Introduction
Microeconomics is the study of individual markets and the decision-making of
individual firms and households that meet in those markets.
Macroeconomics is the study of the economy as a whole. This chapter and the
remainder of this text deal with macroeconomics.
The Economy’s Income and Expenditure
Looking at the aggregate income that everyone in the economy is earning allows
us to judge whether or not the economy is doing well or not. GDP allows us to do
that.
In a nation’s macroeconomy, income must equal expenditure.
● Income of the seller = the expenditure of the buyer
○ E.g. Karen pays Doug $100 to mow her lawn. Doug earns $100 as a
seller of a service; Karen spends $100 as a buyer of the service.
●Gross domestic product (GDP) is a measure of the flow of money (total
income or total output) in the economy.
● Because income equals expenditure, GDP can be measured by adding up the
income earned in the economy (wages, rent, and profit) or the expenditure on
goods and services produced in the economy.
● Income = expenditure = GDP.
The Measurement of Gross Domestic Product
GDP is defined as “the market value of all final goods and services produced
within a country in a given period of time.” This measures the production of the
goods and services.
●“Market value” – production is valued at the price paid for the output. Hence,
items sold at higher prices are more heavily weighted in GDP.
●“Of all” – GDP attempts to measure all production in the economy that is
legally sold in markets.
○ E.g. GDP excludes the production and sale of illegal drugs and
household production, such as when homeowners clean their own
houses.
○ However, in an attempt to be comprehensive, GDP does include the
estimated rental value of owner-occupied housing as an expenditure
on housing services.
●“Final” – GDP includes only goods and services that are sold to the end user.
○ E.g. GDP counts the sale of a Ford automobile when it is sold at retail,
but it excludes Ford’s purchases of intermediate goods such as glass,
steel, and tires used up during the production of the car.
○Intermediate goods are goods that are produced by one firm to be
further processed by another firm.
○ Counting only final goods and services avoids double counting
intermediate production.
●“Goods and services” – while GDP clearly includes tangible manufactured
items such as cars and trucks, it also includes intangible items such as
lawyers’ and doctors’ services.
●“Produced” – we exclude the sale of used items that were produced (and
counted) in a previous period. Again, this avoids double counting.
●“Within a country” – GDP measures the value of production within the
geographic borders of a country.
●“In a given period” – we measure GDP per year or per quarter.
GDP data are statistically “seasonally adjusted” to eliminate the systematic
variations in the data that are caused by seasonal events such as Christmas and
crop harvests.
Our definition of GDP focuses on expenditures. The government also adds up
income to arrive at gross domestic income (GDI). The slight difference between
the two calculations is called the statistical discrepancy.
Other measures of income besides GDP (largest to smallest)
1. Gross national product (GNP): GNP measures the income or production of a
nation’s permanent residents or “nationals” (both people and their factories) no
matter where they are located.
2. Net national product (NNP): NNP is the total income of a nation’s residents
(GNP) minus depreciation.
a. Depreciation is the value of the wear and tear on the economy’s
capital stock.
3. National income: National income is the total income earned by a nation’s
residents.
a. It differs from NNP because of the statistical discrepancy from data
collection.
4. Personal income: Personal income is the income of households and
noncorporate businesses.
a. Excludes retained earnings (corporate income not paid out as
dividends) and subtracts indirect business taxes, corporate income
taxes, and contributions for social insurance.
b. Includes interest income households receive from government debt
and government transfer payments (welfare and Social Security).
5. Disposable personal income: This is the income of households and non
incorporated businesses after they pay their obligations to the government
(taxes, traffic tickets).
The Components of GDP
GDP can be measured by adding up the value of the expenditures on final goods
and services. Economists divide expenditures into four components: consumption
(C), investment (I), government purchases (G), and net exports (NX).
Four Components of Expenditures
1. Consumption (68%) is spending by households on goods and services,
except for new housing.
2. Investment (18%) is spending on business capital, residential capital, and
inventories.
a. Investment does not include spending on stocks, bonds, and mutual
funds.
3. Government purchases (18%) is spending on goods and services by all
levels of government (federal, state, and local).
a. Government purchases do not include transfer payments such as
government payments for Social Security benefits, welfare, and
unemployment benefits because the government does not receive any
product or service in return.
4. Net exports (–4%) is the value of foreign purchases of U.S. domestic
production (exports) minus U.S. domestic purchases of foreign production
(imports).
a. Imports must be subtracted because consumption, investment, and
government purchases include expenditures on all goods, foreign and
domestic, and the foreign component must be removed so that only
spending on domestic production remains.
GDP Equation
Denoting GDP as Y, we can say that Y = C + I + G + NX. The variables are defined
in such a way that this equation is an identity.
Real versus Nominal GDP
Nominal GDP is the value of output measured in current prices, the prices that
existed during the year in which the output was produced.
Real GDP is the value of output measured in constant prices, the prices that
prevailed in some arbitrary (but fixed) base year.
Difference
If we observe that nominal GDP has risen from one year to the next, we are unable
to determine whether the quantity of goods and services has risen or whether the
prices of goods and services have risen.
However, if we observe that real GDP has risen, we are certain that the quantity of
goods and services has risen because the output from each year is valued in terms
of the same base-year prices. Thus, real GDP is the better measure of
production in the economy.
GDP Deflator Equation
The GDP deflator = (nominal GDP/real GDP) × 100
The GDP deflator is a price index that measures the level of prices in the current
year relative to the level of prices in the base year. The percentage change in the
GDP deflator is a measure of the rate of inflation.
In the United States, real GDP has grown, on average, at about 3 percent per year
since 1970. Occasional periods of decline in real GDP are known as recessions.
Is GDP a Good Measure of Economic Well-Being?
Pros of GDP
Real GDP is a strong indicator of the economic well-being of a society.
Countries with a large real GDP per person tend to have:
● better educational systems
● better health care systems
● more literate citizens
● better housing
● a better diet
● a longer life expectancy, and so on.
Cons of GDP
However, GDP is not a perfect measure of material well-being because it
excludes:
● Leisure
● the quality of the environment
● and goods and services produced at home and not sold in markets such as
child rearing, housework, and volunteer work.
In addition, GDP says nothing about the distribution of income. GDP also fails to
capture the underground economy. Regardless, international data clearly shows a
close relationship between a nation's GDP per person and the standard of living of
its citizens.
Lecture Notes
Components of GDP
Who buys the goods and services?
1. Consumers – consumer spending on goods and services is consumption (c)
2. Businesses – business spending on goods and services is investment (I).
a. Investment = purchase of capital goods (e.g. machinery)
b. Does NOT refer to purchases of stocks and bonds; these are savings
3. Government – the government pays private sector firms to provide many
goods and services, including highways
a. Salaries paid to public employees are part of GDP
b. Money paid to individuals that is NOT for services rendered (i.e. social
security payments, unemployment benefits, etc.) are transfer
payments and are not part of GDP (recall: Income = expenditure =
GDP.)
4. Foreign sector – consumers and businesses in other countries buy American
goods and services; these are exports (X)
a. Not all goods and services purchased by American consumers and
businesses are manufactured in the US.
b. Goods purchased from abroad are called imports (M) and need to be
subtracted from GDP
c. Net exports = Exports – Imports
i. Positive if exports > imports
ii. Negative if exports < imports
GDP is the sum of all components of persons or businesses that buy goods and
services.
GDP = C + I + G + (X – M)
GDP Example
Real vs. Nominal GDP
Observations
● The fact that I spent more gas in 2014 is misleading
● I spent more because the price of gas was higher in 2014 than 2017
Problem comparing GDP year to year
● 2008: US GDP was $14.72 trillion
● 2010: US GDP was $14.96 trillion
Questions to consider
Which year did the US produce the most goods and services? Was GDP higher in 2010
because we produced more, because prices were higher, or both?
The US GDP numbers are nominal figures; we can’t compare them. In order to compare them,
they need to be converted to real GDP by holding prices constant.
Definitions
Nominal GDP measures the volume of goods and services produced at current prices.
● Prices and quantities change yearly
● We cannot compare nominal GDP figures from one year to the next to determine which
year is more productive
○ We use Real GDP to do this
Real GDP measures the volume of goods and services produced at constant prices.
● What would the GDP be if the prices never changed?
● Allows us to compare GDP from one year to the next
Example using Nominal GDP
● Using nominal GDP makes it seem like we produced more in year 2 than in year 1
● In reality, prices were higher and quantity produced was lower in year 2
● Nominal GDP increased due to inflation
Example using Real GDP
● Note that the real GDP in the base year = nominal GDP
● Real GDP measures current output at the base year’s prices
● In the base year, current prices ARE base year’s prices
● To sum: GDP focuses on production, not prices.
GDP Deflator
● Nominal GDP measures output at current prices
● Real GDP measures output at constant prices
● We calculate Real GDP because it allows us to compare the nation’s productivity from
year to year
What if our goal was to measure changes in prices?
Taking the ratio of nominal and real GDP
● Ratio > 1: Current prices are higher than base year prices
● Ratio < 1: Current prices are lower than base year prices
● Ratio = 1: Current prices are the same as base year prices
Calculating GDP Deflator
● Used to measure the average change in prices for the goods and services that
comprise GDP
○ Ratio > 100: Current prices are higher than base year prices
○ Ratio < 100: Current prices are lower than base year prices
○ Ratio = 100: Current prices are the same as base year prices
Steps in calculating GDP deflator
1. Calculate nominal GDP for Year X
a. Current year prices * Quantity
2. Calculate real GDP for Year X
a. Base year prices * Quantity
3. Calculate the GDP deflator
a. Nominal GDP/Real GDP * 100
How to interpret a GDP Deflator
Suppose GDP Deflator = 200 (versus 100)
1. Prices are 100% higher than they were in the base year
2. Prices are 200% of what they were in the base year
3. Prices are 2.00 times higher than they were in the base year
Suppose GDP Deflator = 125 (versus 100)
1. Prices are 25% higher than they were in the base year
2. Prices are 125% of what they were in the base year
3. Prices are 1.25 times higher than they were in the base year
Compare prices between non-base years
Calculating Real GDP using GDP Deflator
Calculating the Inflation Rate using GDP Deflator
Inflation Rate =
[ (GDP Deflator of Year 2 – GDP Deflator of Year 1) / GDP Deflator of Year 1 ] * 100
GDP and Economic Well Being
Measurements in GDP
GDP – the single best measure of the economic well-being of society
● Economy’s total income; economy’s total expenditure
● Larger GDP = good life, better healthcare, better educational systems
However, GDP leaves out many important factors contributing to well-being:
●Leisure – time spent out of work
○ more work, higher production of goods and services
○ Are we better off? Not necessarily.
●Home production – GDP only includes things produced in the marketplace; it excludes
the value of almost all activity that takes place outside of the market
○ E.g. childcare by parents, cooking at home (cooking at the restaurant as your job
is what is included in GDP)
●Quality of the environment – GDP may rise if firms are able to produce more goods
and services without considering the pollution (air and water) they create in doing so
●Distribution of income –
○ If GDP is $5 million and we have 100 people, the GDP per person is $50,000.
○ But if 10 people earn $500,000, the other 90 people suffer with no income.
○ GDP per person tells us that happens to the average person, but behind the
average lies a large variety of personal experiences.
GDP and Quality of Life
● Rich countries (Higher GDP per person) – higher life expectancy, literacy rates, and
internet uses
● Poor countries (Lower GDP per person) – lower life expectancy, literacy rates, and
internet usage
Main conclusion: GDP is a good measure of economic well-being for most, but not all
purposes.
