a Measuring Nation's Income Microeconomics is the study of how individual households and firms make decisions and how they interact with one another in markets. Macroeconomics is the study of the economy as a whole. Its goal is to explain the economic changes that affect many households, firms, and markets at once. Macroeconomics answers questions like the following: Why is average income high in some countries and low in others? Why do prices rise rapidly in some time periods while they are more stable in others? Why do production and employment expand in some years and contract in others? THE ECONOMY'S INCOME AND EXPENDITURE When judging whether the economy is doing well or poorly, it is natural to look at the total income that everyone in the economy is earning. For an economy as a whole, income must equal expenditure because: Every transaction has a buyer and a seller. Every dollar of spending by some buyer is a dollar of income for some seller.
The Circular-Flow Diagram
MARKETS FOR GOODS AND SERVICES Firms sell Goods Households buy and services sold Revenue
Spending Goods and services bought
FIRMS Produce and sell goods and services Hire and use factors of production
HOUSEHOLDS Buy and consume goods and services Own and sell factors of production
Factors of production Wages, rent, and profit
MARKETS FOR FACTORS OF PRODUCTION Households sell Firms buy
Labor, land, and capital Income = Flow of inputs and outputs = Flow of dollars
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THE MEASUREMENT OF GROSS DOMESTIC PRODUCT
Gross domestic product (GDP) is a measure of the income and expenditures of an economy. GDP is the total market value of all final goods and services produced within a country in a given period of time. The equality of income and expenditure can be illustrated with the circular-flow diagram.
1.For an economy as a whole, a. income is greater than expenditure b. expenditure is greater than income. c. income is equal to expenditure. d. GDP measures income more precisely than it measures expenditure. 2. Gross domestic product serves as a measure of two things: a. the total spending of everyone in the economy and the total saving of everyone in the economy. b. the total income of everyone in the economy and the total expenditure on the nation's output of goods and services. c. the value of the nation's output of goods and services for domestic citizens and the value of the nation's output of goods and services for the rest of the world. d. the nation's saving and the nation's investment. 3. Because every transaction has a buyer and a seller, a. GDP is more closely associated with a nation's income than it is with a nation's expenditure. b. every transaction contributes equally to an economy's income and to its expenditure. c. the number of firms must be equal to the number of households in a simple circular-flow diagram. d. firms' profits are necessarily zero in a simple circular-flow diagram. 4. Gross domestic product is defined as a. the market value of all final goods and services produced within a country in a given period of time. b. the market value of all tangible goods produced within a country in a given period of time. c. the quantity of all final goods and services supplied within a country in a given period of time. d. the quantity of all final goods and services demanded within a country in a given period of time. "GDP is the Market Value . . ." Output is valued at market prices. ". . . Of All. . ." Includes all items produced in the economy and legally sold in markets ". . . Final . . ." It records only the value of final goods, not intermediate goods (the value is counted only once). ". . . Goods and Services . . ." It includes both tangible goods (food, clothing, cars) and intangible services (haircuts, housecleaning, doctor visits). ". . . Produced . . ." It includes goods and services currently produced, not transactions involving goods produced in the past. " . . . Within a Country . . ." It measures the value of production within the geographic confines of a country. ". . . In a Given Period of Time." It measures the value of production that takes place within a specific interval of time, usually a year or a quarter (three months).
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THE COMPONENTS OF GDP GDP includes all items produced in the economy and sold legally in markets. What Is Not Counted in GDP? GDP excludes most items that are produced and consumed at home and that never enter the marketplace. It excludes items produced and sold illicitly, such as illegal drugs.
5.Which of the following is not included in GDP? a. unpaid cleaning and maintenance of houses b. services such as those provided by lawyers and hair stylists c. the estimated rental value of owner-occupied housing d. production of foreign citizens living in the United States 6. Which of the following transactions adds to U.S. GDP for 2006? a. In 2006, Ashley sells a car that she bought in 2002 to William for $5,000. b. An American management consultant works in Mexico during the summer of 2006 and earns the equivalent of $30,000 during that time. c. When John and Jennifer were both single, they lived in separate apartments and each paid $750 in rent. John and Jennifer got married in 2006 and they bought a house that, according to reliable estimates, could be rented for $1,600 per month. d. None of the above transactions adds to GDP for 2006. 7. Which of the following transactions adds to U.S. GDP for 2006? a. In 2006, Marvin Windows manufactures 20 windows that will eventually be installed in an office building in Minneapolis. The windows remain in Marvin's inventory at the end of 2006. b. An Irish marketing consultant works in Boston during the summer of 2006 and earns $30,000 during that time. c. When Sara and David were both single, they lived in separate apartments and each paid $800 in rent. Sara and David got married in 2006 and they bought a house that, according to reliable estimates, could be rented for $1,800 per month. d. All of the above transactions adds to GDP for 2006. 8. The value of the housing services provided by the economy's owner-occupied houses is a. included in GDP and the estimated rental values of the houses is used to place a value on these housing services. b. included in GDP and the actual mortgage payments made on the houses is used to estimate the value of these rental services. c. excluded from GDP since these services are not sold in any market. d. excluded from GDP since the value of these housing services cannot be estimated with any degree of precision. 9. Suppose an apartment complex converts to a condominium, so that the former renters are now owners of their housing units. Suppose further that a current estimate of the value of the condominium owners' housing services is the same as the rent they previously paid. What happens to GDP as a result of this conversion? a. GDP necessarily increases. b. GDP necessarily decreases. c. GDP is unaffected because neither the rent nor the estimate of the value of housing services is included in GDP.
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d. GDP is unaffected because previously the rent payments were included in GDP, and now the rent payments are replaced in GDP by the estimate of the value of housing services. 10. Estimates of the values of which of the following non-market goods or services are included in GDP? a. the value of unpaid housework b. the value of vegetables and other foods that people grow in their gardens c. the estimated rental value of owner-occupied homes d. All of the above are included. 11. Over the last few decades, Americans have chosen to cook less at home and eat more at restaurants. This change in behavior, by itself, has a. reduced measured GDP. b. not affected measured GDP. c. increased measured GDP only to the extent that the value of the restaurant meals exceeded the value of meals previously cooked at home. d. increased measured GDP by the full value of the restaurant meals. 12. Ralph pays someone to mow his lawn, while Mike mows his own lawn. Regarding these two practices, which of the following statements is correct? a. Only Ralph's payments are included in GDP. b. Ralph's payments as well as the estimated value of Mike's mowing services are included in GDP. c. Neither Ralph's payments nor the estimated value of Mike's mowing services is included in GDP. d. Ralph's payments are definitely included in GDP, while the estimated value of Mike's mowing services is included in GDP only if Mike voluntarily provides his estimate of that value to the government. 13. If a state made a previously-illegal activity such as gambling or prostitution legal, then, other things equal, GDP a. necessarily decreases. b. necessarily increases. c. doesn't change because both legal and illegal production are included in GDP. d. doesn't change because these activities are never included in GDP. 14. A steel company sells some steel to a bicycle company for $100. The bicycle company uses the steel to produce a bicycle, which it sells for $200. Taken together, these two transactions contribute a. $100 to GDP. b. $200 to GDP. c. between $200 and $300 to GDP, depending on the profit earned by the bicycle company when it sold the bicycle. d. $300 to GDP. 15. The total sales of all firms in the economy for a year a. equals GDP for the year. b. is larger than GDP for the year. c. is smaller than GDP for the year. d. equals GNP for the year.
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16. One bag of flour is sold for $1.50 to a bakery, which uses the flour to bake bread that is sold for $4.00 to consumers. A second bag of flour is sold to a consumer in a grocery store for $2.00. Taking these three transactions into account, what is the effect on GDP? a. GDP increases by $1.50. b. GDP increases by $3.50. c. GDP increases by $6.00. d. GDP increases by $7.50. 17. The local Chevrolet dealership has an increase in inventory of 25 cars in 2006. In 2007 it sells all 25 cars. Which of the following statements is correct? a. The full value of the increased inventory will be counted as part of GDP in 2006, and the value of the cars sold in 2007 will not cause 2007 GDP to increase. b. The value of the increased inventory will not affect 2006 GDP; instead, the full value of the inventory will be counted as part of 2007 GDP. c. The value of the increased inventory will be counted as part of 2006 GDP and the value of the cars sold in 2007 will increase 2007 GDP. d. One-half of the value of the increased inventory will be counted as part of 2006 GDP and the other one-half of the value will be counted as part of 2007 GDP. 18. Until recently, George lived in a home that was newly constructed in 2005. In 2005, he paid $200,000 for the brand new house. He sold the house in 2006 for $225,0000. Which of the following statements is correct regarding the sale of the house? a. The 2006 sale increased 2006 GDP by $225,000 and had no effect on 2005 GDP. b. The 2006 sale increased 2006 GDP by $25,000 and had no effect on 2005 GDP. c. The 2006 sale increased 2006 GDP by $225,000; furthermore, the 2006 sale caused 2005 GDP to be revised upward by $25,000. d. The 2006 sale affected neither 2005 GDP nor 2006 GDP. 19. Anna, a U.S. citizen, works only in Germany. The value she adds to production in Germany is included a. in U.S. GDP, but is it not included in German GDP. b. in German GDP, but it is not included in U.S. GDP. c. in both German GDP and U.S. GDP. d. in neither German GDP nor U.S. GDP. 20. Suppose there are only two firms in an economy: Cowhide, Inc. produces leather and sells it to Couches, Inc., which produces and sells leather furniture. With each $1,000 of leather that it buys from Cowhide, Inc., Couches, Inc. produces a couch and sells it for $2,000. Neither firm had any inventory at the beginning of 2006. During that year, Cowhide produced enough leather for 20 couches. Couches, Inc. bought 80% of that leather for $16,000 and promised to buy the remaining 20% for $4,000 in 2007. Couches, Inc. produced 16 couches during 2006 and sold each one during that year for $2,000. What was the economy's GDP for the year? $ ____________ Other measure of income Gross national product (GNP) is the total income earned by a nation's permanent residents
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21. U.S. GDP and U.S. GNP are related as follows: a. GNP = GDP - Income earned by foreigners in the U.S. + Income earned by U.S. citizens abroad. b. GNP = GDP + Income earned by foreigners in the U.S. - Income earned by U.S. citizens abroad. c. GNP = GDP + Value of exported goods - Value of imported goods. d. GNP = GDP - Value of exported goods + Value of imported goods.
GDP (Y) is the sum of the following: Consumption (C) Investment (I) Government Purchases (G) Net Exports (NX) Y = C + I + G + NX
Consumption (C): The spending by households on goods and services, with the exception of purchases of new housing. Investment (I): The spending on capital equipment, inventories, and structures, including new housing. Government Purchases (G): The spending on goods and services by local, state, and federal governments. Does not include transfer payments because they are not made in exchange for currently produced goods or services. Net Exports (NX): Exports minus imports.
23. The component of GDP called consumption consists of a. household spending on durable goods, but not household spending on nondurable goods or on services. b. household spending on durable and nondurable goods, but not household spending on services. c. household spending on durable and nondurable goods as well as household spending on services. d. spending by households and business firms on durable and nondurable goods as well as spending by households and business firms on services. 24. For the purpose of calculating GDP, investment is spending on a. stocks, bonds, and other financial assets. b. real estate and financial assets.
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c. new capital equipment, inventories, and structures, including new housing. d. capital equipment, inventories, and structures, excluding household purchases of new housing. 25. The value of goods added to a firm's inventory in a certain year is treated as a. consumption, since the goods will be sold to consumers in another period. b. saving, since the goods are being saved until they are sold in another period. c. investment, since GDP aims to measure the value of the economy's production. d. spending on durable goods, since the goods could not be inventoried unless they were durable. 26. Household spending on education is included in a. consumption, although it might be argued that it would fit better in investment. b. investment, although it might be argued that it would fit better in consumption. c. government spending, based on the fact that most higher-education students attend publicly-supported colleges and universities. d. None of the above is correct; in general, household spending on services is not included in any component of GDP. 27. Consider two items that might be included in GDP: (1) The estimated rental value of owner-occupied housing; and (2) purchases of newly-constructed homes. How are these two items accounted for when GDP is calculated? a. Both item (1) and item (2) are included in the consumption component of GDP. b. Item (1) is included in the consumption component, while item (2) is included in the investment component. c. Item (1) is included in the investment component, while item (2) is included in the consumption component. d. Only item (2) is included in GDP and it is included in the investment component. 28. The U.S. government pays an economist at the U.S. Department of Commerce $50,000 in salary in 2006. The economist then retires. In 2007, the government pays him $30,000 in retirement benefits. Which of the following is correct? a. Each payment will be included in GDP as government purchases for the respective years. b. The 2006 payment is included in 2006 GDP as government purchases, but the 2007 payment is not included in 2007 GDP. c. The 2006 payment is included in 2006 GDP as government purchases, and the 2007 payment is included in 2007 GDP as government transfer payments. d. The 2006 payment is included in 2006 GDP as government purchases, and the 2007 payment is allocated to previous years' GDP according to the amount of work performed by the economist each year. 29. Social Security payments are a. included in GDP because they represent payments for work performed in the past. b. included in GDP because they represent potential consumption. c. excluded from GDP because they are not private pensions. d. excluded from GDP because they do not represent current government purchases of goods and services. 30. For a certain economy in 2005, GDP was $2,000; investment was $400; government purchases were $300; and net exports were $70. It follows that consumption was $___________ 31. In a certain economy in 2005, the value of imports amounted to 80 percent of the value of exports. Consumption, investment, and government purchases added up to $5,000. The market value of all final
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goods and services produced within the economy was $5,500. It follows that the economy exported $___________ worth of goods and services. REAL VERSUS NOMINAL GDP
Nominal GDP values the production of goods and services at current prices. Real GDP values the production of goods and services at constant prices. An accurate view of the economy requires adjusting nominal to real GDP by using the GDP deflator.
Table 2 Real and Nominal GDP
The GDP Deflator The GDP deflator is a measure of the price level calculated as the ratio of nominal GDP to real GDP times 100. It tells us what portion of the rise in nominal GDP that is attributable to a rise in prices rather than a rise in the quantities produced. The GDP deflator is calculated as follows:
G D P d e fla to r =
N o m in a l G D P 100 R eal G D P
Nominal GDP is converted to real GDP as follows:
R e a l G D P20X X =
N o m in a l G D P 20X X 100 G D P d e f la to r2 0 X X
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Figure 2 Real GDP in the United States
Billions of 2000 Dollars $10,000 9,000 8,000 7,000 6,000 5,000
4,000
3,000 2,000
1970
1975
1980
1985
1990
1995
2000
2005
32. Refer to Table 10-3. Nominal GDP is $_________ for 2006, $_________ for 2007, and $_________ for 2008. 33. Refer to Table 10-3. Using 2007 as the base year, for 2006, real GDP is $______and the GDP deflator is ____ 34. Refer to Table 10-3. Using the GDP deflator to measure the average level of prices and using 2006 as the base year, the economy's inflation rate is a. 20 percent for 2007 and 12.5 percent for 2008. b. 20 percent for 2007 and 30 percent for 2008. c. 25 percent for 2007 and 28 percent for 2008. d. 44.7 percent for 2007 and 45.5 percent for 2008.
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35. Suppose that the country of Samiam produces only eggs and ham. In 2005 it produced 100 dozen eggs at $3 per dozen and 50 pounds of ham at $4 per pound. In 2004, the base year, eggs sold for $1.50 per dozen and ham sold for $5 per pound. For 2005, a. nominal GDP is $500, real GDP is $400, and the GDP deflator is 80. b. nominal GDP is $500, real GDP is $400, and the GDP deflator is 125. c. nominal GDP is $400, real GDP is $400, and the GDP deflator is 100. d. nominal GDP is $400, real GDP is $500, and the GDP deflator is 125. 36. Which statement represents most correctly the relationship between nominal GDP and real GDP? a. Nominal GDP measures base-year production using base-year prices, whereas real GDP measures current production using current prices. b. Nominal GDP measures current production using base-year prices, whereas real GDP measures current production using current prices. c. Nominal GDP measures current production using current prices, whereas real GDP measures current production using base-year prices. d. Nominal GDP measures current production using current prices, whereas real GDP measures base-year production using base-year prices. 37. If a small country has current nominal GDP of $20 billion and a GDP deflator of 50, what is its real GDP? $_____billion. 38. A farmer produces the same output in 2004 as in 2003. His input prices increase by 50 percent, but so does his product price. We can conclude that a. the farmer is better off in 2004. b. the farmer was better off in 2004. c. the farmer is equally well off in 2004 as in 2003. d. we cannot tell whether the farmer is better off in 2004 or in 2003 without additional information.
IS GDP A GOOD MEASURE OF ECONOMIC WELL-BEING? GDP is the best single measure of the economic well-being of a society. GDP per person tells us the income and expenditure of the average person in the economy. Higher GDP per person indicates a higher standard of living. GDP is not a perfect measure of the happiness or quality of life, however. Some things that contribute to well-being are not included in GDP. The value of leisure. The value of a clean environment. The value of almost all activity that takes place outside of markets, such as the value of the time parents spend with their children and the value of volunteer work.
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Table 3 GDP and the Quality of Life
39. Which of the following statements about GDP is correct? a. GDP measures two things at once: the total income of everyone in the economy and the total expenditure on the economy's output of goods and services. b. Money continuously flows from households to firms and then back to households, and GDP measures this flow of money. c. GDP is generally regarded as the best single measure of a society's economic well-being. d. All of the above are correct. Summary Because every transaction has a buyer and a seller, the total expenditure in the economy must equal the total income in the economy. Gross domestic product (GDP) measures an economy's total expenditure on newly produced goods and services and the total income earned from the production of these goods and services. GDP is the market value of all final goods and services produced within a country in a given period of time. GDP is divided among four components of expenditure: consumption, investment, government purchases, and net exports. Nominal GDP uses current prices to value the economy's production. Real GDP uses constant base-year prices to value the economy's production of goods and services. The GDP deflator--calculated from the ratio of nominal to real GDP--measures the level of prices in the economy. GDP is a good measure of economic well-being because people prefer higher to lower incomes. It is not a perfect measure of well-being because some things, such as leisure time and a clean environment, are not measured by GDP.
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