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MTSU Econ 3510 - Chapter 2

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Stuart Fowler

on 20 January 2016

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Transcript of MTSU Econ 3510 - Chapter 2

Chapter 2, Measurement
Nominal GDP
Real GDP and Price Indices
Savings, Wealth, and the Labor Market
Def: Nominal gross domestic product (GDP) is the current value of all goods and services produced by a country in a given time period.

Rule: It is true that GDP also equals (ii) total income of the agents in the country and (iii) expenditures on goods and services produced by a country in a given time period.

That is:

GDP := Output = Income = Expenditures
We want to measure GDP because it approximates welfare!

That is, most countries that have high GDP, also have high standards of living, good health care, well educated, long life expectancy, ....etc.

Thus, economists use GDP to measure the health of the economy and the welfare of those in it.
Note: GDP sometimes fails to approximate welfare:

Doesn't account for the distribution of income (bill gates moves to Cuba, GDP should go up but not welfare.
GDP assigns no value to leisure time
GDP assigns no value to freedoms

Q: Why then use GDP to compute welfare?
Proof to follow later
Computing Nominal GDP
Generally, there are three main approachs to compute GDP:

Product approach
Expenditure approach
Income aproach

Consider the example from book of a fictional island economy that produces coconuts and restaurant products from coconuts. There are also consumers and a govt.
Product
Expenditure
Income
Def: GDP is computed as the sum of all goods and services produced:
GDP = P1*Q1+P2*Q2+P3*Q3+ .....

However, this will can lead to 5 main problems and must be modified:

1: (double counting problem) Notice that the coconut soup includes the value of the coconuts bought by the restaurant. Thus, using the formula above, we would count the coconut twice: GDP does not equal 50 (20 + 30)
Solution: Only count the value added (in terms of goods) of each producer.
EX: value added of coconut producer = $20
value added of restaurant = 18 (30-12)
2: (gov't counting problem) Notice that the gov't produced a good, defense. However, it was never sold on an open market. That makes it hard to find its value.
Solution: Count the defense, but value it based on cost to build. Unfortunately, this can lead to "The Simpsons" escalator to nowhere/monorail type situation.
3: (inventory investment problem) Suppose instead that the coconut producer put $10 of her $20 production into inventory. Her value added is still $20.
Solution: Count inventory investments as part value added.
4: (inventory divestment problem) Instead, the coconut producer picked $10 of coconuts. But she sold $20 because she took $10 coconuts out of inventory. Only $10 worth of coconuts are made however.
Solution: Don't count inventory divestments in value added. It was counted when it whent into inventory.
5: (capital investment problem) Instead, the coconut producer replants $10 of her $20 of produced coconuts. It will grow into a tree to be used later. Should it be subtracted out later?
Solution: Count capital investments the day that they are made. Do not subtract them out later.

6: (capital divestment) capital depreciation is the wear an tear of capital.
Solution: Subtract all capital depreciation from GDP
Def: GDP is computed by adding the expenditures on

ALL FINAL goods by households (C),
net investments by firms (I),
net investments and final goods by governments (G),
all goods and all investments exported less all goods and all investments imported (NX).

Def: a final good is not used in the production of other goods.
Def: an intermediate good is used up in the production of other goods.
Def: Net investments are= capital and inventory investments less capital and inventory divestments.
Q: What if the restaurant sold an imported coconut. Should we count it in GDP?

Q: What is GDP for the book example using the product approach?

Q: Acme Steel Co. produces 1000 tons of steel. Steel sells for $30 per ton. Acme pays wages of $10,000. Acme buys $15,000 worth of coal, which is needed to produce the steel. Acme pays $2,000 in taxes. Acme's contribution to GDP is?
Formula for expenditure approach:

GDP = C + I + G + NX

Q: What is GDP for the book example using the expenditure approach?

Q: Peabody Coal makes 100 tons of coal worth $1 per ton. Sells 50 tons to consumers and the rest to Acme. Acme Steel produces 100 tons of steel. Steel sells for $3 per ton. Acme puts 50 tons into inventory and sells the rest to a firm in Italy. What is GDP using both the product and expenditure approach?
Q: What are the after tax profits of the firm in the book example?

Q: What are the after tax compensation of the consumers in the book example?

Q: What is GDP for the book example using the income approach?
Q: Peabody Coal makes 100 tons of coal worth $1 per ton. Sells 50 tons to consumers and the rest to Acme. Acme Steel produces 110 tons of steel using 50 tons of coal from Peabody and another 20 tons imported from Canada. Steel sells for $3 per ton. Acme puts 50 tons into inventory and sells the rest to a firm in Italy. What is GDP using both the product and expenditure approach?
Def: GDP is computed by adding the incomes of

all after tax compensation of EMPLOYEES (wages, salaries, non gov't benefits), (do not include dividends or gov't benefits)
after tax profits of firms (both corporate and proprietors)
after tax rental income
after tax net interest income
all taxes from businesses and households (gov't income)

Def: after tax profits of a firm are found by:
pi = totalrevenue - compofemployees - interest - cost of inputs - taxes
GDP in the USA
GDP was first developed by Simon Kuznets for a US Congress report in 1934 (who immediately said not to use it as a measure for welfare).

Today, GDP is computed by the The Bureau of Economic Analysis (BEA at http://www.bea.gov/) that is an agency in the United States Department of Commerce (http://www.commerce.gov/)

A good article can be found at: http://www.bea.gov/about/pdf/jep_spring2008.pdf
In general, nominal GDP has been growing over time.
Q: Do these graphs imply welfare is growing over time?

Maybe. Unfortunately, DGP may be going up due to inflation.

Def: Inflation is an increase in the price of goods from period 1 to period 2. The inflation rate is computed as the percentage change in the price of goods.
inflationrate = (P2 - P1)/P1

Def: Price index is used to compute the economy's inflation rate. The price index is a weighted average of a set of observed prices that gives a measure of the price level.
Def: Real GDP is GDP where price increases have been taken out. Likewise, real consumption, real investment, ... etc., is where price increase have been taken out.

There are two main methods to compute real GDP:
Deflator method
CPI method

Def: The deflator method (i) fixes a base year and uses only thoses prices to (ii) compute real GDP. Thus, prices have been held fixed. Then, the (iii) difference between nominal and real is inflation. This difference is (iv) used to compute the price level.

Def: The CPI method fixes a (i) base year and uses those quantities of goods purchased to (ii) compute the cost of that basket each year. Then, the (iii) increases in costs are computed for each year (this is the price level). Finally, the (iv) increases in costs are divided out of nominal to compute real GDP.
Year 1
Year 2
Q1
P1
Q2
P2
50 $1.00 100 $0.80
80 $1.25 120 $1.60
Nominal GDP
Real GDP
Q: Compute real GDP using the deflator method
Year 1
Year 2
Q1
P1
Q2
P2
50 $1.00 100 $0.80
80 $1.25 120 $1.60
Cost of basket
Increase in cost Relative to base
Q: Compute real GDP using the CPI method
Real GDP
The Price Level and Inflation
Two commonly used measures of the price level: (i) inplicit price delfator and (ii) the consumer price index (CPI).

Def: the implicit price deflator is:
GDP price deflator = Nominal GDP / Real GDP
Note: book multiplies by 100.

Def: the CPI is:
CPI = Cost of base year basket at current prices / cost of base year basket.
Note: book multiplies by 100.
Year 1
Year 2
Q1
P1
Q2
P2
50 $1.00 100 $0.80
80 $1.25 120 $1.60
GDP Deflator
CPI
Q: Compute Inflation using the Deflator and CPI
Inflation Deflator
Inflation CPI
Which to use?
Problems with the Deflator and CPI
The relative prices of goods change over time – a problem for CPI measurement.
The quality of goods and services changes over time.
New goods and services are introduced, and some goods and services become obsolete.
All the components of GDP, (consumption, investment, gov't spending, NX) are flows = a rate per unit of time. For example, consumption, and thus GDP, is measured in dollars spent per period.

Alternatively, the amount of inventories and capital are stocks (investment is the addition to the stock).

An important stock is national wealth.
In general, the following relationship will hold:
wealth(t) = wealth(t-1) + savings(t).

There are two forms of savings: domestic net capital investment and foreign net capital investment.

domestic net capital investment:
Non residential investment: Expenditures by firms for machines, tools and so on...
Residential Investment: Includes expenditures by households and firms on apartments, buildings, new factories,...
Change in inventories: The change of firm inventories in a given period. (Inventory: is the goods that are produced by firms but kept to be sold later).
Public investment: Roads, schools, ..
Less depriciation
foreign net capital investment:
current account surplus = net new claims on foreigners capital (net of domestic capital)
EX: Suppose that coconut island has 3 trees worth $5 in 2010. Its 2010 wealth is $15. Then, in 2011, it invests $10 in trees and $2 in coconut inventory.

Q: What is coconut island's savings for 2011?
Q: What is coconut island's end of 2011 wealth?

EX: In 2012, coconut island divest its $2 coconut inventory by new sales. Also, the island buys a tree on the island next door worth $5.

Q: What is coconut island's saving for 2012?
Q: What is coconut island's end of 2012 wealth?
Labor Market Measurement
A. Main Categories
Employed
Unemployed
Not in the Labor Force
B. The Unemployment Rate: number unemployes / labor force.
C. The Participation Rate: Labor force / total working age population
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