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Chapter 2

    The Measurement and Structure

    of the National Economy

    ; Learning Objectives

     I. Goals of Chapter 2

    A. National income accounts; relationships among key macroeconomic variables (Sec. 2.1)

    B. Gross domestic productthe main measure of output (Sec. 2.2)

    C. Saving and wealthprivate and government (Sec. 2.3)

    D. Real GDP, price indexes, and inflation (Sec. 2.4)

    E. Interest rates (Sec. 2.5)

     II. Notes to Sixth Edition Users

    A. The application ―Wealth vs. Saving‖ has been deleted

    B. A new application ―The Fed’s Preferred Inflation Measures,‖ has been added, which discusses

    the different measures the Federal Reserve uses to measure inflation and why their preferred

    measure is the personal consumption expenditures price index rather than the CPI ; Teaching Notes

     I. National Income Accounting: The Measurement of Production, Income, and Expenditure

    (Sec. 2.1)

    A. National income accounts: an accounting framework used in measuring current economic

    activity

    B. Three alternative approaches give the same measurements

    1. Product approach: the amount of output produced

    2. Income approach: the incomes generated by production

    3. Expenditure approach: the amount of spending by purchasers

    C. Juice business example shows that all three approaches are equal

    1. Important concept in product approach: value added value of output minus value of inputs

    purchased from other producers

    D. Why are the three approaches equivalent?

    1. They must be, by definition

    2. Any output produced (product approach) is purchased by someone (expenditure approach)

    and results in income to someone (income approach)

    3. The fundamental identity of national income accounting:

     total production total income total expenditure (2.1)

    ?2011 Pearson Education, Inc.

    12 Abel/Bernanke/Croushore Macroeconomics, Seventh Edition

     II. Gross Domestic Product (Sec. 2.2)

    A. The product approach to measuring GDP

    1. GDP (gross domestic product) is the market value of final goods and services newly

    produced within a nation during a fixed period of time

    Data Application

    The period referred to here is either a quarter or a year. You may want to show students what some of the tables from the National Income and Product Accounts look like, or send them to the library (or the Internet at www.bea.doc.gov) to find the accounts in the Survey of Current

    Business.

    Students are also interested in seeing what happens in the financial markets and to public opinion on the day a new GDP report comes out.

    2. Market value: allows adding together unlike items by valuing them at their market prices

    a. Problem: misses nonmarket items such as homemaking, the value of environmental

    quality, and natural resource depletion

    Analytical Problems 1 and 3 both discuss difficulties in counting nonmarket items for GDP, including the important idea that GDP is not the same as welfare.

    b. There is some adjustment to reflect the underground economy

    c. Government services (that aren’t sold in markets) are valued at their cost of production

    3. Newly produced: counts only things produced in the given period; excludes things produced

    earlier

    4. Final goods and services

    a. Don’t count intermediate goods and services (those used up in the production of other

    goods and services in the same period that they themselves were produced)

    b. Final goods & services are those that are not intermediate

    c. Capital goods (goods used to produce other goods) are final goods since they aren’t used

    up in the same period that they are produced

    d. Inventory investment (the amount that inventories of unsold finished goods, goods

    in process, and raw materials have changed during the period) is also treated as a final

    good

    e. Adding up value added works well, since it automatically excludes intermediate goods 5. GNP vs. GDP

    a. GNP (gross national product) output produced by domestically owned factors

    of production

     GDP output produced within a nation

    b. GDP GNP NFP (net factor payments from abroad) (2.2)

    c. NFP payments to domestically owned factors located abroad minus payments

    to foreign factors located domestically

    ?2011 Pearson Education, Inc.

    Chapter 2 The Measurement and Structure of the National Economy 13

Data Application

    Prior to December 1991, the United States used GNP as its main measure of production; after that time GDP became the main concept. The main reasons for the switch were that GDP is more relevant to production in an open economy (though GNP is more relevant for income), and GDP is more precise than GNP in the advance estimate, since net factor payments are difficult to measure quickly. See Survey of Current Business, November 1991, for a discussion of the switch.

    d. Example: Engineering revenues for a road built by a U.S. company in Saudi Arabia is

    part of U.S. GNP (built by a U.S. factor of production), not U.S. GDP, and is part of

    Saudi GDP (built in Saudi Arabia), not Saudi GNP

    e. Difference between GNP and GDP is small for the United States, about 0.2%, but higher

    for countries that have many citizens working abroad

    Data Application

    The timeline for national income and product account releases is generally:

    Advance release Last week of month following end of quarter

    Preliminary release Last week of second following month

    Final release Last week of third following month

    Revisions occur every July for the following three years, then every fifth year for a new benchmark release. Each new release contains either additional new data that was not available before, or a change in seasonal factors, or a correction of errors made previously. B. The expenditure approach to measuring GDP

    1. Measures total spending on final goods and services produced within a nation during a

    specified period of time

    2. Four main categories of spending: consumption (C), investment (I), government purchases

    of goods and services (G), and net exports (NX)

    3. Y C I G NX, the income-expenditure identity (2.3)

    4. Consumption: spending by domestic households on final goods and services

    (including those produced abroad)

    a. About 2/3 of U.S. GDP

    b. Three categories

    (1) Consumer durables (examples: cars, TV sets, furniture, and major appliances)

    (2) Nondurable goods (examples: food, clothing, fuel)

    (3) Services (examples: education, health care, financial services, and transportation) Data Application

    Note that the consumption category in the national income and product accounts does not correspond to economists’ concept of consumption, because it includes the full value of durable

    goods. When economists study consumption behavior, they must account for this; one way to do so is to assume that durable goods provide services that are proportional to their existing stock. Total consumption is this fraction of the stock of consumer durables, plus nondurables and services.

    ?2011 Pearson Education, Inc.

    14 Abel/Bernanke/Croushore Macroeconomics, Seventh Edition

    5. Investment: spending for new capital goods (fixed investment) plus inventory investment

    a. About 1/6 of U.S. GDP

    b. Business (or nonresidential) fixed investment: spending by businesses on structures and

    equipment and software

    c. Residential fixed investment: spending on the construction of houses and apartment

    buildings

    d. Inventory investment: increases in firms’ inventory holdings

    Data Application

    A major change in the national income and product accounts came in October 1999, when computer software purchased by businesses and government was classified as investment, rather than an input used up in production. As a result, real GDP and investment were revised up significantly, especially for the 1990s.

    6. Government purchases of goods and services: spending by the government on goods or

    services

    a. About 1/5 of U.S. GDP

    b. Most by state and local governments, not federal government

    c. Not all government expenditures are purchases of goods and services

    (1) Some are payments that are not made in exchange for current goods and services

    (2) One type is transfers, including Social Security payments, welfare, and

    unemployment benefits

    (3) Another type is interest payments on the government debt

    d. Some government spending is for capital goods that add to the nation’s capital stock, such

    as highways, airports, bridges, and water and sewer systems

    Data Application

    People often don’t realize how large transfer programs are relative to federal government consumption expenditures. For example, in 2002, transfer payments were $932 billion, while government consumption expenditures were only $587 billion. Of that amount, most ($387 billion) was for national defense; nondefense consumption expenditures ($200 billion) were less than one-fourth of the amount of transfers. Other federal government expenditures included $306 billion in grants to state and local governments, $208 billion in net interest paid, and $44 billion in net subsidies to government enterprises. Gross investment by the federal government ($107 billion) was just slightly more than depreciation ($102 billion), so net investment was small ($5 billion).

    7. Net exports: exports minus imports

    a. Exports: goods produced in the country that are purchased by foreigners

    b. Imports: goods produced abroad that are purchased by residents in the country

    c. Imports are subtracted from GDP, as they represent goods produced abroad, and were

    included in consumption, investment, and government purchases

    ?2011 Pearson Education, Inc.

    Chapter 2 The Measurement and Structure of the National Economy 15

    Data Application

    Behind the scenes at the Bureau of Economic Analysis (BEA), a major change is taking place concerning the national income accounts and the data on GDP. Because the types of goods and services people buy has changed so much in recent years, the BEA has decided to modify how it categorizes industries when it collects data on production. The new system is known as NAICS: the North American Industry Classification System; it replaces a system called SIC: Standard Industrial Classification. NAICS differs from SIC in both principle and in practice. The key principle governing NAICS is that firms that use similar production processes will be classified in the same industry, which was not true under SIC. The result is that the number of firms in different industries will change; for example, the manufacturing industry is different under NAICS than under SIC.

    One of the main reasons for the switch from SIC to NAICS is the growth of service industries and computer-related industries. In the past 70 years, manufacturing output has declined from 54 percent of GDP to 38 percent, while the output of service industries has increased from 35 percent of GDP to 54 percent. The SIC has not been updated to reflect the changes in the economy. NAICS will also improve the compatibility of U.S. statistics with those in other countries.

    The disadvantage of the switch from SIC to NAICS is that data from today based on NAICS will not be exactly comparable to data from the past based on SIC. But the BEA believes that the improved quality of the data will justify the loss of historical comparability. In addition, NAICS has the advantage of being very adaptable when industries change; for example, its information sector includes such categories as Internet publishing and broadcasting. Adding new categories will not be difficult as technology changes further and new industries evolve.

    C. The income approach to measuring GDP

    1. Adds up income generated by production (including profits and taxes paid to the government)

    a. National income compensation of employees (including benefits) proprietors’

    income rental income of persons corporate profits net interest taxes on production

    and imports business current transfer payments current surplus of government

    enterprises

    Data Application

    Note that the definition of income was changed in several ways in 2003. Several categories were broken down in more detail, indirect business taxes were included in the larger category of taxes on production and imports, and less netting was done for transfers, interest, and surplus or subsidies of government enterprises.

    b. National income statistical discrepancy net national product

    c. Net national product depreciation (the value of capital that wears out in the period)

    gross national product (GNP)

    d. GNP net factor payments (NFP) GDP

    2. Private sector and government sector income

    a. Private disposable income income of the private sector private sector income

    earned at home (Y or GDP) and abroad (NFP) payments from the government sector

    (transfers, TR, and interest on government debt, INT) taxes paid to government

     (T) Y NFP TR INT T (2.4)

    ?2011 Pearson Education, Inc.

    16 Abel/Bernanke/Croushore Macroeconomics, Seventh Edition

    b. Government’s net income taxes transfers interest payments T TR INT (2.5)

    c. Private disposable income government’s net income GDP NFP GNP Numerical Problems 1, 2, 3, 4, and 5 provide practice in working with the national income and

    product accounts.

    III. Saving and Wealth (Sec. 2.3)

    A. Wealth

    1. Household wealth a household’s assets minus its liabilities

    2. National wealth sum of all households’, firms’, and governments’ wealth within the nation

    3. Saving by individuals, businesses, and government determine wealth

    B. Measures of aggregate saving

    1. Saving current income current spending

    2. Saving rate saving/current income

    3. Private saving private disposable income consumption

     S (Y NFP T TR INT) C (2.6) pvt

    4. Government saving net government income government purchases of goods and services

     S (T TR INT) G (2.7) govt

    a. Government saving government budget surplus government receipts government

    outlays

    b. Government receipts tax revenue (T)

    c. Government outlays government purchases of goods and services (G) transfers (TR)

    interest payments on government debt (INT)

    d. Government budget deficit S govt

    e. Despite the BEA’s change in methods that explicitly recognize government investment,

    the text simplifies matters by counting government investment as government purchases,

    not investment. This avoids complications when the concepts are introduced and can be

    modified for further analysis later.

    5. National saving

    a. National saving private saving government saving

    b. S S S pvtgovt

     [Y NFP T TR INT C] [T TR INT G] (2.8)

     Y NFP C G GNP C G

    C. The uses of private saving

    1. S I (NX NFP) (2.9)

     S I CA (2.10)

     Derived from S Y NFP C G and Y C I G NX

     CA NX NFP current account balance

    ?2011 Pearson Education, Inc.

    Chapter 2 The Measurement and Structure of the National Economy 17 2. S I (S) CA (2.11) pvtgovt

     {using S S S} pvtgovt

     The uses-of-saving identitysaving is used in three ways:

    a. investment (I)

    b. government budget deficit (S) govt

    c. current account balance (CA)

    Analytical Problem 4 has students examine how the uses-of-savings identity would change if we redefined government saving so that government investment was separate from government consumption expenditures, so that G GCE GI and S (T TR INT) GCE. govt

    D. Relating saving and wealth

    1. Stocks and flows

    a. Flow variables: measured per unit of time (GDP, income, saving, investment) b. Stock variables: measured at a point in time (quantity of money, value of houses, capital stock) c. Flow variables often equal rates of change of stock variables

    2. Wealth and saving as stock and flow (wealth is a stock, saving is a flow) 3. National wealth: domestic physical assets net foreign assets

    a. Country’s domestic physical assets (capital goods and land)

    b. Country’s net foreign assets foreign assets (foreign stocks, bonds, and capital goods

    owned by domestic residents) minus foreign liabilities (domestic stocks, bonds, and

    capital goods owned by foreigners)

    c. Wealth matters because the economic well-being of a country depends on it d. Changes in national wealth

    (1) Change in value of existing assets and liabilities (change in price of financial assets,

    or depreciation of capital goods)

    (2) National saving (S I CA) raises wealth

    e. Comparison of U.S. saving and investment with other countries

    (1) The United States is a low-saving country; Japan is a high-saving country

    (2) U.S. investment exceeds U.S. saving, so we have a negative current-account balance

    IV. Real GDP, Price Indexes, and Inflation (Sec. 2.4)

    A. Real GDP

    1. Nominal variables are those in dollar terms

    2. Problem: do changes in nominal values reflect changes in prices or quantities? 3. Real variables: adjust for price changes; reflect only quantity changes 4. Example of computers and bicycles

    5. Nominal GDP is the dollar value of an economy’s final output measured at current market prices

    6. Real GDP is an estimate of the value of an economy’s final output, adjusting for changes

    in the overall price level

    ?2011 Pearson Education, Inc.

    18 Abel/Bernanke/Croushore Macroeconomics, Seventh Edition

    Data Application

    The first time that the national income and product accounts reported real GNP was in February

    1959; prior to that time, inflation was usually so low that nominal GNP was all that it was thought necessary to examine.

    Numerical Problem 5 provides practice in calculating real and nominal GDP and price indexes given several goods with different prices and quantities in two years.

    B. Price Indexes

    1. A price index measures the average level of prices for some specified set of goods and

    services, relative to the prices in a specified base year

    2. GDP deflator 100 nominal GDP/real GDP

    Data Application

    There are two price indexes available for consumption expenditures: the price index for personal consumption expenditures (PCE) and the consumer price index (CPI). The CPI is available monthly, while the PCE price index is only available quarterly, but provides a better measure of inflation for most purposes, which is why it’s the main inflation measure used by the Federal

    Reserve.

    3. Note that base year P 100

    4. Consumer Price Index (CPI)

    a. Monthly index of consumer prices; index averages 100 in reference base period

    (1982 to 1984)

    b. Based on basket of goods in expenditure base period (2003 to 2004) 5. In Touch with Data and Research: The computer revolution and chain-weighted GDP

    a. Choice of expenditure base period matters for GDP when prices and quantities of a good,

    such as computers, are changing rapidly

    b. BEA compromised by developing chain-weighted GDP

    c. Now, however, components of real GDP don’t add up to real GDP, but discrepancy is

    usually small

    Data Application

    Calculating chain-weighted indexes is not too hard and you can use the computer-bicycle example in Table 2.4 to illustrate how to do so. Define the Laspeyres quantity index (using year 1 prices) for year 1 as the value of year 1 output at year 1 prices: L $46,000; the Laspeyres 1

    quantity index of year 2 output is L $62,000. Define the Paasche quantity index (using year 2 2

    prices) for year 1 as the value of year 1 output at year 2 prices: P $51,000; the Paasche quantity 1

    index of year 2 output is P $66,000. (These amounts are all calculated in Table 2.4, they just 2

    are not labeled this way.) The chain-weighted index is just the geometric mean of the Laspeyres 1/21/21/2and Paasche indexes: C (L P) (46,000 51,000) $48,400; C (L P) (62,000 1 112 221/2 66,000) $63,970.

    Note that the growth rate of real GDP in this case is ($63,970 $48,400)/$48,400 32.06%,

    which is close to the average growth rate calculated by the Laspeyres (34.8%) and Paasche (29.4%) indexes, which is 32.095%.

    ?2011 Pearson Education, Inc.

    Chapter 2 The Measurement and Structure of the National Economy 19

    6. Inflation

    a. Calculate inflation rate: ( (P P)/P P/P t1t1ttt1t

    b. Text Fig. 2.4 shows the U.S. inflation rate since 1960 for the GDP deflator

7. In Touch With Data and Research: CPI inflation vs Core Inflation

     a. CPI inflation is not an accurate measure of the cost of living

     Price indexes with fixed sets of goods don’t reflect substitution by consumers when

    one good becomes relatively cheaper than another

     The fixed basket does not reflect the declining prices of new technology goods

     Some commodities such as foods and energy are prone to fluctuations

    b. Core inflation rate is sometime used to get a more accurate measure of inflation

    c. It excludes commodities with volatile prices and extreme individual price movement

    d. Core inflation reflects changes in inflation that are not transitory but long-lived therefore it

    helps individuals in making better decisions

Data Application

    A symposium on the CPI appeared in the Journal of Economic Perspectives 12 (Winter 1998).

    Many different aspects of measurement problems are explored. Although the BLS claims that quality adjustments are made, William Nordhaus points out that other than in the categories of new cars and trucks and women’s apparel, only 0.1 percent of all priced commodities were deemed to have quality changes in a recent year.

C. Application: The Fed’s preferred inflation measures

    1. The Federal Reserve focuses its attention on the personal consumption expenditures (PCE)

    price index

    a. The Fed forecasts both the overall PCE price index and the core PCE price index 2. The PCE price index is superior to the CPI because it avoids substitution bias and is revised

    when better data are available

    3. Differences between the PCE price index and the CPI include formulas used in their

    calculation, coverage of different items, and weights given to different items 4. The Fed uses the core PCE price index to measure the underlying trend in inflation 5. But the Fed forecasts both the core and overall PCE price index because the Fed needs to

    keep its eye on both underlying trends but also the actual inflation rate faced by households 6. The inflation rate in the overall PCE price index tends to revert to the core measure after a

    period when the two measures deviate

    ?2011 Pearson Education, Inc.

20 Abel/Bernanke/Croushore Macroeconomics, Seventh Edition

    Data Application

    There are many problems with price indexes; they are imperfect measures of price changes.

    What do the indexes do when new goods are introduced? What happens as more efficient stores

    replaces stores that had higher intermediate costs? How do we account for the fact that people

    substitute cheaper goods for higher-priced goods? Inadequate treatment of these questions means

    the measures of prices give an overestimate of the inflation rate. The BLS has fixed a number of

    these problems in recent years, but some overestimate remains. In a recent comprehensive review

    of these measurement issues, David E. Lebow and Jeremy B. Rudd (―Measurement Error in the

    Consumer Price Index: Where Do We Stand?‖ Journal of Economic Literature (March 2003),

    pp. 159201) conclude that the overestimate of inflation in the CPI is now about 0.9 percent per

    year. More recently, Robert Gordon suggests that the overstatement may still exceed 1.0 percent

    per year (―The Boskin Commission Report: A Retrospective One Decade Later,‖ NBER

    Working Paper No. 12311, June 2006.).

    Numerical Problems 7 and 9 give practice in calculating inflation rates.

     V. Interest Rates (Sec. 2.5)

    A. Real vs. nominal interest rates

    1. Interest rate: a rate of return promised by a borrower to a lender

    2. Real interest rate: rate at which the real value of an asset increases over time

    3. Nominal interest rate: rate at which the nominal value of an asset increases over time

    4. Real interest rate i (;(2.12)

     Text Fig. 2.5 plots nominal and real interest rates for the United States since 1960

    B. The expected real interest rate

    e 1. r i ((2.13)

    e2. If ( (, real interest rate expected real interest rate

    Numerical Problem 8 provides practice in calculating real interest rates.

    ; Additional Issues for Classroom Discussion

    1. Welfare Does Not Equal GDP

    You can get students involved in a useful discussion of how our national-income accounts fail to measure our well-being. GDP covers only market activity. Ask your students to come up with some non-market activities that are valuable to society, but which aren’t covered as part of GDP. Then you might discuss some activities that increase GDP but reduce welfare in some way, such as activities that cause pollution. The San Francisco think tank called ―Redefining Progress‖ collects data on what it labels ―genuine progress‖ and compares it to GDP. The genuine progress indicator (GPI) has been declining since the

    mid-1960s, even though real GDP has been rising. Unlike GDP, which measures only market activity, the GPI accounts for resource depletion, income distribution, housework and nonmarket transactions, changes in leisure time, unemployment and underemployment, pollution, long-term environmental damage, the lifespan of consumer durables and infrastructure, defensive expenditures, and sustainable investments.

    ?2011 Pearson Education, Inc.

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