measuring the economy 1

8/4/2019 Measuring the Economy 1

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Measuring the Economy 1

Terms and Formulas

TermsBase year - The year from which constant prices or quantities are taken in calculationsof such indices as real GDP and CPI.Bureau of Labor Statistics - The government organization responsible for regularlygathering data about the economic status of the population.Consumer price index (CPI) - A cost of living index that measures the total cost ofgoods and services purchased by a typical consumer within a country.Fixed basket - A set group of goods and services whose quantities do not change overtime. This is used, for instance, in the calculation of the CPI.Gross domestic product (GDP) - The sum of the market values of all final goods andservices produced within a particular country during a period of time.

Gross domestic product deflator (GDP deflator) - The ratio of nominal GDP to realGDP for a given year minus 1. The GDP deflator shows how much of the change in theGDP from a base year is reliant on changes in the price level.Gross domestic product per capita (GDP per capita) - GDP divided by the number ofpeople in the population. This measure describes what portion of the GDP an averageindividual gets.Gross national product (GNP) - An alternative measure of economic activity to GDP.GNP is the sum of the market values of all goods and services produced by the citizens ofa country regardless of their physical location.Nominal gross domestic product (nominal GDP) - The sum value of goods andservices produced in a country and valued at current prices.

Real gross domestic product (real GDP) - The sum value of goods and servicesproduced in a country and valued at constant prices, calibrated from some base year. RealGDP frees year-to-year comparisons of output from the effects of changes in the pricelevel.

Formulae

Gross Domestic Product

GDP = [(quantity of A X price of A) + (quantity of B Xprice of B) + ... + (quantity of N X price of N)] forevery good and service produced within the country

GDP = (national income) = Y = (C + I + G + NX)

GDP Growth RateGDP growth rate = [(GDP for year N) / (GDP for yearN-1)] - 1

GDP Deflator GDP deflator = [(nominal GDP) / (real GDP)] - 1

GDP Per Capita GDP per capita = (GDP) / (population)


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Gross Domestic Product (GDP)

The Gross Domestic Product measures the value of economic activity within a country.Strictly defined, GDP is the sum of the market values, or prices, of all final goods andservices produced in an economy during a period of time. There are, however, three

important distinctions within this seemingly simple definition:

1. GDP is a number that expresses the worth of the output of a country in localcurrency.

2. GDP tries to capture all final goods and services as long as they are producedwithin the country, thereby assuring that the final monetary value of everythingthat is created in a country is represented in the GDP.

3. GDP is calculated for a specific period of time, usually a year or a quarter of ayear.

Taken together, these three aspects of GNP calculation provide a standard basis for the

comparison of GDP across both time and distinct national economies.

Computing GDP

Now that we have an idea of what GDP is, let's go over how to compute it. We know thatin an economy, GDP is the monetary value of all final goods and services produced. Forexample, let's say Country B only produces bananas and backrubs.

Figure %: Goods and Services Produced in Country B

In year 1 they produce 5 bananas that are worth $1 each and 5 backrubs that are worth $6each. The GDP for the country in this year equals (quantity of bananas X price ofbananas) + (quantity of backrubs X price of backrubs) or (5 X $1) + (5 X $6) = $35. Asmore goods and services are produced, the equation lengthens. In general, GDP =(quantity of A X price of A) + (quantity of B X price of B) + (quantity of whatever Xprice of whatever) for every good and service produced within the country.

In the real world, the market values of many goods and services must be calculated todetermine GDP. While the total output of GDP is important, the breakdown of this outputinto the large structures of the economy can often be just as important. In general,macroeconomists use a standard set of categories to breakdown an economy into itsmajor constituent parts; in these instances, GDP is the sum of consumer spending,investment, government purchases, and net exports, as represented by the equation:


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Y = C + I + G + NXBecause in this equation Y captures every segment of the national economy, Y representsboth GDP and the national income. This because when money changes hands, it isexpenditure for one party and income for the other, and Y, capturing all these values, thusrepresents the net of the entire economy.

Let's briefly examine each of the components of GDP.

Consumer spending, C, is the sum of expenditures by households on durablegoods, nondurable goods, and services. Examples include clothing, food, andhealth care.

Investment, I, is the sum of expenditures on capital equipment, inventories, andstructures. Examples include machinery, unsold products, and housing.

Government spending, G, is the sum of expenditures by all government bodies ongoods and services. Examples include naval ships and salaries to governmentemployees.

Net exports, NX, equals the difference between spending on domestic goods byforeigners and spending on foreign goods by domestic residents. In other words,net exports describes the difference between exports and imports.

GDP vs. GNP

GDP is just one way of measuring the total output of an economy. Gross NationalProduct, or GNP, is another method. GDP, as said earlier, is the sum value of all goodsand services produced within a country. GNP narrows this definition a bit: it is the sumvalue of all goods and services produced by permanent residents of a country regardlessof their location. The important distinction between GDP and GNP rests on differences in

counting production by foreigners in a country and by nationals outside of a country. Forthe GDP of a particular country, production by foreigners within that country is countedand production by nationals outside of that country is not counted. For GNP, production by foreigners within a particular country is not counted and production by nationalsoutside of that country is counted. Thus, while GDP is the value of goods and servicesproduced within a country, GNP is the value of goods and services produced by citizensof a country.

For example, in Country B, represented in , bananas are produced by nationals andbackrubs are produced by foreigners. Using figure 1, GDP for Country B in year 1 is (5 X$1) + (5 X $6) = $35. GNP for country B is (5 X $1) = $5, since the $30 from backrubs is

added to the GNP of the foreigners' country of origin.

The distinction between GDP and GNP is theoretically important, but not often practically consequential. Since the majority of production within a country is bynationals within that country, GDP and GNP are usually very close together. In general,macroeconomists rely on GDP as the measure of a country's total output.


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Growth Rate of GDP

GDP is an excellent index with which to compare the economy at two points in time.That comparison can then be used formulate the growth rate of total output within anation.

In order to calculate the GDP growth rate, subtract 1 from the value received by dividingthe GDP for the first year by the GDP for the second year.

GDP growth rate = [(GDP1)/(GDP2] - 1For example, using , in year 1 Country B produced 5 bananas worth $1 each and 5backrubs worth $6 each. In year 2 Country B produced 10 bananas worth $1 each and 7backrubs worth $6 each. In this case the GDP growth rate from year 1 to year 2 would be:[(10 X $1) + (7 X $6)] / [(5 X $1) + (5 X $6)] - 1 = 49%

There is an obvious problem with this method of computing growth in total output: both

increases in the price of goods produced and increases in the quantity of goods producedlead to increases in GDP. From the GDP growth rate it is therefore difficult to determineif it is the amount of output that is changing or if it is the price of output undergoingchange.

This limitation means that an increase in GDP does not necessarily imply that aneconomy is growing. If, for example, Country B produced in one year 5 bananas eachworth $1 and 5 backrubs each worth $6, then the GDP would be $35. If in the next yearthe price of bananas jumps to $2 and the quantities produced remain the same, then theGDP of Country B would be $40. While the market value of the goods and servicesproduced by Country B increased, the amount of goods and services produced did not.

This problem can make comparison of GDP from one year to the next difficult aschanges in GDP are not necessarily due to economic growth.

Real GDP vs. Nominal GDP

In order to deal with the ambiguity inherent in the growth rate of GDP, macroeconomistshave created two different types of GDP, nominal GDP and real GDP.

Nominal GDP is the sum value of all produced goods and services at currentprices. This is the GDP that is explained in the sections above. Nominal GDP ismore useful than real GDP when comparing sheer output, rather than the value of

output, over time. Real GDP is the sum value of all produced goods and services at constant prices.

The prices used in the computation of real GDP are gleaned from a specified baseyear. By keeping the prices constant in the computation of real GDP, it is possibleto compare the economic growth from one year to the next in terms of productionof goods and services rather than the market value of these goods and services. Inthis way, real GDP frees year-to-year comparisons of output from the effects ofchanges in the price level.


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The first step to calculating real GDP is choosing a base year. For example, to calculatethe real GDP for in year 3 using year 1 as the base year, use the GDP equation with year3 quantities and year 1 prices. In this case, real GDP is (10 X $1) + (9 X $6) = $64. Forcomparison, the nominal GDP in year 3 is (10 X $2) + (9 X $6) = $74. Because the priceof bananas increased from year 1 to year 3, the nominal GDP increased more than the

real GDP over this time period.

GDP Deflator

When comparing GDP between years, nominal GDP and real GDP capture differentelements of the change. Nominal GDP captures both changes in quantity and changes inprices. Real GDP, on the other hand, captures only changes in quantity and is insensitiveto the price level. Because of this difference, after computing nominal GDP and real GDPa third useful statistic can be computed. The GDP deflator is the ratio of nominal GDP toreal GDP for a given year minus 1. In effect, the GDP deflator illustrates how much ofthe change in the GDP from a base year is reliant on changes in the price level.

For example, let's calculate, using , the GDP deflator for Country B in year 3, using year1 as the base year. In order to find the GDP deflator, we first must determine bothnominal GDP and real GDP in year 3.

Nominal GDP in year 3 = (10 X $2) + (9 X $6) = $74Real GDP in year 3 (with year 1 as base year) = (10 X $1) + (9 X $6) = $64The ratio of nominal GDP to real GDP is ( $74 / $64 ) - 1 = 16%.This means that the price level rose 16% from year 1, the base year, to year 3, thecomparison year.

Rearranging the terms in the equation for the GDP deflator allows for the calculation ofnominal GDP by multiplying real GDP and the GDP deflator. This equation demonstratesthe unique information shown by each of these measures of output. Real GDP captureschanges in quantities. The GDP deflator captures changes in the price level. NominalGDP captures both changes in prices and changes in quantities. By using nominal GDP,real GDP, and the GDP deflator you can look at a change in GDP and break it down intoits component change in price level and change in quantities produced.

GDP Per Capita

GDP is the single most useful number when describing the size and growth of a country's

economy. An important thing to consider, though, is how GDP is connected withstandard of living. After all, to the citizens of a country, the economy itself is lessimportant than the standard of living that it provides.

GDP per capita, the GDP divided by the size of the population, gives the amount of GDPthat each individual gets, on average, and thereby provides an excellent measure ofstandard of living within an economy. Because GDP is equal to national income, thevalue of GDP per capita is therefore the income of a representative individual. This


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number is connected directly to standard of living. In general, the higher GDP per capitain a country, the higher the standard of living.

GDP per capita is a more useful measure than GDP for determining standard of livingbecause of differences in population across countries. If a country has a large GDP and a

very large population, each person in the country may have a low income and thus maylive in poor conditions. On the other hand, a country may have a moderate GDP but avery small population and thus a high individual income. Using the GDP per capitameasure to compare standard of living across countries avoids the problem of division ofGDP among the inhabitants of a country.

Consumer Price Index (CPI)

The consumer price index or CPI is a more direct measure than per capita GDP of thestandard of living in a country. It is based on the overall cost of a fixed basket of goodsand services bought by a typical consumer, relative to price of the same basket in some

base year. By including a broad range of thousands of goods and services with the fixedbasket, the CPI can obtain an accurate estimate of the cost of living. It is important toremember that the CPI is not a dollar value like GDP, but instead an index number or apercentage change from the base year.

Constructing the CPI

Each month, the Bureau of Labor Statistics publishes an updated CPI. While in practicethis is a rather daunting task that requires the consideration of thousands of items andprices, in theory computing the CPI is simple.

The CPI is computed through a four-step process.

1. The fixed basket of goods and services is defined. This requires figuring outwhere the typical consumer spends his or her money. The Bureau of LaborStatistics surveys consumers to gather this information.

2. The prices for every item in the fixed basket are found. Since the same basket ofgoods and services is used across a number of time periods to determine changesin the CPI, the price for every item in the fixed basket must be found for everypoint in time.

3. The cost of the fixed basket of goods and services must be calculated for eachtime period. Like computing GDP, the cost of the fixed basket of goods and

services is found by multiplying the quantity of each item times its price.4. A base year is chosen and the index is computed. The price of the fixed basket of

goods and services for each comparison year is then divided by the price of thefixed basket of goods in the base year. The result is multiplied by 100 to give therelative level of the cost of living between the base year and the comparisonyears.


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Figure %: Goods and Services Consumed in Country B

For example, let's compute the CPI for Country B. In this simplified example, consumersin Country B only purchase bananas and backrubs (lucky fools). The first step is to fixthe basket of goods. The typical consumer in Country B purchases 5 bananas and 2backrubs in a given period of time, so our fixed basket is 5 bananas and 2 backrubs. Thesecond step is to find the prices of these items for each time period. This data is reportedin the table, above. The third step is to compute the basket's cost for each time period. Intime period 1 the fixed basket costs (5 X $1) + (2 X $6) = $17. In time period 2 the fixedbasket costs (5 X $2) + (2 X $7) = $24. In time period 3 the fixed basket costs (5 X $3) +(2 X $8) = $31. The fourth step is to choose a base year and to compute the CPI. Sinceany year can serve as the base year, let's choose time period 1. The CPI for time period 1is ($17 / $17) X 100 = 100. The CPI for time period 2 is ($24 / $17) X 100 = 141. TheCPI for time period 3 is ($31 / $17) X 100 = 182. Since the price of the goods andservices that comprise the fixed basket increased from time period 1 to time period 3, theCPI also increased. This shows that the cost of living increased across this time period.

Changes in the CPI over time

As we have just seen, the CPI changes over time as the prices associated with the items inthe fixed basket of goods change. In the example just explored, the CPI of Country Bincreased from 100 to 141 to 182 from time period 1 to time period 3. The percent changein the price level from the base year to the comparison year is calculated by subtracting100 from the CPI. In this example, the percent change in the price level from the baseperiod (time period 1) to time period 2 is 141 - 100 = 41%. The percent change in theprice level from time period 1 to time period 3 is 182 - 100 = 82%. In this way, changesin the cost of living can be calculated across time.

Problems with the CPI

While the CPI is a convenient way to compute the cost of living and the relative pricelevel across time, because it is based on a fixed basket of goods, it does not provide acompletely accurate estimate of the cost of living. Three problems with the CPI deservemention: the substitution bias, the introduction of new items, and quality changes. Let'sexamine each of these in detail.

Substitution Bias


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The first problem with the CPI is the substitution bias. As the prices of goods andservices change from one year to the next, they do not all change by the same amount.The number of specific items that consumers purchase changes depending upon therelative prices of items in the fixed basket. But since the basket is fixed, the CPI does notreflect consumer's preference for items that increase in price little from one year to the

next. For example, if the price of backrubs in Country B jumped to $20 in time period 4while the cost of bananas remained fixed at $3, consumer would likely purchase more bananas and fewer backrubs. This intuitive phenomenon of consumers substitutingpurchase of low priced items for higher priced items is not accounted for by the CPI.

Introduction of New Items

The second problem with the CPI is the introduction of new items. As time goes on, newitems enter into the basket of goods and services purchased by the typical consumer. Forexample, if in time period 4 consumers in Country B began to purchase books, this wouldneed to be included in an accurate estimate of the cost of living. But since the CPI uses

only a fixed basket of goods, the introduction of a new product cannot be reflected.Instead, the new items, books, are left out of the calculation in order to keep time period 4comparable with the earlier time periods.

Quality Changes

The third problem with the CPI is that changes in the quality of goods and services arenot well handled. When an item in the fixed basket of goods used to compute the CPIincreases or decreases in quality, the value and desirability of the item changes. Forexample, if backrubs in time period 4 suddenly became much more satisfying than inearlier time periods, but the price of backrubs did not change, then the cost of living

would remain the same while the standard of living would increase. This change wouldnot be reflected in the CPI from one year to the next. While the Bureau of Labor Statisticsattempts to correct this problem by adjusting the price of goods in the calculations, inreality this remains a major problem for the CPI.

measuring the economy 1

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