February 15, 2021
GDP and GDP per capita are measures used to measure the size of an economy and the economic well being of people within that economy.
While not perfect measures, they are widely regarded as the best measures for measuring differences in standards of living and tracking those changes over time.
GDP can be used to compare the size of economies, while GDP per capita is a better measure of the well being of people within an economy.
The right panel displays the world’s 10 largest economies in 2018.
Clearly, having a large economy (GDP) is not the same as having a high standard of living (GDP per capita).
Country | GDP (Millions of USD) | GDP per Capita (USD) |
---|---|---|
China | $21,229,364 | $15,242.99 |
United States | $20,090,749 | $61,498.37 |
India | $8,787,694 | $6,496.81 |
Japan | $5,197,069 | $41,074.10 |
Germany | $4,457,689 | $53,768.13 |
Russian Federation | $3,915,637 | $26,667.73 |
United Kingdom | $3,073,442 | $46,244.75 |
Brazil | $3,057,466 | $14,596.25 |
France | $3,051,034 | $45,561.00 |
Indonesia | $3,043,743 | $11,371.53 |
The change in standards of living over time is best looked at by looking at the growth of GDP per capita.
The right panel displays US GDP per capita since 1947, and the shaded regions demarcate economic recessions.
Gross Domestic Product (GDP) is the market value of all final goods and services produced within a country in a year.
GDP per capita is simply GDP divided by a country’s population.
Let’s examine more closely at the underlined parts of the definition.
GDP measures total production. This raises a couple practical issues:
The solution to both of these issues is to denominate production in dollar terms, so we multiply the quantities of final goods and services by their market prices and add up these values.
Assume that the US economy produces 10 million automobiles and 2 billion pencils each year.
Next, assume that the average price of an automobile is $40,000 and the average price of a pencil is $0.10.
This implies that the market value of automobiles is \(10{,}000{,}000\times\$40{,}000=\$400{,}000{,}000{,}000\) and the market value of pencils is \(2{,}000{,}000{,}000\times\$0.10=\$200{,}000{,}000\).
Adding these together, the GDP generated from automobiles and pencils is \(\$400{,}000{,}000{,}000 + \$200{,}000{,}000 = \$400{,}200{,}000{,}000\)
Intermediate goods are sold to firms and then bundled or processed with other goods or services for sale at a later stage.
Final goods are the finished goods sold to final users and then consumed or held in personal inventories.
To avoid double-counting, only final goods are included in GDP.
Goods are tangible. e.g. cars, food, clothes.
Services are intangible. Transportation, haircuts, medical care.
Both are included in GDP
Since the 1950s, the portion of the economy created by services nearly doubled.
Most of that increase happened before the year 2000.
Since 2000, the shares of services, durable goods, and non durable goods has remained roughly constant.
Durable Goods – Goods that are expected to last for a year or more Nondurable Goods – Goods that are expected to be used up within a year
GDP only calculates what is produced, not what already exists. Thus:
GDP only includes production that takes place within the borders.
Examples:
Gross National Product (GNP) is a measure that looks at the nationality of the person doing the production, not the location of the production.
GDP is a flow measure of income:
This is contrast to a nation’s wealth:
Putting the definition back together:
Gross Domestic Product (GDP) is the market value of all final goods and services produced within a country in a year.
GDP per capita is simply GDP divided by a country’s population.
Questions:
The growth rate of GDP tells us how rapidly a country’s production is rising or falling over time.
The formula for calculating the growth rate from year 1 to year 2 \(\frac{GDP_{y2}-GDP_{y1}}{GDP_{y1}}\)
For example, in 2004 US GDP was $11.7T and in 2005 it was $12.5T.
GDP growth was therefore \(\frac{\$12.5T-\$11.7T}{\$11.7T} = 6.8\%\)
If GDP in 1990 was $5.8 trillion and GDP in 1991 was $6.0 trillion, what was the growth rate of (nominal) GDP?
If GDP in 2008 was $14.4 trillion and GDP in 2009 was $13.9 trillion, what was the growth rate of (nominal) GDP?
Nominal variables, such as nominal GDP, have not been adjusted for changes in prices.
Real variables, such as real GDP, have been adjusted for changes in prices.
Economists usually are more interested in real GDP because increases in real GDP reflect increases in the standard of living.
Whenever one is looking at changes in a monetary variable over time, it is essential to use real variables
In 2005, Nominal GDP was $$12.4T in 1995, Nominal GDP was $7.4T
The Growth of Nominal GDP was therefore \(\frac{\$12.4T-\$7.4T}{\$7.4T} = 67.6\%\)
The problem with this calculation is that 2 things changed between 1995 and 2005:
Converting from nominal to real GDP eliminated the effect of the price change, so you are only measuring the increase in production.
2005 GDP was $12.4T, which was the amount of stuff produced in 2005 valued at 2005 prices.
1995 GDP was $7.4T, which was the amount of stuff produced in 1995 valued at 1995 prices.
What if we calculated 1995 GDP using 2005 prices instead?
1995 production valued at 2005 prices was $9.0T
Real GDP growth between 1995 and 2005, therefore, was \(\frac{\$12.4T-\$9.0T}{\$9.0T} = 37.8\%\)
Most economists would choose real GDP growth as the best single indicator of economic performance.
Real Growth per Capita is the best reflection of changing living standards.
To convert these prices to current prices, multiply by 6.14
To convert these prices to current prices, multiply by 2.78
To convert these prices to current prices, multiply by 9.48
Another way to put this in perspective: roughly speaking, a typewriter in 1957 cost about the same as a basic calculator in 1973, a microwave in 1982, and an iPhone today.
A recession is:
…a significant, widespread decline in economic activity spread across the economy, lasting for more than a few months, normally visible [as a decline] in real GDP, real income, employment, industrial production, and wholesale-retail sales.
—National Bureau of Economic Research (NBER)
The NBER is an economic research institution located in Cambridge, Massachusetts.
They are the most authoritative source of identifying recessions.
How often do recessions occur?
Defining when a recession begins and ends is not easy.
Example: Dating the 2001 Recession.
Who cares?
Example: Dating the 2020 Recession.
Who cares?
There are two common ways of splitting GDP
Both approaches are useful for understanding business cycles and economic growth.
The national spending identity is:
These shares have remained fairly constant since WWII
Government spending does not include transfers, so this graph does not capture the increase in government.
During the Great Depression, spending was roughly 20% of GDP.
Between WWI and the Depression, spending was around 12%.
Prior to WWI, government spending accounted for about 7% of GDP.
Since the end of WWII, the size of government (spending + transfers) has increased by over 50%.
WHen money gets spent, it winds up as some else’s income. This gives rise to the the Factor Income Approach:
\(Y = Wages + Rent + Interest + Profit\)
In theory, adding up GDP this way should give the same answer as the spending approach.
A major issue with GDP calculations is that there are many products for which we do not actually know the market value:
The next few slides have some examples of the problems these issues may cause.
The entry of women into the workplace since the 1950s may have biased GDP growth upward.
GDP differences between developed and less developed countries may be exaggerated.
GDP may be overstated in times of government expansion
In addition to these issues regarding accurately measuring output, there are additional issues with respect to GDP as a measure of well being.
Some examples:
Let’s look more closely at the taxing and spending plan of the US Federal government.
A budget deficit exists in years when the amount of money the government spends is greater than tax revenues.
Typically, buget deficits are financed by borrowing, If the government has a deficit, this gets added to the National Debt
A budget surplus occurs when the government spends less than it collects in taxes. Budget surpluses reduce the debt
The government has run a debt for most of the last century.
Deficits spike during recessions, creating debt, but the debt rarely gets paid off afterwards.
This is an example of the flypaper effect or the ratchet effect.
The Congressional Budget Office (CBO) net government debt as a share of GDP since 1790.
They project debt to increase sharply for the foreseeable future.
This graph pre-dates Covid-19!
The CBO reports net debt, which excludes intergovernmental debt.
Because intergovernmental debt must eventually be paid with taxes, many people prefer to use gross debt, which is intergovernmental debt plus debt held by the public.
The national debt has expanded considerably since the 1980s.
Some argue that this may be misleading, as interest rates have fallen during this time period.
But could the government pay its debt down to 1970s levels if interest rates rose again?
The US Debt Clock is a great resource for looking at the various components of federal spending and revenue sources.
Reducing debts and deficits is difficult:
The long-term federal budget outlook has worsened considerably since 2010.
Federal debt as a share of GDP is approaching WWII levels
CBO projections are for debt to continue to rise for at least 25 years.
The CBO expects:
This CBO projection shows no end in sight for federal budget deficits.
Dealing with the debt is difficult because most people do not understand the source of the debt.
Polling generally shows that the American public:
Government debt has real economic consequences due to a phenomenon called crowding out.
When the government finances deficits by borrowing, interest rates rise in financial markets.
Thus, rising interest rates reduce, or crowd out, private borrowing and private investment.
There are significant negative consequences of a large and growing federal debt:
Development Economics focuses on understanding the economic and social conditions in developing countries.
While many things that are important for quality of life are not included in GDP, they tend to be correlated with GDP.
For example, health outcomes tend to be far better in developed countries than in less-developed countries
The Gapminder website has some interesting visualizations of the relationship between economic outcomes and health outcomes.
Three stylized facts.
The differences in GDP per capita between poor and rich nations are huge.
This is a relatively recent change – not so long ago, everyone in the world was poor.
Some countries are growth miracles, some are growth disasters.
The richest country in the world, Luxembourg, has 149.8 times the GDP per capita as the poorest country in the world, Burundi.
The US, which is more representative of developed countries than Luxembourg, has GDP per capita 80.8 times that of Burundi.
Economic Historian Angus Maddison has Approximated GDP per Capita for various civilizations throughout history all the way back to the year 1 AD.
In 1 AD, the richest regions in the world were what is modern day Greece and Italy, with per capita GDP around $800.
1500 years later, Italy was still the richest region in the world with GDP per capita near $1,500.
300 years after that, in 1800 AD, the Netherlands was the richest region of the world with $2,600 per capita GDP.
The divergence between rich and poor countries doesn’t really begin until the late 1800s.
While the vast majority of economic growth in human history has happened in the past 100 years, the difference in growth rates is shockingly small.
The Rule of 70 states that the amount of time it takes for an economy to double in size is \(\frac{70}{growth rate}\)
The Rule of 70 implies that small differences in growth rates can create huge differences in a short period of time.
Example: In 1972 North Korean per capita GDP was $3,702 while South Korea was at $3,031.
Between 1972 and 1992, North Korea grew at a rate of 0.03% per year, while South Korea’s annual growth rate was 6.92%
In 1992, North Korea’s GDP per capita was $3,726, but South Korea jumped considerably ahead with GDP per capita of $12,104.
Another way to think about this idea:
Poverty is not the phenomenon to be explained. The 200,000 year history of Homo sapiens is roughly 190,000 years of poverty, 9,900 years of very slow growth, and 100 years of massive increases in prosperity in a small handful of places.
Poverty is the norm. Prosperity is the outlier and is the thing to be explained.
Many of the developed countries in the world (US, Canada, Australia, New Zealand, Western Europe) became developed by sustaining moderate growth rates over the past century or two.
Growth Miracles – Some countries that are rich today were poor in the mid 1900s.
Growth Disasters – Some countries have simply failed to grow.
What does an economy need to grow?
These factors are necessary but not sufficient for economic growth and development.
The answers lie in the institutions that these countries adopt
Institutions are the rules that structure social interaction and give rise to economic incentives
Some key institutions of economic growth:
A fascinating case study in economic institutions is in looking at North vs. South Korea.
These institutional differences had significant and wide ranging effects.
In terms of GDP per capita, North Korea has not progressed since the end of the Korean War, while South Korea is a developed country.
The graphs on the left are from Sunyoung Pak (2004, top), and Pak and Daniel Schwekendiek (2009, bottom).
They found significant differences in the heights of North and South Koreans among both adults and children.
The graph of children’s height probably understates the differences between the North and South; according to UNICEF, North Korea has a child mortality rate about 6x that of South Korea.
Another stark difference is in access to basic utilities – the image below is NASA satellite of the Korean Peninsula at night.
Private property rights are essential for economic growth and development. They:
Country | CPI |
---|---|
Denmark | 91 |
Finland | 90 |
Sweden | 89 |
New Zealand | 88 |
Netherlands | 87 |
Norway | 87 |
Switzerland | 86 |
Singapore | 85 |
Canada | 83 |
Germany | 81 |
Luxembourg | 81 |
United Kingdom | 81 |
Country | CPI |
---|---|
Korea (North) | 8 |
Somalia | 8 |
Afghanistan | 11 |
Sudan | 12 |
Angola | 15 |
South Sudan | 15 |
Iraq | 16 |
Libya | 16 |
Guinea-Bissau | 17 |
Haiti | 17 |
Venezuela | 17 |
These tables show the most and least corrupt countries in 2015 according to Transparency International’s Corruption Perception Index (CPI).
CPI ranges from 0 (very corrupt) to 100 (very transparent).
In 2015, the United States was tied with Austria as the 16th least corrupt country with CPI=76.
Open and transparent governments are essential for protecting the rights (including property rights) of citizens.
Corrupt governments severely hamper an economy by siphoning resources out of the private sector and government to corrupt officials.
Political stability is essential for economic growth
When governments change via violent means (e.g. civil war, military coup), economic agents face uncertainty and invest far less in human and/or physical capital.
Orderly succession of governments from one regime to the next (and one party to the next) create a stable environment for economic flourishing.
Rule of law refers to the notion that laws are clear, publicly known, fair, enforced, and applied evenly to all members in society.
In the economic context, this facilitates contracts and allows for trade, without which an economy will struggle to grow.
Free and competitive markets allow for resources to be used in ways that enhance growth and well being. Governments often impede markets in a variety of ways:
Ultimately, what is preventing growth in less developed countries? Institutions that generate bad incentives.
Where do institutions come from?