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1.
Below is a simplified circular-flow diagram for the economy of Micronia. a. What is the value of GDP in Micronia? b. What is the value of net exports? c. What is the value of disposable income? d. Does the total flow of money out of householdsthe sum of taxes paid and consumer spendingequal the total flow of money into households? e. How does the government of Micronia finance its purchases of goods and services?
Government purchases of goods and services = $100 Government Taxes = $100 Households Consumer spending = $650 Wages, profit, interest, rent = $750 Factor markets Gross domestic product Firms Wages, profit, interest, rent = $750

Markets for goods and services

Exports = $20 Rest of world Imports = $20

1. Solution

a. We can measure GDP in Micronia as the sum of all spending on domestically produced final goods and services. Spending consists of consumer spending, government purchases of goods and services, and exports less imports, or $750 ($650 + $100 + $20 $20). b. Net exports are exports less imports. In Micronia, net exports equal zero ($20 $20). c. Disposable income is income received by households less taxes plus government transfers. In Micronia, disposable income equals $650 ($750 $100). d. Yes. Consumer spending plus taxes equals $750the same as the wages, profit, interest, and rent received by households. e. The government finances its purchases of goods and services with tax revenue.

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23 7
ECONOMICS

chapter:

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2.

A more complex circular-flow diagram for the economy of Macronia is shown below. a. What is the value of GDP in Macronia? b. What is the value of net exports? c. What is the value of disposable income? d. Does the total flow of money out of householdsthe sum of taxes paid, consumer spending, and private savingsequal the total flow of money into households? e. How does the government finance its spending?
Government purchases of goods and services = $150 Government Taxes = $100 Households Consumer spending = $510 Markets for goods and services Gross domestic product Firms Investment spending = $110 Exports = $50 Rest of world Imports = $20 Foreign lending and purchases of stock = $100 Wages, profit, interest, rent = $800 Wages, profit, interest, rent = $800 Factor markets Financial markets Government transfers = $10 Private savings = $200

Government borrowing = $60

Borrowing and stock issues by firms = $110

Foreign borrowing and sales of stock = $130

Solution 2.

a. We can measure GDP in Macronia as the sum of all spending on domestically produced final goods and services. Spending consists of consumer spending, investment spending, government purchases of goods and services, and exports less imports, or $800 ($510 + $110 + $150 + $50 $20). b. Net exports are exports less imports. In Macronia, net exports equal $30 ($50 $20). c. Disposable income is income received by households less taxes plus government transfers. In Macronia, disposable income equals $710 ($800 $100 + $10). d. Yes. Consumer spending plus taxes plus private savings equals $810the same as the wages, profit, interest, rent, and government transfers received by households. e. In Macronia, the government needs to finance $160 in spending ($150 on purchases of goods and services and $10 in government transfers). The government finances $100 of its spending with tax revenue and the other $60 through borrowing in financial markets.

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3.

The components of GDP in the accompanying table were produced by the Bureau of Economic Analysis.
Components of GDP in 2007 (billions of dollars)

Category

Consumer spending Durable goods Nondurable goods Services Private investment spending Fixed investment spending Nonresidential Structures Equipment and software Residential Change in private inventories Net exports Exports Imports Government purchases of goods and services and investment spending Federal National defense Nondefense State and local 979.3 662.2 317.1 1,695.5 1,662.4 2,370.2 2,134.0 1,503.8 480.3 1,023.5 630.2 3.6 $1,082.8 2,833.0 5,794.4

a. Calculate consumer spending. b. Calculate private investment spending. c. Calculate net exports. d. Calculate government purchases of goods and services and investment spending. e. Calculate gross domestic product. f. Calculate consumer spending on services as a percentage of total consumer spending. g. Calculate exports as a percentage of imports. h. Calculate government purchases on national defense as a percentage of federal government purchases of goods and services.

3. Solution

All figures below are in billions of dollars. a. Consumer spending is $1,082.8 + $2,833.0 + $5,794.4 = $9,710.2. b. Private investment spending is $2,134.0 $3.6 = $2,130.4. c. Net exports are $1,662.4 $2,370.2 = $707.8. d. Government purchases of goods and services and investment spending are $1,695.5 + $979.3 = $2,674.8. e. Gross domestic product is $9,710.2 + $2,130.4 + $2,674.8 $707.8 = $13,807.6. f. Consumer spending on services as a percentage of total consumer spending is ($5,794.4/$9,710.2) 100 = 59.7%. g. Exports as a percentage of imports is ($1,662.4/$2,370.2) 100 = 70.1%. h. Government purchases of goods and services on national defense as a percentage of federal purchases of goods and services is ($662.2/$979.3) 100 = 67.6%.

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4.

The small economy of Pizzania produces three goods (bread, cheese, and pizza), each produced by a separate company. The bread and cheese companies produce all the inputs they need to make bread and cheese, respectively. The pizza company uses the bread and cheese from the other companies to make its pizzas. All three companies employ labor to help produce their goods, and the difference between the value of goods sold and the sum of labor and input costs is the firms profit. The accompanying table summarizes the activities of the three companies when all the bread and cheese produced are sold to the pizza company as inputs in the production of pizzas.
Bread company Cheese company Pizza company

Cost of inputs Wages Value of output

$0 15 50

$0 20 35

$50 (Bread) 35 (Cheese) 75 200

a. Calculate GDP as the value added in production. b. Calculate GDP as spending on final goods and services. c. Calculate GDP as factor income.

4. Solution

a. To calculate GDP as the value added in production, we need to sum all value added (value of output less input costs) for each company. Value added in the bread company is $50; in the cheese company, $35; and in the pizza company, $115 ($200 $50 $35). The total value added in production is $200 ($50 + $35 + $115).

b. To calculate GDP as spending on final goods and services, we only need to estimate the value of pizzas because all bread and cheese produced are intermediate goods used in the production of pizzas. Spending on final goods and services is $200. c. To calculate GDP as factor income, we need to sum factor income (wages and profits) for each firm. For the bread company, factor income is $50: labor earns $15 and profit is $35. For the cheese company, factor income is $35: labor earns $20 and profit is $15. For the pizza company, factor income is $115: labor earns $75 and profit is $40 ($200 $75 $50 $35). Factor income is $200 ($50 + $35 + $115).

5.

In the economy of Pizzania (from Problem 4), bread and cheese produced are sold both to the pizza company for inputs in the production of pizzas and to consumers as final goods. The accompanying table summarizes the activities of the three companies.
Bread company Cheese company Pizza company

Cost of inputs Wages Value of output

$0 25 100

$0 30 60

$50 (Bread) 35 (Cheese) 75 200

a. Calculate GDP as the value added in production. b. Calculate GDP as spending on final goods and services. c. Calculate GDP as factor income.

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Solution 5.

a. To calculate GDP as the value added in production, we need to sum all value added (value of output less input costs) for each company. Value added in the bread company is $100; in the cheese company, $60; and in the pizza company, $115 ($200 $50 $35). The total value added in production is $275. b. To calculate GDP as spending on final goods and services, we need to sum the value of bread, cheese, and pizzas sold as final goods. GDP equals $275 because the bread company sells $50 worth as final goods, the cheese company sells $25 worth as final goods, and all $200 worth of pizzas are final goods. c. To calculate GDP as factor income, we need to sum factor income (labor and profits) for each firm. For the bread company, factor income is $100: labor earns $25 and profit is $75. For the cheese company, factor income is $60: labor earns $30 and profit is $30. For the pizza company, factor income is $115: labor earns $75 and profit is $40 ($200 $75 $50 $35). As factor income, GDP equals $275 ($100 + $60 + $115).

6.

Which of the following transactions will be included in GDP for the United States? a. Coca-Cola builds a new bottling plant in the United States. b. Delta sells one of its existing airplanes to Korean Air. c. Ms. Moneybags buys an existing share of Disney stock. d. A California winery produces a bottle of Chardonnay and sells it to a customer in Montreal, Canada. e. An American buys a bottle of French perfume in Tulsa. f. A book publisher produces too many copies of a new book; the books dont sell this year, so the publisher adds the surplus books to inventories.

6. Solution

a. When Coca-Cola builds a new bottling plant, it is investment spending and included in GDP. b. If Delta sells one of its airplanes to Korean Air, this transaction is not included in GDP because it does not represent production during the current time period. The airplane would have been included in GDP when it was produced; now it is just a sale of a used item. c. When an individual buys an existing share of stock, the transaction is not included in GDP because there is no production. d. If a California winery sells a bottle of Chardonnay to a customer in Montreal, it is a U.S. export and is entered as such in U.S. GDP. e. When an American buys a bottle of French perfume, it is a consumption expenditure as measured by GDP. But since it does not represent production in the United States, it is also deducted from GDP as an import. The net effect of the transaction does not change GDP in the United States. f. If a book publisher produces too many copies of a new book and the books dont sell in the year they are produced, the publisher adds the surplus books to inventories. These books are considered investment spending and added to GDP. It is as if the publisher bought the books itself.

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7.

The economy of Britannica produces three goods: computers, DVDs, and pizza. The accompanying table shows the prices and output of the three goods for the years 2005, 2006, and 2007.
Computers Year Price Quantity Price DVDs Quantity Price Pizza Quantity

2005 2006 2007

$900 1,000 1,050

10 10.5 12

$10 12 14

100 105 110

$15 16 17

2 2 3

a. What is the percent change in production of each of the goods from 2005 to 2006 and from 2006 to 2007? b. What is the percent change in prices of each of the goods from 2005 to 2006 and from 2006 to 2007? c. Calculate nominal GDP in Britannica for each of the three years. What is the percent change in nominal GDP from 2005 to 2006 and from 2006 to 2007? d. Calculate real GDP in Britannica using 2005 prices for each of the three years. What is the percent change in real GDP from 2005 to 2006 and from 2006 to 2007?

7. Solution

a. From 2005 to 2006, the percent change in the production of computers is 5.0% (equal to ((10.5 10)/10) 100); of DVDs, 5.0% (equal to ((105 100)/100) 100); and of pizza, 0% (equal to ((2 2)/2) 100). From 2006 to 2007, the percent change in the production of computers is 14.3% (equal to ((12 10.5)/10.5) 100); of DVDs, 4.8% (equal to ((110 105)/105) 100); and of pizza, 50.0% (equal to ((3 2)/2) 100). b. From 2005 to 2006, the percent change in the price of computers is 11.1% (equal to (($1,000 $900)/$900) 100); of DVDs, 20.0% (equal to (($12 $10)/$10) 100); and of pizza, 6.7% (equal to (($16 $15)/$15) 100). From 2006 to 2007, the percent change in the price of computers is 5.0% (equal to (($1,050 $1,000)/$1,000) 100); of DVDs, 16.7% (equal to (($14 $12)/$12) 100); and of pizza, 6.25% (equal to (($17 $16)/$16) 100). c. Nominal GDP for each year is calculated by summing up the value of the three goods produced in that year:
Year Nominal GDP Percent change in nominal GDP

2005 2006 2007

$10,030 11,792 14,191 17.6% 20.3%

d. Real GDP in 2005 prices is calculated by summing up the value of the three goods produced each year using 2005 prices:
Real GDP (2005 dollars)

Year

Percent change in real GDP

2005 2006 2007

$10,030 10,530 11,945 5.0% 13.4%

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8.

The accompanying table shows data on nominal GDP (in billions of dollars), real GDP (in billions of 2000 dollars), and population (in thousands) of the United States in 1960, 1970, 1980, 1990, 2000, and 2007, years in which the U.S. price level consistently rose.
Nominal GDP (billions of dollars) Real GDP (billions of 2000 dollars) Population (thousands)

Year

1960 1970 1980 1990 2000 2007

$526.4 1,038.5 2,789.5 5,803.1 9,817.0 13,841.3

$2,501.8 3,771.9 5,161.7 7,112.5 9,817.0 11,566.8

180,671 205,052 227,726 250,132 282,388 301,140

a. Why is real GDP greater than nominal GDP for all years before 2000 and lower for 2007? Does nominal GDP have to equal real GDP in 2000? b. Calculate the percent change in real GDP from 1960 to 1970, 1970 to 1980, 1980 to 1990, and 1990 to 2000. Which period had the highest growth rate? c. Calculate real GDP per capita for each of the years in the table. d. Calculate the percent change in real GDP per capita from 1960 to 1970, 1970 to 1980, 1980 to 1990, and 1990 to 2000. Which period had the highest growth rate? e. How do the percent change in real GDP and the percent change in real GDP per capita compare? Which is larger? Do we expect them to have this relationship?

8. Solution

a. Real GDP is greater than nominal GDP for all years before 2000 because from 1960 to 2000 prices rose. So to calculate real GDP for the years 1960, 1970, 1980, and 1990, we would multiply output in those years by the higher prices that existed in 2000. To calculate nominal GDP, we would multiply output by the lower prices that existed in those particular years. Since prices rose from 2000 to 2007, valuing the output in 2007 using 2000 prices (real GDP) will result in a lower number than valuing the output in 2007 using 2007 prices. Real GDP equals nominal GDP in 2000 because the year 2000 is the base year and we use the same set of prices to value both real and nominal GDP in that year. b. The accompanying table shows the percent change in real GDP from 1960 to 1970, 1970 to 1980, 1980 to 1990, and 1990 to 2000. The percent change in real GDP was the highest during the 1960s.
Real GDP (billions of 2000 dollars)

Year

Percent change in real GDP

1960 1970 1980 1990 2000

$2,501.8 3,771.9 5,161.7 7,112.5 9,817.0 50.8% 36.8% 37.8% 38.0%

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c. We can calculate real GDP per capita by dividing real GDP by population. The accompanying table shows real GDP per capita for each of the years in the table. Remember that real GDP is measured in billions and population is measured in thousands. Real GDP per capita in 1960 was $13,847.27 (equal to $2,501,800,000,000/180,671,000).
Real GDP (billions of 2000 dollars) Population (thousands)

Year

Real GDP per capita

1960 1970 1980 1990 2000 2007

$2,501.8 3,771.9 5,161.7 7,112.5 9,817.0 11,566.8

180,671 205,052 227,726 250,132 282,388 301,140

$13,847.27 18,394.85 22,666.27 28,434.99 34,764.23 38,410.04

d. The accompanying table shows the percent change in real GDP per capita from 1960 to 1970, 1970 to 1980, 1980 to 1990, and 1990 to 2000. The percent change in real GDP per capita was the highest during the 1960s.
Real GDP (billions of 2000 dollars)

Year

Population (thousands)

Real GDP per capita

Percent change in real GDP per capita

1960 1970 1980 1990 2000

$2,501.8 3,771.9 5,161.7 7,112.5 9,817.0

180,671 205,052 227,726 250,132 282,388

$13,847.27 18,394.85 22,666.27 28,434.99 34,764.23 32.8% 23.2% 25.5% 22.3%

e. In this example, the percent change in real GDP is larger than the percent change in real GDP per capita. As long as the population is growing, the two will always have this relationship.

9.

Eastland College is concerned about the rising price of textbooks that students must purchase. To better identify the increase in the price of textbooks, the dean asks you, the Economics Departments star student, to create an index of textbook prices. The average student purchases three English, two math, and four economics textbooks. The prices of these books are given in the accompanying table.
2005 2006 2007

English textbook Math textbook Economics textbook

$50 70 80

$55 72 90

$57 74 100

a. What is the percent change in the price of an English textbook from 2005 to 2007? b. What is the percent change in the price of a math textbook from 2005 to 2007? c. What is the percent change in the price of an economics textbook from 2005 to 2007? d. Using 2005 as a base year, create a price index for these books for all years. e. What is the percent change in the price index from 2005 to 2007?

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Solution 9.

a. The percent change in the price of an English textbook from 2005 to 2007 is 14.0% (equal to (($57 $50)/$50) 100). b. The percent change in the price of a math textbook from 2005 to 2007 is 5.7% (equal to (($74 $70)/$70) 100). c. The percent change in the price of an economics textbook from 2005 to 2007 is 25% (equal to (($100 $80)/$80) 100). d. To create an index of textbook prices, you must first calculate the cost of the market basket (three English, two math, and four economics textbooks) in each of the three years; then normalize it by dividing the cost of the market basket in a given year by the cost of the market basket in the base period; and then multiply by 100 to get an index value (base period of 2005 = 100). Cost of textbooks in 2005 = (3 $50) + (2 $70) + (4 $80) = $610 Cost of textbooks in 2006 = (3 $55) + (2 $72) + (4 $90) = $669 Cost of textbooks in 2007 = (3 $57) + (2 $74) + (4 $100) = $719 Index value for 2005 = ($610/$610) 100 = 100 Index value for 2006 = ($669/$610) 100 = 109.7 Index value for 2007 = ($719/$610) 100 = 117.9 e. The percent change in the price index for textbooks from 2005 to 2007 is 17.9% (equal to ((117.9 100)/100) 100).

10.

The consumer price index, or CPI, measures the cost of living for a typical urban household by multiplying the price for each category of expenditure (housing, food, and so on) times a measure of the importance of that expenditure in the average consumers market basket and summing over all categories. However, using data from the consumer price index, we can see that changes in the cost of living for different types of consumers can vary a great deal. Lets compare the cost of living for a hypothetical retired person and a hypothetical college student. Lets assume that the market basket of a retired person is allocated in the following way: 10% on housing, 15% on food, 5% on transportation, 60% on medical care, 0% on education, and 10% on recreation. The college students market basket is allocated as follows: 5% on housing, 15% on food, 20% on transportation, 0% on medical care, 40% on education, and 20% on recreation. The accompanying table shows the November 2007 CPI for each of the relevant categories.
CPI November 2007

Housing Food Transportation Medical care Education Recreation

210.7 206.3 190.7 357.0 121.4 118.8

Calculate the overall CPI for the retired person and for the college student by multiplying the CPI for each of the categories by the relative importance of that category to the individual and then summing each of the categories. The CPI for all items in November 2007 was 210.2. How do your calculations for a CPI for the retired person and the college student compare to the overall CPI?

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10. Solution

To calculate the CPI for the retired person and for the college student, we need to weight the CPI for each component with the importance of that component in his or her market basket. The CPI for the retired person is 286.93 and for the college student is 150.54. Since the CPI for the average consumer was 210.2, the CPI overstates the increase in the cost of living for the college student and understates it for the retired person. For the retired person:
CPI November 2007 CPI Contribution

Weight

Housing Food Transportation Medical care Education Recreation Overall CPI

0.1 0.15 0.05 0.6 0 0.1

210.7 206.3 190.7 357.0 121.4 111.8

21.07 30.945 9.535 214.2 0 11.18 286.93

For the college student:

CPI November 2007 CPI Contribution

Weight

Housing Food Transportation Medical care Education Recreation Overall CPI

0.05 0.15 0.2 0 0.4 0.2

210.7 206.3 190.7 357.0 121.4 118.8

10.535 30.945 38.14 0 48.56 23.76 151.94

11.

Each month the Bureau of Labor Statistics releases the Consumer Price Index Summary for the previous month. Go to www.bls.gov and find the latest report. (On the Bureau of Labor Statistics home page, click on News Release under Latest NumbersConsumer Price Index and then choose Consumer Price Index Summary.) What was the CPI for the previous month? How did it change from the previous month? How does the CPI compare to the same month one year ago?

Solution 11.

Answers will vary with the latest data. For November 2007, the CPI was 210.2; it rose 0.6% from October 2007. The CPI was 4.3% higher than in November 2006.

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12.

The accompanying table provides the annual real GDP (in billions of 2000 dollars) and nominal GDP (in billions of dollars) for the United States.
2002 2003 2004 2005 2006

Real GDP (billions of 2000 dollars) 10,048.8 10,301.0 10,675.8 11,003.4 11,319.4 Nominal GDP (billions of dollars) 10,469.6 10,960.8 11,685.9 12,433.9 13,194.7

a. Calculate the GDP deflator for each year. b. Use the GDP deflator to calculate the inflation rate for all years except 2002.

Solution 12.

a. The GDP deflator in a given year is 100 times the ratio of nominal GDP to real GDP, yielding the figures in the accompanying table.
2002 2003 2004 2005 2006

Real GDP (billions of 2000 dollars) Nominal GDP (billions of dollars) GDP deflator

10,048.80

10,301.00

10,675.80

11,003.40

11,319.40

10,469.60 104.19

10,960.80 106.41

11,685.90 109.46

12,433.90 113.00

13,194.70 116.57

b. The inflation rate obtained by using the GDP deflator is calculated using the formula ((current GDP deflator GDP deflator in the previous year)/(GDP deflator in the previous year)) 100, yielding the figures in the accompanying table.
2002 2003 2004 2005 2006

GDP deflator Inflation

104.19

106.41 2.13%

109.46 2.87%

113.00 3.23%

116.57 3.16%

13.

The accompanying table contains two price indexes for the years 2004, 2005, and 2006: the GDP deflator and the CPI. For each price index, calculate the inflation rate from 2004 to 2005 and from 2005 to 2006.
Year GDP deflator CPI

2004 2005 2006

109.5 113.0 116.6

188.9 195.3 201.6

Solution 13.
Year

The accompanying table calculates the inflation rates based on the GDP deflator and on the CPI.
GDP deflator Inflation rate (based on GDP deflator) Inflation rate (based on CPI)

CPI

2004 2005 2006

109.5 113.0 116.6 3.2% 3.2%

188.9 195.3 201.6 3.4% 3.2%

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14.

The cost of a college education in the United States is rising at a rate faster than inflation. The table below shows the average cost of a college education in the United States in 2006 and 2007 for public and private colleges. Assume the costs listed in the table are the only costs experienced by the various college students in a single year.
Tuition and fees Cost of college education (averages in 2006 dollars) Books and supplies Room and board Transportation Other expenses

Two-year public college: commuter Four-year public college: resident Four-year public college: commuter Four-year public college: out-of-state Four-year private college: resident Four-year private college: commuter

$ 2,272 5,836 5,836 15,783 22,218 22,218

Tuition and fees

$850 942 942 942 935 935

$6,299 6,690 6,917 6,960 8,149 7,211

$1,197 880 1,224 880 722 1,091

$1,676 1,739 2,048 1,739 1,277 1,630

Other expenses

Cost of college education (averages in 2007 dollars) Books and supplies Room and board Transportation

Two-year public college: commuter Four-year public college: resident Four-year public college: commuter Four-year public college: out-of-state Four-year private college: resident Four-year private college: commuter

$ 2,361 6,185 6,185 16,640 23,712 23,712

$921 988 988 988 988 988

$6,875 7,404 7,419 7,404 8,595 7,499

$1,270 911 1,284 911 768 1,138

$1,699 1,848 2,138 1,848 1,311 1,664

a. Calculate the cost of living for an average college student in each category for 2006 and 2007. b. Assume the quantity of goods purchased in each category, i.e., the market basket, is identical for 2006 and 2007. Calculate an inflation rate for each type of college student between 2006 and 2007.

Solution
14.

a. To calculate the cost of living, we add all the costs in each category. The cost of living for each type of student is calculated in the accompanying table.
Average cost of attendance in dollars 2006 2007

Two-year public college: commuter Four-year public college: resident Four-year public college: commuter Four-year public college: out-of-state Four-year private college: resident Four-year private college: commuter

$12,294 16,087 16,967 26,304 33,301 33,085

$13,126 17,336 18,014 27,791 35,374 35,001

b. The inflation rate for each type of student is calculated as follows: ((price index in 2007)/(price index in 2006)) 100. Because the market basket stays the same for each type of student, the cost of living can be used as a price index. Using the formula, the inflation rates are calculated in the following table.
Inflation rate

Two-year public college: commuter Four-year public college: resident Four-year public college: commuter Four-year public college: out of state Four-year private college: resident Four-year private college: commuter

6.8% 7.8% 6.2% 5.7% 6.2% 5.8%