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....
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