Chapter2TheMeasurementandStructureoftheNationalEconomy11

Chapter2
TheMeasurementandStructure
oftheNationalEconomy

Learning Objectives
I. GoalsofChapter2
A. Nationalincomeaccounts;relationshipsamongkeymacroeconomicvariables(Sec.2.1)
B. Grossdomesticproductthemainmeasureofoutput(Sec.2.2)
C. Savingandwealthprivateandgovernment(Sec.2.3)
D. RealGDP,priceindexes,andinflation(Sec.2.4)
E. Interestrates(Sec.2.5)
II. NotestoSixthEditionUsers
A. TheapplicationWealthvs.Savinghasbeendeleted
B. AnewapplicationTheFedsPreferredInflationMeasures,hasbeenadded,whichdiscusses
thedifferentmeasurestheFederalReserveusestomeasureinflationandwhytheirpreferred
measureisthepersonalconsumptionexpenditurespriceindexratherthantheCPI

Teaching Notes
I. NationalIncomeAccounting:TheMeasurementofProduction,Income,andExpenditure
(Sec.2.1)
A. Nationalincomeaccounts:anaccountingframeworkusedinmeasuringcurrenteconomic
activity
B. Threealternativeapproachesgivethesamemeasurements
1. Productapproach:theamountofoutputproduced
2. Incomeapproach:theincomesgeneratedbyproduction
3. Expenditureapproach:theamountofspendingbypurchasers
C. Juicebusinessexampleshowsthatallthreeapproachesareequal
1. Importantconceptinproductapproach:valueaddedvalueofoutputminusvalueofinputs
purchasedfromotherproducers
D. Whyarethethreeapproachesequivalent?
1. Theymustbe,bydefinition

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2. Anyoutputproduced(productapproach)ispurchasedbysomeone(expenditureapproach)
andresultsinincometosomeone(incomeapproach)
3. Thefundamentalidentityofnationalincomeaccounting:
totalproductiontotalincometotalexpenditure (2.1)

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 Chapter2TheMeasurementandStructureoftheNationalEconomy13
II. GrossDomesticProduct(Sec.2.2)
A. TheproductapproachtomeasuringGDP
1. GDP(grossdomesticproduct)isthemarketvalueoffinalgoodsandservicesnewly
producedwithinanationduringafixedperiodoftime

Data Application
Theperiodreferredtohereiseitheraquarterorayear.Youmaywanttoshowstudentswhat
someofthetablesfromtheNationalIncomeandProductAccountslooklike,orsendthemtothe
library(ortheInternetatwww.bea.doc.gov)tofindtheaccountsintheSurveyofCurrent
Business.
Studentsarealsointerestedinseeingwhathappensinthefinancialmarketsandtopublicopinion
onthedayanewGDPreportcomesout.

2. Marketvalue:allowsaddingtogetherunlikeitemsbyvaluingthemattheirmarketprices
a. Problem:missesnonmarketitemssuchashomemaking,thevalueofenvironmental
quality,andnaturalresourcedepletion

AnalyticalProblems1and3bothdiscussdifficultiesincountingnonmarketitemsforGDP,
includingtheimportantideathatGDPisnotthesameaswelfare.

b. Thereissomeadjustmenttoreflecttheundergroundeconomy
c. Governmentservices(thatarentsoldinmarkets)arevaluedattheircostofproduction
3. Newlyproduced:countsonlythingsproducedinthegivenperiod;excludesthingsproduced
earlier
4. Finalgoodsandservices
a. Dontcountintermediategoodsandservices(thoseusedupintheproductionofother
goodsandservicesinthesameperiodthattheythemselveswereproduced)
b. Finalgoods&servicesarethosethatarenotintermediate
c. Capitalgoods(goodsusedtoproduceothergoods)arefinalgoodssincetheyarentused
upinthesameperiodthattheyareproduced
d. Inventoryinvestment(theamountthatinventoriesofunsoldfinishedgoods,goods
inprocess,andrawmaterialshavechangedduringtheperiod)isalsotreatedasafinal
good
e. Addingupvalueaddedworkswell,sinceitautomaticallyexcludesintermediategoods
5. GNPvs.GDP
a. GNP(grossnationalproduct)outputproducedbydomesticallyownedfactors
ofproduction
GDPoutputproducedwithinanation
b. GDPGNPNFP(netfactorpaymentsfromabroad) (2.2)
c. NFPpaymentstodomesticallyownedfactorslocatedabroadminuspayments
toforeignfactorslocateddomestically

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Data Application
PriortoDecember1991,theUnitedStatesusedGNPasitsmainmeasureofproduction;afterthat
timeGDPbecamethemainconcept.ThemainreasonsfortheswitchwerethatGDPismore
relevanttoproductioninanopeneconomy(thoughGNPismorerelevantforincome),andGDP
ismoreprecisethanGNPintheadvanceestimate,sincenetfactorpaymentsaredifficultto
measurequickly.SeeSurveyofCurrentBusiness,November1991,foradiscussionoftheswitch.

d. Example:EngineeringrevenuesforaroadbuiltbyaU.S.companyinSaudiArabiais
partofU.S.GNP(builtbyaU.S.factorofproduction),notU.S.GDP,andispartof
SaudiGDP(builtinSaudiArabia),notSaudiGNP
e. DifferencebetweenGNPandGDPissmallfortheUnitedStates,about0.2%,buthigher
forcountriesthathavemanycitizensworkingabroad

Data Application
Thetimelinefornationalincomeandproductaccountreleasesisgenerally:
Advancerelease Lastweekofmonthfollowingendofquarter
Preliminaryrelease Lastweekofsecondfollowingmonth
Finalrelease Lastweekofthirdfollowingmonth
RevisionsoccureveryJulyforthefollowingthreeyears,theneveryfifthyearforanew
benchmarkrelease.Eachnewreleasecontainseitheradditionalnewdatathatwasnotavailable
before,orachangeinseasonalfactors,oracorrectionoferrorsmadepreviously.

B. TheexpenditureapproachtomeasuringGDP
1. Measurestotalspendingonfinalgoodsandservicesproducedwithinanationduringa
specifiedperiodoftime
2. Fourmaincategoriesofspending:consumption(C),investment(I ),governmentpurchases
ofgoodsandservices(G),andnetexports(NX)
3. YCIGNX,theincomeexpenditureidentity (2.3)
4. Consumption:spendingbydomestichouseholdsonfinalgoodsandservices
(includingthoseproducedabroad)
a. About2/3ofU.S.GDP
b. Threecategories
(1) Consumerdurables(examples:cars,TVsets,furniture,andmajorappliances)
(2) Nondurablegoods(examples:food,clothing,fuel)
(3) Services(examples:education,healthcare,financialservices,andtransportation)

Data Application
Notethattheconsumptioncategoryinthenationalincomeandproductaccountsdoesnot
correspondtoeconomistsconceptofconsumption,becauseitincludesthefullvalueofdurable
goods.Wheneconomistsstudyconsumptionbehavior,theymustaccountforthis;onewaytodo
soistoassumethatdurablegoodsprovideservicesthatareproportionaltotheirexistingstock.
Totalconsumptionisthisfractionofthestockofconsumerdurables,plusnondurablesandservices.

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 Chapter2TheMeasurementandStructureoftheNationalEconomy15
5. Investment:spendingfornewcapitalgoods(fixedinvestment)plusinventoryinvestment
a. About1/6ofU.S.GDP
b. Business(ornonresidential)fixedinvestment:spendingbybusinessesonstructuresand
equipmentandsoftware
c. Residentialfixedinvestment:spendingontheconstructionofhousesandapartment
buildings
d. Inventoryinvestment:increasesinfirmsinventoryholdings

Data Application
AmajorchangeinthenationalincomeandproductaccountscameinOctober1999,when
computersoftwarepurchasedbybusinessesandgovernmentwasclassifiedasinvestment,rather
thananinputusedupinproduction.Asaresult,realGDPandinvestmentwererevisedup
significantly,especiallyforthe1990s.

6. Governmentpurchasesofgoodsandservices:spendingbythegovernmentongoodsor
services
a. About1/5ofU.S.GDP
b. Mostbystateandlocalgovernments,notfederalgovernment
c. Notallgovernmentexpendituresarepurchasesofgoodsandservices
(1) Somearepaymentsthatarenotmadeinexchangeforcurrentgoodsandservices
(2) Onetypeistransfers,includingSocialSecuritypayments,welfare,and
unemploymentbenefits
(3) Anothertypeisinterestpaymentsonthegovernmentdebt
d. Somegovernmentspendingisforcapitalgoodsthataddtothenationscapitalstock,such
ashighways,airports,bridges,andwaterandsewersystems

Data Application
Peopleoftendontrealizehowlargetransferprogramsarerelativetofederalgovernment
consumptionexpenditures.Forexample,in2002,transferpaymentswere$932billion,
whilegovernmentconsumptionexpenditureswereonly$587billion.Ofthatamount,most
($387billion)wasfornationaldefense;nondefenseconsumptionexpenditures($200billion)were
lessthanonefourthoftheamountoftransfers.Otherfederalgovernmentexpendituresincluded
$306billioningrantstostateandlocalgovernments,$208billioninnetinterestpaid,and$44
billioninnetsubsidiestogovernmententerprises.Grossinvestmentbythefederalgovernment
($107billion)wasjustslightlymorethandepreciation($102billion),sonetinvestmentwas
small($5billion).

7. Netexports:exportsminusimports
a. Exports:goodsproducedinthecountrythatarepurchasedbyforeigners
b. Imports:goodsproducedabroadthatarepurchasedbyresidentsinthecountry
c. ImportsaresubtractedfromGDP,astheyrepresentgoodsproducedabroad,andwere
includedinconsumption,investment,andgovernmentpurchases

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Data Application

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 Chapter2TheMeasurementandStructureoftheNationalEconomy17

BehindthescenesattheBureauofEconomicAnalysis(BEA),amajorchangeistakingplace
concerningthenationalincomeaccountsandthedataonGDP.Becausethetypesofgoodsand
servicespeoplebuyhaschangedsomuchinrecentyears,theBEAhasdecidedtomodifyhowit
categorizesindustrieswhenitcollectsdataonproduction.ThenewsystemisknownasNAICS:
theNorthAmericanIndustryClassificationSystem;itreplacesasystemcalledSIC:Standard
IndustrialClassification.NAICSdiffersfromSICinbothprincipleandinpractice.
ThekeyprinciplegoverningNAICSisthatfirmsthatusesimilarproductionprocesseswillbe
classifiedinthesameindustry,whichwasnottrueunderSIC.Theresultisthatthenumberof
firmsindifferentindustrieswillchange;forexample,themanufacturingindustryisdifferent
underNAICSthanunderSIC.
OneofthemainreasonsfortheswitchfromSICtoNAICSisthegrowthofserviceindustries
andcomputerrelatedindustries.Inthepast70years,manufacturingoutputhasdeclinedfrom
54percentofGDPto38percent,whiletheoutputofserviceindustrieshasincreasedfrom
35percentofGDPto54percent.TheSIChasnotbeenupdatedtoreflectthechangesinthe
economy.NAICSwillalsoimprovethecompatibilityofU.S.statisticswiththoseinother
countries.
ThedisadvantageoftheswitchfromSICtoNAICSisthatdatafromtodaybasedonNAICS
willnotbeexactlycomparabletodatafromthepastbasedonSIC.ButtheBEAbelievesthatthe
improvedqualityofthedatawilljustifythelossofhistoricalcomparability.Inaddition,NAICS
hastheadvantageofbeingveryadaptablewhenindustrieschange;forexample,itsinformation
sectorincludessuchcategoriesasInternetpublishingandbroadcasting.Addingnewcategories
willnotbedifficultastechnologychangesfurtherandnewindustriesevolve.

C. TheincomeapproachtomeasuringGDP
1. Addsupincomegeneratedbyproduction(includingprofitsandtaxespaidtothe
government)
a. Nationalincomecompensationofemployees(includingbenefits)proprietors
incomerentalincomeofpersonscorporateprofitsnetinteresttaxesonproduction
andimportsbusinesscurrenttransferpaymentscurrentsurplusofgovernment
enterprises

Data Application
Notethatthedefinitionofincomewaschangedinseveralwaysin2003.Severalcategorieswere
brokendowninmoredetail,indirectbusinesstaxeswereincludedinthelargercategoryoftaxes
onproductionandimports,andlessnettingwasdonefortransfers,interest,andsurplusor
subsidiesofgovernmententerprises.

b. Nationalincomestatisticaldiscrepancynetnationalproduct
c. Netnationalproductdepreciation(thevalueofcapitalthatwearsoutintheperiod)
grossnationalproduct(GNP)
d. GNPnetfactorpayments(NFP)GDP
2. Privatesectorandgovernmentsectorincome
a. Privatedisposableincomeincomeoftheprivatesectorprivatesectorincome
earnedathome(YorGDP)andabroad(NFP)paymentsfromthegovernmentsector
(transfers,TR,andinterestongovernmentdebt,INT)taxespaidtogovernment
(T)YNFPTRINTT (2.4)

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b. GovernmentsnetincometaxestransfersinterestpaymentsTTRINT (2.5)
c. PrivatedisposableincomegovernmentsnetincomeGDPNFPGNP

NumericalProblems1,2,3,4,and5providepracticeinworkingwiththenationalincomeand
productaccounts.

III. SavingandWealth(Sec.2.3)
A. Wealth
1. Householdwealthahouseholdsassetsminusitsliabilities
2. Nationalwealthsumofallhouseholds,firms,andgovernmentswealthwithinthenation
3. Savingbyindividuals,businesses,andgovernmentdeterminewealth
B. Measuresofaggregatesaving
1. Savingcurrentincomecurrentspending
2. Savingratesaving/currentincome
3. Privatesavingprivatedisposableincomeconsumption
Spvt(YNFPTTRINT)C (2.6)
4. Governmentsavingnetgovernmentincomegovernmentpurchasesofgoodsandservices
Sgovt(TTRINT)G (2.7)
a. Governmentsavinggovernmentbudgetsurplusgovernmentreceiptsgovernment
outlays
b. Governmentreceiptstaxrevenue(T)
c. Governmentoutlaysgovernmentpurchasesofgoodsandservices(G)transfers(TR)
interestpaymentsongovernmentdebt(INT)
d. GovernmentbudgetdeficitSgovt
e. DespitetheBEAschangeinmethodsthatexplicitlyrecognizegovernmentinvestment,
thetextsimplifiesmattersbycountinggovernmentinvestmentasgovernmentpurchases,
notinvestment.Thisavoidscomplicationswhentheconceptsareintroducedandcanbe
modifiedforfurtheranalysislater.
5. Nationalsaving
a. Nationalsavingprivatesavinggovernmentsaving
b. SSpvtSgovt
[YNFPTTRINTC][TTRINTG] (2.8)
YNFPCGGNPCG
C. Theusesofprivatesaving
1. SI(NXNFP) (2.9)
SICA (2.10)
DerivedfromSYNFPCGandYCIGNX
CANXNFPcurrentaccountbalance

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 Chapter2TheMeasurementandStructureoftheNationalEconomy19
2. SpvtI(Sgovt )CA (2.11)
{usingSSpvtSgovt}
Theusesofsavingidentitysavingisusedinthreeways:
a. investment(I )
b. governmentbudgetdeficit(Sgovt)
c. currentaccountbalance(CA)

AnalyticalProblem4hasstudentsexaminehowtheusesofsavingsidentitywouldchangeifwe
redefinedgovernmentsavingsothatgovernmentinvestmentwasseparatefromgovernment
consumptionexpenditures,sothatGGCEGIandSgovt(TTRINT )GCE.

D. Relatingsavingandwealth
1. Stocksandflows
a. Flowvariables:measuredperunitoftime(GDP,income,saving,investment)
b. Stockvariables:measuredatapointintime(quantityofmoney,valueofhouses,capitalstock)
c. Flowvariablesoftenequalratesofchangeofstockvariables
2. Wealthandsavingasstockandflow(wealthisastock,savingisaflow)
3. Nationalwealth:domesticphysicalassetsnetforeignassets
a. Countrysdomesticphysicalassets(capitalgoodsandland)
b. Countrysnetforeignassetsforeignassets(foreignstocks,bonds,andcapitalgoods
ownedbydomesticresidents)minusforeignliabilities(domesticstocks,bonds,and
capitalgoodsownedbyforeigners)
c. Wealthmattersbecausetheeconomicwellbeingofacountrydependsonit
d. Changesinnationalwealth
(1) Changeinvalueofexistingassetsandliabilities(changeinpriceoffinancialassets,
ordepreciationofcapitalgoods)
(2) Nationalsaving(SICA)raiseswealth
e. ComparisonofU.S.savingandinvestmentwithothercountries
(1) TheUnitedStatesisalowsavingcountry;Japanisahighsavingcountry
(2) U.S.investmentexceedsU.S.saving,sowehaveanegativecurrentaccountbalance

IV. RealGDP,PriceIndexes,andInflation(Sec.2.4)
A. RealGDP
1. Nominalvariablesarethoseindollarterms
2. Problem:dochangesinnominalvaluesreflectchangesinpricesorquantities?
3. Realvariables:adjustforpricechanges;reflectonlyquantitychanges
4. Exampleofcomputersandbicycles
5. NominalGDPisthedollarvalueofaneconomysfinaloutputmeasuredatcurrentmarket
prices
6. RealGDPisanestimateofthevalueofaneconomysfinaloutput,adjustingforchanges
intheoverallpricelevel

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Data Application
ThefirsttimethatthenationalincomeandproductaccountsreportedrealGNPwasinFebruary
1959;priortothattime,inflationwasusuallysolowthatnominalGNPwasallthatitwasthought
necessarytoexamine.
NumericalProblem5providespracticeincalculatingrealandnominalGDPandpriceindexes
givenseveralgoodswithdifferentpricesandquantitiesintwoyears.

B. PriceIndexes
1. Apriceindexmeasurestheaveragelevelofpricesforsomespecifiedsetofgoodsand
services,relativetothepricesinaspecifiedbaseyear
2. GDPdeflator100nominalGDP/realGDP

Data Application
Therearetwopriceindexesavailableforconsumptionexpenditures:thepriceindexforpersonal
consumptionexpenditures(PCE)andtheconsumerpriceindex(CPI).TheCPIisavailable
monthly,whilethePCEpriceindexisonlyavailablequarterly,butprovidesabettermeasureof
inflationformostpurposes,whichiswhyitsthemaininflationmeasureusedbytheFederal
Reserve.

3. NotethatbaseyearP100
4. ConsumerPriceIndex(CPI)
a. Monthlyindexofconsumerprices;indexaverages100inreferencebaseperiod
(1982to1984)
b. Basedonbasketofgoodsinexpenditurebaseperiod(2003to2004)
5. InTouchwithDataandResearch:ThecomputerrevolutionandchainweightedGDP
a. ChoiceofexpenditurebaseperiodmattersforGDPwhenpricesandquantitiesofagood,
suchascomputers,arechangingrapidly
b. BEAcompromisedbydevelopingchainweightedGDP
c. Now,however,componentsofrealGDPdontadduptorealGDP,butdiscrepancyis
usuallysmall

Data Application
Calculatingchainweightedindexesisnottoohardandyoucanusethecomputerbicycle
exampleinTable2.4toillustratehowtodoso.DefinetheLaspeyresquantityindex(usingyear1
prices)foryear1asthevalueofyear1outputatyear1prices:L 1$46,000;theLaspeyres
quantityindexofyear2outputisL2$62,000.DefinethePaaschequantityindex(usingyear2
prices)foryear1asthevalueofyear1outputatyear2prices:P1$51,000;thePaaschequantity
indexofyear2outputisP2$66,000.(TheseamountsareallcalculatedinTable2.4,theyjust
arenotlabeledthisway.)ThechainweightedindexisjustthegeometricmeanoftheLaspeyres
andPaascheindexes:C1(L1P1)1/2(46,00051,000)1/2$48,400;C2(L2P2)1/2(62,000
66,000)1/2$63,970.

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 Chapter2TheMeasurementandStructureoftheNationalEconomy21

NotethatthegrowthrateofrealGDPinthiscaseis($63,970$48,400)/$48,40032.06%,
whichisclosetotheaveragegrowthratecalculatedbytheLaspeyres(34.8%)andPaasche
(29.4%)indexes,whichis32.095%.

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6. Inflation
a. Calculateinflationrate:t1(Pt1Pt)/PtPt1/Pt
b. TextFig.2.4showstheU.S.inflationratesince1960fortheGDPdeflator
7. DoesCPIinflationoverstateincreasesinthecostofliving?
a. TheBoskinCommissionreportedthattheCPIwasbiasedupwardsbyasmuchasoneto
twopercentagepointsperyear
b. Oneproblemisthatadjustingthepricemeasuresforchangesinthequalityofgoodsis
verydifficult
c. Anotherproblemisthatpriceindexeswithfixedsetsofgoodsdontreflectthesubstitution
byconsumersthatgoesonwhenonegoodbecomesrelativelycheaperthananother;this
problemisknownassubstitutionbias

Data Application
AsymposiumontheCPIappearedintheJournalofEconomicPerspectives12(Winter1998).
Manydifferentaspectsofmeasurementproblemsareexplored.AlthoughtheBLSclaimsthat
qualityadjustmentsaremade,WilliamNordhauspointsoutthatotherthaninthecategoriesof
newcarsandtrucksandwomensapparel,only0.1percentofallpricedcommoditieswere
deemedtohavequalitychangesinarecentyear.

d. Ifinflationisoverstated,thenrealincomesarehigherthanwethoughtandweve
overindexedpaymentslikeSocialSecurity
e. Latestresearch(July2006)suggestsbiasisstill1%peryearorhigher
C. Application:TheFedspreferredinflationmeasures
1. TheFederalReservefocusesitsattentiononthepersonalconsumptionexpenditures(PCE)
priceindex
a. TheFedforecastsboththeoverallPCEpriceindexandthecorePCEpriceindex
2. ThePCEpriceindexissuperiortotheCPIbecauseitavoidssubstitutionbiasandisrevised
whenbetterdataareavailable
3. DifferencesbetweenthePCEpriceindexandtheCPIincludeformulasusedintheir
calculation,coverageofdifferentitems,andweightsgiventodifferentitems
4. TheFedusesthecorePCEpriceindextomeasuretheunderlyingtrendininflation
5. ButtheFedforecastsboththecoreandoverallPCEpriceindexbecausetheFedneedsto
keepitseyeonbothunderlyingtrendsbutalsotheactualinflationratefacedbyhouseholds
6. TheinflationrateintheoverallPCEpriceindextendstoreverttothecoremeasureaftera
periodwhenthetwomeasuresdeviate

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Data Application
Therearemanyproblemswithpriceindexes;theyareimperfectmeasuresofpricechanges.
Whatdotheindexesdowhennewgoodsareintroduced?Whathappensasmoreefficientstores
replacesstoresthathadhigherintermediatecosts?Howdoweaccountforthefactthatpeople
substitutecheapergoodsforhigherpricedgoods?Inadequatetreatmentofthesequestionsmeans
themeasuresofpricesgiveanoverestimateoftheinflationrate.TheBLShasfixedanumberof
theseproblemsinrecentyears,butsomeoverestimateremains.Inarecentcomprehensivereview
ofthesemeasurementissues,DavidE.LebowandJeremyB.Rudd(MeasurementErrorinthe
ConsumerPriceIndex:WhereDoWeStand?JournalofEconomicLiterature(March2003),
pp.159201)concludethattheoverestimateofinflationintheCPIisnowabout0.9percentper
year.Morerecently,RobertGordonsuggeststhattheoverstatementmaystillexceed1.0percent
peryear(TheBoskinCommissionReport:ARetrospectiveOneDecadeLater,NBER
WorkingPaperNo.12311,June2006.).
NumericalProblems7and9givepracticeincalculatinginflationrates.

V. InterestRates(Sec.2.5)
A. Realvs.nominalinterestrates
1. Interestrate:arateofreturnpromisedbyaborrowertoalender
2. Realinterestrate:rateatwhichtherealvalueofanassetincreasesovertime
3. Nominalinterestrate:rateatwhichthenominalvalueofanassetincreasesovertime
4. Realinterestratei (2.12)
TextFig.2.5plotsnominalandrealinterestratesfortheUnitedStatessince1960
B. Theexpectedrealinterestrate
1. ri e (2.13)
2. If e,realinterestrateexpectedrealinterestrate

NumericalProblem8providespracticeincalculatingrealinterestrates.

Additional Issues for Classroom Discussion

1.Welfare Does Not Equal GDP
Youcangetstudentsinvolvedinausefuldiscussionofhowournationalincomeaccountsfailtomeasure
ourwellbeing.GDPcoversonlymarketactivity.Askyourstudentstocomeupwithsomenonmarket
activitiesthatarevaluabletosociety,butwhicharentcoveredaspartofGDP.Thenyoumightdiscuss
someactivitiesthatincreaseGDPbutreducewelfareinsomeway,suchasactivitiesthatcausepollution.
TheSanFranciscothinktankcalledRedefiningProgresscollectsdataonwhatitlabelsgenuine
progressandcomparesittoGDP.Thegenuineprogressindicator(GPI)hasbeendecliningsincethe
mid1960s,eventhoughrealGDPhasbeenrising.UnlikeGDP,whichmeasuresonlymarketactivity,the
GPIaccountsforresourcedepletion,incomedistribution,houseworkandnonmarkettransactions,changes
inleisuretime,unemploymentandunderemployment,pollution,longtermenvironmentaldamage,the
lifespanofconsumerdurablesandinfrastructure,defensiveexpenditures,andsustainableinvestments.

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2.More Implications of Price Mismeasurement
AskyourstudentstoexploretheramificationsofthebiasintheCPIandotherpricemeasures.IftheCPI
hasbeenoverstatedbyonepercentagepointperyearoverthepastdecade,howmuchlowershouldSocial
Securitypaymentsbe?Ifyouseedatathatsaytherealwagehasbarelygrownoverthepastdecade,where
realwagegrowthismeasuredbytakingnominalwagegrowthandsubtractingofftherateofinflation,what
doesthatimplyabouthowfastrealwageshavetrulygrown?Someofthesamebiasestothepriceindex
thatapplytotheCPIalsoapplytotheGDPpriceindex(thoughnotthesubstitutionbias).UsingtheGDP
priceindex,officialgovernmentdatashowthatmultifactorproductivity(ameasureofaverageoutputthat
accountsforgrowthinbothcapitalandlabor)haschangedlittleoverthepast20years.Butiftheprice
indexisbiasedupwards,whatdoesthatimplyaboutbothrealGDPgrowthoverthepast20yearsand
aboutmultifactorproductivityoverthattimeperiod?Whatothermacroeconomicvariablesmightbe
affectedbypricemismeasurement?

3.Should the CPI Measure Changes in Prices or Changes in the Cost

of Living?
TheBoskinCommissiononthebiasintheCPIraisedapointthateconomistshaveknownaboutforsome
time.Theeconomicconceptthatwedlikeourpricemeasurestocaptureischangesinthecostofliving,
butourpriceindexesaresetuptomeasurethechangeinaverageprices.Thedifferenceissubtle,yet
important.Agreatmedicalbreakthrough,likethediscoveryofthepoliovaccine,greatlyimprovesthe
qualityoflife,reducingthecostofliving.Inventionslikethevacuumcleanerorthetransistoralsochanged
thethingswedoindailylife,vastlyimprovingthequalityofourlives.Morerecently,advancesincomputer
technologyhavechangedthewaywegetinformationandthewaybusinessesoperate.Butthesegreat
inventionsseldomhavemuchofanimpactonpriceindexesliketheCPIoroutputmeasureslikeGDP.
Thequalityoflifeimprovementsengenderedbynewproductsareverydifficulttomeasure.Sothe
governmentrecordkeeperslettheincomeandpriceaccountsreflectsuchqualitychangesinonlyalimited
way.Butshouldthey?TheBoskinCommissionrecommendedthatthegovernmentstatisticalagenciestry
tomeasurechangesinthequalityoflife,ratherthanjustmeasuringthepricesofexistinggoods.Yetthere
canneverbesolidknowledgeofexactlyhowmuchbetternewinventionsmakeourlives.Soshouldthe
governmentagenciessimplycontinuetodowhattheyvebeendoing,andjustmeasureprices?Orshould
theytaketheirbestguessastotheimprovementinourlivesthatnewinventionsanddiscoveriescause?
WouldthefactthatsuchaguessinfluencesthingslikethemonthlypaymentstoSocialSecurity
recipientsaffectyourdecision?

Answers to Textbook Problems

Review Questions
1. Thethreeapproachestonationalincomeaccountingaretheproductapproach,theincomeapproach,
andtheexpenditureapproach.Theyallgivethesameanswerbecausetheyaredesignedthatway;any
entrybasedononeapproachhasanentryintheotherapproacheswiththesamevalue.Whenever
outputisproducedandsold,itsproductioniscountedintheproductapproach,itssaleiscountedin
theexpenditureapproach,andthefundsreceivedbythesellerarecountedintheincomeapproach.

2. GoodsaremeasuredatmarketvalueinGDPaccountingsothatdifferenttypesofgoodsandservices
canbeaddedtogether.Usingmarketpricesallowsustocountupthetotaldollarvalueofallthe
economysoutput.Theproblemwiththisapproachisthatnotallgoodsandservicesaresoldin
markets,sowemaynotbeabletocounteverything.Importantexamplesarehomemakingand
environmentalquality.

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 Chapter2TheMeasurementandStructureoftheNationalEconomy25
3. Intermediategoodsandservicesareusedupinproducingothergoodsinthesameperiod(year)in
whichtheywereproduced,whilefinalgoodsandservicesarethosethatarepurchasedbyconsumers
orarecapitalgoodsthatareusedtoproducefutureoutput.Thedistinctionisimportant,becausewe
wanttocountonlythevalueoffinalgoodsproducedintheeconomy,notthevalueofgoods
producedeachstepalongtheway.

4. GNPisthemarketvalueoffinalgoodsandservicesnewlyproducedbydomesticfactorsofproduction
duringthecurrentperiod,whereasGDPisproductiontakingplacewithinacountry.Thus,GNP
differsfromGDPwhenforeignfactorsareusedtoproduceoutputinacountry,orwhendomestic
factorsareusedtoproduceoutputinanothercountry.GDPGNPNFP,whereNFPnetfactor
paymentsfromabroad,whichequalsincomepaidtodomesticfactorsofproductionbytherestofthe
worldminusincomepaidtoforeignfactorsofproductionbythedomesticeconomy.Acountrythat
employsmanyforeignworkerswilllikelyhavenegativeNFP,soGDPwillbehigherthanGNP.

5. Thefourcomponentsofspendingareconsumption,investment,governmentpurchases,andnetexports.
Importsmustbesubtracted,becausetheyareproducedabroadandwewantGDPtocountonlythose
goodsandservicesproducedwithinthecountry.Forexample,supposeacarbuiltinJapanisimported
intotheUnitedStates.ThecarcountsasconsumptionspendinginU.S.GDP,butissubtractedasan
importaswell,soonnetitdoesnotaffectU.S.GDP.However,itiscountedinJapansGDPasan
export.

6. Privatesavingisprivatedisposableincomeminusconsumption.Privatedisposableincomeistotal
outputminustaxespaidplustransfersandinterestreceivedfromthegovernment.Privatesavingis
usedtofinanceinvestmentspending,thegovernmentbudgetdeficit,andthecurrentaccount.
Nationalsavingisprivatesavingplusgovernmentsaving.

7. Nationalwealthisthetotalwealthoftheresidentsofacountry,andconsistsofitsdomesticphysical
assetsandnetforeignassets.Wealthisimportantbecausethelongruneconomicwellbeingofa
countrydependsonit.Nationalwealthisrelatedtonationalsavingbecausenationalsavingisthe
flowofadditionstothestockofnationalwealth.

8. RealGDPistheusefulconceptforfiguringoutacountrysgrowthperformance.NominalGDPmay
risebecauseofincreasesinpricesratherthangrowthinrealoutput.

9. TheCPIisapriceindexthatiscalculatedasthevalueofafixedsetofconsumergoodsandservices
atcurrentpricesdividedbythevalueofthefixedsetatbaseyearprices.CPIinflationisthegrowth
rateoftheCPI.CPIinflationoverstatestrueinflationbecauseitishardtomeasurechangesinquality,
andbecausethepriceindexdoesntaccountforsubstitutionawayfromgoodsthatbecomerelatively
moreexpensivetowardsgoodsthatbecomerelativelycheaper.

10. Thenominalinterestrateistherateatwhichthenominal(ordollar)valueofanassetincreasesover
time.Therealinterestrateistherateatwhichtherealvalueorpurchasingpowerofanassetincreases
overtime,andisequaltothenominalinterestrateminustheinflationrate.Theexpectedrealinterest
rateistherateatwhichtherealvalueofanassetisexpectedtoincreaseovertime.Itisequaltothe
nominalinterestrateminustheexpectedinflationrate.Theconceptthatismostimportanttoborrowers
andlendersistheexpectedrealinterestrate,becauseitaffectstheirdecisionstoborroworlend.

2011PearsonEducation,Inc.PublishingasAddisonWesley
26Abel/Bernanke/CroushoreMacroeconomics,SeventhEdition
Numerical Problems
1. GDPisthevalueofallfinalgoodsandservicesproducedduringtheyear.Thefinaloutputofcoconuts
is1000,whichisworth500fish,becausetwococonutsareworthonefish.Thefinaloutputoffishis
500fish.Sointermsoffish,GDPconsistsof500fishworthofcoconutsplus500fish,withatotal
valueof1000fish.
Tofindconsumptionandinvestment,wemustfindoutwhathappenstoallthecoconutsandfish.
Gilliganconsumesallhis200coconuts(worth100fish)and100fish,sohisconsumptionisworth
200fish.TheProfessorstores100coconutswithavalueof50fish.Inanidealaccountingsystem,
thesestoredcoconutswouldbetreatedasinvestment.However,inthenationalincomeaccounts,
becauseitissodifficulttotellwhendurablegoodsareconsumedandwhentheyaresaved,theyare
countedasconsumption.SotheProfessorsconsumptionconsistsof800coconuts(value400fish)
and400fish,foratotalvalueof800fish.Thustheeconomystotalconsumptionisvaluedat1000
fishandinvestmentiszero.
Intermsofincome,Gilligansincomeisclearlyworth200fish(100fishplus200coconutsworth
100fish).TheProfessorsincomeis800coconuts(1000coconutsminusthe200coconutspaidto
Gilligan)plus400fish(500fishminus100fishpaidtoGilligan).Intermsoffish,theProfessors
incomehasavalueof800fish.
Thisquestionillustratessomeofthenuancesofnationalincomeaccounting.Manydifficultchoices
andmeasurementissuesareinvolvedinconstructingtheaccounts.Here,forexample,itisclearthat
whatwecallconsumptionreallyisntjusttheamountofgoodsconsumersuseupduringtheyear,but
alsoincludesconsumptiongoodsthatarepurchasedbutsavedforthefuture.Sincethereisnowayto
measurewhengoodsareusedaftertheyarepurchased,theaccountsareunabletodistinguish
consumptionfromstorageofgoods.

2. (a) FurnituremadeinNorthCarolinathatisboughtbyconsumerscountsasconsumption,
soconsumptionincreasesby$6billion,investmentisunchanged,governmentpurchasesare
unchanged,netexportsareunchanged,andGDPincreasesby$6billion.
(b) FurnituremadeinSwedenthatisboughtbyconsumerscountsasconsumptionandimports,
soconsumptionincreasesby$6billion,investmentisunchanged,governmentpurchasesare
unchanged,netexportsfallby$6billion,andGDPisunchanged.
(c) FurnituremadeinNorthCarolinathatisboughtbybusinessescountsasinvestment,
soconsumptionisunchanged,investmentincreasesby$6billion,governmentpurchases
areunchanged,netexportsareunchanged,andGDPincreasesby$6billion.
(d) FurnituremadeinSwedenthatisboughtbybusinessescountsasinvestmentandimports,
soconsumptionisunchanged,investmentincreasesby$6billion,governmentpurchasesare
unchanged,netexportsdeclineby$6billion,andGDPisunchanged.

3. (a) ABCproducesoutputvaluedat$2millionandhastotalexpensesof$1.3million($1millionfor
labor,$0.1millioninterest,$0.2milliontaxes).Soitsprofitsare$0.7million.XYZproduces
outputvaluedat$3.8million($3millionforthethreecomputersthatweresold,plus$0.8million
fortheunsoldcomputerininventory)andhasexpensesof$3.2million($2millionforcomponents,
$0.8millionforlabor,and$0.4millionfortaxes).Soitsprofitsare$0.6million.
Accordingtotheproductapproach,theGDPcontributionsofthesecompaniesare$3.8million,
thevalueofthefinalproductofXYZ.ABCsproductionisofanintermediategood,used
completelybyXYZ,andsoisnotcountedinGDP.

2011PearsonEducation,Inc.PublishingasAddisonWesley
 Chapter2TheMeasurementandStructureoftheNationalEconomy27
Accordingtotheexpenditureapproach,theGDPcontributionisalso$3.8million,with
$3million(ofsoldcomputers)addingtothecapitalstock(asinvestmentspending),and$0.8
million(theunsoldcomputer)asinventoryinvestment.
TheincomeapproachyieldsthesameGDPtotalcontribution.Theamountsare:

ABC XYZ TOTAL

Labor $1.0million $0.8million $1.8million
Profit $0.7million $0.6million $1.3million
Taxes $0.2million $0.4million $0.6million
Interest $0.1million $0.0million $0.1million

Totalofallincomes$3.8million

(b) IfABCpaysanadditional$.5millionforcomputerchipsfromabroad,theresultschange
slightly.Thecorrectansweriseasiesttoseeusingtheexpenditureapproach.Asinparta,thereis
$3.8millionspentonfinalgoods,butnowtherearealsonetexportsof$0.5million.Sothetotal
expenditureondomesticallyproducedgoodsisonly$3.3million.Theproductapproachgetsthe
sameanswerbecausethe$0.5millionisacontributiontoGDPofthecountryinwhichthechips
weremade,andsomustbedeductedfromtheGDPoftheUnitedStates.Thevalueaddedinthe
UnitedStatesisonly$3.3million.Finally,theincomeapproachgivesthesameanswerasin
parta,exceptthatthecostofimportingthechipsreducesABCsprofitsby$0.5million,sothe
sumoftheincomesisonly$3.3million.

4. (a) Productapproach:$2gasstationsvalueadded$28productminus$26valueofproduct
producedinthepreviousyear.Expenditureapproach:$2$28consumptionspendingplus
inventoryinvestmentof$26.Incomeapproach:$2paidtothefactorsofproductionatthegas
station(wagesofemployees,interest,taxes,profits).
(b) Productapproach:$60,000brokersfeeforprovidingbrokerageservices.Expenditureapproach:
$60,000countsasresidentialinvestmentmadebythehomebuyer.Theimportantpointhereis
thatthetransferofanexistinggood,evenatahighervaluethanthatatwhichitwasoriginally
sold,doesnotaddtoGDP.Incomeapproach:$60,000incometothebrokerforwages,
profits,etc.
(c) Productapproach:$40,000salaryplus$16,000childcareequals$56,000.Notethatthereisa
senseinwhichthechildcareisanintermediateserviceandshouldnotbecounted,because
withoutitthehomemakerwouldnotbeabletowork.Butinpracticethereisnowaytoseparate
suchintermediateservicesfromfinalservices,sotheyarealladdedtoGDP.Expenditure
approach:$56,000($16,000consumptionspendingonchildcareservicesplus$40,000in
categoriesthatdependonwhatthehomemakerspendshisorherincome).Incomeapproach:
$56,000($40,000compensationofhomemakerplus$16,000incometothefactorsproducing
thechildcare:employeeswages,interest,taxes,profits).
(d) Productapproach:$100millionofacapitalgood.Sinceitisproducedwithlocallaborand
materials,andassumingnopaymentsgotoJapanesefactorsofproduction,thisisalladded
toU.S.GDP.Expenditureapproach:$100millionnetexports,sincetheplantisownedbythe
Japanese.(Itisnotpartofgrossdomesticinvestmentbecausetheplantisnotacapitalgood
ownedbyU.S.residents.)Incomeapproach:$100millionpaidtoU.S.factorsofproduction.

2011PearsonEducation,Inc.PublishingasAddisonWesley
28Abel/Bernanke/CroushoreMacroeconomics,SeventhEdition
(e) Productapproach:$0becausenothingisproduced.Expenditureapproach:$0becausethisisa
transfer,notagovernmentpurchaseofgoodsorservices.Incomeapproach:$0,becausethisis
notapaymenttoafactorofproduction,justatransfer.
(f) Productapproach:$5,000worthofadvertisingservices.Expenditureapproach:$5,000of
governmentpurchases.Incomeapproach:$5,000compensationofemployees.

2011PearsonEducation,Inc.PublishingasAddisonWesley
 Chapter2TheMeasurementandStructureoftheNationalEconomy29
(g) Productapproach:$120millioncomposedof$100millionofnewcarsproducedplus$20million
ofsalesservicesprovidedbytheconsortium($60millionsalespriceminus$40millioncost).
Expenditureapproach:$100millionbyHertzasinvestmentplus$60millionbythepublicfor
consumptionoftheusedcarsminus$40millionofinvestmentgoodssoldbyHertz,foratotalof
$120million.Incomeapproach:$100milliontothefactorsofproductionofGMplus$20million
inpaymentstothefactorsofproductionandprofitsfortheconsortium.

5. Givendata:I40,G30,GNP200,CA20NXNFP,T60,TR25,INT15,NFP
792.SinceGDPGNPNFP,GDP200(2)202Y.SinceNXNFPCA,NX
CANFP20(2)18.SinceYCIGNX,CY(IGNX)202(4030
(18))150.
Spvt(YNFPTTRINT)C(202(2)602515)15030.Sgovt(TTRINT)
G(602515)3010.SSpvtSgovt30(10)20.
(a) Consumption150
(b) Netexports18
(c) GDP202
(d) Netfactorpaymentsfromabroad2
(e) Privatesaving30
(f) Governmentsaving10
(g) Nationalsaving20

6.
BaseYearQuantitiesatCurrentYearPrices AtBaseYearPrices
Apples 3000$3$9,000 3000$2$6,000
Bananas 6000$2$12,000 6000$3$18,000
Oranges 8000$5$40,000 8000$4$32,000
Total $61,000 $56,000

CurrentYearQuantitiesatCurrentYearPrices AtBaseYearPrices
Apples 4,000$3$12,000 4,000$2$8,000
Bananas 14,000$2$28,000 14,000$3$42,000
Oranges 32,000$5$160,000 32,000$4$128,000
Total $200,000 $178,000

2011PearsonEducation,Inc.PublishingasAddisonWesley
30Abel/Bernanke/CroushoreMacroeconomics,SeventhEdition
(a) NominalGDPisjustthedollarvalueofproductioninayearatpricesinthatyear.NominalGDP
is$56thousandinthebaseyearand$200thousandinthecurrentyear.NominalGDPgrew
257%betweenthebaseyearandthecurrentyear:[($200,000/$56,000)1]100%257%.
(b) RealGDPiscalculatedbyfindingthevalueofproductionineachyearatbaseyearprices.
Thus,fromthetableabove,realGDPis$56,000inthebaseyearand$178,000inthecurrentyear.
Inpercentageterms,realGDPincreasesfromthebaseyeartothecurrentyearby
[($178,000/$56,000)1]100%218%.
(c) TheGDPdeflatoristheratioofnominalGDPtorealGDP.Inthebaseyear,nominalGDP
equalsrealGDP,sotheGDPdeflatoris1.Inthecurrentyear,theGDPdeflatoris
$200,000/$178,0001.124.ThustheGDPdeflatorchangesby[(1.124/1)1]100%12.4%
fromthebaseyeartothecurrentyear.
(d) NominalGDProse257%,pricesrose12.4%,andrealGDProse218%,somostoftheincrease
innominalGDPisbecauseoftheincreaseinrealoutput,notprices.Noticethatthequantityof
orangesquadrupledandthequantityofbananasmorethandoubled.

7. Calculatinginflationrates:
192930:[(50.0/51.3)1]100%2.5%
193031:[(45.6/50.0)1]100%8.8%
193132:[(40.9/45.6)1]100%10.3%
193233:[(38.8/40.9)1]100%5.1%
Theseallshowdeflation(pricesaredecliningovertime),whereasrecentlywehavehadnothingbut
inflation(pricesrisingovertime).

8. Thenominalinterestrateis[(545/500)1]100%9%.Theinflationrateis[(214/200)1]
100%7%.Sotherealinterestrateis2%(9%nominalrate7%inflationrate).Expectedinflation
wasonly[(210/200)1]100%5%,sotheexpectedrealinterestratewas4%(9%nominalrate
5%expectedinflationrate).

9. (a) TheannualrateofinflationfromJanuary1,2008,toJanuary1,2010,is10%.Thiscanbefound
bycalculatingtheconstantrateofinflationthatwouldraisethedeflatorfrom200to242intwo
years.Thisgivestheequation(1)(1)(242/200),whichhasthesolution10%.
Aneasywaytothinkaboutthisquestionisthis.Aconstantinflationrateof raisesthedeflator
from200onJanuary1,2008,to200(1)onJanuary1,2009,andto200(1)(1)
242onJanuary1,2010.Soweneedtosolvetheexpression(1)2242/200.
(b) Bysimilarreasoning,theinflationrateoverthethreeyearperiodis(1)3266.2/200,
or10%.
(c) Wecanderiveageneralexpressioninthesameway:
1P1/P0
1P2/P1



1Pn/Pn1

2011PearsonEducation,Inc.PublishingasAddisonWesley
 Chapter2TheMeasurementandStructureoftheNationalEconomy31
Multiplyingalltheselinestogether,weget:
(1)n(P1/P0)(P2/P1)(Pn/Pn1)Pn/P0

2011PearsonEducation,Inc.PublishingasAddisonWesley
32Abel/Bernanke/CroushoreMacroeconomics,SeventhEdition
Analytical Problems
1. ThekeytothisquestionisthatrealGDPisnotthesamethingaswellbeing.Peoplemaybebetteroff
evenifrealGDPislower;forexample,thismayoccurbecausetheimprovementinthehealthof
workersismorevaluabletosocietythanthelossofGDPduetotheregulation.Ideally,wewouldlike
tobeabletocomparethecostsandbenefitsofsuchregulations;theyshouldbeputinplaceifthe
overallcosts(thereducedGDPinthiscase)arevaluedlessthantheoverallbenefits(theworkers
health).

2. NationalsavingdoesnotrisebecauseoftheswitchtoCheapCallbecausealthoughconsumption
spendingdeclinesby$2million,sohavetotalexpenditures(GDP),whichequaltotalincome.Since
incomeandspendingbothdeclinedbythesameamount,nationalsavingisunchanged.

3. (a) Theprobleminaplannedeconomyisthatpricesdonotmeasuremarketvalue.Whentheprice
ofanitemistoolow,thengoodsarereallymoreexpensivethantheirlistedpricesuggestswe
shouldincludeintheirmarketvaluethevalueoftimespentbyconsumerswaitingtomake
purchases.Becausetheitemsvalueexceedsitscost,measuredGDPistoolow.
Whenthepriceofanitemistoohigh,goodsstockedontheshelvesmaybevaluedtoohighly.
Thisresultsinanovervaluationoffirmsinventories,sothatmeasuredGDPistoohigh.
ApossiblestrategyfordealingwiththisproblemistohaveGDPanalystsestimatewhatthemarket
priceshouldbe(perhapsbylookingatpricesofthesamegoodsinmarketeconomies)anduse
thisshadowpriceintheGDPcalculations.
(b) ThegoodsandservicesthatpeopleproduceathomearenotcountedintheGDPfiguresbecause
theyarenotsoldonthemarket,makingtheirvaluedifficulttomeasure.Onewaytodoitmight
betolookatthestandardoflivingrelativetoamarketeconomy,andestimatewhatincomeit
wouldtakeinamarketeconomytosupportthatstandardofliving.
old new
4. Undertheolddefinition, Sgovt (TTRINT)G;underthenewdefinition, Sgovt
(TTRINT)GCE,whereGCEgovernmentconsumptionexpenditures,GGCEGI,
andGIgovernmentinvestment.Withthosedefinitions:
old
Sgovt (TTRINT)G
(TTRINT)(GCEGI)
[(TTRINT)GCE]GI
new
Sgovt GI.

Theusesofsavingsidentityis

SpvtI ( Sgovt ) CA
old

I ( Sgovt GI ) CA
new

IGI ( Sgovt ) CA.

new

2011PearsonEducation,Inc.PublishingasAddisonWesley
 Chapter2TheMeasurementandStructureoftheNationalEconomy33

Usingdatafor2002,theoldusesofsavingsidentityis(wheresdisthestatisticaldiscrepancy):
SpvtsdI ( Sgovt ) CA
old

1595(117)1593374(489)
14781478
sotheidentityholds.

Thenewusesofsavingsidentityis:

SpvtsdIGI ( Sgovt ) CA
new

1595(117)159335222(489)
14781478
sotheidentityholds.

2011PearsonEducation,Inc.PublishingasAddisonWesley