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Measuring the Macroeconomy

Explain how economists use gross domestic product (GDP) to measure total production and total income.

Understand how to calculate the unemployment rate.

Discuss the difference between real GDP and nominal GDP.

Explain how the inflation rate is measured and distinguish between real and nominal interest rates.

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Learning Objectives
After studying this chapter, you should be able to:
2.1

2.2
2.3

2.4

How do we know we are in a recession?

Dates for recessions are determined by the National Bureau of Economic Research (NBER) Business Cycle Dating Committee.

NBER Business Cycle Dating Committee uses a broad range of factors and data to determine that recessions begin when there is “a significant decline in economic activity [that] spreads across the economy and can last from a few months to more than a year.”

Data used to determine recessions is primarily collected by the government with substantial lags and uncertainty. The NBER Business Cycle Dating Committee waited 12 months before declaring the peak of December 2007, and waited 15 months before declaring the last trough in June 2009.

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The unemployment rate can rise even though a recession has ended.

How accurately does the government measure the unemployment rate?

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Key Issue and Question

Issue:

Question:

Measuring the macroeconomy

Three important measures of macroeconomic performance.

Gross domestic product (GDP)

The unemployment rate

The inflation rate

Macroeconomics is about describing not just what has happened, but also about building models to understand why macroeconomic events like recessions and high inflation, and other macroeconomic events, have happened.

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Explain how economists use gross domestic product (GDP) to measure total production and total income.

2.1

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Learning Objective

GDP: Measuring total production and total income

Gross domestic product (GDP) The market value of all final goods and services produced in a country during a period of time.

Final good or service A good or service purchased by a final user.

Intermediate good or service A good or service that is an input into another good or service such as a tire on a truck.

GDP data is collected by the Bureau of Economic Analysis (BEA).

Reports on GDP and related statistics released every three months.

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How the government calculates GDP

GDP is measured using market values, not quantities.

GDP is the total value in dollars of all goods and services produced.

GDP includes only the market values of final goods.

Only counting final goods and services avoids double counting.

GDP measures production within a country regardless of who does the production.

GDP includes some imputed values.

For example rent to homeowners, police services are estimated to provide value at cost.

The BEA does not count some types of production.

Underground and home production are excluded from GDP.

GDP includes only current production.

GDP measures an amount of production during a time period.

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Production and income

National income accounting The rules used in calculating GDP and related measures of total production and total income.

Income indicates that the BEA measures both total production and total income.

The BEA’s official name for the U.S. national income accounts is the National Income and Product Accounts (NIPA).

The value of total production in an economy is equal to the value of total income.

All expenditures are someone else’s income.

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The circular flow of income

The circular-flow diagram shows how the flow of spending and money in the economy equals the total value of income.

Income is divided into four categories:

Wages: paid to households in exchange for labor.

Interest: paid for the use of capital.

Rent (economic definition): paid for the use of natural resources.

Profit: return to entrepreneurs for organizing factors of production and reward for bearing the risk of production.

The circular flow of income and the measurement of GDP

Figure 2.1

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The circular flow of income

Factors of production are usually divided into three categories.

Labor

Capital

Natural resources

Factor of production Any input used to produce goods and services.

Capital Goods, such as machine tools, computers, factories, and office buildings, that are used to produce other goods and services.

The circular flow of income and the measurement of GDP

Figure 2.1

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Reminders

Financial Intermediaries

An institution such as a commercial bank that borrows funds from savers to lend to borrowers.

Financial Markets

A place or channel for buying or selling stocks, bonds, or other financial assets.

The circular flow of income

Firms sell goods to domestic households, foreign firms and households, and the government.

Financial system The financial intermediaries and financial markets that together facilitate the flow of funds from lenders to borrowers.

The circular flow of income and the measurement of GDP

Figure 2.1

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Reminders

Financial Intermediaries

An institution such as a commercial bank that borrows funds from savers to lend to borrowers.

Financial Markets

A place or channel for buying or selling stocks, bonds, or other financial assets.

An example of measuring GDP

The BEA collects and uses data on quantities and prices of final goods and services to determine the value of GDP during a given period of time.

In a simple economy with only Windows 8 and McDonald’s Big Mac hamburgers, we would calculate GDP as:

GDP = (Quantity of Windows 8 × Price of Windows 8) + (Quantity of Big Macs × Price of Big Macs)

If 1,000 copies of Windows 8 are sold at $100 each, and 10,000 Big Macs are sold at a price of $4 per Big Mac, then the value of GDP is:

GDP = (1,000 × $100) + (10,000 × $4) = $140,000

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National income identities and the components of GDP

The BEA divides GDP into four major categories of expenditures, which combine into the national income identity, where Y is total GDP.

Consumption (C) The purchase of new goods and services by households.

Investment (I) Spending by firms on new factories, office buildings, machinery, and additions to inventories plus spending by households and firms on new houses.

Government purchases (G) Spending by federal, state, and local governments on goods and services.

Net exports (NX) The value of all exports minus the value of all imports.

Y = C + I + G + NX

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GDP in 2011

Gross Domestic Product in 2011

Table 2.1

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The components of GDP: Consumption, Investment

Consumption is broken down into three more refined categories.

Durable goods are tangible goods with an average life of three years or more.

Nondurable goods are shorter-lived goods such as food and clothing.

Services are consumed at the time and place of purchase, such as haircuts, food, and clothing.

Investment is divided further into three categories and adds to the stock of capital goods that exist.

Fixed investment is spending by firms on new factories, office buildings, and machinery used to produce other goods.

Residential investment is spending by households or firms on new single-family and multi-family homes.

Inventories are goods that have been produced and not yet sold. Any goods produced during a given period but not sold are counted towards GDP in the period in which they were produced.

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The components of GDP: Government Purchases

Government purchases are made at the federal, state, and local levels.

Government purchases occur when paying salaries of government workers like teachers, police officers, or FBI agents.

Government investment occurs when the government purchases new structures or equipment allowing for the future provision of services.

Government purchases do not include transfer payments.

Transfer payments Payments by the government to individuals for which the government does not receive a good or service in return.

Not in GDP

Examples of transfer payments include

Social Security payments to those who are retired and disabled.

Unemployment insurance payments to qualifying individuals.

Medicare payments to provide healthcare services to those over 65.

Government purchases are distinguished from government expenditures in that expenditures include all purchases plus government transfers and also interest payments on the debt.

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Government purchases and government expenditures

Transfer payments made up an increasing fraction of government expenditures, including spending on Social Security, Medicare, and state and local spending on public pensions.

As a percentage of GDP, government purchases in 2011 were the same as in 1951. Government expenditures were 75% greater in 2011 than in 1951.

Government purchases and government expenditures, 1951-2011

Figure 2.2

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The components of GDP: Net Exports

Net exports display the trade balance of a country.

Trade deficits are observed when imports are greater than exports, yielding a negative value for net exports.

Trade surpluses are observed when imports are less than exports, yielding a positive value for net exports.

If exports equal imports, net exports are zero and we have balanced trade.

When someone purchases an imported good like a Nintendo Wii, U.S. consumption rises, net exports fall by the same amount, and GDP is left unchanged.

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The relationship between GDP and GNP

Gross national product (GNP) The value of final goods and services produced by residents of a country, even if the production takes place outside the country.

GDP = GNP + Net factor payments

For example, a factor payment to another country from the U.S. would be the profit received by the Japanese owners of a Toyota factory based in the U.S.

Net factor payments are the difference between factor payments from other countries and factor payments to other countries.

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GDP versus GDI

The circular flow diagram implies two ways to measure national income:

The Expenditure Approach

Calculate the value of total expenditure on final goods and services

BEA uses this method to calculate GDP

The Income Approach

Calculate the value of total income

BEA uses this method to calculate Gross Domestic Income (GDI)

In theory, these should be the same. They are not, due to statistical discrepancy, arising from using different data sources.

Which is better? GDI seems to correlate more closely with other business cycle indicators; but GDP is available 1-2 months earlier than GDI.

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Real GDP and Real GDI

The discrepancy between real GDP and real GDI was largest during the recession of 2007-2009.

GDI indicated the recession sooner than GDP.

Movements in Real GDP and Real GDI, 2005-2012

Figure 2.3

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GDP and National Income

The BEA publishes several other measures of total income:

National Income = GDP – Depreciation

Depreciation represents the value of worn-out or obsolete capital.

The BEA refers to depreciation as consumption of fixed capital.

Personal Income = National Income – Retained Earnings + Transfer Payments + Interest on Government Bonds

Retained earnings are profits reinvested by firms.

Disposable Personal Income = Personal Income – Personal Taxes

This is the best measure of what households have available to spend.

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Shares of national income

Employee compensation is by far the largest component of national income, averaging 70%; corporate profits have averaged less than 12%.

Opinion polls suggest the public believe corporate profits average 40%!

Shares of national income in the United States, 1950-2011

Figure 2.4

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Discuss the difference between real GDP and nominal GDP

2.2

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Learning Objective

Real GDP and nominal GDP

Nominal GDP The value of final goods and services calculated using current-year prices.

Real GDP The value of final goods and services using base-year prices. (Tries to adjust for inflation)

Choice of base year is arbitrary; current “official” base year is 2005.

Nominal GDP and Real GDP, 1990-2011

Figure 2.5

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Calculating real GDP

Consider a very simple economy that produces only four final goods and services: apples, plums, hamburgers, and teeth whitening. Assume that the base year is 2005. Use the information in the following table to calculate nominal and real GDP for 2005 and 2013.

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Solved Problem

Calculating real GDP

Step 1 Review the chapter material.

Step 2 Calculate nominal GDP for the two years. Multiply the quantities produced during a year by the prices for that year to obtain the value of production for each good and service. Then add up the products of your calculations.

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Solved Problem

Calculating real GDP

Step 3 Calculate real GDP for 2013, using the prices for 2005. Multiply quantities in 2013 by prices for 2005.

Step 4 Determine real GDP for 2005, using the prices for 2005. Since the current and base years are the same, the real and nominal GDP are equal.

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Solved Problem

Price indexes and the GDP deflator

GDP deflator A measure of the price level, calculated by dividing nominal GDP by real GDP and multiplying by 100; also called the GDP implicit price deflator.

We can use the GDP implicit price deflator to estimate inflation rates between two points in time. By calculating the GDP deflator for two consecutive years (t-1 and t), we obtain a measure of the inflation rate in the second year, which is a percentage increase in the price level from the first year to the next.

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Calculating the inflation rate

Use values for nominal GDP and real GDP given in the following table to calculate the inflation rate during 2011

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Solved Problem

Calculating the inflation rate

Step 1 Review the chapter material.

Step 2 Calculate the GDP deflator for each year. To calculate the GDP deflator, divide nominal GDP by real GDP and multiply by 100.

Step 3 Calculate the inflation rate for 2011 and provide an interpretation. The inflation rate is the percentage change in the GDP deflator: The value of 2.2% tells us that an average of the prices of all final goods and services produced in the U.S. rose 2.2% from 2010 to 2011.

XXX

Typo in TextBook

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Solved Problem

The chain-weighted measure of real GDP

Over time, prices change relative to each other, such as the price of cell phones falling relative to the value of milk.

Goods and services change over time. Prices from 2005 may not reflect goods sold in 2011.

For example, what was the value of an Apple iPad 2 in 2005?

Since the iPad did not exist in 2005, we do not have a direct measure of its price in that year.

In 1996, the BEA switched to using chain-weighted prices. Using chain-weighting effectively updates the prices for the base year each year and reduces the errors from changes in relative prices and the introduction of new good and services.

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Trying to hit a moving target: forecasting

Policymaking depends on forecasts of GDP data, and data provided by the BEA is frequently revised.

A first estimate of real GDP released about a month after the end of a quarter.

The second estimate of a quarter’s GDP is released about two months after the end of the quarter.

The third estimate comes about three months after the end of the quarter.

Benchmark revisions occur in later years, which lead to further revisions.

GDP is a comprehensive measure of output, and data collection is time consuming.

Data collected from surveys by Commerce Department on retail sales and manufacturing.

Data collected from trade organizations.

Government spending is estimated.

Over time the BEA refines its estimates.

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Making the Connection

Trying to hit a moving target: forecasting

Revisions can change a great deal. The first estimate of the first quarter 2001 real GDP growth was a 2.0% annual rate.

Over time, the growth rate was revised downward to show a decline of 1.3%. These revisions have led some to debate if the 2001 recession actually began late in 2000.

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Making the Connection

Comparing GDP across countries

Cross-country comparisons of GDP are difficult because each measure is estimated in the local currency.

2011 GDP Estimates

China 47.2 trillion yuan

Japan 468.4 trillion yen

U.S. 15.1 trillion dollars

Using exchange rates, we can translate our estimates into a single currency.

e.g., if Japanese GDP were ¥500 trillion with an exchange rate ¥100 = $1, Japanese GDP in U.S. dollars = ¥500 / (¥100 /$1) = $5 trillion U.S. dollars.

However, exchange rates can change dramatically during a short period. An alternative is to consider Purchasing Power Parity.

Purchasing power parity (PPP) is the number of units of a country’s currency required to buy the same amount of goods and services in the country as one U.S. dollar would buy in the United States.

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The incredible shrinking Chinese economy

The World Bank coordinates the International Comparison Program (ICP)

Collects data on over 1,000 goods and services in 146 countries.

ICP creates price levels for each country over time based on PPP.

China did not participate in ICP before 2007.

Data had been collected by Chinese economists since 1986.

In 2007, ICP found China’s prices were higher than previously reported.

Previous PPP exchange rates were too low, thus dollar value estimates were too high.

ICP estimated China’s 2005 GDP was $8.8 trillion (U.S. dollars).

Revised estimate was $5.3 trillion, nearly 40% less.

The adjustment reduced China’s share of world GDP from 14% to 10%.

While new price estimates are an improvement, they are based on only 11 cities and surrounding rural areas.

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Making the Connection

Explain how the inflation rate is measured and distinguish between real and nominal interest rates.

2.3

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Learning Objective

The consumer price index

Consumer price index (CPI) An average of the prices of the goods and services purchased by the typical urban family of four.

The U.S. Bureau of Labor Statistics (BLS) surveys 30,000 households to determine spending habits.

From the survey, the BLS creates a basket of 211 goods in eight categories. About 75% of the basket is housing, food, and transportation.

The Consumer Price Index: the market basket for the CPI

Figure 2.6a

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The consumer price index

Annual CPI inflation has varied from above 10% in the late 1970s and early 1980s, to an average below 5% since the 1980s.

The U.S. experienced deflation during the 2007-2009 recession.

The Consumer Price Index: inflation as measured by the CPI

Figure 2.6b

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The CPI as a measure of inflation

The CPI does a better job than the GDP deflator at estimating the changes in the cost of living for a typical household.

The GDP deflator calculates the price level using all goods produced, but the CPI estimates the price level for goods actually purchased by consumers.

The CPI weights all components in the representative basket according to the average expenditure on those goods and services. Over 23,000 stores in 87 cities are surveyed monthly to determine the price level of the representative basket.

The CPI is widely used in indexing to protect dollar values against inflation. Social Security, tax brackets, and some union wage contracts are typically increased by the annual rate of increase in prices as measured by the CPI. Indexing is done to keep the real value of a payment consistent.

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Does the CPI measure inflation well for everyone?

CPI measures inflation for an average urban family of four.

For example, weight placed on college tuition is 1.7%.

What about a family of four with a college student?

That family likely spends much more than 1.7% of their income on college tuition.

From the CPI’s “base year” of 1982-1984, to 2011, college tuition rose about 500%, while the overall CPI rose about 125%.

So families with college students have experienced more inflation than average.

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Making the Connection

How accurate is the CPI?

Most economists believe the CPI overstates the true rate of inflation

Substitution bias assumes consumers purchase the same bundle of goods every month, when it is more likely they substitute towards products whose prices have increased at a slower rate.

The introduction of new goods is important to the possible overstatement of inflation since the basket is only updated every two years. The prices of new goods, like Blu-ray players, often decrease significantly but may not be in the market basket or therefore the CPI.

The quality of goods and services is not controlled for over time. If prices remain constant, but goods improve in quality, there may be an upward bias in the CPI measured rate of inflation.

Outlet bias results from the BLS only collecting data from traditional retailers while ignoring outlets like discount stores and the Internet.

It is believed the CPI overstates inflation by 0.5% to 1.0% annually. Since many wages are tied to the CPI, this has important consequences.

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The way the Federal Reserve measures inflation

Federal Reserve The central bank of the United States; usually referred to as “the Fed.”

In 2000, the Fed decided to rely on the Personal Consumption Expenditures price index instead of the CPI.

Personal consumption expenditures (PCE) price index A price index similar to the GDP deflator, except that it includes only the prices of goods from the consumption category of GDP.

One of the Fed’s main goals is to maintain an inflation rate around 2% annually. Since 2000, the Fed has relied on the PCE to determine the rate of inflation.

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The way the Federal Reserve measures inflation

The Fed has listed three main advantages for using the PCE to measure inflation:

The PCE is a chain-type index rather than a market-based index. As consumers shift their mix of products, market-based indexes overstate the actual rate of inflation. Chain-type indexes allow the bundle of goods to change.

The PCE includes more goods and services than the CPI.

Past values of the PCE can be recalculated with updated methods and data.

The Fed has focused on core PCE since 2004, which excludes volatile food and energy prices.

Severe weather, drought, and political tensions are examples of reasons food and energy prices might rise or fall.

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CPI, PCE, and Core PCE

Note that CPI, PCE, and core PCE all move together, but core PCE is more stable.

During 2009, the PCE and CPI indicated a falling price level, while the PCE still measured an inflation rate of around 1.5%.

The Measures of the Inflation Rate, 1998-2012

Figure 2.7

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Interest rates

Interest rate The cost of borrowing funds, usually expressed as a percentage of the amount borrowed.

Nominal interest rate The stated interest rate on a loan.

Real interest rate The nominal interest rate adjusted for the effects of inflation.

Actual real interest rates equal nominal interest rates minus the actual inflation rates.

For outstanding loans, higher inflation rates than expected can benefit borrowers in real terms because the actual real rate of borrowing is lower than expected.

If actual inflation is lower than expected, the actual real interest rate will be higher and lenders benefit in real terms.

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Interest rates

If you borrow $100 for a year and have to repay $105 at the end of the year, you pay $5 interest, yielding an interest rate of:

($5/$100) x 100 = 5%

Nominal interest reflects returns in terms of the actual dollar amount, while real interest accounts for the change in purchasing power over time as measured by the rate of inflation.

If a person buys a $1,000 bond that pays $50 interest each year for five years, the purchasing power declines since the $50 each year in the future is worth less since prices are higher.

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Interest rates

Since borrowers do not know the rate of inflation in the future, we measure real interest rates using expected future rates of inflation (πe).

This equation implies that nominal interest rates reflect expected real interest rates and expected rates of inflation.

Both the real interest rate and expected inflation rate are unknown when nominal interest rates are determined. If you borrow money at 5%, expecting inflation to be 2%, you are paying a 3% real cost to borrow money. If inflation turns out to be higher at 4%, your real cost of borrowing is only 1%.

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This equation is of course an approximation; the approximation is best for low values of inflation.

Nominal and real interest rates

The nominal interest rate is often measured by economists as the interest rate on U.S. Treasury bills maturing in three months. Real rates are calculated here using the CPI inflation rate.

Note that nominal and real interest rates tend to rise and fall together.

Nominal rates can be lower than real rates if experiencing deflation.

Nominal and real interest rates, 1982-2012

Figure 2.8

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Understand how to calculate the unemployment rate

2.4

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Learning Objective

Measuring employment and unemployment

Labor force The sum of employed and unemployed workers in the economy.

Unemployment rate The percentage of the labor force that is unemployed.

Reminders

Employed If a person worked in the week before the survey, or was temporarily away from his or her job due to illness, vacation, strike, or another reason.

Unemployed If a person did not work in the previous week, but had actively looked for work in the previous four weeks.

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Measuring employment and unemployment

In September 2012, there were approximately 12,088,000 unemployed workers out of a labor force of 155,063,000. The unemployment rate was calculated as:

Unemployed workers are often difficult to differentiate from those who are not in the labor force.

Discouraged workers have given up looking for a job.

Including discouraged workers with the unemployed raises the previously estimated unemployment rate to 8.3%.

Part-time workers are considered employed, when they might prefer to be working full time.

Including both discouraged workers and involuntary part-time workers would raise the previous estimate to 14.7%

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The BLS refers to the official unemployment rate as the U-3 measure of unemployment. The broadest

measure of the unemployment rate is the U-6 measure, which includes marginally attached workers and

part-time workers who would prefer to work full time. This is the BLS's definition of marginally attached

workers: “Persons marginally attached to the labor force are those who currently are neither working

nor looking for work but indicate that they want and are available for a job and have looked for work

sometime in the past 12 months. Discouraged workers, a subset of the marginally attached, have given a

job-market related reason for not currently looking for work.”

Alternative measures of the unemployment rate

The BLS estimates a number of different unemployment rates, both including and excluding discouraged workers and involuntary part-time workers.

The long-term unemployment rate is only for those workers who have been unemployed for 15 weeks or more.

Alternative measures of the unemployment rate, 1948-2012

Figure 2.9

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Answering the key question

“How accurately does the government measure the unemployment rate?”

The BLS reports several different unemployment rates, both including and excluding those who are considered involuntary part-time workers and those who are marginally attached to the labor force.

Everyone without a job should not be considered unemployed, such as those who are retired, in school, and homemakers.

Additionally, the BLS does not verify responses of people to the survey questions. Underground workers, often engaged in illegal activity, are also not considered part of the labor force.

Conclusion: the unemployment rate provides useful information, but it is far from an exact measure of joblessness in the economy.

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