Growth and national income accounts
# 4
4 October 2016
Measuring growth,
measuring development
Since October 1947 the standard measure of growth has been GDP (per capita)
In the wake of the Keynesian revolution But GDP is a relatively rough indicator of
very complex phenomena
Human Development Index (HDI)
Since 1990 UNs introduced HDI [Sen] to measure development as the result of capabilities and choices
Aggregate output/income
National income and product accounts
measure the aggregate output, or
income (aggregate means total): GDP and were introduced in the mid-1940s
after major contributions by Simon Kuznets and Richard Stone in the 1930s
time (historical) series prior to 1947 have been retrospectively estimated
GDP: production and income
The measure of aggregate output is called the gross domestic product (GDP),
referring to the product within a nation regardless of the producer’s nationality whilst the gross national product (GNP) is
defined as the product made by residents even outside the country
GDP and GNP tend to be by and large
similar, with exceptions when large sums are invested abroad (Norway, Kuwait)
The construction of GDP
To understand how GDP is constructed we can use a simple example, a very
simplified two-firm economy, as a way to define it and calculate it
Steel Company (Firm 1) Revenues from sales $100 Expenses $ 80
Wages $80
Profit $ 20
Car Company (Firm 2) Revenues from sales $200 Expenses $170
Wages $70
Profit $ 30
How to calculate GDP in our two- firm economy?
Would you define aggregate output as the sum of the values of all the goods
produced?
steel ($100) plus car ($200)? So $300?
Or would you define aggregate output as the value of cars (the final goods),
equal to $200?
The right answer is $200. Why?
Because steel is an intermediate good
Avoid double counting!
An intermediate good like steel goes into the production of the final good (cars)
$300 would imply a double counting!
steel + cars would entail counting more than once the same good or value
Hence, the first definition of GDP:
GDP is the value of the final goods and services produced in the economy
during a given period (usually, one year) It would be confirmed in case of a merger
The value added approach to GDP
The value added means exactly what a firm actually does:
the value added by a firm is defined as the value of its production minus the value of intermediate goods
That’s a second way of thinking about GDP (and constructing it):
GDP is the sum of value added in the
economy during a given period
From the production side to the income side
May one think of GDP from a different perspective? Is it just production?
Or may one look at it even from the income side?
actually, wages and profits are paid for getting their own income
Revenues going to pay workers and capital are specific components of GDP, called labour income and profit income
Calculating GDP as income
In our two-firm economy as a whole labour income is equal to $150 ($80 + $70) and capital income (profits) is equal to $50 ($20 + $30)
Steel Company (Firm 1) Revenues from sales $100 Expenses $ 80
Wages $80
Profit $ 20
Car Company (Firm 2) Revenues from sales $200 Expenses $170
Wages $70
Profit $ 30
A third definition of GDP (and its composition)
GDP is the sum of incomes in the economy during a given period
And who has got the larger slice of the cake? Capital or labour?
In our example labour gets 75% and capital 20%: is it realistic?
The composition of GDP in the USA, 1966 and 2006
1960 2006
Labour income 66% 64%
Capital income 26% 29%
Indirect taxes 8% 7%
US labour income: a sharp decline in
the last decades, 1947-2011
Nominal and real GDP
U.S. GDP was worth $17,419 billion in
2014 compared to $526 billion in 1960, but was US output really 13.11 times higher?
Much of the increase reflects an increase in prices rather than in quantities
This leads to the distinction between nominal and real GDP as prices are
monetary values susceptible to inflation or deflation (money/goods and services)
Why do we need real values?
Nominal GDP is the sum of final goods and services at current prices, not constant
Thus, GDP increases over time depend on two simple facts:
the production of most goods increases over time
the prices of most goods also increase over time
To measure and compare output over time we must eliminate the effect of prices
How to construct the real GDP?
The real GDP is the sum of the quantities of goods and services multiplied by constant prices, not current
Problems in practice: there is more than one good (cars), differences in qualities and
technological progress (hedonic pricing)
Quantities of cars
Prices of cars Nominal GDP Real GDP in 2000 dollars
1999 10 $20,000 $200,000 $240,000
2000 12 $24,000 $288,000 $288,000
2001 13 $26,000 $338,000 $312,000
Comparing the US GDP over time adjusted for inflation, 1960-1997
By construction, nominal GDP is equal to real GDP ($1993) US national
accounts are constructed in chained prices in order to
overcome problems of relative prices and their
weight
The real GDP allows to catch long-
run and cyclical phenomena
GDP per capita
One must be careful when comparing countries different in size and population
One has to calculate the ratio of real GDP to the population in order to get real
comparisons – GDP per capita
China GDP is $10,354.80 billion (2014), compared to Switzerland, $685,4 billion (2013): more than 15 times
But China GDP per capita is $6.807 (2013) whilst Switzerland GDP per capita is $84.815 (2013), that is Swiss are 12.45 times richer than Chinese!
May we get a better measure of differences by countries?
How to avoid exchange rate variations (volatility) and even distortions?
Cassel [1918] elaborated a method to compare per capita income in different countries:
The Purchasing Power Parity (PPP)
to estimate what the exchange rate between two
currencies would have to be if the currencies were at par with the respective purchasing power
Another way to have a purchasing power adjustment is the Geary-Khamis dollar (the "international dollar") [1970, 1972]
The Big Mac Index (The Economist)
GDP: level versus growth rate
GDP growth is constructed as follows (Yt – Yt-1)/Yt-1
where Y is GDP and t is the year to which real GDP is referred to
Can we infer longer term trends?
US real GDP growth rate, 1940-2014
An alternative indicator:
Human Development Index
HDI is a composite index relating longevity (population), education (skills) and
output/income as a form of material wellbeing (
The average of three indicators:
life expectancy at birth
education (now MYS mean years of schooling + EYS expected years of schooling)
income per capita
Taking inequality into account
Inequality-adjusted Human Development Index (I-HDI) is a more recent indicator (2010) introduced to take into account inequality
as inequality could limit the growth potential negatively affecting capabilities and skills, as well as longevity within certain groups criticisms: an egalitarian bias?
In fact, HDI estimates suggest that has a predictive value of future growth
Human Development Index (1870-1991)
1870 1913 1950 1973 1991
Italy 0,288 0,453 0,656 0,794 0,861
United Kingdom
0,493 0,637 0,757 0,822 0,864
Germany 0,450 0,601 0,734 0,819 0,873
France 0,456 0,599 0,720 0,824 0,880
Holland 0,475 0,639 0,774 0,841 0,874
Sweden 0,474 0,633 0,771 0,845 0,876
Spain 0,289 0,409 0,616 0,786 0,866
Japan 0,236 0,452 0,663 0,825 0,892
USA 0,499 0,873 0,795 0,854 0,897
The facts of growth:
capital formation and technology
# 5
5 October 2016
Growth: an overview
Looking at output levels and growth rate in the last decades one can yield two main conclusions:
there has been a large increase in output per capita there has been convergence of output per person
across countries
Yearly growth output rate pc
Real output per person (US2000 dollars)
1950-2004 1950 2004 2004/1950
France 3.3 5,920 26,186 4.4
Japan 4.6 2,187 24,661 11.2
UK 2.7 8,091 26,762 3.3
USA 2.6 11,233 36,098 3.2
Average 3.5 6,875 28,422 3.9
Convergence: what is it?
Convergence means getting closer,
reducing differences in level of output by growing faster, catching up with the gap between the richer and the poorer
the force of compounding: a small difference becomes a significant amount over time
The post-war convergence between the four-country sample is not specific, it extends to a larger set of countries (OECD, 1948)
OECD countries (the club of winners):
the output convergence, 1950-1992
Convergence: a general rule?
A large set of countries steadily
converged after 1950 catching up with the richest (USA) as a result of an
asymmetrical variation in growth rates But is enough to take it as a general rule?
to be accepted in the club success is a prerequisite
hence, a huge bias: actually, the sample is a biased selection of “economic winners”!
The world economies, 1960-1992
Does every country converge?
By constructing a larger sample of economies (almost all the economies) convergence
does not appear the general rule, although is not a solely OECD phenomenon:
Which regional areas converged or are still converging?
Europe as a whole
North and South America, with exceptions Asia (four tigers)
But it is not the rule for African countries
OECD countries, Africa and Asia
How can we explain growth?
A starting model could be Solow’s based on the aggregate production function [Cobb-Douglas, 1928]
Y = F/(K,N)
where inputs are K (aggregate capital stock) and N (aggregate employment)
The actual output depends on the state of technology given a certain amount of factors K and N (proximate causes)
What does define technology?
Two definitions of the state of technology:
a narrow one: the range of products and the techniques available to produce them
a broader one: the first definition + the way the economy is organised from firms’
organisation to legal and political systems
Let’ start with the former one
How does the aggregate production function work?
Increasing quantities of inputs (both K and N) produce positive effects on aggregate output according to constant returns to scale (no
scale effects!)
Yet, if just one input increases
additional quantities of inputs will lead to a smaller and smaller
increase in output:
decreasing returns to capital/labour Hence, the upward-sloping curve,
but a change in the state of technology can modify the aggregate production function
F(K/N)1
Technology and the aggregate
production function
Capital accumulation or technological
progress? The US evidence
The sources of growth
Thus, growth comes from capital accumulation (K/N) and technological progress (innovation) But capital accumulation in itself does not sustain
growth in the long term (that’s why there is an upward slopping curve!)
Hence, (higher) saving rates cannot contribute but partially and temporarily
In the long term growth depends on technological progress, but what exactly produces
innovation? What is the ultimate cause?
The ultimate causes of economic growth:
models and evidence
# 6
6 October 2016
Institutions: a definition
Technology is the proximate cause of growth.
But what - the ultimate cause - does make a country more innovative than others?
The idea that institutions could shape
economic behaviour and choice is a long lasting one (since Locke and Smith)
Institutions: the “rules of the game”, explicit and implicit/tacit rules within an
economy/society [North, 1990]
Institutions are a set/structure of incentives
A competing explanation
Institutions matter for economic growth because they shape the incentives of key actors
[Acemoglu, Johnson, Robinson, 2005]
in particular, they influence investments in physical and human capital (K + H), in technology and the organisation of production
Other competing factors:
Geography [Montesquieu, 1748; Marshall, 1890;
Sachs, 2001]
Culture [Weber, 1905; Huntington, 1993 and 1996]
Chance and Randomness [Wrigley, 1988]
A dynamic perspective
The economic institutions affect not only the current aggregate economic growth
potential of the economy, but also
determine future outcomes by influencing the distribution of resources
wealth, capital, human capital
They determine the size of the economy and the income distribution amongst groups
and individuals, now and in the future
Proximate and ultimate causes of prosperity
If technology and capital accumulation (both K and H) are proximate causes of wealth, that is productivity, yet they are not necessarily the fundamental causes of prosperity for societies
Three hypotheses compete for explaining why some countries are richer than others and why some countries might remain poor
The geography hypothesis
This approach claims that differences in
geography, climate and ecology ultimately determine the large differences in wealth across the world
Such circumstances are out of their control and such conditions make it impossible or unlikely to accumulate or effectively use the factors of production
The climate [Montesquieu, 1748; Marshall, 1890]
or disease (malaria, dengue fever) in tropical areas [Sachs, 2001] affect human capital
How to escape
from the “geography trap”?
A great geographical divide:
temperate zones vs tropical zones
These countries are permanently
disadvantaged and they should not be expected to catch up with the rest of the world
although some large-scale investments in transport technology and disease eradication may, at least, partially redress such disadvantages
But was Montesquieu right?
The culture hypothesis
Societies are different because they
respond differently because of specific shared experiences, different values, cultural and religious beliefs, family ties and tacit social norms
some societies encourage hard work,
saving and investment, adoption of new technologies
whilst other nurture superstition and mistrust technologies
Weber and Huntington
Max Weber recognised in Protestantism the ultimate cause of the European
industrialisation as it encouraged hard work (education), thrift and investment
i.e., a market economy and economic growth a variant: Anglo-Saxon culture vs Iberian
culture
Samuel Huntington contrasts the West and the Islamic world (the “clash of
civilisations”) or North and South Korea
Summing up
To measure economic growth we need an adequate indicator
GDP, GDP per capita, etc.
To understand the relationship between inputs and output we use the aggregate production function (productivity
depends on K/N + technology)
But technology is just the proximate cause…
