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Understanding the Shortcomings of GDP: Limitations and Economic Implications

This chapter explores the key limitations of Gross Domestic Product (GDP) as an economic indicator. It highlights five major issues, including the exclusion of nonmarket activities like household work, the challenge of improving product quality over time, and the existence of the underground economy. The chapter also addresses how GDP growth doesn't necessarily lead to an increase in disposable income and the impacts of inflation and deflation on nominal and real GDP. By examining the GDP price index and its implications, we better understand the complexities of measuring economic well-being.

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Understanding the Shortcomings of GDP: Limitations and Economic Implications

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  1. Macro Chapter 6 Presentation 3

  2. Shortcomings of GDP • 1. Nonmarket Activities Excluded- ex. The work of a housewife or a carpenter fixing his own home • 2. Improved Product Quality- a $200 cell phone now is much better than one from 2000 • 3. Underground Economy- illegal and off the books activities such as gambling and under the table work • 4. No accounting for the negative pollution caused by work • 5. Raising GDP does not necessarily improve a country

  3. Disposable Income • Personal income minus taxes (state, local, federal income tax, property tax, and inheritance tax)--- Save or Spend what’s left

  4. Change in Prices • Inflation- a rise in the general level of prices in an economy • Deflation- a decline in the economy’s price level

  5. Nominal GDP • The GDP measured using the price of the goods purchased • = the sum of: # of units Sold x Price • Not adjusted for inflation

  6. Real GDP • Adjusted for inflation • Inflated (when prices fall) or deflated (when prices rise) to show changes in price level • Ex- a hamburger in 1970 sold for $.50 now may sell for $4.00- this is the same amount of output at a higher $$ (deflate this to compare with 1970)

  7. GDP Price Index (GDP Deflator) • A measure of the price of a specific collection of goods and services, called a “market basket,” in a given year as compared to the price of an identical or very similar basket in a reference year • The reference year is known as the “base year”

  8. GDP Price Index Contd. • Price index in a given year = (price of market basket in specific year/ price of same basket in base year) x100

  9. Example of Price Index • A pizza costs $10 in year 1, the base year. In year 2 the price goes to $20. • Price Index = ??? • PI = 20/10 x 100 = 200 • Rate of change = (new – old)/old x 100 • = ((200-100)/100) x 100 • That is, the price rose by 100%, since the base year price index always = 100

  10. Finding Real GDP • Real GDP = nominal GDP/price index (in hundredths)

  11. Alternative Method • Price index (in hundredths) = nominal GDP/Real GDP ***manipulation of the previous formula

  12. GDP Index Example • Year Units $ Nominal Real Price In. • 1 5 10 $50 $50 100 • 2 7 20 $140 $70 200 • 3 8 25 $200 $80 250 • 4 10 30 ____ ____ ____ • 5 11 28 ____ ____ ____

  13. Answers- Year 4 • Nominal GDP = $30 x 10 units = 300 • Price index = price of market basket/basket price base year x 100 = 30/10 x 100= 300 • Real GDP = nominal GDP/ price index (hund.) = 300/3.00 = $100

  14. Year 5 • Nominal GDP = 11 units x $28 = $308 • Price index = (basket price given yr./price of basket in base year) x 100 • = 28/10 x 100 = 280 • Real GDP = Nominal GDP/price index (hund.) = 308/2.80 = $110

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