PRINCIPLES OF MACROECONOMICS
Ranjit Dighe
WEEK 5 (LECTURES 13 & 14)
Feb. 21-25, 2000

[There were just two lectures this week, since the first exam was on Wednesday.  The material corresponds to parts of Case & Fair's Chapter 7.]

LECTURE 13
Mon., Feb. 21, 2000

0. IMPEDIMENTA

* Today: GDP accounting, continued
    I.    A bit more about GDP and GNP
    II.  Pros and cons of GDP
    III. Go over Problem Set 3

* FIRST EXAM IS WEDNESDAY
-- It covers through: today's lecture / Problem Set 3 / Chapter 7
---- What to focus on, in order of importance:
------ (1) the three problem sets (and their solution sheets)
------ (2) the lecture notes (check your own notes against these Internet versions of my notes)
------ (3) the book chapters
-- Solutions to Problem Set 3 have been posted on the Internet
 

I.  A BIT MORE ABOUT GDP AND GNP

Comparing GDP and GNP: Going back to the definitions of the two, they are the same except for the final phrase:
"located within a country" (GDP) vs. "owned by a country's citizens" (GNP).

-- Exs.:
---- My teaching services in this classroom: counted in U.S. GNP, because I'm an American citizen, and U.S. GDP.
---- The teaching services of a visiting faculty member from Holland: not in GNP, because he's not a U.S. citizen, but it is in GDP.
---- A car produced at a Subaru plant in Indiana, owned by Japanese but using American labor: some of its output is in GNP; all of its output is in GDP.
---- A car produced at a Subaru plant in Japan: none of its output is in U.S. GNP or GDP.

National income and product accounting (NIPA), like macro, itself is a relatively new phenomenon, and was invented in the 1930s.
-- Recall that John Maynard Keynes published The General Theory in 1936, during and largely as an answer to the Great Depression.
-- Simon Kuznets, the father of national income accounting (and later a recipient of the Nobel Prize in economics), published his first estimates of U.S. national output in 1934 and continued to do so through the 1940s. Kuznets estimated U.S. output retroactively to 1869.

Historical note: In the 1940s, during World War II, the U.S. and England had national income accounting, and Hitler's Germany did not. That knowledge about national production capabilities made a tremendous contribution to the Allies' military victory.

Calculating the level of GNP or GDP is not easy -- the U.S. Commerce Department employs huge teams of economists and accountants to crunch out the "National Income and Product Accounts" (NIPA).
 

II.  PROS AND CONS OF GDP

Q: Why should you care about what the level of GDP is?
A: GDP has been called a country's "economic report card."  It's not bad as a bottom-line measure of how a nation is doing economically.

Per-capita GDP is a reasonable measure of a country's standard of living. In fact, "standard of living" and "per capita GDP" have come to be virtually synonymous. Higher per capita GDP <==> on average, people eating better, living in better dwellings, healthier, better clothed, better educated, consuming more luxuries, etc.

A large absolute GDP ==> a powerful country (politically, militarily, diplomatically)
-- The U.S., with the world's largest GDP by far, is also "the world's only remaining superpower." Like the 900-pound gorilla that sits wherever it wants, an economic powerhouse like the U.S. wields enormous influence in world politics.

Also, you should care because it's an essential part of macro. Economics is about measuring social data as well as interpreting it. Most people would agree that interpreting the data is a lot more fun-- e.g., arguing over whether Reagan's supply-side policies worked or didn't work -- and we'll get to that soon in this course. But for now, let's learn a bit about what the data looks like and where it comes from.

GDP as the nation's "economic report card"? Obviously a bit limited. Economist Paul Krugman, by contrast, stresses three "Roots of Economic Welfare":

1. Productivity Growth
-- (Productivity = Output per worker, or Output per worker-hour)
-- very similar to per-capita GDP (= GDP/population)
2. Income Distribution (i.e., should not be too skewed in favor of rich)
3. Job Creation
-- Krugman: "If these things are satisfactory, not much else can go wrong [in the economy]. If they are not, nothing can go right."
-- Note: #1 and #3 are closely related to GDP growth. Productivity growth generally translates into per-capita GDP growth, and rising GDP is generally associated with rising employment.
-- #2 implicitly makes the obvious point that if most of the gains in national income are going to a very small slice of the population, then most people's "economic welfare" won't be improving much. And, in fact, according to economist Paul Krugman, in the 1980s, 66% of the after-tax gains went to the top 1% of wage-earners.
-- In an earlier lecture we noted that the distribution of U.S. income is very uneven. The distribution of world income, as measured by GDP, is even more uneven.
-- The U.S., "Euroland," and Japan together account for 71% of world economic output.
---- ("Euroland" = the 11 Western European countries that are adopting a common currency, the "Euro")

Other limitations of GDP and NDP:

1. They omit depreciation of the environment.
-- Ex.: If a 3rd-World country cuts down 1 million acres of rainforest in a year to sell timber, the depreciation of the chainsaws and the logging trucks is counted as depreciation, but the depreciation of the rainforest itself is not.
-- Ex.: Exxon Valdez spill was good for GDP! Poisoning of Prince Wm. Sound does not count against GDP, but payments to cleanup crew count towards GDP.

2. They omit important household services, especially those that are normally performed by women (e.g., child-rearing, cooking, and cleaning).
-- Such activities are only counted when you pay someone else to do them (and report that income/payment to the government). Granted, the word "market" doesn't apply to these services when homemakers perform them for free, but when a household hires a maid or a nanny or a cook, those services are counted in GDP. Moreover, not every entry in GDP is a transaction where money changes hands-- ex., "imputed" rent from owner-occupied houses.
-- Ex.: 1950s family: Dad earns $50,000/year, Mom raises their two children, cooks, cleans, etc. Then, Dad gets laid off and takes a lower-paying job and Mom takes job, such that both now earn $25,000/year. They pay a nanny $10,000/year, a cook $10,000/year, and a maid $10,000/year. The family is almost certainly worse off, yet they're now contributing a lot more to GDP than before.
-- Ex.: Two welfare mothers who currently stay home and take care of their kids. Neither is contributing to GDP. Under new reforms, they leave welfare and get jobs, taking care of each other's kids. Now the work they do is counted in GDP.

3. They count military and wartime spending that provide no tangible good or service. While one could think of military spending as providing a service (or "public good") in the form of protection against foreign aggressors, GDP pioneer Simon Kuznets himself advocated a "peacetime" concept of GDP and said:
"there is little sense in talking of protection of life and limb against external enemies as an economic service to individuals -- it is a precondition of such service, not a service in itself."

4. They omit the value of leisure time.
-- If many Americans are "running faster and faster just to stay in place" -- i.e., working ever-longer hours without seeing much of a rise in their pay -- they are probably worse off, yet GDP wouldn't reflect their forgone leisure time.
-- In a recent book called The Overworked American, Harvard economist Juliet Schor argues that Americans' work weeks are the longest of any major industrialized country and that the typical American's work week has gotten much longer in recent years.
-- Historical example: After Emancipation in 1865, the total labor supply of former slaves in the American South fell by one-third. Per-capita income per capita went down because people -- namely the ex-slaves were better off. Instead of being compelled to work in the fields from sunup till sundown, they now had the options of working less (consuming leisure) or spending more time in household production (fixing up their houses, sewing their own clothes, etc.). Clearly their quality of life had greatly improved, yet the South's per-capita GDP would have fallen off greatly.

Alternative measures of economic well-being:

Net Economic Welfare (N.E.W.), invented by two Yale economists, William Nordhaus and James Tobin, in 1972.
-- Start with NNP (Net National Product), modify as follows:
    + value of leisure time
    + underground economy (excludes illegal activities, but includes under-the-table services such as babysitting, etc.)
    - environmental damages
    ...
==> N.E.W. has been growing steadily, but also more slowly, than NNP since 1929.
        Since 1940, N.E.W. < NNP.

Genuine Progress Indicator (GPI), created in the 1990s by a group in San Francisco (Redefining Progress).  Like the N.E.W., it takes into account environmental damages and leisure time. It also adds in the value of unpaid household production and subtracts out spending on services like anti-theft devices and private bodyguards that are purchased merely as protections against social ills like crime.
 

III. GO OVER PROBLEM SET 3 (PS3) -- [you kind of had to be there...]

PS3 was the mini-PS that you were supposed to do over the weekend. The problems were:
CASE & FAIR, CHAPTER 7, #1, 2, 5, 7, 9.
Solutions were posted on the Internet before noon today.

***

Wed., Feb. 23, 2000: FIRST EXAM

***

PRINCIPLES OF MACROECONOMICS
WEEK 5, LECTURE 14
Fri., Feb. 25, 2000

Today:
I. Nominal vs. real GDP
II. Go over first exam
 

I. NOMINAL VS. REAL GDP

A few items for your consideration:

These examples point to one of the most important distinctions in economics - the difference between REAL and NOMINAL measurements.

Defn. REAL: adjusted for inflation; relative to the prices of other goods or other years.

Defn. NOMINAL: measured in current dollars, without regard to other prices or purchasing power.

Defn. NOMINAL GDP: GDP measured in current dollars; computed by adding up the market value of all final goods and services produced.
-- How we compute nominal GDP: For each good or service, total up the quantity produced (q) and multiply it by the price (p) of that good or service. Then add all of those values together (the product, p*q, of each good), and their sum is nominal GDP.
-- Shorthand:  nominal GDP = Spiqi, where i is each good or service.
                                                  |

is the Greek letter "sigma" and it means "summation," or "sum of."
-- Ex.: A small island economy, which produces just three goods -- beer, pretzels, and bicycles. Using hypothetical prices and quantities of those goods, we can compute nominal GDP as follows:
 
Commodity  q p times q
Case of beer  $20  100    $2000
Bag of pretzels  $1 100 +   $100
Bicycle  $200    10 + $2000
TOTAL GDP     $4100

Defn. REAL GDP: GDP measured in constant dollars, i.e. the prices of a "base" year. Ex.: 1992 nominal GDP was $6 trillion, 1992 real GDP was $5 trillion in 1987 dollars.

Now for some notation:
Q = real GDP
P = price index
-- P = 100 for a base year (say, 1992) that we use to compute real GDP
             \
             The price index is really a percentage of the base year's price level. So it's equal to 100% in the base year.
-- The price index we'll be using today is the GDP price index, or GDP deflator, which is used for converting nominal GDP into real GDP. It's also our broadest measure of the general price level.

Now, here's how to compute real GDP from nominal GDP:

     Real GDP = (Nominal GDP)/[(GDP Price Index)/100]

     or, writing the same thing in our shorthand notation:
          Q = (Nominal GDP)/(P/100)

-- In the base year, when P=100, nominal GDP and real GDP will always be equal.
-- In years when P > 100, real GDP will be less than nominal GDP.
-- In years when P < 100, real GDP will be greater than nominal GDP.

To compute nominal GDP from the GDP price index (P) and real GDP (Q):

      Nominal GDP = (P/100) * Q

To compute the GDP price index (P) from nominal GDP and real GDP (Q):

      P = [(nominal GDP)/(real GDP)] *100

[At this point we worked through some examples of calculating real GDP from PQ and P, and also calculating P from PQ and Q. With a calculator, these computations are easy.]

-- Exs.:

Year  Nominal GDP
(billions$)
Real GDP 
(billions$)
GDP price index
1992  6244.4  6244.4 100.00
1993  6558.1  6389.6 ______
1995  7265.4  ______ 107.76

-- The base year is 1992.  We know that because the price index (P) = 100 in 1992.

-- Now, let's fill in the blanks:

---- Real GDP in 1995 = (nominal GDP)/(P/100) = 7265.4/(107.76/100) = 7265.4/1.0776 = 6741.3

---- GDP price index in 1993 = ((nominal GDP)/Q) * 100 = 6558.1/6389.6 (*100) = 1.0264 * 100 = 102.64
 

II. GO OVER FIRST EXAM

[I presented summary statistics, showed an overhead of the answers (also available online), and handed back the exams. Next week we'll go over a few items from the exam.]