EXPENDITURE APPROACH: The expenditures on all final goods and services made by all sectors of the economy are added to calculate GDP. Expenditures are

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1 Chapter 1 MEASURING GDP AND PRICE LEVEL MEASURING EONOMIC ACTIVITY 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. It also discusses the issues and policies concerning economic growth, unemployment, inflation, the government budget deficit, and the international trade balance. 1 2 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: 1. Product (or Value Added) Approach: output produced by all firms to be sold 2. Expenditure Approach: amount spent by ultimate buyers 3. Income Approach: income received by producers from the sale of the total output 3 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 is important because it 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? 4 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: Market value of a good = The sum of Price of each good or service multiplied by its Quantity = (P i )(Q i ) 5 2. Final Goods and Services: To calculate GDP we count only the value of the final goods and services produced. We do not count intermediate goods to avoid double counting. 3. Produced within the border of a country: 4. In a given time period: GDP includes only goods and services that are newly produced within the current year. The year of production not the year of sale determines the allocation of GDP 6 1

2 EXPENDITURE APPROACH: 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: 1. consumption expenditure (C), 2. investment (I), 3. government expenditure (Purchase) (G), and 4. net exports, which is exports minus imports (NX = X M). 7 Using expenditure approach, the largest component of GDP is usually personal consumption expenditures. GDP = Y = aggregate expenditure = C + I + G + X M = C + I + G + NX 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. 8 (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. t 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. These new capital goods are used to produce other goods and services. 2. Inventories, which 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 Note - Investment does not include stocks or bonds or other financial assets. Why? These assets only involve transfers of ownership - no physical asset is directly created because of these assets Goods that are produced this year, stored in inventories, and then sold to consumers next year count in this year s GDP 11 If a Bahraini firm buys new machines from Japan, Bahrain s investment would increase. 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 C 12 2

3 Government Expenditure (G) Government expenditure on goods and services (also called government purchase) (G) may include 1. buying goods and services from firms, 2. building roads and bridges, 3. purchase of military equipment, 4. 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. 13 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. 14 Which of the following is not included in 2004 GDP? 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. C 15 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. 16 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 17 If a Bahraini firm buys new machines from Japan, Bahrain s net export would. decrease 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? inventories part of investment part of GDP of n

4 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 d. BAC sells its product to a company in Saudi Arabia e. Some of BAC products are unsold this year 19 INCOME APPROACH: The income approach of calculating GDP is the sum of incomes paid to resources of production. Income is divided into 5 categories 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 Rental income: The income earned by the owners of land, and any other rented resources. 3. Net interest: The income earned by the owners of machines and equipments. = the interest the domestic owners of the capital receive - the interest they pay 4. Corporate profit: What is left to the firm after all payments. It includes both of profits distributed as dividend plus undistributed profits. 5. Proprietor s income: The income of self employed small businesses such as private doctor s clinics, attorney s office, mini-mart 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). 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. 23 To calculate GDP using market value we must add: 1. Net indirect tax (NIT), which is indirect taxes minus subsidies. This 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). Thus, GDP = NDI + (IT subsidies) + D = NDI + NIT + D 24 4

5 Gross and Net Domestic Product Gross means before accounting for the depreciation of capital. Net means after accounting for the depreciation of capital. Net domestic product = GDP depreciation 25 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 Calculate GDP Calculate Net domestic product 26 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 investment 27 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. Is there government budget deficit or surplus? 28 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. The income of an Indian working in Bahrain is part of Bahrain's GDP as well as India's GNP 29 NOMINAL GDP vs. REAL GDP: Recall that GDP is calculated by adding the market value of all final goods produced. Thus, the market value of production and hence GDP can increase either : 1. because of the increase in production of goods and services, 2. because of the increase in the prices of goods and services, or 3. because of the increase in both. 30 5

6 To determine whether the increase is only due to the increase in real production rather than in the price level, economists distinguish real from nominal GDP. Nominal GDP is the value of GDP measured at the prices that prevailed in that same year (current prices). Nominal GDP increases when the prices and / or quantities of goods and services increase. Thus, using nominal GDP to compare among different years does not give us the actual picture of the performance of the economy. Using nominal GDP, we can measure the changes in the cost of living due to the changes in the price level. Cost of living is the amount of money it takes to buy goods and services Real GDP is the value of GDP measured at constant prices (base year prices). It 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. 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. 33 The first step to calculate real GDP is to choose a base year. The base-year method is to choose a reference year (a bench mark year if you like) and then use that year prices of goods and services for all other years. The base year is the year in which real GDP = nominal GDP The base year is roughly revised every 5 to 10 years 34 RGDP shows the change in production. RGDP is used to measure: 1. the size of the economy, and 2. the growth in the economy If RGDP > NGDP then prices were higher in the base period than the current period. If RGDP < NGDP, current prices are higher than base period prices. RGDP = NGDP for the base period. In years with inflation, nominal GDP increases faster than real GDP. 35 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. a. Calculate nominal GDP b. Calculate real GDP c. Calculate GDP deflator 36 6

7 Good 1 Good 2 Year P P Q Q $/ unit $/unit 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. 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. 38 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 GrowthRate= 100 RGDP last year The new method of calculating real GDP, which is called the chain-weighted output index method. chain-weighted output index uses the prices of two adjacent years (or of several years) to calculate the RGDP growth rate and. 39 If real GDP in 2003 is $9 billion and real GDP in 2004 is $9.27 billion, what is the economic growth rate in 2004? Answer: 3.0 percent 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: $ We use the economic growth rate to make: 1. economic welfare comparisons 2. international comparison 3. business cycle forecasts 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)

8 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 per person = (RGDP/population) 43 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. 44 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 i as a measure of economic welfare because: 1. It does not include non-market activities. 2. It does not include underground economy transactions GDP per person is only a measure of the average level of output per person in the economy. 4. degradation of environmental quality 5. Government services (not sold in markets) are measured by their cost of production 6. RGDP 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 Does not include leisure time 8. Governments overstate or understate GDP for different political, economic, or social reasons. 9. Over-adjustment for inflation: 10. New goods create problems in calculating Real GDP. International Comparisons and Purchasing Power Parity (PPP)

9 APPENDIX: 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. Capital and Investment 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. 49 Investment is the flow that changes the stock of capital. Depreciation (D) is the decrease in the capital stock that results from wear and tear, and obsolescence. Capital consumption is another name for depreciation. Gross investment is the purchases of new capital. Net investment is the change in the stock of capital. Net Investment = gross investment -D 50 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. Public Saving which is the government budget surplus (T G) 3. Borrowing from the rest of the world (M X). 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 Therefore, RGDP can be written as; Y = C + I + G + X - M (reflecting its aggregate expenditure), or Y = C + S + T (reflecting the use of RGDP, income) So we have C + I + G + (X M) = C + S + T Cancel the C's and move X - M to the financing side you get I + G = S + T + (M X) This equation shows us that financing for I and G come from private saving, taxes, and foreign sources. 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) 53 Private saving (S) = Y T C = disposable income consumption = income tax consumption Government (Public) saving = T G If (T G) > 0 surplus If (T G) < 0 deficit National saving = private saving + government saving = (Y T C) + (T G) = Y C G Private investment = National Saving + borrowing from the rest of the world 54 9

10 Suppose an economy has the following data (in million of dollars) Y = 200, C = 130, T = 30, and G = 20, then S = Y C T = = 40 Public saving = T G = = 10 National saving = Y C G = = 50,or = private saving + public saving = = 50 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 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? 57 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 the most popular two: 1. The GDP Deflator 2. The Consumer Price Index (CPI) 58 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. 59 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 60 10

11 Real GDP = (Nominal GDP*100)/GDP deflator Nominal GDP = (Real GDP * GDP deflator)/100 The larger the nominal GDP for a given RGDP the higher is the price level and the larger is the GDP deflator Find GDP Deflator for the above example Suppose the nominal GDP per person is $10,000 in 2004, the 2004 GDP deflator is 110 then the real GDP per person is $ 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. 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. 63 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 64 The CPI is defined to equal 100 for the reference base period. 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 P in bought 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 $

12 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 CPI in 2001 (the base year) = (2900/2900)x100 = 100 (always) CPI in 2002 = (3700/2900) x 100 = 128 the cost of living has increased from 2001 to 2002 by 28% CPI in 2003 = (4000/2900) x 100 = 138 the cost of living has increased from 2001 to 2003 by 38% Shortcomings of CPI 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 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 overestimate inflation; the price of computing has decreased even though h 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. 70 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 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

13 Exercise The average price of the imported food in Bahrain has increased in recent years. This increase must show up a. in Bahrain s GDP deflator b. in Bahrain s CPI c. both in Bahrain s CPI and Bahrain s GDP deflator d. 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 INFLATION RATE: The inflation rate is the percentage change in the price level from one year to the next. PriceLevel(thisyear)- PriceLe vel(last year) Inflation Rate = 100 Pi PriceLevel(last year) Price Level (this year) - Price Le vel (last year) Inflation Rate = 100 Price Level (last year) 75 13