Because the macroeconomic models we will study in this course address the impacts of government policy on total output, income, and prices we will spend some time understanding how total output, income, and in the next chapter, the average level of prices (inflation) are measured.
| "One reads with dismay of Presidents Hoover and then Roosevelt designing policies to combat the Great Depression of the 1930's on the basis of such sketchy data as stock price indices, freight car loadings, and incomplete indices of industrial production. The fact was that comprehensive measures of national income and output did not exist at the time."
Richard T. Foyen |
In the 1930's, economists at the Department of Commerce and National Bureau of Economic Research, under the leadership of Nobel Prize winner Simon Kuznets, developed the first comprehensive measures of national income. The original set of income accounts was presented to Congress in 1937 and in a research report, National Income, 1929-35. In the 1940's, World War II planning needs were the impetus for the development of product or expenditure estimates (gross national product).
Today the National Income and Product Accounts (NIPA) is the official U.S. government accounting system that keeps track of national income and national output. The purpose of this chapter is not to document all the details of the NIPA (this is available from the Bureau of Economic Analysis, www.bea.doc.gov), but to present the basic methodology of measuring total output, income, and inflation and emphasize those components and terms that will be important to us in future chapters.
Total output is measured by the money (dollar) value of all final goods and services produced by an economy during a given period of time, usually a year. Total output includes the values of goods produced, like CD players and houses, and the value of services, like haircuts and teachers' salaries.
Why do we measure output in dollar value rather than actual physical units of output? Quite simply, it's not very meaningful to add the production of 1,000 cars to the production of 10,000 dolls and say we produced 11,000 goods. But, if we take quantities times market prices, we can say we produced $20 million worth of cars and $100 thousand worth of dolls for total output of $20.1 million. Money value provides a common measure for combining dissimilar goods and services into an aggregate measure of output.
| Table 4-1. Using Market Prices to Add Cars and Dolls | ||||||
| Quantity | times | Price | equals | Market Value | ||
| Cars | 1,000 | x | $20,000 | = | $20,000,000 | |
| Dolls | 10,000 | x | $10 | = | $100,000 | |
| Total Value of Output | $20,100,000 | |||||
The value of a nation's aggregate output is measured by two very similar concepts, called gross domestic product (GDP) and gross national product (GNP).
| Nominal Gross Domestic Product (GDP) - the market value of final goods and services (i.e., sold to final consumers) produced by a nation during a specific period, usually 1 year.
Nominal Gross National Product (GNP) - the market value of final goods and services produced by labor and property supplied by the residents of a nation during a specific period, usually 1 year. GDP and GNP are compiled and reported quarterly by the Bureau of Economic Analysis (http://www.bea.doc.gov) |
The difference between GNP and GDP is the income from the goods and services produced abroad using the labor and property supplied by U.S. residents less payments to the rest of the world for the goods and services produced in the United States using the labor and property supplied by foreign residents (referred to a net factor payments from abroad). In a simple example, the profits of a Japanese-owned Toyota plant in Tennessee would be included in GDP, but not GNP; while the profits of a U.S.-owned Ford Motor plant in Mexico would be included in GNP, but not GDP.
| GDP | GNP | |||
| Production within U.S. by foreign-owned firms |
Included | Excluded | ||
| Production in foreign countries by U.S.-owned companies |
Excluded | Included | ||
Of course the accounting is more complicated than this when we recognize that the U.S. automobile producer (Ford) pays interest and dividend income to foreign residents who own stocks or bonds issued by the U.S. company. Those payments must be excluded from GDP since they represent the contribution of production factors owned by foreigners. Payments received by U.S. residents from stocks and bonds of foreign-based companies (Toyota) would be included in GDP. In this course we'll try not to get bogged down in these accounting details.
What is the significance of the usually small difference between GNP and GDP? If all you own is your own labor, then what you are probably most interested in is the growth of output and the related job opportunities within the U.S. That would include the Tennessee Toyota plant, and you may care little about the Ford plant in Mexico. On the other hand, if you are a capitalist and your health and welfare depends on the the stock market then you may be more interested in the output of U.S. firms, no matter where their production plants are located. Because our economic models and government policies are generally limited to domestic operations, GDP is the favored measure of total output.
Some countries have much larger differences between GNP and GDP than the U.S. Countries that have many citizens working abroad may have a much larger GNP than GDP. The reason is that remittances sent home by workers abroad are part of a country's GNP but not its GDP.
| GDP and GNP are measured on a quarterly basis. Usually, when quarterly figures are reported in the press they are reported as "seasonally adjusted annual rates." This means the raw quarterly numbers are "seasonally adjusted" and then multiplied by four.
What does seasonally adjusted mean? Usually total sales (GDP) during the fourth quarter of the year (October through December) is larger than the first quarter (January through March) because of Christmas. Consequently we shouldn't be alarmed when sales and GDP decline after every Christmas season (usually by about 8 percent). It always happens. What we should be interested in is if the decline is larger or smaller than normal. To make quarter-to-quarter comparisons meaningful we seasonally adjust the numbers. For example, if based on past experience and after adjusting for economic growth, fourth quarter sales are usually 4 percent larger than annual average and the first quarter is 4 percent lower than the annual average we would divide the fourth quarter raw GDP figure by 1.04 and multiply the first quarter by 1.04. The seasonally adjusted GDP figures would then indicate what an annual average GDP might be if sales continued to follow the normal seasonal pattern. Strength or weakness in the economy can then be more easily identified. The actual procedure used is the Census X-11 (or X-12) seasonal adjustment method, which is available in most computer statistical packages. |
Many analysts make the mistake of interpreting GDP as a measure of social welfare or our standard of living. The fact that a good or service is sold implies that it is in limited supply and satisfies some human wants and needs. Presumably, as total output increases our needs are satisfied to a greater degree (assuming a rising tide lifts all boats). Unfortunately, GDP does not capture the value of all resources consumed, productive efforts, and costs of production. For example, GDP does not include the following:
First, and probably foremost, GDP omits the value of leisure time. Time is a limited resource and if its use in leisure were not highly valued, we would all be working 16-hour days, 7 days a week. If the government were to reduce the 40-hour work week there would be a decrease in GDP because of the reduction in production, income and spending. But, would we necessarily be worse off? It depends on how much a few additional hours of leisure time is valued.
Home and volunteer services are productive efforts that are not included in GDP. GDP does not include productive efforts that are not exchanged in a market (e.g., a price paid and/or income received). The services of a hired housekeeper would be included in GDP, while the identical effort of someone doing their own housework is not. Hiring a contractor to remodel your home is included in GDP, do-it-yourself remodeling is not. Volunteer charitable work, home education, child raising, and many other productive efforts for which an income is not paid are left out of GDP.
GDP does not include market transactions that are not reported to the government. The underground economy consists of transactions that are not documented for various reasons. For example, the transactions may be illegal (e.g., drugs) or income may be hidden to avoid taxes or compliance with regulations. Government statisticians do make an attempt to include an estimate of the underground economy's size, but these estimates are not included in GDP.
The value of nonrenewable natural resources like petroleum, natural gas, coal, and nonfuel minerals extracted from the ground is included in GDP in the products produced from them. But, changes in the availability of resources is ignored in the national accounts. For example, when the Alaskan oil fields fields were developed in the 1970s there was little initial impact on GDP. As oil flowed from the Alaskan fields over the next 30 years GDP has steadily benefited. It could be argued that the real contribution to the welfare of the economy was when the oil fields were first found and developed and we have since then been falsely claiming credit for past efforts. Neither the economic importance of new discoveries nor the gradual depletion of the resource base is recognized. Exploration and development generate new subsoil mineral assets just as investment creates new produced capital assets. Similarly, the extraction of mineral deposits results in the depletion of these assets just as use and time cause produced capital assets to depreciate. GDP accounts include the accumulation (a positive impact) and depreciation (a negative impact) of capital assets, but they do not consider the generation and depletion of subsoil assets. Nonrenewable resources could also be thought of as inventory (discussed later in this chapter). Newly found resources could be recorded as an inventory investment and their value included in GDP. The removal or the resources would then be recorded as inventory disinvestment, which would lower GDP. The problem is that properly accounting for natural resources in the GDP accounts would be very difficult and costly.
Finally, GDP does not include costs of production that are not paid by firms and thus are not included in market prices. Pollution represents a cost or reduction in social welfare. The operating and capital costs to control or reduce pollution are included in the price of the good or service provided and the total market value of output. However, the pollution that firms are not held responsible for are not reflected in market prices and do not appear in GDP. GDP may grow because of increases in output, but the possible associated increase in pollution is not recognized.
Not only do these omissions from GDP make it inappropriate as a measure of social welfare, but they also make international comparisons of output unreliable. For example, in developing countries a larger proportion of output may come from unrecorded home production. Other countries may have a much larger underground economy.
The U.S. Bureau of Economic Analysis is taking steps to address some of these omissions such as nonrenewable resources and pollution by developing the Integrated Environmental and Economic Satellite Accounts.
There are several ways to measure the value of aggregate (total) economic output. Consider the circular flow of income and expenditures for a very simple economy.
| Figure 4-1. Circular Flow of Income and Expenditures |
 |
We can measure aggregate output by adding up the total expenditures by households. Then, if we assume that one person's spending is another person's income, an equivalent measure of the value of total output would be the total income reported by individuals. Income would include not only labor income (e.g., wages) but also income to the owners of capital (e.g., stock dividends, rents, etc.). Thus, we have two primary methods for measuring aggregate output:
This simple observation, that expenditures equals income (with certain accounting adjustments discussed below), is very important in the macroeconomic models we will present in upcoming chapters. In particular, we will assume that total output is equivalent to total income, and that the economy is in equilibrium only when total expenditures (aggregate demand) equals total income/output (aggregate supply), i.e., there is no undesired inventory build or draw. If there is a disturbance to expenditures (negative or positive) then production and income must adjust.
The expenditure approach measures total economic activity by adding the amount spent by all ultimate or final consumers of products and services. Total GDP is the sum of four categories of final demand:
GDP = C + I + G + NX
| Table 4-2. Expenditure Approach to Measuring GDP, 2002 | ||
| Billions of current dollars |
Percent of GDP | |
| Personal Consumption Expenditure (C) | 7,304 | 69.9 % |
| Durable goods | 872 | |
| Nondurable goods | 2,115 | |
| Services | 4,317 | |
| Gross Private Domestic Investment (I) | 1,593 | 15.3 % |
| Fixed investment - nonresidential | 1,117 | |
| Fixed investment - residential | 472 | |
| Change in business inventories | 4 | |
| Government Purchases of Goods and Services (G) | 1,973 | 18.9 % |
| Federal | 694 | |
| State and Local | 1,279 | |
| Net Exports (NX) | - 424 | - 4.1 % |
| Exports | 1.015 | |
| Imports | - 1,439 | |
| Gross Domestic Product (GDP) | 10,446 | - |
| Source: Bureau of Economic Analysis, May 15, 2003 | ||
Consumption is probably the ultimate objective of economic activity; people work and produce in order to obtain goods and services to consume. Consumption includes all spending by domestic households on final goods and services, with the exception of housing, which is reported as residential investment (see Investment below). Consumption expenditures are grouped into three categories:
If you regularly read the business section of the newspaper your knee-jerk response to the term investment is to think of buying stocks or bonds. This is not what economists consider as investment in macroeconomic models. When you buy a stock or bond you are only purchasing an ownership share in a corporation. You are not increasing the productive capacity or the physical assets of the economy. Investment in macroeconomic models represents the flow of spending that adds to the physical stock of real capital.
| Investment in Real Capital - production and accumulation of goods for future use in production processes. |
The National Income and Product Accounts (NIPA) includes these categories of private domestic investment expenditures:
It may strike you as unusual that residential housing is included. New apartment buildings certainly represent investment because, like a factory or machine, they are intended to become income-producing assets. In future years the apartment building will produce shelter, for which the owner will charge a rent. Owner-occupied houses serve the same productive purpose; houses supply shelter in future years. In GDP accounting the family is treated as a firm that rents the house to itself. Government economists estimate what the market rent for an owner-occupied home would be if it were rented and includes this estimate (also called an imputed value) in GDP. We could also calculate rents for other durable goods like cars and furniture, which are counted as consumption, but this would make life for the economists a lot more trouble than it is worth.
Accounting for Inventory Changes. The change in business inventories is also included as investment. Inventories are stocks of unsold finished goods, intermediate goods, and raw materials held by firms. Changes in inventories (inventory investment) can be either positive or negative. If a firm produces goods that it can't sell or consume in the production process, the resulting increase in inventories counts as investment by the firm. An increase in inventories is counted as a positive investment because they will be used in a future period to produce goods for final consumption. For GDP accounting, the firm has, in effect, purchased the unsold goods from itself. A decline in inventories represents a negative inventory investment since there is a conversion of capital (inventories) to consumer goods. The negative investment should be offset by a consumption expenditure on the final goods that were produced from those inventories.
We can illustrate the effect of production to inventory on GDP with a simple example. Suppose that Ford Motor Co. produces and sells a car to one of its retailers in 1998 for $18,000. The retailer sells the car the following year (1999) to a consumer for $20,000. Nominal GDP for 1998 and 1999 are:
| GDP Account | 1998 | 1999 | |
| Consumption | 0 | $20,000 | |
| Investment (inventories) | $18,000 | - $18,000 | |
| Total GDP | $18,000 | $2,000 |
The 1998 GDP includes the value of production of the car by Ford, while 1999 GDP includes the value of services provided by the retailer in selling the car to the consumer.
Land Is Excluded. Investment does not include nonproduced assets. Two characteristics of what economists call real capital rule out land:
Financial Investment Is Excluded. As mentioned above, investment does not include the purchase of financial assets such as stocks and bonds. Financial capital is simply a piece of paper that designates a claim of ownership. A piece of paper by itself produces nothing. Your purchase of a new bond may provide the cash needed for a new piece of equipment for the firm, but the investment is not counted until the equipment is actually bought.
Government Spending Is Excluded. Finally, we should note that investment here refers to private domestic investment. We include only private investment, since government investment (roads, dams, etc.) is included as part of Government Spending (refer to next section). We include only domestic investment, since the purchase and export of real capital for investment outside the country is included as part of Net Exports (see below).
Government purchases of goods and services include federal, state, and local government spending. Although state and local government spending accounts for about 2/3 of total government spending, the macroeconomic models in this course generally refer to the federal government when considering the effects of changes in government spending on the economy.
The government is treated as a final consumer even though it acts like a firm in that it uses resources in the production of goods and services for consumption by its citizens. But, the goods and services supplied by government, such as national defense, public education, building and maintenance of roads, generally have no market prices (e.g., "user fees") associated with them. The solution that has been adopted is that government production is valued at the cost of production. This implies that GDP may increase as government functions become privatized. In other words, both the cost of production and profits of private firms show up in prices and GDP, while the imputed price of government output is not credited with any profit. Of course, this assumes that the cost of production would not be reduced with privatization.
There is a significant exception when accounting for government expenditures. The government may spend money for which it does not receive any good or service in return. Transfer payments, such as social security benefits, unemployment compensation, and various welfare benefits, are excluded from government spending in GDP accounting because they do not reflect productive activity in the period in which they occur. Similarly, interest payments on the national debt are not counted as part of government spending in the GDP accounts.
| Transfer Payment - a payment made for which no goods or services are provided in return. Transfer payments are excluded from GDP. |
Net exports (NX) equals exports (X) minus imports (M), or NX = X - M. Net exports are positive if exports are greater than imports (a trade surplus) and negative if imports exceed exports (a trade deficit).
Exports are included as a positive addition to GDP because exports are final goods and services produced within the country that are purchased by foreigners. It is interesting to note that a good or service doesn't actually have to leave the country to be counted as an export. For example, a German tourist visits New York and rents a hotel room, hires a taxi, and eats meals. Since these goods and services have been produced by Americans, they are counted as part of GDP. Since they are paid by a foreigner, they are considered an export.
The consumption, investment, and government spending categories include spending on imported goods. Rather than subtract out the imported component from each of these categories, the national income accounts simply subtract out imports as a lump sum.
There are several measures of aggregate income. One measure is National Income (NI), which is the sum of incomes that originate in the production of goods and services from labor and property supplied by U.S. residents. A second aggregate measure is Personal Income (PI), which is income received by persons from all sources. National Income and Personal Income differ in two major respects:
Not all National Income is income received by persons. For example, some corporate profits are not distributed to stockholders but are taxed by the government or retained by firms for investment. Thus, corporate profits reported in National Income is larger that personal dividend income reported in Personal Income.
Many persons receive income that was not generated in the production of goods and services. Government transfer payments (e.g., social security, unemployment benefits) are included in Personal Income but not National Income.
| Table 4-3. Comparison of National Income and Personal Income, 1998 | ||
| National Income |
Personal Income | |
| Compensation of employees | ||
| Wage and salary accruals | 4,190 | - |
| Supplements to wages and salaries | 822 | - |
| Wage and salary disbursements | - | 4,186 |
| Other labor income | - | 516 |
| Proprietor's income | 606 | 606 |
| Rental income | 137 | 137 |
| Corporate profits | 846 | - |
| Personal dividend income | - | 348 |
| Net interest | 436 | - |
| Personal interest income | - | 898 |
| Transfer payments to persons | - | 984 |
| Less: Personal contributions for social insurance | - | (316) |
| Total Income | 7,036 | 7,359 |
| Source: Bureau of Economic Analysis, January 29, 1999 | ||
A third important measure of income is Disposable Personal Income (DPI). Not all Personal Income is available to households to spend. The government takes a large cut in the form of income tax and withholding for social security (a future transfer payment).
| Personal Income (PI) |
| - Personal Income Taxes |
| - Social Security Withholding |
| Disposable Personal Income (DPI) |
We do not attempt to distinguish between National Income and Personal Income in the macroeconomic models in this course. In fact, in the interest of working with as simple a model as possible, we will also ignore the differences between these income measures and Gross Domestic Product. As mentioned earlier, we will assume that aggregate supply is equivalent to total income. The distinction between total income and disposable income is important, though, as we consider the effects of changes in personal taxes on consumption demand and the economy.
| Table 4-4. Relationship Between National Income, GDP and GNP, 1998 | ||
| Billions of current dollars |
Percent of GDP | |
| Compensation of employees | 5,011 | 57.2 % |
| Proprietors' (self-employed) income | 606 | 6.9 % |
| Rental income of persons | 137 | 1.6 % |
| Corporate profits | 846 | 9.7 % |
| Net interest | 436 | 5.0 % |
| Equals National Income | 7,036 | 80.3 % |
| Plus: Indirect business taxes (sales, excise, property) | 677 | 7.7 % |
| Plus: Miscellaneous Other | (30) | 0.3 % |
| Equals Net National Product (NNP) | 7,683 | 87.7 % |
| Plus: Depreciation | 1,067 | 12.2 % |
| Equals Gross National Product (GNP) | 8,750 | 99.9 % |
| Less: Factor income received from rest of world | (285) | 3.3 % |
| Plus: Payments of factor income to rest of world | 295 | 3.4 % |
| Equals: Gross Domestic Product (GDP) | 8,760 | - |
| Source: Bureau of Economic Analysis, January 29, 1999 | ||
As must be expected, measurement of total output is not simple. Two significant problems in GDP accounting are double counting and depreciation.
The definition of GDP refers only to final goods and services produced during a specific period. The terms "final" and "produced" are important because of the potential for double counting in the expenditure approach to GDP accounting.
Final goods and services are those purchases made by the ultimate consumers (i.e., not intended for resale or consumed in a subsequent production process). GDP excludes intermediate goods and services, which are used up in the production of other goods in the same period they themselves were produced. Consider a very simple accounting of the different steps in producing a car:
| Step | Firm | Transaction | Market Value |
| 1 | Steel Manufacturer | Sells steel to auto manufacturer | $5,000 |
| 2 | Auto Manufacturer | Sells finished auto to retailer | $20,000 |
| 3 | Auto Retailer | Sells auto to consumer | $25,000 |
If we were count each transaction in the expenditure approach to GDP accounting, we would have total output of $50,000. The problem is we counted the sale of the car twice -- once by the auto manufacturer and once by the retailer. And, even worse, we counted the sale of the steel contained in the car 3 times.
To avoid this problem we must recognize that it is the intended use, rather than the physical characteristics of a product, that determines whether or not it is a final good. When gasoline is bought by a service station, it is an intermediate good; it is intended for resale to the public. When the gasoline is purchased by a farmer or trucker, it is still an intermediate good, since it will be used to harvest grain or produce trucking services. However, when it is bought by a tourist or even by someone for driving to work, it is a final good.
GDP counts only the value of goods and services produced during the period of measurement. GDP excludes sales of used goods. The purchase of a used good is simply a transfer of ownership. Nothing is produced when a used good is purchased. The used good was already included in GDP in a previous period when it was produced sold for the first time. Including the sale of a used good would be double counting.
How do you count the sale of a used car by the auto retailer? The sale of a used car represents a "final" sale just like the sale of a new car. But, sale of used equipment is not included in GDP unless "rebuilt" and then only to extent of improvement. In other words, we count only the value added by a firm. The services provided by the used car dealer (e.g., the cost of maintaining a used car inventory, salespersons, paperwork, etc.) are included in GDP as a service that added value to the car.
| Value Added - the amount by which the value of a firm's finished products exceeds the value of goods and services the firm purchases. |
Another example of the exclusion of the sale of a used good is the resale of a home. When the house was originally built and sold it was included in GDP (as investment). When the house is resold at a later date, the sale is not recorded in GDP even if the resale price of the home is significantly higher than the original purchase price (remember, we're measuring the value of current output, not wealth). The usual 6% fee charged by real estate agents, however, would be included in GDP as a service provided during that period. What about remodeling that added value to the home and contributed to the higher resale price? Remodeling should have been in included in GDP during the period it was actually done, by recording the services and materials provided by contractors or the materials purchased by do-it-yourselfers.
Since capital goods are used in the production of other goods shouldn't purchases of capital goods (investment) be excluded from GDP as intermediate goods rather than counted as investment? The key characteristic of capital goods is that they are durable and not consumed within the period they are purchased. Investment by business in a durable good (e.g., equipment) is included in GDP as final demand because it is not "consumed" in a subsequent production process in the same period it was produced.
 |
Figure 4-2. Depreciation of Private Capital Stock.
Data Source: U.S. Dept. of Commerce, Bureau of Economic Analysis (http://www.bea.doc.gov/) |
However, equipment deteriorates, or depreciates, over time from wear and tear and obsolescence. Some portion of new investment does not represent an expansion of the capital base but replacement of depreciated capital. If we want to know how much the stock of real capital has actually increased during the year we must make an adjustment for depreciation. Consequently, two measures of investment should be distinguished: gross investment and net investment:
Corresponding to these two concepts of investment we can refine our definition of Gross Domestic Product:
Net Domestic Product (NDP) = C + In + G + NX = GDP - depreciation
| Gross Investment (Ig) - equal to the total expenditures for new plant, equipment, and residential buildings, plus the change in inventories.
Net Investment (In) - the increase in the capital stock, equal to gross investment less depreciation. Depreciation - (also known as consumption of fixed capital) the change in value associated with the aging of an asset. As an asset ages, its prices changes because it declines in efficiency, or yields fewer productive services, in the current period and all future periods. |
In short-run macroeconomic models GDP is usually the preferred measure because we are interested in total spending, which would include gross investment. In long-run models, on the other hand, net investment may be the preferred measure because we are more interested in growth of the productive capacity of our economy.
Depreciation is difficult to estimate in practice. How do you measure wear and tear or obsolescence? Does the value of an investment depreciate quickly at first, or does it steadily decline over time? Economists have developed estimates of depreciation rates for different equipment and these are used in the NIPA estimates. Generally depreciation is estimated using a geometric pattern (a constant percent rate of depreciation a year) or a straight-line pattern (a constant dollar depreciation every year). For example, we could estimate the rate of depreciation for a car by looking at new and used "Blue Book" values (www.kbb.com) for a particular model car. In Table 4-5 we give an example of what geometric and straight-line depreciation patterns might look like. Geometric depreciation produces a faster decline in value during the first few years and becomes smaller over time.
| Table 4-5. Hypothetical Depreciated Values for an Automobile | |||||||||
| Model Year | Age of Car (years) |
Geometric Depreciation |
Straight-line Depreciation | ||||||
| 2003 | 0 | $20,000 | $20,000 | ||||||
| 2002 | 1 | $17,000 | $17,500 | ||||||
| 2001 | 2 | $14,450 | $15,000 | ||||||
| 2000 | 3 | $12,280 | $12,500 | ||||||
| Assumes a new car in each model year cost $20,000. Geometric Depreciation = 15% per year. Straight-line Depreciation = $2,500 per year. | |||||||||
There's one significant problem in measuring any economic aggregate in monetary (dollar) terms. Prices change. For example, if we produced $1 billion worth of cars last year, and $1.1 billion dollars worth of cars this year, did the number of cars produced increase? Not necessarily. If the average price of cars increased by more than 10%, then actual physical (real) output declined, even though the total money (nominal) value of output increased.
We can (approximately) decompose changes in nominal economic aggregates (e.g., GDP, income, consumption expenditures, investment, net imports, etc. measured in monetary terms) into that part due to changes in prices and that part due to changes in quantities. One way to eliminate the effect of price changes is to measure the total value of output in each period by using prices from some base year. Then any change in the total value of output (using base year prices) might be attributed to changes in quantities and not changes in prices.
| Real GDP - value of total output corrected for any changes in prices. Also referred to as "constant-dollar" GDP. Real GDP is reported quarterly by the Bureau of Economic Analysis (http://www.bea.doc.gov) |
The first step in calculating real GDP is picking a "base" year. The choice is arbitrary. The objective is to take a snapshot of market prices at some point in time and to apply those prices to the quantities of goods sold in different years. From time-to-time a new base year is selected because there are products marketed today that may not even have been conceived of 10 years ago. It would be hard to evaluate the value of total output today using 1970 prices.
Table 4-6 presents a sample calculation of real GDP for the years 1992 and 1994 assuming 1992 is the base year. Real GDP for 1992 is 1992 quantities times 1992 base year prices. Real GDP for 1994 is 1994 quantities times 1992 base year prices.
| Table 4-6. Calculating Real GDP (Base Year = 1992) | |||||||||
| Average Prices | Quantity Sold | 1992 Nominal GDP |
1992 Real GDP |
1994 Nominal GDP |
1994 Real GDP | ||||
| 1992 | 1994 | % change | 1992 | 1994 | |||||
| Food | $ 12 | $ 14 | 17 % | 4 | 5 | $ 48 | $ 48 | $ 70 | $ 60 |
| Housing | 9 | 10 | 11 % | 3 | 3 | 27 | 27 | 30 | 27 |
| Fun | 4 | 5 | 25 % | 3 | 4 | 12 | 12 | 20 | 16 |
| Machines | 20 | 20 | 0 % | 2 | 2 | 40 | 40 | 40 | 40 |
| $127 | $127 | $160 | $143 | ||||||
| 1994 Nominal GDP = | sum of [1994 (current year) Prices x 1994 (current year) Quantities] |
| = | ($14 x 5) + ($10 x 3) + ($5 x 4) + ($20 x 2) |
| = | $70 + $30 + $20 + $40 |
| = | $160 |
| 1994 Real GDP = | sum of [1992 (base year) Prices x 1994 (current year) Quantities] |
| = | ($12 x 5) + ($9 x 3) + ($4 x 4) + ($20 x 2) |
| = | $60 + $27 + $16 + $40 |
| = | $143 |
Recognize that the 1992 Nominal GDP is exactly the same as the 1992 Real GDP because 1992 is the designated base year. In other words, in 1992 "current" prices and "base year" prices are identical:
| 1992 Real GDP = | 1992 Nominal GDP |
| = | ($12 x 4) + ($9 x 3) + ($4 x 3) + ($20 x 2) |
| = | $48 + $27 + $12 + $40 |
| = | $127 |
Having calculated the 1992 and 1994 real GDP figures we can now determine if our economy grew or contracted. An increase in nominal GDP really tells us nothing because we don't know if the increase was due to higher prices or more physical output. Because the change in prices has been eliminated in the calculation of real GDP, an increase in real GDP tells us that our economy actually expanded. In our example, the economy grew by 12.6% between 1992 and 1994:
| Change in Real GDP, percent = | (Real GDP Year 2 - Real GDP Year 1) * 100 |
| Real GDP Year 1 | |
| = | (143 - 127) * 100 |
| 127 | |
| = | 12.62 % |
An empirical study is a test of a proposition or theory using actual observations or numbers. The National Income and Product Accounts and price indexes provide a rich source of observations for testing innumerable theories about how our economy has evolved over time and in comparison with other economies. These data are available not just for the nation as a whole but also for states, many large cities, and for specific industries.
Use Real rather than Nominal values. The bane of economists are news journalists who must have been bored with economics as undergraduates and skipped class. All too often we read of the horrors of how some spending is out of control. Headline -- federal government spending has increased almost 80 percent over the last 15 years! The only horror is that we are being misled. A nominal measure of spending does not indicate that more goods and services are being purchased because of the effect of inflation. After correcting for inflation, real government spending has increased by less than 8 percent. In fact, as most government employees can attest, real government spending has declined by over 17 percent since 1991. When comparing spending or income over time use real rather than nominal measures.
Compare Per Capita rather than Aggregates. If the total real (physical) output of the economy increased by 2 percent last year, were we better off (ignoring complications such as pollution, distribution of wealth, etc.)? Not necessarily, the total population may have increased by more than 2 percent so that we are now producing/purchasing less per person on average. When comparing outcomes over time (or across different countries) it is common practice to divide an economic measure like output (or income, consumption, etc.) by the total population for a per capita measure. A related question is, did each person on average produce more? Again, maybe not. The total labor force (or labor-hours) may have increased by more than 2 percent. In this situation we have more workers but less output per worker (or per labor-hour). Comparisons of aggregate output over time or across countries should be based on measures of output per unit of labor input -- for example, per worker or per hour of work.
| GDP Per Capita - total GDP (nominal or real) divided by the total population
Productivity - average output per hour of labor (e.g., total real GDP divided by the total number of labor-hours worked) |
Compare Growth Rates rather than Levels. Although growth in U.S. real GDP per capita in Figure 4-2 appears to be relatively steady, the growth rate has actually slowed over the last 30 years. Over the last 10 years (1987 to 1997), real GDP per capita grew by 16.5 percent, which compares poorly with the 31 percent growth recorded during the 10 years between 1957 and 1967 (Figure 4-3).
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Figure 4-3. U.S. Real GDP per Capita.
Data Source: U.S. Dept. of Commerce, Bureau of Economic Analysis (http://www.bea.doc.gov/) |
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Figure 4-4. U.S. Real GDP per Capita Growth Rates, 10-year Averages.
Data Source: U.S. Dept. of Commerce, Bureau of Economic Analysis (http://www.bea.doc.gov/) |
The trick is that an increase from $10,000 to $15,000 is much greater (50 percent) than growth from $30,000 to $35,000 (17 percent). Similarly, a 100 point increase in the stock market's Dow Jones Industrial Average today is not nearly as dramatic as it was ten years ago.
File last modified: May 1, 2003.
© Tancred Lidderdale (Tancred@Lidderdale.com)