Macroeconomics

Session 3
Dr. Jithin P
IIM Raipur
The Components of GDP
GDP (Y) is the sum of the following:
◦ Consumption (C)
◦ Investment (I)
◦ Government Purchases (G)
◦ Net Exports (NX)

National income identity

Y = C + I + G + NX
 Consumption (C)
• The spending by households on goods and services, with the
exception of purchases of new housing.
• Consumption is the sole end and purpose of all production. —Adam
Smith
• All forms of consumption together make up about two-thirds of GDP.
China’s consumption expenditure (as percentage of GDP) is much
smaller (38%) than is the case in the US (68.3%) and India (58.5%).
• Disposable income: income after the payment of all taxes, Y + TR-TA
• Households divide their disposable income between consumption
and saving.
• We assume that the level of consumption depends directly on the
level of disposable income. A higher level of disposable income leads
to greater consumption.
Investment (I)
• Both firms and households purchase investment goods.
Firms buy investment goods to add to their stock of capital
and to replace existing capital as it wears out.
• Households buy new houses, which are also part of
investment.
Business fixed investment
• It includes the equipment and structures that businesses buy
to use in production.
• The largest piece of investment spending, accounting for
about three-quarters of the total, is business fixed investment.
• Business fixed investment represents the spending by
businesses to increase production capacity
Investment (I)
Inventory Investment
• It includes those goods that businesses put aside in storage, including
materials and supplies, work in process, and finished goods.
• It is one of the smallest components of spending, averaging about 1
percent of GDP.
Residential Investment
• It includes the new housing that people buy to live in and that
landlords buy to rent out. It varies from 3 per cent to 5 per cent of
GDP in various countries.
• Net investment is gross investment minus depreciation.
Government Purchases (G):
• It refers to government final consumption expenditure on goods and
services.
• The federal government buys guns, missiles, and the services of
government employees. Local governments buy library books, build
schools, and hire teachers.
• Government also makes transfer payments- payments made to people
without their providing a current service in exchange.
• Ex. Widow pension, old age pension, pension, unemployment benefits,
various types of subsidies
• Transfer payments (TR) are NOT included in GDP since they are not
expenditures on goods and services by the government. Subsidies are not
included as they do not reflect the market value/price.
• Government expenditure = transfers + purchases
• Govt purchases are included in GDP not the government transfers.
Net Exports (NX)
• Exports(X) are purchases of domestic goods by foreigners.
• Imports (M) are purchases of foreign goods by domestic residents.
• Imports need to be subtracted from the GDP as they are not
expenditures on domestically produced goods and services.
• Exports need to be added to the GDP as they are expenditures on
domestically produced goods and services.
• Net Exports(X-M) of goods and services are the value of exports
minus imports. It is the net foreign spending on domestically
produced goods and services.
GDP=C+I+G+X-M
• India has had a negative net exports reflecting a high level of imports
and lower level of exports.
Real Versus Nominal GDP
If total spending rises from one year to the next, at least one of two things must be true: (1)
the economy is producing a larger output of goods and services, or (2) goods and services
are being sold at higher prices.
Nominal GDP values the production of goods and services at current prices.
▪ This measure does not accurately reflect how well the economy can satisfy the demands
of households, firms, and the government.
▪ If all prices doubled without any change in quantities, nominal GDP would double.
Real GDP values the production of goods and services at constant prices.
A Numerical Example
An accurate view of the economy requires adjusting nominal to real GDP by using the GDP
deflator.
Assume an economy produces only two goods – apples and potatoes.
◦ Table 2a shows the quantities of the two goods produced and their prices in the years 2016,
2017 and 2018.
Table 2a Data example for calculating the real
and nominal GDP
Table 2b Nominal and Real GDP

Part of the rise is attributable to the increase in the quantities of apples and
potatoes and part to the increase in the prices of apples and potatoes. To
take out the effect of changes in prices we use real GDP

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EMEA 2017
The GDP Deflator
The GDP deflator is a measure of the price level calculated as the ratio of nominal GDP
to real GDP times 100.
It tells us the rise in nominal GDP that is attributable to a rise in prices rather than a rise
in the quantities produced.

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EMEA 2017
The GDP Deflator
The GDP deflator is calculated as follows:

Nominal GDP
GDP deflator =  100
Real GDP

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EMEA 2017
Table 2c Calculating the GDP deflator

For year 2016, nominal GDP is €200, and real GDP is €200, so
the GDP deflator is 100.

We now need the nominal GDP and the the real GDP for the
other two years to complete our calculations (see table 2a).

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EMEA 2017
Problems of GDP Measurement

GDP data are, in practice, used not only as a measure of how much is
being produced but also as a measure of the welfare of the residents of a
country.
❑The GDP is not measured correctly. Some outputs are poorly measured
because they are not traded in the market. If you bake homemade pie, the
value of your labor isn’t counted in official GDP statistics.
Problems of GDP Measurement
• A large amount of economic activity is not declared to governments
(illegal activity, involved with tax evasion or simply not declared to
the statisticians). This underground economy is often quite
substantial.
• The value of a clean environment. The accounts do not subtract
anything for environmental pollution and degradation.
• When a factory produces chemicals, it puts pollutants into the air
Suppose the chemical output is traded in the market, but not the
pollution, then the environmental damage is not included in GDP.
• It is difficult to account correctly for improvements in the quality of
goods.
• Value of leisure