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Intermediate Macroeconomics Unit 1: Measuring the Macroeconomy

Before you can model the economy you need to measure it. This unit covers how GDP, price indexes and unemployment are built, and what each one leaves out.

Covers: GDP and the expenditure identity, Nominal vs real GDP and the deflator, Consumer price index and its biases, Labor force statistics, GDP vs GNP and the income side, Saving, investment and net exports identities

Study guide

Gross domestic product (GDP) is the market value of all final goods and services produced within a country during a period. Three approaches give the same number. The expenditure approach adds spending on final output: Y = C + I + G + NX. The income approach adds the incomes earned in production: wages, rent, interest and profit, plus depreciation and indirect taxes. The value-added approach sums, across firms, the value of output minus the cost of intermediate inputs. Each works because every dollar spent on a final good is a dollar of income to someone. Intermediate goods are left out to avoid double counting, as are used goods, financial transactions and transfer payments, none of which is current production.

Each spending component has a precise meaning. Consumption (C) is household spending on goods and services. Investment (I) is not buying stocks: it is spending on new capital such as equipment and structures, new housing and changes in inventories. Government purchases (G) include goods and services bought by all levels of government, but not transfers such as Social Security or interest on debt. Net exports (NX) are exports minus imports. Imports are subtracted because they are already counted inside C, I and G. GNP differs from GDP by adding factor income residents earn abroad and subtracting factor income foreigners earn at home.

Nominal GDP values output at current prices, so it can rise because of more output or higher prices. Real GDP values output at the prices of a base year, isolating quantity changes. The GDP deflator, nominal GDP ÷ real GDP × 100, is a price index for everything produced domestically. Because using a single base year distorts growth when relative prices shift (computer prices, for example), U.S. statistics use chain-weighted real GDP, which updates the weights every year. A useful approximation: the percentage change in nominal GDP ≈ the percentage change in the deflator + the percentage change in real GDP.

The consumer price index (CPI) prices a fixed basket of goods a typical consumer buys, compared with the base period. Because the basket is fixed, the CPI is a Laspeyres index; the deflator, which uses current output, behaves like a Paasche index. The CPI tends to overstate the true rise in living costs because of substitution bias, the arrival of new goods and unmeasured quality improvements. The two indexes also differ in coverage: the CPI includes imported consumer goods but not capital goods; the deflator includes domestically produced capital goods and government services but not imports.

Labor statistics come from a monthly household survey. Adults are employed, unemployed (no job, available, and searching in the past four weeks) or not in the labor force. The labor force is employed plus unemployed. The unemployment rate is unemployed ÷ labor force, and the participation rate is labor force ÷ adult population. Discouraged workers who give up searching leave the labor force, which lowers the measured unemployment rate even though nothing improved. Finally, the accounting identities link saving and the trade balance: national saving S = Y − C − G, and S − I = NX, so a country that invests more than it saves must run a trade deficit and borrow from abroad.

Key ideas

• GDP counts current production of final goods and services inside a country's borders.
• Expenditure, income and value added give the same GDP because spending equals income.
• Real GDP removes price changes; the deflator is nominal over real times 100.
• The CPI uses a fixed basket and tends to overstate cost-of-living increases.
• The CPI includes imports; the GDP deflator includes capital goods and government output instead.
• Unemployment rate = unemployed ÷ labor force; discouraged workers are not counted as unemployed.
• National saving minus investment equals net exports.

Formulas and rules

Common mistakes

• Counting transfer payments, used goods or stock purchases as part of GDP.
• Treating 'investment' as buying financial assets instead of new capital, housing and inventories.
• Dividing the unemployed by the adult population or by employment instead of by the labor force.
• Assuming the CPI and the deflator must move together when import prices or capital-goods prices change.
• Using current prices when computing real GDP growth, which mixes inflation into the answer.

Before the test, make sure you can

• Calculate GDP from expenditure data and from value added along a production chain.
• Classify spending as C, I, G, NX or excluded from GDP.
• Calculate real GDP, the GDP deflator and real growth from price and quantity data.
• Compute a CPI from a basket and explain its three main biases.
• Explain why the CPI and the GDP deflator can diverge.
• Calculate the unemployment rate and participation rate and explain the effect of discouraged workers.
• Use S − I = NX to find national saving, net exports or the effect of a budget change.

Words to know

GDP

Market value of all final goods and services produced within a country in a given period.

GNP

GDP plus factor income earned abroad by residents minus factor income earned at home by foreigners.

Value added

A firm's output value minus the cost of the intermediate goods it buys; summing value added across firms gives GDP.

Intermediate good

A good used up in producing another good; excluded from GDP to avoid double counting.

Investment (I)

Spending on new capital equipment, structures, new housing and inventory changes.

Transfer payment

A government payment, such as Social Security, made without receiving a good or service in return; not part of G.

Net exports

Exports minus imports; also equals national saving minus investment.

Nominal GDP

Output valued at current-year prices.

Real GDP

Output valued at constant base-year prices, measuring changes in quantity.

GDP deflator

Nominal GDP divided by real GDP times 100; a price index for all domestic output.

Chain-weighted GDP

Real GDP computed with weights updated each year to limit base-year distortions.

CPI

Cost of a fixed consumer basket relative to a base period, times 100.

Laspeyres index

A price index with a fixed base-period basket, like the CPI.

Paasche index

A price index using the current-period basket, like the GDP deflator.

Substitution bias

The CPI's overstatement of living costs because it ignores consumers switching toward relatively cheaper goods.

Labor force

Adults who are employed plus those unemployed and actively searching.

Discouraged worker

Someone who wants a job but has stopped searching, so is counted outside the labor force.

National saving

Y − C − G, the sum of private saving and public saving.

Sample practice questions

30 more questions like these, from level 1 to 5, are in the practice set.