AGENDA

DEFINE GDP
DISCUSS COMPONENTS
REAL VS NOMINAL VARIABLES
MEASURING THE COST OF LIVING
GDP DEFLATOR
CONSUMER PRICE INDEX

Gross Domestic Product (GDP) Is

the market value of all final goods &
services produced within a country
in a given period of time.
Goods are valued at their market prices, so:

All goods measured in the same units

(e.g., dollars in the U.S.)

Things that dont have a market value are

excluded, e.g., housework you do for yourself.

the market value of all final goods &

services produced within a country
in a given period of time.
Final goods: intended for the end user
Intermediate goods: used as components
or ingredients in the production of other goods
GDP only includes final goods they already
embody the value of the intermediate goods
used in their production.

the market value of all final goods &

services produced within a country
in a given period of time.
GDP includes tangible goods
(like DVDs, mountain bikes, beer)
and intangible services
(dry cleaning, concerts, cell phone service).

the market value of all final goods &

services produced within a country
in a given period of time.
GDP includes currently produced goods,
not goods produced in the past.

the market value of all final goods &

services produced within a country
in a given period of time.
GDP measures the value of production that occurs
within a countrys borders, whether done by its own
citizens or by foreigners located there.

the market value of all final goods &

services produced within a country
in a given period of time.
Usually a year or a quarter (3 months)

Production = Expenditure = Income

You can take the economys pulse
(measure its GDP) when products
flow to final users, when revenue
flows to firms, or when income
flows to the firms workers,
owners and lenders.

Gross Domestic Product:

Expenditure and Income
Two approaches:
Total expenditure on domestically-produced
final goods and services.
Total income earned by domestically-located
factors of production.
Expenditure
Expenditure equals
equals income
income because
because
every
every dollar
dollar spent
spent by
by aa buyer
buyer
becomes
becomes income
income to
to the
the seller.
seller.

Expenditure Approach
Four components:
Consumption (C)
Investment (I)
Government Purchases (G)
Net Exports (NX)

These components add up to GDP

(denoted Y):
Y
Y =
= C
C +
+ II +
+ G
G +
+
NX
NX

Consumption (C)
definition: The value of all
goods and services bought
by households. Includes:

durable goods
last a long time
e.g., cars, home
appliances
nondurable goods
last a short time
e.g., food, gas
services
work done for
consumers
e.g., dry cleaning,
air travel

Consumption of Housing Services

A consumers spending on a new house counts under investment,
not consumption.
A tenants spending on rent counts under services - rent is
considered spending on housing services.
So what happens if a renter buys the house she had been renting?
Conceptually, consumption should remain unchanged: just
because she is no longer paying rent, she is still consuming the
same housing services as before.
In national accounting, (the services category of) consumption
includes the imputed rental value of owner-occupied housing.

U.S. consumption, 2013

$ billions
Consumption

$11,484

% of GDP
68.5%

Durables

1,249

7.5

Nondurables

2,602

15.5

Services

7,633

45.5

Investment (I)
Spending on goods bought for future use
(i.e., capital goods)
Includes:
Business fixed investment
Spending on plant and equipment
Note:
does
Residential
Note: Investment
Investment
does not
not
fixed investment
mean
the
purchase
of
Spending
consumers
landlords on
meanby
the
purchaseand
of financial
financial
housing
unitslike
assets
assets
like stocks
stocks and
and bonds.
bonds.
Inventory investment
The change in the value of all firms
inventories

U.S. Investment, 2013

$ billions
Investment
Business fixed
Residential
Inventory

$2,648

% of GDP
15.8%

2,054

12.2

520

3.1

74

0.4

Investment vs. Capital

Note: Investment is spending on new
capital.
Example (assumes no depreciation):
1/1/2013:
economy has $500b worth of capital
during 2013:
investment = $60b
1/1/2014:
economy will have $560b worth of capital

Stocks vs.
Flows

Flow

Stock

A stock is a
quantity measured
at a point in time.

E.g.,
The U.S. capital stock
was $26 trillion on
January 1, 2010.

A flow is a quantity measured per unit of

time.
E.g., U.S. investment was $2.5 trillion
during 2010.

Stocks vs. Flows - examples

stock

flow

a persons wealth

a persons
annual saving

# of people with
college degrees

# of new college
graduates this year

the govt debt

the govt budget deficit

QUIZ:

Stock or Flow?
the balance on your credit card statement
how much you study economics outside of
class each week
the size of your DVD collection
the inflation rate
the unemployment rate

Government purchases(G)
G includes all government purchases on
goods and services.
G excludes transfer payments
(e.g., unemployment insurance
payments), because they do not represent
spending on goods and services.

U.S. Government Purchases, 2013

$ billions
Govt spending
- Federal

$3,144

% of GDP
18.7%

1,232

7.3

Non-defense

462

2.8

Defense

770

4.6

1,912

11.4

- State & local

Net Exports (NX)

NX = exports imports
Exports represent foreign spending on
the economys g&s.
Imports are the portions of C, I, and G
that are spent on g&s produced abroad.
Adding up all the components of GDP
gives:
Y
Y =
= C
C +
+ II +
+ G
G +
+
NX
NX

U.S. Net Exports, 2013

$ billions
Net exports of g & s
Exports
Goods
Services
Imports
Goods
Services

% of GDP

$508

3.0%

2,262

13.5%

1,563

9.3%

699

4.2%

2,770

16.5%

2,302

13.7%

468

2.8%

QUIZ
In each of the following cases, determine how much
GDP and each of its components is affected (if at all).
A. Debbie spends $200 to buy her husband dinner
at the finest restaurant in Boston.
B. Sarah spends $1800 on a new laptop to use in her
publishing business. The laptop was built in China.
C. Jane spends $1200 on an used computer to use in
her editing business.
D. General Motors builds $500 million worth of cars,
but consumers only buy $470 million worth of
them.

QUIZ

Answers
A. Debbie spends $200 to buy her husband dinner
at the finest restaurant in Boston.
Consumption and GDP rise by $200.
B. Sarah spends $1800 on a new laptop to use in
her publishing business. The laptop was built in
China.
Investment rises by $1800, net exports fall
by $1800, GDP is unchanged.

QUIZ

Answers
C. Jane spends $1200 on an used computer to
use in her editing business.
Current GDP and investment do not change.
D. General Motors builds $500 million worth of
cars, but consumers only buy $470 million of
them.
Consumption rises by $470 million,
inventory investment rises by $30 million,
and GDP rises by $500 million.

Gross Domestic Product

Production Approach
Value added:
The value of output minus
the value of the intermediate goods
used to produce that output

QUIZ:

Identifying value-added
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 value added at each stage
of production and GDP

QUIZ:

Identifying value-added
A farmer grows a bushel of wheat
and sells it to a miller for $1.00.+$1
The miller turns the wheat into flour
and sells it to a baker for $3.00. +$2
The baker uses the flour to make a loaf of
bread and sells it to an engineer for
$6.00.=$3
Total of $6 in value added!

Final goods, value added, and

GDP
GDP = value of final goods produced
= sum of value added at all stages
of production.
The value of the final goods already includes
the value of the intermediate goods,
so including intermediate and final goods in
GDP would be double-counting.

GDP: SUMMARY
We have now seen that GDP measures:
total income
total output
total expenditure
the sum of value-added at all stages
in the production of final goods

GDP and Economic Well-Being

Real GDP per capita is the main
indicator of the average persons
standard of living.
But GDP is not a perfect measure of
well-being.
Robert Kennedy issued a very eloquent
yet harsh criticism of GDP:

Gross Domestic Product

does not allow for the health of our

children, the quality of their education,
or the joy of their
play.not
It does
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 courage, nor our wisdom,
nor our devotion Ittomeasures
our country.
everything, in short, except
that which makes life worthwhile, and it can tell us
everything about America except why we are proud that
we are Americans.
- Senator Robert Kennedy, 1968

GDP Does Not Value:

the quality of the environment
leisure time
non-market activity, such as the child care
a parent provides his or her child at home
an equitable distribution of income

Then Why Do We Care About

GDP?
Having a large GDP enables a country to
afford better schools, a cleaner
environment, health care, etc.
Many indicators of the quality of life are
positively correlated with GDP. For
example

Life expectancy (years)

GDP and Life Expectancy

Indonesia
China

Japan

Mexico

U.S.
Germany

Brazil
Pakistan
India

Russia

Bangladesh
Nigeria

Real GDP per capita

GDP and Literacy

China

Russia

Adult Literacy
(% of population)

Mexico

Germany

Japan

Brazil
Indonesia
Nigeria
India
Pakistan
Bangladesh

Real GDP per capita

U.S.

GDP and Internet Usage

Internet Usage
(% of population)

Japan

Pakista
n
Nigeria

Germany

Indonesia

Brazil
Mexico

Russia
China
India

Bangladesh

Real GDP per capita

U.S.

Real versus Nominal GDP

Inflation can distort economic variables like
GDP, so we have two versions of GDP:
One is corrected for inflation, the other is
not.
Nominal GDP values output using current
prices. It is not corrected for inflation.
Real GDP values output using the prices of
a base year. Real GDP is corrected for
inflation.

EXAMPLE:
year
2005
2006
2007

Pizza
P
$10
$11
$12

Q
400
500
600

Latte
P
$2.00
$2.50
$3.00

Compute nominal GDP in each year:

2005: $10 x 400 +

$2 x 1000

2006: $11 x 500 + $2.50 x 1100

2007: $12 x 600 +

Q
1000
1100
1200
Increase:

= $6,000
= $8,250

$3 x 1200 = $10,800

37.5%
30.9%

EXAMPLE:
year
2005
2006
2007

Pizza
P
$10$10
$11
$12

Q
400
500
600

Latte
P
$2.00
$2.00
$2.50
$3.00

Compute real GDP in each year,

using 2005 as the base year:

2005: $10 x 400 + $2 x 1000 = $6,000

2006: $10 x 500 + $2 x 1100 = $7,200
2007: $10 x 600 + $2 x 1200 = $8,400

Q
1000
1100
1200
Increase:
20.0%
16.7%

EXAMPLE:
Nominal
year
GDP
2005
$6000
2006
$8250
2007 $10,800

Real
GDP
$6000
$7200
$8400

In each year,
nominal GDP is measured using the
(then) current prices.
real GDP is measured using constant
prices from the base year (2005 in this
example).

EXAMPLE:
Nominal
Real
year
GDP
GDP
2005
$6000
$6000
37.5%
2006
$8250
$7200
30.9%
2007 $10,800
$8400

20.0%
16.7%

The change in nominal GDP reflects both

prices and quantities.

The change in real GDP is the amount that

GDP would change if prices were constant
(i.e., if zero inflation).
Hence, real GDP is corrected for inflation.

Nominal and Real GDP in the U.S.,

Real GDP
(base year
2000)

Nominal
GDP

The GDP Deflator

The GDP deflator is a measure of the
overall level of prices.
Definition:
nominal GDP
GDP
GDP deflator
deflator == 100
100 xx real GDP

One way to measure the economys inflation

rate is to compute the percentage increase in
the GDP deflator from one year to the next.

EXAMPLE:
year
2005
2006
2007

Nominal
Real
GDP
GDP
$6000 $6000
$8250 $7200
$10,800 $8400

GDP
Deflator
100.0
114.6
128.6

14.6%
12.2%

Compute the GDP deflator in each year:

2005:

100 x (6000/6000) = 100.0

2006:

100 x (8250/7200) = 114.6

2007:

100 x (10,800/8400) =

128.6

QUIZ

Computing GDP
2007 (base
yr)
P
Q
Good
A

$30

Good
B

$100

900

2008
P

2009

$31 1,000

192 $102

200

$36 1050
$100

A. Compute nominal GDP in 2007.

B. Compute real GDP in 2008.
C. Compute the GDP deflator in 2009.

205

QUIZ

Answers
Good A
Good B

2007 (base yr)

P
Q
$30
900
$100
192

2008
P
$31
$102

Q
1,000
200

A. Compute nominal GDP in 2007.

$30 x 900 + $100 x 192 = $46,200
B. Compute real GDP in 2008.
$30 x 1000 + $100 x 200 = $50,000

2009
P
$36
$100

Q
1050
205

QUIZ

Answers
2007 (base yr)

Good A
Good B

P
$30
$100

Q
900
192

2008
P
$31
$102

Q
1,000
200

2009
P
$36
$100

Q
1050
205

C. Compute the GDP deflator in 2009.

Nom GDP = $36 x 1050 + $100 x 205 = $58,300
Real GDP = $30 x 1050 + $100 x 205 = $52,000
GDP deflator = 100 x (Nom GDP)/(Real GDP)
= 100 x ($58,300)/($52,000) = 112.1

2.4 Comparing Economic

Performance across Countries
The exchange rate:
Price at which different currencies are traded.

To make comparisons of GDP across

countries we must take the following steps:
GDP must be expressed in a common currency
by first adjusting it by the exchange rate.
This value of nominal GDP must be multiplied
by the ratio of prices in the countries.

 Example: China and U.S. (in 2010)

First, use the exchange rate to turn
Chinese yuan into U.S. dollars.

Adjust for relative price level of goods.

Price level ratio is about (1/0.54), so the

real GDP of China is $10.8 trillion.

 Comparison of countries:
In general, rich countries tend to have higher
price levels than poor countries.
This is mainly because poor countries have
lower wages.

The Consumer Price Index

(CPI)
measures the typical consumers cost of
living
the basis of cost of living adjustments
(COLAs) in many contracts and in Social
Security

How the CPI Is Calculated

1. Fix the basket.
The Bureau of Labor Statistics (BLS) surveys
consumers to determine whats in the typical
consumers shopping basket.
2. Find the prices.
The BLS collects data on the prices of all the
goods in the basket.
3. Compute the baskets cost.
Use the prices to compute the total cost of the
basket.

How the CPI Is Calculated

4. Choose a base year and compute the index.
The CPI in any year =
cost of basket in current year
100 x
cost of basket in base year
5. Compute the inflation rate.
The percentage change in the CPI from the
preceding period.
Inflation
=
rate

CPI this year CPI last year

x 100%
CPI last year

EXAMPLE

basket: {4 pizzas, 10 lattes}

year

price of
pizza

price of
latte

2007

$10

$2.00

$10 x 4 + $2 x 10

2008

$11

$2.50

$11 x 4 + $2.5 x 10 = $69

2009

$12

$3.00

$12 x 4 + $3 x 10

cost of basket
= $60
= $78

Compute CPI in each year usingInflation

2007 base
rate:year:
2007: 100 x ($60/$60) = 100
2008: 100 x ($69/$60) = 115
2009: 100 x ($78/$60) = 130

115 100
x 100%
100
130 115
x 100%
13% =
115

15% =

QUIZ

Calculate the CPI

CPI basket:
{10 lbs beef,
20 lbs chicken}
The CPI basket cost
$120 in 2004, the base
year.

price
price of
of
chicken
beef
2004

$4

$4

2005

$5

$5

2006

$9

$6

A. Compute the CPI in 2005.

B. What was the CPI inflation rate from 2005-2006?

QUIZ

Answers
CPI basket:
{10 lbs beef,
20 lbs chicken}
The CPI basket cost
$120 in 2004, the base
year.

price
price of
of
chicken
beef
2004

$4

$4

2005

$5

$5

2006

$9

$6

A. Compute the CPI in 2005:

Cost of CPI basket in 2005

= ($5 x 10) + ($5 x 20) = $150
CPI in 2005 = 100 x ($150/$120) = 125

QUIZ

Answers
CPI basket:
{10 lbs beef,
20 lbs chicken}
The CPI basket cost
$120 in 2004, the base
year.

price
price of
of
chicken
beef
2004

$4

$4

2005

$5

$5

2006

$9

$6

B. What was the inflation rate from 2005-2006?

Cost of CPI basket in 2006
= ($9 x 10) + ($6 x 20) = $210

CPI in 2006 = 100 x ($210/$120) = 175

CPI inflation rate = (175 125)/125 = 40%

Whats in the CPIs Basket?

Problems with the CPI:

Substitution Bias
Over time, some prices rise faster than
others.
Consumers substitute toward goods that
become relatively cheaper.
The CPI misses this substitution because
it uses a fixed basket of goods.
Thus, the CPI overstates increases in the
cost of living.

Problems with the CPI:

Introduction of New Goods
The introduction of new goods increases
variety, allows consumers to find products
that more closely meet their needs.
In effect, dollars become more valuable.
The CPI misses this effect because it
uses a fixed basket of goods.
Thus, the CPI overstates increases in the
cost of living.

Problems with the CPI:

Unmeasured Quality Change
Improvements in the quality of goods in
the basket increase the value of each
dollar.
The BLS tries to account for quality
changes but probably misses some, as
quality is hard to measure.
Thus, the CPI overstates increases in the
cost of living.

Problems with the CPI

Each of these problems causes the CPI to
overstate cost of living increases.
The BLS has made technical adjustments,
but the CPI probably still overstates
inflation
by about 0.5 percent per year.
This is important because Social Security
payments and many contracts have
COLAs tied to the CPI.

Two Measures of Inflation

Contrasting the CPI and GDP

Deflator
Imported
Imported consumer
consumer goods:
goods:
included
included in
in CPI
CPI
excluded
excluded from
from GDP
GDP deflator
deflator
Capital
Capital goods:
goods:
excluded
excluded from
from CPI
CPI
included
in
GDP
deflator
included
in
GDP
deflator
The
basket:
The basket:
(if
(if produced
produced domestically)
domestically)
CPI
uses
fixed
basket
CPI uses fixed basket
GDP
GDP deflator
deflator uses
uses basket
basket of
of
currently
currently produced
produced goods
goods && services
services
This
This matters
matters ifif different
different prices
prices are
are
changing
changing by
by different
different amounts.
amounts.

QUIZ

CPI vs. GDP deflator

In each scenario, determine the effects on
the
CPI and the GDP deflator.
A. Starbucks raises the price of Frappuccinos.
B. Caterpillar raises the price of the industrial
tractors it manufactures at its Illinois factory.
C. Armani raises the price of the Italian jeans it
sells in the U.S.

QUIZ

Answers
A. Starbucks raises the price of Frappuccinos.
The CPI and GDP deflator both rise.
B. Caterpillar raises the price of the industrial
tractors it manufactures at its Illinois factory.
The GDP deflator rises, the CPI does not.
C. Armani raises the price of the Italian jeans it
sells in the U.S.
The CPI rises, the GDP deflator does not.