Chapter 15: Measuring a Nation’s Income Questions for Review: 1. An economy's income must equal its expenditure, because every transaction has a buyer and a seller. Thus, expenditure by buyers must equal income by sellers. 2. The production of a luxury car contributes more to GDP than the production of an economy car because the luxury car has a higher market value. 3. The contribution to GDP is $3, the market value of the bread, which is the final good that is sold. 4. The sale of used records does not affect GDP at all because it involves no current production. 5. The four components of GDP are consumption, such as the purchase of a music CD; investment, such as the purchase of a computer by a business; government purchases, such as an order for military aircraft; and net exports, such as the sale of American wheat to Russia. (Many other examples are possible.) 6. Economists use real GDP rather than nominal GDP to gauge economic well-being because real GDP is not affected by changes in prices, so it reflects only changes in the amounts being produced. You cannot determine if a rise in nominal GDP has been caused by increased production or higher prices. 7. Year 2005 2006 Nominal GDP 100 X $2 = $200 200 X $3 = $600 Real GDP 100 X $2 = $200 200 X $2 = $400 GDP Deflator ($200/$200) X 100 = 100 ($600/$400) X 100 = 150 The percentage change in nominal GDP is (600 − 200)/200 x 100 = 200%. The percentage change in real GDP is (400 − 200)/200 x 100 = 100%. The percentage change in the deflator is (150 − 100)/100 x 100 = 50%. 8. It is desirable for a country to have a large GDP because people could enjoy more goods and services. But GDP is not the only important measure of well-being. For example, laws that restrict pollution cause GDP to be lower. If laws against pollution were eliminated, GDP would be higher but the pollution might make us worse off. Or, for example, an earthquake would raise GDP, as expenditures on cleanup, repair, and rebuilding increase. But an earthquake is an undesirable event that lowers our welfare. Problems and Applications 1. a. b. c. Consumption increases because a refrigerator is a good purchased by a household. Investment increases because a house is an investment good. Consumption increases because a car is a good purchased by a household, but investment decreases because the car in Ford’s inventory had been counted as an investment good until it was sold. d. e. f. g. 2. 3. Consumption increases because pizza is a good purchased by a household. Government purchases increase because the government spent money to provide a good to the public. Consumption increases because the bottle is a good purchased by a household, but net exports decrease because the bottle was imported. Investment increases because new structures and equipment were built. With transfer payments, nothing is produced, so there is no contribution to GDP. If GDP included goods that are resold, it would be counting output of that particular year, plus sales of goods produced in a previous year. It would double-count goods that were sold more than once and would count goods in GDP for several years if they were produced in one year and resold in another. 4. a. Calculating nominal GDP: 2005: ($10 per football 200 footballs) + ($8 per baseball 75 baseballs) = $2,600 2006: ($14 per football 200 footballs) + ($10 per baseball 75 baseballs) = $3,550 2007: ($14 per football 350 footballs) + ($10 per baseball 125 baseballs) = $6,150 Calculating real GDP (base year 2005): 2005: ($10 per football 200 footballs) + ($8 per baseball 75 baseballs) = $2,600 2006: ($10 per football 200 footballs) + ($8 per baseball 75 baseballs) = $2,600 2007: ($10 per football 350 footballs) + ($8 per baseball 125 baseballs) = $4,500 Calculating the GDP deflator: 2005: ($200/$200) 100 = 100 2006: ($3,550/$2,600) 100 = 137 2007: ($6,150/$4,500) 100 = 137 b. Calculating the percentage change in nominal GDP: Percentage change in nominal GDP in 2006 = [($3,550 − $2,600)/$2,600] 100 = 37%. Percentage change in nominal GDP in 2007 = [($6,150 − $3,550)/$3,550] 100 = 73%. Calculating the percentage change in real GDP: Percentage change in real GDP in 2006 = [($2,600 − $2,600)/$2,600] 100 = 0%. Percentage change in real GDP in 2007 = [($4,500 − $2,600)/$2,600] 100 = 73%. Calculating the percentage change in GDP deflator: Percentage change in the GDP deflator in 2006 = [(137 − 100)/100] 100 = 37%. Percentage change in the GDP deflator in 2007 = [(137 − 137)/137] 100 = 0%. Prices did not change from 2006 to 2007. Thus, the percentage change in the GDP deflator is zero. Likewise, output levels did not change from 2005 to 2006. This means that the percentage change in real GDP is zero. c. Economic well-being rose more in 2007 than in 2006, since real GDP rose in 2007 but not in 2006. In 2007, real GDP rose but prices did not. In 2006, real GDP did not rise but prices did. 5. Year 2000 1999 a. b. c. d. e. f. Nominal GDP (billions) $9,873 $9,269 GDP Deflator (base year: 1996) 118 113 The growth rate of nominal GDP is ($9,873 − $9,269)/$9,269 100% = 6.5%. The growth rate of the deflator is (118 − 113)/113 100% = 4.4%. Real GDP in 1999 (in 1996 dollars) is $9,269/(113/100) = $8,203. Real GDP in 2000 (in 1996 dollars) is $9,873/(118/100) = $8,367. The growth rate of real GDP is ($8,367 − $8,203)/$8,203 100% = 2.0%. The growth rate of nominal GDP is higher than the growth rate of real GDP because of inflation. 6. Economists ignore the rise in people's incomes that is caused by higher prices because although incomes are higher, the prices of the goods and services that people buy are also higher. Therefore, they will not necessarily be able to purchase more goods and services. For this reason, economists prefer to look at real GDP instead of nominal GDP. 7. 8. Many answers are possible. a. b. c. GDP equals the dollar amount Barry collects, which is $400. NNP = GDP – depreciation = $400 − $50 = $350. National income = NNP − sales taxes = $350 − $30 = $320. d. e. Personal income = national income − retained earnings = $320 − $100 = $220. Disposable personal income = personal income − personal income tax = $220 − $70 = $150. 9. a. b. GDP is the market value of the final good sold, $180. Value added for the farmer: $100. Value added for the miller: $150 – $100 = $50. Value added for the baker: $180 – $150 = $30. c. Together, the value added for the three producers is $100 + $50 + $30 = $180. This is the value of GDP. 10. In countries like India, people produce and consume a fair amount of food at home that is not included in GDP. So GDP per person in India and the United States will differ by more than their comparative economic well-being. 11. If the government cares about the total income of Americans, it will emphasize GNP, because that measure includes the incomes of Americans that is earned abroad and excludes the incomes of foreigners living in the United States. If the government cares about the total amount of economic activity occurring in the United States, it will emphasize GDP, which measures the level of production in the country, whether produced by domestic citizens or foreigners. 12. a. The increased labor-force participation of women has increased GDP in the United States, because it means more people are working and production has increased. b. If our measure of well-being included time spent working in the home and taking leisure, it would not rise as much as GDP, because the rise in women's labor-force participation has reduced time spent working in the home and taking leisure. c. Other aspects of well-being that are associated with the rise in women's increased labor-force participation include increased self-esteem and prestige for women in the workforce, especially at managerial levels, but decreased quality time spent with children, whose parents have less time to spend with them. Such aspects would be quite difficult to measure. Chapter 16: Measuring the Cost of Living Questions for Review 1. A 10% increase in the price of chicken has a greater effect on the consumer price index than a 10% increase in the price of caviar because chicken is a bigger part of the average consumer's market basket. 2. The three problems in the consumer price index as a measure of the cost of living are: (1) substitution bias, which arises because people substitute toward goods that have become relatively less expensive; (2) the introduction of new goods, which are not reflected quickly in the CPI; and (3) unmeasured quality change. 3. If the price of a Navy submarine rises, there is no effect on the consumer price index, because Navy submarines are not consumer goods. But the GDP price index is affected, because Navy submarines are included in GDP as a part of government purchases. 4. Because the overall price level doubled, but the price of the candy bar rose sixfold, the real price (the price adjusted for inflation) of the candy bar tripled. 5. The nominal interest rate is the rate of interest paid on a loan in dollar terms. The real interest rate is the rate of interest corrected for inflation. The real interest rate is the nominal interest rate minus the rate of inflation. Problems and Applications 1. a. Find the price of each good in each year: Year 2006 2007 b. Ham $3 $4 Chicken $4 $4 Roast Beef $5 $6 If 2006 is the base year, the market basket used to compute the CPI is 50 pounds of ham, 35 pounds of chicken, and 100 pounds of roast beef. We must now calculate the cost of the market basket in each year: 2006: (50 x $3) + (35 x $4) + (100 x $5) = $790 2007: (50 x $4) + (35 x $4) + (100 x $6) = $940 Then, using 2006 as the base year, we can compute the CPI in each year: 2006: $790/$790 x 100 = 100 2007: $940/$790 x 100 = 119 c. We can use the CPI to compute the inflation rate for 2007: (119 − 100)/100 x 100% = 19% 2. 3. Many answers are possible. a. The percentage change in the price of tennis balls is (2 – 2)/2 × 100% = 0%. The percentage change in the price of golf balls is (6 – 4)/4 × 100% = 50%. The percentage change in the price of Gatorade is (2 – 1)/1 × 100% = 100%. b. The cost of the market basket in 2006 is ($2 × 100) + ($4 × 100) + ($1 × 200) = $200 + $400 + $200 = $800. The cost of the market basket in 2007 is ($2 × 100) + ($6 × 100) + ($2 × 200) = $200 + $600 + $400 = $1,200. The percentage change in the cost of the market basket from 2006 to 2007 is (1,200 – 800)/800 × 100% = 50%. c. This would lower my estimation of the inflation rate because the value of a bottle of Gatorade is now greater than before. The comparison should be made on a per-ounce basis. d. More flavors enhance consumers’ well-being. Thus, this would be considered a change in quality and would also lower my estimate of the inflation rate. 4. a. Because the increase in cost was considered a quality improvement, there was no increase registered in the CPI. b. The argument in favor of this is that consumers are getting a better good than before, so the price increase equals the improvement in quality. The problem is that the increased cost might exceed the value of the improvement in air quality, so consumers are worse off. In this case, it would be better for the CPI to at least partially reflect the higher cost. 5. a. introduction of new goods; b. unmeasured quality change; c. substitution bias; d. unmeasured quality change; e. substitution bias 6. a. b. c. ($0.75 − $0.15)/$0.15 x 100% = 400%. ($14.32 − $3.23)/$3.23 x 100% = 343%. In 1970: $0.15/($3.23/60) = 2.8 minutes. In 2000: $0.75/($14.32/60) = 3.1 minutes. d. 7. a. Workers' purchasing power fell in terms of newspapers. If the elderly consume the same market basket as other people, Social Security would provide the elderly with an improvement in their standard of living each year because the CPI overstates inflation and Social Security payments are tied to the CPI. b. Because the elderly consume more health care than younger people do, and because health care costs have risen faster than overall inflation, it is possible that the elderly are worse off. To investigate this, you would need to put together a market basket for the elderly, which would have a higher weight on health care. You would then compare the rise in the cost of the "elderly" basket with that of the general basket for CPI. 8. When bracket creep occurred, inflation increased people's nominal incomes, pushing them into higher tax brackets, so they had to pay a higher proportion of their incomes in taxes, even though they were not getting higher real incomes. As a result, real tax revenue rose. 9. In deciding how much income to save for retirement, workers should consider the real interest rate, because they care about their purchasing power in the future, not the number of dollars they will have. 10. a. When inflation is higher than was expected, the real interest rate is lower than expected. For example, suppose the market equilibrium has an expected real interest rate of 3% and people expect inflation to be 4%, so the nominal interest rate is 7%. If inflation turns out to be 5%, the real interest rate is 7% minus 5% equals 2%, which is less than the 3% that was expected. b. Because the real interest rate is lower than was expected, the lender loses and the borrower gains. The borrower is repaying the loan with dollars that are worth less than was expected. c. Homeowners in the 1970s who had fixed-rate mortgages from the 1960s benefited from the unexpected inflation, while the banks that made the mortgage loans were harmed.