A Tour of the

Book

CHAPTER 2
CHAPTER2
© 2008 Pearson Education Macroeconomics, 5/e Olivier Blanchard
Chapter 2: A Tour of the Book The problems with GDP definition

Consider the following examples

• A person spends $100 for a doctor visit.
• You spend a day as a volunteer teaching children
mandarin.
• China's central finance would arrange RMB70 billion
this year for the post-earthquake reconstruction.
• U.S has spent more $ 600 billion in Iraq War. It's like
spending $121,000 per person ($484,000 per family of
4) in the US. The Iraq war has already cost the lives of
nearly 4,000 U.S. troops. But this is counted as a part of
GDP!!!

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Chapter 2: A Tour of the Book Going beyond GDP

http://www.youtube.com/watch?v=Ep4DWx1--s

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Chapter 2: A Tour of the Book Short Summary of GDP

• GDP is a basic measure of a country's

economic performance and is the
market value of all final goods and
services made within the borders of an
economy in a year . It is a fundamental
measurement of production and is very
often positively correlated with the
standard of living.
• GDP can be defined in three ways (total
production, total expenditure, total
income), all of which are conceptually
identical.

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Chapter 2: A Tour of the Book Short Summary of GDP

But GDP as an indicator of economic health also has the following

limitations:
• Wealth distribution – GDP does not take disparity in incomes
between the rich and poor into account.
• Non-market transactions – GDP excludes activities that are
not provided through the market, such as household production
and volunteer or unpaid services.
• Underground economy – Official GDP estimates may not take
into account the underground economy
• What is being produced – GDP counts work that produces no
net change or that results from repairing harm. For example,
rebuilding after a natural disaster or war may boost GDP.
• Externalities – GDP ignores externalities or economic bads
such as damage to the environment. GDP does not deduct bads
or accounting for the negative effects of higher production,
such as more pollution.
• Sustainability of growth – GDP does not measure the
sustainability of growth.

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 The Other Major
2-2
Macroeconomic Variables
Chapter 2: A Tour of the Book

GDP is obviously the most important

macroeconomic variable. But two other variables
tell us about other important aspects of how an
economic is performing:
 Inflation
 Unemployment

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Chapter 2: A Tour of the Book Nominal and Real GDP

Nominal GDP is the sum of the quantities

of final goods produced times their current
price.
Nominal GDP increases over time because:
 The production of most goods increases
over time.
 The prices of most goods also increase
over time.
Real GDP is constructed as the sum of the
quantities of final goods times constant
(rather than current) prices.

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Chapter 2: A Tour of the Book Nominal and Real GDP

Year Quantity Price Nominal GDP Real GDP

of Cars of cars
(in 2000 dollars)
1999 10 $20,000 $200,000 $240,000
2000 12 $24,000 $288,000 $288,000
2001 13 $26,000 $338,000 $312,000

 To construct real GDP, multiply the number of

cars in each year by a common price.
Suppose we use the price of the car in 2000
as the common price. This approach gives us,
in effect, real GDP in 2000 dollars.

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Chapter 2: A Tour of the Book Nominal and Real GDP

 Nominal GDP is also called dollar GDP

or GDP in current dollars.
 Real GDP is also called GDP in terms of
goods, GDP in constant dollars, GDP
adjusted for inflation.
 GDP will refer to real GDP, and Yt will
denote real GDP in year t.
 Nominal GDP will be denoted by a dollar
sign in front of it: $Yt.

Real GDP, Technological Progress,

and the Price of Computers
Hedonic pricing puts an implicit price on each of a
good’s characteristics.
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Chapter 2: A Tour of the Book Nominal and Real GDP

Figure 1 - 2
Nominal and Real
GDP U.S. GDP Since
1960
From 1960 to 2003, nominal
GDP increased by a factor of
21. Real GDP increased by a
factor of 4.

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Chapter 2: A Tour of the Book Nominal and Real GDP

Real GDP per capita is the ratio of real GDP to

the population of the country.
GDP growth equals:
(Yt − Yt −1 )
Yt −1
 Periods of positive GDP growth are called
expansions.
 Periods of negative GDP growth are called
recessions.

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Chapter 2: A Tour of the Book Nominal and Real GDP

Figure 2-2
Growth Rate of U.S.
GDP Since 1960
Since 1960, the
U.S. economy has
gone through a
series of
expansions
interrupted by
short recessions.

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 The GDP Deflator

The GDP deflator in year t, Pt, is defined as the

Chapter 2: A Tour of the Book

ratio of nominal GDP to real GDP in year t:

n o m i nP t a $ lY t G D
Pt = =
r e a l t G DY t P
The GDP deflator is what is called an index
number—set equal to 100 in the base year.
The rate of change in the GDP deflator equals
the rate of inflation:
( P t − P t−1 )
P t−1
Nominal GDP is equal to the GDP deflator times
real GDP:
$ Y t = P tY t
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Chapter 2: A Tour of the Book The Inflation Rate

Inflation is a sustained rise in the general level

of prices—the price level.

The inflation rate is the rate at which the price

level increases. (Conversely, deflation is a
sustained decline in the price level. It
corresponds to a negative inflation rate).
Deflation is rare, but it does happen. Japan has
experienced deflation since the late 1990s.

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Chapter 2: A Tour of the Book Example

The country of Myrule has produced the following quantity

of oranges and potatoes, with the price of each listed in
dollar terms.
Year
1 2
Quantity Price Quantity Price
Oranges 8,000 $4 10,000 $3
Potatoes 6,000 $8 5,000 $14
(a) Using Year 1 as the base year, what is the growth rate
of real GDP from Year 1 to Year 2?
(b) Based on the GDP deflator, what is the inflation rate
from Year 1 to Year 2?

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Chapter 2: A Tour of the Book

Answer :

(a) Real GDP for Year 1 = Year 1 quantities at Year 1 prices

= (8000 x $4) + (6000 x $8) = $80,000.
Real GDP for Year 2 = Year 2 quantities at Year 1 prices =
(10,000 x $4) + (5000 x $8) = $80,000.
Growth rate of real GDP = 0%
(b) Nominal GDP for Year 1 = Year 1 quantities at Year 1 prices =
(8000 x $4) + (6000 x $8) = $80,000.
Nominal GDP for Year 2 = Year 2 quantities at Year 2 prices =
(10,000 x $3) + (5000 x $14) = $100,000.
GDP deflator = nominal GDP/real GDP
GDP deflator in Year 1 = $80,000/$80,000 = 1.
GDP deflator in Year 2 = $100,000/$80,000 = 1.25.
Inflation rate = [(1.25/1) - 1] x 100% = 25%.

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Chapter 2: A Tour of the Book The Consumer Price Index

The GDP deflator measures the average price of

output, while the consumer price index, or CPI,
measures the average price of consumption, or
equivalently, the cost of living.

The CPI gives the cost in dollars of a specific list

of goods and services over time, which attempts
to represent the consumption basket of a typical
urban consumer.

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Chapter 2: A Tour of the Book The Consumer Price Index

The set of goods produced in the economy is not

the same as the set of goods purchased by
consumers for two reasons:
 Some of the goods are sold to firms, the
government, or to foreigners.
 Some of the goods are not produced
domestically but are imported from abroad.

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Chapter 2: A Tour of the Book The Consumer Price Index

Figure 2-4
Inflation Rate, Using
the CPI and the GDP
Deflator since 1960

The inflation
rates, computed
using either the
CPI or the GDP
deflator, are
largely similar.

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Chapter 2: A Tour of the Book The Consumer Price Index

Figure 2-4 yields two conclusions:

 The CPI and the GDP deflator move together
most of the time. In most years, the two
inflation rates differ by less than 1%.
 There are clear exceptions, however. In both
1974 and in the late 1970s, the increase in
the CPI was significantly larger than the
increase in the GDP deflator.

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 Why Do Economists Care
About Inflation?
Chapter 2: A Tour of the Book

Economists care about inflation for two reasons:

 During periods of inflation, not all prices and
wages rise proportionately, inflation affects
income distribution.
 Inflation leads to other distortions.

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Chapter 2: A Tour of the Book The Unemployment Rate

The Current Population Survey (CPS) is used

to compute the unemployment rate.
Only those looking for work are counted as
unemployed. Those not working and not looking
for work are not in the labor force.
People without jobs who give up looking for work
are known as discouraged workers.
l a b o er f o r c
Participation rate =
p o p u lo a f t wi og o n ar kg i e n

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Chapter 2: A Tour of the Book The Unemployment Rate

labor force = employment + unemployment

L = N + U

U
Unemployment rate: u=
L
8 .8
u = = 6 .0 %
2 0 0 3
1 3 . 7 +7 8 . 8

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Chapter 2: A Tour of the Book The Unemployment Rate

Figure 2-3
U.S. Unemployment
Rate Since 1960.
Since 1960, the U.S.
unemployment rate
has fluctuated
between 3 and 10%,
going down during
expansions, and
going up during
recessions.

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 Why Do Economists Care
About Unemployment?
Chapter 2: A Tour of the Book

Economists care about unemployment for

two reasons:
 Because of its direct effects on the welfare of the
unemployed.
 Because it signals that the economy may not be using
some of its resources efficiently.

Did Spain Really Have a 24%

Unemployment Rate in 1994?
The underground economy is not measured in
official statistics.
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Chapter 2: A Tour of the Book A Tour of the Book

The book is organized into three parts:

 A core which has three parts – the short run,
the medium run, and the long run.
 Three extensions which explore the role of
expectations, closed economies, and
expansion and recessions.
 A deeper look at the role of microeconomic
policy.

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 2-4 A Tour of the Book
Figure 2-5
Chapter 2: A Tour of the Book

The Organization of
the Book

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 The Short Run,
2-3
the Medium Run, the Long Run
Chapter 2: A Tour of the Book

Output is determined by:

 demand in the short run, say, a few years,
 the level of technology, the capital stock, and the
labor force in the medium run, say, a decade or
so,
 factors such as education, research, saving, and
the quality of government in the long run, say, a
half century or more.

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