Economics – Theory Through Applications Chapter 18 The State of the Economy

Chapter 18 The State of the Economy The IMF Comes to Town In early 2002 , a team from the International Monetary Fund ( IMF ) to Buenos Aires , Argentina . Argentina had been prospering during most of the , but more recently it had begun to run into economic problems . The IMF is an organization that attempts to help countries having financial difficulties . An IMF team consists of professionally trained economists . These teams visit many countries , such as Argentina , on a regular basis . In this chapter , we imagine that the IMF added you to this mission and asked you to report back on the state of the Argentine economy . As we proceed , we think about how you might have approached this task . You arrive at de Airport , which is a clean and modern airport on the outskirts of Buenos Aires . You ride into the city in a new car along modern highways lined with fancy billboards . When you get to the city center , you notice that there are luxurious shopping malls . You see stores selling luxury brands , such as Louis , Versace , Hermes , and Christian URL books 783

. The city seems prosperous , reminiscent of Paris or New York . Just looking around , you see immediately that you are not in one of the really poor countries of the world . Figure Source Image taken by authors . As you explore the city , though , you begin to look more closely and notice that things are not quite what they seemed at glance . The luxury stores do not have many customers in them . Some buildings show signs of a lack of maintenance it has been a while since they were repainted . Some stores are boarded up or bear signs saying that they are going out of business . There seem to be a lot of people who are not working or who are making a living selling goods on the street . on these clues to Argentina prosperity , you quickly realize that it is to assess the health of an economy by casual observation . In addition , you have seen almost nothing of the country . Argentina covers over one million square miles it is almost of the size of the United URL books 784

States and has a population of nearly 40 million . The more you think about this , the harder the problem seems . Forty million people are buying things , selling things , making things , and consuming things every day . It seems an impossible task to make sense of all this activity and say anything useful about the economy as a whole . That challenge is the subject of this chapter . How can we evaluate the overall performance of something as complicated as an economy ?

Road Map If you think about this question for a bit , you will realize that it has more than one dimension . First , we need measurement . We must summarize the economy in a manageable way , which is impossible unless we find some way of measuring what is going on in the economy . One of the primary tasks of economics is accounting . That leads to other questions what should we count , and how should we count it ?

Data are not enough . Measurement will not take us very far unless we can combine it with some understanding of how the economy works . We need to know how to interpret the things we count . We need to know what our numbers mean . For this , we need that help us make sense of the economy . These two ideas guide our discussion in this chapter . Think for a moment in very general terms about what happens in an economy . An economy possesses some resources . These include the time and abilities of the people who live in the economy , as well as natural resources , such as land or mineral deposits . An economy also possesses various means of changing , or transforming , one set of things into other things ( see the following figure ) For example , we have a process for making tea . We produce tea by taking cold water , energy , and dried leaves and transforming those inputs into a hot beverage that people like to drink . The simple act of making a cup of tea is an example of production . URL books 785

Figure From Inputs to Output . I Ell . I I One of the main economic activities is production the transformation of inputs ( raw materials , labor time , etc . into output ( goods and services that people value ) We are interested in measuring how much production occurs in an economy . Obviously , however , we can not hope to count all the times that people drop a teabag into a cup , and it would not make much sense to do so . Economic activity typically involves more than production it also includes the notion of and selling . If you make a cup of tea for yourself at home , we do not think of this as economic activity . If you buy a cup of tea at your local coffee shop , we do think of this as economic activity . A very rough of economic activity is as follows . Economic activity is the production of goods and services for sale . URL books 786

Any definition this straightforward is bound to be too simple , and we will see that there are several subtleties in the actual measurement of economic activity , particularly since some goods and services are not actually bought and sold . Still , if you keep this idea in mind , it will help you as we progress through the basics of economic measurement in this chapter . Measuring Economic Activity LEARNING OBJECTIVES After you have read this section , you should be able to answer the following questions . What is the measure of total output ofan economy ?

What is the difference between real and nominal gross domestic product ( is data driven . Government statisticians and other organizations gather Vast amounts of data on the performance of various aspects of the , and try to make sense of all this information . If we want to explain economic data , then we first have to get the measurement right , and a big part of this is ensuring that we get the accounting right . To make sure that we do , we begin by constructing simple examples . This is not because a simple example is enough to describe an economy but because can not hope to understand the complicated accounting unless we do the simple accounting correctly . The Pizza Economy URL books 787

To understand the economic health of any other begin by looking at production in the economy . Let us imagine that Argentina produces a single . Each pizza is sold for 10 pesos ( which is about US ) To be concrete , suppose that every worker in the economy works in a pizza factory in which ( each hour worked produces pizza , each worker works 40 hours per week , and ( each worker works 50 weeks per year . Suppose there are about 15 million workers in the economy . We measure total economic activity by determining the total value of the pizzas produced in this economy . We obtain this by multiplying the previous numbers together . There are 40 pizzas per worker per week , so there are pizzas per worker per year ( 40 50 ) which means that there are pizzas per year ( 40 50 ) The value of those pizzas is pesos per year ( 40 50 10 ) The total value of all the production in the economy is called nominal gross domestic product ( nominal ) The word nominal indicates that something is being measured in terms of this case , Argentine pesos . For this economy , nominal is 300 billion pesos per year . The economy we have just described is extremely stylized and somewhat dull from a culinary perspective . We begin with such a simple economy because it allows us to understand the basic workings of the economy without getting bogged down in a lot of details . We did , however , choose numbers that are the right order of magnitude for the Argentine economy in 2002 the total number of workers in Argentina in URL books 788

2002 was about 15 million , and nominal was about 300 billion pesos . In 2010 , estimated for Argentina was trillion pesos , and the workforce was over 16 million . Measuring Nominal We now consider a more formal definition of nominal and go through it term by term . Nominal is the market value of the final goods and services produced by an economy in a given period of time . Market Value Our example pretended that there was only a single good produced in the . In real economies , millions of different goods and services are produced , ranging from cars at an assembly plant to haircuts sold by a local barber . If our goal is to measure the overall output of an economy , we are faced with the problem of how to add together these goods and services . How do you add cubic meters of natural gas , trucks , and head of cattle ( to pick just a few examples of goods produced in Argentina ) We need a common denominator . Economists use the market value of the goods and services . This means that the common denominator is dollars in the United States , pesos in Argentina , kroner in Sweden , euros in Portugal , and so on . Nominal equals total output produced in a year , valued at the actual market prices prevailing in that year . We choose market value for two reasons . One is simplicity data on the market prices of goods and services are relatively easy to come by . The second reason is much more important . Market value tells us how much people are willing to pay for different goods and services , which gives us a measure of the relative value of different commodities . For example , if a new laptop computer costs and a new hardcover novel costs 20 , then the market is telling us that people are willing to trade off these goods at the rate of 100 novels to laptop . In effect , the market is telling us that the laptop is 100 times more valuable than the novel . Let look at an example of the calculation . Table Calculating Nominal considers a very small economy that produces three goods and services , music downloads , and meals . We show data for URL books 789

two years . To calculate in 2012 , we take the market value of the ( 20 10 200 ) the market value of the music downloads ( 50 50 ) and the market value of the meals ( 25 150 ) Adding these , we discover that nominal is 400 ( 20 10 ) 50 ) 25 ) 200 50 150 400 . Doing the same operations for 2013 , we find that nominal is 442 ( 22 12 ) 60 ) 26 ) 264 48 130 442 . We can see that lots of things changed between the two years . The price of and meals slightly increased , while music downloads became cheaper . Firms produced more and music downloads but fewer meals . Table Calculating Nominal ) Price ( 39 ) Quantity Price ( 39 ) Quantity Price ( 11 ) Quantity 2012 10 50 2013 12 60 On the surface , 2013 appears to have been a good year in this economy . Nominal increased substantially relative to 2012 . Dig a little deeper , however , and it is harder to interpret this change . Production increased for some products and decreased for others . Some prices increased , and others decreased . Was 2013 really better than 2012 ?

We come back to this question shortly . Final Goods and Services In Table Calculating Nominal , we assumed that all of the goods and services purchased were purchased by their users . That is , the , music downloads , and meals were all purchased by households for consumption purposes . Households are not the only group that consumes final goods and services in an economy . Firms , the government , and households in other countries can also be final URL books 790

consumers . We term these goods ( and final services ( music downloads and restaurant meals ) In contrast , intermediate goods and services are products such as raw materials and energy that are completely used the production of other goods and services . We do not include intermediate goods in . Think about a bottle of wine , for example . It might be bought by a consumer at a wine store , in which case it is counted in . Alternatively , it might be bought by a restaurant to sell with its meals . In this case , the cost of the meal is included in , and the cost of the wine is already included in the cost of the meal . The restaurant may have purchased the wine from a supplier , but that purchase isnot included as part of . If both the sale of wine to the restaurant and the sale of that wine to a customer of the restaurant were counted in , the same bottle of wine would be counted twice . By excluding the sale of intermediate goods in calculating , we avoid such double counting . Being intermediate is therefore not a feature of the good itself . It depends on how the good is used . Wine sold to a consumer directly is a good wine sold to a restaurant is an intermediate good . This with the idea that we want to measure goods as they are valued by consumers . Produced by an Economy Most of the time when we talk about an economy , we are speaking of a particular country . Thus we talk about US , Argentine , Indian , or . Similarly , most of the statistics that are collected refer to economic activity within a country . The term economy can be much more general , though , for it simply means a particular set of households and . We can speak of the world economy , the North Dakota economy , the Buenos Aires economy , or even the economy of a street of your hometown . The basic concepts are the same no matter what region we choose to discuss . Over a Given Period is measured over a specified period of time . In principle , that time period could be week , a month , a quarter ( three months ) or a year . In the United States and many other countries , is measured on a quarterly basis . However , it is typically reported on an annual basis . In other words , URL books , 791

government statisticians might measure for the first three months of 2012 and that it was trillion . That is , over that period , trillion worth of goods and services was produced . The number would typically be reported as 16 trillion on an annual It does not make any sense to talk about US at the instant the clock strikes noon on February 29 , 2012 . The amount of produced at any instant of time is , for all intents and purposes , zero . Instead , we think of as a . We can count the number of pizzas produced only if we specify some interval of time . Other variables can be sensibly measured even at a given instant . For example , we principle at the number of pizza ovens in existence at any given time . The number of pizza ovens at a point in time is an example of a stock . The requirement that we count goods and services produced in a certain period means that we should also ignore the resale of goods produced in earlier periods of time . If a construction company builds a new house and sells it to you , the production of that home is counted as part of . By contrast , if you buy a house that is 10 years old , the sale of that house is not counted in . However , if you employed a real estate company to find the old house for you , payment to that company would be included as part of . In the same way , if you purchase a used textbook that was produced years ago , that purchase is not counted in . Nominal in the United States and Argentina In , our data come to us in the form of time series . Time series are a sequence of dated variables in 2000 , in 2001 , in 2002 , and so on . Usually these data are annual , but they could also be quarterly or monthly ( or even daily or hourly ) If we go to the Economic Report of the President ( ov eo ) we can find data for nominal . In the United States , the Bureau of Economic Analysis ( BEA national ) in the Department of Commerce is responsible for calculating nominal . Table Nominal in the United States , gives an example of a time series . Table Nominal in the United States , URL books 792

Year ( Billions of Dollars ) 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 It is often more revealing to show a time series as a picture rather than a list of numbers . Figure Nominal in the United States , shows the data from Table Nominal in the United States , in a graph . Looking at this , we see immediately that the US economy grew over these years . The level of nominal ( in billions ) was trillion in 2000 and trillion in 2006 . Figure ( in ( Status . goon ' I ! 131 . um . sum . sum . Nominal in the United States most ofthe last decade but declined in 2009 . Source 2011 Economic Report of the President , accessed July 29 , 2011 , Table . URL books 793

Let us return to your International Monetary Fund ( IMF ) mission in Argentina . From talking to other members of the team , you learn that the Argentine government has statistics on nominal . This is good news , for it means you do have information on the total value of production in the economy . Figure Nominal in Argentina , shows nominal for Argentina over the decade prior to your arrival ( In 1993 , it was 237 billion pesos . In 2002 , it was 313 billion pesos . Thus nominal grew by about over the course of the decade . Figure in Argentina , 401 ! mu ul luv ! Int 2414 ) The graph shows nominal in Argentina between 1993 and 2002 . Nominal grew overall during this period , although it decreased for several years in the second half of the decade . Source International Monetary Fund World Economic Outlook database ( external pubs 2010 01 ) Now suppose that in your hotel room one morning you hear on the radio that government statisticians in Argentina forecast that nominal next year will be 300 million pesos greater than this year . How should you interpret this news ?

Without some context , it is difficult to make any judgment at all . The thing to do is to work out if 300 million pesos is a big number or a small number . It certainly sounds like a big number or looks like a big number if we write it out in full ( If we stacked 300 million peso bills on top of each other , the pile would be over 100 miles high . But the real question is whether this is a big number relative to existing nominal . We have been told that the URL books 794

change in nominal is 300 million , but we would like to know what this is as a growth rate , which is change . Toolkit Section Growth Rates A growth rate is a percentage change in a variable from one year to the next . That is , a growth rate is the change in a variable over time divided by its value in the beginning period . For example , the growth rate of is calculated as follows growth rate of change in . In our example for Argentina , the percentage change is equal to the change in nominal divided by its initial value . Remember than nominal in 2002 was about 300 billion pesos , so percentage change in nominal change in nominal value of nominal percent . When we express this change in nominal as a percentage , therefore , we see that it is in fact very of percent . If you heard on the radio that nominal was expected to grow by 300 million pesos in a peso economy , the correct conclusion would be that nominal would hardly change at all . By contrast , if the news announced a projected increase in nominal of 30 billion pesos , the percentage change is 30 billion 10 percent . This is a substantial change in nominal . Measuring Real In your bid to understand the economy of Argentina , you have seen that nominal increased by third between 1993 and 2002 . One possibility is that Argentina is producing more pizzas than it was a decade billion pizzas instead of billion pizzas . This would be good news . Producing more pizzas is something we would normally think of as a good thing because it means that we are experiencing economic growth there are more goods and services for people to consume . URL books 795

In talking to people about the Argentine economy , however , you learn something disconcerting . They tell you that the prices of goods and services are greater this year than they were last year and much greater than they were a decade ago . You begin to wonder perhaps Argentina is producing no more pizzas than before but instead pizzas have become more expensive than they formerly were . We would typically feel very differently about this outcome . Yet another possibility is that there has been an increase in both the number of pizzas produced and the price of pizza , and the combined effect doubled nominal . We need a way of distinguishing among these different possibilities . Separating Nominal into Price and Output In our pizza economy , it is easy to tell the difference between an increase in production and an increase in prices . We can measure increased production by counting the number of pizzas , and we can measure increased prices by looking at the price of a pizza . We call the number of pizzas real gross domestic product ( the word real here indicates that we are effectively measuring in terms of goods and services rather than dollars ) and we call the price of a pizza the price level in the economy . Then it follows that nominal price level real . In our example , the price level is 10 pesos , and real is 30 billion pizzas . Multiplying these numbers together , we that nominal is indeed 300 billion pesos . Sometimes , for shorthand , we use the term price to mean the price level in a given year and the term output to mean real in a given year . Real is the variable that most interests us because it measures the quantity of goods and services produced in an economy . We would therefore like to find a way to decompose nominal into the price level and the level of real in actual economies . But real economies produce lots of different goods and services , the prices of which are continually changing . In our fictional economy , where it URL books 796

makes sense to measure real as the number of is no natural unit for real in an actual economy . In fact , even in our pizza economy , there is still an arbitrariness about the units . Imagine that we cut each pizza into 10 slices . Then we could just as easily say that real is 300 billion pizza slices instead of 30 billion pizzas , but that the price price per peso . We would still conclude that nominal number of slices multiplied by the price per 300 billion pesos . So is it possible to say , in a real economy producing multiple goods and services , that nominal is equal to the product of the price level and the level of real ?

Does it still make sense to write nominal price level real as we did for the pizza economy ?

The answer , as it turns out , is yes . To see how this works , we begin by looking at how prices and output change from one year to another . we divide 2013 nominal by 2012 nominal . This is one measure of the growth in nominal from 2012 to 2013 . Remember that nominal equals total output produced in a year , valued at the prices prevailing in that year . Comparing nominal in 2012 and 2013 therefore gives us nominal in 2013 in 2012 output in 2013 valued at 2013 in 2012 valued at 2012 prices . Now we use a trick . Multiply above and below the line by output in 2013 valued at 2012 prices and then rearrange nominal in in 2012 output in 2013 valued at 2013 in 2012 valued at 2012 in 2013 valued at 2012 in 2013 Va at 2012 prices output in 2013 valued at 2013 in 2013 valued at 2012 in 2013 valued at 2012 in 2012 Va at 2012 prices . Look carefully at this calculation to make sure you understand what we did here . URL books 797

Now examine the two ratios on the side of the second line . The compares the cost of the same bundle of goods ( output in 2013 ) at two different sets of prevailing in 2013 and those prevailing in 2012 . Think of the bundle as being a grocery cart full of goods . If you compare how much it costs to buy exactly the same collection at two times , you have a measure of what has happened to prices . The second ratio on the side is a measure of the increase in real . It uses the same prices to compare the value of output in 2012 and 2013 . In other words , it tells you how much it costs to buy two collections of goods at exactly the same prices . To reiterate , the first ratio compares the same bundle of goods at two different sets of prices . The second ratio compares two different bundles of goods at the same prices . We have succeeded in separating the change in nominal into two components a price change and a change in real . Measuring Real and the Price Level We can illustrate this technique using the data in Table Calculating Nominal . In that example , the growth in nominal equals percent because output in 2013 valued at 2013 in 2012 valued at 2012 prices . Now we choose an arbitrary year that we call the base year . For the base year , we set the price level equal to . In our calculations , we choose 2012 as our base year . Because nominal equals the price level times real , this means that real in 2012 is 400 . When we choose 2012 as our base year , we use the prices of , music downloads , and meals in 2012 for our calculations of real for 2012 and 2013 . Table Real Using 2012 as the Base Year shows what we find . The first row is exactly the same as in Table Calculating Nominal . Nominal in 2012 same as real in 2012 because we are using 2012 as the base year . The second row of the table calculates real for 2013 it uses 2013 quantities but 2012 prices . Notice also the heading in the column of the table Real ( Year 2012 dollars ) The term URL books 798

in parentheses tells us that everything is being measured according to the prices that prevailed in our base year of 2012 . Table Real Using 2012 as the Base Year Real ( 2012 ) Dollars ) 2012 Price 2012 Price 2012 Price ( Quantity ( Quantity ( Quantity 2012 20 10 50 25 400 2013 20 12 60 25 425 We previously calculated that 2013 nominal put in 2013 valued at 2013 442 . By contrast , Table Real Using 2012 as the Base Year shows that , when valued in year 2012 dollars , the total output of this economy in 2013 is 425 . In other words , output in 2013 valued 2112012 in 2012 valued at 2012 prices 400 . Nominal increased by percent between the two years , but real is increased by only percent . From this we see that not all of the increase in nominal is due to increased output . Some of the increase is because prices increased between 2012 and 2013 . In our pizza economy , we said that nominal was equal to the price per pizza multiplied by the quantity of pizza . In our example here , we have calculated something very similar . Nominal equals the price level multiplied by real . In the base year , the price level equals ( that is what it means to choose the base year ) and so real equals nominal in that year . Because we can calculate the increase in the price level and the increase in real from one year to the next , we can obtain a time series for the price level and a time series for real . In each year , nominal equals the price level in that year times real in that year . There is , however , one difference between the calculation for our pizza economy and measurement in real economies . In the pizza economy , because there was a single good , we were able to measure real in physical number of pizzas . In real economies , there is no single good , and so we measure real URL books 799

in base year dollars rather than as a physical quantity . The price level in , say , 2013 is not , strictly speaking , the price of real in terms of 2013 dollars but rather is the price of a base year dollar in terms of 2013 dollars . But this is a technical difference . From an intuitive point of view , it is simplest to think about real as being a physical number of pizzas . In this book we therefore imagine that real is actually a bundle of goods and services all melded together to create a composite good . We call that good units of real , and we call the price level the price of a unit of . In fact , we could think about the pizza economy in that same way . Even a basic pizza is itself composed of dough , sauce , and cheese it is a bundle of items melded into one . So when we talk about the physical quantity of pizza , we are really talking about the number of bundles of these ingredients . Likewise , when we talk of real , we are talking about a bundle of goods that we measure in base year dollars . Real is our most basic measure of economic performance . It is a very broad measure because it tells us how much economic activity of any kind ( at least , any kind that we can measure ) is going on in our economy . Real tells us how much we have produced of all the different goods and services that people enjoy and want to consume . For this reason , real statistics are among the most closely watched of all the figures released by a government . Real in the United States and Argentina Figure Real in the United States , shows real for the US economy from 1929 to 2008 in year dollars . The figure shows that the US economy grew substantially over those years . The level of real was in 1929 and in 2008 ( in billions of 2000 ) Figure Real in the States . 1929 2009 URL books 800

! I ( woo ! Source national Figure Real ( in 1993 Pesos ) in Argentina in the 10 Years Prior to 2002 shows real in Argentina and thus reveals that our earlier data for nominal were indeed misleading . Nominal may have increased between 1993 and 2002 , but real in 2002 was at the same level as in the previous decade . Moreover , real had been decreasing for the prior four years before the IMF visit . Figure Real ( in 1993 Pesos ) in Argentina in the 10 Years Prior to . 00 . II Paws I ! Real in Argentina was between 1993 and 2002 . URL books 801

Source International Monetary Fund World Economic Outlook database ( external pubs 2010 01 ) This helps you to make sense of your contradictory impressions of Buenos Aires . Argentina became poorer , not richer , in the late and early . The presence of luxury goods stores , for example , is a reminder that Argentina was a relatively rich country , but the absence of shoppers in those stores tells you that people are not feeling very rich at this time . KEY TAKEAWAYS Economists and measure output as . This is a measure of the total value of all production in an economy . Nominal measures the total value of all production using current prices , while real measures total output and corrects for changes in prices relative to a base year . Checking Your Understanding . Why is there no natural unit for calculating real in an actual economy compared to the pizza economy ?

If your income is currently 150 each week and you received a raise of 50 , what is the percentage change in your weekly income ?

Next We take as given here that the market tells us how much people are willing to a reasonable measure of the value of a good or a service . More precisely , it measures the value of the good or service at the margin , meaning it measures the value of having one more unit of the good or the service . Explaining why this is usually a sensible interpretation of the market price ( and when it is not ) is a topic covered in courses . There are two kinds of goods used in the production of other goods . Intermediate goods are completely used up as part of the production process . Capital as factories and not completely used up URL books 802

but live to produce another day . We discuss capital goods in more detail in Chapter 20 Globalization and Competitiveness i Specifically , this measures the gross growth rate of nominal . It is equal to the percentage change in nominal . See the toolkit for details of the mathematics of growth rates . If you look at this figure , you will see that real is listed as chain weighted . This method of calculating real averages growth rates by using different base years . By averaging , this measure has the virtue that calculations of real are less sensitive to the selection of an arbitrary base year . For more information on weighted measures , see Charles , The New Approach to Measuring , Current Issues in Economics and Finance , no ( 1995 ) accessed June 28 , Measuring Prices and Inflation LEARNING OBJECTIVES After you have read this section , you should be able to answer the following questions . How are price indices such as the Consumer Price Index ( calculated ?

What is the difference between the and gross domestic product ( deflator ?

What are some of the difficulties of measuring changes in prices ?

If nominal increased in Argentina but real did not , then prices must have increased . So now we look in more detail at the measurement of prices . The Price Index Remember that we defined the change in prices as follows output in 2013 valued at 2013 in 2013 valued at 2012 prices . We can use the data in Table Calculating Nominal to calculate this ratio as well . This time , however , we compare the cost of the same basket of goods ( in this case , output in 2013 ) according to the URL books , 803

prices prevailing at two different times . The basket of goods in 2013 is shown in Table Calculating the Price Index as the quantities of the three goods and services produced that year 12 , 60 music downloads , and meals . As we saw earlier , the cost in dollars of this basket of goods and services is 442 . Table Calculating the Price Index ' Cost of 2013 ( Price ( Quantity Price ( 39 ) Quantity Price ( Quantity 2012 20 12 60 25 425 2013 22 12 60 26 442 Table Calculating the Price Index also shows the total cost of consuming the 2013 basket in 2012 , which we already know is 425 . Thus the price index for 2012 is 425 , and the price index for 2013 is 425 For the simple economy described in Table Calculating Nominal , we therefore have the following nominal in in 2012 output in 2013 valued at 2013 in 2013 valued at 2012 prices in 2013 valued at 2012 in 2012 Va 2112012 prices ( Prices increased by percent , real increased by percent , and nominal increased by percent . To summarize , the basic principle for calculating is as follows ( We decide on a bundle of goods and look at how much it costs in a given year . Then we look at the same bundle of goods in the following year and see how much it costs . The ratio of the two is called a price index and provides a measure of one plus the rate . Toolkit Section Correcting for A price index for a given year is calculated as the cost of a bundle of goods in that year divided by the cost of the same bundle in the base year . The growth rate of the price index from one year to the next is a measure of the rate . URL books 804

Different Price There are many different price indices that are constructed and used for different purposes . They can be constructed for particular categories of goods or regions , for example . If you listen to the news , you may hear references to the Producer Price Index or the Wholesale Price Index . Ultimately , the differences among different price indices simply come down to the bundle of goods that is chosen . Figure An Example of a Price Index shows an example of a very particular price index that was used by a supermarket in Thailand to advertise its prices . The store placed two supermarket carts at the entrance with the same bundle of goods in each . The one on the left , with the black label , showed the cost of this cartload of goods at the old prices . It used to cost Thai baht ( approximately US 28 ) The one on the right , with the red label , showed that the cost of this same bundle of goods was now Thai baht . The reduction in price for the basket of goods was Thai baht , or about percent . le ( Price A supermarket in , Thailand , used an actual basket of groceries to show that its prices had been reduced . This is an example of a price index . Source Image taken by the authors . URL books 805

The Consumer Price Index In this book , we use price indices that measure the general level of . There are several such measures , but we do not need to worry about this . The differences among these different measures are usually small and typically unimportant for our basic understanding of the economy . The measure of that we have used so far is called the , a price index that uses as the bundle of goods everything that goes into . A more common measure of is the Consumer Price Index ( which uses as the bundle of goods the typical purchases of households . The is the most familiar measure of prices . When economic commentators speak of , they usually mean the percentage change in the . As the name suggests , the is intended to measure as consumers experience it . The bundle of goods included in the is supposed to correspond to the bundle of goods purchased by a typical household . This means that certain goods that are included in do not show up in the . For example , an increase in the price of stealth bombers does not show up in the because ( we hope ! households do not buy stealth bombers . However , stealth bombers do show up in the . At the same time , certain goods that are not part of are included in the importantly , consumer goods that are imported from other countries . Because imported goods are not produced in the domestic economy , they do not show up in the however , because domestic consumers purchase imported goods , they do show up in the . Households differ dramatically in their consumption patterns , so different households have very different experiences of . An individual who drives 100 miles daily to get to work views variations in the price of gasoline very differently from someone who rides a bicycle to work . The captures the average experience of all households , which can be quite different from the actual experience of an individual household . Figure The Rate in the United States , shows the rate ( that is , the percentage change of the ) from 1914 to 2008 in the United States . In some early years , prices URL books 806

actually decreased from one year to the next , meaning that the rate was negative . Since 1960 , however , the United States has experienced a positive rate . Figure The Rate in the United States , re . Source pub Figure The Price Level in Argentina shows the price level in Argentina between 1993 and 2002 . The most striking thing about this picture is that there was very little for most of this period . In the year , however , prices increased substantially . Notice that our picture for the United States shows the rate , whereas for Argentina we are looking at the level of prices . Either way of presenting the data is valid , but it is critical to understand the difference between them . Make sure you understand the difference between the level of prices and the percentage change in prices . Figure The Price Level in Argentina 19 ' 2000 1001 The price level in Argentina was roughly constant between 1993 and 2001 . However , there was a big jump in the price level in books 807

Source International Monetary Fund World Economic Outlook database ( external pubs 2010 01 ) Calculation of the in Practice The actual calculation of the is more complicated than our example suggests . The Bureau of Labor Statistics ( is the US government agency that is responsible for this calculation , while other countries have similar agencies . The procedure is , in essence , the one we have described it compares the cost of the same bundle of goods in different years . However , the confronts several difficulties that we have ignored so far . Quality changes . Imagine that you now work for the ( you took this job after you left the International Monetary Fund IMF ) and are asked to look at changes in the price of laptop computers . You decide to use the IBM computer . You discover that in 1992 a cost on average . Then you that it is possible to purchase a in 2011 for 899 . You calculate the percentage change in the price as ( 899 ) and conclude that the is 79 percent cheaper than two decades previously . You report this to your boss and then go home . But then you start to worry . The 2011 is nothing like the 1992 version . The 1992 computer had 120 of memory and weighed over pounds . The 2011 has of memory and weighs pounds less . It has a vastly bigger hard drive , wireless Internet connection , and a superior display . In short , there were huge quality improvements over this period . A computer with the of the 1992 would be worth much less than 899 . By ignoring the improvements in quality , you have understated how much the price of computers has fallen . This problem is particularly acute for computers , but it applies to all sorts of different goods . The new car that you purchase today is very different from a car that your mother or your grandfather might have bought . Cars today come equipped with computerized braking systems , global positioning system ( navigational tools , and numerous other sophisticated engineering features . They are also much more reliable your grandparents will tell you that cars used to break down all the time , whereas now that is a URL books sos

relatively rare event . It would be a big mistake to say that a 2012 automobile is the same as a 1961 automobile . New goods and old goods . The typical basket of goods bought by consumers is changing . In 1970 , no one had a mobile phone , an player , or a plasma television . Similarly , people today are not buying vinyl records , videocassette recorders , or Polaroid cameras . The needs to keep up with every change . As the economy evolves and new goods replace old ones , they must change the basket of goods . Changes in purchasing patterns . The bundle purchased by the typical household also changes over time because of changes in the prices of goods and services . The typical household will substitute away from expensive goods to relatively cheaper ones . If the basket of goods is held , the calculation of the will overstate the increase in the cost of living . This effect is most severe if there are two goods that are very close substitutes and the price of one increases significantly relative to another . Perhaps these seem like minor details in the calculation of the . They are not . A government commission chaired by the economist Michael provided an extensive report on biases in computing the in 1996 . The Commission concluded the following The Commission best estimate of the size of the upward bias looking forward is percentage points per year . The range of plausible values is to percentage points per That is , the Commission concluded that if as measured by the was , say , percent , the true rate was only percent . In response to these concerns with measurement , the responded by taking actions to reduce the biases in the measurement of the and deal more effectively with the introduction of new goods . Correcting for Inflation The data on nominal and real in Argentina illustrate the dangers of looking at nominal rather than real variables . Had you looked at only nominal , you would have concluded that the Argentine economy had been growing between 1993 and 2002 , when it was actually stagnating . But many economic only nominal typically quoted in terms of dollars ( pesos , euros , or whatever the currency of the country is ) To make sense of such statistics , we must URL books 809

understand whether changes in these statistics represent real changes in the economy or are simply a result of . Toolkit Section Correcting for If you have some data expressed in nominal terms ( for example , in dollars ) and you want to covert them to real terms , use the following steps . Select your . In most cases , the is the best to use . Select your base year . Find the value of the index in that base year . For all years ( including the base year ) divide the value of the index in that year by the value in the base year . This means that the value for the base year is . For each year , divide the value in the nominal data series by the number you calculated in Step . This gives you the value in base year dollars . Here is an example of how to correct for . Suppose that a sales manager wants to evaluate her company sales performance between 2000 and 2005 . She gathers the sales data shown in Table Sales , Table Sales , Year Sales ( Millions of Dollars ) 2000 2001 2002 2003 23 2004 2005 At glance , these numbers look reasonably encouraging . Sales have grown every year between 2000 and 2005 . But then she remembers that these data are in nominal terms , and there was also some over this time period . So she decides to correct for . She first goes to the Economic URL books ' 810

Report of the President and downloads the data in Table Consumer Price Index , 2005 . She decides to use 2000 as the base wants to measure sales in year 2000 dollars . So there are two steps to her calculations , as shown Sales Data Corrected for , 2005 . First , she takes the series and divides every term by the 2000 value ( that is , This gives the third column of Table Sales Data Corrected for , labeled Price Then she divides each of the sales figures by the corresponding price index to obtain the real ( that is , corrected for ) value of sales . These are given in the final column of the table . Table Consumer Price Index , Your ( PI 2000 2001 2002 2003 2004 2005 Source pub Table Sales Data Corrected for , Price ( Base Sales ( of Real Sales ( Millions ' 2000 Your ( PI 2000 ) Dollars ) Dollars ) 2000 2001 2002 2003 2004 2005 UL books ' 811

We can see that the sales data are much less rosy after we account for . Sales were increasing between 2000 and 2003 in real terms , but real sales decreased in 2004 and 2005 . Had she just looked at the dollar measure of sales , she would have completely missed the fact that the business had experienced a downturn in the last two years . Economic statistics reported in the news or used by businesspeople are very often given in nominal rather than real terms . Perhaps the single most important piece of economic literacy that you can learn is that you should always correct for . Likewise , you should be on your guard for misleading statistics that fail to make this correction . Here is an example from an article that appeared in the Washington Post . The Clinton recovery has been far less egalitarian than the Reagan era of Between 1990 and 1995 , the real average family income actually declined slightly while the number of people with a net worth over million more than Can you see why this sentence is so misleading ?

It mixes together a real measure and a nominal measure in the same sentence . Real family is , family income corrected for in the half of the . But the number of millionaires is a nominal measure . In a time of , we would expect to have more millionaires , even if people are not really getting any richer . KEY TAKEAWAYS A price index is created by calculating the cost of purchasing a fixed basket of goods in different years . The is a price index for goods and services , including imported goods , consumed by households , while the deflator is based on all the goods and services that compose . Calculating a price index is difficult due to the introduction of new products , quality changes , and changes in purchasing patterns . Checking Your Understanding . The has an calculator on its website ( which is shown in Figure Calculator . URL books 812

Figure Calculator You enter an amount and two different years , and then it tells you the other amount . Explain the calculation that this program performs . In Table Sales Data Corrected for , calculate the rate ( that is , the percentage change in the price index ) and the growth rate of sales in each year . What is the relationship between these two variables ( a ) when real sales are increasing and ( when real sales are decreasing ?

ext Frequently , the value for the price index is multiplied by 100 , so the price index for 2013 would be given as 104 . Inflation data and more details about the construction of price indices can be found at the website of the Bureau of Labor Statistics ( URL books 813

For the history of the , see A Brand That Made History , accessed June 28 , 2011 , for the 2011 specifications and prices , see Announces Premium Edge , Notebooks , January , 2011 , accessed July 20 , 2011 , For the complete Commission Report , see Advisory Commission to Study the Consumer Price Index , Toward a More Accurate Measure of the Cost of Living , Social Security Administration , December , 1996 , accessed June 28 , 2011 , For the response to the report , see Consumer Price Index Executive Summary , Bureau of Labor Statistics , October 16 , 2011 , accessed June 28 , 2011 , See Economic Report of the President , 2011 , Table , accessed June 28 , ov eo . See and , Keep the Champagne on Ice , The Washington Post , reprinted in The Guardian Weekly , June , 1998 . In fact , the quote in the newspaper was even more misleading because it did not even make it clear that the family income figure was adjusted for inflation . The Circular Flow of Income LEARNING OBJECTIVES After you have read this section , you should be able to answer the following questions . What is the circular flow of income ?

What is the national income identity ?

Looking at some basic measurements of the economy has allowed you to be more concrete about the problems in Argentina . You report back to the International Monetary Fund ( IMF ) team that production has been declining in recent years . You also report that there was a recent increase in the price level . As yet , though , you do not know anything about either the causes or the consequences of these events . URL books 814

Measurement of the economy tells you what has happened , but it tells you neither why it happened nor what it means . Measurement is not enough . We need to help us make sense of the data that we gather . Economists use many different kinds of to make sense of an economy . One of the most important is called the circular of income . To understand the circular , recall our working definition of economic activity goods and services produced for So far , we have focused on production . Now we think about the for sale part . Toolkit Section The Circular Flow of Income As individuals and buy and sell goods and services , money among the different sectors of the economy . The circular of income describes these of dollars . From a simple version of the circular , we learn that , as a matter of accounting , gross domestic product ( income production spending . This relationship lies at the heart of analysis . There are two sides to every transaction . When you purchase a piece of computer software , you give money to the seller , and the seller gives the software to you . You might literally hand over dollar bills and receive a , or you might enter a credit card number into a website you to a download . The idea is the same either way . There is a of money from you to the seller and a of goods or services from the seller to you . This is true for all transactions as individuals and buy and sell goods and services , money among the different sectors of the economy . follow the money . By tracking these , we can understand the links between different markets by understanding these links , we gain insight into the functioning of an economy . URL books , 815

One linkage is between income and spending . The spending by households on goods and services is funded by the income that households earn . But this income comes from firms , and they get their income from the spending of households . Thus there is a circular of income in an economy as a whole . Household income comes from two main sources ( Households contain workers who sell their time to and receive wages in return . Households are the ultimate owners of the live in houses thus any that firms make are returned to households . All firms in an economy are owned by someone , and any they make do not vanish into thin air but must eventually show up as someone income . Households take this income and do one of two things they either spend it or save it . To start , let us out what would happen if no household income is saved . Households spend all their income , and this money becomes the revenue of firms . Firms send these revenues back to households , either as labor income or profits , and so the circular continues . The Simplest Version of the Circular Flow We can make this idea more precise , using the pizza economy to illustrate . Imagine that our economy is composed of two sectors , which we call households and firms . Households supply labor to firms and are paid wages in return . Firms use that labor to produce pizzas and sell those pizzas to households . There is a of goods ( pizzas ) from to households and a of labor services ( worker hours ) from households to . Because there are two sides to every transaction , there is also a of dollars from households to , as households purchase pizza , and a of dollars from to households , as pay workers . For now , think of as very simple entities that pay out all the income they receive in the form of wages to workers . As a result , 300 billion pesos from the household sector to the sector ( the purchase of pizzas ) each year , while 300 billion pesos from the firm sector to the household sector ( the payment of wages ) These of pesos are illustrated in Figure The Simplest Version of the Circular Flow . Think of this diagram as representing the interaction of many households with many . A particular household works for one ( or perhaps a few firms ) but purchases goods and services URL books 816

from many firms . If you like , imagine that different specialize in different kinds of pizza . A feature of modern economies is that individuals specialize in production of goods and services but generalize in consumption by consuming many varieties of goods and services . Figure ) Circular Flow i , Am The circular of income follows the money in an economy . In the pizza economy , produce pizzas and sell them to households , while households sell labor to and purchase pizzas from them . The circular reveals that there are several different ways to measure the level of economic activity . From the household perspective , we can look at either the amount of income earned by households or their level of spending . From the firm perspective , we can look at either the level of revenues earned from sales or the amount of their payments to workers and shareholders . In all cases , the level of nominal economic activity would be measured at 300 billion pesos . Corresponding to the of pesos shown in Figure The Simplest Version of the Circular Flow , there are of goods and services between these sectors , as shown in Figure The Flows of Goods and Labor within the Circular Flow . The wage income received by consumers is payment for labor services that from households to . The consumption spending of households is payment for the goods that from to households . URL books ( 817

Figure The , and within the ( Flow Labor ' mu ant There are of goods and labor services that correspond to the of pesos shown in Figure The Simplest Version of the Circular Flow . Three hundred billion pesos worth of pizza to households , and 300 billion pesos worth of labor services from households to . Of course , there are also of dollars within the household and sectors as well as between them . Importantly , firms purchase lots of goods and services from other . One of the beauties of the circular construct is that it allows us to describe overall economic activity without having to go into the detail of all the among . Figure Income , Spending , Payments to , and Revenues in the Simple Circular Flow shows us that the in and out of each sector must balance . In the household sector , total spending by the household equals total income for the household . If spending equals income for each individual household , then spending also equals income for the household sector as a whole . Similarly , each firm has a balance sheet . Accounting rules ensure that all of a revenues must ultimately show up on the other side of the balance sheet as payments for the inputs that the firm uses ( in our simple example , the only input is labor ) As this is true for each individual , it is also true for the sector as a whole . URL books ( 818

Figure , to Inputs . in the Simple Circular low Hon pea ) In each household , and thus in the household sector as a whole , income must equal spending . In each , and thus in the sector as a whole , revenues must equal payments to inputs . measures the production of the economy and total income in the economy . We can use the terms production , income , spending , and interchangeably . Although this version of the circular is simple , it teaches us four key insights that remain true ( albeit in slightly forms ) in more sophisticated versions as well . URL Spending production . The total value of all spending by households becomes an into the firm sector and thus ends up on the revenue side of a balance sheet . The revenues received by firms provide us with a measure of the total value of production in an economy . Production payments to inputs . Flows in and out of the sector must balance . The revenues received by are ultimately paid out to households . Payments to inputs income . Firms are legal entities , not people . We may talk in common speech of a making money , but any income generated by a firm must ultimately end up in the hands of real is , in the household sector of an economy . The total value of the goods produced by becomes an of dollars from the firm sector . These dollars end up in the hands of households in the form of income . This ownership is achieved through many forms , ranging from firms that are owned and operated by individuals to giant corporations whose ownership is determined by stock holdings . Not all households own firms in this way , but books 819

in it is sufficient to think about the average household that does own stock in . Income spending . We complete the circle by looking at the household sector . The dollars that into the household sector are the income of that sector . They must equal the dollars that out of the household spending . The circular of income highlights a critical fact of national income accounting income spending production . Earlier , we emphasized that measures the production of an economy . Now we see that is equally a measure of the income of an economy . Again , this the fact that there are two sides to each transaction . We can use the terms income , spending , production , and completely interchangeably . What does this mean for your assessment of Argentina ?

For one thing , it tells you that the decline in real implies a corresponding decline in income . Economists pay a great deal of attention to real statistics for exactly this reason such statistics provide information on the total amount of income earned in an economy . The Complete Circular Flow Figure The Complete Circular Flow shows a more complete version of the circular . It includes sectors the household and firm sectors that we have seen already , a government sector , a financial sector , and a foreign sector . In every sector of the circular , accounting rules tell us that the of money in must equal the of money out . When we look at this sector by sector , we discover accounting relationships , each playing an important role in . For now , we take a very quick look at each one in Figure The ( URL books

mum . Inn mi . ru i , I ' run up A I . The circular of income describes the of money among the sectors of an economy . This representation includes the main sectors households , government , the sector , and the rest of the world . The Firm Sector The in and out of the sector of an economy must balance . The total of dollars from the firm sector measures the total value of production in the economy . The total of dollars into the sector equals total expenditures on , which we divide up into four categories . Toolkit Section The Circular Flow of Income The national income identity is the condition that production consumption investment government purchases net exports . It is the most fundamental relationship in the national accounts . Consumption refers to total expenditures by households on goods and services . Investment refers to the purchase of goods and services that , in one way or another , help to produce more output in the future . Government purchases are all the purchases of goods and services by the government . Net exports are the difference between exports and imports they measures the total expenditure associated with the rest of the world . URL books 821

The Household Sector Households receive income from . They also receive money from the government ( transfers ) and must pay money to the government ( taxes ) Households spend some of their disposable income and save the rest . In other words , income transfers taxes consumption private savings . There are many different ways of saving , but we do not focus on these differences . We simply imagine that households take their savings to markets to purchase assets . Some individual households are net borrowers , but , overall , the household sector saves . There is , on net , a of dollars from the household sector to the financial sector of an economy . These dollars are then available for to borrow to build new factories , install equipment , and so on . That is , they are available for investment . The Government Sector From a perspective , the key functions of government are as follows It purchases goods and services . It collects revenues through personal and corporate taxes and other fees . It gives transfers to households . The amount that the government collects in taxes does not need to equal the amount that it pays out for government purchases and transfers . If the government spends more than it gathers in taxes , then it must borrow from the financial markets to make up the shortfall . Figure The Complete Circular Flow shows two into the government sector and one out . Since the in and out of the government sector must balance , we know that government purchases tax revenues transfers government borrowing . URL books 822

Government borrowing is commonly referred to as the budget . It is also possible that the government takes in more than it spends , in which case the government is saving rather than borrowing , so there is a budget surplus rather than a . The Financial Sector The financial sector of an economy is at the heart of the circular . It summarizes the behavior of banks and other institutions . Most importantly , this sector of the circular shows us that the savings of households provide the source of investment funds for firms . On the side , the shows a of dollars from the household sector into financial markets , representing the saving of households . Though we have not included it in Figure The Complete Circular Flow , also save , by means of that they retain to new investment rather than distribute to their shareholders . As far as the national accounts are concerned , it is as if firms sent these funds to the market and then borrowed them back again . When we borrow from other countries , there is a second of dollars into the markets . On the side , there is a of money from the sector into the firm sector , representing the funds that are available to firms for investment purposes . The linkage between the saving of households and the investment of firms is one of the most important ideas in . The financial sector is also linked to the government sector and the foreign sector . These can go in either direction . As we have already seen , if the government runs a deficit , it does so by borrowing from the financial markets . There is a from the financial sector to the government sector . This is the case we have drawn in Figure The Complete Circular Flow . If the government were to run a surplus , the would go in the other direction government would provide an additional source of saving . The foreign sector can provide an additional source of funds for investment , if those in other countries decide they want to use some of their savings to purchase assets in our economy . In this case , there is a from the foreign sector into the sector . Again , this is the case we have drawn . If we lend to other countries , then the goes in the other direction . The in and out of the financial sector must balance , so URL books 823

investment government borrowing private savings borrowing from other countries . The Foreign Sector The foreign sector is perhaps the hardest part of the circular to understand because we have to know how international transactions are carried out . Some of the goods produced in an economy are not consumed by domestic households or firms in an economy but are instead exported to other countries . Whenever one country sells something to another country , it acquires an asset from that country in exchange . For example , suppose a US movie company sells to an Australian distributor . The simplest way to imagine this is to suppose that the distributor hands over Australian dollar bills to the movie company The movie , more generally , the US now acquired a foreign dollars . Because these Australian dollars can be used to purchase Australian goods and services at some time in the future , the US economy has acquired a claim on Australia . In effect , the United States has made a loan to Australia . It has sent goods to Australia in exchange for the promise that it can claim Australian products at some future date . Similarly , some of the goods consumed in our economy are not produced locally . For example , suppose that a US restaurant chain purchases Argentine beef . These are imports . We could imagine that the restaurant chain hands over US dollars to the Argentine farmers . In this case , the United States has borrowed from Argentina . It has received goods from Argentina but has promised that it will give some goods or services to Argentina in the future . Of course , international transactions in practice are more complicated than these simple examples . Yet the insight we have just uncovered remains true no matter how intricate the underlying financial transactions are . Exports are equivalent to a loan to the rest of the world . Imports are equivalent to borrowing from the rest of the world . If we import more than we export , then we are borrowing from the rest of the world . We can see this by looking at the in and out of the foreign sector URL books 824

borrowing from abroad imports exports . If we export more than we import , are lending to the rest of the world , and there is a of dollars from the markets to the rest of the world . The Causes of a Decrease in Real We saw that , in Argentina , real decreased between 1998 and 2002 . The circular of income tells us that when real decreases , it must also be the case that real production decreases and real spending decreases . The IMF team in 2002 wanted to understand why real decreased . We are not going to answer that question in this all , we are still at the very beginning of your study of . Still , the circular still teaches us something very important . If real decreased , then there are really only two possibilities . For some reason , firms decided to produce less output . As a consequence , households reduced their spending . For some reason , households decided to spend less money . As a consequence , reduced their production . Of course , it could be the case that both of these are true . This insight from the circular is a starting point for explaining what happened in Argentina and what happens in other countries when output decreases . KEY TAKEAWAYS The circular flow of income illustrates the links between income and spending in an economy . In its simplest form , revenue earned by firms by selling their output ultimately flows to households , which spend this income on the output produced by firms . URL books 825

The national income identity says that total spending must equal total output and also must equal total income . Checking Your Understanding . What changes in Figure The Complete Circular Flow if the government takes in more revenue than it spends ?

We said that borrowing from abroad equals imports minus exports . Is there an analogous relationship that holds for an individual ?

Next When we revisit each sector in different chapters ofthis book , we include more precise definitions and more detailed discussion ofthe individual flows ( such as consumption or government purchases ) These terms are explained in detail in Chapter 22 The Great Depression . The flows in and out of the household sector are discussed in Chapter 27 Income Taxes . Government finances are discussed in Chapter 29 Balancing the Budget . The Meaning of Real LEARNING OBJECTIVES After you have read this section , you should be able to answer the following questions URL books 826

. When the focus is on real gross domestic product ( real ) what aspects of economic welfare are then missed ?

What are some other useful measures of economic welfare ?

As you leave Argentina , you might well find yourself wondering about the implications of your work . You know that real decreased , and from your study of the circular , you know that income decreased as well . Argentines have become poorer , as you might have guessed from the stores you saw when you arrived in the country . You hope that , with the help of your observations , the International Monetary Fund ( IMF ) and the Argentine government will together a way to enact good policies to increase the is , the individuals who live and work in the economy . Our happiness is surely by our material ability to live in comfort enjoy good food have access to books , music , computers , and videogames and so forth . In addition , it depends on our having the leisure time to enjoy these comforts socialize with our friends and go to movies , plays , and restaurants . However , our happiness depends on many other factors that are beyond the purview of economics and the of economic . Our happiness depends on our friends , families , health , and much more . Economics can not help us very much with such matters . So , you wonder , is it enough to look at real ?

Real and Economic Welfare Real is certainly a useful indicator of how well an economy is performing . This does not necessarily mean that it tells us about the welfare of those who live there . Some countries , such as China or India , have a large real simply because they have large populations . Living standards in these countries are nonetheless relatively low because the large must be shared by a very large number of people . To correct for this , we look at real per person , which measures how much would be available if we shared it equally across the entire population . URL books 827

If two countries have substantially different levels of real per person , we can fairly reliably infer that the richer country , by this measure , is also the country with higher living standards . Real per person in Germany is about 25 times greater than real per person in Kenya . Even a few minutes spent in the streets of and Berlin would that Germany enjoys much higher material living standards . However , when we compare countries with similar levels of real per person , it is rash to assume that a richer country necessarily enjoys a higher standard of living . This is because there are several ways in which real per person is as an indicator of economic welfare . Remember , first , that measures market transactions only . National income accounts can measure activities that are traded only in markets . If people clean their own homes , tend their own gardens , repair their own cars , or cook their own meals , these activities are not included in our measurement of . There are a few exceptions . Most notably , statistics impute a value to housing statistics effectively pretend that homeowners rent their houses from themselves . This leads to some unfortunate inconsistencies in accounting . Suppose you and your neighbor both work as auto mechanics . If you each maintain and repair your own cars , these activities do not show up in . But if you hire your neighbor to maintain your car , and she hires you to repair her car , then does include this economic activity . Yet another possibility is that you barter with your neighbor , so she looks after your car and you look after hers but no money changes hands . Again , this work goes unrecorded in national accounts . Barter is more prevalent in developing countries than in developed countries and causes more of a problem for measurement of in poorer countries . It is a particular source of difficulty when we want to compare economic activity in different countries . People also value their leisure time . measures the goods and services that people consume but does not tell us anything about how much time they must give up to produce those goods . For example , people in the United States are richer , on average , than people in Spain . But people in the United States work longer hours than people in Spain , and Spanish workers also enjoy much longer vacations . If we use measures of to compare welfare in the United States and Spain , we will capture the fact that URL books 828

Americans can afford more players , but we will miss the fact that they have less time to watch . measures material rather than overall welfare . The economic activity that goes into the production of also often has negative consequences for economic welfare that go unmeasured . A leading example is pollution . power plants generate sulfur dioxide as a of the production of electricity . When sulfur dioxide gets into the atmosphere , it leads to acid rain that damages forests and buildings . This damage is not accounted for in . Emissions from automobiles contribute to the buildup of greenhouse gases in the atmosphere , contributing to global climate change . They also generate smog ( technically , particulate matter ) that is damaging to health . These adverse effects are not accounted for in . Critics sometimes argue that not only fails to measure negative effects from production but also erroneously includes measures taken to offset those measures . This criticism is misplaced . Consider the 2010 oil spill in the Gulf of Mexico . The environmental damage from that spill is not included in , which is indeed a problem with using to measure welfare . The costs of cleaning up the gulf are included in , and the inclusion of cleanup costs does make a better measure of welfare . To clean up means to produce a cleaner environment from a dirty environment , which increases economic welfare . The problem is the failure to include the original environmental damage , not the inclusion of the cleanup . Finally , real is an aggregate measure . It does not the ways in which goods and services are distributed across the many households of an economy . In comparing two economies , we may feel differently about an economy in which resources are distributed relatively equitably compared to one in which some people are very rich and others are very poor , even if overall real per person is the same . Similarly , we may feel quite differently about changes in real depending on who is reaping the benefit of those changes . In summary , real is far from a perfect measure of economic welfare , but then again it is not designed to be . It is designed to measure economic activity , and it imperfect measure of material URL books 829

. Nevertheless , when we want to understand what is happening to overall economic or get an idea of comparative welfare in various countries , we begin with real per person . For all its , it is the best single indicator that we have . Other Indicators of Societal Welfare Because real is an imperfect a measure of , we look at other statistics as well to gauge overall economic welfare . Here are some examples of economic statistics that we also use as indicators of economic welfare . Unemployment The unemployment rate is one of the most frequently cited statistics about the it is the percentage of people who are not currently employed but are actively seeking a job . It signals the difficulty households face in employment . data are reported on a quarterly basis only , but unemployment statistics are reported monthly and so contain more information than . Figure The Unemployment Rate in the United States shows the unemployment rate in the United States from 1940 to 2010 . On average , the rate of unemployment over this period was percent . The unemployment rate was at its 1940 and its 1944 . The low unemployment in 1944 was largely due to World War II ( and is an indication that low unemployment is not always a sign that all is well in an economy ) From 1995 to 2008 , the unemployment rate was never above percent , but it jumped to percent in the major recession of 2008 and by had still not fallen back below percent . Figure The ) fU Late in the ( URL books 830

' Luau , I ' I , II ' Ill ! Source . 01 ) In the United States , and measuring the unemployment rate and other labor market variables is the job of the Bureau of Labor Statistics ( Each month , about households are asked about their recent employment experience . The takes care to be sure that the sample is representative of the entire population of the United States . Notice that it is households who are interviewed , not people . So when a household is interviewed , information is acquired about all household members age 16 and over . As a consequence of the interview , individuals are placed in one of three categories ( out of the labor force , in the labor force and working , and ( in the labor force and looking for a job . Similar surveys are conducted to measure unemployment in other countries . The ( civilian ) labor force is all individuals who are either working or actively looking for work . That is , it comprises all employed and unemployed workers . Individuals who are not in the labor force are neither employed nor looking for a job . These include those at school or choosing to stay at home . Individuals in the labor force are either employed or seeking work . Employment can be temporary or even part time as long as someone has a job , he or she is counted as employed . Those who are not at work due to vacation , illness or family issues but who still have jobs are also counted as employed . The other group in the labor force is a bit more problematic what exactly does it mean to be looking for a job ?

The considers you unemployed if you do not have a job and have been seeking one during the past four weeks . Here , seeking is intended to be active ( going out for job interviews ) not passive ( reading want ads ) Individuals on temporary layoff are considered to be unemployed even if they are not URL books 831

actively looking for a new job . The does not directly ask individuals to classify themselves into one of these three categories . Instead , interviewers ask a series of questions to facilitate the . The sum of the civilian labor force and those out of the labor force equals the civilian working age population . Figure The Unemployment Rate in Argentina shows the unemployment rate in Argentina between 1993 and 2002 . Unemployment was quite high throughout this period it was in excess of 10 percent in every year from 1994 onward . In addition , the unemployment rate increased substantially in the period when real was decreasing , from percent in 1998 to almost 20 percent in 2002 . The economic distress you witnessed on the streets of Buenos Aires is in this statistic . Figure The Rate ) The unemployment rate in Argentina was about in 1993 . It increased sharply over the next two years , decreased somewhat in the mid to late , and then increased again to almost in 2002 . Source de de Argentina . Real Wages Average real tell us nothing about how is shared in an economy . They tell us how big the pie is but not who has the largest and smallest slices . Economists therefore also look at other measures that tell us about the economic environment as it is experienced by workers and households . Wages in an economy provide a sense of how workers are doing . However , the wage in dollars nominal not the best indicator . While salaries and pay scales for jobs are quoted in dollar terms , decisions on whether or not to take a job and how many hours to work at that job depend on what those dollars can buy in terms of goods and services . If all prices in the economy were to double , then 10 would buy only half as much as it used to , so a job paying 10 an hour would seem much less attractive than it did before . URL books 832

For this reason , we instead look at the real wage in the economy . As with real , real here refers to the fact that we are correcting for . It is real nominal tell us how an economy is doing . To convert nominal wages to real wages , we need a price index , and because we are looking at how much households can buy with their wages , we usually choose the Consumer Price Index ( as the index . Toolkit Section The Labor Market The real wage is the wage corrected for . To obtain the real wage , simply divide the wage in nominal the price level real wage nominal level . Figure Real and Nominal Wages shows the nominal ( hourly ) wage paid to private sector industrial workers from 1964 to 2010 . Over this period , the nominal wage rate increased almost eightfold from a low of in January 1964 to nearly by the end of the The real wage series in Figure Real and Nominal Wages shows the nominal wage divided by the ( times 100 so that the real and nominal wages are equal in the base year of the ) The nominal wage increased over this period by over times , but the real wage actually decreased at times . It peaked at near in 1973 , decreased to in 1995 , and has risen only slowly since that time . Figure and ( Wages 10 I ! In I I I . I 09 I . zom 10 I I I books 833

Source US Department , Bureau ' Statistics , av I It is a remarkable fact that , even though US real is now more than 150 percent greater than it was in the early 19705 , real wages are still significantly lower than they were at that time . What is going on here ?

Part of the story is that other forms of compensation have become increasingly over the past few decades . The most important of these are benefits . When these and other benefits are included , we find that overall compensation has increased reasonably steadily and is about 50 percent greater now than in the early . Total compensation is , in fact , a better measure than real wages . Even so , total compensation has been increasing at a far slower rate than real over the last few decades . Noneconomic Indicators of Welfare We turn finally to some noneconomic measures of societal welfare , such as statistics on health and education . Table Noneconomic Indicators of Welfare shows some examples of indicators for four countries . Large differences in per person , such as the difference between the United States and Argentina , are in these other measures . per person is about three times greater in the United States than in Argentina , and the United States also has higher adult literacy , higher secondary school enrolment , lower infant mortality , and higher life expectancy . Table Noneconomic Indicators of Welfare ( States ' iI ' per person , 2005 ( US ) Infant mortality rate , 2006 ( deaths per live births ) Life expectancy at birth , 2006 ( years ) Adult literacy rate , 2003 ( Secondary school enrollment ratio , 88 95 86 81 URL books ' 834

Differences in per person are a much less reliable guide when we compare relatively rich countries . For example , the United States has greater per person than the United Kingdom or Greece . But both of those countries have lower infant mortality rates and higher life expectancy . They also have similar rates of literacy and school enrollment . In fact , based on these measures , the United Kingdom looks like a more attractive country to live in than the United States , even though its per person is 25 percent lower . KEY TAKEAWAYS Real measures total output and thus total income in an economy , but it does not measure economic activity at home , ignores income distribution , and excludes the effects of economic activity on the environment . Measures of unemployment , real wages , and indicators of health and education are also useful indicators of economic welfare . Checking Your Understanding . If there is an increase in investment and an associated increase in real , why does this increase economic welfare ?

If there is a decrease in real wages and an offsetting increase in a , does this affect overall household income ?

If not , what effect does it have on the household sector ?

Next There have been many attempts by economists to amend the measure to take environmental issues into account . For an early discussion on this issue , see William and James , Growth Obsolete ?

Yale University , Foundation paper 398 , accessed June 28 , 2011 , Chapter 23 Jobs in the contains more discussion of the definition and measurement of the unemployment rate . URL books 835 To be more precise , in addition to being age 16 or older , the survey excludes people in an institution ( such as prison ) or in the armed forces . Average Hourly Earnings Total Private Industries from the Bureau of Labor Statistics , The Employment Situation , which is seasonally adjusted . The is the Consumer Price Index for All Urban Consumers All Items , Bureau of Labor Statistics Consumer Price Index , 1982 84 100 . More precisely , real hourly compensation in the nonfarm business sector increased by percent between 1970 and 2007 . See Labor Productivity and Costs , Bureau of Labor Statistics , accessed June 28 , 2011 , The World , Central Intelligence Agency , accessed June 28 , 2011 , The Complete World Development Report Online , World Bank , accessed June 28 , 2011 , Data . Material In Conclusion Understanding the meaning and measurement of variables is vital for your ability to evaluate the abundance of information you receive through various forms of the media about the state of the aggregate economy . The faced by the team of International Monetary Fund ( IMF ) economists with which we opened the chapter are not that different from the problems each of us faces in understanding what is happening in the economy . The concepts and variables you have discovered in this chapter are used over and over again in the various applications discussed in this book . We use the concepts of real gross domestic product ( real ) the rate , the unemployment rate , and so forth almost everywhere in our study of . URL books 836

Key Links Economic Report of the Bureau of Labor Statistics ( Unemployment ( Bureau of Economic Analysis ( BEA ) World Economic Outlook , International Monetary Fund external pubs 2011 01 World Bank EXERCISES . Which of the following variables are stocks ?

Which are flows ?

a . The number of cars parked on the street where you live . The number of cars that drive past your house every day . The number of people losing theirjobs and becoming unemployed . The blue jeans on the shelves of a GAP store . The amount of water in a reservoir . The amount of money you have on your person right now . The amount of money you spent this week . Suppose an economy produces at least as maybe every good and service this year compared to last year . Also suppose that the price of every single good and service is at least as high this year as it was last year . What , if anything , can you conclude about nominal , real , and the price level between the two years ?

Why do we exclude intermediate goods when calculating ?

Redo Table 183 Real Using 2012 as the Base Year assuming that 2013 is the base year . Suppose that Australia had nominal last year equal to trillion Australian dollars and that in the first quarter of this year , its nominal is 252 billion Australian dollars . What is Australia growth rate of nominal ?

URL books 837 10 . 11 . 12 . Suppose that , between 2012 and 2013 , a country experiences percent negative inflation ( this is known as deflation ) In other words , prices are on average percent lower in 2013 compared to 2012 . However , the economy also experiences real economic growth of percent . Is nominal in 2013 greater or less than in 2012 ?

If nominal in country A grows faster than nominal in country , what , if anything , can you conclude about the inflation rates in the two countries ?

Suppose that the price of Brazilian coffee decreases . What does that imply for the Consumer Price Index ( in Germany ?

What does that imply for the deflator in Japan ?

Is it possible for prices to be increasing and the inflation rate to be decreasing at the same time ?

Explain why or why not . Is it possible for an economy production to increase at the same time that total income in the economy decreases ?

Explain why or why not . Which of the following people are classified as unemployed ?

a . A student who also works part time in a store selling . A worker who would like a job but has given up looking because she was unable to find one . An who was recently laid off and is looking for a . A member of the military who is not currently on active duty . A woman on maternity leave from herjob . A man who is actively applying . Give three reasons why real is an imperfect measure of economic welfare . Economics Detective . URL Update Table Nominal in the United States , and Figure Nominal in the United States , using data from the Bureau of Economic Analysis ( BEA ) Using the IMF World Economic Outlook Database ( create tables to show nominal , the price deflator , and real for Argentina . A version of that takes into account environmental effects is called environmental accounting or green Use the Internet to find a discussion of this alternative way of calculating . List books 838

some of the differences between the usual way of calculating and the environmental or green accounting method . Do other countries employ these alternative measures ?

Try to find out whether people in richer countries are happier than those in poorer countries . Spreadsheet Exercise . TABLE DATA our Price ( Quantity Price ( Quantity Price ( Quantity 2012 25 12 60 25 2013 30 10 50 23 . Using the data in the preceding table , reconstruct Table Calculating Nominal to calculate nominal , Table 183 Real Using 2012 as the Base Year to calculate real , and Table Calculating the Price Index to calculate a price index and the inflation rate . URL books 839