CHAPTER2NATIONALINCOMEACCOUNTINGCHAPTEROUTLINEREALANDNOMINALGDPTHECOMPOSITIONOFGDPTHEVALUEADDEDNATIONALINCOMEIDENTITIESPRICEINDEXESCOREINFLATIONTHEUNEMPLOYMENTRATEEXCHANGERATESREALANDNOMINALINTERESTRATESCHANGESFROMTHEPREVIOUSEDITIONTHEBASICSTRUCTUREOFTHISCHAPTERISUNCHANGEDALLFIGURESANDTABLESHAVEBEENUPDATEDANDBOX23HASBEENREVISEDSECTION25NOWINCLUDESAPARAGRAPHONCOREINFLATIONANDMAKESREFERENCETOTHEPERSONALCONSUMPTIONEXPENDITUREDEFLATORINTRODUCTIONTOTHEMATERIALCHAPTER2EXAMINESTHEMEANINGOFGROSSDOMESTICPRODUCTGDP,THEBASICMEASUREOFANATIONSECONOMICPERFORMANCETHEDIFFERENCEBETWEENGROSSDOMESTICPRODUCTGDPANDGROSSNATIONALPRODUCTGNPARISESSINCEPARTOFACOUNTRYSOUTPUTISPRODUCEDBYFOREIGNOWNEDFACTORSOFPRODUCTIONTHISDIFFERENCEISFAIRLYSMALLFORTHEUS,BUTITISIMPORTANTTOSTRESSTHISDISTINCTION,SINCEINSOMEOTHERCOUNTRIES,SUCHASIRELANDANDSWITZERLAND,THEDIFFERENCEISSUBSTANTIALGNPISALSOSOMETIMESCALLEDGNI,THATIS,GROSSNATIONALINCOMEEXPLAININGGDPINTERMSOFFACTORPAYMENTSWILLHELPINTHESTUDYOFAGGREGATESUPPLYANDECONOMICGROWTHTHEAGGREGATEPRODUCTIONFUNCTIONSHOWSTHEFACTORSOFPRODUCTIONINPUTS,SUCHASLABORANDCAPITALTHATCONTRIBUTETOTHEPRODUCTIONOFFINALGOODSANDSERVICESOUTPUTDIVIDINGGDPINTOITSFOURMAINSPENDINGCOMPONENTSCONSUMPTIONC,INVESTMENTI,GOVERNMENTPURCHASESGANDNETEXPORTSNXWILLHELPINTHESTUDYOFAGGREGATEDEMANDTHEUSEOFNATIONALINCOMEIDENTITIESINTHISCHAPTERPROVIDESABASICUNDERSTANDINGOFTHERELATIONSHIPBETWEENIMPORTANTMACROECONOMICVARIABLESDISCUSSINGTHESEIDENTITIESALLOWSINSTRUCTORSTOPOINTOUTTHEAMBIGUITIESINCAUSEANDEFFECTTHATAREOFTENPRESENTINMACROECONOMICSTHISISESPECIALLYTRUEWHENITCOMESTOTHERELATIONSHIPBETWEENPRIVATEDOMESTICSAVING,PRIVATEDOMESTICINVESTMENT,THEBUDGETSURPLUS,ANDTHETRADESURPLUSANINDEPTHDISCUSSIONOFTHESERELATIONSHIPSWILL,OFCOURSE,HAVETOBEDELAYEDUNTILLATERNONETHELESS,STUDENTSWILLFINDITEXCITINGANDMOTIVATINGTOSEETHATEVENTHESIMPLEEQUATIONSPRESENTEDHERECANBEUSEDTOADDRESSSOMERATHERCOMPLEXREALWORLDPROBLEMSITISPARTICULARLYIMPORTANTTOPOINTOUTTHATTHEFOLLOWINGTWOEQUATIONSYCIGNXANDSIGTRTANXARETREATEDASNATIONALINCOMEIDENTITIESHEREBUTWILLALSOBEUSEDASEQUILIBRIUMCONDITIONSINLATERCHAPTERS,WITHTHESECONDEQUATIONSLIGHTLYREDEFINEDITISNOTALWAYSEASYTOMEASUREINFLATIONARYTRENDSACCURATELY,ESPECIALLYSINCETHEPRICESOFSOMEGOODSCANBEVOLATILETHEREFOREPOLICYMAKERSOFTENLOOKATTHETRENDOFCOREINFLATION,WHICHEXCLUDESENERGYANDFOODPRICESALTERNATIVEMEASURESOFINFLATION,SUCHASTHEGDPDEFLATOR,THECONSUMERPRICEINDEXCPI,THEPERSONALCONSUMPTIONEXPENDITUREDEFLATORPCE,ANDTHEPRODUCERPRICEINDEXPPI,AREDISCUSSED,ALONGWITHSOMEOFTHEPROBLEMSTHATCOMEWITHMEASURINGINFLATIONABRIEFDISCUSSIONOFTHEUSEFULNESSANDSHORTCOMINGSOFTHESEDIFFERENTMEASURESOFINFLATIONSHOULDPOINTOUTWHYTHEPRICEINDEXESDONOTALWAYSCHANGEATTHESAMERATEEVENTHOUGHTHEIRRATESOFCHANGEOVERLONGTIMESPANSTENDTOBEFAIRLYSIMILARTHEPPIMEASURESPRICEINCREASESATANEARLYSTAGEOFPRODUCTIONFROMAMARKETBASKETTHATINCLUDESRAWMATERIALSANDSEMIFINISHEDGOODSTHECPIMEASURESTHEAVERAGEPRICEINCREASEOFAMARKETBASKETOFGOODSANDSERVICESTHATANAVERAGEURBANHOUSEHOLDMIGHTCONSUMETHEPERSONALCONSUMPTIONEXPENDITUREDEFLATORPCEISACHAINWEIGHTEDINDEXMEASURINGINFLATIONINCONSUMERPURCHASES,BASEDONTHECONSUMERSECTOROFTHENATIONALINCOMEACCOUNTTHEGDPDEFLATORISTHEMOSTCOMPREHENSIVEMEASUREANDINCLUDESALLGOODSANDSERVICESCURRENTLYPRODUCEDWITHINACOUNTRYUNFORTUNATELY,EARLYESTIMATESOFGDPANDTHUSTHEGDPDEFLATORTENDTOBEFAIRLYUNRELIABLEDUETOMEASUREMENTPROBLEMSANOTHERMEASURETHATCANGIVEANINDICATIONOFHOWWELLANATIONISPERFORMINGECONOMICALLYISTHEUNEMPLOYMENTRATE,THATIS,THEFRACTIONOFTHELABORFORCETHATISCURRENTLYOUTOFWORKBUTACTIVELYLOOKINGFORAJOBORWAITINGTOBERECALLEDFROMALAYOFFTHEDISTINCTIONBETWEENREALANDNOMINALINTERESTRATESISALSOVERYIMPORTANTNOMINALINTERESTRATESREPRESENTTHEACTUALRATEOFRETURNONFINANCIALINSTRUMENTSASTHEYARESTATEDINTHENEWSPAPERSHOWEVER,AFINANCIALINVESTORSHOULDBEINTERESTEDMUCHMOREINTHEREALRATEOFRETURN,THATIS,THESTATEDINTERESTRATEADJUSTEDFORINFLATIONVERYFEWFINANCIALINSTRUMENTSGUARANTEEAREALRATEOFRETURNANDTHEUSGOVERNMENTHASONLYRECENTLYSTARTEDTOISSUEINFLATIONINDEXEDGOVERNMENTBONDSFINANCIALINVESTORSSEEKINGGOODYIELDSFROMFOREIGNSECURITIESALSOHAVETOPAYATTENTIONTOTHEEXCHANGERATE,THATIS,THEPRICEPAIDTOBUYFOREIGNCURRENCYWHILEANINDEPTHDISCUSSIONOFTHEIMPORTANCEOFEXCHANGERATESWILLHAVETOBEDELAYED,INSTRUCTORSSTILLMAYWANTTOPOINTOUTFIGURE27,THATSHOWSANINVERSERELATIONSHIPBETWEENTHEGDPDEFLATORANDTHEVALUEOFTHEUSDOLLARASITBECOMESINCREASINGLYIMPORTANTFORSTUDENTSTOKNOWHOWTOACCESSSTATISTICALDATATHATAREUSEFULININTERPRETINGTHEPERFORMANCEOFTHEECONOMY,SECTION29PROVIDESSOMELINKSFOROBTAININGDATAANDSTUDENTSSHOULDBEENCOURAGEDTOMAKEUSEOFTHEMSUGGESTIONSFORLECTURINGINSTRUCTORSSHOULDSTARTTHISCHAPTERBYGIVINGSTUDENTSTHEEXACTDEFINITIONOFGDPASTHEMARKETVALUEOFALLFINALGOODSANDSERVICESCURRENTLYPRODUCEDWITHINACOUNTRYINAGIVENTIMEPERIODUSUALLYAYEAR,ANDTHENASKINGTHEMTOEXPLAINHOWCERTAINEVENTSMAYAFFECTGDPFORSUGGESTIONSLOOKUNDER“ADDITIONALPROBLEMS“BELOWINDISCUSSINGTHECONCEPTOFGDP,INSTRUCTORSSHOULDMAKEITCLEARTHATEARLYDATAREPORTSONGDPTENDTOBEUNRELIABLE,SINCEMUCHOFTHEDATAUSEDTOPREPARETHEMISBASEDONESTIMATESRATHERTHANDIRECTMEASUREMENTINADDITION,SOMEDATA,SUCHASUNREPORTEDACTI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SIBDNXWHERE10GTRTABDISTHEBUDGETDEFICIT,AND11NXXQREPRESENTSNETEXPORTSEXPORTSIMPORTSEQUATION9ACANTHENBEMANIPULATEDINTO9BSIBDTD,WHICHSTATESTHATTHEDIFFERENCEBETWEENPRIVATEDOMESTICSAVINGANDPRIVATEDOMESTICINVESTMENTISEQUALTOTHEDIFFERENCEBETWEENTHEBUDGETDEFICITANDTHETRADEDEFICITTHISEQUATIONIMPLIESTHATANINCREASEINTHEBUDGETDEFICITUNLESSACCOMPANIEDBYANEQUALINCREASEINPRIVATEDOMESTICSAVINGWILLLEADTOTHECROWDINGOUTOFPRIVATEDOMESTICINVESTMENTAND/ORNETEXPORTSTHEEQUATIONCANTHEREFOREBEUSEDTOEXPLAINTHEDEVELOPMENTOFTHE“TWINDEFICITS“INTHEEARLY1980SFINALLY,ITCANBEEXPLAINEDWHYTHEDECREASEINUSBUDGETDEFICITSTHATLEADTOBUDGETSURPLUSESINTHELATE1990SWASNOTACCOMPANIEDBYADECREASEINTRADEDEFICITSMANYSTUDENTSAREWORRIEDTHATTHEUSHASMOVEDFROMBEINGTHELARGESTCREDITORNATIONTOBEINGTHELARGESTDEBTORNATIONINTHEWORLDABRIEFDISCUSSIONOFWHETHERWESHOULDBECONCERNEDBYTHISFACTANDWHETHERFOREIGNOWNERSHIPOFASSETSINTHEUSACTUALLYHELPSTOMAINTAINDOMESTICJOBSCANBEUSEFULHERE,BUTAMOREINDEPTHDISCUSSIONOFTHESEISSUESSHOULDPROBABLYBELEFTFORLATERSOMEINSTRUCTORSMAYWANTTOUSEFIGURE26,WHICHSHOWSTHEFEDERALDEBTASAPERCENTAGEOFGNPFROM17902005,INDICATINGALSOPERIODSOFRECESSIONANDWAR,ASAWAYTOSOLICITSTUDENTOPINIONSOFWHATFACTORSMAYCAUSEASIGNIFICANTINCREASEINTHENATIONALDEBTANDATWHATPOINTAHUGENATIONALDEBTMAYBECOMEACONCERNTOPOLICYMAKERSCHAPTER19STRESSESTHEFACTTHATANINCREASEINTHENATIONALDEBTDOESNOTNECESSARILYIMPLYANINCREASEINTHEDEBTINCOMERATIO,THATIS,THEDEBTASAPORTIONOFGDP,BUTSOMEINSTRUCTORSMAYWANTTOMENTIONTHISHEREALREADYSINCELATERCHAPTERSUSETHECONCEPTOFTHEBUDGETSURPLUSBSWHENDISCUSSINGFISCALPOLICY,SOMEINSTRUCTORSMAYACTUALLYPREFERTOUSETHEFOLLOWINGEQUATIONRATHERTHANEQUATION1010ABSTAGTR,MULTIPLYINGEQUATION9BBY1,WECANOBTAINTHEFOLLOWINGEQUATION9CISBSNXOR9DNXSBSI,WHICHSTATESTHATIFNATIONALSAVINGISNOTSUFFICIENTTOFINANCEPRIVATEDOMESTICINVESTMENTI,THENFUNDSHAVETOBEBORROWEDFROMABROAD,CAUSINGNETEXPORTSNXTOBECOMENEGATIVENATIONALSAVINGCONSISTSOFPRIVATEDOMESTICSAVINGSANDGOVERNMENTSAVING,WHICHISPOSITIVEIFTHEGOVERNMENTRUNSABUDGETSURPLUSADISTINCTIONBETWEENGOVERNMENTPURCHASESGANDGOVERNMENTEXPENDITURESGTRSHOULDALSOBEMADE,ASMANYSTUDENTSARENOTAWARETHATTRANSFERPAYMENTSTRARETREATEDSEPARATELYFROMGOVERNMENTPURCHASESGTRANSFERPAYMENTSDONOTDIRECTLYENTERGDP,SINCENOPRODUCTIVEACTIVITYTAKESPLACEWHENSUCHPAYMENTSAREMADEADDITIONALREADINGSBOSKIN,MICHAEL,ETAL,“CONSUMERPRICES,THECONSUMERPRICEINDEX,ANDTHECOSTOFLIVING,”JOURNALOFECONOMICPERSPECTIVES,WINTER,1998BOSKIN,MICHAEL,ETAL,“GETTINGTHE21STCENTURYGDPRIGHT,”AMERICANECONOMICREVIEW,MAY,2000DEVINE,JAMES,“THECOSTOFLIVINGANDHIDDENINFLATION,”CHALLENGE,MARCH/APRIL,2001CLARK,TODD,“ACOMPARISONOFTHECPIANDTHEPCEPRICEINDEX”ECONOMICREVIEW,FRBOFKANSASCITY,THIRDQUARTER,1999THEECONOMIST,THEECONOMISTGUIDETOECONOMICINDICATORSMAKINGSENSEOFECONOMICS,WILEYANDSONS,NEWYORK,1998EISNER,ROBERT,“THETOTALINCOMESSYSTEMOFACCOUNTS,”SURVEYOFCURRENTBUSINESS,JANUARY,1985FRUMKIN,NORMAN,THEGUIDETOECONOMICINDICATORS,THIRDEDITION,MESHARPE,NEWYORK,2000HOUSTON,JOEL,“THEUNDERGROUNDECONOMYATROUBLINGISSUEFORPOLICYMAKERS,”BUSINESSREVIEW,FRBOFPHILADELPHIA,SEPTEMBER/OCTOBER,1987LEBOW,D,ANDBUDD,J,“MEASUREMENTERRORINTHECONSUMERPRICEINDEXWHEREDOWESTAND,”JOURNALOFECONOMICLITERATURE,MARCH,2003MADIGAN,KATHLEEN,“UNVEILINGTHESECRETSOFTHECPI,”BUSINESSWEEK,JULY12,1999MANDEL,MICHAEL,“WHYTHEECONOMYISALOTSTRONGERTHANYOUTHINK,”BUSINESSWEEK,FEBRUARY13,2005NORDHAUS,WILLIAM,“QUALITYCHANGEINPRICEINDEXES,”JOURNALOFECONOMICPERSPECTIVES,WINTER,1998POLLAK,ROBERT,“THECONSUMERPRICEINDEXARESEARCHAGENDAANDTHREEPROPOSALS,”JOURNALOFECONOMICPERSPECTIVES,WINTER,1998RITTER,JOSEPH,“FEEDINGTHENATIONALACCOUNTS,”REVIEW,FRBOFSTLOUIS,MARCH,2000UCHITELLE,LOUIS,“SEIZINGINTANGIBLESFROMTHEGDP,”THENEWYORKTIMES,APRIL9,2006LEARNINGOBJECTIVESSTUDENTSSHOULDBECOMEFAMILIARWITHTHEFOURMAINCOMPONENTSOFSPENDINGASWELLASTHEIRMAGNITUDERELATIVETOGDPSTUDENTSSHOULDBECOMEFAMILIARWITHTHERELATIVEIMPORTANCEOFTHEFACTORPAYMENTSLABORANDCAPITALSTUDENTSSHOULDGAINANUNDERSTANDINGOFTHEDIFFICULTIESTHATARISEINACCURATELYMEASURINGGDPANDTHERATEOFINFLATIONSTUDENTSSHOULDBECOMEFAMILIARWITHTHEBASICNATIONALINCOMEACCOUNTINGIDENTITIESPRESENTEDINTHETEXTSTUDENTSSHOULDGAINANUNDERSTANDINGOFTHERELATIONSHIPSBETWEENPRIVATEDOMESTICSAVING,PRIVATEDOMESTICINVESTMENT,THEBUDGETDEFICIT,ANDTHETRADEDEFICIT,ANDTHECOMPLEXITYOFISSUESTHATAREASSOCIATEDWITHTHEINTERRELATIONSHIPSAMONGTHESEVARIABLESSTUDENTSSHOULDBEABLETODIFFERENTIATEBETWEENTHETHREEPRICEINDEXESDISCUSSED,THATIS,THEGDPDEFLATOR,THEPCE,THECPI,ANDTHEPPISTUDENTSSHOULDBEABLETODIFFERENTIATEBETWEENREALANDNOMINALINTERESTRATESSOLUTIONSTOPROBLEMSINTHETEXTBOOKCONCEPTUALPROBLEMS1GOVERNMENTTRANSFERPAYMENTSTRDONOTARISEOUTOFANYPRODUCTIONACTIVITYANDARETHUSNOTCOUNTEDINTHEVALUEOFGDPIFTHEGOVERNMENTHIREDTHEPEOPLEWHORECEIVETRANSFERPAYMENTS,THENTHEIRWAGESWOULDBECOUNTEDASPARTOFGOVERNMENTPURCHASESG,WHICHISCOUNTEDINGDPTHEREFOREGDPWOULDRISEEVENIFTHESEWORKERSWEREPAIDTODONOTHING,ASGOVERNMENTPURCHASESAREMEASUREDONACOSTBASIS2AIFTHEFIRMBUYSACARFORANEXECUTIVESUSE,THEPURCHASECOUNTSASINVESTMENTIHOWEVER,IFTHEFIRMPAYSTHEEXECUTIVEAHIGHERSALARYANDSHETHENBUYSACAR,THEPURCHASEOFHERCARISCOUNTEDASCONSUMPTI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