Download Output Market: Output and the Price Level

Output Market: Output
and the Price Level
"[b]y the curious standard of the GDP, the nation's hero is a terminal
cancer patient who is going through a costly divorce."
Overview
Let’s start with two seemingly simple questions.
1. Who is better off - you, your parents, your grandparents, or great grandparents?
2. In what country would you want to live because of its high standard of living?
If you could choose, where and when would you live? It turns out these are not easy questions to answer.
What do use as a guide in making the choice? Is it income and earnings, education, political freedom, war
and peace, education, or maybe health reflected in average height, weight, or life expectancy? All of these
affect what we would call our standard of living, and each of us would value them differently. For example,
in revolutionary America it was “give me liberty or give me death,” while in modern China it is, “Give me
liberty or give me growth.” The French, meanwhile, have accepted less income as the price of more leisure,
and Americans have accepted greater economic anxiety as the price of faster growth.
In many respects asking which country is the best is similar to asking what is the best college football team,
or the best university, and in each case a "magic" number has been produced to answer the question. In
college football we measure teams by their BCS ranking, in college it would be US News’ National
University Rankings, and for economies it tends to be Gross Domestic Product (GDP). None of these is
perfect because it is extremely difficult to come up with single measures of performance, especially when it
is an economy with hundreds of millions of people and millions of firms.i
One argument for using GDP is a strong correlation between it and many other performance indicators. For
example, below is a scatter diagram with GDP per capita and life expectancy that clearly indicates a
positive relationship – as GDP per person rises so does life expectancy, although there does seem to be an
upper limit to life expectancy. The impact of AIDS on life expectancies in some sub Saharan countries,
such as South Africa, is also evident. These countries have lower life expectancies than expected based on
GDP per capita.
1
There are, however, some challenges to the use of GDP and GDP per capita as the macro economy’s
primary performance indicators. China, for example, is recognized as an economic “rock star” because of
its ability to sustain over decades GDP growth in excess of 10%, but there are growing questions about the
value of GDP as an indicator of well-being. There have been numerous articles with headlines like, “GDP
per capita record masks economic woes, didn’t transform lives: experts,”ii and “Cost of Environmental
Damage in China Growing Rapidly Amid Industrialization.”iii In a 2010 report that cost was estimated at
3.5% of GDP, although there is reason to believe it is a low estimate. A World Bank study a few years
earlier pegged the cost of just air and water pollution at nearly 6% of GDP.iv There have also been
challenges to GDP’s dominance by those offering alternative measures that get closer to happiness and to
well-being, an example of the latter being the Social Progress Index.
Production - GDP
Definition
The National Income and Product Accounts (NIPA) provide the framework for generating estimates of
Gross Domestic Product (GDP) that is defined as: the market value of final goods and services produced
annually within a country. It turns out each term in this definition is there for a reason and if we look
briefly at each of the terms we will have a better sense of what GDP is - and what it is not.v
GDP is the market value ... GDP is simply the weighted sum of output from all sectors of the economy,
where output is valued at market prices. If market prices reflect what people pay for goods and services,
then prices must reflect how people value them. If you pay $16 for a CD and 10 CDs are produced and sold
at that price, then $160 worth of value has been created.
GDP is the market value of final ... Let's assume you have a summer job in a factory producing CD ROMs
to be used to store computer software. The manufacturer sells the CDs to the software company for $10,
and the software company adds the software instructions to the CD and sells it for $50. The $10 would be
considered an intermediate product and would not be included in GDP. The only final good would be the
CD with the software sold to the computer user for $50. [Note: we could also calculate GDP by looking at
the value added of each producer. The CD maker adds $10 in value assuming the material to produce the
CD and the software maker adds $40 ($50-$10), so the entire operation adds $50 - precisely the value of
the final goods produced.
GDP is the market value of final goods and services ... Included in GDP are the values of goods, such as
the cars you drive, and the value of services, such as the education and medical treatment you receive this
semester. There was a time when nearly all people were employed in agriculture - the time of Plimouth
Plantations - but the agrarian life gave way to the industrial life reflected in the mills you see in Pawtucket
and Fall River - and that is giving way to a post-industrial or information age economy where growth will
be in the production of services.
GDP is the market value of final goods and services produced ... There are a number of things we buy that
are not the product of current production and are thus excluded from GDP. Missing from GDP calculations
would be the value of the sales of existing homes, used cars, and antiques, although the sales commissions
are included because they represent payment for a currently provided service. Similarly, when you buy
stocks, bonds, or mutual funds, only the commissions / fees would be included in GDP because there is no
production directly involved.
GDP is the market value of final goods and services produced annually ... . GDP is defined as the value of
goods and services produced during a year, although the data is tabulated and reported four times a year.
What would be reported for the first quarter of 2007 would be the value of what would be produced for the
year if the rate of production that existed during January, February and March were maintained for the
entire year.
2
GDP is the market value of final goods and services produced annually within a country... The work of
Juan, a Mexican national who works in the fields of Southern California helping to harvest a crop of
avocados would be included in GDP while the value created by Mary, a native of Boston working in
Germany for IBM would not be included.vi
Regardless of what you look at, you need to recognize the fact they are both measures of value and
therefore, as we saw in the Data Analysis unit, we need to be careful to adjust the data for price changes, so
now let's look at the adjustment.
Real vs. Nominal GDP: Correcting for price changes.
Because GDP is the price-weighted sum of all "stuff" produced, GDP can rise if prices rise or if output
rises, and there is a substantial difference between the two since in the first you simply have higher prices,
while in the second you have more "stuff." To separate the two effects the Bureau of Economic Analysis
(BEA) calculates two measures of GDP.vii Current-dollar GDP (Nominal GDP) is calculated using actual
prices, while Constant-dollar GDP (Real GDP) is calculated using constant prices. viii
The difference between the two GDP measures is evident in the table and graph below that are based on
BEA web site data. Based on the nominal GDP data, the 1970s looks like the period of most rapid growth about 10% a year - but this is wrong because no adjustment has been made for inflation, and as you saw
earlier, the US experienced rapid inflation in the 1970s. It turns out that the major share of the increase in
GDP came from rising prices rather than actual output. In the graphs below the table you see that the 10.4%
per year nominal growth is only a 3.2% per year rise in real GDP. This adjustment reveals that the fastest
growth was in the 1960s when the growth rate exceeded 4% per year, while the slowest was the 2000s
when growth averaged approximately 2.5% a year.ix
Current $ and Constant $ GDP
1950
1960
1970
1980
1990
2000
2006
Current GDP
(Billions $s)
293.8
526.4
1,038.50
2,789.50
5,803.10
9,817.00
13,246.60
Real GDP (Billions of
2000 $s)
1,777.30
2,501.80
3,771.90
5,161.70
7,112.50
9,817.00
11,415.30
It is real GDP that should be used when examining changes in the size of the economy,
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Decomposition of GDP: If you demand it, they will build it.
There are three approaches to measuring GDP: who produces it, who earns the income generated in the
production process, and who buys it. Of the three approaches, the last is by far the most popular and the one
on which we will focus. The key concept is Aggregate Demand that equals the sum of spending by
households (consumption spending (C)), by businesses (Investment spending (I)), by governments
(Government spending (G)), and by foreigners (Export spending (X). But, because some of that spending is
on goods imported into the US, we subtract the value of spending on imports (-M) to get aggregate demand
for domestic production.
GDP = (C + I + G) + ( X - M)
The breakdown of aggregate demand in the US economy in 2009 appears in the chart below. What is clear
is the importance of consumption spending - averaging approximately 71% of GDP, which is higher than
the longer-term average of approximately 2/3rds.
In the chart below the rising importance of consumption in the US is evident as is the fact that the US’s
share of GDP devoted to consumption is higher than the share of the other rich countries (Japan and
Germany) despite the fact that Japan’s rapid growth in the 1960s and 1970s was fueled in part by
consumption’s increasing share of GDP. As Japan’s economy boomed the Japanese people consumed an
increasingly large share of GDP, while in China there was a sharp decline in consumption’s share of GDP –
from 63% to 37%. This falling consumption share is the result of a high savings rate and indicates that the
Chinese people have not been the primary beneficiaries of the economic growth that China has experienced
since it opened up to the west in 1979.
One of the features of the post WWII world economy has been the “explosion” in international trade, which
is very evident in the chart below. In all of the selected countries there has been an increase in the share of
GDP accounted for by exports, which reflects the globalization process. Export's share of GDP in the US
has more than doubled (6% to 13%), while imports share more than tripled (5% to 18%), with the majority
of the increase coming only after 1970, which explains the rise in the US balance of trade deficit and may
help explain the upward trend in long-term unemployment rates in the 1970s and 1980s. Internationally, the
spread of globalization shows up in across-the-board increases in the share of GDP accounted for by
exports and imports, with the biggest increases were in Germany, Mexico and China. In Germany,
Europe’s biggest economy, exports account for 47% of GDP, which was the highest among the selected
countries, while in China exports have been the driver behind its remarkable growth economic growth. In
this 38-year period, exports’ share of GDP in China rose from 3% to 38%, slightly faster than imports’
share of GDP, which is reflected in China’s balance of trade surplus. The growth in Mexico’s share
partially reflects the impact of passage of NAFTA in the early 1990s, while China’s share reflects the
decision of Deng Xiaoping to open China to the world in 1979.
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Government's' share of GDP in the US, meanwhile, is slightly lower in 2006 from what it was in 1960,
rising through 1980s and then falling thereafter - the result of the "Reagan revolution."
International comparisons
GDP is often used as a basis for comparing the performance of the US economy with that of other
countries, and The World Economic Outlook Databases allows you to create your own tables for
international comparisons. At that site you will find that GDP 2013 was 318 billion Euros in Austria and
183 billion euros in Greece, 57,716 billion Yuan in China GDP, 110,701 billion rupees in India, and
$16,237 billion dollars in the US. Unfortunately, these numbers are virtually meaningless for two reasons.
First, these figures are in domestic currencies, so we would need to convert them to a common currency to
make any international comparisons in the size of the economies. Second, if we were looking for
differences in the standard of living – something similar to average income – we would want to look at per
capita GDP.
The first step toward making international comparisons would be to generate the GDP in US $s, which is
the data that appears in the second column in the table below. Once they are converted to a common
currency, we see the value of GDP in Austria is approximately 3% of GDP in the US, while India’s
economy is 12% of the US economy. China’s economy, meanwhile, is four times the size of India’s and
about 56% the size of the US economy.
But, China has about 1.3 billion people, while in the US there are slightly more than 300 million, so to
compare the standards of living in the countries we need to account for the differences in the number of
people. We do this with GDP per capita that is simply GDP divided by the population, and it provides a
very different “picture.” Austria’s economy was only about 1/3rd the size of India’s, but given the
population differences, real GDP per capita in Austria is nearly 30 times that in India when measured in US
$s. In China, the economy was more than half the size of the US, but because of the larger population
China’s GDP per person is only $6,628 – about 13% of the US figure.
Alternative Measures of GDP: 2013
Austria
China
Greece
India
US
GDP in domestic
currency
318.199
57,715.87
183.47
110,701.95
16,237.75
GDP in US $s
422.894
9,020.31
243.836
1,972.84
16,237.75
GDP per capita in
domestic currency
37,504.36
42,414.33
16,286.74
89,328.97
51,248.21
GDP per capita
in US $s
49,844.20
6,628.86
21,645.47
1,591.95
51,248.21
Source: IMF
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There is still a problem, however, because there is no account for price differences in the two countries, and
these price differences can be quite large. The Economist magazine publishes the Big Mac Index that is
described in a note at the end of this section. According to the Index, in January 2013 it cost $4.37 to buy a
Big Mac in the US, while it cost 16 Yuan to buy it in China and 3.59 euros to buy it in Europe’s euro area.
What really matters to me when I am traveling, though, is what it costs in US Ss. I knew when I was
traveling in China that things were cheaper than home, and I also knew Europe was not cheap, both of
which are reflected in the last column of the table. That Big Mac in China actually cost only $2.57, while it
cost $4.88 in Europe and $2.54 in Taiwan based on the exchange rates at that time. This is why, as we will
see in a later unit, there has been such a heated debate between the US and China over the appropriate
exchange rate. The US claims the rate is too low so that China’s prices are too low and this makes US
goods uncompetitive, which leads to the trade deficit. If that Big Mac is so ‘cheap,’ so will be the
electronics and clothes.
Big Mac Prices: January 2013
Price in domestic
currency
United States
Price in US
$s
4.37
4.37
China
16.00
2.57
Japan
320.00
3.51
75.00
2.54
3.59
4.88
Taiwan
Euro area
Once you acknowledge the differences in prices, then there is a problem with the international comparisons
specified above, which is precisely the same problem we have when comparing the wages of someone in
Kingston, RI with someone from Anchorage, Alaska. Prices are notoriously high in Anchorage, so the $
does not go as far and simple comparisons of salary would not be very useful to someone considering a
move. According to the online calculator at MySalary.com, the cost of living in Anchorage is 11.3% more
than in RI, so if you moved to Alaska from RI for the same salary, it would seem like a loss in income of
about 10%.
To account for differences in prices there is a second set of GDP numbers - the purchasing power parity
GDP (PPP) figures.x Its back to The World Economic Outlook Databases, and as you see below, the
rankings can be quite different. The US numbers are the same in all columns because in the second and
third columns GDP data are specified in US $s. In the table you see that the GDP figures for Greece and
Austria are close for the two measures suggesting that the purchasing power of a US $ is comparable in
these countries – that the Big Mac will be close to the $4.37 cost in the US. In Austria the PPP GDP figure
is below the US $ GDP figure indicating higher prices in Austria, while in India and China the opposite is
true.
So how big is China’s economy? If we adjust our GDP data to account for the lower prices in China,
China’s economy is 84% of the US economy, a significant increase over the 56% when using the exchange
rate conversion.
Alternative Measures of GDP: 2013
GDP national
currency
Austria
China
Greece
India
US
318
57,716
183
110,702
16,238
GDP US $
423
9,020
244
1,973
16,238
GDP PPP $
368
13,623
270
5,032
16,238
% of US in
GDP US $
3%
56%
2%
12%
100%
% of US in
GDP PPP $
2%
84%
2%
31%
100%
6
Now let’s look briefly at the historical track record of the US.
The track record: US
1.
2.
3.
The long-term upward trend in GDP is quite evident in the first graph. The two most pronounced
deviations from the trend are in the 1930s, when output was below trend during the Great Depression,
and the 1940s, when it was above the trend during WW II.
The short-term fluctuations are best seen by converting annual GDP data to annual percentage change
that appears in the second graph. One striking feature is the change that takes place around
1950. Before 1950 volatility in GDP was substantially higher than in recent years - with years of
double-digit increases and decreases - far higher than anything that we see in the post 1950 period. The
economy has become more stable since 1950.
The fastest growing components of Aggregate Demand have been import spending (M) and export
spending (X) that increased by approximately 300% and 233% between 1990 and 2008, just before the
Great Recession devastated both. Between 2008 and 2009 imports to the US dropped 23%, while
exports dropped 15% - in one year. Since 1960 there were few instances where exports and imports
actually declined, and in the steepest decline in 1982, exports fell 7% while imports dropped 5%. The
most stable components have been government spending (G) and consumption spending (C), although
the Great recession had an impact on both of these two components. Since 1960 neither consumption
nor government spending had never declined year-to-year, but in the Great Recession consumption fell
while government spending leveled off. The most volatile component, as you can see in the downturn
in the Great Recessions was investment spending (I) that declined nearly 20% between 2008 and 2009.
The track record: International
1.
Economic growth in the Middle East, which includes many of the major oil producing states, was
closely tied to the price of oil. In the 1980s when the price of oil was low, GDP grew slowly, while in
the 2000 when the price rose sharply, so did GDP growth rates.
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2.
3.
4.
5.
6.
The 1980s was also difficult for Latin America. The growth rates in GDP fell by almost two-thirds
from the 1970s as the continent weathered the Latin American Debt Crisis in the early 1980s. Many
Latin American countries plus Mexico had borrowed BIG money in the 1970s, and when the recession
hit in the early 1980s they could not pay their bills, beginning with Mexico in 1982. As lending to the
region collapsed so did their economies, which is reflected in the very slow growth in the decade – not
enough to offset the population growth.
Growth in the wealthy European Union was notably slower than the rest of the advanced countries in
the 1980s and 1990s, but the gap closed in the 2000s.
The 1990s was not kind to the Commonwealth of Independent States – the countries that formerly
belonged to the Soviet Union. Annual GDP growth in the 1990s averaged -6% as they struggled with
the conversion from communism to capitalism.
Asia was clearly THE success story. Newly industrialized Asian economies (think Hong Kong, Korea,
Taiwan) and Developing Asia (think China and India) sustained real GDP growth rates of 7% a year –
more than twice as fast as the advanced countries (think Europe, US and Japan) and fast enough to
double GDP in a decade).
Africa's growth lagged that of the other developing countries for the 1980s and 1990s, but by the 2000s
they had growth rates that equaled that of other developing economies, in large part driven by the
growing world demand for natural resources that are abundant there. .
For those interested in data for individual countries, you should check out the IMF's World Economic
Databases or a summary of some of the more notable features of world economic growth.
Real GDP (annual % change)
1980s
1990s
2000s
Advanced economies
Newly industrialized Asian economies
3%
8%
3%
6%
2%
4%
European Union
Emerging and developing economies
Central and eastern Europe
Commonwealth of Independent States
Developing Asia
Latin America and the Caribbean
Middle East and North Africa
Sub-Saharan Africa
2%
3%
2%
6%
7%
2%
1%
3%
2%
4%
2%
-6%
7%
3%
4%
2%
2%
6%
4%
6%
8%
3%
5%
6%
Now that you know the “facts” concerning GDP, let’s look a little closer at what we are really measuring
sine there are a number of limitations with the way we measure the size of the economy.
Limitations
This looks pretty easy, and reasonable, and to politicians and policy makers talking about GDP, size
matters. Bigger is definitely better, and when this accounting system was merged with Keynes'
macroeconomic theory, GDP became enshrined as a key barometer of economic prosperity even though it
is at best an imperfect economic well-being, a point emphasized in Cobb, Halstead, and Rowe's Atlantic
Monthly article: "If the GDP is Up, Why is America Down? When I think of GDP I think of a statement I
once read that went something like this: "All that is important is not measured, and all that is measured is
not important." GDP is an important measure, but there are many things included in it that a reasonable
person would not look at as a "good", and there are many things left unmeasured that affect one's well
being, and now we will examine some of the limitations of GDP as a measure of welfare.
1.
Nonmarket activities: In a country such as the US many services are provided outside of the market
and are therefore excluded from GDP calculations. "[L]left out two large realms: the functions of
family and community on the one hand, and the natural habitat on the other."xi There is no question
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2.
3.
4.
5.
value is being created by a mother at home raising kids, but this value does not show up in GDP. The
result is that as "parenting becomes child care, visits on the porch become psychiatry and VCRs, the
watchful eyes of neighbors become alarm systems and police officers, the kitchen table becomes
McDonald's - up and down the line, the things people used to do for and with one another turn into
things they have to buy,"xii GDP rises indicating that GDP growth has been biased upwards over the
second half of the 20th century as a result of the movement of women into the workforce - GDP has
risen faster than output in this period.xiii This also raises questions about comparisons of GDP in the
US over long periods of time, and questions about GDP comparisons among nations with very
different patterns of market and nonmarket activity.
Illegal activities: You most likely all know people who "work under the table" because they want to
avoid the IRS and paying taxes, the INS because they are illegal immigrants, or law enforcement
agencies because they are conducting illegal activities such as illegal gambling, prostitution, and
drugs. These activities, which are often described as the underground economy or informal economy,
are substantial - but hard to measure. One ambitious effort at creating international comparisons found
Africa and Latin America at the top of the list with the informal economy averaging about 42 % of
GDP, and the Transition Countries where the average was 38%.xiv Among the world's wealthier
countries, the 20 OECD countries, the average was 18%, ranging from 27% in Greece and 27% in Italy
to 9% in Switzerland and the US. What was also clear in the study was that the informal economy, at
least in the wealthier OECD countries, grew substantially in the 1990s, and that the size of the informal
economy is affected by tax rates, the extent of industry regulation, and the rule of law.
Leisure: There is no question leisure is a good - more leisure is preferred to less - and individuals are
often willing to trade off work and income against leisure. Given that people chose to take the time off,
they are better off by doing it, but GDP would go down in this situation. This certainly seems relevant
in light of the substantial differences between the average workweek across different countries. The
US Bureau of Labor Statistics compiled the average annual hours worked per employee that is
available at A Chartbook of International Labor Comparisons (2010 Edition). Workers in the US
worked substantially more hours than workers in Europe.xv In 2008 Americans worked 1792 hours more than 30% more hours than workers in Norway, 25% more than workers in Germany, and 15%
more than workers in France. Americans did work substantially fewer hours than workers in Korea –
23% less - and about the same as workers in Japan.xvi If you want to read a little more about the
American worker's workweek, you should check out The Overworked American by Juliet Schor.
Inequality and Aggregation: Consider the situation where we have two countries with ten people each.
In Country A you have an equitable distribution of income and between years 1 and 2 all the people
experience a 10% increase in income so the per capita (per person) figure provides useful insight into
what has happened to the economic condition of the people in Country A. The same cannot be said in
country B where the reported per capita growth would be the same 10%, except here one person
experienced a 14% gain while the other 9 experienced a 10% cut in income. In this case the reported
10% increase is virtually meaningless.xvii When looking at "real" world data, the income in the US is
more inequitably distributed than the other wealthy countries, so caution must be exercised when doing
international comparisons of the living conditions of the "average" individual. The growing inequality
of the US in the last twenty years of the 20th century, meanwhile, also limits the ability to look at
growth in average GDP per capita as a useful indicator of changes in standard of living.
Bads: Because of the nature of the GDP calculations, "[i]t does not distinguish between costs and
benefits, between productive and destructive activities, or between sustainable and unsustainable ones.
The nation's central measure of well being works like a calculating machine that adds but cannot
subtract."xviii Given this system, a natural disaster can provide a boost to the economy in much the
same way as a war. An example would be the boost to GDP given by the recovery efforts following the
destruction of hurricane Andrew, or the economic growth in Germany and Japan in the 1930s as they
mobilized for war. These "bads" would tend to push up GDP as long as the hurricane devastated
primarily residential areas, as Andrew did, or the wars are fought in other countries, which was not the
case in Yugoslavia, the Congo, and Rwanda where wars in the 1990s had a devastating effect on the
economy. The nature of GDP computations also means the enormous sums spent on security tend to
push GDP higher, as we saw following the bombing in Oklahoma City that gave the economy a little
boost as it generated demand for security systems. While it may be a bit of an overstatement, "[b]y the
curious standard of the GDP, the nation's hero is a terminal cancer patient who is going through a
costly divorce."xix
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6.
7.
Environment and natural resources: GDP is to the national economy what annual income is to you,
and as you know, income alone is an incomplete measure of your well-being.15a For example, consider
the situation of two people who live on annual incomes of $50,000. The first person has a job that pays
an annual salary of $50,000, while second has savings of $500,000 that is reduced each year by a
withdrawal of $50,000 used to live. Each has $50,000 to live on, but for the second person the
withdrawals from the account are not sustainable. We have a similar situation when we look at GDP.
Every country possesses an endowment of natural resources that can generate annual income and an
environment that sustains life, and changes in neither of these are accounted for in GDP. If you are a
Middle Eastern oil producing nation, GDP might be quite high due to the revenues from selling oil, but
the oil is running out and the GDP figures would not reflect the fact that you have a country that is
selling off its assets and leaving nothing for future generations.xx
Also included under this limitation would be the pollution of the environment. When the
nation spends $300 billion to clean up pollution, this shows up in GDP, but this expenditure is
quite different from $300 billion spent on computers. This spending on clean up is not an
increase in welfare in the sense that two countries with similar levels of pollution, one that
attained it with $300 billion of clean-up costs and the other that spent nothing because it
created no pollution, would be expected to have similar levels of well-being, although in the
first GDP would be $300 billion larger. And if things get really dirty as a result of pollution
and you have to paint your house more often or seek medical treatment more often, then this
pollution will give GDP a further boost. The limitations of this can be seen in the "haze" that
blocked the sun in much of Southeast Asia in the summer of 1997 - pollution produced as a
by-product of the rapid economic growth. This point was emphasized by Barber Conable,
then president of the World Bank, who in 1989 acknowledged that: "Current calculations
ignore the degradation of the natural resource base and view the sales of nonrenewable
resources entirely as income."xxi According to Herman Daly, a former World Bank economist,
"the current accounting system treats the earth as a business in liquidation." The depletion of
natural resources is completely ignored in the national accounts, which makes sense only
when the supply of resources is unlimited.xxii
New Goods and Quality Changes: For new goods consider the situation in early 1980s after the
personal computer had been introduced, but the government was still using the base year of 1972 when
there were no personal computers.xxiii To calculate the price changes of computers the government
assumed the prices would rise at the same rate as that for typewriters. In fact, computer prices rose
much slower than typewriter prices so when the revisions were made to GDP after the new base year
was established in 1982, real GDP was revised upward. A similar problem exists when we talk about
quality. All computers are not created equal - and neither are all cars. In fact, personal computers have
not been around all that long, which made it difficult for the "bean counters" to calculate the price of
computers backwards. Furthermore, a computer today is very different from a computer in 1990, and a
car today is also very different. The computer in 1990 would have had an Intel 486 microprocessor
with 1.18 million transistors, but by 2000 it would have contained the Pentium 4 processor with 42
million transistors. You would also have access to the web with a web browser, which you didn't have
back in 1990. If you look at cars, you find a similar situation. Today's cars drive longer without a need
for servicing, the stereo systems are much better, as are the heating and steering systems, and on some
cars you even have GPS so you can't get lost. The problem is, do you attribute the price increase to
higher prices for the same good, or similar price for more good. If you opted for the second, you would
find GDP to be higher. This limitation of GDP was well known to Kuznets who wrote in a 1962 New
Republic article that "[o]nce you start asking 'what' as well as 'how much' - that is, about quality
instead of just quantity - the premise of national accounts as an indicator of progress begins to
disintegrate, and along with it much of the conventional economic reasoning on which those accounts
are based."
Alternatives
Given all of these limitations, it should be no surprise that there has been interest in alternative measures of
well being that can be traced back at least to Robert Kennedy statement in 1968.
10
Gross Domestic Product does not allow for the health of our children, the quality of their
education, or the joy of their play. It does not include the beauty of our poetry or the strength of
our marriages, the intelligence of our public debate, or the integrity of our public officials. It
measures everything, in short, except that which makes life worthwhile, and it can tell us
everything about America, except why we are proud that we are Americans.
By the early 1970s economists Nordhaus and Tobin developed Measured Economic Welfare (MEW), but it
never gained much popularity.xxiv An alternative approach was taken by Richard Easterlin who identified
alternative measures of quality of life / or standard of living.xxv One of the possibilities was health, which
makes sense since you would consider a healthier life to be a better life. Since the 1940s we have seem
most of the major diseases, at least in the world's wealthy countries, controlled so there has been little
concern about crippling polio or deadly plague that were ever present dangers for older
generations. Imagine the pain in a world with no Novocain or ether. A good indicator of how health, and
health care, has changed is the following description of the treatment someone in 1826 in Philadelphia
would have received for chills and pains in the neck and head.
he was bled till symptoms of fainting came on. Took an emetic, which operated well.
For several days after, kept his bowels moved in Sulp. Soda, Senna, tea, etc. Then he
employed a Physician who prescribed another Emetic...
This is a not an image I am too comfortable with, which makes me unlikely to go too far back in time when
given the chance. What I do know is many of these changes are reflected in biological measures. Life
expectancy statistics, for example, have risen sharply - from about 25 years in 1800 to about 66 years in
2000 - and as we saw earlier, GDP per capita is correlated with life expectancy.xxvi
A second possibility would be what Easterlin calls, Family Circumstances - what I might call individual
freedom and something with which the female readers should be able to readily identify. Imagine the
following description of a working-class woman's life at the end of the 19th century.
Their typical working-class mother of the 1890's, married in her teens or early twenties
and experiencing ten pregnancies, spent about fifteen years in a state of pregnancy and in
nursing a child for the first five years of life. She was tied, for this period of time, to the
wheel of childbearing. Today, for the typical mother, the time so spent would be about
four years. A reduction of such magnitude in only two generations in the time devoted to
childbearing represents nothing less than a revolutionary enlargement of freedom for
women.
Would you want to give up the freedom you have today to determine the number of children you have, and
how much of your life you devote to child rearing? As for an indicator, it is not easy, but maybe we could
use the fertility rate - the expected number of children a woman is expected to have in her lifetime. And the
fertility rate tends to drop as economies develop and as individual's income increases, which suggests that
the fertility rate does track other potential indicators of the "quality of life." It is no accident that countries
such as Afghanistan, Somalia, Yemen, and Saudi Arabia, where the rights of women are quite limited, all
have fertility rate above 6, among the highest in the world, while Japan and many European countries have
fertility rates below 2, which is why their populations are projected to decline. If you were a woman and
thinking about quality of life, then the fertility rate might be a good barometer when making the choice of
where and when to live.
It is a good deal easier to complain about GDP than to come up with an alternative, but the pressure is
mounting to identify some alternatives. In October of 2008 the New York Times reported on some of the
efforts in Economix
The Organization for Economic Cooperation and Development has studied its own G.D.P.
alternatives that take into account leisure. Others have proposed the Index of Sustainable
11
Economic Welfare, which factors in both pollution and income distribution, and the Genuine
Progress Indicator, which tries to determine if economic growth has improved a country’s welfare.
Alternative efforts try to supplement or supplant traditional income-based measures with
happiness-based measures. These include the Happy Planet Index, a Gross National Happiness
measure and work on National Well-Being Accounts, which our Daily Economist Alan Krueger
has studied extensively.
Here we will look briefly at some alternatives that fit into one of three categories – modifications of GDP,
direct measures of welfare, and composite indexes.
Modify GDP
The most obvious approach is to add some “goods” that GDP misses and subtract some “bads.” The first
attempt to modify GDP was the Measure of Economic Welfare (MEW) developed in 1972 and adjusted
GDP to account for the contributions of household and volunteer work and leisure and the costs of
pollution. In 1989 the Index of Sustainable Economic Welfare (ISEW) extended MEW to include
reductions for private defensive expenditures and the depreciation of natural capital, which resulted in
growth rates sharply lower than those of GDP. At the web site it describes its efforts as “an attempt to
measure the portion of economic activity which delivers genuine increases in our quality of life - in one
sense 'quality' economic activity,” and in fact if you go to that site you can generate your own indexes by
changing the weighting scheme for the 19 “adjustment terms built into ISEW” to reflect your preferences.
In 1993 the Bureau of Economic Analysis began constructing Environmental Satellite Accounts as part of
President Clinton’s call for green GDP measures, but Congress banned them in 1994, and in 2007 China’s
political leaders banned the publication of green GDP figures that were developed the preceding year
because of a substantial loss in economic growth.
In 1989, Barber Conable, president of World Bank, proclaimed that “Current calculations ignore the
degradation of the natural-resource base and view that the sales of nonrenewable resources as entirely
income … A better way must be found,” and the World Bank has made an effort to modify GDP to better
capture the environment missing in GDP data. The information is available at their Environmental
Economics and Indicators sitexxvii where you will find a set of environmental indicators including two
indicators linking the macro-economy and the environment - adjusted net savings and wealth. Adjusted net
saving is designed to measure the true saving rate in a country by accounting for investments in human
capital, depreciation of produced assets, and the depletion and degradation of the environment.xxviii Wealth
accounting, meanwhile, was designed to take account of the value, and depletion, of a nation’s resources produced, natural, and intangible capital.
Direct measures of well-being
In addition to modifying GDP there have been attempts to develop direct measures of well-being that tend
to be more subjective. Rather than compile data on how much “stuff” you consumed in a year, take a
survey and ask people how they feel about your current situation. At a personal level, a longitudinal study
that followed a sample of Harvard grads for 75 years attempted to do just that and found some interesting
results reported in “What makes us happy?”xxix At the national level, the idea gained some press when
English Prime Minister David Cameron announced in 2010 that a new well-being measure would be
developed that would better reflect how people were doing than GDP. The index “encompasses objective
prerequisites for achieving well-being, such as education, health, housing and income. Combined with
these, are more subjective measures of well-being which include a person’s sense of purpose, happiness,
and life satisfaction.”xxx
Cameron’s effort was not the first. That distinction goes to Bhutan’s creation of Gross National Happiness
that was based on a survey of people’s level of well-being. Since then there have been other efforts that are
chronicled at the World Database of Happiness that contains a compilation of studies on happiness and
quality of life. As with life expectancy, there is a positive correlation between GDP per capita and
12
happiness / satisfaction evident in the graph below. As GDP per person rises the percent of the population
reporting that they are very/quite happy rises, although it seems to level off at $20,000 with higher GDP not
producing higher happiness.
In 2008 there were two developments in this area. First, the Gallup-Healthways Well-Being Index was
developed to, according to their web site, “create the official statistic for measuring Americans' wellbeing.” It includes measures in six categories Life Evaluation, Emotional Health, Physical Health, Healthy
Behavior, Work Environment, and Basic Access. Second, President Sarkozy of France established a
Commission on the Measurement of Economic Performance and Social Progress that concluded “There is
no single indicator that can capture something as complex as our society” and suggested three alternatives
to GDP – a subjective measure (how do you ‘feel?” objective measures (health, education, political
voice…) and measures of sustainability. Two years later, the new prime minister of England, David
Cameron proposed that the Office of National Statistics measure the country’s ‘general well-being’ (GWB)
as a complement to GDP.
Composite indexes
The most widely known composite measure in the UN’s UN Human Development Index (HDI) that was
designed to capture a wide array of indicators that measure a country's performance on three dimensions - a
healthy life, knowledge, and standard of living.xxxi When comparing rankings based on the HDI and GDP
we find there are some differences in the rankings, but generally you have European countries and the US
at the top of the lists - Luxembourg and the US at the top when measured by GDP per capita and Norway
and Iceland when measured by HDI. At the bottom of both lists African countries, although the rankings
change a bit depending on the measure. In fact some as a weakness of the HDI sees the strong correlation
between the two variables because it seems to add little beyond GDP.
13
More recently we have the Social Progress Index of national well-being that “measures the extent to which
countries provide for the social and environmental needs of their citizens. Fifty-two indicators in the areas
of basic human needs, foundations of wellbeing, and opportunity show relative performance in order to
elevate the quality of discussion on national priorities and to guide social investment decisions.”xxxii
A third composite measure is the Happy Planet Index (HPI) that claims its goal as revealing “the ecological
efficiency with which human well-being is delivered,” which it does by creating an “index combines
environmental impact with human well-being to measure the environmental efficiency with which, country
by country, people live long and happy lives.” More specifically it contains data on three dimensions – life
expectancy, life satisfaction, and ecological footprint, and at the HPI web site you can find world maps for
each of the components plus the composite, which also appear at the end of the footnotes. And once again
there appears to be a relationship between GDP and the alternative measure – this time “happy life years.”
14
Now it is time to look at how we measure prices and inflation.
Prices - CPI
It wasn't easy to measure quantity, and it certainly is not going to be easy to measure prices, but it will
make it easier for you to understand the press if you note the distinction between the price level and the
inflation rate. The price level is a measure of the buying power of money at a point in time, while the
inflation rate is a measure of the rate of change in the price level. It is also important to recognize that all
price increases are not the same - and all price increases do not represent inflation. Prices change all the
time - maybe a bad harvest will drive up the price of wheat, or the decision by OPEC ministers to cut the
supply of oil will drive up oil prices, or technological improvements in the production of computers will
drive down computer prices. These are called changes in relative prices. It is only when the price increases
occur for a large number of goods that we would refer to it as inflation, and most often it would be a
concern to policy makers only if it was an increase that was sustained. In this section we will look at the
CPI (Consumer Price Index) – what it is, why it is so controversial, and what the track record has been
within the US and internationally.xxxiii The CPI is also used to calculate the inflation rate that you hear
mentioned so often. The inflation rate is simply the percentage change in the CPI for a year.
Definitions and measures
The Bureau of Labor Statistics (BLS) provides monthly estimates of the price level based on surveys of
household spending patterns. Once the spending patterns have been observed and an average "market
basket" of goods and services has been established, then every month BLS workers go shopping to
determine the cost of purchasing that market basket. According to the BLS:
The CPI market basket is developed from detailed expenditure information provided by
families and individuals on what they actually bought. For the current CPI, this
information was collected from the Consumer Expenditure Survey over the three years
1993, 1994, and 1995. In each of these three years, more than 5,000 families from around
the country provided information on their spending habits in a series of quarterly
interviews. To collect information on frequently purchased items such as food and
personal care products, another 5,00 families in each of the 3 years kept diaries listing
everything they bought during a 2-week period.
Once the shopping is completed, BLS releases data on the Consumer Price Index that is computed by
dividing the market basket's current cost by its cost during the base year (year of survey) and multiplying
by 100. For example, in November 2007 the CPI was reported as being 210 with a base year of 1982-84
(1982-84=100). This means that between 1983 and 2007 the price level rose approximately 110%.
Now that you understand what is behind the price indexes and inflation rates, it's time to see why policy
makers care so much about inflation and why the CPI is so controversial.
Costs of Inflation
It is easy to understand why we care about unemployment because we can relate to those unable to find
work, but why do we care about rising prices? Think about why you care about inflation before you read on
because there are real costs.
First, there are winners and losers with unexpected inflation, which is one of the major costs of
inflation. As a general rule unexpected inflation hurts those on fixed incomes and those who have lent out
money. If inflation doubles your food bill while that monthly pension check remains constant, then your
buying power and welfare have certainly been reduced. An example of this would be the excessive inflation
15
in Russia after the collapse of the communist system that eroded the buying power of Russia's
pensioners.xxxiv
Second, there are also "menu costs" - the costs of continually changing brochures and menus to update
prices. Resources that might have gone into the production of "stuff" now goes into the production of
menus.
Third, in periods of inflation it is difficult for decision makers to forecast prices and this is likely to result in
inefficiencies since wrong decisions will be made by those who fail to recognize the difference between
real and nominal values. In this situation, especially if the inflation rate is high or rising, you can expect
decision makers to be more cautious in decisions that involve longer horizons - a decision to buy a house,
to buy corporate stock, or to build a new factory being three examples. In the extreme case where there is
hyperinflation similar to what destroyed Germany's economy in the early 1920s, the entire economic
system will breakdown as money no longer has any value.
Fourth, inflation is also important because it shows up in contracts that have a cost-of-living escalator
clause (COLA). The best example of this would be Social Security. Recognizing the effects of inflation on
the buying power of earnings, the Social Security Administration adjusts benefits each year to keep benefits
rising with prices so the value of "real" benefits will remain unchanged. If prices rise 5% this year then
retirees checks rise 5% so the buying power of those checks does not change - they get 5% more that helps
them pay the 5% higher prices.xxxv Social Security offers an example of just such a contract. The benefits
next year (SS(2)) depend upon Social Security benefits this year (SS(1)) plus an adjustment reflecting
inflation (%DCPI).
SS(2) = SS(1)*(1+%ΔCPI)
So far so good, but there is one BIG problem. Most economists believe the official inflation rate based on
the CPI overestimates inflation, then we have BIG problems.29 First, as you can see in equation 1, if you
overestimate inflation then the official price index (CPI) is too high and your estimate of real (R) is too
low. Second, all COLA clauses would mean future payments would be higher than needed to keep a
person's cost-of-living constant. We will not get into the details of this debate, but you should be aware that
this is a BIG issue because SS is so expensive and controversial because of the power of the AARP that
represents the elderly whose membership will swell with the boomers reaching age 65.
What we'll do now is look at the domestic and international track record of inflation.
The track record: US
The two graphs below provide an overview of the history of inflation in the US, at least since the early
1800s. Here are a few observations based on the data.
1. The history of the price level in the US can be divided at WW II into two sub periods. In the pre WWII
period there is at best a minimal upward trend in the price level. The price level as the US entered the Great
Depression in 1930 was little different from what it was in 1820 - what appears to be a sustained period of
price stability. The only recognizable increases in the price level during that period were around the early
1860s and the late 1910s - the Civil War and WW I. Things changed considerably after WW II, however,
with the price level rising continuously after 1940, most notably during the 1970s.
16
The history of the price level in the US can be divided at WW II into two sub periods. In the pre WWII
2. The history of inflation in the US can also be divided at WWII into two distinct sub periods. In the pre
war period it is clear that what looked like stable prices was far from that. In fact it was characterized by
alternating periods of substantial inflation (rising prices) and deflation (falling prices) - hardly what would
be described as a period of price stability. In the Post WWII period, meanwhile, the period of sustained
increases in the price level was actually a mix of inflation and disinflation (declines in inflation rate). The
fluctuations occurred around an upward trend through the 60s and 70s and a downward trend in the 80s and
90s. Comparing these inflation data with the GDP data, we find the pre WWII era volatility of GDP was
matched by volatility in the inflation rate. GDP expansions were matched by inflation, and recessions were
matched by deflations. In the post WW II period, meanwhile, the greater stability in output was
accompanied by sustained, and less volatile, inflation.
3. Wars matter - at least historically. To finance wars governments tend to print money - lots of money and this shows up in higher prices reflected in higher rates of inflation, followed by deflation once peace
breaks out. The inflation rate during the Civil War (1860s) exceeded 20% a year - enough to double prices
in less than four years. During WWI prices also rose sharply, averaging greater than 15% a year for the
years 1917-1920, so that in the decade ending in 1920 the price level in the US had doubled. Things were
substantially different in WW II (1941-1945), in large part because of the imposition of rationing and price
controls during the war. Price increases during the war were modest, averaging less than 5% a year, but
once the war was over and controls were lifted, the pent up demand pushed prices sharply higher - 26% in
1946. Finally, during the Vietnam War (late 1960s) inflation began to trend upwards, a trend that continued
through the 1970s.
4. The state of the economy matters. Inflation tends to be higher during years of strong GDP growth and
low unemployment - and lower during bad years of declining GDP and high unemployment. The severe
recession of the late 1870s, 1890s, and the 1930s all show up in the inflation rate graph as periods of
deflation. It is important to note that even though there are costs of inflation, the costs are generally less
than when there is deflation. In the late 19th century the US experienced a decline in prices that led to the
Populist movement and the famous Cross of Gold speech of William Jennings Bryan as well as The Wizard
of Oz. What remains to be seen at a later time, is the nature of the causality - was it deflation that caused
the economy to slow, or was it the slow economy that pushed prices down.
5. Monetary policy matters. The only period of sustained peacetime inflation in the US occurred in the
1970s, a period when the US experimented with Keynesian monetary policy. The experiment turned out
badly and by the end of the decade the nation's central bank, the Federal Reserve, conducted a second
experiment. The links between the policies and inflation is the subject of the 1970s unit.
6. The inflation rates of the various components of the CPI market basket tend to move together because
they are subject to the same macroeconomic influences. What is also very clear from the diagram below is
the magnitude of the OPEC-induced oil price shocks in 1973 and 1979 when the inflation rate in the energy
category approached 40% and the extent of the collapse in the mid 1980s when energy prices fell about
20%. Oil prices rose again in 1990 during the Gulf War and again in 1996, before a fall in 1997 &1998 as
Asia struggled through the Asian crisis. Once the world economy recovered by the 1999 oil prices rose
sharply and continued to do so throughout most of the 2000s, pushed higher by the rapid growth in the
world economy/ Only the recessions in 2001 and 2008 drove prices down. Also evident in the graph is the
17
above average rate of inflation in the medical care category in the 1980s and 90s that prompted Bill Clinton
to initiate the process of reforming the health care industry.xxxvi
Before leaving the discussion of inflation, let's look a bit more closely at the inflation track record to see if
some patterns emerge.
The track record: International
Inflation rates by the late 1990s appeared to be under control in the US, but what was the track record
internationally. Let's begin with where you might find international inflation rate data. One place would be
the BLS, the agency responsible for the US inflation rate data. A second place would be The World
Economic Outlook Databases at the IMF. An examination of the data reveals the following "inflation
facts."
Average Inflation Rates: Consumer Prices
Country Group Name
World
Advanced economies
Major advanced economies (G7)
Newly industrialized Asia
European Union
Emerging and developing economies
Central and eastern Europe
Commonwealth of Independent States
Developing Asia
Latin America and the Caribbean
Middle East and North Africa
Sub-Saharan Africa
1.
1980s
16.2
6.3
5.5
6.6
9.0
43.6
30.6
9.6
136.3
11.8
16.6
1990s
18.3
2.9
2.6
4.8
9.3
57.5
69.5
372.3
8.6
129.2
11.9
28.0
2000s
4.0
2.0
1.9
2.0
2.5
6.8
12.2
13.9
3.8
7.1
6.8
10.4
Inflation rates in the advanced countries tended to rise in the 1970s and then fall in the 1980s, and
fall further in the 1990s and fall even further in the 2000s. Inflation rates in Europe have
converged in the 1990s, in large part the result of the move toward a common currency - the euro
– that involved meeting certain limits on inflation rates for those countries that were converting
their currencies to the euro in 1999. You also see that the northern European countries have tended
to have lower inflation rates and Germany has always maintained low rates. Within Europe,
Greece is the inflation rate success story in the 1990s. The inflation rate fell from 20% in the
1980s to 9.1% in the 1990s to 3.4% in the 2000s. Other success stories were in Portugal, Spain
and Italy where near double digit rates were eliminated.
18
Average Inflation Rates Euro Countries: Consumer Prices
Country
Austria
Belgium
Cyprus
Finland
France
Germany
Greece
Ireland
Italy
Luxembourg
Malta
Netherlands
Portugal
Slovak Republic
Slovenia
Spain
2.
1980s
1990s
2000s
3.4%
4.5%
4.9%
6.6%
6.3%
2.6%
19.6%
7.6%
9.8%
5.4%
2.2%
2.4%
17.2%
2.0%
2.0%
3.8%
1.9%
1.8%
2.3%
9.1%
2.6%
3.7%
2.2%
3.1%
2.3%
4.7%
9.3%
4.0%
1.8%
2.0%
2.4%
1.7%
1.9%
1.6%
3.4%
2.2%
2.2%
2.3%
2.4%
2.2%
2.4%
4.1%
4.1%
2.8%
Inflation rate were extremely high during the 1990s in the countries that were members of the
Soviet Union (Commonwealth of Independent States) at the beginning of the 1990s. The fiercest
bouts of hyperinflation were reported in Armenia in 1994 (5,273%), Georgia in 1994 (15,606%),
Turkmenistan in 1993 (3,102), Tajikistan in 1993 (2,194) and Ukraine in 1993 (4,734). Russia's
inflation peaked in 1992 and 1734%. As for the decade, the worst inflation rates were in
Turkmenistan and Belarus where the annual rate exceeded 320%, fast enough so that in the decade
a loaf of bread that cost 100 Manat in Turkestan in 1992 would cost 15.6 million Manat in 2000.
Average Inflation Rates CIS Countries: Consumer Prices
1990s
Armenia
Azerbaijan
Belarus
Georgia
Kazakhstan
Kyrgyz Republic
Moldova
Mongolia
Russia
Tajikistan
Turkmenistan
Ukraine
Uzbekistan
3.
4.
2000s
208%
149%
327%
151%
85%
85%
52%
121%
245%
346%
209%
164%
4%
7%
20%
7%
9%
7%
10%
9%
12%
14%
7%
11%
14%
Developing Asia has done a better job of controlling inflation than the rest of the developing
world. In the 1980s and 1990s, when inflation in the developing countries exceeded 43%, in
developing Asia it did not exceed 10%, and in the Newly industrialized Asia (Asian Tigers) it was
even lower.
Inflation rates were exceptionally high in Latin America during the 1980s as countries attempted
to deal with a crushing international debt burden. When confronted with large debts, the countries
turned to their printing presses and printed currency. The most virulent inflation in the region was
in the 1980s in Bolivia (210%) and Brazil (336%) and the 1990s (204%). In most of the countries
you also see inflation trended downward through the three decades with substantially lower
inflation rates in the 2000s in all countries with the exception of Venezuela. In Argentina the
inflation rate for all but one year in the 1980s was above 100%, and it peaked in 1989 at
3,100%. Other bouts of hyperinflation - above 1,000 % a year - were experienced in Bolivia in
1984 (1200%) and 1985 (12,000%), Peru in 1989 and 1990 (51,00% and 7,485%), and Brazil in
1989 and 1992-1994 when it ranged from 100% to 3000%). To give you some perspective on
19
these numbers and why hyperinflation is so debilitating, consider the plight of an individual in
Bolivia at the beginning of 1985 who purchased a loaf of bread for 100 boliviano. By the end of
the year that bread would have cost 12,000 bolivano.
Average Inflation Rates Latin America: Consumer Price
Country
Argentina
Bolivia
Brazil
Chile
Colombia
Ecuador
Mexico
Paraguay
Peru
Uruguay
Venezuela
5.
1980s
1990s
210.1%
336.3%
20.3%
23.6%
36.3%
65.1%
27.7%
60.6%
23.3%
2000s
15.7%
9.1%
204.4%
9.4%
20.0%
42.5%
18.3%
13.4%
38.0%
35.2%
43.3%
9.6%
4.7%
6.7%
3.3%
5.6%
8.2%
4.7%
7.8%
2.4%
8.7%
22.1%
Japan in the 1990s was actually experiencing deflation, which as we saw earlier in our discussion
of the US, tends to occur in tough economic times. This was not surprising in an era described by
some as the Quiet Depression.
What we can be certain of is that the government's measures of the output market will continue to undergo
revisions and that policy makers will continue to worry about inflation and GDP growth. Now it is time for
us to move from the description phase to the explanation phase of the course - to move from describing
periods of inflation or unemployment to explaining them.
20
MM Output Market
i
Ronald Reagan was very successful with the "Misery Index" that he "sold" as an indicator of a poorly performing
economy in the 1980 presidential election, something John Kerry could not duplicate in 2004 with his Middle-Class
Misery Index. Reagan's misery index was the sum of the inflation and unemployment rates, while Kerry combined
seven variables (median family income, college tuition, health costs, gasoline costs, bankruptcies, homeownership rate,
private-sector job growth) in his.
ii
Song Shengxia, “GDP per capita record masks economic woes, didn’t transform lives: experts,” Global Times,
February 23, 2013
iii
Edward Wong, “Cost of Environmental Damage in China Growing Rapidly Amid Industrialization,” NYT March 29,
2013
iv
Costs of pollution in China,” World Bank, February, 2007
v
Interest in "keeping the books" on the US economy developed during the Great Depression and over the years a
system of accounts has evolved that generates THE central measure of the economy's size. In 1931, as the depression
deepened, some leading experts were assembled before Congress and asked to answer some basic questions about the
economy - questions they could not answer because they had very little data. Congress attempted to remedy the
situation when the Senate assigned the Commerce Department the task of developing a system of national income
accounts that would provide a measure of the nation's output - and the Commerce Department turned to Simon
Kuznets. Today, if you are looking for GDP data you will find it published in a series of releases, the timing of which
are inversely related to the size of the samples used to derive the statistics and to their accuracy. As a result, you will
find it difficult to assemble a consistent time-series because of continual revisions of earlier data. For example, if you
look for GDP data in two issues of Economic Indicators or the Survey of Current Business, you will find there will be
two different figures for GDP. In recent years the quality of these initial estimates has declined, in part a result of
reductions in the budget appropriations for the data collection agencies in the government. The best sources for
consistent time-series would be the Economic Report of the President, for annual data. For those interested in recent
data, you will find it at Economic Indicators or The Economic Briefing Room. Information on the estimation procedure
is available on-line (Methodology, National Income and Product Accounts, 1929-94, as is the actual data at BEA's
National Accounts Site.
vi
GDP includes in the US figure only the value created by Juan, while GNP would include only the value created by
Mary. GNP is the market value of currently produced, final goods and services produced by permanent residents of a
nation within a specified period of time. Of the two, I grew up hearing about GNP, but you will hear most about GDP.
Those older than 40 grew up with gross national product (GNP), but you are likely to hear more about gross domestic
product (GDP). GDP has become the primary economic measure used in analyses of economic growth and inter
country comparisons of standards of living. GDP focuses on the economic activity within the 50 states, while GNP
focuses on the economic activity of a nation's factors of production. The movement away from GNP to GDP, reflects
the globalization process currently underway. As the international sector of the US economy expands, it is beginning to
resemble that of the other developed countries, which have used GDP as their measure of output. In this sense the move
toward GDP is comparable to the move toward the metric system, a move toward a common yardstick, although care
must be taken when making intertemporal and international comparisons. There may be another reason to favor GDP
over GNP, at least based on the work of Cobb et al. According to these authors, "[u]nder the old measure, the gross
national product, the earnings of a multinational firm were attributed to the country where the firm was owned - and
where the profits would eventually return. Under the gross domestic product, however, the profits are attributed to the
country where the factory or mine is located, even though it won't stay there. This accounting shift has turned many
struggling nations into statistical boomtowns, while aiding the push for a global economy. Conveniently, it has hidden a
basic fact: the nations of the North are walking off with the South's resources, and calling it a gain for the South."
vii
Information on the procedure for converting nominal GDP to real GDP is available on-line (Methodology, National
Income and Product Accounts, 1929-94.
viii
The equation below captures the relationship between current-dollar GDP (N), constant-dollar GDP (R), and the
price level (PI) which is the GDP Price Deflator, one measure of the price level.
(1) R =N/PI
The logic of the equation is quite straightforward. If prices (PI) double and the value of goods and services (N) doubles,
then there is no change in real output (R). What should also be evident is the importance of the measure of the price
level since if we have a measure of prices that has PI rising too rapidly, then our measure of real GDP (R) will be too
low - an issue we touch on in the section on the CPI.
Now that you see the scope of the problem, we'll look at one more wrinkle proposed by William Nordhaus who made
an effort to look at the long-term changes in the price of illumination as an alternative to traditional measures of
price. According to De Long, "The argument that our commodity-focused price indices miss most of the real action ñ
that price indices focusing on the services provided would produce vastly greater estimates of long-run economic
21
growth ñ is made most powerfully by William Nordhaus in his study of the economic cost of light." What Nordhaus did
in essence was ask the question, what does it cost me to get a lumen of light, the basic unit of light, rather than the
traditional approach of what does it cost me to purchase the commodity that provides light. The differences are
staggering. He concludes that the past hundred years have seen a ten thousand-fold decline in the real price of
illumination, yet commodity-based price indices have only captured a ten-fold decline in this price. Based on these
findings, Nordhaus concludes that a "comparison of the true price of light with a traditional light price indicates that
traditional price indexes overstate price growth, and therefore understate output growth, by a factor between 900 and
1,600 since the beginning of the nineteenth century. This finding suggests that the "true" growth of real wages and real
output may have been significantly understated during the period since the Industrial Revolution."
ix
The base year is 2000, which is reflected in the equality of the real and nominal GDP values and in the title (2000 $s).
x
A simple example is described by Michael Pakko and Patricia Pollard in "Burger Survey Provides Taste of
International Economics." You pick a universal good, something that you can by anywhere - the Big Mac. According
to data in Pakko and Pollard's article, in the US an Big Mac was $2.71, in Argentina it was 4.10 pesos, and the
exchange rate was 2.88 pesos per dollar. At these exchange rate the Big Mac in Argentina would cost you $1.42
because with those 4.1 pesos you could buy $1.42. You would do the same if you had GDP data for the two countries.
For example, GDP per capita in Japan in 2000 was 4,044,261 yen and the US$ exchange rate was 107.76 yen, therefore
GDP per capita in US $s in Japan would be $37,528 [4,044,261/107.76]. The figure for GDP per capita in the US at
that time was $35,069.
But what if prices were substantially higher in Japan? Then your money would not go as far in Japan as it does in the
US and you would feel poorer in Japan despite the fact GDP per capita figures indicated GDP per person was higher in
Japan. The same thing is true if you are thinking about moving somewhere in the US and comparing local salaries. The
price of a house in San Francisco is substantially higher than the price in Providence, RI and it would therefore be
unreasonable to assume someone with an income of $50,000 would have the same buying power or lifestyle in the two
cities. The problem is exchange rates do not reflect differences in buying power associated with price differentials whether we are talking about Japan vs. the US or Providence vs. San Francisco. And then there is that burger that costs
much more in the US than in Argentina.
When we take into account purchasing power differences, international rankings can be substantially affected as you
can see in the table below based on the OECD data. Turkey's economy is 1/4 the size of Japan's if we use the PPP
method, but only 1/12 the size if we use the exchange rate method. Mexico, meanwhile is nearly 25% of the size of the
US economy if the PPP method is used, substantially higher than the 15% figure when the exchange rate method is
used. For those who like to keep score, you will also note that the relative ranking of Japan and the US depends upon
the method adopted. If we accept the PPP method, then per capita GDP in the US is substantially above that in Japan,
but if we accept the exchange rate method, Japan comes out on top. To test your mastery of the table, you should
attempt to explain the flip-flop as we compare the US and Japan using the two measures. The PPP measure reflects the
fact that when an American with $s travels to Japan, the $ does not buy as much. In Mexico, meanwhile, prices seem
cheap so their GDP based on PPP is higher that the exchange rate GDP. Looking at this a little differently, if you were
going to travel, you would feel much wealthier in a country in which the current exchange rate GDP is lower than the
PP GDP.
1999 GDP per capita ( US $s)
OECD
Member
Countries
based on
based on
current exchange current purchasing Ratio
rates
power parities
Mexico
4921
8383
1.7
United States
33836
33836
1.0
Japan
35517
25590
.72
Germany
25729
23840
.93
Switzerland (1)
36247
28697
.79
Turkey (1)
2809
6338
2.26
xi
Clifford Cobb, Ted Halstead, and Jonathan Rowe, "If the GDP is UP, Why is America Down?," Atlantic Monthly
October 1995
xii
ibid
xiii
An interesting spin on nonmarket goods was provided by Dora Costa & Matthew Kahn in "The rising price of
nonmarket goods," (AER May 2003). They see the standard of living as comprising both market and nonmarket goods
and they posit that to generate a measure of welfare you would need to weigh both with their prices. And they find that
the value of nonmarket goods has increased and that this should be reflected in any analysis. If you did this you would
find that existing measures of welfare would be biased downward.
22
xiv
Freidrich Schnieder's "Size and measurement of the Informal Economy in 110 Countries Around the World" (World
Bank Working Paper, July 2002). The worst, which was no surprise based on what we hear in the news, were
Zimbabwe, Tanzania, and Nigeria in Africa where the informal economy exceeded 55% of GDP, and Bolivia, and
Panama in Latin America and Georgia and Azerbaijan in the former Soviet Union where it exceeded 60%.
xv
The data from the report are:
Annual hours worked per employed person, 1990 and 2001 (BLS)
1990 2001 Change
U.S.
1838 1821
-17
Australia
1866 1837
-29
Japan
2031 1821 -210
Korea
2514 2447
-67
New Zealand 1820 1817
-3
Denmark
1492 1482
-10
France
1657 1532 -125
Germany
1560 1467
-93
Ireland
1922 1674 -248
Italy
1674 1606
-68
Netherlands 1654 1346 -308
Norway
1432 1364
-68
Spain
1824 1816
-8
Sweden
1549 1603
54
U.K.
1838 1711 -127
1.
xvi
Annual hours worked per employed person
Source: BLS, Charting International Labor Comparisons (2010 Edition) Chart 2.9 - Annual hours worked per employed
person, 1998 and 2008 (HTM) (PDF)
xvii
13. Here are the data that generate the numbers
Individuals
Country A Country B
Year 1
Year 2
% change
Year 1
Year 2
% change
23
1
$50,000
$55,000
10%
$410,000
$469,000
14%
2
$50,000
$55,000
10%
$10,000
$9,000
-10%
3
$50,000
$55,000
10%
$10,000
$9,000
-10%
4
$50,000
$55,000
10%
$10,000
$9,000
-10%
5
$50,000
$55,000
10%
$10,000
$9,000
-10%
6
$50,000
$55,000
10%
$10,000
$9,000
-10%
7
$50,000
$55,000
10%
$10,000
$9,000
-10%
8
$50,000
$55,000
10%
$10,000
$9,000
-10%
9
$50,000
$55,000
10%
$10,000
$9,000
-10%
10
$50,000
$55,000
10%
$10,000
$9,000
-10%
$50,000
$55,000
10%
$50,000
$55,000
10%
Per capita / average
xviii
Clifford Cobb, Ted Halstead, and Jonathan Rowe, "If the GDP is UP, Why is America Down?," Atlantic Monthly
October 1995. These authors point out this limitation of GDP when they suggest the problem of a local police chief
reporting that "'activity' on the city streets had increased by 15%..." People would want to know what type of activity
increased - was it sales at the local Gap store, or the local steel mill, or was it arrests for drug sales or prostitution? The
first two of these would be considered goods, while the second two would be considered as bads, but there would be no
distinction between the two in the activity measure.
xix
Clifford Cobb, Ted Halstead, and Jonathan Rowe, "If the GDP is UP, Why is America Down?," Atlantic Monthly
October 1995.
xx
This is one of the concerns in Middle Eastern countries that are working to diversify their economies. Check out
Dubai and Qatar for examples of ambitious efforts to remake the national economy with less reliance on oil. In 2004
Dubai was in the press for its establishment of Internet City to help it become the India of the Middle East, while Qatar
gained notoriety when its national airline was among the first buyers of the Airbus A380-800 super jumbo jet that will
have up to 800 passengers.
xxi
The UN has also picked up the idea and at their site you will find a link to environmental statistics where the UN has
created an "adjusted measure of total national output, including only the consumption and investment items that
contribute directly to economic well-being. Calculated as additions to gross national product (GNP), including the
value of leisure and the underground economy, and deductions such as environmental damage. It is also known as net
economic welfare (NEW) (Samuelson and Nordhaus, 1992)." Since 2003 the UN has also been developing its
Integrated Environmental and Economic Accounting (SEEA) that it describes as follows.
...a satellite system of the System of National Accounts. It brings together economic and environmental
information in a common framework to measure the contribution of the environment to the economy and the
impact of the economy on the environment. It provides policy-makers with indicators and descriptive
statistics to monitor these interactions as well as a database for strategic planning and policy analysis to
identify more sustainable paths of development.
The SEEA 2003 comprises four categories of accounts:
• Flow accounts for pollution, energy and materials (Chapters 3 and 4). These accounts provide
information at the industry level about the use of energy and materials as inputs to production and
the generation of pollutants and solid waste.
• Environmental protection and resource management expenditure accounts (Chapters 5 and 6).
These accounts identify expenditures incurred by industry, government and households to protect
the environment or to manage natural resources. They take those elements of the existing SNA,
which are relevant to the good management of the environment and show how the environmentrelated transactions can be made more explicit.
• Natural resource asset accounts (Chapters 7 and 8). These accounts record stocks and changes in
stocks of natural resources such as land, fish, forest, water and minerals.
• Valuation of non-market flows and environmentally adjusted aggregates (Chapters 9 and 10). This
component presents non-market valuation techniques and their applicability in answering specific
policy questions. It discusses the calculation of several macroeconomic aggregates adjusted for
depletion and degradation costs and their advantages and disadvantages. It also considers
adjustments concerning the so-called defensive expenditures.
xxii
There is also a problem with the measurement of the service sector and government. The service and government
sectors are enormous, but they pose real problems to bean counters trying to determine real output and price indexes. It
is easy to measure the output of an auto plant, but how do you measure the output of government or education or
banking, and how do you decompose nominal GDP changes into output and price changes. The solution devised by the
24
Commerce Department is to use inputs to measure output - if employment in universities rises by 5%, then output is
assumed to rise by 5%. Then there is the question of value. You would expect students and the families that pay some
of the education bills would only make this investment if it was worth the money, and as you saw in the unit on
opportunity cost, the cost of education is larger than the tuition rate. Unfortunately, in GDP accounting education is
valued at the tuition so GDP would underestimate the value of education. In banking, it was not so long ago that
dealing with the bank meant dealing with bankers' hours, a very short day that did not include weekends, and the wait
for turnaround on loans often took weeks. Today banking services are available 24-, and often you needn't leave home
to access these services - but none of this "increase in the quality" of services is picked up in GDP. As a final example
consider the run up in stock prices in the late 1990s. Since the value of the broker services are tied to the prices of
stocks, the commissions, which do show up in GDP, rose substantially and this pushed output higher - and as we will
see later, it also showed up as higher productivity in the broker industry.
xxiii
Comparisons over time turn out to be a verrrry difficult problem because of the dramatic changes in the types and
qualities of goods available to people. To get an idea of the situation, consider the following examples provided by
Brad DeLong and Easterlin.
Looking Backward. Looking Backward is a novel that sold extraordinary numbers of copies in the
1890s because it struck a utopian cord. In it the narrator, thrown forward in time from 1895 to
2000, is asked by his hosts in the year 2000--more than a century in his future--the question:
"Would you like to hear some music?"
He expects his host to play the piano--a social accomplishment of upper-class women around
1900.To listen to music on demand then, you had to have in your house or nearby an instrument,
and someone trained to play it. It would have cost the average worker some 2400 hours, roughly a
year at a 50-hour workweek, to earn the money to buy a high-quality piano, and then there would
be the expense and the time committed to piano lessons. Now the labor-time value of a Steinway
piano has fallen in price from 2400 average worker-hours a century ago to 1100 average workerhours today. But if what you value is not the piano itself but the capability of listening to music at
home, the cost has fallen from 2400 average worker-hours a century ago to 10 hours today (240
dollars for the boom-box plus 10 dollars for the CD).
and
The transformation of living levels has been qualitative as well as quantitative. By comparison with
the conveniences and comforts widely available in developed economies at the end of the 20th
century, everyday life two centuries ago was most akin to what we would know today as 'camping
out.' In the late 18th century United States (which even then was a relatively rich society), for
example, among the rural population, which comprised 95% of the total, housing consisted of
'[one] story log houses and frame houses with one or two rooms and an attic under the rafters.
Cellars and basements were practically unknown and frequently there was no flooring except the
hard earth. The fireplace with the chimney provided heating and cooking. "The worldwide standard
of living since 1800," Journal of Economic Perspectives, Winter 2000.
For those interested in some of the mechanics of estimating computer prices, you should read A Note on the Impact of
Hedonics and Computers on Real GDP by Stephen Landefeld and Bruce Grimm. For those interested, we can make this
a little more concrete with the example in the table below where one computer and one car are produced and computers
originally cost 25% as much as a car and individuals spend 20% of their budget on computers. As a result of
significant price cuts in computers, by Year 2 the price of computers has fallen by 50% so that they cost 12.5% of what
a car costs. Individuals, meanwhile, have responded by increasing their purchase of computers - doubling their
purchases to two. At the lower prices, individuals are now buying twice as many computers, but they are spending the
same share of their income on computers.
Real (Constant $) GDP
Output
Output
year 1
Output
year 2
Prices
year 1
Prices
year 2
GDP in GDP - Year 1 at GDP - Year 2 at GDP in
year 1
year 2 prices
year 1 prices
year 2
cars
1
1
$80
$80
$80
$80
$80
$80
computers
1
2
$20
$10
$20
$10
$40
$20
$100
$90
$120
$100
Now let's construct the two fixed-weight indexes.
Index A = Hypothetical GDP(2) / Nominal GDP(1) = $120/$100 = 1.20
Index B = Nominal GDP(2) / Hypothetical GDP(1) / = 100/90 = 1.11
When using the Year 1 base prices, the two computers produced in Year 2 equal $40 which overstates the increase in
real computer output in Year 2. Similarly, when using the Year 2 base prices, the one computer produced in Year 1
equals $10, which understates the increase in real computer output in Year 2.
25
xxiv
MEW would start with GNP and then subtract from it some bads (pollution, crime..) and some services that do not
increase welfare (public spending such as national security, police and fire, ... ) and add in some nonmarket activities
such as leisure and householder services. Interest in alternative measures of economic welfare did not last long, though,
and very little came of MEW once the country and its economic policies moved to the ideological right behind the
leadership of Ronald Reagan.
xxv
Richard Easterlin, "The worldwide standard of living since 1800," Journal of Economic Perspectives, Winter 2000.
you also might be interested in Brad De Long's suggestion of computing how many hours of work it takes to purchase
some of the "basics." (Long in his article "Cornucopia: Increasing Wealth in the Twentieth Century." For De Long) For
example, to purchase a one speed bicycle, based on the Montgomery Ward Catalogue, it would have taken you 260
hours of work at average wage rates in 1895. A century later it would have taken you 7.2 hours, which makes the
average person about 36 times better off. If we used that Steinway piano, meanwhile, we would only be twice as well
off. Even an approach such as this, however, may be a bit misleading since today people would not need a silver
teaspoon, but would settle for an inexpensive alloy providing the same function as the silver spoon at much less cost, or
the online encyclopedia that is virtually free.
Multiplication of Productivity 1895-2000
Time Needed for an Average Worker to Earn the Purchase Price of Various Commodities
Commodity
Time-to-Earn in 1895 (Hours) Time-to-Earn in 2000 (Hours) Productivity Multiple
Horatio Alger (6 vols.)
21
0.6
35
One-speed bicycle
260
7.2
36.1
Cushioned office chair
24
2
12
100-piece dinner set
44
3.6
12.2
Hair brush
16
2
8
Cane rocking chair
8
1.6
5
Solid gold locket
28
6
4.7
Encyclopedia Britannica
140
33.8
4.1
Steinway piano
2400
1107.6
2.2
xxvi
. Richard Steckel, "Biological Measures of the Standard of Living," Journal of Economic Perspectives, Winter 2008
At the national level they can also be used for clarifying objectives and setting priorities." Included is Green
Accounting that is defined as follows.
..."greener" national accounts holds the promise of placing environmental problems into a
framework that key economic ministries in any government will understand. For too long now,
ministries of finance and planning have paid scant attention to the exploitation of the natural
resource base, or the damaging effects of environmental pollution. At the same time, countries have
been developing national environmental action plans that read as if they were written by the
environment ministry with no links to the economics ministries.
In The Little Green Data Book you will find many of the indicators that appear in the World Development Indicators
including measures of forestry and biodiversity, energy, emissions and pollution, water and sanitation, and environment
and health. Below is a sample of the available data from the 2006 book for the Low and High Income countries, and as
expected, there are significant differences. GDP per capita is nearly 64 times higher in the High Income countries,
while the infant mortality rate is 17 times higher in the Low Income countries. CO2 emissions per capita are about 60%
higher in the wealthy countries, even though energy consumption per capita is nearly 11 times higher in these countries.
Little Green Data Book Data
xxvii
Low Income
High Income
GDP per capita
507
% land in forests
25%
29%
501
5410
8
12.8
122
7
Energy per capita (kg of oil)
CO2 emissions per capita (M tons)
< 5 mortality rate (per 1,000 people)
32,112
xxviii
According to the World Bank, "Adjusted net savings departs from standard national accounting in several ways.
The most obvious difference concerns resource depletion. While the rents on natural resource extraction are included
implicitly in standard income measures, adjusted net savings makes this explicit by deducting the value of depletion of
the underlying resource asset (although in the case of forests that are sustainably managed, there is no net depletion).
Deducting pollution damages, including lost welfare in the case of human morbidity and mortality, is appropriate as
long as it is assumed that society is aiming to maximize welfare. Finally, adjusted net savings estimates consider
26
current educational spending as an increase in saving, since this spending may be considered to be an investment in
human capital (rather than consumption, as in the traditional national accounts)."
In 2004 the adjusted savings rates ranged from 32% in Namibia to -82% in Chad. Among the 8 countries with the
highest savings rates, 5 are from Asia, including China, which is a reflection of the high personal savings rate in those
countries. The list of countries on a potentially dangerous, unsustainable path are not surprises and consist primarily of
Middle Eastern, African and Western Asian countries that are depleting their mineral resources. Among the high net
savings group are surprises including Namibia, China, and Mongolia - all of which have high savings rates. The
estimates of total wealth that appear below once again reveal an all-too common pattern - the high wealth countries
include the US, Europe, and Japan while the low wealth countries tend to be in Africa.
Green Accounting
Net Savings (% of GNI (2004))
Best
Wealth per capita in 2000$ (2000)
Worst
Namibia
Singapore
China
Maldives
34.31 Nigeria
33.04 Trinidad and Tobago
27.80 Syrian Arab Republic
27.76 Angola
-28.22 Switzerland
-28.31 Denmark
-28.42 Sweden
-36.32 United States
Best
Worst
648,241 Niger
575,138 Congo, Rep.
513,424 Sierra Leone
512,612 Tajikistan
3,695
3,516
3,293
3,193
Mongolia
Philippines
Ireland
Korea, Rep.
26.59 Uzbekistan
25.89 Azerbaijan
23.33 Oman
22.94 Chad
-37.04 Germany
-39.99 Japan
-40.56 Austria
-82.21 Iceland
496,447 Burundi
493,241 Nigeria
493,080 Congo, DR
482,367 Ethiopia
2,859
2,748
2,174
1,965
xxix
Joshua Wolf Shenk, “What makes us happy?” The Atlantic, June 1, 2009
Siobhan Farmer and Barbara Hanratty, “Well-being: David Cameron’s happiness index,” Oxford University Press
blog, May 17, 2012
xxxi
The Human Development Index includes measures of a healthy life, measured by life expectancy; knowledge,
measured by the adult literacy rate and enrollment in school; and the standard of living, measured by the purchasing
power parity version of GDP. According to Wikipedia, The Human Development Index (HDI) is "used to determine
and indicate whether a country is a developed, developing, or underdeveloped country and also to measure the impact
of economic policies on quality of life. The index was developed in 1990 by Indian Nobel prize winner Amartya Sen,
Pakistani economist Mahbub ul Haq, with help from Gustav Ranis of Yale University and Lord Meghnad Desai of the
London School of Economics and has been used since then by the United Nations Development Programme in its
annual Human Development Report. Described by Sen as a "vulgar measure", because of its limitations, it nonetheless
focuses attention on aspects of development more sensible and useful than the per capita income measure it supplanted,
and is a pathway for serious researchers into the wide variety of more detailed measures contained in the Human
Development Reports." What the index does not measure that the UN correctly identifies as important dimensions of
welfare would be respect for human rights, democracy, and inequality.
Comparison Rankings: Human Development Index and GDP Per Capita (2007)
Best
Worst
xxx
HDI
GDP
HDI
GDP
Iceland
Luxembourg
Mali
Niger
Norway
US
Niger
Tanzania
Australia
Norway
Guinea-Bissau
Congo
Canada
Ireland
Bukina Faso
Burundi
Ireland
Iceland
Sierra Leone
Malawi
Source: 2007 tables
The World Bank, in its World Development Report and Poverty Net site also includes a variety of variables on
individual countries and for individuals in those countries. You will find GDP, but you will also find Social Indicators
and a measure of household living standards where you will find data on life expectancies, illiteracy, malnutrition,
infant mortality and accessibility to sanitation. In somewhat of a surprise, Elliot Berg, when reviewing data on Africa
and South America in the 1980s, found there were some inconsistencies when comparing the economic indicators and
quality of life indicators, that the 1980s looked better in many instances than the economic results showed. The
significance of this is that an assessment of the policies of the 1980s might look different depending upon what
indicators we use. As mentioned earlier, The Economist (1/22/2000), in a similar, yet much less formal way, attempted
to take a broader view of the impact of the Asian crisis of 1998 that traditionally has been assessed in terms of
27
employment or GDP. They reported that as the economy collapsed, the number of suicides, children in orphanages,
babies abandoned, and child drug abuse rose sharply. There was, however, some potentially good news in that alcohol
and tobacco spending dropped nearly 30%. For those who like maps, you might want to check out Mapping Global
Environment web site at the World Bank to see an interesting interactive site that identifies environmental problems
around the world.
At home, as far as I can tell the Commerce Department began to compute a "Green GDP" that accounts for resources
used up in the production process. April 21, 1993 Clinton directed Commerce to calculate "Green GDP." According to
Clinton in his address:
The existing national income accounting system - used here and in other countries essentially
ignores the impact of economic development on the environmental resources that are the
foundation of economic prosperity. For example, an oil tanker spill can increase GDP if the cost of
cleanup is included as income to workers while the pollution costs of fouling the beach go
unrecorded.
In April of 1994 the Bureau of Economic Analysis, the agency responsible for computing GDP, laid out its plan
for Integrated Economic and Environmental Satellite Accounts in the Survey of Current Business, but I cannot find
evidence of its existence now.
28
xxxii
Social Progress Imperative web site. http://www.socialprogressimperative.org/data/spi
The CPI was developed during WW I by the federal government to provide cost-of-living increases to shipbuilders
at a time where prices were rising rapidly. (Remember that Massachusetts' first index was also constructed to help pay
soldiers during a period of steep price increases).
To get a handle on the CPI let's look at a simple example of how we might approach the problem of determining what
has happened to the price of entertainment. Let's assume we followed the BLS approach and conducted a survey in
1997 of what people do for entertainment and collected data on the prices of each form of entertainment. In the table
below are the results of the survey indicating the number of tickets purchased and the prices of those tickets. If this
were the consumer price index, then included here would be items from the major expenditure categories - Food and
beverages, Housing, Apparel and its upkeep, Transportation, Medical care, Recreation, Education and communication,
and Other goods and services. In this example the average person in 1997 went to the theatre 6 times and paid $10 a
visit and also went to 2 football games at a price of $8 a game, while in 2004 the 3 trips to the theatre cost $15 each and
the 3 football games cost $10 each.
Between 1997 and 2007 both the mix of entertainment events attended and the prices of those events changed. With
these data in mind, think about what we mean when we ask: what happened to the price of entertainment? What we will
do here is walk through a process similar to that the BLS does when computing the CPI.
ENTERTAINMENT PURCHASES
xxxiii
Price
Quantity
1997 2007
1997
2007
Theatre Ticket
10
15
6
3
Concert Ticket
3.5
10
4
1
Basketball Ticket
4
5
6
8
Football Ticket
8
10
2
3
Dinner
8
12
8
6
29
Hotel Room
30
75
3
2
The first step in the creation of the index is the estimation of total expenditures in the base year - the year of the survey,
which in this case is 1997. Actual expenses in 1997 are $268.
ACTUAL 1997 EXPENSES = 10*6 +3.5*4 +4*6 +8*2 +8*8 +30*3 = $268
The second step would be a computation of 2007 expenses that would be $347. So far so good except that in the "real"
world this would not be possible to compute because there is no survey done of purchasing at this time. The surveys of
purchasing patterns are only done periodically, and in the interim all the information that is collected would be current
prices.
ACTUAL 2007 EXPENSES = 15*3 +10*1 +5*8 +10*3 +12*6 +75*2=$347
If all of this information existed, you would be able to say that expenses increased 29% between 1997 and 2007
[347/268-1 = .29 = 29%]. It would seem as though you would say that the cost of entertainment increased 29% between
the two years, but be careful. As we saw with the calculations of GDP, entertainment expenses changed as a result of
changes in prices (e.g.. the price of a dinner increased from $8 to $12) AND changes in purchases (e.g. the number of
concerts attended dropped from 4 to 1). To calculate the change in prices, we need to separate out the two effects by
computing a new hypothetical expenditure figure - the expenditures that would need to be made in 2007 if a person
paid the 2007 prices but purchased the same basket of entertainment as in 1997. The hypothetical expenses would be
$501.
HYPOTHETICAL 2004 EXPENSES (1997 purchases at 2001 prices) = 15*6 +10*4 +5*6+ 10*2+
12*8+ 75*3 = $501
If you had not changed your behavior between 1997 and 2007 then your entertainment costs would have risen from
$347 to $501. It is now possible to construct an price index, the Entertainment Price Index (EPI), that would measure
what happened to entertainment prices. [If we were talking about the BLS market basket of goods consumed by US
households, then we would be talking about the Consumer Price Index (CPI).] In both cases you first must initialize the
index at 100 for the base year - the year in which the initial survey was taken. In this example, the EPI would have a
value of 100 in 1997. The EPI for the year 2007 is computed using the following formula.
EPI(2007) = 100*(501/268) = 187
So what does this mean? The EPI of in 2007 is 187 can be interpreted in a number of ways.
(1) WHAT COST $100 IN 1997 COST $187 IN 2007
(2) PRICES WENT UP 87% (187-100)
(4) A 2004 DOLLAR IS WORTH $.54 (100/187)
What you cannot yet calculate is the inflation rate because it is defined as the percentage change in the price index for
one year. To calculate the annual inflation rates we would need to have annual figures for the EPI, which appear in the
table below. The inflation rate for 2007 was 4% [501/480-1 = .04 = 4%].
ENTERTAINMENT PRICE INDEX AND INFLATION RATES
Inflation
rate
EPI
1997
268
-
1998
284
6%
1999
302
6%
...
...
...
2004
390
2005
440
13%
2006
480
9%
2007
501
4%
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Barry Hobijn & David Lagakos, "Inflation Inequality in the United States," FRBNY Staff Paper October 2003
When making the adjustment for inflation using the official CPI statistics, in addition to the above mentioned
concerns, you should also not lose sight of the peculiarities of the CPI that limit its value to you in your individual
calculations of inflation's impact. The CPI is based on a market basket of what the "average" consumer in the US buys,
and this average may be very different from the basket you buy. For example, fuel oil is relied on heavily for heat in
the Northeast and when there are dramatic shifts in the price of home heating oil, these will have a greater impact on
consumers in the Northeast. Similarly, if I were trying to estimate the change in the value of state appropriations to a
public university, I would probably be interested in measuring the buying power of the funds that most certainly would
not be used to purchase the CPI market basket of goods and services. The basket of goods and services purchased by
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the university would be quite different, which is why there is a higher education price index (HEPI). In the period
1981-1995 the HEPI increased at an annual rate of 5%, substantially higher than the 4% rate for the CPI. The
implication is that even if a university received increases in funding equal to increases in the CPI, by 1995 their budgets
would not have been able to buy them as much as their budgets in 1981. The Wall Street Journal, recognizing its
readers may not be too "average" has at time published its Luxury Spending Index that includes Greenwich home
prices, caviar, and luxury yacht charters.
xxxvi
Questions concerning the accuracy of the CPI have been around as long as the index. During World War II the
BLS's Cost of Living Index (later to become the Consumer Price Index) had become a hot topic because it was an input
in labor negotiations. The value of the index helped determine workers' wages (Persky 1998), and according to
organized labor, the index underestimated price increases due to the existence of rationing, black markets, and the
deterioration in quality - an underestimate some thought reached 50%. A commission was formed, and after a review
of the data, they reported the overestimate was only 5%.
More recently the Boskin Commission was formed to once again examine the adequacy of the CPI. The approaches of
the two price level commissions were quite different, and on most of the major issues, the two commissions took
opposite positions. The similarity was in their conclusions. According to Persky, the "net effect was that the
recommendation of the Mitchell commission served to defend the government from paying workers more to
compensate them for wartime inflation, and the recommendations of the Boskin committee have served to argue that
the government should index a lower rate of inflation, and thus pay less in retirement benefits and collect more in
taxes. A cynic might conclude that economists as a group are committed to a political agenda aimed at limiting the
demands that indexation may make on the public purse." For those interested, you might want to check out the BLS
response to the Boskin Commission's report.
For those interested in checking out some of the issues and solutions, you will find a link Measurement Issues at the
BLS site that provides some background on the substantial changes that have been made in the CPI in response to the
initial recommendations made by the Advisory Commission to Study the Consumer Price Index, commonly known as
the Boskin Commission, in December of 1996. This Commission, established to once again examine the validity of the
current measure of the CPI, concluded "Using empirical evidence and the members' own judgments about the
magnitude of these biases, [the commission] concludes that the CPI overstates the true cost-of-living change by 1.1
percentage points per year." This may not sound like much, but think of this in light of the debate over Social Security
after we do a simple calculation. If we went back to 1993 we would see Social Security payments in the US budget
were nearly $305 billion. Now let's ask what those payments would be if they increased by the stated inflation rate and
if they had been increased by an adjusted inflation rate that was 1% per year lower. The difference would be about $40
billion, which is no small change. And if you projected it out twenty-five years into the future when the last of the baby
boomers will reach age 65, the savings gets even larger because of the compounding. Assuming that the official
inflation rate averages 3.5%, the difference in Social Security benefits would be about $275 billion - and that is even
without the increase in number of retirees due to the baby boomers ageing. It is no surprise that the proposal was
fought by the AARP and that eventually the effort just disappeared.
What was it that made the commission think the CPI overestimated inflation? We will not go into specifics, but we can
see some of the issues with our simple entertainment example.
Commodity substitution bias: In the EPI problem we saw that the mix of entertainment activities changed over time,
although the EPI did not allow for this. Normally you expect, based on traditional demand theory, that as the price of
one entertainment activity rises you will substitute less expensive activities for it, and that is what we saw in our
example. Concerts increased most in price (86%), while football and basketball games increases least (50%), and the
response was predictable. Concert going was cut substantially while more football and basketball games were
attended. Some of this adjustment would be expected and would not mean you were worse off because of the changed
behavior, so the EPI, which assumes no such adjustment, overestimates inflation.
Outlet Substitution bias: In the years since the first sample, you have seen the average price of a dinner increase from
$8 to $12, which suggests a 50% increase. If you had been going to the same restaurants over this period then the 50%
is probably a reasonable estimate of the price increase, but what if you changed the restaurants you attended. What if
you moved from Burger King to Casey's in Wakefield. In this case the 50% would be an overestimate of the true
increase in the cost of your dinners because it would also include a cost of moving a bit upscale. When estimating the
CPI, we have seen the rise of the box stores that tend to have lower prices which means that increasing numbers of
shoppers are shopping in these big box stores. The CPI, however, is based on a set basket of goods and retail outlets so
the move to box stores is not reflected in the CPI.
Quality adjustments: Let's look at the football game where during this period they introduced the wide screen displays
that allow the audience to watch instant replays.
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