Like every Friday, we are posting one of Raj Nallari’s teaching notes.
Before we examine how economic growth is measured (through the concept of GDP), we have a look at some basic macroeconomic concepts.
Arising from the interaction and behavior of the economic sectors we studied last Friday, there are certain key macroeconomic concepts that play a central role in macroeconomic analysis. These are defined in the framework of the System of National Accounts (SNA).
- Gross output – the value of all goods and services produced in the economy. This measure suffers, however, from double counting; e.g., the value of wheat may be counted twice, first in the production of bread and second in the value of bread output. One way around this is the concept of value added.
- Value added – the value of gross output less the value of intermediate goods. A microchip bought by a computer company and used in the production of its computers is an intermediate good because the ultimate purchase of the chip is as part of a final good, the computer. A distinction is also made between market output and non-market output that includes subsistence farming and owner-occupied housing.
- Consumption – there are two different kinds – final consumption and intermediate consumption. The latter refers to inputs into production while the former refers to goods and services – both imported and domestically produced – used by households and the government sector. In the microchip/computer example above, if a computer is purchased by households it is called consumption, if it is purchased by enterprises it is called investment and if it is purchased by government, it is called government expenditure.
- Gross domestic product – is the sum of value added across all sectors in the economy. It measures the value of final goods and services in an economy. To ensure that total output is measured accurately, goods and services produced in a specific year must be counted only once. Most products go through several production stages before reaching the market and thus may be bought and sold several times. To avoid multiple counting of goods, which would exaggerate the value of GDP, only the market value of final goods is included, not that of intermediate or second-hand goods.
- Gross Investment (gross capital formation) refers to the additions to the physical stock of capital. This includes:
- All final purchases of machinery, equipment and tools by business enterprises
- All construction
- Changes in inventories.
- Inventory changes are considered a part of investment as long as they cover products produced in that particular year, and as long as they are not sold in that same year. GDP has to include the market value of any additions to inventories accruing during that year as part of current production along with the value of goods which were manufactured and sold during that year. Conversely, decline in inventories must be subtracted in figuring out GDP.
- Net Investment and Economic Growth – The amount of a nation’s capital worn out or used up in a particular year is called depreciation. The relationship between gross investment and depreciation indicates whether an economy’s production capacity is expanding, static or declining.
- Depreciation – sometimes called the consumption of capital, reflects natural wear and tear over time, and is used to differentiate net from gross investment.
- Net Investment = Gross Investment – Depreciation.
- Net exports are the value of exports of goods and services minus the value of imports of goods and services. It measures the impact of the foreign trade on aggregate demand (the total demand for goods and services in an economy) and on GDP (total output).
- Absorption or domestic aggregate demand is the sum of total final consumption from the government and nongovernment sectors (C) and gross investment (I): A=C+I
Next Friday: Determining GDP