Chapter 6 (Chapter 26)
GDP and the
Measurement of
Progress
MODERN PRINCIPLES OF ECONOMICS
Third Edition
Outline
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What Is GDP?
Growth Rates
Nominal vs. Real GDP
Cyclical and Short-Run Changes in GDP
The Many Ways of Splitting GDP
Problems with GDP as a Measure of
Output and Welfare
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Introduction
 India has both extreme poverty and rapid
economic growth:
• Two-thirds of India’s population lives on less
than $2 a day.
• At the same time, at least 100 million people
are at an American standard of living.
 a remarkable increase from just a few decades
ago.
 Gross Domestic Product (GDP) and GDP per
capita gives us a way to measure changes in
economic output and the standard of living.
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Introduction
Real GDP per capita in India
4
Definition
Gross Domestic Product (GDP):
the market value of all final goods and
services produced within a country in a year.
GDP per capita:
GDP divided by population.
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Introduction
 In this chapter, we will explain:
• 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
6
Introduction
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GDP
 GDP is the market value of all final goods
and services produced within a country in a
year.
 An economy’s total output includes millions of
different goods and services.
 Some goods are more valuable than others, so
we can’t just add up quantities.
 GDP uses market values to determine how
much each good or service is worth and then
sums the total.
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GDP
 Final goods and services are sold to final users
and then consumed or held in personal
inventories.
 Intermediate goods are sold to firms and then
bundled or processed with other goods or
services for sale at a later stage.
 To avoid double counting, only final goods are
included in GDP.
 However, machinery and equipment used to
produce other goods are included in GDP.
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GDP
 GDP measures production, so sales of old
houses, used goods, and financial assets do
not add to GDP.
 Sales of used goods: NOT included
 Sale of financial assets: NOT included
 Services of stockbrokers, realtors, used car
salesmen ARE included
 Products produced by not sold in same year are
included as “inventory”
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Self-Check
Which of the following is a final good:
a. A book in Amazon’s inventory.
b. Tires purchased by a Toyota plant.
c. Tires purchased by you for your car.
Answer: c – tires purchased by you are a final
good because they are for your own use
(consumption), not for resale.
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GDP
 The output of an
economy includes both
goods and services.
 Haircuts, transportation,
and medical care
provide a benefit to
individuals without a
Services are increasing as a
share of U.S. GDP.
tangible output.
 Since 1950, the portion of U.S. GDP created by
services has doubled from 21% to 42%.
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GDP
 U.S. GDP includes goods and services
produced by labor and capital located in the
United States, regardless of the nationality of
the workers or property owners.
 Gross national product (GNP) is similar to
GDP but measures what is produced by the
labor and property supplied by U.S. permanent
residents.
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Definition
Gross National Produce (GNP):
the market value of all final goods and
services produced by a country’s permanent
residents, wherever located, within a year.
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GDP
 GDP tells us how much the nation produced in
a year, not how much it has accumulated in its
entire history.
 GDP is like annual income, not wealth
 National wealth refers to the value of a nation’s
entire stock of assets.
 GDP is calculated by the Bureau of Economic
Analysis (BEA), which is part of the Department
of Commerce and based in Washington, D.C.
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US GDP vs Rest of World (ROW)
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GDP Growth = Job Growth
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Growth Rates
 GDP tells us how much a country produced.
 The growth rate of GDP tells us how rapidly the
country’s production is rising or falling.
GDP2013  GDP2012
 100  GDP growth rate for 2013
GDP2012
 Using actual numbers (in billions):
$16,798  $16,245
 100  3.4%
$16,245
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Self-Check
If GDP in 1990 was $5,803 billion and GDP in
1991 was $5,995 billion, what was the growth
rate of GDP?
a. 1.92%
b. 3.20%
c. 3.31%
Answer: c – The growth rate was
[(5995 – 5803) / 5803] x 100 = 3.31%
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Nominal vs. Real GDP
 Nominal Growth Rate is the rate of growth just
calculated did not adjust for price changes and is
called the “nominal growth rate.”
 Nominal GDP is calculated using prices at the
time of sale.
• GDP in 2013 is calculated using 2013 prices.
• GDP in 2000 is calculated using 2000 prices.
 If there is an increase in nominal GDP, we can’t
tell if it was due to greater production or
increased prices.
 It is increases in production, not increases in
prices, that improve the standard of living.
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Definition
Nominal variables:
variables such as GDP that have not
been adjusted for changes in price.
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Nominal vs. Real GDP
 To remove the effect of price changes, we can
calculate GDP in constant prices.
2013 GDP in 2013 dollars:
2013 prices × 2013 quantities = $16.8 trillion
2000 GDP in 2013 dollars:
2013 prices × 2000 quantities = $13.8 trillion
 We can now find the increase in real GDP.
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Definition
Real variables:
variables such as GDP that have been
adjusted for changes in prices by using
the same set of prices in all time
periods.
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Nominal vs. Real GDP
2013 nominal GDP
2013 prices × 2013 quantities
$16.8 trillion
2000 nominal GDP
2000 prices × 2000 quantities
$10.3 trillion
Increase in nominal GDP = (16.8 − 10.3) / 10.3 × 100 = 63%
2013 real GDP
2013 prices × 2013 quantities
$16.8 trillion
2000 real GDP
2013 prices × 2000 quantities =
$13.8 trillion
Increase in real GDP = (16.8 − 13.8) / 13.8 × 100 = 21.7%
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Real GDP Growth per Capita
Growth Rate in Nominal GDP =
• Inflation Rate (change in price level) +
Growth Rate in Real GDP
• Real GDP growth = (Nominal GDP growth
rate) – (Inflation rate)
 where the growth rate in nominal GDP is the
growth rate in spending (C + I + G + NX)
So if Nominal GDP growth is 5%, it could be:
1% inflation + 4% growth in Real GDP or
2% inflation + 3% growth in Real GDP or
5% inflation + 0% growth in Real GDP
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Real GDP Growth per Capita
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Self-Check
Real GDP is:
a. Adjusted for changes in the price level.
b. Not adjusted for changes in the price level.
c. Adjusted for price increases but not
decreases.
Answer: a – Real GDP is adjusted for changes in
the price level.
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GDP Deflator
 The GDP Deflator is a price index that can be
used to measure inflation.
 It is the ratio of nominal to real GDP:
Nominal GDP
GDP Deflator 
 100
Real GDP
 If 2013 nominal GDP = $16.79 trillion and 2013
real GDP = $15.76 trillion,
16.79 trillion
GDP Deflator 
 100  106.5
15.76 trillion
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Real GDP Growth
The Growth Rate of Real GDP in the U.S.
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Real GDP Growth per Capita
 Growth in real GDP does not account for
changes in population.
 Growth in real GDP per capita is usually the
best reflection of changing living standards.
 There can be large differences for countries with
rapidly growing populations.
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Real GDP Growth per Capita
% annual
growth
real GDP
1993-2003
% annual
growth
population
1993-2003
% annual
growth
real GDP
per capita
Guatemala
3.6%
2.8%
0.8%
United States
3.6%
1.2%
2.1%
Country
Source: Bureau of Economic Analysis, and the U.S. Census Bureau
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.
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Real GDP Growth per Capita
Fifty Years of Economic Growth
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Cyclical and Short-run Changes
 GDP is used to compare economic output across
countries and over long periods.
 GDP is also used to measure short-run
fluctuations in an economy.
 According to the National Bureau of Economic
Research (NBER), a recession is
“a significant decline in economic activity spread across
the economy, lasting more than a few months, normally
visible in real GDP, real income, employment, industrial
production, and wholesale–retail sales.”
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Definition
Recession:
a significant, widespread decline in real
GDP and employment.
(Unofficially – two quarter of negative
real GDP growth)
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Cyclical and Short-run Changes
U.S. Recessions Since 1948
Quarterly Growth Rates Expressed as Annualized Rates
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Cyclical and Short-run Changes
Defining when a recession begins and ends is not
always easy.
 Quarterly data are not available until almost a
month after the quarter is over.
 The government often makes significant
changes in the GDP estimates between the
initial and final estimates.
 Updates can even occur years after the first
estimates are released.
 It is normal for real GDP to fluctuate around its
long-term trend or “normal” growth rate
(business fluctuations or cycles).
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Cyclical and Short-run Changes
Why is dating recessions so import?
• 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?
 U.S. 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.
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Definition
Business cycles:
short-run movements in real GDP
around its long-term trend.
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Self-Check
A widespread decline in real GDP and
employment is called:
a. Inflation.
b. Recession.
c. A business cycle.
Answer: b – a decline in real GDP and
employment is called a recession.
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Splitting GDP
 Economists split the production of goods and
services in many different ways.
 Two common ways are:
1. National spending approach – add up the
components of spending:
Y = C + I + G + NX
2. Factor income approach – add up the income
generated by producing goods and services:
Y = Wages + Rent + Interest + Profit
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National Spending Approach
Y = C + I + G + NX
Y
Nominal GDP
The market value of all final goods and
services.
C
Consumption
Private spending on final goods and services.
I
Investment
G
Government
purchases
Spending by all levels of government on final
goods and services. Transfers are not included
in government purchases.
Net exports
The value of exports minus the value of
imports.
NX
Private spending on tools, plant, and
equipment used to produce future output.
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National Spending Approach
U.S. GDP and Its Components, 2013
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Factor Income Approach
Y = Employee Compensation + Rent + Interest + Profit
 When a consumer spends money, the money is
received by workers, landlords, owners of
capital, and businesses.
 We can therefore calculate GDP by adding up all
of the incomes received.
 When using the factor income approach, we
need to make adjustments for things like sales
taxes.
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Factor Income Approach
 Employee Compensation: Salaries, wages, and fringe
benefits such as health or retirement. This also includes
unemployment insurance and government taxes for Social
Security.
 Rent: Income received from property received by households.
Royalties from patents, copyrights and assets as well
as imputed rent are included.
 Interest: Income received by households through the lending
of their money to corporations and business firms.
Government and household interest payments are not
included in the national income.
 Profits: The amount firms have left after paying their rent,
interest on debt, and employee compensation. GDP
calculation involves accounting profit and not economic profit.
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Which Approach is the Right One?
The answer depends on what you want
to study.
• Want to understand business fluctuations?
It’s worthwhile to study the national
spending approach.
• Want to study how the income from
production is divided amongst people and
resources? It’s worthwhile to focus on the
factor income approach.
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Self-Check
Which of the following splits GDP according to
the national spending approach?
a. C + I + G + NX.
b. Revenues - expenses.
c. Employee compensation + rent + interest +
profit.
Answer: a – C + I + G + NX.
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The BIG Question
 Consider the following two claims. The first would be a
typical statement at the magazine The Nation:
“Europeans have strong labor unions, so their workers
get a bigger share of the pie than American workers.”
The second would be a typical statement at the
magazine National Review: “Since European
businesses are highly regulated, they have little
incentive to make big profits. Therefore, they get a
much smaller share of national product than American
workers.” Which statement is more correct/do you
agree with more?
a) The first
b) The second
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Problems With GDP
 Illegal or underground-market transactions are
omitted from GDP.
 Underground transactions are especially
significant in countries with higher levels of
corruption and taxes.
 The informal sector in Latin America is estimated
at 41% of officially measured GDP.
 In the U.S. or Western Europe, the underground
economy is likely 10% - 20% of GDP.
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Problems With GDP
 GDP does not count non priced production, when
valuable goods and services are produced but
no monetary payment is made.
• Housework, reading free blogs, volunteering
 This introduces two biases into GDP statistics:
biases over time and biases across nations.
• As more women in the U.S. entered the workforce,
housework shifted from unpaid to paid.
• Women’s participation in the workforce varies across
countries, changing the proportion of work included in
GDP.
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Avg Hours Worked by Country
Tyler Cowen and Alex Tabarrok
Modern Principles: Macroeconomics, Third Edition / Modern Principles of Economics, Third Edition
Copyright © 2015 by Worth Publishers
Problems With GDP
 GDP does not count leisure, although people
value it.
 GDP does not count economic “bads” such as
pollution, crime, or the extinction of species.
• Cleaning up pollution ADDS to GDP
 GDP does not measure the distribution of
income.
• Endless arguments can ensue
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GDP & Income Distribution
Tyler Cowen and Alex Tabarrok
Modern Principles: Macroeconomics, Third Edition / Modern Principles of Economics, Third Edition
Copyright © 2015 by Worth Publishers
Takeaway
 GDP is an estimate of the economic output of a
nation over a year.
 GDP can be summed up in different ways.
 The national spending identity, Y = C + I + G +
NX, splits GDP according to different classes of
income spending.
 The factor income approach, Y = Employee
compensation + Interest + Rent + Profit, splits
GDP into different classes of income receiving.
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Takeaway
 GDP per capita is a rough estimate of the
standard of living in a nation.
 Real GDP is corrected for inflation by using the
same set of prices in every year.
 GDP does not include:
• The value of leisure
• Goods in the underground economy
• The value of goods that are difficult to price.
• How equally income is distributed.
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