Domestic Gross Product Gross domestic product (GDP) is used by economists to measure the level of spending on final goods in a given period, and to gauge how aggregate demand is changing over time. 1More specifically, GDP in a quarter/year = the $ value of the final goods produced in the country in that quarter/year OK, but what are final goods? Final goods are goods not used in the production of other goods that period. This definition implies that a specific quantity of a given good, such as milk, may or may not be a final good. Think about that. In 2006 the dollar value of the milk produced in the U.S. was $29.6 billion. Would the entire $29.6 billion be included in 2006 GDP? The answer is no. Why? Because a lot of that milk was used to produce other goods that year, e.g. cheese, ice cream, yoghurt, etc. So only a part of that production would be included in GDP. Only that part that wasn't used to produce other goods. Therefore, use determines if a good is a final good or intermediate good (good used in the production of another good), not the good itself. (Be aware that GDP is also referred to as nominal GDP, or GDP in current dollars/prices.) Note that this definition of final good means that any good produced and then put into inventory would be considered a final good. Think about that. Say a metal stamping plant stamps out 120,000 automobile fenders one year, but only 105,000 are put onto new cars by auto manufacturers that year. The rest end up in inventories (it doesn't matter whose inventory, the metal stamping company or an auto manufacturer). Well, the dollar value of the fenders going into inventories that year and staying there would be included in GDP. So, algebraically, GDP in a quarter/year = price of good 1 x quantity of good 1 that's a final good + price of good 2 x quantity of good 2 that's a final good + . . . . . . . . . . . . . +
price of good last x quan. of good last that's a final good Now let's think about measuring changes in the economies output over time. Could we use GDP for this purpose? Obviously not. When we look at the formula for GDP we realize that its determined by two things: the quantities of final goods produced = the economy's output, and the prices of final goods. So output is in it.
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Aggregate demand refers to the demand for all final goods in a given period.
It's going to go up and down as output goes up and down. But it's also going to go up and down as prices go up and down. Think about what that implies. Suppose we observe that GDP in the U.S. in 2000 was $10 trillion and in 2001 it was $10.3 trillion. Therefore, GDP increased by .3/10 x 100% = 3% in 2001, i.e. it was 3% greater in 2001 than in 2000. On the basis of that observation could we conclude that output was 3% greater in 2001 and 2000? Of course not. What if output was exactly the same in 2001 as 2000 but prices were 3% higher? Then 1) output did not increase in 2001, but 2) GDP would be 3% higher in 2001 than 2000. The fact is, prices have the same effect on GDP as output. A ceteris paribus x% increase in all prices would have the same effect on GDP as a ceteris paribus x% increase in the production of each good. Both of these changes would cause GDP to increase by x%. Too bad. Yes, it is. But output is in GDP. To reiterate, GDP will go up and down as output goes up and down. Thus, to get an idea of how output is changing, all we need to do is remove the effect of changes in prices on GDP. That is, somehow, someway, negate or take out the effect of prices on it. If we can do that, then the change we observe after taking out the effect of prices would be due solely to the effect of output on GDP. Note removing the effect of a change in average price on an economic variable is referred to as deflating it. You say: That's so exciting that I'm almost ready to stop playing Grand Theft Auto while I'm reading this. How could that be done? Actually, it's pretty easy, as least if we'd be satisfied with a rough estimate (and we will be). Let's suppose we observe GDP that GDP increased by 6.5% between 2003 and 2004. Let's suppose that we took a sample of final goods prices in 2003 and averaged them. Then we took the prices of those same goods in 2004 and averaged them. Well, say we found that this average of final goods prices increased by 4%. What could we reasonably conclude? Answer: prices went up by 4% in 2004 and therefore, there was a 4% increase in GDP because of higher prices. Well, if we subtract out that 4% increase in average price from that 6.5% increase in GDP, what are we left with. We think: hmm. GDP went up by 6.5% because prices and/or output changed. But prices went up by 4%. So since every 1% increase in prices causes GDP to go up by 1%, 4 of those 6.5 percentage points are due to price increases. Hey, that means that 6.5% 4% = 2.5% must be the increase in GDP due to the change in output! Right you are. By figuring out the percentage change in average price over the year and subtracting that from the percentage change in GDP that year, we come up with an estimate of the percentage change in output that year. The moral to this fascinating tale is this. By adjusting GDP down/up to eliminate the effect of higher/lower prices on average over time, by deflating it, we obtain what is referred to as real GDP. Real GDP is actually an index that is used primarily to determine if a country's output is increasing/decreasing over time, and at what rate. It's safe to think of it as the value of the economy's output in a given quarter/year calculated using the prices in a specific year, called the base year. If you go to the website of the Bureau of Economic Analysis (www.bea.gov) and look at real GDP, you'll see the data presented under the heading, "Real Gross Domestic Product, Chained
Dollars [billions of chained (2005) dollars]." This means (basically) that the value of the economy's output for each year in the data set has been calculated using prices in 2005. (Like GDP, real GDP goes by a number of different names. They are: real GDP, GDP in constant dollars/prices, adjusted GDP for inflation, deflated GDP) So let's calculate the annual growth rate for the U.S. economy last year (20072008). An economy's growth rate = the period-to-period % change in its output, and so its estimated by taking the percentage change in real GDP over the period. So we could estimate the quarterly growth rate (= quarter-to-quarter % change in real GDP), the annual growth rate (= year-to-year % change) or even say, a five-year growth rate (= the % change over a five year period). Looking at the data from www.bea.gov we see that real GDP in the U.S. in 2008 = 13.312 trillion 2005 $ real GDP in the U.S. in 2007 = 13.254 trillion 2005 $ Therefore, the percentage change in real GDP from 2007 to 2008 was (13.312 13.254)/13.254 x 100% = .058/13.254 x 100% = .00438 x 100% = .4438% This indicates that there was very little growth in the U.S. economy from 2007 to 2008, less than 1/2 of a percent. That was so much fun, let's do it again. Let's go back to 1998-99. We see that real GDP in the U.S. in 1999 = 10.779 trillion 2005 $ real GDP in the U.S. in 1998 = 10.283 trillion 2005 $ Therefore, the percentage change in real GDP from 1998 to 1999 was (10.779 10.283)/10.283 x 100% = .496/10.283 x 100% = .0482 x 100% = 4.82% Quite a difference, huh? FYI, an annual growth rate of 4+ % is a very good growth rate for high income countries (like the U.S., Japan, Germany, etc.). Think about what a growth rate of 4% vs. a growth rate of 1% implies. If an economy's growth rate is 4%, its output will double in 18 years. But if output is growing only 1% a year, it takes 72 years for output to double (four times as long). OK, what do you need to remember when it comes time to figure a growth rate?
One, two, three: always divide by the number from the earlier period. Be aware, if you divide by the wrong number, you'll get a different answer, the wrong answer. Let's finish up with a brief discussion of price indexes. A price index is designed to indicate what is happening to an average of prices. For instance, the consumer price index is designed to indicate what's happening to the prices of consumer goods, on average i.e. whether the average price of consumer goods is rising or falling over time, and at what rate. (Yes, prices can fall over time. What happened to average price during the Great Depression?) Because of what a price index is designed to do, we estimate an economy's inflation rate using a price index. This is because an economy's inflation rate = the period to period change in average price The price indexes most commonly used to estimate the U.S. inflation rate are the consumer price index (the CPI for short) and the GDP price index (also known as the GDP deflator, since it's the price index used to deflate GDP). The first step in constructing a price index is choosing a base year. This is just a reference point. We want to be able to say if prices are going up or down, and up/down is relative. For example, say the Standard & Poors 500 (an average of stock prices) was 1400 in July 2008, 900 in January 2009, and 1050 in September 2009. Is the S & P 500 up or down? Well, relative to its value in July 2008 its down. But relative to its value in January 2009 its up. So we pick our base year, say 2000. Then we pick the goods whose prices we'll be averaging and we figure the average of the prices of these goods in 2000. Let AP2000 denote that average. Then each year we take the average of the prices of those goods, we divide each of those averages by AP2000, and finally, we multiply that quotient by 100. All right, suppose we're constructing a CPI and our base year is 2000. And say we start our index in 1990. Then CPI1990 = AP1990/AP2000 x 100, CPI1991 = AP1991/AP2000 x 100, CPI1992 = AP1992/AP2000 x 100, . . .
Note that the value of a price index in a given year tells you how much higher/lower prices were on average that year than in the base year. For example, suppose CPI1992 was 85. That would mean AP1992/AP2000 x 100 = 85 and therefore, that
AP1992/AP2000 = .85 That is, average price in 1992 was 85% of average price in 2000; in other words, average price in 1992 was 15% lower than average price in 2000. 2 Now suppose CPI2006 was 112. If so, AP2006/AP2000 x 100 = 112 or that AP2006/AP2000 = 1.12 That says average price in 2006 was 1.12 times what it was in 2000, and that means it was 12% higher in 2006 than in 2000. Due to the way in which a price index is calculated, the period to period percentage change in it indicates the period to period percentage change in average price (because ave. pr. in the base year cancels out when we take the percentage change in the index, leaving the percentage change in ave. price between the two periods). Let's use the actual values of the CPI (computed by the Bureau of Labor Statistics) to estimate the inflation rate in the U.S. In 2008 the CPI was 215.3 vs. 207.3.3 Thus, between 2007 and 2008, the CPI increased by (215.3 207.3)/207.3 x 100% = 3.86% and that would be our estimate of the inflation rate in 2008, if we used the CPI. Of course we could use some other index, such as the GDP deflator. In 2008 that index stood at 108.48 vs. 106.22 in 2007. The percentage change in it from '07 to '08 was (108.48 106.22)/106.22 x 100% = 2.13% and so we see that this index indicates a lower inflation rate for 2008. This shows that estimates of the inflation rate can change dramatically when you change the index you use to estimate it.
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If AP1992/AP2000 = .85, then AP1992 = .85 AP2000, which means ave. pr. in '92 was 85% of ave. pr. in '00. So, to figure out how much higher/lower ave. pr. was in a given year than in the base year, percentagewise, just subtract 100 from the value of the index in that year. For example, 85 100 = 15, implying a 15% decrease, i.e. ave. pr. was 12% lower in 1992 than 2000; 112 100 = 12, i.e. ave. pr. in 2006 was 12% higher in 2006 than in 2000. 3 The base year for this index is 1982-84. That means the BLS uses average price over a 3 year period as a reference point. The base year for the GDP price index is 2005.