Chapter 4: Monitoring the Value of Production

Apples and Oranges: The Challenge of Macroeconomics

- Microecon: zoomed in
- Can consider just the market for apples
- Easy
- Macroecon: zoomed out
- We want to measure the total production in a country in a year
- Single market for apples and oranges and smartphones and cars…
- How to combine all of those things into one number?
- Need a method of accounting that combines apples and oranges.
- This is trickier.

Gross Domestic Product

- GDP: Market value of the final goods and services produced within a
country in a given time period.
- GDP is the most common way of measuring how productive a country is…
- …and therefore how wealthy it is.

Gross Domestic Product: Prices of Definition

- What does GDP really represent?
- Let’s break the definition into pieces.
- 1. Market values = the prices at which items are traded in markets
- If we want to know the value of minivans and apples produced…
- ….we could just add up the number of minivans and apples.
- Is this a good idea?
- Better approach:
- Calculate the total dollar value of apples:
- (PA X QA)
- Calculate the total dollar of minivans:
- (PA X QA)
- Add those dollar values together
o Total market value of apples and minivans

1000 apples
 QA= 1000

Price of an apple = $2

PA = 2

10 minivans

QM = 10

Price of a minivan = $10,000

PM = 10000

Dollar value of apples = PA * QA = 10,000 * 2 = 20,000

Gross Domestic Product: Pieces of the Definition

- 2. Final good = an item that is bought by its final user during a specified
time period
- This contrasts with…
- Intermediate good = an item that is produced by one firm, bought by
another firm, and is used as a component of a final good or service
- Only the value of final goods count toward GDP.
o Let’s use a story to see why

Gross Domestic Product: WE ONLY COUNT THE FINAL GOODS

- Bob the Lumberjack sells a log to Lumber Co. for $1.
- Lumber Co turns log into a sheet of plywood
- Christine buys sheet of plywood for $10.
- She uses it to make a cornhole board which she sells for $100.
- Cornhole board: Final good
o Counts towards GDP
- Log & plywood: intermediate goods
o Don’t count toward GDP.

Gross Domestic Product: Pieces of the Definition

- 3. Produced within a country (“domestic”)
- Goods produced withing the US count toward GDP of the US
- Goods produced within Mexico count toward GDP of Mexico
- 4. Produced in a given time period
- Goods are being produced everyday
- To measure GDP, we need to pick a time period and measure the goods
produced only during that time period.
- Usually either quarter-year (“quarterly GDP” Q1, Q2….)
- ….or a year (“annual GDP”)

The Circular Flow of Expenditure and Income

- We can represent payments in an economy as a flow.
- Imagine each arrow is a tube carrying water in the direction shown.

- Each tube carries payment from the payer to the seller.

Expenditure
- Payments that go through goods markets toward firms are
“expenditures.”
- These are shown in red.
- There are 4 key types of expenditures:
o Consumption expenditure
o Investment
o Government expenditure
o Net Exports

Types of Expenditure: Consumption Expenditure

- Payments from households to firms are consumption expenditure.
o Note: You are a household!
- Denoted as C
 o Largest component of GDP

Types of Expenditure: Investment

- Payments from firms to firms are investment.
- Denoted as I.
- Example: UPS buys a new delivery van.

- Capital can break or go bad.

- Depreciation is the decrease in the value of a firm’s capital that results
from wear and tear and obsolescence.
- Because of depreciation, there are 2 different ways to measure
investment.
- Gross investment is the total amount spent on both new capital and
replacement capital.
- Net investment is the increase in value of capital.
- Analogy: How much water did I “invest” into my swimming pool?
- Net investment =

Gross investment

 Depreciation
- Gross investment is what counts toward Gross Domestic Product.

Types of Expenditure: Government Expenditure

- Payments from governments to firms are government expenditure.
- Denoted as G

- Includes purchases that government makes

o Roads, tanks, buildings
- Careful! G doesn’t include taxes.

Types of Expenditure: Net Exports

- Payments from the rest of the world to US firms are net exports.
- Exports (X) are the things we sell to the rest of the world.
- Imports (M) are the things we buy from the rest of the world.
Expenditure
- Net exports = X – M
- Export more than we import

 Net exports are positive

o Payments are flowing into the US overall

- Export less than we import
 Net exports are negative
o Payments are flowing out of the US overall.

Income
- Payment flows from firms through factor markets to households are
income.
- Denoted Y
- Most income is wages.
- Other income: interest, profits, rent

GDP = AGGREGATE EXPENDITURE = AGGREGATE INCOME

- Our goal: measure the value of everything produced.
o Two ways to do this:
1. Add up all the payments for the final goods
 “Expenditure approach”
 2. Add up all the income that households get from producing those
goods
 “Income approach”
- Aggregate expenditure = C + I + G + X – M
- Aggregate income = Y
- GDP = Y = C + I + G + X – M

Mathematical Note
- We just learned that Y = C + I + G + X – M
- If we know C I G X AND M, then we can calculate Y.
- If we know Y and we know all of the other variables but one,
- …then we can rearrange this equation to solve for the missing variable.
- One example: Y – I – G – X + M = C

Nominal GDP and Real GDP

- So far, we have learned how to calculate GDP for one single year.
- What if we want to compare GDP from one year with GDP from another
year?
- We might have a problem!
- Nominal GDP is the value of final goods and services produced in a given
year when valued at the prices of that year.
- Just a more precise name for GDP
- Let’s compare nominal GDP for two years with different prices.
- This is probably not the best way to compare nominal GDP for two years
with different prices.
- Real GDP is the value of final goods and services produced in a given
year when valued at the prices of a reference base year.
- To find it, “pretend” that prices never changed from the base year.

Real GDP and Changes Over Time

- Real GDP does a pretty good job of tracking changes in total production of
an entire country over time.
- What if we want to track standard living of the average resident over
time?
- Real GDP per person = Real GDP/population
- Illustrates how much better off your generation are than your
grandparents’ generation, on average
- Potential GDP: The highest level of GDP that is sustainable in the long
run, given the factors of production that are available.
- Potential GDP increases pretty steadily over time.
- Real GDP stays pretty close to potential GDP, but real GDP bounces
around from year to year.
- This bouncing of real GDP is referred to as “fluctuations.”

- Fluctuations follow a common pattern: the business cycle

- 1. Expansion: Real GDP increases
- 2. Peak: Real GDP hits a temporary high point
- 3. Recession: Real GDP decreases
- Trough: Real GDP reaches a temporary low point
- Then we start over again with expansion
- Expansions are usually bigger and longer than recessions, so real GDP
grows over time.
- Business cycle repeats itself, but the timing is irregular—not predictable.
- We don’t know when a trough or peak has happened until after it has
passed.
Real GDP and Comparisons Across Countries
- We’ve seen that nominal GDP is bad at measuring changes in standard of
living over time. Real GDP fixed this.
- But real GDP still has a problem
- It’s bad at comparing differences in standards of living across different
countries.
- Real GDP for the US: easiest to measure in dollars.
- Real GDP in China: easiest to measure in yuan.
- To compare the two, we must do a conversion
- China’s real GDP per person ≈ 95,000 yuan
- We want to convert that to dollars, so we can compare to U.S
- Today’s market exchange rate: 1 dollar costs 7.1 yuan
- The average Chinese citizen could turn those 95,000 yuan into 13,000
dollars
- So China’s real GDP per person is about 13,000 dollars.
- 13,000 is the average number of dollars that a Chinese person could
purchase with a year’s worth of income.
- 86,000 is the average number of dollars that a US person earns in a year.
- We want to compare standard of living between China and US.
- “US real GDP per person is over 6 times higher than China’s.”
- This is a very misleading statistic.
- Real GDP did a bad job of comparing standard of living across countries.
- Dollars are pieces of paper.
- Standard of living depends on the stuff you are able to purchase, not
pieces of paper!
- This depends on both money income and prices.
- Prices of most things are lower in China than in US.
- Example: Big Mac
- US price = $5.66
- China price = 22.40 yuan
o Only $3.12
- Real GDP measured at purchasing power parity (PPP) prices corrects for
the difference in prices across countries.
- To measure China’s real GDP per person at PPP prices…
- …we see how much stuff the average Chinese resident can buy from a
year’s income,
- …then see how much that stuff is worth based on US prices instead of
Chinese prices.
- China’s real GDP per person is about $13,000.
- Chian’s real GDP per person is about $30,000.
- Much better way to compare standards of living in China versus the US.
- PPP approach uses the same prices to calculate the value of each
country’s products.

Limitations of Real GDP

- Real GDP counts the payments that flow through the economy.
- But some valuable stuff never gets sold at all…
- And other stuff gets sold without the government noticing it.
- If that stuff isn’t getting counted, then real GDP is understating how rich
we are!
- Household Production: Productive activities that are never traded on the
market.
- Not counted in GDP.
- Household production doesn’t count toward GDP.
- Result: GDP underestimates total production.
- Recent US trend:

Fewer homemakers, more paycheck-earners

- Result: Growth rate of GDP overestimates the growth rate of total

production.
- Underground economic activity: Goods and services that are paid for but
that aren’t observed by the government.
- “Cash under the table”
- Why do people do this?
o Avoid taxes
o Avoid getting caught
- Leisure: Activities that people do for fun, rather than to produce
something
- Leisure is great!
- But it doesn’t count toward real GDP.
- A country where people vacation a lot will probably have lower GDP.
- But they’re probably pretty happy, too!
- Environmental quality (clean air, clean water, etc.) is valuable.
- But it doesn’t factor into real GDP.
- “Smogland” and “Cleanland” both produce the same amount of stuff…
- …then they will have the same real GDP,
- …even though Cleanland is a way better place to live.
- Totally, new goods are being invented all the time.
- Real GDP is calculated from base year prices.
- If the base year is 1980…
- …how do we look up the base year price of a smartphone?
- We can’t!
- Big limitation of using real GDP to compare standards of living over time.
- Smart people have suggested alternative measures of economic well-
being
o Human Development Index
o Green Net National Product
o Happiness Index
- Despite its limitations, GDP is the most used-statistic in macroeconomics.