Chapter 3: Measuring the Economy

J. Bradford DeLong

--Draft 2.0--

1999-09-01: 11746 words


Economics is a social science: it is about us and what we do. Because economics is a social science, one of our important sources of information is simple introspection, either our’s ("why did I do that?" or "if I had done that, what would I have been thinking?" or someone else’s "I did that because…"). Indeed, in most other social sciences the overwhelming source of information is through introspection.

But macroeconomics is in a better position. We have data as well. And having data allows us to do much more. With data, we can apply our theories to the economy. Not just qualitative forecasts of direction (as in political science: "revolutions become more likely if…") but quantitative forecasts of magnitudes ("the change from Carter to Reagan-era fiscal policy reduced the growth rate of the U.S. economy by 0.4% per year…") become possible. With data we can try to figure out which theories were correct: testing alternative approaches by comparing what they predicted to what is actually the case would be impossible.

Six Key Variables

Of all the collected by the NIPA (and other data-collection efforts) six are key:

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. But of all of these the most central is the measure of the circular flow of economic activity: GDP.



Box: Recent Snapshot Values of the Six Key Variables

The Commerce Department's standard chart reports estimates of real quarterly growth in GDP (calculated at an annual rate) for the current calendar year and for the previous six calendar years. The chart shows how volatile quarter-to-quarter economic growth is--and most of this volatility is the result not of errors in measurement but of "choppiness" in the actual pace at which production expands (or in recessions contracts).

The Federal Reserve's rule of thumb used to be that growth could not be sustained at a rate higher than 2.3% per year without eventually generating accelerating inflation. Yet since the end of 1995 growth has averaged more than 3% per year, with--so far--no significant signs of accelerating inflation.


The unemployment rate in mid-1999 was at its lowest level in a generation: its lowest level since the Vietnam War years of the late 1960s. Unemployment had fallen steadily since its peak in mid-1992, just after the Gulf War recession of George Bush's presidency.

At the end of 1993 the Bureau of Labor Statistics made some changes in the Current Population Survey from which the unemployment rate is calculated. At the time the BLS thought that these changes would raise the reported unemployment rate by half a percentage point or so: that there would be a half-a-percentage point jump when the shift was made from the old survey (blue line) to the new survey (red line) not because of any change in the economy but because the new, better measurements would reveal that previous statistics had understated unemployment. This turned out not to be the case: there is no difference between the old survey and the new survey estimates of unemployment.


The Bureau of Labor Statistics calculates the consumer price index. The series plotted here--the CPI-U--is the rate of increase of the BLS's index of consumer prices for all urban consumers. For each month the number plotted is the total increase in consumer prices over the twelve previous months. The solid line gives the increase in the whole CPI-U. The dotted line excludes food prices and energy prices from the index--food and energy prices are notoriously volatile from month to month, and excluding them produces a smoother series that is perhaps a better guide to what the underlying inflation trends really are.

Inflation accelerated in the late 1980s to a peak of between five and six percent per year. The Federal Reserve then moved to fight inflation by raising interest rates in an attempt to reduce investment spending and thus total demand. The Federal Reserve's policy was successful at reducing inflation: the inflation rate as measured by the CPI-U without food and energy fell from 5.3% per year in late 1990 to 3.3% per year in late 1992. Unfortunately the Federal Reserve's shift in policy also sent the economy into a recession that turned out to be stubbornly long: the unemployment rate rose from 5.3% in mid 1990 to 7.8% by early 1992. This recession was costly for America and--on the political level--disastrous for George Bush's reelection prospects.

Since 1992 the Federal Reserve has sought to allow the economy to expand at the maximum pace consistent with low inflation. It has been successful: the pace of inflation has been gradually declining over the 1990s.

On-The-Run U.S. Treasury Yield Curve 09/05/99 09:00 Pacific



3mo - 12/02/99 0.24 4.76% 4.74% 4.882%

6mo - 03/02/00 0.49 4.93% 4.90% 5.117%

1yr - 08/17/00 0.95 4.94% 4.94% 5.194%

2yr 5 1/2% 08/31/01 1.99 99 25/32 99 27/32 5.617%

5yr 6% 08/15/04 4.94 100 31/32 100 31/32 5.770%

10yr 6% 08/15/09 9.94 100 26/32 100 28/32 5.890%

30yr 6 1/8% 08/15/29 29.94 101 12/32 101 14/32 6.024%



The interest rate is the price at which purchasing power can be shifted from the future into the present: borrowed today with a promise to pay it back--with interest--in the future.

Economists speak of "the" interest rate because different interest rates move up or down together. But in actual fact there are a very large number of different interest rates, applying to loans that mature at different times in the future, and to loans of different degrees of risk. (After all, the person or business entity to whom you loaned your money may find themselves unable to pay it back: that is a risk you accept when you make a loan.) Those people or business enterprises who think that they could make good use of additional financial resources now borrow. Those business enterprises or people who have no sufficiently productive or utilitarian use for their financial resources today lend. When interest rates are low--money is "cheap"--investment tends to be high, because businesses find that even less-profitable investments will still generate the cash flow needed to pay the interest and repay the principal sum borrowed.

Interest rates on long-term debt--like the ten-year notes issued by the U.S. Treasury--are usually higher than interest rates on short-term debt instruments like the three-month Treasury Bills issued by the U.S. Treasury.

The level of the stock market is the key economic quantity that you likely hear about most--you most likely hear about it every single day on the news. The level of the stock market is an index of expectations of how bright the economic future is likely to be. When the stock market is high, average opinion expects economic growth to be rapid, profits high, and unemployment relatively low in the future. (Note, however, that there is a certain mirror-like and tail-chasing element in the stock market: perhaps it would be better to say that the stock market is high when average opinion expects that average opinion will expect that economic growth will be rapid in the future.) When the stock market is low, average opinion expects the economic future to be relatively gloomy.

The United States has had a relatively thick market in equities--the "stocks" of a corporation, the pieces of paper that carry shares of its ownership--for more than a century and a quarter. One of the major indices that tracks the performance of the stock market as a whole is the Standard and Poor's composite index--the S&P 500. Over the past century, on average a share of stock has traded for about fifteen times its "trailing" earnings per share--the profits of the corporation in the previous year, divided by the number of shares of stock the corporation has outstanding. But companies with good prospects for growth sell for more than fifteen times their earnings, and corporations seen as in decline sell for less.

There are some years in which expectations of the future of the economy are relatively depressed, and stock indices--a measure of the stock market as a whole--sell for much less than the fifteen-times-earnings rule-of-thumb that has been normal over the past century. Look at 1982, when the stock market as a whole was undervalued by perhaps 40 percent on the basis of the fifteen-times-earnings rule-of-thumb. And their are times--like the end of the 1960s, or today--when the stock market appears significantly overvalued on the basis of standard historical patterns. During such episodes in which the stock market is high, investors are implicitly forecasting a major boom and the continuation of rapid productivity growth--or else many people are going to be very disappointed with their stock market investments.

Current Exchange Rates


Country Value Change High Low

Australian dollar * 0.6465 -0.0002 0.6467 0.6467

British pound * 1.60200 -.00210 1.60410 1.60250

Canadian dollar 1.49000 -.00010 1.49170 1.49100

The euro * 1.06080 0.00000 1.06100 1.06080

French franc 6.1783 0.0000 6.1783 6.1783

German mark 1.8425 0.0000 1.8425 1.8421

Italian lira 1824.00 0.00 1824.00 1824.00

Japanese yen 109.85 -0.15 110.01 109.90

New Zealand dollar * 0.5180 -0.0007 0.5186 0.5186

Swiss franc 1.5065 +0.0002 1.5065 1.5060


* means U.S. dollars per currency unit; otherwise currency units per U.S. dollar.
Updated as of: Sep 05, 1999 @ 12:03 pm ET
The terms on which Americans can buy goods and services made in other countries--and sell the goods and services they make--is the exchange rate. The nominal exchange rates plotted above tell how many units of currency of one country can be exchanged for another as of lunchtime on America's east coast on September 5, 1999.
The real exchange rate adjusts for differences in the rate of inflation between countries: it is thus an attempt to measure the relative price of typical tradeable goods made in one country in terms of the goods of another.

The circular flow and GDP

The circular flow

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. The variables then collected, measured, and estimated by the NIPA (and by other data-collection efforts) sparked economists to try to build theories that would let economists understand the variables' behavior.

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]

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.

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 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.

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 complete.

Different measures of the circular flow

This circular flow can be 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 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.


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.

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."

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.

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 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.

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.

Second, different measurements will differ because of differences in exact 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.

Computing 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.


Making index numbers

Inventories and intermediate goods

So-called "intermediate goods"--goods made by a company and then sold not to a 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-the-consumer--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 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 value-added 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.


The NIPA treatment of inventories.

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.

[Picture: acres and acres of unsold Model-T Fords]


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.
[Figure: Circular flow diagram with inventory changes explicitly added]

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.
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 wants to buy.
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.
[Figure: transactions within the household sector don't affect GDP; they just transfer income from one unit of the household sector to another]
What if you 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 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 your basement, while it does pay interest on bonds.


Components of GDP.

So what is the NIPA actually measuring when it reports a measure of GDP? The Bureau of Economic Analysis estimates, and includes in GDP [Y], the value of:

Add all of these up to arrive at the level of GDP. This definition is called the national income identity:

It is the equation that you will write down most frequently as you take any macroeconomics course.

[Box: Policy] Recent estimates of the components of GDP (and of alternative measures of output).

Investment: gross and net

Whenever you see the word "gross" in the definition of any economic quantity, you should immediately think that the word "gross" has one meaning: in economics, to say that a quantity is "gross" means that some relevant factor--some counterbalancing factor--has not yet been subtracted from it.

For example, when we think of "investment" we think that investment adds to the capital stock. But the change in the capital stock is not equal to gross investment. Gross investment is total spending on capital goods. But to turn gross investment into the change in the economy's capital stock--to turn gross investment into net investment--you need to subtract depreciation: the wearing-out, scrapping, and retirement of old capital that is no longer useful. "Net investment" is gross investment minus depreciation. Gross investment" is the level of investment before the counterbalancing factor of depreciation has been subtracted.


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 the end of the book that the course often did not get to.

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.

Similarly, "gross exports" are exports before the counterbalancing factor of imports have been subtracted. Usually we are most interested not in gross exports but in net exports--in 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 prefer to have the "net" measure. But often we don't have the choice. Usually the reason we don't is that the estimating agencies do not trust their estimates of "net" quantities. 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 it doesn't trust its depreciation estimates.


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 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.



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.

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 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 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.

[Picture: within-the-households production]

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.


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.

[Picture: Los Angeles basin on a smoggy day]

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 whether other social and economic changes are causing people to use up resources attempting to neutralize them.


Real and nominal GDP

Nominal quantities have not been adjusted for any changes in the average level of prices. They have not been adjusted for inflation or deflation. They are measured in plain old dollars: units of spending without specifying that prices are fixed at the levels of any particular year.

In 1995 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 growth rate of nominal GDP between 1995 and 1996 was 4.5 percent.

Does that mean that economic activity was 4.5 percent larger in 1996 than 1995? It depends what you mean by "economic activity." Certainly the total number of dollars spent by consumers and other final users (investors, exporters, and the government) to buy goods and services went up by 4.5 percent. But the nominal GDP numbers don't tell you whether this increase was because more goods and services were produced, sold, and bought; or because the goods and services were sold and bought at higher dollar prices in 1996 than in 1995.

[Figure: Real GDP, nominal GDP, and the price level]

Thus every economist would immediately ask: "How much did real GDP grow?"

Real quantities have been adjusted for changes in the overall price level, for episodes of deflation or inflation. The levels of real quantities are equal to nominal quantities divided by the current price level. The idea is to produce an estimate of what would have happened if the overall price level had been constant, and the commodity value of the dollar been unchanged.

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 rate of price inflation--the 2.0 percent rate of growth of the level of prices--between 1995 and 1996. Real GDP between 1995 and 1996 rose by only 2.5 percent, not 4.5 percent.

The growth rate of a real quantity--like real GDP--is equal to the growth rate of the corresponding nominal quantity--nominal GDP--minus the rate of inflation--the rate of change of the price level. This is a case of a more general principle: the mathematical principle that when you calculate levels by division, you calculate growth rates by subtraction.


General inflation with constant relative prices.

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.

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.

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 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.

It is defined implicitly as the quotient of the other two measures. Thus you may 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. 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.

Chain weighting

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, 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 chain-weighted 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.



Other sources and kinds of economic data

Stock and flow variables

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 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.

[Graphic: stocks and flows]

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. But GDP--a flow quantity--is $8 trillion per year.



Keeping unemployment low--keeping workers who want to work employed at jobs they like--is perhaps the chief goal of modern macroeconomic stabilization 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 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.

The BLS classified the people it interviews into four catagories:

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)}.

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.

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 less-educated, the not-white, and the young has been that these groups are much less 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.

The question "how long is the typical person unemployed for" turns out to be a 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.


[Box: Details] How can the question of the length of the average spell of unemployment have two answers?…

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.

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.

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 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.


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 faster than potential output, unemployment falls. Whenever national product output grows slower than potential output, unemployment rises. On average, a one percentage point fall in unemployment is associated with an extra two-and-a-half percentage points of real GDP produced.

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]

[Box: Policy] Why is the Okun's Law coefficient so large?

Why do 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%.

The Exchange Rate

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 prices of a certain amount of purchasing power or productivity in the two countries.

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.

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:

where e 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.

The second convention goes more easily with the terms used in day-to-day conversation to describe exchange rate movements. But the first convention is more common (on this side of the Atlantic at least), and will almost surely be used in any subsequent courses you take. Thus in this book the (nominal) exchange rate is always the value of foreign currency, the (real) exchange rate is always the value of foreign goods in terms of home goods. An appreciation or revaluation of the dollar is a reduction in the numerical value of the exchange rate, and a depreciation or devaluation of the dollar is an increase in the numerical value of the exchange rate.

I don't like it either. But I believe that consistency with subsequent courses is the most important consideration.








Chapter summary

Main points

[To be written]


Analytical exercises

[To be written]


Policy exercises

[To be written, and revised for each year within editions]