Fiscal Policy

Fiscal policy is carried out by the legislative and/or the executive branches of government. The two main instruments of fiscal policy are government expenditures and taxes. The government collects taxes in order to finance expenditures on a number of public goods and services—for example, highways and national defense.

Budget deficits and surpluses. When government expenditures exceed government tax revenues in a given year, the government is running a budget deficit for that year. The budget deficit, which is the difference between government expenditures and tax revenues, is financed by government borrowing; the government issues long‐term, interest‐bearing bonds and uses the proceeds to finance the deficit. The total stock of government bonds and interest payments outstanding, from both the present and the past, is known as the national debt. Thus, when the government finances a deficit by borrowing, it is adding to the national debt. When government expenditures are less than tax revenues in a given year, the government is running a budget surplus for that year. The budget surplus is the difference between tax revenues and government expenditures. The revenues from the budget surplus are typically used to reduce any existing national debt. In the case where government expenditures are exactly equal to tax revenues in a given year, the government is running a balanced budget for that year.

Expansionary and contractionary fiscal policy. Expansionary fiscal policy is defined as an increase in government expenditures and/or a decrease in taxes that causes the government's budget deficit to increase or its budget surplus to decrease. Contractionary fiscal policy is defined as a decrease in government expenditures and/or an increase in taxes that causes the government's budget deficit to decrease or its budget surplus to increase.

Classical and Keynesian views of fiscal policy. The belief that expansionary and contractionary fiscal policies can be used to influence macroeconomic performance is most closely associated with Keynes and his followers. The classical view of expansionary or contractionary fiscal policies is that such policies are unnecessary because there are market mechanisms—for example, the flexible adjustment of prices and wages—which serve to keep the economy at or near the natural level of real GDP at all times. Accordingly, classical economists believe that the government should run a balanced budget each and every year.

Combating a recession using expansionary fiscal policy. Keynesian theories of output and employment were developed in the midst of the Great Depression of the 1930s, when unemployment rates in the U.S. and Europe exceeded 25% and the growth rate of real GDP declined steadily for most of the decade. Keynes and his followers believed that the way to combat the prevailing recessionary climate was not to wait for prices and wages to adjust but to engage in expansionary fiscal policy instead. The Keynesians' argument in favor of expansionary fiscal policy is illustrated in Figure .

Assume that the economy is initially in a recession. The equilibrium level of real GDP, Y ₁, lies below the natural level, Y ₂, implying that there is less than full employment of the economy's resources. Classical economists believe that the presence of unemployed resources causes wages to fall, reducing costs to suppliers and causing the SAS curve to shift from SAS ₁ to SAS ₂, thereby restoring the economy to full employment. Keynesians, however, argue that wages are sticky downward and will not adjust quickly enough to reflect the reality of unemployed resources.

Consequently, the recessionary climate may persist for a long time. The way out of this difficulty, according to the Keynesians, is to run a budget deficit by increasing government expenditures in excess of current tax receipts. The increase in government expenditures should be sufficient to cause the aggregate demand curve to shift to the right from AD ₁ to AD ₂, restoring the economy to the natural level of real GDP. This increase in government expenditures need not, of course, be equal to the difference between Y ₁ and Y ₂. Recall that any increase in autonomous aggregate expenditures, including government expenditures, has a multiplier effect on aggregate demand. Hence, the government needs only to increase its expenditures by a small amount to cause aggregate demand to increase by the amount necessary to achieve the natural level of real GDP.

Keynesians argue that expansionary fiscal policy provides a quick way out of a recession and is to be preferred to waiting for wages and prices to adjust, which can take a long time. As Keynes once said, “In the long run, we are all dead.”

Combating inflation using contractionary fiscal policy. Keynesians also argue that fiscal policy can be used to combat expected increases in the rate of inflation. Suppose that the economy is already at the natural level of real GDP and that aggregate demand is projected to increase further, which will cause the AD curve in Figure to shift from AD ₁ to AD ₂.

As real GDP rises above its natural level, prices also rise, prompting an increase in wages and other resource prices and causing the SAS curve to shift from SAS ₁ to SAS ₂. The end result is inflation of the price level from P ₁ to P ₃, with no change in real GDP. The government can head off this inflation by engaging in a contractionary fiscal policy designed to reduce aggregate demand by enough to prevent the AD curve from shifting out to AD ₂. Again, the government needs only to decrease expenditures or increase taxes by a small amount because of the multiplier effects that such actions will have.

Secondary effects of fiscal policy. Classical economists point out that the Keynesian view of the effectiveness of fiscal policy tends to ignore the secondary effects that fiscal policy can have on credit market conditions. When the government pursues an expansionary fiscal policy, it finances its deficit spending by borrowing funds from the nation's credit market. Assuming that the money supply remains constant, the government's borrowing of funds in the credit market tends to reduce the amount of funds available and thereby drives up interest rates. Higher interest rates, in turn, tend to reduce or “crowd out” aggregate investment expenditures and consumer expenditures that are sensitive to interest rates. Hence, the effectiveness of expansionary fiscal policy in stimulating aggregate demand will be mitigated to some degree by this crowding‐out effect.

The same holds true for contractionary fiscal policies designed to combat expected inflation. If the government reduces its expenditures and thereby reduces its borrowing, the supply of available funds in the credit market increases, causing the interest rate to fall. Aggregate demand increases as the private sector increases its investment and interest‐sensitive consumption expenditures. Hence, contractionary fiscal policy leads to a crowding‐in effect on the part of the private sector. This crowding‐in effect mitigates the effectiveness of the contractionary fiscal policy in counteracting rising aggregate demand and inflationary pressures.

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The Demand for Money

The demand for money is affected by several factors, including the level of income, interest rates, and inflation as well as uncertainty about the future. The way in which these factors affect money demand is usually explained in terms of the three motives for demanding money: the transactions, the precautionary, and the speculative motives.

Transactions motive. The transactions motive for demanding money arises from the fact that most transactions involve an exchange of money. Because it is necessary to have money available for transactions, money will be demanded. The total number of transactions made in an economy tends to increase over time as income rises. Hence, as income or GDP rises, the transactions demand for money also rises.

Precautionary motive. People often demand money as a precaution against an uncertain future. Unexpected expenses, such as medical or car repair bills, often require immediate payment. The need to have money available in such situations is referred to as the precautionary motive for demanding money.

Speculative motive. Money, like other stores of value, is an asset. The demand for an asset depends on both its rate of return and its opportunity cost. Typically, money holdings provide no rate of return and often depreciate in value due to inflation. The opportunity cost of holding money is the interest rate that can be earned by lending or investing one's money holdings. The speculative motive for demanding money arises in situations where holding money is perceived to be less risky than the alternative of lending the money or investing it in some other asset.

For example, if a stock market crash seemed imminent, the speculative motive for demanding money would come into play; those expecting the market to crash would sell their stocks and hold the proceeds as money. The presence of a speculative motive for demanding money is also affected by expectations of future interest rates and inflation. If interest rates are expected to rise, the opportunity cost of holding money will become greater, which in turn diminishes the speculative motive for demanding money. Similarly, expectations of higher inflation presage a greater depreciation in the purchasing power of money and therefore lessen the speculative motive for demanding money. 

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Functions of Money

Money is often defined in terms of the three functions or services that it provides. Money serves as a medium of exchange, as a store of value, and as a unit of account.

Medium of exchange. Money's most important function is as a medium of exchange to facilitate transactions. Without money, all transactions would have to be conducted by barter, which involves direct exchange of one good or service for another. The difficulty with a barter system is that in order to obtain a particular good or service from a supplier, one has to possess a good or service of equal value, which the supplier also desires. In other words, in a barter system, exchange can take place only if there is a double coincidence of wants between two transacting parties. The likelihood of a double coincidence of wants, however, is small and makes the exchange of goods and services rather difficult. Money effectively eliminates the double coincidence of wants problem by serving as a medium of exchange that is accepted in all transactions, by all parties, regardless of whether they desire each others' goods and services.

Store of value. In order to be a medium of exchange, money must hold its value over time; that is, it must be a store of value. If money could not be stored for some period of time and still remain valuable in exchange, it would not solve the double coincidence of wants problem and therefore would not be adopted as a medium of exchange. As a store of value, money is not unique; many other stores of value exist, such as land, works of art, and even baseball cards and stamps. Money may not even be the best store of value because it depreciates with inflation. However, money is more liquid than most other stores of value because as a medium of exchange, it is readily accepted everywhere. Furthermore, money is an easily transported store of value that is available in a number of convenient denominations.

Unit of account. Money also functions as a unit of account, providing a common measure of the value of goods and services being exchanged. Knowing the value or price of a good, in terms of money, enables both the supplier and the purchaser of the good to make decisions about how much of the good to supply and how much of the good to purchase.

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Definition of Money

What is money? Money is any good that is widely used and accepted in transactions involving the transfer of goods and services from one person to another. Economists differentiate among three different types of money: commodity money, fiat money, and bank money. Commodity money is a good whose value serves as the value of money. Gold coins are an example of commodity money. In most countries, commodity money has been replaced with fiat money. Fiat money is a good, the value of which is less than the value it represents as money. Dollar bills are an example of fiat money because their value as slips of printed paper is less than their value as money. Bank money consists of the book credit that banks extend to their depositors. Transactions made using checks drawn on deposits held at banks involve the use of bank money.

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Supply of Money

There are several definitions of the supply of money. M1 is narrowest and most commonly used. It includes all currency (notes and coins) in circulation, all checkable deposits held at banks (bank money), and all traveler's checks. A somewhat broader measure of the supply of money is M2, which includes all of M1 plus savings and time deposits held at banks. An even broader measure of the money supply is M3, which includes all of M2 plus large denomination, long‐term time deposits—for example, certificates of deposit (CDs) in amounts over $100,000. Most discussions of the money supply, however, are in terms of the M1 definition of the money supply.

Banking business. In order to understand the factors that determine the supply of money, one must first understand the role of the banking sector in the money‐creation process. Banks perform two crucial functions. First, they receive funds from depositors and, in return, provide these depositors with a checkable source of funds or with interest payments. Second, they use the funds that they receive from depositors to make loans to borrowers; that is, they serve as intermediaries in the borrowing and lending process.

When banks receive deposits, they do not keep all of these deposits on hand because they know that depositors will not demand all of these deposits at once. Instead, banks keep only a fraction of the deposits that they receive. The deposits that banks keep on hand are known as the banks' reserves. When depositors withdraw deposits, they are paid out of the banks' reserves. The reserve requirement is the fraction of deposits set aside for withdrawal purposes. The reserve requirement is determined by the nation's banking authority, a government agency known as the central bank. Deposits that banks are not required to set aside as reserves can be lent to borrowers, in the form of loans. Banks earn profits by borrowing funds from depositors at zero or low rates of interest and using these funds to make loans at higher rates of interest.

A balance sheet for a typical bank is given in Table . The balance sheet summarizes the bank's assets and liabilities. Assets are valuable items that the bank owns and consist primarily of the bank's reserves and loans. Liabilities are valuable items that the bank owes to others and consist primarily of the bank's deposit liabilities to its depositors. In Table , the bank's assets (reserves and loans) total $1 million. The bank's liabilities (deposits) total $1 million. A banking firm's assets must always equal its liabilities.

You can infer from Table that the reserve requirement in this example is 10%.

How banks create money. Consider what happens when the same bank receives a $100,000 deposit from one of its depositors. The bank is required to set aside 10% of this deposit, or $10,000, as reserves. It then lends out its excess reserves—in this case, the remaining $90,000 of the initial deposit. Suppose, for the sake of simplicity, that all borrowers redeposit their loans into the same bank. The bank thus receives $90,000 in new deposits of which it sets $9,000 aside as reserves and lends out all of its excess reserves. Suppose again that all borrowers redeposit their loans in the same bank, that the bank sets aside a portion of these deposits, and that the bank then lends out the remainder, which is again redeposited in the bank and so on and so on. This repeated chain of events is summarized in Table .

If one were to follow this multiple deposit expansion process to its completion, the end result would be that the bank's deposits would increase by $1 million, its loans would increase by $900,000, and its reserves would increase by $100,000, all due to the initial deposit of $100,000.

Money multiplier. The amount by which bank deposits expand in response to an increase in excess reserves is found through the use of the money multiplier, which is given by the formula

In the example of deposit expansion found in Table , the reserve requirement is 10%; so, the money multiplier in this case is (1/.10) = 10. The excess reserves resulting from the initial deposit of $100,000 are $90,000. Multiplying $90,000 by the money multiplier, 10, yields $900,000, which is the amount of additional deposits created by the banking system as the result of the initial $100,000 deposit.

In reality, loan recipients do not deposit all of their loan funds into a bank. More typically, they hold a fraction of their loan funds as currency. If some loan funds are held as currency, then there is a leakage of money out of the banking system. In this case, the money multiplier will still be greater than 1, but it will be less than the inverse of the reserve requirement.

Central banking and the supply of money. A portion of each nation's money supply ( M1) is controlled by a government agency known as the central bank. The central bank is unique in that it is the only bank that can issue currency. The U.S. central bank is called the Federal Reserve Bank but is frequently referred to as “the Fed.” The Fed issues all U.S. dollar bills, known as Federal Reserve Notes. Thus, the Fed has control over the supply of the U.S. currency. The Fed also has control over the private bank reserves that banks entrust to the Fed. Banks hold a portion of their required reserves with the Fed because the Fed acts as a clearing house for all sorts of transactions between banks—for example, the processing of all checks.

The Fed's liabilities therefore consist of all Federal Reserve Notes in circulation plus all private bank deposits held at the Fed as reserves On the asset side, the Fed owns a large amount of government debt in the form of U.S. government bonds. These bonds have been issued by the U.S. Treasury to pay for current and past government deficits. A simplified example of the Fed's balance sheet is provided in Table . Note that the Fed's total liabilities are equal to its total assets.

The Fed's control over the money supply stems from its ability to change the composition of its balance sheet. For example, the Fed may decide to purchase additional government bonds on the open market from bondholders or private banks. This type of action is referred to as an open market operation by the Fed. In exchange for these government bonds, the Fed increases the reserves of private banks by the amount of the purchase. Banks, in turn, lend out their excess reserves and initiate the multiple deposit expansion process discussed above. Thus, when the Fed buys U.S. government bonds on the open market, it increases the supply of money by increasing bank reserves and inducing an expansion in the amount of deposits. Similarly, when the Fed sells some of its stock of U.S. government bonds to bondholders or private banks, the Fed compensates itself for the sale by reducing the reserves of private banks. The sale of government bonds by the Fed reduces the supply of money by reducing the reserves available to private banks and thereby decreasing the amount of deposit expansion that is possible.

The Fed can also control the supply of money by its choice of the reserve requirement. Recall that the money multiplier is the reciprocal of the reserve requirement. If the Fed increases the reserve requirement, the money multiplier decreases, implying that deposit creation and the money supply are reduced. If the Fed decreases the reserve requirement, the money multiplier increases, causing both the creation of deposits and the money supply to expand further.

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The Keynesian Theory

Keynes's theory of the determination of equilibrium real GDP, employment, and prices focuses on the relationship between aggregate income and expenditure. Keynes used his income‐expenditure model to argue that the economy's equilibrium level of output or real GDP may not correspond to the natural level of real GDP. In the income‐expenditure model, the equilibrium level of real GDP is the level of real GDP that is consistent with the current level of aggregate expenditure. If the current level of aggregate expenditure is not sufficient to purchase all of the real GDP supplied, output will be cut back until the level of real GDP is equal to the level of aggregate expenditure. Hence, if the current level of aggregate expenditure is not sufficient to purchase the natural level of real GDP, then the equilibrium level of real GDP will lie somewhere below the natural level.

In this situation, the classical theorists believe that prices and wages will fall, reducing producer costs and increasing the supply of real GDP until it is again equal to the natural level of real GDP.

Sticky prices. Keynesians, however, believe that prices and wages are not so flexible. They believe that prices and wages are sticky, especially downward. The stickiness of prices and wages in the downward direction prevents the economy's resources from being fully employed and thereby prevents the economy from returning to the natural level of real GDP. Thus, the Keynesian theory is a rejection of Say's Law and the notion that the economy is self‐regulating.

Keynes's income‐expenditure model. Recall that real GDP can be decomposed into four component parts: aggregate expenditures on consumption, investment, government, and net exports. The income‐expenditure model considers the relationship between these expenditures and current real national income. Aggregate expenditures on investment, I, government, G, and net exports, NX, are typically regarded as autonomous or independent of current income. The exception is aggregate expenditures on consumption. Keynes argues that aggregate consumption expenditures are determined primarily by current real national income. He suggests that aggregate consumption expenditures can be summarized by the equation 

where C denotes autonomous consumption expenditure and Y is the level of current real income, which is equivalent to the value of current real GDP. The marginal propensity to consume ( mpc), which multiplies Y, is the fraction of a change in real income that is currently consumed. In most economies, the mpc is quite high, ranging anywhere from .60 to .95. Note that as the level of Y increases, so too does the level of aggregate consumption.

Total aggregate expenditure, AE, can be written as the equation 

where A denotes total autonomous expenditure, or the sum C + I + G + NX. Different levels of autonomous expenditure, A, and real national income, Y, correspond to different levels of aggregate expenditure, AE.

Equilibrium real GDP in the income‐expenditure model is found by setting current real national income, Y, equal to current aggregate expenditure, AE. Algebraically, the equilibrium condition that Y = AE implies that 

In words, the equilibrium level of real GDP, Y*, is equal to the level of autonomous expenditure, A, multiplied by m, the Keynesian multiplier. Because the mpc is the fraction of a change in real national income that is consumed, it always takes on values between 0 and 1. Consequently, the Keynesian multiplier, m, is always greater than 1, implying that equilibrium real GDP, Y*, is always a multiple of autonomous aggregate expenditure, A, which explains why m is referred to as the Keynesian multiplier.

The determination of equilibrium real national income or GDP using the income‐expenditure approach can be depicted graphically, as in Figure . This figure shows three different aggregate expenditure curves, labeled AE ₁, AE ₂, and A ₃, which correspond to three different levels of autonomous expenditure, A ₁, A ₂, and A ₃. The upward slope of these AE curves is due to the positive value of the mpc. As real national income Y rises, so does the level of aggregate expenditure. The Keynesian condition for the determination of equilibrium real GDP is that Y = AE. This equilibrium condition is denoted in Figure by the diagonal, 45° line, labeled Y = AE.

To find the level of equilibrium real national income or GDP, you simply find the intersection of the AE curve with the 45° line. The levels of real GDP that correspond to these intersection points are the equilibrium levels of real GDP, denoted in Figure as Y ₁, Y ₂, and Y ₃. Note that each AE curve corresponds to a different equilibrium level for Y. Note also that each Y is a multiple of the level of autonomous aggregate expenditure, A, as was found in the algebraic determination of the level of equilibrium real GDP.

Graphical illustration of the Keynesian theory. The Keynesian theory of the determination of equilibrium output and prices makes use of both the income‐expenditure model and the aggregate demand‐aggregate supply model, as shown in Figure .

Suppose that the economy is initially at the natural level of real GDP that corresponds to Y ₁ in Figure . Associated with this level of real GDP is an aggregate expenditure curve, AE ₁. Now, suppose that autonomous expenditure declines, from A ₁ to A ₃, causing the AE curve to shift downward from AE ₁ to AE ₃. This decline in autonomous expenditure is also represented by a reduction in aggregate demand from AD ₁ to AD ₂. At the same price level, P ₁, equilibrium real GDP has fallen from Y ₁ to Y ₃. However, the intersection of the SAS and AD ₂ curves is at the lower price level, P ₂, implying that the price level falls. The fall in the price level means that the aggregate expenditure curve will not fall all the way to AE ₃ but will instead fall only to AE ₂. Therefore, the new level of equilibrium real GDP is at Y ₂, which lies below the natural level, Y ₁.

Keynes argues that prices will not fall further below P ₂ because workers and other resources will resist any reduction in their wages, and this resistance will prevent suppliers from increasing their supplies. Hence, the SAS curve will not shift to the right as in the classical theory and the economy will remain at Y ₂, where some of the economy's workers and resources are unemployed. Because these unemployed workers and resources earn no income, they cannot purchase goods and services. Consequently, the aggregate expenditure curve remains stuck at AE ₂, preventing the economy from achieving the natural level of real GDP. Figure therefore illustrates the Keynesians' rejection of Say's Law, price level flexibility, and the notion of a self‐regulating economy.

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GDP

GDP is defied as the market value of all final goods and services produced domestically in a single year and is the single most important measure of macroeconomic performance. A related measure of the economy's total output product is gross national product (GNP), which is the market value of all final goods and services produced by a nation in a single year.

GDP or GNP? The difference between GDP and GNP is rather technical. GDP includes only goods and services produced by a nation's own citizens and firms. Goods and services produced outside a nation's boundaries by the nation's own citizens and firms are included in GNP but are excluded from GDP. Goods and services produced within a nation's boundaries by foreign citizens and firms are excluded from GNP but are included in GDP. Typically, there is not much difference in the reported values of GDP and GNP; so one may use either statistic to measure overall macroeconomic activity. The rest of this section will therefore focus on GDP.

Measuring GDP: the expenditure and income approaches. There are two ways of measuring GDP, the expenditure approach and the income approach. The expenditure approach is to add up the market value of all domestic expenditures made on final goods and services in a single year. Final goods and services are goods and services that have been purchased for final use or goods and services that will not be resold or used in production within the year. Intermediate goods and services, which are used in the production of final goods and services, are not included in the expenditure approach to GDP because expenditures on intermediate goods and services are included in the market value of expenditures made on final goods and services. Including expenditures on both intermediate and final goods and services would lead to double counting and an exaggeration of the true market value of GDP.

Total expenditure on final goods and services is broken down into four large expenditure categories, according to the type of good or service purchased. The sum total of these four expenditure categories equals GDP. These four expenditure categories are

1. Consumption expenditures: Personal consumption expenditures on goods and services comprise the largest share of total expenditure. Consumption good expenditures include purchases of nondurable goods, such as food and clothing, and purchases of durable goods, such as appliances and automobiles. Consumption service expenditures include purchases of all kinds of personal services, including those provided by barbers, doctors, lawyers, and mechanics.
2. Investment expenditures: Investment expenditures can be divided into two categories: expenditures on fixed investment goods and inventory investment. Fixed investment goods are those that are useful over a long period of time. Expenditures on fixed investment goods include purchases of new equipment, factories, and other nonresidential housing as well as purchases of new residential housing. Also included in fixed investment expenditures is the cost of replacing existing investment goods that have become worn out or obsolete. The market value of all investment goods that must be replaced in a single year is referred to as the depreciation for that year. Inventory goods are final goods waiting to be sold that firms have on hand at the end of the year. The year‐to‐year change in the market value of firms' inventory goods is considered an investment expenditure because these inventory goods will eventually yield a flow of consumption or production services.
3. Government expenditures: Government expenditures on consumption and investment goods and services are treated as a separate category in the expenditure approach to GDP. Examples of government expenditures include the hiring of civil servants and military personnel and the construction of roads and public buildings. Social security, welfare, and other transfer payments are not included in government expenditures. Recipients of transfer payments do not provide any current goods or services in exchanges for these payments. Hence, government expenditures on transfer payments do not involve the purchase of any new goods or services and are therefore excluded from the calculation of government expenditures.
4. Net exports: Exports are goods and services produced domestically but sold to foreigners, while imports are goods and services produced by foreigners but sold domestically. In the expenditure approach to GDP, expenditures on exports are added to total expenditures, while expenditures on imports are subtracted from total expenditures. Alternatively, one can calculate net exports, which is defined as expenditures on exports minus expenditures on imports, and add the value of net exports to the nation's total expenditures.

The income approach to measuring GDP is to add up all the income earned by households and firms in a single year. The rationale behind the income approach is that total expenditures on final goods and services are eventually received by households and firms in the form of wage, profit, rent, and interest income. Therefore, by adding together wage, profit, rent, and interest income, one should obtain the same value of GDP as is obtained using the expenditure approach.

There are two types of expenditures, however, that are included in the expenditure approach to GDP measurement but do not provide households or firms with any form of income: depreciation expenditures and indirect business taxes. Depreciation expenditures, made to replace existing but deteriorated investment goods, do increase the incomes of those providing the replacement goods, but they also decrease the profit incomes of those purchasing the replacement goods. The result is that aggregate income remains unchanged. Indirect business taxes consist of sales taxes and other excise taxes that firms collect but that are not regarded as a part of firms' incomes. Consequently, indirect business taxes are not included in the expenditure approach to determining GDP, rather it is included in the income approach.

The difference between the expenditure and income approaches to GDP measurement is illustrated in Figure .

GDP is defined as the total market value of all expenditures made on consumption, investment, government, and net exports in one year. If one subtracts depreciation and indirect business taxes from these expenditures, one arrives at national income, which is the sum of all wage, profit, rent, and interest incomes earned in the same year.

Growth rate of GDP. The value of GDP by itself is not very interesting. What is interesting is the annual growth rate, or year‐to‐year percentage change, in the value of GDP. To calculate the percentage change in a statistic, such as GDP, one needs to know the value of the statistic at two dates in time. Suppose that the value of GDP last year was Y _L and the value of GDP in the current year is Y _C. Then, the percentage change, or growth rate, of GDP is given by

This formula is valid for calculating the percentage change in any statistic, not just the percentage change in GDP.

A positive growth rate of GDP implies that the economy is expanding, while a negative growth rate of GDP implies that the economy is contracting. An expanding economy is said to be in a boom, while a contracting economy is said to be in a recession.

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