PRINCIPLES OF MACROECONOMICS
WEEK 5, LECTURE 13
Mon., Sept. 27, 1999

O. IMPEDIMENTA

* Today:
I. GDP accounting (finish)
II. Business cycles (beginning of Chapter 8)

* First exam is this Fri., Oct. 1. Will cover through Wed.'s lecture and will include at least one New York Times question.
-- 40% multiple choice, 60% short answer
-- One New York Times question -- The article ("Clinton Vetoes Tax Cut but Seeks Accord," from Fri., Sept. 24, page A20) is posted on my door.
 

I.  GDP ACCOUNTING (finish)

We left off last time with a bit of history about national income accounting. We also went over a "T-account" table that showed the different components of GDP by the product/expenditure approach and by the income approach. Recall that by the income approach,

GDP = NATIONAL INCOME
            + Indirect business taxes minus subsidies
            + Depreciation
            + Net foreign factor income

and national income -- which equals wages and salaries (plus fringe benefits and tips) + proprietors' income + rents (net of depreciation) + corporate profits + interest -- is about 82% of GDP.

Now, a few more definitions are in order:

Defn. Net national product = GDP - Depreciation
-- (Yet another alternative to GDP. There are several more -- "national income," "personal income," "disposable income" -- which we may touch upon later in this course.)

Defn. Nominal GDP: GDP measured in current dollars; computed by summing up piqi, for all i goods and services.
-- How we compute nominal GDP: For each good or service, total up the quantity produced and multiply it by the price 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.
---- 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 * 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.

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
-- 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.
---- Last week 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.
---------- Aside:  Here's a way to remember which 11 countries they are: BAFFLING SIP (the first letters of each of those countries' names -- Belgium, Austria, France, Finland, Luxembourg, Ireland, Netherlands, Germany, Spain, Italy, Portugal)

Other limitations of GDP and NDP (or, reasons why "GDP and NDP are politically incorrect"):

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.: The 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 (such as child-rearing, cooking, and cleaning) that are normally performed by women.
-- 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-- e.g., "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 provides 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 downbecause 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.

Two Yale economists, William Nordhaus and James Tobin, in 1972 computed an alternative measure: Net Economic Welfare (N.E.W.).
-- To compute N.E.W., you 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.

More recently, a group in San Francisco (Redefining Progress) has created an alternative measure called the Genuine Progress Indicator (GPI). 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.
 

II.  BUSINESS CYCLES (begin)

Theme: "We must distinguish between trend economic growth and business cycle fluctuations."

Defn. Economic growth: An increase in real output (or real per capita output).

Defn. Business cycle: the more or less regular fluctuations of GDP around its long-run trend, along with associated changes in levels of employment, unemployment, and prices

***

PRINCIPLES OF MACROECONOMICS
WEEK 5, LECTURE 14
Wed., Sept. 29, 1999

* Today:
I.  A note on nominal vs. real GDP
II. Business cycles
 

I.  A NOTE ON NOMINAL VS. REAL GDP

First, 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.

PQ = nominal GDP

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

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

Q =           PQ/P (if P is entered as a percentage, e.g. 100% = 1.00)
          or    PQ/(P/100) (if P is entered as a regular number, e.g. 100.00)

-- 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 the GDP price index (P) from nominal GDP (PQ) and real GDP (Q):

P = PQ/Q (*100%)

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

PQ =         P * Q (if P is entered as a percentage)
          or    (P/100) * Q (if P is entered as a regular number)

[At this point we worked through some examples of calculating real GDP from PQ and P, and also calculating P from PQ and Q. We used an overhead of McConnell's Table 7-7, "Nominal GDP, real GDP, and GDP price index, selected years." 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

---- Real GDP in 1995 = 7264.4/(107.76/100) = 7264.4/1.0776 = 6741.3

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

II.  BUSINESS CYCLES (finish)

Where we left off last time:
Theme: "We must distinguish between trend economic growth and business cycle fluctuations."

[We saw an overhead of McConnell's Figure 8-2, which generically shows the business cycle -- a "trend" level of real GDP that steadily risesover time, and an actual level of real GDP that cycles around that trend, sometimes being above the trend and sometimes below it.]

The best, most precise ways to describe the ups and downs of economic activity:

Defn. Contraction: a period over which real GDP steadily falls. (Also sometimes called a RECESSION.)

Defn. Expansion: a period over which real GDP steadily rises. (Also sometimes called a RECOVERY.)

Two less precise, but very common, ways to describe the ups and downs of economic activity:

Defn. Recession: (no universally accepted definition, but)

(1) conventionally, a period in which real output declines for two consecutive quarters.
(2) alternatively, a period in which actual GDP falls well short of potential GDP.

Defn. Boom: a prolonged period when actual GDP exceeds potential GDP.

Two concepts that are very useful in distinguishing between long-term GDP growth trends and shorter-term business cycles are:

Defn. Capacity GDP (Qcapacity): a country's maximum possible level of real GDP, given its endowments of labor, capital, land, technology, etc.

Defn. Potential GDP (Q*): The maximum sustainable level of real GDP (Q), given the economy's endowments of labor, capital, and other resources.
-- "Sustainable" in this case means "won't cause the inflation rate to accelerate."
-- Potential GDP is often referred to as potential output or trend GDP.
-- Underlying idea: Very high levels of real GDP, relative to potential GDP, are inflationary.

Q: Why might Q > Q* generate high inflation?
A:
-- (1) With many more people working and having incomes to spend, firms may raise their prices more aggressively.
-- (2) Workers are harder to replace when unemployment is very low, so workers may be more aggressive in demanding higher wages. Their higher wages then get passed on to the consumer as higher prices.

Note:  potential GDP < capacity GDP
-- At potential GDP, the unemployment rate is about 4%-5%. At capacity GDP, it would be near 0%.
-- At potential GDP, the economy's CAPACITY UTILIZATION RATE (the rate at which factories and equipment are operated compared with the maximum possible rate) is about 80-85%. (At capacity GDP, the capacity utilization rate would be 100%.)

***

Fri., Oct. 1, 1999 -- FIRST EXAM