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Chapter 2 THE DATA OF MACROECONOM I CS. Goals and Outline of Chapter 2:. Gross Domestic Product (GDP) What is Gross Domestic Product and how we measure it? Why is this measure important? What are the definitions of the major expenditure components?

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Chapter 2



Goals and Outline of Chapter 2:

Gross Domestic Product (GDP)

What is Gross Domestic Product and how we measure it?

Why is this measureimportant?

What are the definitions of the major expenditure components?

What are the trends in these components over time?

2. Inflation

What is the difference between ‘Real’ and ‘Nominal’ variables?

How is inflationmeasured?

3. Unemployment

How is Unemploymentmeasured?

Why do we care about Unemployment?


GDP is a measure of output!

Why Do We Care?

Because output is highly correlated (at certain times) with things we care about

(standard of living, wages, unemployment, inflation, budget and trade deficits, valueof currency, etc…)

Formal Definition:


is the market value of all final goods and services newly produced on

domestic soil during a given time period

(different than GNP)



Gross Domestic Product

GDP is the best single measure of the economic well-being of a society.

Production Method:

Measure the Value Added summed across allfirms (value added = sale price less cost of rawmaterials)

Income Method:

Labor Income (wages/salary) +

Capital Income (rent, interest, dividends, profits)+

Government Income (taxes)

Three ways

of measuring GDP

Expenditure Method:

Spending by consumers (C)

+ Spending by businesses(I)

+ Spending by government (G)

+ Net Spending byforeign sector (NX)




CalculatingGDP (example)

To see how all these approaches work we consider a simple example.

Consider a very simple economy where there is a coconut producer, a restaurant,some consumers and a government.



The product approach (or value added)

In this approach, to calculate the GDP:

we add the value of all goods and servicesproduced and then subtract

the value of all intermediate goods used in production.

intermediate goods

Goods that are produced by one firm for use in further processing by another firm.

We subtract the value of the intermediate goods to avoid

double counting in thecalculation.

Using this approach the GDP is simply defined as the sum of value added to goodsand services across all productive units in the economy.



The product approach (or value added)



The expenditure approach

In this approach, GDP is defined as:

the total spending on all final goods and servicesproduced in theeconomy in a given period of time.

Notice: the word final in the definition implies that we do not count spending on intermediategoods.

Y = GDP = the value of total output

C + I + G + NX = aggregateexpenditure



The expenditure approach (components)


I produce applesand I can potentially:

    • Sell them to some domestic customer (Consumption)
    • Sell them to some business (Investment)
    • Keep them in my stock room as inventory (Investment)
    • Sell them to the othercityfor their shelters (Government spending)
    • Sell them to some foreign customer (Net Export)

Simple example



The expenditure approach

From our example, using the expenditure approach we have that

I = 0 and NX = 0.

There is no investment in our example and no international trade.

The GDP is then given by: C + G



The income approach

Components of the income approach:

  • Wages, salaries, and supplements
  • Net interest
  • Rental income of persons
  • Income of unincorporated enterprises
  • Corporate profits before taxes
  • Indirect taxes
  • Depreciation


The income approach

In this approach, GDP is defined as the sum of all income received by economic agentscontributingto production.

Income includes the profits of firms.


The different components of aggregate

  • expenditure:
  • Consumption (C)
  • the value of all goods and services bought by households.
  • Includes:
  • durable goods
  • Goods that last a relatively long time, such as cars and household appliances.
  • nondurable goods
  • Goods that are used up fairly quickly, such as food and clothing.
  • services
  • The things we buy that do not involve the production of physical things,
  • such as legal and medical services and education.

The different components of aggregate



gross private domestic investment (I)

Totalinvestment in capital—that is, the purchase of new housing, plants, equipment, and inventory by the private (or nongovernment) sector.

nonresidential investment

Expenditures by firms for machines, tools, plants, and so on.

residential investment

Expenditures by households and firms on new houses and apartment buildings.

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.

Land purchases are NOT counted as part of GDP (land is not produced!)

Stock purchases are NOT counted as part of GDP

(stock transactions do NOT represent production – they are saving!)


The different components of aggregate


Government spending(G)


includes all government spending ongoodsand services.


excludestransfer payments (e.g.unemployment insurance payments),

because they do not represent spending on

goods and services.


The different components of aggregate


Net exports (NX = EX - IM)

The difference between

exports (sales to foreigners of country-produced goods and services) and

imports (country purchases of goods and services from abroad).

The figure can be positive or negative.


Another Measure of Total Income


Gross National Product (GNP):

total income earned by the nation’s factors ofproduction, regardless of where located

Gross Domestic Product (GDP):

total income earned by domestically-locatedfactors of production, regardless of nationality.

GNP = GDP + Net Factor Income from Abroad (NFIA)

NFIA = Receipts of factor income from the rest of the World –

Payments of factor income to the rest of the World


Another Measure of Total Income


net national product (NNP)

Gross national product minus depreciation; a nation’s total product minus what is required to maintain the value of its capital stock.

NNP = GNP – Depreciation

personal income

The total income of households.


Real vs. Nominal GDP

  • GDP is the value of all final goods andservices produced.
  • Nominal GDP measures these valuesusing current prices.
  • Real GDP measure these values usingthe prices of a base year.
  • base year
  • The year chosen for the weights in a fixed-weight procedure.
  • fixed-weight procedure
  • A procedure that uses weights from a given base year.
  • Nominal GDP = Current year Quantities x Current year Prices
  • Real GDP = Current year Quantities x Base year Prices

Real GDP = Nominal GDP / price index


Changes in nominal GDP can be due to:

          • changes in prices
          • changes in quantities of outputproduced
  • Changes in real GDP can only be due tochanges in quantities,
  • because real GDP is constructed using constant base-year prices.

Real GDP controls for inflation


Computenominal GDP in 2012 and 2013

  • Compute real GDP in each year using2012 as the base year.

Practice problem


Solutions :

Nominal GDP

multiply Ps & Qs from same year

2012: $1 x 10 + $10 x 3 = $40

2013: $2 x 15 + $15 x 4 = $90

Real GDP

multiply each year’s Qs by 2012 Ps

2012: as above: $40

2013: $1 x 15 + $10 x 4 = $55 (2012$)

So in real terms,

GDP did not rise as much asit would seem from nominal terms.


The inflation rate

is the percentageincrease in the overall level of prices.

One measure of the price level isthe

GDP Deflator, defined as

GDP deflator identifies an index that measures

the overall pricelevelin a given year.

Inflation rate is the rate of change of that index from

one year to the following.

Calculating the GDP Deflator


Example with 3 goods:

For goodi = 1, 2, 3

Pit= the market price of good iin month t

Qit = the quantity of good iproduced in month t

NGDPt= Nominal GDP in month t

RGDPt= Real GDP in month t

The GDP deflator is a weighted average of prices.

The weight on each price reflectsthat good’s relative importance in GDP.

Note that the weights change over time.

Understandingthe GDP deflator


The Consumer Price Index


A price index computed each month by the Statistical institute using a bundle that is meant to represent the “market basket” purchased monthly by the typical urban consumer.

The CPI market basket shows how a typical consumer

divides his or her money among various goods and services.

Most of a consumer’s money goes toward

housing, transportation, and food and beverages.


Understandingthe CPI

Example with 3 goods:

For goodi = 1, 2, 3

Ci= the amount of good iin the CPI’s basket

Pit= the price of good i in month t

Et = the cost of the CPI basket in month t

Eb = cost of the basket in the base period

The CPI is a weighted average of prices.

The weight on each price reflectsthat good’s relative

importance in the CPI’s basket.

Weights remain fixed over time.


prices of capital goods

          • included in GDP deflator (if produced domestically)
          • excluded from CPI
  • prices of imported consumer goods
          • included in CPI
          • excluded from GDP deflator
  • the basket of goods
          • CPI: fixed
          • GDP deflator: changes every year

CPI vs. GDP deflator



working at a paid job


not employed but looking for a job

labor force

the amount of labor available for producinggoods and services;

allemployed plusunemployed persons

Labor Force = Employed +Unemployed

not in the labor force

not employed, not looking for work.

Not in The Labor Force= Population – Labor Force

Measuring Unemployment:

Categories of the population


Unemployment Rate = Number of Unemployed

Labor Force

 100

LaborForce Participation Rate = Labor Force

Adult Population

 100

unemployment rate

percentage of the labor force that isunemployed

labor force participation rate

the fraction of the adult populationthat ‘participates’ in the labor force

Two important labor force concepts


Number employed = 146.1 million

Number unemployed = 6.9 million

Adult population = 231.7 million

Labor Force = 146.1 + 6.9 = 153.0

Not in The Labor Force= 231.7 – 153 = 78.7

Unemployment Rate= (6.9/153) x 100% = 4.5%

LaborForce Participation Rate = (153.0/231.7)x100 %= 66 %

Practice problem


A stock is aquantity measuredat a point in time.

A flow is a quantity measured per unit of time.

Stock Flow

a person’s wealth a person’s annual saving

# of people with college degrees # of new college graduates this year

the government debt the government budget deficit

Stock Variables vs Flow variables


Gross domestic product (GDP)

Consumer Price Index (CPI)

Unemployment rate

National income accounting

Stocks and flows

Value added

Imputed value

Nominal versus real GDP

GDP deflator

National income accounts identity



Government purchases

Net exports

Labor force

Labor-force participation rate

Key Concepts of Chapter 2


Measuring GDP using the Income Approach and the Expenditure Approach

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