Dr. Mohammed Alwosabi
Dr. Mohammed Alwosabi
Dr. Mohammed Alwosabi
Chapter 1
MEASURING GDP AND PRICE LEVEL
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Dr. Mohammed Alwosabi Econ 141: Macroeconomics - Ch.1
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Dr. Mohammed Alwosabi Econ 141: Macroeconomics - Ch.1
o Using market value allows us to add goods and services produced together,
and to compare the GDP of one year to that of another. We can see here that
GDP increases in 2006. This means the economy has grown from 2005 to
2006.
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Dr. Mohammed Alwosabi Econ 141: Macroeconomics - Ch.1
o Exercise:
Which of the following expenditures of a country is an intermediate good?
a. The government of a country buys new batteries for its military trucks
b. You buy a new battery for your used car
c. A car producer in the country buys new batteries to install in the cars it is
producing
d. A battery company in the country sells new batteries to other countries
o Exercise:
Which of the following is not considered a final good?
a. The purchase of a car by a household
b. A tailor buys textiles to make shirts
c. The purchase of food by household
d. A company buys a new machine for its production of goods
o Exercise
Bahrain Aluminum Company (BAC) produces and sells aluminum products.
If BAC sold an oven to a bakery that used it to produce breads, do you
consider this oven as an intermediate good or a final good?
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Dr. Mohammed Alwosabi Econ 141: Macroeconomics - Ch.1
EXPENDITURE APPROACH:
In this approach of measuring GDP, the expenditures on all final goods and
services made by all sectors of the economy are added to calculate GDP.
Expenditures are divided into 4 different categories: consumption expenditure (C),
investment (I), government expenditure on goods and services (G), and net exports
over a period of time, which is exports minus imports (NX = X – M).
Using expenditure approach, the largest component of GDP is usually personal
consumption expenditures.
GDP can be computed as the sum of total expenditures of personal consumption,
gross private investment, government purchase of goods and services, and net
export over a period of time.
If GDP denoted by Y then,
GDP = Y = aggregate expenditure = C + I + G + X – M = C + I + G + NX
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Dr. Mohammed Alwosabi Econ 141: Macroeconomics - Ch.1
Consumption (C)
Firms sell and households buy consumers’ goods and services in the goods
markets. The total payments for these goods and services are called consumption
expenditure.
Personal consumption expenditure (C) includes expenditures spent on goods and
services produced inside the country and the rest of the world.
Buildings and houses are not included in the consumption expenditure. They are
part of the investment.
Purchased of stocks and bonds are not part of consumption expenditure.
Investment (I)
Investment (also called gross private domestic investment) (I) as used in
macroeconomics refers to
1. The purchase of new capital. Firms buy from each other new capital goods
such as machines, tools, equipments and buildings in the goods markets.
These new capital goods are used to produce other goods and services.
2. Some of what firms produce is not sold but is added to inventory (can be
considered as if the firm is buying from itself). Inventories include a firm’s
stock of unsold goods, goods in process and raw materials.
3. Purchases of all new residential buildings are also part of investment.
Both capital goods and inventory investment are treated as final goods and
included in the GDP.
Note - Investment does not include stocks or bonds or other financial assets. These
assets only involve transfers of ownership - no physical asset is directly created
because of these assets
Example:
Goods that are produced this year, stored in inventories, and then sold to
consumers next year count in this year’s GDP
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Dr. Mohammed Alwosabi Econ 141: Macroeconomics - Ch.1
Example:
If a Bahraini firm buys new machines from Japan, Bahrain’s investment would
increase.
Exercise:
True or False: An example of investment in calculating this year GDP using
expenditure approach is the purchase of one year old beautiful house by a newly
married couple.
Exercise:
A computer manufacturer makes a computer this year to be sold next year. This
computer will be counted in
a. next year ‘s GDP
b. next year’s investment
c. this year’s investment and this year’s GDP
d. next year’s investment and next year’s GDP
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Dr. Mohammed Alwosabi Econ 141: Macroeconomics - Ch.1
Net Export:
Countries trade with each other.
Our country sells goods and services to the rest of the world. This is called the
value of exports (X). Exports are added because they are produced domestically
but not measured as part of C, I, or G.
Our country buys goods and services from the rest of the world. This is called the
value of imports (M). Imports subtracted because they are typically included in C,
I, or G, but they are not domestic production.
Total adjustment results in adding net export (NX)
NX = Exports – Imports = X – M
If X > M ⇒ NX > 0 ⇒ trade surplus
If X < M ⇒ NX < 0 ⇒ trade deficit
Example:
If a Bahraini firm buys new machines from Japan, Bahrain’s net export would
decrease.
Exercise:
If a furniture company makes 300 dining tables in 2003 and sold 200 of them in
the same year, using expenditure approach, how to count the unsold dining tables?
Exercise:
Bahrain Aluminum Company (BAC) produces and sells aluminum products. Place
each of the following transaction in one of the four components of expenditure
a. BAC sells its product to the Bahrain Defense Force
b. BAC sells its product to a private company
c. BAC sells its product to a housewife
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Dr. Mohammed Alwosabi Econ 141: Macroeconomics - Ch.1
INCOME APPROACH:
Since total value of a product is equal to the amount of income generated by its
production, GDP can also be calculated by adding all the income generated in the
production of GDP.
The income approach of calculating GDP is the sum of incomes paid to resources
of production.
National Income and Product Accounts divide incomes into five categories:
compensation to employees, rental income, net interest, corporate profits, and
proprietors' income.
1. Compensation to employees. It is the labor Income, which includes all
wages, salaries, and benefits paid to labor, plus social security contributions.
This is the largest component of GDP, using income approach.
2. Rent for the use of land. It is the income earned by the owners of land,
and any other rented resources.
3. Net interest for the use of the capital. It is the income earned by the owners
of machines and equipments. It equals the interest the domestic owners of
the capital receive minus the interest they pay
4. Corporate profit. It refers to what is left to the firm after all payments. It
includes both of profits distributed as dividend plus undistributed profits.
5. Proprietor’s income. It is the income of self employed small businesses
such as private doctor’s clinics, Attorney’s office, mini-mart stores, small
farms and so on. Proprietors' income might be a mix of incomes from labor,
capital and land.
The sum of these five incomes results in national income or net domestic income
at factor cost (NDI).
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Dr. Mohammed Alwosabi Econ 141: Macroeconomics - Ch.1
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Dr. Mohammed Alwosabi Econ 141: Macroeconomics - Ch.1
Exercise:
Government purchase $400
Gross private domestic investment $500
Personal consumption expenditure $700
Personal income taxes $150
Depreciation $200
Net taxes $100
Net exports $200
Net interest $130
a. Calculate GDP
b. Calculate Net domestic product
Exercise:
Net interest $200
Net indirect tax $300
Corporate profits $400
Proprietors’ income $150
Compensation of employees $1200
Depreciation $350
Rental income $100
Personal consumption expenditure $1500
Net exports $50
Government purchase $600
a. Calculate GDP
b. Calculate net domestic product
c. Calculate gross private domestic investment
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Dr. Mohammed Alwosabi Econ 141: Macroeconomics - Ch.1
Exercise:
Item Billions of dollars
C 80
G 30
T 35
I 20
M 10
X 20
D 10
Calculate:
a. GDP
b. Net domestic product
c. the value of net exports
d. the value of private saving
e. the value of government saving
f. Is there government budget deficit or surplus?
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Dr. Mohammed Alwosabi Econ 141: Macroeconomics - Ch.1
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Dr. Mohammed Alwosabi Econ 141: Macroeconomics - Ch.1
Nominal GDP in 2001 = (P1, 2001) (Q1, 2001) + (P2, 2001) (Q2, 2001)
= ($15) (2500) + ($20) (600) = 49500
Nominal GDP in 2002 = (P1, 2002) (Q1, 2002) + (P2, 2002) (Q2, 2002)
= ($20) (2300) + ($27) (500) = 59500
Nominal GDP in 2003 = ((P1, 2003) (Q1, 2003) + (P2, 2003) (Q2, 2003)
= ($23) (2800) + ($30) (700) = 85400
We can see that nominal GDP of 2002 is higher than that of 2001. This may be
because the country produced more in 2002 than 2001 or may be because the
prices in 2002 are higher than prices in 2001. (If producing more goods and
services the standard of living would increase. If paying higher prices the cost of
living would increase).
We can see in our case that the country produces fewer goods and services in 2002
and prices were higher. People were worse off in 2002 than in 2001. But still
nominal GDP was higher in 2002.
GDP in 2003 was the highest for the two reasons: higher production and higher
price level.
Thus, using nominal GDP to compare among different years does not give us the
actual picture of the performance of the economy. We cannot say for sure that a
country produces more in a particular year than any other year. Nominal GDP tells
us the change in price level that affects our cost of living.
Cost of living is the amount of money it takes to buy goods and services.
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Dr. Mohammed Alwosabi Econ 141: Macroeconomics - Ch.1
To calculate real GDP (RGDP) we select a base year, and then we use the price of
that year (the constant price) to calculate GDP in different years. In our example,
the base year was 2002. Thus, goods will be added up using 2002 prices.
RGDP in 2001 = (P1, 2002) (Q1, 2001) + (P2, 2002) (Q2, 2001)
= ($20) (2500) + ($27) (600) = 66200
RGDP in 2002 = P1, 2002) (Q1, 2002) + (P2, 2002) (Q2, 2002)
= ($20) (2300) + ($27) (500) = 59500
RGDP in 2003 = P1, 2002) (Q1, 2003) + (P2, 2002) (Q2, 2003)
= ($20) (2800) + ($27) (700) = 74900
Comparing RGDP of different years allows us to say for sure that a country
produces more (or less) goods and services in one particular year than any other
year if the RGDP of that year is higher (or lower) than the other years.
RGDP tells us the change in production and it is used to measure the size of the
economy and the growth in the economy (the change in the quantities of goods and
services).
If Real GDP > Nominal GDP then prices were higher in the base period than the
current period.
If Real GDP < Nominal GDP, current prices are higher than base period prices.
Real GDP = Nominal GDP for the base period.
In years with inflation, nominal GDP increases faster than real GDP.
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Dr. Mohammed Alwosabi Econ 141: Macroeconomics - Ch.1
RGDP is a good measure with which we compare the economy at two points in
time. That comparison can then be used to formulate the growth rate of total output
within a country.
The economic growth rate is the percentage change in the quantity of goods and
services produced from one year to the next.
RGDP this year - RGDP last year
Economic Growth Rate = × 100
RGDP last year
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Dr. Mohammed Alwosabi Econ 141: Macroeconomics - Ch.1
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Dr. Mohammed Alwosabi Econ 141: Macroeconomics - Ch.1
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Dr. Mohammed Alwosabi Econ 141: Macroeconomics - Ch.1
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Dr. Mohammed Alwosabi Econ 141: Macroeconomics - Ch.1
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Dr. Mohammed Alwosabi Econ 141: Macroeconomics - Ch.1
APPENDIX:
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Dr. Mohammed Alwosabi Econ 141: Macroeconomics - Ch.1
We can see these three sources of investment finance by using the fact that
aggregate expenditure equals aggregate income.
Households’ income is consumed, saved, or paid in taxes: Y = C + S + T
RGDP can be written as;
o Y = C + I + G + X - M (reflecting its aggregate expenditure), or
o Y = C + S + T (reflecting the use of RGDP, income)
o So we have C + I + G + (X –M) = C + S + T
o Cancel the C's and move X - M to the financing side you get
I + G = S + T + (M – X)
o This equation shows us that financing for I and G come from private saving,
taxes, and foreign sources.
o Move G to the financing side and you have I = S + (T – G) + (M – X)
This formula shows that investment is financed using saving, a government budget
surplus, (T − G) and borrowing from the rest of the world, (X − M)
o Private saving (S) = disposable income – consumption
= income – tax – consumption = Y – T – C
o Government (Public) saving = T – G
If (T – G) > 0 ⇒ surplus
If (T – G) < 0 ⇒ deficit
Private investment = National Saving + borrowing from the rest of the world
National saving = private saving + government saving
= (Y – T – C) + (T – G) = Y – C – G
Example:
Suppose an economy has the following data (in million of dollars)
Y = 200, C = 130, T = 30, and G = 20, then
Private saving = Y – C – T = 200 – 130 – 30 = 40
Public saving = T – G = 30 – 20 = 10
National saving = Y – C – G = 200 – 130 – 20 = 50, or
= private saving + public saving = 40 + 10 = 50
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Dr. Mohammed Alwosabi Econ 141: Macroeconomics - Ch.1
Exercise:
If you have the following data: government saving = 0, RGDP = $2500 million,
private consumption = $1300 million, tax = $350 million; calculate the country’s
national saving
Exercise:
If national saving is $200,000, net taxes equal $100,000 and government purchases
of goods and services are $50,000, how much are households and businesses
saving?
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Dr. Mohammed Alwosabi Econ 141: Macroeconomics - Ch.1
To see how the change in prices changes the cost of living we should analyze the
changes in price level.
Price level (also called price index) is a weighted average of prices of goods and
services in a given year relative to the prices in a specified base year.
Price level is a unit free measure.
There are many types of price level measurements but we will focus only on the
most popular two of them.
1. The GDP Deflator
2. The Consumer Price Index (CPI)
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Dr. Mohammed Alwosabi Econ 141: Macroeconomics - Ch.1
The larger the nominal GDP for a given RGDP the higher is the price level and the
larger is the GDP deflator.
Example:
From the example in pages 14-15, the GDP Deflator is as follows:
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Dr. Mohammed Alwosabi Econ 141: Macroeconomics - Ch.1
2. The introduction of new goods poses a problem when calculating Real GDP;
therefore, it poses a problem in calculating the GDP deflator because the deflator is
the ratio of nominal to Real GDP.
3. If prices of imported goods fall but prices of domestic goods are high, consumer’s
purchasing power may not fall by much even if the GDP deflator indicates a high
price level.
Cost of the CPI basket at 2001 prices = ($0.50)(2000) + ($1)(1000) + ($1.5)(600) = $2900
Cost of the CPI basket at 2002 prices = ($0.55)(2000) + ($1.2)(1000) +($2)(600) = $3700
Cost of the CPI basket at 2003 prices = ($0.60)(2000) + ($1.30)(1000) + ($2.5)(600) = $4000
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Dr. Mohammed Alwosabi Econ 141: Macroeconomics - Ch.1
2900
CPI in 2001 (the base year) = × 100 = 100 (always 100)
2900
3700
CPI in 2002 = × 100 ≈ 128 ⇒ the cost of living has increased from 2001 to
2900
2002 by 28%
4000
CPI in 2003 = × 100 ≈ 138 ⇒ the cost of living has increased from 2001 to
2900
2003 by 38%
Exercise:
Redo the above example assuming 2002 is the base year.
Exercise
An average urban family consumes only bread, meat and cloth. In the base year the
family spent $300 on bread, $450 on meat, and $800 on cloth. Prices in the base
year were $1 per bread, $3 per kg of meat, and $5 per yard of cloth. Prices in the
current year are $1.5 per bread, $5 per kg of meat, and $8 per yard of cloth.
a. What was the cost of living for this family in the current year?
b. What was the CPI for the current year?
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Dr. Mohammed Alwosabi Econ 141: Macroeconomics - Ch.1
overestimate inflation; the price of computing has decreased even though the
price of the computer is unchanged.
3. The introduction of new goods that render old goods obsolete may pose a
problem because the old goods still remain in the CPI basket until the basket is
revised again.
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Dr. Mohammed Alwosabi Econ 141: Macroeconomics - Ch.1
INFLATION RATE:
The inflation rate is the percentage change in the price level from one year to the
next.
GDP Deflator this year - GDP Deflator last year
Inflation Rate = × 100
GDP Deflator last year
From the examples in page 23
114 − 100
For 2003 Inflation rate = × 100 = 14
100
OR
CPI this year - CPI last year
Inflation Rate = × 100
CPI last year
From the examples in page 24-25
138 − 128
For 2003 Inflation rate = × 100 ≈ 8
128
So far, we have described how aggregate measures of output and price level of the
economy are constructed.
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