Chapter 2 Measurement Macroeconomics Stephen D. Williamson 6th Edition Copyright © 2018, 2015, 2011 Pearson Education, Inc. All rights reserved.

Learning Objectives, Part I 2.1 Construct measures of gross domestic product using the product approach, the expenditure approach, and the income approach. 2.2 State the importance of each expenditure component of GDP, and the issues associated with measuring each. Measurement in economics is very important, as there is an interplay between theory and measurement. How we measure economic activity helps us understand where we need theory to clarify what is going on in the world. Economic theory can also tell us what it is that we need to measure, and how we should measure it. Indeed, the national income accounting system we use to measure GDP was designed by economists. Copyright © 2018, 2015, 2011 Pearson Education, Inc. All rights reserved.

Learning Objectives, Part II 2.3 Construct real and nominal GDP, and price indices, from data on quantities and prices in different years. 2.4 State the key difficulties in measuring GDP and the price level. Copyright © 2018, 2015, 2011 Pearson Education, Inc. All rights reserved.

Learning Objectives, Part III 2.5 State the accounting relationships among savings and income in the private and public sectors, and explain the importance of these relationships for wealth accumulation. 2.6 Construct the key labor market measures from the household survey data. Copyright © 2018, 2015, 2011 Pearson Education, Inc. All rights reserved.

Measuring GDP: The National Income and Product Accounts (NIPA) GDP Measured Using: (i) the product approach; (ii) the expenditure approach; (iii) the income approach. Show how this is done using an example. Our first step is to study how gross domestic product is measured in the National Income and Product Accounts (NIPA). There are three approaches to measuring GDP, and each approach will give us the same answer, provided there is no measurement error. Of course, in practice, there can be substantial measurement error, so we will typically get different answers when we try to add up the components of GDP. Copyright © 2018, 2015, 2011 Pearson Education, Inc. All rights reserved.

National Income Accounting Example Fictional Island Economy Coconut Producer, Restaurant, Consumers, Government The easiest way to understand NIPA is by using a simple example. This is a fictitious economy in which the only raw material is coconuts, and the only final goods and services are coconuts and restaurant food made with coconuts. The key element of the example is that coconuts are both a final good and an intermediate good. The economic agents in this world are a coconut producer, a restaurant, consumers, and the government. Copyright © 2018, 2015, 2011 Pearson Education, Inc. All rights reserved.

Table 2.1 Coconut Producer This slide tells us the data that the national income accountant has collected from the coconut producer. Copyright © 2018, 2015, 2011 Pearson Education, Inc. All rights reserved.

Table 2.2 Restaurant This is data collected from the restaurant. Copyright © 2018, 2015, 2011 Pearson Education, Inc. All rights reserved.

Table 2.3 After-Tax Profits This is a calculation done from the previous two tables, which gives after-tax profits from the producers in this economy. We’ll need after-tax profits for later calculations. Copyright © 2018, 2015, 2011 Pearson Education, Inc. All rights reserved.

Table 2.4 Government This is relevant data collected from the government – the tax revenue that comes in, and the wages paid to government workers. Copyright © 2018, 2015, 2011 Pearson Education, Inc. All rights reserved.

Table 2.5 Consumers This is the relevant data for the consumers, which tells us their total income, the taxes they paid to the government, and profits received by producers that ultimately are the income of some consumers. Copyright © 2018, 2015, 2011 Pearson Education, Inc. All rights reserved.

Table 2.6 GDP Using the Product Approach To measure GDP using the product (or value-added) approach, we add up value-added for each final good and service in the economy, at each stage of production. Copyright © 2018, 2015, 2011 Pearson Education, Inc. All rights reserved.

Table 2.7 GDP Using the Expenditure Approach Using the expenditure approach, we measure GDP by adding up expenditure on all final goods and services. The key expenditure components are consumption, investment, government expenditures, and net exports. In the example, there is no investment, and no trade with the outside world, so investment and net exports are zero. Note that we get the same answer as for the product approach. Copyright © 2018, 2015, 2011 Pearson Education, Inc. All rights reserved.

Table 2.8 GDP Using the Income Approach Following the income approach, GDP is the sum of all incomes received by people in this economy. Income will show up as wage income, after-tax profits, interest income, and taxes, in the example. Note that we get the same answer as for the product and expenditure approaches. Total GDP is total output produced, total income, and total expenditure. All goods produced are sold to someone, and represent income for someone else. Copyright © 2018, 2015, 2011 Pearson Education, Inc. All rights reserved.

Table 2.9 Gross Domestic Product for 2015 Component of GDP $Billions % of GDP GDP $17,937.8 100.0 Consumption $12,267.9 68.4 Investment $3,017.8 16.8 Net Exports -$531.9 -3.0 Government Expenditures $3,184.0 17.8 The slide shows the key components of GDP for the United States during the year 2015. Note that GDP is a flow over the year, and the units are current dollars. Consumption is the largest component of GDP. Investment is not as large, but is very important for business cycles, as it is more variable. Investment is output produced in terms of goods that are used in the future to produce other goods and services. Government expenditures is 17.8%, but this does not represent the full reach of the government. Government expenditures does not include transfers, for example, such as social security benefits and unemployment insurance. Copyright © 2018, 2015, 2011 Pearson Education, Inc. All rights reserved.

Problems in Measuring GDP Economic activity in the underground economy cannot be measured directly – this activity might be measured indirectly by accounting for the use of currency. Government production is difficult to measure, as the output (for example defense services) is typically not sold in the market. GDP is certainly not measured without error –we need to take NIPA numbers with a grain of salt. There is a substantial amount of underground activity that takes place – economic activity that should be included in GDP but is not, because people have an interest in hiding it. Underground activity includes illegal transactions – drugs and prostitution, for example – and activity that goes unreported because people want to avoid paying taxes. A second measurement problem is associated with the government. Government services are not sold at market prices, so government activity is measured at cost, which could overvalue or undervalue it. Copyright © 2018, 2015, 2011 Pearson Education, Inc. All rights reserved.

Nominal and Real GDP and Price Indices Price Index: Weighted average of a set of observed prices that gives a measure of the price level. Price indices allow us to measure the inflation rate – the rate of change in the price level. A measure of the inflation rate allows us to determine how much of an increase in GDP is nominal and how much is real. Macroeconomists are interested in the price level and the inflation rate. The price level is the average level of prices across goods and services, and the inflation rate is the rate of change over time in the price level. We thus need methods for calculating averages of prices across goods and services. In NIPA, measuring the price level also gives us a measure of real GDP as a byproduct. Real GDP is a measure of the physical quantity of goods and services produced in a given year, which gives us a standard to measure growth in economic welfare, in the aggregate, over time. Copyright © 2018, 2015, 2011 Pearson Education, Inc. All rights reserved.

Table 2.10 Data for Real GDP Example As with NIPA, it helps to work through an example to understand how real GDP and price indexes are calculated. The example is a simple economy with two products, apples and oranges. Copyright © 2018, 2015, 2011 Pearson Education, Inc. All rights reserved.

Figure 2.1 Nominal GDP and Chain-Weighted Real GDP The figure shows measured real and nominal GDP for the United States, with real GDP measured in 2009 dollars. Note that when the effects of inflation are taken out, real GDP increases at a lower rate than nominal GDP, reflecting the fact that average inflation was positive over the whole period and particularly high in the 1970s. Copyright © 2018, 2015, 2011 Pearson Education, Inc. All rights reserved.

Table 2.11 Implicit GDP Price Deflators, Example There are different ways to measure the GDP price deflator – the measure of the price level that comes from NIPA. The base year will matter, for example, because of changes in relative prices over time. As well, in the U.S., chain-weighting is used in the NIPA. Under this approach, there is not a specific base year – chain weighting is like having a rolling base year. Copyright © 2018, 2015, 2011 Pearson Education, Inc. All rights reserved.

Figure 2.2 Inflation Rate Calculated from the CPI and from the Implicit GDP Price Deflator We get different measures of the price level when we take different approaches. The chart shows how the inflation rate looks different if we measure it as the rate of change in the CPI or the rate of change in the GDP deflator. Note that CPI inflation tends to be more volatile. The GDP deflator is a better measure of the price level, but the CPI is available monthly, and the data is released sooner. Copyright © 2018, 2015, 2011 Pearson Education, Inc. All rights reserved.

Figure 2.3 The Price Level as Measured by the CPI and the Implicit GDP Price Deflator The chart illustrates one of the problems with the CPI as a measure of the price level. CPI inflation tends to be biased upward, and this effect cumulates over time. In the chart, a large gap between the CPI and GDP deflator develops over time, with each time series normalized to 100 in 1947. Copyright © 2018, 2015, 2011 Pearson Education, Inc. All rights reserved.

Problems in Measuring Real GDP and the Price Level The relative prices of goods change over time – a problem for CPI measurement. The quality of goods and services changes over time. New goods and services are introduced, and some goods and services become obsolete. The slide lists three problems in measuring real GDP and the price level. Note that real GDP and price level measurement are tied together, as they are just the flip side of the same measurement exercise. If relative prices change over time, this causes difficulties, as shown in the running example. Further, if the quality of goods changes over time, we could have difficulty in measuring GDP – for example, the quality of cars has changed substantially over time. A 2016 car is not the same car as a 1950 car – we now get much more car for the money. Also, as goods become obsolete and are replaced by new ones, it becomes very difficult to compare aggregate output in one year with aggregate output in another year. Copyright © 2018, 2015, 2011 Pearson Education, Inc. All rights reserved.

Savings, Wealth, and Capital: Part I Private Disposable Income: The next slides are a series of definitions. This material may seem dull, but it is critical for what we do in our models in the rest of the text. First, disposable income is defined as total GDP plus net factor payments from abroad, plus transfers from the government, plus interest paid on the government debt to domestic residents, minus taxes paid to the government. This is what is available for consumers to spend. Copyright © 2018, 2015, 2011 Pearson Education, Inc. All rights reserved.

Savings, Wealth, and Capital: Part II Private Sector Saving: Private sector saving is the income that is available to spend, minus what is actually spent. That is, private saving is disposable income minus consumption, and then we substitute for disposable income from the equation on the previous slide. Copyright © 2018, 2015, 2011 Pearson Education, Inc. All rights reserved.

Savings, Wealth, and Capital: Part III Government Saving = - Government Deficit: The government is much like consumers, in how we account for its income and spending. Government saving, or the government surplus, or minus the government deficit, is equal to taxes, minus transfers to the private sector, minus interest on the government debt, minus government expenditures on goods and services. Copyright © 2018, 2015, 2011 Pearson Education, Inc. All rights reserved.

Savings, Wealth, and Capital: Part IV National Saving = Private Saving + Government Saving: For the nation as a whole, we obtain national saving by adding private sector saving and government saving to get GDP plus net factor payments from abroad, minus consumption, minus government expenditures. Copyright © 2018, 2015, 2011 Pearson Education, Inc. All rights reserved.

Savings, Wealth, and Capital: Part V National savings is reflected in investment (new capital stock) plus the current account surplus (acquisition of claims on foreigners): This identity is interesting because it tells us that national savings is reflected in investment plus the current account surplus. That is, when we save as a nation we accumulate wealth in the form of physical capital (that’s investment) and claims on people in other countries (that’s the current account surplus). Copyright © 2018, 2015, 2011 Pearson Education, Inc. All rights reserved.

Labor Market Measurement The Bureau of Labor Statistics monthly household survey divides the working-age population into three groups: Employed Unemployed Not in the Labor Force Labor force = employed + unemployed Another key element in macroeconomic measurement, discussed further in Chapter 6, is labor market measurement. One important set of measurements comes from the BLS monthly household survey, or CPS (current population survey). This survey serves to divide the population into three groups: the employed, the unemployed, and those not in the labor force. Copyright © 2018, 2015, 2011 Pearson Education, Inc. All rights reserved.

Three Key Labor Market Measures     Once we know how many employed, unemployed, and not-in-the-labor-force there are, we can calculate three key measures: the unemployment rate, the participation rate, and the employment/population ratio. The unemployment rate gives us a measure of labor market tightness, while the participation rate tells us about participation in the labor force. The employment/population ratio is an indicator of the size of the labor input to production.   Copyright © 2018, 2015, 2011 Pearson Education, Inc. All rights reserved.