Introduction to Macroeconomics Chapter 20. Measuring the Macroeconomy

Measuring the Macroeconomy 1. Measuring Total Output 2. How to Measure Total Output 3. GDP Accounting Complications 4. Measuring Price Changes 5. Empirical Applications

1. Measuring Total Output Monetary Measure of Value GDP versus GNP Omissions from GDP - does not measure social welfare Social Welfare Examples in text - unregulated pollution. Home and volunteer labor. Chicken waste - chicken prices are lower -> GDP lower also seafood production from Chesapeake Bay lower. 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.

2. How to Measure GDP Expenditure Approach Income Approach

Circular Flow of Income and Expenditures

Expenditure Approach GDP = Consumption Spending (C) + Private Domestic Investment (I) + Government Spending (G) + Exports - Imports (NX) GDP = C + I + G + NX

Expenditure Shares 1998 U.S. Nominal Gross Domestic Product Government Spending 17.5 % Consumption 66.8 % Investment 17.5 % Net Exports = - 1.7 % (not shown in slide)

Consumption Trends U.S. Japan 1998 U.S. 66.8 % Japan 59.7 % Is this a valid comparison? What other explanations for differences in consumption? - Government spending socialized medicine education

Government Spending Trends U.S. Japan 1998 U.S. 17.5 % Japan 18.2 % Government spending includes: Salaries of gov’t workers Spending on roads, schools, etc. Does not includes: Transfer payments (e.g., social security, unemployment benefits)

Investment Trends Japan U.S. 1998 U.S. 17.5 % Japan 20.0 % 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 = Gross - depreciation Discussed under Accounting Complications

Net Export Trends Japan 1998 U.S. - 1.7 % Japan 2.1 % U.S.

National Income National Income with corrections = GDP National Income with corrections = Personal Income Personal Income - Personal income taxes - Social Security withholding = Disposable Personal Income

3. GDP Accounting Complications Double Counting Intended for “final” use excludes intermediate products Value added excludes used goods Depreciation Depreciation Net investment (In) = Gross Investment (Ig) - Depreciation NDP = GDP - Depreciation GDP = C + Ig + G + NX NDP = C + In + G + NX

Depreciation Gross Domestic Product (GDP) - Depreciation = Net Domestic Product (NDP)

Depreciation of Private Capital Stock Percent of Gross Private Investment Percent of GDP

4. Measuring Price Changes Price Index - a measure of the change in the average level of prices GDP Deflator Consumer Price Index

GDP Deflator Nominal GDP Real GDP GDP Deflator 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 GDP Deflator = Nominal GDP ÷ Real GDP

Simple Economy Was the economy better or worse off in 1994 compared with 1992? Nominal GDP: 1992 = 12*4 + 9*3 + 4*20 + 20*2 = $195 1994 = 14*5 + 10*3 + 5*16 + 20*2 = $220 Real GDP: 1994 = 12*5 + 9*3 + 4*16 + 20*2 = $191 GDP Deflator = ( Nominal GDP / Real GDP ) * 100 1992 GDP Deflator = (195/195) * 100 = 100 1994 GDP Deflator = (220/191) * 100 = 115.1 Economy worse off - Decline in real GDP. Inflation = 100 * (Index2 - Index1) / Index1 = 15.1%

Current year Quantities Nominal GDP Current year Quantities x Current year Prices

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

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

Current year Quantities Real GDP Current year Quantities x Base year Prices

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

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

GDP Growth Growth in Nominal GDP Growth in Real GDP = (160 - 127) • 100 = 26% 127 Growth in Real GDP = (143 - 127) • 100 = 13%

GDP Deflator GDP Deflator = Nominal GDP • 100 Real GDP 127 1994 GDP Deflator = 160 • 100 = 111.9 143

Inflation 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

Price Indexes GDP Deflator Consumer Price Index Base-year prices Quantities variable Imports excluded Consumer Price Index 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

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

5. Empirical Applications Use Real rather than Nominal values Compare Per Capita rather than Aggregates Compare Growth Rates rather than Levels Two types of empirical studies: Longitudinal - time trends Examining single sector at different points in time - use Real or Real per capita to eliminate effects of both inflation and population differences Comparing sectors over a period of time use Real growth rates or Real per capita growth rates Cross-sectional Comparing different sectors at same point in time - either nominal or real OK Comparing different geographic areas (e.g., countries) - use per Capita Nominal or Real Purchasing power parity corrects for differences in average price levels .Indexes - not mentioned in text but used in earlier slides. Consumption as a share of total GDP. Eliminates problem of differences in population. Differences in inflation between the part and the whole can usually be ignored.