Economists studying economic activity in the nineteenth century or during the Great Depression had no measure of aggregate activity (aggregate is the word macroeconomists use for total) on which to rely. They had to put together bits and pieces ol information, such as the shipments ol iron ore, or sales at some department stores, to try to infer what was happening to the economy as a whole.
It wasn't until the end of World War II that national income and product accounts or national income accounts, for short ) were put together. Measures of aggregate output have been published on a regular basis in Australia since I960. (You will lind measures ol aggregate output for earlier limes, but these have been constructed retrospectively.)
CHAPTER©
A Tour of the Book
Like any accounting system the national income accounts first deline concepts, and then constmct measures corresponding lo these concepts. You need only to look at statistics from countries that haven't yet developed such accounts to realise how crucial arc precision and consistency. Without these characteristics, numbers that should add up don't, and trying to understand what is going on olten (eels like trying lo balance someone else's books. We won't burden you with the details ol national income
accounting here. But, because you will occasionally need to know the delinition ol a variable and how variables relate to each other, Appendix I at the end of the book gives you the basic accounting Iramework used in Australia (and, with minor variations, in most other countries) today. You will find it useful whenever you want to look at economic data on your own.
GDP: Production and income
The measure of aggregate output in the national income accounts is gross domestic product, or GDP. To understand how C.DP is constructed, it is best to work with a simple example. Consider an economy composed ol just two firms:
• Finn I produces steel, employing workers and using machines to produce the steel. It sells the steel for $100 to Firm 2, which produces cars. Firm I then pays its workers $80, leaving $20 in protit lo the lirm.
• Firm 2 buys the steel and uses it, together with workers and machines, lo produce cars. Revenues from car sales are $2 10. Ol the $210. $100 goes to pay for the steel and $70 goes to workers in the firm, leaving $40 in profit to the firm.
An intermediate good ► is a good used in the production of another good. Some goods can be both final goods and intermediate goods. Potatoes sold direcdy to consumers are final goods. Potatoes used to produce potato chips are ntermediate goods. Can you think of other examples?
This information can be summarised in a table-.
Steel company (Firm I) Car company (Firm 2)
Revenues from sales $100 Revenues from sales $210
Expenses $80 Expenses $170
Wages $80 Wages $70
Steel purchases $100
Profit $20 Profit $40
There are then three ways of defining GDP in this economy, all equivalent: GDP is the value of the final goals anil services produced in the economy during и given period. The important word here is final. To see why, ask yourself: Should GDP be constructed as the sum of the values of al! production in ihe economy—the sum ot $100 from the production ot steel plus $210 from the production ol cars, so $310? Or should GDP be constructed as the value ot the production of final goods, here cars, equal to $210?
Some thought suggests that the right answer must be $210, Why? Because steel is an intermediate good a good used up in the production of the final good cars, and thus shouldn't be counted in GDP-—the value of final output. We can look at this example in another way. Suppose the two firms merged, so thai the sale ol siecl took place inside the new firm and was no longer recorded. The accounts of the new firm would be given bv-.
Revenues from sales $2 10
Expenses $ 150
Profit $60
All we would see would be one firm selling cars for $2 10, paying workers $80 + $70 = $ 150, and making $20 + $40 = $60 in profits. The $2 10 measure would remain unchanged—as it should.
This first definition suggests one way to construct GDP: by recording and adding up the production of final goods—and this is roughly the way actual GDP numbers are put together. But it also suggests a second way ot thinking about and constructing GDP. GDP is the sum of value added in the economy during a given period.
You may come across ►
another term, gross national product, or GNP.There is a subtle difference between 'domestic' and 'national', and thus between GDP and GNP. We examine the distinction in Chapter 18 (also in Appendix I at the end of ihe book). For new.
ignore it. In reality, not only ► workers and machines are required for steel production, but so are eleccricity. iron ore. etc. We ignore these to keep the example simple.
1 he term value added means exactly what it suggests. The value added by a firm in the production process is defined as the value ot its production minus the value ol the intermediate goods it uses in production.
In our iwo-lirm example, the steel company doesn't use intermediate goods. Its value added is simply equal to the value ol the steel it produces, $100. The car company, however, uses steel as an intermediate good. Thus, value added by the car company is equal to the value ol the cars it produces minus the value ol the steel il uses in production, $210 — $ I DO - $110. Total value added in the economy, or GDP, equals $100 + $110 $210. Note that aggregate value added would remain the same il the steel and car firms merged and became a single lirm. In this case, we wouldn't observe intermediate goods ai all—as sleel would be produced and then used to produce cars within the single firm—and the value added in the single firm would simply he equal to the value of the cars. $210.)
This definition gives us a second way of thinking about GDP. Put together, the two definitions imply that the value of final goods and services—the lirst definition ol GDP can also be thought of as the sum of the value added by all the firms in the economy—the second definition of GDP.
3. GDP is the sum of incomes in the economy during a green period.
So tar, we have looked at GDP from the production side. The other way of looking at GDP is Irom the income side. Think about the revenues lelt to a firm after it has paid tor its intermediate
goods:
• Some of the revenues are collected by the government in the form of taxes on sales—such taxes are called indirect tuxes. The government also gives subsidies to some firms to assist them, and this adds to the revenues that they can use.
• Some ol the remaining revenues go to pav workers—this component is called labour income.
• The rest goes to the firm—that component is called capital income or profit income.
In short, looking at it Irom the income side, value added is the sum ot indirect taxes less subsidies, labour income and capital income.
Return to our example. Indirect taxes and subsidies equal zero. Ol the $100 ot value added by the steel manufacturer, $80 goes to workers< labour income) and the remaining $20 goes to the firm capital income . Ol the $1 10 ol value added bv the car manufacturer, $70 goes it) labour income and $40 to capital income, for the economy as a whole, value added is $210 ($100 + $110), ol winch $150 ($80 + $70> goes to labour income and $60 $20 + $40 goes to capital income.
In our example, labour income accounts for 71 per cent of GDP. capital income for 29 per cent, and indirect taxes less subsidies for 0 per cent. Table 2.1 shows the breakdown of value added among the different types of income in Australia in I960 and 2008. The table shows that, except tor indirect taxes less subsidies (zero in our example . the proportions we have been using in our example aren't very different Irom the proportions lor the Australian economy in the last fifty years. Labour income accounts now for 55 per cent ot Australian GDP. Capital income accounts tor 33 per cent. Indirect taxes less subsidies account lor the remaining 12 per cent. The proportions have changed since I960— labours share has dropped by 15 percentage points, while capital's share has increased by 12 percentage points.
Table 2.1 The composition of Australian GDP by type of income, I960 and 2008
I960 2008
% %
Labour income 71.7 56.1
Capital income 20.8 33.3
Indirect taxes less subsidies 7.5 10.6
(Labour Income = compensation of employees and gross mixed income, wheh includes income of the seif-emploved) SOURCE- ABS. cat. no 5206.Table 7
©
To summarise: You can think about aggregate output—GDP—in three dillerent but equivalent ways.
• From the production side-. GDP equals the value ol the linal goods and services produced in the economy during a given period.
• Also from the production side-. GDP is the sum of value added in the economy during a given period.
• From the income side-. GDP is the sum ol incomes in the economy during a given period.
Nominal and real GDP
In the twelve months to lune 2(108, Australian GDP was $1 ПО billion, compared with $16.25 billion in I960. Was Australian output really seventy times higher in 2008 than in I960? Obviously not: much ol the increase rellecled an increase in prices, rather than an increase in quantities produced. This leads to the distinction between nominal GDP and real GDP.
Nominal GDP is the sum ol the quantities ol linal goods produced times their current price. This definition makes clear that nominal GDP increases over time lor two reasons:
• 1 he production ot most goods increases over time.
• The prices ol most goods also increase over time.
Il our intention is to measure production and its change over time, we need to eliminate the effect of increasing prices on our measure of GDP. Thatx why real GDP is constructed as the sum ol the quantities of linal goods times constant (rather than current) prices.
It the economy produced only one linal good—say, a particular car model—constructing real GDP would be easy. We would use the price of the car in a given year, and then use it to multiply the quantity ol cars produced in each year.
To be sure, calculate real GDP in 2008 prices, and calculate the rate of * growth from 2006 to 2007 and from 2C07 to 2008.
A simple example will help. Consider an economy that produces only cars—and. to avoid issues we will tackle later, assume that the same model is produced every year. Suppose the number and the price of cars in three successive years are given by:
Year Quantity of cars Price of cars Nominal GDP
2006 10 $20.000 $200,000
2007 12 $24.000 $288,000
2008 13 $26.000 $338,000
1 1
Nominal GDP, which is equal to the quantity of cars times their price, goes up from $200,000 in 2006 to $288,000 in 2007—a 44 per cent increase—and from $288,000 in 2007 to $338,000 in 2008— a 16 per cent increase.
• To construct real GDP, we need to multiply the number ot cars in each year by a common price. Suppose we use the price ol a car in 2007 as the common price. This approach gives us, in effect, real С DP in 2007 dollars.
• Using this approach, real GDP in 2006 (in 2007 dollars equals 10 cars C" $24,000 per car = $240,000. Real GDP in 2007 (in 2007 dollars! equals 12 cars (? $24,000 per car = $288,000, the same as nominal GDP in 2007. Real GDP in 2008 (in 2007 dollars) is equal to 13 (a $24.000 = $.312,000. So, real GDP goes up from $240,000 in 2006 to $288,000 in 2007—a 20 per cent increase- and from $288,000 in 2007 to $3 12,000 in 2008—an 8 per cent increase.
Two lessons to ► remember: I. GDP is the measure of aggregate output, which we can think of from the production side (aggregate production) or the income side (aggregate income).
2. Aggregate production and aggregate income are always equal.
Warning! People often ► use 'nominal' to denote small amounts.
Economists use 'nominal' for variables expressed in current prices. And they surely don't refer to small amounts: die numbers typically run in the billions, or even trillions, of dollars.
• How different would our results have been if we had decided to construct real GDP using the price of a car in. say. 2008 rather than 2007? Obviously, the level ol real GDP in each year would be different because the prices aren't the same in 2008 as in 2007); but its rate of change from year to year would be the same as above.
The problem in constructing real GDP in practice is thai there is obviously more than one linal good. Real GDP must be defined as a weighted average of the output of all final goods, and this brings us to what the weights should be.
The relative prices of the goods would appear to be the natural weights. If one good costs twice as much per unit as another, then that good should count for twice as much as the other in the construction ol real output. But this raises the question: What il, as is typically the case, relative prices change over time? Should we choose the relative prices in a given year as weights, or should we change the weights over time? More discussion ol these issues, and ol the way real GDP is constructed in Australia, is left to the appendix to this chapter. Here, what you should know is that the measure ol real GDP in Australian national income accounts is called real GDP in chained 2005-06) dollars ('2005-06' because this covers the year when, by construction, real GDP is equal to nominal GDP). It uses weights that reflect relative prices and that change over time. It is a measure ot the output ol the Australian economy, and its evolution shows how Australian output has increased over time.
Figure 2.1 plots the evolution ol both nominal GDP and real GDP since I960 in Australia. By constmction, the two arc equal in 2005-06. Figure 2.1 shows that real GDP in 2008 was 5.5 times its level in 1960—a considerable increase, but clearly much less than the seventy-told increase in nominal GDP over the same period. The difference between the two results comes from the increase in prices over the period.
The terms nominal GDP and real GDP each have many synonyms, and you are likely to encounter them in your readings:
• Nominal GDP is also called dollar GDP or GDP in current dollars.
• Real GDP is also called GDP in terms of goods, GDP in constant dollars. GDP adjusted for inflation, or GDP in chained 2005-06) dollars—it the year in which real C.DP is set equal to nominal GDP is 2005-06, as is the case in Australia at this time.
This concludes your introduction to the main macroeconomic variable, GDP. In the chapters that follow, unless indicated otherwise,
• GDP will refer to real GDP and V, will denote real GDP in year t.
4 Suppose that real GDP was measured in 1994/5 dollars rather than 2005/6 dollars. Where would the nominal GDP and real GDP lines on the graph intersect!
A TOUR OF THE BOO< chapter 1
• Nominal GDP, and variables measured in current dollars, will be denoted by a dollar sign in front— for example, $Y. for nominal GDP in year t.
Figure 2.1
1,200-,
2 800- rt
"o ■o
о 600
(Л
С О
400
200-
Real GDP
Nominal GDP
0 I I I I I I I I l I I I I I I I l ll I I I l I I II I I I I I I I I I l I II II I I I I I I I 1
I960 1965 1970 1975 1980 1985 1990 1995 2000 2005
1,000
Nominal and real GDP in Australia. 1960-2008
From 1960 to 2008. nominal CDP increased by a factor of 70. Rea! GDP increased by a factor of S.5. SOURCE RBA Bulletin. Table Gil.
GDP: Level versus growth rate
The focus so iar has been on the level ot real CDP This is an important number, which gives the economic size of a country. A country with twice the GDP of another is economically twice as big. Г-qually important is the level ol real GDP per capita, the ratio ol real GDP to the population. It gives us the average standard ol living ol the country
In assessing the perlormance ol the economy Irom year to year, economists locus on the rate of growth of real GDP—GDP growth. Periods of positive GDP growth arc called expansions. Periods ol negative C.DP growth are called recessions. There is no ollicial definition ol what constitutes a recession, but to avoid calling iust one quarter ot negative growth a recession, macroeconomists usually reler to a recession' only il the economy undergoes at least two consecutive quarters of negative growth.
Warning! One must be ► careful about how one does the comparison. Recall the discussion in Chapter I about PPP measures, particularly with regard to China. You'll learn more on this in Chapter 10.
To measure real GDP growth in year I we compute V. — YM )/Y,_t. The evolution of Australian GDP since 1961 is given in figure 2.2. It shows how the Australian economy has gone through a series of expansions, interrupted by short recessions. The average growth rate over the past forty-five years was 3.6 percent. The Australian recession ol 1990—91 was characterised by live consecutive quarters of negative growth. Australia hadn't experienced another recession up until the time ol writing (mid-2008), an unusually long period ol expansion.
Figure 2.2 Growth rate of real GDP in Australia, 1961 2008
racus
'BOX
Since 1961. the Australian economy has gone through a series of expansions interrupted by short recessions. SOURCE: R3A Bulletin.Table GIO (col. B).
REAL GDP,TECHNOLOGICAL PROGRESS AND THE PRICE OF COMPUT"c
A tough problem in calculating real GDP is how to deal with changes in quality of existing goods. One of the most difficult cases is computers. It would clearly be absurd to assume that a personal computer produced in 2008 s the same good as a computer produced in 1981 (the year in which the IBM PC was introduced): the same price clearly buys much more computing in 2008 than it bought in 1981. But, how much more? Does a 2008 computer provide ten times, 100 times or 1,000 times the computing services of a 1981 computer? How should we take into account the improvements in internal speed, the size of the RAM or of the hard disk, the fact that computers can wirelessly access the Internet, and so on?
The approach used by economists to adjust for these improvements is to look at the market for computers and how it values computers with different characteristics in a given year. Example: Suppose the evidence from prices of different models on the market show that people are willing to pay 10 per cent more for a computer with a speed of 2.4 gigahertz than for one with a speed of 2.0 gigahertz. Suppose all new computers this year have a speed of 2.4 gigahertz, compared with a speed of 2.0 gigahertz for new computers last year. And suppose the dollar price of new computers this year is the same as the dollar price of new computers last year. Then, economists in charge of calculating the adjusted price of computers will assume that new computers are in fact 10 per cent cheaper than last year.
This approach, which treats goods as providing a collection of characteristics—here speed, memory, and so on—each with an implicit price, is called hedonic pricing (hedone means pleasure in Greek). It is used by the US Department of Commerce, which constructs estimates of real GDP. to estimate changes in the price of complex and fast-changing goods, such as motor vehicles and computers. Using this approach, the US Department of Commerce estimates that, for a given price, the quality of new computers has increased on average by 15 per cent a year since 1981. Put another way, a typical personal computer in 2008 delivers I.I528 = SO times the computing services a typical personal computer delivered in 1981.
Not only do computers deliver more services, they have become cheaper as well. Their dollar price has declined by about 10 per cent a year since 1981. Putting this together with the information in the previous paragraph, this implies that their quality-adjusted price has fallen at an average rate of 15 per cent + 10 per cent = 25 per cent per year. Put another way. a dollar spent on a computer today buys 1.2528 = 517 times more computing services than a dollar spent on a computer in 1981.
In Australia until 2005, the ABS used the US hedonic price measures adjusted for the exchange rate to compute Australian price indices. It now constructs its own hedonic estimates using Australian computer sales data.
2.2 THE OTHER MAJOR MACROECONOMIC VARIABLES
Because it is a measure of aggregate activity, CDP is obviously the most important macroeconomic variable. But two other variables, unemployment and inflation, tell us about other important aspects of how an economy is performing.
The unemployment rate
To think about the unemployment rate, start with the definition ol labour force. I he labour force is the sum of those employed and those unemployed:
L N + LI
labour force - employed + unemployed
The unemployment rate is then delined as the ratio of the number ol people who are unemployed lo the number ol people in the labour force:
и - IL
i
unemployment rate - unemployed/labour force
Determining whether somebody is employed is straightforward. But how do we assess whether somebody is unemployed or just not looking lor work?
ATCUR ОГТНЬ BOOK chapter 2
Until the 1950s in Australia, the number ot unemployed people could be obtained only from the annual reports by trade unions ol their unemployed members. When the Commonwealth Employment Service (CES) was set up in 1947 to assist people to lind appropriate jobs, it counted the number of unemployed as those seeking unemployment benefits. As in many other countries, this became the official source of data on unemployment until the 1970s. This system led to a poor measure of unemploy¬ment. The number of the truly unemployed who were actually registered at the unemployment ollices
varied both across countries and across time. Those who had no incentive to register—for example, those who had exhausted their unemployment benefits—were unlikely to take the time to come to the unemployment office, so they weren't counted. Countries with less generous benefit systems were likely to have fewer unemployed registering, and therefore smaller measured unemployment rates.
Today, most rich countries rely on large surveys ol households to calculate the unemployment rate. In Australia, this survey is called the Labour Force Survey (LFS). It has relied on interviews of 55,000 households every month, but this figure was cut to 42,000 in luly 2008 because of government budget cuts. The survey classilies a person as employed if he or she has a job at the time ol the interview, it classifies a person as unemployed if lie or she doesn't have a job mni has been looking for work in the last four weeks. Most other countries use a similar definition of unemployment. In Australia, estimates based on the LFS survey show that, in July 2008, on average 10.72 million people were employed, and 0.48 million people were unemployed, so the unemployment rate was 0.48/(10.72 + 0.48) = 4.3 per cent.
Note that only those looking for work arc counted as unemployed,- those not working and not looking for work are counted as not in the labour force. When unemployment is high, some ol those without jobs give up looking for work and therefore are no longer counted as unemployed. These people are known as discouraged workers. An extreme example: II all workers without a job gave up looking lor work, the unemployment rate would equal zero. This would make the unemployment rate a very poor indicator of what is happening in the labour market. The example is too extreme, in practice, when the economy slows down, we typically observe an increase both in unemployment and in the number of people who drop out of the labour force. Equivalently, a higher unemployment rate is typically associated with a lower participation rate, defined as the ratio of the labour force to the total population of working age.
At the start of economic reform in Eastern Europe in the early 1990s, unemployment increased dramatically. But equally dramatic was the fall in the participation rate. In Poland in 1990.70 per cent of the decrease ^ in employment was reflected in early retirements—by people dropping out of the labour force rather than becoming unemployed.
INTRODUCTION chapter 2
Figure 2.3 shows the evolution ol unemployment in Australia since I960. It has fluctuated between about 2 per cent and I I per cent, going up in recessions and going down during expansions. Note how much it went up during the recession of 1990-91, and how much it has come down in the long expansion since. (In 2009. it is expected to rise.)
Year
Figure 2.3 The Australian unemployment rate. 1960-2008
Since 1960 the Australian unemployment rate has fluctuated between about 2 per cent and 11 per cent going down during expansions and going up during recessions.
SOURCE: R3A Bulletin. Table G7.
ATCUR OF I HE. BOOK chapter 2
Why do macroeconomists care about unemployment?
Economists care about unemployment tor two reasons:
• Unemployment has important social consequences.
• The unemployment rate gives them an indication ol whether an economy is operating above or below its normal level of activity.
Let us discuss both reasons in turn. Social implications of unemployment
Macroeconomists care about unemployment because ot its direct effect on the welfare of the
unemployed. Although unemployment benefits are greater today than they were during the Great
Depression, unemployment is still often associated with financial and psychological suffering. How
much suffering depends on the nature of the unemployment. One image ol the unemployed is that ot
a stagnant pool, of people remaining unemployed lor long periods of time. As you will see later in the < Things are quite
book, this image doesn't rellect what happens in Australia. In Australia each month, many people different in Europe.
become unemployed, and many ol the unemployed (on average, 18-22 per cent of them) find jobs. But, There, the unemployed
even in Australia, some groups (olten the young, the ethnic minorities and the unskilled) suffer typically remain
disproportionately from unemployment, remaining chronically unemployed and being most vulnerable ""«"ip'oyed for a long
I i j i .1 i .. time, and the image of a
to becoming unemployed when the unemployment rate increases.
stagnant pool is much more appropriate.
Unemployment and output
Economists also care about the unemployment rate because it provides a signal that the economy may not be using some ol its resources efficiently. Many workers who want to work do not lind iobs: the economy is not efficiently using its human resources. From this viewpoint, can very low unemployment also be a problem? Like an engine running at too high a speed, an economy in which unemployment is very low may be over-using its human resources and may run into labour shortages. How low is 'too low ? This is a difficult question and one that we will take up later in the book.
The question came up in late 2007 in Australia, when economists worried that the prevailing unemployment rate, which went down to 4.0 per cent, was actually too low. A very low unemployment rate, they argued, might actually be bad lor the economy, leading to labour shortages lor firms, and to increasing wages, and then inflation. So. while they didn't advocate creating a recession, they favoured policy to achieve lower (bu; positive) output growth for some time, so as to allow the unemployment rate to increase to a somewhat higher level. Other economists felt that unemployment was about right and that there was no need for policy-makers to change anything yet. Their belief was that there was still some risk that Australian output growth might stall anyway. This latter group turned out to be right. The world economy slowed in 2008-00 and Australia's unemployment rate rose.
The inflation rate
Inflation is a sustained rise in the general level of prices—the price level. The inflation rate is the rate 4 Deflation is rare.bu: it
at which the price level increases. (Symmetrically, deflation is a sustained decline in the price level. It happens. Inflation in
corresponds to a negative inflation rate.) J_aPan was negative f-om
The practical issue is how to deline the price level. Macroeconomists typically look at two measures of the price level, at two price indexes-, the GDI' deflator and the consumer price index.
The GDP deflator
2000 to 2002 and 0 per cent from 2003 to 2008.
II we see nominal GDP increase faster than real GDP, the difference must come from an increase in prices. This remark motivates the definition ol the GDP deflator. The GDP deflator in year t. P,. is defined as the ratio ol nominal GDP to real GDP in year t-.
nominal GDP, $Y,
real GDP, Y,
DID SPAIN REALLY HAVE A 24 PER CENT UNEMPLOYMENT
In 1994. che official unemployment rate in Spain reached 24 per cent. (It has decreased since then, but was still 9.6 per cent in 2008.) This was roughly the same unemployment rate as in Australia in 1932, the worst year of the Great Depression. Yet, Spain in 1994 looked nothing like Australia in 1932: there were few homeless people, and most cities looked prosperous. Can we really believe that nearly one-quarter of the Spanish labour force was looking for work?
To answer this, we must first examine how the Spanish unemployment number is put together. Much as in Australia, it comes from a large survey of 60.000 households. People are classified as unemployed if they indicate that they are not working but are seeking work.
Can we be sure that people tell the truth? No. Although there is no obvious incentive to lie—answers to the survey are confidential and aren't used to determine whether people are eligible for unemployment benefits—those who are working in the underground economy may prefer to play it safe and report that they are unemployed.
The size of the underground economy—that part of economic activity that isn't measured in official statistics, either because the activity is illegal or because firms and workers would rather not report it and thus not pay taxes—is an old issue in Spain. And because of that, we actually know more about the underground economy in Spain than in many other countries. In 1985. the Spanish government, in an attempt to find out what was really going on in their economy, organised a detailed survey of 60,000 individuals.To try to elicit the truth from those interviewed, the questionnaire asked interviewees for an extremely precise account of the use of their time, making it difficult to misreport. The answers were interesting. The underground economy in Spain—defined as the number of people working without declaring it to the social security administration—accounted for 10-15 per cent of employment. But it was composed mostly of people who already had a job and were taking a second or even a third job.The best estimate from the survey was that only about 15 per cent of the unemployed were in fact working.This implied that the unemployment rate, which was officially 21 per cent at the time, was in fact closer to 18 per cent, still a very high number. In short, the Spanish underground economy is significant, but it isn't the case that most of the Spanish unemployed work in the underground economy.
How do the unemployed survive? Do they survive because unemployment benefits are unusually generous in Spain? No. Except for very generous unemployment systems in two regions,Andalusia and Extremadura— which turn out to have even higher unemployment than the rest of the country—unemployment benefits are roughly similar to unemployment benefits in other OECD countries. Benefits are typically 70 per cent of the wage for the first six months, and 60 per cent thereafter. They are paid for a period of four to twenty-four months, depending on how long people have worked before becoming unemployed. The 30 per cent of the unemployed who have been unemployed for more than two years don't receive unemployment benefits.
Index numbers are often ( set equal to 100 (in the base year) rather than to I.You will see that the consumer price index is normally set equal to 100 in the base year.
So, how do these people survive? A key to the answer lies with the Spanish family structure. The unemployment rate is highest among the young. In 1994, it was close to 50 per cent for those between 16 and 19, and was around 40 per cent for those between 20 and 24.The young typically stay at home until their late twenties, and have increasingly done so as unemployment has increased. Looking at households rather than at individuals, the proportion of households where nobody was employed in 1994 was less than 10 per cent; the proportion of households that received neither wage income nor unemployment benefits was around 3 per cent. In short, the family structure, and transfers from the rest of the family, is what allows many of the unemployed to survive.
Note that, in the year in which, hy construction, real CDP is equal to nominal CDP (2005/6 at this point in Australia), this definition implies that the price level is equal to I This is worth emphasising. The Gf )P dellator is what is called an index number. Its level is chosen arbitrarily—here it is equal to I in 2005-06—and has no economic interpretation. But its rate ol change, '/',- PM);P,.|. has a clear economic interpretation: it gives the rate at which the general level ol prices increases over lime- the rate ol inflation.
One advantage to defining the price level as the GDI dellator is that it implies that a simple relation holds between nominal CDP real CDP and the CDP deflator. To see this, reorganise the previous equation to get:
$У, = P.Y,
Nominal GDP is equal to the CDP deflator times real CDP The consumer price index
The CDP deflator gives the average price of output—the final goods produced in the economy. But consumers care about the average price of consumption—the goods they consume. The two prices needn't be the same: the set of goods produced in the economy isn't the same as the set ot goods purchased by consumers, for two reasons:
• Some ot the goods in CDP are sold not to consumers but to lirms machine tools, tor example), to the government or to foreigners.
• And some of the goods bought by consumers arent produced domestically, but rather are imported from abroad.
To measure the average price ol consumption, or, equivalently, the cost of living, macroeconomists look at another index, the consumer price index, or CPI. I he CP1 was first produced in Australia in
1960 with values calculated back to 1948, and is published quarterly.
The CPI gives the cost in dollars ol a specilic list of goods and services over time. The list, which is based on a detailed study ol consumer spending—the Household Expenditure Survey—attempts to represent the consumption basket ot a typical urban consumer. The list is updated roughly once every five years, and is now based on 2005 weights. These weights have changed signilicanily—for example, back in I960 a 30 per cent weight was given to food,- now it is halt that.
Each quarter. Australian Bureau ot Statistics field staff visit stores to find out what has happened to the price ol the goods on the list, prices are collected in the eight capital cities, Irom about 8,000 retail stores, car dealerships, garages hospitals, and so on. These prices are then used to construct the consumer price index.
I .ike the CDP deflator (the price level associated with aggregate output, CDP), the CPI is an index. It is set equal to 100 in the period chosen as the base period and so its level has no particular significance. I he current base period is 1989—90, so the average lor the period 1989—90 is equal to 100. In June 2008, the CPI was 161,• thus, it cost 61 per cent more in dollars lo purchase the same consumption basket than it did in 1989 90.
You may wonder how the rale ol inllaiion differs depending on whether the CDP deflator or the CPI is used to measure it. The answer is given in f igure 2.4 which plots ihe two inflation rates since
1961 for Ausiralia. The figure yields two conclusions:
• The CPI and the GDP deflator move together most of the time. In most years, the two inflation rates differ by less than 1 percent.
• But there are clear exceptions. For example, in 1974 the increase in the CPI was signilicantly less than the increase in the GDP deflator. The reason isn't hard to find.
< Calculate the GDP deflator and the associated rate of inflation from 2005 to
2006 and from 20C6 to
2007 in our car example in Section 2.1. when real GDP is constructed using the 2006 price of cars as the common price.
4 Don't confuse the CPI with the PPI, or 'producer price index', which is an index of prices of domestically produced goods in manufacturing, mining, agriculture, fishing, forestry and electric utility industries.
A 'OUR Of THE BOOK chapter 2
Recall thai the GDP dellaior is the price ol goods produced in Australia, whereas the CPI is the price ol goods consumed in Australia. This means that when the price ol imported goods decreases relative to the price ot goods produced in Australia, the C.DP deflator increases laster than the CPI. This is precisely what happened in 1974, when the price of oil doubled and ihe price of most other commodities went up as well. And although Australia is a consumer of all commodities, it produces much more than it consumes: it was, and still is. a major commodity exporter. Thus, the exchange rate appreciated, which mcani you could get more foreign currency lor an Australian dollar. In lurn, this implied that imports were cheaper, and so there was a smaller increase in the CPI compared with the GDP deflator. A similar story can be told lor 2004-08 as oil and other commodity prices increased substantially. The RBA has an index measure for commodity prices, and from 2004 to 2008 it doubled: This has major implications lor a commodity-exporting country like Australia.
■ Inflation rate using the GDP deflator
l l l l i i~T
1965 1969
I I I I I I I I I I I I I I I I I I I I
1973 1977 1981 1985 1989
I I I I I I I I 1
2001 2005
Figure 2.4 Inflation rate, using the CPI and the GDP deflator. Australia. 1961-2008
A TOUR Ol- ГНЬ БОО< chapter 2
4 This is known as bracket creep. In Australia now. tax brackets are not indexed to inflation. They were indexec for a brief period in the 1970s. In the United States, the tax brackets are now adjusted automatically for inflation; if inflation is 5 per cent, all tax brackets also go up by 5 per cent—in other words, there is no bracket creep in the United States.
which arc lixed by law or by regulation, lag behind the others, leading to changes in relative prices. Taxation interacts with inflation to create more distortions. If tax brackets aren't adjusted for inflation, for example people move into higher and higher tax brackets as their nominal income increases, even it their real income remains the same.
To summarise: High inllation affects income distribution, creates distortions and increases uncertainty. How important these problems are and whether they justify trying to achieve and maintain, say, zero inflation are much-debated questions. We will take them up later in the book.
2.3 A ROAD MAP
A tour of the book
The book is organised in three parts—a core, three extensions and, finally, an in-depth look at the role ol macroeconomic policy. This organisation is shown in Figure 2.5.
The core
The core is composed ol three parts—the short run, the medium run and the long run.
• Chapters 3 to 5 look at the determination ot output in the short run. The focus is on the determi¬nation ol the demand tor goods. To focus on the role of demand, we assume that firms are willing to supply any quantity at a given price,- in other words, we ignore supply constraints.
Chapter 3 looks at the goods market. Chapter I focuses on linanciai markets. Chapter 5 puts goods and financial markets together.
The resulting framework is known as the IS—LM model. Developed in the late 1030s, the IS-LM model still provides a simple way ol thinking about the determination of output in the short run, and it remains a basic building block of macroeconomics. It also allows lor a first pass at studying the role ol liscal policy and monetary policy in allecting output.
• Chapters 6 to 9 develop the supply side, and look at the determination of output in the medium run.
Chapter 6 introduces the labour market. Chapter 7 puts together goods, financial and labour markets, and shows you how to think about the determination ot output both in the short run and in the medium run. The model developed in Chapter 7 is called the aggregate supply—aggregate demand [AS-AD' model of output. Chapters 8 and 9 then show how the AS-AD model can be used
A tour of the world (Chapter I) A tour of the book (Chapter 2)
Figure 2.5 The organisation of the book
The short run (IS-IM) Chapters 3 to 5
Expectations Chapters 14 to 17
The medium run (AS-AD) Chapters 6 to 9
The long run Chapters 10 to 13
Chapters 25 to 27
Chapter 28
A TOUR OF THE BOOK chapter 2
to think ahout many issues, from the relation between output and inflation to the role ol monetary and fiscal policy both in the short am and in the medium run. Chapter 9 develops the model so that we can use it to understand the relationships between output growth, inflation and unemployment.
• Chapters 10 to I 3 focus on the long run.
Chapter 10 introduces the relevant facts, and looks at the growth of output both across countries and across long periods ol time. Chapters 11 and 12 then discuss the role and the determinants of both capital accumulation and technological progress in growth. Chapter I 3 looks at the interaction between technological progress, wages and unemployment.
Extensions
The core chapters give you a way of thinking about the determination of output land unemployment and inllation) over the short, medium and long run. However, they leave out several elements, which are explored in three extensions.
• The core chapters largely ignore the role of expectations. But expectations play an essential role in macroeconomics. Nearly all the economic decisions people and firms make—whether to buy bonds or stocks whether or not to buy a machine—depend on their expectations of future prolits, of future interest rates, and so on. fiscal and monetary policy affect activity not only through their direct effects but also through their effect on expectations.
Chapters 14 to 17 focus on the role ol expectations, and their implications lor liscal and monetary policy.
• The core chapters treat the economy as closed, ignoring its interactions with the rest of the world. But economies are increasingly open, trading with other countries both in goods and in linanciai assets. As a result, countries are more and more interdependent.
The nature of this interdependence and the implications for liscal and monetary policy are the topics of Chapters 18 to 21.
• The core chapters on the short mn and the medium run focus on fluctuations in output—on expansions and on recessions. Sometimes, however, the word 'fluctuations' doesn't accurately capture what is happen ng. Sometimes things go very wrong. Serious linanciai crises appear from time to time, with share prices collapsing and credit markets freezing up. as happened in 2008. Or, as was the case during the Great Depression, unemployment remains very high lor a very long time. Or, as is the case with lapan in the last fifteen years, a country goes through a prolonged economic slump. Or. inllation reaches extremely high rates,- lor example, the inflation rate in Zimbabwe reached 233 million per cent in 2008!
These pathologies arc the topics of Chapters 22 to 24. Back to policy
Monetary policy and liscal policy are discussed in nearly every chapter of this book. But. once the core and the extensions have been covered, il is useful to go back, put things together and assess the role of policy.
• C.hapter 25 focuses on general issues of policy such as whether macroeconomists know enough to use policy at all, and on whether policy-makers can be trusted lo do whal is right.
• Chapters 2ft and 27 then assess the role ot monetary and liscal policy.
Epilogue
Macroeconomics isn't a fixed body ol knowledge, h evolves over time. The final chapter. Chapter 28, looks at the recent history ol macroeconomics and how macroeconomists have come to believe what they believe today, brom the outside, macroeconomics often looks like a field divided between schools—Keynesians, monetarists, new classicals, supply-siders, real business cycle theorists and so on—hurling arguments at each other. The actual process of research is more orderly and more
productive than this image suggests. We identity what we see as the main differences between macro- economists, and the set of propositions that define the core of macroeconomics today.
We can think ot GDI* the measure ol aggregate activity, in three equivalent ways: (I) СЛ)Р is the value ol the linal goods and services produced in the economy during a given period,- (2' GDP is the sum ol value added in the economy during a given period- and (.3) GDP is the sum ot incomes in the economy during a given period.
Nominal GDP is the sum of the quantities ol final goods produced times their current price. This
implies that changes in nominal GDP reflect both changes in quantities and changes in prices. Real
GDP is a measure of output. Changes in real GDP reflect changes in quantities only.
The labour force is the sum of those employed and those unemployed. The unemployment rate is
the ratio of the number of people unemployed to the number of people in the labour force. People
are classified as unemployed il they don't have a job and have been looking lor work in the last tour
weeks.
Inllation is a rise in the general level ol prices—the price level The inllation rate is the rate at which the price level increases. Macroeconomists look at two measures ol the price level. The lirst is the GDP deflator, which gives the average price of the goods produced in the economy. The second is the consumer price index (CPI1, which gives the average price ol goods consumed in the economy. Inflation leads to changes in income distribution. It also leads to distortions and increased uncertainty.
Macroeconomists distinguish between the short run (a few years!, the medium mn (a decade) and the long run (a half-century or more). They think ol output as being determined by demand in the short run, by the level of technology, the capital stock and the labour lorce in the medium run, and by lactors such as education, research saving and the quality of government in the long run.
national income and product accounts, 27
aggregate output. 27
gross domestic product, or GDP, 28
gross national product, or GNP, 28
final good, 28
intermediate good, 28
value added. 28
nominal GDP, 30
real GDP, 30
real GDP in chained dollars, 31
dollar GDP. GDP in current dollars, 31
GDP in terms ol goods. 31
GDP in constant dollars. 31
GDP adjusted for inllation, 31
GDP in chained dollars, 31
GDP growth, expansions, recessions, 32 hedonic pricing, 33
labour force, 33
unemployment rate, 33
Labour force Survey (ITS), 34
not in the labour lorce, 34
discouraged workers, 34
participation rate, 34
inflation, deflation, 35
price level, 35
inllation rate, 35
CDP deflator, 35
underground economy, 36
index number, 36
cost ol living, 37
consumer price index (CPI), 37
short run, medium run, long mn, 39
QUESTIONS AND PROBLEMS
Quick check
1. Using tlw information in this chapter, label each of the following statements 'true', 'false' or 'uncertain'. Explain briefly.
a. The share ol labour income in GDP is much larger than the share ol capital income.
b. Australian GDP was seventy times higher in 2008 than it was in I960.
c. When the unemployment rale is high, the participation rate is also likely to be high.
d. Unemployment tends to tall i rise during expansions (recessions).
e. It the Japanese CPI is currently at 108 and the Australian CPI is al 104 the lapanese rate ol inflation is higher than the Australian rate of inflation.
f. The rale of inflation calculated using ihe CPI is a better index of inflation than the rate of inflation calculated using the GDP deflator.
g. 1 he high unemployment rate in Spain is no mystery,- it is primarily ihe result ol workers taking jobs in the underground economy.
2. Suppose you are measuring annual Australian GDP by adding up the final value of all goods and services produced in the economy. Determine the effect of each of the following transactions on GDP:
a. You buy $10 worth of potatoes from a market gardener, which you cook and eat at home.
b. A restaurant buys $10 worth of potatoes from market gardener.
c. Qantas buys a new jet from Boeing.
d. The Australian government buys a llect of cars from Holden lor $1 million.
e. The Australian government sells one ol these cars to you tor $50,000.
3. During a given year, the following activities occur:
i. A silver-mining company pays its workers S20G,000 to mine 7.5 kilograms of silver. The silver is then sold to a jewellery manufacturer for S300,000.
ii. The jewellery manufacturer pays its workers S.250,000 to make silver necklaces, which it sells directly to consumers for SI million.
a. Using the 'production ot linal goods' approach, what is GDP in this economy?
b. What is the value added at each stage ol production? Using the value added approach, what is GDP?
c. What are the total wages and profits earned? Using the income approach, what is (.DP?
4. An economy produces three goods: cars, computers and oranges. Quantities and prices per unit for years 2007, 2008 and 2009 are as follows:
2007 Quantity Price 2008 Quantity Price 2009 Quantity Price
Cars 10 $2,000 12 $3,000 II $2.500
Computers 4 $1,000 6 $500 5 $750
Oranges 1.000 $1 1,000 $1 1,000 $1
a. What is nominal GDP in 2007, 2008 and 2009? By what percentage does nominal GDP change from 2007 to 2008 and 2008 to 2009?
b. Using the prices for 2007 as the set of common prices, what is real GDP in 2007, 2008 and 2009? By what percentage does real GDP change from 2007 to 2008 and 2008 to 2009?
c. Using the priccs for 2008 as the set of common prices, what is real GDP in 2007 and in 2008? By what percentage does real GDP change from 2007 to 2008 and 2008 to 2009?
d. Why are the two output growth rates constructed in 1 h1 and с > different? Which one is correct? Explain your answer.
5. Use the data from problem 4 to answer the following:
a. Suppose we use the prices lor 2007 as the set of common prices to calculate real GDP in 2007, 2008 and 2009. Calculate the GDP deflator lor each year, and the rate of inflation from 2007 to 2008 and 2008 to 2009.
b. Suppose we use the prices for 2008 as the set ol common prices to calculate real GDP in 2007 2008 and 2009. Calculate the GDP deflator for each year, and the rates of inflation.
c. Why are the rates oi inflation Irom (a) and b different? Which one is correct? Explain your answer.
6. Chain measures
Use the economy described in problem 4.
a. Construct real GDP ior years 2007 and 2008. using the average price of each good in 2007 and 2008.
b. By what percentage does real GDP change Irom 2007 to 2008?
c. What is the GDP deflator in 2007 and 2008? What is the rate of inflation from 2007 to 2008, using the GDP deflator?
d. Repeat (ai, (b) and (с» lor years 2008 and 2009.
e. Set the real GDP index in 2007 to nominal GDP in 2007. Construct the chain volume of real GDP in 2008, by multiplying the 2007 index by (1+ the growth rate obtained in (b)/l00). Repeat this process lor 2009 using the growth rate obtained in ■ d .
I. Is this an attractive solution to the problems pointed out in problems 4 and 5 (that is, two different growth rates and two different inllation rates, depending on what set ol prices was used i? 'The answer is yes. and is the basis lor the construction ol chained-type deflators.)
Dig deeper
7. Hedonic pricing
,4s the first focus box of this chapter explains, it is hard to measure the true increase in prices of goods whose characteristics change over time, lledonic pricing offers a method of calculating the quality- adjusted increase in prices.
a. Consider the case ol a routine medical check-up. Name some reasons why you may want to use hedonic pricing to measure the change in the price of this service.
Now consider the case of a medical check-up for a pregnant woman. Suppose that the year a new ultrasound method is introduced the price of this check-up increases by 20 per cent, and all doctors adopt the ultrasound simultaneously.
b. What information do you need in order to determine the quality-adjusted increase in pregnancy check-ups?
c. Is that inlormation available? Explain. What can you say about the quality-adjusted price increase ol pregnancy check-ups?
8. Measured and true GDP
Suppose that instead of spending an hour cooking dinner you decide to -work an extra hour, earning an additional SI2. You then buy some take-away Chinese food, which costs you S10.
a. By how much does measured CDP increase?
b. Should true GDP increase by more or less? Explain.
Explore further
9. To answer this question, you will need quarterly data on Australian unemployment rates and real GDP growth rates. The basic data can be retrieved from the Australian Bureau of Statistics website I e.g.
a. Plot the quarterly real GDP growth rates since 2001.
b. Plot the quarterly change in the unemployment rate.
c. Do a scatter plot of the two. Does there appear to he a negative relation between the two? II you know how, check it with a regression of the two.
d. Suppose thai Australian policy-makers want to reduce the unemployment rate by one percentage point in one year. Using the answer to (cl, try to estimate the growth rate needed to achieve this reduction in the unemployment rate.
We invite you to visit the Blanchard-Sheen page on the Pearson Australia website at
www.pearson.com.au/highered/blanchardsheen3e
for many World Wide Web exercises relating to issues similar to those in this chapter.
FURTHER READINGS
• II you want to know more about the definition and the construction ot the many economic indicators that are regularly reported on the news—from the help-wanted index to the retail sales index—two easy-to-read references are:
- Norman frumkin, The Guide to Economic Indicators, 3rd edn New York: M. E. Sharpe, 2000).
- The Economist Guide to Economic Indicators i New York: Wiley & Sons, 1998).
• In 1995, the US Senate set tip a commission to sutdy the construction ot the CPI, and to make recommendations about potential changes. That commission concluded that the rate of inflation calculated using the CPI was on average about 1 per cent too high. If this conclusion is correct, it implies, in particular, that real wages nominal wages divided by the CPI i have grown at 1 per cent more a year than is currently reported. For more on the conclusions ol the commission, and some ot the exchanges that followed, read Michael Boskin et al., 'Consumer prices, the consumer price index, and the cost of living', journal of Economic Perspectives, vol. 12, no. I, Winter 1998, pp. 3-26.
• For a short history ol the construction of the national income accounts, read Chapter I in the ABS publication: Australian National Accounts: Concepts, Sources and Methods, cat. no. 5216.0 (available on the ABS website:
• For a discussion ot some of the problems involved in measuring activity, read Katherine Abraham, What we don't know could hurt us: Some reflections on the measurement of economic activity', journal of Economic Perspectives, 2005, vol. 19, no. 3, pp. 3-18. For why it is hard to measure the price level and output correctly, read Paul Krugman. Viagra and the Wealth of Nations (1998) (Internet address:
APPENDIX: THE CONSTRUCTION OF REAL GDP AND CHAIN-TYPE INDEXES
The example used in the chapter had only one final good—cars—so constructing real GDP was easy. But how do we construct real GDP when there is more than one final good? This is what this appendix is about.
All that is needed to make the relevant points about the construction of real GDP in an economy with many final goods is to look at an economy where there are just two final goods. What we do for two goods works just as well for millions of goods.
So. suppose that an economy produces two final goods—say, cars and potatoes:
• In year 0, it produces 100.000 kilograms of potatoes, at a price of $ I a kilogram, and ten cars that sell for $10,000 a car.
• In year I, it produces and sells 100,000 kilograms of potatoes at a price of $ 1.20 a kilogram, and I I cars at $10,000 a car.
• Nominal GDP in year 0 is therefore equal to $200,000. Nominal GDP in year I is equal to $230,000. This information is summarised in the following table.
Nominal GDP in year 0 and in year 1
Year 0 Quantity $ Price $ Value
Potatoes 100,000 1.00 100,000
Cars 10 10,000 100.000
Nominal GDP 200,000
Year 1 Quantity $ Price $ Value
Potatoes 100,000 1.20 120,000
Cars II 10.000 110.000
Nominal GDP 230.000
1 1
The increase in nominal GDP from year 0 to year I is equal to $30,000/$200.000 = 15 per cent. But what is the increase in real GDP?The basic idea in constructing real GDP is to evaluate quantities in both years using the same set of prices.
Suppose we choose, for example, the prices of year 0: year 0 is then called the base year. The calculation is then as follows:
• Real GDP in year 0 is the sum of the quantity in year 0 times the price in year 0, for both goods: (100,000 x $1) + (10 x $10,000) = $200,000.
• Real GDP in year I is the sum of the quantity in year I times the price in year 0, for both goods: (100,000 x $1) + (I I x $10,000) = $210,000.
• The rate of change of real GDP from year 0 to year I is ($210,000 - $200,000)/$200.000, or 5 per cent. This answer raises, however, an important issue: instead of using year 0 as the base year, we could have used
year I, or any other year. If, for example, we had used year I as the base year, then:
• Real GDP in year 0 would be equal to (100,000 x $ 1.2 + 10 x $ 10.000) = $220,000.
• Real GDP in year I would be equal to (100,000 x $1.2 + II x $10,000) = $230,000.
• The rate of change of real GDP from year 0 to year I would be equal to $ 10,000/$220,000, or 4.5 per cent. The answer using year I as the base year would therefore be different from the answer using year 0 as the
base year. So, if the choice of the base year affects the constructed rate of change of output, what base year should one choose?
Until the mid-1990s in Australia—and still in most countries today—the practice was to choose a base year and change it every five years. For example, in Australia, 1989-90 was the base year used from December 1991
to December 1995.That is. measures of real GDP published,for example, in 1994 for both 1994 and for all earlier years were constructed using 1989/90 prices. In December 1995, national income accounts shifted to 1994-95 as a base year; measures of real GDP for all earlier years were recalculated using 1994-95 prices.
This practice was logically unappealing. Every time the base year was changed, and a new set of prices was used, all past real GDP numbers—and all past rates of change of real GDP—were recalculated. History was, in effect, rewritten every five years! Starting in 1998, the Australian Bureau of Statistics—the government office that produces the GDP numbers—shifted to a new method, which doesn't suffer from this problem. The method requires three steps:
1. The rate of change of real GDP from each year to the next is calculated using as the common set of prices the average of the prices for the two years. For example, the rate of change of GDP from 2006 to 2007 is calculated by:
• constructing real GDP for 2006 and real GDP for 2007 using as the common set of prices the average of the prices for 2006 and 2007; and
• calculating the rate of change of real GDP from 2006 to 2007. (This is actually a slighdy simplified description of what the ABS does; but it is close enough, and much easier to understand.)
2. An index for the level of real GDP is then constructed by linking—or chaining—the constructed rates of change for each year.
The index is set equal to I in some arbitrary year. At the time of writing (2008), the arbitrary year is 2005/6. Given that the constructed rate of growth from 2005 to 2006 by the ABS is 3.9 per cent, the index for 2006 equals (I +3.9 per cent) = 1.039.
The index for 2007 is obtained by multiplying the index for 2006 by the rate of growth from 2006 to 2007, and so on.
3. Finally, this index is multiplied by nominal GDP in 2005-06 to give real GDP in chained (2005-06) dollars.
As the index is I in 2005-06, this implies that real GDP in 2005—06 equals nominal GDP in 2005—06.
Chained' refers to the chaining of rates of change described above.The year in parentheses—(2005-06)— refers to the year where, by construction, real GDP is equal to nominal GDP. (You will find the value of real GDP in chained (2005-06) dollars in column В ofTable GI0 on the RBA's statistics website.)
This index is more complicated to construct than the indexes used before 1995. However, it is clearly better conceptually.The prices used to evaluate real GDP in two adjacent years are the right prices—namely, the average prices for those two years. And. because the rate of growth from one year to the next is constructed using the prices in those two years rather than the set of prices in an arbitrary base year, history won't be rewritten every five years or so—as it used to be when, under the previous method for constructing real GDP, the base year was changed.
base year. 46
FURTHER READING
4 Note that we are ignoring the distinction between the fiscal year 2005-06 and the calendar year 2005.
The AHS explains more about chain indexes in its 1998 publication Information Paper: Introduction of Chain Volume Measures in the Australian National Accounts, cat. no. 5248. which can be downloaded from its website (
The Core
The Short Run
In the short run, demand determines output. Many factors affect demand, from consumer confidence to fiscal and monetary policy.
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