Measuring the Macroeconomy

This is Unit Three of Principles of Macroeconomics: measuring the whole economy's output. Unit two closed on one market at a time. This unit counts everything at once. Carry one idea through. GDP measures production, and measures it well, so the discipline is knowing what that does and does not tell you. The definition is written word by word, a three-question test decides what counts, and the last entry weighs the measure. By the end you will sort a figure into the right component, decide whether something counts this year, convert a nominal figure to a real one, place a moment on the business cycle, and say what GDP does and does not tell you about how people live.

Seven entries on what GDP measures and the usual way of adding it up.

What the measure counts.

MAC 0201 What GDP Measures

Gross domestic product is the market value of all final goods and services produced within a country in a year. Every word carries weight: market value excludes what is not sold, final excludes parts, and within a country excludes what citizens produce abroad.

The usual way of adding it up.

MAC 0202 The Expenditure Approach

Add what everyone spends: consumption, investment, government purchases, and net exports. GDP equals C plus I plus G plus exports minus imports. Imports are subtracted because they were produced abroad, not because buying them harms the economy.

The largest component.

MAC 0203 Consumption

Consumption is household spending on goods and services: groceries, rent, haircuts, cars, medical care. It is the largest component, around two thirds of GDP, and the steadiest. Being large and stable, it rarely drives a recession, though it deepens one when it falls.

The component that moves most.

MAC 0204 Investment Means New Capital

In GDP, investment means newly produced capital: business structures and equipment, new housing, and the change in inventories. It is the most volatile component. A new factory counts; a thousand dollars of shares does not, because that transfers ownership without producing anything new.

What government spending counts.

MAC 0205 Government Purchases and Transfer Payments

Government purchases are spending on goods and services at every level of government. Transfer payments are excluded, because nothing is produced in return: a teacher's salary counts, a pension does not. The pension is counted later, when the recipient spends it.

The fourth component.

MAC 0206 Net Exports

Net exports are exports minus imports, the trade balance. Exports exceeding imports is a surplus; imports exceeding exports a deficit. The United States has run deficits in most years since the early nineteen eighties. A deficit subtracts from GDP by construction, which is not to say it makes a country poorer.

Putting the four together.

MAC 0207 Computing GDP from Components

Sort every figure into one of four bins, then add. Consumption is household spending. Investment is newly produced capital, including the change in inventories. Government purchases never include transfers. Net exports are exports minus imports. Anything fitting no bin is left out rather than placed in the nearest one. Take consumption four hundred, equipment fifty, housing twenty, inventories up ten, government purchases one hundred and twenty, exports one hundred, imports one hundred and twenty, and pensions of sixty. Investment is eighty, the pensions are transfers and excluded, so GDP is five hundred and eighty. Transfers are bait, and inventories count even when goods went unsold.

Four entries on counting each thing exactly once.

Which goods are counted.

MAC 0208 Final and Intermediate Goods

A final good is bought by its last user. An intermediate good is bought to produce something else, and counting both would double count: count the loaf, not the flour. Flour unsold at year end is counted, as an addition to inventories.

Avoiding the double count another way.

MAC 0209 Value Added

Value added is a firm's output minus what it bought from other firms, and summing it across every stage gives the same total as counting final goods: logs, lumber, house. The two methods are alternatives, not additions, and doing both would double count everything.

What the measure misses.

MAC 0210 What GDP Leaves Out

GDP counts market production only, leaving out household production, used goods, and transactions unrecorded to avoid tax or the law. Cooking dinner adds nothing; buying the same meal adds its price. A used car was counted when it was built, so counting the resale would count it twice.

Deciding case by case.

MAC 0211 Is It Counted in GDP?

Ask three questions in order. Was it produced? A transfer of money or of an existing object produces nothing. Was it produced this year? Output counts in the year it was made, never when it changes hands. Was it a final good sold in a market? Parts are intermediate, and work outside any market is not measured. A used car fails the second; a share and a pension fail the first; a tire sold to a car plant and a meal cooked at home fail the third; a newly built house passes all three. The dealer's commission does count, because a service was produced this year.

Three entries widening the picture to the whole economy.

The economy drawn as a loop.

MAC 0212 The Expanded Circular Flow

Unit one's circular flow had households and firms alone. The full version adds government, which taxes and buys, and the rest of the world, which buys exports and sells imports. Taxes, saving and imports leak out of the flow; government purchases, investment and exports inject back in.

Why spending and income agree.

MAC 0213 Income Equals Output

Everything spent becomes someone's income, so total output equals total income, and GDP can be measured by adding spending or by adding wages, rent, interest and profit. The two estimates come from different surveys, so they never match exactly, and the gap is reported as a statistical discrepancy.

Three measures that sound alike.

MAC 0214 GDP, GNP and NNP

GDP counts production inside a country's borders. GNP counts production by a country's residents wherever they are. Net national product is GNP minus depreciation. A foreign-owned factory here is in American GDP but not in American GNP. Depreciation is the capital worn out during the year.

Four entries separating output from prices.

Separating output from prices.

MAC 0215 Nominal and Real

A nominal value is measured at the prices of its own time; a real value is adjusted for price changes, so it reflects quantities. Nominal GDP can rise because output rose, because prices rose, or both. When the question is whether the country produced more, only the real figure answers it.

The index that adjusts it.

MAC 0216 The GDP Deflator

The GDP deflator is a price index covering everything in GDP: nominal GDP divided by real GDP, equal to one hundred in the base year, where real and nominal are the same. Some sources report it around one rather than one hundred, so check the convention before dividing.

Doing the conversion.

MAC 0217 Nominal to Real

Divide the nominal figure by the price index for that year. When the index is stated around one hundred, divide it by one hundred first, then divide the nominal figure by that, and the result is in base-year prices. In the base year the two are equal. After it, with prices higher, the real figure is smaller; before it, larger. Nominal GDP of twenty-two trillion with a deflator of one hundred and ten gives one point one, and twenty-two divided by one point one is twenty trillion. Divide, never subtract, and always name the base year.

Measuring how fast it changed.

MAC 0218 Computing a Growth Rate

A growth rate is a percentage change, computed two ways. The simple method divides the change by the starting value; the midpoint method divides it by the average of start and end. For one period they are close, but over a long series the midpoint is steadier, because the simple method answers differently depending which end you start from. Real GDP rising from twenty trillion to twenty point six gives three percent the simple way, about two point nine six the midpoint way. Growth in output always means real values. Quarterly growth is reported annualized, which is not the quarterly figure times four.

Three entries on the pattern those growth rates trace.

The pattern output traces.

MAC 0219 The Business Cycle

The business cycle is the economy's pattern of expansion and contraction: peak, contraction, trough, expansion, and back to a peak. The peak ends an expansion, the trough ends a contraction. The cycle runs around a rising trend, so a trough usually sits above the previous trough.

The downward half.

MAC 0220 Recession

A recession runs from peak to trough. The common rule of two consecutive quarters of falling real GDP is not the official definition: in the United States a private research bureau dates the cycle, judging a significant decline spread across the economy, lasting more than a few months, and weighing income, employment and sales as well as output.

Locating a moment on it.

MAC 0221 Placing a Moment on the Business Cycle

Look at the direction of real output rather than its level. Rising output is expansion; falling output is contraction. The turning points are named for what ends there: a peak is the last moment of an expansion, a trough the last moment of a contraction. Each is defined by the change in direction, not by the height. If output rises for three quarters, falls for two, then rises again, the last rising quarter is the peak and the last falling quarter the trough. A trough is not the worst moment to live through: unemployment usually keeps rising after output turns up.

Two entries on using the numbers.

Comparing one country with another.

MAC 0222 GDP per Capita and PPP

Comparing countries needs two adjustments: divide by population for GDP per capita, and convert to a common currency. A country can have large total output and small output per person. Market exchange rates swing daily, so economists prefer purchasing power parity rates, which compare what money actually buys.

Reading the numbers sceptically.

MAC 0223 Reading a Series Honestly

The same true series can be drawn to tell opposite stories, and four choices do it. Stretching the horizontal axis flattens a spike; stretching the vertical magnifies every wobble. Where the vertical scale starts and stops makes the same movement look large or small. Averaging over longer intervals smooths away the peaks that were the point. And where the series begins and ends can make a flat record look like a steady rise. None of the four requires a false number. Accuracy and honesty are different tests, and this course's own figures are subject to both.

One entry to close the unit.

What the measure is worth.

MAC 0224 What GDP Does and Does Not Tell You

Here the unit's governing idea is at work. GDP measures the market value of what a country produces, and does that well. What it does not measure is how well people live, and the gap runs both ways. It understates: it counts no leisure, so a country working fewer hours for the same output looks worse; it counts spending rather than outcomes, registering what is spent on health but not whether people are healthier; and it ignores everything produced outside a market, a larger share in poorer countries. It also overstates: it counts spending forced by things going wrong, such as rebuilding after a storm; it says nothing about who receives the income, since a per capita figure is an average; and some apparent growth is production moving from the household into the market. Two countries can report the same figure while one works fifty hours a week with income concentrated in a tenth of its people, and the other works thirty-five with income spread evenly. None of this makes GDP useless, and the opposite error is as common: it moves together with longer lives, more schooling and less child mortality, and there is no better single number. Use it to answer how much was produced, and reach elsewhere when the question is how well people live.

Look at what you can now do. You can sort a figure into the right component and leave out what belongs in none, remembering that transfers never count and inventories do. You can decide whether something counts this year by asking whether it was produced, produced this year, and sold as a final good in a market. You can convert a nominal figure to a real one by dividing by the index rather than subtracting, and name the base year. You can place a moment on the business cycle by the direction of output rather than its height. And you can say what GDP does and does not tell you about how people live, without mistaking a rough measure for a useless one. Unit four turns to long-run growth.