Lecture 2 · Slides L2 · Mankiw ch. 2 · ABC ch. 2 · about 40 min

Measuring the Economy: GDP, Prices and Unemployment

The three numbers every macroeconomic argument starts from: how GDP is counted, how price indices turn nominal values into real ones, and how unemployment is measured.

By the end you can

Compute GDP by value added and by expenditure, and say what is left out
Separate nominal from real GDP and compute the GDP deflator
Compute the CPI and explain three differences between the CPI and the deflator
Compute the unemployment rate and labour-force participation rate, and use Okun's law

Why measurement comes first

Every claim in this course, such as “the economy grew 4%”, “inflation is 40%” or “unemployment rose”, depends on a statistic someone had to define. Each definition includes some things and leaves others out, and exam questions often test exactly those edges.

This lecture covers the three statistics that matter most: GDP, price indices and unemployment.

Three ways to measure the same thing

National income accounting is the system that measures economic activity and its parts. There are three approaches, and they must give the same number:

Product approach: the value of output produced.
Income approach: the incomes generated by that production.
Expenditure approach: the spending by those who buy the output.

Fundamental identity of national income accountingIdentityFormula sheet →

\text{Total production} = \text{Total income} = \text{Total expenditure}

Use it when a question asks why the three approaches agree. Every lira spent on a final good is a lira of someone's income and a lira of recorded output.

Gross domestic product

Every word in that definition rules something out.

Market value: goods are added up at their prices, so a laptop counts more than a loaf of bread. Things with no market price, like housework, are left out.
Final: intermediate goods used up in making other goods are not counted separately. Otherwise they would be counted twice.
Newly produced: sales of used goods and financial assets are transfers of existing things, not production. If you buy a three-year-old car from a dealer, the car is not in GDP, but the dealer’s service (its margin) is.
Market value also leaves out the underground economy. Some non-market output, such as the housing services of owner-occupied homes, is included at an imputed value.
Within a country’s borders: a Turkish firm’s factory in Germany adds to German GDP. Output of nationals abroad belongs in GNP, not GDP.

Value added

A simple way to avoid double counting is to add up the value added at each stage of production: the value of a firm’s output minus the value of the intermediate goods it bought.

The expenditure approach

GDP is also total spending on domestic output, split by who buys it:

Expenditure identityFormula sheet →

Y = C + I + G + NX

$C$: consumption
$I$: investment, including inventories
$G$: government purchases, excluding transfers
$NX$: X - M, net exports

Use it when you add up GDP from spending components, or check what counts where.

$C$ : household purchases of goods and services.
$I$ : business fixed investment, residential investment (new houses) and inventory investment.
$G$ : government purchases of goods and services. Transfer payments like pensions are not included, because nothing is produced in exchange.
$NX = X - M$ : net exports.

Some detail the lecture adds on each component:

Consumption splits into durables (cars, televisions, furniture), non-durables (food, clothing, fuel) and services (education, health care, transport).
Investment is business fixed investment (structures, equipment and intellectual property such as software and R&D), residential investment and inventory investment. For an economist, buying shares or bonds is not investment: investment means buying new physical capital.
Government purchases include government consumption (health care, police) and government investment (highways, airports, bridges). Transfers and interest on government debt are not in $G$ .
Imports are subtracted because they were already counted inside $C$ , $I$ and $G$ but were produced abroad.

Income measures

GDP counts production inside the borders. Other measures count income by who earns it.

GNP and GDPFormula sheet →

\text{GNP} = \text{GDP} + NFP

$NFP$: net factor payments from abroad: income residents earn abroad minus income foreigners earn here

Use it when a question separates output produced in the country (GDP) from income earned by the country's residents (GNP).

In the Abel-Bernanke-Croushore accounts used in the lecture, the income the private sector can spend is:

Private disposable incomeFormula sheet →

Y^{pvt}_d = Y + NFP + TR + INT - T

$Y$: GDP
$TR$: transfers received from the government
$INT$: interest on government debt
$T$: taxes

Use it when you need the income households and firms actually have to spend or save.

and the government’s net income is taxes minus transfers minus interest: $T - TR - INT$ .

Nominal and real GDP

Nominal GDP values output at current prices. It can rise because more is produced or because prices went up. To separate the two, real GDP values output at the prices of a fixed base year.

\text{Nominal GDP}_t = \sum P_t\,Q_t \qquad\qquad \text{Real GDP}_t = \sum P_{base}\,Q_t

The ratio of the two is the GDP deflator:

GDP deflatorFormula sheet →

\text{Deflator}_t = \frac{\sum P_t Q_t}{\sum P_{base} Q_t} \times 100

$P_t, Q_t$: current prices and quantities
$P_{base}$: base-year prices

Use it when you need the price level of everything produced domestically. Current basket (Paasche).

GDP data are seasonally adjusted to remove regular swings within the year, such as the dip in cold months. When the relative prices of some goods change sharply, a fixed base year can mislead, so statistical offices use chain-weighted measures that let the base year move continuously.

A useful approximation for growth rates: the percentage change in a product is about the sum of the percentage changes.

\%\Delta\,\text{Nominal GDP} \approx \%\Delta\,\text{Deflator} + \%\Delta\,\text{Real GDP}

The consumer price index

The CPI asks: how much does a fixed basket of goods, the one a typical consumer bought in the base year, cost today compared with then?

Consumer price indexFormula sheet →

\text{CPI}_t = \frac{\sum P_t\,Q_{base}}{\sum P_{base}\,Q_{base}} \times 100

$Q_{base}$: the fixed base-year consumer basket

Use it when you need the cost of living for consumers. Fixed basket (Laspeyres).

The deflator uses current quantities as weights (a Paasche index). The CPI uses base-year quantities (a Laspeyres index). Edit the table below and compare them.

Because consumers switch toward goods that become relatively cheaper, a fixed basket overstates the rise in the cost of living. This is substitution bias. New goods and unmeasured quality improvements push the CPI upward too.

Other price measures

Core inflation strips out the most volatile items, usually energy and food, to show the underlying trend.
The producer price index (PPI) measures prices firms pay for inputs and receive for output. It often moves before the CPI because input costs pass through to consumers with a lag.

In Türkiye TÜİK publishes the CPI with base year 2003 = 100. The lecture’s slide shows it at about 2,526 in September 2024: the price level rose roughly 25-fold in 21 years.

Unemployment

Every adult is in one of three groups: employed, unemployed (without a job but actively looking), or not in the labour force (students, retirees, people not looking).

Labour market ratesFormula sheet →

u = \frac{U}{E + U} \times 100 \qquad \text{LFPR} = \frac{E + U}{\text{Adult pop.}} \times 100

$E$: employed
$U$: unemployed and looking
$E + U$: labour force

Use it when a question gives counts of people. The unemployment denominator is the labour force, not the population.

Okun’s law

Unemployment and output move together in the opposite direction. In US data, a rise of one percentage point in the unemployment rate goes with roughly two percentage points lower real GDP growth:

Okun's lawUS estimateFormula sheet →

\%\Delta\,\text{Real GDP} \approx 3\% - 2 \times \Delta u

$\Delta u$: change in the unemployment rate, in percentage points

Use it when you translate a change in unemployment into GDP growth, or the reverse.

The 3% is the approximate normal growth rate when unemployment is stable. The coefficients differ across countries, but the negative relationship holds widely.

Time series data

Macroeconomic data are almost all time series: observations of one variable recorded in order over time, hourly, daily, monthly, quarterly or yearly. Share prices, trade volumes, price indices and GDP are all time series.

A series is continuous if observed continuously, discrete if recorded at specific, usually equally spaced times. Most economic series are discrete.
The process that produces the data is the data generating process (DGP). For GDP it is stochastic (random): harvests depend on weather, for example.
A time series can be broken into four components:

Component	What it is	Example
Trend	the long-run direction	GDP rising over decades
Seasonal	regular swings within a year	retail sales peak before holidays
Cyclical	swings over several years	business cycles
Irregular	random, unpredictable noise	a strike, an earthquake

Summary and review

GDP: market value of final goods and services newly produced within the borders in a period.
Value added at each stage sums to the value of final output.
$Y = C + I + G + NX$ . Inventories count as investment; transfers are not in $G$ .
Real GDP uses base-year prices. Deflator $=$ nominal / real $\times 100$ .
CPI uses a fixed consumer basket; the deflator uses current domestic production.
$u = U/(E + U)$ . Discouraged workers lower measured unemployment.
Okun’s law: $\%\Delta Y \approx 3\% - 2\Delta u$ .
Production $=$ income $=$ expenditure. GDP is a flow.
$\text{GNP} = \text{GDP} + NFP$ .
Time series: trend, seasonal, cyclical, irregular.