© 2007 thomson south-western the measurement of gross domestic product gross domestic product (gdp)...

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THE MEASUREMENT OF GROSS DOMESTIC PRODUCT• Gross domestic product (GDP) is …

– the total market value of all final goods and services produced within a country in one year.

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THE MEASUREMENT OF GROSS DOMESTIC PRODUCT• “GDP is the Market Value . . .”

– Output is valued at market prices.

• “. . . Of All. . .”– Includes all items produced in the economy and legally

sold in markets

• “. . . Final . . .”– It records only the value of final goods, not intermediate

goods (the value is counted only once).

• “. . . Goods and Services . . .”– It includes both tangible goods (food, clothing, cars) and

intangible services (haircuts, housecleaning, doctor visits).

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THE MEASUREMENT OF GROSS DOMESTIC PRODUCT• “. . . Produced . . .”

– It includes goods and services currently produced, not transactions involving goods produced in the past.

• “ . . . Within a Country . . .”– It measures the value of production within the geographic

confines of a country.

• “. . . In One Year.”– Sums the dollar value of what has been produced in the

economy over the year.

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THE COMPONENTS OF GDP

• GDP includes all items produced in the economy and sold legally in markets.

• What Is Not Counted in GDP?– GDP excludes most items that are produced and

consumed at home and that never enter the marketplace.

– It excludes items produced and sold illicitly, such as illegal drugs.

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THE COMPONENTS OF GDP

GDP (Y) is the sum of the following: Personal Consumption (C) Domestic Investment (I) Government Purchases (G) Net Exports (NX)

Y = C + I + G + NX

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THE COMPONENTS OF GDP

• Personal Consumption (C):• spending by households on …

• Durable goods • Non durable goods• services

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THE COMPONENTS OF GDP

• Domestic Investment (I):• All final purchases of machinery, equipment, and

tools by businesses.• All construction• Changes in business inventory

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THE COMPONENTS OF GDP

• Government Purchases (G):– Spending by local, state, and federal governments.– All direct purchases of resources (labor in

particular)

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THE COMPONENTS OF GDP

• Net Exports (NX):– All spending on goods produced in the US

• Purchases both here and abroad (exports)

– Goods purchases in the US which are produced elsewhere (imports)

– Net Exports = exports - imports

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NOT INCLUDED IN GDP

• Second Hand Sales– Reselling a car

• Purely Financial Transactions– Public transfer payments

• Social security• Sale of stocks and bonds

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REAL VERSUS NOMINAL GDP

• Nominal GDP values the production of goods and services at current prices.

• Real GDP values the production of goods and services at constant prices.

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Calculating Nominal GDP

(P(year) * Q(year)) + (P(year) * Q(year)) + …

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Real and Nominal GDP

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Real and Nominal GDP

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Calculating Real GDP

(P(base year) * Q(real year)) + (P(base year) * Q(real year)) + …

Base year = a designated year for the price

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Real and Nominal GDP

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Real and Nominal GDP

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Calculating Real GDPin % Terms

Real GDP – Real GDP base year

Real GDP base year)

Base year = a designated year for the price

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IS GDP A GOOD MEASURE OF ECONOMIC WELL-BEING?

• GDP – best single measure of the economic well-being of a

society. – per person

• the income and expenditure of the average person in the economy.

– Higher GDP per person indicates a higher standard of living.

– not a perfect measure of the happiness or quality of life

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GDP AND ECONOMIC WELL-BEING• Some things that contribute to well-being are

not included in GDP.– The value of leisure.– The value of a clean environment.– The value of almost all activity that takes place

outside of markets, such as the value of the time parents spend with their children and the value of volunteer work.

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Table 3 GDP and the Quality of Life

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Bureau of Labor Statistics (BLS) Labor Categories

An adult is over 16 years old is …– Employed - those who are working at least one hour/week at a paid job.– Unemployed – those who are not working at least one hour/week but seeking employment.– Not in the labor force - A person who fits neither of these categories.

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How Is Unemployment Measured?

Labor force - the sum of employed and unemployed.

Labor Force (LF) =

Number of Employed (E) + Number of Unemployed (U)

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How Is Unemployment Measured?

• Labor-force participation rate - the percentage of the working-age population in the labor force.

LFPR% = 100*(LF) / (civilian population >= 16)

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How Is Unemployment Measured?

• Unemployment rate - the percentage of the labor force that is not employed

UR% = 100*(# unemployed)/(# LF)

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How is Unemployment Measured?

• Natural Rate of Unemployment– The amount of unemployment that the economy

normally experiences– There is ALWAYS a level of unemployment

• Natural Unemployment =

Frictional Unemployment + Structural Unemployment

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Why Are There Always Some People Unemployed?

• Frictional unemployment - – Those searching for jobs– Waiting to take jobs soon

• College student graduates and their job starts in a month

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Why Are There Always Some People Unemployed?

Structural unemployment -

more people are seeking jobs than there are jobs available– Skills– Geographic distribution

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Structural Unemployment

We know that when D decreases, P (W) decrease.

What if the wage does not adjust downward? What would cause this to happen?

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Structural Unemployment

1. Minimum Wage– Price floor– Surplus of labor

• Fast food

2. Labor Unions1. Negotiate with employers on behalf of their workers.

1. Goal is to raise wages above market equilibrium2. May be some unemployment

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Structural Unemployment

3. Efficiency Wages1. Wages above equilibrium wage rate

1. Incentive for better performance2. May create a surplus of workers

4. Side Effects of Public Policy2. Benefits to laid off workers

1. Reduces the incentive to quickly find work

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Cyclical Unemployment

Cyclical Unemployment – – the portion of unemployment which arises from

the business cycle.

Actual Unemployment =

Natural Unemployment + Cyclical Unemployment

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Changes in the Natural Rate of Unemployment

1. Labor Force Characteristics1. People are working longer.

1. Decline in Natural Rate of Unemployment

2. Labor Market Institutions1. Decline in the role of labor unions.

1. Reduced Structural Unemployment

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Changes in the Natural Rate of Unemployment

3. Government Policies1. Subsidies to employers to employ and/or retrain

workers with obsolete skills.1. Lessen the Natural Rate of Employment

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Inflation and Deflation

Matthew has income of $20/week to spend on Gasoline ($2/gallon) or Venti Mochaccino Café Lattes ($4/cup). His purchasing possibilities are:

Most Gas Most Lattes OC of one more latte

10 gallons 5 cups 2 gallons

One gallon of gas uses up 10% of his income.One cup of latte uses up 20% of his income.

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Inflation and Deflation

Now, the price of gas doubles - $4/gallon, and the price of a latte doubles - $8/cup.

Most Gas Most Lattes OC of one more latte

5 gallons 2.5 cups 2 gallons

One gallon of gas uses up 20% of his income.One cup of latte uses up 40% of his income.

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Inflation and Deflation

What would Matthew do?

What would the sellers of gas and café lattes do?

Inflation creates costs for both groups of people.

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Inflation and Deflation

Inflation is the over all rise in prices.

Deflation is the overall decline in prices.

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Costs of Inflation

• Shoe Leather Costs• Menu Costs• Unit-of-Account Costs

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Shoe Leather Costs

• Shoe Leather costs - resources wasted when inflation encourages people to reduce their money holdings.– Inflation reduces the real value of money – People have an incentive to minimize their cash holdings. – Less cash requires more frequent trips to the bank

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Menu Costs

Menu costs are the costs of adjusting prices.

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Inflation and Deflation

• Unit-of-Accounts Costs– These costs arise due to the way inflation affects

the value of money.– Less reliable unit of measure.

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Winners and Losers from Inflation

• Inflation can often just redistribute money from one person to another.– Borrowers and lenders

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Winners and Losers from Inflation

Suppose you lend a friend $100 and she promises to pay you back in a year. You decide to charge her interest on the $100.

How do you determine how

much to charge?

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Winners and Losers from Inflation

• Compensation for not having the money to use during the year.

• Inflation will have eroded the purchasing power of the original $100.

How do you determine how

much to charge?

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Winners and Losers from Inflation

Interest Rate has two parts:

1. Service compensation

2. Inflation offset

How do you determine how

much to charge?

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Winners and Losers from Inflation

Nominal Interest Rate =

real interest rate + expected inflation

How do you determine how

much to charge?

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Winners and Losers from Inflation

Inflation = 5%

Lending services = 3%

3% + 5% = 8%

Nominal Interest Rate = 8%

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Winners and Losers from Inflation

Expected Inflation

Actual Inflation

Effects Who Benefits

5% 5% No change Even

5% 1% Purchasing power

increased

Lender gains

5% 8% Purchasing power

decreased

Borrower gains

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Price Indices and

the Aggregate Price Level

Inflation - the economy’s overall price level is rising.

– % change in the price level from the previous period.

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THE CONSUMER PRICE INDEX

Consumer price index (CPI) – Measures the overall cost of the goods and

services bought by a typical consumer. – The Bureau of Labor Statistics (BLS) reports the

CPI each month.– Monitors changes in the cost of living over time.– Rising CPI - more dollars need to be spent to

maintain the same standard of living.

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Market Baskets and Price

Market Basket:– The typical basket of goods and services purchased

by a consumer.

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Our Economy of Four FoodsItem in the

Market BasketQ Consumed in a

Typical Year (pounds)

2008 prices(per pound)

2009 prices(per pound)

Salami 300 $4 $6

Corned Beef 200 $5 $7

Bologna 100 $2 $1.50

Cheese 500 $3 $2.50

Prices changed between 2008 and 2009.

Calculate the 2008 and 2009 Market Basket Costs.(Q * P)+ (Q * P) + …

2008 cost = 300x4 + 200x5 + 100x2 + 500x3 = $39002009 cost = 300x6 + 200x7 + 100x1.5o + 500x2.50 = $4600

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Our Economy of Four FoodsItem in the

Market BasketQ Consumed in a

Typical Year (pounds)

2008 prices(per pound)

2009 prices(per pound)

Salami 300 $4 $6

Corned Beef 200 $5 $7

Bologna 100 $2 $1.50

Cheese 500 $3 $2.50

We look at these answers as a ration. Most recent year

Other year4600/3900 = 1.179What does this ratio tell us? 18%

increase.

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How the Consumer Price Index Is Calculated

• Compute the price index:

Price index in year t =

100x(Cost of the market basket in year t)(Cost of the market basket in the base year)

Base year is the benchmark year.

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How the Consumer Price Index Is CalculatedUse 2008 as the base year.• Compute the price index:

PI 2008 = 100x(3900/3900) = 100

PI 2009 = 100x(4600/3900) = 117.9

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How the Consumer Price Index Is CalculatedInflation Rate = % change between any two price index values.

Inflation Rate from 2009 – 2008 =

100x(PI2009 – PI2008)/(PI2008)

100(117.9 – 100/100) = 17.9%

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A C T I V E L E A R N I N G 1:

Calculate the CPI

58

CPI basket: {10 lbs beef, 20 lbs chicken}

The CPI basket cost $120 in 2004, the base year.

A. Compute the CPI in 2005.

B. What was the CPI inflation rate from 2005-2006?

price of beef

price of chicken

2004 $4 $4

2005 $5 $5

2006 $9 $6

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A C T I V E L E A R N I N G 1:

Answers

59

beef chicken

2004 $4 $4

2005 $5 $5

2006 $9 $6

A. Compute the CPI in 2005:

Cost of CPI basket in 2005= ($5 x 10) + ($5 x 20) = $150

CPI in 2005 = 100 x ($150/$120) = 125

CPI basket: {10 lbs beef, 20 lbs chicken}

The CPI basket cost $120 in 2004, the base year.

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A C T I V E L E A R N I N G 1:

Answers

60

beef chicken

2004 $4 $4

2005 $5 $5

2006 $9 $6

CPI basket: {10 lbs beef, 20 lbs chicken}

The CPI basket cost $120 in 2004, the base year.

B. What was the inflation rate from 2005-2006?

Cost of CPI basket in 2006= ($9 x 10) + ($6 x 20) = $210

CPI in 2006 = 100 x ($210/$120) = 175

CPI inflation rate = (175 – 125)/125 = 40%