KrugWellsECPS3e Macro CH07

8/10/2019 KrugWellsECPS3e Macro CH07

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Solution

S-99

chapter:

GDP and the CPI:

Tracking the Macroeconomy

1. Below is a simplified circular-flow diagram for the economy of Micronia. (Note thatthere is no investment spending in Micronia.)

a. What is the value of GDP in Micronia?

b.What is the value of net exports?

c. What is the value of disposable income?

d. Does the total flow of money out of householdsthe sum of taxes paid and con-sumer spendingequal the total flow of money into households?

e. How does the government of Micronia finance its purchases of goods and services?

Government purchases ofgoods and services = $100

Consumerspending = $650

Imports = $20

Exports = $20

Wages, profit,interest,rent = $750

Grossdomesticproduct

Wages,profit,

interest,rent = $750

Government

Households

Taxes = $100

Markets for goodsand services

Factormarkets

Firms

Rest of world

1. a. We can measure GDP in Micronia as the sum of all spending on domesticallyproduced final goods and services. Spending consists of consumer spending,government purchases of goods and services, and exports less imports, or $750($650 + $100 +$20 $20).

b.Net exports are exports less imports. In Micronia, net exports equal zero($20 $20).

c. Disposable income is income received by households less taxes plus governmenttransfers. In Micronia, disposable income equals $650 ($750 -$100).

d. Yes. Consumer spending plus taxes equals $750the same as the wages, profit,interest, and rent received by households.

e. The government finances its purchases of goods and services with tax revenue.

722ECONOMICS

MACROECONOMICS

KrugWellsECPS3e_Macro_CH07.indd S 99KrugWellsECPS3e_Macro_CH07.indd S-99 4/19/12 114/19/12 1


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Solution

S-100 MACROECONOMICS , CHAPTER 7ECONOMICS , CHAPTER 22

2. A more complex circular-flow diagram for the economy of Macronia is shown below.(Note that Macronia has investment spending and financial markets.)

a. What is the value of GDP in Macronia?

b. What is the value of net exports?

c. What is the value of disposable income?

d. Does the total flow of money out of householdsthe sum of taxes paid, consumerspending, and private savingsequal the total flow of money into households?

e. How does the government finance its spending?

Government purchases ofgoods and services = $150 Government borrowing = $60

Consumerspending = $510

Imports = $20

Exports = $50

Wages, profit,interest,

rent = $800

Grossdomesticproduct

Investmentspending = $110

Wages, profit,interest,

rent = $800

Borrowing andstock issues byfirms = $110

Foreign borrowingand sales of stock = $130

Foreign lending andpurchases of stock = $100

Government

Households

Taxes = $100 Government transfers = $10Private savings = $200

Markets for goodsand services

Financialmarkets

Factormarkets

Firms

Rest of world

2. a. We can measure GDP in Macronia as the sum of all spending on domesticallyproduced final goods and services. Spending consists of consumer spending,investment spending, government purchases of goods and services, and exportsless imports, or $800 ($510 +$110 +$150 +$50 -$20).

b. Net exports are exports less imports. In Macronia, net exports equal$30 ($50 -$20).

c. Disposable income is income received by households less taxes plus governmenttransfers. In Macronia, disposable income equals $710 ($800 -$100 +$10).

d. Yes. Consumer spending plus taxes plus private savings equals $810the same asthe wages, profit, interest, rent, and government transfers received by households.

e. In Macronia, the government needs to finance $160 in spending ($150 on pur-chases of goods and services and $10 in government transfers). The government

finances $100 of its spending with tax revenue and the other $60 through bor-rowing in financial markets.



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Solution

3. The components of GDP in the accompanying table were produced by the Bureau ofEconomic Analysis.

GDP AND THE CP I : TRACK I NG THE M ACROECONOM Y S-101

Components of GDP in 2010Category (billions of dollars)

Consumer spending

Durable goods $1,085.5

Nondurable goods 2,301.5

Services 6,858.5

Private investment spending

Fixed investment spending 1,728.2

Nonresidential 1,390.1

Structures 374.4

Equipment and software 1,015.7

Residential 338.1

Change in private inventories 66.9

Net exports

Exports 1,839.8 Imports 2,356.7

Government purchases of goods andservices and investment spending

Federal 1,222.8

National defense 819.2

Nondefense 403.6

State and local 1,780.0

a. Calculate 2010 consumer spending.

b.Calculate 2010 private investment spending.

c. Calculate 2010 net exports.

d. Calculate 2010 government purchases of goods and services and investment spending.

e. Calculate 2010 gross domestic product.

f. Calculate 2010 consumer spending on services as a percentage of total consumerspending.

g. Calculate 2010 exports as a percentage of imports.

h.Calculate 2010 government purchases on national defense as a percentage of fed-eral government purchases of goods and services.

3. All figures below are in billions of dollars.a. Consumer spending in 2010 was $1,085.5 +$2,301.5 +$6,858.5 =$10,245.5.

b.Private investment spending in 2010 was $1,728.2 +$66.9 =$1,795.1.

c. Net exports in 2010 were $1,839.8 $2,356.7 =$516.9.

d. Government purchases of goods and services and investment spending in 2010were $1,222.8 +1,780.0 =$3,002.8.

e. Gross domestic product in 2010 was $10,245.5+$1,795.1+$3,002.8 $516.9=$14,526.5.

f. Consumer spending on services as a percentage of total consumer spending in2010 was ($6,858.5/$10,245.5)100 =66.9%.

g. Exports as a percentage of imports in 2010 was ($1,839.8/$2,356.7)100=78.1%.

h. Government purchases of goods and services on national defense as a percentage of fed-eral purchases of goods and services in 2010 was ($819.2/$1,222.8)100=67.0%.



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Solution

a. Calculate GDP as the value added in production.

b. Calculate GDP as spending on final goods and services.

c. Calculate GDP as factor income.

4. The small economy of Pizzania produces three goods (bread, cheese, and pizza), eachproduced by a separate company. The bread and cheese companies produce all theinputs they need to make bread and cheese, respectively. The pizza company uses thebread and cheese from the other companies to make its pizzas. All three companies

employ labor to help produce their goods, and the difference between the value ofgoods sold and the sum of labor and input costs is the firms profit. The accompany-ing table summarizes the activities of the three companies when all the bread andcheese produced are sold to the pizza company as inputs in the production of pizzas.


Bread Cheese Pizza company company company

Cost of inputs $0 $0 $50 (bread)

35 (cheese)

Wages 15 20 75

Value of output 50 35 200

a. Calculate GDP as the value added in production.

b.Calculate GDP as spending on final goods and services.

c. Calculate GDP as factor income.

4. a. To calculate GDP as the value added in production, we need to sum all valueadded (value of output less input costs) for each company. Value added in thebread company is $50; in the cheese company, $35; and in the pizza company,$115 ($200 $50 $35). The total value added in production is $200 ($50 +$35 +$115).

b. To calculate GDP as spending on final goods and services, we only need to esti-mate the value of pizzas because all bread and cheese produced are intermediategoods used in the production of pizzas. Spending on final goods and services is$200.

c. To calculate GDP as factor income, we need to sum factor income (wages andprofits) for each firm. For the bread company, factor income is $50: labor earns$15 and profit is $35. For the cheese company, factor income is $35: labor earns

$20 and profit is $15. For the pizza company, factor income is $115: labor earns$75 and profit is $40 ($200 $75 $50 $35). Factor income is $200 ($50 +$35 +$115).

5. In the economy of Pizzania (from Problem 4), bread and cheese produced aresold both to the pizza company for inputs in the production of pizzas and to con-sumers as final goods. The accompanying table summarizes the activities of the threecompanies.

Bread Cheese Pizza company company company

Cost of inputs $0 $0 $50 (bread)

35 (cheese)

Wages 25 30 75

Value of output 100 60 200



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Solution

Solution


5. a. To calculate GDP as the value added in production, we need to sum all valueadded (value of output less input costs) for each company. Value added in thebread company is $100; in the cheese company, $60; and in the pizza company,$115 ($200 $50 $35). The total value added in production is $100 +$60 +

$115=

$275. b. To calculate GDP as spending on final goods and services, we need to sum the

value of bread, cheese, and pizzas sold as final goods. GDP equals $275 becausethe bread company sells $50 worth as final goods, the cheese company sells $25worth as final goods, and all $200 worth of pizzas are final goods.

c. To calculate GDP as factor income, we need to sum factor income (labor andprofits) for each firm. For the bread company, factor income is $100: labor earns$25 and profit is $75. For the cheese company, factor income is $60: labor earns$30 and profit is $30. For the pizza company, factor income is $115: labor earns$75 and profit is $40 ($200 $75 $50 $35). As factor income, GDP equals$275 ($100 +$60 +$115).

6. Which of the following transactions will be included in GDP for the United States?

a. Coca-Cola builds a new bottling plant in the United States.

b.Delta sells one of its existing airplanes to Korean Air.

c. Ms. Moneybags buys an existing share of Disney stock.

d. A California winery produces a bottle of Chardonnay and sells it to a customer inMontreal, Canada.

e. An American buys a bottle of French perfume in Paris.

f. A book publisher produces too many copies of a new book; the books dont sellthis year, so the publisher adds the surplus books to inventories.

6. a.When Coca-Cola builds a new bottling plant, it is investment spending andincluded in GDP.

b. If Delta sells one of its airplanes to Korean Air, this transaction is not included inGDP because it does not represent production during the current time period. The

airplane would have been included in GDP when it was produced; now it is just asale of a used item.

c. When an individual buys an existing share of stock, the transaction is not includ-ed in GDP because there is no production.

d. If a California winery sells a bottle of Chardonnay to a customer in Montreal, it isa U.S. export and is entered as such in U.S. GDP.

e. When an American buys a bottle of French perfume, it is a consumption expendi-ture as measured by GDP. But since it does not represent production in the UnitedStates of either perfume manufacture or perfume retailing, it is also deductedfrom GDP as an import. The net effect of the transaction does not change GDP inthe United States.

f. If a book publisher produces too many copies of a new book and the books dontsell in the year they are produced, the publisher adds the surplus books to inven-tories. These books are considered investment spending and added to GDP. It is as

if the publisher bought the books itself.



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d. Real GDP in 2010 prices is calculated by summing up the value of the three goodsproduced each year using 2010 prices:

Solution

7. The economy of Britannica produces three goods: computers, DVDs, and pizza. Theaccompanying table shows the prices and output of the three goods for the years2010, 2011, and 2012.


Computers DVDs Pizzas

Year Price Quantity Price Quantity Price Quantity

2010 $900 10 $10 100 $15 2

2011 1,000 10.5 12 105 16 2

2012 1,050 12 14 110 17 3

a. What is the percent change in production of each of the goods from 2010 to 2011and from 2011 to 2012?

b.What is the percent change in prices of each of the goods from 2010 to 2011 andfrom 2011 to 2012?

c. Calculate nominal GDP in Britannica for each of the three years. What is the per-cent change in nominal GDP from 2010 to 2011 and from 2011 to 2012?

d. Calculate real GDP in Britannica using 2010 prices for each of the three years. Whatis the percent change in real GDP from 2010 to 2011 and from 2011 to 2012?

7. a. From 2010 to 2011, the percent change in the production of computers is 5.0%(equal to ((10.5 10)/10) 100); of DVDs, 5.0% (equal to ((105 100)/100)100); and of pizza, 0% (equal to ((2 2)/2) 100). From 2011 to 2012,the percent change in the production of computers is 14.3% (equal to ((12 10.5)/10.5) 100); of DVDs, 4.8% (equal to ((110 105)/105) 100); and ofpizza, 50.0% (equal to ((3 2)/2) 100).

b.From 2010 to 2011, the percent change in the price of computers is 11.1%(equal to (($1,000 $900)/$900) 100); of DVDs, 20.0% (equal to(($12 $10)/$10) 100); and of pizza, 6.7% (equal to (($16 $15)/$15)100). From 2011 to 2012, the percent change in the price of computersis 5.0% (equal to (($1,050 $1,000)/$1,000) 100); of DVDs, 16.7%(equal to (($14 $12)/$12) 100); and of pizza, 6.25% (equal to

(($17

$16)/$16)

100). c. Nominal GDP for each year is calculated by summing up the value of the three

goods produced in that year:

Year Nominal GDP Percent change in nominal GDP

2010 $10,030

2011 11,792 17.6% = (($11,792 $10,030)/$10,030) 100

2012 14,191 20.3% = (($14,191 $11,792)/$11,792) 100

Real GDPYear (2005 dollars) Percent change in real GDP

2010 $10,030

2011 10,530 5.0% = (($10,530 $10,030)/$10,030) 100

2012 11,945 13.4% = (($11,945 $10,530)/$10,530) 100



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Solution

8. The accompanying table shows data on nominal GDP (in billions of dollars), realGDP (in billions of 2005 dollars), and population (in thousands) of the UnitedStates in 1960, 1970, 1980, 1990, 2000, and 2010. The U.S. price level rose consis-tently over the period 19602010.

a. Why is real GDP greater than nominal GDP for all years until 2000 and lower for2010?

b. Calculate the percent change in real GDP from 1960 to 1970, 1970 to 1980, 1980 to

1990, 1990 to 2000, and 2000 to 2010. Which period had the highest growth rate?

c. Calculate real GDP per capita for each of the years in the table.

d. Calculate the percent change in real GDP per capita from 1960 to 1970, 1970to 1980, 1980 to 1990, 1990 to 2000, and 2000 to 2010. Which period had thehighest growth rate?

e. How do the percent change in real GDP and the percent change in real GDP percapita compare? Which is larger? Do we expect them to have this relationship?

8. a. Real GDP is greater than nominal GDP for all years until 2000 because the baseyear is 2005, and from 1960 to 2005, prices rose. So to calculate real GDP for theyears 1960, 1970, 1980, 1990, and 2000, we would multiply output in those yearsby the higher prices that existed in 2005. To calculate nominal GDP, we wouldmultiply output by the lower prices that existed in those particular years. Since

prices rose from 2005 to 2010, valuing the output in 2010 using 2005 prices (realGDP) will result in a lower number than valuing the output in 2010 using 2010prices (nominal GDP). By the way, real GDP would equal nominal GDP in 2005because 2005 is the base year and we use the same set of prices to value both realand nominal GDP in that year.

b.The accompanying table shows the percent change in real GDP from 1960 to1970, 1970 to 1980, 1980 to 1990, 1990 to 2000, and 2000 to 2010. The percentchange in real GDP was the highest during the 1960s.

Nominal GDP Real GDP(billions of (billions of Population

Year dollars) 2005 dollars) (thousands)

1960 $526.4 $2,828.5 180,760

1970 1,038.5 4,226.3 205,089

1980 2,788.1 5,834.0 227,726

1990 5,800.5 8,027.1 250,181

2000 9,951.5 11,216.4 282,418

2010 14,526.5 13,088.0 310,106

Real GDP Percent(billions of change in

Year 2005 dollars) real GDP

1960 $2,828.5

1970 4,266.3 50.8%

1980 5,834.0 36.7%

1990 8,027.1 37.6%

2000 11,216.4 39.7%

2010 13,088.0 16.7%



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Solution

a. What is the percent change in the price of an English textbook from 2010 to 2012?

b. What is the percent change in the price of a math textbook from 2010 to 2012?

c. What is the percent change in the price of an economics textbook from 2010 to 2012?

d. Using 2010 as a base year, create a price index for these books for all years.

e. What is the percent change in the price index from 2010 to 2012?

9. a. The percent change in the price of an English textbook from 2010 to 2012 is14.0% (equal to (($57 $50)/$50) 100).

b. The percent change in the price of a math textbook from 2010 to 2012 is 5.7%(equal to (($74 $70)/$70) 100).

c. The percent change in the price of an economics textbook from 2010 to 2012 is

25% (equal to (($100

$80)/$80)

100).d. To create an index of textbook prices, you must first calculate the cost of the mar-

ket basket (three English, two math, and four economics textbooks) in each of thethree years; then normalize it by dividing the cost of the market basket in a given

year by the cost of the market basket in the base period; and then multiply by 100to get an index value (base period of 2010=100).

2010 2011 2012

English textbook $50 $55 $57

Math textbook 70 72 74

Economics textbook 80 90 100

c.

d. The years from 1960 through 1970 had the highest growth rate, as shown in the table.

e. For a given time period, the percent change in real GDP is consistently larger thanthe percent change in real GDP per capita. We should expect this pattern becausethe U.S. population was growing from 1960 to 2010.

9. Eastland College is concerned about the rising price of textbooks that students mustpurchase. To better identify the increase in the price of textbooks, the dean asks you,the Economics Departments star student, to create an index of textbook prices. Theaverage student purchases three English, two math, and four economics textbooksper year. The prices of these books are given in the accompanying table.

Real GDP per capita (2005 dollars)

1960 $15,648

1970 20,607

1980 25,619

1990 32,085

2000 39,716

2010 42,205

Percent change in real GDP per capita

19601970 31.7%

19701980 24.3%

19801990 25.2%

19902000 23.8%

20002010 6.3%



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Solution

Cost of textbooks in 2010=(3 $50)+(2 $70)+(4 $80) =$610

Cost of textbooks in 2011=(3 $55)+(2 $72)+(4 $90) =$669

Cost of textbooks in 2012 =(3$57)+(2$74)+(4$100)=$719

Index value for 2010 =($610/$610) 100 =100

Index value for 2011 =($669/$610) 100 =109.7

Index value for 2012 =($719/$610) 100 =117.9

e. The percent change in the price index for textbooks from 2010 to 2012 is 17.9%(equal to ((117.9 100)/100)100).

10. The consumer price index, or CPI, measures the cost of living for a typical urban house-hold by multiplying the price for each category of expenditure (housing, food, and soon) times a measure of the importance of that expenditure in the average consumersmarket basket and summing over all categories. However, using data from the consumerprice index, we can see that changes in the cost of living for different types of consum-ers can vary a great deal. Lets compare the cost of living for a hypothetical retired per-son and a hypothetical college student. Lets assume that the market basket of a retiredperson is allocated in the following way: 10% on housing, 15% on food, 5% on trans-portation, 60% on medical care, 0% on education, and 10% on recreation. The collegestudents market basket is allocated as follows: 5% on housing, 15% on food, 20% ontransportation, 0% on medical care, 40% on education, and 20% on recreation. Theaccompanying table shows the July 2011 CPI for each of the relevant categories.

CPI November 2007

Housing 220.2

Food 228.3

Transportation 216.2

Medical care 400.3

Education 206.2

Recreation 113.5

Calculate the overall CPI for the retired person and for the college student by multi-plying the CPI for each of the categories by the relative importance of that categoryto the individual and then summing each of the categories. The CPI for all items in

July 2011 was 225.9. How do your calculations for a CPI for the retired person andthe college student compare to the overall CPI?

10. For the retired person:

CPI CPI Weight July 2011 Contribution

Housing 0.1 220.2 22.02

Food 0.15 228.3 34.245

Transportation 0.05 216.2 10.81

Medical care 0.6 400.3 240.18

Education 0 206.2 0

Recreation 0.1 113.5 11.35

Overall CPI 318.605



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Solution

Solution

2006 2007 2008 2009 2010

Real GDP

(billions of

2005 dollars) 12,958.5 13,206.4 13,161.9 12,703.1 13,088.0

Nominal GDP

(billions of

dollars) 13,377.2 14,028.7 14,291.5 13,939.0 14,526.5

a. Calculate the GDP deflator for each year.

b. Use the GDP deflator to calculate the inflation rate for all years except 2006.

12. a. The GDP deflator in a given year is 100 times the ratio of nominal GDP to realGDP, yielding the figures in the accompanying table.

2006 2007 2008 2009 2010

Real GDP

(billions of 2005 dollars) 12,958.5 13,206.4 13,161.9 12,703.1 13,088.0

Nominal GDP

(billions of dollars) 13,377.2 14,028.7 14,291.5 13,939.0 14,526.5

GDP deflator 103.2 106.2 108.6 109.7 111.0

To calculate the CPI for the retired person and for the college student, we need to weightthe CPI for each component with the importance of that component in his or her marketbasket. The CPI for the retired person is 318.605 and for the college student is 193.675.Since the CPI for the average consumer was 225.9, the CPI will overstate the increase in

the cost of living for the college student and understates it for the retired person.

11. Each month the Bureau of Labor Statistics releases the Consumer Price Index Summaryfor the previous month. Go to The Bureau of Labor Statistics home page at www.bls.gov. Place the cursor over the Economic Releases tab and then click on MajorEconomic Indicators in the drop-down menu that appears. Once on the MajorEconomic Indicators page, click on Consumer Price Index. Use the not seasonallyadjusted figures. On that page, under Table of Contents, click on Consumer PriceIndex Summary. What was the CPI for the previous month? How did it change fromthe previous month? How does the CPI compare to the same month one year ago?

11. Answers will vary with the latest data. For July 2011, the (not seasonally adjusted) CPIwas 225.922; it rose 0.5% from June 2011. The CPI was 3.6% higher than in July 2010.

12. The accompanying table provides the annual real GDP (in billions of 2005 dollars)and nominal GDP (in billions of dollars) for the United States.

For the college student:

CPI CPI Weight November 2011 Contribution

Housing 0.05 220.2 11.01Food 0.15 228.3 34.245

Transportation 0.2 216.2 43.24

Medical care 0 400.3 0

Education 0.4 206.2 82.48

Recreation 0.2 113.5 22.7

Overall CPI 193.675



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Solution

b.The inflation rate obtained by using the GDP deflator is calculated using the for-mula ((current GDP deflator GDP deflator in the previous year)/(GDP deflatorin the previous year)) 100, yielding the figures in the accompanying table.

13. The accompanying table contains two price indexes for the years 2008, 2009, and2010: the GDP deflator and the CPI. For each price index, calculate the inflation ratefrom 2008 to 2009 and from 2009 to 2010.

13. The accompanying table calculates the inflation rates based on the GDP deflator andon the CPI.

14. The cost of a college education in the United States is rising at a rate faster thaninflation. The table below shows the average cost of a college education in the UnitedStates during the academic year that began in 2009 and the academic year that began

in 2010 for public and private colleges. Assume the costs listed in the table are theonly costs experienced by the various college students in a single year.

Inflation rateGDP (based on Inflation rate

Year deflator GDP deflator) CPI (based on CPI)

2008 108.582 215.303

2009 109.729 1.1% 214.537 0.4%

2010 110.992 1.2% 218.056 1.6%

GDPYear deflator CPI

2008 108.582 215.303

2009 109.729 214.537

2010 110.992 218.056

2006 2007 2008 2009 2010

GDP deflator 103.2 106.2 108.6 109.7 111.0

Inflation 2.9% 2.2% 1.1% 1.2%

Cost of college education during academic year beginning 2009(averages in 2009 dollars)

Tuitionand fees

Roomand board

Booksand supplies Transportation Other expenses

Two-year public college: commuter $2,544 $7,202 $1,098 $1,445 $1,996

Four-year public college: in-state, on-campus 7,020 8,193 1,122 1,079 1,974

Four-year public college: out-of-state, on-campus 18,548 8,193 1,122 1,079 1,974

Four-year private college: on-campus 26,273 9,363 1,116 849 1,427

Cost of college education during academic year beginning 2010(averages in 2010 dollars)

Tuitionand fees Roomand board Booksand supplies Transportation Other expenses

Two-year public college: commuter $2,713 $7,259 $1,133 $1,491 $2,041

Four-year public college: in-state, on-campus 7,605 8,535 1,137 1,073 1,989

Four-year public college: out-of-state, on-campus 19,595 8,535 1,137 1,073 1,989

Four-year private college: on-campus 27,293 9,700 1,181 862 1,440



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Solution

a. Calculate the cost of living for an average college student in each category for2009 and 2010.

b. Calculate an inflation rate for each type of college student between 2009 and2010.

14. a. To calculate the cost of living, we add all the costs in each category. The cost ofliving for each type of student is calculated in the accompanying table.

b. The inflation rate for each type of student is calculated as follows: ((price indexin 2010 price index in 2009)/(price index in 2009)) 100. Because each typeof student consumes the same goods and services in 2009 and 2010, the cost ofliving can be used as a price index. Using the formula, the inflation rates are cal-culated in the following table.

Average cost of attendance in dollars

2009 2010

Two-year public college: commuter $14,285 $14,637

Four-year public college: in-state,

on-campus 19,388 20,339

Four-year public college: out-of-state,

on-campus 30,916 32,329

Four-year private college: on-campus 39,028 40,476

Inflation rate

Two-year public college: commuter 2.5%

Four-year public college: in-state, on-campus 4.9%

Four-year public college: out-of-state, on-campus 4.6%

Four-year private college: on-campus 3.7%

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KrugWellsECPS3e Macro CH07