Chapter 2 Measurement Copyright © 2010 Pearson Education Canada

Chapter 2

Measurement

Copyright © 2010 Pearson Education Canada

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-2

Chapter 2 Topics

• Measuring GDP

• Nominal and real GDP and price indices

• Savings, wealth and capital

• Labour market measurement



Measuring GDP: The National Income and Expenditure Accounts

• Measuring GDP

• Nominal and real GDP and price indices

• Savings, wealth and capital

• Labour market measurement



Measuring GDP: The National Income and Expenditure Accounts (NIEA)

• GDP is the quantity of final goods and services produced within a country’s borders over a particular period of time.

• GDP Measured Using: (i) the product approach; (ii) the expenditure approach; (iii) the income approach.

• Show how this is done using an example.



National Income Accounting Example

• Fictional Island Economy

• Coconut Producer, Restaurant, Consumers, Government

• In the current year coconut producer produces 10 million coconuts which are sold to consumers and restaurant for $2 each.

• Consumers buy 4 million coconuts and the restaurant buys 6 million coconuts.



Coconut Producer


Two roles of Coconuts in the Economy

1. Coconut is an intermediate good, a good that is produced and then used an input to another production process – here, the production restaurant food such as “shredded coconut in its own milk”, “coconut soup”, and “coconut in the half-shell”.

2. It is a final consumption good, in that consumers purchase coconuts.


Restaurant



After-Tax Profits


Calculation of After-Tax Profits for Producers

• After-tax Profits = Total Revenue – Wages –Interest- Cost of intermediate inputs – Taxes

• After-tax Profits of Coconut Producers = $20m - $5m - $0.5m - $1.5m = $13m

• After-tax Profits of Restaurant = $30m - $4m - $12m - $3m = $11m

The government’s Role

• To provide protection from attacks by other islands.

• The government collects taxes to provide national defence. That is, it uses all of its tax revenue to pay wages to the army.


Government



Consumers


The Product Approach to Measuring GDP

• The product approach to NIEA is also called the value-added approach

• GDP is calculated as the sum of value added to goods and services in production across all productive units in the economy.

• Total Value Added = Value of all goods produced – Value of all intermediate goods

• This approach helps to avoid double-counting problem


GDP Using the Product Approach


The Expenditure Approach to Measuring GDP

• We calculate GDP as total spending on all final goods and services production in the economy.

• We do not count spending on intermediate goods.• Total Expenditure (GDP) = Consumption Expenditure

(C) + Investment Expenditure (I) + Government Expenditure (G)+ Net exports (NX)

• NX = Exports - Imports


GDP Using the Expenditure Approach


The Income Approach to Measuring GDP

• We calculate GDP by adding up all incomes received by economic agents contributing to production.

• In the NIEA, income include compensation of employees (wages, salaries, and benefits), corporate profits, net interest, net income of farm operators and unincorporated businesses, taxes less subsidies on factors of production, taxes less subsidies on products, government business enterprise profits before taxes, inventory valuation adjustment, and depreciation.

The Income Approach to Measuring GDP

• Depreciation represents the value of productive capital (plant and equipment) that wears out during period we are considering.

• Depreciation is taken out when we calculate profits, so it needs to be added in again when we compute GDP.

• The inventory valuation adjustment enters for a similar reason.


GDP Using the Income Approach


Income-Expenditure identity

• Why do the product approach, the expenditure approach, and the income yield the same result?

• If we let Y denote total GDP in the economy, then Y is total aggregate output, and it is also aggregate income.

• It is also true as an identity that aggregate income equals aggregate expenditure, or

Y=C+I+G+NX

An Example with Inventory Investment

• One component of investment expenditures is inventory investment, which consists of any goods that are produced but are not consumed during the current period.

• Example: automobiles that are stored on the lot, goods in process, and raw materials.

• Consider the fictional island economy again.• Everything is same as before, except that the coconut

producer produces 13 million coconuts, and that the extra 3 million coconuts are not sold but stored as inventory.

• Calculate the GDP using the three NIEA approaches.


GDP using the Product Approach:Value added – coconut producer $26 mValue added – restaurant $18 mValue added – government $5.5 mGDP $49.5 m

• Note that we value the coconut inventory at the market price of coconuts in this example. In practice this need not be the case.


GDP using the Expenditure Approach:• C = $38m, NX = 0, G = $5.5m as before, but

now I = $6m.• So, GDP = C + I + G + NX = $49.5 million• Is it odd that inventory investment of $6m is

counted as investment expenditure?• The convention is to treat the inventory

investment here as if the coconut producer bought $6 million in coconuts from itself.


GDP using the Income Approach:Wage income $14.5mInterest income $0.5mTaxes $4.5mProfits distributed by producers $30m So, GDP $49.5

• Everything is same as before except the after-tax profits of coconut producers, which are raised to:

($20m - $5m - $0.5m - $1.5m) +$6m = $19m• We add the $6 million in inventories to the coconut producer’s profit

because this is an addition to the firm’s assets.• The after-tax profits of the restaurant remain unchanged at $11m.

An Example with International Trade

• Alter our original example of the fictional island economy slightly

• Suppose, the restaurant imports 2 million coconuts from other islands at $2 each, in addition to the coconuts purchased from the domestic coconut producer.

• All of these imported coconuts are used in the restaurant.

• The restaurant still sells $30 million in restaurant food to domestic consumers.

• Calculate the GDP using the three NIEA approaches.


GDP using the Product Approach:Value added – coconut producer $20 mValue added – restaurant $14 mValue added – government $5.5 mGDP $39.5 m

• Only the value-added of the restaurant has changed: ($30m -$12m -$4m)=$14m


GDP using the Expenditure Approach:• C = $38m, I = 0, G = $5.5m as before, but now

NX= Exports – Imports = 0-$4m = -$4m.• So, GDP = C + I + G + NX = $39.5 million.


GDP using the Income Approach:Wage income $14.5mInterest income $0.5mTaxes $4.5mProfits distributed by producers $20m So, GDP $39.5

• Everything is same as before except the after-tax profits of the restaurant, which are reduced to:

($30m - $4m - $12m - $4m - $3m) = $7m• The after-tax profits of coconut producer remain unchanged

at $13m.

Gross National Product (GNP)

• At one time GNP was used in Canada as the official measure of aggregate production.

• In line with international practice, however, the official measure is now GDP.

• GNP measures the value of output produced by domestic factors of production, whether or not the production takes place (as is the case for GDP) inside a country’s borders.

• GNP = GDP + Net Receipts of Factor Income from the Rest of the World

Gross National Product (GNP)• For example, if an oil well in South America is owned

and managed by Canadian residents, then the incomes accruing to Canadian factors of production include the managerial income and profits of this oil, and this is included in Canadian GNP, but not in Canadian GDP.

• GNP is typically significantly smaller than GDP in Canada (see Fig 2.1 in the textbook).

• In the second quarter of 2008, GDP was 1.02% higher than GNP in Canada.

• Reason: a significant fraction of productive plant and equipment in Canada is foreign owned.

What does GDP Leave Out?

• GDP is intended simply as a measure of the quantity of output produced and exchanged in the economy as a whole.

• But, sometimes GDP, or GDP per person, is used as a measure of aggregate economic welfare. There are at least two problems with this approach.1. GDP ignores income distribution.2. GDP leaves out all nonmarket activity, such as work in the home.

What does GDP Leave Out?

• There are also at least two problems with GDP as a measure of aggregate output.1. Economic activities in the so-called underground economy are, by definition, not counted in GDP.2. Method of counting government expenditures.

• The size of underground economy may be significant in Canada (evidence: Canadian currency held per Canadian resident was about $1524 at the end of 2008)


Gross Domestic Product For 2007


Nominal and Real GDP and Price Indices

• For many purposes we would like to make comparisons of GDP in different time periods.

• Such comparisons can tell us something about growth in the productive capacity of the economy over time and about growth in our standard of living.

• Obstacle: the average level of prices changes over time, so that part of the increase in GDP that we typically observe is due to inflation.


• We will learn how to adjust for this effect of inflation on the growth in GDP, and in so doing we also learn a measure of the price level and the inflation rate.

• A price index is a weighted average of the prices of a set of the goods and prices produced in the economy over a period of time.

• If the price index includes prices of all goods and services, then that price index is a measure of the general price level, or the average level of prices across all goods and services.


• Price indices allow us to measure the inflation rate – the rate of change in the price level from one period of time to another.

• A measure of the inflation rate allows us to determine how much of an increase in GDP is nominal and how much is real.

• A nominal change in GDP is a change in GDP that occurred only because the price level changed.

• A real change in GDP is an increase in the physical quantity of output.


Data for Real GDP Example


Notations

• Let Qa1 denote the quantities of apples

produced in year 1.• Let Qo

1 denote the quantities of oranges produced in year 1.

• Let Qa2 denote the quantities of apples

produced in year 2.• Let Qo

2 denote the quantities of oranges produced in year 2.

Notations

• Let Pa1 denote the price of apples in year 1.

• Let Po1 denote the price of oranges in year 1.

• Let Pa2 denote the price of apples in year 2.

• Let Po2 denote the price of oranges in year 2.

Nominal GDP and Nominal Change

• Year 1 Nominal GDP isGDP1= Pa

1 Qa1+ Po

1 Qo1=($150)+($0.8100)=$130

• Year 2 Nominal GDP isGDP2= Pa

2 Qa2+ Po

2 Qo2=($1.2580)+($1.60120)=$292

• The percentage change in nominal GDP from year 1 to year 2 is equal to

[(GDP2-GDP1)/GDP1] 100% = [(GDP2/GDP1) - 1] 100% [($292/$130) – 1] 100% = 125%.• How much of this increase in nominal GDP is accounted for by

inflation, and how much by an increase in the real quantity of aggregate output produced?

Real GDP and Real Change

• Until recently, the practice in Canadian NIEA was first to choose a base year and then calculate real GDP using these base year prices.

• Rather than multiplying the quantities produced in a given year by current year prices, we multiply base year prices to obtain real GDP.

Real GDP and Real Change• In our previous example, suppose that we use Year 1

as the base year• Let RGDP1

1 and RGDP12 denote real GDP in years 1

and 2, respectively, calculated using year 1 as the base year.

• Note: In the notations for real GDP, superscript shows the base year and the subscript shows the year for which we are calculating real GDP.

• In year 1, real GDP is same as the nominal GDP because year 1 is the base year. So, we have

RGDP11 = GDP1= $130.


• For year 2 real GDP, we use year 2 quantities and year 1 prices to obtain

RGDP12 = Pa

1 Qa2+ Po

1 Qo2=($180)+($0.80120)=$176

• The ratio of real GDP in year 2 to real GDP in year 1, using year 1 as the base year, is

g1= (RGDP12/ RGDP1

1)=($176/$130)=1.354.

• So, the percentage increase in real GDP using this approach is (1.354-1) 100% = 35.4%.


• Alternatively, now suppose that we use Year 2 as the base year

• Let RGDP21 and RGDP2

2 denote real GDP in years 1 and 2, respectively, calculated using year 2 as the base year.

• In year 2, real GDP is same as the nominal GDP because year 2 is the base year. So, we have

RGDP22 = GDP2= $292.


• For year 1 real GDP, we use year 1 quantities and year 2 prices to obtain

RGDP21 = Pa

2 Qa1+ Po

2 Qo1=($1.2550)+($1.6100)=$222.50

• The ratio of real GDP in year 2 to real GDP in year 1, using year 2 as the base year, is

g2= (RGDP22/ RGDP2

1)=($292/$222.5)=1.312.

• So, the percentage increase in real GDP using this approach is (1.312-1) 100% = 31.2%.


• A key message from the example is that the choice of the base year matters for the calculation of real GDP.

• If year 1 is used as the base year, then the increase in real GDP is 35.4%, and if year 2 is the base year, real GDP is calculated to increase by 31.2%.


• The reason the choice of the base year matters in the example, and in reality, is that the relative prices of goods change over time.

• The relative price of apples to oranges in year 1 is (Pa

1 / Po1 ) = ($1/$0.8)= 1.25 oranges.

• The relative price of apples to oranges in year 2 is (Pa

2/ Po2 ) = ($1.25/$1.6)= 0.78 oranges.

• Therefore, apples became cheaper relative to oranges from year 1 to year 2.

• If relative prices had remained the same between year 1 and year 2, then the choice of the base year would not matter.

A Chain-weighting scheme for calculating Real GDP

• The problem of changing relative prices could be severe in calculating real GDP far away from base year, in calculating real GDP in 2008 relative to a base year in 1982.

• Solution: use a chain-weighting scheme for calculating real GDP.

• With the chain-weighting approach, a “Fisher Index” is used, and the approach essentially like using a rolling base year.


• In our previous example, the chain-weighted ratio of real GDP in year 2 to real GDP in year 1 is

gc= square root of (g1 g2)

= square root of (1.354 1.312) = 1.333

• The chain-weighted ratio of real GDP in the two years is basically a geometric average of the ratios calculated using each of years 1 and 2 as base years.

• The percentage increase in real GDP using the chain-weighting method is (1.333-1) 100% = 33.3%.

• The growth rate in this case falls between the growth rates we calculated using the other two approaches. Why?


• Using gc, we can now calculate real GDP in terms of the dollars of any year we choose.

• In our previous example, if we want real GDP in year 1 dollars, then real GDP in year 1 is the same as the nominal GDP or GDP1=$130.

• And the real GDP in year 2 is equal toGDP1 gc= =$130 1.33 = 173.29.


• Alternatively, in our previous example, if we want real GDP in year 2 dollars, then real GDP in year 2 is the same as the nominal GDP or GDP2=$292.

• And the real GDP in year 1 is equal to(GDP2 / gc) =($292 / 1.33) = 219.05.

• In practice, the growth rates in real GDP in adjacent years are calculated just as we have done it her, and the real GDP is “chained” together from one year to the next.

• See Figure 2.2


Nominal GDP and Chain-Weighted Real GDP


Measures of the Price Level

• Implicit GDP price deflator = (Nominal GDP/Real GDP) 100• Here, multiplying by 100 just normalizes the price deflator to

100 in the base year• For our previous example, the implicit GDP price deflator we

calculate would depend on whether we use year 1 or year 2 as a base year, or compute the chain-weighted real GDP.


Implicit GDP Price Deflators, Example


CPI

• The alternative measure of the price level is the Consumer Price Index (CPI).

• Current Year CPI = ( Cost of base year quantities at current prices / Cost of base yaer quantities at base year prices) 100


Inflation Rate Calculated from the CPI and from the Implicit GDP Price Deflator


Problems with Measuring Real GDP and the Price Level

• The measurement of real GDP and the measurement of price level are closely related.

• If a particular measure of real GDP underestimates the growth in real GDP, the rate of inflation will be overestimated.

• In practice, there are three important problems with measuring real GDP and the price level:


1. The first problem is that the relative prices change over time. i) Solution: the chain-weighting approachii) Changes in relative prices can also introduce severe bias in how the CPI measures inflation – biased upwardiii) This could increase the government budget deficit.iv) Read Macro in Action 2.1 in pages 48-49.


2. A second problem in measuring real GDP concerns the changes in the quality of goods over time.

3. A third problem is how measured GDP takes account of new goods.

Savings, Wealth, and Capital

• A key aspect of the economy that is of interest to macroeconomists is aggregate productive capacity and how aggregate savings add to this productive capacity.

• We will explore the relationships among savings, wealth, and capital.

• Two important concepts: flows and stocks.• A flow is a rate per unit time.• A stock is the quantity in existence of some object at

a point in time.


• GDP, consumption, investment, government spending, and net exports are all flows in the NIEA.

• The quantity of housing in existence in Canada at the end of a given year is a stock.

• National saving is a flow, while the nation’s wealth is a stock.

• National saving is the flow that is added to the stock of the nation’s wealth in each year.


• Savings: private sector saving (Sp), government saving (Sg), and national saving (S)

• To determine Sp, we first need to start with what the private sector has available to spend, which is private disposable income, denoted Yd.

• Yd = Y + NFP + TR + INT – T,where Y is GDP, NFP is net factor payment from abroad to domestic residents, TR is transfers from the government to the private sector, INT is the interest on the government debt, and T is taxes.

• Recall, GNP = Y + NFP


• What the private sector saves is simply what it has available to spend minus what is consumes.

• Sp = Yd – C = Y + NFP + TR + INT – T - C• What the government has available to spend is (T-

TR-INT)• What the government consumes is government

expenditures, G. • Thus, government saving, Sg = T – TR – INT – G


• Government saving is the government surplus or budget surplus.

• The government surplus is equal to the negative of the government deficit, denoted D.

D = - Sg = -(T – TR – INT – G) = TR + INT + G – T• The government deficit is just government outlays

minus government receipts.• S = Sp + Sg = Y + NFP+TR+INT–T- C + T – TR – INT – G• S = Y + NFP – C – G (1)


• Recall, income – expenditure Identity: Y = C + I + G + NX (2)

• Substitute Y from equation (1) using equation (2),S = Y + NFP – C – G

= C + I + G + NX + NFP – C – GSo, S = I + NX + NFP (3)

• Thus, national saving must equal investment plus net exports plus net factor payments from abroad.


• The quantity NX + NFP is the current account surplus with the rest of the world, which we will denote CA.

• CA is measure of the balance of trade in goods and services with the rest of the world.

• Using the definition of CA in equation (3),S = I + CA (4)

• The identity (4) implies that any domestic savings not absorbed by domestic investment must be shipped outside the country in form of goods and services.


• As a flow, national saving represents additions to the national wealth which is the stock of assets held by the country as whole.

• Since S= I + CA, wealth is accumulated in two ways.1. Wealth is accumulated through investment, I, which

is the addition to the nation’s capital stock. The capital stock is the quantity of plant, equipment, housing and inventories in existence in an economy at a point in time.


2. Wealth is accumulated through current account surpluses, CA, since a current account surplus implies that Canadian residents are accumulating claims on foreigners.

• If goods are flowing from Canada to other countries, then these goods must be paid for with a transfer of wealth from outside Canada to Canadian residents.

Labour Market Measurement• Focus on the monthly household survey carried out

by Statistics Canada.• In this survey, the population aged 15 and older is

divided into three groups:1. the employed – those who worked part-time or

full-time during the past week;2. the unemployed – those who were not employed

during the past week but actively searched for work at some time during the last four weeks;

3. not in the labour force – those who are neither employed nor unemployed.

Labour Market Measurement

• Three important measurements:Unemployment rate

= Number of unemployed/ Labour force

2. Participation rate= Labour Force / Total working-age population3. Employment/population ratio = Employment/ Total working-age population

Labour Market Measurement• The unemployment is potentially useful as a measure of

labour market tightness, which is the degree of difficulty firms face in hiring workers.

• A decrease in unemployment implies an increase in the market tightness.

• But there are two ways in which the unemployment rate might mismeasure labour market tightness.

1. Existence of discouraged workers - refers to the people who are not counted in the labour force and have stopped searching for work but actually want to be employed.

2. The unemployment rate does not adjust for how intensively the unemployed are searching for work.

Labour Market Measurement

• Partly because of problems in interpreting what movements in the unemployment rate mean, macroeconomists often focus attention on the level an growth rate of employment.

• The behaviour of the participation rate and the employment/ population ratio are relatively more interesting than the unemployment rate for some empirical studies.

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Chapter 2 Measurement Copyright © 2010 Pearson Education Canada