Comparing GDP

The GDP calculation discussed in the previous post is a fine way to compare different areas at the same point in time. It does, however, have two weaknesses.

The first weakness is that the value of the unit of account changes. Anyone living long enough knows that over time the dollar bill can purchase less as time passes. The nominal price level increases, so that makes it difficult to compare one year to another and less useful the more time that passes. If economists wanted to look at growth in one country that had a GDP of one trillion in 1995 and ten trillion in 2014, does it make sense for her to say that in the intervening years, the economy of that country had grown ten times? The answer is “no” because we do not have a measure of the inflation between those years. First, the economist would have to find the rate of inflation so that those two numbers are being compared in terms of dollars that have the same value. Once this adjustment is made, then the economist can compare the overall size of the economy more accurately. This measurement of calculating the GDP as if prices did not change is the Real GDP (Krugman & Wells, 2013, p. 199). Stating measurement of GDP in terms of Real GDP allows measurement of the same country across time.

The second weakness of the nominal GDP obtained from addition of the inputs is that it is not easily used to compare across countries. A good example of the comparison is that between the United States and China. China recently passed Japan to become the world’s second largest economy in terms of the nominal GDP, and they are closing in on the United States in pure dollars. Politicians have raised the specter of a rising China as a competitor to the US. The problem is that such comparisons rely on the innumeracy of the electorate. Though the China is approaching the US in terms of overall size, the population of the country is roughly four times that of the United States. That means that if you took the final value of the goods and services that accrued to China and divided it by the population of China, and made the same calculation for the United States, the value of these goods and services per each individual would be almost four times higher for those in the United States. This measurement is the GDP per Capita measurement (Krugman & Wells, 2013, p. 199). Looking at GDP in this manner allows economists to compare countries of different population size. If the measurement is then put in constant dollars, economist can then look at countries at a point in time and then across time. A big drawback of this method is that it assumes that growth accumulated to all the individuals in a country at the same rate, though it is easy shorthand for looking at the overall rate of a country’s growth concerning how it is experienced by the population.

References

Krugman, P. & Wells, R. (2013). Macroeconomics. New York, NY : Worth Publishers

 

GDP Basics

There are three ways that economists use to calculate GDP. One is to look at the total income of all people in a country (or other area that is being looked at, being a state, region of a country, or an international collection of countries). The other way is to look at the total value of all the goods and services produced. The third and final way is to measure all the spending that flows into firms from the final users of the goods and services (Krugman & Wells, 2013, p. 192).

The focus on the final user is important because it does not inflate the final value of the GDP. If economists were to measure the price all firms added to the goods and services that are measured for GDP calculations, every layer of sales would add in more value. Therefore, the value of the Ritz cracker, for example, which is paid by the consumer, is what is calculated as being a component of the GDP. This avoids counting as sales what the company paid to the farmer in Kansas for the wheat and the farmer in Wisconsin for the butter.

Ultimately, there are four separate inputs that are counted as part of GDP and is shown commonly as the equation GDP= C + I + G + (X-M). The “C” stands for all the consumer purchases. The “I” stands for the investments businesses make to facilitate the creation of the goods and services. For example, the farmer who is growing wheat will pass on the cost of the seed to the end-user, but that same farmer might purchase a combine to help harvest the grain faster and more efficiently. All comparable purchases are included in the “I” component of the GDP calculation. The “G” part is the amount that the government spends on the goods and services it purchases, from the most cutting-edge fighter jets to the red pens at the IRS. The final part is shown as two letters, both “X” and “M,” but it is one term. “X-M” is the net balance of exports minus imports. Currently the United States is a world leader in both exports and imports, but the final value of the imports is greater than the final value of the exports, so this part has the effect to be an overall decrease in the GDP for the US (Krugman & Wells, 2013, p. 194).

Overall, the largest input in this GDP calculation comes from the consumers. With over seventy percent of the current calculation (Krugman & Wells, 2013, p. 195), a shift in the amount consumers are willing (or not willing) to spend has a huge effect on the economy. If businesses see consumers willing to spend, they will be able to make the investments for the future and the government will be able to reap more tax revenues. Perhaps the government would also prefer pay off debt or reduce tax rates. Conversely, if consumers pull back their spending, businesses will delay their investments and the federal government will have to fill the hole in spending or risk widespread penury and face political discontent. As illustrated, the governments have more options politically when the consumers are spending, so they are not just the larger part of the equation, but consumer response can drive many political responses.

References

Krugman, P. & Wells, R. (2013). Macroeconomics. New York, NY : Worth Publishers

 

The CPI: A Basic Introduction

If you live long enough, you will have the phenomenon where you go to a store and buy something, and you will realize that the price you paid now is much different from the price you remember paying for it as a youth. Live even longer and then you can regale the neighbor kids with all you memories of lower prices when you were their age. This is result of inflation, which is a general rise in the price levels. You are not necessarily better or worse off from inflation. Though that loaf of bread may have increased in raw value four times over your life, chances are that the amount you are paid for similar work has also increased in that time. 

Economists want more precision in their measures than the ranting of an parsimonious man. Instead, they base their judgments on the rise in the price level by putting together a list of things that people buy all the time for both goods and services.  This list is called a market basket. By watching the fluctuations in the change in prices of the market basket, economist can then compare what the prices of a standardized set of items have done in comparison with the previous year’s set of prices. Creating a ratio between the current year’s level of prices and the prices of the year you use as a baseline gives you a price index. Once you have a price index, you can compare the change in the price indexes and then you can come up with the rate of inflation (Krugman & Wells, 2013, p. 203). The change in the rate of inflation is important to track because there are many contracts tied to inflation so that the purchasing power of an individual is not lessened. Tax rates and social security benefits are some of the most visible examples of this. The federal government will usually increase the payment of social security benefits so seniors can afford the necessities of everyday living. Conversely, the IRS will peg also increase the income levels at which different tax brackets go into effect so as not to take too much away from the income of people who have more money through inflation.

The price level indicator that is used most in the United States is the consumer price index (CPI).The responsibility for creating the CPI falls to the Bureau of Labor Statistics, in the Department of Labor. They gather the prices of some 80,000 different distinct goods and services in 87 urban areas. If they cannot find the exact item, they substitute a new item and record the change in quality (‘How BLS Measures Changes in Consumer Prices”). The BLS has hundreds of employees, and they repeat this process every month to keep constant tabs on the shifting of the overall price levels, and the levels of prices in individual sectors such as housing and education (Krugman & Wells, 2013, p. 203). The measure of inflation as experienced by consumers is a lagging indicator, as the prices have already adjusted to whatever information that led to the increase, for example agricultural goods becoming more expensive in response to a drought (“Frequently Asked Questions”). There are other related indicators. There is a measure of the prices that suppliers are paying for their inputs, this is the producer price index (PPI). This indicator is closer to a coincident indicator because they firms are closer the signal and thus will react to price changes faster. There is also a competitive reason not to pass on price changes to consumers immediately; producers want their products to be competitive in the market. The PPP and the CPI move closely together though.

The relation between the CPI and overall growth in the GDP is somewhat difficult to unpack. The best explanation is that growth in the CPI reflects growth in the rate of inflation. Inflation is somewhat like salt in the human diet. Too much is detrimental, and not enough may be even worse. There is a goldilocks area where it is just right. The Federal Reserve targets a two percent rate in in inflation because any higher makes making future financial decisions difficult, and anything lower makes the specter of deflation raise its head (“Why does the Federal Reserve aim for 2 percent inflation over time?”). If the CPI contracts, this means that there has been a lowering of the price level, and thus deflation happened. This will mean that the GDP is on its way to shrinking. Conversely, if the CPI increases too much, the economy is over-heating with the proverbial “Too much money chasing too few goods”. The economy will be hot, and the GDP will be growing, but it is a signal that a bubble may be brewing and it could be cause for alarm in the long run. The graph below is a linear scale of the change in CPI from the Saint Louis Federal Reserve’s FRED website. Looking at the CPI for the last ten years, it is easy to see how during the Great Recession, the CPI first accelerated and then crashed. The current growth path is consistent with the steady recovery we have been in for the last five years. The forecast is that barring any outside shocks, the CPI shows that the trend is expected to continue.

Figure 1 From https://research.stlouisfed.org/fred2/graph/?graph_id=205692#

UPDATE: Changed Log to Linear referencing the graph.

References

Board of Governors of the Federal Reserve System. (2013). Why does the Federal Reserve aim for 2 percent inflation over time? Retrieved from http://www.federalreserve.gov/faqs/economy_14400.htm

Bureau of Labor Statistics. (2011).How BLS Measures Changes in Consumer Prices. Retrieved from http://www.bls.gov/cpi/cpifact2.htm

Bureau of Labor Statistics (2014). Frequently Asked Questions (FAQ). Retrieved from http://www.bls.gov/cpi/cpifaq.htm

Federal Reserve Economic Data. (2014). Consumer Price Index for All Urban Consumers: All Items, Index 1982-84=100, Monthly, Seasonally Adjusted Retrieved from https://research.stlouisfed.org/fred2/graph/?graph_id=205692#

Krugman, P. & Wells, R. (2013). Macroeconomics. New York, NY : Worth Publishers

An Econ 101 Look at Choices and the Magic of the Market

                Krugman does not phrase it this way exactly, but the generalized definition of the study of economics is that it is the study of how you allocate finite resources in the face of unlimited wants. There is in modern society almost anything that an individual could want, excepting jetpacks. The problem is that all these wants have some sort of cost, in terms of time and / or resources, so these costs add up. An individual economic actor only has so much time, and only so much money. This situation means that choices have to be made.

                These choices can seem minor. Somewhere a student is working on a paper instead of going out with his friends. The cost of writing that paper are not just the easily thought of accounting costs like the electricity to run the paper and the amortized portion of his Comcast bill. Instead the costs also include the things that were not done, in this example the fun that may have been had with the student’s friends, this cost is known in economics as the “Opportunity Cost” (Krugman & Wells, 2013, p. 7).

            `The choice to stay in and work on the paper the student makes is not made in a vacuum. An important part of the choices an economic actor makes is that the choices made are in response to incentives. The student likes to go out, but he knows that going out on the day he had set aside for working on his paper would be a detriment to his grade. Instead of a short-term myopia about what the student is missing out on, he is acting in response to a long-term incentive where he knows that the success in the class will be positively correlated with success in his academic program and it will help in his career (Krugman & Wells, 2013, p. 9).

            The choices are not just seen at the individual level. Companies and governments have the same issues, only writ larger. Just as the student is an accountant, and has worked hard at getting to the place in the career he is at, companies and governments also can specialize. GM has made cars for over 100 years, giving it an advantage and institutional knowledge on how to makes cars. The United States leads the world in healthcare, higher education and manufacture of airplanes. This specialization leads to advantages where those who are good at something are also less good at something else. They are able then to trade with other firms or states that have an advantage in manufacture of different items. GM can focus on the design and manufacture of their automobiles because they can import the tires from China, the manufacture of which does not require the specialized labor force the United States employs. Likewise, the US can send those finished autos abroad an import Bangladeshi clothing because the Bengal workers enjoy a comparative advantage in clothing. It is important to note that the US could also manufacture those clothes more efficiently than the companies in Bangladesh, but that would require giving up so much more than the Bengals give up. Because the imported clothes have a lower opportunity cost, they are cheaper overall. This is comparative advantage in action. This trade means that everyone is better off than if each country tried to be self-sustaining. Trade makes all economic actors better off (Krugman & Wells, 2013, p. 12).

            It sounds like all these individual choices would just make a mess, but the magic of the market and Smith’s Invisible hand means that it all works out. Markets move towards equilibrium, where the price people are willing to pay nicely intersects the amount of goods suppliers are willing to bring to the market. Over time, there are no shortages or surpluses and the market makes everyone better off through their choices – unless the government finds it politically expedient to stay the movement of the invisible hand (Krugman & Wells, 2013, p. 16).