Chapter 23

Measuring a Nations Income

Microeconomics: The study of economics that focuses on the individual parts of the economy. In particular, how individuals, households, and rms make decisions and how they interact in specic markets. Macroeconomics: The study of economics that looks at the economy as a whole. In particular, economy-wide phenomena including ination, unemployment, and economic growth. 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 ination? 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 nal goods and services produced within a country in a given period of time. 3

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 System of National Accounts (1993), which was prepared by representatives of the International Monetary Fund, European Union, Organization for Economic Cooperation and Development, United Nations and the World Bank. In the U.S., the Bureau of Economic Analysis (BEA) is responsible for calculating the GDP. 3. ...Final Goods and Services... Good: A tangible item. Generally, an item is considered a good if it could feasibly be resold. Final Good: A good that requires no further processing or transformation to be ready for use by consumers, investors, or government. Intermediate Good: A good that is used solely in the production of a nal good. Services: An intangible item. Generally, an item is considered a service if 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 boundaries of a particular country. 5. ...In a Given Period of Time. Generally reported quarterly. Seasonal biases are removed.

23.2

GDP - What It Is Not

1. A complete analysis of legal economic activity: Nonmarket productive activities are neglected, inating the GDP gap between highly industrialized countries and less developed nations. 2. A complete analyis of illegal economic activity: Illegal forms of economic activity (drug trade, gambling) and activity that is not reported for tax reasons are neglected.

International Dierences in the Underground Economy Country Underground Economy as a Percent of GDP Bolivia 68% Zimbabwe 63 Peru 61 Thailand 54 Mexico 33 Argentina 29 Sweden 18 Australia 13 United Kingdom 12 Japan 11 Switzerland 9 United 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 leisuretime, negative externalities, and the potentially unequitable distribution of income. 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 countries were: 1. Nigeria 5

2. Mexico 3. Venezuela 4. El Salvador 5. Puerto Rico When individuals were asked the above happiness question and the results were combined with the following question: All things considered, how satised are you with your life as a whole these days? a ranking of subjective well-being for the following countries was achieved. 1. Puerto Rico 2. Mexico 3. Denmark 4. 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 It

Refer to gure 23.1

Figure 23.1: GDP and Life Expectancy in 12 Countries

23.4

Components of the GDP

Generally, 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 to produce more goods. This does NOT include the purchase of nancial assets such as stocks and bonds. 3. Government Expenditure (G): Total spending on the goods and services purchased by the government at the federal, state, and local levels. Does NOT include transfer payments such as social security. 4. Net Exports NX: Exports - Imports GDP is calculated as Y=C+I+G+NX 7

Figure 23.2: GDP and Adult Literacy in 12 Countries

Example 23.1 - Components of the GDP For each of the following determine how much GDP and each of its components are aected (if at all) a. Debbie spends $200 to buy her husband dinner at the nest restaurant in Boston. b. Sarah spends $1800 on a new laptop to use in her publishing business. The laptop was built in China. c. Jane spends $1200 on a computer to use in her editing business. She got last years model on sale for a great price from a local manufacturer. d. General Motors builds $500 million worth of cars, but consumers only buy $470 million worth of them.

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 ination.

Figure 23.4: Nominal GDP, Real GDP, and Implicit GDP Inator, 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.

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 services bought 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 determine whats in the typical consumers shopping basket. The contents of the basket are divided into 8 major groups.

(a) Food and Beverages (15%): service meals and snacks, etc.

breakfast cereal, milk, coee, chicken, wine,

(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 vehicle insurance, etc. (e) Medical Care (6%): prescription drugs and medical supplies, physicians services, eyeglasses and eye care, hospital services, etc. (f) Recreation (6%): televisions, pets and pet products, sports equipment, admissions, etc.

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(g) Education and Communication (6%): college tuition, postage, telephone services, 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 visit or call thousands of retail stores, service establishments, rental units, and doctors oces, all over the United States to obtain information on the prices of the thousands of items used to track and measure price changes in the CPI. These economic assistants record the prices of about 80,000 items each month representing a scientically selected 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 ination rate: The ination 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/Ination Rate

24.2.2

Example

24.3
24.3.1

Problems With the CPI

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 xed 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 nd products that more closely meet their needs. This has the eect of making each dollar more valuable. The CPI misses this eect because it uses a xed basket of goods. Thus, the CPI overstates increases in the cost of living.

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

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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 overstates ination by about 0.5 percent per year. This is important, because Social Security payments and many contracts have COLAs tied to the CPI.

24.4

Correcting Economic Variables for the Eects of Ination

A dollar in 2004 is NOT the same as a dollar in 2005. As such, we need to perform a unit conversion. Example 24.2 - Price Conversion A 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 Conversion 1980: CPI = 90 1980 avg starting salary for econ majors = $24,000 2005: CPI = 180 2005 avg starting salary for econ majors = $50,000 Are econ majors better o today or in 1980?

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24.5

Real versus Nominal Interest Rates

Real interest rate = nominal interest rate - ination rate

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Chapter 25

Production and Growth

The consequences for human welfare in questions like these are simply staggering: Once one 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: 41 years; 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: unit. The quantity of goods and services produced from each unit of labor

25.1

Determinants of Productivity

Physical Capital per Worker (Physical) Capital: The stock of equipment and structures that are used to produce goods and services. Examples include computers, welding machines, and lathes. Human Capital per Worker Human Capital: The knowledge and skills that workers acquire through education, 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 Worker Natural Resources: Inputs into production that are provided by nature. Examples include land (for farming), rivers (for shing), and oil (for running machinery). Technological Knowledge Technological Knowledge: The understanding of the best ways to produce goods 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 the science on which electronics are based.

25.2
25.2.1

Economic Growth and Public Policy

Saving and Investment

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

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

25.2.2

Diminishing Returns and the Catch-Up Eect

Diminishing Returns: The property whereby the benet from an extra unit of an input declines as the quantity of the input increases. Catch-Up Eect: The property whereby countries that start o poor tend to grow more rapidly than countries that start o 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 was greater 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 is nanced with foreign money but operated by domestic residents. 27

Figure 25.7: Diminishing Returns

Some of the benets of foreign investment ow back to foreign owners. But the economy still 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 ow of investment to poor countries The World Bank obtains funds from developed countries such as the United States and makes loans to less-developed countries so that they can invest in roads, sewer systems, schools, and other types of capital. The World Bank also oers 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 arguments against it (with corresponding counter-arguments), please visit http://www.slate.com/ id/56497/. 28

25.2.4

Education

Govt can increase productivity by promoting educationinvestment in human capital via. public schools, subsidized loans for college, etc. Education has signicant eects: In the U.S., each year of schooling raises a workers wage by 10%. As with savings/investment decisions, additional schooling requires a tradeo. I think these programs [that give families incentives to educate their children] are as close as you can come to a magic bullet in development. -president of the Center for Global Development

25.3

Health and Nutrition

In countries with signicant malnourishment,raising workers caloric intake raises productivity: Over 1962-95, caloric consumption rose 44% in S. Korea and economic growth was spectacular. Nobel winner Robert Fogel estimtates 30% of Great Britains growth from 1790-1980 was due to improved nutrition. Example 25.1 - Growth Policy 38.8% of Swazilands population currently has AIDS. In what ways is this restricting Swazilands 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, rms must bribe govt ocials for permits 29

 Political instability (e.g. frequent coups) creates uncertainty over whether property rights will be protected in the future. Economic stability, eciency, and healthy growth require law enforcement, eective courts, a stable constitution, and honest govt ocials. Example 25.2 - Growth Policy Last year, Hugo Chavez(president of Venezuela) nationalized the oil elds privately owned by BP, ConocoPhillips, Exxon Mobil, Chevron, Total and Statoil of Norway. He is also in the process of nationalizing electricity companies in Venezuela and the biggest telecommunications company. He also threatened to take over private hospitals if they continued raising prices for health care. In the short-run, why are these actions winning him widespread support? 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 agricultural countries 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 aect living standards in 3 dierent ways: 1. Stretching natural resources 200 years ago, Malthus argued that pop. growth would strain societys ability to provide for itself. 30

 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 attainment To combat this, many developing countries use policy to control population growth. 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, engineers = more frequent discoveries Evidence from Michael Kremer: Over the course of human history, growth rates increased as the worlds population increased. In particular, more populated regions grew faster than less populated ones.

25.4
25.4.1

Growth Policies in the Reagan, Bush, and Clinton Adminstrations

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 recipients were removed from the tax rolls. Reduction in Business Taxes Implemented the Accelerated Cost Recovery system (ACRS) which allowed equipment to be depreciated on a 5-year schedule instead of an 8.6 year schedule (allowing for much higher deductions per year). 31

 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 eort to control the federal decit. 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 markets eciencies and its imperfections. Proposed a stimulus package consisting of public investment in infrastructure, worker retraining, and partnerships between business and government to move resources 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 , liberalized provisions for IRA accounts, and balanced the federal budget.

25.5

Results of the Reagan, Bush, and Clinton Growth Policies

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