## Unit 2 Study Guide: Macroeconomics: Goals, Measures, and Challenges

#### 2a: Define nominal gross domestic product and real gross domestic product.

• Define servicesdurable goodsnondurable goodsstructures, and change in inventories.
• Define gross domestic product (GDP).
• Define market value.
• Define final and intermediate goods and services.
• How does including intermediate goods and services or inputs to production when calculating GDP reflect double counting?
• Does the calculation for GDP include the value of goods and services that foreign nationals (residents who are not citizens) produce?
• Does the calculation for GDP include the value of goods and services that all nationals (citizens who live in foreign countries) produce?
Definition and Components of Gross Domestic Product

The concept of gross domestic product (GDP) is central to macroeconomics. The media and government officials and the media use it to document the health of a country's economy. The size of a nation's overall economy is typically measured by its gross domestic product (GDP), which is the value of all final goods and services produced within a country in a given year (page 133 of Macroeconomics).

Remember four central elements economists use to calculate gross domestic product (GDP) from this definition:

1. market value;
2. final goods and services;
3. within one country; and
4. during one given year.

Gross domestic product (GDP) tallies up the services, durable goods, nondurable goods, structures, and change in inventories a country produces. GDP measures domestic economic activity.

When we calculate gross domestic product (GDP) or economic activity from this supply-side or output-driven perspective, we tend to focus on the physical objects an economy produces, such as cars, machines, or computers. However, the services comprise the largest part of today's gross domestic product (GDP) by far.

In today's economy, most jobs involve working behind a computer screen, coordinating activities, creating plans, and meeting with our co-workers, customers, and suppliers to cater to the needs of our individual customers and clients. Today's leading service industries include healthcare, education, and legal and financial services. Do not forget to include these major producers when you think of GDP.

Economists assign five categories to the goods and services they include in GDP: services, durable goods, nondurable goods, structures, and the change in inventories.

1. We just explored services.
2. Durable goods include long-lasting items, such as cars and refrigerators.
3. Nondurable goods include short-lived items that last less than a year, such as food and clothing (this category includes clothing even though many clothes last longer than a year!).
4. Structures include homes, office buildings, shopping malls, and factories.
5. Inventories refer to the goods a business has already produced, but not yet sold to consumers. They are sitting in warehouses and on shelves.
Review GDP in the following materials.

#### 2b: Compare and contrast as well as discuss various measures of output and income.

• Define consumptioninvestmentgovernmentexports and imports.
• Does investment refer to financial capital or physical capital?
• Which component reflects new home purchases?
• What common unit of measurement do economists use to measure GDP?
In national income accounting, we calculate the GDP to identify economic activity in a given country. Economists use two primary methods to calculate GDP: the income and expenditure methods. These calculations of GDP should produce the same result: every transaction has a seller who receives income from the sale proceeds and a buyer who spends money to purchase goods and services. The nationally-reported numbers for income and expenditures frequently differ slightly due to errors or omissions in measurement and reporting.

Seller receives income from the sale of the product or service (income approach)

Product or service (market value)

Buyer spends money to purchase the product or service (expenditure approach)

Until this point, we have calculated GDP in terms of the supply side, business income, and total production of domestically-produced goods and services. This task is straightforward: take the quantity of everything a country produces and multiply this quantity by the price for each product sold. This calculation describes an income-based approach.

To calculate GDP, the expenditure approach focuses on consumer demand or total amount households, business, government, and foreign sectors spend to purchase domestic goods and services.

Demand or Expenditure Side of GDP

From the demand or expenditure perspective, GDP includes four main components:

1. Consumption – consumer spending or expenditures on final goods and services;
2. Investment – business spending or expenditures on new capital equipment, inventory, structures, and consumer spending or expenditures on new homes;
3. Government – expenditures;
4. Spending or expenditures on net exports – the trade balance.

Note that we need to remove imported goods from our equation of gross domestic product (GDP). As its name suggests, GDP should only reflect goods and services produced domestically. Imports describe goods and services produced in a foreign country. In our equation for GDP from the demand side, we must subtract imports (M) because consumption (C) includes ALL consumption spending, including the purchase of imported goods.

GDP = Consumption + Investment + Government + Trade balance (exports – imports)

GDP = C + I + G + (X – M)

• Define national income and gross domestic income (GDI).
• Define employee compensationprofitsrental incomenet interestdepreciation, and indirect taxes.
• Which component of GDI is the largest?
Measuring
Total National and Domestic Income

National income includes all wages or employee compensation, profits, rental income, net interest, depreciation, and indirect taxes. Gross domestic income (GDI) restricts national income to the income residents earn within a country's borders.

Review gross domestic income (GDI) in the following resources.

#### 2c: Distinguish between real and nominal values.

• Define real GDP and explain the difference between real and nominal values?
• How do economists calculate real values?
• Define the GDP deflator and how economists use it used to calculate real GDP?
Consider the measure of gross domestic product (GDP) we studied in the previous section as nominal GDP because it describes total spending in the economy: we measure the prices for goods and services at the time of the calculation.

While, nominal GDP measures overall spending, it may not accurately portray whether the economy has really grown, or has really been more productive from one year to the next. We need to eliminate the effect of inflation when making these types of comparisons to get a more accurate reading of how well the economy is really doing.

For example, when we compare nominal GDP in 2017 ($18 trillion dollars) to nominal GDP in 2018 ($20 trillion dollars), we do not know if the $2 trillion increase was due to higher production levels or higher prices (inflation). The economy grew if the increase was due to higher production levels − a great outcome. However, if the$2 trillion increase was due to a rise in prices, we attribute the increase in nominal GDP to inflation, not production. A large increase in inflation could hide the fact that production levels may have held stagnant or even dropped.

The concept of "real" GDP removes the effect prices and inflation have on GDP. An increase in real GDP always means the economy is growing; a drop in real GDP always means that the economy is contracting.

Review this material in the following resources.

Economists use real GDP to evaluate and make comparisons about economic activity over time. Economists say the economy is in recession when GDP falls for two successive quarters. A depression describes a severe or prolonged economic downturn, specifically a recession that lasts more than two years. We explore the business cycle in more detail in Unit 4.

Figure 6.10 U.S. GDP, 1900–2014

Figure 6.10 (page 148) shows the pattern of U.S. real GDP since 1900. The generally upward long-term path of GDP has been regularly interrupted by short-term decline. A significant decline in real GDP is called a recession. An especially lengthy and deep recession is called a depression. The severe drop in GDP that occurred during the Great Depression of the 1930s is clearly visible in the figure, as is the Great Recession of 2008–2009.

#### 2d: Analyze the problems associated with using GDP as a measure of well-being.

• Define service sectorhousehold productionunderground economy, and leisure.
• Explain some measurement problems that exist with GDP calculations, such as when we measure production from the service sector, household production, the underground economy, and leisure.
• Explain how GDP can present a misleading measure of economic well-being, such as toxic elements of production or negative byproducts, such as crime, disease, and pollution.
While gross domestic product (GDP) provides a good overall measure of economic well-being, it is not a perfect measure. Certain measurement problems reduce its accuracy.

Review this material in GDP and Economic Well-Being from Principles of Macroeconomics and the lecture notes Introduction to Macrodata by Veronica Guerrieri.

#### 2e: Identify the components of the expenditure and the income approaches to the measurement of GDP.

Review the components of the expenditure and income approaches to the measurement of GDP in learning outcome 2b above.

#### 2f: Explain how consumer income relates to spending and saving.

In economics, investment refers to investment in physical capital, not investment in financial capital. Consumption refers to household spending on new final goods and services, except for new home purchases which we consider investment.

For example, economic investment includes spending on machinery and equipment, factories, inventories, and new houses. Investments in financial assets, such as stocks and bonds, are not economic investments for the purposes of economic theory.

Savings and consumption are linked to disposable income. We spend disposable income (after-tax income) in two ways: for consumption and savings. Saved income is a funding source for investment.

For example, we consider the money we deposit into a savings account, "savings." However, the bank where we deposit our money, will loan our savings out to other individuals and businesses, who may use the money to expand or start a new business (investment).

Consumption + Savings = Disposable Income

Savings = Investment

Review the video Investment and Consumption from Khan Academy.

#### 2g: Describe the consumption and savings functions and the terms attached to their slopes.

Review the shape of the long-run aggregate supply curve and factors that shift this curve over time. We review the production possibility curve in more detail in Unit 4.

Review this material Aggregate Demand and Aggregate Supply from Principles of Macroeconomics, and the video Long-Run Aggregate Supply from Khan Academy.

#### 2h: Define automatic stabilizers, and explain changes in government spending and taxing during a macroeconomic recession and expansion.

• Define automatic stabilizer.
• Define transfer payments and progressive income taxes.
• Explain how transfer payments, progressive income taxes, budget deficits, and budget surpluses work as automatic stabilizers.
Fiscal policy describes the power governments have to influence the aggregate economy, real GDP, and the price level (inflation or deflation) through spending and taxation. Governments use discretionary fiscal policy tools (laws and legislation) and automatic stabilizers to influence the economy. We will review discretionary fiscal policy in more detail in unit 5.

As their name implies, automatic stabilizers work automatically and usually in a direction that is opposite to the direction the economy is taking to achieve stabilize the economy. For example, automatic stabilizers stimulate aggregate demand and real GDP during periods of recession. They reduce aggregate demand and real GDP during economic upswings or periods of economic growth, because too much expansion can cause inflation to spiral out of control. Unemployment and welfare benefits, and the individual and business tax rate, are examples of automatic stabilizers.

Review automatic stabilizers in the following resources.

#### 2i: Describe how savings and investment contribute to economic growth.

Review how savings and investment contribute to economic growth in learning outcome 2f above.

#### 2j: Define economic growth in terms of changes in the production possibilities curve and in real gross domestic product.

Review economic growth and real gross domestic product where we discuss aggregate demand in learning outcome 2g. Review the production possibilities curve in Unit 7 (learning outcome 7d below).

#### Unit 2 Vocabulary

• Automatic stabilizer
• Consumer demand
• Consumer preferences
• Consumption
• Depreciation
• Depression
• Disposable Income
• Double counting
• Durable good
• Employee compensation
• Export
• Final good and service
• Financial capital
• Foreign national
• GDP deflator
• GDP per capita
• Government expenditure
• Gross domestic income (GDI)
• Gross domestic product (GDP)
• Gross national product (GNP)
• Household production
• Import
• Income
• Indirect tax
• Interest
• Intermediate good
• Investment
• Market value
• National
• National income
• Net national product (NNP)
• Nominal value
• Nondurable good
• Physical capital
• Progressive income tax
• Real GDP
• Real value
• Recession
• Savings
• Service sector