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The Data of Macroeconomics

Chapter Two

Introduction

This chapter focuses on the measurement of three statistics that


economists and policymakers use to make policy decisions:

Gross Domestic Product (GDP) tells us the nations total income and
the total expenditure of its output of goods and services
Consumer Price Index (CPI) measures the overall level of prices
Unemployment Rate tells us the fraction of workers who are
unemployed

These statistics are by far three of the most important economic


statistics

Policymakers and businesspersons use them to monitor the economy


and formulate appropriate policies
Economists use them to develop and test theories about how the
economy works

Measuring the Value of Economic Activity:


Gross Domestic Product

GDP is often used as a measure of how well the economy is


performing; if GDP growth is high then the economy is healthy, if
GDP growth is low then the economy is stagnating.
The goal of GDP is to summarize in a single number the dollar value
of economic activity in a given period of time.
There are two ways to define GDP:

Total income earned by domestically-located factors of production


(owners of labor and capital)
Total expenditure on domestically-produced final goods and services

How can GDP measure both the economys income and the
expenditure on its output?
The reason is that these two quantities are actually the same: for the
economy as a whole, income must equal expenditure.

Why expenditure = income?


InInevery
everytransaction,
transaction,
the
thebuyers
buyersexpenditure
expenditure
becomes
becomesthe
thesellers
sellersincome.
income.
Thus,
Thus,the
thesum
sumofofall
allexpenditure
expenditure
equals
equals
the
thesum
sumofofall
allincome.
income.
When Dagny buys steel from Hank for $100,000, that $100,000 is income for
Hank and expenditure by Dagny. The transaction contributes $100,000 to
GDP, regardless of whether we are adding up all income or adding up all
expenditure.

Income, Expenditure, and the Circular Flow

Economy produces 1
good, bread, from 1
input, labor
What does the inner
loop represent?
What does the outer
loop represent?
GDP measures the flow
of dollars in this
economy and can be
computed 2 ways; GDP
is the total income from
the production of bread
= wages + profit = top
half of the circular flow;
GDP is the total
expenditure on
purchases of bread =
bottom half of the
circular flow chart

Income
($)
Labor

Households

Firms

Goods
(bread
)
Expenditure
($)

Rules for Computing GDP

Unlike our single good economy (bread), computing GDP in a


complex economy is more complicated
Gross Domestic Product is the market value of all final goods and
services produced within an economy in a given period of time.
Suppose economy produces 4 apples and 3
oranges:

How do we compute the total


value of numerous different
goods and services? We use
actual market prices because
they reflect how much
people are willing to pay for
a good or a service.

1 apple costs $0.50


1 orange costs $1.00
GDP = (Price of Apples Quantity of Apples) +
(Price of Oranges Quantity of Oranges)
= ($0.50 4) + ($1.00 3)
= $5.00

What about used goods and inventories?

Suppose that you purchase a $500,000 Van Gogh at an art auction;


Does the $500,000 contribute to our GDP? Why or why not?
The sale of the painting reflects the transfer of an asset from one
person to another, it does not reflect an addition to the economys
income or output.
The sale of used goods is not included as part of GDP
Suppose that John Deer hires workers to build 1 more tractor, pays
their wages, and then fails to sell the additional tractor; how is GDP
affected?

Suppose tractor breaks down before being sold; what happens to


wages? What happens to the firms profit? What happens to total
expenditure in the economy? So what happens to GDP?
Suppose instead John Deer puts the tractor into inventory; what
happens to wages? What happens to the firms profit? What happens
to total expenditure? So what happens to GDP?
What happens later when John Deer sells the tractor out of inventory?

Intermediate Goods and Value Added

Suppose Hank purchases $25,000 worth of iron ore from Ken, uses
the ore to make steel and then sells the steel to Wyatt for $100,000;
should GDP include both the ore and the steel (a total of $125,000) or
just the steel ($100,000)?
Remember GDP includes only the value of final goods; why would
we not want to include the value of intermediate goods (iron ore)?
This suggests an alternative way to compute GDP:

A firms value added is the value of its output minus the value of the
intermediate goods the firm used to produce that output.
To compute GDP simply sum the value added at each stage of
production:
In our case, what is Kens value added (assuming he used no other
inputs)? What is Hanks value added? What is the total value added?
The sum of all value added must equal the value of all final goods and
services

Exercise: (Problem 2, p.40)


A farmer grows a bushel of wheat
and sells it to a miller for $1.00.
The miller turns the wheat into flour
and sells it to a baker for $3.00.
The baker uses the flour to make a loaf of
bread and sells it to an engineer for $6.00.
The engineer eats the bread.
Compute
value added at each stage of production
GDP

The Components of Expenditure

GDP is important but so is the allocation of this


output among alternative uses
GDP is divided into 4 broad categories:

Consumption (C)
Investment (I)
Government Purchases (G)
Net Exports (NX)

Consumption (C)
def: the value of all
goods and services
bought by households.
Includes:

durable goods
last a long time
ex: cars, home
appliances
non-durable goods
last a short time
ex: food, clothing
services
work done for
consumers
ex: dry cleaning,
air travel.

U.S. Consumption, 2005

Investment (I)
def1: spending on (the factor of production) capital.
def2: spending on goods bought for future use.
Includes:

business fixed investment


spending on plant and equipment that firms will use to
produce other goods & services
residential fixed investment
spending on housing units by consumers and landlords
inventory investment
the change in the value of all firms inventories

U.S. Investment, 2005

Investment vs. Capital

Capital is one of the factors of production.


At any given moment, the economy has a certain overall stock of
capital.

Investment is spending on new capital.

Example (assumes no depreciation):

1/1/2002:
economy has $500b worth of capital

during 2002:
investment = $37b

1/1/2003:
economy will have $537b worth of capital

Stocks vs. Flows

Stock

Flow

More
examples:

stock

flow

a persons wealth

a persons saving

# of people with
college degrees

# of new college
graduates

the govt. debt

the govt. budget deficit

Government Purchases (G)

G includes all government spending on goods and services.


G excludes transfer payments (e.g. unemployment insurance
payments), because they do not represent spending on goods and
services.

$ billions

Net exports (NX = EX - IM)

50
0
-50
-100
-150
-200
-250
-300
-350
-400
1960

def: the value of total exports


(EX)
minus the value of total imports
U.S. Net Exports, 1960-2000
(IM)

1965

1970

1975

1980

1985

1990

1995

2000

An important identity
Y = C + I + G + NX
where
Y = GDP = the value of total output
C + I + G + NX = aggregate
expenditure

An identity is an equation that always holds because of the way


the variables are defined.

Other Measures of Income: GDP vs. GNP

Gross National Product (GNP) is the total income earned by the


nations factors of production regardless of what country those
factors of production reside.
Gross Domestic Product (GDP) is the total income earned
domestically-located factors of production regardless of nationality.
To obtain GNP we add receipts of factor income (wages, profit, and
rent) from the rest of the world and subtract payments of factor
income to the rest of the world:
GNP = GDP + Factor Payments from Abroad Factor Payments to Abroad

Example: Lance Armstrong owns a bicycle shop in Paris. The income he


earns is part of the GDP of France because it is earned in France but because
this income is a factor payment to a U.S. national, it is not part of French GNP.

(GNP GDP) as a percentage of GDP


for selected countries, 1997.
U.S.A.
Bangladesh
Brazil
Canada
Chile
Ireland
Kuwait
Mexico
Saudi Arabia
Singapore

0.1%
3.3
-2.0
-3.2
-8.8
-16.2
20.8
-3.2
3.3
4.2

Real GDP vs. Nominal GDP

Is GDP always a good measure of economic well-being?


Consider again the apples/oranges economy:
GDP = (Price of Apples Quantity of Apples) + (Price of Oranges Quantity
of Oranges)

What are the 2 ways that GDP can change?


If all prices doubled without any change in quantities, what would happen to
GDP? Does this accurately reflect how much output is being produced?
Nominal GDP the total value of goods and services measured at current prices
A superior measure of economic health would tally the economys output of
goods and services and would not be influenced by changes in prices.
Real GDP the total value of goods and services measured using a constant set
of prices
Changes in real GDP can only be due to changes in quantities, because real GDP
is constructed using constant base-year prices.

Practice problem, part 1


2001

2002

2003

good A

$30

900

$31

1,000

$36

1,050

good B

$100

192

$102

200

$100

205

Compute nominal GDP in each year


Compute real GDP in each year
using 2001 as the base year.

Answers to practice problem, part 1

Nominal GDP multiply Ps & Qs from same year


2001: $46,200 = $30 900 + $100 192
2002:
2003:

Real GDP multiply each years Qs by 2001 Ps


2001:
2002:
2003:

(billions of U.S. dollars)

U.S. Real & Nominal GDP, 19672001


11,000
10,000
9,000
8,000
7,000
6,000
5,000
4,000
3,000
2,000
1,000
0
1965

1970

1975

1980

NGDP (billions of $)

1985

1990

1995

RGDP (billions of 1996 $)

2000

The GDP Deflator

The GDP Deflator, or the implicit price deflator, is defined as the ratio of nominal GDP to real GDP:

Nominal GDP
GDP deflator = 100
Real GDP
The GDP Deflator indicates whats happening to the overall level of
prices.
Consider again the 1 good (bread) economy: GDP Deflator = ?
GDP Deflator = 100 (P Q)/(Pbase Q) = 100 (P/Pbase)
Writing it in this way we see that the GDP deflator is simply the ratio of
current to base year prices
What does it mean if the GDP deflator is > 100? < 100?

Practice problem, part 2


Nom.
GDP

Real GDP

2001

$46,200

$46,200

2002

51,400

50,000

2003

58,300

52,000

GDP
deflator

inflation
rate
n.a.

Use your previous answers to compute


the GDP deflator in each year.

Use GDP deflator to compute the inflation rate


from 2001 to 2002, and from 2002 to 2003.

Understanding the GDP deflator


Example with 3 goods
For good i = 1, 2, 3
Pit = the market price of good i in year t
Qit = the quantity of good i produced in year t
NGDPt = Nominal GDP in year t
RGDPt = Real GDP in year t

Understanding the GDP deflator


NGDPt
P1tQ1t P2tQ2t P3tQ3t
GDP deflator 100
100
RGDPt
RGDPt
Q1t

Q2t
Q 3t
100
P1t
P2t
P3t
RGDP
RGDPt
RGDP
t
t
The
TheGDP
GDPdeflator
deflatorisisaaweighted
weightedaverage
averageof
ofprices.
prices.
The
Theweight
weighton
oneach
eachprice
pricereflects
reflects
that
thatgoods
goodsrelative
relativeimportance
importancein
inGDP.
GDP.
Note
Notethat
thatthe
theweights
weightschange
changeover
overtime.
time.

Consumer Price Index (CPI)

Just as GDP turns the quantities of many goods into a single number
measuring the value of production, the CPI turns the prices of many
goods into a single index measuring the overall level of prices.
The CPI is computed every month by the Bureau of Labor Statistics
The BLS constructs the CPI in the following way:

Survey consumers to determine composition of the typical


consumers basket of goods

Every month, collect data on prices of all items in the basket;


compute cost of basket

CPI in any month equals:

Cost of basket in that month


100
Cost of basket in base period

Exercise: Compute the CPI


The basket contains 20 pizzas and
10 compact discs.
prices:
2000
2001
2002
2003

pizza
$10
$11
$12
$13

CDs
$15
$15
$16
$15

For each year,


compute
the cost of the
basket
the CPI (use 2000
as the base year)
the inflation rate
from the preceding

answers:
cost of
basket
2000
2001
2002
2003

CPI

inflation
rate
n.a.

The composition of the CPIs basket


Food and bev.
17.6%

Housing

5.9%
2.8%

Apparel
Transportation

5.8%

2.5%
4.5%

4.8%

Medical care
Recreation
16.2%

Education
Communication
Other goods and
services

40.0%

Understanding the CPI


Example with 3 goods: For good i = 1, 2, 3
Ci = the amount of good i in the CPIs
basket
Pit = the price of good i in month t
Et = the cost of the CPI basket in month t
Eb = cost of the basket in the base period

Et
CPI in month t 100
Eb

P1tC1 + P2tC2 + P3tC3


100
Eb

C1

C
2
C3
100 P1t P2t P3t
Eb

E
b
Eb
The CPI is a weighted average of prices.
The weight on each price reflects
that goods relative importance in the CPIs basket.
Note that the weights remain fixed over time.

CPI vs. GDP deflator

1)

There are 3 key differences between the CPI and the GDP deflator as
measures of whats happening to the overall level of prices:
GDP deflator measures the prices of all goods produced, whereas the CPI
measures the prices of only the goods bought by consumers.
1)

2)

GDP deflator includes only goods produced domestically; imported goods


are not included.
1)

3)

Do the prices of capital goods and government goods show up in both?

An increase in the price of a Nintendo system affects which one?

The CPI assigns fixed weights to the prices of different goods, whereas the
GDP deflator assigns changing weights. The CPI is computed using a fixed
basket of goods, whereas the GDP deflator allows the basket of goods to
change over time as the composition of GDP changes.
1)

A drought causes the wheat crop to fail resulting in skyrocketing prices for
bread. Are both price indices greatly affected? Why or why not?

Two measures of inflation

Measuring Joblessness: The Unemployment Rate

The unemployment rate is the statistic that measures the percentage of those people
wanting to work who do not have jobs.
To compute the official unemployment rate, the BLS places survey responders into
1 of 3 categories:

The labor force is the sum of the employed and unemployed persons

Labor Force = # of people employed + # of people unemployed

The unemployment rate is the percentage of the labor force that is unemployed

Employed the person spent some (part-time included) of the previous week working
at a paid job
Unemployed the person is not employed and has been actively seeking a job or is on
temporary layoff
Not in labor force a person who fits neither of the first 2 categories; full-time
student, retiree, discouraged worker

Unemployment Rate = (# of unemployed)/(labor force) 100

The labor-force participation rate is the percentage of the adult population that is
in the labor force

Labor-Force Participation Rate = (Labor Force)/(Adult Population) 100

Exercise: Compute labor force statistics


U.S. adult population by group, April 2002
Number employed
Number unemployed
Adult population

=
=
=

134.0 million
8.6 million
213.5 million

Use the above data to calculate

the labor force


the number of people not in the labor force
the labor force participation rate
the unemployment rate

Answers:

data: E = 134 , U = 8.6, POP = 213.5

labor force
L = E + U = __________

not in labor force


NILF = POP L = __________

unemployment rate
(U/L) 100 = __________

labor force participation rate


(L/POP) 100 = __________

Chapter Summary
1.

Gross Domestic Product (GDP) measures both total income and total
expenditure on the economys output of goods & services.

2.

Nominal GDP values output at current prices; real GDP values output at
constant prices. Changes in output affect both measures, but changes in
prices only affect nominal GDP.

3.

GDP is the sum of consumption, investment, government purchases, and net


exports.

4.

The overall level of prices can be measured by either

the Consumer Price Index (CPI), the price of a fixed basket of goods
purchased by the typical consumer

the GDP deflator, the ratio of nominal to real GDP

5.

The unemployment rate is the fraction of the labor force that is not
employed.

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