Measuring a Nation’s Income: Nominal vs. Real GDP, Applications and Implications

1. Measuring a Nation’s Income:Nominal vs. Real GDP, Applications and Implications Introduction to Political Economy: Macroeconomics Washington University – St. Louis Mark Vaughan Fall 2008

2. Lecture Outline • Transition from micro to macro economics • Define gross domestic product (GDP) • Differentiate real and nominal GDP • Break GDP into component parts • Outline stylized GDP facts • Evaluate GDP as measure of well-being • Use GDP data to prediction elections • Examine misuse of income statistics

3. From Micro to Macroeconomics Goals in Part II of Course: • Master basic “stylized facts” of macroeconomics. • Build simple models to account for these facts. • Develop a framework for assessing macroeconomic policy interventions. • Identity key institutional features for explaining facts and assessing policy.

4. Gross Domestic Product (GDP) • Definition:Total market value of all final goods and services produced within a country in a given period of time. • Valuable as tool for measuring long-run economic growth and short-run economic fluctuations. • Measures income and expenditures in the economy. • GDP can be measured by summing income received or expenditures on goods/services.

5. The Circular-Flow Diagram MARKETS FOR Spending Revenue GOODS AND SERVICES • Firms sell Goods and Goods • Households buy services and services bought sold HOUSEHOLDS FIRMS • Buy and consume • Produce and sell goods and services goods and services • Own and sell factors • Hire and use factors of production of production MARKETS Labor, land, Factors of FOR and capital production FACTORS OF PRODUCTION • Households sell Wages, rent, Income • Firms buy and profit = Flow of inputs and outputs = Flow of dollars For the economy as a whole, income must equal expenditure!

6. What is GDP? Gross domestic product is: • “the market value . . .” • Output is valued at marketprices. • “of all. . .” • GDP includes all items produced / sold legally in markets. • Anomaly: Legalize marijuana and GDP rises. • Sometimes values are imputed: • Rental housing counted. • Rental values for owner-occupied housing imputed. • GDP does not count non-market transactions • Restaurant meals – YES! • Value-added by home-cooked meals – NO! • Anomaly: Marry your cook and GDP falls.

7. What is GDP? Gross domestic product is the market value of all… • “final . . .” • GDP excludes intermediate goods to avoid double counting. • Inventory investment only exception. • “goods and services . . .” • GDP includes both tangible goods (food, clothing, cars) and intangible services (haircuts, housecleaning, doctor visits).

8. What is GDP? Gross domestic product is the market value of all final goods and services: • “produced . . .” • GDP does not include goods produced in the past. Example: • Valued-added by used-car salesman – YES! • Value of used car – NO! • “within a country . . .” • GDP measures production taking place inside border of a nation. Example: • Wash U. student from PRC shelving books in Olin Library on work-study program – Counted in U.S. GDP!

9. What is GDP? Gross domestic product is the market value of all final goods and services produced within a country… • “in a given period of time.” • GDP measures production taking place during a given interval, generally a quarter or year. • Quarterly GDP is generally adjusted in two ways (SAAR): • Annualized (multiplied by 4) • Seasonally adjusted

10. Real vs. Nominal GDP Nominal GDPvalues production of goods and services at current prices. • Nominal GDP can rise because physical output of goods/ services rises (c.p.), prices of goods/services rise (c.p.), or both. • To gauge growth of physical output (and incomes derived from), prices must be “deflated.” SOLUTION: Real GDP!

11. Real vs. Nominal GDP Real GDPvalues production of goods and services at constant prices. Conceptual Experiment: • Values GDP in any given year at prices obtaining in some base year. • Changes in GDP then represent changes in physical production only.

12. Real vs. Nominal GDP Example: • Note: Between 2005 and 2007, • Price of hot dogs triples and price of hamburgers doubles. • Production of hot dogs doubles and production of hamburgers triples.

13. Real vs. Nominal GDP Example: • Note: • Nominal GDP values current production at current prices. • Nominal GDP rises six-fold between 2005 and 2007.

14. Real vs. Nominal GDP Example: • Note: • Real GDP values current production at constant prices. • Real GDP rises 2.5 times between 2005 and 2007.

15. What if quantities are not observable? Use GDP deflator to “deflate” nominal GDP(i.e., revalue in prices obtaining in base year). Notes on GDP Deflator: • Value of GDP deflator is 100 for base year. • “General price level” is another name for GDP deflator. • Percentage change in GDP deflator is a measure of inflation. Formally, GDP Deflator = (Nominal GDP / Real GDP) x 100

16. Real vs. Nominal GDP Example: • Note: • General price level rises 71% from 2005 to 2006. • General price level rises 40.4% from 2006 to 2007.

17. Real vs. Nominal GDPHow to “Deflate” GDP deflator formula can be manipulated to express nominal GDP in base-year prices: If… GDP Deflator = (Nominal GDP / Real GDP) x 100, Then…Real GDP = Nominal GDP / [GDP Deflator / 100]

18. Real vs. Nominal GDPExample of “Deflating” Example: Mankiw, “Problems/Applications,” p. 222, #5 • Growth of nominal GDP, 1999-2000? ($9,873 – $9,269) / $9,269 = 6.5% • Growth of GDP deflator, 1999-2000? (118 -113) / 113 = 4.4% • What was real GDP in 1999, measured in 1996 prices? $9,269 / [113 / 100] = $8,203 • What was real GDP in 2000, measured in 1996 prices? $9,873 / [118 / 100] = $8,367 • What was real GDP growth, 1999-2000? ($8,367 - $8,203) / $8,203 = 2.0% • Was the growth rate of nominal GDP higher or lower than the growth rate of real GDP? Explain. Higher, b/c prices rose as well as physical output.

19. GDP Components GDP (Y) is the sum of the following: • Consumption (C) • Investment (I) • Government Purchases (G) • Net Exports (NX) Y = C + I + G + NX Note: Equation is an identity.

20. GDP Components (2007) Government Purchases (G) 19.5% Net Exports (NX) -5.1% Investment (I) 15.4% GDP = $13,807.5 C = $9,710.2 I = $2,130.4 G = $2,674.8 NX = $707.8 Billions of 2007 Dollars Consumption (C) 70.3%

21. GDP Components:Consumption (C) • Spending by households: • Consumer durables (examples: cars, appliances) • Consumer non-durables (examples: food, clothing) • Services (examples: haircuts, medical care) • Stable component • Fluctuates less than GDP

22. GDP Components:Investment (I) • Spending by firms on: • Capital equipment (example: new computers) • Structures (example: new plants) • Note: Spending on capital equipment and structures equals fixed private investment. • Inventories • Spending by households on: • Residential housing • Volatile component • Fluctuates far more than GDP

23. GDP Components(G, NX) • Government Purchases (G): • Spending on goods/services by local, state, and federal governments. • Does not include transfer payments. • Net Exports (NX): • Exports minus imports • Imports subtracted to avoid double counting (already included in other GDP components)

24. Stylized Facts: Real GDP in the United States Rule of 70=(70/growth rate)=Years to Double=70/3.26=21.5

25. What is a recession? • Definition: General period of macroeconomic decline, characterized by falling production, employment and income. • Rule of Thumb: Two consecutive quarters of declining real GDP (i.e., negative real GDP growth). • Determining Body: Business Cycle Dating Committee of the National Bureau of Economic Research (NBER) • Contraction (recession): period from business-cycle peak to trough • Expansion:period from business-cycle trough to peak

26. What is a recession? Business Cycle Dating: • NBER Business Cycle Dating Committee (BCDC) considers real GDP the single best measure of aggregate economic activity. • Because real GDP is reported quarterly, the BCDC also looks at key monthly series when calling peaks and troughs. • Personal income less transfer payments, in real terms • Employment • Industrial production • Sales volume in manufacturing & wholesale-retail sectors, adjusted for price changes. • Sometimes NBER calls a recession using (1)-(4) even though “2-quarter rule” does not hold.

27. Stylized Facts: Per Capita Real GDP in the United States

28. Stylized Facts: Investment more Volatile than Consumption

29. How Good is GDP? • GDP is best measure of societal economic well-being. • GDP per capita is best measure of income / expenditureof average person. • Higher GDP per person implies higher living standard (c.p.) • Stylized facts: • U.S. real GDP per capita, 2008:Q3 (2000 $) =$38,387 • U.S. real GDP per capita growth, 1870-2003 = 1.82% • U.S. real GDP per capita growth, 1959:Q1-2008:Q3= 2.11%

30. How Good is GDP? GDP is not perfect measure of happiness/quality of life. Not captured: • Value of leisure • Value of a clean environment • Value of most activity taking place outside of markets Example: • Value of time spent with children • Value of volunteer work • Maldistribution of income Potential Bias Beware careful with cross-country comparisons. Differences in extent of legal markets can affect real per capita GDP.

31. GDP and Quality of Life Source: Human Development Report 2004, U.N. 12 of the world’s most populous countries, ranked by real GDP per person Note: Positive correlation between per capita real GDP and various quality of life measures.

32. Forecasting Elections:An Econometric Approach Ray Fair (Yale) – built most well-respected econometric forecasting model for predicting popular vote shares in presidential elections. • Fair (1978): Model predicting presidential elections, based on 1916-76 sample. • Model updated every four years (only one substantive revision – post 1992) • 2008 equation is: FORECAST VARIABLE • VOTEP: Republican share of two-party presidential vote in 2008 EXPLANATORY VARIABLES • GROWTH: Growth rate of real per capita GDP in first 3 quarters of 2008 (annual rate) • INFLATION: Growth rate of GDP deflator in first 15 quarters of 2nd Bush term[i.e., 2005:1-2008:3 (seasonally adjusted, annual rate)] • GOODNEWS: Number of quarters in first 15 quarters of 2nd Bush term in which real per capita GDP growth > 3.2 percent (annual rate) • CONTROLS: Party occupying White House, Incumbent running for re-election, Duration of incumbent party occupancy of White House, and “War” Elections

33. Forecasting Elections:An Econometric Approach VOTEP = 46.61 + 0.680*GROWTH - 0.657*INFLATION + 1.075*GOODNEWS EXPLANATORY VARIABLES • CONTROLS: Captured by constant term • GROWTH: Growth of real GDP per capita, 2008:Q1-2008:Q3 = 0.22% • INFLATION: Growth rate of GDP deflator, 2008:Q1-2008:Q3 = 2.88% • GOODNEWS: # of quarters, 2005:q1-2008:q3, growth of real GDP per capita> 3.2% (annual rate) = 3 FORECAST VARIABLE • VOTEP: Republican share of 2008 two-party vote = 48.09% McCain (51.91% Obama) • Results: • McCain’s prospects do not look good (spread = 3.82 percentage points) • Republican share of two-party House vote even worse (44.24%, spread = 11.52 percentage points) • Irony: • Presidents do not have much impact on the economy in the short run.

34. Presidential Economics:Economic Performance by Party Since 1961, under Democratic Administrations: • Real GDP growth has been faster. • Employment growth has been faster. • Inflation has been lower. • The DJIA has risen faster. Interpretation:Causation or correlation? Source: www.currencythoughts.com, August 19, 2008

35. Misuse of Income Statistics Fallacy: Except for rich, U.S. incomes have stagnated Fact: Growth of U.S. real GDP per capita 1959:Q1-2008:Q3 (2.11%) above 1870-2003 average (1.82%)

36. Misuse of Income Statistics Fallacy: Except for rich, U.S. incomes have stagnated Reasons for Specious Analysis: • Focus on wage growth – increasing % of working income from fringe benefits • Focus on household income – more year-round full-time workers in upper 20% households than lower %; rising living standards lead to more upper 20% households • Focus on incomes rather than wealth – many low income people are not poor • Focus on income “snapshot” rather than income migration – people in upper/lower quintiles do not stay put • Focus on earnings rather than “all in” income – rich pay taxes / poor receive transfers

37. Misuse of Income Statistics Fallacy: Corporate CEOs are overpaid at the expense of stockholders/consumers Fact: • Professional athletes / movie stars earn as much. • “Greed” only works if someone gives in. • No evidence corporate boards of directors captured by senior management. Economic Justification for High Salaries: • Small set of people with requisite skills. • Value created (destroyed) by good (bad) decisions immense. • Lehman Bros. had assets of $639 billion at bankruptcy (1% = $6.39 billion) • Golden parachutes needed to boot failed executives. • Caps ineffective – lead to payment in benefits / perks.

38. Misuse of Income Statistics Fallacy: Corporate CEOs are overpaid at the expense of stockholders/consumers Caution about Caps on Wall Street Salaries: • Just discovered job is harder than expected. • Politics will make it harder still. • Good idea to weaken incentive to work in financial services?

39. Questions over: Measuring a Nation’s Income:Nominal vs. Real GDP, Applications and Implications? Introduction to Political Economy: Macroeconomics Washington University – St. Louis Mark Vaughan Fall 2008