Chapter 4: GDP - Measuring Total Production, Income and Economic Growth

Question 1

What is microeconomics?

Answer 1

The study of how households and firms make choices, how they interact in markets and how the government attempts to influence their choices.

Question 2

What is macroeconomics?

Answer 2

The study of the economy as a whole, including topics such as inflation, unemployment and economic growth.

Question 3

What is economic growth?

Answer 3

The ability of the economy to produce increasing quantities of goods and services. Economic growth is important because an economy that grows too slowly fails to raise living standards.

Question 4

What is the unemployment rate?

Answer 4

The percentage of the labour force that is unemployed.

Question 5

What is a business cycle?

Answer 5

Alternating periods of economic expansion and economic contraction relative to the long-term trend rate of economic growth.

Question 6

What is expansion?

Answer 6

The period of a business cycle during which total production and total employment growth rates are increasing above trend growth rates.

Question 7

What is contraction?

Answer 7

The period of a business cycle during which total production and total employment growth rates are falling below trend growth rates.

Question 8

What is recession?

Answer 8

The period of a business cycle during which total production and total employment are decreasing.

Question 9

What is the inflation rate?

Answer 9

he percentage increase in the general level of prices in the economy from one year to the next.

Question 10

What does macroeconomic analysis provide?

Answer 10

It provides information that consumers and firms need in order to understand current economic conditions and to help predict future predictions. Macroeconomic analysis can also aid the federal government in designing policies that help the economy perform more efficiently.

• A family may be reluctant to borrow money to buy a house if employment in the economy is declining because some family members may be at risk of losing their jobs.
• Similarly, firms may be reluctant to invest in building new factories or to undertake major new expenditures on information technology if they expect future sales to be weak.

Question 11

What are the four main policy objectives of Australian macroeconomic policy?

Answer 11

1. A stable and strong rate of economic growth
2. Low unemployment
3. Stable and low inflation
4. A manageable balance in overseas trade and finance.

Question 12

What is Gross Domestic Product (GDP)?

Answer 12

The market value of all final goods and services produced in a country during a period of time. The Australian Bureau of Statistics (ABS) compiles the data needed to calculate GDP. The ABS issues reports on GDP every 3 months (quarterly).

Question 13

What are some features of GDP?

Answer 13

• GDP is measured using market values, not quantities
• GDP include only the market value of final goods and services
• GDP includes only current production

Question 14

Explain the following feature of GDP: It includes only the market value of final goods and services

Answer 14

In measuring GDP we include only the market value of final goods and services. In contrast, intermediate goods and services are not used as they are used in the production of another good or service. In calculating GDP, we include the value of the bread, but not the value of the flour and other ingredients. If we included the value of both, we would be double counting.

Question 15

What is a final good or service?

Answer 15

A new good or service that is the end product of the production process and that is purchased by the final user. An example of final goods and services is a haircut purchased by a consumer or a computer purchased by a business.

Question 16

What is an intermediate good or service?

Answer 16

A good or service that is an input into the production of another good or service. For example, Bakers Delight does not produce the flour used in its bread making; it buys the flour from a flour mill. The flour purchased by Bakers Delight stores is an intermediate good, whereas a loaf of bread purchased by a person for their consumption is a final good.

Question 17

Explain the following feature of GDP: It only includes current production

Answer 17

GDP includes only current production that takes place during the indicated time period. For example, GDP in 2018 includes only the goods and services produced during that year. In particular, GDP does not include the value of used goods.
Example:
If you buy a new DVD of Star Trek from Kmart = purchase is included in GDP
6 months later you resell that DVD on eBay = transaction is not included in GDP since nothing new has actually been produced.

Question 18

What is an alternative way of calculating GDP?

Answer 18

The value-added method.

Question 19

What is the value-added method?

Answer 19

The market value a firm adds to a product. This is equal to the difference between the price the firm sells a good for and the price it paid other firms for intermediate goods.

Question 20

Calculating value added: Firm — Value (V) of product — Value added

Answer 20

Sheep farmer — v of raw wool = $1 — value added by sheep farmer = $1
Woollen mill — v of raw wool woven into thread = $3 — v added by woollen mill = $3 - $1 = $2
Clothing manufacturer — v of thread made into a jumper = $15— V added by clothing manufacturer = $15 - $3 = $12
Big W — v of jumper for sale by Big W = $35 — V added by big Q = $35 - $15 = $20
Totally value added = $1 + $2 + $12 + $20 = $35
Notice: the jumper at Big W stores is exactly equal to the sum of the value added by each firm involved in the production of the jumper.

Question 21

What are other measures of total production an total income?

Answer 21

The most important measure of total production and total income is GDP, however the ABS also calculates Net Domestic Product (NDP) and Gross National Income (GNI).

Question 22

What is Net Domestic Product (NDP)?

Answer 22

NDP is calculated by measuring GDP and subtracting the value of depreciation on capital equipment. Depreciation is the reduction in the value of capital equipment that results form use or obsolescence.

Question 23

What is Gross National Income (GNI)?

Answer 23

GNI is the market value of final goods and services produced within Australia. GNI = GDP + Income generated overseas by Australian residents and firms – Income generated in Australia by non-residents and foreign firms.

Question 24

What are the 3 different methods of calculating GDP?

Answer 24

• The production method
• The expenditure method
• The income method

Question 25

Explain the following method of calculating GDP: The Production Method

Answer 25

This is the sum of the value of all goods and services produced by industries in the economy in a year minus the costs of goods and services used in the productive process, leaving the value added by the industries.

Question 26

Explain the following method of calculating GDP: The Expenditure Method

Answer 26

The sum of the total expenditure on final goods and services by households, investors, government and net exports.

Question 27

What are net exports?

Answer 27

The expenditure on exports minus the expenditure on imports.

Question 28

Explain the following method of calculating GDP: The Income Method

Answer 28

The sum of the income generated from the production of goods and services, which includes profits, wages and other employee payments, income from rent and interest earned.

Question 29

Production, expenditure and income, and the circular-flow diagram.

Answer 29

When we measure the value of total production in the economy by calculating GDP, we are simultaneously measuring the value of total production and the value of total expenditure on goods and services.
If we add up the value of every god and service sold in the economy, we must get a total that is exactly equal to the value of all the income in the economy. E.g. suppose you buy a steak meal for $25 at pub, all of that $25 must end up as someone’s income (suppliers of meat, suppliers of potato chips, suppliers of potato chips, staff at the pub). Note: any sales tax on the meal will be collected by the Pub and sent tot eh government without immediately ending up as anyone’ income.

Question 30

How does the circular-flow diagram illustrate the flow of transactions in the economy?

Answer 30

Households at top, financial system to right, firms on bottom, rest of world on left and the government in the middle.
Household connections to:
- Financial institutions – saving
- Government – taxes
- Firms – expenditures on goods and services
- Rest of the world – imports (expenditures by domestic households on foreign goods and services)
Financial system connections to:
- Households – saving
- Government – borrowing
- Firms – borrowing
- Rest of the world – N/A in diagram
Government connections to:
- Households – payments of wages, interest and transfer payments
- Financial system – borrowing
- Firms – expenditures on goods and services
- Rest of the world – N/A in diagram
Firms connections to:
- Households – payments of wages, interest, rent and profits
- Financial system – borrowing
- Government – taxes
- Firms – borrowing
- Rest of the world – exports (expenditures by foreign households on domestically produced goods and services)
What do firms use to produce goods and service?
Factors of production: labour, capital, natural resources and entrepreneurship.
Households supply the factors of production to firms in exchange for income.
How do we divide income?
Into 4 categories:
- Wages
- Interest
- Rent and
- Profit (this is what remains after a firm has paid wages, interest and rent)
The sum of wages, interest, rent and profit is total income in the economy.

Question 31

What are transfer payments?

Answer 31

Payments by the government to individuals for which the government does not receive a good or service in return. This includes social security payment sot retired and disabled people, unemployment benefits to unemployed workers and a variety of other payments to families.

Question 32

Why are transfer payments not included in GDP?

Answer 32

Because they are not received in exchange for production of a new good or service.

Question 33

What are the components of GDP?

Answer 33

Consumptions, investment, government and net exports expenditures.
GDP = C + I + G + (X - M) — high school equation
OR
Y = C + I + G + NX — textbook equation
Economists use these categories to understand why GDP fluctuates and to forecast future GDP.

Question 34

Explain the following component of GDP: Consumption

Answer 34

This refers to spending by households on goods and services, not including spending on new houses (as this is included in the investment category). Consumption expenditures are divided into 3 categories:

• Expenditures on services, such as medical care, education and haircuts
• Expenditures on non-durable goods, such as food and clothing
• Expenditures on durable goods, such as cars and furniture

Question 35

Explain the following component of GDP: Investment (AKA gross private domestic investment)

Answer 35

This refers to spending by firms on new factories, office buildings, machinery and inventories, plus spending by households on new houses. Investments are divided into 3 categories:

• Business fixed investments (this is spending by firms on new factories, office buildings and machinery used to produce other goods)
• Residential investment (this is spending by households and firms on new housing)
• Changes in business inventories (these are changes in the stocks of goods that have been produced but not yet sold)

Question 36

Explain the following component of GDP: Government purchases (AKA government consumption and gross investment)

Answer 36

This refers to spending by federal, state and local governments on goods and services, such as education, roads and submarines. Government spending on transfer payments is not included in government purchases because it does not result in the production of new goods and services.

Question 37

Explain the following component of GDP: Net exports (AKA net exports of goods and services)

Answer 37

Net exports are equal to the expenditure on exports minute the expenditure on imports.

Question 38

What are exports?

Answer 38

Exports are goods and services produced in Australia, but purchased y foreign firms, households and governments.

Question 39

What are imports?

Answer 39

These are goods and service produced in foreign countries and purchased by Australian firms, households and governments.

Question 40

What does GDP measure?

Answer 40

Economists use GDP to measure total production in the economy. For that purpose we would like GSP to be as comprehensive as possible, not overlooking any significant production that takes place in the economy.
GDP is also sometimes used as a measure of wellbeing. Although it is generally true that the more goods and services people have the better off they are, we will see that GDP is not a comprehensive measure of wellbeing, and nor is it intended to be.

Question 41

What are the shortcomings of GDP as a measure of total production?

Answer 41

When the ABS calculates GDP it does not include the non-observed economy. The non-observed economy includes two types of production: production in the home and production in the underground economy (AKA ‘cash economy’, ‘black economy’ and ‘shadow economy’).

Question 42

Explain the following type of non-observed economy: Household Production

Answer 42

With few exceptions, the ABS does not attempt to estimate the value of goods and services that are not bought and sold in markets. If a carpenter makes and sells bookcases, the value of those bookcases will be counted in GDP. If he carpenter makes a bookcase for personal use, I will not be counted in GDP.
Household production refers to goods and services people produce for themselves.

Question 43

Explain the following type of non-observed economy: The Underground Economy

Answer 43

This is the buying and selling of goods and services that is concealed from the government to avoid taxes or regulations or because the goods and services are illegal.

Question 44

Why do developing countries have such large underground economics?

Answer 44

Estimates of the underground economy in Australia range widely, between 1.5% (estimated by the ABS) and 14% (estimatd by the World Bank) of measured GDP. The underground economy is much larger in many developing countries, and may be more than 50% of measured GDP. In developing countries, the underground economy is often referred to as the informal sector, as opposed to the formal sector.

Question 45

What are the shortcomings of GDP as a measure of wellbeing?

Answer 45

Although increases in GDP often do lead to increases in the wellbeing of the population, and have been extremely important in reducing poverty in many parts of the world, it is important to be aware that GDP is not a perfect measure of wellbeing for several reasons:

• The distribution of GDP
• The value of leisure is not included in GDP
• The level and quality of health care and education
• GDP is no adjusted for pollution or other negative effects of production
• GDP is not adjusted for changes in crime and other social problems

Question 46

Explain the following shortcoming of GDP as a measure of wellbeing: The distribution of GDP

Answer 46

When measuring the wellbeing of a country’s population, what is important is not only the level of GDP but also how the income and output are distributed among the population. If the income is generated from production is concentrated among only a small part of the population, economic wellbeing may be unchanged or become relatively worse for other sections of the population.

Question 47

Explain the following shortcoming of GDP as a measure of wellbeing: The value of leisure is not included in GDP

Answer 47

If an economic consultant decides to retire, GDP will decline even though the consultant may value increased leisure more than the income they were earning running a consulting firm. The consultant’s wellbeing has increased, but GDP has decreased.

Question 48

Explain the following shortcoming of GDP as a measure of wellbeing: The level and quality of health care and education

Answer 48

GDP is a measure of the market value of a country’s production; however, it takes no account of the composition of the goods and services produced. The availability and quality of health care facilities and education are strongly linked to the standard of living in a country. For example, production levels may be high but the availability of health care may be limited or too expensive for many people to afford. Any measure of wellbeing must include measures of access and affordability of essential goods and services.

Question 49

Explain the following shortcoming of GDP as a measure of wellbeing: GDP is not adjusted for pollution or other negative effects of production

Answer 49

When a dry cleaner cleans and presses clothes, the value of this service is included in GDP. If the chemicals used by the dry cleaner pollute the air or water, GDP is not adjusted to compensate for the costs of the pollution. Similarly, the value of cigarettes produced is included in GDP with no adjustment made for the costs of the lung cancer that some smokers develop. If a country decided to log all its forests, its GDP would rise but the natural environment would be depleted and atmospheric carbon dioxide would rise.

Question 50

Explain the following shortcoming of GDP as a measure of wellbeing: GDP is not adjusted for changes in crime and other social problems

Answer 50

An increase in crime will reduce wellbeing but may actually increase GDP if it leads to greater spending on police, security guards and alarm systems. GDP is also no adjusted for changes in divorce rates, drug addiction or other factors that may affect people’s wellbeing.

Question 51

What is nominal GDP?

Answer 51

The market value of final goods and services measured at current year prices.

Question 52

What is Real GDP?

Answer 52

A measure of the volume of final goods and services, holding prices constant.

Question 53

What is the economic growth rate?

Answer 53

The rate of change of real GDP from one year to the next.
How do you calculate the economic growth rate?
(Real GDP (current year) – Real GDP (previous year))/Real GDP (previous year) x 100
e.g.
Real GDP in the financial year 2014/2015 = $1.621 Trillion
Real GDP in the financial year 2015/2016 = $1.669 Trillion
Rate of economic growth = (($1.669 - $1.621)/$1.621) x 100
= 3.0%

Question 54

What is the GDP deflator?

Answer 54

A measure of the price level, calculated by dividing nominal GDP by real GDP and multiplying by 100.
GDP deflator = (nominal GDP/real GDP) x 100

Question 55

What is the price level?

Answer 55

A measure of the average prices of goods and services in the economy.