Answers to Exercises

1. The value-added approach to calculating GDP can be used to compute the value of the computer in the GDP. Because each intermediate step in manufacturing the computer is listed by value added, we can simply add the values together to obtain the increment added to GDP. When this is done, we find that the value is $2,300.

2. a. GDP plus net factor income from abroad equals gross national product.
b. GNP less capital consumption allowances equals net national product.
c. NNP less indirect business taxes equals national income.
d. NI plus income received but not earned in the current year less income earned but not received in the current year equals personal income.
e. PI less personal taxes equals disposable personal income.

3. a. Real GDP for year 1 = $3 x 100 + $3 x 100 = $600.

Real GDP for year 2 = $3 x 150 + $3 x 75 = $675

The growth rate of real GDP = 100 x ($675/$600 - 1) = 12.5 percent

b. Real GDP for year 1 = $3 x 100 + $4 x 100 = $700.

Real GDP for year 2 = $3 x 150 + $4 x 75 = $750

The growth rate of real GDP = 100 x ($750/$700 - 1) = 7.14 percent

c.[MAKE GRAPHIC: SQUARE ROOT OF (1.125x1.0714)]- 1 = [MAKE GRAPHIC: SQUARE ROOT OF 1.21] - 1= 10 percent.

4. To understand this concept, recall the circular flow model. For business to produce output it must pay factor incomes to the households that equal the value of output. Households, in turn, spend that income on the goods and services that businesses produce.

5. We cannot simply count the total number of goods and services produced each year because we have no common measure. Just as we cannot add apples and oranges, we cannot add computers and machine tools. We must use money values as the common measure.

6. The CPI is not a useful measure of any particular person's cost of living because the market basket of goods and services used to calculate the CPI may not be an accurate representation of that individual's purchases. The CPI is meant to be a measure of prices for the typical or average consumer, not for any particular individual consumer.

7. GDP = C + I + G + X = $400 + $40 + $100 + $10 = $550 (Remind students that the "I" in the equation is gross investment, not net investment.)

8. GNP = GDP + net factor income from abroad = $550 + $2 = $552

9. NNP = GNP - capital consumption allowance = $552 - $20 = $532

10. NI = NNP - indirect business taxes = $532 - $5 = $527

11. Gross investment = net investment + capital consumption allowance = $20 + $20 = $40

12. If we do not add indirect business taxes and capital consumption allowance to the payments to factors of production, then GDP as income will not equal GDP as output. However, indirect business taxes and capital consumption allowance may be considered as expenses incurred in production just like wages, interest, rent, or profits.

13. The fact that nominal GDP has grown faster than real GDP indicates that prices have risen over time. An economy that had real GDP growing faster than nominal GDP would have a falling price level.

14. GDP does not include goods that are not produced in the current year, illegal transactions, goods or services that are not exchanged for money or barter (like housework by a wife or husband), and intermediate goods. Since GDP is the value of goods produced in the current year, we exclude goods produced in previous years. Illegal transactions cannot be observed or measured and so cannot be included. Goods or services not exchanged in a market (either monetary or barter) cannot be easily measured and so are not included. Intermediate goods cannot be counted along with the value of final goods and services without double-counting the value of output (although using the value-added method we could use intermediate goods to measure GDP).

15. Changes in inventory capture the value of goods produced this year but not sold until next year. The production of the surfboard that goes unsold will increase surfboard inventories. Such inventory changes are considered part of investment spending in current GDP.

Answers to Study Guide Homework

1. GDP stands for gross domestic product, and measures the market value of all final goods and services produced in a year in a country.

2. GDP = consumption + investment + government spending + net exports

3. GDP = wages + interest + rent + profit - net factor income from abroad + capital consumption allowance + indirect business taxes

4 a. 1994 real GDP = 1.02 billion dimmens; 1995 real GDP = 1.029 billion dimmens

b. Real GDP was higher in 1995, so the people of Dimmenland had a larger economy in 1995.

5. Cost in 1991 = $6.70 (1.20*3 + 1.50*2 + .20*.5)

Cost currently = $7.10

CPI = 105.97 ((7.10/6.70)*100)

Answers to Internet Exercise

This exercise will allow students to access current information regarding three widely used price indexes. Students will then compare indexes and calculate rates of inflation to determine which price index they would rather use in determining a pay raise. Be sure to point out to students that wage contracts are often based on one of these price indexes, but are typically in effect for a number of years.

Answers will vary based on the most recent information available. Be sure to verify the calculations for the rate of inflation as many students have difficulties calculating percentages.

Students should choose the price index which gives them the highest rate of inflation, thus resulting in the highest pay increase.

The same price index would not always be the best choice for determining future raises. Economic swings and business cycles could cause an alternative price index to provide a higher rate of increase.