Macroeconomics for Non-Finance People Part 2: GDP Basics

So far we’ve focused our study of macroeconomics on firms. Now let’s take a further step back and look at the economy as a whole. To begin with, let’s start with GDP, a term you’ll be hearing a lot when you read about macroeconomics. GDP stands for Gross Domestic Product, and is the measure of a country’s goods and services in terms of dollars (or euro, or yen, etc.). It is a key statistic economists use to gauge the health of an economy.

The basic idea is that the higher a country’s GDP, the more goods and services it produces and consumes. GDP is thus often used as an indicator of a population’s standard of living. Whether or not it accurately reflects a population’s actual material well-being, however, is a matter of opinion. Nevertheless, it is a good indicator of productivity, in my view, and it is needed to understand other concepts in macroeconomics.

Ilusion Concept Sketch: Mall Development in Allegro Central Business District (watercolor and graphite)

Ilusion Concept Sketch: Mall Development in Allegro Central Business District (watercolor and graphite)

When we talk about GDP, Several important concepts from microeconomics play an important role. For example, the concepts of supply meeting demand and time frames also apply to GDP.

When GDP supply meets demand, we say that it is in equilibrium. However, how GDP supply meets demand is very different between the short run and the long run. Why is that?

Before we take a look at GDP equilibrium in the short- and long-run, we need to look at some key factors that influence GDP supply and demand:

Unemployment – There are three types employment:

  1. Frictional Unemployment – The least problematic type of unemployment, since it exists even when an economy is doing well. Frictional unemployment is the normal phenomenon of people entering or leaving the work force.
  2. Cyclical Unemployment – This type of unemployment increases and decreases with the business cycle. It’s lower during an economic expansion and higher during a recession.
  3. Structural Unemployment – Think skills. If country A can produce a good cheaper and/or better than country B, workers in country B will be unemployed until they retrain and gain skills for other industries. Not only can international competition lead to structural unemployment; technology can as well. For example, better machines that put factory workers out of work. Structural employment can last for long periods of time.

An economy is considered at full employment when there is no cyclical unemployment (frictional and structural unemployment still exist). The unemployment rate at full employment is known as the natural unemployment rate.

Potential GDP – GDP reaches potential GDP when unemployment is at the natural rate, or, alternately at full employment.

Wage rate – The quantity of goods and services an hour’s worth of work can buy. This is denominated in currencies (ie, dollars).

Now, let’s get back to GDP:

The supply of GDP is the amount that firms plans to produce. It changes when potential GDP grows. Potential GDP grows because of three factors:

  1. Quantity of labor increases
  2. Quantity of capital increases (in this case capital means the assets of a firm, such as factory plants, but also includes human capital, ie skills)
  3. Advances in technology

Potential GDP growth is effectively economic growth, since a greater quantity of goods and services can be produced at full employment.

The demand for GDP is:

Consumption + Investment + Government Expenditure + Exports – Imports.

What this equation yields is the total amount of goods and services households, firms, governments, and foreigners plan to buy. It changes due to

  1. Change in expectations – of future income, inflation, and profits
  2. Fiscal policy
  3. Monetary policy
  4. Changes in the exchange rate

…Fiscal policy? Monetary policy? We’ll get to these concepts in future posts. Meanwhile, back to GDP!

In the short run equilibrium for GDP, the wage rate does not change. This is because wages are “sticky”, meaning that they change slowly in response to changes in the economy. For example, few people would voluntarily take a pay cut in times of recession. Because wage rates change slowly, firms have to either increase or cut production of their products to meet demand, which changes for the reasons I outlined above. This phenomenon over the short term creates the business cycle, where GDP is either below or above potential GDP, implying employment levels that are below or above full employment, respectively.

In the long run equilibrium for GDP, potential GDP equals actual GDP, as firms are able to change the wage rate. This is because as an economy expands/contracts, firms increase/decrease the price of their products. When wages remain unchanged in an expansion, workers demand higher wages (or they leave the firm), so firms increase wages. In a contraction, the wages firms pay are expensive relative to the price of their product, so they lower wages.

And that’s it for GDP basics. In our next post, we’ll go over some of the terms I mentioned during this article – fiscal policy, monetary policy, and inflation. See you there!

Ramon Rodrigo Cuenca, CFA
Equities Analyst

Sources: CFA Program Curriculum Level I, 2009, volume 2: Economics, pp. 294, 300-302, 316-317, 321, 323, 328-331, 333-334, Investopedia GDP definition

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