Chapter 1. Measuring Economic Aggregates
Simply put, macroeconomics is the study of economic aggregates in the short run and in the long run. The word “aggregate” means sum total; so, as you might expect, macroeconomics deals with big variables like an economy’s gross output or national income. Other important economic aggregates are the overall price level, its rate of change (inflation and deflation), employment and unemployment. In macro theory we study determinant of the levels of economic aggregates and we investigate why many aggregates fluctuate in the short run and grow in the long run. We also study the relationships among certain aggregates, like inflation and unemployment (the well-known Phillips Curve).
A useful source of online macro data to know about is FRED, maintained by the St. Louis Federal Reserve (http://research.stlouisfed.org/fred2/). With FRED, you can easily download and graph more than 60,000 data series for the United States and many foreign countries. Its most frequently requested US data series include: the Consumer Price Index; gross domestic product (both current and constant dollars); civilian unemployment rate; total nonfarm employment; interest rates (on various assets like 10-year treasury bonds, 3-month treasury bills, 30 year mortgages and overnight federal funds); and several measures of the nation’s money supply. Data in this chapter are extracted from FRED and there are some suggested problems at the end of this chapter to introduce you to working with FRED.
Traditionally, macroeconomics focuses on both the short run and the long run. In the short run, many economic variables—most especially total production—tend to fluctuate. Short run fluctuations are known as the business cycle, as the economy experiences regular upswings or expansions and downturns or contractions. In the long run, production and national income tend to grow. Long run macroeconomics studies living standards and the rate of economic growth.
As we will see, short run and long run macroeconomics not only focus on different kinds of questions, but employ different economic models as well. In this book, we begin our study of macro theory with the short run (parts 2-4), before turning to the long run (part 5). This is not because the long run is any less important, but simply because the short run so-often demands our current attention, as we focus on day-to-day headlines about recession, unemployment, inflation, government budget deficits and exchange rates. As the great 20th century British macroeconomist John Maynard Keynes famously observed: “in the long run, we are all dead.”
Macroeconomics also focuses on the role of government policies to help stabilize the economy in the short run and to grow faster in the long run. These policies include monetary policy—setting interest rates and monetary aggregates—and fiscal policy—setting tax rates and spending levels. In the United States, the Federal Reserve conducts monetary policy while the Congress and President make fiscal policy.
Section 1. Long Run Economic Growth and Short Run Business Cycles
Perhaps the single most important economic aggregate is one you know: the total value of a nation’s output, or Gross Domestic Product (GDP). Figure 1 uses FRED to graph US real GDP since 1947. The term “real” means a nominal variable (that is, a variable expressed in current prices) has been adjusted for the effects of inflation by measuring it at a constant set of prices (in this case, 2009 prices).
Figure 1.1 US Real Gross National Product (in 2009 Dollars) 1947 – 2012
From 1947 to 2012, production of goods and services in the US expanded nearly 8 fold, from $1,938 billion to $15,471 billion. Measured at a constant rate of growth, the economy grew 3.25 percent per year. Given population growth, real GDP per person (or per-capita) expanded about 2 percent per year.
But, as Figure 1.1 makes clear, economies do not grow at a constant rate. The areas shaded in gray indicate recessions—periods of declining production—separated by periods of growth or economic expansion. In the US, a private group of economists at the National Bureau of Economic Research (NBER) determines the dates of business cycles. Their website (http://www.nber.org/cycles/main.html) defines a recession or contraction as a period of significant decline in economic activity that spreads across the economy and lasts from a few months to more than a year. Similarly, an expansion is a substantial rise in economic activity that spreads across the economy, and usually lasts several years. The NBER business cycle committee measures economic activity not only by real GDP, but also by some other indicators, including total nonfarm employment and industrial production.
The NBER records a total of 33 complete business cycles dating back to 1854. Over time, recessions have tended to be less frequent and shorter in duration. There were 16 recessions from 1854-1919 (lasting, on average, 22 months) and just 11 recessions from 1948 to 2009 (averaging 11 months). Over the same two time periods, the average duration of economic expansions has been getting longer, growing from 27 to 58 months. Since the end of WWII, the shortest recession on record lasted only 6 months (January – July 1980); the longest ran 18 months (December 2007 – June 2009). The shortest post-war expansion lasted 12 months (July 1980 – July 1981); the longest ran 120 months (March 1991 – March 2001).
The most recent recession of 2007-09, which many are calling the Great Recession, shows the largest and steepest decline in output since the Great Depression of the 1930s (when GDP fell nearly 30 percent). Figure 1.2 compares three of the past four recessions on the basis of output lost and recovery times. Real output declined 4.3 percent in the Great Recession. By contrast, in the previous recession (2001), output showed no decline (although employment did fall). In 1981-82, unemployment rose to more than 10 percent, but output fell less than 3 percent. The Great Recession looks even worse measured by recovery times: it took 3.5 years for output to return to its pre-recession level, compared with 1.75 years for the 1981-82 recession.
(Source:http://www.minneapolisfed.org/publications_papers/studies/recession_perspective/index.cfm.)
Figure 1.2 Comparing Three Recent Recessions and Recoveries
Section 2. Measuring Nominal Gross Domestic Product
This section looks at how we can measure aggregate output. We begin with some general observations about economic variables and GDP accounting. Then, we look at recent GDP numbers compiled by the Bureau of Economic Analysis (BEA), the agency within the Department of Commerce that publishes the official National Income and Product Accounts of the United States. These accounts can trace their history back to the pioneering work done by Simon Kuznets in the 1930s and 1940s.
Flows and Stocks
In general, there are two types of economic variables: flow variables and stock variables. A flow variable is any activity that can be measured over a period of time; say an hour, a day, a week, a month, a quarter (i.e., 3 months), or a year. As we will see, output, income and production are flow variables. By contrast, a stock variable is a quantity that can be measured at one point in time. (Measuring a stock variable is like taking a picture and then counting up how much you see.) Capital, money, assets and debts are stock variables.
Stock and flow variables are related to each other: the change over time in a stock is often one way to measure an economic flow. Taking a bath is a useful analogy here (and one we return to several times in this section). When you close the drain and open the faucet, water begins to flow into the bathtub. We can measure the rate of flow into the tub as cubic centimeters of water per minute—a flow variable. At any point in time, we can measure the total stock of water already in the bathtub—a stock variable. Suppose you were to measure the stock of water in the tub at exactly 10:00pm, and then measure it again at exactly 10:01pm. If you take the difference between the two stock measurements, you get another measure of the rate of flow per minute of water coming into the tub.
Gross Domestic Product (GDP) is a flow variable. GDP is defined as the total market value of new final goods and services produced within one year by all the resources (or factors of production) located within the borders of the economy. Resources include labor (unskilled and skilled), land (and natural resources) and the physical capital stock. The physical capital stock (a stock variable) consists of all buildings, machines and equipment produced in the past and available for current production.
Capital is durable, but over time it wears down (or depreciates) and will need to be replaced. If the total amount of capital formation in any year exceeds the rate of depreciation, then the capital stock grows. We use the term gross investment to mean total capital formation per year (a flow variable), consisting of replacement investment plus net investment. Like our bathtub analogy, one way to measure net investment is by the change over time in the stock of capital. In additional to physical capital, we can think of skilled labor resources as human capital. When students go to school or workers enter a job-training program, they are said to invest in their human capital. In summary, in macroeconomics the term investment simply means capital formation.
To repeat, GDP is the market value of newly-produced final goods and services. Market value means that we restrict our attention to goods and services sold at an observable price. The reason for this is that we solve the aggregation problem (of how to combine apples and oranges and haircuts) by adding together the values of goods sold. Newly-produced means we count new goods, but not the sale of used goods. That 2006 sports car you just bought may be new to you, but there is no reason to include it in this year’s GDP—it was already counted in 2006. Final goods are goods sold to the ultimate purchaser. If you buy a new set of tires for your car, they get counted in GDP; but if Ford Motor Company buys new tires for a car it is assembling, they would not be counted, since the final sales price of its new car will include the value added by the tires. Instead, Ford’s tire purchase is considered an intermediate good. Any new good purchased by households is considered a final good. Investment goods (but not intermediate goods) purchased by business firms are considered final goods. Most new goods purchased by the government sector are also considered final goods.
Circular Flow Diagram
Ignoring the government sector, let’s suppose households own all resources, while all production takes place within business firms. Each year, households rent their resources to firms (through input markets) and get income payments in return—wages and salaries paid to labor, interest and depreciation paid to owners of capital, rental income to land, and profits to entrepreneurs (a specialized form of labor that is willing to take risks and manage production). Households use their income to purchase the newly produced goods and services of the business sector—spending we call consumption expenditures. Any residual income that is not devoted to consumption is called personal saving. All newly-produced goods that are not sold to households get purchased by business firms as gross investment—consisting of physical capital formation and changes in the stock of unsold goods (inventory).
This simple economy is shown in figure 1.3, which illustrates the circular flow of production, income and spending. If we think of the value of new production by firms as GDP, then figure 1.3 tells us there are two ways to measure GDP: we can measure either total income generated from production or total spending by firms and households to buy this new production. At least in theory, the income and expenditure approaches should provide the same value for GDP. In other words, income and output are two sides of the same coin.
Financial Markets
Personal Saving Gross Investment
Consumption Expenditures
Final goods & services
Households Firms
Labor, Land, Capital
Income paid to Resources
Figure 1.3 The Circular Flow of Income and Expenditures in a Simple Economy
Figure 1.3 also illustrates how saving by households is related to investment by firms. Saving represents the new loanable funds households channel into financial markets; firms borrow these funds to finance their gross investment expenditures. But, even without financial markets, personal saving has to equal gross investment for the circular flow to remain in balance. To see this, think about our bathtub analogy once again. Saving is a leakage out of the spending stream—like opening the drain in the tub. Investment is a new injection of spending—like turning on the faucet. For the level of water in the bathtub to remain constant, leakages out the drain (saving) need to balances with injections from the faucet (investment).
Before we leave the simple circular flow, one final warning: Don’t confuse the word saving—a flow variable, with the word savings—a stock variable. Savings is simply another word for wealth or assets. Household savings consists of the value of homes, durable goods (like automobiles) and the paper ownership claims (through financial markets) to the physical capital located within business firms. Another way to measure saving (besides income minus consumption) would be the change over time in savings.
Once we add government, the circular flow diagram gets more complicated, but the basic message remains the same: We can still measure GDP either by total spending or total income. Federal, state and local governments compete with households and firms to purchase new production, so total government spending has to be added to consumption and gross investment in the spending approach. By the way, don’t confuse government spending on goods and services with government outlays, which include not only government spending, but also transfer payments (like social security checks and unemployment compensation). Transfer payments are not included in measures of total income, because they do not arise from current production; thus, transfer payments do not get counted in total spending either. To finance these outlays, the government levies taxes on both income and production. Income taxes do not complicate GDP accounting, as long as we can measure gross income paid to households before income taxes are withheld. Production taxes (like sales, excise and value-added) do need to be counted separately (as we will see in table 1.2), since spending exceeds income by the value of production taxes.
We can also add foreign trade—exports and imports. Exports are purchases of domestic production by the rest of the world; imports are purchases of foreign made goods. At first blush, it would appear we could simply ignore imports and measure aggregate spending as the sum of consumption, investment, government spending and exports. But, it turns out that imported goods are already included in the value of consumption spending (say, when a household buys a bottle of French wine), in investment (say, when a firm buys a new computer made in Taiwan) and in government spending (say, when the Army buys weapons made in Germany). As a result, imports need to be subtracted from aggregate spending to get a measure of total spending on domestically produced goods only.
Some More Accounting Identities
As we have seen, total spending (denoted Y) is the sum of consumption (C), gross investment (I), government purchases of goods and services (G), and net exports (NX)—that is, exports (EX) minus imports (IM):
Y = C + I + G + NX = C + I + G + EX – IM
In this equation, Y represents total expenditures to purchase GDP, but from the logic of the circular flow, Y is also total income generated from producing GDP. Let’s suppose that the government levies income taxes (T) but no production taxes. We can write:
Y = C + S + T,
In other words, total income received by households is used to finance consumption, saving and income taxes. Since aggregate spending equals total income, we can set these two equations equal to each other:
C + I + G + EX – IM = C + S + T
Or, dropping the C from each side and moving IM from left to right side:
I + G + EX = S + T + IM
With this equation, we are back to our bathtub analogy. On the right, saving, taxes and imports are 3 leakages away from spending—like opening the drain. On the left, investment, government spending and exports are 3 injections of spending—like turning on the faucet. To maintain the accounting balance between income and spending, total leakages have to balance with total injections.
Let’s rewrite the previous equation one more way:
I = S + (T – G) + (IM – EX)
To appreciate this equation, we need to introduce a bit more terminology. The government runs a budget surplus when taxes exceed spending (T –G > 0) and a budget deficit when spending exceeds taxes (T –G < 0). When the government runs a budget surplus (spending less than its revenue), we can call this government or public saving. When net exports are negative (IM > EX), a nation runs a trade deficit; if net exports are positive (EX > IM), it runs a trade surplus. Usually, the sale of exports to the rest of the world is what finances imports. But, if a nation runs a trade deficit (buying more from abroad than it sells), its excess imports get paid for by borrowing from abroad, sometimes called foreign saving. So, to conclude, we can interpret the last equation above as saying: gross investment gets financed by total saving, where total saving is the sum of personal, public and foreign saving.
Recent US GDP Data
Table 1.1 shows recent data published by the Bureau of Economic Analysis (BEA) for nominal GDP—that is, total production at current prices. The table shows expenditures on GDP in 2006, 2009 and 2012 expressed in billions of dollars and as a percent of total GDP.
In the United States, like most countries, personal consumption is by far the largest expenditure category of GDP, around 68 percent of total spending. Services account for two-thirds of overall consumption, with the rest divided between durable goods (like automobiles, furniture and appliances) and nondurables (like food and fuel). Consumption is not only the largest single category, but it is also the most stable.
Gross private domestic investment (GPDI) is both tangible (physical) and intangible (ideas) capital formation by the business sector. Over the long run GPDI in the US has averaged about 17 percent of total spending, but it is extremely volatile: in the boom year 2006, it was 19 percent of GDP; in the recession year 2009, it fell to 13 percent. In summer 2013 the BEA revised GPDI to include five categories: business spending on equipment; business spending on nonresidential structures (offices and factories); spending by businesses and individuals on residential structures (homes and apartments); business sector spending on intellectual property (like software, research and development and artistic creations) and change in inventories (which can be positive or negative). In 2009, because inventory change was negative, we can deduce that total production that year was less than total spending.
2006 2009 2012
Gross Domestic Product 13,858 14,418 16,245
Personal consumption expenditures 9,298 [67%] 9,843 [68%] 11,150 [69%]
Durable goods 1,156 1,023 1,203
Nondurable goods 2,080 2,175 2,567
Services 6,062 6,645 7,380
Gross Private Domestic Investment 2,681 [19%] 1,878 [13%] 2,475 [15%]
Equipment 856 644 908
Nonresidential structures 416 438 437
Residential structures 837 392 439
Intellectual property products 505 551 625
Change in private inventories 67 -148 66
Government spending 2,642 [19%] 3,089 [21%] 3,167 [19%]
Federal 1,002 1,218 1,296
Consumption 764 934 1,012
Gross investment 238 284 284
State and Local 1,640 1,871 1,871
Consumption 1,326 1,508 1,536
Gross investment 314 363 335
Net Exports of goods & services -762 [-5%] -392 [-3%] -547[-3%]
Exports 1,479 1,584 2,196
Imports 2,241 1,976 2,743
Source: BEA, National Income and Product Accounts, Table 1.5.5
Table 1.1 Nominal GDP: Expenditure Approach (billions of dollars)
Government spending includes spending by the federal government and by state and local governments. We often think of tax and spending decisions being made in Washington, but in fact, state and local authorities do more than 60 percent of all government spending. In recent years, the BEA has allocated government spending between spending on current needs (consumption) and spending on capital projects (investment). Most government spending is like consumption. Historically, total government spending has averaged around 19 percent of GDP; it rose during the Great Recession.
While both exports and imports are volatile, net exports are consistently negative, as Americans tend to import more goods and services each year than we export. (The last year the US ran a trade surplus was 1975.) Exports rose from 11 percent of GDP in 2006 to 14 percent in 2012. Imports fell from 16 percent of GDP in 2006 to 14 percent in 2009, but rose again to 17 percent by 2012.
Table 1.2 shows nominal GDP for 2006, 2009 and 2012 measured from the income approach. Gross domestic income is total income derived from production (before income taxes are withheld) consisting of payments to labor called compensation of employees (wages, salaries and fringe benefits) and the net operating surplus of businesses, consisting of interest, rent and profit income. Gross domestic income also includes government taxes on production and imports (less subsidies to government enterprises like the postal service) and depreciation of capital. Notice that compensation of employees is the single largest income category. To reconcile the income with the expenditure approach, there is a statistical discrepancy that can be either positive or negative.
2006 2009 2012
Gross Domestic Product 13,858 14,418 16,245
Gross Domestic Income 14,073 14,346 16,262
Compensation of Employees 7,503 7,788 8,620
Net Operating Surplus 3,593 3,222 4,033
Taxes on production (less subsidies) 941 968 1,066
Depreciation of Fixed Capital 2,136 2,368 2,543
Statistical Discrepancy -215 72 -17
Source: BEA, National Income and Product Accounts, Table 1.10
Table 1.2 Nominal GDP: Income Approach (billions of dollars)
Gross domestic income measures total payments to the factors of production, but economists who study household consumption and saving behavior often prefer an alternative measure known as personal income. Starting from gross domestic income, personal income excludes items that households cannot readily spend or save—depreciation, undistributed corporate profits and required contributions for government social insurance programs (like Medicare and Social Security taxes). Then it adds in some other items not counted in gross domestic income—such as the interest payments received from government bonds and government transfer payments (social security checks to the elderly and the disabled, welfare checks to poor families with children, unemployment compensation, veteran’s benefits, etc.).
In 2012, personal income was $13,744 billion. Subtracting personal income taxes paid, disposable personal income was $12,246 billion, the amount available to finance consumption and saving. Personal or household saving in 2012 was $687 billion—just 5.6 percent of disposable personal income. (The source of these data: http://www.bea.gov/newsreleases/national/gdp/2013/pdf/gdp2q13_adv.pdf)
Section 3. Nominal GDP, Real GDP and Prices
When nominal GDP rises as it almost always does from year to year, the dollar value of current production increases. But nominal GDP can rise for two very different reasons: either the price tags of some goods and services have increased, or the quantities produced have increased. We need a way to distinguish price increases from increases in quantities. The way to do this is to calculate real GDP—that is, current production at a constant or base year set of prices. Then, if we compare real GDP from year to year, we can be sure that any increase (or decrease) is a change in the total quantity of goods produced, not a change in their prices.
Table 1.3 shows BEA estimates of nominal and real GDP each year since 2006. For any given year, nominal GDP is that year’s production valued at that year’s prices; real GDP is production valued at prices in the base year, 2009. Calculating real GDP can be a difficult task; it involves knowing thousands of individual prices of specific goods and services that make up aggregate production. There is a practice problem at the end of this chapter that should give the interested reader a better sense of the magnitude of this undertaking.
The final column in table 1.3 shows the implicit price deflator for each year. The price deflator for any given year (say 2012) equals nominal GDP for 2012 divided by real GDP for 2012 (and then multiplied by 100). This deflator shows the average level of prices in a given year relative to average prices in the base year, which is set equal to 100. Comparing 2012 to 2009, we can say that on average prices have risen 5.00 percent. Notice also that nominal GDP and real GDP in the base year 2009 are identical—not surprising, since they use the same set of prices.
Nominal GDP Real GDP Implicit
(current $) (2009 $) Price Deflator
2006 13,857.9 14,615.2 94.82
2007 14,480.3 14,876.8 97.33
2008 14,720.3 14,833.6 99.24
2009 14,417.9 14,417.9 100.00
2010 14,958.3 14,779.4 101.21
2011 15,533.8 15,052.4 103.20
2012 16,244.6 15,470.7 105.00
Source: BEA, National Income and Product Accounts, Table 1.16
Table 1.3 Nominal GDP (billions of dollars), Real GDP (billions of 2009 dollars)
and the Implicit Price Deflator
Table 1.4 converts the data on output and prices from table 1.3 into annual (or year-to-year) percentage changes. For example, to get the percentage change in nominal GDP from 2006 to 2007, you would divide the change in GDP (14,480.3 – 13,857.9) by its starting value (13,857.9) and multiply the result by 100.
Percent Change Percent Change Percent Change
Nominal GDP Real GDP Price Deflator
2006-07 4.49 1.79 2.65
2007-08 1.66 -0.29 1.95
2008-09 -2.05 -2.80 0.77
2009-10 3.75 2.51 1.21
2010-11 3.85 1.85 1.96
2011-12 4.58 2.78 1.75
Table 1.4 Annual Percentage Changes in Nominal and Real GDP and Prices
The first column of data in table 1.4 shows the year-to-year percentage changes in nominal GDP. These numbers do not contain much useful information on their own, although perhaps it is interesting to note that nominal GDP actually fell (at a 2.05% rate) between 2008 and 2009, something that rarely happens.
The middle column of data shows annual percentage changes in real GDP. These numbers do convey useful information: they represent the yearly rate of economic growth. We can see that the economy grew from 2006-07 (at 1.79%), and then shrank over the period 2007-09 (during the Great Recession), before starting to growth again.
The last column of data shows annual percentage changes in the implicit price deflator. These numbers also convey information: they are one measure of the annual rate of inflation. As we can see, prices rose each and every year, although the rate of increase varied. Prior to the Great Recession, prices were rising at between 2 and 3 percent per year. From 2008-09, the rate of inflation fell below 1 percent, and has remained below 2 percent annually since then.
The clever reader might have noticed something else about the percentage data in table 1.4: the numbers in the first column are approximately equal to the sum of those in the second and third columns. For example, the 4.49% increase in nominal GDP from 2006-07 is approximately equal to the 1.79% growth in real GDP plus the 2.65% rate of inflation. In general, we can write:
% Δ Ynominal ≈ % Δ Yreal + % Δ P
where the symbol Δ is a quick way to say “change in”, Ynominal is nominal GDP, Yreal is real GDP, and P is the price level. In other words, we can always decompose the rate of change of nominal GDP into two parts—the rate of economic growth and the rate of inflation.
Does Real GDP Capture All Economic Activity?
As we have seen, real GDP is a much better measure of production than is nominal GDP, because real GDP controls for price changes. But, does real GDP provide an accurate measure of all productive activity occurring in the economy? It is rather widely acknowledged that official GDP data underestimate total economic activity. The reason for this is that GDP counts only market transactions—that is, activities with buyers and sellers where prices can be observed. Production that takes place outside the normal market economy—either because it is illegal activity or because there are no prices involved—will be omitted.
GDP omits production in the underground economy. The underground economy consists of illegal transaction (like gambling, drugs and prostitution); it also includes activities that go unreported for reasons of tax avoidance. If you pay someone who works for you in cash, it is likely that most of their earnings will go unreported and untaxed. By some estimates, the underground economy would add another 10-20 percent to US GDP if we could count all of it.
Another area of production omitted from GDP is household production, which is the production families do for themselves (like cooking and cleaning) without direct compensation. When a working mother quits her job to stay at home to take care of her own young children, the value of her own child-care activities is not counted in GDP. What makes this omission particularly troubling is that if she had remained at work and hired a nanny, her spending on child care (and the nanny’s income) would have been counted. Over time, as more women have become full time workers, it is likely that do-it-yourself household production has declined, while the purchases of market substitutes (child care, meals away from home, etc.) have increased.
Besides home production, volunteer activities outside the home are also omitted from GDP. If you serve on a jury, help out in a soup kitchen or mentor a troubled teen, you are providing valuable services to society. Just don’t expect your contributions to show up in GDP.
Another important criticism of GDP centers on the investment component of spending. Investment means capital formation, but does gross private domestic investment (GPDI) really measure total capital formation? The short answer is no. GPDI only includes capital formation by the business sector (along with increases in the housing stock). It omits any investment activities by households and the government. Public capital formation by government (like highways, the internet, public parks, water and sewage treatment plants, etc.) is not counted. Fortunately, in recent years, the BEA has begun distinguishing government consumption from government investment spending. The most important form of capital formation by households is human capital formation through job training and schooling. The BEA counts tuition and fee payments and purchases of books and other school supplies as consumption not investment. The largest cost of schooling—the opportunity cost of students—is not counted at all, since it represents foregone earnings.
Does Real GDP Measure Economic Welfare?
If real GDP goes up, are we better off? We have taken account of price changes, but nothing else. At a minimum, we might also want to control for population and look at changes in per-capita GDP. As we have seen, the rate of growth in per-capita GDP in the US has averaged about 2 percent per year. In the past few decades, per capita GDP growth in China has averaged 8 percent. Is economic welfare (or well-being) rising four times as fast in China as in America?
All told, most of us would rather live in a country with a high real GDP per capita than in a country with a lower living standard. But, even still, we know that GDP is not the same as well-being. For example, one way to raise GDP is to have everyone work longer hours, but because we value our leisure time, working longer would not necessarily make us better off.
An increase in GDP might come at the expense of the environment. China has been growing quickly, but growth has come at a cost: the quality of air and water has been seriously harmed. So, there is probably a tradeoff between economic growth and environmental quality. More generally, we can say that negative externalities which diminish well-being should be subtracted from GDP.
Section 4. Measuring Prices, Inflation and Deflation
As we have seen, the implicit GDP price deflator provides us with one measure of overall prices, and its rate of change is a measure of inflation. In the United States, there are several other well-known measures of prices, including the Consumer Price Index (CPI). In this section we look briefly at how the CPI measures the aggregate price level and review criticisms that changes in the CPI tend to overstate the rate of inflation. We also look at the price level in Japan, which has been plagued in recent years by falling prices—deflation.
With its interest in workers and wages the Labor Department’s statistical division, the Bureau of Labor Statistics (BLS) has been tracking price changes since 1919. It’s most widely used measure, the Consumer Price Index for All Urban Consumers, is a monthly price index that is a weighted average of prices paid by urban consumers (87 percent of the US population) for a representative market basket of more than 200 individual goods and services spread across 8 major expenditure categories (food and beverages, housing, apparel, transportation, medical care, recreation, education and communication, and all others). To get individual price weights, the BLS conducts a survey of consumer expenditures, which is updated periodically (most recently in 2007-08). Figure 1.4 shows the CPI from 1947-2013, where the index is centered at 100 over the period 1982-84.
Figure 1.4 The Consumer Price Index for All Urban Consumers 1947 – 2013
According to the Consumer Price Index shown in figure 1.4, the overall level of consumer prices in the US roughly doubled in the 26 years from 1947 and 1973. Prices doubled again in less than 8 years, from 1973 to 1981, and then took 20 more years to double once again, from 1981 to 2000. A market basket of goods and services that cost $100 back in August 1983 cost $231 by January 2013. Clearly over the long run, prices are on the rise, but over some shorter time periods they can fall: that same market basket cost $219.02 in July 2008 and then fell to $212.52 in March 2009.
Figure 1.5 shows the annual rate of inflation (measured as the percent change in the monthly CPI from its value a year earlier) for the last 50 years, 1963-2013. To make sure you understand how the rate of inflation is calculated, let’s look at some of the underlying data from figure 1.4:
December 2010 CPI = 220.468
December 2011 CPI = 227.137
December 2012 CPI = 231.137
The annual rate of inflation for December 2011 is calculated as the change in the CPI from a year earlier (227.137 – 220.468 = 6.669) divided by the December 2010 CPI, with the result multiplied by 100. That is, (6.669/220.468)*100 = 3.02%. Similarly, the inflation rate for December 2012 is (4/237.137)*100 = 1.76%.
Figure 1.5 The Annual Inflation Rate Derived from the Consumer Price Index
Figure 1.5 shows that the rate of inflation in the US has varied widely over the past 50 years. Average inflation rates rose from less than 2 percent per year in the early 1960s to often double-digit rates in the 1970s. The inflation rate fell dramatically in the early 1980s and remained relatively low and stable for a period lasting 25 years from 1983-2008. This remarkable period has been dubbed the Great Moderation; in part because inflation rates around the world were low and economic growth was widespread. During the Great Recession of 2007-09, inflation rates fell further and there was even a brief period of deflation.
It has often been argued that the CPI overstates true inflation. Both the so-called Stigler committee in 1961 and the Boskin commission in 1996 recommended major changes to the way the BLS tracks prices to get a more accurate measure of inflation. Over time the BLS has modified the CPI, but some criticism remains. The most basic complaint is that the CPI tends to overstate inflation because its fixed weights do not allow consumers to substitute away from goods whose prices have risen the most. A related concern is that new goods (whose prices often decline over time) are not incorporated into the index more quickly. Another concern is that price increases of some goods (for example, consumer durables and medical care) may signal quality improvements instead of price inflation. For all these reasons (and more), the Boskin commission famously estimated that the CPI overstates true inflation by about one percent per year.
Making sure the CPI measures inflation accurately is important because of the many ways the CPI is used. Labor unions and firms use the CPI to adjust wage contracts. The Internal Revenue Service adjusts tax brackets and exemptions to the CPI and the Social Security Administration links monthly social security checks to it.
Some policymakers, including many of those at the Federal Reserve, favor an alternative inflation measure derived from the Personal Consumption Expenditure Price Index (PCE). Unlike the CPI, the PCE allows for substitution of goods over time. The preferred inflation measure of Federal Reserve chairman Ben Bernanke is the so-called core PCE, which removes volatile food and energy prices from the index. His argument for this measure is that it may be the single best indicator of future inflation rates.
We tend to think of inflation as a universal problem, and for much of the world it is. Sometimes inflation rates can get extremely high, as they did in 1920s Germany and more recently in Zimbabwe. High rates of inflation are called hyperinflation and have been know to destroy currencies and ruin economies. But rising prices are not the only problem. Falling prices, when they occur, can be just as bad, if not worse. Figure 1.6 shows the monthly consumer price index for Japan since 2000. A basket of goods and services with an index cost of 102.4 in January 2000 had an index value of only 98.9 in January 2013. In other word, over 13 years, the overall level of prices in Japan fell more than 3 percent. Over the same period, the rate of economic growth in Japan was well below one percent per year.
Figure 1.6 The Consumer Price Index for Japan, 2000 – 2013
Before we leave the topic of prices, a few words on how inflation and deflation affect interest rates. If you take out a car loan or put money into a savings account, you get quoted a nominal rate of interest. We call this a nominal interest rate because it is a percentage rate based on money values. For example, suppose you put $1000 into your savings account and it grows to $1030 a year from now because the bank gives you $30 in interest. We would say the nominal interest rate is 3 percent (30/1000). Now suppose that over the same period the cost of the CPI market basket rises from $100 to $102—that is, inflation is 2 percent. Measured in terms of goods, you put 10 baskets (that is, $1000/$100) into your savings account and it grew to 10.1 baskets (1030/102 ≈ 10.1) within a year. As a result, the real interest rate (based on the real purchasing power of money) is only about 1 percent. More generally, as the early 20th century American economist Irving Fisher noted:
Nominal interest rate ≈ real interest rate + inflation rate
It is often said that nominal interest rates can never go below zero (because a dollar today is still a dollar tomorrow). But what the Fisher equation tells us is that with positive rates of inflation, the real interest rate can be (and often has been) negative. For example, at least since the end of 2008 when the Federal Reserve lowered short- term interest rates (the so-called fed funds rate) to nearly zero, many banks have been paying their depositors negative real interest rates. And when a country like Japan experiences deflation, its real interest rate exceeds its nominal rate, which as we will see, deters borrowing, investment spending and growth.
Section 5. Measuring Employment and Unemployment
Economists, like meteorologists, like to forecast the future. To make predictions, it is helpful to have accurate and timely data about the present. Unfortunately, many economic aggregates—most especially GDP—are only available with a considerable time lag, only available quarterly and are subject to lengthy and substantial revision. Therefore, it is notable that information about the labor market is available on a monthly basis and is not subject to revision (or only to minor revisions). Thanks to the Bureau of Labor Statistics, we get a monthly snapshot of conditions in the labor market, including total nonfarm payroll jobs and the rate of unemployment. As you might imagine these data are closely watched by policymakers.
Every month the BLS conducts two separate surveys on or around the 12th of the month—a household survey (to about 60,000 households) and an establishment survey (sent to half a million worksites). The household survey gives us estimates of the total labor force, the number of persons employed (including self-employed), the number of persons unemployed and the overall rate of unemployment. The establishment survey gives us payroll data on employment, hours and earnings, including how many new jobs were added (or lost) during the month. About three weeks after the survey—on the first Friday of the month—the BLS releases its findings. The data can move the stock market and get the attention of policymakers, including the Federal Reserve, which pledged in December 2012 not to raise interest rates until the unemployment rate falls below 6.5 percent.
Let’s look at some recent BLS data from its household survey for January 2013. The BLS reported the following seasonally adjusted estimates in thousands:
Civilian population 244,663
Not in Labor Force 89,008
Labor Force 155,654
Employed 143,322
Unemployed 12,332
The civilian population (all non-institutionalized persons age 16) is divided into two groups: not in labor force and labor force. The labor force consists of those persons who are employed and those who are unemployed. To be counted as employed, a person must be working for pay or profit one hour or more during the survey week or working without pay in a family business 15 hours a week or more. To be counted as unemployed, a person must be on temporary layoff or have been actively seeking work within the last 4 weeks.
From these data, the unemployment rate (u-rate) is calculated as the number of persons unemployed as a fraction of the labor force, so:
u-rate = Unemployed / Labor Force = 12,332 / 155,654 = 7.9%
We can also calculate the labor force participation rate, defined as the labor force as a percent of the population. For January 2013, the participation rate was 63.6%. By sex, men’s participation rate was 70.3%; women’s participation rate was 57.4%.
Figure 1.7 shows a graph of the monthly unemployment rate since 1961. As you might expect, unemployment tends to rise during recessions (shaded areas) and to fall during economic expansions. For the years 1966-70 and in part of 2000, the unemployment rate fell below 4%, but it averaged 6.1% for the entire period. The unemployment rate peaked at 10.8% in December 1982. More recently it rose to a high of 10.0% in October 2009, 4 months after the end of the Great Recession.
Figure 1.7 The Civilian Unemployment Rate in the US, 1961 – 2013
Some observers believe that the official unemployment rate tends to understate true unemployment, particularly during and immediately following a recession. The reason is that BLS data on the unemployed do not count two groups of persons: discouraged workers and underemployed workers. Discouraged workers are persons who have been out of work so long that they have given up actively seeking employment even though they still want a job (and so the BLS classifies them as not in the labor force). Underemployed workers are part-time workers who want to be working more hours, but are unable to find full-time employment. In response to its critics, the BLS has begun tabulating several alternative unemployment measures (with data back to 1994). One measure (the so-called U-6 rate) counts discouraged and underemployed workers as being unemployed; for January 2013, the U-6 rate was 15.4%.
The second half of the monthly employment report is data from the establishment survey, including nonfarm payroll jobs added or lost during the month, both in total and by industry and sector (private and public). For example, in December 2012, the BLS reported businesses added 166,000 private service sector jobs, 58,000 private sector jobs in manufacturing, mining and construction and lost 5,000 jobs in the government sector, for a total gain of 219,000 new jobs.
Figure 1.8 graphs the monthly change in total nonfarm payroll employment from 2004 – 2013. During periods of expansion, it is not uncommon to add 200,000 new payroll jobs per month or more. As you might expect, payroll employment declines during recessions. In the worst months of the Great Recession, the US economy was shedding more than 750,000 jobs per month in early 2009.
Figure 1.8 Monthly Change in Total Nonfarm Payrolls from 2004 – 2013
In the past 10 years, the BLS began conducting a monthly business establishment survey known as JOLTS, the job openings and labor turnover survey that measures the demand for labor. In bad economic times like 2009, there have been as many as five unemployed workers for every job opening; in good times there are about twice as many unemployed workers as job vacancies.
Section 6. A Roadmap to the Textbook
This chapter has provided a brief introduction to economic aggregates. Readers who want to know more about specific economic indicators might want to review an introductory macro textbook or consult one of several popular-press books written primarily for stock market enthusiasts, like The Secrets of Economic Indicators by Bernard Baumohl. These days, there are also many good user-friendly macro-data website like FRED and Econoday (www.econoday.com). But, if you feel comfortable with the information in this first chapter, you already know enough to begin your study of macroeconomic theory, the core of this textbook.
Schools of Thought in Macro
Unlike any other field in economics, the teaching of macroeconomics often tends to emphasize the disagreements among economists. This approach has its uses (and we use it some in chapter 5), but it also has a major drawback: by focusing so much attention on disagreements, students are likely to come away from intermediate macro simply confused, not seeing the many areas where macroeconomists agree.
One reason disagreements persist in macroeconomics is that it is difficult to test alternative macro theories. It is seldom possible to do controlled experiments in the real world. For example, did President Obama’s fiscal stimulus in 2009 shorten the Great Recession, or only lengthen the road to recovery? There is no easy way to decide, since we cannot re-run history with and without the stimulus. Sometimes, however, policy disputes can be resolved. The classic case of this is the Keynesian-monetarist debate of the 1950s about the effectiveness of fiscal versus monetary policy. As we will show in chapter 5, this debate has ended, because it was shown that the disagreement was about the size of some underlying behavioral parameter that could be estimated. Once they were estimated with micro data, it became clear that neither side’s extreme views were correct.
This book emphasizes the many areas of macroeconomic theory where the majority of economists agree, including almost all of parts 2, 4 and 5. Some of the materials on aggregate supply and economic fluctuations in part 3 remain controversial, and there will be instructors who prefer to take other approaches.
Even though there are broad areas of agreement in macro, it is important to know about the alternative schools of thought that do persist. These include Keynesians, monetarists, new Keynesians, and new classical economists. Let’s describe each of these briefly.
Keynesians: Early followers of J M Keynes who focus more on the short run than the long run, more on demand than supply, and more on fiscal than monetary policy. Keynesians prefer activist, discretionary policymaking instead of fixed policy rules.
Monetarist: Descendants of 18th and 19th century classical economists, they focus more on the long run than the short run, more on supply than demand, and more on monetary than fiscal policy. The most famous monetarist, Milton Friedman, was an advocate of fixed policy rules.
New Keynesians: Believers in Keynesian principles, who advocate developing the micro-foundations of fixed prices and non-market clearing.
New Classical: Believers in classical and monetarist principles, who also advocate a micro-foundations approach to macro. Some new classical adherents (real business cycle economists) think that technology shocks are the primary source of short run fluctuations.
What to expect in this book
Chapter 2 begins our study of macroeconomic theory, by looking at the short-run determinants of the level of GDP (or production and income) and at fluctuations in GDP over the business cycle. This chapter is based on the simple Keynesian cross model and the multiplier, which you may have learned about in your introductory macro course. (If this material is new to you, please read it carefully.)
Part Two (chapters 3-5) looks at the determination of both output and interest rates in the short run. Chapter 3 introduces the famous IS-LM model, which you will need to master for understanding future chapters. Chapter 4 uses the IS-LM model and multipliers to look a monetary and fiscal policy. Chapter 5 extends the basic IS-LM model in several new directions. (The material in Chapter 5 is not essential for later chapters, so the hurried reader could skip it.)
Part Three (chapters 6-8) extends the IS-LM model by allowing the price level to change. Chapter 6 introduces aggregate demand and aggregate supply as part of a larger IS-LM-AD-AS model. Chapter 7 offers some background on the aggregate supply curve in the short run and in the long run. Chapter 8 uses the complete IS-LM-AD-AS model along with the labor market to determine how real output, interest rates, prices, employment and wages can fluctuate when the economy is buffeted by economic shocks like a downturn in investment or an increase in energy prices.
Part Four (chapter 9-11) adds inflation (and expected inflation) to the model. Chapter 9 is an overview of the causes and consequences of inflation. Chapter 10 studies the Phillips Curve, the relationship between inflation and unemployment. Chapter 11 looks at economic policies to keep inflation and unemployment low.
Part Five (chapter 12-15) focuses on the long run. Chapter 12 is an introduction to economic growth. Chapter 13 studies the neoclassical growth model and some extensions. Chapter 14 is more about fiscal policy issues. Chapter 15 is more about monetary policy, including policy responses by the Federal Reserve to the recent financial crisis and Great Recession.
Terms to Review
Budget deficit or surplus (p. 8)
Business cycle, expansion, recession, contraction (pp. 1-2)
Capital stock, physical capital, human capital (pp. 4-5)
Classical and new classical economists (p. 22)
Compensation of employees (p. 9)
Consumption expenditures (p. 5)
Consumer Price Index (p. 14)
Core PCE (p. 17)
Discouraged workers (p. 20)
Economic aggregate (p. 1)
Economic growth (p. 1)
Fiscal policy (p. 1)
Fisher equation (p. 18)
Flow variable versus stock variable (p. 4)
Foreign trade, exports, imports, net exports, foreign saving (pp. 7-8)
FRED (p. 1)
Government outlays versus Government spending on goods and services (p. 6)
Great Depression, Great Recession (p. 3)
Great Moderation (p. 16)
Gross Domestic Income (p. 9)
Gross Domestic Product (p. 4)
Gross National Product (p. 4)
Gross Private Domestic Investment (p. 8)
Implicit price deflator (p. 11)
Income taxes (p. 7)
Inflation and hyperinflation (p. 17)
Inventory and change in inventory (p. 5)
Investment, gross investment, net investment, replacement investment (pp. 4-5)
Keynesians and New Keynesians economists (p. 22)
Labor force and Labor force participation rate (p. 19)
Long run versus Short run (p. 1)
Monetarist economists (p. 22)
Monetary policy (p. 1)
Net operating surplus (p. 9)
Nominal GDP versus Real GDP (p. 8 and p. 11)
Nominal interest rate versus real interest rate (p. 18)
Personal income and disposable personal income (p. 10)
Production taxes (p. 7)
Saving, personal saving, private saving, national saving (p. 5)
Transfer payments (p. 6)
Trade deficit or surplus (p. 8)
Unemployment rate (p. 19)
Unemployment versus underemployment (p. 20)
Questions for Review
1. Over the business cycle, real GDP tends to increase during the expansion and decrease during the contraction. Can you name some other macro variables that fluctuate over the business cycle like GDP does? Can you name some macro variables that do not fluctuate like GDP?
2. In the long run, real GDP tends to grow over time. Can you name some other macro variables that also tend to grow over time? Can you name some macro variables that do not grow over time?
3. What is meant by the term stock variable? Give at least 3 examples of economic stocks. What is meant by the term flow variable? Give at least 3 examples of economic flows. Explain how stocks and flows are related to each other, and give at least one specific example.
4. Explain how it would be possible for GDP to exceed GNP this year, and then for GNP to exceed GDP next year.
5. What are the two basic methods or approaches for counting GDP? Explain why they should get the same answer.
6. How does a macroeconomist define the term “investment”? When you buy stocks or bonds, people often say that you made an investment. Would a macroeconomist agree? If not, what are you doing when you buy stocks and bonds?
7. In an economy closed to international trade, what are two sources of finance to pay for investment spending?
8. In the 1980s, economists in the US wrote about the so-called “twin deficits.” That is, the US experienced both a government budget deficit and a trade deficit. Suppose that gross investment exceeds private saving. Explain why a country with a budget deficit must also show a trade deficit.
9. In the late 1990s, the US experienced a trade deficit and a budget surplus. In other words, the “twin deficits” got separated. Explain how this is possible in light of your answer to question 8.
10. In the text, Table 1.3 shows real GDP expressed in 2009 prices for the years 2006-2012. Given the information in this table, explain how you could express real GDP (for any year) in 2012 prices.
11. Suppose that real GDP is rising faster than nominal GDP. What can we say about prices?
12. If real GDP increases by 3 percent while nominal GDP increases by 6 percent, what happens to prices?
13 – 16. Suppose a simple economy produces bread and wine. The table below shows the quantities produced and the prices paid for bread and wine in two years.
Year Quantity Bread Quantity Wine Price Bread Price Wine
(per loaf) (per barrel)
1 100 loaves 50 barrels $1.00 $10.00
2 90 loaves 60 barrels $2.00 $9.00
13. Calculate nominal GDP for year 1 and year 2. By what percent did nominal GDP go up?
14. Calculate real GDP for both years using year 1 prices as the base year. By what percent did real GDP increase?
15. Calculate real GDP for both years using year 2 prices as the base year. By what percent did real GDP increase?
16. Using your answers to questions 13 and 14, estimate inflation between years 1 and 2. Using your answers to questions 13 and 15, estimate inflation over the same period. Suppose you average your two estimates of inflation. What does this imply for the rate of economic growth?
17. This question introduces you to the power of FRED.
Log on to: http://research.stlouisfed.org/fred2/
Click on the tab “popular series” and then click on “Real GDP”. You should be here:
http://research.stlouisfed.org/fred2/series/GDPC1/
Besides seeing real GDP in the graph, you can click “view data” on the left of your screen and you will see a listing of the data.
Below the graph, click on “edit graph”. Now change the frequency from quarterly to annual. Change the units from “billions of chained 2005 dollars” to “percent change from year ago”. Now click “redraw graph”.
You can shorten the time period as well: for example, you might begin in the year and month of your birth. Now click “redraw graph” once again. Notice, at the top of the page, you can download the data in your graph into an excel file.
You can also add a second data series to your graph. Click “add data series” at the bottom of the screen. You can either browse for another series or start putting in a search name. Try finding US nominal GDP (called simply Gross Domestic Product in FRED). Make sure you use the same frequency and same units for both variables.
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