Measuring the size of the economy

Measuring the size of the economy

Key concepts

•Gross Domestic Product (GDP)

•Further on measuring GDP

•The expenditure approach

•GDP shortcomings as a measure of economic welfare

•Other national accounts

•Relationship between community (national) saving and investment

•Changing nominal GDP to real GDP

Gross domestic product (GDP)

What does GDP include?

Value Added

•GDP also can be used to measure how much value each stage of production adds to the overall price of the final good or service.

•The following slide shows how the $420 sale price of a wool suit is split up overs its stages of production.

 Non-productive financial transactions

•GDP does not count transactions such as giving gifts, stocks and/or bonds, or making transfer payments.

•Transfer payments are government payments to individuals, not in exchange for goods or services currently produced, for example:

–pensions

–job search allowance.

GDP and the whole economy

•GDP counts the value of production in all markets for products, resources, consumers, workers and businesses.

•The circular flow model shows how we can think of all the economy’s sectors in one ‘whole’.

The circular flow model

•The upper half of the diagram represents product markets.

•There is a flow of money between households and businesses.

•In a market without government interference, the forces of demand and supply determine the price and quantity of products exchanged.

•The lower half of the diagram represents factor markets.

•There is a flow of money between businesses and households.

•Firms demand productive resources (factors) from households, and make factor payments in return, for example, wages for labour.

Flow versus stock

•Flow is a rate of change in a quantity during a given time period, for example:

–weekly consumption spending

–annual income.

•Stock is a quantity measured at one point in time, for example:

–the amount of money in a bank account.

•All measurements in the circular flow model are flows.

A four-sector circular
flow model

•Most household income is spent on domestic goods. However:

–part of household income is saved

–part of household income is taxed

–part is spent on goods from overseas (imports).

•These parts are called leakages from the main flow.

•An injection is spending that comes into the circular flow from any of the following:

–firms investing in new plants and equipment

–government spends on consumption and capital items

–foreigners purchasing exports.

The circular flow
model of an open economy

Approaches to measuring GDP

•The expenditure approach to measuring GDP adds all spending for final goods during a period of time.

•The income approach to measuring GDP adds the incomes of all factors of production

•Both approaches should yield the same result.

The expenditure approach

Household consumption expenditures (C)

•The largest component of GDP in any year (about 60% of GDP) is household consumption expenditures.

•GDPC is made up of spending on:

–services (education, medical visits, haircuts etc.)

–durable goods (cars, appliances, furniture)

–non-durable goods (food, clothing, petrol).

Gross private domestic investment (I)

•Spending that maintains or increases the stock of capital equipment in the economy.

•GPDI is the sum of:

–fixed investment for newly produced capital goods

–changes in business inventories (unsold finished goods and raw materials).

Gross private domestic investment (I) (cont.)

•Expenditure on new housing is classified as investment – it provides services over time into the future, which the owner could choose to rent out for financial return.

•Cars are an investment if purchased by the business sector but consumption when purchased by the household sector. 

Note on the definition of investment

•Investment refers to spending on physical products that are intended to be used as inputs in the production process.

•This is very different to the everyday usage of the term, which refers to transfer of financial assets from one person to another.

Government consumption & gross public investment expenditures (G)

•Includes government spending on current goods – the salaries of its workers and the inputs it consumes in government departments.

•It also includes spending on investment goods (often called infrastructure) such as highways, buildings and bridges.

•GDPG does not include transfer payments from one level of government to another.

NET EXPORTS (X – M)

•Exports (X) are expenditures by foreigners on domestically produced goods and services.

•Imports (M) are the dollar amount of a nation’s purchases from producers in other countries.

GDP IN OTHER COUNTRIES

GDP SHORTCOMINGS AS A MEASURE OF ECONOMIC WELFARE

•GDP is seen as not being able to fully measure issues of economic welfare:

–non-market transactions

–distribution, kind and quality of products

–neglect of leisure time

–the underground economy

–economic negatives such as pollution etc.

•It is a quantitative, rather than qualitative, measure of output.

Other national accounts

•Net domestic product (NDP) which removes depreciation of plant and equipment from the GDP calculation

•Net national product (NNP)  then removes the interest and dividends paid to overseas investors from the NDP.

Relationship between community (national) saving & investment

•Households decide how much to save, while businesses decide how much they wish to invest in capital equipment.

•Total household saving may not always equal desired investment.

•In a simple economy, potential investment is limited by actual saving.

Relationship between community (national) saving & investment 

•In an open economy, the rest of the world can contribute some of its saving to another country’s investment pool (foreign investment).

•If investment in a period exceeds savings, the country has a current account deficit (CAD).

Financing the current account deficit (CAD)

•To finance the CAD, a country could:

–incur debts to foreigners

–provide them with a share of the ownership of productive factors.

•These flows are recorded in the capital account in the balance of payments.

•In theory, a CAD must be exactly offset by a capital account surplus (KAS).

CHANGING NOMINAL GDP
TO REAL GDP

•Nominal GDP is the value of all final goods and services based on the prices existing during the time period of production.

•Nominal GDP grows over time as a result of:

–increases in the output level

–general prices.

Real GDP

•It is necessary to adjust nominal GDP so it only reflects changes in output.

•Real GDP is the value of all final goods produced during a given time period based on the prices existing in a selected base year.

•It is also referred to as constant-dollar GDP.

The GDP chain price index

•The GDP implicit price deflator index is a measure that compares changes in the prices of all final goods during a given period to the prices of those goods in a base year.

        Real GDP =   Nominal GDP x 100

  GDP implicit price deflator index

TRACKING real GDP

•Nominal GDP grows faster than real GDP because it includes price level changes.

•Real GDP is the preferred method of analysis for GDP as it allows comparisons.

TRACKING real GDP