Exercise
At the beginning of the year, your wealth is $20,000. During the year, you have an
income of $60,000 and you spend $40,000 on consumption. You pay no taxes.
What is your wealth at the end of the year?

How Investment Is Financed?

— Financial markets are used to finance deficits, pay for investment, and save.
Investment is financed from three sources:
1. Private saving (S), is the amount that households have left after they have
paid their taxes and bought their consumption goods and services
2. Government budget surplus (T – G)
3. Borrowing from the rest of the world (M – X).

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Dr. Mohammed Alwosabi Econ 141: Macroeconomics - Ch.1

— We can see these three sources of investment finance by using the fact that
aggregate expenditure equals aggregate income.
— Households’ income is consumed, saved, or paid in taxes: Y = C + S + T
— RGDP can be written as;
o Y = C + I + G + X - M (reflecting its aggregate expenditure), or
o Y = C + S + T (reflecting the use of RGDP, income)
o So we have C + I + G + (X –M) = C + S + T
o Cancel the C's and move X - M to the financing side you get
I + G = S + T + (M – X)
o This equation shows us that financing for I and G come from private saving,
taxes, and foreign sources.
o Move G to the financing side and you have I = S + (T – G) + (M – X)
— This formula shows that investment is financed using saving, a government budget
surplus, (T − G) and borrowing from the rest of the world, (X − M)
o Private saving (S) = disposable income – consumption
= income – tax – consumption = Y – T – C
o Government (Public) saving = T – G
ƒ If (T – G) > 0 ⇒ surplus
ƒ If (T – G) < 0 ⇒ deficit
— Private investment = National Saving + borrowing from the rest of the world
— National saving = private saving + government saving
= (Y – T – C) + (T – G) = Y – C – G
— Example:
Suppose an economy has the following data (in million of dollars)
Y = 200, C = 130, T = 30, and G = 20, then
Private saving = Y – C – T = 200 – 130 – 30 = 40
Public saving = T – G = 30 – 20 = 10
National saving = Y – C – G = 200 – 130 – 20 = 50, or
= private saving + public saving = 40 + 10 = 50

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Dr. Mohammed Alwosabi Econ 141: Macroeconomics - Ch.1

— Exercise:
If you have the following data: government saving = 0, RGDP = $2500 million,
private consumption = $1300 million, tax = $350 million; calculate the country’s
national saving
— Exercise:
If national saving is $200,000, net taxes equal $100,000 and government purchases
of goods and services are $50,000, how much are households and businesses
saving?

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Dr. Mohammed Alwosabi Econ 141: Macroeconomics - Ch.1

PRICE LEVEL (PRICE INDEX)

— To see how the change in prices changes the cost of living we should analyze the
changes in price level.
— Price level (also called price index) is a weighted average of prices of goods and
services in a given year relative to the prices in a specified base year.
— Price level is a unit free measure.
— There are many types of price level measurements but we will focus only on the
most popular two of them.
1. The GDP Deflator
2. The Consumer Price Index (CPI)

THE GDP DEFLATOR:

— Nominal GDP captures both changes in quantity and changes in prices.
— Real GDP, on the other hand, captures only changes in quantity.
— Because of this difference, after computing nominal GDP and real GDP, a third
useful statistic can be computed -- the GDP deflator, which captures the changes in
the price level.
— GDP deflator is a measure of the price level of goods and services included in
GDP. It is an average of the prices of the goods in GDP in the current year
expressed as a percentage of the base year prices.
— GDP deflator is a general indicator of inflation because it measures changes in
prices of goods and services included in GDP. It takes the contribution of rising
prices (inflation) out of nominal GDP so that we can see what happen to RGDP.
— It is equal to 100 times nominal GDP divided by real GDP.
Nominal GDP
GDP Deflator = × 100
Real GDP
— Real GDP = (Nominal GDP*100)/GDP deflator
— Nominal GDP = (Real GDP * GDP deflator)/100

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Dr. Mohammed Alwosabi Econ 141: Macroeconomics - Ch.1

— The larger the nominal GDP for a given RGDP the higher is the price level and the
larger is the GDP deflator.
— Example:
From the example in pages 14-15, the GDP Deflator is as follows:

Nominal GDP 49500

GDP deflator in 2001 = × 100 = × 100 ≈ 75
Real GDP 66200
59500
GDP deflator in 2002 = × 100 = 100
59500
85400
GDP deflator in 2003 = × 100 = 114
74900
— Price level in 2001 is less than that of the base year by 25%.
— Price level in the base year (here, 2002) is always 100.
— Price level in 2003 is higher than that of the base year by 14%.
— Example:
Suppose the nominal GDP per person is $10,000 in 2004, the 2000 GDP deflator is
100 and the 2004 GDP deflator is 110 then the real GDP per person is $9091
— Example:
If nominal GDP is $5 billion and the GDP deflator is 125, then RGDP = (5*100) /
125 = $4 billion
— Exercise:
Why if GDP deflator for 2004 is 125, this means nominal GDP is greater than real
GDP in 2004?

Shortcomings of Using GDP Deflator to Measure Price Level

1. It is unable to fully incorporate the increased purchasing power that comes with
improvements in quality so this tends to push the deflator to overestimate inflation.

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Dr. Mohammed Alwosabi Econ 141: Macroeconomics - Ch.1

2. The introduction of new goods poses a problem when calculating Real GDP;
therefore, it poses a problem in calculating the GDP deflator because the deflator is
the ratio of nominal to Real GDP.
3. If prices of imported goods fall but prices of domestic goods are high, consumer’s
purchasing power may not fall by much even if the GDP deflator indicates a high
price level.

THE CONSUMER PRICE INDEX (CPI):

— The consumer price index (CPI) is a measure of the average of the prices paid by
urban consumer for a fixed “basket” of consumer goods and services.
— CPI compares the cost in the current period to the cost in a base period of a basket
of goods typically consumed in the base period.
Cost of the CPI basket at the current year prices
CPI = × 100
Cost of the CPI basket at the base year prices
— The CPI is defined to equal 100 for the reference base period.
— Example:
Suppose a typical family consumes three goods: breads, gasoline and haircut.
Quantities and prices of the three goods in three different years are given in the
table below (assuming no weights given to any item). Suppose the base year is
2001
Good Quantities P in P in 2002 P in 2003
bought 2001
Bread 2000 bread $0.50 $0.55 $0.60
Gasoline 1000 liter $1.00 $1.20 $1.30
Haircut 600 times $1.5 $2.00 $2.50

Cost of the CPI basket at 2001 prices = ($0.50)(2000) + ($1)(1000) + ($1.5)(600) = $2900
Cost of the CPI basket at 2002 prices = ($0.55)(2000) + ($1.2)(1000) +($2)(600) = $3700
Cost of the CPI basket at 2003 prices = ($0.60)(2000) + ($1.30)(1000) + ($2.5)(600) = $4000

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Dr. Mohammed Alwosabi Econ 141: Macroeconomics - Ch.1

2900
CPI in 2001 (the base year) = × 100 = 100 (always 100)
2900
3700
CPI in 2002 = × 100 ≈ 128 ⇒ the cost of living has increased from 2001 to
2900
2002 by 28%
4000
CPI in 2003 = × 100 ≈ 138 ⇒ the cost of living has increased from 2001 to
2900
2003 by 38%
— Exercise:
Redo the above example assuming 2002 is the base year.
— Exercise
An average urban family consumes only bread, meat and cloth. In the base year the
family spent $300 on bread, $450 on meat, and $800 on cloth. Prices in the base
year were $1 per bread, $3 per kg of meat, and $5 per yard of cloth. Prices in the
current year are $1.5 per bread, $5 per kg of meat, and $8 per yard of cloth.
a. What was the cost of living for this family in the current year?
b. What was the CPI for the current year?

Shortcomings of Using CPI to Measure Price Level

— CPI is not a perfect measure of the price level. It overstates the true inflation
because:
1. It does not reflect the substitution by consumers as price change. For example,
suppose that chicken is an item in the CPI basket. If chicken becomes more
expensive than beef then some consumers may stop eating chicken altogether
and start eating beef, however, the same quantity of chicken remains part of the
CPI basket even though people are consuming less.
2. It does not account for changes in quality which improve purchasing power- the
average computer today is much faster and more powerful than computers two
years ago and price may be the same if not falling. This causes the CPI to

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Dr. Mohammed Alwosabi Econ 141: Macroeconomics - Ch.1

overestimate inflation; the price of computing has decreased even though the
price of the computer is unchanged.
3. The introduction of new goods that render old goods obsolete may pose a
problem because the old goods still remain in the CPI basket until the basket is
revised again.

The Differences between the GDP Deflator and the CPI

— There are three differences between the GDP deflator and the CPI:
1. The GDP deflator measures the prices of all goods and services produced
whereas the CPI measures the prices of only the goods and services bought
by consumers. Thus, an increase in the price of goods bought by the firms
or government will be included in the GDP deflator but not in the CPI.
2. The GDP deflator includes only those goods and services produced
domestically. Imported goods are not part of the GDP and not included in
the GDP deflator; but they are included in the CPI because consumers buy
imported goods as well.
3. GDP deflator is not based on a fixed market basket of goods and services.
The basket is allowed to change with people’s consumption and investment
patterns. CPI quantity is the same for different years. It is based on a fixed
basket of goods and services.
— Exercise
The average price of the imported food in Bahrain has increased in recent years.
This increase must show up
c. in Bahrain’s GDP deflator
d. in Bahrain’s CPI
e. both in Bahrain’s CPI and Bahrain’s GDP deflator
f. neither in Bahrain’s CPI nor in Bahrain’s GDP deflator
— To measure changes in the cost of living and in the value of money we need to
calculate the inflation rate using price indexes.

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Dr. Mohammed Alwosabi Econ 141: Macroeconomics - Ch.1

INFLATION RATE:
— The inflation rate is the percentage change in the price level from one year to the
next.
GDP Deflator this year - GDP Deflator last year
Inflation Rate = × 100
GDP Deflator last year
From the examples in page 23
114 − 100
For 2003 Inflation rate = × 100 = 14
100
OR
CPI this year - CPI last year
Inflation Rate = × 100
CPI last year
From the examples in page 24-25
138 − 128
For 2003 Inflation rate = × 100 ≈ 8
128
So far, we have described how aggregate measures of output and price level of the
economy are constructed.

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