4.

Measuring GDP and Economic Growth

 GDP is a measure of total production and total income.
 Real GDP measures production of goods and services.
 GDP can be used to make comparisons over time and across countries.

I. Gross Domestic Product

 GDP or gross domestic product is the market value of all the final goods and services produced within a
country in a given time period.

 The items in GDP are valued at their market values, that is, at their prices. So if 100,000,000 slices of
pizza are sold for $3 each, slices of pizza contribute $300,000,000 to GDP. Using market values
means that the total value of output, that is, GDP will be in the dollars (or whatever the country’s
currency unit might be).
 A final good is an item that is bought by its final user. It contrasts with an intermediate good,
which is an item that is produced by one firm, bought by another firm, and used as a component of a
final good or service.
 To avoid double counting, GDP includes only final goods and services (no intermediate goods and
services are directly counted).
 Only the goods and services produced within a country are counted. A Honda produced in North
Carolina is counted in U.S. GDP.
 GDP is measured over a period of time, typically a quarter of a year or a year.

GDP and the Circular Flow of Expenditure and Income

 The circular flow illustrates the equality of income, expenditure, and the value of production. The circular
flow diagram shows the transactions among four economic agents—households, firms, governments, and
the rest of the world—in two aggregate markets—goods markets and factor markets.
 In the goods market, households, firms, governments, and foreigners buy goods and services. For analytical
purposes, we can categorize spending by these four agents in the calculation of GDP:
 The total payment for goods and services by households in the goods markets is consumption
expenditure, C.
 The purchases of new plants, equipment, and buildings and the additions to inventories are
investment, I.
 Governments buy goods and services, called government expenditure or G, from firms.
 Firms sell goods and services to the rest of the world, exports or X, and buy goods and services
from the rest of the world, imports or M. Exports minus imports are called net exports, X  M.

 In factor markets households receive income from selling the services of resources to firms. The total
income received is aggregate income. It includes wages paid to workers, interest for the use of capital,
rent for the use of land and natural resources, and profits paid to entrepreneurs; retained profits can be
viewed as part of household income, lent back to firms.

GDP Equals Expenditure Equals Income

 Aggregate expenditure equals C + I + G + (X  M). Aggregate expenditure equals GDP because all the
goods and services that are produced are sold to households, firms, governments, or foreigners. (Goods
 and services not sold are included in investment as inventories and hence are “sold” to the producing
firm.)
 Because firms pay out as income everything they receive as revenue from selling goods and services,
aggregate income equals aggregate expenditure equals GDP.

Why “Domestic” and Why “Gross”?

 Depreciation is the decrease in the stock of capital that results from wear and tear and obsolescence.
The total amount spent on purchases of new capital and on replacing depreciated capital is called gross
investment. The amount by which the stock of capital increases is net investment. Net investment =
Gross investment  Depreciation.
 The “Gross” in gross domestic product reflects the fact that the investment in GDP is gross investment
and so part of it goes to replace depreciating capital. Net domestic product subtracts depreciation from
GDP.
II. Measuring U.S. GDP

The Expenditure Approach

 The expenditure approach measures GDP as the sum of consumption expenditure, C, investment, I,
government expenditure on goods and services, G, and net exports of goods and services, (X  M). So
GDP = C + I + G + (X  M) or, in 2014 and in billions of dollars, $11,729 + $2,714 + $3,139 + $538 =
$17,044.

The Income Approach

 The income approach measures GDP as the sum of compensation of employees, net interest, rental
income, corporate profits, and proprietors’ income. This sum equals net domestic income at factor costs.
To obtain GDP, indirect taxes (which are taxes paid by consumers when they buy goods and services)
minus subsidies plus depreciation are included. Finally any discrepancy between the expenditure approach
and income approach is included in the income approach as “statistical discrepancy.”

Nominal GDP and Real GDP

 The market value of production and hence GDP can increase either because the production of goods and
services are higher or because the prices of goods and services are higher.
 Real GDP allows the quantities of production to be compared across time. Real GDP is the value of final
goods and services produced in a given year when valued at the prices of a reference base year.
 Nominal GDP is 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 Data for 2014
 Traditionally, real GDP is calculated using Item Quantity Price Market Value
prices of the reference base year (the year in
Books 40 $25 $1,000
which real GDP=nominal GDP).
Coffee 1,000 $2 $2,000
 The tables to the right show this method of
calculating real GDP for an economy that Nominal GDP $3,000
produces only books and coffee. If 2014 is Data for 2015
the reference base year, nominal GDP in Item Quantity Price Market Value
2014 in the top table equals real GDP in
Books 50 $30 $1,500
2014 Real GDP in 2014 is $3,000.
Coffee 1,500 $3 $4,500
 The second table shows the calculation for
nominal GDP in 2015. Nominal GDP $6,000
 Real GDP in 2015 is in the bottom table. It 2015 Quantities and 2014 Prices
values 2015 production using the prices from
Item Quantity Price Market Value
the reference base year, 2014. Real GDP in
Books 50 $25 $1,250
2015 is $4,250.
Coffee 1500 $2 $3,000
Real GDP $4,250
(2010
dollars)

REQUIRES MATHEMATICAL NOTE: Chained-Dollar Real GDP

 The top table to the right has data for 2014
GDP Data for 2014
for an economy that produces only books
Item Quantity Price Market Value
and coffee. In 2014, nominal GDP is $3,000.
The second table to the right has the same Books 40 $25 $1,000
data for 2015. (These tables are the same as Coffee 1,000 $2 $2,000
used above to calculate real GDP using the Nominal GDP $3,000
standard method.) In 2015, nominal GDP is
GDP Data for 2015
$6,000.
 Nominal GDP has doubled but how much Item Quantity Price Market Value
has real GDP changed between these years? Books 50 $30 $1,500
 To determine how real GDP changes, Coffee 1,500 $3 $4,500
suppose that 2014 is the base year. Then we Nominal GDP $6,000
need to determine the growth rate between
2014 and 2015 by calculating the value of
production in both years using 2014 prices and also calculating it in both years using 2015 prices.
 Using 2014 prices, the value of production increases from $3,000 (the first table) to $4,250 (the third
table). Using 2014 prices, the value of production has grown by
100  ($4,250  $3,000)/$3,000 = 41.7 percent.
 Using 2015 prices, real GDP increases from $4,200 (the fourth table) to $6,000 (the second table). Using
2015 prices, the value of production has grown by
 100  ($6,000  $4,200)/$4,200 = 42.9 percent.
 The average growth rate is equal to (41.7 2015 Quantities and 2014 Prices
percent + 42.9 percent)/2 = 42.3 percent. Item Quantity Price Market Value
So real GDP between these years has Books 50 $25 $1,250
grown by 42.3 percent. If 2014 is the base
Coffee 1500 $2 $3,000
year, real GDP in 2011 is $3,000  1.423
Value of $4,250
= $4,269.
production
 Similar calculations are made for each pair (2010 dollars)
of adjacent years from the reference base
year onwards. This procedure chains real 2014 Quantities and 2015 Prices
GDP back to the reference base year. Item Quantity Price Market Value
Books 40 $30 $1,200
III. The Uses and Limitations of Real Coffee 1,000 $3 $3,000
GDP Value of $4,200
The Standard of Living Over Time production
(2011 dollars)
 One measure of the standard of living
over time is real GDP per person, or real
GDP divided by the population. Real GDP per person tells us the value of goods and services that the
average person can enjoy.
 The value of real GDP when all the economy’s labor, capital, land, and entrepreneurial ability are fully
employed is called potential GDP. Potential GDP grows at a steady pace because the quantities of the
factors of production and their productivity grow at a steady pace.
 The growth rate of real GDP slowed in the productivity growth slowdown after 1970. This slowdown
created a Lucas wedge. A Lucas wedge is the dollar value of the accumulated gap between what real
GDP per person would have been if the growth rate had persisted and what real GDP per person actually
turned out to be.
 Fluctuations in the pace of expansion of real GDP is denoted the business cycle, periodic but irregular
increases and decreases in the total production and other measures of economic activity. Each cycle is
categorized by: trough, expansion, peak, recession.

The Standard of Living Across Countries

 Real GDP can be used to compare living standards across countries. But two problems arise in using real
GDP to compare living standards:
 First, the real GDP of one country must be converted into the same currency unit as the real GDP of
the other country.
 Second, the goods and services in both countries must be valued at the same prices. Relative prices in
countries will differ, so goods and services should be weighted accordingly. For example, if more prices
are lower in China than in the United States, China’s prices put a lower value on China’s production than
would U.S. prices. If all the goods and services produced in China are valued using U.S. prices, than a more
valid comparison can be made of real GDP in the two countries. This comparison using the same prices is
called purchasing power parity (PPP) prices.

Limitations of Real GDP

 Some of the factors that influence the standard of living are not part of real GDP. Omitted from GDP are:
 Household Production: As more services, such as childcare, are provided in the marketplace, the
measured growth rate overstates development of all economic activity.
 Underground Economic Activity: If the underground economy is a reasonably stable proportion of all
economic activity, though the level of GDP will be too low, the growth rate will be accurate.
 Health and Life Expectancy: Better health and long life are not directly included in real GDP.
 Leisure Time: Increases in leisure time lower the economic growth rate, but we value our leisure time
and we are better off with it.
 Environmental Quality: Pollution does not directly lower the economic growth rate.
 Political Freedom and Social Justice: Political freedom and social justice are not measured by real
GDP.