Gross Domestic Product (GDP)
and Business Fluctuations
MSc EPS
Hilary term 2013 (S2)
Professor Dermot McAleese
OUTLINE
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Definition of GDP
Real vs. nominal GDP
GDP vs. GNP
GDP estimation
Shadow vs Official Economy
PPP vs. current exchange rate
Potential GDP and the output gap
Business Fluctuations
2
GROSS DOMESTIC PRODUCT (GDP)
GDP refers to the output of goods and services
produced in an economy during a specific period of
time.
The importance of GDP statistic




Business forecasts
Monetary and fiscal policy
Political significance
International comparisons
3
Real vs. Nominal GDP
Nominal GDP is the current value of output (goods and
services) produced in an economy.
Real GDP measures volume of output.
 computed by valuing the quantities of goods and services
produced in 2 periods with the same set of prices.
P1 x X 1 + P1 y Y 1
(5, 10) (8, 12)
€146
Year 2:
P2x X2 + P2y Y2
(6, 11) (9, 14) €192 (+31%)
To compute real GDP:
(1) Calculate value of Year 2 quantities at Year 1 prices
P1x X2 + P1y Y2 = 5 x 11 + 8 x 14 = 55+112= 167
(2) Express this as % of base year GDP. Real GDP increased by 14%.
Year 1:
4
GDP vs GNP (GNI)
GDP is output produced by
productive factors located in the
country, regardless of their owners’
nationality.
GNP refers to output produced by
productive factors owned by
permanent residents (‘citizens’) of a
country.
For most countries the difference is very small
5
(GDP – GNP)/GNP for 181 countries
40%
20%
0%
-20%
-40%
-60%
-80%
-100%
6
Countries with GDP > GNP -- Top 16
Congo, Rep.
Liberia
Chad
Ireland
St. Kitts and Nevis
Suriname
Azerbaijan
29.4
25.7
23.1
18.2
15.6
15.4
14.6
Angola
Nigeria
Yemen, Rep.
Belize
Gabon
Lao PDR
Kazakhstan
Chile
Dominica
14.2
14.1
12.5
11.2
10.8
10.4
10.4
10.1
9.1
GDP-GNP (% of GDP)
7
WDI 2007 World Bank CDRom
Countries with GNP > GDP -- Top 16
% gap
Timor-Leste
36.8
Marshall Islands
19.8
Lesotho
18.3
Moldova
11.0
Kuwait
9.9
West Bank and Gaza
9.0
Djibouti
8.7
Philippines
7.8
Switzerland
7.7
Bangladesh
4.9
Bosnia and Herzegovina
4.5
Micronesia, Fed. Sts.
4.4
Mauritania
3.4
Jordan
2.9
Palau
2.8
Japan
2.3
Memo:
China
US
0.5%
0.3%
World Bank Indicators 2007
(GNP-GDP)/GDP 8* 100
HOW TO COMPUTE GDP
Production
 Value added
=
Gross
Domestic
Product
___________
Income
Disposal income
of households
+
Non distributed
profits
+
Net direct taxes
= National
Income
______
Net Indirect
Taxes
____________
Depreciation
Expenditure
Private
consumption
+
Gross
Investment
(incl. 
inventories)
+
Public
Consumption
+
Exports Imports
(including
income flows)
9
GDP = C + I + G + X - M
C = private sector consumption
I = investment (capital formation)
G = government current spending
X = exports of goods and services
M = imports of goods and services
10
Composition of EU GDP
Source: European Economy 2011
11
12
GDP by sector
Agriculture
Fishing
Industry Services
Euro Area
2.2
26.6
71.1
China
(2010)
10
47
44
France
2.5
21.3
76.3
4
Poland
5.1
31.0
64.0
18
Germany
1.1
29.1
69.8
2
(incl Cons)
% of
workforce
in agric
4
40
Source: WTO Trade Policy Review “European Communities” 22 Jan 2012
13
Real US after-tax income
(% increase 1979-2007)
Average income increase 1979-2007
62%
Median income increase 1979-2007
35%
Martin Wolf “Romney would be a backward step” FT Wed Oct 31st 2012
14
CBO = Congressional Budget
Congressional
Budget
Office, Washington
DC
Office,
Washington
DC
15
Real US after-tax income
By percentile, % increase, 1979-2007
300
Average income increase 62%
250
200
150
100
50
0
Top 1%
81-99
61-80
41-60
21-40
Source: Congressional Budget office Report November 2011
0-20
16
17
18
CBO Report Oct 2011
Ref to OECD study 2008
19
Purchasing Power Parity (PPP)
1. Nominal exchange rate in 2008 was 6.9 Yuan = US$1 . Hence $1000 = 6,900 yuan.
2. Buy a representative basket of goods and services in Washington DC.
A representative basket might, for example, contain
2 kilos of rice
1 kilo beef
5 inner city bus rides
one month’s rent of a two-bed apartment
1 personal computer
2 visits to doctor
etc.
(the list could run into hundreds of items)
3. Suppose this representative basket costs $1,000 to buy in Washington. Now buy exactly the same
basket in China. Suppose it costs 3,800 yuan.
Purchasing Power Parity (PPP) rate of exchange = 3,800 yuan divided by $1000
PPP exchange rate: 3.8 yuan = $1
4. GDP per head in China (2008) = 22,640 Yuan = $3,260 at nominal exchange rate. [6.9 yuan per dollar].
China’s GDP per head of 22,640 yuan per head = $5,962 at PPP (3.8 yuan per dollar].
20
Comparison between GDP per capita at current exchange rates
and at PPP
Country
GDP per capita ($)
(current prices and exchange rates)
India
GDP per capita ($)
(PPP)
736
3452
Morocco
1711
4555
Argentina
4728
14,280
Mexico
7454
10,751
China
1713
6757
UK
36,509
33,238
France
34,936
30,386
Canada
34,484
33,375
US
41,890
41,890
Source: UN HDR Report 2007-2008
21
 GDP calculated from nominal exchange rates
underestimates the living standards of
developing countries
This happens because non traded goods
(services) are much cheaper in developing
countries
 Divergences in prices of traded goods are much
less because of the law of one price
 The gap between GDP measured at current
exchange rate and GDP measured at PPP can be
substantial
22
Review Questions
In HDR 2011 table, most countries’ GDP per capita is
higher in PPP than in current exchange rates.
For some countries GDP at current exchange rates is
higher than in PPP terms.
What is the reason for this difference?
23
Shares of world production -- PPP vs
current exchange rates (%)
PPP weight US$ weight
China
13.2
4.1
Japan
6.9
11.4
US
21.0
28.7
EU
21.4
32.7
Source: Bank of America 2006
24
Source: The Economist Feb 27, 2010
25
Source: The Economist Feb 27,262010
‘The Gross National Product 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 wisdom nor
our learning neither our compassion nor our
devotion to our country; it measures
everything, in short, except that which makes
life worthwhile.’
Robert F. Kennedy (1968) quoted in Finance and Development,
December 1993, p. 20
27
The basic purpose of development is to
enlarge people’s choices. People often value
achievements that do not show up at all, or
not immediately, in income or growth figures:
greater access to knowledge, better nutrition
and health services, more secure livelihoods,
security against crime and physical violence,
satisfying leisure hours, political and cultural
freedoms and sense of participation in
community activities. The objective of
development is to create an enabling
environment for people to enjoy long, healthy
and creative lives.
Mahbub ul Haq, Founder of the Human Development Report.
28
Classwork
pp 273-274
• E1, E2, E3
• Q1 (p 273)
29
Which of the following transactions should be included as
part of GDP?
(a) A consumer pays €10 for a meal at the restaurant
(b) A company buys a plant from another firm for €1 million.
(c) A supplier sells computer chips to another firm that makes personal
computers.
(d) A person buys a second-hand car from a dealer for
€5,000.
(e) A person buys a new car for €15,000.
(f) A factory exports €2m worth of PCs and sells €5m on the domestic market.
It imports €2m component parts for the PCs.
(g) Chinese residents abroad send €5m to their relatives in China; China gives
€5m aid to UN; Chinese temporary workers earn €5m in foreign countries
30
2. A person saves €10,000 of this year's income and
spends it on new machinery. Explain how this
would be recorded in the national accounts.
Another person takes €10,000 from a deposit
account and buys shares on the stock market.
Would this be recorded in GDP?
31
Ex 3 p 274
Consider an economy with only three goods. Their market
prices are P1 = 5, P2 = 10 and P3 = 15. The production (and
consumption) of each good during 2002 was Q1 = 20, Q2 = 25
and Q3 = 10.
(a) What is the value of nominal GDP?
(b) Assume that in 2003 prices rise to P1 = 6, P2 = 12 and P3 =
17, and quantities produced (and consumed) go to Q1 = 21, Q2
= 27 and Q3 = 11. Calculate the value of nominal GDP.
Compute real GDP, using 2002 prices as the base year. What
is the real rate of growth of the economy?
What is the rate of inflation?
(c) Calculate the change in real GDP using 2003 prices as the
base year. Explain why your answer is different to that in (b).
32
Shadow vs Official Economy (DMcA p.150)
TOTAL
ECONOMIC
ACTIVITY
FORMAL
ECONOMY
Nonmarketed
economic
activity
SHADOW
ECONOMY
Marketed
economic
activity
Marketed
economic
activity
TOTAL MARKET
ECONOMY
Nonmarketed
economic
activity
33
Estimates of size of shadow economy
March 2002 study shows from sample of 85
countries
• 35-44% average range in developing
countries (Nigeria and Egypt 77 and 69%,
Thailand 70%, while only 14% in HK and
Singapore, 19% in Chile)
• 21-30% in transition countries Georgia 64%,
Russia 44%
• 14-16% in developed countries (US 10%)
Source: F Schneider and D. Enste “Hiding in the Shadows: the Growth of the Underground Economy” IMF
Economic Issues 30, Washington DC 2002
34
Size of the shadow economy (% GDP)
Country
1990
2002
2008
2010
Austria
5
11
8.1
8.7
Belgium
20
22
17.5
17.9
Canada
14
16
12.0
12.7
Denmark
11
18
13.9
14.4
Germany
12
16
14.2
14.7
Greece
27
28
24.3
25.2
France
9
15
11.1
11.7
Ireland
12
16
12.2
13.2
Italy
23
27
21.4
22.2
Netherlands
14
13
9.6
10.3
Norway
15
19
14.7
15.4
Spain
21
23
18.7
19.8
Sweden
16
19
14.9
15.6
7
9
7.9
8.3
10
12
10.1
11.1
7
9
7.0
7.8
Switzerland
UK
USA
Source: DMcA Economics for Business; F Schneider “The
influence of the economic crisis on the underground economy”
University of Linz, Austria Jan 2010
35
36
POTENTIAL GDP and the OUTPUT GAP
Potential GDP is the maximum output that an
economy can produce if capital, labour and other
factors of production are fully utilised, consistent
over the medium term with price stability.
The Output Gap =
[(actual GDP - potential GDP)/ potential GDP] x 100
37
POTENTIAL VS. ACTUAL GDP
Actual GDP > Potential GDP  price stability in jeopardy, indicators point to
inflation
Actual GDP < Potential GDP  resources being wasted, unemployment,
indicators point to recession
Actual > Potential
Real GDP
Actual < Potential
Actual
Potential
38
time
Source: Goldman Sachs “The long good buy” 21 March 2012
39
Output gaps for 2012 and 2013
0
-2
2012
2013
-4
-6
-8
-10
-12
Notes: Output gap = [(actual GDP - potential GDP)/ potential GDP]
Source: OECD, Economic Outlook, May 2012
40
ESTIMATION OF POTENTIAL GDP
 Trend extrapolation
 Production function approach
Growth in potential
output
Growth in
government
sector
Growth in the
business sector
Growth in
employment
Growth in
capital
stock
Growth in
TFP
Advances in
technology
Enterprise-friendly
economic policies
41
OECD June 2012
42
Class exercise: define headings and interpret statistics in this table
Source: OECD Nov43
2011
Class exercise: define headings and interpret statistics in this table
OECD June 2012
44
Business Fluctuations (ch 16)
 What are business fluctuations?
 Why do they matter?
 What causes them?
 What can be done about them? --- next sessions –
MONETARY AND FISCAL POLICY
45
What are business fluctuations?
Business fluctuations are fluctuations in aggregate
economic activity that are widely diffused throughout
the economy and have identifiable “peaks” and
“troughs”
FLUCTUATIONS  CYCLES
46
THE BUSINESS CYCLE WILL NOT DISAPPEAR
….
The inevitability of the business cycle, as it used to be called, I
take for granted. Good times bring into existence: first,
incompetent business executives; second, wrongful
government policies; and, third, speculators. Working
together, they ensure the eventual bust.
J K Galbraith “Challenges of the New Millennium” Finance and
Development
December 1999 p 5
47
2011
2010
2008
2006
2004
2002
2000
1998
1996
1994
1992
1990
1988
1986
1984
1982
1980
1978
1976
1974
1972
1970
1968
1966
1964
United States: GDP growth (% p.a.)
Average growth
rate 2.93%
8
6
4
2
0
-2
-4
-6
48
Source: The Economist Jan 2009
49
JAPAN Real GDP growth 1961-2011 (% p.a.)
15
10
Average 4.47% pa
5
0
-5
-10
50
UNITED KINGDOM Real GDP Growth 1964-2010
10
Av growth 2.3% p.a.
8
6
4
2
0
-2
-4
-6
2011
1.8
2012
0.9
51
GERMANY: Real GDP annual % growth
Average 3.2% p.a.
52
China 1977-2010 (real GDP growth % p.a.)
16.00
14.00
12.00
10.00
Trend line
8.00
6.00
4.00
2.00
2007
2005
2003
2001
1999
1997
1995
1993
1991
1989
1987
1985
1983
1981
1979
1977
0.00
53
Facts About Fluctuations
 Negative growth infrequent
 Irregular periodicity
 No evidence of systematic long run cycles
 Sustained period of growth followed by relative or absolute downturn
 Industrial countries stay 3 times longer in the expansion phase of the cycle
than in recession
 Strong synchronisation (contagion) effects – few cycles “made at home”
 Expanding role of emerging countries (now account for 2/3rds of world
economy growth)
54
Two Strong Forces at work in macro economy 2009-12
a)
Downward Force due to adverse deflation dynamic – multiplier effect
b)
Upward Force due to:
Automatic Stabilisers
Demand stimulation policies (countercyclical)
55
56
Why Do Business Fluctuations Matter?
 Long term economic growth is higher when
stability is greater. Volatility not independent of
trend. Fluctuations affect trend growth rate
negatively.
 Most people prefer stability to an unstable,
boom-and-bust growth path.
57
What can be done to achieve long term growth
and to moderate macroeconomic
fluctuations?
58