Vijaya Raj Sharma, Ph.D.

These notes are not edited. They also do not necessarily cover every material that will be discussed in the class. Students are responsible for additional materials discussed in the class. These notes broadly follow the chapters of the textbook - Macroeconomics: Private and Public Choice, by James D. Gwartney, Richard L. Stroup, and Russell S. Sobel, Ninth Edition, Dryden Press, 2000

VI. GDP, UNEMPLOYMENT, AND INFLATION

(Chapters 7 and 8)

1. GDP

Gross Domestic Product (GDP) is a measure of income or output produced in an economy in a specified period. It is defined as the market value of all final goods and services produced domestically during a specific period. It is the sum of the quantity of each good produced times its price. The current GDP of the U.S. is over $6 trillion. The U.S. is the largest economy in the world. Simon Kuznets (Nobel Prize in Economics in 1971) introduced the national accounting system.

Note that only final goods are added in GDP; intermediate and primary goods are not added to avoid double counting because the values of these goods are included in the value of the final goods. For example, the market value of bread already includes market value of wheat that has gone into making bread.

Only goods produced in a specific period are included. For example, GDP of 1998 would not include sales of old houses built in say 1990. Resale of previously produced goods are not included.

A good to be included in the U.S. GDP must have been produced within the geographical boundary of the U.S., irrespective of whether the producing firm is owned by a U.S. citizen or not. Thus, cars produced within the U.S. by Toyota are included in the U.S. GDP, but not in the Japanese GDP. Similarly, cars produced in Mexico City by a plant owned by G.M. are not accounted in the U.S. GDP, but they are accounted in the Mexican GDP.

2. GNP

Gross National Product (GNP) is the market value of all final goods and services produced by the "nationals" of a country during a specific period. GNP is similar to GDP except that the GDP accounts only goods produced with the territory of a country, irrespective of the nationality of the producer, whereas GNP accounts for goods produced by the nationals, irrespective of the territory where they are produced. For example, cars produced by GM in Mexico City are included in GNP but excluded in GDP. Lectures on economics produced by me in this class are included in the U.S. GDP but not in the U.S. GNP because I am not a U.S. citizen.

Prior to 1991, the U.S. used to publish GNP data. Since 1991, the U.S. publishes GDP data, as do other countries in the world. In the U.S. the difference between GDP and GNP is less than one percent.

3. Circular Flow

There are four principal sectors in an economy: households, business firms, government, and foreigners, or the rest of the world. Draw a diagram to show the circular flow of dollars in an economy.

Households buy goods and services from Goods and Services Market; thus, they make consumption expenditures (C). Households supply labor services, land, and capital to firms through Resource Market; thus, they receive payments of wages, rents, and profits from the resource market. Households supply net savings (savings net of borrowing) to Loanable Funds Market and receive interest income on their savings. Households may also supply labor and capital services to the rest of the world and receive net income from abroad (income net of any payments made to the rest of the world for foreign capital and labor).

Firms sell their goods and receive sales revenue from Goods and Services Market. Firms buy investment goods; thus, they make investment expenditures (I) in Goods and Services Market. They supply goods to the rest of the world also through the Goods and Services Market and receive revenue from net exports (NX) - exports net of imports. Finally, firms also supply goods that are bought by the government; thus, they receive revenue from those sales too.

Firms borrow money from Loanable Funds Market and make interest payments. Firms also make payments to resources they hire from the Resource Market. Firms lose some amount every year in terms of depreciation or obsolescence of capital goods, and they also pay indirect business taxes.

Government makes government purchases (G) in buying goods and services from Goods and Services Market. It can borrow from the Loanable Funds Market. Government collects taxes from households and firms. It may transfer income to households under various programs, such as food stamp, unemployment benefits, etc. We shall use this circular flow diagram to explain two methods of measuring GDP.

4. Measurement of GDP

Draw again the circular flow to explain the two methods of measuring GDP: expenditures approach and resource cost-income approach.

5. Expenditures approach of accounting

The expenditures approach adds up expenditures of all the four sectors of the economy: consumption expenditures, investment expenditures, government purchases, and net exports - these are also called the four components of GDP. GDP=C+I+G+NX. Note that this sum is the total amount of sales in the Goods and Services Market. This sum is also the total revenue of the firms producing goods and services.

In the U.S. GDP, consumption expenditures account for about 68%, investment about 14%, government purchases about 19%, and net exports -1%.

6. Resource cost - income approach of accounting

It is evident from the circular flow diagram that the total revenue of the firms are distributed as resource costs or incomes of resource owners, including depreciation and indirect business taxes as costs.

The resource cost-income approach adds up incomes to resource owners and costs to producers to calculate GDP. Note that incomes to resource owners include net incomes from abroad, which should not be accounted in GDP. GDP=wages+rents+profits+interest+depreciation+indirect business taxes-net income earned abroad.

In the GDP, wages, or compensations to employees, account for about 60%, rental income less than 1%, profits about 14%, interest income 7%, depreciation 11%, and indirect taxes 8%.

Since the aggregate expenditure in the economy should be equal to the aggregate income, the both approaches lead to the same estimates of GDP. Addition of net income earned abroad to the GDP should equal the GNP in either approach.

7. Other Income Measures

GDP is gross output as it ignores depreciation of capital goods in the production process. If depreciation is deducted from GDP, we get the net domestic product (NDP).

When depreciation and indirect business taxes are excluded from GNP, the estimate is called the national income. Note that the national income includes net income earned from abroad. In other words, national income is the income received by households in the form of wages, rents, profits, and interest, irrespective of whether they are earned domestically or abroad. Show in the circular flow diagram.

If you look at your paychecks, there are deductions for FICA and Medicare. As households cannot keep this part of their income, personal income is national income net of deductions for corporate and social security taxes. But personal income includes any income transfers from the government such as food stamps. On this personal income, families pay income taxes. Personal income net of taxes is the actual disposable income available to households. The U.S. Department of Commerce publishes quarterly data on GDP.

8. Real and Nominal GDP

There are two types of GDP: nominal and real. Nominal GDP is measured in current dollars, i.e., goods are valued at current prices.

Consider a single good for simplicity. Nominal GDP=Price * Quantity of the good produced. If nominal GDP increases from $100 in 1997 to $110 in 1998, this increase may either be coming from price level increase or quantity increase or both. If quantity has not increased and only the price level has increased, output has not increased in real terms; the increase is only nominal, in dollar terms. Real GDP is a measure of the real level of output, adjusted for effects of inflation. Real GDP is the GDP measured in constant dollars, in prices of the base year.

To calculate real GDP, changes in price level have to be accounted. GDP deflator is a price index that reveals the cost of purchasing the items included in the GDP during the specified period, relative to the cost of purchasing those same items during a base year (currently, 1992). Since the base year is assigned a price index of 100, a price index of 110 in a year indicates that the price level has increased by 10% since the base year.

Real GDP in year y is (b denotes base year):

Example:

In the above example, although nominal GDP increased by 16% during 1992-1995, a large portion of the increase reflected inflation. Prices rose by 7.5%. Actual increase in real output, as measured by real GDP, increased by only 7.9%.

9. Problems with GDP

Although GDP is a commonly used measure of current production or income, this is not a perfect measure for a number of reasons.

It only accounts market production and excludes household production. For this reason, baby sitting services of a parent to his or her child are not included in GDP, but the same services are included if they are provided by paid babysitters. Therefore, GDP understates output, especially in developing countries characterized by large subsistence sector. This is a rational behind allowing tax-deferred individual retirement account deposits by even non-working spouses of employed persons. For this reason, a comparison of GDPs overstates outputs of developed countries because household production is generally substantial in developing countries. For this reason, GDP also overstates output when compared over time. Women in last couple of decades have increasingly joined the labor force; their output once in the labor force is accounted in GDP but their household production in earlier years was not accounted.

GDP excludes activities of underground economy, because they are either unreported or undetected. Estimates of the size of the underground economy range from 10 to 15 percent of total output in the U.S.

GDP excludes leisure and human drudgery associated with jobs. People value leisure like any market commodity. Production of market goods is accounted but production of leisure is left out. An economy that produces $20,000 per capita GDP with 30-hours of work week indicates better well-being of its citizens compared to another economy that produces the same per capita GDP with 50-hours of work week. Similarly, with inventions of better technologies, jobs are becoming physically less strenuous; GDP does not account for these changes.

GDP does not account quality changes. Computers may have not increased in prices, but they have certainly increased in computational speed and capability. Dollar values of computers miss quality changes.

GDP also does not account changes in quality of life, such as increased road congestion and degradation of environment. GDP is not adjusted for economic "bads." Destruction of outputs by hurricanes is not accounted in GDP, whereas rebuilding after a disaster is included in the GDP. Therefore, GDP overstates living standards at the time of rebuilding.

Alternative measure? GDP may not be a perfect measure of well-being, but there is no other better measure. Therefore, a number of social indicators also are monitored, besides GDP. For example, education, health, nutrition, sanitation, etc.

10. Macro Policy Goals of Government

Government pursues four macro policy goals:

* Rapid and stable growth of output, or GDP (for sustained economic growth)

* Stable prices (for minimizing uncertainty and maintaining purchasing power of money)

* Low unemployment (for reducing economic hardships of households)

* International stability (for maintaining stable exchange rate and smooth functioning of international trade).

11. Business Cycle

Only rarely are prices, outputs, and unemployment stable. Economies generally experience swings in economic activities, which are called business cycles. Business cycles are periods of growth in real output followed by periods of decline in output. Draw a figure of business cycle to show expansionary and recessionary periods of economic activities. Output fluctuates around a trend line. Output expands above the average trend for some periods and reaches a peak, then it contracts and reaches a trough in the following periods. A downturn in economic activity is called a recession. More precisely, recession is defined as a decline in real GDP for two consecutive quarters. A recession which is prolonged and severe is called depression.

Show Exhibit 7-1 of the textbook. The recession in early 1990s is the Bush recession. The recessions in early 1970s and towards the end of 1970s and the beginning of 1980s are the two oil shocks. The average growth rate of real GDP during the period 1960-1995 was about 3.0 percent annually. During the Great Depression (not shown in the Exhibit), real GDP declined by 7.5 percent or more each year, between 1930 and 1932. The real GDP in 1933 was almost 30 percent less than the real GDP in 1929.

12. Unemployment

Fluctuations in real GDP also bring in fluctuations in employment. Unemployment increases during recession and decreases during expansion. Unemployment created by the swings in economic activities is called cyclical unemployment. Let us first look at the way unemployment is measured.

Of the entire civil population (16 years and older), some are in the labor force and some are not. Those not in the labor force are students, retirees, disabled, and household workers; they are not seeking jobs. This group also includes discouraged workers who in the past looked for job but couldn't get employment and are now discouraged and have given up seeking employment. On the other hand, those who are employed or are actively seeking employment make up the labor force. A person who either is registered at an employment agency or has met with prospective employers or has checked with friends and relatives regarding jobs, or has placed or answered advertisements, or has written letters of application or is on a union or professional register is considered actively seeking employment. Labor force participation rate is defined as

Labor force participation in the U.S. was 66.6 percent in 1995. Among men, this rate decreased from 87 percent in 1948 to 75.4 percent in 1995. Among women, the rate increased from 32.7 percent in 1998 to 59.2 percent in 1995. There has been a substantial change in gender composition of labor force in the U.S.

Of those in the labor force, some are employed and some are unemployed. The number of unemployed persons as a percentage of those in labor force is the rate of unemployment.

Unemployment rate was 5.6 percent in 1995. It is about 4.6 percent at this time. Note that unemployment rate understates the true unemployment in the economy for two reasons. One, it excludes discouraged workers (they are not considered in the labor force). According to an estimate, there were about one million discouraged workers during 1991 recession. Two, even part-time workers are considered employed; thus, underemployment is ignored. Because of this limitation, another indicator of employment is also defined.

The rate of employment was 62.9 percent in 1995. Note that the sum of the rate of unemployment and the rate of employment will not add to 100 because they are defined as percentages of different things. The Bureau of Labor Statistics collects monthly statistics on unemployment by surveying randomly 59,500 households from 729 locations.

There are three types of unemployment. Cyclical unemployment is caused by economic swings or downturns in the economy. Structural unemployment is caused by changes in the structure of the economy because of new technologies and new products. For example, many defense bases in the U.S. were closed by the government after the end of the cold war, making many persons in the bases unemployed. Then, there is frictional unemployment because of lack of information on prospective employers and prospective employees. Every one seeks the best job he or she could have. Similarly, every employer seeks the best employee it could have. It takes time to match the skills of the job seeker with the skills of the job. Frictional and structural unemployment are consistent with economic theory. Frictional unemployment is a period of matching skills to the most suitable job and structural unemployment is the period of retraining the obsolete skill into something useful to the economy. Therefore, economists are most concerned with cyclical unemployment.

13. Natural Rate of Unemployment, Full Employment and Potential GDP

For the reasons of structural and frictional unemployment, there is always some unemployment in an economy even when all other resources are fully utilized. This level of unemployment (due to structural and frictional conditions of an economy) is called the natural rate of unemployment. The natural rate of unemployment, however, can change with dynamic changes in labor market, in the structure of the economy, in the technology of information dissemination, and in public policies such as minimum wage, unemployment benefits, welfare programs, etc. Milton Friedman, the 1976 Nobel Laureate in Economics, coined this term - natural rate of unemployment - in 1968.

During periods of economic boom, actual unemployment is lower than the natural rate, whereas during periods of recession, actual unemployment is higher than the natural rate. When actual unemployment is equal to the natural rate, the economy is said to be in full employment.

Potential output is the output that can be produced when the economy is at full employment. Note that this potential output is what we referred to while talking about production possibilities frontier (PPF) of an economy. When actual output is below the potential level, there is recession; the economy is operating inside its PPF because resources are underutilized. When actual output is equal to or exceeds the potential level, there is economic boom; the economy is operating on or outside the PPF. An economy can operate outside its PPF only for a short period by stretching use of resources, including labor, beyond normal working hours. Overtime use of resources cannot persist for long and may lead to possible inflation, which we define next.

14. Inflation

Inflation is a continuing rise in the general price level, an aggregate representation of prices of all commodities. In other words, inflation is a decline in the value or purchasing power of dollar. In a market, prices of some commodities fall and those of others rise. During inflation, there are more commodities that rise in prices compared to commodities that fall in prices.

GDP deflator, we talked about earlier, is one index of general price level; there are other indices also, such as Consumer Price Index (CPI) and Producer Price Index (PPI). CPI is the cost of purchasing market basket of consumption goods bought by a typical consumer during a period, relative to the cost of purchasing the same market basket in the base year. U.S. Bureau of Labor Statistics publishes every month the CPI. The Bureau sends 250 surveyors to 21,000 stores around the nation to report prices of 364 consumption goods that go into the market basket.

Let us demonstrate the method of computing CPI with a hypothetical example.

Price Index in 1985=100 (price index is always taken as 100 in the base year). Price index in 1996= (324/200)*100=162. According to this example, the general price level increased by 62 percent (162-100) in the 11-year period from 1985 to 1996.

GDP deflator and PPI too are calculated similarly, except that the market baskets are different. GDP deflator use the market basket of commodities that go into computations of GDP: consumption goods, investment goods, goods purchased by the government and the goods internationally traded. CPI uses the market basket of consumption goods, whereas PPI uses the market basket of producer goods.

Inflation in year t+1 is measured as

Example:

15. Problems with CPI

The use of CPI for measurement of inflation has some problems.

If there has been a change in the lifestyle of consumers such that the base year's market basket does not reflect the recent market basket, CPI may not reflect the true general price level.

CPI generally overstates inflation because consumers tend to substitute away from market basket goods to other cheaper goods if prices of market basket goods go up. If prices of beef go up, consumers may substitute it by chicken. Energy prices went up by 218 percent in the period 1972 to 1980, but actual energy expenses of consumers went up by 140 percent only. According to some estimates, CPI overestimates inflation by about 1 to 1.5 percent. This is a reason behind the proposal of lowering the cost of living adjustments of social security payments, which are currently adjusted for inflation as measured by CPI.

CPI overstates inflation also because it ignores quality improvements. For example, computers purchased in 1996 for the same cost are far superior in quality compared to computers purchased in 1985.

16. Real and Nominal Interest Rates.

If you lend me $1,000 today to be paid back in a year from now, you forego the possibility of using that money for one full year to buy goods you enjoy. Everyone values present more than future. Therefore, you will seek from me a compensation for the sacrifice (the postponement of enjoyment) you are making by lending me money. Suppose that you want me to return, besides the principal amount of $1,000, an additional $40 towards compensation (a real return of 4% on the amount loaned). This rate of return is the real interest rate.

Consider a possibility that the borrower may default, and you may either lose the principal amount or you may have to go to a court and spend on litigation to recover the principal amount. Each lender faces this kind of risk and includes a risk premium in the interest rate. Let this premium be 1%, which would raise the interest rate from 4% to 5%. In other words, real interest rate is the return you want for your time preference (i.e., to compensate for the postponement of current consumption) and for risks associated with lending.

Suppose you lent me $1,000 at 5% interest rate. Accordingly, I returned you $1,050 at the end of the year. You got a return of $50 over and above your $1,000. What if the prices of all goods increased by 3% this year? That means that the goods that cost $1,000 a year ago would cost now $1,030. Inflation, or general price increase, erodes the purchasing power of dollar. So, your real return is not $50 but $20 only, after accounting for the loss of purchasing power ($50 minus $30). Lenders face this possibility and, therefore, they add a premium for expected inflation. If you could correctly anticipate inflation, you would have demanded an interest rate of 8% (5% for real return and 3% for expected inflation). When the interest rate includes expected inflation rate, this is called nominal interest rate. Nominal interest rate = real interest rate + expected inflation rate. Interest rates that are quoted by banks and lenders in the market are nominal interest rates. To find the real interest rate, you have to subtract inflation rate from the nominal interest rate.

Hyperinflation is a very rapid and high growth rate of prices, over 50 percent per month. Stagflation is a period of stagnation or recession (decline in output) combined with rapid inflation.

According to the Permanent Income Hypothesis of Nobel Laureate Milton Friedman, households do not change their consumption habits from temporary gain or loss of income. Consumption of households is largely determined by their long-range expected or permanent income. Instead of changing consumption, households save more when there is a temporary increase in income, and they save less or even dig into prior savings if there is a temporary decline in income.

Changes in real wealth (for reasons other than the change in price index).⁽¹⁾ Example: stock market boom or crash changes the value of the stock holding (wealth). Increase in real wealth makes people feel wealthier, increasing their consumption and, thus, AD. Decrease in real wealth would reduce AD.

Changes in real interest rate (for reasons other than the change in price index- see the interest rate effect in the previous lecture). Example: government borrowing from the loanable funds market can increase interest rate. An increase in interest rate suppresses interest-sensitive expenditures on consumption and investment, decreasing AD. Decrease in interest rate increases AD. ⁽²⁾

When an economy is in a long-run equilibrium producing full employment level of goods and services, a decrease in AD can lead the economy into a recession temporarily.⁽³⁾ During the recession, real GDP shrinks below the full employment level, actual rate of unemployment exceeds the natural rate, and price level declines below the anticipated level. Higher unemployment and lower outputs decrease household income. According to our model, these changes are temporary, and the self-correcting mechanism of the market pulls the economy back into a new long-run equilibrium of full employment level. The principal self-correcting mechanism is the flexibility of wages and resource prices. Wages and resource prices fall during recession, making resources cheaper. Cheaper resources encourage producers to use more resources to increase production for gradual restoration of long-run equilibrium.

Wages and resource prices in the economy are fixed by contracts based on an anticipated price level; this anticipated price level is the actual price level when the economy is in a long-run equilibrium, i.e., PI₀ in our graph. Thus, producers and labors had been working on the presumption that PI₀ would be maintained, but they find that the price level actually declines. This decline of price level increases the real wage (the purchasing power of wage) of labor, but on the other hand, it reduces prices of outputs of producers, eroding profitability of producers. Producers would have to wait until the expiry of the current wage contract to renegotiate lowering of wages. Thus, In the long run, wages are renegotiated and decline.⁽⁴⁾ Lower wages make production cheaper and increase SRAS to the right. Label the new curve SRAS₂ and draw it such that both this curve and AD₁ intersect with LRAS at the same point. Call this point, the new long-run equilibrium, E₂. At the new equilibrium, the full employment level is restored. The economy, thus, bounced back from recession. According to Classical Economics, there is no need for the government to intervene even when the economy goes into recession. The self-correcting mechanism of the market would restore full employment, although that may take some time.

When an economy is in a long-run equilibrium producing full employment level of goods and services, an increase in AD can lead the economy into inflation temporarily.⁽⁵⁾ During inflationary period, real GDP expands above the full employment level, actual rate of unemployment is below the natural rate, and price level is continually increasing above the anticipated level. Persistent inflation causes uncertainty, especially regarding long-term contracts and transactions. It also erodes purchasing power of those who live on fixed income, like retirees. According to our model however, these changes are temporary. The self-correcting mechanism of the market pulls the economy back into a new long-run equilibrium of full employment level. Once again, the principal self-correcting mechanism is the flexibility of wages and resource prices. Wages and resource prices increase during inflationary period, making resources more expensive and discouraging producers from the use of these resources in production. This forces gradual reduction of output to the long-run equilibrium level.

Keynes assumed completely inflexible prices and wages downwards. He essentially implied an inverted L-shaped short-run supply curve. Draw a graph with Y in the horizontal axis and PI in the vertical axis. Draw the LRAS curve (a vertical line at Y_f). Draw AD₀ and let the long-run equilibrium be the point of intersection of AD₀ and LRAS. Label this point as E₀. For E₀ to be the long-run equilibrium, the SRAS must also be passing through this point. According to Keynesian assumption, SRAS is drawn as a horizontal line to the left of E₀ and as a vertical line above E₀ (the vertical part coincides with the LRAS), thus, it looks like an inverted L. The horizontal part of the SRAS is called the keynesian range of the short-run supply curve. In this model, any decline in AD (draw AD₁ to the left to AD₀) results in decline in output (Y) with no change in price level (sticky prices). On the other hand, any increase in AD (draw AD₂ to the right of AD₀) results in higher price level with no change in output.

According to Keynes, consumption expenditures of a household is a function of disposable income. Consumption consists of two components, autonomous consumption (a) which is independent of income and discretionary consumption (b * DI) which is dependent on disposable income. C = a + b (DI). If t=0, then C = a + b Y. Even when a household has no income, it has to spend on food, clothing, and other basic needs for survival - this is autonomous consumption. The household may dig on its past savings or even borrow for this purpose. Other consumption expenditures are discretionary which depend on the marginal propensity to consume (MPC). Parameter b is the MPC, a factor less than one. MPC is the fraction of additional income a household spends on consumption. If MPC=0.75, it implies that the household spends $0.75 on consumption when its income increases by $1. This then also implies that the rest of $1, i.e., $0.25 is saved. The marginal propensity to save (MPS) = 0.25. MPS = 1 - MPC. Note that consumption and savings are interrelated.

In an economy an individual's expenditure becomes the income of another. Let government increase its expenditure by $1. This expenditure becomes income of someone in the economy, who spends $0.75 (assuming MPC = 0.75) and saves $0.25. This expenditure of $0.75, in turn, becomes income of another person who will spend 0.75*$0.75. This chain of income and expenditure goes on in the economy, multiplying the initial government expenditure of $1 into many individuals' incomes. The term 'multiplier' is used to indicate the number by which the initial expenditure would be multiplied to obtain the total summation of the increases in income. Read the discussion on Exhibit 10-9 in the textbook for further clarification. This multiplier is called expenditure multiplier or income multiplier. If MPC is 0.75 i.e., 3/4, the multiplier would be 4.

M = 1 / (1-MPC) is called the theoretical multiplier because there are three other sources of leakage (other than savings) in the multiplier process this formula ignores. They are: taxes, imports, and the changes in price level. This formula ignores taxes. A tax takes away a part of the income from multiplication process. Dollars going to foreign suppliers for imports are leaked out of the domestic multiplier process. In Keynesian model, price level remains unchanged in the keynesian range; therefore, all changes in output are real. However, some of the output changes are actually only nominal in the real world and, thus, can be considered as a kind of leakage from the multiplication of real income. For these reasons, the actual multiplier is generally smaller than the theoretical multiplier. In this course, we will ignore the leakages.