1. How is the total output of an economy measured?

Suppose you read an article in the financial section of today's newspaper in which the president argues that the Federal Reserve should lower interest rates because of recent slow growth in the economy. How did the president know that the economy was growing slowly?

We want to be able to compare the condition of the economy across different points in time and also against the economies of other countries. How can we tell whether the economy is better or worse than before? If we are producing more goods and services than before, the economy is growing. In order to combine dissimilar items like apples and oranges, economists use the market value of goods and services, the gross domestic product (GDP) is the market value of all final goods and services produced in a year in a country. We use final goods and services to avoid double-counting. If a tire is to be sold directly to a consumer, the value of the tire is included in the GDP. But if the tire is sold as part of an automobile, its value is already included in the value of the automobile, so we do not count it separately.

2. What is the difference between nominal and real GDP?

Nominal GDP measures output in terms of its current dollar value. A rise in nominal GDP can be from an increase in physical goods and services, a rise in prices, or both. Real GDP measures output in constant prices. Real GDP can only increase if the production of physical goods and services increases. Real GDP is thus a better indicator of economic activity than nominal GDP.

3. What is a price index?

A price index measures the level of average prices and shows how prices, on average, have changed. If a pair of running shoes costs $75 this year, then 10 pairs of running shoes have a market value of $750. If the same shoes cost $80 next year, then 10 pairs have a market value of $800. The nominal value has increased, but we still have only 10 pairs of shoes. A price index adjusts values for price changes.

4. How is money traded internationally?

People trade one currency for another in foreign exchange markets. It is not necessary for large traders to go to a specific place to conduct such transactions. They call a bank that deals in foreign currency and ask the bank to convert some of their dollars to the currency they want. The amount of foreign currency exchanged for dollars depends on the exchange rate-the price of one country's money in terms of another.

5. How do nations record their transactions with the rest of the world?

The record of a nation's transactions with the rest of the world is called the balance of payments. The balance of payments is divided into two categories: the current account and the capital account. The current account is the sum of the balances for merchandise, services, investment income, and unilateral transfers. The capital account records the transactions necessary to move these into and out of the country. The net balance in the balance of payments must be zero, so a deficit (or surplus) in the current account must be offset by a surplus (or deficit) in the capital account. A country becomes a larger net debtor (or smaller net creditor) if it shows a deficit in its current account (or surplus in its capital account).