GDP, Economic Growth,

the Business Cycle

Week 8 1
 The Basic Model
• The two sector closed economy with no
government and no savings.

• R=Y=E=O
Week 8 2
 Definitions
• Production/output = the creation of new
goods and services.

• Gross Domestic Product (GDP) = a measure of

a country’s production
– Price acts as a measure of value
– Aggregating prices sold is the basis of GDP
– Most non marketed production e.g. housework
not counted in GDP
– Valuing government production
Week 8 3
The three methods to calculate GDP

1. The value added method: GDP is the total

sales receipts of a country minus total material
costs (including exports but not imports).

–Value added = the value of production firms

create.
–Total material costs deducted in the formula
to prevent their ‘double counting’ in GDP

Week 8 4
 Calculating GDP using the ‘value added’
approach
Stage of Producer Sales Material
Production Receipts Costs of
Production
Primary: Wheat $10 0
farmer
Secondary: Bread $15 $10
factory
Tertiary: Retail bread $20 $15
shop GDP
Workings $
Week 8 5
Three methods to calculate GDP cont’d
2. The final expenditures method: GDP is the
market value of all final goods and services
produced in a country during a period of time.
• Final good or service: A finished good or service sold to
the final user.
• Intermediate g+s (inputs to other g+s) not
included in the final expenditures method since a
final price includes an allowance for their value.
• If intermediate g+s were not deducted, their
value would be ‘double counted’.

Week 8 6
 Calculating GDP using the ‘final
expenditures’ approach
Stage of Producer Sales Material
Production Receipts Costs of
Production
Primary: Wheat $10 0
farmer
Secondary: Bread $15 $10
factory
Tertiary: Retail bread $20 $15
shop GDP
identify final expenditures $
Week 8 7
Three methods to calculate GDP cont’d

3. The incomes received approach: GDP is the

sum of all incomes (profits, wages, rent, interest)

• GDP can be calculated this way because after

deducting total material costs from total sales
receipts what is left (excluding net indirect taxation
and depreciation allowances) is distributed as
income payments

Week 8 8
 Calculating GDP using the ‘incomes
received’ approach
Stage of Producer Sales Material Profits and
Production Receipts Costs of Wages
Production
Primary Wheat $10 0 $10
farmer
Secondary Bread $15 $10 $5
factory
Tertiary Retail bread $20 $15 $5
shop
Calculate GDP this way $
Week 8 9
 The ‘incomes received’ approach
cont’d

• The incomes received approach does not include the

addition of transfer payments.

• Transfer payments = Payments by the government to

individuals for which the government does not
receive a good or service in return e.g. age pensions,
unemployment benefits, family benefit payments.

• Note: the ‘statistical discrepancy’

Week 8 10
 GDP is a measure of aggregate
demand.
The final expenditures method of calculating GDP says

GDP = the sum of the total expenditure on final goods

and services by households, business, government and
net exports (the value of exports minus the value of
imports).

Therefore GDP is a measure of aggregate demand and

production
Week 8 11
 Components of aggregate
demand (GDP)

▪ The ABS divides GDP into four major categories of

expenditures.

Y = C + I + G + NX

Week 8 12
Components of aggregate demand (GDP)
1. Private Consumption (C): Spending by
households on goods and services, not
including spending on new houses.
2. Private Investment (I): Spending by firms on
new capital equipment e.g. factories, office
buildings, and machinery, plus spending by
households on new houses.

Week 8 13
 Components of GDP cont’d
3. Government purchases (G): Spending by
federal, state and local governments on goods
and services.
4. Net exports (NX): The expenditure on exports
minus the expenditure on imports.
Examining the components of GDP helps identify
causes of fluctuations in GDP and economic forecasts.

Week 8 14
 Components of GDP, 2016/17

($ millions)
Consumption $988 286
Investment
Dwellings 101 765
Non-dwelling construction 93 733
Machinery and equipment 71 326
Other 74 708
Total 344 820

Government 415157
Net Exports
Exports 366 161
Imports 353 181
Total 12 980
TOTAL GDP 1 755 638
15
Week 8 15
SOURCE: Based on Australian Bureau of Statistics (2017), Australian National Accounts: Income, Expenditure and Product, Cat. No. 5206.0, Table
 Components of GDP, 2016/17

SOURCE: Based on Australian Bureau of Statistics (2017), Australian National Accounts: Income, Expenditure and Product, Cat. No. 5206.0, Table 9:
‘Expenditure on GDP, Current prices: Seasonally adjusted’, at <www.abs.gov.au>, viewed 23 October 2017.
16 16
Week 8
 Shortcomings of GDP as a measure
of total production
1. GDP can be underestimated due to:
▪ Non marketed production not counted: Goods and
services people produce for themselves e.g. household
production - cooking, cleaning, childcare, etc
▪ The underground economy: Buying and selling of goods
and services that is concealed from the government to
avoid taxes or regulations or because the goods and
services are illegal.

Week 8 17
Shortcomings of GDP as a measure of
total production
2. GDP can be overestimated due to inflation

• GDP = an aggregate of final sales receipts (price X

quantity).

• GDP can rise due to increased prices, increased actual

quantities or both.

• It is important to separate a rise in GDP due to price

changes from real quantity changes

Week 8 18
 Real GDP versus Nominal GDP
▪ Nominal GDP: The market value of final goods and
services evaluated at current year prices.

- Nominal GDP can change over time due to changes in

price and/or output.

▪ Real GDP: A measure of the volume of final goods and

services, holding prices constant.

- Real GDP shows changes in output only

19
Week 8
 Real GDP versus Nominal GDP
Nominal GDP = Current Year Prices X Current Year Quantities
Real GDP = Base Year Prices X Current Year Quantities

Quantity Price Nominal GDP Real GDP

Year One 20 $5

Year Two 20 $10

Year Three 10 $15

Assume Base Year = Year One

20
Week 8
 Changing nominal GDP into real GDP

Since 1989 the ABS has used chain volume measures

(an index number series using base year prices) to
estimate real GDP.

– Prices in each year are ‘chained’ to prices from

the previous year to minimise the distortion from
changes in relative prices.

21
Week 8
 Calculating the real GDP growth rate

▪ Economic growth rate: The rate of change in real

GDP from one year to the next.

Real GDP Current year - Real GDP Previousyear

Economic Growth Rate = x 100
Real GDPPreviousyear

22
Week 8
 Calculating real economic growth

▪ Example: Real GDP for Australia was:

– 2012/13: $1 525 283 million.
– 2013/14: $1 569 477 million.

▪ Calculate the economic growth rate as follows:

$1 569 477 - $1 525 283

Economic growth rate = x 100 = 2.9%
$1 525 283

23
Week 8 23
 Uses of GDP

1. A measure of production: GDP does a good job

at measuring total production, although it is not
flawless.

2. A measure of living standards: GDP is sometimes

used as a measure of wellbeing, but it is not a
comprehensive measure of wellbeing, and it is not
intended to be.

Week 8 24
Shortcomings of GDP as a measure of wellbeing

1. The distribution of GDP is not captured in

GDP estimates. GDP per capita used to see
how much each person could receive, but
assumes GDP is shared equally.

2. Note: if GDP grows faster than population,

GDP per capita rises but if GDP grows slower
than population, GDP per capita falls

Week 8 25
 Shortcomings of GDP as a measure of wellbeing
cont’d

• 3. Inflation causes GDP to increase but implies

a false increase in living standards - real GDP
used to overcome the effects of inflation.

• 4. The value of leisure is not included in GDP.

• 5. The level, quality of, and access to health

care and education is not measured in GDP.

Week 8 26
 Shortcomings of GDP as a measure of wellbeing
cont’d

• 6. GDP is not adjusted for pollution or other

negative effects of production.

• 7. GDP is not adjusted for changes in crime and

other social problems

• Real GDP per capita widely used to measure changing

living standards over time

Week 8 27
Economic Growth the Key to Rising
Living Standards

▪ Economic growth occurs when there is growth in

the employed workforce and/or when productivity
(production per worker).
▪ Increased living standards (increases in real GDP
per capita) more likely to occur with growth in
productivity.

Week 8 28
 Real GDP per capita, Australia, 1901 - 2014
7000

6000

5000
1966-67 prices (dollars)

4000

3000

2000

1000

0
1901 1911 1921 1931 1941 1951 1961 1971 1981 1991 2001 2011
Source: Created from D. Meredith and B. Dyster (1999), Australia in the Global Economy: Continuity and Change, Cambridge University Press. Data for 1999–2014 derived from Australian
Bureau of Statistics (2014), Australian National Accounts, Cat. No. 5206.0, Time Series Workbook, Table 1: Key National Accounts Aggregates, at <www.abs.gov.au>, viewed 6 November
2014. Week 8
2 Copyright ©2016 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781486022847/Hubbard Essentials of Economics/3e
 Two key factors determine labour
productivity:

1. Increases in capital per hour worked.

▪ Capital: Manufactured goods that are used to
produce other goods and services; examples include
computers, office buildings and machines.
▪ Human capital: The accumulated knowledge and
skills that workers acquire from education and
training or from their life experiences.

30 Week 8
 Two key factors determine labour
productivity:

2. Technological change:
This is change in the ability of a firm to produce more
output with a given quantity of inputs.

Associated with:
Better machinery and equipment.
Improved human capital.
Better means of organising and managing production.

Technological change: key to higher real GDP per capita

31 Week 8
 Is economic growth good or bad?
It is undeniable that economic growth has reduced
poverty and increased health, education and many
other measures of welfare.

Criticisms of economic growth include:

• Economic growth contributes to global warming,
deforestation and other environmental
problems.
• Globalisation undermines distinctive cultures.
• Multi-national firms exploit developing
countries.
32

• Globalisation undermines distinctive cultures.

Week 8
Phases of the Business Cycle
Level of business activity
PEAK Recession

Expansion

TOUGH

Time
Week 8 33
 Phases of the Business Cycle

Business cycle definitions

▪ The business cycle refers to periods of economic

expansion and economic contraction relative to the
trend rate of economic growth.
▪ The expansion phase - production, employment and
income are increasing above trend growth.
▪ The business cycle peak.
▪ The contraction phase - production, employment and
income are falling below trend growth.
34
Week 8
 Phases of the Business Cycle

▪ The business cycle trough.

▪ A recession - production, employment and income are
decreasing throughout the economy and the rate of
economic growth is negative.
▪ Technical definition of recession: Two successive
quarters of negative economic growth.

35
Week 8
Australian Economic Growth, 1987 - 2011

Week 8 36
 The business cycle
What happens during the business cycle, cont.
The effect of the business cycle on the inflation rate:

▪ During economic expansions the inflation rate usually

increases.
– Exception: If the expansion is due to rising
productivity levels and an expansion of potential
GDP.
▪ During contractions the inflation rate usually decreases.
– Exception: If the recession is caused by a supply
Week 8 37

shock.
The impact of a recession on the inflation rate: Figure 14.3
14
82/83 recession
12

10
GST
8 91/92 recession
Per cent

Source: Created from Reserve Bank of Australia (2014), Statistics: Consumer Price
38 Index, All Goods, at <www.rba.gov.au/statistics>, viewed 12 November 2014.. Copyright ©2016 Pearson Australia (a division of Pearson Australia Group
Pty Ltd) – 9781486022847/Hubbard Essentials of Economics/3e
Week 8 38
 The business cycle
What happens during the business cycle, cont.
The effect of the business cycle on the unemployment rate:
▪ Contractions and recessions cause the unemployment rate
to increase.
▪ The rate of unemployment continues to rise after a
recession is over, because:
– Discouraged workers re-enter the labour force.
– Firms continue to operate below capacity after the
recession is over and may not re-hire workers for some
39
time.
Week 8
 The impact of a recession on the unemployment rate

12
82/83 recession
11

10
GFC contraction
9
Per cent

6
91/92 recession
5

Source: Created from Australian Bureau of Statistics (2014), Labour Force:

Copyright ©2016 Pearson Australia (a division of Pearson Australia Group
40 Electronic Delivery, Cat. No. 6203.0, at <www.abs.gov.au>, viewed 12
Pty Ltd) – 9781486022847/Hubbard Essentials of Economics/3e
November 2014.
Week 8 40