ECN60204 Macroeconomics

Lecture 2
The Macroeconomic
Environment: GDP & Business
Fluctuations
Disclaimer: All materials and content
discussed in this session is only for the
Taylor’s University students who are
Hubbard, Ch 19 and 20 enrolled into ECN60204 in August 2020 1

semester.
Learning Outcomes

• Define GDP
• How to calculate GDP using expenditure approach
and income approach.
• Use the circular flow to explain why GDP is the same
regardless of the method of calculation applied.
• Difference between nominal and real GDP
• Business Cycle
• Unemployment / Inflation

© 2010 Pearson Addison-Wesley

 Definition of Gross Domestic Product

GDP or gross domestic product is the market value

of all final goods and services produced in a country in
a given time period.
A pencil retails at RM1, cost
This definition has four parts: of 10 pencils will be RM10
 Market value (price at which items are traded in the
market) tyers & cars,
sand/cement & houses
 Final goods and services (excludes intermediate
goods)
to avoid double counting
 Produced within a country
Domestic production
 In a given time period
Eg car produced & sold in
What2010
about
– GDP
car produced
2010
in 2010 but sold in 2011–
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GDP 2010.
 Why Is Domestic Product Gross?

“Gross” means before deducting the depreciation

of capital.
The opposite of gross is net.
“Net” means after deducting the depreciation of
capital.

Our focus is on GDP

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 Measuring GDP

Two approaches to measure GDP:

 The expenditure approach
 The income approach

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 Many Facets of GDP
Expenditure approach
Consumption personal Income approach
household consumption
Investment expenditure by Compensation
businesses
Profits
Government consumption
of goods & services & gross Proprietors’ Income
fixed capital GDPRent
Net export
interest
Production
Output

Income = Expenditure = Output

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 GDP = Expenditure = Income

Total expenditure on final goods and services equals GDP.

GDP = C + I + G + X – M.
Aggregate income (Y) equals the total amount paid for the
use of factors of production: wages, interest, rent, and profit.

Income = Expenditure
Y = C + I + G + (X – M)

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 The circular flow of income

Firms

Consumption of
Factor domestically
payments produced goods
and services (Cd)

Households
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National Income: The Circular Flow
Closed (Simple) Economy

Savings, S
Households
Leakage/withdrawal

C Y
C=Y Land,
Goods Factor Labour,
Markets Markets Capital

S=I
Investment, I
Injection
Firms

9
National Income: The Circular flow
Open Economy

–S leakage
–TA Households
Govern
-ment C Y
G
Injection Factor
Goods
Markets Markets
–M

World X

I Firms

10
 The Fundamental National
Income Identity

Y = C + I + G + NX
C Consumption
I Investment
G Government spending
NX (Ex-Im) Net Exports
11
Consumption (C)
 Private sector expenditure on final g & s
 Personal consumption
Personal household
consumption
 largest component
 most stable (especially when goods
are non-durable essentials)

Clothes, cars, watches, phones – durables

Food – non-durables

Consumption goods i.e. goods which are

consumed in the present time 12
 Goods which are not consumed in the
Investment (I) present time. Instead used for generating
future GDP

• housing construction (dwellings)

Office buildings, factories,
• non-residential construction warehouses, etc

• machinery & equipment

• changes to inventory
accumulation of goods not sold in the period

When sold in 2011, minus from (- ) A car produced in 2010 but

inventory and add to consumption (plus sold in 2011– Added to (+)
car agent’s profits/value add, etc) for inventory in 2010
2011 GDP
13
Government Spending (G)
Spending on goods & services on:
• Public consumption
• Development (public capital investment)

Excludes Transfer Payments (TR) to avoid

double counting

Note: Examples of TR are unemployment benefits, welfare

payments, etc…..

14
Net Exports (NX)
Some consumption & investment
• Exports - Imports. goods are not produced here but
overseas and does not lift
domestic production

Demand for domestic

goods and services by
foreign countries

15
 UK GDP by category of expenditure: 2009
£million
Consumption expenditure of households (C) 908 788
Government final consumption (G) 327 682
Gross capital formation (I) 190 667
Exports of goods and services (X) 386 648
less Imports of goods and services (M) –418 671
Statistical discrepancy 2 409

Gross domestic product (GDP) (at market prices) 1 392 705

The Expenditure Approach

GDP = C + I + G + (X  M)
= £ 1 392 705 million

© 2010 Pearson Addison-Wesley

 Nominal GDP and Real GDP

Nominal GDP (Money GDP) is the value of goods

and services produced during a given year valued at
the prices that prevailed in that same year.
a.k.a. GDP at CURRENT prices

Real GDP = the value of final goods and services

produced in a year valued at the prices of a reference
base year (usually a previous year).
Currently, the base year is 2010

It is common to refer to real GDP as at 2010 prices or

GDP at CONSTANT prices

© 2010 Pearson Addison-Wesley

 Real GDP
Between nominal and real GDP, economists consider real
GDP as the more important measurement of goods and
services or output.
WHY?

Nominal GDP includes current prices i.e. inflation.

Inflation overstates GDP & distorts (reduces) standard
of living!
Objective is to adjust (remove) inflation ie prices
rise from Nominal GDP to obtain real GDP
How?
We use a price index call the GDP Deflator
The Consumer Price Index (CPI) is
© 2010 Pearson Addison-Wesley another example of a price index
Measuring Real GDP with use of GDP Deflator
Price Index
Real GDP (Base year
Nominal GDP (Base year 2004) = 100) 1
Items Qty Price Expenditure Price Expenditure

2008 $1/kg $ 100 105.0

Apples 100kg $1.05/kg $ 105
$20 $ 100
$ 200
CDs 5 units $ 21 $ 105
Items Qty Price $ Expenditure
210 Price Expenditure
2009 $1/kg $ 110
Apples 110kg $1.10/kg $ 121 $20 $ 120 108.7
$ 230
CDs 6 units
$ 21.50 $ 129
1
GDP Deflator Price Index
$ 250
= Current expenditure x 100
3.7
Real expenditure points
By using real GDP, we remove any influence that rising prices
and a rising cost of living might have had on our comparison.
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Measuring Growth Rates (between 2008 to 2009)
Year Nominal Real Price
GDP GDP Index
2008 210 200 105 Nominal GDP growth = 19%
2009 250 230 108.7 Real GDP growth = 15%
Inflation rate = 3.52%

Nominal GDP Growth Rate (for 2009)

= NominalGDP 2009 – Nominal GDP 2008
X 100
Nominal GDP 2008

Real GDP Growth Rate (for 2009)

= Real GDP 2009 – Real GDP 2008 X 100
Real GDP 2008

To measure inflation rate (2008-2009)

= Current year’s Price Index – last year’s Price Index x 100
Last year’s Price Index
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 The Uses of Real GDP

Economists use estimates of real GDP for several purposes:

1. To compare the standard of living over time and across
countries
2. Determining policy decisions and
3. Measure and predict effect of policy on economic
performance

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 Potential, Real GDP and Business
Cycle Fluctuations
■ The growth of potential real GDP
■ Fluctuations of actual real GDP around potential real
GDP
The value of real GDP when all factors of production are
fully employed is called potential real GDP.

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 Potential GDP, Real GDP and Business
Cycle Fluctuations

A business cycle is a periodic but irregular up-and-down movement

of total production and other measures of economic activity.
Every cycle has two phases:
1. Expansion
2. Recession Actual peak
Real GDP
and two turning points:

ion
Real GDP
1. Peak peak t en tial

ans
Po DP
l G
2. Trough re a

Exp
rec
peak

n
nsio

ess
rec

expa

ion
Notice when actual GDP trough
ess

fluctuates, it moves away

ion

from potential GDP trough

year
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Output Gap

The output gap is the difference between what the

economy is actually producing and its full employment
(potential) output

Output = Potential - Actual

Gap Output Output

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 Inflation Gap and Recession Gap

peak
Inflation Gap = Actual > Potential
Real GDP

Output Output
Recession = Potential > Actual Output
Gap Output
trough

2002 2005 Year

• A Recession Gap implies high unemployment, low inflation,

surplus resources, excess productive capacity
• An Inflation Gap implies low unemployment, high inflation,
shortages, insufficient capacity
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Full Employment & Unemployment

OUTPUT = POTENTIAL  ACTUAL

GAP OUTPUT
OUTPUT
Output when all factors of production are at
full employment
With Natural unemployment:
 Frictional
 Structural

In a recession gap, unemployment is =

 Frictional
 Structural
 Cyclical
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 Limitations of Real GDP

Real GDP measures the value of goods and services that

are bought in markets. Some of the factors that influence
the standard of living and that are not part of GDP are
 Household production
 Underground economic activity
 Health and life expectancy
 Leisure time
 Environmental quality
 Political freedom and social justice

© 2010 Pearson Addison-Wesley

NEXT WEEK
Aggregate Demand and Aggregate Supply [PART 1]
Factors determining aggregate demand & supply
(AD/AS), short run & long run supply curves, potential
output, inflation & recession gap.

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