Text transcription of Chapter 5 – Measuring a Nation’s Income

Welcome to the Chapter 5 Lecture on the Measuring a Nation’s Income. We are going to start working with statistics to measure the size of economies and track growth over time. The math in this chapter is not complicated, but it is important that you use the correct formulas when calculating each statistic. The way to measure a nation’s income is by calculating GDP.

GDP stands for Gross Domestic Product. GDP is the measure of the total income of a nation. This is one of the most closely watch economic statistics because it tells us whether or not we are in a recession, but we’ll get to take in the coming chapters. GDP is the single best measure of economic well being that we have. This does not mean that GDP is a perfect statistic; we’ll discuss some of the problems with GDP at the end of this chapter.

GDP measures two things at once – Total income of everyone in the economy and total expenditures on the economy’s output of goods and services. GDP can measure two things at once because income and expenditures are essentially the same. Think through the following logic: Every transaction has a buyer and a seller. Every dollar of spending by some buyer is a dollar of income for some seller. The money continuously flows from the buyers to the sellers and then back to buyers, just like how money flowed in the circular-flow diagram. GDP is just measuring the flow of money, in one direction it is total income and in the other direction it is total expenditure. The words “expenditure” and “spending” mean the same thing.

The formal definition of GDP is the market value of all final goods and services produced within a country in a given period of time. Let’s break down this definition and understand each part. First, “market value” – Market value means dollar value of products. We are not adding up the quantity of goods and services produced, rather the dollar value of the goods and services produced. Next, “off all” – Off all means goods and services, GDP is

a comprehensive measure of all items produced and sold legally. Everything from cars to textbooks to getting your haircut to buying a piece of fruit to buying a home.

“Final” means goods sold to the end user. Intermediate goods do not count towards GDP. Intermediate goods are goods used to make final goods. Intermediate goods are not accounted for to avoid the double counting problem. The value of intermediate goods (think of flour, sugar and eggs) are included in the value of final products (a cake). The price of the cake sold to the end user includes the value of everything that was used to produce it. “Goods and services” means both tangible goods, like food and clothing, to intangible services, like getting your haircut or teeth cleaned at the dentist. “Produced” means only goods that are currently produced. A sale of a new car would count towards GDP, but a sale of used car would not count. A sale of a new home would count towards GDP, but a sale of a home built a few years ago would not count. Only new items are included in GDP.

“Within a country” limits GDP to items produced within the geographic boundaries of a country. It does not matter who is producing the goods, if they are produced within the geographic boundary of a country, then it counts towards that country’s GDP. Lastly, “in a given period of time” means that GDP measures the value of production for a given period of time, which is usually one year. GDP is also measured quarterly, which is every three months.

GDP can be divided into four components. We are going to use the variable “Y” for GDP. When we start working on the math, it will be easier to have a single letter variable for Gross Domestic Product, rather than a three-letter variable. GDP is divided into consumption (“C”), investment (“I”), government purchases “G”), and Net Exports (“NX”). Consumption plus investment plus government purchases plus net exports equals GDP. This equation is an identity, meaning it must hold because the way the variables are defined. Let’s explain each of these four components in more detail.

Consumption. This is everything we do – Consumption is spending by households on goods and services. Household spending can be divided into three groups – Durable goods, nondurable goods and services. Durable goods are goods that last, examples include cars, dish washers, computers. You buy them and you have these goods for at least a few years. Nondurable goods are goods that typically don’t last too long. Examples include food and clothing. Some food, like peanut butter, might stay in your pantry for a long time, but the vast majority of food does not have a very long shelf life. Clothing is the same way. You might have a nice winter jacket for several years. However, you might buy a t-shirt and wear in once a week all summer, then it is faded and wore by winter. Services include haircuts, healthcare, dry cleaning, just to name a few. Consumption is the largest component of GDP.

Investment. “Investment” to an economist does not mean financial investment, like purchasing stock and bonds. Rather, “investment” to an economist means the purchase of goods and services that will be used to produce more goods and services. This includes capital equipment, inventories and structures, including new residential homes.

Government Purchases includes spending on goods and services by local, state and federal governments. This is everything from city public works projects, like roads and parks, to teacher’s salaries to the war in Afghanistan.

The last component of GDP is net exports. Net exports is the purchase of domestically produced goods by foreigners minus the domestic purchase of foreign goods. Simply, net exports is exports minus imports. NX equals “E” minus “I”. The “net” in “net exports” refers to the fact that imports are subtracted from the exports.

There are two different ways to calculate GDP – Real GDP and Nominal GDP. Remember, GDP measure total spending. If total spending increases, one of two things must be true. The economy is producing more goods and services OR goods and services are being sold at higher prices. We want to separate these two effects, therefore we calculate nominal GDP (which includes both effects) and real GDP (which focuses on the quantity being produced).

Real GDP is the total quantity of goods and services the economy is producing that is NOT affected by changes in the price of those goods and services. Real GDP shows how overall production changes over time because it is a measure of quantity. Real GDP is calculated with constant prices. Nominal GDP is calculated with current prices.

Let’s go through a numeric example of calculating real and nominal GDP. I am going to review the same example as the textbook. First, assume the economy is only producing two goods – hot dogs and hamburgers. This keeps our math simple. Next, we need data. We are going to calculate GDP for three years – 2008, 2009 and 2010. The price of hot dogs starts at $1,increases to $2 and then to $3. The quantity of hot dogs starts at 100 in 2008, 150 in 2009 and 200 in 2010. Hamburgers start at $2, increase to $3 and then to $4. The quantity of hamburgers increases from 50 to 100 to 150.

The first thing we are going to solve is nominal GDP. Nominal GDP calculates the value of goods and services during current prices. Current prices are the prices prevailing in the year of production. For 2008, hot dogs cost $1, we multiply by the quantity produced in 2008, 100 hot dogs. We add the value of the hamburgers, $2 per hamburger times 50 hamburgers being produced. In total, the value of the hot dogs and the hamburgers for 2008 are $200. Therefore, $200 is the nominal GDP for 2008. To calculate nominal GDP for 2009, we use the prices and quantity prevailing in that year. $2 per hot dog times 150 hot dogs, plus $3 per hamburger times 100

hamburgers. The total value of hot dogs and hamburgers in 2009 is $600; therefore nominal GDP is $600. For 2010 nominal GPD, update for the new prices and new quantities. $3 per hot dog times 200 hot dogs, plus $4 per hamburger times 150 hamburgers. Nominal GDP for 2010 is $1200.

Next, let’s calculate real GDP. Real GDP corrects nominal GDP for inflation by using constant prices. The first thing we do is choose one year as the “base year”. The base year is our benchmark, which we will compare the other years to. The base year is always the first year, chronologically, in the sequence. 2008 is the first year in our sequence, therefore we are only going to use the prices from 2008. I will highlight all the 2008 prices in red, so it is easy to see that they do not change. 2008 real GDP will be exactly the same as 2008 nominal GDP because there is no difference in the prices or quantities being used for the calculation. $1 per hot dog times 100 hot dogs, plus $2 per hamburger times 50 hamburgers. Real GDP for 2008 is $200. You’ll see the difference when we calculate real GDP for 2009. Remember, prices are constant, so we are still using the $1 per hot dog but multiplying by the quantity produced in 2009, 150 hot dogs. We add to the constant $2 hamburger times 100 hamburgers that were produced in 2009. Real GDP for 2009 is $350. In 2010, we still use the base year prices. $1 per hot dog times 200 hot dogs plus $2 per hamburger times 150 hamburgers. Real GDP for 2010 is $500. Notice that all the prices are highlighted in red. I did just to show that with real GDP the prices are constant.

Since prices stay constant with real GDP, it only reflects change in the amount of goods and services being produced since quantity is the only variable changing. The goal of calculating GDP is the gauge how well the economy is doing. Economist prefer real GDP over nominal GDP because it is a better gauge of economic well-being since if reflects the economy’s ability to satisfy people’s needs and wants.

The last calculation for this chapter is the GDP deflator. We can use nominal and real GDP to calculate the level of inflation using the GDP deflator. The GDP deflator is nominal GDP divided by real GDP times one hundred. In 2008, nominal GDP was $200, real GDP was $200, therefore $200 divided by $200 times 100 equals a GDP deflator of 100. In 2009, nominal GDP was $600, real GDP was $350; therefore the GDP deflator for 2009 is 171. In 2010, nominal GDP was $1200, real GDP was $500; therefore the GDP deflator for 2010 is 240. The GDP deflator is not a dollar value or a percentage. It is a three-digit whole number.

The GDP deflator by itself does not tell us very much. We need to use a rate formula to calculate the level of inflation. The inflation rate formula is GDP deflator from year 2 minus GDP deflator from year 1, divided by GDP deflator from year 1, multiplied by 100. Order of operations is very important, so be sure to simplify the fraction. We always calculate inflation over a period of two years - that is why we have year 1 and year 2. Year 1 is the first year chronologically and year 2 is the second year chronologically. If we calculate inflation from 2008 to 2009, 2008 is year 1 and 2009 is year 2. Therefore, we take 171 minus 100, divided by 100 to get .71. We multiply by 100 to move the decimal into a percentage and get 71%. From 2008 to 2009, prices have increased by 71%. If we calculate inflation from 2009 to 2010, 2009 is year 1 and 2010 is year 2. Therefore, we take 240 minus 171, divided by 171 to get .40. Multiply by 100 to move the decimal into a percentage and we can see that prices increased by 40%.

We finish the chapter with a quick discussion about how good of a measure GDP is to gauge economic wellbeing. The answer is GDP is not a perfect measure. GDP omits the value of goods and services produced

at home. Only goods and services produced and sold in legal markets are counted towards GDP, so anything produced at home does not get accounted for. GDP excludes the quality of the environment, education or healthcare. When we talk about the wellbeing of a country, the quality of the environment, the availability of education and access to healthcare should be considered. However, GDP does not tell us anything about the quality of those factors. GDP says nothing about distribution of income. Calculating GDP does not tell us the size of the middle class or how income is divided between the upper, middle and lower classes. Lastly, GDP misses many transactions that occur in the underground economy. The underground economy is everything from illegal drugs to lemonade stands. If a transaction does not occur legally, it is not included in GDP. In conclusion, GDP is a good measure for the most part. It is the single best statistic we have. But, it is important to keep it mind what it includes and what it leaves out.

This is the end of the chapter 5 lecture. Be sure to review the math work covered in this chapter. You will see it again on your chapter quiz and on exam 2. Let me know if you have any questions.