CHAPTEr 2 The data of macroeconomics questions for Review 1. GDP measures both the total income of everyone in the economy and the total expendi- ture on the economy's output of goods and services. GDP can measure two things at once because both are really the same thing: for an economy as a whole, income must equal expenditure. As the circular flow diagram in the text illustrates, these are alter- native, equivalent ways of measuring the flow of dollars in the economy 2. The consumer price index measures the overall level of prices in the economy. It tells us the price of a fixed basket of goods relative to the price of the same basket in the base 3. The Bureau of labor Statistics classifies each person into one of the following three cat- egories: employed, unemployed, or not in the labor force. The unemployment rate which is the percentage of the labor force that is unemployed, is computed as follows Unemployment Rate Number of Unemployed x 100 Note that the labor force is the number of people employed plus the number of people unemployed. 4. Okun's law refers to the negative relationship that exists between unemployment and real GDP. Employed workers help produce goods and services whereas unemployed decreases in real GDP. Okun's law can be summarized by the equation,Ssociated with workers do not. Increases in the unemployment rate are therefore as %△ Real gDP=3%-2×(△ Unemployment Rate) That is, if unemployment does not change, the growth rate of real GDP is 3 percent For every percentage-point change in unemployment(for example, a fall from 6 percent to 5 percent, or an increase from 6 percent to 7 percent), output changes by 2 percent in the opposite direction Problems and applications 1. A large number of economic statistics are released regularly. These include the follow Gross Domestic Product-the market value of all final goods and services produced in a The Unemployment Rate the percentage of the civilian labor force who do not have a Corporate Profits-the accounting profits remaining after taxes of all manufacturing corporations. It gives an indication of the general financial health of the corporate sec The Consumer Price Index(CPia measure of the ay that consumers pay for the goods they buy; changes in the cpi are a measure of inflation The Trade Balance-the difference between the value of goods exported abroad and the alue of goods imported from abroad
Questions for Review 1. GDP measures both the total income of everyone in the economy and the total expenditure on the economy’s output of goods and services. GDP can measure two things at once because both are really the same thing: for an economy as a whole, income must equal expenditure. As the circular flow diagram in the text illustrates, these are alternative, equivalent ways of measuring the flow of dollars in the economy. 2. The consumer price index measures the overall level of prices in the economy. It tells us the price of a fixed basket of goods relative to the price of the same basket in the base year. 3. The Bureau of Labor Statistics classifies each person into one of the following three categories: employed, unemployed, or not in the labor force. The unemployment rate, which is the percentage of the labor force that is unemployed, is computed as follows: Unemployment Rate = . Note that the labor force is the number of people employed plus the number of people unemployed. 4. Okun’s law refers to the negative relationship that exists between unemployment and real GDP. Employed workers help produce goods and services whereas unemployed workers do not. Increases in the unemployment rate are therefore associated with decreases in real GDP. Okun’s law can be summarized by the equation: %∆Real GDP = 3% – 2 × (∆Unemployment Rate). That is, if unemployment does not change, the growth rate of real GDP is 3 percent. For every percentage-point change in unemployment (for example, a fall from 6 percent to 5 percent, or an increase from 6 percent to 7 percent), output changes by 2 percent in the opposite direction. Problems and Applications 1. A large number of economic statistics are released regularly. These include the following: Gross Domestic Product—the market value of all final goods and services produced in a year. The Unemployment Rate—the percentage of the civilian labor force who do not have a job. Corporate Profits—the accounting profits remaining after taxes of all manufacturing corporations. It gives an indication of the general financial health of the corporate sector. The Consumer Price Index (CPI)—a measure of the average price that consumers pay for the goods they buy; changes in the CPI are a measure of inflation. The Trade Balance—the difference between the value of goods exported abroad and the value of goods imported from abroad. 5 Number of Unemployed × 100 Labor Force CHAPTER 2 The Data of Macroeconomics
Answers to Textbook Questions and problems 2. Value added by each person is the value of the good produced minus the amount the person paid for the materials necessary to make the good. Therefore, the value added by the farmer is $1.00($1-0=$1). The value added by the miller is $2: she sells the flour to the baker for $3 but paid $1 for the flour The value added by the baker is $3 she sells the bread to the engineer for $6 but paid the miller $3 for the flour. GDP is the total value added, or $1 +$2+$3=$6. Note that gdP equals the value of the final rood (the bread) 3. When a woman marries her butler gDP falls by the amount of the butlers salary. This happens because measured total income, and therefore measured GDP, falls by the amount of the butlers loss in salary. If GDP truly measured the value of all goods and ervices, then the marriage would not affect gDP since the total amount of economic activity is unchanged. Actual GDP, however, is an imperfect measure of economic activ ity because the value of some goods and services is left out. Once the butlers work becomes part of his household chores, his services are no longer counted in GDP. As this example illustrates, GDP does not include the value of any output produced in the home. Similarly, gDP does not include other goods and services, such as the imputed rent on durable goods(e.g, cars and refrigerators) and any illegal trade 4. a. government purchases b. investment c. net exports d. consumption 5. Data on parts(a) to(g) can be downloaded from the Bureau of Economic Analysis (www.bea.docgov-followthelinkstoGdpandrelateddata).Mostofthedata(not necessarily the earliest year)can also be found in the Economic Report of the president By dividing each component(a)to(g) by nominal GDP and multiplying by 100, we obtain the following percentages 1950 2000 a. Personal consumption expenditures 63.0% b. Gross private domestic investment 14.1% c. Government consumption purchases 15.9% 22.1% 176% d. Net exports -3.7% e. National defense purchases 6.6% f. State and local purchases 7.1% 12.8% 11.7% g. Import 14.9% (Note: These data were downloaded February 5, 2002 from the BEa web site. Among other things, we observe the following trends in the economy over the period 1950-2000 (a) Personal consumption expenditures have been around two-thirds of gdP, although the share increased about 5 percentage points between 1975 and 2000 (b) The share of GDP going to gross private domestic investment fell from 1950 to 1975 but en re (c) The share going to government consumption purchases rose more than 6 percentage points from 1950 to 1975 but has receded somewhat (d)Net exports, which were positive in 1950 and 1975, were substantially negative in (e) The share going to national defense purchases fell from 1975 to 2000 (f) The share going to state and local purchases rose from 1950 to 1975 (g)Imports have grown rapidly relative to GDP
2. Value added by each person is the value of the good produced minus the amount the person paid for the materials necessary to make the good. Therefore, the value added by the farmer is $1.00 ($1 – 0 = $1). The value added by the miller is $2: she sells the flour to the baker for $3 but paid $1 for the flour. The value added by the baker is $3: she sells the bread to the engineer for $6 but paid the miller $3 for the flour. GDP is the total value added, or $1 + $2 + $3 = $6. Note that GDP equals the value of the final good (the bread). 3. When a woman marries her butler, GDP falls by the amount of the butler’s salary. This happens because measured total income, and therefore measured GDP, falls by the amount of the butler’s loss in salary. If GDP truly measured the value of all goods and services, then the marriage would not affect GDP since the total amount of economic activity is unchanged. Actual GDP, however, is an imperfect measure of economic activity because the value of some goods and services is left out. Once the butler’s work becomes part of his household chores, his services are no longer counted in GDP. As this example illustrates, GDP does not include the value of any output produced in the home. Similarly, GDP does not include other goods and services, such as the imputed rent on durable goods (e.g., cars and refrigerators) and any illegal trade. 4. a. government purchases b. investment c. net exports d. consumption e. investment 5. Data on parts (a) to (g) can be downloaded from the Bureau of Economic Analysis (www.bea.doc.gov—follow the links to GDP and related data). Most of the data (not necessarily the earliest year) can also be found in the Economic Report of the President. By dividing each component (a) to (g) by nominal GDP and multiplying by 100, we obtain the following percentages: 1950 1975 2000 a. Personal consumption expenditures 65.5% 63.0% 68.2% b. Gross private domestic investment 18.4% 14.1% 17.9% c. Government consumption purchases 15.9% 22.1% 17.6% d. Net exports 0.2% 0.8% –3.7% e. National defense purchases 6.7% 6.6% 3.8% f. State and local purchases 7.1% 12.8% 11.7% g. Imports 3.9% 7.5% 14.9% (Note: These data were downloaded February 5, 2002 from the BEA web site.) Among other things, we observe the following trends in the economy over the period 1950–2000: (a) Personal consumption expenditures have been around two-thirds of GDP, although the share increased about 5 percentage points between 1975 and 2000. (b) The share of GDP going to gross private domestic investment fell from 1950 to 1975 but then rebounded. (c) The share going to government consumption purchases rose more than 6 percentage points from 1950 to 1975 but has receded somewhat since then. (d) Net exports, which were positive in 1950 and 1975, were substantially negative in 2000. (e) The share going to national defense purchases fell from 1975 to 2000. (f) The share going to state and local purchases rose from 1950 to 1975. (g) Imports have grown rapidly relative to GDP. 6 Answers to Textbook Questions and Problems
Chapter 2 The Data of Macroeconomics 6. a. 1. Nominal GDP is the total value of goods and services measured at current prices. Therefore Nominal GDP2ooo =(P 2000 xQ2000)+(P bread xQ bread ($50,000×100)+($10×500,000 =$5,000,000+$5,000,000 =$10,000,000 Nominal gDP20=(P20×Q0)+(Pbd×Qbmd) =($60,000×120)+($20×400,000) =$7,200,000+$8,000,000 $15,200000 ii. Real gDP is the total value of goods and services measured at constant prices. Therefore, to calculate real GDP in 2010(with base year 2000), multi- ply the quantities purchased in the year 2010 by the 2000 prices Real gDP =($50,000×120)+($10×400,000 =$6,000,000+$4,000,000 =$10,000,000 Real GDP for 2000 is calculated by multiplying the quantities in 2000 by the prices in 2000. Since the base year is 2000, real GDP2ooo equals nominal GDP2ooo, which is $10,000,000. Hence, real GDP stayed the same between 2000and2010 iii. The implicit price deflator for GDP compares the current prices of all goods and services produced to the prices of the same goods and services in a base year. It is calculated as follows Implicit Price Deflator2o10 Nominal gdP2o1o Real gDP2o1o Using the values for Nominal gDPzono and real gdPgono calculated above Implicit Price Deflator2010 $15,200,000 $10,000000 This calculation reveals that prices of the goods produced in the year 2010 increased by 52 percent compared to the prices that the goods in the economy sold for in 2000. ( Because 2000 is the base year the value for the implicit price deflator for the year 2000 is 1.0 because nominal and real gDP are the same for the base year. v. The consumer price index(CPI) measures the level of prices in the economy The CPI is called a fixed-weight index because it fixed basket of goods over time to weight prices. If the base year is 2000, the CPI in 2010 is an average of prices in 2010, but weighted by the composition of goods produced in 2000. The CPlgo1o is calculated as follows CPI200=D20 ×500,000) ×500,000) $16,000,000 $10,000,000
6. a. i. Nominal GDP is the total value of goods and services measured at current prices. Therefore, Nominal GDP2000 = (P × Q ) + (P × Q ) = ($50,000 × 100) + ($10 × 500,000) = $5,000,000 + $5,000,000 = $10,000,000. Nominal GDP2010 = (P × Q ) + (P × Q ) = ($60,000 × 120) + ($20 × 400,000) = $7,200,000 + $8,000,000 = $15,200,000. ii. Real GDP is the total value of goods and services measured at constant prices. Therefore, to calculate real GDP in 2010 (with base year 2000), multiply the quantities purchased in the year 2010 by the 2000 prices: Real GDP2010 = (P × Q ) + (P × Q ) = ($50,000 × 120) + ($10 × 400,000) = $6,000,000+ $4,000,000 = $10,000,000. Real GDP for 2000 is calculated by multiplying the quantities in 2000 by the prices in 2000. Since the base year is 2000, real GDP2000 equals nominal GDP2000, which is $10,000,000. Hence, real GDP stayed the same between 2000 and 2010. iii. The implicit price deflator for GDP compares the current prices of all goods and services produced to the prices of the same goods and services in a base year. It is calculated as follows: Implicit Price Deflator2010 = . Using the values for Nominal GDP2010 and real GDP2010 calculated above: Implicit Price Deflator2010 = = 1.52. This calculation reveals that prices of the goods produced in the year 2010 increased by 52 percent compared to the prices that the goods in the economy sold for in 2000. (Because 2000 is the base year, the value for the implicit price deflator for the year 2000 is 1.0 because nominal and real GDP are the same for the base year.) iv. The consumer price index (CPI) measures the level of prices in the economy. The CPI is called a fixed-weight index because it uses a fixed basket of goods over time to weight prices. If the base year is 2000, the CPI in 2010 is an average of prices in 2010, but weighted by the composition of goods produced in 2000. The CPI2010 is calculated as follows: CPI2010 = = = = 1.6. Chapter 2 The Data of Macroeconomics 7 2000 cars 2000 cars 2000 bread 2000 bread 2010 cars 2010 cars 2010 bread 2010 bread 2000 cars 2010 cars 2000 bread 2010 bread Nominal GDP2010 Real GDP2010 $15,200,000 $10,000,000 $16,000,000 $10,000,000 ($60,000 × 100) + ($20 × 500,000) ($50,000 × 100) + ($10 × 500,000) ( )( ) ( PQ PQ P Q cars cars bread bread cars c 2010 2000 2010 2000 2000 ×+× × ars bread bread 2000 2000 2000 )( ) + × P Q
Answers to Textbook Questions and problems This calculation shows that the price of goods purchased in 2010 increased by 6 percent compared to the prices these goods would have sold for in 2000. The CPI for 2000, the base year, equals 1.0 b. The implicit price deflator is a Paasche index because it is computed with a chang ing basket of goods; the CPI is a Laspeyres index because it is computed with a fixed basket of goods. From(5. a iii), the implicit price deflator for the year 2010 is 1.52, which indicates that prices rose by 52 percent from what they were in the prices rose by 60 percent from what they were in the year 200( ich indicates that ear 2000. From(5. a iv. the CPI for the year 2010 If prices of all goods rose by, say, 50 percent, then one could say unam- biguously that the price level rose by 50 percent. Yet, in our example, relative prices have changed. The price of cars rose by 20 percent; the price of bread rose by 100 percent, making bread relatively more expensive As the discrepancy between the CPi and the implicit price deflator illus- trates, the change in the price level depends on how the goods' prices are weight- ed. The CPI weights the price of goods by the quantities purchased in the year 2000. The implicit price deflator weights the price of goods by the quantities pur- chased in the year 2010. The quantity of bread consumed was higher in 2000 than in 2010, so the CPi places a higher weight on bread. Since the price of bread increased relatively more than the price of cars, the CPi shows a larger increase in the price level. c. There is no clear-cut answer to this question. Ideally, one wants a measure of the price level that accurately captures the cost of living. As a good becomes relatively more expensive, people buy less of it and more of other goods. In this example consumers bought less bread and more cars. an index with fixed weights such as the CPl, overestimates the change in the cost of living because it does not take into account that people can substitute less expensive goods for the ones that become more expensive On the other hand, an index with changing weights, such as the gdp deflator, underestimates the change in the cost of living because it does not take into account that these induced substitutions make people less well 7. a. The consumer price index uses the consumption bundle in year l to figure out how much weight to put on the price of a given good Qm)+(Ppen×x ($2×10)+($1×0) ($1×10)+($2×0) According to the cpl, prices have doubled. Nominal spending is the total value of output produced in each year. In year 1 and 2, Abby buys 10 apples for $1 each, so her nominal spending remains con- stant at $10. For example Nominal Spending =(Pred xQ2ed)+( 82×0)+($1×10)
This calculation shows that the price of goods purchased in 2010 increased by 60 percent compared to the prices these goods would have sold for in 2000. The CPI for 2000, the base year, equals 1.0. b. The implicit price deflator is a Paasche index because it is computed with a changing basket of goods; the CPI is a Laspeyres index because it is computed with a fixed basket of goods. From (5.a.iii), the implicit price deflator for the year 2010 is 1.52, which indicates that prices rose by 52 percent from what they were in the year 2000. From (5.a.iv.), the CPI for the year 2010 is 1.6, which indicates that prices rose by 60 percent from what they were in the year 2000. If prices of all goods rose by, say, 50 percent, then one could say unambiguously that the price level rose by 50 percent. Yet, in our example, relative prices have changed. The price of cars rose by 20 percent; the price of bread rose by 100 percent, making bread relatively more expensive. As the discrepancy between the CPI and the implicit price deflator illustrates, the change in the price level depends on how the goods’ prices are weighted. The CPI weights the price of goods by the quantities purchased in the year 2000. The implicit price deflator weights the price of goods by the quantities purchased in the year 2010. The quantity of bread consumed was higher in 2000 than in 2010, so the CPI places a higher weight on bread. Since the price of bread increased relatively more than the price of cars, the CPI shows a larger increase in the price level. c. There is no clear-cut answer to this question. Ideally, one wants a measure of the price level that accurately captures the cost of living. As a good becomes relatively more expensive, people buy less of it and more of other goods. In this example, consumers bought less bread and more cars. An index with fixed weights, such as the CPI, overestimates the change in the cost of living because it does not take into account that people can substitute less expensive goods for the ones that become more expensive. On the other hand, an index with changing weights, such as the GDP deflator, underestimates the change in the cost of living because it does not take into account that these induced substitutions make people less well off. 7. a. The consumer price index uses the consumption bundle in year 1 to figure out how much weight to put on the price of a given good: CPI2 = = = 2. According to the CPI, prices have doubled. b. Nominal spending is the total value of output produced in each year. In year 1 and year 2, Abby buys 10 apples for $1 each, so her nominal spending remains constant at $10. For example, Nominal Spending2 = (P × Q ) + (P × Q ) = ($2 × 0) + ($1 × 10) = $10. 8 Answers to Textbook Questions and Problems ($2 × 10) + ($1 × 0) ($1 × 10) + ($2 × 0) 2 red 2 red 2 green 2 green ( )( ) ( )( PQ P Q PQ P Q red red green green red red green gre 21 2 1 11 1 ×+ × ×+ × en 1 )
Chapter 2 The Data of Macroeconomics c. Real spending is the total value of output produced in each year valued at the prices prevailing in year 1. In year 1, the base year, her real spending equals her nominal spending of $10. In year 2, she consumes 10 green apples that are each valued at their year 1 price of $2, so her real spending is $20. That is Real Spending2=(PHd×Q2d)+(Plen×Qen) =($1×0)+($2×10) Hence, abby s real spending rises from $10 to $20 d. The implicit price deflator is calculated by dividing Abby's nominal spending in year 2 by her real spending that year: Implicit Price Deflator, =Nominal Spending Real Spendi $10 Thus, the implicit price deflator suggests that prices have fallen by half. The rea prices prevailing in year 1. From this perspective green apples appear very val son for this is that the deflator estimates how much abby values her apples usin able. In year 2, when Abby consumes 10 green apples, it appears that her con sumption has increased because the deflator values green apples more highly than red apples. The only way she could still be spending $10 on a higher consumption bundle is if the price of the good she was consuming feel. e. If Abby thinks of red apples and green apples as perfect substitutes, then the cost of living in this economy has not changed--in either year it costs $10 to consume 10 apples. according to the CPl, however the cost of living has doubled. This because the CPi only takes into account the fact that the red apple price has dou bled; the CPI ignores the fall in the price of green apples because they were not in the consumption bundle in year 1. In contrast to the CPi, the implicit price defla- or estimates the cost of living has halved. Thus, the CPl, a Laspeyres index, over states the increase in the cost of living and the deflator, a Paasche index, under- states it. This chapter of the text discusses the difference between Laspeyres and Paasche indices in more detail 8. a. Real GDP falls because Disney does not produce any services while it is closed This corresponds to a decrease in economic well-being because the income of work ers and shareholders of Disney falls (the income side of the national accounts), and people' s consumption of Disney falls (the expenditure side of the national accounts) b. Real GDP rises because the original capital and labor in farm production now pro- duce more wheat. This corresponds to an increase in the economic well-being of society, since people can now consume more wheat. (If people do not want to con- sume more wheat, then farmers and farmland can be shifted to producing other goods that society values.) c. Real GDP falls because with fewer workers on the job, firms produce less. This accurately reflects a fall in economic well-being Real GDP falls because the firms that lay off workers produce less. This decreases economic well-being because workers' incomes fall (the income side), and there are fewer goods for people to buy(the expenditure side) e. Real GDP is likely to fall, as firms shift toward production methods that produce fewer goods but emit less pollution. Economic well-being, however, may rise. The economy now produces less measured output but more clean air; clean air is not
c. Real spending is the total value of output produced in each year valued at the prices prevailing in year 1. In year 1, the base year, her real spending equals her nominal spending of $10. In year 2, she consumes 10 green apples that are each valued at their year 1 price of $2, so her real spending is $20. That is, Real Spending2 = (P × Q ) + (P × Q ) = ($1 × 0) + ($2 × 10) = $20. Hence, Abby’s real spending rises from $10 to $20. d. The implicit price deflator is calculated by dividing Abby’s nominal spending in year 2 by her real spending that year: Implicit Price Deflator2 = = = 0.5. Thus, the implicit price deflator suggests that prices have fallen by half. The reason for this is that the deflator estimates how much Abby values her apples using prices prevailing in year 1. From this perspective green apples appear very valuable. In year 2, when Abby consumes 10 green apples, it appears that her consumption has increased because the deflator values green apples more highly than red apples. The only way she could still be spending $10 on a higher consumption bundle is if the price of the good she was consuming feel. e. If Abby thinks of red apples and green apples as perfect substitutes, then the cost of living in this economy has not changed—in either year it costs $10 to consume 10 apples. According to the CPI, however, the cost of living has doubled. This is because the CPI only takes into account the fact that the red apple price has doubled; the CPI ignores the fall in the price of green apples because they were not in the consumption bundle in year 1. In contrast to the CPI, the implicit price deflator estimates the cost of living has halved. Thus, the CPI, a Laspeyres index, overstates the increase in the cost of living and the deflator, a Paasche index, understates it. This chapter of the text discusses the difference between Laspeyres and Paasche indices in more detail. 8. a. Real GDP falls because Disney does not produce any services while it is closed. This corresponds to a decrease in economic well-being because the income of workers and shareholders of Disney falls (the income side of the national accounts), and people’s consumption of Disney falls (the expenditure side of the national accounts). b. Real GDP rises because the original capital and labor in farm production now produce more wheat. This corresponds to an increase in the economic well-being of society, since people can now consume more wheat. (If people do not want to consume more wheat, then farmers and farmland can be shifted to producing other goods that society values.) c. Real GDP falls because with fewer workers on the job, firms produce less. This accurately reflects a fall in economic well-being. d. Real GDP falls because the firms that lay off workers produce less. This decreases economic well-being because workers’ incomes fall (the income side), and there are fewer goods for people to buy (the expenditure side). e. Real GDP is likely to fall, as firms shift toward production methods that produce fewer goods but emit less pollution. Economic well-being, however, may rise. The economy now produces less measured output but more clean air; clean air is not Chapter 2 The Data of Macroeconomics 9 1 red 2 red 1 green 2 green Nominal Spending2 Real Spending2 $10 $20