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Macroeconomics, Third Edition Solution Manual

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    iii Part 1 Preliminaries Chapter 1 | Introduction to Macroeconomics 1 Chapter 2 | Measuring the Macroeconomy 6 Part 2 The Long Run Chapter 3 | An Overview of Long-Run Economic Growth 14 Chapter 4 | A Model of Production 21 Chapter 5 | The Solow Growth Model 31 Chapter 6 | Growth and Ideas 41 Chapter 7 | The Labor Market, Wages, and Unemployment 49 Chapter 8 | Inflation 56 Part 3 The Short Run Chapter 9 | An Introduction to the Short Run 64 Chapter 10 | The Great Recession: A First Look 70 Chapter 11 | The IS Curve 76 Chapter 12 | Monetary Policy and the Phillips Curve 84 Chapter 13 | Stabilization Policy and the AS/AD Framework 92 Chapter 14 | The Great Recession and the Short-Run Model 104 Chapter 15 | DSGE Models: The Frontier of Business Cycle Research 111 TABLE OF CONTENTS

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    iv | Contents Part 4 Applications and Microfoundations Chapter 16 | Consumption 120 Chapter 17 | Investment 125 Chapter 18 | The Government and the Macroeconomy 132 Chapter 19 | International Trade 139 Chapter 20 | Exchange Rates and International Finance 146 Chapter 21 | Parting Thoughts 151

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    1 our students learn, and how they learn. Most students who have recently had a principles course and who are comfort- able with a little algebra should be able to handle Chapters 1 through 14 in a semester. How much time you spend on these chapters, whether or not you omit coverage of any of these chapters, and the nature and skill level of your students will influence your coverage of the later chapters. Moreover, if you want to leave room for a few supplemen- tary articles, a nontechnical book, or a major empirical proj- ect or two, then you might have to tread lightly over some of the math in the growth- and labor-market models, which are self-contained and don’t directly come up again later in the semester. Advice on how to do this is given in later chapters of this manual. This third edition of the book provides an innovative chapter on dynamic stochastic general equilibrium (DSGE) models. This chapter provides a bridge between long-run economic growth and short-run economic fluctuations, and fits in nicely at the end of Part 3 of the textbook to remind us of the links between the long run and the short run. I’d rec- ommend that you make time in the semester to include Chapter 15 as a capstone to a semester course. ONE- QUARTER COURSE OR ONE- SEMESTER COURSE WITH MANY OUTSIDE READINGS AND PROJECTS Chapters 1– 4 (Introduction through the basics of growth and productivity), 8–11, and 15 (inflation, business cycles, and DGSE models), and two of the following: Chapters 5, 6.1– 6.3, and 7, or 12–14, and 18–20. TWO- QUARTER COURSE OR TWO- SEMESTER COURSE The entire book— one quarter on long-run growth, labor markets, inflation, consumption, and investment (Chapters CHAPTER OVERVIEW This is a conventional first textbook chapter: it defines mac- roeconomics, it mentions a few interesting topics, it says what a model is, and it lays out the book’s separation into Long Run, Short Run, and Applications and Microfounda- tions. It is quite a short chapter with few surprises, so rather than summarizing it, I will instead talk a little about what makes this book different, and lay out a few different ways you can use it in your course. WHAT MAKES THIS BOOK DIFFERENT It offers solid long-run growth coverage—including endog- enous growth—while simplifying the New Keynesian busi- ness cycle dramatically, and it does all this without any calculus. Chad shows how long-run macroeconomic growth models have evolved and how tweaking the assumptions of the model can lead to new and interesting insights and pol- icy conclusions. Moreover, Chad is able to easily deduce a short-run model from the long-run model, and therefore link short-run and long-run economic analyses. By streamlining the coverage while teaching surprisingly solid microfounda- tions, Chad’s text gives you a solid chance to spend more time on intelligent, model-driven policy discussions about growth and business cycles. HOW TO USE THIS TEXTBOOK CONVENTIONAL ONE- SEMESTER CLASS In this day and age of assessment, we are ever conscious of what we teach, how we teach it, who our students are, what CHAPTER 1 Introduction to Macroeconomics

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    2 | Chapter 1 Every chapter in this manual also has a sample lecture that you can use, written on a topic that students typically have a tough time with. Finally, each chapter of this manual also contains a few case studies, often building on Chad’s own case studies. In the case studies I provide some addi- tional facts or theories that might help to flesh out a lec- ture or provoke classroom discussion. I hope you find this manual useful in getting the most out of Charles Jones’s Macroeconomics. SAMPLE LECTURE: GIVING YOU ALL THE ANSWERS UP FRONT Of great concern to the economics profession is the eco- nomic literacy of our students. In particular, do our students really own an understanding of the subject matter or do they simply borrow an understanding for the course? One of my teaching objectives is to ensure, as much as possible, that students own an understanding of economics. To that end, I begin the introductory class with a set of unfolding ques- tions. I start with the most basic question, What is econom- ics? The better students respond with the textbook definition given in principles, which is fine. But then I ask the ques- tion, Would your brother or sister, friend or parent under- stand that answer? Most students respond by saying no. Loosely following the late great Robert Heilbroner, I’ll say that economics is the study of the economy (and I’ll get a laugh) and students will relax. But then that compels the question, What’s the economy? And we go around on differ- ent definitions, and we work up to the point, again following Heilbroner, that the economy is a set of social institutions/ relationships devised to produce and distribute goods and bads. Then we pull that definition apart (to produce—to transform nature into something useful; to distribute—to decide who gets what; the goods and the bads— things that are literally good and/or bad.) So the next question is, Why study economics? Because of the economic prob- lem. What economic problem? Scarcity. What’s scarcity? Not having enough resources or goods to meet needs and desires. What causes scarcity? Resource constraints inher- ent in nature and the process of social interaction that create wants and desires for goods. Again, via modified Heil- broner, How does a society, regardless of space and time, confront scarcity? People must be induced to work more when they want to work less; people must be induced to con- sume less when they want to consume more; and technology (the art of production) must be modified/improved. What economic system does most of the world use today to con- front scarcity? Students will say capitalism or markets. What are markets? Markets are the process whereby buyers and sellers interact to determine prices and quantities. What two approaches do we have for studying markets? Micro- economics, the study of the individual parts of the economy, and macroeconomics, the study of the economy as a whole 1–8, 16, and 17); one quarter on short-run business cycles, the Great Recession, monetary policy, the Phillips curve, fis- cal policy, the aggregate demand/aggregate supply model, DSGE models, international trade, exchange rates, and inter- national finance (Chapters 9–15, 18–21)—with enough time for a supplementary book each quarter and a few articles and data projects. This would be a great way to teach this course. CHAPTERS THAT MAY BE OMITTED I include this list because instructors often want to know if they can leave out a chapter without omitting facts or theories that come back in later chapters. These chapters each build on previous chapters, but none are directly used in later chapters: 6 Growth and Ideas, the last growth chapter 7 The Labor Market, Wages, and Unemployment 15 Dynamic Stochastic General Equilibrium (DSGE) Models 16 Consumption 17 Investment 18 The Government and the Macroeconomy 19 International Trade 20 Exchange Rates and International Finance 21 Parting Thoughts In particular, the International Trade chapter (19) is indepen- dent of the Foreign Exchange chapter (20), so you can choose just one or the other depending upon your needs. For math-averse students, Chapter 5 (Solow) may be omitted if necessary, while key parts of Chapter 6 (Growth and Ideas) may be covered without difficulty (Sections 6.1 through 6.3). That means that instructors can still teach the economics of ideas (a largely math-free topic), yet avoid the math of the Solow model. HOW TO USE THIS INSTRUCTION MANUAL Chad provides excellent summaries at the end of each chap- ter, and the student study guide performs much the same function. This instruction manual does something different: it is written to help you do a better job teaching with this innovative textbook. In this manual, I walk through each chapter from begin- ning to end, discussing how you might approach topics that students often find troublesome—for instance, the Solow steady state, making sense of the three ways to measure GDP, or what the Fisher equation really means. Also, I sometimes recommend that you organize your lecture differently than the text does—some topics just flow together particularly well when you’re up there at the chalk- board. I always try to point out which topics you can safely gloss over or omit, and I often mention an illustration or two that might make your lectures a bit more relevant.

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    Introduction to Macroeconomics | 3 insurance companies, and brokerage houses became insol- vent as their assets proved insufficient to cover their liabili- ties; and a chain of bankruptcies threatened the strength and stability of the United States and global economies. Prior to the financial crisis, the price of crude oil rose from under $70 in August 2007 to over $140 by July 2008. Two of the big three U.S. auto makers were on the brink of bankruptcy. Unprecedented steps were taken by the Federal Reserve and the U.S. Treasury to bail out the financial sector and to save the automakers. An economic stimulus bill was passed that included tax credits for first-time homebuyers, cash for clunk- ers, tax cuts, and funding for so-called shovel-ready projects (to name a few). The economic stimulus bill, combined with the War on Terrorism and the downturn in the economy, sub- sequently increased the federal government budget deficit from around $160 billion in 2007, to about $460 billion in 2008, over $1.4 trillion in 2009, and almost $1.3 trillion in 2011. Moreover, despite bailouts and the stimulus, we have seen the money supply (M2) grow by 8 percent in 2009, 2.5 in 2010, 7.3 in 2011, and 8.5 in 2012. The threat of worldwide recession remains. Even as of this writing, the recovery is slow and fragile, and the debate over austerity versus stimulus continues to rage (see John Cassidy, “The Reinhart and Rog- off Controversy: A Summing Up,” The New Yorker , available at http://www.newyorker.com /online/blogs/johncassidy/2013 /04/the-rogoff-and-reinhart-controversy-a-summing-up.html). This experience has taken the economics profession by sur- prise, and is currently causing us to reevaluate what we think about how the economy works. In this course, we’ll spend the first half of the semester talking about why some countries are richer than others, and why the average person today lives so much better than someone one or two hundred years ago. A generation ago, such topics would barely have been mentioned, but with the rise of globalization, the spread of markets around the world, and a new concern about global growth prospects, a new emphasis in economics has emerged. In the second half of the semester, we’ll talk about eco- nomic busts and booms, which economists often call the “business cycle” or “economic fluctuations.” The book’s goal is to provide a framework for understanding the nature, causes, and solutions to both short-run and long-run fluctuations. A generation ago, the business cycle section would’ve been almost the whole course. Back then, many macroecon- omists thought they could control the overall level of GDP on a year-to-year basis. That’s certainly what the textbooks taught back then. In those days, we spent the semester talk- ing about how to control the demand for goods and services in the economy. Back then, we thought we actually could control things. Today’s macroeconomics is largely about teaching macroeconomists—myself and my colleagues—to be hum- ble. We’ll learn that the Federal Reserve can have an impact on the average rate of inflation. There are increases in the with emphasis on factors like economic growth, economic fluctuations, unemployment, inflation, and international economic relations. Microeconomics is rooted in the writ- ings of Adam Smith in An Inquiry into the Nature and Causes of the Wealth of Nations (1776) (I like to say the full title—it sums up what most of economics is about). Smith showed that markets promote order and stability by allowing individuals to freely express self-interest through markets, and that the expression of self-interest promotes the social good. (Most students will be familiar with the “invisible hand” but not familiar with its strong political implications.) Of course, if Smith is correct then markets, as a set of institutions, become a set of goods that promote social welfare. Well, what about macroeconomics? Where did it come from? Macroeconomics’ origins can be traced to the Great Depres- sion, the writings of John Maynard Keynes, World War II, and the Employment Act of 1946. If anything, macroeco- nomics was the consequence of market failures as evidenced by the Great Depression. To illustrate the market failures, Keynes invoked fallacies of composition in reasoning, like the paradox of thrift (that wage deflation in isolation can sta- bilize a labor market, but wage deflation in the economy as a whole will do little to reduce unemployment and may actually destabilize the economy). Keynes’s ideas were too revolutionary to gain acceptance, but World War II taught my parents’ generation that government coordination of the economy to ensure high levels of spending and the national defense of the United States ended the Great Depression. The World War II generation, wanting to eliminate future unemployment, had the Employment Act of 1946 passed. According to this legislation, government should pursue policies to promote maximum employment, production, and purchasing power. In addition, this legislation created the Council of Economic Advisors and the Joint Economic Com- mittee to advise the president and Congress on the economy. Subsequently, macroeconomics, along with microeconomics, became part of every core economics curriculum. Although there is little disagreement as to how to teach microeconom- ics, tension remains as to how to teach macroeconomics. In particular, conflict occurs over whether to emphasize the long run or the short run. Chad’s textbook gives you the flexibility of emphasizing either concept or both. Today, the U.S. economy continues to recover from the Great Recession—the greatest recession since the Great Depression. Clearly the emphasis in policy has shifted to the short run, but long-run concerns remain. The unemployment rate rose from 4.6 percent in 2007 to 5.8 percent in 2008, then to over 10 percent in 2009, and was 7.3 percent as of October 2013 (almost two percentage points above the natu- ral unemployment rate). While the financial markets have largely recovered, still fresh in the public’s mind is that the Dow Jones Industrial stock index, along with many other stock indexes, lost 40 percent of its value in a matter of weeks; housing prices in many markets collapsed; record numbers of bankruptcies and foreclosures have been recorded; banks,

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    4 | Chapter 1 to risk those 1.5 percent up-and-down shocks to your con- sumer spending? Lucas ran some estimates and found that the average per- son would be willing to pay about 0.06 percent per year for an insurance policy like that. For a person earning $50,000 per year, it would cost $30 per year to guarantee a steady growth in your standard of living. Even when taking into account that it’s hard to buy goods when you lose your job— you just might not be able to borrow the money to put food on the table—he found that in the United States, unemployment insurance benefits are usually good enough that the average person still wouldn’t want to pay a lot for insurance to get rid of their consumption risk. This suggests that modern unem- ployment insurance is pretty good insurance already. Quite possibly, the average poor person in the United States would pay more than $30 per year for that kind of insurance policy. For poorer people, every dollar counts more. But Lucas was trying to come up with an average estimate of how much the typical American would pay to get rid of business cycles. And he just couldn’t find a way to make that number look big. Economists David Romer and Lawrence Ball 1 think that Lucas is missing the point entirely. They think that the big cost of economic fluctuations isn’t the fact that you can’t go to restaurants as often during a recession; it’s that you might not have a job. They’ve run some estimates based on what they think the average person is like and they find that eco- nomic fluctuations have a much higher cost than Lucas believes. They agree that the average person doesn’t get hit hard on the consuming side during a recession, but they think that people really don’t like going in and out of the workforce. They find that people would rather work a steady 40-hour week than work 45 hours most of the time with some random layoffs thrown in. And of course, surveys and common sense do show that people hate being out of work. Over the course of 50 years the economics profession has gone from the notion that business cycles could be tamed (Samuelson and the Keynesians) to the ideas of Lucas and others that markets are self-regulating and that government intervention has ill or nil effects. In light of current events, you will be challenged throughout this course with ques- tions regarding what should be done to end recessions and reduce unemployment. For a nice review of the current debate, see the aforemen- tioned New Yorker article. REVIEW QUESTIONS 1–3. Based on personal preference. 4. Ingredients: Inputs, the model itself, and outputs. We can call these “exogenous variables,” “equations or words,” and 1. Laurence Ball and David Romer, “Real Rigidities and the Non- neutrality of Money,” Review of Economic Studies , vol. 57, no. 2, (April 1990), pp. 183–203. overall price level, but at the same time we’ll see that the Federal Reserve has a limited impact on reducing the aver- age rate of unemployment—the fraction of workers who can’t find jobs. (The Federal Reserve might be able to tem- porarily reduce the unemployment rate below some “natu- ral” rate, but subsequently risk high inflation without any long-run reduction in the unemployment rate.) One point to take away from the semester is this: the Fed- eral Reserve might be able to smooth out the bumps on the road— emphasis on “might”—but it can’t make the trip go any faster. For the average American to have a better stan- dard of living in the long run, we’ll have to focus on some- thing other than interest-rate policy. That’s why we’ll spend quite a bit of time in the first half of the semester on the “supply side” of the economy: the supply of people willing to work, the supply of machines, equipment, and natural resources, and the supply of useful, practical ideas. Economists tend to think that if you have a good supply of those four things—people, machines, natu- ral resources, and ideas—then in a market economy, those “inputs” will usually get combined to create “outputs” that we really want, like cars and movies and doctor’s appoint- ments and books and vacations and food. By spending time in the first half of the semester talking about the supply side, the hope is that when you’re voting or when you’re serving in government, you’ll remember that how well people live doesn’t depend on whether there’s a demand for goods—as you learned in principle or by talking with your friends, people’s demands are basically unlimited. The key problem of economics is scarcity—and the miracle of long-term eco- nomic growth is that most of the things people want are a little bit less scarce each year. CASE STUDY: HOW MUCH WOULD YOU PAY TO GET RID OF RECESSIONS? Given that the U.S. economy has just emerged from the so- called Great Recession and is perhaps teetering on the brink of another recession, Nobel Prize winner Robert Lucas’s ques- tion, How much would you pay to get rid of recessions? remains apropos. Lucas’s answer to this question was: not much. As is well described in “After the Blowup” by John Cassidy ( The New Yorker , January 11, 2010), Lucas won the Nobel Prize, in part, for reinventing the notion that markets are self- regulating. So Lucas’s answer is not surprising. Lucas noticed that consumer spending—the part of our income we use to buy happiness— doesn’t really change that much for the aver- age person from year to year. It only fluctuates from year to year by about 1.5 percent (aside: that’s the standard deviation of real consumption) for the average person. There’s a strong annual upward trend of about 2 percent, but around that trend there’s a small wiggle, averaging about 1.5 percent per year. So how much would you, personally, be willing to pay for an insurance policy that promised that you’d never have

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    Introduction to Macroeconomics | 5 wage. (Of course, you could just collapse this to equilibrium labor supply and equilibrium wage without losing much of interest.) (c) w * = ( G − ê )/(1 + ā ) L * = ( G − w* ) Now might be a good time to review the importance of the associative rule—students often forget about the importance of parentheses when doing algebra. (d) If ê increases, the wage falls, and the equilibrium quan- tity of labor increases. This is just what we expect: The supply of labor increased exogenously, and workers were willing to work the same hours at a lower wage. In equilib- rium, firms decided to hire more workers at a new, lower wage. (e) This is an increase in demand: the quantity and wage of labor will both rise in equilibrium. The wage rises a bit, to which workers respond by supplying more labor. 7 . (a) Q D = demand for computers = F ( P , 9 ) 9 is exogenous, and captures consumers’ understanding of how to use computers. Q S = supply of computers = G ( P , ĵ ) ĵ is exogenous, and captures manufacturing skill of the computer industry. In equilibrium Q S = Q D = Q *, so this model is really two equations and two variables. If the demand and supply functions are straight lines, then there must be a unique solution. (b) Q D = demand for classical music = F ( P , 9 ) 9 is exogenous, and captures consumers’ interest in clas- sical music. Q S = supply of classical music = G ( P , ĵ ) ĵ is exogenous, and captures the technology for recover- ing and cleaning up old classical music recordings. (c) Q D = demand for dollars = F ( P , 9 ) 9 is exogenous, and captures the domestic and foreign beliefs about the relative safety of the dollar versus the yen, the euro, and the pound. Q S = supply of dollars = G ( P , ĵ ) ĵ is exogenous, and captures the Federal Reserve’s supply of currency. “endogenous variables” respectively. The best short sum- mary of the power of models is Robert Lucas’s speech “What Economists Do.” It is available widely on the Web. This is possibly his best line: “I’m not sure whether you will take this as a confession or a boast, but we are basically storytellers, creators of make-believe economic systems.” Lucas explains that if you want to be a matter-of-fact person who understands how the world works, you actually need to be creative and imaginative. EXERCISES 1–2 . Based on personal preference. 3 . (a) From www.stanford.edu/~chadj/snapshots.pdf: Ethiopia: 1.6 percent India: 8.4 percent Mexico: 28.9 percent Japan: 76 percent (b) Botswana’s per capita growth rate between 1960 and 2010 was about 5.33 percent. China’s per capita growth rate was somewhere between 4.62 percent and 6.02 percent depending on which version of the data in the “snapshot” file provided by Chad is used. (c) Population, biggest to smallest: USA (310.2 million), Indo- nesia (243 million), Brazil (201.1 million), Bangladesh (156.1 million), Nigeria (152.2 million), Russia (139.4 million). (d) Government purchases are larger in poor countries, while investment expenditures are higher in rich countries. (e) While there are many exceptions, it appears that money in poorer countries has less value per unit compared to rich countries. This is largely because some poor countries have a history of high inflation, so that one unit of their currency becomes worth very little compared to the dollar. High infla- tion is rare in rich countries, and much more common in poor countries. 4 . Based on personal preference. 5 . This is a worked exercise. Please see the text for the solution. 6 . (a) ā tells us how the quantity of labor supplied responds to wages. Informally, it tells us how sensitive workers are to wages when deciding how much to work. (b) This is the same as in 5: quantity of labor supplied, quan- tity of labor demanded, equilibrium labor supply, and the

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    6 did without it. Throughout this chapter, you may want to look for ways to emphasize how many bad ways there are to count economic activity—this lets students know that you’re not just belaboring the obvious. In addition, you may want to emphasize that the system of national accounts consti- tutes a set of accounting identities—statements that are true by definition. These definitions are important in framing questions and finding answers. For example, if we define “spending” as C + I + G + NX , then we will ask how C , I , G , and NX changed to cause spending to change. In contrast, if we define “spending” as the money supply times velocity ( M × V ), then we will ask how the money supply and veloc- ity changed to cause spending to change. Definitions are an essential part of economic theory. The national accounts pro- vide ample definitions for asking questions. A useful analogy comes from medicine. How can you tell whether a human being is healthy? Doctors have settled on a few key variables for summing up human health: body tem- perature, blood pressure, heart rate, and breathing rate. The first two of the vital signs, in par ticular, could be measured in a number of ways—so doctors had to settle on the one best way to measure body temperature and blood pressure. Over the centuries, many different “vital signs” were put forward as being the key to measuring health, but only these four passed the test. Even today, many doctors push to include a fifth or sixth vital sign— oxygen levels in the blood, pupil size, emotional distress, pain—but the profession as a whole resists these efforts. So too with GDP: we’re always tinkering with ways to improve the GDP measure. We remind students of its limita- tions: we look at other numbers as well, but we keep coming back to GDP because it seems to be one of the vital signs of the nation’s economic health. GDP is also the most compli- cated vital sign to explain—not unlike blood pressure in that regard—so we spend a whole chapter explaining it. CHAPTER OVERVIEW By and large, this is a conventional “What is gross domestic product (GDP)?” chapter. Jones runs through the produc- tion, expenditure, and income approaches, and emphasizes that the labor share in the United States is roughly constant (well worth emphasizing, since it helps justify the Cobb- Douglas production function that plays a major role later). There’s a particularly clear discussion of how to com- pare GDP numbers across countries; even if you don’t plan on covering international topics in your course, this is probably worth discussing, since cross-country GDP com- parisons are so central to the economic growth chapters (and many students have an intuition that prices differ across countries). Interest rates and the unemployment rate are deferred to later chapters, so you can focus your energies on an intel- lectual triumph that we economists usually take for granted: the definition of GDP. 2.1 Introduction Chad starts off by emphasizing just how hard it is to measure “an economy.” What should we include? What should we leave out? How can we add up things that are wildly dissimilar— automobile production and grocery store employment and resales of homes and on and on—into one number that tells us what is happening? Simon Kuznets found a reasonable way to do this, and was awarded the 1971 Nobel Prize in economics largely for creating the definition of GDP that we use today. Econo- mists and citizens take GDP for granted—but it really is one of the great intellectual contributions to economics. What did we ever do without it? Bad macro policy: that’s what we CHAPTER 2 Mea sur ing the Macroeconomy

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    Mea sur ing the Macroeconomy | 7 It’s worth remembering that GDP is by and large an account- ing measure, using accounting intuition. Students are often confused by the rhetoric of macroecon- omists. A case in point arises here. Macroeconomists often use the terms “real income,” “output,” and “GDP” interchange- ably. Since the value of output, as realized through sales, is distributed in the form of various incomes, output, GDP, and income are identical. THE EXPENDITURE APPROACH TO GDP Here we run through C , I , G , and NX just as in Principles. Fortunately, Chad places less emphasis on the minutiae of the four categories and instead focuses on how these shares have changed over time—and by emphasizing time series, he gives the students stylized facts for macroeconomic the- ory to explain. In one case he begins a theoretical explanation immedi- ately. He draws attention to the rise in the U.S. consumption share, noting that it could reflect the fact that it’s been easier for average consumers to borrow in recent decades. Alterna- tively, the rise in today’s consumption share could reflect an expected rise in future income. A few points that might be worth noting: • It’s always worth emphasizing the difference between government purchases (measured in GDP) and govern- ment spending (which is what the media cares about, and what matters for many fiscal policy questions, but is not a formal category of GDP). As Chad notes, Social Secu- rity, Medicare, and interest on the debt are not included in G . They are transfer payments, and in practice most Social Security and all Medicare payments are used to purchase C , consumer goods and services. • It’s worth noting that composition of spending is sensi- tive to where the economy is during the business cycle. During the current downturn in the economy, we see investment’s share of GDP falling, as consumption and government purchases’ shares are increasing. It’s also worth emphasizing what NX really does: it makes sure we count everything exactly once. For example, C con- tains all purchases of consumer goods within the United States, not all production of consumer goods within the United States. So some of the C in GDP is really produced in Germany or China or Canada—and if our final measure of GDP is really going to measure U.S. production , we have to subtract that to make sure it doesn’t show up in our final number. So when an American buys a $400 Chinese TV from the local appliance store, it shows up twice on the right-hand side of the national income identity: as + $400 in C , and again as − $200 in NX . That’s how we make sure that the portion of the TVs produced abroad doesn’t show up in U.S. gross domestic product. 2.2 Mea suring the State of the Economy Let’s start with Chad’s phrasing of the definition of GDP: “Gross domestic product is defined as the market value of the final goods and services produced in an economy over a certain period.” The words of this definition that can be emphasized are “market value,” “final,” “produced,” and “services.” By emphasizing “market value,” we stress that GDP is val- ued in some currency, such as dollars, and that unalike quan- tities of goods cannot be added up to measure the nation’s output. By highlighting “final” I emphasize that one key to accu- rately measur ing GDP is to avoid double counting . I like to use examples in which common sense conflicts with Kuznets’ GDP measure, as in the sample lecture below. By highlighting “produced” I emphasize that GDP doesn’t include sales of used items (such as homes and cars), and doesn’t include purely financial transactions (such as buying stocks or moving money between bank accounts). Moreover, GDP is a flow. A flow represents an economic variable that is measured through time, for example how much income was earned or spent last week. In contrast, economic vari- ables measured at a point in time are called stocks. These variables are found in our balance sheets (our statements of assets, liabilities, and net worth). How much money you hold is a question about an economic stock. By highlighting “services” I emphasize that a large part of economic activity in the United States isn’t about making things—it’s about providing valuable services. If we leave out the ambiguous “housing services” part of GDP, the remain- ing ser vice items—transportation, medical care, tourism, and “other”—add up to about $3.5 trillion, about one-fourth of our $13 trillion U.S. economy. Consumer ser vices repre- sent the largest category of consumer spending in the United States, about two-thirds of total consumer spending. In short, consumer services are almost half (around 47 percent) of GDP. PRODUCTION = EXPENDITURE = INCOME A clear example about Homer and Marge running a farm makes the point that if you measure correctly, there are three equivalent ways to measure GDP. You can remind stu- dents that this is the same “circular flow” idea they saw back in Principles: you can take the economy’s pulse when prod- ucts flow to final users, when revenue flows to firms, or when income flows to the firm’s workers, owners, and lenders. It may be worth emphasizing that Chad’s “profits” are what Principles texts often call “accounting profits.” They’re different from “economic profits,” which don’t come into play at all when measuring GDP (recall that the difference between accounting and economic profits is the opportunity cost of the entrepreneur’s time and the investor’s capital).

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    8 | Chapter 2 a good example, as is anything locally made and then sold in a local store). Economic sense says something different: “Measure the size of the local economy by summing up the value added by each local business.” To do that, you need to know the cost of each company’s outputs and inputs, and then just sum all the values of the outputs while subtracting the sum of all the values of the inputs. WHAT IS INCLUDED IN GDP AND WHAT IS NOT? Of course, we have to explain the limitations of GDP— Chad’s discussion differs from many by pointing to recent research showing that health matters more than is measured in GDP, while environmental degradation likely matters very little. In addition, you might emphasize the importance of leisure as a good that is excluded from GDP. In this third edition of the textbook, Chad provides a case study in which a nation’s welfare is linked to consump- tion (government and personal) per person, life expectancy, leisure, and consumption inequality. The resulting measure of welfare is contrasted to relative per capita GDP. When comparing the welfare measures across countries two impor- tant results emerge. First, relative to the United States, in developed countries like those of Northern Europe welfare rises in comparison to per capita GDP because of: (1) more government consumption, (2) more leisure, (3) higher life expectancy, and (4) less consumption inequality. Second, in poorer countries relative welfare decreases in comparison to relative per capita GDP for the opposite reasons. Chad’s case study complements and provides results similar to the United Nations Development Programme’s Human Devel- opment Index (available at http:// hdr.undp.org/en /statistics / hdi). 2.3 Mea suring Changes Over Time Now we get to the distinction between nominal and real GDP. In Section 2.3.1, Jones runs through a simple apples- and-computers example, yielding what you really need to cover: Nominal GDP and Real GDP. In Sections 2.3.2, 2.3.3, and 2.3.5, he runs through the vari- ous types of price indexes—Laspeyres, Paasche, and chain- weighted. If you want to avoid these price-index details, that’s easy: just cover 2.3.1 to teach the old standby of “Real GDP in Year X Prices.” Then use the basic equation at the beginning of 2.3.1 (nominal GDP = real GDP × price level) to back out the price level. From there, proceed directly to 2.3.4 and to the defi ni- tion of inflation, which is probably what you care about anyway. Chain weighting doesn’t ever come up again aside from a parenthetical reference between equations 2.3 and 2.4. The surprise is that C , I , G , and NX all reflect purchases by different groups, but they are defined in such a way that they sum up to U.S. production . THE INCOME APPROACH TO GDP This section gives just enough information for students to learn that the labor share is fairly stable across time within the United States. The only point I might emphasize is that the two forms of business income (net operating surplus and depreciation) are actually one item: income going to owners of capital, which we might call “gross operating surplus of business.” The “depreciation” item is imputed (that is, scien- tifically made up) based on assumptions about the decay of the U.S. capital stock. And just why is there an item called “indirect business taxes,” if so many other forms of taxes—income and payroll taxes, in particular— don’t show up here? The easy answer is probably the right one: it’s because the creators of the national accounts are following accounting methods. In accounting terms, the answer to “Who pays a sales-type tax?” is empirically ambiguous: in the typical case, the cus- tomer “pays” the tax, since it’s added onto the bill, but in reality, the business owner sends the proceeds on to the gov- ernment. By lumping these ambiguous taxes together, we reduce the ambiguity of the other income categories. THE PRODUCTION APPROACH TO GDP Once again, this gives you another chance to emphasize the importance of counting everything exactly once. In the pro- duction method, you have only two choices: 1. Either only measure final goods and ser vices , or 2. Only measure the value added at each stage of pro- duction as a good moves from firm to firm to final purchaser. Why bother with (2)? For an economist (or businessperson) trying to figure out which industries are most productive, it is useful to know which industries add the most value to their inputs. In Chad’s example, you could use the value- added method to answer the question, “Where does most of a car’s value come from—the raw materials or the assembly of those materials?” In the diamond jewelry industry, the answer might be quite different (if the “raw” material is cut diamonds). I often emphasize that when measuring the size of a local economy, common sense and economic sense are likely to conflict. Common sense says, “Measure the size of the local economy by adding up the sales of all the local businesses.” But that would include massive double counting—just think of all the products that are sold from one local business to the next before they reach their final user (farm products are

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    Mea sur ing the Macroeconomy | 9 for practical purposes, the chapter) by noting that the same goods and services are often cheaper in the poorest countries—haircuts are a classic example. Also, the Econo- mist ’s Big Mac Index is always worth a mention, since stu- dents can grasp that idea quickly. So while on paper the world’s wealthiest countries may appear 100 times richer than the world’s poorest countries, the actual difference is closer to 30 times richer. That is still a massive difference that demands explanation—and that is the topic of the next few chapters. 2.5 Concluding thoughts Just as a reminder, there are two popular topics that Chad (mercifully) leaves out of this chapter in order to get us away from the economic anatomy and toward the economic models that are our field’s strength. These are the Consumer Price Index and how price indexes measure quality changes. Chad provides coverage of the former later on in Chapter 8, while this manual provides some coverage on quality changes when discussing that chapter. You may want to mention these topics in class at some point, to let the students know you’ll come back to them: • The Consumer Price Index’s “basket” method is differ- ent from the other price indexes covered in this chapter. (The CPI is used to index tax brackets and Social Secu- rity payments, so it has policy relevance.) • It’s difficult to measure changes in quality over time (key in a new-economy world). The Census Bureau’s hedonic price indexes for computers and Alan Green- span’s speech on the falling real price of cataract sur- gery come to mind. Finally, students might be interested to know that national accounts provide a wealth of useful definitions that can be used as a starting point for analyzing important questions such as what causes the national budget deficit, and what role the national budget deficit plays in affecting national savings and gross savings. SAMPLE LECTURE: PRODUCTION, EXPENDITURE, AND INCOME IN A TRUCK ECONOMY In this lecture, you can tie together all three GDP measure- ment methods in a simple economy with one output good. Since I find that most misunderstandings and most of the insights in national income accounting come from the pro- duction/value-added method, we’ll use Chad’s example of steel being used to make trucks. Let’s consider the economy of Pickupia. The only two companies in Pickupia produce steel (SteelCo) and trucks (TruckCo). Chad’s coverage of the three types of price indexes is quite clear and brief, so if you do want to cover it, it shouldn’t take more than half an hour in class. 2.4 Comparing Economic Performance across Countries Students often have a strong intuition that prices vary across countries, and since cross-country GDP comparisons will play a major role in the next four chapters, it may be worth- while to spend a little time on this section. There is one par ticular point that I would expand on a bit with most stu- dents, and that is the meaning of the final equation in this section: real Chinese GDP in U.S. prices = (U.S. price level/ Chinese price level) × Chinese nominal GDP The easiest way to make sense of this equation is to first convert Chinese nominal GDP from yuan into dollars. Stu- dents can then see, given the exchange rate, how much those many trillion yuan are worth in dollars. Then you can point out that goods cost less in China than in the United States, and therefore those dollars purchase more goods than they would have purchased in the United States. If those dollars purchase more goods, real GDP in China is increased. This real Chinese GDP in U.S. dollars can then simply be found by dividing China’s nominal dollar GDP by the ratio of the Chinese price level to the U.S. price level (multiplying nom- inal dollar GDP by the ratio of the U.S. price level to the Chinese price level). The key takeaway here should be that if prices are “lower” in China than in the United States, then Chinese real GDP is higher than Chinese nominal GDP. Compare actual, uncorrected, right-off-the-website U.S. prices (in dollars) for certain goods and ser vices against actual, uncorrected, right-off-the-website Chinese prices (in yuan) for the same goods and services. Convert those yuan prices into dollars at the actual, uncorrected nominal dollar/ yuan exchange rate, and you’ve got a commonsense mea- sure of where prices are lower. Add in a big bud get and doz- ens of well-meaning bureaucrats, and you’ve got the United Nations International Comparisons Program. If goods and services cost less in China than in the United States (in fact they do, after you convert yuan into dollars), then that means the price level is lower in China than in the United States. So while China’s nominal GDP may look relatively small at $5.8 trillion (when converted into dollars), when adjusting for relative prices, the Chinese real GDP is relatively large at $10.8 trillion. Figuring out why the same goods and services are more or less expensive in some countries than in others is a task usually left to international economics, so I won’t attempt even a quick explanation here. Chad closes this section (and

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    10 | Chapter 2 Emphasize how different this answer is from “common sense.” If I wanted a commonsense answer to how much is produced in this economy, I’d add up SteelCo’s 100 in sales plus TruckCo’s 500 in sales to get my answer: 600. The commonsense answer—which is what you’d get if you just surveyed both businesses and added their answers— turns out to be completely wrong, because it double counts the steel. Making sure you count everything exactly once is the key to a good accounting system—and that’s harder to do than you might think. CASE STUDY: CAPITAL GAINS—WHY AREN’T THEY PART OF GDP? If you buy a share of Microsoft stock for $100 and then sell it a year later for $150, common sense tells you that you’ve earned $50. The $50 increase is called a “capital gain.” Sim- ilarly, if you bought a house for $100,000 and sell it two years later for $125,000, that $25,000 sure feels like income to you—it’s money you can spend just as if you had received a $25,000 bonus at work. But economists’ measure of GDP doesn’t include capital gains at all—so we have a case of “economists versus com- mon sense.” If we focus on the income approach to GDP, we include labor income, capital income, and a few adjust- ments. “Capital gains” sounds a lot like “capital income,” so why aren’t capital gains counted as part of capital income? The short answer is that capital gains can’t be part of capi- tal income because capital gains (or losses) merely reflect a change in the future profitability of an asset. For example, a stock price might rise because people believe that their com- pany will earn more profits in the future. And if those people are correct, those future profits will show up in future GDP. Of course, stock prices rise and fall for many reasons, and in a course on asset pricing you can cover that topic. But the main point holds: a rise in the price of a home, a painting, or the collection of machines and workers we call “Microsoft” doesn’t reflect any current-year production . And remember, GDP is all about current-year production. Capital gains aren’t part of the government’s measure of “national income,” but many capital gains are still taxed by the state and federal income tax. CASE STUDY: ROBERT HALL AND “ INTANGIBLE CAPITAL ” According to some economists—most prominently Robert Hall 1 of Stanford—the previous case study is completely 1. Robert E. Hall, “The Stock Market and Capital Accumulation,” Ameri- can Economic Review , vol. 9, no. 5, (December 2001), pp. 1185–1202. SteelCo TruckCo Wages 70 Wages 250 Sales Tax 0 Sales Tax 30 Cost of Inputs 0 Cost of Inputs 100 + Profit 30 + Profit 120 Total Steel Sales 100 Total Truck Sales 500 There are four different customers for TruckCo’s trucks: Pickupia’s consumers buy $200 worth of trucks for per- sonal use. Pickupia’s businesses buy $100 worth of trucks to haul products and workers. Pickupia’s government buys $150 worth of trucks to haul products and workers. Foreign countries buy $50 worth of trucks for unknown reasons. Pickupia’s consumers also import $100 worth of other goods and services from foreign countries. This is a complete description of the Pickupia economy. Now, let’s work out the GDP measures based on the expen- diture, income, and production methods. Expenditure: GDP = C + I + G + total exports − total imports GDP = (200 on trucks + 100 on imports) + 100 + 150 + 50 − 100 on imports = 500 There’s no trick here—just a reminder that C includes all purchases by domestic consumers, regardless of whether those goods are made here or overseas. Income: total wages: 320 total sales tax (an “indirect tax”): 30 total profits: 150 total income = 320 + 30 + 150 (assuming no depreciation of capital) = 500 (This 64 percent wage share is close to the true U.S. value, which may be a surprise to many students who suspect that the vast majority of GDP is profits.) Production: Value Added by SteelCo: Somehow, they get their raw ore for free, so their value added is just: revenue − cost of inputs = 100 − 0 = 100 Value Added by TruckCo: revenue − cost of inputs = 500 − 100 = 400 total domestic production = value added by all firms in the economy = 100 + 400 = 500

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    Mea sur ing the Macroeconomy | 11 1. John Wallis and Nobel laureate Douglass North esti- mate that “transactions costs, that is, expenditures to negotiate and enforce contracts, rose from a quarter of national income in 1870 to over half of national income in 1970” (cited in McCloskey and Klamer, 1995). 2 Transaction costs include attorneys’ fees, the cost of the legal system, most of the cost of running the nation’s banking and financial systems, auditors, office workers who do accounts payable and receivable, locks on doors, security guards, and almost anything else that makes it possible for you to (1) keep your property, (2) feel enough trust to transfer your property to someone else, or (3) receive property from someone else. Transaction costs aren’t just part of G : As the list above shows, there are a lot of private-sector purchases involved, so they show up in C , I , and NX as well. According to Wallis and North, about half of GDP gets spent just so that we can interact and exchange with each other. 2. McCloskey and Klamer go further: They estimate how much of GDP is just devoted to “sweet talk,” to persua- sion. Even when a person is providing information, much of the work isn’t just about giving raw data, but about selling the audience on the data. “Why should I listen to you?” That’s the question answered by persuasion. The importance of persuasion was noted by the father of economics himself. Adam Smith, in his Lectures on Jurisprudence , noted, “Everyone is practicing oratory on others thro the whole of his life” (cited in McCloskey and Klamer). Broadly, McCloskey and Klamer want to count up all human communication that isn’t about providing either information (for example, telephone operators or col- lege professors) or commands (such as much of the work of police officers and CEOs). They count up lawyers, actors, and members of the clergy; they count up three- quarters of the work done by salespeople, therapists, and job supervisors; and half the work done by police officers, technical writers, and nurses. Their rough esti- mate is the title of their paper: one-quarter of GDP is persuasion. REVIEW QUESTIONS 1–4. These essentially summarize the entire chapter, so I will refrain from answering them. 2. Donald McCloskey and Arjo Klamer, “One-Quarter of GDP Is Persua- sion,” American Economic Review , vol. 85, no. 2, (May 1995), pp. 191–95. John Joseph Wallis and Douglass North, “Measur ing the Transaction Sector in the American Economy, 1870–1970,” in S. L. Engerman and R. E. Gallman, eds., Long-Term Factors in American Economic Growth (Chicago: University of Chicago Press, 1986). wrong for an economically important reason. Hall shows that under some fairly strict assumptions (inter alia, that a company’s stock price doesn’t reflect either future monopoly profits or changes in the rate of time preference), then changes in the stock price must reflect changes in the size of the nation’s total stock of capital. That would mean that an increase in a stock’s price must reflect corporate investment, while stock price decreases must reflect decay of past corpo- rate investment. But clearly, stock prices change too often and by too large an amount to reflect changes in the physical amount of corporate capital— roughly measured by the I part of GDP— so Hall argues that many changes in stock price must reflect changes in the stock of the nation’s “intangible capital.” Intangible capital might include a corporation’s ability to create new ideas, its form of corporate organization, its ability to motivate employees to work hard, and many other things that a corporation can do today to help it to produce more out- put in the future . That, after all, is what investment goods do, right? What we call “investment goods” are just products we create today in order to reap a benefit down the road. Perhaps we can think of “intangible investment” as ser vices we cre- ate today in order to reap a benefit in the future. In Hall’s view, then, the rise in the stock market in the late 1990s reflected the market’s guess that modern tech- nology would enable fi rms to create much more output in the future with very few workers— something that sounds quite a bit like the “new economy” in a nutshell. Of course, since the NASDAQ (a tech-heavy stock market index) plummeted by 75 percent between 2000 and 2003, the big question is, Where did all of that intangible capital go? Did hundreds of billions in “intangible capital” somehow get destroyed? There is a large literature on “intangible capital,” also known as “organizational capital.” In the future, economists may find a coherent, practical way to include these important forms of investment activity in the I part of GDP. If Hall’s view has merit, then accurately measured GDP should include some portion of capital gains income. If these improved measures are even half as volatile as the stock market, then GDP is much more volatile than we currently believe. CASE STUDY: “ONE QUARTER OF GDP IS PERSUASION” As we saw before, services are about one-quarter of U.S. GDP. That means that much economic activity isn’t about making things, it’s about interacting with other people. There are two other ways of slicing up GDP that might be of interest:

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    12 | Chapter 2 This isn’t exact, as Chad notes, but it’s good enough for our purposes. This implies: growth in nominal GDP − growth in real GDP = inflation rate All we need to do is add in our three definitions of “growth in real GDP,” and we’ll have our three answers: Paasche: 14.8 percent − 6.9 percent = 7.9 percent Laspeyres: 14.8 percent − 6.8 percent = 8 percent Chained: 14.8 percent − 6.85 percent = 7.95 percent 6 . (a) Without taking relative price differences into account, India’s economy is 11.9 percent of the size of the U.S. econ- omy (78.9 trillion/45.7) / 14.5 trillion). (b) Taking relative price differences into account, India’s economy is 32.3 percent, or about one-third, the size of the U.S. economy (11.9 percent/0.368). (c) The numbers are different because many consumer goods—food, haircuts, medical visits—are very cheap in India when you are measur ing in U.S. dollars. This is usu- ally true in poor countries. As we’ll see in Chapter 14, when we look at The Economist ’s “Big Mac Index” of exchange rates, the same McDonald’s hamburger is much cheaper in poor countries than in rich countries when you compare prices in U.S. dollars. Wages, rents, and taxes cost less in poor coun- tries, which makes it cheaper to produce a hamburger or a haircut or even a doctor’s visit. That means that while India is a very poor country, the Indian economy is not one-tenth the size of the U.S. econ- omy. It is closer to one-third. 7 . (a) 37.7 percent (b) 30.3 percent (c) The numbers are different because many goods are more expensive in Japan than in the United States. 8 . (a) If fewer people have homes, then the average person must be worse off when it comes to homeownership—after all, now people have to share homes or live in less desirable places. People will be working to rebuild things that they already had before. This is a loss, not a benefit. It is likely that if there hadn’t been an earthquake, most of the people rebuilding these lost homes would have been able to build something new and valuable, rather than rebuilding some- thing old and valuable. (b) Measured GDP will likely rise—people will want to work hard and quickly to rebuild homes, or they will pay a high price to have other workers rebuild their homes. These wages for workers and purchases of materials (which are mostly wages for other workers, probably) all show up in GDP. EXERCISES 1 . This is a worked exercise. Please see the text for the solution. 2 . (a) GDP rises by $2 million (final sale price of computers). (b) GDP rises by the $6,000 commission (capital gains—an increase in the price of an asset like a home, car, or painting—are not part of GDP since the asset wasn’t pro- duced that year. They aren’t part of national income, either). (c) No impact. This is a government transfer payment, not a government purchase of a good or service. If the government hired the unemployed and paid them to dig ditches or pro- gram in C ++ , then their wages would count as a government purchase. (d) No impact. I rises by $50 million, but NX falls by $50 mil- lion, so the two effects cancel out and have no impact on GDP. (e) U.S. GDP rises by $50 million: NX rises by $50 million. (Incidentally, this has no impact on European GDP for the same reason as in part (d) ). (f) GDP rises by $25,000: NX falls by $100,000 but C rises by $125,000. The store added $25,000 of value to the U.S. economy, so it shows up in GDP. 3 . Real GDP in 2020 in 2018 prices: 5,950; 19 percent growth between 2019 and 2020. Real GDP in 2018 in 2010 prices: 6,500. Real GDP in chained prices, benchmarked to 2020: 6,483. ( Note : output of apples and computers didn’t change between 2018 and 2019, so the average of the Paasche and Laspeyres zero growth rates is still zero.) 4 . 2016 2017 Percent change 2016–2017 Quantity of oranges 100 105 5 Quantity of boomerangs 20 22 10 Price of oranges (dollars) 1 1.10 10 Price of boomerangs (dollars) 3 3.10 3.33 Nominal GDP 160 183.7 14.8 Real GDP in ‘16 prices 160 171 6.9 Real GDP in ‘17 prices 172 183.7 6.8 Real GDP in chained prices, benchmarked to 2017 171.9 183.7 6.85 Here GDP growth only shows a tiny difference between the various methods. 5 . We’ll use Chad’s shortcut from Section 2.3.4: growth in nominal GDP = growth in price level (a.k.a. inflation) + growth in real GDP

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    Mea sur ing the Macroeconomy | 13 the suit since he has to replace his window. So he would’ve “created new jobs” in the suitmaking industry, but now he won’t get that new and valuable suit. Instead, he’ll spend his scarce dollars replacing something old and valuable. So our earthquake is like the broken window: workers who could have created something new instead have to replace something. It would have been better for citizens if the earthquake had not happened. This question illustrates a famous parable in economics, the “fallacy of the broken window.” 3 If a person breaks a shop window, the shop owner has to pay to repair that window. If we only look at the direct effect, we will only notice that the person who broke the window has “created new jobs” in the windowmaking industry. That’s true, but what we don’t see is that if the window hadn’t been broken, the shop owner would have bought a new suit later that week. Now, he doesn’t get 3. Henry Hazlitt, Economics in One Lesson , Chapters 1 and 2.

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