MACROECONOMICS - CLUTCH CH GROSS DOMESTIC PRODUCT (GDP) AND CONSUMER PRICE INDEX (CPI)

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2 CONCEPT: CALCULATING GDP Gross Domestic Product (GDP) is the value of the final goods and services produced by a country during a year GDP as a statistic is used to measure growth in an economy and the well-being of the citizenry > Economists tend to rationalize that higher output means happier citizens! GDP can be calculated by adding up all the expenditures during the year and has main components > Note that GDP can also be calculated by adding up all the income during the year (less common) Consumption spending by on goods and services > Excludes the household purchases of Investment spending on capital equipment, inventory, and structures > Think of this generally as businesses spending on their long-term growth > Includes the household purchases of Government Purchases spending on goods and services by local, state, and federal > Paying teacher salaries, building highways, buying military equipment > Does not include transfer payments, such as welfare (does not result in production) Net Exports = Exports imports > Exports goods produced but sold > Imports goods produced but sold GDP = C + I + G + NX Nominal GDP uses prices when calculating the value of goods Real GDP uses prices when calculating the value of goods A few extra technicalities worth mentioning regarding GDP: Final goods and services are purchased by the final user à included in GDP > Intermediate goods are purchased to be used in another product (i.e. paper to create a greeting card) Second-hand sales are not included in GDP > The purchase of a TV from Walmart is included in GDP, but when you sell it used on Craigslist it is not Financial transactions are not included in GDP (i.e. transfer payments and stock market transactions) Page 2

3 CONCEPT: DETAILED EXPLANATION OF GDP COMPONENTS Consumption spending by on goods and services Services An (intangible) act or use for which a consumer, firm, or government is willing to pay. > In the United States, consumer spending on services is greater than spending on goods Nondurable Goods products with less than years of expected life Durable Goods products with more than years of expected life Examples of Services: Examples of Nondurable Goods: Examples of Durable Goods: Investment spending on capital equipment, inventory, and structures Business Fixed Investment spending by firms on new factories, buildings, and equipment to produce goods Residential Investment spending by households and firms on homes (single family or multi-unit) > Note that the resale of previously constructed homes are NOT included in investment Changes in Inventories changes in the supply of goods produced but not yet sold > The change in inventory can be positive or negative January 1: Sony had $100M of unsold televisions December 31: Sony had $20M of unsold televisions January 1: Sony had $100M of unsold televisions December 31: Sony had $160M of unsold televisions The in inventory would investment The in inventory would investment Financial transactions (sale of stocks/bonds) are included in Investment Government Purchases spending on goods and services by local, state, and federal > Does not include transfer payments, such as welfare (does not result in production) Net Exports = Exports imports Exports goods produced but sold Imports goods produced but sold Page 3

4 CONCEPT: VALUE-ADDED METHOD FOR MEASURING GDP Remember: GDP is the value of the final goods and services produced by a country during a year The normal approach takes the market value of these final goods (i.e. a Chevy Malibu) > However, there are many intermediate steps in producing a final product Value added the market value that a firm adds to a product EXAMPLE: Mining Company Corporation extracts iron ore from its deposits and is able to sell the ore for a price of $5,100 per ton. The Refinery Company Corporation refines iron ore and sells the refined ore for $7,800 per ton. Steel Company Corporation purchases refined iron ore and produces steel, which it sells for $11,200 per ton. Chevrolet purchases steel to produce a Malibu, which it sells to consumers at a price of $16,900. What is the increase in GDP for each Malibu produced? Stage of Production Sales Value of Material Value Added Mining Company Corporation: Iron ore extracted The Refinery Company Corporation: Iron ore refined Steel Company Corporation: Steel produced Chevrolet: Chevy Malibu produced Total PRACTICE: A cotton farmer produces raw cotton, which it can sell to a processor at a price of $2. The processor weaves the cotton into fabric and sells it for $3. A clothing company purchases the fabric and creates a crappy t-shirt, which it can sell for $7. Urban Outfitters buys crappy t-shirts and resells them for $45. What is the value added by the clothing company? a) $3 b) $4 c) $7 d) $38 Page 4

5 CONCEPT: NOMINAL GDP AND REAL GDP Gross Domestic Product (GDP) is the value of the final goods and services produced by a country during a year Nominal GDP uses prices when calculating the value of goods Real GDP uses prices when calculating the value of goods GDP = C + I + G + NX C = I = G = NX = Nominal GDP = (Quantity 1 Current Price 1 ) + (Quantity 2 Current Price 2 ) + Real GDP = (Quantity 1 Base Price 1 ) + (Quantity 2 Base Price 2 ) + EXAMPLE: The simple economy of Clutchtopia produces three final goods and services necessary for the survival of its citizens, the Clutchtopians: Pizza, Caffeine Pills, and Exam Reviews. Use the information in the following table to compute nominal GDP and real GDP for Assume that the base year is Product Quantity Price Quantity Price Pizza 250 $8 220 $10 Caffeine Pills 1,200 $5 1,500 $4 Exam Reviews 90 $ $20 Since Real GDP holds prices, it is seen as a better measure of changes in production of goods and services Drawback: over time, prices may change relative to each other > Price of HDTVs have fallen since 2006, while the price of milk has stayed relatively constant Solution: use chain-weighted prices a adjusted average price, rather than a constant base year price > Calculation beyond scope of this course Page 5

6 Inflation refers to a state of the economy where are rising from one year to the next We can use nominal GDP and real GDP to monitor inflation and general price levels in the economy The GDP deflator is a statistic that measures only the prices of goods and services: GDP deflator = Nominal GDP Real GDP 100 Inflation Rate = GDP deflator in Year 2 GDP Deflator in Year 1 GDP deflator in Year 1 In the base year, the GDP deflator = > This is because Nominal GDP Real GDP in the base year PRACTICE: The United States of Barbeque produces two goods: Hot Dogs and Hamburgers. Use the following information to calculate the GDP Deflator for 2012, assuming the base year is Year Price of Quantity of Price of Quantity of Hot Dogs Hot Dogs Hamburgers Hamburgers 2010 $1 400 $ $ $ $ $ PRACTICE: Using the information above, calculate the inflation rate for 2012 in the United States of Barbeque. Page 6

7 CONCEPT: SHORTCOMINGS OF GDP GDP is a variable used to measure (1) total in the economy and (2) the of its citizens. Goods and services are produced but do not contribute to the GDP calculation, though they arguably should: Household Production the value of goods produced for > A carpenter produces bookshelves for a living, but also produced one to use at home > The services of a homemaker (stay-at-home parent) compared to a hired nanny or maid service Underground Economy buying and selling of goods that is from the government > Illegal goods and services, such as drugs and prostitution > Avoiding taxes on income earned > Avoiding government regulations Does the exclusion of household production and underground economy significantly affect GDP s usefulness? > In the short run, the changes in GDP from year to year from these sources is generally constant > In the long run, social changes can have drastic effects on these sources - Example: In the 1970s, the number of women in the workforce increased dramatically - This led to artificial increases to GDP: Previously unmeasured production was now included GDP per capita can be used to signify the well-being of the citizens, but a measure of well-being should arguably include: Value of Leisure: GDP would be higher if everyone worked 80 hours a week Environmental effects: GDP would be higher without environmental regulations > Example: As a measure of well-being, GDP should arguably be reduced for health hazards from pollution Crime and Social Problems: More crime means more government spending on police, but is that actually good? Equity in GDP: GDP measures the size of the pie, but not how it is divided > Even if GDP is increasing, consumption may not increase equally per person Page 7

8 CONCEPT: CALCULATING GDP USING THE INCOME APPROACH Gross Domestic Product (GDP) is the value of the final goods and services produced by a country during a year GDP can be calculated by adding up all the expenditures during the year and has main components > Note that GDP can also be calculated by adding up all the income during the year (less common) > They produce the same result because all the income earned is equal to all the expenditures made The income approach starts by adding up all components of national income: Compensation of Employees: wages and salaries paid by businesses and government to employees > The largest part of national income Rents: income received by landlords on rented properties (residential and business) > Net rental income = Gross Rental Receipts Depreciation of Rental Property Interest: income earned on loans by banks and depository savings by households Proprietors Income: profits earned by sole proprietorships, partnerships, and other unincorporated businesses Corporate Profits: profits earned by corporations > Corporate income taxes are part of GDP because they are earned by the government > Dividends are profits paid out to stockholders > Undistributed Corporate Profits are retained earnings used to re-invest in the corporation Taxes on Production and Imports: any general taxes levied by the government > Taxes are included in GDP Income because Government Purchases are included in GDP Expenditures National income is then adjusted to reflect GDP: Net Foreign Factor Income: GDP measures domestic income > We must remove income earned by Americans for supplying resources abroad > We must add income earned by foreigners for supplying resources to the United States Consumption of Fixed Capital: Depreciation on long-term assets (such as equipment that lasts several years) Statistical Discrepancy: basically an error adjustment made by the accountants ($209 billion in 2009!) Page 8

9 2009 Accounting Statement for the U.S. Economy (in billions) Gross Domestic Product: Expenditures Approach Gross Domestic Product: Income Approach Sum of: Sum of: Personal consumption expenditures (C) $10,089 Compensation of employees $7,792 Gross private domestic investment (Ig) 1,628 Rents 268 Government purchases (G) 2,931 Interest 788 Net exports (Xn) (392) Proprietors income 1,041 Corporate profits 1,309 Taxes on production and imports 1,090 Equals: National Income $12,288 Adjustments: Less: Net foreign factor income (105) Plus: Consumption of fixed capital 1,864 Plus: Statistical Discrepancy 209 Equals: Equals: Gross Domestic Product $14,256 Gross Domestic Product $14,256 Source: Bureau of Economic Analysis, Page 9

10 CONCEPT: OTHER MEASURES OF TOTAL PRODUCTION AND TOTAL INCOME Gross Domestic Product (GDP) focuses on the value of goods and services produced domestically Gross National Product (GNP) focuses on the value of goods and services produced by the country s citizens GNP includes goods and services produced by US-owned facilities abroad GNP excludes goods and services produced by foreign-owned facilities in the US GDP is used because developing countries tend to have many foreign-owned investments > These foreign-owned investments would not be included in GNP and thus make production seem smaller Net Domestic Product (NDP) is GDP adjusted for depreciation National Income is the flip side of total production We calculated GDP using an expenditures approach (C + I + G + NX), but expenditures = income The total value spent on expenditures must be, on the other hand, earned by the sellers Generally, beyond the scope of this course Personal Income is the income received by households Excludes the earnings of corporations Includes transfer payments received from the government (i.e. welfare, interest on financial investments) Disposable Personal Income is the income received by households, less required taxes This represents the amount of money households actually have available to spend Disposable Income can be used for Consumption or Savings Page 10

11 CONCEPT: CONSUMER PRICE INDEX (CPI) Consumer Price Index (CPI) measure of the average change in prices of a typical family s basket of goods Step 1: The government surveys households to see what kind of goods are typically purchased the basket A typical family in Simple Land purchases these items during a given year: 50 jugs of Water and 75 pounds of Food Step 2: The prices of the goods in the basket are determined Step 3: The total cost of the basket is computed 2017 Cost of Basket = 2018 Cost of Basket = 2019 Cost of Basket = Year Price of Water Price of Food 2017 $5 $ $5.05 $ $5.20 $25 Step 4: The cost of the basket is compared to the chosen base-year CPI is calculated Formula CPI for 2017 CPI for 2018 CPI for 2019 CPI CY = Basket Cost CY Basket Cost BY 100 Step 5: The CPI is used to calculate inflation rate (changes in prices over time) Formula Inflation for 2017 Inflation for 2018 Inflation for 2019 Inflation CY = CPI CY CPI PY CPI PY 100 The typical family s spending habits used to construct the basket of goods comes from a government survey of 14,000 households. Source: U.S. Bureau of Labor Statistics Page 11

12 CONCEPT: USING CPI TO ADJUST FOR INFLATION The Consumer Price Index (CPI) can be a useful tool for measuring purchasing power at different points in time Formula for converting dollars from Year T to today s dollars: Amount in CY dollars = Amount in Year T dollars CPI CY CPI T This formula can help you adjust worker wages or prices for goods at different points in time EXAMPLE: Billy the Millennial and Gen X Johnny are caught in a heated dispute. Billy the Millennial exclaims, My student loans are enormous! I can barely afford to go to college! Gen X Johnny haughtily retorts, Ha! You make me sick! Your generation is so lazy! Back in 1975, I worked my way through college making $4.00 an hour at my part-time job at a movie theatre! You just want everything handed to you for free! Not only that, when I left college I worked my butt off 40 hours a week for just $14,000 annual salary and purchased my 3 bedroom home for $42,000. Your generation will never have the work ethic that I put in! Knowing that the CPI was 53.8 in 1975 and 240 in 2016, calculate the following: (a) Gen X Johnny s part-time wage in 2016 dollars (b) Gen X Johnny s annual salary in 2016 dollars (c) Gen X Johnny s home price in 2016 dollars Page 12

13 CONCEPT: PROBLEMS WITH THE CONSUMER PRICE INDEX The Consumer Price Index (CPI) as a measure of inflation can run into biases that tend to overstate inflation: Substitution Bias CPI assumes that the same amount of each product is purchased each month > However, customers are likely to buy fewer of products that increase in price (and vice versa) > Example: Apple prices rise significantly, orange prices rise slightly Substitute apples with oranges > Since the CPI assumes apple purchases remain constant, the CPI will overstate the actual basket price Quality Bias Over time, items in the basket improve in quality > Example: faster computers; safer cars > Higher quality items will have these quality improvements embedded into the price > Thus, although prices may have increased by inflation, they may have increased due to quality as well New Product Bias New products introduced since the last basket will not be included in the basket > Example: Cell phones were not included in CPI until the late 1990s, though millions were in use > Price decreases tend to happen in years following new technology (i.e. DVD players, HDTVs) > If the technology is not included in the basket, then these price decreases will not reflect in CPI Outlet Bias The way people shop has changed over the years > CPI was consistently calculated at full-retail prices available in stores > However, consumers also purchased at discount chains (Costco, Sam s Club) and online > The prices used could overstate the actual prices paid by consumers depending on the chosen outlet Page 13