Description                                  
In this presentation, the narrator examines the significance of the gross domestic product and the different ways in which GDP can be measured. 

Narrator: 
Why is the gross domestic product such an important measure of economic performance? And, how is GDP data useful to the government in determining fiscal policy? 

Narrator: 
The GDP is important because it is the broadest measurement available for evaluating the performance of the overall economy. It measures a country's total production of final goods and services in a given time period... usually a year. But, there is more than one way to measure the GDP and it's important to understand the assumptions and terminology associated with each method. 

Narrator: 
One way of measuring the GDP is the expenditure approach... calculating the aggregate expenditure in the economy by summing household consumption, investment spending, government purchases and net exports.  

Narrator: 
Another way of measuring the GDP is the income approach... summing up all wages, rent, interest and profits that arise from production. 

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Since every dollar of expenditure is received by someone as income, GDP and aggregate income are essentially the same thing. In other words, GDP equals aggregate income, which in turn equals aggregate expenditure. 

Narrator: 
Now that we know the basis for calculating GDP, we need to take a closer look at how to account for changing price levels in the economy. 

Narrator: 
We are all familiar with the term inflation. Inflation describes an increase in the overall price level. The price level is a composite measure that reflects the average price of all goods and services produced in the economy. To accurately compare gross domestic product from year to year, we need to account for changes in the price level. This is most commonly estimated using the consumer price index, which measures changes over time in the price of a fixed collection of goods typically purchased by the average American family. 

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To illustrate the basic notions of calculating a price index, let's say that a typical year's worth of shopping by the average American family includes 50 gallons of milk, 100 loaves of bread and twelve months of cable television. 

Narrator: 
To see how the consumer price index is calculated, consider the total cost of these goods and services each year over a three-year period. We arbitrarily assign 1995 to be the base year... when a year's worth of these goods and services cost $600. The base year is given an index of 100 to represent 100% of the base year price. 

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The index for 1996 and 1997 is computed by dividing the current year's price by the base year's price then multiplying by 100. Carrying out the calculation yields an index of 105 for 1996 and 115 for 1997. 

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The federal government actually includes about 400 items in its consumer price index calculation. This chart shows how the CPI has changed over the last four years. 

Narrator: 
Data for gross domestic product can be misleading unless we account for changes in the price level across time. For example, the 1994 GDP in current dollars was $6,936 billion. This is nominal GDP or GDP expressed in current purchasing power.  

Narrator: 
By contrast, real GDP is computed from nominal GDP after allowing for inflation. This is done by expressing GDP in terms of a base year's dollars, in this case, 1992. From the chart, we can see how nominal and real GDP have increased since 1991. 

Narrator: 
Rather than using the consumer price index to account for inflation, economists use a broader measure called the GDP deflater. Unlike the CPI, which measures price for only the household sector, the GDP deflater measures prices for all sectors of the economy. Dividing the nominal GDP by the real GDP gives us the GDP deflater. The GDP deflater for 1994 tells us that the price level in 1994 was 5% higher than the price level in the base year, 1992. 

Narrator: 
A figure that is often compared to real GDP is potential GDP. Potential GDP is the value of aggregate income or aggregate expenditure when the nation is at full employment. 

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In other words, potential GDP is equal to full employment GDP. Full employment doesn't mean zero unemployment; rather, it refers to the natural rate of employment, which is the minimum level of employment than can exist over time without accelerating inflation. 

Narrator: 
So, real GDP is equal to potential GDP only when resources are fully employed. In reality, real GDP fluctuates above and below potential GDP reflecting business cycles of expansion and contraction. 

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