Macroeconomics Principles, Applications, and Tools O'Sullivan Sheffrin Perez Eighth Edition

Macroeconomics Principles, Applications, and Tools O'Sullivan Sheffrin Perez Eighth Edition

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application 3 THE LINKS BETWEEN SELF-REPORTED HAPPINESS AND GDP APPLYING THE CONCEPTS #3: Do increases in gross domestic product necessarily translate into improvements in the welfare of citizens? Two economists, David Blanchflower of Dartmouth College and Andrew Oswald of Warwick University in the United Kingdom, have systematically analyzed surveys over a nearly 30-year period that ask individuals to describe themselves as happy, pretty happy, or not too happy. The results of their work are provocative. Over the last 30 years, reported levels of happiness have declined slightly in the United States and remained relatively flat in the United Kingdom despite very large increases in per capita income in both countries. Could it be the increased stress of everyday life has taken its toll on our happiness despite the increase in income? At any point in time, however, money does appear to buy happiness. Holding other factors constant, individuals with higher incomes do report higher levels of personal satisfaction. But these other factors are quite important. Unemployment and divorce lead to sharply lower levels of satisfaction. Blanchflower and Oswald calculate that a stable marriage is worth $100,000 per year in terms of equivalent reported satisfaction. Perhaps most interesting are their findings about trends in the relative happiness of different groups in our society. While whites report higher levels of happiness than African Americans, the gap has decreased over the last 30 years, as the happiness of African Americans has risen faster than that of whites. Men s happiness has risen relative to that of women over the last 30 years. Finally, in recent work Blanchflower and Oswald looked at how happiness varies over the life cycle. Controlling for income, education, and other personal factors, they found that in the United States, happiness among men and women reaches a minimum at the ages of 49 and 45, respectively. Since these are also the years in which earnings are usually the highest, it does suggest that work takes its toll on happiness. Related to Exercises 6.2 and 6.9. SOURCE: David Blanchflower and Andrew Oswald, Well-Being Over Time in Britain and the USA, (working paper 7847, National Bureau of Economic Research, January 2000) and Is Well-being U-Shaped over the Life Cycle, (working paper 12935, February 2007). benefits. Macroeconomists may use data based either on the production that occurs in the economy or on its flip side, the income that is generated, depending on whether they are more focused on current production or on current income. 4 A Closer Examination of Nominal and Real GDP We have discussed different ways to measure the production of an economy, looking at both who purchases goods and services and the income it generates. Of all the measures we have discussed, GDP is the one most commonly used both by the public and by economists. Let s take a closer look at it. Measuring Real versus Nominal GDP Output in the economy can increase from one year to the next. And prices can rise from one year to the next. Recall that we defined nominal GDP as GDP measured in current prices, and we defined real GDP as GDP adjusted for price changes. Now we take a closer look at how real GDP is measured in modern economies. Let s start with a simple economy in which there are only two goods cars and computers produced in the years 2011 and 2012. The data for this economy the 111

prices and quantities produced for each year are shown in Table 4. The production of cars and the production of computers increased, but the production of computers increased more rapidly. The price of cars rose, while the price of computers remained the same. TABLE 4 GDP Data for a Simple Economy Quantity Produced Price Year Cars Computers Cars Computers 2011 4 1 $10,000 $5,000 2012 5 3 12,000 5,000 Let s first calculate nominal GDP for this economy in each year. Nominal GDP is the total market value of goods and services produced in each year. Using the data in the table, we can see that nominal GDP for the year 2011 is (4 cars * +10,000) + (1 computer * +5,000) = +45,000 Similarly, nominal GDP for the year 2012 is (5 cars * +12,000) + (3 computers * +5,000) = +75,000 Now we ll find real GDP. To compute real GDP, we calculate GDP using constant prices. What prices should we use? For the moment, let s use the prices for the year 2011. Because we are using 2011 prices, real GDP and nominal GDP for 2011 are both equal to $45,000. But for 2012, they are different. In 2012, real GDP is (5 cars * +10,000) + (3 computers * +5,000) = +65,000 Note that real GDP for 2012, which is $65,000, is less than nominal GDP for 2012, which is $75,000. The reason real GDP is less than nominal GDP here is that prices of cars rose by $2,000 between 2011 and 2012, and we are measuring GDP using 2011 prices. We can measure real GDP for any other year simply by calculating GDP using constant prices. We now calculate the growth in real GDP for this economy between 2011 and 2012. Because real GDP was $45,000 in 2011 and $65,000 in 2012, real GDP grew by $20,000. In percentage terms, this is a $20,000 increase from the initial level of $45,000 or Percentage growth in real GDP = +20,000 +45,000 =.444 which equals 44.4 percent. This percentage is an average of the growth rates for both goods cars and computers. Figure 5 depicts real and nominal GDP for the United States from 1950 to 2011. Real GDP is measured in 2005 dollars, so the curves cross in 2005. Before 2005, nominal GDP is less than real GDP because prices in earlier years were lower than they were in 2005. After 2005, nominal GDP exceeds real GDP because prices in later years were higher than they were in 2005. How to Use the GDP Deflator GDP deflator An index that measures how the prices of goods and services included in GDP change over time. We can also use the data in Table 4 to measure the changes in prices for this economy of cars and computers. The basic idea is that the differences between nominal GDP and real GDP for any year arise only because of changes in prices. So by comparing real GDP and nominal GDP, we can measure the changes in prices for the economy. In practice, we do this by creating an index, called the GDP deflator, that measures how prices of goods and services change over time. Because we are calculating real GDP using year 2011 prices, we will set the value of this index equal to 100 in the 112

16,000 14,000 12,000 Billions of dollars 10,000 8,000 6,000 Real GDP 4,000 Nominal GDP 2,000 0 1950 1960 1970 1980 1990 2000 2010 Year FIGURE 5 U.S. Nominal and Real GDP, 1950 2011 This figure plots both real and nominal GDP for the United States in billions of dollars. Real GDP is measured in 2005 dollars. MyEconLab Real-time data year 2011, which we call the base year. To find the value of the GDP deflator for the year 2012 (or other years), we use the following formula: GDP Deflator = Nominal GDP Real GDP * 100 Using this formula, we find that the value of the GDP deflator for 2012 is +75,000 +65,000 * 100 = 1.15 * 100 = 115 Because the value of the GDP deflator is 115 in 2012 and was 100 in the base year of 2011, this means prices rose by 15 percent between the two years: 115-100 100 = 15 100 = 0.15 Note that this 15 percent is a weighted average of the price changes for the two goods cars and computers. Until 1996, the Commerce Department, which produces the GDP figures, used these formulas to calculate real GDP and measure changes in prices. Economists at the department chose a base year and measured real GDP by using the prices in that base year. They also calculated the GDP deflator, just as we did, by taking the ratio of nominal GDP to real GDP. Today, the Commerce Department calculates real GDP and the price index for real GDP using a more complicated method. In our example, we measured real GDP using 2011 prices. But we could have also measured real GDP using prices from 2012. If we did, we would have come up with slightly different numbers both for the increase in prices between the two years and for the increase in real GDP. To avoid this problem, the Commerce Department now uses a chain-weighted index, which is a method for calculating price changes that takes an average of price changes using base years from consecutive years (that is, 2011 and 2012 in our example). If you look online or at the data produced by the Commerce Department, you will see real GDP measured in chained dollars and a chain-type price index for GDP. chain-weighted index A method for calculating changes in prices that uses an average of base years from neighboring years. 113

5 Fluctuations in GDP recession Commonly defined as six consecutive months of declining real GDP. peak The date at which a recession starts. trough The date at which output stops falling in a recession. expansion The period after a trough in the business cycle during which the economy recovers. As we have discussed, real GDP does not always grow smoothly sometimes it collapses suddenly, and the result is an economic downturn. We call such fluctuations business cycles. Let s look at an example of a business cycle from the late 1980s and early 1990s. Figure 6 plots real GDP for the United States from 1988 to 1992. Notice that in mid-1990, real GDP begins to fall. A recession is a period when real GDP falls for six or more consecutive months. Economists talk more in terms of quarters of the year consecutive three-month periods than in terms of months. So they would say that a recession occurs when real GDP falls for two consecutive quarters. The date at which the recession starts that is, when output starts to decline is called the peak. The date at which it ends that is, when output starts to increase again is called the trough. In Figure 6, we see the peak and trough of the recession. After a trough, the economy enters a recovery period, or period of expansion. 13,500 13,400 Peak Real GDP (billions of 2005 dollars) 13,300 13,200 13,100 13,000 12,900 12,800 12,700 Trough Recovery phase 12,600 2006 2007 2008 2009 2010 Year FIGURE 6 The 2007 2009 Recession Recessions can be illustrated by peaks, troughs, and an expansion phase. The date at which the recession starts and output begins to fall is called the peak. The date at which the recession ends and output begins to rise is called the trough. The expansion phase begins after the trough. The 2007 2009 recession began in December 2007 and ended in June 2009. SOURCE: U.S. Department of Commerce. From World War II through 2010, the United States experienced 11 recessions. Table 5 contains the dates of the peaks and troughs of each recession, the percent decline in real GDP from each peak to each trough, and the length of the recessions in months. The recession from 1973 to 1975, which started as a result of a sharp rise in world oil prices, was very severe. The recession from 2007 to 2009 was perhaps the worst downturn since World War II. In the last three decades, there have been four recessions, three of them starting near the beginning of each of the decades: 1981, 1990, and 2001. In the 2001 recession, employment began to fall in March 2001, before the terrorist attack on the United States on September 11, 2001. The attack further disrupted economic activity and damaged producer and consumer confidence, and the economy tumbled through a recession. The recession that began in December 2007 followed a sharp decline in 114

TABLE 5 Eleven Postwar Recessions Peak Trough Percent Decline in Real GDP Length of Recession (months) November 1948 October 1949 1.5 11 July 1953 May 1954 3.2 10 August 1957 April 1958 3.3 8 April 1960 February 1961 1.2 10 December 1969 November 1970 1.0 11 November 1973 March 1975 4.1 16 January 1980 July 1980 2.5 6 July 1981 November 1982 3.0 16 July 1990 March 1991 1.4 8 March 2001 November 2001 0.6 8 December 2007 June 2009 4.1 18 SOURCE: National Bureau of Economic Research, Business Cycle Expansions and Contractions, http://www.dev.nber.org/cycles/cyclesmain.html. the housing sector and the financial difficulties associated with this decline. It deepened during the financial crisis that hit in September and October of 2008. As credit became less available to both businesses and consumers, the effects of the financial crisis began to show up in reduced consumer spending for durable goods such as automobiles and reduced business investment. Throughout the broader sweep of U.S. history, other downturns have occurred 20 of them from 1860 up to World War II. Not all were particularly severe, and in some unemployment hardly changed. However, some economic downturns, such as those in 1893 and 1929, were severe. Although we used the common definition of a recession as a period when real GDP falls for six months, in practice, a committee of economists at the National Bureau of Economics Research (NBER), a private research group in Cambridge, Massachusetts, of primarily academic economists, officially proclaims the beginning and end of recessions in the United States using a broader set of criteria than just GDP. The NBER s formal definition is a significant decline in economic activity, spread across the economy, lasting more than a few months, normally visible in production, employment, real income, and other indicators. As you can see, it uses a wide variety of indicators to determine whether a recession has occurred and its length. Depression is the common term for a severe recession. In the United States, the Great Depression refers to the years 1929 through 1933, the period when real GDP fell by over 33 percent. This drop in GDP created the most severe disruptions to ordinary economic life in the United States during the twentieth century. Throughout the country and in much of the world, banks closed, businesses failed, and many people lost their jobs and their life savings. Unemployment rose sharply. In 1933, over 25 percent of people who were looking for work failed to find jobs. Although the United States has not experienced a depression since that time, other countries have. In the last 20 years, several Asian countries (for example, Thailand) and Latin American countries (for example, Argentina) suffered severe economic disruptions that were true depressions. depression The common name for a severe recession. 6 GDP as a Measure of Welfare GDP is our best measure of the value of output produced by an economy. As we have seen, we can use GDP and related indicators to measure economic growth within a country. We can also use GDP to compare the value of output across countries as well. Economists use GDP and related measures to determine if an economy has fallen into a recession or has entered into a depression. But while GDP is a very valuable measure of the health of an economy, it is not a perfect measure. 115