Numerical tasks: Write an appropriate equation and use it to compute the answer.

1. The real GDP increases from the previous year $200 billion to $210 billion this year. What is the of economic growth rate?

2. The decrease in inflation by 1 percentage point is associated with a fall in real GDP by 5% per year. According to the Okun law, the deviation of the unemployment rate from the natural rate by 1 percentage point causes changes in GNP by 2% over the same period. What will the level of cyclical unemployment be if inflation falls by 3 percentage points?  

3. Nominal GDP is $ 750 billion, natural unemployment rate is 5%, actual unemployment rate is 9%. What is the loss in the volume of production in the country in money terms when the unemployment rate is higher than the natural level of unemployment (assuming the Okun coefficient equals 2.5)?

4. Compute the gap between the potential GDP and the actual GDP if the actual unemployment rate is 2 percentage points higher than the natural level of unemployment.

5. If real GDP rose by 6% and the population increased by 3% in the same year. How did real GDP per capita change?

6. Nominal versus real GDP: Suppose that nominal GDP is $10 trillion in 2003 and $11 trillion in 2004. Suppose that the implicit price deflator has gone from 1.063 in 2003 to 1.091 in 2004. 1) Compute real GDP in 2003 and 2004. 2) Using the percentage change in the implicit price deflator as the gauge, what was the inflation rate over the period?

7. Unemployment: Use the data in the table to compute the unemployment rate in Year One and in Year Two. Explain why, in this example, both the number of people employed and the unemployment rate increased.

Year	Number employed (in millions)	Number unemployed (in millions)
1	20	2
2	21	2.4

 

 

Chapter 2. Measuring Total Output and Income

Unit 2.1 The Components of GDP

Learning objectives

1. Define gross domestic product and its four major spending components and illustrate the various flows using the circular flow model.

2. Distinguish between measuring GDP as the sum of the values of final goods and services and as the sum of values added at each stage of production.

GDP is the total value of all final goods and services produced during a particular period valued at prices in that period. We can divide the goods and services produced during any period into four broad components, based on who buys them. These components of GDP are personal consumption (C), gross private domestic investment (I), government purchases (G), and net exports (X _n).

GDP = C + I + G + Xn

Personal Consumption

Personal consumption is a flow variable that measures the value of goods and services purchased by households during a time period. Purchases by households of groceries, health-care services, clothing, and automobiles—all are counted as consumption.

Personal consumption represents a demand for goods and services placed on firms by households. Figure Personal Consumption in the Circular Flow presents a circular flow model for an economy that produces only personal consumption goods and services. We will add the other components of GDP to the circular flow as we discuss them. Spending for these goods flows from households to firms; it is the arrow labeled ‘Personal consumption’. Firms produce these goods and services using factors of production: labor, capital, and natural resources. These factors are ultimately owned by households. The production of goods and services thus generates income to households; we see this income as the flow from firms to households labeled ‘Factor incomes’.

Figure Personal Consumption in the Circular Flow

Private Investment

Gross private domestic investment, often simply referred to as ‘private investment’ is the value of all goods produced during a period for use in the production of other goods and services. Like personal consumption, private investment is a flow variable. A hammer produced for a carpenter is private investment. A printing press produced for a magazine publisher is private investment, as is a conveyor-belt system produced for a manufacturing firm. Capital includes all the goods that have been produced for use in producing other goods; it is a stock variable. Private investment is a flow variable that adds to the stock of capital during a period.

Note!

The term “ investment ” can generate confusion. In everyday conversation, we use the term “ investment ” to refer to uses of money to earn income. We say we have invested in a stock or invested in a bond. Economists, however, restrict “ investment ” to activities that increase the economy’s stock of capital.

 

Private investment includes three flows that add to or maintain the nation’s capital stock:

1. expenditures by business firms on new buildings, plants, tools, equipment, and software that will be used in the production of goods and services;

2. expenditures on new residential housing;

3. changes in business inventories. Any addition to a firm’s inventories represents an addition to investment; a reduction subtracts from investment. For example, if a clothing store stocks 1,000 pairs of jeans, the jeans represent an addition to inventory and are part of gross private domestic investment. As the jeans are sold, they are subtracted from inventory and thus subtracted from investment.

Despite its relatively small share of total economic activity, private investment plays a crucial role in the macroeconomy for two reasons:

1. Private investment adds to the economy’s capacity to produce and shifts its production possibilities curve outward. Investment is thus one determinant of economic growth, which is explored in another chapter.

2. Private investment is a relatively volatile component of GDP; it can change dramatically from one year to the next. Fluctuations in GDP are often driven by fluctuations in private investment.

Private investment represents a demand placed on firms for the production of capital goods. While it is a demand placed on firms, it flows from firms. In the circular flow model in Figure “Private Investment in the Circular Flow”, we see a flow of investment going from firms to firms. The production of goods and services for consumption generates factor incomes to households; the production of capital goods for investment generates income to households as well.

Figure Private Investment in the Circular Flow

 

Government Purchases

Government agencies at all levels purchase goods and services from firms. They purchase office equipment, vehicles, buildings, services, and so on. Many government agencies also produce goods and services. Police departments produce police protection. Public schools produce education.

Government purchases are the sum of purchases of goods and services from firms by government agencies plus the total value of output produced by government agencies themselves during a time period.

Government purchases are not the same thing as government spending. Much government spending takes the form of transfer payments, which are payments that do not require the recipient to produce a good or service in order to receive them. Transfer payments include Social Security and other types of assistance to retired people, welfare payments to poor people, and unemployment compensation to people who have lost their jobs. Transfer payments do not count in a nation’s GDP, because they do not reflect the production of a good or service.

Government purchases represent a demand placed on firms, represented by the flow shown in Figure Government Purchases in the Circular Flow. Like all the components of GDP, the production of goods and services for government agencies creates factor incomes for households.

Figure Government Purchases in the Circular Flow

Net Exports

Sales of a country’s goods and services to buyers in the rest of the world during a particular time period represent its exports. A purchase by a Japanese buyer of a Ford produced in the United States is a U.S. export. Imports are purchases of foreign-produced goods and services by a country’s residents during a period. Subtracting imports from exports yields net exports.

Exports (X) − imports (M) = net exports (Xn)

Net exports can be positive or negative. Negative net exports constitute a trade deficit. The amount of the deficit is the amount by which imports exceed exports. When exports exceed imports there is a trade surplus.

In the circular flow diagram in Figure Net Exports in the Circular Flow, net exports are shown with an arrow connecting firms to the rest of the world.

Figure Net Exports in the Circular Flow

 

A nation’s GDP

The production of goods and services for personal consumption, private investment, government purchases, and net exports makes up a nation’s GDP. Firms produce these goods and services in response to demands from households (personal consumption), from other firms (private investment), from government agencies (government purchases), and from the rest of the world (net exports). All of this production creates factor income for households. Figure Spending in the Circular Flow Model shows the circular flow model for all the spending flows discussed.

Figure Spending in the Circular Flow Model

The circular flow model identifies some of the forces at work in the economy, forces that we will be studying in later chapters. For example, an increase in any of the flows that place demands on firms (personal consumption, private investment, government purchases, and exports) will induce firms to expand their production. This effect is characteristic of the expansion phase of the business cycle. An increase in production will require firms to employ more factors of production, which will create more income for households. Households are likely to respond with more consumption, which will induce still more production, more income, and still more consumption. Similarly, a reduction in any of the demands placed on firms will lead to a reduction in output, a reduction in firms’ use of factors of production, a reduction in household incomes, a reduction in income, and so on. This sequence of events is characteristic of the contraction phase of the business cycle.

Final Goods and Value Added

GDP is the total value of all final goods and services produced during a particular period valued at prices in that period. That is not the same as the total value of all goods and services produced during a period. This distinction gives us another method of estimating GDP in terms of output.

Suppose, for example, that a logger cuts some trees and sells the logs to a sawmill. The mill makes lumber and sells it to a construction firm, which builds a house. The market price for the lumber includes the value of the logs; the price of the house includes the value of the lumber. If we try to estimate GDP by adding the value of the logs, the lumber, and the house, we would be counting the lumber twice and the logs three times. This problem is called ‘double counting’, and the economists who compute GDP seek to avoid it.

Another approach to estimating the value of final production is to estimate for each stage of production the value added, the amount by which the value of a firm’s output exceeds the value of the goods and services the firm purchases from other firms. Table Final Value and Value Added illustrates the use of value added in the production of a house.

Table Final Value and Value Added

Good	Produced by	Purchased by	Price	Value Added
Logs	Logger	Sawmill	$12,000	$12,000
Lumber	Sawmill	Construction firm	$25,000	$13,000
House	Construction firm	Household	$125,000	$100,000
		Final Value	$125,000
		Sum of Values Added		$125,000

 

If we sum the value added at each stage of the production of a good or service, we get the final value of the item. The example shown here involves the construction of a house, which is produced from lumber that is, in turn, produced from logs.

Suppose the logs produced by the logger are sold for $12,000 to a mill, and that the mill sells the lumber it produces from these logs for $25,000 to a construction firm. The construction firm uses the lumber to build a house, which it sells to a household for $125,000. The value of the final product, the house, is $125,000. The value added at each stage of production is estimated as follows:

a. The logger adds $12,000 by cutting the logs.

b. The mill adds $13,000 ($25,000 − $12,000) by cutting the logs into lumber.

c. The construction firm adds $100,000 ($125,000 − $25,000) by using the lumber to build a house.

The sum of values added at each stage ($12,000 + $13,000 + $100,000) equals the final value of the house, $125,000.

The value of an economy’s output in any period can thus be estimated in either of two ways. The values of final goods and services produced can be added directly, or the values added at each stage in the production process can be added.