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Chapter 2
Measuring the Macroeconomy
Brief Chapter Summary
2.1 GDP: Measuring Total Production and Total Income
(pages 25–33)
Learning Objective 1
Explain how economists use gross domestic product (GDP) to measure
total production and total income.
 The Bureau of Economic Analysis (BEA) compiles the data needed to calculate gross
national product (GDP). The rules used in calculating GDP are called national income
accounting.
 By calculating GDP, the BEA measures both total production and total income.
2.2 Real GDP, Nominal GDP, and the GDP Deflator (pages 33–
41)
Learning Objective 2
Discuss the difference between real GDP and nominal GDP.
 Nominal GDP is calculated by summing the current values of final goods and services. Real
GDP is calculated by designating a particular year as the base year and then using prices in
the base year to calculate the value of goods and services in all other years.
2.3 Inflation Rates and Interest Rates (pages 41–47)
Learning Objective 3
Explain how the inflation rate is measured and distinguish between real
and nominal interest rates.
 The nominal interest rate is the stated interest rate on a loan. Lenders and borrowers base
their decisions on the real interest rate, which is the nominal interest rate adjusted for the
effects of inflation.
2.4 Measuring Employment and Unemployment (pages 47–49)
Learning Objective 4
Understand how to calculate the unemployment rate.
 The Bureau of Labor Statistics (BLS) uses monthly data collected by the Bureau of the
Census to measure the unemployment rate. The labor force is the sum of employed and
unemployed workers. The unemployment rate is the percentage of the labor force that is
unemployed. The BLS also uses the establishment survey to measure total employment in the
economy.
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List of Key Terms
Capital, p. 27. Goods, such as machine tools, computers, factories, and office buildings that are
used to produce other goods and services.
Consumer price index (CPI), p. 42. An average of the prices of the goods and services
purchased by the typical urban family of four.
Consumption, p. 29. The purchase of new goods and services by households.
Factor of production, p. 27. Any input used to produce goods and services.
Federal Reserve, p. 44. The central bank of the United States; usually referred to as “the Fed.”
Final good or service, p. 25. A good or service purchased by a final user.
Financial system, p. 27. The financial intermediaries and financial markets that together
facilitate the flow of funds from lenders to borrowers.
GDP deflator, p. 35. A measure of the price level, calculated by dividing nominal GDP by real
GDP and multiplying by 100; also called the GDP implicit price deflator.
Government purchases, p. 30. Spending by federal, state, and local governments on newly
produced goods and services.
Gross domestic product (GDP), p. 25. The market value of all final goods and services
produced in a country during a period of time.
Gross national product (GNP), p. 33. The value of final goods and services produced by
residents of a country, even if the production takes place outside that country.
Interest rate, p. 45. The cost of borrowing funds, usually expressed as a percentage of the
amount borrowed.
Intermediate good or service, p. 25. A good or service that is an input into another good or
service, such as a tire on a truck.
Investment, p. 29. Spending by firms on new factories, office buildings, machinery, and
additions to inventories, plus spending by households and firms on new houses.
Labor force, p. 47. The sum of employed and unemployed workers in the economy.
National income accounting, p. 26. The rules used in calculating GDP and related measures of
total production and total income.
Net exports, p. 33. The value of all exports minus the value of all imports.
Nominal GDP, p. 33. The value of final goods and services calculated using current-year prices.
Nominal interest rate, p. 45. The stated interest rate on a loan.
Personal consumption expenditures (PCE) price index, p. 44. A price index similar to the
GDP deflator, except that it includes only the prices of goods from the consumption category of
GDP.
Real GDP, p. 33. The value of final goods and services calculated using base-year prices.
Real interest rate, p. 46. The nominal interest rate adjusted for the effects of inflation.
Transfer payments, p. 31. Payments by the government to individuals for which the government
does not receive a new good or service in return.
Unemployment rate, p. 47. The percentage of the labor force that is unemployed.
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Chapter Outline
HOW DO WE KNOW WHEN WE ARE IN A RECESSION?
The Business Cycle Dating Committee of the National Bureau of Economic Research (NBER)
determines when a recession begins and ends. The NBER defines a recession as “a significant
decline in economic activity [that] spreads across the economy and can last from a few months to
more than a year.” Government agencies collect most of the data the NBER uses to determine
these dates. There is a lag before the first estimates of these data are released, and the first
estimates are based on incomplete data. As a result, the NBER committee takes time to analyze
the revised data before announcing when a recession has begun or ended. For example, the
committee waited 15 months to announce that the recession that began in 2007 ended in June
2009. Government and private decision makers are typically unwilling to wait a year or more
before taking action in response to their belief that a recession has began. Knowledge of key
macroeconomic data is important for the determination of business cycle dates as well as making
critical economic decisions.
Teaching Tips
The NBER is a private nonprofit research organization founded in 1920 and dedicated to
promoting a greater understanding of how the economy works. Although the NBER began
announcing business cycle dates in 1929, the Business Cycle Dating Committee was not
formed until 1978. Giving the committee of a private organization rather than a federal
government agency the responsibility for determining the dates when a recession begins and
ends removes the suspicion that these decisions are influenced by political motives. The
webpage of the NBER (www.nber.org) has a broad range of information about business cycle
history (including an FAQ page regarding how the committee makes its decisions) and the
research conducted by NBER economists. Press reports will often refer to a definition of a
recession as two consecutive quarters of negative growth of real GDP, but this is not the
NBER’s definition.
AN INSIDE LOOK at the end of this chapter examines how the construction industry was
affected by the 2007–2009 recession.
Key Issue: The unemployment rate can rise even though a recession has ended.
Key Question: How accurately does the government measure the unemployment rate?
2.1 GDP: Measuring Total Production and Total Income
(pages 25–33)
Learning Objective: Explain how economists use gross domestic product
(GDP) to measure total production and total income.
Economists measure total production by gross domestic product. Gross domestic product
(GDP) is the market value of all final goods and services produced in a country during a period of
time. The Bureau of Economic Analysis (BEA) compiles the data needed to calculate GDP.
A. How the Government Calculates GDP
GDP
 is measured using market values, not quantities.
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 includes only the market value of final goods. A final good or service is a good or service
purchased by a final user. An intermediate good or service is a good or service that is an
input into another good or service, such as a tire on a truck.
 measures production within a country, regardless of who does the production.
 includes some imputed values. In some cases where there is no market for a good or service,
the value has to be imputed, or estimated.
 does not include some types of production. These types of production include services
provided by homemakers and goods and services produced in the underground economy.
Measures of the changes in total production would not be much different if the BEA were
able to impute values for every good or service.
 includes only current production.
B. Production and Income
National income accounting refers to the rules used in calculating GDP and related measures of
total production and total income. The value of total production in an economy is equal to the
value of total income.
C. The Circular Flow of Income
The circular-flow diagram uses the flow of spending and money in the economy to show how the
total value of spending on goods and services, total expenditures, equals the total value of
income. We can measure GDP by adding up the total expenditures of households and firms,
foreign households and firms, and the government on goods and services produced in the United
States.
Firms use factors of production to produce goods and services. A factor of production is any
input used to produce goods and services. Factors of production include labor, capital, and natural
resources. Capital refers to goods, such as machine tools, computers, factories, and office
buildings that are used to produce other goods and services. Natural resources are land and raw
materials used to produce goods and services. Income is divided into four categories: wages,
interest, rent, and profit. Profit is the income that remains after a firm has paid wages, interest,
and rent; profit is the return to entrepreneurs for organizing the other factors of production and for
bearing the risk of producing and selling goods and services. The sum of wages, interest, rent, and
profit is the total income received by households.
Some of the income households earn is not spent or paid in taxes but is deposited in checking
or savings accounts in banks or other financial intermediaries, or used to buy financial assets in
financial markets. The financial system refers to financial intermediaries and financial markets
that together facilitate the flow of funds from lenders to borrowers.
D. An Example of Measuring GDP
The BEA gathers data on quantities and prices of final goods and services, multiplies the quantity
of each good or service by its price, and adds up the totals to determine the value of GDP.
E. National Income Identities and the Components of GDP
The BEA divides its statistics on GDP into four major categories of expenditures:
1. Personal consumption expenditures, or “Consumption” (C)
2. Gross private domestic investment, or “Investment” (I)
3. Government consumption and gross investment, or “Government purchases” (G)
4. Net exports of goods and services, or “Net exports” (NX)
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If we let Y represent GDP, then we have the following national income identity:
Y = C + I + G + NX
Consumption is the purchase of new goods and services by households. The BEA tracks
three categories of consumption: Durable goods are tangible goods with an average life of three
years or more. Nondurable goods are shorter-lived goods, such as food and clothing. Services are
consumed at the time and place of purchase.
Investment is spending by firms on new factories, office buildings, machinery, and additions to
inventories, plus spending by households and firms on new houses. Investment spending is
divided into three categories: Fixed investment is spending by firms on new factories, office
buildings, and machinery to produce other goods. Residential investment is spending by
households or firms on new single-family and multifamily homes. Changes in business
inventories are also included in investment. Inventories are goods that have been produced but
not sold.
Government purchases are spending by federal, state, and local governments on goods and
services.
Some government purchases represent consumption spending. Other government purchases
represent investment spending. Government purchases do not include transfer payments.
Transfer payments are payments by the government to individuals for which the government
does not receive a new good or service in return.
F. Net Exports
Net exports refer to the value of all exports minus the value of all imports.
G. The Relationship Between GDP and GNP
Prior to the mid-1990s, the BEA’s main measure of total production was gross national product.
Gross national product (GNP) is the value of final goods and services produced by residents of
a country, even if the production takes place outside the country. The BEA defines net factor
payments as the difference between factor payments from other countries and factor payments to
other countries. GDP and GNP are related by the following identity:
GDP = GNP + Net factor payments
Teaching Tips
Making the Connection on page 31 discusses the difficulty that lawmakers in Wisconsin and
other states have had in recent years in balancing their budgets. Unlike the federal government,
Wisconsin and most other states have laws that require balanced budgets. Wisconsin and other
states received funds from the American Recovery and Reinvestment Act that helped to pay
their bills between 2009 and 2011. But state funding from this source ended in 2011.
2.2 Real GDP, Nominal GDP, and the GDP Deflator (pages 33–
41)
Learning Objective: Discuss the difference between real GDP and nominal
GDP.
The BEA separates price changes from quantity changes by calculating a measure of production
called real GDP. Nominal GDP is the value of final goods and services calculated using current-
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year prices. Real GDP is the value of final goods and services calculated using base-year prices.
Real GDP is calculated by designating a particular year as the base year and then using prices in
the base year to calculate the value of goods and services in all other years. Currently, the BEA
has designated 2005 as the base year.
A. Price Indexes and the GDP Deflator
To gauge what is happening to prices in the economy as a whole, economists need a measure of
the price level, which is an average of the prices of goods and services in the economy.
Economists measure the price level with a price index, which is a measure of the average of the
prices of goods and services in one year relative to the base year. We can use values for nominal
GDP and real GDP to calculate a price index called the GDP deflator. The GDP deflator is a
measure of the price level and is calculated by dividing nominal GDP by real GDP and
multiplying by 100; it is also called the GDP implicit price deflator.
By calculating the GDP deflator for two consecutive years, we get a measure of the inflation
rate in the second year. If Pt is the price level in the first year, Pt+1 is the price level in the second
year, and πt+1 is the inflation rate during the second year, then:
Inflation rate  r 1 
Pt 1  P1
100
P1
B. The Chain-Weighted Measure of Real GDP
In 1996, the BEA switched to using chain-weighted prices and publishes statistics on real GDP in
“chained (2005) dollars.” Starting with the base year, the BEA takes an average of prices in that
year and prices in the following year. The BEA then uses this average to calculate real GDP in
the year following the base year. For the next year, the BEA calculates real GDP by taking an
average of prices in that year and the previous year. Prices in each year are “chained” to prices
from the previous year, and the distortion from changes in relative prices is minimized.
C. Comparing GDP Across Countries
Comparison of GDP across countries is complicated because countries calculate GDP in terms of
their own currencies. Exchange rates can be used to convert GDP values into a single currency,
but exchange rates fluctuate widely. To get around this problem, economists use the purchasing
power parity (PPP) exchange rate, which is the number of units of a country’s currency required
to buy the same amount of goods and services in the country as one U.S. dollar would buy in the
United States. PPP exchange rates are more stable than actual exchange rates.
D. GDP and National Income
In addition to GDP and GNP, the BEA publishes data on other measures of total income.
Depreciation represents the value of worn-out or obsolete capital. If we subtract the value of
depreciation from GDP, we are left with national income. There are five categories of income:
employee compensation, proprietors’ income, rental income, corporate profits, and net interest
payments. The BEA also publishes data on personal income, which is income received by
households. Personal income equals national income minus the earnings that corporations retain,
rather than pay to shareholders as dividends, plus the household receipts of transfer payments and
interest on government bonds. The BEA also publishes data on disposable personal income,
which is equal to personal income minus personal tax payments. Disposable personal income is
the best measure of the income households have available to spend.
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Teaching Tips
Figure 2.3 on page 34 compares real GDP and nominal GDP for the United States between
1990 and 2010. The base year for real GDP was changed from 2000 to 2005 in 2009, part of the
comprehensive revision of the National Income and Product Accounts by the Bureau of
Economic Analysis. These revisions are described in a March 2009 article (“Preview of the
2009 Comprehensive Revision of the NIPAs”) in the Survey of Current Business authored by
Clinton P. McNully and Steven Payson.
2.3 Inflation Rates and Interest Rates (pages 41–47)
Learning Objective: Explain how the inflation rate is measured and
distinguish between real and nominal interest rates.
For some purposes, the GDP deflator is too broad a measure of the inflation rate. Economists and
policy makers are usually interested in inflation as it affects the prices paid by the typical
household. The consumer price index does a better job of measuring changes in the cost of living
as experienced by the typical household.
A. The Consumer Price Index
The consumer price index (CPI) is an average of the prices of goods and services purchased by
the typical urban family of four. To compute the CPI, the U.S. Bureau of Labor Statistics (BLS)
surveys 30,000 households nationwide on their spending habits. The BLS uses the survey to
construct a market basket of 211 types of goods and services purchased by the typical urban
family of four. Each month, hundreds of BLS employees visit 23,000 stores in 87 cities and
record prices of goods and services in the market basket. Each price in the CPI is given a weight
equal to the fraction of the typical family’s budget spent on that good or service. The CPI in a
given year is equal to the ratio of the dollar amount necessary to buy the market basket of goods
in that year divided by the amount necessary to buy the market basket of goods in the base year,
multiplied by 100. The CPI is widely used for indexing, which involves increasing a dollar value
to protect against inflation.
B. How Accurate Is the CPI?
Most economists believe that there are four reasons the CPI overstates the true inflation rate.
First, the CPI suffers from substitution bias. Because the BLS assumes that consumers buy fixed
quantities of goods and services, the CPI will overstate the prices of goods and services that
increase the most, and understate the prices that increase the least. Second, the CPI suffers from a
bias due to the introduction of new goods because the market basket is updated only every two
years. Third, the quality of goods and services changes over time, and these changes are not
completely reflected in the CPI. Four, there is an outlet bias in the CPI data. Many households
shop at large discount stores and on the Internet; these sources are underrepresented in the sample
of prices the BLS gathers.
Despite BLS attempts to improve the accuracy of the CPI, many economists still believe that
the CPI overstates the true inflation rate by 0.5 to 1 percentage point. These differences can be
large when compounded over long periods of time.
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C. The Way the Federal Reserve Measures Inflation
The Federal Reserve is the central bank of the United States; it is usually referred to as “the Fed.”
To meet its goal of price stability, the Fed has an informal target for the inflation rate of about
2%. Because the CPI suffers from biases, the Fed announced in 2000 that it would rely more on
the personal consumption expenditures price index than on the CPI in tracking inflation. The
personal consumption expenditures (PCE) price index is similar to the GDP deflator, except that
it includes only the prices of goods from the consumption category of GDP.
The Fed believes there are three advantages to using the PCE:
1. The PCE is a chain-type price index, which allows the mix of products to change each year.
2. The PCE includes the prices of more goods and services than the CPI, so it is a broader
measure of inflation.
3. Past values of the PCE can be recalculated as better ways of computing price indexes are
developed and as new data become available.
Since 2004, the Fed has focused on a subcategory of the PCE, the core PCE, which excludes food
and energy prices.
D. Interest Rates
A key economic variable in understanding the financial system is the interest rate. The interest
rate is the cost of borrowing funds, usually expressed as a percentage of the amount borrowed.
The nominal interest rate is the stated interest rate on a loan. Lenders and borrowers know that
inflation reduces the purchasing power of interest income, so they base their decisions on the real
interest rate. The real interest rate is the nominal interest rate adjusted for the effects of inflation.
For the economy as a whole, economists often measure the nominal interest rate as the interest
rate on U.S. Treasury bills that mature in three months.
Teaching Tips
Making the Connection on page 43 discusses the impact of using the Consumer Price Index to
index Social Security payments. A study by Gopi Goda, John Shoven, and Sita Slavov argues
that because retirees spend a larger portion of their incomes on medical services than the
average consumer, and the prices of medical services have risen more than other prices, the CPI
may understate the impact of inflation on Social Security recipients. This study is interesting
since most economists assume that percentage changes in the CPI overstate the impact of
inflation on the average consumer.
2.4 Measuring Employment and Unemployment (pages 47–49)
Learning Objective: Understand how to calculate the unemployment rate.
Each month, the U.S. Bureau of the Census conducts the Current Population Survey to collect
data used to compute the unemployment rate. People are considered employed if they worked
during the week before the survey or if they were temporarily away from their jobs because they
were ill, on vacation, on strike, or for other reasons. People are considered unemployed if they did
not work in the previous week but were available for work and had actively looked for work at
some time during the previous four weeks. The labor force is the sum of employed and
unemployed workers in the economy. The unemployment rate is the percentage of the labor force
that is unemployed. Some discouraged workers might prefer to have a job but have given up
looking because they believe finding a job is too difficult. Because these workers are not actively
looking for a job, they are not considered to be in the labor force and so aren’t counted as
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unemployed. Therefore, the unemployment rate as measured by the BLS may understate the true
degree of joblessness in the economy. Also, the BLS counts people with part-time jobs as being
employed, even if those people would prefer to hold full-time jobs. As a result of problems with
the official unemployment rate, the BLS publishes data on several different measures of the
unemployment rate. For example, the long-term unemployment rate shows the percentage of the
labor force that has been unemployed for 15 weeks or more.
In addition to the household survey, the BLS uses the establishment survey, or payroll survey,
to measure total employment in the economy. This monthly survey samples about 300,000
business establishments and provides information on the total number of persons who are
employed and on a company payroll. The establishment survey has three drawbacks. First, it does
not provide information on self-employed persons. Second, the survey may fail to count some
persons as employed at newly opened firms not included in the survey. Third, the survey provides
no information on unemployment. However, the establishment survey is determined by actual
payrolls rather than by unverified answers to survey questions.
Teaching Tips
Figure 2.9 on page 48 compares changes in the official unemployment rate with alternative
measures of unemployment. The increase in the long-term unemployment rate (the percentage
of the labor force that has been unemployed for 15 weeks or more) during the recession of
2007–2009 is worrisome for policy makers because the longer workers are unemployed, the
more their skills deteriorate, which can increase the difficulty they face in finding new jobs.
Solutions to the End-of-Chapter
Questions and Problems
Answers to Thinking Critically questions that accompany the An Inside Look newspaper feature.
1.
a. A single-family home is included in the “investment” component of GDP as a part of
“residential fixed investment.” Although single-family homes are most often purchased
by private households, since residential housing provides housing services for many
years, single-family homes are included in “investment” rather than “consumption.”
b. A commercial office building is included in the “investment” component of GDP as a
part of “nonresidential fixed investment.”
c. A public school is included in the “government expenditure” component of GDP. Since
most public schools are financed by local governments, this type of new construction
would most likely fall under the “state and local” section of “government expenditure.”
d. An interstate highway is included in the “government expenditure” component of GDP.
Interstate highways are often financed with a combination of federal and state funding, so
new construction would most likely be divided between the “federal (nondefense)”
section and the “state and local” section of “government expenditure.”
e. A private hospital, constructed with private (and not government) funds, is included in
the “investment” component of GDP as a part of “nonresidential fixed investment.”
f. An apartment building is included in the “investment” component of GDP as a part of
“residential fixed investment.” As with a single-family home, an apartment building
provides housing services for many years and is therefore considered as “investment” and
not “consumption.”
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g. A manufacturing factory with warehouse space is included in the “investment”
component of GDP, as a part of “nonresidential fixed investment.”
2. The size of the economy is the value of goods and services produced rather than sold. Since
the new homes were constructed in 2010, they would be counted as a part of the GDP for
2010. Since the new homes were not sold in 2010, they would be treated as inventory that
was purchased by the home builders on the last day of 2010. When the new homes were sold
in 2011 and 2012, they would be considered “used” for purposes of GDP and, therefore, not
counted in the GDP calculations in the years they were sold.
2.1 GDP: Measuring Total Production and Income
Learning Objective: Explain how economists use gross domestic product
(GDP) to measure total production and total income.
Review Questions
1.1 Gross domestic product (GDP) is the market value of all final goods and services produced in
a country during a period of time. The circular flow shows that GDP is both a measure of
production and income, because the production of every output requires payment to the inputs
that produce it. Thus, we can measure GDP by either counting up the value of all outputs or by
counting up the payments to inputs.
1.2 Intermediate goods are not counted toward GDP because their value is included in the final
value of the products that they go into. If intermediate goods were counted, we would be doublecounting and overstating the value of GDP. An imputed value is an estimated value, used when
there is no market for the good or service. Examples of such goods include the value of living in a
house you own and the value of police and fire services.
1.3 All factors of production, such as land, labor, and capital, are owned by some member of a
household. Workers receive wages for their labor. Landlords receive payment for use of their
land. Owners of capital receive a return to the ownership of those assets.
1.4 Consumption: purchases by consumers
Investment: purchases by firms or purchases of new housing
Government spending: purchases by government, whether federal, state, or local (transfer
payments are excluded)
Net exports: Purchases of domestic goods by foreigners less domestic purchases of foreign
goods
1.5 GDP represents all production that takes place within a country’s borders. GNP represents the
production of all the factors of production that are national to a country, regardless of their
location. The difference between GDP and GNP for the United States is only about 1%.
Problems and Applications
1.6 a. No effect; not measured.
b. Increase in GDP because output increases (although true GDP falls by less because of a
loss of household production).
c. Measured GDP is likely to increase due to funds spent on cleanup efforts. The decline in
environmental quality is not measured.
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d. Measured GDP will fall (although true GDP falls by less due to the increase in household
production).
1.7 a. These changes would increase measured GDP, both through more women in the
workforce and through measured production such as daycare.
b. The net effect was probably an increase in actual GDP (assuming that the value of
women in market production is greater than their value in household production) but by
less than measured GDP, since it would be necessary to subtract the value of household
production that either no longer takes place or is being produced by someone else.
1.8 a.
b.
c.
d.
Included as consumption.
Not counted because painting is household production.
Included as consumption.
Not counted, because the house was counted in the year that it was built. Any realtor fees
would be counted in consumption.
e. Counted as consumption. If the car was produced in another country, it would also be
subtracted as an import.
f. Not counted because the truck is not this year’s production.
1.9 a. 2010: $225
2011: $297.50
2012: $361.25
b. (297.50 – 225)/225 = 0.32, or 32%
c. (361.25 – 297.50)/297.50 = 0.21 or 21%
d. No, it does not. Since both prices and output are changing, this method does not show the
change in output alone (or in prices alone). In fact, production did not change from 2011
to 2012, but nominal GDP increased due to the rise in prices.
1.10 Uncertain or false. Students may answer in different ways, but revisions tend to be relatively
minor, and preliminary results certainly show the direction of GDP movement if not the precise
figure, and thus are valuable and useful for policymaking.
1.11 a. No, it is not counted, because it is a transfer payment.
b. States are required to have balanced budgets, so money spent on pensions cannot be spent
on other goods.
c. The federal budget is not required to be balanced, so it does not face exactly the same
problem, although increases in one program do require either a greater budget deficit or
cuts in other programs.
2.2 Real GDP, Nominal GDP, and the GDP Deflator
Learning Objective: Discuss the difference between real GDP and nominal
GDP.
Review Questions
2.1 Nominal GDP reflects both price and quantity changes. Real GDP reflects only quantity
changes. Since prices generally rise at least somewhat, changes in nominal GDP overstate
changes in total production.
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2.2 A price index is a measure of the price level relative to prices in some base year. Dividing
nominal GDP by real GDP (and, usually, multiplying by 100) gives a price index. In the base
year, nominal and real GDP are the same.
2.3 A purchasing power parity (PPP) rate is the number of units of a country’s currency that is
required to buy the same amount of goods and services in the country as one U.S. dollar would
buy in the United States. A PPP rate can be used to compare purchasing power of currencies (in
terms of actual goods, rather than units of currency). In other words, the PPP rate can be used to
compare the cost of a comparable bundle of goods in different countries.
2.4 National income (NI) is the sum of all net income earned in production (employee
compensation, proprietors’ income, rental income, corporate profits, and net interest payments),
while GDP is sum of all spending (consumption, investment, government spending, and net
exports). Personal income is income received by households. To calculate personal income, the
BEA subtracts from national income the earnings that corporations retain rather than pay to
shareholders in the form of dividends.
2.5 There are five types of income: employee compensation, proprietor’s income (the income to
noncorporate businesses), rental income, corporate profits, and net interest payments. Employee
compensation is the largest category of national income. Answers about changes will vary (refer
to Figure 2.5).
Problem and Applications
2.6 a. Since these figures are nominal, it is impossible to tell the relative change in quantity of
oil imported versus price.
b. Change in nominal oil imports = (35.2 – 26.5)/26.5 = 0.33, or 33%.
Change in prices = (91 – 75)/75 = 0.21 or 21%.
Thus, change in quantity of oil imports = 33 – 21 = 12%.
2.7 a. 2010: 225
2011: 297.50
2012: 297.50
b. Output growth between 2010 and 2011 was positive, while there was no change in output
between 2011 and 2012.
2.8 Nominal 2005 = $935
Real 2005 (assuming that 2005 is the base year) = $935
Nominal 2012 = $1,278.50
Real 2012 (assuming that 2005 is the base year) = $1,112.50
2.9 Answers will vary; any number of possible answers will satisfy the criteria. For example, the
answer could be identical to the Solved Problem table with the addition of a fourth product. If all
prices remain constant except the price of the fourth product (which increases), nominal GDP will
still be greater than real GDP.
2.10 $14,453.8 billion/$13,149.5 billion = 1.099, or 110
2.11 GDP deflator for the first year: $103.6 billion/$977 billion = 0.1060
GDP deflator for the second year: $91.2 billion/$892.8 billion = 0.1024
Inflation = (0.1024 – 0.106)/0.106 = –0.033, or –3.3%
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2.12 Answers will vary, but large revisions make initial data less reliable, so policy makers
should be less likely to make broad changes based on this data.
2.13 China’s GDP in dollars will be greater if the purchasing power measure is used. Since the
purchasing power of the yuan (in China) exceeds the purchasing power of an equivalent amount
of dollars (in the United States), the market exchange rate understates the value of the yuan and
China’s GDP.
2.14 a. The Atlas method accounts for fluctuations in market rates and for inflation, and thus
presents a more accurate picture of per capita incomes.
b. The revised data still does not adjust for purchasing power parity. (The answer could also
note general problems in comparing developed countries with countries in which there is
a significant amount of nonmarket activity).
c. See the answer to part (b). In general, purchasing power in less-developed countries is
higher than measured by market rates due to different portions of consumption bundles
accounted for by factors such as nonmarket activities and systematic differences in the
valuation of services.
d. Before: $47,580/$730 = 65 times (rounded)
After: $47,580/$1,580 = 30 times (rounded)
2.15 If the economy experiences deflation, real GDP will exceed nominal GDP in the years
following the deflation.
2.3 Inflation Rates and Interest Rates
Learning objective: Explain how the inflation rate is measured and
distinguish between real and nominal interest rates.
Review Questions
3.1 The price level is the average price of goods and services in the economy. The rate of
inflation is the percentage change in the price level.
3.2 The CPI is calculated based on a fixed market basket of goods. Since the CPI does not allow
for substitution, quality change, or the introduction of new goods, it is likely to overstate the
inflation rate.
3.3 The GDP deflator includes the prices of all goods, while the PCE deflator uses only
consumption goods. The BEA calculates two price indices for the PCE. The first is a PCE
deflator similar to the GDP deflator, and the second is the PCE chain-weighted price index
similar to the GDP chain-weighted price index. However, the annual inflation rate from the two
PCE price indices is nearly identical. The core PCE excludes foods and energy prices, which
historically have been more volatile. Because either rapid increases or rapid decreases in food and
energy prices tend not to persist over time, including these prices in a price index can give a
misleading indication of the underlying inflation rate.
3.4 The real interest rate is the nominal interest rate minus the inflation rate. If the actual rate is
greater than the expected inflation rate, borrowers gain because they repay loans in “cheaper”
dollars.
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Problems and Applications
3.5 The difference between the CPI and PCE is that the CPI tracks the relative cost of a fixed
basket of goods over time, while the PCE tracks the price of a fixed basket of goods actually
purchased in the economy. The Fed prefers the PCE deflator because it avoids some of the biases
inherent in the CPI, such as substitution bias and bias due to the introduction of new goods.
3.6 Effect on the CPI: The price of apples will rise, so the price level as measured by the CPI will
rise, since the market basket will not change (thus overstating inflation).
Effect on the PCE: The quantity of apples that consumers buy will fall (since they are more
expensive and there are fewer of them). Thus the PCE deflator will not increase by as much as the
CPI.
3.7 a. The situation is likely to worsen since medical care costs are likely to continue to rise
more rapidly than prices of other goods.
b. One example might be students, due to escalating education costs.
3.8 a. The real interest rate became negative.
b. Savers lose, since they receive a negative return on savings. Borrowers gain, because the
costs of borrowing falls.
c. Your savings account would be lower every month; the negative nominal rate would be
like a tax on your savings.
2.4 Measuring Employment and Unemployment
Learning Objective: Understand how to calculate the unemployment rate.
Review Questions
4.1 Unemployment Rate 
Unemployed
100
Labor Force
4.2 The BLS definition is as follows: “Persons marginally attached to the labor force are those
who currently are neither working nor looking for work but indicate that they want and are
available for a job and have looked for work sometime in the past 12 months. Discouraged
workers, a subset of the marginally attached, have given a job-market related reason for not
currently looking for work.”
4.3 The unemployment rate does not include discouraged workers, marginally attached worker,
and underemployed workers.
4.4 Each month, the U.S. Bureau of the Census conducts the Current Population Survey (often
referred to as the household survey) to collect data needed to compute the unemployment rate.
The bureau interviews adults in a sample of 60,000 households, chosen to represent the U.S.
population, about the employment status of everyone in the household 16 years of age and older.
The BLS uses these data to calculate the monthly unemployment rate. The BLS uses the
establishment survey to measure total employment in the economy. This monthly survey samples
about 300,000 business establishments. The establishment survey provides information on the
total number of persons who are employed and on a company payroll. In recent years, some
economists have come to rely more on establishment survey data than on household survey data
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in analyzing current labor market conditions due to some of the problems in the household
survey’s estimation of the unemployment rate (such as failure to count marginally attached
workers and underemployed workers.)
Problems and Applications
4.5 a.
b.
c.
d.
e.
f.
Included, employed.
Included, employed (although underemployed).
Not included in the labor force.
Not included in the labor force.
Not included in the labor force.
Included, unemployed.
4.6 a. They are counted as unemployed.
b. They are not counted in standard measures of unemployment.
c. As the economy improves, the discouraged workers will reenter the labor force, causing
the unemployment rate to (temporarily) increase.
4.7 a. The unemployment rate would stay the same.
b. GDP would be half as large (assuming that a person working 20 hours produces exactly
half of what a person working 40 hours produces, which may not be the case).
c. The unemployment rate does not measure workers who are underemployed. To the extent
that there are underemployed workers, the economy has more slack than the
unemployment data shows.
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