Worth: Mankiw Economics 5e 20|PA reduced by the additional wages it has paid. Because the higher wages raise total income, and greater spending on inventory raises total expenditure, the econ- omy s GDP rises What happens later when the firm sells the bread out of inventory? This case is much like the sale of a used good. There is spending by bread consumers, but there vestment in inventory is counted as expenditure by the firm owners. Thur ei is inventory disinvestment by the firm. This negative spending by the firm offsets th positive spending by consumers, so the sale out of inventory does not affect GL The general rule is that when a firm increases its inventory of goods, this in duction for inventory increases GDP just as much as production for final sale. A sale out of inventory, however, is a combination of positive spending(the pur- chase)and negative spending(inventory disinvestment), so it does not influence GDP. This treatment of inventories ensures that GDP reflects the economy current production of goods and services Intermediate Goods and Value Added Many goods are produced in stages raw materials are processed into intermediate goods by one firm and then sold to another firm for final processing. How should we treat such products when computing GDP? For example, suppose a cattle rancher sells one-quarter pound of meat to McDonald's for $0.50, and then McDonalds sells you a hamburger for $1.50 Should GDP include both the meat and the hamburger (a total of $2.00), or just the hamburger($1. 50)? The answer is that GDP includes only the value of final goods. Thus, the ham burger is included in GDP but the meat is not: GDP increases by $1.50, not by $2.00. The reason is that the value of intermediate goods is already included as part of the market price of the final goods in which they are used To add the intermedi- ate goods to the final goods would be double counting-that is, the meat would be ounted twice. Hence, GDP is the total value of final goods and services produced One way to compute the value of all final goods and services is to sum the value added at each stage of production. The value added of a firm equals the alue of the firms output less the value of the intermediate goods that the firm purchases. In the case of the hamburger, the value added of the rancher is $0.50 g that the rancher bought no intermediate goods), and the value added of McDonald's is $1.$0.50. or $1.00. Total value added is $0.50+$1. 00 which equals $1.50. For the economy as a whole, the sum of all value added must equal the value of all final goods and services. Hence, GDP is also the total value added of all firms in the economy. Housing Services and Other Imputations Although most goods and services are valued at their market prices when computing GDP, some are not sold in the marketplace and therefore do not have market prices. If GDP is to include the value of these goods and services, we must use an estimate of their value. Such an estimate is called an imputed value Imputations are especially important for determining the value of housing. A person who rents a house is buying housing services and providing income for the landlord; the rent is part of GDP, both as expenditure by the renter and as income for the landlord. Many people, however, live in their own homes. Although they do not pay rent to a landlord, they are enjoying housing services similar to those that User JOENA: Job EFF01418: 6264_ch02: Pg 20: 24938#/eps at 1004 I l Tue,Feb12,20028:404M
User JOEWA:Job EFF01418:6264_ch02:Pg 20:24938#/eps at 100% *24938* Tue, Feb 12, 2002 8:40 AM reduced by the additional wages it has paid. Because the higher wages raise total income, and greater spending on inventory raises total expenditure, the economy’s GDP rises. What happens later when the firm sells the bread out of inventory? This case is much like the sale of a used good.There is spending by bread consumers, but there is inventory disinvestment by the firm.This negative spending by the firm offsets the positive spending by consumers, so the sale out of inventory does not affect GDP. The general rule is that when a firm increases its inventory of goods, this investment in inventory is counted as expenditure by the firm owners.Thus, production for inventory increases GDP just as much as production for final sale.A sale out of inventory, however, is a combination of positive spending (the purchase) and negative spending (inventory disinvestment), so it does not influence GDP. This treatment of inventories ensures that GDP reflects the economy’s current production of goods and services. Intermediate Goods and Value Added Many goods are produced in stages: raw materials are processed into intermediate goods by one firm and then sold to another firm for final processing. How should we treat such products when computing GDP? For example, suppose a cattle rancher sells one-quarter pound of meat to McDonald’s for $0.50, and then McDonald’s sells you a hamburger for $1.50. Should GDP include both the meat and the hamburger (a total of $2.00), or just the hamburger ($1.50)? The answer is that GDP includes only the value of final goods.Thus, the hamburger is included in GDP but the meat is not: GDP increases by $1.50, not by $2.00.The reason is that the value of intermediate goods is already included as part of the market price of the final goods in which they are used.To add the intermediate goods to the final goods would be double counting—that is, the meat would be counted twice. Hence, GDP is the total value of final goods and services produced. One way to compute the value of all final goods and services is to sum the value added at each stage of production.The value added of a firm equals the value of the firm’s output less the value of the intermediate goods that the firm purchases. In the case of the hamburger, the value added of the rancher is $0.50 (assuming that the rancher bought no intermediate goods), and the value added of McDonald’s is $1.50 − $0.50, or $1.00. Total value added is $0.50 + $1.00, which equals $1.50. For the economy as a whole, the sum of all value added must equal the value of all final goods and services. Hence, GDP is also the total value added of all firms in the economy. Housing Services and Other Imputations Although most goods and services are valued at their market prices when computing GDP, some are not sold in the marketplace and therefore do not have market prices. If GDP is to include the value of these goods and services, we must use an estimate of their value. Such an estimate is called an imputed value. Imputations are especially important for determining the value of housing. A person who rents a house is buying housing services and providing income for the landlord; the rent is part of GDP, both as expenditure by the renter and as income for the landlord.Many people,however,live in their own homes.Although they do not pay rent to a landlord, they are enjoying housing services similar to those that 20 | PART I Introduction
Worth: Mankiw Economics 5e CHAPTER 2 The Data of Macroeconomics |21 renters purchase To take account of the housing services enjoyed by homeowners, GDP includes the"rent"that these homeowners"pay"to themselves. Of course, homeowners do not in fact pay themselves this rent. The Department of Com- merce estimates what the market rent for a house would be if it were rented and includes that imputed rent as part of GDP. This imputed rent is included both in the homeowner's expenditure and in the homeowner's income Imputations also arise in valuing government services. For example, police of ficers, firefighters, and senators provide services to the public. Giving a value to these services is difficult because they are not sold in a marketplace and therefore do not have a market price. The national income accounts include these services in gdp by valuing them at their cost. That is, the wages of these public servants are used as a measure of the value of their output In many cases, an imputation is called for in principle but, to keep things sim- ple, is not made in practice. Because GDP includes the imputed rent on owner- occupied houses, one might expect it also to include the imputed rent on cars, lawn mowers, jewelry, and other durable goods owned by households. Yet the ralue of these rental services is left out of GDP. In addition, some of the output of the economy is produced and consumed at home and never enters the mar ketplace. For example, meals cooked at home are similar to meals cooked at a restaurant, yet the value added in meals at home is left out of GDP. Finally, no imputation is made for the value of goods and services sold in the derground economy. The underground economy is the part of the economy that people hide from the government either because they wish to evade taxation or because the activity is illegal. Domestic workers paid "off the books "is one ex- ple. The illegal drug trade is another Because the imputations necessary for computing GDP are only approximate, and because the value of many goods and services is left out altogether, GDP is an imperfect measure of economic activity. These imperfections are most prob- lematic when comparing standards of living across countries. The size of the un- derground economy, for instance, varies from country to country. Yet as long as the magnitude of these imperfections remains fairly constant over time, GDP useful for comparing economic activity from year to year Real GdP Versus Nominal gdp Economists use the rules just described to compute GDP, which values the econ- omy's total output of goods and services. But is gDP a good measure of eco- nomic well-being? Consider once again the economy that produces only apples and oranges. In this economy GDp is the sum of the value of all the apples pro- duced and the value of all the oranges produced. That is GDP=(Price of Apples X Quantity of Apples) +(Price of Oranges X Quantity of Oran Notice that GDP can increase either because prices rise or because quantities rise It is easy to see that gDP computed this way is not a good gauge of eco- nomic well-being. That is, this measure does not accurately reflect how well the User JOENA: Job EFF01418: 6264_ch02: Pg 21: 24939 #/eps at 1004 Ig Tue,Feb12,20028:404M
User JOEWA:Job EFF01418:6264_ch02:Pg 21:24939#/eps at 100% *24939* Tue, Feb 12, 2002 8:40 AM renters purchase.To take account of the housing services enjoyed by homeowners, GDP includes the “rent’’ that these homeowners “pay’’ to themselves. Of course, homeowners do not in fact pay themselves this rent.The Department of Commerce estimates what the market rent for a house would be if it were rented and includes that imputed rent as part of GDP. This imputed rent is included both in the homeowner’s expenditure and in the homeowner’s income. Imputations also arise in valuing government services. For example, police of- ficers, firefighters, and senators provide services to the public. Giving a value to these services is difficult because they are not sold in a marketplace and therefore do not have a market price.The national income accounts include these services in GDP by valuing them at their cost.That is, the wages of these public servants are used as a measure of the value of their output. In many cases, an imputation is called for in principle but, to keep things simple, is not made in practice. Because GDP includes the imputed rent on owneroccupied houses, one might expect it also to include the imputed rent on cars, lawn mowers, jewelry, and other durable goods owned by households.Yet the value of these rental services is left out of GDP. In addition, some of the output of the economy is produced and consumed at home and never enters the marketplace. For example, meals cooked at home are similar to meals cooked at a restaurant, yet the value added in meals at home is left out of GDP. Finally, no imputation is made for the value of goods and services sold in the underground economy.The underground economy is the part of the economy that people hide from the government either because they wish to evade taxation or because the activity is illegal. Domestic workers paid “off the books” is one example.The illegal drug trade is another. Because the imputations necessary for computing GDP are only approximate, and because the value of many goods and services is left out altogether, GDP is an imperfect measure of economic activity.These imperfections are most problematic when comparing standards of living across countries.The size of the underground economy, for instance, varies from country to country.Yet as long as the magnitude of these imperfections remains fairly constant over time, GDP is useful for comparing economic activity from year to year. Real GDP Versus Nominal GDP Economists use the rules just described to compute GDP, which values the economy’s total output of goods and services. But is GDP a good measure of economic well-being? Consider once again the economy that produces only apples and oranges. In this economy GDP is the sum of the value of all the apples produced and the value of all the oranges produced.That is, Notice that GDP can increase either because prices rise or because quantities rise. It is easy to see that GDP computed this way is not a good gauge of economic well-being.That is, this measure does not accurately reflect how well the GDP = (Price of Apples × Quantity of Apples) + (Price of Oranges × Quantity of Oranges). CHAPTER 2 The Data of Macroeconomics | 21
Worth: Mankiw Economics 5e Conomy can satisfy the demands of households, firms, and the government. If prices doubled without any change in quantities, GDP would double. Yet it would be misleading to say that the economy's ability to satisfy demands has doubled, because the quantity of every good produced remains the same Econ- omits call the value of goods and services measured at current prices nomina GDP A better measure of economic well-being would tally the economy's output of goods and services and would not be influenced by changes in prices. For this purpose, economists use real GDP, which is the value of goods and services measured using a constant set of prices. That is, real GDP shows what would have happened to expenditure on output if quantities had changed but prices had not To see how real GDP is computed, imagine we wanted to compare output in 2002 and output in 2003 in our apple-and-orange economy We could begin by hoosing a set of prices, called base-year prices, such as the prices that prevailed in 2002. Goods and services are then added up using these base-year prices to value the different goods in both years. Real GDP for 2002 would be Real gDp=(2002 Price of Apples X 2002 Quantity of Apples) +(2002 Price of Oranges X 2002 Quantity of Oranges) Similarly, real GDP in 2003 would be Real gDp=(2002 Price of Apples X 2003 Quantity of Apples) +(2002 Price of Oranges X 2003 Quantity of Oranges) And real GDP in 2004 would be Real gdp=(2002 Price of Apples X 2004 Quantity of Apples) +(2002 Price of Oranges x 2004 Quantity of oranges) Notice that 2002 prices are used to compute real GDP for all three years. Because he prices are held constant, real GDP varies from year to year only if the quanti- ties produced vary. Because a society's ability to provide economic satisfaction for its members ultimately depends on the quantities of goods and services produced, real GDP provides a better measure of economic well-being than nominal GDP The GdP Deflator From nominal GDP and real GDp we can compute a third statistic: the gdp de fator. The GDP deflator, also called the implicit price deflator for GDP, is defined as the ratio of nominal gdp to real gDp Nominal GDP DP Deflator Real GDP The GDp deflator reflects what's happening to the overall level of prices in the economy To better understand this, consider again an economy with only one good, bread. If P is the price of bread and Q is the quantity sold, then nominal gDP is User JOENA: Job EFF01418: 6264_cho2: Pg 22: 24940#/eps at 1009 Illl Tue,Feb12,20028:404M
User JOEWA:Job EFF01418:6264_ch02:Pg 22:24940#/eps at 100% *24940* Tue, Feb 12, 2002 8:40 AM economy can satisfy the demands of households, firms, and the government. If all prices doubled without any change in quantities, GDP would double.Yet it would be misleading to say that the economy’s ability to satisfy demands has doubled, because the quantity of every good produced remains the same. Economists call the value of goods and services measured at current prices nominal GDP. A better measure of economic well-being would tally the economy’s output of goods and services and would not be influenced by changes in prices. For this purpose, economists use real GDP, which is the value of goods and services measured using a constant set of prices.That is, real GDP shows what would have happened to expenditure on output if quantities had changed but prices had not. To see how real GDP is computed, imagine we wanted to compare output in 2002 and output in 2003 in our apple-and-orange economy. We could begin by choosing a set of prices, called base-year prices, such as the prices that prevailed in 2002. Goods and services are then added up using these base-year prices to value the different goods in both years. Real GDP for 2002 would be Similarly, real GDP in 2003 would be And real GDP in 2004 would be Notice that 2002 prices are used to compute real GDP for all three years. Because the prices are held constant, real GDP varies from year to year only if the quantities produced vary. Because a society’s ability to provide economic satisfaction for its members ultimately depends on the quantities of goods and services produced, real GDP provides a better measure of economic well-being than nominal GDP. The GDP Deflator From nominal GDP and real GDP we can compute a third statistic: the GDP de- flator. The GDP deflator, also called the implicit price deflator for GDP, is defined as the ratio of nominal GDP to real GDP: GDP Deflator = . The GDP deflator reflects what’s happening to the overall level of prices in the economy. To better understand this, consider again an economy with only one good, bread. If P is the price of bread and Q is the quantity sold, then nominal GDP is Nominal GDP Real GDP Real GDP = (2002 Price of Apples × 2004 Quantity of Apples) + (2002 Price of Oranges × 2004 Quantity of Oranges). Real GDP = (2002 Price of Apples × 2003 Quantity of Apples) + (2002 Price of Oranges × 2003 Quantity of Oranges). Real GDP = (2002 Price of Apples × 2002 Quantity of Apples) + (2002 Price of Oranges × 2002 Quantity of Oranges). 22 | PART I Introduction
Worth: Mankiw Economics 5e CHAPTER 2 The Data of Macroeconomics |23 the total number of dollars spent on bread in that year, Px Q. Real GDP is the number Caves o f bread produced in that year times the price of bread in some base year, Pbase x Q. The gDp deflator is the price of bread in that year elative to the price of bread in the base year, P/pbase. The definition of the GDp deflator allows us to separate nominal GDP into two parts: one part measures quantities(real GDP)and the other measures prices (the GDP deflator). That is Nominal GDP= Real GDP X GDP Deflator Nominal GDP measures the current dollar value of the output of the economy. Real GDP measures output valued at constant prices. The gDP deflator measures the price of output relative to its price in the base year. We can also write this equation as Real GDP Nominal GDP GDP Deflator In this form, you can see how the deflator earns its name: it is used to deflate (that is, take inflation out of nominal GDP to yield real GDP Chain-Weighted Measures of Real GDP We have been discussing real gdP as if the prices used to compute this measure never change from their base-year values. If this were truly the case, over time the prices would become more and more dated. For instance, the price of com- puters has fallen substantially in recent years, while the price of a year at college has risen. When valuing the production of computers and education, it would be misleading to use the prices that prevailed ten or twenty years ago. To solve this problem, the Bureau of Economic Analysis used to update period- ically the prices used to compute real GDP. About every five years, a new base year was chosen. The prices were then held fixed and used to measure year-to-year changes in the production of goods and services until the base year was updated In 1995, the bureau announced a new policy for dealing with changes in the base year. In particular, it now emphasizes chain-wveighted measures of real GDP With these new measures, the base year changes continuously over time. In essence, average prices in 2001 and 2002 are used to measure real growth from 2001 to 2002; average prices in 2002 and 2003 are used to measure real growth from 2002 to 2003; and so on. These various year-to-year growth rates are then put together to form a"chain that can be used to compare the output of goods and services between any two dates This new chain-weighted measure of real GDP is better than the more tradi- tional measure because it ensures that the prices used to compute real GDP are never far out of date. For most purposes, however, the differences are not impor tant. It turns out that the two measures of real GDP are highly correlated with each other. The reason for this close association is that most relative prices hange slowly over time. Thus, both measures of real GDP reflect the same thing: economy-wide changes in the production of goods and services. User JOENA: Job EFF01418: 6264_ch02: Pg 23: 24941#/eps at 1004 I Tue,Feb12,20028:404M
User JOEWA:Job EFF01418:6264_ch02:Pg 23:24941#/eps at 100% *24941* Tue, Feb 12, 2002 8:40 AM the total number of dollars spent on bread in that year, P × Q. Real GDP is the number of loaves of bread produced in that year times the price of bread in some base year, Pbase × Q. The GDP deflator is the price of bread in that year relative to the price of bread in the base year, P/Pbase. The definition of the GDP deflator allows us to separate nominal GDP into two parts: one part measures quantities (real GDP) and the other measures prices (the GDP deflator). That is, Nominal GDP = Real GDP × GDP Deflator. Nominal GDP measures the current dollar value of the output of the economy. Real GDP measures output valued at constant prices.The GDP deflator measures the price of output relative to its price in the base year.We can also write this equation as Real GDP = . In this form, you can see how the deflator earns its name: it is used to deflate (that is, take inflation out of ) nominal GDP to yield real GDP. Chain-Weighted Measures of Real GDP We have been discussing real GDP as if the prices used to compute this measure never change from their base-year values. If this were truly the case, over time the prices would become more and more dated. For instance, the price of computers has fallen substantially in recent years, while the price of a year at college has risen.When valuing the production of computers and education, it would be misleading to use the prices that prevailed ten or twenty years ago. To solve this problem, the Bureau of Economic Analysis used to update periodically the prices used to compute real GDP. About every five years,a new base year was chosen. The prices were then held fixed and used to measure year-to-year changes in the production of goods and services until the base year was updated once again. In 1995, the bureau announced a new policy for dealing with changes in the base year. In particular, it now emphasizes chain-weighted measures of real GDP. With these new measures, the base year changes continuously over time. In essence, average prices in 2001 and 2002 are used to measure real growth from 2001 to 2002; average prices in 2002 and 2003 are used to measure real growth from 2002 to 2003; and so on.These various year-to-year growth rates are then put together to form a “chain” that can be used to compare the output of goods and services between any two dates. This new chain-weighted measure of real GDP is better than the more traditional measure because it ensures that the prices used to compute real GDP are never far out of date. For most purposes, however, the differences are not important. It turns out that the two measures of real GDP are highly correlated with each other. The reason for this close association is that most relative prices change slowly over time. Thus, both measures of real GDP reflect the same thing: economy-wide changes in the production of goods and services. Nominal GDP GDP Deflator CHAPTER 2 The Data of Macroeconomics | 23