Chapter 6
GDP and the
Measurement of
Progress
1
Chapter Outline





What is GDP?
Growth Rates
Cyclical and Short-Run Changes in GDP
The Many Ways of Splitting GDP
Problems with GDP as a Measure of
Output and Welfare
2
Introduction
 A Visitor to India will be struck by the dramatic
difference in living standards.
• 75% of the population live on less than $2 a day
(2007).
• Over 100 million Indians live at an American or
European standard living.
 GDP and GDP per capita are measures used
to reflect changes and differences in
standards of living.
 The following figure and table show how GDP
is used to measure growth and differences
between countries.
3
Introduction
India is now growing rapidly
4
Introduction
5
Introduction
 What Will We Learn in This Chapter?
• What the GDP statistic means and how it is
measured.
• The difference between the level of GDP and the
growth rate of GDP.
• The difference between nominal GDP and real
GDP.
• How growth in per capita real GDP is a standard
measure of economic progress.
• The use of GDP in business cycle measurement.
• Problems with GDP as a measure of output and
welfare.
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What is GDP?
 Gross domestic product (GDP) – the
market value of all final goods and
services produced within a country in a
year.
 GDP per capita is GDP divided by a
country’s population.
 Let’s look more closely at the definition of
GDP.
7
GDP is the Market Value
 Two problems:
• How do you add up different goods and
services and get a number that makes
sense?
• Some goods are more important than
others. e.g. producing two houses is more
important than producing two packs of
gum.
• Solution: Multiply the quantities of final goods and
services by their market prices and add up these
values.
8
GDP is the Market Value
 Let’s use an example to illustrate our point
GDP Is Calculated by Multiplying the Price of Final Goods
and Services by Their Quantities and Adding the Market Values
Final Good
Price x Quantity = Market Value
Cars
$28,000 x 12 million
Computers
$1,000 x 20 million = $20 Billion
Total Added
to GDP
= $336 billion
$356 billion
9
Of All Final…
 Of All Final Goods and Services
• Intermediate goods are sold to firms and
then bundled or processed with other
goods or services for sale at a later stage.
• Final goods are the finished goods sold to
final users and then consumed or held in
personal inventories.
• To avoid double-counting, only final goods
are included in GDP.
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…Goods and Services
 Goods are tangible. e.g. cars, food
 Services are intangible. Transportation,
haircuts, medical care.
 Both are included in GDP
 Since 1950 the portion of U.S. GDP
created by the production of services
has doubled from 21% to 42%.
We see this in the next figure.
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…Goods and Services
12
…Produced…
 GDP measures production
 Sale of used goods are not included.
 The sale of financial assets such as
stocks and bonds are not included.
 The services of realtors, stock brokers,
used car salesmen are included
because their services represent current
economic activity.
13
…Within a Country…
 Only production that takes place within the
borders of a country is included in GDP.
• Examples
 Cars produced in Mexico by American firms
are not included.
 Cars produced in the U.S. by Japanese
firms are included.
 GNP (Gross National Product) The value
of goods and services produced by U.S.
residents no matter where they live.
14
…In a Year
 GDP is a flow which means it measures
the rate of production during a given
time period.
 This contrasts to a nations wealth which
is the value of a nations assets at a point
in time and has no time dimension.
15
Check Yourself
 The interstate Bakeries Corporation buys wheat
flour to make into Wonder Bread. Does the
purchase of wheat flour add to GDP?
 On eBay, you sell your collection of Pokémon
cards. Does your sale add to GDP?
 An immigrant from Colombia works as a cook in a
New York restaurant. Is the money he earns
considered part of the GDP of the United States or
Colombia?
16
Growth Rates
 The growth rate of GDP tells us how
rapidly the country’s production is rising or
falling over time.
GDP2005  GDP2004
 100  GDP growth rate for 2005
GDP2004
Example: Using actual data (numbers are in billions)
$12,455  $11,712
100  6.34%
$11,712
17
Check Yourself
 If GDP in 1990 was $5,803 billion and
GDP in 1991 was $5,995 billion, what was
the growth rate of (nominal) GDP?
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Nominal vs. Real GDP
 Nominal variables, such as nominal GDP,
have not been adjusted for changes in
prices.
 Real variables, such as real GDP, have
been adjusted for changes in prices.
 Economists usually are more interested in
real GDP because increases in real GDP
reflect increases in the standard of living.
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Nominal vs. Real GDP
 It is important to distinguish between
nominal and real GDP
• Example: Calculating nominal GDP
1995 GDP in 2005 Dollars  1995 Prices  1995 Quantities  $7.4 trillion
2005 GDP in 2005 Dollars  2005 Prices  2005 Quantities  $12.4 trillion
Growth of nominal GDP1995 -2005
12.4  7.4

 100  67.6%
7 .4
• Problem: The growth of nominal GDP includes price
increases as well as increases in output.
Let’s see how we can fix this.
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Nominal vs. Real GDP
 It is important to distinguish between
nominal and real GDP(cont.)
• Solution: Calculate GDP in each year using
the same year’s prices.
GDP1995 in 2005 Dollars  Prices2005  Quantities 1995  $9.0 trillion
GDP2005 in 2005 Dollars  Prices2005  Quantities 2005  $12.4 trillion
Growth rate of real GDP1995 -2005
12.4  9.0

 100  37.8%
9 .0
21
Nominal vs. Real GDP
 Real GDP Growth
• Most economists would choose real GDP
growth as the best single indicator of
economic performance.
• Media usually report growth in nominal GDP.
• If we want to compare GDP over time, we
should always use real GDP.
 It doesn’t matter which year’s prices we use
to calculate real GDP.
22
Real GDP Growth
23
Real GDP Growth
 What do we learn from the previous slide?
• Normally, real growth is positive.
• Growth in the 50s and 60s was high.
• Rising inflation and oil price shocks resulted in
low growth in the 70s.
• The economy has done better since the 70s.
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The GDP Deflator
 A price index that can be used to measure
inflation:
Nominal GDP
GDP Deflator 
Real GDP
 100
 Data from The U.S. Bureau of Economic
Analysis (http://www.bea.gov/ ):
Year
2011
Nominal GDP
($ trillions)
Real GDP
($ trillions, 2005 prices)
15.1
13.3
$15.1 trillion
GDP Deflator 
 100  113.5
$ 13.3 trillion
25
Real GDP Growth per Capita
real GDP
Per capita real GDP 
Population
greal GDP per capita  greal GDP  gpopulation
Where: g is the growth rate of each variable
 Example:
• Annual growth of per capita real GDP = 4%
• Growth rate of the population growth rate = 2%
• Growth rate of per capita real GDP = 4% – 2% =
2%.
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Real GDP Growth Per Capita
 There can be large differences for
countries with rapidly growing populations.
Country
% annual
growth
real GDP
1993-2003
% annual
growth
population
1993-2003
% annual
growth
per capita
real GDP
Guatemala 3.6%
2.8%
0.8%
United
States
1.2%
2.4%
3.6%
Source: Bureau of Economic Analysis, and the U.S. Census Bureau
Conclusion: Even though the U.S. and Guatemala had
the same growth rate of real GDP, the standard of living
in the U.S. grew much faster.
27
Real GDP Growth Per Capita
 Real Growth per Capita (cont.)
The Extremes:
1. Taiwan had the highest growth rate = 6% per year.
2. Nigeria even though a member of OPEC had close to negative growth.
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Check Yourself
 Name a country with a high GDP but a low
GDP per capita.
 Name a country with a low GDP but a high
GDP per capita.
 Why do we often convert nominal
variables into real variables?
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Cyclical and Short-Run Changes in GDP
 Recession – “…a significant, widespread
decline in economic activity spread across
the economy, lasting for more than a few
months, normally visible [as a decline] in
real GDP, real income, employment,
industrial production, and wholesale-retail
sales.”
• National Bureau of Economic Research
(NBER) – Most authoritative source of
identifying recessions. http://www.nber.org/cycles.html)
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Cyclical and Short-Run Changes in GDP
 How often do recession occur?
• There have been 10 recessions since
1948.
• There have been 3 recession since 1990
 Business fluctuations or business cycles
 Short-run movements in real GDP around
its long-run trend.
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Real GDP Growth Rate (%)
Cyclical and Short-Run Changes in GDP
All Recessions Since 1948
15
10
5
0
-5
-10
Year
Note: Shaded areas indicate recessions.
Source: Bureau of Economic Analysis
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Cyclical and Short-Run Changes in GDP
 Defining when a recession begins and
ends is not always easy.
• Quarterly data is not available until
almost a month after the quarter is
over.
• Data is often revised.
• Updates can even occur years after the
first estimates are released.
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Cyclical and Short-Run Changes in GDP
 Example: Dating the 2001 recession
• Official NBER starting date is March 2001.
• Data revisions have led many analysts to
conclude that the recession began late
2000.
• Who cares?
 Presidency changed at the beginning of 2001.
• Democrats: Recession was a result of the
new administration policies.
• Republicans: Recession began during
President Clinton’s term.
34
Check Yourself
 What are business fluctuations?
 Why is it sometimes difficult to determine if
an economy is in a recession?
35
The Many Ways of Splitting GDP
 Two common ways of splitting GDP:
• National Spending Approach: Add up all the
components of spending.
GDP = C + I + G + NX
• Factor Income Approach: Add up all of the
income generated by producing goods and
services:
GDP = Wages + Rent + Interest + Profit
 Both approaches help us understand the
business cycle.
36
The National Spending Approach
 We begin with Y = C + I + G + NX
Y = Nominal GDP, market value of all final goods
and services
C = The market value of consumption goods and
services
I = The market value of investment goods
G = The market value of government purchases
NX = Net exports (market value of exports minus
market value of imports)
Let’s look at each of the components in turn.
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The National Spending Approach
 Consumption spending (C) – sometimes
referred to as spending by households.
 Investment Spending (I) – Private
spending on tools, plant, and equipment
used to produce future output.
 Government spending (G)
• Includes all levels of government
• Does not include government transfers.
38
The National Spending Approach
 Net exports (NX) – The value of exports
minus the value of imports
• Exports – Market value of goods and services
sold to residents of other countries.
• Imports – Market value of goods and services
purchased by U.S. residents from other
nations.
• The next figure shows the composition of U.S.
GDP for 2007.
39
The National Spending Approach
40
The Factor Income Approach
 The Other Side of the Expenditure Coin
• When money is spent it ends up as someone’s
income.
• Adding up the types of income will result in the
value of total spending, or, GDP.
Y = Wages + Rent + Interest + Profit
• Caveat: Not every dollar that is spent is
income because of such factors as sales
taxes.
 Adjustments must be made to get the two
approaches to “balance”.
41
The Many Ways of Splitting GDP
 Why Split GDP?
• Both ways throw a different light on the
economy.
 The different components of spending behave
differently over time, and it is important to
understand why.
 The factor income approach is useful in
determining the relative size and growth of the
income shares.
• The two approaches provide a check for
errors.
42
Check Yourself
 Which is the largest of the national
spending components: C, I, G, or NX?
 Which is more stable, consumption
spending or investment spending?
 Why does the income approach to GDP
give the same answer (in theory) as the
spending approach? (In practice, the
answers are close but differ because of
accounting errors and data omissions.)
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Problems With GDP as a Measure of
Output
 There are many goods and services for which
we do not know the market value.
• GDP does not count the underground economy
 Illegal activities
 “Off-the-books” activities
• GDP does not count
non-priced production
 Example: Work done in the
home by household
members.
44
GDP Does Not Count the Underground
Economy
 Results in two biases
• Biases over time
 Example: Number of women in the labor forces has
almost doubled since 1950.
• When they were at home unpaid work was not
counted.
• Now much of the same work is paid for and
therefore counted.
• Result: growth in real GDP is exaggerated
• Biases across nations


Example: Nonmarket activity is more prevalent in less
developed countries.
Exaggerate differences in GDP
45
GDP Noes Not Count Non-Priced
Production
 We do not know the market value of many
goods and services
 GDP does not add value of leisure
• In the U.S. the average workweek has fallen.
• The workweek is longer in poor countries
• Implication: GDP differences are exaggerated.
• GDP does not subtract the value of “bads”.
• Pollution
• Depletion of resources
• Crime
46
GDP Does Not Count The Value of
Leisure
47
GDP Does Not Reflect the Distribution
of Income
 Growth in GDP per capita does not mean
that everyone’s income grows at the same
rate.
 Implication: While growth in GDP per
capita is necessary for improvements in
standards of living, it may not be sufficient
for large numbers of the population.
48
Check Yourself
 Why does GDP not account for or try to
measure certain things? What is the
common thread throughout all of the
uncounted variables?
 If two countries have the same GDP per
capita, do they necessarily have the same
level off inequality?
 If GDP does not account for everything,
does that make the GDP statistic useless?
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Take Away
 The concept of GDP was developed to
quantify economic growth and fluctuations.
 When we say the economy is growing, we
mean that real GDP or real GDP per
capita is growing.
 When we say that an economy is booming
or contracting, we mean that growth in real
GDP is above or below its long-run trend.
50
Take Away
 There are two ways to measure GDP
1. National Income Approach
2. Factor Income Approach
 GDP per capita is a rough measure of the
standard of living.
 GDP statistics are imperfect.
1. Many goods are not included.
2. “Bads” are not subtracted
3. Do not tell us anything about the distribution
of income or who benefits from growth.
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End of Chapter 6
Second Edition
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