Chapter Two 1

A PowerPointTutorialto Accompany macroeconomics, 5th ed.

N. Gregory Mankiw

Mannig J. Simidian

®

CHAPTER TWOThe Data of Macroeconomics

Chapter Two 2

Gross Domestic Product (GDP) is the market value of all final goods and services produced within an economy in a given period of time.

The consumer price index (CPI) measures the level of prices.

The unemployment rate tells us the fraction of workers who are unemployed.

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There are 2 ways of viewing GDP

Total income of everyone in the economy

Total expenditure on the economy’s output of goods and services

Households Firms

Income $

Labor

Goods

Expenditure $

For the economy as a whole, income must equal expenditure. GDP measures the flow of dollars in this economy.

Income, Expenditure And the Circular Flow

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1) To compute the total value of different goods and services, the national income accounts use market prices. Thus, if

$0.50 $1.00

GDP = (Price of apples Quantity of apples) + (Price of oranges Quantity of oranges)

= ($0.50 4) + ($1.00 3)GDP = $5.00

2) Used goods are not included in the calculation of GDP.3) The treatment of inventories depends on if the goods are stored orif they spoil. If the goods are stored, their value is included in GDP.If they spoil, GDP remains unchanged. When the goods are finally soldout of inventory, they are considered used goods (and are not counted).

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4) Intermediate goods are not counted in GDP– only the value offinal goods. Reason: the value of intermediate goods is already included in the market price. Value added of a firm equals the value of the firm’s output less the value of the intermediate goodsthe firm purchases.

5) Some goods are not sold in the marketplace and therefore don’thave market prices. We must use their imputed value as an estimateof their value. For example, home ownership and government services.

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The value of final goods and services measured at current prices is called nominal GDP. It can change over time either because there is a change in the amount (real value) of goods and services or a change in the prices of those goods and services. Hence, nominal GDP Y = P y, where P is the price level and y is real output– and remember we use output and GDP interchangeably. Real GDP or, y = YP is the value of goods and services measured using a constant set of prices. This distinction between real and nominal can also be applied to other monetary values, like wages. Nominal (or money) wages can be denoted by W and decomposed into a real value (w) and a price variable (P). Hence, W = nominal wage = P • w

w = real wage = w/PThis conversion from nominal to real units allows us to eliminate the problems created by having a measuring stick (dollar value) that essentially changes length over time, as the price level changes.

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Let’s see how real GDP is computed in our apple and orange economy.

For example, if we wanted to compare output in 2002 and output in 2003, we would obtain base-year prices, such as 2002 prices.

Real GDP in 2002 would be: (2002 Price of Apples 2002 Quantity of Apples) +(2002 Price of Oranges 2002 Quantity of Oranges).Real GDP in 2003 would be:(2002 Price of Apples 2003 Quantity of Apples) +(2002 Price of Oranges 2003 Quantity of Oranges).Real GDP in 2004 would be:(2002 Price of Apples 2004 Quantity of Apples) +(2002 Price of Oranges 2004 Quantity of Oranges).

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Nominal GDP measures the current dollar value of the output of the economy.

Real GDP measures output valued at constant prices.

The GDP deflator, also called the implicit price deflator for GDP, measures the price of output relative to its price in the base year. Itreflects what’s happening to the overall level of prices in the economy.

GDP Deflator = Nominal GDP Real GDP

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In some cases, it is misleading to use base year prices that prevailed 10 or 20 years ago (i.e. computers and college). In 1995, the Bureau of Economic Analysis decided to use chain-weighted measures of

real GDP. The base year changes continuously over time. This new chain-weighted

measure is better than the more traditional measure because it ensures that prices will not be

too out of date.

Average prices in 2001and 2002 are used to measurereal growth from 2001 to 2002.Average prices in 2002 and 2003are used to measure real growth from2002 to 2003 and so on. These growthrates are united to form a chain that isused to compare output between any twodates.

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Governmentpurchases of goods

and services

Governmentpurchases of goods

and services

Y = C + I + G + NXY = C + I + G + NXY = C + I + G + NXY = C + I + G + NX

Total demandfor domestic output (GDP)

Total demandfor domestic output (GDP)

is composed of

is composed of

Consumptionspending byhouseholds

Consumptionspending byhouseholds

Investmentspending by

businesses andhouseholds

Investmentspending by

businesses andhouseholds Net exports

or net foreigndemand

Net exportsor net foreign

demand

This is the called the national income accounts identity.

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To see how the alternative measures of income relate to one another, we start with GDP and add or subtract various quantities.To obtain gross national product (GNP), we add receipts of factorincome (wages, profit, and rent) from the rest of the world andsubtract payments of factor income to the rest of the world.

GNP = GDP+Factor Payments from Abroad -Factor Payments to Abroad

Whereas GDP measures the total income produced domestically, GNPmeasures the total income earned by nationals (residents of a nation).

To obtain net national product (NNP), we subtract the depreciation ofcapital-- the amount of the economy’s stock of plants, equipment, andresidential structures that wears out during the year:

NNP = GNP - Depreciation

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The Consumer Price Index (CPI) turns the prices of many goods and services into a single index

measuring the overall level of prices.

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Let’s see how the CPI would be computed in ourapple and orange economy.

For example, suppose that the typical consumer buys 5 apples and 2 oranges every month. Then the basket of goods consists of 5 apples and 2 oranges, and the CPI is:

CPI= ( 5 Current Price of Apples) + (2 Current Price of Oranges)

( 5 2002 Price of Apples) + (2 2002 Price of Oranges)

In this CPI calculation, 2002 is the base year. The index tells how much it costs to buy 5 apples and 2 oranges in the current year relative to how much it cost to buy the same basket of fruit in 2002.

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The GDP deflator measures the prices of all goods produced, whereas the CPI measures prices of only the goods and services bought by consumers. Thus, an increase in the price of goods bought by firms or the government will show up in the GDP deflator but not in the CPI.

Also, another difference is that the GDP deflator includes only those goods and services produced domestically. Imported goods are not a part of GDP and therefore don’t show up in the GDP deflator.

The final difference is the way the two aggregate the prices in the economy. The CPI assigns fixed weights to the prices of different goods, whereas the GDP deflator assigns changing weights.

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The labor force is defined as the sum of the employed and unemployed, and the unemployment rate is defined as the percentage of the labor force that is unemployed.The labor force participation rate is the percentage of the adult population who are in the labor force.

Unemployment Rate = Number of Unemployed Labor Force

100

Labor-Force Participation Rate = Labor Force Adult Population

100

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The negative relationship between unemployment and GDP is calledOkun’s Law, after Arthur Okun, the economist who first studied it.

In short, it is defined as:Percentage Change in Real GDP = 3% - 2 the Change in the Unemployment Rate

If the unemployment rate remains the same, real GDP grows byabout 3 percent. For every percentage point the unemployment raterises, real GDP growth typically falls by 2 percent. Hence, if theunemployment rate rises from 6 to 8 percent, then real GDP growthwould be:

Percentage Change in Real GDP = 3% - 2 (8% - 6%) = - 1%

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National income accounts identity Consumption Investment Government Purchases Net Exports Labor force Labor-force participation rate Okun’s Law

Gross domestic product (GDP) Consumer Price Index (CPI) Unemployment Rate National income accounting Stocks and flows Value added Imputed value Nominal versus real GDP GDP deflator