ECO 509 PP2 GDP and Components Revised

7/31/2019 ECO 509 PP2 GDP and Components Revised

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Accounting for the economy Economists must have a system of

accounts that summarize economic

activity across the economy This data base is called The National

Income and Product Accounts

Issued quarterly, though the data areannualized

Sitting atop the NIPA is Gross DomesticProduct


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Gross Domestic Product is our broadest

measure of production

GDP: the dollar market value of all finalgoods, services and structures produced

by labor and property located in theUnited States in one year

Note that GDP is a flow concept, as areall parts of the NIPAs because we aremeasuring activity over time; in thiscase one year (or in some cases, onequarter)


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Key observations about the

nature of GDP GDP is measured in dollars, or dinars, or

euros, not physical units of weight or size

GDP is limited to market activities, and toprices as actually paid in the market

We must avoid double counting production,so we limit GDP to final goods and services

Most Important: GDP is a measure of currentproduction


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GDP can be computed three ways The sum of all expenditures in the economy:

consumption, investment, government, net

exports The sum of income payments and costs

incurred in production in the economy:purchasing power of households and the

financial status of businesses The sum of gross value added (gross output

less intermediate purchases) across all privateindustries and government


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Reporting of GDP The expenditures approach is most reliable,

and is used by most all analysts worldwide

GDP is computed and reported by theDepartment of Commerce, Bureau ofEconomic Analysis (www.bea.gov)

In Bahrain it is done by the CentralInformatics Organization(http://www.cio.gov.bh/cio_eng/SubDetailed.aspx?subcatid=233 )
http://www.bea.gov/http://www.cio.gov.bh/cio_eng/SubDetailed.aspx?subcatid=233http://www.cio.gov.bh/cio_eng/SubDetailed.aspx?subcatid=233http://www.cio.gov.bh/cio_eng/SubDetailed.aspx?subcatid=233http://www.cio.gov.bh/cio_eng/SubDetailed.aspx?subcatid=233http://www.bea.gov/


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Three ways to report GDP Reporting styles vary across countries, and can lead

to confusion if you are not careful

1.

Growth from one quarter to the next, called quarterover quarter (Q/Q)

2. Growth over the past 12 months, comparing GDP in2009Q2 to 2008Q2, called year over year (Y/Y)

3.

Seasonally adjusted annual rate (s.a.a.r.),annualizes quarter over quarter data by assuminggrowth continues for one year at the Q/Q rate; USdata reported as s.a.a.r.


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How s.a.a.r works GDP is computed in one quarter, and then

compared to GDP the quarter before,

resulting in a rate of change This Q/Q rate is then annualized essentially

by multiplying Q/Q rate by 4

So, if the change from Q1 to Q2 is 1.0%,then the s.a.a.r. is roughly 4.0%, which is thenumber that will be reported by the BEA


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Adjusting GDP for changes in

prices GDP is computed first using current prices

and quantities, called current dollar GDP (e.g.$14.867 trillion current dollars in 2011Q1)

Cannot compare current dollar GDP from yearto year due to possible changes in the valueof the dollar within the country (inflation ordeflation)

GDP adjusted for changes in prices is calledreal GDP (e.g. $13.227 trillion chained 2005dollars in 2011Q1)


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Adjusting GDP results in an overall

measure of inflation Price changes are removed using a

price index; a different index is used for

each category of good because inflationrates vary by sector

The overall index for inflation economy-wide is called the chain-weighted index

Once price effects are removed we cancompare values for RGDP over time


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What is a good number for

GDP growth? To decide if GDP is growing as it should

we must establish some standard

Can use history as a standard: theaverage reported growth rate of GDPover several decades can serve as abenchmark (3.32% per year since 1946for US, 5.4% for Bahrain since 1989)

Or we can establish some measure ofpotential (not computed by BEA)


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Potential GDP is our best

benchmark for assessing growth Potential GDP is the sum of labor force

growth, productivity growth, and the

change in the number of hours worked Potential GDP is different for every

country, and for the same country at

different times because thedeterminants of potential change overtime


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The Growth Cycle The Growth Cycle, defined as fluctuations in

the rate of growth of RGDP around its long-

run trend growth rate

The gap between actual growth and potentialgrowth can tells us much about production,and it can be a signal about other facets ofthe economy


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Setting the Growth Cycle

benchmark The Growth Cycle is segmented by how

actual RGDP growth compares to the

benchmark growth rate The preferred benchmark is potential

RGDP

Many economists put potential currentlyat 2.25 - 2.5%, with labor growing alittle less than 1% and productivitygrowing around 1.25-1.5%


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The Growth Cycle graph

0

Growth Rateof Real GDP

Time

Potential GDP

Growth Expansion:

Actual Growth > Potential

Growth Recession:0 < Actual Growth < Potential

Recession:Actual Growth < 0

Potential Growth:Growth of Productivity

+Growth of Labor Force

+

Change in Hours Worked


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A three-part interpretation When assessing the implications of a single

observation we must evaluate three facets:

Where exactly are we, above or belowpotential?

Where have we been over the past four to sixquarters?

What are the values of other importantvariables such as unemployment andinflation?


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Segments of the Growth Cycle:

growth expansion The area on the Growth Cycle graph where

actual growth is greater than potential

Can involve a rise in inflationary pressures, afall in unemployment, and often a rise ininterest rates

Interest rates will not be raised in a growthexpansion directly after a recession, whenunemployment is still well above its naturalrate


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growth recession Involves a weak but growing economy where

actual growth is lower than potential, but

greater than zero Growth is too slow to create enough new jobs

to accommodate new labor-market entrants,so unemployment usually rises

Usually inflationary pressures fall, as willinterest rates if the Fed fears a recession willsoon follow


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recession The area of the Growth Cycle graph

where the growth rate of RGDP falls

below zero (Note: RGDP in dollar termsis falling as well)

Results in falling inflationary pressures,rising unemployment, and a fall ininterest rates as the Fed attempts tostimulate spending


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Coming in for a landing The Fed responds to a prolonged growth expansion

by raising interest rates to stave off inflation, butwhere do we end up when the economy ultimately

slows?

A soft landing occurs when we achieve our goal,which is actual growth equal to potential

A hard landing occurs when we end up in a growth

recession

A crash landing occurs when the result is a recession


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The components of GDP: why

they matter Provides information on what parts of

the economy are weak or strong; can

guide analysts and policy makers Comparing actual GDP to the sum of

planned spending by the four

components allows us to determine thefuture direction of the economy


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The concept of equilibrium In macroeconomics, equilibrium exists

when the planned spending of all

economic agents (households, firms,government, and foreigners) match theactual output of the economy, RGDP

Requires we specify what constitutesplanned spending, and then compare itto actual RGDP


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Why equilibrium matters Equilibrium is the only level of RGDP (Y) that

can exist with no tendency for change

Levels ofY that are not equilibriums will notlast, and actual Y will drift towards a stableequilibrium level, which we called Ye

In short, once Ye

is known and compared toactual Y, we can forecast the next move in Y

Plans reality always results in change


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Equilibrium condition specified If equilibrium means reality equals planned

spending, then we must define both

Reality will be measured by RGDP, Y Plans will be measured by aggregate planned

expenditures of all four agents:

AEp = C + I + G + NXSo, equilibrium will require that

Y = AEp = C + I +G + NX


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Violation of the equilibrium

condition How will we know if plans and reality do not match?

Lets call this error unplanned investment, Iu

It shows up in unwanted accumulation ofinventories:

1. If(Y- AEp)>0, then spending was less than firmsexpected and produced for, and inventories rise;Iu>0

2. If(Y- AEp)


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The components of GDP:

Consumption Consumption is spending done by households

on goods and services

Officially called Personal ConsumptionExpenditures

Comprised of: services, non-durables, anddurables (lasting 3 years or more)

Services and non-durables are stable Spending on durables can be highly unstable,

and is of utmost importance to analysts


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Modeling consumption Households receive income, and two things

are done with the money: some is spent, andsome is saved: y = C + S

The amount spent is called Consumption, andit is a positive function ofy:

C= f (y) ; dC/dy > 0

Then we can run the function in a linearform, and the consumption function is:

C = a + by


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Components of the

consumption function The component arepresents the amount of

spending dependent on factors other than

income It is called autonomous consumption, which is

spending independent of income

The bis the slope of the consumption function,and is equal to dC/dy; the name ofbis themarginal propensity to consume, or MPC


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The consumption function

C = a + by

C = y

a

C

y0


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Income not spent is called saving Since y = C+S, and C = a + by, then

the saving function is

S = -a + (1-b)y The (1-b)is the marginal propensity to

save

Saving is found graphically as thevertical gap between the consumptionfunction and the C=yline


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Finding saving

C = a + by

C = y

a

C

y0

y2 y0 y1

S < 0

S > 0


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Saving on the graphAt any given y, ifC>y, then the

household is drawing funds from its

savings accounts to spend more than itmakes - called dissaving

At any given y, ifC


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Investment Consists of spending done by firms on final

goods Officially known as Gross Private Domestic

Investment Divided into three components: residential

construction, non-residential construction,and changes in inventory

All three components can be unstable,especially inventories, thus investment iswatched by analysts constantly


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The plans of firms: investment Investment divided into two parts: planned

and unplanned

Planned Investment is spending by firms, andit depends on the cost of funds and theprofitability of the capital; at any point in timeit is independent of income but dependent on

interest rates Unplanned are unwanted additions to

inventories


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Where does the money for

investment come from? Saving involves households setting

aside for the future, foregoing

spending now so that they may spendin the future

Investment is exactly the samebehavior, just done by firms

For investment to occur, householdsmust save, and I = S


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Government Involves government purchase of goods

and services only, not all government

expenditures Excludes transfer payments because

they do not involve current production

Has a stabilizing effect on the economydue to size and constancy over time


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The plans of the government

sector Government spending depends on a budget,

and at any one time it is a fixed amount,

independent of GDP, which we will call G Need taxes to pay for the G, and the most

simple way is to pay a lump sum, which willcan call T; All taxes will be paid by the

households, so now we have a newconsumption function:

C = a + b (y-T)


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Deficits and the debt A fiscal deficit occurs when, in one fiscal year,

a government spends more in total (including

transfer payments) than it receives in taxrevenue

If total spending is less than total taxrevenues, then the government has a fiscal

surplus The running total of unpaid deficits is called

the national debt


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The components of GDP: Net

Exports Calculated as dollar value of exports minus

dollar value of imports

NX can be either positive (a trade surplus) ornegative (a trade deficit)

Is a relatively small net number in total GDPin most countries, so it has not historically

been the source of business cycles or inflation


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The foreign sector is part of

total spending plans We cannot ignore this sector because

several sectors of the economy are

absolutely dependent on the foreignproducers and buyers, e.g. automobiles,electronics, machinery, apparel

Generally speaking, imports arecorrelated with the growth rate of GDP:when GDP growth rises, imports rise

ECO 509 PP2 GDP and Components Revised

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