Chapter 4 notes - Monitoring the Value of
Production: GDP
January 11, 2022 9:29 PM
GDP
• Gross domestic product (GDP): the market value of the final goods and services produced within a country in a given time
period
○ This definition has four parts:
▪ Market value
□ To measure total production, we must do more than count, as we don’t know what is the greater
production between items
□ GDP answers this question by valuing items at their market values—the prices at which items are
traded in markets
□ Ex. If the price of an apple is 10¢, then the market value of 50 apples is $5
If the price of an orange is 20¢, then the market value of 100 oranges is $20
□ By using market prices to value production, we can add the apples and oranges together
▪ Final goods and services
□ To calculate GDP, we value final goods and services produced
□ Final goods/services: an item bought by its final user during a specified time period
□ Intermediate goods/services: an item produced by one firm, bought by another firm, and used as a
component of a final good or service
Ex. A ford truck is a final good, but the firestone tires on it are intermediate goods
□ If we were to add the value of intermediate goods and services produced to the value of final goods and
services, we would count the same thing many times—a problem called double counting
The value of a truck already includes the value of the tires
□ Some goods can be an intermediate good in some situations and a final good in other situations
Ex. the ice cream that you buy on a hot summer day is a final good, but the ice cream that a
restaurant buys and uses to make sundaes is an intermediate good
□ Whether a good is an intermediate good or a final good depends on what it is used for, not what it is
□ Some items that people buy are neither final goods nor intermediate goods and they are not part of
GDP
Ex. financial assets—stocks and bonds—and secondhand goods—used cars or existing homes
◊ A secondhand good was part of GDP in the year in which it was produced, but not in GDP
this year
▪ Produced within a country
□ Only goods and services that are produced within a country count as part of that country’s GDP
Ex. Roots, a Canadian firm, produces T-shirts in Taiwan, and the market value of those shirts is
part of Taiwan’s GDP, not part of Canada’s GDP
Ex. Toyota, a Japanese firm, produces automobiles in Cambridge, Ontario, and the value of this
production is part of Canada’s GDP, not part of Japan’s GDP
▪ In a given time period
□ GDP measures the value of production in a given time period—normally either a quarter of a year—
called the quarterly GDP data—or a year—called the annual GDP data
□ GDP measures not only the value of total production but also total income and total expenditure
The equality between the value of total production and total income is important because it
shows the direct link between productivity and living standards
Our standard of living rises when our incomes rise and we can afford to buy more goods and
services, But we must produce more goods and services if we are to be able to buy more goods
and services
○ Rising incomes and a rising value of production go together - They are two aspects of the same phenomenon:
increasing productivity
• Figure 4.1 illustrates the circular flow of expenditure and income
○ The economy consists of households, firms, governments, and the rest of the world (the rectangles), which trade in
factor markets and goods (and services) markets
• Households sell and firms buy the services of labour, capital, and land in factor markets
○ For these factor services, firms pay income to households: wages for labour services, interest for the use of capital,
and rent for the use of land
▪ A fourth factor of production, entrepreneurship, receives profit
○ Firms’ retained earnings—profits that are not distributed to households—are part of the household sector’s income
○ You can think of retained earnings as being income that households save and lend back to firms
▪ Figure 4.1 shows the total income— gate income—received by households, including retained earnings, as the
blue flow labelled Y
○ Firms sell and households buy consumer goods and services—such as inline skates and haircuts—in the goods
market
▪ Consumption expenditure: the total payment for consumer goods and services
○ Firms buy and sell new capital equipment—such as computer systems, airplanes, trucks, and assembly line
equipment—in the goods market
○ Some of what firms produce is not sold but is added to inventory
▪ Ex. if GM produces 1,000 cars and sells 950 of them, the other 50 cars remain in GM’s inventory of unsold
cars, which increases by 50 cars
○ When a firm adds unsold output to inventory, we can think of the firm as buying goods from itself
▪ Investment: the purchase of new plant, equipment, and buildings, and additions to inventories, shown by the
red flow labelled I
• Governments buy goods and services from firms and their expenditure on goods and services is called government
expenditure
The table in Fig. 4.1 shows the values of the expenditures for 2016 and
○ In Fig. 4.1, government expenditure is shown as the red flow G
that their sum is $2,028 billion, which also equals aggregate income
○ Governments finance their expenditure with taxes, But taxes are not part of the circular flow of expenditure and
income
○ Governments also make financial transfers to households, such as social security benefits and unemployment
benefits, and pay subsidies to firms
▪ These financial transfers, like taxes, are not part of the circular flow of expenditure and income
▪ These are not included in GDP because it does not create production activity - it is literally just a transfer of
cash from the government to individuals or vice versa
▪ No new production activity has taken place in this transaction to it is not included
• Firms in Canada sell goods and services to the rest of the world—exports—and buy goods and services from the rest of
the world—imports
○ The value of exports (X) minus the value of imports (M) is called net exports (NX), the red flow X - M in Fig. 4.1
▪ If net exports are positive, the net flow of goods and services is from Canadian firms to the rest of the world
▪ If net exports are negative, the net flow of goods and services is from the rest of the world to Canadian firms
• Gross domestic product can be measured in two ways: by the total expenditure on goods and services or by the total
income earned producing goods and services
○ The total expenditure—aggregate expenditure—is the sum of the red flows in Fig. 4.1
▪ Aggregate expenditure equals consumption expenditure plus investment plus government expenditure plus
net exports
○ Aggregate income is equal to the total amount paid for the services of the factors of production used to produce
final goods and services—wages, interest, rent, and profit
▪ The blue flow in Fig. 4.1 shows aggregate income
▪ Because firms pay out as incomes (including retained profits) everything they receive from the sale of their
output, aggregate income (the blue flow) equals aggregate expenditure (the sum of the red flows):
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, output, aggregate income (the blue flow) equals aggregate expenditure (the sum of the red flows):
□
○ Because aggregate expenditure equals aggregate income, the two methods of measuring GDP give the same answer
▪ GDP equals aggregate expenditure and equals aggregate income
• Domestic product is gross because "Gross" means before subtracting the depreciation of capital
○ The opposite of “gross” is “net,” which means after subtracting the depreciation of capital
○ Depreciation: the decrease in the value of a firm’s capital that results from wear and tear and obsolescence
○ gross investment: The total amount spent both buying new capital and replacing depreciated capital
○ net investment: The amount by which the value of capital increases
▪ Net investment equals gross investment minus depreciation
○ Ex. if an airline buys 5 new airplanes and retires 2 old airplanes from service, its gross investment is the value of the
5 new airplanes, depreciation is the value of the 2 old airplanes retired, and net investment is the value of 3 new
airplanes
○ Gross investment is one of the expenditures included in the expenditure approach to measuring GDP, So the
resulting value of total product is a gross measure
○ Gross profit, which is a firm’s profit before subtracting depreciation, is one of the incomes included in the income
approach to measuring GDP, So again, the resulting value of total product is a gross measure
Measuring Canada's GDP
• The expenditure approach
○ The expenditure approach measures GDP as the sum of consumption expenditure (C), investment (I), government
expenditure on goods and services (G), and net exports of goods and services (X - M)
○ These expenditures correspond to the red flows through the goods markets in the circular flow model in Fig. 4.1
○ Table 4.1 shows these expenditures and the calculation of GDP for 2016
▪ Consumption expenditure is the expenditure by Canadian households on goods and services produced in
Canada and in the rest of the world and is shown by the red flow C
□ They include goods such as avocados and books and services such as banking and legal advice, As well as
the purchase of consumer durable goods, such as computers and microwave ovens
□ But they do not include the purchase of new homes, which Statistics Canada counts as part of
investment
▪ Investment is the expenditure on capital equipment and buildings by firms and the additions to business
inventories
□ It also includes expenditure on new homes by households, Investment is the red flow I
▪ Government expenditure on goods and services is the expenditure by all levels of government on goods and
services, such as national defense and garbage collection
□ It does not include transfer payments, such as unemployment benefits, because they are not
expenditures on goods and services
□ Government expenditure is the red flow G
▪ Net exports of goods and services are the value of exports minus the value of imports
□ This item includes telephone equipment that Nortel sells to AT&T (a Canadian export), and Japanese
DVD players that Sears buys from Sony (a Canadian import) and is shown by the red flow X - M
○ Table 4.1 shows the relative magnitudes of the four items of aggregate expenditure
• The income approach
○ The income approach measures GDP by summing the incomes that firms pay households for the factors of
production they hire—wages for labour, interest for capital, rent for land, and profit for entrepreneurship
○ These incomes sum to the blue flows through the factor markets in the circular flow model in Fig. 4.1
○ We divide the incomes in the National Income and Expenditure Accounts into two broad categories:
▪ Wages, salaries, and supplementary labour income
□ Wages, salaries, and supplementary labour income is the payment for labour services
□ It includes gross wages plus benefits such as pension contributions and is shown by the blue flow W in
Fig. 4.3
▪ Other factor incomes
□ Other factor incomes include corporate profits, interest, farmers’ income, and income from non-farm
unincorporated businesses
□ These incomes are a mixture of interest, rent, and profit and include some labour income from self-
employment
□ They are included in the blue flow OFI in Fig. 4.3
○ Table 4.2 shows these incomes and their relative magnitudes - They sum to net domestic income at factor cost
▪ indirect tax: a tax paid by consumers when they buy goods and services
▪ direct tax: a tax on income
□ An indirect tax makes the market price exceed factor cost
▪ Subsidy: a payment by the government to a producer
□ With a subsidy, factor cost exceeds market price, so To get from factor cost to market price, we add
indirect taxes and subtract subsidies
□ Making this adjustment brings us to net domestic income at market prices
▪ We still must get from a net to a gross measure - Total expenditure is a gross number because it includes gross
investment
□ Net domestic income at market prices is a net income measure because corporate profits are measured
after deducting depreciation - They are a net income measure
□ To get from net income to gross income, we must add depreciation
▪ We’ve now arrived at GDP using the income approach
▪ This number is not exactly the same as GDP using the expenditure approach
□ The gap between the expenditure approach and the income approach is called the statistical
discrepancy and it is calculated as the GDP expenditure total minus the GDP income total
□ The discrepancy is never large - In 2016, it was less than $0.5 billion, which rounds to $0 billion
• Often, we want to compare GDP in two periods, say 2000 and 2016
• In 2000, GDP was $1,102 billion, and in 2016 it was $2,028 billion—84 percent higher than in 2000
• This increase in GDP is a combination of an increase in production and a rise in prices
○ To isolate the increase in production from the rise in prices, we distinguish between real GDP and nominal GDP
○ Real GDP: the value of final goods and services produced in a given year when valued at the prices of a reference
base year
▪ By comparing the value of production in the two years at the same prices, we reveal the change in production
▪ Currently, the reference base year is 2007 and we describe real GDP as measured in 2007 dollars—in terms of
what the dollar would buy in 2007
○ Nominal GDP: the value of final goods and services produced in a given year when valued at the prices of that year
▪ Nominal GDP is just a more precise name for GDP
• We’ll calculate real GDP for an economy that produces one consumption good, one capital good, and one government
service, so Net exports are zero
○ Table 4.3 shows the quantities produced and the prices in 2007 (the base year) and in 2016
○ In part (a), we calculate nominal GDP in 2007
▪ For each item, we multiply the quantity produced in 2007 by its price in 2007 to find the total expenditure on
the item
▪ We sum the expenditures to find nominal GDP, which in 2007 is $100 million
▪ Because 2007 is the base year, both real GDP and nominal GDP equal $100 million
○ In Table 4.3(b), we calculate nominal GDP in 2016, which is $300 million
▪ Nominal GDP in 2016 is three times its value in 2007
▪ But by how much has production increased? Real GDP will tell us
○ In Table 4.3(c), we calculate real GDP in 2016
▪ The quantities of the goods and services produced are those of 2016, as in part (b)
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, ○ In Table 4.3(b), we calculate nominal GDP in 2016, which is $300 million
▪ Nominal GDP in 2016 is three times its value in 2007
▪ But by how much has production increased? Real GDP will tell us
○ In Table 4.3(c), we calculate real GDP in 2016
▪ The quantities of the goods and services produced are those of 2016, as in part (b)
□ The prices are those in the reference base year—2007, as in part (a)
▪ For each item, we multiply the quantity produced in 2016 by its price in 2007
▪ We then sum these expenditures to find real GDP in 2016, which is $160 million
□ This number is what total expenditure would have been in 2016 if prices had remained the same as they
were in 2007
○ Nominal GDP in 2016 is three times its value in 2007, but real GDP in 2016 is only 1.6 times its 2007 value—a 60
percent increase in production
The Uses and Limitations of Real GDP
• Economists use estimates of real GDP for two main purposes:
○ To compare the standard of living over time
○ To compare the standard of living across countries
• Over time:
○ One method of comparing the standard of living over time is to calculate real GDP per person in different years
○ Real GDP per person: real GDP divided by the population
○ Real GDP per person tells us the value of goods and services that the average person can enjoy
○ By using real GDP, we remove any influence that rising prices and a rising cost of living might have had on our
comparison
▪ We’re interested in both the long-term trends and the shorter-term cycles in the standard of living
○ A handy way of comparing real GDP per person over time is to express it as a ratio of some reference year
▪ Ex. in 1961, real GDP per person was $18,000, and in 2016 it was $50,000 (both rounded to the nearest
thousand)
▪ So real GDP per person in 2016 was 2.8 times its 1961 level
▪ To the extent that real GDP per person measures well-being, people were almost three times as well off in
2016 as their grandparents had been in 1961
○ Figure 4.4 shows the path of Canadian real GDP per person from 1961 to 2016 and highlights two features of our
expanding living standard:
▪ The growth of potential GDP per person
▪ Fluctuations of real GDP per person
○ Potential GDP: the maximum quantity of real GDP that can be produced while avoiding shortages of labour, capital,
land, and entrepreneurial ability that would bring rising inflation
▪ Potential GDP per person, the smoother black line in Fig. 4.4, grows at a steady pace because the quantities of
the factors of production and their productivities grow at a steady pace
▪ But potential GDP per person doesn’t grow at a constant pace - During the 1960s, it grew at 3.4 percent per
year but slowed to 2.4 percent per year during the 1970s
▪ This slowdown might seem small, but it had big consequences, as you’ll soon see
○ You can see that real GDP per person shown by the red line in Fig. 4.4 fluctuates around potential GDP per person,
and sometimes real GDP per person shrinks
▪ How costly was the slowdown in productivity growth after 1970? The answer is provided by the Lucas wedge,
which is the dollar value of the accumulated gap between what real GDP per person would have been if the
growth rate of the 1960s had persisted and what real GDP per person turned out to be
▪ Figure 4.5 illustrates the Lucas wedge
▪ The wedge started out small during the 1970s, but by 2016 real GDP per person was $54,000 per year lower
than it would have been with no growth slowdown, and the accumulated gap was an astonishing $790,000
per person
○ We call the fluctuations in the pace of expansion of real GDP the business cycle
○ Business cycle: the periodic but irregular up and down movement of total production and other measures of
economic activity
○ the business cycle isn’t a regular predictable cycle like the phases of the moon, but every cycle has two phases:
▪ Expansion
▪ Recession
○ And two turning points:
▪ Peak
▪ Trough
○ Figure 4.6 shows these features of the most recent Canadian business cycle:
▪ Expansion: a period during which real GDP increases
□ In the early stage of an expansion real GDP returns to potential GDP, and as the expansion progresses
potential GDP grows, and real GDP eventually exceeds potential GDP
▪ A common definition of recession is a period during which real GDP decreases—its growth rate is negative—
for at least two successive quarters
□ A more general definition of recession and one used by the U.S. National Bureau of Economic Research
is “a period of significant decline in total output, income, employment, and trade, usually lasting from
six months to a year, and marked by contractions in many sectors of the economy”
▪ An expansion ends and recession begins at a business cycle peak, which is the highest level that real GDP has
attained up to that time
▪ A recession ends at a trough, when real GDP reaches a temporary low point and from which the next
expansion begins
• Across countries
○ Two problems arise in using real GDP to compare living standards across countries
▪ First, the real GDP of one country must be converted into the same currency units as the real GDP of the other
country
▪ Second, the goods and services in both countries must be valued at the same prices
○ Comparing China and the United States provides a striking example of these two problems
▪ In 2016, nominal GDP per person in the United States was $51,200 and in China it was 53,908 yuan
▪ The yuan is the currency of China and the price at which the dollar and the yuan exchanged, the market
exchange rate, was 6.64 yuan per $1 U.S.
▪ Using this exchange rate, 53,908 yuan converts to $8,119, and On these numbers, GDP per person in the
United States in 2016 was 6.3 times that in China
○ The red line in Fig. 4.7 shows real GDP per person in China from 1980 to 2016 when the market exchange rate is
used to convert yuan to U.S. dollars
○ Figure 4.7 shows a second estimate of China’s real GDP per person that values China’s production on the same
terms as U.S. production
▪ It uses purchasing power parity or PPP prices, which are the same prices for both countries
▪ The prices of some goods are higher in the United States than in China, so these items get a smaller weight in
the calculation of China’s real GDP than they get in U.S. real GDP
▪ Ex. a Big Mac, which costs $5.30 in Chicago, but In Shanghai, a Big Mac costs 19.40 yuan, which is the
equivalent of $2.92
□ So in China’s real GDP, a Big Mac gets about half the weight that it gets in U.S. real GDP.
□ Check out big mac index
○ Some prices in China are higher than in the United States but more prices are lower, so Chinese prices put a lower
value on China’s production than do U.S. prices
○ According to the PPP comparisons (same prices in both countries), real GDP per person in the United States in 2016
was 3.8 times that of China, not 6.3 times
• You’ve seen how real GDP is used to make standard of living comparisons over time and across countries. But real GDP
isn’t a perfect measure of the standard of living, and we’ll now examine its limitations
• Some of the factors that influence the standard of living and that are not part of GDP are:
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, • Some of the factors that influence the standard of living and that are not part of GDP are:
○ Household production
▪ Preparing meals, changing a light bulb, mowing a lawn, washing a car, and caring for a child are all examples of
household production
□ Because these productive activities are not traded in markets, they are not included in GDP
▪ The omission of household production from GDP means that GDP underestimates total production
□ But it also means that the growth rate of GDP overestimates the growth rate of total production
The reason is that some of the growth rate of market production (included in GDP) is a
replacement for home production
So part of the increase in GDP arises from a decrease in home production
○ Underground economic activity
▪ The underground economy is economic activity hidden from the view of the government to avoid taxes and
regulations or because the activity is illegal
□ Because underground economic activity is unreported, it is omitted from GDP
□ The Canadian underground economy is estimated to range between 5 and 15 percent of GDP ($100
billion to $300 billion)
○ Leisure time
▪ Leisure time is an economic good that adds to our economic well-being and the standard of living
□ Other things remaining the same, the more leisure we have, the better off we are
▪ Our working time is valued as part of GDP, but our leisure time is not, Yet that leisure time must be at least as
valuable to us as the wage that we earn for the last hour worked
□ If it were not, we would work instead of taking leisure
▪ Over the years, leisure time has steadily increased
□ The workweek has become shorter, more people take early retirement, and the number of vacation
days has increased
▪ These improvements in economic well-being are not reflected in real GDP
○ Environmental quality
▪ Economic activity directly influences the quality of the environment
□ The burning of hydrocarbon fuels is the most visible activity that damages our environment, but it is not
the only example
□ The depletion of non-renewable natural resources, the mass clearing of forests, and the pollution of
lakes and rivers are other major environmental consequences of industrial production
▪ Resources used to protect the environment are valued as part of GDP
□ Ex. the value of catalytic converters that protect the atmosphere from automobile emissions is part of
GDP
▪ An industrial society might produce more atmospheric pollution than an agricultural society does, but
pollution does not always increase as we become wealthier
□ Wealthy people value a clean environment and are willing to pay for one
▪ Compare the pollution in China today with pollution in Canada - The air in Beijing is much more polluted than
that of Toronto or Montreal
○ Health and life expectancy
▪ These things are valued high when considering standard of living (What GDP measures) but isn't used
▪ Free/good healthcare
○ Political freedom and social justice
▪ Social programs ex. Assisting with covid 19 by paying the unemployed, developing countries don’t do this
▪ Also used to rank country's happiness
• Do we get the wrong message about the level and growth in economic well-being and the standard of living by looking at
the growth of real GDP? The influences that are omitted from real GDP are probably large
○ Developing countries have a larger amount of household production than do developed countries, so the gap
between their living standards is exaggerated
○ Also, as real GDP grows, part of the growth is a switch from home production to market production
▪ This switch overstates the growth in economic well-being and the improvement in the standard of living
○ It is possible to construct broader measures that combine the many influences that contribute to human happiness,
But Despite all the alternatives, real GDP per person remains the most widely used indicator of economic well-being
Chained-dollar real GDP
• Steps for chained-dollar real GDP with 2 different years expressed in year 1 prices:
1. Calculate real GDP for both years with year 1 as base
2. Calculate real GDP growth rate with year 1 as base
3. Calculate real GDP for both years with year 2 as base
4. Calculate real GDP growth rate with year 2 as base
5. Average the growth rates
6. Add one to the average growth rate
7. Multiply the year 1 nominal GDP by the average growth rate
• Growth rate (GR): new-old/old
• Example:
○ Part (a) shows the quantities and prices in 2015
○ Part (b) shows the quantities and prices in 2016
○ Part (c) the quantities of 2016 valued at 2015 prices
○ Part (d) the quantities of 2015 valued at prices of 2016
○ Parts (a) and (c) value the quantities of both years at 2015 prices
▪ That is, valuing the goods and services at 2015 prices, real GDP increased from $145 million to $160 million
○ Parts (b) and (d) value the quantities in both years at 2016 prices
▪ That is, valuing the goods and services at 2016 prices, real GDP increased from $275 million in 2015 to $300
million in 2016
○ In part (a), at 2015 prices, production increased by 10.3%
○ In part (b), at 2016 prices, production increased by 9.1%
▪ The average increase in production is 9.7%
○ Add 1 to get 1.097
▪ 2015 nominal GDP x avg growth rate = 145 x 1.097 = 159.065
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