# What is the second most important aspect of CBO measurement that makes it a better gauge of real household income than CB’s? How does that factor explain the more rapid rise of the CBO measure over CB’s estimate?

Module 1 Assignment. Short-Answer: (The numbers in square brackets give the breakdown of the points for various parts of each question. To receive full credit, please explain your answers.)

This question is based on the article, “The average American is much better off now than four decades ago,” published by The Economist on March 31, 2018. The article can be viewed through UIUC Library Online Resources. For your convenience, the article is copied below. The article compares the real income figures for the median American household as calculated by the Census Bureau (CB) and the Congressional Budget Office (CBO). The article mentions three methodological differences that explain the gap between the two measures. It also argues that the CBO measure, which shows a much larger rise in the median household income, is closer to reality.

(a) The article shows that the biggest part of gap is due to CBO’s use of the personal-consumption expenditures (PCE) index to measure inflation, compared to CB’s use of the consumer-price index (CPI). Given what we know about the CPI measurement problems, what are the aspects of PCE that make it a better price index for deflating household income? [10]

(b) What is the second most important aspect of CBO measurement that makes it a better gauge of real household income than CB’s? How does that factor explain the more rapid rise of the CBO measure over CB’s estimate? [8]

(c) What are the additional pieces of evidence that the article presents corroborating the picture of income increase painted by the CBO? [7]

This year, Company A in the US has developed an AI software package, using only its own labor and capital. The Company has sold the package to Company B and has received \$100,000 in compensation. Company B has in turn put this package into use along with its own capital and labor and no other intermediate input. This has enabled B to offer a new service to its customers as a final good with a sale value of \$200,000.

If the AI software package is treated as an intermediate good, how much GDP has been produced by the two companies together? [5]

If the AI software package is treated as an investment good, how much GDP has been produced by the two companies together? [5]

1. Suppose this year the prices of goods and services produced in Japan, especially for housing and food, rise in terms of the local currency, Japanese yen, while the market exchange rate and the prices in the US remain constant. Further assume that the quantities of all goods and services consumed in those countries are given.

1. If we measure income by PPP GDP based on US prices in terms of US dollars, how do higher prices in Japan affect its measured per capita income relative to the measured per capita incomes of the US? Why? [5]

1. If we measure income by GDP at market prices and market exchange rates, how do higher prices in Japan affect its measured per capita income relative to the measured per capita incomes of the US? Why? [6]

Alternative stats

The average American is much better off now than four decades ago

Estimates of income growth vary greatly depending on methodology

Print edition | Finance and economics

Mar 31st 2018

JUST how bad have the past four decades been for ordinary Americans? One much-cited figure suggests they have been pretty bad. The Census Bureau estimates that for the median household, halfway along the distribution, income has barely grown in real terms since 1979. But a recent report by the Congressional Budget Office (CBO), a non-partisan think-tank, gives a cheerier rise of 51% for median household income between 1979 and 2014. Which is nearer to reality?

The gap between the two is accounted for by three methodological differences (see chart). First, the CBO takes demography into account. This seems sensible: more Americans are living alone and American women are having fewer children, so households have fewer mouths to feed.

The second is that the CBO uses the personal-consumption expenditures (PCE) index to measure inflation, whereas the Census Bureau uses the consumer-price index (CPI). These differ in two main ways. The CPI includes only what consumers spend on themselves, whereas the PCE index also includes expenditures on their behalf, such as employee health insurance. And the CPI’s basket of goods is updated every two years, whereas that for the PCE index is updated quarterly. This means it is quicker to pick up substitutions: as the price of one item (apples, say) rises, consumers seek cheaper alternatives (for example, pears).

In 2000 the Federal Reserve’s rate-setting body switched from the CPI to the PCE index for its inflation target, citing this reason. Growth in the PCE index has generally been half a percentage point below the CPI. The gap, small in the short run, grows wider with each passing year.

The third difference is that the Census Bureau uses pre-tax incomes, whereas the CBO takes taxes and transfers, such as government-funded health insurance, into account. Between 1979 and 2014 the average federal tax rate for families in the middle fifth of the pre-tax income distribution fell from 19% to 14%. Transfers rose from 0.8% of pre-tax income to 4.7%.

Other data also suggest that the CBO’s methods paint a fairer picture. Bruce Sacerdote of Dartmouth College has calculated that household expenditure, converted to 2015 dollars using the CPI, has risen by 32% since 1972. Spending on food and clothing has fallen from 27% of the total to 16% in 2016, and the share spent on health care and housing has stayed roughly constant. That means more left over for luxuries. Homes have got bigger, and the number of cars per household has risen from 1 to 1.6.

The past four decades have been hard for many Americans. Trade and technology have upended the labour market, and many low-skilled men have left the workforce. Economic growth has been weak in non-coastal states, and the top few percent take home a greater share of all income. Wage growth, by any measure, has been far lower than in the post-war decades. But the idea that the typical American is little better off than four decades ago does not withstand scrutiny.