CHAPTER 4 The Aggregate Economy FUNDAMENTAL QUESTIONS 1. What is the private sector? 2. What is a household, and what is household income and spending? Dimas Ardian/Bloomberg/Contributor/Getty Images 3. What is a business firm, and what is business spending? 4. How does the international sector affect the economy? 5. What is the public sector? What is public sector spending? 6. How do the private and public sectors interact? Preview top: ! Carsten Reisinger/Shutterstock If there is a point on which most economists agree, it is that trade among nations makes the world better off. When a firm or an individual buys a good or a service produced more cheaply abroad, the firm or individual benefits. The good is cheaper, thereby leaving them with more income to spend elsewhere; the product may better fit their needs than similar domestic offerings; or the good may not be available domestically. The foreign producer also benefits by making more sales than it could selling solely in its own market and by earning foreign exchange (currency) that can be used by itself or others in the country to purchase foreign-made products. 65 Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 66 Chapter 4 The Aggregate Economy When we discuss international trade, it is not typically the individual buyer or seller microeconomics The study of economics using the individual – individual consumer, individual firm. macroeconomics The study of economics using aggregate sectors – households, businesses, government, and the foreign sector. we are talking about. It is, instead, the country as a whole or specific sectors of economies such as the household, business, or government sector. When economists examine individual markets, individual buyers, and individual sellers, they are engaging in microeconomics. When they look at how the aggregate sectors of the economy and other economies interact, they are involved with macroeconomics. In this chapter we introduce the aggregate sectors of an economy. 4-1 The Private Sector household One or more persons who occupy a unit of housing. Buyers and sellers of goods and services and resource owners are linked together in an economy and across economies. For every dollar someone spends, someone else receives a dollar as income. For instance, suppose you decide to buy a new Toyota, so you go to a Toyota dealer and exchange money for the car. The Toyota dealer has rented land and buildings and hired workers in order to make cars available to you and other members of the public. The employees earn incomes paid by the Toyota dealer and then use those incomes to buy food from the grocery store. This transaction generates revenue for the grocery store, which hires workers and pays them incomes that they then use to buy groceries and Toyotas. Your Toyota may have been manufactured in Japan and then shipped to the United States before it was sold by the local Toyota dealer. Your purchase of the Toyota thus creates revenue for both the local dealer and the manufacturer, which pays autoworkers to assemble the cars. When you buy your Toyota, you pay a sales tax, which the government uses to support its expenditures on police, fire protection, national defense, the legal system, and other services. In short, many people in different areas of the economy are involved in what seems to be a single transaction. The aggregate sectors involved are the household sector, the business sector, and the foreign sector. We classify the buyers and the resource owners into the household sector; the sellers or business firms are the business sector; households and firms in other countries, who may also be buyers and sellers of this country’s goods and services, are the international sector. These three sectors—households, business firms, and the international firms and consumers—constitute the private sector of the economy. The private sector refers to any part of the economy that is not part of government. The public sector refers to the government, government spending and taxing, and government-sponsored and government-run entities. The relative sizes of private and public sectors vary from economy to economy. The market economies tend to have smaller public sectors relative to the total economy than do the more socialist or centrally planned economies. consumption Household spending. 4-1a Households 1. What is the private sector? private sector Households, businesses, and the international sector. public sector The government. NOW YOU TRY IT What is the difference between the “private” sector and the “public” sector? 2. What is a household, and what is household income and spending? A household consists of one or more persons who occupy a unit of housing. The unit of housing may be a house, an apartment, or even a single room, as long as it constitutes separate living quarters. A household may consist of a single person, related family members, like a father, mother, and children, or it may comprise unrelated individuals, like three college students sharing an apartment. The person in whose name the house or apartment is owned or rented is called the householder. Household spending is called consumption. Household spending (also called consumer spending) per year in the United States is shown in Figure 1, along with household income. The pattern is generally one of steady increase, but you can see that from the second quarter 2008 to the second quarter 2010, real household expenditures actually declined. (A quarter Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Chapter 4 67 The Aggregate Economy FIGURE 1 Consumption or household spending and income 12,000 11,000 10,000 9,000 Billion Dollars 8,000 7,000 Personal Income 6,000 5,000 Personal Consumption 4,000 3,000 2,000 1,000 0 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 Year Household spending is the largest of the aggregate sectors in the economy. The primary determinant of the spending is income. Source: U.S. Department of Commerce, Bureau of Economic Analysis; www.census.gov. refers to three months.) This was a period of financial crisis and recession. As income declined, so did consumption. Spending by the household sector is the largest component—constituting about 70 percent of total spending in the economy. 4-1b Business Firms A business firm is a business organization controlled by a single management. The terms company, enterprise, and business are used interchangeably with firm. Firms are organized as sole proprietorships, partnerships, or corporations. A sole proprietorship is a business owned by one person. This type of firm may be a one-person operation or a large enterprise with many employees. In either case, the owner receives all the profits and is responsible for all the debts incurred by the business. A partnership is a business owned by two or more persons who share both the profits of the business and the responsibility for the firm’s losses. The partners can be individuals, estates, or other businesses. A corporation is a business whose identity in the eyes of the law is distinct from the identity of its owners. For instance, the owners are not responsible for the debts of the corporation. This is referred to as limited liability. The liabilities of the corporation are limited to the extent that an owner’s own assets cannot be taken to pay the liabilities of the corporation. In fact, a corporation is an economic entity that, like a person, can own property and borrow money in its own name. business firm A business organization controlled by a single management. sole proprietorship A business owned by one person who receives all the profits and is responsible for all the debts incurred by the business. partnership A business with two or more owners who share the firm’s profits and losses. 3. What is a business firm, and what is business spending? corporation A legal entity owned by shareholders whose liability for the firm’s losses is limited to the value of the stock they own. Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 68 Chapter 4 The Aggregate Economy multinational business A firm that owns and operates producing units in foreign countries. investment Spending on capital goods to be used in producing goods and services. NOW YOU TRY IT Why do you think that investment fluctuates more than consumption? A firm may refer to a business at a single location or a worldwide business. Many firms are global in their operations, even though they may have been founded and may be owned by residents of a single country. Firms typically first enter the international market by selling products to foreign countries. As revenues from these sales increase, the firms realize advantages by locating subsidiaries in foreign countries. In addition, companies seek the location where taxes and regulations are the lowest and, of course, where profit potential is highest. A multinational business is a firm that owns and operates producing units in foreign countries. The best-known U.S. corporations are multinational firms. Ford, IBM, PepsiCo, and McDonald’s all own operating units in many different countries. Expenditures by business firms for capital goods—machines, tools, and buildings—that will be used to produce goods and services are called investment. Notice in Figure 2 that investment spending declined from 2007 to 2010; businesses had reduced expenditures on capital goods in 2007 through 2009 because sales had declined and the outlook for future sales was not very good. Investment slowly increased from 2009 to 2013, reflecting the slow growth of the overall economy. Sales declined because households were spending less. Investment is equal to roughly one-fourth of consumption, or household spending, but fluctuates a great deal more than consumption. Investment spending between 1959 and 2013 is shown in Figure 2. Unlike consumption, which generally just increases, investment rises but does not do so in a smooth manner. 4-1c The International Sector 4. How does the international sector affect the economy? Economic conditions in the United States affect conditions throughout the world, and conditions in other parts of the world have a significant effect on economic conditions in the United States. The nations of the world may be divided into two categories: industrial countries and developing countries. (Developing countries are often referred to as emerging markets or FIGURE 2 U.S. Investment Spending 3,000 U.S. Investment (billion dollars) 2,500 2,000 Investment Expenditures 1,500 1,000 500 0 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 Year Business expenditures on capital goods have been increasing erratically since 1959. Source: Economic Report of the President, 2010. Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Chapter 4 The Aggregate Economy LDCs, less-developed countries.) Developing countries greatly outnumber industrial countries (see Figure 3). The World Bank (an international organization that makes loans to developing countries) groups countries according to per capita income (income per person). Low-income economies are those with per capita incomes of less than $1,000. Middle-income economies have per capita annual incomes of $1,000–$10,000. High-income economies—oil exporters and industrial market economies—are distinguished from the middle-income economies and have per capita incomes of greater than $10,000. Some countries are not members of the World Bank and so are not categorized, and information about a few small countries is so limited that the World Bank is unable to classify them. It is readily apparent from Figure 3 that low-income economies are heavily concentrated in Africa and Asia. As we discussed in the first chapter, an important question in economics is: Why are some countries rich and others poor? Why are poor countries concentrated in Africa and Asia with some in Latin America? FIGURE 3 World Economic Development N o r t h A m e r i c a S o u t h A m e r i c a Low-income economies $1,000 or less Lower-middle-income economies $1,000 to $4,999 Upper-middle-income economies $5,000 to $10,000 High-income economies $10,000 or more The colors on the map identify low-income, middle-income, and high-income economies. Countries have been placed in each group on the basis of GNP per capita and, in some instances, other distinguishing economic characteristics. Source: World Bank; http://nebula.worldbank.org/website/GNIwdi/viewer.htm. Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 69 70 Chapter 4 The Aggregate Economy ECONOMIC INSIGHT The Successful Entrepreneur Sometimes It’s Better to Be Lucky Than Good Entrepreneurs do not always develop an abstract idea into reality when starting a new firm. Sometimes people stumble onto a good thing by accident and then are clever enough and willing to take the necessary risk to turn their lucky find into a commercial success. In 1875, a Philadelphia pharmacist on his honeymoon tasted tea made from an innkeeper’s old family recipe. The tea, made from 16 wild roots and berries, was so delicious that the pharmacist asked the innkeeper’s wife for the recipe. When he returned to his pharmacy, he created a solid concentrate of the drink that could be sold for home consumption. The pharmacist was Charles Hires, a devout Quaker, who intended to sell “Hires Herb Tea” to hard-drinking Pennsylvania coal miners as a nonalcoholic alternative to beer and whiskey. A friend of Hires suggested that miners would not drink anything called “tea” and recommended that he call his drink “root beer.” The initial response to Hires Root Beer was so enthusiastic that Hires soon began nationwide distribution. The yellow box of root beer extract became a familiar sight in homes and drugstore fountains across the United States. By 1895, Hires, who started with a $3,000 loan, was operating a business valued at half a million dollars (a lot of money in 1895) and bottling ready-to-drink root beer across the country. Hires, of course, is not the only entrepreneur who was clever enough to turn a lucky discovery into a business success. In 1894, in Battle Creek, Michigan, a sanitarium handyman named Will Kellogg was helping his older brother prepare wheat meal to serve to patients in the sanitarium’s dining room. The two men would boil wheat dough and then imports Products that a country buys from other countries. exports Products that a country sells to other countries. run it through rollers to produce thin sheets of meal. One day they left a batch of the dough out overnight. The next day, when the dough was run through the rollers, it broke up into flakes instead of forming a sheet. By letting the dough stand overnight, the Kelloggs had allowed moisture to be distributed evenly to each individual wheat berry. When the dough went through the rollers, the berries formed separate flakes instead of binding together. The Kelloggs toasted the wheat flakes and served them to the patients. They were an immediate success. In fact, the brothers had to start a mail-order flaked-cereal business because patients wanted flaked cereal for their households. Kellogg saw the market potential of the discovery and started his own cereal company (his brother refused to join him in the business). He was a great promoter who used innovations like four-color magazine ads and free-sample promotions. In New York City, he offered a free box of corn flakes to every woman who winked at her grocer on a speci!, but Kellogg’s fied day. The promotion was considered risque sales in New York increased from two railroad cars of cereal a month to one car a day. Will Kellogg, a poorly paid sanitarium worker in his midforties, became a daring entrepreneur after his mistake with wheat flour led to the discovery of a way to produce flaked cereal. He became one of the richest men in America because of his entrepreneurial ability. Source: From FUCINI. ENTREPRENEURS. 1985 Gale, a part of Cengage Learning, Inc. The World Bank uses per capita income to classify countries as either low income or high income; low-income countries are called “emerging” and high-income are called “industrial market economies,” or in the case where oil or another resource makes a country high income but not an industrial country, it is called “still developing.”. The economies of the industrial nations are highly interdependent, meaning that as conditions change in one country, business firms and individuals may shift large sums of money from one country to another, thereby affecting many economies. As a result, countries are forced to pay close attention to each other’s economic policies. The United States tends to buy primary products such as agricultural produce and minerals from the developing countries and manufactured products from the industrial nations. Products that a country buys from another country are called imports. Products that a country sells to another country are called exports. The United States tends to sell, or export, manufactured goods to all countries. Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. The Aggregate Economy David R. Frazier Photolibrary, Inc. / Alamy Chapter 4 “The best and brightest are leaving.” Statements like this are heard in many nations throughout the world. The best trained and most innovative people in many countries find their opportunities greater in the United States. As a result, they leave their countries to gain citizenship in the United States. But it is not easy for people to move from one country to another. The flow of goods and services among nations—international trade—occurs more readily than does the flow of workers. The economic activity of the United States with the rest of the world includes U.S. spending on foreign goods and foreign spending on U.S. goods. Figure 4 shows how U.S. exports and imports are spread over different countries. Notice that the largest trading partners with the United States are Canada, Mexico, China, and Western Europe. FIGURE 4 Direction of U.S. Trade 450,000 400,000 350,000 300,000 250,000 200,000 150,000 100,000 50,000 0 Canada Japan Western Europe U.S. Exports to: Mexico China OPEC U.S. Imports from: This chart shows that a trade deficit exists for the United States, since U.S. imports greatly exceed U.S. exports. The chart also shows that the largest trading partners with the U.S. are Western Europe, Japan, Canada, Mexico, and China. Source: Economic Report of the President, 2010; www.census.gov/foreign-trade/Press-Release/current_press_release/exh14a.xls. Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 71 72 Chapter 4 The Aggregate Economy FIGURE 5 Net Exports 100 0 –100 (Billions of Dollars) –200 –300 –400 –500 –600 –700 –800 –900 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 Year U.S. Exports are sales of U.S. goods and services to other countries. U.S. Imports are purchases by the United States of goods and services from other countries. Exports minus Imports is Net Exports. Negative net exports means that imports exceed exports or that the United States has a trade deficit. Source: U.S. Department of Commerce: Bureau of Economic Analysis trade surplus The situation that exists when imports are less than exports. trade deficit The situation that exists when imports exceed exports. net exports The difference between the value of exports and the value of imports. When exports exceed imports, a trade surplus exists. When imports exceed exports, a trade deficit exists. The term net exports refers to the difference between the value of exports and the value of imports: Net exports equals exports minus imports. Figure 5 traces U.S. net exports over time. Positive net exports represent trade surpluses; negative net exports represent trade deficits. The trade deficits (indicated by negative net exports) starting in the 1980s were unprecedented. Reasons for this pattern of international trade are discussed in later chapters. RECAP 1. A household consists of one or more persons who occupy a unit of housing. 4. Business investment spending fluctuates widely over time. 2. Household spending is called consumption. 5. The majority of U.S. trade is with the industrial market economies. 3. Business firms may be organized as sole proprietorships, partnerships, or corporations. Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Chapter 4 73 The Aggregate Economy 4-2 The Public Sector When we refer to the public sector, it is government that we are talking about. Government in the United States consists of federal, state, and local government. In the United States, government’s influence is extensive. From conception to death, individuals are affected by the activities of the government. Many mothers receive prenatal care through government programs. We are born in hospitals that are subsidized or run by the government. We are delivered by doctors who received training in subsidized colleges. Our births are recorded on certificates filed with the government. Ninety percent of students attend public schools as opposed to private schools. Many people live in housing that is directly subsidized by the government or have mortgages that are insured by the government. Most people, at one time or another, put savings into accounts that are insured by the government. Virtually all of us, at some time in our lives, receive money from the government—from student loan programs, unemployment compensation, disability insurance, food stamps, social security, or Medicare. We drive on government roads, recreate on government lands, and fish in government waters. 5. What is the public sector? What is public sector spending? 4-2a Growth of Government Blair_witch/Dreamstime.com The United States was founded as a republic, meaning that government is divided between the federal level and state and local levels. Local government includes county, regional, and municipal units. Each level affects us through its taxing and spending decisions and its laws regulating behavior. In 1900, the federal government was a small player. States had the power—called states’ rights—because the country’s founders believed that government closest to the people The United States Capitol is where the Senate and House of Representatives meet. The Capitol represents the public sector—government. Thomas Jefferson insisted the legislative building be called the “Capitol” rather than “Congress House.” He thought “Capitol” represented the shining city on a hill. The word capitol comes from Latin, meaning city on a hill. Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 74 Chapter 4 The Aggregate Economy could be constrained better than a federal government. But soon after the country’s founding, people began to demand more federal government and less states’ rights. From 1789 until 1930 government grew, but compared to what has occurred since 1930, that growth was minimal. The number of people employed by the local, state, and federal governments combined grew from 3 million in 1930 to more than 18 million today; there are now more people employed in government than in manufacturing. Annual expenditures by the federal government rose from $3 billion in 1930 to $4.5 trillion today. In 1929, government spending constituted less than 2.5 percent of total spending in the economy. Today it is around 35 percent, as shown in Figure 6. 4-2b Government Spending transfer payments Income transferred by the government from a citizen who is earning income to another citizen. Federal, state, and local government spending for goods and services as a percent of the total spending in the economy is shown in Figure 6. Total government spending is larger than investment spending but smaller than consumption. In addition to purchasing goods and services, government also takes money from some taxpayers and gives it to others. This is called a transfer payment. In 2013, total expenditures of federal, state, and local government for goods and services were about $6.5 trillion. In this same year, transfer payments made by the federal government were about $2.5 trillion. Federal government transfer payments are shown in Figure 7. The magnitude of federal government spending relative to federal government revenue from taxes has become an important issue in recent years. The federal budget (revenue less 0.45 0.40 0.35 0.30 0.25 0.20 0.15 0.10 2013 2010 2005 2000 1995 1990 1985 1980 1975 1970 1965 1960 1955 0 1950 0.05 1947 U.S. Government Spending (billion dollars) FIGURE 6 Government Spending Year State and Local as percent of GDP Federal as percent of GDP Total Govt as percent of GDP Total Government Spending—federal, state, and local divided by gross domestic product (GDP)—the total spending of all sectors in the economy as a percent of total GDP. In 1929, government spending constituted less than 2.5 percent of total spending in the economy. Today it is around 37 percent. Source: U.S. Department of Commerce: Bureau of Economic Analysis retrieved from Federal Reserve Bank of St. Louis. FRED data retrieval. Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Chapter 4 75 The Aggregate Economy FIGURE 7 Federal Government and Total Government Transfer Payments Billions of Dollars Quarterly 3000 2500 2000 1500 1000 500 0 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 Year Transfer payments are payments made by government that do not purchase anything. They are funds transferred from one group to another group. Source: U.S. Department of Commerce: Bureau of Economic Analysis spending) was roughly balanced until the early 1970s. The budget is a measure of spending and revenue. A balanced budget occurs when federal spending is approximately equal to federal revenue. This was the case through the 1950s and 1960s. If federal government spending is less than tax revenue, a budget surplus exists. The federal government deficit and surplus are shown in Figure 8. By the early 1980s, federal government spending was much larger than revenue, so a large budget deficit existed. The federal budget deficit grew very rapidly to about $290 billion by the early 1990s before budget surplus The excess that results when government spending is less than tax revenue. budget deficit The shortage that results when government spending is greater than tax revenue. FIGURE 8 Federal Government Surplus or Deficit. 400000 Federal Surplus or Deficit [–] 200000 0 –200000 –400000 –600000 –800000 –1000000 –1200000 2010 2005 2000 1995 1990 1985 1980 1975 1970 1965 1960 1955 1950 1945 1940 1935 1930 1925 1920 1915 1910 1905 –1600000 1900 –1400000 Year The difference between federal government expenditures and tax revenues is the surplus or deficit. Since 1930 the government has run a deficit in all but 3 years. Source: Data are from the Economic Report of the President, 2010. Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 76 Chapter 4 The Aggregate Economy FIGURE 9 Total Government Debt 18000000 Federal Debt: Total Public Debt 16000000 14000000 12000000 10000000 8000000 6000000 4000000 2000000 0 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 Year When the federal government borrows in order to finance its deficits, it creates public debt. The total public debt has risen to about $17 trillion today. beginning to drop and turning to surplus by 1998. After four years of surpluses, a deficit was again realized in 2002, and the deficit has grown since then. It exploded during the period 2008 to 2013. Since the deficit rose, so too did government debt; when the federal government spends more than it takes in, it must borrow. Debt is the accumulation of deficits; each deficit adds to the debt. The total debt of the U.S. federal government exceeds $17 trillion. The federal government debt is shown in Figure 9. RECAP 1. The public sector refers to government. 2. Government spending is larger than investment spending but much smaller than consumption spending. 3. When government spending exceeds tax revenue, a budget deficit exists. When government spending is less than tax revenue, a budget surplus exists. 4-3 Interaction Among Sectors and Economies Households purchase goods and services from businesses, pay taxes to government, and receive wages and salaries from their jobs with business or with government, while businesses purchase resources from households and pay taxes to government. In addition, businesses purchase resources from foreign households and goods from foreign businesses, households travel to other nations, and governments provide aid or receive aid from other governments. These are just some of the interactions of the sectors of the economy. To understand the aggregate economy, it is necessary to understand how the sectors of the economy interact and how economies interact with each other. 4-3a Households and Businesses Households own all the basic resources, or factors of production, in the economy. Household members own land and provide labor, and they are the stockholders, proprietors, and partners who own business firms. Businesses, governments, and foreign businesses employ Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Chapter 4 77 The Aggregate Economy the services of resources in order to produce goods and services. Households receive wages, salaries, and benefits for their services. This is their income. What do households do with the income they receive? They spend most of it, they pay taxes, and they often save some. When households save, they do so in different ways. The most common way is to deposit their savings in banks and credit unions. The banks and credit unions are called financial intermediaries because they lie between the household saver and the borrower. Households may also put money into pension funds, through what are called 401(k) funds or IRAs. These funds may be stocks and bonds as well as cash. Financial intermediaries use the deposits from savers to make loans to borrowers. Households borrow money to purchase homes, cars, and other items. Businesses borrow money to purchase machines, equipment, and buildings, and to hire labor. So the money that is saved by households reenters the economy in the form of business and household spending. financial intermediaries Institutions that accept deposits from savers and make loans to borrowers. 4-3b Government The government sector buys goods and services from businesses and hires labor from households. It pays for these things with money it collects in taxes and with loans it undertakes— its debt. The government uses the resource services and final goods and services to carry out its many activities—everything from national defense to subsidies for solar companies and welfare and unemployment compensation. 6. How do the private and public sectors interact? 4-3c The International Sector Foreign countries also affect and are affected by the household, business, and government sectors of the home country. We typically buy a foreign-made product from a local business firm rather than directly from the foreign producer. For instance, glancing at products in retail stores, we can see “Made in China” or “Made in Mexico” on many of the products. Yet you purchase these from U.S. firms using dollars. The business firm purchases the items from the foreign countries. Even in some “Made in America” products you are purchasing foreign products and services. For instance, when you purchase an iPod, you are purchasing a product that has parts from Japan, the Philippines, Taiwan, and China, as well as the United States. This makes it difficult to accurately measure the relative values of goods and services purchased and sold from one country to another. About 30 to 40 percent of the iPod’s price is actually counted as an import (purchase of a Chinese good by the United States) from China to the United States. Nevertheless, we attempt to provide some measures of the extent of trade among nations with exports (sales) and imports (purchases). As mentioned previously, net exports is the difference between exports of goods from one country and imports of goods by that country. Net exports of the home country may be either positive (a trade surplus) or negative (a trade deficit). When net exports are positive, there is a net flow of goods from the firms of the home country to foreign countries and a net flow of money from foreign countries to the firms of the home country. When net exports are negative, the opposite occurs. A trade deficit involves net flows of goods from foreign countries to the firms of the home country and net money flows from the domestic firms to the foreign countries. As an example, the United States has been a negative net exporter with China, so Chinese goods have flowed to the United States while U.S. dollars have flowed to China. If exports and imports are equal, net exports are zero because the value of exports is offset by the value of imports. NOW YOU TRY IT Total spending in the economy consists of what? Total income in the economy consists of what? 4-3d Macroeconomics What goes on in one sector affects what occurs in other sectors, and what goes on in one economy often affects what goes on in other economies. This is essentially what we study in Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 78 Chapter 4 The Aggregate Economy macroeconomics. For instance, when the government increases taxes on the business sector, the business sector might reduce employment and purchases of resources from the private sector. This lowers the income of the private sector and thus reduces their spending and saving. When the government increases its deficit (increases spending more than revenue), it might have to finance that debt by selling bonds to the financial intermediaries. This could reduce the amount of money the intermediaries have to lend to households and businesses. Foreigners and foreign governments might purchase the bonds the government sells, and this could affect spending and income in the foreign countries. Should the home country place a tax on foreign goods and services, households and businesses would reduce spending on foreign goods and increase spending on domestic goods, or those not subject to the higher tax. This could lead to retaliation by other countries, thereby reducing the home country’s sales to foreign businesses and households, or it could lead to higher prices domestically. In macroeconomics we will examine these and many other issues. RECAP 1. Domestic households, firms, and government interact among themselves and with households, firms, and government in other countries. 3. Firms sell goods and services to government and receive income. 4. Firms buy resources and receive goods from firms in other countries. 2. Households get government services and pay taxes; they provide resource services and receive income. SUMMARY 1. What is the private sector? • • The private sector refers to the household, business, and nongovernmental international sectors. §4-1 The public sector refers to government. §4-1 2. What is a household, and what is household income and spending? • • A household consists of one or more persons who occupy a unit of housing. §4-1a • • • • • Household spending is called consumption and is the largest component of spending in the economy. §4-1a 3. What is a business firm, and what is business spending? • 4. How does the international sector affect the economy? A business firm is a business organization controlled by a single management. §4-1b Businesses may be organized as sole proprietorships, partnerships, or corporations. §4-1b Business investment spending—the expenditure by business firms for capital goods—fluctuates a great deal over time. §4-1b The international trade of the United States occurs predominantly with the other industrial economies. §4-1c Exports are products sold to the rest of the world. Imports are products bought from the rest of the world. §4-1c Exports minus imports equal net exports. Positive net exports mean that exports are greater than imports and that a trade surplus exists. Negative net exports mean that imports exceed exports and that a trade deficit exists. §4-1c 5. What is the public sector? What is public sector spending? • • The public sector refers to all levels of government— federal, state, and local. §4-2 When a government spends more than it receives in taxes, the government runs a deficit; when it receives more than it spends, it runs a surplus. §4-2a Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Chapter 4 6. How do the private and public sectors interact? • The Aggregate Economy 79 they provide resource services and receive income. Firms sell goods and services to government and receive income. §4-3a Government interacts with both households and firms. Households get government services and pay taxes; KEY TERMS budget deficit, 75 budget surplus, 75 business firm, 67 consumption, 66 corporation, 67 exports, 70 financial intermediaries, 77 household, 66 imports, 70 investment, 68 macroeconomics, 66 microeconomics, 66 multinational business, 68 net exports, 72 partnership, 67 private sector, 66 public sector, 66 sole proprietorship, 67 trade deficit, 72 trade surplus, 72 transfer payments, 74 EXERCISES 1. Is a family a household? Is a household a family? 2. Which sector (households, business, or international) spends the most? Which sector spends the least? Which sector has the most volatility of spending? 3. What does it mean if net exports are negative? 4. People sometimes argue that imports should be limited by government policy. Suppose a government quota on the quantity of sugar imported to the United States occurs. What is likely to happen to the price of sugar in the United States and in the rest of the world? 5. Suppose there are three countries in the world. Country A exports $11 million worth of goods to Country B and $5 million worth of goods to Country C; Country B exports $3 million worth of goods to Country A and $6 million worth of goods to Country C; and Country C exports $4 million worth of goods to Country A and $1 million worth of goods to Country B. a. What are the net exports of countries A, B, and C? b. Which country is running a trade deficit? A trade surplus? 6. List the four sectors of the economy along with the type of spending associated with each sector. Order the types of spending in terms of magnitude, and give an example of each kind of spending. 7. Using the interconnection between sectors of the economy, explain the effects of imposing an increase in taxes on the household sector. 8. Can a household spend more than it earns? How? Can the government spend more than it receives in tax revenues? How? What is the difference between households running deficits and governments running deficits, or are there any? What is the ratio of government spending to GDP? What is the ratio of payments on the debt (interest payments) to GDP? (You may find this at www.gpoaccess.gov/eop/tables11.html.) 9. See if you can find the ratio of debt to GDP for several developed nations. Who has the highest ratio? Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. ECONOMICALLY SPEAKING 2014 ECONOMIC REPORT OF THE PRESIDENT, PP. 29–30, CHAPTER 1 A s part of the budget deal, Congress also agreed on discretionary funding levels for the remainder of FY 2014 and all of FY 2015, offering a way to avoid another counterproductive shutdown. Earlier this year, Congress passed appropriations bills for FY 2014 consistent with these spending levels and also extended the debt limit into 2015. As fiscal headwinds ease at the Federal level, State and local governments are also showing encouraging signs. After shedding more than 700,000 jobs from 2009 to 2012, State and local governments added 32,000 jobs in 2013. p. 56, Chapter 2: 2014 EROP Consumer Spending Real consumer spending grew about 2 percent during each of the past three years. With consumer spending constituting 68 percent of GDP, that stability explains much of the stability of the growth of aggregate demand during those three years. Yet the stability of consumption growth during 2013 results from several offsetting developments. pp. 58–59 Business Investment Business Fixed Investment. Real business fixed investment grew moderately, 3.0 percent during the four quarters of 2013, down from a 5.0 percent increase during 2012. The slower pace of business investment during 2013 was concentrated in structures and equipment investment, while investment in intellectual property products grew faster in 2013 than the year earlier. Investment in nonresidential structures declined 0.2 percent following robust growth of 9.2 percent during 2012. Investment in equipment slowed to 3.8 percent, following a 4.5 percent increase in 2012. In contrast, investment in intellectual property products picked up to 4.0 percent during 2013 from 2.9 percent in 2012. pp. 62–63 State and Local Governments Although State and local governments continued to experience fiscal pressure in 2013, the four-year contraction in the sector—measured in terms of both purchases (consumption and investment) and employment— finally appears to have ended. State and local purchases, which had generally declined for 13 quarters through the first quarter of 2013, ended the year at a higher level than in the first quarter, marking its first increase over three quarters since 2009. The cumulative decline in State and local purchases during this recovery contrasts with the usual experience during recoveries (Figure 2-10). In a typical recovery, growth in State and local government bolsters the economic recovery. In contrast, declines in State and local government have been a headwind to private-sector growth and hiring during the first four years of this recovery. International Trade In 2013, U.S. exports of goods and services to the world averaged nearly $189 billion a month and imports averaged nearly $229 billion a month (Figure 2-12). Exports accounted for 13.5 percent of U.S. production (GDP) in 2013, the same as in 2011 and 2012. The U.S. trade deficit, the excess of the Nation’s imports over its exports, averaged nearly $40 billion a month in 2013. 80 Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. COMMENTARY T he Economic Report of the President is an annual report created by the President’s Council of Economic Advisers (CEA). The report is a summary of developments in the U.S. economy over the past year. The report is macroeconomic in nature, reporting developments by major sector: federal and state and local governments, households, businesses, and the foreign sector. The report not only presents data but also interprets the data. Typically, the report by a Democratic ((shouldn’t this be Democrat? We are referring to the party not the election procedure) administration will be focused more on the benefits of government, while the report from a Republican administration will emphasize individual initiatives. Yet, the CEA of both parties devotes most of the report to discussing recent past developments and expected future developments in the various sectors. 81 Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. CHAPTER 5 National Income Accounting FUNDAMENTAL QUESTIONS 1. How is the total output of an economy measured? 2. Who produces the nation’s goods and services? 3. Who purchases the goods and services produced? ªTungCheung/Shutterstock.com 4. Who receives the income from the production of goods and services? 5. What is the difference between nominal and real GDP? 6. What is a price index? Preview top: ª Carsten Reisinger/Shutterstock The Korean economy grew at an average rate of 3.9 percent per year from 2000 to 2012. This compares with an average rate of 1.6 percent per year for the United States over the same period. Still, the U.S. economy is much larger than the Korean economy—in fact, it is larger than the economies of the 50 largest developing countries combined. The size of an economy cannot be compared across countries without common standards of measurement. National income accounting provides these standards. Economists use this system to evaluate the economic condition of a country and to compare conditions across time and across countries. 83 Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 84 Chapter 5 National Income Accounting A national economy is a complex arrangement of many different buyers and sellers— households, businesses, and government units—and of their interactions with the rest of the world. To assess the economic health of a country or to compare the performance of an economy from year to year, economists must be able to measure national output and real gross domestic product (GDP). Without these data, policymakers cannot evaluate their economic policies. For instance, in the United States, real GDP fell in 1980, 1981, and 1982, and again in 1990–1991, 2001, and 2008–2009. This drop in real GDP was accompanied by widespread job losses and a general decline in the economic health of the country. As this information became known, political and economic debate centered on economic policies, on what should be done to stimulate the economy. Without real GDP statistics, policymakers would not have known that there were problems, let alone how to go about fixing them. 5-1 Measures of Output and Income 1. How is the total output of an economy measured? national income accounting The framework that summarizes and categorizes productive activity in an economy over a specific period of time, typically a year. The most common measure of a nation’s output is GDP. gross domestic product (GDP) The market value of all final goods and services produced in a year within a country. In this chapter, we discuss GDP, real GDP, and other measures of national productive activity by making use of the national income accounting system used by all countries. National income accounting provides a framework for discussing macroeconomics. Figure 1 reproduces the circular flow diagram you saw in the chapter “The Aggregate Economy.” The lines connecting the various sectors of the economy represent flows of goods and services and of money expenditures (income). National income accounting is the process of counting the value of the flows between sectors and then summing them to find the total value of the economic activity in an economy. National income accounting fills in the dollar values in the circular flow. National income accounting measures the output of an entire economy as well as the flows between sectors. It summarizes the level of production in an economy over a specific period of time, typically a year. In practice, the process estimates the amount of activity that occurs. It is beyond the capability of government officials to count every transaction that takes place in a modern economy. Still, national income accounting generates useful and fairly accurate measures of economic activity in most countries, especially wealthy industrial countries that have comprehensive accounting systems. 5-1a Gross Domestic Product Modern economies produce an amazing variety of goods and services. To measure an economy’s total production, economists combine the quantities of oranges, golf balls, automobiles, and all the other goods and services produced into a single measure of output. Of course, simply adding up the number of things produced—the number of oranges, golf balls, and automobiles—does not reveal the value of what is being produced. If a nation produces 1 million more oranges and 1 million fewer automobiles this year than it did last year, the total number of things produced remains the same. But because automobiles are much more valuable than oranges, the value of the nation’s output has dropped substantially. Prices reflect the value of goods and services in the market, so economists use the money value of things to create a measure of total output, a measure that is more meaningful than the sum of the units produced. The most common measure of a nation’s output is gross domestic product. Gross domestic product (GDP) is the market value of all final goods and services produced in a year within a country’s borders. A closer look at three parts of this definition—market value, final goods and services, and produced in a year—will make clear what the GDP does and does not include. Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 85 Chapter 5 National Income Accounting FIGURE 1 The Circular Flow: Households, Firms, Government, and Foreign Countries Financial Intermediaries Savings ($) Investment ($) Payments for Goods and Services ($) Goods and Services Taxes ($) Households Taxes ($) Government Services Government Resource Services Government Services Firms Goods and Services Payments for Resource Services ($) Payments for Goods and Services ($) Resource Services Payments for Resource Services ($) Foreign Countries Exports Imports Net Exports Payments for Net Exports ($) The value of national output equals expenditures plus income. If the domestic economy has positive net exports (a trade surplus), goods and services flow out of the domestic firms toward the foreign countries and money payments flow from the foreign countries to the domestic firms. If the domestic economy has negative net exports (a trade deficit), just the reverse is true. 5-1a-1 Market Value The market value of final goods and services is their value at market price. The process of determining market value is straightforward when prices are known and transactions are observable. However, there are cases in which prices are not known and transactions are not observable. For instance, illegal drug transactions are not reported to the government, which means that they are not included in GDP statistics. In fact, almost any activity that is not traded in a market is not included. For example, production that takes place in households, such as homemakers’ services, is not counted, nor are unreported barter and cash transactions. For instance, if a lawyer has a sick dog and a veterinarian needs some legal advice, by trading services and not reporting the activity to the tax Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 86 Chapter 5 National Income Accounting authorities, each can avoid taxation on the income that would have been reported had they sold their services to each other. If the value of a transaction is not recorded as taxable income, it generally does not appear in the GDP. There are some exceptions, however. Contributions to GDP are estimated for in-kind wages, such as nonmonetary compensation like room and board. GDP values also are assigned to the output consumed by a producer—for example, the home consumption of crops by a farmer. 5-1a-2 Final Goods and Services The second Tony Gervis/Robert Harding World Imagery/Getty Images part of the definition of GDP limits the measure to final goods and services, the goods and services that are available to the ultimate consumer. This limitation avoids double counting. Suppose a retail store sells a shirt to a consumer for $20. The value of the shirt in the GDP is $20. But the shirt is made of cotton that has been grown by a farmer, woven at a mill, and cut and sewn by a manufacturer. What would happen if we counted the value of the shirt at each of these stages of the production process? We would overstate the market value of the shirt. Intermediate goods are goods that are used in the production of a final product. For instance, the All final goods and services produced in a year are counted in the GDP. ingredients for a meal are intermediate goods to a For instance, the value of a horseback excursion through the Grand Canyon is part of the national output of the United States. The value of restaurant. Similarly, the cotton and the cloth are inthe trip would be equal to the amount that travelers would have to pay the termediate goods in the production of the shirt. The guide company in order to take the trip. This price would reflect the value stages of production of the $20 shirt are shown in of the personnel, equipment, and food provided by the guide company. Figure 2. The value-of-output axis measures the value of the product at each stage. The cotton prointermediate good duced by the farmer sells for $1. The cloth woven by the textile mill sells for $5. The shirt A good that is used as an manufacturer sells the shirt wholesale to the retail store for $12. The retail store sells the input in the production of final shirt—the final good—to the ultimate consumer for $20. Remember that GDP is based on the goods and services. market value of final goods and services. In our example, the market value of the shirt is $20. That price already includes the value of the intermediate goods that were used to produce the shirt. If we added to it the value of output at every stage of production, we would be counting the value of the intermediate goods twice, and we would be overstating the GDP. value added It is possible to compute GDP by computing the value added at each stage of producThe difference between the tion. Value added is the difference between the value of output and the value of the intermevalue of output and the value diate goods used in the production of that output. In Figure 2, the value added by each stage of the intermediate goods of production is listed at the right. The farmer adds $1 to the value of the shirt. The mill used in the production of that takes the cotton worth $1 and produces cloth worth $5, adding $4 to the value of the shirt. output. The manufacturer uses $5 worth of cloth to produce a shirt that it sells for $12, so the manufacturer adds $7 to the shirt’s value. Finally, the retail store adds $8 to the value of the shirt: It pays the manufacturer $12 for the shirt and sells it to the consumer for $20. The sum of the value added at each stage of production is $20. The total value added, then, is equal to the market value of the final product. Economists can thus compute GDP using two methods. The final goods and services method uses the market value of the final good or service; the value-added method uses the value added at each stage of production. Both methods count the value of intermediate goods only once. This is an important distinction: GDP is not based on the market value of all goods and services, but on the market value of all final goods and services. Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 87 Chapter 5 National Income Accounting FIGURE 2 Stages of Production and Value Added in Shirt Manufacturing Final Good Retail Shirt Intermediate Goods $8 Wholesale Shirt 12 $7 7 Cloth 5 $4 1 0 Sum = $38 $38 8 4 Cotton $1 Cotton Farmer Value Added (dollars) Value of Output (dollars) 20 1 Textile Mill Shirt Manufacturer Retail Store $20 $20 = Sum A cotton farmer sells cotton to a textile mill for $1, adding $1 to the value of the final shirt. The textile mill sells cloth to a shirt manufacturer for $5, adding $4 to the value of the final shirt. The manufacturer sells the shirt wholesale to the retail store for $12, adding $7 to the value of the final shirt. The retail store sells the final shirt to a consumer for $20, adding $8 to the value of the final shirt. The sum of the prices received at each stage of production equals $38, which is greater than the price of the final shirt. The sum of the value added at each stage of production equals $20, which equals the market value of the shirt. 5-1a-3 Produced in a Year GDP measures the value of the output produced in a year. The value of goods produced last year is counted in last year’s GDP; the value of goods produced this year is counted in this year’s GDP. The year of production, not the year of sale, determines the allocation to GDP. Although the value of last year’s goods is not counted in this year’s GDP, the value of services involved in the sale is. This year’s GDP does not include the value of a house built last year, but it does include the value of the real estate broker’s fee; it does not include the value of a used car, but it does include the income earned by the used-car dealer in the sale of that car. To determine the value of goods produced in a year but not sold in that year, economists calculate changes in inventory. Inventory is a firm’s stock of unsold goods. If a shirt that is produced this year remains on the retail store’s shelf at the end of the year, it increases the value of the store’s inventory. A $20 shirt increases that value by $20. Changes in inventory allow economists to count goods in the year in which they are produced, whether or not they are sold. Changes in inventory can be planned or unplanned. A store may want a cushion above expected sales (planned inventory changes), or it may not be able to sell all the goods that it expected to sell when it placed the order (unplanned inventory changes). For instance, suppose Jeremy owns a surfboard shop, and he always wants to keep 10 more surfboards than he expects to sell. He does this so that in case business is surprisingly good, he does not have to turn away customers and lose those sales to his competitors. At the beginning of the year, inventory The stock of unsold goods held by a firm. NOW YOU TRY IT Use the following information to find the value of: a. GDP b. GNP c. NNP Consumption Gross investment Government spending Net exports Income earned but not received Income received but not earned Personal taxes Capital consumption allowance Receipts of factor income from the rest of the world Payments of factor income to the rest of the world Indirect business taxes Statistical Discrepancy d. NI e. PI f. DPI $600 $100 $200 $100 $ 20 $ 30 $200 $230 $ 50 $ 50 $ 90 $ 0 Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 88 Chapter 5 National Income Accounting Jeremy has 10 surfboards, and he then builds as many new boards during the year as he expects to sell. He plans on having an inventory at the end of the year of 10 surfboards. Suppose Jeremy expects to sell 100 surfboards during the year, so he builds 100 new boards. If business is surprisingly poor and he sells only 80 surfboards, how do we count the 20 new boards that he made but did not sell? We count the change in his inventory. He started the year with 10 surfboards and ends the year with 20 more unsold boards, for a year-end inventory of 30. The change in inventory of 20 (equal to the ending inventory of 30 minus the starting inventory of 10) represents output that is counted in GDP. In Jeremy’s case, the inventory change is unplanned, since he expected to sell the 20 extra surfboards that he has in his shop at the end of the year. But whether the inventory change is planned or unplanned, changes in inventory will count output that is produced but not sold in a given year. 2. Who produces the nation’s goods and services? GDP is the value of final goods and services produced by domestic households, businesses, and government. 3. Who purchases the goods and services produced? 5-1a-4 GDP as Output The GDP is a measure of the market value of a nation’s total output in a year. Remember that economists divide the economy into four sectors: households, businesses, government, and the international sector. Figure 1 shows how the total value of economic activity equals the sum of the output produced in each sector. Figure 3 indicates where the U.S. GDP is actually produced. Since GDP counts the output produced in the United States, U.S. GDP is produced in business firms, households, and government located within the boundaries of the United States. Not unexpectedly in a capitalist country, privately owned businesses account for the largest percentage of output: In the United States, 76 percent of the GDP is produced by private firms. Government produces 12 percent of the GDP, and households produce 12 percent. Figure 3 defines GDP in terms of output: GDP is the value of final goods and services produced in a year by domestic households, businesses, and government units. Even if some of the firms producing in the United States are foreign owned, the output that they produce in the United States is counted in the U.S. GDP. 5-1a-5 GDP as Expenditures The circular flow diagram in Figure 1 shows not only the output of goods and services from each sector but also the payments for goods and services. Here we look at GDP in terms of what each sector pays for the goods and services that it purchases. The dollar value of total expenditures—the sum of the amount that each sector spends on final goods and services—equals the dollar value of output. In the chapter “The Aggregate Economy,” you learned that household spending is called consumption. Households spend their income on goods and services to be consumed. Business spending is called investment. FIGURE 3 U.S. Gross Domestic Product by Sector (billion dollars) Households $2084.6 (12%) Government $2033.3 (12%) Business Firms $12739.8 (76%) Business firms produce 76 percent of the U.S. GDP. Government produces 12 percent; households, 12 percent. Source: Bureau of Economic Analysis, Q3 2013, www.bea.gov, Table 1.3.5 Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 89 Chapter 5 National Income Accounting Investment is spending on capital goods that will be used to produce other goods and services. The other two components of total spending are government spending and net exports. Net exports are the value of exports (goods and services sold to the rest of the world) minus the value of imports (goods and services bought from the rest of the world). GDP ¼ consumption þ investment þ government spending þ net exports Or, in the shorter form commonly used by economists, GDP ¼ C þ I þ G þ X GDP ¼ C þ I þ G þ X where X is net exports. Figure 4 shows the U.S. GDP in terms of total expenditures. Consumption, or household spending, accounts for 68 percent of national expenditures. Government spending represents 19 percent of expenditures, and business investment represents 16 percent. Net exports are negative (#3 percent), which means that imports exceeded exports. To determine total national expenditures on domestic output, the value of imports, or spending on foreign output, is subtracted from total expenditures. 5-1a-6 GDP as Income The total value of output can be calculated by adding up the expenditures of each sector. And because one sector’s expenditures are another’s income, the total value of output can also be computed by adding up the income of all sectors. Business firms use factors of production to produce goods and services. Remember that the income earned by factors of production is classified as wages, interest, rent, and profits. Wages are payments to labor, including fringe benefits, social security contributions, and retirement payments. Interest is the net interest paid by businesses to households plus the net interest received from foreigners (the interest that they pay us minus the interest that we pay them). Rent is income earned from selling the use of real property (houses, shops, and farms). Finally, profits are the sum of corporate profits plus proprietors’ income (income from sole proprietorships and partnerships). Figure 5 shows the U.S. GDP in terms of income. Notice that wages account for 53 percent of the GDP. Interest and profits account for 4 and 10 percent of the GDP, respectively. Proprietors’ income accounts for 8 percent. Rent (4 percent) is very small in comparison. Net factor income from abroad is income received from U.S.-owned resources located in other countries minus income paid to foreign-owned resources located in the United States. Since U.S. GDP refers only to income earned within U.S. borders, we must add income payments from the rest of the world and subtract income payments to the rest of the world to arrive at GDP (1 percent). 4. Who receives the income from the production of goods and services? FIGURE 4 U.S. Gross Domestic Product as Expenditures (trillion dollars) Investment $2.69 (16%) Net Exports –0.49 (–3%) Government $3.14 (19%) Consumption $11.53 (68%) Consumption by households accounts for 68 percent of the GDP, followed by government spending at 19 percent, investment by business firms at 16 percent, and net exports at #3 percent. Source: U.S. Bureau of Economic Analysis, Q3 2013, www.bea.gov, Table 1.1.5 Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 90 Chapter 5 National Income Accounting FIGURE 5 U.S. Gross Domestic Product as Income Received (billion dollars) Indirect Business Taxes $1138.8 (7%) Interest $591.7 (4%) Rent $587.7 (4%) Capital Consumption Allowance $2631.9 (16%) Corporate Profits $1684.3 (10%) Net Factor Income from Abroad $246.9 (1%) Wages $8819.7 (53%) Proprietors' Income $1341.5 (8%) The largest component of income is wages, at 53 percent. Profits represent 10 percent; interest, 4 percent; proprietors’ income, 8 percent; and rent, 4 percent. Capital consumption allowance (16 percent) and indirect business taxes (7 percent) are not income received but still must be added; net factor income from abroad must be added (1 percent). (Note: Percentages do not always equal 100 percent). Source: U.S. Bureau of Economic Analysis, third quarter 2013; www.bea.gov. capital consumption allowance The estimated value of depreciation plus the value of accidental damage to capital stock. depreciation A reduction in the value of capital goods over time as a result of their use in production. indirect business tax A tax that is collected by businesses for a government agency. The GDP as income is equal to the sum of wages, interest, rent, and profits, less net factor income from abroad, plus capital consumption allowance and indirect business taxes. Figure 5 also includes two income categories that we have not discussed: capital consumption allowance and indirect business taxes. Capital consumption allowance is not a money payment to a factor of production; it is the estimated value of capital goods used up or worn out in production plus the value of accidental damage to capital goods. The value of accidental damage is relatively small, so it is common to hear economists refer to capital consumption allowance as depreciation. Machines and other capital goods wear out over time. The reduction in the value of the capital stock as a result of its being used up or worn out over time is called depreciation. A depreciating capital good loses value each year of its useful life until its value is zero. Even though capital consumption allowance does not represent income received by a factor of production, it must be accounted for in GDP as income. If it were not, the value of GDP measured as output would be higher than the value of GDP measured as income. Depreciation is a kind of resource payment, part of the total payment to the owners of capital. All of the income categories—wages, interest, rent, profits, and capital consumption allowance—are expenses incurred in the production of output. The last item in Figure 5 is indirect business taxes. Indirect business taxes, like capital consumption allowance, are not payments to a factor of production. They are taxes collected by businesses that then are turned over to the government. Both excise taxes and sales taxes are forms of indirect business taxes. For example, suppose a hotel room in Florida costs $100 a night, but a consumer would be charged $110. The hotel receives $100 of that $110 as the value of the service sold; the other $10 is an excise tax. The hotel cannot keep the $10; it must turn it over to the state government. (In effect, the hotel is acting as the government’s tax collector.) The consumer spends $110; the hotel earns $100. To balance expenditures and income, we have to allocate the $10 difference to indirect business taxes. To summarize, GDP measured as income includes the four payments to the factors of production: wages, interest, rent, and profits. These income items represent expenses incurred in the production of GDP. From these we must subtract net factor income from abroad and then add two nonincome items—capital consumption allowance and indirect business taxes—to find real GDP. Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 91 Chapter 5 National Income Accounting GDP ¼ wages þ interest þ rent þ profits # net factor income from abroad þ capital consumption allowance þ indirect business taxes The GDP is the total value of output produced in a year, the total value of expenditures made to purchase that output, and the total value of income received by the factors of production. Because all three are measures of the same thing—GDP—all must be equal. 5-1b Other Measures of Output and Income GDP is the most commonly used measure of a nation’s output, but it is not the only measure. Economists rely on a number of other measures as well in analyzing the performance of components of an economy. 5-1b-1 Gross National Product Gross national product (GNP) equals GDP plus receipts of factor income from the rest of the world minus payments of factor income to the rest of the world. If we add to GDP the value of income earned by U.S. residents from factors of production located outside the United States and subtract the value of income earned by foreign residents from factors of production located inside the United States, we have a measure of the value of output produced by U.S.-owned resources—GNP. Figure 6 shows the national income accounts in the United States. The figure begins with the GDP and then shows the calculations necessary to obtain the GNP and other measures of national output. In 2013, the U.S. GNP was $16,907.9 billion. gross national product (GNP) Gross domestic product plus receipts of factor income from the rest of the world minus payments of factor income to the rest of the world. 5-1b-2 Net National Product Net national product (NNP) equals GNP minus capital consumption allowance. The NNP measures the value of goods and services produced in a year less the value of capital goods that became obsolete or were used up during the year. Because NNP includes only net additions to a nation’s capital, it is a better measure of the expansion or contraction of current output than is GNP. Remember how we previously defined GDP in terms of expenditures: net national product (NNP) Gross national product minus capital consumption allowance. GDP ¼ consumption þ investment þ government spending þ net exports The investment measure in GDP (and GNP) is called gross investment. Gross investment is total investment, which includes investment expenditures required to replace capital goods consumed in current production. The NNP does not include investment expenditures required to replace worn-out capital goods; it includes only net investment. Net investment is equal to gross investment minus capital consumption allowance. Net investment measures business spending over and above that required to replace worn-out capital goods. Figure 6 shows that in 2013 the U.S. NNP was $14,276 billion. This means that the U.S. economy produced over $14 trillion worth of goods and services above those required to replace capital stock that had depreciated. Over $1.61 trillion in capital was “worn out” in 2013. gross investment Total investment, including investment expenditures required to replace capital goods consumed in current production. 5-1b-3 National Income National income (NI) equals the NNP plus or minus a small adjustment called “statistical discrepancy.” The NI captures the costs of the factors of production used in producing output. Remember that GDP includes a nonincome expense item: capital consumption allowance. Subtracting this plus the statistical discrepancy from the GDP leaves the income payments that actually go to resources. Because the NNP equals the GNP minus capital consumption allowance, we can subtract the statistical discrepancy from the NNP to find NI, as shown in Figure 6. This measure helps economists analyze how the costs of (or payments received by) resources change. national income (NI) Net national product plus or minus statistical discrepancy. net investment Gross investment minus capital consumption allowance. Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 92 Chapter 5 National Income Accounting FIGURE 6 U.S. National Income Accounts, 2013 (billion dollars) Net Factor Income from Abroad Capital Consumption Allowance + Income currently received but not earned – Income currently earned but not received $263 $2659.6 Statistical Discrepancy –$91.7 –$382.6 Personal Taxes $1657.6 $16912.9 $17175.9 $14516.3 $14607.9 $14225.3 $12567.7 Gross Domestic Product (GDP) Gross National Product (GNP) Net National Product (NNP) National Income (NI) Personal Income (PI) Disposable Personal Income (DPI) Gross domestic product plus receipts of factor income from the rest of the world minus payments of factor income to the rest of the world equals gross national product. Gross national product minus capital consumption allowance equals net national product. Net national product minus statistical discrepancy equals national income. National income plus income currently received but not earned (transfer payments, personal interest, dividend income) minus income currently earned but not received (retained corporate profits, net interest, social security taxes) equals personal income. Personal income minus personal taxes equals disposable personal income. Source: Bureau of Economic Analysis, third quarter 2013; www.bea.gov personal income (PI) National income plus income currently received but not earned, minus income currently earned but not received. transfer payment Income transferred by the government from a citizen who is earning income to another citizen. 5-1b-4 Personal Income Personal income (PI) is national income adjusted for income that is received but not earned in the current year and income that is earned but not received in the current year. Social security and welfare benefits are examples of income that is received but not earned in the current year. As you learned in the chapter “The Aggregate Economy,” these are called transfer payments. Transfer payments represent income transferred from one citizen who is earning income to another citizen, who may not be. The government transfers income by taxing one group of citizens and using the tax payments to fund the income for another group. An example of income that is currently earned but not received is profits that are retained by a corporation to finance current Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 93 Chapter 5 National Income Accounting needs rather than paid out to stockholders. Another is social security (FICA) taxes, which are deducted from workers’ paychecks. 5-1b-5 Disposable Personal Income Disposable personal income (DPI) equals personal income minus personal taxes—income taxes, excise and real estate taxes on personal property, and other personal taxes. DPI is the income that individuals have at their disposal for spending or saving. The sum of consumption spending plus saving must equal disposable personal income. RECAP 1. Gross domestic product (GDP) is the market value of all final goods and services produced in an economy in a year. 2. The GDP can be calculated by summing the market value of all final goods and services produced in a year, by summing the value added at each stage of production, by adding total expenditures on goods and services (GDP ¼ consumption þ investment þ government spending þ net exports), and by using the total income earned in the production of goods and services (GDP ¼ wages þ interest þ rent þ profits), subtracting net factor income from abroad, and adding depreciation and indirect business taxes. 3. Other measures of output and income include gross national product (GNP), disposable personal income (DPI) Personal income minus personal taxes. net national product (NNP), national income (NI), personal income (PI), and disposable personal income (DPI). National Income Accounts GDP ¼ consumption þ investment þ government spending þ net exports GNP ¼ GDP þ receipts of factor income from the rest of the world — payments of factor income to the rest of the world NNP ¼ GNP # capital consumption allowance NI PI ¼ NNP # statistical discrepancy ¼ NI # income earned but not received þ income received but not earned DPI ¼ PI # personal taxes 5-2 Nominal and Real Measures The GDP is the market value of all final goods and services produced within a country in a year. Value is measured in money terms, so the U.S. GDP is reported in dollars, the German GDP in euro, the Mexican GDP in pesos, and so on. Market value is the product of two elements: the money price and the quantity produced. 5-2a Nominal and Real GDP Nominal GDP measures output in terms of its current dollar value. Real GDP is adjusted for changing price levels. In 1980, the U.S. GDP was $2,790 billion; in 2013, it was $16,857 billion— an increase of 504 percent. Does this mean that the United States produced 504 percent more goods and services in 2013 than it did in 1980? If the numbers reported are for nominal GDP, we cannot be sure. Nominal GDP cannot tell us whether the economy produced more goods and services, because nominal GDP changes both when prices change and when quantity changes. Real GDP measures output in constant prices. This allows economists to identify the changes in the actual production of final goods and services: Real GDP measures the quantity of goods and services produced after eliminating the influence of price changes contained in nominal GDP. In 1980, real GDP calculated using chained-dollar estimates in the United States was $6,376 billion; in 2013, it was $15,790 billion, an increase of just 247 percent. A large part of the 504 percent increase in nominal GDP reflects increased prices, not increased output. 5. What is the difference between nominal and real GDP? nominal GDP A measure of national output based on the current prices of goods and services. real GDP A measure of the quantity of final goods and services produced, obtained by eliminating the influence of price changes from the nominal GDP statistics. Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. Chapter 5 National Income Accounting Because we prefer more goods and services to higher prices, it is better to have nominal GDP rise because of higher output than because of higher prices. We want nominal GDP to increase as a result of an increase in real GDP. Consider a simple example that illustrates the difference between nominal GDP and real GDP. Suppose a hypothetical economy produces just three goods: oranges, coconuts, and pizzas. The dollar value of output in three different years is listed in Figure 7. As shown in Figure 7, in year 1, 100 oranges were produced at $.50 per orange, 300 coconuts at $1 per coconut, and 2,000 pizzas at $8 per pizza. The total dollar value of output in year 1 is $16,350. In year 2, prices remain constant at the year 1 values, but the quantity of each good has increased by 10 percent. The dollar value of output in year 2 is $17,985, 10 percent higher than the value of output in year 1. In year 3, the quantity of each good FIGURE 7 Prices and Quantities in a Hypothetical Economy Price Year 1 (base year) + 94 Quantity .50 100 Oranges 1.00 300 Coconuts 8.00 = Output $16,350 2,000 Pizzas Nominal GDP = Real GDP Year 2 (quantities increase 10%) .50 110 Oranges 1.00 330 Coconuts 8.00 $17,985 2,200 Pizzas Nominal GDP Increases Real GDP Increases Year 3 (prices increase 10%) .55 100 Oranges 1.10 300 Coconuts 8.80 $17,985 2,000 Pizzas Nominal GDP Increases Real GDP Remains Constant In year 1, total output was $16,350. In year 2, prices remained constant but quantities produced increased by 10 percent, resulting in a higher output of $17,985. With prices constant, we can say that both nominal GDP and real GDP increased from year 1 to year 2. In year 3, quantities produced returned to the year 1 level but prices increased by 10 percent, resulting in the same increased output as in year 2, $17,985. Production has not changed from year 1 to year 3, however, so although nominal GDP has increased, real GDP has remained constant. Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 95 Chapter 5 National Income Accounting is back at the year 1 level, but prices have increased by 10 percent. Oranges now cost $.55, coconuts $1.10, and pizzas $8.80. The dollar value of output in year 3 is $17,985. Notice that the dollar value of output ($17,985) in years 2 and 3 is 10 percent higher than the dollar value in year 1. But there is a difference here. In year 2, the increase in output is due entirely to an increase in the production of the three goods. In year 3, the increase is due entirely to an increase in the prices of the goods. Because prices did not change between years 1 and 2, the increase in nominal GDP is entirely accounted for by an increase in real output, or real GDP. In years 1 and 3, the actual quantities produced did not change, which means that real GDP was constant; only nominal GDP was higher, a product only of higher prices. Figure 8 plots the growth rate of real GDP for several of the industrial countries. One can see in the figure that the countries show somewhat different patterns of real GDP growth over time. For instance, over the period beginning in the mid-1990s, real GDP grew at a slower pace in Japan than in the other countries. Most of the countries had fairly fast rates of GDP growth in the late 1990s, only to experience a falling growth rate in the early 2000s followed by a pickup in growth, and then the most recent downturn associated with the global recession. Following the deep recession where countries experienced negative growth rates, all of the countries grew in 2010. 5-2b Price Indexes The total dollar value of output or income is equal to price multiplied by the quantity of goods and services produced: Dollar value of output ¼ price $ quantity 6. What is a price index? FIGURE 8 Real GDP Growth in Some Industrial Countries Real GDP Growth (percent per annum) 8 6 Canada 4 France 2 Germany 0 Italy Japan –2 United Kingdom –4 United States –6 19 19 94 95 19 96 19 97 19 9 19 8 99 20 0 20 0 01 20 02 20 03 20 04 20 05 20 0 20 6 07 20 08 20 09 20 10 20 11 20 12 –8 Year Real GDP grew at a fast pace in the late 1990s in most countries depicted in the figure, only to fall dramatically in 2001 and 2002. Japan has experienced slower growth of real GDP over this period than the other countries. Note how severe the drop in real GDP growth was during the financial crisis of 2008–2009. Source: OECD.Stat Copyright 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 96 Chapter 5 National Income Accounting By dividing the dollar value of output by price, you can determine the quantity of goods and services produced: Quantity ¼ price index A measure of the average price level in an economy. The value of the price index in any particular year indicates how prices have changed relative to the base year. base year The year against which other years are measured. dollar value of output price In macroeconomics, a price index is a measure of the average level of prices in an economy; it shows how prices, on average, have changed. Prices of individual goods can rise and fall relative to one another, but a price index shows the general trend in prices across the economy. 5-2b-1 Base Year The example in Figure 7 provides a simple introduction to price indexes. The first step is to pick a base year, the year against which other years are measured. Any year can serve as the base year. Suppose we pick year 1 in Figure 7. The value of the price index in year 1, the base year, is defined to be 100. This simply means that prices in year 1 are 100 percent of prices in year 1 (100 percent of 1 is 1). In the example, year 2 prices are equal to year 1 prices, so the price index is equal to 100 in year 2 as well. In year 3, every price has risen 10 percent relative to the base-year (year 1) prices, so the price index is 10 percent higher in year 3, or 110. The value of the price index in any particular year indicates how prices have changed relative to the base year. A value of 110 indicates that prices are 110 percent of base-year prices, or that the average price level has increased 10 percent. Price index in any year ¼ 100 ! percentage change in prices from the base year 5-2b-2 Types of Price Indexes The price of a single good is easy to determine. But how GDP price index (GDPPI) A broad measure of the prices of goods and services included in the gross domestic product. consumer price index (CPI) A measure of the average price of goods and services purchased by the typical household. cost-of-living adjustment (COLA) An increase in wages that is designed to match increases in the prices of items purchased by the typical household. producer price index (PPI) A measure of average prices received by producers. do economists determine a single measure of the prices of the millions of goods and services produced in an economy? They have constructed price indexes to measure the price level; there are several different price indexes used to measure the price level in any economy. Not all prices rise or fall at the same time or by the same amount. This is why there are several measures of the price level in an economy. The price index that is used to estimate constant-dollar real GDP is the GDP price index (GDPPI), a measure of prices across the economy that reflects all of the categories of goods and services included in GDP. The GDP price index is a very broad measure. Economists use other price indexes to analyze how prices in more specific categories of goods and services change. Probably the best-known price index is the consumer price index (CPI). The CPI measures the average price of consumer goods and services that a typical household purchases. (See Economic Insight, “The Consumer Price Index.”) The CPI is a narrower measure than the GDPPI because it includes fewer items. However, because of the relevance of consumer prices to the standard of living, news reports on price changes in the economy typically focus on consumer price changes. In addition, labor contra...
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