Module 3

Three Main Macroeconomic Variables:

Gross Domestic Product
 From Micro to Macro
Macroeconomics builds upon microeconomics!

Microeconomics focuses on individuals… Macroeconomics focuses on totals…

 Your individual income.  Total income in the whole country.
 The output your business produces.  Total output produced by all businesses.
 Your spending, or the spending of  Total spending across all people, businesses,
your family, or your company. and the country’s government.

Do NOT think of micro and macro as two distinct halves of economics!

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Key Definition (1 of 4)
Diving into the Definition
Interdependence in the
Circular flow diagram: a simple macroeconomy:
model of the economy that illustrates
how households and businesses are Your household income depends on how
linked. many people businesses hire…
Which depends on how much output they
RECALL the interdependence principle
from the core principle of economics: want to produce…

 Your best choice depends on Which depends on how much households

multiple other factors. want to spend…
 Everything is connected! Which depends on how much households
earn!
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 The Circular Flow (1 of 3)

© Worth Publishers
Green arrows show the
flow of real resources:

 Inputs in the production

process, like the labor
households sell to
businesses.

 Outputs like the goods

and services businesses
sell to households.

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 The Circular Flow

© Worth Publishers
(2 of 3)
Purple arrows show the flow
of money :
 Spending on inputs in the
production process, like the
wages and profits from the
sale of goods and services
(which translates into
households’ income).
 Spending on outputs like
the goods and services
households buy from
businesses.

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 The Circular Flow (3 of 3)

© Worth Publishers
Each flow of real resources is matched by
an equal and opposite flow of money.

The circular flow shows:

1. The market value of total output must
be equal to total spending.
2. Total spending must equal total
income.

 Total output, total spending, and

total income are all equal.

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Key Definition (2 of 4)
Diving into the Definition
Gross domestic product: the market value
of all final goods and services produced The GDP of a country tallies up the value
within a country in a given year. of all the goods and services they produce:
 Key measure of economic activity.  Add up all the cereal, bananas, t-shirts,
pants, movies, education housing,
In 2021, the GDP of the United States was $23 cars…EVERYTHING that was produced
trillion. in a given year.
 We’ll focus on GDP per person (GDP per
Now let’s unpack the formal definition of
capita), $69,200.
GDP piece by piece.
 Divide $23 trillion by the 332.2 million
people living in the United States.
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 Gross Domestic Product (GDP) (1 of 5)

Gross domestic product: the market value of all final goods and services produced
within a country in a given year.

“The market value…”  value each product at its market price.

 You are literally adding apples and oranges (by their common unit)!
 Common unit = the dollar
GDP values each good according to its market price:
 Example: A $1,500 couch is 100 times as valuable as a $15 water bottle.

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 Gross Domestic Product (GDP) (2 of 5)
Gross domestic product: the market value of all final goods and services produced within a
country in a given year.

“…of all…”  include all goods and services.

Includes not just what you purchase for yourself from the market, but also what the
government purchases for you.
 vaccines, public education, road and bridge construction, national defense, etc.

Does NOT include economic activity that occurs outside of markets.

 If you wash your car yourself, your labor is not included in GDP. However, if you take
your car to the car wash, then that service is counted as GDP.

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 Gross Domestic Product (GDP) (3 of 5)

Gross domestic product: the market value of all final goods and services produced within a
country in a given year.

“…final goods and services…”  count only final goods and services, omitting intermediate
goods.
 The price of a final good incorporates all the contributions of the prior stages of production.
 Thus, GDP does NOT count intermediate goods: goods and services that are used as inputs in
the production of other products.
Car example: The new car you buy for $35,000 is considered a final product (you are the final
user!). The $35,000 price includes the value of all the contributions that created that car:
 Intermediate goods: the metal, wires, plastic, glass, the workers who processed and assembled those
pieces, the truck driver who delivered the car to the sales lot, and the salesperson who sold the car to you.

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 Gross Domestic Product (GDP) (4 of 5)
Gross domestic product: the market value of all final goods and services produced
within a country in a given year.

“…produced…”  omit resale of already-purchased goods.

GDP does NOT count resale of existing finished goods.
 Second-hand sales merely change ownership of goods that have already been
produced and were previously counted in GDP.
 Example: If you bought a used car, that purchase would not be counted in GDP.

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 Gross Domestic Product (GDP) (5 of 5)

Gross domestic product: the market value of all final goods and services produced within a country
in a given year.

“…within a country…”  include all goods produced within the United States.
Include everything produced in workplaces in the United States.
 Even if the goods are made by foreign-owned business within the United States, and even if the
goods are sold to people outside the United States.
 Excludes any goods produced in other countries — even if it’s a good produced in an
American-owned factory in another country.
“…in a given year…”  add up the flow of output over a year.
Add up all the activity that’s occurred during a given time period (typically one year).
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 © Worth Publishers
Key take-aways: GDP and the Macroeconomy

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 Three Perspectives on GDP
1. Total Spending 2. Total Output 3. Total Income
Measure GDP by adding Measure GDP by adding Measure GDP by adding
up every dollar of up every dollar’s worth up every dollar of
spending. of output produce. income earned.

Highlights who’s doing Highlights what’s being Highlights where income

the spending, and what made, and by whom. It is going, and who’s
they are buying. helps map the structure enjoying the fruits of all
of production. the economic activity.

These three measurements are all the same in theory, but they get different names because real-
world measurements can differ due to different sources of imperfect data.
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 Perspective 1: GDP Measures Total Spending (1 of 4)

Photo left to right: Alalal/Shutterstock; Vasily Gamayunov/Shutterstock ©Worth Publishers

GDP equals total spending on final goods…

…which embodies the value created at earlier stages.

Final goods

GDP includes new inventories:

 GDP counts goods in the year they’re made, regardless of the year in which they’re sold.

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 Perspective 1: GDP Measures Total Spending (2 of 4)

When you track GDP by spending, you can track who is doing all the spending.
Economics uses the following identity to describe each type of spending:

Y = C + I + G + NX
GDP Consumption Investment Government Net exports
purchases

The spending summarized in this equation collectively defines all the goods and
services produced in the economy.

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 Perspective 1: GDP Measures Total Spending (3 of 4)

Y = C + I + G + NX
GDP Consumption Investment Government Net exports
purchases

Consumption: household spending on final goods and services.

 Clothes, shoes, food, gas, internet bill, haircuts, computers, cars, etc.

Investment: spending on new capital assets that increase the economy’s productive capacity.
 Any long-lasting good used in a business.
 Research and development spending, office furniture, equipment, etc.
 Buying a newly built house counts as an investment (but not if you buy an existing house).

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 Perspective 1: GDP Measures Total Spending (4 of 4)

Y = C + I + G + NX
GDP Consumption Investment Government Net exports
purchases

Government purchases: government purchases of goods and services.

 Spending on schools, highways, military, vaccine research, etc.
 Excludes transfer payments: payments that transfer income from one person to another.
 Social security checks, or unemployment insurance checks.
Net exports: spending on exports minus spending on imports.
 Exports: goods or services produced domestically and purchased by foreign buyers.
 Imports: goods or services produced overseas and purchased by domestic buyers.
 We subtract spending on imports to offset the fact that spending on imports has already been counted in other categories.

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 Perspective 2: GDP Measures Total Output

Photo left to right: Alalal/Shutterstock; Vasily Gamayunov/Shutterstock ©Worth Publishers

The “total output” GDP perspective highlights what what is being made and by whom.

Value added: the amount by which the value of an item is increased at each stage of production.
 Measures your contribution toward producing that item.
 = Total sales − Cost of intermediate inputs

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 Perspective 3: GDP Measures Total Income (1 of 2)
The “total income” GDP perspective tracks whether this income is going to workers as wages or
to business owners as profits.
 GDP is total income, which is the sum of total wages and total profits.

Photo left: Vasily Gamayunov/Shutterstock ©Worth Publishers

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 Perspective 3: GDP Measures Total Income (2 of 2)

Labor’s share of income is declining.

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 © Worth Publishers
Key take-aways: GDP measures

1. GDP is total spending

 This measurement is called “Gross Domestic Product”
 Y = C + I + G + NX
2. GDP is total output
 This measurement is called “Value Added”
 Sum of value added ( = total sales − cost of intermediate inputs)
3. GDP is total income
 This measurement is called “Gross Domestic Income”
 Total wages + Total profits

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 Is GDP an adequate gauge of economic conditions?

“[GDP] 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.”

-Former U.S. Senator Robert F. Kennedy

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 Limitations of GDP (1 of 6)
Recall, GDP is the market value of all goods
Limitations of GDP: and services.

1. Prices are not values.  But our values are not the same as
market prices.
2. Nonmarket activities —
including household GDP counts your spending on a good, but your
production — are excluded. benefit is often much larger if you enjoy
3. The shadow economy is consumer surplus.
missing.
Consider the following:
4. Environmental degradation
isn’t counted.  Internet services like Google and Wikipedia
are sold at a price of zero.
5. Leisure doesn’t count.
 PewDiePie’s book of meme-like wisdom
6. GDP ignores distribution. for $15.99 versus a literary classic for
$7.99.
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Limitations of GDP (2 of 6)
GDP only measures goods and services that
Limitations of GDP: are sold in markets.
1. Prices are not values.  This misses a lot of productive activity!
2. Nonmarket activities —
including household Examples of nonmarket activity:
production — are excluded.  Doing your own laundry.
3. The shadow economy is  Shopping for your own groceries.
missing.
 Cooking your own meals.
4. Environmental degradation
isn’t counted.  Raising and taking care of your own child
(or pet!).
5. Leisure doesn’t count.
6. GDP ignores distribution. If you had hired out these jobs in the market,
then that would have been counted in GDP!
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Limitations of GDP (3 of 6) The shadow economy refers to the economic
Limitations of GDP: activity purposefully conducted out of view of
the government, and, thus, excluded from
1. Prices are not values.
GDP.
2. Nonmarket activities —
including household  Examples: Illegal products (drugs),
production — are excluded. gambling, businesses operating without
licenses, use of cash of avoid paying taxes.
3. The shadow economy is
missing. How much larger would GDP be if it counted
4. Environmental degradation the shadow economy?
isn’t counted.
5. Leisure doesn’t count.
6. GDP ignores distribution.

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Limitations of GDP (4 of 6)
GDP treats natural resources as if they have no
Limitations of GDP: value until they’re transformed into something
1. Prices are not values. else.
2. Nonmarket activities — GDP ignores the costs of environmental
including household degradation.
production — are excluded.
Examples:
3. The shadow economy is
missing.  If you clear-cut a forest to make new
lumber, GDP only focuses on the new
4. Environmental degradation lumber produced.
isn’t counted.
 GDP focuses on the new cars produced by
5. Leisure doesn’t count. the automobile industry, and ignores the
6. GDP ignores distribution. pollution emitted by the production and
consumption of that good.

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Limitations of GDP (5 of 6)
GDP counts the benefit of work but omits the
Limitations of GDP: cost of work  less leisure!
1. Prices are not values.  Working extra hours means less time to
spend with friends or family, relax, watch a
2. Nonmarket activities — movie, or take a leisurely walk.
including household
production — are excluded. United States versus France: Work-leisure
3. The shadow economy is trade-off
missing. The United States has a 40-hour workweek,
4. Environmental degradation whereas France has a 35-hour workweek
isn’t counted. plus substantial paid vacation time, sick
leave, and paid parental leave.
5. Leisure doesn’t count.
 Typical French employee works 300–400
6. GDP ignores distribution. fewer hours in a year (10 fewer weeks!).
 French GDP per person is 28% lower than
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Limitations of GDP (6 of 6)
GDP measures the size of the economic pie,
Limitations of GDP: and GDP per person measures the size of the
average slice.
1. Prices are not values.
 But people care about their actual slice!
2. Nonmarket activities —
including household  GDP does not address the distribution
production — are excluded. of income.
3. The shadow economy is
missing.
4. Environmental degradation
isn’t counted.
5. Leisure doesn’t count.
6. GDP ignores distribution.

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31
GDP as an indicator of national well-being

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 © Worth Publishers
Key take-aways:
What GDP captures and what it misses
Limitations of GDP:
1. Prices are not values.
2. Nonmarket activities — including household production — are
excluded.
3. The shadow economy is missing.
4. Environmental degradation isn’t counted.
5. Leisure doesn’t count.
6. GDP ignores distribution.

…but GDP does measure the resources that a society has available to
pursue what matters in life.

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Key Definition (3 of 4) Diving into the Definition

Example: Last year, your local grocery

Nominal GDP: GDP measured in store sold milk for $3.40 per gallon. This
today’s prices. year, that same gallon of milk is priced at
$4.20.
Useful for…
 Last year’s nominal GDP will use $3.40
 Analyzing what GDP is right now, per gallon.
based on the prices you face right  This year’s nominal GDP will use $4.20
now. per gallon.
Not useful for… Even if the grocery store sells the same
quantity of milk, nominal GDP this year
 Comparisons of GDP over time.
will be greater than last year’s because
the price of milk rose.
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Key Definition (4 of 4)
Diving into the Definition
Distinguishing between price changes
Real GDP: GDP measured in constant and quantity changes is important:
prices.
 excludes the effects of price changes.  Increases in the quantity of stuff we
produced reflect a rise in the
It’s called real GDP because it measures standard of living.
the real change in production. Real GDP measurements allow us to
 focuses on changes in the quantity isolate growth in production that has
produced. taken place.

Useful for… Let’s work through some calculations to

fully understand nominal versus real
 Comparisons of GDP over time. GDP!
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 You Try! Calculating nominal and real GDP (2 of 2)

Quantity sold Actual price Nominal GDP Average price Real GDP
𝑃𝑃𝑡𝑡 + 𝑃𝑃𝑡𝑡−1
Q P =P×Q P= =P×Q
2

Last 80 shoes $30 $30 x 80 $33 $33 x 80

Year = $2,400 = $2,640

This 90 shoes $36 $36 x 90 $33 $33 x 90

Year = $3,240 = $2,970

Growth +12.5% +20% +35% +0% +12.5%

rate
Reflects both an increase in Reflects only the increase
price and quantity of shoes. in the production of shoes.
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 Helpful trick for quickly jumping between real and nominal GDP

For changes over short periods of time (i.e., just a few years):
% Change in nominal GDP ≈ % Change in real GDP + % Change in prices
or you can rearrange a bit differently to get…
% Change in real GDP ≈ % Change in nominal GDP − % Change in prices

Revisiting previous example:

12.5% ≈ 35% − 20%
As you can see, 12.5% is not too far off from the exact result of 15%.

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 Concept Check: Nominal and Real GDP

Last semester, you provided 50 hours of tutoring and charged $15 per hour.
This semester, you provided 55 hours of tutoring and charged $18 per hour.
Calculate the following:
a. the growth rate of your contribution to nominal GDP.
b. the growth rate of your contribution to real GDP.

a. Growth rate of nominal GDP b. Growth rate of real GDP

Last semester: $15 x 50 = $750 Average price: $16.50

This semester: $18 x 55 = $990 Last semester: $16.5 x 50 = $825
Nominal growth rate: 32% This semester: $16.5 x 55 = $907.5
Real growth rate: 10%
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 © Worth Publishers
Key take-aways: Real and Nominal GDP

Nominal GDP: adds up the market value of total production in a year using
the current prices prevailing in that year.

Real GDP: excludes the effects of price changes, so it isolates economic

growth that’s due to changes in the quantity of output produced.

Quick approximation trick:

% Change in real GDP ≈ % Change in nominal GDP − % Change in prices

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New Line/Everett Collection © Worth Publishers

Holding the world ransom…

for one million dollars

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 Strategy 1: Evaluate what it means per person

Reduce the number into more human terms  what does this number mean per person?
Helpful baseline numbers when applying strategy one:
• The world population is nearly 8 billion.
• The U.S. population is about 330 million.
• There are around 100 million households in the United States.

The U.S. government spent $201 million on the The U.S. government spent $767 billion on Medicare
National Endowment for the Arts in fiscal year 2022. in fiscal year 2022.
Per household = $201 million/100 million = $2.01 Per household = $767 billion/100 million = $7,670
Per person = $201 million/330 million = $0.61 Per person = $767 billion/330 million = $2,324

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 Strategy 2: Compare big numbers Strategy 3: Compare big numbers
to the size of the economy. to their own history.

Scale big numbers by comparing them to Evaluate the size of a number relative to
the size of the total economy. its previous values.
Example: Example:
The U.S. Department of Education spent 6 million Americans were unemployed in
$260.45 billion in fiscal year 2021. 2021.
 The federal government spent $6.8 In January of 2010, there were
trillion total in fiscal year 2021. approximately 15 million Americans
 Roughly 3.8% of total federal unemployed.
spending went to K-12 public  View “6 million” in a broader context!
education.

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 Strategy 4: Use the Rule of 70 to evaluate long-run growth rates

Rule of 70: Divide 70 by the annual growth rate to approximately get the number of years
until the original amount doubles.
70
Years it takes something to double ≈
Annual growth rate

Example: Between 1971 and 2021, real GDP

per person in the United States grew at an
average rate of 1.75% per year.
 It would take ≈ 70/1.75 = 40 years for the
average income to double.
 Be careful: This rule becomes inaccurate
for large growth rates.
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