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Introduction to GDP, Growth, and Instability
CHAPTER TWELVE
INTRODUCTION TO GDP, GROWTH, AND INSTABILITY
CHAPTER OVERVIEW
News headlines frequently report the status of the nation’s economic conditions, but to many citizens the
information is confusing or incomprehensible. This chapter acquaints students with the basic language
of macroeconomics and national income accounting. GDP, growth, business cycles, unemployment, and
inflation are all defined and explained. The chapter sets the stage for the analytical presentation in later
chapters.
Measurement of GDP through expenditures is developed, as is the process of deflating nominal GDP to
find real GDP. Global comparisons are made with respect to size of national GDP and size of the
underground economy.
Economic growth is defined and the arithmetic and sources of economic growth are examined. The
record of growth in the U.S. is viewed from several perspectives including an international comparison
in Global Snapshot 12.3. The business cycle is introduced in historical perspective and is presented in
stylized form (Figure 12.1).
The section on unemployment first addresses the measurement process. The various types of
unemployment—frictional, structural, and cyclical – are then described and considered in terms of full
employment. The economic costs of unemployment are presented, and finally, Global Snapshot 12.4
gives an international comparison of unemployment rates.
Inflation is accorded a rather detailed treatment from both a cause and an effect perspective.
Measurement of inflation using the CPI is developed, followed by historical data on U.S. inflation since
1960 (Figure 12.3). International comparisons of inflation rates in the post-1994 period are given in
Global Snapshot 12.5. . Demand-pull and cost-push inflation are described. The effects of inflation are
examined in terms of deflating nominal income to real income, changes in output, and the effects of
anticipated and unanticipated inflation on various subgroups of the population. The chapter ends with
historical cases of hyperinflation to remind students that inflationary fears have some basis in fact.
INSTRUCTIONAL OBJECTIVES
After completing this chapter, students should be able to:
1. Define Gross Domestic Product (GDP).
2. List and explain the expenditure components of GDP.
3. Compute GDP using either expenditure data.
4. Explain why changes in inventories are investments.
5. Find real GDP using price and output data for various years.
6. Explain what is meant by the underground economy and state its approximate size in the U.S. and
how that compares to other nations.
7. Define two measures of economic growth.
8. Explain why growth is a desirable goal.
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9. Identify two main sources of growth.
10. Explain the “rule of 70.”
11. Summarize growth rates information since 1996 for the U.S. and other nations as depicted in
Global Snapshot 12.3.
12. Describe what has happened to U.S. real GDP and real GDP per capita since 1950.
13. Explain what is meant by a business cycle.
14. Graph and describe the four phases of an idealized business cycle.
15. Describe the U.S. experience with recessions since 1950.
16. Describe how the Bureau of Labor Statistics (BLS) measures unemployment.
17. Define and state causes of frictional, cyclical, and structural unemployment.
18. Define full employment.
19. Identify the economic costs of unemployment.
20. Define inflation and list two types of inflation.
21. Use price data to construct a consumer price index (CPI), and use the CPI to calculate the rate of
inflation and how long it will take for prices to double.
22. Calculate and explain how inflation affects real income.
23. List three groups who are hurt and two groups who may benefit from unanticipated inflation.
24. Present three possible effects of inflation on output and employment.
25. Compare U.S. inflation and unemployment rates to one or more industrialized nations.
26. Define and identify terms and concepts listed at the end of the chapter.
LECTURE NOTES
I.
Gross Domestic Product
A. GDP is one of the National Income and Product Accounts (NIPA) compiled by the
Commerce Department’s Bureau of Economic Analysis (BEA).
B. GDP is the monetary measure of the total market value of all final goods and services
produced within a nation’s borders in one year.
1. Money valuation allows the summing of sofas and computers; money acts as the
common denominator. (See Table 12.1.)
2. GDP includes only final products and services; it avoids double or multiple counting, by
eliminating any intermediate goods used in production of these final goods or services.
3. Secondhand sales are excluded, they do not represent current output. (However, any
value added between purchase and resale is included, e.g. used car dealers.)
C. Measuring GDP
1. GDP is divided into the categories of buyers in the market; household consumers,
businesses, government, and foreign buyers.
2. Personal Consumption Expenditures—(C)—includes durable goods (lasting 3 years or
more), nondurable goods, and services.
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3. Gross Private Domestic Investment—(Ig)
a. All final purchases of machinery, equipment, and tools by businesses.
b. All construction (including residential).
c. Changes in business inventory.
i. If total output exceeds current sales, inventories build up.
ii. If businesses are able to sell more than they currently produce, this entry will be a
negative number.
4. Government Purchases (of consumption goods and capital goods) – (G)
a. Includes spending by all levels of government (federal, state and local).
b. Includes all direct purchases of resources (labor in particular).
c. This entry excludes transfer payments (e.g. Social Security, welfare) since these
outlays do not reflect current production.
5. Net Exports—(Xn)
a. All spending on final goods produced in the U.S. must be included in GDP, whether
the purchase is made here or abroad.
b. Often goods purchased and measured in the U.S. are produced elsewhere (imports).
c. Therefore, net exports, (Xn) is the difference: (exports minus imports) and can be
either a positive or negative number depending on which is the larger amount.
6. Summary: GDP = C + Ig + G + Xn
7. Global Snapshot 12.1: Comparative GDPs in Trillions of U.S. Dollars, Selected
Nations, 2003.
II.
Nominal GDP versus Real GDP
A. Nominal GDP is the market value of all final goods and services produced in a year.
1. GDP is a (P x Q) figure including every item produced in the economy. Money is the
common denominator that allows us to sum the total output.
2. To measure changes in the quantity of output, we need a yardstick that stays the same
size. To make comparisons of length, a yard must remain 36 inches. To make
comparisons of real output, a dollar must keep the same purchasing power.
3. Nominal GDP is calculated using the current prices prevailing when the output was
produced but real GDP is a figure that has been adjusted for price level changes.
B. Valid year-to-year comparisons cannot be made with nominal GDP alone, since both prices
and quantities are subject to change.
1. When there has been inflation, nominal GDP must be deflated; if deflation has occurred,
nominal GDP must be inflated to put GDP in real terms.
2. Using a one good economy as an example, real GDP for a given year can be found by
taking the quantity of goods produced in that year times the base year price of the good.
Any GDP changes from the base year will then reflect genuine output changes, as prices
are held constant.
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C. U.S. nominal GDP in 2004 was $11,734 billion; real GDP in 2004 (measured in 2000 base
year prices) was $10,842 billion.
D. The Underground Economy
1. Illegal activities are not counted in GDP (estimated to be around 8% of U.S. GDP –
about $939 billion in 2004).
2. Legal economic activity may also be part of the “underground,” usually in an effort to
evade taxation.
III.
Growth and the Business Cycle
A. Two definitions of economics growth are given.
1. The increase in real GDP, which occurs over a period of time. This definition is useful
for measuring military potential or political preeminence.
2. The increase in real GDP per capita, which occurs over time. This definition is superior
if comparison of living standards is desired. For example, China’s 2003 GDP was $1410
billion compared to Denmark’s $212 billion, but per capita GDP’s wee $1110 and
$33,750 respectively.
3. Growth in real GDP does not guarantee growth in real GDP per capita. If the growth in
population exceeds the growth in real GDP, real GDP per capita will fall.
B. Growth is an important economic goal because it means more material abundance and ability
to meet the economizing problem. Growth lessens the burden of scarcity.
C. The arithmetic of growth is impressive. Using the “rule of 70,” a growth rate of 2 percent
annually would take 35 years for GDP to double, but a growth rate of 4 percent annually
would only take about 18 years for GDP to double. (The “rule of 70” uses the absolute value
of a rate of change, divides it into 70, and the result is the number of years it takes the
underlying quantity to double.)
D. Main sources of growth are increasing inputs or increasing productivity of existing inputs.
1. About one-third of U.S. growth comes from more inputs.
2. About two-thirds comes from increased productivity.
E. Growth Record of the United States (Table 12.3) is impressive.
1. Real GDP has increased over sixfold since 1950, and real per capita GDP has risen over
threefold. (See columns 2 and 4, Table 12.3)
2. Rate of growth record shows that real GDP has grown 3.4 percent per year since 1950
and real GDP per capita has grown 2.1 percent per year. But the arithmetic needs to be
qualified.
3. Global Snapshot 12.3 compares U.S. growth rates since 1996 with those of France,
Germany, Italy, Japan, and the U.K.
a. For most of the period since 1950, U.S. growth has lagged behind the other nations.
b. Since 1994, U.S. real GDP has grown faster.
IV.
Overview of the Business Cycle
A. Historical record:
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1. The United States’ impressive long-run economic growth has been interrupted by periods
of instability.
2. Uneven growth has been the pattern, with inflation often accompanying rapid growth,
and declines in employment and output during periods of recession and depression (see
Figure 12.1 and Table 12.4).
B. Four phases of the business cycle are identified over a several-year period. (See Figure 12.1)
1. A peak is when business activity reaches a temporary maximum with full employment
and near-capacity output.
2. A recession is a decline in total output, income, employment, and trade lasting six
months or more.
3. The trough is the bottom of the recession period.
4. Recovery is when output and employment are expanding toward full-employment level.
V.
Unemployment (One Result of Economic Downturns)
A. Measuring unemployment (see Figure 12.2 for 2004):
1. The population is divided into three groups: those under age 16 or institutionalized,
those “not in labor force,” and the labor force that includes those age 16 and over who
are willing and able to work, and actively seeking work (demonstrated job search
activity within the last four weeks).
2. The unemployment rate is defined as the percentage of the labor force that is not
employed. (Note: Emphasize not the percentage of the population.)
3. Unemployment data are collected by a random survey of 60,000 households nationwide.
(Note: Households are in survey for four months, out for eight, back in for four, and then
out for good; interviewers use the phone or home visits using laptops.) .
B. Types of unemployment:
1. Frictional unemployment consists of those searching for jobs or waiting to take jobs
soon; it is regarded as somewhat desirable, because it indicates that there is mobility as
people change or seek jobs.
2. Structural unemployment: due to changes in the structure of demand for labor; e.g.,
when certain skills become obsolete or geographic distribution of jobs changes.
a. Glass blowers were replaced by bottle-making machines.
b. Oil-field workers were displaced when oil demand fell in 1980s.
c. Airline mergers displaced many airline workers in 1980s.
d. Foreign competition has led to downsizing in U.S. industry and loss of jobs.
e. Call centers have been relocated to countries such as India as communication
technology has improved.
3. Cyclical unemployment is caused by the recession phase of the business cycle.
4. It is sometimes not clear which type describes a person’s unemployment circumstances.
C. Definition of “Full Employment”
1. Full employment does not mean zero unemployment.
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2. The economy is at full-employment unemployment when there is only frictional and
structural unemployment.
3. The level of real GDP associated with full employment is called potential output or
potential GDP.
D. Economic cost of unemployment:
1. GDP gap: The GDP gap is the difference between potential and actual GDP.
2. Higher rates of unemployment are correlated with a greater negative GDP gap.
3. Lost GDP for the nation also means lost income for unemployed workers, meaning the
burden of the lost output is unequal. Additionally, lower-skilled workers have higher
rates of unemployment than higher-skilled workers
4. Teenagers, especially African-American teenagers, are especially susceptible to
unemployment.
E. International comparisons. (Global Snapshot 12.4)
VI.
Inflation: Defined and Measured
A. Definition: Inflation is a rising general level of prices (not all prices rise at the same rate,
and some may fall).
B. The main index used to measure inflation is the Consumer Price Index (CPI).
1. The CPI is found by taking the price of the most recent market basket in a particular year
divided by the price of the same market basket in the base year (1982-84 in text).
2. To measure inflation, subtract last year’s price index from this year’s price index and
divide by last year’s index; then multiply by 100 to express as a percentage. Using the
text numbers: [(188.9 – 184.0)/184.0] x 100 = 2.7 percent.
C. “Rule of 70” permits quick calculation of the time it takes the price level to double: Divide
70 by the percentage rate of inflation and the result is the approximate number of years for
the price level to double. If the inflation rate is 7 percent, then it will take about ten years for
prices to double. (Note: You can also use this rule to calculate how long it takes savings to
double at a given compounded interest rate.)
D. Facts of inflation:
1. Prices have risen every year since 1960 (no deflation). The highest rates of inflation
during this period occurred from 1973-1980.
2. All industrial nations have experienced the problem (see Global Snapshot 12.5).
3. Some nations experience astronomical rates of inflation (Zimbabwe’s was 350 percent in
2004).
E. Causes and theories of inflation:
1. Demand-pull inflation: Spending increases faster than production. It is often described
as “too much spending chasing too few goods.”
2. Illustrating the Idea: Clipping Coins
a. Princes would clip coins, paying peasants with the clipped coins and using the
clippings to mint new coins.
b. Clipping was essentially a tax on the population as the increased money supply
caused inflation and reduced the purchasing power of each coin.
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3. Cost-push or supply-side inflation: Prices rise because of rise in per-unit production
costs (Unit cost = total input cost/units of output).
a. Output and employment decline while the price level is rising.
b. Supply shocks have been the major source of cost-push inflation. These typically
occur with dramatic increases in the price of raw materials or energy.
VII.
Redistributive Effects of Inflation
A. The price index is used to deflate nominal income into real income. Inflation may reduce the
real income of individuals in the economy, but won’t necessarily reduce real income for the
economy as a whole (someone receives the higher prices that people are paying).
B. Unanticipated inflation has stronger impacts; those expecting inflation may be able to adjust
their work or spending activities to avoid or lessen the effects.
C. Fixed-income groups will be hurt because their real income suffers. Their nominal income
does not rise with prices.
D. Savers will be hurt by unanticipated inflation, because interest rate returns may not cover the
cost of inflation. Their savings will lose purchasing power.
E. Debtors (borrowers) can be helped and lenders hurt by unanticipated inflation. Interest
payments may be less than the inflation rate, so borrowers receive “dear” money and are
paying back “cheap” dollars that have less purchasing power for the lender.
F. If inflation is anticipated, the effects of inflation may be less severe, since wage and pension
contracts may have inflation clauses built in, and interest rates will be high enough to cover
the cost of inflation to savers and lenders.
1. “Inflation premium” is amount that interest rate is raised to cover effects of anticipated
inflation.
2. “Real interest rate” is defined as nominal rate minus inflation premium. (Figure 12.4)
VIII.
Output Effects of Inflation
A. Cost-push inflation, where resource prices rise unexpectedly, could cause both output and
employment to decline. Real income falls.
B. Mild inflation (<3%) has uncertain effects. It may be a healthy by-product of a prosperous
economy, or it may have an undesirable impact on real income.
C. Applying the Analysis: Hyperinflation
1. Prices increase dramatically and unevenly, disrupting normal transactions.
a. Businesses are unsure what to charge in the face of the rapidly eroding purchasing
power of money.
b. Consumers are unsure what to pay, but may go on a “spending spree” to beat the
price increases (while simultaneously fueling them).
c. Eventually the monetary system breaks down, production and exchange drop, and
people resort to barter.
2. Historic examples of hyperinflation include Germany after World War I, and Japan after
World War II. More recent (since 1986) examples include Nicaragua (11.9 trillion
percent from 1986-1991) and Serbia (156.3 million percent from 1993-1994).
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