Unit 3: Growth and GDP

Measures: GDP, Real GDP, and Growth

In the last Unit we concluded that any society basically has four goals for the macro-economy:

  1. Achieve high growth in amount of goods and  services produced.
  2. Achieve stable money and prices
  3. Achieve stable, predictable growth without declines
  4. Make full use of all resources, particularly labor.

In this unit, we will focus on the first of these goals: Growth in goods and services.  After all, our living standard is largely based on the quantity and quality of goods and services we can consume, and we can’t consume them unless we produce them first.  A successful economic system should produce improving living standards and that means increasing the amount of goods and services we can produce.

In this unit we are going to study first how we can measure the total production (called output) of the economy using a measure called Gross Domestic Product (GDP). Then we will evaluate that measure to see if it really tells us what we want to know.  As a result, we will derive a couple of modifications to this measure that result in measures called Per-Capita GDP.  Then we will see how changes in the value of money over the years can distort our measure of GDP. This will force us to develop another concept and measure called “Real GDP”.  Finally, we will survey what economists have concluded are the real sources of economic growth over the long-run.

Learning Objectives for Unit 3:

  • Calculate and explain measures of aggregate output (GDP), aggregate income (national income), and the price level.
  • Criticize and evaluate the use GDP and Per-Capita GDP as measures of economic well-being.
  • Describe the components of aggregate demand (spending on GDP), their relative size, and their historical volatility.
  • Identify and describe the sources of long-run economic growth and what factors promote high rates of growth.
  • Explain what the difference is between “Real” amounts and “Nominal” amounts, and apply the concept to GDP.
  • Describe what a price index does and use it to convert between Real GDP and Nominal GDP

Goal: Economic Growth

More and faster is better — that means we have more stuff, more goods, more needs being satisfied.. No real surprise here. Just as most people would rather have more and/or better goods and services for them to consume, as a society we want more also.  So, the first goal for an economy is to produce a growing supply of goods and services for us to consume.

A Jim’s Observation:

Mainstream economics assumes that more-and-more goods is the goal; that’s it’s a good thing for society.  Some critics (myself included) have criticized this assumption, particularly environmentalists and a growing minority of economists called “ecological economists” have criticized it.  They maintain that the goal of society should be a sustainable, improved quality of life, not just more consumption of more goods.  To a degree, these critics have a valid criticism.  Mainstream macroeconomics is largely the result of 200 years of study, during which time nations clearly did not have enough goods. Mainstream macro has not fully developed theories for economies that are mature in their ability to provide goods and a high-living standard for all.   This is clearly an opportunity for new research and theorizing.  On the other hand, the criticism is not completely valid since our methods of measuring the amount of goods actually measures the value of the goods – not the physical quantity.  In other words, an economy which produces the same physical quantity of goods each year, but increases the quality and value of those goods each year would still show as having a growing GDP. For this course, we will stick to the mainstream approach.

While you, I, and even individual firms don’t usually have a hard time measuring whether or not we are more productive than in the past, it is a difficult question when asked in the aggregate.  For example. suppose an economy only produced four goods:  pounds of beef, gallons of Coke, movies, and automobiles. We could actually count the physical quantities of these four goods produced each year.  If next year we produce more of all four goods, then fine, we know we have grown our aggregate output.  But what if we produce more movies and Coke, but less beef, and the same number of cars?  Do we conclude that total output has increased or decreased?  It’s the old “adding apples and oranges problem” that your elementary math teacher always warned you about.  Now think about the problems involved when there aren’t four goods, but there are millions of different products!  How do we add Buicks and pizzas? Or add haircuts-provided and schools-built?

Economists have developed a solution to this “apples-and-oranges, Buicks-and-pizzas” problem.  Instead of counting the physical quantities of output, we count the value of what was produced.  How do we know the value of each item produced?  We use the money price when the item was sold.  So, if a new Buick is sold for $35,000 and a new pizza is sold for $5, then it takes 7,000 pizzas to equal one Buick.  In other words, we don’t really count the physical quantities of goods produced, we count and add up the dollar value of the goods produced.  The process of counting and reporting the value of all these things produced in the economy is a task of the Census Bureau and Commerce Dept. of the Federal Government (they don’t just count people!).   They actually produce a set of records for the economy, much like a business produces accounting statements.  The process and logic involved is called National Income Accounting.  And, the bottom line, the total number for the whole economy is a number called GDP – Gross Domestic Product.

GDP: The Key Measure

GDP – It’s important to think of GDP as a measure of the value of everything produced. Since we have to produce before we consume, it’s also a measure of what’s available to society to consume. More GDP –> more stuff –> better living.  It helps us measure how well society and the economy is performing in addressing the “economic problem”.

GDP is the total value (in $) of everything they produce and sell each year. Since everything that is sold is also being bought at the same time, GDP is the same as the total spending, or Aggregate Expenditures, for the economy. This total spending can be broken down into four categories or types of spending, depending upon who is doing the spending and why. The four types of spenders are consumers (C for Consumption Spending), businesses investing new capital (I for Investment), governments spending on all kinds of things (G for Government spending), and whatever the rest of the world buys from us (called Net Exports). Since we also buy from the rest of the world, we measure Net Exports as (X-M) where X stands for total eXports and M stands for total iMports. Count what everybody buys and you get Aggregate Expenditure. Since we had to produce it to be able to buy it, Aggregate Expenditure must be equal to total production, which is what GDP is.

In the readings for this unit there are a lot of definitions of measures, and a lot quasi-accounting jargon. Don’t get distracted by the details. There are only three really important equations. If you learn what the symbols or notation mean, they’re fairly easy. Two of these equations appear here and define important relationships.

C + I + G + (X – M) = Aggregate expenditure = GDP
Aggregate expenditure (total spending) = GDP = Aggregate income.

Where do we get the money to spend on buying the GDP? The answer is – GDP itself. While “we” spent the money on GDP, we were also paying that money to “ourselves”. We produced it. We sold it. And we bought it. So we sold it to ourselves. So the total value of what we produced and sold (GDP) also turns out to be the total value of what our income was. After all, we earned the income by producing and selling the goods. This is the circular flow we discussed before. This total income is called Aggregate Income. The Aggregate income may be divided into to two parts, according to who gets to spend the income. “DI” stands for “Disposable Income” – it’s the total income that households (you and I) have available to spend. “T” stands for “Net Taxes” – it’s the income that the government gets to decide how to spend because they’ve taxed it away from us.  It is useful to refer to the circular flow to see these relationships.

Limitations of GDP and National Income Accounting

We’ve already seen in my observation earlier, that some criticize the use of GDP as a measure because it is built on the assumption that more goods is always desirable.  But that’s not the only possible criticism.  In many ways, GDP is a very poor measure of economic well-being. It has many shortcomings.  But, it’s the best we’ve been able to figure out so far (probable Nobel prize waiting for anyone that figures out a better measure!). It’s only a rough estimate of market-oriented behavior.  But, it’s all we have – and we didn’t even have this before 1920! Economists are always trying to improve the measurement of macro- well-being, but it’s a tough problem.

Given that GDP is counting the value of all goods produced-and-sold, at the prices they are sold, it has some limitations. First, if the price of something changes, then it affects the GDP, even if the actual good itself didn’t change.  This introduces a powerful distortion into the data which we will discuss below under “Real GDP” vs. “Nominal GDP”.  A second problem with GDP is all the economic activity it ignores.  Usually any activity, no matter how productive, that doesn’t result in a legal sale of a product for money will not be counted in GDP.  So the tomatoes you grow in your garden and eat for dinner don’t get counted, even though they added to your economic well-being. Any illegal trade, be it gambling, drugs, or whatever, it won’t be counted in GDP no matter how much it improves well-being.  GDP also only counts the production of new goods, not the sale of used goods or purely financial assets.

Real GDP, Nominal GDP, and “Price Level”

The biggest problem with GDP as it is counted is its dependence on the prices at which the goods are sold. This introduces a tremendous possible distortion when we compare one year’s GDP to another year’s GDP unless we can adjust for it.  Suppose for a moment that we counted up GDP for one year and it came to $1 trillion.  Now suppose the following year that we produced EXACTLY the same PHYSICAL QUANTITIES of goods as the year before.  We produce the same number of pizzas,  Buicks, pounds of beef, movies, etc. as we did the first year.  But suppose that in the second year everybody marked up the price of everything by 10%.  The pizza that originally sold for $5.00 now sells for $5.50.  The Buick that sold for $30,000. now sells for $33,000, and so on for all products. Everybody’s wages were also increased 10% since a wage is also a price – the price of labor.  We really wouldn’t be any better off than we were – we would still be producing the same quantities of the same goods.  But, because GDP is figured by adding up the dollar value at which goods are sold, GDP in the second year would %10 higher than the first year.  Yet, objectively we wouldn’t really be any better off or have any more goods and services.

This type of distortion is introduced into GDP whenever we make year-to-year comparisons and there has been either inflation or deflation. We will examine the issues of inflation and deflation in more detail in the next unit.  For now it is sufficient to describe inflation as a general increase in the level of all prices. Deflation is a general decrease in the level of all prices.  Inflation/deflation will distort GDP numbers and exaggerate the amount growth from year-to-year.  To avoid this distortion, economists try to “adjust” the GDP numbers to reflect how much inflation/deflation has occurred.  Economists create what is called a Price Index.  A Price Index is a measure of what the general level of prices are.  We pick a particular year to start with (called the base year) and decide that the general level of prices that year is = 100.  Then economists track how much the general level prices moves up or down from year-to-year.  If most prices move up the next year, then the price index for the next year is increased to reflect it.  Say prices went up 10%. The new price index value would then be 110 (the previous year’s 100 x 110% = 110).  If prices went up 10% again in year three, then the price index will be adjusted to 121 (110 x 110% =121). We will study how price indexes are constructed in the next unit.

Economists use price indexes to adjust GDP numbers so that we can compare year-to-year numbers.  This leads to two new terms: Real GDP and Nominal GDP.  Nominal GDP is always the actual amount counted and observed in a particular year.  So this year’s nominal GDP reflects the physical quantities of goods produced this year as sold at the prices that exist this year.  Nominal GDP can be directly observed and counted.  Nominal GDP can also be called “current year quantities at current year prices”.  But since nominal GDP numbers can reflect the distortion of inflation, we need to adjust it if we are going to make year-to-year growth comparisons.  We do this by using the price increases reflected in the price index to take the inflationary distortion out of nominal GDP.  This gives us a number we call Real GDP.  Real GDP is a way to estimate the physical quantities produced this year as if they had been sold at the prices that existed in the base year (when the price index =100).  Real GDP is only as accurate as the Price Index used to adjust nominal GDP (which isn’t always that accurate). But it’s the best way we have of taking the inflation distortion out of nominal GDP numbers.  When we compare Real GDP numbers from one year to another year, we can be reasonably certain that whatever increase in Real GDP exists reflects a genuine, or “real”, increase in actual physical quantities of goods available.

Since our major goal for the economy is growth in the amount of goods and services, the most important measure of the economy’s performance is the yearly increase or growth rate in Real GDP.  Of course we have to count nominal GDP first and then adjust using the price index, but increases in Real GDP are what we want to see.

Technically, there’s one more way we could improve our measurement of economic well-being though.  That is we could adjust the Real GDP number for the size of the population.  If we divide Real GDP by population, we get Real GDP per Capita.  This is the preferred way to compare living standards between countries or over time.

Growth Over The Long-Run

Of course being able to measure increases in Real GDP over the years doesn’t ensure that there will be increases in Real GDP and increases in living standards.  In this unit we also want to look at what causes an economy to grow over the long-run. The single biggest determinant of an economy’s living standard is it’s labor productivity: the ability of its workers to produce goods and services.  This is why it is so important for an economy to have full employment – all its available workers working (see Unit 5).  Improvements in productivity will increase Real GDP.

But what causes productivity to improve?  Three factors will increase labor productivity:

  1. increased physical capital (business machines and equipment and factories) available for workers
  2. improved human capital (knowledge and skills of workers)
  3. improved technology

Why do growth rates differ between nations? In short, because nations differ in their ability and willingness to accumulate physical capital, human capital and acquire technology.  Go back to the circular flow diagram.  Imagine if there were no savings – consumers spent 100% of their income.  Then  since there would be no savings, there would be no money for businesses to borrow to finance their investment spending. If there’s no investment spending, then businesses aren’t acquiring new physical capital.  No new physical capital and there’s no increase in productivity or real GDP.  In contrast, a nation with high investment spending is likely accumulating physical and human capital and acquiring new technology.  It’s ability to produce will grow over time and Real GDP will grow with it.

What determines a nation’s ability to invest in capital accumulation? The following factors help determine how fast a nation accumulates capital and improves productivity:

  • the rate of savings and investment spending
  • the amount of foreign investment capital attracted
  • the education of its people (education is human capital)
  • the state of its infrastructure: roads, power lines, ports, networks
  • the amount it devotes to R&D (this doesn’t show up well in the circular flow)
  • the degree of political stability and property rights that exist

Looking Ahead

Growth of Real GDP means there are more goods and services available — which means a rising living standard.  But increasing real GDP isn’t our only goal.  There are three other goals as well.

In the next unit we will take a closer look at another goal and at some more measures.  In particular, we are going to take a closer look at the issues of inflation, deflation, and price indexes.