ch 20 ap econ

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GDP and the

Standard o

Living

Chapter

CHAPTER OUTLINE

1. Define GDP and explain why the value of production, income, and

expenditure are the same for an economy.

A. GDP Defined

1. Value Produced

2. What Produced

3. Where Produced

4. When Produced

B. Circular Flows in the U.S. Economy

1. Consumption Expenditure

2. Investment

3. Government Expenditure on Goods and Services

4. Net Exports of Goods and Services

5. Total Expenditure

6. Income

C. Expenditure Equals Income

2. Describe how economic statisticians measure GDP in the United States.

A. The Expenditure Approach

1. Expenditures Not in GDPB. The Income Approach

1. Wages

2. Interest, Rent, and Profit

3. From Factor Cost to Market Price

4. From Gross to Net

5. Statistical Discrepancy

C. GDP and Related Measures of Production and Income

1. Gross National Product

2. Disposable Personal Income

3. Distinguish between nominal GDP and real GDP and define the GDP

deflator.

A. Calculating Real GDP

1. Traditional Method of Calculating Real GDP

2. Chained-Dollar Method of Calculating Real GDP

B. Calculating the GDP Deflator

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498 Part 7 . MONITORING THE MACROECONOMY

4. Describe and explain the limitations of real GDP as a measure of the

standard of living.

A. The Standard of Living Over Time

1. Long-Term Trend

2. Short-Term Fluctuations

B. The Standard of Living Among Countries

C. Goods and Services Omitted from GDP1. Household Production

2. Underground Production

3. Leisure Time

4. Environment Quality

D. Other Influences on the Standard of Living

1. Health and Life Expectancy

2. Political Freedom and Social Justice

CHAPTER ROADMAP

Whats New in this Edition?The

material

in

Chapter

20

has

been

updated.

The

phrase

governmentpurchasesofgoodsandserviceshasbeenre

placedwithgovernmentexpenditureongoodsandser

vices.IntheincomeapproachtoGDP,thecomponentsare

nowwagesandinterest,rent,andprofitratherthan

compensationofemployees,netinterest,rentalincome

ofpersons,corporateprofits,andproprietorsincome.

Thestatisticaldiscrepancybetweentheincomeandexpendi

tureapproachtoGDPisnowdiscussed.Thereisanex

tendeddiscussionoftherelationshipsamongGDP,GNP,

anddisposablepersonalincome.Thenewmethodforcalcu

latingGDP

is

called

the

chained

dollar

method

rather

than

thechainlinkingmethod.Thecoverageofvalueaddedis

eliminated.InCheckpoint4thereisnowcoverageofthe

standardoflivingintheUnitedStatesovertimeandbrief

coverageofthestandardoflivingamongcounties.

Where We AreInChapter20,wedefineGDPandexplainwhyfortheecon

omy,thevalueofproductionequalsincome,whichalso

equalsexpenditure.Wedescribehoweconomicstatisticians

measureGDPintheUnitedStates.Nextwedistinguishbe

tweennominalGDPandrealGDP,anddefinetheGDPde

flator.Lastly,

we

explain

and

describe

the

limitations

of

real

GDPasameasureofthestandardofliving.

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Chapter 20 . GDP and the Standard of Living 499

Where Weve BeenThisisthefirstchapterthatdirectlyexploresmacroeconom

ics.

Where Were GoingIn

Chapter

21,

we

continue

with

the

overview

of

how

the

economyoperates.Wecoverhowtheunemploymentrateis

calculated,reviewlabormarketindicatorsaswellastrends

andfluctuationsinthelabormarket,andthenexplorethe

sourcesandtypesofunemployment.

IN THE CLASSROOM

Class Time NeededThematerialinthischaptercanbecoveredbetweenoneandahalftotwoclass

sessions.

Anestimateofthetimeperchecklisttopicis:

20.1GDP,Income,andExpenditure15minutes 20.2MeasuringU.S.GDP25minutes 20.3NominalGDPVersusRealGDP40minutes 20.4RealGDPandtheStandardofLiving20minutes

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CHAPTER LECTURE

20.1 GDP, Income, and ExpenditureGDP Defined

GDPorgross domestic productisthemarketvalueofallthefinalgoodsandservicesproduced

within

acountry

in

agiven

time

period

Valueproduced:TheitemsinGDParevaluedattheirmarketvalues,thatis,attheirprices.Soif1,000,000slicesofpizzaaresoldfor$4each,slicesofpizzacontribute

$4,000,000toGDP.

Whatproduced:Toavoiddoublecounting,GDPincludesonlyfinalgoodsandservices.Afinalgoodorserviceisanitemthatisproducedforitsfinaluserandnot

usedasacomponentofanothergoodorservice.Itcontrastswithanintermediate

goodorservice,whichisanitemthatisproducedbyonefirm,boughtbyanother

firm,andusedasacomponentofafinalgoodorservice.

Whereproduced:Onlythegoodsandservicesproducedwithinacountryarecounted.SoaHondaproducedinNorthCarolinaiscountedinU.S.GDP.

When

produced:

GDP

measures

production

during

a

given

period

of

time,

typically

a

quarterofayearorayear.

Circular Flows in the U.S. Economy

Inthegoodsmarket,households,firms,governments,andforeignersbuygoodsandservices.

Consumption expenditure,C,istheexpenditurebyhouseholdsonconsumptiongoodsandservices.

Investment,I,isthepurchasesofnewcapitalgoods(tools,instruments,machines,buildings,andotheritems)andadditionstoinventories.

Government expenditures on goods and services,G,istheexpendituresbyalllevelsofthegovernmentongoodsandservices.

Net exports of goods and services,

NX,

is

the

value

of

exports

of

goods

and

services

minusthevalueofimportsofgoodsandservices.Exports of goods and servicesare

theitemsthatfirmsintheUnitedStatesproduceandselltotherestoftheworld.

Imports of goods and servicesaretheitemsthathouseholds,firms,andgovern

mentsintheUnitedStatesbuyfromtherestoftheworld.

Governmenttransferpayments,suchasSocialSecuritypayments,arenotpartofgovernmentexpendituresongoodsandservicesbecausetheseexpendituresincludeonlyfundsusedbythegovernmenttobuygoodsandservices.Transferpaymentsarenotbuyingagoodorserviceforthegovernmentandsoarenotincludedingovernmentexpendituresongoodsandservices.

Total Expenditure

TotalexpenditureequalsC+I+G+(XM). Householdsreceivewages,capital,interest,rent,andprofitasincome.Somepartoftotal

incomeisnotpaidouttohouseholdsbyfirms,butfromaneconomicstandpoint,this

undistributedprofitisincomepaidtohouseholdsandthenloanedbacktofirms.

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Expenditure Equals Income

Becausefirmspayoutasincomeeverythingtheyreceiveasrevenuefromsellinggoodsandservices,totalincome,Y,equalstotalexpenditure.So:

Y=C+I+G+(XM). Forafirm,thevalueofitsproductionisthecostoftheproduction,whichequalsthein

come

generated

by

the

production.

So

the

value

of

production

equals

income

equals

ex

penditure,or

GDP=Y=C+I+G+(XM). 20.2 Measuring U.S. GDPThe Expenditure Approach

TheexpenditureapproachmeasuresGDPasthesumofconsumptionexpenditure,C,investment,I,governmentexpendituresongoodsandservices,G,andnetexportsofgoods

andservices,(XM).SoGDP=C+I+G+(XM)or,inthesecondquarterof2005,annualized,andintrillionsofdollars,$8.7+$2.1+$2.3+$0.7=$12.4.

ExpendituresnotinGDPinclude: Usedgoods:ExpendituresonusedgoodsarenotpartofcurrentGDPbecausethese

goodswerepartofGDPduringtheperiodinwhichtheywereproduced.

Financialassets:Thepurchaseoffinancialassets,suchasstocks,isnotpartofGDPbecausethesearenotexpendituresongoodsandservices.

The Income Approach

TheincomeapproachmeasuresbyGDPinseveralsteps: Theincomeapproachstartswiththesumofwagesplusinterest,rent,andprofit

(calledoperatingsurplusinthenationalincomeaccounts).Thissumequalsnetdo

mesticincomeatfactorcost.

Tochangethemeasurefromfactorcosttomarketprice,indirecttaxeslesssubsidiesare

added

because

these

are

government

taxes

and

transfers

that

affect

market

prices.

Thenextstepaddsdepreciation,thedecreaseinthevalueofcapitalthatresultsfromitsuseandobsolescence.

Ifeverythingismeasuredcorrectly,addingdepreciationwouldyieldGDP.Butthereoftenisastatisticaldiscrepancy,thedifferencebetweentheexpenditureapproach

andtheincomeapproach.Thedifferenceismeasuredastheexpenditureapproach

minustheincomeapproach,soanystatisticaldiscrepancyisaddedtoyieldthein

comeapproachGDP.

GDP and Related Measures of Production and Income

Grossnationalproduct,(GNP)isthemarketvalueofallfinalgoodsandservicesproducedanywhereintheworldinagiventimeperiodbythefactorsofproductionsup

plied

by

the

residents

of

the

country.

So

pharmaceutical

drugs

produced

in

Ireland

by

a

U.S.drugcompanyispartofU.S.GNPbutnotpartofU.S.GDP.

U.S.GNPequalsU.S.GDPplusnetfactorincomefromabroad.

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Disposablepersonalincomeistheincomereceivedbyhouseholdsminuspersonalincometaxespaid.ItequalsGNPminusdepreciationminusanystatisticaldiscrepancymi

nusretainedprofitsbybusinessesplustransferpaymentsminuspersonalincometaxes.

20.3 Nominal GDP Versus Real GDPThe

market

value

of

production

and

hence

GDP

can

increase

either

because

the

production

of

goodsandservicesarehigherorbecausethepricesofgoodsandservicesarehigher.

Calculating Real GDP

RealGDPallowsthequantitiesofproductiontobecomparedacrosstime.Real GDPisthevalueoffinalgoodsandservicesproducedinagivenyearexpressedinthepricesofa

baseyear.

Nominal GDPisthevalueofthefinalgoodsandservicesproducedinagivenyearexpressedinthepricesofthatsameyear.

Traditionally,realGDPiscalculatedusingpricesofthebaseyear(theyearinwhichrealGDP=nominalGDP).Butthismethodhasbeengenerallyreplacedwithanew,chained

dollarmethodthatusesthepricesoftwoadjacentyearstocalculatetherealGDPgrowth

rateandthenusesthegrowthratestocreateachainlinkingthebaseyearrealGDPtotherealGDPinfutureyears.

The Chained-Dollar Method for Calculating Real GDP

Thetoptabletotherighthasdatafor2005foraneconomy

thatproducesonlybooksand

coffee.In2005,nominalGDPis

$3,000.Thesecondtabletothe

righthasdatafor2006.In2006,

nominalGDPis$6,000.

NominalGDPhasdoubledbuthowmuchhasrealGDP

changedbetweentheseyears?

TodeterminehowrealGDPchanges,supposethat2005is

thebaseyear.Thenweneedto

determinethegrowthratebe

tween2005and2006bycalcu

latingGDPinbothyearsusing

2005pricesandcalculating

GDPinbothyearsusing2006

prices.

GDPDatafor2005

Item Quantity Price MarketValue

Books 40 $25 $1,000

Coffee 1,000 $2 $2,000

NominalGDP $3,000

GDPDatafor2006


Books 50 $30 $1,500

Coffee 1,500 $3 $4,500

NominalGDP $6,000

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Using2005prices,realGDPincreasesfrom$3,000(thefirstta

ble)to$4,250(thethirdtable).

Using2005prices,realGDPhas

grownby[($4,250$3,000)

$3,000]100=41.7percent.

Using2006prices,realGDPincreasesfrom$4,200(thefourth

table)to$6,000(thesecondta

ble).Using2006prices,realGDP

hasgrownby[($6,000$4,200)

$4,200]100=42.9percent.

TheaveragegrowthrateofrealGDPisequalto(41.7percent+

42.9percent)2=42.3percent.

SorealGDPbetweentheseyears

hasgrownby42.3percent.If

2005is

the

base

year,

real

GDP

in

2006is$3,0001.423=$4,269.

Calculating the GDP Deflator

TheGDP deflatoristheaverageofcurrentyearpricesexpressedasapercentageofbaseyearprices.Intermsofaformula,GDPdeflator=(NominalGDPRealGDP)100.

Usingtheexampleworkedabove,nominalGDPin2006is$6,000andrealGDPis$4,269.SotheGDPdeflatorfor2006is($6,000$4,269)100=140.5.

20.4 The Use and Limitations of Real GDPRealGDPcanbeusedtocomparethestandardoflivingovertimeandtocomparethestandard

ofliving

among

countries.

The Standard of Living Over Time

RealGDPperpersoncanbeusedtocomparethestandardofliving.Real GDP per per-sonisrealGDPdividedbythepopulation.

IntheUnitedStates,realGDPperpersonis2.4timeslargerthanitwasin1964.RealGDPperpersonhasdoubledaboutevery30yearsforthepast100years.

FluctuationsinthegrowthofrealGDPreflectbusinesscycles.Abusiness cycleistheperiodicbutirregularupanddownmovementoftotalproductionandothermeasuresof

economicactivity.Businesscycleshavefourstages:

Expansion:TheexpansionphaseistheperiodduringwhichrealGDPisincreasing. Peak:Anexpansioncontinuesuntilapeakisreach.Apeakisthehighestlevelofreal

GDPyetattained.

2006Quantitiesand2005Prices


Books 50 $25 $1,250

Coffee

1500

$2

$3,000

RealGDP(2005dollars)

$4,250

2005Quantitiesand2006Prices


Books 40 $30 $1,200

Coffee 1,000 $3 $3,000

RealGDP(2006dollars)

$4,200

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Recession:Followingthepeakisarecession.ArecessionisperiodduringwhichrealGDPdecreasesforatleastsixmonths.

Trough:Aftertherecessionisthetrough,thelowpointinrealGDPafterwhichfollowsanexpansion.

The Standard of Living Among Countries

Tocompare

real

GDP

per

person

among

countries,

the

real

GDPs

should

be

calculated

using

a

commonsetofprices,calledpurchasingpowerparityprices.Whenthisisdown(asthedatainChapter2show)U.S.realGDPperpersonmeasuredasincomeperpersonishigherthaninother

advancedeconomies.

Goods and Services Omitted From GDP

GDPmeasuresthevalueofgoodsandservicesthatareboughtinmarkets,soitexcludes:

HouseholdProduction:Householdproductionisproductiveactivitiesatthehomethatdonotinvolvemarkettransactions.Asmoreservices,suchaschildcare,areprovidedinthe

marketplace,themeasuredgrowthrateoverstatesdevelopmentofalleconomicactivity.

UndergroundProduction:Undergroundproductionisthepartoftheeconomythatishiddenfromtheviewofthegovernmenteitherbecausepeoplewanttoavoidtaxesand

regulationsor

because

the

goods

and

services

being

produced

are

illegal.If

the

under

groundeconomyisareasonablystableproportionofalleconomicactivity,thegrowth

ratewillbeaccurate.

LeisureTime:LeisuretimeisaneconomicgoodthatdoesnotgetmeasuredintheofficialGDPfigures.Increasesinleisuretimelowertheeconomicgrowthrate,butwevalueour

leisuretimeandwearebetteroffwithit.

EnvironmentalQuality:Pollutiondoesnotdirectlylowertheeconomicgrowthrate.Ifourstandardoflivingisadverselyaffectedbypollution,ourGDPmeasuredoesnotshow

thisfact.Thereasonisthatthedevicesthatweproducetomitigatepollutioncountas

partofGDPbutthepollutionitselfisnotsubtracted

Other Influences on the Standard of Living

Omittedfrom

GDP

but

important

for

the

standard

of

living

is:

HealthandLifeExpectancy:Whileobviouslyimportantfactorsdeterminingthestandardofpeoplesliving,theyareomittedfromrealGDP.Healthandlifeexpectancyhaveim

provedasinfantdeathsanddeathinchildbirthhavealmostbeeneliminated.Lifeexpec

tancyhasincreasedfrom70yearsattheendofWWIItonearly80yearstoday.These

gainshavebeencheckedsomewhatbyAIDSanddrugabuse,whichtakeawayfromour

standardofliving.

PoliticalFreedomandSocialJustice:PoliticalfreedomandsocialjusticearenotmeasuredbyrealGDP.AcountrymightenjoyaverylargeGDPbuthavelimitedpoliticalfreedom

andsocialjusticeandhencehavealowerstandardofliving.

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Lecture Launchers1. Asteachers,weoftendont liketowritedefinitionsontheboard.Wewill

askstudentstorefertothetextorwemighthurriedlyverbalizethem.This

generalpropensityisamissedopportunitytofocusontheeleganceofthe

definitionofGDP.Fromthetext,GDPisdefinedas:GrossDomesticProd

uctis

the

market

value

of

all

the

final

goods

and

services

produced

within

acountryinagiventimeperiod.Askyourstudentstogothroughthedefini

tionandpullouttheessentialparts.Youwillgetthislist:marketvalue,fi

nalgoodsandservices,produced,withinacountry,and timeperiod.Ex

plainthatthewordschoseninthisdefinitionwereselectedcarefully.First,

ifthephrasemarketvaluehadbeenleftout,therewouldberoomforlots

ofproblems.Noticethatwhenthegovernmentreportsthisfigure,itdoesnt

announcehowmany trains,planes,andautomobiles thecountryhaspro

ducedbutratheritannouncesamonetaryvalue.Usingmonetaryvaluesaf

fordsus theopportunitytobeabletogetaroundtheproblemofaggrega

tionwhen the items inquestionaremarkedlydifferent.Wesolve itbyal

lowing themarketplace todetermine theweights.Thesecond itemon the

list isfinalgoodsandservices.Theexplanationhere isstraightforward:

Wearedistinguishingbetween finalproductsand intermediateproducts.

Intermediategoodsaregoodsthatareboughtbyonefirmtobeusedinthe

productionofanothergoodthatwillbeultimatelyconsumed.Ifweinclude

theseintermediategoods,thenwewoulddoublecountthenationsoutput.

Now we come to theword produced.Thisword is to make clear that

sales are not important. If we only counted sales, then the GDP figures

wouldunderstateproductionbecausenotalloutputissold.Someofitbe

comes inventory.Next is thephrasewithinacountry.Thisphrase is to

makeclearthatwedontcountoutputthatwasntproducedonanations

soilregardlessofwhowasresponsibleforproducingit.Lastly,isthephrase

timeperiod.

Here

we

want

to

make

unambiguous

that

we

are

only

talk

ingaboutproduction thatoccurred inacertainperiod.Thisphrase leaves

nodoubtthatproductionofagoodorserviceproducedinaprevioustime

period(even ifperhapssold in thepresent timeperiod)doesnotcount in

thisperiodsGDP.

2. You might like to tell your students thatmeasuring realGDP is actually

verycheap.TheBEA(intheDepartmentofCommerce)employsfewerthan

500 economists, accountants, statisticians, and IT specialists at an annual

costoflessthat$70million.ItcostseachAmericanlessthan0.25(aquarter

ofacent)tomeasurethevalueofthenationsproduction.Forsomefurther

perspective,theNationalOceanicandAtmosphericAdministration(alsoin

theDepartment

of

Commerce),

whose

mission

is

to

describe

and

predict

changes in theEarthsenvironment,andconserveandmanagewisely the

nationscoastalandmarineresourcessoastoensuresustainableeconomic

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opportunities,employsmorethan11,000scientistsandsupportpersonnel

atanannualcostof$3.2billion!

MostoftheincomedatausedbytheBEAcomesfromtheIRS.Expendi

turedatacomesfromavarietyofsources.

Inrecentyears,thefirstestimatesofGDP,whicharebasedoncompanies

reported

profits,

have

been

revised

downward

when

data

on

company

profitsasreportedtotheIRSbecameavailable.Enronstyleaccountinghas

contaminatedtheinitialestimatesofGDPbutnotthefinalestimates.

Youcanmakeanicepointwithoneexampleofcreativeaccounting.For

someyears,initsreportstoshareholdersAOLrecordeditsadvertisingex

penditureasinvestmentandamortizeditoveranumberofyears.

First,youcanexplainthatthecorrecttreatmentofthisitem isasanex

penditure on intermediate goods and servicesby AOL and as a charge

againstAOLsprofit.YoucangoontoexplainthatAOLsaccountingprac

ticewouldmisleadinglyswellGDPbycausingsomedoublecounting.On

theexpenditureapproach,AOLsadvertisingexpenditureshowsupas in

vestment in the national accounts. On the income approach,because the

expenditure is not a cost, it swells profit, so AOLs corporate profit in

creasesbythesameamountasitsinvestment.IfAOLfileditsincometax

return in this same way, the national income accounts wouldnt get cor

rected.ButwhenAOLfilesitstaxreturns,itcallsitsadvertisingacostand

lowers itsprofitsby thatamount.TheBEApicksup thesenumbers from

theIRSandthenationalaccountsgetadjustedappropriately.Thedifference

inreportednumbersbyAOL indicateswhy thestatisticaldiscrepancybe

tween the expenditure and income approaches tomeasuringGDP exists.

One question students might ask ishowbig is thediscrepancy.You can

showthemthatthestatisticaldiscrepancyisasmallpercentageoftheover

allfigures.Ifthediscrepancysuddenlyvarieswildlyforagivenyear,then

thiswould

indicate

that

the

numbers

need

to

be

rechecked.

This

example

alsohighlightswhywehavedifferentcalculationsforGDP,sothatweare

notrelyingsolelyononesetofestimates

3. AdiscussionofomissionsfromGDPcanarousestudentsinterest.Forex

ample,youmightpointoutthatifoneofyourstudentsmowsher/hisown

lawn,thevalueofthestudentsproductiondoesntshowupinGDP.Butif

youhirethestudenttomowyourlawn(andifyourstudentreportsthein

come earned correctly to the IRS), the value of the students production

doesshowupinGDP.

WhydontwemeasurealllawnmowingaspartofGDP?Somereasons

arecostofcollectingdataandthedegreeofintrusivenesswedbewillingto

tolerate.But

note

how

little

we

spend

on

collecting

the

GDP

data

and

how

relatively inexpensive itwouldbe toadd somequestionsaboutdomestic

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production to either the Labor Force Survey or the Family Expenditure

Survey.

Youmightliketoexplainhowtheomissionofillegalgoodsandservices

also leads to some misleading comparisons. For instance, the daybefore

prohibitionended,theproductionofillegalbeerwasnotcountedaspartof

GDP.

But

the

day

after

prohibition

ended,

the

production

of

now

legal

beer

counted.Askyourstudentstosuggesttwogoodreasonswhyillegalgoods

andservicesareomitted.First,thedataarehardbutnotimpossibletoob

tain.Second, theremaybe themoralposition that illegalactivitiesshould

notbe included inGDP.This latterobservationcan lead toan interesting

discussion.Askthestudentsiftheythinkthattheproductionof,say,mari

juana shouldbe included inGDP.Some,maybeevenmany,of themwill

see no problem with this. Then ask about the production of murderfor

hire. The response, we hope, willbe significantly different. Does such a

goodhaveanyvalue?

4. Foraglobalemphasis,discussmore fullysomeof thedifferences inGDP

acrosscountries.ConsiderwhatisleftoutofGDPandaskstudentstothink

abouthow

well

GDP

measures

welfare.

It

might

be

helpful

to

point

out

that

GDPisameasureofthestandardoflivingbasedonwhatisproducedbut

doesnotsayanythingaboutincomeequalityorwhogetswhatisproduced.

Pointoutagain that this isa focusonapositivequestion (measuringout

put)notanormativequestion(whoshouldgetwhatisproduced).Onepos

sibility is touse the information in theEye on theGlobal Economy. The

HumanDevelopment Index, todiscuss thehumandevelopment indexas

analternativeoradditionalmeasuretocomparedifferenteconomies.Goto

the human development webpage (www.undp.org/hdro) and pull out

some countriesyoumaybe interested in to showdifferenthumandevel

opmentindexes.Youcanthentalkaboutwhataspectsmaybecapturedin

theHDI

that

are

not

captured

with

GDP.

The

human

development

report

websitestatesthattheHDImeasuresaverageachievementsinacountryin

threebasicdimensions:a longandhealthy lifeasmeasuredby lifeexpec

tancyatbirth,knowledgeasmeasuredbytheadultliteracyrateandschool

enrollment,andadecentstandardoflivingasmeasuredbyGDPpercapita

inpurchasingpowerparityU.S.dollars.

Anotherpossibility is tocompare theUnitedStates toEuropeancountries

to highlight why GDP might fall short as an international comparison

number. I discuss some of the things omitted from GDP to examine

whethertheUnitedStateshasahigherlivingstandardthansomeEuropean

countries given that the United States has the highest GDP. There is an

Economistarticle

that

describes

adjustments

to

real

GDP

made

by

Robert

Gordon toaccount fordifferences in leisure,spendingonheating/cooling,

spending on jails, etc... that bring the measure of income between the

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UnitedStatesandEuropemuchclosertogether(Chasingtheleader,Feb

6th2003,TheEconomistprintedition,AreEuropeansreallysomuchworseoff than Americans?; based on the article Two centuries of economic

growth:Europechasing theAmericanfrontier,availableathttp://faculty

web.at.northwestern.edu/economics/gordon/355.pdf). Gordon first adjusts

GDP per capita for the extra leisure time taken in European countries

(bringingEuropesincomepercapitato82percent,fromtheofficialfigure

of77percentofAmericasincomepercapita).Hethenexaminesthehigher

spendingonairconditioningandheatingintheUnitedStatestoaccountfor

moreextremeclimatechangesandthehigherspendingonprisonsandse

curityservicesintheUnitedStatestoaccountforthehighercrimerate.Fi

nally,hediscussesthehigherspendingonroadsandenergyintheUnited

Statestoaccountforthegreaterdispersionofindividualsinsuburbanareas

with little public transportation options. Taking account of this greater

wastefulspending intheUnitedStatesandplacingavalueonEuropes

public transport system and the greater amount of leisure time,he finds

thatEuropesadjusted incomepercapita is92percentofU.S. incomeper

capita,much

closer

than

the

77

percent

based

on

GDP

per

capita.

Introduc

ingafewoftheseideascanleadtoaninterestingdiscussionofculturaldif

ferencesandthechoicesmadebyindividualsthatmaynotbemeasuredby

GDP. Invariably students will point out that some of these may notbe

wasteful spendingbut simply indicatedifferences inattitude, suchas the

valueplacedonlargerhousesandyardsascomparedtotheconcentration

andsizeofhomesinmanyEuropeancountries.

Land Mines1. Atanintuitivelevel,theequalitybetweenincomeandexpenditureisnota

difficult concept to get across. It makes sense to students that whatever

someonespends

must

ultimately

end

up

as

income

to

someone

else.

The

problemcomeswhenweput this intopractice.Thereasonhastodowith

the fact that thereare twononincomechargesagainstGDP (depreciation

andindirecttaxeslesssubsidies).Iftheyareignored,thenwhenusingthe

incomeapproach the figureobtainedwillbe less than the figureobtained

usingtheexpenditureapproach.

Asalwayswearefacedwithatradeoff.Youcanproceedimmediatelyto

introducedepreciationand indirect taxes lesssubsidiesanddoacompre

hensivejob.Itwillbeaccurate,butyoursimpleandpowerfulpointthatin

comeequalsexpenditurewillbelost.Thesecondalternativeistowaitand

lettheintuitiveequalitysinkin.Thisprocedurehasthebenefitofpreserv

ingthe

expenditure/income

equality

without

prematurely

exhausting

your

students.Thedownside is thatyoudelay the inevitable.Youwilleventu

allyhavetoexplainthediscrepancysometime.

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2. StudentsoftengetcaughtupinthemathwhencalculatingtheGDPdeflator

and forgetwhat thepoint is to thesecalculations.Youmightwant touse

theEyeontheEconomy,DeflatingtheGDPBalloon,beforepresentingany

formulas.EmphasizetheintuitionthatrealGDPgivesameasureoftheac

tualoutputproduced.Pointout thatnominalGDPcan increasedue toan

increaseinthegoodsandservicesproducedorduetoanincreaseinprices.

When wemeasuregrowth, however,we want toknow how much more

stuff isproduced.Thus, to focusjustonoutputchanges,wehave to take

outthepricechanges.ThisisexactlywhatthecalculationofrealGDPdoes.

3. GDPisprobablyoneofthemostwidelyreportedeconomicstatisticsinthe

world.Itispartofnewsstoriesontelevision,radio,andnewspapers.Busi

nesses,consumers,investors,andgovernmentofficialshaveallcometode

pendonitasayardstickofeconomicprogress.However,aswithjustabout

anyeconomicstatistic ithas itsflaws.Themostprominentshortcoming is

thatitisnotaperfectmeasureofsocialwelfare.Thetextdoesaverygood

joboutliningsomeoftheseproblems.However,itisanareathatstilltrips

up

a

good

many

students.

So

if

wouldnt

be

a

bad

idea

to

spend

extra

time

withsomeofthecentralissues.

Lets take the environment. Suppose the

economyisoperatingatfullemploymenton

theproductionpossibilitiesfrontier.Assume

furthermore that GDP increases along the

frontier, as depicted in the figure by the

movementfrompointAtopointB.Askyour

students if this movement necessarily

involves an improvement in this countrys

standard of living. Granted, output has

expanded,

but

it

has

come

at

the

expense

of

a dirtier environment. Most students will

respondby saying that it is difficult to say

because it depends onjust howbadly the

environmenthasdeteriorated.Thatistosay,

if the increase in GDP more than

compensatesforthereductioninthequality

of the environment, then perhaps it is a

welfareenhancingmoveandthestandardof

livinghas indeedgoneup.Pointoutthatthis issue isthecruxof thecon

troversymeasuringsomethingaselusiveasacleanenvironment.

Youmight considerasking students if there isanywayoutof thisdi

lemma.One

possible

answer

is

that

the

standard

of

living

could

actually

improve ifthereweredevelopmentsthatpushedtheproductionpossibili

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tiesfrontieroutward.Inthiscase,wewouldbeintheenviablepositionof

beingabletoenjoyahigherGDPcoupledwithgreaterenvironmentalqual

ity.

Towrapup thediscussionyoumightwant tomakeaconnectionwith

thislectureandthematerialcoveredinChapter4onDemandandSupply.

First,

ask

students

what

kind

of

a

good

they

think

the

environment

is.

That

is,ask them if it isanormalgoodoran inferiorgood.Theymightbalkat

firstattheideabyquestioningwhetheritisagoodinthefirstplace.Dont

let this problem derail you from your task. Explain that there are many

things thatwe enjoy thatarenotnecessarilyboughtand sold inmarkets

thatqualifyasgoods.Acleanenvironment is something that is injustas

much demand as national defense, fire protection, or a safe workplace.

With this discussion, someone isbound to say that the environment is a

normalgood.Refreshtheirmemorybyrestatingwhatittakesforagoodto

beanormalgood.Nowyoucanpointoutthatwehaveananswerforour

dilemma in the production possibilities frontier. That is, as a nation ex

pandsitsnationaloutputthereis,foratime,damagedonetotheenviron

ment.However,

as

anation

prospers

it

has

agreater

demand

and

prefer

enceforacleanerenvironment.And,youcanpointoutthatthisoutcomeis

exactlywhathappenedinEurope.WhenthericherWestGermanyreunited

withthepoorerEastGermanyinthelate1980s,observerswerestunnedby

how environmentally dirty East Germany was, especially compared to

WestGermany!

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ANSWERS TO CHECKPOINT EXERCISES

CHECKPOINT 20.1: GDP, Income, and Expenditure1a. Thefertilizerisanintermediategoodbecauseitwillbeusedtogrowtoma

toes.

1b.

Theringtone

is

a

final

good

because

you

are

the

final

user.

It

is

part

of

con

sumptionexpenditure.

1c. Thecomputersareafinalgood.BecausetheyarepurchasedbyPepsi,they

areinvestment.

1d. TheaircraftboughtbySouthwestAirlinesisafinalgood.Becausetheyare

purchasedbySouthwestAirlines,theyareinvestment.

2a. Totalexpenditureequalsthesumofconsumptionexpenditure,investment,

governmentexpenditure,andnetexports.SoGDPequals$60million+$25

million+$15million+$0=$100million.

2b. Totalincomeequalstotalexpenditure,sototalincomeequals$100million.

2c. To calculate net taxes, subtract from households total income their con

sumptionexpenditure

and

their

saving.

Total

income

equals

total

expendi

ture,sototalincomeequals$100million.Consumptionexpenditurewas$60

millionandsavingwas$20million,sonettaxesequals$20million.

CHECKPOINT 20.2: Measuring U.S. GDP1a. Using theexpenditureapproach,GDP=C+ I+G+NX=$7,376billion+

$1,579billion+$1,957billion$425billion=$10,487billion.

1b. Usingtheincomeapproach,netdomesticproductatfactorcost=Wages+

Interest,rent,andprofit=$6,075billion+$2,399billion=$8,474billion.

1c. The statistical discrepancy equals the GDP expenditure total minus the

GDP income total. GDP calculated using the expenditure approach is

$10,487billion.

To

calculate

GDP

using

the

income

approach,

to

net

domes

ticproductatfactorcostwemustaddindirecttaxeslesssubsidiesandthen

adddepreciation.SoGDPusingtheincomeapproachequals$8,474billion

+ $724 billion + $1,304 = $10,502. So the statistical discrepancy equals

$10,487$10,502=$15billion.

1d. GNPequalsGDPplusnetfactorincomefromabroad,sothedifferencebe

tween the two isnet factor income from abroad.Net factor income from

abroad=GNPGDP,sousingthedata intheproblem,netfactor income

fromabroad=$10,514billion$10,487billion=$27billion.

1e. U.S. national income = GNP depreciation statistical discrepancy =

$10,514billion$1,304billion($15billion)=$9,225billion.

1f.

Disposablepersonal

income

=national

income

retained

profits

plus

trans

ferpaymentspersonalincometaxes=$9,225billon$347billion$1,051

billion=$7,827billion.

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1g. AsapercentageofU.S.national income,disposable income is ($7,827bil

lion$9,225billion)100=84.8percent.

1h. Asapercentageofdisposablepersonalincome,consumptionis($7,376bil

lion$7,827billion)100=94,2percent.

CHECKPOINT 20.3: Nominal GDP Versus Real GDP

1a. NominalGDPin2004=($1590)+($2020)=$1,350+$400=$1,750.

1b. NominalGDPin2005=($20100)+($2525)=$2,000+$625=$2,625.

1c. Thevalueof 2005production in2004prices is ($15 100) + ($20 25) =

$1,500+$500=$2,000.

1d. In2004prices,thevalueofproduction increasedfrom$1,750to$2,000,an

increase of $250. The percentage increase is ($250 $1,750) 100, which

is14.29percent.

1e. Thevalueof2004productionin2005pricesis($2090)+($2520)=$1,800

+$500=$2,300.

1f. In2005prices,thevalueofproduction increasedfrom$2,300to$2,625,an

increaseof

$325.

The

percentage

increase

is

($325

$2,300)

100,

which

is

14.13percent.

1g. RealGDP in2004=$1,750.It isequaltothenominalGDPbecause2004is

thebaseyear.TocalculaterealGDPin2005computethegrowthrateofreal

GDPbetween2004and2005.Thatgrowthrateistheaverageofthegrowth

ratesbetween2004and2005usingpricesfrom2004andusingpricesfrom

2005.Theanswerstoparts(d)and(f)giveusthesegrowthrates.Theaver

agepercentage increase is14.21percent.SorealGDP in2005 is14.21per

centgreater than realGDP in2004.RealGDP in2004was$1,750, soreal

GDPin2005equals($1,750)(1.1421)=$1,999.

1h. TheGDPdeflator=(NominalGDPRealGDP)100=($2,625$1,999)

100

=

131.

CHECKPOINT 20.4: Real GDP and the Standard of Living1. The relativelyhigh lifeexpectancyandpolitical freedommeansCanadas

and theUnitedStates relative rankings rise.The low lifeexpectancyand

politicalfreedomdecreaseChinasandRussiasrankings.

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ANSWERS TO CHAPTER CHECKPOINT EXERCISES

1. FlowQisincome.FlowRisnettaxes.FlowUisgovernmentexpenditures

ongoodsandservices.FlowVissaving.FlowWisconsumptionexpendi

ture.FlowX is firmsborrowing for investment.FlowZ isnetexportsof

goodsandservices.

2a. GDPequalsC+I+G+NX.Rearranging,NX=GDPCIG.SoIberiasnetexportsequal$100billion$67billion$21billion$20billion,which

is$8billion.

2b. Netexportsequalexports imports,so importsequalexportsminusnet

exports.Iberias importsequal$30billion($8billion),whichis$38bil

lion.

2b. Frompart(a),Iberiasnetexportsare$8billion.

2c. FlowQequals$100billion.FlowRisnettaxesandequals$18billion.Flow

U isgovernmentexpendituresongoodsandservicesandequals$20bil

lion.FlowV issavingandequals$15billion.FlowW isconsumptionex

penditure and equals $67billion.Flow X is firmsborrowing for invest

mentand

equals

$21

billion.

Flow

Z

is

net

exports

of

goods

and

services

andequals$8billion.

3a. FlowQisincome,Y.RecallthatYequalsC+I+G+NX.FlowUisgovernmentexpendituresongoodsand services,G; flowW isconsumptionex

penditure, C; flow X is investment, I; and flow Z isnet exports, NX.So

flowQ=$7,376billion+$1,579billion+$1,957billion$424billion,which

is$10,488billion.

3b. FlowR isnet taxespaid to thegovernmentand flowV issaving.House

holdsdividetheirincome,flowQof$10,488billion,intoconsumptionex

penditure, flowW(equal to$7,376billion),net taxes, flowR,andsaving,

flowV

.

So

the

sum

of

net

taxes

plus

saving

(flowR

+

flowV

)

equals

income

(flow Q)minusconsumptionexpenditure (flowW),which is$10,488bil

lion$7,376billion=$3,112billion.

3c. GDPequalsincome,flowQ.SoGDPequals$10,488billion.

4a. FlowQ is income,Y.FlowX is investment.YequalsC+I+G+NX.Rearranging,I=YCGNX.FlowUisgovernmentexpendituresongoodsandservices,G;flowWisconsumptionexpenditure,C;and,flowZisnet

exports,NX.So flowX=$1,092billion$621billion$231billion$56

billion,whichis$184billion.

4b. GDPequalsincome,flowQ.SoGDPequals$1,092billion.

5a. For the expenditure approach, GDP equals the sum of consumption ex

penditure,investment,

government

expenditures

on

goods

and

services,

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andnetexports.Fortunately, thesedatawere saved from the fire.Hence

GDP=C+I+G+NX=$2,000+$800+$400$200=$3,000.5b. From the incomeapproach,GDPequals the sumofwagesplus interest,

rent, and profit plus indirect taxes less subsidies plus depreciation. The

value of the income approach GDP survived the fire and is $2,900. The

sum

of

wages

plus

interest,

rent,

and

profit

plus

indirect

taxes

less

subsi

diesequals$2,000+$500+$100=$2,600.Sodepreciationequals$2,900

$2,600=$300.

5c. Netdomesticproductatfactorcostequalsthesumofwages,interest,rent,

andprofit.Onceagain,allthesedatawerefortunatelysavedfromthefire,

sonetdomesticproductatfactorcost=$2,000+$500=$2,500.

5d. The statistical discrepancy equals GDP from the expenditure approach,

$3,000frompart(a),minusGDPfromtheincomeapproach,$2,900.Sothe

statisticaldiscrepancyis$100.

5e. GNPequalsGDPplusnetfactorincomefromabroad.Formpart(a),GDP

is$3,000.Netfactorincomefromabroadis$50.SoGNPequals$3,000+$50

=$3,050.

6a. TheGDPdeflatorequals(nominalGDPrealGDP)100.SotheGDPde

flator in2004equals ($11,734.4billion$10,755.7billion)100,which is

109.1.

6b. TheGDPdeflator in thebaseyearequals100.0because in thebaseyear

nominalGDPequalsrealGDP.

6c. Thepricelevelroseby9.1percent.

6d. RealGDProseby($10,755.7billion$9,817billion)$9,817billion100,

whichis9.6percent.

6e. NominalGDProseby($11,734.3billion$9,817billion)$9,817billion

100,whichis19.5percent.

7a.

NominalGDP

equals

(real

GDP

GDP

deflator)

100.

So

nominal

GDP

in

1990equals($7,112.5billion81.6)100,whichis$5,803.8billion.

7b. NominalGDPequals(realGDPGDPdeflator)100.SonominalGDPin

2004equals($10,755.7billion109.1)100,whichis$11,734.5billion.

7c. NominalGDProseby($11,734.5billion$5,803.8billion)$5,803.8billion

100,whichis102.2percent.

7d. Thepercentage increase inproduction ismeasuredby thepercentage in

creaseinrealGDP.RealGDProseby($10,755.7$7,112.5)$7,112.5100,

whichis51.2percent.

7e. Thepercentageincreaseinthecostoflivingismeasuredbythepercentage

increaseinthepricelevel.Thepricelevelroseby(109.181.6)81.6100,

whichis

33.7

percent.

8a. NominalGDPin2005is(40)($2)+(60)($3)=$80+$180,whichis$260.

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8b. NominalGDP in2006 is (44) ($3)+ (72) ($2)=$132+$144,which is

$276.

8c. RealGDP in2006usingthetraditionalmethodvaluesproduction in2006

using2005prices.So the traditionalmeasureofrealGDP is (44) ($2)+

(72)($3)=$88+$216,whichis$304.

8d.

The

chained

dollar

method

multiplies

real

GDP

in

the

previous

year

by

the

averagegrowthrateofGDPovertheyear,wheretheaveragegrowthrate

istheaverageofthegrowthratewhenpreviousyearpricesareusedand

whencurrentyearpricesareused.

RealGDPinthebaseyearisthesameasnominalGDP,sorealGDPin2005

is$260.GDP in2006using2005prices is (44) ($2)+ (72) ($3)=$88+

$216,whichis$304.GDP in2005using2005pricesis$260.SoGDPusing

2005pricesgrewby($304$260)$260100=16.9percent.

GDP in 2005using 2006prices is (40) ($3) + (60) ($2)= $120 + $120,

which is$240.GDP in2006using2006prices is$276.SoGDPusing2006

pricesgrewby($276$240)$240100=15.0percent.

The

average

growth

rate

is

16.0

percent.

So,

real

GDP

in

2006

using

the

chaineddollarmethodis($260)1.160,whichis$302.

8e. TheGDPdeflatorequals(nominalGDPrealGDP)100.SotheGDPde

flatorin2006equals($276$302)100,whichis91.4.

8f. ProductionismeasuredbyrealGDPandrealGDPgrewby16percent.

9a. NominalGDPin2003is(50)($3)+(72)($3)=$150+$216,whichis$366.

9b. NominalGDPin2008is(51)($4)+(80)($6)=$204+$480,whichis$684.

9c. RealGDP in2007usingthetraditionalmethodvaluesproduction in2007

using2005prices.So the traditionalmeasureofrealGDP is (50) ($2)+

(72)($3)=$100+$216,whichis$316.

9d. RealGDP in2008usingthetraditionalmethodvaluesproduction in2008

using2005

prices.

So

the

traditional

measure

of

real

GDP

is

(51)

($2)

+

(80)($3)=$102+$240,whichis$342.

9e. ThechaineddollarmethodmultipliesrealGDPinthepreviousyearbythe



whencurrentyearpricesareused.

Frompart (d)of thepreviousexercise,realGDP in2006 is$302.GDP in

2007using2006prices is (50) ($3)+ (72) ($2)=$150+$144,which is

$294. GDP in 2006 using 2006 prices is $276. So GDP using 2006 prices

grewby($294$276)$276100=6.5percent.

GDP in2007using2007prices is$366.GDP in2006using2007prices is

(44)

($3)

+(72)

($3)

=$132

+$216,

which

is

$348.

So

GDP

using

2007


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The average growth rate is 5.9 percent. So, real GDP in 2007 using the


9f. ThechaineddollarmethodmultipliesrealGDPinthepreviousyearbythe



when

current

year

prices

are

used.

Frompart(e),realGDP in2007 is$320.GDP in2008using2007prices is

(51)($3)+(80)($3)=$153+$240,whichis$393.GDPin2007using2007

pricesis$366.SoGDPusing2007pricesgrewby($393$366)$266100

=7.4percent.

GDP in2008using2008prices is$684.GDP in2007using2008prices is

(50) ($4)+ (72) ($6)=$200+$432,which is$652.SoGDPusing2008


The average growth rate is 6.2 percent. So, real GDP in 2008 using the


9g. TheGDPdeflatorequals(nominalGDPrealGDP)100.SotheGDPde

flator

in

2007

equals

($366

$320)

100,

which

is

114.4.

And

the

GDP

de

flatorin2008equals($684$340)100,whichis201.2.

9h. ProductionismeasuredusingrealGDP.Between2006and2008,realGDP

increasedfrom$302to$340,whichisa12.6percentincrease.

9i. The cost of living is measured using the price level. Between 2006 and

2008,thepricelevelrosefrom91.4to201.2,whichisanincreaseof120per

cent.

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Critical Thinking10a.Goods and services produced within the United States are part of U.S.

GDP.Boeingsdecisiontoproduceitsnew787airlinerinJapanmeansthat

thisproduction isnotproducedwithin theUnitedStatesand so it isnot

partofU.S.GDP.Goodsandservicesproducedanywhereintheworldus

ingfactors

of

production

supplied

by

residents

of

the

United

States

are

partofU.S.GNP.Boeingsdecision toproduce airliners inJapanmeans

that Boeing will supplyU.S. owned factors production toJapan. For in

stance,U.S.engineersemployedbyBoeingandworkinginJapanareaU.S.

factorofproductionproducingagoodinanothercountry.Sopaymentsto

U.S.engineersandotherU.S.citizensaswellaspaymentstootherU.S.fac

torsofproduction,suchasBoeingsprofit,willbeincludedinU.S.GNP.

10b.Goods and services produced within the United States are part of U.S.

GDP. So Toyotas decision to outsource its manufacture of cars to Ken

tuckymeansthatthisproductionwillbeincludedaspartofU.S.GDPbe

causeittakesplacewithintheUnitedStates.Goodsandservicesproduced

anywherein

the

world

using

factors

of

production

supplied

by

residents

of

theUnitedStatesarepartofU.S.GNP.Someof thefactorsofproduction

making theToyota carsareJapanese factorsofproduction,For instance,

Japanese engineersworking inKentuckyareJapanese notU.S. factorsof

production.ThepaymentstoalltheJapanesefactorsofproductionwork

inginKentuckyarenotpartofU.S.GNP

11. Undergroundeconomicactivitiesundermine (!) theusefulnessof thena

tional income accounts. For example, there is abias in the comparison

when comparing GDP in an Eastern European country, where under

groundactivitiesareextensive,withGDPinaWesternEuropeancountry,

whereundergroundactivitiesarelessextensive.ComparedtotheWestern

Europeancountry,

the

Eastern

European

countrys

standard

of

living

looks

much lower than itactually is.Undergroundeconomicactivities include

jobsdoneforcashtoavoidpayingtaxes,aswellasproductionandsaleof

illegalgoodsandservices.Someof theseactivitiescontribute to thestan

dardof living.Inparticular,thejobsoffthebooksdoneforcashtoavoid

taxescontributethesameamounttothestandardoflivingasiftheywere

doneonthebooks.IntheUnitedStates,undergroundeconomicactivities

are probably not extensive enough to warrant spending a large sum of

moneyto try tomeasure them.Inothercountries, though,theamountof

underground economic activities may be substantial enough to make

measuringthemaworthwhileendeavor.

12.

Ifthe

United

Nations

is

trying

to

measure

the

standard

of

living,

pollution

andpolitical freedom shouldbe included.Thedifficulty comes indeter

mining theirvalues.For instance,howmuch ispolitical freedomvalued?

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Doweadd50timesthemeasureofpoliticalfreedomtoGDPordoweadd

100 timespolitical freedom toGDP?Another important factor thatcould

be included isthevalueofleisuretime.Thisvalueisabiteasiertocalcu

late.Leisuretimemustbeatleastasvaluableastimespentatwork(orelse

more time wouldbe spent at work) so the wage rate provides a good

measureofthevalueofleisuretime.Thedistributionofincomemightalso

beusedintheUnitedNationsmeasureiftheU.N.isinterestedinmeasur

ingthestandardoflivingofatypicalpersonwithinanation.

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Web Exercises13a.Yourstudentsanswerswillvaryaccordingtowhenyouassigntheprob

lem.Bywayofexample,inJuly2005,themostrecentlyreleaseddatawere

forthe1stquarterof2005.FromtheBEAsWebsite,thenominaldataare:

Consumptionexpenditure (calledpersonalconsumptionexpenditures),

$8,538.5billion;

Investment

(called

gross

private

domestic

investment),

$2,084.5billion;Governmentexpenditures(calledgovernmentconsump

tionexpendituresandgrossinvestment),$2,259.4;andNetexports,$690.7

billion.(Therealdataforthesamequarterare:Consumptionexpenditure,

$7,815.8 billion; Investment, $1,962.9 billion; Government expenditure,

$1,954.8;andNetexports,$637.5billion.)

13b.Thesumofthesefournominalexpenditurecategories is$12,191.7billion,

whichispreciselythesameasthereportednominalGDP.(Thesumofthe

fourrealexpenditurecategoriesis$11,096.0billion,abitdifferentfromthe

reported real GDP of $9,096.2billion. Though the students will notbe

aware of it, the larger difference for the real numbers compared to the

nominalnumbers

is

that

each

of

the

four

real

components

and

real

GDP

is

calculatedseparatelyusingitsownchainofgrowthrates.Sotherealcom

ponentswillnotnecessarilysumtoequalrealGDP.)

13c. Theimplicitpricedeflatorwasreportedas109.873.

13d.NominalGDPwas$12,191.7billion, so realGDP, calculatedbydividing

nominal GDPby the GDP deflator and then multiplyingby 100, equals

($12,191.7billion109.873)100,whichis$11,096.2billion.

13e.The cost of living definitely was higherbecause the GDP deflator was

higher.In2000,thebaseyear,theGDPdeflatorwas100andintherecent

quarteritwas109.873.Pricesincreasedbetween2000andthe1stquarterof

2005,sothecostoflivingincreased.

14a.Your

students

answers

will

vary

according

to

your

state.

14b.Yourstudentsanswerswillvaryaccordingtoyourstate.

15a.Yourstudentsanswerswillvaryaccordingtowhenyouassigntheprob

lem.Foranexampleofananswer,using thedataavailable in2005,U.S.

realGDPperpersoninconstantdollarsin1980was$22,676.53andin2005

was $37,867.28. So in the United States, real GDP per person grewby

[($37,867.28$22,676.53)$22,676.53]100=67.0percent.InJapan,Japa

nese realGDPperperson in constantyen in1980was2,590,421and in

2005was4,202,027.InJapanovertheseyearsrealGDPperpersongrewby

[(4,202,027 2,590,421) 2,590,421] 100 = 62.2 percent. (Source:

http://www.imf.org/external/pubs/ft/weo/2005/01/data/dbginim.cfm).

15b.Yourstudentsanswerswillvaryaccordingtowhenyouassigntheprob

lem.Foranexample, inJuly2005,theU.S.GDPwas20.9percentofworld

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GDP and the Japanese GDP was 6.9 percent of world GDP. (Source:

http://www.imf.org/external/pubs/ft/weo/2005/01/pdf/statappx.pdf) Or, us

ingpurchasingpowerparityGDP, theU.S.GDPwas20.7percentof the

worldGDPandtheJapaneseGDPwas6.7percentoftheworldGDP.(the

sourceofthesedataisthesameasinpart(a)).

15c.

Your

students

answers

will

vary

according

to

when

you

assign

the

prob

lem.ProbablythemajorissueisthattocalculatethelevelofrealGDPper

personinJapanasapercentageofthatintheUnitedStates,estimatesmust

be in thesamecurrency.Foranexampleofananswer,dataongrossdo

mestic product per personbased on purchasingpowerparity prices are

available.(Thesedatacannotbeusedtocalculatethegrowth inrealGDP

perperson inpart(a)becausetheGDPsarenominalGDP.)In2005,Japa

neseGDPperpersonwas$31,384andU.S.GDPperpersonwas$41,557.

SorealGDPperpersoninJapanwas75.5percentthatintheUnitedStates.

15d.Your students answers might vary according to when you assign the

problem.Ingeneral,however,part(a)showsthatU.S.realGDPperperson

grewmorerapidlythatJapaneserealGDPperperson,sothestandardof

livinggrew

more

rapidly

in

the

United

States.

Part

(c)

shows

that

the

stan

dardof living is lower inJapanbecauseJapansGDPperperson isonly

about75percentofGDPperpersonintheUnitedStates.

ADDITIONAL EXERCISES FOR ASSIGNMENT

Questions CHECKPOINT 20.1: GDP, Income, and Expenditure1. Identifyeachof the followingaseither includedornot included inGDP.

Makesuretogiveanexplanationforthosethatyoujudgeasnotincluded.

Inaddition,

state

whether

each

included

item

is

consumption,

investment,

governmentexpenditure,ornetexports.

1a. The purchase of copy paperby PepsiCo, which is usedby the company

staff.

1b. The purchase of an electronic handheld organizerby a sales manager to

keeptrackofclients.

1c. ThepurchaseofanewaircraftcarrierbytheNavy.

1d. AnincreaseinDellsinventoryofunsoldpersonalcomputers.

1e. AfamilyeatingdinneratTacoBell.

1f. ThesalaryofthePresidentoftheUnitedStates.

1g. AMombakingabirthdaycakeforher8yearolddaughter.

1h.The

sale

of

aused

computer.

1i. Yourdonationofausedcomputertoalocalelementaryschool.

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2006 2007

Item Quantity Price Quantity Price

Lobsters 100 $20 each 110 $25 each

Crabs 25 $25 each 30 $30 each

1j. ThepurchasebyaGermanresidentinGermanyofanAmericanmadeceil

ingfanproducedintheUnitedStates.

CHECKPOINT 20.2: Measuring U.S. GDPItem Dollars

Consumption expenditure 800

Investment 400Government expenditures 200Exports 50Imports 75Depreciation 100

2. Usingtheinformationinthetableabove,calculateGDP.

Item

Amount

(trillions of dollars)

Consumption expenditure 4.97Investment 1.14Government expenditures 1.37Net exports 0.08Wages 4.20Interest, rent, and profit 1.68Depreciation 0.89

3. The tableabovegives someof the items in theU.S.National Incomeand

ProductAccountsin1995.

3a. UsetheexpenditureapproachtocalculateU.S.GDPin1995.

3b. Use the incomeapproach to calculateU.S.netdomesticproductat factor

costin1995.

3c. CalculateGDPminusnetdomesticproductatfactorcostin1995.

3d. Calculateindirecttaxeslesssubsidiesin1995.

CHECKPOINT 20.3: Nominal GDP Versus Real GDP

4. An island economy

produces only lobsters

and crabs. The table

gives the quantities

produced and the

prices in 2006, and the

quantitiesproducedandthepricesin2007.Thebaseyearis2006.Calculate:

4a. NominalGDPin2006.

4b. NominalGDPin2007.

4c. Thevalueof2007productionin2006prices.

4d.

Percentage

increase

in

production

when

valued

at

2006

prices.

4e. Thevalueof2006productionin2007prices.

4f. Percentageincreaseinproductionwhenvaluedat2007prices.

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4g. RealGDPin2006and2007.

4h. TheGDPdeflatorin2007.

5. IfnominalGDP in1998was$8,759.9billionandrealGDPwas$8,165bil

lion,calculatetheGDPdeflatorin1998.

Answers CHECKPOINT 20.1: GDP, Income, and Expenditure1a. Notincludedbecauseitisanintermediategood.

1b. Includedaspartofinvestment.

1c. Includedaspartofgovernmentexpenditures.

1d. Includedaspartofinvestment.

1e. Includedaspartofconsumptionexpenditure.

1f. Includedaspartofgovernmentpurchases.

1g. Notincludedbecauseitishouseholdproduction.

1h. NotincludedbecauseitwasincludedinGDPintheyearitwasproduced.

1i. NotincludedbecauseitwasincludedinGDPintheyearitwasproduced.

1j. Includedaspartofnetexports.

CHECKPOINT 20.2: Measuring U.S. GDP2. GDPequalsthesumofconsumptionexpenditure,investment,government

expenditureongoodsandservices,andnetexports.SoGDP=$800+$400+

$200+($50$75),whichis$1,375.Theamountofdepreciationisnotused.

3a. Using theexpenditureapproach,GDP =C+ I+G+NX=$4.97 trillion+$1.14trillion+$1.37trillion$0.08trillion=$7.40trillion.

3b. Usingtheincomeapproach,netdomesticproductatfactorcost=Wages+

Interest,rent,andprofit=$4.20trillion+$1.68trillion=$5.88trillion.

3c. GDPminusnetdomesticproductat factorcost=$7.40 trillion$5.88tril

lion=$1.52

trillion.

3d. ThedifferencebetweenGDPandnetdomesticproductatfactorcost,$1.52

trillion,isequaltodepreciationplus(indirecttaxesminussubsidies).From

the table, depreciation, $0.89 trillion. So indirect taxes minus subsidies =

$1.52trillion$0.89trillion=$0.63trillion.

CHECKPOINT 20.3: Nominal GDP Versus Real GDP4a. NominalGDPin2006=($20100)+($2525)=$2,000+$625=$2,625.

4b. NominalGDPin2007=($25110)+($3030)=$2,750+$900=$3,650.

4c. Using2006prices,thevalueof2007productionis($20110)+($2530)=

$2,200+$750=$2,950.

4d.In

2006

prices,

the

value

of

production

increased

from

$2,625

to

$2,950,

an

increaseof$325.Thepercentage increase isequal to($325$2,625)100,

whichis12.38percent.

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4e. Thevalueof 2006production in 2007prices is ($25 100) + ($30 25) =

$2,500+$750=$3,250.

4f. In2007prices,thevalueofproductionincreasedfrom$3,250 to$3,650,an

increaseof$400.Thepercentage increase is($400$3,250)100,which is

12.31percent.

4g.

Real

GDP

in

2006

=

$2,625.

It

is

equal

to

nominal

GDP

because

2006

is

the

baseyear.

TocalculaterealGDPin2007computethegrowthrateofrealGDPbetween

2006and2007.Thatgrowthrateistheaverageofthegrowthratesbetween

2006and2007usingprices from2006andusingprices from2007.Taking

theaverageoftheanswerstoparts(d)and(f)givesusanaveragepercent

ageincreaseof12.35percent.

RealGDPin2007is12.35percentgreaterthanrealGDPin2006.RealGDP

in2006was$2,625,sorealGDPin2007equals($2,625)(1.1235),whichis

$2,949.

4h. TheGDPdeflator=(NominalGDPRealGDP)100=($3,650$2,949)

100

=

124.

5. The GDP deflator equals (Nominal GDP Real GDP) 100, which is

($8,759.9$8,165)100=107.3.

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USING EYE ON THE U.S. ECONOMY

Is a Computer Program an Intermediate Good or a Final Good?Thisarticlepresentsaperfectopportunity todemonstrate to students thateco

nomicstatisticsarenotperfect.After reading it, theymightget the impression

thateconomists

are

being

arbitrary

about

the

classification

of

software

in

the

na

tional incomeaccounts.Remind them that the reason for the reclassificationof

softwarefromanintermediategoodtoinvestmentreflectsthefactthatsoftware

hasmanyofthesamecharacteristicsasothertypesofinvestment.Forinstance,it

hasalifespanjustlikecapitalandithelpsimproveproductivity.Inaddition,it

alsodepreciatesjust likecapital.Studentswontneed toomuchconvincing for

themtoagree.Butjustincase,itwouldnthurttomentionthatsoftwareeventu

allybecomesobsoleteasnewsoftwareisdevelopedtomeetthechangingneeds

ofindustry.Pointoutthatthemeaningofdepreciationherecomeswithabitofa

twistbecausethesoftwaredoesntactuallygetusedupthewayphysicalmachin

erytoolsorfactorieswouldbutinsteadgetsusedupasitbecomesobsolete.

Deflating the GDP BalloonThissegmentmightbebestusedifyouintroduceitbeforeyouactuallypresent

the formula for theGDP deflator.The GDP deflator is one of these topics for

which the formula itselfdoesnoteffectively communicate theunderlyingeco

nomicforcesatwork.Theballoonmetaphorisanexcellentwaytoappealtostu

dentsintuitions.

USING EYE ON THE GLOBAL ECONOMY

The Human Development IndexExplain

to

students

that

economists

have

long

wrestled

with

the

inadequacies

of

using GDP to measure the standard of living. In fact, economists have never

thoughtofitasasingularmeasureofsocialwelfareforthereasonsthataremen

tionedattheendofthechapter.TheeffortbytheUnitedNationsisastepinthe

direction toamelioratesomeof these shortcomings.However, the troublewith

theHumanDevelopmentIndexisthatitcombinesvariablesthataredifficultto

aggregatebecause theyaremeasured inmarkedlydifferentunits.For instance,

there isnoobviousway tocombinerealGDPperpersonwith lifeexpectancy.

Perhapsyoucouldaskstudentshowtheythinkitwouldbeappropriatetotreat

thesedissimilarvariablesintherankingofstandardofliving.Forexample,you

mightask them toprovideaweighting foreachcategoryandprovidejustifica

tionfor

the

weightings.

ch 20 ap econ

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