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Money as the Measuring Rod: Real versus Nominal GDP
The GDP consists of a bewildering variety of goods and services: computer chips and
potato chips, tanks and textbooks, ballet performances and rock concerts. How can we
combine all of these into a single number? To an economist, there is a natural way to
do so: First, convert every good and service into money terms, and then add all the
money up. Thus, contrary to the clich©, we can add apples and oranges. To add
10 apples and 20 oranges, first ask: How much money does each cost? If apples cost
20 cents and oranges cost 25 cents, then the apples count for $2 and the oranges for $5,
so the sum is $7 worth of “output.” The market price of each good or service is used as
an indicator of its value to society for a simple reason: Someone is willing to pay that
much money for it.
This decision raises the question of what prices to use in valuing different outputs.
The official data offer two choices. Most obviously, we can value each good and service
at the price at which it was actually sold. If we take this approach, the resulting measure
is called nominal GDP, or GDP in current dollars. This seems like a perfectly sensible
Nominal GDP is calcu-
lated by valuing all outputs choice, but it has one serious drawback as a measure of output: Nominal GDP rises when
at current prices. prices rise, even if there is no increase in actual production. For example, if hamburgers
cost $2.00 this year but cost only $1.50 last year, then 100 hamburgers will contribute $200
to this year™s nominal GDP, whereas they contributed only $150 to last year™s nominal
GDP. But 100 hamburgers are still 100 hamburgers”output has not grown.
For this reason, government statisticians have devised alternative measures that cor-
rect for inflation by valuing goods and services produced in different years at the same set
of prices. For example, if the hamburgers were valued at $1.50 each in both years, $150
worth of hamburger output would be included in GDP in each year. In practice, such cal-
culations can be quite complicated, but the details need not worry us in an introductory
course. Suffice it to say that, when the calculations are done, we obtain real GDP or GDP
Real GDP is calculated by
valuing outputs of different in constant dollars. The news media often refer to this measure as “GDP corrected for in-
years at common prices. flation.” Throughout most of this book, and certainly whenever we are discussing the
Therefore, real GDP is a far
nation™s output, we will be concerned with real GDP.
better measure than nomi-
The distinction between nominal and real GDP leads us to a working definition of a re-
nal GDP of changes in total
cession as a period in which real GDP declines. For example, between the fourth quarter of
production.
2000 and the third quarter of 2001, America™s last recession, nominal GDP rose from $9,954
billion to $10,135 billion, but real GDP fell from $9,888 billion to $9,871 billion. In fact, it
has become conventional to say that a recession occurs when real GDP declines for two or
more consecutive quarters.


What Gets Counted in GDP?
The next important aspect of the definition of GDP is that
The GDP for a particular year includes only goods and services produced within the
year. Sales of items produced in previous years are explicitly excluded.



Certain exceptions to the definition are dealt with in the appendix to Chapter 8. Some instructors may prefer to
2

take up that material here.




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Chapter 5 89
An Introduction to Macroeconomics



For example, suppose you buy a perfectly beautiful 1985 Thunderbird from a friend
next week and are overjoyed by your purchase. The national income statistician will
not share your glee. She counted that car in the GDP of 1985, when it was first pro-
duced and sold, and will never count it again. The same is true of houses. The resale
values of houses do not count in GDP because they were counted in the years they
were built.
Next, you will note from the definition of gross domestic product that
Only final goods and services count in the GDP. Final goods and services
are those that are pur-
The adjective final is the key word here. For example, when Dell buys computer chips chased by their ultimate
from Intel, the transaction is not included in the GDP because Dell does not want the users.
chips for itself. It buys them only to manufacture computers, which it sells to con-
sumers. Only the computers are considered a final product. When Dell buys chips from
Intel, economists consider the chips to be intermediate goods. The GDP excludes sales An intermediate good is
a good purchased for resale
of intermediate goods and services because, if they were included, we would wind up
or for use in producing an-
counting the same outputs several times.3 For example, if chips sold to computer manu-
other good.
facturers were included in GDP, we would count the same chip when it was sold to the
computer maker and then again as a component of the computer when it was sold to a
consumer.
Next, note that
The adjective domestic in the definition of GDP denotes production within the
geographic boundaries of the United States.
Some Americans work abroad, and many American companies have offices or factories in
foreign countries. For example, roughly half of IBM™s employees work outside the United
States. While all of these foreign employees of American firms produce valuable outputs, none
of it counts in the GDP of the United States. (It counts, instead, in the GDPs of the other coun-
tries.) On the other hand, quite a few foreign companies produce goods and services in the
United States. For example, if your family owns a Toyota or a Honda, it was most
likely assembled in a factory here. All that activity of foreign firms on our soil
does count in our GDP.4
Permission, Cartoon Features Syndicate.
SOURCE: From The Wall Street Journal”




Finally, the definition of GDP notes that
For the most part, only goods and services that pass through organized
markets count in the GDP.
This restriction, of course, excludes many economic activities. For example,
illegal activities are not included in the GDP. Thus, gambling services in
Atlantic City are part of GDP, but gambling services in Chicago are not.
Garage sales, although sometimes lucrative, are not included either. The defi-
nition reflects the statisticians™ inability to measure the value of many of the “More and more, I ask myself what™s
economy™s most important activities, such as housework, do-it-yourself re- the point of pursuing the meaning
pairs, and leisure time. These activities certainly result in currently produced of the universe if you can™t have a
goods or services, but they all lack that important measuring rod”a market rising GNP.”
price.
This omission results in certain oddities. For example, suppose that each of two
neighboring families hires the other to clean house, generously paying $1,000 per
week for the services. Each family can easily afford such generosity because it collects
an identical salary from its neighbor. Nothing real has changed, but GDP goes up by
$104,000 per year. If this example seems trivial, you may be interested to know that,


Actually, there is another way to add up the GDP by counting a portion of each intermediate transaction. This
3

is explained in the appendix to Chapter 8.
There is another concept, called gross national product, which counts the goods and services produced by all
4

Americans, regardless of where they work. For consistency, the outputs produced by foreigners working in the
United States are not included in GNP. In practice, the two measures”GDP and GNP”are very close.




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Licensed to:
Part 2
90 The Macroeconomy: Aggregate Supply and Demand



according to one estimate made some years ago, America™s GDP might be a stunning
44 percent higher if unpaid housework were valued at market prices and counted
in GDP.5


Limitations of the GDP: What GDP Is Not
Now that we have seen in some detail what the GDP is, let™s examine what it is not. In
particular:
Gross domestic product is not a measure of the nation™s economic well-being.
The GDP is not intended to measure economic well-being and does not do so for
several reasons.

Only Market Activity Is Included in GDP As we have just seen, a great deal of
work done in the home contributes to the nation™s well-being but is not counted in GDP
because it has no price tag. One important implication of this exclusion arises when we
try to compare the GDPs of developed and less developed countries. Americans are al-
ways amazed to hear that the per-capita GDPs of the poorest African countries are less
than $250 per year. Surely, no one could survive in America on $5 per week. How can
Africans do it? Part of the answer, of course, is that these people are terribly poor. But
another part of the answer is that
International GDP comparisons are vastly misleading when the two countries differ
greatly in the fraction of economic activity that each conducts in organized markets.
This fraction is relatively large in the United States and relatively small in the poorest
countries. So when we compare their respective measured GDPs, we are not comparing
the same economic activities. Many things that get counted in the U.S. GDP are not
counted in the GDPs of very poor nations because they do not pass through markets. It is
ludicrous to think that these people, impoverished as they are, survive on what an
American thinks of as $5 per week.
A second implication is that GDP statistics take no account of the so-called under-
ground economy”a term that includes not just criminal activities, but also a great deal of
legitimate business that is conducted in cash or by barter to escape the tax collector. Natu-
rally, we have no good data on the size of the underground economy. Some observers,
however, think that it may amount to 10 percent or more of U.S. GDP”and much more in
some foreign countries.

GDP Places No Value on Leisure As a country gets richer, its citizens normally take
more and more leisure time. If that is true, a better measure of national well-being that in-
cludes the value of leisure would display faster growth than conventionally measured
GDP. For example, the length of the typical workweek in the United States fell steadily for
many decades, which meant that growth in GDP systematically underestimated the growth
in national well-being. But then this trend stopped and may even have reversed. (See “Are
Americans Working More?” on the next page.)

“Bads” as Well as “Goods” Get Counted in GDP There are also reasons why the
GDP overstates how well-off we are. Here is a tragic example. Disaster struck the United
States on September 11, 2001. No one doubts that this made the nation worse off. Thousands
of people were killed. Buildings and businesses were destroyed. Yet the disaster almost cer-
tainly raised GDP. The government spent more for disaster relief and cleanup, and later for
reconstruction. Businesses spent more to rebuild and repair damaged buildings and replace
lost items. Even consumers spent more on cleanup and replacing lost possessions. No one
imagines that America was better off after 9/11, despite all this additional GDP.

Ann Chadeau, “What Is Households™ Non-Market Production Worth?” OECD Economic Studies, 18 (1992),
5

pp. 85“103.




Copyright 2009 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
Licensed to:

Chapter 5 91
An Introduction to Macroeconomics




Are Americans Working More?
According to conventional wisdom, the workweek in the United We are eating more, but we are burning up those calories
States is steadily shrinking, leaving Americans with more and more at work. We have color televisions and compact disc players, but
leisure time to enjoy. But a 1991 book by economist Juliet Schor we need them to unwind after a stressful day at the office. We
pointed out that this view was wrong: Americans were really work- take vacations, but we work so hard throughout the year that
ing longer and longer hours. Her findings were both provocative they become indispensable to our sanity.
and controversial at the time. But since then, the gap between the
typical American and European workweeks has widened.
In the last twenty years the amount of time Americans have
spent at their jobs has risen steadily. . . . Americans report that
they have only sixteen and a half hours of leisure a week, after
the obligations of job and household are taken care of. . . . If
present trends continue, by the end of the century Americans




SOURCE: © Comstock Images/Getty Images
will be spending as much time at their jobs as they did back in
the nineteen twenties.
The rise in worktime was unexpected. For nearly a hundred
years, hours had been declining. . . . Equally surprising, but also
hardly recognized, has been the deviation from Western Europe.
After progressing in tandem for nearly a century, the United
States veered off into a trajectory of declining leisure, while in
Europe work has been disappearing. . . . U.S. manufacturing
employees currently work 320 more hours [per year]”the
equivalent of over two months”than their counterparts in West SOURCE: Juliet B. Schor, The Overworked American (New York: Basic Books;
Germany or France. . . . We have paid a price for prosperity. . . . 1991), pp. 1“2, 10“11.




Wars represent an extreme example. Mobilization for a war fought on some other na-
tion™s soil normally causes a country™s GDP to rise rapidly. But men and women serving in
the military could be producing civilian output instead. Factories assigned to produce ar-
maments could instead be making cars, washing machines, and televisions. A country at
war is surely worse off than a country at peace, but this fact will not be reflected in its GDP.

Ecological Costs Are Not Netted Out of the GDP Many productive activities
of a modern industrial economy have undesirable side effects on the environment. Au-
tomobiles provide an essential means of transportation, but they also despoil the
atmosphere. Factories pollute rivers and lakes while manufacturing valuable com-
modities. Almost everything seems to produce garbage, which creates serious disposal
problems. None of these ecological costs are deducted from the GDP in an effort to give
us a truer measure of the net increase in economic welfare that our economy produces.
Is this omission foolish? Not if we remember that national income statisticians are try-
ing to measure economic activity conducted through organized markets, not national
welfare.
Now that we have defined several of the basic concepts of macroeconomics, let us
breathe some life into them by perusing the economic history of the United States.


THE ECONOMY ON A ROLLER COASTER
Growth, but with Fluctuations
The most salient fact about the U.S. economy has been its seemingly limitless growth; it

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