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CB2402 Macroeconomics

GDP: Measuring Total Production

and Income
Japanese Economy Enters Recession
• In Q3 2014, real gross domestic product fell
1.6%, following a 7.3% contraction in the Q2.
• Japan met one definition of a recession: two
consecutive quarters of contraction.

Japan Falls Into Recession. Wall Street

Journal. 17 November 2014.
• The prime minister Abe
delayed the sales tax
increase, along with the
Bank of Japan’s move to
pump tens of billions of
dollars of cash into the
economy in 2014, will
keep so-called
Abenomics to continue.

• The exchange rate

drops from 80 • One of the arrows of
JPY/US to 120 Abenomics is to increase the
JPY/US, a fall of 26% money supply to stimulate
around two years. consumption
• The Nikkei index increase from around 10,000 to
17,000 in two years (70% increase)
US recovery
• The U.S. economy grew at its fastest pace in
more than two years in the Q3 2017.
• Growth was powered by robust business
spending, … tax cuts passed by Congress this
• Gross domestic product expanded at a 3.2
percent annual rate last quarter (Q3), the
Commerce Department said.
Final reading on US Q3 GDP is up 3.2%, vs 3.3%
growth expected. CNBC. 21 December 2017
From the Economist
1. What is Gross Domestic Product (GDP)
2. Calculation of GDP
3. Nominal versus Real GDP
4. Limitations of the GDP Concept.
Microeconomics and Macroeconomics
• Microeconomics is the study of how
households and firms make choices, how they
interact in markets, and how the government
attempts to influence their choices.
• In contrast, macroeconomics is the study of
the economy as a whole (aggregate behavior),
including topics such as inflation,
unemployment, and economic growth.
What are economic fluctuations?
• In the short run, GDP fluctuates around its
– Recessions: periods of falling real incomes
and rising unemployment
– Depressions: severe recessions (very rare)
– Recovery: periods of rising real incomes
and falling unemployment
– Boom: Peak of the business cycle

• Short-run economic fluctuations are often

called business cycles.
History of GDP
• Before World War II, there was no
formal/systematic way to measure a country’s
aggregate (total) output.
• Near the end of World War II (1944), Professor
Kuznet presented the original formulation of
• His idea is to capture all economic production
by individual, companies and the government in
a single measure. It is the birth of GDP.
History of GDP
• Measures of aggregate output have been
published on a regular basis in the US since
October 1947. (*measures of aggregate output
for earlier times, but these have been
constructed retrospectively.)
Two economists, Simon Kuznets, from Harvard
University, and Richard Stone, from Cambridge
University, were given the Nobel Prize (in 1971)
in Economics for their contributions to the
development of the national income and
product accounts, a great contribution in
empirical achievement.

Simon Kuznets Richard Stone

What is Gross Domestic Product (GDP)
• Gross domestic product (GDP) is the total
market value of all final goods and services
produced within a given period (one year) by
factors of production located within a country.
a. Market Values
• We cannot add together the number of cars,
melons, haircuts, and all other goods and
services without agreeing on a common way
to measure them.
• The best practical way is to value each good
and service in monetary terms; and the best
measure of this that we have is the price that
each good or service is sold for.
• Market Value = Price x output
b. Final Goods and Services
• Final goods and services are goods and
services produced for final use.
• GDP excludes intermediate goods which are
the goods that are produced by one firm for
use in further processing by another firm.
• Otherwise, double counting exist.
Value Added in the Production of i-phone

Stage Of Production Value Of Sales Value Added

(1) Idea 2500 2500
(2) Assembly 3500 1000
(3) Advertisement 5000 1500
(4) Retail sale 6000 1000
Total value added $6000

What is the GDP in this example?

 Not to add all value of sales, its not final
c. Exclusion of old outputs
(During a Period of Time)
• GDP is concerned only with new, or current,
production. Old output is not counted in
current GDP because it was already counted
when it was produced.
• GDP does not count transactions in which
money or goods changes hands but in which
no new goods and services are produced.
c. Exclusion of Output Produced Abroad
• GDP is the value of output produced by factors of
production located within a country.
 exclude foreign production
 Factors of production: Land, Labour,…
• Gross national product (GNP): The total market
value of all final goods and services produced
within a given period by factors of production
owned by a country’s citizens, regardless of
where the output is produced.
 GDP is within a country, GNP is by citizens
e.g. in US, Hong Kong’s GDP unchanged, but Hong Kong’s
GNP changed
Income and Expenditure
• Gross Domestic Product (GDP) measures
total income of everyone in the economy.
• GDP also measures total expenditure on the
economy’s output of goods and services.

For the economy as a whole,

income equals expenditure, because
every dollar of expenditure by a buyer
is a dollar of income for the seller.
The Circular-Flow Diagram
• is a simple model to show economic activity.
• illustrates GDP as spending, revenue,
factor payments, and income.
• Notice that:
– Factors of production are inputs like labor, land,
capital, and natural resources.
– Factor payments are payments to the factors of
production. (e.g., wages, rent, interest)
The Circular Flow and the Measurement of GDP
• In a very simple model
of the economy, we
could start with
households and firms.
• Household’s income is Tax Transfer
equal to its spending. Payment

Expense by Household Government

= Consumption

•The circular flow and the

measurement of GDP
© Pearson Education Limited 2015 22 of 41
Adding Government to the Circular Flow
How does the government
affect economic activity?
• It taxes households and
• It uses those taxes to buy
goods and services, and to
make transfer payments—
payments to households
for which the government
does not receive a good or
service in return.

•The circular flow and the

measurement of GDP
© Pearson Education Limited 2015 23 of 41
Adding the Rest of the World to the Circular Flow
Economic activity with
the rest of the world.
• Households buy goods
and services from
firms in other
countries; these are
known as imports.
• Firms sell goods and
services to households
in other countries;
these are known as
•The circular flow and the
measurement of GDP
© Pearson Education Limited 2015 24 of 41
Adding the Financial System to the Circular Flow
The Financial system.
• Households can save some
incomes in the financial
system (banks).
• These financial system
firms lend money to other
firms and the government.

•The circular flow and the

measurement of GDP
© Pearson Education Limited 2015 25 of 41
Calculation of GDP
• Expenditure approach - measures the total
amount spent on all final goods and services
during a given period. [focus]
• Income approach - measures the income—
wages, rents, interest, and profits—received
by all factors of production in producing final
goods and services.
• Value added approach A method of summing
the value added in the economy (side 17)
The Expenditure Approach
There are four main categories of expenditure:
• Personal consumption expenditures (C): household
spending on consumer goods
• Gross private domestic investment (I): spending by
firms and households on new capital, that is, plant,
equipment, inventory, and new residential structures
• Government consumption and gross investment (G)
• Net exports (NX= EX - IM): net spending by the rest
of the world, or exports (EX) minus imports (IM)

GDP = C + I + G + NX
GDP = Y = Output
Hong Kong Government Half yearly Economic Report 2017
a. Personal Consumption Expenditures
Personal consumption expenditures (C)
Expenditures by consumers on goods and services.
(i) Durable goods Goods that last a relatively long
time, such as cars and household appliances (e.g.
 Proxy for Recession:
If the economy is recession, you will sell durable goods
(ii) Nondurable goods Goods that are used up fairly
quickly, such as food and clothing.

(iii) Services The things we buy that do not involve

the production of physical things, such as legal and
medical services and education.
Hong Kong Government Half yearly Economic Report 2017
b. Gross Private Domestic Investment
Gross private domestic investment (I) Total
investment in capital—that is, the purchase of new
housing, plants, equipment, and inventory by the
private (or nongovernment) sector.
(i) nonresidential investment (fixed investment)
Expenditures by firms for machines, tools, plants,
and so on.
(purchase of new capital (k))
(ii) residential investment Expenditures by
households and firms on new houses and apartment
Gross Private Domestic Investment (I)
(iii) change in business inventories The amount
by which firms’ inventories change during a
period. Inventories are the goods that firms
produce now but intend to sell later.

Change in inventories = Inventories at the end

of year – Inventories at the beginning of the
It can say: Property industry
supporting Hong Kong Economy
Hong Kong Government Half yearly Economic Report 2017
Government Consumption and Gross
Investment (G)
Government consumption and gross investment
(G) Expenditures by governments for final goods
and services such as teachers’ salaries, highways,
and aircraft carriers.

This does not include transfer payments, since

those do not result in immediate production of new
goods and services.
G = Export – Import
Export = Goods + Services
Net exports (NX = EX - IM) The difference between
exports (sales to foreigners of domestically
produced goods and services) and imports
(domestic purchases of goods and services from
abroad). The figure can be positive or negative.
Hong Kong Government Half yearly Economic Report 2017
In 2013, China has stock market crisis
Hong Kong Government Half yearly Economic Report 2017
What components of GDP would each of the following
transaction affect?
1. You buy a second hand Mankiw Textbook in Shenzhen. Then,
you resell it to your classmate
 Since it’s second hand and production is not within Hong
Kong, the change in GDP is 0.
2. Hong Kong government hires more civil servants.
 Increase in G, change in GDP will larger than 0.
3. There is a big stock market boom. Many people gain money from
speculating in stock.
 Speculation gain should not be counted in GDP as it is not
production. But in terms of commission on services for broker,
the change in GDP will larger than 0.
4. You produce 5 computers this year, but 2 computers are unsold.
 In 2016, you purchase 3 computer for each $1000, the Y
(output) will be $5000. C = $3000 , I = $2000
 In 2017, since C = $2000, I =$-2000, change in GDP = 0.
Hong Kong Property Bubble








82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 14


From Rating and Valuation Department

Hong Kong Property Bubble
320 160,000

280 140,000

240 120,000

200 100,000

160 80,000

120 60,000

80 40,000

40 20,000

0 0
82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 14

From Rating and Valuation Department Bar = Land Supply, Line = Property Supply
China stock market
crisis in 2015 Hong Kong Government Half yearly Economic Report 2017
Hong Kong’s Property Bubble
• Starting from 2009, Hong Kong property
price has increased from 100 to around
349.1 (Average of Class A, B and C, in
• According to Demographia’s report in
2017, it takes 18.1 years to buy a
property in Hong Kong.
• Is the soaring property price sustainable?
Demographia report 2017
(i) Affordability decrease

Hong Kong Government Half yearly Economic Report 2017

(ii) Supply of property increase
(ii) Fed Fund Rate Increasing Interbank (Mr. Powell)

The Probability of rate

increase for 21 March 2018
Fed. Reserve meeting

Is it the time to buy property

in Hong Kong? Justify.
Nominal versus Real GDP
• Inflation can distort economic variables like
GDP, so we have two versions of GDP:
One is corrected for inflation, the other is not.
• Nominal GDP values output using current
prices. It is not corrected for inflation.
 Current Price x Current Output (Q)
• Real GDP values output using the prices of
a base year. Real GDP is corrected for
1. N.GDP = Current Price x Current Output (Q)
EXAMPLE: 2. N.GDP Growth Rate

Pizza Latte
year P Q P Q
2002 $10 400 $2.00 1000
2003 $11 500 $2.50 1100
2004 $12 600 $3.00 1200
Nominal GDP
Compute nominal GDP in each year: Growth Rate
 Increase:
2002: $10 x 400 + $2 x 1000 = $6,000
2003: $11 x 500 + $2.50 x 1100 = $8,250
2004: $12 x 600 + $3 x 1200 = $10,800
EXAMPLE (Base year method):
Pizza Latte
year P Q P Q
2002 $10 400 $2.00 1000
2003 $11 500 $2.50 1100
2004 $12 600 $3.00 1200
Compute real GDP in each year, Real GDP
using 2002 as the base year: Growth Rate
 Increase:
2002: $10 x 400 + $2 x 1000 = $6,000
2003: $10 x 500 + $2 x 1100 = $7,200
2004: $10 x 600 + $2 x 1200 = $8,400
Nominal Real
year GDP GDP
2002 $6000 $6000
2003 $8250 $7200
2004 $10,800 $8400

In each year,
• nominal GDP is measured using the (then)
current prices.
• real GDP is measured using constant prices from
the base year (2002 in this example).
Nominal Real
year GDP Inflation GDP Inflation
2002 $6000 $6000
37.5% 20.0%
2003 $8250 $7200
30.9% 16.7%
2004 $10,800 $8400
• The change in nominal GDP reflects both prices and
 The change in real GDP is the amount that
GDP would change if prices were constant
(i.e., if zero inflation).
Hence, real GDP is corrected for inflation.
The GDP Deflator
• The GDP deflator is a measure of the overall
level of prices.
• Definition:
nominal GDP
GDP deflator = 100 x
real GDP

 One way to measure the economy’s inflation rate is

to compute the percentage increase in the GDP
deflator from one year to the next.
Nominal Real GDP
year GDP GDP Deflator
2002 $6000 $6000 100.0
2003 $8250 $7200 114.6
2004 $10,800 $8400 128.6 12.2%

Compute the GDP deflator in each year:

2002: 100 x (6000/6000) = 100.0

2003: 100 x (8250/7200) = 114.6

2004: 100 x (10,800/8400) = 128.6

Year Price of Quantity Price of Quantity
Milk of Milk Honey of
2010 $1 100 $2 50
2011 $1 200 $2 100
2012 $2 200 $4 100

a. Compute nominal GDP, real GDP, and the GDP deflator for
each year, using 2010 as the base year.
b. Compute the percentage change nominal GDP, real GDP,
and the GDP deflator in 2011 and 2012 from the preceding
year. For each year, identify the variable that does not
change. Explain in words why your answer makes sense.
c. Did economic well-being rise more in 2011 or 2012? Explain
Current Price x Real GDP GDP Deflator
Current Quantity

2010 $1 x 100 + $2 x 50 $200 100

(base year) =$200

2011 $1 x 200 + $2 x $1 x 200 + $2 x $400/$400 x 100

[Output Increase] 100 100 =100
=$400 =$400
2012 $2 x 200 + $4 x $1 x 200 + $2 x $800/$800 x 100
[Inflation] 100 100 =200
=$800 =$400 (100% of 2011)
GDP and Economic Well-Being
• Real GDP per capita is the main indicator of
the average person’s standard of living.
– but GDP is not a perfect measure
• GDP does not measure
– the quality of the environment
– leisure time
– non-market activity, such as DIY product
– distribution of income
– Political freedom and social justice are not
included in real GDP.
The quality of the environment

Polluted river in Guangdong (Reuters) Land pollution in Hainan (China Daily)

The quality of the environment

Beijing Smog . (Yahoo)

• The World Bank report finds that the health costs
of air and water pollution in China amount to
about 4.3% of its GDP in 2007.

• By adding the non-health impacts of pollution,

which are estimated to be about 1.5% of GDP, the
total cost of air and water pollution in China is
about 5.8% of GDP.
• The burden of both air and water pollution is
not distributed evenly across the country.
• For example, China’s poor (in rural area) are
disproportionately affected by the
environmental health burden and only six
provinces bear 50% of the effects of acid rain
in the country.
PM2.5 Concentration in China, 2010

Real Time Air Quality
Case Study – Rare Earth in China

The town of Baotou, in Inner Mongolia, largest Chinese source of rare earth

Photograph: David
Case Study – Rare Earth in China
• Rare earth is essential to advanced technology
from smartphones to GPS receiver, wind farms
to electric cars.
• China accounts for 97% of global output of it,
with two-thirds produced in Baotou.
Case Study – Rare Earth in China
• To extract rare earth, a lot of toxic chemicals
must be used. These chemicals cause cancers
to people.
• The villagers have obtained the promise of
financial compensation, as yet only partly
Rare-earth mining in China comes at a heavy
cost for local villages, Guardian, 7 August 2012