CH. 11 - GROSS DOMESTIC PRODUCT (GDP) AND CONSUMER …lightcat-files.s3.amazonaws.com/packets/admin... · Gross Domestic Product: Expenditures Approach Gross Domestic Product: Income

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MACROECONOMICS - CLUTCH

CH. 11 - GROSS DOMESTIC PRODUCT (GDP) AND CONSUMER PRICE INDEX (CPI)

CONCEPT: CALCULATING GDP

● Gross Domestic Product (GDP) is the value of the final goods and services produced by a country during a year

□ GDP as a statistic is used to measure growth in an economy and the “well-being” of the citizenry

> Economists tend to rationalize that “higher output means happier citizens!”

□ GDP can be calculated by adding up all the expenditures during the year and has ________ main components

> Note that GDP can also be calculated by adding up all the income during the year (less common)

□ Consumption – spending by _______________ on goods and services

> Excludes the household purchases of ________________

□ Investment – spending on capital equipment, inventory, and structures

> Think of this generally as businesses spending on their long-term growth

> Includes the household purchases of ________________

□ Government Purchases – spending on goods and services by local, state, and federal _________________

> Paying teacher salaries, building highways, buying military equipment

> Does not include transfer payments, such as welfare (does not result in production)

□ Net Exports = Exports _________ imports

> Exports – goods produced _________________ but sold _________________

> Imports – goods produced _________________ but sold _________________

𝐺𝐷𝑃 = 𝐶 + 𝐼 + 𝐺 + 𝑁𝑋 ● Nominal GDP uses __________________ prices when calculating the value of goods

● Real GDP uses __________________ prices when calculating the value of goods

● A few extra technicalities worth mentioning regarding GDP:

□ “Final” goods and services are purchased by the final user à included in GDP

> Intermediate goods are purchased to be used in another product (i.e. paper to create a greeting card)

□ Second-hand sales are not included in GDP

> The purchase of a TV from Walmart is included in GDP, but when you sell it used on Craigslist it is not

□ Financial transactions are not included in GDP (i.e. transfer payments and stock market transactions)



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CONCEPT: DETAILED EXPLANATION OF GDP COMPONENTS

● Consumption – spending by _______________ on goods and services

□ Services – An (intangible) act or use for which a consumer, firm, or government is willing to pay.

> In the United States, consumer spending on services is greater than spending on goods

□ Nondurable Goods – products with less than __________ years of expected life

□ Durable Goods – products with more than __________ years of expected life

Examples of Services:

Examples of Nondurable Goods:

Examples of Durable Goods:

● Investment – spending on capital equipment, inventory, and structures

□ Business Fixed Investment – spending by firms on new factories, buildings, and equipment to produce goods

□ Residential Investment – spending by households and firms on _________ homes (single family or multi-unit)

> Note that the resale of previously constructed homes are NOT included in investment

□ Changes in Inventories – changes in the supply of goods produced but not yet sold

> The change in inventory can be positive or negative

January 1: Sony had $100M of unsold televisions December 31: Sony had $20M of unsold televisions The _________ in inventory would _________ investment

January 1: Sony had $100M of unsold televisions December 31: Sony had $160M of unsold televisions The _________ in inventory would _________ investment

□ Financial transactions (sale of stocks/bonds) are _______ included in Investment

● Government Purchases – spending on goods and services by local, state, and federal _________________

> Does not include transfer payments, such as welfare (does not result in production)

● Net Exports = Exports _________ imports

□ Exports – goods produced _________________ but sold _________________

□ Imports – goods produced _________________ but sold _________________



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CONCEPT: VALUE-ADDED METHOD FOR MEASURING GDP

● Remember: GDP is the value of the final goods and services produced by a country during a year

□ The normal approach takes the market value of these final goods (i.e. a Chevy Malibu)

> However, there are many intermediate steps in producing a final product

□ Value added – the market value that a firm adds to a product

EXAMPLE: Mining Company Corporation extracts iron ore from its deposits and is able to sell the ore for a price of $5,100

per ton. The Refinery Company Corporation refines iron ore and sells the refined ore for $7,800 per ton. Steel Company

Corporation purchases refined iron ore and produces steel, which it sells for $11,200 per ton. Chevrolet purchases steel to

produce a Malibu, which it sells to consumers at a price of $16,900. What is the increase in GDP for each Malibu produced?

Stage of Production Sales Value of Material Value Added

Mining Company Corporation: Iron ore extracted

The Refinery Company Corporation: Iron ore refined

Steel Company Corporation: Steel produced

Chevrolet: Chevy Malibu produced

Total

PRACTICE: A cotton farmer produces raw cotton, which it can sell to a processor at a price of $2. The processor weaves

the cotton into fabric and sells it for $3. A clothing company purchases the fabric and creates a crappy t-shirt, which it can

sell for $7. Urban Outfitters buys crappy t-shirts and resells them for $45. What is the value added by the clothing company?

a) $3

b) $4

c) $7

d) $38



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CONCEPT: NOMINAL GDP AND REAL GDP


□ Nominal GDP uses __________________ prices when calculating the value of goods

□ Real GDP uses __________________ prices when calculating the value of goods

𝐺𝐷𝑃 = 𝐶 + 𝐼 + 𝐺 + 𝑁𝑋 C = _______________ I = _______________ G = _______________ NX = _______________

𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃 = (𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦1 ∗ 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑃𝑟𝑖𝑐𝑒1) + (𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦2 ∗ 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑃𝑟𝑖𝑐𝑒2) + ⋯

𝑅𝑒𝑎𝑙 𝐺𝐷𝑃 = (𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦1 ∗ 𝐵𝑎𝑠𝑒 𝑃𝑟𝑖𝑐𝑒1) + (𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦2 ∗ 𝐵𝑎𝑠𝑒 𝑃𝑟𝑖𝑐𝑒2) + ⋯

EXAMPLE: The simple economy of Clutchtopia produces three final goods and services necessary for the survival of its

citizens, the Clutchtopians: Pizza, Caffeine Pills, and Exam Reviews. Use the information in the following table to compute

nominal GDP and real GDP for 2018. Assume that the base year is 2006.

Product

2006 2018

Quantity Price Quantity Price

Pizza 250 $8 220 $10

Caffeine Pills 1,200 $5 1,500 $4

Exam Reviews 90 $15 130 $20

● Since Real GDP holds prices __________, it is seen as a better measure of changes in production of goods and services

□ Drawback: over time, prices may change relative to each other

> Price of HDTVs have fallen since 2006, while the price of milk has stayed relatively constant

□ Solution: use chain-weighted prices – a adjusted average price, rather than a constant base year price

> Calculation beyond scope of this course



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● Inflation refers to a state of the economy where ___________ are rising from one year to the next

□ We can use nominal GDP and real GDP to monitor inflation and general price levels in the economy

□ The GDP deflator is a statistic that measures only the prices of goods and services:

𝐺𝐷𝑃 𝑑𝑒𝑓𝑙𝑎𝑡𝑜𝑟 =𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃

𝑅𝑒𝑎𝑙 𝐺𝐷𝑃∗ 100

𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑅𝑎𝑡𝑒 =𝐺𝐷𝑃 𝑑𝑒𝑓𝑙𝑎𝑡𝑜𝑟 𝑖𝑛 𝑌𝑒𝑎𝑟 2 − 𝐺𝐷𝑃 𝐷𝑒𝑓𝑙𝑎𝑡𝑜𝑟 𝑖𝑛 𝑌𝑒𝑎𝑟 1

𝐺𝐷𝑃 𝑑𝑒𝑓𝑙𝑎𝑡𝑜𝑟 𝑖𝑛 𝑌𝑒𝑎𝑟 1

□ In the base year, the GDP deflator = _______

> This is because Nominal GDP ____ Real GDP in the base year

PRACTICE: The United States of Barbeque produces two goods: Hot Dogs and Hamburgers. Use the following information

to calculate the GDP Deflator for 2012, assuming the base year is 2010.

Year Price of

Hot Dogs Quantity of Hot Dogs

Price of Hamburgers

Quantity of Hamburgers

2010 $1 400 $2 600

2011 $1.05 450 $2.05 700

2012 $1.10 500 $2.10 800

PRACTICE: Using the information above, calculate the inflation rate for 2012 in the United States of Barbeque.



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CONCEPT: SHORTCOMINGS OF GDP

● GDP is a variable used to measure (1) total ______________ in the economy and (2) the ______________ of its citizens.

● Goods and services are produced but do not contribute to the GDP calculation, though they arguably should:

□ Household Production – the value of goods produced for ___________________

> A carpenter produces bookshelves for a living, but also produced one to use at home

> The services of a homemaker (stay-at-home parent) compared to a hired nanny or maid service

□ Underground Economy – buying and selling of goods that is _______________ from the government

> Illegal goods and services, such as drugs and prostitution

> Avoiding taxes on income earned

> Avoiding government regulations

□ Does the exclusion of household production and underground economy significantly affect GDP’s usefulness?

> In the short run, the changes in GDP from year to year from these sources is generally constant

> In the long run, social changes can have drastic effects on these sources

- Example: In the 1970s, the number of women in the workforce increased dramatically

- This led to “artificial” increases to GDP: Previously unmeasured production was now included

● GDP per capita can be used to signify the well-being of the citizens, but a measure of well-being should arguably include:

□ Value of Leisure: GDP would be higher if everyone worked 80 hours a week

□ Environmental effects: GDP would be higher without environmental regulations

> Example: As a measure of well-being, GDP should arguably be reduced for health hazards from pollution

□ Crime and Social Problems: More crime means more government spending on police, but is that actually good?

□ Equity in GDP: GDP measures the “size” of the pie, but not how it is divided

> Even if GDP is increasing, consumption may not increase equally per person



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CONCEPT: CALCULATING GDP USING THE INCOME APPROACH


□ GDP can be calculated by adding up all the expenditures during the year and has ________ main components

> Note that GDP can also be calculated by adding up all the income during the year (less common)

> They produce the same result because all the income earned is equal to all the expenditures made

● The income approach starts by adding up all components of national income:

□ Compensation of Employees: wages and salaries paid by businesses and government to employees

> The largest part of national income

□ Rents: income received by landlords on rented properties (residential and business)

> Net rental income = Gross Rental Receipts – Depreciation of Rental Property

□ Interest: income earned on loans by banks and depository savings by households

□ Proprietors’ Income: profits earned by sole proprietorships, partnerships, and other unincorporated businesses

□ Corporate Profits: profits earned by corporations

> Corporate income taxes are part of GDP because they are earned by the government

> Dividends are profits paid out to stockholders

> Undistributed Corporate Profits are retained earnings used to re-invest in the corporation

□ Taxes on Production and Imports: any general taxes levied by the government

> Taxes are included in GDP Income because Government Purchases are included in GDP Expenditures

● National income is then adjusted to reflect GDP:

□ Net Foreign Factor Income: GDP measures “domestic” income

> We must remove income earned by Americans for supplying resources abroad

> We must add income earned by foreigners for supplying resources to the United States

□ Consumption of Fixed Capital: Depreciation on long-term assets (such as equipment that lasts several years)

□ Statistical Discrepancy: basically an error adjustment made by the accountants ($209 billion in 2009!)



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2009 Accounting Statement for the U.S. Economy (in billions)

Gross Domestic Product: Expenditures Approach Gross Domestic Product: Income Approach Sum of: Sum of: Personal consumption expenditures (C) $10,089 Compensation of employees $7,792 Gross private domestic investment (Ig) 1,628 Rents 268 Government purchases (G) 2,931 Interest 788 Net exports (Xn) (392) Proprietors’ income 1,041 Corporate profits 1,309 Taxes on production and imports 1,090 Equals: National Income $12,288 Adjustments: Less: Net foreign factor income (105) Plus: Consumption of fixed capital 1,864 Plus: Statistical Discrepancy 209 Equals: Equals: Gross Domestic Product $14,256 Gross Domestic Product $14,256

Source: Bureau of Economic Analysis, www.bea.gov



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CONCEPT: OTHER MEASURES OF TOTAL PRODUCTION AND TOTAL INCOME

● Gross Domestic Product (GDP) focuses on the value of goods and services produced domestically

● Gross National Product (GNP) focuses on the value of goods and services produced by the country’s citizens

□ GNP includes goods and services produced by US-owned facilities abroad

□ GNP excludes goods and services produced by foreign-owned facilities in the US

□ GDP is used because developing countries tend to have many foreign-owned investments

> These foreign-owned investments would not be included in GNP and thus make production seem smaller

● Net Domestic Product (NDP) is GDP adjusted for depreciation

● National Income is the flip side of total production

□ We calculated GDP using an expenditures approach (C + I + G + NX), but expenditures = income

□ The total value spent on expenditures must be, on the other hand, earned by the sellers

□ Generally, beyond the scope of this course

● Personal Income is the income received by households

□ Excludes the earnings of corporations

□ Includes transfer payments received from the government (i.e. welfare, interest on financial investments)

● Disposable Personal Income is the income received by households, less required taxes

□ This represents the amount of money households actually have available to spend

□ Disposable Income can be used for Consumption or Savings



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CONCEPT: CONSUMER PRICE INDEX (CPI)

● Consumer Price Index (CPI) – measure of the average change in prices of a typical family’s “basket of goods”

□ Step 1: The government surveys households to see what kind of goods are typically purchased the “basket”

A typical family in Simple Land purchases these items during a given year: 50 jugs of Water™ and 75 pounds of Food™

□ Step 2: The prices of the goods in the “basket” are determined

Year Price of Water™ Price of Food™

2017 $5 $20

2018 $5.05 $22

2019 $5.20 $25

□ Step 3: The total cost of the “basket” is computed

2017 Cost of Basket =



□ Step 4: The cost of the “basket” is compared to the chosen base-year CPI is calculated

Formula CPI for 2017 CPI for 2018 CPI for 2019

𝐶𝑃𝐼𝐶𝑌 =𝐵𝑎𝑠𝑘𝑒𝑡 𝐶𝑜𝑠𝑡𝐶𝑌

𝐵𝑎𝑠𝑘𝑒𝑡 𝐶𝑜𝑠𝑡𝐵𝑌

∗ 100

□ Step 5: The CPI is used to calculate inflation rate (changes in prices over time)

Formula Inflation for 2017 Inflation for 2018 Inflation for 2019

𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛𝐶𝑌 =𝐶𝑃𝐼𝐶𝑌 − 𝐶𝑃𝐼𝑃𝑌

𝐶𝑃𝐼𝑃𝑌

∗ 100

The typical family’s spending

habits used to construct the

“basket of goods” comes from a

government survey of 14,000

households.

Source: U.S. Bureau of Labor Statistics



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CONCEPT: USING CPI TO ADJUST FOR INFLATION

● The Consumer Price Index (CPI) can be a useful tool for measuring purchasing power at different points in time

□ Formula for converting dollars from Year T to today’s dollars:

𝐴𝑚𝑜𝑢𝑛𝑡 𝑖𝑛 𝐶𝑌 𝑑𝑜𝑙𝑙𝑎𝑟𝑠 = 𝐴𝑚𝑜𝑢𝑛𝑡 𝑖𝑛 𝑌𝑒𝑎𝑟 𝑇 𝑑𝑜𝑙𝑙𝑎𝑟𝑠 ∗𝐶𝑃𝐼𝐶𝑌

𝐶𝑃𝐼𝑇

□ This formula can help you adjust worker wages or prices for goods at different points in time

EXAMPLE: Billy the Millennial and Gen X Johnny are caught in a heated dispute. Billy the Millennial exclaims, “My student

loans are enormous! I can barely afford to go to college!” Gen X Johnny haughtily retorts, “Ha! You make me sick! Your

generation is so lazy! Back in 1975, I worked my way through college making $4.00 an hour at my part-time job at a movie

theatre! You just want everything handed to you for free! Not only that, when I left college I worked my butt off 40 hours a

week for just $14,000 annual salary and purchased my 3 bedroom home for $42,000. Your generation will never have the

work ethic that I put in!” Knowing that the CPI was 53.8 in 1975 and 240 in 2016, calculate the following:

(a) Gen X Johnny’s part-time wage in 2016 dollars

(b) Gen X Johnny’s annual salary in 2016 dollars

(c) Gen X Johnny’s home price in 2016 dollars



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CONCEPT: PROBLEMS WITH THE CONSUMER PRICE INDEX

● The Consumer Price Index (CPI) as a measure of inflation can run into biases that tend to overstate inflation:

□ Substitution Bias – CPI assumes that the same amount of each product is purchased each month

> However, customers are likely to buy fewer of products that increase in price (and vice versa)

> Example: Apple prices rise significantly, orange prices rise slightly Substitute apples with oranges

> Since the CPI assumes apple purchases remain constant, the CPI will overstate the actual basket price

□ Quality Bias – Over time, items in the basket improve in quality

> Example: faster computers; safer cars

> Higher quality items will have these quality improvements embedded into the price

> Thus, although prices may have increased by inflation, they may have increased due to quality as well

□ New Product Bias – New products introduced since the last “basket” will not be included in the “basket

> Example: Cell phones were not included in CPI until the late 1990s, though millions were in use

> Price decreases tend to happen in years following new technology (i.e. DVD players, HDTVs)

> If the technology is not included in the basket, then these price decreases will not reflect in CPI

□ Outlet Bias – The way people shop has changed over the years

> CPI was consistently calculated at full-retail prices available in stores

> However, consumers also purchased at discount chains (Costco, Sam’s Club) and online

> The prices used could overstate the actual prices paid by consumers depending on the chosen outlet



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CH. 11 - GROSS DOMESTIC PRODUCT (GDP) AND CONSUMER …lightcat-files.s3.amazonaws.com/packets/admin... · Gross Domestic Product: Expenditures Approach Gross Domestic Product: Income