Gross Domestic Product

Class Lecture Notes Measuring the Macroeconomy

Professor Shari Lyman, Ph.D.

GDP Measures

GDP is Gross Domestic Product

GDP is the value of all final goods and services produced within a country’s borders by its own citizens or foreign citizens in a given time period.

GNP is Gross National Product

GNP is the value of all final goods and services produced by a country’s citizens within the country’s borders or in foreign lands in a given time period. http://www.diffen.com/difference/GDP_vs_GNP

Intermediate goods are used to produce other goods. For example, when Pizza Hut buys cheese to produce pizzas, the cheese is an intermediate good.

Final goods are purchased by the end user. When the Lyman household purchases cheese, the cheese is a final good.

GDP is represented by the variable Y in macroeconomic calculations.

The formula for GDP is:

Y=Consumption(C)+Investment(I)+Government Expenditures(G)+Net Exports(X-M). 

Consumption (durable and non-durable goods and services for individual household consumption)

Investment (Consumption of new physical capital and new housing such as factories, machines, tools, transportation systems, new houses, etc.) Investment is purchased using financial capital instruments.

Government expenditures (all Federal, State, and Local government purchases from paper clips to aircraft carriers).

Net Exports (Trade Balance=Exports-Imports)

Macroeconomic Measures introduces the student to 3 different methods of measuring GDP:

1.the incomes approach (simplified circular flow model-resource flow approach)

2.the expenditures approach (simplified circular flow model (D) money flow approach)

3.the output approach (simplified circular flow model (S) product flow approach).

Incomes Approach (Input/resource approach)

GDP (also known as national income which is indicated by Y) is equal to the inputs used in the production process. The inputs include:

land in the form of rent

labor in the form of wages

capital in the form of interest

entrepreneurship in the form of profit.

Y = rent + wages + interest + profit.

Expenditures Approach (Demand side approach)

GDP (also known as aggregate demand (AD) which is indicated by Y) is equal to the total output demanded in the economy. The outputs include:

consumption

investment

government expenditures

net exports

Y=Consumption(C)+Investment(I)+Government Expenditures(G)+Net Exports(X-M)

Output Approach (Supply side approach)

GDP (also known as national output which is indicated by Y) is equal to the outputs supplied to the economy. The outputs include:

household goods (durable and nondurable goods and services)

investment goods (new housing and capital)

government (durable and nondurable goods and services)

net exports (goods for export minus goods imported)

Y = Household (C) + Firm and HH (I) + (G) + Net Exports (X-M)

The Keynesian Consumption (Spending) Multiplier

The Keynesian Consumption Multiplier is based on the assumption that for each additional dollar a household receives some portion of that dollar will be spent on the consumption of goods and services and some portion will be saved:

To calculate the Multipliers, one must understand the marginal propensity to consume (mpc) and the marginal propensity to save (mps).

For each additional dollar one receives, one will consume with a portion and save a portion.

mpc + mps = 1

mpc + mps cannot equal more than 1 or less than 1, it must equal 1.

MK = 1/mps

Given that 1 is mps + mpc. This is a math identity.

We can restate MK = 1/(mps) to the following:

MK = 1/[(1 - mpc)]

Therefore, given mps or mpc, one can calculate the MK.

Once the MK is calculated, one can determine the effects of policy on the overall economy in that the initial change in one of the GDP variables (C, I, G, or X-IM) will generate a greater change in GDP:

Change in Y = MK [change in C, change in I, change in G, or change in (X-IM)]

The Keynesian Tax Multiplier

The Keynesian Tax Multiplier uses the notion that taxes affect Y through C using the same ideas of mps and mpc.

MT = -[(mpc)/(mps)]

Therefore, given mps or mpc, one can calculate the MT.

Once the MT is calculated, one can determine the effects of policy on the overall economy in that the initial change in taxes will generate a greater change in GDP:

Change in Y = MT (change in T)

Business Cycle

Business cycle is defined as the alternating periods of economic expansion and economic recession.

The business cycle is made up of expansionary (growth, inflationary, upswings, positive) periods in which:

1. The overall price levels are increasing (inflation)

For healthy economic growth, the inflation should be creeping inflation.

2. The unemployment levels are decreasing.

3. The national output (GDP) is increasing.

The growth period will reach its highest point (peak), then the business cycle will enter a downturn.

The business cycle is made up of contractionary (slowdowns, downturn, recessionary, negative) periods in which

1. The overall price levels are decreasing (deflation)

2. The unemployment levels are increasing.

3. The national output (GDP) is decreasing.

The slowdown period will bottom out at its lowest point (trough), then the business cycle will enter an upturn.

Unemployment

Unemployed is defined as:

actively seeking paid work

not currently engaged in paid work

at least age 16

Employment is working full or part time as a paid worker.

Unemployment rate is the percentage of the labor force that is not working, but actively seeking work.

If unemployment is increasing, it is demonstrated as a downturn on the business cycle and a shift inward to the left of the aggregate demand curve. when accompanied by decreasing prices and decreasing GDP. This type of unemployment can be resolved using traditional contractionary fiscal and/or monetary policies.

Labor Force is the sum of the employed and the unemployed workers in the economy.

Discouraged worker is someone who is available for paid labor, but has given up looking for work.

Labor Force Participation Rate is the percentage of the working age population in the labor force.

The Three Main Categories of Unemployment

Frictional Unemployment is short term unemployment arising from the process of matching workers with jobs. This is a household level (microeconomic) unemployment that is considered very temporary.

Structural Unemployment is a persistent mismatch between skill sets and characteristics of workers and the job requirements. This is a household level (microeconomic) unemployment that is considered more permanent requiring retraining, re-skilling, and re-education of the labor unit. However, if this type of obsolescence occurs on a large scale in a specific industry or group of industries, then it may become a regional or national level (macroeconomic) unemployment that requires government funding for education and training programs.

Natural Rate of Unemployment (Full-Employment Unemployment) is the sum of frictional unemployment and structural unemployment. This is due to the natural changes in a dynamic developing and growing economy.

Cyclical unemployment occurs when the macroeconomy enters a recessionary phase on the business cycle due to a decrease in aggregate demand. This type of unemployment indicates the economy is suffering loss in output. According to Keynes, this is when expansionary fiscal and/or monetary policies would benefit an economy by stimulating demand to which supply can respond positively.

Inflation

Inflation is a general increase in the overall price level.

The Three Main Categories of Inflation

Creeping inflation is a low-level, steady increase in overall price level that demonstrates a steady, healthy growing economy. In the US economy, creeping inflation generally is considered any inflation between 0% and 3%. This type of inflation allows for growth in the resource market and the product market at a rate that can be accommodated with increases in demand and supply, as well as slight increases in prices, including wages.

http://useconomy.about.com/od/inflationfaq/tp/Types-of-Inflation.htm

Galloping inflation is a fast-paced inflation at a rate of 10% or greater for the US economy. This type of inflation is disruptive to both consumers and producers since prices are not easily maintained or predicted.

http://useconomy.about.com/od/inflationfaq/tp/Types-of-Inflation.htm

Hyperinflation is a rapid increase in price levels at a rate of 50% or more. This is a very destabilizing type of inflation that may create instability in the economy and the political system. This type of inflation creates a vacuum in the social-political-economic system as seen during the US Civil War, during the 1920s in Germany, in many Latin American countries in the 1980s, and during 2004-2009 in Zimbabwe.

“Hyperinflation is when the prices of most goods and services skyrocket, usually more than 50% a month. It usually starts when a country's Federal government begins printing money to pay for fiscal spending . As the money supply increases, prices creep up as in regular inflation .

However, instead of tightening the money supply to lower inflation, the government keeps printing more money to pay for spending. Once consumers realize what is happening, they expect inflation. This causes them to buy more now to avoid paying a higher price later. This boosts demand , causing inflation to spiral out of control. The only winners in hyperinflation are those who borrowed before the hyperinflation. They find that higher prices makes their debt worth less by comparison, until it is virtually wiped out.”

http://useconomy.about.com/od/inflationfaq/tp/Types-of-Inflation.htm

Hyperinflation may create a political vacuum in which leadership crumbles and new leaders such as Adolf Hitler are able become the champion of stability and a good economy regardless of their other dangerous rhetoric and violence.

Two Causes of Inflation

Demand-Pull Inflation is a general increase in the overall price level due to an increase in aggregate demand.

This type of inflation is demonstrated by an outward shift to the right of the Aggregate Demand curve. In small increments, it demonstrates creeping inflation which indicates a healthy, growing economy. In larger increments, it may demonstrate galloping or hyperinflation which are destabilizing to the economy.

Also, this type of inflation is demonstrated by the expansionary phase on the business cycle.

This type of inflation, if considered creeping inflation, is an indicator of a healthy, growing economy due to the increases in price levels, decreases in unemployment, and the increases in GDP.

If this type of inflation becomes a problem, it can be resolved using traditional contractionary fiscal and/or monetary policies.

Cost-Push Inflation is a general increase in the overall price level due to a decrease in aggregate supply.

This type of inflation is demonstrated by an inward shift to the left of the Aggregate Supply curve due to an increase in price and/or decrease in availability of a significant input (resource) into the production process.

This type of inflation cannot be demonstrated on the business cycle.

This type of inflation is an indicator of an economy experiencing loss and economic challenges that cannot be resolved with traditional fiscal and/or monetary expansionary or contractionary policies due to the increases in price levels, increases in unemployment, and the decreases in GDP.

This type of inflation cannot be resolved using traditional fiscal and monetary policy tools. Cost-Push Inflation can result in stagflation in which the government must step outside the realm of economic policies and use diplomacy, political policies, military actions, and other resolutions.

http://useconomy.about.com/od/inflationfaq/tp/Types-of-Inflation.htm