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Chapter 2Measuring the MacroeconomyBrief Chapter Summary2.1 GDP:Measuring Total Production and Total Income

(pages 27–37)

Learning Objective 1Explain how economists use gross domestic product (GDP) to measure total production and total income.

The Bureau of Economic Analysis (BEA) compiles the data needed to calculate gross national product (GDP).The rules used in calculating GDP are called national income accounting.

By calculating GDP, the BEA measures both total production and total income.

2.2 Real GDP, Nominal GDP, and the GDP Deflator (pages 37–44)

Learning Objective 2 Discuss the difference between real GDP and nominal GDP.

Nominal GDP is calculated by summing the current values of final goods and services.Real GDP is calculated by designating a particular year as the base year and then using prices in the base year to calculate the value of goods and services in all other years.

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15 Hubbard, O’Brien, and Rafferty|Macroeconomics, Second Edition

2.3 Inflation Rates and Interest Rates (pages 44–51)

Learning Objective 3 Explain how the inflation rate is measured and distinguish between real and nominal interest rates.

The inflation rate is measured as the percentage change in a price index, such as the Consumer Price Index (CPI). The nominal interest rate is the stated interest rate on a loan.Lenders and borrowers base their decisions on the real interest rate, which is the nominal interest rate adjusted for the effects of inflation.

2.4 Measuring Employment and Unemployment (pages 51–53)

Learning Objective 4 Understand how to calculate the unemployment rate.

The Bureau of Labor Statistics (BLS) uses monthly data collected by the Bureau of the Census to measure the unemployment rate.The labor force is the sum of employed and unemployed workers.The unemployment rate is the percentage of the labor force that is unemployed.The BLS also uses the establishment survey to measure total employment in the economy.

List of Key TermsCapital, p. 29. Goods, such as machine tools, computers, factories, and office buildings,that are used to produce other goods and services.

Consumer price index (CPI), p. 45.An average of the prices of the goods and services purchased by the typical urban family of four.

Consumption, p. 32.The purchase of new goods and services by households.

Factor of production, p. 29.Any input used to produce goods and services.

Federal Reserve, p. 48. The central bank of the United States; usually referred to as “the Fed.”

Final good or service, p. 27.A good or service purchased by a final user.

Financial system, p. 31.The financial intermediaries and financial markets that together facilitate the flow of funds from lenders to borrowers.

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GDP deflator, p. 40.A measure of the price level, calculated by dividing nominal GDP by real GDP and multiplying by 100; also called the GDP implicit price deflator.

Government purchases, p. 33.Spending by federal, state, and local governments on newly produced goods and services.

Gross domestic product (GDP), p. 27.The market value of all final goods and services produced in a country during a period of time.

Gross national product (GNP), p. 35.The value of final goods and services produced by residents of a country, even if the production takes place outside that country.

Interest rate, p. 49.The cost of borrowing funds, usually expressed as a percentage of the amount borrowed.

Intermediate good or service, p. 27.A good or service that is an input into another good or service, such as a tire on a truck.

Investment, p. 33.Spending by firms on new factories, office buildings, machinery, and additions to inventories, plus spending by households and firms on new houses.

Labor force, p. 51.The sum of employed and unemployed workers in the economy.

National income accounting, p. 29.The rules used in calculating GDP and related measures of total production and total income.

Net exports, p. 34.The value of all exports minus the value of all imports.

Nominal GDP, p. 38.The value of final goods and services calculated using current-year prices.

Nominal interest rate, p. 49.The stated interest rate on a loan.

Personal consumption expenditures price (PCE) index, p. 48.A price index similar to the GDP deflator, except that it includes only the prices of goods from the consumption category of GDP.

Real GDP, p. 38.The value of final goods and services calculated using base-year prices.

Real interest rate, p. 49.The nominal interest rate adjusted for the effects of inflation.



Transfer payments, p. 33.Payments by the government to individuals for which the government does not receive a good or service in return.

Unemployment rate, p. 51.The percentage of the labor force that is unemployed.

Chapter OutlineHOW DO WE KNOW WHEN WE ARE IN A RECESSION?

The Business Cycle Dating Committee of the National Bureau of Economic Research (NBER) determines when a recession begins and ends.The NBER defines a recession as “a significant decline in economic activity [that] spreads across the economy and can last from a few months to more than a year.”Government agencies collect most of the data the NBER uses to determine these dates.There is a lag before the first estimates of these data are released, and the first estimates are often revised several times as more complete information becomes available.As a result, the NBER committee takes time to analyze the revised data before announcing when a recession has begun or ended.For example, the committee waited 15 months to announce that the recession that began in 2007 ended in June 2009.Government and private decisionmakers are typically unwilling to wait a year or more before taking action if they believe that a recession has begun.Knowledge of key macroeconomic data is important to determine business cycle dates as well as to make critical economic decisions.measure the unemployment rate?

Teaching Tips

The material in this chapter may be familiar to many students from their principles course. If so, then you may wish to cover it quickly, relying on online quizzes to ensure that they review the material. Some instructors, though, believe that a thorough grounding in basic macroeconomic statistics is important both to increase student understanding of media reporting of these statistics and to make sure that students understand basic macroeconomic relationships. For example, the equality of total production and total income will be referred to a number of times in later chapters. Making sure that students grasp this basic relationship, as shown in the national income accounts, can help reduce difficulties in understanding the discussion of topics later in the course.



The NBER is a private nonprofit research organization founded in 1920 and dedicated to promoting a greater understanding of how the economy works. Although the NBER began announcing business cycle dates in 1929, the Business Cycle Dating Committee was not formed until 1978. Giving the committee of a private organization rather than a federal government agency the responsibility for determining the dates when a recession begins and ends removes the suspicion that these decisions are influenced by political motives. The webpage of the NBER (www.nber.org) has a broad range of information about business cycle history, including an FAQ page regarding how the committee makes its decisions, and the research conducted by NBER economists. Press reports will often refer to a definition of a recession as two consecutive quarters of negative growth of real GDP, but this is not the NBER’s definition.

Key Issue: The unemployment rate can rise even though a recession has ended.

Key Question: How accurately does the government measure the unemployment rate?

2.1 GDP:Measuring Total Production and Total Income(pages 27–37)

Learning Objective:Explain how economists use gross domestic product (GDP) to measure total production and total income.

Economists measure total production by gross domestic product (GDP), which is the market value of all final goods and services produced in a country during a period of time.The Bureau of Economic Analysis (BEA) compiles the data needed to calculate GDP.

A. How the Government Calculates GDPGDP

is measured using market values, not quantities.



includes only the market value of final goods.A final good or service is a good or service purchased by a final user.An intermediate good or service is a good or service that is an input into another good or service, such as a tire on a truck.

measures production within a country, regardless of who does the production.

includes some imputed values.In some cases where there is no market for a good or service, the value has to be imputed, or estimated.

does not include some types of production.These types of production include services provided byhomemakers and goods and services produced in the underground economy.Measures of the changes in total production would not be much different if the BEA were able to impute values for every good or service.

includes only current production.

B. Production and IncomeNational income accounting refers to the rules used in calculating GDP and related measures of total production and total income.The value of total production in an economy is equal to the value of total income.

C. The Circular Flow of IncomeThe circular-flow diagram uses the flow of spending and money in the economy to show how the total value of spending on goods and services—total expenditures—equals the total value of income.We can measure GDP by adding up the total expenditures of households and firms, foreign households and firms, and the government on goods and services produced in the United States.

A factor of production is any input firms use to produce goods and services.Factors of production include labor, capital, and natural resources.Capital refers to goods, such as machine tools, computers, factories, and office buildings,that are used to produce other goods and services.Natural resources are land and raw materials used to produce goods and services.Income is divided into four categories:wages, interest, rent, and profit.Profit is the income that remains after a firm has paid wages, interest, and rent; profitis the return to entrepreneurs for organizing the other factors of production and for bearing the risk of producing and selling goods and services.The sum of wages, interest, rent, and profit is the total income received by households.



Some of the income households earn is not spent or paid in taxes but is deposited in checking or savings accounts in banks or other financial intermediaries, or used to buy financial assets in financial markets.The financial system refers to financial intermediaries and financial markets that together facilitate the flow of funds from lenders to borrowers.

D. An Example of Measuring GDPThe BEA gathers data on quantities and prices of final goods and services, multiplies the quantity of each good or service by its price, and adds up the totals to determine the value of GDP.

E. National Income Identities and the Components of GDP The BEA divides its statistics on GDP into four major categories of expenditures:

1. Personal consumption expenditures, or “Consumption” (C)

2. Gross private domestic investment, or “Investment” (I)

3. Government consumption and gross investment, or “Government purchases” (G)

4. Net exports of goods and services, or “Net exports” (NX)

If we let Y represent GDP, then we have the following national income identity:

Y = C + I + G +NX

Consumption is the purchase of new goods and services by households.The BEA tracks three categories of consumption:Durable goods are tangible goods with an average life of three years or more.Nondurable goods are shorter-lived goods, such as food and clothing.Services are consumed at the time and place of purchase.

Investment is spending by firms on new factories, office buildings, machinery, and additions to inventories, plus spending by households and firms on new houses.Investment spending is divided into three categories:Fixed investment is spending by firms on new factories, office buildings, and machinery to produce other goods.Residential investment is spending by households or firms on new single-family and multifamily homes.Changes in business inventories are also included in investment. Inventories are goods that have been produced but not yet sold.

Government purchases are spending by federal, state, and local governments on newly produced goods and services.



Some government purchases represent consumption spending and somerepresent investment spending.Government purchases do not includetransfer payments, which are payments by the government to individuals for which the government does not receive a good or service in return.

Net exportsequal the value of all exports minus the value of all imports.

F. The Relationship Between GDP and GNPPrior to 1991, the BEA’s main measure of total production was gross national product (GNP): The value of final goods and services produced by residents of a country, even if the production takes place outside that country.The BEA defines net factor payments as the difference between factor payments from other countries and factor payments to other countries.GDP and GNP are related by the following identity:

GDP = GNP + Net factor payments.

G. GDP Versus GDIWe can measure the value of total production in the economy either by calculating the value of total expenditure on final goods and services or by calculating the value of total income. The expenditure approach is used to calculate GDP, while the income approach is used to calculate gross domestic income (GDI). Although GDP and GDI move together closely, GDI may be a more accurate measure of the state of the economy. A key drawback to GDI is that for the first three quarters of the year the BEA releases its initial estimate for GDI a month later than it releases its estimate of GDP. For the fourth quarter, the BEA releases its estimate of GDI two months after it releases its estimate of GDP.

H. GDP and National IncomeThe BEA publishes data on several other measures of total income in addition to GDP and GNP. If we subtract consumption of fixed capital, or depreciation, from GDP we are left with national income. Personal income, or income received by households, is equal to national income minus the earnings corporations retain, plus household receipts of transfer payments and interest on government bonds. Disposable personal income is equal to personal income minus personal tax payments.



2.2 Real GDP, Nominal GDP, and the GDP Deflator (pages 37–44)

Learning Objective: Discuss the difference between real GDP and nominal GDP.

The BEA separates price changes from quantity changes by calculating a measure of production called real GDP.Nominal GDP is the value of final goods and services calculated using current-year prices.Real GDP is the value of final goods and services calculated using base-year prices. Real GDP is calculated by designating a particular year as the base year and then using prices in the base year to calculate the value of goods and services in all other years. Currently, the BEA has designated 2005 as the base year.

A. Price Indexes and the GDP DeflatorTo gauge what is happening to prices in the economy as a whole, economists need a measure of the price level, which is an average of the prices of goods and services in the economy. Economists measure the price level with a price index, which is a measure of the average of the prices of goods and services in one year relative to a base year.We can use values for nominal GDP and real GDP to calculate a price index called the GDP deflator.The GDP deflator is a measure of the price level,calculated by dividing nominal GDP by real GDP and multiplying by 100; it is also called the GDP implicit price deflator.

By calculating the GDP deflator for two consecutive years, we can calculate the inflation rate in the second year.If Pt is the price level this year, Pt-1 is the price level last year, and πt is this year's inflation rate, then:

Inflation rate=Pt−Pt−1

Pt−1

B. The Chain-Weighted Measure of Real GDPIn 1996, the BEA switched to using chain-weighted prices and publishes statistics on real GDP in “chained (2005) dollars.”Starting with the base year, the BEA takes an average of prices in that year and prices in the following year.The BEA then uses this average to calculate real GDP in the year following the base year.For the next year, the BEA calculates real GDP by taking an average of prices in that year and the previous year.Prices in each



year are “chained” to prices from the previous year, and the distortion from changes in relative prices is minimized.

C. Comparing GDP Across CountriesComparison of GDP across countries is complicated because countries calculate GDP in terms of their own currencies.Exchange rates can be used to convert GDP values into a single currency, but exchange rates fluctuate widely.To get around this problem, economists use the purchasing power parity (PPP) exchange rate, which is the number of units of a country’s currency required to buy the same amount of goods and services in the country as one U.S. dollar would buy in the United States.PPP exchange rates are more stable than actual exchange rates.

Teaching Tips

Figure 2.5 on page 38 compares real GDP and nominal GDP for the United States between 1990 and 2011.The base year for real GDP was changed from 2000 to 2005 in 2009, part of the comprehensive revision of the National Income and Product Accounts by the Bureau of Economic Analysis.These revisions are described in the following article:Eugene P. Seskin and Shelly Smith,“Preview of the 2009 Comprehensive Revision of the NIPAs,”Survey of Current Business, Vol. 89, No. 3, March 2009, pp. 10-27

2.3 Inflation Rates and Interest Rates (pages 44–51)

Learning Objective: Explain how the inflation rate is measured and distinguish between real and nominal interest rates.

For some purposes, the GDP deflator is too broad a measure of the inflation rate.Economists and policymakers are usually interested in inflation as it affects the prices paid by the typical household.The consumer price index does a better job of measuring changes in the cost of living as experienced by the typical household.

A. The Consumer Price IndexThe consumer price index (CPI) is an average of the prices of goods and services purchased by the typical urban family of four. To compute the CPI, the U.S. Bureau of Labor Statistics (BLS) surveys 30,000 households nationwide on their spending habits.The BLS uses the survey to construct a market basket of 211 types of goods and services purchased by the typical



urban family of four.Each month, hundreds of BLS employees visit 23,000 stores in 87 cities and record prices of goods and services in the market basket.Each price in the CPI is given a weight equal to the fraction of the typical family’s budget spent on that good or service.The CPI in a given year is equal to the ratio of the dollar amount necessary to buy the market basket of goods in that year divided by the amount necessary to buy the market basket of goods in the base year, multiplied by 100. The CPI is widely used for indexing, which involves increasing a dollar value to protect against inflation.

B. How Accurate Is the CPI?Most economists believe that there are four reasons the CPI overstates the true inflation rate:

1. The CPI suffers from substitution bias.Because the BLS assumes that consumers buy fixed quantities of goods and services, the CPI will overstate the prices of goods and services that increase the most, and understate the prices that increase the least.

2. The CPI suffers from a bias due to the introduction of new goods because the market basket is updated only every two years.

3. The quality of goods and services changes over time, and these changes are not completely reflected in the CPI.

4. There is an outlet bias in the CPI data.Many households shop at large discount stores and on the Internet; these sources are underrepresented in the sample of prices the BLS gathers.

Despite the BLS’s attempts to improve the accuracy of the CPI, many economists still believe that the CPI overstates the true inflation rate by 0.5 to 1 percentage point.These differences can be large when compounded over long periods of time.

C. The Way the Federal Reserve Measures InflationTheFederal Reserve is the central bank of the United States; usually referred to as “the Fed.”To meet its goal of price stability, the Fed has an inflation target of 2%.Because the CPI suffers from biases, the Fed announced in 2000 that it would rely more on the personal consumption expenditures price index than on the CPI in tracking inflation.The personal consumption expenditures price (PCE) indexis a price index similar to the GDP deflator,



except that it includes only the prices of goods from the consumption category of GDP.

The Fed believes there are three advantages to using the PCE:

1. The PCE is a chain-type price index, which allows the mix of products to change each year.

2. The PCE includes the prices of more goods and services than the CPI, so it is a broader measure of inflation.

3. Past values of the PCE can be recalculated as better ways of computing price indexes are developed and as new data become available.

Since 2004, the Fed has focused on a subcategory of the PCE: the corePCE, which excludes food and energy prices.

D. Interest RatesA key economic variable in understanding the financial system is the interest rate, whichis the cost of borrowing funds, usually expressed as a percentage of the amount borrowed.The nominal interest rate is the stated interest rate on a loan.Lenders and borrowers know that inflation reduces the purchasing power of interest income, so they base their decisions on the real interest rate, which is the nominal interest rate adjusted for the effects of inflation.For the economy as a whole, economists often measure the nominal interest rate as the interest rate on U.S. Treasury bills that mature in three months.



Teaching Tips

Making the Connection on page 46 discusses how the Consumer Price Index can understate the effect of inflation on families with college students. Another study by GopiGoda, John Shoven, and SitaSlavov argues that because retirees spend a larger portion of their incomes on medical services than the average consumer, and the prices of medical services have risen more than other prices, the CPI may understate the effect of inflation on Social Security recipients. These cases are interesting because most economists assume that percentage changes in the CPI overstate the impact of inflation on the average consumer. Reference: Gopi Shah Goda, John Shoven, and SitaSlavov, “How Well Are Social Security Recipients Protected from Inflation?”National Tax Journal, Vol. 64, No. 2, June 2011, pp. 429-450.

2.4 Measuring Employment and Unemployment (pages 51–53)

Learning Objective: Understand how to calculate the unemployment rate.

Each month, the U.S. Bureau of the Census conducts the Current Population Survey to collect data used to compute the unemployment rate.People are considered employed if they worked during the week before the survey or if they were temporarily away from their jobs because they were ill, on vacation, on strike, or for other reasons.People are considered unemployed if they did not work in the previous week but were available for work and had actively looked for work at some time during the previous four weeks.The labor force is the sum of employed and unemployed workers in the economy.The unemployment rate is the percentage of the labor force that is unemployed.Some discouraged workers might prefer to have a job but have given up looking because they believe finding a job is too difficult.Because these workers are not actively looking for a job, they are not considered to be in the labor force and so aren’t counted as unemployed.Therefore, the unemployment rate as measured by the BLS may understate the true degree of joblessness in the economy.Also, the BLS counts people with part-time jobs as being employed, even if those people would prefer to hold full-time jobs.As a result of problems with the official unemployment rate, the BLS publishes data on several different measures of the unemployment rate. For example, the long-term unemployment rate shows the percentage of the labor force that has been unemployed for 15 weeks or more.



In addition to the household survey, the BLS uses the establishment survey, or payroll survey, to measure total employment in the economy.This monthly survey samples about 300,000 business establishments and provides information on the total number of persons who are employed and on a company payroll.The establishment survey has three drawbacks:

1. It does not provide information on self-employed persons.

2. It may fail to count some persons as employed at newly opened firms not included in the survey.

3. It provides no information on unemployment.

Despite these drawbacks, many economists consider the establishment survey a better gauge of the state of the labor market because the establishment survey is determined by actual payrolls rather than by unverified answers to survey questions.

Teaching Tips

Figure 2.9 on page 52 compares changes in the official unemployment rate with alternative measures of unemployment.The increase in the long-term unemployment rate, the percentage of the labor force that has been unemployed for 15 weeks or more, during the recession of 2007–2009 is worrisome for policymakers because the longer workers are unemployed, the more their skills deteriorate, which can increase the difficulty they face in finding new jobs.



Solutions to the End-of-Chapter Questions, Problems, and Data Exercises2.1 GDP: Measuring Total Production and Total

Income

Learning Objective: Explain how economists use gross domestic product (GDP) to measure total production and total income.

Review Questions

1.1 The circular flow shows that GDP is both a measure of production and income because the production of every good or service requires payment to the inputs that produce it. Therefore, we can measure GDP by either counting up the value of final goods and services or by counting up the payments to all inputs.

1.2 GDP represents all production that takes place within a country’s borders. GNP represents the value of final goods and services produced by residents of a country, even if production takes place outside of the country. The difference between GDP and GNP is large from some countrie, but for the United States the difference is only about 1%.

1.3 The BEA calculates GDP using the expenditure approach, which calculates the total expenditure on final goods and services, and it calculates GDI using the income approach, which calculates the value of total income. It could matter which approach is used to measure the level of economic activity. Fed economist Jeremy Nalewaik argues that GDI may give a more accurate measure of the state of the economy because other business cycle indicators are more closely correlated to GDI than GDP. One drawback to GDI is that quarterly GDI estimates are released later than GDP estimates for the same time period.

1.4 National income is the sum of all net income earned in production (employee compensation, proprietors’ income, rental income, corporate profits, and net interest payments), while GDP is sum of all spending (consumption, investment, government spending, and net exports). In the data published by the BEA, national income equals GDP minus the consumption of fixed capital. Personal income is income received by households. To calculate personal income, the BEA subtracts from national income the earnings that corporations retain rather than pay to shareholders



in the form of dividends and adds in household receipts of transfer payments and interest on government bonds.

Problems and Applications1.5 a. No effect because sales of illegal goods are not included in GDP.

b.Measured GDP is likely to increase due to funds spent on cleanup efforts. The decline in environmental quality is not measured.

c. Measured GDP will fall. Used cars are not included in GDP, so the surge in sales will have no effect. New cars are included in GDP, so the decline in sales will reduce GDP.

1.6 a. These changes increased measured GDP because the additional women in the paid workforce produced goods and services that are included in GDP and because production of some services, such as daycare, that had been not included in GDP when they were produced by women in the home would be included when purchased from paid providers.

b.The net effect would probably have been an increase in actual GDP (assuming that the value of women in market production is greater than their value in household production) but by less than measured GDP. To calculate the effect on measured GDP, we would need to subtract the value of household production that no longer tookplace or household production that had been previously been provided without explicit pay that was now being provided through the market.

1.7 a. Included as consumption.

b.Not counted because painting is household production.

c. Included as consumption.

d. The sale of the house is not included because the house was counted in the year that it was built. Any realtor fees would be counted in consumption. The purchase of the new condominium is included as investment (residential investment).

e. Counted as consumption. If the car was produced in Japan, it would be both added to GDP as consumption and subtracted as an import.

f. Not counted because the truck is not included in current production.

g.Not counted because government pensions are transfer payments.



1.8 a. 2011: $225.00

2012: $297.50

2013: $361.25

b.Growth rate between 2011 and 2012: (297.50 – 225)/225 = 0.32, or 32%

Growth rate between 2012 and 2013: (361.25 – 297.50)/297.50 = 0.21 or 21%

c. No, they do not. Because both prices and output are changing, this method does not show the change in output alone (or in prices alone). In fact, production did not change from 2012 to 2013, but nominal GDP increased due to the increase in prices.

1.9 Real GDP measured on the product side uses the expenditure approach, and real GDP measured on the income side uses the income approach and is called gross domestic income (GDI). The two measures are not always identical because different data sources are used to calculate each measure, and neither measures production or income exactly. Some economists prefer to use GDI because they believe it gives a more accurate measure of the state of the economy and other business cycle indicators are more closely correlated with GDI than GDP. One reason the NBER prefers to use the expenditure approach is that quarterly GDP estimates using the expenditure approach are released earlier than GDI estimates for the same time period.

1.10 Because initial GDP growth estimates tend to be revised upward or downward to come closer to initial GDI growth estimates, initial GDI growth estimates appear to be more accurate and therefore are better measures of economic growth.

2.2 Real GDP, Nominal GDP, and the GDP Deflator

Learning Objective: Discuss the difference between real GDP and nominal GDP.

Review Questions

2.1 Nominal GDP reflects both price and quantity changes. Real GDP reflects only quantity changes. Since prices usually rise over time changes in nominal GDP usually overstate changes in total production. The GDP deflator, a price index, is derived by dividing nominal GDP by real GDP and multiplying by 100. In the base year, nominal and real GDP are the same.



Problems and Applications

2.2 a. Becausethese figures are nominal, it is impossible to distinguish changes in the quantity of oil imported from changes in the price of oil.

b.

January 2010 January 2011

Oil imports (price x quantity) $26.5 billion $35.2 billion

Price per barrel (price) $75 $91

Quantity of oil imports (price x quantity)/price

0.35 billion barrels 0.39 billion barrels

The percentage change in the quantity of oil = (0.39 - 0.35)/0.35 = 0.114, or 11.4%

2.3 a. 2011 is the base year, so nominal GDP and real GDP have the same values: (100 × $0.50) + (75 ×$1.00)+ (20 ×$5.00) = $225.

To calculate real GDP for 2012, we use 2012 quantities and 2011 prices: (125 × $0.50) + (85 ×$1.00)+ (30 ×$5.00) = $297.50.

To calculate real GDP for 2013, we use 2013 quantities and 2011 prices: (125 × $0.50) + (85 ×$1.00)+ (30 ×$5.00) = $297.50. Because the quantities did not change from 2012 to 2013, the value of real GDP did not change.

b.Output growth between 2011 and 2012 was positive, whereas there was no change in output between 2012 and 2013.

2.4 Nominal 2005 = (400× $0.50) + (90×$0.50)+ (7×$30.00) + (60×$8.00)=$935

Real 2005 (assuming that 2005 is the base year) = $935

Nominal 2013 = (440 × $0.75) + (85 ×$0.60)+ (10×$32.00) + (70 ×$8.25) = $1,278.50

Real 2013 (calculated using prices from the base year 2005 and quantities from 2013) = (440 × $0.50) + (85 ×$0.50)+ (10×$30.00) + (70 ×$8.00) = $1,122.50



2.5 Answers will vary; any number of possible answers will satisfy the criteria. For example, if all prices remain constant except the price of the fourth product (which increases), nominal GDP will still be greater than real GDP.

2.6($15,478.3 billion/$13,506.4 billion) ×100 = 114.6

2.7 GDP deflator for the first year, 1929: ($103.6 billion/$977 billion) x 100 = 10.60

GDP deflator for the second year, 1930: ($91.2 billion/$892.8 billion) x 100 = 10.22

Inflation = [(10.22 – 10.6)/10.6] x 100 = –3.6%. Note that because the inflation rate was negative in 1930, we know that the United States experienced deflation that year.

2.8 Knowing that GDP data is sometimes subject to large revisions, policymakers should not rely solely on GDP data, but should also consider data on other economic indicators when making decisions on how best to conduct policy.

2.9 China’s GDP in dollars will be greater if the purchasing power measure is used. Because the purchasing power of the yuan (in China) exceeds the purchasing power of an equivalent amount of dollars (in the United States), the market exchange rate understates the value of the yuan and, therefore, the dollar value of China’s GDP.

2.10 a. The Atlas method smooths fluctuations in the exchange rate by using the average exchange rate over a three-year period, and therefore presents a more accurate picture of per capita incomes.

b.The revised data are still not adjusted for differences in purchasing power parity. There are also problems in comparing GDP per capita in high-income countries with GDP per capita in countries in which there is a significant amount of nonmarket activity.

c. See the answer to part (b). In general, purchasing power in less-developed countries is higher than measured by market exchange rates due to differences in the extent of nonmarket activities and differences in the valuation of some services.

d. Before purchasing power adjustment: $47,800/$790 = 61 times (rounded)



After purchasing power adjustment: $47,800/$1,700 = 28 times (rounded)

2.11No. The normal relationship between nominal GDP and real GDP will be reversed: For years before the base year, real GDP will be less than nominal GDP. For years after the base year, real GDP will be greater than nominal GDP.

2.3 Inflation Rates and Interest Rates

Learning objective: Explain how the inflation rate is measured and distinguish between real and nominal interest rates.

Review Questions

3.1 Substitution bias, the introduction of new goods, the quality of goods and services, and the outlet bias may cause CPI to overstate the actual inflation rate.

3.2 The GDP deflator includes the prices of all final goods and services, while the PCE deflator uses only consumption goods. The BEA calculates two price indices for the PCE. The first is a PCE deflator similar to the GDP deflator, and the second is the PCE chain-weighted price index similar to the GDP chain-weighted price index. However, the annual inflation rate from the two PCE price indices is nearly identical. The core PCE excludes foods and energy prices, which historically have been more volatile than other prices. Because either rapid increases or rapid decreases in food and energy prices tend not to persist over time, including these prices in a price index can give a misleading indication of the underlying inflation rate.

3.3 If the actual inflation rate is greater than the expected inflation rate, borrowers gain because the real interest rate is lower than the expected real interest rate.


3.4 The difference between the CPI and PCE is that the CPI tracks the price of a fixed basket of goods and services over time, while the PCE includes all the goods and services included in the consumption component of GDP. The Fed prefers the PCE deflator because it avoids some of the biases inherent in the CPI, such as the substitution bias and the bias due to the introduction of new goods.



3.5 Effect on the CPI: The price of apples will rise, so the price level as measured by the CPI will rise, because the quantity of apples in the market basket will not change.

Effect on the PCE: The quantity of apples that consumers buy will fall (both because they have higher prices and a smaller quantity is available). So, the PCE deflator will not increase by as much as the CPI and may possibly decrease.

3.6 a. The price increase for housing would have the greatest effect on the CPI because housing has the largest weight in the market basket the BLS uses to compute the CPI. The price increase for education and communication would have the least effect on the CPI because education and communication has the smallest weight in the market basket.

b.Answers will vary by individual student, but education and communication would most likely have a great effect on students’ expenditures.

3.7 a. The real interest rate became negative because the real interest rate equals the nominal interest rate minus the inflation rate.

b.Savers lose, becausethey receive a negative real return on their saving. Borrowers gain, because the real cost of borrowing falls.

c. The dollar value of your savings account would be smaller every month; the negative nominal interest rate would be like a tax on your savings.

2.4 Measuring Employment and Unemployment

Learning Objective: Understand how to calculate the unemployment rate.

Review Questions4.1 Unemployment rate = (number of unemployed / labor force) x 100

4.2 Discouraged workers have given up looking for a job because they believe finding a job is too difficult. These workers are not considered to be in the labor force and are not counted as unemployed. Therefore, the unemployment rate as measured by the BLS may understate the true degree of joblessness in the economy.

4.3 Each month, the U.S. Bureau of the Census conducts the Current Population Survey (often called the household survey) to collect data needed



to compute the unemployment rate. The bureau interviews adults in a sample of 60,000 households, chosen to represent the U.S. population, about the employment status of everyone in the household 16 years of age and older. The BLS uses these data to calculate the monthly unemployment rate. The BLS uses the establishment survey to measure total employment in the economy. This monthly survey samples about 300,000 business establishments. The establishment survey provides information on the total number of persons who are employed and on a company payroll. In recent years, some economists have come to rely more on establishment survey data than on household survey data in analyzing current labor market conditions because the establishment survey reflects actual payrolls rather than by unverified answers to survey questions.


4.4 a. Included, employed

b. Included, employed (although underemployed)

c. Not included in the labor force (neither employed nor unemployed); a discouraged worker

d.Not included in the labor force (neither employed nor unemployed)

e. Not included in the labor force (neither employed nor unemployed)

f. Included, unemployed

4.5 a. They are counted as unemployed.

b.They are considered discouraged workers and not counted in the usual measure of unemployment.

c. As the economy improves, the discouraged workers will reenter the labor force, causing the unemployment rate to (temporarily) increase.

4.6 a. The unemployment rate would stay the same.

b.GDP would be half as large (assuming that a person working 20 hours produces exactly half of what a person working 40 hours produces, which may not be the case).

c. The unemployment rate does not measure workers who are underemployed. To the extent that there are underemployed workers, the economy has more slack than the unemployment data shows.



4.7 The long-term unemployment rate and the official unemployment rate would most likely decrease because many of these individuals would no longer be counted in the labor force if they stop looking for work as they are required to do in order to receive unemployment insurance payments. The official unemployment rate plus marginally attached workers and the official unemployment rate plus marginally attached workers plus workers working part-time for economic reasons would probably remain about the same because these individuals would most likely move from being categorized as “in the labor force” to “not in the labor force,” and these two measures include both of these categories.

Data Exercises

D2.1 a. Data from FRED, answers will vary

b. Data from FRED, answers will vary

c. Data from FRED, answers will vary

D2.2 a. Data for secondquarter of 2012:

Consumption = 57% (U.S. equivalent: 71%)

Investment = 19% (U.S. equivalent: 13%)

Government purchases = 25% (U.S. equivalent: 20%)

Net exports = 1% (U.S. equivalent: 4%)

b. Canada has a higher saving rate than the United States, so in percentage terms, consumption is lower and investment is higher in Canada. Canada also has more government services, such as national health care, so government purchases are higher in Canada.

c. The trends for Canada and the United States are similar.


b. Using the data from FRED, this answer should be calculated by:



(PCDG value+PCNDvalue)PCEC value

×100


b.Inventory investment is the difference between gross private domestic investment and fixed private investment. Inventory investment = GDPI value – (PNFI value + PRFI value)

The difference reflects residential investment and changes in business inventories.


b. To compute the value of net exports for each year, it is the EXPGSCA value minus the IMPGSCA value in that year.


b. GDP is the value of all final goods and services produced within the United States and GNP is the value of final goods and services produced by residents of the United States. If the value of GNP exceeds the value of GDP, then foreign production by U.S. firms (which is included in GNP but not GDP) will exceed U.S. production by foreign firms (which is excluded from GNP but included in GDP).

c. Output of foreign-owned firms in the domestic economy is included in GDP but not in GNP. Developing countries typically have a large amount of foreign-owned firms producing domestic output but have few domestic-owned firms producing in foreign countries. This indicates that GDP should be larger than GNP in developing economies.


b. Tax payments are the difference between personal income and disposable personal income.

Tax Payments = PINCOME value – DPI value



c. The ratio of personal consumption to disposable income is equal to ThePCEC valueThe DPI value

Given the high value of this ratio, it would be expected that a tax cut would be largely spent by households.


b. The GDP deflator for each year is found by

Nominal GDPReal GDP

×100∨usingthe data¿FRED theGDPvaluetheGDPC 1value

c. The year-over-year rate of price inflation is equal to the percentage change in the GDP price deflator between two years. The rate is found by using this equation:

(TheGDP pricedeflator year 2– TheGDP price deflator year1)TheGDP pricedeflator year 1

×100

d. The base year is used to set the prices that all other years will be adjusted for. In the base year, nominal and real GDP are equal. Because of this the ratio of Nominal GDP to Real GDP is equal to 1, therefore, the GDP deflator is equal to 100.


b. Real GDP is found by the ratio of Nominal GDP to the GDP deflator in the same period times 100.

RealGDP= NominalGDP year 1TheGDP pricedeflator year 1

×100

¿using thedata ¿FRED theGDP valuetheGDPDEFvalue

×100



c. The growth rate real GDP is equal to the percentage change in the real GDP between two periods. The rate is found by using this equation:

(RealGDP year 2 – RealGDP year 1)Real GDP year1

×100


b. The inflation rate is computed as the percentage change in the CPI. The rate is found

by using this equation:

(CPIAUCSL period 2 –CPIAUCSL period 1)CPIAUCSL period 1

×100


b. Data from FRED, answers will vary. Calculate

Percent change=(CPI t−CPI t−1)

CPI t−1×100


d. Data from FRED, answers will vary


b. Data from FRED, answers will vary. Calculate



Percent change=(CPI t−CPI t−1)

CPI t−1×100


d. Data from FRED, answers will vary


b. Answers will vary. Each of the change in prices are found by using this equation:

(Datavalue present period – Data value∈2010)Datavalue∈2010

×100

c. Answers will vary based on calculations from FRED data


b. Answers will vary. The new value can be found by taking the original value times 1 + the percent increase. So, for this problem the new value will be the original value x 1.1.

c. Answers will vary. To find the contribution, multiply the change in the variables times the weight. For housing, the contribution would be:

(the New Value – the Original value) x 0.410.

d. The variables are that are more heavily weighted will carry more influence on the overall CPI. If prices rise more rapidly in a higher weight category, such as housing, the overall CPI will also rise more rapidly.

D2.15 a. Data from FRED, answers will vary. The data are monthly and in thousands of persons.



b. Answers will vary. The civilian unemployment rate is found by using this equation:

UnemployedCivilian Labor Force

×100

The civilian unemployment rate including persons who are underemployed is found by using this equation:

(Unemployed+Valueof underemployed)Civilian Labor Force

×100

D2.16 a. Data from FRED, answers will vary. The data are monthly and in thousands of persons.

b. Answers will vary.

The civilian unemployment rate for men is found by using this equation:

Unemploymed−menCivilian Labor Force−men

×100

The civilian unemployment rate for women is found by using this equation:

Unemploymed−womenCivilian Labor Force−women

×100

c. Workers become discouraged because they believe that no jobs are available for them and therefore give up searching. If unemployed workers become discouraged workers, they are no longer counted as unemployed. If the number of employed workers is unchanged, the result is that both the numerator and denominator of the unemployment



rate formula will become smaller, with the decline being relatively greater for the numerator.

D2.17 a. Data from FRED, answers will vary.

b. Answers will vary.

The working age population = (UNEMPLOY) + (CE16OV) + Not in Labor Force (LNS15000000).

The employment population ratio = CivilianEmployment

Theworking age population×100

c. During a recession, the civilian employment level will decrease as output is decreasing. The working age population should not beaffected. Therefore, the employment population ratio should decrease as the numerator is falling and the denominator remains the same.


b. The unemployment rate is found by taking the number of unemployed divided by the labor force. In this case, using the values in part the unemployment rate would be:

TheUNEMPLOY value(TheUNEMPLOY value+TheCE16OV value)

×100

c. A broader unemployment rate would also include those who are employed part-time for economic reasons as well as those who are available for work but haven't recently searched. This broader unemployment rate would equal:

(TheUNEMPLOY value+The LNU 05026642 value+The LNS 12032194 value)(TheUNEMPLOY value+TheCE 16OV value+The LNU 05026642value)

×100



Those employed part-time for economic reasons would need to be added to the numerator to count them as unemployed, however they are already included in the denominator as part of the number of persons counted as employed.

d. During a recession, we would expect the gap between the official unemployment rate and the broader unemployment rate to increase because an economy experiencing weak production would probably experience an increase in people who are employed part-time for economic reasons.


b. We can compute the expected real interest rate for each variable as follows:

The 30-Year Conventional Mortgage Rate (MORTG) minus the University of Michigan Inflation Expectation (MICH).

Moody's Seasoned Aaa Corporate Bond Yield (AAA) minus the University of Michigan Inflation Expectation (MICH).

The 3-Month Treasury Bill: Secondary Market Rate (TB3MS) minus the University of Michigan Inflation Expectation (MICH).

The 10-Year Treasury Constant Maturity Rate (GS10) minus the University of Michigan Inflation Expectation (MICH).

c. If the inflation rate is greater than the expected inflation rate, then the real interest rate is less than the expected real interest rate. In this case, borrowers are better off and lenders are worse off because the amount being repaid is less in real terms than was expected.


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