Output Market: Output

and the Price Level "[b]y the curious standard of the GDP, the nation's hero is a terminal cancer patient who is going through a costly divorce."

Overview

Let’s start with two seemingly simple questions. 1. Who is better off - you, your parents, your grandparents, or great grandparents? 2. In what country would you want to live because of its high standard of living?

If you could choose, where and when would you live? It turns out these are not easy questions to answer. What do use as a guide in making the choice? Is it income and earnings, education, political freedom, war and peace, education, or maybe health reflected in average height, weight, or life expectancy? All of these affect what we would call our standard of living, and each of us would value them differently. For example, in revolutionary America it was “give me liberty or give me death,” while in modern China it is, “Give me liberty or give me growth.” The French, meanwhile, have accepted less income as the price of more leisure, and Americans have accepted greater economic anxiety as the price of faster growth.

In many respects asking which country is the best is similar to asking what is the best college football team, or the best university, and in each case a "magic" number has been produced to answer the question. In college football we measure teams by their BCS ranking, in college it would be US News’ National University Rankings, and for economies it tends to be Gross Domestic Product (GDP). None of these is perfect because it is extremely difficult to come up with single measures of performance, especially when it is an economy with hundreds of millions of people and millions of firms.i

One argument for using GDP is a strong correlation between it and many other performance indicators. For example, below is a scatter diagram with GDP per capita and life expectancy that clearly indicates a positive relationship – as GDP per person rises so does life expectancy, although there does seem to be an upper limit to life expectancy. The impact of AIDS on life expectancies in some sub Saharan countries, such as South Africa, is also evident. These countries have lower life expectancies than expected based on GDP per capita.

1 There are, however, some challenges to the use of GDP and GDP per capita as the macro economy’s primary performance indicators. China, for example, is recognized as an economic “rock star” because of its ability to sustain over decades GDP growth in excess of 10%, but there are growing questions about the value of GDP as an indicator of well-being. There have been numerous articles with headlines like, “GDP per capita record masks economic woes, didn’t transform lives: experts,”ii and “Cost of Environmental Damage in China Growing Rapidly Amid Industrialization.”iii In a 2010 report that cost was estimated at 3.5% of GDP, although there is reason to believe it is a low estimate. A World Bank study a few years earlier pegged the cost of just air and water pollution at nearly 6% of GDP.iv There have also been challenges to GDP’s dominance by those offering alternative measures that get closer to happiness and to well-being, an example of the latter being the Social Progress Index.

Production - GDP

Definition

The National Income and Product Accounts (NIPA) provide the framework for generating estimates of Gross Domestic Product (GDP) that is defined as: the market value of final goods and services produced annually within a country. It turns out each term in this definition is there for a reason and if we look briefly at each of the terms we will have a better sense of what GDP is - and what it is not.v

GDP is the market value ... GDP is simply the weighted sum of output from all sectors of the economy, where output is valued at market prices. If market prices reflect what people pay for goods and services, then prices must reflect how people value them. If you pay $16 for a CD and 10 CDs are produced and sold at that price, then $160 worth of value has been created.

GDP is the market value of final ... Let's assume you have a summer job in a factory producing CD ROMs to be used to store computer software. The manufacturer sells the CDs to the software company for $10, and the software company adds the software instructions to the CD and sells it for $50. The $10 would be considered an intermediate product and would not be included in GDP. The only final good would be the CD with the software sold to the computer user for $50. [Note: we could also calculate GDP by looking at the value added of each producer. The CD maker adds $10 in value assuming the material to produce the CD and the software maker adds $40 ($50-$10), so the entire operation adds $50 - precisely the value of the final goods produced.

GDP is the market value of final goods and services ... Included in GDP are the values of goods, such as the cars you drive, and the value of services, such as the education and medical treatment you receive this semester. There was a time when nearly all people were employed in agriculture - the time of Plimouth Plantations - but the agrarian life gave way to the industrial life reflected in the mills you see in Pawtucket and Fall River - and that is giving way to a post-industrial or information age economy where growth will be in the production of services.

GDP is the market value of final goods and services produced ... There are a number of things we buy that are not the product of current production and are thus excluded from GDP. Missing from GDP calculations would be the value of the sales of existing homes, used cars, and antiques, although the sales commissions are included because they represent payment for a currently provided service. Similarly, when you buy stocks, bonds, or mutual funds, only the commissions / fees would be included in GDP because there is no production directly involved.

GDP is the market value of final goods and services produced annually ... . GDP is defined as the value of goods and services produced during a year, although the data is tabulated and reported four times a year. What would be reported for the first quarter of 2007 would be the value of what would be produced for the year if the rate of production that existed during January, February and March were maintained for the entire year.

2 GDP is the market value of final goods and services produced annually within a country... The work of Juan, a Mexican national who works in the fields of Southern California helping to harvest a crop of avocados would be included in GDP while the value created by Mary, a native of Boston working in Germany for IBM would not be included.vi

Regardless of what you look at, you need to recognize the fact they are both measures of value and therefore, as we saw in the Data Analysis unit, we need to be careful to adjust the data for price changes, so now let's look at the adjustment.

Real vs. Nominal GDP: Correcting for price changes.

Because GDP is the price-weighted sum of all "stuff" produced, GDP can rise if prices rise or if output rises, and there is a substantial difference between the two since in the first you simply have higher prices, while in the second you have more "stuff." To separate the two effects the Bureau of Economic Analysis (BEA) calculates two measures of GDP.vii Current-dollar GDP (Nominal GDP) is calculated using actual prices, while Constant-dollar GDP (Real GDP) is calculated using constant prices. viii

The difference between the two GDP measures is evident in the table and graph below that are based on BEA web site data. Based on the nominal GDP data, the 1970s looks like the period of most rapid growth - about 10% a year - but this is wrong because no adjustment has been made for inflation, and as you saw earlier, the US experienced rapid inflation in the 1970s. It turns out that the major share of the increase in GDP came from rising prices rather than actual output. In the graphs below the table you see that the 10.4% per year nominal growth is only a 3.2% per year rise in real GDP. This adjustment reveals that the fastest growth was in the 1960s when the growth rate exceeded 4% per year, while the slowest was the 2000s when growth averaged approximately 2.5% a year.ix

Current $ and Constant $ GDP

Current GDP Real GDP (Billions of (Billions $s) 2000 $s) 1950 293.8 1,777.30 1960 526.4 2,501.80 1970 1,038.50 3,771.90 1980 2,789.50 5,161.70 1990 5,803.10 7,112.50 2000 9,817.00 9,817.00 2006 13,246.60 11,415.30

It is real GDP that should be used when examining changes in the size of the economy,

3 Decomposition of GDP: If you demand it, they will build it.

There are three approaches to measuring GDP: who produces it, who earns the income generated in the production process, and who buys it. Of the three approaches, the last is by far the most popular and the one on which we will focus. The key concept is Aggregate Demand that equals the sum of spending by households (consumption spending (C)), by businesses (Investment spending (I)), by governments (Government spending (G)), and by foreigners (Export spending (X). But, because some of that spending is on goods imported into the US, we subtract the value of spending on imports (-M) to get aggregate demand for domestic production.

GDP = (C + I + G) + ( X - M)

The breakdown of aggregate demand in the US economy in 2009 appears in the chart below. What is clear is the importance of consumption spending - averaging approximately 71% of GDP, which is higher than the longer-term average of approximately 2/3rds.

In the chart below the rising importance of consumption in the US is evident as is the fact that the US’s share of GDP devoted to consumption is higher than the share of the other rich countries (Japan and Germany) despite the fact that Japan’s rapid growth in the 1960s and 1970s was fueled in part by consumption’s increasing share of GDP. As Japan’s economy boomed the Japanese people consumed an increasingly large share of GDP, while in China there was a sharp decline in consumption’s share of GDP – from 63% to 37%. This falling consumption share is the result of a high savings rate and indicates that the Chinese people have not been the primary beneficiaries of the economic growth that China has experienced since it opened up to the west in 1979.

One of the features of the post WWII world economy has been the “explosion” in international trade, which is very evident in the chart below. In all of the selected countries there has been an increase in the share of GDP accounted for by exports, which reflects the globalization process. Export's share of GDP in the US has more than doubled (6% to 13%), while imports share more than tripled (5% to 18%), with the majority of the increase coming only after 1970, which explains the rise in the US balance of trade deficit and may help explain the upward trend in long-term unemployment rates in the 1970s and 1980s. Internationally, the spread of globalization shows up in across-the-board increases in the share of GDP accounted for by exports and imports, with the biggest increases were in Germany, Mexico and China. In Germany, Europe’s biggest economy, exports account for 47% of GDP, which was the highest among the selected countries, while in China exports have been the driver behind its remarkable growth economic growth. In this 38-year period, exports’ share of GDP in China rose from 3% to 38%, slightly faster than imports’ share of GDP, which is reflected in China’s balance of trade surplus. The growth in Mexico’s share partially reflects the impact of passage of NAFTA in the early 1990s, while China’s share reflects the decision of Deng Xiaoping to open China to the world in 1979.

4

Government's' share of GDP in the US, meanwhile, is slightly lower in 2006 from what it was in 1960, rising through 1980s and then falling thereafter - the result of the "Reagan revolution."

International comparisons

GDP is often used as a basis for comparing the performance of the US economy with that of other countries, and The World Economic Outlook Databases allows you to create your own tables for international comparisons. At that site you will find that GDP 2013 was 318 billion Euros in Austria and 183 billion euros in Greece, 57,716 billion Yuan in China GDP, 110,701 billion rupees in India, and $16,237 billion dollars in the US. Unfortunately, these numbers are virtually meaningless for two reasons. First, these figures are in domestic currencies, so we would need to convert them to a common currency to make any international comparisons in the size of the economies. Second, if we were looking for differences in the standard of living – something similar to average income – we would want to look at per capita GDP.

The first step toward making international comparisons would be to generate the GDP in US $s, which is the data that appears in the second column in the table below. Once they are converted to a common currency, we see the value of GDP in Austria is approximately 3% of GDP in the US, while India’s economy is 12% of the US economy. China’s economy, meanwhile, is four times the size of India’s and about 56% the size of the US economy.

But, China has about 1.3 billion people, while in the US there are slightly more than 300 million, so to compare the standards of living in the countries we need to account for the differences in the number of people. We do this with GDP per capita that is simply GDP divided by the population, and it provides a very different “picture.” Austria’s economy was only about 1/3rd the size of India’s, but given the population differences, real GDP per capita in Austria is nearly 30 times that in India when measured in US $s. In China, the economy was more than half the size of the US, but because of the larger population China’s GDP per person is only $6,628 – about 13% of the US figure.

Alternative Measures of GDP: 2013 GDP in domestic GDP per capita in GDP per capita currency GDP in US $s domestic currency in US $s Austria 318.199 422.894 37,504.36 49,844.20 China 57,715.87 9,020.31 42,414.33 6,628.86 Greece 183.47 243.836 16,286.74 21,645.47 India 110,701.95 1,972.84 89,328.97 1,591.95 US 16,237.75 16,237.75 51,248.21 51,248.21 Source: IMF

5 There is still a problem, however, because there is no account for price differences in the two countries, and these price differences can be quite large. The Economist magazine publishes the Big Mac Index that is described in a note at the end of this section. According to the Index, in January 2013 it cost $4.37 to buy a Big Mac in the US, while it cost 16 Yuan to buy it in China and 3.59 euros to buy it in Europe’s euro area. What really matters to me when I am traveling, though, is what it costs in US Ss. I knew when I was traveling in China that things were cheaper than home, and I also knew Europe was not cheap, both of which are reflected in the last column of the table. That Big Mac in China actually cost only $2.57, while it cost $4.88 in Europe and $2.54 in Taiwan based on the exchange rates at that time. This is why, as we will see in a later unit, there has been such a heated debate between the US and China over the appropriate exchange rate. The US claims the rate is too low so that China’s prices are too low and this makes US goods uncompetitive, which leads to the trade deficit. If that Big Mac is so ‘cheap,’ so will be the electronics and clothes.

Big Mac Prices: January 2013 Price in domestic Price in US currency $s United States 4.37 4.37 China 16.00 2.57 Japan 320.00 3.51 Taiwan 75.00 2.54 Euro area 3.59 4.88

Once you acknowledge the differences in prices, then there is a problem with the international comparisons specified above, which is precisely the same problem we have when comparing the wages of someone in Kingston, RI with someone from Anchorage, Alaska. Prices are notoriously high in Anchorage, so the $ does not go as far and simple comparisons of salary would not be very useful to someone considering a move. According to the online calculator at MySalary.com, the cost of living in Anchorage is 11.3% more than in RI, so if you moved to Alaska from RI for the same salary, it would seem like a loss in income of about 10%.

To account for differences in prices there is a second set of GDP numbers - the purchasing power parity GDP (PPP) figures.x Its back to The World Economic Outlook Databases, and as you see below, the rankings can be quite different. The US numbers are the same in all columns because in the second and third columns GDP data are specified in US $s. In the table you see that the GDP figures for Greece and Austria are close for the two measures suggesting that the purchasing power of a US $ is comparable in these countries – that the Big Mac will be close to the $4.37 cost in the US. In Austria the PPP GDP figure is below the US $ GDP figure indicating higher prices in Austria, while in India and China the opposite is true.

So how big is China’s economy? If we adjust our GDP data to account for the lower prices in China, China’s economy is 84% of the US economy, a significant increase over the 56% when using the exchange rate conversion.

Alternative Measures of GDP: 2013 GDP national GDP US $ GDP PPP $ % of US in % of US in currency GDP US $ GDP PPP $ Austria 318 423 368 3% 2% China 57,716 9,020 13,623 56% 84% Greece 183 244 270 2% 2% India 110,702 1,973 5,032 12% 31% US 16,238 16,238 16,238 100% 100%

6 Now let’s look briefly at the historical track record of the US.

The track record: US

1. The long-term upward trend in GDP is quite evident in the first graph. The two most pronounced deviations from the trend are in the 1930s, when output was below trend during the Great Depression, and the 1940s, when it was above the trend during WW II. 2. The short-term fluctuations are best seen by converting annual GDP data to annual percentage change that appears in the second graph. One striking feature is the change that takes place around 1950. Before 1950 volatility in GDP was substantially higher than in recent years - with years of double-digit increases and decreases - far higher than anything that we see in the post 1950 period. The economy has become more stable since 1950.

3. The fastest growing components of Aggregate Demand have been import spending (M) and export spending (X) that increased by approximately 300% and 233% between 1990 and 2008, just before the Great Recession devastated both. Between 2008 and 2009 imports to the US dropped 23%, while exports dropped 15% - in one year. Since 1960 there were few instances where exports and imports actually declined, and in the steepest decline in 1982, exports fell 7% while imports dropped 5%. The most stable components have been government spending (G) and consumption spending (C), although the Great recession had an impact on both of these two components. Since 1960 neither consumption nor government spending had never declined year-to-year, but in the Great Recession consumption fell while government spending leveled off. The most volatile component, as you can see in the downturn in the Great Recessions was investment spending (I) that declined nearly 20% between 2008 and 2009.

The track record: International

1. Economic growth in the Middle East, which includes many of the major oil producing states, was closely tied to the price of oil. In the 1980s when the price of oil was low, GDP grew slowly, while in the 2000 when the price rose sharply, so did GDP growth rates.

7 2. The 1980s was also difficult for Latin America. The growth rates in GDP fell by almost two-thirds from the 1970s as the continent weathered the Latin American Debt Crisis in the early 1980s. Many Latin American countries plus Mexico had borrowed BIG money in the 1970s, and when the recession hit in the early 1980s they could not pay their bills, beginning with Mexico in 1982. As lending to the region collapsed so did their economies, which is reflected in the very slow growth in the decade – not enough to offset the population growth. 3. Growth in the wealthy European Union was notably slower than the rest of the advanced countries in the 1980s and 1990s, but the gap closed in the 2000s. 4. The 1990s was not kind to the Commonwealth of Independent States – the countries that formerly belonged to the Soviet Union. Annual GDP growth in the 1990s averaged -6% as they struggled with the conversion from communism to capitalism. 5. Asia was clearly THE success story. Newly industrialized Asian economies (think Hong Kong, Korea, Taiwan) and Developing Asia (think China and India) sustained real GDP growth rates of 7% a year – more than twice as fast as the advanced countries (think Europe, US and Japan) and fast enough to double GDP in a decade). 6. Africa's growth lagged that of the other developing countries for the 1980s and 1990s, but by the 2000s they had growth rates that equaled that of other developing economies, in large part driven by the growing world demand for natural resources that are abundant there. .

For those interested in data for individual countries, you should check out the IMF's World Economic Databases or a summary of some of the more notable features of world economic growth.

Real GDP (annual % change) 1980s 1990s 2000s Advanced economies 3% 3% 2% Newly industrialized Asian economies 8% 6% 4% European Union 2% 2% 2% Emerging and developing economies 3% 4% 6% Central and eastern Europe 2% 2% 4% Commonwealth of Independent States 6% -6% 6% Developing Asia 7% 7% 8% Latin America and the Caribbean 2% 3% 3% Middle East and North Africa 1% 4% 5% Sub-Saharan Africa 3% 2% 6%

Now that you know the “facts” concerning GDP, let’s look a little closer at what we are really measuring sine there are a number of limitations with the way we measure the size of the economy.

Limitations

This looks pretty easy, and reasonable, and to politicians and policy makers talking about GDP, size matters. Bigger is definitely better, and when this accounting system was merged with Keynes' macroeconomic theory, GDP became enshrined as a key barometer of economic prosperity even though it is at best an imperfect economic well-being, a point emphasized in Cobb, Halstead, and Rowe's Atlantic Monthly article: "If the GDP is Up, Why is America Down? When I think of GDP I think of a statement I once read that went something like this: "All that is important is not measured, and all that is measured is not important." GDP is an important measure, but there are many things included in it that a reasonable person would not look at as a "good", and there are many things left unmeasured that affect one's well being, and now we will examine some of the limitations of GDP as a measure of welfare.

1. Nonmarket activities: In a country such as the US many services are provided outside of the market and are therefore excluded from GDP calculations. "[L]left out two large realms: the functions of family and community on the one hand, and the natural habitat on the other."xi There is no question

8 value is being created by a mother at home raising kids, but this value does not show up in GDP. The result is that as "parenting becomes child care, visits on the porch become psychiatry and VCRs, the watchful eyes of neighbors become alarm systems and police officers, the kitchen table becomes McDonald's - up and down the line, the things people used to do for and with one another turn into xii things they have to buy," GDP rises indicating that GDP growth has been biased upwards over the second half of the 20th century as a result of the movement of women into the workforce - GDP has risen faster than output in this period.xiii This also raises questions about comparisons of GDP in the US over long periods of time, and questions about GDP comparisons among nations with very different patterns of market and nonmarket activity. 2. Illegal activities: You most likely all know people who "work under the table" because they want to avoid the IRS and paying taxes, the INS because they are illegal immigrants, or law enforcement agencies because they are conducting illegal activities such as illegal gambling, prostitution, and drugs. These activities, which are often described as the underground economy or informal economy, are substantial - but hard to measure. One ambitious effort at creating international comparisons found Africa and Latin America at the top of the list with the informal economy averaging about 42 % of xiv GDP, and the Transition Countries where the average was 38%. Among the world's wealthier countries, the 20 OECD countries, the average was 18%, ranging from 27% in Greece and 27% in Italy to 9% in Switzerland and the US. What was also clear in the study was that the informal economy, at least in the wealthier OECD countries, grew substantially in the 1990s, and that the size of the informal economy is affected by tax rates, the extent of industry regulation, and the rule of law. 3. Leisure: There is no question leisure is a good - more leisure is preferred to less - and individuals are often willing to trade off work and income against leisure. Given that people chose to take the time off, they are better off by doing it, but GDP would go down in this situation. This certainly seems relevant in light of the substantial differences between the average workweek across different countries. The US Bureau of Labor Statistics compiled the average annual hours worked per employee that is available at A Chartbook of International Labor Comparisons (2010 Edition). Workers in the US worked substantially more hours than workers in Europe.xv In 2008 Americans worked 1792 hours - more than 30% more hours than workers in Norway, 25% more than workers in Germany, and 15% more than workers in France. Americans did work substantially fewer hours than workers in Korea – 23% less - and about the same as workers in Japan.xvi If you want to read a little more about the American worker's workweek, you should check out The Overworked American by Juliet Schor. 4. Inequality and Aggregation: Consider the situation where we have two countries with ten people each. In Country A you have an equitable distribution of income and between years 1 and 2 all the people experience a 10% increase in income so the per capita (per person) figure provides useful insight into what has happened to the economic condition of the people in Country A. The same cannot be said in country B where the reported per capita growth would be the same 10%, except here one person experienced a 14% gain while the other 9 experienced a 10% cut in income. In this case the reported 10% increase is virtually meaningless.xvii When looking at "real" world data, the income in the US is more inequitably distributed than the other wealthy countries, so caution must be exercised when doing international comparisons of the living conditions of the "average" individual. The growing inequality of the US in the last twenty years of the 20th century, meanwhile, also limits the ability to look at growth in average GDP per capita as a useful indicator of changes in standard of living. 5. Bads: Because of the nature of the GDP calculations, "[i]t does not distinguish between costs and benefits, between productive and destructive activities, or between sustainable and unsustainable ones. The nation's central measure of well being works like a calculating machine that adds but cannot subtract."xviii Given this system, a natural disaster can provide a boost to the economy in much the same way as a war. An example would be the boost to GDP given by the recovery efforts following the destruction of hurricane Andrew, or the economic growth in Germany and Japan in the 1930s as they mobilized for war. These "bads" would tend to push up GDP as long as the hurricane devastated primarily residential areas, as Andrew did, or the wars are fought in other countries, which was not the case in Yugoslavia, the Congo, and Rwanda where wars in the 1990s had a devastating effect on the economy. The nature of GDP computations also means the enormous sums spent on security tend to push GDP higher, as we saw following the bombing in Oklahoma City that gave the economy a little boost as it generated demand for security systems. While it may be a bit of an overstatement, "[b]y the curious standard of the GDP, the nation's hero is a terminal cancer patient who is going through a costly divorce."xix

9 6. Environment and natural resources: GDP is to the national economy what annual income is to you, and as you know, income alone is an incomplete measure of your well-being.15a For example, consider the situation of two people who live on annual incomes of $50,000. The first person has a job that pays an annual salary of $50,000, while second has savings of $500,000 that is reduced each year by a withdrawal of $50,000 used to live. Each has $50,000 to live on, but for the second person the withdrawals from the account are not sustainable. We have a similar situation when we look at GDP. Every country possesses an endowment of natural resources that can generate annual income and an environment that sustains life, and changes in neither of these are accounted for in GDP. If you are a Middle Eastern oil producing nation, GDP might be quite high due to the revenues from selling oil, but the oil is running out and the GDP figures would not reflect the fact that you have a country that is selling off its assets and leaving nothing for future generations.xx

Also included under this limitation would be the pollution of the environment. When the nation spends $300 billion to clean up pollution, this shows up in GDP, but this expenditure is quite different from $300 billion spent on computers. This spending on clean up is not an increase in welfare in the sense that two countries with similar levels of pollution, one that attained it with $300 billion of clean-up costs and the other that spent nothing because it created no pollution, would be expected to have similar levels of well-being, although in the first GDP would be $300 billion larger. And if things get really dirty as a result of pollution and you have to paint your house more often or seek medical treatment more often, then this pollution will give GDP a further boost. The limitations of this can be seen in the "haze" that blocked the sun in much of Southeast Asia in the summer of 1997 - pollution produced as a by-product of the rapid economic growth. This point was emphasized by Barber Conable, then president of the World Bank, who in 1989 acknowledged that: "Current calculations ignore the degradation of the natural resource base and view the sales of nonrenewable resources entirely as income."xxi According to Herman Daly, a former World Bank economist, "the current accounting system treats the earth as a business in liquidation." The depletion of natural resources is completely ignored in the national accounts, which makes sense only when the supply of resources is unlimited.xxii 7. New Goods and Quality Changes: For new goods consider the situation in early 1980s after the personal computer had been introduced, but the government was still using the base year of 1972 when there were no personal computers.xxiii To calculate the price changes of computers the government assumed the prices would rise at the same rate as that for typewriters. In fact, computer prices rose much slower than typewriter prices so when the revisions were made to GDP after the new base year was established in 1982, real GDP was revised upward. A similar problem exists when we talk about quality. All computers are not created equal - and neither are all cars. In fact, personal computers have not been around all that long, which made it difficult for the "bean counters" to calculate the price of computers backwards. Furthermore, a computer today is very different from a computer in 1990, and a car today is also very different. The computer in 1990 would have had an Intel 486 microprocessor with 1.18 million transistors, but by 2000 it would have contained the Pentium 4 processor with 42 million transistors. You would also have access to the web with a web browser, which you didn't have back in 1990. If you look at cars, you find a similar situation. Today's cars drive longer without a need for servicing, the stereo systems are much better, as are the heating and steering systems, and on some cars you even have GPS so you can't get lost. The problem is, do you attribute the price increase to higher prices for the same good, or similar price for more good. If you opted for the second, you would find GDP to be higher. This limitation of GDP was well known to Kuznets who wrote in a 1962 New Republic article that "[o]nce you start asking 'what' as well as 'how much' - that is, about quality instead of just quantity - the premise of national accounts as an indicator of progress begins to disintegrate, and along with it much of the conventional economic reasoning on which those accounts are based."

Alternatives

Given all of these limitations, it should be no surprise that there has been interest in alternative measures of well being that can be traced back at least to Robert Kennedy statement in 1968.

10

Gross Domestic Product does not allow for the health of our children, the quality of their education, or the joy of their play. It does not include the beauty of our poetry or the strength of our marriages, the intelligence of our public debate, or the integrity of our public officials. It measures everything, in short, except that which makes life worthwhile, and it can tell us everything about America, except why we are proud that we are Americans.

By the early 1970s economists Nordhaus and Tobin developed Measured Economic Welfare (MEW), but it xxiv never gained much popularity. An alternative approach was taken by Richard Easterlin who identified alternative measures of quality of life / or standard of living.xxv One of the possibilities was health, which makes sense since you would consider a healthier life to be a better life. Since the 1940s we have seem most of the major diseases, at least in the world's wealthy countries, controlled so there has been little concern about crippling polio or deadly plague that were ever present dangers for older generations. Imagine the pain in a world with no Novocain or ether. A good indicator of how health, and health care, has changed is the following description of the treatment someone in 1826 in Philadelphia would have received for chills and pains in the neck and head.

he was bled till symptoms of fainting came on. Took an emetic, which operated well. For several days after, kept his bowels moved in Sulp. Soda, Senna, tea, etc. Then he employed a Physician who prescribed another Emetic...

This is a not an image I am too comfortable with, which makes me unlikely to go too far back in time when given the chance. What I do know is many of these changes are reflected in biological measures. Life expectancy statistics, for example, have risen sharply - from about 25 years in 1800 to about 66 years in 2000 - and as we saw earlier, GDP per capita is correlated with life expectancy.xxvi

A second possibility would be what Easterlin calls, Family Circumstances - what I might call individual freedom and something with which the female readers should be able to readily identify. Imagine the following description of a working-class woman's life at the end of the 19th century.

Their typical working-class mother of the 1890's, married in her teens or early twenties and experiencing ten pregnancies, spent about fifteen years in a state of pregnancy and in nursing a child for the first five years of life. She was tied, for this period of time, to the wheel of childbearing. Today, for the typical mother, the time so spent would be about four years. A reduction of such magnitude in only two generations in the time devoted to childbearing represents nothing less than a revolutionary enlargement of freedom for women.

Would you want to give up the freedom you have today to determine the number of children you have, and how much of your life you devote to child rearing? As for an indicator, it is not easy, but maybe we could use the fertility rate - the expected number of children a woman is expected to have in her lifetime. And the fertility rate tends to drop as economies develop and as individual's income increases, which suggests that the fertility rate does track other potential indicators of the "quality of life." It is no accident that countries such as Afghanistan, Somalia, Yemen, and Saudi Arabia, where the rights of women are quite limited, all have fertility rate above 6, among the highest in the world, while Japan and many European countries have fertility rates below 2, which is why their populations are projected to decline. If you were a woman and thinking about quality of life, then the fertility rate might be a good barometer when making the choice of where and when to live.

It is a good deal easier to complain about GDP than to come up with an alternative, but the pressure is mounting to identify some alternatives. In October of 2008 the New York Times reported on some of the efforts in Economix

The Organization for Economic Cooperation and Development has studied its own G.D.P. alternatives that take into account leisure. Others have proposed the Index of Sustainable

11 Economic Welfare, which factors in both pollution and income distribution, and the Genuine Progress Indicator, which tries to determine if economic growth has improved a country’s welfare. Alternative efforts try to supplement or supplant traditional income-based measures with happiness-based measures. These include the Happy Planet Index, a Gross National Happiness measure and work on National Well-Being Accounts, which our Daily Economist Alan Krueger has studied extensively.

Here we will look briefly at some alternatives that fit into one of three categories – modifications of GDP, direct measures of welfare, and composite indexes.

Modify GDP

The most obvious approach is to add some “goods” that GDP misses and subtract some “bads.” The first attempt to modify GDP was the Measure of Economic Welfare (MEW) developed in 1972 and adjusted GDP to account for the contributions of household and volunteer work and leisure and the costs of pollution. In 1989 the Index of Sustainable Economic Welfare (ISEW) extended MEW to include reductions for private defensive expenditures and the depreciation of natural capital, which resulted in growth rates sharply lower than those of GDP. At the web site it describes its efforts as “an attempt to measure the portion of economic activity which delivers genuine increases in our quality of life - in one sense 'quality' economic activity,” and in fact if you go to that site you can generate your own indexes by changing the weighting scheme for the 19 “adjustment terms built into ISEW” to reflect your preferences.

In 1993 the Bureau of Economic Analysis began constructing Environmental Satellite Accounts as part of President Clinton’s call for green GDP measures, but Congress banned them in 1994, and in 2007 China’s political leaders banned the publication of green GDP figures that were developed the preceding year because of a substantial loss in economic growth.

In 1989, Barber Conable, president of World Bank, proclaimed that “Current calculations ignore the degradation of the natural-resource base and view that the sales of nonrenewable resources as entirely income … A better way must be found,” and the World Bank has made an effort to modify GDP to better capture the environment missing in GDP data. The information is available at their Environmental Economics and Indicators sitexxvii where you will find a set of environmental indicators including two indicators linking the macro-economy and the environment - adjusted net savings and wealth. Adjusted net saving is designed to measure the true saving rate in a country by accounting for investments in human xxviii capital, depreciation of produced assets, and the depletion and degradation of the environment. Wealth accounting, meanwhile, was designed to take account of the value, and depletion, of a nation’s resources - produced, natural, and intangible capital.

Direct measures of well-being

In addition to modifying GDP there have been attempts to develop direct measures of well-being that tend to be more subjective. Rather than compile data on how much “stuff” you consumed in a year, take a survey and ask people how they feel about your current situation. At a personal level, a longitudinal study that followed a sample of Harvard grads for 75 years attempted to do just that and found some interesting results reported in “What makes us happy?”xxix At the national level, the idea gained some press when English Prime Minister David Cameron announced in 2010 that a new well-being measure would be developed that would better reflect how people were doing than GDP. The index “encompasses objective prerequisites for achieving well-being, such as education, health, housing and income. Combined with these, are more subjective measures of well-being which include a person’s sense of purpose, happiness, and life satisfaction.”xxx

Cameron’s effort was not the first. That distinction goes to Bhutan’s creation of Gross National Happiness that was based on a survey of people’s level of well-being. Since then there have been other efforts that are chronicled at the World Database of Happiness that contains a compilation of studies on happiness and quality of life. As with life expectancy, there is a positive correlation between GDP per capita and

12 happiness / satisfaction evident in the graph below. As GDP per person rises the percent of the population reporting that they are very/quite happy rises, although it seems to level off at $20,000 with higher GDP not producing higher happiness.

In 2008 there were two developments in this area. First, the Gallup-Healthways Well-Being Index was developed to, according to their web site, “create the official statistic for measuring Americans' well- being.” It includes measures in six categories Life Evaluation, Emotional Health, Physical Health, Healthy Behavior, Work Environment, and Basic Access. Second, President Sarkozy of France established a Commission on the Measurement of Economic Performance and Social Progress that concluded “There is no single indicator that can capture something as complex as our society” and suggested three alternatives to GDP – a subjective measure (how do you ‘feel?” objective measures (health, education, political voice…) and measures of sustainability. Two years later, the new prime minister of England, David Cameron proposed that the Office of National Statistics measure the country’s ‘general well-being’ (GWB) as a complement to GDP.

Composite indexes

The most widely known composite measure in the UN’s UN Human Development Index (HDI) that was designed to capture a wide array of indicators that measure a country's performance on three dimensions - a healthy life, knowledge, and standard of living.xxxi When comparing rankings based on the HDI and GDP we find there are some differences in the rankings, but generally you have European countries and the US at the top of the lists - Luxembourg and the US at the top when measured by GDP per capita and Norway and Iceland when measured by HDI. At the bottom of both lists African countries, although the rankings change a bit depending on the measure. In fact some as a weakness of the HDI sees the strong correlation between the two variables because it seems to add little beyond GDP.

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More recently we have the Social Progress Index of national well-being that “measures the extent to which countries provide for the social and environmental needs of their citizens. Fifty-two indicators in the areas of basic human needs, foundations of wellbeing, and opportunity show relative performance in order to elevate the quality of discussion on national priorities and to guide social investment decisions.”xxxii

A third composite measure is the Happy Planet Index (HPI) that claims its goal as revealing “the ecological efficiency with which human well-being is delivered,” which it does by creating an “index combines environmental impact with human well-being to measure the environmental efficiency with which, country by country, people live long and happy lives.” More specifically it contains data on three dimensions – life expectancy, life satisfaction, and ecological footprint, and at the HPI web site you can find world maps for each of the components plus the composite, which also appear at the end of the footnotes. And once again there appears to be a relationship between GDP and the alternative measure – this time “happy life years.”

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Now it is time to look at how we measure prices and inflation.

Prices - CPI

It wasn't easy to measure quantity, and it certainly is not going to be easy to measure prices, but it will make it easier for you to understand the press if you note the distinction between the price level and the inflation rate. The price level is a measure of the buying power of money at a point in time, while the inflation rate is a measure of the rate of change in the price level. It is also important to recognize that all price increases are not the same - and all price increases do not represent inflation. Prices change all the time - maybe a bad harvest will drive up the price of wheat, or the decision by OPEC ministers to cut the supply of oil will drive up oil prices, or technological improvements in the production of computers will drive down computer prices. These are called changes in relative prices. It is only when the price increases occur for a large number of goods that we would refer to it as inflation, and most often it would be a concern to policy makers only if it was an increase that was sustained. In this section we will look at the CPI (Consumer Price Index) – what it is, why it is so controversial, and what the track record has been within the US and internationally.xxxiii The CPI is also used to calculate the inflation rate that you hear mentioned so often. The inflation rate is simply the percentage change in the CPI for a year.

Definitions and measures

The Bureau of Labor Statistics (BLS) provides monthly estimates of the price level based on surveys of household spending patterns. Once the spending patterns have been observed and an average "market basket" of goods and services has been established, then every month BLS workers go shopping to determine the cost of purchasing that market basket. According to the BLS:

The CPI market basket is developed from detailed expenditure information provided by families and individuals on what they actually bought. For the current CPI, this information was collected from the Consumer Expenditure Survey over the three years 1993, 1994, and 1995. In each of these three years, more than 5,000 families from around the country provided information on their spending habits in a series of quarterly interviews. To collect information on frequently purchased items such as food and personal care products, another 5,00 families in each of the 3 years kept diaries listing everything they bought during a 2-week period.

Once the shopping is completed, BLS releases data on the Consumer Price Index that is computed by dividing the market basket's current cost by its cost during the base year (year of survey) and multiplying by 100. For example, in November 2007 the CPI was reported as being 210 with a base year of 1982-84 (1982-84=100). This means that between 1983 and 2007 the price level rose approximately 110%.

Now that you understand what is behind the price indexes and inflation rates, it's time to see why policy makers care so much about inflation and why the CPI is so controversial.

Costs of Inflation

It is easy to understand why we care about unemployment because we can relate to those unable to find work, but why do we care about rising prices? Think about why you care about inflation before you read on because there are real costs.

First, there are winners and losers with unexpected inflation, which is one of the major costs of inflation. As a general rule unexpected inflation hurts those on fixed incomes and those who have lent out money. If inflation doubles your food bill while that monthly pension check remains constant, then your buying power and welfare have certainly been reduced. An example of this would be the excessive inflation

15 in Russia after the collapse of the communist system that eroded the buying power of Russia's pensioners.xxxiv

Second, there are also "menu costs" - the costs of continually changing brochures and menus to update prices. Resources that might have gone into the production of "stuff" now goes into the production of menus.

Third, in periods of inflation it is difficult for decision makers to forecast prices and this is likely to result in inefficiencies since wrong decisions will be made by those who fail to recognize the difference between real and nominal values. In this situation, especially if the inflation rate is high or rising, you can expect decision makers to be more cautious in decisions that involve longer horizons - a decision to buy a house, to buy corporate stock, or to build a new factory being three examples. In the extreme case where there is hyperinflation similar to what destroyed Germany's economy in the early 1920s, the entire economic system will breakdown as money no longer has any value.

Fourth, inflation is also important because it shows up in contracts that have a cost-of-living escalator clause (COLA). The best example of this would be Social Security. Recognizing the effects of inflation on the buying power of earnings, the Social Security Administration adjusts benefits each year to keep benefits rising with prices so the value of "real" benefits will remain unchanged. If prices rise 5% this year then retirees checks rise 5% so the buying power of those checks does not change - they get 5% more that helps them pay the 5% higher prices.xxxv Social Security offers an example of just such a contract. The benefits next year (SS(2)) depend upon Social Security benefits this year (SS(1)) plus an adjustment reflecting inflation (%DCPI).

SS(2) = SS(1)*(1+%ΔCPI)

So far so good, but there is one BIG problem. Most economists believe the official inflation rate based on the CPI overestimates inflation, then we have BIG problems.29 First, as you can see in equation 1, if you overestimate inflation then the official price index (CPI) is too high and your estimate of real (R) is too low. Second, all COLA clauses would mean future payments would be higher than needed to keep a person's cost-of-living constant. We will not get into the details of this debate, but you should be aware that this is a BIG issue because SS is so expensive and controversial because of the power of the AARP that represents the elderly whose membership will swell with the boomers reaching age 65.

What we'll do now is look at the domestic and international track record of inflation.

The track record: US

The two graphs below provide an overview of the history of inflation in the US, at least since the early 1800s. Here are a few observations based on the data.

1. The history of the price level in the US can be divided at WW II into two sub periods. In the pre WWII period there is at best a minimal upward trend in the price level. The price level as the US entered the Great Depression in 1930 was little different from what it was in 1820 - what appears to be a sustained period of price stability. The only recognizable increases in the price level during that period were around the early 1860s and the late 1910s - the Civil War and WW I. Things changed considerably after WW II, however, with the price level rising continuously after 1940, most notably during the 1970s.

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The history of the price level in the US can be divided at WW II into two sub periods. In the pre WWII

2. The history of inflation in the US can also be divided at WWII into two distinct sub periods. In the pre war period it is clear that what looked like stable prices was far from that. In fact it was characterized by alternating periods of substantial inflation (rising prices) and deflation (falling prices) - hardly what would be described as a period of price stability. In the Post WWII period, meanwhile, the period of sustained increases in the price level was actually a mix of inflation and disinflation (declines in inflation rate). The fluctuations occurred around an upward trend through the 60s and 70s and a downward trend in the 80s and 90s. Comparing these inflation data with the GDP data, we find the pre WWII era volatility of GDP was matched by volatility in the inflation rate. GDP expansions were matched by inflation, and recessions were matched by deflations. In the post WW II period, meanwhile, the greater stability in output was accompanied by sustained, and less volatile, inflation. 3. Wars matter - at least historically. To finance wars governments tend to print money - lots of money - and this shows up in higher prices reflected in higher rates of inflation, followed by deflation once peace breaks out. The inflation rate during the Civil War (1860s) exceeded 20% a year - enough to double prices in less than four years. During WWI prices also rose sharply, averaging greater than 15% a year for the years 1917-1920, so that in the decade ending in 1920 the price level in the US had doubled. Things were substantially different in WW II (1941-1945), in large part because of the imposition of rationing and price controls during the war. Price increases during the war were modest, averaging less than 5% a year, but once the war was over and controls were lifted, the pent up demand pushed prices sharply higher - 26% in 1946. Finally, during the Vietnam War (late 1960s) inflation began to trend upwards, a trend that continued through the 1970s. 4. The state of the economy matters. Inflation tends to be higher during years of strong GDP growth and low unemployment - and lower during bad years of declining GDP and high unemployment. The severe recession of the late 1870s, 1890s, and the 1930s all show up in the inflation rate graph as periods of deflation. It is important to note that even though there are costs of inflation, the costs are generally less than when there is deflation. In the late 19th century the US experienced a decline in prices that led to the Populist movement and the famous Cross of Gold speech of William Jennings Bryan as well as The Wizard of Oz. What remains to be seen at a later time, is the nature of the causality - was it deflation that caused the economy to slow, or was it the slow economy that pushed prices down. 5. Monetary policy matters. The only period of sustained peacetime inflation in the US occurred in the 1970s, a period when the US experimented with Keynesian monetary policy. The experiment turned out badly and by the end of the decade the nation's central bank, the Federal Reserve, conducted a second experiment. The links between the policies and inflation is the subject of the 1970s unit. 6. The inflation rates of the various components of the CPI market basket tend to move together because they are subject to the same macroeconomic influences. What is also very clear from the diagram below is the magnitude of the OPEC-induced oil price shocks in 1973 and 1979 when the inflation rate in the energy category approached 40% and the extent of the collapse in the mid 1980s when energy prices fell about 20%. Oil prices rose again in 1990 during the Gulf War and again in 1996, before a fall in 1997 &1998 as Asia struggled through the Asian crisis. Once the world economy recovered by the 1999 oil prices rose sharply and continued to do so throughout most of the 2000s, pushed higher by the rapid growth in the world economy/ Only the recessions in 2001 and 2008 drove prices down. Also evident in the graph is the

17 above average rate of inflation in the medical care category in the 1980s and 90s that prompted Bill Clinton to initiate the process of reforming the health care industry.xxxvi

Before leaving the discussion of inflation, let's look a bit more closely at the inflation track record to see if some patterns emerge.

The track record: International

Inflation rates by the late 1990s appeared to be under control in the US, but what was the track record internationally. Let's begin with where you might find international inflation rate data. One place would be the BLS, the agency responsible for the US inflation rate data. A second place would be The World Economic Outlook Databases at the IMF. An examination of the data reveals the following "inflation facts."

Average Inflation Rates: Consumer Prices Country Group Name 1980s 1990s 2000s World 16.2 18.3 4.0 Advanced economies 6.3 2.9 2.0 Major advanced economies (G7) 5.5 2.6 1.9 Newly industrialized Asia 6.6 4.8 2.0 European Union 9.0 9.3 2.5 Emerging and developing economies 43.6 57.5 6.8 Central and eastern Europe 30.6 69.5 12.2 Commonwealth of Independent States 372.3 13.9 Developing Asia 9.6 8.6 3.8 Latin America and the Caribbean 136.3 129.2 7.1 Middle East and North Africa 11.8 11.9 6.8 Sub-Saharan Africa 16.6 28.0 10.4

1. Inflation rates in the advanced countries tended to rise in the 1970s and then fall in the 1980s, and fall further in the 1990s and fall even further in the 2000s. Inflation rates in Europe have converged in the 1990s, in large part the result of the move toward a common currency - the euro – that involved meeting certain limits on inflation rates for those countries that were converting their currencies to the euro in 1999. You also see that the northern European countries have tended to have lower inflation rates and Germany has always maintained low rates. Within Europe, Greece is the inflation rate success story in the 1990s. The inflation rate fell from 20% in the 1980s to 9.1% in the 1990s to 3.4% in the 2000s. Other success stories were in Portugal, Spain and Italy where near double digit rates were eliminated.

18 Average Inflation Rates Euro Countries: Consumer Prices Country 1980s 1990s 2000s Austria 3.4% 2.0% 1.8% Belgium 4.5% 2.0% 2.0% Cyprus 4.9% 3.8% 2.4% Finland 6.6% 1.9% 1.7% France 6.3% 1.8% 1.9% Germany 2.6% 2.3% 1.6% Greece 19.6% 9.1% 3.4% Ireland 7.6% 2.6% 2.2% Italy 9.8% 3.7% 2.2% Luxembourg 5.4% 2.2% 2.3% Malta 2.2% 3.1% 2.4% Netherlands 2.4% 2.3% 2.2% Portugal 17.2% 4.7% 2.4% Slovak Republic 4.1% Slovenia 4.1% Spain 9.3% 4.0% 2.8%

2. Inflation rate were extremely high during the 1990s in the countries that were members of the Soviet Union (Commonwealth of Independent States) at the beginning of the 1990s. The fiercest bouts of hyperinflation were reported in Armenia in 1994 (5,273%), Georgia in 1994 (15,606%), Turkmenistan in 1993 (3,102), Tajikistan in 1993 (2,194) and Ukraine in 1993 (4,734). Russia's inflation peaked in 1992 and 1734%. As for the decade, the worst inflation rates were in Turkmenistan and Belarus where the annual rate exceeded 320%, fast enough so that in the decade a loaf of bread that cost 100 Manat in Turkestan in 1992 would cost 15.6 million Manat in 2000.

Average Inflation Rates CIS Countries: Consumer Prices 1990s 2000s Armenia 208% 4% Azerbaijan 149% 7% Belarus 327% 20% Georgia 7% Kazakhstan 151% 9% Kyrgyz Republic 85% 7% Moldova 85% 10% Mongolia 52% 9% Russia 121% 12% Tajikistan 245% 14% Turkmenistan 346% 7% Ukraine 209% 11% Uzbekistan 164% 14%

3. Developing Asia has done a better job of controlling inflation than the rest of the developing world. In the 1980s and 1990s, when inflation in the developing countries exceeded 43%, in developing Asia it did not exceed 10%, and in the Newly industrialized Asia (Asian Tigers) it was even lower. 4. Inflation rates were exceptionally high in Latin America during the 1980s as countries attempted to deal with a crushing international debt burden. When confronted with large debts, the countries turned to their printing presses and printed currency. The most virulent inflation in the region was in the 1980s in Bolivia (210%) and Brazil (336%) and the 1990s (204%). In most of the countries you also see inflation trended downward through the three decades with substantially lower inflation rates in the 2000s in all countries with the exception of Venezuela. In Argentina the inflation rate for all but one year in the 1980s was above 100%, and it peaked in 1989 at 3,100%. Other bouts of hyperinflation - above 1,000 % a year - were experienced in Bolivia in 1984 (1200%) and 1985 (12,000%), Peru in 1989 and 1990 (51,00% and 7,485%), and Brazil in 1989 and 1992-1994 when it ranged from 100% to 3000%). To give you some perspective on

19 these numbers and why hyperinflation is so debilitating, consider the plight of an individual in Bolivia at the beginning of 1985 who purchased a loaf of bread for 100 boliviano. By the end of the year that bread would have cost 12,000 bolivano.

Average Inflation Rates Latin America: Consumer Price Country 1980s 1990s 2000s Argentina 15.7% 9.6% Bolivia 210.1% 9.1% 4.7% Brazil 336.3% 204.4% 6.7% Chile 20.3% 9.4% 3.3% Colombia 23.6% 20.0% 5.6% Ecuador 36.3% 42.5% 8.2% Mexico 65.1% 18.3% 4.7% Paraguay 27.7% 13.4% 7.8% Peru 38.0% 2.4% Uruguay 60.6% 35.2% 8.7% Venezuela 23.3% 43.3% 22.1%

5. Japan in the 1990s was actually experiencing deflation, which as we saw earlier in our discussion of the US, tends to occur in tough economic times. This was not surprising in an era described by some as the Quiet Depression.

What we can be certain of is that the government's measures of the output market will continue to undergo revisions and that policy makers will continue to worry about inflation and GDP growth. Now it is time for us to move from the description phase to the explanation phase of the course - to move from describing periods of inflation or unemployment to explaining them.

20 MM Output Market

i Ronald Reagan was very successful with the "Misery Index" that he "sold" as an indicator of a poorly performing economy in the 1980 presidential election, something John Kerry could not duplicate in 2004 with his Middle-Class Misery Index. Reagan's misery index was the sum of the inflation and unemployment rates, while Kerry combined seven variables (median family income, college tuition, health costs, gasoline costs, bankruptcies, homeownership rate, private-sector job growth) in his. ii Song Shengxia, “GDP per capita record masks economic woes, didn’t transform lives: experts,” Global Times, February 23, 2013 iii Edward Wong, “Cost of Environmental Damage in China Growing Rapidly Amid Industrialization,” NYT March 29, 2013 iv Costs of pollution in China,” World Bank, February, 2007 v Interest in "keeping the books" on the US economy developed during the Great Depression and over the years a system of accounts has evolved that generates THE central measure of the economy's size. In 1931, as the depression deepened, some leading experts were assembled before Congress and asked to answer some basic questions about the economy - questions they could not answer because they had very little data. Congress attempted to remedy the situation when the Senate assigned the Commerce Department the task of developing a system of national income accounts that would provide a measure of the nation's output - and the Commerce Department turned to Simon Kuznets. Today, if you are looking for GDP data you will find it published in a series of releases, the timing of which are inversely related to the size of the samples used to derive the statistics and to their accuracy. As a result, you will find it difficult to assemble a consistent time-series because of continual revisions of earlier data. For example, if you look for GDP data in two issues of Economic Indicators or the Survey of Current Business, you will find there will be two different figures for GDP. In recent years the quality of these initial estimates has declined, in part a result of reductions in the budget appropriations for the data collection agencies in the government. The best sources for consistent time-series would be the Economic Report of the President, for annual data. For those interested in recent data, you will find it at Economic Indicators or The Economic Briefing Room. Information on the estimation procedure is available on-line (Methodology, National Income and Product Accounts, 1929-94, as is the actual data at BEA's National Accounts Site. vi GDP includes in the US figure only the value created by Juan, while GNP would include only the value created by Mary. GNP is the market value of currently produced, final goods and services produced by permanent residents of a nation within a specified period of time. Of the two, I grew up hearing about GNP, but you will hear most about GDP. Those older than 40 grew up with gross national product (GNP), but you are likely to hear more about gross domestic product (GDP). GDP has become the primary economic measure used in analyses of economic growth and inter country comparisons of standards of living. GDP focuses on the economic activity within the 50 states, while GNP focuses on the economic activity of a nation's factors of production. The movement away from GNP to GDP, reflects the globalization process currently underway. As the international sector of the US economy expands, it is beginning to resemble that of the other developed countries, which have used GDP as their measure of output. In this sense the move toward GDP is comparable to the move toward the metric system, a move toward a common yardstick, although care must be taken when making intertemporal and international comparisons. There may be another reason to favor GDP over GNP, at least based on the work of Cobb et al. According to these authors, "[u]nder the old measure, the gross national product, the earnings of a multinational firm were attributed to the country where the firm was owned - and where the profits would eventually return. Under the gross domestic product, however, the profits are attributed to the country where the factory or mine is located, even though it won't stay there. This accounting shift has turned many struggling nations into statistical boomtowns, while aiding the push for a global economy. Conveniently, it has hidden a basic fact: the nations of the North are walking off with the South's resources, and calling it a gain for the South." vii Information on the procedure for converting nominal GDP to real GDP is available on-line (Methodology, National Income and Product Accounts, 1929-94. viii The equation below captures the relationship between current-dollar GDP (N), constant-dollar GDP (R), and the price level (PI) which is the GDP Price Deflator, one measure of the price level.

(1) R =N/PI

The logic of the equation is quite straightforward. If prices (PI) double and the value of goods and services (N) doubles, then there is no change in real output (R). What should also be evident is the importance of the measure of the price level since if we have a measure of prices that has PI rising too rapidly, then our measure of real GDP (R) will be too low - an issue we touch on in the section on the CPI.

Now that you see the scope of the problem, we'll look at one more wrinkle proposed by William Nordhaus who made an effort to look at the long-term changes in the price of illumination as an alternative to traditional measures of price. According to De Long, "The argument that our commodity-focused price indices miss most of the real action ñ that price indices focusing on the services provided would produce vastly greater estimates of long-run economic

21 growth ñ is made most powerfully by William Nordhaus in his study of the economic cost of light." What Nordhaus did in essence was ask the question, what does it cost me to get a lumen of light, the basic unit of light, rather than the traditional approach of what does it cost me to purchase the commodity that provides light. The differences are staggering. He concludes that the past hundred years have seen a ten thousand-fold decline in the real price of illumination, yet commodity-based price indices have only captured a ten-fold decline in this price. Based on these findings, Nordhaus concludes that a "comparison of the true price of light with a traditional light price indicates that traditional price indexes overstate price growth, and therefore understate output growth, by a factor between 900 and 1,600 since the beginning of the nineteenth century. This finding suggests that the "true" growth of real wages and real output may have been significantly understated during the period since the Industrial Revolution." ix The base year is 2000, which is reflected in the equality of the real and nominal GDP values and in the title (2000 $s). x A simple example is described by Michael Pakko and Patricia Pollard in "Burger Survey Provides Taste of International Economics." You pick a universal good, something that you can by anywhere - the Big Mac. According to data in Pakko and Pollard's article, in the US an Big Mac was $2.71, in Argentina it was 4.10 pesos, and the exchange rate was 2.88 pesos per dollar. At these exchange rate the Big Mac in Argentina would cost you $1.42 because with those 4.1 pesos you could buy $1.42. You would do the same if you had GDP data for the two countries. For example, GDP per capita in Japan in 2000 was 4,044,261 yen and the US$ exchange rate was 107.76 yen, therefore GDP per capita in US $s in Japan would be $37,528 [4,044,261/107.76]. The figure for GDP per capita in the US at that time was $35,069. But what if prices were substantially higher in Japan? Then your money would not go as far in Japan as it does in the US and you would feel poorer in Japan despite the fact GDP per capita figures indicated GDP per person was higher in Japan. The same thing is true if you are thinking about moving somewhere in the US and comparing local salaries. The price of a house in San Francisco is substantially higher than the price in Providence, RI and it would therefore be unreasonable to assume someone with an income of $50,000 would have the same buying power or lifestyle in the two cities. The problem is exchange rates do not reflect differences in buying power associated with price differentials - whether we are talking about Japan vs. the US or Providence vs. San Francisco. And then there is that burger that costs much more in the US than in Argentina. When we take into account purchasing power differences, international rankings can be substantially affected as you can see in the table below based on the OECD data. Turkey's economy is 1/4 the size of Japan's if we use the PPP method, but only 1/12 the size if we use the exchange rate method. Mexico, meanwhile is nearly 25% of the size of the US economy if the PPP method is used, substantially higher than the 15% figure when the exchange rate method is used. For those who like to keep score, you will also note that the relative ranking of Japan and the US depends upon the method adopted. If we accept the PPP method, then per capita GDP in the US is substantially above that in Japan, but if we accept the exchange rate method, Japan comes out on top. To test your mastery of the table, you should attempt to explain the flip-flop as we compare the US and Japan using the two measures. The PPP measure reflects the fact that when an American with $s travels to Japan, the $ does not buy as much. In Mexico, meanwhile, prices seem cheap so their GDP based on PPP is higher that the exchange rate GDP. Looking at this a little differently, if you were going to travel, you would feel much wealthier in a country in which the current exchange rate GDP is lower than the PP GDP. 1999 GDP per capita ( US $s) OECD based on based on Member current exchange current purchasing Ratio Countries rates power parities Mexico 4921 8383 1.7 United States 33836 33836 1.0 Japan 35517 25590 .72 Germany 25729 23840 .93 Switzerland (1) 36247 28697 .79 Turkey (1) 2809 6338 2.26 xi Clifford Cobb, Ted Halstead, and Jonathan Rowe, "If the GDP is UP, Why is America Down?," Atlantic Monthly October 1995 xii ibid xiii An interesting spin on nonmarket goods was provided by Dora Costa & Matthew Kahn in "The rising price of nonmarket goods," (AER May 2003). They see the standard of living as comprising both market and nonmarket goods and they posit that to generate a measure of welfare you would need to weigh both with their prices. And they find that the value of nonmarket goods has increased and that this should be reflected in any analysis. If you did this you would find that existing measures of welfare would be biased downward.

22 xiv Freidrich Schnieder's "Size and measurement of the Informal Economy in 110 Countries Around the World" (World Bank Working Paper, July 2002). The worst, which was no surprise based on what we hear in the news, were Zimbabwe, Tanzania, and Nigeria in Africa where the informal economy exceeded 55% of GDP, and Bolivia, and Panama in Latin America and Georgia and Azerbaijan in the former Soviet Union where it exceeded 60%. xv The data from the report are: Annual hours worked per employed person, 1990 and 2001 (BLS) 1990 2001 Change U.S. 1838 1821 -17 Australia 1866 1837 -29 Japan 2031 1821 -210 Korea 2514 2447 -67 New Zealand 1820 1817 -3 Denmark 1492 1482 -10 France 1657 1532 -125 Germany 1560 1467 -93 Ireland 1922 1674 -248 Italy 1674 1606 -68 Netherlands 1654 1346 -308 Norway 1432 1364 -68 Spain 1824 1816 -8 Sweden 1549 1603 54 U.K. 1838 1711 -127

1. xvi Annual hours worked per employed person

Source: BLS, Charting International Labor Comparisons (2010 Edition) Chart 2.9 - Annual hours worked per employed person, 1998 and 2008 (HTM) (PDF) xvii 13. Here are the data that generate the numbers Individuals Country A Country B Year 1 Year 2 % change Year 1 Year 2 % change

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1 $50,000 $55,000 10% $410,000 $469,000 14% 2 $50,000 $55,000 10% $10,000 $9,000 -10% 3 $50,000 $55,000 10% $10,000 $9,000 -10% 4 $50,000 $55,000 10% $10,000 $9,000 -10% 5 $50,000 $55,000 10% $10,000 $9,000 -10% 6 $50,000 $55,000 10% $10,000 $9,000 -10% 7 $50,000 $55,000 10% $10,000 $9,000 -10% 8 $50,000 $55,000 10% $10,000 $9,000 -10% 9 $50,000 $55,000 10% $10,000 $9,000 -10% 10 $50,000 $55,000 10% $10,000 $9,000 -10% Per capita / average $50,000 $55,000 10% $50,000 $55,000 10% xviii Clifford Cobb, Ted Halstead, and Jonathan Rowe, "If the GDP is UP, Why is America Down?," Atlantic Monthly October 1995. These authors point out this limitation of GDP when they suggest the problem of a local police chief reporting that "'activity' on the city streets had increased by 15%..." People would want to know what type of activity increased - was it sales at the local Gap store, or the local steel mill, or was it arrests for drug sales or prostitution? The first two of these would be considered goods, while the second two would be considered as bads, but there would be no distinction between the two in the activity measure. xix Clifford Cobb, Ted Halstead, and Jonathan Rowe, "If the GDP is UP, Why is America Down?," Atlantic Monthly October 1995. xx This is one of the concerns in Middle Eastern countries that are working to diversify their economies. Check out Dubai and Qatar for examples of ambitious efforts to remake the national economy with less reliance on oil. In 2004 Dubai was in the press for its establishment of Internet City to help it become the India of the Middle East, while Qatar gained notoriety when its national airline was among the first buyers of the Airbus A380-800 super jumbo jet that will have up to 800 passengers. xxi The UN has also picked up the idea and at their site you will find a link to environmental statistics where the UN has created an "adjusted measure of total national output, including only the consumption and investment items that contribute directly to economic well-being. Calculated as additions to gross national product (GNP), including the value of leisure and the underground economy, and deductions such as environmental damage. It is also known as net economic welfare (NEW) (Samuelson and Nordhaus, 1992)." Since 2003 the UN has also been developing its Integrated Environmental and Economic Accounting (SEEA) that it describes as follows. ...a satellite system of the System of National Accounts. It brings together economic and environmental information in a common framework to measure the contribution of the environment to the economy and the impact of the economy on the environment. It provides policy-makers with indicators and descriptive statistics to monitor these interactions as well as a database for strategic planning and policy analysis to identify more sustainable paths of development. The SEEA 2003 comprises four categories of accounts: • Flow accounts for pollution, energy and materials (Chapters 3 and 4). These accounts provide information at the industry level about the use of energy and materials as inputs to production and the generation of pollutants and solid waste. • Environmental protection and resource management expenditure accounts (Chapters 5 and 6). These accounts identify expenditures incurred by industry, government and households to protect the environment or to manage natural resources. They take those elements of the existing SNA, which are relevant to the good management of the environment and show how the environment- related transactions can be made more explicit. • Natural resource asset accounts (Chapters 7 and 8). These accounts record stocks and changes in stocks of natural resources such as land, fish, forest, water and minerals. • Valuation of non-market flows and environmentally adjusted aggregates (Chapters 9 and 10). This component presents non-market valuation techniques and their applicability in answering specific policy questions. It discusses the calculation of several macroeconomic aggregates adjusted for depletion and degradation costs and their advantages and disadvantages. It also considers adjustments concerning the so-called defensive expenditures. xxii There is also a problem with the measurement of the service sector and government. The service and government sectors are enormous, but they pose real problems to bean counters trying to determine real output and price indexes. It is easy to measure the output of an auto plant, but how do you measure the output of government or education or banking, and how do you decompose nominal GDP changes into output and price changes. The solution devised by the

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Commerce Department is to use inputs to measure output - if employment in universities rises by 5%, then output is assumed to rise by 5%. Then there is the question of value. You would expect students and the families that pay some of the education bills would only make this investment if it was worth the money, and as you saw in the unit on opportunity cost, the cost of education is larger than the tuition rate. Unfortunately, in GDP accounting education is valued at the tuition so GDP would underestimate the value of education. In banking, it was not so long ago that dealing with the bank meant dealing with bankers' hours, a very short day that did not include weekends, and the wait for turnaround on loans often took weeks. Today banking services are available 24-, and often you needn't leave home to access these services - but none of this "increase in the quality" of services is picked up in GDP. As a final example consider the run up in stock prices in the late 1990s. Since the value of the broker services are tied to the prices of stocks, the commissions, which do show up in GDP, rose substantially and this pushed output higher - and as we will see later, it also showed up as higher productivity in the broker industry. xxiii Comparisons over time turn out to be a verrrry difficult problem because of the dramatic changes in the types and qualities of goods available to people. To get an idea of the situation, consider the following examples provided by Brad DeLong and Easterlin. Looking Backward. Looking Backward is a novel that sold extraordinary numbers of copies in the 1890s because it struck a utopian cord. In it the narrator, thrown forward in time from 1895 to 2000, is asked by his hosts in the year 2000--more than a century in his future--the question: "Would you like to hear some music?" He expects his host to play the piano--a social accomplishment of upper-class women around 1900.To listen to music on demand then, you had to have in your house or nearby an instrument, and someone trained to play it. It would have cost the average worker some 2400 hours, roughly a year at a 50-hour workweek, to earn the money to buy a high-quality piano, and then there would be the expense and the time committed to piano lessons. Now the labor-time value of a Steinway piano has fallen in price from 2400 average worker-hours a century ago to 1100 average worker- hours today. But if what you value is not the piano itself but the capability of listening to music at home, the cost has fallen from 2400 average worker-hours a century ago to 10 hours today (240 dollars for the boom-box plus 10 dollars for the CD). and The transformation of living levels has been qualitative as well as quantitative. By comparison with the conveniences and comforts widely available in developed economies at the end of the 20th century, everyday life two centuries ago was most akin to what we would know today as 'camping out.' In the late 18th century United States (which even then was a relatively rich society), for example, among the rural population, which comprised 95% of the total, housing consisted of '[one] story log houses and frame houses with one or two rooms and an attic under the rafters. Cellars and basements were practically unknown and frequently there was no flooring except the hard earth. The fireplace with the chimney provided heating and cooking. "The worldwide standard of living since 1800," Journal of Economic Perspectives, Winter 2000. For those interested in some of the mechanics of estimating computer prices, you should read A Note on the Impact of Hedonics and Computers on Real GDP by Stephen Landefeld and Bruce Grimm. For those interested, we can make this a little more concrete with the example in the table below where one computer and one car are produced and computers originally cost 25% as much as a car and individuals spend 20% of their budget on computers. As a result of significant price cuts in computers, by Year 2 the price of computers has fallen by 50% so that they cost 12.5% of what a car costs. Individuals, meanwhile, have responded by increasing their purchase of computers - doubling their purchases to two. At the lower prices, individuals are now buying twice as many computers, but they are spending the same share of their income on computers. Real (Constant $) GDP Output Output Prices Prices GDP in GDP - Year 1 at GDP - Year 2 at GDP in Output year 1 year 2 year 1 year 2 year 1 year 2 prices year 1 prices year 2 cars 1 1 $80 $80 $80 $80 $80 $80 computers 1 2 $20 $10 $20 $10 $40 $20 $100 $90 $120 $100 Now let's construct the two fixed-weight indexes. Index A = Hypothetical GDP(2) / Nominal GDP(1) = $120/$100 = 1.20 Index B = Nominal GDP(2) / Hypothetical GDP(1) / = 100/90 = 1.11 When using the Year 1 base prices, the two computers produced in Year 2 equal $40 which overstates the increase in real computer output in Year 2. Similarly, when using the Year 2 base prices, the one computer produced in Year 1 equals $10, which understates the increase in real computer output in Year 2.

25 xxiv MEW would start with GNP and then subtract from it some bads (pollution, crime..) and some services that do not increase welfare (public spending such as national security, police and fire, ... ) and add in some nonmarket activities such as leisure and householder services. Interest in alternative measures of economic welfare did not last long, though, and very little came of MEW once the country and its economic policies moved to the ideological right behind the leadership of Ronald Reagan. xxv Richard Easterlin, "The worldwide standard of living since 1800," Journal of Economic Perspectives, Winter 2000. you also might be interested in Brad De Long's suggestion of computing how many hours of work it takes to purchase some of the "basics." (Long in his article "Cornucopia: Increasing Wealth in the Twentieth Century." For De Long) For example, to purchase a one speed bicycle, based on the Montgomery Ward Catalogue, it would have taken you 260 hours of work at average wage rates in 1895. A century later it would have taken you 7.2 hours, which makes the average person about 36 times better off. If we used that Steinway piano, meanwhile, we would only be twice as well off. Even an approach such as this, however, may be a bit misleading since today people would not need a silver teaspoon, but would settle for an inexpensive alloy providing the same function as the silver spoon at much less cost, or the online encyclopedia that is virtually free. Multiplication of Productivity 1895-2000 Time Needed for an Average Worker to Earn the Purchase Price of Various Commodities Commodity Time-to-Earn in 1895 (Hours) Time-to-Earn in 2000 (Hours) Productivity Multiple Horatio Alger (6 vols.) 21 0.6 35 One-speed bicycle 260 7.2 36.1 Cushioned office chair 24 2 12 100-piece dinner set 44 3.6 12.2 Hair brush 16 2 8 Cane rocking chair 8 1.6 5 Solid gold locket 28 6 4.7 Encyclopedia Britannica 140 33.8 4.1 Steinway piano 2400 1107.6 2.2 xxvi . Richard Steckel, "Biological Measures of the Standard of Living," Journal of Economic Perspectives, Winter 2008 xxvii At the national level they can also be used for clarifying objectives and setting priorities." Included is Green Accounting that is defined as follows. ..."greener" national accounts holds the promise of placing environmental problems into a framework that key economic ministries in any government will understand. For too long now, ministries of finance and planning have paid scant attention to the exploitation of the natural resource base, or the damaging effects of environmental pollution. At the same time, countries have been developing national environmental action plans that read as if they were written by the environment ministry with no links to the economics ministries. In The Little Green Data Book you will find many of the indicators that appear in the World Development Indicators including measures of forestry and biodiversity, energy, emissions and pollution, water and sanitation, and environment and health. Below is a sample of the available data from the 2006 book for the Low and High Income countries, and as expected, there are significant differences. GDP per capita is nearly 64 times higher in the High Income countries, while the infant mortality rate is 17 times higher in the Low Income countries. CO2 emissions per capita are about 60% higher in the wealthy countries, even though energy consumption per capita is nearly 11 times higher in these countries. Little Green Data Book Data Low Income High Income GDP per capita 507 32,112 % land in forests 25% 29% Energy per capita (kg of oil) 501 5410 CO2 emissions per capita (M tons) 8 12.8 < 5 mortality rate (per 1,000 people) 122 7 xxviii According to the World Bank, "Adjusted net savings departs from standard national accounting in several ways. The most obvious difference concerns resource depletion. While the rents on natural resource extraction are included implicitly in standard income measures, adjusted net savings makes this explicit by deducting the value of depletion of the underlying resource asset (although in the case of forests that are sustainably managed, there is no net depletion). Deducting pollution damages, including lost welfare in the case of human morbidity and mortality, is appropriate as long as it is assumed that society is aiming to maximize welfare. Finally, adjusted net savings estimates consider

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current educational spending as an increase in saving, since this spending may be considered to be an investment in human capital (rather than consumption, as in the traditional national accounts)." In 2004 the adjusted savings rates ranged from 32% in Namibia to -82% in Chad. Among the 8 countries with the highest savings rates, 5 are from Asia, including China, which is a reflection of the high personal savings rate in those countries. The list of countries on a potentially dangerous, unsustainable path are not surprises and consist primarily of Middle Eastern, African and Western Asian countries that are depleting their mineral resources. Among the high net savings group are surprises including Namibia, China, and Mongolia - all of which have high savings rates. The estimates of total wealth that appear below once again reveal an all-too common pattern - the high wealth countries include the US, Europe, and Japan while the low wealth countries tend to be in Africa.

Green Accounting Net Savings (% of GNI (2004)) Wealth per capita in 2000$ (2000) Best Worst Best Worst Namibia 34.31 Nigeria -28.22 Switzerland 648,241 Niger 3,695 Singapore 33.04 Trinidad and Tobago -28.31 Denmark 575,138 Congo, Rep. 3,516 China 27.80 Syrian Arab Republic -28.42 Sweden 513,424 Sierra Leone 3,293 Maldives 27.76 Angola -36.32 United States 512,612 Tajikistan 3,193 Mongolia 26.59 Uzbekistan -37.04 Germany 496,447 Burundi 2,859 Philippines 25.89 Azerbaijan -39.99 Japan 493,241 Nigeria 2,748 Ireland 23.33 Oman -40.56 Austria 493,080 Congo, DR 2,174 Korea, Rep. 22.94 Chad -82.21 Iceland 482,367 Ethiopia 1,965

xxix Joshua Wolf Shenk, “What makes us happy?” The Atlantic, June 1, 2009 xxx Siobhan Farmer and Barbara Hanratty, “Well-being: David Cameron’s happiness index,” Oxford University Press blog, May 17, 2012 xxxi The Human Development Index includes measures of a healthy life, measured by life expectancy; knowledge, measured by the adult literacy rate and enrollment in school; and the standard of living, measured by the purchasing power parity version of GDP. According to Wikipedia, The Human Development Index (HDI) is "used to determine and indicate whether a country is a developed, developing, or underdeveloped country and also to measure the impact of economic policies on quality of life. The index was developed in 1990 by Indian Nobel prize winner Amartya Sen, Pakistani economist Mahbub ul Haq, with help from Gustav Ranis of Yale University and Lord Meghnad Desai of the London School of Economics and has been used since then by the United Nations Development Programme in its annual Human Development Report. Described by Sen as a "vulgar measure", because of its limitations, it nonetheless focuses attention on aspects of development more sensible and useful than the per capita income measure it supplanted, and is a pathway for serious researchers into the wide variety of more detailed measures contained in the Human Development Reports." What the index does not measure that the UN correctly identifies as important dimensions of welfare would be respect for human rights, democracy, and inequality. Comparison Rankings: Human Development Index and GDP Per Capita (2007) Best Worst HDI GDP HDI GDP Iceland Luxembourg Mali Niger Norway US Niger Tanzania Australia Norway Guinea-Bissau Congo Canada Ireland Bukina Faso Burundi Ireland Iceland Sierra Leone Malawi Source: 2007 tables The World Bank, in its World Development Report and Poverty Net site also includes a variety of variables on individual countries and for individuals in those countries. You will find GDP, but you will also find Social Indicators and a measure of household living standards where you will find data on life expectancies, illiteracy, malnutrition, infant mortality and accessibility to sanitation. In somewhat of a surprise, Elliot Berg, when reviewing data on Africa and South America in the 1980s, found there were some inconsistencies when comparing the economic indicators and quality of life indicators, that the 1980s looked better in many instances than the economic results showed. The significance of this is that an assessment of the policies of the 1980s might look different depending upon what indicators we use. As mentioned earlier, The Economist (1/22/2000), in a similar, yet much less formal way, attempted to take a broader view of the impact of the Asian crisis of 1998 that traditionally has been assessed in terms of

27 employment or GDP. They reported that as the economy collapsed, the number of suicides, children in orphanages, babies abandoned, and child drug abuse rose sharply. There was, however, some potentially good news in that alcohol and tobacco spending dropped nearly 30%. For those who like maps, you might want to check out Mapping Global Environment web site at the World Bank to see an interesting interactive site that identifies environmental problems around the world. At home, as far as I can tell the Commerce Department began to compute a "Green GDP" that accounts for resources used up in the production process. April 21, 1993 Clinton directed Commerce to calculate "Green GDP." According to Clinton in his address: The existing national income accounting system - used here and in other countries essentially ignores the impact of economic development on the environmental resources that are the foundation of economic prosperity. For example, an oil tanker spill can increase GDP if the cost of cleanup is included as income to workers while the pollution costs of fouling the beach go unrecorded. In April of 1994 the Bureau of Economic Analysis, the agency responsible for computing GDP, laid out its plan for Integrated Economic and Environmental Satellite Accounts in the Survey of Current Business, but I cannot find evidence of its existence now.

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xxxii Social Progress Imperative web site. http://www.socialprogressimperative.org/data/spi xxxiii The CPI was developed during WW I by the federal government to provide cost-of-living increases to shipbuilders at a time where prices were rising rapidly. (Remember that Massachusetts' first index was also constructed to help pay soldiers during a period of steep price increases). To get a handle on the CPI let's look at a simple example of how we might approach the problem of determining what has happened to the price of entertainment. Let's assume we followed the BLS approach and conducted a survey in 1997 of what people do for entertainment and collected data on the prices of each form of entertainment. In the table below are the results of the survey indicating the number of tickets purchased and the prices of those tickets. If this were the consumer price index, then included here would be items from the major expenditure categories - Food and beverages, Housing, Apparel and its upkeep, Transportation, Medical care, Recreation, Education and communication, and Other goods and services. In this example the average person in 1997 went to the theatre 6 times and paid $10 a visit and also went to 2 football games at a price of $8 a game, while in 2004 the 3 trips to the theatre cost $15 each and the 3 football games cost $10 each. Between 1997 and 2007 both the mix of entertainment events attended and the prices of those events changed. With these data in mind, think about what we mean when we ask: what happened to the price of entertainment? What we will do here is walk through a process similar to that the BLS does when computing the CPI. ENTERTAINMENT PURCHASES Price Quantity 1997 2007 1997 2007 Theatre Ticket 10 15 6 3 Concert Ticket 3.5 10 4 1 Basketball Ticket 4 5 6 8 Football Ticket 8 10 2 3 Dinner 8 12 8 6

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Hotel Room 30 75 3 2 The first step in the creation of the index is the estimation of total expenditures in the base year - the year of the survey, which in this case is 1997. Actual expenses in 1997 are $268. ACTUAL 1997 EXPENSES = 10*6 +3.5*4 +4*6 +8*2 +8*8 +30*3 = $268 The second step would be a computation of 2007 expenses that would be $347. So far so good except that in the "real" world this would not be possible to compute because there is no survey done of purchasing at this time. The surveys of purchasing patterns are only done periodically, and in the interim all the information that is collected would be current prices. ACTUAL 2007 EXPENSES = 15*3 +10*1 +5*8 +10*3 +12*6 +75*2=$347 If all of this information existed, you would be able to say that expenses increased 29% between 1997 and 2007 [347/268-1 = .29 = 29%]. It would seem as though you would say that the cost of entertainment increased 29% between the two years, but be careful. As we saw with the calculations of GDP, entertainment expenses changed as a result of changes in prices (e.g.. the price of a dinner increased from $8 to $12) AND changes in purchases (e.g. the number of concerts attended dropped from 4 to 1). To calculate the change in prices, we need to separate out the two effects by computing a new hypothetical expenditure figure - the expenditures that would need to be made in 2007 if a person paid the 2007 prices but purchased the same basket of entertainment as in 1997. The hypothetical expenses would be $501. HYPOTHETICAL 2004 EXPENSES (1997 purchases at 2001 prices) = 15*6 +10*4 +5*6+ 10*2+ 12*8+ 75*3 = $501 If you had not changed your behavior between 1997 and 2007 then your entertainment costs would have risen from $347 to $501. It is now possible to construct an price index, the Entertainment Price Index (EPI), that would measure what happened to entertainment prices. [If we were talking about the BLS market basket of goods consumed by US households, then we would be talking about the Consumer Price Index (CPI).] In both cases you first must initialize the index at 100 for the base year - the year in which the initial survey was taken. In this example, the EPI would have a value of 100 in 1997. The EPI for the year 2007 is computed using the following formula.

EPI(2007) = 100*(501/268) = 187 So what does this mean? The EPI of in 2007 is 187 can be interpreted in a number of ways. (1) WHAT COST $100 IN 1997 COST $187 IN 2007 (2) PRICES WENT UP 87% (187-100) (4) A 2004 DOLLAR IS WORTH $.54 (100/187) What you cannot yet calculate is the inflation rate because it is defined as the percentage change in the price index for one year. To calculate the annual inflation rates we would need to have annual figures for the EPI, which appear in the table below. The inflation rate for 2007 was 4% [501/480-1 = .04 = 4%]. ENTERTAINMENT PRICE INDEX AND INFLATION RATES Inflation EPI rate 1997 268 -

1998 284 6%

1999 302 6%

......

2004 390

2005 440 13%

2006 480 9%

2007 501 4% xxxiv Barry Hobijn & David Lagakos, "Inflation Inequality in the United States," FRBNY Staff Paper October 2003 xxxv When making the adjustment for inflation using the official CPI statistics, in addition to the above mentioned concerns, you should also not lose sight of the peculiarities of the CPI that limit its value to you in your individual calculations of inflation's impact. The CPI is based on a market basket of what the "average" consumer in the US buys, and this average may be very different from the basket you buy. For example, fuel oil is relied on heavily for heat in the Northeast and when there are dramatic shifts in the price of home heating oil, these will have a greater impact on consumers in the Northeast. Similarly, if I were trying to estimate the change in the value of state appropriations to a public university, I would probably be interested in measuring the buying power of the funds that most certainly would not be used to purchase the CPI market basket of goods and services. The basket of goods and services purchased by

30 the university would be quite different, which is why there is a higher education price index (HEPI). In the period 1981-1995 the HEPI increased at an annual rate of 5%, substantially higher than the 4% rate for the CPI. The implication is that even if a university received increases in funding equal to increases in the CPI, by 1995 their budgets would not have been able to buy them as much as their budgets in 1981. The Wall Street Journal, recognizing its readers may not be too "average" has at time published its Luxury Spending Index that includes Greenwich home prices, caviar, and luxury yacht charters. xxxvi Questions concerning the accuracy of the CPI have been around as long as the index. During World War II the BLS's Cost of Living Index (later to become the Consumer Price Index) had become a hot topic because it was an input in labor negotiations. The value of the index helped determine workers' wages (Persky 1998), and according to organized labor, the index underestimated price increases due to the existence of rationing, black markets, and the deterioration in quality - an underestimate some thought reached 50%. A commission was formed, and after a review of the data, they reported the overestimate was only 5%. More recently the Boskin Commission was formed to once again examine the adequacy of the CPI. The approaches of the two price level commissions were quite different, and on most of the major issues, the two commissions took opposite positions. The similarity was in their conclusions. According to Persky, the "net effect was that the recommendation of the Mitchell commission served to defend the government from paying workers more to compensate them for wartime inflation, and the recommendations of the Boskin committee have served to argue that the government should index a lower rate of inflation, and thus pay less in retirement benefits and collect more in taxes. A cynic might conclude that economists as a group are committed to a political agenda aimed at limiting the demands that indexation may make on the public purse." For those interested, you might want to check out the BLS response to the Boskin Commission's report. For those interested in checking out some of the issues and solutions, you will find a link Measurement Issues at the BLS site that provides some background on the substantial changes that have been made in the CPI in response to the initial recommendations made by the Advisory Commission to Study the Consumer Price Index, commonly known as the Boskin Commission, in December of 1996. This Commission, established to once again examine the validity of the current measure of the CPI, concluded "Using empirical evidence and the members' own judgments about the magnitude of these biases, [the commission] concludes that the CPI overstates the true cost-of-living change by 1.1 percentage points per year." This may not sound like much, but think of this in light of the debate over Social Security after we do a simple calculation. If we went back to 1993 we would see Social Security payments in the US budget were nearly $305 billion. Now let's ask what those payments would be if they increased by the stated inflation rate and if they had been increased by an adjusted inflation rate that was 1% per year lower. The difference would be about $40 billion, which is no small change. And if you projected it out twenty-five years into the future when the last of the baby boomers will reach age 65, the savings gets even larger because of the compounding. Assuming that the official inflation rate averages 3.5%, the difference in Social Security benefits would be about $275 billion - and that is even without the increase in number of retirees due to the baby boomers ageing. It is no surprise that the proposal was fought by the AARP and that eventually the effort just disappeared. What was it that made the commission think the CPI overestimated inflation? We will not go into specifics, but we can see some of the issues with our simple entertainment example. Commodity substitution bias: In the EPI problem we saw that the mix of entertainment activities changed over time, although the EPI did not allow for this. Normally you expect, based on traditional demand theory, that as the price of one entertainment activity rises you will substitute less expensive activities for it, and that is what we saw in our example. Concerts increased most in price (86%), while football and basketball games increases least (50%), and the response was predictable. Concert going was cut substantially while more football and basketball games were attended. Some of this adjustment would be expected and would not mean you were worse off because of the changed behavior, so the EPI, which assumes no such adjustment, overestimates inflation. Outlet Substitution bias: In the years since the first sample, you have seen the average price of a dinner increase from $8 to $12, which suggests a 50% increase. If you had been going to the same restaurants over this period then the 50% is probably a reasonable estimate of the price increase, but what if you changed the restaurants you attended. What if you moved from Burger King to Casey's in Wakefield. In this case the 50% would be an overestimate of the true increase in the cost of your dinners because it would also include a cost of moving a bit upscale. When estimating the CPI, we have seen the rise of the box stores that tend to have lower prices which means that increasing numbers of shoppers are shopping in these big box stores. The CPI, however, is based on a set basket of goods and retail outlets so the move to box stores is not reflected in the CPI. Quality adjustments: Let's look at the football game where during this period they introduced the wide screen displays that allow the audience to watch instant replays.

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