Commonwealth of Learning Executive MBA/MPA

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C5 Economic Environment of Business

Block 2
Measures of Economic Activity

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  C5, Economic Environment of Business,Block 2 page 1 of 22

 

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Course author Farrokh Zandi, PhD
Professor, Schulich School of Business
York University
Toronto, Canada

Course designer Catherine Kerr, BEd

Principal, Bookthought Content Company
Vancouver, Canada

Copyright  Commonwealth of Learning, 2002

All rights reserved. No part of this course may be reproduced in any form by any means
without prior permission in writing from:

The Commonwealth of Learning

1285 West Broadway
Suite 600
Vancouver, BC V6H 3X8
CANADA
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e-mail: info@col.org

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Contents
1 A Tour of Block Two: Objectives and Introduction.............................................. 4
1.1 Introduction......................................................................................................... 4
1.1.1 Management and Measurement.................................................................. 4
1.2 Gross Domestic Product ..................................................................................... 5

2
1.3 Copyrights
Unemployment Rate ........................................................................................... 5
Measuring Economic Performance: Output and Income .................................... 6
2.1 GDP versus GNP ................................................................................................ 7
2.2 Practice................................................................................................................ 8
2.3 Income, Expenditure, and the Circular Flow ...................................................... 8
2.4 Value Added and Intermediate Goods................................................................ 9
2.5 Practice.............................................................................................................. 10
3 Several Measures of Income .................................................................................. 10
3.1 Potential GDP ................................................................................................... 11
3.2 Practice.............................................................................................................. 12
4 Real versus Nominal GDP...................................................................................... 12
4.1 Practice.............................................................................................................. 13
5 Price Indexes and Inflation .................................................................................... 14
5.2 The Consumer Price Index (CPI)...................................................................... 14
5.3 Implicit GDP Deflator....................................................................................... 14
5.4 Inflation Rate .................................................................................................... 15
5.5 Practice.............................................................................................................. 16
6 Unemployment Statistics ........................................................................................ 17
6.1 Problems with Unemployment Statistics .......................................................... 17
6.2 Practice.............................................................................................................. 18
7 Summary and Review............................................................................................. 19
8 Self-Test Questions.................................................................................................. 19
9 Review Problems..................................................................................................... 20
10 Answers to Review Problems............................................................................. 22

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1 A Tour of Block Two: Objectives and

Introduction
After working through Block Two of this course, you should be able to:

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1. Define Gross Domestic Product (GDP).

2. Account for the different approaches to measuring GDP.

3. Distinguish between nominal GDP and real GDP.

4. State how the unemployment rate is defined, and describe how it is determined.

5. Explain the definition and construction of the GDP deflator and the Consumer
Price Index.

1.1 Introduction
Block Two is designed to increase the accuracy and power of your economic vocabulary
by spelling out the strict meaning of economic measurement terms that you encounter
often in business reading. Exercises and learning tips help you to grasp and remember
distinctions between similar kinds of measures and indices. You will also have a chance
to reflect on certain problems of aggregation such as those which arise in the
measurement of a nation’s productivity when many of its passport holders are employed
outside its boundaries.

1.1.1 Management and Measurement

Business managers normally make decisions specific to their department or part of the
firm. These decisions usually take into account the concerns of the company as a whole
and, at times, are subject to wider industry or market conditions. But how do you describe
and measure such conditions?
In this block, we will focus on the main measures of economic activity. Fluctuations in
economic activity set the conditions within which the market, industry, and company
must operate, and these measures reflect those fluctuations. There are many measures and
indicators of overall (macroeconomic) activity such as the number of people with jobs,
the total income of persons, the output of factories, the total quantity of goods and
services produced in the economy, the unemployment rate, the consumer price index,
retail sales, housing starts, etc. Such measures are regularly reported in newspapers and

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television and radio news. At the least, well-equipped business and public sector
managers must understand these economic indicators in order to be able to make
informed business decisions. The following pages focus on the main measures of
economic activity to provide you with a working knowledge of economic indicators.

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1.2 Gross Domestic Product

GDP is the most comprehensive measure of economic activity and a broad measure of
people’s income and well-being. The growth in real GDP is hence a measure of the
growth of people's real incomes and therefore the pace of improvement in living
standards. Differences in its growth rates produce large differences in living standards

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between countries. Much of macro economics is about trying to understand the causes of
growth and the reasons for persistent differences in growth rates and income levels
between countries.
GDP can be viewed from either the demand side or the supply side. On the demand side,
it provides insight into the interaction of the various decision-making sectors of the
aggregate economy (households; business firms; government entities; and foreigners). A
competent manager recognizes that these elements constitute the market demand that a
firm faces.
The supply of goods and services requires firms to bring together the factors of
production, particularly labour and capital, and to employ the best available technology,
in order to produce output that meets demand. As a manager, you need to be aware of
these limits and any ongoing changes in them to manage your resources efficiently.
Sometimes economic growth is rapid and at other times it is slow. There are even
occasions when the economy stops growing and actually shrinks for a period. A rapidly
growing economy is one in which people enjoy rapidly rising living standards and in
which good jobs are easy to find. In a slow-growing or shrinking economy, living
standards decline and unemployment becomes a serious problem.

1.3 Unemployment Rate

The labour market performance is measured by a number of indicators including the
unemployment rate, the employment rate, and the participation rate. The unemployment
rate is the key and the most watched indicator. At times when the unemployment rate is
high, a person may take a long time to find a job. Today, the rapid pace of technological
changes and the onslaught of globalization are responsible for the widespread
displacement of workers.
Although unemployment is a permanent feature of our economic life, it sometimes
becomes an extremely serious problem. One such time was the period of high
unemployment and rapid contraction that occurred in the late 1920s and the 1930s
throughout the world known as the Great Depression, which was to a great extent the
result of the collapse of the international financial system as well as mutual adoption by
many countries in the West of high-tariff policies. In the West we also witnessed other

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periods of high unemployment and stagnation in the early 1980s and the early 1990s,
although these were less severe than earlier in the century. The economic slump of the
early1980s was primarily caused by a combination of a second oil price increase from
OPEC (the Organization of Petroleum Exporting Countries) and the anti-inflation policies

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of the central banks of the developed oil-importing nations. The slowdown of the early
1990s perpetuated itself in Japan for at least ten years with a widespread impact in Asia.
Recently, dating back to 1997, the economies of major economic powers in Asia—Korea,
China, and Indonesia—have suffered serious financial and economic crises, as have
many in Latin America and subsequently the economy of Russia as well.

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Business decisions are increasingly made in an international contextthe global
economy is becoming increasingly borderless so that macroeconomic thinking
necessarily becomes broader to consider the international trade and finance flows that
affect business. It is not enough for a manager to take into account the conditions that
affect the domestic economy. Furthermore, attempts by governments to stimulate growth
and employment have often resulted in inflation and balance of payments crises.
Even when societies do achieve growth, it is often short-lived. This is especially true in
developing countries where—for historical, sociological, and economic reasons—
governments take the central role not only in initiating stimulating economic packages
but also in implementing them. In the absence of a reliable tax system, governments of
developing countries often wind up financing their growth strategies by creating inflation.
In those nations that rely on the regular tax channels for financing their growth strategies,
the outcome is typically high foreign and domestic debts and the ensuing current account
crises. As discussed in Block One, these have prompted the governments of developed as
well as the emerging economies such as India and Indonesia, Brazil, etc. to reformulate
their economic policies around the basic principles of greater emphasis on market
mechanisms (less government intervention) and a stable macroeconomic framework..
In light of the discussion above, it is no surprise that governments have set the following
as goals of macroeconomic policy:
• sustained income growth
• low unemployment
• mild fluctuations
• price stability
• exchange rate stability
• balance of trade surplus.

2 Measuring Economic Performance:

Output and Income
The output of ‘the economy”our particular nation’s productive capacity, exclusive of
unpaid workconsists of millions of different goods. We could report how much of each
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good the economy produced: 1,400,362 computers, 1,650,562,382 metres of fibre-optic
cable, 13,220,490 bottles of beer, and so forth. Such data may he useful for some
purposes, but they do not provide us with the information we want. If next year the output
of computers falls by 10 percent, the output of cable goes down by 2 per cent, and the
output of beer rises by 3 percent, has total output gone up or down? And by how much?

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We need a single number that summarizes these outputs of the economy. But how do we
add up the computers, cable, beer, and millions of other products produced in the
economy? We do this by adding the money value of all the final goods and services
produced (those that are not used to make other goods and services) to arrive at a single
number that encapsulates the production of the economy.
The most common measures of production of the economy are Gross Domestic Product
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(GDP) and Gross National Product or income (GNP). GDP and GNP refer to production
during a particular time period, which we usually take to be a year or a quarter of a year.
They are the flow of new products during the year (or the quarter) and are measured in
dollars or the currency of the local economy.

2.1 GDP versus GNP

GDP is total income earned domestically: all economic activity that takes place within
the country. It includes income earned domestically by foreigners, but it excludes income
earned by domestic residents on foreign ground. This total value of goods produced
would also measure the total value of domestic residents’(nationals’) incomes, but only if
1. no domestic worker had a job in another country,
2. no foreigner had a job in our domestic economy
3. all machines and factories used both here and elsewhere were owned by domestic
residents or nationals (residents of a nation)
However, since some income is received from individuals owning capital equipment in
other countries, GDP is not a perfect measure of total domestic income. Thus,
statisticians also compute an alternative measure of aggregate economic activity, the
gross national product (GNP). GNP is total income earned by nationals. It includes the
income that nationals earn abroad, but it does not include the income earned within a
country by foreigners. The difference between GDP and GNP is, therefore, known as ‘net
investment income from non-residents.”
Most countries pay more attention to GDP than to GNP for measuring aggregate
economic activity. For the purpose of stabilizing employment, we are interested in a
broad measure of job-creating activity within the nation. GDP is that measure. For
evaluating trends in the standard of living of many nations, including the OECD
(Organization for Economic Cooperation and Development) nations, GNP is more
appropriate. Despite a possible gap between GDP and GNP, possibly arising from either
foreigners owning some capital equipment operating within the nation or nationals being
in debt to foreigners, we simplify by ignoring the difference between them (and focus
only on GDP) for many discussions within this course.

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There are three different ways to think about and measure GDP. Statisticians can measure
either:
1. the production of each industryagriculture, mining, manufacturing, and so on
2. the income that this production generateswages, salaries, profits, and so on

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3. the expenditure on the goods and services producedspending by households,

firms, governments, and so on.
Aggregate economic activity can be measured in terms of aggregate expenditure. To see
how GDP can measure all these things at once, we must discuss national accounting, the
accounting system used to measure GDP and many related statistics.

2.2 Practice Copyrights

If a Canadian company in Brazil employs a Canadian citizen, the income that she earns
is:
A. Part of Canadian GDP and Brazil’s GNP.
B. Part of Canadian GDP and Brazil’s GDP.
C. Part of Canadian GNP and Brazil’s GNP.
D. Part of Canadian GNP and Brazil’s GDP.
Answer: D. Since it is income by a Canadian national abroad, it is part of the Canadian
GNP. However, since she contributes via a Canadian firm (a foreign firm to
Brazil), it is also part of Brazil’s domestic production, GDP.

2.3 Income, Expenditure, and the Circular Flow

Imagine an economy that produces a single good, bread, from a single input, labour.
Figure 2-1 illustrates all the economic transactions that occur between households and
firms in this economy.
Figure 2-1: An economy producing a single good with a single input

FOREIGN SECTOR
Product
market
Sell goods Buy
goods
Firms Households
Buy Labour Sell
labour market labour

Invest in Borrow Save

capital money money
goods

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market
GOVERNMENT

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This figure illustrates the flows between firms and households in an economy that
produces one good or product, bread, from one input, labour. The inner loop represents
the flows of firms selling the bread they produce to households. The outer loop represents
the corresponding flows of dollars: households pay the firms for the bread, and the firms
pay wages and profit to the households. In this economy, GDP is both the total
expenditure on bread and the total income from the production of bread.

2.4 Copyrights
Value Added and Intermediate Goods
Several difficulties arise when output is measured. Let us explore two of them. Suppose a
farmer produces $5 worth of wheat, which he sells to a baker. The baker exerts $20 worth
of effort to turn the wheat into bread, which she sells for $25. At the end of the day, what
has been produced? The answer is just $25 worth of bread. But if we ask the farmer and
the baker to report their output for the day, the farmer says, ‘I produced $5 worth of
wheat,’ and the baker says, ‘I produced $25 worth of bread."
A statistician who naively adds these numbers might think that there has been $30 of
output in the economy. The statistician is led astray by counting the wheat, which is not a
final good but rather an intermediate good that disappears after it is used to produce the
bread. There are two ways to avoid this measurement pitfall:
1. Ask the farmer and the baker to report the value of their sales of final goods to
consumers. The baker reports $25 and the farmer reports $0, because his wheat is
not a final good.
2. Ask the farmer and the baker to report the contribution of each made to the total.
The farmer reports $5 worth of wheat, and the baker reports $20 worth of effort,
for a total value of $25 worth of output.
We call the baker's contribution to output her value added, which the baker calculates by
subtracting her costs, $5, from her revenue, $25. The baker's value added is thus $20. The
farmer's value added is $5: in our example, the farmer had no costs. When businesses
report their output to the government, they subtract their costs, so they are reporting value
added. The government then sums the value added by all businesses to arrive at GDP.

There are many examples of intermediate goodse.g., wheatwhose value should not
be double-counted when output is computed. Other examples are oil, shipping, and
advertising.
For businesses to know what to report as their contributions or value added, they have to
know how much of their costs they should subtract from their revenues. Thus, the
government must define ‘intermediate goods’ quite explicitly. Officially, an intermediate
good or service is one that is used up in the production of other goods or services during

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the same period in which it was produced. The key phrases in this definition are ‘used up’
and ‘same period.’ Let us see how these concepts clarify which goods are intermediate
and which are final.

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Learning Tip

If we simply added the value of all goods and services (both intermediate
and final) exchanged in an economy during a given period, we would
overestimate the value of GDP for two reasons:

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Some of the transactions that occur in year t represent the value of
intermediate goods. If t were 2001 and we added, for example, both the
value of a new 2001 Ford Taurus sedan and the va1ue of the Goodyear
tires Ford purchased from Goodyear in 2001, we would ‘double count’ the
value of the tires; and

Some final goods sold in 2001 were produced in a previous period and
therefore were already included in the previous period's measure of GDP
(e.g., the sale of a used 1998 Ford, used personal computer, etc.).

2.5 Practice
A farmer who grows barley and sells some for $1.00 to a miller, who turns the barley into
flour and then sells the flour to a baker for $3.00. The baker uses the flour to make bread
that he sells for $5.00 to an economist, who eats the bread. What is the value added by
each person? What is GDP?
Answer: The farmer’s value added is $1.00, as she starts from scratch. The miller’s
contribution (value added) is ($3.00 -$1.00 = $2.00). The baker’s contribution
is ($5.00 - $3.00 = $2.00). The value of GDP is the sum of the values added
($1.00 + $2.00 + $2.00 = $5.00), which is equal the value of the final product
(bread).

3 Several Measures of Income

The national accounts include other measures of income that differ slightly in definition
from GDP and GNP, and economists and the press often refer to them. You can see how
the alternative measures of income relate to one another by starting with GDP and
subtracting various quantities. First, to obtain GNP from GDP, we subtract the net
income of foreigners who own factors of production employed in Canada:

GNP = GDP - Net Income of Foreigners.

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GDP and GNP are gross measures of economic activity because of gross investment
firms' expenditure on new capital and additions to inventories. The capital stock
increases because of investment and decreases because of depreciation. The total
additions to the capital stock in a given period of time are called gross investment. The

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change in the capital stock equals gross investment minus depreciation and is called net
investment. To obtain net national product (NNP), we subtract the depreciation of capital,
i.e., the amount of the economy's stock of plants, equipment, and residential structures
that wear out during the year:

NNP = GNP - Depreciation.

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In the national accounts, depreciation is called the capital consumption allowances. Since
the depreciation of capital is a cost in producing the output of the economy, subtracting
depreciation shows the net result of economic activity. For this reason, some economists
believe that NNP is a better measure of economic well-being.
The next adjustment in the national accounts is for indirect business taxes, such as sales
taxes and subsidies. These taxes place a wedge between the price that consumers pay for
a good and the price that firms receive. Because firms never receive this tax wedge, it is
not part of their income. Once we subtract indirect business taxes from NNP, we obtain a
measure called national income:

National Income = NNP - Indirect Business Taxes.

National income is a measure of how much everyone in the economy has earned.
GDP data are, in practice, used not only as a measure of how much is being produced but
also as a measure of the welfare of the residents of a country. Economists and politicians
talk as if an increase in real GDP means that people are better off. In reality, however,
GDP data are far from perfect. Most of the difficulties of' measuring GDP arise because
some outputs do not go through the market. Examples are volunteer activities,
housework, and do-it-yourself home improvements. In the case of the government sector,
we already noted that production is valued at cost. That is because much of government
output is not sold in the market, nor is there a simple technique available that would make
it possible to estimate the value of government output. How would we measure safety
from criminals as the value of output that police expenditures are supposed to produce?

3.1 Potential GDP

You saw that GDP measures how much the economy actually produces. But the economy
is generally capable of producing more than it actually does. Another measure, potential
GDP, indicates what the economy could produce if labour and machines were fully used
up. Although it is true that actual GDP usually falls short of its potential, sometimes it
could exceed it. This happens when the rate of utilization of the labour force and that of
other factors of production exceeds their normal rates. Strong upward fluctuations are
called booms, and downwards ones are called recessions. Severe downturns are referred

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to as depressions. The last depression, called the Great Depression because of its length
and depth, began in 1929. The economy did not fully recover from it until four years
later. There is no technical definition of a boom, hut there is one of a recession; a
recession is said to have occurred when GDP falls for at least two consecutive quarters.

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The economy's fluctuations are sometimes called business cycles but the term ‘cycle’
suggests a kind of regularity that cannot be found between one downturn and the next.
Economists have seen patterns repeat often enough to have given a name to the bottom of
a recession (a trough) and the top of a boom (a peak). However, we also know that as
little as two years and as much as ten can elapse between one and the other.

3.2 Practice
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Net national product (NNP) is equal to
A. GDP minus consumption of fixed capital.
B. GNP minus consumption of fixed capital.
C. Personal disposable income plus net interest payments.
D. Personal income plus net interest payments.
Answer: B. The difference between gross and net is what is known as personal
consumption allowances or depreciation. NNP is obtained from GNP not GDP.

4 Real versus Nominal GDP

Both GDP and GNP, discussed above, are valued at market prices, the prices paid by the
final user. There is, however, one problem with using money as a measure of output: the
value of a dollar changes over time. Chocolate bars, books, movie tickets and cars cost
more today than they did ten years ago, whereas computers cost less. We use prices not
only because they are a convenient way of making comparisons but also because prices
reflect how consumers value different goods. If the price of an orange is twice that of an
apple, it means an orange is worth twice as much at the margin as an apple. Another way
of saying this is that a dollar does not buy as much as it did ten years ago. We do not
want to be misled into believing that the output is higher when in fact only the price level
has risen. To keep the comparisons of different years straight, economists adjust GDP for
changes in the average level of prices. Unadjusted GDP is known as nominal GDP ($Yt).
The term real GDP (Yt) is used for inflation-adjusted GDP figures, which are true year-
to-year measurements of what the economy actually produces. To calculate real GDP,
economists take the nominal value of GD the money value of all the goods and
services produced in the economyand divide it by a measure of the price level. Thus,
real GDP is defined by the equation:

Real GDP = Nominal GDP/ Price level

If, for instance, nominal GDP has risen 5 percent in the past year but prices have also
increased by 5 percent, then real GDP is unchanged. If nominal GDP has risen 5 percent
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in the past year but prices have increased by 6 percent, real GDP has actually decreased.

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Learning Tip

Be careful when interpreting changes in nominal GDP (or changes in the

value of a variable measured in nominal terms that is measured in current
dollars). Suppose $Yt (nominal GDP) increases by 6% in 2001 (above its
2000 level). This increase in $Yt can occur for two reasons, separately or

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combined:
1. The actual amount of final goods and services produced can increase
2. The prices of these final goods and services can increase.

Real GDP in year t (Yt) is the sum of the quantities of goods and services
produced in year t times the prices of the same goods and services in some
particular year. This ‘particular year’ is called the base year. To calculate
Yt we must first choose a base yearsay, 1997. Then real GDP in any
year is the value of that year's final goods and services measured at 1997
prices. Real GDP is also called GDP in terms of goods, GDP in constant
dollars, GDP adjusted for inflation and, in the case of our example, GDP
in 1997 dollars.

Economists focus on real GDP since it eliminates the effects of changing

prices on the measure of output. For example, if real GDP in 2001
(measured at 1997 prices) increased by 2% over the level of real GDP in
2001, we know that total output increased. When we receive information
about nominal GDP, we do not know whether nominal GDP is changing
because of changes in the amount of goods and services produced or
because of changes in prices.

4.1 Practice
Suppose nominal GDP increased by 5% in 2001 (over its previous year 2002). Given this
information, we know that:
A. The aggregate price level (i.e., the GDP deflator) increased in 2001.
B. Real GDP increases in year 2001.
C. Both the aggregate price level and real GDP rose in 2001.
D. More information is necessary to answer this question.
Answer: D. Nominal GDP is equal to real GDP multiplied by price. Therefore, it is not
clear from the available information which of the two elements of nominal
GDP is behind the 5% change, or whether perhaps both are.

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5 Price Indexes and Inflation

In macroeconomics, the price level is the average level of prices measured by a price
index. For example, in Canada, two main price indexes that are used today are the
Consumer Price Index and the GDP Deflator.

5.2 Copyrights
The Consumer Price Index (CPI)
The CPI is a measure of the price level that considers the price of a list of specific goods
and services purchased by a typical household at current prices. The nation’s statistics
agency typically starts with this ‘basket’ of purchases and calculates this year's CPI by
expressing the cost of the basket in the current year as a percentage of the cost of that
same basket in the base year. The CPI is the weighted average of price movements of
several thousands goods and services grouped into several hundred categories. More
precisely:
value of fixed basket in current prices
CPI = x 100
value of fixed basket at base year prices
where the value of the basket represents total expenditure on (or the cost of) the basket in
any period, month or year. The base year is an arbitrary year employed by the nation’s
statistics agency that, depending on the agency’s approach, its targets and its feasibility,
normally changes once every five to ten years. Until 2000, the basket of goods and
services in Canada was based on 1992 spending behaviour; therefore, 1992 represented
the base year. In 2001 the base year was changed to 1997, reflecting a new spending
behaviour.

Learning tip

Suppose the CPI in 2001 equals 107.6. This suggests that the average price
of goods and services in 2001 is 7.6% higher than the average price of the
same basket of goods and services in the base period (i.e., 1997).

5.3 Implicit GDP Deflator

Economists generally tend to prefer measures of the inflation rate that are broader than
the CPI. The broadest such measure is the implicit GDP deflator (sometimes called just
the GDP deflator for short). The GDP deflator is an average of the prices of all goods in
the economy, weighted by the quantities of those goods that are actually purchased. The
computation of the price deflator is simple. It is equal to nominal GDP (expressed in
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dollars) as a percentage of real GDP (expressed in the dollars of the base year):

Nominal GDP
GDP Deflator = x 100
Real DGP

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The deflator, then, is highly inclusive. Another main difference between the CPI and the
deflator is that the CPI is a fixed-basket index whereas the deflator is a variable-basket
index.
Expressed in terms of a time period, the GDP deflator in year t (Pt) is defined as the ratio
of nominal GDP to real GDP in year t: Pt = $Yt/Yt. The GDP deflator gives the average
price of all goods and services included in GDP.

Learning Tip
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Pt = 1 in the base year. Why? In the base year, say l997, $Y97 = Y97. In
other words, in the base year, the real and nominal value of GDP will be
the same since, when obtaining real GDP, we will use the current prices to
calculate this inflation-adjusted measure of output.
How do you interpret the size of Pt? Suppose Pt = 1.37. This suggests
that the average price of goods and services in year t is 37% higher than in
the base year.
We can rearrange the definition of Pt to illustrate why changes in nominal
GDP can occur for two reasons. Multiply both sides by Pt so that $Yt =
Pt.Yt. An increase in Pt and/or increase in Yt will cause increases in $Yt.

Learning Tip
Be aware that, while both the GDP deflator and the CPI are price indexes
and generally move together over time, there can be periods when the
change in the CPI is different from the change in the GDP deflator. This is
because:

1. The CPI includes the price of some goods NOT included in GDP and,
therefore, not taken into account in the GDP deflator (e.g., the price of
imported goods).
2. The GDP deflator includes the price of all final goods and services
produced in the economy. Some of these goods are NOT consumed by
households and, therefore, not included in the CPI (e.g., some
expenditures by the government and by firms).

Both the GDP deflator and the CPI can be used to calculate the inflation rate.

5.4 Inflation Rate

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The percent change in the price level is called the inflation rate. If the price level rises
from $20 per good to $22 per good over a period of time, the inflation rate for the period
is 10 percent. If the price level falls from $20 per good to $18 per good, the inflation rate
is -10 percent; that is, there is a 10 percent deflation. The measure of inflation most
frequently cited by the media is the CPI:

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CPIt – CPIt-1
Inflation Rate = x 100 x
CPIt-1

An alternative rate of inflation can be calculated by replacing the CPI with the
deflator.

Learning Tip
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Be careful when interpreting price indexes and the rate of inflation. If the
CPI in 2001 equals 107.6, this does NOT mean that there has been a 7.6%
ANNUAL rate of inflation between the 1997 and 2001 periods. This
number DOES indicate that the average price of the basket of goods and
services has increased 7.6% over the ENTIRE period. The inflation rate
almost always is calculated on an annual basis indicating, for example, the
percent change in the average price level from one year to the next.

5.5 Practice
1. From the data given in the table below compute Northton’s nominal and real GDP
for the current year, its CPI, and its rate of inflation from the base year.

Data from Northton

Price ($) Quantity

Item Base Current Base Current
Rubber ducks 1.00 1.25 100 100
Beach towels 9.00 6.00 12 14

Answer: Nominal GDP is equal to Price x Quantity. For the current year, it is (100 x
$1.25 + 14 x $6.00 = $209). Real GDP is (100 x $1.00 + 14 x $9.00 = $226).
The CPI is calculated by dividing the current outlay on a fixed basket by the
outlay on the same basket in the base year:

CPI = (100 x $1.25 + 12 x $6.00)/(100 x $1.00 + 12 x $9.00) = 197/208 = .947

(or 94.7 as the CPI should be multiplied by 100).

Inflation rate is [(94.7 – 100)/ 100] x 100 = 5.3%. Remember that the CPI for
the base year is, by convention, equal to 100.
2. Use the following information to
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a. calculate the rate of inflation between 1997 and 2001,
b. calculate the rate of inflation between 1998 and 1999, and
c. calculate the rate of inflation between 2000 and 2001.

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GDP Deflator
1997 100
1998 101.7
1999 102.4
2000 105

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2001 107.1

Answer: (a) 7.1%. You can do this simply by taking the difference between the base
year price index (100) and the price index in 2001 (107.1 -100) x 100). (b) This
and the next part cannot be found as readily as the first part of the question.
Inflation in 1999 is [(102.4 -101.7)/101.7] x 100 = .688%. (c) [(107.1 -
105)/105] x 100 = 2%

6 Unemployment Statistics
In most countries, unemployment data are collected by their respective statistics agencies,
which survey a representative mix of households and ask each whether a member of the
household is currently seeking employment. The unemployment rate is the ratio of the
number seeking employment to the total labour force:

Unemployment rate = Number of Unemployed x 100

Labour Force

Labour force = Number Employed + Number Unemployed

6.1 Problems with Unemployment Statistics

Some economists believe that the statistics agencies’ unemployment surveys provide too
high an estimate of the true unemployment rate. These statistics typically come from the
labour force survey conducted by the agency in charge. Based on the survey questions,
each working age individual is placed into one of three categories: employed,
unemployed and not in the labour force. The main difference between an unemployed
individual and one who is in the labour force is that the latter is deemed not actively
looking for a job. Some workers who do not have jobs may have in fact abandoned hope
of finding one. They are referred to as discouraged workers. Statistics will not count
them as unemployed, thus will provide an underestimate of the number that would choose
to work if a job were available.

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The sharp focus on the unemployment rate by economists, policy makers, and the media
is to a degree misguided. As discussed above, some of those classified as not in the
labour force are in fact discouraged workers. These workers would typically take a job if
offered it even though they are not looking for one. This is why economists sometimes

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focus on the employment rate. Employment rate is the ratio of employment to working
age (adult) population:
Number of Employed
Employment Rate = x 100
Adult Population
Finally, the fraction of the working age population that is employed or seeking
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employment is called the labour force participation rate, which is the ratio of labour
force to population. Because of discouraged workers, the labour force participation tends
to decline in recessions:
Labour Force
Participation Rate = x 100
Adult Population

Learning Tip

To be part of the labour force, an individual must either be: (1) employed;
or (2) unemployed and actively searching for a job. Unemployed
individuals who stop searching will no longer be counted as part of the
labour force. These individuals are called discouraged workers. The exit or
entry of discouraged labour workers from or into the labour force can
cause the unemployment rate to change without any change in the number
of employed workers.

The participation rate is defined as the ratio of the labour force to the
working age population. A high unemployment rate is typically associated
with a low participation rate. Why? Because a larger number of
unemployed individuals will drop out of the labour force (i.e., become
discouraged workers) when the unemployment rate is high.

6.2 Practice
1. Use the information provided below to answer the following questions.

Civilian population 30 million

Employed 15 million
Unemployed 1.5 million

(a) What is the size of the labour force?

(b) How many individuals are out of the labour force?

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(c) Calculate the unemployment rate.
Answer: (a) Labour force = employed + unemployed = 15 = 1.5 = 16.5 million. (b) 30-
15.5 = 14.5 million are out of labour force for a variety of reasons. (c) 1.5/ 16.5
= .909 or 9.09%.

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7 Summary and Review

1. GDP and GNP are the two most widely used measures of performance of an
economy.

2. GDP is the value of the final goods and services produced in the economy, by
foreign or domestic firms, during a given year.

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3. GNP is the value of final goods and services produced by that country’s nationals
regardless of their geographical location.

4. To obtain GNP, we first add to GDP receipts of factor income from the rest of the
world and then subtract from GDP payments of factor income to the rest of the
world.

5. Nominal and real GDP differ in that the former incorporates changes in the price
from the previous year, whereas the latter abstracts from it.

6. Value added a certain stage of the production of a good is defined as the value of
its product minus the value of the intermediate inputs used in the production
process.

7. National income is the sum of wages and non wage benefits, corporate profits, net
interest income, proprietor’s income, and rental income.

8. GDP deflator is defined as the ratio of nominal GDP to real GDP in a given year.

9. The consumer price index (CPI) measures the price of a given basket of goods
and services consumed by households.

10. Unemployment represents the percentage of the labour force that is not employed.

11. To be counted as unemployed, an individual must not have a job and must have
been looking for work actively.

8 Self-Test Questions
1. Define Gross Domestic Product.

2. Explain the difference between nominal GDP and real GDP.

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3. What does the unemployment rate measure? Briefly explain how it is calculated.

4. What is the GDP deflator and how is it calculated?

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5. What is the Consumer Price Index (CPI) and how is it calculated?

6. Why should we be concerned about an increase in the unemployment rate?

Briefly explain.

7. Increases in the rate of inflation can have a number of negative effects on the

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economy. Briefly explain two (2) of them.

9 Review Problems
1. Consider an imaginary economy that produces only three goods: steaks, eggs and
wine Information on the quantities and prices of each good sold for two years is
given below.
1997 2001
Output
Steak (kgs) 10 7
Eggs (dozens) 10 13
Wine (bottles) 8 11

Price
Steak (per kg) $9.10 $11.50
Eggs (per dozen) $1 .10 $ 1.30
Wine (per bottle) $6.00 $ 6.50

For this hypothetical economy, calculate each of the following:

a. Nominal GDP.
b. Real GDP in constant 1997 dollars (i.e., 1997 is the base year).
c. GDP deflator.
d. The percentage change in real GDP and the GDP deflator between 1997
and 2001.
2. On the basis of your analysis in #1, was nominal GDP in 1997 greater than, less
than or equal to real GDP in 1997? If the values for nominal and real GDP in
1997 are different, explain why this is so.
3. Suppose you are provided with the following information about an economy that
consists of just three firms.

STEEL COMPANY LOBSTER COMPANY

Revenues from sales $400 Revenues from sales $200
Expenses (wages) $340 Expenses (wages) $160
Profits

CAR COMPANY
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Revenues from sales $1000

Expenses

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Wages $500
Steel purchases $400
Profits $100

a. Using the final goods approach, what is GDP?

b. Calculate the value added for each of the three firms. Based on your

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calculations, what is GDP using the value-added approach?
What are the total wages (i.e., what is the labour income) in this economy?
What are total profits in this economy? Given your calculations and using
the incomes approach, what is GDP?
d. Compare the levels of GDP obtained in parts (a), (b) and (c). Which of
these approaches yields the highest and smallest level of GDP? Explain.
e. Based on your analysis, what percentage of GDP is allocated to: (1) labour
income; and (2) profits?

4. Suppose nominal GDP in 2000 increased by 7% (over its level in 1999). Basing
your answer on this information, what happened to the rate of inflation (as
measured by the GDP deflator) and real GDP growth between 1999 and 2000?
Explain.

5. Use the information provided below to answer the following questions.

Year Nominal GDP GDP Deflator Real GDP

(millions of dollars) (1997 = 1.0) (in millions of 1992
dollars)
1996 839,331 .989
1997 885,022 885,022
1998 .996 919,770
1999 975,059 1.009
2000 1,055,604 104.6

Source: CANSIM (Canadian Statistics), January 2002.

a. What was nominal GDP in 1998? What was the GDP deflator in 1997?
b. Using the GDP deflator (where 1997 = 1.0), calculate real GDP for the
remaining years.
c. Using your calculations in part (b), compare the levels of real GDP with
the levels of nominal GDP for each year. What does this comparison
suggest about prices in that year (relative to 1997)?
d. Explain why economists focus on real rather than nominal GDP when
analysing the level of economic activity.

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10 Answers to Review Problems

1. a. Nominal GDP in 1997 ($Y) = $9.10 x 10 + $1.10 x 10 + $6 (8) = $150
In 2001: $Y = $11.50 (7) + $1.30 (13) + $6.50 (11) = $168.90

b. Real GDP in constant 1997 dollars: Y = $9.10 (7) + $1.1 (13) + $6 (11) = $144.

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GDP deflator in 1997 = base year = 1 by definition.
GDP deflator in 2001 = $Y/Y = $168.9 = 1.17
$144

d. % change in Y = −4%. % change in the deflator is 17%.

2. Nominal GDP and real GDP in 1997 are the same since we use the same prices to
calculate both figures (base year).

3. a. The final product of steel is 0 since steel is not a final good. The final product
of the lobster company is $200, and the final product of the car company is
$1000. GDP = $200 + $1000 = $1200.

b. Value added for steel is $400. Value added for the lobster company is $200.
Value added for the car company is $1000 = $400 = $600. GDP = $400 + $200
+ $600 = $1200

c. Total wages are $1000. Total profits are $200. GDP is $1000 + $200 = $1200.

d. All three approaches to GDP yield the same value.

e. Labour share is 83%, profit’s share is 17%.

4. Without more information, we can say nothing about inflation rate and real GDP.
Nominal GDP can change because of changes of either one or both.

5. a. $Y (1998) = $91609.92 million (919,770 X .996)

The deflator is = 1

b. Y (1996) = $839,331 million, Y(1999) = $966,361.74, in 2000 (Y=$1,009,181)

c. Where the deflator is less than 1 (prior to 1997), real GDP is greater than
nominal GDP. Where it is greater than 1 (after 1997), real GDP is less than
nominal, and where the deflator is equal to 1 (in 1997), real and nominal GDP

d.
are equal.
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Because nominal GDP incorporates changes in price and quantity and therefore
does not offer useful information from the perspective of the study of growth
and business cycles.

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