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GrossDomesticProduct

1.DefiningGDP(GrossDomesticProduct)
GDPincludesthetotalvalueoffinalproductsthatareproducedandsold(andnotresold)withinthecurrent
year.In1947,percapitaGDPoftheUSwasonlyabout$1700,buthassincegrowntoabout$47,000in2008,
andhasnotbeenincreasinginrecentmonths,duetotheworstrecessionlastyear.Thegrowthratehasbeen
about5.5%peryear.Ofcourse,muchofthisreflectsinflation.Forthesameperiod,theinflationrate(GDP
deflator)hasbeenabout3.5%.Thus,thenetorrealpercapitaGDPgrowthratehasbeenabout2%intheUS.

DuringthepostWWIIperioduntilabout1980,businesscycleshadshortduration.Arecessionoccurred
abouteveryfiveyears.After1980,itoccurredonceadecade.

2.Whichproductsareexcluded?

1.Exclusionofnonmarket
products

Inafreemarketeconomy,GDPincludesonlythoseproductsthatare
soldthroughthemarket.Thatis,consumersarewillingtopayprices
fortheproductstheyconsume.Inprinciple,GDPdoesNOTinclude
thoseproductsconsumersdonotpayfor.Thisisakindof
chauvinisticmeasure,notcountingthevalueofoutputsthatare
producedandconsumedbymanyhouseholdssuchashomecooking,
babysitting,servingandhelpingothermembersofthehousehold.
Wedonotincludethevalueoftheseproducts,primarilybecauseitis
difficulttoputvaluesonsuchhouseholdservicesthatdonotgo
throughthemarketmechanism.
Inrecentyears,GDPofnorthernEuropeancountriesaremuch
higherduetotheinclusionofmanyservices(suchasbabysitting)
thataremutuallysoldbetweenhouseholds.

2.Nointermediategoods

Somegoodsareusedasingredientinputstoproduceothergoods.
Forinstance,assumethereareonlytwotypesoffarmers,one
producingcornandtheotherpork.Ifcornfarmersproduce$1billion
worthofcorn,whichareonlyusedasfeedtoproduce$2billion
worthofpork,weshouldnotaddthevalueofcornusedasinputto
obtainGDP.Likewise,GeneralMotorsbuyhighstrengthsteelto
makechassis.WeshouldnotaddthevalueofGMcarssoldandthat
ofsteel.Thisresultsindoublecounting.

GDPdoesnotincludethevalueofintermediateinputs(inthiscase,
corn)butonlythevalueoffinalproducts.Alternatively,wecan
sumthevalueaddedofeachindustrytoobtainGDP.

3.Badsandresource
depletionareexcluded

Environmentalpollution,watercontaminationandresourcedepletion
areexcluded.GDPisnotreducedbypollutionandbadsthatare
producedintheprocess.
Eventhoughresourcesaredepleted,theireconomicvalueorcosts
areexcludedintheGDPcalculation.
Outputsproducedbyillegalactivitiesareexcluded.

4.IllegalGoods

Undergroundeconomy:howbigitisisnotknown.Insome
countries,itcouldbeover10%ofGDP.
Illegaltrade(narcotics,etc.)

3.TheExpenditureApproach
Withthisapproach,GDPistheamountmarketparticipantsspendonfinalgoodsandservicesoveragiven
periodoftime,usually1year.
GDP=C+I+G+(XM)

Expendituresofthehouseholdsectortobuydomestically
producedgoods.

Consumption

Thisunderstatestotalconsumptionbecauseimportsarenot
included.In2009,C=$10,130billion(70%ofGDP)
Nondurables=foodandclothing.
durables=longlivedconsumergoodssuchashouses,cars,washing
machines,etc.
services=insurance,travelservices.Asincomeincreases,service
shareincreases.(about2/3ofconsumption)
Investmentisthecreationofcapitalgoods,whichareusedto
producegoods.(buyingstocksisNOTinvestmenthere.)
Fixedinvestment(machinery,buildings,housingconstruction)
InventoryInvestment
Planned
inventory

Everybusinessneedsinventorytoconduct
business.Someareplanned.
unintendedinventoryaccumulationunsold
productspilingup.

Unintended
inventory
Investment

unintendedinventorydecumulationinventory
isdepletingfasterthanplanned.
Actualinventory=plannedinventory
equilibriumoutput.

Investmentisabout15%ofGDP.

However,investmentisthemostvolatilecomponentofGDP.
Investmentvolatilityisthesourceofbusinesscycles.$1billion
investmentcausesalargerchangeinGDP(multipliereffect,as
shownlater)
Someportionisneededtomaintainproductioncapacity(about10%)
=replacementinvestment.
Anythingabovereplacementinvestmentisnetinvestment,which
increasestheproductioncapacityoftheeconomy.
Governmetpurchasesofgoodsandservices.
Thereisnomarketforpublicgoods.Outputsofthegovernment
sectorisevaluatedbythepurchasingprices.Forexample,theoutput
ofagovernmentofficialishis/hersalary.

Governmentspending

employeesalaries,costsofpublicgoodsandservices.

TransferpaymentsareNOTincludedingovernment
spending.Thisisatransferofincomebetweenindividualsandfirms,
i.e.,fromtherichtothepoor(orviceversa)andbetweenfirmsand
households.
XM
NetExports

ExportsImports=netexports.
Imports=consumptiononimportedgoods.
Importsareanincreasingfunctionofincome.

4.GNPvsGDP
GrossNationalProduct

GNP=GDP+factorpaymentsfromothercountriesfactor
paymentstoothercountries.
factorpayments=interestpaymentsforforeignborrowingand
lending+dividendincomesfromthesubsidiariesofmultinational
firmslocatedinothercountries.
foreignwageincomesarenegligible.
GNPDepreciation
Capitalgoodsaredurableandlastmanyyears.Eachyear,some
portionisconsideredtobewornout(wearandtear).
Depreciationaccountsforabout10%ofGDP.

NetNationalProduct

Infrastructurecapital(suchashighways,bridges,dams)lasts
longer.Forinstance,highwaysandbridgeslastabout50years.
(concreteconstruction).
UShighwayswerebuiltduringEisenhoweradministration(1953
1961),andneedtoberebuilt.(Inotherwords,theUSdoesnot

havemodernhighways,becauseofdepreciation.)
GDPdepreciation

NetDomesticProduct

thenetvalueofoutputsproducedinthedomesticmarket.
(annual)Investmentmustexceed10%ofGDPfortheeconomy's
productioncapacitytogrow.

ReplacementInvestment

Ifreplacementinvestment=10%,thecountry'sproductive
capacityremainsconstant.
Ifreplacementinvestment>10%,theproductivecapacitygrows.
Intheabsenceofforeigncapital,moneytoinvestcomesfrom
domesticsavings.

Savings

Ifsavingsfalllessthan10%ofGDP,theeconomyisintrouble.

5.FourSectorsinatypicaleconomy
Householdsector

Businesssector

buysconsumptiongoodsfromthebusinesssector,andsupplies
laborandcapitalinputs(throughsavings).
producesproductsusingcapitalandlaborinputsandsellsthemto
consumers.
FinancialSectorispartofthebusinesssector:Itreceivessavings
fromthehouseholdsectorandlendsmoneytobusinessfirms.
Thegovernmentcollectstaxesandspendstherevenue.

Governmentsector

Redistributesincome,supposedlyfromthepoortotorichto
stabilizethesociety.
Whenincomedistributionisunequal,thereisahigherchanceofa
revolutionoroverthrowofthegovernment.

Foreignsector

Theforeignsectorbuysdomesticproductsandsuppliesforeign
productstodomesticconsumers.

6.TwinDeficits
Inrecentyears,theUSaswellasmanyEuropeancountriesaresufferingfromtwindeficits.These
governmentsarerunninglargebudgetdeficits,i.e.,governmentspendingfarexceedstaxrevenue.
Budgetdeficit

Tradedeficit

TG<0budgetdeficit
TG>0budgetsurplus(=TG)
XM>0tradesurplus(=XM)=netexports
XM<0tradedeficit

Atthesametime,thesecountriesareimportingfarmorethantheyexport,thusincurringtradedeficits.These
situationsdescribecountriesthatarenotinequilibrium.

7.Greece'sproblem

amphitheaterinAthens.
OlympicstadiumsinmanycountriesaremodifiedversionsofGreekamphitheaters.
Greeks(specifically,Cretans)inventedplumbing.

Greece'sGDP

$340billion

population

11million

percapita
GDP

$32,000(approximate)

Exports

$18billion

Imports

$61billion(TradeDeficit=$43billion)in2008

workhours

1800hours/year.(Japan=1830hours,USA=1777,SouthKorea=2400hours.China:no
reliablestatistics,maybe10hoursperday,sixdaysaweek.)

Government
spending

about40%.socialisteconomy

problem

biggovernment,nomanufacturing,nohightechindustry,peopledependonpensionsfor
whichtheyhavenotworked.
Thegovernmentneedstocutpensions,butpeoplearerevolting.

8.Equilibriuminaclosedeconomy
Aggregateexpenditureisdefinedas:
EC+I+G+(XM).

Ontheotherhand,totalpersonalincomemay
bespentonconsumption,savingsandtax.
YC+S+T.

Sinceincome=expenditure,

or

C+I+G+(XM)=C+S+T,

I+G+(XM)=S+T.

Ifthecountryisaclosedeconomy(X=
M=0),

then

Ifthegovernmenthasabudgetsurplus
ordeficit,thesituationisnot
sustainable,anditisnotalongrun(LR)
equilibrium.

thenLRequilibriumrequires

I+G=S+T.

I=S.
Thatis,LRdomesticequilibriumrequires

LRequilibriumrequiresthatthe
governmentbudgetbebalanced
(G=T),

investmentsavingsequality.
ThisistheoriginoftheIScurve,tobestudied
later.

9.DisposablePersonalIncome
DisposableIncomeistheportionofGDPthatconsumerscanspend.

WhydepreciationshouldnotbeincludedinnetGDP?

depreciation

depreciationisconsumptionofthecapitalgoods.Eachyearsomefractionofthe
capitalinputisusedupthroughwearandtear,andmustbereplenishedinorderto
maintaintheproductivecapacity.
Depreciationcostsarenotcountedascorporateprofits,andhenceshouldnotbepart
ofnetincome.
Whendepreciationisincludedinincome,wecallit"Gross"domesticproduct.

Net
Domestic
Product

=GDPdepreciation.
=firmspaysalestaxesandpropertytaxes(whicharegenerallyusedbylocal
governmentstobuildschools,highways,etc.)

Indirect
Business
Taxes

HongKonghasnosalestax,butinothercitieshavehighsalestax.
NewYorkcityhasahighsalestax,especiallyongoodstouristsbuy(hotels,
restaurants).
Intent:letvisitorspay.

Domestic
Income

=NDPIndirectBusinessTaxes.

Undistributed Corporationsdonotgenerallydistributealltheprofitstostockholders.
Corporate
Thesearecalledretainedearnings,andusedforfutureinvestment.
profits

10.ProblemsinComparingGDPoverTime

1.pricesarenotheld
constant

WhencalculatingandcomparingGDPovertime,weshouldremember
thatpricesarenotheldconstant.Inthe1970s,theworldeconomywas
greatlyperturbedbytwooilpriceshocks.Oilpricemorethanquadrupled
duringthisdecade.Oilisalsousedasinputinmanyindustries,andthe
pricesoftheseproductsalsorosesignificantly.
Accordingly,between1970and1978,GDPintheUnitedStatesmorethan
doubled.However,dollartheyardstickalsochangedinvalueduring
thisperiod,becausethepricesofmostgoodincreased.
InsteadofGDP,canweusephysicalquantitieswhichdonotchangevalue
overtimeasameaureofoutput?
No.quantitiesareimpractical.

2.CanWeUseQuantities?

ThemainproblemisthattheUSproducesmillionsofdifferentproducts
eachyear.Wecannotaddapplesandoranges,steelandwheat,because
theyaremeasuredindifferentunitsofmeasurement.Thatisthereasonto
useGDPinthefirstplace.
Wehavetousesomesortofpriceindextoadjustforthechangingvalueor
purchasingpowerofthedollar.Apriceindexcanbeusedtodeflatethe
nominalGDP(GDPincurrentdollars).
First,atypicalbundleofgoodsconsumersbuyischosenanditscostinthe
baseyearisgivenanindexof100.
Second,computethecostofthesamebundleinotheryears.Next,
computehowmuchmoreinanygivenyearrelatvetothebaseyear.Ifthe
indexis120thisyear,itmeansitcosts20%morethanthebaseyearto
purchasethechosenbundleofgoods.

3.PriceIndicesareused.
Priceindicesareusefulforcomparingoutputsoverashortperiod
oftime,saylessthan510years.
Notusefulwhencomparingincomesoverlongperiodsoftime,sayover
10years.
Why?theconsumptionbundleschangesignificantly.
VeryfewpeoplebuyVHSvideotapes.EvenDVDswillsoonbecome
obsolete.
Outputsareoftenmeasuredquarterly.
Thereareseasonalfluctuations.(about8%intheUS)
Incoldregions,seasonalvariationsarehigher,duetolongwinter.
4.Seasonaladjustment

Goodclimateisconducivetoeconomicactivities.
(i)cropsareharvestedinthefall
(ii)lessoutdooractivitiesareheldinthewinter.
Insteadofreportingrawdata,economistsoftenreportseasonallyadjusted
outputsbyeliminatingexpectedseasonalchangesoraveragingthe
outputs.

11.RealvsNominalGDP
Ifthereisnoinflation

RealGDP=NominalGDP
Thesamenominalincomehasmorepurchasing
power.

Ifdeflationoccurs

DeflationoccurredinJapaninthe1990s.
DeflationoccurredinHongKongaftertheAsian
financialcrisisin1997andendedonlyin2004.
Duringthisperiod,assetpricesfell.

Ifinflationoccurs

Thesamenominalincomeisworthless,andits
purchasingpowerdeclines.Sometimes,inflationis
calledthesilenttax.

12.NominalGDP
NominalGDP=ipiyi=p1y1+p2y2+...
wherepiandyiarethepriceandoutputofgoodiduringthecurrentyear.
NominalGDPissimplythesumofexpendituresoneachandeverygoodconsumedatcurrentprices.
Example
2009price

2009quantity

2009expenditure

200

200

10

10

100

30

300

9000

NomilalGDP=200+100+9000
=9300.

Thenextyear,bothpricesandoutputschange.
2010price

2010quantity

2010expenditure

300

300

10

20

200

50

200

10000

NominalGDP=300+200+10000
=10500.

ThetwotablesshownominalGDPincreasedfrom$9300to10500.
Doesitmeanconsumersarebetteroff?SincenominalGDPoverstatesrealGDPduringperiodsofinflation,
theextentofoverstatmentcanbeestimatedbytheGDPdeflator.

13.RealGDP
Pricesin2010aredifferentfromthosein2009.TogetrealGDPin2010,instead
ofusing2010prices,weusethebaseyear(2009)pricestoevaluatetotaloutputs.
2009price

2010quantity

hypothetical2010expenditureifpriceswere
heldconstant

300

300

10

20

200

30

200

6000

RealGDP=300+200+6000=6500.(Real
incomedeclined)

Whenthebaseyear(2009)pricesareused,thevalueofoutputsactuallyshrankin2010.WhilenominalGDP
in2010is10230,realGDPactuallydeclinedto6500.Thus,
GDPdeflatorin2010is=$10500/6500.

Becausepriceschangeovertime.
WhyrealGDP?

WhencomparingGDPfiguresovertime,nominalGDPsometimes
overestimatesrealoutputs.Thisisbecausepricesgenerallytendto
rise.

Whenincomerises
fasterthanprice
level

Consumersarebetteroff.

Whenincomerises

pricelevelalsorises.

Whenincomeis
stagnant

Usually,thepricelevelstillrises.Itdependsontheeconomy.

Whenincomefalls
inarecession

priceleveldoesnotrisemuch.Sometimesthepricelevelfalls.
Whenone'sincomerisesby10%inagivenyear,pricesarenot
generallyheldconstant.
Ifpricesfall,asinrecession,a5%fallinincomemeansrealincome
usuallyfallslessthan5%becauseoffallingprices.
However,onaverageduringanormalyear,pricestendtorise.

Ifpricesrise4%,a10%increaseinnominalincomerepresentsonlya
6%increaseinrealincome.
Nominalamountsareexpressedusingcurrentdollarprices,i.e.,they
areactualamountspaidorreceived.Thus,economistssometimesare
interestedinfiguringoutthechangesinrealincome,excludingthe
paymentsforriseinprices.

Oncepriceindicesarecalculated,realGDPcanbecalculatedusingtheaboveformula.Usually,anindex
numberof100isassignedtosomebaseyear.
Forinstance,ifoneisinterestedinGDPgrowthduringthepostWWIIera,onecanassignanindexof100to
1945or1946,andthencomputethepriceindicesforotheryears.
Whichbaseyearshouldoneuse?Italldependsonthepurposeofcomparison.
ChainWeightedMeasureofRealGDP
Relativepriceschangeover
time.

Forinstance,priceofpersonalcomputerskeeps
fallingeachyear.
Foodpricehasbeenrisingfasterthanothers.

BurealofEconomicAnalysis
choosesbaseyeareveryfive
years.

GDPsarecomputedduringthenextfewyears,
assumingpricesareheldconstantwhentheyare
not.

Since1995,chainweighted
measuresofrealGDPare
computed.

Theaveragepricesin2009and2010areusedto
measuretheGDPgrowthfrom2009to2010.

14.GDPperCapita
AhigherGDPisbetter,butdoesnotalwaysmakepeoplebetteroff.SometimesahigherGDPisbrought
aboutbyanincreaseinpopulation.Thus,ahigherGDPdoesnotnecesarilymeaneconomicgrowth.When
comparingwelfareovertimeandbetweencountries,weoftnuseGDPpercapita.WedivideGDPbythetotal
population.ToobtainrealGDPpercapita,onealsodividesrealGDPbythepopulation.
WorldGDP(misnomer,GrossWorldProduct)in2010isestimatedtobeabout$73trillion.PercapitaGWP
isabout$12,000in2010.

IfGDPrisesby3%,andalsothepopulationgrowsatthesamerate,thereisnochangeinwelfareofthe
representativepersoninthatcountry.

15.OtherProblemswithGDP

(1)Nonmarket
Transactions

Thesearethetransactionsoutsidethemarket,andhencethereisnoreliable
priceinformationaboutthem.Themostimportanttransactionexcludedfrom
theGDPistheservicesofhouswives.Thesearenotsoldinthemarket,and
hencenotenteredintotheGDP.
InLDCs,asignificantamountoffoodandclothingisproducedinthehome,
butnotincludedintheGDP.Thus,welfareisoftenunderstatedinLDCs.On
theotherhand,insomeEuropeancountries,differentfamiliespayoneanother
forbabysittingexpendituresandgettaxcredit,andtheseexpendituresare
includedinGDP.Thus,GDPtendtooverstatewelfareinthesecountries.
Thereisnotmuchdataaboutthemagnitudeoftheundergroundeconomy,
whichincludesbothlegalandillegaleconomies.Incomefromillegalactivities
arenotincludedintheGDP,andhenceGDPunderstatesactualeconomic
activities.Theyarenotexcludedbecausetheyareimmoral,buttheamounts
arenotreported.Also,cashpayments"underthetable"tocorruptofficialsand
businessmenarenotreported.

(2)TheUnderground
Economy

Also,asignificantamountisunderreportedbyselfemployedpeoplewhoare
doingbusinesslegally.
AccordingtoastudyofOECD(OrganizationforEconomicCooperationand
Development)countries,about17%ofeconomicactivitiesareunreported.
Also,blackmarketsarelargeindevelopingcountries.Incountriessuchas
Spain,Portugal,Italy,BelgiumandGreece,thisundergroundeconomy
exceeds20%.
Mostpeoplecangetaparttimejob,inadditiontotheirregularjobs,by
workingintheeveningsandonweekends.However,theychoosenotto.
Why?Becausetheyvalueleisuremorethantheadditionalincometheycould
earn!
Youcannotgotoparties,watchTV,orgotothemovies.Ifsomehowthese
peopleareforcedtoworkextrahours,GDPwillgoup,butnottheirwelfare.
GDPdoesNOTincludethevalueofleisure,althoughitisanimportant
elementofwelfare.
Annualworkinghours:
Korea:2400

(3)ValueofLeisure

Japan:1828
US:1777
UK:1650
Germany:1360
Netherlands:1300
India:28003400hours
13thcenturyfarmer:1600hours(UK)
UKin1840:3600
(Aswageraterises,workinghoursdecline)

Manyindustriesproducepollutionintheproductionprocess.Forinstance,a

(4)Pollutionandother
Externalities

steelmillproducespollutionwhileproducingsteelproducts.Likewise,theoil
industrypollutestheocean.Onlythevalueofoutputsproducedisincludedin
GDP,butnotthepollution.
Ifweareinterestedinmeasuringwelfare,thecostofpollutionshouldbe
subtractedfromthevalueofoutputs.
Iftheindustryorgovermentcleansupthemess,resourcesareusedup,and
theirvalueisincludedinGDP.Thus,GDPoverstatestheactualvalueof
outputs,whetherthepollutedenvironmentiscleanedupornot.

(5)QualityofGoods

GDPmissesanimportantelementofwelfare.ThequalityofTVs,washing
machines,computersandclothingarenotincludedinGDP.Forexample,
everyotheryearthequalityofpersonalcomputersseemtodoublebuttheir
priceshalved.
Whiletechnologicaladvancesoftenimprovethequalityoftheproductsand
hencewelfare,theylowerpricesandhencedecreaseGDP.

Source:ThomasWalter(http://www.geography.hunter.cuny.edu/~tbw/wc.notes/13.air.pollution/notes_chap13.htm)

16.WhyGDP?
Thereareothermeasuresofsocialwellbeing.Lifeexpectancies,infantmortalityrates,crimerates,health
care,etc.However,despiteallitsproblems,GDPisasingleindexthatmeasuresthevalueofoutputsofa
nation.Ittendstobepositivelyrelatedtowellbeing,butnotaprecisemeasureofsocialwelfare.

17.UnemploymentReducesGDP
Eachmonththegovernmentannouncestheunemploymentrate,thatsomanylostjobs,etc.Toverifywhether
oneisunemployed,thegovernmentneedstocontacteverybody.IntheUnitedStatesthisisdoneoncea
decade(decennialCensusofPopulation)Itiscostlytointerviewallworkers.Accordingly,thegovernment
conductscensusonlyoncein10years.Also,eachmonththeCensusBureauinterviewsabout60,000
households(orabout110,000individuals).Forstabilityonly1/4ofthesesamplesarereplacedeachmonth.
OftenthesuccessofaPresident'seconomicpolicyismeasuredbythenumberofjobscreated.Thisisavery
dangerouscriterion.(Remember:Associationisnotcausation!)

Onecansystematicallyhirepeopletobreakglassesofbuildingsandfactories.Theyneedtobe
repairedorreplaced,whichcreatejobsandincreasesGDP.However,thewellbeingofthecitizensdoesnot
increase,butactuallywilldecline,despitetheincreaseinjobscreatedandGDP.
TotalLaborForce=ArmedForces+CivilianEmployed+Unemployed.
HowtheGovernmentMeasuresUnemployment