GDP and the Business Cycle

In Microeconomics the focus is on the economic decisions of individual consumers and

firms. In Macroeconomics, we are focused on output, employment, inflation, interest rates
and economic growth. Macroeconomics looks at macro measures of these variables as they
occur throughout the economy. In our study we will consider what determines the level of
output in a country and why output in some economies grow while in other countries
output contracts. We will consider why the economy of some countries grows faster than
the economy of other countries. We will also look at what causes prices to go up and how
certain levels of inflation affect decision making. Of course, a key macroeconomic issue is
what causes unemployment and which types of unemployment are most worrisome. As part
of that analysis, we will investigate why one country’s unemployment rate is higher than
another and whether unemployment rates tend to be higher in the long run in certain
countries.

As we proceed to unravel the mysteries of the overall economy of a country, we will deem
an economy as healthy if its annual output of products and services grows at a steady rate
that keeps unemployment low, without setting off costly inflation. We will look at what
levels of inflation pose a threat to sustained growth and employment, as well as why zero
inflation could be as harmful as high inflation. We must also discuss which economic
conditions might make it necessary for the government to intervene. When the economy
falters, unemployment, or inflation (or both!) can rise, and often there are calls from elected
representatives for the government intervention. The effect of government policies on
economic measures-such as employment, inflation, and interest rates-is a major topic of
macroeconomics. When most states in the United States implemented partial shutdowns in
the spring of 2020, many workers were laid off in restaurants, airlines, hotels, and theme
parks because most people stop going to those places. As a result, total output in the
United States fell in the summer and fall of 2020 but began to recover in early 2021, Out of
fear that the massive layoffs throughout the country would cause severe economic calamity,
Congress passed several stimulus bills to provide extra cash to most American families.

To assess the growth of an economy, economists use a measure known as GDP, which
stands for Gross Domestic Product. Gross meaning in total, domestic meaning output
produced within the borders of the United States and product meaning output. Gross
Domestic Product (GDP) is the total value of all final goods and services produced within
the borders of a country during a given year or other specified period.

Let’s start with final. Final goods are those sold to consumers for personal consumption and
not to be resold to others. Think about the entire process of getting a good, such as
furniture, into your local retail store. First, someone must cut down the trees. Then the trees
are transported to the sawmill where they are cut into lumber. Then the lumber is trucked to
the furniture factory where it becomes furniture Then the factory ships the completed item
to the retail store where consumers make their purchase.

When the lumber from the sawmill is sold to the furniture factory, it is known as an
intermediate good because it is an input in the intermediate phase of the total production
process from forest to retail store. Why the big deal about differentiating between
intermediate and final goods? Because only final goods are part of the calculation of GDP. If
we counted intermediate goods, we would be double counting because their value is
already reflected in the selling price of the final good. Many goods and services are
purchased by firms to use as inputs in producing something else to be sold to other firms or
consumers. Consider a pizza maker who buys flour to make pizzas. If GDP counted the value
of the flour and the value of the pizza sold to consumers, that would double count the flour
because the value of the flour is reflected in the price of the pizza.

Other goods are not included in GDP calculation as well, mostly because it is nearly
impossible to detect the presence and value of such production. The government is largely
dependent on official reporting forms from factories and producers to calculate GDP each
quarter. Purchasing managers and other factory personnel may be required to provide
certain reporting forms to various government agencies. Naturally, no reporting of output is
provided by those engaging in illegal activity, so the value of illegal activity is not reported
or included in GDP. Also, GDP is focused on the value of production occurring in the current
year. Resales of goods produced in previous years will not be included in GDP. Also, services
offered on a cash only basis will not be reported or counted in GDP.

The second critical part of the definition of GDP is that it only includes goods that are
produced within the borders of a country. For the United States, we only count goods
produced within the borders of the United States, regardless of who owns the factories
here. For instance, the value of all the vehicles produced in Japanese, South Korean, and
German automobile factories located in the United States is counted in U.S. GDP. The value
of soft drinks produced by Coca-Cola in France is counted in France’s GDP.

GDP reflects the total dollar value of all goods and services produced within the borders of
a country in a given period, usually a year. If GDP rises, it is a signal that the economy is
growing. A growing economy is one that uses more labor and materials to produce more
goods and provide more services. To determine if an increase in GDP truly reflects a
growing economy, we must adjust the GDP number for the effects of inflation.

Keep in mind that GDP is expressed in the dollars, because it is the dollar value of all final
goods and services produced within the borders of the United States in a year. If GDP
increases by 5% one year and then we find out that inflation was 5% that year, that means
there was no real increase in output. All of the change in the dollar value of GDP came from
inflation.
The purpose of measuring and tracking GDP is to determine if the economy is growing.
Growth in the economy means that more output is being produced. But if all the change in
the GDP measure comes from inflation, there has been no growth in total production. So, to
determine if an increase in GDP truly reflects a growing economy, we have to take out the
effects of inflation.

One way to extract the effect of inflation is to value output in two different years with the
same prices. Let’s imagine an economy only produces cars and trucks. In 2000, one million
cars were made, and one million trucks were made. To make the math easy, we will suppose
that the average price of a 2000 car was $100, and the average price of a 2000 truck was
$150. So, GDP for our magical 2000 economy was $250 million.

Now we want to determine if the economy grew from 2000 to 2020. However, the average
price of a car in 2020 we will assume is $200 and the average price of a truck is $300. Once
again, a million of each type of vehicle will be sold. So, our 2020 GDP is $500 million. GDP in
2020 was twice that of 2000. Did we have true economic growth? In this fanciful example,
GDP doubled because prices doubled.

One way to neutralize the effect of inflation on measuring GDP is to use the first-year prices
to calculate GDP in the subsequent year. So, we would assume that 2020 cars sell for $100
and 2020 trucks sell for $150. Now we see that GDP for 2020 was the same as it was for
2000. When we calculate GDP in this fashion, we refer to the final measure as Real GDP.
Real GDP is just GDP corrected for inflation. In comparison, nominal GDP (usually just
referred to as GDP), is the total dollar value of final goods and services made within a
country during a particular period that is valued in the prices for that period.

Another way to calculate Real GDP is to just subtract the effect of inflation from the growth
rate of GDP. If GDP increases 8% but inflation was 3%, Real GDP has risen 5%. The use of
real measures is very common in economics. In macroeconomics we will look at Real GDP,
real interest rates, and real changes in income. All of these measures are simply adjusted for
the effects of inflation.

In the next module, we will examine the various elements that comprise GDP and how that
knowledge informs various government policies designed to stimulate the economy to
achieve greater growth in production, jobs, and income. For now, we will use the concept of
GDP in terms of the business cycle, which is the natural and inevitable expansion and
contraction of an economy over time.

We will save a detailed discussion of the computation of GDP for another chapter. In this
section, our goal is to use the concept of real GDP to look at the business cycle - the
economy's pattern of expansion, then contraction, then expansion again - and at growth of
real GDP.
The business cycle shows how an economy goes through stages of growth and contraction.
At times, Real GDP is expanding, which causes growth in output, investment, jobs, and
incomes. At other times, Real GDP can contract, which causes a reduction in output, jobs,
and incomes. The government measures GDP every quarter. A quarter is one fourth. There
are 12 months in a year, so a quarter is 3 months. Every three months, the government
reports GDP for the previous three months, or quarter. However, usually the government
must make corrects to the initial report of GDP for the previous quarter as new data is made
available. From the middle of 2009 to the massive COVID shutdowns in the spring of 2020,
U.S. GDP grew every quarter, albeit at historically low rates. However, it was the longest
period of economic growth the U.S. had experienced since World War II.

If GDP falls for two consecutive quarters (6 straight months), the government will declare an
official recession. We have had numerous recessions of varying intensity and length since
World War II. The 2008-2009 recession was one of the worst on record. The United States
was very fortunate to get out of that recession as quickly as we did.

When the economy is growing, the business cycle is rising and will continue to rise until it
reaches a peak and then the cycle will begin to fall until it reaches the lowest point, called
the trough. After the trough, comes another period of the cycle rising yet again. When the
economy passes the peak it begins to contract, and if that contraction continues for two
consecutive quarters, an official recession is underway. The challenge is that we do not know
when the peak will come before it comes, nor do we always know when the trough will
bottom out until it has already happened. Most predictions of a peak are not correct, but
many are. Therefore, we cannot always predict when a recession will begin. Most
declarations by the government of a recession occur 6 to 12 months after that recession
began.

References

Coppock, Lee, Mateer, Dirk. (2014). Principles of Microeconomics. New York: W. W. Norton.

Gwartney, J. D., Stroup, R., & Studenmund, A. H. (1980). Economics, private and public choice. New York:
Academic Press.

McConnell, C. R., Brue, S. L., & Flynn, S. M. (2009). Economics: Principles, problems, and policies. Boston:
McGraw-Hill Irwin.