Macroeconomic Theory Book Reference:

ECON2202.05 Jones – Chapter 2

Spring 2023 Measuring the Macroeconomy

2.1 Introduction
In this chapter, we will 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.
Introduction
National income accounting:
• Method of aggregating the production of diverse goods into a single
measure of overall economic activity

The data provided by national accounting can help us analyze

• contemporaneous economic status (snapshot at a given point in time),
• economic trends over time (picture of economic growth), and
• relative economic performance (cross-country).
2.2 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
• http://www.bea.gov/

United States GDP:

• $12.5 trillion in 2005
• $14.4 trillion in 2008 ($47,000 per person)
• $20.5 trillion in 2018 ($62,000 per person)
 Measuring the State of the Economy—1
2005 2006 2007 2008 U.S. GDP
14.4 7%
GDP 12.6 13.4 14.0 14.3
14.2
(in trillions 6%
of $) 14
13.8 5%
Growth 6.3% 4.5% 2.1%
rate GDP 13.6 4%
13.4
13.2 3%
13 2%
12.8
1%
12.6
12.4 0%
2005 2006 2007 2008
GDP (in trillions of $) Growth rate GDP
Measuring the State of the Economy—2
Production measure of GDP:
• The number of goods produced in the economy
Expenditure measure of GDP:
• Total purchases in the economy
Income measure of GDP:
• All income earned in the economy
All three approaches give identical measures of GDP:

Production Expenditures Income

The Expenditure Approach to GDP
The national income accounting identity states:

where:

• ! = GDP (in dollars)

• " = Consumption
• # = Investment
• $ = Government purchases (Notice: excludes transfer
payments, i.e. social security payments)
• %& = X – M = Exports – Imports
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)
Imports
• Why do Imports enter negatively in expenditure measure of GDP?
Y= C + I + G + X -M
+100 -100

• You subtract M because it is already included in C

Y= C + I + G + X -M
0= +100 -100
• GDP measures domestic production, while import is foreign
production: you subtract it from consumption to not count it
• More info: https://research.stlouisfed.org/publications/page1-
econ/2018/09/04/how-do-imports-affect-gdp
 Variables 2018 % of GDP Per Capita
Gross Domestic Product 20,580.20 100.00 62,794.60
Personal Consumption Expenditures ( C ) 13,998.70 68.02 42,713.03
Goods 4,364.80 21.21 13,317.94
Durable Goods 1,475.60 7.17 4,502.37
Nondurable goods 2,889.20 14.04 8,815.57
Services 9,633.90 46.81 29,395.09
Gross Private Domestic Investment ( I ) 3,628.30 17.63 11,070.72
Fixed Investment 3,573.60 17.36 10,903.82
Nonresidential 2,786.90 13.54 8,503.43
Structures 633.2 3.08 1,932.03
Equipment 1,222.60 5.94 3,730.41
Intellectual Property Products 931.1 4.52 2,840.99
Residential 786.7 3.82 2,400.39
Change in private inventories 54.7 0.27 166.90
Net Exports of Goods and Services ( NX) -638.2 -3.10 -1,947.28
Exports 2,510.30 12.20 7,659.46
Goods 1,661.30 8.07 5,068.98
Services 848.9 4.12 2,590.18
Imports 3,148.50 15.30 9,606.75
Goods 2,570.60 12.49 7,843.45
Services 577.9 2.81 1,763.30
Government Consumption Expenditures and Gross
Investment ( G ) 3,591.50 17.45 10,958.44
Federal 1,347.30 6.55 4,110.90
National Defense 793.6 3.86 2,421.44
Nondefense 553.7 2.69 1,689.46
State and Local 2,244.20 10.90 6,847.54
Source: Bureau of Economic Analysis
Notes: Billions of Dollars (per capita in dollars): Last Revised on: September 30, 2019
Expenditure Shares of U.S. GDP

• Consumption has increased; NX being significantly negative; Decline in government purchases.

• Trade deficits: U.S. consumers increase their consumption now at the expense of lower future consumption.
The Income Approach to GDP
The income approach
• Measures the sum of all income earned in the economy:
For every dollar of product sold there is a dollar of income earned

• Wages, salaries, employee benefits, proprietors’ income,

rental income of persons, royalties, corporate profits, net
interest (interest earned by individuals minus interest paid)
The Income Approach to U.S. GDP in 2018
Understanding Table 2.2
• Wages and Salaries + Benefits = Employees Compensation

• Net operating surplus of business = Profits or Normal Profits or

Accounting Profits

• Normal profits include the “competitive” returns on the

entrepreneurs’ own labor (i.e. the opportunity cost of being an
entrepreneur rather than doing another activity) and on capital.

• In other words, normal profits are the net income earned by the
entrepreneur after subtracting the dollar value of all explicit
costs from total revenue.
Understanding Table 2.2
• Normal profits differ from Economic Profits, the latter do not enter
GDP.

• Economic profits are the above normal returns associated with

non-competitive prices.

• Hence, if markets are competitive, economic theory predicts that

Economic profits are zero.

• Even in a competitive market with zero economic profits, normal

or accounting profits will typically be positive.
Understanding Table 2.2
Capital
• Inputs into production other than labor that are not used up in
the production process
• Increased by firms through investment

Depreciation: The deterioration of the capital stock due to wear and tear
Compensation/income for decrease in the value of capital

GDP – Depreciation = Net Domestic Product

Total Share of GDP to Inputs
Another way to look at the composition of income is to assign all
income to labor or capital (easier mapping to models)

Share of GDP to labor (“labor’s share”)

• Two-thirds (approx.)
• Labor’s share of GDP has remained approximately constant
over much of the 20th century
• Labor’s share appears to be declining since the 1980s at least

Share of GDP to capital (“capital’s share”)

• One-third (approx.)
 Labor’s Share of GDP

Open debate: Increase in market concentration, markups and economic profits?

The Production/Value Added Approach to GDP
GDP: The value of final goods and services produced in an
economy during a given period.
No “double counting”: Only the final sale of goods and services
count.

Value added
• The amount each producer contributes to GDP
• The revenue generated by each producer minus the value of
intermediate products

Only new production of goods and services counts toward GDP.

Measures of Well-Being
GDP is used by economists as a proxy for standards of living.

Several Pros & Cons for long-run and short-run analysis.

Easy to map to theoretical models.

Not included:
• Government transfer payments
• Environmental conditions
• A measure of a nation’s health
• Time spent cooking at home
• Babysitter
 2.3 Measuring Changes Over Time
GDP is intended to measure changes in production.

When examining GDP over time, we need to take into account

changes in prices.

Nominal GDP:
• A measure of GDP when prices and quantities have not been
separated, using current year prices

Real GDP:
• Actual quantity of goods and services, using base year prices
Measuring Changes Over Time
To compare GDP across time, we must use a certain year’s prices.

• Nominal GDP is measured in current dollars.

• Real GDP will be measured in a certain year’s dollars (base year).

Nominal GDP:
• where N is the total number of goods and services in the economy and
are prices in year t.

Real GDP:

• where N is the total number of goods and services in the economy and
are prices in year t-1.
An Example of Changes in Nominal GDP—2
Suppose: Year Price of Quantity Price of Quantity of
Steak of Steak Basketballs Basketballs
2014 $10 50 $25 100
2015 $12 50 $28 100
Nominal GDP in 2014:

Nominal GDP in 2015:

Another Example
Now suppose: Year Price of Quantity Price of Quantity of
Steak of Steak Basketballs Basketballs
2014 $10 50 $25 100
2015 $12 60 $28 105
Nominal GDP in 2015:

Real GDP in 2015 (in 2014 prices):

Real and Nominal GDP in a Simple Economy, 2018–2020
Quantity Indexes
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 (depends on how much relative prices have
changed).
Chain Weighting
The Fisher index (chain weighting) is the preferred approach to
calculating real GDP.

• Average of RGDP growth using the Laspeyres and Paasche

index

!"#$%&'()ℎ+,-./01 = (!"#$%&'()ℎ4-560785 + !"#$%&'()ℎ9--5:,0 )/2

• We found the RGDP growth, but what about the level?

• Given the growth rate and the final level of NGDP, you find the
implied RGDP in chained prices

!"#$+,-./01,?@A(1 + !"#$%&'()ℎ+,-./01 ) = !"#$?

Price Indexes
For each quantity index there is a corresponding price index.

Recall:

We can compute the % change in price level:

Using Chain-Weighted Data
Main reason for using chain-weighted data:
• Prices of computers rapidly changed in the 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.
2.4 Comparing Economic Performance across Countries
To make comparisons of GDP across countries GDP must be
expressed in a common currency

We have to consider the exchange rate:

• Price at which different currencies are traded

Thus:
• GDP first adjusted it by the exchange rate.

But prices are different across countries as well.

• Nominal GDP must be multiplied by the ratio of prices in the
countries.
An Example of Comparisons of Economies
Suppose we are trying to compare GDP in China and the United States.

1. Use the exchange rate to turn Chinese yuan into U.S. dollars:
$1
26.4 %&'((')* +,-*× = $3.5 %&'((')*
7.6 +,-*
2. Comparison in real terms. Adjust for relative price level of goods:
Comparison of Countries
• In general, rich countries tend to have higher price levels than
poor countries.

• This is mainly because poor countries have lower wages.