User JOEWA:Job EFF01418:6264_ch02:Pg 15:24933#/eps at 100% *24933* Tue, Feb 12, 2002 8:40 AM Scientists, economists, and detectives have much in common: they all want to figure out what’s going on in the world around them.To do this, they rely on both theory and observation.They build theories in an attempt to make sense of what they see happening.They then turn to more systematic observation to eval- uate the theories’ validity. Only when theory and evidence come into line do they feel they understand the situation.This chapter discusses the types of obser- vation that economists use to develop and test their theories. Casual observation is one source of information about what’s happening in the economy.When you go shopping, you see how fast prices are rising.When you look for a job, you learn whether firms are hiring. Because we are all partic- ipants in the economy, we get some sense of economic conditions as we go about our lives. A century ago, economists monitoring the economy had little more to go on than these casual observations. Such fragmentary information made economic policymaking all the more difficult. One person’s anecdote would suggest the economy was moving in one direction, while a different person’s anecdote would suggest it was moving in another. Economists needed some way to com- bine many individual experiences into a coherent whole.There was an obvious solution: as the old quip goes, the plural of “anecdote” is “data.” Today, economic data offer a systematic and objective source of information, and almost every day the newspaper has a story about some newly released statis- tic. Most of these statistics are produced by the government.Various government agencies survey households and firms to learn about their economic activity— how much they are earning, what they are buying, what prices they are charging, whether they have a job or are looking for work, and so on. From these surveys, various statistics are computed that summarize the state of the economy. Econo- mists use these statistics to study the economy; policymakers use them to moni- tor developments and formulate policies. This chapter focuses on the three statistics that economists and policymakers use most often. Gross domestic product, or GDP, tells us the nation’s total income | 15 2 The Data of Macroeconomics CHAPTER It is a capital mistake to theorize before one has data. Insensibly one begins to twist facts to suit theories, instead of theories to fit facts. — Sherlock Holmes TWO User JOEWA:Job EFF01418:6264_ch02:Pg 16:24934#/eps at 100% *24934* Tue, Feb 12, 2002 8:40 AM and the total expenditure on its output of goods and services. The consumer price index, or CPI, measures the level of prices.The unemployment rate tells us the fraction of workers who are unemployed. In the following pages, we see how these statistics are computed and what they tell us about the economy. 2-1 Measuring the Value of Economic Activity: Gross Domestic Product Gross domestic product is often considered the best measure of how well the economy is performing.This statistic is computed every three months by the Bu- reau of Economic Analysis (a part of the U.S. Department of Commerce) from a large number of primary data sources.The goal of GDP is to summarize in a sin- gle number the dollar value of economic activity in a given period of time. There are two ways to view this statistic. One way to view GDP is as the total income of everyone in the economy.Another way to view GDP is as the total expendi- ture on the economy’s output of goods and services. From either viewpoint, it is clear why GDP is a gauge of economic performance. GDP measures something peo- ple care about—their incomes. Similarly, an economy with a large output of goods and services can better satisfy the demands of households, firms, and the government. How can GDP measure both the economy’s income and the expenditure on its output? The reason is that these two quantities are really the same: for the economy as a whole, income must equal expenditure.That fact, in turn, follows from an even more fundamental one: because every transaction has both a buyer and a seller, every dollar of expenditure by a buyer must become a dollar of in- come to a seller.When Joe paints Jane’s house for $1,000, that $1,000 is income to Joe and expenditure by Jane.The transaction contributes $1,000 to GDP, re- gardless of whether we are adding up all income or adding up all expenditure. To understand the meaning of GDP more fully, we turn to national income accounting, the accounting system used to measure GDP and many related statistics. Income, Expenditure, and the Circular Flow Imagine an economy that produces a single good, bread, from a single input, labor. Figure 2-1 illustrates all the economic transactions that occur between households and firms in this economy. The inner loop in Figure 2-1 represents the flows of bread and labor. The households sell their labor to the firms.The firms use the labor of their workers to produce bread, which the firms in turn sell to the households. Hence, labor flows from households to firms, and bread flows from firms to households. The outer loop in Figure 2-1 represents the corresponding flow of dollars. The households buy bread from the firms.The firms use some of the revenue 16 | PART I Introduction User JOEWA:Job EFF01418:6264_ch02:Pg 17:24935#/eps at 100% *24935* Tue, Feb 12, 2002 8:40 AM from these sales to pay the wages of their workers, and the remainder is the profit belonging to the owners of the firms (who themselves are part of the household sector). Hence, expenditure on bread flows from households to firms, and in- come in the form of wages and profit flows from firms to households. GDP measures the flow of dollars in this economy. We can compute it in two ways. GDP is the total income from the production of bread, which equals the sum of wages and profit—the top half of the circular flow of dollars. GDP is also the total expenditure on purchases of bread—the bottom half of the circular flow of dollars.To compute GDP, we can look at either the flow of dollars from firms to households or the flow of dollars from households to firms. These two ways of computing GDP must be equal because the expenditure of buyers on products is, by the rules of accounting, income to the sellers of those products. Every transaction that affects expenditure must affect income, and every transaction that affects income must affect expenditure. For example, suppose that a firm produces and sells one more loaf of bread to a household. Clearly this transaction raises total expenditure on bread, but it also has an equal effect on total income. If the firm produces the extra loaf without hiring any more labor (such as by making the production process more efficient), then profit increases. If the firm produces the extra loaf by hiring more labor, then wages increase. In both cases, expenditure and income increase equally. CHAPTER 2 The Data of Macroeconomics | 17 figure 2-1 Income ($) Labor Goods (bread ) Expenditure ($) Households Firms The Circular Flow This figure illustrates the flows between firms and households in an economy that produces one good, bread, from one input, labor. The inner loop represents the flows of labor and bread: households sell their labor to firms, and the firms sell the bread they produce to households. The outer loop represents the corresponding flows of dollars: households pay the firms for the bread, and the firms pay wages and profit to the households. In this economy, GDP is both the total expenditure on bread and the total income from the production of bread. User JOEWA:Job EFF01418:6264_ch02:Pg 18:24936#/eps at 100% *24936* Tue, Feb 12, 2002 8:40 AM Rules for Computing GDP In an economy that produces only bread, we can compute GDP by adding up the total expenditure on bread. Real economies, however, include the produc- tion and sale of a vast number of goods and services.To compute GDP for such a complex economy, it will be helpful to have a more precise definition: gross 18 | PART I Introduction FYI Many economic variables measure a quantity of something—a quantity of money, a quantity of goods, and so on. Economists distinguish be- tween two types of quantity variables: stocks and flows. A stock is a quantity measured at a given point in time, whereas a flow is a quantity mea- sured per unit of time. The bathtub, shown in Figure 2-2, is the clas- sic example used to illustrate stocks and flows. The amount of water in the tub is a stock: it is the quantity of water in the tub at a given point in time. The amount of water coming out of the faucet is a flow: it is the quantity of water being added to the tub per unit of time. Note that we measure stocks and flows in different units. We say that the bathtub contains 50 gallons of water, but that water is coming out of the faucet at 5 gallons per minute. GDP is probably the most important flow variable in economics: it tells us how many dol- lars are flowing around the economy’s circular flow per unit of time. When you hear someone say that the U.S. GDP is $10 trillion, you should Stocks and Flows understand that this means that it is $10 trillion per year. (Equivalently, we could say that U.S. GDP is $317,000 per second.) Stocks and flows are often related. In the bathtub example, these relationships are clear. The stock of water in the tub represents the accu- mulation of the flow out of the faucet, and the flow of water represents the change in the stock. When building theories to explain economic vari- ables, it is often useful to determine whether the variables are stocks or flows and whether any re- lationships link them. Here are some examples of related stocks and flows that we study in future chapters: ? A person’s wealth is a stock; income and ex- penditure are flows. ? The number of unemployed people is a stock; the number of people losing their jobs is a flow. ? The amount of capital in the economy is a stock; the amount of investment is a flow. ? The government debt is a stock; the govern- ment budget deficit is a flow. figure 2-2 Flow Stock Stocks and Flows The amount of water in a bathtub is a stock: it is a quantity measured at a given moment in time. The amount of water coming out of the faucet is a flow: it is a quantity measured per unit of time. User JOEWA:Job EFF01418:6264_ch02:Pg 19:24937#/eps at 100% *24937* Tue, Feb 12, 2002 8:40 AM domestic product (GDP) is the market value of all final goods and services produced within an economy in a given period of time. To see how this definition is applied, let’s dis- cuss some of the rules that economists follow in constructing this statistic. Adding Apples and Oranges The U.S. economy produces many different goods and services—hamburgers, haircuts, cars, computers, and so on. GDP combines the value of these goods and services into a single measure.The diver- sity of products in the economy complicates the calculation of GDP because different products have different values. Suppose, for example, that the economy produces four apples and three oranges. How do we compute GDP? We could simply add apples and oranges and conclude that GDP equals seven pieces of fruit. But this makes sense only if we thought ap- ples and oranges had equal value, which is generally not true. (This would be even clearer if the economy had produced four watermelons and three grapes.) To compute the total value of different goods and services, the national in- come accounts use market prices because these prices reflect how much people are willing to pay for a good or service.Thus, if apples cost $0.50 each and or- anges cost $1.00 each, GDP would be GDP equals $5.00—the value of all the apples, $2.00, plus the value of all the oranges, $3.00. Used Goods When the Topps Company makes a package of baseball cards and sells it for 50 cents, that 50 cents is added to the nation’s GDP. But what about when a collector sells a rare Mickey Mantle card to another collector for $500? That $500 is not part of GDP. GDP measures the value of currently produced goods and services.The sale of the Mickey Mantle card reflects the transfer of an asset, not an addition to the economy’s income.Thus, the sale of used goods is not included as part of GDP. The Treatment of Inventories Imagine that a bakery hires workers to produce more bread, pays their wages, and then fails to sell the additional bread. How does this transaction affect GDP? The answer depends on what happens to the unsold bread. Let’s first suppose that the bread spoils. In this case, the firm has paid more in wages but has not re- ceived any additional revenue, so the firm’s profit is reduced by the amount that wages are increased. Total expenditure in the economy hasn’t changed because no one buys the bread. Total income hasn’t changed either—although more is distributed as wages and less as profit. Because the transaction affects neither ex- penditure nor income, it does not alter GDP. Now suppose, instead, that the bread is put into inventory to be sold later. In this case, the transaction is treated differently. The owners of the firm are assumed to have “purchased’’ the bread for the firm’s inventory, and the firm’s profit is not GDP = (Price of Apples × Quantity of Apples) + (Price of Oranges × Quantity of Oranges) = ($0.50 × 4) + ($1.00 × 3) = $5.00. CHAPTER 2 The Data of Macroeconomics | 19 User JOEWA:Job EFF01418:6264_ch02:Pg 20:24938#/eps at 100% *24938* Tue, Feb 12, 2002 8:40 AM reduced by the additional wages it has paid. Because the higher wages raise total income, and greater spending on inventory raises total expenditure, the econ- omy’s GDP rises. What happens later when the firm sells the bread out of inventory? This case is much like the sale of a used good.There is spending by bread consumers, but there is inventory disinvestment by the firm.This negative spending by the firm offsets the positive spending by consumers, so the sale out of inventory does not affect GDP. The general rule is that when a firm increases its inventory of goods, this in- vestment in inventory is counted as expenditure by the firm owners.Thus, pro- duction for inventory increases GDP just as much as production for final sale.A sale out of inventory, however, is a combination of positive spending (the pur- chase) and negative spending (inventory disinvestment), so it does not influence GDP. This treatment of inventories ensures that GDP reflects the economy’s current production of goods and services. Intermediate Goods and Value Added Many goods are produced in stages: raw materials are processed into intermediate goods by one firm and then sold to another firm for final processing. How should we treat such products when computing GDP? For example, suppose a cattle rancher sells one-quarter pound of meat to McDonald’s for $0.50, and then McDonald’s sells you a hamburger for $1.50. Should GDP include both the meat and the hamburger (a total of $2.00), or just the hamburger ($1.50)? The answer is that GDP includes only the value of final goods.Thus, the ham- burger is included in GDP but the meat is not: GDP increases by $1.50, not by $2.00.The reason is that the value of intermediate goods is already included as part of the market price of the final goods in which they are used.To add the intermedi- ate goods to the final goods would be double counting—that is, the meat would be counted twice. Hence, GDP is the total value of final goods and services produced. One way to compute the value of all final goods and services is to sum the value added at each stage of production.The value added of a firm equals the value of the firm’s output less the value of the intermediate goods that the firm purchases. In the case of the hamburger, the value added of the rancher is $0.50 (assuming that the rancher bought no intermediate goods), and the value added of McDonald’s is $1.50 ? $0.50, or $1.00. Total value added is $0.50 + $1.00, which equals $1.50. For the economy as a whole, the sum of all value added must equal the value of all final goods and services. Hence, GDP is also the total value added of all firms in the economy. Housing Services and Other Imputations Although most goods and services are valued at their market prices when computing GDP, some are not sold in the marketplace and therefore do not have market prices. If GDP is to include the value of these goods and services, we must use an estimate of their value. Such an estimate is called an imputed value. Imputations are especially important for determining the value of housing. A person who rents a house is buying housing services and providing income for the landlord; the rent is part of GDP, both as expenditure by the renter and as income for the landlord. Many people, however, live in their own homes.Although they do not pay rent to a landlord, they are enjoying housing services similar to those that 20 | PART I Introduction User JOEWA:Job EFF01418:6264_ch02:Pg 21:24939#/eps at 100% *24939* Tue, Feb 12, 2002 8:40 AM renters purchase.To take account of the housing services enjoyed by homeowners, GDP includes the “rent’’ that these homeowners “pay’’ to themselves. Of course, homeowners do not in fact pay themselves this rent.The Department of Com- merce estimates what the market rent for a house would be if it were rented and includes that imputed rent as part of GDP. This imputed rent is included both in the homeowner’s expenditure and in the homeowner’s income. Imputations also arise in valuing government services. For example, police of- ficers, firefighters, and senators provide services to the public. Giving a value to these services is difficult because they are not sold in a marketplace and therefore do not have a market price.The national income accounts include these services in GDP by valuing them at their cost.That is, the wages of these public servants are used as a measure of the value of their output. In many cases, an imputation is called for in principle but, to keep things sim- ple, is not made in practice. Because GDP includes the imputed rent on owner- occupied houses, one might expect it also to include the imputed rent on cars, lawn mowers, jewelry, and other durable goods owned by households.Yet the value of these rental services is left out of GDP. In addition, some of the output of the economy is produced and consumed at home and never enters the mar- ketplace. For example, meals cooked at home are similar to meals cooked at a restaurant, yet the value added in meals at home is left out of GDP. Finally, no imputation is made for the value of goods and services sold in the underground economy.The underground economy is the part of the economy that people hide from the government either because they wish to evade taxation or because the activity is illegal. Domestic workers paid “off the books” is one ex- ample.The illegal drug trade is another. Because the imputations necessary for computing GDP are only approximate, and because the value of many goods and services is left out altogether, GDP is an imperfect measure of economic activity.These imperfections are most prob- lematic when comparing standards of living across countries.The size of the un- derground economy, for instance, varies from country to country.Yet as long as the magnitude of these imperfections remains fairly constant over time, GDP is useful for comparing economic activity from year to year. Real GDP Versus Nominal GDP Economists use the rules just described to compute GDP, which values the econ- omy’s total output of goods and services. But is GDP a good measure of eco- nomic well-being? Consider once again the economy that produces only apples and oranges. In this economy GDP is the sum of the value of all the apples pro- duced and the value of all the oranges produced.That is, Notice that GDP can increase either because prices rise or because quantities rise. It is easy to see that GDP computed this way is not a good gauge of eco- nomic well-being.That is, this measure does not accurately reflect how well the GDP = (Price of Apples × Quantity of Apples) + (Price of Oranges × Quantity of Oranges). CHAPTER 2 The Data of Macroeconomics | 21 User JOEWA:Job EFF01418:6264_ch02:Pg 22:24940#/eps at 100% *24940* Tue, Feb 12, 2002 8:40 AM economy can satisfy the demands of households, firms, and the government. If all prices doubled without any change in quantities, GDP would double.Yet it would be misleading to say that the economy’s ability to satisfy demands has doubled, because the quantity of every good produced remains the same. Econ- omists call the value of goods and services measured at current prices nominal GDP. A better measure of economic well-being would tally the economy’s output of goods and services and would not be influenced by changes in prices. For this purpose, economists use real GDP, which is the value of goods and services measured using a constant set of prices.That is, real GDP shows what would have happened to expenditure on output if quantities had changed but prices had not. To see how real GDP is computed, imagine we wanted to compare output in 2002 and output in 2003 in our apple-and-orange economy. We could begin by choosing a set of prices, called base-year prices, such as the prices that prevailed in 2002. Goods and services are then added up using these base-year prices to value the different goods in both years. Real GDP for 2002 would be Similarly, real GDP in 2003 would be And real GDP in 2004 would be Notice that 2002 prices are used to compute real GDP for all three years. Because the prices are held constant, real GDP varies from year to year only if the quanti- ties produced vary. Because a society’s ability to provide economic satisfaction for its members ultimately depends on the quantities of goods and services produced, real GDP provides a better measure of economic well-being than nominal GDP. The GDP Deflator From nominal GDP and real GDP we can compute a third statistic: the GDP de- flator. The GDP deflator, also called the implicit price deflator for GDP, is defined as the ratio of nominal GDP to real GDP: GDP Deflator = . The GDP deflator reflects what’s happening to the overall level of prices in the economy. To better understand this, consider again an economy with only one good, bread. If P is the price of bread and Q is the quantity sold, then nominal GDP is Nominal GDP Real GDP Real GDP = (2002 Price of Apples × 2004 Quantity of Apples) + (2002 Price of Oranges × 2004 Quantity of Oranges). Real GDP = (2002 Price of Apples × 2003 Quantity of Apples) + (2002 Price of Oranges × 2003 Quantity of Oranges). Real GDP = (2002 Price of Apples × 2002 Quantity of Apples) + (2002 Price of Oranges × 2002 Quantity of Oranges). 22 | PART I Introduction User JOEWA:Job EFF01418:6264_ch02:Pg 23:24941#/eps at 100% *24941* Tue, Feb 12, 2002 8:40 AM the total number of dollars spent on bread in that year, P × Q. Real GDP is the number of loaves of bread produced in that year times the price of bread in some base year, P base × Q. The GDP deflator is the price of bread in that year relative to the price of bread in the base year, P/P base . The definition of the GDP deflator allows us to separate nominal GDP into two parts: one part measures quantities (real GDP) and the other measures prices (the GDP deflator). That is, Nominal GDP = Real GDP × GDP Deflator. Nominal GDP measures the current dollar value of the output of the economy. Real GDP measures output valued at constant prices.The GDP deflator measures the price of output relative to its price in the base year. We can also write this equation as Real GDP = . In this form, you can see how the deflator earns its name: it is used to deflate (that is, take inflation out of ) nominal GDP to yield real GDP. Chain-Weighted Measures of Real GDP We have been discussing real GDP as if the prices used to compute this measure never change from their base-year values. If this were truly the case, over time the prices would become more and more dated. For instance, the price of com- puters has fallen substantially in recent years, while the price of a year at college has risen.When valuing the production of computers and education, it would be misleading to use the prices that prevailed ten or twenty years ago. To solve this problem, the Bureau of Economic Analysis used to update period- ically the prices used to compute real GDP. About every five years, a new base year was chosen. The prices were then held fixed and used to measure year-to-year changes in the production of goods and services until the base year was updated once again. In 1995, the bureau announced a new policy for dealing with changes in the base year. In particular, it now emphasizes chain-weighted measures of real GDP. With these new measures, the base year changes continuously over time. In essence, average prices in 2001 and 2002 are used to measure real growth from 2001 to 2002; average prices in 2002 and 2003 are used to measure real growth from 2002 to 2003; and so on.These various year-to-year growth rates are then put together to form a “chain” that can be used to compare the output of goods and services between any two dates. This new chain-weighted measure of real GDP is better than the more tradi- tional measure because it ensures that the prices used to compute real GDP are never far out of date. For most purposes, however, the differences are not impor- tant. It turns out that the two measures of real GDP are highly correlated with each other. The reason for this close association is that most relative prices change slowly over time. Thus, both measures of real GDP reflect the same thing: economy-wide changes in the production of goods and services. Nominal GDP GDP Deflator CHAPTER 2 The Data of Macroeconomics | 23 User JOEWA:Job EFF01418:6264_ch02:Pg 24:24942#/eps at 100% *24942* Tue, Feb 12, 2002 8:41 AM The Components of Expenditure Economists and policymakers care not only about the economy’s total output of goods and services but also about the allocation of this output among alternative uses. The national income accounts divide GDP into four broad categories of spending: ? Consumption (C) ? Investment (I ) ? Government purchases (G) ? Net exports (NX). Thus, letting Y stand for GDP, Y = C + I + G + NX. 24 | PART I Introduction FYI For manipulating many relationships in econom- ics, there is an arithmetic trick that is useful to know: the percentage change of a product of two vari- ables is approximately the sum of the percentage changes in each of the variables. To see how this trick works, consider an exam- ple. Let P denote the GDP deflator and Y denote real GDP. Nominal GDP is P × Y. The trick states that Percentage Change in (P × Y) ≈ (Percentage Change in P) + (Percentage Change in Y). For instance, suppose that in one year, real GDP is 100 and the GDP deflator is 2; the next year, real GDP is 103 and the GDP deflator is 2.1. We can calculate that real GDP rose by 3 percent and that the GDP deflator rose by 5 percent. Nominal GDP rose from 200 the first year to 216.3 the second year, an increase of 8.15 per- cent. Notice that the growth in nominal GDP Two Arithmetic Tricks for Working With Percentage Changes (8.15 percent) is approximately the sum of the growth in the GDP deflator (5 percent) and the growth in real GDP (3 percent). 1 A second arithmetic trick follows as a corol- lary to the first: the percentage change of a ratio is ap- proximately the percentage change in the numerator minus the percentage change in the denominator. Again, consider an example. Let Y denote GDP and L denote the population, so that Y/L is GDP per person. The second trick states Percentage Change in (Y/L) ≈ (Percentage Change in Y) ? (Percentage Change in L). For instance, suppose that in the first year, Y is 100,000 and L is 100, so Y/L is 1,000; in the sec- ond year, Y is 110,000 and L is 103, so Y/L is 1,068. Notice that the growth in GDP per person (6.8 percent) is approximately the growth in in- come (10 percent) minus the growth in popula- tion (3 percent). 1 Mathematical note: The proof that this trick works begins with the chain rule from calculus: d(PY ) = YdP+ PdY. Now divide both sides of this equation by PY to obtain d(PY )/(PY ) = dP/P + dY/Y. Notice that all three terms in this equation are percentage changes. User JOEWA:Job EFF01418:6264_ch02:Pg 25:24943#/eps at 100% *24943* Tue, Feb 12, 2002 8:41 AM GDP is the sum of consumption, investment, government purchases, and net ex- ports. Each dollar of GDP falls into one of these categories.This equation is an identity—an equation that must hold because of the way the variables are de- fined. It is called the national income accounts identity. Consumption consists of the goods and services bought by households. It is divided into three subcategories: nondurable goods, durable goods, and services. Nondurable goods are goods that last only a short time, such as food and cloth- ing. Durable goods are goods that last a long time, such as cars and TVs. Services include the work done for consumers by individuals and firms, such as haircuts and doctor visits. Investment consists of goods bought for future use. Investment is also di- vided into three subcategories: business fixed investment, residential fixed invest- ment, and inventory investment. Business fixed investment is the purchase of new plant and equipment by firms. Residential investment is the purchase of new housing by households and landlords. Inventory investment is the increase in firms’ inventories of goods (if inventories are falling, inventory investment is negative). Government purchases are the goods and services bought by federal, state, and local governments.This category includes such items as military equipment, highways, and the services that government workers provide. It does not include CHAPTER 2 The Data of Macroeconomics | 25 FYI Newcomers to macroeconomics are sometimes confused by how macroeconomists use familiar words in new and specific ways. One example is the term “investment.” The confusion arises be- cause what looks like investment for an individ- ual may not be investment for the economy as a whole. The general rule is that the economy’s in- vestment does not include purchases that merely reallocate existing assets among different individ- uals. Investment, as macroeconomists use the term, creates new capital. Let’s consider some examples. Suppose we observe these two events: ? Smith buys for himself a 100-year-old Victo- rian house. ? Jones builds for herself a brand-new contem- porary house. What is total investment here? Two houses, one house, or zero? A macroeconomist seeing these two transac- tions counts only the Jones house as investment. What Is Investment? Smith’s transaction has not created new housing for the economy; it has merely reallocated exist- ing housing. Smith’s purchase is investment for Smith, but it is disinvestment for the person sell- ing the house. By contrast, Jones has added new housing to the economy; her new house is counted as investment. Similarly, consider these two events: ? Gates buys $5 million in IBM stock from Buf- fett on the New York Stock Exchange. ? General Motors sells $10 million in stock to the public and uses the proceeds to build a new car factory. Here, investment is $10 million. In the first trans- action, Gates is investing in IBM stock, and Buf- fett is disinvesting; there is no investment for the economy. By contrast, General Motors is using some of the economy’s output of goods and ser- vices to add to its stock of capital; hence, its new factory is counted as investment. User JOEWA:Job EFF01418:6264_ch02:Pg 26:24944#/eps at 100% *24944* Tue, Feb 12, 2002 8:41 AM transfer payments to individuals, such as Social Security and welfare. Because transfer payments reallocate existing income and are not made in exchange for goods and services, they are not part of GDP. The last category, net exports, takes into account trade with other countries. Net exports are the value of goods and services exported to other countries minus the value of goods and services that foreigners provide us. Net exports represent the net expenditure from abroad on our goods and services, which provides income for domestic producers. 26 | PART I Introduction CASE STUDY GDP and Its Components In 2000 the GDP of the United States totaled about $10 trillion.This number is so large that it is almost impossible to comprehend.We can make it easier to un- derstand by dividing it by the 2000 U.S. population of 275 million. In this way, we obtain GDP per person—the amount of expenditure for the average American— which equaled $36,174 in 2000. Total Per Person (billions of dollars) (dollars) Gross Domestic Product 9,963.1 36,174 Consumption 6,757.3 24,534 Nondurable goods 2,010.0 7,298 Durable goods 820.3 2,978 Services 3,927.0 14,258 Investment 1,832.7 6,654 Nonresidential fixed investment 1,362.2 4,946 Residential fixed investment 416.0 1,510 Inventory investment 54.5 198 Government Purchases 1,743.7 6,331 Federal 595.2 2,161 Defense 377.0 1,369 Nondefense 218.2 792 State and local 1,148.6 4,170 Net Exports ?370.7 ?1,346 Exports 1,097.3 3,984 Imports 1,468.0 5,330 Source: U.S. Department of Commerce. GDP and the Components of Expenditure: 2000 table 2-1 User JOEWA:Job EFF01418:6264_ch02:Pg 27:24945#/eps at 100% *24945* Tue, Feb 12, 2002 8:41 AM Other Measures of Income The national income accounts include other measures of income that differ slightly in definition from GDP. It is important to be aware of the various mea- sures, because economists and the press often refer to them. To see how the alternative measures of income relate to one another, we start with GDP and add or subtract various quantities.To obtain gross national product (GNP), we add receipts of factor income (wages, profit, and rent) from the rest of the world and subtract payments of factor income to the rest of the world: GNP = GDP + Factor Payments From Abroad ? Factor Payments to Abroad. Whereas GDP measures the total income produced domestically, GNP measures the total income earned by nationals (residents of a nation). For instance, if a Japanese resident owns an apartment building in New York, the rental income he earns is part of U.S. GDP because it is earned in the United States. But because this rental income is a factor payment to abroad, it is not part of U.S. GNP. In the United States, factor payments from abroad and factor payments to abroad are similar in size—each representing about 3 percent of GDP—so GDP and GNP are quite close. To obtain net national product (NNP), we subtract the depreciation of capital— the amount of the economy’s stock of plants, equipment, and residential struc- tures that wears out during the year: NNP = GNP ? Depreciation. In the national income accounts, depreciation is called the consumption of fixed capital. It equals about 10 percent of GNP. Because the depreciation of capital is a cost of producing the output of the economy, subtracting depreciation shows the net result of economic activity. The next adjustment in the national income accounts is for indirect business taxes, such as sales taxes.These taxes, which make up about 10 percent of NNP, place a wedge between the price that consumers pay for a good and the price CHAPTER 2 The Data of Macroeconomics | 27 How did this GDP get used? Table 2-1 shows that about two-thirds of it, or $24,534 per person, was spent on consumption. Investment was $6,654 per per- son. Government purchases were $6,331 per person, $1,369 of which was spent by the federal government on national defense. The average American bought $5,330 of goods imported from abroad and produced $3,984 of goods that were exported to other countries. Because the average American imported more than he exported, net exports were negative. Furthermore, because the average American earned less from selling to foreigners than he spent on foreign goods, the difference must have been financed by taking out loans from foreigners (or, equivalently, by selling them some assets).Thus, the average American borrowed $1,346 from abroad in 2000. User JOEWA:Job EFF01418:6264_ch02:Pg 28:24946#/eps at 100% *24946* Tue, Feb 12, 2002 8:41 AM that firms receive. Because firms never receive this tax wedge, it is not part of their income. Once we subtract indirect business taxes from NNP, we obtain a measure called national income: National Income = NNP ? Indirect Business Taxes. National income measures how much everyone in the economy has earned. The national income accounts divide national income into five components, depending on the way the income is earned.The five categories, and the per- centage of national income paid in each category, are ? Compensation of employees (70%).The wages and fringe benefits earned by workers. ? Proprietors’ income (9%).The income of noncorporate businesses, such as small farms, mom-and-pop stores, and law partnerships. ? Rental income (2%).The income that landlords receive, including the im- puted rent that homeowners “pay’’ to themselves, less expenses, such as de- preciation. ? Corporate profits (12%).The income of corporations after payments to their workers and creditors. ? Net interest (7%).The interest domestic businesses pay minus the interest they receive, plus interest earned from foreigners. A series of adjustments takes us from national income to personal income, the amount of income that households and noncorporate businesses receive.Three of these adjustments are most important. First, we reduce national income by the amount that corporations earn but do not pay out, either because the corporations are retaining earnings or because they are paying taxes to the government.This ad- justment is made by subtracting corporate profits (which equals the sum of corpo- rate taxes, dividends, and retained earnings) and adding back dividends. Second, we increase national income by the net amount the government pays out in transfer payments.This adjustment equals government transfers to individuals minus social insurance contributions paid to the government.Third, we adjust national income to include the interest that households earn rather than the interest that businesses pay.This adjustment is made by adding personal interest income and subtracting net interest. (The difference between personal interest and net interest arises in part from the interest on the government debt.) Thus, personal income is Personal Income = National Income ? Corporate Profits ? Social Insurance Contributions ? Net Interest + Dividends + Government Transfers to Individuals + Personal Interest Income. 28 | PART I Introduction User JOEWA:Job EFF01418:6264_ch02:Pg 29:24947#/eps at 100% *24947* Tue, Feb 12, 2002 8:41 AM Next, if we subtract personal tax payments and certain nontax payments to the government (such as parking tickets), we obtain disposable personal income: Disposable Personal Income = Personal Income ? Personal Tax and Nontax Payments. We are interested in disposable personal income because it is the amount house- holds and noncorporate businesses have available to spend after satisfying their tax obligations to the government. CHAPTER 2 The Data of Macroeconomics | 29 CASE STUDY The Seasonal Cycle and Seasonal Adjustment Because real GDP and the other measures of income reflect how well the econ- omy is performing, economists are interested in studying the quarter-to-quarter fluctuations in these variables.Yet when we start to do so, one fact leaps out: all these measures of income exhibit a regular seasonal pattern.The output of the economy rises during the year, reaching a peak in the fourth quarter (October, November, and December), and then falling in the first quarter ( January, Febru- ary, and March) of the next year.These regular seasonal changes are substantial. From the fourth quarter to the first quarter, real GDP falls on average about 8 percent. 2 It is not surprising that real GDP follows a seasonal cycle. Some of these changes are attributable to changes in our ability to produce: for example, build- ing homes is more difficult during the cold weather of winter than during other seasons. In addition, people have seasonal tastes: they have preferred times for such activities as vacations and holiday shopping. When economists study fluctuations in real GDP and other economic vari- ables, they often want to eliminate the portion of fluctuations caused by pre- dictable seasonal changes.You will find that most of the economic statistics reported in the newspaper are seasonally adjusted.This means that the data have been adjusted to remove the regular seasonal fluctuations. (The precise statis- tical procedures used are too elaborate to bother with here, but in essence they involve subtracting those changes in income that are predictable simply from the change in season.) Therefore, when you observe a rise or fall in real GDP or any other data series, you must look beyond the seasonal cycle for the explanation. 2 Robert B. Barsky and Jeffrey A. Miron,“The Seasonal Cycle and the Business Cycle,’’ Journal of Political Economy 97 ( June 1989): 503-534. User JOEWA:Job EFF01418:6264_ch02:Pg 30:24948#/eps at 100% *24948* Tue, Feb 12, 2002 8:41 AM 2-2 Measuring the Cost of Living: The Consumer Price Index A dollar today doesn’t buy as much as it did 20 years ago. The cost of almost everything has gone up.This increase in the overall level of prices is called infla- tion, and it is one of the primary concerns of economists and policymakers. In later chapters we examine in detail the causes and effects of inflation. Here we discuss how economists measure changes in the cost of living. The Price of a Basket of Goods The most commonly used measure of the level of prices is the consumer price index (CPI).The Bureau of Labor Statistics, which is part of the U.S. Department of Labor, has the job of computing the CPI. It begins by collecting the prices of thousands of goods and services. Just as GDP turns the quantities of many goods and services into a single number measuring the value of production, the CPI turns the prices of many goods and services into a single index measuring the overall level of prices. How should economists aggregate the many prices in the economy into a single index that reliably measures the price level? They could simply com- pute an average of all prices.Yet this approach would treat all goods and ser- vices equally. Because people buy more chicken than caviar, the price of chicken should have a greater weight in the CPI than the price of caviar. The Bureau of Labor Statistics weights different items by computing the price of a basket of goods and services purchased by a typical consumer.The CPI is the price of this basket of goods and services relative to the price of the same bas- ket in some base year. For example, suppose that the typical consumer buys 5 apples and 2 oranges every month.Then the basket of goods consists of 5 apples and 2 oranges, and the CPI is CPI = . In this CPI, 2002 is the base year.The index tells us how much it costs now to buy 5 apples and 2 oranges relative to how much it cost to buy the same basket of fruit in 2002. The consumer price index is the most closely watched index of prices, but it is not the only such index.Another is the producer price index, which mea- sures the price of a typical basket of goods bought by firms rather than con- sumers. In addition to these overall price indices, the Bureau of Labor Statistics computes price indices for specific types of goods, such as food, housing, and energy. (5 × Current Price of Apples) + (2 × Current Price of Oranges) (5 × 2002 Price of Apples) + (2 × 2002 Price of Oranges) 30 | PART I Introduction User JOEWA:Job EFF01418:6264_ch02:Pg 31:24949#/eps at 100% *24949* Tue, Feb 12, 2002 8:41 AM The CPI Versus the GDP Deflator Earlier in this chapter we saw another measure of prices—the implicit price de- flator for GDP, which is the ratio of nominal GDP to real GDP. The GDP defla- tor and the CPI give somewhat different information about what’s happening to the overall level of prices in the economy. There are three key differences be- tween the two measures. The first difference is that the GDP deflator measures the prices of all goods and services produced, whereas the CPI measures the prices of only the goods and services bought by consumers. Thus, an increase in the price of goods bought by firms or the government will show up in the GDP deflator but not in the CPI. The second difference is that the GDP deflator includes only those goods produced domestically. Imported goods are not part of GDP and do not show up in the GDP deflator. Hence, an increase in the price of a Toyota made in Japan and sold in this country affects the CPI, because the Toyota is bought by con- sumers, but it does not affect the GDP deflator. The third and most subtle difference results from the way the two measures aggregate the many prices in the economy.The CPI assigns fixed weights to the prices of different goods, whereas the GDP deflator assigns changing weights. In other words, the CPI is computed using a fixed basket of goods, whereas the GDP deflator allows the basket of goods to change over time as the composition of GDP changes. The following example shows how these approaches differ. Suppose that major frosts destroy the nation’s orange crop. The quantity of oranges produced falls to zero, and the price of the few or- anges that remain on grocers’ shelves is driven sky-high. Because oranges are no longer part of GDP, the increase in the price of oranges does not show up in the GDP deflator. But because the CPI is computed with a fixed basket of goods that includes oranges, the increase in the price of oranges causes a sub- stantial rise in the CPI. Economists call a price index with a fixed basket of goods a Laspeyres index and a price index with a changing basket a Paasche index. Economic theorists have studied the properties of these different types of price indices to determine which is a better measure of the cost of living.The answer, it turns out, is that neither is clearly superior.When prices of different goods are changing by differ- ent amounts, a Laspeyres (fixed basket) index tends to overstate the increase in the cost of living because it does not take into account that consumers have the opportunity to substitute less expensive goods for more expensive ones. By con- trast, a Paasche (changing basket) index tends to understate the increase in the cost of living. Although it accounts for the substitution of alternative goods, it does not reflect the reduction in consumers’ welfare that may result from such substitutions. The example of the destroyed orange crop shows the problems with Laspeyres and Paasche price indices. Because the CPI is a Laspeyres index, it overstates the impact of the increase in orange prices on consumers: by using a fixed basket of goods, it ignores consumers’ ability to substitute apples for oranges. By contrast, CHAPTER 2 The Data of Macroeconomics | 31 User JOEWA:Job EFF01418:6264_ch02:Pg 32:24950#/eps at 100% *24950* Tue, Feb 12, 2002 8:41 AM because the GDP deflator is a Paasche index, it understates the impact on con- sumers: the GDP deflator shows no rise in prices, yet surely the higher price of oranges makes consumers worse off. Luckily, the difference between the GDP deflator and the CPI is usually not large in practice. Figure 2-3 shows the percentage change in the GDP deflator and the percentage change in the CPI for each year since 1948. Both measures usually tell the same story about how quickly prices are rising. 32 | PART I Introduction figure 2-3 16 14 12 10 8 6 4 2 0 ?2 GDP deflator Percentage change 1948 1953 1958 1963 1968 1973 Year 1978 1983 1988 1993 1998 2003 CPI The GDP Deflator and the CPI This figure shows the percentage change in the GDP deflator and in the CPI for every year since 1948. Although these two measures of prices diverge at times, they usually tell the same story about how quickly prices are rising. Both the CPI and the GDP deflator show that prices rose slowly in most of the 1950s and 1960s, that they rose much more quickly in the 1970s, and that they rose slowly again in the 1980s and 1990s. Source: U.S. Department of Commerce, U.S. Department of Labor. CASE STUDY Does the CPI Overstate Inflation? The consumer price index is a closely watched measure of inflation. Policymak- ers in the Federal Reserve monitor the CPI when choosing monetary policy. In addition, many laws and private contracts have cost-of-living allowances, called COLAs, which use the CPI to adjust for changes in the price level. For instance, User JOEWA:Job EFF01418:6264_ch02:Pg 33:24951#/eps at 100% *24951* Tue, Feb 12, 2002 8:41 AM CHAPTER 2 The Data of Macroeconomics | 33 Social Security benefits are adjusted automatically every year so that inflation will not erode the living standard of the elderly. Because so much depends on the CPI, it is important to ensure that this mea- sure of the price level is accurate. Many economists believe that, for a number of reasons, the CPI tends to overstate inflation. One problem is the substitution bias we have already discussed. Because the CPI measures the price of a fixed basket of goods, it does not reflect the abil- ity of consumers to substitute toward goods whose relative prices have fallen. Thus, when relative prices change, the true cost of living rises less rapidly than the CPI. A second problem is the introduction of new goods.When a new good is in- troduced into the marketplace, consumers are better off, because they have more products from which to choose. In effect, the introduction of new goods in- creases the real value of the dollar.Yet this increase in the purchasing power of the dollar is not reflected in a lower CPI. A third problem is unmeasured changes in quality.When a firm changes the quality of a good it sells, not all of the good’s price change reflects a change in the cost of living.The Bureau of Economic Analysis does its best to account for changes in the quality of goods over time. For example, if Ford increases the horsepower of a particular car model from one year to the next, the CPI will reflect the change: the quality-adjusted price of the car will not rise as fast as the unadjusted price.Yet many changes in quality, such as comfort or safety, are hard to measure. If unmeasured quality improvement (rather than unmeasured quality deterioration) is typical, then the measured CPI rises faster than it should. Because of these measurement problems, some economists have suggested re- vising laws to reduce the degree of indexation. For example, Social Security benefits could be indexed to CPI inflation minus 1 percent. Such a change would provide a rough way of offsetting these measurement problems. At the same time, it would automatically slow the growth in government spending. In 1995, the Senate Finance Committee appointed a panel of five noted economists—Michael Boskin, Ellen Dulberger, Robert Gordon, Zvi Griliches, and Dale Jorgenson—to study the magnitude of the measurement error in the CPI.The panel concluded that the CPI was biased upward by 0.8 to 1.6 percent- age points per year, with their “best estimate” being 1.1 percentage points.This report led to some changes in the way the CPI is calculated, so the bias is now thought to be slightly under 1 percentage point.The CPI still overstates inflation, but not by as much as it once did. 3 3 For further discussion of these issues, see Matthew Shapiro and David Wilcox,“Mismeasure- ment in the Consumer Price Index: An Evaluation,” NBER Macroeconomics Annual, 1996, and the symposium on “Measuring the CPI” in the Winter 1998 issue of The Journal of Economic Perspectives. User JOEWA:Job EFF01418:6264_ch02:Pg 34:24952#/eps at 100% *24952* Tue, Feb 12, 2002 8:41 AM 2-3 Measuring Joblessness: The Unemployment Rate One aspect of economic performance is how well an economy uses its resources. Because an economy’s workers are its chief resource, keeping workers employed is a paramount concern of economic policymakers.The unemployment rate is the statistic that measures the percentage of those people wanting to work who do not have jobs. Every month the U.S. Bureau of Labor Statis- tics computes the unemployment rate and many other statistics that economists and policymakers use to monitor developments in the labor market. These statistics come from a survey of about 60,000 households. Based on the responses to sur- vey questions, each adult (16 years and older) in each household is placed into one of three cate- gories: employed, unemployed, or not in the labor force. A person is employed if he or she spent some of the previous week working at a paid job. A person is unemployed if he or she is not em- ployed and has been looking for a job or is on temporary layoff. A person who fits into neither of the first two categories, such as a full-time student or retiree, is not in the labor force. A person who wants a job but has given up looking—a discouraged worker—is counted as not being in the labor force. The labor force is defined as the sum of the employed and unemployed, and the unemployment rate is defined as the percentage of the labor force that is un- employed.That is, Labor Force = Number of Employed + Number of Unemployed, and Unemployment Rate =×100. A related statistic is the labor-force participation rate, the percentage of the adult population that is in the labor force: Labor-Force Participation Rate =×100. The Bureau of Labor Statistics computes these statistics for the overall popula- tion and for groups within the population: men and women, whites and blacks, teenagers and prime-age workers. Labor Force Adult Population Number of Unemployed Labor Force 34 | PART I Introduction “Well, so long Eddie, the recession’s over.’’ Dr awing M. St evens; ? 1980 The New Y o r k er Magazine, Inc. User JOEWA:Job EFF01418:6264_ch02:Pg 35:24953#/eps at 100% *24953* Tue, Feb 12, 2002 8:41 AM Figure 2-4 shows the breakdown of the population into the three categories for 2000.The statistics broke down as follows: Labor Force = 135.2 + 5.7 = 140.9 million. Unemployment Rate = (5.7/140.9) × 100 = 4.0%. Labor-Force Participation Rate = (140.9/209.7) × 100 = 67.2%. Hence, about two-thirds of the adult population was in the labor force, and about 4 percent of those in the labor force did not have a job. CHAPTER 2 The Data of Macroeconomics | 35 figure 2-4 Not in labor force: 68.8 million Employed: 135.2 million Unemployed: 5.7 million Labor force Population: 209.7 million (16 years and older) The Three Groups of the Population When the Bureau of Labor Statistics surveys the population, it places all adults into one of three categories: employed, unemployed, or not in the labor force. This figure shows the num- ber of people in each category in 2000. Source: U.S. Department of Labor. CASE STUDY Unemployment, GDP, and Okun’s Law What relationship should we expect to find between unemployment and real GDP? Because employed workers help to produce goods and services and unem- ployed workers do not, increases in the unemployment rate should be associ- ated with decreases in real GDP.This negative relationship between unemploy- ment and GDP is called Okun’s law, after Arthur Okun, the economist who first studied it. 4 4 Arthur M. Okun,“Potential GNP: Its Measurement and Significance,’’ in Proceedings of the Business and Economics Statistics Section,American Statistical Association (Washington, DC:American Statistical Association, 1962), 98-103; reprinted in Arthur M. Okun, Economics for Policymaking (Cambridge, MA: MIT Press, 1983), 145-158. User JOEWA:Job EFF01418:6264_ch02:Pg 36:24954#/eps at 100% *24954* Tue, Feb 12, 2002 8:41 AM 36 | PART I Introduction Figure 2-5 uses annual data for the United States to illustrate Okun’s law. This figure is a scatterplot—a scatter of points where each point represents one obser- vation (in this case, the data for a particular year). The horizontal axis represents the change in the unemployment rate from the previous year, and the vertical axis represents the percentage change in GDP. This figure shows clearly that year-to-year changes in the unemployment rate are closely associated with year-to-year changes in real GDP. We can be more precise about the magnitude of the Okun’s law relationship. The line drawn through the scatter of points (estimated with a statistical proce- dure called ordinary least squares) tells us that Percentage Change in Real GDP = 3% ? 2 × Change in the Unemployment Rate. If the unemployment rate remains the same, real GDP grows by about 3 percent; this normal growth in the production of goods and services is a result of growth in the labor force, capital accumulation, and technological progress. In addition, for every percentage point the unemployment rate rises, real GDP growth typi- figure 2-5 1951 1984 1999 2000 1993 1982 1975 ?3 ?2 ?10 Change in unemployment rate Percentage change in real GDP 12 43 10 8 6 4 2 0 ?2 Okun’s Law This figure is a scatterplot of the change in the unemployment rate on the horizontal axis and the percentage change in real GDP on the vertical axis, using data on the U.S economy. Each point represents one year. The negative correlation between these variables shows that increases in unemployment tend to be associated with lower-than-normal growth in real GDP. Source: U.S. Department of Commerce, U.S. Department of Labor. User JOEWA:Job EFF01418:6264_ch02:Pg 37:24955#/eps at 100% *24955* Tue, Feb 12, 2002 8:41 AM 2-4 Conclusion: From Economic Statistics to Economic Models The three statistics discussed in this chapter—gross domestic product, the con- sumer price index, and the unemployment rate—quantify the performance of the economy. Public and private decisionmakers use these statistics to monitor changes in the economy and to formulate appropriate policies. Economists use these statistics to develop and test theories about how the economy works. In the chapters that follow, we examine some of these theories. That is, we build models that explain how these variables are determined and how eco- nomic policy affects them. Having learned how to measure economic perfor- mance, we are now ready to learn how to explain it. Summary 1. Gross domestic product (GDP) measures both the income of everyone in the economy and the total expenditure on the economy’s output of goods and services. 2. Nominal GDP values goods and services at current prices. Real GDP values goods and services at constant prices. Real GDP rises only when the amount of goods and services has increased, whereas nominal GDP can rise either because output has increased or because prices have increased. 3. GDP is the sum of four categories of expenditure: consumption, investment, government purchases, and net exports. 4. The consumer price index (CPI) measures the price of a fixed basket of goods and services purchased by a typical consumer. Like the GDP deflator, which is the ratio of nominal GDP to real GDP, the CPI measures the over- all level of prices. 5. The unemployment rate shows what fraction of those who would like to work do not have a job.When the unemployment rate rises, real GDP typi- cally grows slower than its normal rate and may even fall. CHAPTER 2 The Data of Macroeconomics | 37 cally falls by 2 percent. Hence, if the unemployment rate rises from 6 to 8 per- cent, then real GDP growth would be Percentage Change in Real GDP = 3% ? 2 × (8% ? 6%) =?1%. In this case, Okun’s law says that GDP would fall by 1 percent, indicating that the economy is in a recession. User JOEWA:Job EFF01418:6264_ch02:Pg 38:24956#/eps at 100% *24956* Tue, Feb 12, 2002 8:41 AM 38 | PART I Introduction KEY CONCEPTS Gross domestic product (GDP) Consumer price index (CPI) Unemployment rate National income accounting Stocks and flows Value added Imputed value Nominal versus real GDP GDP deflator National income accounts identity Consumption Investment Government purchases Net exports Labor force Labor-force participation rate Okun’s law 1. List the two things that GDP measures. How can GDP measure two things at once? 2. What does the consumer price index measure? 3. List the three categories used by the Bureau of QUESTIONS FOR REVIEW Labor Statistics to classify everyone in the econ- omy. How does the bureau compute the unem- ployment rate? 4. Explain Okun’s law. PROBLEMS AND APPLICATIONS 1. Look at the newspapers for the past few days. What new economic statistics have been released? How do you interpret these statistics? 2. A farmer grows a bushel of wheat and sells it to a miller for $1.00.The miller turns the wheat into flour and then sells the flour to a baker for $3.00. The baker uses the flour to make bread and sells the bread to an engineer for $6.00.The engineer eats the bread. What is the value added by each person? What is GDP? 3. Suppose a woman marries her butler. After they are married, her husband continues to wait on her as before, and she continues to support him as before (but as a husband rather than as an em- ployee). How does the marriage affect GDP? How should it affect GDP? 4. Place each of the following transactions in one of the four components of expenditure: consump- tion, investment, government purchases, and net exports. a. Boeing sells an airplane to the Air Force. b. Boeing sells an airplane to American Airlines. c. Boeing sells an airplane to Air France. d. Boeing sells an airplane to Amelia Earhart. e. Boeing builds an airplane to be sold next year. 5. Find data on GDP and its components, and com- pute the percentage of GDP for the following components for 1950, 1975, and 2000. a. Personal consumption expenditures b. Gross private domestic investment c. Government purchases d. Net exports e. National defense purchases f. State and local purchases g. Imports Do you see any stable relationships in the data? Do you see any trends? (Hint: A good place to look for data is the statistical appendices of the Economic Report of the President, which is written each year by the Council of Economic Advisers. Alterna- tively, you can go to www.bea.doc.gov, which is the Web site of the Bureau of Economic Analysis.) 6. Consider an economy that produces and con- sumes bread and automobiles. In the following table are data for two different years. User JOEWA:Job EFF01418:6264_ch02:Pg 39:24957#/eps at 100% *24957* Tue, Feb 12, 2002 8:41 AM CHAPTER 2 The Data of Macroeconomics | 39 Year Year 2000 2010 Price of an automobile $50,000 $60,000 Price of a loaf of bread $10 $20 Number of auto- mobiles produced 100 120 Number of loaves of bread produced 500,000 400,000 a. Using the year 2000 as the base year, compute the following statistics for each year: nominal GDP, real GDP, the implicit price deflator for GDP, and a fixed-weight price index such as the CPI. b. How much have prices risen between year 2000 and year 2010? Compare the answers given by the Laspeyres and Paasche price in- dices. Explain the difference. c. Suppose you are a senator writing a bill to index Social Security and federal pensions. That is, your bill will adjust these benefits to offset changes in the cost of living. Will you use the GDP deflator or the CPI? Why? 7. Abby consumes only apples. In year 1, red apples cost $1 each, green apples cost $2 each, and Abby buys 10 red apples. In year 2, red apples cost $2, green apples cost $1, and Abby buys 10 green apples. a. Compute a consumer price index for apples for each year.Assume that year 1 is the base year in which the consumer basket is fixed. How does your index change from year 1 to year 2? b. Compute Abby’s nominal spending on apples in each year. How does it change from year 1 to year 2? c. Using year 1 as the base year, compute Abby’s real spending on apples in each year. How does it change from year 1 to year 2? d. Defining the implicit price deflator as nominal spending divided by real spending, compute the deflator for each year. How does the defla- tor change from year 1 to year 2? e. Suppose that Abby is equally happy eating red or green apples. How much has the true cost of living increased for Abby? Compare this an- swer to your answers to parts (a) and (d).What does this example tell you about Laspeyres and Paasche price indexes? 8. Consider how each of the following events is likely to affect real GDP. Do you think the change in real GDP reflects a similar change in economic well-being? a. A hurricane in Florida forces Disney World to shut down for a month. b. The discovery of a new, easy-to-grow strain of wheat increases farm harvests. c. Increased hostility between unions and man- agement sparks a rash of strikes. d. Firms throughout the economy experience falling demand, causing them to lay off workers. e. Congress passes new environmental laws that prohibit firms from using production methods that emit large quantities of pollution. f. More high-school students drop out of school to take jobs mowing lawns. g. Fathers around the country reduce their work- weeks to spend more time with their children. 9. In a speech that Senator Robert Kennedy gave when he was running for president in 1968, he said the following about GDP: [It] does not allow for the health of our children, the quality of their education, or the joy of their play. It does not include the beauty of our poetry or the strength of our marriages, the intelligence of our public debate or the integrity of our public officials. It measures neither our courage, nor our wisdom, nor our devotion to our country. It mea- sures everything, in short, except that which makes life worthwhile, and it can tell us everything about America except why we are proud that we are Americans. Was Robert Kennedy right? If so, why do we care about GDP?