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# e202nipa - Chapter 2 Measuring Economic Activity Before it...

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Chapter 2 Measuring Economic Activity Before it is even possible to explain macroeconomic phenomena, one has to be able to describe them. This chapter deals with measuring the economy. I concentrate on GDP and its components and the general price level. Some additional measurement issues are contained in the chapters on inflation and business cycles. 2.1 Gross National Product In order to be able to make statements about economic growth or business cycles, we need to define a mea- sure of aggregate economic activity. The one most commonly employed is called Gross Domestic Product, or GDP. GDP is defined as the value of everything that is produced in an economy during a specified period of time, usually a year. The “gross” refers to the fact that GDP is not adjusted for depreciation, whereas the “domestic” indicates that we look at production in a given geographic area. I will come back to these points later. There are three different ways to measure GDP, and I will discuss each of them in turn. Measuring GDP by Production Since GDP for a year is the value of everything that is produced in that year, one way of computing GDP is to ask firms about their production directly. However, there is one caveat. If we add the value of the production of all firms in the economy, we encounter the problem of double counting. Double counting occurs if the production of one firm enters as an intermediary product into the production of another firm. In that case the intermediate product would be counted twice, once as revenue for the producer of the intermediate good, and another time as revenue for the user of the intermediate good, who will incorporate the cost of the intermediate good into the price of his product. To see this, imagine an economy with only two firms, a miller and a baker. Let us assume that the miller sells flour for \$60 to the baker. The baker uses the flour to bake bread and sells the bread for \$140 to some consumer. If we now add the revenue of the miller and the baker, we get a value of \$200. But in fact the only thing that was produced in the economy was the bread, since the flour got used up in baking the bread. Therefore \$200 overstates GDP, the correct number should be \$140. There are two ways of arriving at the correct number. The first possibility is to count only sales that are for final use. In that case the contribution of the baker to GDP would be \$140, since the bread is for final use, whereas the production of the miller would not be counted, since all the flour is used in the production of 1

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the baker. The second possibility, the one that is practiced, is to employ the concept of value added. The value added of a firm is defined as revenue minus cost of intermediate goods purchases. Value Added = Revenue - Cost of Intermediate Goods We then get GDP by summing value added over all firms in the economy. Since all intermediate good purchases are subtracted, double counting is avoided.
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e202nipa - Chapter 2 Measuring Economic Activity Before it...

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