Gross Domestic Product
GDP is the value of total production of goods and services in an economy during a particular period (normally a year). As we saw earlier, it can be expressed in current prices (nominal GDP), or in terms of the prices of a particular base year (real GDP). Here we will consider nominal GDP, and explore its component parts. The key in this analysis is to understand that the value of total production will also be equal to both income and expenditures in the economy (what goes around comes around).
There are four distinct types of expenditures that make up aggregate expenditures (in product markets) on goods and services: consumption, investment, government, and net exports. Consumption expenditures (C) represent the total payments made by households for the goods and services produced and sold in the economy. Investment expenditures (I) are made by firms, and consist of purchases of new plant, equipment, and buildings, as well as additions to inventories of raw materials and semi-finished goods.
Investment adds to the stock of capital, and is a critical engine of economic growth. Note the distinction between stocks and flows: a stock is a quantity that exists at a point in time, while a flow is a quantity per unit of time; cf., body weight and daily calorie intake and expenditure, wealth vs. income. Investment each year is thus a flow that adds to the stock of capital. However, offsetting the capital accumulation that results from investment is depreciation -- the decrease in the stock of capital that results from wear and tear and the passage of time. Hence, we have to distinguish between gross investment -- the total amount of investment during a particular period -- and net investment, which equals gross investment minus depreciation (i.e., gross investment represents the total amount spent on replacing depreciated capital and adding to the capital stock, while net investment covers only the latter component). The change in the capital stock from year to year thus equals gross investment minus depreciation, or net investment:
where K = the change in the capital stock, Ig = gross investment, D = depreciation, and In = net investment.
Governments, like households, also make purchases of goods and services in product markets. These purchases (G) are part of aggregate expenditures in the economy. Finally, we also interact with the rest of the world (in economic terms) via exports and imports. The difference between the two (exports minus imports) constitutes net exports (NX), and it is the final component in our equation. Pulling this all together, then, and letting Y represent aggregate income, we have
as our national income equation (Parkin presents and discusses all of this in the context of the circular flow diagram, and you may find his discussion helpful; here, I've tried to focus on the most critical elements).
Expenditures in each category are paid for in different ways (household factor incomes, tax revenues, capital account), but the significance of investment for long-term economic growth merits consideration of how investment is financed. In brief, investment is financed from national saving and from borrowing from the rest of the world. You'll see more on this in your recitations later this week.
Measuring U.S. GDP
The national income equation above (Y = C + I + G + NX; 1994 data in billions of $: 6738 = 4628 + 1033 + 1175 - 98; in percentages: 100= 69 + 15 + 17 -1) reflects the expenditure approach to measuring GDP, based on final expenditure (excluding intermediate goods and services, used goods, and financial assets).
An alternate approach looks at factor incomes. Note that the largest component of factor incomes by far is compensation of employees (59.4% of 1994 GDP; note also that most of proprietors' income (7% of '94 GDP) is labor income, while corporate profits represented 8.1% of GDP in 1994.
The Price Level and Inflation
We talked earlier about the CPI, a price index based on a "market basket" of around 400 goods and services. The market basket is meant to represent "typical" household purchases. The current value of the CPI tells us the cost at present of the market basket, expressed as a percentage of the cost of the same basket of goods and services in a base period (presently, 1982-84=100). Changes in the CPI thus give us a measure of inflation -- the change in the average level of prices.
An alternate and more comprehensive price index is the GDP deflator, which measures the average level of prices of all goods and services included in GDP:
The GDP deflator is more comprehensive than the CPI because it covers all goods and services, not just 400 or so. It can easily be shown mathematically that each price index (the CPI and the GDP deflator) is a weighted average of the price changes of individual goods and services.
To calculate the rate of inflation between two years, we need to know the value of the GDP deflator for each year, and then apply the same formula that we used to calculate inflation with the CPI: inflation (expressed as a percentage) = [the value of the deflator at the end minus the value at the beginning] divided by the value of the deflator at the beginning, all multiplied by 100.
For example, at the back of the book Parkin gives us a value for the GDP deflator for 1994 of 126.1, and the GDP deflator for 1993 is given as 123.5 (the base year is 1987, which means that the GDP deflator = 100.0 for 1987). The rate of inflation between 1993 and 1994, as measured by the GDP deflator, is thus
given by the formula 
.
In 1984, the GDP deflator was equal to 91.0, so between 1984 and
1994 the total amount of inflation as measured by the GDP
deflator was 38.6% [
]. (Note that the
average annual inflation for the 10 years is NOT 3.86 percent per
year -- it's lower, reflecting compound growth).
Consider again our equation for the GDP deflator:
With a little algebra, we can modify this formula to get
We can interpret this equation as telling us that the GDP deflator is what we use to adjust nominal GDP so as to obtain real GDP. Recall that nominal GDP for any year measures that year's output at that year's prices, while real GDP for the same year measures that year's output at prices from a base year. Hence, the GDP deflator essentially removes the effects of price changes and allows us to compare real changes in the value of economic output.
For example, in 1994 nominal GDP was equal to a little more than 6.7 trillion dollars. In 1993 nominal GDP was more than 6.3 trillion dollars. The increase in nominal GDP of 0.4 trillion dollars represented growth of 6.2 percent. However, this overstates the real economic growth that took place -- as we've already seen, prices rose by more than 2 percent, so real economic growth from 1993 to 1994 was smaller than 6.2 percent; real GDP in fact grew by just over 4 percent.
Now let's go back to our consideration of the GDP deflator as a measure of inflation. As shown in Parkin's Fig. 6.6, the CPI and the GDP deflator are highly correlated and tend to move together. It's also clear from the figure that there is somewhat more variation in the CPI. Of more fundamental importance, however, is Parkin's contention that both measures probably do not accurately reflect the true, underlying inflation rate.
We need an accurate estimate of the extent of inflation for two major reasons. First, as Parkin notes, welfare for the elderly (also known as Social Security) incorporates cost-of-living adjustments (COLAs), based on the CPI. Hence, if the CPI does not accurately reflect the true underlying rate of inflation, COLAs for social security will be either too large or too small. Consequently, the elderly might be either overcompensated or undercompensated for inflation.
Similarly, many other contracts and agreements provide for COLAs (e.g., union wage contracts, adjustments to tax brackets), so again if the CPI does not accurately reflect inflation these adjustments will be either too large or too small (and hence, affect income distribution and government tax revenue).
The second major reason for concern about the accuracy of our measures of inflation is that (as we saw earlier) they are used to adjust nominal GDP to real GDP, and hence to estimate real economic growth. If we have trouble measuring the extent of inflation, then that automatically implies that we will also have trouble measuring the degree of real economic growth.
© 1996 David Shapiro
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