Lecture notes

EC210 MT Weeks 1-5

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Module
EC210 (EC210)

Institution
London School Of Economics (LSE)

A complete, comprehensive summary of the entire course in MT1-5 (requirement for the January exam). The notes include all content discussed in the lectures as well as my own personal additions, and revising from them resulted in me achieving an extremely high first in the January Exam.

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MT1

Lecture 1: Measuring GDP

What is GDP? An example island economy
- Corporate sector: fish producers
¡ Production= sales (revenue) + net addition to inventory
¡ Gross operating profits= production – wages – interest on debt
¡ Dividends = Gross operating profits + net borrowing – net addition to inventory –
investment
• Net addition to inventory much be taken away as this money has not actually been
realised, these ‘fish’ were never sold
- Corporate sector: restaurants
¡ Production = sales
• Not possible to have an inventory of restaurant meals
¡ Gross operating profits = production – purchases of intermediate goods (fish) – wages
paid to workers – rent of land – tax on sales
¡ Dividends = gross operating profits – retained earnings
- Government sector
¡ Tax revenue = income tax on wages (direct taxes) + sales tax on restaurant meals
(indirect taxes)
¡ Expenditure = wages of government employees + interest on debt
¡ Budget deficit = expenditure – tax revenue
- Household sector
¡ Income
• Total wage income = wage income from fish producers +wage income from
restaurants + wage income from government
• Total dividends and rents = dividends from fish producers + dividends from
restaurants + rents from restaurants
• Household income = total wage income + total dividends and rents
¡ Expenditure
• Disposible income = household income – income tax
• Consumption = purchases of fish +purchases of restaurant meals
- International trade and income
¡ Net exports = exports (restaurant meals- tourism) + imports (eg new boat)
¡ Domestic income received by foreigners = interest paid by firms to foreigners +
interest paid by government to foreigners
¡ Net International Income = Foreign Income received by domestic residents - domestic
income received by foreigners
¡ Current account of balance of payments = net exports + net international income

How to measure national income- GDP
- Gross Domestic Product (GDP)
¡ GDP is the most common measure of the ‘size’ of an economy
¡ Definition: Value of all goods and services produced in a country in a period of time
• ‘Gross’: opposite of ‘net’, not accounting for depreciation
• ‘Domestic’: covers the geographic area of a country, irrespective of ownership or
nationality

, • ‘Product’: based on the amount of goods newly produced, irrespective of what is
sold
¡ Points to note about the definition of GDP
• GDP aims to include all output for sale in the ‘market’ and also some ‘non-
market’ output
• Value means market value where possible
• Only final goods are counted
o Intermediate goods (goods entirely used up producing other goods in the same
time period) are excluded
• GDP is a ‘flow’ not a ‘stock’
o Measured in a period of time: a year or a quarter
- There are three equivalent approaches to measure GDP:
¡ Production approach
• Sum of value added over all industries producing goods and services
¡ Expenditure approach
• Sum of all expenditure on final goods and services
¡ Income approach
• Sum of all incomes derived from producing goods and services
¡ In theory, these approach all give the same answer, however in practice there are
statistical differences
- Production approach to GDP
¡ GDP=value added over all industries producing goods and services
¡ Value added: value of output produced minus value of intermediate goods used in
production
• Avoids double counting of production (some of the value of the final goods
reflects the value of the intermediate goods)
¡ Use market value where possible
• Value = Price x Quantity
• Not possible for many services provided by government: use cost of production
instead
• Value imputed for some non-market output eg services from owner-occupied
housing
¡ Back to the island model:
• Value added from restaurant meals = value of restaurant meals produced + value
of fish used in producing restaurant meals
• Sum of value added = value of fish + value added from restaurant meals + value
added of public services (at cost of production)
- Expenditure approach to GDP
¡ GDP = household consumption + investment + government consumption + net
exports
• Household consumption = purchases of goods and services by households
• Investment = Purchases of new capital goods by firms (fixed investments) +
purchases of new residential structures + net change in inventories of goods
o Thus expenditure by households on newly constructed houses is ‘investment’
not ‘consumption’
• Government consumption = purchases of goods to provide public services
(including own production)
• Net exports = Exports – Imports
¡ Capital goods (used for future production) included, intermediate goods excluded

, ¡ Back to the island model:
• Household consumption = fish + restaurant meals
• Investment = gross fixed investment (new boat) + changes in inventories (stocks
of fish)
• Government consumption = provision of public services
• Net exports = exports – imports
• Sum of final expenditure = C + I + G + NE
- Reasons why GDP by expenditure and production may not be the same:
¡ Intermediate goods not included
• Excluded from GDP by production as we looked at value added
• Excluded from GDP by expenditure as they simply weren’t counted
• Therefore, no problem as excluded from both
¡ Buying goods from the rest of the world
• GDP by production: will appear as a negative in ‘net exports’
• Thus will be consistent with GDP as domestic production
¡ Production of goods that aren’t actually sold
• ‘Artificial' category of changes in inventory accounts for it: essentially as if the
- Income approach to GDP
¡ GDP= sum of all income derived from production
• Wages, rents, net interest paid by firms, profits, indirect taxes
o As indirect taxes were deducted from profits, they must be added back in for
consistency
¡ Incomes are paid by firms or the government (workers hired to provide public
services)
¡ Back to the island example:
• Total gross operating profits = gross operating profits of fish producers + gross
operating profits of restaurants
• All incomes + indirect taxes = wages + rents + interest income from firms + total
gross operating profits +indirect taxes

How to measure national income- Other measures
- Although GDP is the most common measure of national income, there are several
variants
¡ Gross national product (GNP) = GDP + net international income
• Income from production earned by domestic residents, irrespective of where
production occurs as well as income produced domestically but earned by
international residents
o Can be an important measure to consider when a country has a large
population of people who are working overseas or temporary migrants coming
in, if lots of foreign assets have been built up or domestic assets have been
sold to foreigners
¡ Net National Product = GNP – Depreciation
• Deducts cost of maintaining existing stock of capital
¡ NNP at basic prices = NNP – Indirect taxes
• Deduct impact of indirect taxes on market prices

Singapore vs US
- Similar GDP per capita, but very different breakdowns
- GDP by expenditure

, ¡ US has a much higher consumption expenditure, while Singapore has very high
positive net exports and investment
¡ Singapore is investing in physical capital and building up assets abroad
- GDP by income
¡ US has a much higher percentage of labour income: 58% vs 43%

Problems in measuring GDP
- Difficult to obtain timely GDP data
¡ Initial estimates of GDP based on very limited data
¡ Often large revisions made to GDP
¡ As the economy becomes more service based, with smaller firms, it is more difficult
to obtain accurate GDP estimates
- Difficult to obtain comprehensive data on all economic activity
¡ Informal/underground economy
• Some parts of the world have more accurate estimates of how big this sector of the
economy is, some do not
¡ Tax evasion
¡ Criminal activity
- Difficulties in measuring the output of particular sectors of the economy
¡ Financial services
• Easy to estimate the income contribution, very complicated for the value added
¡ Owner-occupied housing
- The prices people pay for goods and services reflect the value placed on them so adding
all the prices up assesses how much the economy is contributing to peoples welfare

Issues in the interpretation of GDP
- GDP is often used as a measure of economic success
- Can we say that GDP is a good measure of welfare/living standards on a country?
- If market prices reflect the value of different goods and services to consumers, adding up
the value of all output should give a fair representation of how much benefit consumers
derive from economic activity
- But to interpret GDP as a measure of welfare, need to make some adjustments:
¡ Adjust for price differences (over time or across countries)- real GDP, not nominal
GDP
¡ Divide by population (GDP per person)
¡ Still would only describe welfare of ‘average; person (no consideration of
inequality/distributional questions)
- Issues with GDP as a measure of welfare
¡ Don’t have market prices for all goods: public services valued at cost; imputed rents
used for owner-occupied housing
• What public employees are being paid often doesn’t accurately reflect the welfare
their service is providing (can be underpaid or overpaid, consider quality of
service)
¡ Total benefit derived from goods greater than price (think of internet services with no
charge, eg Google)
¡ Cost of production not reflected in price (eg pollution)
¡ Increase in GDP might be due to more spending to deal with ‘bads’ (eg more crime,
more police needed)
¡ Exclusion of non-market activities (home production: cooking, childcare etc)

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