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CHAPTER 6
TRACKING THE U.S. ECONOMY
In this chapter, you will find:
Chapter Outline with PowerPoint Script
Chapter Summary
Teaching Points (as on Prep Card)
Answers to the End-of-Book Questions and Problems for Chapter 6
Supplemental Cases, Exercises, and Problems
INTRODUCTION
This chapter discusses the economy’s scorecard using the national income accounting system to explain
economic activity. It begins with a discussion of the national income accounts. The alternative ways of
measuring gross domestic product are the income approach and the expenditure approach. Limitations of
the national income accounts are reviewed along with the methods used to adjust for changes in the price
level over time. The circular flow diagram is introduced as an excellent way to summarize the flow of
income and spending throughout the economy.
This chapter distinguishes between two aggregate price measures: the consumer price index (CPI) and the
GDP price index. The CPI is based on the cost of a fixed representative set of consumer goods. The GDP
index, on the other hand, is based on the production levels of all goods and services in the national
accounts.
LEARNING OUTCOMES
1
Explain the gross domestic product
Gross domestic product, or GDP, measures the market value of all final goods and services produced during the
year by resources located in the United States, regardless of who owns those resources. The expenditure approach to GDP adds up the market value of all final goods and services produced in the economy during the
year. The income approach to GDP adds up all the income generated as a result of that production.
2
Discuss the circular flow of income and expenditure
The circular-flow model summarizes the flow of income and spending through the economy. Saving, net taxes,
and imports leak from the circular flow. These leakages equal the injections into the circular flow from investment, government purchases, and exports.
3
Assess the limitations of national income accounting
GDP reflects market production in a given period, usually a year. Most household production and the underground economy are not captured by GDP. Improvements in the quality and variety of products also are often
missed in GDP. In other ways GDP may overstate production. GDP fails to subtract for the depreciation of the
capital stock or for the depletion of natural resources and fails to account for any negative externalities arising
from production.
4
Explain how to account for price changes
Nominal GDP in a particular year values output based on market prices when the output was produced. To determine real GDP, nominal GDP must be adjusted for price changes. The consumer price index, or CPI, tracks
prices for a basket of goods and services over time. The GDP price index tracks price changes for all output. No
adjustment for price changes is perfect, but current approaches offer a reasonably good estimate of real GDP
both at a point in time and over time.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Chapter 6
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80
CHAPTER OUTLINE WITH POWERPOINT SCRIPT
USE POWERPOINT SLIDE 2 FOR THE FOLLOWING SECTION
The Product of A Nation: Measured historically by:
 The stock of precious metals in the 17th & 18th centuries (Mercantilism)
 The circular flow of output and income late 18th Century (Francois Quesnay).
 The detailed national income accounting system developed by Kuznets in the 1930s
USE POWERPOINT SLIDES 3-5 FOR THE FOLLOWING SECTION
National Income Accounts
 Gross domestic product (GDP): Measures the market value of all final goods and services produced
during a year by resources located in the United States, regardless of who owns the resources. GDP
can be measured by the expenditure approach or the income approach.
 Final goods and services: Sold to the final, or end, user.
 Intermediate goods and services: Purchased for additional processing and resale.
USE POWERPOINT SLIDES 6-10 FOR THE FOLLOWING SECTION
GDP Based on the Expenditure Approach
 Consumption (C): Personal consumption expenditures by households for services and for durable
and nondurable goods.
 Investment (I): Gross private domestic investment; spending on new capital goods and on net
additions to inventories.
 Government Purchases (G): Government consumption and gross investments; includes government
spending for goods and services.
 Net exports (X-M): Value of U.S. exports minus the value of U.S. imports.
 Aggregate expenditure: C + I + G + (X – M) = Aggregate Expenditure = GDP
USE POWERPOINT SLIDES 11-13 FOR THE FOLLOWING SECTION
GDP Based on the Income Approach: Sum of wages, interest, rent, and profit arising from production.
Avoids double counting by either including only the market value of the good or service or summing the
value added at each stage of production. (Aggregate expenditure = GDP = Aggregate income)
USE POWERPOINT SLIDES 14-21 FOR THE FOLLOWING SECTION
Circular Flow of Income and Expenditure:

The main stream flows clockwise first as income from firms to households (the upper half) and then as
spending from households back to firms (the lower half). For each flow of money, there is an equal
and opposite flow of goods or resources
Income Half of the Circular Flow
 The production of aggregate output equals aggregate income. GDP = Aggregate income assuming no
depreciation and no retained earnings.
 Disposable income (DI) is take-home pay. DI = Aggregate income – (Taxes + Transfers)
 Net Taxes (NT) equals taxes – transfer payments.
 Aggregate income: GDP = Aggregate income = DI + NT
Expenditure Half of the Circular Flow: DI = C + S
 Households with disposable income must use it to consume or save.
 C + I + G + (X  M) = Aggregate expenditure = GDP
Injections Equal Leakages
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Chapter 6
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81
Accounting Identity 1: Aggregate expenditure = Aggregate income
C + I + G + X  M = DI + NT
C + I + G + X  M = C + S + NT
Accounting Identity 2: Injections = Leakages
I + G + X = S + NT + M
USE POWERPOINT SLIDES 22-24 FOR THE FOLLOWING SECTION
Limitations of National Income Accounting
Some Production Is Not Included in GDP:
 Do-it-yourself production
 Production in the underground economy.
 Some production that does not involve market exchange is included in GDP:
– Imputed rental income that homeowners receive from home ownership.
– Imputed value of wages paid in kind.
– Imputed value of food produced on a farm for that farm family’s own consumption.
Leisure, Quality, and Variety: GDP does not measure changes in the availability of leisure time, the
quality of products, or in the availability of new products.
What’s gross about Gross Domestic Product?
 GDP is called “gross” because it does not take into account the depreciation of capital.
 Depreciation: The value of capital stock that is used up or becomes obsolete in the production
process.
 Net Domestic Product (NDP) = GDP - depreciation
 Gross investment: The value of all investment spending during a year.
 Net Investment: Gross investment minus depreciation.
GDP Does Not Reflect All Costs:
 Ignores negative externalities and the depletion of natural resources
GDP and Economic Welfare
USE POWERPOINT SLIDES 25-26 FOR THE FOLLOWING SECTION
CaseStudy: GDP and The State of the USA
USE POWERPOINT SLIDES 27-29 FOR THE FOLLOWING SECTION
Accounting for Price Changes: To make meaningful comparisons of GDP across years, nominal
GDP must be deflated. This allows the focus to be on real changes in production.
 Nominal GDP (current $ GDP): Based on prices prevailing when production occurs.
 Real GDP: Measured in terms of the goods and services produced.
Price Indexes: Used to compare the value of some variable in a particular year to its value in a base year.
Consumer Price Index: Measures changes over time in the cost of buying a “market basket” of goods
and services purchased by a typical family.
USE POWERPOINT SLIDES 30-31 FOR THE FOLLOWING SECTION
Problems with the CPI: By failing to reflect new products and improved quality, estimates of the
possibilities of substitution, and shifts to discount outlets, the CPI is overstated.
USE POWERPOINT SLIDES 32-33 FOR THE FOLLOWING SECTION
The GDP Price Index: (Nominal GDP/ Real GDP)  by 100 measures average price of all goods and
services produced in the economy.
Moving from Fixed Weights to Chain Weights
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
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Chapter 6
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82
CHAPTER SUMMARY
Gross domestic product, or GDP, measures the market value of all final goods and services produced
during the year by resources located in the United States, regardless of who owns those resources.
The expenditure approach to GDP adds up the market values of all final goods and services produced in
the economy during the year. The income approach to GDP adds up all the income generated as a result of
that production.
The circular flow model summarizes the flow of income and spending through the economy. Saving, net
taxes, and imports leak from the circular flow. These leakages equal the injections into the circular flow
from investment, government purchases, and exports.
GDP reflects market production in a given period, usually a year. Most household production and the
underground economy are not captured by GDP. Improvements in the quality and variety of products also
are often missed in GDP. In other ways GDP may overstate production. GDP fails to subtract for the
depreciation of the capital stock or for the depletion of natural resources and fails to account for any
negative externalities arising from production.
Nominal GDP in a particular year values output based on market prices when the output was produced. To
determine real GDP, nominal GDP must be adjusted for price changes. The consumer price index, or CPI,
tracks prices for a basket of goods and services over time. The GDP price index tracks price changes for
all output. No adjustment for price changes is perfect, but current approaches offer a reasonably good
estimate of real GDP both at a point in time and over time.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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83
TEACHING POINTS
1. Many instructors do not spend a great deal of time discussing national income accounting, but it is
important to realize this chapter deals with actual data and measurement. Students typically have not
thought about how to add up goods produced in the economy and therefore are unaware of the basis of
and shortcomings associated with the GDP. In this sense, a cursory review of this chapter may be
insufficient.
2. The circular flow can be as complicated as you wish to make it. The key point of the circular flow
diagram is that the national output is the same as national income. Emphasize this point, since the
terms output and income will be used synonymously throughout the rest of the text.
3. The idea that leakages must equal injections gives rise to the twin deficits idea. Make sure that the
class recognizes that the equation (G  NT) = (S – I) – (X – M) is an identity and therefore shows
association rather than causality.
4. The increasing importance of the underground economy has made it essential to discuss its relation to
GDP estimation. You should make a distinction between the cash economy and the illegal goods
economy. Most people would accept that the cash economy involves goods and services that belong in
the estimate of GDP, but the illegal goods economy may not qualify. The inclusion of illegal drug
sales, for example, is harder to justify.
5. Students may get the idea that national income accounting is a little like accounting for the firm. You
should remind them that an estimate of GDP that errs by as little as 1 percent will be off by more than
$100 billion. Also, the United States has excellent statistics compared with those of most other
countries. The Economic Report of the President now contains more than 1,000 time series. You may
wish to emphasize that one of the functions of government is to assess the performance of the
economy and to provide such information to the public. This information is costly, which is why most
less developed countries cannot afford to gather such data.
6. The online appendix provides other aggregates that you may wish to discuss in class.
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Chapter 6
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84
ANSWERS TO END-OF-BOOK QUESTIONS AND PROBLEMS
1.1 (Income Approach to GDP) How does the income approach to measuring GDP differ from the
expenditure approach? Explain the meaning of value added and its importance in the income
approach. Consider the following data for the selling price at each stage in the production of a fivepound bag of flour sold by your local grocer. Calculate the final market value of the flour.
Stage of Production
Farmer
Miller
Wholesaler
Grocer
Sale Price
$0.30
$0.50
$1.00
$1.50
The expenditure approach adds up the total spending on new production, while the income approach
adds up all of the income earned by the resource suppliers in producing flour. The value added is the
selling price at each stage of production minus the amount already paid for resources by the firms in
earlier stages of production. The sum of the value added at each stage equals the final market price of
the good. To avoid double counting, aggregate income can be determined by summing the values
added at each stage production. The final market value of the bag of flour, for example, is calculated
as $0.30 + 0.20 + 0.50 + 0.50 = $1.50.
1.2 (Expenditure Approach to GDP) Given the following annual information about a hypothetical
country, answer questions a through d.
Personal consumption expenditures
Personal taxes
Exports
Depreciation
Government purchases
Gross private domestic investment
Imports
Government transfer payments
Billions of Dollars
$200
50
30
10
50
40
40
20
a.
b.
c.
d.
What is the value of GDP?
What is the value of net domestic product?
What is the value of net investment?
What is the value of net exports?
a.
b.
c.
d.
C + Igross + G + (XM) = 200 + 40 + 50 + (3040) = $280 billion
GDP  depreciation = 28010 = $270 billion.
Gross investment  depreciation = 4010 = $30 billion
XM = 3040 = $10 billion
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Chapter 6
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85
1.3 (Investment) Given the following annual data, answer questions a through c.
New residential construction
Purchases of existing homes
Sales value of newly issued stocks and bonds
New physical capital
Depreciation
Household purchases of new furniture
Net change in firms’ inventories
Production of new intermediate goods
Billions of Dollars
$500
250
600
800
200
50
100
700
a. What is the value of gross private domestic investment?
b. What is the value of net investment?
c. Are any intermediate goods included in the measure of gross investment?
a. $1.4 trillion = 500 (new residential construction) + 800 (new physical capital) + 100 (net
changes in firms’ inventories)
b. $1.2 trillion = 1.4 trillion (gross investment) – 200 ( depreciation)
c. Any intermediate goods that were produced during the year but not yet reprocessed or resold are
included in the figure for net changes in firms’ inventories.
2.1 (Leakages and Injections) What are the leakages from and injections into the circular flow? How are
leakages and injections related in the circular flow?
Leakages include net taxes, saving, and imports. Injections consist of investment spending,
government purchases, and exports. In equilibrium, leakages from the circular flow equal injections
into the circular flow.
3.1 (Limitations of National Income Accounting) Explain why each of the following should be taken into
account when GDP data are used to compare the “level of well-being” in different countries:
a. Population levels
b. The distribution of income
c. The amount of production that takes place outside of markets
d. The length of the average work week
e. The level of environmental pollution
This question highlights some of the problems that accompany the indiscriminate use of GDP
comparisons across countries or over long periods to compare welfare levels.
a. GDP per capita is better for measuring well-being than the level of GDP is, and therefore GDP
comparisons must be adjusted for population differences
b. Distribution is ignored in calculating GDP, yet distribution is clearly relevant in using GDP to
measure the degree to which the economy is meeting people’s needs.
c. GDP includes only goods and services sold in markets (with minor exceptions). Yet goods
produced informally also affect well-being. In countries where many goods and services are
produced outside the official marketplace, the GDP will underestimate the true amount of annual
production. Thus, comparing GDP figures can be problematic for countries at varying stages of
development.
d. GDP ignores the value of leisure in contributing to well-being. Increased leisure may lead to an
improved quality of life
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Chapter 6
e.
Tracking the U. S. Economy
86
GDP ignores production costs that are not included in the prices of items sold in markets. To the
extent that rising GDP occurs with rising pollution levels, GDP statistics overstate the level of
well-being.
4.1 (Consumer Price Index) Calculate a new consumer price index for the data in the following exhibit.
Assume that current year prices of Twinkies, fuel oil, and cable TV are $0.95/package, $1.25/gallon,
and $15.00/month, respectively. Calculate the current year’s cost of the market basket and the value of
the current year’s price index. What is this year’s percent change in the price level compared to the
base year?
Good or
Service
Twinkies
Fuel Oil
Cable TV
Quantity in
Market Basket
365 packages
500 gallons
12 months
Prices in
Base Year
$ .89/package
1.00/gallon
30.00/month
Cost of Basket
in Base Year
$324.85
500.00
360.80
$1,184.85
Prices in
Current Year
$ .95/package
1.25/gallon
$15.00/month
Cost of Basket
in Current Year
$346.75
625.00
180.00
$1,151.75
Current expenditures now equal $346.75 for Twinkies, $625.00 for fuel oil, and $180.00 for cable TV.
Thus, the current year’s cost of the market basket is $1,151.75, and the new price index is 97—the
average price level has fallen by 3 percent since the base year. The percentage change is equal to the
change in the index (97100) divided by the base year index (100) then multiplied by 100. The fall in
the price of cable TV outweighed the effect of the increase in the price of fuel oil and Twinkies.
4.2 (Consumer Price Index) Given the following data, what was the value of the consumer price index in
the base year? Calculate the annual rate of consumer price inflation in 2013 in each of the following
situations:
f.
g.
h.
i.
The CPI equals 200 in 2012 and 240 in 2013.
The CPI equals 150 in 2012 and 175 in 2013.
The CPI equals 325 in 2012 and 340 in 2013.
The CPI equals 325 in 2012 and 315 in 2013.
A price index always equals 100 in the base year.
a. 20.0 percent
b. 16.7 percent
c. 4.6 percent
d. −3.1 percent (the price level fell)
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Chapter 6
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87
SUPPLEMENTAL CASES, EXERCISES, AND PROBLEMS
Case Studies
These cases are available to students online at www.cengagebrain.com.
GDP and The State of the USA
GDP estimates have been refined for decades and are arguably the most complex data aggregation effort
in the world. But they have their limits, as discussed already, and they have their critics. One criticism is
that GDP leaves out much of what’s going on in the nation—with health care, the environment, the family,
energy use, and so on. One challenge to GDP as the primary indicator of national progress is coming from
a nonprofit group that has developed a Web site to bring together hundreds of indicators. The idea is to
help Americans assess the progress of the United States by using quality data selected by experts.
First, a little background. In 2003, a team at the U.S. Government Accountability Office, the
investigative arm of Congress, was looking for alternatives to GDP to assess national progress. The team
became an independent nonprofit agency in 2007 and took the name “The State of the USA.” With startup
funding from the Gates, Hewlett, MacArthur, and Rockefeller foundations, the group set out to identify
data that would amount to a report card on how the country is doing in specific areas—such as health care,
education, the environment, safety, energy, transportation, the economy, the family, and so forth. The goal
is to help citizens and leaders assess what progress has been made and where we need to improve.
The effort got a big boost from a small provision in the massive 2010 health care bill that requires
Congress to help finance and oversee a “key national indicator system.” State of the USA will become that
system, overseen by the National Academy of Sciences, a group of preeminent scholars established by
Abraham Lincoln in 1863 to “investigate, examine, experiment, and report upon any subject of science or
art” whenever called upon to do so by any department of the government (half the 20 economists in the
National Academy are Nobel laureates). Along with the federal authorization came federal funding
totaling $70 million between 2010 and 2018.
The objective is not so much to replace GDP as the primary measure of economic performance, but to
broaden the conversation and the debate by including many more data series. Instead of just having one
gauge on the dashboard, GDP, there would be many gauges. The State of the USA Web site went live in
2010, and is accessible for free. Eventually, The State of the USA plans to offer about 300 indicators.
Rather than develop original data, the site compiles and displays data gathered by others. Despite the
number of data series, the group says the site will be selective, not encyclopedic. For example, in health
care alone the government collects about 1,000 different measures. The State of the USA offers what they
claim are the 20 most crucial health care measures. The group says its objective is not to interpret the data
but to disseminate it in a strictly nonpartisan manner.
The idea is to offer data in a form that can be easily shared to promote as wide a distribution as
possible. Data will be available on the national level, state level, and as far down the jurisdictional chain as
possible. For example, one of the 20 health care measures reports smoking rates by state (West Virginia is
the highest and Utah is the lowest). The State of the USA will also offer a variety of interactive features to
encourage exploration, such as motion charts with audio tutorials focusing on health costs and outcomes
for the developed world. Check out the site and see what you think.
Sources: Jon Gertner, “The Rise and Fall of the G.D.P.” New York Times, 10 May 2010; and The State of
the USA site at http://www.stateoftheusa.org/.
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Chapter 6
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Price Check on Aisle 2
The U.S. economy is one of the most dynamic in the world, marked by rapid technological change. The
Bureau of Labor Statistics (BLS), the government agency that calculates the CPI each month, employs
dozens of economists to analyze the impact of any quality changes to products in the CPI market basket.
Each month 400 data collectors visit stores to record about 85,000 prices for 211 item categories in the
CPI basket. About a week before the CPI is released, the BLS office is locked down with bright red
“restricted area” signs on all the doors. A total of 90 people, including product specialists and the other
economists working on the CPI, compute the basic indexes in each category. Results are released at 8:30
a.m., Eastern Time, about two weeks after the end of the month in question. This release is a big deal.
Most price adjustments are straightforward. For example, if a candy bar shrinks but its price doesn’t,
the CPI shows this as a price increase. But sometimes a product changed in a more complicated way. Each
economist at BLS specializes in particular products, such as televisions, automobiles, kitchen appliances,
and so on. One of their greatest challenges is to identify substitutes for products that are no longer
available. For example, data collectors find the model of TV they priced the previous month is missing
about one-fifth of the time. When a particular product is missing, a four-page checklist of features such as
screen size and the type of remote control guides the data collector to the nearest comparable model. That
price is reported and the product specialist in Washington must then decide whether it’s an acceptable
substitute.
For example, the TV specialist decided that the newer version of the 27-inch model had some
important improvements, including a flat screen. A complex computer model estimated that the
improvements alone would be valued by consumers as worth $135 more. After factoring improvements
into the price of the $330 set, the analyst determined that the price of the TV had actually declined 29
percent [= 135/(330 + 135)]. In another example, the price of a 57-inch TV dropped from $2,239 to
1,910, for an apparent decline of 15 percent. But on closer inspection, the analyst found that the new
model lacked an HDTV tuner that had been included in the model it replaced. This tuner would be valued
by consumers at $514. So, instead of declining 15 percent, the price of the 57-inch TV actually rose 11
percent [= 1,910/(2,239 − 514)].
The TV analyst is applying the hedonic method, which breaks down the item under consideration into
its characteristics, and then estimates the dollar value of each characteristic. This is a way of capturing the
impact of a change in product quality on any price change. Otherwise, price changes would not reflect the
fact that consumers are getting more or less for their money as productfeatures change over time.
Sources: Jon Hilsenrath, “A Deeper Look at the Fed’s Inflation Debate,” Wall Street Journal, 5 April
2010; Javier Hernandez, “Prices of Consumer Goods Hold Steady, Indicating That Inflation Is at Bay,”
New York Times, 18 March 2010; and Mary Kokoski, Keith Waehrer, and Patricia Rosaklis, “Using
Hedonic Methods for Quality Adjustment in the CPI,” U.S. Bureau of Labor Statistics Working Paper
(2000) found at http://www.bls.gov/cpi/cpiaudio.htm.
Experiential Exercises
1. One often-heard criticism of the U.S. national income accounts is that they ignore the effect of
environmental pollution. The World Bank’s group on Environmental Economics and Indicators has
been investigating ways of assessing environmental degradation. Have students take a look at the World
Bank’s work on “green accounting” at
http://web.worldbank.org/WBSITE/EXTERNAL/TOPICS/ENVIRONMENT/EXTEEI/0,,contentMDK:
20487830~menuPK:1187769~pagePK:148956~piPK:216618~theSitePK:408050,00.html
Ask them what kinds of problems the World Bank has identified, and what proposals it has made to deal
with those problems?
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Chapter 6
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89
2. Data on the consumer price index are released near the middle of each month. Data on GDP are
released on the last Friday of each month (in preliminary, revised, and then final form). Analysis of these
data releases appears in the first section of the following weekday’s Wall Street Journal. Ask students to
look in the Economy section to find the story. What do the latest available data say about the current rate
of inflation and the current rate of GDP growth? Is the economy in a recession or an expansion?
3. New economic data are regularly reported in the Wall Street Journal. Look in section C of the paper
(the Money and Investing section) the day after a major piece of economic information was released to
see how the stock market reacted to the news.
4. (Global Economic Watch) Go to the Global Economic Crisis Resource Center. Select Global Issues in
Context. In the Basic Search box at the top of the page, enter the phrase "G.D.P. R.I.P." On the Results
page, go to the Global Viewpoints Section. Click on the link for the August 10, 2009, article "G.D.P.
R.I.P." What does the author mean by "gross domestic transactions"?
The author suggested gross domestic transactions as a substitute name for gross domestic product. This
would be an accurate name as GDP does measure the dollar value of certain market transactions. The
author believes that this new name would lead to people no longer thinking of GDP as a measure of
economic welfare.
5.(Global Economic Watch) Go to the Global Economic Crisis Resource Center. Select Global Issues in
Context. In the Basic Search box at the top of the page, enter the phrase "price index." Write a summary
of an article about a price index in a foreign country.
Student answers will vary. Possible analyses include a focus on consumer or producer prices, increases
or decreases in prices, or changes in the contents of the market basket.
Additional Questions and Problems
(From student Web site at www.cengagebrain.com)
1. (National Income Accounting) Identify the component of aggregate expenditure to which each of the
following belongs:
a. A U.S. resident’s purchase of a new automobile manufactured in Japan
b. A household’s purchase of one hour of legal advice
c. Construction of a new house
d. An increase in semiconductor inventories over last year’s level
e. A city government’s acquisition of 10 new police cars
a. Net exports
b. Consumption
c. Investment
d. Investment
e. Government purchases
2. (National Income Accounting) Define gross domestic product. Determine whether each of the
following would be included in the 2012 U.S. gross domestic product:
a. Profits earned by Ford Motor Company in 2012 on automobile production in Ireland
b. Automobile parts manufactured in the United States in 2012, but not used until 2013
c. Social Security benefits paid by the U.S. government in 2012
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d. Ground beef purchased and used by McDonald’s in 2012
e. Ground beef purchased and consumed by a private U.S. household in 2012
f. Goods and services purchased in the United States in 2012 by a Canadian tourist
Gross domestic product is the market value of all final goods and services produced in a country
during one year by resources located in that country.
a. No, this production occurred outside U.S. borders
b. Yes, this current production is treated as inventory investment
c. No, these are transfer payments
d. No, this is an intermediate good
e. Yes, this is a final good, used for consumption
f. Yes, these are U.S. exports
3. (National Income Accounting) Explain why intermediate goods and services usually are not included
directly in GDP. Are there any circumstances under which they would be included directly?
Intermediate goods and services are further processed and resold to become part of the value of final
goods and services. The market value of final goods and services already includes the value of
intermediate goods and services used up in the production of the final good or service. If the
intermediate goods and services were also counted directly, they would be counted twice in GDP, once
as themselves and again as part of the price of the final good or service. However, intermediate goods
and services that are produced in a given year—but not yet processed and resold to become part of a
final good or service—must be included directly in GDP. These intermediate goods and services
become part of the firms’ inventories and, thus, part of the investment component of GDP.
4. (Investment) In national income accounting, one component of investment is net changes in
inventories. Last year’s inventories are subtracted from this year’s inventories to obtain a net change.
Explain why net inventory increases are counted as part of GDP. Also, discuss why it is not sufficient
to measure the level of inventories only for the current year. (Remember the difference between stocks
and flows.)
First, inventories are a stock, not a flow. Some of the inventories now existing were produced in
earlier years and have nothing to do with this year’s production. To obtain only this year’s
production of inventories, we need to subtract the total amount of inventories this year from that of
the previous year. Second, inventories should be considered a type of investment good, since they are
produced with the understanding that they will yield a revenue over time, just as plants and equipment
do. The time frame over which they do this is usually very short. Finally, inventory changes should be
considered part of national income because they are current production and are not sold to other
firms. The final sale in this case is to the firm itself.
5. (Nominal GDP) Which of the following is a necessary condition —something that must occur—for
nominal GDP to rise? Explain your answers.
a. Actual production must increase.
b. The price level must increase.
c. Real GDP must increase.
d. Both the price level and actual production must increase.
e. Either the price level or real GDP must increase
Only the last condition is necessary for nominal GDP to increase. Nominal GDP measures the market
value of production in terms of current prices. It is affected both by price changes and by actual
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output changes, whereas real GDP is affected only by actual production changes. Nominal GDP can
increase as a result of (1) price level increases only, (2) production increases only, (3) increase in
both the price level and production, (4) price level decreases that are more than offset by increases in
production, or (5) production decreases that are more than offset by increases in the price level.
6. (Price Indexes) E-readers and HDTVs have not been part of the U.S. economy for very long. Both
goods have been decreasing in price and improving in quality. What problems does this pose for
people who are responsible for calculating a price index?
During the base year, HDTVs may not have been an important part of the budget of the average
household or an important good in the economy as a whole. Thus, their share of the current market
basket will be understated. Because of this, a fall in the price of HDTVs will not affect the index very
much. Today, a fall in the price of HDTVs may affect people’s standard of living greatly. In this sense,
the index may be biased. Another problem has been the changing quality of HDTVs and e-readers. If
HDTVs become more expensive but have twice as much capacity to entertain, who is to say that the
actual price has risen? Such changes in quality introduce a different type of bias into the index.
7. (GDP and Depreciation) What is gross about gross domestic product? Could an economy enjoy a
constant—or growing—GDP while not replacing worn-out capital?
Gross Domestic Product ignores depreciation. Depreciation measures the value of the capital stock
that is used up or grows obsolete in the production process. GDP could grow without replacing wornout capital, but it would imply a falling net domestic product (NDP). NDP is equal to GDP minus
depreciation.
8. (Consumer Price Index) One form of the CPI that has been advocated by lobbying groups is a “CPI
for the elderly.” The Bureau of Labor Statistics currently produces only indexes for “all urban
households” and “urban wage earners and clerical workers.” Should the BLS produce such an index
for the elderly?
The CPI is based on the cost of a set of goods purchased by the typical urban wage earner. If the
elderly purchase a different set of goods (more medical care, for example), a CPI for the elderly could
change in a manner very different from that of the official CPI indexes. This could be important to the
elderly because the CPI is used to index changes in Social Security, Medicare, and programs.
Whether such an index is worth producing depends on how the costs of producing such an index
compared with the benefits that would accrue to the users of the index.
9. (GDP Price Index) The health expenditure component of the GDP price index has been rising
steadily. How might this index be biased by quality and substitution effects? Are there any substitutes
for health care?
For some time now, health care costs have been rising steadily. However, the rise in some types of
health care prices has been caused partly by the rising costs associated with better quality care. For
example, a CAT scan procedure is relatively recent. There are many other examples of quality rising
along with prices.
As prices of health care rise, people find substitutes. For example, they may take better care of
themselves (e.g., smoking less, eating well, and exercising). They may not consult a doctor when
illness is not severe, preferring home or non-prescription remedies instead.
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ANSWERS TO ONLINE CASE STUDIES
1. (CaseStudy: GDP and The State of the USA) Is The State of the USA designed to replace GDP as the
primary measure of economic performance?
The State of the USA is designed not to replace but to supplement GDP. The text says that the goal is
to "broaden the conversation" by providing data on many indicators of economic performance and
quality of life, which are not emphasized in the compilation of GDP. Eventually, The State of the USA
plans to offer about 300 indicators.
2. (CaseStudy: Price Check on Aisle 2) What is the hedonic method and why is it sometimes used to
track changes in the Consumer Price Index?
The hedonic method breaks down the product under consideration into its characteristics, and then
estimates the value to the consumer of each characteristic. This is a way of capturing the impact of a
feature change on the product price. Otherwise, price changes would not reflect the fact that
consumers are getting more or less for their money as product features change over time. The
hedonic method is necessary because some products in the CPI market basket are not available from
month to month so analysts must estimate the value, or price, of the closest substitute.
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