Conceptual Problems

1. Government transfer payments (TR) do not arise out of any production activity and are thus
not counted in the value of GDP. If the government hired the people who receive transfer
payments, then their wages would be counted as part of government purchases (G), which is
counted in GDP. Therefore GDP would rise even if these workers were paid to do nothing, as
government purchases are measured on a cost basis.

2.a. If the firm buys a car for an executive's use, the purchase counts as investment (I). However,
if the firm pays the executive a higher salary and she then buys a car, the purchase of her car
is counted as consumption (C). In either case, GDP will increase.

2.b. The services that a homemaker provides are not counted in GDP (regardless of their value).
However, if an individual officially hires his or her spouse to perform household duties at a
certain wage rate, the wages earned will be counted in GDP and GDP will increase.

2.c. If you buy a German car, consumption (C) will increase but net exports (NX = X - Q) will
decrease. Overall GDP will increase by the value added at the foreign car dealership, since
the import price is likely to be less than the sales price. If you buy a new American car,
consumption and thus GDP will increase by the full value of the car.

3. GDP is the market value of all final goods and services currently produced within the
country. The U.S. GDP includes the value of the Hondas produced by a Japanese-owned
assembly plant that is located in the U.S., but it does not include the value of Nike shoes that
are produced by an American-owned shoe factory located in Malaysia.
GNP is the market value of all final goods and services currently produced using assets
owned by domestic residents. Here the value of the Hondas produced by a Japanese-owned
Honda plant in the U.S. is not counted in GNP but the value of the Nike shoes by the
American-owned shoe plant in Malaysia is.
Neither is necessarily a better measure of the output of a nation. The actual values of the
GDP and GNP for the U.S. are fairly close.

4. NDP (net domestic product) is defined as GDP minus depreciation. Depreciation measures
the value of the capital that wears out during the production process and has to be replaced.
Therefore NDP comes closer to measuring the net amount of goods produced in this country.
If this is what you want to measure, then NDP should be used.

5. Increases in real GDP do not necessarily mean increases in people’s welfare. For example, if
the population of a country increases proportionally more than real GDP, then the population
of the country is on average worse off. Also some increases in output come from events that

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 reduce peoples’ welfare. For example, increased pollution may cause more lung cancer, and
the treatment of the lung cancer will contribute to GDP. Similarly, an increase in crime may
lead to overtime work for police officers, whose increased salary will increase GDP. But the
welfare of the people in the country will not have increased in either of these cases. On the
other hand, GDP also does not always accurately measure quality improvements in goods or
services (faster computers or improved health care) that improve people's welfare.

6. The CPI (consumer price index) and the PPI (producer price index) are both measured by
looking at a certain market basket. The CPI’s basket contains mostly finished goods and
services that consumers tend to buy regularly. The PPI’s basket contains raw materials and
semi-finished goods, that is, it measures costs to the producer of a good. The CPI is a
concurrent economic indicator, whereas the PPI is a leading economic indicator; so if you
want to assess current inflation, you need to look at the CPI, but if you want to assess the
possibility of future inflation, you need to look at the PPI.

7. The GDP-deflator is a price index that covers the average price increase of all final goods
and services currently produced within an economy. It is defined as the ratio of current
nominal GDP to current real GDP. Nominal GDP is measured in current dollars, while real
GDP is measured in so-called base-year dollars. Even though early estimates of the GDP-
deflator tend to be unreliable, the GDP-deflator can be a more comprehensive price index
than the CPI or PPI (both of which are fixed market baskets). This is true for two reasons:
first it measures a much wider cross-section of goods and services; second, a fixed market
basket cannot account for people substituting away from goods whose relative prices have
changed, while the GDP-deflator, which includes all final goods and services produced
within the country, can.

8. If nominal GDP has suddenly doubled, it is most likely due to an increase in the average
price level. To calculate how much real output (GDP) has changed, the first thing you would
want to check is how much the GDP-deflator has changed. If nominal GDP and the GDP-
deflator have both doubled, then real GDP should remain unchanged.

9. Assume the loan you made yields you an annual nominal return of 7%. If the rate of inflation is
3%, then your rate of return in real terms is only 4%. If, on the other hand, the inflation rate
is 10%, then you will actually get a negative real rate of return, that is, your yield will be
-3%. One way to get protection against such a loss of purchasing power is to adjust the
interest rate for inflation, that is, to index the loan. In other words, you can require that, in
addition to a specified interest rate of the loan, the borrower also has to pay an inflation
premium equal to the percentage change in the CPI. In this case, a specified positive real rate
of return can be guaranteed.

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5. Comment on the following statement:
“Real per-capita GDP is a good measure of economic welfare.”

Real GDP per capita is an imperfect measure of economic welfare as it does not include non-
market activities which affect well being, such as the value of household services, volunteer
work, the loss of natural wilderness areas resulting from economic development, pollution,
and so on. In spite of these limitations, however, real GDP per capita still does provide some
measure of economic welfare.

6. If nominal GDP in Germany increased by 2.8% last year, but U.S. GDP increased by
4.2%, can we conclude that the welfare of U.S. citizens increased by more than that of
German citizens? Why or why not?

A country's nominal GDP is not a good measure of the economic welfare of its people, since
nominal GDP can change solely due to inflation. Only if real GDP grows faster than
population, will real income per capita increase. But real GDP per capita still does not take
into account changes in income distribution, changes in environmental quality, or leisure, all
of which influence the economic welfare of the people in a country. Therefore we cannot say
whether the welfare of the people in the U.S. has increased more than that of the people in
Germany.

7. Assume last year's real GDP was $7,000 billion, this year's nominal GDP is $8,820
billion, and the GDP-deflator for this year is 120. What was the growth rate of real
GDP?

RGDP(1) = [NGDP(1)/GDP-deflator]*100 = [8,820/120]*100 = 7,350

Since RGDP(0) = 7,000 it follows that the growth rate of RGDP is

y = [7,350 - 7,000]/7,000 = 0.05 = 5%.

8. Assume real GDP in 2000 was $7,000 billion, nominal GDP in 2004 was $8,316 billion,
and the GDP-deflator has increased from 100 to 110 between 2000 and 2004. What is
the average annual growth rate of real GDP from 2000 to 2004? Do you think the
welfare of all people in the country has increased during that time? Why or why not?

RGDP = (NGDP/deflator)*100 = (8,316/110)*100 = 7,560

Growth rate of GDP = (7,560 – 7,000)/7,000 = 560/7,000 = 0.08 = 8%

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 Therefore real GDP has grown 8% in four years, or at an average annual growth rate of 2%.

10. Calculate the values for government purchases (G), private domestic saving (S), and
private domestic investment (I) from the following information (all variables are in
billions of dollars).
national income Y = 5,200 budget deficit BuD = 150
disposable income YD = 4,400 trade deficit TD = 110
consumption C = 4,100

From YD = C + S ==> S = YD - C = 4,400 - 4,100 = 300.

From S - I = BuD - TD ==> 300 - I = 150 - 110 ==> I = 260.

From Y = C + I + G + NX ==> G = Y - C - I - NX

==> G = 5,200 - 4,100 - 260 + 110 = 950.

11. From the following information calculate the value of government purchases (G),
consumption (C), and private domestic investment (I) (all variables are in billions of
dollars).
national income Y = 6,000 tax revenues TA = 1,500
private domestic saving S = 1,000 transfer payments TR = 700
net exports NX = - 120 budget deficit BuD = 230

From YD = Y - TA + TR ==> YD = 6,000 - 1,500 + 700 ==> YD = 5,200.

From YD = C + S ==> C = YD - S = 5,200 - 1,000 = 4,200.

From S - I = BuD - TD ==> 1,000 - I = 230 - 120 ==> I = 890.

From Y = C + I + G + NX ==> G = Y - C - I - NX

==> G = 6,000 - 4,200 - 890 + 120 = 1,030.

Check: BuS = TA - TR - G ==> -230 = 1,500 - 700 - G ==> G = 1,030.

12. From the information below (all variables are in billions of dollars) calculate the level of
private domestic investment (I), consumption (C), and national income (Y).
government purchases G = 1,200 budget surplus BuS = 60
disposable income YD = 4,500 net exports NX = -110
private domestic saving S = 500

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From YD = C + S ==> C = YD - S = 4,500 - 500 = 4,000.

From S - I = BuD - TD ==> 500 - I = - 60 - 110 ==> I = 670.

From Y = C + I + G + NX ==> Y = 4,000 + 1,200 + 670 - 110 = 5,760.

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