GDP Summary

Okay – so we all need to plan and the pace of GDP expansion or contraction might be important for our own particular planning.  We know that AD is one thing that might cause GDP to change – implying impacts on national outputs or prices or both. We also know that AD itself is determined by the changes in spending of households, firms, governments, and foreigners. But what causes them to change how much they want to buy?

Before we get to this question we come to another fork in the road. Two more frequently used terms that link very closely to real GDP are Potential Real GDP and the GDP gap. These terms are very useful because they help us get from talking about the current amount of GDP to thinking about what GDP could or should be. By comparing today’s actual GDP to what it could or should be – we have a way of thinking about predicting future change. It might also help us think about national AD policy.

Real GDP and National Welfare

If one divides the value of a nation’s real GDP by the population of that country, this yields real GDP per person. The link below takes you to a US Department of Labor Study of real per capita GDP with estimates of several countries for 2004. Of the countries chosen, the US was at the top with $38,400 per person. In second place was Norway with $27,400. Korea was the lowest in this group of mostly richer countries with $19,700. http://www.bls.gov/fls/flsgdp.pdf

GDP is more than a gauge of business activity – it has become a relative measure of country economic success – some go so far as to say a measure of welfare or happiness. If, for example, the real per capita GDP of country X exceeds that of Country Y, this would be taken as a positive sign by the residents of X.

But this might be taking things too far. While real GDP does contain a lot of useful information, it is not a perfect measure of national welfare or happiness. GDP is noticeably silent on many important scores. If production chews up the environment most of that loss is not subtracted or netted out properly. GDP does not include the value of most of home production and it misses most of the informal (illegal, grey, or simply unmeasured) economy. GDP most clearly does not measure the happiness that one gets on a sunny day in spring or when a grandmother is presented with her first grandchild. Two countries might have the same per capita real GDP but in one country incomes are evenly distributed while in the other they are not. One country might have a high literacy or low crime rate while the other does not.

The following link provides a provocative discussion of these issues by E. J. Dodson: http://www.progress.org/2005/dodson12.htm. Dodson contrasts GDP with estimates of what he calls the “Genuine Progress Indicator” which is meant to take into consideration how the goods and services produced affect the “well-being of the population.” For example, economic efforts made to reconstruct New Orleans add positively to GDP and may make the US look like it was being better off in the year after the flood than the year before while peoples’ well-being was down. This is a valid perspective, but clearly, apart from such simple cases, what affects the well-being of the population positively depends highly on one’s own values and preferences. Economists prefer GDP because they think that the market price used to value the goods and services produced ultimately reflect peoples’ valuation of these goods and services adequately.

Furthermore, GDP per capita is closely related to other things about human life that we value highly. Figure 1 below plots per-capita GDP against life expectancy in an international comparison for the year 2004. Each dot marks a country and the bigger the dot, the larger the country’s population. Clearly, the two are positively correlated. Figure 2 plots GDP per capita against child mortality. Clearly, GDP per capita and child mortality are negatively correlated.

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An even broader concept is the Gross National Happiness approach which takes into consideration not only goods and services produced and sold on markets but cultural and ethic factors and non-market production.

See the link http://www.gpiatlantic.org/conference/media/nyt1004.pdf . One does not have to be a Buddhist to realize that these are ideas that deserve some thought. For practical people like economists, however, the use of GDP data remains the simplest indicator of national welfare in comparisons both over time and across countries, though admittedly it has its flaws and weaknesses. Figure 3 below shows Gross National Product, a concept closely related to GDP (see below), per capita together with the happiness scores of different countries in 2000. The happiness score is derived from the number of people who answer “yes” to the question “Do you generally feel happy?” While the relationship is generally positive, there are countries (those in the big circle) where people are happier than their economic status would suggest. Figure 4 relates happiness to the development of mean household incomes in the US. It suggests that Americans are typically happier when their incomes rise. Thus, while GDP per capita is not a perfect measure of welfare, we can still use it as an indicator of economic well being.

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There are more issues relating to measurement. While there are United Nation’s standards for reporting information that goes into accounting for GDP, some countries allocate fewer resources to collection and may have less accurate figures. When doing comparisons we use exchange rates to convert all GDPs to the same currency – usually dollars. Do you use today’s exchange rate or a longer term “equilibrium” value for the exchange rate (often called the purchasing power parity value of the exchange rate)?

The list of data issues is very long and goes beyond the purposes of this reader but it does lead us to a conclusion. Like many things in life, GDP is not perfect and probably never will be. But that does not mean that we ignore it. When a country’s real GDP rises, it means more goods and services are being produced. It means the nation is earning more income. It probably means that the “average” person is better off but the answer to that question depends on what you mean by “average” and what you mean by “better-off.” Keeping this little discussion in mind is helpful to keep some perspective on real GDP and national welfare.

Potential Real GDP and the GDP Gap

Potential Real GDP is the amount of real GDP that could be produced if all resources (productive inputs) were fully utilized. On any given day the unemployment rate may be higher or lower than what we consider to be a fully employed labor force (see the note on Employment & Unemployment for more about this point).

For example, full employment might imply an unemployment rate of about 4% in the U.S.  If today’s unemployment rate is 5%, then we would say that the economy is not at full employment. Similarly, the nation’s capital might not be exactly fully employed (over or under a capacity utilization rate of about 90%).

We say that a GDP gap is negative if today’s real GDP is less than Potential GDP. That negative gap tells you that the amount of real GDP being produced today is less than we could produce if resources were fully used – it also tells you that the nation’s labor and capital are not being fully utilized. A negative gap is used as a means by some people to advocate a stronger AD policy. The idea is that if policy can move the economy to a higher level of AD, firms would want to produce more and they would hire more inputs to do so.

It is logically possible but not frequent to have a positive GDP gap – implying that the country is producing more than Potential GDP. In this case resources are being stretched or over utilized. This rare situation is often the case of too much AD in the economy. This would indicate a need for policymakers to withdraw or reduce AD through policy.

People refer to the U.S. in the late 1990s as having a positive GDP gap. It might seem strange that there could be too much AD in a country, but the truth is that running a nation’s economy too fast can be as bad as running it too slow. Imagine trying to run a marathon at a sprinter’s pace – clearly much faster than your “normal” pace for 26 miles. It’s not good for the body. Running your car too fast too long can be bad for its long-term good. The same goes for an economic system. We will say more about this problem ahead.

GDP and Gross National Income

GDP is the value of all final goods and services produced within the borders of a country during a given period of time. In a country with no economic ties to any other countries – a “closed economy” – it is also the sum of all incomes earned by its residents during that period. The reason is simple: Firms and businesses producing the goods and services included in GDP pay wages to their employees, interest to their debtors, rent to the owners of their buildings and the land they use, and profits to their shareholders or the owners of their capital. Thus, GDP in a closed economy is equal to Gross National Income, GNI.

In general, this is not true, because some of the residents of the country may receive wages or profits from firms and businesses residing in other countries, while some of the businesses of the country may pay wages and profits to residents of other countries. An example for the former would be a resident of Detroit, an MBA student, who does a paid internship at Mercedes in Stuttgart, Germany, an example of the latter a resident of Mexico who works for GM during the summer. To define GNI properly, we have

GNI = GDP + incomes earned abroad by domestic residents

                           – incomes paid to foreign residents.

While GDP gives us the value of domestic production during a year, GNI tells us the value of what domestic residents can afford during a year without tapping into their savings. Note: Older texts call GNI “gross national product,” a misnomer, since it is an income, not a product!