Lecture Week 2

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					                                      Week 2

                        Measuring Economic Variables

Gross domestic product (GDP symbolically) = the dollar value of all final output
produced in a years time.

Intermediate goods are used in the production of other goods. Final goods are
not used in the production of other goods. Salt sold to a cannery is an
intermediate good. Table salt sold to a household is a final good. The value of
the intermediate good will be accounted for when the canned good is sold.

                          GDP  P X 1  P2 X 2  P2 X 2 

In practice

                            GDP  VA1  VA2  VA3 

GDP represents how much output was produced in the U.S. in a years time. We
want to go from GDP to disposable personal income that represents how much
U.S. households have to spend.

Gross National Product (GNP)

         + income earned by U.S. residents and firms from goods and
           services    produced in foreign countries
         – income earned by foreigners from goods and services produced
           in the U.S.

Net National Product (NNP) and Depreciation

Some of the output produced will be used to replace capital used up in the
process of production (Depreciation). This is considered a cost of doing
business and will not be paid out as factor income to the household sector.

                            NNP  GNP  Depreciation

National Income (NI) and Indirect Business Tax (IBT)

Part of the final price of many goods is a sales tax (IBT=Indirect Business Tax).
These are monies that have been included in GNP but will not become part of
household (factor) income.

                                 NI  NNP  IBT

National Income (NI)

                                 NI  GDP  IBT

Personal Income (PI)

                                  PI = NI
                                       - Corporate taxes, undistributed profits,
                                         valuation adjustment
                                       - Contributions to social security (payroll

Disposable Personal Income (DPI)

                                  DPI = PI - Personal Taxes

Initially we will ignore the foreign sector so that GDP=GNP. Likewise we will
ignore depreciation and indirect business taxes so that GDP = NI. We will further
ignore corporate taxes, undistributed profits, the valuation adjustment, and
payroll taxes, so that

                                  GDP = PI

Some national income accounting identities

Let Y be the symbol for personal income. Because of the assumptions we have

                    Y  PI  NI  NNP  GNP  GDP  Output

We will view all taxes to come from the household sector. Let Tx stand for the
taxes households pay. Some households will receive payments from the

government (these are called transfer payments and include government interest
payments.) Let Tr be the symbol for transfer payments, then net taxes are

                                    T  Tx  Tr

Disposable personal income, then is

                                     YD  Y  T

If GDP is dollar value of output produced in a year, then GDP must also be equal
to spending on output (the dollar value of what got bought must equal the dollar
value of what got sold). In our initial model the follow sectors purchase output (a)
households (consumption C), (b) businesses (investment I r ), and (c) the
government (G).

                              Total Spending = C+I+G

When we say investment we mean the purchase of output by firms, we don’t
mean financial investment such as someone’s purchase of a stock. So

               I r  the amount of final goods purchased by businesses
where the subscript r is used to specify realized investment. Business
investment includes inventories. We will use I to symbolize desired investment
spending. If businesses are holding the amount of inventory they wish then

                                       Ir  I

It may be the case that businesses have excess inventory (they haven’t sold as
much as they thought they would). In that case

                                       Ir  I

and businesses will reduce their purchases of output until the excess inventory is
worked off.

It might also be the case that firms have inventory shortages (they sold more
than they thought). In that case

                                       Ir  I

and businesses will purchase additional inventory to avoid missed sales.

So total purchases of output are

                               Y  GDP  C  I r  G
                               Y  C  Ir  G

where Y is also household income. Now what can households do with income?
They can consume (C), and pay taxes (T) and what’s left over is savings (S). So
income is also equal to

                                   Y  C  S T

Finally we have

                             C  Ir  G  Y  C  S  T
                             Ir  G  S  T

Prices and real and nominal GDP.

The consumer price index (CPI)

The Bureau of Business Research at Arizona State used to compute a consumer
price index for food for the Phoenix area. In some base year a market basket of
groceries was constructed made up of items they fest that a typical family would
purchase during a week. Some of the items might be

1 dozen eggs
1 gallon milk
2 pounds hamburger
1 pound of bacon

Then they would send graduate students out to the groceries in the Phoenix are
to record the prices of these goods each month. The average would then
determine the cost of the market basket for that month. Suppose that the initial
basket cost $20. If at some time in the future the same market basket cost $40
we could conclude that the price level for groceries had doubled. The same
basket of goods now costs twice as much.

Now suppose that we have a market basket of all goods (the CPI). We will
mathematically normalize the basket of goods so that its average price is 100 in
the base year. If the price of the basket is 110 one year from now then we would
say that the price level has increased by 10%. Somewhat loosely we could say

the inflation rate is 10% (a one time increase in the price level is not inflation –
inflation is a sustained increase in the price level for some time). If the CPI rose
to 200 we would conclude that the dollar would only buy half as much as it did in
the base year.

We can use the CPI to estimate real GDP.

                                        nominal GDP
                           real GDP                100

Nominal GDP is gross domestic product measured in current years dollars. This
is what you get when you sum up valued added for all firms. This will measure
GPD using inflated dollars.

Suppose that in the base year nominal income was $500 (bil.) and CPI=100. In
this case

                               real GDP        100  500

and real and nominal income are the same. Suppose that 10 years later

                               nominal GDP        1000
                  real GDP                100       100  500
                                  CPI              200

in which case the increase in nominal income is solely due to price increases.
But if

                               nominal GDP        1000
                  real GDP                100       100  1000
                                   CPI             100

This would represent an increase in real output.

Note the order in which we compute things. We start with nominal GDP and then
obtain an estimate of the price level (CPI). Using these two we get an estimate
of real GDP.

Does the CPI overstate inflation?

Many economists criticize the CPI as overstating inflation. Note that the CPI keeps the
market basket fixed. But people tend to adjust their actual market basket. Consider the
grocery market basket mentioned earlier. If the price of hamburger increased
substantially, people would substitute some cheaper good for the hamburger. The CPI
ignores this substitution effect.

The CPI also ignores the fact that peoples taste change. We might eat less red meat and
more fish over time. It also ignores the introduction of new goods that presumably makes
our lives better – else why use them.

The implicit GDP deflator (P).

Another way to compute a price index is

                                       nominal GDP
                          this years output in the base year price
                          nominal GDP
                            real GDP

The chief difference is that the CPI measures what the base years basket would cost
today while the deflator tries to measure what people actually purchase today in the base
years price. Because it uses what people actually buy today rather than a market basket
determined sometime in the past, the deflator should be able to account for the defects in
the CPI mentioned previously.

The unemployment rate and the employment ratio

The U.S. Bureau of labor statistics provides the following definitions:

 The civilian labor force comprises all civilians 16 years of age and over
 classified as employed or unemployed. Employed persons are (a) all civilians
 who, during the reference week, did any work at all as paid employees, in their
 own business, profession, or on their own farm, or who worked 15 hours or
 more as unpaid workers in an enterprise operated by a member of the family,
 and (b) all those who were not working but who had jobs or businesses from
 which they were temporarily absent because of illness, bad weather, vacation,
 child-care problems, maternity or paternity leave, labor-management disputes,
 job training, or other family or personal reasons, whether or not they were paid
 for the time off or were seeking other jobs. Each person is counted only once,
 even if he or she holds more than one job.

 Unemployed persons are all persons who had no employment during the
 reference week, were available for work, except for temporary illness, and had
 made specific efforts to find employment some time during the 4-week period
 ending with the reference week. Persons who were waiting to be recalled to a
 job from which they had been laid off need not have been looking for work to be
 classified as unemployed.

 The unemployment rate for all civilian workers represents the number of
 unemployed as a percent of the civilian labor force.

 Scope and Methodology:

 Civilian labor force estimates are the product of a federal-state cooperative
 program in which state employment security agencies prepare labor force and
 unemployment estimates under concepts, definitions, and technical procedures
 established by the Bureau of Labor Statistics (BLS).

 The national unemployment statistics published monthly by BLS are obtained
 from the Current Population Survey (CPS), a survey of households conducted
 for BLS by the Census Bureau. The size of the CPS is sufficiently large to
 obtain reliable annual average unemployment estimates for all states and the
 District of Columbia. County estimates, which are controlled to the CPS-based
 state totals, are then derived through the use of statistics derived from state
 unemployment insurance operations, as well as adjustments based on data
 from the CPS, decennial census, and other sources.

The unemployment rate is defined to be

                                            LF  E

where LF is the total number of people in the labor force and E is the number of people
who are employed. There is some reason to believe that the unemployment rate can often
be misleading.

                           Period         LF          E        U
                             1           100         95    5.00%
                             2           100         90   10.00%
                             3            92         90    2.17%
                             4           100         95    5.00%

The table above shows values for the unemployment rate for four different time periods.
In time period two, five people loose their jobs and both the unemployment rate and
employment ratio show worse values. In time period 3, five of the unemployed workers
become discouraged and drop out of the labor force. The unemployment rate would
suggest that this was a better situation than that which prevailed in time period one. Time
period four represents and economy in recovery. More workers have jobs and the
discouraged workers reenter the labor force. The unemployment rate looks worse than in
time period three. This sort of thing actually does occur in recessions.