Measuring a nation’s outputMeasuring a nation’s output Having a number that summarizes the Having a number that summarizes the

level of economic activity is clearly level of economic activity is clearly convenientconvenient

Alternative would be to see how much of Alternative would be to see how much of each type of good is availableeach type of good is available

But then it is hard to compareBut then it is hard to compare– One year output is 2 apples, 2 bananasOne year output is 2 apples, 2 bananas– Next year 3.5 apples, 1 bananaNext year 3.5 apples, 1 banana– Did output go up or down? Not clear!!Did output go up or down? Not clear!!

How would you measure How would you measure a nation’s output?a nation’s output?

Gross domestic productGross domestic product

Most frequently used measure of an Most frequently used measure of an economy’s outputeconomy’s output

Definition:Definition: GDP is the GDP is the market valuemarket value of the of the finalfinal goods and services goods and services produced in a country during a produced in a country during a given given periodperiod

Computing GDP (Example)Computing GDP (Example)

The GDP produced in a typical night in The GDP produced in a typical night in SoBeSoBe

100 people go to a nightclub (cover 100 people go to a nightclub (cover is $20 each)is $20 each)

100 go to the new world orchestra 100 go to the new world orchestra ($40 dlls per ticket)($40 dlls per ticket)

300 rolls of sushi are prepared ($15 300 rolls of sushi are prepared ($15 per roll)per roll)

50 gallons of orange juice are 50 gallons of orange juice are consumed ($5 per gallon)consumed ($5 per gallon)

Computing GDP (Example)Computing GDP (Example)

A typical night at southbeachA typical night at southbeach 100 nightclub (times $20)100 nightclub (times $20) 100 orchestra (times $40)100 orchestra (times $40) 300 rolls of sushi (times $15)300 rolls of sushi (times $15) 50 gallons of OJ (times $5)50 gallons of OJ (times $5)

$2000$2000

+$4000+$4000

+$4500+$4500

+$ 250+$ 250

GDP=$10750GDP=$10750

Remark: GDP is a sum of quantities weighted by price

Important remarksImportant remarks

When computing GDP more When computing GDP more expensive items receive a higher expensive items receive a higher weight than cheaper onesweight than cheaper ones

Is that reasonable?Is that reasonable?– Idea behind it: Amount people are Idea behind it: Amount people are

willing to pay is an indication of the willing to pay is an indication of the benefit they receivebenefit they receive

Important remarks (2)Important remarks (2) Only Only final goodsfinal goods are counted in GDP are counted in GDP

We did not include (to name a few)We did not include (to name a few)– The DJ wages paid by the nightclubThe DJ wages paid by the nightclub– The wages of the musicians of the The wages of the musicians of the

orchestraorchestra– The ingredients needed for sushi: Fish, The ingredients needed for sushi: Fish,

rice, wasabirice, wasabi– Oranges purchased to prepare OJOranges purchased to prepare OJ

A A final goodfinal good is the end product of a is the end product of a process and it is the good or service process and it is the good or service that consumers actually usethat consumers actually use

The goods or services produced on The goods or services produced on the way towards making the final the way towards making the final product are called product are called intermediateintermediate

DefinitionsDefinitions: Final vs intermediate goods: Final vs intermediate goods

If we computed GDP by adding If we computed GDP by adding market value of final + intermediate market value of final + intermediate goods we would be double counting goods we would be double counting – Oranges (intermediate good) are Oranges (intermediate good) are

purchased to produce juice (final good) purchased to produce juice (final good) and the final good price includes the and the final good price includes the cost of the necessary inputs to produce cost of the necessary inputs to produce itit

Why GDP includes only final Why GDP includes only final goods?goods?

Computing GDP is rather Computing GDP is rather complicated and costly!complicated and costly!

A list of each final good produced A list of each final good produced during the year is required (together during the year is required (together with prices).with prices).

It is mathematically simple, but the It is mathematically simple, but the amount of information required is amount of information required is hugehuge

Is there any alternative way?Is there any alternative way?

The expenditure method for The expenditure method for measuring GDPmeasuring GDP

Any good or service that is produced Any good or service that is produced will also be purchased and used by will also be purchased and used by some economic agentsome economic agent

The 4 economic agents considered in The 4 economic agents considered in national accounts are:national accounts are:– HouseholdsHouseholds– FirmsFirms– GovernmentGovernment– Foreign sectorForeign sector

Expenditure method (contd)Expenditure method (contd)

Note: Amounts that purchasers Note: Amounts that purchasers spend on various goods and services spend on various goods and services is equal to the market value of those is equal to the market value of those goodsgoods

GDP can be measured with equal GDP can be measured with equal accuracy by either of two methods:accuracy by either of two methods:

Adding up the market value of all goods and Adding up the market value of all goods and services that are domestically producedservices that are domestically produced

Adding up the total amount spent by each of Adding up the total amount spent by each of the four groups on final goods and services, and the four groups on final goods and services, and subtracting spending on imported goods & subtracting spending on imported goods & servicesservices

(output) (output) GDP=C+I+G+X-MGDP=C+I+G+X-M (total expenditure) (total expenditure)

What economists mean by investmentWhat economists mean by investment

Investment is spending by firms on Investment is spending by firms on newnew factories, office buildings, machinery, and factories, office buildings, machinery, and inventories and spending by households inventories and spending by households on on newnew houses. Improvements on existing houses. Improvements on existing structures are also included.structures are also included.

Buying stocks only changes ownership and Buying stocks only changes ownership and does not add to GDP (this type of financial does not add to GDP (this type of financial expenditure is not investment in expenditure is not investment in economics)economics)

The need for computing “real” GDPThe need for computing “real” GDP

Economists like making time Economists like making time comparisons of aggregate data to comparisons of aggregate data to see “how the economy is see “how the economy is performing”performing”

Near elections a president would like Near elections a president would like saying that the economy grew during saying that the economy grew during her/his term her/his term

Measured by GDP Mexico and Angola grow Measured by GDP Mexico and Angola grow

much faster than the USmuch faster than the US

GDP, annual growth (% rate)

0

5

10

15

20

25

30

35

40

year

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

0

100

200

300

400

500

600

700

Mexico USA Angola

What is going on then?What is going on then?Consider the following hypothetical Consider the following hypothetical

economyeconomy Year: 2002Year: 2002

Goods producedGoods produced 10 Microsoft office 2000 10 Microsoft office 2000

($100 each)($100 each) 2 Pentium 4 ($2000 2 Pentium 4 ($2000

each)each)GDP = GDP =

10*100+2*2000=$500010*100+2*2000=$5000

Year: 2003Year: 2003

Goods producedGoods produced 10 Microsoft office 2000 10 Microsoft office 2000

($200 each)($200 each) 2 Pentium 4 ($4000 each)2 Pentium 4 ($4000 each)GDP = GDP =

10*200+2*4000=$10,00010*200+2*4000=$10,000

The quantities of goods and services produced are thesame, yet, GDP doubled. Why?

We need to exclude the effects of We need to exclude the effects of price changes!!!!!price changes!!!!!

How to do it?How to do it?– Standard approach is to use a common Standard approach is to use a common

set of prices to value quantities set of prices to value quantities produced in different yearsproduced in different years

– One picks a particular year, called One picks a particular year, called base base yearyear, and uses the prices for that year to , and uses the prices for that year to calculate the market value of output for calculate the market value of output for all other yearsall other years

Compute Real GDP for our exampleCompute Real GDP for our example Step 1. Set the base yearStep 1. Set the base year

Year: 2002Year: 2002

Goods producedGoods produced 10 Microsoft office 2000 10 Microsoft office 2000

($100 each)($100 each) 2 Pentium 4 ($2000 2 Pentium 4 ($2000

each)each) Real GDP =Real GDP =

Year: 2003Year: 2003

Goods producedGoods produced 10 Microsoft office 2000 10 Microsoft office 2000

($200 each)($200 each) 2 Pentium 4 ($4000 each)2 Pentium 4 ($4000 each)Real GDP =Real GDP =

One problem with real One problem with real GDP: New goods biasGDP: New goods bias

How to make cross-country income How to make cross-country income comparisons?comparisons?

• Each country reports GDP in terms of their local currency

• How can we compare incomes across countries?

Illustrative ExampleIllustrative Example

Suppose all countries produce, each year, one good: a big-mac

If GDP measures the quantity of goods and services produced by each given country, any sensible measure of GDP in this example should say all countries have the same GDP

GDP in dollars is extremely different GDP in dollars is extremely different across countries!!!across countries!!!

Country Big mac price (local currency, april 2003)

In US dollars

US 2.71 2.71

China Yuan 9.90 1.20

Mexico Peso 23.00 2.18

Argentina Peso 4.10 1.43

Switzerland S Franc 6.30 4.59

Source: The economist’s big mac index

What is going on?, How to construct What is going on?, How to construct comparable GDP figures?comparable GDP figures?

• A dollar has very different purchasing power across countries

• In other words, relative prices vary a lot across the world

• When making cross country comparisons use PPP adjusted measures

• Method (in simple terms): Use one country’s prices to compute the GDP of all other countries

REAL GDP growth in Angola, REAL GDP growth in Angola, Mexico and the USMexico and the US

Real GDP, annual growth (% rate)

-8

-6

-4

-2

0

2

4

6

8

year

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

0

2

4

6

8

10

12

14

16

Mexico USA Angola

Measuring Economic Growth

The economic growth rate is the percentage change in the quantity of goods and services produced from one year to the next.

Growth year 2004: (GDP2004-GDP2003)/GDP2003 - 1

GDP vs Welfare

Real GDP is not a perfect measure of economic welfare because:

1. Quality improvements tend to be neglected in calculating real GDP so the inflation rate is overstated and real GDP understated.

2. Real GDP does not include household production, that is, productive activities done in and around the house by members of the household.

GDP vs Welfare

3. Real GDP, as measured, omits the underground economy, which is illegal economic activity or legal economic activity that goes unreported for tax avoidance reasons.

4. Health and life expectancy are not directly included in real GDP.

5. Leisure time, a valuable component of an individual’s welfare, is not included in real GDP.

6. Environmental damage is not deducted from real GDP.

7. Political freedom and social justice are not included in real GDP.