Lecture: Measuring Output: Gross Domestic Product
Lecture script · about 15–20 minutes spoken · Week 2
Opening
Think about the last time you heard someone on the news say "the economy grew." A small-business owner hears that and wonders whether customers will spend more. A city budget office hears it and starts planning next year's tax revenue. A family hears it and asks whether their raise kept up with prices. All three are leaning on one number, and almost nobody stops to ask how it was built.
That number is gross domestic product, and in this lecture I want to build it with you from the ground up.
In Week 1, you learned to see the economy as a whole. You drew the production possibilities frontier, and you traced the circular flow, where households and firms trade in product markets and factor markets. Hold on to that circular flow, because it is the reason this week works. Every dollar spent on new output is a dollar of income for someone.
Here's the plan. We'll define GDP and see what each word in the definition does. We'll add up spending in four groups. We'll decide which sales count and which don't. Then we'll pull prices apart from quantities with real and nominal GDP, build a price index called the GDP deflator, and check the whole story with one multiplication. Next week, in Week 3, the course measures inflation and unemployment, and you'll use this week's split between prices and quantities again.
Let's start with a single price tag.
1. One price tag on a year of production
Picture a farmers' market at the end of a busy market day. One stall sold jars of honey. Another sold tomatoes. A third sold quilts. If someone asked you how much the market produced, you couldn't add jars to quilts. But you could add up their prices, because dollars add up. A jar of honey and a quilt both have a price tag, and price tags speak the same language.
That's the whole trick behind gross domestic product, or GDP: the market value of all final goods and services produced within a country during a given period, such as a year.
Every phrase in that definition is doing a job, so let's take them one at a time. "Market value" means each item is counted at the price it sells for. That's how apples and haircuts end up in one number. "Final" means we count only things bought by their last user, and I'll show you why in a few minutes. "Produced" means newly made in this period, so something built years ago and sold again now doesn't count a second time. "Within a country" means we care where it was made, not who owns the factory. And "during a given period" means GDP is a flow, like the water running through a pipe each minute, not a pile that built up over years.
Here's a way to hold all of that in your head. Imagine the economy as a giant checkout line for one year. GDP is the total on the receipt, but only for new things, only for things made here, and only for the last buyer in the chain.
Pause and try this. A collector buys a painting that was made long ago. Which word in the definition keeps that sale out of this year's GDP?
Take a moment and pick the word before I go on.
Here's the answer. The word is "produced." The painting was produced long ago and was counted back then, so selling it again doesn't create anything new this year.
2. Add up the spending
Now let's sort every purchase of new output by who bought it. Households buy groceries and phones. Businesses buy machines and put up new buildings. Governments buy roads and pay teachers. And there's trade with other countries, which runs in both directions.
That sorting is called the expenditure approach: measuring GDP by adding up all spending on new final goods and services in four groups: consumption, investment, government purchases, and net exports.
Each group has a letter. Consumption, written C, is household spending on new goods and services, such as groceries, rent, phones, and haircuts. Investment, written I, is business spending on new machines and buildings, plus new homes and additions to inventories. Notice that investment here does not mean buying stocks or bonds. Government purchases, written G, is what all levels of government spend on goods and services, including the pay of public employees. The fourth group is net exports, written NX: exports minus imports. Exports, written X, are goods and services made here and sold to buyers in other countries. Imports, written IM, are goods and services made in other countries and bought here. We write imports as IM, never as a single M, because M will stand for the money supply later in the course.
Why subtract imports? Because some of the spending in C, I, and G went to things made abroad. Those things weren't produced here. Subtracting imports takes them back out.
Let's run the illustrative expenditure account, a set of numbers built for this course, not real data. Everything is in billions of dollars. Consumption is 700. Investment is 200. Government purchases are 250. Exports are 100, and imports are 150.
First, net exports on their own. Exports of 100 minus imports of 150 gives negative 50. More came in than went out, which is a trade deficit. Next, add the three spending groups: 700 plus 200 plus 250 is 1,150. Finally, bring in net exports with their sign. 1,150 minus 50 is 1,100.
So this economy produced 1,100, in billions of dollars, of final goods and services in the year. The trade deficit pulled GDP below the 1,150 that households, businesses, and government spent.
Pause and try this. Someone working the same account writes 700 plus 200 plus 250 plus 50 and gets 1,200. What went wrong?
Find the one sign that flipped.
Here's the answer. They added the trade deficit instead of subtracting it. Net exports are negative 50, so they lower GDP to 1,100. Writing net exports on their own line first, with the sign, is the habit that prevents this slip.
3. Decide what counts
Picture a loaf of bread on a kitchen counter. Before it got there, a farm grew wheat, a mill turned the wheat into flour, and a bakery baked the loaf. Three businesses each made a sale. If we added up all three sales, we'd count the wheat three times: once as wheat, again inside the flour's price, and again inside the bread's price.
That's why GDP counts only final goods and services: goods and services bought by their last user, such as a loaf of bread a family eats or a haircut, rather than used up to make something else for sale. The flour is an intermediate good, a good bought by a business to be used up in making another good for sale. And counting the flour on its own and again inside the bread is called double counting.
There's a second road to the same answer, called value added: the amount a producer adds at its stage of production, which is the price of what it sells minus the cost of the intermediate goods it bought.
Let's put illustrative prices on the bread chain. The farm sells wheat to the mill for 1 dollar. The mill sells flour to the bakery for 2 dollars. The bakery sells the loaf for 5 dollars. The farm adds 1 dollar. The mill adds 2 minus 1, which is 1 dollar. The bakery adds 5 minus 2, which is 3 dollars. And 1 plus 1 plus 3 is 5 dollars, exactly the price of the loaf. Both methods agree. If you added every sale instead, you'd get 1 plus 2 plus 5, which is 8 dollars, and that overstates output by 3 dollars, the wheat and flour counted a second time.
The same thinking sorts everyday sales. A family buys a newly built house, and it counts in investment, because new homes are investment. A city pays a public-school teacher, and it counts in government purchases, because the government is buying a service. A student buys a used laptop from a roommate, and it doesn't count, because the laptop was counted the year it was made. A worker buys shares of stock, and it doesn't count, because ownership changed hands but nothing new was made.
And then there's the one that trips almost everyone. A retiree receives a Social Security check. That's a transfer payment: a payment from the government to a person that buys no good or service in return. It stays out of government purchases and out of GDP. When the retiree spends the check on groceries, the groceries count in consumption. The check itself is money moving, not output being made.
Pause and try this. The government writes a Social Security check. Does that check belong in government purchases?
Ask what the government got back in return.
Here's the answer. No. The government got no good or service back, so the check is a transfer payment, not a purchase, and it stays out of GDP.
4. Separate prices from quantities
Imagine a taco truck that brought in more money this year than last. Good news? Maybe. If it sold more tacos, the business grew. If it sold the same number of tacos at higher prices, it didn't make one extra taco. A dollar total always mixes two things: how much was made and what it sold for.
Economists pull those apart. Nominal GDP is the value of a period's final goods and services measured at the prices of that same period, so it rises when either output or prices rise. Real GDP is the value of a period's final goods and services measured at the fixed prices of a chosen base year, so it changes only when the amount of output changes. And the base year is the year whose prices we use to value output in every year.
Let's do it by hand with the illustrative two-good economy. This tiny economy makes only pizzas and coffees, and every value is in dollars.
In the base year it makes 40 pizzas at 5 dollars and 100 coffees at 1 dollar. That's 200 plus 100, or 300 dollars. In the base year, nominal and real GDP are the same 300 dollars, because the base year's prices are this year's prices.
In year 2, it makes 44 pizzas at 5.50 and 110 coffees at 1.10. Nominal GDP uses those year-2 prices: 44 times 5.50 is 242, and 110 times 1.10 is 121, so nominal GDP is 363 dollars.
Real GDP uses the same year-2 quantities at base-year prices: 44 times 5 is 220, and 110 times 1 is 110, so real GDP is 330 dollars.
Here's the moment to slow down. Measured at year-2 prices, the economy looks like 363 dollars. Measured at fixed prices, it made 330 dollars' worth of stuff. The gap of 33 dollars is prices going up, not extra pizza or coffee.
Pause and try this. Nominal GDP went from 300 to 363 dollars. Did this economy make 63 dollars more stuff?
Compare the two year-2 totals before you decide.
Here's the answer. No. Real GDP rose only from 300 to 330, so output rose by 30 dollars' worth at base-year prices. The rest of the rise in nominal GDP is higher prices.
5. Build the GDP deflator
Once you have nominal and real GDP for the same year, you can compare them, and that comparison tells you how far prices have moved since the base year.
A price index is a number that compares the overall level of prices in a period with the level in a base year, which is set to 100. The GDP deflator is the price index for everything counted in GDP: nominal GDP divided by real GDP, times 100. In the base year it equals 100.
Let's compute it twice. In the expenditure account, nominal GDP is 1,100, in billions of dollars, and the same output valued at base-year prices is a real GDP of 1,000. Divide 1,100 by 1,000 and multiply by 100, and the deflator is 110. In the two-good economy, divide 363 by 330 and multiply by 100, and you also get 110. And in the two-good economy's base year, 300 divided by 300, times 100, gives 100, exactly as the definition promises.
Both datasets tell one story: prices sit 10 percent above the base year. One small but important habit goes with this. The deflator is a level, so it carries no percent sign. You say "the deflator is 110," and then "prices are 10 percent above the base year."
Here's an analogy that helps. Think of the deflator as a measuring tape that stretches when prices rise. Nominal GDP is measured with the stretched tape. Dividing by the deflator shrinks the reading back to the base year's tape, and what's left is real GDP.
Pause and try this. A friend reads a deflator of 110 and says, "So the economy grew 10 percent." What did they mix up?
Think about what the deflator measures and what it leaves out.
Here's the answer. They read a price measure as an output measure. The deflator of 110 says prices are 10 percent above the base year; output growth comes from real GDP, not from the deflator.
6. Check the story
We now have three changes in the two-good economy, and they should fit together.
Real growth first. Real GDP went from 300 to 330. The change is 30, and 30 divided by the starting value of 300, times 100, is 10 percent. Output grew 10 percent.
Nominal growth next. Nominal GDP went from 300 to 363. The change is 63, and 63 divided by 300, times 100, is 21 percent.
And prices: the deflator went from 100 to 110, so prices rose 10 percent.
Here's the check that ties them together. One plus real growth, times one plus inflation, equals one plus nominal growth. That's 1.10 times 1.10, which is 1.21, and 1.21 is one plus 0.21. Ten percent more output at ten percent higher prices is 21 percent more spending. So output grew 10 percent, and the rest of the 21 percent rise in nominal GDP came from higher prices.
Notice the check multiplies; it doesn't add. Adding ten and ten gives 20, which is close, but the extra point is real. It's the price increase on the extra output. For small rates, adding gets you near the answer. Multiplying gets you the answer exactly.
One more thing before we close, and it's an honest limitation. GDP measures output, not well-being. It leaves out unpaid work at home, free time, and damage to the environment. That doesn't make GDP useless. It makes GDP a measure of one thing, read with care, and you'll get to argue about it in this week's discussion.
Pause and try this. If someone adds real growth and inflation and gets 20 percent, why does the check say 21?
Think about the price of the extra pizzas.
Here's the answer. The extra output was sold at the new, higher prices too. Multiplying 1.10 by 1.10 captures that price increase on the added output, which is the extra point that adding misses.
Closing
Let's pull it together. GDP is the market value of all final goods and services produced within a country in a period, and every word in that definition rules something in or out. By spending, GDP is consumption plus investment plus government purchases plus net exports, and in the illustrative account that came to 1,100, in billions of dollars, with a trade deficit of 50 pulling it down.
We count final goods or value added, never both, and we leave out used goods, financial trades, and transfer payments like a Social Security check. Nominal GDP uses each year's prices, and real GDP uses base-year prices, which is how 363 dollars of nominal GDP became 330 dollars of real output. The GDP deflator, nominal over real times 100, came out at 110 in both datasets. And the check, 1.10 times 1.10 equals 1.21, told us the 21 percent nominal rise was 10 percent more output at 10 percent higher prices.
Next in this module, open the slide deck and the Readings & Resources page, then try the lecture tutorial and the practice set before the quiz. In Week 3, Measuring Inflation & Unemployment, you'll meet a second price index built from a market basket, and you'll measure who is counted as out of work.
Built with The Course Maker · samples.thecoursemaker.com