Chapter One

A Word to the Wise

Measuring the Macroeconomy

Gross Domestic Product

Gross Domestic Product (or GDP for short) is the market value of all final goods and services produced within a country in a year.

That sentence is jam-packed with meaning and nuance! In the video, you'll learn what each part means.

After watching the video, try the MRU Practice Exercise: What's Included in U.S. GDP?

Open Video Transcript

Gross Domestic Product (or GDP) is the market value of all final goods and services produced within a country in a year. It was first introduced by Sir William Petty in 1691 in a book titled Verbum Sapienti, which translates from Latin as something like “A Word to the Wise”. Today, it is the central statistic used to measure economic activity.Our economic standard of living depends on what we are able to produce, so GDP is a measure of the health of our economy. It’s also a way that we can compare the economic activity of different countries or the same country across time. But this definition is jam-packed with meaning, so let’s break it down step-by-step.--First let’s talk about the market value. When economists talk about markets, we aren’t only talking about stores. We are talking about all of the ways in which buyers and sellers interact in order to make an exchange. Markets are a great way to determine the value of a good or service to society, and so we measure the value of goods and services using the market price, or the price that people actually pay for the stuff they buy. Those market prices are determined by the forces of supply and demand reaching an equilibrium, and setting the price people pay for each product. This means we can use market data to figure out how much is being added to GDP. Take cars for example. If our car company sells 12 million vehicles for an average market price of $28,000, then the total value added to GDP would be $336 billion, which is 12 million multiplied by 28,000. Here’s another example, if Netflix has 74 million subscribers all paying an average market price of $168 per year, then their annual contribution to GDP is $12.4 billion, or 74 million multiplied by 168. The goal of GDP is to figure out how much production there is in the economy, but not all production is the same. So, we want to use the market value of what is produced in order to get the best possible picture of our economy. --Next, we need to figure out what “final goods and services are”. Imagine you owned a bakery where you make cakes. In order to make a cake, you would need eggs, butter, sugar, flour, and milk. And of course, you’d have to buy those ingredients from a supplier. And then you would mix them together according to your recipe, and your time and effort has to be compensated as well. All told, this cake would cost $10, and let’s say you can sell it at that price. What counts in GDP? The key here is that we only need to count the sale of the cake to a customer for $10. That $10 purchase includes the cost of the eggs, butter, sugar, flour, and milk as well as your time and effort or the income you would earn from selling the cake. All of those things are what we call intermediate goods and services. Whereas the cake is the final good. GDP only counts the market value of final goods and services, because that’s all we actually want to count. If we counted the sale of the ingredients to the baker and the sale of the cake to a customer, we would be double counting the value of those intermediate goods. So, we leave those out. --One important thing to note is that only activity with a market value can count. So, if you decide to bake a cake for yourself that you make in your free time, then those ingredients become the final goods being consumed, and they are all that gets added to GDP. Unlike the professional baker, who is selling their products, the value of your time and effort is not added to GDP because there was no market transaction for it. The same would be true if a baker volunteers their time and effort. --We should also talk about what it means to be a good or service. Goods and services are the products we make and buy. Goods are items that are usually (but not always) tangible, such as pens, books, salt, apples, and hats. Services are activities provided by other people, who include doctors, lawn care workers, dentists, barbers, waiters, or online servers, a book, a digital videogame or a digital movie. And it doesn’t have to be either/or, most things fall somewhere on the spectrum between being a good and being a service. Taken together, it is the production, distribution, and consumption of goods and services which underpins all economic activity and trade. So that’s what counts as GDP.Most things that we produce count as goods and service, but some notable things that do not are stocks and bonds. While stocks and bonds are an important part of our economy, they do not constitute production of goods or services, and so they do not count as part of GDP. --Next, we note that only final goods and service produced within our country count as part of GDP. If you go on Amazon.com and buy some charging cables for your phone that are imported from China, the value of those cables will not count as part of our GDP, because those will be part of China’s GDP. They’re the ones that produced them. The part of the price that goes towards the services Amazon provides, and to the American delivery drivers who bring to your doorstep would still count in our GDP, but the value of goods and services imported from other countries does not count. Of course, that also means that if someone in Canada subscribes to Netflix, which is an American company producing the service, that counts in our GDP as an export, and not in the GDP of Canada. So again, it is only our own domestic production that counts in GDP. --And lastly, we have “in a year”. GDP only counts the production that happens in a calendar year, which allows us to compare the strength of the economy over time. That means any goods or services produced in previous years which are re-sold this year do not count. That includes things like houses built in prior years or used books sold at a used bookstore. Only new production counts. But remember, services count in GDP. And so, the services of real estate agent selling a house this year or of the used book store clerk would count, since they are newly produced services from this year. --Alright, that’s Gross Domestic Product. Next, we’ll learn how we can actually calculate it.

Calculating GDP

There are three standard approaches to calculating GDP:

The Production Approach adds up the value added at each stage of production:

Value Added = Value of Output - Value of Intermediate Consumption

GDP = Sum of All Value Added

The Income Approach adds up each type of income:

GDP = Wages + Interest + Rent + Profits

The Expenditure Approach adds up each component of spending:

GDP = C + I + G + X - M

Whichever way you choose, you should arrive at the same answer. Every dollar spent on domestic goods and services is a dollar earned for domestic goods and services.

Open Video Transcript

There are three approaches to calculating Gross Domestic Product, or GDP. They are the production approach, the income approach, and the expenditure approach. All three approaches should lead to the same result, though in practice there is often a little bit of error in the estimation. But each one also helps illuminate what GDP is trying to measure, and what it doesn’t measure. Let’s go through each one. --First, the production approach. Let’s use an example. Let’s think about the production of a loaf of bread. We would start with the farmer growing some wheat. Let’s say that they grow and sell $0.10 worth of wheat to a mill. The mill buys that wheat for $0.10, but them processes it into flour, adding to its value. They might be able to sell the resulting flour for $0.25, and so their value added is $0.15. A baker then buys the wheat for the $0.25, and uses it to make a loaf of bread. If they sell that bread for $0.50, then their value added is $0.25. But at the end, we get a final loaf of bread whose market value is $0.50. You can see that if we added up the value added at each stage of production, we would get the final market value, which is what we want for GDP. --The Production Approach adds together the value added by every business at every stage of production.Remember, this is just an approach to calculating GDP, which is the market value of all final goods and services produced within a country in a year. We only want to count the final goods and services, not the intermediate goods made along the way. But the production approach gets us that result in a way that might be easier to actually compute. We can use the tax returns of businesses to identify the difference between their sales and the costs of raw materials. Note, this is not the same as profit, since a lot of that difference will be going to pay the workers and other costs the businesses face to add the value they add. But by looking at the value added across all businesses in the country, we don’t have to worry about whether or not the products they make are final goods and services or intermediate ones, which can be harder to measure in practice. --The income approach is really just a twist on the production approach. The value added by each business isn’t going to disappear. It is going to end up in somebody’s pocket in the form of income. Economists like to categorize things into four factors of production: Labor, capital, land or resources, and entrepreneurship. Each one of these factors is paid by some form of income. Wages are paid to labor, interest is paid to capital – which are the tools of production like machines, software, factories, and other kinds of things like that – rent is paid to landlords and resource owners, and profits are paid to entrepreneurs or business owners. --The income approach computes GDP as the sum of all four types of income: wages + interest + rent + profits. The nice thing about this approach is that it can use the tax returns of individuals and households. For example, someone’s tax return might indicate that they made $70,000 that year working as a software engineer for General Electric, or some other company. These were their wages. They may also be earning royalties for a software program they developed which is licensed to other companies. They may also be renting out a spare room in their house on AirBnB or something, and they would be earning rent on that resource. And if they spend some of their spare time producing artwork that they sell on Etsy as part of their own business, those would be profits. Of course, most people aren’t as busy contributing to GDP as this person seems to be, but you can see how these then total up to GDP. Everything produced and sold becomes income for people, and so the total income earned in a year should be the same as the market value of all final goods and services. If it wasn’t, it means someone threw their earnings into a fire, which wouldn’t be a very good idea. --Last, we have the expenditure approach. The expenditure approach is the most commonly used approach in the U.S. It breaks GDP down into four major categories of spending. Consumption spending is all private household spending on final goods and services, like housing, utilities, food, transportation, travel, amenities, things like that. Investment spending is the spending by private businesses on capital and inventory. That’s stuff like raw materials, parts, machinery, software, and the rest. Remember, capital is the tools we use for production. And then any inventory that a company produces but doesn’t sell this year will get added into this category. Government spending comes from all levels of government – federal, state, and local – and includes only the spending on goods and services the government does. That would by stuff like spending on the military, police, building roads, maintenance on government facilities, and that sort of stuff. It does not include government transfers, which would be stuff like social security payments or stimulus checks. If the government is just sending people money, that’s a transfer, not an expenditure. And last is net exports, which his exports minus imports. And spending foreigners do on goods and services produced in the U.S. gets added to our GDP, but any spending we do on goods and services produced elsewhere gets taken out. --The Department of Commerce runs the Bureau of Economic Analysis, which uses statistical data from across many agencies like the Treasury Department, the Bureau of Labor Statistics, and all of these other sources to compute what is called the National Income and Product Accounts. These are estimates of the expenditures in each of those categories. Then, we can compute GDP as consumption (c), plus investment (i), plus government spending (g), plus exports (we use x for that), minus imports (we use m for imports). Here is the data for 2020. Household consumption spending was a little over $14 trillion. Private business spending and inventories was over $3.6 trillion. All levels of government spent over $9 trillion in 2020, but the bulk of that was those transfers like social security and stimulus payments. Only about $3.8 trillion was actually government expenditure on goods and services. We exported $2.1 trillion worth of stuff to other countries, but we imported over $2.7 trillion from other countries. So, $14 trillion plus $3.6 trillion, plus $3.8 trillion, plus $2.1 trillion, minus $2.77 trillion gets us to the total of $20.9 trillion in GDP in 2020. And that’s how we calculate GDP.

GDP per Capita

When measuring the standard of living, it is best to use GDP per Capita, or GDP per person.

GDP per Capita = GDP / Population

To measure the GDP per Capita, you take a country's GDP and divide it by the population of that country. From the 'Income Approach' to calculating GDP, we saw that GDP is equivalent to the total income earned within the country in a year. That means we can interpret GDP per Capita as the average income in that country.

Let's use GDP per Capita to compare two countries: The United Kingdom and Japan.

Source: International Monetary Fund

First, notice the units. the GDP in Japan was $5,378,136 million in 2020. If we write that out, it would be $5,378,136,000,000, which is over 5 trillion. Always be sure to watch your units when doing calculations with GDP, because the numbers are often really big!

We can see that Japan's economy was "bigger" than the UK's because their GDP is higher. But that doesn't mean people in Japan were more productive than people in the UK. According to the World Bank, the population in 2020 of the United Kingdom was 67,215,293 people, while the population of Japan was 125,836,021 people. With that, we can calculate GDP per Capita:

GDP per Capita in the UK:

$3,124,650,000,000 / 67,215,293 = $46,487.19

GDP per Capita in Japan:

$5,378,136,000,000 / 125,836,021 = $42,739.24

So, while Japan produced more overall in 2020, the United Kingdom produced more per person. For this reason, we might conclude that the standard of living was higher in the United Kingdom than it was in Japan, but we'll check in with that claim after the practice questions.

Practice Questions

1. A survey of U.S. businesses, households, and governments yields the following estimates for the economy:

Consumption Spending: $10 trillion
Investment Spending: $6 trillion
Government Spending: $4 trillion
Exports: $2 trillion
Imports: $3 trillion

What is GDP?

Reveal the Answer

We can use the Expenditure Method to calculate GDP:

GDP = C + I + G + X - M

The question lists out each component of the equation in order. So...

GDP = $10T + $6T + $4T + $2T - $3T

Note that the 'T' just represents "trillion". When we add these values together we get: GDP = $19 trillion!

2. Additional statistics reveal the following:

Income paid as interest: $5 trillion
Income paid as rent: $4 trillion
Income paid as profits: $3 trillion

Given your answer to question 1, how much income was paid as wages?

Reveal the Answer

We can use the Income Method to deduce what was paid as wages:

GDP = Wages + Interest + Rent + Profits

We know from question 1 that GDP was $19 trillion. We also know interest, rent, and profits. If we fill in those values, we can then solve for wages:

$19T = Wages + $5T + $4T + $3T

Note that the 'T' just represents "trillion". We can add up our values on the right-hand side of the equations:

$19T = Wages + $12T

Then we subtract the $12T from the left-hand side:

$19T - $12T = Wages
$7T = Wages

That means the income paid as wages was $7 trillion!

3. This same country has a population of 330 million people. What is their GDP per Capita?

Are there living standards higher or lower than a country with a GDP per Capita of $70,000?

Reveal the Answer

With a GDP of $19 trillion and a population of 330 million, we can calculate GDP per Capita as follows:

GDP per Capita = $19 trillion / 330 million
GDP per Capita = $19,000,000,000,000 / 330,000,000

GDP per Capita = $57,575.76

So, our answer to the first part of the question is that GDP per Capita is $57,575.76. But is that a higher or lower living standard than a country with a GDP per Capita of $70,000? Well, judging strictly on GDP per person, it's a lower living standard, since $57,575.75 is less than $70,000.

But as we will see, GDP isn't everything...

Problems with GDP

GDP does not measure...

The Underground Economy
Non-priced Production
Leisure
Economic "Bads"
The Distribution of Income

Other measures of the standard of living, such as the Human Development Index, attempt to capture more than just production.

Open Video Transcript

When comparing the standard of living across countries or time periods, GDP per capita is a good measure. For example, when comparing the standard of living between the United Kingdom and Japan, it would be mistake to look at their GDP alone, where Japan’s is much higher. --Per capita, which means per person, GDP is higher in the United Kingdom. But, can we really say the standard of living is higher in the United Kingdom? To get a better picture of things, let’s think about the things GDP does not measure. --When we calculate GDP, we use market data and tax returns. But those data won’t include any economic activity that is happening off the books. This is what we call the underground economy. It isn’t just illegal drugs and stolen goods, but also the large informal economy. If you pay a local kid to mow your lawn, or if you pay an older family member to babysit your younger kids, you probably aren’t reporting it to the IRS, and so it doesn’t end up being counted as part of GDP. Estimates differ, but some have found the size of the underground economy in the United States to be around $2.25 trillion per year, which is around 11 or 12% of GDP. That’s actually on the smaller side, and in developing countries the underground economy can be 60-65% of GDP that is going uncounted. Unlike some of the other issues we will discuss next, this one is really just a problem of measurement. We would count this production in GDP if we could, it’s just that people aren’t really willing to report this activity. --We can extend the idea of the underground economy to all of the production that happens but no one actually charges for it. This is production which has no price. An example is when you make yourself or your family a meal. When you go to a restaurant and pay someone to cook for you, that counts in GDP because at the end you pay the bill. But when you cook dinner yourself, no one drops a bill off for all the time and effort you contributed after the dessert. We already encountered this concept when talking about GDP. When you buy a cake from the store, you pay for the labor that went into baking that cake and that gets counted in GDP. But if you bake the cake yourself, the price of the labor is $0, and so nothing gets added to GDP. Historically, this has often meant that the contributions of women who stayed at home went uncounted in the economy, but over the past few decades, as women have entered the workforce in greater and greater numbers, that imbalance has shrunk. --Back when I was going to college, I worked part-time as a cashier at a grocery store. Sometimes, when the store was a little slow, my manager would ask if I wanted to leave an hour early. If I agreed, it meant I got to go home early and enjoy some time off, but it also meant I wasn’t going to earn any money for that hour of work. Other times I would get a call from my manager while I was at home asking if I could come in an hour early. In both cases, I was deciding between labor and leisure. If I work that extra hour, then I earned my hourly pay, which at the time was around $10 an hour. And since that income counts in GDP, working the extra hour means GDP increases by $10. On the other hand, if I decided not to work, and enjoyed my leisure time instead, GDP would stay the same, and wouldn’t go up. Leisure time is something we value, but we don’t pay for it directly. We pay for our leisure by forgoing potential income. But since the payment is the absence of production, that means the value of leisure time is not reflected in GDP. --Normally in economics we talk about goods and services, but some of our production isn’t a good, it’s a bad. Air and water pollution are examples of some of the economic "bads" that get produced by the economy. The World Health Organization estimates that air pollution kills around 4.2 million people per year. It’s definitely something that reduces our standard of living, but because there is no market transaction for pollution, no one is out there buying or selling it, it doesn’t get included in GDP. --GDP also does not tell us anything about the distribution of income in a country. Take these three countries for example: Nigeria, Honduras, and Pakistan. Each of them has a pretty similar GDP per Capita. However, in Nigeria, about 39.1% of the population lives on under $2 per day, which is considered the extreme poverty line. In Honduras, around 14.8% of the population is living on less than $2 per day. And in Pakistan, around 4.4% are living below that level. The distribution of income is very different in each of these countries, even though the average income is pretty similar. It is a lot less equal in Nigeria than it is in Pakistan. --So, is GDP per Capita really a good measure of the standard of living? Yes and no. When it comes to the United Kingdom and Japan, which have similar levels of pollution, hours spent working, and inequality, it probably does pretty well. But, because GDP per Capita doesn’t capture some of these things we just talked about, it may not always work. --The United Nations developed the Human Development Index as a way to account for some of the shortcomings of GDP per Capita. The HDI is a statistic composite index, which means it blends together different statistics in a systematic way. The HDI incorporates measures of life expectancy and health, years of schooling and literacy, as well as per capita income. The published results of the 2019 index showed Norway at the top of the list, followed by Ireland, Switzerland, and Hong Kong. The United States came in at #17. One thing to note is that the HDI doesn’t produce results drastically different from just using GDP per Capita. There are no poor countries at the top or rich countries at the bottom of the HDI. And so, while it isn’t everything, GDP per Capita does work pretty well as a measure of people’s economic standard of living.

Inflation

Prices rise and fall for all sorts of reasons. However, when prices everywhere are rising, we call it inflation.

Open Video Transcript

Inflation is a general rise in the level of prices. The price level is the average price of final goods and services produced in the economy. You can imagine an elevator where some people are jumping up and others are kneeling down. But as the elevator rises, the average distance everybody is from the ground will be increasing. The same logic applies to the price level. At any given time, some prices might be going up and others might be going down, but inflation is when that average level of prices is rising. --To get an idea of how inflation happens, let’s do a little thought experiment. Imagine that tomorrow the President or whoever comes out and says, “Everyone, I’ve decided to change our money. All of the $1 bills will now be $10 bills. Go ahead and write in the extra zero. And all the $10s will become $100s and all the $100s will become $1,000-dollar bills and so on and so forth for all the denominations and coins and everything. Now of course, we have to look out for businesses, so they will multiply all their prices by 10 as well. But they’ll also multiply all your salaries by 10” What would be the impact of this change? Well, everything at the store for 10x more expensive, but you are now earning 10x as much money. So, basically, nothing has really changed. All we did was multiply everything by 10, but what you can afford remains exactly the same. That would be an increase in the price level. Our price level is going up, but nothing else is really changing. This is the purest concept we have for inflation. Of course, in the real world, things don’t all happen at once like that. --It is important to remember though that if you see specific prices going up, that isn’t necessarily an indicator of inflation. For example, the cost of tuition to colleges across the country has been rising for many decades. But we wouldn’t necessarily call these specific price increases inflation. You can think of prices as a bunch of boats on the water. Some are bobbing up while others are bobbing down. But inflation is a tide which lifts all boats, at least eventually.

Measuring Inflation

Measuring inflation is a real challenge, and no one measure is perfect. The most common measure is the Consumer Price Index (CPI) which tracks the prices of the same basket of goods and services over time.

Open Video Transcript

Because market prices are always fluctuating, inflation can be difficult to measure. We are trying to measure an increase in the average price of things, and so that forms the foundation of our approach. --Here is an example. Let’s say that the only goods and services consumed in our economy was three apples, one apple computer, and internet services. What we could do is track the price of these things over time. For example, in the first year, the price of the apples might be $1 each, the price of the computer might be $1,500, and the price of a year’s worth of internet service could be $1,200. To compute our price level, we would take the average of these prices. So, we add them together, 1 plus 1 plus 1 plus 1500 plus 1200, and then we divide by the number of things which is 5, and that gives us an average price of $540.60. Then we would just look and see what the prices are next year. Let’s say the apples went up to $1.25 each, the computer is now $1,800, and the internet let’s say goes down in price to $1,150. Now the average price of these things is $590.75. Even though internet service is cheaper, the average price has gone up 9.3%. And so, we would say this small economy has experienced 9.3% inflation, which is pretty high.This is nice and easy for a fake economy with only five things. But for the real economy, we have millions of people all buying different things from millions of goods and services. So, how do we do it? --The most common approach, and the main approach in the U.S., is to build what we call a consumer price index. The Consumer Price Index (or CPI) tracks the prices for the basket of goods consumed by the typical urban family of four. They look at the typical things consumers in urban areas are buying, and then they compute a weighted average of all of those prices based on how big a slice they are of the budget of a typical family of four. The CPI is also indexed to a starting point, or base year. In the U.S., our CPI is indexed to the base years of 1982-1984. That means the price level over that time period is normalized to 100. So, they calculated the average prices, and let’s say it was $1,280 – this isn’t the actual number but just an example – and then they normalize this to be 100, which means they divide by the same $1,280 and then multiply by 100. So, in the end the Consumer Price Index for the base years is 100. Then, in 1985, they check the same prices again and if they found the numbers added up to $1,377.28, they would again divide by the base year number of $1,280 and multiply by 100, and so the CPI this time would be 107.6. Then they do it again in 1986, where they just normalize the values to those base years. The up side of doing things this way is that the CPI value reported is a lot easier to work with and interpret. I can tell by just looking that prices in 1987 were 13.617% higher than they were in the base years.The CPI is not without its issues though. First, we have to use the same exact basket of goods and services over time. When brand new products are introduced, there are no previous prices to compare them to. So, we have no way to tell if the price is higher or lower than it would have been last year. This leads to some bias in the calculation of inflation. One source of bias is that the CPI does not reflect how consumers substitute one good for another when prices change. The CPI might look at see that beef is getting more expensive, and so the average price of food will be going up. But consumers will probably choose to eat less beef if its price is rising, eating chicken or pork or going vegetarian instead. For this reason, the CPI might overstate inflation. Another source of bias is that the CPI cannot include brand new goods. Consider how much cheaper it has gotten over the past couple decades to take a picture of something. You used to have to buy an expensive camera and film and have the picture developed at a lab. But these days the cameras come attached to our phones and you don’t need to develop them. The CPI has no way of really measuring how that price is going down for people. So again, this means the CPI probably overstates inflation.And the last bias I’ll mention is that the CPI doesn’t account for changes in quality. Cars have gotten a lot more expensive over time, but they have also gotten a lot safer, they get better gas mileage, and they are more comfortable to drive in. The CPI only sees rising prices, it doesn’t measure that increase in quality. So, all three of these sources of bias lead economists to believe that the CPI will typically overstate inflation. --A second source of problems for the CPI is that it weights the basket of goods it tracks based on the budgets of a typical urban family of four. And so, the CPI may overstate or understate the impact inflation is having on other groups such as people living in rural or suburban areas, or people who are not living in a family of four such as single parents, young professionals, or retirees. Many different versions of the CPI have been developed which focus on these different groups. Others, like Core CPI try to strike a different balance with the basket of goods and services which is tracked. Core CPI follows the same basket as regular CPI, but omits food and energy costs. Those two categories in particular tend to have very volatile prices, and abrupt changes in them due to supply and demand factors can overwhelm the regular the CPI measure. Most economists believe that Core CPI represents a better picture of the true inflation the country is experiencing, though it still suffers from many of the same issues. Another important price index is called the Producer Price Index. This works almost the same way as the Consumer Price Index, but instead it tracks the costs of materials needed for production. The PPI is important for getting a sense of what businesses are facing when it comes to inflation. Last, we have the GDP deflator. The GDP deflator uses the whole set of goods and services produced to measure inflation. So, it tracks the change in prices of all goods and services from one year to the next, but if there are any new goods and services it will just use the new prices for that year. That means that the basket of goods is allowed to change from year to year, solving a lot of the problems faced by the CPI. For this reason, many economists prefer the GDP deflator. --You can see here these four main measures of inflation. As we would have predicted, the GDP deflator shows less inflation than the CPI, and Core CPI is a bit more stable. We can also see that the Producer Price Index is a lot more volatile than the others. Measuring inflation is a tough business, but it is a critical step in identifying which changes in the economy are real, and which ones are just due to inflation.

Real vs. Nominal GDP

Using our measures of inflation, we can calculate Real GDP, which is Nominal GDP adjusted for inflation.

Open Video Transcript

Now that we understand both GDP and inflation, it is important to tie them together. GDP is the market value of all final goods and services produced within a country in a year, and there are two ways we can get GDP to go up. We can either produce more goods and services, adding to that total, or we increase the market value of what we are already producing by increasing the price level. When we increase production, we call that economic growth, which is the key ingredient in improving our living standards. When we increase the price level we call that inflation, which means we’ve increased GDP without increasing our standard of living at all. So, it is important to separate those two effects.--We can identify what part of an increase in GDP is due to actual economic growth by calculating real GDP. Since living standards are best measured by GDP per Capita, let’s calculate that. Here is the data for GDP, or what we will now call Nominal GDP, as well as population, GDP per capita, and the CPI for the US in 1950 and the US in 2020.Nominal GDP, which is the regular value we would calculate for GDP, in 1950 was $300 billion. And in 2020, it was $21 trillion. These are the values for GDP we get using the production approach or the income approach or the expenditure approach. The population in 1950 was 152 million people, while in 2020 we had 330 million people. With these numbers, we can compute GDP per Capita. In 1950, $300 billion divided by 152 million people is $1,974 per person. In 2020, $21 trillion divided by 330 million people is $63,636. This is a big increase. Nominal GDP per Capita is over 32 times higher in 2020 than in 1950. But a lot of that difference is due to inflation, not an actual increase in living standards. In 1950, the CPI was 24.063 and in 2020 it was 258.844, which is almost 11 times bigger.What we can do is convert GDP per Capita in 1950 to 2020 dollars. Essentially, we are figuring out how much all of the goods and services produced in 1950 would sell for in 2020, therefore adjusting the value for inflation. To do this, we take GDP per Capita in 1950, which was $1,974 and we multiply it by the ratio of the CPIs in our two years. 258.844 goes on top because that is our destination year. We are adjusting to 2020 dollars. That means the 1950 CPI will go in the denominator, because it is our starting year. This gives us $21,234.18. What that means is that you would need $21,234.18 in 2020 to buy the same basket of goods and services that they were buying with $1,974 in 1950. We would call this $21,234.18 the real GDP per capita.But if you are wondering why we put things in 2020 dollars and not 1950 dollars, well, that’s an option too. If we convert GDP per capita in 2020 to 1950 dollars, this is what we get. $63,636 times the destination year CPI of 24.063 divided by the starting year CPI of 258.844 gives us a real GDP per capita of $5,915.81. That means the basket of goods you can buy with $63,636 in 2020 cost about $5,915.81 in 1950. Note that our real GDP per capita is expressing the GDP in terms of another year’s prices, allowing us to compare the actual economic growth between the two years. Whether you compare $21,234.18 to $63,636, or if you compare $5,915.81 to $1,974, you get the same ratio. Real GDP per Capita is about 3x bigger in 2020 than in 1950.--Here is an example I like to use to differentiate between real and nominal values, because we can adjust any dollar amounts for inflation the same way as GDP. Take these two movies. Gone with the Wind was released in 1939 and it made $189,523,031 in its initial theatrical run. It was a box office sensation. But, in 2015, Star Wars: The Force Awakens managed to gross $936,662,225 in its initial theatrical run, quite a bit more than Gone with the Wind. Those are the nominal values for the box office gross. But instead, we could compare their real values. First, note that in 1939 the average ticket price was around $0.94. In 2015, the average ticket price was $8.43. So, let’s divide each nominal value by its price level.--When you divide the box office grosses by the average ticket price, you get the number of tickets sold to each film. Already we can see that Gone with the Wind sold a lot more tickets than The Force Awakens. But this is analogous to real GDP. Nominal GDP is the market value of all final goods and services. But real GDP is a measure of the quantity of goods and services we are producing. It’s more like the number of tickets sold to a movie than it is like the amount of money a movie made at the box office.--And if we take the last step of multiplying by the prices in our destination year, in this case I chose 2015, we get the real value for the box office gross for Gone with the Wind using 2015 prices. This real value for Gone with the Wind is now directly comparable to the nominal value for The Force Awakens. So, while – at the time of this recording – The Force Awakens holds the domestic box office record, we can see that adjusted for inflation Gone with the Wind did better, and is indeed the highest grossing film when we do account for inflation. But if you want my advice, I’d watch Star Wars.

Rates of Change

Whether you are trying to find the Inflation Rate or the Growth Rate in GDP, rates of change are calculated the same way:

Growth Rate = (New - Old) / Old

Here is an example:

Real GDP per Capita increased from $51,730 in 2012 to $52,324 in 2013. So, our new value is the real GDP per Capita in 2013, which was $52,324. Our old value is the real GDP per Capita in 2012, which was $51,730. To find the growth rate, you plug in the numbers and solve:

(Step 1) Growth Rate = ($52,324 - $51,730)/$51,730

(Step 2) Growth Rate = $594 / $51,730

(Step 3) Growth Rate = 0.0115

Typically, we put rates of change in percentage form, which moves the decimal place over two places:

Growth Rate = 0.0115 = 1.15%

The same procedure works when calculating the inflation rate or any other rate of change.

Practice Questions

1. From 2016 to 2017, the CPI rose from 240.005 to 245.136. What was the rate of inflation between these years?

Reveal the Answer

The rate of inflation can be calculated with the equation for a rate of change:

(New - Old) / Old

Filling in our values for new and old using the CPI data for 2017 and 2016 respectively:

(245.136 - 240.005) / 240.005

= 0.0214 or 2.14%

2. The Texas Instruments TI-84 calculator had a retail price of $150 in 2005, when the CPI was 195.267. In 2020, the retail price has remained $150, but the CPI has risen to 258.844. Adjusted for inflation, how much did a 2005 TI-84 cost in 2020 dollars?

Reveal the Answer

When adjusting for inflation, you want to identify the starting year and the destination year. In this case, we are starting in 2005 and ending in 2020, because at the end we want the price to be "in 2020 dollars". To adjust for inflation, you divide by the starting year and multiply by the destination year:

$150 x (258.844 / 195.267) = $198.84

So, the nominal price of the TI-84 in 2005 was $150, but in 2020 dollars, that is equivalent to $198.84.

3. A person's income rose from $50,000 to $55,000, but at the same time the CPI rose from 100 to 120. What was the change in this person's real income?

Reveal the Answer

Nominal income rose 10% from $50,000 up to $55,000, but the price level rose 20% from 100 to 120. We can compute this person's real income by adjusting the new income back to the previous year's prices:

$55,000 x (100 / 120) = $45,833.33

We can see that even though their nominal income increased, their real income fell. The percentage change is:

($45,833.33 - $50,000) / $50,000 = -0.0833 or -8.33%

This person's real income fell by 8.33%.

4. Use the data below to calculate the growth rate in real GDP per Capita from 1987 to 1988.

Nominal GDP
1987: $ 4,855,216,000,000
1988: $ 5,236,438,000,000

Population
1987: 242,843,000
1988: 245,061,000

CPI
1987: 113.617
1988: 118.275

Reveal the Answer

Step 1: Find GDP per Capita

1987:

$4,855,216,000,000 / 242,843,000 = $19,993.23

1988:

$5,236,438,000,000 / 245,061,000 = $21,367.90

Step 2: Adjust for inflation

Converting 1988's GDP per Capita to 1987 dollars we get:

$21,367.90 x (113.617 / 118.275) = $20,526.37

Step 3: Calculate the growth rate

The growth rate in real GDP per Capita is:

($20,526.37 - $19,993.23) / $19,993.23 = 0.0267 or 2.67%

Quick Quiz

Now is the time to test yourself on these concepts! This quick quiz is a great way to see what has clicked and what needs more attention. It is also a good time to reach out to your instructor with questions.

Click on the book to open the quiz, or use this link: https://forms.gle/MGAnYLC9oVeKw3zs7

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Deeper Thoughts and Extra Practice

Dr. Goegan Explains...

Example Question
In 2020, the CPI for the nation of Bikal was 125.3. In 2021, the CPI was 144.2.

Calculate the rate of inflation between these two years.

Put your answer in percentage form (e.g. 30.51 not 0.3051) and then round to two decimal places.

Video Solution

Dr. Goegan Explains...

Example Question
The table below lists CPI figures for Tandang

Year CPI

1990 111.8

2000 150.6

2010 205.5

2020 254.8

Malcolm earned $52,000 in 1990. What would be the equivalent amount of income in 2010?

Video Solution

Dr. Goegan Explains...

Example Question
Use the chart below to calculate the growth rate in real GDP per Capita.

Nominal GDP Population CPI

Year 1 13,067,005 520 209

Year 2 16,062,881 521 236.2

Do not round until your final answer. Put your answer in percentage form (e.g. 30.57% not 0.3057) and round your final answer to two decimal places. It is possible to have a positive or negative number for your answer.

Video Solution

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