GDP and The Measurement of Progress What is GDP Gross Domestic Product (GDP) is the market value of all final goods and services produced within a country in a year. GDP per capita GDP divided by population Gross National Product is the market value of all final goods and services produced by a country s permanent residents, wherever they may be located, in a year. Breaking it down 1. Market value goods are measured in terms of their market prices. A car ($30,000) adds more than a pen ($1). 1
2. Final goods only final goods and services are counted. These goods are sold to final users and then consumed or held in personal inventories. Intermediate goods are goods that are bundled or processed with other goods and services. These are not counted in GDP until they are sold in the fully assembled good or service. A microprocessor sold by Intel to HP for inclusion in a desktop computer doesn t count. It gets counted in the price of the computer when it is sold to a person or business. A John Deere tractor sold that is used to harvest soy beans does count though. The tractor is a finished good and not really considered part of a soybean. Machinery and equipment sold to businesses is considered part of final output and is included in GDP. 3. Goods and services haircuts and carwashes (services) count just like new computers or new textbooks. 4. Produced new stuff or services count, but not used goods that have already been produced in an earlier period. 5. Within a country for US GDP the good has to be produced within the geographic area of the U.S. Buying a Ford produced in Mexico does not count (at least the part produced in Mexico). Buying a Toyota produced in Ohio does count (at least the part that was produced in the USA). 2
6. in a given period of time that usually means within a year or quarter. Tell us how much is produced in a year, not the sum total of our wealth Wealth would be the value of a nation s entire stock of assets, which accumulate and depreciate over time. Compiled quarterly by the Bureau of Economic Analysis (BEA) which is part of the U.S. Department of Commerce in Washington, D.C. Growth rates This tells us how rapidly output is growing or falling over time. GDP t GDP t 1 GDP t 1 100 = GDP growth rate for year t Example: GDP for the 3rd quarter of 2013 was $15,681.0 billion. For the 2nd quarter it was $15,583.9. Second quarter growth is estimated to be: 15681.0 15583.9 15583.9 100 = 0.62 per quarter To make this comparable to yearly growth, multiply by 4. 4 quarters 0.62/quarter = 2.49 3
This is often approximated using a slightly different calculation that works well when growth rates are relatively low. Continuously Compounded Annual Rate of Change [ln(gdp t ) ln(gdp t 1 )] 100) number of obs per yr = The function ln is the natural logarithm. In terms of our example that would be [ln($15, 681.0) ln($15, 583.9)] 100 4 = 2.485 This is probably the most widely used way of calculating growth rates based on time series data, though there are others. Just be aware that growth rates that you calculate may not match exactly those computed by others since there are small variations in the formulae. Nominal vs Real GDP Economists usually are more interested in increases in production than increases in prices because only increases in production are true increases in the standard of living. To measure increases in production, we look at growth rates of real GDP. Nominal GDP is calculated based on prices at the time of sale. 4
Real Variables variables such as real GDP that have been adjusted for changes in prices by using the same set of prices in all time periods. A real variable is one that corrects for inflation, namely a general increase in prices over time. Real GDP is the market value of all final goods and services produced within a country in a year that has been adjusted for changes in prices, that is for any inflation that may have occurred. Price Index A measure of the overall level of prices in the economy. GDP Deflator a price index used to compute inflation. It is found by dividing nominal GDP by the real GDP in any given year. GDP Deflator = Nominal GDP Real GDP 100 (1) Measuring Real GDP at least in principle To measure real GDP in any given year you first select a base year that establishes the prices you will be using. Then, you evaluate the goods and services produced in the year using the prices from the base year. It doesn t matter much what prices we use to calculate real GDP, so long as we use the same prices in all years. 5
Figure 1: Example from Cowen For example, lets calculate the GDP Deflator for 2010. We can easily find 2010 nominal GDP and 2010 real GDP (using 2005 dollars) from the U.S. Bureau of Economic Analysis. Here are the numbers: Real GDP Growth If pressed to choose a single indicator of current economic performance, most economists would probably choose real GDP growth. Figure 2 shows the annual percentage changes in real GDP for the United States from 1948 to 2009. U.S. real GDP growth was high during the 1960s, but rising inflation and the 1973 and 1979 oil price shocks lowered growth in the 1970s and early 1980s. The farther apart the time periods are that you want to compare, the less precise these comparisons be- 6
Figure 2: Real GDP growth for the USA, 1948-2009 7
come. The main reason has to do with the introduction of new goods (computers) that don t exist in periods long past. Quality changes have to be accounted for as well. There are some tricks that can be used to account for these changes, but clearly there is room for errors to creep in and compound over time. Per capita growth If the population is growing rapidly, a county may experience GDP growth, but citizens may become worse off. Growth in real GDP per capita is usually the best reflection of changing living standards. Cyclical changes in GDP Fluctuations in real GDP around its average long-term trend are referred to as the business cycle. Potential GDP This is a measure of what the economy is capable of producing at normal levels of employment and productivity. Essentially, this is used as the benchmark for the long-run trend for GDP. 8
Recession significant, widespread declines in real income and employment. Boom significant economic growth above the long-term trend. NBER National Bureau of Economic Research a research organization based in Cambridge, Massachusetts, is considered the most authoritative source on identifying U.S. recessions. The official NBER definition of a recession is as follows: A recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales. Notice that the blue line is moving downward during each recession, which means output is falling. Ways of measuring GDP 1. National Spending Approach 2. Factor Income Approach Y = C + I + G + NX Y = Wages + Rent + Interest + Profit 9
Figure 3: Real GDP for USA, 1965-2013. Recessions are indicated by the grey bars. There have been 7 recessions since 1965, the last one being the most severe. 10
Figure 4: Real GDP growth for USA, 1965-2013. Recessions are indicated by the grey bars. There have been 7 recessions since 1965, the last one being the most severe. Average growth over the period is about 4%. 11
Spending Approach The national spending identity: Y = C + I + G + NX where: Y = Nominal GDP (the market value all final goods and services) C = The market value of consumption goods and services I = The market value of investment goods, also called capital goods G = The market value of government purchases NX = Net exports, defined as the market value of exports minus the market value of imports We explain each of these factors more in turn. Consumption Consumer spending on final goods and services. 12
Investment Investment is private spending on tools, plant, and equipment that are used to produce future output. It also included spending on new houses. Government Purchases Spending by all levels of government on final goods and services. G does not include transfer payments, which are a large part of what government does: transfer money from one citizen to another citizen. About 21% of the spending of the federal government, for example, is for Social Security payments. Unemployment and disability insurance, various welfare programs, and Medicare are also large transfer programs. Net Exports exports minus imports. Importing reduces GDP. The good is purchased in the U.S. but is produced elsewhere; we only measure purchased goods produced here. Exporting increases our GDP. If a good is produced in the U.S. and purchased abroad, then it should count towards our output. 13
Figure 5: U.S. GDP by components in 2007 14
Factor Income Approach When a consumer spends money, the money is received by workers (employee compensation = wages + benefits), landlords (rent), owners of capital (interest), and businesses (profit). Thus, we have yet another way of calculating GDP: We can add up all the spending or we can add up all the receiving. The first method is called the spending approach, while the second is called the factor income approach. The factor income approach: Y = Wages + Rent + Interest + Profit 15
Shortcomings of GDP as measure of output and well-being GDP measures the market value of final goods and services. But there are many goods and services for which we do not know the market value. So, what are its shortcomings in measuring overall economic well-being of a country? 1. Does not count the underground economy. Only counts things traded though regular channels in markets. 2. It does not count production of things that have no price. Mow your own yard? It doesn t count unless you hire someone to do it for you. In either case production occurs, but it only gets counted if you pay someone else to do it for you. 3. Leisure does not count. Leisure is good. More is better. But since no one pays you to enjoy it, it does not count toward a nation s GDP. 4. GDP doesn t count bad stuff. Pollution, for example, is a bad that is produced every year, but this bad is not counted in the GDP statistics. GDP statistics also do not count the destruction of water aquifers, the accumulation of carbon dioxide in the atmosphere, or changing supplies of natural resources. Similarly, GDP statistics do not count the loss 16
of animal or plant species as economic costs, unless those animals and plants had a direct commercial role in the economy. Other bads are also not counted in GDP. The bad of crime, for example, is not counted in the GDP statistics. (Cowen and Tabarrok, 2011, p. 108) 17
Bibliography Cowen, Tyler and Alex Tabarrok (2011), Modern Principles of Economics, 2nd edn, Worth, New York. 18