Ch. 9 - “Sizing Up The Economy Using GDP” Study Guide
The Circular Flow
● Illustrates how money, resources, and goods move through the economy between businesses and households.
○ Households provide businesses with resources (like labor) and receive income in return. They then use this
income to purchase goods and services from businesses, creating a continuous flow of money and goods.
● Every resource flow is matched by an equal and opposite money flow, ensuring that all spending in the economy
ultimately becomes someone else’s income.
Gross Domestic Product (GDP)
● GDP: The market value of all final goods and services produced within a country in a year.
○ What’s Excluded?
■ Intermediate goods (their value is already included in the final price).
■ Resale of goods (already counted in previous GDP calculations).
● GDP per capita: GDP divided by population, allows for comparison between countries.
Three Ways to Measure GDP
● Total Spending
○ GDP = Consumption + Investment + Government Purchases + (Exports - Imports)
■ Consumption: Household spending on final goods and services.
● Durable goods: Products that last for an extended period of time and provide utility over their lifespan.
■ Investment: Business purchases of new capital that increases the economy’s productive capacity (e.g., factories,
equipment, research, newly built homes, etc.)
● Focuses on physical capital, not financial investments (e.g, bonds, stocks).
■ Government Purchases: Government spending on goods and services (e.g, schools, military, salaries, etc.)
● Excludes transfer payments (e.g, Social Security, unemployment benefits) since they reflect a transfer of
money between people rather than new production.
○ Transfer payments are most commonly provided by the government and don’t expect anything
in return.
■ Exports are included in GDP, but imports are not.
● Imports neither add nor subtract from GDP because they are subtracted from exports but added into other
categories.
● Total Output
○ GDP is the sum of value added at each stage of production.
■ Value added = Total sales - Intermediate costs (or input costs)
● Total Income
○ GDP is the total income in the economy, which includes:
■ Total wages paid to workers.
■ Total profits earned by businesses.
■ Capital gains and losses are excluded because they involve asset resale, not new productive income.
■ “Every dollar spent is a dollar earned for someone else”.
Limitations of GDP
● GDP measures prices, not values (Diamond/Water Paradox: Essential goods like water may have low prices but high
value).
● Excludes non-market activities, such as household production.
● The shadow economy (unreported transactions, like informal labor or black-market activity) is not counted.
● Environmental costs are ignored (e.g, pollution-related destruction can still count as “production”).
● Leisure is not accounted for, even though it increases well-being.
● GDP doesn’t measure distribution, only the average output per person, which may not reflect economic inequality.
Real and Nominal GDP
● Nominal GDP: Measured in today’s prices (not adjusted for inflation, making comparisons over time unreliable).
● Real GDP: Adjusted for inflation using constant prices (isolates actual changes in quantity produced)
○ Calculation: Use average prices or a base year to adjust for inflation.
Trick: % Change in Nominal GDP ∼ % Change in Real GDP + % Change in Prices
Rule of 70: Divide 70 by the annual growth rate to approximately get the number of years until the original amount doubles.
, Ch. 10 - “Economic Growth” Study Guide
Production Function
● Production function: How inputs are transformed into output, showing the production possible with existing resources.
○ The aggregate production function links GDP to labor, human capital, and physical capital
■ Human capital: The skills and knowledge workers bring to the job
■ Physical capital: Tools, machinery, and structures used in production
Ingredient 1: Labor and Total Hours Worked
● Population: A larger population boosts total GDP, but not GDP per person as it is spread over more people.
● Working Age: An unfavorable dependency ratio (proportion of people too young/old to work) slows economic growth.
● Who Chooses to Work: The share of people that chooses to work directly affects GDP.
● How Many Hours Worked: More hours worked can raise GDP, but can also reduce well-being and quality of life.
Ingredient 2: Human Capital
● Labor productivity: Amount of goods and services produced per person per hour of work (depends on human capital)
● Education is the primary drive of labor productivity (expanding higher education will expand human capital.
○ Primary education develops literacy, while secondary education promotes productivity across various jobs.
Ingredient 3: Capital Accumulation
● Capital stock: The total amount of physical capital available for production.
● Investment in capital depends on the saving rate, as capital is built from resources saved rather than consumed.
● Foreign investment builds capital stock (e.g., foreign companies operating in US provide machinery and infrastructure).
Analyzing the Production Function
● Insight 1: Constant returns to scale means doubling inputs will double output.
○ Constant returns to scale: Increasing ALL inputs by some proportion will cause output to rise by the same proportion
■ Supported by the replication argument (if production is doubled, output should double).
● Insight 2: There are diminishing returns to capital.
○ Law of Diminishing Returns: When ONE input is fixed, increases in the other input will begin to yield small and smaller
increases in output (increasing but at a decreasing rate).
● Insight 3: Poor countries can enjoy catch-up growth.
○ Catch-up growth: Poor countries start lower on production function curve and grow faster by investing in physical capital.
Capital Accumulation and the Solow Model
● Insight 1: The capital stock will grow as long as investment outpaces depreciation.
○ Depreciation: The decline in capital due to wear and tear
● Insight 2: Capital per worker will eventually stop growing when investment equals depreciation (aka “steady state”).
● Insight 3: Capital accumulation can’t sustain economic growth (due to rising depreciation and diminishing returns).
○ Ultimately, it is technological progress that sustains economic growth.
Technological Progress
● Technological progress: New methods that increase efficiency and productivity using existing resources
○ New ideas can drive unlimited growth because:
■ Ideas can be freely shared.
■ Ideas do not depreciate over time (no need for ongoing investment to keep using an idea).
■ Ideas often promote other ideas.
○ Driven by the speed at which ideas are created and how many resources are devoted to creating new ideas.
Public Policy: Why Institutions Matter For Growth
● Property rights: Control over a tangible or intangible resource
○ Clear property rights incentivize investment and innovation by ensuring individuals can benefit from their efforts.
● Government Stability
○ Political instability discourages investment and innovation.
● Efficiency of Regulation
○ Excessive regulation hinders economic growth (6 days to open business in the US and 230 in Venezuela).
● Government Policy to Encourage Innovation
○ Increase MB: Protecting intellectual property (patents, trademarks, copyrights, etc.) ensures innovators benefit from work.
○ Decrease MC: Subsidizing research and development lowers the cost of innovation.
The Circular Flow
● Illustrates how money, resources, and goods move through the economy between businesses and households.
○ Households provide businesses with resources (like labor) and receive income in return. They then use this
income to purchase goods and services from businesses, creating a continuous flow of money and goods.
● Every resource flow is matched by an equal and opposite money flow, ensuring that all spending in the economy
ultimately becomes someone else’s income.
Gross Domestic Product (GDP)
● GDP: The market value of all final goods and services produced within a country in a year.
○ What’s Excluded?
■ Intermediate goods (their value is already included in the final price).
■ Resale of goods (already counted in previous GDP calculations).
● GDP per capita: GDP divided by population, allows for comparison between countries.
Three Ways to Measure GDP
● Total Spending
○ GDP = Consumption + Investment + Government Purchases + (Exports - Imports)
■ Consumption: Household spending on final goods and services.
● Durable goods: Products that last for an extended period of time and provide utility over their lifespan.
■ Investment: Business purchases of new capital that increases the economy’s productive capacity (e.g., factories,
equipment, research, newly built homes, etc.)
● Focuses on physical capital, not financial investments (e.g, bonds, stocks).
■ Government Purchases: Government spending on goods and services (e.g, schools, military, salaries, etc.)
● Excludes transfer payments (e.g, Social Security, unemployment benefits) since they reflect a transfer of
money between people rather than new production.
○ Transfer payments are most commonly provided by the government and don’t expect anything
in return.
■ Exports are included in GDP, but imports are not.
● Imports neither add nor subtract from GDP because they are subtracted from exports but added into other
categories.
● Total Output
○ GDP is the sum of value added at each stage of production.
■ Value added = Total sales - Intermediate costs (or input costs)
● Total Income
○ GDP is the total income in the economy, which includes:
■ Total wages paid to workers.
■ Total profits earned by businesses.
■ Capital gains and losses are excluded because they involve asset resale, not new productive income.
■ “Every dollar spent is a dollar earned for someone else”.
Limitations of GDP
● GDP measures prices, not values (Diamond/Water Paradox: Essential goods like water may have low prices but high
value).
● Excludes non-market activities, such as household production.
● The shadow economy (unreported transactions, like informal labor or black-market activity) is not counted.
● Environmental costs are ignored (e.g, pollution-related destruction can still count as “production”).
● Leisure is not accounted for, even though it increases well-being.
● GDP doesn’t measure distribution, only the average output per person, which may not reflect economic inequality.
Real and Nominal GDP
● Nominal GDP: Measured in today’s prices (not adjusted for inflation, making comparisons over time unreliable).
● Real GDP: Adjusted for inflation using constant prices (isolates actual changes in quantity produced)
○ Calculation: Use average prices or a base year to adjust for inflation.
Trick: % Change in Nominal GDP ∼ % Change in Real GDP + % Change in Prices
Rule of 70: Divide 70 by the annual growth rate to approximately get the number of years until the original amount doubles.
, Ch. 10 - “Economic Growth” Study Guide
Production Function
● Production function: How inputs are transformed into output, showing the production possible with existing resources.
○ The aggregate production function links GDP to labor, human capital, and physical capital
■ Human capital: The skills and knowledge workers bring to the job
■ Physical capital: Tools, machinery, and structures used in production
Ingredient 1: Labor and Total Hours Worked
● Population: A larger population boosts total GDP, but not GDP per person as it is spread over more people.
● Working Age: An unfavorable dependency ratio (proportion of people too young/old to work) slows economic growth.
● Who Chooses to Work: The share of people that chooses to work directly affects GDP.
● How Many Hours Worked: More hours worked can raise GDP, but can also reduce well-being and quality of life.
Ingredient 2: Human Capital
● Labor productivity: Amount of goods and services produced per person per hour of work (depends on human capital)
● Education is the primary drive of labor productivity (expanding higher education will expand human capital.
○ Primary education develops literacy, while secondary education promotes productivity across various jobs.
Ingredient 3: Capital Accumulation
● Capital stock: The total amount of physical capital available for production.
● Investment in capital depends on the saving rate, as capital is built from resources saved rather than consumed.
● Foreign investment builds capital stock (e.g., foreign companies operating in US provide machinery and infrastructure).
Analyzing the Production Function
● Insight 1: Constant returns to scale means doubling inputs will double output.
○ Constant returns to scale: Increasing ALL inputs by some proportion will cause output to rise by the same proportion
■ Supported by the replication argument (if production is doubled, output should double).
● Insight 2: There are diminishing returns to capital.
○ Law of Diminishing Returns: When ONE input is fixed, increases in the other input will begin to yield small and smaller
increases in output (increasing but at a decreasing rate).
● Insight 3: Poor countries can enjoy catch-up growth.
○ Catch-up growth: Poor countries start lower on production function curve and grow faster by investing in physical capital.
Capital Accumulation and the Solow Model
● Insight 1: The capital stock will grow as long as investment outpaces depreciation.
○ Depreciation: The decline in capital due to wear and tear
● Insight 2: Capital per worker will eventually stop growing when investment equals depreciation (aka “steady state”).
● Insight 3: Capital accumulation can’t sustain economic growth (due to rising depreciation and diminishing returns).
○ Ultimately, it is technological progress that sustains economic growth.
Technological Progress
● Technological progress: New methods that increase efficiency and productivity using existing resources
○ New ideas can drive unlimited growth because:
■ Ideas can be freely shared.
■ Ideas do not depreciate over time (no need for ongoing investment to keep using an idea).
■ Ideas often promote other ideas.
○ Driven by the speed at which ideas are created and how many resources are devoted to creating new ideas.
Public Policy: Why Institutions Matter For Growth
● Property rights: Control over a tangible or intangible resource
○ Clear property rights incentivize investment and innovation by ensuring individuals can benefit from their efforts.
● Government Stability
○ Political instability discourages investment and innovation.
● Efficiency of Regulation
○ Excessive regulation hinders economic growth (6 days to open business in the US and 230 in Venezuela).
● Government Policy to Encourage Innovation
○ Increase MB: Protecting intellectual property (patents, trademarks, copyrights, etc.) ensures innovators benefit from work.
○ Decrease MC: Subsidizing research and development lowers the cost of innovation.
