Do you Know Macroeconomics?

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N. Gregory Mankiw

Macroeconomics

Brief Principles of

Sixth Edition

Measuring a Nation’s Income

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Premium PowerPoint Slides by Ron Cronovich

2012 UPDATE

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It would be helpful to have your students bring their calculators to class for this chapter so they can practice calculating real and nominal GDP and so forth.

This is the first purely macro chapter in the textbook. It covers the definition of GDP, the spending components of GDP, real vs. nominal GDP, the GDP deflator, and why GDP is a useful but not perfect measure of a nation’s well-being.

In this chapter, look for the answers to these questions:

What is Gross Domestic Product (GDP)?

How is GDP related to a nation’s total income and spending?

What are the components of GDP?

How is GDP corrected for inflation?

Does GDP measure society’s well-being?

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Micro vs. Macro

Microeconomics: The study of how individual households and firms make decisions, interact with one another in markets.

Macroeconomics: The study of the economy as a whole.

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This is the first strictly macro chapter of the textbook, so it’s worth spending a moment emphasizing the difference between microeconomics and macroeconomics.

Examples of questions that microeconomics seeks to answer:

How do consumers decide how much of each good to buy?

How do firms decide how much output to produce and what price to charge?

What determines the price and quantity of individual goods and services?

How do taxes on specific goods and services affect the allocation of resources?

Examples of questions that macroeconomics seeks to answer:

How do consumers decide how to divide their income between spending and saving?

What determines the total amount of employment and unemployment?

What determines the overall level of prices and the rate of inflation?

Why does the economy go through cycles, where things are great for a few years (like the late ’90s) and then lousy for a year or two (like 2001–2002)?

When unemployment is high, what can the government do to help?

We begin our study of macroeconomics with income and expenditure….

Income and Expenditure

Gross Domestic Product (GDP) measures total income of everyone in the economy.

GDP also measures total expenditure on the economy’s output of g&s.

For the economy as a whole, income equals expenditure because every dollar a buyer spends is a dollar of income for the seller.

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Notes:

1. The text in the first bullet point is NOT the formal textbook definition of GDP. The formal definition is given and discussed in detail immediately after the Circular-Flow Diagram.

2. “g&s” = goods and services

A good way to judge how well someone is doing economically is to look at his or her income. We can judge how well a country is doing economically by looking at the total income that everyone in the economy is earning. GDP is our measure of the economy’s total income, often called “national income.”

GDP also measures total expenditure on the goods and services produced in the economy, and the value of the economy’s output (production) of goods and services. Thus, GDP is also referred to as “output.”

The equality of income and expenditure is an accounting identity (not, for example, an equilibrium condition): it must be true that income equals expenditure.

The Circular-Flow Diagram

a simple depiction of the macroeconomy

illustrates GDP as spending, revenue, factor payments, and income

Preliminaries:

Factors of production are inputs like labor, land, capital, and natural resources.

Factor payments are payments to the factors of production (e.g., wages, rent).

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If your students already know the terms “factors of production” and “factor payments,” you may wish to delete the “preliminaries” from this slide.

The Circular-Flow Diagram

Households:

own the factors of production, sell/rent them to firms for income

buy and consume goods & services

Households

Firms

Firms:

buy/hire factors of production, use them to produce goods and services

sell goods & services

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This and the following slide build the Circular-Flow Diagram piece by piece.

The Circular-Flow Diagram

Markets for Factors of Production

Households

Firms

Income (=GDP)

Wages, rent, profit (=GDP)

Factors of production

Labor, land, capital

Spending (=GDP)

G & S bought

G & S sold

Revenue (=GDP)

Markets for Goods & Services

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In this diagram, the green arrows represent flows of income/payments. The red arrows represent flows of goods & services (including services of the factors of production in the lower half of the diagram).

To keep the graph simple, we have omitted the government, financial system, and foreign sector, as discussed on the next slide.

Changing the animation on this slide:

If you wish, you can easily change the order in which the markets and arrows appear. From the “Slide Show” drop-down menu, choose “Custom Animation…” Then, a box will appear (maybe along the right-hand-side of your PowerPoint window) that allows you to modify the order in which things appear (as well as other aspects of the animation). For further information, open PowerPoint help and search on “change the sequence of animations.”

What This Diagram Omits

The government

collects taxes, buys g&s

The financial system

matches savers’ supply of funds with borrowers’ demand for loans

The foreign sector

trades g&s, financial assets, and currencies with the country’s residents

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In future chapters, we will study the role of each of these in greater detail.

We could draw a more complicated circular flow diagram that includes the government, financial system, and foreign sector. Including them, however, would not change the basic conclusion that GDP simultaneously measures the country’s total income, expenditure, revenue, and factor payments.

…the market value of all final goods & services produced within a country in a given period of time.

Gross Domestic Product (GDP) Is…

Goods are valued at their market prices, so:

All goods measured in the same units (e.g., dollars in the U.S.)

Things that don’t have a market value are excluded, e.g., housework you do for yourself.

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This slide and the five that follow focus on the meaning of each part of this critically important definition.

Note that transactions occurring in the so-called “underground economy” are also omitted from the official measure of GDP. In the textbook, near the end of this chapter, an “In the News” box contains an excellent article on the underground economy.

…the market value of all final goods & services produced within a country in a given period of time.

Gross Domestic Product (GDP) Is…

Final goods: intended for the end user

Intermediate goods: used as components or ingredients in the production of other goods

GDP only includes final goods—they already embody the value of the intermediate goods used in their production.

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…the market value of all final goods & services produced within a country in a given period of time.

Gross Domestic Product (GDP) Is…

GDP includes tangible goods (like DVDs, mountain bikes, beer)

and intangible services (dry cleaning, concerts, cell phone service).

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…the market value of all final goods & services produced within a country in a given period of time.

Gross Domestic Product (GDP) Is…

GDP includes currently produced goods, not goods produced in the past.

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…the market value of all final goods & services produced within a country in a given period of time.

Gross Domestic Product (GDP) Is…

GDP measures the value of production that occurs within a country’s borders, whether done by its own citizens or by foreigners located there.

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…the market value of all final goods & services produced within a country in a given period of time.

Gross Domestic Product (GDP) Is…

Usually a year or a quarter (3 months)

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The Components of GDP

Recall: GDP is total spending.

Four components:

Consumption (C)

Investment (I)

Government Purchases (G)

Net Exports (NX)

These components add up to GDP (denoted Y):

Y = C + I + G + NX

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Each of the four components is defined and discussed in detail on the following slides.

Consumption (C)

is total spending by households on g&s.

Note on housing costs:

For renters, consumption includes rent payments.

For homeowners, consumption includes the imputed rental value of the house, but not the purchase price or mortgage payments.

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Mostly, the term “consumption” refers to what students probably already think of as total consumer spending. The note about the treatment of owner-occupied housing is an exception, and some of the test bank questions are designed to see if students remember this exception.

(For more on this issue, see the notes accompanying the following slide.)

Investment (I)

is total spending on goods that will be used in the future to produce more goods.

includes spending on

capital equipment (e.g., machines, tools)

structures (factories, office buildings, houses)

inventories (goods produced but not yet sold)

Note: “Investment” does not mean the purchase of financial assets like stocks and bonds.

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More on the treatment of owner-occupied housing:

In the national income and product accounts, a house is considered a piece of capital that is used to produce a flow of services—housing services.

When a consumer (as a tenant) rents a house or apartment, the consumer is buying housing services. These services are considered consumption, so the price paid for these services – rent – is counted in the “consumption” component of GDP .

When someone buys a new house to live in, she is both a producer and a consumer. As a producer, she has made an investment (the purchase of the house) that will produce a service. She is also the consumer of this service, which is valued at the market rental rate for that type of house. So, the accounting conventions treat this situation as if the person is her own landlord and rents the house to/from herself.

When students begin to understand this, they may wonder why certain other goods (like cars) that produce a flow of consumer services are not also treated this way. There really is no good answer. It’s just a convention of the national income and product accounts.

Government Purchases (G)

is all spending on the g&s purchased by govt at the federal, state, and local levels.

G excludes transfer payments, such as Social Security or unemployment insurance benefits.

They are not purchases of g&s.

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You might tell your students that transfer payments, like Social Security checks, are excluded from G to avoid double-counting: retired persons spend part or all of their Social Security benefits on food, rent, prescriptions, and so forth, all of which count in consumption. If we also counted the Social Security check as part of G, then the same money would be counted twice, which would make GDP look bigger than it really is.

Net Exports (NX)

NX = exports – imports

Exports represent foreign spending on the economy’s g&s.

Imports are the portions of C, I, and G that are spent on g&s produced abroad.

Adding up all the components of GDP gives:

Y = C + I + G + NX

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The “net” in “net exports” refers to the fact that we are subtracting imports from exports. This subtraction is important, because imports are also counted in the other components of GDP; failing to subtract them would cause GDP to measure not just the value of goods produced domestically, but also goods produced abroad and imported.

For example, if a consumer spends $100 on a DVD player imported from Japan, that $100 counts in “consumption,” even though the player was not produced domestically. We subtract off that $100 import so that GDP ends up including the value of only domestically-produced goods and services.

U.S. GDP and Its Components, 2012

–1,915

9,767

6,657

35,459

$49,968

per capita

–3.8

19.5

13.3

71.0

100.0

% of GDP

–598

3,048

2,078

11,068

$15,596

billions

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An updated version of Table 1 in this chapter of the textbook. The data shown are for 2012 2nd quarter, the latest available at the time I’m writing this. If you’d like to update this before showing in your class, you can find the latest figures here:

Source for data on GDP & components: http://www.bea.gov

http://www.bea.gov/national/index.htm

Source for population data (used to calculate the per capita figures):

http://research.stlouisfed.org/fred2/series/POPTHM?cid=104

Original source: U.S. Department of Commerce: Census Bureau, www.census.gov

ACTIVE LEARNING 1 GDP and its components

In each of the following cases, determine how much GDP and each of its components is affected (if at all).

A. Debbie spends $200 to buy her husband dinner at the finest restaurant in Boston.

B. Sarah spends $1800 on a new laptop to use in her publishing business. The laptop was built in China.

C. Jane spends $1200 on a computer to use in her editing business. She got last year’s model on sale for a great price from a local manufacturer.

D. General Motors builds $500 million worth of cars, but consumers only buy $470 million worth of them.

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Suggestion: Show these questions, and give your students 1–3 minutes to formulate their answers. When you are ready to discuss the answers, go to the next slide…

ACTIVE LEARNING 1 Answers

A. Debbie spends $200 to buy her husband dinner at the finest restaurant in Boston.

Consumption and GDP rise by $200.

B. Sarah spends $1800 on a new laptop to use in her publishing business. The laptop was built in China.

Investment rises by $1800, net exports fall by $1800, GDP is unchanged.

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Suggestion (continued from previous slide): Show part A (but not the answer) and ask for someone to volunteer his or her response. Then show the answer to part A. Repeat for parts B, C, and D. (The answers to parts C and D appear on the following slide.)

After showing the answer to part A, ask your students whether the answer would be different if Debbie were a government employee. The correct answer is NO. Government employees engage in consumption, just like everyone else.

ACTIVE LEARNING 1 Answers

C. Jane spends $1200 on a computer to use in her editing business. She got last year’s model on sale for a great price from a local manufacturer.

Current GDP and investment do not change, because the computer was built last year.

D. General Motors builds $500 million worth of cars, but consumers only buy $470 million of them.

Consumption rises by $470 million, inventory investment rises by $30 million, and GDP rises by $500 million.

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Regarding part C:

Jane’s purchase causes investment (for her own business) to increase by $1200. However, the computer is sold out of inventory, so inventory investment falls by $1200. The two transactions cancel each other, leaving aggregate investment and GDP unchanged.

Regarding part D:

This problem illustrates why expenditure always equals output, even when firms don’t sell everything they produce due to lackluster demand. The point here is that unsold output is counted in inventory investment, even when that “investment” was unintentional.

Real versus Nominal GDP

Inflation can distort economic variables like GDP, so we have two versions of GDP:

Nominal GDP

values output using current prices

not corrected for inflation

Real GDP

values output using the prices of a base year

is corrected for inflation

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EXAMPLE:

Compute nominal GDP in each year:

2011: $10 x 400 + $2 x 1000 = $6,000

2012: $11 x 500 + $2.50 x 1100 = $8,250

2013: $12 x 600 + $3 x 1200 = $10,800

	Pizza		Latte
year	P	Q	P	Q
2011	$10	400	$2.00	1000
2012	$11	500	$2.50	1100
2013	$12	600	$3.00	1200

37.5%

Increase:

30.9%

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This example is similar to that in the text, but using different goods and different numerical values.

Suggestion: Ask your students to compute nominal GDP in each year before revealing the answers. Ask them to compute the rate of increase before revealing the answers.

In this example, nominal GDP grows for two reasons: prices are rising, and the economy is producing a larger quantity of goods.

Thinking of nominal GDP as total income, the increases in income will overstate the increases in society’s well-being because part of these increases are due to inflation.

We need a way to take out the effects of inflation, to see how much people’s incomes are growing in purchasing power terms. That is the job of real GDP.

EXAMPLE:

Compute real GDP in each year, using 2011 as the base year:

	Pizza		Latte
year	P	Q	P	Q
2011	$10	400	$2.00	1000
2012	$11	500	$2.50	1100
2013	$12	600	$3.00	1200

20.0%

Increase:

16.7%

$10

$2.00

2011: $10 x 400 + $2 x 1000 = $6,000

2012: $10 x 500 + $2 x 1100 = $7,200

2013: $10 x 600 + $2 x 1200 = $8,400

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This example shows that real GDP in every year is constructed using the prices of the base year and that the base year doesn’t change.

The growth rate of real GDP from one year to the next is the answer to this question:

“How much would GDP (and hence everyone’s income) have grown if there had been zero inflation?”

Thus, real GDP is corrected for inflation.

EXAMPLE:

In each year,

nominal GDP is measured using the (then) current prices.

real GDP is measured using constant prices from the base year (2011 in this example).

year	Nominal GDP	Real GDP
2011	$6000	$6000
2012	$8250	$7200
2013	$10,800	$8400

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The table in the top half of this slide merely summarizes the answers from the previous two slides. This table will be used shortly to compute the growth rates in nominal and real GDP and to compute the GDP deflator and inflation rates.

EXAMPLE:

The change in nominal GDP reflects both prices and quantities.

year	Nominal GDP	Real GDP
2011	$6000	$6000
2012	$8250	$7200
2013	$10,800	$8400

20.0%

16.7%

37.5%

30.9%

The change in real GDP is the amount that GDP would change if prices were constant (i.e., if zero inflation).

Hence, real GDP is corrected for inflation.

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Again, the growth rate of real GDP from one year to the next is the answer to this question:

“How much would GDP (and hence everyone’s income) have grown if there had been zero inflation?”

This is why real GDP is corrected for inflation.

Nominal and Real GDP in the U.S., 1965–2012

Real GDP (base year 2005)

Nominal GDP

billions

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The source I used: http://research.stlouisfed.org/fred2/

The original source: U.S. Department of Commerce: Bureau of Economic Analysis

Since you have just finished covering real vs. nominal GDP, it might be worthwhile pointing out the following to your students:

The graph shows that nominal GDP rises faster than real GDP. This should make sense, because growth in nominal GDP is driven by growth in output AND by inflation. Growth in real GDP is driven only by growth in output.

The two lines cross in the year 2005 (the base year for the real GDP data in this graph). This should make sense because real GDP equals nominal GDP in the base year. (Better yet, ask your students whether there’s anything significant about the point where the two lines cross.)

Before the base year, real GDP > nominal GDP. For example, in 1981, nominal GDP is about $3 trillion, while real GDP is about $6 trillion (in 2005 dollars). This should make sense because prices were so much higher in 2005 than in 1981, so using those high 2005 prices to value 1981 output would lead to a bigger result than valuing 1981 output using 1981 prices.

Similarly, after 2005, nominal GDP is higher than real GDP because prices are higher in later years than they were in 2005.

NGDP 1960 1960.25 1960.5 1960.75 1961 1961.25 1961.5 1961.75 1962 1962.25 1962.5 1962.75 1963 1963.25 1963.5 1963.75 1964 1964.25 1964.5 1964.75 1965 1965.25 1965.5 1965.75 1966 1966.25 1966.5 1966.75 1967 1967.25 1967.5 1967.75 1968 1968.25 1968.5 1968.75 1969 1969.25 1969.5 1969.75 1970 1970.25 1970.5 1970.75 1971 1971.25 1971.5 1971.75 1972 1972.25 1972.5 1972.75 1973 1973.25 1973.5 1973.75 1974 1974.25 1974.5 1974.75 1975 1975.25 1975.5 1975.75 1976 1976.25 1976.5 1976.75 1977 1977.25 1977.5 1977.75 1978 1978.25 1978.5 1978.75 1979 1979.25 1979.5 1979.75 1980 1980.25 1980.5 1980.75 1981 1981.25 1981.5 1981.75 1982 1982.25 1982.5 1982.75 1983 1983.25 1983.5 1983.75 1984 1984.25 1984.5 1984.75 1985 1985.25 1985.5 1985.75 1986 1986.25 1986.5 1986.75 1987 1987.25 1987.5 1987.75 1988 1988.25 1988.5 1988.75 1989 1989.25 1989.5 1989.75 1990 1990.25 1990.5 1990.75 1991 1991.25 1991.5 1991.75 1992 1992.25 1992.5 1992.75 1993 1993.25 1993.5 1993.75 1994 1994.25 1994.5 1994.75 1995 1995.25 1995.5 1995.75 1996 1996.25 1996.5 1996.75 1997 1997.25 1997.5 1997.75 1998 1998.25 1998.5 1998.75 1999 1999.25 1999.5 1999.75 2000 2000.25 2000.5 2000.75 2001 2001.25 2001.5 2001.75 2002 2002.25 2002.5 2002.75 20 03 2003.25 2003.5 2003.75 2004 2004.25 2004.5 2004.75 2005 2005.25 2005.5 2005.75 2006 2006.25 2006.5 2006.75 2007 2007.25 2007.5 2007.75 2008 2008.25 2008.5 2008.75 2009 2009.25 2009.5 2009.75 2010 2010.25 2010.5 2010.75 2011 2011.25 2011.5 2011.75 2012 527 526.20000000000005 529 523.70000000000005 528 539 549.5 562.6 576.1 583.20000000000005 590 593.29999999999995 602.5 611.20000000000005 623.9 633.5 649.6 658.9 670.5 675.6 695.7 708.1 725.2 747.5 770.8 779.9 793.1 806.9 817.8 822.3 837 852.7 879.8 904.1 919.3 936.2 960.9 976.1 996.3 1004.5 1017.1 1033.0999999999999 1050.5 1052.7 1098.0999999999999 1118.8 1139.0999999999999 1151.4000000000001 1190.0999999999999 1225.5999999999999 1249.3 1286.5999999999999 1335.1 1371.5 1390.7 1431.8 1446.5 1484.8 1513.7 1552.8 1569.4 1605 1662.4 1713.9 1771.9 1804.2 1837.7 1884.5 1938.5 2005.2 2066 2110.8000000000002 2149.1 2274.6999999999998 2335.1999999999998 2416 2463.3000000000002 2526.4 2599.6999999999998 2659.4 2724.1 2728 2785.2 2915.3 3051.4 3084.3 3177 3194.7 3184.9 3240.9 3274.4 3312.5 3381 3482.2 3587.1 3688.1 3807.4 3906.3 3976 4034 4117.2 4175.7 4258.3 4318.7 4382.3999999999996 4423.2 4491.3 4543.3 4611.1000000000004 4686.7 4764.5 4883.1000000000004 4948.6000000000004 5059.3 5142.8 5251 5360.3 5453.6 5532.9 5581.7 5708.1 5797.4 5850.6 5846 5880.2 5962 6033.7 6092.5 6190.7 6295.2 6389.7 6493.6 6544.5 6622.7 6688.3 6813.8 6916.3 7044.3 7131.8 7248.2 7307.7 7355.8 7452.5 7542.5 7638.2 7800 7892.7 8023 8137 8276.7999999999993 8409.9 8505.7000000000007 8600.6 8698.6 8847.2000000000007 9027.5 9148.6 9252.6 9405.1 9607.7000000000007 9709.5 9949.1 10017.5 10129.799999999999 10165.1 10301.299999999999 10305.200000000001 10373.1 10498.7 10601.9 10701.7 10766.9 10887.4 11011.6 11255.1 11414.8 11589.9 11762.9 11936.3 12123.9 12361.8 12500 12728.6 12901.4 13161.4 13330.4 13432.8 13584.2 13758.5 13976.8 14126.2 14253.2 14273.9 14415.5 14395.1 14081.7 13893.7 13854.1 13920.5 14087.4 14277.9 14467.8 14605.5 14755 14867.8 15012.8 15176.1 15319.4 15454 RGDP 1960 1960.25 1960.5 1960.75 1961 1961.25 1961.5 1961.75 1962 1962.25 1962.5 1962.75 1963 1963.25 1963.5 1963.75 1964 1964.25 1964.5 1964.75 1965 1965.25 1965.5 1965.75 1966 1966.25 1966.5 1966.75 1967 1967.25 1967.5 1967.75 1968 1968.25 1968.5 1968.75 1969 1969.25 1969.5 1969.75 1970 1970.25 1970.5 1970.75 1971 1971.25 1971.5 1971.75 1972 1972.25 1972.5 1972.75 1973 1973.25 1973.5 1973.75 1974 1974.25 1974.5 1974.75 1975 1975.25 1975.5 1975.75 1976 1976.25 1976.5 1976.75 1977 1977.25 1977.5 1977.75 1978 1978.25 1978.5 1978.75 1979 1979.25 1979.5 1979.75 1980 1980.25 1980.5 1980.75 1981 1981.25 1981.5 1981.75 1982 1982.25 1982.5 1982.75 1983 1983.25 1983.5 1983.75 1984 1984.25 1984.5 1984.75 1985 1985.25 1985.5 1985.75 1986 1986.25 1986.5 1986.75 1987 1987.25 1987.5 1987.75 1988 1988.25 1988.5 1988.75 1989 1989.25 1989.5 1989.75 1990 1990.25 1990.5 1990.75 1991 1991.25 1991.5 1991.75 1992 1992.25 1992.5 1992.75 1993 1993.25 1993.5 1993.75 1994 1994.25 1994.5 1994.75 1995 1995.25 1995.5 1995.75 1996 1996.25 1996.5 1996.75 1997 1997.25 1997.5 1997.75 1998 1998.25 1998.5 1998.75 1999 1999.25 1999.5 1999.75 2000 2000.25 2000.5 2000.75 2001 2001.25 2001.5 2001.75 2002 2002.25 2002.5 2002.75 2003 2003.25 2003.5 2003.75 2004 2004.25 2004.5 2004.75 2005 2005.25 2005.5 2005.75 2006 2006.25 2006.5 2006.75 2007 2007.25 2007.5 2007.75 2008 2008.25 2008.5 2008.75 2009 2009.25 2009.5 2009.75 2010 2010.25 2010.5 2010.75 2011 2011.25 2011.5 2011.75 2012 2845.3 2832 2836.6 2800.2 2816.9 2869.6 2915.9 2975.3 3028.7 3062.1 3090.4 3097.9 3138.4 3177.7 3237.6 3262.2 3335.4 3373.7 3419.5 3429 3513.3 3560.9 3633.2 3720.8 3812.2 3824.9 3850 3881.2 3915.4 3916.2 3947.5 3977.6 4059.5 4128.5 4156.7 4174.7 4240.5 4252.8 4279.7 4259.6000000000004 4252.8999999999996 4260.7 4298.6000000000004 4253 4370.3 4395.1000000000004 4430.2 4442.5 4521.8999999999996 4629.1000000000004 4673.5 4750.5 4872 4928.3999999999996 4902.1000000000004 4948.8 4905.3999999999996 4918 4869.3999999999996 4850.2 4791.2 4827.8 4909.1000000000004 4973.3 5086.3 5124.6000000000004 5149.7 5187.1000000000004 5247.3 5351.6 5447.3 5446.1 5464.7 5679.7 5735.4 5811.3 5821 5826.4 5868.3 5884.5 5903.4 5782.4 5771.7 5878.4 6000.6 5952.7 6025 5950 5852.3 5884 5861.4 5866 5938.9 6072.4 6192.2 6320.2 6442.8 6554 6617.7 6671.6 6734.5 6791.5 6897.6 6950 7016.8 7045 7112.9 7147.3 7186.9 7263.3 7326.3 7451.7 7490.2 7586.4 7625.6 7727.4 7799.9 7858.3 7920.6 7937.9 8020.8 8052.7 8052.6 7982 7943.4 7997 8030.7 8062.2 8150.7 8237.2999999999993 8322.2999999999993 8409.7999999999993 8425.2999999999993 8479.2000000000007 8523.7999999999993 8636.4 8720.5 8839.7999999999993 8896.7000000000007 8995.5 9017.6 9037 9112.9 9176.4 9239.2999999999993 9399 9480.7999999999993 9584.2999999999993 9658 9801.2000000000007 9924.2000000000007 10000.299999999999 10094.799999999999 10185.6 10320 10498.6 10592.1 10674.9 10810.7 11004.8 11033.6 11248.8 11258.3 11325 11287.8 11361.7 11330.4 11370 11467.1 11528.1 11586.6 11590.6 11638.9 11737.5 11930.7 12038.6 12117.9 12195.9 12286.7 12387.2 12515 12570.7 12670.5 12735.6 12896.4 12948.7 12950.4 13038.4 13056.1 13173.6 13269.8 13326 13266.8 13310.5 13186.9 12883.5 12663.2 12641.3 12694.5 12813.5 12937.7 13058.5 13139.6 13216.1 13227.9 13271.8 13331.6 13429 13491

The GDP Deflator

The GDP deflator is a measure of the overall level of prices.

Definition:

One way to measure the economy’s inflation rate is to compute the percentage increase in the GDP deflator from one year to the next.

GDP deflator = 100 x

nominal GDP

real GDP

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The GDP Deflator gets its name because it is used to “deflate” (i.e., take the inflation out of) nominal GDP to get real GDP.

EXAMPLE:

Compute the GDP deflator in each year:

year	Nominal GDP	Real GDP	GDP Deflator
2011	$6000	$6000
2012	$8250	$7200
2013	$10,800	$8400

2011: 100 x (6000/6000) = 100.0

100.0

2012: 100 x (8250/7200) = 114.6

114.6

2013: 100 x (10,800/8400) = 128.6

128.6

14.6%

12.2%

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ACTIVE LEARNING 2 Computing GDP

Use the above data to solve these problems:

A. Compute nominal GDP in 2011.

B. Compute real GDP in 2012.

C. Compute the GDP deflator in 2013.

	2011 (base yr)		2012		2013
	P	Q	P	Q	P	Q
Good A	$30	900	$31	1000	$36	1050
Good B	$100	192	$102	200	$100	205

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The data in the table are for a hypothetical economy that produces two final goods, A and B. For all parts of this problem, use 2011 as the base year.

If you’re running short on time, you can skip part A—it’s the least challenging. If you only have time for one of the three, you might skip A and B, as C by itself covers all of the material: it requires students to compute nominal and real GDP before they can compute the GDP deflator.

ACTIVE LEARNING 2 Answers

A. Compute nominal GDP in 2011.

$30 x 900 + $100 x 192 = $46,200

B. Compute real GDP in 2012.

$30 x 1000 + $100 x 200 = $50,000

	2011 (base yr)		2012		2013
	P	Q	P	Q	P	Q
Good A	$30	900	$31	1,000	$36	1050
Good B	$100	192	$102	200	$100	205

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ACTIVE LEARNING 2 Answers

C. Compute the GDP deflator in 2013.

Nom GDP = $36 x 1050 + $100 x 205 = $58,300

Real GDP = $30 x 1050 + $100 x 205 = $52,000

GDP deflator = 100 x (Nom GDP)/(Real GDP)

= 100 x ($58,300)/($52,000) = 112.1

	2011 (base yr)		2012		2013
	P	Q	P	Q	P	Q
Good A	$30	900	$31	1,000	$36	1050
Good B	$100	192	$102	200	$100	205

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GDP and Economic Well-Being

Real GDP per capita is the main indicator of the average person’s standard of living.

But GDP is not a perfect measure of well-being.

Robert Kennedy issued a very eloquent yet harsh criticism of GDP:

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Most economists, policymakers, social scientists, and businesspersons use a country’s real GDP per capita as the main indicator of the average person’s standard of living in that country.

Gross Domestic Product…

“… does not allow for the health of our children, the quality of their education, or the joy of their play.

It does not include the beauty of our poetry or the strength of our marriages, the intelligence of our public debate or the integrity of our public officials.

It measures neither our courage, nor our wisdom, nor our devotion to our country.

It measures everything, in short, except that which makes life worthwhile, and it can tell us everything about America except why we are proud that we are Americans.”

- Senator Robert Kennedy, 1968

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Very scathing words, indeed!

GDP Does Not Value:

the quality of the environment

leisure time

non-market activity, such as the child care a parent provides his or her child at home

an equitable distribution of income

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Much of what Robert Kennedy said about GDP is correct.

Then Why Do We Care About GDP?

Having a large GDP enables a country to afford better schools, a cleaner environment, health care, etc.

Many indicators of the quality of life are positively correlated with GDP. For example…

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Then why do we care about GDP?

Because a large GDP does in fact help us to lead a good life. GDP does not measure the health of our children, but nations with larger GDP can afford better health care for their children. GDP does not measure the beauty of our poetry, but nations with larger GDP can afford to teach more of their citizens to read and enjoy poetry. GDP does not take account of our intelligence, integrity, courage, wisdom, or devotion to country, but all of these laudable attributes are easier to foster when people are less concerned about being able to afford the material necessities of life.

In short, GDP does not directly measure those things that make life worthwhile, but it does measure our ability to obtain the inputs into a worthwhile life.

GDP and Life Expectancy in 12 countries

Life expectancy (years)

Real GDP per capita

U.S.

Germany

Japan

Mexico

Russia

Brazil

China

India

Indonesia

Pakistan

Bangladesh

Nigeria

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This figure and the two that follow are from the data in Table 3 of the textbook.

Real GDP per capita figures are expressed in U.S. dollars.

Source: Human Development Report 2007/2008, United Nations.

GDP and Literacy in 12 countries

Adult Literacy (% of population)

Real GDP per capita

U.S.

Germany

Japan

Mexico

Russia

Brazil

China

India

Indonesia

Nigeria

Pakistan

Bangladesh

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Source: Human Development Report 2007/2008, United Nations.

GDP and Internet Usage in 12 countries

Internet Usage (% of population)

Real GDP per capita

U.S.

Germany

Japan

Mexico

Russia

Brazil

China

India

Indonesia

Nigeria

Bangladesh

Pakistan

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Source: Human Development Report 2007/2008, United Nations.

SUMMARY

Gross Domestic Product (GDP) measures a country’s total income and expenditure.

The four spending components of GDP include: Consumption, Investment, Government Purchases, and Net Exports.

Nominal GDP is measured using current prices. Real GDP is measured using the prices of a constant base year and is corrected for inflation.

GDP is the main indicator of a country’s economic well-being, even though it is not perfect.

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