• Identify the major economic indicators used to assess the state of the macroeconomy.

LEARNING ACTIVITIES

• Reading: The Macroeconomic Perspective
• Self Check: Economic Indicators

Macroeconomics

• measures of aggregate production, like GDP
• measures of employment and unemployment, and measures of inflation, like the percent change in the Consumer Price Index
• the “Misery Index”—the sum of the inflation and unemployment rates as a measure of how bad (i.e., miserable) the economy is

Self Check: Economic Indicators

You’ll have more success on the Self Check if you’ve completed the Reading in this section.

• Explain the expenditure approach to calculating GDP
• Explain the national income approach to calculating GDP

LEARNING ACTIVITIES

• Reading: Calculating GDP
• Reading: Measuring Total Output
• Self Check: Calculating GDP

Each of the market transactions that enter into GDP must involve both a buyer and a seller. The GDP of an economy can be measured either by the total dollar value of what is purchased in the economy, or by the total dollar value of what is produced. There is even a third way, as we will explain later.

GDP Measured by Components of Demand

• consumer spending (consumption)
• business spending (investment)
• government spending on goods and services
• spending on net exports

LINK IT UP

What is meant by the word "investment"?

What do economists mean by investment, or business spending? In calculating GDP, investment does not refer to the purchase of stocks and bonds or the trading of financial assets. It refers to the purchase of new capital goods, that is, new commercial real estate (such as buildings, factories, and stores) and equipment, residential housing construction, and inventories. Inventories that are produced this year are included in this year’s GDP—even if they have not yet sold. From the accountant’s perspective, it is as if the firm invested in its own inventories. Business investment in 2012 was over $2 trillion, according to the Bureau of Economic Analysis. Table 5.1 shows how these four components added up to the GDP in 2012. Figure 5.4 (a) shows the levels of consumption, investment, and government purchases over time, expressed as a percentage of GDP, while Figure 5.4 (b) shows the levels of exports and imports as a percentage of GDP over time. A few patterns about each of these components are worth noticing. Table 5.1 shows the components of GDP from the demand side. Figure 5.3 provides a visual of the percentages.

Table 5.1. Components of U.S. GDP in 2012: From the Demand Side
	Components of GDP on the Demand Side (in trillions of dollars)	Percentage of Total
Consumption	$11.1	68.6%
Investment	$2.5	15.2%
Government	$3.2	19.5%
Exports	$2.2	13.5%
Imports	–$2.7	–16.9%
Total GDP	$16.2	100%
Source: http://bea.gov/iTable/iTable.cfm?ReqID=9&step=1

Percentage of Components of U.S. GDP on the Demand Side

[caption id="attachment_4459" align="aligncenter" width="390"] Figure 5.3. Percentage of Components of U.S. GDP on the Demand Side. Consumption makes up over half of the demand side components of the GDP. (Source: http://bea.gov/iTable/iTable.cfm?ReqID=9&step=1).[/caption]  

Components of GDP on the Demand Side

[caption id="attachment_4461" align="aligncenter" width="780"] Figure 5.4. Components of GDP on the Demand Side (a) Consumption is about two-thirds of GDP, but it moves relatively little over time. Business investment hovers around 15% of GDP, but it increases and declines more than consumption. Government spending on goods and services is around 20% of GDP. (b) Exports are added to total demand for goods and services, while imports are subtracted from total demand. If exports exceed imports, as in most of the 1960s and 1970s in the U.S. economy, a trade surplus exists. If imports exceed exports, as in recent years, then a trade deficit exists. (Source: http://bea.gov/iTable/iTable.cfm?ReqID=9&step=1).[/caption]

HOW DO STATISTICIANS MEASURE GDP?

Trade Balance

GDP Measured by What is Produced

Percentage of Components of GDP on the Production Side

Types of Production

In thinking about what is produced in the economy, many non-economists immediately focus on solid, long-lasting goods, like cars and computers. By far the largest part of GDP, however, is services. Moreover, services have been a growing share of GDP over time. A detailed breakdown of the leading service industries would include healthcare, education, and legal and financial services. It has been decades since most of the U.S. economy involved making solid objects. Instead, the most common jobs in a modern economy involve a worker looking at pieces of paper or a computer screen; meeting with co-workers, customers, or suppliers; or making phone calls.

Even within the overall category of goods, long-lasting durable goods like cars and refrigerators are about the same share of the economy as short-lived nondurable goods like food and clothing. The category of structures includes everything from homes, to office buildings, shopping malls, and factories. Inventories is a small category that refers to the goods that have been produced by one business but have not yet been sold to consumers, and are still sitting in warehouses and on shelves. The amount of inventories sitting on shelves tends to decline if business is better than expected, or to rise if business is worse than expected.

The Problem of Double Counting

GDP is defined as the current value of all final goods and services produced in a nation in a year. What are final goods? They are goods at the furthest stage of production at the end of a year. Statisticians who calculate GDP must avoid the mistake of double counting, in which output is counted more than once as it travels through the stages of production. For example, imagine what would happen if government statisticians first counted the value of tires produced by a tire manufacturer, and then counted the value of a new truck sold by an automaker that contains those tires. In this example, the value of the tires would have been counted twice-because the price of the truck includes the value of the tires.

To avoid this problem, which would overstate the size of the economy considerably, government statisticians count just the value of final goods and services in the chain of production that are sold for consumption, investment, government, and trade purposes.Intermediate goods, which are goods that go into the production of other goods, are excluded from GDP calculations. From the example above, only the value of the Ford truck will be counted. The value of what businesses provide to other businesses is captured in the final products at the end of the production chain.

The concept of GDP is fairly straightforward: it is just the dollar value of all final goods and services produced in the economy in a year. In our decentralized, market-oriented economy, actually calculating the more than $16 trillion-dollar U.S. GDP—along with how it is changing every few months—is a full-time job for a brigade of government statisticians.

Counting GDP

• Consumption
• Business investment
• Government spending on goods and services
• Net exports

• Intermediate goods
• Transfer payment and non-market activities
• Used goods
• Illegal goods

An economy produces a mind-boggling array of goods and services. In 2007, for example, Domino’s Pizza produced 400 million pizzas. The United States Steel Corporation, the nation’s largest steel company, produced 23.6 million tons of steel. Strong Brothers Lumber Co., a Colorado firm, produced 2.1 million board feet of lumber. The Louisiana State University football team drew 722,166 fans to its home games—and won the national championship. Leonor Montenegro, a pediatric nurse in Los Angeles, delivered 387 babies and took care of 233 additional patients. A list of all the goods and services produced in any year would be virtually endless.

So—what kind of year was 2007? We would not get very far trying to wade through a list of all the goods and services produced that year. It is helpful to have instead a single number that measures total output in the economy; that number is GDP.

The Components of GDP

We can divide the goods and services produced during any period into four broad components, based on who buys them. These components of GDP are personal consumption (C), gross private domestic investment (I), government purchases (G), and net exports or exports minus imports (X-M). Thus

GPD = consumption (C) + private investment (I) + government purchases (G) + net exports (X-M)

OR

GPD = C + I + G + (X-M)

 We will examine each of these components, and we will see how each fits into the pattern of macroeconomic activity. Before we begin, it will be helpful to distinguish between two types of variables: stocks and flows. A flow variable is a variable that is measured over a specific period of time. A stock variable is a variable that is independent of time. Income is an example of a flow variable. To say one’s income is, for example, $1,000 is meaningless without a time dimension. Is it $1,000 per hour? Per day? Per week? Per month? Until we know the time period, we have no idea what the income figure means. The balance in a checking account is an example of a stock variable. When we learn that the balance in a checking account is $1,000, we know precisely what that means; we do not need a time dimension. We will see that stock and flow variables play very different roles in macroeconomic analysis.

Personal Consumption

Personal consumption is a flow variable that measures the value of goods and services purchased by households during a time period. Purchases by households of groceries, health-care services, clothing, and automobiles—all are counted as consumption.

The production of consumer goods and services accounts for about 70% of total output. Because consumption is such a large part of GDP, economists seeking to understand the determinants of GDP must pay special attention to the determinants of consumption. In a later chapter we will explore these determinants and the impact of consumption on economic activity.

Personal consumption represents a demand for goods and services placed on firms by households. In the chapter on demand and supply, we saw how this demand could be presented in a circular flow model of the economy. Figure 6.1 "Personal Consumption in the Circular Flow" presents a circular flow model for an economy that produces only personal consumption goods and services. (We will add the other components of GDP to the circular flow as we discuss them.) Spending for these goods flows from households to firms; it is the arrow labeled “Personal consumption.” Firms produce these goods and services using factors of production: labor, capital, and natural resources. These factors are ultimately owned by households. The production of goods and services thus generates income to households; we see this income as the flow from firms to households labeled “Factor incomes” in the exhibit.

[caption id="" align="aligncenter" width="529"] Figure 6.1 Personal Consumption in the Circular Flow. Personal consumption spending flows from households to firms. In return, consumer goods and services flow from firms to households. To produce the goods and services households demand, firms employ factors of production owned by households. There is thus a flow of factor services from households to firms, and a flow of payments of factor incomes from firms to households.[/caption]

In exchange for payments that flow from households to firms, there is a flow of consumer goods and services from firms to households. This flow is shown in Figure 6.1 "Personal Consumption in the Circular Flow" as an arrow going from firms to households. When you buy a soda, for example, your payment to the store is part of the flow of personal consumption; the soda is part of the flow of consumer goods and services that goes from the store to a household—yours.

Similarly, the lower arrow in Figure 6.1 "Personal Consumption in the Circular Flow" shows the flow of factors of production—labor, capital, and natural resources—from households to firms. If you work for a firm, your labor is part of this flow. The wages you receive are part of the factor incomes that flow from firms to households.

Because our focus is macroeconomics, the study of aggregates of economic activity, we will think in terms of the total of personal consumption and the total of payments to households in the circular flow.

Private Investment

Gross private domestic investment is the value of all goods produced during a period for use in the production of other goods and services. Like personal consumption, gross private domestic investment is a flow variable. It is often simply referred to as “private investment.” A hammer produced for a carpenter is private investment. A printing press produced for a magazine publisher is private investment, as is a conveyor-belt system produced for a manufacturing firm. Capital includes all the goods that have been produced for use in producing other goods; it is a stock variable. Private investment is a flow variable that adds to the stock of capital during a period.

Heads Up!

The term “investment” can generate confusion. In everyday conversation, we use the term “investment” to refer to uses of money to earn income. We say we have invested in a stock or invested in a bond. Economists, however, restrict “investment” to activities that increase the economy’s stock of capital. The purchase of a share of stock does not add to the capital stock; it is not investment in the economic meaning of the word. We refer to the exchange of financial assets, such as stocks or bonds, as financial investment to distinguish it from the creation of capital that occurs as the result of investment. Only when new capital is produced does investment occur. Confusing the economic concept of private investment with the concept of financial investment can cause misunderstanding of the way in which key components of the economy relate to one another.

Gross private domestic investment includes three flows that add to or maintain the nation’s capital stock: expenditures by business firms on new buildings, plants, tools, equipment, and software that will be used in the production of goods and services; expenditures on new residential housing; and changes in business inventories. Any addition to a firm’s inventories represents an addition to investment; a reduction subtracts from investment. For example, if a clothing store stocks 1,000 pairs of jeans, the jeans represent an addition to inventory and are part of gross private domestic investment. As the jeans are sold, they are subtracted from inventory and thus subtracted from investment.

By recording additions to inventories as investment and reductions from inventories as subtractions from investment, the accounting for GDP records production in the period in which it occurs. Suppose, for example, that Levi Strauss manufactures 1 million pairs of jeans late in 2007 and distributes them to stores at the end of December. The jeans will be added to inventory; they thus count as investment in 2007 and enter GDP for that year. Suppose they are sold in January 2008. They will be counted as consumption in GDP for 2008 but subtracted from inventory, and from investment. Thus, the production of the jeans will add to GDP in 2007, when they were produced. They will not count in 2008, save for any increase in the value of the jeans resulting from the services provided by the retail stores that sold them.

Private investment accounts for about 16% of GDP. Despite its relatively small share of total economic activity, private investment plays a crucial role in the macroeconomy for two reasons:

1. Private investment represents a choice to forgo current consumption in order to add to the capital stock of the economy. Private investment therefore adds to the economy’s capacity to produce and shifts its production possibilities curve outward. Investment is thus one determinant of economic growth, which is explored in another chapter.
2. Private investment is a relatively volatile component of GDP; it can change dramatically from one year to the next. Fluctuations in GDP are often driven by fluctuations in private investment. We will examine the determinants of private investment in a chapter devoted to the study of investment.

Private investment represents a demand placed on firms for the production of capital goods. While it is a demand placed on firms, it flows from firms. In the circular flow model in Figure 6.2 "Private Investment in the Circular Flow," we see a flow of investment going from firms to firms. The production of goods and services for consumption generates factor incomes to households; the production of capital goods for investment generates income to households as well.

[caption id="" align="alignnone" width="671"] Figure 6.2 Private Investment in the Circular Flow. Private investment constitutes a demand placed on firms by other firms. It also generates factor incomes for households. To simplify the diagram, only the spending flows are shown—the corresponding flows of goods and services have been omitted.[/caption]

Figure 6.2 "Private Investment in the Circular Flow" shows only spending flows and omits the physical flows represented by the arrows in Figure 6.1 "Personal Consumption in the Circular Flow." This simplification will make our analysis of the circular flow model easier. It will also focus our attention on spending flows, which are the flows we will be studying.

Government Purchases

Government agencies at all levels purchase goods and services from firms. They purchase office equipment, vehicles, buildings, janitorial services, and so on. Many government agencies also produce goods and services. Police departments produce police protection. Public schools produce education. The National Aeronautics and Space Administration (NASA) produces space exploration.

Government purchases are the sum of purchases of goods and services from firms by government agencies plus the total value of output produced by government agencies themselves during a time period. Government purchases make up about 20% of GDP.

Government purchases are not the same thing as government spending. Much government spending takes the form of transfer payments, which are payments that do not require the recipient to produce a good or service in order to receive them. Transfer payments include Social Security and other types of assistance to retired people, welfare payments to poor people, and unemployment compensation to people who have lost their jobs. Transfer payments are certainly significant—they account for roughly half of all federal government spending in the United States. They do not count in a nation’s GDP, because they do not reflect the production of a good or service.

Government purchases represent a demand placed on firms, represented by the flow shown in Figure 6.3 "Government Purchases in the Circular Flow." Like all the components of GDP, the production of goods and services for government agencies creates factor incomes for households.

[caption id="" align="alignnone" width="556"] Figure 6.3 Government Purchases in the Circular Flow. Purchases of goods and services by government agencies create demands on firms. As firms produce these goods and services, they create factor incomes for households.[/caption]

Net Exports

Sales of a country’s goods and services to buyers in the rest of the world during a particular time period represent its exports. A purchase by a Japanese buyer of a Ford Taurus produced in the United States is a U.S. export. Exports also include such transactions as the purchase of accounting services from a New York accounting firm by a shipping line based in Hong Kong or the purchase of a ticket to Disney World by a tourist from Argentina. Imports are purchases of foreign-produced goods and services by a country’s residents during a period. United States imports include such transactions as the purchase by Americans of cars produced in Japan or tomatoes grown in Mexico or a stay in a French hotel by a tourist from the United States. Subtracting imports from exports yields net exports.

Exports (X) – imports (M) = net exports (X-M)

In the third quarter of 2008, foreign buyers purchased $1,971.3 billion worth of goods and services from the United States. In the same year, U.S. residents, firms, and government agencies purchased $2,677.9 billion worth of goods and services from foreign countries. The difference between these two figures, −$706.6 billion, represented the net exports of the U.S. economy in the third quarter of 2008. Net exports were negative because imports exceeded exports. Negative net exports constitute a trade deficit. The amount of the deficit is the amount by which imports exceed exports. When exports exceed imports there is a trade surplus. The magnitude of the surplus is the amount by which exports exceed imports.

The United States has recorded more deficits than surpluses since World War II, but the amounts have typically been relatively small, only a few billion dollars. The trade deficit began to soar, however, in the 1980s and again in the 2000s. We will examine the reasons for persistent trade deficits in another chapter. The rest of the world plays a key role in the domestic economy and, as we will see later in the book, there is nothing particularly good or bad about trade surpluses or deficits. Goods and services produced for export represent roughly 14% of GDP, and the goods and services the United States imports add significantly to our standard of living.

In the circular flow diagram in Figure 6.4 "Net Exports in the Circular Flow," net exports are shown with an arrow connecting firms to the rest of the world. The balance between the flows of exports and imports is net exports. When there is a trade surplus, net exports are positive and add spending to the circular flow. A trade deficit implies negative net exports; spending flows from firms to the rest of the world.

[caption id="" align="alignnone" width="640"] Figure 6.4 Net Exports in the Circular Flow. Net exports represent the balance between exports and imports. Net exports can be positive or negative. If they are positive, net export spending flows from the rest of the world to firms. If they are negative, spending flows from firms to the rest of the world.[/caption]

The production of goods and services for personal consumption, private investment, government purchases, and net exports makes up a nation’s GDP. Firms produce these goods and services in response to demands from households (personal consumption), from other firms (private investment), from government agencies (government purchases), and from the rest of the world (net exports). All of this production creates factor income for households. Figure 6.5 "Spending in the Circular Flow Model" shows the circular flow model for all the spending flows we have discussed. Each flow is numbered for use in the exercise at the end of this section.

[caption id="" align="alignnone" width="668"] Figure 6.5 Spending in the Circular Flow Model. GDP equals the sum of production by firms of goods and services for personal consumption (1), private investment (2), government purchases (3), and net exports (4). The circular flow model shows these flows and shows that the production of goods and services generates factor incomes (5) to households.[/caption]

The circular flow model identifies some of the forces at work in the economy, forces that we will be studying in later chapters. For example, an increase in any of the flows that place demands on firms (personal consumption, private investment, government purchases, and exports) will induce firms to expand their production. This effect is characteristic of the expansion phase of the business cycle. An increase in production will require firms to employ more factors of production, which will create more income for households. Households are likely to respond with more consumption, which will induce still more production, more income, and still more consumption. Similarly, a reduction in any of the demands placed on firms will lead to a reduction in output, a reduction in firms’ use of factors of production, a reduction in household incomes, a reduction in income, and so on. This sequence of events is characteristic of the contraction phase of the business cycle. Much of our work in macroeconomics will involve an analysis of the forces that prompt such changes in demand and an examination of the economy’s response to them.

Figure 6.6 "Components of GDP, 2008 (Q3) in Billions of Dollars" shows the size of the components of GDP in 2008. We see that the production of goods and services for personal consumption accounted for about 70% of GDP. Imports exceeded exports, so net exports were negative.

[caption id="" align="aligncenter" width="554"] Figure 6.6 Components of GDP, 2008 (Q3) in Billions of Dollars. Consumption makes up the largest share of GDP. Net exports were negative in 2008. Total GDP—the sum of personal consumption, private investment, government purchases, and net exports—equaled $14,420.5 billion in 2008.[/caption]

LEARNING ACTIVITIES

• Reading: Alternative Ways to Measure the Economy
• Reading: Gross National Product: An Alternative Measure of Output
• Self Check: GDP and Income

The difference between GDP and GNP is a subtle one. The GDP of a country equals the value of final output produced within the borders of that country; the GNP of a country equals the value of final output produced using factors owned by residents of the country. Most production in a country employs factors of production owned by residents of that country, so the two measures overlap. Differences between the two measures emerge when production in one country employs factors of production owned by residents of other countries.

Suppose, for example, that a resident of Bellingham, Washington, owns and operates a watch repair shop across the Canadian–U.S. border in Victoria, British Columbia. The value of watch repair services produced at the shop would be counted as part of Canada’s GDP because they are produced in Canada. That value would not, however, be part of U.S. GDP. But, because the watch repair services were produced using capital and labor provided by a resident of the United States, they would be counted as part of GNP in the United States and not as part of GNP in Canada.

Because most production fits in both a country’s GDP as well as its GNP, there is seldom much difference between the two measures. The relationship between GDP and GNP is given by

• Critique the unemployment rate as a measure of the unemployment problem

LEARNING ACTIVITIES

• Reading: Unemployment
• Reading: Calculating Unemployment
• Self Check: The Unemployment Rate
• Reading: Criticisms of Measuring Unemployment
• Reading: Difficulties Measuring Unemployment
• Self Check: Critiquing the Unemployment Rate

Introduction to Unemployment

Self Check: The Unemployment Rate

You’ll have more success on the Self Check if you’ve completed the two Readings in this section.

Calculating the Unemployment Rate

Figure 7.2 shows the three-way division of the over-16 adult population. In 2012, 63.7% of the adult population was “in the labor force;” that is, either employed or without a job but looking for work. Those in the labor force can be divided into the employed and the unemployed. These values are also shown in Table 7.1. The unemployment rate is not the percentage of the total adult population without jobs, but rather the percentage of adults who are in the labor force but who do not have jobs:

[latex]\text{Unemployment rate}=\frac{\text{Unemployed people}}{\text{Total labor force}}\times{100}[/latex]

[caption id="attachment_4465" align="aligncenter" width="390"] Figure 7.2. Employed, Unemployed, and Out of the Labor Force Distribution of Adult Population (age 16 and older), 2012 The total adult, working-age population in 2012 was 243.2 million. Out of this total population, 142.4 million were classified as employed and 12.5 million were classified as unemployed. The remaining 88.3 million were classified as out of the labor force. As you will learn, however, this seemingly simple chart does not tell the whole story.[/caption]

Table 7.1. U.S. Employment and Unemployment, 2012
Total adult population over the age of 16	243.2 million
In the labor force	154.9 million (63.7%)
Employed	142.4 million
Unemployed	12.5 million
Out of the labor force	88.3 million (36.3%)
Source: www.bls.gov

Calculating Labor Force Percentages

[latex]\begin{array}{l}\text{Percentage in the labor force}=\frac{154.9}{243.2}\\\text{Percentage in the labor force}=0.6369\\\text{Percentage in the labor force}=63.7\text{ percent}\end{array}[/latex]

[latex]\begin{array}{l}\text{Percentage in the labor force}=\frac{88.3}{243.2}\\\text{Percentage in the labor force}=0.3631\\\text{Percentage in the labor force}=36.3\text{ percent}\end{array}[/latex]

[latex]\begin{array}{l}\text{Unemployment rate}=\frac{12.5}{154.9}\\\text{Unemployment rate}=0.0807\\\text{Unemployment rate}=8.1\text{ percent}\end{array}[/latex]

LEARNING ACTIVITIES

• Reading: Types of Employment
• Reading: Patterns of Unemployment
• Reading: Changes in Unemployment over the Short Run
• Reading: Changes in Unemployment over the Long Run
• Self Check: Types of Unemployment

References

Attributions

• the assumptions of the model
• what the difference is between savings and investing
• explaining an expansionary and recessionary gap
• how Classical economists state economic problems will be resolved

Assumptions of the Model

• Prices and the price of wages must be fully flexible
• A competitive marketplace
• Savings must equal investment

The Bureau of Labor Statistics defines a person as unemployed if he or she is not working but is looking for and available for work. The labor force is the total number of people working or unemployed. The unemployment rate is the percentage of the labor force that is unemployed.

To estimate the unemployment rate, government surveyors fan out across the country each month to visit roughly 60,000 households. At each of these randomly selected households, the surveyor asks about the employment status of each adult (everyone age 16 or over) who lives there. Many households include more than one adult; the survey gathers information on about roughly 100,000 adults. The surveyor asks if each adult is working. If the answer is yes, the person is counted as employed. If the answer is no, the surveyor asks if that person has looked for work at some time during the previous four weeks and is available for work at the time of the survey. If the answer to that question is yes, the person is counted as unemployed. If the answer is no, that person is not counted as a member of the labor force. Figure 5.8 "Computing the Unemployment Rate" shows the survey’s results for the civilian (nonmilitary) population for October 2008. The unemployment rate is then computed as the number of people unemployed divided by the labor force—the sum of the number of people not working but available and looking for work plus the number of people working. In October 2008, the unemployment rate was 6.5%.

[caption id="" align="alignnone" width="774"] Figure 5.8 Computing the Unemployment Rate. A monthly survey of households divides the civilian adult population into three groups. Those who have jobs are counted as employed; those who do not have jobs but are looking for them and are available for work are counted as unemployed; and those who are not working and are not looking for work are not counted as members of the labor force. The unemployment rate equals the number of people looking for work divided by the sum of the number of people looking for work and the number of people employed. Values are for October 2008. All numbers are in thousands.[/caption]

There are several difficulties with the survey. The old survey, designed during the 1930s, put the “Are you working?” question differently depending on whether the respondent was a man or woman. A man was asked, “Last week, did you do any work for pay or profit?” A woman was asked, “What were you doing for work last week, keeping house or something else?” Consequently, many women who were looking for paid work stated that they were “keeping house”; those women were not counted as unemployed. The BLS did not get around to fixing the survey—asking women the same question it asked men—until 1994. The first time the new survey question was used, the unemployment rate among women rose by 0.5 percentage point. More than 50 million women are in the labor force; the change added more than a quarter of a million workers to the official count of the unemployed.For a description of the new survey and other changes introduced in the method of counting unemployment, see Janet L. Norwood and Judith M. Tanur, “Unemployment Measures for the Nineties,” Public Opinion Quarterly 58, no. 2 (Summer 1994): 277–94.

The problem of understating unemployment among women has been fixed, but others remain. A worker who has been cut back to part-time work still counts as employed, even if that worker would prefer to work full time. A person who is out of work, would like to work, has looked for work in the past year, and is available for work, but who has given up looking, is considered a discouraged worker. Discouraged workers are not counted as unemployed, but a tally is kept each month of the number of discouraged workers.

The official measures of employment and unemployment can yield unexpected results. For example, when firms expand output, they may be reluctant to hire additional workers until they can be sure the demand for increased output will be sustained. They may respond first by extending the hours of employees previously reduced to part-time work or by asking full-time personnel to work overtime. None of that will increase employment, because people are simply counted as “employed” if they are working, regardless of how much or how little they are working. In addition, an economic expansion may make discouraged workers more optimistic about job prospects, and they may resume their job searches. Engaging in a search makes them unemployed again—and increases unemployment. Thus, an economic expansion may have little effect initially on employment and may even increase unemployment.

Self Check: Critiquing the Unemployment Rate

You’ll have more success on the Self Check if you’ve completed the two Readings in this section.

Workers may find themselves unemployed for different reasons. Each source of unemployment has quite different implications, not only for the workers it affects but also for public policy.

Figure 5.9 "The Natural Level of Employment" applies the demand and supply model to the labor market. The price of labor is taken as the real wage, which is the nominal wage divided by the price level; the symbol used to represent the real wage is the Greek letter omega, ω. The supply curve is drawn as upward sloping, though steep, to reflect studies showing that the quantity of labor supplied at any one time is nearly fixed. Thus, an increase in the real wage induces a relatively small increase in the quantity of labor supplied. The demand curve shows the quantity of labor demanded at each real wage. The lower the real wage, the greater the quantity of labor firms will demand. In the case shown here, the real wage, ω_e, equals the equilibrium solution defined by the intersection of the demand curve D₁ and the supply curve S₁. The quantity of labor demanded, L_e, equals the quantity supplied. The employment level at which the quantity of labor demanded equals the quantity supplied is called the natural level of employment. It is sometimes referred to as full employment.

[caption id="" align="alignnone" width="472"] Figure 5.9 The Natural Level of Employment. The employment level at which the quantity of labor demanded equals the quantity supplied is called the natural level of employment. Here, the natural level of employment is Le, which is achieved at a real wage ωe.[/caption]  

Even if the economy is operating at its natural level of employment, there will still be some unemployment. The rate of unemployment consistent with the natural level of employment is called the natural rate of unemployment. Business cycles may generate additional unemployment. We discuss these various sources of unemployment below.

Cyclical Unemployment

Of course, the economy may not be operating at its natural level of employment, so unemployment may be above or below its natural level. In a later chapter we will explore what happens when the economy generates employment greater or less than the natural level. Cyclical unemployment is unemployment in excess of the unemployment that exists at the natural level of employment.

Figure 5.10 "Unemployment Rate, 1960–2008" shows the unemployment rate in the United States for the period from 1960 through October 2008. We see that it has fluctuated considerably. How much of it corresponds to the natural rate of unemployment varies over time with changing circumstances. For example, in a country with a demographic “bulge” of new entrants into the labor force, frictional unemployment is likely to be high, because it takes the new entrants some time to find their first jobs. This factor alone would raise the natural rate of unemployment. A demographic shift toward more mature workers would lower the natural rate. During recessions, highlighted in Figure 5.10 "Unemployment Rate, 1960–2008," the part of unemployment that is cyclical unemployment grows. The analysis of fluctuations in the unemployment rate, and the government’s responses to them, are an important macroeconomic topic that will recur throughout this course.

[caption id="" align="alignnone" width="710"] Figure 5.10 Unemployment Rate, 1960–2008. The chart shows the unemployment rate for each year from 1960 to 2008. Recessions are shown as shaded areas. Source: Economic Report of the President, 2008, Table B-42. Date for 2008 is average of first ten months from the Bureau of Labor Statistics home page.[/caption]

KEY TAKEAWAYS

• People who are not working but are looking and available for work at any one time are considered unemployed. The unemployment rate is the percentage of the labor force that is unemployed.
• When the labor market is in equilibrium, employment is at the natural level and the unemployment rate equals the natural rate of unemployment.
• Even if employment is at the natural level, the economy will experience frictional and structural unemployment. Cyclical unemployment is unemployment in excess of that associated with the natural level of employment.

LEARNING ACTIVITIES

• Reading: Introduction to Inflation
• Reading: Computing the Rate of Inflation
• Self Check: Rate of Inflation

Concern about changes in the price level has always dominated economic discussion. With inflation in the United States generally averaging only between 2% and 3% each year since 1990, it may seem surprising how much attention the behavior of the price level still commands. Yet inflation was a concern in 2004 when there was fear that the rising price of oil could trigger higher prices in other areas. Just the year before, when inflation fell below 2%, there was talk about the risk of deflation. That did not happen; prices continued rising. Inflation rose substantially in the first half of 2008, renewing fears about subsequent further increases. Just what are inflation and deflation? How are they measured? And most important, why do we care? These are some of the questions we will explore in this section.

Inflation is an increase in the average level of prices, and deflation is a decrease in the average level of prices. In an economy experiencing inflation, most prices are likely to be rising, whereas in an economy experiencing deflation, most prices are likely to be falling.

There are two key points in these definitions:

1. Inflation and deflation refer to changes in the average level of prices, not to changes in particular prices. An increase in medical costs is not inflation. A decrease in gasoline prices is not deflation. Inflation means the average level of prices is rising, and deflation means the average level of prices is falling.
2. Inflation and deflation refer to rising prices and falling prices, respectively; therefore, they do not have anything to do with the level of prices at any one time. “High” prices do not imply the presence of inflation, nor do “low” prices imply deflation. Inflation means a positive rate of change in average prices, and deflation means a negative rate of change in average prices.

Reflection Questions

• What learning outcome relates to this content?
• What are the key topics covered in this content?
• How can the content in this section help you demonstrate mastery of the learning outcome?
• What questions do you have about this content?

HOW DO U.S. GOVERNMENT STATISTICIANS MEASURE THE CONSUMER PRICE INDEX?

[caption id="attachment_4478" align="alignright" width="585"] Figure 8.2. The Weighting of CPI Components Of the eight categories used to generate the Consumer Price Index, housing is the highest at 41%. The next highest category, transportation at 16.8%, is less than half the size of housing. Other goods and services, and apparel, are the lowest at 3.4% and 3.6%, respectively. (Source: www.bls.gov/cpi)[/caption]

The CPI and Core Inflation Index

Imagine if you were driving a company truck across the country- you probably would care about things like the prices of available roadside food and motel rooms as well as the truck’s operating condition. However, the manager of the firm might have different priorities. He would care mostly about the truck’s on-time performance and much less so about the food you were eating and the places you were staying. In other words, the company manager would be paying attention to the production of the firm, while ignoring transitory elements that impacted you, but did not affect the company’s bottom line.

In a sense, a similar situation occurs with regard to measures of inflation. As we’ve learned, CPI measures prices as they affect everyday household spending. Well, a core inflation index is typically calculated by taking the CPI and excluding volatile economic variables. In this way, economists have a better sense of the underlying trends in prices that affect the cost of living.

Examples of excluded variables include energy and food prices, which can jump around from month to month because of the weather. According to an article by Kent Bernhard, during Hurricane Katrina in 2005, a key supply point for the nation’s gasoline was nearly knocked out. Gas prices quickly shot up across the nation, in some places up to 40 cents a gallon in one day. This was not the cause of an economic policy but rather a short-lived event until the pumps were restored in the region. In this case, the CPI that month would register the change as a cost of living event to households, but the core inflation index would remain unchanged. As a result, the Federal Reserve’s decisions on interest rates would not be influenced. Similarly, droughts can cause world-wide spikes in food prices that, if temporary, do not affect the nation’s economic capability.

As former Chairman of the Federal Reserve Ben Bernanke noted in 1999 about the core inflation index, “It provide(s) a better guide to monetary policy than the other indices, since it measures the more persistent underlying inflation rather than transitory influences on the price level.” Bernanke also noted that it helps communicate that every inflationary shock need not be responded to by the Federal Reserve since some price changes are transitory and not part of a structural change in the economy.

In sum, both the CPI and the core inflation index are important, but serve different audiences. The CPI helps households understand their overall cost of living from month to month, while the core inflation index is a preferred gauge from which to make important government policy changes.

Practical Solutions for the Substitution and the Quality/New Goods Biases

By the early 2000s, the Bureau of Labor Statistics was using alternative mathematical methods for calculating the Consumer Price Index, more complicated than just adding up the cost of a fixed basket of goods, to allow for some substitution between goods. It was also updating the basket of goods behind the CPI more frequently, so that new and improved goods will be included more rapidly. For certain products, the BLS was carrying out studies to try to measure the quality improvement. For example, with computers, an economic study can try to adjust for changes in speed, memory, screen size, and other characteristics of the product, and then calculate the change in price after these product changes are taken into account. But these adjustments are inevitably imperfect, and exactly how to make these adjustments is often a source of controversy among professional economists. By the early 2000s, the substitution bias and quality/new goods bias had been somewhat reduced, so that since then the rise in the CPI probably overstates the true rise in inflation by only about 0.5% per year. Over one or a few years, this is not much; over a period of a decade or two, even half of a percent per year compounds to a more significant amount. In addition, the CPI tracks prices from physical locations, and not at online sites like Amazon, where prices can be lower. When measuring inflation (and other economic statistics, too), a tradeoff arises between simplicity and interpretation. If the inflation rate is calculated with a basket of goods that is fixed and unchanging, then the calculation of an inflation rate is straightforward, but the problems of substitution bias and quality/new goods bias will arise. However, when the basket of goods is allowed to shift and evolve to reflect substitution toward lower relative prices, quality improvements, and new goods, the technical details of calculating the inflation rate grow more complex.

Additional Price Indices: PPI, GDP Deflator, and More

The basket of goods behind the Consumer Price Index represents an average hypothetical U.S. household, which is to say that it does not exactly capture anyone’s personal experience. When the task is to calculate an average level of inflation, this approach works fine. What if, however, you are concerned about inflation experienced by a certain group, like the elderly, or the poor, or single-parent families with children, or Hispanic-Americans? In specific situations, a price index based on the buying power of the average consumer may not feel quite right. This problem has a straightforward solution. If the Consumer Price Index does not serve the desired purpose, then invent another index, based on a basket of goods appropriate for the group of interest. Indeed, the Bureau of Labor Statistics publishes a number of experimental price indices: some for particular groups like the elderly or the poor, some for different geographic areas, and some for certain broad categories of goods like food or housing. The BLS also calculates several price indices that are not based on baskets of consumer goods. For example, the Producer Price Index (PPI) is based on prices paid for supplies and inputs by producers of goods and services. It can be broken down into price indices for different industries, commodities, and stages of processing (like finished goods, intermediate goods, crude materials for further processing, and so on). There is an International Price Index based on the prices of merchandise that is exported or imported. An Employment Cost Index measures wage inflation in the labor market. The GDP deflator, measured by the Bureau of Economic Analysis, is a price index that includes all the components of GDP (that is, consumption plus investment plus government plus exports minus imports). Unlike the CPI, its baskets are not fixed but re-calculate what that year’s GDP would have been worth using the base-year’s prices. What’s the best measure of inflation? If concerned with the most accurate measure of inflation, use the GDP deflator as it picks up the prices of goods and services produced. However, it is not a good measure of cost of living as it includes prices of many products not purchased by households (for example, aircraft, fire engines, factory buildings, office complexes, and bulldozers). If one wants the most accurate measure of inflation as it impacts households, use the CPI, as it only picks up prices of products purchased by households. That is why the CPI is sometimes referred to as the cost-of-living index. As the Bureau of Labor Statistics states on its website: “The ‘best’ measure of inflation for a given application depends on the intended use of the data.”

Self Check: Consumer Price Index vs. Producer Price Index

Answer the question(s) below to see how well you understand the topics covered in the previous section. This short quiz does not count toward your grade in the class, and you can retake it an unlimited number of times.

You’ll have more success on the Self Check if you’ve completed the four Readings in this section.

Use this quiz to check your understanding and decide whether to (1) study the previous section further or (2) move on to the next section. https://assessments.lumenlearning.com/assessments/518

LEARNING ACTIVITIES

• Reading: The Confusion Over Inflation
• Reading: Why Care about Inflation?
• Self Check: Consequences of Price Instability

Why Do We Care?

What difference does it make if the average level of prices changes? First, consider the impact of inflation.

Inflation is measured as the annual rate of increase in the average level of prices. Figure 5.6 "Inflation, 1960–2008" shows how volatile inflation has been in the United States over the past four decades. In the 1960s the inflation rate rose, and it became dramatically worse in the 1970s. The inflation rate plunged in the 1980s and continued to ease downward in the 1990s. It remained low in the early 2000s and began to accelerate in 2007 and during most of 2008.

[caption id="" align="alignnone" width="767"] Figure 5.6. Inflation, 1960–2008. The U.S. inflation rate, measured as the annual rate of change in the average level of prices paid by consumers, varied considerably over the 1960–2008 period. Source: Bureau of Labor Statistics, All Urban Consumers CPI-U, 1982–84 = 100, Dec.–Dec. inflation rate. Data for 2008 is through October.[/caption]

Whether one regards inflation as a “good” thing or a “bad” thing depends very much on one’s economic situation. If you are a borrower, unexpected inflation is a good thing—it reduces the value of money that you must repay. If you are a lender, it is a bad thing because it reduces the value of future payments you will receive. Whatever any particular person’s situation may be, inflation always produces the following effects on the economy: it reduces the value of money and it reduces the value of future monetary obligations. It can also create uncertainty about the future.

Suppose that you have just found a $10 bill you stashed away in 1990. Prices have increased by about 50% since then; your money will buy less than what it would have purchased when you put it away. Your money has thus lost value.

Money loses value when its purchasing power falls. Since inflation is a rise in the level of prices, the amount of goods and services a given amount of money can buy falls with inflation.

Just as inflation reduces the value of money, it reduces the value of future claims on money. Suppose you have borrowed $100 from a friend and have agreed to pay it back in one year. During the year, however, prices double. That means that when you pay the money back, it will buy only half as much as it could have bought when you borrowed it. That is good for you but tough on the person who lent you the money. Of course, if you and your friend had anticipated such rapid inflation, you might have agreed to pay back a larger sum to adjust for it. When people anticipate inflation, they can adjust for its consequences in determining future obligations. But unanticipated inflation helps borrowers and hurts lenders.

Inflation’s impact on future claims can be particularly hard on people who must live on a fixed income, that is, on an income that is predetermined through some contractual arrangement and does not change with economic conditions. An annuity, for example, typically provides a fixed stream of money payments. Retirement pensions sometimes generate fixed income. Inflation erodes the value of such payments.

Given the danger posed by inflation for people on fixed incomes, many retirement plans provide for indexed payments. An indexed payment is one whose dollar amount changes with the rate of change in the price level. If a payment changes at the same rate as the rate of change in the price level, the purchasing power of the payment remains constant. Social Security payments, for example, are indexed to maintain their purchasing power.

Because inflation reduces the purchasing power of money, the threat of future inflation can make people reluctant to lend for long periods. From a lender’s point of view, the danger of a long-term commitment of funds is that future inflation will wipe out the value of the amount that will eventually be paid back. Lenders are reluctant to make such commitments.

Uncertainty can be particularly pronounced in countries where extremely high inflation is a threat. Hyperinflation is generally defined as an inflation rate in excess of 200% per year. Inflation of that magnitude erodes the value of money very quickly. Hyperinflations occurred in Germany in the 1920s and in Yugoslavia in the early 1990s. There are stories about how people in Germany during the hyperinflation brought wheelbarrows full of money to stores to pay for ordinary items. In Yugoslavia in 1993 there was a report of a shop owner barring the entrance to his store with a mop while he changed his prices.

The inflation rate rose to an astronomical rate in 2008 in Zimbabwe. As the government printed more money and put it in circulation, prices rose. When inflation began to accelerate, the government found it “necessary” to print more and more money, causing prices to rise very fast. The inflation rate in Zimbabwe reached an astonishing 11.2 million percent in July of 2008, according to Zimbabwe’s Central Statistics Office. A loaf of bread cost 200,000 Zimbabwe dollars in February 2008. That same loaf cost 1.6 trillion Zimbabwe dollars by August.“Zimbabwe Inflation Hits 11,200,000%,” CNN.com, August 19, 2008.

Do the problems associated with inflation imply that deflation would be a good thing? The answer is simple: no. Like inflation, deflation changes the value of money and the value of future obligations. It also creates uncertainty about the future.

If there is deflation, the real value of a given amount of money rises. In other words, if there had been deflation since 2000, a $10 bill you had stashed away in 2000 would buy more goods and services today. That sounds good, but should you buy $10 worth of goods and services now when you would be able to buy even more for your $10 in the future if the deflation continues? When Japan experienced deflation in the late 1990s and early 2000s, Japanese consumers seemed to be doing just that—waiting to see if prices would fall further. They were spending less per person and, as we will see throughout our study of macroeconomics, less consumption often meant less output, fewer jobs, and the prospect of a recurring recessions.

And, if you had to use the $10 to pay back a debt you owed, the purchasing power of your money would be higher than when you borrowed the money. The lender would feel good about being able to buy more with the $10 than you were able to, but you would feel like you had gotten a raw deal.

Unanticipated deflation hurts borrowers and helps lenders. If the parties anticipate the deflation, a loan agreement can be written to reflect expected changes in the price level.

The threat of deflation can make people reluctant to borrow for long periods. Borrowers become reluctant to enter into long-term contracts because they fear that deflation will raise the value of the money they must pay back in the future. In such an environment, firms may be reluctant to borrow to build new factories, for example. This is because they fear that the prices at which they can sell their output will drop, making it difficult for them to repay their loans.

Deflation was common in the United States in the latter third of the 19th century. In the 20th century, there was a period of deflation after World War I and again during the Great Depression in the 1930s.

Self Check: Consequences of Price Instability

You’ll have more success on the Self Check if you’ve completed the two Readings in this section.

• Define the consumer price index and the producer price index
• Calculate a price index number given a basket of goods & services and the nominal price of each in a base year and at some later time

LEARNING ACTIVITIES

• Reading: Price Indexes
• Self Check: Price Indexes
• Reading: The CPI and PCE
• Reading: How Changes in the Cost of Living are Measured
• Self Check: Consumer Price Index vs. Producer Price Index
• Reading: Tracking Inflation
• Self Check: Calculating Price Indexes

How do we actually measure inflation and deflation (that is, changes in the price level)? Price-level change is measured as the percentage rate of change in the level of prices. But how do we find a price level?

Economists measure the price level with a price index. A price index is a number whose movement reflects movement in the average level of prices. If a price index rises 10%, it means the average level of prices has risen 10%.

There are four steps one must take in computing a price index:

1. Select the kinds and quantities of goods and services to be included in the index. A list of these goods and services, and the quantities of each, is the “market basket” for the index.
2. Determine what it would cost to buy the goods and services in the market basket in some period that is the base period for the index. A base period is a time period against which costs of the market basket in other periods will be compared in computing a price index. Most often, the base period for an index is a single year. If, for example, a price index had a base period of 1990, costs of the basket in other periods would be compared to the cost of the basket in 1990. We will encounter one index, however, whose base period stretches over three years.
3. Compute the cost of the market basket in the current period.
4. Compute the price index. It equals the current cost divided by the base-period cost of the market basket.

Price index = Current cost of basket / Base-period cost of basket

(While published price indexes are typically reported with this number multiplied by 100, our work with indexes will be simplified by omitting this step.)

Suppose that we want to compute a price index for movie fans, and a survey of movie watchers tells us that a typical fan rents 4 movies on DVD and sees 3 movies in theaters each month. At the theater, this viewer consumes a medium-sized soft drink and a medium-sized box of popcorn. Our market basket thus might include 4 DVD rentals, 3 movie admissions, 3 medium soft drinks, and 3 medium servings of popcorn.

Our next step in computing the movie price index is to determine the cost of the market basket. Suppose we surveyed movie theaters and DVD-rental stores in 2007 to determine the average prices of these items, finding the values given in Table 5.1 "Pricing a Market Basket." At those prices, the total monthly cost of our movie market basket in 2007 was $48. Now suppose that in 2008 the prices of movie admissions and DVD rentals rise, soft-drink prices at movies fall, and popcorn prices remain unchanged. The combined effect of these changes pushes the 2008 cost of the basket to $50.88.

Table 5.1 Pricing a Market Basket

Using the data in Table 5.1 "Pricing a Market Basket", we could compute price indexes for each year. Recall that a price index is the ratio of the current cost of the basket to the base-period cost. We can select any year we wish as the base year; take 2007. The 2008 movie price index (MPI) is thus

The value of any price index in the base period is always 1. In the case of our movie price index, the 2007 index would be the current (2007) cost of the basket, $48, divided by the base-period cost, which is the same thing: $48/$48 = 1.

LEARNING ACTIVITIES

• Reading: Nominal and Real Values
• Reading: Computing Real Values Using Price Indexes
• Self Check: Price Indexes and Real Data

Suppose your uncle started college in 1998 and had a job busing dishes that paid $5 per hour. In 2008 you had the same job; it paid $6 per hour. Which job paid more?

At first glance, the answer is straightforward: $6 is a higher wage than $5. But $1 had greater purchasing power in 1998 than in 2008 because prices were lower in 1998 than in 2008. To obtain a valid comparison of the two wages, we must use dollars of equivalent purchasing power. A value expressed in units of constant purchasing power is a real value. A value expressed in dollars of the current period is called a nominal value. The $5 wage in 1998 and the $6 wage in 2008 are nominal wages.

To convert nominal values to real values, we divide by a price index. The real value for a given period is the nominal value for that period divided by the price index for that period. This procedure gives us a value in dollars that have the purchasing power of the base period for the price index used. Using the CPI, for example, yields values expressed in dollars of 1982–1984 purchasing power, the base period for the CPI. The real value of a nominal amount X at time t, X_t, is found using the price index for time t:

Real value of X_t = X_t / Price index at time t

Let us compute the real value of the $6 wage for busing dishes in 2008 versus the $5 wage paid to your uncle in 1998. The CPI in 1998 was 163.0; in 2008 it was 216.5. Real wages for the two years were thus,

Real wage in 1998 = $5 / 1.630 = $3.07

Real wage in 2008 = $6 / 2.165 = $2.77

Given the nominal wages in our example, you earned about 10% less in real terms in 2008 than your uncle did in 1998.

Price indexes are useful. They allow us to see how the general level of prices has changed. They allow us to estimate the rate of change in prices, which we report as the rate of inflation or deflation. And they give us a tool for converting nominal values to real values so we can make better comparisons of economic performance across time.

Self Check: Price Indexes and Real Data

You’ll have more success on the Self Check if you’ve completed the two Readings in this section.

LEARNING ACTIVITIES

• Reading: The Implicit Price Deflator
• Self Check: Defining the GDP Price Index

• Use the GDP price index to compute real GDP from nominal GDP

LEARNING ACTIVITIES

• Reading: Real GDP
• Reading: Converting Nominal to Real GDP
• Self Check: Nominal and Real GDP

To determine whether the economy of a nation is growing or shrinking in size, economists use a measure of total output called real GDP. Real GDP, short for real gross domestic product, is the total value of all final goods and services produced during a particular year or period, adjusted to eliminate the effects of changes in prices. Let us break that definition up into parts.

Notice that only “final” goods and services are included in GDP. Many goods and services are purchased for use as inputs in producing something else. For example, a pizza parlor buys flour to make pizzas. If we counted the value of the flour and the value of the pizza, we would end up counting the flour twice and thus overstating the value of total production. Including only final goods avoids double-counting. If the flour is produced during a particular period but has not been sold, then it is a “final good” for that period and is counted.

We want to determine whether the economy’s output is growing or shrinking. If each final good or service produced, from hammers to haircuts, were valued at its current market price, and then we were to add the values of all such items produced, we would not know if the total had changed because output changed or because prices changed or both. The market value of all final goods and services produced can rise even if total output falls. To isolate the behavior of total output only, we must hold prices constant at some level. For example, if we measure the value of basketball output over time using a fixed price for valuing the basketballs, then only an increase in the number of basketballs produced could increase the value of the contribution made by basketballs to total output. By making such an adjustment for basketballs and all other goods and services, we obtain a value for real GDP. In contrast, nominal GDP, usually just referred to as gross domestic product (GDP), is the total value of final goods and services for a particular period valued in terms of prices for that period. Real GDP fell in the third quarter of 2008. But, because the price level in the United States was rising, nominal GDP rose 3.6%.

Converting Nominal to Real GDP

[caption id="attachment_4485" align="aligncenter" width="390"] Figure 5.7. U.S. Nominal GDP, 1960–2010 Nominal GDP values have risen exponentially from 1960 through 2010, according to the BEA.[/caption]

[latex]\text{Value}=\text{Price}\times\text{Quantity}[/latex]

[latex]\text{Nominal GDP}=\text{GDP Deflator}\times\text{Real GDP}[/latex]

[latex]\text{Coolshirt's nominal revenue from sales}=\text{Price}\times\text{Quantity}=9\times{10}=90[/latex]

[latex]\displaystyle\text{Coolshirt's real income}=\frac{\text{Nominal revenue}}{\text{Price}}=\frac{90}{9}=10[/latex]

[latex]\displaystyle\text{Real GDP}=\frac{\text{Nominal GDP}}{\text{Price Index}}[/latex]

[latex]\displaystyle\text{Real GDP}=\frac{\text{Nominal GDP}}{\frac{\text{Price Index}}{100}}[/latex]

Real GDP = Price × Quantity

% change in real GDP = % change in price + % change in quantity OR % change in quantity = % change in real GDP – % change in price

Self Check: Nominal and Real GDP

You’ll have more success on the Self Check if you’ve completed the two Readings in this section.

LEARNING ACTIVITIES

• Reading: Tracking Real GDP Over Time
• Reading: Phases of the Business Cycle
• Reading: Overheating and Stagflation
• Video: The Business Cycle
• Self Check: The Business Cycle

In this section, our goal is to use the concept of real GDP to look at the business cycle—the economy’s pattern of expansion, then contraction, then expansion again—and at growth of real GDP.

Figure 5.1 "Phases of the Business Cycle" shows a stylized picture of a typical business cycle. It shows that economies go through periods of increasing and decreasing real GDP, but that over time they generally move in the direction of increasing levels of real GDP. A sustained period in which real GDP is rising is an expansion; a sustained period in which real GDP is falling is a recession. Typically, an economy is said to be in a recession when real GDP drops for two consecutive quarters, but in the United States, the responsibility of defining precisely when the economy is in recession is left to the Business Cycle Dating Committee of the National Bureau of Economic Research (NBER). The Committee defines a recession as a “significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.”

[caption id="" align="aligncenter" width="489"] Figure 5.1. Phases of the Business Cycle. The business cycle is a series of expansions and contractions in real GDP. The cycle begins at a peak and continues through a recession, a trough, and an expansion. A new cycle begins at the next peak. Here, the first peak occurs at time t1, the trough at time t2, and the next peak at time t3. Notice that there is a tendency for real GDP to rise over time.[/caption]

At time t₁ in Figure 5.1 "Phases of the Business Cycle", an expansion ends and real GDP turns downward. The point at which an expansion ends and a recession begins is called the peak of the business cycle. Real GDP then falls during a period of recession. Eventually it starts upward again (at time t₂). The point at which a recession ends and an expansion begins is called the trough of the business cycle. The expansion continues until another peak is reached at time t₃.Some economists prefer to break the expansion phase into two parts. The recovery phase is said to be the period between the previous trough and the time when the economy achieves its previous peak level of real GDP. The “expansion” phase is from that point until the following peak. A complete business cycle is defined by the passage from one peak to the next.

Because the Business Cycle Dating Committee dates peaks and troughs by specific months, and because real GDP is estimated only on a quarterly basis by the Bureau of Economic Analysis, the committee relies on a variety of other indicators that are published monthly, including real personal income, employment, industrial production, and real wholesale and retail sales. The committee typically determines that a recession has happened long after it has actually begun and sometimes ended! In large part, that avoids problems when data released about the economy are revised, and the committee avoids having to reverse itself on its determination of when a recession begins or ends, something it has never done. In December 2008, the Committee announced that a recession in the United States had begun in December 2007. Interestingly, real GDP fell in the fourth quarter of 2007, grew in the first and second quarters of 2008, and shrank in the third quarter of 2008, so clearly the Committee was not using the two consecutive quarters of declining GDP rule-of-thumb. Rather, it was taking into account the behavior of a variety of other variables, such as employment and personal income.

Business Cycles and the Growth of Real GDP in the United States

Figure 5.2 "Expansions and Recessions, 1960–2008" shows movements in real GDP in the United States from 1960 to 2008. Over those years, the economy experienced eight recessions, shown by the shaded areas in the chart. Although periods of expansion have been more prolonged than periods of recession, we see the cycle of economic activity that characterizes economic life.

[caption id="" align="alignnone" width="714"] Figure 5.2. Expansions and Recessions, 1960–2008. The chart shows movements in real GDP since 1960. Recessions—periods of falling real GDP—are shown as shaded areas. On average, the annual rate of growth of real GDP over the period was 3.3% per year. Source: Bureau of Economic Analysis, NIPA Table 1.1.6. Real Gross Domestic Product, Chained Dollars [Billions of chained (2000) dollars]. Seasonally adjusted at annual rates. Data for 2008 is through 3rd quarter.[/caption]

Real GDP clearly grew between 1960 and 2008. While the economy experienced expansions and recessions, its general trend during the period was one of rising real GDP. The average annual rate of growth of real GDP was about 3.3%.

During the post–World War II period, the average expansion has lasted 57 months, and the average recession has lasted about 10 months. The 2001 recession, which lasted eight months, was thus slightly shorter than the average. The Great Recession (2007-2009), lasted longer than the average recession at nineteen months.

Economists have sought for centuries to explain the forces at work in a business cycle. Not only are the currents that move the economy up or down intellectually fascinating but also an understanding of them is of tremendous practical importance. A business cycle is not just a movement along a curve in a textbook. It is new jobs for people, or the loss of them. It is new income, or the loss of it. It is the funds to build new schools or to provide better health care—or the lack of funds to do all those things. The story of the business cycle is the story of progress and plenty, of failure and sacrifice.

The effects of recessions extend beyond the purely economic realm and influence the social fabric of society as well. Suicide rates and property crimes—burglary, larceny, and motor vehicle theft tend to rise during recessions. Even popular music appears to be affected. Terry F. Pettijohn II, a psychologist at Coastal Carolina University, has studied Billboard No. 1 songs from 1955–2003. He finds that during recessions, popular songs tend to be longer and slower, and to have more serious lyrics. “It’s ‘Bridge over Troubled Water’ or ‘That’s What Friends Are For’,” he says. During expansions, songs tend to be faster, shorter, and somewhat sillier, such as “At the Hop” or “My Sharona."

In our study of macroeconomics, we will gain an understanding of the forces at work in the business cycle. We will also explore policies through which the public sector might act to make recessions less severe and, perhaps, to prolong expansions. We turn next to an examination of price-level changes and unemployment.

• Identify the sources of economic growth
• Explain productivity and relate productivity growth to improvements in the standard of living

LEARNING ACTIVITIES

• Reading: Introduction to Economic Growth
• Reading: Economic Growth
• Reading: The Significance of Economic Growth
• Self Check: Defining Economic Growth
• Reading: Rule of Law and Economic Growth
• Reading: Components of Economic Growth
• Reading: Determinants of Economic Growth
• Self Check: Sources of Economic Growth
• Reading: Labor Productivity and Economic Growth
• Reading: The "New Economy" Controversy
• Self Check: Productivity

Global Economic Growth

WHAT WERE ECONOMIC CONDITIONS LIKE BEFORE 1870?

By many measures, a revolution in the human condition is sweeping the world. Most people today are better fed, clothed, and housed than their predecessors two centuries ago. They are healthier, live longer, and are better educated. Women’s lives are less centered on reproduction and political democracy has gained a foothold. Although Western Europe and its offshoots have been the leaders of this advance, most of the less developed nations have joined in during the 20th century, with the newly emerging nations of sub-Saharan Africa the latest to participate. Although the picture is not one of universal progress, it is the greatest advance in the human condition of the world’s population ever achieved in such a brief span of time.

To demonstrate the impact of economic growth on living standards of a nation, we must start with a clear definition of economic growth and then study its impact over time. We will also see how population growth affects the relationship between economic growth and the standard of living an economy is able to achieve.

Economic growth is a long-run process that occurs as an economy’s potential output increases. Changes in real GDP from quarter to quarter or even from year to year are short-run fluctuations that occur as aggregate demand and short-run aggregate supply change. Regardless of media reports stating that the economy grew at a certain rate in the last quarter or that it is expected to grow at a particular rate during the next year, short-run changes in real GDP say little about economic growth. In the long run, economic activity moves toward its level of potential output. Increases in potential constitute economic growth.

Earlier we defined economic growth as the process through which an economy achieves an outward shift in its production possibilities curve. How does a shift in the production possibilities curve relate to a change in potential output? To produce its potential level of output, an economy must operate on its production possibilities curve. An increase in potential output thus implies an outward shift in the production possibilities curve. In the framework of the macroeconomic model of aggregate demand and aggregate supply, we show economic growth as a shift to the right in the long-run aggregate supply curve.

There are three key points about economic growth to keep in mind:

1. Growth is a process. It is not a single event; rather, it is an unfolding series of events.
2. We define growth in terms of the economy’s ability to produce goods and services, as indicated by its level of potential output.
3. Growth suggests that the economy’s ability to produce goods and services is rising. A discussion of economic growth is thus a discussion of the series of events that increase the economy’s ability to produce goods and services.

Figure 8.1 "A Century of Economic Growth" shows the record of economic growth for the U.S. economy over the past century. The graph shows annual levels of actual real GDP and of potential output. We see that the economy has experienced dramatic growth over the past century; potential output has soared more than 30-fold. The figure also reminds us of a central theme of our analysis of macroeconomics: real GDP fluctuates about potential output. Real GDP sagged well below its potential during the Great Depression of the 1930s and rose well above its potential as the nation mobilized its resources to fight World War II. With the exception of these two periods, real GDP has remained close to the economy’s potential output. Since 1950, the actual level of real GDP has deviated from potential output by an average of less than 2%.

[caption id="" align="aligncenter" width="384"] Figure 8.1. A Century of Economic Growth. At the start of the 21st century, the level of potential output reached a level nearly 30 times its level a century earlier. Over the years, actual real GDP fluctuated about a rising level of potential output. Source: 1900–1949 data from Robert Gordon, Macroeconomics, 6th ed. (New York: HarperCollins, 1993), Table A-1, pp. A1–A3; data for 1950–2008 from Congressional Budget Office, The Budget and Economic Outlook, September 2008.[/caption]

We urge you to take some time with Figure 8.1 "A Century of Economic Growth." Over the course of the last century, it is economic growth that has taken center stage. Certainly, the fluctuations about potential output have been important. The recessionary gaps—periods when real GDP slipped below its potential—were often wrenching experiences in which millions of people endured great hardship. The inflationary gaps—periods when real GDP rose above its potential level—often produced dramatic increases in price levels. Those fluctuations mattered. It was the unemployment and/or the inflation that came with them that made headlines. But it was the quiet process of economic growth that pushed living standards ever higher. We must understand growth if we are to understand how we got where we are, and where we are likely to be going during the 21st century.

Figure 8.2 "Cyclical Change Versus Growth" tells us why we use changes in potential output, rather than actual real GDP, as our measure of economic growth. Actual values of real GDP are affected not just by changes in the potential level of output, but also by the cyclical fluctuations about that level of output.

[caption id="" align="aligncenter" width="328"] Figure 8.2. Cyclical Change Versus Growth. The use of actual values of real GDP to measure growth can give misleading results. Here, an economy’s potential output (shown in green) grows at a steady rate of 2.5% per year, with actual values of real GDP fluctuating about that trend. If we measure growth in the first 10 years as the annual rate of change between beginning and ending values of real GDP, we get a growth rate of 3.5%. The rate for the second decade is 0.5%. Growth estimates based on changes in real GDP are affected by cyclical changes that do not represent economic growth.[/caption]  

Given our definition of economic growth, we would say that the hypothetical economy depicted in Figure 8.2 "Cyclical Change Versus Growth" grew at a 2.5% annual rate throughout the period. If we used actual values of real GDP, however, we would obtain quite different interpretations. Consider, for example, the first decade of this period: it began with a real GDP of $900 billion and a recessionary gap, and it ended in year 10 with a real GDP of $1,408 billion and an inflationary gap. If we record growth as the annual rate of change between these levels, we find an annual rate of growth of 4.6%—a rather impressive performance.

Now consider the second decade shown in Figure 8.2 "Cyclical Change Versus Growth." It began in year 10, and it ended in year 20 with a recessionary gap. If we measure the growth rate over that period by looking at beginning and ending values of actual real GDP, we compute an annual growth rate of 0.5%. Viewed in this way, performance in the first decade is spectacular while performance in the second is rather lackluster. But these figures depend on the starting and ending points we select; the growth rate of potential output was 2.5% throughout the period.

By measuring economic growth as the rate of increase in potential output, we avoid such problems. One way to do this is to select years in which the economy was operating at the natural level of employment and then to compute the annual rate of change between those years. The result is an estimate of the rate at which potential output increased over the period in question. For the economy shown in Figure 8.2 "Cyclical Change Versus Growth," for example, we see that real GDP equaled its potential in years 5 and 15. Real GDP in year 5 was $1,131, and real GDP in year 15 was $1,448. The annual rate of change between these two years was 2.5%. If we have estimates of potential output, of course, we can simply compute annual rates of change between any two years.

The Rule of 72 and Differences in Growth Rates

The U.S. growth rate began slowing in the 1970s, did not recover until the mid-1990s, only to slow down again in the 2000s. The question we address here is: does it matter? Does a percentage point drop in the growth rate make much difference? It does. To see why, let us investigate what happens when a variable grows at a particular percentage rate.

Suppose two economies with equal populations start out at the same level of real GDP but grow at different rates. Economy A grows at a rate of 3.5%, and Economy B grows at a rate of 2.4%. After a year, the difference in real GDP will hardly be noticeable. After a decade, however, real GDP in Economy A will be 11% greater than in Economy B. Over longer periods, the difference will be more dramatic. After 100 years, for example, income in Economy A will be nearly three times as great as in Economy B. If population growth in the two countries has been the same, the people of Economy A will have a far higher standard of living than those in Economy B. The difference in real GDP per person will be roughly equivalent to the difference that exists today between Great Britain and Mexico.

Over time, small differences in growth rates create large differences in incomes. An economy growing at a 3.5% rate increases by 3.5% of its initial value in the first year. In the second year, the economy increases by 3.5% of that new, higher value. In the third year, it increases by 3.5% of a still higher value. When a quantity grows at a given percentage rate, it experiences exponential growth. A variable that grows exponentially follows a path such as those shown for potential output in Figure 8.1 "A Century of Economic Growth" and Figure 8.2 "Cyclical Change Versus Growth." These curves become steeper over time because the growth rate is applied to an ever-larger base.

A variable growing at some exponential rate doubles over fixed intervals of time. The doubling time is given by the rule of 72, which states that a variable’s approximate doubling time equals 72 divided by the growth rate, stated as a whole number. If the level of income were increasing at a 9% rate, for example, its doubling time would be roughly 72/9, or 8 years. Notice the use of the words roughly and approximately. The actual value of an income of $1,000 growing at rate r for a period of n years is $1,000 × (1 + r)ⁿ. After 8 years of growth at a 9% rate, income would thus be $1,000 (1 + 0.09)⁸ = $1,992.56. The rule of 72 predicts that its value will be $2,000. The rule of 72 gives an approximation, not an exact measure, of the impact of exponential growth.

Let us apply this concept of a doubling time to the reduction in the U.S. growth rate. Had the U.S. economy continued to grow at a 3.5% rate after 1970, then its potential output would have doubled roughly every 20 years (72/3.5 = 20). That means potential output would have doubled by 1990, would double again by 2010, and would double again by 2030. Real GDP in 2030 would thus be eight times as great as its 1970 level. Growing at a 2.4% rate, however, potential output doubles only every 30 years (72/2.4 = 30). It would take until 2000 to double once from its 1970 level, and it would double once more by 2030. Potential output in 2030 would thus be four times its 1970 level if the economy grew at a 2.4% rate (versus eight times its 1970 level if it grew at a 3.5% rate). The 1.1% difference in growth rates produces a 100% difference in potential output by 2030. The different growth paths implied by these growth rates are illustrated in Figure 8.3 "Differences in Growth Rates."

[caption id="" align="aligncenter" width="510"] Figure 8.3. Differences in Growth Rates. The chart suggests the significance in the long run of a small difference in the growth rate of real GDP. We begin in 1970, when real GDP equaled $2,873.9 billion. If real GDP grew at an annual rate of 3.5% from that year, it would double roughly every 20 years: in 1990, 2010, and 2030. Growth at a 2.4% rate, however, implies doubling every 30 years: in 2000 and 2030. By 2030, the 3.5% growth rate leaves real GDP at twice the level that would be achieved by 2.4% growth.[/caption]

Rule of Law and Economic Growth

Economic growth depends on many factors. Key among those factors is adherence to the rule of law and protection of property rights and contractual rights by a country’s government so that markets can work effectively and efficiently. Laws must be clear, public, fair, enforced, and equally applicable to all members of society. Property rights are the rights of individuals and firms to own property and use it as they see fit. If you have $100, you have the right to use that money, whether you spend it, lend it, or keep it in a jar. It is your property. The definition of property includes physical property as well as the right to your training and experience, especially since your training is what determines your livelihood. The use of this property includes the right to enter into contracts with other parties with your property. Individuals or firms must own the property to enter into a contract.

In this section, we review the main determinants of economic growth. We also examine the reasons for the widening disparities in economic growth rates among countries in recent years.

• Define aggregate demand (AD) and explain the factors that cause it to change
• Define aggregate supply (AS) and explain the factors that cause it to change
• Use the AD-AS model to explain periods of recession, and expansion, demand-pull inflation and cost-push inflation
• Use the AD-AS model to explain periods of economic growth

LEARNING ACTIVITIES

• Reading: The Aggregate Demand-Aggregate Supply Model
• Reading: Macroeconomic Perspectives on Demand and Supply
• Reading: Building a Model of Aggregate Supply and Aggregate Demand
• Reading: Aggregate Demand
• Reading: Shifts in Aggregate Supply
• Reading: The Long Run and the Short Run
• Reading: Shifts in Aggregate Demand
• Self Check: The Aggregate Demand-Aggregate Supply Model
• Reading: Growth and Recession in the AS–AD Diagram
• Reading: The AS–AD Model and Economic Growth
• Simulation: Spend or Save—Government Edition
• Self Check: The AD-AS Model and Growth, Recession, Expansion, and Inflation

WHY DOES AS CROSS POTENTIAL GDP?

The Aggregate Demand Curve

Aggregate demand (AD) is the relationship between the total spending in an economy on domestic goods and services and the price level for output. (Strictly speaking, AD is what economists call total planned expenditure. For now, just think of aggregate demand as total spending.) It includes all four components of demand: consumption, investment, government spending, and net exports (exports minus imports). This demand is determined by a number of factors, but one of them is the price level—recall though, that the price level is an index number such as the GDP deflator that measures the average price of the things we buy. The aggregate demand (AD) curve shows the total spending on domestic goods and services at each price level. Figure 10.4 presents an aggregate demand (AD) curve. Just like the aggregate supply curve, the horizontal axis shows real GDP and the vertical axis shows the price level. The AD curve slopes down, which means that increases in the price level of outputs lead to a lower quantity of total spending. The reasons behind this shape are related to how changes in the price level affect the different components of aggregate demand. The following components make up aggregate demand: consumption spending (C), investment spending (I), government spending (G), and spending on exports (X) minus imports (M): C + I + G + X – M. [caption id="attachment_4502" align="aligncenter" width="585"] Figure 10.4. The Aggregate Demand Curve Aggregate demand (AD) slopes down, showing that, as the price level rises, the amount of total spending on domestic goods and services declines.[/caption]   The wealth effect holds that as the price level increases, the buying power of savings that people have stored up in bank accounts and other assets will diminish, eaten away to some extent by inflation. Because a rise in the price level reduces people’s wealth, consumption spending will fall as the price level rises. The interest rate effect is that as prices for outputs rise, the same purchases will take more money or credit to accomplish. This additional demand for money and credit will push interest rates higher. In turn, higher interest rates will reduce borrowing by businesses for investment purposes and reduce borrowing by households for homes and cars—thus reducing consumption and investment spending. The foreign price effect points out that if prices rise in the United States while remaining fixed in other countries, then goods in the United States will be relatively more expensive compared to goods in the rest of the world. U.S. exports will be relatively more expensive, and the quantity of exports sold will fall. U.S. imports from abroad will be relatively cheaper, so the quantity of imports will rise. Thus, a higher domestic price level, relative to price levels in other countries, will reduce net export expenditures. Truth be told, among economists all three of these effects are controversial, in part because they do not seem to be very large. For this reason, the aggregate demand curve in Figure 10.4 slopes downward fairly steeply; the steep slope indicates that a higher price level for final outputs reduces aggregate demand for all three of these reasons, but that the change in the quantity of aggregate demand as a result of changes in price level is not very large. Read the following worked example to learn how to interpret the AS–AD model. In this example, aggregate supply, aggregate demand, and the price level are given for the imaginary country of Xurbia.

INTERPRETING THE AS–AD MODEL

Table 10.1 shows information on aggregate supply, aggregate demand, and the price level for the imaginary country of Xurbia. What information does Table 10.1 tell you about the state of the Xurbia’s economy? Where is the equilibrium price level and output level (this is the SR macroequilibrium)? Is Xurbia risking inflationary pressures or facing high unemployment? How can you tell?

Table 10.1. Price Level:Aggregate Supply–Aggregate Demand

Price Level	Aggregate Demand	Aggregate Supply
110	$700	$600
120	$690	$640
130	$680	$680
140	$670	$720
150	$660	$740
160	$650	$760
170	$640	$770