Mankiw LE3 Coverage PDF

Chapter W 23 hen you finish...

Chapter W 23 hen you finish school and start looking for a full-time job, your experience will, to a large extent, be shaped by prevail- ing economic conditions. In some years, firms throughout the economy are expanding their production of goods and services, employment is rising, and jobs are easy to find. In other years, firms are cutting back production, employment is declining, and jobs are hard to find. Not surprisingly, any college graduate would rather enter the labor force in a year of economic expansion than in a year of economic contraction. Measuring a Nation’s Because the health 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, check an online Income news service, or turn on the TV without seeing some newly reported economic statistic. The statistic might measure the total income of everyone in the economy (gross domestic product), the rate at which average prices are rising or falling (inflation/deflation), the per- centage of the labor force that is out of work (unemployment), total spending at stores (retail sales), or the imbalance of trade between the iStock.com/lolostock; George Rudy/Shutterstock.com Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). 38314_ch23_hr_467-486.indd 467has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Editorial review 23/09/19 11:02 am  468 part VIII The Data of Macroeconomics United States and the rest of the world (the trade deficit). All these statistics are macroeconomic. Rather than telling us about a particular household, firm, or market, 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 the study of how individual households and firms make decisions and how they interact with households and firms one another in markets. Macroeconomics is the study of the economy as a make decisions and how whole. The goal of macroeconomics is to explain the economic changes that they interact in markets affect many households, firms, and markets simultaneously. Macroeconomists macroeconomics address a broad variety of questions: Why is average income high in some the study of economy- countries and low in others? Why are prices sometimes rapidly rising and other wide phenomena, times more stable? Why do production and employment expand in some years including inflation, and contract in others? What, if anything, can the government do to promote unemployment, and rapid growth in incomes, low inflation, and stable employment? These ques- economic growth tions are all macroeconomic in nature because they concern the workings of the entire economy. Because the economy as a whole is a collection of many households and many firms interacting in many markets, microeconomics and macroeconomics are closely linked. The tools of supply and demand, for instance, are as central to macroeconomic analysis as they are to microeconomic analysis. Yet studying the economy in its entirety raises some new and intriguing challenges. In this and the next chapter, 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 chapter considers gross domestic product (GDP), which measures the total income of a nation. GDP is the most closely watched economic statistic because it is thought to be the single best measure of a society’s economic well-being. 23-1 The Economy’s Income and Expenditure If you were to judge how a person is doing economically, you might first look at her income. A person with a high income can more easily afford life’s necessities and luxuries. It is no surprise that people with higher incomes enjoy higher standards of living—larger houses, better healthcare, 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 aggregate income that everyone in the economy is earning. Gross domestic product allows us to do just that. GDP measures two things at once: the total income of everyone in the econ- omy and the total expenditure on the economy’s output of goods and services. GDP can perform the trick of measuring both total income and total expenditure because these two things are the same. For an economy as a whole, income must equal expenditure. Why is this true? An economy’s income equals its expenditure because 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, 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. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). 38314_ch23_hr_467-486.indd 468has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Editorial review 23/09/19 11:02 am  CHAPTER 23 Measuring a Nation’s Income 469 Another way to see the equality of income and expenditure is with the c­ ircular-flow diagram in Figure 1. As you may recall from Chapter 2, this diagram describes all the transactions between households and firms in a simple econ- omy. It ­simplifies matters by assuming that all goods and services are bought by ­households and that households spend all of their income. In this economy, when households buy goods and services from firms, these expenditures flow through the markets for goods and services. When the firms 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. Money continu- ously flows from households to firms and then back to households. GDP measures this flow of money. We can compute it for this economy in either 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 1. Households do not spend all of their income; they pay some of it to the government in taxes, and they save some for use in the future. In addition, house- holds do not buy all 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 the basic lesson remains the same: Regardless of whether a household, government, or firm buys a good or service, the transaction always has a buyer and a seller. Thus, for the economy as a whole, expenditure and income are the same. Figure 1 Revenue Spending (= GDP) (= GDP) The Circular-Flow Diagram MARKETS FOR Households buy goods and services GOODS AND from firms, and firms use their Goods SERVICES Goods and revenue from sales to pay wages and services services to workers, rent to landowners, sold bought and profit to firm owners. GDP equals the total amount spent by households in the market for goods and services. It also equals the total wages, rent, and profit paid FIRMS HOUSEHOLDS by firms in the markets for the factors of production. Factors of Labor, land, production MARKETS FOR and capital FACTORS OF Wages, rent, PRODUCTION Income (= GDP) and profit 5 Flow of inputs (= GDP) and outputs 5 Flow of dollars Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). 38314_ch23_hr_467-486.indd 469has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Editorial review 23/09/19 11:02 am  470 part VIII The Data of Macroeconomics QuickQuiz 1. An economy’s gross domestic product is 2. Sam bakes a cake and sells it to Carla for a. the excess of spending over $10. Woody pays Diane $30 to tutor him. income. In this economy, GDP is b. the excess of income over a. $10. spending. b. $20. c. total income and total spending. c. $30. d. total income times total spending. d. $40. Answers at end of chapter. 23-2 The Measurement of GDP Having discussed the meaning of gross domestic product in general terms, let’s be more precise about how this statistic is measured. Here is a definition of GDP that focuses on GDP as a measure of total expenditure: 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 This definition might seem simple enough. But in fact, many subtle issues arise produced within a country when computing an economy’s GDP. Let’s therefore consider each phrase in this in a given period of time definition with some care. 23-2a “GDP Is the Market Value...” 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. 23-2b “... 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 c­ alculate— the rent equals both the tenant’s expenditure and the landlord’s income. Yet many people own their homes and, therefore, do not pay rent. The government includes this owner-occupied housing in GDP by estimating its rental value. In effect, GDP is based on the assumption that the owner is renting the house to herself. The imputed rent is included both in the homeowner’s expenditure and in her income, so it adds to GDP. Some products, however, are excluded from GDP because they are hard to ­measure. GDP excludes most items produced and sold illicitly, such as illegal drugs. It also excludes most items that are produced and consumed at home and, there- fore, never enter the marketplace. For instance, GDP includes vegetables you buy at the grocery store but not vegetables you grow in your garden. These exclusions from GDP can at times lead to paradoxical results. For ­example, when Karen pays Doug to mow her lawn, that transaction is part of GDP. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). 38314_ch23_hr_467-486.indd 470has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Editorial review 23/09/19 11:02 am  CHAPTER 23 Measuring a Nation’s Income 471 But suppose Doug and Karen get married. 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, their marriage reduces GDP. 23-2c “... Final...” When International Paper makes paper, which Hallmark then uses to make ag ­ reeting card, the paper is called an intermediate good and the card is called a final good. GDP includes only the value of final goods because 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 ­counting. 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 for use or sale 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 included as part of GDP. Thus, additions to inventory add to GDP, and when the goods in inventory are later used or sold, the reductions in inventory subtract from GDP. 23-2d “... 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 band, you are buying a good, and the purchase price is part of GDP. When you pay to hear a concert by the same band, you are buying a service, and the ticket price is also part of GDP. 23-2e “... Produced...” GDP includes goods and services currently produced. It does not include transac- tions involving items produced in the past. When Ford produces and sells a new car, the value of the car is included in GDP. But when one person sells a used car to another person, the value of the used car is not included in GDP. 23-2f “... Within a Country...” GDP measures the value of production within the geographic confines of a country. When a Canadian citizen works temporarily in the United States, her production counts toward U.S. GDP. When an American citizen owns a factory in Haiti, the production at her factory does not contribute to U.S. GDP. (It contributes to Haiti’s GDP.) Thus, items are included in a nation’s GDP if they are produced d­ omestically, regardless of the nationality of the producer. 23-2g “... 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, as well as its flow of 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 four. 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 adjust- ment. The unadjusted data show that the economy produces more goods and services during some times of the year than during others. (As you might guess, Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). 38314_ch23_hr_467-486.indd 471has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Editorial review 23/09/19 11:02 am  472 part VIII The Data of Macroeconomics December’s holiday shopping season is a high point.) When monitoring 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. This definition focuses on GDP as total expenditure in the economy. But recall that every dollar spent by a buyer of a good or service becomes a dollar of income to the seller of that good or service. Therefore, in addition to adding up total expen- diture in the economy to calculate GDP, the government also adds up total income in the economy to arrive at gross domestic income (GDI). GDP and GDI give almost exactly the same number. (Why “almost”? The two measures should be precisely the same, but data sources are not perfect. The difference between GDP and GDI is called the statistical discrepancy.) 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 about the nuances of its calculation. But even now you can see that each phrase in this definition is packed with meaning. Other Measures of Income W hen the U.S. Department of Commerce computes the nation’s GDP, it also computes various other measures of income to get a more com- plete picture of what’s happening in the economy. These other measures net national product. These two measures differ because of the ­statistical discrepancy that arises from problems in data collection. Personal income is the income that households and noncorporate differ from GDP by excluding or including certain categories of income. businesses receive. Unlike national income, it excludes retained What follows is a brief description of five of these income measures, earnings, the income that corporations earn but do not pay out to ordered from largest to smallest. their owners. It also subtracts indirect business taxes (such as sales taxes), corporate income taxes, and contributions for social Gross national product (GNP) is the total income earned by a nation’s insurance (mostly Social Security taxes). In addition, personal permanent residents (called nationals). It differs from GDP in that it income includes the interest income that households receive from includes income that our citizens earn abroad and excludes income their holdings of government debt and the income that households that foreigners earn here. For example, when a Canadian citizen works receive from government transfer programs, such as welfare and temporarily in the United States, her production is part of U.S. GDP, but Social Security. it is not part of U.S. GNP. (It is part of Canada’s GNP.) For most coun- Disposable personal income is the income that households and non- tries, including the United States, domestic residents are responsible corporate businesses have left after satisfying all their obligations to for most domestic production, so GDP and GNP are quite close. the government. It equals personal income minus personal taxes and Net national product (NNP) is the total income of a nation’s residents certain nontax payments (such as traffic tickets). (GNP) minus losses from depreciation. Depreciation is the wear and tear on the economy’s stock of equipment and structures, such as Although the various measures of income differ in detail, they almost trucks rusting and old computer models becoming obsolete. In the always tell the same story about economic conditions. When GDP grows national income accounts prepared by the Department of Commerce, rapidly, these other measures of income tend to grow rapidly. And depreciation is called the “consumption of fixed capital.” when GDP falls, these other measures tend to fall as well. As a result, for National income is the total income earned by a nation’s residents monitoring fluctuations in the overall economy, it does not matter much in the production of goods and services. It is almost identical to which measure of income we use. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). 38314_ch23_hr_467-486.indd 472has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Editorial review 23/09/19 11:02 am  CHAPTER 23 Measuring a Nation’s Income 473 QuickQuiz 3. If the price of a hot dog is $2 and the price of a a. $40 hamburger is $4, then 30 hot dogs contribute as b. $60 much to GDP as _________ hamburgers. c. $80 a. 5 d. $100 b. 15 5. After graduation, an American college student moves c. 30 to Japan to teach English. Her salary is included d. 60 a. only in U.S. GDP. 4. Angus the sheep farmer sells wool to Barnaby the b. only in Japan’s GDP. knitter for $20. Barnaby makes two sweaters, each c. in both U.S. GDP and Japan’s GDP. of which has a market price of $40. Collette buys d. in neither U.S. GDP nor Japan’s GDP. one of them, while the other remains on the shelf of Barnaby’s store to be sold later. What is GDP here? Answers at end of chapter. 23-3 The Components of GDP Spending in an economy takes many forms. At any moment, the Lopez family may be having lunch at Burger King; Ford may be building a car factory; the U.S. 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 study the composition of GDP among various types of spending. To do this, GDP (which we denote as Y ) is divided into four components: consumption (C), investment (I ), government purchases (G), and net exports (NX): Y 5 C 1 I 1 G 1 NX. This equation is an identity—an equation that must be true because of how the ­variables in the equation are defined. In this case, because each dollar of expendi- ture included in GDP is placed into one of the four components of GDP, the total of the four components must be equal to GDP. Let’s look at each of these four components more closely. 23-3a Consumption Consumption is spending by households on goods and services, with the exception consumption of purchases of new housing. Goods include durable goods, such as automobiles spending by households and appliances, and nondurable goods, such as food and clothing. Services include on goods and services, such intangible items as haircuts and medical care. Household spending on educa- with the exception of tion is also included in consumption of services (although one might argue that it purchases of new housing would fit better in the next component). 23-3b Investment Investment is the purchase of goods (called capital goods) that will be used in the investment future to produce more goods and services. Investment is the sum of purchases spending on business of business capital, residential capital, and inventories. Business capital includes capital, residential business structures (such as a factory or office building), equipment (such as a capital, and inventories Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). 38314_ch23_hr_467-486.indd 473has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Editorial review 23/09/19 11:02 am  474 part VIII The Data of Macroeconomics worker’s computer), and intellectual property products (such as the software that runs the computer). Residential capital includes the landlord’s apartment build- ing and a homeowner’s personal residence. By convention, the purchase of a new house is the one type of household spending categorized as investment rather than consumption. As mentioned earlier, the treatment of inventory accumulation is noteworthy. When Apple produces a computer and adds it to its inventory instead of selling it, Apple is assumed to have “purchased” the computer for itself. That is, the national income accountants treat the computer as part of Apple’s investment spending. (When Apple later sells the computer out of inventory, the sale will subtract from Apple’s inventory investment, offsetting the positive expenditure of the buyer.) Inventories are treated this way because GDP aims to measure the value of the econo- my’s production, and goods added to inventory are part of that period’s production. Note that GDP accounting uses the word investment differently from how you might hear the term in everyday conversation. When you hear the word ­investment, you might think of financial investments, such as stocks, bonds, and mutual funds—topics that we study later in this book. By contrast, because GDP measures expenditure on goods and services, here the word investment means pur- chases of goods (such as business capital, residential structures, and inventories) that will be used to produce other goods and services in the future. 23-3c Government Purchases government purchases Government purchases measure spending on goods and services by local, state, spending on goods and and federal governments. This component includes the salaries of government services by local, state, workers as well as expenditures on public works. Recently, the U.S. national income and federal governments accounts have switched to the longer label government consumption expenditure and gross investment, but here we will use the traditional and shorter term government purchases. The meaning of government purchases requires some clarification. When the government pays the salary of an Army general or a schoolteacher, that salary is included in government purchases. But when the government pays a Social Security benefit to an elderly person or an unemployment insurance benefit to a recently laid off worker, the story is very different: These are called transfer payments because they are not made in exchange for a currently produced good or service. Transfer payments alter household income, but they do not reflect the economy’s production. (From a macroeconomic standpoint, transfer payments are like nega- tive taxes.) Because GDP is intended to measure income from, and expenditure on, the production of goods and services, transfer payments are not counted as government purchases. 23-3d Net Exports net exports Net exports equal the foreign purchases of domestically produced goods (exports) spending on domestically minus the domestic purchases of foreign goods (imports). A domestic firm’s sale to produced goods by a buyer in another country, such as Boeing’s sale of an airplane to British Airways, foreigners (exports) minus increases net exports. spending on foreign The net in net exports refers to the fact that imports are subtracted from exports. goods by domestic This subtraction is made because other components of GDP include imports of residents (imports) goods and services. For example, suppose that a household buys a $50,000 car from Volvo, the Swedish carmaker. This transaction increases consumption by $50,000 because car purchases are part of consumer spending. It also reduces net exports by $50,000 because the car is an import. In other words, net exports include goods Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). 38314_ch23_hr_467-486.indd 474has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Editorial review 23/09/19 11:02 am  CHAPTER 23 Measuring a Nation’s Income 475 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 does not affect GDP because it reduces net exports by the same amount that it raises consumption, investment, or government purchases. The Components of U.S. GDP Case Table 1 shows the composition of U.S. GDP in 2018. In this year, the Study GDP of the United States was more than $20 trillion. Dividing this number by the 2018 U.S. population of 327 million yields GDP per person (sometimes called GDP per capita) and reveals that the income and expen- diture of the average American in 2018 was $62,609. Consumption made up 68 percent of GDP, or $42,609 per person. Investment was $11,154 per person. Government purchases were $10,758 per person. Net exports were −$1,911 per person. This number is negative because Americans spent more on foreign goods than foreigners spent on American goods. These data come from the Bureau of Economic Analysis, the part of the U.S. Department of Commerce that produces the national income accounts. You can find more recent data on GDP on its website, http://www.bea.gov. Total Per Person Percent Table 1 (in billions of dollars) (in dollars) of Total GDP and Its Components Gross domestic product, Y $20,501 $62,609 100% This table shows total GDP for the U.S. economy in 2018 and the Consumption, C 13,952 42,609 68 breakdown of GDP among its Investment, I 3,652 11,154 18 four components. When reading Government purchases, G 3,523 10,758 17 this table, recall the identity Y 5 C 1 I 1 G 1 NX. Net exports, NX −626 −1,911 −3 Source: U.S. Department of Commerce. Parts may not sum to totals due to rounding. QuickQuiz 6. Which of the following does NOT add to U.S. GDP? c. Net exports fall, while GDP does not a. Boeing manufactures and sells a plane to Air change. France. d. Net exports do not change, while GDP b. General Motors builds a new auto factory in North rises. Carolina. 8. Which is the largest component of GDP? c. The city of New York pays a salary to a policeman. a. consumption d. The federal government sends a Social Security b. investment check to your grandmother. c. government purchases 7. An American buys a pair of shoes made in Italy. d. net exports How do the U.S. national income accounts treat the transaction? a. Net exports and GDP both rise. b. Net exports and GDP both fall. Answers at end of chapter. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). 38314_ch23_hr_467-486.indd 475has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Editorial review 23/09/19 11:02 am  476 part VIII The Data of Macroeconomics 23-4 Real versus Nominal GDP As we have seen, GDP measures the total spending on goods and services in all mar- kets in the economy. If total spending rises from one year to the next, at least one of two things must be true: (1) the economy is producing a larger output of goods 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 econ- omy is producing independent of changes in the prices of those goods and services. To do this, economists use a measure called real GDP. Real GDP answers a hypo- thetical question: What would be the value of the goods and services produced this year if valued using the prices that prevailed in some specific year in the past? By eval- uating current production using prices that are fixed at past levels, real GDP shows how the economy’s overall production of goods and services changes over time. To see more precisely how real GDP is constructed, let’s consider an example. 23-4a A Numerical Example Table 2 shows some data for an economy that produces only two goods: hot dogs and hamburgers. The table shows the prices and quantities produced of the two goods in the years 2019, 2020, and 2021. To compute total spending in this economy, we multiply the quantities of hot dogs and hamburgers by their prices. In the year 2019, 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 Table 2 Prices and Quantities Real and Nominal Price of Quantity of Price of Quantity of GDP Year Hot Dogs Hot Dogs Hamburgers Hamburgers This table shows how to calculate real GDP, 2019 $1 100 $2 50 nominal GDP, and the 2020 2 150 3 100 GDP deflator for a 2021 3 200 4 150 hypothetical economy that produces Calculating Nominal GDP only hot dogs and 2019 ($1 per hot dog 3 100 hot dogs) 1 ($2 per hamburger 3 50 hamburgers) 5 $200 hamburgers. 2020 ($2 per hot dog 3 150 hot dogs) 1 ($3 per hamburger 3 100 hamburgers) 5 $600 2021 ($3 per hot dog 3 200 hot dogs) 1 ($4 per hamburger 3 150 hamburgers) 5 $1,200 Calculating Real GDP (base year 2019) 2019 ($1 per hot dog 3 100 hot dogs) 1 ($2 per hamburger 3 50 hamburgers) 5 $200 2020 ($1 per hot dog 3 150 hot dogs) 1 ($2 per hamburger 3 100 hamburgers) 5 $350 2021 ($1 per hot dog 3 200 hot dogs) 1 ($2 per hamburger 3 150 hamburgers) 5 $500 Calculating the GDP Deflator 2019 ($200/$200) 3 100 5 100 2020 ($600/$350) 3 100 5 171 2021 ($1,200/$500) 3 100 5 240 Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). 38314_ch23_hr_467-486.indd 476has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Editorial review 23/09/19 11:02 am  CHAPTER 23 Measuring a Nation’s Income 477 equals $100. Total expenditure in the economy—the sum of expenditure on hot dogs and expenditure on hamburgers—is $200. This amount, the production of goods and services valued at current prices, is called nominal GDP. nominal GDP The table shows the calculation of nominal GDP for these three years. Total the production of goods spending rises from $200 in 2019 to $600 in 2020 and then to $1,200 in 2021. Part of and services valued at this rise is attributable to the increase in the quantities of hot dogs and hamburgers, current prices and part is attributable to the increase in the prices of hot dogs and hamburgers. To remove the effect of price changes and obtain a measure of the amount pro- duced, we use real GDP, which is the production of goods and services valued at real GDP constant prices. We calculate real GDP by first designating one year as a base year. the production of goods We then use the prices of hot dogs and hamburgers in the base year to compute the and services valued at value of goods and services in all the years. In other words, the prices in the base constant prices year provide the basis for comparing quantities in different years. Suppose that we choose 2019 to be the base year in our example. We can then use the prices of hot dogs and hamburgers in 2019 to compute the value of goods and services produced in 2019, 2020, and 2021. Table 2 shows these calculations. To com- pute real GDP for 2019, we multiply the prices of hot dogs and hamburgers in 2019 (the base year) by the quantities of hot dogs and hamburgers produced in 2019. (Thus, for the base year, real GDP always equals nominal GDP.) To compute real GDP for 2020, we multiply the prices of hot dogs and hamburgers in 2019 (the base year) by the quantities of hot dogs and hamburgers produced in 2020. Similarly, to compute real GDP for 2021, we multiply the prices in 2019 by the quantities in 2021. When we find that real GDP has risen from $200 in 2019 to $350 in 2020 and then to $500 in 2021, we know that the increase is attributable to an increase in the quantities produced because the prices are being held fixed at base-year levels. To sum up: Nominal GDP uses current prices to value the economy’s production of goods and services. Real GDP uses constant base-year prices to value the economy’s produc- tion of goods and services. Because price changes do not affect real GDP, changes in real GDP reflect only changes in the quantities produced. Thus, real GDP measures the economy’s production of goods and services. Our goal in computing GDP is to gauge how well the overall economy is ­performing. Because real GDP measures the economy’s production of goods and services, 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. 23-4b The GDP Deflator As we have just seen, nominal GDP reflects both the quantities of goods and ­services the economy is producing and the prices of those goods and services. 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 deflator, which reflects only the prices of goods and services. The GDP deflator is calculated as follows: GDP deflator a measure of the price Nominal GDP level calculated as the GDP deflator 5 3 100. Real GDP ratio of nominal 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 change in nominal GDP from the base year that cannot be attributable to a change in real GDP. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). 38314_ch23_hr_467-486.indd 477has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Editorial review 23/09/19 11:02 am  478 part VIII The Data of Macroeconomics 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 examples. 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 at the same rate, 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. Notice that, in both cases, the GDP deflator reflects what’s happening to prices but not to quantities. Let’s now return to our numerical example in Table 2. The GDP deflator is com- puted at the bottom of the table. For the year 2019, nominal GDP is $200 and real GDP is $200, so the GDP deflator is 100. (The deflator is always 100 in the base year.) For the year 2020, nominal GDP is $600 and real GDP is $350, so the GDP deflator is 171. Economists use the term inflation to describe a situation in which the economy’s overall price level is rising. The inflation rate is the percentage change in some measure of the price level from one period to the next. Using the GDP deflator, the inflation rate between two consecutive years is computed as follows: GDP deflator in year 2 2 GDP deflator in year 1 Inflation rate in year 2 5 3 100. GDP deflator in year 1 Because the GDP deflator rose in year 2020 from 100 to 171, the inflation rate is 100 3 (171 2 100)/100, or 71 percent. In 2021, the GDP deflator rose to 240 from 171 the previous year, so the inflation rate is 100 3 (240 2 171)/171, or 40 percent. The GDP deflator is one measure that economists use to monitor the aver- age level of prices in the economy and thus the rate of inflation. The GDP deflator gets its name because it can be used to take inflation out of nominal GDP—that is, to “deflate” nominal GDP for the rise that is due to increases in prices. In the next chapter, we examine another measure of the economy’s price level, called the consumer price index, and discuss the differences between the two measures. A Half Century of Real GDP Case Now that we know how real GDP is defined and measured, let’s look Study at what this macroeconomic variable tells us about the recent history of the United States. Figure 2 shows quarterly data on real GDP for the U.S. economy since 1965. The most obvious feature of these data is that real GDP grows over time. The real GDP of the U.S. economy in 2018 was more than four times its 1965 level. Put dif- ferently, the output of goods and services produced in the United States has grown on average about 3 percent per year. Because this continued growth in real GDP exceeds the rate of population growth, it enables most Americans to enjoy greater economic prosperity than their 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 2 marks recessions with shaded vertical bars. (There is no ironclad rule for when the official business cycle dating committee will declare that a recession has occurred, but an old 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. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). 38314_ch23_hr_467-486.indd 478has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Editorial review 23/09/19 11:02 am  CHAPTER 23 Measuring a Nation’s