MACROECONOMICS
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Lecture.docxModule 2 Lecture - GDP: A Measure Of Total Production And Income (cont'd)-2
Using Real GDP To Measure Our Standard of Living
A common method for measuring the standard of living in the US involves comparing per capita Real GDP (that’ total gross domestic product divided by the population) from the present to some pre-determined past year. Table 14.4, pg. 383 shows the per person Real GDP from 2016 as compared to the per person Real GDP in 1960. From looking at that table it appears the US has done very well, increasing from $17,217 per person in 1960 to $56,200 per person in 2016. This isn’t the whole story, however.
Potential GDP
Potential GDP is the level of real GDP per person when all factors of production (land, labor, capital, entrepreneurship) have been utilized to their fullest. This would be the productivity goal of the US economy. If some of these factors are underutilized or underemployed, real GDP is producing below its potential. Think of the loss of productivity with high rates of unemployment or large tracts of land that are used only occasionally (football and baseball stadiums or public schools which lie vacant during 3 months of vacations). The only way to get a true look at how well the US economy is doing is to look at its production levels in past years and compare them with the full potential of production of which the US economy is capable. Figure 14.3, pg. 384 which I’ve reproduced for you below, gives us a pretty clear picture of how well the US has achieved its production potential since 1960.
Follow the red line upward from 1960 and especially note how much it lies above or below the black line. The red line represents Real GDP per person. The black line represents the actual potential of productive output per person.
Note that the red line rises above potential from 1960 to about 1970. The potential productive output per person was actually rising at about 2.8% per year.
Since 1970 the red line is either on or well below the black line (except for two minor rises). Real GDP per person has fallen below the economy’s potential. It actually shows a growth rate of only about 1.9% a year since 1970. This means that the economy’s POTENTIAL GDP has fallen well below that of 1960.
If the economy had kept up with the 1960’s rate of growth in production it would mean a cumulative effect (from 1960 to 2013) of about $406,000 added income/productivity per person. This is one of the more compelling reasons behind the emphasis on not just per capita (per person) Real GDP but also its comparison to POTENTIAL GDP. Wouldn’t it have been nice to have an extra $400,000 over a span of 40 years (1970-2010)? That’s an extra $10,000 a year; serious added income.
Why Does Real GDP (levels of production and income) Increase Positively Some Years And Then Become Negative In Other Years?
The Business Cycle: this is a term used to describe fluctuations in economic activity. In a sense, it measures the economic growth during the expansion phase (more investment, more jobs, more income, more growth) and the economic decline during the contraction stage (less investment, fewer jobs, less income, less spending). The goal for economists is to keep the highs and lows of the economy to a bare minimum. Think of the U.S. economy as running in a marathon – always trying to move forward at a sustainable pace in a seemingly never-ending journey. Obviously, going backward in a marathon is undesirable as we are moving farther away from where we are trying to get to – moving forward is the desired direction. But it’s not just about moving forward – we want to move forward at a relatively swift pace, not just walk (we’re better than that!). However, a marathon needs to be run at a sustainable pace. Trying to sprint a marathon is unsustainable and will lead to over-exhaustion and ultimately slow us down in the long run. A recession is going backwards in the marathon (with a negative real GDP growth rate), while an expansion is moving forward in the marathon (with a positive real GDP growth rate). A peak is when we stop moving forward and start to go backward (turning point between positive and negative), while a trough is when we stop going backward and start moving forward again (turning point between negative and positive).
Our goal is for a sustainable pace for expansion, which is typically thought of as a real GDP growth rate of approximately 3 percent - that is the jogging pace at which the U.S. economy has demonstrated it is capable of sustainably expanding.
Expanding more rapidly than that can only be done temporarily, and trying to expand beyond that pace for an extended period will lead to “overheating” in the economy (which leads to high inflation and loss of purchasing power of the dollar in the US) and an eventual backlash - a recession. Expanding less than that level is not living up to our potential.
This also brings up the non-technical term of “ growth recession” – when the economy is growing (so it can’t technically be in a recession), though growing so slowly there will still be some recession-like characteristics (such as rising or high unemployment). A growth recession is like walking in the marathon. While growth recession is not defined by the National Bureau of Economic Research (NBER) or introduced in this textbook, it has grown in popularity in the media as it sometimes serves as a useful description of the seemingly “gray” area of the business cycle that is not a recession, but not a healthy expansion either. Growth recession sometimes precedes actual recession (a slowdown before GDP growth ultimately turns negative – such as the tail end of the expansions before the early 80s double-dip recession and the 2001 recession), follows a recession (GDP growth turns positive but is still lower than a healthy rate – such as the recoveries following 1990-1991, 2001, and 2007-2009 recessions), or in the middle of an expansion (a slowdown that almost takes the place of an actual recession – such as the soft patch in the mid-90s).
Business cycles or economic fluctuations of the production level in an economy are defined by 2 phases which have 2 corresponding turning points:
· Expansion: The expansion phase is the period during which real GDP is increasing.
· Recession: The recession phase is commonly defined as a period during which real GDP decreases for at least six months, though the NBER has a broader definition.
· Peak: A peak is the highest level of real GDP yet attained. A peak is a turning point between an expansion and a recession.
· Trough: A trough is the temporary low-point in real GDP. A trough is a turning point between a recession and an expansion.
Let’s look at a picture of the US’s business cycles or fluctuations from 2003 through September of to 2013 as seen in Figure 14.4, and reproduced below:
It’s interesting to see the long period of expansion between 2003 to the latter part of 2007. For much of that period Real GDP was actually greater than Potential GDP. The growth period was so long that economists focused more on sustaining even faster growth rather than looking at the warning signs of the business cycle model that they had begun to ignore. Then in 2008 the bubble burst, reaching bottom or trough in 2009 but since 2009 the expansion has been extremely slow, falling well below Potential GDP.
This continued expansion, especially above the ‘potential’ GDP line, illustrates an overheated economy – too much spending, higher inflation rates, higher employment levels etc. The economy in this situation will eventually correct itself falling back to or a little below the ‘potential’ GDP line. In the 2008-2009 case, however; Real GDP hit an almost record low. The economy was then in a severe recession highlighted by little spending or investment, high unemployment rate, severe corrections in both the stock and real estate markets, etc.
Even though economists tend to avoid the word ‘cycle’ that’s pretty much what you see when looking at Figure 14.4: slow expansion then mild contraction over and over (cycle) until the huge contraction in 2008-2009.
Explaining the Business Cycle
Economists tend to link business fluctuations to 3 main forces: external factors, business investment, and government activity.
External Shocks
External events can cause or contribute to a fluctuation in the US economy. World War II for instance (something occurring outside the US economy) had a tremendous impact upon the US economy. It turned a nation from a devastating economic depression where 13 million people were unemployed, productive output was down to 35% of the nation’s productive capacity, and farm income down to 20% of its 1929 level, to a nation of full employment and production that exceeded US output at any other time. The demand for war supplies was so great that factories operated on a 24-hour basis, employing all able-bodied workers including women.
Business Investment
When businesses believe its future prospects for profit are positive, they increase capital investment: buying new machines, building new factories, expanding old ones etc. This produces more jobs, more productivity, and more income. When businesses expect poor future prospects from the US economy as to create more profit, they will do the exact opposite of the above which will decrease productivity, jobs, and income, slowing down consumer spending.
Government Activity
The government’s changing economic policies may also influence business fluctuations in the US economy. Raising or lowering taxes or increasing or decreasing government expenditures may have either a positive or negative effect upon the economy.
PUTTING IT ALL TOGETHER: ECONOMIC FLUCTUATIONS (ALSO CALLED THE BUSINESS CYCLE)
Everything we’ve discussed thus far in all modules both Micro and Macro come together to define an economy as one that is growing at an acceptable rate to one that is stagnant or even contracting. These economic fluctuations are common to all economies and, although sometimes termed business cycles, there is no predictable pattern as to the up and down movement of our economy’s growth over a period of time. What causes these fluctuations is extremely difficult and cause for debate among most economists. What occurs during the fluctuations is easier to identify. I want to give you an oversimplified example of an economic fluctuation from expansion to contraction. This is a model only, but it does reflect some degree what occurs during one cycle:
1. Assume you are a retailer selling casual and dress shoes. At the moment, your sales are fairly stagnant, so for every pair of shoes on the sales’ floor, you have one pair of shoes in inventory. There are plenty of people who want to purchase a pair of shoes for you, but most of them just don’t have the disposable income necessary to do so
2. Now, assume that there is an increase in economic activity. Christmas is a few months away, and many part-time positions are being filled by people who had been unemployed.
3. Now that more people are employed, there is more money in the hands of consumers. Many of them now have the ability to purchase a pair of shoes from you.
4. When demand initially increases for your product, you’re caught short of inventory, so you order more from the manufacturer. You now need five pairs of shoes in inventory for every one pair you have on the retail floor.
5. The manufacturer, fairly idle until now, is caught short, so he hires more labor and purchases more resources to accommodate this new demand.
6. The new labor means people are making even more money and therefore spending more, creating even more shortages. The economy is now booming with rapid growth.
7. Eventually, the manufacturer and retailers catch up to the demand and possess the number of inventories and labor that they need to satisfy consumer demand.
8. Once this new demand is satisfied, however, retailers find they have too much inventory. So they cut back on their demand for manufactured products. Orders drop at the same rate as when they went up.
9. Because of the decrease in orders, manufacturers begin laying off labor, meaning fewer incomes, meaning less demand (purchases) for your product.
10. The retailers feel this decrease in demand and stop ordering from the manufacturer altogether.
11. Plants close down and all workers are laid off.
12. This creates another drop in demand for retailers who lay off all of their workers before going out of business altogether. The economy is now in recession
FACTS ABOUT ECONOMIC FLUCTUATIONS
The above gives you a broad idea of what takes place during economic fluctuations, and how an economy might go from boom to bust over an extended period of time. Since we know that these fluctuations will always occur, the goal for any economy is to keep both the expansions and the contractions at a minimum level. We also would like to see expansions occur over long periods of time while minimizing the period of time for the contractions. As much controversy as there is about causes and remedies for business fluctuations, there are a few facts which always hold true about them:
1. As I stated before, they are unpredictable. Remember that ‘Real’ GDP is the value of all final goods and services produced in our economy. That means we may use measurements of ‘Real’ GDP to determine the level of our economy’s activity.
2. As ‘Real’ GDP falls into recession so does investment spending. If corporations and businesses discontinue investment, profits will fall, as will spending by consumers, which foreshadow decreases in sales across the economic spectrum: retail, cars, homes etc. Decreases in sales and profits for corporations and businesses leads to;
3. Layoffs and high unemployment levels. Notice this rippling effect throughout the entire economy. Using only the housing industry as an example, look at the tremendous number of people affected by layoffs because of a recession: the producers of wood, cement, and other materials used in housing construction as well as the tremendous number of foundation layers, carpenters, window installers, floor tilers, plumbers, electricians etc. In 2008-2009, the combination of failures by major banks, corporations, automobile manufacturers, and the housing industry drove the U.S. into its most devastating and serious recession since the Great Depression of the 1930’s.
Does Real GDP Give an Accurate Measure of an Economy’s Standard of Living?
If you look back on pg. 46, Figure 2.3 you’ll see that the average income per person per day in the US outranks all other countries. Income per person per day in the US is 3x that of Russia and 6x that of China. Using a common factor to compare incomes we also see some startling results of income disparities among countries. While we in the US enjoy a per person income of over $125 per day, 66% of the world’s population which is Africa earn a per person income of less than $2 per day.
Limitations of Real GDP Measurements
Remember that Real GDP measures the value of goods and services that are bought and sold in the marketplace. But what about those goods or services that are not sold in the marketplace?
Household Production
It sometimes seems rather ironic that a stay-at-home Mom (or Dad) has no value when it comes to Real GDP because their services (raising children, cooking meals, shopping etc.) are not for sale in the marketplace. In the late 20th and now 21st century in the US, some of this has begun to change primarily because of the increase in the number of women in the workforce. Now that many women no longer stay at home they purchase child care services on the open market and rely more and more upon fast foods for their families because they no longer have the time to prepare meals at home.
Illegal or Underground Production
Almost any good or service deemed illegal in the US can be purchased in the illegal underground market. The most notable of these is the sale of illegal prescription and non-prescription drugs. It also includes prostitution, sales of restricted firearms, pornography, unlicensed gambling etc. Added to these are the unreported tips by food servers, hairdressers, and cab drivers as well as unreported income of illegal immigrants. As state in your text, the estimated total of unreported underground production not included in GDP makes up 16% of GDP (early 1990’s figure). This, of course, is just an educated guess based upon the number of people caught engaging in these enterprises. The figure may actually be quite higher since people involved in illegal activities will not report their activities to the authorities.
Leisure Time
It’s very difficult to put a monetary value on leisure time unless you calculate the opportunity cost in $ of the money you could be making during your leisure time. This would be a legitimate figure for a $ amount value of our leisure time but is not included in GDP.
Levels of Happiness
