Introduction to GDP | CFA Level I Economics

PREREQUISITE LESSON

This lesson is a prerequisite for the course. While you won’t be directly tested on its content in the exam, it’s assumed you’ve gained this knowledge or skill during your university studies. We strongly recommend reviewing this lesson, as its content may be essential for understanding subsequent parts of the curriculum.

In this lesson, we’ll dive into macroeconomics, focusing on aggregate output, prices, and economic growth. We’ll learn about GDP, its different approaches to calculation, and the difference between nominal GDP and real GDP. Finally, we’ll see how the GDP deflator defines the relationship between nominal and real GDP. So, let’s dive right in!

Understanding Aggregate Output, Income, and Expenditure

Imagine a simple, isolated economy with households and companies. Households supply factors of production like labor and capital to companies in exchange for wages and profit (income). Companies use these inputs to produce goods and services, which households pay for using their income (expenditure).

Aggregate output is the value of all goods and services produced in a specified time period. Aggregate income is the value of all payments earned by the suppliers of factors used in production. Since the output value must accrue to the factors of production, aggregate output and aggregate income must be equal.

Aggregate expenditure is the total amount spent on goods and services produced in the economy during the period. Assuming an isolated economy, aggregate expenditure must equal aggregate output and aggregate income. These three concepts – aggregate output, income, and expenditure – represent different aspects of the same quantity: gross domestic product (GDP).

GDP: Definition and Approaches

GDP is the total market value of goods and services produced in an economy within a specific time period. Two common approaches to calculating GDP are the expenditure approach and the income approach. Both approaches should produce the same result, but measurement issues may cause differences in practice.

Criteria for Measuring GDP Consistently

To ensure consistent GDP measurement over time and across countries, three broad criteria are used:

1. Goods and services included must be produced during the measurement period.
2. The value of goods and services must be determined by being sold in the market.
3. When using the expenditure approach, only the market value of final goods and services should be included.

Nominal GDP vs Real GDP

Nominal GDP is the sum of current prices multiplied by the quantity produced for each good in the economy. However, growth in nominal GDP includes the effect of price increases, making it less representative of actual production growth. Economists prefer to analyze the real GDP growth rate, which strips away inflation effects.

Let’s consider the case of Tinyland (hypothetical):

In 2016, Tinyland’s nominal GDP is $396, and in 2017, it’s $500, resulting in a 26% GDP growth. However, this growth rate includes the effect of price increases.

To find the real GDP growth, we’ll use 2016 as the base year and calculate the real GDP for 2017 using 2016 prices. This results in a real GDP of $430 for 2017. The real GDP growth for 2017 is actually 8.6%, as the effect of price increase has been removed, reflecting the actual increase in production for 2017.

Real GDP is calculated relative to a base year, using base-year prices and current-year output quantities. Per-capita real GDP is real GDP divided by population and is often used to measure a country’s residents’ economic well-being.

GDP Deflator

The GDP deflator is a price index used to convert nominal GDP into real GDP. It can be calculated using the formula:

GDP Deflator = Nominal GDP/Real GDP × 100

For Tinyland, the GDP deflator for 2017 is 500/430 x 100 = 116.3.

Wrapping Up

And that’s it for our introductory lesson on GDP! We’ve covered the basics of aggregate output, income, expenditure, and the calculation of GDP using expenditure and income approaches. We’ve also looked at the differences between nominal and real GDP and the role of the GDP deflator. In the next lesson, we’ll dive deeper into the various components of GDP.