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1. INTRODUCTION1.1. Introduction
Economists refer to the total activity in an economy as aggregate economic activity. Macroeconomics is the study of
aggregate economic activity.
- Inflation: annual percentage increase in the total cost of living
- Economic growth: annual growth rate of a country’s total economic output
- Unemployment rate: the fraction of labor force that is unemployed
Gross Domestic Product (GDP): the market value of final goods and services produced within a country’s borders over a
particular period of time.
NOTE: GDP is a measure of production, not a measure of sales to consumers. So something that is produced is counted in
GDP even if it is not sold to a customer. For example, Ford will increase its inventory of (unsold) cars if it manufactures a
car in 2015 but doesn’t sell it in 2015. Production that goes into inventories counts as part of GDP.
• The time series of GDP can be separated into trend and business cycle components.
1.2. Measuring GDP
GDP can be measured in three different ways, and in principle these three methods should all yield the same answer:
Production = Expenditure = Income.
• National income accounts measure the level of aggregate economic activity in a country.
1.2.1. Production Approach
Production-based accounting: sums up each firm’s value added, which is the firm’s sales revenue minus the firm’s
purchases of intermediate products from other firms.
1.2.2. Income Approach
Income-based accounting: sums up labour income (wages, salary, workers’ health insurance, and workers’ pension
benefits) and capital income (physical capital (e.g. house, machine) or financial capital (stocks and bonds))
Note: many people receive both types of income
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,1.2.3. Expenditure Approach
Expenditure-based accounting: sums up the purchases of goods and services by different groups or categories.
There are five main categories. Y = C + I + G + X - M ‘national income accounting identity’
1. Consumption goods and consumption services bought by domestic households, excludes residential construction (C)
2. New physical capital (investment) bought by domestic households and domestic firms (I)
3. Government expenditures on goods and services (G)
4. Exports of goods and services produced domestically and sold abroad (X)
5. Imports of goods and services produced abroad and sold domestically (M)
Note: Investment doesn’t refer to financial investment but to new physical capital
Note: Government expenditure excludes transfer payments (Social Security) and interest paid on government debt (avoid
double counting)
• Recessions are periods (lasting at least two quarters) in which aggregate economic output falls. During recessions the
unemployment rate, one of the most important macroeconomic variables, rises. A person is officially unemployed if three
conditions are satisfied: he or she
(1) does not have a job
(2) has actively looked for work in the prior four weeks
(3) is currently available for work.
Example: Great Depression (1929-1939)
1.3. Limitations of GDP measures
GDP has limitations as a measure of economic activity and well-being:
1. It omits the depreciation of the physical capital stock and resources as it is hard to measure
2. It omits negative externalities such as pollution, noise…
3. It doesn’t capture transactions made in the underground/informal economy (10% GDP for developed countries)
- How could we measure the size of the underground economy?
- Some estimated it based on currency demand as cash is often used for transaction in the underground
economy (The Indian government’s recalled all 500 and 1000 rupee currency bills on 2016)
4. It omits home production of cleaning, cooking, and child care done in the household.
- The decision of ‘marketisation’ is important – buy from market or produce at home (If a mother decides to go to
work, two jobs are created and both increase GDP, eat in or out)
5. It omits leisure, which contributes to well-being
GDP records production in the country regardless of whose labor and capital (domestic or foreign) is used whereas Gross
National Product (GNP) records production of domestically owned labor and capital in the country and abroad. It is the
market value of production generated by the factors of production—both capital and labor—possessed or owned by the
residents of a particular nation.
• They are nearly the same for many countries (U.S. 2013: GNP $17.1 trillion — GDP $16.8 trillion)
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,1.4. Real vs. nominal GDP, price indexes and inflation
An increase in GDP will record both increases in actual production (and income) and increases in prices of those goods
and services. We therefore need to distinguish between nominal GDP and real GDP.
1.4.1. Nominal and real (what you hear in the news) GDP
Nominal GDP is the total value of production using current market prices to determine the value of each unit that is
produced. Real GDP is the total value of production using market prices from a specific base year to determine the value of
each unit that is produced
1.4.2. GDP deflator and CPI
GDP deflator: measures how much prices of goods and services produced in a country have risen since the base year
Consumer Price Index (CPI): the price level of a particular basket of consumer goods and services.
NOTE: we are only interested in the change of prices, therefore, fix the quantity for the items as that of the base year’s.
(Quiz 2, question 2)
- The GDP deflator includes things not purchased by households, like trains, subways, and submarines (GDP basket)
- The CPI includes imports like Chinese laptops but GDP deflator doesn’t (it only counts domestics)
- Housing-related expenditures like shelter and utility bills have a large weight in the CPI. (40% in CPI and 20% in GDP)
1.4.3. GDP growth and inflation rate
Inflation rate: is the rate of increase in prices and is calculated as the year-on-year percentage increase in a price index
(either the GDP deflator or or the CPI, the choice doesn’t have a large impact so the CPI is normally used as it is more
relevant for households). They are defined as a percentage change
3
, 2. INEQUALITY AROUND THE WORLD
2.1. Comparing GDP across countries
We use the two terms, income per capita and GDP per capita, interchangeably in this course:
Income per capita = GDP per capita = (GDP / Total population)
2.1.1. How do we compare GDP across countries with different currencies?
1. Convert GDP into the currency, using current exchange rates:
However, we observe the Penn-Balassa-Samuelson effect: prices
tend to be higher in richer countries.
• If we made real GDP comparisons across countries by just
expressing in the same currencies, then we would exaggerate the
differences in income between rich and poor countries.
• Penn World Tables (http://pwt.econ.upenn.edu/) – make international
real GDP comparisons based on PPP.
2. Convert one country’s GDP by using the prices of goods and services in that country relative to the prices of the same
goods and services in the other country (purchasing power parity):
GDP per capita = GDP per capita in local currency × PPP adjustment
Note: PPP constructs the cost of a representative bundle of commodities
in each country and uses these relative costs for comparing income across
countries. Even though PPP adjustments raise the income levels of the
developing countries, there are still very large disparities in income per
capita across countries.
There is a positive relationship between income per capita (and per worker) and various measures of standard of living.
- Absolute poverty rates
- Life expectancy
- Human Development Index: combines information on income per capita, life expectancy, averages years of schooling
and the enrolment of children in school
In a well-cited research paper published in 1999, Robert Hall and Chad Jones documented:
"In 1988 output per worker in the United States was more than 35 times higher than output per worker in Niger. In just over
ten days the average worker in the United States produced as much as an average worker in Niger produced in an entire
year.”
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