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INTRODUCTORY
MACROECONOMICS ECON10003 LECTURE 2: GROSS DOMESTIC PRODUCT • In the previous lecture, we had a brief look at some Australian GDP growth data. • Recall that this chart presents the quarterly and year-ended percentage change in GDP. • It is perhaps the most cited economic statistic in the mainstream news media. THIS LECTURE 1. The concept of GDP 2. National income accounting 3. Nominal vs. Real GDP 4. GDP levels vs. GDP growth Reading: BOFAH chapters 1 and 2 THE THREE SECTOR CIRCULAR FLOW MODEL Households Firms Supply of goods and services Revenue Consumption expenditure Factors of Production Wages, rents, interest Income Supply of labour, land, capital Government Taxes & transfers Taxes & transfers Government expenditure Goods & Services MEASURING THE ECONOMY – GROSS DOMESTIC PRODUCT • How do we quantify a system such as that depicted in the circular flow model? • One useful way to characterize an economy is in terms of its output. That is, how much does this system produce? • The standard measure that is used today is Gross Domestic Product or GDP. This is defined as the market value of final goods and services that are produced in an economy over a given time period. Computing GDP in this manner is known as the production approach for measuring GDP. • Therefore, there are four elements to this definition: 1. Market value 2. Final goods and services 3. Produced in an economy (i.e., within a defined geographic boundary) 4. A given period of time (i.e., a quarter or a year) MARKET VALUE • An economy typically produces a multitude of goods and services. So, we need a common unit in order to value the entirety of its output. • Since the local currency functions as a commonly agreed upon store of value, the current market value of the goods and services allows us to aggregate the total goods and services produced by the economy. • This implies that non-market economic activity is not included in GDP. Examples include: • Home production (i.e., childcare, cleaning, cooking) • Black market goods and activities • Government production (e.g., defense, public education, public health etc.) often has no market price and it is valued at cost. FINAL GOODS AND SERVICES • Not all goods and services produced in an economy end up being consumed by the final end user. Many are used up in the production process of other goods and services and are known as intermediate goods. • GDP is the sum of final goods and services in order to avoid the double counting of intermediate goods used in production. • To illustrate, consider the following production process: Wheat (farmer) Flour (miller) Bread (baker) A GIVEN PERIOD OF TIME • GDP measures economic activity (i.e., production) that takes place within a defined period of time (e.g., per quarter, per year). • Goods that have been produced in previous periods have already been accounted for. Therefore, any purchases of goods produced in previous periods do not count towards the current period’s GDP. • Purchases of financial assets such as stocks and bonds also do not count towards GDP. They are not considered to be goods or services. • The services that facilitate these transactions (i.e., real estate agent fees, stockbroking fees, etc.) however do count towards GDP. NATIONAL INCOME ACCOUNTS • There are three equivalent ways to measure GDP per period: 1. Market value of production of all final goods and services (production approach) 2. Sum of all domestic expenditures (expenditure approach) 3. Sum of all domestic income (income approach) • These are three ways of measuring the same underlying phenomenon (i.e., the production of goods and services)! PRODUCTION AND INCOME APPROACHES • As we saw in the circular flow diagram, the production of goods and services generates income for the factors of production utilized in the production process. • Every purchase of final goods and services by the household generates revenue to the firm. • Firm revenues are paid to the factors of production (labour and capital). PRODUCTION AND INCOME APPROACHES • Consider the following production process: STEEL COMPANY Inputs • Labour $80 • Capital $20 Output • Steel $100 CAR COMPANY Inputs • Labour $70 • Capital $40 • Steel $100 Output • Cars $210 PRODUCTION AND INCOME APPROACHES • Value of production of all final goods and services • steel is used to produce cars • steel is an intermediate good • value of final goods (i.e., cars) is $210 • Equivalently, we can also compute the sum of all value added • value of steel production $100 • value-added of cars $210 - $100 = $110 • total value added $100 (steel) + $110 (cars) = $210 • Also, we can compute the sum of all income • labour $80 (steel) + $70 (cars) = $150 • capital $20 (steel) + $40 (cars) = $60 • total income $150 (labour) + $60 (capital) = $210 Note: The income earned by capital is known as gross operating surplus and is computed as the total value of gross output less costs incurred in producing said output. THE EXPENDITURE APPROACH • An equivalent way of measuring economic activity is to consider the value of total expenditure on final goods and services produced within an economy over a given period of time. • This is represented using the national income accounting identity: = + + + ( −) = . . , = = = ℎ( −) = THE EXPENDITURE APPROACH = • The spending by households on goods and services such as food, clothing and entertainment is classified by statistical agencies as private Consumption and has two major subcategories: • Durables which include long lived goods such as cars, white goods and furniture • Non-Durables which include all services as well as shorter lived goods such as food, clothing and personal devices. THE EXPENDITURE APPROACH = • The spending by firms on final goods and services is classified by statistical agencies as private Investment and has three major subcategories: • Business Fixed Investment which include capital goods such as machines, computers, factories and office buildings. Capital goods are distinct from intermediate goods in the sense that they are not used up in the production process. This is alternatively known as gross fixed capital formation. • Changes to inventories which include all goods that are produced by the firm that has not been sold in the same period. If a firm produces a good that is not sold in the same period, statistical agencies will treat that good as if it had been bought by the firm that produced it. • Residential investment which includes all newly constructed homes and apartments. Statistical agencies treat all newly constructed residences as if they were purchased by firms which then go on to sell the residences to households. This is to ensure that new constructions are accounted for at the time of their completion. THE EXPENDITURE APPROACH = ℎ • The spending by the government on final goods and services is classified by statistical agencies as Government Expenditure. • Government expenditure does not include transfer payments such as welfare benefits or pensions. Interest paid on any debt held by the government is also excluded. THE EXPENDITURE APPROACH ( −) = • Exports represent the purchases of domestically produced goods and services by foreign households, firms and governments. • Imports represent the purchases of foreign goods and services by domestic households, firms and governments. • Since we only want to include expenditures on goods and services produced within the domestic economy (i.e., the economy of interest) we need to add exports and subtract imports. POLICY IMPLICATIONS OF GDP SHARE • Understanding the expenditure components of GDP can yield insights into important policy considerations faced by major economies around the world. • Let’s look at the private consumption share of GDP across a range of countries: • Here is an interesting article by Michael Pettis, a professor in finance at Peking University (link: https://carnegieendowment.org/chinafinancialmarkets/87007) COUNTRY HOUSEHOLD CONSUMPTION SHARE OF GDP Australia 52% Japan 54% United Kingdom 61% United States 67% China 38% THE LIMITATIONS OF GDP • GDP is a measure of average income at market prices – • it leaves out non-market activity • we may want to value things at other than market prices • GDP does not account for the depletion of natural resources and the impact of pollution and environmental degradation. • GDP per person tells us nothing about the income distribution – two countries may have very similar GDP per person but very different amounts of inequality. • Put simply, GDP is not a measure of national well-being. • No need to treat it like it’s the only thing worth caring about. COMPARING GDP OVER TIME AND ACROSS COUNTRIES • So far, have looked at GDP for one time period and one country. • For this we can express GDP in dollars (or whatever happens to be the domestic currency). • This is known as nominal (or current) GDP. • But to make comparisons over time, need to adjust for the changing purchasing power of currency units. • And to make comparisons across countries, need to adjust for changing value of domestic currency relative to foreign currency. NOMINAL GDP vs. REAL GDP • In order to facilitate these comparisons, we will need to decompose nominal GDP as the product of a quantity index and a price index. = ( )×( ) • We refer to the quantity index as real GDP • We refer to the price index as the GDP deflator • Indices summarise complex distributions of quantities and prices • Real GDP is a measure of aggregate quantity that controls for the changing purchasing power of currency. CONSTRUCTING REAL GDP TRADITIONAL APPROACH (FIXED BASE YEAR) • Use (an arbitrarily chosen) base year prices to calculate value of output in given year • Pros: simple, captures changes in economic activity over time • Cons: base year prices may not reflect changing economy • new types of goods • innovation: new qualities or varieties of existing goods • changing tastes, demographics • base year will need to be changed at regular intervals. This will have the effect of rewriting history!