Gross Domestic Product

00:01 Hello. My name is James DeNicco.

00:03 Welcome back to your online presentation of macroeconomics.

00:07 This presentation will be about GDP or GROSS Domestic Product. So what is GDP? Well, GDP is the first of the three major macroeconomic variables we're going to look at to measure the health of the economy.

00:21 So what GDP is, it measures the the wealth or the income or the production of an economy. It's all those things because we account for it that way.

00:30 And GDP also gives us our measure of standard of living.

00:34 If we divide it by the number of people out there, we would call that GDP per capita. And so that's a that's a major topic in economics standards of living, how we evolve, standards of living.

00:45 So that's what this measure captures.

00:48 So in this presentation, we're going to talk about what GDP is, what's included in GDP or the shortcomings of GDP.

00:58 It's a manmade measure.

00:59 And anytime you have a manmade measure, it's, of course, can be flawed.

01:03 So we'll talk about some of those flaws.

01:05 But even though it's flawed, it's not useless.

01:07 It gives us a consistent measure over time to see if economies are improving or not.

01:12 And last, we'll talk about how you calculate GDP in real terms, which worries about changes in quantities and in nominal terms, which looks at changes in dollar figures. So first, let's talk more about what GDP is.

01:26 The definition is a good place to start.

01:28 So GDP is the market value of final goods and services produced in a country during a specified time period.

01:37 Now, all the words in that definition are important because those are accounting rules for GDP.

01:44 Gdp is closely related to what we call GNP or gross national product. The difference is GDP looks at everything produced within a country's borders, no matter who's producing it.

01:57 So it's looking at the health of an economy within a country's borders.

02:01 If the United States produces within its borders, that's part of his GDP.

02:05 If Germany produces something within the United States borders, it counts towards the United States GDP, GNP.

02:13 On the other hand, that's whatever a country produces, no matter where it produces it.

02:17 If the United States produces in Germany, it's part of the United States GNP, but not part of their GDP.

02:24 For most countries, it's not too big of a difference.

02:27 We'll be concentrating here on GDP.

02:30 So let's bear down a little more on what the definition of GDP is.

02:35 Let's take each one of those words in the definition and talk more about it.

02:39 First, we measure GDP using market values.

02:43 In other words, we're going to turn it into dollar figures.

02:46 The reason being, it would be very hard to go out and calculate, okay, this country makes 1000 cars, this country makes 1000 apples, 200 pairs of shoes. Now this country, it makes a million cars and 4000 apples and 20 pairs of shoes.

03:01 It's hard to compare across countries unless you turn that into dollar figures.

03:06 For instance, if you have one country that produces 10,000 cars and another that produces a million shoes, lose more productive ones producing more than the other. But a car is a lot harder to put together than a shoe.

03:19 So you turn that into dollar figure so you can compare more easily.

03:24 Next, it's only final goods and services.

03:27 This is as opposed to intermediate goods and services.

03:30 We don't want to count intermediate goods and services in our GDP because what that does is it double counts.

03:37 So let's take the example of coffee, beans versus coffee.

03:40 So if you're a coffee manufacturer, you go out there and you buy coffee beans, you grind up the coffee beans, you make your coffee and then you sell it to people.

03:49 Just that final sale of the coffee is going to be included in GDP. You don't want to count the coffee beans because the manufacturer of the coffee already accounts for the cost of the coffee beans in the final sale of his coffee.

04:05 So if you counted the cost of the coffee beans and the coffee, it would double count and make production look greater than it actually is.

04:14 So we say final goods and services.

04:17 Goods are all the things you purchase at the store, like tangible items, services, or things like going to a concert or going to a game.

04:26 So both those final goods and services are included in GDP.

04:31 Also, we only want to get new products, things produced in the current year. That's as opposed to use products.

04:38 So when we measure GDP, it's a measure in the current year of what's being produced or sold.

04:45 If you include used products, well then you're kind of messing up the picture.

04:50 You're skewing it a little bit that those things weren't produced in this current year.

04:54 So you don't want to count them, even if it's a chandelier, an antique chandelier worth $1,000,000 or even $15 Million.

05:03 That's a big sale.

05:04 There's a lot of money flowing around, but you don't want to count that because it wasn't produced in this year.

05:10 You want to capture current year production.

05:13 Also, we have to have it within a country's borders, as we're talking about and within a given time frame that so we can have a consistent measure.

05:21 So whenever you're playing a game, you have the rules of the game, you have the boundaries of the field and you have the time frame that the game is played in.

05:29 So in baseball, if a guy hits 1000 foot shot but is left of the foul pole, it doesn't count.

05:36 It has to be within the borders of the game.

05:38 If a guy in basketball takes a shot from halfcourt and hits it, but it's after the buzzer sounds, that doesn't count either.

05:45 It wasn't within the confines of the game.

05:48 So to keep a to keep a consistent measure, we make it happen within the borders and within that specified time period.

05:58 So let's bear down now a little more on the equations for GDP.

06:02 So there's two main approaches and they're going to be equal to each other.

06:07 As I said before, GDP is the income earned in an economy and it's also the production and the expenditures in the economy.

06:14 We're going to focus on the income approach and the expenditure approach here on this slide. But after that, we're just going to concentrate on the expenditure approach.

06:23 That's the more conventional and more classically used one.

06:27 So that's what we're going to go with.

06:29 So first, the income approach.

06:31 So why here is our production, that's our GDP.

06:36 W are wages.

06:38 R that's the that's the rent paid, I that's our interest and PR those are our profits.

06:46 So wages are paid to labor.

06:48 We pay rent our natural resources.

06:52 That's where we account for in economics.

06:54 We rent those natural resources from people.

06:57 You pay interest on your capital.

06:59 That's like your machines, your equipment, and then entrepreneurs earn profits.

07:04 So that's all the money that firms are going to pay to the household.

07:08 You have two main sides here.

07:10 You have your household and your firms.

07:12 So money is going to flow from the firm to the household in the form of this income. On the other side of it, you have the expenditure approach and you can think about that as the flow of money from the household to the firm.

07:26 The expenditure approach again Y equals GDP.

07:31 Now C is consumption I is investment.

07:35 G are government expenditures, and an x is net exports.

07:39 We're going to talk a little bit more about what each one of those are.

07:43 But with that, again, you're seeing money is going to flow from the household to the firm.

07:49 With the income approach, you're going to see the money flowing from the firm to the household. It's all interconnected and we account for it so that they equal each other. Every dollar spent has to go to somebody.

08:01 So that's how we account for it.

08:03 We actually have a model here, a diagram to give you, a visual of that.

08:08 So in this diagram here we have the households and then over here we have the firms. So what you're going to see is you're going to see these two flows going back and forth.

08:19 You're going to have two markets, the markets for goods and services and your markets for your factors of production.

08:26 So the household is going to provide factors of production to the firms.

08:33 In order to provide those factors, the firm is going to have to provide money to the household.

08:39 So what are the factors of production the household provides to the firm? They provide that labor.

08:44 They provide the natural resources as a people, as a society, we own those natural resources.

08:51 So the firms have to rent those from us.

08:54 They're also going to pay us interest on the capital.

08:56 And as we get more on our lectures, we'll talk about why we call that interest.

09:00 So if you use your money to buy physical capital, that's our machines.

09:04 You're missing out on the interest that you can be earning and having that money in the bank. Or if you borrow money to buy that physical capital, you have to pay interest on it. So the wages we have, the natural resources and we have the physical capital and also there's payments to entrepreneurs and for their profits, all the factors of production there.

09:25 The entrepreneur is providing the risk, right? They're going out and taking the risk to start these businesses.

09:31 So we have the flow of these factors of production from the household to the firm.

09:35 The firm is going to give payments back to the household.

09:39 And on the other side of it, you have the firm here.

09:43 The firm is going to provide the goods and services to the household.

09:47 So the household is going to buy those goods and services from the firm.

09:52 So the firm provides those goods and services.

09:55 The household gives them money in return.

09:57 That's our consumption, our investment, our government expenditures and our net exports, which we're going to bear down a little bit more here in a second.

10:06 Consumption that comes from the households investment, those are purchases from firms, government expenditures, obviously from the government.

10:15 And then net export, we have an open economy.

10:18 Then you're talking about trade exports minus imports.

10:22 So let's get more into that right now.

10:25 So first, consumption consumption is the spending by households on goods and services with the exception of new home purchases.

10:33 So this covers almost everything you buy as an individual.

10:37 So these are your shirts, your shoes, your hats, your iPods, your iPhones, your iPads, all the i everything that exists out there, all that, all those purchases.

10:48 That's money going from the household to the firm.

10:51 This is our consumption.

10:52 When you go to the grocery store or you go to the mall, all those entail consumption.

10:58 That's the first part of it.

10:59 It counts for about two thirds of GDP, at least in the United States, and it counts for a large portion of GDP in most countries.

11:08 So next is investment.

11:10 Now, investment is spending on capital equipment, inventories and new structures, including household purchases.

11:18 So there's three parts of investment.

11:20 The first is physical capital.

11:22 So physical capital, those are tangible assets used by firms in production. So this sounds a lot like an intermediate good, but it's different in the sense that it's not destroyed upon the production of the final good.

11:36 So we go back to our example of using coffee beans to make coffee.

11:40 Now the coffee beans that we grind up to make the coffee, that's an intermediate good right.

11:46 It's used to make a file of good is destroyed in the production of final good.

11:51 We don't want to count it because it will be double counting for GDP.

11:55 Now, the machine that you use to grind up the coffee beans, well, that's used to make the final product, but it's long lasting.

12:03 It's something the firm purchases and has for a long time to make that coffee. We count that towards GDP.

12:10 That's a final purchase for the firm.

12:12 When I say firms, I'm talking about businesses, corporations, sole proprietorships, partnerships, whatever kind of business you want to think of.

12:18 Those are our firms.

12:20 So the tangible assets used in firms production that are long lasting, that's our physical capital.

12:27 The second part of it is what we call inventory investment.

12:31 So every now and then you make goods and they're not sold in the year that they're produced. Well, we want to capture production in the current year.

12:40 So what we do say you have a company that makes cars, Volkswagen makes 100 cars in a year.

12:46 They only sell 70 of those cars in that current year.

12:49 Well, those 70, they would go towards consumption.

12:52 But we want to capture the other 30 in the year that are produced.

12:56 So what we do is we put them in this bucket with this category called inventory investment so that we captured the production in that year.

13:05 So now the next year, if those 30 are sold, there's actually going to be two buckets effective now. All right.

13:11 So consumption is going to go up.

13:13 So in 2014, they made 100 cars, they sold 70 and they had 30 left over.

13:18 So in 2015, they sell those 30.

13:20 Consumption will go up for those 30 cars, but inventory investment now will go down, will cancel each other out.

13:28 So the reason we do that, again, the inventory investment, we want to capture the production in the year those things are made, but then it's not exactly in the right buckets if those things get sold.

13:38 So in the following year, when they get sold, we get things in the proper category.

13:42 But GDP isn't affected because consumption and inventory investment go up and down by the same amounts to cancel each other out.

13:50 So that's the second part of investment.

13:52 The third part are new structures, including new home sales. So most of our household items that are purchased go into consumption, but not new structures, including the new homes that actually goes into investment.

14:08 So whenever a family buys a used home, no, that doesn't even count towards GDP. Remember, it's production and sales in the current year, so used goods aren't counted, but we have a purchase of a new structure.

14:21 You build a new addition to your house or you buy new house.

14:25 Those things count towards GDP.

14:28 So now we have consumption and we have investment.

14:31 The next one we're going to talk about are government purchases.

14:34 So government purchases are spending by local, state and federal governments. So what is included here? Salaries, the public workers.

14:44 That's a service, right? So your teachers, you pay your teachers to go out there and teach government goods. Here we have a picture of a Navy ship.

14:53 So, I mean, your aircraft carrier is your helicopters, all those things that the government buys. There's new purchases of goods, those count towards GDP and your public services.

15:06 You pay people to go out and build the roads or maintain the roads.

15:09 Those are current services.

15:11 All of those count towards GDP through government purchases.

15:16 Now, what's not counted, transfer payments.

15:19 Transfer payments are not considered productive by GDP standards by the definition of GDP social benefits.

15:27 So you're in the United States, Medicare, Medicaid, your different welfare programs.

15:34 Not to say that they aren't productive in the normal sense that we use the word that giving somebody unemployment benefits so they can get back on their feet and get back to work. We're not saying that isn't a productive or a worthwhile use, but there's no good or service being being given in return.

15:51 It's just taking money from one person and transferring it to another.

15:55 So that is not counted in GDP.

15:58 So now we have our consumption, our investment, our government purchases.

16:02 There's one more left.

16:03 That's our net exports.

16:05 So net exports, the word net makes you think there's more than one thing involved.

16:10 So there's a positive and a negative.

16:12 Exports are the positive.

16:14 Imports are the negative.

16:15 So any time you export something that's going to count positively towards your GDP imports, that's going to take away from your GDP. So whenever you go and you import something, there's actually again, there's going to be two categories affected.

16:32 So if you go to the store and buy a bottle of Italian wine and you're from the United States, you're going to see consumption go up because you're purchasing something, you're purchasing it good, but you're also going to see imports go up.

16:44 Now, imports are considered a negative they take away from GDP.

16:49 So, again, net exports, it's exports minus imports.

16:53 So consumption goes up, but imports also goes up by equal and opposite amount. So it takes away so it doesn't count towards GDP because you want production within the country's borders.

17:06 So again, net exports is the spending on domestically produced goods by foreigners. That's our exports, minus spending on foreign goods by domestic residents.

17:17 Those are imports.

17:19 So now we've covered all our different areas of GDP.

17:22 We've got our consumption, our investment, our government expenditures and our net exports, which are our exports minus our imports.

17:31 Those are all are different pieces of GDP.

17:34 So let's talk about some of the shortcomings.

17:37 Again, it's not a perfect measure.

17:40 It's a manmade measure.

17:41 So it's flawed like the rest of us.

17:44 All of us are flawed, right? We're just people.

17:46 So when people go and they try to construct a measure, it's not going to be perfect.

17:51 It's worthwhile.

17:52 You can use it over time to measure the economy to see if it improves, but it does miss something.

17:58 So let's take a look at some of the things that it misses.

18:00 It misses household production.

18:03 So my mother, she's a wonderful seamstress.

18:06 She made me this quilt that I love.

18:08 It's a fabulous quilt.

18:10 But even though I value that quilt quilt, even though I think it's fantastic, her making that quilt doesn't count towards GDP because it's not sold as a final good or service.

18:21 Now her going to the store and buying the fabric to make the quilt that counts, but the value that she adds to it when she makes it into a quilt that does not count towards GDP.

18:33 If you grow your own vegetables or you have your own cattle, you make your own food, that stuff doesn't count towards GDP.

18:43 So it misses that even though there's value to it, it doesn't include the underground economy, drugs, prostitution, things like these.

18:51 Even if somebody values them, somebody is paying for these things.

18:54 If they're illegal, it's not going to capture that.

18:57 It misses it. Those things will be hard to capture anyway.

19:00 People usually don't advertise so that the government can see they're doing those things now. Times are changing and and things are becoming legal every day that used to not be legal. So maybe they're going to have to change their measures.

19:12 But things that are still considered illegal and done in the underground economy, those things are going to be missed.

19:18 So if GDP is a measure of well being, how well an economy is doing well, then it should account for leisure as well.

19:26 That's our number three.

19:27 But it misses leisure.

19:28 Leisure is the time we use for ourselves to relax.

19:32 So for me, it might be playing with my kids or for you it might be playing video games or or going out and hanging out with our friends.

19:40 Those things add to our well-being.

19:42 They make us better off.

19:44 But GDP doesn't capture that.

19:46 What fun would it be if we all worked 100 hours a week until we were so tired that we could do nothing else but sleep? Some countries value leisure more than others.

19:56 If a country values leisure more than another country, so maybe they don't work as much. That doesn't mean they're not well off as or as well off as the country working more. Maybe they value that leisure time, but GDP misses that.

20:10 It doesn't account for pollution and other negative effects of production.

20:14 So if a company is producing very efficiently, they're making a lot of product, but they're polluting the air so that we're all getting sick and our streams are becoming polluted so that our children are drinking the water.

20:27 That's obviously not a good thing.

20:29 We're degrading the environment.

20:31 Gdp misses that.

20:32 They just see that production.

20:34 They don't see the negative consequences of that pollution.

20:38 And it doesn't account for changes in crime and other social problems.

20:42 Obviously, if there's high crime rates in a city or a country that is going to devalue your well being last, it doesn't account for inequality.

20:51 So GDP and even GDP per capita when you divide it by the number of people. Doesn't account for inequality.

20:59 Gdp doesn't really care if one guy has it all and everybody else has nothing. It's going to say that you're just as well off as if everybody had equal shares.

21:10 Now, when you go to GDP per capita, which is what we use for a measure of a standard of living, how well people are doing on average, it's a closer measure for how well people are doing, but it still doesn't account for inequality.

21:24 If one guy has it all and nobody else says anything, the average will still be the same as if everybody has equal shares.

21:31 So it doesn't account for inequality as well.

21:34 So these are the shortcomings of GDP.

21:37 So let's do an example here.

21:39 All right. So in our example here, we're going to have an economy that just produces cars and it produces airplanes.

21:48 And we'll look at three different years.

21:50 We're going to have 2009, 2010, 2011.

21:55 We have the price of the cars, 10,000, 15,018 thousand. So that you see there's inflation.

22:03 The price of that good is going up for our airplanes.

22:07 Our airplanes in 2009 cost $1,000,000, then $1.25 million in 2010 and in 2011, $2 million.

22:17 So in 2009, we're selling 1000 airplanes in 2010, 1200 airplanes.

22:23 In 2011, we're selling 700 airplanes.

22:26 So in our simple example here, we're going to calculate first our nominal GDP. We do that just by using price times quantity so that you'll see here our nominal GDP is our 10,000 for our car, times our cars plus our million dollars for our airplanes, times our 1000 airplanes.

22:47 So just 10,000 times our number of cars and our price for our airplanes, a million times 1000 airplanes that we make that calculates our nominal GDP. What is that, 1 billion, $100 million in 2010? Again, our 15,000 times our 11,000 cars, our price of 1.25 million for our airplanes, times our 1200 airplanes.

23:14 And the total comes out to be $1,665,000,000.

23:21 So for 2011, we have our 18,000 per car, times the 19,000 cars we produce, plus the $2 million for the airplane, times the 700 airplanes that we produced.

23:34 You put that together and you have your nominal GDP of 1,000,742,000. So now let's take a look at real GDP.

23:45 You're going to notice that it looks like we have growth in GDP here.

23:48 And we do. We have growth in nominal GDP.

23:51 The nominal GDP is getting larger over time, but the growth is going to be exaggerated because of inflation.

23:59 Now, with real GDP, we're going to account that inflation, the way we do that is using a base year.

24:05 So we're just going to pick a year's prices and we're just going to use those prices for our calculation of GDP.

24:12 For all the years here, we're picking our base year 2009, so we're going to keep our prices constant, 10,001 million.

24:21 That's the price we're going to use for all our calculations.

24:24 So for real GDP in 2009, it's not going to change.

24:28 It's again, it's going to be 10,000 times 10,000 plus a million times 1000 equals 1 billion, $100 million.

24:38 So that's not going to change it all.

24:40 But now for the rest of the years, you're going to see it's bit different than it was using nominal GDP.

24:45 So here for 2010, we use our 10,000 times 11,000 cars plus $1,000,000 times 1200 airplanes. So you're going to see our real GDP is $1,000,000,310 Million.

25:01 Now, you see how that's less than it was for the nominal GDP.

25:05 For the nominal GDP, it said it was $1,000,000,665 million for our GDP.

25:12 That skews it because it doesn't account for inflation.

25:16 When you do account for that, you see there's still growth.

25:19 We still go from 1 billion, 100 million to 1 billion, 310 million.

25:24 But the growth is smaller now because we're looking at the change in quantities to calculate our real GDP for 2011.

25:32 Again, we use our prices from 2009.

25:34 So 10,000 times the cars, which are 19,000 here, plus the airplanes, $1,000,000 times our 700 airplanes.

25:43 And what we're going to see is our real GDP in 2011 is only 890 million, only $890 million.

25:51 That's a lot. But in our example here, look at the difference before when we're using nominal GDP.

25:57 It looked like there was actually growth.

26:00 We went from 1000000665 million to 1000000742 million. But now when we account for inflation, we actually see that we had negative growth.

26:09 We went from 1,310,000,000 down to $890 million.

26:15 So when you account for inflation, the story is different.

26:18 So as economists, we want to use that real GDP when we're measuring the health of the economy over time so we can also calculate inflation using GDP. This is going to be the first measure we use to calculate inflation.

26:32 In our next presentation, the next presentation in the series, we're going to calculate inflation using what's called the CPI or the Consumer Price Index.

26:41 There's more than one way to account for inflation.

26:44 Inflation. So here we're going to use what's called the GDP deflator.

26:48 So very simply, the equation is nominal GDP divided by real GDP times 100.

26:56 So the GDP is a measure of the price level calculated as a ratio of nominal GDP to real GDP times 100.

27:05 That times 100 makes it an index is what it does.

27:08 It doesn't change the story too much.

27:09 It just adds a couple zeros.

27:11 So our GDP deflator here again, nominal GDP, GDP divided by real GDP times 100.

27:19 And then we can calculate our inflation rate once we get our index as the GDP deflator in your T minus the GDP deflator in your T minus one divided by the GDP deflator in your T minus one, that's just a percent change. It would be like, what is the GDP deflator in 2014 minus the GDP deflator in 2013 divided by the GDP deflator in 2013.

27:44 It gives us a percent change of our index, and that index is looking at the ratio of nominal to real GDP or how much bigger is nominal GDP to real GDP? How much are prices changing the picture from nominal GDP to real GDP? That's what the GDP deflator accounts for.

28:06 So again, in our example here, we can take a look for our base year.

28:10 The GDP deflator is always going to be 100 because nominal and real is the same. So our nominal GDP is $1,100,000,000.

28:20 Our real GDP is $1,100,000,000.

28:24 You take the ratio, it's just one times 100, it's 100.

28:29 But now for the other years you're going to see it's a bit different.

28:33 Our nominal GDP in 2010 divided by our real GDP in 2010 times 100 comes out to 127.

28:41 It's greater than 100.

28:43 Therefore, there's been inflation from 2009 to 2010.

28:47 In 2011, our nominal GDP divided by our real GDP times 100 comes out to 196.

28:56 Again, it's greater than 2010.

28:58 It's greater in 2009.

29:00 We see there's been inflation.

29:02 So to calculate the inflation rate for year 2010, you would say 127 -100 divided by 100.

29:11 That gives us a percent change.

29:13 There's been a 27% increase in prices.

29:17 The inflation rate is 27% for 2011.

29:22 If you go 196 -127 divided by one, 27 times 100, you took that percent change in the GDP deflator from 2010 to 2011, and you get an inflation rate of 54%. So you can see the prices are going up over time. That's why we want to account for that and use real GDP.

29:45 So what have we learned here? We've come to the end of our presentation.

29:49 We've covered the the first of our three major macroeconomic variables that we're going to look at to measure the health of the economy.

29:56 This one looks at the wealth or the income or the production of account of an economy, all those things, because we account for it that way.

30:04 We know the definition and accounting rules for GDP.

30:08 It's very specific, the things that are included and things that are not included.

30:13 We've learned GDP's a measure of well-being, but not a perfect one.

30:17 It's flawed. Like anything made by man, it's going to be flawed.

30:20 We have accounting rules and we're subject to those accounting rules.

30:24 That's to keep our measure consistent.

30:26 Over time, we learn the difference between nominal and real GDP and how to calculate those those measures.

30:33 And we've started to take a look at inflation.

30:36 We're going to get more into that in our next presentation.

30:39 But we've learned how to calculate it using the GDP deflator.

30:42 Thank you very much.