Intermediate Macroeconomics Chapter 2 Measuring the Macroeconomy

Measuring the Macroeconomy 1. Measuring Total Output 2. How to Measure GDP 3. Measuring Price Changes Intermediate Macroeconomics

1. Measuring Total Output Monetary Measure of Value GDP versus GNP Omissions from GDP - does not measure social welfare Intermediate Macroeconomics

1. Measuring Total Output Monetary measure of value Quantity times Price equals Market Value Cars 1,000 x $20,000 = $20,000,000 Dolls 10,000 x $ 10 = $ 100,000 Total Value of Output = $20,100,000 Intermediate Macroeconomics

1. Measuring Total Output GDP versus GNP Nominal Gross Domestic Product (GDP) - the market value of final goods and services produced by a nation during a specific period, usually 1 year. Nominal Gross National Product (GNP) - the market value of final goods and services produced by labor and property supplied by the residents of a nation during a specific period, usually 1 year. Toyota plant Ford plant in Tennessee in Mexico GDP included excluded GNP excluded included Parse GDP definition Market value – earlier slide, dollar value Final goods and services – excludes intermediate goods Produced – excludes used goods By a nation – distinguishes from GDP Intermediate Macroeconomics

1. Measuring Total Output Omissions from GDP GDP is a poor measure of social welfare: Leisure Home and volunteer labor (non market production) Depletion of nonrenewable resources Unregulated pollution Distribution of income Differences in preferences Social Welfare Leisure – European worker vacation days Home and volunteer labor – home remodeling, production in less developed countries. Additional examples not in text. Depletion of nonrenewable natural resources. When nonrenewable resources like oil and minerals are extracted and sold, their total sale value is included in GDP in the final products produced from them. But, the reduction in wealth in terms of the abundance of nonrenewable natural resources is not recognized. Distribution of income. Some economists suggest that redistribution of income from the very rich to the very poor raises the welfare of the poorer persons more than it reduces the welfare of the rich so that in total there is an increase in society’s net welfare. A country with a lower GDP per capita may have a “better” distribution of income. Preferences - Aunt on isle of Mull (West Coast of Scotland). One road goes around the island. Many houses do not have electricity. No lawnmower - sheep. A country with lower GDP per capita may prefer it that way. Intermediate Macroeconomics

Expenditure Approach Income Approach 2. How to Measure GDP Intermediate Macroeconomics

2. How to Measure GDP Circular flow of income and expenditures Resources Business Firms Households Goods and Services Expenditures Solid Lines - Flow of Money Dashed lines - Flow of Goods and Services Intermediate Macroeconomics

2. How to Measure GDP Expenditure approach GDP = Consumption Spending (C) + Private Domestic Investment (I) + Government Spending (G) + Exports - Imports (net exports, NX) GDP = C + I + G + NX Intermediate Macroeconomics

2. How to Measure GDP Expenditure approach: Expenditure Shares 2003 U.S. Gross Domestic Product Government Spending 18.9 % Consumption 70.5 % Investment 15.1 % Net Exports = - 4.5 % (not shown in slide) Intermediate Macroeconomics

2. How to Measure GDP Expenditure Approach: Consumption 1990-91 recession Real Consumption excluding durables Real consumption of nondurables + services, which accounts for over 85% of total consumption, appears less volatile that real GDP. Consumption: Durable goods: cars, appliances Non-durable goods: food, gasoline Services: haircuts, lawyers, education Real GDP 1981-82 recession 1973-75 recession Intermediate Macroeconomics

2. How to Measure GDP Expenditure Approach: Investment Gross Investment = Net Investment + Depreciation Investment = production and accumulation of goods for future use in production processes. Capital resources = any resources that are used to produce other goods and are themselves produced. Investment represents a foregone opportunity for consumption Investment includes Purchases of durable plant and equipment by firms New homes Inventory change (may be positive or negative) Investment does not include: purchases of financial capital (e.g., stocks and bonds) purchase of land investment in human capital (education) Gross versus Net Investment Net Investment = Gross Investment - depreciation Intermediate Macroeconomics

2. How to Measure GDP Expenditure approach: Government U.S. Government Spending Share of GDP Government spending includes: Salaries of government workers Spending on roads, schools, etc. Does not include: Transfer payments (e.g., social security, unemployment benefits) Payment on Federal debt 2003 = 18.9% 2000 = 17.5% 1996 = 18.1% 1992 = 20.0% 1988 = 20.4% Intermediate Macroeconomics

2. How to Measure GDP Expenditure Approach: Net exports Trade Deficit Imports Post World War 2 Surplus Exports W W 2 Source: Bureau of Economic Analysis, www.bea.gov Intermediate Macroeconomics

2. How to Measure GDP Income approach National Income = GDP (with corrections) Personal Income = National Income (with corrections) Personal Income - Personal income taxes - Social Security withholding = Disposable Personal Income Intermediate Macroeconomics

3. Measuring Price Changes Nominal and Real GDP GDP Deflator Consumer Price Index GDP Deflator / CPI Differences Problems with Traditional Price Indexes Chain-weighted Price Index Price Index: a measure of the change in the average level of prices Intermediate Macroeconomics

3. Measuring Price Changes Nominal and Real GDP Nominal GDP Value of output measured at actual prices (current dollar output) Does not correct for inflation Real GDP Value of output based on prices of some base period (“constant” dollar output) eliminates effect of inflation Intermediate Macroeconomics

3. Measuring Price Changes Sample problem Was the economy better or worse off in 1994 compared with 1992? What was the rate of inflation between 1992 and 1994? Intermediate Macroeconomics

3. Measuring Price Changes Definition of Nominal GDP = Current year Quantities x Current year Prices Intermediate Macroeconomics

3. Measuring Price Changes Sample problem: 1992 Nominal GDP = 1992 Quantities x 1992 Prices = 1992 Spending on Food Housing Fun Machines = 4 • $12 + 3 • $9 + 3 • $4 + 2 • $20 = $48 + $27 + $12 + $40 = $127 Intermediate Macroeconomics

3. Measuring Price Changes Sample problem: 1994 Nominal GDP = 1994 Quantities x 1994 Prices = 1994 Spending on Food Housing Fun Machines = 5 • $14 + 3 • $10 + 4 • $5 + 2 • $20 = $70 + $30 + $20 + $40 = $160 Intermediate Macroeconomics

3. Measuring Price Changes Definition of Real GDP = Current year Quantities x Base year Prices Intermediate Macroeconomics

3. Measuring Price Changes Sample problem: 1992 Real GDP = 1992 Quantities x 1992 Prices Food Housing Fun Machines = 4 • $12 + 3 • $9 + 3 • $4 + 2 • $20 = $48 + $27 + $12 + $40 = $127 Base year assumed to be 1992 Intermediate Macroeconomics

3. Measuring Price Changes Sample problem: 1994 Real GDP = 1994 Quantities x 1992 Prices Food Housing Fun Machines = 5 • $12 + 3 • $9 + 4 • $4 + 2 • $20 = $60 + $27 + $16 + $40 = $143 Base year assumed to be 1992 Intermediate Macroeconomics

3. Measuring Price Changes Sample problem: GDP growth Growth in Nominal GDP = (160 - 127) • 100 = 26% 127 Growth in Real GDP = (143 - 127) • 100 = 13% Intermediate Macroeconomics

3. Measuring Price Changes Definition of GDP Deflator GDP Deflator = Nominal GDP x 100 Real GDP or, Real GDP = Nominal GDP x 100 GDP Deflator GDP deflator - rice index that measures change in average level of prices of all goods and services counted in the GDP Intermediate Macroeconomics

3. Measuring Price Changes Sample problem: GDP deflator 127 1994 GDP Deflator = 160 • 100 = 111.9 143 Base year assumed to be 1992 Intermediate Macroeconomics

3. Measuring Price Changes Inflation Rate from the GDP Deflator Change in Average Level of Prices = Percent Change in GDP Deflator Inflation from 1992 to 1994: = (1994 Deflator - 1992 Deflator) • 100 1992 Deflator = (111.9 - 100.0) • 100 = 11.9% 100.0 Intermediate Macroeconomics

3. Measuring Price Changes Consumer Price Index Use base year (“market basket”) of goods and compare the total cost of the market basket between two years. Market basket includes only goods and services consumed by households. Market basket includes imported goods and services. Intermediate Macroeconomics

3. Measuring Price Changes Consumer Price Index Was the economy better or worse off in 1994 compared with 1992? What was the rate of inflation between 1992 and 1994? CPI: Machines not included. Base year quantities (market basket) rather than base year prices used. Intermediate Macroeconomics

3. Measuring Price Changes Consumer Price Index = 1992 Quantities x 1992 Prices = 4 • $12 + 3 • $9 + 3 • $4 = $48 + $27 + $12 = $87 = 1992 Quantities x 1994 Prices = 4 • $14 + 3 • $10 + 3 • $5 = $56 + $30 + $15 = $101 CPI = (1994 / 1992) x 100 = (101 / 87) = 116 Intermediate Macroeconomics

3. Measuring Price Changes GDP Deflator / CPI Differences All goods included Base-year prices Quantities variable Imports excluded Consumer Price Index Includes only consumer goods Base year quantities Prices variable Imports included CPI Market basket 1993-95 Consumer Expenditure Survey of over 30,000 families Collects monthly prices on 71,000 goods and services at about 22,000 retail outlets Survey of 35,000 rental units to determine cost of housing Intermediate Macroeconomics

3. Measuring Price Changes Problems with price indexes Substitution bias - changes in relative prices between goods (butter vs margarine) between stores (small vs large discounters) Quality changes and new products Chain-weighted indexes Why are changes in cost of living so hard to measure? literally millions of goods and services available in modern market economies a single supermarket may contain 30,000 differently price items WalMart store over 40,000 CPI overstated by about 1.1 percent due to Substitution bias: between goods - 0.4 percent between stores - 0.1 percent Quality changes and new products - 0.6 percent Intermediate Macroeconomics