How do we determine the health of an economy? The broadest measure of the health of any country’s economy is its gross domestic product (GDP), which measures how productive a nation is, that is, the overall market value of final goods and services produced in a country in a year. It is important to note that only those goods that are actually produced in the country are counted in the country’s GDP (hence the term domestic in gross domestic product). For example, Toshiba Corporation, a Tokyo-based high-tech company, has a plant in Lebanon, Tennessee, that manufactures color television sets. The value of all television sets produced in the Tennessee plant is counted in the U.S. GDP, not in Japan’s GDP.

How does the GDP act as an economic indicator? GDP is the most widely used indicator of economic growth by countries worldwide. It is a coincident indicator and moves at the same time the economy does. A rising GDP indicates that more goods and services are being produced and that businesses are doing well. A downward-moving GDP indicates that fewer goods are being produced, fewer services are being offered, and businesses are not doing as well. Business owners such as Greg use GDP data to forecast sales and adjust production and their investment in inventory.

A nation’s GDP is often viewed in tandem with the country’s debt level. A low debt-to-GDP ratio indicates an economy that is healthy, whereas a high debt-to-GDP ratio indicates a country that is spending beyond its means. The debt-to-GDP ratio is calculated by dividing either the amount of government debt or total national debt by the country’s GDP. As illustrated in Figure 2.7 the most current data indicates that Japan’s debt-to-GDP ratio is close to 200 percent almost double that of the United States.5

Figure 2.7

Debt to GDP of World Economies

What else is used to gauge the health of an economy? There are two price indices used as economic indicators: the consumer price index and the producer price index. You may not hear about these indicators often, but you’ve probably heard of inflation and deflation. A consistent increase in either indicator indicates inflation. Inflation is a rise in the general level of prices over time. A decrease in the rate of inflation is disinflation, and a continuous decrease in prices over time is deflation.

How are changes in the price of consumer products measured? The consumer price index (CPI) is a benchmark used to track changes in the price of goods and services that consumers purchase over a period of time. It is a lagging indicator, so it shifts after the economy changes. The CPI measures price changes by creating a “market basket” of a specified set of goods and services that represent the average buying pattern of urban households. The value of this market basket is determined by the combined prices of these goods and services and is compared to its value in a prior period (generally a month). The change in the overall price of these goods is then noted.

What goods and services are included in the CPI? The basket of goods and services is evaluated by the U.S. Bureau of Labor Statistics to ensure that it reflects current consumer buying habits. The current market basket was determined by tracking the spending habits of about 7,000 families during 2011 and 2012.6 The goods and services are classified into 200 categories, which are further arranged into eight major groups7 (see Figure 2.8):

Figure 2.8

CPI Components

• Apparel

• Education and communication

• Food and beverages

• Housing

• Medical care

• Recreation

• Transportation

• Other goods and services (such as tobacco and smoking products, haircuts and other personal services, and funeral services)

Does the CPI measure the change in price of all goods? The CPI measures the change in prices of consumer goods only. It does not measure the change in prices of those resources that are used to create the goods. The producer price index (PPI) is a coincident indicator that tracks the average change in prices at the wholesale level (i.e., from the seller’s perspective). The PPI tracks the prices of goods sellers use to create products, such as raw materials, product components that require further processing, and finished goods sold to retailers. The PPI excludes energy prices and prices for services.

Why are price indices important? The CPI and PPI are important economic indicators because they measure purchasing power and consequently trigger some business decisions. During periods of increasing prices as reflected by the CPI, the purchasing power of a dollar decreases—meaning that less is bought with a dollar today than could have been purchased with the same dollar yesterday. As a result, wages eventually need to be increased to compensate employees for the higher cost of living (see the Biz Chat in this section). Businesses in turn must eventually increase the prices of their products to offset the higher cost of labor. Similarly, if the price of intermediary products used to produce final goods or services sold to consumers increases (as measured by the PPI), businesses may need to pass on those cost increases in the form of higher prices, again decreasing the consumer’s purchasing power. Therefore, business leaders watch the CPI and the PPI to determine the rate at which consumer and wholesale prices, respectively, change.

What other indicators are used to measure the economy? The unemployment rate is a lagging indicator that measures the number of workers who are at least 16 years old and who are not working but have tried to find jobs within the past four weeks. Because there are different reasons why people are not working, there are several different measurements of unemployment:

• Frictional unemployment is temporary unemployment that results when workers move between jobs, careers, and locations. Frictional employment occurs because it simply takes a certain amount of time for workers to find the right jobs and employers to find the right workers.

• Structural unemployment is permanent unemployment that occurs when an industry changes in such a way that those jobs are terminated completely. Many steelworkers and miners lost their jobs when there was a decline in those industries. Likewise, robots have replaced many automobile workers, and computers have replaced many newspaper typesetters. Workers displaced by these types of circumstances can hopefully learn new skills or receive additional training in an effort to keep their jobs or find new ones.

• Cyclical unemployment is unemployment that occurs when firms must cut back their workforces when there is a downturn in the business cycle. Once the demand for goods and services increases, companies begin to hire again.

• Seasonal unemployment occurs when workers get laid off during the off-season, such as those in snow- or beach-related industries or agriculture or after the holiday shopping season ends.

Unlike other economic recoveries, unemployment in the United States has remained at historically high levels since the end of the Great Recession. There is still no consensus as to what is causing the high unemployment rate. The debate centers on whether it is because of reduced demand as a direct result of the recession (cyclical unemployment) or whether the lost jobs are never coming back because of changes in business and technology (structural unemployment).8

Why is unemployment an important economic measure? Businesses, as well as government policymakers, pay close attention to unemployment rates. High unemployment results in an increase in unemployment benefits and government spending on social programs, such as Social Security, welfare (now called Temporary Assistance for Needy Families), and Medicare. High unemployment can also result in increases in mental stresses and physical illnesses and can bring on increases in crime. It is costly for businesses to lay off workers and then, as the economy improves, hire and train new employees. In a declining economy, businesses prefer to reduce their workforces through retirement and natural attrition, which takes planning.

Ironically, if the unemployment rate drops too low, meaning the workforce is nearly fully staffed, policymakers in the government become concerned that the economy is overheating: More workers have increased buying power and spend more, which ultimately causes prices to increase, resulting in increasing inflation. The challenge for policymakers is to keep both inflation and unemployment low—a difficult task because the two seem to have an inverse relationship to each other.

How is the productivity of a firm’s workforce measured? In its broadest terms, productivity measures the quantity of goods and services that a firm’s human and physical resources can produce in a given time period. It can be calculated as a physical measure or as a monetary measure. For example, an automobile assembly plant might measure its productivity in terms of the total number of cars it produced in a given period of time (week, month, or year) per worker-hours needed to produce them. Or the plant might measure its productivity as the total dollar value of cars produced in a given period per worker-hours needed to produce the cars. As you might expect, the calculation of productivity in the service sector may be slightly different, but it generally focuses on revenues generated per employee for a certain time period.

Why is measuring productivity important to businesses? No matter how it is measured, productivity is an indicator of a business’s health. An increase in productivity indicates that workers are producing more goods or services in the same amount of time. Therefore, higher productivity numbers often result in lower costs and lower prices. Increasing productivity means that the existing resources are producing more, which generates more income and more profitability. Companies can reinvest the economic benefits of productivity growth by increasing wages and improving working conditions, by reducing prices for customers, by increasing shareholder value, and by increasing tax revenue to the government, thus improving the GDP. In aggregate, overall productivity is an important economic indicator of an economy’s health.