Gross Domestic Product (GDP)

When an entrepreneur organizes a business, she does so in the hope of making money, by
buying the inputs to produce a product or service that can be sold for a higher price than the
cost of the inputs. However, businesses take time to organize and to become profitable. In
the meantime, a business has to know how it is doing. Accounting is a means of assessing
that performance. Similarly, it would be advantageous to be able to assess the state of the
economy and its rate of growth.
National income accounting is accounting for the nation as a whole. The Bureau of
Economic Analysis (BEA), an agency of the Commerce Department, assesses the health of
the economy by collecting statistics about the economy periodically and comparing levels
of production with recent and historical measurements. The most important national account
is the gross domestic product.
Gross domestic product (GDP) is the total market value of all final goods and services
produced in a given year within the United States, whether produced by citizens,
companies, or by foreigners in the United States. Hence, cars manufactured by GM, Ford,
Toyota, and Honda in the United States are considered part of the gross domestic product.
However, cars produced by GM and Ford in China are not included nor are Toyotas and
Hondas that are manufactured in Japan.
GDP is a monetary measure output is measured by summing the prices of all final
products and services produced within the United States. Only final goods and services are
counted, to avoid multiple counting, since their prices covers the cost of all intermediate
products and services that were used to produce the final output. Another way to calculate
GDP is to measure thevalue added to each product or service at each stage of its
production.
GDP excludes nonproduction transactions: public transfer payments, such as Social
Security, private transfer payments, such as gifts, and financial market transactions,
since securities represent either ownership, such as with stocks, or they represent loans,

such as bonds. Financial securities do not represent real production, but simply represent the
means to finance production. Likewise, secondhand sales are excluded because no
production is involved except for the sales service. For instance, goods sold in a
consignment shop would not be part of the GDP, but the services provided by the
consignment shop would be included.

The Gross Domestic Product (GDP) in Ethiopia was worth 46.87 billion US dollars in 2013.
The GDP value of Ethiopia represents 0.08 percent of the world economy. GDP in Ethiopia
averaged 14.35 USD Billion from 1981 until 2013, reaching an all time high of 46.87 USD
Billion in 2013 and a record low of 7.27 USD Billion in 1981. GDP in Ethiopia is reported
by the World Bank.
Because GDP measures output in terms of prices, the buyer pays the price and the seller receives
it. Therefore, GDP can be measured by using either the expenditures approach, which sums the
amount paid for final goods and services, or the income approach, which measures the income
received for producing products and services.
Determining GDP Using the Expenditures Approach
Since everything that is produced by the economy is purchased, one method of measuring
GDP is by measuring total expenditures. Expenditures can be divided into 4 major

categories: personal consumption expenditures, gross private domestic investment,

government purchases, and net exports. Personal consumption expenditures includes
purchases for durable consumer goods, which are goods that have an expected lifetime of
greater than one year, such as automobiles, household appliances, and electronic
equipment; nondurable consumer goods, which are goods with an expected lifetime of
less than 1 year, such as food and toiletries, and consumer expenditures for services, such as
for doctors, dentists, and lawyers.
Gross private domestic investment includes all final purchases of machinery, equipment,
and tools by businesses; all construction; plus changes in inventories. Private domestic
investment means that the goods were not purchased by a government or one of its
agencies. Domestic means that it was purchased within the country. Investment includes
residential construction, since residential buildings can be rented out, even if they are
occupied by owners. Owner occupied residences have animputed rent, which is added to
GDP, even though the homes are not actually rented out.
Inventory is included because businesses invest in producing inventory; however, not all of
it is sold. If inventories declined during the year, then the difference between the prior year's
and the current year's inventory is subtracted from investments; otherwise, it would be
counted twice, since some inventory was sold that was produced in a previous year. For
instance, suppose there was an inventory of 10 million cars at the beginning of the year and
5 million cars at the end of the year. That means that 5 million cars were sold but not
produced in the current year, so they would be counted as consumer expenditures since they
are durable consumer goods, but since they were not produced in the current year, their
value would have to be subtracted.
Business investment does not include the transfer of securities or tangible assets, such as
real estate, furniture, or motor vehicles. Securities simply represent ownership or some
other financial relationship but are not actual goods or services. Tangible assets that are
resold are also not included in GDP, since this simply transfers ownership it does not
represent production. Investment in the economic sense means the production of real goods
and services, not the transfer of ownership.

Another important measure of the economy is the net addition of capital stock. Since some
of the capital goods that were produced are used to replace worn-out machinery and
equipment, this investment does not increase the stock of real capital in the economy.Gross
investment includes all investment, including capital for replacing worn-out machinery and
equipment. Net investmentequals the gross investment minus depreciation, which is a
measure of the capital stock that must be replaced. An increase in the stock of capital
expands the production possibility frontier the economy can produce a greater output.
Net Investment = Gross Investment - Depreciation
Government purchases include goods and services that the government uses to provide
public services and expenditures forsocial capital, such as for schools and highways.
Government purchases include purchases made by all government entities, including
federal, state, and local governments. However, it does not include transfer payments,
such as the payment of Social Security or welfare benefits.
When computing total expenditures, imported goods must be subtracted from purchases,
since imported goods and services were not produced within the country. Exports, however,
are included since they are produced within the country. However, they must be added as a
separate item because they are purchased by foreigners and so would not be included in the
other categories. Rather than subtracting imports and adding exports, government
economists use net exports, which is simply equal to exports minus imports, which is often
represented by the symbol X. Note that when the value of imports is greater than the value
of exports, then net exports is negative, and is subtracted from the GDP.
Net Exports (X) = Exports - Imports
To summarize, GDP can be calculated thus:
GDP = Personal Consumption Expenditures + Gross Private Domestic Investment +
Government Purchases + Net Exports
Usually, this equation is written in the following abbreviated form:

GDP = C + I + G + X
Determining GDP Using the Income Approach
Since goods and services are sold, someone receives that income. Hence, another way of
calculating GDP is by calculating thenational income, which is equal to the compensation
of all employees, rents, interest, proprietors' income, and corporate profits. The largest part
of national income is, by far, employee compensation. Compensation includes payments by
the employer into social security and private pension funds, and payments for health and
disability insurance for employees. Rents include the money received for renting out real
estate by owners of the property, whether they are households or businesses. However,
only net rentsare included, which is the total rent minus depreciation of rental property.
Interest includes the total sums paid by private businesses for loans, including the interest
paid on savings, certificates of deposits, and corporate bonds.
Proprietors' income includes not only income earned by proprietorships, but also
partnerships and other unincorporated businesses, such as limited partnerships. Corporate
profits are generally divided into 3 categories:
1. corporate income taxes;
2. retained earnings, which is used for future expansion and to maintain liquidity;
3. dividends, which is that portion of after-tax earnings paid to stockholders of the
company.
The first 5 terms of the equation yield national income, which is the total income of
Americans, whether earned domestically or abroad.
The national income approach yields a figure which is less than the expenditures approach,
because indirect business taxes are added to the expenditures approach. These taxes
include general sales taxes, excise taxes, property taxes, license fees, and custom duties. For
example, if a consumer purchases something for one dollar and there is a 6% sales tax, then

the consumer will have to pay $1.06 total. This $1.06 is added as a whole to the expenditure
approach, but the $.06 sales tax was not used to produce the good or service, so it is not
included in national income indirect business taxes are simply a form a transfer payment
from the taxpayer to the government. Hence, indirect business taxes must be added to
national income to more accurately compare it to the expenditures approach.
Another adjustment that must be made is the consumption of fixed capital, which is the
depreciation of durable goods. Any good that has a lifetime greater than one year will wear
out over time, which is calculated as depreciation. If capital goods were expensed in the
year that they were produced, it would understate profits for the first year, but overstate
profits in succeeding years, resulting in a distortion of actual profits. To account for the
extended lifetime of durable goods, various methods of depreciation are used, that expense
capital goods over their expected lifetime, thus giving a better measure of profitability. For
instance, suppose you purchased a delivery truck for $50,000. If this was all expensed in the
first year, then your profit would be less by $50,000. In the 2nd year, profits would increase
by $50,000 for the same revenue and expenses except for the truck, since you do not have to
purchase a new truck. However, at some point the truck will have to be replaced. Hence,
some money must be set aside to make this purchase, and this is usually done by
apportioning part of the cost of the capital good over its expected lifetime.
Because national income includes income earned by Americans abroad, which is not
counted in the expenditures approach, this income must be subtracted in the income
approach, while the income earned by foreigners from domestic production must be added
since such income is not included in national income but is counted as part of the
expenditure approach. These adjustments are summarized as the net foreign factor income:
Net Foreign Factor Income = Income Earned by Foreigners from Domestic Production
- Income Earned by Americans Abroad
Hence, the net foreign factor income is added in the income approach to equalize it to the
figure derived from the expenditures approach. To summarize:

Consumption Expenditures by Households + Investment Expenditures by Businesses +

Government Purchases of Goods and Services + Domestic Expenditures by Foreigners
= Wages + Rents + Interest + Profits + Indirect Business Taxes + Net Foreign Factor
Income = GDP
GDP Does Not Measure What Is Not Reported
GDP does not measure total output or total utility. Because GDP measures only the value of
all final goods and services, which is measured by the prices of those goods and services,
any output that is not sold or not reported will not be included in the GDP. For instance, if
someone sells his services as a housecleaner, and he cleans someone's house for payment,
that is included as GDP.(Assuming that he claims the income!) However, if he cleans his
own residence, then that is not included as part of the GDP, even though it is economic
output. (After all, the house gets cleaned whether he does it himself or pays someone else to
do it.)
Another source of economic output that is not measured in the GDP is the underground
economy, whose output is unreported because people wish to avoid taxes or because the
output is illegal, such as selling heroin or other illicit drugs. Many immigrants, for instance,
work under the table, as they say, to avoid detection by immigration authorities and to avoid
the payment of taxes. Other activities of the underground economy include the manufacture
and transport of drugs, money laundering services, and prostitution.
Not all illegal activities would be included in the GDP anyway, even if they were reported.
Burglary and robbery, for instance, would not be included since these activities simply
transfer the ownership of the stolen items.
Activities that are free are not included in the GDP, while those that cost money are
included. For instance, playing basketball at an outdoor court would not be included in
GDP, but paying to see a movie would be included.

GDP also does not account for the quality of the goods and services, since there is no simple
relationship between the price of the output and the quality of the output. GDP also does not
include the cost of negative externalities, such as littering and pollution, unless the
government forces companies to pay for them, such as by the assessment of a carbon tax.
Leisure has value, evidenced by the fact that as compensation increases, most people
choose to consume more leisure and work less. However, because leisure does not have a
price tag, there is no measure of it in the GDP.
GDP also does not measure whether the distribution of output is fair. More of the GDP is
distributed to those with more money. However, more money does not necessarily go to
those who work the hardest. Indeed, it often goes to those who work the least, since
inheritance is generally taxed much less than working income. Tax laws are often skewed to
favor the wealthy, since they can influence legislators with their money. In most countries,
working income is taxed the most, while investment income and inheritance is taxed
considerably less both forms of income accrue mostly to the wealthy, and because of its
lower taxation, allows the wealthy to increase their wealth even more.
Conclusion
Even though GDP does not measure all output, it still allows economists to assess the state
of the economy, providing a solid foundation to predict its future course and to measure the
results of public policies.
National Accounts
The gross domestic product measures the final output by people and businesses located
within the United States. However, there are several other national accounts that give a
slightly different view of the economy.

Gross National Product

The gross national product (GNP) measures the value of the final output created by
Americans, whether they are located within the United States or outside of it. What is
included in the gross domestic product (GDP) but not in GNP is the domestic production by
foreign workers and companies. So the production of Mercedes-Benz cars in Alabama is
counted in GDP but not GNP. On the other hand, the production of cars by GM in China is
counted in the GNP but not GDP. The differences between GDP and GNP are small because
the additions or subtractions of foreigners working within the United States and Americans
working abroad are small relative to the size of the United States economy.
Net Domestic Product
A more accurate measure of growth than the GDP is the net domestic product (NDP),
which is simply the GDP minus capital depreciation, which is a measure of the amount of
output that was used to replace aging stock of capital. Net domestic product measures how
much the economy has grown. Generally, the smaller the difference between GDP and NDP,
the more efficient the economy. The amount of depreciation is lowered by producing better
quality that lasts longer, lessening the need for replacement.
Obsolescence also contributes to capital depreciation, since many firms abandon equipment
and machinery that is outdated, since they can reduce their production costs by shifting to
new, more efficient machinery and equipment. Because there is always some capital
depreciation, the rate of NDB growth will always be less than GDP growth.
National Income
National income (NI) sums the total amount earned by Americans for their land, labor,
capital, and entrepreneurial talent, whether within the United States or abroad. Hence,
national income is sometimes referred to as factor income, because it is equal to the income
received by Americans for all factors of production provided by them. NI can be derived
from NDP by subtracting 2 quantities that are used in the domestic product but not pertinent

to the national income. First, net foreign factor income must be subtracted from NDP since
it is the income earned by foreigners in the United States minus the income earned by
Americans abroad. This makes sense, since the earnings of foreigners should not be
included in the United States national income. Indirect business taxes, including sales
taxes, excise taxes, custom duties, business property taxes, and license fees are also
excluded from NDP because they are not payments for factors of production. National
income can also be calculated by simply summing up all employee compensation, rent,
interest, proprietors' income, and corporate profits.
Personal Income
Personal income (PI) is all income received by Americans, whether it is earned or
unearned. The main difference between personal income and national income is that
personal income includes transfer payments, such as private pension payments, retirement
benefits, unemployment insurance benefits, veteran benefits, disability payments, welfare,
and farmer subsidies. They are called transfer payments because the government takes the
money from those who earn the income and gives it to the beneficiaries of the transfer
payments.
Additional differences between personal income and national income includes income that
is earned but not received, which must, therefore, be subtracted, from national income plus
interest earned from government securities. The interest earned on government bonds,
notes, and bills are part of personal income but not national income, because the
government is not considered a resource, since it is not a factor of production. Therefore,
the interest earned by lending to the government is not counted as part of national income.
Disposable Income
Another national account is disposable income (DI), which is simply personal income
minus income taxes. That is what many people call take-home pay. Personal taxes include
any type of tax which decreases the income that a person actually receives, such as income

and inheritance taxes. Hence, disposable income is the money that people have to either
spend or to save.
Measuring Real GDP Using Nominal GDP, GDP Price Index, GDP Deflator
A primary benefit of measuring the Gross Domestic Product (GDP) is that it can show the
growth of the economy over time, or its lack thereof. However, GDP as measured by current
prices does not measure the growth of real GDP, since prices depend on themoney supply,
which varies independently of GDP from year to year. Nominal GDP is the GDP measured
by actual prices, which are unadjusted for inflation. Real GDP measures output in constant
dollars, so that the economic output of one year can be accurately compared to a previous
year. Since prices change from year to year, GDP would change from year to year even if
the real GDP did not change. Hence, there must be some adjustment in GDP to reflect the
change in prices. Rising prices inflate GDP while falling prices deflate GDP. Therefore, to
obtain real GDP, the operation must be reversed. Since prices usually rise, GDP is deflated
by the amount of the inflation to arrive at real GDP. Hence, it is often called the GDP
deflator.
The GDP deflator is based on a GDP price index and is calculated much like the Consumer
Price Index (CPI), based on data collected by the government. Although the GDP index is
much like the CPI, it covers many more goods and services. The CPI only covers consumer
goods and services, while the GDP index also covers capital goods, purchases by the
government, and goods and services that are traded worldwide.
To determine the value of the GDP deflator, a GDP price index must be constructed that
shows how much prices have changed from year to year for a representative sample of all
products and services. The relative weights of various goods and services in the GDP price
index are adjusted annually, unlike the CPI, which is a fixed weight price index for a market
basket whose composition is only updated occasionally by the BLS.
A price index is a measure of how much prices have changed in any given year as
compared to a base year:

Price of Representative Market Basket in Specific Year

Price Index in a Given Year

Price of Representative Market Basket in Base Year

The multiplication by 100 gives a nice round number, especially for reporting. However, to
determine real GDP, the nominal GDP is divided by the price index divided by 100.
To simplify comparisons, the value of the price index is set at 100 for the base year.
Previous to the base year, prices were generally lower, so those GDP values must be inflated
to compare them to the base year. When prices are less in any given year than they were in
the base year, then the price index will be less than 100, so that when real GDP is calculated
by dividing the nominal GDP by the price index, it will be greater than the nominal GDP.
Another method of calculating real GDP is to enumerate the volume of output, then
multiplying that volume by the prices of the base year. So if a gallon of gas cost $2 in the
year 2000, and the United States produced 10,000,000,000 gallons, then these values can be
compared to a later year. For instance, if the United States produced 15,000,000,000 gallons
of gasoline in the year 2010, then the real increase in GDP with respect to gasoline could be
calculated by simply multiplying the 15 billion by the 2000 price of $2 per gallon. The price
index can then be calculated by dividing the nominal GDP by the real GDP. So if gasoline
was $3 per gallon in 2010, then the price index would be equal to 3 divided by 2 multiplied
by 100 which is equal to 150.
Of course, there are many complexities to calculating real GDP by either method.
Statisticians must necessarily use assumptions about the proportion of each type of goods
and services purchased during a given year. If you would like to dive into the details of
calculating this chain-type annual-weights price index, be my guest: Box: Basic Formulas
for Calculating Chain-Type Quantity and Price Indexes.
Economic Growth and Business Cycles
Economic growth is either an increase in real GDP or an increase in real GDP per capita
occurring over a specific time period. High GDP indicates high output by the economy, but

100

a high GDP per capita indicates a high standard of living. For instance, China's GDP is
much greater than Denmark's, but Denmark's GDP per capita is much higher; hence,
Denmark enjoys a higher standard of living than most Chinese.
There are 2 main sources of growth: increases in the factors of production, and increases in
the productivity of converting those factors of production into finished products and
services.
Adam Smith cited 4 principal causes of economic growth in his book The Wealth of
Nations as being increases in:
1. the labor force,
2. the degree of labor specialization,
3. the amount of capital stock, and
4. the level of technology.
Labor and capital stock are inputs used to produce economic output, while the specialization
of labor and technology makes more productive use of the inputs, thus expanding economic
output even more. Increases in entrepreneurship also increases productivity as entrepreneurs
discover more efficient ways of providing products and services, or even producing new
products and services. Generally, the rate of economic growth is commensurate with the
rate of growth of these factors of production. Although land is a major factor of production,
it cannot be increased, so it is not a source of growth. Although the population of the world
is still increasing, leisure is also increasing, so the growth of the labor force is starting to
flatten.
The main sources of growth today occur from the advancement of technology, especially in
computers, automation, and networking. With better technology, the quantity of production
can be increased while also lowering costs. Thus, technology expands theproduction
possibility frontier. For instance, electronic publications, such as documents posted on the
Internet, e-books, and other sources of electronic information, have reduced the need for

paper, the need to deliver the publications to various destinations, and the need to store such
publications in warehouses. Moreover, electronic publications can be produced much faster
and the information is much more usable, since it can be easily searched.
The rate of economic growth also depends on the size of the economy. Smaller economies
tend to grow faster than larger economies because they are growing from a smaller base.
Just as for businesses, the larger the economy, the lower the growth rate tends to be.
Moreover, smaller economies are usually less well developed, so they benefit from
assistance from more developed nations. Additionally, less-developed nations often copy the
newest technologies, buy it outright, or their domestic companies often partner with
companies of developed economies with leading-edge technology. China, for instance, is
leveraging many partnerships with leading-edge companies from around the world so that it
can acquire the latest technologies and learn the newest methods of doing business.
Increases in productivity also allow an economy to invest more in research and
development and take more risks in new enterprises. With economic growth, products and
services increase in quality, and people generally enjoy greater amounts of leisure.
Real economic growth is measured by subtracting the real GDP of the previous year from
the real GDP of the measured year, then dividing that difference by the real GDP of the
previous year.
Real GDP for Year - Real GDP for Previous Year
Real Economic Growth

=
Real GDP for Previous Year

For instance, the real domestic product for 2010 was $13.088 trillion in 2005 dollars, while
real GDP in 2009 was $12.703 trillion. Therefore, real economic growth from 2009 - 2010
was equal to 13.088-12.703=0.385, 0.385/12.703 = 0.0303 = 3.03%

Business Cycles
Economic growth does not increase continually, but rather in spurts, by cycling through
peaks and recessions. Often, peaks are associated with higher prosperity, but also with
higher inflation, while recessions are associated with higher unemployment. However,
business cycles are not uniform some are short, lasting for several months, while some
last for several years. After the economy peaks, then there is a downturn, lessening the
amount of inflation, raising unemployment, and lowering economic productivity. Economic
output reaches a maximum at the peak of the business cycle, while it reaches a minimum at
the trough. The trend of economic growth, however, is generally upward.
Causes of Business Cycles
Many hypotheses attempt to explain the causes of the business cycle. Some say that major
innovations are the cause of business cycles, such as the development of the railroad, motor
vehicle, and computer technology. Indeed, when fundamental innovations are made, many
business people discover how to capitalize on the new technology. For instance, the
framework of the Internet as it exists today coupled with programming languages,
especially open source programming languages, allows innovators to develop a wide variety
of services based on these fundamental technologies.
Others argue that variations in the supply of money cause business cycles. Indeed, an
increase in the money supply will have a stimulatory effect, at least at first, but eventually it
ends because people start anticipating inflation that results when the money supply is
continually increasing. However, the contraction of the money supply will certainly cause a
contraction of the economy, because businesses cannot make a profit without being able to
sell their wares. When money supply declines, deflation sets in, which causes many people
to hold onto their money since it becomes more valuable in time.
However, the main cause of business cycles is a fluctuation in consumer spending. As the
economy recovers from recession, people's confidence increases, so their spending
increases, which gives rise to a multiplier effect, raising the income of both individuals and

businesses, which in turn, stimulates more spending. However, at some point, the business
cycle peaks because people have no more money to spend, and indeed, many people have
borrowed money, so their debt load forces them to stop spending at some point, since they
have to repay their debt, with the result that consumer spending declines.
How Capital Goods and Consumer Durables Are Affected by the Business Cycle
When the economy starts to decline, the first companies that suffer are the ones that produce
capital goods and durable consumer items, such as automobiles, computers, and appliances.
Businesses generally do not have a need to increase their purchase of capital stock in a
declining economy, because the equipment that they have can produce enough output to
satisfy declining needs. Likewise, consumers lose confidence in the economy, so they cut
back on major purchases, such as cars and trucks, computers, and appliances, since most
people replace these items when they want a newer or better version. However, in an
uncertain economy, people will hold onto what they have for longer periods of time.
Through the multiplier effect, the economy slows even more until it reaches a trough.
However, most services and nondurable consumer goods are relatively unaffected by
recession, because it is difficult for consumers to put off such purchases, such as for food,
clothing, and medical services. Indeed, some firms actually receive increased business
during a recession, such as auto repair shops and law firms specializing in bankruptcy, since
the need for these services usually increases as a result of the recession.
At some point however, the economy bottoms out because people can only put off
purchases for so long. Indeed, because they have put off purchases, there is actually an
acceleration of purchases as the economy recovers. For instance, people can keep their cars
and trucks for a few more years, but at some point, repairs will start to get more expensive
than buying a new vehicle. Likewise, many people who were contemplating elective
medical procedures can delay the procedures until a later time, but at some point, they
usually have to get it done. Another factor that helps the economy to recover is that people
pay down their debt, since they have reduced their spending, so they have more money
when they decide to start buying again.

Unemployment
The major problem of economic recessions and depressions is high unemployment. When
unemployment is severe or prolonged, it can lead to social disintegration, loss of job skills,
and increased difficulty of finding a new job. It can also cause social unrest because more
people fall into poverty. However, not everyone who is not working is considered
unemployed only those who are part of the labor force, those who are actively seeking
employment.
Labor Force
The total population of any economy is divided into 4 major sections, in regards to
employment:
1. Those who are under 16 or institutionalized are not considered part of the labor force
and are not eligible to seek employment.
2. Those who are able to work but are not in the labor force, because they are not seeking
employment, such as homemakers, full-time students, and retirees.
3. Almost half of the population that is employed.
4. The small number of people who are unemployed, which are those who are able to
work and are actively seeking employment.
Discouraged workers are also not included in the labor force, because, although they
would like work, they have given up looking for it.
The labor force consists of all those people who are either employed or unemployed, but
seeking work.
Unemployment Rate

Number of Unemployed

100

Number in Labor Force

In the United States, the unemployment rate is determined by the Bureau of Labor
Statistics (BLS), which conducts a monthly nationwide random survey of about 140,000
businesses and government agencies, representing approximately 440,000 individual
worksites, providing detailed industry data on nonfarm employment, hours, and earnings of
workers. The results of this sampling are then projected to the entire nation.
However, economists have criticized the BLS statistics because it counts part-time
employment as full employment, even if the workers are seeking full-time employment.
Also, the BLS only counts those people who are actively seeking work, but, especially in
recessions, there are many people who would like to be employed, but are discouraged and
so stop seeking employment. Hence, the actual unemployment rate is usually greater than
what the BLS statistics suggest.
The BLS also determines the labor force participation rate from the same survey, which is
the percentage of adults in the labor force:
Number in Labor Force
Labor-Force Participation Rate

100
Number of Adults

Types of Unemployment
Unemployment is generally classified into 3 types, according to the cause of
unemployment: frictional, structural, and cyclical.
Frictional unemployment is the unemployment that results when people are between jobs
or when they first start looking for jobs. Many people quit or get fired from their job,
causing them to be unemployed temporarily. Although most people looking for work
eventually find another job, there are always others who lose their job for one reason or
another, and so become part of the unemployment pool. Because this happens continually,

frictional unemployment is persistent, and represents the minimum that the unemployment
rate can go.
Structural unemployment results when there is a mismatch between the skills demanded
by employers and the skills that workers have. Structural unemployment may also result
from the relocation of jobs to different geographical areas, because many people tend to
remain where they have lived most of their lives. Structural unemployment can persist over
many months or even a few years, until people can retrain or develop new skills or they
become willing to relocate in new areas where there are jobs.
Cyclical unemployment results from the decreased aggregate expenditures by the economy
during a recession, when businesses have cut back on their production of output. Since labor
is an input, reduced output lowers the demand for labor. Hence this type of unemployment
is sometimes referred to as deficient-demand unemployment. For instance, during the
credit crisis from 2007 to 2010, the unemployment rate in United States hovered slightly
under 10% for several years.
Full Employment
Because frictional and structural unemployment are part of any economy, true, full
employment, where everyone in the labor force has a job, does not occur. Instead,
economists talk about a natural rate of unemployment (NRU), which is the absence of
cyclical unemployment, but not frictional or structural unemployment. In other words, the
unemployment rate will rarely drop below the natural rate of unemployment. Generally,
when there is a natural rate of unemployment, the number of job vacancies equals the
number of job seekers. Sometimes, however, the unemployment rate can drop a little below
the natural unemployment rate, because demand for labor is so high, that even workers who
were not actually looking for a job may be enticed by higher wages and the ready
availability of jobs. The natural rate of unemployment has come down over the years,
largely due to improvements in technology. The Internet, for instance, allows employers to
post available jobs for little or no cost, or they can search resumes online to find people with

the appropriate skill set. People looking for jobs also have it much easier, since they can
search for jobs on their own home computers.
The natural rate of unemployment differs among nations. For instance, France, Germany,
and the United Kingdom generally have higher unemployment rates than the United States,
probably because they have more generous unemployment benefits, which lessen the need
to find a new job.
The economy is considered at full employment when the unemployment rate is equal to the
economy's natural rate of unemployment, which is also when economic output is at a
maximum.
Economic Cost of Unemployment
Unemployment above the natural rate means that the economy is producing less than its
potential output. This is referred to as theGDP output gap, or simply the GDP gap. Higher
unemployment rates create a larger GDP output gap.
The size of the output gap created by a specific amount of unemployment was first
quantified by the economist Arthur Okun and has, since, become known as Okun's
Law. Okun's Law indicates that for every 1% of unemployment above the natural
unemployment rate creates a GDP output gap of about 2%. So for a $10 trillion economy, a
1% unemployment rate above the natural rate of unemployment creates a $200 billion
output gap. In the United States, the unemployment rate averaged 9.6% in 2010, which is
about 5% above the natural unemployment rate. Since the United States had a nominal GDP
of about $14.5 trillion, the high unemployment rate according to Okun's Law would be
equal to an almost $1.5 trillion output gap.
Generally, unemployment rates are higher for people with fewer skills or for people
working in lower skilled occupations. Lower skilled workers are also less likely to be selfemployed. Teenagers generally have higher unemployment rates because they have lower
skill levels, frequently quit their jobs or get fired, and have less geographic mobility than
adults. Blacks and Hispanics also suffer a higher unemployment rate than whites because

more of them have less education, and are more concentrated in lower skilled occupations.
Discrimination also increases the rate of unemployment. People with higher education
normally experience lower unemployment rates.