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Additional Issues for Classroom Discussion
1. Welfare Does Not Equal GDP
You can get students involved in a useful discussion of how our national-income accounts fail to measure
our well-being. GDP covers only market activity. Ask your students to come up with some non-market
activities that are valuable to society, but which aren’t covered as part of GDP. Then you might discuss
2. More Implications of Price Mismeasurement
Ask your students to explore the ramifications of the bias in the CPI and other price measures. If the CPI
has been overstated by one percentage point per year over the past decade, how much lower should Social
Security payments be? If you see data that say the real wage has barely grown over the past decade, where
real wage growth is measured by taking nominal wage growth and subtracting off the rate of inflation, what
3. Should the CPI Measure Changes in Prices or Changes in the Cost of Living?
The Boskin Commission on the bias in the CPI raised a point that economists have known about for some
time. The economic concept that we’d like our price measures to capture is changes in the cost of living,
but our price indexes are set up to measure the change in average prices. The difference is subtle, yet
important. A great medical breakthrough, like the discovery of the polio vaccine, greatly improves the
quality of life, reducing the cost of living. Inventions like the vacuum cleaner or the transistor also changed
the things we do in daily life, vastly improving the quality of our lives. More recently, advances in computer
technology have changed the way we get information and the way businesses operate. But these great
inventions seldom have much of an impact on price indexes like the CPI or output measures like GDP. The
quality-of-life improvements engendered by new products are very difficult to measure. So the
government record-keepers let the income and price accounts reflect such quality changes in only a limited
way. But should they? The Boskin Commission recommended that the government statistical agencies try
to measure changes in the quality of life, rather than just measuring the prices of existing goods. Yet there
can never be solid knowledge of exactly how much better new inventions make our lives. So should the
government agencies simply continue to do what they’ve been doing, and just measure prices? Or should
they take their “best guess” as to the improvement in our lives that new inventions and discoveries cause?
Would the fact that such a “guess” influences things like the monthly payments to Social Security
recipients affect your decision?
Answers to Textbook Problems
1. The three approaches to national income accounting are the product approach, the income approach,
and the expenditure approach. They all give the same answer because they are designed that way; any
2. Goods are measured at market value in GDP accounting so that different types of goods and services
can be added together. Using market prices allows us to count up the total dollar value of all the
3. Intermediate goods and services are used up in producing other goods in the same period (year) in
which they were produced, while final goods and services are those that are purchased by consumers
4. GNP is the market value of final goods and services newly produced by domestic factors of production
during the current period, whereas GDP is production taking place within a country. Thus, GNP
5. The four components of spending are consumption, investment, government purchases, and net exports.
Imports must be subtracted, because they are produced abroad and we want GDP to count only those
6. Private saving is private disposable income minus consumption. Private disposable income is total
output minus taxes paid plus transfers and interest received from the government. Private saving is
7. National wealth is the total wealth of the residents of a country, and consists of its domestic physical
assets and net foreign assets. Wealth is important because the long-run economic well-being of a
8. Real GDP is the useful concept for figuring out a country’s growth performance. Nominal GDP may
rise because of increases in prices rather than growth in real output.
9. The CPI is a price index that is calculated as the value of a fixed set of consumer goods and services
at current prices divided by the value of the fixed set at base-year prices. CPI inflation is the growth
10. The nominal interest rate is the rate at which the nominal (or dollar) value of an asset increases over
time. The real interest rate is the rate at which the real value or purchasing power of an asset increases
1. GDP is the value of all final goods and services produced during the year. The final output of coconuts
is 1000, which is worth 500 fish, because two coconuts are worth one fish. The final output of fish is
500 fish. So in terms of fish, GDP consists of 500 fish worth of coconuts plus 500 fish, with a total
value of 1000 fish.
200 fish. The Professor stores 100 coconuts with a value of 50 fish. In an ideal accounting system,
these stored coconuts would be treated as investment. However, in the national income accounts,
and 400 fish, for a total value of 800 fish. Thus the economy’s total consumption is valued at 1000
fish and investment is zero.
In terms of income, Gilligan’s income is clearly worth 200 fish (100 fish plus 200 coconuts worth 100
fish). The Professor’s income is 800 coconuts (1000 coconuts minus the 200 coconuts paid to
Gilligan) plus 400 fish (500 fish minus 100 fish paid to Gilligan). In terms of fish, the Professor’s
2. (a) Furniture made in North Carolina that is bought by consumers counts as consumption,
so consumption increases by $6 billion, investment is unchanged, government purchases are
unchanged, net exports are unchanged, and GDP increases by $6 billion.
(b) Furniture made in Sweden that is bought by consumers counts as consumption and imports,
so consumption increases by $6 billion, investment is unchanged, government purchases are
3. (a) ABC produces output valued at $2 million and has total expenses of $1.3 million ($1 million for
labor, $0.1 million interest, $0.2 million taxes). So its profits are $0.7 million. XYZ produces
output valued at $3.8 million ($3 million for the three computers that were sold, plus $0.8 million
for the unsold computer in inventory) and has expenses of $3.2 million ($2 million for components,
$0.8 million for labor, and $0.4 million for taxes). So its profits are $0.6 million.
4. (a) Product approach: $2 gas station’s value added $28 product minus $26 value of product
produced in the previous year. Expenditure approach: $2 $28 consumption spending plus
inventory investment of $26. Income approach: $2 paid to the factors of production at the gas
station (wages of employees, interest, taxes, profits).
(b) Product approach: $60,000 broker’s fee for providing brokerage services. Expenditure approach:
5. Given data: I 40, G 30, GNP 200, CA 20 NX NFP, T 60, TR 25, INT 15, NFP
7 9 2. Since GDP GNP NFP, GDP 200 (2) 202 Y. Since NX NFP CA, NX
CA NFP 20 (2) 18. Since Y C I G NX, C Y (I G NX) 202 (40 30
(18)) 150.
Spvt (Y NFP T TR INT) C (202 (2) 60 25 15) 150 30. Sgovt (T TR
INT) G (60 25 15) 30 10. S Spvt Sgovt 30 (10) 20.
6.
Base-Year Quantities at Current-Year Prices At Base-Year Prices
Apples 3000 $3 $ 9,000 3000 $2 $ 6,000
Bananas 6000 $2 $12,000 6000 $3 $18,000
Oranges 8000 $5 $40,000 8000 $4 $32,000
257% between the base year and the current year: [($200,000/$56,000) 1] 100% 257%.
(b) Real GDP is calculated by finding the value of production in each year at base-year prices.
1.124. Thus the GDP deflator changes by [(1.124/1) 1] 100% 12.4% from the base year to
the current year.
7. Calculating inflation rates:
1929–30: [(50.0/51.3) 1] 100% 2.5%
1930–31: [(45.6/50.0) 1] 100% 8.8%
1931–32: [(40.9/45.6) 1] 100% 10.3%
1932–33: [(38.8/40.9) 1] 100% 5.1%
These all show deflation (prices are declining over time), whereas recently we have had nothing but
8. The nominal interest rate is [(545/500) 1] 100% 9%. The inflation rate is [(214/200) 1]
100% 7%. So the real interest rate is 2% (9% nominal rate 7% inflation rate). Expected inflation
was only [(210/200) 1] 100% 5%, so the expected real interest rate was 4% (9% nominal rate
5% expected inflation rate).
9. (a) The annual rate of inflation from January 1, 2011, to January 1, 2013, is 10%. This can be found
by calculating the constant rate of inflation that would raise the deflator from 200 to 242 in two
242 on January 1, 2013. So we need to solve the expression (1 )2 242/200.
(b) By similar reasoning, the inflation rate over the three-year period is (1 )3 266.2/200,
1 P1/P0
1 P2/P1
1 Pn/Pn–1
Multiplying all these lines together, we get:
1. The key to this question is that real GDP is not the same thing as well-being. People may be better off
even if real GDP is lower; for example, this may occur because the improvement in the health of
2. National saving does not rise because of the switch to CheapCall because although consumption
spending declines by $2 million, so have total expenditures (GDP), which equal total income. Since
3. (a) The problem in a planned economy is that prices do not measure market value. When the price
of an item is too low, then goods are really more expensive than their listed price suggests—we
should include in their market value the value of time spent by consumers waiting to make
purchases. Because the item’s value exceeds its cost, measured GDP is too low.
When the price of an item is too high, goods stocked on the shelves may be valued too highly.
4. Example from 2012:Q1 (amounts in billions of dollars): Gross saving = 1945.6, gross domestic
investment = 2499.9, and current account balance = –553.6. So gross domestic investment + current
1. The three approaches to national income accounting are the product approach, the income approach,
and the expenditure approach. They all give the same answer because they are designed that way; any
2. Goods are measured at market value in GDP accounting so that different types of goods and services
can be added together. Using market prices allows us to count up the total dollar value of all the
3. Intermediate goods and services are used up in producing other goods in the same period (year) in
which they were produced, while final goods and services are those that are purchased by consumers
4. GNP is the market value of final goods and services newly produced by domestic factors of production
during the current period, whereas GDP is production taking place within a country. Thus, GNP
5. The four components of spending are consumption, investment, government purchases, and net exports.
Imports must be subtracted, because they are produced abroad and we want GDP to count only those
6. Private saving is private disposable income minus consumption. Private disposable income is total
output minus taxes paid plus transfers and interest received from the government. Private saving is
7. National wealth is the total wealth of the residents of a country, and consists of its domestic physical
assets and net foreign assets. Wealth is important because the long-run economic well-being of a
8. Real GDP is the useful concept for figuring out a country’s growth performance. Nominal GDP may
rise because of increases in prices rather than growth in real output.
9. The CPI is a price index that is calculated as the value of a fixed set of consumer goods and services
at current prices divided by the value of the fixed set at base-year prices. CPI inflation is the growth
10. The nominal interest rate is the rate at which the nominal (or dollar) value of an asset increases over
time. The real interest rate is the rate at which the real value or purchasing power of an asset increases
1. GDP is the value of all final goods and services produced during the year. The final output of coconuts
is 1000, which is worth 500 fish, because two coconuts are worth one fish. The final output of fish is
500 fish. So in terms of fish, GDP consists of 500 fish worth of coconuts plus 500 fish, with a total
value of 1000 fish.
200 fish. The Professor stores 100 coconuts with a value of 50 fish. In an ideal accounting system,
these stored coconuts would be treated as investment. However, in the national income accounts,
and 400 fish, for a total value of 800 fish. Thus the economy’s total consumption is valued at 1000
fish and investment is zero.
In terms of income, Gilligan’s income is clearly worth 200 fish (100 fish plus 200 coconuts worth 100
fish). The Professor’s income is 800 coconuts (1000 coconuts minus the 200 coconuts paid to
Gilligan) plus 400 fish (500 fish minus 100 fish paid to Gilligan). In terms of fish, the Professor’s
2. (a) Furniture made in North Carolina that is bought by consumers counts as consumption,
so consumption increases by $6 billion, investment is unchanged, government purchases are
unchanged, net exports are unchanged, and GDP increases by $6 billion.
(b) Furniture made in Sweden that is bought by consumers counts as consumption and imports,
so consumption increases by $6 billion, investment is unchanged, government purchases are
3. (a) ABC produces output valued at $2 million and has total expenses of $1.3 million ($1 million for
labor, $0.1 million interest, $0.2 million taxes). So its profits are $0.7 million. XYZ produces
output valued at $3.8 million ($3 million for the three computers that were sold, plus $0.8 million
for the unsold computer in inventory) and has expenses of $3.2 million ($2 million for components,
$0.8 million for labor, and $0.4 million for taxes). So its profits are $0.6 million.
4. (a) Product approach: $2 gas station’s value added $28 product minus $26 value of product
produced in the previous year. Expenditure approach: $2 $28 consumption spending plus
inventory investment of $26. Income approach: $2 paid to the factors of production at the gas
station (wages of employees, interest, taxes, profits).
(b) Product approach: $60,000 broker’s fee for providing brokerage services. Expenditure approach:
5. Given data: I 40, G 30, GNP 200, CA 20 NX NFP, T 60, TR 25, INT 15, NFP
7 9 2. Since GDP GNP NFP, GDP 200 (2) 202 Y. Since NX NFP CA, NX
CA NFP 20 (2) 18. Since Y C I G NX, C Y (I G NX) 202 (40 30
(18)) 150.
Spvt (Y NFP T TR INT) C (202 (2) 60 25 15) 150 30. Sgovt (T TR
INT) G (60 25 15) 30 10. S Spvt Sgovt 30 (10) 20.
6.
Base-Year Quantities at Current-Year Prices At Base-Year Prices
Apples 3000 $3 $ 9,000 3000 $2 $ 6,000
Bananas 6000 $2 $12,000 6000 $3 $18,000
Oranges 8000 $5 $40,000 8000 $4 $32,000
257% between the base year and the current year: [($200,000/$56,000) 1] 100% 257%.
(b) Real GDP is calculated by finding the value of production in each year at base-year prices.
1.124. Thus the GDP deflator changes by [(1.124/1) 1] 100% 12.4% from the base year to
the current year.
7. Calculating inflation rates:
1929–30: [(50.0/51.3) 1] 100% 2.5%
1930–31: [(45.6/50.0) 1] 100% 8.8%
1931–32: [(40.9/45.6) 1] 100% 10.3%
1932–33: [(38.8/40.9) 1] 100% 5.1%
These all show deflation (prices are declining over time), whereas recently we have had nothing but
8. The nominal interest rate is [(545/500) 1] 100% 9%. The inflation rate is [(214/200) 1]
100% 7%. So the real interest rate is 2% (9% nominal rate 7% inflation rate). Expected inflation
was only [(210/200) 1] 100% 5%, so the expected real interest rate was 4% (9% nominal rate
5% expected inflation rate).
9. (a) The annual rate of inflation from January 1, 2011, to January 1, 2013, is 10%. This can be found
by calculating the constant rate of inflation that would raise the deflator from 200 to 242 in two
242 on January 1, 2013. So we need to solve the expression (1 )2 242/200.
(b) By similar reasoning, the inflation rate over the three-year period is (1 )3 266.2/200,
1 P1/P0
1 P2/P1
1 Pn/Pn–1
Multiplying all these lines together, we get:
1. The key to this question is that real GDP is not the same thing as well-being. People may be better off
even if real GDP is lower; for example, this may occur because the improvement in the health of
2. National saving does not rise because of the switch to CheapCall because although consumption
spending declines by $2 million, so have total expenditures (GDP), which equal total income. Since
3. (a) The problem in a planned economy is that prices do not measure market value. When the price
of an item is too low, then goods are really more expensive than their listed price suggests—we
should include in their market value the value of time spent by consumers waiting to make
purchases. Because the item’s value exceeds its cost, measured GDP is too low.
When the price of an item is too high, goods stocked on the shelves may be valued too highly.
4. Example from 2012:Q1 (amounts in billions of dollars): Gross saving = 1945.6, gross domestic
investment = 2499.9, and current account balance = –553.6. So gross domestic investment + current
