Economics 1022A/B Chapter Notes - Chapter 4: Real Wages, Loanable Funds, Government Budget Balance
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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
Republic that produces only
bananas and coconuts.
Calculate Tropical Republic’s
nominal GDP in 2008 and
2009 and its chained-dollar
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
$2 a bunch
$3 a bunch
$10 a bunch
$8 a bunch