EQ: Why is Economic Growth Good? EQ: What is Economic Growth? EQ: What is Gross Domestic Product? EQ: How is Economic Growth Measured?

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1 EQ: What is Economic Growth? Economic growth is an increase in total output of goods & services within an economy. Economic growth occurs when more goods & services are produced and consumed within an economy than previously. Example: In one year, businesses make cars, food, houses, and offer services which are all bought and used by households and organizations. The next year, businesses make more than they made the year before and it is all bought and used by households and organizations. EQ: Why is Economic Growth Good? Remember that the goal of economics is to provide as much consumer satisfaction as possible with the limited resources available. Consumer satisfaction is the usefulness or happiness that people get from using goods and services The more goods and services consumed, the more consumer satisfaction there is. Since economic growth results in more goods and services available for consumption, economic growth results in greater consumer satisfaction. EQ: How is Economic Growth Measured? The way we determine whether we are achieving the goal of economic growth is by examining: Gross Domestic Product (GDP) A method of determining economic growth (which is fundamentally a question of real physical production) in terms of money value (which is a nominal approximation). Note that GDP is not actual economic growth, but merely a money value approximation of economic growth. There are 3 methods of measuring GDP: Value Added (Product) the compounded money values of each step of added value in the value chain (manufacturing & retailing). National Income the total money value paid for all resources within the economy (wages, rents, materials, etc.). Total Expenditures the total value of all money spent by people and organizations for goods & services purchased for final consumption. We will focus on GDP measured as Total Expenditures only, but all 3 methods should result in the same money value. EQ: What is Gross Domestic Product? Let s break down the concept: Gross a total value before taking out deductions for expenses, costs, or taxes. Domestic pertaining to one s own country as apart from other countries. Product the totality of goods or services made. So, Gross Domestic Product (GDP) is the total value of all goods and services made within a specific country (separate from other countries) before taking out deductions for the expenses and costs of businesses. Let s now explore the philosophy behind why we even use GDP.

2 EQ: What is Gross Domestic Product? We said that GDP is a method of determining economic growth in terms of money value. Remember that economic growth has to do with how many goods & services are produced and consumed which is an issue of physical production and consumption. However, there are thousands of goods and services in the economy and it is impossible to account for all of the quantities of these produced and consumed. We need to convert the production and consumption of all of these goods & services into one common value. Thankfully, we already have a tool that does this money as a measure of value. So, we convert all goods & services produced and consumed into their individual money values and then add them all together. The resulting money value is called GDP. What is Total Expenditures? Total Expenditures (TE) in an economy is the sum total of all nominal expenditures on goods and services intended for consumption in the economy. All the goods and services purchased are going to be used up and not included in something else that will be sold. The nominal money values spent on stuff. Nominal money values added together into a single value. Total expenditures consists of four types of spending: Consumption (C) Investment (I) Government Spending (G) Net Exports (X M) Total Expenditures (TE) = C + I + G + (X M) EQ: What are the Components of Total Expenditures? TE consists of four types of spending: Consumption (C) is the sum of all nominal spending on goods and services by households for the purpose of consumption. Examples (no used goods!): Food, Clothing, and Furniture Dental Care and Accounting Services Movies, Car Rentals, and Hotel Rooms Investment Government Spending Net Exports EQ: What are the Components of Total Expenditures? TE consists of four types of spending: Consumption Investment (I) is the sum of all nominal spending on goods and services by businesses for the purpose of consumption (long/short term). Examples (no resale items!): Computers, Desks, and Office Supplies Toilet Paper for Bathrooms and Light Bulbs for Lamps Janitorial and Accounting Services Government Spending Net Exports

3 EQ: What are the Components of Total Expenditures? TE consists of four types of spending: Consumption Investment Government Spending (G) is the sum of all nominal spending on goods and services by governments for the purpose of consumption. Examples (no welfare payments!): Computers, Desks, and Office Supplies Toilet Paper for Bathrooms and Light Bulbs for Lamps Janitorial and Accounting Services Net Exports EQ: What are the Components of Total Expenditures? TE consists of four types of spending: Consumption Investment Government Spending Net Exports (X M) is all nominal spending in this country on stuff to be consumed in other countries (i.e., exports) minus all nominal spending in other countries on stuff to be consumed in this country (i.e., imports). Net Exports = Exports (X) Imports (M) EQ: What is NOT Included in GDP? Materials and other inputs used in the production of final goods, but not final consumable goods themselves (e.g., McDonald s frozen hamburgers and soda syrup). These are not counted in GDP now because they will eventually be included in GDP when they are sold for consumption. EQ: What is NOT Included in GDP? Used Goods these were already counted when they were sold new. Financial Transactions money gifts, loans, and stock or bond purchases not goods or services, just money. Transfer Payments welfare payments from governments to households; money only no goods or services.

4 EQ: What is NOT Included in GDP? Productive economic activity that is not bought or sold in a market; these cannot be tracked or recorded in GDP. Stay-at-home moms/dads provide valuable services. Do-it-yourself projects produce valuable output. Because non-market production provides consumer satisfaction but is not recorded, GDP is often understated. EQ: What is NOT Included in GDP? Production activity that is not reported to the government but nonetheless provides consumer satisfaction. Some business owners evade paying income taxes by not reporting income on goods or services sold. Illegal activity is not recorded for obvious reasons (e.g., illegal drugs, selling pirate copies of DVDs/software, etc.). EQ: What is NOT Included in GDP? Even though leisure time is non-productive, it does provide satisfaction to those that enjoy it. For example, a family may spend a week at Disney World and spend lots of money (which would be counted in GDP); or they could spend that week camping for free and get the same satisfaction. EQ: What is NOT Included in GDP? Some economic activity is destructive to future economic activity (e.g., abuse of natural resources, pollution, failure to maintain capital equipment). Philosophically, this should be deducted from GDP since it is eroding economic growth. There is no plausible way to account for these effects.

5 EQ: What is the Difference between Nominal GDP & Real GDP? So, the value that is referred to in these definitions is GDP: Nominal GDP A measure of GDP in prices that are current to the time of purchase. GDP that is unadjusted for changes in price level. Since GDP is a money value measure of production output of goods and services: Nominal GDP is the total dollar value of all production output of goods and services within an economy, unadjusted for changes in the price level. Nominal GDP accounts for both changes in production and changes in the price level. EQ: What is the Difference between Nominal GDP & Real GDP? So, the value that is referred to in these definitions is GDP: Real GDP GDP that has been converted as if there were no inflation at all. GDP that is adjusted for changes in the price level. Since GDP is a money value measure of production output of goods and services: Real GDP is the total dollar value of all production output of goods and services within an economy adjusted for changes in the price level. Real GDP accounts for only changes in production and NOT for changes in the price level. EQ: What is the Difference between Nominal GDP & Real GDP? Did you notice that the only difference between Nominal GDP and Real GDP is inflation? Nominal GDP includes price level changes. Real GDP dissects out the inflation. Why distinguish between Nominal & Real GDP? Changes in the price level skew (inflate) the measure of GDP. Real GDP is supposed to be actual production of output in an economy, regardless of money prices. Nominal GDP focuses on prices while Real GDP focuses on output of goods and services. So, Real GDP is a better measure of economic growth and consumer satisfaction in an economy. EQ: How Do I Calculate Real GDP? Why calculate Real GDP? Real GDP is calculated so you can compare 2 or more years of output to one another. Basically, you are removing the change in price level from Nominal GDP by adjusting it to the same price level from another year, which is chosen and set as the objective Real GDP year. You will need: The CPI from the comparison Real GDP year (CPI 1 ). Nominal GDP & the CPI from another year (CPI 2 ). Calculation First, divide CPI 2 by CPI 1. Nominal GDP Then, divide Nominal GDP 2 by this quotient. ( CPI 2 /CPI 1)

6 EQ: How Do I Calculate Real GDP? Example #1: In 1990: Nominal GDP was $5,803 billion CPI was In 1991 Nominal GDP was $5,996 billion CPI was What was Real GDP in 1991, adjusted to the 1990 price level? *Round to the nearest billion $ 1990 is the comparison year, so we will call the Nominal GDP from 1990 the Real GDP in 1990 for comparison purposes. So, we want to know what GDP was for 1991 in terms of the value of money in Real GDP (1991) = Nominal GDP 2 = $5,996B = $5,754* billion ( CPI 2 /CPI1 ) ( / ) EQ: How Do I Calculate Real GDP? Example #2: In 1972: Nominal GDP was $1,238 billion CPI was 41.8 In 1973 Nominal GDP was $1,383 billion CPI was 44.4 What was Real GDP in 1973, adjusted to the 1972 price level? *Round to the nearest billion $ 1972 is the comparison year, so we will call the Nominal GDP from 1972 the Real GDP in 1972 for comparison purposes. So, we want to know what GDP was for 1973 in terms of the value of money in Real GDP (1973) = Nominal GDP 2 = $1,383B = $1,302* billion ( CPI 2 /CPI1 ) ( 44.4 / 41.8 ) EQ: What is Natural Real GDP? Remember the last time you heard Natural? That s right the Natural Unemployment Rate. Natural Real GDP is related to Natural Unemployment Rate Natural Rate of Unemployment The rate of unemployment remaining when an economy is at full employment (i.e., no cyclical unemployment). It is also the lowest rate of unemployment that can be sustained without increasing inflation. At the Natural Rate of Unemployment, we achieve: Full Employment Price Level Stability Natural Real GDP is the level of economic output achieved at the Natural Rate of Unemployment. EQ: What is Natural Real GDP? Natural Real GDP is the ideal level of output in an economy because it results in: Price Level Stability Full Employment Also, due to technological advances and growth of population, Natural Real GDP will increase over time, which is economic growth. The bottom line: Natural Real GDP is the level of economic output (Real GDP) in an economy where the economy can achieve all three of its macroeconomic goals.

7 EQ: What is the Difference between Absolute and Per Capita Economic Growth? Absolute Economic Growth is an increase in Real GDP. It is what we have been talking about so far when we refer to economic growth. Per Capita Economic Growth is an increase in the average productivity of each member of society. Per capita means per person. So, per capita economic growth means economic growth per person (i.e., Real GDP per person). To calculate this, you divide Real GDP by the population of the economy. It is the amount of total output divided by the number of people, resulting in the amount of output per person. Per capita Real GDP is a measure of the standard of living (how comfortable people are) in an economy. EQ: What is the Difference between Absolute and Per Capita Economic Growth? Per capita Real GDP is a measure of the standard of living in an economy. Standard of living is the level of material wellbeing of consumers in an economy. Since per capita Real GDP is a measure of how much output is produced by people on average in an economy, it can also be used as an approximation for how much material stuff each person has in the economy. So, if each person produces more output, it can be assumed that each person in the economy has more to consume. Remember economic growth is an increase in the output of actual physical goods or valued services, not just an increase in money spent. Anything that can help increase the physical production of goods or the provision of services in an economy will cause economic growth. There are 2 categories of sources for increased output: The quantities of resources and their productivity. Government policies related to production activity. Long Run vs. Short Run In the short run, output can increase simply by using existing resources and technology. So short run economic growth is possible without increasing the stock of resources or level of technology. In the long run, output can only increase by increasing the stock of resources or technology.

8 Resources Natural Resources (Land) Simply having more natural resources allows greater production because you have more inputs. More natural resources can be gained by mining existing deposits, buying from other countries, or through imperial/military force. Resources Labor Simply having a larger labor force allows greater production because more inputs are available. Without an increase in capital or technology also, these increases will gradually become smaller and smaller due to the Law of Diminishing Returns (LDR the more labor resources you add to a fixed set of capital or land, the less per unit output you will receive from each labor input). An increase in the productivity of the existing labor force through increases in human capital due to: Education/Training - increasing the knowledge & skills of labor allows for greater quantity and quality of economic output. Work Experience becoming more efficient through repetition and understanding of the job and tasks performed. Productivity is quantity of output per unit of input employed. Resources Capital Increasing the capital stock in an economy will allow for greater production in 2 ways: Some capital that is autonomous (car wash, assembly line robots, etc.) can produce goods and services without labor. Capital that is used by labor (hammers, computers, etc.) increases the productivity of labor so that each worker can produce more output. Capital stock is the aggregate of all factories, roads, machinery, tools, etc. (the sum of all capital goods) in a country. Resources Technology (Entrepreneurship: new ideas) Technical progress (i.e., technological advance) is a resource productivity improvement that enables factors of production to: Provide the greater output using the same inputs. Provide the same output using fewer inputs. There are 2 types of technical progress affecting output: Capital Improvements better machines with better features.» Example: a power saw vs. a hand saw. Process Improvements better ideas for how to produce.» Example: assembly line vs. full unit production. Theories of economic growth focus primarily on technical progress as the main reason for significant increases in the standard of living in an economy.

9 Government Policies Strong Private Property Rights motivates resource owners to use their property to be most productive. Property rights can be strengthened by: Enforcement of property rights through criminal/civil law. Low tax rates to encourage saving & investment. Minimal government regulation. Minimal government corruption. Free & Competitive Markets by encouraging competition and allowing market forces (supply & demand) to determine price and output decisions, resources are used more efficiently and for the best and highest level of production activity. Government Policies Free International Trade Access to lower-priced markets of production factors. New markets for selling produced output (exports). Additional goods for consumption (imports). A Stable Price Level Excessive inflation or deflation makes investors nervous and leads to decreased investment. Decreased investment inhibits economic growth. A Small Government Private businesses use resources more efficiently than public sector organizations (governments). Government is necessary to protect property rights and provide economic infrastructure & public services. Smaller gov t allows more resources for the private sector. EQ: What is a Trade-Off? A Trade-Off is a decision situation in which you must give up one good thing in order to have another good thing. With trade-offs: You can t have your cake and eat it, too. You are choosing between 2 goods things, so the decision is very difficult. Trade-Offs are an essential feature of economics because they exist as a result of scarcity. Every decision requires a trade-off: It is unreasonable when people say that they can have it all or there are no down sides to a decision. Every decision made has a lost opportunity attached to it. EQ: What kinds of trade-offs have to be made when pursuing the 3 economic goals? We said before that Natural Real GDP is the ideal level of economic output because it results in: Economic Growth Full Employment (Natural Rate of Unemployment) Price Level Stability However, we never know whether we are at this level in an economy it is more a theoretical state than a practical tool. As a result, we are rarely operating at this state. When we are not at this ideal state, these three goals are not in balance and trade-offs have to be made about which of the 3 is more important.

10 EQ: What kinds of trade-offs have to be made when pursuing the 3 economic goals? Economic Growth-Full Employment Trade-Offs EQ: What kinds of trade-offs have to be made when pursuing the 3 economic goals? Economic Growth-Price Level Trade-Offs EQ: What kinds of trade-offs have to be made when pursuing the 3 economic goals? Price Level-Full Employment Trade-Offs EQ: What kinds of trade-offs have to be made when pursuing the 3 economic goals? By focusing all economic decisions on achieving output equal to Natural Real GDP, the trade-offs we make will optimize consumer satisfaction and provide the most stable and long-lasting economic welfare. We are giving up more growth, less unemployment, and lower prices in the short-term so we can have all three in the long-term.