Week 1

Aggregate Production and Prices

Reference: e-book Chapter 1

Key Ideas

• Measuring aggregate output (GDP)

• Measuring aggregate prices and inflation

What is Gross Domestic Product (GDP)?

2
Which of the following is the correct definition of annual
GDP?

(a)Value of all goods and services bought and sold during a

year.

(b) Value of all new goods and services produced during a

year.

(c) Value of all final goods and services purchased during a

year.

(d) None of the above.

3
What is Gross Domestic Product (GDP)?

Informal:

Measure of a country’s aggregate output or production.

4
What is Gross Domestic Product (GDP)?

Informal:

Measure of a country’s aggregate output or production

Formal Definition:

The monetary value of final goods and services produced in

a country during a given period.

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The monetary value of final goods and services produced in
a country during a given period.

GDP is measure of aggregate production or output

- cars, oranges, computers, lectures, Big Macs

How do we add “apples and oranges?”

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The monetary value of final goods and services produced in
a country during a given period.

Use market prices to value (or weight) quantities of various

goods and services.

Example: Quantity Market Price

10 cars $20,000 per car

10,000 apples $1 per apple

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The monetary value of final goods and services produced in
a country during a given period.

Use market prices to value (or weight) quantities of various

goods and services

Example: Quantity Market Price

10 cars $20,000 per car

10,000 apples $1 per apple

GDP = $20,000×10 + $1×10,000 = $210,000

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What about goods and services with no observed market
price?

Some are excluded from GDP:

• Unpaid housework (e.g. cooking & cleaning)

Economic term is Household Production.

• Production of goods and services by households for own

consumption using their own labour and capital.

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What about goods and services with no observed market
price?

Some are included in GDP:

• Police services

• Public hospital

• Rental value of owner-occupied dwellings

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How are unpriced goods valued in GDP?

1. Publicly provided goods and services such as police,

public servants, public hospitals.

Use the cost of providing these goods and services as a

measure of their contribution to GDP.

2. Rent on owner-occupied dwellings.

Imputed by ABS using data from Census on rents and the

type and location of owner-occupied dwellings.

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The monetary value of final goods and services produced in
a country during a given period.

GDP measures the value of final goods and services.

The production of final goods and services may involve the

use of intermediate inputs.

Intermediate inputs are goods and services used-up in the

production process.

Example: In the production of a loaf of bread, the flour used

is an intermediate input.

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The monetary value of final goods and services produced in
a country during a given period.

In calculating GDP it is important to ensure that intermediate

goods and services are not (double) counted.

Concept of Value Added:

The market value of a firm’s production less the cost of

inputs purchased from other firms.

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Value Added for Computer Sales

Value Added = value of sales – cost of intermediate inputs

Firm Sales Input Costs Value

(Intermediate) Added

Intel Incorp 20,000 0 20,000

Macro Soft 5,000 0 5,000
Bell 80,000 25,000 55,000
PC Charlie’s 100,000 80,000 20,000

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Value Added for Computer Sales

Firm Sales Input Costs Value

(Intermediate) Added
Intel Incorp 20,000 0 20,000
Macro Soft 5,000 0 5,000
Bell 80,000 25,000 55,000
PC Charlie’s 100,000 80,000 20,000

PC Charlie’s final sales = $100,000

Sum of Value Added = $100,000

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The monetary value of final goods and services produced in
a country during a given period.

GDP measures production within a specified geographic

location.

Excludes goods and services produced in other countries, but

consumed in Australia.

- Imports of goods and services

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The monetary value of final goods and services produced in
a country during a given period.

GDP is a flow variable – measured over a period of time.

Excludes goods and services produced in an earlier period,

but re-sold in the current period.

- Second-hand goods

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The monetary value of final goods and services produced in
a country during a given period.

GDP is a flow variable – measured over a period of time.

Quarter – March, June, September, December

Australian GDP in Sept 2017 = $449.6 billion

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The monetary value of final goods and services produced in
a country during a given period.

Annual/Year – just add-up GDP over 4 quarters

• Calendar – Mar-16 + Jun-16 + Sep-16 + Dec-16

• Financial – Sep-16 + Dec-16 + Mar-17 + Jun-17

Australian GDP for 2016/17 = $1,756.4 billion

Approximately ≈ $1.8 trillion

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What is Gross Domestic Product (GDP)?

3 Equivalent Ways to Measure GDP

1. Production Method (based on value added approach)

2. Expenditure Method

3. Income Method

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Expenditure Method

Accounting Identity

expenditure on goods and services by final users

value of their production

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Expenditure Method

Main Components of Expenditure

• Consumption (C) – purchases by Households

• Investment (I) – purchases by Firms

• Government (G) – Government purchases

• Net Exports (NX ) – net purchases by foreign sector

NX = Exports (X) – Imports (M)

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National Income Accounting Identity

GDP ≡ Expenditure

Y ≡ C + I + G + NX

Y≡C+I+G+X–M

Y+M≡C+I+G+X

Supply of G & S ≡ Demand for G & S

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 Australian GDP March Quarter 2017
Expenditure Approach
$billion
Household Consumption 248.2
Private Investment 85.0
Government (Public) Spending 103.1
Change in Inventories 2.6
Exports 98.2
Less Imports 88.9
Total 448.1
Statistical discrepancy -2.3
GDP 445.8
http://www.abs.gov.au/AUSSTATS/abs@.nsf/allprimarymainfeatu
res/52AFA5FD696482CACA25768D0021E2C7?opendocument

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Income Method

GDP also equals the aggregate incomes paid to

• Labour (L)

• Capital (K)

in the production of goods and services

plus

• indirect taxes – subsidies

25
Income Method

GDP = Labour Income + Capital Income + Net Indirect Taxes

GDP = (W×L) + (R×K) + Net Indirect Taxes

Net indirect taxes = Indirect Taxes – Subsidies

Labour Income = W×L Capital Income = R×K

W = wages and salaries R = return to capital

L = labour K = capital stock

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 Australian GDP March Quarter 2017
Income Approach
$billion
Compensation of Employees 206.0
Gross Operating Surplus 154.8
Gross Mixed Income 39.1
Total Factor Income 399.9
Indirect Taxes – Subsidies 43.9
Total 443.8
Statistical discrepancy 2.1
GDP (Market Prices) 445.8

http://www.abs.gov.au/AUSSTATS/abs@.nsf/DetailsPage/5206.0Mar%202017
?OpenDocument

27
Which of the following is the correct definition of annual
GDP?

(a)Value of all goods and services bought and sold during a

year

(b) Value of all new goods and services produced during a

year

(c) Value of all final goods and services purchased during a

year

(d) None of the above

28
Which of the following is the correct definition of annual GDP?

(a)Value of all goods and services bought and sold during a year
(This would include second-hand goods)

(b) Value of all new goods and services produced during a year
(This would double count intermediate goods)

(c) Value of all final goods and services purchased during a year
(Option says purchased (not produced) so includes imported
goods and services)

(d) None of the above (Correct choice)

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Gross National Income (GNI)

GDP is based on the location of production.

But suppose a country uses a large number of foreign

workers (i.e. non-permanent residents) or a large amount of
foreign-owned capital in producing its GDP.

Some of the income from production of GDP will accrue to

foreign nationals.

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Gross National Income (GNI)

GNI measures income payments to Australian workers and

Australian-owned capital.

GNI = GDP + net primary (or factor) income from non-

residents

Net primary (or factor) income =

Primary income credits (receipts)
less
Primary income debits (payments)

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Gross National Income (GNI)

March 2017
($ billion)
GNI 431.7
GDP 445.8

NPI -14.1

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Nominal and Real GDP

With our current measure of GDP, the number could

increase due to a general increase in the prices of goods and
services.

Important to have a measure of changes in physical

production or volume of goods and services produced.

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Nominal and Real GDP

Nominal
• values quantities of goods and services produced at
their current year (or year of production) prices

Real (or constant price or chain volume measure)

• values quantities of goods and services produced at
base year prices – measure of the actual physical
volume of production

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 Example
2007 2008 % Change
No. of Cars 10 10 0
Price of Cars $20,000 $40,000 100
No. of Apples 100 100 0
Price of Apples $1 $2 100
________________________________________________
Nominal GDP $200,100 $400,200 100
________________________________________________

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 Example
2007 2008 % Change
No. of Cars 10 10 0
Price of Cars $20,000 $40,000 100
No. of Apples 100 100 0
Price of Apples $1 $2 100
________________________________________________
Nominal GDP $200,100 $400,200 100
________________________________________________
Real GDP
2007 prices $200,100

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 Example
2007 2008 % Change
No. of Cars 10 10 0
Price of Cars $20,000 $40,000 100
No. of Apples 100 100 0
Price of Apples $1 $2 100
________________________________________________
Nominal GDP $200,100 $400,200 100
________________________________________________
Real GDP
2007 prices $200,100 $200,100 0

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 Example
2007 2008 % Change
No. of Cars 10 10 0
Price of Cars $20,000 $40,000 100
No. of Apples 100 100 0
Price of Apples $1 $2 100
________________________________________________
Nominal GDP $200,100 $400,200 100
_________________________________________________
Real GDP
2007 prices $200,100 $200,100 0

2008 prices $400,200

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 Example
2007 2008 % Change
No. of Cars 10 10 0
Price of Cars $20,000 $40,000 100
No. of Apples 100 100 0
Price of Apples $1 $2 100
________________________________________________
Nominal GDP $200,100 $400,200 100
_________________________________________________
Real GDP
2007 prices $200,100 $200,100 0

2008 prices $400,200 $400,200 0

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Choice of Base Year

In the above example whether we use 2007 or 2008 as base

year prices gives the same answer for the growth rate of real
GDP

This is not the case in general, particularly if you are

comparing real GDP over a 5-10 year period.

• Using initial prices (i.e. 2007) is known as a Laspeyres

index
• Using final prices (i.e. 2008) is known as a Paasche index

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 Example
2007 2008 % Change
No. of Cars 10 10 0
Price of Cars $20,000 $40,000 100
No. of Apples 100 1000 900
Price of Apples $10 $25 150
________________________________________________
Nominal GDP $201,000 $425,000 111
________________________________________________
Real GDP
2007 prices $201,000 $210,000 4.5

2008 prices $402,500 $425,000 5.6

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Chain-weighted measure of Real GDP

1. Take average of growth rates implied by 2007 and 2008

prices.
5.05 = (4.5 + 5.6)/2

2. Choose either 2007 or 2008 as the base-year

(nominal=real GDP). Let’s pick 2007

2007 2008
Nominal GDP 201,000 425,000

Real GDP 201,000 211,151 (201,000×1.0505)

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Chain Weighting

For any two consecutive years compute the growth rates of

real GDP implied by both the Laspeyres and the Paasche
indexes.

Then take the average of the two growth rates and this is the
chain-weighted growth rate. This can be used to compute a
real chained-weighted GDP.

Finally to compute a change index over a long period, the

above approach is applied on a year-by-year basis.

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Chain Volume Measures of GDP and Components

ABS Website

http://www.abs.gov.au/ausstats/abs@.nsf/0/52AFA5FD696482C
ACA25768D0021E2C7?Opendocument

44
Nominal and Real GDP

The following relationship holds:

nominal GDP = price level × real GDP

If we know any 2 variables we can derive the 3rd

• price level = (nominal GDP)/real GDP

• real GDP = (nominal GDP)/price level

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Real GDP per Capita

Real GDP per capita = (Real GDP)/Pop

Pop = population

Commonly used as an indicator of economic progress (economic

growth).

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 $, cvm

0
10,000
12,000
14,000
16,000
18,000
20,000

2,000
4,000
6,000
8,000
Sep-1973
Mar-1975
Sep-1976
Mar-1978
Sep-1979
Mar-1981
Sep-1982
Mar-1984
Sep-1985
Mar-1987
Sep-1988
Mar-1990
Sep-1991
Mar-1993
Sep-1994
Mar-1996
Sep-1997
Mar-1999
Sep-2000
Mar-2002
Sep-2003
Mar-2005
Sep-2006
Mar-2008
Sep-2009
Mar-2011
Sep-2012
Mar-2014
Real Quarterly GDP per-capita – Australia (1973-2017)

Sep-2015
Mar-2017
47
Is GDP A Good Measure of Economic Wellbeing?

Omissions from GDP that might matter for economic welfare:

• Leisure Time (extra week of holidays)

• Household production (cook at home)
• Environmental Degradation (pollution)
• Quality of Life (happiness)
• Economic Inequality (distribution of income)

48
Is GDP positively correlated with economic welfare?

Yes: medical care

No: Income distribution over last 20 years

Maybe: Income and measures of Happiness

49
Alternatives (complements) to GDP

1. Direct measures of Happiness

• Survey-based measures (ask people how happy they

are on a scale of 1 to 10.

http://www1.eur.nl/fsw/happiness/index.html

2. Indexes of variables that might affect welfare

http://www.smh.com.au/national/wellbeing-index-shows-
impact-of-jobless-on-society-20140606-39okt.html

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Business Cycles

Economies tend to experience periods of expansion and

contraction in the level of economic activity.

If we focus on GDP as a measure or economic activity then:

• A contraction is a period during which the level of GDP

falls.

• An expansion is a period when the level of GDP is rising.

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Peaks and Troughs

In moving between periods of expansion and contraction the

economy will experience peaks and troughs.

• A peak is the beginning of a contraction, the high point of

GDP prior to a downturn.

• A trough is the end of a contraction, the low point of

economic activity prior to a recovery.

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Stylised Representation of a Business Cycle

Level of
GDP expansion

contraction

Peak Trough Peak Time (quarters)

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“Rule of Thumb” Definition of Recession

A recession occurs when there are at least two consecutive

quarters of negative economic growth.

This means the level of GDP has to fall for at least two
quarters.

This has not occurred in the Australian economy since

beginning of the 1990s.

Did not happen during Global Financial Crisis (GFC).

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Measures of the Price Level

Want to measure the average level of prices in the economy.

Main Measures

• GDP Deflator or Price Index

• Consumer Price Index (CPI)

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Consumer Price Index (CPI)

CPI – For a given period, measures the cost in that period of

a given basket of goods and services relative to their cost in a
fixed year – called a base year.

56
Construct a CPI

Choose a basket of goods and services

Basket (fixed) 2000 (base) 2015

______________________________________________
Rent (2 bedroom flat) $500 $630
Hamburgers (60) $150 $150
Books (2) $30 $70
_______________________________________________
Total Expenditure $680 $850
_______________________________________________

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Construct a CPI

2000 (base) 2015

____________________________________________
Total Expenditure $680 $850
____________________________________________

CPI = Cost of base-year basket in current year

Cost of base-year basket in base year

CPI = $850/$680 = 1.25

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Implications

• Cost of living is 25 percent higher in 2015 than it was in

2000
• Average prices are 25 percent higher in 2015 than in 2000

Australian CPI
• Published quarterly by ABS
• Household Expenditure Survey used to determine typical
basket (known as weights)
• (Historically) Base year weights changed every 5 years
• From end-2017 weights are updated on an annual basis

59
Inflation (and Deflation)

Inflation is measured by the percentage change in the CPI

over a given period.

𝐶𝑃𝐼−𝐶𝑃𝐼−1
Inflation rate =
𝐶𝑃𝐼−1

Inflation rate = 0 implies prices are constant

Inflation rate > 0 implies prices are rising

Inflation rate < 0 implies prices are falling – known as

deflation.

60
 61

Mar-2017
Mar-2014
Australian Inflation - Consumer Price Index Measure

Mar-2011
Mar-2008
Mar-2005
Mar-2002
Mar-1999
Mar-1996
Mar-1993
Mar-1990
Mar-1987
Mar-1984
Mar-1981
Mar-1978
Mar-1975
Mar-1972
Mar-1969
Mar-1966
Mar-1963
Mar-1960
20.0

15.0

10.0

-5.0
5.0

0.0
Year-ended percentage changes
Limitations with CPI
Quality Adjustment and New Goods Bias
• Quality improvements may show up as higher prices
for goods and services
• New goods are often not included until CPI is re-
based
Substitution Bias
• Use of a fixed basket means that no allowance is
made for consumers’ substitution toward relatively
less expensive goods.

CPI tends to overstate the rate of inflation.

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Costs of Inflation
Important to distinguish between relative price change
and a change in the general price level.

Unexpected Inflation:

• Unexpected re-distributions of wealth:

(Borrowers/lenders, fixed nominal incomes)

• Distorts tax systems (if not indexed to inflation).

• Introduces noise into the (relative) price mechanism.

63
Costs of Inflation

Fully Anticipated Inflation: (full indexation)

• Shoe-leather costs
• inflation reduces the real purchasing power of a
given amount of money
• requires more frequent “trips to bank”

• Menu costs
• any real cost associated with changing prices

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Optimal Inflation Rate

Policymakers generally wish to:

• avoid high and variable inflation
• avoid deflation

View that a low positive inflation rate is helpful for

allowing moderate falls in real wages.

Many countries have inflation targets:

• inflation rate of around 1 – 3 % per annum

65