Download Chapter 3: Measuring the Economy

Chapter 3
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Chapter 3: Measuring the Economy
J. Bradford DeLong
--Draft 0.9-1999-02-01: 14,977 words
Economics and measurement
Social science and introspection.
Economics is a social science. That means that it is about us: what we do and
what happens to us as a result. Because economics is a social science, one of our
important sources of information is simple introspection. The appeal to
introspection--what would you do in this particular situation, with these
opportunities and working under these constraints?--is a very common and very
powerful intellectual move for economists to make. We will make it often in this
book.
But introspection alone is not enough to make macroeconomics possible.
Economics and data.
Uses of data.
Most importantly, macroeconomics would be impossible without data. Without
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data we could not figure out how to apply our theories to the economy: forecasts
would be impossible. And without data we could not figure out which theories
were correct: testing alternative approaches--comparing what they predicted to
what is actually the case--would be impossible as well.
The NIPA.
The principal source of data used by economists is a system of measurements
and estimates by the U.S. Department of Commerce's Bureau of Economic
Analysis, the national income and product accounts [NIPA]. The NIPA evolved in a
symbiotic relationship with modern macroeconomics. The NIPA was created to
measure and estimate the quantities that macroeconomic theory suggested
would be interesting. And variables of interest measured by the NIPA and by
other data-collection efforts then sparked economists to try to theorize about
how to understand their behavior.
Six key variables.
Of all the statistics collected by the NIPA and other data-collection efforts, six are
the most important: the level of total production (and of income) in the economy,
GDP, Gross Domestic Product; the unemployment rate; the price level (usually
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as measured by the Consumer Price Index, the CPI), the level of the stock market,
the interest rate, and the exchange rate. Know these six measurements of the
economy--what their current values are, what their time trends have been, and
what their future values are projected to be--and you have an excellent
knowledge of the state of the economy.
Your own situation.
A potentially dangerous source of information about the overall state of the
economy is your own particular set of circumstances, or those of your family.
The United States is a very, very big place. What is going on in your life, or in
your neighborhood, or for your family may well not be in any sense typical of
what is going on in the country as a whole.
Types of economic data
Stocks and flows.
Economic data come in many different flavors: net and gross, real and nominal,
stocks and flows.
Stock and flow--see, there is the hydraulic circular-flow metaphor again--are
closely related. The rate of change of a stock is a flow. The cumulated integrated
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value over time of a flow is a stock. Think of the stock variable as being like the
total amount of water in a reservoir, and the flow variable as the flow of water
into or out of the reservoir.
Thus flows are measures of ongoing processes. A flow will be measured as so
many dollars per unit of time--per day, per month, per year. GDP or the rate of
net investment--how much businesses are spending in additions to the total
capital of a country--are flow quantities.
You can tell a flow quantity if it needs a "per unit of time" attached to a number
in order for it to make sense
Stocks are measures of quantities in being at some particular exact moment of
time. The capital stock is the total amoun tof useful machines, buildings, and
other past investments that add to the economy's productivity. The capital stock
is--no surprise--a stock. The money stock is the total value of liquid assets in the
economy at some particular moment.
You can tell a stock quantity if adding a "per unit of time" to its number would
produce nonsense. The U.S. capital stock is $24 trillion, not $24 trillion per year.
GDP--a flow--is $8 trillion per year.
Notionally, at least, you could bring a stock quantity together into one big pile
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and count it. The total capital stock of a country at a particular moment is one
example of a stock quantity. This includes the total value of all the machines that
have been installed, all the buildings that have been built, all the infrastructure
that has been created, and all the inventories that have been built up to support
production.
Real and nominal magnitudes.
Nominal quantities are quantities that have not been adjusted for overall changes
in the average level of prices--have not been adjusted for inflation a deflation.
They are quantities measured in terms of dollars, paying no mind to any changes
in the value of the dollar, and making no attempt to get an estimate of what they
would have been had the average level of prices been more-ore-less unchanging.
A nominal quantity is expressed in terms of current dollars, or is simply one
current-dollar sum divided by another. In 1995 total nominal GDP (at 1995's
prices) was $7,254 billion; in 1996 total nominal GDP (measured at 1996's prices)
was $7,581 billion. The nominal GDP growth rate between 1995 and 1996 was 4.5
percent.
Real quantities are quantities that have been adjusted for changes in the overall
price level, for episodes of deflation or inflation. They have been divided by the
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current price level in order to produce an estimate of what spending would have
been if the price level had been constant.
When measured using 1995's prices, GDP in 1996--real GDP--was not $7,581
billion but only $7,410 billion. The difference--the gap between $7,410 and $7,581-was due to the 2.0 percent general inflation in the level of prices between 1995
and 1996.
Nominal and real magnitudes are related by the price level. Between 1992 and
1996 the nominal prices of consumer services in the United States increased by
12.8%. Meanwhile, the nominal price of machines-producers' durable
equipment-increased by only 0.7%. The Commerce Department's Bureau of
Economic Analysis combined these two estimates with estimates for all the other
components of GDP and calculated that between 1992 and 1996 the overall price
level increased by 9.9%.
How did the BEA come up with that number? By constructing an index number.
It took the rate of inflation for each good or category and multiplied it by the
share of final expenditure in that good or category to produce an appropriatelyweighted index of overall, general inflation.
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Gross and net magnitudes.
Gross magnitudes are quantities that have not been corrected for
counterbalancing magnitudes. Net investment--the rate at which the capital stock
is changing is equal to total spending on investment goods minus depreciation-the wearing-out, scrapping, and retirement of old capital. Gross investment is
total spending on investment goods. Net investment is gross investment minus
depreciation.
Similarly, net exports are the net flow of goods out of the United States to other
countries. Gross exports are the total flow of goods out of the United States.
Imports are the total flow of goods into the United States. Net exports are equal
to gross exports minus imports.
Almost always we economists would prefer to have the "net" quantity to work
with and think about. But sometimes we don't. Usually the reason that we don't
is that the estimating agencies do not trust their estimates of the "net" quantity.
Thus the Department of Commerce's Bureau of Economic Analysis greatly,
greatly prefers to report GDP--gross domestic product--than NDP--net domestic
product--because they do not trust their estimates of depreciation.
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The estimating process.
Estimating agencies.
All economic magnitudes reported--from GDP to the unemployment rate down
to consumer confidence and new investment orders--are estimates. In the United
States today, most such estimates come from two places: the Bureau of Economic
Analysis (BEA), a part of the Department of Commerce, and the Bureau of Labor
Statistics (BLS), a part of the Department of Labor.
The BLS.
The Bureau of Labor Statistics compiles the Consumer Price Index (CPI)--the
most frequently used gauge of inflation--and also calculates the unemployment
rate. Each month the BLS announces two different estimates of employment and
unemployment, coming from two different surveys. The official unemployment
rate is calculated from what the BLS calls the Current Population Survey, which
is a survey of households by BLS workers that asks them whether they have or
are looking for jobs. The official estimate of employment comes from the BLS's
survey of business establishments, which asks them how many people are at
work.
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The BEA.
The Bureau of Economic Analysis, part of the Department of Commerce,
compiles the National Income and Product Accounts and publishes the Survey of
Current Business once a month, which contains more statistics than you would
ever wish for.
Sources of information.
There are more manageable sources for BEA-produced estimates that you are
likely to be interested in or need. These are the annual Economic Report of the
President, which includes some 110 tables of economic variables; the annual
Statistical Abstract of the United States; the Paris-published OECD Economic
Outlook; and--most accessibly--the final few pages in each issue of the British
newsweekly The Economist.
The White House has a World Wide Web site--http://www.whitehouse.gov/-that includes an economic briefing room where the most frequently-cited and
often-used government-produced economic statistics are presented.
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Gross domestic product and the circular flow
Gross Domestic Product--GDP.
GDP as the most-used economic statistic.
The most often used frequently cited measure of how the economy is performing
is Gross Domestic Product (GDP). GDP is a measure of the circular flow of
economic activity: it is measured in real (that is, adjusted for changes in the price
level) dollars per year, and tells us the rate at which useful goods and services
are being produced. Because it is a measure of the circular flow, GDP is a
measure not only of the flow of production, but also of the total incomes
generated in the economy, and of the total amount of spending as well.
Near synonyms for GDP.
GDP, however, is just the most frequently-cited measures: you will see other
measures, near-synonyms to GDP like GNP (Gross National Product), NNP (Net
National Product), NDP (Net Domestic Product), and NI (National Income) used
as well. You will also hear “total output,” “total production,” “national product,”
“gross national product,” “net domestic product,” and “national income.” Except
when the discussion is focusing on the details of the NIPA, whenever you hear
any of these expressions think “GDP.”
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At the level of intermediate macroeconomics, economists pay little attention to
the differences between domestic product, national product, and national
income.
Indeed, in this book we will use "total income" and "total output" and "total
spending" all as synonyms for "GDP": our summary measure of the circular flow
of economic activity.
The circular flow.
The circular flow metaphor.
Economists think of economic activity--the pattern of production and spending
of the economy--as a circular flow of purchasing power thorough the economy.
This circular flow metaphor allows us confidently to predict that changes in one
piece of the economy will affect the whole, and how such changes will affect the
whole. It allows us to simplify economic behavior, to understand the entire
complex set of decisions taken by different actors in different parts of the
economy by thinking of a few typical decisions taken by representative agents
that govern one or the other parts of economic activity's circular flow.
[Figure: Circular Flow Diagram Once Again]
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What happens in the circular flow of economic activity? Money payments flow
from firms to households as businesses pay their workers and their owners for
their labor and their capital--this is the income side of the flow. Money payments
then flow from households to firms as households buy consumer goods, pay
taxes, and save, and as their taxes and savings then are spent by the government
on goods and services that it buys and are loaned to and then spent by firms
engaged in investments to boost their capital stock--this is the expenditure side
of the flow.
Measuring the circular flow.
This circular flow is measured at three different points in the circular flow.
Economists measure GDP at the point in the circular flow where consumers,
exporters, the government, and firms making investments purchases goods and
services from businesses: this is called total output—the total economy-wide
production of goods and services--the expenditure-side measure of the circular
flow.
Economists measure the level of economic activity at the point in the circular
flow where businesses pay households for factors of production. Businesses need
labor, capital, and natural resources to make things. All these factors of
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production are owned by households. When businesses buy them, they provide
households with their earned incomes: this is called total income or national
income.
[Figure: Circular Flow Diagram and the Three Points of Measurement]
Third, economists measure the level of economic activity at the point where
households decide how to use their incomes: How much do they save? How
much do they pay in taxes? How much do they spend buying consumption
goods? This is the uses of income measure of economic activity.
The measure used most often is the expenditure side measure: the Gross
Domestic Product produced by firms and demanded by purchasers, estimated
by counting up the four components of spending (and sales): consumption,
government purchases, investment, and net exports.
All measures of the circular flow are equal.
If we compare the expenditure side measure of GDP with the income-side or
uses-of-income-side measures of the circular flow, we find that they are equal.
They are equal because the circular flow principle is designed into the National
Income and Product Accounts (NIPA). Every expenditure on a final good or
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service is accounted for as a payment to a business. Every dollar payment that
flows into a business is then accounted for as paid out to somebody. It can be
paid out as income--wages, fringe benefits, profits, interest, or rent. It can be paid
out to buy goods from another business, which then pays it out to somebody.
Thus, ultimately every dollar of spending on goods produced by a business
flows out of the business sector to the household sector, for ultimately it will be
paid out as income to somebody, after some series of transactions with suppliers
of intermediate goods and raw materials.
Accounting definitions and statistical discrepancies.
The statistical discrepancy.
Now the different measures of the circular flow will not exactly balance. First,
there is the so-called statistical discrepancy. All pieces of GDP reported by the
Commerce Department are estimates. All estimates are imperfect. It is not
unusual for $100 billion a year to go "missing" in the circular flow.
Accounting definitions.
Second, different measurements will differ because of differences in exact
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accounting definitions. For example, measures of Net Domestic Product (NDP)
and National Income (NI) exclude depreciation expenditures. NI excludes
indirect business taxes. Domestic Product (DP) includes and National Product
(NP) excludes incomes earned in the United States by people who are not
citizens or permanent residents here.
The circular flow diagram.
Understanding the diagram.
Economists illustrate the circular flow principle with a simple diagram: the
circular flow diagram.
Along the top of the diagram, expenditures by businesses as they purchase labor
and other factors of production become the components of household incomes:
wages and salaries, benefits, profits, interest, and rent. Along the bottom of the
diagram, household uses-of-incomes--consumption spending, savings, and taxes-become the components of aggregate demand: consumption spending, investment
spending, government purchases of goods and services, and net exports.
Within the business sector, businesses buy and sell intermediate goods from each
other as they strive to produce goods and services and make profits. Within the
household sector, households buy and sell assets from and to one another. These
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within-the-business-sector and within-the-household-sector transactions are
important components of the economy. But because they net out to zero within
the business sector or within the household sector, they are not counted as part
of the circular flow of economic activity.
Following the circular flow.
Let's take a look at one particular piece in the circular flow: a dollar paid out by a
business as a dividend to someone who had previously invested in the company
by buying a share of stock when the company had undertaken its initial public
offering, or IPO.
[The circular flow diagram: following the flow]
When the dividend check is deposited, it becomes part of that shareholder's
household income. Suppose that the household doesn't spend it but simply
keeps the extra money in the bank--saves it. The bank will soon notice that it has
an extra dollar of deposits, and it will loan that dollar out to a business seeking
cash to add to its inventory. That business will then spend the dollar buying
goods and services as it builds up its inventory, and it may buy them from the
very company that originally issued the dividend check. In any event, as soon as
the dollar shows up as a component of investment spending, the circular flow is
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complete.
GDP estimates and national income identities
Counting GDP.
Quarterly estimates of GDP.
The Department of Commerce's Bureau of Economic Analysis computes
estimates of GDP every three months, each estimate covering a three-month
period--a quarter of a year. When you hear the newscasters announce the GDP
estimate, they will report it in one of two ways. They may report a level at an
annual rate--a statement that if production for an entire year took place at the
same rate as in the particular quarter being measured, then $7,854 billion worth
of goods and services would be produced: a GDP of $7,854 billion per year. They
may report a growth rate--a statement that GDP in the particular quarter being
measured was higher than in the immediately preceding quarter by an amount
such that if GDP grew over an entire year at the same rate, then after a year GDP
would be 5.6% higher: a growth rate of 5.6% per year.
Components of GDP.
So what is the NIPA actually measuring when it reports a measure of GDP? The
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Bureau of Economic Analysis estimates, and includes in GDP [Y], the value of:

Goods and services that are ultimately bought and used by households
(except for newly constructed buildings) make up consumption spending [C].

Goods and services (including newly constructed buildings) that become part
of society's business or residential capital stock are investment spending [I].
Investment is divided into two parts: depreciation simply replaces worn-out
or obsolete capital; net investment increases society's total capital stock.

Government purchases [G] of goods and services make up the third
component of GDP. Government purchases do not include any transfer
payments: do not include any payments to individuals the government
makes not in payment for anything provided to the government (whether a
dam or an hour of a bureaucrat's time) but simply as a free transfer of money
to the recipient.

And as a balancing item to make the national income and product accounts
consistent, net exports [NX]--the difference between exports and imports--are
also included in GDP.
Add all of these up to arrive at the level of GDP. This definition is called the
national income identity:
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Y  C  I  G  NX
It is the equation that you will write down most frequently as you take any
macroeconomics course.
The income side.
Types of income earned.
Another way of arriving at the same number for GDP--or at the same number
except for the "statistical discrepancy" caused by the fact that measurements are
imperfect, and NIPA estimates are just that, estimates--is to count up not total
goods produced but total incomes earned. (Note that this must be incomes
earned--unearned income that comes from government transfer payments cannot
be included here, or it won't work.)
Add together:

workers' wages and salaries (including benefits like health insurance
purchased by companies for their workers)

entrepreneurs' and businesses' profits (noting that any money earned as
corporate profits that is not distributed to shareholders--so-called retained
earnings--are shareholders' property, and should be imputed as income to the
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shareholders)

money lenders' interest

landlords' rent.
Accounting definitions.
And add in as well so-called "indirect business taxes" paid by businesses and not
by households, plus depreciation allowances--expenditures to replace worn-out
or obsolete capital that are not counted as part of anyone's income but that
nevertheless set in motion real purchases of useful goods--and find that you have
arrived back (save for the statistical discrepancy) at the same GDP estimate as
you found by adding together consumption C, investment I, government
purchases G, and net exports NX.
Why? Because of the circular flow principle.
The uses-of-income side.
Total expenditure equals total income equals uses of income.
The circular flow of activity has not only an expenditure side and an income side
but a uses-of-income side as well. The total earned incomes received by
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households, which we will call Y (the same Y as the total level of production: at
this level of generality we are ignoring the facts that indirect business taxes and
depreciation allowances are deductions from production before it is translated
into anyone's income), must be used in some way or another by the households
that receive them.
Because every dollar of household income shows up somewhere in household
uses-of-income, because every dollar flowing out of the household sector shows
up as a purchase of goods or services from the business sector, and because every
dollar spent on business products eventually shows up as someone's income, the
flow of economic activity is--surprise!--circular.
Uses of income.
This means that a household that earns income must use it by either:

Having it taxed away by the government, a total amount that we will call T,
for net taxes. Note that the government doesn't just take money, it gives
money out--food stamps, disability payments, social security payments, and
other government transfers partially offset the total amount removed from
income by the government. When we speak of "taxes" in macroeconomics, we
always mean "net taxes": tax collections minus these transfer payments that
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add to household resources.

Spending it on consumption goods, the amount C that we have seen before.

Saving it by putting it in the bank or using it to buy some financial
investment or some newly-produced investment good or other. We will use
the letter S for such private savings--private because they are undertaken by
private households.
No leakages from the circular flow.
What if you do not want to do any of these three things with a piece of your
income? Suppose you simply take the dollar bills that are your income and use
them to buy something old and precious from another household--a bar of gold,
say--that you then keep in your basement. Then you no longer have your
income, but the household that you bought the gold ingot from does have your
income. They will then either spend it on consumption goods, save it, or have it
taxed away.
What if you do not want to do any of these three things, and decide that you are
just going to take the dollar bills themselves and hide them in your basement?
When the Bureau of Engraving and Printing notices that the total number of
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dollar bills circulating in the economy has dropped, they will print up more. The
government will spend these extra dollar bills that replace the ones you have
hidden. The net effect would be the same as if you had saved that portion of your
income by loaning it out to the government and bought a Treasury bond--a
promise by the government to repay your principal plus interest at the set time
that marks the duration of the loan. The only difference is that you have a stack
of dollar bills in your basement rather than a piece of paper with the words
"Treasury bond" written on it--and that the government doesn't pay interest on
dollar bills hidden in the basement.
Thus even if you try not to use your income, the household sector as a whole still
winds up using all of its income Y as either consumption spending C, private
savings S, or net taxes T. This is another identity true by definition, the uses of
income identity:
3.3.3.1
Y CST
Why does this work? Because of the circular flow principle.
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The national savings identity and international trade.
Deriving the national savings identity.
If we combine the uses-of-income identity (3.3.3.1) and the national income
identity () we can immediately discover an interesting principle relating
international tarde and national savings: the so-called national savings identity.
On the expenditure side, consumption plus investment plus government
purchases plus net exports are equal to total output:
3.3.4.1
Y  C  I  G  NX
On the uses-of-income side, consumption plus private savings plus net taxes are
equal to total income:
3.3.4.2
Y CST
Since the circular flow principle tells us that total output is equal to total income:
3.3.4.3
C  S  T  C  I  G  NX
Since "C" is on both sides of the equation, we can simply cross it out. And if we
then move everything except net exports to the left hand side, we find that:
3.3.4.4
(T  G) (S  I)  NX
This is the national savings identity. It tells us that if we add together the
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government's surplus (the difference T-G between net taxes and government
spending) and the excess of private saving over investment (the difference S-I
between private saving and investment spending), then the sum is equal to net
exports NX.
What we mean by "identity."
This principle 3.2.4.4 is an identity. That is, it must hold always. It is a consequence
of the way that the NIPA are defined.
The national savings identity and the determinants of the trade balance.
This national savings identity is of interest because we usually think of net
exports--the economy's trade balance--as simply the difference between exports
and imports, each of which has largely independent causes. Instead, the national
savings identity tells us that net exports are determined by two things not
usually seen as affecting foreign trade--the government's budget, which
determines T-G, and the difference between private savings and investment, S-I
When net exports are negative, you can count on newspapers, columnists, and
those hoping for protection against foreign competitors to decry this trade
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deficit--exports less than imports--as a sign of the collapse of American industry
or as the consequence of the unfair trade practices of foreign countries. When net
exports are positive you can count on politicians in office to triumphally declaim
on the strength and competitivenss of the American economy.
The national savings identity tells us: not so--not so in either case. A trade deficit-net exports less than zero--is the result of (a) investment running ahead of
private saving, or (b) a government in deficit that is spending more than it is
taxing. A trade surplus--net exports greater than zero--is the result of a
government in surplus, or of investment that is strong relative to private saving.
A few danger spots.
Economists' strange definition of "investment."
There are two points that are potential sources of confusion that are worth
flagging. First, what economists mean when they say "investment" is probably
not what you mean when you say "investment." Second, the distinction between
"gross" and "net"--as in gross and net investment, gross and net taxes, or gross
and net domestic product--is an important one for you to be aware of.
First, it is important to make note of the fact that when economists refer to
investment or investment spending, they are using the words as a technical term
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that does not correspond to everyday language. To economists, an investment is
the purchase and installation by a business of a machine that increases
productivity, the construction of a building, or an increase in the total value of
inventories. A purchase of a stock or a bond--what most people would call an
investment--would be called an asset sale by an economist. Do not let yourself
become confused by this terminological oddity!
"Gross" quantities and "net" quantities.
Second, it is important to note the difference between "gross" and "net"
quantities. So far we have seen two examples of this. In the case of taxes, the
national income accounts balanced and the national income identities worked
only if we used T to refer to so-called "net taxes"--taxes collected by the
government minus transfer payments made back to households--not gross taxes.
In the case of investment we have already run into the difference between gross
and net investment: depreciation.
Some purchases of machinery or construction serve to replace worn-out and
obsolete capital. Other purchases of machinery or construction of buildings
increase that capital stock of goods that amplify Americans' productivity. The
total sum of spending on machines, building structures, and adding toward
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inventories is gross investment. The amount of such investment spending that
does not replace obsolete and worn-out capital but increases the capital stock is
net investment. The difference is depreciation--the economy's consumption of
capital.
If we are talking about GDP, it is more natural and convenient to think of
investment as "gross investment"--indeed, this reference to gross investment is
where the "G" in GDP comes from. But on the income side it would be more
natural to think of net investment, for depreciation allowances are a deduction
from production before it becomes income; depreciation allowances are no one's
income.
In this textbook we will always use "I" to mean "gross investment" and "Y" to
mean Gross--rather than Net--Domestic Product. This means that whenever we
are thinking about the income side of the NIPA, we will have to remember that
we are implicitly adjusting total income by including depreciation allowances in
it.
What's in and what's out of GDP
Depreciation and net output.
Some things that NIPA measures and that are thus included in GDP should
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probably not be. Every year a portion of the capital stock loses its value. It wears
out or becomes obsolete--it is no longer worth keeping it operating because the
cost of keeping it operating is higher than the value of the goods it produces.
Replacing such worn-out or obsolete capital is a cost of production. It is as much
a cost of production to a business (or a government) as is meeting the business's
payroll.
Yet the NIPA counts such depreciation expenditures as part of GDP. They are
seen not as a cost of production but instead as the near-equivalent of building a
new factory to expand the business's productive capacity. The investment
component of GDP is total gross investment spending, not net investment
spending. The investment component of GDP includes both that part of
investment spending that actually adds to the value of the capital stock and that
part that merely keeps the economy's capital stock--and the firm's productive
potential--constant.
Depreciation expenditures are counted because the statisticians who compile the
NIPA have no confidence in their estimates of economy-wide depreciation.
Intermediate goods.
So-called "intermediate goods"--goods made by a company and then sold not to a
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consumer or the government (or exported, or bought by some firm undertaking
to increase its capital stock) but to another business--are excluded from GDP.
Such intermediate should be excluded form GDP: a product made by one
business and sold to another will show up in the NIPA only when the second
business sells its products to a consumer, an investor, a foreign purchaser, or the
government.
Why should intermediate goods be excluded from GDP? Because the value of the
intermediate goods has already been counted in GDP. The value of the
intermediate goods is included in the price of the final--that is, the sold-to-theconsumer--goods that the intermediate goods were used to make. If a home
builder buys wood from a lumber mill to build a house, the value of the wood is
then included in the value of the house.
To count the value of the wood again--to include the sale of the wood to the
home builder as well as the sale of the newly-constructed house to its first
purchaser--would be to count the value of the wood twice. And then what would
happen if the home builder bought the lumber mill? GDP shouldn't go down just
because two businesses have merged if the total amount produced remains the
same.
One good way to think about intermediate goods is to think that the goal of GDP
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31
is to count up the value-added in the economy at every stage of production. The
value added by any one business is equal to the total value of the firm's products
minus the value of the materials and intermediate goods that the firm purchases.
As we add up value-added over all the businesses in the economy, we find that
each intermediate good and material is entering our calculations twice--once
with a plus sign, when we calculate the value-added by the business that made
the intermediate good; and once with a minus sign, when we calculate the valueadded by the business that uses the intermediate good in its own process of
production.
Thus when we calculate GDP using this value-added approach, every good and
service in the economy cancels out except for those that are not sold to other
businesses which use them in the process of production. Which goods are not
intermediate goods? The final goods and services, of course--consumption
goods, goods purchased by the government, goods purchased as part of
investment, and net exports. Hence GDP--defined as the total value-added of all
firms in the economy--is equal to GDP--defined as the total value of final goods
and services produced in the economy.
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Housing
About half the people in the United States rent their dwellings. About half the
people in the United States own their own homes. When a landlord rents a house
to a tenant, he or she is selling them a service--the usefulness of having a roof
over one's head--just as much as a barber is selling you a service when you get a
haircut. Thus rent is one item of consumer spending--consumer spending on
services. It is part of expenditure in the FIRE--"finance, insurance, and real estate"
sector, one of the largest sectors of demand in the economy.
But suppose that you own your own home. You don't pay rent to yourself. Does
this mean that GDP goes down if a tenant buys the house he or she lives in from
the landlord? Before the purchase there was a month-by-month money flow-rent--from the tenant to the landlord; after the purchase there was no such flow.
Back when the NIPA were set up, it was decided that it would be too great an
anomaly for the level of GDP to depend on the relative proportions of renters
and homeowners. So it was decided that GDP would include "implicit" rent: the
BEA would calculate GDP as if all homeowners were schizophrenically divided
into renters and landlords, and that they would "impute" an amount of rent that
the renter-half of the person notionally paid each month to the landlord-half of
each person.
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33
This "imputed rent on owner-occupied housing" component of GDP is perhaps
the most poorly estimated component of GDP, for it is th eonly component of
aggregate demand that does not correspond to any real flow of spending in the
economy.
The government.
Also counted in GDP are government purchases of goods and services. The
government uses the goods and services it produces to provide some services of
its own: building roads, providing police protection and courts, maintaining
armies in West Germany to deter a Russian attack on Europe during the Cold
War, issuing weather reports, maintening the national parks.
Many of these services are of a kind that, if provided by private businesses,
would be counted as intermediate goods: things that are not goods-in-themselves
but instead are aids to private-sector production. As such, they would be
excluded from the GDP.
Think about it. Suppose that two companies made a contract. And suppose that
they agreed in their contract that so-and-so would be the judge of any disputes
that arose during the terms of the contract, and suppose that they paid so-and-so
a retainer. The services of the (private) judge that they hired would be counted in
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34
the NIPA as an intermediate good--something that was not part of final demand
because it was part of the process of production.
But all government purchases of goods and services are counted as part of GDP,
including the money that the government collects in taxes and then pays to its
own judges, bailiffs, and clerks who decide business-to-business disputes. A
large chunk of government consumption expenditures are of this form--items
that are counted as part of GDP, but that would not be counted had they been
made for analogous substantive purposes by private businesses.
What's not in GDP--but should be.
Moreover, many things are excluded from the NIPA system of measurement,
and thus from the GDP, that probably should not be. Production that takes place
within the household is excluded from GDP. That is, work that family members
do in order to keep the household going, but for which they are not paid, is
excluded from NIPA-based measures of the circular flow of economic activity.
This is surely a mistake that warps our picture of the economy. This year some
129 million Americans will work a total of some 206 billion hours (and some 7
million Americans will spend a total of 5 billion hours looking for jobs). But
Americans--overwhelmingly adult women--will also spend at least 100 billion
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35
hours doing things that would count as service-sector employment and would
count in GDP if they were doing them for pay rather than for their families--such
as cooking, cleaning, shopping, and chauffeuring.
Within-the-household production has never been counted as part of GDP. Back
when the NIPA was designed, its designers believed that it would be too hard to
obtain reasonable, credible, and defensible estimates of the economic value of
within-the-household production. The excuse remains that it would be hard to
measure.
The exclusion of within-the-household production makes a difference not just for
the level of national product but for its rate of growth. Over time the border
between market paid and nonmarket within-the-household unpaid work has
shifted. Be suspicious of economic growth rates that measure total GDP, or GDP
per capita, or GDP per adult, because they are distorted by the shifting dividing
line between what we do and how society arranges it. A meal cooked is a meal
cooked whether it is part of the market paid work of a chef at a restaurant, or
part of the nonmarket unpaid work of a housewife cooking for a family. Over
time the share of meals eaten prepared in the first way has grown, and the share
prepared in the second way has shrunk. This shift in the dividing line has raised
measured GDP. But it did not reflect an increase in society’s wealth.
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Depletion, pollution, and "bads".
The NIPA system makes no allowance for the depletion of scarce natural
resources. To the extent that an economy produces a high volume of income at
the expense of destroying valuable natural resources, such income is not true
income at all but is instead the dissipation of the economy's natural resource
capital. Kuwait, Qatar, and Saudi Arabia have high levels of real GDP per
worker. But a very large chunk of high current national incomes and products in
these resource-rich economies arise not out of sustainable production but out of
the sale of what are limited and depletable natural resources. A better system of
accounts for keeping track of the economy would have a category for the
depletion of natural resources.
Moreover, the NIPA contain no category for the production of "bads"--things
which are the opposite of economic "goods," things that you would rather not
have.
Producing more smog does not diminish GDP. Producing more cigarettes and
hence more cases of lung cancer does not diminish GDP. If the demand for locks
and alarm systems rises because crime increases, GDP increases. As noted, GDP
is a measure of productive potential only: not of economic welfare and not of
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whether other social and economic changes are causing people to use up
resources attempting to neutralize them.
The NIPA treatment of inventories.
Unwanted inventory buildup.
Suppose that a business produces too much of its output--then finds it cannot sell
it, and so the extra output piles up in the parking lot, protected from the rain by a
tarp. Doesn't this cause an interruption in the circular flow? After all, the
business has paid its workers to produce the stuff--hence income has been
generated--but the stuff sits there unsold, hence no sales or expenditures are
generated by it.
The accounting convention adopted by the NIPA is to treat the piling-up of
unsold inventory as an "investment" by the firm. The firm has expanded its
capital stock, in this case its stock of working capital tied up in goods already
made. Thus the firm is deemed to have "bought" its own inventory, and the
piling-up of inventory is treated as a form of investment.
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Inventory investment and the NIPA.
The NIPA adopts this accounting convention so that the circular flow principle
will continue to hold. The payments of wages and salaries must be matched by
some final expenditure, and in this case they are matched by an (involuntary)
investment by the business in an extra-large inventory of its unsold goods.
Changes in inventories and changes in economic activity.
Although they don't break the circular flow, such so-called involuntary
investments (or declines) in inventory are a principal cause of business cycles.
For buildups or drawdowns of inventory are an important cause of changes in
the magnitude of the circular flow, as changes in inventories induce businesses to
expand or contract production.
Suppose that in the economy as a whole inventories are growing rapidly.
Suppose that aggregate demand--again, the sum of consumption spending,
investment spending (not including inventory accumulation), government
purchases of goods and services, and net exports together--add up to
significantly less than total production. Then businesses as a whole will be
selling fewer goods than they are making, and economy-wide total inventories
will be rising.
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39
How will businesses respond to such a sudden--and undesired--increase in their
inventories? Some businesses will respond by cutting their prices, thus reducing
inflation (or, if the inflation rate is low enough causing deflation--falls in the
general price level). Other businesses will contract production to match demand,
and will fire workers because they no longer need to employ so many. Thus the
rate of the circular flow of economic activity will fall. The economy will contract.
Suppose, on the other hand, that aggregate demand adds up to more than total
production. Then businesses will be selling more than they are making. And total
economy-wide inventories will be falling. Some businesses will respond to
falling inventories by boosting their prices, trying to earn more profit per good
sold, and adding to inflation. Other businesses will expand production to match
demand, hiring more workers (and paying their existing workers higher
incomes). Thus the rate of the circular flow of economic activity will increase.
The economy will expand.
In the short run of months or a year or two, the changes in the magnitude of the
circular flow of economic activity that we see are mostly the result of expansions
and contractions of aggregate demand, and of the response of businesses as they
hire and fire workers in the process of trying to avoid either exhaustion of their
inventories or undesired buildup of surplus inventories of products that nobody
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wants to buy.
Making index numbers
Measures of material well being.
What would a good index of material well-being look like?
GDP per worker is our most frequently used measure of material well-being.
Presidents trumpet rapid growth and explain away declines in GDP per worker.
Columnists use GDP per worker to rank the relative desirability of life in
different countries.
But is GDP per worker a good index of material well-being and economic
productivity? What would a good index of material well-being look like?
If the economy produced just one and only one type of good--say, the meals of
ambrosia that the ancient Greek gods who lived on Mount Olympus were
supposed to consume--then there would be no conceptual problems at all in
measuring material well-being, or in constructing an index of GDP. Simply count
up how many meals of ambrosia were produced (and consumed) per worker.
That would be your quantitative index of material well-being.
Now such an index of material well-being might not tell you what you wanted to
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41
know about human happiness. Perhaps the jump from one meal of ambrosia a
day to two meals a day leads to an important and significant increase in human
happiness, but that increases from two to three and three to four meals of
ambrosia a day have only a trivial effect on psychological well-being. You would
like a good measure of human happiness to register that psychological fact. But
our index, created simply by counting meals created, would not do so.
Nevertheless such an index would be a perfectly adequate and satisfactory index
of economic productivity. If we were making the additional assumption that the
disutility of work--the blood, sweat, toil, and tears involved in production--did
not rise over time, then we could use our index of GDP per worker--meals of
ambrosia produced per worker--economic productivity--as a perfectly adequate
index of total material well-being as well.
More than one good.
Even if the economy produced more than one good--say, ambrosia on the one
hand and personal computers on the other--there still would be no problem
constructing a quantitative index of material well-being as long as the prices of
ambrosia and personal computers remained unchanged.
Suppose, for example, that one meal of ambrosia always cost $10 and that one
Chapter 3
42
personal computer always cost $1000. Then it would be straightforward to add
up the different quantities of goods produced: simply multiply the number of
computers produced by $1000, multiply the number of meals produced by $10,
add the dollar sums together, and you have a measure of economic productivity,
or GDP per worker.
An example.
Suppose that last year demand and producer supply said that each personal
computer was worth $1,000 while each meal of ambrosia was worth $10. If
average production and consumption in the economy consisted of one personal
computer plus two hundred meals of ambrosia per year for every worker, then
last year's GDP per worker was $3,000. If production (and consumption)
increased this year to two personal computers (plus two hundred meals of
ambrosia) per year for every worker, we would say that this year's GDP per
worker was $4,000--a year-over-year increase in GDP of 33%.
In the standard indifference-curve budget-set analysis of intermediate
microeconomics courses, as long as relative prices remain the same each increase
in the total value of goods produced is associated with a shift to a consumption
bundle on a better indifference curve for the representative consumer--a new
indifference curve that the consumer strictly prefers to the old indifference curve
Chapter 3
43
which was the best that he or she could reach before the total value of goods
produced has increased. Once again the quantitative yardstick provided by the
money value of the goods produced may not tell us much about changes in
human happiness (for that you would need to interview them, and to have a
psychologist on hand to interpret the interviews for you). But no one can take
exception to this quantitative yardstick of GDP per worker as a measure of
economic productivity, or (if we can once again conclude that the disutility of
work remains constant as productivity increases) as a measure of material wellbeing.
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44
Real and nominal GDP.
General inflation with constant relative prices.
Even if the prices of goods in terms of dollars changed, there would still be no
problem in constructing our quantitative index of material well-being--of GDP
per worker--as long as the changes in prices were restricted to a general inflation
or deflation that changed the level of all prices by the same amount, and left
relative prices--the price of one good in terms of the other--unchanged.
Consider our example in which production per worker rises from 1 personal
computer and 200 meals of ambrosia last year to 2 PC's and 200 meals of
ambrosia this year, and suppose that the government prints a lot of money,
distributes it to citizens to make them feel happy, and that inflation is the result:
so that this year the price of a PC is not the $1,000 it was last year but $2,000, and
the price of a meal of ambrosia is not the $10 that it was last year but $20.
Then the sum of the prices times the quantities of goods produced per worker-what economists call nominal GDP per worker--would have risen from $3,000 last
year to $8,000 this year--a year-over-year increase of 167%. This seems wrong.
Production of ambrosia has not increased at all. Production of PC's has increased
100%. Surely our index of output--which ought to be some kind of average of
production in all different industries--should increase by more than the biggest
increase in the production of any single commodity.
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The problem is that measured nominal GDP, the sum of all the goods produced
in the economy in a year multiplied by their prices, changes not just when the
amount of goods produced but when their prices change too. Yet such a change
in prices has no impact on the actual goods and services produced and
consumed, and should have no impact on human happiness (unless, of course,
you are made happier by consuming goods with larger price tags, even if they
are the exact same goods you saw before).
As long as all increases in prices are the same proportion, economists can solve
this inflation-or-deflation problem by calculating another measure, real GDP, a
measure of what nominal GDP would have been had there been no changes in
prices from one year to the next.
We would simply ask what the (new) bundle of goods produced and consumed
would have been worth at the (old) prices, and use the old prices to value
production and thus construct our estimate of real GDP per worker. Once again
we would have an unexceptionable measure of economic productivity, of real
GDP per worker, and--perhaps--of material well being.
The example
In the terms of our example, we would say that real GDP per worker measured
Chapter 3
46
at last year's prices has increased from $3,000 to $4,000, a 33% increase. Or we
could say that real GDP per worker measured at this year's prices has increased
from $6,000 to $8,000, a 33% increase. As long as relative prices do not change
and as long as we are clear about which year's prices we are using--which year
we are choosing for the base year--it doesn't matter which particular set of prices
we use to construct our estimates of real GDP per worker.
Many goods.
The same principal would apply no matter how many goods the economy
produces, as long as their relative prices remain unchanged. Multiply each good
by its price, and sum the totals to obtain the natural index of GDP per worker, or
economic productivity. If the overall price level has changed, make all
measurements in the prices that held in some suitably chosen base year. Once
again if we can make the additional assumption that the disutility of work--the
blood, sweat, toil, and tears involved in production--does not change, then our
index of GDP per worker--economic productivity--remains a perfectly adequate
index of total material well-being. And once again it is less satisfactory as a
measure of human happiness.
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The index-number problem.
Changes in relative prices.
But what if prices do not all increase or decrease by the same proportion? What if
relative prices change? What then would a good index of material well-being-and of GDP per worker--look like?
It is easy to see that there is at least the potential for big trouble. Let us extend
our previous example.
Suppose that this year the ambrosia harvest fails--no ambrosia meals at all. And
that the last leftover scraps of ambrosia are sold and eaten at a price of $100 per
meal this year. And suppose we look back not one year before the present, but
five years before the present back when personal computers were very scarce
and very expensive.
The table below shows prices and quantities of per worker annual production
and consumption in this model economy. What then do our attempts to produce
estimates of changes in real GDP produce?
Year
Five years ago
Four years ago
Three years ago
Ambrosia
200
200
200
Ambrosia
Price
$10
$10
$10
Personal
Computers
.001
.01
.1
PC
Price
$10000
$5000
$3000
Chapter 3
48
Two years ago
Last year
This year
200
200
0
$10
$10
$100
.5
1
2
$2000
$1000
$1000
And suppose that we take five years ago as our base year, so that we use the
prices of five years ago in calculating our index of total output, real GDP per
worker. Then production per worker today (measured at prices of five years ago)
is:
(3.4.3.1)
(2 PC' s  $10,000)  $20,000
And the value of production five years ago (measured at the prices of five years
ago) per worker was:
(3.4.3.2)
(200 ambrosia meals  $10)  (.001 PC' s  $10,000)  $2,010
At the prices of five years ago, the economy today is (in spite of the total failure of the
ambrosia harvest) more than nine times as productive as the economy of five years ago: in
dollars of five years ago, real GDP per worker (measured at the prices of five years ago) has
risen from $2.01 to $20 thousand.
But if we take prices today as the prices to use in calculating our index of total production,
then production today (measured at today's prices) is:
(3.4.3.3)
(2 PC' s  $1,000)  $2,000
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49
While production five years ago (measured at today's prices) was:
(3.4.3.4)
(200 ambrosia meals  $100)  (.001 PC' s  $1,000)  $20,001
And so at the prices of today, the economy today (with the failed ambrosia
harvest) is less than one-tenth as productive as the economy of five years ago:
real GDP per worker (measured at today's prices) has fallen from $20 to $2
thousand.
So which do we believe? Has real production shrunk by 90%? Or has it risen by
more than 900%?
The problem is that using the date five years ago as the base year puts an
extraordinarily high weight on PC's--for they were extraordinarily expensive
then. Because production of computers has boomed, real GDP with five years
ago as the base sees an extraordinary increase in production. By contrast, using
this year as the base year puts a high weight on ambrosia--for ambrosia is
expensive this year because it is very hard to find. Using this year as the base
year sees an extraordinary decline in production, because the ambrosia harvest
has failed.
So the answer is that we believe neither. When prices are changing rapidly and
significantly, no choice of price weights corresponding to a particular base year
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50
to measure changes in real GDP per worker will give a good and unambiguous
answer to the question "how much has real GDP per worker changed?"
Let me hasten to add that in the real world things are not nearly as bad as they are
in the cooked example above. Neverthless, it is not out of the question for
estimates of U.S. economic growth over a year to shift by a full percentage point
as the base year is moved from ten years in the past to five years in the past to the
present to five years in the future.
Chain indices.
In order to minimize the problems involved in measuring real GDP over time
spans in which prices change significantly, today the Commerce Department's
Bureau of Economic Analysis constructs estimates of real GDP through a process
called chain-weighting. Use 1997's prices to construct estimates of real GDP
growth between 1997 and 1998; use 1998's prices to construct estimates of real
GDP growth between 1998 and 1999; use 1999's prices to construct estimates of
real GDP growth between 1999 and 2000; and then chain all of these growth
estimates together to produce a value for real GDP in 2000 relative to real GDP in
1997. The advantage of chain indices is that they make the index-number
problem small: since relative prices change little between one year and the next,
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51
there is little opportunity for the different weights implicit in shifting prices to
cause differences in estimated growth from one year to the next.
These chain-weighted measures are superior to measures of real GDP that never
change the base year used to choose prices. After all, over time prices change. It
is very misleading to measure changes in productivity today using prices from
some long-ago base year in which the relative values of goods were much
different than they are today. As long as the chain-weighted index never allows
the prices it uses to drift far away from prevailing market prices, the chainweighted index will come as close as possible to solving index number problems,
and be close to a true cost-of-living based estimate of real GDP.
The GDP deflator.
From our estimates of real GDP (however derived) and our estimates of nominal
GDP we can derive a particular expression for the average level of prices: the
GDP deflator. The GDP deflator is that number which turns nominal GDP into
real GDP.
No min al GDP P1  Qgood 1  ...  Pn  Qgood n 
GDP Deflator 
 base
now
base
now
Re al GDP
 Qgood
P1  Qgood
1  ...  Pn
n
now
3.4.3.5
now
now
now
It is defined implicitly as the quotient of the other two measures. Thus you may
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52
sometimes see it referred to as the "implicit price (or GDP) deflator." The GDP
deflator suffers from the same sorts of ambiguity and dependence on the base
year as do the GDP measures from which it is derived.
Although easily calculated, the GDP deflator is not the most frequently used
measure of inflation. The most frequently used estimate of the changing price
level is the consumer price index--the result of a direct survey of the prices of
goods and services by the Department of Labor's Bureau of Labor Statistics.
The consumer price index.
Constructing the CPI.
The most commonly-used measure of the overall level of prices and inflation is
the consumer price index, calculated each month by the Bureau of Labor
Statistics. The Federal Reserve watches the CPI very closely. Private contracts
with cost-of-living allowances built into them--adjustments that change the
number of dollars that one party has to pay as the overall price level changes-almost always use the CPI as their measure of the price level. The government as
well uses the CPI to adjust its programs: where the tax brackets are is indexed to
the CPI. Social Security benefits are adjusted upward each year by the same
proportional amount as the increase in the CPI.
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53
The consumer price index attempts to summarize the information in the prices of
many different goods and services into a single number that measures the
"overall level" of prices paid by consumers.
How do economists construct the CPI? The Bureau of Labor Statistics surveys
consumers and constructs a list of the items purchased by the typical consumer.
It then constructs its market basket: each good having the same share of the
market basket as its share of the typical consumer's expenditure pattern. As the
prices of goods in the market basket change, so the consumer price index will
change in proportion.
Substitution bias in the CPI.
How good a measure of the inflation is the consumer price index?
One problem with the CPI is that it is subject to substitution bias. The CPI
measures the price of one particular set of goods, the fixed market basket chosen
in the base year. Thus it does not take account of the power consumers have to
raise their welfare by shifting their consumption towards goods whose relative
prices have fallen. Indeed, this is why the CPI is called the consumer price index
rather than the consumer cost of living index.
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54
The fact that the CPI considers only the cost of a fixed basket of goods (albeit a
basket of goods that is updated every five years or so) means that it tends to
overestimate the rate of inflation. Suppose that the price of ambrosia goes skyhigh because the quantity of ambrosia is greatly reduced--as in our example
above. The CPI would record a very large increase in the level of prices. But if
you asked a consumer how much of an increase in income would he or she need
in order to compensate for the increase in ambrosia prices, the answer you would
get would be a smaller number than the percentage increase in the CPI.
Why? Increasing income by the same amount as the increase in the CPI would
allow the consumer to purchase the same goods and services as before the price
rise. But when the customer took a look at the prices he or she was paying, he or
she would be very unlikely to want to purchase the same goods and services as
before. Look at how much ambrosia is costing! Do you really like ambrosia that
much? Given that it is so expensive, wouldn't you rather cut back on ambrosia
purchases and spend your money on other, cheaper commodities that you like
more?
In response to a large increase in the price of any one good, consumers substitute
away from it--hence the name "substitution bias." Because consumers have the
ability to buy more of goods that have become relatively cheap--to shift their
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55
consumption pattern in response to scarcities signalled by rises in prices--the cost
of living will have gone up by less than the consumer price index.
[Substitution bias figure]
Substitution bias is limited, however. The CPI is periodically rebased, every five
years or so. The hope is that this rebasing limits substitution bias to 0.2% per year
of understatement of inflation or so.
New goods and new kinds of goods.
A more important problem with the CPI is the fact that new goods and new
types of goods and continually being introduced, and the CPI cannot take
account of them until some time--usually some considerable time--after they
have been introduced. Whenever a new good that performs the same service for
consumers as an old good--only better--is introduced into the marketplace, there
is a discrete upward jump in consumer well-being. But unless the CPI is rapidly
and carefully adjusted, at least some part of this upward jump in consumer wellbeing will be missed.
[New goods and new types of goods figure]
Things may well be worse when a new good is introduced that performs a
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genuinely new service for consumers. Consumers are certainly better off--they
have more choice, and those of them who choose to consume the new good are
definitely happier. But this increase in well-being never makes its way into the
CPI.
Changes in quality.
Yet another problem is the fact that the BLS's ability to track changes in the
quality of different goods is limited. Whenever a firm changes the quality of an
existing product, or replaces an existing product with a new product that does
more at the same price, consumer welfare is enhanced. Yet do the estimators
have the information that they need to accurately track changes in quality?
Probably not.
Government statisticians do their best to take account of quality changes. Some
parts of the process of constructing the CPI make explicit reference to the
characteristics of the goods priced.
[Changes in quality figure]
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57
What bias remains?
But the belief is that all of these adjustments that can be reasonably made are a
partial solution only, and that the CPI does overstate the rate of inflation. By how
much--half a percent per year, a full percent per year, or one and a half percent
per year? Nobody really knows.
Most economists do, however, believe that the consumer price index (and other
price indices as well) do overstate inflation by some amount. If our price indices
overstate inflation, and if our nominal GDP and nominal spending measures are
more-or-less unbiased (as we believe them to be), then our real GDP and other
real output estimates are understating economic growth.
[Figure: effects of hypothetical biases]
The amount by which our real GDP, other real output estimates, and other real
estimates (like our estimates of the real wage, or the real rate of interest) are
understating true economic growth is uncertain--it is simply the reverse side of
the coin that is our uncertainty about the magnitude of bias in our price indices.
This means that the true news about economic growth is slightly better than you
will read in the newspapers.
For how long have our estimates of economic growth been biased? There is no
reason to believe that the bias is any greater now than it has been at any other
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time in the twentieth century. Before the last quarter of the nineteenth century,
however, the pace at which new goods--or at least new consumer goods--was
introduced was much slower. So there is reason to think that the bias in standard
statistical measures of economic growth was markedly less back before 1875, and
was probably effectively zero before 1700.
Measuring the international economy
Imports and exports.
Definitions of imports and exports.
Goods (and services) produced abroad yet consumed or used here at home are
our imports. Goods (and services) produced here and shipped abroad to be
consumed or used there are our exports.
The growing relative importance of international trade.
In the years just after World War II, imports and exports from the U.S. were
about five percent of GDP--amounted to about one-twentieth of total economic
output. The United States then was more-or-less a closed economy, and
macroeconomics textbooks proceeded more-or-less ignoring the importance of
international trade and finance, save for one "open economy macro" chapter near
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the end of the book that the course often did not get to.
[Imports and Exports as Shares of GDP, 1890-2000]
Today imports and exports from the U.S. are about fifteen percent of GDP--three
times as large a share as fifty years ago--and are headed higher. The American
economy is no longer a closed economy, and international economics issues can
no longer be relegated to a chapter at the back of the textbook.
Other major economies are even more open.
However, the U.S. economy is still one of the more closed economies in the
world. Of the major industrial economies, only Japan has a lower share of
imports and exports in GDP.
[Imports and exports as shares of GDP in other countries]
The current account and the capital account.
Classifying international transactions.
Imports and exports together make up what international economists call the
current account: they are purchases and sales of goods and services for current
use. But there are other international transactions--capital account transactions--
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that involve not the purchase and sale of goods and services for current
consumption and other uses but the purchase and sale of pieces of property,
investments, assets valued because they hold the potential to generate income in
the future.
[Balance of payments diagram]
There is also--whenever governments get into the act, and conduct large foreign
exchange transactions of their own, an official settlements account.
The balance-of-payments identity.
The current account, capital account, and official settlements account are all
related by the so-called balance-of-payments identity:
3.5.2.1
NX  (OI  OI )  OS  0
d
f
Net exports (NX) plus overseas investments abroad made by domestic residents
(OId) minus overseas investments in the U.S. made by foreign residents (OIf) plus
official settlements transactions (OS) must equal zero.
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Why the balance-of-payments identity holds.
Why must this balance-of-payments identity hold?
Think of it this way. When Americans export goods to foreigners, they don't get
paid in dollars--foreigners pay for American exports using their own, foreign
currencies. Some of that foreign currency-denominated sum that American
exporters earn is then traded by them to those who want to import goods from
abroad. But imports don't match exports--the difference is net exports, NX. And
so American exporters are left with an amount NX of foreign currency that they
have earned by selling abroad, and that they have been unable to exchange for
dollars with those wishing to import goods into the United States.
So what can exporters then do with these extra holdings of foreign currency, an
amount NX, that they have earned? They can either trade them to some
government (if some government is carrying out official settlements transactions)
or they can trade them to someone in America who wants foreign currency
because he or she wants to buy property abroad--wants to make a foreign
investment and so engage in a capital-account transaction. But people in America
seeking to invest overseas and demanding foreign currency could also get the
foreign currency they need from foreigners seeking to invest in America: only to
the extent that there are more Americans investing abroad than there are
foreigners investing here will the capital account be a source of demand for the
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excess foreign currency earned by net exports.
[Diagram: possible uses of foreign currency earned by exporters.]
No leakages from the balance-of-payments.
But must the balance-of-payments identity hold? Suppose an exporter doesn't
want to trade his foreign currency to someone seeking to make overseas
investments, but instead hides his foreign currency under his mattress. Then--by
the same logic as in the analysis of the household trying to hoard dollar bills in
the uses-of-income section above--the exporter has made an overseas investment:
by hoarding the foreign country's currency he or she has made an interest-free
loan to the foreign government that issued the currency.
Exchange rates.
The exchange rate is the relative price of two different kinds of money.
The exchange rate is the rate at which the currencies used in two different
countries can be traded or exchanged for each other. When economists talk of the
exchange rate, they try to distinguish between the nominal exchange rate and the
real exchange rate--between the relative prices of two currencies and the relative
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prices of a certain amount of purchasing power or productivity in the two
countries.
[Diagram: the U.S. nominal exchange rate over time]
Nominal and real exchange rates.
The nominal exchange rate is the number reported on the financial pages of
newspapers. The nominal exchange rate is the relative price of two different
kinds of money. If the exchange rate between the dollar and the euro is $1.20,
that means that it takes one dollar and twenty cents of U.S. currency--1.2 of the
U.S. currency unit, the dollar--to buy a single euro, to buy a single unit of the EC
currency unit. Conversely, it then takes 0.83 and change euros to buy a single
unit of the U.S. currency, the dollar.
The real exchange rate is the nominal exchange rate divided by the respective
countries' price levels. The real exchange rate is best thought of as the relative
price of goods made in the two different countries--the terms of trade at which
we can exchange the goods made in one country for the goods made I the other,
or at which we can exchange purchasing power over the goods made in one
country for purchasing power over the goods made in the other.
[Diagram: U.S. nominal and real exchange rates]
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Calculating the real exchange rate.
We calculate the real exchange rate by (a) taking the nominal exchange rate and
(b) multiplying it by the ratio of the price levels in the two countries:
3.5.3.1
  e
P
P*
where  is the real exchange rate, e is the nominal exchange rate, P is the price
level here in the United States, in the home country, and P* is the price level
abroad.
Beware! Economists follow two inconsistent conventions in measuring exchange
rates, both real and nominal. Some textbooks define the nominal exchange rate as
the price (in terms of the home currency) of the foreign currency (and define the
real exchange rate as the price in terms of home goods of foreign goods). Under
such a definition when the dollar is appreciated--when the dollar is more valuable-the measured exchange rate is low because the price of foreign currency is low.
Other textbooks define the nominal exchange rate as the value (in terms of
foreign currency) of the home currency, the dollar--and define the real exchange
rate as the value of home goods in terms of foreign goods.
[Diagram: the value of the dollar/the price of foreign currency]
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The second convention goes much more easily with the terms used in day-to-day
conversation to describe exchange rate movements. It is much more natural to
say that as the dollar appreciates (becomes more valuable) the exchange rate rises.
At any rate, I think that the second convention has less potential to cause
confusion.
Thus in this book the (nominal) exchange rate is always the value of the home
currency, the (real) exchange rate is always the value of home goods in terms of
foreign goods. An appreciation or revaluation of the dollar is a rise in the
exchange rate, and a depreciation or devaluation of the dollar is a fall in the
exchange rate.
Relative purchasing power.
Purchasing power parity.
Is there any economic principle that governs what fluctuations exchange rates
undergo? Economists believe that exchange rates are loosely--very loosely--tied
to the anchors provided by so-called purchasing-power-parity: the belief that if I
take a sum of dollars it ought to buy roughly the same amount of goods in San
Francisco as it would buy if turned into Hong Kong dollars and spent in Hong
Kong. After all, if the same amount of money at current exchange rates bought
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much more in Hong Kong then in San Francisco then it would be to my
advantage to move to Hong Kong to spend my money, and it would be to the
advantage of entrepreneurs in Hong Kong to export to San Francisco and
undercut the current market price here.
The principle of purchasing power parity thus declares that exchange rates
should stay close to the values that gives a dollar--exchanged into the local
currency--the same purchasing power everywhere. And the principle of
purchasing power parity places some limits on exchange rate fluctuations: toolarge exchange rate fluctuations should cause goods (and people!) to move across
national boundaries to take advantage of profit and consumption opportunities.
Barriers to trade and migration.
But people are hard to move across national borders. People generally like to live
among those who speak their birth-tongue. And governments are in the business
of making large-scale permanent migrations of large groups of people illegal.
And while some goods--portable computers, chairs, textiles, light fixtures--are
very cheap and easy to ship across oceans and borders, there are many other
goods and especially services (fresh tuna or crab, haircuts, guided tours of the
Grand Tetons, or someone to vacuum your car) that are next to impossible to
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trade.
Purchasing power parity properly understood.
Thus purchasing power parity, properly stated, declares not that the purchasing
power of a dollar--exchanged into the local currency--should be the same
everywhere, but that the purchasing power of a dollar over goods that can be
easily and cheaply traded across borders should be roughly the same anywhere.
[Diagram: real exchange rates and the Balassa effect]
In relatively rich countries factory productivity is relatively high and the wages
of unskilled labor are relatively high, and so the types of manufactured goods
that are easily traded are very cheap in terms of labor or of the price level as a
whole. In relatively poor countries factory productivity is relatively low and the
wages of unskilled labor are relatively low, and so the types of manufactured
goods that are easily traded are expensive in terms of labor or of the price level
as a whole. Purchasing power parity works to make the prices of easily-traded
manufactured goods the same in different countries, but in one--rich--country
labor is expensive relative to manufactures, and in another--poor--country labor
is cheap relative to manufactures.
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Poor countries tend to have adverse terms of trade.
Thus we would expect the overall price level and real exchange rate in a poor
country to be lower than in a rich country because purchasing power parity
works to equalize the price across borders of the goods in which the rich country
has a comparative advantage--internationally-traded manufactures--but not the
prices across borders in which the poor country has a comparative advantage-labor-intensive services. We would expect a dollar to go farther in a poor country
than a rich one, and for the poor country to have relatively disadvantageous
terms of trade.
Measuring unemployment
Who's unemployed?
Estimating the unemployment rate.
Keeping unemployment low--keeping workers who want to work employed at
jobs they like--is perhaps the chief goal of modern economic policy, and is one of
the most important indicators of economic performance. Every month the Labor
Department's Bureau of Labor Statistics [BLS] sends interviewers to talk to 60,000
households in a nationwide statistical survey of the U.S. population, the Current
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Population Survey. And every month the BLS produces an estimate of the
current unemployment rate: the fraction of people who (a) wanted a job, (b)
looked for a job, but (c) could not find an acceptable job in the preceding month.
[Diagram: unemployment and its components]
The BLS classified the people it interviews into four catagories:

(1) Those who were employed--had a job, of some sort.

(2) Those who were out of the labor force and did not want a job right now.

(3) Those who did want a job right now, but who had not been looking
because they did not think they could find one they would take.

(4) Those who did want a job right now, had been looking, but had not found
a job that they would take.
The BLS defines the labor force as the sum of group (1) and group (4): those who
had jobs plus those who looked for jobs. The unemployment rate that the BLS
reports is equal to the number of the unemployed divided by the labor force:
group (4)/{group(1) + group(4)}.
[Diagram: unemployment over time]
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Alternative estimates.
Perhaps the BLS's report is an underestimate of the real experience of
unemployment in the United States today. Someone in group (3)--who wants a
job, but who has given up looking because he or she feels that it is hopeless--may
well feel as unemployed as someone in group (4). Perhaps the press should
include such discouraged workers among the unemployed and should report a
higher unemployment rate, calculated as: {group(3) + group(4)}/{group(3) +
group(4) + group(1)}. And some of those who are in group (1) have part-time
jobs but wish for full-time jobs. Perhaps those who are part-time for economic
reasons should be counted as unemployed--or as half-unemployed--as well.
Labor force participation.
An alternative way of looking at the CPS survey is to look at the labor force
participation rate--the percentage of the adult population in the labor force.
Fluctuations in labor force participation mirror the fluctuations in the
unemployment rate: When the unemployment rate is relatively high, the labor
force participation rate is likely to be relatively low.
[Diagram: labor force participation]
Underneath those fluctuations in the labor force participation rate caused by the
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business cycle, however, is the secular increase in labor force participation
largely driven by the increased labor force participation of women. Fifty years
ago sex discrimination was rife--and legal. It was not uncommon for a woman to
be fired when she got married, just because she got married.
Today women's labor force participation is still lower than that of men for most
ages and ethnic groups. But it is much higher than it was even a single
generation ago.
Unemployment and race, sex, and age.
There are striking and persistent variations in unemployment by demographic
group and by class. Teenagers (16-19) have higher unemployment rates than
adults, blacks have higher unemployment rates than whites, high-school
dropouts have higher unemployment rates than those who have post-graduate
degrees. For most of the post-WWII period (but not recently) women have had
higher unemployment rates than men.
[Diagram: Unemployment by demographic groups over time]
One of the most important reasons for high unemployment among the lesseducated, the not-white, and the young has been that these groups are much less
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likely than the married white prime-age well-educated to hold stable long-term
jobs. The non-white, the less-educated, and the young lose their jobs much more
often.
A large part of this is the legacy of discrimination. Past discrimination leads to
present poverty, present poverty leads to underinvestment in education. Low
education, current discrimination, and little work experience tends to make it
more likely that one holds a 'dead-end' job, or a temporary job. These jobs don't
last, and so the young, the less-educated, and the non-white have to spend a lot
of time lookijng for work.
Women traditionally had higher levels of unemployment because they had a
high propensity to leave the labor force upon the birth of a child. Thus a large
proportion of their job tenures were cut short. And they too had to spend a
greater fraction of their time in the labor force looking for jobs, hence had higher
unemployment rates. Since the early 1980s, however, female unemployment
rates in the United States have been lower than male unemployment rates.
How long are they unemployed for?
The duration of unemployment.
The question "how long is the typical person unemployed for" turns out to be a
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subtle one that is remarkably hard to answer. It is remarkably hard to answer
because the question is fundamentally ambiguous. Most people who first become
unemployed on any one particular day--say January 15, 2001--will stay
unemployed for only a short time: more than half will find a job within a month.
Yet if we look at all the people unemployed on January 15, 2001, we will find that
some three-quarters of them will have been unemployed for more than two
months before they find another job.
[diagram: unemployment by duration of spells]
An analogy.
The reason for this is the same as the reason that your college's deans can tell
your parents that most courses taught are small and yet that you always seem to
wind up in enormous courses. Suppose that of every ten courses taught at a
university, nine have twenty students each and the tenth has 320 students. Then
the size of the average course that a professor teaches is fifty:
3.7.2.1
9  20   1 320 
10
 50
But the size of the average course that a student takes is much larger--for 180
students take a course of size 20, and 320 students take a course of size 320. The
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size of the average course that a student takes is 212:
3.7.2.2
320  320   180  20 
500
 212
Similarly, the average person who becomes unemployed will be unemployed for
only a short period of time. But the average unemployed person (at any one
moment) has probably been unemployed for a while, and probably will remain
unemployed for a considerable length of time.
Kinds of un and underemployment: frictional, structural, and cyclical.
Types of unemployment.
The kind of unemployment that falls and rises with the business cycle is cyclical
unemployment. But there are other kinds as well.
Frictional unemployment arises inevitably as people change jobs and as firms
hire workers in the same way that inventories of goods are needed as goods are
moved from place to place and sold to consumers.
"Structural" unemployment arises whenever there is a class of workers whom
employers fear lack the skills necessary for their work to be worth the wages they
would have to be paid.
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Frictional unemployment.
Think of frictional unemployment as the economy's "inventory" of workers. But
it is an inventory that changes in size. Some public programs (such as job search
assistance) reduce frictional unemployment by making it easier to match up
firms with workers. Others public programs (such as unemployment insurance)
increase frictional unemployment by giving workers the financial cushion to
search longer for better jobs.
Some amount of frictional unemployment is inevitable, and it is not necessarily a
bad thing. If the extra time frictionally unemployed people spend searching for
better jobs does land them one in which they are more productive, it is time well
spent.
[Diagram: types of and reasons for unemployment]
Structural unemployment.
The structurally unemployed are those whom employers think add less value
than their wage cost, and who believe that no potential employer would offer a
wage high enough to make employment worthwhile. People fall into this
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category because the industries in which they used to work shut down, or
something went wrong in their transition from school to work and they never
became attached to the labor force.
Structural unemployment remains even when the business cycle reaches its peak.
Cyclically unemployed people will, if their unemployment lasts too long, become
"structurally" unemployed. This happened in the U.S. in the 1930s, and it has
happened in Europe in the 1990s.
Cyclical unemployment and GDP
Okun's law.
Macroeconomics courses focus on the business cycle: shifts in inflation, in
unemployment (around its natural rate), and in national product relative to the
productive potential of the economy--the economy's potential output.
The link between business cycles and long-run growth is made through Okun's
law: a strong relationship between the unemployment rate and the level of
national product.
Okun's law holds that, when unemployment is at its natural rate, national
product is equal to potential output. Whenever national product output grows
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faster than potential output, unemployment falls. Whenever national product
output grows slower than potential output, unemployment rises.
The strength of Okun's law.
The Okun's law link between national product and unemployment is very
strong. Fluctuations in unemployment relative to its natural rate and in national
product relative to potential output are so highly correlated as to leave no
significant distinction between the two.
Thus economists sometimes talk about business cycles as fluctuations in
unemployment relative to the natural rate, and sometimes as fluctuations in
national product relative to potential output. Because of the strength of Okun's
law, there is no distinction between the two.
[Diagram: Okun's law]
Why are fluctuations in output proportionally larger than fluctuations in
unemployment?
This is not a 1-to-1 relation but a 2.5-to-1 relation. In other words, take the
difference between the natural rate and the current rate of unemployment and
multiply by 2.5: The result is the percentage gap between national product and
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potential output. So, for example, when unemployment is two percentage points
above its natural rate, national product will be 5% below potential output.
Why does it take such a large change in output to reduce unemployment?
Instead of a 2.5:1 ratio of a change in output to change in unemployment, why
not 1:1?
One part of the answer is that the unemployment rate as officially measured does
not capture all the people unemployed as a result of a recession. In a recession,
the number of people at work falls. The number of people looking for work rises.
And the number of "discouraged workers"-people who are not looking for work
because they do not think they could find jobs, but would be at work if business
conditions were better-rises.
The unemployment rate does not include these discouraged workers.
Moreover, when business is good, firms' initial response is not to hire more
employees, but to ask existing employees to work more hours. So, instead of
unemployment quickly going down, average hours of work per week go up.
[Diagram: Sources of the 2.5-1 Okun's law coefficient]
Second, some industries find that employing more workers increases production
by more than a proportional amount: Product design and set-up tasks need to be
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done only once no matter how much is produced. So they do not need twice as
many workers to produce twice as much output.
Why people fear recessions so much.
In an average recession, unemployment rises by 2%. Okun's law predicts that, in
such a case, national product relative to potential output falls by about 5%. That's
about three years' worth of economic growth. Yet people fear a recession much
more than they value an extra three years' of economic growth.
Why? Because recessions do not distribute their impact equally. Workers who
keep their jobs are only lightly affected, while those who lose their jobs suffer a
near-total loss of income. People fear a 2% chance of losing half their income
much more than they fear a certain loss of 1%. Thus it is much worse for 2% of
the people each to lose half of their income than for everyone to lose 1%.
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