Questions - Johan Lindén, Mälardalens högskola
Chapter 5The Wealth of Nations: Defining and Measuring Macroeconomic AggregatesQuestions1.Find and list three recent stories in the media that would typically be studied in macroeconomics. (Cite the date and source of the stories you choose.) Discuss why they would fall within the subject matter of macroeconomics.Answer: Solutions may vary.2.How is gross domestic product defined? Answer: Gross domestic product is defined as the market value of the final goods and services produced within the borders of a country during a particular period.3.What is an accounting identity? Explain the accounting identity Production = Expenditure = Income.Answer: Variables are related by an accounting identity when they are defined in a way that makes them mathematically identical. The circular flow diagram demonstrates that total production in the economy in a given year, total expenditure on goods and services over the year, and the total income received by all factors of production, will always be equal. Hence, GDP can be measured by any of the three. 4.Use the circular flow diagram to show how expenditure, production, and income relate to one another. Answer: The concept of the circular flow between households and firms highlights the four kinds of flows that connect households and firms—production, factors of production, expenditure, and income.Households provide the factors of production that firms need—labor and capital. In turn, firms supply households with goods and services. These flows of goods and services are balanced by reverse flows of payments. Firms make factor payments to households for their labor and capital, which constitutes households’ incomes. The households use this income to make payments for the goods and services purchased from the firms, which constitutes aggregate expenditure on goods and services. Therefore, the value of production is equal to the value of expenditure, which is equal to the value of income. This means that GDP estimated using the income-based accounting approach will be equal to the estimate calculated using the expenditure-based accounting approach, which will also be equal to the estimate of GDP calculated using the production-based accounting approach.5.How is production-based accounting used to estimate GDP? Discuss the role of value-added.Answer: Production-based accounting sums up the value that is added by each domestic firm in the production process. From the total revenue earned by a firm from the sale of a good, all of the productive activity of other firms in the supply chain is deducted to arrive at the value added by the firm.6.How is GDP calculated using expenditure-based accounting?Answer: Expenditure-based accounting tracks the purchases of the goods and services produced in the economy. These purchases come in three key categories: goods and services that are bought by households (C); investment goods that are bought by households and firms (I); goods and services that are purchased by the government (G); and the expenditure of foreign agents on exports minus the value of domestic expenditure on imported goods (X – M). GDP can be calculated as the sum of these components: Y = C + I + G + (X – M).7.Which category of expenditure accounts for the highest share of GDP in the United States? Answer: Consumption expenditure has consistently represented about two thirds of economic activity. In 2013, consumption represented 68.5 percent of U.S. GDP.8.How is the level of economic activity calculated using the income method?Answer: The income-based accounting system calculates the aggregate level of economic activity in an economy by measuring the income generated as a result of such activity. Income payments come in two key categories: labor income and capital income. Labor income includes wages, salary, workers’ health insurance, and workers’ retirement benefits. It also includes every other way that people are explicitly or implicitly paid for their labor. Capital income includes dividends paid to shareholders, interest paid to lenders, earnings retained by corporations, rent payments made to landlords, and the benefits of living in one’s own house.9.According to the U.S. Bureau of Economic Analysis, the real GDP of the United States for the first quarter of 2017, using constant 2009 dollars, was $16.9 trillion. The total expenditure was $17.5 trillion. What might be the reasons underlying a difference between expenditure and production?Answer: According to this chapter, production = expenditure = income. As stated above, the actual expenditure over this period was $17.5 trillion. The reason underlying this difference might be due to the inclusion of the underground economy in expenditure, but not in production.Source: of download: September 12, 2017 10.What is meant by capital depreciation? Answer: Capital depreciation refers to the loss in value of capital over time due to wear and tear on capital equipment and structures.11.Explain three important factors that GDP leaves out. Answer: GDP does not account for capital depreciation, which is the loss in the value of capital over time as it gets used. It also excludes the value of home production. Activities like cooking your own meals, doing your laundry, or cleaning your house are not accounted for. Economic transactions that take place in the black market are also excluded from GDP estimates. Negative externalities, such as pollution, are not accounted for. The value of leisure is also not included in the estimates of a country’s national income, although leisure is a key ingredient in human well-being.12.You decide to cook your own meal rather than eat in a restaurant. How will this affect GDP? Answer: GDP does not include home production because there is no market transaction, market price, or measurable quantity that accompanies home production. Therefore, if you cook your own meal rather than eating in a restaurant, it will not be included in GDP. GDP would thus be lower than if you ate in a restaurant.13.When would a country’s gross domestic product exceed its gross national product?Answer: Although gross domestic product includes the market value of everything produced within the borders of a country, gross national product includes the market value of production generated by the factors of production possessed or owned by the residents of a particular nation. Domestic Gross National Product (GNP) = GDP + production of domestic country-owned capital/labor within the borders of foreign countries – production of foreign country-owned capital/labor within the domestic country’s borders. GDP is likely to exceed GNP when production by domestic factors within the borders of foreign countries is lower than production by foreign factors within domestic borders.14.Nobel laureate Simon Kuznets, who did significant work on national income accounts in the 1930s, said that the welfare of a nation can scarcely be inferred from a measurement of national income. Would you agree with him? Why or why not? Answer: GDP is a summary figure of the level of economic activity in the economy, but per capita GDP is often used as a proxy for determining the well-being of a society. This is because per capita GDP shows a strong positive correlation with life satisfaction; countries with higher levels of per capita GDP report higher levels of life satisfaction. The same relationship also shows up within each country. In other words, low-income households report substantially lower life satisfaction than high-income households.15. Why is it essential to differentiate between real and nominal growth rates of GDP?Answer: It is essential to differentiate between real and nominal growth rates of GDP in order to understand whether output has actually grown from one year to the next. An increase in the nominal value of GDP could have been due to an increase in prices rather than an increase in output. The growth rate of real GDP, however, shows the increase in the actual quantity of goods and services produced. 16.What are the key differences between the Consumer Price Index (CPI) and the GDP deflator?Answer: The main difference between the CPI and the GDP deflator is the basket of goods that each formula considers. The GDP deflator is based on a country’s total GDP, the basket of goods that is produced domestically. In other words, the GDP deflator utilizes the basket of goods that represents the total output of the domestic economy. Therefore, it includes many goods not ordinarily purchased by consumers. In contrast, the CPI is based on the basket of goods and services that an “average” consumer typically buys. This basket is constructed to reflect the types and quantities of goods that are purchased by a typical household. As a result, the CPI includes items that are purchased by households—like imported goods—that are not included in GDP. And because they are not included in GDP, their prices are not reflected in the GDP deflator.Another difference involves the weighting of goods in the two indices. Housing, for example, represents a major portion of a typical household’s budget; hence, it has a high weighting in the calculation of the CPI. However, it has a much smaller weighting in the calculation of the deflator.A final difference is that the CPI is announced monthly, whereas the GDP deflator is only released quarterly. Hence, the CPI is more timely. 17.How is the Consumer Price Index similar to the GDP Deflator? Answer: Both the CPI and the GDP deflator use current prices in the numerator and base-year prices in the denominator. The formulas for the CPI and the GDP deflator both contain a ratio that compares what it would cost to buy goods in the current year (in the numerator) to what it would have cost to buy the same goods using base-year prices (in the denominator). Both formulas also have the same interpretation: A higher ratio implies a greater price increase from the base-year to the current year.Problems1.Which of the following would be considered a final good in the calculation of U.S. GDP? Explain your answers. Processors manufactured in California for Apple’s new range of laptops (that will be sold in the United States)Foot massages at spas in CaliforniaPredator drones purchased by the federal governmentAnswer:a. In this case, Apple’s new range of U.S. laptops will be included as a final good in the calculation of GDP. The value of the processors would not be included in GDP estimates because they are an input used in the production of a final good. b.Foot massages at spas are an example of a final good and so would be included in GDP estimates. c.Predator drones purchased by the federal government will be counted as a final good as the government purchases them for its own use. 2.By how much would GDP change because of each of the following changes? Briefly explain your answers.A couple decides that their child should visit a private language tutor as opposed to attending a language school. The cost of the private language teacher is €10 per session, whereas the language school costs €8 per session. If the private language tutor does not report the income to the tax authorities, what would be the impact on the calculation of GDP?A couple moves to the countryside from Rome, Italy, for health reasons. They have a small garden, where they grow vegetables for home use. While they were living in Rome they spent €2,000 annually on vegetables, but now they spend only €500. Answer:a.Attending the language school added €8 to GDP. Since the child is attending the private tutor, who does not declare this ‘produced service’ to the tax authorities, the service produced will not manifest itself in the production-based GDP. Therefore, GDP will decrease by €8 because of the underground economy increasing.b.In this case, Italy’s GDP decreased by €1,500 as the couple is no longer buying vegetables worth €2,000 from the supermarket, instead only spending €500 on what they cannot grow themselves. 3. In order to generate estimates of GDP, the Bureau of Economic Activity must aggregate a variety of data sources, such as expenditure surveys. a. What measurement problems might the government face in trying to estimate GDP? Consider the three accounting methods we discussed in this chapter; what kinds of information would you need for each? b. In its quarterly estimates, the BEA uses both expenditures-based and income-based accounting; in order to differentiate between the two, it refers to the expenditures-based estimate as GDP and the income-based estimate as GDI. What would we expect the relationship between GDP and GDI to be? c. Now, go to the BEA NIPA tables (), and compare the actual estimates for GDP (table 1.1.5) and GDI (table 1.10). What are the estimates for GDP and GNI in the first quarter of 2016? What factors could explain any differences you notice? Answer: a.Solutions may vary, but should touch on the concepts introduced in the chapter. For example, the government may have trouble measuring informal or black-market production. The three accounting methods should be listed: production-based accounting, income-based accounting, and expenditure-based accounting. To measure production, the government would need information on both quantities produced and market prices, for every good produced in the U.S. economy. To measure income, the government would need all investment and labor income (including, for an accurate estimate, any wages paid in cash). Finally, to measure expenditure, the government would need information on all sales, including the size of all inventories in every company. b. Although, in theory, we would expect them to be equal, in practice they likely vary due to the measurement issues discussed in part a. c. GDI is around 200-300 billion dollars higher than GDP, at least in the last few years. This discrepancy could be due to limitations in, for example, measuring company inventories or certain kinds. (solutions may vary)4.Suppose that there are only two small countries in the world: Ascot, with a population of 30,000 people, and Delwich, with a population of 20,000 people. Ascot’s GDP is equal to $150 million, while Delwich’s GDP is $250 million. Delwich’s GNP has been estimated to be equal to $280 million. Use this information to calculate Ascot’s GNP, the GDP per capita in Ascot, and the GNP per capita in Delwich. Answer: Because there are only two countries in the world, the total of the two country’s GDP has to equal the total of the two country’s GNP. The total GDP is $150M + $250M = $400M. Because Delwich’s GNP = $280M, Ascot’s GNP must equal $120M.Per capita GDP in Ascot = 150,000,000/30,000 = $5,000.Per capita GNP in Delwich = 120,000,000/20,000 = $6,000.5.The following table gives data for a small country, Magnolia. ComponentExpenditure (in thousands)Social Security payments$250Depreciation$47Private investment$630Exports$260Imports$300Salaries earned by foreigners working in Magnolia$160Household consumption$850Purchases of raw materials$270Government purchases$900Capital income$290Salaries earned by Magnolian citizens working abroad$350Use the data to calculate GDP for this economy using the expenditure method. Calculate the value of Magnolia’s GNP. Does Magnolia’s GDP differ from its GNP? Why? Answer:a. According to the expenditure approach, GDP = C + G + I + (X – M). Here, C represents household consumption expenditure, G represents government expenditure on goods and services, I represents investment, and (X – M) represents net exports. The value of Magnolia’s GDP = household consumption + gross private investment + government purchases + (exports – imports) = 850,000 + 630,000 + 900,000 + (260,000 – 300,000) = $2,340,000.b. Gross National Product (GNP) is the market value of production generated by the factors of production—both capital and labor—possessed or owned by the citizens of a particular nation. Therefore, Magnolia’s gross national product = Magnolia’s GDP + salaries earned by Magnolian citizens working abroad – salaries earned by foreigners working in Magnolia. Magnolia’s GNP = 2,340,000 + 350,000 – 160,000 = $2,530,000.Magnolia’s GNP is a little higher than its GDP because the production of Magnolian factors of production within the borders of foreign countries exceeds the production of foreign factors of production within Magnolia’s borders.6.Most products we buy go through a lengthy series of intermediate steps before they are available for us to purchase. For this problem, say we are tracing the stages, and the associated transaction values, involved in the production of a hypothetical tin of coffee:StageValueFactory buys beans from farmers€2Factory buys tin box€1Factory sells tins of coffee to wholesaler€8Wholesaler sells to retail chain€11Retail chain starts a marketing campaign€1Retail chain sells to public€15Calculate the addition to GDP contributed by this tin of coffee, using the following:a.Expenditure-based accountingb.Income-based accountingc.Production-based accountingAnswer:a.Expenditure-based: Consumer buys the tin of coffee for €15, so consumption and GDP increase by €15.b.Income-based: Farmer’s income €2 Tin box maker’s income €1 Factory’s income€5 Wholesaler’s income€3 Marketing consultant’s income€1 Retail chain’s income€3Total addition to GDP€15c.Production-based:Value added by farmer €2 Value added by tin box maker€1 Value added by factory€5 Value added by wholesaler€3 Value added by marketing consultant€1 Value added by retailer€3 Total value added = Total addition to GDP€157. With the rise of globalization, supply chains now spread across the world. Consider the following simplified stages of production for a smartphone:The U.S.-based smartphone company develops the designs for the new smartphone. A rare minerals broker in China buys 15 billion dollars worth of minerals from around the world, including 5 billion from U.S. mines. A microchip producer Japan buys half of these minerals for 10 billion dollars; a camera and screen producer in South Korea buys the other half for 10 billion dollars. A manufacturing factory in China buys the microchip, cameras and screens for 22 billion dollars; it obtains the rest of the assembly materials domestically, for a total of 3 billion dollars. The U.S. based smartphone company pays the factory 28 billion dollars for the manufactured phones. It programs and uploads the software. Any updates from previous versions of the software are available for existing phone-owners as a free download. The company keeps 10 billion worth of smartphones in inventory, then sells the rest to U.S. retailers for 25 billion. The retailers sell the phones within the U.S., for a total of 30 billion in revenue. Calculate how much this process contributes to U.S. GDP. Explain your calculation.b. What sources of value might not be captured in your calculation in part a.? Answer:a.17 billion. To calculate this number, we have to look at the value added by U.S. entities. First, there’s the 5 billion from U.S. mines for raw materials. Next, we jump to the smartphone company, which bought the phones for 28 billion and produced 35 billion dollars worth of value: 7 billion of value added. Finally, the U.S. retailers buy 25 billion worth of smartphones and sell 20 billion: 5 billion dollars of value added. Overall, then, that’s 5 + 5 + 7 = 17 billion in value added. b.Primarily, we’re missing any added value from technological development—if this phone is a large technological improvement over the former phone, then we would ideally like to capture that in GDP. We’re also not considering any depreciation of the phones in inventory. (additional answers may vary). 8.The country of Sylvania produces and consumes only three goods: Red Bull, pizza, and T-shirts. The quantity produced and price of each good in 2011 and 2012 is given in the following table:20112012QuantityPriceQuantityPriceT-Shirts100$25110$25Red Bull (cans)500$1500$1.50Pizza (slices)1000$2900$4Calculate nominal GDP for 2011 and 2012.Using 2011 as the base year, calculate real GDP for 2011 and 2012.Based on your answer from part (b), by what percentage did real GDP grow between 2011 and 2012?Now calculate real GDP for 2011 and 2012 using 2012 as the base year.Based on your answer from part (d), by what percentage did real GDP grow between 2011 and 2012?Using 2011 as the base year, what was the GDP deflator in 2011 and 2012?Based on your answer from part (f), by what percentage did prices change between 2011 and 2012?Answer:a.For 2011:Nominal GDP = (100 T-shirts) × ($25) + (500 cans Red Bull) × ($1) + (1000 slices pizza) × $2 =?$5,000For 2012:Nominal GDP = (110 T-shirts) × ($25) + (500 cans Red Bull) × ($1.50) + (900 slices pizza) × $4 = $7,100b. Base year = 2011For 2011:Real GDP = (100 T-shirts) × ($25) + (500 cans Red Bull) × ($1) + (1000 slices pizza) × ($2) = $5,000= 2011 Nominal GDP (because 2011 is the base year)For 2012:Real GDP = (110 T-shirts) × ($25) + (500 cans Red Bull) × ($1) + (900 slices pizza) × ($2) = $5,050c.To calculate the percentage change, or growth rate, between 2011 and 2012, we simply take:So, real GDP grew by 1 percent from 2011 to 2012.d.For this exercise, the base year has been switched. Now the real GDP calculation for 2012 is simply the calculation of 2012 nominal GDP, which is $7,100.The calculation of 2011 real GDP, using 2012 as a base, is as follows:Base year = 2012For 2011:Real GDP = (100 T-shirts) × ($25) + (500 cans Red Bull) × ($1.50) + (1000 slices pizza) × ($4) =?$7,250For 2012:Real GDP = (110 T-shirts) × ($25) + (500 cans Red Bull) × ($1.50) + (900 slices pizza) × ($4) =?$7,100= 2012 Nominal GDP (because 2012 is the base year)Notice how sensitive these calculations are to what year is chosen as the base.e.The calculation is now:Because the base year on which our calculations are based has changed, we get a very different picture of the performance of Sylvania’s economy between 2011 and 2012.f.The GDP deflator is calculated as follows:Thus, the deflator for 2011 is.(This will always be the case when calculating the deflator for the base year, i.e., the deflator will always be 100.)The GDP deflator for 2012 isNominal GDP in 2012 Real GDP in 2012 (using 2011 as a base)= $7,100$5,050 ≈1.41 × 100=141 g.The percentage change in prices between 2011 and 2012 can be calculated just like any other percentage change:Deflator in 2012-Deflator in 2011 Deflator in 2011 = 141-100100=0.41=41% Hence, prices changed by about 40 percent from 2011 to 2012. This is one measure of the inflation rate over the year. 9. The following table contains some of the CPI components for the United Kingdom between 2009 and 2016. Each component is a part per 1,000.2009201601Food and non-alcoholic beverages11810303Clothing and footwear577104Housing, water, electricity, gas and other fuels12612005Furniture, household equipment, and maintenance665906Health222807Transport15115308Communication233209Recreation and culture14514810Education212511Restaurants and hotels12812312Miscellaneous goods and services 9996Provide possible reasons why average spending has changed in a.Food and non-alcoholic beverages, which fell by 13 percent. b.Clothing and footwear, which grew by 24.5 percent. munications, which grew by 39 percent.Answer:People in the United Kingdom may have started spending less on food and beverages because they may have realized that reduction in food consumption might lead to a healthier lifestyle. Alternatively, the share of this component may have decreased automatically because of an increase in the share of other components.As 2009 was a year of the global financial crisis, one area where people would have cut back unnecessary expenditure on was clothing. Hence, the lower representation of clothing and footwear in the consumption basket. By 2016, it became trendy to spend more on clothing or dress fashionably, hence the increase in spending on clothing and footwear.Due to advancements in communication technology and tastes, people are spending an increased amount of money on anything that is smart: from expensive phones to watches and glasses. The mobile services for such gadgets are more expensive; hence, there is an increase in price. In addition, in 2009, there were fewer affordable smart items available; therefore, the quantities of these products sold were lower.Data is from . 10. Social Security payments in the United States are currently linked to the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W). This means that as the CPI-W shows an increase in the price level, Social Security payments will also increase, keeping the real value of the payment constant. The following table shows the weighting given to the different components in the CPI-W consumption basket. Item Weight Food and Beverages15.948Housing 39.867Apparel 3.623Transportation 18.991Medical care5.767Recreation5.528Education and communication 6.766Other goods and services 3.510Total 100.000It has been suggested that using the CPI-W to adjust Social Security payments understates inflation for seniors. Do you agree? Why might this be the case? Answer: Yes, it is possible that using the CPI-W understates inflation for senior citizens. The CPI studies a particular basket of consumer goods that a typical household purchases. Each item in this basket is given a certain weighting depending on its relative importance in consumption. As can be seen from the table given in the question, medical care is given a relatively low weighting in the CPI-W. However, most seniors are likely to spend a substantial amount on medical care and perhaps lower amounts on the other categories in the basket. So if the rate of health care inflation is higher than the rate of inflation for the other items in the basket, the CPI-W would understate inflation for seniors. Based on: Data taken from: 11.12.On May 22, 2013, Forbes magazine reported that Bill Gates had overtaken Mexican businessman Carlos Slim as the “richest man in the world.” Gates’ fortune on that date was estimated at $70 billion, whereas Slim’s was a mere $69.86 billion. ()But, does this make Gates the richest American who ever lived? John D. Rockefeller, the founder of Standard Oil, is usually credited with this distinction. At the time of his death in 1937, the founder of the Standard Oil empire had an estimated net worth of $1.4 billion. a.Go to the BLS CPI site at . Under “Consumer Price Index-All Urban Consumers,” select “US All Items, 1982-84=100” and click the “Retrieve data” button at the bottom of the page. Adjust the years to retrieve data from 1937 through 2013. Use the data under the “Annual” column to calculate Gates’s 2013 net worth measured in 1937 dollars. You should find that Gates’s wealth does have more buying power than Rockefeller’s wealth.b.Some analysts say that Rockefeller’s net worth was economically equivalent to $250 billion today. However, this figure is arrived at in a particular way. First, his net worth in 1937 is calculated as a percentage of total U.S. GDP in 1937. That percentage is then multiplied by the current level of GDP to arrive at the equivalent figure in current dollars. See if you can approximate the $250 billion figure. You can find the relevant GDP figures at are the pros and cons of the two different methods—reviewed in the previous parts of this question—of adjusting Rockefeller’s net worth to make it comparable to the wealth of business leaders today?Answer:a.Gates’ net worth = $70B in 2013. 1937 CPI = 14.4. May 2013 CPI = 232.957.Adjustment factor = 14.4/232.957 = 0.062. So, Gates’ 2013 fortune in 1937 = $70B × 0.062 = $4.3B.b.Rockefeller’s net worth in 1937 = $1.4B. 1937 GDP = $93B. Percentage of GDP represented by Rockefeller’s net worth = 1.4/93 × 100 = 0.015 = 1.5%. 2013 GDP was equal to $16,768 billion. 1.5% of $16,768 billion is $252 billion. So, if Rockefeller was alive in 2013, and his net worth was 1.5% of 2013 GDP, he would be worth $252 billion.c.The main advantage to this method of updating Rockefeller’s net worth is that it expresses it relative to the economy as a whole. In other words, given that Rockefeller’s wealth was 1.5 percent of 1937 GDP, a net worth today that represented an equivalent percentage of GDP would be around $250 billion. However, a disadvantage is that this method might actually overstate Rockefeller’s standard of living in 1937 compared to the present. Even someone with his resources did not have such modern essentials as air conditioning, computers, the Internet, or a host of life-saving drugs and medical procedures. So while his net worth was extraordinary when translated to a comparable contemporary figure, it is important to remember that people’s lives have been transformed by the progress of technology unavailable even to the wealthiest individuals in Rockefeller’s time. This is not accounted for in a simple numerical calculation of dollar values. ................
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