output and inflation are we measuring them correctly?

Output and Inflation

Are We Measuring Them Correctly?

Measuring Economic Welfare

• The standard benchmark for economic well being is Gross Domestic Product (GDP)



• GDP is defined as the current market value of all goods and services produced within a country’s borders during a fixed time period (the BEA measures GDP on a quarterly basis)



• GDP is defined as the current market value of all goods and services produced within a country’s borders during a fixed time period (the BEA measures GDP on a quarterly basis)

• Is GDP an adequate measure of economic well being?

GDP vs. GNP

• While GDP allocates production based on location, GNP (Gross National Product) allocates production based on nationality

GDP vs. GNP


• GNP is defined as the total market value of goods and services produced by a country’s citizens

GDP vs. GNP


• GNP is defined as the total market value of goods and services produced by a country’s citizens

• GDP = GNP – Net Factor Payments

Example: GNP vs. GDP

• Suppose that Toyota has a plant in Ohio producing $100M worth of cars per year. Toyota’s labor costs are $70M per year.



• Meanwhile, Nike has a plant in Singapore producing $200M worth of sneakers per year. Nike’s labor costs are $10M per year



• Meanwhile, Nike has a plant in Singapore producing $200M worth of sneakers per year. Nike’s labor costs are $10M per year

• There is $300M in total production. How much does the US get credit for?


• GDP in the US would include the entire $100M worth of cars, but none of the $200M in sneakers.



• GNP would count the $70M earned by US workers plus the $190M earned by Nike shareholders abroad for a total of $260M




• Net Factor Payments are equal to income earned abroad by US citizens minus income earned by foreign citizens in the US





• In the case, NFP = $190M - $30M = $160M





• In the case, NFP = $190M - $30M = $160M

• Recall, GDP = GNP - NFP

Calculating GDP

• Rule #1: Be sure and count everything!

Calculating GDP

• Rule #1: Be sure and count everything!

• Rule #2: Don’t count anything more than once!

Calculating GDP: An easy example

• There are two farmers: one farmer produces 1,000 bushels of oranges while the other produces 2,000 bushels of apples



• Apples cost $3/Bushel and oranges cost $2/Bushel



• Apples cost $3/Bushel and oranges cost $2/Bushel

1,000 x $2 = $2,000

+ 2,000 x $3 = $6,000

GDP = $8,000

A more complicated example

• Intel produces 1,000 computer chips (P = $100). Intel sells 900 of these chips to Dell and the remaining 100 directly to consumers.



• Dell uses 500 chips to produce 500 computers (P=$1,000) which are sold to consumers.




1,000 x $100 = $100,000

+ 500 x $1,000 = $500,000

GDP = $600,000?




1,000 x $100 = $100,000

+ 500 x $1,000 = $500,000

GDP = $600,000?

• $50, 000 worth of computer chips are already included in the value of the computers. Therefore, the above calculation counts them twice!

The Output Approach

• To avoid double counting, the output approach requires firms to report value added (value of output – value of inputs)

The Output Approach


• Note, however, that Dell actually has two types of output: consumer goods (computers) and inventories (remaining computer chips)

The Output Approach


• Note, however, that Dell actually has two types of output: consumer goods (computers) and inventories (remaining computer chips)

Intel: $100,000

- $0

$100,000

Dell: $500,000

+ $40,000

- $90,000

$450,000

Total = $550,000

The expenditure approach

• The expenditure approach recognizes that ALL produced output is purchased by someone



• Expenditures are roughly classified as consumer expenditures, business investment, government purchases, exports, and imports



• Expenditures are roughly classified as consumer expenditures, business investment, government purchases, exports, and imports

• Y = C + I + G + (X-M)

Intel: $0

Dell: $40,000 (Inventory Investment)

Consumers: $500,000

+ $10,000

$510,000

Total: $550,000

The income approach

• The value added produced in an economy will accrue to someone in the form of income

The income approach


• In the previous example, the $100,000 of value added from Intel plus the $450,000 of value added from Dell will accrue to either Intel and Dell workers in the form of wages, or the owners (shareholders) of Intel and Dell in the form of corporate profits.

The income approach



• The broad classifications of income are: wages, proprietor income, corporate profits, rental income, and interest.

The income approach



• The broad classifications of income are: wages, proprietor income, corporate profits, rental income, and interest.

• Output = Expenditures = C + I + G + NX

Flow of Funds

• Recall that Y = C + I + G + NX (Output = Expenditures)

• Further, Y = C + S + T (Income = Outlays)

Flow of Funds



C + S + T = C + I + G + NX

Flow of Funds



C + S + T = C + I + G + NX

S = I + (G-T) + NX

The NIPA Accounts

• Begun in the 1930’s, the National Income and Product Accounts are calculated on a quarterly basis by the Bureau of Economic Analysis (A division of the Department of Commerce)

• The “Advance” estimates are released approximately 1 month after the end of the quarter, followed by the “Preliminary” revision (1 month later) and the “Final” Revision (2 months later)

• Even after the Final release, the data is revised annually for 2 years and undergoes a comprehensive revision after 5 years

GDP 2004Q2 (Billions)

Category Amount (B)

% of Total Growth

Consumption $8,146.2 70% 4.0%

Investment $1,891.2 16% 12%

Government $2,172.9 18% 6%

Net Exports -561.0 -4% ----

GDP $11,649.3 100% 6.0%

Output Equals Income (Almost)

GDP ($11,649.3)

+ Net Factor Payments ($73.5)

GNP ($11,722.8)


GDP ($11,649.3)


GNP ($11,722.8)

- Depreciation ($1,370.1)

Net National Product ($10,352.7)


GDP ($11,649.3)


GNP ($11,722.8)

- Depreciation ($1,370.1)

Net National Product ($10,352.7)

- Indirect Taxes ($834.4)

National Income ($9518.3)

National Income 2004Q2Category Amount(B) % of Total Growth

Wages $6,600.6 69% 5%

Proprietor’s Income

$902.8 9% 14%

Rental Income $173.8 2% 2%

Corporate Profits $1294.2 14% 36%

Interest $546.9 6% -4%

National Income $9518.3 100% 6%

Personal Income/Outlays 2004Q2

Category Amount(B) % of Total

Personal Income $9614.8 100%

Taxes $1030.3 10%

Consumption $8146.2 85%

Interest $296.3 3%

Personal Savings

142.0 2%

Savings/Investment 2004Q2

Category Amount(B) % of Total

Gross Investment

$1631.3 100%

Depreciation $1355.0 85%

Private Saving $142.0 9%

Undistributed Profits

$506.7 31%

Government -$372.4 -25%

Borrowing by Sector 2004Q1Category Amount(B) % of Total

Total $2801.3 100%

Financial Sector $805.7 28%

Federal Government $466.0 17%

State & Local Government $149.7 5%

Non-Financial Business $303.3 11%

Household $1008.2 37%

Foreign $68.4 2%

Does GDP accurately reflect well being?

• GDP in 2003 is $10,688.4 Billion while GDP in 1950 was $275.7 Billion. (an increase of 3800%). Are we 38 times as well off now than we were in 1950?



• Real GDP (1996 $s) in 2003 was $9,562.9 Billion while Real GDP in 1950 was $1,610.5 Billion (A 600% increase). Are Americans 6 times as well of now compared to 1950?




• Real GDP per capita in 2003 is $36,911 compared to $10,736 in 1950 ( a 350% increase). Are we 3.5 times better off?




• Real GDP per capita in 2003 is $36,911 compared to $10,736 in 1950 ( a 350% increase). Are we 3.5 times better off?

• Median real income in 2003 is approximately $24,000 while median real income in 1950 was approximately $8,000 (a 300% increase)

Does GDP adequately measure welfare?

• Annual defense spending has grown from $35B in 1950 to $400B in 2003. Should this be subtracted out?



• The service industry has grown from 30M employees in 1950 to 108M in 2003. Is this really “new activity”?




• Should we count things like pollution as economic “bads”?




• Should we count things like pollution as economic “bads”?

• How do we account for the added quality and convenience of new products and technologies?

Price Indices

• We mentioned earlier that nominal variables are in terms of currency (i.e., your income is $50,000/yr) while real variables are in terms of goods (i.e., if the price of oranges is $2/orange, then your real income is 25,000 oranges per year)

Price Indices


• To calculate real variables, we divide the corresponding nominal variable by a price (i.e., 50,000/2 = 25,000).

Price Indices


• To calculate real variables, we divide the corresponding nominal variable by a price (i.e., 50,000/2 = 25,000).

• Real GDP = Nominal GDP/P , but what should we use for “price”?

Fixed Weight Indices

• A price index is meant to capture the average price of goods and services in the economy. Therefore, any price index should be a weighted average of all (or at least, most) prices in the economy.



• With any fixed weight index, the weights used in the index are chosen ex ante and remain fixed over time (hence, the name fixed weight index).



• With any fixed weight index, the weights used in the index are chosen ex ante and remain fixed over time (hence, the name fixed weight index).

• Think of the a fixed weight index as simply defining a “basket” of goods. The value of that index is the cost of that basket.

Example: A Fixed Weight Index

• Suppose that in 2002, Apples cost $3 and Oranges cost $5. In 2003, Apples cost $4 (a 30% increase) and oranges cost $6. (20% increase)



• Let’s define the price index as

.5(Apples) + .5(Oranges)





P(2002) = .5($3) + .5($5)

= $4.





P(2002) = .5($3) + .5($5)

= $4.

P(2003) = .5($4) + .5($6)

= $5




.5( Apples) + .5(Oranges)

• Usually, prices are in represented in terms of a “base year”. This is done by dividing every year by the base year price

P(2002) = .5($3) + .5($5)

= $4.

P(2003) = .5($4) + .5($6)

= $5




.5( Apples) + .5(Oranges)

• Usually, prices are in represented in terms of a “base year”. This is done by dividing every year by the base year price

P(2002) = .5($3) + .5($5)

= $4.

P(2003) = .5($4) + .5($6)

= $5

If 2002 is the “base year”, then

P(2002) = 1 (or 100)

P(2003) = $5/$4 = 1.25 (or 125)

The Consumer Price Index

40%

5%17%

6%

6%

5%

1%

4%

16%Housing

Apparel

Transportation

Medical

Recreation

Education &CommunicationTobacco & SmokingProductsPersonal Care

Food & Beverage

The Consumer Price index

• The CPI is calculated monthly by the Bureau of Labor Statistics using the fixed weights.



• The inflation rate is just the percentage change in the CPI.




• The “core inflation rate” is the the percentage change in the CPI less energy and food prices (known to be extremely volatile)




• The “core inflation rate” is the the percentage change in the CPI less energy and food prices (known to be extremely volatile)

• The producer price index (PPI) is the corporate analogue to the CPI

Problems with the CPI

• A formal commission headed by Stanford economist Michael Boskin in 1996 determined that the CPI overestimated by as much as 2.4% per year

Problems with the CPI

• A formal commission headed by Stanford economist Michael Boskin in 1996 determined that the CPI overestimated by as much as 2.4% per year

Formula Bias: .3-.4%

Substitution Bias: .2-.4%

Outlet Bias: .1-.3%

New Products: .2-.7%

Quality Bias: .2-.6%

Total: 1 - 2.4%

Why should we care?

Why should we care?

• Cost of living adjustments for social security as well as government pension plans are indexed to the CPI

Why should we care?


• All federal assistance are based on the official poverty line, which is indexed to the CPI

Why should we care?



• Tax Brackets are indexed to the CPI

Why should we care?



• Tax Brackets are indexed to the CPI• A 1% overstatement in inflation amounts to a $50-

$60 billion loss to the federal government

Variable Weight Indices

• Variable weight indices correct for the substitution bias of the CPI by allowing the weights to vary over time.



• The GDP Deflator (or, more commonly, the deflator) uses actual production of each commodity as a fraction of total GDP for the weights. Therefore as production (and, hence, consumption) of a commodity rises, so does its weight in the deflator.



• The GDP Deflator (or, more commonly, the deflator) uses actual production of each commodity as a fraction of total GDP for the weights. Therefore as production (and, hence, consumption) of a commodity rises, so does its weight in the deflator.

• The deflator is defined as

deflator = value of GDP at current prices value of GDP at base year prices

Example: Variable Weight Index




• In 2002, we had production of 100 apple and 100 oranges. In 2003 we had production of 200 apples and 150 oranges.




• Let 2002 be the base year. Note that the deflator in the base4 year is, by definition, equal to 1.





2003 GDP (Using 2003 prices)

$4(200) + $6(150) = $1700






$4(200) + $6(150) = $1700


$3(200) + $5(150) = $1350






$4(200) + $6(150) = $1700


$3(200) + $5(150) = $1350

P(2003) = $1700/$1350 = 1.26

Example: Choosing a Base Year

• Consider the following example: Apples Oranges

Price (2002) $10 $5Quantity (2002) 100 200

Price(2003) $5 $10Quantity (2003) 200 100

• There is no aggregate growth in this economy, there is only a “sectoral shift”


Using 2002 as a base year

2002

GDP = $2000

Real GDP = $2000

P = 1

2003

GDP = $2000

Real GDP = $2500

P = .8



2002

GDP = $2000

Real GDP = $2000

P = 1

2003

GDP = $2000

Real GDP = $2500

P = .8


2002

GDP = $2000

Real GDP = $2500

P = .8

2003

GDP = $2000

Real GDP = $2000

P = 1

Chain Weighting

• During periods of large relative price changes, the choice of base year is critical for determining real growth and the behavior of prices.

Chain Weighting

• During periods of large relative price changes, the choice of base year is critical for determining real growth and the behavior of prices.

• Chain weighting is a process by which a range of years is chosen for the “base year” and that range moves over time.

The New Economy

0

0.5

1

1.5

2

2.5

3

1950s 1960's 1970's 1980's 1990's

Productivity Using a Base Year

Labor ProductivityTotal Productivity

The New Economy: A fluke?

0

0.5

1

1.5

2

2.5

3

3.5

1950s 1960's 1970's 1980's 1990's

Productivity Using Chain Weighting

Labor ProductivityTotal Productivity

The New Economy?

• It was previously assumed that the productivity gains from IT eventually appeared in the mid nineties and was the underlying reason for fast growth/low inflation

The New Economy?


• When the BEA switched to chain weighting as the standard methodology for calculating real GDP, the sharp rise in productivity disappeared. Why?

The New Economy?



• During the 1990’s there was a large relative price change as goods (specifically tech goods) fell in price while the cost of services (notably health care) rose.

The New Economy?



• During the 1990’s there was a large relative price change as goods (specifically tech goods) fell in price while the cost of services (notably health care) rose.

• Apparently, the largest productivity gains from computers occurred during the 80’s, not the 90’s!

output and inflation are we measuring them correctly?

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