CHAPTER 22 MEASURING A NATION’S INCOME 507 Table 22-3 GDP, L IFE E XPECTANCY , AND L ITERACY . The table shows GDP per person and two measures of the quality of life for 12 major countries. R EAL GDP PER L IFE A DULT C OUNTRY P ERSON , 1997 E XPECTANCY L ITERACY United States $29,010 77 years 99% Japan 24,070 80 99 Germany 21,260 77 99 Mexico 8,370 72 90 Brazil 6,480 67 84 Russia 4,370 67 99 Indonesia 3,490 65 85 China 3,130 70 83 India 1,670 63 53 Pakistan 1,560 64 41 Bangladesh 1,050 58 39 Nigeria 920 50 59 Source: Human Development Report 1999, United Nations. Measuring a nation’s gross domestic product is never easy, but it becomes especially difficult when people have every incentive to hide their economic activities from the eyes of government. The Russian Economy: Notes from Underground B Y M ICHAEL R. G ORDON If you want to know what is happening in the Russian economy, it helps to think about bread. Government statistics show that people are eating more bread and bakeries are selling less. Or consider vod- ka. Distillers are able to produce far more vodka than is officially being sold. But giv- en the well-deserved Russian fondness for vodka there is every reason to think the distilleries are operating at full capacity. The Russian Government’s top number crunchers say the contradictions are easy to explain: high taxes, govern- ment red tape, and the simple desire to sock away some extra cash have driven much of Russia’s economic activity underground. For the last six years, the Russian economy has been going down, down, down. But as President Boris N. Yeltsin tries to deliver the growth he has promised, economists are taking a clos- er look at the murky but vibrant shadow economy. It includes everything from small businesses that never report their sales to huge companies that understate their production to avoid taxes. Government experts insist that if the shadow economy is taken into account, the overall economy is finally starting to grow. In turn, Mr. Yeltsin’s critics com- plain that the new calculations are more propaganda than economics. . . . There is no question that measuring economic activity in a former Communist country on the road to capitalism is a frustratingly elusive task. “There is a serious problem with post-socialist statistics,” said Yegor T. Gaidar, the former Prime Minister and pro-reform director of the Institute of Economic Problems of the Transitional Period. “Seven years ago to report an increase in the amount of production was to become a Hero of Socialist Labor,” he said. “Now it is to get addi- tional visits from the tax collector.” S OURCE : The New York Times, May 18, 1997, Week in Review, p. 4. IN THE NEWS Hidden GDP 508 PART EIGHT THE DATA OF MACROECONOMICS maternal mortality, higher rates of child malnutrition, and less common access to safe drinking water. In countries with low GDP per person, fewer school-age children are actually in school, and those who are in school must learn with fewer teachers per student. These countries also tend to have fewer televisions, fewer telephones, fewer paved roads, and fewer households with electricity. International data leave no doubt that a nation’s GDP is closely associated with its citizens’ standard of living. QUICK QUIZ: Why should policymakers care about GDP? CONCLUSION This chapter has discussed how economists measure the total income of a nation. Measurement is, of course, only a starting point. Much of macroeconomics is aimed at revealing the long-run and short-run determinants of a nation’s gross domestic product. Why, for example, is GDP higher in the United States and Japan than in India and Nigeria? What can the governments of the poorest countries do to promote more rapid growth in GDP? Why does GDP in the United States rise rapidly in some years and fall in others? What can U.S. policymakers do to reduce the severity of these fluctuations in GDP? These are the questions we will take up shortly. At this point, it is important to acknowledge the importance of just measuring GDP. We all get some sense of how the economy is doing as we go about our lives. But the economists who study changes in the economy and the policymakers who formulate economic policies need more than this vague sense—they need concrete data on which to base their judgments. Quantifying the behavior of the economy with statistics such as GDP is, therefore, the first step to developing a science of macroeconomics. ◆ Because every transaction has a buyer and a seller, the total expenditure in the economy must equal the total income in the economy. ◆ Gross domestic product (GDP) measures an economy’s total expenditure on newly produced goods and services and the total income earned from the production of these goods and services. More precisely, GDP is the market value of all final goods and services produced within a country in a given period of time. ◆ GDP is divided among four components of expenditure: consumption, investment, government purchases, and net exports. Consumption includes spending on goods and services by households, with the exception of purchases of new housing. Investment includes spending on new equipment and structures, including households’ purchases of new housing. Government purchases include spending on goods and services by local, state, and federal governments. Net exports equal the value of goods and services produced domestically and sold abroad (exports) minus the value of goods and services produced abroad and sold domestically (imports). ◆ Nominal GDP uses current prices to value the economy’s production of goods and services. Real GDP uses constant base-year prices to value the economy’s production of goods and services. The GDP deflator— Summary CHAPTER 22 MEASURING A NATION’S INCOME 509 calculated from the ratio of nominal to real GDP— measures the level of prices in the economy. ◆ GDP is a good measure of economic well-being because people prefer higher to lower incomes. But it is not a perfect measure of well-being. For example, GDP excludes the value of leisure and the value of a clean environment. Key Concepts microeconomics, p. 494 macroeconomics, p. 494 gross domestic product (GDP), p. 496 consumption, p. 499 investment, p. 499 government purchases, p. 499 net exports, p. 499 nominal GDP, p. 502 real GDP, p. 502 GDP deflator, p. 503 Questions for Review 1. Explain why an economy’s income must equal its expenditure. 2. Which contributes more to GDP—the production of an economy car or the production of a luxury car? Why? 3. A farmer sells wheat to a baker for $2. The baker uses the wheat to make bread, which is sold for $3. What is the total contribution of these transactions to GDP? 4. Many years ago Peggy paid $500 to put together a record collection. Today she sold her albums at a garage sale for $100. How does this sale affect current GDP? 5. List the four components of GDP. Give an example of each. 6. Why do economists use real GDP rather than nominal GDP to gauge economic well-being? 7. In the year 2001, the economy produces 100 loaves of bread that sell for $2 each. In the year 2002, the economy produces 200 loaves of bread that sell for $3 each. Calculate nominal GDP, real GDP, and the GDP deflator for each year. (Use 2001 as the base year.) By what percentage does each of these three statistics rise from one year to the next? 8. Why is it desirable for a country to have a large GDP? Give an example of something that would raise GDP and yet be undesirable. Problems and Applications 1. What components of GDP (if any) would each of the following transactions affect? Explain. a. A family buys a new refrigerator. b. Aunt Jane buys a new house. c. Ford sells a Thunderbird from its inventory. d. You buy a pizza. e. California repaves Highway 101. f. Your parents buy a bottle of French wine. g. Honda expands its factory in Marysville, Ohio. 2. The “government purchases” component of GDP does not include spending on transfer payments such as Social Security. Thinking about the definition of GDP, explain why transfer payments are excluded. 3. Why do you think households’ purchases of new housing are included in the investment component of GDP rather than the consumption component? Can you think of a reason why households’ purchases of new cars should also be included in investment rather than in consumption? To what other consumption goods might this logic apply? 4. As the chapter states, GDP does not include the value of used goods that are resold. Why would including such transactions make GDP a less informative measure of economic well-being? 5. Below are some data from the land of milk and honey. P RICE Q UANTITY P RICEOF Q UANTITY Y EAR OF M ILK OF M ILK H ONEY OF H ONEY 2001 $1 100 qts. $2 50 qts. 2002 $1 200 $2 100 2003 $2 200 $4 100 510 PART EIGHT THE DATA OF MACROECONOMICS a. Compute nominal GDP, real GDP, and the GDP deflator for each year, using 2001 as the base year. b. Compute the percentage change in nominal GDP, real GDP, and the GDP deflator in 2002 and 2003 from the preceding year. For each year, identify the variable that does not change. Explain in words why your answer makes sense. c. Did economic well-being rise more in 2002 or 2003? Explain. 6. Consider the following data on U.S. GDP: N OMINAL GDP GDP D EFLATOR Y EAR ( IN BILLIONS )( BASEYEAR 1992) 1996 7,662 110 1997 8,111 112 a. What was the growth rate of nominal GDP between 1996 and 1997? (Note: The growth rate is the percentage change from one period to the next.) b. What was the growth rate of the GDP deflator between 1996 and 1997? c. What was real GDP in 1996 measured in 1992 prices? d. What was real GDP in 1997 measured in 1992 prices? e. What was the growth rate of real GDP between 1996 and 1997? f. Was the growth rate of nominal GDP higher or lower than the growth rate of real GDP? Explain. 7. If prices rise, people’s income from selling goods increases. The growth of real GDP ignores this gain, however. Why, then, do economists prefer real GDP as a measure of economic well-being? 8. Revised estimates of U.S. GDP are usually released by the government near the end of each month. Go to a library and find a newspaper article that reports on the most recent release. Discuss the recent changes in real and nominal GDP and in the components of GDP. (Alternatively, you can get the data at www.bea.doc.gov, the Web site of the U.S. Bureau of Economic Analysis.) 9. One day Barry the Barber, Inc., collects $400 for haircuts. Over this day, his equipment depreciates in value by $50. Of the remaining $350, Barry sends $30 to the government in sales taxes, takes home $220 in wages, and retains $100 in his business to add new equipment in the future. From the $220 that Barry takes home, he pays $70 in income taxes. Based on this information, compute Barry’s contribution to the following measures of income: a. gross domestic product b. net national product c. national income d. personal income e. disposable personal income 10. Goods and services that are not sold in markets, such as food produced and consumed at home, are generally not included in GDP. Can you think of how this might cause the numbers in the second column of Table 22-3 to be misleading in a comparison of the economic well- being of the United States and India? Explain. 11. Until the early 1990s, the U.S. government emphasized GNP rather than GDP as a measure of economic well- being. Which measure should the government prefer if it cares about the total income of Americans? Which measure should it prefer if it cares about the total amount of economic activity occurring in the United States? 12. The participation of women in the U.S. labor force has risen dramatically since 1970. a. How do you think this rise affected GDP? b. Now imagine a measure of well-being that includes time spent working in the home and taking leisure. How would the change in this measure of well- being compare to the change in GDP? c. Can you think of other aspects of well-being that are associated with the rise in women’s labor force participation? Would it be practical to construct a measure of well-being that includes these aspects? 511 IN THIS CHAPTER YOU WILL . . . Learn the distinction between real and nominal interest rates Compare the CPI and the GDP deflator as measures of the overall price level Learn how the consumer price index (CPI) is constructed Consider why the CPI is an imperfect measure of the cost of living See how to use a price index to compare dollar figures from different times In 1931, as the U.S. economy was suffering through the Great Depression, famed baseball player Babe Ruth earned $80,000. At the time, this salary was extraordi- nary, even among the stars of baseball. According to one story, a reporter asked Ruth whether he thought it was right that he made more than President Herbert Hoover, who had a salary of only $75,000. Ruth replied, “I had a better year.” Today the average baseball player earns more than 10 times Ruth’s 1931 salary, and the best players can earn 100 times as much. At first, this fact might lead you to think that baseball has become much more lucrative over the past six decades. But, as everyone knows, the prices of goods and services have also risen. In 1931, a nickel would buy an ice-cream cone, and a quarter would buy a ticket at the local movie theater. Because prices were so much lower in Babe Ruth’s day than they are in ours, it is not clear whether Ruth enjoyed a higher or lower standard of liv- ing than today’s players. MEASURING THE COST OF LIVING 512 PART EIGHT THE DATA OF MACROECONOMICS In the preceding chapter we looked at how economists use gross domestic product (GDP) to measure the quantity of goods and services that the economy is producing. This chapter examines how economists measure the overall cost of liv- ing. To compare Babe Ruth’s salary of $80,000 to salaries from today, we need to find some way of turning dollar figures into meaningful measures of purchasing power. That is exactly the job of a statistic called the consumer price index. After see- ing how the consumer price index is constructed, we discuss how we can use such a price index to compare dollar figures from different points in time. The consumer price index is used to monitor changes in the cost of living over time. When the consumer price index rises, the typical family has to spend more dollars to maintain the same standard of living. Economists use the term inflation to describe a situation in which the economy’s overall price level is rising. The inflation rate is the percentage change in the price level from the previous period. As we will see in the coming chapters, inflation is a closely watched aspect of macroeconomic performance and is a key variable guiding macroeconomic policy. This chapter provides the background for that analysis by showing how econo- mists measure the inflation rate using the consumer price index. THE CONSUMER PRICE INDEX The consumer price index (CPI) is a measure of the overall cost of the goods and services bought by a typical consumer. Each month the Bureau of Labor Statistics, which is part of the Department of Labor, computes and reports the consumer price index. In this section we discuss how the consumer price index is calculated and what problems arise in its measurement. We also consider how this index compares to the GDP deflator, another measure of the overall level of prices, which we examined in the preceding chapter. HOW THE CONSUMER PRICE INDEX IS CALCULATED When the Bureau of Labor Statistics calculates the consumer price index and the inflation rate, it uses data on the prices of thousands of goods and services. To see exactly how these statistics are constructed, let’s consider a simple economy in which consumers buy only two goods—hot dogs and hamburgers. Table 23-1 shows the five steps that the Bureau of Labor Statistics follows. 1. Fix the Basket. The first step in computing the consumer price index is to determine which prices are most important to the typical consumer. If the typical consumer buys more hot dogs than hamburgers, then the price of hot dogs is more important than the price of hamburgers and, therefore, should be given greater weight in measuring the cost of living. The Bureau of Labor Statistics sets these weights by surveying consumers and finding the basket of goods and services that the typical consumer buys. In the example in the table, the typical consumer buys a basket of 4 hot dogs and 2 hamburgers. consumer price index (CPI) a measure of the overall cost of the goods and services bought by a typical consumer CHAPTER 23 MEASURING THE COST OF LIVING 513 2. Find the Prices. The second step in computing the consumer price index is to find the prices of each of the goods and services in the basket for each point in time. The table shows the prices of hot dogs and hamburgers for three different years. 3. Compute the Basket’s Cost. The third step is to use the data on prices to calculate the cost of the basket of goods and services at different times. The table shows this calculation for each of the three years. Notice that only the prices in this calculation change. By keeping the basket of goods the same (4 hot dogs and 2 hamburgers), we are isolating the effects of price changes from the effect of any quantity changes that might be occurring at the same time. 4. Choose a Base Year and Compute the Index. The fourth step is to designate one year as the base year, which is the benchmark against which other years are compared. To calculate the index, the price of the basket of goods and Table 23-1 C ALCULATING THE C ONSUMER P RICE I NDEX AND THE I NFLATION R ATE : A N E XAMPLE . This table shows how to calculate the consumer price index and the inflation rate for a hypothetical economy in which consumers buy only hot dogs and hamburgers. S TEP 1: S URVEY C ONSUMERS TO D ETERMINE A F IXED B ASKET OF G OODS 4 hot dogs, 2 hamburgers S TEP 2: F IND THE P RICE OF E ACH G OOD IN E ACH Y EAR Y EAR P RICE OF H OT D OGS P RICE OF H AMBURGERS 2001 $1 $2 2002 2 3 2003 3 4 S TEP 3: C OMPUTE THE C OST OF THE B ASKET OF G OODS IN E ACH Y EAR 2001 ($1 per hot dog ϫ 4 hot dogs) ϩ ($2 per hamburger ϫ 2 hamburgers) ϭ $8 2002 ($2 per hot dog ϫ 4 hot dogs) ϩ ($3 per hamburger ϫ 2 hamburgers) ϭ $14 2003 ($3 per hot dog ϫ 4 hot dogs) ϩ ($4 per hamburger ϫ 2 hamburgers) ϭ $20 S TEP 4: C HOOSE O NE Y EARASA B ASE Y EAR (2001) AND C OMPUTE THE C ONSUMER P RICE I NDEX IN E ACH Y EAR 2001 ($8/$8) ϫ 100 ϭ 100 2002 ($14/$8) ϫ 100 ϭ 175 2003 ($20/$8) ϫ 100 ϭ 250 S TEP 5: U SE THE C ONSUMER P RICE I NDEX TO C OMPUTE THE I NFLATION R ATE FROM P REVIOUS Y EAR 2002 (175 Ϫ 100)/100 ϫ 100 ϭ 75% 2003 (250 Ϫ 175)/175 ϫ 100 ϭ 43% 514 PART EIGHT THE DATA OF MACROECONOMICS services in each year is divided by the price of the basket in the base year, and this ratio is then multiplied by 100. The resulting number is the consumer price index. In the example in the table, the year 2001 is the base year. In this year, the basket of hot dogs and hamburgers costs $8. Therefore, the price of the basket in all years is divided by $8 and multiplied by 100. The consumer price index is 100 in 2001. (The index is always 100 in the base year.) The consumer price index is 175 in 2002. This means that the price of the basket in 2002 is 175 percent of its price in the base year. Put differently, a basket of goods that costs $100 in the base year costs $175 in 2002. Similarly, the consumer price index is 250 in 2003, indicating that the price level in 2003 is 250 percent of the price level in the base year. 5. Compute the Inflation Rate. The fifth and final step is to use the consumer price index to calculate the inflation rate, which is the percentage change in the price index from the preceding period. That is, the inflation rate between two consecutive years is computed as follows: inflation rate the percentage change in the price index from the preceding period When constructing the con- sumer price index, the Bureau of Labor Statistics tries to include all the goods and ser- vices that the typical consumer buys. Moreover, it tries to weight these goods and ser- vices according to how much consumers buy of each item. Figure 23-1 shows the breakdown of consumer spend- ing into the major categories of goods and services. By far the largest category is housing, which makes up 40 percent of the typical consumer’s budget. This category includes the cost of shelter (30 percent), fuel and other utilities (5 per- cent), and household furnishings and operation (5 percent). The next largest categor y, at 17 percent, is transportation, which includes spending on cars, gasoline, buses, subways, and so on. The next category, at 16 percent, is food and beverages; this includes food at home (9 percent), food away from home (6 percent), and alcoholic beverages (1 per- cent). Next are medical care at 6 percent, recreation at 6 percent, apparel at 5 percent, and education and communi- cation at 5 percent. This last category includes, for exam- ple, college tuition and personal computers. Also included in the figure, at 5 percent of spending, is a categor y for other goods and ser vices. This is a catchall for things consumers buy that do not naturally fit into the other categories, such as cigarettes, haircuts, and funeral expenses. FYI What Is in the CPI’s Basket? 16% Food and beverages 17% Transportation Other goods and services Medical care Apparel Recreation 5% 6% 5% 5% 6% 40% Housing Education and communication Figure 23-1 T HE T YPICAL B ASKET OF G OODS AND S ERVICES . This figure shows how the typical consumer divides his spending among various categories of goods and services. The Bureau of Labor Statistics calls each percentage the “relative importance” of the category. S OURCE : Bureau of Labor Statistics. CHAPTER 23 MEASURING THE COST OF LIVING 515 Inflation rate in year 2 ϭϫ100. In our example, the inflation rate is 75 percent in 2002 and 43 percent in 2003. Although this example simplifies the real world by including only two goods, it shows how the Bureau of Labor Statistics (BLS) computes the consumer price index and the inflation rate. The BLS collects and processes data on the prices of thousands of goods and services every month and, by following the five foregoing steps, determines how quickly the cost of living for the typical consumer is rising. When the bureau makes its monthly announcement of the consumer price index, you can usually hear the number on the evening television news or see it in the next day’s newspaper. In addition to the consumer price index for the overall economy, the BLS cal- culates several other price indexes. It reports the index for specific regions within the country (such as Boston, New York, and Los Angeles) and for some narrow categories of goods and services (such as food, clothing, and energy). It also calcu- lates the producer price index, which measures the cost of a basket of goods and services bought by firms rather than consumers. Because firms eventually pass on their costs to consumers in the form of higher consumer prices, changes in the pro- ducer price index are often thought to be useful in predicting changes in the con- sumer price index. PROBLEMS IN MEASURING THE COST OF LIVING The goal of the consumer price index is to measure changes in the cost of living. In other words, the consumer price index tries to gauge how much incomes must rise in order to maintain a constant standard of living. The consumer price index, how- ever, is not a perfect measure of the cost of living. Three problems with the index are widely acknowledged but difficult to solve. The first problem is called substitution bias. When prices change from one year to the next, they do not all change proportionately: Some prices rise by more than others. Consumers respond to these differing price changes by buying less of the goods whose prices have risen by large amounts and by buying more of the goods whose prices have risen less or perhaps even have fallen. That is, consumers sub- stitute toward goods that have become relatively less expensive. Yet the consumer price index is computed assuming a fixed basket of goods. By not taking into account the possibility of consumer substitution, the index overstates the increase in the cost of living from one year to the next. Let’s consider a simple example. Imagine that in the base year, apples are cheaper than pears, and so consumers buy more apples than pears. When the Bureau of Labor Statistics constructs the basket of goods, it will include more apples than pears. Suppose that next year pears are cheaper than apples. Con- sumers will naturally respond to the price changes by buying more pears and few- er apples. Yet, when computing the consumer price index, the Bureau of Labor Statistics uses a fixed basket, which in essence assumes that consumers continue buying the now expensive apples in the same quantities as before. For this reason, the index will measure a much larger increase in the cost of living than consumers actually experience. CPI in year 2 Ϫ CPI in year 1 CPI in year 1 producer price index a measure of the cost of a basket of goods and services bought by firms 516 PART EIGHT THE DATA OF MACROECONOMICS The second problem with the consumer price index is the introduction of new goods. When a new good is introduced, consumers have more variety from which to choose. Greater variety, in turn, makes each dollar more valuable, so consumers need fewer dollars to maintain any given standard of living. Yet because the con- sumer price index is based on a fixed basket of goods and services, it does not reflect this change in the purchasing power of the dollar. Again, let’s consider an example. When VCRs were introduced, consumers were able to watch their favorite movies at home. Compared to going to a movie theater, the convenience is greater and the cost is less. A perfect cost-of-living index would reflect the introduction of the VCR with a decrease in the cost of living. The consumer price index, however, did not decrease in response to the introduction of the VCR. Eventually, the Bureau of Labor Statistics did revise the basket of goods B EHIND EVERY MACROECONOMIC STATISTIC are thousands of individual pieces of data on the economy. This article fol- lows some of the people who collect these data. Is the CPI Accurate? Ask the Federal Sleuths Who Get the Numbers B Y C HRISTINA D UFF T RENTON , N.J.—The hospital’s finance director is relentlessly unhelpful, but she is still no match for Sabina Bloom, gov- ernment gumshoe. Mrs. Bloom wants to know the exact prices of some hospital services. “Nothing’s changed,” the woman says. “Well, do you have the ledger?” Mrs. Bloom asks. “We haven’t changed any prices,” the woman insists. Mrs. Bloom’s fast talk finally pries the woman from behind her desk, and she gets the numbers. It turns out that a semiprivate surgery recovery room now costs $753.80 a day—or $0.04 less than a month ago. Chalk up another small success for Mrs. Bloom, one of about 300 Bureau of Labor Statistics employees who gather the information that is fed into the monthly Consumer Price Index. . . . Mrs. Bloom’s travails sometimes read like a detective novel. Each month, she covers 900 miles in her beat-up Geo Prizm (three accidents in the past 18 months) to visit about 150 sites. Her mission: to record the prices of certain items, time and again. If prices change, she needs to find out why. Each month, some 90,000 prices are shipped to Washington, plugged into a computer, scrutinized, aggregated, adjusted for seasonal ups or downs, and then spit out as the monthly CPI report. Choosing what to price—for ex- ample, the “regular” or “fancy” baby parakeet—can seem arbitrary. After con- sulting surveys that track consumer buy- ing habits, the labor statistics bureau selects popular stores and item cate- gories—say, women’s tops. The price- taker then asks a store employee to help zero in on an item of the price-taker’s choosing. They narrow to the size of the top, its style (short-sleeve, long-sleeve, tank, or turtleneck), and so on; items that generate the most revenue in a cat- egory have the best chance of getting picked. Shoppers know that relying on employees for anything can be chancy. At a downtown Chicago department store (the government doesn’t disclose IN THE NEWS Shopping for the CPI T HE INTRODUCTION OF NEW PRODUCTS BIASES THE CPI. . Measurement is, of course, only a starting point. Much of macroeconomics is aimed at revealing the long-run and short-run determinants of a nation’s gross. measure of well-being. For example, GDP excludes the value of leisure and the value of a clean environment. Key Concepts microeconomics, p. 494 macroeconomics,