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Introduction to GDP, Growth, and Instability
CHAPTER TWELVE
INTRODUCTION TO GDP, GROWTH, AND INSTABILITY
ANSWERS TO END-OF-CHAPTER QUESTIONS
12-1
Why do national income accountants compare the market value of the total outputs in various
years rather than actual physical volumes of production? What problem is posed by any
comparison over time of the market values of various total outputs? How is this problem
resolved?
If it is impossible to summarize oranges and apples as one statistic, as the saying goes, it is surely
even more impossible to add oranges and, say, computers. If the production of oranges increases
by 100 percent and that of computers by 10 percent, it does not make any sense to add the 100
percent to the 10 percent, then divide by 2 to get the average and say total production has
increased by 55 percent.
Since oranges and computers have different values, the quantities of each commodity are
multiplied by their values or prices. Adding together all the results of the price times quantity
figures leads to the aggregate figure showing the total value of all the final goods and services
produced in the economy. Thus, to return to oranges and computers, if the value of orange
production increases by 100 percent from $100 million to $200 million, while that of computers
increases 10 percent from $2 billion to $2.2 billion, we can see that total production has
increased from $2.1 billion (= $100 million + $2 billion) to $2.4 billion (= $200 million + $2.2
billion). This is an increase of 14.29 percent [= ($2.4 billion - $2.1 billion)/$2.1 billion)]—and
not the 55 percent incorrectly derived earlier.
Comparing market values over time has the disadvantage that prices change. If the market value
in year 2 is 10 percent greater than in year 1, we cannot say the economy’s production has
increased 10 percent. It depends on what has been happening to prices; on whether the economy
has been experiencing inflation or deflation.
To resolve this problem, statisticians deflate (in the case of inflation) or inflate (in the case of
deflation) the value figures for the total output so that only “real” changes in production are
recorded. To do this, each item is assigned a “weight” corresponding to its relative importance in
the economy. Housing, for example, is given a high weight because of its importance in the
average budget. A book of matches would be given a very low weight. Thus, the price of
housing increasing by 5 percent has a much greater effect on the price index used to compare
prices from one year to the next, than would the price of a book of matches increasing by 100
percent.
12-2
Why only include final goods in measuring GDP for a particular year? Why isn’t the value of
the used furniture bought and sold?
The dollar value of final goods includes the dollar value of intermediate goods. If intermediate
goods were counted, then multiple counting would occur. The value of steel (intermediate good)
used in autos is included in the price of the auto (the final product).
Used furniture was produced in some previous year; it was counted as GDP then. Its resale does
not measure new production.
12-3
What are the three main types of consumption expenditures? Why are purchases of new houses
considered to be investment expenditures rather than consumption expenditures?
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Introduction to GDP, Growth, and Instability
The three types of consumption expenditures are for durable goods (expected to last more than 3
years), nondurable goods (expected to last less than 3 years), and services.
Purchases of new houses are considered to be investment rather than consumption because the
houses could be used as income generating assets.
12-4
Why are changes in inventories included as part of investment spending? Suppose inventories
declined by $1 billion during 2004. How would this affect the size of gross private domestic
investment and gross domestic product in 2004? Explain.
Anything produced by business that has not been sold during the accounting period is something
in which business has invested—even if the “investment” is involuntary, as often is the case with
inventories. But all inventories in the hands of business are expected eventually to be used by
business—for instance, a pile of bricks for extending a factory building—or to be sold—for
instance, a can of beans on the supermarket shelf. In the hands of business both the bricks and
the beans are equally assets to the business, something in which business has invested.
If inventories declined by $1 billion in 2004, $1 billion would be subtracted from both gross
private domestic investment and gross domestic product. A decline in inventories indicates that
goods produced in a previous year have been used up in this year’s production. If $1 billion is
not subtracted as stated, then $1 billion of goods produced in a previous year would be counted
as having been produced in 2004, leading to an overstatement of 2004’s production.
12-5
Suppose foreigners spend $7 billion on American exports in a specific year and Americans spend
$5 billion on imports from abroad in the same year. What is the amount of United States’ net
exports? Explain how net exports might be a negative amount.
If American exports are $7 billion and imports are $5 billion, then American net exports are +$2
billion. If the figures are reversed, so that Americans export $5 billion and import $7 billion,
then net exports are -$2 billion—a negative amount.
12-6
Which of the following are included in this year’s GDP? Explain your answer in each case.
a. The services of a commercial painter in painting the family home.
b. An auto dealer’s sale of a new car to a nonbusiness customer.
c. The money received by Smith when she sells her biology textbook to a used-book buyer.
d. The publication and sale of a new economics textbook.
e. A $2 billion increase in business inventories.
f.
Government purchases of newly produced aircraft.
(a) Included. Payment for a final service received by a household.
(b) Included. Purchase of a final good by a household.
(c) Excluded. Secondhand sales are not counted; the textbook is counted only when sold for the
first time.
(d) Included. Purchase of a final good by a household.
(e) Included. Represents production that occurred during the year.
(f) Included. Purchases of final goods by government are included.
12-7
Using the following NIPA data, compute GDP. All figures are in billions.
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Introduction to GDP, Growth, and Instability
Personal consumption expenditures
Wages and salaries
Imports
Corporate profits
Consumption of fixed capital (depreciation)
Gross private domestic investment
Government purchases
Exports
$245
223
18
42
28
86
82
9
GDP = $404 = [$245 + 86 + 82 + (9-18)]
12-8
Suppose that in 1984 the total output in a single-good economy was 7,000 buckets of chicken.
Also suppose that in 1984 each bucket of chicken was priced at $10. Finally, assume that in
2004 the price per bucket of chicken was $16 and that 22,000 buckets were purchased.
Determine real GDP for 1984 and 1996, in 1984 prices.
Real GDP for 1984 = 7,000 x $10 = $70,000.
Real GDP for 1996 (in 1984 prices) = 22,000 x $10 = $220,000.
12-9
Suppose an economy’s real GDP is $30,000 in year 1 and $31,200 in year 2. What is the growth
rate of its real GDP? Assume that population was 100 in year 1 and 102 in year 2. What is the
growth rate of GDP per capita?
Growth rate of real GDP = 4 percent (= $31,200 - $30,000)/$30,000). GDP per capita in year 1 =
$300 (= $30,000/100). GDP per capita in year 2 = $305.88 (= $31,200/102). Growth rate of
GDP per capita is 1.96 percent = ($305.88 - $300)/300).
12-10 Use the following data to calculate (a) the size of the labor force and (b) the official
unemployment rate: total population, 500; population under 16 years of age or institutionalized,
120; not in labor force, 150; unemployed, 23; part-time workers looking for full-time jobs, 10.
Labor force = 500 – 120 – 150 = 230.
Official unemployment rate = (23/230) x 100 = 10%.
12-11 Since the U.S. has an unemployment compensation program which provides income for those out
of work, why should we worry about unemployment?
The unemployment compensation program merely gives the unemployed enough funds for basic
needs, and it is only temporary. Furthermore, many of the unemployed do not qualify for
unemployment benefits. The programs apply only to those workers who were covered by the
insurance, and this may be as few as one-third of those without jobs. Most of the unemployed
get no sense of self-worth or accomplishment out of drawing this compensation. Moreover, from
the economic point of view, unemployment is a waste of resources and potential output is lost;
when the unemployed go back to work, nothing is forgone except undesired leisure. Finally,
unemployment could be inflationary and costly to taxpayers: The unemployed are producing
nothing—their supply is zero – but the compensation helps keep demand in the economy high
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Introduction to GDP, Growth, and Instability
12-12 What is the Consumer Price Index (CPI) and how is it determined each month? What effect does
inflation have on the purchasing power of a dollar? How does it explain differences between
nominal and real interest rates? How does deflation differ from inflation?
The CPI is constructed from a “market basket” sampling of goods that consumers typically
purchase. Prices for goods in the market basket are collected each month, weighted by the
importance of the good in the basket (cars are more expensive than bread, but we buy a lot more
bread), and averaged to form the price level.
Inflation reduces the purchasing power of the dollar. Facing higher prices with a given number
of dollars means that each dollar buys less than it did before.
The rate of inflation in the CPI approximates the difference between the nominal and real interest
rates. A nominal interest rate of 10% with a 6% inflation rate will mean that real interest rates
are approximately 4%.
Deflation means that the price level is falling, whereas with inflation overall prices are rising.
Deflation is undesirable because the falling prices mean that incomes are also falling, which
reduces spending, output, employment, and, in turn, the price level (a downward spiral).
Inflation in modest amounts (<3%) is tolerable, although there is not universal agreement on this
point.
12-13 If the CPI was 110 last year and is 121 this year, what is this year’s rate of inflation? What is the
“rule of 70”? How long would it take for the price level to double if inflation persisted at (a) 2,
(b) 5, and (c) 10 percent per year?
This year’s rate of inflation is 10% or [(121 – 110)/110] x 100.
Dividing 70 by the annual percentage rate of increase of any variable (for instance, the rate of
inflation or population growth) will give the approximate number of years for doubling of the
variable.
(a) 35 years (  70/2); (b) 14 years ( 70/5); (c) 7 years ( 70/10).
12-14 Briefly distinguish between demand-pull inflation and cost-push inflation.
Demand-pull inflation occurs when prices rise because of an increase in aggregate spending not
fully matched by an increase in aggregate output. It is sometimes expressed as “too much
spending (or money) chasing too few goods.” Cost-push inflation describes prices rising because
of increases in per unit costs of production.
Demand-pull inflation is more likely to occur with rising GDP; cost-push inflation will generally
coincide with falling GDP.
12-15 How does unanticipated inflation hurt creditors and help borrowers?
Inflation causes the dollars repaid by the borrower to be worth less than the dollars initially
borrowed from the creditor (lender); the lender receives back dollars with eroded purchasing
power. If the rate of inflation exceeds the nominal interest rate, the creditor will lose (in absolute
real terms) from the loan transaction.
If the inflation is unanticipated, the initial nominal interest rate will be set too low. If it is a fixed
nominal rate, the creditor will lose more than if the rate is variable and can be adjusted as
inflation rises. Even with variable rates, lenders are still better off if they can anticipate the
inflation and adjust the rates as or before the inflation is occurring.
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