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GDP and the Standard of Living

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 GDP B. 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



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 GDP 1. 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


Whats New in this Edition?

ThematerialinChapter20hasbeenupdated.Thephrase governmentpurchasesofgoodsandserviceshasbeenre placedwithgovernmentexpenditureongoodsandser vices.IntheincomeapproachtoGDP,thecomponentsare nowwagesandinterest,rent,andprofitratherthan compensationofemployees,netinterest,rentalincome ofpersons,corporateprofits,andproprietorsincome. Thestatisticaldiscrepancybetweentheincomeandexpendi tureapproachtoGDPisnowdiscussed.Thereisanex tendeddiscussionoftherelationshipsamongGDP,GNP, anddisposablepersonalincome.Thenewmethodforcalcu latingGDPiscalledthechaineddollarmethodratherthan thechainlinkingmethod.Thecoverageofvalueaddedis eliminated.InCheckpoint4thereisnowcoverageofthe standardoflivingintheUnitedStatesovertimeandbrief coverageofthestandardoflivingamongcounties.

Where We Are
InChapter20,wedefineGDPandexplainwhyfortheecon omy,thevalueofproductionequalsincome,whichalso equalsexpenditure.Wedescribehoweconomicstatisticians measureGDPintheUnitedStates.Nextwedistinguishbe tweennominalGDPandrealGDP,anddefinetheGDPde flator.Lastly,weexplainanddescribethelimitationsofreal GDPasameasureofthestandardofliving.

Chapter 20 . GDP and the Standard of Living


Where Weve Been

Thisisthefirstchapterthatdirectlyexploresmacroeconom ics.

Where Were Going

InChapter21,wecontinuewiththeoverviewofhowthe economyoperates.Wecoverhowtheunemploymentrateis calculated,reviewlabormarketindicatorsaswellastrends andfluctuationsinthelabormarket,andthenexplorethe sourcesandtypesofunemployment.

IN THE CLASSROOM Class Time Needed

The material in this chapter can be covered between one and a half to two class sessions. Anestimateofthetimeperchecklisttopicis: 20.1GDP,Income,andExpenditure15minutes 20.2MeasuringU.S.GDP25minutes 20.3NominalGDPVersusRealGDP40minutes 20.4RealGDPandtheStandardofLiving20minutes




GDP, Income, and Expenditure

GDP Defined
GDPorgross domestic productisthemarketvalueofallthefinalgoodsandservices producedwithinacountryinagiventimeperiod Valueproduced:TheitemsinGDParevaluedattheirmarketvalues,thatis,attheir prices.Soif1,000,000slicesofpizzaaresoldfor$4each,slicesofpizzacontribute $4,000,000toGDP. Whatproduced:Toavoiddoublecounting,GDPincludesonlyfinalgoodsandser vices.Afinalgoodorserviceisanitemthatisproducedforitsfinaluserandnot usedasacomponentofanothergoodorservice.Itcontrastswithanintermediate goodorservice,whichisanitemthatisproducedbyonefirm,boughtbyanother firm,andusedasacomponentofafinalgoodorservice. Whereproduced:Onlythegoodsandservicesproducedwithinacountryarecounted. SoaHondaproducedinNorthCarolinaiscountedinU.S.GDP. Whenproduced:GDPmeasuresproductionduringagivenperiodoftime,typicallya quarterofayearorayear. Inthegoodsmarket,households,firms,governments,andforeignersbuygoodsandser vices. Consumption expenditure,C,istheexpenditurebyhouseholdsonconsumption goodsandservices. Investment,I,isthepurchasesofnewcapitalgoods(tools,instruments,machines, buildings,andotheritems)andadditionstoinventories. Government expenditures on goods and services,G,istheexpendituresbyalllev elsofthegovernmentongoodsandservices. Net exports of goods and services,NX,isthevalueofexportsofgoodsandservices minusthevalueofimportsofgoodsandservices.Exports of goods and servicesare theitemsthatfirmsintheUnitedStatesproduceandselltotherestoftheworld. Imports of goods and servicesaretheitemsthathouseholds,firms,andgovern mentsintheUnitedStatesbuyfromtherestoftheworld.

Circular Flows in the U.S. Economy

Governmenttransferpayments,suchasSocialSecuritypayments,arenotpartofgovernment expendituresongoodsandservicesbecausetheseexpendituresincludeonlyfundsusedbythe governmenttobuygoodsandservices.Transferpaymentsarenotbuyingagoodorservicefor thegovernmentandsoarenotincludedingovernmentexpendituresongoodsandservices.

Total Expenditure
TotalexpenditureequalsC+I+G+(XM). Householdsreceivewages,capital,interest,rent,andprofitasincome.Somepartoftotal incomeisnotpaidouttohouseholdsbyfirms,butfromaneconomicstandpoint,this undistributedprofitisincomepaidtohouseholdsandthenloanedbacktofirms.

Chapter 20 . GDP and the Standard of Living


Expenditure Equals Income

Becausefirmspayoutasincomeeverythingtheyreceiveasrevenuefromsellinggoods andservices,totalincome,Y,equalstotalexpenditure.So:

Forafirm,thevalueofitsproductionisthecostoftheproduction,whichequalsthein comegeneratedbytheproduction.Sothevalueofproductionequalsincomeequalsex penditure,or

GDP=Y=C+I+G+(XM). 20.2

Measuring U.S. GDP

The Expenditure Approach

TheexpenditureapproachmeasuresGDPasthesumofconsumptionexpenditure,C,in vestment,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,isnotpartofGDPbe causethesearenotexpendituresongoodsandservices. TheincomeapproachmeasuresbyGDPinseveralsteps: Theincomeapproachstartswiththesumofwagesplusinterest,rent,andprofit (calledoperatingsurplusinthenationalincomeaccounts).Thissumequalsnetdo mesticincomeatfactorcost. Tochangethemeasurefromfactorcosttomarketprice,indirecttaxeslesssubsidies areaddedbecausethesearegovernmenttaxesandtransfersthataffectmarketprices. Thenextstepaddsdepreciation,thedecreaseinthevalueofcapitalthatresultsfrom itsuseandobsolescence. Ifeverythingismeasuredcorrectly,addingdepreciationwouldyieldGDP.Butthere oftenisastatisticaldiscrepancy,thedifferencebetweentheexpenditureapproach andtheincomeapproach.Thedifferenceismeasuredastheexpenditureapproach minustheincomeapproach,soanystatisticaldiscrepancyisaddedtoyieldthein comeapproachGDP. Grossnationalproduct,(GNP)isthemarketvalueofallfinalgoodsandservicespro ducedanywhereintheworldinagiventimeperiodbythefactorsofproductionsup pliedbytheresidentsofthecountry.SopharmaceuticaldrugsproducedinIrelandbya U.S.drugcompanyispartofU.S.GNPbutnotpartofU.S.GDP. U.S.GNPequalsU.S.GDPplusnetfactorincomefromabroad.

The Income Approach

GDP and Related Measures of Production and Income



Disposablepersonalincomeistheincomereceivedbyhouseholdsminuspersonalin cometaxespaid.ItequalsGNPminusdepreciationminusanystatisticaldiscrepancymi nusretainedprofitsbybusinessesplustransferpaymentsminuspersonalincometaxes.


Nominal GDP Versus Real GDP

ThemarketvalueofproductionandhenceGDPcanincreaseeitherbecausetheproductionof goodsandservicesarehigherorbecausethepricesofgoodsandservicesarehigher.

Calculating Real GDP

RealGDPallowsthequantitiesofproductiontobecomparedacrosstime.Real GDPis thevalueoffinalgoodsandservicesproducedinagivenyearexpressedinthepricesofa baseyear. Nominal GDPisthevalueofthefinalgoodsandservicesproducedinagivenyearex pressedinthepricesofthatsameyear. Traditionally,realGDPiscalculatedusingpricesofthebaseyear(theyearinwhichreal GDP=nominalGDP).Butthismethodhasbeengenerallyreplacedwithanew,chained dollarmethodthatusesthepricesoftwoadjacentyearstocalculatetherealGDPgrowth rateandthenusesthegrowthratestocreateachainlinkingthebaseyearrealGDPtothe realGDPinfutureyears.

The Chained-Dollar Method for Calculating Real GDP

Thetoptabletotherighthas datafor2005foraneconomy thatproducesonlybooksand coffee.In2005,nominalGDPis $3,000.Thesecondtabletothe righthasdatafor2006.In2006, nominalGDPis$6,000. NominalGDPhasdoubledbut howmuchhasrealGDP changedbetweentheseyears? TodeterminehowrealGDP changes,supposethat2005is thebaseyear.Thenweneedto determinethegrowthratebe tween2005and2006bycalcu latingGDPinbothyearsusing 2005pricesandcalculating GDPinbothyearsusing2006 prices. GDPDatafor2005 Item Books Coffee NominalGDP Quantity 40 1,000 Price $25 $2 MarketValue $1,000 $2,000 $3,000

GDPDatafor2006 Item Books Coffee NominalGDP Quantity 50 1,500 Price $30 $3 MarketValue $1,500 $4,500 $6,000

Chapter 20 . GDP and the Standard of Living


Using2005prices,realGDPin creasesfrom$3,000(thefirstta ble)to$4,250(thethirdtable). Using2005prices,realGDPhas grownby[($4,250$3,000) $3,000]100=41.7percent. Using2006prices,realGDPin creasesfrom$4,200(thefourth table)to$6,000(thesecondta ble).Using2006prices,realGDP hasgrownby[($6,000$4,200) $4,200]100=42.9percent. Theaveragegrowthrateofreal GDPisequalto(41.7percent+ 42.9percent)2=42.3percent. SorealGDPbetweentheseyears hasgrownby42.3percent.If 2005isthebaseyear,realGDPin 2006is$3,0001.423=$4,269.

2006Quantitiesand2005Prices Item Books Coffee RealGDP (2005dollars) Quantity 50 1500 Price MarketValue $25 $2 $1,250 $3,000 $4,250

2005Quantitiesand2006Prices Item Books Coffee RealGDP (2006dollars) Quantity 40 1,000 Price MarketValue $30 $3 $1,200 $3,000 $4,200

Calculating the GDP Deflator

TheGDP deflatoristheaverageofcurrentyearpricesexpressedasapercentageofbase yearprices.Intermsofaformula,GDPdeflator=(NominalGDPRealGDP)100. Usingtheexampleworkedabove,nominalGDPin2006is$6,000andrealGDPis$4,269. SotheGDPdeflatorfor2006is($6,000$4,269)100=140.5.


The Use and Limitations of Real GDP

RealGDPcanbeusedtocomparethestandardoflivingovertimeandtocomparethestandard oflivingamongcountries.

The Standard of Living Over Time

RealGDPperpersoncanbeusedtocomparethestandardofliving.Real GDP per personisrealGDPdividedbythepopulation. IntheUnitedStates,realGDPperpersonis2.4timeslargerthanitwasin1964.Real GDPperpersonhasdoubledaboutevery30yearsforthepast100years. FluctuationsinthegrowthofrealGDPreflectbusinesscycles.Abusiness cycleisthepe riodicbutirregularupanddownmovementoftotalproductionandothermeasuresof economicactivity.Businesscycleshavefourstages: Expansion:TheexpansionphaseistheperiodduringwhichrealGDPisincreasing. Peak:Anexpansioncontinuesuntilapeakisreach.Apeakisthehighestlevelofreal GDPyetattained.



Recession:Followingthepeakisarecession.Arecessionisperiodduringwhichreal GDPdecreasesforatleastsixmonths. Trough:Aftertherecessionisthetrough,thelowpointinrealGDPafterwhichfol lowsanexpansion.

The Standard of Living Among Countries

TocomparerealGDPperpersonamongcountries,therealGDPsshouldbecalculatedusinga commonsetofprices,calledpurchasingpowerparityprices.Whenthisisdown(asthedatain Chapter2show)U.S.realGDPperpersonmeasuredasincomeperpersonishigherthaninother advancedeconomies.

Goods and Services Omitted From GDP

GDPmeasuresthevalueofgoodsandservicesthatareboughtinmarkets,soitexcludes: HouseholdProduction:Householdproductionisproductiveactivitiesatthehomethatdo notinvolvemarkettransactions.Asmoreservices,suchaschildcare,areprovidedinthe marketplace,themeasuredgrowthrateoverstatesdevelopmentofalleconomicactivity. UndergroundProduction:Undergroundproductionisthepartoftheeconomythatishid denfromtheviewofthegovernmenteitherbecausepeoplewanttoavoidtaxesand regulationsorbecausethegoodsandservicesbeingproducedareillegal. Iftheunder groundeconomyisareasonablystableproportionofalleconomicactivity,thegrowth ratewillbeaccurate. LeisureTime:Leisuretimeisaneconomicgoodthatdoesnotgetmeasuredintheofficial GDPfigures.Increasesinleisuretimelowertheeconomicgrowthrate,butwevalueour leisuretimeandwearebetteroffwithit. EnvironmentalQuality:Pollutiondoesnotdirectlylowertheeconomicgrowthrate.Ifour standardoflivingisadverselyaffectedbypollution,ourGDPmeasuredoesnotshow thisfact.Thereasonisthatthedevicesthatweproducetomitigatepollutioncountas partofGDPbutthepollutionitselfisnotsubtracted

Other Influences on the Standard of Living

OmittedfromGDPbutimportantforthestandardoflivingis: HealthandLifeExpectancy:Whileobviouslyimportantfactorsdeterminingthestandardof peoplesliving,theyareomittedfromrealGDP.Healthandlifeexpectancyhaveim provedasinfantdeathsanddeathinchildbirthhavealmostbeeneliminated.Lifeexpec tancyhasincreasedfrom70yearsattheendofWWIItonearly80yearstoday.These gainshavebeencheckedsomewhatbyAIDSanddrugabuse,whichtakeawayfromour standardofliving. PoliticalFreedomandSocialJustice:Politicalfreedomandsocialjusticearenotmeasuredby realGDP.AcountrymightenjoyaverylargeGDPbuthavelimitedpoliticalfreedom andsocialjusticeandhencehavealowerstandardofliving.

Chapter 20 . GDP and the Standard of Living


Lecture Launchers
1. As teachers, we often dont like to write definitions on the board. We will ask students to refer to the text or we might hurriedly verbalize them. This general propensity is a missed opportunity to focus on the elegance of the definition of GDP. From the text, GDP is defined as: Gross Domestic Prod uctisthemarketvalueofallthefinalgoodsandservicesproducedwithina country in agiven time period.Ask your students to go through the defini tion and pull out the essential parts. You will get this list: market value, fi nal goods and services, produced, within a country, and time period. Ex plain that the words chosen in this definition were selected carefully. First, ifthephrasemarketvaluehadbeenleftout,therewouldberoomforlots ofproblems.Noticethatwhenthegovernmentreportsthisfigure,itdoesnt announce how many trains, planes, and automobiles the country has pro ducedbutratheritannouncesamonetaryvalue.Usingmonetaryvaluesaf fords us the opportunity to be able to get around the problem of aggrega tion when the items in question are markedly different. We solve it by al lowing the marketplace to determine the weights. The second item on the list is final goods and services. The explanation here is straightforward: We are distinguishing between final products and intermediate products. Intermediate goods are goods that are bought by one firm to be used in the productionofanothergoodthatwillbeultimatelyconsumed.Ifweinclude these intermediategoods, then we would double count the nations output. Now we come to the word produced. This word is to make clear that sales are not important. If we only counted sales, then the GDP figures would understate production because not all output is sold. Some of it be comes inventory. Next is the phrase within a country. This phrase is to make clear that we dont count output that wasnt produced on a nations soilregardlessofwhowasresponsibleforproducingit.Lastly,isthephrase time period. Here we want to make unambiguous that we are only talk ing about production that occurred in a certain period. This phrase leaves no doubt that production of a good or service produced in a previous time period (even if perhaps sold in the present time period) does not count in thisperiodsGDP. 2. You might like to tell your students that measuring real GDP is actually verycheap.TheBEA(intheDepartmentofCommerce)employsfewerthan 500 economists, accountants, statisticians, and IT specialists at an annual costoflessthat$70million.ItcostseachAmericanlessthan0.25(aquarter of a cent) to measure the value of the nations production. For some further perspective, the NationalOceanicand AtmosphericAdministration (also in the Department of Commerce), whose mission is to describe and predict changes in the Earths environment, and conserve and manage wisely the nations coastal and marine resources so as to ensure sustainable economic



opportunities, employs more than 11,000 scientists and support personnel atanannualcostof$3.2billion! Most of the income data used by the BEA comes from the IRS. Expendi turedatacomesfromavarietyofsources. Inrecentyears,thefirstestimatesofGDP,whicharebasedoncompanies reported profits, have been revised downward when data on company profits as reported to the IRS became available. Enronstyle accounting has contaminatedtheinitialestimatesofGDPbutnotthefinalestimates. You can make a nice point with one example of creative accounting. For some years, in its reports to shareholders AOL recorded its advertising ex penditureasinvestmentandamortizeditoveranumberofyears. First, you can explain that the correct treatment of this item is as an ex penditure on intermediate goods and services by AOL and as a charge againstAOLsprofit.Youcangoonto explainthatAOLsaccountingprac tice would misleadingly swell GDP by causing some double counting. On the expenditure approach, AOLs advertising expenditure shows up as 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. But when AOL files its tax returns, it calls its advertising a cost and lowers its profits by that amount. The BEA picks up these numbers from theIRSandthenationalaccountsgetadjustedappropriately.Thedifference in reported numbers by AOL indicates why the statistical discrepancy be tween the expenditure and income approaches to measuring GDP exists. One question students might ask is how big is the discrepancy. You can showthemthatthestatisticaldiscrepancyisasmallpercentageoftheover all figures. If the discrepancy suddenly varies wildly for a given year, then this would indicate that the numbers need to be rechecked. This example also highlights why we have different calculations for GDP, so that we are notrelyingsolelyononesetofestimates 3. A discussion of omissions from GDP can arouse students interest. For ex ample, you might point out that if one of your students mows her/his own lawn, the value of the students production doesnt show up in GDP. But if you hire the student to mow your lawn (and if your student reports the in come earned correctly to the IRS), the value of the students production doesshowupinGDP. Why dont we measure all lawn mowing as part of GDP? Some reasons arecostofcollectingdataandthedegreeofintrusivenesswedbewillingto tolerate. But note how little we spend on collecting the GDP data and how relatively inexpensive it would be to add some questions about domestic

Chapter 20 . GDP and the Standard of Living


production to either the Labor Force Survey or the Family Expenditure Survey. You might like to explainhow the omission of illegal goods and services also leads to some misleading comparisons. For instance, the day before prohibitionended,theproductionofillegalbeerwasnotcounted aspartof GDP. But the day after prohibition ended, the production of nowlegal beer counted. Ask your students to suggest two good reasons why illegal goods and services are omitted. First, the data are hard but not impossible to ob tain. Second, there may be the moral position that illegal activities should not be included in GDP. This latter observation can lead to an interesting discussion. Ask the students if they think that the production of, say, mari juana should be included in GDP. Some, maybe even many, of them will see no problem with this. Then ask about the production of murderfor hire. The response, we hope, will be significantly different. Does such a goodhaveanyvalue? 4. For a global emphasis, discuss more fully some of the differences in GDP acrosscountries.ConsiderwhatisleftoutofGDPandaskstudentstothink abouthowwellGDPmeasureswelfare.Itmightbehelpfultopointoutthat GDP is a measure of the standard of living based on what is produced but doesnotsayanythingaboutincomeequalityorwhogetswhatisproduced. Point out again that this is a focus on a positive question (measuring out put)notanormativequestion(whoshouldgetwhatisproduced).Onepos sibility is to use the information in the Eye on the Global Economy. The Human Development Index, to discuss the human development index as an alternative or additional measure to compare different economies. Go to the human development webpage ( and pull out some countries you may be interested in to show different human devel opment indexes. You can then talk about what aspects may be captured in the HDI that are not captured with GDP. The human development report website states that the HDI measures average achievements in a country in three basic dimensions: a long and healthy life as measured by life expec tancy at birth, knowledgeas measuredby the adult literacy rate and school enrollment,andadecentstandardoflivingasmeasuredbyGDPpercapita inpurchasingpowerparityU.S.dollars. Another possibility is to compare the United States to European countries 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 Economist article that describes adjustments to real GDP made by Robert Gordon to account for differences in leisure, spending on heating/cooling, spending on jails, etc... that bring the measure of income between the



United States and Europe much closer together (Chasing the leader, Feb 6th 2003, TheEconomist print edition,Are Europeans really so much worse off than Americans?; based on the article Two centuries of economic growth: Europe chasing the American frontier, available at http://faculty Gordon first adjusts GDP per capita for the extra leisure time taken in European countries (bringing Europes income per capita to 82 percent, from the official figure of 77 percent of Americas income per capita). He then examines the higher spendingonairconditioningandheatingintheUnitedStatestoaccountfor more extreme climate changes and the higher spending on prisons and se curity services in the United States to account for the higher crime rate. Fi nally, he discusses the higher spending on roads and energy in the United Statestoaccountforthegreaterdispersionofindividualsinsuburbanareas with little public transportation options. Taking account of this greater wasteful spending in the United States and placing a value on Europes public transport system and the greater amount of leisure time, he finds that Europes adjusted income per capita is 92 percent of U.S. income per capita, much closer than the 77 percent based on GDP per capita. Introduc inga few of these ideas can lead to aninteresting discussion of cultural dif ferences and the choices made by individuals that may not be measured by GDP. Invariably students will point out that some of these may not be wasteful spending but simply indicate differences in attitude, such as the value placed on larger houses and yards as compared to the concentration andsizeofhomesinmanyEuropeancountries.

Land Mines
1. At an intuitive level, the equality between income and expenditure is not a difficult concept to get across. It makes sense to students that whatever someone spends must ultimately end up as income to someone else. The problem comes when we put this into practice. The reason has to do with the fact that there are two nonincome charges against GDP (depreciation and indirect taxes less subsidies). If they are ignored, then when using the income approach the figure obtained will be less than the figure obtained usingtheexpenditureapproach. Asalways we arefaced with a tradeoff. You can proceed immediately to introduce depreciation and indirect taxes less subsidies and do a compre hensive job. It will beaccurate, but your simpleand powerful point that in come equals expenditure will be lost. The second alternative is to wait and let the intuitive equality sink in. This procedure has the benefit of preserv ing the expenditure/income equality without prematurely exhausting your students. The downside is that you delay the inevitable. You will eventu allyhavetoexplainthediscrepancysometime.

Chapter 20 . GDP and the Standard of Living


2. StudentsoftengetcaughtupinthemathwhencalculatingtheGDPdeflator and forget what the point is to these calculations. You might want to use the Eye on the Economy, Deflating the GDP Balloon, before presenting any formulas. Emphasize the intuition that real GDP gives a measure of the ac tual output produced. Point out that nominal GDP can increase due to an increasein the goodsand services produced or due to an increase in prices. When we measure growth, however, we want to know how much more stuff is produced. Thus, to focus just on output changes, we have to take outthepricechanges.ThisisexactlywhatthecalculationofrealGDPdoes. 3. GDP is probably one of the most widely reported economic statistics in the world. It is part of news stories on television, radio, and newspapers. Busi nesses, consumers, investors, andgovernment officials haveall come to de pendonitasayardstickofeconomicprogress.However,aswithjustabout any economic statistic it has its flaws. The most prominent shortcoming is that it is not a perfect measure of social welfare. The text does a very good job outlining some of these problems. However, it is an area that still trips up a good many students. So if wouldnt be a bad idea to spend extra time withsomeofthecentralissues. Lets take the environment. Suppose the economy is operating at full employment on the production possibilities frontier. 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 respond by saying that it is difficult to say because it depends on just how badly the environment has deteriorated. That is to say, if the increase in GDP more than compensates for the reduction in the quality of the environment, then perhaps it is a welfareenhancingmoveandthestandardof living has indeed gone up. Point out that this issue is the crux of the con troversymeasuringsomethingaselusiveasacleanenvironment. You might consider asking students if there is any way out of this di lemma. One possible answer is that the standard of living could actually improve if there were developments that pushed the production possibili



ties frontier outward. In this case, we would be in the enviable position of beingabletoenjoyahigherGDPcoupledwithgreaterenvironmentalqual ity. To wrap up the discussion you might want to make a connection with this lecture and the material covered in Chapter 4 on Demand and Supply. First, ask students what kind of a good they think the environment is. That is, ask them if it is a normal good or an inferior good. They might balk at first at the idea by questioning whether it is a good in the first place. Dont let this problem derail you from your task. Explain that there are many things that we enjoy that are not necessarily bought and sold in markets that qualify as goods. A clean environment is something that is in just as much demand as national defense, fire protection, or a safe workplace. With this discussion, someone is bound to say that the environment is a normal good. Refresh their memory by restating what it takes foragood to be a normal good. Now you can point out that we have an answer for our dilemma in the production possibilities frontier. That is, as a nation ex pands its national output there is, for a time, damage done to the environ ment. However, as a nation prospers it has a greater demand and prefer enceforacleanerenvironment.And,youcanpointoutthatthisoutcomeis exactlywhathappenedinEurope.WhenthericherWestGermanyreunited with the poorer East Germany in the late 1980s, observers were stunned by how environmentally dirty East Germany was, especially compared to WestGermany!

Chapter 20 . GDP and the Standard of Living



1a. The fertilizer is an intermediate good because it willbe used to grow toma toes. 1b. The ringtone is a final good because you are the final user. It is part of con sumptionexpenditure. 1c. The computers are a final good. Because they are purchased by Pepsi, they areinvestment. 1d. The aircraft bought by Southwest Airlines is a final good. Because they are purchasedbySouthwestAirlines,theyareinvestment. 2a. Total expenditure equals the sum of consumption expenditure, investment, government expenditure, and net exports. So GDP equals $60 million + $25 million+$15million+$0=$100million. 2b. Totalincomeequalstotalexpenditure,sototalincomeequals$100million. 2c. To calculate net taxes, subtract from households total income their con sumption expenditure and their saving. Total income equals total expendi ture,sototalincomeequals$100million.Consumptionexpenditurewas$60 millionandsavingwas$20million,sonettaxesequals$20million.

CHECKPOINT 20.2: Measuring U.S. GDP

1a. Using the expenditure approach, GDP = C + I + G + NX = $7,376 billion + $1,579billion+$1,957billion$425billion=$10,487billion. 1b. Using the income approach, net domestic product at factor cost = 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.TocalculateGDPusingtheincomeapproach,tonetdomes ticproductatfactorcostwemustaddindirecttaxeslesssubsidiesandthen add depreciation. So GDP using the income approach equals $8,474 billion + $724 billion + $1,304 = $10,502. So the statistical discrepancy equals $10,487$10,502=$15billion. 1d. GNP equals GDP plus net factor income from abroad, so the difference be tween the two is net factor income from abroad. Net factor income from abroad = GNP GDP, so using the data in the problem, net factor income fromabroad=$10,514billion$10,487billion=$27billion. 1e. U.S. national income = GNP depreciation statistical discrepancy = $10,514billion$1,304billion($15billion)=$9,225billion. 1f. Disposablepersonalincome=nationalincomeretainedprofitsplustrans fer payments personal income taxes = $9,225 billon $347 billion $1,051 billion=$7,827billion.



1g. As a percentage of U.S. national income, disposable income is ($7,827 bil lion$9,225billion)100=84.8percent. 1h. As a percentage of disposable personal income, consumption is ($7,376 bil 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. The value of 2005 production in 2004 prices is ($15 100) + ($20 25) = $1,500+$500=$2,000. 1d. In 2004 prices, the value of production increased from $1,750 to $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. In 2005 prices, the value of production increased from $2,300 to $2,625, an increase of $325. The percentage increase is ($325 $2,300) 100, which is 14.13percent. 1g. Real GDP in 2004 = $1,750. It is equal to the nominal GDP because 2004 is thebaseyear.TocalculaterealGDPin2005computethegrowthrateofreal GDP between 2004 and 2005. That growth rate is the average of the growth rates between 2004 and 2005 using prices from 2004 and using prices from 2005. The answers to parts (d) and (f) give us these growth rates. The aver age percentage increase is 14.21 percent. So real GDP in 2005 is 14.21 per cent greater than real GDP in 2004. Real GDP in 2004 was $1,750, so real GDPin2005equals($1,750)(1.1421)=$1,999. 1h. The GDP deflator = (Nominal GDP Real GDP) 100 = ($2,625 $1,999) 100=131.

CHECKPOINT 20.4: Real GDP and the Standard of Living

1. The relatively high life expectancy and political freedom means Canadas and the United States relative rankings rise. The low life expectancy and politicalfreedomdecreaseChinasandRussiasrankings.

Chapter 20 . GDP and the Standard of Living



1. Flow Q is income. Flow R is net taxes. Flow U is government expenditures on goods and services. Flow V is saving. Flow W is consumption expendi ture. Flow X is firms borrowing for investment. Flow Z is net exports of goodsandservices.

2a. GDP equals C +I +G +NX. Rearranging, NX = GDP C I G. So Iberias netexportsequal$100billion$67billion$21billion$20billion,which is$8billion. 2b. Net exports equal exports imports, so imports equal exports minus net exports. Iberias imports equal $30 billion ($8 billion), which is $38 bil lion. 2b. Frompart(a),Iberiasnetexportsare$8billion. 2c. FlowQequals$100billion.FlowRisnettaxesandequals$18billion.Flow U is government expenditures on goods and services and equals $20 bil lion. Flow V is saving and equals $15 billion. Flow W is consumption ex penditure and equals $67 billion. Flow X is firms borrowing for invest ment and equals $21 billion. Flow Z is net exports of goods and services andequals$8billion. 3a. Flow Q is income, Y. Recall that Y equals C +I +G +NX. Flow U is govern ment expenditures on goods and services, G; flow W is consumption ex penditure, C; flow X is investment, I; and flow Z is net exports, NX. So flowQ=$7,376billion+$1,579billion+$1,957billion$424billion,which is$10,488billion. 3b. Flow R is net taxes paid to the government and flow V is saving. House holds divide their income, flow Q of $10,488 billion, into consumption ex penditure, flow W (equal to $7,376 billion), net taxes, flow R, and saving, flowV.Sothesumofnettaxesplussaving(flowR+flowV)equalsincome (flow Q) minus consumption expenditure (flow W), which is $10,488 bil lion$7,376billion=$3,112billion. 3c. GDPequalsincome,flowQ.SoGDPequals$10,488billion. 4a. Flow Q is income, Y. Flow X is investment. Y equals C +I +G +NX. Rear ranging, I = Y C G NX. Flow U is government expenditures on goods and services, G; flow W is consumption expenditure, C; and, flow Z is net exports, NX. So flow X = $1,092 billion $621 billion $231 billion $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,







and net exports. Fortunately, these data were saved from the fire. Hence GDP=C+I+G+NX=$2,000+$800+$400$200=$3,000. From the income approach, GDP equals the sum of wages plus 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 dies equals $2,000 + $500 + $100 = $2,600. So depreciation equals $2,900 $2,600=$300. Net domestic productat factor cost equals the sum of wages, interest, rent, and profit. Once again, all these data were fortunately saved from the fire, sonetdomesticproductatfactorcost=$2,000+$500=$2,500. The statistical discrepancy equals GDP from the expenditure approach, $3,000 from part (a), minus GDP from the income approach, $2,900. So the statisticaldiscrepancyis$100. GNP equals GDP plus net factor income from abroad. Form part (a), GDP is$3,000.Netfactorincomefromabroadis$50.SoGNPequals$3,000+$50 =$3,050.

6a. The GDP deflator equals (nominal GDP real GDP) 100. So the GDP de flator in 2004 equals ($11,734.4 billion $10,755.7 billion) 100, which is 109.1. 6b. The GDP deflator in the base year equals 100.0 because in the base year nominalGDPequalsrealGDP. 6c. Thepricelevelroseby9.1percent. 6d. Real GDP rose by ($10,755.7 billion $9,817 billion) $9,817 billion 100, whichis9.6percent. 6e. Nominal GDP rose by ($11,734.3 billion $9,817 billion) $9,817 billion 100,whichis19.5percent. 7a. Nominal GDP equals (real GDP GDP deflator) 100. So nominal GDP in 1990equals($7,112.5billion81.6)100,whichis$5,803.8billion. 7b. Nominal GDP equals (real GDP GDP deflator) 100. So nominal GDP in 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. The percentage increase in production is measured by the percentage in creaseinrealGDP.RealGDProseby($10,755.7$7,112.5)$7,112.5100, whichis51.2percent. 7e. Thepercentageincreaseinthecostoflivingismeasuredbythepercentage increaseinthepricelevel.Thepricelevelroseby(109.181.6)81.6100, whichis33.7percent. 8a. NominalGDPin2005is(40)($2)+(60)($3)=$80+$180,whichis$260.

Chapter 20 . GDP and the Standard of Living


8b. Nominal GDP in 2006 is (44) ($3) + (72) ($2) = $132 + $144, which is $276. 8c. Real GDP in 2006 using the traditional method values production in 2006 using 2005 prices. So the traditional measure of real GDP is (44) ($2) + (72)($3)=$88+$216,whichis$304. 8d. ThechaineddollarmethodmultipliesrealGDPinthepreviousyearbythe average growth rate of GDP over the year, where the average growth rate is the average of the growth rate when previous year prices are used and whencurrentyearpricesareused. RealGDPinthebaseyearisthesameasnominalGDP,sorealGDPin2005 is $260. GDP in 2006 using 2005 prices is (44) ($2) + (72) ($3) = $88 + $216, which is $304. GDP in 2005 using 2005 prices is $260. So GDP using 2005pricesgrewby($304$260)$260100=16.9percent. GDP in 2005 using 2006 prices is (40) ($3) + (60) ($2) = $120 + $120, which is $240. GDP in 2006 using 2006 prices is $276. So GDP using 2006 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. The GDP deflator equals (nominal GDP real GDP) 100. So the GDP de 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. Real GDP in 2007 using the traditional method values production in 2007 using 2005 prices. So the traditional measure of real GDP is (50) ($2) + (72)($3)=$100+$216,whichis$316. 9d. Real GDP in 2008 using the traditional method values production in 2008 using 2005 prices. So the traditional measure of real GDP is (51) ($2) + (80)($3)=$102+$240,whichis$342. 9e. ThechaineddollarmethodmultipliesrealGDPinthepreviousyearbythe average growth rate of GDP over the year, where the average growth rate is the average of the growth rate when previous year prices are used and whencurrentyearpricesareused. From part (d) of the previous exercise, real GDP in 2006 is $302. GDP in 2007 using 2006 prices 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 in 2007 using 2007 prices is $366. GDP in 2006 using 2007 prices is (44) ($3) + (72) ($3) = $132 + $216, which is $348. So GDP using 2007 pricesgrewby($366$348)$348100=5.2percent.





9h. 9i.

The average growth rate is 5.9 percent. So, real GDP in 2007 using the chaineddollarmethodis($302)1.059,whichis$320. ThechaineddollarmethodmultipliesrealGDPinthepreviousyearbythe average growth rate of GDP over the year, where the average growth rate is the average of the growth rate when previous year prices are used and whencurrentyearpricesareused. From part (e), real GDP in 2007 is $320. GDP in 2008 using 2007 prices is (51)($3)+(80)($3)=$153+$240,whichis$393.GDPin2007using2007 pricesis$366.SoGDPusing2007pricesgrewby($393$366)$266100 =7.4percent. GDP in 2008 using 2008 prices is $684. GDP in 2007 using 2008 prices is (50) ($4) + (72) ($6) = $200 + $432, which is $652. So GDP using 2008 pricesgrewby($684$652)$652100=4.9percent. The average growth rate is 6.2 percent. So, real GDP in 2008 using the chaineddollarmethodis($320)1.062,whichis$340. The GDP deflator equals (nominal GDP real GDP) 100. So the GDP de flator in 2007 equals ($366 $320) 100, which is 114.4. And the GDP de flatorin2008equals($684$340)100,whichis201.2. Production is measured using real GDP. Between 2006 and 2008, real GDP increasedfrom$302to$340,whichisa12.6percentincrease. The cost of living is measured using the price level. Between 2006 and 2008,thepricelevelrosefrom91.4to201.2,whichisanincreaseof120per cent.

Chapter 20 . GDP and the Standard of Living


Critical Thinking
10a. Goods and services produced within the United States are part of U.S. GDP.Boeingsdecisiontoproduceitsnew787airlinerinJapanmeansthat this production is not produced within the United States and so it is not partofU.S.GDP.Goodsandservicesproducedanywhereintheworldus ing factors of production supplied by residents of the United States are part of U.S. GNP. Boeings decision to produce airliners in Japan means that Boeing will supply U.S. owned factors production to Japan. For in stance,U.S.engineersemployedbyBoeingandworkinginJapanareaU.S. factor of production producing a good in another country. So payments to 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 tucky means that this production will be included as part of U.S. GDP be causeittakesplacewithintheUnitedStates.Goodsandservicesproduced anywhereintheworldusingfactorsofproductionsuppliedbyresidentsof the United States are part of U.S. GNP. Some of the factors of production making the Toyota cars are Japanese factors of production, For instance, Japanese engineers working in Kentucky are Japanese not U.S. factors of production. The payments to all the Japanese factors of production work inginKentuckyarenotpartofU.S.GNP 11. Underground economic activities undermine (!) the usefulness of the na tional income accounts. For example, there is a bias in the comparison when comparing GDP in an Eastern European country, where under ground activities are extensive, with GDP in a Western European country, where undergroundactivities are less extensive. Compared to the Western Europeancountry,theEasternEuropeancountrysstandardoflivinglooks much lower than it actually is. Underground economic activities include jobs done for cash to avoid paying taxes, as well as production and sale of illegal goods and services. Some of these activities contribute to the stan dard of living. In particular, the jobs off the books done for cash to avoid taxes contribute the same amount to the standard of living as if they were done on the books. In the United States, underground economic activities are probably not extensive enough to warrant spending a large sum of money to try to measure them. In other countries, though, the amount of underground economic activities may be substantial enough to make measuringthemaworthwhileendeavor. 12. If the United Nations is trying to measure the standard of living, pollution and political freedom should be included. The difficulty comes in deter mining their values. For instance, how much is political freedom valued?



Doweadd50timesthemeasureofpoliticalfreedomtoGDPordoweadd 100 times political freedom to GDP? Another important factor that could be included is the value of leisure time. This value is a bit easier to calcu late.Leisuretimemustbeatleastasvaluableastimespentatwork(orelse more time would be spent at work) so the wage rate provides a good measureofthevalueofleisuretime.Thedistributionofincomemightalso beusedintheUnitedNationsmeasureiftheU.N.isinterestedinmeasur ingthestandardoflivingofatypicalpersonwithinanation.

Chapter 20 . GDP and the Standard of Living


Web Exercises
13a. Your students answers will vary according to when you assign the prob lem. By wayof example,in July2005, the most recently releaseddata were for the 1st quarter of 2005. From the BEAs Web site, the nominal data are: Consumption expenditure (called personal consumption expenditures), $8,538.5 billion; Investment (called gross private domestic investment), $2,084.5 billion; Government expenditures (called government consump tionexpendituresandgrossinvestment),$2,259.4;andNetexports,$690.7 billion. (The real data for the same quarter are: Consumption expenditure, $7,815.8 billion; Investment, $1,962.9 billion; Government expenditure, $1,954.8;andNetexports,$637.5billion.) 13b. The sum of these four nominal expenditure categories is $12,191.7 billion, which is precisely the same as the reported nominal GDP. (The sum of the four real expenditure categories is$11,096.0 billion,a bit different from the reported real GDP of $9,096.2 billion. Though the students will not be aware of it, the larger difference for the real numbers compared to the nominal numbers is that each of the four real components and real GDP is calculated separately using its own chain of growth rates. So the real com ponentswillnotnecessarilysumtoequalrealGDP.) 13c. Theimplicitpricedeflatorwasreportedas109.873. 13d.Nominal GDP was $12,191.7 billion, so real GDP, calculated by dividing nominal GDP by the GDP deflator and then multiplying by 100, equals ($12,191.7billion109.873)100,whichis$11,096.2billion. 13e. The cost of living definitely was higher because the GDP deflator was higher. In 2000, the base year, the GDP deflator was 100 and in the recent quarteritwas109.873.Pricesincreasedbetween2000andthe1stquarterof 2005,sothecostoflivingincreased. 14a. Yourstudentsanswerswillvaryaccordingtoyourstate. 14b. Yourstudentsanswerswillvaryaccordingtoyourstate. 15a. Your students answers will vary according to when you assign the prob lem. For an example of an answer, using the data available in 2005, U.S. real GDP perperson in constant dollars in 1980was$22,676.53 and in2005 was $37,867.28. So in the United States, real GDP per person grew by [($37,867.28 $22,676.53) $22,676.53] 100 = 67.0 percent. In Japan, Japa nese real GDP per person in constant yen in 1980 was 2,590,421 and in 2005 was 4,202,027. In Japan over these years real GDP per person grew by [(4,202,027 2,590,421) 2,590,421] 100 = 62.2 percent. (Source: 15b. Your students answers will vary according to when you assign the prob lem. For an example, in July 2005, the U.S. GDP was 20.9 percent of world



GDP and the Japanese GDP was 6.9 percent of world GDP. (Source: Or, us ing purchasingpowerparity GDP, the U.S. GDP was 20.7 percent of the world GDP and the Japanese GDP was 6.7 percent of the world GDP. (the sourceofthesedataisthesameasinpart(a)). 15c. Your students answers will vary according to when you assign the prob lem. Probably the major issue is that to calculate the level of real GDP per personinJapanasapercentageofthatintheUnitedStates,estimatesmust be in the same currency. For an example of an answer, data on gross do mestic product per person based on purchasingpowerparity prices are available. (These data cannot be used to calculate the growth in real GDP per person in part (a) because the GDPs are nominal GDP.) In 2005, Japa nese GDP per person was $31,384 and U.S. GDP per person was $41, 557. SorealGDPperpersoninJapanwas75.5percentthatintheUnitedStates. 15d.Your students answers might vary according to when you assign the problem.Ingeneral,however,part(a)showsthatU.S.realGDPperperson grew more rapidly that Japanese real GDP per person, so the standard of living grewmore rapidlyin the United States. Part (c) shows that the stan dard of living is lower in Japan because Japans GDP per person is only about75percentofGDPperpersonintheUnitedStates.


CHECKPOINT 20.1: GDP, Income, and Expenditure 1. Identify each of the following as either included or not included in GDP. Make sure to give an explanation for those that you judge as not included. In addition, state whether each included item is consumption, investment, governmentexpenditure,ornetexports. 1a. The purchase of copy paper by PepsiCo, which is used by the company staff. 1b. The purchase of an electronic handheld organizer by a sales manager to keeptrackofclients. 1c. ThepurchaseofanewaircraftcarrierbytheNavy. 1d. AnincreaseinDellsinventoryofunsoldpersonalcomputers. 1e. AfamilyeatingdinneratTacoBell. 1f. ThesalaryofthePresidentoftheUnitedStates. 1g. AMombakingabirthdaycakeforher8yearolddaughter. 1h. Thesaleofausedcomputer. 1i. Yourdonationofausedcomputertoalocalelementaryschool.

Chapter 20 . GDP and the Standard of Living


1j. The purchase by a German resident in Germany of an Americanmade ceil ingfanproducedintheUnitedStates. CHECKPOINT 20.2: Measuring U.S. GDP Item Consumption expenditure Investment Government expenditures Exports Imports Depreciation Dollars 800 400 200 50 75 100

2. Usingtheinformationinthetableabove,calculateGDP. Item Consumption expenditure Investment Government expenditures Net exports Wages Interest, rent, and profit Depreciation Amount (trillions of dollars) 4.97 1.14 1.37 0.08 4.20 1.68 0.89

3. The table above gives some of the items in the U.S. National Income and ProductAccountsin1995. 3a. UsetheexpenditureapproachtocalculateU.S.GDPin1995. 3b. Use the income approach to calculate U.S. net domestic product at factor costin1995. 3c. CalculateGDPminusnetdomesticproductatfactorcostin1995. 3d. Calculateindirecttaxeslesssubsidiesin1995. CHECKPOINT 20.3: Nominal GDP Versus Real GDP 4. An island economy 2006 2007 produces only lobsters Item Quantity Price Quantity Price and crabs. The table gives the quantities Lobsters 100 $20 each 110 $25 each produced and the Crabs 25 $25 each 30 $30 each prices in 2006, and the quantitiesproducedandthepricesin2007.Thebaseyearis2006.Calculate: 4a. NominalGDPin2006. 4b. NominalGDPin2007. 4c. Thevalueof2007productionin2006prices. 4d. Percentageincreaseinproductionwhenvaluedat2006prices. 4e. Thevalueof2006productionin2007prices. 4f. Percentageincreaseinproductionwhenvaluedat2007prices.



4g. RealGDPin2006and2007. 4h. TheGDPdeflatorin2007. 5. If nominal GDP in 1998 was $8,759.9 billion and real GDP was $8,165 bil lion,calculatetheGDPdeflatorin1998.

CHECKPOINT 20.1: GDP, Income, and Expenditure 1a. 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. GDP 2. GDP equals the sum of consumption expenditure, investment, government expenditureongoodsandservices,andnetexports.SoGDP=$800+$400+ $200+($50$75),whichis$1,375.Theamountofdepreciationisnotused. 3a. Using the expenditure approach, GDP = C + I + G + NX = $4.97 trillion + $1.14trillion+$1.37trillion$0.08trillion=$7.40trillion. 3b. Using the income approach, net domestic product at factor cost = Wages + Interest,rent,andprofit=$4.20trillion+$1.68trillion=$5.88trillion. 3c. GDP minus net domestic product at factor cost = $7.40 trillion $5.88 tril lion=$1.52trillion. 3d. The difference between GDP and net domestic product at factor cost, $1.52 trillion, is equal to depreciation plus (indirect taxes minus subsidies). 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 GDP 4a. NominalGDPin2006=($20100)+($2525)=$2,000+$625=$2,625. 4b. NominalGDPin2007=($25110)+($3030)=$2,750+$900=$3,650. 4c. Using 2006 prices, the value of 2007 production is ($20 110) + ($25 30) = $2,200+$750=$2,950. 4d. In 2006 prices, the value of production increased from $2,625 to $2,950, an increase of $325. The percentage increase is equal to ($325 $2,625) 100, whichis12.38percent.

Chapter 20 . GDP and the Standard of Living


4e. The value of 2006 production in 2007 prices is ($25 100) + ($30 25) = $2,500+$750=$3,250. 4f. In 2007 prices, the value of production increased from $3,250 to $3,650, an increase of $400. The percentage 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 2006 and 2007. That growth rate is the average of the growth rates between 2006 and 2007 using prices from 2006 and using prices from 2007. Taking the average of the answers to parts (d) and (f) gives us an average percent ageincreaseof12.35percent. Real GDP in 2007 is 12.35 percent greater than real GDP in 2006. Real GDP in 2006 was $2,625, so real GDP in 2007 equals ($2,625) (1.1235), which is $2,949. 4h. The GDP deflator = (Nominal GDP Real GDP) 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.



USING EYE ON THE U.S. ECONOMY Is a Computer Program an Intermediate Good or a Final Good?
This article presents a perfect opportunity to demonstrate to students that eco nomic statistics are not perfect. After reading it, they might get the impression that economists are being arbitrary about the classification of software in the na tional income accounts. Remind them that the reason for the reclassification of software from an intermediate good to investment reflects the fact that software hasmanyofthesamecharacteristicsasothertypesofinvestment.Forinstance,it has a life span just like capital and it helps improve productivity. In addition, it also depreciates just like capital. Students wont need too much convincing for them to agree. But just in case, it wouldnt hurt to mention that software eventu ally becomes obsolete as new software is developed to meet the changing needs ofindustry.Pointoutthatthemeaningofdepreciationherecomeswithabitofa twistbecausethesoftwaredoesntactuallygetusedupthewayphysicalmachin erytoolsorfactorieswouldbutinsteadgetsusedupasitbecomesobsolete.

Deflating the GDP Balloon

This segment might be best used if you introduce it before you actually present the formula for the GDP deflator. The GDP deflator is one of these topics for which the formula itself does not effectively communicate the underlying eco nomic forces at work. Theballoon metaphor is an excellent way to appeal to stu dentsintuitions.


Explain 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 tioned at the end of the chapter. The effort by the United Nations is a step in the direction to ameliorate some of these shortcomings. However, the trouble with the Human Development Index is that it combines variables that are difficult to aggregate because they are measured in markedly different units. For instance, there is no obvious way to combine real GDP per person with life expectancy. Perhaps you could ask students how they think it would be appropriate to treat these dissimilar variables in the ranking of standard of living. For example, you might ask them to provide a weighting for each category and provide justifica tionfortheweightings.