Measuring the Size of the Economy: Gross Domestic Product
Adjusting Nominal Values to Real Values
Tracking Real GDP over Time (Time Series)
Comparing GDP among Countries
How Well GDP Measures the Well-Being of Society
Code
import osimport numpy as npimport pandas as pdimport matplotlib.pyplot as pltimport seaborn as snstitleSize =18legendSize =14ylabelSize =14tickSize =14sns.set_style("whitegrid", {'grid.linestyle': ':'})# -----------------------------------------------------------------------------# Load datadf_a = pd.read_csv('Graphs/Annual_FRED.csv', header=0, index_col=0, parse_dates=True)df_q = pd.read_csv('Graphs/Quarterly_FRED.csv', header=0, index_col=0, parse_dates=True)df_m = pd.read_csv('Graphs/Monthly_FRED.csv', header=0, index_col=0, parse_dates=True)
Macroeconomics focuses on the economy as a whole (or on whole economies as they interact). What causes recessions? What makes unemployment stay high when recessions are supposed to be over? Why do some countries grow faster than others? Why do some countries have higher standards of living than others? These are all questions that macroeconomics addresses. Macroeconomics involves adding up the economic activity of all households and all businesses in all markets to get the overall demand and supply in the economy. However, when we do that, something curious happens. It is not unusual that what results at the macro level is different from the sum of the microeconomic parts. Indeed, what seems sensible from a microeconomic point of view can have unexpected or counterproductive results at the macroeconomic level. Imagine that you are sitting at an event with a large audience, like a live concert or a basketball game. A few people decide that they want a better view, and so they stand up. However, when these people stand up, they block the view for other people, and the others need to stand up as well if they wish to see. Eventually, nearly everyone is standing up, and as a result, no one can see much better than before. The rational decision of some individuals at the micro level—to stand up for a better view—ended up being self-defeating at the macro level. This is not macroeconomics, but it is an apt analogy.
Macroeconomics is a rather massive subject. How are we going to tackle it? Figure 5.1 illustrates the structure we will use. We will study macroeconomics from three different perspectives: We will study macroeconomics from three different perspectives:
What are the macroeconomic goals? (Macroeconomics as a discipline does not have goals, but we do have goals for the macro economy.)
What are the frameworks economists can use to analyze the macroeconomy?
Finally, what are the policy tools governments can use to manage the macroeconomy?
Figure 5.1: Macroeconomic Goals, Framework, and Policies This chart shows what macroeconomics is about. The box on the left indicates a consensus of what are the most important goals for the macro economy, the middle box lists the frameworks economists use to analyze macroeconomic changes (such as inflation or recession), and the box on the right indicates the two tools the federal government uses to influence the macro economy.
Goals
In thinking about the overall health of the macroeconomy, it is useful to consider three primary goals: economic growth, low unemployment, and low inflation.
Economic growth ultimately determines the prevailing standard of living in a country. Economic growth is measured by the percentage change in real (inflation-adjusted) gross domestic product. A growth rate of more than 3% is considered good.
Unemployment, as measured by the unemployment rate, is the percentage of people in the labor force who do not have a job. When people lack jobs, the economy is wasting a precious resource-labor, and the result is
Frameworks
As you learn in the micro part of this book, principal tools used by economists are theories and models (see Welcome to Economics! for more on this). In microeconomics, we used the theories of supply and demand; in macroeconomics, we use the theories of aggregate demand (AD) and aggregate supply (AS). This book presents two perspectives on macroeconomics: the Neoclassical perspective and the Keynesian perspective, each of which has its own version of AD and AS. Between the two perspectives, you will obtain a good understanding of what drives the macroeconomy.
Policy Tools
National governments have two tools for influencing the macroeconomy. The first is monetary policy, which involves managing the money supply and interest rates. The second is fiscal policy, which involves changes in government spending/purchases and taxes. Each of the items in Figure will be explained in detail in one or more other chapters. As you learn these things, you will discover that the goals and the policy tools are in the news almost every day.
5.1 Measuring the Size of the Economy: Gross Domestic Product
Section Learning Objectives
Explain demand, quantity demanded, and the law of demand
Identify a demand curve and a supply curve
Explain supply, quantity supply, and the law of supply
Explain equilibrium, equilibrium price, and equilibrium quantity
Macroeconomics is an empirical subject, so the first step toward understanding it is to measure the economy. How large is the U.S. economy? The size of a nation’s overall economy is typically measured by its gross domestic product (GDP), which is the value of all final goods and services produced within a country in a given year. The measurement of GDP involves counting up the production of millions of different goods and services—smart phones, cars, music downloads, computers, steel, bananas, college educations, and all other new goods and services produced in the current year—and summing them into a total dollar value.
This task is straightforward: take the quantity of everything produced, multiply it by the price at which each product sold, and add up the total. In 2021, the U.S. GDP totaled USD 24 trillion, the largest GDP in the world. Each of the market transactions that enter into GDP must involve both a buyer and a seller. The GDP of an economy can be measured either by the total dollar value of what is purchased in the economy, or by the total dollar value of what is produced. There is even a third way, as we will explain later.
How is GDP traditionally measured? There are three basic ways to determine a nation’s GDP.
The Expenditure Approach
This method of determining GDP adds up the market value of all domestic expenditures made on final goods and services in a single year, including consumption expenditures, investment expenditures, government expenditures, and net exports. Add all of the expenditures together and you determine GDP.
The Production (Value Added) Approach
This method also called the Net Product or Value added method requires three stages of analysis. First gross value of output from all sectors is estimated. Then, intermediate consumption such as cost of materials, supplies and services used in production final output is derived. Then gross output is reduced by intermediate consumption to develop net production.
The Income Approach
This method of determining GDP is to add up all the income earned by households and firms in the year. The total expenditures on all of the final goods and services are also income received as wages, profits, rents, and interest income. By adding together all of the wages, profits, rents, and interest income, you determine GDP.
The three methods of measuring GDP should result in the same number, with some possible difference caused by statistical and rounding differences. The credibility of data is always a significant concern in any form of research. An advantage of using the Expenditure Method is data integrity. The U.S. Bureau of Economic Analysis considers the source data for expenditure components to be more reliable than for either income or production components.
5.1.1 GDP Measured by Components of Demand (Expenditure Approach)
Who buys all of this production? This demand can be divided into four main parts: consumer spending (consumption), business spending (investment), government spending on goods and services, and spending on net exports. (See the note below to understand what is meant by investment.)
In the following table we print the current nominal GDP in Billion of current US Dollars.
The following figures show how these four components added up to GDP in the past five years. The second figure below shows the components of GDP from the demand side.
Code
fig, ax = plt.subplots(figsize=(7,6))ax.get_xaxis().set_visible(False) # Hide Ticksdf_sub.iloc[-5:].plot(marker='o', ax=ax, fontsize=tickSize)pd.plotting.table(ax, np.round(df_sub.iloc[-5:].T, 1), loc='bottom', fontsize=titleSize)ax.set_title('Y = C + I + G + Ex - Im', fontsize=titleSize)ax.set_ylabel('Billion current US$', fontsize=ylabelSize)ax.legend(loc='right', bbox_to_anchor= (1.0, 0.4), fontsize=legendSize)#f_saveToPNG('Y_CIGNX_Fig11.png')plt.show()
We next show the percentage decomposition for the latest year.
Code
# Print percent-composition of GDP in latest year# -----------------------------------------------------------------------------df_a['NetExports'] = df_a['Exports'] - df_a['Imports']df_temp = df_a[['Consumption', 'Investment', 'GovernmentSpending', 'NetExports']].iloc[-2]/df_a['GDP'].iloc[-2]*100df_temp.name ='Year: '+ df_temp.name.strftime('%Y')fig, ax = plt.subplots(figsize=(7,7))df_temp.plot.bar(fontsize=14)ax.set_title("Y = C + I + G + NX", fontsize=18)ax.set_ylabel("% of GDP", fontsize=18);# create a list to collect the plt.patches datatotals = []# find the values and append to listfor i in ax.patches: totals.append(i.get_height())# set individual bar lables using above listtotal =sum(totals)# set individual bar lables using above listfor i in ax.patches:# get_x pulls left or right; get_height pushes up or down ax.text(i.get_x()-.03, np.abs(i.get_height())+1.0, \str(round((i.get_height()/total)*100, 2))+'%', fontsize=15, color='dimgrey')ax.set_xticklabels(["Consumption", "Investment","Government Purchases", "Net Exports"], rotation=0, fontsize=11)plt.axhline(y=0, xmin=0, xmax=2020, linewidth=2, linestyle='--', color='black')
We next show the same information in a pie chart.
WHAT IS MEANT BY THE WORD “INVESTMENT”?
What do economists mean by investment, or business spending? In calculating GDP, investment does not refer to the purchase of stocks and bonds or the trading of financial assets.
It refers to the purchase of new capital goods, that is, new commercial real estate (such as buildings, factories, and stores) and equipment, residential housing construction, and inventories.
Inventories that are produced this year are included in this year’s GDP—even if they have not yet sold. From the accountant’s perspective, it is as if the firm invested in its own inventories. Business investment in 2014 was almost $3 trillion, according to the Bureau of Economic Analysis.
Net investment equals gross investment minus depreciation. Depreciation refers to the devaluation of old investments that use value over time because of usage (wear and tear).
Figure 5.2 Panel (a) shows the levels of consumption, investment, and government purchases over time, expressed as a percentage of GDP, while Figure 5.2 Panel (b) shows the levels of exports and imports as a percentage of GDP over time. A few patterns about each of these components are worth noticing.
Figure 5.2: GDP Components on the Demand Side
Panel (a) Consumption is about two-thirds of GDP, but it moves relatively little over time. Business investment hovers around 15% of GDP, but it increases and declines more than consumption. Government spending on goods and services is around 20% of GDP.
Panel (b) Exports are added to total demand for goods and services, while imports are subtracted from total demand. If exports exceed imports, as in most of the 1960s and 1970s in the U.S. economy, a trade surplus exists. If imports exceed exports, as in recent years, then a trade deficit exists. (Source: http://bea.gov/iTable/index_nipa.cfm)
Consumption expenditure by households is the largest component of GDP, accounting for about two-thirds of the GDP in any year. This tells us that consumers’ spending decisions are a major driver of the economy. However, consumer spending is a gentle elephant: when viewed over time, it does not jump around too much.
Investment expenditure refers to purchases of physical plant and equipment, primarily by businesses. If Starbucks builds a new store, or Amazon buys robots, these expenditures are counted under business investment. Investment demand is far smaller than consumption demand, typically accounting for only about 15–18% of GDP, but it is very important for the economy because this is where jobs are created. However, it fluctuates more noticeably than consumption. Business investment is volatile; new technology or a new product can spur business investment, but then confidence can drop and business investment can pull back sharply.
If you have noticed any of the infrastructure projects (new bridges, highways, airports) launched during the recession of 2009, you have seen how important government spending can be for the economy. Government expenditure in the United States is about 20% of GDP, and includes spending by all three levels of government: federal, state, and local. The only part of government spending counted in demand is government purchases of goods or services produced in the economy. Examples include the government buying a new fighter jet for the Air Force (federal government spending), building a new highway (state government spending), or a new school (local government spending). A significant portion of government budgets are transfer payments, like unemployment benefits, veteran’s benefits, and Social Security payments to retirees. These payments are excluded from GDP because the government does not receive a new good or service in return or exchange. Instead they are transfers of income from taxpayers to others. If you are curious about the awesome undertaking of adding up GDP, read the following Clear It Up feature.
Note
HOW DO STATISTICIANS MEASURE GDP?
Government economists at the Bureau of Economic Analysis (BEA), within the U.S. Department of Commerce, piece together estimates of GDP from a variety of sources.
Once every five years, in the second and seventh year of each decade, the Bureau of the Census carries out a detailed census of businesses throughout the United States. In between, the Census Bureau carries out a monthly survey of retail sales. These figures are adjusted with foreign trade data to account for exports that are produced in the United States and sold abroad and for imports that are produced abroad and sold here. Once every ten years, the Census Bureau conducts a comprehensive survey of housing and residential finance. Together, these sources provide the main basis for figuring out what is produced for consumers.
For investment, the Census Bureau carries out a monthly survey of construction and an annual survey of expenditures on physical capital equipment.
For what is purchased by the federal government, the statisticians rely on the U.S. Department of the Treasury. An annual Census of Governments gathers information on state and local governments. Because a lot of government spending at all levels involves hiring people to provide services, a large portion of government spending is also tracked through payroll records collected by state governments and by the Social Security Administration.
With regard to foreign trade, the Census Bureau compiles a monthly record of all import and export documents. Additional surveys cover transportation and travel, and adjustment is made for financial services that are produced in the United States for foreign customers.
Many other sources contribute to the estimates of GDP. Information on energy comes from the U.S. Department of Transportation and Department of Energy. Information on healthcare is collected by the Agency for Health Care Research and Quality. Surveys of landlords find out about rental income. The Department of Agriculture collects statistics on farming.
All of these bits and pieces of information arrive in different forms, at different time intervals. The BEA melds them together to produce estimates of GDP on a quarterly basis (every three months). These numbers are then “annualized” by multiplying by four. As more information comes in, these estimates are updated and revised. The “advance” estimate of GDP for a certain quarter is released one month after a quarter. The “preliminary” estimate comes out one month after that. The “final” estimate is published one month later, but it is not actually final. In July, roughly updated estimates for the previous calendar year are released. Then, once every five years, after the results of the latest detailed five-year business census have been processed, the BEA revises all of the past estimates of GDP according to the newest methods and data, going all the way back to 1929.
When thinking about the demand for domestically produced goods in a global economy, it is important to count spending on exports—domestically produced goods that are sold abroad. By the same token, we must also subtract spending on imports—goods produced in other countries that are purchased by residents of this country. The net export component of GDP is equal to the dollar value of exports (X) minus the dollar value of imports (M), (X – M). The gap between exports and imports is called the trade balance. If a country’s exports are larger than its imports, then a country is said to have a trade surplus. In the United States, exports typically exceeded imports in the 1960s and 1970s, as shown in Figure (b).
Since the early 1980s, imports have typically exceeded exports, and so the United States has experienced a trade deficit in most years. Indeed, the trade deficit grew quite large in the late 1990s and in the mid-2000s. Figure (b) also shows that imports and exports have both risen substantially in recent decades, even after the declines during the Great Recession between 2008 and 2009.
Video - Measuring GDP with the Expenditure Approach
As noted before, if exports and imports are equal, foreign trade has no effect on total GDP. However, even if exports and imports are balanced overall, foreign trade might still have powerful effects on particular industries and workers by causing nations to shift workers and physical capital investment toward one industry rather than another.
Based on these four components of demand, GDP can be measured as:
\[GDP = Consumption + Investment + Government + Trade Balance\]
\[GDP = C + I + G + (X - M)\]
C = Personal Consumption Expenditures
I = Gross Private Fixed Investment
G = Government Expenditures and Investment
X = Exports
M = Imports
Understanding how to measure GDP is important for analyzing connections in the macro economy and for thinking about macroeconomic policy tools.
The Expenditure Approach is the most commonly discussed method of representing GDP particularly in non-academic examinations of economic activity.
5.1.2 GDP Measured by What is Produced (Value Added Approach)
Everything that is purchased must be produced first. Table 5.1 breaks down what is produced into five categories: durable goods, nondurable goods, services, structures, and the change in inventories. Before going into detail about these categories, notice that total GDP measured according to what is produced is exactly the same as the GDP measured by looking at the five components of demand.
Services make up over half of the production side components of GDP in the United States.
Since every market transaction must have both a buyer and a seller, GDP must be the same whether measured by what is demanded or by what is produced. Figure 5.3 shows these components of what is produced, expressed as a percentage of GDP, since 1960.
Figure 5.3: Services are the largest single component of total supply, representing over half of GDP. Nondurable goods used to be larger than durable goods, but in recent years, nondurable goods have been dropping closer to durable goods, which is about 20% of GDP. Structures hover around 10% of GDP. The change in inventories, the final component of aggregate supply, is not shown here; it is typically less than 1% of GDP.
In thinking about what is produced in the economy, many non-economists immediately focus on solid, long-lasting goods, like cars and computers. By far the largest part of GDP, however, is services. Moreover, services have been a growing share of GDP over time. A detailed breakdown of the leading service industries would include healthcare, education, and legal and financial services. It has been decades since most of the U.S. economy involved making solid objects. Instead, the most common jobs in a modern economy involve a worker looking at pieces of paper or a computer screen; meeting with co-workers, customers, or suppliers; or making phone calls.
Even within the overall category of goods, long-lasting durable goods like cars and refrigerators are about the same share of the economy as short-lived nondurable goods like food and clothing. The category of structures includes everything from homes, to office buildings, shopping malls, and factories. Inventories is a small category that refers to the goods that have been produced by one business but have not yet been sold to consumers, and are still sitting in warehouses and on shelves. The amount of inventories sitting on shelves tends to decline if business is better than expected, or to rise if business is worse than expected.
5.1.3 GDP Measured by the Generated Income (Income Approach)
Before moving forward in our discussion, it should be noted, the income approach is gathering a growing following. This is true particularly among economic blogs, investment publications and cable news business programs due to its concentration on the importance of wages.
An alternative method of calculating GNP using the Income Approach is “RIPSAW.”
The mnemonic “RIPSAW” breaks down as follows:
\[GDP = R + I + P + S + A + W\]
R = rents
I = interests
P = profits
SA = statistical adjustments (corporate income taxes, dividends, undistributed corporate profits
W = wages
5.1.4 The Problem of Double Counting
GDP is defined as the current value of all final goods and services produced in a nation in a year. What are final goods? They are goods at the furthest stage of production at the end of a year. Statisticians who calculate GDP must avoid the mistake of double counting, in which output is counted more than once as it travels through the stages of production. For example, imagine what would happen if government statisticians first counted the value of tires produced by a tire manufacturer, and then counted the value of a new truck sold by an automaker that contains those tires. In this example, the value of the tires would have been counted twice-because the price of the truck includes the value of the tires.
To avoid this problem, which would overstate the size of the economy considerably, government statisticians count just the value of final goods and services in the chain of production that are sold for consumption, investment, government, and trade purposes. Intermediate goods, which are goods that go into the production of other goods, are excluded from GDP calculations. From the example above, only the value of the Ford truck will be counted. The value of what businesses provide to other businesses is captured in the final products at the end of the production chain.
The concept of GDP is fairly straightforward: it is just the dollar value of all final goods and services produced in the economy in a year. In our decentralized, market-oriented economy, actually calculating the more than $24 trillion-dollar U.S. GDP—along with how it is changing every few months—is a full-time job for a brigade of government statisticians.
Table 5.2: Counting GDP
What is Counted in GDP
What is not included in GDP
Consumption
Intermediate goods
Business investment
Transfer payments and non-market activities
Government spending on goods and services
Used goods
Net exports
Illegal goods Household production
Notice the items that are not counted into GDP, as outlined in Table 5.2. The sales of used goods are not included because they were produced in a previous year and are part of that year’s GDP. The entire underground economy of services paid “under the table” and illegal sales should be counted, but is not, because it is impossible to track these sales.
In a recent study by Friedrich Schneider of shadow economies, the underground economy in the United States was estimated to be 6.6% of GDP, or close to $2 trillion dollars in 2013 alone.
Transfer payments, such as payment by the government to individuals (e.g., Medicare, Medicaid, Social Security, Unemployment benefits), are not included, because they do not represent production.
Also, production of some goods—such as home production as when you make your breakfast—is not counted because these goods are not sold in the marketplace.
Note
Home Production
If a dad takes care of his baby, these services are not included in GDP as it falls under home production. If the same family hires a babysitter that they pay officially for care services, then the value of these services is counted towards GDP.
5.1.5 Other Ways to Measure the Economy
Besides GDP, there are several different but closely related ways of measuring the size of the economy. We mentioned above that GDP can be thought of as total production and as total purchases. It can also be thought of as total income since anything produced and sold produces income.
One of the closest cousins of GDP is the gross national product (GNP). GDP includes only what is produced within a country’s borders. GNP adds what is produced by domestic businesses and labor abroad, and subtracts out any payments sent home to other countries by foreign labor and businesses located in the United States.
In other words, GNP is based more on the production of citizens and firms of a country, wherever they are located, and GDP is based on what happens within the geographic boundaries of a certain country. For the United States, the gap between GDP and GNP is relatively small; in recent years, only about 0.2%. For small nations, which may have a substantial share of their population working abroad and sending money back home, the difference can be substantial.
Net national product (NNP) is calculated by taking GNP and then subtracting the value of how much physical capital is worn out, or reduced in value because of aging, over the course of a year. The process by which capital ages and loses value is called depreciation. The NNP can be further subdivided into national income, which includes all income to businesses and individuals, and personal income, which includes only income to people.
GNP = GDP + net factor payments (roughly: subtract income of foreign firms operating in US and add income of US firms operating in foreign countries)
NNP = GNP - capital depreciation
National income = NNP - indirect taxes, where indirect taxes are sales taxes or excise taxes on products.
For practical purposes, it is not vital to memorize these definitions. However, it is important to be aware that these differences exist and to know what statistic you are looking at, so that you do not accidentally compare, say, GDP in one year or for one country with GNP or NNP in another year or another country. To get an idea of how these calculations work, follow the steps in the following example.
The size of a nation’s economy is commonly expressed as its gross domestic product (GDP), which measures the value of the output of all goods and services produced within the country in a year. GDP is measured by taking the quantities of all goods and services produced, multiplying them by their prices, and summing the total. Since GDP measures what is bought and sold in the economy, it can be measured either by the sum of what is purchased in the economy or what is produced.
Demand can be divided into consumption, investment, government, exports, and imports. What is produced in the economy can be divided into durable goods, nondurable goods, services, structures, and inventories. To avoid double counting, GDP counts only final output of goods and services, not the production of intermediate goods or the value of labor in the chain of production.
Self-Check Questions
Which of the following are included in GDP, and which are not?
The cost of hospital stays
The rise in life expectancy over time
Child care provided by a licensed day care center
Child care provided by a grandmother
The sale of a used car
The sale of a new car
The greater variety of cheese available in supermarkets
The iron that goes into the steel that goes into a refrigerator bought by a consumer.
What are the main components of measuring GDP with what is demanded?
5.2 Adjusting Nominal Values to Real Values
Section Learning Objectives
Contrast nominal GDP and real GDP
Explain GDP deflator
Calculate real GDP based on nominal GDP values
When examining economic statistics, there is a crucial distinction worth emphasizing. The distinction is between nominal and real measurements, which refer to whether or not inflation has distorted a given statistic. Looking at economic statistics without considering inflation is like looking through a pair of binoculars and trying to guess how close something is: unless you know how strong the lenses are, you cannot guess the distance very accurately. Similarly, if you do not know the rate of inflation, it is difficult to figure out if a rise in GDP is due mainly to a rise in the overall level of prices or to a rise in quantities of goods produced. The nominal value of any economic statistic means the statistic is measured in terms of actual prices that exist at the time. The real value refers to the same statistic after it has been adjusted for inflation. Generally, it is the real value that is more important.
5.2.1 Calculating Nominal GDP and calculating Real GDP
Imagine a simple economy where three final consumption goods and services are produced, Automobiles, computers, and haircuts, in year 2018.
2018
Current Price
Quantity
Nominal Value
Automobiles
$5,000
2,000
$10,000,000
Computers
$1,000
10,000
$10,000,000
Haircuts
$10
1,000,000
$10,000,000
You can calculate nominal GDP for year 2014 by simply adding up the total value of all three product categories, which results in a nominal GDP of $30 million.
Now let's have a look at the next year, 2019. For 2019 some of the prices will change as will the quantities produced. Below you will have a detailed breakdown of the changes.
2019
Current Price
Quantity
Nominal Value
Automobiles
$10,000
1,000
$10,000,000
Computers
$2,000
5,000
$10,000,000
Haircuts
$20
500,000
$10,000,000
If we were to calculate nominal GDP for year 2019 we would again find that GDP is $30 million. The economy, in terms of nominal GDP, is of equal size. It produces the same value of final goods and services than in the previous year.
The growth rate \(g\) of nominal GDP between 2018 and 2019 is
Now have a careful look at the tables. Nominal GDP says there was no change in terms of economic activity. In other words the economy did not grow or shrink in size. Have a careful look at the tables. Is this accurate? It seems that the economy in 2019 produces only half of all the goods and services that it produced in 2018. Less 'stuff' is made. However, the prices have increased. So if you multiply price with quantity, you do not see the "real" change of an actual decline in the quantity of goods and services that are now available for production. Nominal GDP is not a good measure to compare economic activity over time as you can clear see from this example. So how can we do better?
How about we evaluate the dollar value of final goods and services in the two years with the VERY SAME PRICES? Pick say, the prices from year 2018, and calculate GDP in both years with these prices. If you do this, you get the following GDP figures (these is now referred to as real GDP).
2018
Current Price
Quantity
Real Value
Automobiles
$5,000
2,000
$10,000,000
Computers
$1,000
10,000
$10,000,000
Haircuts
$10
1,000,000
$10,000,000
Real GDP for 2018 is again $30 million. This is an important fact. By definition, in the base year (and we said above that we treat 2018 as our base year) nominal GDP is the same as real GDP.
When setting up the table for 2019 we now use the same prices from 2018. We call 2018 the BASE YEAR.
2019
Price 2018
Quantity
Real Value
Automobiles
$5,000
1,000
$5,000,000
Computers
$1,000
5,000
$5,000,000
Haircuts
$10
500,000
$5,000,000
Video - Nominal vs. Real GDP
Real GDP in 2019 is $15 million. We now clearly see that the economy shrank by half. When calculating real GDP we basically ignore the price effects. The growth rate \(g\) of real GDP between 2018 and 2019 is
Have a look at the following video for another example of nominal vs. real GDP.
The GDP deflator is the ratio of nominal to real GDP.
\[\text{GDP-Deflator}=100 \times \frac{\text{Nominal-GDP in year t}}{\text{Real-GDP in year t}}\]
The GDP deflator is a price index that indicates the magnitude of economy wide prices changes of all final goods and services. It is not a percentage. In our example the GDP-Deflator is
In a later chapter you will learn that one measure of price inflation is the rate of change in price indices. The GDP deflator is one such index. The consumer price index (CPI) is another price index. We will discuss the CPI later.
If we were to calculate inflation using the GDP deflator in this example we need to calculate the GDP-deflator for 2018 and the GDP-deflator for 2019 and then calculate the rate of change (or growth rate) of the GDP deflator.
\[\text{GDP-Deflator-2018}=100 \times \frac{\text{Nominal-GDP in 2018}}{\text{Real-GDP in 2018}} = 100 \times \frac{$30 mill}{$30 mill} = 100\]
\[\text{GDP-Deflator-2019}=100 \times \frac{\text{Nominal-GDP in 2019}}{\text{Real-GDP in 2019}} = 100 \times \frac{$30 mill}{$15 mill} = 200\]
It is important to keep in mind that we used 2018 as the BASE YEAR. You then see that the CPI in the base year is by definition equal to 100. In the base year nominal GDP and real GDP are the same! The ratio of the two is then obviously equal to one.
We now calculate the rate of change in the GDP-deflator, which is our price index, in order to get a measure for inflation
The following Table shows U.S. GDP at five-year intervals since 1960 in nominal dollars; that is, GDP measured using the actual market prices prevailing in each stated year.
Code
# GDP Deflatordf_a['GDP_Deflator'] = df_a['GDP']/df_a['rGDP']*100df1_a = df_a[['GDP', 'GDP_Deflator']].copy()print(df1_a.loc['1960'::])
This information is also reflected in the next graph.
Code
df_a[['GDP']].loc['1960'::].plot(style = ['-'])plt.title('Nominal GDP', fontsize=titleSize)plt.ylabel('in Billion US $')plt.show()
If an unwary analyst compared nominal GDP in 1960 to nominal GDP in 2010, it might appear that national output had risen by a factor of twenty-seven over this time (that is, GDP of $14,958 billion in 2010 divided by GDP of $543 billion in 1960).
This conclusion would be highly misleading. Recall that nominal GDP is defined as the quantity of every good or service produced multiplied by the price at which it was sold, summed up for all goods and services. In order to see how much production has actually increased, we need to extract the effects of higher prices on nominal GDP. This can be easily done, using the GDP deflator.
GDP deflator is a price index measuring the average prices of all goods and services included in the economy. We explore price indices in detail and how they are computed in Inflation, but this definition will do in the context of this chapter. The data for the GDP deflator are given in the table above and are shown graphically in the following figure.
This figure shows that the price level has risen dramatically since 1960. The price level in 2010 was almost six times higher than in 1960 (the deflator for 2010 was 110 versus a level of 19 in 1960). Clearly, much of the apparent growth in nominal GDP was due to inflation, not an actual change in the quantity of goods and services produced, in other words, not in real GDP. Recall that nominal GDP can rise for two reasons: an increase in output, and/or an increase in prices.
What is needed is to extract the increase in prices from nominal GDP so as to measure only changes in output. After all, the dollars used to measure nominal GDP in 1960 are worth more than the inflated dollars of 1990—and the price index tells exactly how much more. This adjustment is easy to do if you understand that nominal measurements are in value terms, where
\[Value = Price \times Quantity\]
or
\[Nominal\ GDP = GDP\ Deflator \times Real\ GDP\]
Note
Micro Example
Let’s look at an example at the micro level. Suppose the t-shirt company, Coolshirts, sells 10 t-shirts at a price of $9 each.
\[real\ income = \frac{Nominal\ revenue}{Price} \]\[ = \frac{$90}{$9} = 10\]
In other words, when we compute “real” measurements we are trying to get at actual quantities, in this case, 10 t-shirts.
With GDP, it is just a tiny bit more complicated. We start with the same formula as above:
\[Real\ GDP = \frac{Nominal\ GDP}{Price\ Index}\]
For reasons that will be explained in more detail below, mathematically, a price index is a two-digit decimal number like 1.00 or 0.85 or 1.25. Because some people have trouble working with decimals, when the price index is published, it has traditionally been multiplied by 100 to get integer numbers like 100, 85, or 125. What this means is that when we “deflate” nominal figures to get real figures (by dividing the nominal by the price index). We also need to remember to divide the published price index by 100 to make the math work.
So the formula becomes:
\[Real\ GDP = \frac{Nominal\ GDP}{Price\ Index /100}
= \frac{Nominal\ GDP}{Price\ Index} \times 100\]
The following figure plots nominal and real US-GDP with 2012 as base year. This is the reason why the two lines cross in 2012.
Note
Real and Nominal GDP in Base Year
By definition, in the base year real GDP is the same as nominal GDP.
Code
df_q[['GDP', 'rGDP']].plot(style = ['-', '--'])plt.title('Nominal and Real US-GDP (2012 Base Year)' , fontsize=titleSize)plt.ylabel('in Billion US $')plt.show()
Key Concepts and Summary
The nominal value of an economic statistic is the commonly announced value. The real value is the value after adjusting for changes in inflation. To convert nominal economic data from several different years into real, inflation-adjusted data, the starting point is to choose a base year arbitrarily and then use a price index to convert the measurements so that they are measured in the money prevailing in the base year.
Self-Check Questions
What is the difference between a series of economic data over time measured in nominal terms versus the same data series over time measured in real terms?
How do you convert a series of nominal economic data over time to real terms?
5.3 Tracking Real GDP over Time
Section Learning Objectives
Explain recessions, depressions, peaks, and troughs
Evaluate the importance of tracking real GDP over time
When news reports indicate that “the economy grew 1.2% in the first quarter,” the reports are referring to the percentage change in real GDP. By convention, GDP growth is reported at an annualized rate: Whatever the calculated growth in real GDP was for the quarter, it is multiplied by four when it is reported as if the economy were growing at that rate for a full year.
The following figure shows the pattern of U.S. real GDP since 1900.
Code
df_q['rGDP'].plot(style = ['-'])plt.title('Real US-GDP (2012 Base Year)' , fontsize=titleSize)plt.ylabel('in Billion US $')plt.show()
The generally upward long-term path of GDP has been regularly interrupted by short-term declines. A significant decline in real GDP is called a recession.
Note
Recession
A recession is commonly defined as six consecutive months of declining real GDP.
An especially lengthy and deep recession is called a depression. The severe drop in GDP that occurred during the Great Depression of the 1930s is clearly visible in the figure, as is the Great Recession of 2008–2009.
Real GDP is important because it is highly correlated with other measures of economic activity, like employment and unemployment. When real GDP rises, so does employment.
The most significant human problem associated with recessions (and their larger, uglier cousins, depressions) is that a slowdown in production means that firms need to lay off or fire some of the workers they have. Losing a job imposes painful financial and personal costs on workers, and often on their extended families as well. In addition, even those who keep their jobs are likely to find that wage raises are scanty at best—or they may even be asked to take pay cuts.
Table 5.4 lists the pattern of recessions and expansions in the U.S. economy since 1900. The highest point of the economy, before the recession begins, is called the peak; conversely, the lowest point of a recession, before a recovery begins, is called the trough. Thus, a recession lasts from peak to trough, and an economic upswing runs from trough to peak. The movement of the economy from peak to trough and trough to peak is called the business cycle. It is intriguing to notice that the three longest trough-to-peak expansions of the twentieth century have happened since 1960. The most recent recession started in December 2007 and ended formally in June 2009. This was the most severe recession since the Great Depression of the 1930’s.
A private think tank, the National Bureau of Economic Research (NBER), is the official tracker of business cycles for the U.S. economy. However, the effects of a severe recession often linger on after the official ending date assigned by the NBER.
Key Concepts and Summary
Over the long term, U.S. real GDP have increased dramatically. At the same time, GDP has not increased the same amount each year. The speeding up and slowing down of GDP growth represents the business cycle. When GDP declines significantly, a recession occurs. A longer and deeper decline is a depression. Recessions begin at the peak of the business cycle and end at the trough.
Self-Check Questions
What are the typical patterns of GDP for a high-income economy like the United States in the long run and the short run?
Why do you suppose that u.s. gdp is so much higher today than 50 or 100 years ago?
Why do you think that GDP does not grow at a steady rate, but rather speeds up and slows down
5.4 Comparing GDP among Countries
Section Learning Objectives
Explain how GDP can be used to compare the economic welfare of different nations
Calculate the conversion of GDP to a common currency by using exchange rates
Calculate GDP per capita using population data
It is common to use GDP as a measure of economic welfare or standard of living in a nation. When comparing the GDP of different nations for this purpose, two issues immediately arise. First, the GDP of a country is measured in its own currency: the United States uses the U.S. dollar; Canada, the Canadian dollar; most countries of Western Europe, the euro; Japan, the yen; Mexico, the peso; and so on. Thus, comparing GDP between two countries requires converting to a common currency. A second issue is that countries have very different numbers of people. For instance, the United States has a much larger economy than Mexico or Canada, but it also has roughly three times as many people as Mexico and nine times as many people as Canada. So, if we are trying to compare standards of living across countries, we need to divide GDP by population.
5.4.1 Converting Currencies with Exchange Rates
To compare the GDP of countries with different currencies, it is necessary to convert to a “common denominator” using an exchange rate, which is the value of one currency in terms of another currency. Exchange rates are expressed either as the units of country A’s currency that need to be traded for a single unit of country B’s currency (for example, Japanese yen per British pound), or as the inverse (for example, British pounds per Japanese yen).
Two types of exchange rates can be used for this purpose, market exchange rates and purchasing power parity (PPP) equivalent exchange rates. Market exchange rates vary on a day-to-day basis depending on supply and demand in foreign exchange markets. PPP-equivalent exchange rates provide a longer run measure of the exchange rate. For this reason, PPP-equivalent exchange rates are typically used for cross country comparisons of GDP.
5.4.2 GDP Per Capita
The U.S. economy has the largest GDP in the world, by a considerable amount. The United States is also a populous country; in fact, it is the third largest country by population in the world, although well behind China and India. So is the U.S. economy larger than other countries just because the United States has more people than most other countries, or because the U.S. economy is actually larger on a per-person basis? This question can be answered by calculating a country’s GDP per capita; that is, the GDP divided by the population.
GDP per capita = GDP/population GDP per capita = GDP/population
The second column of Table lists the GDP of the same selection of countries that appeared in the previous Tracking Real GDP over Time and Table, showing their GDP as converted into U.S. dollars (which is the same as the last column of the previous table). The third column gives the population for each country. The fourth column lists the GDP per capita. GDP per capita is obtained in two steps: First, by dividing column two (GDP, in billions of dollars) by 1000 so it has the same units as column three (Population, in millions). Then dividing the result (GDP in millions of dollars) by column three (Population, in millions).
Key Concepts and Summary
Over the long term, U.S. real GDP have increased dramatically. At the same time, GDP has not increased the same amount each year. The speeding up and slowing down of GDP growth represents the business cycle. When GDP declines significantly, a recession occurs. A longer and deeper decline is a depression. Recessions begin at the peak of the business cycle and end at the trough.
Self-Check Questions
What are the two main difficulties that arise in comparing the GDP of different countries?
Is it possible for GDP to rise while at the same time per capita GDP is falling? Is it possible for GDP to fall while per capita GDP is rising?
5.5 How Well GDP Measures the Well-Being of Society
Section Learning Objectives
Discuss how productivity influences the standard of living
Explain the limitations of GDP as a measure of the standard of living
Analyze the relationship between GDP data and fluctuations in the standard of living
The level of GDP per capita clearly captures some of what we mean by the phrase “standard of living.” Most of the migration in the world, for example, involves people who are moving from countries with relatively low GDP per capita to countries with relatively high GDP per capita.
“Standard of living” is a broader term than GDP. While GDP focuses on production that is bought and sold in markets, standard of living includes all elements that affect people’s well-being, whether they are bought and sold in the market or not. To illuminate the gap between GDP and standard of living, it is useful to spell out some things that GDP does not cover that are clearly relevant to standard of living.
5.5.1 Limitations of GDP as a Measure of the Standard of Living
While GDP includes spending on recreation and travel, it does not cover leisure time. Clearly, however, there is a substantial difference between an economy that is large because people work long hours, and an economy that is just as large because people are more productive with their time so they do not have to work as many hours. The GDP per capita of the U.S. economy is larger than the GDP per capita of Germany, as was shown in [link], but does that prove that the standard of living in the United States is higher? Not necessarily, since it is also true that the average U.S. worker works several hundred hours more per year more than the average German worker. The calculation of GDP does not take the German worker’s extra weeks of vacation into account.
While GDP includes what is spent on environmental protection, healthcare, and education, it does not include actual levels of environmental cleanliness, health, and learning. GDP includes the cost of buying pollution-control equipment, but it does not address whether the air and water are actually cleaner or dirtier. GDP includes spending on medical care, but does not address whether life expectancy or infant mortality have risen or fallen. Similarly, it counts spending on education, but does not address directly how much of the population can read, write, or do basic mathematics.
GDP includes production that is exchanged in the market, but it does not cover production that is not exchanged in the market. For example, hiring someone to mow your lawn or clean your house is part of GDP, but doing these tasks yourself is not part of GDP. One remarkable change in the U.S. economy in recent decades is that, as of 1970, only about 42% of women participated in the paid labor force. By the second decade of the 2000s, nearly 60% of women participated in the paid labor force according to the Bureau of Labor Statistics. As women are now in the labor force, many of the services they used to produce in the non-market economy like food preparation and child care have shifted to some extent into the market economy, which makes the GDP appear larger even if more services are not actually being consumed.
GDP has nothing to say about the level of inequality in society. GDP per capita is only an average. When GDP per capita rises by 5%, it could mean that GDP for everyone in the society has risen by 5%, or that of some groups has risen by more while that of others has risen by less—or even declined. GDP also has nothing in particular to say about the amount of variety available. If a family buys 100 loaves of bread in a year, GDP does not care whether they are all white bread, or whether the family can choose from wheat, rye, pumpernickel, and many others—it just looks at whether the total amount spent on bread is the same.
Likewise, GDP has nothing much to say about what technology and products are available. The standard of living in, for example, 1950 or 1900 was not affected only by how much money people had—it was also affected by what they could buy. No matter how much money you had in 1950, you could not buy an iPhone or a personal computer.
In certain cases, it is not clear that a rise in GDP is even a good thing. If a city is wrecked by a hurricane, and then experiences a surge of rebuilding construction activity, it would be peculiar to claim that the hurricane was therefore economically beneficial. If people are led by a rising fear of crime, to pay for installation of bars and burglar alarms on all their windows, it is hard to believe that this increase in GDP has made them better off. In that same vein, some people would argue that sales of certain goods, like pornography or extremely violent movies, do not represent a gain to society’s standard of living.
5.5.2 Does a Rise in GDP Overstate or Understate the Rise in the Standard of Living?
The fact that GDP per capita does not fully capture the broader idea of standard of living has led to a concern that the increases in GDP over time are illusory. It is theoretically possible that while GDP is rising, the standard of living could be falling if human health, environmental cleanliness, and other factors that are not included in GDP are worsening. Fortunately, this fear appears to be overstated.
In some ways, the rise in GDP understates the actual rise in the standard of living. For example, the typical workweek for a U.S. worker has fallen over the last century from about 60 hours per week to less than 40 hours per week. Life expectancy and health have risen dramatically, and so has the average level of education. Since 1970, the air and water in the United States have generally been getting cleaner. New technologies have been developed for entertainment, travel, information, and health. A much wider variety of basic products like food and clothing is available today than several decades ago. Because GDP does not capture leisure, health, a cleaner environment, the possibilities created by new technology, or an increase in variety, the actual rise in the standard of living for Americans in recent decades has exceeded the rise in GDP.
On the other side, rates of crime, levels of traffic congestion, and inequality of incomes are higher in the United States now than they were in the 1960s. Moreover, a substantial number of services that used to be provided, primarily by women, in the non-market economy are now part of the market economy that is counted by GDP. By ignoring these factors, GDP would tend to overstate the true rise in the standard of living.
5.5.3 GDP is Rough, but Useful
A high level of GDP should not be the only goal of macroeconomic policy, or government policy more broadly. Even though GDP does not measure the broader standard of living with any precision, it does measure production well and it does indicate when a country is materially better or worse off in terms of jobs and incomes. In most countries, a significantly higher GDP per capita occurs hand in hand with other improvements in everyday life along many dimensions, like education, health, and environmental protection.
No single number can capture all the elements of a term as broad as “standard of living.” Nonetheless, GDP per capita is a reasonable, rough-and-ready measure of the standard of living.
HOW IS THE ECONOMY DOING? HOW DOES ONE TELL?
To determine the state of the economy, one needs to examine economic indicators, such as GDP. To calculate GDP is quite an undertaking. It is the broadest measure of a nation’s economic activity and we owe a debt to Simon Kuznets, the creator of the measurement, for that. The sheer size of the U.S. economy as measured by GDP is huge—as of the third quarter of 2013, $16.6 trillion worth of goods and services were produced annually. Real GDP informed us that the recession of 2008–2009 was a severe one and that the recovery from that has been slow, but is improving.
GDP per capita gives a rough estimate of a nation’s standard of living. This chapter is the building block for other chapters that explore more economic indicators such as unemployment, inflation, or interest rates, and perhaps more importantly, will explain how they are related and what causes them to rise or fall.
Key Concepts and Summary
GDP is an indicator of a society’s standard of living, but it is only a rough indicator.
GDP does not directly take account of leisure, environmental quality, levels of health and education, activities conducted outside the market, changes in inequality of income, increases in variety, increases in technology, or the (positive or negative) value that society may place on certain types of output.
Self-Check Questions
List some of the reasons why GDP should not be considered an effective measure of the standard of living in a country.
