GDP and Inflation

Objectives of this Chapter We start this chapter by defining gross domestic product, GDP. GDP is the most useful and important summary statistic describing aggregate domestic production. We explain the conceptual difference between nominal and real GDP and then document the historical behavior of both the nominal and real GDP data. We explain how the growth rate of real GDP is computed and then explain why, under certain conditions, growth in real GDP reflects aggregate changes to well-being. Next, we show that GDP can be viewed as the sum of four components relating to spending by households, firms, and the government. These four components are consumption, investment, government, and net exports. The description of GDP as the sum of these four components is commonly called the “the expenditure method” for computing GDP. We explain why disaggregating GDP into these particular components is useful, and discuss specific patterns in the historical data related to each component. Next, we note that the rules of accounting imply that aggregate expenditures equal aggregate income. For this reason, GDP can also be measured as the sum of income accruing to all sources. This method of computing GDP is commonly referred to as the “income method.” We divide aggregate income earned by all sources into income earned by capital and income earned by labor. We show that the shares of aggregate income earned by capital and labor have been roughly constant over history. In the final part of the chapter, we define inflation – the rate of change of the price level – and show the historical data on consumer-price inflation in the United States.