ECO302:

Spring 2021
Intermediate Macroeconomic Theory I

Chapter-2: Introduction to Macroeconomics

Charles I. Jones Chapter1

Instructor: Biplob Nandi

East West University
LECTURE OUTLINE

 National Income Accounting: The

Measurement of Production, Income,
and Expenditure
 Gross Domestic Product
 Real GDP, Price Indexes, and Inflation
MEASURING THE STATE OF THE ECONOMY
 Gross domestic product (GDP)
The market value of the final goods and services produced in an
economy over a certain period.
 Bangladesh GDP in 2018-2019
• 129.68 billion (constant 2005-06 USD) (BBS)
• Growth rate – 8.15% (BBS)
• Tk. 25425 billion (about $303 billion) at current price (BBS)
• Tk. 10,897 billion at constant market price (base year 2005-06)
(BBS)
 Per capita GDP at current market prices in 2018-2019 is
Tk.153,578 or $1828 (BBS)
NATIONAL INCOME ACCOUNTING

 Gross Domestic Product measures the total value

of production in an economy in a year

 Everything produced must be purchased (or be

placed in an inventory), that is, bought and sold

 Therefore, total production equals total

expenditures equals total income
NATIONAL INCOME ACCOUNTING

 An example
 Homer and Marge own a tangerine farm with workers
 Production: In 2019, their workers picked 100 tangerines
whose market value was $1 per tangerine
 Expenditure: In 2019, their fruit stand sold 100 tangerines
at $1 per tangerine
 Income: In 2019, Homer and Marge netted a profit of $33
while their workers earned $67
 Measured each way, GDP for the farm is $100 in 2019
 NATIONAL INCOME ACCOUNTING
Three alternative approaches to measure GDP
Production measure of GDP (Product approach): the
amount of output produced
Income approach: the incomes generated by
production
Expenditure approach: the amount of spending by
purchasers
All three approaches give identical measures of GDP,
that is, Production = Expenditure = Income
NATIONAL INCOME ACCOUNTING
NATIONAL INCOME ACCOUNTING

 Juice business example shows that all

three approaches are equal – Important
concept in product approach:
value added = value of output minus value of
inputs purchased from other producers
NATIONAL INCOME ACCOUNTING
 Why are the three approaches equivalent?
– They must be, by definition
– Any output produced (product approach) is purchased by someone
(expenditure approach) and results in income to someone (income
approach)
– The fundamental identity of national income accounting:
total production = total income = total
expenditure
 The national income accounting identity states:
Y=C+I+G+NX
Where Y=GDP, C=Consumption, I=Investment, G=Government
purchase, NX=Net export=Export-Import.
NATIONAL INCOME ACCOUNTING
 The income approach
Measures the sum of all income earned in the economy.
 Capital
• Inputs into production other than labor that are not used
up in the production process.
• Firms increase capital through investment.
 Depreciation
• The deterioration of the capital stock due to wear and
tear.
 GDP – depreciation = net domestic product.
 NATIONAL INCOME ACCOUNTING
 GDP is “value added”
• The macro-economy is filled with many interdependent
consumers and firms, not just one Homer and Marge, Inc.
• When measuring the total value of production, it is vital
not to double
count by mistreating the value of intermediate production;
You
must either count only final goods OR value added
 Example:
• A steel company produces $10 million worth of steel
• A car company buys it and produces $100 million in cars
• Total GDP is $100 million: either the $100 million in final goods (the
cars) or the $10 million in steel produced plus the value added by the
car company, which is 100 – 10 = $90 million
 NATIONAL INCOME ACCOUNTING
 Total shares of GDP to inputs for the US
economy
• Share of GDP to Labor: two-thirds
• Share of GDP to Capital: one-third.
• Labor’s share of GDP has remained approximately
constant over time.
WHAT IS INCLUDED IN GDP AND WHAT’S NOT?
 The product approach to measuring GDP
– GDP (gross domestic product) is the market value of
final goods and services newly produced within a nation
during a fixed period of time

 This definition identifies 4 important aspects of GDP:

1. Market value
2. Newly produced, i.e., produced in a given time period
3. Final goods and services
4. Produced within a country
 WHAT IS INCLUDED IN GDP AND WHAT’S NOT?

 Market value: allows adding together unlike items by valuing them

at their market
prices
– Problem: misses nonmarket items such as homemaking, the value of
environmental
quality, and natural resource depletion
– There is some adjustment to reflect the underground economy
– Government services (that aren’t sold in markets) are valued at their
cost of production

 Newly produced: counts only things produced in the given period;

excludes things produced earlier
 WHAT IS INCLUDED IN GDP AND WHAT’S NOT?

Final goods and services:

– Don’t count intermediate goods and services (those used up in the production of
other goods and services in the same period that they themselves were produced)
– Final goods & services are those that are not intermediate
– Capital goods (goods used to produce other goods) are final goods since
they aren’t used up in the same period that they are produced
Produced within a country: GDP measures production within a country—
domestic production
GDP does not include:
– Government transfer payments to individuals.
• Old age pension skim, relief following natural disasters, etc.
– A measure of the health of a nation’s people.
– Changes in environmental resources.
GROSS DOMESTIC PRODUCT
 GNP vs. GDP
– GNP (gross national product) = output produced
by domestically owned
factors of production
– GDP = output produced within a nation
– GDP = GNP – NFP
– NFP = net factor payments from abroad
= payments to domestically owned factors located abroad
minus payments to foreign factors located domestically
 GROSS DOMESTIC PRODUCT
GNP vs. GDP
– Example: Engineering revenues for a road built by a
U.S. company in Saudi Arabia is part of U.S. GNP
(built by a U.S. factor of production), not U.S. GDP,
and is part of Saudi GDP (built in Saudi Arabia), not
Saudi GNP
– Difference between GNP and GDP is small for the
United States, about 0.2%, but higher for countries
that have many citizens working abroad
EXPENDITURE APPROACH TO MEASURING REAL
GDP IN BANGLADESH, 2018-19 (BASE YEAR 2005-
06)

GDP Components: Billion Taka % of GDP

Consumption 6904.459 63.36
Investment 3734.96 34.27
Govt. Purchase 634.566 5.82
Exports 1724.225 15.82
Imports 2101.155 19.28
GDP 10,897 100
Net factor income from abroad 494.118 4.53
GNI 11,391 104.53
Note: Statistical discrepancies are ignored in this table.
Source: BBS, 2020
MEASURING CHANGES OVER TIME
 Nominal GDP
– A measure of GDP when prices and
quantities have not been separated.

 Real GDP
– Actual quantity of goods and services.

 Nominal GDP = Price Level x Real GDP

A SIMPLE EXAMPLE: WHERE REAL GDP
DOESN’T CHANGE

 To compute GDP across time, we must use one

year’s price.
– Real GDP will be measured in a certain year’s dollars
– Nominal GDP is measured in current dollars.

 Consider Apples and Computers:

Nominal GDP = (current price of apples x quantity
of apples) + (current price of computers x
quantity of computers)
A SIMPLE EXAMPLE: WHERE REAL GDP
DOESN’T CHANGE
 If the quantity of goods and services produced
does not change, but prices do change
– Nominal GDP will change.
– Real GDP will not change.
 A SECOND EXAMPLE: WHERE REAL GDP
CHANGES
 The magnitude of the change in real GDP will depend on the
year’s prices we select to calculate real GDP.

 GDP in 2019 at 2019 price

GDP in 2020 at 2019 price

Growth rate = 18.3%

 A SECOND EXAMPLE: WHERE REAL GDP
CHANGES
GDP in 2019 at 2020 price

GDP in 2020 at 2020 price

Growth rate = 17.7%

The change in real GDP differs depending on the base year

REAL GDP, PRICE INDEXES, AND INFLATION
Chain-weighted RGDP: Problem with the fixed weighted
measure of RGDP:
1. Substitution Bias
2. Changes in base year leads to revisions
of historical growth rates
Problem: Chain-weighted real GDP does not
generally equal the sum of real consumption,
real investment, real government
expenditures, and real net exports
Real GDP, Price Indexes, and Inflation
REAL GDP, PRICE INDEXES, AND INFLATION
Chain-weighted RGDP:
REAL GDP, PRICE INDEXES, AND INFLATION
Main disadvantage of chain-weighted real GDP
measure
– 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.
REAL GDP, PRICE INDEXES, AND INFLATION
Price Indexes
– A price index measures the average level of prices for some
specified set
of goods and services, relative to the prices in a specified base
year
– GDP deflator = 100 x(nominal GDP/real GDP)
– Note that base year P = 100
REAL GDP, PRICE INDEXES, AND INFLATION

Price Indexes
– Consumer Price Index (CPI)
• Monthly index of consumer prices; index averages 100
in base period (2005-06 in Bangladesh)
• Based on basket of goods in expenditure in base
period (updated periodically)
HOW BBS CONSTRUCTS THE CPI
1. Collects price data of “basket” of goods from 140 (64
from urban, 64 from rural and 12 from Dhaka City
Corporation) main markets across the country.
2. The basket contains 151 food items as well as 271 non-
food items in urban areas, 133 food items as well as 185
non-food items in rural areas. The weights are
presented in the table in the next slide.
3. CPI in any month/year equals
100 × (Cost of the basket in current period /Cost of the
basket in base period)
UNDERSTANDING THE CPI

The CPI is a weighted average of prices. The weight on each price

reflects that good’s relative importance in the CPI’s basket. Note that
the weights remain fixed over time.
 WHY THE CPI MAY OVERSTATE INFLATION
Substitution bias:
The CPI uses fixed weights, so it cannot reflect consumers’ ability to
substitute toward
goods whose relative prices have fallen.
Introduction of new goods:
The introduction of new goods makes consumers better off and, in effect,
increases the real
value of the dollar. But it does not reduce the CPI, because the CPI uses fixed
weights.
Unmeasured changes in quality:
Quality improvements increase the value of the dollar, but are often not fully
measured.
Outlet bias when price rises, people may buy less from convenience store
and more from
supper market or discount store.
 REAL GDP, PRICE INDEXES, AND INFLATION
Price Indexes
– The computer revolution and chain-weighted GDP
• Choice of expenditure base period matters for GDP when
prices and quantities of a good, such as computers, are
changing rapidly
• BEA compromised by developing chain-weighted GDP
• Now, however, components of real GDP don’t add up to
real GDP, but discrepancy is usually small
REAL GDP, PRICE INDEXES, AND INFLATION
Price Indexes
– Inflation
Calculate inflation rate:
REAL GDP, PRICE INDEXES, AND INFLATION
Chain-weighted Price
Index: Similar approach applied