6.3Tracking Real GDP over Time

FIGURE 6.9U.S. Nominal and Real GDP, 1960–2020The red line measures U.S. GDP in nominal dollars. The black line measures U.S. GDP in real dollars, where all dollar values are converted to 2012 dollars. Since we express real GDP in 2012 dollars, the two lines cross in 2012. However, real GDP will appear higher than nominal GDP in the years before 2012, because dollars were worth less in 2012 than in previous years. Conversely, real GDP will appear lower in the years after 2012, because dollars were worth more in 2012 than in later years. Let’s return to the question that we posed originally: How much did GDP increase in real terms? What was the real GDP growth rate from 1960 to 2020? To find the real growth rate, we apply the formula for percentage change: In other words, the U.S. economy has increased real production of goods and services by nearly a factor of five since 1960. Of course, that understates the material improvement since it fails to capture improvements in the quality of products and the invention of new products. There is a quicker way to answer this question approximately, using another math trick. Because: Therefore, real GDP growth rate (% change in quantity) equals the growth rate in nominal GDP (% change in value) minus the inflation rate (% change in price). Note that using this equation provides an approximation for small changes in the levels. For more accurate measures, one should use the first formula.

6.3 Tracking Real GDP over Time

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

• Explain recessions, depressions, peaks, and troughs
• Evaluate the importance of tracking real GDP over time

When news reports indicate that “the economy grew 1.2% in the first quarter,” the reports are referring to the percentage change in real GDP. By convention, governments report GDP growth at an annualized rate: Whatever the calculated growth in real GDP was for the quarter, we multiply it by four when it is reported as if the economy were growing at that rate for a full year.

FIGURE 6.10U.S. GDP, 1930–2020Real GDP in the United States in 2020 (in 2012 dollars) was about $18.4 trillion. After adjusting to remove the effects of inflation, this represents a roughly 20-fold increase in the economy’s production of goods and services since 1930. (Source: bea.gov) Figure 6.10 shows the pattern of U.S. real GDP since 1930. Short term declines have regularly interrupted the generally upward long-term path of GDP. We call a significant decline in real GDP a recession. We call an especially lengthy and deep recession a depression. The severe drop in GDP that occurred during the 1930s Great Depression is clearly visible in the figure, as is the 2008–2009 Great Recession and the recession induced by COVID-19 in 2020. Real GDP is important because it is highly correlated with other measures of economic activity, like employment and unemployment. When real GDP rises, so does employment. The most significant human problem associated with recessions (and their larger, uglier cousins, depressions) is that a slowdown in production means that firms need to lay off or fire some of their workers. Losing a job imposes painful financial and personal costs on workers, and often on their extended families as well. In addition, even those who keep their jobs are likely to find that wage raises are scanty at best—or their employers may ask them to take pay cuts. Table 6.7 lists the pattern of recessions and expansions in the U.S. economy since 1900. We call the highest point of the economy, before the recession begins, the peak. Conversely, the lowest point of a recession, before a recovery begins, is the trough. Thus, a recession lasts from peak to trough, and an economic upswing runs from trough to peak. We call the economy's movement from peak to trough and trough to peak the business cycle. It is intriguing to notice that the three longest trough-to-peak expansions of the twentieth century have happened since 1960. The most recent recession was caused by the COVID-19 pandemic. It started in February 2020 and ended formally in May 2020. This was the most severe recession since the 1930s Great Depression, but also the shortest. The previous recession, called the Great Recession, was also very severe and lasted about 18 months. The expansion starting in June 2009, the trough from the Great Recession, was the longest on record—ending 128 months with the pandemic-induced recession. Trough Peak Months of Contraction Months of Expansion December 1900 September 1902 18 21 August 1904 May 1907 23 33 June 1908 January 1910 13 19 January 1912 January 1913 24 12 December 1914 August 1918 23 44 March 1919 January 1920 7 10 July 1921 May 1923 18 22 July 1924 October 1926 14 27 November 1927 August 1929 23 21 March 1933 May 1937 43 50 June 1938 February 1945 13 80 October 1945 November 1948 8 37 October 1949 July 1953 11 45 May 1954 August 1957 10 39 April 1958 April 1960 8 24 February 1961 December 1969 10 106 November 1970 November 1973 11 36 March 1975 January 1980 16 58 July 1980 July 1981 6 12 November 1982 July 1990 16 92 March 1991 March 2001 8 120 November 2001 December 2007 8 73 January 2009 February 2020 2 128 April 2020 TBD TBD TBD TABLE 6.7U.S. Business Cycles since 1900(Source: http://www.nber.org/cycles/ main.html) A private think tank, the National Bureau of Economic Research (NBER), tracks business cycles for the U.S. economy. However, the effects of a severe recession often linger after the official ending date assigned by the NBER.

6.4 Comparing GDP among Countries

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

• Explain how we can use GDP to compare the economic welfare of different nations
• Calculate the conversion of GDP to a common currency by using exchange rates
• Calculate GDP per capita using population data

It is common to use GDP as a measure of economic welfare or standard of living in a nation. When comparing the GDP of different nations for this purpose, two issues immediately arise. First, we measure a country's GDP in its own currency: the United States uses the U.S. dollar; Canada, the Canadian dollar; most countries of Western Europe, the euro; Japan, the yen; Mexico, the peso; and so on. Thus, comparing GDP between two countries requires converting to a common currency. A second issue is that countries have very different numbers of people. For instance, the United States has a much larger economy than Mexico or Canada, but it also has almost three times as many people as Mexico and nine times as many people as Canada. Thus, if we are trying to compare standards of living across countries, we need to divide GDP by population.

Converting Currencies with Exchange Rates

To compare the GDP of countries with different currencies, it is necessary to convert to a “common denominator” using an exchange rate, which is the value of one currency in terms of another currency. We express exchange rates either as the units of country A’s currency that need to be traded for a single unit of country B’s currency (for example, Japanese yen per British pound), or as the inverse (for example, British pounds per Japanese yen). We can use two types of exchange rates for this purpose, market exchange rates and purchasing power parity (PPP) equivalent exchange rates. Market exchange rates vary on a day-to-day basis depending on supply and demand in foreign exchange markets. PPP-equivalent exchange rates provide a longer run measure of the exchange rate. For this reason, economists typically use PPP-equivalent exchange rates for GDP cross country comparisons. We will discuss exchange rates in more detail in Exchange Rates and International Capital Flows. The following Work It Out feature explains how to convert GDP to a common currency. WORK IT OUT Converting GDP to a Common Currency Using the exchange rate to convert GDP from one currency to another is straightforward. Say that the task is to compare Brazil’s GDP in 2020 of 7.4 trillion reals with the U.S. GDP of $20.9 trillion for the same year. Step 1. Determine the exchange rate for the specified year. In 2020, the exchange rate was 2.362 reals = $1. (These numbers are realistic, but rounded off to simplify the calculations.) Step 2. Convert Brazil’s GDP into U.S. dollars: Step 3. Compare this value to the GDP in the United States in the same year. The U.S. GDP was $20.9 trillion in 2020, which is almost seven times that of GDP in Brazil. Step 4. View Table 6.8 which shows the size of and variety of GDPs of different countries in 2020, all expressed in U.S. dollars. We calculate each using the process that we explained above.