CHINA PASSES JAPAN AS Second-Largest Economy.” That was the headline in the New York Times on August 15, 2010. Citing economic data suggesting that Japan’s economy was weakening while China’s was roaring ahead, the article predicted—correctly, as it turned out—that 2010 would mark the first year in which the surging Chinese economy finally overtook Japan’s, taking second place to the United States on the world economic stage. “The milestone,” wrote the Times, “though anticipated for some time, is the most striking evidence yet that China’s ascendance is for real and that the rest of the world will have to reckon with a new economic superpower.”

But wait a minute—what does it mean to say that China’s economy is larger than Japan’s? The two economies are, after all, producing very different mixes of goods. Despite its rapid advance, China is still a fairly poor country whose greatest strength is in relatively low-tech production. Japan, by contrast, is very much a high-tech nation, and it dominates world output of some sophisticated goods, like electronic sensors for automobiles. That’s why the 2011 earthquake in northeastern Japan, which put many factories out of action, temporarily caused major production disruptions for auto factories around the world.

How can you compare the sizes of two economies when they aren’t producing the same things?

The answer is that comparisons of national economies are based on the value of their production. When news reports declared that China’s economy had overtaken Japan’s, they meant that China’s gross domestic product, or GDP—a measure of the overall value of goods and services produced—had surpassed Japan’s GDP.

GDP is one of the most important measures used to track the macroeconomy—that is, to quantify movements in the overall level of output and prices. Measures like GDP and price indexes play an important role in formulating economic policy, since policy-makers need to know what’s going on, and anecdotes are no substitute for hard data. They’re also important for business decisions—to such an extent that, as the business case at the end of the chapter illustrates, corporations and governments are willing to pay for early reads on what official economic measurements are likely to find.

In this chapter, we explain how macroeconomists measure key aspects of the economy. We first explore ways to measure the economy’s total output and total income. We then turn to the problem of how to measure the level of prices and the change in prices in the economy.