Chapter 5

Measuring Economic Activity: GDP and

Unemployment

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 Learning Objectives
1. Explain how economists define an economy's
output.
2. Apply the production, expenditure, and income
methods for measuring GDP to analyze
economic activity.
3. Define and compute nominal GDP and real
GDP.
4. Discuss the relationship between real GDP and
economic well-being.
5. Calculate the unemployment rate and the
participation rate and discuss the costs of
unemployment.

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 Macroeconomics
• Data on output, employment, prices
– Vital signs of the economy
• Employment, unemployment, average work hours
• Stock values and trends
• Prices and inflation
– Reported often in the news
• Systematic measurement of economic output
developed during World War II
– Common systems and measures used virtually worldwide
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 Measuring Output

Gross Domestic Product (GDP) is

The market value of

Final goods and services

Produced in a country in a given

period of time

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GDP definition

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 Market Value
• Aggregate measure of quantities produced
• More expensive items receive a higher
weighting
– Willingness to pay is an indication of benefit
received from the good
Orchardia Apples Bananas Shoes
Price $0.25 $0.50 $20.00
Quantity 4 6 3
GDP contribution $1.00 $3.00 $60.00

• Orchardia's GDP is $64

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 Some Non-Market Goods Included
• Government goods and services are not sold in the
market
– These goods have value
– Increase overall output
– Quantities are known
– Prices cannot be established
• Government production is valued at cost
– Overstates GDP if there is waste and inefficiency

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 Final Goods and Services
• Final goods and services are consumed by the ultimate user
– End products of production
– Included in GDP
• Intermediate goods and services are used up in the production
of final goods
– Not included in GDP to avoid double counting
• A barber's assistant earns $2 per haircut for providing services
such as shampooing and sweeping up
– Barber charges $10 per haircut
– Haircut's contribution to GDP is $10

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 Goods Can Be Final and Intermediate
• Milk can be sold as a final product or used as an intermediate good
– Gallons of milk in the store
– Gallons of milk sold to restaurants
– Count only the final goods
• A capital good is a long-lived good used in the production of other
goods and services
– Houses, apartments, and motels
– Stoves in restaurants, cooking schools
– Delivery vehicles and taxis
• Money is not a capital good

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 Value Added
• Value added is the market value of the
product minus the cost of inputs
purchased from other firms
– Count value added in the year it is produced
– Hot'n'Fresh buys flour and other inputs to
make bread that sells for $2.00
Cost of Purchased Value
Company Revenues
Inputs Added
ABC Grain $0.50 $0.00 $0.50
General Flour $1.20 $0.50 $0.70
Hot'n'Fresh $2.00 $1.20 $0.80
Total $2.00
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 Produced in a Country in a Period of Time
• "Domestic" in GDP means the activity is measured
within a country's borders
– Nationality of owners or company is not relevant
• Value must be produced in the year considered
– Sell a 20-year-old house for $200,000
• Pay $12,000 commission
• Value added is $12,000
• House was not produced in the period of time studied
• Count income generated from the sale of used goods

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 Expenditure Method for Measuring GDP
• Four users of final goods
§ Households ■ Firms
§ Government ■ Foreigners
• All goods produced are purchased by one of these groups
in a given year
• Amount spent = market value
• GDP can be measured two ways
– Market value
– Total spending for final goods less value of imports

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 US GDP, 2019 (billions of dollars)
Consumption $14,562.7
Durable Goods $1,526.8
Non-durable Goods 2,978.1
Services 10,057.7
Investment 3,743.9
Business Fixed Investment 2,878.1
Residential 797.5
Inventory 68.3
Government Purchases 3,753.0
Net Exports – 631.9
Exports 2,504.3
Imports 3,136.1
GDP $21,427.7
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 Consumption Expenditure
• Consumption expenditure is spending by households for
goods and services
– Consumer durables are long-lived consumer goods
■ Cars ■ Furniture ■ Appliances

– Consumer non-durable goods are shorter-lived goods

■ Clothing ■ Food ■ Bedding

– Services are the largest component of consumer spending

■ Education ■ Taxi rides ■ Haircuts

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 Investment
• Investment is spending by firms on final goods and services
• Business fixed investment is purchases of new capital goods
■ Plant ■ Property ■ Equipment

• Residential investment is construction of new homes and

apartment buildings
• Inventory investment is the change in unsold goods to the
company's inventory
– These goods are produced but not yet sold
– This entry can be positive or negative

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 Economic Investment and Financial
Investment
• Financial investment
– Purchases of stocks, bonds, and other financial assets
– Purchase generally transfers ownership of a portion of the firm's
existing capital stock
– Does not correspond to any increase in physical capital or
production capacity, in most cases
• New stock issues can be an exception
• Economic investment: the increase in the capital goods
used to produce other goods
– This value is based on the purchase price of the capital goods,
not on stock value

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 Government Purchases
• Government purchases are final goods and services bought by
federal, state, and local governments
■ Fighter jets ■ Teaching ■ Office Supplies

• Excludes transfer payments

– Transfer payments are made by government, but the government
receives no current goods or services
■ Social Security ■ Food Stamps

• No purchases of final goods and services involved in transfer

payments
– Spending by recipients is included in GDP
• Excludes interest paid on government debt

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 Net Exports
• Net exports equal exports minus imports
– Exports are goods and services produced domestically and
sold abroad
• Exports reduce the amount available to the domestic economy
– Imports are purchases in the U.S. of goods and services
produced abroad
• Imports can be consumption, investment, or government spending
• Imports increase the amount available to the domestic economy

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 GDP Expenditures Equation
Terminology
Y Gross Domestic Product or output
C Consumption Expenditure
I Investment
G Government Purchases
NX Net Exports
• Expenditure approach to measuring GDP

Y = C + I + G + NX
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 GDP Example
• Total production is 1 million cars, $15,000 each
• Production value is 1 million times $15,000 =
$15 billion
Sector # Cars Purchased GDP Contribution
Consumers 700,000 $10.500 billion
Businesses
Businesses 225,000
200,000 $3.375 billion
$3.000 billion
Government 50,000 $0.750 billion
Net exports 25,000 $0.375 billion
Total
Total 1,000,000
975,000 $15.000
$14.625 billion
billion

– 25,000 cars are unsold

• Investment in inventories increases by $0.375 billion

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 Income Approach to GDP
• When a good is sold, its proceeds are distributed to workers or
business owners
• GDP = labor income + capital income
• Labor income is wages, salaries, benefits, and incomes of the self-
employed
– About ⅔ of GDP
• Capital income pays for physical capital and intangibles
• Profits for business owners • Rent for land
• Interest for bond holders • Royalties
– Measured before taxes

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The Three Faces of GDP

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Circular Flow Diagrams

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 Adjusting for Price Changes
• Compare GDP for different years to see how much
output has changed
• GDP changes over time because
– Prices change AND
– Quantity of output changes
• To see how much output has grown, use only the
changes in quantities
– Hold prices constant

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The Pizza and Calzone Economy
• GDP in 2016 is $175; GDP in 2020 is $420
– GDP in 2020 is 2.4 times the GDP in 2016
• Only twice as many pizzas and calzones
were produced in 2020
– Market value of output grew faster than the
physical volume of output
Number of Price of Number of Price of
Pizzas Pizza Calzones Calzones
2016 10 $10 15 $5
2020 20 $12 30 $6

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 Real GDP and Nominal GDP
• Real GDP values output in the current year using the
prices from the base year
– The base year is a reference year that changes infrequently
– Real GDP measures the physical volume of production
• Nominal GDP values output in the current year using
prices from the current year
– Nominal GDP is the current dollar value of production

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 Calculating Real GDP for 2020
• Use 2016 as the base year
• Nominal GDP for 2016 is $175 and for 2020, $420
• Calculate real GDP using current year quantities and
base year prices
– Real GDP in 2020 is
(20 pizzas) ($10) + (30 calzones) (5) = $350
• Real GDP doubled between 2016 and 2020

Number of Price of Number of Price of

Pizzas Pizza Calzones Calzones
2016 10 $10 15 $5
2020 20 $12 30 $6
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 Observations on Real and Nominal
GDP
• Usually, nominal and real GDP increase each year
• Nominal GDP can go up and real GDP go down
– Fewer goods and services produced AND
– Prices increase faster than output decreased
• Nominal GDP will be smaller than real GDP if the prices in the
current year are less than in the base year
– Usually true for years before the base year
• Real GDP could rise and nominal GDP fall, but this is rare
– Prices are falling faster than output is increasing

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 Real GDP and Economic Well-Being
• Real GDP is a flawed measure of well-being
– It values only market transactions
• Omits illegal transactions, volunteer work, and household
production
• Maximizing GDP will not necessarily maximize
national well-being
– Whether increases in output increase welfare is a case-by-
case issue

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 GDP Does Not Value Leisure
• Amount of leisure time has increased in the past 100
years
– Work weeks are shorter
– People enter the labor force at an older age
– People retire earlier
• Leisure produces no goods for market
– GDP places a value of zero on all leisure time
– Opportunity cost of an hour of leisure is your hourly wage
– Omission of the value of leisure time makes GDP seem smaller

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 Nonmarket Economic Activities
• GDP omits services that are not traded in markets
– Household production
– Volunteer services
• Valuing these services would be difficult
• Nonmarket activities are important in poor countries
– Self-sufficient households and bartered goods and services

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 Underground Economy
• Underground economy is all unreported transactions,
legal and illegal
• Casual labor is often paid in cash
– Failure to report transaction reduces taxes

• Some underground activity is illegal

– A service of value is provided
– Drug dealers, bookies, fences, prostitution, etc
• Estimates suggest the underground economy is large
regardless of national income level

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 Environmental Quality
• Suppose a factory is built in your town
– People are employed and output is produced
• Productive activity is included in GDP
• Suppose further that the factory creates pollution
– Your city hires a company to restore the environment to its
initial condition
– Clean-up activities are included in GDP
• Gets environment back to its starting point, not better

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 Resource Depletion
• No adjustment is made for the decline in resource
availability when mining or other harvesting is done
– One more barrel of oil on the market means one less barrel
for future use
• Environmental quality and resource depletion are
difficult to value
– They have value and that value is omitted from GDP

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 Other Quality of Life Considerations
• GDP does not account for intangibles people value
– Crime rates
– Traffic congestion
– Civic organizations
– Open space
– Sense of community

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 Poverty and Economic Inequality
• GDP does not capture the effects of income inequality
– Most would prefer living in a relatively equal society to one
with a few wealthy and many poor
• U.S. uses an absolute standard of poverty
– In 2019, a family of four was poor if their income was less
than $25,750
• Inequality matters and it is increasing in the U.S.

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 GDP as a Welfare Measure
• GDP omits and undervalues some goods and services
• GDP per capita is positively associated with several measures of well-
being
– Material standard of living: more goods and services
– Health and life expectancy
• Residents of industrialized countries fare better than residents
of developing countries in a range of health measures
– Education
• Literacy and school enrollment rates are higher in high-income
countries
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Real GDP and standard of living

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 Unemployment
• Bureau of Labor Statistics (BLS) estimates
employment and unemployment monthly
Population Age 16+

Unemployed
Out of
the
Employed
Labor
Force

• Labor force = employed + unemployed

• Unemployment rate = unemployed / labor force
• Participation rate = labor force / population 16+
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 U.S. Employment Data

U.S. Employment Data, November 2019 (in millions)

Employed 158.59 million
Unemployed 5.81 million
Labor Force 164.40 million
Not in the Labor Force 95.62 million
Working-Age Population 260.02 million
Unemployment Rate 3.5%
Participation rate 63.5%

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U.S. Unemployment Rate,
1965 - 2019

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 Costs of Unemployment
• Economic costs
– Lost wages and production
– Decreased taxes and increased transfers
• Psychological costs
– Individual self-esteem
– Family stress of decreased income and increased uncertainty
• Social costs
– Potential increases in crimes and social problems
• Social resources spent to address these

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 Duration of Unemployment
• Costs of unemployment are directly related to
the length of time a person has been
unemployed
– Unemployment spell is the period during which
an individual is continuously unemployed
– Duration of unemployment is the length of the
unemployment spell
• The unemployed population:
Duration (weeks) 5 or less 5 – 14 More than 14
% of unemployed (Apr 2011) 20% 22% 58%
% of unemployed (Nov 2019) 34% 30% 36%
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 Duration of Unemployment
• Long-term unemployed have been out of work for 6
months or longer
• Short-term unemployed have several possible outcomes
– Find a permanent job after searching a few weeks
• Economic costs are low
– Leave the labor force
– Short-term or temporary job that leads to unemployment again
• These chronically unemployed have costs similar to the long-term
unemployed

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 Other Unemployment Issues
• Discouraged workers would like to have a job but they have not looked
for work in the past four weeks because they believe they are no jobs
available
– Counted as out of the labor force
– Could be counted as unemployed but they are not
• Involuntary part-time workers are people who like to work full-time but
cannot find a full-time job
– Counted as employed
• November 2019 unemployment rate was 3.5%
– Including discouraged workers and involuntary part-time
workers would make the rate 6.9%

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 Spending, Income, and GDP
Gross Domestic
Unemployment
Product

Production Employed /
Real and
Method Costs Unemployed
Nominal
Values
Expenditure Out of Labor
Method Force
GDP and Well- Duration
Being
Income
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