Introduction to Macroeconomics

Ch. 12: Gross Domestic Product

Goal of This Chapter
“U.S. Second-Quarter GDP Rose 3.1%”
“Canada GDP Stalls in February”
“China Premier Says GDP Growth Target Is around 6.5% for 2017”
“German GDP Grows at Fastest Rate in Five Years”

What is GDP? How is GDP measured?

• Goal: to figure out how to measure the total output of an economy.
• Being able to measure total output is incredibly important, since much of
macroeconomics depends on our ability to measure and predict aggregate economic
activity.
Chapter Outline
12.1 Gross Domestic Product Measures Total Production

12.2 Does GDP Measure What We Want It to Measure?

12.3 Real GDP versus Nominal GDP

12.4 Other Measures of Total Production and Total Income

12.1 Gross Domestic Product Measures Total
Production
Explain how total production is measured.

The most common measure used by economists of overall economic activity in an economy is
gross domestic product, or GDP.

Gross domestic product (GDP): the market value of all final goods and services produced in a
country during a period of time, typically one year.

We will examine each of the parts of this definition in turn.

“Market Value”
Gross domestic product: the market value of all final goods and services
produced in a country during a period of time, typically one year.

We cannot add together the number of cars, melons, haircuts, and all other
goods and services without agreeing on a common way to measure them.

The best practical way is to value each good and service in monetary terms,
and the best measure of this that we have is the price that each good or
service is sold for.
“Final Goods and Services”
Gross domestic product: the market value of all final goods and services
produced in a country during a period of time, typically one year.

A final good or service is a good or service purchased by a final user. These

are what are used to calculate GDP.
• Why? If we counted intermediate goods and services as well, ones that were inputs
into another good or service, such as a tire on a truck, then we would end up double
counting.

Example: If we counted the value of the ice cream bought by a store and also
counted the value of that ice cream when it was sold to a consumer, we
would be double counting the wholesale value of the ice cream.
“During a Period of Time”
Gross domestic product: the market value of all final goods and services produced
in a country during a period of time, typically one year.

To measure total output in a given year, we measure the goods and services
produced only in that given year.

• Again, this avoids double counting: if you buy a DVD in 2011, that DVD counts in
2011’s GDP. If you resell it in 2012, it will not count again in 2012.

• So GDP counts only new goods and services. Used items were previously
produced and counted, so don’t need to be counted again.
Numerical Example:
• Compute GDP for the following economy:

Product Quantity Price per unit ($)

Eye examinations 100 50
Pizzas 80 10
Shoes 20 100
Mozzarella Cheese 80 2
Production and Income
There are two main conceptual ways to measure the total economic activity
in an economy: total production or total income.

When we measure one, we are also measuring the other. Why?

• Everything that is produced and sold constitutes income for someone; so

we have the choice of measuring the value of products produced and sold,
or the value of incomes.

• Each is a valid way of measuring economic activity.

 Figure 12.1 The Circular Flow and the Measurement of GDP (1 of 4)

In a very simple model of the

economy, we could start with
households and firms.
To measure overall economic
activity, we could measure the
amount of money that
households spend on goods and
services.
Or we could measure income to
households.
 Figure 12.1 The Circular Flow and the Measurement of GDP (2 of 4)

Let’s add in some more layers.

We’ll start with government.
How does the government affect
economic activity?
• It takes in taxes from households
and firms.
• It uses those taxes to buy goods
and services, and to make
transfer payments—payments
to households for which the
government does not receive a
good or service in return.
 Figure 12.1 The Circular Flow and the Measurement of GDP (3 of 4)

Some economic activity

takes place between
households, firms, and the
rest of the world.
• Households buy goods
and services from firms
in other countries; these
are known as imports.
• Firms sell goods and
services to households in
other countries; these
are known as exports.
 Figure 12.1 The Circular Flow and the Measurement of GDP (4 of 4)

Finally, there are firms that

deal specifically in flows of
money; we label these
firms the financial system.
• Households elect not to
spend some of their
income and instead save
it with financial system
firms like banks.
• These financial system
firms lend money to
other firms and the
government.
Follow the Spending to Measure GDP
To measure GDP, economists measures four major categories of
expenditures:
• Personal consumption expenditures, or consumption (C)
• Gross private domestic investment, or investment (I)
• Government consumption and gross investment, or government purchases (G)
• Net exports of goods and services, or net exports (NX)

GDP can be expressed as the sum of these:

Y = C + I + G + NX
We will examine each component of GDP in turn.
Consumption
Y = C + I + G + NX
Consumption is spending by households on goods and services, not
including spending on new houses (which are counted instead in
investment).

Consumption is further divided into expenditure on

• Services, such as medical care, education, and haircuts
• Nondurable goods, such as food and clothing, and
• Durable goods, such as automobiles and furniture.
 Investment
Y = C + I + G + NX
Investment is spending by firms on new factories, office buildings, machinery,
and additions to inventories, plus spending by households and firms on new
houses.

Economists measures the following categories of investment:

• Business fixed investment, such as new factories, office buildings, machinery, and
research and development.
• Residential investment, i.e. new single-family and multi-unit houses.
• Changes in business inventories, i.e. goods that have been produced but not yet sold.

Note: in economics, “Investment” does not been buying stocks and bonds
etc., like it does in finance.
Government Purchases
Y = C + I + G + NX
Government purchases are spending by state, and local governments
on goods and services.

This includes both government consumption (like teachers’ salaries and

office supplies) and government investment (like highways and military
bases).
 Net Exports
Y = C + I + G + NX
Net exports are the value of exports minus the value of imports.
This difference might be positive or negative.

Since we want to count domestic production (production in Egypt),

we add up the value of the goods and services sold to foreigners and
subtract the value of the goods and services sold to Egyptians by
foreigners.
• An export is not counted otherwise (in C, I, or G) so we need to count it
somehow as production.
• An import is counted (in C, usually) but we are trying to measure domestic
production, so we don’t want to count it. Subtracting it off achieves this
goal.
12.2 Does GDP Measure What We Want It to Measure?
Discuss whether GDP is a good measure of well-being.

GDP can be a useful tool to measure total output in an economy. Many people go further than
this, interpreting GDP as a measure of the well-being of citizens.

However, GDP has shortcomings as both a

• Measure of total production and a
• Measure of well-being.
Shortcomings of GDP as a Measure of Total Production
Two important types of production are omitted from GDP measurement:
Household production such as childcare, cleaning, and cooking is not
typically paid for with money.
• But such contributions are real—if they were performed by a non-
household member, they would be paid for and counted in GDP.

Underground economy: Buying and selling of goods and services that is

concealed from the government to avoid taxes or regulations, or because
the goods and services are illegal.
• This may be 10 percent or more of the economy in the U.S. and
substantially more in low-income countries.
Shortcomings of GDP as a Measure of Well-Being
Even if GDP accurately measured total production, it would not reflect:
• The value of leisure

• Pollution and other negative effects of production

• Crime and other social problems

• The distribution of income

12.3 Real GDP versus Nominal GDP
Discuss the difference between real GDP and nominal GDP.

Suppose GDP increases; is the increase in GDP due to production increasing, or due to prices increasing?
• To separate these effects, economists calculate both Nominal GDP—the value of final goods and
services evaluated at current-year prices—and Real GDP—the value of final goods and services
evaluated at base-year prices.

The choice of a base-year is arbitrary; we might use any year’s prices to compare real GDP.
Calculating Real GDP: An Example
Blank 2009 Blank 2019 Blank
Product Quantity Price Quantity Price
Eye examinations 80 $40 100 $50
Pizzas 90 11 80 10
Shoes 15 90 20 100
GDP $5,540 $7,800

The table shows output and prices in 2009 (base year) and 2019.
• Calculating the total value of output in 2009 gives:
$3,200 + $990 + $1,350 = $5,540.
To calculate real GDP in 2019, we use the prices from 2009.
• This gives real 2019 GDP in 2009 dollars of $6,680.
• Compare this to nominal GDP in 2019 of $7,800.
The GDP Deflator
Economists and policy-makers are interested in the price level: a measure of the average prices of
goods and services in the economy.
• Why? Stable prices are desirable because they allow households and firms to plan for the future
appropriately.
In order to know whether we are achieving price stability, we need to measure the price level.
• One way to do this is using the GDP deflator: a measure of the price level, calculated by dividing
nominal GDP by real GDP and multiplying by 100:

Nominal GDP
GDP deflator = 100
Real GDP

Since nominal and real GDP will be the same in the base year, the GDP deflator will be 100 in the
base year.
Calculating GDP Deflator: An Example
Blank 2015 2016
Nominal GDP $18,037 billion $18,569 billion
Real GDP $16,397 billion $16,662 billion

Formula Applied to 2015 Applied to 2016

 Nominal GDP   $18,037 billion   $18,569 billion 
GDP deflator =   ×100    100 = 110.0    100 = 111.4
 Real GDP   $16,397 billion   $16,662 billio n 

The first table gives nominal and real GDP for 2015 and 2016.
We can use this to calculate the GDP deflator in each year.
• The GDP deflator increased from 110.0 to 111.4:
 111.4 − 110.0 
   100 = 1.3%
 110.0 

So we can say the price level rose by 1.3% over this period.
Data sources
• Egyptian Ministry of Planning and Economic Development
• National Accounts Data: https://mped.gov.eg/Analytics?id=61&lang=en

• Central Bank of Egypt:

• https://www.cbe.org.eg/en/EconomicResearch/Statistics/Pages/TimeSeries.aspx

• The World Bank – World Development Indicators

• https://databank.worldbank.org/reports.aspx?source=2

• The International Monetary Fund – International Financial Statistics

• https://data.imf.org/?sk=4C514D48-B6BA-49ED-8AB9-52B0C1A0179B