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133 Chapter 6 | The Macroeconomic Perspective

6 | The Macroeconomic
Perspective

Figure 6.1 The Great Depression At times, such as when many people having trouble making ends meet, it is easy
to tell how the economy is doing. This photograph shows people lined up during the Great Depression, waiting for
relief checks. At other times, when some are doing well and others are not, it is more difficult to ascertain how the
economy of a country is doing. (Credit: modification of work by the U.S. Library of Congress/Wikimedia Commons)

How is the Economy Doing? How Does One Tell?

The 1990s were boom years for the U.S. economy. Beginning in the late 2000s, from 2007 to 2014 economic
performance in in the U.S. was poor. What causes the economy to expand or contract? Why do businesses
fail when they are making all the right decisions? Why do workers lose their jobs when they are hardworking
and productive? Are bad economic times a failure of the market system? Are they a failure of the government?
These are all questions of macroeconomics, which we will begin to address in this chapter. We will not be able
to answer all of these questions here, but we will start with the basics: How is the economy doing? How can
we tell?

The macro economy includes all buying and selling, all production and consumption; everything that goes
on in every market in the economy. How can we get a handle on that? The answer begins more than 80
years ago, during the Great Depression. President Franklin D. Roosevelt and his economic advisers knew
things were bad—but how could they express and measure just how bad it was? An economist named Simon
Kuznets, who later won the Nobel Prize for his work, came up with a way to track what the entire economy is
producing. In this chapter, you will learn how the government constructs GDP, how we use it, and why it is so
important.

134 Chapter 6 | The Macroeconomic Perspective

Introduction to the Macroeconomic Perspective
In this chapter, you will learn about:

• Measuring the Size of the Economy: Gross Domestic Product

• Adjusting Nominal Values to Real Values

• Tracking Real GDP over Time

• Comparing GDP among Countries

• How Well GDP Measures the Well-Being of Society

Macroeconomics focuses on the economy as a whole (or on whole economies as they interact). What causes
recessions? What makes unemployment stay high when recessions are supposed to be over? Why do some countries
grow faster than others? Why do some countries have higher standards of living than others? These are all questions
that macroeconomics addresses. Macroeconomics involves adding up the economic activity of all households and
all businesses in all markets to obtain the overall demand and supply in the economy. However, when we do
that, something curious happens. It is not unusual that what results at the macro level is different from the sum
of the microeconomic parts. What seems sensible from a microeconomic point of view can have unexpected or
counterproductive results at the macroeconomic level. Imagine that you are sitting at an event with a large audience,
like a live concert or a basketball game. A few people decide that they want a better view, and so they stand up.
However, when these people stand up, they block the view for other people, and the others need to stand up as well if
they wish to see. Eventually, nearly everyone is standing up, and as a result, no one can see much better than before.
The rational decision of some individuals at the micro level—to stand up for a better view—ended up as self-defeating
at the macro level. This is not macroeconomics, but it is an apt analogy.

Macroeconomics is a rather massive subject. How are we going to tackle it? Figure 6.2 illustrates the structure we
will use. We will study macroeconomics from three different perspectives:

1. What are the macroeconomic goals? (Macroeconomics as a discipline does not have goals, but we do have
goals for the macro economy.)

2. What are the frameworks economists can use to analyze the macroeconomy?

3. Finally, what are the policy tools governments can use to manage the macroeconomy?

Figure 6.2 Macroeconomic Goals, Framework, and Policies This chart shows what macroeconomics is about.
The box on the left indicates a consensus of what are the most important goals for the macro economy, the middle
box lists the frameworks economists use to analyze macroeconomic changes (such as inflation or recession), and the
box on the right indicates the two tools the federal government uses to influence the macro economy.

Goals

In thinking about the macroeconomy’s overall health, it is useful to consider three primary goals: economic growth,
low unemployment, and low inflation.

• Economic growth ultimately determines the prevailing standard of living in a country. Economists measure
growth by the percentage change in real (inflation-adjusted) gross domestic product. A growth rate of more
than 3% is considered good.

• Unemployment, as measured by the unemployment rate, is the percentage of people in the labor force who
do not have a job. When people lack jobs, the economy is wasting a precious resource-labor, and the result is

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135 Chapter 6 | The Macroeconomic Perspective

lower goods and services produced. Unemployment, however, is more than a statistic—it represents people’s
livelihoods. While measured unemployment is unlikely to ever be zero, economists consider a measured
unemployment rate of 5% or less low (good).

• Inflation is a sustained increase in the overall level of prices, and is measured by the consumer price index. If
many people face a situation where the prices that they pay for food, shelter, and healthcare are rising much
faster than the wages they receive for their labor, there will be widespread unhappiness as their standard of
living declines. For that reason, low inflation—an inflation rate of 1–2%—is a major goal.

Frameworks

As you learn in the micro part of this book, principal tools that economists use are theories and models (see
Welcome to Economics! for more on this). In microeconomics, we used the theories of supply and demand. In
macroeconomics, we use the theories of aggregate demand (AD) and aggregate supply (AS). This book presents two
perspectives on macroeconomics: the Neoclassical perspective and the Keynesian perspective, each of which has its
own version of AD and AS. Between the two perspectives, you will obtain a good understanding of what drives the
macroeconomy.

Policy Tools

National governments have two tools for influencing the macroeconomy. The first is monetary policy, which involves
managing the money supply and interest rates. The second is fiscal policy, which involves changes in government
spending/purchases and taxes.

We will explain each of the items in Figure 6.2 in detail in one or more other chapters. As you learn these things,
you will discover that the goals and the policy tools are in the news almost every day.

6.1 | Measuring the Size of the Economy: Gross Domestic

Product

By the end of this section, you will be able to:

• Identify the components of GDP on the demand side and on the supply side

• Evaluate how economists measure gross domestic product (GDP)

• Contrast and calculate GDP, net exports, and net national product

Macroeconomics is an empirical subject, so the first step toward understanding it is to measure the economy.

How large is the U.S. economy? Economists typically measure the size of a nation’s overall economy by its gross
domestic product (GDP), which is the value of all final goods and services produced within a country in a given
year. Measuring GDP involves counting the production of millions of different goods and services—smart phones,
cars, music downloads, computers, steel, bananas, college educations, and all other new goods and services that a
country produced in the current year—and summing them into a total dollar value. This task is straightforward: take
the quantity of everything produced, multiply it by the price at which each product sold, and add up the total. In 2016,
the U.S. GDP totaled $18.6 trillion, the largest GDP in the world.

Each of the market transactions that enter into GDP must involve both a buyer and a seller. We can measure an
economy’s GDP either by the total dollar value of what consumers purchase in the economy, or by the total dollar
value of what is the country produces. There is even a third way, as we will explain later.

GDP Measured by Components of Demand
Who buys all of this production? We can divide this demand into four main parts: consumer spending (consumption),
business spending (investment), government spending on goods and services, and spending on net exports. (See
the following Clear It Up feature to understand what we mean by investment.) Table 6.1 shows how these four
components added up to the GDP in 2016. Figure 6.4 (a) shows the levels of consumption, investment, and
government purchases over time, expressed as a percentage of GDP, while Figure 6.4 (b) shows the levels of exports
and imports as a percentage of GDP over time. A few patterns about each of these components are worth noticing.
Table 6.1 shows the components of GDP from the demand side.

https://Inflationisasustainedincreaseintheoveralllevelofprices,andismeasuredbytheconsumerpriceindex.If

136 Chapter 6 | The Macroeconomic Perspective

Components of GDP on the Demand Side (in trillions of
dollars)

Percentage of
Total

Consumption $12.8 68.8%

Investment $3.0 16.1%

Government $3.3 17.7%

Exports $2.2 11.8%

Imports –$2.7 –14.5%

Total GDP $18.6 100%

Table 6.1 Components of U.S. GDP in 2016: From the Demand Side (Source: http://bea.gov/iTable/
index_nipa.cfm)

Figure 6.3 Percentage of Components of U.S. GDP on the Demand Side Consumption makes up over half of the
demand side components of the GDP. (Source: http://bea.gov/iTable/index_nipa.cfm)

What does the word “investment” mean?

What do economists mean by investment, or business spending? In calculating GDP, investment does not
refer to purchasing stocks and bonds or trading financial assets. It refers to purchasing new capital goods, that
is, new commercial real estate (such as buildings, factories, and stores) and equipment, residential housing
construction, and inventories. Inventories that manufacturers produce this year are included in this year’s
GDP—even if they are not yet sold. From the accountant’s perspective, it is as if the firm invested in its own
inventories. Business investment in 2016 was $3 trillion, according to the Bureau of Economic Analysis.

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137 Chapter 6 | The Macroeconomic Perspective

Figure 6.4 Components of GDP on the Demand Side (a) Consumption is about two-thirds of GDP, and it has
been on a slight upward trend over time. Business investment hovers around 15% of GDP, but it fluctuates more than
consumption. Government spending on goods and services is slightly under 20% of GDP and has declined modestly
over time. (b) Exports are added to total demand for goods and services, while imports are subtracted from total
demand. If exports exceed imports, as in most of the 1960s and 1970s in the U.S. economy, a trade surplus exists. If
imports exceed exports, as in recent years, then a trade deficit exists. (Source: http://bea.gov/iTable/index_nipa.cfm)

Consumption expenditure by households is the largest component of GDP, accounting for about two-thirds of the
GDP in any year. This tells us that consumers’ spending decisions are a major driver of the economy. However,
consumer spending is a gentle elephant: when viewed over time, it does not jump around too much, and has increased
modestly from about 60% of GDP in the 1960s and 1970s.

Investment expenditure refers to purchases of physical plant and equipment, primarily by businesses. If Starbucks
builds a new store, or Amazon buys robots, they count these expenditures under business investment. Investment
demand is far smaller than consumption demand, typically accounting for only about 15–18% of GDP, but it is
very important for the economy because this is where jobs are created. However, it fluctuates more noticeably than
consumption. Business investment is volatile. New technology or a new product can spur business investment, but
then confidence can drop and business investment can pull back sharply.

If you have noticed any of the infrastructure projects (new bridges, highways, airports) launched during the 2009
recession, you have seen how important government spending can be for the economy. Government expenditure in
the United States is close to 20% of GDP, and includes spending by all three levels of government: federal, state,
and local. The only part of government spending counted in demand is government purchases of goods or services
produced in the economy. Examples include the government buying a new fighter jet for the Air Force (federal
government spending), building a new highway (state government spending), or a new school (local government
spending). A significant portion of government budgets consists of transfer payments, like unemployment benefits,
veteran’s benefits, and Social Security payments to retirees. The government excludes these payments from GDP
because it does not receive a new good or service in return or exchange. Instead they are transfers of income from
taxpayers to others. If you are curious about the awesome undertaking of adding up GDP, read the following Clear It
Up feature.

How do statisticians measure GDP?

Government economists at the Bureau of Economic Analysis (BEA), within the U.S. Department of
Commerce, piece together estimates of GDP from a variety of sources.

Once every five years, in the second and seventh year of each decade, the Bureau of the Census carries

http://bea.gov/iTable/index_nipa.cfm

138 Chapter 6 | The Macroeconomic Perspective

out a detailed census of businesses throughout the United States. In between, the Census Bureau carries
out a monthly survey of retail sales. The government adjusts these figures with foreign trade data to account
for exports that are produced in the United States and sold abroad and for imports that are produced abroad
and sold here. Once every ten years, the Census Bureau conducts a comprehensive survey of housing
and residential finance. Together, these sources provide the main basis for figuring out what is produced for
consumers.

For investment, the Census Bureau carries out a monthly survey of construction and an annual survey of
expenditures on physical capital equipment.

For what the federal government purchases, the statisticians rely on the U.S. Department of the Treasury. An
annual Census of Governments gathers information on state and local governments. Because the government
spends a considerable amount at all levels hiring people to provide services, it also tracks a large portion of
spending through payroll records that state governments and the Social Security Administration collect.

With regard to foreign trade, the Census Bureau compiles a monthly record of all import and export
documents. Additional surveys cover transportation and travel, and make adjustments for financial services
that are produced in the United States for foreign customers.

Many other sources contribute to GDP estimates. Information on energy comes from the U.S. Department
of Transportation and Department of Energy. The Agency for Health Care Research and Quality collects
information on healthcare. Surveys of landlords find out about rental income. The Department of Agriculture
collects statistics on farming.

All these bits and pieces of information arrive in different forms, at different time intervals. The BEA melds
them together to produce GDP estimates on a quarterly basis (every three months). The BEA then
“annualizes” these numbers by multiplying by four. As more information comes in, the BEA updates and
revises these estimates. BEA releases the GDP “advance” estimate for a certain quarter one month after a
quarter. The “preliminary” estimate comes out one month after that. The BEA publishes the “final” estimate
one month later, but it is not actually final. In July, the BEA releases roughly updated estimates for the previous
calendar year. Then, once every five years, after it has processed all the results of the latest detailed five-year
business census, the BEA revises all of the past GDP estimates according to the newest methods and data,
going all the way back to 1929.

Visit this website (http://openstaxcollege.org/l/beafaq) to read FAQs on the BEA site. You can even email your
own questions!

When thinking about the demand for domestically produced goods in a global economy, it is important to count
spending on exports—domestically produced goods that a country sells abroad. Similarly, we must also subtract
spending on imports—goods that a country produces in other countries that residents of this country purchase. The
GDP net export component is equal to the dollar value of exports (X) minus the dollar value of imports (M), (X –
M). We call the gap between exports and imports the trade balance. If a country’s exports are larger than its imports,
then a country has a trade surplus. In the United States, exports typically exceeded imports in the 1960s and 1970s,
as Figure 6.4(b) shows.

Since the early 1980s, imports have typically exceeded exports, and so the United States has experienced a trade

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139 Chapter 6 | The Macroeconomic Perspective

deficit in most years. The trade deficit grew quite large in the late 1990s and in the mid-2000s. Figure 6.4 (b) also
shows that imports and exports have both risen substantially in recent decades, even after the declines during the Great
Recession between 2008 and 2009. As we noted before, if exports and imports are equal, foreign trade has no effect on
total GDP. However, even if exports and imports are balanced overall, foreign trade might still have powerful effects
on particular industries and workers by causing nations to shift workers and physical capital investment toward one
industry rather than another.

Based on these four components of demand, we can measure GDP as:

GDP = Consumption + Investment + Government + Trade balance
GDP = C + I + G + (X – M)

Understanding how to measure GDP is important for analyzing connections in the macro economy and for thinking
about macroeconomic policy tools.

GDP Measured by What is Produced
Everything that we purchase somebody must first produce. Table 6.2 breaks down what a country produces into five
categories: durable goods, nondurable goods, services, structures, and the change in inventories. Before going
into detail about these categories, notice that total GDP measured according to what is produced is exactly the same
as the GDP measured by looking at the five components of demand. Figure 6.5 provides a visual representation of
this information.

Goods

Components of GDP on the Supply Side (in trillions of
dollars)

Percentage of
Total

Durable goods $3.0 16.1%

Nondurable goods $2.5 13.4%

Services $11.6 62.4%

Structures $1.5 8.1%

Change in

inventories

$0.0 0.0%

Total GDP $18.6 100%

Table 6.2 Components of U.S. GDP on the Production Side, 2016 (Source: http://bea.gov/iTable/
index_nipa.cfm)

http://bea.gov/iTable

140 Chapter 6 | The Macroeconomic Perspective

Figure 6.5 Percentage of Components of GDP on the Production Side Services make up over 60 percent of the
production side components of GDP in the United States.

Since every market transaction must have both a buyer and a seller, GDP must be the same whether measured by
what is demanded or by what is produced. Figure 6.6 shows these components of what is produced, expressed as a
percentage of GDP, since 1960.

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141 Chapter 6 | The Macroeconomic Perspective

Figure 6.6 Types of Production Services are the largest single component of total supply, representing over 60
percent of GDP, up from about 45 perent in the early 1960s. Durable and nondurable goods constitute the
manufacturing sector, and they have declined from 45 percent of GDP in 1960 to about 30 percent in 2016.
Nondurable goods used to be larger than durable goods, but in recent years, nondurable goods have been dropping
to below the share of durable goods, which is less than 20% of GDP. Structures hover around 10% of GDP. We do
not show here the change in inventories, the final component of aggregate supply. It is typically less than 1% of GDP.

In thinking about what is produced in the economy, many non-economists immediately focus on solid, long-lasting
goods, like cars and computers. By far the largest part of GDP, however, is services. Moreover, services have been a
growing share of GDP over time. A detailed breakdown of the leading service industries would include healthcare,
education, and legal and financial services. It has been decades since most of the U.S. economy involved making
solid objects. Instead, the most common jobs in a modern economy involve a worker looking at pieces of paper or a
computer screen; meeting with co-workers, customers, or suppliers; or making phone calls.

Even within the overall category of goods, long-lasting durable goods like cars and refrigerators are about the same
share of the economy as short-lived nondurable goods like food and clothing. The category of structures includes
everything from homes, to office buildings, shopping malls, and factories. Inventories is a small category that refers
to the goods that one business has produced but has not yet sold to consumers, and are still sitting in warehouses and
on shelves. The amount of inventories sitting on shelves tends to decline if business is better than expected, or to rise
if business is worse than expected.

Another Way to Measure GDP: The National Income Approach

GDP is a measure of what is produced in a nation. The primary way GDP is estimated is with the Expenditure
Approach we discussed above, but there is another way. Everything a firm produces, when sold, becomes revenues
to the firm. Businesses use revenues to pay their bills: Wages and salaries for labor, interest and dividends for capital,
rent for land, profit to the entrepreneur, etc. So adding up all the income produced in a year provides a second way
of measuring GDP. This is why the terms GDP and national income are sometimes used interchangeably. The total

142 Chapter 6 | The Macroeconomic Perspective

value of a nation’s output is equal to the total value of a nation’s income.

The Problem of Double Counting
We define GDP as the current value of all final goods and services produced in a nation in a year. What are final
goods? They are goods at the furthest stage of production at the end of a year. Statisticians who calculate GDP must
avoid the mistake of double counting, in which they count output more than once as it travels through the production
stages. For example, imagine what would happen if government statisticians first counted the value of tires that a tire
manufacturer produces, and then counted the value of a new truck that an automaker sold that contains those tires. In
this example, the statisticians would have counted the value of the tires twice-because the truck’s price includes the
value of the tires.

To avoid this problem, which would overstate the size of the economy considerably, government statisticians count
just the value of final goods and services in the chain of production that are sold for consumption, investment,
government, and trade purposes. Statisticians exclude intermediate intermediate goods, which are goods that go into
producing other goods, from GDP calculations. From the example above, they will only count the Ford truck’s value.
The value of what businesses provide to other businesses is captured in the final products at the end of the production
chain.

The concept of GDP is fairly straightforward: it is just the dollar value of all final goods and services produced in
the economy in a year. In our decentralized, market-oriented economy, actually calculating the more than $18 trillion-
dollar U.S. GDP—along with how it is changing every few months—is a full-time job for a brigade of government
statisticians.

What is Counted in GDP What is not included in GDP

Consumption Intermediate goods

Business investment Transfer payments and non-market activities

Government spending on goods and services Used goods

Net exports Illegal goods

Table 6.3 Counting GDP

Notice the items that are not counted into GDP, as Table 6.3 outlines. The sales of used goods are not included
because they were produced in a previous year and are part of that year’s GDP. The entire underground economy
of services paid “under the table” and illegal sales should be counted, but is not, because it is impossible to track
these sales. In Friedrich Schneider’s recent study of shadow economies, he estimated the underground economy in the
United States to be 6.6% of GDP, or close to $2 trillion dollars in 2013 alone. Transfer payments, such as payment by
the government to individuals, are not included, because they do not represent production. Also, production of some
goods—such as home production as when you make your breakfast—is not counted because these goods are not sold
in the marketplace.

Visit this website (http://openstaxcollege.org/l/undergroundecon) to read about the “New Underground
Economy.”

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Other Ways to Measure the Economy
Besides GDP, there are several different but closely related ways of measuring the size of the economy. We mentioned
above that we can think of GDP as total production and as total purchases. We can also think of it as total income
since anything one produces and sells yields income.

One of the closest cousins of GDP is the gross national product (GNP). GDP includes only what country produces
within its b s. GNP adds what domestic businesses and labor abroad produces, and subtracts any payments that
foreign labor and businesses located in the United States send home to other countries. In other words, GNP is based
more on what a country’s citizens and firms produce, wherever they are located, and GDP is based on what happens
within a certain county’s geographic boundaries. For the United States, the gap between GDP and GNP is relatively
small; in recent years, only about 0.2%. For small nations, which may have a substantial share of their population
working abroad and sending money back home, the difference can be substantial.

We calculate net national product (NNP) by taking GNP and then subtracting the value of how much physical
capital is worn out, or reduced in value because of aging, over the course of a year. The process by which capital
ages and loses value is called depreciation. We can further subdivide NNP into national income, which includes all
income to businesses and individuals, and personal income, which includes only income to people.

For practical purposes, it is not vital to memorize these definitions. However, it is important to be aware that these
differences exist and to know what statistic you are examining, so that you do not accidentally compare, say, GDP
in one year or for one country with GNP or NNP in another year or another country. To get an idea of how these
calculations work, follow the steps in the following Work It Out feature.

Calculating GDP, Net Exports, and NNP

Based on the information in Table 6.4:

a. What is the value of GDP?

b. What is the value of net exports?

c. What is the value of NNP?

Government purchases $120 billion

Depreciation $40 billion

Consumption $400 billion

Business Investment $60 billion

Exports $100 billion

Table 6.4

144 Chapter 6 | The Macroeconomic Perspective

Imports $120 billion

Income receipts from rest of the world $10 billion

Income payments to rest of the world $8 billion

Table 6.4

Step 1. To calculate GDP use the following formula:

GDP = Consumption + Investment + Government spending + (Exports – Imports)
= C + I + G + (X – M)
= $400 + $60 + $120 + ($100 – $120)
= $560 billion

Step 2. To calculate net exports, subtract imports from exports.

Net exports = X – M
= $100 – $120
= –$20 billion

Step 3. To calculate NNP, use the following formula:

NNP = GDP + Income receipts …