Tracking the Macroeconomy Chapter 8 Tracking the Macroeconomy Slides created by Dr. Amy Scott ©2010  Worth Publishers 1

AFTER THE REVOLUTION In December 1975 the government of Portugal feared that it was facing an economic crisis. Newspapers speculated that the economy had shrunk 10 to 15% since the 1974 revolution that had overthrown the country’s long-standing dictatorship. In the face of these reports of economic collapse, some Portuguese were pronouncing democracy itself a failure. How bad was the situation, really? MIT economists looked at the country’s national accounts, and within a week they were able to make a rough estimate: Aggregate output had declined only 3% from 1974 to 1975. The economy had indeed suffered a serious setback, but its decline was much less drastic than the calamity being portrayed in the newspapers. In this chapter, we explain how macroeconomists measure key aspects of the economy. Photo Caption: With accurate economic data, Portugal was able to make the transition from revolution in 1975 to a prosperous democracy today. 2

Chapter Objectives 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.

Measuring the Macroeconomy 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 Gross domestic product or GDP measures the total value of all final goods and services produced in the economy during a given year. It does not include the value of intermediate goods. Final goods and services are goods and services sold to the final, or end, user. Intermediate goods and services are goods and services—bought from one firm by another firm—that are inputs for production of final goods and services.

Calculating Gross Domestic Product: Three Ways 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 Add up all income paid to factors of production

Calculating GDP Three Ways Figure Caption: Figure 11-1: 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.

Our Imputed Lives Some economists have produced alternative measures that try to “impute” the value of household work; what would be the market value of housework if one had to pay for it. But the standard measure of GDP doesn’t contain that imputation. GDP estimates do, however, include an imputation for the value of “owner-occupied housing.” If you buy the home you were formerly renting, GDP does not go down. Statisticians make an estimate of what you would have paid if you rented whatever you live in, whether it’s an apartment or a house. To be accurate, estimates of GDP must take into account the value of housing that is occupied by owners as well as the value of rental housing.

A Great Invention The national accounts owe their creation to the Great Depression. All government officials had were scattered statistics: railroad freight car loadings, stock prices, and incomplete indexes of industrial production. Simon Kuznets developed a set of national income accounts. The first version of these accounts was presented to Congress in 1937 and in a research report titled National Income. The push to complete the national accounts came during World War II, when policy makers were in even more need of comprehensive measures of the economy’s performance. The federal government began issuing estimates of gross domestic product and gross national product in 1942.

What GDP Tells Us Measures the size of the economy Used to compare economic performance year to year Used to compare economic performance country to country Be careful – GDP includes both changes in output and changes in prices To only look at changes in output, use Real GDP

Which of the following statements is true about the three methods to calculate GDP? The total value added of all domestically produced final goods is less than the total spending on domestically produced final goods and services because services are not included in the value added component. The total spending on domestically produced final goods and services is less than the total value added of all domestically produced final goods because the value added component incorporates efficiencies achieved through technology. Total spending on domestically produced final goods and services and total factor income are equal because all spending that is channeled to firms to pay for purchases of domestically produced final goods and services is revenue for firms. There are three methods for calculating GDP that usually produce different results.

Consider the table below and suppose you mistakenly believed that total value added was $30,500, the sum of the sales price of a car and a car’s worth of steel. What items would you be counting twice? You would be counting the wage used to assemble the car twice. You would be counting the total payment to factors twice. You would be counting the value of steel twice. None of the above.

Real vs. Nominal GDP Aggregate Output is the economy’s total quantity of output of final goods and services 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 current prices in the year in which the output is produced.

Real vs. Nominal GDP (continued) Calculating GDP and Real GDP in a Simple Economy Year 1 Year 2 Quantity of apples (billions) 2,000 2,200 Price of apple $0.25 $0.30 Quantity of oranges (billions) 1,000 1,200 Price of orange $0.50 $0.70 GDP (billions of dollars) 1,500 Real GDP (billions of year 1 dollars) $1,000 $1,150 Year 1 Nominal GDP = (2,000b*$0.25) + (1,000b*$0.50) = $1,000 billion Year 2 Nominal GDP = (2,200b*$0.30) + (1,200b*$0.70) = $2,000 billion Year 1 Real GDP = same as Year 1 Nominal GDP = $1,000 billion Year 2 Real GDP (Year 1 prices) = (2,000b*$0.25) + (1,200*$0.50) = $1,150 billion

Real vs. Nominal GDP (continued) Except in the base year, real GDP is not the same as nominal GDP, output valued at current prices. Chained dollars is the method of calculating changes in real GDP using the average between the growth rate calculated using an early base year and the growth rate calculated using a late base year. GDP per capita is a measure of average GDP per person, but is not by itself an appropriate policy goal.

Real vs. Nominal GDP (continued) Nominal versus Real GDP in 1993, 2005, and 2009 Nominal GDP (billions of current dollars) Real GDP (billions of 2005 dollars) 1993 $6,657 $8,523 2005 12,638 2008 14,256 12,987 Source: Bureau of Economic Analysis.

GDP and the Meaning of Life …Rich is better… …Money matters less as you grow richer… …Money isn’t everything… 1) Richer countries on average have higher life satisfaction than poor countries. 2) The gain in life satisfaction as you go from GDP per capita of $5,000 to $20,000 is greater than the gain as you go from $20,000 to $35,000. 3) Danes are poorer than Americans—but they seem more satisfied with their lives. Russia is richer than most Latin American nations, but much more miserable.

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 1997 and 2007, Venezuelan nominal GDP grew by an average of 29% each year—much faster than nominal GDP in the United States or even in booming economies like China. So is Venezuela experiencing an economic miracle?

Miracle in Venezuela? The upper line shows Venezuela’s nominal GDP from 1997 to 2008 The lower line shows Venezuela’s real GDP, measured in 1997 prices. In nominal terms, Venezuela appears to have experienced huge growth. But the great bulk of that growth was inflation. Real GDP rose at 3.4% per year, a rate not noticeably higher than the growth rates of other countries.

What was the price and quantity of french fries in 2007? In 2007, 1,000,000 servings of french fries were sold at $0.40 each and 800,000 servings of onion rings at $0.60 each. From 2007 to 2008, the price of french fries rose by 25% and the servings sold fell by 10%; the price of onion rings fell by 15% and the servings sold rose by 5%. What was the price and quantity of french fries in 2007? $0.65; 900,000 $0.50; 900,000 $0.50; 1,000,000 $0.30; 600,000

What was the price and quantity of onion rings in 2007? In 2007, 1,000,000 servings of french fries were sold at $0.40 each and 800,000 servings of onion rings at $0.60 each. From 2007 to 2008, the price of french fries rose by 25% and the servings sold fell by 10%; the price of onion rings fell by 15% and the servings sold rose by 5%. What was the price and quantity of onion rings in 2007? $0.65; 900,000 $0.50; 900,000 $0.51; 840,000 $0.45; 805,000

Nominal GDP in 2007 is _______. $864,000 $980,000 $880,000 $878,400 French Fries Onion Rings Price Quantity 2007 $0.40 1,000,000 $0.60 800,000 2008 $0.50 900,000 $0.51 840,000

Nominal GDP in 2008 is _______. $864,000 $980,000 $880,000 $878,400 French Fries Onion Rings Price Quantity 2007 $0.40 1,000,000 $0.60 800,000 2008 $0.50 900,000 $0.51 840,000

Real GDP (using 2007 as a base year) in 2008 is _______. $864,000 $980,000 $880,000 $700,000 French Fries Onion Rings Price Quantity 2007 $0.40 1,000,000 $0.60 800,000 2008 $0.50 900,000 $0.51 840,000

Nominal GDP changed by ______ . -0.18% -1.8% 1.6% 1.9% Nominal GDP Real GDP 2007 $880,000 2008 $878,400 $864,000

Real GDP changed by ______ . -0.18% -1.8% 1.6% 1.9% Nominal GDP Real GDP 2007 $880,000 2008 $878,400 $864,000

True or False? From 1990 to 2000, the price of electronic equipment fell dramatically and the price of housing rose dramatically. If 1990 is used as a base year to calculate 2008 real GDP, the price of electronics will be overstated. True False

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 Calculating the Cost of a Market Basket Pre-frost Post-frost Price of orange $0.20 $0.40 Price of grapefruit 0.60 1.00 Price of lemon 0.25 0.45 Cost of market basket (200 × $0.20) + (200 × $0.40) + (200 oranges, 50 grapefruit, (50 × $0.60) + (50 × $1.00) + 100 lemons) (100 × $0.25) = $95.00 (100 × $0.45) = $175.00 Table 11-3 shows the pre-frost and post-frost cost of this market basket. Before the frost, it cost $95; after the frost, the same bundle of goods cost $175. Since $175/$95 = 1.842, the post-frost basket costs 1.842 times the cost of the pre-frost basket, a cost increase of 84.2%. In this example, the average price of citrus fruit has increased 84.2% since the base year as a result of the frost, where the base year is the initial year used in the measurement of the price change. Table 11-3 shows the pre-frost and post-frost cost of this market basket. In this example, the average price of citrus fruit has increased 84.2% since the base year as a result of the frost, where the base year is the initial year used in the measurement of the price change.

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

Consumer Price Index This chart shows the percentage shares of major types of spending in the CPI as of December 2009. Housing, food, transportation, and motor fuel made up about 75% of the CPI market basket. Figure Caption: Figure 11.3: The Makeup of the Consumer Price Index in 2009 This chart shows the percentage shares of major types of spending in the CPI as of December 2009. Housing, food, transportation, and motor fuel made up about 75% of the CPI market basket. Source: Bureau of Labor Statistics.

Consumer Price Index Since 1940, the CPI has risen steadily. However, the annual percentage increases in recent years have been much smaller than those of the 1970s and early 1980s. Figure Caption: Figure 11.4: The CPI, 1913–2009 Since 1940, the CPI has risen steadily. But the annual percentage increases in recent years have been much smaller than those of the 1970s and early 1980s. (The vertical axis is measured on a logarithmic scale so that equal percent changes in the CPI appear the same.) Source: Bureau of Labor Statistics.

Other Price Measures A similar index to CPI for goods purchased by firms is the producer price index (PPI). Economists also use the GDP deflator, which measures the price level by calculating the ratio of nominal 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 PPI, and the GDP Deflator These three different measures of inflation usually move closely together. Each reveals a drastic acceleration of inflation during the 1970s and a return to relative price stability in the 1990s. Figure Caption: Figure 11.5: The CPI, the PPI, and the GDP Deflator As the figure shows, these three different measures of inflation usually move closely together. Each reveals a drastic acceleration of inflation during the 1970s and a return to relative price stability in the 1990s. Sources: Bureau of Labor Statistics; Bureau of Economic Analysis.

Is the CPI biased? The U.S. government takes considerable care in measuring consumer prices. Nonetheless, many economists believe that the consumer price index systematically overstates the actual rate of inflation. One reason is the fact that the CPI measures the cost of buying a given market basket. Yet, consumers typically alter the mix of goods and services they buy, reducing purchases of products that have become relatively more expensive and increasing purchases of products that have become relatively cheaper. The second reason arises from innovation. By widening the range of consumer choice, innovation makes a given amount of money worth more.

Indexing to the CPI The CPI has a direct and immediate impact on millions of Americans. 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. Today, 48 million people receive checks from Social Security. The amount of an individual’s check is determined by a formula that reflects his or her previous payments into the system as well as other factors. In addition, all Social Security payments are adjusted each year to offset any increase in consumer prices over the previous year. The CPI is used to calculate the official estimate of the inflation rate used to adjust these payments yearly.

Using the table, calculate the post-frost price index that includes 100 oranges, 50 grapefruits, and 200 lemons. 100 180 80 56

True or False? A typical family owns more cars than it would have a decade ago. Over that time, the average price of a car has increased more than the average price of other goods. Using a 10-year-old market basket would underestimate inflation. True False

True or False? Virtually no households had broadband Internet access a decade ago. Now many households have it, and the price has regularly fallen each year. Using a 10-year-old market basket would underestimate inflation. True False The 10-year-old market basket will not contain broadband Internet access, so it cannot track the fall in prices of Internet access over the past few years. As a result it will overestimate the true increase in the price level.

The consumer price index in the United States (base period 1982–1984) was 207.3 in 2007 and 215.3 in 2008. What is the inflation rate from 2007 to 2008? 5.7% 2.7% 3.9% Using Equation 11-2, the inflation rate from 2007 to 2008 is ((215.3 − 207.3)/207.3) × 100 = 3.9%).

Summary 1 of 4 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.

2 of 4 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.

3 of 4 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. U.S. statistics on real GDP are always expressed in chained dollars.

Summary 4 of 4 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 producer price index, or PPI. Finally, economists also use the GDP deflator, which measures the price level by calculating the ratio of nominal to real GDP times 100.