Chapter 5 In this chapter we will study how a nation

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Chapter 5 In this chapter we will study how a
nations standard of living is measured by GDP.
GDP (gross domestic product) is the market value
of all final goods and services produced within a
country in a given time period.
To understand how GDP is measured, we return to
the circular flow model
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The circular flow model illustrates
thatExpenditure IncomeThe left-hand side
of the circle equals the right-hand side.
When the firms produce output that is purchased
by the spenders in the economy, the firms
necessarily also generate factor income equal in
value to the output they have produced.
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Let Y income value of output. The circular
flow model shows thatY C I G NX.
It follows that there are two methods that can be
used to measure GDP1. The expenditure
approach2. The income approach
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The Expenditure ApproachWe simply add up all of
the expenditures on final goods and services on
the right-hand side of the circular flow diagram
GDP C I G NX
This calculation will give us the value of all
output produced in the economy, evaluated in
terms of market prices.
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The Income ApproachWe start by adding up all of
the different forms of factor income paid in the
economy
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Compensation of employees
Net interest
Rent
Profit
_______________________________ Net domestic
product at factor cost
Net because firms profits are net of
depreciation.At factor cost because goods are
valued in terms of the factors used to produce
them.
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The expenditure approach gives GDP, which
includes depreciation, evaluated at market
prices. Therefore, to make the income approach
consistent with the expenditure approach, we must
Convert factor costs to market prices add
indirect taxes subtract subsidies
Convert net domestic product to gross add
depreciation
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Net domestic product at factor cost
indirect taxes
- subsidies
depreciation
_______________________________ Gross domestic
product at market prices
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Real versus nominal GDPGDP is measured at
market prices, i.e., in dollars. If this dollar
amount increases, it could be because
we produced more goods and services (our standard
of living increased), or
prices increased (our cost of living increased)
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An increase in the current dollar value of output
produced is called an increase in nominal GDP.
An increase in the amount of output produced is
called an increase in real GDP.
Nominal GDP could increase either because of an
increase in real GDP or because of an increase in
the average level of prices in the economy, or
because both happened. An increase in the price
level is measured by the GDP deflator.
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Nominal GDP is the value of final goods and
services produced in a given year evaluated in
terms of the prices prevailing in that same year
Real GDP is the value of final goods and services
produced in a given year evaluated in terms of
the prices prevailing in a base year, i.e.,
holding prices constant at base-year levels.
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Traditional, and simplest, method of calculating
real GDP
Assume that the economy produces only two goods,
beer and pretzels. 2006 is the current year
2005 is the base year.
In the base year, nominal GDP and real GDP are
the same. Nominal GDP real GDP in 2005 is
calculated by adding up the values of beer and
pretzels produced in 2005 in terms of 2005
prices
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2005 Quantity produced Price per unit Value
beer 90 1.20 108
pretzels 170 0.75 127.50
Total
235.50
235.50 is nominal GDP and real GDP in 2005.
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Nominal GDP in 2006 is the value of beer and
pretzels produced in 2006 in terms of 2006 prices
2006 Quantity produced Price per unit Value
beer 150 1.30 195
pretzels 200 3.00 600
Total
795
795 is nominal GDP in 2006.
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Real GDP in 2006 is the value of beer and
pretzels produced in 2006 in terms of 2005 prices
2006 Quantity produced Price per unit Value
beer 150 1.20 180
pretzels 200 0.75 150
Total
330
330 is real GDP in 2006, i.e., the value of
output produced in 2006 evaluated at base-year
(2005) prices.
Thus, in constant 2005 prices, real GDP increased
from 235.50 to 330, a 40 increase.
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The traditional approach to calculating real GDP
uses base-year prices. The more modern approach,
also called the chained-dollar method, takes
into account what happens when changes in output
are evaluated at constant current-year prices.
To implement the modern approach, we calculate
the value of beer and pretzels produced in 2005
in terms of 2006 prices
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2005 Quantity produced Price per unit Value
beer 90 1.30 117
pretzels 170 3.00 510
Total
627
627 is the value of output produced in 2005 in
terms of 2006 prices. This number may be
compared with 795, which is the value of output
produced in 2006 in terms of 2006 prices.
Thus, at constant 2006 prices, output increased
from 627 to 795, a growth rate of 27.
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The modern method of calculating real GDP takes
the geometric average of the 40 increase in the
value of output holding prices constant at 2005
prices and the 27 increase in the value of
output holding prices constant at 2006 prices
40 X 27 32.86.
Thus, real GDP, according to this approach, has
increased by 32.86 from 2005 to 2006. In 2005
real GDP was 235.50. Therefore real GDP in 2006
must be 32.86 greater than 235.50, or 312.88.
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The GDP deflatorThe GDP deflator is a measure
of the average change in prices between the base
year and a current year.
It is calculated as an average of current prices
expressed as a percentage of base-year
pricesGDP deflator (Nominal GDP/Real GDP) x
100
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In our example, the GDP deflator is given by
GDP deflator in 2005 (235.50/235.50) x 100
100
GDP deflator in 2006 (795/312.88) x 100
254
Thus prices in our economy increased by 154
between 2005 and 2006.