part 4 Monitoring the

MacroeconomyOpen any Australian newspaper or turn on the television news and you willbe confronted with macroeconomic data and issues. The news might begood or bad. During the late 1990s and most of the 2000s, it was mainlygood: Incomes and jobs were growing and prices weren’t rising too fast.Since 2007, the news has been increasingly bad, and especially bad sinceOctober 2008 when the U.S. economy went into meltdown and spread itsgloom around the world.

The goal of macroeconomists is to explain what influences the pace ofeconomic growth, economic fluctuations, unemployment, and inflation. Webreak this large topic into three parts: (1) monitoring the macroeconomy,(2) understanding the macroeconomy, and (3) macroeconomic policy—influencing the macroeconomy through government policy actions.

The two chapters in this part get you started by looking at the keyvariables that describe macroeconomic performance. You will learn howwe measure the value of total production and determine the economicgrowth rate and the standard of living; how we measure employment andunemployment; and how we use index numbers to measure the averagelevel of prices and the cost of living.

CHAPTER 18

Measuring GDP and Economic Growth

CHAPTER 19

Monitoring Jobs and Inflation

�405

Monitoring the Macroeconomy

MEASURING THE WEALTH OF NATIONS

The productivity of a nation determines its wealth. You’ll learn in this part the tight connection between the incomes peo-ple earn, what they spend, and the value of what they produce. But a popular belief is that the amount of gold (or moregenerally the amount of money) a nation possesses determines its wealth. This incorrect belief is called mercantilism andmercantilists believe that, by imposing tariffs to discourage imports and by encouraging exports, a nation can earn morethan it spends in its trade with other nations and become richer by piling up the funds that its trade surplus earns.

The first steps towards the scientific study of macroeconomics were a reaction against mercantilism, and three ofDavid Hume’s essays on money, interest, and the balance of trade were directed towards debunking it.

Hume reached conclusions by a powerful mixture of empirical evidence and thought experiments. His classic thoughtexperiment was to imagine that, by some miracle, ‘four-fifths of all the money in Great Britain ... [was] ... annihilatedin one night’. Imagining the consequences, he went on: ‘Must not the price of all labour and commodities sink in pro-portion? ... What nation could then ... sell manufactures at the same price, which to us would afford sufficient profit? In how little time, therefore, must this bring back the money which we had lost, and raise us to the level of all theneighbouring nations.’

The only economic data available to Hume were international trade statistics. These data were used by EnglishmanWilliam Playfair to draw the first-ever time series graphs. Coincidentally, Hume died in the same year that Playfairinvented the economic graph.

Today, in contrast, we have an abundance of macroeconomic data and the two chapters in this part explain howthey are collected and what they mean.

‘... in every kingdom into

which money begins to

flow in greater abundance

than formerly, everything

takes a new face: labour

and industry gain life; the

merchant becomes more

enterprising, the manu-

facturer more diligent and

skillful, and even the

farmer follows his plow

with greater alacrity and

attention.’

DAVID HUME

Essays, Moral and Political

David Hume, a Scot who lived from 1711 to 1776, didnot call himself an economist. ‘Philosophy and generallearning’ is how he described the subject of his life’s work.Hume was an extraordinary thinker and writer. Publishedin 1742, his Essays, Moral and Political range acrosseconomics, political science, moral philosophy, history,literature, ethics, and religion, and explore such topics aslove, marriage, divorce, suicide, death, and the immor-tality of the soul!

Hume’s economic essays provide astonishing insightsinto the forces that cause inflation, business cycle fluctua-tions, balance of payments deficits, and interest rate fluc-tuations; and they explain the effects of taxes and gov-ernment deficits and debts.

Because data were scarce in Hume’s day, he was notable to draw on detailed evidence to support his analysis.But he was empirical. He repeatedly appealed to experi-ence and evidence as the ultimate judge of the validity ofan argument. Hume’s fundamentally empirical approachdominates macroeconomics today.

�406

Will our economy shrink or expand next year? Many Australian businesses want the answer to this question. Telstra wants to know howrapidly to expand its broadband capacity. Holden wants to know howmany cars it might sell. To assess the state of the economy and to makedecisions about business contraction or expansion, firms such as Telstraand Holden use forecasts of GDP. What exactly is GDP, and what does ittell us about the state of the economy?

Some countries are rich, while others are poor. How do we use GDP tocompare economic well-being in one country with that in another?

In this chapter, you will find out how economic statisticians at theAustralian Bureau of Statistics measure GDP; and in Reading Between theLines at the end of the chapter, we’ll look at Australia’s real GDP in 2008.

Measuring GDP and EconomicGrowth

chapter

18After studying this chapter you

will be able to

x Define GDP and use the circular flow model to explainwhy GDP equals aggregateexpenditure and aggregateincome

x Explain how the ABS measuresAustralia’s GDP

x Describe how real GDP is usedto measure economic growthand fluctuations, and explain thelimitations of real GDP as ameasure of economicwell-being

407

�408

PA R T 4 MONITORING THE MACROECONOMY

Gross Domestic ProductWhat exactly is GDP, how is it calculated, whatdoes it mean, and why do we care about it? You aregoing to discover the answers to these questions inthis chapter. First, what is GDP?

GDP DEFINED

GDP, or gross domestic product, is the market valueof the final goods and services produced within acountry in a given time period. This definition hasfour parts:

Market valueFinal goods and servicesProduced within a countryIn a given time period

We’ll examine each in turn.

Market ValueTo measure total production, we must add togetherthe production of apples and oranges, computersand popcorn. Just counting the items doesn’t get usvery far. For example, which is the greater totalproduction: 100 apples and 50 oranges, or 50apples and 100 oranges?

GDP answers this question by valuing items attheir market values—the prices at which items aretraded in markets. If the price of an apple is 10cents, then the market value of 50 apples is $5. Ifthe price of an orange is 20 cents, then the marketvalue of 100 oranges is $20. By using market pricesto value production, we can add the apples andoranges together. The market value of 50 applesand 100 oranges is $5 plus $20, or $25.

Final Goods and ServicesTo calculate GDP, we value the final goods andservices produced. A final good (or service) is anitem that is bought by its final user during a speci-fied time period. It contrasts with an intermediategood (or service), which is an item that is producedby one firm, bought by another firm, and used asa component of a final good or service.

For example, a Holden Astra is a final good, buta Firestone tyre on the car is an intermediate good.A Dell computer is a final good, but an IntelPentium chip inside it is an intermediate good.

If we were to add the value of intermediategoods and services produced to the value of final

goods and services, we would count the same thingmany times—a problem called double counting.The value of a car already includes the value of thetyres, and the value of a Dell PC already includesthe value of the Pentium chip inside it.

Some goods can be an intermediate good insome situations and a final good in other situa-tions. For example, the ice cream that you buy ona hot summer day is a final good, but the ice creamthat a restaurant buys and uses to make sundaes isan intermediate good. The sundae is the finalgood. Whether a good is intermediate or finaldepends on what it is used for, not what it is.

Some items that people buy are neither finalgoods nor intermediate goods and they are not partof GDP. Examples of such items include financialassets—stocks and bonds—and second-handgoods—used cars or existing homes. A second-hand good was part of GDP in the year in which itwas produced, but not part of GDP this year.

Produced Within a CountryOnly goods and services that are produced within acountry count as part of that country’s GDP. BHPBilliton, an Australian firm, produces copper inChile, and the market value of that copper is partof Chile’s GDP, not part of Australia’s GDP. Toyota,a Japanese firm, produces cars in Altona, Victoria,and the value of this production is part ofAustralia’s GDP, not part of Japan’s GDP.

In a Given Time PeriodGDP measures the value of production in a giventime period—normally either a quarter of a year(called quarterly GDP) or a year (called annualGDP).

GDP measures the value of total production. Italso measures total income and total expenditure.The equality of the value of total production andtotal income is important because it shows thedirect link between productivity and living stan-dards. Our standard of living rises when ourincomes rise and we can afford to buy more goodsand services. But to be able to buy more goods andservices, we must produce more goods and services.

Rising incomes and a rising value of productiongo together. They are two aspects of the same phe-nomenon: increasing productivity. To see why, westudy the circular flow of expenditure and income.

�409

MEASURING GDP AND ECONOMIC GROWTH CHAPTER 18

GDP AND THE CIRCULAR FLOW OFEXPENDITURE AND INCOME

Figure 18.1 illustrates the circular flow of expendi-ture and income. The economy consists of house-holds, firms, governments, and the rest of theworld, which trade in factor markets and goods(and services) markets.

Households and FirmsHouseholds sell and firms buy the services oflabour, capital, and land in factor markets. Forthese factor services, firms pay income to house-holds: wages for labour services, interest for the useof capital, and rent for the use of land. A fourthfactor of production, entrepreneurship, receivesprofit.

Firms’ retained earnings—profits that are notdistributed to households—are part of the house-hold sector’s income. Think of retained earnings as

being income that households save and lend backto firms. Figure 18.1 shows the aggregate income (ortotal income) received by households, includingretained earnings, by the blue flow labelled Y.

Firms sell and households buy consumer goodsand services—such as DVDs and haircuts—in thegoods market. The total payment for these goodsand services is consumption expenditure, shown bythe red flow labelled C.

Firms buy and sell new capital equipment—suchas computer systems, aeroplanes, trucks, andassembly line equipment—in the goods market.Some of what firms produce is not sold but is addedto inventory. For example, if Holden produces1,000 cars and sells 950 of them, the other 50 carsremain in Holden’s inventory of unsold cars, whichincreases by 50 cars. When a firm adds unsold out-put to inventory, we can think of the firm as buy-ing goods from itself. The purchase of new plant,

HOUSEHOLDS

FIRMS

G

G

I

C

C

I

X – M

X – M

Y

Y

GOVERNMENTS

RESTOF

WORLD

FACTORMARKETS

GOODSMARKETS

animation

Households make con-sumption expenditures(C); firms make invest-ments (I); governmentsbuy goods and services(G); and the rest of theworld buys net exports (X – M). Firms payincomes (Y) to house-holds. Aggregate incomeequals aggregate expen-diture.

FIGURE 18.1

The Circular Flow of Expenditure and Income

Billions of dollarsin 2007/08

C = 627I = 275

G = 249X – M = –19

Y = 1,132

Source of data: ABS,National Income,Expenditure and Product,Cat. No. 5206.0.

equipment, and buildings and the additions toinventories are investment, shown by the red flowlabelled I.

GovernmentsGovernments buy goods and services from firmsand the value of these goods and services is calledgovernment expenditure. In Fig. 18.1, the red flow Gshows government expenditure.

Government financial transfers such as unem-ployment benefits and taxes are not part of the cir-cular flow of expenditure and income.

Rest of the WorldFirms in Australia sell goods and services to the restof the world—exports—and buy goods and servicesfrom the rest of the world—imports. The value ofexports (X) minus the value of imports (M) is callednet exports, the red flow (X – M) in Fig 18.1. If netexports are positive, the net flow of goods and serv-ices is from Australian firms to the rest of the world.If net exports are negative, the net flow of goodsand services is from the rest of the world toAustralian firms.

GDP Equals Expenditure Equals IncomeGross domestic product can be measured in twoways: by the total expenditure on goods and serv-ices, or by the total income earned by producinggoods and services.

Aggregate expenditure (or total expenditure) is thesum of the red flows in Fig. 18.1. Aggregate ex-penditure equals consumption expenditure plusinvestment plus government expenditure plus netexports.

Aggregate income is equal to the total amountpaid for the services of the factors of productionused to produce final goods and services—wages,interest, rent, and profit. The blue flow in Fig. 18.1shows aggregate income. Because firms pay out asincomes (including retained profits) everythingthey receive from the sale of their output, aggre-gate income (the blue flow) equals aggregateexpenditure (the sum of the red flows). That is,

Y = C + I + G + (X – M).

The data in Fig. 18.1 shows the numbers for2008. You can see that the sum of the expendituresis $1,132 billion, which also equals aggregateincome.

�410

Because aggregate expenditure equals aggregateincome, the two methods of measuring GDP givethe same answer. So

GDP equals aggregate expenditure and equalsaggregate income.

The circular flow model is the foundation onwhich the national economic accounts are built.

WHY IS DOMESTIC PRODUCT ‘GROSS’?

‘Gross’ means before subtracting the depreciation ofcapital. The opposite of ‘gross’ is ‘net’, whichmeans after subtracting the depreciation of capital.

Depreciation is the decrease in the value of afirm’s capital that results from wear and tear andobsolescence. The total amount spent both buyingnew capital and replacing depreciated capital iscalled gross investment. The amount by which thevalue of capital increases is called net investment.Net investment equals gross investment minusdepreciation.

For example, if Qantas buys 5 new planes andretires 2 old planes from service, its gross invest-ment is the value of the 5 new planes, depreciationis the value of the 2 old planes retired, and netinvestment is the value of 3 new planes.

Gross investment is included in the expenditureapproach to measuring GDP. So the resulting valueof total product is a gross measure.

Gross profit, which is a firm’s profit before sub-tracting depreciation, is included in the incomeapproach to measuring GDP. So again, the result-ing value of total product is a gross measure.

PA R T 4 MONITORING THE MACROECONOMY

Let’s now see how the ideas that you’ve just stud-ied are used in practice. We’ll see how GDP and itscomponents are measured in Australia today.

■ REVIEW QUIZ

1 Define GDP and distinguish between a final good andan intermediate good. Provide examples.

2 Why does GDP equal aggregate income and alsoequal aggregate expenditure?

3 What is the distinction between gross and net?

Work Study Plan 18.1and get instant feedback.

�411

MEASURING GDP AND ECONOMIC GROWTH CHAPTER 18

Measuring Australia’s GDPThe Australian Bureau of Statistics (ABS) uses theconcepts in the circular flow model to measureGDP and its components in the National Income,Expenditure and Product Accounts. Because the valueof aggregate production equals aggregate expendi-ture and aggregate income, there are twoapproaches available for measuring GDP, and bothare used. They are

The expenditure approachThe income approach

THE EXPENDITURE APPROACH

The expenditure approach measures GDP as the sumof consumption expenditure (C), investment (I),government expenditure on goods and services (G),and net exports of goods and services (X – M), cor-responding to the red flows in the circular flowmodel in Fig. 18.1. Table 18.1 shows the result ofthis approach for 2007/08.

Consumption expenditure (called households’final consumption expenditure in the ABS accounts) isthe expenditure on goods and services by house-holds. It includes expenditure on goods such asfood and CDs and on services such as banking andlegal advice. It does not include purchases of newhouses, which are counted as investment.

Investment (private gross fixed capital formationplus the net change in inventories in the ABSaccounts) is the expenditure on buildings andequipment by firms and new residences by house-holds, and the change in business inventories.

Government expenditure (general governmentfinal consumption expenditure, plus public gross fixedcapital formation) is all the expenditure on goodsand services by all levels of government. It does notinclude transfer payments because they are not pur-chases of goods and services.

Net exports of goods and services are the valueof exports minus the value of imports. This itemincludes the steel that BHP Billiton sells to Hyundaiin Korea (an Australian export) and the value ofyour new Hyundai (an Australian import).

Table 18.1 shows the relative importance of thefour items of aggregate expenditure. As you cansee, consumption expenditure is by far the largestof the expenditures that add up to GDP.

THE INCOME APPROACH

The income approach measures GDP by summingthe incomes that firms pay households for the fac-tors of production they hire—wages for labour,interest for capital, rent for land, and profit forentrepreneurship. The National Income, Expenditure,and Product Accounts do not provide data arrangedin these economic categories. Instead, they dividefactor incomes into three accounting categories:1 Compensation of employees2 Gross operating surplus3 Gross mixed incomeCompensation of employees is the payment forlabour services. It includes net wages and salaries(take-home pay), taxes withheld from earnings,fringe benefits such as income paid in kind (forexample, meals or the use of a company car), con-tributions to pension or superannuation schemes,and worker's compensation for injuries.

TABLE 18.1

GDP: The Expenditure Approach

Amountin 2007/08

(billions of PercentageItem Symbol dollars) of GDP

Consumptionexpenditure C 627 55.4

Investment I 275 24.3

Government

expenditure G 251 22.2

Net exports X – M –21 –1.9

Aggregateexpenditure Y 1,132 100.0

The expenditure approach measures GDP as the sum ofconsumption expenditure (C), investment (I), governmentexpenditure on goods and services (G), and net exports (X – M). In 2007/08, the expenditure items summed to$1,132 billion and this number is the expenditure estimateof GDP for that year. Consumption expenditure is by farthe largest expenditure item.

Source of data: ABS, National Income, Expenditure and Product,Cat. No. 5206.0.

�412

PA R T 4 MONITORING THE MACROECONOMY

Gross operating surplus is the gross profit of com-panies. This income is a combination of interestearned by the capital employed by companies, renton the land that they use, and profit earned by theentrepreneurs who operate companies.

The ABS has no detailed data that enables it tosplit this income into the three underlying eco-nomic categories of interest, rent and profit.

Gross mixed income is the income earned by unin-corporated enterprises—small companies. Thisincome category is even broader than gross operat-ing surplus. It is a combination of wages for thelabour that small business owners supply, intereston the capital employed by small firms, rent onland, and profit earned by an entrepreneurship.

Again, the ABS does not have the detailed datathat would enable it to split this income into itsfour economic categories.

Gross Income at Factor CostThe sum of compensation of employees, grossoperating surplus, and gross mixed income is grossincome at factor cost. The term factor cost is usedbecause it measures income and the value of pro-duction as the total cost of the factors of productionused to produce the final goods and services.

When we sum the expenditures on goods andservices, we arrive at a total valued at market prices.The factor cost and market price values of produc-tion would be the same if there were no indirecttaxes or subsidies.

Indirect Taxes Less SubsidiesAn indirect tax is a tax paid by consumers whenthey buy goods and services. (In contrast, a directtax is a tax on income.) The GST, state sales taxes,and taxes on alcohol, petrol, and tobacco productsare indirect taxes. Because of indirect taxes, con-sumers pay more for some goods and services thanproducers receive. Market price exceeds factor cost.For example, with a 20 per cent sales tax on cars,when you pay $24,000 for a new car (marketprice), Holden receives $20,000 (factor cost).

A subsidy is a payment by the government to aproducer. Payments made to dairy farmers andphosphate fertilizer producers are subsidies.Because of subsidies, consumers pay less for somegoods and services than producers receive. Factorcost exceeds market price.

Aggregate Income at Market PricesTo get from factor cost to market price, we add indirect taxes and subtract subsidies. Making thisadjustment gives the income approach estimate ofGDP—aggregate income at market prices.

Table 18.2 summarises the income approachand shows the relative magnitudes of the variousfactor incomes. As you can see, the compensationof employees is by far the largest factor income.

RECONCILING THE EXPENDITURE ANDINCOME APPROACHES

If we could measure the components of aggregateexpenditure and aggregate income accurately, wewould arrive at the same estimate of GDP regard-less of the approach adopted. In practice, the twoapproaches deliver slightly different estimates butthe difference is usually small. The difference in2007/08 was $31 million, or 0.003 per cent of GDP,a number too small to see in Tables 18.1 and 18.2.

TABLE 18.2

GDP: The Income Approach

Amountin 2007/08

(billions of PercentageItem dollars) of GDPCompensation of

employees 539 47.6

Gross operating surplus 374 33.0

Gross mixed income 97 8.6

Gross income atfactor cost 1,010 89.2

Indirect taxes lesssubsidies 122 10.8

Aggregate incomeat market prices 1,132 100.0

The sum of the three categories of factor incomes is grossincome at factor cost. By adding indirect taxes and sub-tracting subsidies, we arrive at aggregate income meas-ured in market prices. The compensation of employees isby far the largest income item.

Source of data: ABS, National Income, Expenditure and Product,Cat. No. 5206.0.

�413

MEASURING GDP AND ECONOMIC GROWTH CHAPTER 18

NOMINAL GDP AND REAL GDP

In 2000/01, GDP was $689 billion, and in 2007/08,it was $1,132 billion—64 per cent higher than in2000/01. This increase combines an increase inproduction and a rise in prices. To isolate theincrease in production from the rise in prices, wedistinguish between real GDP and nominal GDP.

Real GDP is the value of final goods and servicesproduced in a given year when valued at the pricesof a reference base year. By comparing the value ofproduction in the two years at the same prices, wereveal the change in production.

Currently, the reference base year is 2006/07 andwe measure real GDP in terms of what the dollarwould buy in 2006/07.

Nominal GDP is the value of final goods andservices produced in a given year valued at theprices of that year. Nominal GDP is just a more pre-cise name for GDP.

Economists at the ABS calculate real GDP usingthe method described in the Mathematical Note onpp. 422–23. Here, we’ll explain the basic idea butnot the technical details.

CALCULATING REAL GDP

We’ll calculate real GDP for an economy that pro-duces one consumption good, one capital good,and one government service; net exports are zero;and the reference base year is 2008.

Table 18.3 shows the quantities produced andthe prices in 2008 and in 2009. Part (a) calculatesnominal GDP in 2008. For each item, multiply thequantity produced by its price to find the totalexpenditure on the item. Then sum the expendi-tures to find nominal GDP, which in 2008 is $100million. Because 2008 is the base year, real GDPand nominal GDP both equal $100 million.

Table 18.3(b) calculates nominal GDP in 2009,which is $159 million—1.59 its value in 2008. RealGDP will tell us by how much production hasincreased.

Table 18.3(c) calculates real GDP in 2009. Thequantities of the goods and services produced arethose of 2009, as in part (b). The prices are those inthe reference base year—2008, as in part (a).

For each item, multiply the quantity produced in2009 by its price in 2008. Then sum these expendi-tures to find real GDP in 2009, which is $110 mil-

lion. This number is what total expenditure wouldhave been in 2009 if prices had remained the sameas they were in 2008.

Nominal GDP in 2009 is three times its value in2008, but real GDP in 2009 is only 1.1 times its2008 value—a 10 per cent increase in production.

TABLE 18.3

Calculating Nominal GDP and Real GDP

ExpenditureQuantity Price (millions

Item (millions) (dollars) of dollars)

(a) In 2008C T-shirts 40 1 40I Computer chips 10 2 20G Security services 20 2 40

Y Real and nominal GDP in 2008 100

(b) In 2009C T-shirts 48 2 96I Computer chips 15 1 15G Security services 16 3 48

Y Nominal GDP in 2009 159

(c) Quantities of 2009 valued at prices of 2008C T-shirts 48 1 48I Computer chips 15 2 30G Security services 16 2 32

Y Real GDP in 2009 110

In 2008, the reference base year, real GDP equals nomi-nal GDP and was $100 million. In 2009, nominal GDPincreases to $159 million. But real GDP in 2009 in part(c), which is calculated by using the quantities of 2009in part (b) and the prices of 2008 in part (a), was only$110 million—a 10 per cent increase from 2008.

■ REVIEW QUIZ

1 What is the expenditure approach to measuring GDP?2 What is the income approach to measuring GDP?3 What adjustments must be made to total income to

make it equal GDP?4 What is the distinction between nominal GDP and real

GDP?5 How is real GDP calculated?

Work Study Plan 18.2and get instant feedback.

�414

PA R T 4 MONITORING THE MACROECONOMY

The Uses and Limitations ofReal GDPEconomists use estimates of real GDP for two mainpurposes: To compare

The standard of living over timeThe standard of living across countries

THE STANDARD OF LIVING OVER TIME

Real GDP per person, which is real GDP divided bythe population, is a measure of the standard ofliving. We’re interested in both the long-term trendsand the short-term cycles in the standard of living.

Long-Term TrendA handy way of comparing real GDP per personover time is to express it as a ratio of some refer-ence year. For example, in 1959/60, real GDP perperson was $19,438, and in 2007/08, it was$51,253. So real GDP per person in 2007/08 was 2.6times its 1959/60 level. Measured by real GDP perperson, people were 2.6 times as well off in 2007/08as their grandparents had been in 1959/60.

Figure 18.2 shows the path of Australian realGDP per person from 1959/60 to 2007/08 and high-lights two features of the standard of living:

The growth of potential GDP per personFluctuations of real GDP per person

The Growth of Potential GDPWhen all the economy’s labour, capital, land, andentrepreneurial ability are fully employed, thevalue of real GDP is called potential GDP. PotentialGDP per person, the smoother black line in Fig.18.2, grows at a steady pace because the quantitiesof the factors of production and their productivitygrow at a steady pace.

But potential GDP per person doesn’t grow at aconstant pace. During the 1960s, it grew at 3 percent per year, but its growth slowed and after 1970it averaged less than 2 per cent per year. This slow-down in potential GDP per person growth mightseem small, but it had big consequences, as you’llsoon see.

Fluctuations of Real GDPYou can see that real GDP, shown by the red line in Fig. 18.2, fluctuates around potential GDP.Sometimes, real GDP is above potential; some-

times, it is below potential; and sometimes, realGDP shrinks.

Let’s take a closer look at the two features of ourexpanding living standard that we’ve outlined.

Productivity Growth SlowdownYou’ve just seen that the growth rate of real GDPper person slowed after 1970. How costly was thatslowdown? The answer is provided by a numberthat we’ll call the Lucas wedge, which is the dollarvalue of the accumulated gap between what realGDP per person would have been if the 1960sgrowth rate had persisted and what real GDP perperson turned out to be.

University of Chicago economist and NobelLaureate Robert E. Lucas Jr., who drew attention tothis measure, remarked that once he began tothink about the benefits of faster economic growth,he found it hard to think about anything else.

FIGURE 18.2

Australia’s Rising Standard of Living

Real GDP per person in Australia doubled over the 39 yearsbetween 1968/69 and 2007/08. Real GDP per person, thered line, fluctuates around potential GDP per person, theblack line.

Sources of data: ABS, Cat. No. 5206-02, and authors’calculations.

25

50

Rea

l GD

P p

er p

erso

n

(thousa

nds

of

2006/0

7dolla

rs p

er y

ear)

1958/59 1968/69 1978/79 1988/89 1998/99 2008/09Year

18

Potential GDPper person

Real GDPper person

Real GDP per persondoubled in 39 years

animation

�415

MEASURING GDP AND ECONOMIC GROWTH CHAPTER 18

Figure 18.3 illustrates the Lucas wedge. The redline is actual real GDP per person, and the thinblack line is the trend that real GDP per personwould have followed if the 1960s growth rate ofpotential GDP had persisted through the years to2007/08.

You can see in the figure that the gap—thewedge—had accumulated to an astonishing$331,000 per person by 2007/08. The gap startedout small during the 1970s, but in 2007/08 realGDP per person was $18,700 per year lower than itwould have been with no growth slowdown.

Real GDP FluctuationsReal GDP fluctuates in a business cycle, which is aperiodic but irregular up-and-down movement oftotal production and other measures of economicactivity. The business cycle isn’t a regular, pre-dictable, and repeating cycle like the phases of themoon. The timing and intensity of the businesscycle vary a lot, but every cycle has two phases:

1 Expansion2 Recession

and two turning points:

1 Peak2 TroughFigure 18.4 shows these features of the most recentAustralian business cycle.

An expansion is a period during which real GDPincreases. In the early stage of an expansion realGDP returns to potential GDP, and as the expansionprogresses real GDP exceeds potential GDP.Australia experienced an expansion before the thirdquarter of 2000 and after the fourth quarter of 2000.

A recession is a period of significant decline intotal production, income, and employment, usual-ly lasting more than six months and affecting mostof the economy. Usually, in a recession, real GDPshrinks for two successive quarters or more. Butsometimes, as in the most recent recession in 2000,real GDP shrinks for only one quarter.

FIGURE 18.3

The Cost of Slower Growth: The Lucas Wedge

The black line projects the 1960s growth rate of real GDP perperson to 2007/08. The Lucas wedge arises from the slow-down of productivity growth that began during the 1970s.The cost of the slowdown is $331,000 per person.

Sources of data: ABS, Cat. No. 5206-02, and authors’ calculations.

72

Rea

l GD

P p

er p

erso

n(t

housa

nds

of

2006/0

7 d

olla

rs)

1960/61 1970/71 1980/81 1990/91 2000/01 2010/11Year

18

36

Real GDPper person

Projection of 1960sgrowth rate

Lucas wedge$331,000per person

animation

FIGURE 18.4

The Most Recent Australian Business Cycle

The most recent business cycle peak occurred at the end ofan expansion in the third quarter of 2000. A (mini) recessionran from that peak through the fourth quarter of 2000. A newexpansion then began.

Sources of data: ABS, Cat. No. 5206-02, and authors’ calculations.

900

Rea

l GD

P (

bill

ions

of

2006/0

7 d

olla

rs p

er y

ear)

1998 1999 2000 2001 2002 20042003Year

780

760

820

940

920

880

860

800

840

RealGDP

PotentialGDP

Peak

Expansion

Expansion

Recession

Trough

animation

�416

PA R T 4 MONITORING THE MACROECONOMY

A peak is the point in a business cycle at whichreal GDP reaches its highest level in an expansionand from which a recession begins. Australia’s lastpeak occurred in the third quarter of 2000.

A trough is the point in a business cycle at thebottom of a recession when real GDP reaches atemporary low point from which the next expan-sion begins. Australia’s last trough occurred in thefirst quarter of 2001.

Recessions are infrequent and usually short.Expansion is the normal state of the economy. Theexpansion that began in the first quarter of 2001lasted until the third quarter of 2008 when a newrecession began.

THE STANDARD OF LIVINGACROSS COUNTRIES

Two problems arise in using real GDP to compareliving standards across countries. First, the realGDP of one country must be converted into thesame currency units as the real GDP of the othercountry. Second, the goods and services in bothcountries must be valued at the same prices. We’lllook at these two problems by using a strikingexample: a comparison of the United States andChina.

Market Exchange Rate ComparisonIn 2008, real GDP per person in the United Stateswas $38,422 and real GDP per person in Chinawas 16,400 yuan. In that year, $1 U.S. was worth8.3 yuan. If we use this exchange rate to convert16,400 yuan into U.S. dollars, we get $1,976.

This comparison of real GDP per person inChina and the United States makes China lookextremely poor. In 2008, real GDP per person in theUnited States was 19 times that in China.

The red line in Fig. 18.5 shows real GDP per per-son in China from 1980 to 2008 using the marketexchange rate to convert yuan to U.S. dollars.

Purchasing Power Parity ComparisonU.S. real GDP is measured by using U.S. prices, andChina’s real GDP is measured using China’s prices.But the relative prices in these countries are verydifferent.

The prices of some goods are higher in theUnited States than in China, so these items get asmaller weight in China’s real GDP than they get in

U.S. real GDP. For example, a Big Mac that costs$3.57 in Chicago costs 12.5 yuan, which is theequivalent of $1.83, in Shanghai. So in China’s realGDP, a Big Mac gets about half the weight that itgets in U.S. real GDP.

The prices of some other goods are higher inChina than in the United States, so these items geta bigger weight in China’s real GDP than they getin U.S. real GDP. For example, a Buick LaCrossethat costs $25,000 in Chicago costs 239,800 yuan,which is the equivalent of $35,000, in Shanghai. Soa Buick LaCrosse made in China gets about 40 percent more weight than the same car made inDetroit gets in U.S. real GDP.

More prices are lower in China than in theUnited States, so Chinese prices put a lower valueon China’s production than do U.S. prices.

If, instead of using China’s prices, all the goodsand services produced in China are valued at U.S.

FIGURE 18.5

Two Views of Real GDP in China

Real GDP per person in China has grown rapidly. But howrapidly it has grown and to what level depends on how realGDP is valued. When GDP is valued at the market exchangerate, China is a poor developing country. But when GDP isvalued at purchasing power parity prices, China seems to bemuch less poor.

Sources of data: International Monetary Fund, World Economic Outlookdatabase, April 2008; and Alan Heston, Robert Summers, and BettinaAten, Penn World Table Version 6.1, Center for International Comparisonsat the University of Pennsylvania (CICUP), October 2002.

Rea

l GD

P p

er p

erso

n(2

000 U

.S. dolla

rs)

Year

0

5,000

1980 2008200420001996199219881984

3,000

2,000

4,000

1,000

PPP pricesin U.S. dollars

Domestic prices atmarket exchange rate

animation

�417

MEASURING GDP AND ECONOMIC GROWTH CHAPTER 18

prices, then a more valid comparison can be madeof real GDP in the two countries. Such a compari-son uses prices called purchasing power parity, orPPP prices.

Alan Heston, Robert Summers, and BettinaAten, economists at the Center for InternationalComparisons at the University of Pennsylvania,have used PPP prices to construct real GDP datafor more than 100 countries. The IMF now uses amethod similar to that of Heston, Summers, andAten to calculate PPP estimates of real GDP in allcountries. The PPP comparisons tell a remarkablestory.

Figure 18.5 shows the PPP view of China’s realGDP, the green line. According to the PPP compar-isons, real GDP per person in the United States in2008 was 8 times that of China, not the 19 timesimplied by a comparison using China’s own pricesand converting them to U.S. dollars at the marketexchange rate.

You’ve seen how real GDP is used to make stan-dard-of-living comparisons over time and acrosscountries. But real GDP isn’t a perfect measure ofthe standard of living and we’ll now examine itslimitations.

LIMITATIONS OF REAL GDP

Real GDP measures the value of goods and servicesthat are bought in markets. Some of the factorsthat influence the standard of living and that arenot directly part of GDP are

Household productionUnderground economic activityHealth and life expectancyLeisure timeEnvironmental qualityPolitical freedom and social justice

Household ProductionAn enormous amount of production takes placeevery day in our homes. Preparing meals, cleaningthe kitchen, changing a light bulb, cutting thegrass, washing the car, and caring for a child areall examples of household production. Becausethese productive activities are not traded in mar-kets, they are not included in GDP.

The omission of household production from GDPmeans that GDP underestimates total production.But it also means that the growth rate of GDP over-

estimates the growth rate of total production. Thereason is that some of the growth rate of marketproduction (included in GDP) is a replacement forhome production. So part of the increase in GDParises from a decrease in home production.

Two trends point in this direction. One is thenumber of women who have jobs, which increasedfrom 43 per cent in 1978 to 58 per cent in 2008. Theother is the trend in the market purchase of tradi-tionally home-produced goods and services. Forexample, more and more families now eat in fast-food restaurants—one of the fastest-growing indus-tries in Australia—and use day-care services. Thistrend means that an increasing proportion of foodpreparation and child care that were part of house-hold production are now measured as part of GDP.So real GDP grows more rapidly than does realGDP plus home production.

Underground Economic ActivityThe underground economy is the part of the econ-omy that is purposely hidden from the view of thegovernment to avoid taxes and regulations orbecause the goods and services being produced areillegal. Because underground economic activity isunreported, it is omitted from GDP.

The underground economy is easy to describe,even if it is hard to measure. It includes the produc-tion and distribution of illegal drugs, productionthat uses illegal labour that is paid less than theminimum wage, and jobs done for cash to avoidpaying income taxes. This last category might bequite large and includes tips earned by taxi drivers,hairdressers, and hotel and restaurant workers.

Estimates of the scale of the underground eco-nomy in Australia range between 1 and 15 per centof GDP ($11 billion to $170 billion). Provided thatthe underground economy is a reasonably stableproportion of the total economy, the growth rate ofreal GDP still gives a useful estimate of changes ineconomic well-being and the standard of living. Butsometimes production shifts from the undergroundeconomy to the rest of the economy, and sometimesit shifts the other way. The underground economyexpands relative to the rest of the economy if taxesbecome especially high or if regulations becomeespecially restrictive. And the underground econo-my shrinks relative to the rest of the economy if theburdens of taxes and regulations are eased.

�418

PA R T 4 MONITORING THE MACROECONOMY

One of the hoped-for outcomes of the introduc-tion of the GST in July 2000 was a shift of activityfrom the underground economy to the marketeconomy.

Health and Life ExpectancyGood health and a long life—the hopes of every-one—do not show up in real GDP, at least notdirectly. A higher real GDP enables us to spendmore on medical research, health care, a good diet,and exercise equipment. And as real GDP hasincreased, our life expectancy has lengthened—from 70 years at the end of World War II toapproaching 80 years today. Infant deaths anddeath in childbirth, two fearful scourges of the19th century, have been greatly reduced.

But we face new health and life expectancyproblems every year. AIDS and drug abuse are tak-ing young lives at a rate that causes serious con-cern. When we take these negative influences intoaccount, we see that real GDP growth overstatesthe improvements in the standard of living.

Leisure TimeLeisure time is an economic good that adds to oureconomic well-being and our standard of living.Other things remaining the same, the more leisurewe have, the better off we are. Our working time isvalued as part of GDP, but our leisure time is not.Yet that leisure time must be at least as valuable tous as the wage that we earn for the last hourworked. If it were not, we would work instead oftaking leisure. Over the years, leisure time hassteadily increased. The workweek has becomeshorter, more people take early retirement, and thenumber of vacation days has increased. Theseimprovements in economic well-being are notreflected in real GDP.

Environmental QualityEconomic activity directly influences the quality ofthe environment. The burning of hydrocarbonfuels is the most visible activity that damages ourenvironment, but it is not the only example. Thedepletion of nonrenewable natural resources, themass clearing of forests, and the pollution of lakesand rivers are other major environmental conse-quences of industrial production.

Resources that are used to protect the environ-ment are valued as part of GDP. For example, the

value of catalytic converters that help to protect theatmosphere from motor vehicle emissions is part ofGDP. But if we did not use such pieces of equipmentand instead polluted the atmosphere, we would notcount the deteriorating air that we were breathingas a negative part of GDP.

An industrial society possibly produces moreatmospheric pollution than an agricultural societydoes. But pollution does not always increase as webecome wealthier. Wealthy people value a cleanenvironment and are willing to pay for one.Compare the pollution in China today with pollu-tion in Australia. China, a poor country, pollutesits rivers, lakes, and atmosphere in a way that isunimaginable in Australia.

Political Freedom and Social JusticeMost people in the Western world value politicalfreedoms such as those provided by the AustralianConstitution. And they value social justice—equal-ity of opportunity and of access to social securitysafety nets that protect people from the extremes ofmisfortune.

A country might have a very large real GDP perperson but have limited political freedom andsocial justice. For example, a small elite mightenjoy political liberty and extreme wealth whilethe vast majority are effectively enslaved and livein abject poverty. Such an economy would general-ly be regarded as having a lower standard of livingthan one that had the same amount of real GDPbut in which political freedoms were enjoyed byeveryone. Today, China has rapid real GDP growthbut limited political freedoms, while Poland and Ukraine have moderate real GDP growth butdemocratic political systems. Economists have noeasy way to determine which of these countries isbetter off.

The Bottom LineDo we get the wrong message about the growth ineconomic well-being and the standard of living bylooking at the growth of real GDP? The influencesthat are omitted from real GDP are probablyimportant and could be large. Developing coun-tries have a larger underground economy and alarger amount of household production than dodeveloped countries. So as an economy developsand grows, part of the apparent growth of real GDP

�419

MEASURING GDP AND ECONOMIC GROWTH CHAPTER 18

might reflect a switch from underground to regularproduction and from home to market production.This measurement error overstates the growth ineconomic well-being and the improvement in thestandard of living.

Other influences on the standard of livinginclude the amount of leisure time available, thequality of the environment, the security of jobs andhomes, and the safety of city streets.

It is possible to construct broader measures thatcombine the many influences that contribute tohuman happiness. Real GDP will be one element inthose broader measures, but it will by no means bethe whole of those measures.

The United Nations Development Index (HDI) isone example of attempts to provide broader meas-ures of economic well-being and the standard ofliving. But this measure places a good deal ofweight on real GDP.

Dozens of other measures have been proposed.One includes resource depletion and emissions in a‘green’ GDP measure. Another emphasises theenjoyment of life rather than the production ofgoods in a ‘genuine progress index’ or GPI.

To complete your study of GDP, take a look atReading Between the Lines on pp. 420–21, andsee what happened to Australian real GDP in 2008.

■ REVIEW QUIZ

1 Distinguish between real GDP and potential GDP, anddescribe how each grows over time.

2 How does the growth rate of real GDP contribute to animproved standard of living?

3 What is a business cycle, and what are its phases andturning points?

4 What is PPP, and how does it help us to make validinternational comparisons of real GDP?

5 Explain why real GDP might be an unreliable indicatorof the standard of living.

Work Study Plan 18.3and get instant feedback.

A Broader Indicator of Economic Well-BeingThe Human Development Index

The limitations of real GDP reviewed in this chapter affectthe standard of living and general well-being of everycountry. So to make international comparisons of the gen-eral state of economic well-being, we must look at real GDPand other indicators.

The United Nations has constructed a broader measurecalled the Human Development Index (HDI), which com-bines real GDP, life expectancy and health, and education.Real GDP per person (measured on the PPP basis) is amajor component of the HDI.

The dots in the figure show the relationship betweenreal GDP per person and the HDI. Australia has the 16th-highest real GDP per person but the third-highest HDI.(The countries with higher HDIs and GDPs per person arenamed in the figure.)

Australia’s HDI is higher than that of the 15 countriesbecause Australians live longer and have better access tohealth care and education than do the people in those othercountries.

Five African nations have the lowest real GDP per person, and of these, Sierra Leone has the lowest HDI.

0.2 0.6 1.2H

uman

Dev

elop

men

t Ind

exReal GDP per person (PPP index)

0.4

0.8

0.6

0.4

0.2

0

1.2

1.0

1.00.8

Norway andIceland

Norway, United States,Luxembourg, Ireland,Iceland, Switzerland,Hong Kong, Denmark,Austria, Canada, theUnited Kingdom,Netherlands, Sweden,Finland, and Belgium

Niger,Tanzania,Congo, andBurundi

Sierra Leone

The Human Development Index

Australia

Despite all the alternatives, real GDP per personremains the most widely used indicator of econom-ic well-being.

Source of data: United Nations, hdr.undp.org/en/statistics/data.

Readingbetweenthe lines

Essence of the Story

Real GDP grew by 0.1 per cent inthe third (September) quarter of2008.Real GDP would have fallen(growth would have been negative)except for increases in farm production and government expenditure.

Private consumption expenditurestopped growing and was flatduring both the second (June) andthird (September) quarters of2008.

www.afr.com.auAddress:

▲

▲

Recession Looms Large as Growth DropsClose to ZeroAustralia will head into 2009 on the brink of recession after the economy came closeto stalling in the September quarter, leaving the federal government hoping thatrapid-fire interest rate cuts and its $10.4 billion stimulus package will cushion theimpact of a sharp slowdown.

Gross domestic product grew by just 0.1 per cent in the third quarter, according toyesterday’s national accounts data, which also reveal that without a strong reboundin farm production and robust public spending, the economy would have contract-ed for the first time since 2000. …

The current quarter and the first three months of [2009] are shaping as a crucialperiod for hopes that the economy will be able to skirt recession. The government’smassive fiscal stimulus package, which is due to deliver one-off payments of up to$1,400 each to pensioners, carers and lower-income families next week, is expectedto boost pre-Christmas spending.

However, an 8 per cent plunge in household wealth since the start of the year andweak personal credit growth indicate many households are more interested in sav-ing than spending, suggesting retailers could be in for a bleak trading period. …

The [latest] figures suggest that the downturn that has gripped the household sectorfor much of this year is spreading more broadly, raising the risk that the country willslip into recession next year. …

Household spending accounted for the bulk of the slowdown, with private con-sumption growing by a feeble 0.1 per cent last quarter after contracting by a simi-lar amount in the preceding three months.

The overall flat outcome over the six-month period is the worst such result since thetail end of the last recession.

Adrian RollinsAustralian Financial Review4 December 2008Reproduced with kind permission

420

�421

Economic Analysis

This news article reports Australia’sreal GDP grew by 0.1 per centduring the third (September) quarter of 2008.This growth rate is calculated asthe change in real GDP over thethird quarter expressed as a percentage of real GDP in the second (June) quarter.We normally think about a growthrate (like we think about an interestrate) as a percentage per year.To convert a quarterly growth rateto an annual growth rate, we multiply the quarterly growth rateby 4. (This calculation is anapproximation, but it works forsmall growth rates.)So real GDP grew in the thirdquarter of 2008 at a 0.4 per centannual rate.

This growth rate is very low by historical standards, and Fig. 1compares it with the growth ratessince 2000. (These growth ratesare the percentage changes fromone quarter to the next butexpressed at annual rates.)The growth rate fluctuated between–3.6 per cent and 7 per cent, withan average of 3 per cent.You can see the quarterly growthrate of real GDP has fallen sincethe third (September) quarter of2007.If the downward trend continues,then a recession is likely.

Figure 2 shows the contributions toreal GDP growth in the third(September) quarter of 2008.Private consumption expendituredid not contribute at all.Investment (I) and governmentexpenditure (G) contributed equallyto real GDP growth.Net exports (NX) contributed negatively—net exports decreased.Net exports decreased because therest of the world is either in arecession or fast approaching one.If private consumption expenditurefalls further, the Australian economy will tip into recession.

Figure 2 Growth rates of real GDP components

Growth rate (per cent per year)0 21–1–2

Figure 1 Real GDP growth rates: 2000–2008

Rea

l GD

P g

row

th r

ate

(per

cen

t per

yea

r)

0

–4

6

4

2

8

–2

Year/quarter2008/012000/01 2002/01 2004/01 2006/01

Averagegrowth rate

C

I

G

NX

MEASURING GDP AND ECONOMIC GROWTH CHAPTER 18

�422

Mathematical Note:Chain Volume Measure of GDPIn the real GDP calculation on p. 413, real GDP in2009 is 10 per cent higher than its value in 2008.But suppose that we use 2009 as the reference baseyear and value real GDP in 2008 at 2009 prices.Except by accident, we’re not going to get the samegrowth rate with both sets of prices; and in the cal-culations that we do below, you’ll discover thatusing the 2009 prices makes real GDP only 6 percent higher in 2009 than in 2008. So which pricesshould we use: those of 2008 or 2009?

The ABS answer is to use both year’s prices in ameasure of real GDP called chain volume measureof GDP. Three steps are needed to calculate thismeasure:

Value production in the prices of adjacent years.Find the average of two percentage changes.Chain to the reference base year.

VALUE PRODUCTION IN PRICESOF ADJACENT YEARS

The first step is to value production in adjacentyears at the prices of both years. We’ll make thesecalculations for 2009 and 2008.

Table 1 shows the quantities produced and pricesin the two years. Part (a) shows the nominal GDPcalculation for 2008—the quantities produced in2008 valued at the prices of 2008. Nominal GDP in2008 is $100 million. Part (b) shows the nominalGDP calculation for 2009—the quantities producedin 2009 valued at the prices of 2009. Nominal GDPin 2009 is $159 million. Part (c) shows the value ofthe quantities produced in 2009 at the prices of2008. This total is $110 million. Finally, part (d)shows the value of the quantities produced in 2008at the prices of 2009. This total is $150 million.

FIND THE AVERAGE OF TWO PERCENTAGECHANGES

The second step is to find the percentage change in the value of production based on the prices inthe two adjacent years. Table 2 summarises thesecalculations.

Part (a) shows that, valued at the prices of 2008,production increased from $100 million in 2008 to

$110 million in 2009, an increase of 10 per cent.Part (b) shows that, valued at the prices of 2009,production increased from $150 million in 2008 to$159 million in 2009, an increase of 6 per cent.Part (c) shows that the average of these twochanges in the value of production is 8 per cent.

The final step is to repeat the calculation thatwe’ve just described to obtain the real GDP growthrates for all the years for which we have the dataand then chain them to the base year.

PA R T 4 MONITORING THE MACROECONOMY

TABLE 1

Real GDP Calculation Step 1: Value Productionin Adjacent Years at Prices of Both Years

ExpenditureQuantity Price (millions

Item (millions) (dollars) of dollars)

(a) In 2008C T-shirts 40 1 40I Computer chips 10 2 20G Security services 20 2 40

Y Nominal GDP in 2008 100

(b) In 2009C T-shirts 48 2 96I Computer chips 15 1 15G Security services 16 3 48

Y Nominal GDP in 2009 159

(c) Quantities of 2009 valued at prices of 2008C T-shirts 48 1 48I Computer chips 15 2 30G Security services 16 2 32

Y 2009 production at 2008 prices 110

(d) Quantities of 2008 valued at prices of 2009C T-shirts 40 2 80I Computer chips 10 1 10G Security services 20 3 60

Y 2008 production at 2009 prices 150

Step 1 is to value the production of adjacent years at theprices of both years. Here, we value the production of2008 and 2009 at the prices of both 2008 and 2009.The value of 2008 production at 2008 prices, in part (a),is nominal GDP in 2008. The value of 2009 production at2009 prices, in part (b), is nominal GDP in 2009. Part (c)calculates the value of 2009 production at 2008 prices,and part (d) calculates the value of 2008 production at2009 prices. We use these numbers in Step 2.

�423

CHAIN TO THE REFERENCE BASE YEAR

The reference base year is 2008. Nominal GDP in2008, $100 million, is also real GDP in 2008.

We’ve just seen that the chain volume measure ofGDP in 2009 is 8 per cent greater than in 2008. Soreal GDP in 2009 is $108 million (8 per cent greaterthan $100 million.

To find the chain volume measure of GDP in2010, we use the prices and quantities of 2009 and2010 to find the average of the two growth rates forthose two years by using steps 1 and 2 that we’vejust described. Suppose that we find that growthrate to be 6.5 per cent. We apply that growth rateto the level of real GDP in 2009, $108 million, toget real GDP in 2010 in 2008 dollars as $115 mil-lion. Check that the increase of $7 million is 6.5 percent of $108 million.

We use the same method to find the chain vol-ume measure of GDP for years before the referencebase year. For example suppose that steps 1 and 2tell us that real GDP grew by 4.2 per cent from2007, the year before the base year, to 2008, the

base year. We know that real GDP is $100 million(2008 dollars) in 2008, so in 2007, the chain vol-ume measure of GDP was $96 million (2008 dol-lars). Check that 4.2 per cent of $96 equals $4 andthat $96 plus $4 equals $100.

Figure 1 illustrate step 3 over a period of nineyears. First, check that you can see the three calcu-lations that we’ve just described. The reference baseyear, 2008, is highlighted. The growth rate of 8 percent that we calculated earlier, chains real GDP in2009 to the reference base year. The growth rate of6.5 percent in 2010 chains real GDP in 2010 to2009 in 2008 dollars. The growth rate of 4.2 percentin 2008 chains real GDP in 2008 to 2007 in 2008dollars.

The other growth rates and levels of real GDP inFig. 1 show an example of how the chain volumemeasure of GDP can be linked back as far as theavailable data permit.

MEASURING GDP AND ECONOMIC GROWTH CHAPTER 18

TABLE 2

Real GDP Calculation Step 2:Find Average of Two Percentage Changes

MillionsValue of Production of dollars

(a) At 2008 prices

Nominal GDP in 2008 100

2009 production at 2008 prices 110

Percentage change in production at 2008 prices 10

(b) At 2009 prices

2008 production at 2009 prices 150

Nominal GDP in 2009 159

Percentage change in production at 2009 prices 6

(c) Average of percentage change 8

Using the numbers calculated in Step 1, the percentagechange in production from 2008 to 2009 valued at 2008prices is 10 per cent, in part (a). The percentage changein production from 2008 to 2009 valued at 2009 pricesis 6 per cent, in part (b). The average of these two per-centage changes is 8 per cent, in part (c).

Real GDP calculation step 3:chain to base year

Figure 1

Real GDP(millions of

2008 dollars)YearPercentagechange

75

82

86

88

91

96

100

108

115

2002

2003

2004

2005

2006

2007

2008

2009

2010

9.3

4.9

2.3

3.4

5.5

4.2

8.0

6.5

summary

�424

Key Points

GROSS DOMESTIC PRODUCT (PP. 408–10)

GDP, or gross domestic product, is the market value ofall the final goods and services produced in a countryduring a given period.A final good is an item that is bought by its final user.A final good contrasts with an intermediate good,which is a component of a final good.GDP is calculated by using either the expenditure orincome totals in the circular flow model.Aggregate expenditure on goods and services equalsaggregate income and GDP.

MEASURING AUSTRALIA’S GDP (PP. 411–13)

Because aggregate expenditure, aggregate income,and the value of aggregate production are equal, wecan measure GDP by using the expenditure approachor the income approach.The expenditure approach sums consumptionexpenditure, investment, government expenditure ongoods and services, and net exports.The income approach sums factor income and thenadds indirect taxes and subtracts subsidies.Real GDP is measured using a common set of pricesto reveal the change in production.

THE USES AND LIMITATIONS OF REAL GDP(PP. 414–19)

Real GDP is used to compare the standard of livingover time and across countries.Real GDP per person grows and fluctuates around themore smoothly growing potential GDP.Incomes would be much higher today if the growthrate of real GDP per person had not slowed duringthe 1970s.International real GDP comparisons use PPP prices.Real GDP is not a perfect measure of the standard ofliving because it excludes household production, theunderground economy, health and life expectancy,leisure time, environmental quality, and politicalfreedom and social justice.

Key Figures and TablesFigure 18.1 The Circular Flow of Expenditure and

Income, 409Figure 18.2 Australia’s Rising Standard of Living, 414Figure 18.4 The Most Recent Australian Business

Cycle, 415Table 18.1 GDP: The Expenditure Approach, 411Table 18.2 GDP: The Income Approach, 412

Key TermsBusiness cycle, 415Chain volume measure of GDP, 422Consumption expenditure, 409Depreciation, 410Expansion, 415Exports, 410Final good, 408Government expenditure, 410Gross domestic product (GDP), 408Gross investment, 410Imports, 410Intermediate good, 408Investment, 410Lucas wedge, 414Net exports, 410Net investment, 410Nominal GDP, 413Potential GDP, 414Purchasing power parity, (PPP), 417Real GDP, 413Real GDP per person, 414Recession, 415

�425

4 The firm that printed this textbook bought the paperfrom XYZ Paper Mills. Was this purchase of paperpart of GDP? If not, how does the value of the paperget counted in GDP?

5 The table sets out some data for the United Kingdomin 2005.

Item Billions of pounds

Wages paid to labour 685

Consumption expenditure 791

Taxes 394

Transfer payments 267

Profits 273

Investment 209

Government expenditure 267

Exports 322

Saving 38

Imports 366

a Calculate GDP in the United Kingdom.

b Explain the approach (expenditure or income)that you used to calculate GDP.

problems and applicationsWork problems 1–11 in Chapter 18 Study Plan and get instant feedback. Work problems 12–19 as Homework, a Quiz, or a Test if assigned by your lecturer.

HOUSEHOLDS

FIRMS

B

BC

C

D

D

E

E

A

A

RESTOF

WORLD

FACTORMARKETS

GOODSMARKETS

GOVERNMENTS

1 The figure below shows the flows of expenditure and income in Australia. During 2006/07, B was$585 billion, C was $231 billion, D was $241billion, and E was –$13 billion. Name the flows andthen calculate

a Aggregate expenditure

b Aggregate income

c GDP

2 In the figure below, the flows of expenditure and income in Australia during 2005/06, Bwas $604 billion, C was $214 billion, D was$166 billion, and E was $16 billion.

Calculate the quantities in problem 1 during2005/06.

3 In the figure below, the flows of expenditure andincome in Australia during 2004/05, A was $898billion, B was $521 billion, D was $202 billion, and E was –$22 billion. Calculate

a Aggregate expenditure

b Aggregate income

c GDP

d Government expenditure

problems and applications

�426

6 Tropical Republic produces only bananas andcoconuts. The base year is 2008, and the tablesgive the quantities produced and the prices.

Quantities 2008 2009

Bananas 800 bunches 900 bunches

Coconuts 400 bunches 500 bunches

Prices

Bananas $2 a bunch $4 a bunch

Coconuts $10 a bunch $5 a bunch

a Calculate Tropical Republic’s nominal GDP in2008 and 2009.

b Calculate real GDP in 2009 in terms of the base-year prices.

7 Use the Data Grapher in MyEconLab to answer thefollowing questions. In 2007 in which country was

a The growth rate of real GDP highest: Canada,Japan, or the United States?

b The growth rate of real GDP lowest: France,China, or the United States?

8 Barbera Farms a Growing Force withToyota Forklifts

One of Australia’s largest growers of capsicums,tomatoes, and zucchinis has chosen a fleet of Toyotaforklifts for its material handling needs. BarberaFarms has a five-year agreement to rent 15 Toyota 8-Series forklift trucks, in addition to its own fleet of11 forklifts and four tractor forklifts. ...

Logistics, 16 February 2009

a Explain where the rental of 15 forklifts byBarbera Farms from Toyota [Australia] willappear in the expenditure approach tomeasuring Australia’s GDP in 2009. If it doesn’tappear, explain why.

b If the five-year agreement was the only change inBarbera Farms’ capital in 2009, what was itsgross investment and net investment in 2009?

c If Toyota Australia imports these 15 forklift trucksin 2009, does that change the way thisexpenditure appears in the expenditure approachto measuring Australia’s GDP?

9 Brambles Cuts Jobs as Profits Fall

Brambles will cut 750 jobs and scrap nearly 9 percent of its pellet stock as it seeks to weather therecession. ...

Australian Financial Review, 16 February 2009

a What macroeconomic variable does the destruction of pellets change?

b How will the information in this news clip showup in Australia’s GDP for 2009 as measured bythe income approach?

c How will the information in this news clip showup in Australia’s GDP for 2009 as measured bythe expenditure approach?

10 Poor India Makes Millionaires at FastestPace

An article in The Times of India, reported that Indiahas 350 million people living on less than $1 (U.S.)a day, and 700 million living on less than $2 a day.Despite this huge number of people living on verylow incomes, India is creating millionaires at a rapidpace. According to the news report, India had100,000 millionaires in 2006 and 123,000 (or23 per cent more) in 2007.

Based on an article in the Times of India, 25 June 2008

a Why might a measurement of real GDP per person misrepresent the standard of living of theaverage Indian?

b Why might $1 a day and $2 a day underestimate the standard of living of thepoorest Indians?

11 Japan Headed for Longest, Deepest Post-War Recession

Japan’s economy, the world’s second-largest, shrankat the rate of almost 13 per cent in the final threemonths of 2008. ...

As expected, a collapse in exports drove national output into the ground. ...

The Australian, 16 February 2009

a Explain how the collapse in Japanese exportsmight bring about a decrease in Japan’s realGDP.

b The news article goes on to say that the drop inexports contributed 3.3 per cent to the fall in realGDP. What other components of GDP might havefallen? And why might they have fallen?

problems and applications

�427

12 GDP Expands 11.4 per cent, Fastest in 13 Years

An article in the China Daily reported that in 2007,China’s gross domestic product grew by 11.4 percent last year to 24.66 trillion yuan or $US3.42 trillion. This growth rate was fastest since 1994, butChina grew at a 10 per cent or faster rate everyyear between 2003 and 2007.

Because of its rapid GDP growth, China moved upto rank as the world’s fourth largest economy. Onlythe United States, Japan, and Germany are nowlarger than China.

China's rapid growth ran counter to growth in theUnited States, which slowed in 2007. This fact isespecially surprising given that China relies heavilyon exports to the United States and with a U.S.growth slowdown, U.S. imports from China slowed.

Based on an article in the China Daily, 24 January 2008

a Use the expenditure approach for calculatingChina’s GDP to explain why ‘each one per centdrop in the U.S. economy will shave 1.3 per centoff China’s growth’.

b Why might China’s recent double-digit GDPgrowth rates overstate the actual increase in thelevel of production taking place in China?

c Explain the complications involved withattempting to compare the economic welfare inChina and the United States by using the GDPfor each country.

13 The ABS has released the following GDP data broken down by states for 2007/08. [GSP is grossstate product] State/ GSP GSP Territory ($ million) (% of GDP)

New South Wales 359,883 31.8Victoria 267,966 23.7Queensland 214,027 18.9Western Australia 156,752 13.8South Australia 73,262 6.5Australian Capital Territory 23,365 2.1Tasmania 21,300 1.9Northern Territory 15,617 1.4Australia (GDP) 1,132,172 100.0

a As China cuts its imports of iron ore, coal, and other minerals from Australia, whichstate/territory will be affected more than New South Wales?

b With house prices falling, how will consumerspending and GDP change in 2008/09?

c In 2007/08, New South Wales accounted for54 per cent of Australia’s exports of goods andservices and 34 per cent of householdconsumption expenditure. Discuss how the worldrecession will influence New South Wales’circular flow of income and expenditure.

14 Floods in Queensland in January 2009 affected morethan 62 per cent of the state and caused damage of$210 million, while bushfires ravaged Victoria.

a Explain how these devastating events can initiallydecrease Australia’s GDP.

b How can a devastating event then contribute toan increase in Australia’s GDP?

c Does the increase in Australia’s GDP indicate arise in the standard of living as a result of thefloods and the bushfires?

15 Consumer Spending a Big Factor: NBS

The National Bureau of Statistics (NBS) of Chinareported figures for the nation's consumption expenditure that show consumers becoming biggerplayers in contributing to aggregate demand. Thedata reported by the NBS in October 2007 for thefirst three-quarters of that year show that consumption expenditure was 37 per cent of GDP. In the sameperiod, 41.6 per cent of China's real GDP wasaccounted for by investment in new capital and21.4 per cent was net exports-demand by the restof the world.

Another fact reported is that both exports andimports are growing but imports are growing at afaster rate than exports.

The news reports speculation that China will facechallenges in the future and that consumption willgrow slowly. Some Chinese economists believe thatpeople want to save to provide for their own economic security and for health, education, andhousing. Chinese people feel uncertain about thefuture and want to consume cautiously.

They point out that despite rapid economic growth,China still has a low income per person and little inthe way of government provided education andhealth services. Also, many Chinese still live in ruralareas where the future is especially uncertain.

Based on an article in the China Daily, 11 December 2007

a Compare the relative magnitudes of consumptionexpenditure, net exports, and investment in Chinawith those in Australia.

b Why is consumption expenditure in China so low?

problems and applications

�428

16 Totally Gross

Economists are strongly aware of the shortcomings ofGDP and GNP as measures of economic well beingand they have made significant progress indeveloping additional broader measures that catchthings missed by GDP and GNP.

An article in Time magazine in 2008 reported two ofthese effors. One, by Harvard University economistAmartya Sen, is the United Nations’ HumanDevelopment Index (HDI), which combines health,education, and other life quality data with GDP toprovide a broader view of economic well being.

A second measure, which Columbia University economist and former World Bank chief economist,Joseph Stiglitz likes is a ‘green net national product’that includes a subtraction from income for the depletion of natural resources.

More recently, economists have tried to find indexesthat measure happiness and put these indexes in abroader economic welfare measure.

A big problem with all the proposed alternatives toGDP is that they can’t be measured as quickly, or asaccurately, as GDP.

Based on an article on Time.com, 10 April 2008

a Explain the factors identified here that limit theusefulness of using GDP to measure economicwelfare.

b What are the challenges involved in trying toincorporate measurements of those factors in aneffort to better measure economic welfare?

c Australia currently has the third-highest HDI,while on the GDP per person alone, it ranks16th. What does this ranking in the HDI implyabout health and education in Australia relativeto other nations?

17 Telstra to Roll out World’s Fastest WirelessNetwork

Telstra will roll out … the world’s fastest wirelessbroadband network … gradually for all business customers through March and then made availableto consumer customers in April. … Handsets thatcould take advantage of the faster speeds wouldbecome available towards the end of 2009.

theage.com.au, 17 February 2009

a Explain how Telstra’s fastest wireless broadbandnetwork will be part of Australia’s circular flow ofincome and expenditure.

b As consumers upgrade their mobile phones toones with faster speeds, how will this activity influence Australia’s circular flow of income andexpenditure if the handsets are manufactured inAustralia?

c What would be your answer to (b) if thehandsets are imported from China?

18 The United Nations’ Human Development Index(HDI) is based on real GDP per person, life expectancy at birth, and indicators of the quality andquantity of education.

a Explain why the HDI might be better than realGDP as a measure of economic welfare.

b Which items in the HDI are part of real GDP andwhich items are not in real GDP?

c Do you think the HDI should be expanded toinclude items such as pollution, resource depletion, and political freedom? Explain.

d What other influences on economic welfareshould be included in a comprehensive measure?

19 Study Reading Between the Lines onpp. 420–21 and then answer the followingquestions.

a Which components of aggregate expenditureincreased at the fastest rate in the third quarterof 2008?

b Which components of aggregate expenditureincreased at the slowest rate (or decreased at thefastest rate) in the third quarter of 2008?

c For how long has the Australian economy beenexpanding since the last business cycle trough?

d What is the main sign that the economy washeading for recession in 2009?

20 Use the link on MyEconLab (Chapter Resources,Chapter 18, Web links) to find the available datafrom the ABS on GDP and the components ofaggregate expenditure and aggregate income.The data are in current prices (nominal GDP) andconstant prices (real GDP).

a What are the levels of nominal GDP and realGDP (chain volume measure of GDP) in the current quarter?

b What was the level of real GDP in the same quarter of the previous year?

c By what percentage has real GDP changed overthe past year?