GDP and CPI: Tracking the Macroeconomy SECOND CANADIAN EDITION MACROECONOMICS Paul Krugman | Robin Wells Iris Au | Jack Parkinson Chapter 7 GDP and CPI: Tracking the Macroeconomy © 2014 Worth Publishers

How economists use aggregate measures to track the performance of the economy What gross domestic product, or GDP, is and the three ways of calculating it The difference between real GDP and nominal GDP and why real GDP is the appropriate measure of real economic activity What a price index is and how it is used to calculate the inflation rate CHAPTER 7: KEY POINTS

Measurement of Macroeconomic Variables Definition and measurement issues are the focus of Chapters 7 and 8. Big questions: How do you measure the size of an economy? How do you measure prices and inflation? How do you measure unemployment? Measurement and definition problems can yield insights about the structure of the macroeconomy. Start with measuring the economy’s size: “GDP”.

The Circular-Flow Diagram: Basic Version The circular-flow diagram is a model that represents the transactions in an economy by flows around a circle.

Basic Circular-Flow Diagram A simple model of a market-based economy. Decision-makers: Households: buy goods and services with money (goods market); sell factors of production (labour, land, capital) for money in factor markets. Business firms: sell goods and services for money (goods market); buy factors of production with money in factor markets.

Circular-Flow Model Diagram hints at some key macroeconomic ideas. Link between incomes and spending on goods and services. Income → Spending → Income Coordinating role of markets. Interdependence: problems in goods markets spill into factor markets (and vice-versa). Basic Circular-Flow is too simple for measurement of an actual economy.

An Expanded Circular-Flow Diagram Government purchases of goods and services Government borrowing Government Consumer spending Government transfers Taxes Private savings Households Wages, profit, interest, rent Markets for goods and services Financial Markets Factor Markets Wages, profit, interest, rent Figure Caption: Figure 7(22)-1: An Expanded Circular-Flow Diagram: The Flows of Money Through the Economy A circular flow of funds connects the four sectors of the economy—households, firms, government, and the rest of the world—via three types of markets: the factor markets, the markets for goods and services, and the financial markets. Funds flow from firms to households in the form of wages, profit, interest, and rent through the factor markets. After paying taxes to the government and receiving government transfers, households allocate the remaining income— disposable income—to private savings and consumer spending. Via the financial markets, private savings and funds from the rest of the world are channeled into investment spending by firms, government borrowing, foreign borrowing and lending, and foreign transactions of stocks. In turn, funds flow from the government and households to firms to pay for purchases of goods and services. Finally, exports to the rest of the world generate a flow of funds into the economy and imports lead to a flow of funds out of the economy. If we add up consumer spending on goods and services, investment spending by firms, government purchases of goods and services, and exports, then subtract the value of imports, the total flow of funds represented by this calculation is total spending on final goods and services produced in Canada. Equivalently, it’s the value of all the final goods and services produced in Canada—that is, the gross domestic product of the economy. GDP Borrowing and stock issues by firms Investment Firms Foreign borrowing and sales of stock Exports Rest of the world Foreign lending and purchases of stock Imports

Expanded Circular-Flow: What’s New? Decision-makers: two new ones Households and Business Firms (as in Basic Circular-Flow) Government Rest-of-World (foreign households, firms and governments). Markets: one new one Market for Goods and services Factor markets (labour, land, capital etc.) Financial markets.

Expanded Circular-Flow: Financial Markets Markets for financial assets (bonds, stocks, loans, deposits) Core function: match savings with borrowers. Source of savings: Households (private savings): now not all income spent. Foreign sector (foreign lending and purchases of stocks). Borrowing: Business firms (borrowing and stock issues) Government (government borrowing – bonds, Treasury Bills) Foreign sector (foreign borrowing and selling stocks)

Expanded Circular-Flow: Decision-makers Households: buy goods and services (Consumption spending, C), sell factors of production (wage, interest, dividend, rental income) (as before) pays taxes, receives transfer payments from government. ( Disposable income= total household income - taxes + transfers ) saves some of its disposable income: “private savings” Business firms: sell goods, buy factors of production (as before) spends on Investment (I) spending on machinery, building construction, accumulated inventories borrows to finance activities.

Expanded Circular-Flow: (cont’d) Government: Buys goods and services (Government spending, G). Pays transfers to households. Borrows to cover any deficit. Rest-of-World: Buys Canadian goods and services (our Exports, X) Sells foreign goods and services to us (Imports, IM) Borrows from Canadians Lends to Canadians.

Spending on Goods and Services Basic Circular-Flow: Household spending = Demand for goods and services = Dollar value of goods and services. Expanded Circular Flow: Spending on goods and services: C+I+G+X-M Consumption spending (households): C Investment spending (businesses): I Government spending (government): G Export spending (Rest-of-World): X Minus Import spending (ROW): IM Minus? Part of C, I and G is on foreign goods and services.

The National Accounts Almost all countries calculate a set of numbers known as the national income and product accounts. The national income and product accounts, or national accounts, keep track of the flows of money between different parts of the economy.

Gross Domestic Product (GDP) Gross domestic product is the total value of all final goods and services produced in the economy during a given year. Final goods and services are goods and services sold to the final, or end, user. GDP excludes the value of intermediate goods. Intermediate goods and services: inputs produced by one firm and sold to other firms who use then to produce final goods or services.

Calculating Gross Domestic Product GDP can be calculated three ways: Add up the value added of all producers Add up all spending on domestically produced final goods and services. This results in the equation: GDP = C + I + G + X – IM Aggregate expenditure —total spending on domestically produced final goods and services in the economy (C+I+G+X-IM). Add up all income paid to factors of production

Calculating GDP: an example of the 3 methods Figure Caption: Figure 7(22)-2: Calculating GDP In this hypothetical economy consisting of three firms, GDP can be calculated in three different ways: measuring GDP as the value of production of final goods and services, by summing each firm’s value added; measuring GDP as aggregate spending on domestically produced final goods and services; and measuring GDP as factor income earned by households from firms in the economy.

Calculating GDP: Value Added Approach Value added = total sales – value of intermediate inputs e.g. American Motors value added = $21,500-$9,000. Sum of valued added across the three firms=$21,500. Why value added? Why not include intermediate goods? “Double-counting” problem Value of intermediate goods is included in the value of the final good. Summing total sales across the 3 firms counts value of steel twice (total sales of steel firm and in the total sales of car firm) and value of iron ore three times (at each stage of production)!

Calculating GDP: Expenditure Approach Expenditure Approach: sum all spending on final goods and services. In example: total sales of car producer (cars are the only final good in the example): $21,500 For the economy as a whole: GDP = Aggregate Expenditure on final goods and services = C + I + G + X –IM

Calculating GDP: Income Approach Income approach: GDP sum of factor incomes and non- factor payments. In example: sum of wages, interest, rent and profit (all factor incomes) Non-factor payments? Indirect taxes less subsidies: create gap between revenues received by firm and what is paid out as income. e.g. sales taxes: difference between price paid by consumer and what the firm keeps (spending but not income) Capital consumption allowances (for depreciated capital) (some investment spending replaces capital: doesn’t become income)

GDP Measurement Pitfalls GDP: What’s In and What’s Out Included domestically produced final goods and services new productive physical capital changes to inventories Not Included intermediate goods and services (inputs) used goods financial assets like stocks and bonds foreign-produced goods and services Household production, volunteer work Underground economy Environmental damage or amenities

GDP Pitfalls: Consequences of Omissions GDP focuses on final value of market goods and services. Useful for monitoring business cycle fluctuations (origins of national accounts: Great Depression). Useful for monitoring growth in market output. GDP is problematic as a measure of well-being Omits environmental amenities, output or services produced and consumed in the home, illegal output, value of volunteer activities – all these can contribute to well-being. Pitfalls in international comparisons: Poor countries: subsistence agriculture, informal/underground sectors -- GDP per person can seriously understate well-being. Countries with large underground economies (Greece, Italy). Pitfalls across time: GDP growth but environmental deterioration.

Canada’s GDP, 2011: Income and Expenditure Approaches Figure Caption: Figure 7(22)-3: Canada’s GDP in 2011: Two Methods of Calculating GDP The two bars show two equivalent ways of calculating GDP. The height of each bar above the horizontal axis represents $1,720.7 billion, Canada’s GDP in 2011. The bar on the left shows Canada’s GDP calculated according to the expenditure approach. The $21 billion, shown as the area extending below the horizontal axis, is the amount of total spending absorbed by net exports, which means Canada ran a trade deficit in 2011. The bar on the right shows Canada’s GDP according to the income approach. The largest component in the factor income category is labour income (51.7%) while the largest component in the non-factor payments category is capital consumption allowances ($241.7 billion) Source: Statistics Canada.

GROSS WHAT? GDP vs GNP Occasionally you may see references not to gross domestic product but to gross national product, or GNP. GNP is defined as the total factor income earned by residents of a country. It excludes factor income earned by foreigners, like profits paid to foreign investors who own Canadian stocks and payments to foreigners who work temporarily in Canada. And it includes factor income earned abroad by Canadians, like the profits of Blackberry’s European operations that accrue to Blackberry’s Canadian shareholders and the wages of Canadians who work abroad temporarily.

GROSS WHAT? GDP vs GNP GDP’s considered a better indicator of short-run movements in production. GNP a better measure of Canadian’s incomes. In 2011, Canadian GDP was about 1.9% higher than its GNP, mainly because of foreign companies operating in Canada.

ECONOMICS IN ACTION Creating the National Accounts The national accounts owe their creation to the Great Depression. Simon Kuznets developed a set of national income accounts. The first version of these accounts was presented to US Congress in 1937 and in a research report titled National Income. Drawing on Kuznets’s work, Canada published its first annual estimates of the Income and Expenditure Accounts in the latter half of the 1940s.

ECONOMICS IN ACTION Creating the National Accounts Statistics Canada compiles the national accounts using data from many sources including customs records, income tax returns, government public accounts, surveys conducted by government agencies, and so on. These data are used by governments and the Bank of Canada to formulate policies and to assess economic performance.

Real versus Nominal GDP Real GDP is the total value of the final goods and services produced in the economy during a given year, calculated using the prices of a selected base year. Nominal GDP is the value of all final goods and services produced in the economy during a given year, calculated using the prices in the year in which the output is produced. Real GDP changes via changes in final goods and services. Nominal GDP changes via EITHER changes in final goods and services OR changes in prices.

Real versus Nominal GDP Except in the base year, real GDP, output valued at constant prices, is not the same as nominal GDP, output valued at current prices. Real GDP is used to measure changes in the size of the economy over time. (reflects output changes not price changes) GDP per capita is a measure of average GDP per person. - often used for cross-country comparisons at a point in time. - however recall problem of omissions from GDP

Real versus Nominal GDP Calculating GDP and Real GDP in a Simple 2 Good Economy (Base Year is Year 1 for Real GDP)

Real versus Nominal GDP Nominal versus Real GDP in 1992, 2002, and 2011 Source: Bureau of Economic Analysis. Beware: some use nominal figures to make something look like it is growing faster than it really is!

Canada’s Real GDP Growth Rate 1962-2011 Figure Caption: Figure 7-3: Canada’s Real GDP Growth Rate from 1962 to 2011 The figure shows the growth rate of Canadian real GDP from 1962 to 2011. Fluctuations in this growth rate reflect economic expansions and contractions. Source: Statistics Canada. Real GDP Growth Rate 2010-2011= 100%x(Real GDP 2011 – Real GDP 2010)/(Real GDP 2010)

Real GDP Growth: How high? How low? Fastest in 2014 (projected): China 7.3% India 6.0% Indonesia 5.0% Any recessions (negative growth) in 2014? Argentina -1.4% Italy -0.3% Canada 2014: 2.3% A sharp recession: 1981-82 recession -3.0% Fast growth? 6%-7% in 1960s. US very fast in 3rd quarter 2014: 5% (annualized)

GLOBAL COMPARISON: GDP and the Meaning of Life Rich is better Money matters less as you grow richer

ECONOMICS IN ACTION Miracle in Venezuela? The South American nation of Venezuela has a distinction that may surprise you: in recent years, it has had one of the world’s fastest-growing nominal GDPs. Between 2000 and 2010, Venezuelan nominal GDP grew by an average of 29% each year—much faster than nominal GDP in Canada, the United States or even in booming economies like China. So, is Venezuela experiencing an economic miracle?

ECONOMICS IN ACTION Miracle in Venezuela? No, it’s just suffering from unusually high inflation.

Price Indexes and the Aggregate Price Level The aggregate price level is a measure of the overall level of prices in the economy. To measure the aggregate price level, economists calculate the cost of purchasing a market basket. A price index is the ratio of the current cost of that market basket to the cost in a base year, multiplied by 100.

Market Baskets and Price Indexes Price Index (Pre-frost base year) = 100 x (Cost in given year)/$95.00 So: Price Index = 100 x($95)/$95 = 100 in Pre-frost year = 100 x($175)/$95 = 184.2 in Post-frost year

Inflation Rate, CPI, and other Indexes The inflation rate is the yearly percentage change in a price index, typically based on the Consumer Price Index, or CPI, the most common measure of the aggregate price level. The consumer price index measures the cost of the market basket of a typical Canadian family.

CPI: Basket of Average Canadian Family, 2011 Figure Caption: Figure 7(22)-6: The Makeup of the Consumer Price Index in 2011 This chart shows the percentage shares of major types of spending in the CPI as of April 2011 (using the 2009 basket at April 2011 prices). Housing (shelter & household operations), food, transportation, and gasoline comprised about 76% of the CPI 2009 market basket. Source: Statistics Canada.

CPI for Canada

Natural Logarithm of CPI

Price Levels Don’t Always Rise!

FOR INQUIRING MINDS Total CPI vs. Core CPI Total CPI includes all items in the market basket. Core CPI is calculated without volatile items (fruits, vegetables, gasoline, fuel oil, mortgage interest, natural gas, intercity transportation, and tobacco) and an adjustment removes effects of changes in sales taxes. The core CPI is a more reliable measure of changes in the inflation rate in the long term than the total CPI.

FOR INQUIRING MINDS

Other Price Measures A similar index to CPI for goods purchased by firms is the industrial product price index. Economists also use the GDP deflator, which measures the price level by calculating the ratio of nominal GDP to real GDP. The GDP deflator for a given year is 100 times the ratio of nominal GDP to real GDP in that year.

The CPI, the IPPI, and the GDP Deflator Figure Caption: Figure 7(22)-9: The CPI, the IPPI, and the GDP Deflator As the figure shows, the three different measures of inflation, the IPPI (orange), the CPI (green), and the GDP deflator (purple), usually move closely together. Each reveals a drastic acceleration of inflation during the 1970s and a return to relative price stability in the 1990s. Source: Statistics Canada.

ECONOMICS IN ACTION Indexing to the CPI The CPI has a direct and immediate impact on millions of Canadians. The reason is that many payments are tied, or “indexed,” to the CPI—the amount paid rises or falls when the CPI rises or falls. Examples: Public pensions (CPP, OAS, GIS); some labour contracts (COLA – cost-of-living-adjustment); real return bonds.

ECONOMICS IN ACTION Indexing to the CPI Payments on Canada Pension Plan, Old Age Security, or income supplement program amounted to almost $72 billion in 2012. With these payment indexed to inflation, when the rate of inflation goes up by 1%, payments on these income assistance programs rise by $720 million.

Summary Economists keep track of the flows of money between sectors with the national income and product accounts, or national accounts. Households earn income via the factor markets from wages. Disposable income is allocated to consumer spending (C) and private savings. Via the financial markets, private savings and foreign lending are channeled to investment spending (I), government borrowing, and foreign borrowing. Government purchases of goods and services (G) are paid for by tax revenues and any government borrowing. Exports (X) generate an inflow of funds into the country from the rest of the world, but imports (IM) lead to an outflow of funds to the rest of the world.

Summary Gross domestic product, or GDP, measures the value of all final goods and services produced in the economy. It does not include the value of intermediate goods and services, but it does include inventories and net exports (X − IM). It can be calculated in three ways: add up the value added by all producers; add up all spending on domestically produced final goods and services (GDP = C + I + G + X − IM); or add up all the income paid by domestic firms to factors of production. These three methods are equivalent.

Summary Real GDP is the value of the final goods and services produced calculated using the prices of a selected base year. Except in the base year, real GDP is not the same as nominal GDP, the value of aggregate output calculated using current prices. Analysis of the growth rate of aggregate output must use real GDP. Real GDP per capita is a measure of average aggregate output per person but is not in itself an appropriate policy goal.

Summary To measure the aggregate price level, economists calculate the cost of purchasing a market basket. A price index is the ratio of the current cost of that market basket to the cost in a selected base year, multiplied by 100. The inflation rate is the yearly percent change in a price index, typically based on the consumer price index, or CPI, the most common measure of the aggregate price level. A similar index for goods and services purchased by firms is the industrial product price index, or IPPI. Finally, economists also use the GDP deflator, which measures the price level by calculating the ratio of nominal to real GDP times 100.

Key Terms National income and product accounts (national accounts) Intermediate goods and services Gross domestic product (GDP) Consumer spending Aggregate spending Stock Value added Bond Net exports Government transfers Aggregate output Disposable income Real GDP Private savings Nominal GDP Financial markets Chained dollars Government borrowing GDP per capita Government purchases of goods and services Aggregate price level Market basket Exports Price index Imports Inflation rate Inventories Consumer price index (CPI) Investment spending Producer price index (PPI) Final goods and services