Measuring
the Standard of Living
Economists
want to be able to make statements that compare the standard of living between
different countries or between different time periods. This is quite tricky. As we have just observed, people enjoy a very
different mix of products and services at different points in time. In fact, a likely reason that DeLong seized on the example of flour is that flour is one
of the few products that we buy today that we can picture being purchased 500
years ago.
Economists
estimate the average standard of living in a particular year in a particular
country by taking the total value of goods and services produced in that
country in that year and dividing by population. The total value of goods and services
produced is called real Gross Domestic Product, or real GDP. The ratio of GDP to population is called GDP
per capita. GDP per capita is the usual
measure of the standard of living.
GDP
is usually measured in dollars. Although
the Japanese might measure their GDP in yen, we would convert their GDP to
dollars in order to compare it to ours.
We can do such a conversion by using the yen/dollar exchange rate, the
rate at which you can trade yen for dollars.
When
we compare GDP across time, we want to adjust for inflation, which is a general
change in prices. If we produced 100
bags of flour at a price of $0.50 each last year, and this year we produce 100
bags of flour at a price of $1.00, how much did our GDP go up?
If
you said that our GDP doubled from $50 to $100, then you were calculating nominal
GDP, which is the total dollar value of goods and services. Nominal GDP is a misleading measure of the
standard of living. Because we produced
the same 100 bags of flour each year, we would say that real GDP--the
physical production of goods--was exactly the same as last year.
To
arrive at real GDP, we adjust nominal GDP for price changes. We pick one year as a base year, and then we
measure price changes relative to that base year. If last year was the base year, then real GDP
in the base year was $50. Since the
price of flour went up from $0.50 to $1.00, we say that the price level doubled
this year, so that our GDP price deflator is 2.0. We can divide nominal GDP in any given year
by that year’s GDP deflator to arrive at real GDP. Thus, we divide $100 by 2.0 to obtain the
correct $50 figure for real GDP.
The
following is an important relationship:
Real GDP = Nominal GDP/GDP Deflator
In
general, an increase in nominal GDP has two components. One component is the increase in real GDP,
which raises the average standard of living.
The other component is average inflation, which does not raise the
average standard of living. In an
economy with many goods and services, the increase in the implicit GDP deflator
from one year to the next is a measure of average inflation. Inflation is a general increase in the prices
of goods and services.
The
foregoing relationship can be summarized as:
growth in
nominal GDP = growth in real GDP plus growth in inflation
The
average standard of living in a country is defined as its real GDP divided by
population, or real GDP per capita. This
measure of the standard of living is closely related to labor productivity,
which is defined as real GDP divided by the total number of hours worked. By definition,
Standard of living = real
GDP/population
Labor productivity = real GDP/hours
worked
Then
algebraically we have
real
GDP/population = (real GDP/hours worked) (hours worked/population)
We
can call the ratio of hours worked to population the employment ratio. Therefore, the standard of living is equal to
productivity multiplied by the employment ratio. Thus, we can raise the standard of living by
raising the employment ratio. However,
that is an artifact of the way that GDP only measures goods bought and sold in
the market. It does not include leisure,
and it does not include household work, as when a parent stays home to take
care of the children or when homeowners repaint their house themselves.
Other
things equal, an increase in the employment ratio ought to be regarded as a reduction
in the quality of life. It means that
people are working harder. Thus, even
though the ratio of output to population is commonly used to measure the
standard of living, a good argument can be made that productivity (the ratio of
output to hours worked) is more closely related to the real quality of
life. Thus, one could say that it is
more meaningful to compare labor productivity across time and across countries
than to compare the standard of living.
On
the other hand, the employment ratio can change because of demographics. If there is an increase in either the very
old or the very young, that will mean more people for the working-age
population to support. This will show up
as a low employment ratio, and the reduction it entails for the standard of
living is real.
The
magnitudes output, hours worked, and population tend to grow
geometrically. That is, over a period of
several years, the average annual percentage increase is more likely to
be constant than the average annual numerical increase. Suppose that you were to observe population
each year obeying this sequence: 100 million, 103 million, 106.09 million,
109.27 million, 112.55 million, and so on.
You could describe the average increase arithmetically as 3.14 million
per year or geometrically as 3.0 percent per year. However, the 3.0 percent per year figure is
more accurate.