Page 88 (page 490 in Economics)
1. Define GDP and distinguish between a final good and an intermediate good.
GDP is the market value of all the final goods and services produced within a country in
a given time period. A final good or service is an item that is sold to the final user, that
is, the final consumer, government, a firm making investment, or a foreign entity. An
intermediate good or service is an item that is produced by one firm, bought by
another firm, and used as a component of a final good or service. For instance, bread
sold to a consumer is a final good, but wheat sold to a baker to make the bread is an
intermediate good. Distinguishing between final goods and services and intermediate
goods and services is important because only final goods and services are directly
included in GDP; intermediate goods must be excluded to avoid double counting them.
For example, counting the wheat that went into the bread as well as the bread would
double count the wheat—once as wheat and once as part of the bread.
2. Why does GDP equal aggregate income and also equal aggregate expenditure?
GDP equals aggregate income because one way to value production is by the cost of
the factors of production employed. GDP equals aggregate expenditure because
another way to value production is by the price that buyers pay for it in the market.
3. What is the distinction between gross and net?
“Gross” means before subtracting depreciation or capital consumption. “Net” means
after subtracting depreciation or capital consumption. The terms apply to investment,
business profit, and aggregate production.
Page 91 (page 493 in Economics)
1. What is the expenditure approach to measuring GDP?
The expenditure approach measures GDP by focusing on aggregate expenditures. Data
are collected on the different components of aggregate expenditure and then summed.
Specifically, the Bureau of Economic Analysis collects data on consumption expenditure,
C, investment, I, government expenditure on goods and services, G, and net exports,
NX. These expenditures are valued at the prices paid for the goods and services, called
the market price. GDP is then calculated as C + I + G + NX.
2. What is the income approach to measuring GDP?
The income approach measures GDP by focusing on aggregate income. This approach
sums all the incomes paid to households by firms for the factors of production they
hire. The National Income and Product Accounts divide income into five categories:
compensation of employees; net interest; rental income; corporate profits; and
proprietors’ income. Adding these income components does not quite equal GDP,
because it values the output at factor cost rather than the market price and omits
depreciation. So, further adjustments must be made to calculate GDP: Indirect taxes
and depreciation must be added and subsidies subtracted. 3. What adjustments must be made to total income to make it equal GDP?
Total income is net domestic product at factor cost. To convert it to gross domestic
product at market prices, we must add the depreciation of capital and add indirect
taxes minus subsidies.
4. What is the distinction between nominal GDP and real GDP?
Nominal GDP is the value of final goods and services produced in a given year valued
at the prices of that year. Real GDP is the value of final goods and services produced in
a given year when valued at the prices of a reference base year. By comparing the value
of production in the two years at the same prices, we reveal the change in production.
5. How is real GDP calculated?
The traditional method of calculating real GDP is to value each year’s GDP at the
constant prices of a fixed base year.
Page 97 (page 499 in Economics)
1. Distinguish between real GDP and potential GDP and describe how each grows over
Real GDP is the value of final goods and services produced in a given year when valued
at the prices of a reference base year. Potential GDP is the amount of real GDP that
would be produced when all the economy’s labor, capital, land, and entrepreneurial
ability are fully employed. So real GDP is the actual amount produced with the actual
level of employment of the nation’s factors of production while potential GDP is the
amount that would be produced if there were full employment of all factors of
2. How does the growth rate of real GDP contribute to an improved standard of living?
A benefit of long-term economic growth is the increased consumption of goods and
services that is made possible. Growth of real GDP also allows more resources to be
devoted to areas such as health care, research, and environmental protection.
3. What is a business cycle and what are its phases and turning points?
The business cycle is a periodic but irregular up-and-down movement of total
production and other measures of economic activity. A business cycle has two phases:
recession and expansion. The turning points are the peak and the trough. A business
cycle runs from a trough to an expansion to a peak to a recession to a trough and then
back to an expansion.
4. What is PPP and how does it help us to make valid international comparisons of real
PPP is purchasing power parity. To make the most valid international comparisons of
real GDP, we need to value each nation’s production using purchasing power parity
prices rather than by using exchange rates and the prices within each country because
relative prices within different countries can vary widely. As a result, if the real GDP of
each country is valued using the same PPP prices then the comparison of real GDP
among the countries is more accurate.
5. Explain why real GDP might be an unreliable indicator of the standard of living.
Real GDP is sometimes used to measure the standard of living but real GDP can be
misleading for several reasons. Real GDP does not include household production,
productive activities done in and around the house by the homeowner. Because these tasks often are an important component of people’s work, this omission creates a major
measurement problem. Real GDP omits the underground economy, economic activity
that is legal but unreported or that is illegal. In many countries the underground
economy is an important part of economic activity, and its omission creates a serious
measurement problem. Real GDP does not include a measurement of people’s health
and life expectancy, both factors that obviously affect economic well being. The value
of leisure time is not included in real GDP. People value their leisure hours, and an
increase in people’s leisure that enhances people’s economic welfare can lower the
nation’s real GDP and lower the nation’s well-being. Environmental damage is excluded
from real GDP. So an economy wherein real GDP grows but at the expense of its
environment, as was the case with Eastern European countries under communism,
falsely appears to offer greater economic welfare than a similar economy that grows
slightly more slowly but at less environmental cost. Real GDP does not indicate the
extent of political freedom and social justice enjoyed by a nation’s citizens.
Page 101 (page 503 in Economics)
1. The table provides data on
the economy of Tropical Quantities 2008 2009
Bananas 1,000 bunches 1,100 bunches
Republic that produces only Coconuts 500 bunches 525 bunches
bananas and coconuts.
Calculate Tropical Republic’s
nominal GDP in 2008 and
2009 and its chained-dollar Bananas $2 a bunch $3 a bunch
Coconuts $10 a bunch $8 a bunch
real GDP in 2009 expressed in
In 2008, nominal GDP is $7,000. In 2009, nominal GDP is $7,500. Nominal GDP in 2008
is equal to total expenditure on the goods and services produced by Tropical Republic
in 2008. Expenditure on bananas is 1,000 bunches of bananas at $2 a bunch, which is
$2,000, and expenditure on coconuts is 500 bunches at $10 a bunch, which is $5,000.
Total expenditure is $7,000, so nominal GDP in 2008 is $7,000. Nominal GDP in 2009 is
equal to total expenditure on the goods and services produced by Tropical Republic in
2009. Expenditure on bananas is 1,100 bunches at $3 a bunch, which is $3,300 and
expenditure on coconuts is 525 bunches at $8 a bunch, which is $4,200. Total
expenditure is $7,500 so nominal GDP in 2009 is $7,500.
Real GDP in 2009 is $7,475.30. The chained-dollar method uses the prices of 2008 and
2009 to calculate the growth rate in 2009. The value of the 2008 quantities at 2008
prices is $7,000. The value of the 2009 quantities at 2008 prices is $7,450. We now
compare these values. The increase in the value is $450. The percentage increase is
($450 ▯ $7,000) ▯ 100, which is 6.43 percent.
Next the value of the 2008 quantities at 2009 prices is $7,000. The value of the 2009
quantities at 2009 prices is $7,500. We now compare these values. The increase in the
value is $500. The percentage increase is ($500 ▯ $7,000) ▯ 100, which is 7.14 percent.
The chained dollar method calculates the growth rate as the average of these two
percentage growth rates, which means that the growth rate in 2009 is 6.79 percent. So
real GDP in 2009 is calculated as $7,000, which is real GDP in the base year (and is equal
to nominal GDP in that year) multiplied by one plus the growth rate. Real GDP in 2009
is $7,475.30. Ch 6:
Page 135 (page 537 in Economics)
1. What is economic growth and how do we calculate its rate?
Economic growth is the sustained expansion of production possibilities. It is measured
by the increase in real GDP over a given time period. The economic growth rate is the
annual percentage change in real GDP.
2. What is the relationship between the growth rate of real GDP and the growth rate of
real GDP per person?
The growth rate of real GDP tells how rapidly the total economy is expanding while the
growth rate of real GDP per person tells how the standard of living is changing. The
growth rate of real GDP per person approximately equals the growth rate of real GDP
minus the population growth rate.
3. Use the Rule of 70 to calculate the growth rate that leads to a doubling of real GDP
per person in 20 years.
The rule of 70 states that the number of years it takes for the level of any variable to
double is approximately equal to 70 divided by the growth rate. If the level of real GDP
doubles in 20 years, the rule of 70 gives 20 = 70 ▯ (growth rate) so that the growth rate
equals 70 ▯ 20, which is 3.5 percent per year.
Page 138 (page 540 in Economics)
1. What has been the average growth rate of U.S. real GDP per person over the past 100
years? In which periods was growth the most rapid and in which periods was it the
Over the past 100 years, U.S. real GDP per person grew at an average rate of 2 percent
per year. Slow growth occurred during mid-1950s and 1973–1983. Very slow growth
(negative growth!) also occurred during the Great Depression. Growth was rapid during
the 1920s and 1960s. Growth was also (extremely!) rapid during World War II.
2. Describe the gaps between real GDP per person in the United States and other
countries. For which countries is the gap narrowing? For which is it widening? And for
is it remaining the same?
Some rich countries are catching up with the United States, but the gaps between the
United States and many poor countries are not closing. Amongst the rich countries,
since 1960 Japan has closed the gap with the United States but the gaps between the
United States and Canada, and the “Europe Big 4” (France, Germany, Italy, and the
United Kingdom) have tended to remain constant. Other Western European nations
and the former Communist countries of Central Europe have fallen slightly farther
behind the United States. The gap between the United States and most nations in
Africa, and Central and South America has widened. But some nations in Asia—
including Hong Kong, Singapore, Taiwan, Korea, Malaysia, Thailand, and China—have
grown very rapidly. The gap between these nations and the United States has shrunk;
indeed, Singapore has slightly surpassed the United States and Hong Kong has virtually
tied the United States.
3. Compare the growth rates and levels of real GDP per person in Hong Kong, Korea,
Singapore, Taiwan, China, and the United States. How far is China’s real GDP per
person behind that of the other Asian economies?
Since 1960, income per person in the nations of Hong Kong, Singapore, Taiwan, Korea,
and China have grown very rapidly and are rapidly catching up to the United States. Income per person in Hong Kong is virtually the same as that in the United States and
income per person in Singapore slightly exceeds that in the United States. Income in
Taiwan and Korea also are relatively close and income in China is the lowest, though
recently China has been growing the most rapidly. China’s level of income in 2008 is
similar to that of Hong Kong in 1968.
Page 144 (page 546 in Economics)
1. What is the aggregate production function?
The aggregate production function is the relationship that tells us how real GDP
changes as the quantity of labor changes when all other influences on production
remain the same.
2. What determines the demand for labor, the supply of labor, and labor market
The demand for labor depends on the real wage rate. A fall in the real wage rate
increases the quantity of labor demanded because of diminishing returns. The demand
for labor also depends on productivity. If productivity increases, the demand for labor
The supply of labor also depends on the real wage rate. An increase in the real wage
rate increases the quantity of labor supplied because more people enter the labor force
and the hours supplied per person increases.
The real wage adjusts so that the labor market is in equilibrium. If the real wage rate is
above (below) its equilibrium, there is a surplus (shortage) of labor that then causes the
real wage rate to fall (rise). For example, if the real wage rate is above the equilibrium
level, there is a surplus of labor so the real wage rate falls until it reaches its equilibrium.
The equilibrium quantity of employment is the full employment quantity of labor.
3. What determines potential GDP?
Potential GDP is determined from the labor market equilibrium. When the labor market
is in equilibrium, there is full employment. The quantity of real GDP produced by the
full employment quantity of labor is potential GDP.
4. What are the two broad sources of potential GDP growth?
The two broad sources of growth in potential GDP are growth of the supply of labor
and growth of labor productivity.
5. What are the effects of an increase in the population on potential GDP, the quantity
of labor, the real wage rate, and potential GDP per hour of labor?
An increase in population increases the supply of labor. Employment increases and the
real wage rate falls. The increase in employment creates a movement along the
aggregate production function so potential GDP increases. Because of diminishing
returns, real GDP per hour of labor decreases.
6. What are the effects of an increase in labor productivity on potential GDP, the
quantity of labor, the real wage rate, and potential GDP per hour of labor?
The increase in labor productivity shifts the aggregate production function curve
upward. It also increases the demand for labor, and the demand for labor curve shifts
rightward. The increase in the demand for labor raises the real wage rate and increases
employment. The increase in employment as well as the upward shift of the aggregate
production function increase potential GDP. Real GDP per hour of labor increases. Page 147 (page 549 in Economics)
1. What are the preconditions for and sources of labor productivity growth?
The fundamental preconditions for labor productivity growth are: firms, markets,
property rights, and money. These fundamental preconditions create an incentive
system that can lead to labor productivity growth. Once these preconditions are in
place, the sources of labor productivity growth are physical capital growth, human
capital growth, and advances in technology. All of these activities enable an economy
to grow and they all increase labor productivity. They all also interact: human capital
creates new technologies, which are then embodied in both new human capital and
new physical capital.
2. What is the one third rule and how is it used?
The one-third rule holds that on the average, with no change in technology a 1 percent
increase in capital per hour of labor creates a 1/3 percent increase in output per hour of
labor, that is, in productivity. The one-third rule is used to divide observed productivity
growth into growth that is the result of capital accumulation and growth that is the
result of technological advances. The procedure is straightforward: The growth rate in
capital per hour of labor is multiplied by one third. The resulting number is the
productivity growth resulting from capital accumulation. This growth rate is then
subtracted from the total productivity growth rate, and the difference is the
productivity growth caused by technological advances (including growth in human
3. What slowed labor productivity growth between 1973 and 1983?
At one level, the productivity growth slowdown in the United States was the failure of
technology to contribute much to (measured) productivity growth. This answer is
relatively shallow. A deeper answer explains why technology did not contribute much to
measured productivity. Technology did not add much to productivity growth because
of the energy price shocks. The huge price hikes for energy diverted investment in new
technology from enhancing productivity to replacing no longer economical, fuel-
Page 153 (page 555 in Economics)
1. What is the key idea of classical growth theory that leads to the dismal outcome?
The “dismal outcome” in classical theory is the conclusion that in the long run real GDP
per person equals the subsistence level. In classical growth theory, an increase in labor
productivity leads to higher incomes, which causes population increases that return real
GDP per person to the subsistence level because of diminishing returns to labor. In the
classical growth theory, an increase in productivity increases the demand for labor. The
real wage rate rises and GDP increases. The increase in the real wage rate means that
people’s incomes rise, which then creates a population boom. The increase in
population increases the supply of labor. Because of diminishing returns to labor, the
increase in the supply of labor lowers the real wage rate. As long as the real wage rate
remains above the subsistence level, population growth and hence growth in the labor
supply continues. Eventually the real wage rate falls to equal the subsistence level, at
which time the population stops growing. Total GDP is higher than before the increase
in productivity, but GDP per person is the same as before and is at the subsistence
level. 2. What, according to neoclassical growth theory, is the fundamental cause of economic
In neoclassical growth theory, growth results from technological advances, which are
determined by chance.
3. What is the key proposition of new growth theory that makes growth persist?
The key proposition that makes growth persist indefinitely in the new growth theory is the
assumption that the returns to knowledge and human capital do not diminish. As a result,
increases in knowledge do not cause diminishing returns and the incentive to innovate remains
high. As people accumulate more knowledge, the incentive to innovate does not fall and so
people continue to innovate new and better ways to produce new and better products. This
innovation means that economic growth persists indefinitely. Ch 7:
Page 166 (page 568 in Economics)
1. Distinguish between physical capital and financial capital and give two examples of
Physical capital is the actual tools, instruments, machines, buildings and other items
that have been produced in the past and are presently used to produce goods and
services. Financial capital is the funds that businesses use to acquire their physical
capital. Examples of physical capital are the pizza ovens owned by Pizza Hut and the
buildings in which the Pizza Huts are located. Examples of financial capital are the
bonds issued by Pizza Hut to buy pizza ovens and the loans Pizza Hut has made to fund
their purchases of new buildings.
2. What is the distinction between gross investment and net investment?
Gross investment is the total amount spent on new capital; net investment is the
change in the capital stock. Net investment equals gross investment minus
3. What are the three main types of markets for financial capital?
The main types of markets for financial capital are the loan markets, the bond markets,
and the stock markets.
4. Explain the connection between the price of a financial asset and its interest rate.
There is an inverse relationship between the price of a financial asset and its interest
rate. When the price of a financial asset rises, its interest rate falls. Similarly, when the
interest rate on an asset falls, the price of the asset rises.
Page 171 (page 573 in Economics)
1. What is the market for loanable funds?
The market for loanable funds is the market in which households, firms, governments,
banks, and other financial institutions borrow and lend. It is the aggregate of all the
individual financial markets and includes loan markets, bond markets, and stock
markets. The real interest rate is determined in this market.
2. Why is the real interest rate the opportunity cost of loanable funds?
The real interest rate is the opportunity cost of loanable funds because the real interest
rate measures what is forgone by using the funds. If the funds are loaned, then the real
interest rate is received. If the funds are borrowed, then the real interest is paid for the
funds. The real interest rate forgone when funds are used either to buy consumption
goods and services or to invest in new capital goods is the opportunity cost of not
saving or not lending those funds.
3. How do firms make investment decisions?
To determine the quantity of investment, firms compare the expected profit rate from
an investment to the real interest rate. The expected profit from an investment is the
benefit from the investment. The real interest rate is the opportunity cost of investment.
If the expected profit from an investment exceeds the cost of the real interest rate, then
firms make the investment. If the expected profit from an investment is less than the
cost of the real interest rate, then firms do not make the investment. 4. What determines the demand for loanable funds and what makes it change?
The demand for loanable funds depends on the real interest rate and expected profit. If
the real interest rate falls and nothing else changes, the quantity of loanable funds
demanded increases. Conversely, if the real interest rate rises and everything else
remains the same, the quantity of loanable funds demanded decreases. Movements
along the loanable funds demand curve illustrate these events. If the expected profit
increases and nothing else changes, the demand for loanable funds increases and the
demand for loanable funds curve shifts rightward. If the expected profit decreases and
everything else remains the same, the demand for loanable funds decreases and the
demand for loanable funds curve shifts leftward.
5. How do households make saving decisions?
A household’s saving depends on five factors: the real interest rate, the household’s
disposable income, the household’s expected future income, wealth, and default risk. A
household increases its saving if the real interest rate increases, its disposable income
increases, its expected future income decreases, its wealth decreases, or if default risk
6. What determines the supply of loanable funds and what makes it change?
The supply of loanable funds depends on the real interest rate, disposable income,
expected future income, wealth, and default risk. An increase in the real interest rate
increases the quantity of loanable funds supplied; a decrease in the real interest rate
decreases the quantity of loanable funds supplied. An increase in disposable income
increases the supply of loanable funds; a decrease in disposable income decreases the
supply of loanable funds. An increase in wealth decreases the supply of loanable funds;
a decrease in wealth increases the supply of loanable funds. An increase in expected
future income decreases the supply of loanable funds; a decrease in expected future
income increases the supply of loanable funds. Finally, an increase in default risk
decreases the supply of loanable funds; a decrease in default risk increases the supply
of loanable funds.
7. How do changes in the demand for and supply of loanable funds change the real
interest rate and quantity of loanable funds?
The real interest rate is determined by the supply of loanable funds and the demand for
loanable funds. The equilibrium real interest rate is the real interest rate at which the
quantity of loanable funds supplied equals the quantity of loanable funds demanded.
Changes in the demand for or supply of loanable funds change the equilibrium real
interest rate and equilibrium quantity of loanable funds. If the demand for loanable
funds increases (decreases), the real interest rate rises (falls) and the quantity of
loanable funds increases (decreases). If the supply of loanable funds increases
(decreases) the real interest rate falls (rises) and the quantity of loanable funds
Page 174 (page 576 in Economics)
1. How does a government budget surplus or deficit influence the market for loanable
A government budget surplus adds to the supply of loanable funds. A government
budget deficit adds to the demand for loanable funds. 2. What is the crowding-out effect and how does it work?
The crowding out effect refers to the decrease in investment that occurs when the
government budget deficit increases. An increase in the government budget deficit
increases the demand for loanable funds. As a result the real interest rate rises. The rise
in the real interest rate decreases—“crowds out”—investment.
3. What is the Ricardo-Barro effect and how does it modify the crowding-out effect?
The Ricardo-Barro effect points out that the crowding out effect is less than predicted
by looking only at the effect of a budget deficit on the demand for loanable funds. The
Ricardo-Barro effect asserts that as a result of a government budget deficit households
increase their saving to pay the higher taxes that will be needed in the future to repay
the debt issued to fund the deficit. The increase in saving increases the supply of
loanable funds. This increase in the supply of loanable funds offsets the rise in the real
interest rate from the increase in the demand for loanable funds caused by the budget
deficit. Because the real interest rate does not rise as much, the decrease in investment,
that is the amount of crowding out, is less in the presence of the Ricardo-Barro effect.
Page 177 (page 579 in Economics)
1. Why do loanable funds flow among countries?
Loanable funds flow among countries because savers are searching for the highest
(risk-adjusted) real interest rate and borrowers are searching for the lowest (risk-
adjusted) real interest rate.
2. What determines the demand for and supply of loanable funds in an individual
The demand for and supply of loanable funds in an economy with international lending
and borrowing depend on the same factors as in an economy without international
lending and borrowing with one exception: If, at the world real interest rate, the country
has a surplus of funds, it can lend the surplus to the rest of the world while if, at the
world real interest rate, the country has a shortage of funds, it can borrow from the rest
of the world.
3. What happens if a country has a shortage of loanable funds at the world real interest
If a country has a shortage of loanable funds at the world real interest rate, it borrows
from other nations and becomes an international borrower.
4. What happens if a country has a surplus of loanable funds at the world interest rate?
If a country has a surplus of loanable funds at the world real interest rate, it loans to
other nations and becomes an international lender.
5. How is a government budget deficit financed in an open economy?
A government budget deficit increases the demand for loanable funds. In an open
economy, the increase in the demand for loanable funds means the country lends less
to the rest of the world (if it initially was an international lender) or borrows more from
the rest of the world (if it initially was an international borrower). These changes in
lending or borrowing finance the budget deficit. Ch 9:
Page 216 (page 618 in Economics)
1. What is the foreign exchange market and what prices are determined in this market?
The foreign exchange market is the market in which the currency of one country is
exchanged for the currency of another country. The exchange rate, the price at which
one currency is exchanged for another, is the price determined in the foreign exchange
2. Distinguish between appreciation and depreciation of the dollar.
The U.S. dollar appreciates when it rises in value against a foreign currency. The U.S.
dollar depreciates when it falls in value against a foreign currency.
3. What are the world’s major currencies?
The world’s major currencies are the U.S. dollar, the Australian dollar, the Canadian
dollar, the euro, the Japanese yen, the English pound, the Swedish krone, and the Swiss
franc. The Chinese yuan also is becoming important.
4. Against which currencies and during which years has the U.S. dollar appreciated since
Since 1998, the U.S. dollar appreciated against the Mexican peso virtually every year
until 2004. The U.S. dollar generally appreciated against the Canadian dollar until 2002.
The U.S. dollar appreciated against the Japanese yen in 1998, with another slight
appreciation from 2000 to 2001.
5. Against which currencies and during which years has the U.S. dollar depreciated since
The U.S. dollar depreciated slightly against the Mexican peso since 2004 and ever so
slightly in 2000. The U.S. dollar depreciated against the Canadian dollar since 2002. The
U.S. dollar generally depreciated against the Japanese yen from 1999 though the
change has been slight. The U.S. dollar depreciated against the euro since 2002.
6. What is the distinction between the nominal exchange rate and the real exchange
The nominal exchange rate is the value of the U.S. dollar expressed in units of foreign
currency per U.S. dollar. It measures how many units of a foreign currency are necessary
to buy one U.S. dollar. The real exchange rate is the relative price of U.S-produced
goods and services to foreign-produced goods and services. It measures how many
units of foreign-produced GDP one unit of U.S.-produced GDP buys.
7. What does the trade-weighted index measure?
The trade-weighted index shows the average U.S. exchange rate. It is calculated by
weighting each nation’s individual currency exchange rate by its importance in U.S.
Page 220 (page 622 in Economics)
1. What are the influences on the demand for U.S. dollars in the foreign exchange
The demand for U.S. dollars depends on four main factors: the exchange rate, the world
demand for U.S. exports, the interest rate in the United State and other countries, and
the expected future exchange rate. 2. Provide an example of the exports effect on the demand for U.S. dollars.
The exports effect is the result that the larger the value of U.S. exports, the larger the
quantity of dollars demanded for purchasing those exports from U.S. firms. When the
exchange rate for U.S. dollars falls, U.S. exports become cheaper relative to other
countries’ goods and services so the volume of U.S. exp