Tutorial 1(SOLUTION) GROSS DOMESTIC PRODUCT (GDP)

ECON7001Tutorial 1Gross Domestic ProductChapter 4Question 1“Is China about to overtake US as the worlds largest economy?” BBC 30 April 2014 http:www.bbc.comnewsbusiness27216705(a) By what economic measure is this claim being made?(b) What problems arise when making international comparisons of economic activity?(c) Does this mean China is wealthier than the United States?Solutions(a) Comment on the “size” of an economy is normally a reference to its gross domesticproduct (GDP). Note this is total economic value added, NOT per capita. Note that itignores informal economy. Also note that construction of GDP measure (what is inand out, eg. illicit drugs and prostitution) is different across countries. And thatgoods are heterogenous, so different production and consumption profiles lead todifferent totals due to aggregation assumptions (industry deflators etc)

ECON7001Tutorial 1 Gross Domestic Product

Chapter 4

Question 1

“Is China about to overtake US as the world's largest economy?”

- BBC 30 April 2014

- http://www.bbc.com/news/business-27216705

(a) By what economic measure is this claim being made?

(b) What problems arise when making international comparisons of economic activity?

(c) Does this mean China is wealthier than the United States?

Solutions

(a) Comment on the “size” of an economy is normally a reference to its gross domestic product (GDP) Note this is total economic value added, NOT per capita Note that it ignores informal economy Also note that construction of GDP measure (what is in and out, eg illicit drugs and prostitution) is different across countries And that goods are heterogenous, so different production and consumption profiles lead to different totals due to aggregation assumptions (industry deflators etc)


What is GNP and how does that differ?


GDP measures the market value of all final goods and services produced in a

particular place over a particular time (normally a year) GDP is also a measure of the total spending by consumers, businesses, government and foreigners on

domestically produced goods and services Because every dollar that is spent

becomes somebody else’s income GDP is also a measure of income earned from the production of domestically produced goods and services

(b) Since GDP is measured by each country’s currency, international comparison

requires the usage of either exchange rate or PPP Using purchasing power parity

(PPP) requires additional knowledge of comparable baskets of goods - which PPP?

On the flip side, using current exchange rates is problematic because of FX

fluctuations that are fairly meaningless to aggregate production levels in the short run

- Two countries with different levels of development cannot be compared on the basis

of GDP, as GDP will not include the same activities in the two countries (part of economic activity will be excluded from the comparison);

- Also, statistical methods used to measure outputs and prices differ significantly across the world

(c) Not really Even though total Chinese production, spending and income are worth about the same total as the US, that figure is shared amongst many more people in China (1.35billion) compared to the US (319million) To make wealth, or standard of living comparisons it is appropriate to divide total GDP by population (a per capita GDP) Hence, the average Chinese person is only 25% as wealthy as the average US

- Distribution of wealth also matters to what we could consider economic success of raising living standard widely, and much controversy has occurred due to the

ongoing concentration of wealth in many countries into the hands of the top 1%

Question 2

An Australian wool farmer sold some wool to a local textile mill for $5 The textile mill spun

it into yarn and sold it to Grandma Jones for $8 Grandma Jones runs a stall at the

Southbank Markets where she knits the yarn into a custom tea cosy and sells it for $10 a) How much was contributed to Australia’s GDP How much value was added at each step?

b) How does your answer change if Grandma Jones is your Grandma and rather than selling the tea cosy, she gives it to you for your birthday?

c) How does your answer change if the textile mill is owned by a Chinese company? d) How does your answer change if the textile mill is located in China?

Solutions

a) GDP measures the value of all final goods and services Because the wool and the yarn are each steps in the chain to making the final tea cosy (that is, they are

intermediate goods) it would be double-counting if they were added to GDP So $10

is added to GDP

The value added at each stage can be calculated by taking what the good was sold for and deducting what was paid for the raw materials

o The wool farmer started with nothing (presumably they bred and raised the sheep) then sold the wool for $5, so we conclude that they added $5 of value

o The textile mill bought $5 of wool and sold it as yarn for $8 so they added $3

of value (8 – 5)

o Finally Grandma Jones bought the wool for $8 and sold the final product for

$10 so she added $2 of value (10 – 8)

It should be noted that the value-added at each step (5 + 3 + 2) sums to the final value (10)

b) Gifts, domestic work as well as illegal and unreported production are neither

measured nor reported in most estimates of GDP So, the “final” good becomes the yarn that was sold to Grandma for $8

c) Foreign ownership of the factory doesn’t change GDP Remember that GDP

measures everything produced in some place, so the owner of the mill is irrelevant (this effect is accounted for in a different figure called Gross National Product) d) The “domestic” in gross domestic product means that we are only trying to account production that occurred within a particular place (in this case Australia) To account for this we can simply disregard the value added by the foreign textile mill Value added by the farmer is $5 and the value added by Grandma is $2, so domestic GDP is now increased by $7

Question 3

Consider the following production data for the made-up country of Kuznetsistan, which produces only milk and juice

a) Calculate nominal GDP for 2012 and 2013

b) Calculate the growth rate in nominal GDP between these years

c) What can be concluded about the economic growth rate from this figure?

d) Calculate real GDP for 2012 and 2013 using 2012 as the base year

e) Calculate the growth rate in real GDP between these years

f) What can be concluded from this figure?

g) Calculate the GDP deflator for 2012 and 2013 What does this number mean?

Solutions

a) Denoting nominal GDP as PY, prices as P and quantities as Q:

PY in 2012 = P milk in 2012 x Q milk in 2012 + P juice in 2012 x Q juice in 2012

PY in 2012 = 2 x 10 + 5 x 1

PY in 2012 = $25

PY in 2013 = P milk in 2013 x Q milk in 2013 + P juice in 2013 x Q juice in 2013

PY in 2013 = 4 x 8 + 9 x 2

PY in 2012 = $50

b) To calculate percentage growth, we take

(new – old)/old x 100$ = (50-25)/25 x 100% = 100%

c) Nothing An increase in nominal GDP can be caused by an increase in prices or in quantities (or a combination of both)

d) Real GDP (Y) is equal to nominal GDP in the base year, so

Y in 2012 = $25

Real GDP is equal to the quantities from the current year times the prices from the base year, so

PY in 2013 = P milk in 2012 x Q milk in 2013 + P juice in 2012 x Q juice in 2013

PY in 2013 = 2 x 8 + 1 x 9

PY in 2013 = $25 e) It hasn’t changed, so it’s 0%

f) The total value of production in 2012 is the same as in 2013

g) By definition, the GDP deflator is

GDP deflator = (Nominal GDP/Real GDP) x 100

So in 2012

GDP deflator in 2012 = 25/25 x 100 = 100 and in 1013

GDP deflator = 50/25 x 100 = 200 You may have noticed that because nominal and real GDP are equal in the base year, the GDP deflator will always be 100 in the base year As such, we can interpret the GDP deflator as a measure of the price level compared to the base year Because the GDP deflator was 200 in 2013 this means that prices in this year were double that of

2012

Question 4

How would each of the following be recorded using the spending method of calculating Australia’s GDP for this year?

a) Teddy’s Timber Inc in Brisbane buys an Australian-made circular saw

b) Motoko from Mullumbimby buys an Australian-made circular saw

c) The department of Forestry buys an Australian-made circular saw

d) JokoKayu in Jakarta buys an Australian-made circular saw

e) Hamdi’s Hardware in Hobart manufactures a circular saw but does not sell it

f) Hamdi’s Hardware in Hobart sells a circular saw it produced last year to Motoko from Mullumbimby

g) Clive Palmer buys shares of existing company Hancock Prospecting

h) Clive Palmer buys new shares in the new start-up company Digging Pty Ltd

i) Penny from Perth buys a TV from Erik Electrical who imported it from South Korea

Solutions

a) + Investment (capital formation)

b) + Consumption

c) + Government

d) + Net Exports

e) + Investment (inventory investment)

f) + Consumption, - Investment (inventory investment)

g) Nothing to record

h) Nothing to record (although when the Digging Pty Ltd spends this money on capital goods it will be recorded as Investment (capital formation)

i) + Consumption, - Net Exports The retail price of the TV will be recorded as

consumption while the import price of the TV will be recorded under imports GDP will change by the difference

Question 5

Discussion: Who invented GDP? And why? What things can increase GDP and make welfare

go down?

Solutions

The idea of measuring the economy became politically important during the great

depression of the 1930s, triggered by a financial collapse in October 1929 Mass

unemployment and the inability to monitor macro economic conditions led to the formation Bureau of Foreign and Domestic Commerce's Division of Economic Research, headed by prominent economist Simon Kuznets, to develop a method of economic measurement of

the macro economy The foundations for GDP measurement were published in eth 1937 report National Income, 1929–32

That original report is available here

http://www.nber.org/chapters/c2258.pdf

Even within GDP (or more precisely, the System of National Accounts) can be used to

generate other measures that also imply well-being – per capita incomes, wages, etc

http://www.bea.gov/scb/pdf/2010/04%20April/0410_gpd-beyond.pdf

It is also important to understand that the boundary of the formal economy has changed radically over the century – child care, home services, financial services and so forth are included, but may not be welfare enhancing if they

But the usefulness is that in broad terms GDP correlates with many other physical measures

of well-being, though exactly what causes these is NOT the GDP, but usually specific factors that greater economic activity makes relatively more affordable (public health etc)

There are activities/expenditures which are included in GDP calculation but does not directly increase individuals’ welfare: government expenditure for example (government service or military expenditure…) In addition, many destructive events or activities can increase GDP while decreasing overall welfare For example, a massive hailstorm that creates demand for thousands of new roofs and windows in a particular region, for example, is not an economically beneficial event But it would have the effect of increasing GDP, as millions would be spent on acquiring these goods and services Another example, divorce may causea large amount of emotional strife for those involved A high divorce rate

is something almost no one considers beneficial But divorce is expensive, and creates thousands of jobs for lawyers, judges, and other legal mediators If the divorce rate were to increase by 10% one year, this would increase GDP