# 2. Measuring the Macroeconomy

### Contents

1. Measuring Total Output
2. How to Measure GDP
3. Measuring Price Changes (Inflation)

### 1. Measuring Total Output

1. Which of the following activities are not included in GDP (note - all activities occurred during the period in which GDP is being measured):

a. The \$20,000 profit I made by selling my home.
b. The purchase of a Boeing 767 jet by Southwest Airlines.
c. Government payment of unemployment insurance benefits to those who have lost their jobs.
d. Government payment of wages to maintenance workers who clean the White House.
e. The purchase of 100 shares of America-On-Line stock.
f. The cost of a room at the bed-and-breakfast I stayed at on the Isle of Mull in Scotland.
g. The price I paid for a used car I purchased directly from a friend.
h. My friend is a plumber and I gave him \$20 for fixing my leaking pipe after he got off work one day.
i. The 504 million barrels of crude oil produced in Texas in 1998 and sold to U.S. refineries.
j. The bushel of tomatoes I grew in my yard last summer.

Answer: A, C, E, G, H, I, J. The question relates to what is omitted and what is excluded from GDP accounting. First, we do not include transactions for which noting was produced or a service performed. Even though the payment of unemployment benefits (C) is a government expense it is not included as government expenditures in GDP. Similarly, the purchase of stocks and bonds (E) are also excluded.

Productive activities that are omitted are those that can't be measured directly because they are not reported to the government. If the government isn't told then it's hard to include in the GDP accounts. We do not count underground activities. If my plumber friend did not report the \$20 I gave him (H) to the IRS as income then that activity is not counted in GDP. We also do not include home production like housekeeping or growing your own vegetables (J).

Productive activities that are excluded are those that would result in double counting. The sale of the house (A) and used car (G) aren't included in GDP. The the sale of used equipment is not counted because it was included in GDP in some previous year. If some value was added or a paid service performed (e.g., the used car dealer's commission) during the current year then that would be included in current year GDP. We do not include intermediate products like crude oil (I). Intermediate goods and services are excluded since their value would be counted more than once in the several stages of production. The value of the crude oil is counted when the gasoline, heating oil, and other products produced from the oil are sold to final consumers.

Included in GDP are the Boeing airplane (investment) and the White House maintenance (government spending). My vacation at the Scottish bed and breakfast should be counted as an import even though I was in another country. Remember that GDP is equivalent to national Income (with some corrections). Not counting my vacation would leave some of my income missing on the GDP side. And if my Scottish relatives visit the U.S. their expenses while here are included as GDP as an export.

2. The next series of questions approach GDP accounting in terms of changes in market practices.

a. American society has become more urbanized since 1930. Would you expect this to have a positive or negative influence on the size of GDP and national income?

Answer: GDP does not measure productive efforts that do not lead to market transactions such do-it-yourself activities. GDP is probably larger since there are more transactions occurring in the urban marketplace than in a rural setting. Commodities that you may produce for yourself in a rural setting are now traded in a market and measured. Similarly national income should be larger. This consideration is also relevant to cross-national comparisons of developed and less-developed countries. Less-developed countries likely have more home production and the difference between GDPs may be larger than the actual difference in total productive efforts.

b. What would happen to national income and GDP if government hired unemployed workers, who had been receiving unemployment benefits, as government employees and now paid them to do nothing?

Answer: Government transfer payments do not arise out of any production activity and thus are not counted in the value of GDP although they are included in national income. If the people currently receiving transfer payments were hired by the government, their wages would be counted as part of government purchases, G, which is counted in GDP (no judgement is made as to whether government employees are productive or not). Thus national income would be unchanged but GDP would rise.

c. You divorce your spouse because he is a neatness freak. But you like how clean he keeps the house so you hire him as your maid. What happens to GDP?

Answer: The services that a homemaker provides (no matter how valuable) are not counted in GDP. However, once a wage (and income tax) is paid to perform household duties, the service will be counted in GDP. GDP increases. During the last 20 years the number of women joining the labor force has increased dramatically and GDP has grown not only from the higher labor force participation rate but also the increase in home and child care services.

d. What effect do you think the fall of Communism has had on the GDP of Russia?

Answer: This is a tough question relating to underground economic activity, which is not counted in GDP. During the Communist regime production and prices were controlled by the government. Prices on many necessities were held at prices below what they would be in a free market. Price ceilings lead to shortages and shortages lead to black markets. Transactions in black markets are not included in GDP. After the fall of Communism some prices were decontrolled. Although price decontrol should lead to the elimination of the black markets and a likely increase in GDP another type of underground economy has probably risen. Privatization requires the collection of taxes and tax cheating is likely a serious problem in Russia since government institutions are still developing.

### 2. How to Measure GDP

1. This question has three parts relating to how different transactions are reported in the GDP expenditure accounts (consumption, investment, government spending, imports, and exports):

a. In January 2000 I purchased a new Maytag refrigerator from Best Buy for \$800. How will this transaction be reported in the GDP expenditure accounts?

Answer: GDP for the year 2000 should include an \$800 entry under Consumption expenditures.

b. Best Buy purchases a refrigerator (which was built in the U.S.) in December 1999 for \$600 from Maytag, and the refrigerator remained unsold as of December 31, 1999. How is this transaction reported in the GDP expenditure accounts?

Answer: GDP for the year 1999 should include a \$600 entry under Investment for inventory accumulation.

c. Now let's put the transactions in the previous two questions together. Best Buy purchases a refrigerator (which was built in the U.S.) in December 1999 for \$600 from Maytag, and the refrigerator remained unsold as of December 31, 1999. In January 2000 I purchased a new Maytag refrigerator from Best Buy for \$800. How are these transactions reported in GDP?

 Transaction 1999 GDP 2000 GDP Explanation Best Buy purchases a refrigerator in Dec. 1999 \$ 0 \$ 0 Intermediate goods not counted in GDP Best Buy has a refrigerator in inventory on 12/31/1999 \$ 600 (Investment) \$ 0 Inventory accumulation I purchase the refrigerator from Best Buy in Jan. 2000 - \$ 600 (Investment) Inventory decline \$ 800 (Consumption) Sale to final consumer Total GDP \$ 600 \$ 200 Production of the refrigerator included in 1999 GDP and retail services provided by Best Buy counted in 2000 GDP Note: On the income side, national income would include \$600 in 1999 and \$200 in 2000 since expenditures must equal income in the National Income and Product Accounts (NIPA). The income could appear as wages, dividends, or corporate retained earnings. If the refrigerator had been manufactured overseas the 1999 GDP expenditure entry would be \$600 investment and -\$600 net exports (i.e., an import), for total 1999 GDP of \$0 (the refrigerator was not produced in the U.S.). Also there would be no contribution to national income in 1999 since the proceeds of the sale went outside the U.S.

### 3. Measuring Price Changes (Inflation)

1. The following figures are the nominal GDP, real GDP (in billions of 1996 dollars), and GDP deflator for the United States for the years 1989 to 1994.

 Year Nominal GDP GDP Deflator Real GDP 1989 ? 83.6 6,569 1990 ? 86.8 6,683 1991 5,986 ? 6,669 1992 6,319 ? 6,891 1993 6,642 94.2 ? 1994 7,054 96.1 ?

a. Fill in the missing figures.

Answer: If you know two values you can always calculate the third (or you can look up the missing numbers on the Bureau of Economic Analysis web site, http://www.bea.gov):

GDP Deflator = (Nominal GDP / Real GDP) x 100
Nominal GDP = Real GDP x (GDP Deflator / 100)
Real GDP = Nominal GDP / (GDP Deflator / 100)

1989 Nominal GDP = 5,489
1990 Nominal GDP = 5,803
1991 GDP Deflator = 89.8
1992 GDP Deflator = 91.7
1993 Real GDP = 7,054
1994 Real GDP = 7,338

b. During what year(s) was the economy contracting?

Answer: The change in real GDP indicates whether the economy is growing or contracting. The economy grows if real GDP increases. The economy contracts if real GDP declines. The economy contracted in 1991, which was the last recession the U.S. has gone through. Actually the recession lasted from a peak in the business cycle in July 1990 until the trough (bottom point) in March 1991. Note that the base year for calculating real GDP is 1996 and the 1996 GDP deflator = 100.

For a summary of U.S. business cycles expansions and contractions refer to the National Bureau of Economic Research (http://www.nber.org) or The Conference Board (http://www.tcb-indicators.org)

c. During what year(s) was there inflation (i.e., the average level of prices increased)?

Answer: The GDP deflator is a price index. An increase in the value of the GDP deflator represents inflation. A decrease in the GDP deflator indicates deflation, a decline in the average level of prices. The U.S. economy was experiencing inflation every year from 1990 to 1994. We don't know about 1989 since we don't know what the GDP deflator for 1988 was, but it is safe to say the U.S. has experienced inflation every year since 1939.

2. In the text we calculated the change in real GDP in the hypothetical economy of Table 2-6, using the prices of 1992. Calculate the change in real GDP between 1992 and 1994 using the same data but the prices of 1994. Your answer should reveal that the prices that are used to calculate real GDP do affect the calculated growth rate.

 Calculating Real GDP    (Base Year = 1994) Average Prices Quantity Sold 1992NominalGDP 1992RealGDP 1994NominalGDP 1994RealGDP 1992 1994 % change 1992 1994 Food \$ 12 \$ 14 17 % 4 5 \$ 48 \$ 70 Housing 9 10 11 % 3 3 27 30 Fun 4 5 25% 3 4 12 20 Machines 20 20 0 % 2 2 40 40 \$127 ? \$160 ?

Answer: Assuming 1994 is base year:

1992 Real GDP = (4 * \$14) + (3 * \$10) + (3 * \$5) + (2 * \$20) = \$141
1994 Real GDP = (5 * \$14) + (3 * \$10) + (4 * \$5) + (2 * \$20) = \$160 (same as 1994 Nominal GDP)

Change in real GDP (assuming base year is 1994) = 100 * (160 - 141) / 141 = 1.27 = 13.5 %

Change in real GDP (assuming base year is 1992 as in text) = 12.6 %

3. Consider a simple economy in which only three items are in the consumer price index (CPI): food, housing, and entertainment (fun). Assume in the base period, say 1987, the household consumed the following quantities at the then prevailing prices:

 Quantity Price per unit Expenditure Food 5 \$ 14 \$ 70 Housing 3 \$ 10 \$ 30 Fun 4 \$ 5 \$ 20 Total expenditure \$ 120

a. Define the consumer price index

 CPI = sum of [(current prices) x (fixed market basket quantities)]   * 100 sum of [(base year prices) x (fixed market basket quantities)]

b. Assume that the market basket of goods that define the CPI is as given in the table. Calculate the CPI for 1994 if the prices prevailing in 1994 are as follows: food \$30 per unit; housing, \$20 per unit; and fun, \$6 per unit.

 1994 CPI (1987 = 100) = [(5*30 + 3*20 + 4*6) / (5*14 + 3*10 + 4*5)] * 100 = (234 / 120) * 100 = 195

c. What was the total inflation rate over this 7 year period (1987 to 1994)?

 Inflation = (Price Index Year 2 - Price Index Year 1) * 100 Price Index Year 1 = [(195 - 100)/ 100] * 100 = 95 %

Note - to calculate the average annual inflation rate over this period you would have to use the annual compound interest rate formula:

(1 + avg. annual interest rate)no. years = (Price Index Year 2 / Price Index Year 1)
(1 + avg. annual interest rate)7 = 1.95
1 + avg. annual interest rate = 1.10
average annual interest rate = 0.10, or 10%

d. The consumer price index and GDP deflator are both measures of an average price level. How are they different, and when might you prefer one of these measures over the other?

Answer: The CPI measures the increase in the cost of a particular market basket of consumer goods and services purchased by private households while the GDP deflator measures the increase in the cost of all final goods and services, including those purchased by firms and government. The type and quantity of goods and services included in the CPI market basket do not change from year to year while the type and quantities of goods and services covered by the GDP deflator change every year. The CPI includes imported goods and services purchased by households while the GDP deflator does not.

The CPI would be preferred if you were evaluating the cost of living of a typical household. The GDP deflator would be preferred if you were evaluating entire economies.