Measuring a Nation's Income PDF

IN THIS CHAPTER YOU WILL... Consider why an...

IN THIS CHAPTER YOU WILL... Consider why an economy’s total income equals its total expenditure Learn how gross domestic product (GDP) is defined and calculated See the breakdown of GDP into its four major components MEASURING A N AT I O N ’ S INCOME When you finish school and start looking for a full-time job, your experience will, Learn the to a large extent, be shaped by prevailing economic conditions. In some years, distinction between firms throughout the economy are expanding their production of goods and ser- real GDP and vices, employment is rising, and jobs are easy to find. In other years, firms are cut- nominal GDP ting back on production, employment is declining, and finding a good job takes a long time. Not surprisingly, any college graduate would rather enter the labor force in a year of economic expansion than in a year of economic contraction. Because the condition of the overall economy profoundly affects all of us, changes in economic conditions are widely reported by the media. Indeed, it is hard to pick up a newspaper without seeing some newly reported statistic about the Consider whether economy. The statistic might measure the total income of everyone in the economy GDP is a good (GDP), the rate at which average prices are rising (inflation), the percentage of the measure of labor force that is out of work (unemployment), total spending at stores (retail economic well-being 493 494 PA R T E I G H T T H E D ATA O F M A C R O E C O N O M I C S sales), or the imbalance of trade between the United States and the rest of the world (the trade deficit). All these statistics are macroeconomic. Rather than telling us about a particular household or firm, they tell us something about the entire economy. As you may recall from Chapter 2, economics is divided into two branches: microeconomics microeconomics and macroeconomics. Microeconomics is the study of how indi- the study of how households and vidual households and firms make decisions and how they interact with one firms make decisions and how they another in markets. Macroeconomics is the study of the economy as a whole. The interact in markets goal of macroeconomics is to explain the economic changes that affect many households, firms, and markets at once. Macroeconomists address diverse ques- macroeconomics tions: Why is average income high in some countries while it is low in others? Why the study of economy-wide do prices rise rapidly in some periods of time while they are more stable in other phenomena, including inflation, periods? Why do production and employment expand in some years and contract unemployment, and economic in others? What, if anything, can the government do to promote rapid growth in growth incomes, low inflation, and stable employment? These questions are all macroeco- nomic in nature because they concern the workings of the entire economy. Because the economy as a whole is just a collection of many households and many firms interacting in many markets, microeconomics and macroeconomics are closely linked. The basic tools of supply and demand, for instance, are as cen- tral to macroeconomic analysis as they are to microeconomic analysis. Yet study- ing the economy in its entirety raises some new and intriguing challenges. In this chapter and the next one, we discuss some of the data that economists and policymakers use to monitor the performance of the overall economy. These data reflect the economic changes that macroeconomists try to explain. This chap- ter considers gross domestic product, or simply GDP, which measures the total income of a nation. GDP is the most closely watched economic statistic because it is thought to be the best single measure of a society’s economic well-being. THE ECONOMY’S INCOME AND EXPENDITURE If you were to judge how a person is doing economically, you might first look at his or her income. A person with a high income can more easily afford life’s neces- sities and luxuries. It is no surprise that people with higher incomes enjoy higher standards of living—better housing, better health care, fancier cars, more opulent vacations, and so on. The same logic applies to a nation’s overall economy. When judging whether the economy is doing well or poorly, it is natural to look at the total income that every- one in the economy is earning. That is the task of gross domestic product (GDP). GDP measures two things at once: the total income of everyone in the econo- my and the total expenditure on the economy’s output of goods and services. The reason that GDP can perform the trick of measuring both total income and total expenditure is that these two things are really the same. For an economy as a whole, income must equal expenditure. Why is this true? The reason that an economy’s income is the same as its expen- diture is simply that every transaction has two parties: a buyer and a seller. Every dollar of spending by some buyer is a dollar of income for some seller. Suppose, for instance, that Karen pays Doug $100 to mow her lawn. In this case, Doug is a seller of a service, and Karen is a buyer. Doug earns $100, and Karen spends $100. Thus,  CHAPTER 22 M E A S U R I N G A N AT I O N ’ S I N C O M E 495 Figure 22-1 T HE C IRCULAR -F LOW D IAGRAM. Households buy goods and services from firms, and firms use Revenue Spending (= GDP) (= GDP) their revenue from sales to pay MARKETS FOR GOODS AND wages to workers, rent to Goods SERVICES Goods and landowners, and profit to firm and services services owners. GDP equals the total sold bought amount spent by households in the market for goods and services. It also equals the total wages, rent, and profit paid by firms in the markets for the FIRMS HOUSEHOLDS factors of production. Inputs for Labor, land, production MARKETS FOR and capital FACTORS OF Wages, rent, PRODUCTION Income (= GDP) and profit ⫽ Flow of goods (= GDP) and services ⫽ Flow of dollars the transaction contributes equally to the economy’s income and to its expenditure. GDP, whether measured as total income or total expenditure, rises by $100. Another way to see the equality of income and expenditure is with the circular- flow diagram in Figure 22-1. (You may recall this circular-flow diagram from Chapter 2.) This diagram describes all the transactions between households and firms in a simple economy. In this economy, households buy goods and services from firms; these expenditures flow through the markets for goods and services. The firms in turn use the money they receive from sales to pay workers’ wages, landowners’ rent, and firm owners’ profit; this income flows through the markets for the factors of production. In this economy, money continuously flows from households to firms and then back to households. We can compute GDP for this economy in one of two ways: by adding up the total expenditure by households or by adding up the total income (wages, rent, and profit) paid by firms. Because all expenditure in the economy ends up as someone’s income, GDP is the same regardless of how we compute it. The actual economy is, of course, more complicated than the one illustrated in Figure 22-1. In particular, households do not spend all of their income. Households pay some of their income to the government in taxes, and they save and invest some of their income for use in the future. In addition, households do not buy all 496 PA R T E I G H T T H E D ATA O F M A C R O E C O N O M I C S goods and services produced in the economy. Some goods and services are bought by governments, and some are bought by firms that plan to use them in the future to produce their own output. Yet, regardless of whether a household, government, or firm buys a good or service, the transaction has a buyer and seller. Thus, for the economy as a whole, expenditure and income are always the same. Q U I C K Q U I Z : What two things does gross domestic product measure? How can it measure two things at once? THE MEASUREMENT OF GROSS DOMESTIC PRODUCT Now that we have discussed the meaning of gross domestic product in general terms, let’s be more precise about how this statistic is measured. Here is a defini- tion of GDP: gross domestic product ◆ Gross domestic product (GDP) is the market value of all final goods and (GDP) services produced within a country in a given period of time. the market value of all final goods and services produced within a This definition might seem simple enough. But, in fact, many subtle issues arise country in a given period of time when computing an economy’s GDP. Let’s therefore consider each phrase in this definition with some care. “ G D P I S T H E M A R K E T VA L U E... ” You have probably heard the adage, “You can’t compare apples and oranges.” Yet GDP does exactly that. GDP adds together many different kinds of products into a single measure of the value of economic activity. To do this, it uses market prices. Because market prices measure the amount people are willing to pay for different goods, they reflect the value of those goods. If the price of an apple is twice the price of an orange, then an apple contributes twice as much to GDP as does an orange. “OF ALL...” GDP tries to be comprehensive. It includes all items produced in the economy and sold legally in markets. GDP measures the market value of not just apples and oranges, but also pears and grapefruit, books and movies, haircuts and health care, and on and on. GDP also includes the market value of the housing services provided by the economy’s stock of housing. For rental housing, this value is easy to calculate—the rent equals both the tenant’s expenditure and the landlord’s income. Yet many people own the place where they live and, therefore, do not pay rent. The govern- ment includes this owner-occupied housing in GDP by estimating its rental value. That is, GDP is based on the assumption that the owner, in effect, pays rent to him- self, so the rent is included both in his expenditure and in his income. There are some products, however, that GDP excludes because measuring them is so difficult. GDP excludes items produced and sold illicitly, such as illegal  CHAPTER 22 M E A S U R I N G A N AT I O N ’ S I N C O M E 497 drugs. It also excludes most items that are produced and consumed at home and, therefore, never enter the marketplace. Vegetables you buy at the grocery store are part of GDP; vegetables you grow in your garden are not. These exclusions from GDP can at times lead to paradoxical results. For exam- ple, when Karen pays Doug to mow her lawn, that transaction is part of GDP. If Karen were to marry Doug, the situation would change. Even though Doug may continue to mow Karen’s lawn, the value of the mowing is now left out of GDP because Doug’s service is no longer sold in a market. Thus, when Karen and Doug marry, GDP falls. “FINAL...” When International Paper makes paper, which Hallmark then uses to make a greeting card, the paper is called an intermediate good, and the card is called a final good. GDP includes only the value of final goods. The reason is that the value of intermediate goods is already included in the prices of the final goods. Adding the market value of the paper to the market value of the card would be double count- ing. That is, it would (incorrectly) count the paper twice. An important exception to this principle arises when an intermediate good is produced and, rather than being used, is added to a firm’s inventory of goods to be used or sold at a later date. In this case, the intermediate good is taken to be “final” for the moment, and its value as inventory investment is added to GDP. When the inventory of the intermediate good is later used or sold, the firm’s inventory invest- ment is negative, and GDP for the later period is reduced accordingly. “GOODS AND SERVICES...” GDP includes both tangible goods (food, clothing, cars) and intangible services (haircuts, housecleaning, doctor visits). When you buy a CD by your favorite singing group, you are buying a good, and the purchase price is part of GDP. When you pay to hear a concert by the same group, you are buying a service, and the ticket price is also part of GDP. “PRODUCED...” GDP includes goods and services currently produced. It does not include transac- tions involving items produced in the past. When General Motors produces and sells a new car, the value of the car is included in GDP. When one person sells a used car to another person, the value of the used car is not included in GDP. “WITHIN A COUNTRY...” GDP measures the value of production within the geographic confines of a coun- try. When a Canadian citizen works temporarily in the United States, his produc- tion is part of U.S. GDP. When an American citizen owns a factory in Haiti, the production at his factory is not part of U.S. GDP. (It is part of Haiti’s GDP.) Thus, items are included in a nation’s GDP if they are produced domestically, regardless of the nationality of the producer. 498 PA R T E I G H T T H E D ATA O F M A C R O E C O N O M I C S FYI When the U.S. Department ◆ National income is the total income earned by a of Commerce computes the nation’s residents in the production of goods and ser- Other Measures nation’s GDP every three vices. It differs from net national product by excluding of Income months, it also computes vari- indirect business taxes (such as sales taxes) and ous other measures of income including business subsidies. NNP and national income to get a more complete picture also differ because of a “statistical discrepancy” that of what’s happening in the econ- arises from problems in data collection. omy. These other measures dif- ◆ Personal income is the income that households and fer from GDP by excluding or noncorporate businesses receive. Unlike national including certain categories of income, it excludes retained earnings, which is income income. What follows is a brief that corporations have earned but have not paid out to description of five of these their owners. It also subtracts corporate income taxes income measures, ordered from and contributions for social insurance (mostly Social largest to smallest. Security taxes). In addition, personal income includes ◆ Gross national product (GNP) is the total income the interest income that households receive from their earned by a nation’s permanent residents (called holdings of government debt and the income that nationals). It differs from GDP by including income that households receive from government transfer pro- our citizens earn abroad and excluding income that for- grams, such as welfare and Social Security. eigners earn here. For example, when a Canadian citi- ◆ Disposable personal income is the income that house- zen works temporarily in the United States, his holds and noncorporate businesses have left after sat- production is part of U.S. GDP, but it is not part of U.S. isfying all their obligations to the government. It equals GNP. (It is part of Canada’s GNP.) For most countries, personal income minus personal taxes and certain non- including the United States, domestic residents are tax payments (such as traffic tickets). responsible for most domestic production, so GDP and GNP are quite close. Although the various measures of income differ in detail, ◆ Net national product (NNP) is the total income of a they almost always tell the same story about economic con- nation’s residents (GNP) minus losses from depreciation. ditions. When GDP is growing rapidly, these other measures Depreciation is the wear and tear on the economy’s of income are usually growing rapidly. And when GDP is stock of equipment and structures, such as trucks rust- falling, these other measures are usually falling as well. For ing and lightbulbs burning out. In the national income monitoring fluctuations in the overall economy, it does not accounts prepared by the Department of Commerce, matter much which measure of income we use. depreciation is called the “consumption of fixed capital.” “... IN A GIVEN PERIOD OF TIME.” GDP measures the value of production that takes place within a specific interval of time. Usually that interval is a year or a quarter (three months). GDP measures the economy’s flow of income and expenditure during that interval. When the government reports the GDP for a quarter, it usually presents GDP “at an annual rate.” This means that the figure reported for quarterly GDP is the amount of income and expenditure during the quarter multiplied by 4. The government uses this convention so that quarterly and annual figures on GDP can be compared more easily. In addition, when the government reports quarterly GDP, it presents the data after they have been modified by a statistical procedure called seasonal adjustment. The unadjusted data show clearly that the economy produces more goods and services during some times of year than during others. (As you might guess, December’s Christmas shopping season is a high point.) When monitoring the  CHAPTER 22 M E A S U R I N G A N AT I O N ’ S I N C O M E 499 condition of the economy, economists and policymakers often want to look beyond these regular seasonal changes. Therefore, government statisticians adjust the quarterly data to take out the seasonal cycle. The GDP data reported in the news are always seasonally adjusted. Now let’s repeat the definition of GDP: ◆ Gross domestic product (GDP) is the market value of all final goods and services produced within a country in a given period of time. It should be apparent that GDP is a sophisticated measure of the value of economic activity. In advanced courses in macroeconomics, you will learn more of the sub- tleties that arise in its calculation. But even now you can see that each phrase in this definition is packed with meaning. Q U I C K Q U I Z : Which contributes more to GDP—the production of a pound of hamburger or the production of a pound of caviar? Why? THE COMPONENTS OF GDP Spending in the economy takes many forms. At any moment, the Smith family may be having lunch at Burger King; General Motors may be building a car facto- ry; the Navy may be procuring a submarine; and British Airways may be buying an airplane from Boeing. GDP includes all of these various forms of spending on domestically produced goods and services. To understand how the economy is using its scarce resources, economists are often interested in studying the composition of GDP among various types of spend- ing. To do this, GDP (which we denote as Y) is divided into four components: con- sumption (C), investment (I), government purchases (G), and net exports (NX): Y ⫽ C ⫹ I ⫹ G ⫹ NX. consumption spending by households on goods This equation is an identity—an equation that must be true by the way the vari- and services, with the exception of ables in the equation are defined. In this case, because each dollar of expenditure purchases of new housing included in GDP is placed into one of the four components of GDP, the total of the four components must be equal to GDP. investment We have just seen an example of each component. Consumption is spending spending on capital equipment, by households on goods and services, such as the Smiths’ lunch at Burger King. inventories, and structures, Investment is the purchase of capital equipment, inventories, and structures, such including household purchases of as the General Motors factory. Investment also includes expenditure on new hous- new housing ing. (By convention, expenditure on new housing is the one form of household government purchases spending categorized as investment rather than consumption.) Government pur- spending on goods and services by chases include spending on goods and services by local, state, and federal govern- local, state, and federal governments ments, such as the Navy’s purchase of a submarine. Net exports equal the purchases of domestically produced goods by foreigners (exports) minus the net expor ts domestic purchases of foreign goods (imports). A domestic firm’s sale to a buyer in spending on domestically produced another country, such as the Boeing sale to British Airways, increases net exports. goods by foreigners (exports) minus The “net” in “net exports” refers to the fact that imports are subtracted from spending on foreign goods by exports. This subtraction is made because imports of goods and services are domestic residents (imports) 500 PA R T E I G H T T H E D ATA O F M A C R O E C O N O M I C S Ta b l e 2 2 - 1 TOTAL PERCENT GDP AND I TS C OMPONENTS. (IN BILLIONS) PER PERSON OFTOTAL This table shows total GDP for the U.S. economy in 1998 and the Gross domestic product, Y $8,511 $31,522 100% breakdown of GDP among its Consumption, C 5,808 21,511 68 four components. When reading Investment, I 1,367 5,063 16 this table, recall the identity Government purchases, G 1,487 5,507 18 Y ⫽ C ⫹ I ⫹ G ⫹ NX. Net exports, NX ⫺151 ⫺559 ⫺2 SOURCE: U.S. Department of Commerce. included in other components of GDP. For example, suppose that a household buys a $30,000 car from Volvo, the Swedish carmaker. That transaction increases consumption by $30,000 because car purchases are part of consumer spending. It also reduces net exports by $30,000 because the car is an import. In other words, net exports include goods and services produced abroad (with a minus sign) because these goods and services are included in consumption, investment, and government purchases (with a plus sign). Thus, when a domestic household, firm, or government buys a good or service from abroad, the purchase reduces net exports—but because it also raises consumption, investment, or government pur- chases, it does not affect GDP. The meaning of “government purchases” also requires a bit of clarification. When the government pays the salary of an Army general, that salary is part of government purchases. But what happens when the government pays a Social Security benefit to one of the elderly? Such government spending is called a trans- fer payment because it is not made in exchange for a currently produced good or service. From a macroeconomic standpoint, transfer payments are like a tax rebate. Like taxes, transfer payments alter household income, but they do not reflect the economy’s production. Because GDP is intended to measure income from (and expenditure on) the production of goods and services, transfer payments are not counted as part of government purchases. Table 22-1 shows the composition of U.S. GDP in 1998. In this year, the GDP of the United States was about $8.5 trillion. If we divide this number by the 1998 U.S. population of 270 million, we find that GDP per person—the amount of expendi- ture for the average American—was $31,522. Consumption made up about two- thirds of GDP, or $21,511 per person. Investment was $5,063 per person. Government purchases were $5,507 per person. Net exports were –$559 per per- son. This number is negative because Americans earned less from selling to for- eigners than they spent on foreign goods. Q U I C K Q U I Z : List the four components of expenditure. Which is the largest? REAL VERSUS NOMINAL GDP As we have seen, GDP measures the total spending on goods and services in all markets in the economy. If total spending rises from one year to the next, one of two things must be true: (1) the economy is producing a larger output of goods  CHAPTER 22 M E A S U R I N G A N AT I O N ’ S I N C O M E 501 PRICES AND QUANTITIES YEAR PRICE OF HOT DOGS QUANTITY OF HOT DOGS PRICE OF HAMBURGERS QUANTITY OF HAMBURGERS 2001 $1 100 $2 50 2002 2 150 3 100 2003 3 200 4 150 YEAR CALCULATING NOMINAL GDP 2001 ($1 per hot dog ⫻ 100 hot dogs) ⫹ ($2 per hamburger ⫻ 50 hamburgers) ⫽ $200 2002 ($2 per hot dog ⫻ 150 hot dogs) ⫹ ($3 per hamburger ⫻ 100 hamburgers) ⫽ $600 2003 ($3 per hot dog ⫻ 200 hot dogs) ⫹ ($4 per hamburger ⫻ 150 hamburgers) ⫽ $1,200 YEAR CALCULATING REAL GDP (BASE YEAR 2001) 2001 ($1 per hot dog ⫻ 100 hot dogs) ⫹ ($2 per hamburger ⫻ 50 hamburgers) ⫽ $200 2002 ($1 per hot dog ⫻ 150 hot dogs) ⫹ ($2 per hamburger ⫻ 100 hamburgers) ⫽ $350 2003 ($1 per hot dog ⫻ 200 hot dogs) ⫹ ($2 per hamburger ⫻ 150 hamburgers) ⫽ $500 YEAR CALCULATING THE GDP DEFLATOR 2001 ($200/$200) ⫻ 100 ⫽ 100 2002 ($600/$350) ⫻ 100 ⫽ 171 2003 ($1,200/$500) ⫻ 100 ⫽ 240 R EAL AND N OMINAL GDP. This table shows how to calculate real GDP, nominal GDP, Ta b l e 2 2 - 2 and the GDP deflator for a hypothetical economy that produces only hot dogs and hamburgers. and services, or (2) goods and services are being sold at higher prices. When studying changes in the economy over time, economists want to separate these two effects. In particular, they want a measure of the total quantity of goods and services the economy is producing that is not affected by changes in the prices of those goods and services. To do this, economists use a measure called real GDP. Real GDP answers a hypothetical question: What would be the value of the goods and services pro- duced this year if we valued these goods and services at the prices that prevailed in some specific year in the past? By evaluating current production using prices that are fixed at past levels, real GDP shows how the economy’s overall produc- tion of goods and services changes over time. To see more precisely how real GDP is constructed, let’s consider an example. A NUMERICAL EXAMPLE Table 22-2 shows some data for an economy that produces only two goods—hot dogs and hamburgers. The table shows the quantities of the two goods produced and their prices in the years 2001, 2002, and 2003. 502 PA R T E I G H T T H E D ATA O F M A C R O E C O N O M I C S To compute total spending in this economy, we would multiply the quantities of hot dogs and hamburgers by their prices. In the year 2001, 100 hot dogs are sold at a price of $1 per hot dog, so expenditure on hot dogs equals $100. In the same year, 50 hamburgers are sold for $2 per hamburger, so expenditure on hamburgers also equals $100. Total expenditure in the economy—the sum of expenditure on hot dogs and expenditure on hamburgers—is $200. This amount, the production nominal GDP of goods and services valued at current prices, is called nominal GDP. the production of goods and services The table shows the calculation of nominal GDP for these three years. Total valued at current prices spending rises from $200 in 2001 to $600 in 2002 and then to $1,200 in 2003. Part of this rise is attributable to the increase in the quantities of hot dogs and hamburgers, and part is attributable to the increase in the prices of hot dogs and hamburgers. To obtain a measure of the amount produced that is not affected by changes in real GDP prices, we use real GDP, which is the production of goods and services valued at the production of goods and services constant prices. We calculate real GDP by first choosing one year as a base year. We valued at constant prices then use the prices of hot dogs and hamburgers in the base year to compute the value of goods and services in all of the years. In other words, the prices in the base year provide the basis for comparing quantities in different years. Suppose that we choose 2001 to be the base year in our example. We can then use the prices of hot dogs and hamburgers in 2001 to compute the value of goods and services produced in 2001, 2002, and 2003. Table 22-2 shows these calculations. To compute real GDP for 2001, we use the prices of hot dogs and hamburgers in 2001 (the base year) and the quantities of hot dogs and hamburgers produced in 2001. (Thus, for the base year, real GDP always equals nominal GDP.) To compute real GDP for 2002, we use the prices of hot dogs and hamburgers in 2001 (the base year) and the quantities of hot dogs and hamburgers produced in 2002. Similarly, to compute real GDP for 2003, we use the prices in 2001 and the quantities in 2003. When we find that real GDP has risen from $200 in 2001 to $350 in 2002 and then to $500 in 2003, we know that the increase is attributable to an increase in the quan- tities produced, because the prices are being held fixed at base-year levels. To sum up: Nominal GDP uses current prices to place a value on the economy’s pro- duction of goods and services. Real GDP uses constant base-year prices to place a value on the economy’s production of goods and services. Because real GDP is not affected by changes in prices, changes in real GDP reflect only changes in the amounts being produced. Thus, real GDP is a measure of the economy’s production of goods and services. Our goal in computing GDP is to gauge how well the overall economy is per- forming. Because real GDP measures the economy’s production of goods and ser- vices, it reflects the economy’s ability to satisfy people’s needs and desires. Thus, real GDP is a better gauge of economic well-being than is nominal GDP. When economists talk about the economy’s GDP, they usually mean real GDP rather than nominal GDP. And when they talk about growth in the economy, they measure that growth as the percentage change in real GDP from one period to another. T H E G D P D E F L AT O R As we have just seen, nominal GDP reflects both the prices of goods and services and the quantities of goods and services the economy is producing. By contrast, by holding prices constant at base-year levels, real GDP reflects only the quantities produced. From these two statistics, we can compute a third, called the GDP defla- tor, which reflects the prices of goods and services but not the quantities produced.  CHAPTER 22 M E A S U R I N G A N AT I O N ’ S I N C O M E 503 The GDP deflator is calculated as follows: GDP deflator a measure of the price level calculated as the ratio of nominal GDP deflator ⫽ Nominal GDP ⫻ 100. Real GDP GDP to real GDP times 100 Because nominal GDP and real GDP must be the same in the base year, the GDP deflator for the base year always equals 100. The GDP deflator for subsequent years measures the rise in nominal GDP from the base year that cannot be attrib- utable to a rise in real GDP. The GDP deflator measures the current level of prices relative to the level of prices in the base year. To see why this is true, consider a couple of simple exam- ples. First, imagine that the quantities produced in the economy rise over time but prices remain the same. In this case, both nominal and real GDP rise together, so the GDP deflator is constant. Now suppose, instead, that prices rise over time but the quantities produced stay the same. In this second case, nominal GDP rises but real GDP remains the same, so the GDP deflator rises as well. Notice that, in both cases, the GDP deflator reflects what’s happening to prices, not quantities. Let’s now return to our numerical example in Table 22-2. The GDP deflator is computed at the bottom of the table. For year 2001, nominal GDP is $200, and real GDP is $200, so the GDP deflator is 100. For the year 2002, nominal GDP is $600, and real GDP is $350, so the GDP deflator is 171. Because the GDP deflator rose in year 2002 from 100 to 171, we can say that the price level increased by 71 percent. The GDP deflator is one measure that economists use to monitor the average level of prices in the economy. We examine another—the consumer price index—in the next chapter, where we also describe the differences between the two measures. CASE STUDY REAL GDP OVER RECENT HISTORY Now that we know how real GDP is defined and measured, let’s look at what this macroeconomic variable tells us about the recent history of the United States. Fig- ure 22-2 shows quarterly data on real GDP for the U.S. economy since 1970. Figure 22-2 R EAL GDP IN THE U NITED Billions of 1992 Dollars S TATES. This figure shows $8,000 quarterly data on real GDP for the U.S. economy since 1970. $7,000 Recessions—periods of falling real GDP—are marked with the 6,000 shaded vertical bars. SOURCE: U.S. Department of Commerce. 5,000 4,000 3,000 1970 1975 1980 1985 1990 1995 2000 504 PA R T E I G H T T H E D ATA O F M A C R O E C O N O M I C S The most obvious feature of these data is that real GDP grows over time. The real GDP of the U.S. economy in 1999 was more than twice its 1970 level. Put differently, the output of goods and services produced in the United States has grown on average about 3 percent per year since 1970. This continued growth in real GDP enables the typical American to enjoy greater economic prosperity than his or her parents and grandparents did. A second feature of the GDP data is that growth is not steady. The upward climb of real GDP is occasionally interrupted by periods during which GDP declines, called recessions. Figure 22-2 marks recessions with shaded vertical bars. (There is no ironclad rule for when the official business cycle dating com- mittee will declare that a recession has occurred, but a good rule of thumb is two consecutive quarters of falling real GDP.) Recessions are associated not only with lower incomes but also with other forms of economic distress: rising unemployment, falling profits, increased bankruptcies, and so on. Much of macroeconomics is aimed at explaining the long-run growth and short-run fluctuations in real GDP. As we will see in the coming chap- ters, we need different models for these two purposes. Because the short-run fluctuations represent deviations from the long-run trend, we first examine the behavior of the economy in the long run. In particular, Chapters 24 through 30 examine how key macroeconomic variables, including real GDP, are deter- mined in the long run. We then build on this analysis to explain short-run fluc- tuations in Chapters 31 through 33. Q U I C K Q U I Z : Define real and nominal GDP. Which is a better measure of economic well-being? Why? GDP AND ECONOMIC WELL-BEING Earlier in this chapter, GDP was called the best single measure of the economic well- being of a society. Now that we know what GDP is, we can evaluate this claim. As we have seen, GDP measures both the economy’s total income and the econ- omy’s total expenditure on goods and services. Thus, GDP per person tells us the income and expenditure of the average person in the economy. Because most people would prefer to receive higher income and enjoy higher expenditure, GDP per per- son seems a natural measure of the economic well-being of the average individual. Yet some people dispute the validity of GDP as a measure of well-being. When Senator Robert Kennedy was running for president in 1968, he gave a moving cri- tique of such economic measures: [Gross domestic product] does not allow for the health of our children, the quality of their education, or the joy of their play. It does not include the beauty of our poetry or the strength of our marriages, the intelligence of our public debate or the integrity of our public officials. It measures neither our courage, nor our wisdom, nor our devotion to our country. It measures everything, in short, except that which makes life worthwhile, and it can tell us everything about America except why we are proud that we are Americans. 506 PA R T E I G H T T H E D ATA O F M A C R O E C O N O M I C S GDP is not, however, a perfect measure of well-being. Some things that con- tribute to a good life are left out of GDP. One is leisure. Suppose, for instance, that everyone in the economy suddenly started working every day of the week, rather than enjoying leisure on weekends. More goods and services would be produced, and GDP would rise. Yet, despite the increase in GDP, we should not conclude that everyone would be better off. The loss from reduced leisure would offset the gain from producing and consuming a greater quantity of goods and services. Because GDP uses market prices to value goods and services, it excludes the value of almost all activity that takes place outside of markets. In particular, GDP omits the value of goods and services produced at home. When a chef prepares a delicious meal and sells it at his restaurant, the value of that meal is part of GDP. But if the chef prepares the same meal for his spouse, the value he has added to the raw ingredients is left out of GDP. Similarly, child care provided in day care cen- ters is part of GDP, whereas child care by parents at home is not. Volunteer work also contributes to the well-being of those in society, but GDP does not reflect these contributions. Another thing that GDP excludes is the quality of the environment. Imagine that the government eliminated all environmental regulations. Firms could then produce goods and services without considering the pollution they create, and GDP might rise. Yet well-being would most likely fall. The deterioration in the quality of air and water would more than offset the gains from greater production. GDP also says nothing about the distribution of income. A society in which 100 people have annual incomes of $50,000 has GDP of $5 million and, not sur- prisingly, GDP per person of $50,000. So does a society in which 10 people earn GDP REFLECTS THE FACTORY’S $500,000 and 90 suffer with nothing at all. Few people would look at those two sit- PRODUCTION, BUT NOT THE HARM THAT IT uations and call them equivalent. GDP per person tells us what happens to the INFLICTS ON THE ENVIRONMENT. average person, but behind the average lies a large variety of personal experiences. In the end, we can conclude that GDP is a good measure of economic well- being for most—but not all—purposes. It is important to keep in mind what GDP includes and what it leaves out. CASE STUDY INTERNATIONAL DIFFERENCES IN GDP AND THE QUALITY OF LIFE One way to gauge the usefulness of GDP as a measure of economic well-being is to examine international data. Rich and poor countries have vastly different levels of GDP per person. If a large GDP leads to a higher standard of living, then we should observe GDP to be strongly correlated with measures of the quality of life. And, in fact, we do. Table 22-3 shows 12 of the world’s most populous countries ranked in order of GDP per person. The table also shows life expectancy (the expected life span at birth) and literacy (the percentage of the adult population that can read). These data show a clear pattern. In rich countries, such as the United States, Japan, and Germany, people can expect to live into their late seventies, and almost all of the population can read. In poor countries, such as Nigeria, Bangladesh, and Pakistan, people typically live only until their fifties or early sixties, and only about half of the population is literate. Although data on other aspects of the quality of life are less complete, they tell a similar story. Countries with low GDP per person tend to have more infants with low birth weight, higher rates of infant mortality, higher rates of  CHAPTER 22 M E A S U R I N G A N AT I O N ’ S I N C O M E 507 Ta b l e 2 2 - 3 REAL GDP PER LIFE ADULT COUNTRY PERSON, 1997 EXPECTANCY LITERACY GDP, L IFE E XPECTANCY, AND L ITERACY. The table shows United States $29,010 77 years 99% GDP per person and two Japan 24,070 80 99 measures of the quality of life for Germany 21,260 77 99 12 major countries. Mexico 8,370 72 90 Brazil 6,480 67 84 Russia 4,370 67 99 Indonesia 3,490 65 85 China 3,130 70 83 India 1,670 63 53 Pakistan 1,560 64 41 Bangladesh 1,050 58 39 Nigeria 920 50 59 Source: Human Development Report 1999, United Nations. that people are eating more bread and Government experts insist that if the bakeries are selling less. Or consider vod- shadow economy is taken into account, IN THE NEWS ka. Distillers are able to produce far more the overall economy is finally starting to Hidden GDP vodka than is officially being sold. But giv- grow. In turn, Mr. Yeltsin’s critics com- en the well-deserved Russian fondness for plain that the new calculations are more vodka there is every reason to think the propaganda than economics.... distilleries are operating at full capacity. There is no question that measuring The Russian Government’s top economic activity in a former Communist number crunchers say the contradictions country on the road to capitalism is a are easy to explain: high taxes, govern- frustratingly elusive task. ment red tape, and the simple desire to “There is a serious problem with Measuring a nation’s gross domestic sock away some extra cash have driven post-socialist statistics,” said Yegor T. product is never easy, but it becomes much of Russia’s economic activity Gaidar, the former Prime Minister and especially difficult when people have underground. pro-reform director of the Institute of every incentive to hide their economic For the last six years, the Russian Economic Problems of the Transitional activities from the eyes of government. economy has been going down, down, Period. down. But as President Boris N. Yeltsin “Seven years ago to report an The Russian Economy: tries to deliver the growth he has increase in the amount of production Notes from Underground promised, economists are taking a clos- was to become a Hero of Socialist er look at the murky but vibrant shadow Labor,” he said. “Now it is to get addi- BY MICHAEL R. GORDON economy. It includes everything from tional visits from the tax collector.” If you want to know what is happening in small businesses that never report their the Russian economy, it helps to think sales to huge companies that understate SOURCE: The New York Times, May 18, 1997, Week about bread. Government statistics show their production to avoid taxes. in Review, p. 4. 508 PA R T E I G H T T H E D ATA O F M A C R O E C O N O M I C S maternal mortality, higher rates of child malnutrition, and less common access to safe drinking water. In countries with low GDP per person, fewer school-age children are actually in school, and those who are in school must learn with fewer teachers per student. These countries also tend to have fewer televisions, fewer telephones, fewer paved roads, and fewer households with electricity. International data leave no doubt that a nation’s GDP is closely associated with its citizens’ standard of living. Q U I C K Q U I Z : Why should policymakers care about GDP? CONCLUSION This chapter has discussed how economists measure the total income of a nation. Measurement is, of course, only a starting point. Much of macroeconomics is aimed at revealing the long-run and short-run determinants of a nation’s gross domestic product. Why, for example, is GDP higher in the United States and Japan than in India and Nigeria? What can the governments of the poorest countries do to promote more rapid growth in GDP? Why does GDP in the United States rise rapidly in some years and fall in others? What can U.S. policymakers do to reduce the severity of these fluctuations in GDP? These are the questions we will take up shortly. At this point, it is important to acknowledge the importance of just measuring GDP. We all get some sense of how the economy is doing as we go about our lives. But the economists who study changes in the economy and the policymakers who formulate economic policies need more than this vague sense—they need concrete data on which to base their judgments. Quantifying the behavior of the economy with statistics such as GDP is, therefore, the first step to developing a science of macroeconomics. Summary ◆ Because every transaction has a buyer and a seller, the purchases of new housing. Investment includes total expenditure in the economy must equal the total spending on new equipment and structures, including income in the economy. households’ purchases of new housing. Government ◆ Gross domestic product (GDP) measures an economy’s purchases include spending on goods and services by total expenditure on newly produced goods and local, state, and federal governments. Net exports equal services and the total income earned from the the value of goods and services produced domestically production of these goods and services. More precisely, and sold abroad (exports) minus the value of goods and GDP is the market value of all final goods and services services produced abroad and sold domestically produced within a country in a given period of time. (imports). ◆ GDP is divided among four components of expenditure: ◆ Nominal GDP uses current prices to value the consumption, investment, government purchases, and economy’s production of goods and services. Real GDP net exports. Consumption includes spending on goods uses constant base-year prices to value the economy’s and services by households, with the exception of production of goods and services. The GDP deflator—  CHAPTER 22 M E A S U R I N G A N AT I O N ’ S I N C O M E 509 calculated from the ratio of nominal to real GDP— perfect measure of well-being. For example, GDP measures the level of prices in the economy. excludes the value of leisure and the value of a clean ◆ GDP is a good measure of economic well-being because environment. people prefer higher to lower incomes. But it is not a Key Concepts microeconomics, p. 494 investment, p. 499 real GDP, p. 502 macroeconomics, p. 494 government purchases, p. 499 GDP deflator, p. 503 gross domestic product (GDP), p. 496 net exports, p. 499 consumption, p. 499 nominal GDP, p. 502 Questions for Review 1. Explain why an economy’s income must equal its 6. Why do economists use real GDP rather than nominal expenditure. GDP to gauge economic well-being? 2. Which contributes more to GDP—the production of an 7. In the year 2001, the economy produces 100 loaves of economy car or the production of a luxury car? Why? bread that sell for $2 each. In the year 2002, the economy 3. A farmer sells wheat to a baker for $2. The baker uses produces 200 loaves of bread that sell for $3 each. the wheat to make bread, which is sold for $3. What is Calculate nominal GDP, real GDP, and the GDP deflator the total contribution of these transactions to GDP? for each year. (Use 2001 as the base year.) By what percentage does each of these three statistics rise from 4. Many years ago Peggy paid $500 to put together a one year to the next? record collection. Today she sold her albums at a garage sale for $100. How does this sale affect current GDP? 8. Why is it desirable for a country to have a large GDP? Give an example of something that would raise GDP 5. List the four components of GDP. Give an example of and yet be undesirable. each. Problems and Applications 1. What components of GDP (if any) would each of the think of a reason why households’ purchases of new following transactions affect? Explain. cars should also be included in investment rather than a. A family buys a new refrigerator. in consumption? To what other consumption goods b. Aunt Jane buys a new house. might this logic apply? c. Ford sells a Thunderbird from its inventory. 4. As the chapter states, GDP does not include the value of d. You buy a pizza. used goods that are resold. Why would including such e. California repaves Highway 101. transactions make GDP a less informative measure of f. Your parents buy a bottle of French wine. economic well-being? g. Honda expands its factory in Marysville, Ohio. 5. Below are some data from the land of milk and honey. 2. The “government purchases” component of GDP does not include spending on transfer payments such as Social Security. Thinking about the definition of GDP, PRICE QUANTITY PRICE OF QUANTITY explain why transfer payments are excluded. YEAR OFMILK OF MILK HONEY OF HONEY 3. Why do you think households’ purchases of new 2001 $1 100 qts. $2 50 qts. housing are included in the investment component of 2002 $1 200 $2 100 GDP rather than the consumption component? Can you 2003 $2 200 $4 100 510 PA R T E I G H T T H E D ATA O F M A C R O E C O N O M I C S a. Compute nominal GDP, real GDP, and the GDP 9. One day Barry the Barber, Inc., collects $400 for haircuts. deflator for each year, using 2001 as the base year. Over this day, his equipment depreciates in value by b. Compute the percentage change in nominal GDP, $50. Of the remaining $350, Barry sends $30 to the real GDP, and the GDP deflator in 2002 and 2003 government in sales taxes, takes home $220 in wages, from the preceding year. For each year, identify the and retains $100 in his business to add new equipment variable that does not change. Explain in words in the future. From the $220 that Barry takes home, he why your answer makes sense. pays $70 in income taxes. Based on this information, c. Did economic well-being rise more in 2002 or 2003? compute Barry’s contribution to the following measures Explain. of income: 6. Consider the following data on U.S. GDP: a. gross domestic product b. net national product NOMINAL GDP GDP DEFLATOR c. national income YEAR (IN BILLIONS) (BASE YEAR 1992) d. personal income e. disposable personal income 1996 7,662 110 10. Goods and services that are not sold in markets, such as 1997 8,111 112 food produced and consumed at home, are generally not included in GDP. Can you think of how this might a. What was the growth rate of nominal GDP between cause the numbers in the second column of Table 22-3 to 1996 and 1997? (Note: The growth rate is the be misleading in a comparison of the economic well- percentage change from one period to the next.) being of the United States and India? Explain. b. What was the growth rate of the GDP deflator between 1996 and 1997? 11. Until the early 1990s, the U.S. government emphasized c. What was real GDP in 1996 measured in 1992 GNP rather than GDP as a measure of economic well- prices? being. Which measure should the government prefer if d. What was real GDP in 1997 measured in 1992 it cares about the total income of Americans? Which prices? measure should it prefer if it cares about the total e. What was the growth rate of real GDP between amount of economic activity occurring in the United 1996 and 1997? States? f. Was the growth rate of nominal GDP higher or 12. The participation of women in the U.S. labor force has lower than the growth rate of real GDP? Explain. risen dramatically since 1970. 7. If prices rise, people’s income from selling goods a. How do you think this rise affected GDP? increases. The growth of real GDP ignores this gain, b. Now imagine a measure of well-being that includes however. Why, then, do economists prefer real GDP as a time spent working in the home and taking leisure. measure of economic well-being? How would the change in this measure of well- being compare to the change in GDP? 8. Revised estimates of U.S. GDP are usually released by c. Can you think of other aspects of well-being that the government near the end of each month. Go to a are associated with the rise in women’s labor force library and find a newspaper article that reports on the participation? Would it be practical to construct a most recent release. Discuss the recent changes in real measure of well-being that includes these aspects? and nominal GDP and in the components of GDP. (Alternatively, you can get the data at www.bea.doc.gov, the Web site of the U.S. Bureau of Economic Analysis.)