Econ 311
Intermediate Macroeconomics
Professor Eschker
Fall 2014
Today’s Topics
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Finish math refresher
GDP
Deflator
Chain Weighting
News
CBO Projection: Budget Deficits in Future Years to be Smaller than Previous
Forecast
The Congressional Budget Office (CBO) released new budget projections
today An Update to the Budget and Economic Outlook: 2014 to 2024. The
projected budget deficits have been reduced for most of the next ten years,
although the projected deficit for 2014 has been revised up slightly (by $14
billion). NOTE: In the previous update, the CBO revised down their projection
of the deficit for fiscal 2014 from 3.7% to just under 2.9% of GDP.
The federal budget deficit for fiscal year 2014 will amount to $506 billion, CBO
estimates, roughly $170 billion lower than the shortfall recorded in 2013. At 2.9
percent of gross domestic product (GDP), this year's deficit will be much smaller
than those of recent years (which reached almost 10 percent of GDP in 2009) and
slightly below the average of federal deficits over the past 40 years.
CBO's current economic projections differ in some respects from the ones issued
in February 2014. The agency has significantly lowered its projection of growth in
real GDP for 2014, reflecting surprising economic weakness in the first half of the
year. However, the level of real GDP over most of the coming decade is projected
to be only modestly lower than estimated in February. In addition, CBO now
anticipates lower interest rates throughout the projection period and a lower
unemployment rate for the next six years.
http://www.calculatedriskblog.com/#dKL1Bdb3cGlkJF7I.99
National income accounting
Method of aggregating the production of diverse
goods into a single measure of overall economic
activity.
Gross domestic product (GDP)
The value of the final goods and services produced
in an economy over a year.
• The most looked at statistic in regards to
overall economic health of a country
• 2014 II GDP is $17,295 billion
– $54,640 per capita
• www.bea.gov
• http://research.stlouisfed.org/fred2/
3 Equivalent ways to measure GDP
• Production measure of GDP
– The value of goods produced in the economy.
• Expenditure measure
– The total purchases in the economy.
• Income measure
– All the income earned in the economy.
Expenditures
• The national income accounting identity states:
• Where
Y = GDP (in dollars)
C = consumption
I = investment
G = government purchases
NX = net exports = exports – imports
Housing in NIPA
• Just like any “investment”
– Long lived, so not intermediate good
– Depreciates
• New Residential is part of Investment
– But other consumer durables not included
• Flow of housing service is part of Consumption
– Includes imputed owner occupied rent
– Estimated from periodic surveys (imprecise)
• Income from sales of new housing/rent/owner occupied rent is
Income
• Sale of “used” house is NOT in GDP (except realtor commission,
inspection fees, etc.)
Income
• The income approach
– Measures the sum of all income earned in the
economy.
• Capital
– Inputs into production other than labor that are
not used up in the production process.
– Firms increase capital through investment.
• Depreciation
– The deterioration of the capital stock due to wear
and tear.
GDP – depreciation = net domestic product
• When calculating income, we need to
distinguish between “profits” and “economic
profits”
• Profits
– Normal competitive return on inputs.
• Economic profits
– Above-normal returns associated with prices that
exceed those that prevail under perfect
competition.
– In perfect competition, economics profits are zero
• Total shares of GDP to inputs:
Share of GDP to Labor: two-thirds
Share of GDP to Capital: one-third.
– Labor’s share of GDP has remained
approximately constant over time.
5 types of income
by percent of all income
•
•
•
•
•
Wages (71%)
Corporate Profits (12%)
Proprietor’s Income (10%)
Net Interest (5%)
Rent (1%)
Value Added
• There is no “double counting” in GDP; only the
final sale of goods and services count.
• Value added
– The amount each producer contributes to GDP.
– The revenue generated by each producer minus
the value of intermediate products.
• Only new production of goods and services
counts toward GDP.
Exercise:
– A farmer grows a bushel of wheat
and sells it to a miller for $1.00.
– The miller turns the wheat into flour
and sells it to a baker for $3.00.
– The baker uses the flour to make a loaf of
bread and sells it to an engineer for $6.00.
– The engineer eats the bread.
Compute & compare
value added at each stage of production
and GDP
Note: Final Sales are GDP minus changes in inventory
Size of Pie versus
How Pie is Sliced
Economics
• Efficiency refers to how large is the pie
• Equity refers to how the pie is sliced
Two arithmetic tricks for
working with percentage changes
1. For any variables X and Y,
percentage change in (X  Y )
 percentage change in X
+ percentage change in Y
EX:
If your hourly wage rises 5%
and you work 7% more hours,
then your wage income rises
approximately 12%.
2. percentage change in (X/Y )
 percentage change in X
 percentage change in Y
Over Time
Nominal GDP
– A measure of GDP at today’s prices.
– “current dollars”
Real GDP
– GDP adjusted for inflation
– If actual goods and services produced don’t
change, then no change in Real GDP
– “benchmarked dollars” or “constant dollars”
GDP Deflator
(implicit price deflator)
One price level is the GDP deflator, defined as
nominal GDP
GDPdeflator 
real GDP
• The inflation rate is the percentage increase in the
overall level of prices.
• The inflation rate over one year is the growth rate of
the Price Index:
Price Index t 1 - Price Index t
inflation rate 
Price Index t
where t is the year and t+1 the following year
The inflation rate is the percentage change in
the price level.
Or we could also use the following math trick:
_
Practice problem
Nom.
GDP
Real
GDP
2006
$46,200
$46,200
2007
51,400
50,000
2008
58,300
52,000
GDP
deflator
Inflation
rate
n.a.
• Compute the GDP deflator in each year.
• Use GDP deflator to compute the inflation
rate from 2006 to 2007, and from 2007 to
2008.
Answers to practice problem
Nominal
GDP
Real
GDP
GDP
deflator
Inflation
rate
2006
$46,200
$46,200
1.000
n.a.
2007
51,400
50,000
1.028
2.8%
2008
58,300
52,000
1.121
9.1%
Calculating Real GDP
1. A Laspeyres index
– uses initial prices.
2. A Paasche index
– uses final year prices.
• Over long-time intervals the two indexes can
result in substantial differences.
Laspeyres Indexc =
p
initial
i
q
c
i
i
Paasche Indexc =
where
i is the good
p is the price
q is the quantity
c is the current year
p
i
i
final
q
c
i
Practice problem
2006
2007
P
Q
P
Q
$30
900
$31
1,000
DVD
$100
players
192
$102
200
DVDs
• Compute nominal GDP in each year.
• Compute real GDP using Laspeyres and Paasche Indexes.
• Compute growth rate of real GDP using Laspeyres and
Paasche Indexes.
Answers to practice problem
nominal GDP multiply Ps & Qs from same year
2006: $46,200 = $30  900 + $100  192
2007: $51,400 = $31  1000 + $102  200
Growth rate = (51,400-46200)/46200 = .1126 = 11.26%
real GDP (Laspeyres) multiply each year’s Qs by 2006 Ps
2006: $46,200 = $30  900 + $100  192
2007: $50,000 = $30  1000 + $100  200
Growth rate = (50,000-46200)/46200 = .0823 = 8.23%
real GDP (Paasche) multiply each year’s Qs by 2007 Ps
2006: $47,484 = $31  900 + $102  192
2007: $51,400 = $31  1000 + $102  200
Growth rate = (51,400-47,484)/47484 = .0825 = 8.25%
The Fisher index (chain weighting) is the preferred
approach to calculating real GDP.
Geometric Average of the Laspeyres and Paasche index.
– Geometric average 
X *Y
– NOTE: Book shows arithmetic average instead!
X Y
– Arithmetic average 
2
– Preferred because new goods are invented while
others become obsolete —making early or recent
prices inaccurate.
– Can be applied on a year-by-year basis if we
compute real GDP each year.
• Chain weighting allows us to compare changes
in real GDP over time by gradually updating
prices.
• We “link the chain” of comparisons.
Chain Weighted
real GDP (Laspeyres) Growth rate = 8.23%
real GDP (Paasche) Growth rate =8.25%
Geometric Average growth rate = (8.23*8.25)^1/2 = 8.24%
What is real chain weighted GDP in each year benchmarked
to 2007?
Real GDP 2007 = Nominal GDP 2007 = $51,400 (always!)
Real GDP 2006: What would real GDP have to be in 2006 so
that it grows 8.24% and becomes? 51,400?
Real GDP 2006 * (1.0824) = 51,400 or GDP = $47,487
• Main reason for using chain-weighted data:
– Prices of computers rapidly changing in 1990s.
• Main disadvantage:
– The sum of real C, I, G, NX will not equal real
chain-weighted GDP because the prices used in
constructing the components are different.
• General rule to follow:
– For particular components of GDP, we look at the
ratio of nominal variables.
– When you want real rates of economic growth,
use the chain-weighted real measures.
• In Class Problem