Chapter 2 - Measuring the Macroeconomy

Chapter 2: Measuring the Macroeconomy
Ryan W. Herzog
Spring 2021
Ryan W. Herzog (GU) Measurement Spring 2021 1 / 33

Outline
1 Calculating GDP
2 Measuring GDP over Time
3 Comparing Across Countries

GDP
In this chapter, we learn:
The importance of gross domestic product (GDP)
The composition of GDP and how it has changed over time.
How to use GDP to examine...
the evolution of living standards.
differences in living standards across countries.

GDP
Three methods of Measuring GDP
Production:
The number of goods produced in the economy.
Expenditure:
The total purchases in the economy.
Income:
All the income earned in the economy.
All three approaches give identical measures of GDP.
Production = Expenditure = Income

GDP
The Expenditure Approach to GDP
The national income accounting identity states:
Y = C + I + G + NX (1)
where:
Y = GDP (in dollars)
C = consumption
I = investment
G = government purchases
NX = net exports
Data are found through the Bureau of Economic Analysis

GDP
The Composition of US GDP, 1929-2015

GDP
Expenditure Shares of US GDP, 1970-2017

GDP
Investment
Business fixed investment (nonresidential): Spending by firms on
plants, machinery and equipment
Residential investment: Construction of new houses and apartment
buildings
Inventory investment: Changes in inventories (of final or
intermediate goods)

GDP
The Income Approach to GDP
Measures the sum of all income earned in the economy.
Capital income: includes inputs into production other than labor that
are not used up in the production process.
Labor income: includes wages and salaries to workers plus benefits
Depreciation:
The deterioration of the capital stock due to wear and tear.
GDP - depreciation = net domestic product.

GDP
Labor Shares of US GDP, 1950-2017

GDP
The Production Approach to GDP
There is no “double counting” in GDP; only the final sale of goods
and services count.
Value added is
the amount each producer contributes to GDP or
The revenue generated by each producer minus the value of
intermediate products.
Only new production of goods and services counts toward GDP.

GDP
What is Included in GDP and What’s Not
Only goods and services that are transacted through markets are
included in GDP.
GDP does not include:
Government transfer payments to individuals (Social Security,
Medicare, unemployment insurance)
A measure of the health of a nations people.
Changes in environmental resources.

Time
Nominal and Real GDP
Nominal GDP is a measure of GDP when prices and quantities have
not been separated
Real GDP is the actual quantity of goods and services
NGDP = Price × RGDP (2)

Time
A Simple Example: Where Real GDP Doesn’t Change
To compute GDP across time, we must use a constant price.
Real GDP will be measured using prices from a fixed year.
Nominal GDP is measured in current dollars.
Consider two goods Apples (a) and Computers (c)
NGDP = (Pricea × Quantitya) + (Pricec × Quantityc)
Now suppose in 2014, an apple costs $1, a computer costs $900 and
the economy produces 500 apples and 5 computers:
NGDP = ($1 × 500) + ($900 × 5) = $5000

Time
A Simple Example: Where Real GDP Doesn’t Change
Now suppose in 2015 the level of production remains the same but the
prices of apples increases to $2.00 and computers increase to $1,000.
NGDP = ($2 × 500) + ($1000 × 5) = $6000
.
Did the economy produce more goods?
To control for price changes we need to calculate real GDP. To do so
we pick a base year for prices (either 2014 or 2015) and hold prices
constant while calculating GDP.

Time
A Simple Example: Where Real GDP Does Change
Now suppose in 2016 the level of production for apples increases 550
and computers to 6 while prices of apples increase to $3 and
computers remain the same.
To calculate real GDP we must pick a base year for prices (we will
pick 2015)
RGDP2016 = ($2 × 550) + ($1000 × 6) = $7100
Did the economy produce more goods?
It is easy to see we produced more than 2014 and 2015. In fact
compared to 2015 we grew by:
7100
6000
− 1 = 0.18333
Does the base year matter?

Time
A Simple Example: Where Real GDP Does Change
What if we picked 2016 as the base year?
RGDP2016 = ($3 × 550) + ($1000 × 6) = $7650
RGDP2015 = ($3 × 500) + ($1000 × 5) = $6500
We can calculate the growth rate with 2016 as the base year:
7650
6500
− 1 = 0.1769
So yes, the growth rate does vary slightly depending on the base year.

Time
Quantity Indexes: Laspeyres, Paasche, and Chain
Weighting
Calculating real GDP changes over time:
The Laspeyres index calculates changes in real GDP using the initial
prices.
The Paasche index calculates changes in real GDP using the final year
prices.
Over long-time intervals the two indexes can result in substantial
differences

Time
The Fisher Index
The Fisher index (chain weighting) is the preferred approach to
calculating real GDP.
Average of the Laspeyres and Paasche index.
Preferred because new goods are invented while other goods become
obsolete. This makes early or even recent prices inaccurate.
Can be applied on a year-by-year basis if we compute real GDP each
year.

Time
Applying the Fisher Index
We must first calculate the Laspeyres and Paasche indexes (which we
have already done)
Then calculate the weighted average:
0.5 × (0.183 + 0.177) = 0.18
We can now work backwards to find the Real GDP in 2015 and 2014.
For 2015 we know the economy grew at 18% to $7,650 in 2016:
x × (1 + 0.180) = 7650 ⇒ x × 7650/1.180 = 6, 483
This is the real GDP for 2015 benchmarked to 2016 prices.

Time
Nominal and Real GDP for a Simple Economy, 2014-2016
Percent Change
2014 2015 2016 2015-2016
Quantity of Apples 500 500 550 10
Quantity of Computers 5 5 6 20
Price of Apples ($) 1 2 3 50
Price of Computers 900 1,000 1,000 0
Nominal GDP
Real GDP in 2014 prices
Real GDP in chained prices, 2016

Time
Percent Change
2014 2015 2016 2015-2016
Nominal GDP 5,000 6,000 7,650 27.5

Time
Percent Change
2014 2015 2016 2015-2016
Nominal GDP 5,000 6,000 7,650 27.5
Real GDP in 2014 prices 5,000 5,000 5,950 19

Time
Percent Change
2014 2015 2016 2015-2016
Nominal GDP 5,000 6,000 7,650 27.5
Real GDP in 2015 prices 6,000 6,000 7,100 18.3

Time
Percent Change
2014 2015 2016 2015-2016
Nominal GDP 5,000 6,000 7,650 27.5

Time
Percent Change
2014 2015 2016 2015-2016
Nominal GDP 5,000 6,000 7,650 27.5
Real GDP in chained prices, 2016 6,483 6,483 7,650 18.0

Time
Price Indexes and Inflation
Recall the formula for nominal GDP:
nominal GDP = Price Level × real GDP (3)
The GDP deflator is the price level that satisfies the equation.
We could compute this formula for two different years to calculate a
price change.
We could also use the following math trick:
%∆NGDP ≈ %∆pricelevel + %∆RGDP
The inflation rate is the percentage change in the price level.

Time
Example
From 2015-2016 the chain-weighted real GDP grew at 18%.
We computed the growth in nominal GDP during the same period as
27.5.
This means 27.5 − 18 = 9.5 will be inflation rate from 2015-2016.

Time
Using Chain-Weighted Data
Main reason for using chain-weighted data is because prices of
computers rapidly changing in 1990s.
Main disadvantage:
The sum of real C, I, G, NX will not equal real chain-weighted GDP
because the prices used in constructing the components are different.
General rule to follow:
For particular components of GDP, we look at the ratio of nominal
variables.
When you want real rates of economic growth, use the chain-weighted
real measures.

Comparing Across Countries
Comparing Economic Performance
We need to know the exchange rate (Price at which different
currencies are traded).
To make comparisons of GDP across countries we must take the
following steps:
GDP must be expressed in a common currency by first adjusting it by
the exchange rate.
This value of nominal GDP must be multiplied by the ratio of prices in
the countries.

Example: China and United States
Data:
US GDP: $13.7 trillion
China GDP: 26.4 trillion yuan
Exchange rate 7.6 yuan per dollar
First, use the exchange rate to convert Chinese yuan into USD:
26.4 yuan ×
$1
7.6 yuan
= $3.5 trillion
Adjust for relative price level of goods
Recall:
nominal GDP = Price Level × real GDP (4)

Relative Prices
We need China’s real GDP:
real GDPUS prices
China = price levelUS × real GDPChina (5)
We don’t know real GDP in China so:
real GDPUS prices
China = price levelUS ×
nominal GDPChina
price levelChina
(6)
real GDPUS prices
China =
price levelUS
price levelChina
× nominal GDPChina
To calculate real GDP in China we need the price level in China. On
average, goods in China cost 30 percent of the goods in the US so:
real GDPUS prices
China =
1
0.3
× 3.5 = $11.7

Comparing across Countries
In general, rich countries tend to have higher price levels than poor
countries.
This is mainly because poor countries have lower wages.

Chapter 2 - Measuring the Macroeconomy

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