Economics 1021 - Lecture Notes - Professor Fazzari

Economics 1021 - Lecture Notes - Professor Fazzari

Topic II: Macroeconomic Data

(Update January 29, 2013 )

**Important Note** The material covered in this section of the notes on the measurement of inflation and unemployment will not be discussed in class, but you need to learn about these things for the homework and the first exam. The lecture notes for topics B. and C. in this file below provide the material that you need for these topics. Please study these notes carefully on your own.

A. Measuring Aggregate Output

1.  Why Measure Output?

·  To test various theories about the economy, we need measures of total production. For example, we need good measures to determine what happens to the economy when interest rates fall. We also might want to compare economic performance across countries. For these "positive" reasons we need good measures of overall economic performance.

·  Good data are also essential as a guide to policy. For the Fed, the Congress, and the President to know what kinds of policies to pursue, they need good information about the state of the economy. Thus, there are "normative" reasons for measuring output.

·  Macroeconomic measures also have important political ramifications. Most voters may know little about GDP, but news of its weak or strong growth will matter for the outcome of national elections. Example: George H.W. ("Daddy") Bush lost the election of 1992 to Bill Clinton. There were undoubtedly many reasons for this outcome, but perhaps none was more significant than the weak news about the economy during 1992, particularly slow GDP growth. The economic figures also played a large role in the presidential election of 2012. The main theme of the Romney campaign to defeat Obama was that economic performance had been weak during Obama’s first term. These numbers matter!

·  While these points are made specifically about GDP, they also apply to measures of inflation and unemployment discussed in the lecture notes below. Indeed, in recent years, unemployment may be more important for political purposes than GDP because it is more tangible to the average voter.

2.  Adding Up Diverse Products

·  If the economy produced just one kind of physical good (corn, for example), it would be easy to measure total output.

·  But it is difficult to calculate GDP because you have to find a way to measure and compare thousands (millions?) of very diverse products. It’s hard enough to compared physical goods (How many boxes of corn flakes equals one car?). But a large majority of what a mature economy like the U.S. produces is not even physical "goods" that can be counted. Instead a lot of production comes from the “service sector” that employs vastly more people than the goods-producing “manufacturing” sector. In 2009 services accounted for about 75% of the production of developed economies. (See the International Monetary Fund statistics listed by Wikipedia at http://en.wikipedia.org/wiki/List_of_countries_by_GDP_sector_composition ). Examples of services include education, visits to the doctor, much of health care, etc.

·  Somehow, all the diverse goods and services produced must be aggregated to come up with a measure of total national output.

3.  GDP Definition

·  Gross Domestic Product (GDP): the money value of all final goods and services produced in an economy over a given time period.

·  GDP is typically measured over a period of a quarter or a year. GDP always is associated with a time period. It only makes sense to measure output over a period of time, not at a single point in time.

·  The definition of “an economy” is usually a country, but it could be a state or smaller unit. (There are statistics available called “gross state product.”)

a)  Logic of Using Money Values as Weights for Aggregation

·  To meet the challenge of the vast diversity of products, economists use the money value of goods and services to determine their individual values. The money values are then added up to get a measure of aggregate output.

·  Relative money values reflect the different values people put on different goods. The reason a car represents more production to society than a box of corn flakes is that people value a car more highly. This point is reflected in the relative money values of cars and corn flakes, and all other goods produced in a market society.

·  You may be asking yourself, "well, duh, what else could economists possibly use?" An answer to your question is that we could measure GDP based on how many hours were worked to produce the goods and services. However, money values give a better estimate of the relative value society places on different goods and services (as opposed to the effort that goes into producing different things).

·  The computation of GDP is a very complicated statistical process. The Bureau of Economic Analysis in the Department of Commerce conducts surveys and employs tax data to arrive at an estimate of GDP in each quarter. Estimates first appear one month after the end of the quarter but they are subsequently revised. Sometimes substantial revisions occur even after a couple of years.

b)  Final vs. Intermediate Goods and Services

·  A final good is one that is ultimately used by the consumer

·  An intermediate good (or service) is one that is purchased to be used in the production of another good (or service)

·  Only final goods are included in the GDP totals. Intermediate goods are not counted in GDP because we would be double-counting the amount of output that is actually produced.

·  Example: Consider a car that costs $30,000 from the dealer: Let's say the dealer bought the car from the producer for $25,000, and the producer spent $15,000 on parts and materials to make the car. The total value of the transactions involved in producing the car is the sum of $30,000 (the retail cost of the car), $25,000 (the wholesale price the dealer paid to the car manufacturer), and $15,000 (the value of inputs purchased by the manufacturer.) But it should be clear that this approach would greatly overstate the value of goods represented by the car, which is just $30,000. We exclude the purchases of items prior to the sale of a final good to the ultimate consumer as intermediate goods.

·  Another example: the value of electricity used in a home counts towards GDP because the person in the home is the final consumer. Electricity used in a place of business is considered an intermediate good, as that electricity is just an intermediate good that is used to produce another good/service.

c)  GDP Sales and Inventories

·  GDP measures production, NOT sales. However, we do measure GDP in money values, so sales are involved in the calculation of GDP.

·  Goods that are produced during the year but not sold are added to inventories. These goods still count towards GDP at the time they were produced, even though they are not sold.

·  The relationship between GDP and sales is given by the following equation:

GDP = Final Sales + Change in Inventories

·  So, a $1,000 refrigerator produced in the year 2010 but not sold until 2011 will count towards GDP in the year 2000 as a positive change in inventory. When the refrigerator is sold in 2001, final sales will increase and there will be a negative change in inventories, so the net change in GDP for 2001 is zero. In table form:

GDP Final Sales Change in Inventories
2010 +$1,000 -0- +$1,000
2011 -0- +$1,000 -$1,000

d)  Investment: Intermediate or Final Good?

(1) Definition of investment

·  Investment consists of these three components:

o  Structures, equipment, and software purchases by firms. Basically durable goods that firms use to carry out their business. This category is called “nonresidential fixed investment” in the government statistics. Software was added to this component a number of years ago.

o  Residential Construction: value of new housing built in the GDP time period (not the value of existing houses). Home improvement, like a room addition or substantial remodeling, also adds to this component.

o  Change in Inventories

·  Note that "investment" for purposes of this course refers to these components, not the purchase of stocks, bonds, or other financial assets. Thus, the term “investment,” as typically used in macroeconomics, usually means something different from its common usage.

(2) Should investment goods be counted as final output?

·  It may seem like these investment goods purchased by a business should be intermediate goods because they are used to produce other goods and services. However, economists include them in GDP because they are durable. Durable goods are defined as goods that last for at least 3 years. A durable good will still be used for many years after they are produced. An economy that produces a lot of investment goods in a year that are available for future use is more productive than an economy with little investment. Thus, it makes sense to include investment goods in GDP.

·  Software did not used to be counted as investment, it used to be considered a simple intermediate good when purchased by firms (like raw materials or electricity). However, software is “durable” and has recently been included in the investment category. This change of definition would raise GDP, even with no change in the production of anything. (Do you understand the previous sentence fully? If so, you have a pretty good idea of what we have covered so far.)

(3) Gross vs. Net Domestic Product (NDP)

·  One might argue that something should be subtracted from GDP to account for productive goods that are used up during the year.

·  Definition of Depreciation: the value of that portion of the nation’s capital equipment that is used up within the year

·  Net Domestic Product = GDP – Depreciation

·  GDP measures final output and does not take into account the capital used up in the process (which must eventually be replaced). NDP deducts the depreciation to arrive at a net measure of production.

·  NDP is conceptually better than GDP. NDP allows for the fact that investment goods produced this year may not be fully used up this year. But the NDP measure also account for the fact that some investment goods wear out every year.

·  Nevertheless, GDP is the primary measure used by economists and policy makers because depreciation is very difficult to measure accurately. Therefore, NDP is considered a less reliable measure of output than GDP.

e)  Pre-Existing Assets

·  Goods or services sold in a year that were produced in a prior year do not count toward GDP.

·  Example: A 1995 car resold in 2000 does not count towards GDP in the year 2000. Remember that GDP measures production, not sales, and the car was already counted when it was produced in 1995.

·  Other examples include sales of homes built in previous years and sales of artwork produced before the year of interest.

·  The buying and selling of existing businesses would also fall into this category. If one company purchases another one, there is no effect on GDP.

·  Because shares of stock represent ownership of an existing business, exchange of shares of stock does not raise GDP. Note, however, that the value of brokerage services paid by individual investors are counted as the production of a final service and therefore add to GDP. The same principles apply to banking, insurance, real estate, etc. The value of assets bought and sold does not add to GDP, but the amount paid to financial service companies does represent production.

f)  Market versus Non-market Exchange

·  GDP does not measure any transaction that does not go through markets (Examples: work that you do in your own home, illegal activities).

·  This means that hiring a person to mow your lawn for you counts towards GDP, whereas mowing your own lawn does not count towards GDP

·  This is a shortcoming of GDP. In principle, work you do for yourself or other activities that do not go through markets represent production and one could argue that it should be counted in GDP. However, it would be nearly impossible to account for all the non-market transactions that take place.

·  One application of this idea is to analyze the impact of GDP of greater labor force participation of women in recent decades. Their production for the market is now added to GDP, but the work they no longer do in the home (outside of the market) is not subtracted from GDP. Thus, one might argue that the growth rate of measured GDP during the past 40 years is somewhat higher than it should be.

·  If we look at the GDP figures of less developed countries, we will see that the per capita GDP is only a few hundred dollars. These countries are very poor. But their low GDP numbers probably exaggerate the extent of their poverty compared with developed countries. Most likely, a much greater proportion of their production does not go through a market, so it is not counted in GDP. The same problem arises for countries in which the underground economy is large. There exists a downward bias in their GDP because illegal transactions are unreported and uncounted.

g)  The Components of GDP

(1) The GDP equation: GDP = C + I + G + Ex – Im

·  C = Consumption: everything consumers buy except housing. Consumption includes all durable assets (aside from residential housing), like cars and appliances.