GPM First
Chapter 2 of Country Analysis (978-0-5660-9237-4) by David M. Currie

Economic Indicators

CHAPTER 2

In some ways, managing a country is similar to managing a business. Just like business executives, managers of a country must have an idea of what they want to accomplish, they must develop indicators to help measure progress toward the goal, and they must be able to adjust performance in response to the indicators. The major difference, of course, is that in most cases, managing a country does not involve a board of directors or chief executive officer to develop and implement strategy. Furthermore, governments have powers beyond those of corporations or individuals.

Because the majority of this book concerns economic analysis, we begin by introducing several important indicators through which the health of a nation’s economy can be evaluated. Because they measure the economy as a whole, they frequently are referred to as indicators of a country’s macroeconomic performance. You encounter them in the news on a regular basis, so let’s begin by making sure we understand what they mean.

Learning Objectives

After studying this chapter, you should be able to:

  1. explain a variety of economic indicators such as GDP, inflation, per capita income, unemployment, and interest rates;

  2. explain the difference between real and nominal indicators;

  3. explain why per capita figures do not reflect income distribution;

  4. evaluate two different approaches to translating figures from a variety of currencies into a common currency.

 

Gross Domestic Product

Gross domestic product (GDP) is the most comprehensive measure of the performance of a nation’s economy: the market value of all final goods and services produced in a nation during a period of time. There are many nuances associated with measuring a country’s GDP, which you will find in any economics textbook or in the article Measuring the Economy listed at the end of this chapter. For our purposes, think of GDP as an indicator of the economic health of a nation because it measures the output of goods and services that are the basis of an economy. When an economy is growing, its GDP is increasing, businesses are selling more goods and services, and more people are earning higher incomes.

The government isn’t looking over your shoulder to observe every transaction you make during a day, of course. Instead, the government conducts surveys and collects data from a variety of sources, then uses the results to estimate the number and value of other transactions. Surprisingly, measuring a nation’s economy is a relatively recent concept; for example, the US didn’t begin the process until the 1930s. In the US, the Bureau of Economic Analysis (BEA) of the Department of Commerce estimates GDP. The BEA’s quarterly estimates of GDP are one of the most eagerly anticipated statistics in the US because organizations from manufacturing to financial institutions use the information.

At the end of the month following the end of a quarter, the BEA releases an Advanced Estimate of GDP for the quarter just completed. As the weeks go by, more complete data and more reliable data become available, so the BEA publishes a Preliminary Estimate in the second month following the end of the quarter. A month later, it publishes a Revised Estimate for the quarter, before the cycle begins again for the next quarter. The point of all this is that GDP is a series of estimates that are only as good as the underlying information. Even in developed countries, there is a tradeoff between speed and accuracy: the information you obtain quickly may not be as reliable as the information obtained later. Box 2.1 discusses how the GDP figures for the US ultimately revealed the depth of the recession that began in 2008.

 

 
Box 2.1 Gross domestic product

Gross domestic product (GDP) is the most famous measure of a country’s economic performance, so investors, policy makers, and the general public are anxious for its release each quarter. In late 2008, the United States appeared to be in recession even though the most recent statistics showed that the economy grew slightly.

When statistics for the fourth quarter of 2008 were released in January 2009, the Commerce Department reported a 3.8 percent decline in annualized GDP. The United States had indeed been in recession. The following month, more data was available, so the Commerce Department revised its estimate about fourth quarter GDP: the economy declined 6.2 percent on an annualized basis, not the 3.8 percent in the original estimate. This meant that the United States was in its worst recession since 1982.

The United States would not be able to count on its trading partners to help it out of the recession. Japan’s economy declined at an annual rate of 12.7 percent in the fourth quarter of 2008. Europe declined 5.9 percent. Many of the world’s major economies were in recession by the end of 2008.

 

Sources: Conor Dougherty, Kelly Evans, “Economy in worst fall since ‘82”, Wall Street Journal, Feb 28, 2009, p. A1; Yuka Hayashi, “Export slide hits Japan’s economy”, Wall Street Journal, Feb 17, 2009, p. A6; “Odd numbers”, The Economist, Feb 2, 2008, p. 86.

 

 

 

Accounting and Policy Aspects of Gross Domestic Product

GDP is part of a system for organizing accounting information at the national level called National Income and Product Accounts (NIPA). The framework for NIPA can be found in the System of National Accounts, an effort by the United Nations and several other organizations to standardize the principles for collecting macroeconomic information throughout the world. Even so, each country is responsible for preparing its own statistics, and the reliability varies. Developed countries have more sophisticated methods for and transparency in collecting data, so their estimates of GDP tend to be more reliable.

Economists allocate GDP according to the entities who purchase the goods and services: Consumption (C) by individuals, Investment (I) by businesses, Government (G) purchases and investment, and net Exports (X), which are purchases of US-produced goods and services by other nations less US purchases of goods and services produced by other nations. This allocation creates the fundamental equation in the System of National Accounts:

GDP=C+I+G+Xnet

 

Each of the components is broken down further into subcategories, as you see in Table 2.1:

  • Consumption consists of purchases of durable goods, which last three years or longer, nondurable goods, which last less than three years, and services.

  • Investment to an economist is not the same as what most people tend to think of as investment. To an economist, investment by businesses means building plant and equipment – the assets that will help the economy generate more GDP in the future. Investment also consists of residential housing and additions to inventories. The average person thinks of investment in its financial connotation, such as purchasing shares of stock. To an economist, these financial exchanges involve trading one asset (money) for another asset (shares), so they have no impact on economic growth. It is possible to get rich (at least on paper) when share prices increase, but the nation’s productive capacity is unchanged. This is a hint that there is a difference between financial aspects of the economy and real aspects of the economy.

  • Government consumption consists of federal, state, and local purchases of goods and services as well as investment by all levels of government.

  • Net exports are composed of exports minus imports. An export means some of the goods and services produced in the US were sold to other countries, so we need to count them in US production. An import means that some of the goods and services produced in other countries were sold in the US, so we need to subtract them to avoid a misleading picture of US production. As you see in Table 2.1, the number is negative, indicating that the US imported more goods and services than it exported.

 

Although an increase in any of the components will cause GDP to increase, policymakers frequently focus on certain aspects of the economy. For example, reducing corporate taxes will encourage businesses to invest more, leading to an increase in GDP now and potentially increasing future GDP. Providing a tax rebate to households may lead them to purchase more goods and services, so consumption will increase. Higher incomes in other nations will cause them to purchase more US-produced goods and services, so US exports will increase.

The private sector consists of households, businesses, and foreign purchasers. The public sector is government at all levels. A famous economist of the 1930s, John Maynard Keynes, argued that it was the duty of government to increase spending when the private sector wasn’t generating economic activity sufficient to lead to full employment. The theory behind this argument is the basis for most macroeconomics courses at universities. The philosophical debate about the proper role of government in society has gone on for years.

 
Table 2.1 United States gross domestic product, 2006 and 2007 (billions of dollars)

Line

2006

2007

1

Gross domestic product

13,194.7

13,841.3

2

Personal consumption expenditures

9,224.5

9,734.2

3

   Durable goods

1,048.9

1,078.2

4

   Nondurable goods

2,688.0

2,833.2

5

   Services

5,487.6

5,822.8

6

Gross private domestic investment

2,209.2

2,125.4

7

   Fixed investment

2,162.5

2,122.4

8

      Nonresidential

1,397.7

1,481.8

9

         Structures

405.1

472.1

10

         Equipment and software

992.6

1,009.7

11

      Residential

764.8

640.7

12

   Change in private inventories

46.7

2.9

13

Net exports of goods and services

−762.0

−708.0

14

   Exports

1,467.6

1,643.0

15

      Goods

1,030.5

1,152.9

16

      Services

437.1

490.1

17

   Imports

2,229.6

2,351.0

18

      Goods

1,880.4

1,979.4

19

      Services

349.2

371.6

20

Government consumption expenditures and gross investment

2,523.0

2,689.8

21

   Federal

932.5

976.0

22

      National defense

624.3

660.1

23

      Nondefense

308.2

315.9

24

   State and local

1,590.5

1,713.8

Source: Bureau of Economic Analysis, Table 1.1.5.

 

Comparing Gross Domestic Product Year-to-Year

The GDP figures in Table 2.1 are called nominal GDP or GDP at current prices because they are the GDP figures measured in the prices that occur in the year GDP is measured. In 2006, the US produced $13.2 trillion of goods and services measured in 2006 prices. In 2007, the US produced $13.8 trillion of goods and services measured in 2007 prices. It is tempting to conclude that the US economy grew by $0.6 trillion (that’s $600 billion) during the year, an increase of 4.9 percent. But you may be incorrect. The problem is that 2006 GDP is measured in 2006 prices, while 2007 GDP is measured in 2007 prices, and prices may have changed over the year. We need to separate the 4.9 percent increase into its two components. How much of the change was due to an increase in prices, and how much was due to an increase in output of goods and services?

If prices increased during the year, the actual amount of goods and services changed by less than $600 billion. If prices decreased during the year, the actual amount of goods and services changed by more than $600 billion. The point is that we don’t know exactly how many more goods and services were produced over the year because the numbers include two effects: a change in the number of goods and services and a change in prices. If we are to measure the change in goods and services, first we need to develop a measure of prices.

Inflation

Prices frequently go up, and occasionally come down, for a variety of reasons. For example, more people wishing to purchase an item (such as corn produced for ethanol) may cause its price to increase. On the other hand, improvements in technology may cause prices to decrease. Pocket calculators were very expensive when they were introduced 40 years ago, but you can purchase them for less than $1 now. These changes in relative prices (some prices go up or down relative to prices of other products) are important in determining income distribution (who gets how much) in an economy.

To measure the general level of prices in a country, statisticians compute a price index – an indicator that goes up or down depending on the prices of a variety of goods and services, much like a thermometer goes up or down depending on the temperature. The Dow Jones Industrial Average is a price index based on a selection of 30 industrial stocks trading on the New York Stock Exchange. Just expand the concept to the entire economy and you have a feel for an index designed to measure prices of goods and services. There is much economic and statistical theory involved in constructing a reliable price index, featuring concepts such as Laspeyres or Paasche processes. As difficult as it is to believe, some people enjoy that sort of work.

There are several famous price indices. Perhaps the most newsworthy is the consumer price index (CPI), which measures the value of a basket of goods and services that are purchased by consumers. Each month, representatives of the Labor Department’s Bureau of Labor Statistics (BLS) survey establishments about the prices of about 80,000 goods (such as computers) and services (such as hospital stays). The BLS folks try to find goods or services that are identical to be sure they are comparing the same product from one month to the next. However, this sometimes is difficult to accomplish. To make sure that the basket of goods and services reflects actual goods and services purchased by consumers, the BLS surveys 30,000 consumers about once each decade about the goods and services they purchase. The BLS then changes the components and weights of the components according to results of the survey.

To illustrate the problems facing the BLS, consider computers. Personal computers didn’t exist until the late 1970s, so they weren’t included in the price survey. In the intervening years, computers have become so common that they make up a portion of most households’ purchases. The basket of goods and services had to be revised to include computers. Another issue is that computing power has increased dramatically since computers were introduced in the 1970s (have you ever heard of the 286, 386, or 486 chips?), while computer prices have generally fallen. To compensate for the increase in computing power, the price index has had to be adjusted to reflect that each dollar purchases more computing power. These are not easy decisions, but they are typical of the judgments that must be made when measuring price changes.

A more comprehensive index that measures prices for all the goods and services is the GDP deflator. Although this price index is not as glamorous as the CPI, it has the advantage of including a broader range of goods and services. The GDP deflator, rather than the CPI, is the index that economists use when measuring the general price level for the economy.

An increase in prices as measured by the price index is called inflation; a decrease is deflation. Prices increase in most countries, which means that some inflation is typical. A few countries, such as Japan, face the opposite problem of declining prices, so Japanese policy makers are concerned about deflation. Table 2.2 shows rates of inflation for selected countries from 2005 to 2006. Notice the relatively modest rates of inflation in developed countries such as Canada, the US, and the eurozone, the deflation in Japan, and the dramatic rate of inflation in Zimbabwe.

 
Table 2.2 Rates of inflation for selected countries, 2006

Country

Inflation

Canada

2.3%

China

3.6%

Eurozone

2.3%

Japan

−0.9%

United States

3.2%

Zimbabwe (2005)

237.9%

Source: World Bank, World Development Indicators.

 

Of course, inflation is more than a measurement problem. Inflation, particularly unexpected inflation, distorts decisions by consumers and business executives. For example, inflation leads to more borrowing because debtors repay debt with money that has reduced buying power. Inflation introduces uncertainty into decisions about investing or consuming because prices are distorted, and prices convey a multitude of information in a market economy. Inflation also changes horizons; the long run becomes a few weeks or months rather than several years because prices are changing so rapidly. A good example is a country experiencing hyperinflation – a rate of yearly inflation in high double digits, triple digits, or sometimes, quadruple digits. In these countries, it may be impossible to borrow money for more than a month, and even then the interest rate will be very high.

Inflation also promotes social unrest. People begin to point fingers at others they believe are taking advantage by raising prices. Workers blame corporations, executives blame suppliers or laborers or bankers, in an endless chain of accusation. Inflation sometimes leads to revolt, such as in 2008 when people rioted or protested in several countries about dramatic increases in prices of food. In fact, the protests forced the Prime Minister of Haiti to resign.

Because of this potential for social unrest, governments are hardly disinterested observers when it comes to measuring inflation. Even in the US, political careers are made or lost because of inflation (look up Jimmy Carter and the misery index for proof), and each time the Commerce Department proposes revising the statistics, there is a political dogfight. In other countries, it is even worse. Governments have been known to prepare “official” figures that are distant from the actual level of inflation. Sometimes governments even enact laws forbidding price increases (look up Richard Nixon and price controls, for example), but these efforts almost always fail. Box 2.2 explains how inflation sometimes leads to social unrest.

Nominal vs. Real Gross Domestic Product

Now that we have developed a price index, we can determine how much of the change in nominal GDP in 2007 was due to a price change. The GDP deflator at the end of 2006 was 116.568; the deflator at the end of 2007 was 119.668 (BEA, Table 1.1.4 Price Indexes for Gross Domestic Product). This means that prices increased 2.7 percent during the year 2007 (119.668/116.568 – 1 = 2.7 percent). If the total change in nominal GDP was 4.9 percent and 2.7 percent of that was due to increased prices, then the increase in production of goods and services must have been 2.2 percent. (In reality, the relationship is multiplicative rather than additive, but this is a good approximation.)

Another way to address the same issue is to divide each year’s nominal GDP by the price index for that year to obtain a price-adjusted figure. Real GDP is nominal GDP adjusted for the price level. Table 2.3 shows nominal and real GDPs for 2006 and 2007. If we measure the change in real GDP from 2006 to 2007, we obtain the same 2.2 percent increase we just calculated. The figure for real GDP frequently is multiplied by 100 so that it is in same scale as nominal GDP. Alternatively, real GDP sometimes is presented as an index to facilitate year-to-year comparisons.

Once we have calculated real GDP, we have a measure of the output of goods and services. When real GDP increases, it means that more goods and services were produced. Economic growth is the increase in goods and services from one period to the next, and it is measured by the increase in real GDP. We have solved the problem of separating observed GDP figures into the two components of inflation and output of goods and services.

What happens when the output of goods and services declines? Obviously, it’s not a good thing because it means that the economy is contracting. We frequently call these declines recessions, although the organization that declares a recession in the US does not focus solely on the output of goods and services. Table 2.4 shows rates of inflation and economic growth for the same sample of countries.

 

 

Box 2.2 Inflation’s subtle influence

Inflation has a subtle effect on society because it promotes mistrust and blame. Executives blame workers for demanding higher wages. Workers blame businesses for raising prices. John Maynard Keynes, a famous economist, agreed with Vladimir Lenin, a famous revolutionary, when he said that there was no surer way to tear the fabric of society than to create inflation. The big winner in the process is the government, which is able to repay its debts with money that is less valuable.

Among the countries experiencing protests against inflation in 2008 were:

  • Spain and Portugal: Fishermen conduct nationwide strikes protesting increases in fuel costs.

  • Iceland: The economy collapsed amid a financial crisis. Protests occur regularly against government officials responsible for the crisis and against inflation of 19 percent.

  • Egypt: Inflation of 23 percent leads to factory strikes and urban riots.

  • South Africa: Mines, shops, and factories closed when 25,000 protestors marched in Johannesburg, complaining of 11 percent inflation, particularly a 28 percent increase in electricity rates.

  • South Korea: Protests against inflation and a slowing economy forced the president to make a public apology.

Because of the threat of social unrest, governments frequently take steps to disguise the true rate of inflation. In 2009, Venezuela used price controls, setting prices on many commodities (particularly food), on interest rates, and on pay for workers in some industries. Argentina goes further by dictating to the statistics office the figures that it will release for inflation. In both countries, the true rate of inflation is higher than the official rate released by the government.

 

 

Sources: J.M. Keynes, The Economic Consequences of the Peace, p. 235; Ciaran Giles, “Iberian fishermen strike over fuel costs”, Orlando Sentinel, May 31, 2008, p. A7; “After the thaw”, The Banker, Mar 2009; “Will the dam burst?”, The Economist, Sep 13, 2008; Tom Burgis, “South Africa hit by strikes over rising living costs”, Financial Times, Jul 24, 2008, p. 2; Anna Fifield, “Inflation and protests create economic storm”, FT.com, Jun 21, 2008; “Venezuela”, Caribbean Update, Sep 2009, p. 20; “Marital bliss”, The Economist, Dec 15, 2007, p. 43.

 

 

 

 

 

In the US, the National Bureau of Economic Research (NBER) is responsible for deciding whether the nation is in recession. The NBER defines a recession as “a significant decline in activity spread across the economy, lasting more than a few months, visible in industrial production, employment, real income, and wholesale-retail trade.” A committee of economists – the Business Cycle Dating Committee (BCDC) – declares a recession by interpreting a variety of statistics measuring the phenomena described in the explanation, and they do so after waiting several months so that the information is reliable. The task is more difficult than one might think because not all statistics move in the same direction at the same time. Some indicators may actually improve even though the economy is in recession. The NBER emphasizes that it does not focus strictly on changes in real GDP.

 
Table 2.3 US nominal and real GDP, 2006 and 2007

2006

2007

Nominal GDP (billions of dollars)

13,194.7

13,841.3

Price deflator (2000 = 100)

116.568

119.668

Real GDP

113.193

115.664

Real GDP (billions of dollars)

11,319.3

11,566.4

Source: Bureau of Economic Analysis.

 
Table 2.4 Rates of inflation and economic growth for selected countries, 2006

Country

Inflation

Economic growth

Canada

2.3%

2.8%

China

3.6%

10.7%

Eurozone

2.3%

2.7%

Japan

−0.9%

2.2%

United States

3.2%

2.9%

Zimbabwe (2005)

237.9%

−5.3%

Source: World Bank, World Development Indicators.

 

Per Capita Figures

GDP is a measure of how a country’s economy is performing over time, but it is not a measure of how individuals within the country are doing. For that, we need to calculate GDP per capita (GDPpc), which means GDP per person. It is possible to calculate nominal GDPpc or real GDPpc, depending on what the analyst wishes to measure. We calculate real GDP per capita because it is possible for real GDP to increase (which means that the nation is producing more goods and services) but real GDPpc to decrease (which means that production of goods and services per person is declining). This could happen if population was growing faster than real GDP.

China encountered this problem in the 1950s and 1960s. Mao Zedong, who was leader at the time, encouraged families to have plenty of children so that China could catch up to western countries. Unfortunately, the economy did not grow as rapidly as did the population, so GDP per person declined. The next leader, Deng Xiaoping, instituted a one-child policy in an effort to slow population growth. In the 1980s and 90s, economic growth outpaced population growth, so GDPpc increased. The one-child policy apparently worked, at least from an economic standpoint.

Table 2.5 shows real GDPpc for each of the countries in the sample, except that Germany replaces the eurozone because the IMF doesn’t publish GDPpc for the eurozone. As you look at the table, focus on each country by comparing 2006 to 2000. If 2006 real GDPpc is higher than in 2000, it means that the average person is better off because the average person is producing more goods and services. Can you identify the country in which the average person was worse off in 2006 than in 2000? (Don’t be confused by the monetary units, because each statistic is in the currency of that country. At this point, you can’t compare the numbers for Canada to the numbers for Japan because they are measured in different currencies.)

 
Table 2.5 GDP per capita, domestic currency in constant prices, 2000 and 2006

Country

2000

2006

Canada (Canadian dollar)

35,905

39,327

China (Yuan)

3,944

6,676

Germany (Euro)

25,073

26,513

Japan (Yen)

3,966,842

4,303,631

United States (US dollar)

34,773

37,848

Zimbabwe (Zimbabwean dollar)

30

23

Source: International Monetary Fund, World Economic Outlook Database.

 

Income Distribution

Although it is a widely accepted indicator of development, GDPpc still is not the ideal indicator. Measuring something on a per capita basis means that we are taking an average per person. The trouble is that incomes may be distributed unequally in a country. A few families, an educated elite, owners of valuable resources, or some other special group may earn high incomes, while a large majority of the population earns low incomes.

Economists address the issue of income distribution by using any of several indicators. The most straightforward measure of income distribution is to compare the share of income held by the richest 10 percent or 20 percent of the population to the share of income held by the poorest 10 percent or 20 percent of the population. In a country with a more unequal income distribution, the ratio will be higher.

Another, more sophisticated measure of income distribution was developed by an Italian statistician. The Gini Coefficient measures income distribution by comparing how much income shares for each segment of the population deviate from what the shares would be if incomes were distributed equally. If incomes are distributed equally, the Gini Coefficient is 0 because there is no deviation. If incomes are distributed unequally, the Gini Coefficient has a maximum value of 1. If the Gini Coefficient is multiplied by 100, the result is the Gini Index, which can range from 0 to 100.

Table 2.6 shows these two indicators for the countries in the sample. You’ll see that according to the Gini Index, incomes are distributed most unevenly in Zimbabwe, followed by China and the US. According to the ratio of incomes, China is the most uneven, followed by Zimbabwe and the US. Compared to other developed countries such as Canada, Germany, or Japan, incomes are much less evenly distributed in the US.

 
Table 2.6 Indicators of income distribution

Country

Gini Index*

Ratio of richest 20% to poorest 20%

Canada

32.6

5.5

China

46.9

12.2

Germany

28.3

4.3

Japan

24.9

3.4

United States

40.8

8.4

Zimbabwe

50.1

12

Notes: * The Gini Index is the Gini Coefficient multiplied by 100. A number closer to zero represents more equal distribution of income.

Source: United Nations Development Programme, Human Development Indicators.

 

A word of caution: measuring income distribution is not equivalent to measuring poverty. Income distribution is a relative measure: what share of incomes does a certain segment of the population earn? Poverty is an absolute measure: is the income sufficiently high to enable the household to eat, for example? When it comes to poverty, most of the world’s population exists on less than the equivalent of $2 per day. Try getting by on that sometime.

Another interesting approach is to compare income distribution within a country over time. According to the US Census Bureau, income inequality in the US increased from 1968 through 1998, the year of the most recent study. The trend continued into 2002, according to the study by Smeeding. Incomes were distributed more unequally in the US than in all of the high-income countries in the Organization for Economic Cooperation and Development (OECD), which includes countries such as Germany, France, Italy, Norway, Canada, and Switzerland.

Globalization has helped alleviate poverty around the world, but it has been accompanied by increased disparity of incomes. Average incomes have increased, but distribution of incomes has become more unequal. Economists are still investigating why the two results have occurred. In Box 2.3, you will read about income redistribution and how it may lead to undesirable consequences.

US Dollar Equivalents

We need to address one other topic before leaving GDP. Countries measure their GDPs in their own currencies, which is fine if you’re only worried about one country. But when you try to make international comparisons, you’d like to have GDPs for all the countries in a common currency, such as the US dollar.

There are two approaches to converting statistics from one country’s currency to a different currency. The most direct method is to use market exchange rates, which reflect the values of the currencies on the currency market. Although this method is easy, it is potentially more volatile because exchange rates fluctuate. The picture of two economies may vary drastically from one year to the next simply because of changes in the exchange rate.

 

 

Box 2.3 Globalization and income distribution

Globalization has increased living standards around the world, but a closer examination of the evidence indicates that the distribution of incomes is becoming more unequal. Income distribution in Latin America is more unequal than anywhere outside of Africa because a wealthy elite skews tax laws and government programs toward them. In Mexico, for example, workers in the top 10th percentile earned 4.7 times what workers in the bottom 10th percentile earned in 2004; in 1987, the number was 4.0. The Chinese Communist Party worries about increasingly unequal income distribution because its legitimacy depends on widespread participation in the country’s growth. A study by the Asian Development Bank revealed that inequality had increased in 15 of the 21 countries it studied.

Income disparity also has widened in the United States. Real (adjusted for inflation) after tax incomes declined in the United States during the 2000s. The gap between the highest and lowest income percentiles narrowed during the 1950s and 1960s, but widened since the 1980s. In 2004, the top 1 percent of Americans received 15 percent of the country’s incomes, compared to 8 percent in the 1960s. One difference is that Americans don’t seem to care about income inequality as much as people in other countries do. According to The Economist, “Americans want to join the rich, not soak them.”

Still, there are potential consequences to growing income inequality. Studies have shown that income inequality stifles economic growth, so it is to a country’s advantage to distribute incomes more equally. Even some wealthy Americans warn against the country becoming an aristocracy in which a wealthy ruling class governs the country. The biggest danger is that income inequality can lead to social unrest and class warfare.

 

Sources: Bob Davis, John Lyons, Andrew Batson, “Globalization’s gains come with a price”, Wall Street Journal, May 24, 2007, p. A1; “Improving the Latin rate of growth”, The Economist, May 20, 2006, p. 40; “For whosoever hath, to him shall be given, and he shall have more”, The Economist, Aug 11, 2007, p. 36; “Dividing the pie”, The Economist, Feb 4, 2006, p. 70; “The rich, the poor and the growing gap between them”, The Economist, Jun 17, 2006, p. 28; David Cay Johnston, “Richest are leaving even the rich far behind”, New York Times, Jun 5, 2005, p. 1.

 

 

 

The method favored by economists is to adjust GDP statistics for differences in purchasing power between countries before translating into a common currency. The adjustment is necessary because $1 in the US will purchase a certain amount of goods or services, but the equivalent of $1 in another country may purchase many more goods or services. Because relative prices vary less than exchange rates, purchasing power parity (PPP) provides a more reliable, less volatile measure of countries’ economies.

Table 2.7 shows GDPpc for each of the countries in the original currency, then in US dollars using either market exchange rates or PPP. Notice that adjusting for purchasing power changes the amount of each country’s GDPpc, but the adjustment is greater for less developed countries, where the change in purchasing power is likely to be greatest. The adjustment for developed countries is 10 percent or less, but the adjustment for developing countries is more than 100 percent for China and 50 percent for Zimbabwe.

 
Table 2.7 GDP per capita in USD using exchange rates and PPP, 2006

Country

GDPpc Domestic currency

GDPpc USD

GDPpc USD (PPP)

Canada (Canadian dollar)

44,360

39,114

36,837

China (Yuan)

16,042

2,012

4,650

Germany (Euro)

28,218

35,432

32,432

Japan (Yen)

3,983,875

34,263

32,031

United States (US dollar)

44,118

44,118

44,118

Zimbabwe (Zimbabwean dollar)

69,958

123

195

Source: International Monetary Fund, World Economic Outlook Database, April 2008.

 

Using PPP also can change the way the world’s economies rank. China, which was slightly smaller than Germany in 2007 using exchange rates to compare economies, becomes the world’s second largest economy (and twice the size of Germany) when the comparison is based on PPP. The other seven economies in Table 2.8 are the world’s seven largest industrialized economies, and are known as the G-7. Obviously, China has become one of the seven largest economies! There is much discussion about when China’s economy will overtake the US’s economy. If both economies continue to grow at their current rates, it will happen sometime around the middle of this century. Of course, there was similar discussion in the 1980s about when Japan would overtake the US economy because Japan was growing so rapidly, but as you see in the table, it hasn’t happened yet.

 
Table 2.8 World’s largest economies in USD ranked by exchange rates and PPP, 2007

Country

GDP USD

Country

GDP USD (PPP)

United States

13,808

United States

13,808

Japan

4,382

China

7,035

Germany

3,321

Japan

4,292

China

3,280

Germany

2,812

United Kingdom

2,804

United Kingdom

2,168

France

2,594

France

2,068

Italy

2,105

Italy

1,788

Canada

1,436

Canada

1,270

Source: International Monetary Fund, World Economic Outlook Database, October 2008.

 

Is Gross Domestic Product the Best Measure of a Nation’s Health?

Almost from the time GDP was invented, it has been subject to criticism. The criticisms range from the accounting principles used to develop GDP to its shortcomings as a measure of social welfare in a country. Although some of the criticisms are valid, GDP continues to be the most widely used measure of a nation’s performance. You can read a detailed evaluation of GDP in the article by Van den Bergh in the references at the end of this chapter. The article by Ritter explains several of the issues arising from preparing the national accounts.

Alternatives to GDP have been developed, but they are not yet widely accepted. A typical alternative is the Human Development Index (HDI) that was developed by the United Nations Human Development Programme. The HDI measures development using three dimensions: GDPpc, adult literacy rates, and life expectancy at birth. Table 2.9 shows the countries ranking in the top ten and bottom ten according to the HDI.

Until a more appropriate measure is developed and used more widely, GDP will continue to be the measure of a nation’s performance.

 
Table 2.9 Top ten and bottom ten countries in Human Development Index, 2007

Top 10

Bottom 10

1. Iceland

168. Congo, Democratic Republic

2. Norway

169. Ethiopia

3. Australia

170. Chad

4. Canada

171. Central African Republic

5. Ireland

172. Mozambique

6. Sweden

173. Mali

7. Switzerland

174. Niger

8. Japan

175. Guinea-Bissau

9. Netherlands

176. Burkina Faso

10. France

177. Sierra Leone

Source: United Nations Human Development Programme http://hdr.undp.org/en/statistics/.

 

Unemployment

Although it sounds straightforward, unemployment actually is difficult to measure because people have different motives for working and it is a challenge to evaluate their willingness to work. Attitudes toward work and unemployment also are closely tied to a country’s culture, so that actual unemployment sometimes is disguised through techniques such as keeping surplus workers on the payroll.

Unlike the System of National Accounts, there is no standardized method for measuring unemployment internationally. This means it is up to each country to define and measure unemployment, so comparing results between countries is potentially misleading. Nevertheless, the OECD prepares standardized statistics for the 41 countries that are members. These figures come with a lag of about one month because of the time it takes to standardize the figures from each country. Table 2.10 shows the standardized unemployment rates for the countries in our sample that are members of the OECD.

 
Table 2.10 Standardized unemployment rates, March 2008

Country

Standardized unemployment rate

Canada

6.0%

China

(not an OECD member)

Germany

7.3%

Japan

3.8%

United States

5.1%

Zimbabwe

(not an OECD member)

Source: OECD.Stat, Standardized unemployment rates http://stats.oecd.org/WBOS/Index.aspx?QueryName=251&QueryType=View.

 

One also can learn about a country’s performance by looking at changes in job creation or employment over time. In the US, the Department of Labor conducts two surveys each month to measure the labor market. The most famous is the Current Population Survey (household survey) of approximately 60,000 households, providing an indicator known as the unemployment rate. The focus of the survey is to measure the percentage of the work force that is actively looking for work but is unable to find it.

The second survey is the Current Employment Statistics survey (establishment survey) of approximately 400,000 businesses. The establishment survey measures hours worked, hourly earnings, and job gains or losses to help evaluate whether the economy is generating jobs. Analysts tend to pay more attention to the establishment survey than to the household survey because the establishment survey is more comprehensive (it measures more indicators) and covers a larger sample.

Table 2.11 shows results of each survey for two months in 2008. You’ll see that the unemployment rate declined slightly even though the economy lost 20,000 jobs during the month. These seemingly conflicting results occurred at the time several notable executives and politicians were stating that they thought the US was in recession. Remember the previous point about how difficult it is to identify a recession? In this case, one employment indicator is up (an improved unemployment rate) while another is down (job losses).

 
Table 2.11 Results of US establishment and household surveys, March and April 2008

Indicator (Survey)

April

March

Nonfarm payrolls (Establishment survey)

−20,000

−81,000

Civilian unemployment rate (Household survey)

5.0%

5.1%

 

Interest Rates

Interest is a price, but it is a special price. Just like a loaf of bread costs $1.49 at the supermarket, money costs $5.50 per $100 at the bank. You can buy the use of $100 for one year by paying the bank $5.50 in interest, or an interest rate of 5.5 percent. Interest is the price you pay for money, while the interest rate is the price per $100, which is why the rate is called a percent. If you borrow $100 from the bank for one year at 5.5 percent, you repay the bank $105.50 at the end of the year. The $105.50 is made up of the amount you borrowed ($100), which is called the principal, and the interest.

The math gets slightly more complicated when you borrow for longer periods, but the process remains the same. If you borrow the same $100 for two years rather than one, you pay $5.50 interest for the first year, then repay the bank $105.50 in principal and interest at the end of the second year.

An interest rate reflects all the factors that go into the decision to borrow or lend, but economists typically separate the factors into three categories:

  • The basic lending rate as if you were lending at zero risk; this is usually referred to as the risk-free rate.

  • An extra amount to compensate for all the risks of lending to a borrower who does not have zero risk, such as the length of time of the loan, the chance that the borrower won’t repay the loan, the risk of lending in another currency, or any other dimensions of risk.

  • An extra amount to compensate for any inflation that could occur during the time of the loan; sometimes inflation is included as one of the risks above, but we shall separate it for this discussion.

 

Let’s explore the dimensions of interest rates by starting with the safest loan we can think of: a loan to the US Treasury. The reason we chose the Treasury is that the US Government is the least risky borrower in the US. There is little or no chance that it will default on its borrowing (at least it hasn’t so far!), and every other loan in the US (such as to a corporation, an individual, or a different level of government) involves some greater degree of risk. Let’s call the interest rate on the loan to the Treasury the risk-free rate of interest because the borrower is risk-free.

If you decide to lend to any other borrower, that borrower is more risky than the risk-free borrower, so you will require a higher return on your loan to compensate for lending to a higher-risk borrower. You charge a higher interest rate. That’s why, when you look at any interest rates that are for the same time period (such as three months or 30 years), the lowest interest rate is the US Treasury rate. All other rates are built upon the Treasury rate. Sometimes this additional interest rate to compensate for additional risk is called the risk premium.

Another dimension of interest rates is time. Over longer periods of time, there are more opportunities for things to go wrong with a loan. Besides, you’re giving up your money, which means you can’t do anything else with it during the period of the loan. For these reasons, you expect a higher return when you lend money for a longer period of time, so you require a higher interest rate on the loan. That’s why, when you look at interest rates for any borrower (where the risk is the same), short-term interest rates usually are lower than long-term interest rates. When you plot a graph of the market interest rates for securities of the same risk but for different time periods, you obtain a yield curve, which sometimes is called the term structure of interest rates. Figure 2.1 shows the yield curve for US Treasury securities.

The problem is that the principle in the previous paragraph isn’t always true. There are occasions when short-term interest rates are higher, not lower, than long-term rates. This seemingly counter-intuitive result has intrigued economists for decades. The discrepancy revolves around the concept of expectations about the future of the economy, particularly inflation. You can see an animated view of the Treasury yield curve over time at yieldcurve.com (http://www.yieldcurve.com/marketyieldcurves.asp).

Still another dimension of interest rates is how to incorporate inflation. If inflation is zero, interest rates will behave according to the other dimensions: a risk premium and a time premium. But inflation usually is positive, which means that each time you lend money, you face the threat of losing purchasing power. If something costs $100 today and you expect inflation to be 3 percent over the coming year, the same item will cost $103 next year. If you lend money, you’ll need to charge at least 3 percent interest to compensate for the loss of purchasing power. If you don’t, you won’t be able to purchase as much when you get the money back (plus interest). Because of this principle, interest rates react to expectations about inflation: higher rates of inflation create higher interest rates.

However, the opportunities for inflation differ according to how long a loan is outstanding. If you lend money for one night, there’s little chance of getting hurt from inflation, at least under normal circumstances. (If your country experiences hyperinflation – inflation of 1,000 percent or even 150 percent – then one day matters, but those aren’t normal circumstances in the US.) But if you lend for 30 years, there is a good chance that inflation will occur, so you’ll build the expected rate of inflation into the interest rate that you charge.

 
Figure 2.1 Treasury yield curve, 1/7/10

graphics/fig2_1.jpg

Source: US Department of the Treasury.

 

Here’s the situation so far. The market interest rate has to include the risk-free rate, an adjustment for risk, and an adjustment for inflation. We could write this as a formula:

Market interest rate = risk-free rate + risk premium + inflation premium

 

That’s a pretty useful way to think about interest rates, and you’ll encounter the principles every time you borrow or lend money.

Let’s explore one more topic. The discussion above describes what interest rate you should charge before you lend money; we’re looking forward. What happens if we look backward and see what happens to your actual return if some of the factors change? In particular, what happens to the actual return because of inflation? Suppose you lent out money at 5 percent, but inflation turns out to be 3 percent. You actually received a real return on your loan of only 2 percent. There is a difference between the market interest rate (the nominal interest rate) and the real interest rate (the nominal rate adjusted for inflation). Just as we adjusted nominal GDP for inflation to obtain real GDP, we adjust nominal interest rates for inflation to obtain real interest rates.

Of course, if you’re a smart lender and 2 percent isn’t sufficient to compensate you for the risk-free rate and the risk premium, then next time you lend, you’ll adjust your lending rate upward to compensate for a new level of inflation. But if you don’t do a good job of forecasting, it’s possible for the real interest rate to be negative. Do you see how?

Conclusion

Indicators help us determine whether a country and its citizens are better off or worse off. Indicators used frequently to measure a country’s welfare include gross domestic product, inflation, unemployment, and interest rates. Indicators measuring individual welfare include GDP per capita and income distribution.

Further Reading

9 

Bureau of Economic Analysis (2007) Introduction to the NIPA accounts, http://www.bea.gov/scb/pdf/national/nipa/methpap/mpi1_0907.pdf, accessed 5/22/08.

10 

Bureau of Economic Analysis (2006) Measuring the economy, http://www.bea.gov/national/pdf/nipa_primer.pdf, accessed 5/22/08.

11 

Bureau of Labor Statistics (2007) BLS Handbook of Methods, Chapter 17, The Consumer Price Index http://stats.bls.gov/opub/hom/pdf/homch17.pdf, accessed 5/19/08.

12 

Bureau of Labor Statistics (2007) Monthly employment situation report: Quick guide to methods and measurement issues http://www.bls.gov/bls/empsitquickguide.htm#payroll, accessed 5/28/08.

13 

Cage, R.J. Greenlees. and P. Jackman (2003) Introducing the chained Consumer Price Index, International Working Group on Price Indices http://stats.bls.gov/cpi/super_paris.pdf, accessed 5/19/08.

14 

Callen, T. (2007) PPP versus the market: Which weight matters? International Monetary Fund, Finance and Development http://www.imf.org/external/pubs/ft/fandd/2007/03/basics.htm, accessed 5/20/08.

15 

Jones, A.F. and D.H. Weinberg (2000) The changing shape of the nation’s income distribution, US Bureau of the Census http://www.census.gov/prod/2000pubs/p60-204.pdf, accessed 5/22/08.

16 

National Bureau of Economic Research, The NBER’s recession dating procedure http://www.nber.org/cycles/jan08bcdc_memo.html, accessed 5/24/08.

17 

OECD Observer, Is GDP a satisfactory measure of growth? http://www.oecdobserver.org/news/fullstory.php/aid/1518/, accessed 5/25/08.

18 

Ritter, J.A. (2000) Feeding the national accounts, Federal Reserve Bank of St Louis Review http://research.stlouisfed.org/publications/review/00/03/0003jr.pdf, accessed 5/27/08.

19 

Smeeding, T.M. (2005) Public policy, income inequality, and poverty: The United States in comparative perspective, Social Science Quarterly (86) p. 955.

20 

Stewart, K.J. and S.B. Reed (1999) Consumer Price Index research series using current methods, 1978–98, Bureau of Labor Statistics, Monthly Labor Review http://stats.bls.gov/opub/mlr/1999/06/art4full.pdf, accessed 5/29/08.

21 

United Nations Human Development Programme (2008) http://hdr.undp.org/en/statistics/, accessed 5/23/08.

22 

United Nations, System of National Accounts (1993) http://unstats.un.org/unsd/sna1993/introduction.asp, accessed 5/23/08.

23 

Van den Bergh, J.C.J.M. (2007) Abolishing GDP, Tinbergen Institute http://www.tinbergen.nl/discussionpapers/07019.pdf, accessed 5/25/08.

24 

World Bank (2007) 2005 International Comparison Program preliminary results http://siteresources.worldbank.org/ICPINT/Resources/ICPreportprelim.pdf, accessed 5/22/08.

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