483
Measuring a
Nation’s Income
W
hen you finish school and start looking for a full-time job, your experience
will, to a large extent, be shaped by prevailing economic conditions. In
some years, firms throughout the economy are expanding their production
of goods and services, employment is rising, and jobs are easy to find. In other
years, firms are cutting back production, employment is declining, and finding a
good job takes a long time. Not surprisingly, any college graduate would rather
enter the labor force in a year of economic expansion than in a year of economic
contraction.
Because the health of the overall economy profoundly affects all of us,
changes in economic conditions are widely reported by the media. Indeed, it
is hard to pick up a newspaper, check an online news service, or turn on the
TV without seeing some newly reported statistic about the economy. The
statistic might measure the total income of everyone in the economy (gross
domestic product, or GDP), the rate at which average prices are rising or
Chapter
23
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484	 PARTVIII	 THE DATA OF MACROECONOMICS
falling (inflation/deflation), the percentage of the labor force that is out of work
(unemployment), total spending at stores (retail sales), or the imbalance of trade
between the United States and the rest of the world (the trade deficit). All these
statistics are macroeconomic. Rather than telling us about a particular household,
firm, or market, they tell us something about the entire economy.
As you may recall from Chapter 2, economics is divided into two branches:
­microeconomics and macroeconomics. Microeconomics is the study of how
­individual households and firms make decisions and how they interact with one
another in markets. Macroeconomics is the study of the economy as a whole.
The goal of macroeconomics is to explain the economic changes that affect many
households, firms, and markets simultaneously. Macroeconomists address ­diverse
questions: Why is average income high in some countries while it is low in others?
Why do prices sometimes rise rapidly while at other times they are more
stable? Why do production and employment expand in some years and contract
in others? What, if anything, can the government do to promote rapid growth in
incomes, low inflation, and stable employment? These questions are all macroeconomic
in nature because they concern the workings of the entire economy.
Because the economy as a whole is a collection of many households and many
firms interacting in many markets, microeconomics and macroeconomics are
closely linked. The basic tools of supply and demand, for instance, are as central
to macroeconomic analysis as they are to microeconomic analysis. Yet studying
the economy in its entirety raises some new and intriguing challenges.
In this and the next chapter, we discuss some of the data that economists and
policymakers use to monitor the performance of the overall economy. These data
reflect the economic changes that macroeconomists try to explain. This chapter
considers gross domestic product, which measures the total income of a nation. GDP
is the most closely watched economic statistic because it is thought to be the best
single measure of a society’s economic well-being.
microeconomics
the study of how
households and firms
make decisions and how
they interact in markets
macroeconomics
the study of economywide
phenomena,
including inflation,
unemployment, and
economic growth
23-1 The Economy’s Income and Expenditure
If you were to judge how a person is doing economically, you might first look at
her income. A person with a high income can more easily afford life’s necessities
and luxuries. It is no surprise that people with higher incomes enjoy higher
standards of living—better housing, better healthcare, fancier cars, more opulent
vacations, and so on.
The same logic applies to a nation’s overall economy. When judging whether
the economy is doing well or poorly, it is natural to look at the total income that
everyone in the economy is earning. That is the task of GDP.
GDP measures two things at once: the total income of everyone in the economy
and the total expenditure on the economy’s output of goods and services.
GDP can perform the trick of measuring both total income and total expenditure
­because these two things are really the same. For an economy as a whole, income
must equal expenditure.
Why is this true? An economy’s income is the same as its expenditure because
every transaction has two parties: a buyer and a seller. Every dollar of spending
by some buyer is a dollar of income for some seller. Suppose, for instance,
that Karen pays Doug $100 to mow her lawn. In this case, Doug is a seller of a
service and Karen is a buyer. Doug earns $100 and Karen spends $100. Thus, the art	Tofcoconomicsart	Tofcoconomicsart	Tofcoconomics
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	 CHAPTER 23  MEASURING A NATION’S INCOME 485
transaction contributes equally to the economy’s income and to its expenditure.
GDP, whether measured as total income or total expenditure, rises by $100.
Another way to see the equality of income and expenditure is with the circularflow
diagram in Figure 1. As you may recall from Chapter 2, this diagram ­describes
all the transactions between households and firms in a simple economy. It simplifies
matters by assuming that all goods and services are bought by households
and that households spend all of their income. In this economy, when households
buy goods and services from firms, these expenditures flow through the markets
for goods and services. When the firms in turn use the money they ­receive from
sales to pay workers’ wages, landowners’ rent, and firm owners’ profit, this
income flows through the markets for the factors of production. Money continuously
flows from households to firms and then back to households.
GDP measures this flow of money. We can compute it for this economy in one
of two ways: by adding up the total expenditure by households or by adding up
the total income (wages, rent, and profit) paid by firms. Because all expenditure
in the economy ends up as someone’s income, GDP is the same regardless of how
we compute it.
The actual economy is, of course, more complicated than the one illustrated in
Figure 1. Households do not spend all of their income; they pay some of it to the
government in taxes, and they save some for use in the future. In addition, households
do not buy all goods and services produced in the economy; some goods
and services are bought by governments, and some are bought by firms that plan
FIGURE 1
The Circular-Flow Diagram
Households buy goods and
services from firms, and firms
use their revenue from sales to
pay wages to workers, rent to
landowners, and profit to firm
owners. GDP equals the total
amount spent by households
in the market for goods and
services. It also equals the total
wages, rent, and profit paid
by firms in the markets for the
­factors of production.
Spending
(= GDP)
Goods and
services
bought
Revenue
(= GDP)
Goods
and services
sold
Labor, land,
and capital
Income (= GDP)
5 Flow of inputs
and outputs
5 Flow of dollars
Factors of
production
Wages, rent,
and profit
(= GDP)
FIRMS HOUSEHOLDS
MARKETS FOR
FACTORS OF
PRODUCTION
MARKETS FOR
GOODS AND
SERVICES	 EARAATE	 EARAATE	 EARAATE
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486	 PARTVIII	 THE DATA OF MACROECONOMICS
to use them in the future to produce their own output. Yet the basic lesson ­remains
the same: Regardless of whether a household, government, or firm buys a good or
service, the transaction has a buyer and a seller. Thus, for the economy as a whole,
expenditure and income are always the same.
Quick Quiz  What two things does GDP measure? How can it measure two things at
once?
23-2 The Measurement of GDP
Having discussed the meaning of gross domestic product in general terms, let’s
be more precise about how this statistic is measured. Here is a definition of GDP
that focuses on GDP as a measure of total expenditure:
•	 Gross domestic product (GDP) is the market value of all final goods and
­services produced within a country in a given period of time.
This definition might seem simple enough. But in fact, many subtle issues arise
when computing an economy’s GDP. Let’s therefore consider each phrase in this
definition with some care.
23-2a “GDP Is the Market Value . . .”
You have probably heard the adage “You can’t compare apples and oranges.” Yet
GDP does exactly that. GDP adds together many different kinds of products into a
single measure of the value of economic activity. To do this, it uses market prices.
Because market prices measure the amount people are willing to pay for different
goods, they reflect the value of those goods. If the price of an apple is twice the
price of an orange, then an apple contributes twice as much to GDP as does an
orange.
23-2b “. . . of All . . .”
GDP tries to be comprehensive. It includes all items produced in the economy and
sold legally in markets. GDP measures the market value of not just apples and
oranges but also pears and grapefruit, books and movies, haircuts and healthcare,
and on and on.
GDP also includes the market value of the housing services provided by the
economy’s stock of housing. For rental housing, this value is easy to calculate—
the rent equals both the tenant’s expenditure and the landlord’s income. Yet many
people own their homes and, therefore, do not pay rent. The government includes
this owner-occupied housing in GDP by estimating its rental value. In effect,
GDP is based on the assumption that the owner is renting the house to herself.
The ­imputed rent is included both in the homeowner’s expenditure and in her
­income, so it adds to GDP.
There are some products, however, that GDP excludes because measuring them
is so difficult. GDP excludes most items produced and sold illicitly, such as illegal
drugs. It also excludes most items that are produced and consumed at home and,
therefore, never enter the marketplace. Vegetables you buy at the grocery store are
part of GDP; vegetables you grow in your garden are not.
gross domestic
product (GDP)
the market value of all
final goods and services
produced within a country
in a given period of timeart	Tofcoconomicsart	Tofcoconomicsart	Tofcoconomics
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
	 CHAPTER 23  MEASURING A NATION’S INCOME 487
These exclusions from GDP can at times lead to paradoxical results. For
­example, when Karen pays Doug to mow her lawn, that transaction is part of
GDP. But suppose Doug and Karen marry. Even though Doug may continue
to mow Karen’s lawn, the value of the mowing is now left out of GDP because
Doug’s service is no longer sold in a market. Thus, their marriage reduces GDP.
23-2c “. . . Final . . .”
When International Paper makes paper, which Hallmark then uses to make a
greeting card, the paper is called an intermediate good and the card is called a final
good. GDP includes only the value of final goods. This is done because the value
of intermediate goods is already included in the prices of the final goods. Adding
the market value of the paper to the market value of the card would be double
counting. That is, it would (incorrectly) count the paper twice.
An important exception to this principle arises when an intermediate good is
produced and, rather than being used, is added to a firm’s inventory of goods for
use or sale at a later date. In this case, the intermediate good is taken to be “final”
for the moment and its value as inventory investment is included as part of GDP.
Thus, additions to inventory add to GDP, and when the goods in inventory are
later used or sold, the reductions in inventory subtract from GDP.
23-2d “. . . Goods and Services . . .”
GDP includes both tangible goods (food, clothing, cars) and intangible services
(haircuts, housecleaning, doctor visits). When you buy a CD by your favorite
band, you are buying a good, and the purchase price is part of GDP. When you
pay to hear a concert by the same band, you are buying a service, and the ticket
price is also part of GDP.
23-2e “. . . Produced . . .”
GDP includes goods and services currently produced. It does not include transactions
involving items produced in the past. When Ford produces and sells a new
car, the value of the car is included in GDP. When one person sells a used car to
another person, the value of the used car is not included in GDP.
23-2f “. . . Within a Country . . .”
GDP measures the value of production within the geographic confines of a country.
When a Canadian citizen works temporarily in the United States, her production
is part of U.S. GDP. When an American citizen owns a factory in Haiti, the
production at her factory is not part of U.S. GDP. (It is part of Haiti’s GDP.) Thus,
items are included in a nation’s GDP if they are produced domestically, regardless
of the nationality of the producer.
23-2g “. . . In a Given Period of Time.”
GDP measures the value of production that takes place within a specific interval
of time. Usually, that interval is a year or a quarter (three months). GDP measures
the economy’s flow of income, as well as its flow of expenditure, during that
interval.
When the government reports the GDP for a quarter, it usually presents GDP
“at an annual rate.” This means that the figure reported for quarterly GDP is the
amount of income and expenditure during the quarter multiplied by 4. The government
uses this convention so that quarterly and annual figures on GDP can be
compared more easily.	 EARAATE	 EARAATE	 EARAATE
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488	 PARTVIII	 THE DATA OF MACROECONOMICS
In addition, when the government reports quarterly GDP, it presents the data
after they have been modified by a statistical procedure called seasonal adjustment.
The unadjusted data show clearly that the economy produces more goods and
services during some times of the year than during others. (As you might guess,
December’s holiday shopping season is a high point.) When monitoring the condition
of the economy, economists and policymakers often want to look beyond
these regular seasonal changes. Therefore, government statisticians adjust the
quarterly data to take out the seasonal cycle. The GDP data reported in the news
are always seasonally adjusted.
Now let’s repeat the definition of GDP:
•	 Gross domestic product (GDP) is the market value of all final goods and
­services produced within a country in a given period of time.
This definition focuses on GDP as total expenditure in the economy. But don’t
forget that every dollar spent by a buyer of a good or service becomes a dollar of
income to the seller of that good or service. Therefore, in addition to applying this
definition, the government adds up total income in the economy. The two ways
of calculating GDP give almost exactly the same answer. (Why “almost”? The two
measures should be precisely the same, but data sources are not perfect. The difference
between the two calculations of GDP is called the statistical discrepancy.)
It should be apparent that GDP is a sophisticated measure of the value of economic
activity. In advanced courses in macroeconomics, you will learn more
about the subtleties that arise in its calculation. But even now you can see that
each phrase in this definition is packed with meaning.
Quick Quiz  Which contributes more to GDP—the production of a pound of hamburger
or the production of a pound of caviar? Why?
23-3 The Components of GDP
Spending in the economy takes many forms. At any moment, the Smith family
may be having lunch at Burger King; Ford may be building a car factory; the Navy
may be procuring a submarine; and British Airways may be buying an airplane
from Boeing. GDP includes all of these various forms of spending on domestically
produced goods and services.
To understand how the economy is using its scarce resources, economists
study the composition of GDP among various types of spending. To do this, GDP
(which we denote as Y) is divided into four components: consumption (C), investment
(I), government purchases (G), and net exports (NX):
Y = C + I + G + NX.
This equation is an identity—an equation that must be true because of how the
variables in the equation are defined. In this case, because each dollar of expenditure
included in GDP is placed into one of the four components of GDP, the total
of the four components must be equal to GDP. Let’s look at each of these four
components more closely.art	Tofcoconomicsart	Tofcoconomicsart	Tofcoconomics
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	 CHAPTER 23  MEASURING A NATION’S INCOME 489
23-3a Consumption
Consumption is spending by households on goods and services, with the exception
of purchases of new housing. Goods include durable goods, such as automobiles
and appliances, and nondurable goods, such as food and clothing. Services
include such intangible items as haircuts and medical care. Household spending
on education is also included in consumption of services (although one might
­argue that it would fit better in the next component).
23-3b Investment
Investment is the purchase of goods that will be used in the future to produce
more goods and services. It is the sum of purchases of capital equipment, inventories,
and structures. Investment in structures includes expenditure on new housing.
By convention, the purchase of a new house is the one form of household
spending categorized as investment rather than consumption.
As mentioned earlier in this chapter, the treatment of inventory accumulation is
noteworthy. When Apple produces a computer and adds it to its ­inventory ­instead
of selling it, Apple is assumed to have “purchased” the computer for itself. That is,
Other Measures of Income
When the U.S. Department of Commerce computes the nation’s GDP
every three months, it also computes various other measures of
income to get a more complete picture of what’s happening in the economy.
These other measures differ from GDP by excluding or including
certain categories of income. What follows is a brief description of five
of these income measures, ordered from largest to smallest.
•	 Gross national product (GNP) is the total income earned by a
­nation’s permanent residents (called nationals). It differs from
GDP in that it includes income that our citizens earn abroad and
excludes income that foreigners earn here. For example, when a
Canadian citizen works temporarily in the United States, her production
is part of U.S. GDP, but it is not part of U.S. GNP. (It is part
of Canada’s GNP.) For most countries, including the United States,
domestic residents are responsible for most domestic production, so
GDP and GNP are quite close.
•	 Net national product (NNP) is the total income of a nation’s residents
(GNP) minus losses from depreciation. Depreciation is the wear and
tear on the economy’s stock of equipment and structures, such as
trucks rusting and old computer models becoming obsolete. In the
national income accounts prepared by the Department of ­Commerce,
depreciation is called the “consumption of fixed capital.”
•	 National income is the total income earned by a nation’s residents
in the production of goods and services. It is almost identical to
net national product. These two measures differ because of the
statistical discrepancy
that arises from problems
in data collection.
•	 Personal income is the income that
households and noncorporate businesses
­receive. Unlike national income, it excludes retained earnings,
which is income that corporations have earned but have not paid
out to their owners. It also subtracts indirect business taxes (such
as sales taxes), corporate income taxes, and contributions for ­social
insurance (mostly Social Security taxes). In ­addition, personal
­income includes the interest income that households receive from
their holdings of government debt and the income that households
receive from government transfer programs, such as welfare and
Social Security.
•	 Disposable personal income is the income that households and noncorporate
businesses have left after satisfying all their obligations
to the government. It equals personal income minus personal taxes
and certain nontax payments (such as traffic tickets).
Although the various measures of income differ in detail, they ­almost
always tell the same story about economic conditions. When GDP grows
rapidly, these other measures of income usually grow rapidly. And when
GDP falls, these other measures usually fall as well. For monitoring
fluctuations in the overall economy, it does not matter much which
measure of income we use.
FYI
consumption
spending by households
on goods and services,
with the exception of
purchases of new housing
investment
spending on capital
equipment, inventories,
and structures, including
household purchases of
new housing	 EARAATE	 EARAATE	 EARAATE
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490	 PARTVIII	 THE DATA OF MACROECONOMICS
the national income accountants treat the computer as part of Apple’s ­investment
spending. (If Apple later sells the computer out of inventory, Apple’s inventory
investment will then be negative, offsetting the positive expenditure of the buyer.)
Inventories are treated this way because one aim of GDP is to measure the value of
the economy’s production, and goods added to inventory are part of that ­period’s
production.
Notice that GDP accounting uses the word investment differently from how
you might hear the term in everyday conversation. When you hear the word
­investment, you might think of financial investments, such as stocks, bonds, and
mutual funds—topics that we study later in this book. By contrast, because GDP
measures expenditure on goods and services, here the word investment means
­purchases of goods (such as capital equipment, structures, and inventories) used
to produce other goods and services in the future.
23-3c Government Purchases
Government purchases ­include spending on goods and services by local,
state, and federal governments. It includes the salaries of government workers
as well as expenditures on public works. Recently, the U.S. national income
­accounts have switched to the longer label government consumption expenditure
and gross ­investment, but in this book, we will use the traditional and shorter term
­government purchases.
The meaning of government purchases requires a bit of clarification. When
the government pays the salary of an Army general or a schoolteacher, that salary
is part of government purchases. But when the government pays a Social
­Security benefit to a person who is elderly or an unemployment insurance benefit
to a worker who was recently laid off, the story is very different: These are
called ­transfer payments because they are not made in exchange for a currently
produced good or service. Transfer payments alter household income, but they
do not ­reflect the economy’s production. (From a macroeconomic standpoint,
transfer payments are like negative taxes.) Because GDP is intended to measure
income from, and expenditure on, the production of goods and services, transfer
payments are not counted as part of government purchases.
23-3d Net Exports
Net exports equal the foreign purchases of domestically produced goods ­(exports)
minus the domestic purchases of foreign goods (imports). A domestic firm’s
sale to a buyer in another country, such as Boeing’s sale of an airplane to British
­Airways, increases net exports.
The net in net exports refers to the fact that imports are subtracted from exports.
This subtraction is made because other components of GDP include imports of
goods and services. For example, suppose that a household buys a $40,000 car from
Volvo, the Swedish carmaker. This transaction increases consumption by $40,000
because car purchases are part of consumer spending. It also reduces net exports
by $40,000 because the car is an import. In other words, net exports include goods
and services produced abroad (with a minus sign) because these goods and services
are included in consumption, investment, and government purchases (with
a plus sign). Thus, when a domestic household, firm, or government buys a good
or service from abroad, the purchase reduces net exports, but because it also raises
consumption, investment, or government purchases, it does not affect GDP.
government purchases
spending on goods and
services by local, state,
and federal governments
net exports
spending on domestically
produced goods by
foreigners (exports) minus
spending on foreign
goods by domestic
residents (imports)art	Tofcoconomicsart	Tofcoconomicsart	Tofcoconomics
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
	 CHAPTER 23  MEASURING A NATION’S INCOME 491
The Components of U.S. GDP
Table 1 shows the composition of U.S. GDP in 2012. In this year, the
GDP of the United States was over $15 trillion. Dividing this number by
the 2012 U.S. population of 314 million yields GDP per person (sometimes
called GDP per capita). In 2012 the income and expenditure of the average
American was $49,923.
Consumption made up 71 percent of GDP, or $35,411 per person. Investment
was $6,557 per person. Government purchases were $9,758 per person. Net
­exports were −$1,806 per person. This number is negative because Americans
spent more on foreign goods than foreigners spent on American goods.
These data come from the Bureau of Economic Analysis, the part of the U.S.
Department of Commerce that produces the national income accounts. You can
find more recent data on GDP on its website, http://www.bea.gov.
case
study
GDP and Its Components
This table shows total GDP
for the U.S. economy in
2012 and the breakdown
of GDP among its four
components. When reading
this table, recall the identity
Y = C + I + G + NX.
Table 1Total
(in billions of dollars)
Per Person
(in dollars)
Percent
of Total
Gross domestic product, Y $15,676 $49,923 100%
Consumption, C 11,119 35,411 71
Investment, I 2,059 6,557 13
Government purchases, G 3,064 9,758 20
Net exports, NX −567 −1,806 −4
Source: U.S. Department of Commerce. Parts may not sum to totals due to rounding.
Quick Quiz  List the four components of expenditure. Which is the largest?
23-4 Real versus Nominal GDP
As we have seen, GDP measures the total spending on goods and services in all
markets in the economy. If total spending rises from one year to the next, at least
one of two things must be true: (1) the economy is producing a larger output of
goods and services, or (2) goods and services are being sold at higher prices. When
studying changes in the economy over time, economists want to separate these
two effects. In particular, they want a measure of the total quantity of goods and
services the economy is producing that is not affected by changes in the prices of
those goods and services.
To do this, economists use a measure called real GDP. Real GDP answers a
­hypothetical question: What would be the value of the goods and services produced
this year if we valued these goods and services at the prices that prevailed
in some specific year in the past? By evaluating current production using prices
that are fixed at past levels, real GDP shows how the economy’s overall production
of goods and services changes over time.	 EARAATE	 EARAATE	 EARAATE
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492	 PARTVIII	 THE DATA OF MACROECONOMICS
Yes, Lady Gaga’s Songs
Contribute to GDP
By Osagie Imasogie and Thaddeus J.
Kobylarz
The U.S. government recently announced a
welcome revision to the way it estimates
gross domestic product. Starting July 31,
the Bureau of Economic Analysis will record
expenditures for “R&D and for entertainment,
literary and artistic originals as fixed investment,”
grouping them with expenditures
for software into a new investment category
called “intellectual property products.”
What does this mean for GDP? Until this
change, as Wellesley economist Daniel ­Sichel
recently told NPR, “If Lady Gaga did a concert
and sold concert tickets, the concert tickets
would count as GDP,” but the money she spent
writing and recording an album wouldn’t.
That didn’t make sense, because as Mr. Sichel
pointed out, the money an artist ­invests in
a film or song is “really quite analogous to
a factory investing in a new ­machine.” The
same is clearly true of money invested in R&D
for new drugs or smartphones.
Taken together, these new revisions are
even more significant than the 1999 revision
that added expenditures for computer
software to the national accounts. Why?
First, by expanding the list of intellectualproperty
investments used to calculate GDP to
The BEA Changes the
Definitions of Investment
and GDP
In 2013, the Bureau of Economic Analysis announced that it
would expand the definitions of investment and GDP to include
the ­production of various forms of intellectual property. This article
­discusses the change. Because the new data were not yet available
as this book was going to press, all the data presented here use
the traditional, narrower definitions.
In the News
To see more precisely how real GDP is constructed, let’s consider an example.
23-4a A Numerical Example
Table 2 shows some data for an economy that produces only two goods: hot dogs
and hamburgers. The table shows the prices and quantities produced of the two
goods in the years 2013, 2014, and 2015.
To compute total spending in this economy, we would multiply the quantities
of hot dogs and hamburgers by their prices. In the year 2013, 100 hot dogs are sold
at a price of $1 per hot dog, so expenditure on hot dogs equals $100. In the same
year, 50 hamburgers are sold for $2 per hamburger, so expenditure on hamburgers
also equals $100. Total expenditure in the economy—the sum of expenditure
on hot dogs and expenditure on hamburgers—is $200. This amount, the production
of goods and services valued at current prices, is called nominal GDP.
The table shows the calculation of nominal GDP for these three years. ­Total
spending rises from $200 in 2013 to $600 in 2014 and then to $1,200 in 2015. Part
of this rise is attributable to the increase in the quantities of hot dogs and hamburgers,
and part is attributable to the increase in the prices of hot dogs and
hamburgers.
To obtain a measure of the amount produced that is not affected by changes in
prices, we use real GDP, which is the production of goods and services valued at
constant prices. We calculate real GDP by first designating one year as a base year.
We then use the prices of hot dogs and hamburgers in the base year to compute
the value of goods and services in all the years. In other words, the prices in the
base year provide the basis for comparing quantities in different years.
Suppose that we choose 2013 to be the base year in our example. We can then
use the prices of hot dogs and hamburgers in 2013 to compute the value of goods
nominal GDP
the production of goods
and services valued at
current prices
real GDP
the production of goods
and services valued at
constant pricesart	Tofcoconomicsart	Tofcoconomicsart	Tofcoconomics
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
	 CHAPTER 23  MEASURING A NATION’S INCOME 493
include R&D and the arts and entertainment
industry, the present U.S. economy is shown
to be roughly 3%—or $400 billion—larger
than thought. (That doesn’t mean we’ll see
a dramatic increase in GDP after July; the
GDP ­figures going back to 1929 will also be
­adjusted, lessening the impact of the change
on current growth rates.)
Second, the revision reflects the economy’s
quiet transformation from one based principally
on industry to one decidedly based on
knowledge and information. Third, this ­revision
opens the door to further changes in the GDP
calculation methodology, since the Bureau of
Economic Analysis has in essence conceded
that the GDP indicator, as now defined, has
fallen behind today’s economic realities.
This change is more than an arcane issue
of interest only to economists. Government
GDP figures are used to determine fundamental
policy matters that affect everyday
citizens’ lives, such as budget decisions and
funding for federal programs. GDP numbers
also constitute a shorthand for evaluating the
performance of the national economy.
A clear goal of the BEA’s decision is to
better reflect the role of intellectual property
as a key contributor to the national economy.
This change in the measurement of GDP will
affect both policy decisions regarding intellectual
property and how we perceive ourselves
as a society.
Right now there are pivotal cases before
the U.S. Supreme Court on the legitimate
scope and subject matter of patent protection,
including in the growing field of genetics
where at least 25% of all human genes have
already been patented by private companies.
Crucial decisions similarly confront us on the
educational funding and direction, particularly
in relation to science, technology, engineering
and math and early childhood education.
In the past two decades, intellectual property
has emerged as the principal driver of
economic growth in the U.S. and other developed
countries. IP is now, in many respects,
the new global currency. This is largely the
result of America’s successful effort to internationalize
its views regarding the economic
importance of IP protection, notwithstanding
the continuing challenge of piracy. In short,
America’s place as a world economic leader
depends on its ability to cultivate a sufficiently
creative “mint” by which to generate,
and profit from, this new global currency.
The government’s new GDP measure suggests
that economists are rightly adjusting to
this new landscape. Whereas traditionalists
have long counted land, labor and capital as
the primary factors of production, economists
are increasingly recognizing the productive
significance of more intangible factors. This
includes IP and, more generally, intellectual
capital.
Source: The Wall Street Journal, May 28, 2013.
Real and 	
Nominal GDP
This table shows
how to calculate
real GDP, nominal
GDP, and the GDP
deflator for a
hypothetical
economy that
produces only
hot dogs and
hamburgers.
Table 2Prices and Quantities
Year
Price of
Hot Dogs
Quantity of
Hot Dogs
Price of
Hamburgers
Quantity of
Hamburgers
2013 $1 100 $2 50
2014 $2 150 $3 100
2015 $3 200 $4 150
Calculating Nominal GDP
2013 ($1 per hot dog × 100 hot dogs) + ($2 per hamburger × 50 hamburgers) = $200
2014 ($2 per hot dog × 150 hot dogs) + ($3 per hamburger × 100 hamburgers) = $600
2015 ($3 per hot dog × 200 hot dogs) + ($4 per hamburger × 150 hamburgers) = $1,200
Calculating Real GDP (base year 2013)
2013 ($1 per hot dog × 100 hot dogs) + ($2 per hamburger × 50 hamburgers) = $200
2014 ($1 per hot dog × 150 hot dogs) + ($2 per hamburger × 100 hamburgers) = $350
2015 ($1 per hot dog × 200 hot dogs) + ($2 per hamburger × 150 hamburgers) = $500
Calculating the GDP Deflator
2013 ($200 / $200) × 100 = 100
2014 ($600 / $350) × 100 = 171
2015 ($1,200 / $500) × 100 = 240	 EARAATE	 EARAATE	 EARAATE
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494	 PARTVIII	 THE DATA OF MACROECONOMICS
and services produced in 2013, 2014, and 2015. Table 2 shows these calculations. To
compute real GDP for 2013, we use the prices of hot dogs and hamburgers in 2013
(the base year) and the quantities of hot dogs and hamburgers produced in 2013.
(Thus, for the base year, real GDP always equals nominal GDP.) To compute real
GDP for 2014, we use the prices of hot dogs and hamburgers in 2013 (the base
year) and the quantities of hot dogs and hamburgers produced in 2014. ­Similarly,
to compute real GDP for 2015, we use the prices in 2013 and the quantities in 2015.
When we find that real GDP has risen from $200 in 2013 to $350 in 2014 and then
to $500 in 2015, we know that the increase is attributable to an increase in the
quantities produced because the prices are being held fixed at base-year levels.
To sum up: Nominal GDP uses current prices to place a value on the economy’s
­production of goods and services. Real GDP uses constant base-year prices to place a value
on the economy’s production of goods and services. Because real GDP is not affected by
changes in prices, changes in real GDP reflect only changes in the amounts being
produced. Thus, real GDP is a measure of the economy’s production of goods and
services.
Our goal in computing GDP is to gauge how well the overall economy is performing.
Because real GDP measures the economy’s production of goods and
­services, it reflects the economy’s ability to satisfy people’s needs and desires. Thus,
real GDP is a better gauge of economic well-being than is nominal GDP. When
economists talk about the economy’s GDP, they usually mean real GDP rather than
nominal GDP. And when they talk about growth in the economy, they measure
that growth as the percentage change in real GDP from one period to another.
23-4b The GDP Deflator
As we have just seen, nominal GDP reflects both the quantities of goods and services
the economy is producing and the prices of those goods and services. By
contrast, by holding prices constant at base-year levels, real GDP reflects only the
quantities produced. From these two statistics, we can compute a third, called the
GDP deflator, which reflects only the prices of goods and services.
The GDP deflator is calculated as follows:
GDP deflator 5
Nominal GDP
Real GDP
3 100.
Because nominal GDP and real GDP must be the same in the base year, the GDP
deflator for the base year always equals 100. The GDP deflator for subsequent
years measures the change in nominal GDP from the base year that cannot be
­attributable to a change in real GDP.
The GDP deflator measures the current level of prices relative to the level
of prices in the base year. To see why this is true, consider a couple of simple
­examples. First, imagine that the quantities produced in the economy rise over
time but prices remain the same. In this case, both nominal and real GDP rise at the
same rate, so the GDP deflator is constant. Now suppose, instead, that prices rise
over time but the quantities produced stay the same. In this second case, nominal
GDP rises but real GDP remains the same, so the GDP deflator rises. Notice that,
in both cases, the GDP deflator reflects what’s happening to prices, not quantities.
Let’s now return to our numerical example in Table 2. The GDP deflator is computed
at the bottom of the table. For the year 2013, nominal GDP is $200 and real
GDP is $200, so the GDP deflator is 100. (The deflator is always 100 in the base
year.) For the year 2014, nominal GDP is $600 and real GDP is $350, so the GDP
deflator is 171.
GDP deflator
a measure of the price
level calculated as the
ratio of nominal GDP to
real GDP times 100art	Tofcoconomicsart	Tofcoconomicsart	Tofcoconomics
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
	 CHAPTER 23  MEASURING A NATION’S INCOME 495
Economists use the term inflation to describe a situation in which the economy’s
overall price level is rising. The inflation rate is the percentage change in some
measure of the price level from one period to the next. Using the GDP deflator, the
inflation rate between two consecutive years is computed as follows:
Inflation rate in year 2 5
GDP deflator in year 2 2 GDP deflator in year 1
GDP deflator in year 1
3 100.
Because the GDP deflator rose in year 2014 from 100 to 171, the inflation rate is
100 × (171 − 100)/100, or 71 percent. In 2015, the GDP deflator rose to 240 from
171 the previous year, so the inflation rate is 100 × (240 − 171)/171, or 40 percent.
The GDP deflator is one measure that economists use to monitor the average
level of prices in the economy and thus the rate of inflation. The GDP deflator
gets its name because it can be used to take inflation out of nominal GDP—that
is, to “deflate” nominal GDP for the rise that is due to increases in prices. We
­examine another measure of the economy’s price level, called the consumer price
index, in the next chapter, where we also describe the differences between the two
measures.
FIGURE 2
Real GDP in the United
States
This figure shows
­quarterly data on
real GDP for the U.S.
­economy since 1965.
Recessions—periods of
falling real GDP—are
marked with the shaded
vertical bars.
Source: U.S. Department of Commerce.
16,000
14,000
12,000
10,000
8,000
6,000
4,000
2,000
0
1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
Year
Billions of
2005 dollars
Real GDP
Real GDP over Recent History
Now that we know how real GDP is defined and measured, let’s look
at what this macroeconomic variable tells us about the recent history of
the United States. Figure 2 shows quarterly data on real GDP for the U.S.
economy since 1965.
The most obvious feature of these data is that real GDP grows over time. The
real GDP of the U.S. economy in 2012 was almost four times its 1965 level. Put
differently, the output of goods and services produced in the United States has
case
study	 EARAATE	 EARAATE	 EARAATE
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496	 PARTVIII	 THE DATA OF MACROECONOMICS
Earlier in this chapter, GDP was called the best single measure of the economic
well-being of a society. Now that we know what GDP is, we can evaluate this
claim.
As we have seen, GDP measures both the economy’s total income and the
economy’s total expenditure on goods and services. Thus, GDP per person tells us
the income and expenditure of the average person in the economy. Because most
people would prefer to receive higher income and enjoy higher expenditure, GDP
per person seems a natural measure of the economic well-being of the average
individual.
Yet some people dispute the validity of GDP as a measure of well-being. When
Senator Robert Kennedy was running for president in 1968, he gave a moving
­critique of such economic measures:
[Gross domestic product] 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 measures 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.
Much of what Robert Kennedy said is correct. Why, then, do we care about GDP?
The answer is that a large GDP does in fact help us to lead good lives. GDP
does not measure the health of our children, but nations with larger GDP can
­afford better healthcare for their children. GDP does not measure the quality of
grown on average about 3 percent per year. This continued growth in real GDP
enables most Americans to enjoy greater economic prosperity than their parents
and grandparents did.
Asecond feature of the GDP data is that growth is not steady. The upward climb
of real GDP is occasionally interrupted by periods during which GDP ­declines,
called recessions. Figure 2 marks recessions with shaded vertical bars. (There is no
ironclad rule for when the official business cycle dating committee will declare
that a recession has occurred, but an old rule of thumb is two consecutive quarters
of falling real GDP.) Recessions are associated not only with lower incomes but
also with other forms of economic distress: rising unemployment, falling profits,
increased bankruptcies, and so on.
Much of macroeconomics is aimed at explaining the long-run growth and
short-run fluctuations in real GDP. As we will see in the coming chapters, we
need different models for these two purposes. Because the short-run fluctuations
represent deviations from the long-run trend, we first examine the behavior of
key macroeconomic variables, including real GDP, in the long run. Then in later
­chapters, we build on this analysis to explain short-run fluctuations.
Quick Quiz  Define real GDP and nominal GDP. Which is a better measure of economic
well-being? Why?
23-5 Is GDP a Good Measure of Economic Well-Being?art	Tofcoconomicsart	Tofcoconomicsart	Tofcoconomics
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
	 CHAPTER 23  MEASURING A NATION’S INCOME 497
their ­education, but nations with larger GDP can afford better educational systems.
GDP does not measure the beauty of our poetry, but nations with larger
GDP can afford to teach more of their citizens to read and enjoy poetry. GDP does
not take account of our intelligence, integrity, courage, wisdom, or devotion to
country, but all of these laudable attributes are easier to foster when people are
less concerned about being able to afford the material necessities of life. In short,
GDP does not directly measure those things that make life worthwhile, but it does
measure our ability to obtain many of the inputs into a worthwhile life.
GDP is not, however, a perfect measure of well-being. Some things that contribute
to a good life are left out of GDP. One is leisure. Suppose, for instance, that
everyone in the economy suddenly started working every day of the week, rather
than enjoying leisure on weekends. More goods and services would be produced,
and GDP would rise. Yet despite the increase in GDP, we should not conclude that
everyone would be better off. The loss from reduced leisure would offset the gain
from producing and consuming a greater quantity of goods and services.
Because GDP uses market prices to value goods and services, it excludes the
value of almost all activity that takes place outside markets. In particular, GDP
omits the value of goods and services produced at home. When a chef prepares a
delicious meal and sells it at her restaurant, the value of that meal is part of GDP.
But if the chef prepares the same meal for her family, the value she has added to
the raw ingredients is left out of GDP. Similarly, child care provided in day-care
centers is part of GDP, whereas child care by parents at home is not. ­Volunteer
work also contributes to the well-being of those in society, but GDP does not
­reflect these contributions.
Another thing that GDP excludes is the quality of the environment. Imagine
that the government eliminated all environmental regulations. Firms could then
produce goods and services without considering the pollution they create, and
GDP might rise. Yet well-being would most likely fall. The deterioration in the
quality of air and water would more than offset the gains from greater production.
GDP also says nothing about the distribution of income. A society in which
100 people have annual incomes of $50,000 has GDP of $5 million and, not surprisingly,
GDP per person of $50,000. So does a society in which 10 people earn
$500,000 and 90 suffer with nothing at all. Few people would look at those two
situations and call them equivalent. GDP per person tells us what happens to the
­average person, but behind the average lies a large variety of personal experiences.
In the end, we can conclude that GDP is a good measure of economic wellbeing
for most—but not all—purposes. It is important to keep in mind what GDP
includes and what it leaves out.
Bloomberg/GettyImages
International Differences in GDP and the Quality of Life
One way to gauge the usefulness of GDP as a measure of economic
well-being is to examine international data. Rich and poor countries have
vastly different levels of GDP per person. If a large GDP leads to a higher
standard of living, then we should observe GDP to be strongly correlated with
various measures of the quality of life. And, in fact, we do.
Table 3 shows twelve of the world’s most populous countries ranked in ­order
of GDP per person. The table also shows life expectancy, the average years of
schooling among adults, and the percentage of the population that ­reports
case
study
GDP reflects the factory’s
­production, but not the harm it
inflicts on the environment.	 EARAATE	 EARAATE	 EARAATE
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
498	 PARTVIII	 THE DATA OF MACROECONOMICS
Searching for the
­Hidden Economy
By Doug Campbell
Here is the brief, unremarkable story of
how I recently came to participate in the
­underground economy:
Midafternoon on the iciest day this past
winter, a man knocked at my front door.
“Shovel your walk?” he asked. “Only $5.”
Outside, it was a bone-chilling 15 
degrees. “Sold,” I said. A half-hour later I
handed over a five-dollar bill and thanked
him for saving me the trouble.
Officially, this was an unofficial
­transaction—off the books, with no taxes
paid or safety regulations followed. (At least,
I assume this hired hand didn’t bother to
­report that income or register with the proper
authorities.) As such, it was technically
­illegal. And, of course, it’s the sort of thing
that happens all the time.
International Differences in the 	
Underground Economy
Country
Underground
Economy as a
Percentage of GDP
Bolivia 68 percent
Zimbabwe 63
Peru 61
Thailand 54
Mexico 33
Argentina 29
Sweden 18
Australia 13
United Kingdom 12
Japan 11
Switzerland 9
United States 8
Source: Friedrich Schneider. Figures are for 2002.
The size of the official U.S. economy, as
measured by Gross Domestic Product (GDP),
was almost $12 trillion in 2004. Measurements
of the unofficial economy—not including illegal
activities like drug dealing and ­prostitution—
differ substantially. But it’s generally agreed to
be significant, somewhere between 6 percent
and 20 percent of GDP. At the midpoint, this
would be about $1.5 trillion a year.
Broadly defined, the underground, gray,
informal, or shadow economy involves otherwise
legal transactions that go unreported
or unrecorded. That’s a wide net, capturing
everything from babysitting fees, to bartering
home repairs with a neighbor, to failing to report
pay from moonlighting gigs. The “underground”
label tends to make it sound much
more sinister than it really is.
The Underground
Economy
The gross domestic product misses many transactions that take place
in the underground economy.
In the News
GDP and the Quality
of Life
The table shows GDP
per person and three
other measures of
the quality of life
for twelve major
countries.
Table 3
Country
Real GDP per
Person
Life
Expectancy
Average Years
of Schooling
Satisfied with
Water Quality
(% of population)
United States $43,017 79 years 12 years 90
Germany 35,854 80 12 95
Japan 32,295 83 12 88
Russia 14, 561 69 10 53
Mexico 13,245 77 9 68
Brazil 10,162 74 7 83
China 7,746 74 8 73
Indonesia 3,716 69 6 87
India 3,468 65 4 63
Pakistan 2,550 65 5 55
Nigeria 2,069 52 5 47
Bangladesh 1,529 69 5 70
Source: Human Development Report 2011, United Nations. Real GDP is for 2011, expressed in 2005 dollars. Average years of schooling is among adults 25 years
and older.art	Tofcoconomicsart	Tofcoconomicsart	Tofcoconomics
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	 CHAPTER 23  MEASURING A NATION’S INCOME 499
Criminal activities make up a large
portion of what could be termed the total
­underground economy. Many studies have
been done on the economics of drug dealing,
prostitution, and gambling. But because
money from crime is almost never recovered,
many policymakers are more interested in
portions of the underground economy that
otherwise would be legal if not hidden from
authorities. Things like shoveling walks.
Despite its intrigue, the informal economy’s
importance and consequences remain
in debate. The reason: “You’re trying to
measure a phenomenon whose entire purpose
is to hide itself from observation,” says
Ed Feige, an economist at the University of
Wisconsin.
This uncertainty poses problems for
policymakers. Without knowing the precise
size, scope, and causes of the underground
economy, how can they decide what—if
anything—to do about it?
Was the man who shoveled my walk
­engaging in a socially positive or negative
activity? Was I? Suffice it to say, some economists
have dedicated their entire careers to
answering questions about the underground
economy—and still there is nothing close to
a consensus about its size or description. . . .
Economists generally agree that the
shadow economy is worse in developing
­nations, whose webs of bureaucratic red tape
and corruption are notorious. For instance,
[economist Friedrich] Schneider in 2003 published
“shadow economy” estimates (defined
broadly as all market-based, legal production
of goods and services deliberately concealed
from the authorities) for countries including:
Zimbabwe, estimated at a whopping 63.2 percent
of GDP, Thailand’s at 54.1 percent, and
Bolivia’s at 68.3 percent. Among former Soviet
bloc nations, Georgia led the way with a
68 percent of GDP shadow economy,
and together those nations
had an average 40.1 percent of
GDP underground. This contrasts
with an average of 16.7 percent
among Western nations. . . .
In his 2003 book, Reefer Madness:
Sex, Drugs and Cheap Labor
in the American Black Market,
investigative writer Eric Schlosser
invokes Adam Smith’s “invisible
hand” theory that men pursuing
their own self-interest will generate benefits
for society as a whole. This invisible hand has
produced a fairly sizable underground economy,
and we cannot understand our entire
economic system without understanding how
the hidden underbelly functions, too. “The underground
is a good measure of the progress
and the health of nations,” Schlosser writes.
“When much is wrong, much needs to be hidden.”
Schlosser’s implication was that much
is wrong in the United States. If he had taken
a more global view, he might have decided
relatively little is hidden here.
Source: “Region Focus,” Federal Reserve Bank of Richmond,
Spring 2005.
A Shadowy Enterprise?
RosemarieGearhart/ArtisticCaptures/iStockphoto.com
­being satisfied with the quality of water they have available. These data show a
clear pattern. In rich countries, such as the United States, Germany, and Japan,
people can expect to live to about 80 and have 12 years of schooling; about
9 out of 10 people are satisfied with the quality of water they have to drink.
In poor countries, such as Bangladesh, Nigeria, and Pakistan, people typically
die 10 to 20 years earlier and have less than half as much schooling; about a
third to a half of the population is unsatisfied with the quality of water locally
available.
Data on other aspects of the quality of life tell a similar story. Countries with
low GDP per person tend to have more infants with low birth weight, higher rates
of infant mortality, higher rates of maternal mortality, and higher rates of child
malnutrition. In countries with low GDP per person, fewer school-age children
are actually in school, those who are in school must learn with fewer teachers per
student, and illiteracy among adults is more common. These countries also tend
to have fewer televisions, fewer telephones, fewer paved roads, fewer households
with electricity, and fewer opportunities to access the Internet. International data
leave no doubt that a nation’s GDP per person is closely associated with its citizens’
standard of living.
Quick Quiz  Why should policymakers care about GDP?	 EARAATE	 EARAATE	 EARAATE
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
500	 PARTVIII	 THE DATA OF MACROECONOMICS
Nations Seek Success
Beyond GDP
By Mark Whitehouse
Money isn’t everything. But in measuring
the success of nations, it isn’t easy to
find a substitute.
Political leaders are increasingly expressing
dissatisfaction with gross domestic
product—a monetary measure of all the
goods and services a country produces—as a
gauge of a nation’s success in raising living
standards.
In November, British Prime Minister David
Cameron announced plans to build measures
of national well-being that would take into
account factors such as peoples’ life satisfaction,
following a similar effort by French
President Nicolas Sarkozy.
Their efforts cut to the core of what economics
is supposed to be about: What makes
us better off? How can we all have more of it?
Anyone hoping for a clear-cut answer, though,
is likely to be disappointed.
“There is more to life than GDP, but it will
be hard to come up with a single measure to
­replace it and we are not sure that a single
measure is the answer,” said Paul Allin, ­director
of the Measuring National Well-Being Project at
the U.K.’s Office of National ­Statistics. “Maybe
we live in a multidimensional world and
we have to get used to handling a reasonable
number of bits of information.”
After a session on creating a national
success indicator at the annual meeting
of the American Economic Association on
­Friday, Carol Graham, fellow at the Brookings
­Institution, summed up the situation thus:
“It’s like a new science. There’s still a lot of
work to be done.”
For much of the past four decades, economists
have puzzled over a paradox that cast
doubt on GDP as the world’s main indicator
of success.
People in richer countries didn’t appear
to be any happier than people in poor countries.
In research beginning in the 1970s,
University of Pennsylvania economist Richard
Easterlin found no evidence of a link between
countries’ income—as measured by GDP
per person—and peoples’ reported levels of
happiness.
More recent research suggests GDP isn’t
quite so bad. Using more data and different
statistical techniques, three economists
at the University of Pennsylvania’s Wharton
School—Daniel Sacks, Betsey Stevenson
and Justin Wolfers—found that a given percentage
increase in GDP per person tends to
coincide with a similar increase in reported
well-being. The correlation held across different
countries and over time.
Still, for measuring the success of policy,
GDP is far from ideal. Making everybody
work 120 hours a week could radically boost
a country’s GDP per capita, but it wouldn’t
make people happier. Removing pollution
limits could boost GDP per hour worked, but
wouldn’t necessarily lead to a world we’d
want to live in.
One approach is to enhance GDP with
other objective factors such as inequality,
leisure and life expectancy. In a paper presented
Saturday at the American Economic
­Association meeting, Stanford economists
Peter ­Klenow and Charles Jones found that
doing so can make a big difference.
By their calculation, accounting for longer
life expectancy, additional leisure time and
lower levels of inequality makes living standards
in France and Germany look almost the
same as those in the U.S., which otherwise
leads the pack by a large margin.
Mr. Klenow points out that the calculation
is fraught with difficulties. For one, many
Measuring Macroeconomic
Well-Being
Can we do better than using gross domestic product?
In the News
23-6 Conclusion
This chapter has discussed how economists measure the total income of a ­nation.
Measurement is, of course, only a starting point. Much of ­macroeconomics
is aimed at revealing the long-run and short-run determinants of a nation’s
GDP. Why, for example, is GDP higher in the United States and ­Japan than in
­India and Nigeria? What can the governments of the poorest countries do to
promote more rapid GDP growth? Why does GDP in the United States rise rapidly
in some years and fall in others? What can U.S. policymakers do to reduce art	Tofcoconomicsart	Tofcoconomicsart	Tofcoconomics
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
	 CHAPTER 23  MEASURING A NATION’S INCOME 501
countries have poor data on crucial factors
such as life expectancy.
For the purpose of comparing well-being
across countries, asking people how they feel
might be better than monetary measures.
Angus Deaton, an economist at ­Princeton
University, notes that placing values on
the extremely different goods and services
consumed in the U.S. and, say, Tajikistan, can
be impossible to do in a comparable way. Just
asking people about their situation could be
much easier and no less accurate.
Surveys already play a meaningful role
in the way many countries assess their performance,
from consumer confidence in the
U.S. to the Netherlands’s Life Situation Index,
which accounts for factors such as relationships
and community involvement.
As part of its effort to gauge well-being,
the U.K. plans to add more subjective questions
to its household surveys.
But surveys can also send misleading
policy signals. Mr. Wolfers, for example, has
found that surveys of women’s subjective
well-being in the U.S. suggest that they are
less happy than they were four decades ago,
despite improvements in wages, education
and other objective measures. That, he says,
doesn’t mean the feminist movement should
be reversed. Rather, it could be related to rising
expectations or greater frankness among the
women interviewed.
Peoples’ true preferences are often
­revealed more by what they do than by what
they say. Surveys suggest people with children
tend to be less happy than those without,
yet people keep having children—and
nobody would advocate mass sterilization to
improve overall well-being.
“What we care about in the world is not
just happiness,” says Mr. Wolfers. “If you
measure just one part of what makes for a
full life you’re going to end up harming the
other parts.”
For the time being, that leaves policy
makers to choose the measures of success
that seem most appropriate for the task at
hand. That’s not ideal, but it’s the best economics
has to offer.
Source: The Wall Street Journal, January 10, 2011.
Happily ever after
More wealth doesn’t always translate into greater quality of life, when factors such as
leisure and length of life are included.
U.S.
Germany
France
Japan
HongKong
Italy
U.K.
Singapore
SouthKorea
Mexico
Brazil
Russia
Thailand
Indonesia
China
SouthAfrica
India
Botswana
Malawi
Well-being index
100.0100.0
74.098.0
70.197.4
72.491.5
82.190.0
69.589.7
69.889.0
82.943.6
47.129.7
25.917.4
21.812.2
20.98.6
18.47.1
10.86.6
11.35.3
21.64.4
6.63.5
17.91.8
2.90.4
Per capita GDP index
the severity of these fluctuations in GDP? These are the questions we will take
up shortly.
At this point, it is important to acknowledge the significance of just measuring
GDP. We all get some sense of how the economy is doing as we go about our
lives. But the economists who study changes in the economy and the policymakers
who formulate economic policies need more than this vague sense—they need
concrete data on which to base their judgments. Quantifying the behavior of the
economy with statistics such as GDP is, therefore, the first step to developing a
science of macroeconomics.	 EARAATE	 EARAATE	 EARAATE
ReprintedwithpermissionofTheWallStreetJournal,Copyright©2011
DowJones&Company,Inc.AllRightsReservedWorldwide.
Note: 2000 data.
Source: Peter Klenow and Charles Jones, Stanford University
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
502	 PARTVIII	 THE DATA OF MACROECONOMICS
Questions for Review
  1.	 Explain why an economy’s income must equal its
expenditure.
  2.	 Which contributes more to GDP—the production of an
economy car or the production of a luxury car? Why?
  3.	 A farmer sells wheat to a baker for $2. The baker uses
the wheat to make bread, which is sold for $3. What is
the total contribution of these transactions to GDP?
  4.	 Many years ago, Peggy paid $500 to put together a
­record collection. Today, she sold her albums at a garage
sale for $100. How does this sale affect current GDP?
  5.	 List the four components of GDP. Give an example
of each.
  6.	 Why do economists use real GDP rather than nominal
GDP to gauge economic well-being?
  7.	 In the year 2013, the economy produces 100 loaves
of bread that sell for $2 each. In the year 2014, the
economy produces 200 loaves of bread that sell for $3
each. Calculate nominal GDP, real GDP, and the GDP
deflator for each year. (Use 2013 as the base year.) By
what percentage does each of these three statistics rise
from one year to the next?
  8.	 Why is it desirable for a country to have a large GDP?
Give an example of something that would raise GDP
and yet be undesirable.
•	 Because every transaction has a buyer and a seller, the
total expenditure in the economy must equal the total
income in the economy.
•	 Gross domestic product (GDP) measures an economy’s
total expenditure on newly produced goods and services
and the total income earned from the production
of these goods and services. More precisely, GDP is the
market value of all final goods and services produced
within a country in a given period of time.
•	 GDP is divided among four components of expenditure:
consumption, investment, government purchases,
and net exports. Consumption includes
spending on goods and services by households, with
the exception of purchases of new housing. Investment
includes spending on new equipment and structures,
including households’ purchases of new housing.
Government purchases include spending on goods
and services by local, state, and federal governments.
Net exports equal the value of goods and services produced
domestically and sold abroad (exports) minus
the value of goods and services produced abroad and
sold domestically (imports).
•	 Nominal GDP uses current prices to value the economy’s
production of goods and services. Real GDP
uses constant base-year prices to value the economy’s
production of goods and services. The GDP deflator—
calculated from the ratio of nominal to real GDP—
measures the level of prices in the economy.
•	 GDP is a good measure of economic well-being because
people prefer higher to lower incomes. But it is
not a perfect measure of well-being. For example, GDP
excludes the value of leisure and the value of a clean
environment.
Summary
microeconomics, p. 484
macroeconomics, p. 484
gross domestic product (GDP), p. 486
consumption, p. 489
investment, p. 489
government purchases, p. 490
net exports, p. 490
nominal GDP, p. 492
real GDP, p. 492
GDP deflator, p. 494
Key Concepts
  1.	 If the price of a hot dog is $2 and the price of a hamburger
is $4, then 30 hot dogs contribute as much to
GDP as _________ hamburgers.
a.	 5
b.	 15
c.	 30
d.	 60
  2.	 Angus the sheep farmer sells wool to Barnaby the
knitter for $20. Barnaby makes two sweaters, each of
which has a market price of $40. Collette buys one of
them, while the other remains on the shelf of Barnaby’s
store to be sold later. What is GDP here?
a.	 $40
b.	 $60
c.	 $80
d.	 $100
Quick Check Multiple Choice
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
	 CHAPTER 23  MEASURING A NATION’S INCOME 503
  1.	 What components of GDP (if any) would each of the
following transactions affect? Explain.
a.	 A family buys a new refrigerator.
b.	 Aunt Jane buys a new house.
c.	 Ford sells a Mustang from its inventory.
d.	 You buy a pizza.
e.	 California repaves Highway 101.
f.	 Your parents buy a bottle of French wine.
g.	 Honda expands its factory in Marysville, Ohio.
  2.	 The government purchases component of GDP does
not include spending on transfer payments such as
Social Security. Thinking about the definition of GDP,
explain why transfer payments are excluded.
  3.	 As the chapter states, GDP does not include the value
of used goods that are resold. Why would ­including
such transactions make GDP a less informative
­measure of economic well-being?
  4.	 Below are some data from the land of milk and honey.
Year
Price of
Milk
Quantity of
Milk
Price of
Honey
Quantity of
Honey
2013 $1 100 quarts $2 50 quarts
2014 $1 200 $2 100
2015 $2 200 $4 100
a.	 Compute nominal GDP, real GDP, and the GDP
­deflator for each year, using 2013 as the base year.
b.	 Compute the percentage change in nominal GDP,
real GDP, and the GDP deflator in 2014 and 2015
from the preceding year. For each year, identify the
variable that does not change. Explain why your
answer makes sense.
c.	 Did economic well-being rise more in 2014 or 2015?
Explain.
  5.	 Consider an economy that produces only chocolate
bars. In year 1, the quantity produced is 3 bars and the
price is $4. In year 2, the quantity produced is 4 bars
and the price is $5. In year 3, the quantity produced is
5 bars and the price is $6. Year 1 is the base year.
a.	 What is nominal GDP for each of these three years?
b.	 What is real GDP for each of these years?
c.	 What is the GDP deflator for each of these years?
d.	 What is the percentage growth rate of real GDP
from year 2 to year 3?
e.	 What is the inflation rate as measured by the GDP
deflator from year 2 to year 3?
f.	 In this one-good economy, how might you have
answered parts (d) and (e) without first answering
parts (b) and (c)?
  6.	 Consider the following data on U.S. GDP:
Year
Nominal GDP
(in billions of dollars)
GDP Deflator
(base year 2005)
2012 15,676 115.4
2002 10,642 92.2
a.	 What was the growth rate of nominal GDP
­between 2002 and 2012? (Hint: The growth rate of
a variable X over an N-year period is calculated as
100 × [(Xfinal/Xinitial)1/N
− 1].)
b.	 What was the growth rate of the GDP deflator
­between 2002 and 2012?
c.	 What was real GDP in 2002 measured in 2005
prices?
Problems and Applications
  3.	 Which of the following does NOT add to U.S. GDP?
a.	 Air France buys a plane from Boeing, the U.S.
­aircraft manufacturer.
b.	 General Motors builds a new auto factory in North
Carolina.
c.	 The city of New York pays a salary to a
policeman.
d.	 The federal government sends a Social Security
check to your grandmother.
  4.	 An American buys a pair of shoes manufactured in
Italy. How do the U.S. national income accounts treat
the transaction?
a.	 Net exports and GDP both rise.
b.	 Net exports and GDP both fall.
c.	 Net exports fall, while GDP is unchanged.
d.	 Net exports are unchanged, while GDP rises.
  5.	 Which is the largest component of GDP?
a.	 consumption
b.	 investment
c.	 government purchases
d.	 net exports
  6.	 If all quantities produced rise by 10 percent and
all prices fall by 10 percent, which of the following
occurs?
a.	 Real GDP rises by 10 percent, while nominal GDP
falls by 10 percent.
b.	 Real GDP rises by 10 percent, while nominal GDP
is unchanged.
c.	 Real GDP is unchanged, while nominal GDP rises
by 10 percent.
d.	 Real GDP is unchanged, while nominal GDP falls
by 10 percent.	 EARAATE	 EARAATE	 EARAATE
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504	 PARTVIII	 THE DATA OF MACROECONOMICS
d.	 What was real GDP in 2012 measured in 2005
prices?
e.	 What was the growth rate of real GDP between
2002 and 2012?
f.	 Was the growth rate of nominal GDP higher or
lower than the growth rate of real GDP? Explain.
  7.	 Revised estimates of U.S. GDP are usually released
by the government near the end of each month. Find
a newspaper article that reports on the most recent
release, or read the news release yourself at http://
www.bea.gov, the website of the U.S. Bureau of
­Economic Analysis. Discuss the recent changes in real
and nominal GDP and in the components of GDP.
  8.	 A farmer grows wheat, which she sells to a miller for
$100. The miller turns the wheat into flour, which she
sells to a baker for $150. The baker turns the wheat
into bread, which she sells to consumers for $180.
Consumers eat the bread.
a.	 What is GDP in this economy? Explain.
b.	 Value added is defined as the value of a producer’s
output minus the value of the intermediate goods
that the producer buys to make the output. Assuming
there are no intermediate goods beyond those
described above, calculate the value added of each
of the three producers.
c.	 What is total value added of the three producers in
this economy? How does it compare to the economy’s
GDP? Does this example suggest another way
of calculating GDP?
  9.	 Goods and services that are not sold in markets, such
as food produced and consumed at home, are generally
not included in GDP. Can you think of how this might
cause the numbers in the second column of ­Table 3 to
be misleading in a comparison of the economic wellbeing
of the United States and India? Explain.
  10.	The participation of women in the U.S. labor force has
risen dramatically since 1970.
a.	 How do you think this rise affected GDP?
b.	 Now imagine a measure of well-being that includes
time spent working in the home and taking leisure.
How would the change in this measure of wellbeing
compare to the change in GDP?
c.	 Can you think of other aspects of well-being that
are associated with the rise in women’s labor-force
participation? Would it be practical to construct a
measure of well-being that includes these aspects?
11.	 One day, Barry the Barber, Inc., collects $400 for haircuts.
Over this day, his equipment depreciates in value
by $50. Of the remaining $350, Barry sends $30 to the
government in sales taxes, takes home $220 in wages,
and retains $100 in his business to add new equipment
in the future. From the $220 that Barry takes home, he
pays $70 in income taxes. Based on this information,
compute Barry’s contribution to the following measures
of income.
a.	 gross domestic product
b.	 net national product
c.	 national income
d.	 personal income
e.	 disposable personal income
Go to CengageBrain.com to purchase access to the proven,
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additional notes and context, practice tests, and much more.art	Tofcoconomicsart	Tofcoconomicsart	Tofcoconomics
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