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3. Gross domestic product

3.1. Definition

Perhaps the most important concept in macroeconomics is Gross Domestic Product (GDP):

Gross Domestic Product (GDP) is defined as the market value of all finished goods and services produced in a country during a certain period of time

Note that we only include finished goods and services - that is, anything that is sold directly to the consumer. Electric power sold to a steel mill is not included while all the electric power sold directly to consumers is included. The reason is simply that we want to avoid "double counting". Consider for example the production of cars. Car producers have parts produced by other firms which in turn have parts delivered by other firms and so on. If we were to count the value of everything produced by a firm, then most parts of a car would be counted several times. This is why only the value of the finished car is used in the calculation of GDP. Note, however, that if a firm buys a robot that it uses in the production of cars, then this robot is counted (if it is produced in the same country). The car producer is then the "final consumer" of the robot - no value is added to it and it is not resold to another firm.

3.2. Real GDP

To be able to make reasonable comparisons of GDP over time, we must adjust for inflation. For example, if prices are doubled over one year, then GDP will double even though exactly the same goods and services are produced as the year before. To eliminate the effect of inflation we divide GDP by a price index and we define real GDP as GDP divided by a price index.

It is not very common to use CPI in the construction of real GDP. The reason is that CPI measures the price evolution of consumer goods while GDP includes investment goods as well as consumer goods. Instead, it is common to use a GDP deflator as a price index. The GDP deflator measures the price evolution of a basket whose composition is close to the composition of GDP. The difference between the CPI and the GDP deflator is fairly small however. To avoid confusion, GDP that is not adjusted for inflation is often called nominal GDP.

3.3. Growth

By (nominal) GDP-growth we mean the percentage change in (nominal) GDP over a specific period of time. Real GDP growth is defined as the percentage change in real GDP. The real growth tells us how much the economy has grown during a particular period when the effect of inflation is removed.

3.4. Purchasing power

One problem in using the exchange rate when comparing GDP per capita between countries is that is fluctuates quite a lot. A way of avoiding dependence on the exchange rate is to use purchasing power.

3.5. GDP is a flow!

Finally, note that GDP is a flow variable and not a stock variable. By a flow variable we mean a variable that is measured in something per unit of time. If you fill a bath tub you may fill it at 40 liters per minute -a flow - while the tub itself may contain 200 liters - a stock. In the same way, income is flow (you may make 9 euro per hour) while the amount of money you have in your bank account is a stock (you would never claim that you have 2400 euro "per month" in your account - you have 2400 euro period).

GDP, being a flow, is not a measure of the total wealth of a country but a measure of the "income" of the country during a certain period of time. Sure, if GDP is high, it is quite likely that the total wealth of the country is increasing over time (some wealth is lost to depreciation). Therefore, there is often a connection between what we perceive as a "rich" country and a high GDP per capita.

4. The components of GDP

4.1. The circular flow - simple version

We have defined GDP, the gross domestic product, as the market value of all finished goods and service produced in a country during a specific period of time. We will now look closer at the definition and the components of GDP - something which is necessary if we want to understand macroeconomics.

In order to better figure out the details of GDP we will use the "circular flow model". The main purpose of the circular flow is to show how goods, services and money flow to and from various sectors in the economy. Such a model may be more or less detailed. We will start with the least detailed version and then construct a more complete model to which we will refer throughout the book.

Fig 4.1

In this model goods (and services) flow counter clockwise while money flows clockwise.

• Firms deliver finished goods to the goods market (semi-manufactured goods circulate within the box firms). Firms are compensated for the goods and this compensation is equal to GDP.

• Consumers receive goods from the goods market where prices are determined through supply and demand.

• In order to pay for the goods, the consumers deliver factors of production (labor and capital) to the factor markets.

• Firms buy factors of production using the income they receive from the goods market.

Note that the flow of money from firms to the factor markets is exactly the same as the flow of money from the goods market to the firms. If this was not the case, firms as a group would make a profit or a loss. But since all firms are owned by individuals (directly or indirectly through pension funds and other funds), all profits or losses must eventually fall on the consumers. This flow is part of the return on capital, a flow of money to the factor market.

 
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