Unit Code: 11102 Handout #2/01
Some Definitions and Preliminaries
A. Measuring aggregate or total output: Gross Domestic Product
Gross Domestic Product or GDP is a measure of the total output of an economy during a particular period, such as a year. Blanchard explains it and related ideas in Chs. 2&3 and appendix 2, but a little briefly and in a US setting. Here I explain it a little more.
Imagine firm A produces 1,000 units of steel priced at £1 per unit, i.e. £1,000 worth of steel. It stores 250 units and sells the remainder to firm B which converts it into 12,000 nails worth 10p each, i.e. £1,200 worth of nails. How is the value of the total output of the economy affected by these transactions? It might seem that output has gone up by £1000 + £1,200 = £2,200; but this double-counts the £750 worth of steel used by the nail manufacturers; the nail manufacturers have only really added £450 worth of value to the steel they bought. The value added by each firm is £1,000 by firm A and £450 by firm B. (Of course, this assumes that firm A produced the steel from nothing; but, in an example, you have to start somewhere.) So the total value added is £1,450. GDP sums the value added by each firm, individual, government organisation: the sum of all values added in an economy is a measure of the economy's total output. It is known as gross domestic product or GDP Alternatively, this same measure can be calculated as the value of the output of final goods and services produced. In the example, this will equal the value of the output of nails, £1,200, plus the value of the output of steel which was not used to produce anything else, that is £250. The other £750 worth of steel is known as an intermediate good.
Let the amount of the ith final good produced (or service provided) in the economy during period t be denoted by . So, for example, might denote the number of Mars bars produced in 1997, the number of Jaguar cars, and pairs of Dr. Martens. Let the price of the ith final good or service in period t be denoted by . And let the number of types of final goods and services produced in the economy be denoted by N. Then the economy's GDP can be measured as:
This sum is known as nominal aggregate output, or nominal GDP, in period t and we shall denote it by or .
In the next period, period t+1, the value of nominal aggregate output, or nominal GDP, will be:
or
Clearly, changes in nominal GDP from period t to period t+1 can occur for two reasons: changes in the quantities of output produced, the s; and changes in the prices of those goods and services, the s. Often we want to separate these two types of change. To do so, we select one particular period, say 1990, as the base year. And we multiply the quantity of each good produced in period t, , by its price in that base year, . Summing over all N goods and services gives,
This quantity is known as real aggregate output, or real GDP, in period t, and we shall denote it by
Real GDP in period t+1 will be or .
Changes in real GDP can only occur because of changes in the quantities of goods and services; prices are, by construction, constant.
The graph shows UK aggregate nominal and real GDP for 1950-1995. The base year for the calculation of real output is 1990. Hence the two graphs intersect in year 1990.
Notice that, over the period, nominal GDP has grown faster than real GDP. Another way of putting this is that prices have risen over the period.
Source: Economic Trends
B. Measuring the General Level of Prices
There are two commonly used ways of calculating the general, or average, level of prices. The first, known as the GDP deflator, simply divides nominal GDP in period t by real GDP in period t, giving,
º {}/{} or
It measures the average price of the goods/services produced in the economy, weighting the price of each by its importance in total output. The GDP deflator is an index number: its level is quite arbitrary. As written above, it equals 1 in 1990, the base year. We could multiply it by 100 so that is 100 rather than 1 in the base year. This is, in fact, the usual practice.
The second and more commonly quoted measure of the general level of prices in the UK is the Retail Price Index or RPI. This works as follows: each month the Office of National Statistics uses 300 price checkers who visit 147 retail outlets, logging the price of more than 120,000 goods in a month. The selection of goods they look at varies from year to year but is supposed to be representative of consumers' purchases. The price of each good is weighted by the good's importance in a typical consumer's expenditure. The current basket contains 600 items, and includes goods such as bread, cheese, burgers, fromage frais, and services such as medical insurance and private school fees. In 1947, when the RPI first appeared, there were only 80 items including wild rabbits, lamp oil, tram fares, rubber roller table mangles, and distemper.
· The two measures of the general price level have moved very closely together over the last 40 years. [For clarity I have rebased the GDP deflator so that it starts off at the same value as the RPI.]
· The GDP deflator has increased slightly more quickly than the RPI.
Source: Economic Trends
A problem for all price indices is how to deal with goods that didn't exist in previous years or whose quality has improved. E.g. 50 years ago the first microwave oven was marketed in the US - it weighed about 350 kilos and was 5 feet 6 inches tall. Today, they are much commoner and more efficient. Recently it has been suggested that, in the US and possibly in other countries too, the imperfect treatment of this problem has led to the rate of increase in prices being overestimated by about 1 percentage point. So the "true" inflation rate may be closer to 2% than the 3% currently reported.
C. The Components of Expenditure on GDP
The goods and services a country produces, its GDP, can be split into two broad groups:
· Goods and services for immediate consumption. Examples are food, cinema tickets, car insurance, the hiring of skips for rubbish removal. Strictly, this type of good or service is one which is consumed almost as it is purchased, but, in practice, "consumer durables", e.g. new cars, fridges, videos, are also classified as consumption goods.
· Investment goods. Goods which are not for immediate consumption but rather for use over a significant period. There are three sub-categories usually identified: (i) fixed capital formation - machinery, computers, factory buildings etc. which help firms produce goods; (ii) residential investment - the construction of new houses; (iii) stockbuilding - goods/raw materials which firms hold as inventories to meet demand in the future for their final products.
Corresponding to these categories of total output there are similar categories of total expenditure, but the picture is slightly more complicated here, especially if the economy we are dealing with is "open" - that is, if it trades with other countries. For any such economy - call it the domestic economy - there are five categories of expenditure we can identify:
· Consumption expenditure. The total amount which the private consumers in the domestic economy spend on consumption goods and services produced both in the domestic economy and abroad.
· Investment expenditure. The total amount which the private sector of the domestic economy spends on investment goods produced both in the domestic economy and abroad.
· Government expenditure. The total amount which the government sector of the domestic economy spends on goods and services produced both in the domestic economy and abroad.
· Exports. The total amount which the rest of the world spends on goods and services produced in the domestic economy.
· Imports. The sub-total of the first three categories which consists of expenditure on goods and services produced abroad.
Total expenditure on goods and services produced in this particular economy is then the sum of the first four categories minus the fifth. These 5 categories of expenditure can be measured either in nominal terms, that is quantities times current prices, or in real terms, that is quantities times base year prices. When measured in the first of these ways the sum of the first four categories minus the fifth provides a measure of nominal aggregate expenditure; when measured in the second way it provides a measure of real aggregate expenditure.
Let , , , , and represent actual, real consumption, investment, government expenditure, exports and imports, respectively. Then total, actual, real expenditure, , will be
The graph shoes the fraction each component has contributed to aggregate spending in the UK from 1950-1995. A similar picture would emerge for other industrialised countries.
Note:
· Consumption expenditure is the most important
component of .
· The contribution of "net exports",
can be positive or negative.
· Investment expenditure appears to be the most
volatile component
Source: Economic Trends
D. National Income Accounting: the three measures of GDP
(a) The output measure of GDP.
On the first page of this handout, when explaining how GDP is the total value of the final goods and services produced in the economy during a period, I gave an example involving two firms producing steels and nails. The total value of final goods and services in that example was £1,450. That method of measuring GDP - the sum of the output of final goods and services - is known as the output measure of GDP. It is possible to measure it in two different ways and, in principle get exactly the same answer.
(b) The expenditure measure of GDP.
The first other method begins by asking what happens to this final output - the £250 worth of steel and the £1,200 worth of nails - in the previous example. By national income conventions, any final good or service must have been bought by someone, whether they wanted to or not. We assumed that firm A stored £250 worth of its output. In national income account terms, firm A bought £250 of its own output, and this would be classified, in the national income accounts, as an act of investment expenditure - under the sub-heading of stockbuilding. As for the £1,200 worth of nails: if they were all sold to consumers or the government, they would be classified as an item of consumption or government expenditure and the two would sum to £1,200. If firm A only managed to sell £1,000 worth of nails in this way, consumption and government expenditure would rise by only £1,000. But the remaining £200 worth of nails would be deemed as having been bought by firm B; firm B has, unwillingly perhaps, bought £200 worth of its own output; again, this would be classified as an item of investment expenditure. In total then, consumption and government expenditure would have risen by £1,000; and investment expenditure would have risen by £200+£250, so total actual expenditure, as measured in the national income accounts, would have risen by £1,450, exactly the amount by which the value of actual output has risen. GDP, therefore, can be measured by adding up all the categories of expenditure on final goods and services. The resultant GDP measure is known as the expenditure measure of GDP. Notice the stress on the word 'actual' in the explanation above. The identity of output and expenditure only holds if we are considering the actual value of output and expenditure or its components. As the example illustrates, it may be that some of this actual expenditure was not intended or desired. The distinction between actual and desired quantities will be crucial later on.
(c) The income measure of GDP
If actual expenditure has increased by £1,450, who has received it? The idea behind the third way of measuring the value of output is that for every act of expenditure there must, in principle, be a recipient, someone who receives as income, in one form or another, the final expenditure on the steel and the nails. To see how this might work out, assume that firm A pays its workers wages of £600; and that firm B pays its workers wages of £300. So, income from employment is £900. What has happened to the other £550? The answer is that it appears as income under the sub-heading profits. To see why profits will equal exactly £550, look first of all at firm B. It has earned £1,200 from selling its nails; it has paid out £750 to firm A for its steel; and it has paid its workers £300. Its profits are £150. Firm A has obtained £750 from firm B; the value of its holdings of its own product has increased by £250, which is counted as an asset item in its balance sheet; and it has paid out £600 to its workers. So firm A's profits are £400. The total profits of the two firms are therefore £550. So total actual income has gone up by £1,450.
Putting this all together we have the three measures of GDP giving the following:
______
GDP Output-based GDP Expenditure-based GDP Income-based
Value added:
Firm A £1000 C £600 Income type:
Firm B £450 I £250 Employment £900
G £600 Profits £550
______
Total £1450 £1450 £1450
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E. Minor technicalities.
There are three other complications which are not very important for the course but which you should be aware of.