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Production, Income,
and Employment
Slides by: John & Pamela Hall
ECONOMICS: Principles and Applications 3e
HALL & LIEBERMAN
© 2005 Thomson Business and Professional Publishing
Production and Gross Domestic
Product, GDP: A Definition
• U.S. government has been measuring
nation’s total production since 1930s
• Many conceptual traps and pitfalls
– This is why economists have come up with a
very precise definition of GDP
– The nation’s gross domestic product (GDP)
• Total value of all final goods and services produced
for the marketplace during a given period within the
nation’s borders
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Production and Gross Domestic
Product, GDP: A Definition
• The total value
– Approach of GDP is to add up dollar value of every good or
service—the number of dollars each product is sold for
• However, using the dollar prices at which goods and services actually
sell also creates a problem
– If prices rise, then GDP will rise, even if we are not actually producing
more
– GDP must be adjusted to take away the effects of inflation
• …of all final…
– When measuring production, we do not count every good or
service produced in the economy
• Only those that are sold to their final users
• Avoids over-counting intermediate products when measuring GDP
– Value of all intermediate products is automatically included in value of final
products they are used to create
3
Production and Gross Domestic
Product, GDP: A Definition
• …goods and services…
– We all know a good when we see one
– Final services count in GDP in the same way as
final goods
• …produced…
– In order to contribute to GDP, something must
be produced
• During the period being considered
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Figure 1: Stages of Production
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Production and Gross Domestic
Product, GDP: A Definition
• …for the marketplace…
– GDP does not include all final goods and services
produced in the economy
• Includes only the ones produced for the marketplace—that is,
with the intention of being sold
• …during a given period…
– GDP measures production during some specific period
of time
• Only goods produced during that period are counted
• GDP is actually measured for each quarter, and then reported
as an annual rate for the quarter
• Once fourth quarter figures are in, government also reports
official GDP figure for entire year
6
Production and Gross Domestic
Product, GDP: A Definition
• …within the nation’s borders
– GDP measures output produced within
U.S. borders
• Regardless of whether it was produced by
Americans
– Americans abroad are not counted
– However, foreigners producing goods or services
within the country are
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The Expenditure Approach to GDP
• The Commerce Department’s Bureau of Economic
Analysis (BEA)
– Agency responsible for gathering, reporting, and analyzing
movements in the nation’s output
– Calculates GDP in several different ways
• Expenditure approach divides output into four categories
according to which group in the economy purchases it as
final users
– Consumption goods and services (C)—purchased by households
– Private investment goods and services (I)—purchased by
businesses
– Government goods and services (G)—purchased by government
agencies
– Net exports (NX)—purchased by foreigners
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The Expenditure Approach to GDP
• Everyone who purchases a good or service
included in U.S. GDP must be either a
– U.S. household
– U.S. business or
– U.S. government agency (including state and
local government)
– Or else is part of the foreign sector
• When we add up the purchases of all four
groups we get GDP
• GDP = C + I + G + NX
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Consumption Spending
• Consumption is the part of GDP purchased by
households as final users
– Almost everything households buy during the year is
included as part of consumption spending when we
calculate GDP
– One exception is construction of new homes
• Counted as private investment
– Some quirky exceptions to the definition of consumption
• Total value of all food products that farm families produce and
consume themselves
• Total value of the housing services provided by owner-occupied
homes
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Private Investment
• Private investment has three components
– Business Purchases of Plant, Equipment, and Software
• A firm’s plant, equipment, and software are intended to last for many years—
only a small part of them is used up to make the current year’s output
• Are regarded and software as final goods, and firms that buy them as final
users of those goods
– New Home Construction
• Residential housing is an important part of nation’s capital stock
• House will continue to provide services into the future
– Changes in Inventories
• We count the charge in firms’ inventories as part of investment in measuring
GDP
• Why?
– When goods are produced but not sold during the year, they end up in some firm’s
inventory stocks
– Part of the nation’s capital stock
– Will provide services in the future, when they are finally sold and used
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Private Investment and the Capital
Stock: Some Provisos
• Changes in the nation’s capital stock are somewhat more complicated
than we are able to capture with private investment alone
• Specifically, private investment does not include
– Government Investment
• An important part of the nation’s capital stock is owned and operated not by
business, but by government—federal, state, and local
– Consumer durables
• Goods such as furniture, automobiles, washing machines, and personal
computers for home use can be considered capital goods
– Will continue to provide services for many years
– Human capital
• To measure the increase in capital stock most broadly we include the additional
skills and training acquired by workforce during the year
• In addition to excluding some types of capital formation, private
investment also errs in the other direction
– Ignores depreciation—the capital that is used up during the year
12
Government Purchases
• Purchases by state, local governments and
federal government are included
• Government purchases include
– Goods
• Fighter jets, police cars, school buildings, spy satellites, etc.
– Services
• Such as those performed by police, legislators, and military
personnel
• Government is considered to be a purchaser even
if it actually produces the goods or services itself
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Government Purchases
• Important to distinguish between
– Government purchases
• Which are counted in GDP
– Government outlays
• As measured by local, state, and federal budgets and reported in the
media
• Transfer payments represent money redistributed from
one group of citizens (taxpayers) to another (poor,
unemployed, elderly)
– While transfers are included in government budgets as outlays
they are not purchases of currently produced goods and services
• Not included in government purchases or in GDP
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Net Exports
• Once we recognize dealings with the rest of
the world, we must correct an inaccuracy in
our measure of GDP
– Deduct all U.S. imports during the year, leaving
us with just output produced in United States
• To properly account for output sold to, and
bought from, foreigners
– Must include net exports—difference between
exports and imports—as part of expenditure in
GDP
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Other Approaches to GDP: The
Value-Added Approach
• Value added
– Firm’s contribution to a product or
– Revenue it receives for its output
• Minus cost of all the intermediate goods that
it buys
• GDP is sum of values added by all
firms in economy
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Other Approaches to GDP: The
Factor Payments Approach
• In any year, value added by a firm is equal to total factor
payments made by that firm
• GDP equals sum of all firms’ value added
– Each firm’s value added is equal to its factor payments
• Thus, GDP must equal total factor payments made by all firms in the
economy
• All of these factor payments are received by households in the form of
wages and salaries, rent, interest or profit
– GDP is measured by adding up all of the income—wages and salaries,
rent, interest, and profit—earned by all households in the economy
• Gives us an important insight into the macroeconomy
– Total output of economy (GDP) is equal to total income earned in
the economy
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Measuring GDP: A Summary
• Different ways to calculate GDP
– Expenditure Approach
• GDP = C + I + G + NX
– Value-Added Approach
• GDP = Sum of value added by all firms
– Factor Payments Approach
• GDP = Sum of factor payments made by all firms
• GDP = Wages and Salaries + interest + rent + profit
• GDP = Total household income
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Real Versus Nominal GDP
• Since GDP is measured in dollars, a serious
problem exists when tracking change in output
over time
– Value of the dollar—its purchasing power—is changing
• Usually need to adjust our measurements to
reflect changes in the value of the dollar
– Nominal—when a variable is measured over time with
no adjustment for the dollar’s changing value
– Real—when a variable is adjusted for the dollar’s
changing value
• Most government statistics are reported in both
nominal and real terms
– Economists focus almost exclusively on real variables
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Real Versus Nominal GDP
• The distinction between nominal and real
values is crucial in macroeconomics
• The public, the media, and sometimes even
government officials have been confused by
a failure to make this distinction
– Since our economic well-being depends, in
part, on the goods and services we can buy
• It is important to translate nominal values—which
are measured in current dollars—to real values—
which are measured in purchasing power
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How GDP Is Used
• Government’s reports on GDP are used to steer
the economy over both short-run and long-run
– In short-run, to alert us to recessions and give us a
chance to stabilize the economy
– In long-run, to tell us whether our economy is growing
fast enough to raise output per capita and our standard
of living, and fast enough to generate sufficient jobs for
a growing population
• Many (but not all) economists believe that, if
alerted in time
– Government can design policies to help keep the
economy on a more balanced course
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Figure 2: Real GDP Growth Rate,
1960–2003
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Problems With GDP
• Quality changes
– While BEA includes impact of quality changes for many
goods and services (such as automobiles and
computers)
• Does not have the resources to estimate quality changes for
millions of different goods and services
• By ignoring these quality improvements, GDP
probably understates true growth from year to
year
23
The Underground Economy
• Some production is hidden from
government authorities
– Either because it is illegal or
• Drugs, prostitution, most gambling
– Because those engaged in it are avoiding taxes
• Production in these hidden markets cannot be
measured accurately
– BEA must estimate it
» Many economists believe that BEA’s estimates are too
low
» As a result, GDP may understate total output
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Non-Market Production
•
GDP does not include non-market production
– Goods and services that are produced, but not sold in the marketplace
•
Whenever a non-market transaction becomes a market transaction GDP will rise
– Even though total production has remained the same
• Can exaggerate the growth in GDP over long periods of time
•
What do these problems tell us about value of GDP?
– For certain purposes—especially interpreting long-run changes in GDP—we must
exercise caution
•
GDP works much better as a guide to short-run performance of economy
– Short-term changes in real GDP are fairly accurate reflections of the state of the
economy
– A significant quarter-to-quarter change in real GDP virtually always indicates a change
in actual production; rather than a measurement problem
•
This is why policy makers, business people, and the media pay such close
attention to GDP as a guide to the economy from quarter to quarter
25
Types of Unemployment
• In United States, people are considered
unemployed if they are not working and actively
seeking a job
– Unemployment can arise for a variety of reasons, each
with its own policy implications
– This is why economists have found it useful to classify
unemployment into four different categories
–
–
–
–
Frictional unemployment
Seasonal unemployment
Structural unemployment
Cyclical unemployment
» Each arises from a different cause and has different
consequences
26
Frictional Unemployment
• Short-term joblessness experienced by people
who are between jobs or who are entering the
labor market for first time or after an absence
• Because frictional unemployment is, by definition,
short-term, it causes little hardship to those
affected by it
• By spending time searching rather than jumping at
the first opening that comes their way
– People find jobs for which they are better suited and in
which they will ultimately be more productive
27
Seasonal Unemployment
• Joblessness related to changes in weather, tourist
patterns, or other seasonal factors
• Is rather benign
– Short-term
– Workers are often compensated in advance for unemployment
they experience in off-season
• To prevent any misunderstandings, government usually
reports the seasonally-adjusted rate of unemployment
– Rate that reflects only those changes beyond normal for the month
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Structural Unemployment
• Joblessness arising from mismatches
between workers’ skills and employers’
requirements
– Or between workers’ locations and employers’
locations
• Generally a stubborn, long-term problem
– Often lasting several years or more
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Cyclical Unemployment
• When the economy goes into a recession and total output falls, the
unemployment rate rises
• Since it arises from conditions in the overall economy, cyclical
unemployment is a problem for macroeconomic policy
• Macroeconomists say we have reached full employment when cyclical
unemployment is reduced to zero
– But the overall unemployment rate at full employment is greater than zero
• Because there are still positive levels of frictional, seasonal, and structural
unemployment
• How do we tell how much of our unemployment is cyclical?
– Many economists believe that today, normal amounts of frictional,
seasonal, and structural unemployment account for an unemployment rate
of between 4 and 4.5% in United States
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Figure 3: U.S. Quarterly
Unemployment Rate, 1960–2003
31
The Costs of Unemployment:
Economic Costs
• Chief economic cost of unemployment is the opportunity
cost of lost output
– Goods and services the jobless would produce if they were working
– But do not produce because they cannot find work
• The unemployed are often given government assistance
– Costs are spread among citizens in general
– However, when there is cyclical unemployment, nation produces less
output
• Some groups within society must consume less output
• Potential output
– Level of output economy could produce if operating at full
employment
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Figure 4: Actual And Potential Real
GDP, 1960–2003
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Broader Costs
• Unemployment—especially when it lasts for many
months or years
– Can have serious psychological and physical effects
– Also causes setbacks in achieving important social
goals
• Burden of unemployment is not shared equally
among different groups in the population
– Tends to fall most heavily on minorities, especially
minority youth
34
How Unemployment is Measured
• The unemployed are those willing and able to
work, but who do not have jobs
• Others were able to work, but preferred not to
– Including millions of college students, homemakers,
and retired people
– Still others were in the military and are counted in the
population
• But not counted when calculating civilian employment statistics
• To be counted as unemployed, you must have
recently searched for work
– But how can we tell who has, and who has not, recently
searched for work?
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The Census Bureau’s Household
Survey
• Every month, thousands of interviewers from United
States Census Bureau—acting on behalf of the U.S.
Bureau of Labor Statistics (BLS)—conduct a survey of
60,000 households across America
– Household members who are under 16, in the military, or currently
residing in an institution like a prison or hospital are excluded from
survey
• Official unemployment rate
– Percentage of the labor force that is unemployed
Unemployme nt rate 
Unemployed
Unemployed

Labor Force (Unemploye d  Employed)
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Figure 5: How BLS Measures
Employment Status
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Problems In Measuring
Unemployment
• Many economists believe that our official measure
seriously underestimates extent of unemployment in our
society due to
– Treatment of involuntary part-time workers
• Some economists have suggested that involuntary part-time workers
should be regarded as partially employed and partially unemployed
– Treatment of discouraged workers
• Individuals who would like to work but, because they feel little hope of
finding a job, have given up searching
– How many discouraged workers are there?
» No one knows for sure
• Still, the unemployment rate—as currently measured—
tells us something important
– Number of people who are searching for jobs, but have not yet
found them
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Figure 6: Employment Status of the
U.S. Population—June 2003
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GDP After September 11
• On September 11, 2001, United States suffered an
unprecedented terrorist attack
• What would happen after September 11?
– Would the recession deepen?
• How badly?
– Could the economy actually tilt into a depression?
– What was the appropriate economic policy, and how should it be
orchestrated?
• Helpful to distinguish between
– Direct impact of GDP
• Direct result of destruction itself
– Indirect impact
• Resulting from choices of economic-decision makers in the weeks,
months, and even years following the attack
40
The Direct Impact On GDP
• At first, it seems that the direct impact of the
attacks on GDP should be huge
• GDP is not designed to measure the
resources at our disposal, but rather the
production we get from those resource
– The destruction caused by the terrorist attacks
of September 11 had almost no direct impact
on the U.S. economy or U.S. GDP
41
Indirect Impacts on GDP: The Short
Run
• Indirect losses to GDP were significant
• Useful to distinguish between
– Short-run impact
• Weeks and months following the attacks
– long-run impact
• We’ll be experiencing for several years
• Did not take long for aftermath of attacks to affect
economic decision making
– Federal government immediately shut down airports
nationwide for more than 48 hours
• With fewer people flying, hotel occupancy rates also
decreased—by about 20%
• Problem spread to manufacturing and raw materials sectors of
the economy
42
Indirect Impacts on GDP: The Short
Run
• Consumers made other decisions that affected
production
– Instances of increased production
– But these increases in production were swamped by
production cuts already rippling through the economy
• GDP did a good job of capturing all of these
changes in spending and production
– Bureau of Economic Analysis reported that production
turned southward in the third quarter of 2001
• With much of the decline occurring during the three weeks of
the quarter that remained after September 11
43
The Long-Run
• In the weeks following the attack, it became clear that U.S.
was about to start on a course it would follow for many
years
– Huge reallocation of national resources toward fighting terrorism
abroad and achieving greater security at home
• Some of these resources are being purchased by the
government
• Over the next two years, U.S. spent billions of additional
dollars pursuing a more aggressive foreign policy including
– Invasion to overthrow regime of Saddam Hussein in Iraq
– Increased aid to allies—and potential allies—in war against
terrorism
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The Long-Run
• But private businesses have been spending more
for security each year than they did before
• All these security expenses are slowing growth of
our potential output
– Therefore slowing growth of real GDP over long-run
– In long-run, as the nation shifts production away from
other goods and services and toward security in the
wake of September 11, impact on real GDP will be
negative
– Potential output—and over the long-run, actual output—
will grow more slowly than it otherwise would have
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