"Data, data, data: how can I make bricks without clay?".

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1 1 Measurement As explained in the previous chapter, measurement is a key component of the scientific method and is necessary to develop and validate theories. Sherlock Holmes, one of the masters of (investigative rather than economic) theory, once said: "Data, data, data: how can I make bricks without clay?". Without measurements, macroeconomics could not be a social science, andwould be more similar to philosophy. Market transactions provide the most simple and direct measurements: through market transactions we can observe both quantities and prices. 1.1 Measurement of GDP In the United States, the official source of measurement of aggregate GDP and its components is the National Income and Product Accounts (NIPA) collected by Bureau of Economic Analysis, an agency of the U.S. Department of Commerce. Nominal GDP Y t is the dollar value of all final goods and services produced within the borders of the US in period t. There are three approaches to measurement of GDP: 1. the product (value added) approach, 2. the expenditure approach, 3. theincomeapproach. PRODUCTION (VALUE ADDED) APPROACH According to this method, nominal GDP, which we will denote as Y t, is calculated as the sum of the value added (VA) to intermediate goods and services by all the production units (public and private firms) in the economy. The value added VA(i) for a given good i is obtained from the value of all sales of good i in the economy, subtracting the costs associated to the purchase of all intermediate goods needed to produce the sales of i. VA= valueofsales-purchaseofintermediategoods Hence, we obtain Y t = IX VA(i) i=1 1

2 One important question arises: why do we sum only value added and not all sales? To avoid double counting. The value added is the correct measure of the contribution to production of a firm Example: 3 firms, A produces $100 of steel and sells to firm B, say Ford, which uses the steel to produce $300 of cars. Firm B sells to C which is a car dealer, parks the cars in ht eparking lot and sells them for $400. Total output is $100+$( )+$( )=$400. Put it differently, only $400 of cars sold by Ctohouseholdsareafinal good. EXPENDITURE APPROACH With this method, GDP is calculated as total spending on all final goods and services produced in the economy. We need to use the fundamental equation of National accounting that states that aggregate income equals aggregate expenditures, or Y t = C t + I t + G t +(E t M t ), (1) where the component of the expenditure side are: Consumption C includes durable goods (car, TV, PC, IPod), nondurable goods (food, drinks, clothing), services (nontangible items like education, health, haircuts, consulting, entertainment). A big component of services is housing. For renters, houseing expenditures are just the value of rent paid. What about for homeowners? NIPA imputes a value of rent expenditures for homeowners by looking at how much tenants of similar houses (same size, neighborhood, etc...) pay in rent. Gross investment I is the sum of non-residential fixed investments expenditures of firms on equipment (industrial machines, cars, PC s) and structures (plants) plus residential fixed investment (new houses), plus the change in their inventories. NetInvestment(gross investments minus depreciation) It NET the addition to the capital stock of the nation represent K t+1 = K t + I t DEPR t (2) = K t + It NET, 2

3 where It NET is the flow of net investments. Hence the capital stock is the quantity of housing, plants, equipment, and inventories existing in the economy at a given point in time. It is useful to develop equation (2) recursively, to show that the capital stock of a nation is the historical sum from today to its far past of all the (undepreciated) investments made, i.e. K t = I t 1 DEPR t 1 + K t 1 = I t 1 DEPR t 1 + I t 2 DEPR t 2 + K t 2 =... X = (I t j DEPR t j ) j=1 Remark 1 Note that capital is a stock, i.e. it is measured at a point in time, whereas investments (and all other expenditures) are a flow, i.e. their measurement refers to a period. Investment in 2003 means all the expenditures in investment goods from 1/1/2003 to 12/31/2003. Government spending G is the sum of all purchases of goods (e.g., pencils for employees) and services (e.g., work of policemen, firefighters, etc...) at the federal, state and local government level. Valuing goods is easy because there is a market price. But how do we value the services of the police since one cannot privately buy them? NIPA value them at cost, i.e. based on the wages paid to employees (policemen, firefighters,...). Note that G does not include transfers, such as Food Stamps or Unemployment Insurance because there is no production associated to a transfer. Example 1 A car can be private consumption, if bought by a household, investment, if bought by a firm that uses it for deliveries or even a government expenditure if purchased by a government agency. So it is not the good itself that makes it C,I or G, but rather its use. Exports E are deliveries of US goods (e.g., Ford car manufactured in Detroit and sold to France) and services (e.g., flight sold by USAIR to French citizen) to the rest of the world Imports M are purchases of foreign goods (e.g., French cheese, Prada shoes) and services (e.g., flight sold by AirFrance to a US resident) by US households. In billions of dollars, in the year 2002, the various components of aggregate expenditures were, approximately: Y =10, 000,C =7, 000,I =1, 500,G=1, 500,E =1, 000,M =1, 000 3

4 To understand where Y =10, 000 comes from, keep in mind that the population of the U.S. is roughly 290 millions and income per capita is $36,000. Remark 2 The difference of exports minus imports (E M) is called trade (or current account) balance. INCOME APPROACH According to the income approach, GDP is calculated as the sum of all types of income received by US households in a given period. These various forms of income include: Compensation of employees: wages, salaries and fringe benefits (68% of total income) Corporate profits: profit earnings of incorporated companies (12%) Proprietor s income: earnings of the self-employed (e.g., law firm, small businesses) (11%) Rental Income: rents received by house owners from their tenants (2%) Net interest: interests paid on US bank accounts (7%) Useful concepts in macroeconomics are the labor share, andthecapital share of income, computed as: labor share = labor income total income, capital share = capital income total income. Labor income is the sum of employees compensation plus a fraction of proprietor s income. Capital share is the sum of the residual fraction of proprietors income, corporate profits, net interests and rental income. The labor share of income is around 70% of total income, the capital share around 30%. The sum of these five components gives National Income (NI). How do we get from NI back to GDP? Below, we explain the necessary steps. NI + Sales Taxes = Net National Product (NNP) NNP + Capital Depreciation = Gross National Product (GNP) GNP- U.S. Income earned Abroad + U.S. Income paid Abroad = Gross Domestic Product (GDP) 4

5 There are some American citizens who live abroad whose income contributes to National Product but not to Domestic Product, and some foreigners that have earnings in the U.S. whose income is part of domestic income but not National Income. Similarly for firms: there are US companies abroad and foreign companies in the US. So GNP is the sum of all income paid to Americans, while GDP is the sum of all income paid (and goods/services produced) in America. Why are these three approaches equivalent? Every final good that is sold and purchased in the economy (and shows up as expenditure) has to be produced, and those who participate to the production process have to be remunerated accordingly through income (salaries of workers, profits of firm s owners, rental income of plants owners, interest rate on owners of financial capital, etc...). F IGURE ON CIRCULAR F LOW GDP is a very good measure of production for all market transactions. But there are a large quantity of transactions that do not occur through markets, hence they go unmeasured. First, home-production: cleaning, washing, cooking and childrearing at home are all activities that produce a service. If they were purchased on the market, through domestic workers, babysitters, etc., would be priced and included in GDP. When they are generated at home, they escape national accounts. Since women have increased their labor force participation substantially in the last 30 years, it is possible that now homeproduction is much smaller than it used to be, but then perhaps true output growth over the past 40 years is overestimated. Some official estimates set the value of home production at 10% of current GDP. Second, the underground economy: activities ranging from hiring a domestic worker off the books to the production of illegal drugs are not captured by national accounts even though they generate output and income. 1.2 Saving-Investment Identity in Closed Economy Savings are defined as aggregate income minus private consumption, minus government consumption expenditures, summarized in the equation below. S t = Y t C t G t. (3) More precisely, within aggregate savings, we need to distinguish three sources of savings: 5

6 Households savings: S h = Y UPROF + INTD h T h + TR h C Business savings: S b = PROF T b + TR b Government savings: S g = T h + T b INTD h TR h TR b G where Y denotes GNP, UPROF denotes profits not distributed to households, INTD denotes interests paid on government debt to households, T denotes taxes, and TR denotes government transfers; moreover, the subscripts h, b, g denote respectively households, business and government. Note that the business sector is the one generating the highest amount of savings, through corporate profits. Remark 3 Household income net of taxes is called household disposable income, i.e. available for expenditures and savings. Remark 4 When the government receipts (T h + T b ) are less (more) than government outlays (INTD h + TR h + TR b + G), we call government s savings a budget deficit (surplus). Recall that the fundamental national accounting equation, in closed economy, is Y t = C t + I t + G t, (4) hence substituting (4) into (3), we arrive to a very important equation: I t = S t +(M t E t ). What does this equation mean? Let s start by assuming a closed economy, i.e. an economy without economic relations with the rest of the world (no imports and exports). In every period t (e.g., year), aggregate savings equal aggregate investments. All income which is not consumed by private households or the government is saved, and savings are used to finance national investments. In an open economy, there is an additional way to finance investments, if I t >S t and the nation does not have enough saving: get the funds from the rest of the world. In this case, like the US are doing currently, the country runs a current account deficit. 1.3 The Balance Sheet of Households Just like firms, households have their own balance sheets including assets and liabilities. The Table below looks at them in detail. 6

7 ASSETS 50, 000 LIABILITIES 8, 000 Real Estate 15, 000 Mortgages 5, 500 Financial Wealth 35, 000 Credit Cards Debts 1, 500 Deposits 5, 000 Other loans 1, 000 Bonds 2, 500 Equities 18, 500 Pension Funds 9, 000 Billion of 2002 $ An interesting point to make, in relationship to the discussion on savings above is on the classification of capital gains and losses, defined as the change in the market value of assets and liabilities, e.g. appreciation of owned home residence, decline in the value of the owned stocks, etc.. Capital gains (and windfall gains from lotteries) made by households are counted as increases in assets rather than savings, and as such they show up in the balance sheet of households, not in the NIPA. Note instead that capital gains made by firms, such as gains realized in the firms financial portfolio are counted as corporate profits, thus are recorded in the NIPA. Some economists argue that households capital gains an losses should be counted as income, since they are perceived as such and in fact they tend to affect saving behavior: in times of large capital gains like the 1990 s, households decrease their savings. 1.4 Real GDP as a measure of living standards Nominal GDP changes between year t and year t +1 because different amounts of goods and services are produced between the two years, and because such goods and services are sold at different prices in the two years. However, standards of living are determined by the quantities of goods and services produced and consumed by households, not by the nominal value they have in the market. As a consequence, it is not very useful to compare nominal GDP across different years, since it GDP could increase or decrease only because of changes in the price level, even though quantities did not change. To make comparisons over time, it is useful to introduce the notion of real GDP Y t. Definition 1 Real GDP Y t is the sum of all final goods and services produced in an economy in period t valued at the prices of a certain base-year (or reference year) 0 Y t = IX p i0 q it i=1 7

8 For example, consider two observations for real GDP at time t and at time t +1 IX Y t = p i0 q it, Y t+1 = i=1 IX p i0 q i,t+1, i=1 and notice that prices at which the goods and services are valued are the same ones, those of the reference year. The fixed reference year for prices avoids contaminating the comparison between GDP s with changes in the price level between t and t +1. In fact,ifwecomparethetwonumbersabovetheyonlydiffer because of the change in the quantity of goods and services produced. Remark 5 If we are interested in quantities, why don t we just sum quantities and forget about prices altogether? You cannot sum 2 apples, 1 car and 3 plane tickets: what s the result? We need prices to convert all goods and services in $ and aggregate them together. The growth rate of real GDP between t and t +1is g y (t, t +1)= Y t+1 Y t = =.03 = 3% Y t 100 When the press writes: GDP increased by 1% this last quarter, usually they refer to real GDP. 1.5 Measurement of Prices There are at least two important price indexes to learn about: 1) the GDP deflator and 2) the Consumers Price Index (CPI). Price indexes describe the evolution of the price level for a given basket of goods which is somewhat representative or interesting. LetusstartfromtheGDPdeflator. Definition 2 The GDP deflator is the ratio of nominal to real GDP in a given year t P 0,t = P I i=1 p itq it P I i=1 p i0q it The GDP deflator tells us how much the price level of the basket of final goods and services produced in period t in the economy increased from the base (or reference) year 0. TheGDPdeflator is based on all goods produced in the economy, even investment goods (such as trucks, planes, oil pipes) which are not of interest to households. 8

9 When prices increase, the purchasing power of households falls. To get a fair assessment of how much it falls, we need to restrict our attention to the typical basket of goods and services purchased by the representative household. This is the role of the CPI. Definition 3 The Consumers Price Index (CPI) is CPI t = P J j=1 p itq j0 P J j=1 p i0q j0 i.e. the CPI is the ratio between the time t and the time 0 value of the typical basket of goods purchased by households at time 0. Time 0 is called the base year. ThechangeintheCPIisusedtomeasure inflation. Definition 4 The inflation rate measures the change in the CPI between time t and time t +1 π t,t+1 = CPI t+1 CPI t = CPI P J t+1 j=1 1= p i,t+1q j0 P CPI t CPI J t j=1 p 1 itq j0 The inflation rate is a very important macroeconomic indicator. The Federal Reserve Bank watches it and decides its monetary policy strategy based on the current andexpectedinflation rate; the stock market reacts to changes in inflation; many social security and welfare benefits are indexed to the CPI, through a measure of the cost of living of American families called COLA (COst of Living Adjustment). There is a difference between the definitions of the GDP deflator and the CPI. More in general, there are two types of price indexes: Laspeyres Index: P L 0,t = P i p itq i0 i p. i0q i0 This price index measures the change in the price level between 0 and t of the basket of goods produced at time 0, which is kept fixed. Paasche Index P P 0,t = P i p itq it i p. i0q it This price index measures the change in price between 0 and t of the basket of goods produced at time t. 9

10 Clearly, the CPI is a Laspeyres index, whereas the GDP deflator is a Paasche index. The difference is what basket of goods we use in our calculation. Is it best to use the same one (of the reference year), or the one at time t which changes period by period? The answer is not obvious. Suppose we choose the Laspeyres index and take the time-zero basket fixed. Suppose that there is an oil-shock (like in the 1970s) at time 0 and the price of oil skyrockets, households reduce the demand for gasoline and cars and increase the use of substitute means of transportation, like the subway. Then, at time t the actual basket of goods includes much less gasoline than at time zero. But the Laspeyres formula does not take it into account, so it will overstate inflation. It is easy to see that the Paasche tends to understate inflation instead, because it gives a small weight to gasoline (it gives it the time t share of expenditures). This problem is called substitution bias, because the origin of the lack of precision is the fact that firms and households substitute away fromexpensivegoodsintocheapgoodsandthecompositionofthebasketchanges. But if the limit of the Laspeyres index is that the weights q i are fixed, whereas the limit of the Paasche index is that they are variable, but they change too fast, can we use a combination of them and construct an ideal price index? This is a long-standing problem in economics: the so-called chain-weighted indexes are the price indexes that come closer to the solution. Chain-weighted indexes basically use a rolling baseyear. The BEA has recently switched from fixed-base year (Laspeyres type) indexes to chain-weighted indexes, re-issuing all the historical data in this new format. Another problem with the measurement of prices is that of quality improvements. Consider Personal Computers (PC s). The average dollar price of a PC now is the same as (maybe even lower than) ten years ago. But can we say that a typical PC produced now is the same as one produces a decade ago? Not really. An orange is always an orange, but the quality of technologically-intensive goods changes very quickly. Computers have larger hard-disks, larger memory, faster processors, better videos, and so on. In this sense, a PC is much cheaper today. This problem is called quality-bias. For example, suppose the price of a computer in 1993 and in 2003 has always been $1,000. The standard PC in 2003 has 256 MB of RAM, while in 1993 it used to have only 128 MB. This means that if we keep constant the quality of PC throughout the last decade, the price of PC has fallen by 50%! The methodology that calculates prices of baskets with constant-quality is called hedonic price technique. Finally, we have the problem due to the introduction of new goods. Consider mobile phones: they are part of the basket of goods purchased by a typical American family. But, what was the price of a mobile phone in 1950 when the good did not 10

11 exist? Notwithstanding the importance of mobile phones today, one cannot include the mobile phones in a basket of goods when comparing the price level in the US in 1950 with the price level of the same group of goods in Recently the use of chain-weighted indexes, and other techniques to minimize problems associated to quality improvements and introduction of new goods has been advocated by the Boskin Commission Report (1996). The Commission concluded that, once all the biases are properly corrected, the inflationrateintheu.s.couldhavebeen overestimated by half to one percentage point per year in the past 50 years. 11