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Introduction to Economics
(Code 102341) Universitat Aut`onoma de Barcelona Bannikova Marina, Fall 2017
Theme 7. Aggregate Magnitudes.
Objective: To introduce fundamental economic aggregates and its measure. Learn how gross domestic product (GDP) and consumer price index (CPI) are defined and calculated. Learn about how to measure unemployment.
7.1 Measuring a Nations Income
Gross domestic product (GDP) the market value of all final goods and services produced within a country in a given period of time.
Pay attention:
- It is measured in market prices, because market prices measure the amount people are willing to pay for different goods, they reflect the value of those goods.
- It includes all items produced in the economy and sold legally in markets. For instance, GDP is based on the assumption that the owner is renting the house to himself. Therefore, even if he lives there himself, the market value of renting of this house is included into GDP. GDP excludes most items produced and sold illicitly, such as illegal drugs. And it excludes the products of self-consumption (the vegetables that you grow in your garden for your consumption.
- GDP includes only the value of final goods. This is done because the value of intermediate goods is already included in the prices of the final goods. Adding the market value of the paper to the market value of the card would be double counting. That is, it would (incorrectly) count the paper twice. An important exception to this principle arises when an intermediate good is produced and, rather than being used, is added to a firms inventory of goods for use or sale at a later date. In this case, the intermediate good is taken to be final for the moment and its value as inventory investment is included as part of GDP
- GDP includes both tangible goods (food, clothing, cars) and intangible services (haircuts, housecleaning, doctor visits).
- GDP includes goods and services currently produced. It does not include transactions involv- ing items produced in the past. (No second-hand market).
- GDP measures the value of production within the geographic confines of a country.
- GDP measures the value of production that takes place within a specific interval of time. Usually, that interval is a year or a quarter (three months). G
Is GDP a Good Measure of Economic Well-Being? - The answer is No. Why is it so:
- GDP does not measure the level of life (though a large GDP does in fact help us to lead good lives.
- GDP does not measure the healthcare (though nations with larger GDP can afford better healthcare).
- GDP does not measure the quality of education (though nations with larger GDP can afford better educational systems).
- Because GDP uses market prices to value goods and services, it excludes the value of almost all activity that takes place outside markets.
- GDP excludes is the quality of the environment.
There are three ways to measure the GDP:
- Expenditure approach (Demand method)
- Income approach
- Value added approach (Supply method)
7.1.1 Expenditure approach.
GDP (which we denote as Y) is divided into four components: consumption (C), investment (I), government purchases (G), and net exports (NX):
Y = C + I + G + N X
Consumption (C) is spending by households on goods and services, with the exception of pur- chases of new housing. Goods include durable goods, such as automobiles and appliances, and nondurable goods, such as food and clothing. Services include such intangible items as haircuts and medical care. Household spending on education is also included in consumption of services (although one might argue that it would fit better in the next component).
Investment (I) is the purchase of goods that will be used in the future to produce more goods and services. It is the sum of purchases of capital equipment, inventories, and structures. Investment in structures includes expenditure on new housing. By convention, the purchase of a new house is the one form of household spending categorized as investment rather than consumption.
Government purchases (G) include spending on goods and services by local, state, and federal governments. It includes the salaries of government workers as well as expenditures on public works.
Net exports (NX) equal the foreign purchases of domestically produced goods ( exports) minus the domestic purchases of foreign goods (imports). The net in net exports refers to the fact that imports are subtracted from exports. This subtraction is made because other components of GDP include imports of goods and services.
Real GDP is the total value of all final goods and services produced in the economy during a given year, calculated using the prices of a selected base year.
Nominal GDP is the value of all final goods and services produced in the economy during a given year, calculated using the prices current in the year in which the output is produced.
Example. Next table shows some data for an economy that produces only two goods: hot dogs and hamburgers. The table shows the prices and quantities produced of the two goods in the years 2013, 2014, and 2015.
Year Price of hot dogs Quantity of hot dogs Price of hamburgers Quantity of hamburgers 2013 1 100 2 50 2014 2 150 3 100 2015 3 200 4 150
To compute total spending in this economy, we would multiply the quantities of hot dogs and hamburgers by their prices. In the year 2013, 100 hot dogs are sold at a price of 1 per hot dog, so expenditure on hot dogs equals 100. In the same year, 50 hamburgers are sold for 2 per hamburger, so expenditure on hamburgers also equals 100. Total expenditure in the economy - the sum of expenditure on hot dogs and expenditure on hamburgers is 200. This amount, the production of goods and services valued at current prices, is called nominal GDP.
GDP (^) N^2013 = 1 · 100 + 2 · 50 = 200
GDP (^) N^2014 = 2 · 150 + 3 · 100 = 600
GDP (^) N^2015 = 3 · 200 + 4 · 150 = 1200
We can calculate the nominal growth:
γ^2014 N =
GDP N^2014 − GDP N^2013
GDP N^2013
γ^2014 N =
GDP N^2015 − GDP N^2014
GDP N^2014
Part of this rise is attributable to the increase in the quantities of hot dogs and hamburgers, and part is attributable to the increase in the prices of hot dogs and hamburgers.
(1) Growth due to the increase of production not prices
To obtain a measure of the amount produced that is not affected by changes in prices, we use real GDP, which is the production of goods and services valued at constant prices. We calculate real GDP by first designating one year as a base year. We then use the prices of hot dogs and hamburgers in the base year to compute the value of goods and services in all the years. In other words, the prices in the base year provide the basis for comparing quantities in different years. Suppose that we choose 2013 to be the base year in our example. We can then use the prices of hot dogs and hamburgers in 2013 to compute the value of goods and services produced in 2013, 2014, and 2015:
GDP (^) R^2013 = 1 · 100 + 2 · 50 = 200
GDP (^) R^2014 = 1 · 150 + 2 · 100 = 350
GDP (^) R^2015 = 1 · 200 + 2 · 150 = 500
The real growth rate shows by how much the real GDP has increased (decreased), that is what was the increase due to the increase in quantity of production:
γ^2014 R =
GDP R^2014 − GDP R^2013
GDP R^2013
γ^2014 R =
GDP R^2015 − GDP R^2014
GDP R^2014
(2) Growth of Nominal GDP due to the increase of prices:
GIven both real and nominal GDP, we can compute a GDP deflator, which reflects the change in the prices of goods and services. It is a measure of the level of prices of all new, domestically produced, final goods and services in an economy. The GDP deflator is calculated as follows:
D 2013 =
GDP N^2013
GDP R^2013
D 2014 =
GDP N^2014
GDP R^2014
D 2015 =
GDP N^2015
GDP R^2015
Because nominal GDP and real GDP must be the same in the base year, the GDP deflator for the base year always equals 100.
Given the deflators we can compute the inflation rate (with the respect to the base year 2013!):
π 2014 =
D 2014 − D 2013
D 2013
π 2015 =
D 2015 − D 2014
D 2014
7.3 Other measures of income
Net Domestic Product (NDP). As a measure of total output, GDP does not make allowances for replacing the capital goods used up in each years production. As a result, it does not tell us how much new output was available for consumption and for additions to the stock of capital. To determine that, we must subtract from GDP the capital that was consumed in producing the GDP and that had to be replaced. That is, we need to subtract consumption of fixed capital (depreciation) from GDP. The result is a measure of net domestic product (NDP) :
N DP = GDP − Depriciation
NDP is simply GDP adjusted for depreciation. It measures the total annual output that the entire economy households, businesses, government, and foreigners can consume without impairing its capacity to produce in ensuing years.
National Income (NI). Is the total income earned by a nations residents in the production of goods and services.
- Compute the inflation rate. Use the consumer price index to calculate the inflation rate, which is the percentage change in the price index from the preceding period. That is, the inflation rate between two consecutive years is computed as follows:
πyear t =
CP It − CP I 0 CP I 0
FYI
Currently in Spain the base year for calculating the CPI is 2016. Before it was 2011. What has changed in these years? In 2011 in the basket of the consumer were included the portable hard drives and were excluded CD-R (RW) and renting films. In 2016, for instance, in the basket of the consumer were included on-line TV services, table games and monodose coffees. It were excluded video cameras, DVD-R and Brandy
7.4.1 Problems in Measuring the Cost of Living
The consumer price index, however, is not a perfect measure of the cost of living. Three problems with the index are widely acknowledged but difficult to solve.
- The first problem is called substitution bias. When prices change from one year to the next, they do not all change proportionately: Some prices rise more than others. Consumers respond to these differing price changes by buying less of the goods whose prices have risen by relatively large amounts and by buying more of the goods whose prices have risen less or perhaps even have fallen. That is, consumers substitute toward goods that have become relatively less expensive. If a price index is computed assuming a fixed basket of goods, it ignores the possibility of consumer substitution and, therefore, overstates the increase in the cost of living from one year to the next.
- The second problem with the consumer price index is the introduction of new goods. When a new good is introduced, consumers have more variety from which to choose, and this in turn reduces the cost of maintaining the same level of economic well-being.
- The third problem with the consumer price index is unmeasured quality change. If the quality of a good deteriorates from one year to the next while its price remains the same.
7.4.2 The GDP Deflator versus the Consumer Price Index
From the first glance, both of them measure the same thing. Then why the results can be different?
The first difference is that the GDP deflator reflects the prices of all goods and services produced domestically, whereas the consumer price index reflects the prices of all goods and services bought by consumers.
The second and subtler difference between the GDP deflator and the consumer price index con cerns how various prices are weighted to yield a single number for the overall level of prices. The consumer price index compares the price of a fixed basket of goods and services to the price of the
basket in the base year. By contrast, the GDP deflator compares the price of currently produced goods and services to the price of the same goods and services in the base year.
7.5 National accounts: some important identities
Recall that GDP is both total income in an economy and the total expenditure on the economys output of goods and services. GDP (denoted as Y) is divided into four components of expenditure: consumption (C), investment (I), government purchases (G), and net exports (NX). We write
Y = C + I + G + N X
7.5.1 Closed economy
We simplify our analysis by assuming that the economy we are examining is closed. A closed economy is one that does not interact with other economies. In particular, a closed economy does not engage in international trade in goods and services, nor does it engage in international borrowing and lending. Actual economies are open economies that is, they interact with other economies around the world. Nonetheless, assuming a closed economy is a useful simplification with which we can learn some lessons that apply to all economies. Moreover, this assumption applies perfectly to the world economy (for interplanetary trade is not yet common).
Because a closed economy does not engage in international trade, imports and exports are exactly zero. Therefore, net exports (NX) are also zero. In this case, we can write
Y = C + I + G
This equation states that GDP is the sum of consumption, investment, and government purchases. Each unit of output sold in a closed economy is consumed, invested, or bought by the government.
From this equation:
I = Y − C − G
Note that Y − C − G is the total income in the economy that remains after paying for consumption and government purchases: This amount is called national saving, or just saving, and is denoted by S. Substituting S for Y − C − G, we can write the last equation as
S = I
The equation S = I reveals an important fact: For the economy as a whole, saving must be equal to investment. The financial system guarantees the fulfilment of this equation: the bond market, the stock market, banks, mutual funds, and other financial markets and intermediaries stand between the two sides of the S 5 I equation. They take in the nations saving and direct it to the nations investment.
As the next step to understand the meaning of national saving, it is helpful to manipulate the definition a bit more. Let T denote the amount that the government collects from households in
government spendings (G). Revenues minus spendings results in the public savings:
S(G) = T − G − T R
The disposable income of the households is the income Y minus the taxes plus the transfers of the state.
Y d = Y − T + T R
Respectively the disposable income can only be used for saving or for consumption.
Y d = C + S(P )
Therefore the private savings in this model equal the disposable income of the households minus consumption.
S(P ) = Y d − C
By this equation the private savings can be written as:
S(P ) = Y − T + T R − C
And the national accounts as:
Y = S(P ) + C + T − T R
where S(P ) + C = Y d is disposable income.
Once this equation is used in Y = C + I + G + X − M we get:
C + I + G + (X − M ) = S(P ) + C + T − T R
In one transformation we get the determination of net exports and investments by private and public savings
S(P ) + S(G) = I + (X − M )
Note that if public savings are negative, then we may write DP = −S(G). Thus,
S(P ) = I + N X + DP
7.6 Unemployment and its natural rate. The flows in the labour market.
Labour force is the total number of workers, including both the employed and the unemployed
Unemployment rate the percentage of the labour force that is unemployed
Unemployment rate =
Number of unemployed Labour force
Frictional unemployment consisting of search unemployment and wait unemployment for workers who are either searching for jobs or waiting to take jobs in the near future. The word frictional implies that the labor market does not operate perfectly and instantaneously (without friction) in matching workers and jobs.
Structural Unemployment. Changes over time in consumer demand and in technology alter the structure of the total demand for labor, both occupationally and geographically. Unemployment results because the composition of the labor force does not respond immediately or completely to the new structure of job opportunities. Workers who find that their skills and experience have become obsolete or unneeded thus find that they have no marketable talents. They are structurally unemployed until they adapt or develop skills that employers want.
The key difference is that frictionally unemployed workers have salable skills and either live in areas where jobs exist or are able to move to areas where they do. Structurally unemployed workers find it hard to obtain new jobs without retraining, gaining additional education, or relocating. Frictional unemployment is short-term; structural unemployment is more likely to be long-term and consequently more serious.
Unemployment that is caused by a decline in total spending is called cyclical unemployment and typically begins in the recession phase of the business cycle. As the demand for goods and services decreases, employment falls and unemployment rises. Cyclical unemployment results from insufficient demand for goods and services. Cyclical unemployment is a very serious problem when it occurs. We will say more about its high costs later, but first we need to define full employment.
