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Chapter 23

Measuring a Nations Income

Microeconomics: The study of economics that focuses on the individual parts of theeconomy. In particular, how individuals, households, and firms make decisions and how

they interact in specific markets.

Macroeconomics: The study of economics that looks at the economy as a whole.In particular, economy-wide phenomena including inflation, unemployment, and economicgrowth.

Some Questions Macroeconomics Answers:

1. How do consumers decide how to divide their income between spending and saving?

2. What determines the total amount of employment and unemployment?

3. What determines the overall level of prices, and the rate of inflation?4. Why does the economy go through cycles, where things are great for a few years (like

the late 90s), and then bad for a year or two (like 2001-2002)?

5. When unemployment is high, what can the government do to help?

23.1 GDP - What It Is

GDP - Gross Domestic Product:

1. A measure of the total income of everyone in the economy.

2. A measure of the total expenditure of everyone in the economy.

3. The market value of all final goods and services produced within a country in a givenperiod of time.

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1. GDP is the Market Value...

GDP uses the market price of goods, allowing us to compare apples to oranges.

GDP does not include items without a market value.

2. ...of all...

GDP includes all items produced in the economy and sold legally

The international standard for measuring GDP is contained in the book Sys-tem of National Accounts (1993), which was prepared by representatives of theInternational Monetary Fund, European Union, Organization for Economic Co-operation and Development, United Nations and the World Bank.

In the U.S., the Bureau of Economic Analysis (BEA) is responsible for calculat-ing the GDP.

3. ...Final Goods and Services...

Good: A tangible item. Generally, an item is considered a good if it couldfeasibly be resold.

Final Good: A good that requires no further processing or transformationto be ready for use by consumers, investors, or government.

Intermediate Good: A good that is used solely in the production of a finalgood.

Services: An intangible item. Generally, an item is considered a serviceif it could not feasibly be resold.

4. ...Produced Within a Country...

Only current production is counted.

Used goods that are sold do not count as part of GDP.

GDP measures the production that takes place within the geographical bound-aries of a particular country.

5. ...In a Given Period of Time.

Generally reported quarterly.

Seasonal biases are removed.

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23.2 GDP - What It Is Not

1. A complete analysis of legal economic activity: Nonmarket productive activi-ties are neglected, inflating the GDP gap between highly industrialized countries and

less developed nations.

2. A complete analyis of illegal economic activity: Illegal forms of economic ac-tivity (drug trade, gambling) and activity that is not reported for tax reasons areneglected.

International Differences inthe Underground Economy

Country Underground Economy asa Percent of GDP

Bolivia 68%Zimbabwe 63

Peru 61Thailand 54

Mexico 33Argentina 29

Sweden 18Australia 13

United Kingdom 12Japan 11

Switzerland 9United States 8

3. An Exact Welfare Measure:

(a) GDP does not take into account the number of people in an economy.

(b) per capita GDP is a reasonable welfare measure, but does not include leisure-time, negative externalities, and the potentially unequitable distribution of in-come.

The University of Michigans World Values Surveys (WVS)

When individuals were asked: Taking all things together, would you say you are: 1. Very

happy, 2. Rather happy, 3. Not very happy, or 4. Not at all happy? the happiest countrieswere:

1. Nigeria

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2. Mexico

3. Venezuela

4. El Salvador5. Puerto Rico

When individuals were asked the above happiness question and the results were combinedwith the following question: All things considered, how satisfied are you with your lifeas a whole these days? a ranking of subjective well-being for the following countries wasachieved.

1. Puerto Rico

2. Mexico

3. Denmark4. Colombia

5. Ireland

6. Iceland

7. N. Ireland

8. Switzerland

9. Netherlands

10. Canada

11. Austria

12. El Salvador

13. Venezuela

14. Luxembourg

15. U.S.

23.3 GDP - Why We Care About ItRefer to figure 23.1

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Figure 23.1: GDP and Life Expectancy in 12 Countries

23.4 Components of the GDPGenerally, the GDP is split into 4 components:

1. Consumption (C) : Total spending by households on goods and services.

2. Investment (I) : Total spending on goods that will be used in the future toproduce more goods. This does NOT include the purchase of financial assets such asstocks and bonds.

3. Government Expenditure (G): Total spending on the goods and services pur-chased by the government at the federal, state, and local levels. Does NOT includetransfer payments such as social security.

4. Net Exports NX: Exports - Imports

GDP is calculated as Y=C+I+G+NX

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Figure 23.2: GDP and Adult Literacy in 12 Countries

Example 23.1 - Components of the GDPFor each of the following determine how much GDP and each of its components are affected(if at all)

a. Debbie spends $200 to buy her husband dinner at the finest restaurant in Boston.

b. Sarah spends $1800 on a new laptop to use in her publishing business. The laptopwas built in China.

c. Jane spends $1200 on a computer to use in her editing business. She got last yearsmodel on sale for a great price from a local manufacturer.

d. General Motors builds $500 million worth of cars, but consumers only buy $470million worth of them.

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Figure 23.3: Nominal GDP and Its Components, Selected Years

23.5 Real Versus Nominal GDP

Nominal GDP: The GDP using current prices.

Real GDP: The GDP using the prices of a base year. Real GDP is corrected for inflation.

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Figure 23.4: Nominal GDP, Real GDP, and Implicit GDP Inflator, Selected Years

23.6 Economic Recessions

Recession: A period in which real GDP falls for consecutive periods. Expansion:

A period in which real GDP rises for consecutive periods.

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Figure 23.5: Real GDP in the U.S.

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Figure 23.6: Real GDP in the U.S.

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Figure 23.7: Recent Quarterly GDP in the U.S.

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Chapter 24

Measuring the Cost of Living

24.1 CPI - What It Is

Consumer Price Index (CPI): A measure of the overall cost of the goods and servicesbought by a typical consumer. Generated once a month by the Bureau of Labor Statistics,which is part of the Department of Labor..

24.2 CPI - How It Is Calculated

1. Fix the basket: The Bureau of Labor Statistics (BLS) surveys consumers to deter-mine whats in the typical consumers shopping basket. The contents of the basketare divided into 8 major groups.

(a) Food and Beverages (15%): breakfast cereal, milk, coffee, chicken, wine,service meals and snacks, etc.

(b) Housing (42%): rent of primary residence, owners equivalent rent, fuel oil,bedroom furniture, etc.

(c) Apparel (4%): mens shirts and sweaters, womens dresses, jewelry, etc.

(d) Transportation (17%): new vehicles, airline fares, gasoline, motor vehicleinsurance, etc.

(e) Medical Care (6%): prescription drugs and medical supplies, physicians ser-vices, eyeglasses and eye care, hospital services, etc.

(f) Recreation (6%): televisions, pets and pet products, sports equipment, ad-missions, etc.

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(g) Education and Communication (6%): college tuition, postage, telephoneservices, computer software and accessories, etc.

(h) Other Goods and Services (4%): tobacco and smoking products, haircuts

and other personal services, funeral expenses, etc.

2. Find the prices: Each month, BLS data collectors called economic assistants visitor call thousands of retail stores, service establishments, rental units, and doctorsoffices, all over the United States to obtain information on the prices of the thousandsof items used to track and measure price changes in the CPI. These economic assis-tants record the prices of about 80,000 items each month representing a scientificallyselected sample of the prices paid by consumers for the goods and services purchased.

3. Compute the baskets cost:

4. Choose a base year and compute the index:

The CPI in any year equals

100 cost of basket in current year

cost of basket in base year

5. Compute the inflation rate:

The inflation rate in a given year equals

100% CPI in the given year - CPI in the previous year

CPI in the previous year

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24.2.1 Example

Figure 24.1:

Example 24.1 - CPI/Inflation Rate

24.2.2 Example

24.3 Problems With the CPI

24.3.1 Substitution Bias

Over time, some prices rise faster than others.

Consumers substitute toward goods that become relatively cheaper.

The CPI misses this substitution because it uses a fixed basket of goods.

Thus, the CPI overstates increases in the cost of living.

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Figure 24.2:

24.3.2 Introduction of New Goods

When new goods become available, variety increases, allowing consumers to find

products that more closely meet their needs.

This has the effect of making each dollar more valuable.

The CPI misses this effect because it uses a fixed basket of goods.


24.3.3 Unmeasured Quality Change

Improvements in the quality of goods in the basket increase the value of each dollar.

The BLS tries to account for quality changes, but probably misses some quality

improvements, as quality is hard to measure.


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24.3.4 Why An Accurate CPI is important

Each of these problems causes the CPI to overstate cost of living increases.

The BLS has made technical adjustments, but the CPI probably still overstatesinflation by about 0.5 percent per year.

This is important, because Social Security payments and many contracts have COLAstied to the CPI.

24.4 Correcting Economic Variables for the Effects of Infla-

tion

A dollar in 2004 is NOT the same as a dollar in 2005. As such, we need to perform a unitconversion.

Example 24.2 - Price ConversionA gallon of gas was sold for $1.42 in 1981. How much is this in 2005 prices?

1. We have been given a unit of 1981 dollars.

2. We need a unit of 2005 dollars.

3.

1.42 1981 dollars = 1.42(1981 dollars)?

?= ? 2005 dollars

Example 24.3 - Price Conversion1980: CPI = 901980 avg starting salary for econ majors = $24,0002005: CPI = 180

2005 avg starting salary for econ majors = $50,000Are econ majors better off today or in 1980?

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24.5 Real versus Nominal Interest Rates

Real interest rate = nominal interest rate - inflation rate

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Chapter 25

Production and Growth

The consequences for human welfare in questions like these are simply staggering: Onceone starts to think about them, it is hard to think about anything else. - Robert Lucas

https://www.cia.gov/library/publications/the-world-factbook/countrylisting.html

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Figure 25.1: Percentage living on less than $1 a day

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Figure 25.2: Typical Family in the U.K.: Real GDP per capita: $30,800; Life expectancy:78 years; Adult literacy: 99%; Infant Mortality Rate: 5.58 deaths/1,000 live births

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Figure 25.3: Typical Family in Mexico.: Real GDP per capita: $9,800; Life expectancy:74 years; Adult literacy: 92%; Infant Mortality Rate: 19.63 deaths/1,000 live births

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Figure 25.4: Typical Family in Mali.: Real GDP per capita: $1,000; Life expectancy: 41years; Adult literacy: 46%; Infant Mortality Rate: 105.65 deaths/1,000 live births

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Figure 25.5: Incomes and Growth Around the World

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Key questions that macroeconomics attempt to answer:

1. Why are some countries richer than others?

2. Why do some countries grow quickly while others seem stuck in a poverty trap?3. What policies may help raise growth rates and long-run living standards?

Productivity: The quantity of goods and services produced from each unit of laborunit.

25.1 Determinants of Productivity

Physical Capital per Worker (Physical) Capital: The stock of equipment and structures that are used toproduce goods and services. Examples include computers, welding machines, and

lathes.

Human Capital per Worker Human Capital: The knowledge and skills that workers acquire through ed-ucation, training, and experience. Examples include knowing how to wire a house,understanding how to drive a tractor, and the ability to program a computer.

Natural Resources per WorkerNatural Resources: Inputs into production that are provided by nature. Exam-ples include land (for farming), rivers (for fishing), and oil (for running machinery).

Technological Knowledge

Technological Knowledge: The understanding of the best ways to producegoods and services. Examples include the knowledge of how assembly lines work,insights into the genetic code that allow us to quickly invent new drugs, and thescience on which electronics are based.

25.2 Economic Growth and Public Policy

25.2.1 Saving and Investment

Because capital is a determinant of productivity, any policy that helps increase capitalgrowth will increase long-term economic growth.

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Figure 25.6: GROWTH AND INVESTMENT. Panel (a) shows the growth rate of GDP perperson for 15 countries over the period from 1960 to 1991. Panel (b) shows the percentageof GDP that each country devoted to investment over this period. The figure shows thatinvestment and growth are positively correlated.

25.2.2 Diminishing Returns and the Catch-Up Effect

Diminishing Returns: The property whereby the benefit from an extra unit of aninput declines as the quantity of the input increases.

Catch-Up Effect: The property whereby countries that start off poor tend to growmore rapidly than countries that start off rich.

Over 1960-1990, the U.S. and S. Korea devoted a similar share of GDP to investment,so you might expect they would have similar growth performance. However, growth wasgreater than 6% in Korea and only 2% in the U.S.

25.2.3 Investment from Abroad

Foreign Direct Investment: Investment that occurs when a capital investment is

owned and operated by a foreign entity.

Foreign Portfolio Investment: Investment that occurs when a capital investment isfinanced with foreign money but operated by domestic residents.

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Figure 25.7: Diminishing Returns

Some of the benefits of foreign investment flow back to foreign owners. But the economystill experiences an increase in the capital stock, which leads to higher productivity and

higher wages.

The World Bank

The World Bank is an organization that tries to encourage the flow of investment to poorcountries

The World Bank obtains funds from developed countries such as the United Statesand makes loans to less-developed countries so that they can invest in roads, sewersystems, schools, and other types of capital.

The World Bank also offers these countries advice on how best to use these funds.

If you would like a more thorough discussion of the WTO and some of the argumentsagainst it (with corresponding counter-arguments), please visit http://www.slate.com/id/56497/.

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25.2.4 Education

Govt can increase productivity by promoting educationinvestment in human capitalvia. public schools, subsidized loans for college, etc.

Education has significant effects: In the U.S., each year of schooling raises a workerswage by 10%.

As with savings/investment decisions, additional schooling requires a tradeoff.

I think these programs [that give families incentives to educate their children] are as closeas you can come to a magic bullet in development. -president of the Center for GlobalDevelopment

25.3 Health and Nutrition

In countries with significant malnourishment,raising workers caloric intake raises produc-tivity:

Over 1962-95, caloric consumption rose 44% in S. Korea and economic growth wasspectacular.

Nobel winner Robert Fogel estimtates 30% of Great Britains growth from 1790-1980was due to improved nutrition.

Example 25.1 - Growth Policy38.8% of Swazilands population currently has AIDS. In what ways is this restricting Swazi-lands economic growth?

25.3.1 Property Rights and Political Stability

In many poor countries, the justice system doesnt work very well:

Contracts arent always enforced Fraud, corruption often go unpunished

In some, firms must bribe govt officials for permits

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Political instability (e.g. frequent coups) creates uncertainty over whether propertyrights will be protected in the future.

Economic stability, efficiency, and healthy growth require law enforcement, effective

courts, a stable constitution, and honest govt officials.

Example 25.2 - Growth PolicyLast year, Hugo Chavez(president of Venezuela) nationalized the oil fields privately ownedby BP, ConocoPhillips, Exxon Mobil, Chevron, Total and Statoil of Norway. He is also inthe process of nationalizing electricity companies in Venezuela and the biggest telecommu-nications company. He also threatened to take over private hospitals if they continued rais-ing prices for health care. In the short-run, why are these actions winning him widespreadsupport? In the long-run, what results will his actions have?

25.3.2 Free Trade

Opening an economy to free trade is equivalent to having a technological revolution.

Physical trade routes are crucial for free trade.

Some argue Americas agricultural subsidies hurt the ability of poor agriculturalcountries to competitively engage in international trade.

25.3.3 Research and Development

Technological progress is the main reason why living standards rise over the long run.

One reason is that knowledge is a public good: ideas can be shared freely, increasing

the productivity of many.

Policies to promote tech. progress:

patent laws

tax incentives or direct support for private sector R&D

grants for basic research at universities

25.3.4 Population Growth

May affect living standards in 3 different ways:

1. Stretching natural resources

200 years ago, Malthus argued that pop. growth would strain societys abilityto provide for itself.

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Since then, the world population has increased sixfold. If Malthus was right,living standards would have fallen. Instead, theyve risen.

Malthus failed to account for technological progress and productivity growth.

2. Diluting the capital stock

The more individuals in a society, the less each can access available capital.

Countries with fast population growth tend to have lower educational attain-ment

To combat this, many developing countries use policy to control populationgrowth.

Chinas one child per family laws

Contraception education & availability

promote female literacy to raise opportunity cost of having babies.

3. Promoting technological progress More people = more scientists, inventors, en-gineers = more frequent discoveries

Evidence from Michael Kremer: Over the course of human history, growth ratesincreased as the worlds population increased. In particular, more populated regionsgrew faster than less populated ones.

25.4 Growth Policies in the Reagan, Bush, and Clinton Ad-

minstrations

25.4.1 Reagan

Personal Income Tax Reductions

Reduced marginal income tax rates, by a total of 23%.

Reduced the higest tax rate from 50% to 28%.

Lowered the top rate on capital gains taxes from 70% to 50%.

Extended the opportunity to use IRA accounts as tax deductible shelters.

Raised personal exemptions so that approximately 6 million low-income recipi-ents were removed from the tax rolls.

Reduction in Business Taxes

Implemented the Accelerated Cost Recovery system (ACRS) which allowedequipment to be depreciated on a 5-year schedule instead of an 8.6 year schedule(allowing for much higher deductions per year).

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Investment tax credit was expanded for certain types of equipment.

Reductions in Nondefense Government Spending

Reductions in Government Regulation Shifted some responsibilities for air pollution to individual states.

Reduced controls on the petroleum markets.

Abolished the Deptartments of Energy and Education.

25.4.2 Bush

Raised some taxes in an effort to control the federal deficit.

Was unable to push a capital gains tax through Congress.

25.4.3 Clinton

Wanted government to take a more activist role, one that recognizes both the mar-kets efficiencies and its imperfections.

Proposed a stimulus package consisting of public investment in infrastructure,worker retraining, and partnerships between business and government to move re-sources from sunset to sunrise industries.

Could not pass his initiatives due to concern over the budget defecit.

After the 1996 elections, he implemented some Republican tax cuts , liberalizedprovisions for IRA accounts, and balanced the federal budget.

25.5 Results of the Reagan, Bush, and Clinton Growth Poli-

cies

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