In this series of articles I will be highlighting and demystifying some of the key concepts of Macroeconomic Theory. I have set out to make a series of easily-digestible articles to aid the intellectually curious and hard-working student alike.

Throughout this series I will be using a variety of resources while following a general format from Gregory Mankiw’s 9th edition Macroeconomics textbook. If you’re a consumer of economics I highly recommend you visit the author’s blog here.

What is Macroeconomic Data?

Whether you realize it or not, macroeconomic data plays a major role in our daily lives. Although it may seem mundane, understanding macroeconomic data is essential when studying macroeconomic theories.

From an individualistic standpoint, your day-to-day lifestyle and decisions are dictated by a key macroeconomic variable: personal income (known simply as the variable “y” which will be introduced in a later lesson). How often you eat out, the investments you make, the house and neighborhood you live in, the amount of vacations you go on, are all decisions made based on your current and future predicted income (this is the idea of consumption theory, a macroeconomic theory that will be covered at a later date).

On a grander scale, policymakers and economist analyze these key macroeconomic indicators when developing and assessing policy decisions. If you have been keeping up with the current Democratic primary you may have heard of Andrew Yang’s freedom dividend, a guaranteed yearly income of $12,000 to all US citizens over the age of 18.

The idea of this proposal is to address the issue of declining US labor force participation, a measure of an economy’s active workforce, due to emerging technologies crowding out civilian jobs.

Our labor participation rate now is only 62.7% — lower than it has been in decades, with 1 out of 5 working-age men currently out of the workforce. This will get much worse as self-driving cars and other technologies come online.
- Andrew Yang

This is an illustration of the role macroeconomic data plays in allowing policymakers and economist alike identify problems and formulate solutions in our global economy.

For this lesson I will be focusing on arguably the most significant macroeconomic indicator, GDP. In the next article focusing macroeconomic data I will touch on the CPI and unemployment.

Topics covered in this article:

• What is GDP?
• Rules for Computing GDP
• Real Versus Nominal GDP
• GDP Deflator
• Components of GDP
• Shortcomings of GDP

Gross Domestic Product (GDP)

If you have taken an introductory economics course you may recognize the following equation of GDP:

Y = C + I + G +NX

What you may not recognize about this equation however, is that it illustrates the duality of GDP as a measure of both the total income of every individual in the economy and the total expenditure of an economy’s output of goods and services. Why is this true you may ask? Simply because every transaction in the economy has two sides, a buyer and a seller.

For example, when a customer buys a new pair of headphones from Apple for $150, that is an expenditure of $150 by the costumer and $150 of income for Apple.

📷📷$150 spent on headphones counts as expenditure by the buyer and new income for the seller. Photo by Suganth on Unsplash

Rules to Remember for GDP

Keep in mind there are some important rules to be aware of when computing GDP:

1. Nominal GDP is the sum of the market price times the quantity of all final goods and services produced within an economy over a given time period.

For example, if we lived in an economy composed solely of pizzas and hot dogs, computing GDP would entail summing the current cost of each pizza and hot dog in the economy.

Given the economy is made up of 4 pizzas and 3 hot dogs, costing $5 and $2 respectively, GDP can be calculated as:

GDP = (Price of pizza) x (Quantity of pizzas) + (Price of hot dogs) x (Quantity of hot dogs) = ($5 x 4) + ($2 x 3) = 20 + 6 = $26

2. The sale of used goods is not counted in the total GDP of an economy

Let’s say you purchase a pair of Nike shoes from a retailer for $150 and resell them in the second-hand market for $300. The $150 originally used to purchase the shoes is counted towards GDP, however the $300 you made reselling then shoes does not. This is due to the fact that the second sale of the shoes or any used goods does not create new value in an economy and is merely the transfer of money between two parties.

3. A firm’s additional inventory is counted towards final GDP.

This is the concept that is often most difficult in GDP accounting. Let’s say a firm hires and pays workers to produce peanut butter and fails to sell all of its stock of peanut butter for the year, how does this effect GDP?

Given the peanut butter is put away into inventory for sale at a later date, this transaction is counted for GDP of the current year. Why does simply storing extra items count towards GDP? The owners of the firm are assumed to have purchased this additional peanut butter for inventory, thus this is counted as an investment expenditure in GDP. When the peanut butter is eventually sold there is no effect on GDP.

Since the extra peanut butter inventory has already been accounted in GDP, no new value is created with the purchase. The eventual sale of the peanut butter is counted as disinvestment (negative expenditure) by the firm and the purchase by the customer as a positive expenditure. Both sides of the transaction cancel out for a net effect of zero dollars on GDP.

4. GDP only includes the value of final goods.

Let’s go back to our earlier example of Apple headphones. To produce the product, Apple purchases raw materials for production like copper. The raw materials are examples of intermediate goods. Assuming the cost of intermediate goods for a single pair of headphones is $50 and Apple sells the headphones for $150, does GDP count $150 or $200 in this transaction?

Counting the full $200 in GDP would result in double counting since the cost of the intermediate goods is already accounted for in the final $150 sale.

This example illustrates the difference between a final good and an intermediate good. While the intermediate goods are counted as the value added in production towards the final good, it is not counted towards GDP when the final good is sold.

Real GDP versus Nominal GDP

In our previous example of an economy composed solely of pizzas and hot dogs we were computing Nominal GDP. The inherent flaw with this methodology is that changing prices do not accurately reflect the amount of goods needed to satisfy demands of an economy.

Using real GDP we keep price changes constant to get a better picture of the change in production capabilities of an economy over a given period of time. Real GDP is the value of final goods and services measured using a constant set of prices (based on base-year prices).

Reverting back to our previous example of an economy that produces 4 pizzas and 3 hot dogs. Assume that base-year prices of both pizzas and hot dogs are $3 and $1 respectively.

Real GDP = (base-year price x quantity of pizza in current year) + (base-year price x quantity of hot dogs in current year) = ($3 x 4) + ($1 x 3) = $15

Adjusting for price yields a Real GDP of $15, in contrast to the Nominal GDP of $26 we calculated earlier.

GDP Deflator

Now that we have computed the real and nominal GDP of our pizza and hot dog economy we have the ability to compute a third statistic: the GDP deflator.

The GDP deflator is the ratio of nominal GDP to real GDP:

GDP Deflator = Nominal GDP / Real GDP

The GDP deflator illustrates what’s happening to the overall level of prices in our current economy. For the pizza and hot dog economy we can calculate the GDP deflator:

GDP deflator = (Nominal GDP) / (Real GDP)= $26 / $15 = 1.73

The interpretation of this GDP deflator in our hot dog and pizza economy is that the prices in the current year of our pizza and hot dog economy are approximately 73% greater than our base year, showing worrisome signs of inflation.

We can also rewrite the GDP deflator equation to help us interpret Nominal GDP and Real GDP.

Nominal GDP = (GDP deflator) x (Real GDP)

This equation reflects the true nature of nominal GDP; a measure of the current dollar value of final goods and services in the economy.

Real GDP = Nominal GDP / GDP deflator

In effect, the GDP deflator serves to deflate the nominal GDP to the real GDP by controlling for changes in price to reflect the true value of final goods and services in the economy.

Example 1: Suppose Real GDP rises by 3% and the GDP deflator rises by 1%, how much does Nominal GDP rise?

Example 2: Suppose Nominal GDP rises by 5% and the GDP deflator rises by 8%, how much does Real GDP rise?

(Answers and explanations below)

Components of GDP

To further understand what makes up GDP let’s return to the equation we began the lesson with:

Y = C + I + G +NX

Consumption (C), consists of household expenditures on final goods and services. Goods can be divided into durable and nondurable goods. Durable goods are long-lasting items like cars, and household appliances like ovens. Nondurable goods are goods consumed in a short-term time-frame such as food and textbooks. Services include intangible items that consumers buy like a personal training session or a haircut.

Fact: Consumption accounts for approximately two-thirds of GDP in the United States

Investment (I), consists of items bought for future use. There are three main forms of investment spending:

• Fixed investments by firms on intellectual property, equipment, and infrastructure.
• Residential investment of housing by households and landlords.
• Inventory investment by firms to increase stock of investments.

Note: Purchase of stocks, bonds, and other financial assets does not count towards GDP. This follows the same principle as used goods. Purchasing these financial assets does not create new value for the economy and is merely an exchange of assets. However, a company selling new shares to the public to finance fixed investment is an example of investment expenditure.

Additional note: The re-purchase of a house does not count towards investment. Purchasing a house, that is not newly built, from another homeowner is simply a reallocation of existing assets and does not create new value for the economy.

Example 3: Which of the following scenarios would increase Investment according to GDP calculations?

a) Buying 300 shares in Apple.

b) Apple sells iPads this year out of inventory from last year.

c) You buy a new MacBook Pro for private use.

d) Google buys new machinery to help manufacture its self-driving cars.

Government expenditures (G), are goods and services purchased by all government entities (federal, state, and local). This includes various expenditures ranging from military equipment to wages paid to government employees.

Note: Payments made for government programs, like social security, does not count as a government expenditure. Similar to our previous example of financial assets, government programs are purely a transfer of existing income rather than a creation of new income in the economy.

Net exports (NX), is the value of goods and services sold to other countries (exports) minus the value of goods and services bought from other countries (imports). Intuitively, this means that when the value of exports of a country is greater than the value of imports, net exports are positive and the country is in a trading surplus.

Fact: For the year of 2017 the US had net exports totaling 12.1% of GDP and imports totaling 15% of GDP. Therefore the US had a trade deficit of 2.9% in the year 2017.

Shortcomings of GDP

While GDP is one of the best economic statistics available to measure the performance of an economy, it has many drawbacks.

1. GDP does not measure quality of life. GDP is solely a measure of economic activity. Quality of life characteristics such as educational attainment and life expectancy are not accounted for. Therefore making any assumptions using GDP about a country aside from economic output is pure speculation.
2. GDP does not account for environmental damage. Whether the output is created at the expense of the environment is irrelevant in GDP calculations. Therefore output created through unsustainable means may increase GDP but create long-term environmental damage and decrease future economic output.
3. GDP does not measure economic activity on the black market. Economic activity involving goods and services paid for in cash is not accounted for in GDP. These types of economies are called shadow economies. In some countries, like Greece, shadow economic activity is valued as much as 20% of GDP.
4. GDP does not track wealth inequality. GDP purely depicts total economic activity in an economy, regardless of the distribution of wealth within that economy. This may lead to incorrect assumptions of the overall picture of an economy that may have large shares of wealth concentrated in a small percentage of the population. For more on this concept I highly recommend reading this article recently posted on the New York Times regarding this subject.

📷📷Photo by Vladimir Solomyani on Unsplash

Solutions

Example 1: The percent change in Nominal GDP equals the percent change in Real GDP plus the percent change in the GDP deflator. This is based off the arithmetic identity that the percentage change of a product of two variables is approximately the sum of the percentage changes in each of the variables.

Therefore:

% Change in Nominal GDP = % Change in Real GDP + % Change in GDP Deflator = 3% + 1% = 4%

Example 2: According to a similar arithmetic identity as the previous example, the percentage change of a ratio is approximately the percentage change in the numerator minus the percentage change in the denominator. Therefore:

% Change in Real GDP = % Change in Nominal GDP - % Change in GDP Deflator = 5% - 8% = -3%

Example 3:

a) Buying 300 shares in Apple.

This is simply an exchange of existing assets and does not create new value in an economy.

b) Apple sells iPads this year out of inventory from last year.

This has a net change of zero on the output of an economy. The inventory from last year is counted in last year’s GDP. Purchasing the inventory in the current year is cancelled out by the disinvestment from the decrease in inventory.

c) You buy a new MacBook Pro for private use.

This is an example of consumption rather than investment.

d) Google buys new machinery to help manufacture its self-driving cars. Correct. This is an example of investment.

What’s Next

In the following article I will cover two more important economic statistics to help gain a full picture of macroeconomic data: the CPI and unemployment. This will lead into the first major macroeconomic theory, the Neoclassical Model.