Gross Domestic Product


1. Defining GDP (Gross Domestic Product)

GDP includes the total value of final products that are produced and sold (and not resold) within the current year. In 1947, per capita GDP of the US was only about $1700, but has since grown to about $47,000 in 2008, and has not been increasing in recent months, due to the worst recession last year. The growth rate has been about 5.5% per year. Of course, much of this reflects inflation. For the same period, the inflation rate (GDP deflator) has been about 3.5%. Thus, the net or real per capita GDP growth rate has been about 2% in the US.
 
During the post-WWII period until about 1980, business cycles had short duration. A recession occurred about every five years. After 1980, it occurred once a decade.
 

2. Which products are excluded?

1. Exclusion of nonmarket products
In a free market economy, GDP includes only those products that are sold through the market. That is, consumers are willing to pay prices for the products they consume. In principle, GDP does NOT include those products consumers do not pay for. This is a kind of chauvinistic measure, not counting the value of outputs that are produced and consumed by many households such as home cooking, baby sitting, serving and helping other members of the household. We do not include the value of these products, primarily because it is difficult to put values on such household services that do not go through the market mechanism.

In recent years, GDP of northern European countries are much higher due to the inclusion of many services (such as baby sitting) that are mutually sold between households.

2. No intermediate goods

Some goods are used as ingredient inputs to produce other goods. For instance, assume there are only two types of farmers, one producing corn and the other pork. If corn farmers produce $1billion worth of corn, which are only used as feed to produce $2 billion worth of pork, we should not add the value of corn used as input to obtain GDP. Likewise, General Motors buy high strength steel to make chassis. We should not add the value of GM cars sold and that of steel. This results in double counting.

GDP does not include the value of intermediate inputs (in this case, corn) but only the value of final products. Alternatively, we can sum the value added of each industry to obtain GDP.

3. Bads and resource depletion are excluded

Environmental pollution, water contamination and resource depletion are excluded. GDP is not reduced by pollution and bads that are produced in the process.

Even though resources are depleted, their economic value or costs are excluded in the GDP calculation.

4. Illegal Goods

Outputs produced by illegal activities are excluded.

Underground economy: how big it is is not known. In some countries, it could be over 10% of GDP.

Illegal trade (narcotics, etc.)

 
 

3. The Expenditure Approach

With this approach, GDP is the amount market participants spend on final goods and services over a given period of time, usually 1 year.

GDP = C + I + G + (X - M)

Consumption

Expenditures of the household sector to buy domestically produced goods.

This understates total consumption because imports are not included. In 2009, C = $10,130 billion (70% of GDP)

Nondurables = food and clothing.

durables = long-lived consumer goods such as houses, cars, washing machines, etc.

services = insurance, travel services. As income increases, service share increases. (about 2/3 of consumption)

Investment

Investment is the creation of capital goods, which are used to produce goods. (buying stocks is NOT investment here.)

Fixed investment (machinery, buildings, housing construction)

Inventory Investment

Planned inventory

Every business needs inventory to conduct business. Some are planned.

Unintended inventory

unintended inventory accumulation ⇒ unsold products piling up.

unintended inventory decumulation ⇒ inventory is depleting faster than planned.

Actual inventory = planned inventory ⇒ equilibrium output.

Investment is about 15% of GDP.

However, investment is the most volatile component of GDP. Investment volatility is the source of business cycles. $1 billion investment causes a larger change in GDP (multiplier effect, as shown later)

Some portion is needed to maintain production capacity (about 10%) = replacement investment.

Anything above replacement investment is net investment, which increases the production capacity of the economy.

Government spending

Governmet purchases of goods and services.

There is no market for public goods. Outputs of the government sector is evaluated by the purchasing prices. For example, the output of a government official is his/her salary.

 

employee salaries, costs of public goods and services.

Transfer payments are NOT included in government spending. This is a transfer of income between individuals and firms, i.e., from the rich to the poor (or vice versa) and between firms and households.

Net Exports

X - M

Exports - Imports = net exports.

Imports = consumption on imported goods.

Imports are an increasing function of income.

 

4. GNP vs GDP

Gross National Product GNP = GDP + factor payments from other countries - factor payments to other countries.
 

factor payments = interest payments for foreign borrowing and lending + dividend incomes from the subsidiaries of multinational firms located in other countries.

foreign wage incomes are negligible.

Net National Product

GNP - Depreciation

Capital goods are durable and last many years. Each year, some portion is considered to be worn out (wear and tear).

Depreciation accounts for about 10% of GDP.

Infrastructure capital (such as highways, bridges, dams) lasts longer. For instance, highways and bridges last about 50 years. (concrete construction).

US highways were built during Eisenhower administration (1953-1961), and need to be rebuilt. (In other words, the US does not have modern highways, because of depreciation.)

Net Domestic Product

GDP - depreciation

the net value of outputs produced in the domestic market.

Replacement Investment

(annual) Investment must exceed 10% of GDP for the economy's production capacity to grow.

If replacement investment = 10%, the country's productive capacity remains constant.

If replacement investment > 10%, the productive capacity grows.

Savings

In the absence of foreign capital, money to invest comes from domestic savings.

If savings fall less than 10% of GDP, the economy is in trouble.

 

 

5. Four Sectors in a typical economy

Household sector

buys consumption goods from the business sector, and supplies labor and capital inputs (through savings).

Business sector

produces products using capital and labor inputs and sells them to consumers.

Financial Sector is part of the business sector: It receives savings from the household sector and lends money to business firms.

Government sector

The government collects taxes and spends the revenue.

Redistributes income, supposedly from the poor to to rich to stabilize the society.

When income distribution is unequal, there is a higher chance of a revolution or overthrow of the government.

 

Foreign sector

The foreign sector buys domestic products and supplies foreign products to domestic consumers.

 

6. Twin Deficits

In recent years, the US as well as many European countries are suffering from twin deficits. These governments are running large budget deficits,i.e., government spending far exceeds tax revenue.

Budget deficit

T - G < 0 ⇒ budget deficit

T - G > 0 ⇒ budget surplus ( = T-G)

Trade deficit

 

X - M > 0 ⇒ trade surplus (= X - M) = net exports

X - M < 0 ⇒ trade deficit

 

At the same time, these countries are importing far more than they export, thus incurring trade deficits. These situations describe countries that are not in equilibrium.

 

7. Greece's problem

 

amphitheater in Athens.

Olympic stadiums in many countries are modified versions of Greek amphitheaters. Greeks (specifically, Cretans) invented plumbing.

plumbing plumbing
Greece's GDP $340 billion
population 11 million
per capita GDP $32,000 (approximate)
Exports $18 billion
Imports $61 billion (Trade Deficit = $43 billion) in 2008
work hours 1800 hours/year. (Japan = 1830 hours, USA =1777, South Korea = 2400 hours. China: no reliable statistics, maybe 10 hours per day, six days a week.)
Government spending about 40%. socialist economy
problem

big government, no manufacturing, no high tech industry, people depend on pensions for which they have not worked.

The government needs to cut pensions, but people are revolting.

   

 

8. Equilibrium in a closed economy

Aggregate expenditure is defined as:

E ≡ C + I + G + (X - M).

On the other hand, total personal income may be spent on consumption, savings and tax.

Y ≡ C + S + T.

Since income = expenditure,

C + I + G + (X - M) = C + S + T,

or

I +G + (X - M) = S + T.

If the country is a closed economy (X = M = 0),

then

I + G = S + T.

If the government has a budget surplus or deficit, the situation is not sustainable, and it is not a long run (LR) equilibrium.

LR equilibrium requires that the government budget be balanced

(G = T),

then LR equilibrium requires

I = S.

That is, LR domestic equilibrium requires investment-savings equality.

This is the origin of the IS curve, to be studied later.

 

 

9. Disposable Personal Income

Disposable Income is the portion of GDP that consumers can spend.

depreciation

Why depreciation should not be included in net GDP?

depreciation is consumption of the capital goods. Each year some fraction of the capital input is used up through wear and tear, and must be replenished in order to maintain the productive capacity.

Depreciation costs are not counted as corporate profits, and hence should not be part of net income.

When depreciation is included in income, we call it "Gross" domestic product.

Net Domestic Product

= GDP - depreciation.
Indirect Business Taxes

= firms pay sales taxes and property taxes (which are generally used by local governments to build schools, highways, etc.)

Hong Kong has no sales tax, but in other cities have high sales tax.

New York city has a high sales tax, especially on goods tourists buy (hotels, restaurants).

Intent: let visitors pay.

Domestic Income

= NDP - Indirect Business Taxes.
Undistributed Corporate profits

Corporations do not generally distribute all the profits to stockholders.

These are called retained earnings, and used for future investment.

 

10. Problems in Comparing GDP over Time

1. prices are not held constant

When calculating and comparing GDP over time, we should remember that prices are not held constant. In the 1970s, the world economy was greatly perturbed by two oil price shocks. Oil price more than quadrupled during this decade. Oil is also used as input in many industries, and the prices of these products also rose significantly.

Accordingly, between 1970 and 1978, GDP in the United States more than doubled. However, dollar — the yardstick — also changed in value during this period, because the prices of most good increased.

2. Can We Use Quantities?

Instead of GDP, can we use physical quantities which do not change value over time as a meaure of output?

No. quantities are impractical.

The main problem is that the US produces millions of different products each year. We cannot add apples and oranges, steel and wheat, because they are measured in different units of measurement. That is the reason to use GDP in the first place.

3. Price Indices are used.

We have to use some sort of price index to adjust for the changing value or purchasing power of the dollar. A price index can be used to deflate the nominal GDP (GDP in current dollars).

First, a typical bundle of goods consumers buy is chosen and its cost in the base year is given an index of 100.

Second, compute the cost of the same bundle in other years. Next, compute how much more in any given year relatve to the base year. If the index is 120 this year, it means it costs 20% more than the base year to purchase the chosen bundle of goods.

Price indices are useful for comparing outputs over a short period of time, say less than 5 - 10 years.

Not useful when comparing incomes over long periods of time, say over 10 years.

Why? the consumption bundles change significantly.

Very few people buy VHS videotapes. Even DVDs will soon become obsolete.

4. Seasonal adjustment

Outputs are often measured quarterly.

There are seasonal fluctuations. (about 8% in the US)

In cold regions, seasonal variations are higher, due to long winter.

Good climate is conducive to economic activities.

(i) crops are harvested in the fall

(ii) less outdoor activities are held in the winter.

Instead of reporting raw data, economists often report seasonally adjusted outputs by eliminating expected seasonal changes or averaging the outputs.

 

 

 

11. Real vs Nominal GDP

If there is no inflation Real GDP = Nominal GDP
If deflation occurs

The same nominal income has more purchasing power.

Deflation occurred in Japan in the 1990s.

Deflation occurred in Hong Kong after the Asian financial crisis in 1997 and ended only in 2004.

During this period, asset prices fell.

If inflation occurs The same nominal income is worth less, and its purchasing power declines. Sometimes, inflation is called the silent tax.

12. Nominal GDP

Nominal GDP = Σipiyi =p1y1 + p2y2 + ...

where pi and yi are the price and output of good i during the current year.

Nominal GDP is simply the sum of expenditures on each and every good consumed at current prices.

Example

2009 price 2009 quantity 2009 expenditure
1 200 200
10 10 100
30 300 9000
    Nomilal GDP = 200 + 100 + 9000 =9300.

The next year, both prices and outputs change.

2010 price 2010 quantity 2010 expenditure
1 300 300
10 20 200
50 200 10000
    Nominal GDP = 300 + 200 + 10000 =10500.

The two tables show nominal GDP increased from $9300 to 10500.

Does it mean consumers are better off? Since nominal GDP overstates real GDP during periods of inflation, the extent of overstatment can be estimated by the GDP deflator.

 

13. Real GDP

Prices in 2010 are different from those in 2009. To get real GDP in 2010, instead of using 2010 prices, we use the base year (2009) prices to evaluate total outputs.

2009 price 2010 quantity hypothetical 2010 expenditure if prices were held constant
1 300 300
10 20 200
30 200 6000
    Real GDP = 300 + 200 + 6000 = 6500. (Real income declined)

When the base year (2009) prices are used, the value of outputs actually shrank in 2010. While nominal GDP in 2010 is 10230, real GDP actually declined to 6500. Thus,

GDP deflator in 2010 is = $10500/6500.

 

Why real GDP?

Because prices change over time.

When comparing GDP figures over time, nominal GDP sometimes overestimates real outputs. This is because prices generally tend to rise.

When income rises faster than price level Consumers are better off.
When income rises price level also rises.
When income is stagnant Usually, the price level still rises. It depends on the economy.
When income falls in a recession price level does not rise much. Sometimes the price level falls.
 

When one's income rises by 10% in a given year, prices are not generally held constant.

If prices fall, as in recession, a 5% fall in income means real income usually falls less than 5% because of falling prices.

However, on average during a normal year, prices tend to rise.

If prices rise 4%, a 10% increase in nominal income represents only a 6% increase in real income.

Nominal amounts are expressed using current dollar prices, i.e., they are actual amounts paid or received. Thus, economists sometimes are interested in figuring out the changes in real income, excluding the payments for rise in prices.

 

 

Once price indices are calculated, real GDP can be calculated using the above formula. Usually, an index number of 100 is assigned to some base year.

For instance, if one is interested in GDP growth during the post WWII era, one can assign an index of 100 to 1945 or 1946, and then compute the price indices for other years.

Which base year should one use? It all depends on the purpose of comparison.

Chain-Weighted Measure of Real GDP

Relative prices change over time.

For instance, price of personal computers keeps falling each year.

Food price has been rising faster than others.

Bureal of Economic Analysis chooses base year every five years. GDPs are computed during the next few years, assuming prices are held constant when they are not.
Since 1995, chain-weighted measures of real GDP are computed. The average prices in 2009 and 2010 are used to measure the GDP growth from 2009 to 2010.

 

 

14. GDP per Capita

A higher GDP is better, but does not always make people better off. Sometimes a higher GDP is brought about by an increase in population. Thus, a higher GDP does not necesarily mean economic growth. When comparing welfare over time and between countries, we oftn use GDP per capita. We divide GDP by the total population. To obtain real GDP per capita, one also divides real GDP by the population.

World GDP (misnomer, Gross World Product) in 2010 is estimated to be about $73 trillion. Per capita GWP is about $12,000 in 2010.

 

If GDP rises by 3%, and also the population grows at the same rate, there is no change in welfare of the representative person in that country.

15. Other Problems with GDP

(1) Nonmarket Transactions

 

These are the transactions outside the market, and hence there is no reliable price information about them. The most important transaction excluded from the GDP is the services of houswives. These are not sold in the market, and hence not entered into the GDP.

In LDCs, a significant amount of food and clothing is produced in the home, but not included in the GDP. Thus, welfare is often understated in LDCs. On the other hand, in some European countries, different families pay one another for babysitting expenditures and get tax credit, and these expenditures are included in GDP. Thus, GDP tend to overstate welfare in these countries.

(2) The Underground Economy

There is not much data about the magnitude of the underground economy, which includes both legal and illegal economies. Income from illegal activities are not included in the GDP, and hence GDP understates actual economic activities. They are not excluded because they are immoral, but the amounts are not reported. Also, cash payments "under the table" to corrupt officials and businessmen are not reported.

Also, a significant amount is underreported by self-employed people who are doing business legally.

According to a study of OECD (Organization for Economic Cooperation and Development) countries, about 17% of economic activities are unreported. Also, black markets are large in developing countries. In countries such as Spain, Portugal, Italy, Belgium and Greece, this underground economy exceeds 20%.

(3) Value of Leisure

Most people can get a part time job, in addition to their regular jobs, by working in the evenings and on weekends. However, they choose not to. Why? Because they value leisure more than the additional income they could earn!

You cannot go to parties, watch TV, or go to the movies. If somehow these people are forced to work extra hours, GDP will go up, but not their welfare. GDP does NOT include the value of leisure, although it is an important element of welfare.

Annual working hours:

Korea: 2400

Japan: 1828

US: 1777

UK: 1650

Germany: 1360

Netherlands: 1300

India: 2800 - 3400 hours

13th century farmer: 1600 hours (UK)

UK in 1840: 3600

(As wage rate rises, working hours decline)

 

(4) Pollution and other Externalities

Many industries produce pollution in the production process. For instance, a steel mill produces pollution while producing steel products. Likewise, the oil industry pollutes the ocean. Only the value of outputs produced is included in GDP, but not the pollution.

If we are interested in measuring welfare, the cost of pollution should be subtracted from the value of outputs.

If the industry or goverment cleans up the mess, resources are used up, and their value is included in GDP. Thus, GDP overstates the actual value of outputs, whether the polluted environment is cleaned up or not.

(5) Quality of Goods

 

GDP misses an important element of welfare. The quality of TVs, washing machines, computers and clothing are not included in GDP. For example, every other year the quality of personal computers seem to double but their prices halved.

While technological advances often improve the quality of the products and hence welfare, they lower prices and hence decrease GDP.

 

Source: Thomas Walter (http://www.geography.hunter.cuny.edu/~tbw/wc.notes/13.air.pollution/notes_chap13.htm)

16. Why GDP?

There are other measures of social wellbeing. Life expectancies, infant mortality rates, crime rates, health care, etc. However, despite all its problems, GDP is a single index that measures the value of outputs of a nation. It tends to be positively related to wellbeing, but not a precise measure of social welfare.

 

17. Unemployment Reduces GDP

Each month the government announces the unemployment rate, that so many lost jobs, etc. To verify whether one is unemployed, the government needs to contact everybody. In the United States this is done once a decade (decennial Census of Population) It is costly to interview all workers. Accordingly, the government conducts census only once in 10 years. Also, each month the Census Bureau interviews about 60,000 households (or about 110,000 individuals). For stability only 1/4 of these samples are replaced each month.

Often the success of a President's economic policy is measured by the number of jobs created. This is a very dangerous criterion. (Remember: Association is not causation!)

One can systematically hire people to break glasses of buildings and factories. They need to be repaired or replaced, which create jobs and increases GDP. However, the well being of the citizens does not increase, but actually will decline, despite the increase in jobs created and GDP.

Total Labor Force = Armed Forces + Civilian Employed + Unemployed.

How the Government Measures Unemployment