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GDP and the
Standard o
Living
Chapter
CHAPTER OUTLINE
1. Define GDP and explain why the value of production, income, and
expenditure are the same for an economy.
A. GDP Defined
1. Value Produced
2. What Produced
3. Where Produced
4. When Produced
B. Circular Flows in the U.S. Economy
1. Consumption Expenditure
2. Investment
3. Government Expenditure on Goods and Services
4. Net Exports of Goods and Services
5. Total Expenditure
6. Income
C. Expenditure Equals Income
2. Describe how economic statisticians measure GDP in the United States.
A. The Expenditure Approach
1. Expenditures Not in GDPB. The Income Approach
1. Wages
2. Interest, Rent, and Profit
3. From Factor Cost to Market Price
4. From Gross to Net
5. Statistical Discrepancy
C. GDP and Related Measures of Production and Income
1. Gross National Product
2. Disposable Personal Income
3. Distinguish between nominal GDP and real GDP and define the GDP
deflator.
A. Calculating Real GDP
1. Traditional Method of Calculating Real GDP
2. Chained-Dollar Method of Calculating Real GDP
B. Calculating the GDP Deflator
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498 Part 7 . MONITORING THE MACROECONOMY
4. Describe and explain the limitations of real GDP as a measure of the
standard of living.
A. The Standard of Living Over Time
1. Long-Term Trend
2. Short-Term Fluctuations
B. The Standard of Living Among Countries
C. Goods and Services Omitted from GDP1. Household Production
2. Underground Production
3. Leisure Time
4. Environment Quality
D. Other Influences on the Standard of Living
1. Health and Life Expectancy
2. Political Freedom and Social Justice
CHAPTER ROADMAP
Whats New in this Edition?The
material
in
Chapter
20
has
been
updated.
The
phrase
governmentpurchasesofgoodsandserviceshasbeenre
placedwithgovernmentexpenditureongoodsandser
vices.IntheincomeapproachtoGDP,thecomponentsare
nowwagesandinterest,rent,andprofitratherthan
compensationofemployees,netinterest,rentalincome
ofpersons,corporateprofits,andproprietorsincome.
Thestatisticaldiscrepancybetweentheincomeandexpendi
tureapproachtoGDPisnowdiscussed.Thereisanex
tendeddiscussionoftherelationshipsamongGDP,GNP,
anddisposablepersonalincome.Thenewmethodforcalcu
latingGDP
is
called
the
chained
dollar
method
rather
than
thechainlinkingmethod.Thecoverageofvalueaddedis
eliminated.InCheckpoint4thereisnowcoverageofthe
standardoflivingintheUnitedStatesovertimeandbrief
coverageofthestandardoflivingamongcounties.
Where We AreInChapter20,wedefineGDPandexplainwhyfortheecon
omy,thevalueofproductionequalsincome,whichalso
equalsexpenditure.Wedescribehoweconomicstatisticians
measureGDPintheUnitedStates.Nextwedistinguishbe
tweennominalGDPandrealGDP,anddefinetheGDPde
flator.Lastly,
we
explain
and
describe
the
limitations
of
real
GDPasameasureofthestandardofliving.
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Chapter 20 . GDP and the Standard of Living 499
Where Weve BeenThisisthefirstchapterthatdirectlyexploresmacroeconom
ics.
Where Were GoingIn
Chapter
21,
we
continue
with
the
overview
of
how
the
economyoperates.Wecoverhowtheunemploymentrateis
calculated,reviewlabormarketindicatorsaswellastrends
andfluctuationsinthelabormarket,andthenexplorethe
sourcesandtypesofunemployment.
IN THE CLASSROOM
Class Time NeededThematerialinthischaptercanbecoveredbetweenoneandahalftotwoclass
sessions.
Anestimateofthetimeperchecklisttopicis:
20.1GDP,Income,andExpenditure15minutes 20.2MeasuringU.S.GDP25minutes 20.3NominalGDPVersusRealGDP40minutes 20.4RealGDPandtheStandardofLiving20minutes
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500 Part 7 . MONITORING THE MACROECONOMY
CHAPTER LECTURE
20.1 GDP, Income, and ExpenditureGDP Defined
GDPorgross domestic productisthemarketvalueofallthefinalgoodsandservicesproduced
within
acountry
in
agiven
time
period
Valueproduced:TheitemsinGDParevaluedattheirmarketvalues,thatis,attheirprices.Soif1,000,000slicesofpizzaaresoldfor$4each,slicesofpizzacontribute
$4,000,000toGDP.
Whatproduced:Toavoiddoublecounting,GDPincludesonlyfinalgoodsandservices.Afinalgoodorserviceisanitemthatisproducedforitsfinaluserandnot
usedasacomponentofanothergoodorservice.Itcontrastswithanintermediate
goodorservice,whichisanitemthatisproducedbyonefirm,boughtbyanother
firm,andusedasacomponentofafinalgoodorservice.
Whereproduced:Onlythegoodsandservicesproducedwithinacountryarecounted.SoaHondaproducedinNorthCarolinaiscountedinU.S.GDP.
When
produced:
GDP
measures
production
during
a
given
period
of
time,
typically
a
quarterofayearorayear.
Circular Flows in the U.S. Economy
Inthegoodsmarket,households,firms,governments,andforeignersbuygoodsandservices.
Consumption expenditure,C,istheexpenditurebyhouseholdsonconsumptiongoodsandservices.
Investment,I,isthepurchasesofnewcapitalgoods(tools,instruments,machines,buildings,andotheritems)andadditionstoinventories.
Government expenditures on goods and services,G,istheexpendituresbyalllevelsofthegovernmentongoodsandservices.
Net exports of goods and services,
NX,
is
the
value
of
exports
of
goods
and
services
minusthevalueofimportsofgoodsandservices.Exports of goods and servicesare
theitemsthatfirmsintheUnitedStatesproduceandselltotherestoftheworld.
Imports of goods and servicesaretheitemsthathouseholds,firms,andgovern
mentsintheUnitedStatesbuyfromtherestoftheworld.
Governmenttransferpayments,suchasSocialSecuritypayments,arenotpartofgovernmentexpendituresongoodsandservicesbecausetheseexpendituresincludeonlyfundsusedbythegovernmenttobuygoodsandservices.Transferpaymentsarenotbuyingagoodorserviceforthegovernmentandsoarenotincludedingovernmentexpendituresongoodsandservices.
Total Expenditure
TotalexpenditureequalsC+I+G+(XM). Householdsreceivewages,capital,interest,rent,andprofitasincome.Somepartoftotal
incomeisnotpaidouttohouseholdsbyfirms,butfromaneconomicstandpoint,this
undistributedprofitisincomepaidtohouseholdsandthenloanedbacktofirms.
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Chapter 20 . GDP and the Standard of Living 501
Expenditure Equals Income
Becausefirmspayoutasincomeeverythingtheyreceiveasrevenuefromsellinggoodsandservices,totalincome,Y,equalstotalexpenditure.So:
Y=C+I+G+(XM). Forafirm,thevalueofitsproductionisthecostoftheproduction,whichequalsthein
come
generated
by
the
production.
So
the
value
of
production
equals
income
equals
ex
penditure,or
GDP=Y=C+I+G+(XM). 20.2 Measuring U.S. GDPThe Expenditure Approach
TheexpenditureapproachmeasuresGDPasthesumofconsumptionexpenditure,C,investment,I,governmentexpendituresongoodsandservices,G,andnetexportsofgoods
andservices,(XM).SoGDP=C+I+G+(XM)or,inthesecondquarterof2005,annualized,andintrillionsofdollars,$8.7+$2.1+$2.3+$0.7=$12.4.
ExpendituresnotinGDPinclude: Usedgoods:ExpendituresonusedgoodsarenotpartofcurrentGDPbecausethese
goodswerepartofGDPduringtheperiodinwhichtheywereproduced.
Financialassets:Thepurchaseoffinancialassets,suchasstocks,isnotpartofGDPbecausethesearenotexpendituresongoodsandservices.
The Income Approach
TheincomeapproachmeasuresbyGDPinseveralsteps: Theincomeapproachstartswiththesumofwagesplusinterest,rent,andprofit
(calledoperatingsurplusinthenationalincomeaccounts).Thissumequalsnetdo
mesticincomeatfactorcost.
Tochangethemeasurefromfactorcosttomarketprice,indirecttaxeslesssubsidiesare
added
because
these
are
government
taxes
and
transfers
that
affect
market
prices.
Thenextstepaddsdepreciation,thedecreaseinthevalueofcapitalthatresultsfromitsuseandobsolescence.
Ifeverythingismeasuredcorrectly,addingdepreciationwouldyieldGDP.Butthereoftenisastatisticaldiscrepancy,thedifferencebetweentheexpenditureapproach
andtheincomeapproach.Thedifferenceismeasuredastheexpenditureapproach
minustheincomeapproach,soanystatisticaldiscrepancyisaddedtoyieldthein
comeapproachGDP.
GDP and Related Measures of Production and Income
Grossnationalproduct,(GNP)isthemarketvalueofallfinalgoodsandservicesproducedanywhereintheworldinagiventimeperiodbythefactorsofproductionsup
plied
by
the
residents
of
the
country.
So
pharmaceutical
drugs
produced
in
Ireland
by
a
U.S.drugcompanyispartofU.S.GNPbutnotpartofU.S.GDP.
U.S.GNPequalsU.S.GDPplusnetfactorincomefromabroad.
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502 Part 7 . MONITORING THE MACROECONOMY
Disposablepersonalincomeistheincomereceivedbyhouseholdsminuspersonalincometaxespaid.ItequalsGNPminusdepreciationminusanystatisticaldiscrepancymi
nusretainedprofitsbybusinessesplustransferpaymentsminuspersonalincometaxes.
20.3 Nominal GDP Versus Real GDPThe
market
value
of
production
and
hence
GDP
can
increase
either
because
the
production
of
goodsandservicesarehigherorbecausethepricesofgoodsandservicesarehigher.
Calculating Real GDP
RealGDPallowsthequantitiesofproductiontobecomparedacrosstime.Real GDPisthevalueoffinalgoodsandservicesproducedinagivenyearexpressedinthepricesofa
baseyear.
Nominal GDPisthevalueofthefinalgoodsandservicesproducedinagivenyearexpressedinthepricesofthatsameyear.
Traditionally,realGDPiscalculatedusingpricesofthebaseyear(theyearinwhichrealGDP=nominalGDP).Butthismethodhasbeengenerallyreplacedwithanew,chained
dollarmethodthatusesthepricesoftwoadjacentyearstocalculatetherealGDPgrowth
rateandthenusesthegrowthratestocreateachainlinkingthebaseyearrealGDPtotherealGDPinfutureyears.
The Chained-Dollar Method for Calculating Real GDP
Thetoptabletotherighthasdatafor2005foraneconomy
thatproducesonlybooksand
coffee.In2005,nominalGDPis
$3,000.Thesecondtabletothe
righthasdatafor2006.In2006,
nominalGDPis$6,000.
NominalGDPhasdoubledbuthowmuchhasrealGDP
changedbetweentheseyears?
TodeterminehowrealGDPchanges,supposethat2005is
thebaseyear.Thenweneedto
determinethegrowthratebe
tween2005and2006bycalcu
latingGDPinbothyearsusing
2005pricesandcalculating
GDPinbothyearsusing2006
prices.
GDPDatafor2005
Item Quantity Price MarketValue
Books 40 $25 $1,000
Coffee 1,000 $2 $2,000
NominalGDP $3,000
GDPDatafor2006
Item Quantity Price MarketValue
Books 50 $30 $1,500
Coffee 1,500 $3 $4,500
NominalGDP $6,000
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Chapter 20 . GDP and the Standard of Living 503
Using2005prices,realGDPincreasesfrom$3,000(thefirstta
ble)to$4,250(thethirdtable).
Using2005prices,realGDPhas
grownby[($4,250$3,000)
$3,000]100=41.7percent.
Using2006prices,realGDPincreasesfrom$4,200(thefourth
table)to$6,000(thesecondta
ble).Using2006prices,realGDP
hasgrownby[($6,000$4,200)
$4,200]100=42.9percent.
TheaveragegrowthrateofrealGDPisequalto(41.7percent+
42.9percent)2=42.3percent.
SorealGDPbetweentheseyears
hasgrownby42.3percent.If
2005is
the
base
year,
real
GDP
in
2006is$3,0001.423=$4,269.
Calculating the GDP Deflator
TheGDP deflatoristheaverageofcurrentyearpricesexpressedasapercentageofbaseyearprices.Intermsofaformula,GDPdeflator=(NominalGDPRealGDP)100.
Usingtheexampleworkedabove,nominalGDPin2006is$6,000andrealGDPis$4,269.SotheGDPdeflatorfor2006is($6,000$4,269)100=140.5.
20.4 The Use and Limitations of Real GDPRealGDPcanbeusedtocomparethestandardoflivingovertimeandtocomparethestandard
ofliving
among
countries.
The Standard of Living Over Time
RealGDPperpersoncanbeusedtocomparethestandardofliving.Real GDP per per-sonisrealGDPdividedbythepopulation.
IntheUnitedStates,realGDPperpersonis2.4timeslargerthanitwasin1964.RealGDPperpersonhasdoubledaboutevery30yearsforthepast100years.
FluctuationsinthegrowthofrealGDPreflectbusinesscycles.Abusiness cycleistheperiodicbutirregularupanddownmovementoftotalproductionandothermeasuresof
economicactivity.Businesscycleshavefourstages:
Expansion:TheexpansionphaseistheperiodduringwhichrealGDPisincreasing. Peak:Anexpansioncontinuesuntilapeakisreach.Apeakisthehighestlevelofreal
GDPyetattained.
2006Quantitiesand2005Prices
Item Quantity Price MarketValue
Books 50 $25 $1,250
Coffee
1500
$2
$3,000
RealGDP(2005dollars)
$4,250
2005Quantitiesand2006Prices
Item Quantity Price MarketValue
Books 40 $30 $1,200
Coffee 1,000 $3 $3,000
RealGDP(2006dollars)
$4,200
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504 Part 7 . MONITORING THE MACROECONOMY
Recession:Followingthepeakisarecession.ArecessionisperiodduringwhichrealGDPdecreasesforatleastsixmonths.
Trough:Aftertherecessionisthetrough,thelowpointinrealGDPafterwhichfollowsanexpansion.
The Standard of Living Among Countries
Tocompare
real
GDP
per
person
among
countries,
the
real
GDPs
should
be
calculated
using
a
commonsetofprices,calledpurchasingpowerparityprices.Whenthisisdown(asthedatainChapter2show)U.S.realGDPperpersonmeasuredasincomeperpersonishigherthaninother
advancedeconomies.
Goods and Services Omitted From GDP
GDPmeasuresthevalueofgoodsandservicesthatareboughtinmarkets,soitexcludes:
HouseholdProduction:Householdproductionisproductiveactivitiesatthehomethatdonotinvolvemarkettransactions.Asmoreservices,suchaschildcare,areprovidedinthe
marketplace,themeasuredgrowthrateoverstatesdevelopmentofalleconomicactivity.
UndergroundProduction:Undergroundproductionisthepartoftheeconomythatishiddenfromtheviewofthegovernmenteitherbecausepeoplewanttoavoidtaxesand
regulationsor
because
the
goods
and
services
being
produced
are
illegal.If
the
under
groundeconomyisareasonablystableproportionofalleconomicactivity,thegrowth
ratewillbeaccurate.
LeisureTime:LeisuretimeisaneconomicgoodthatdoesnotgetmeasuredintheofficialGDPfigures.Increasesinleisuretimelowertheeconomicgrowthrate,butwevalueour
leisuretimeandwearebetteroffwithit.
EnvironmentalQuality:Pollutiondoesnotdirectlylowertheeconomicgrowthrate.Ifourstandardoflivingisadverselyaffectedbypollution,ourGDPmeasuredoesnotshow
thisfact.Thereasonisthatthedevicesthatweproducetomitigatepollutioncountas
partofGDPbutthepollutionitselfisnotsubtracted
Other Influences on the Standard of Living
Omittedfrom
GDP
but
important
for
the
standard
of
living
is:
HealthandLifeExpectancy:Whileobviouslyimportantfactorsdeterminingthestandardofpeoplesliving,theyareomittedfromrealGDP.Healthandlifeexpectancyhaveim
provedasinfantdeathsanddeathinchildbirthhavealmostbeeneliminated.Lifeexpec
tancyhasincreasedfrom70yearsattheendofWWIItonearly80yearstoday.These
gainshavebeencheckedsomewhatbyAIDSanddrugabuse,whichtakeawayfromour
standardofliving.
PoliticalFreedomandSocialJustice:PoliticalfreedomandsocialjusticearenotmeasuredbyrealGDP.AcountrymightenjoyaverylargeGDPbuthavelimitedpoliticalfreedom
andsocialjusticeandhencehavealowerstandardofliving.
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Chapter 20 . GDP and the Standard of Living 505
Lecture Launchers1. Asteachers,weoftendont liketowritedefinitionsontheboard.Wewill
askstudentstorefertothetextorwemighthurriedlyverbalizethem.This
generalpropensityisamissedopportunitytofocusontheeleganceofthe
definitionofGDP.Fromthetext,GDPisdefinedas:GrossDomesticProd
uctis
the
market
value
of
all
the
final
goods
and
services
produced
within
acountryinagiventimeperiod.Askyourstudentstogothroughthedefini
tionandpullouttheessentialparts.Youwillgetthislist:marketvalue,fi
nalgoodsandservices,produced,withinacountry,and timeperiod.Ex
plainthatthewordschoseninthisdefinitionwereselectedcarefully.First,
ifthephrasemarketvaluehadbeenleftout,therewouldberoomforlots
ofproblems.Noticethatwhenthegovernmentreportsthisfigure,itdoesnt
announcehowmany trains,planes,andautomobiles thecountryhaspro
ducedbutratheritannouncesamonetaryvalue.Usingmonetaryvaluesaf
fordsus theopportunitytobeabletogetaroundtheproblemofaggrega
tionwhen the items inquestionaremarkedlydifferent.Wesolve itbyal
lowing themarketplace todetermine theweights.Thesecond itemon the
list isfinalgoodsandservices.Theexplanationhere isstraightforward:
Wearedistinguishingbetween finalproductsand intermediateproducts.
Intermediategoodsaregoodsthatareboughtbyonefirmtobeusedinthe
productionofanothergoodthatwillbeultimatelyconsumed.Ifweinclude
theseintermediategoods,thenwewoulddoublecountthenationsoutput.
Now we come to theword produced.Thisword is to make clear that
sales are not important. If we only counted sales, then the GDP figures
wouldunderstateproductionbecausenotalloutputissold.Someofitbe
comes inventory.Next is thephrasewithinacountry.Thisphrase is to
makeclearthatwedontcountoutputthatwasntproducedonanations
soilregardlessofwhowasresponsibleforproducingit.Lastly,isthephrase
timeperiod.
Here
we
want
to
make
unambiguous
that
we
are
only
talk
ingaboutproduction thatoccurred inacertainperiod.Thisphrase leaves
nodoubtthatproductionofagoodorserviceproducedinaprevioustime
period(even ifperhapssold in thepresent timeperiod)doesnotcount in
thisperiodsGDP.
2. You might like to tell your students thatmeasuring realGDP is actually
verycheap.TheBEA(intheDepartmentofCommerce)employsfewerthan
500 economists, accountants, statisticians, and IT specialists at an annual
costoflessthat$70million.ItcostseachAmericanlessthan0.25(aquarter
ofacent)tomeasurethevalueofthenationsproduction.Forsomefurther
perspective,theNationalOceanicandAtmosphericAdministration(alsoin
theDepartment
of
Commerce),
whose
mission
is
to
describe
and
predict
changes in theEarthsenvironment,andconserveandmanagewisely the
nationscoastalandmarineresourcessoastoensuresustainableeconomic
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506 Part 7 . MONITORING THE MACROECONOMY
opportunities,employsmorethan11,000scientistsandsupportpersonnel
atanannualcostof$3.2billion!
MostoftheincomedatausedbytheBEAcomesfromtheIRS.Expendi
turedatacomesfromavarietyofsources.
Inrecentyears,thefirstestimatesofGDP,whicharebasedoncompanies
reported
profits,
have
been
revised
downward
when
data
on
company
profitsasreportedtotheIRSbecameavailable.Enronstyleaccountinghas
contaminatedtheinitialestimatesofGDPbutnotthefinalestimates.
Youcanmakeanicepointwithoneexampleofcreativeaccounting.For
someyears,initsreportstoshareholdersAOLrecordeditsadvertisingex
penditureasinvestmentandamortizeditoveranumberofyears.
First,youcanexplainthatthecorrecttreatmentofthisitem isasanex
penditure on intermediate goods and servicesby AOL and as a charge
againstAOLsprofit.YoucangoontoexplainthatAOLsaccountingprac
ticewouldmisleadinglyswellGDPbycausingsomedoublecounting.On
theexpenditureapproach,AOLsadvertisingexpenditureshowsupas in
vestment in the national accounts. On the income approach,because the
expenditure is not a cost, it swells profit, so AOLs corporate profit in
creasesbythesameamountasitsinvestment.IfAOLfileditsincometax
return in this same way, the national income accounts wouldnt get cor
rected.ButwhenAOLfilesitstaxreturns,itcallsitsadvertisingacostand
lowers itsprofitsby thatamount.TheBEApicksup thesenumbers from
theIRSandthenationalaccountsgetadjustedappropriately.Thedifference
inreportednumbersbyAOL indicateswhy thestatisticaldiscrepancybe
tween the expenditure and income approaches tomeasuringGDP exists.
One question students might ask ishowbig is thediscrepancy.You can
showthemthatthestatisticaldiscrepancyisasmallpercentageoftheover
allfigures.Ifthediscrepancysuddenlyvarieswildlyforagivenyear,then
thiswould
indicate
that
the
numbers
need
to
be
rechecked.
This
example
alsohighlightswhywehavedifferentcalculationsforGDP,sothatweare
notrelyingsolelyononesetofestimates
3. AdiscussionofomissionsfromGDPcanarousestudentsinterest.Forex
ample,youmightpointoutthatifoneofyourstudentsmowsher/hisown
lawn,thevalueofthestudentsproductiondoesntshowupinGDP.Butif
youhirethestudenttomowyourlawn(andifyourstudentreportsthein
come earned correctly to the IRS), the value of the students production
doesshowupinGDP.
WhydontwemeasurealllawnmowingaspartofGDP?Somereasons
arecostofcollectingdataandthedegreeofintrusivenesswedbewillingto
tolerate.But
note
how
little
we
spend
on
collecting
the
GDP
data
and
how
relatively inexpensive itwouldbe toadd somequestionsaboutdomestic
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Chapter 20 . GDP and the Standard of Living 507
production to either the Labor Force Survey or the Family Expenditure
Survey.
Youmightliketoexplainhowtheomissionofillegalgoodsandservices
also leads to some misleading comparisons. For instance, the daybefore
prohibitionended,theproductionofillegalbeerwasnotcountedaspartof
GDP.
But
the
day
after
prohibition
ended,
the
production
of
now
legal
beer
counted.Askyourstudentstosuggesttwogoodreasonswhyillegalgoods
andservicesareomitted.First,thedataarehardbutnotimpossibletoob
tain.Second, theremaybe themoralposition that illegalactivitiesshould
notbe included inGDP.This latterobservationcan lead toan interesting
discussion.Askthestudentsiftheythinkthattheproductionof,say,mari
juana shouldbe included inGDP.Some,maybeevenmany,of themwill
see no problem with this. Then ask about the production of murderfor
hire. The response, we hope, willbe significantly different. Does such a
goodhaveanyvalue?
4. Foraglobalemphasis,discussmore fullysomeof thedifferences inGDP
acrosscountries.ConsiderwhatisleftoutofGDPandaskstudentstothink
abouthow
well
GDP
measures
welfare.
It
might
be
helpful
to
point
out
that
GDPisameasureofthestandardoflivingbasedonwhatisproducedbut
doesnotsayanythingaboutincomeequalityorwhogetswhatisproduced.
Pointoutagain that this isa focusonapositivequestion (measuringout
put)notanormativequestion(whoshouldgetwhatisproduced).Onepos
sibility is touse the information in theEye on theGlobal Economy. The
HumanDevelopment Index, todiscuss thehumandevelopment indexas
analternativeoradditionalmeasuretocomparedifferenteconomies.Goto
the human development webpage (www.undp.org/hdro) and pull out
some countriesyoumaybe interested in to showdifferenthumandevel
opmentindexes.Youcanthentalkaboutwhataspectsmaybecapturedin
theHDI
that
are
not
captured
with
GDP.
The
human
development
report
websitestatesthattheHDImeasuresaverageachievementsinacountryin
threebasicdimensions:a longandhealthy lifeasmeasuredby lifeexpec
tancyatbirth,knowledgeasmeasuredbytheadultliteracyrateandschool
enrollment,andadecentstandardoflivingasmeasuredbyGDPpercapita
inpurchasingpowerparityU.S.dollars.
Anotherpossibility is tocompare theUnitedStates toEuropeancountries
to highlight why GDP might fall short as an international comparison
number. I discuss some of the things omitted from GDP to examine
whethertheUnitedStateshasahigherlivingstandardthansomeEuropean
countries given that the United States has the highest GDP. There is an
Economistarticle
that
describes
adjustments
to
real
GDP
made
by
Robert
Gordon toaccount fordifferences in leisure,spendingonheating/cooling,
spending on jails, etc... that bring the measure of income between the
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508 Part 7 . MONITORING THE MACROECONOMY
UnitedStatesandEuropemuchclosertogether(Chasingtheleader,Feb
6th2003,TheEconomistprintedition,AreEuropeansreallysomuchworseoff than Americans?; based on the article Two centuries of economic
growth:Europechasing theAmericanfrontier,availableathttp://faculty
web.at.northwestern.edu/economics/gordon/355.pdf). Gordon first adjusts
GDP per capita for the extra leisure time taken in European countries
(bringingEuropesincomepercapitato82percent,fromtheofficialfigure
of77percentofAmericasincomepercapita).Hethenexaminesthehigher
spendingonairconditioningandheatingintheUnitedStatestoaccountfor
moreextremeclimatechangesandthehigherspendingonprisonsandse
curityservicesintheUnitedStatestoaccountforthehighercrimerate.Fi
nally,hediscussesthehigherspendingonroadsandenergyintheUnited
Statestoaccountforthegreaterdispersionofindividualsinsuburbanareas
with little public transportation options. Taking account of this greater
wastefulspending intheUnitedStatesandplacingavalueonEuropes
public transport system and the greater amount of leisure time,he finds
thatEuropesadjusted incomepercapita is92percentofU.S. incomeper
capita,much
closer
than
the
77
percent
based
on
GDP
per
capita.
Introduc
ingafewoftheseideascanleadtoaninterestingdiscussionofculturaldif
ferencesandthechoicesmadebyindividualsthatmaynotbemeasuredby
GDP. Invariably students will point out that some of these may notbe
wasteful spendingbut simply indicatedifferences inattitude, suchas the
valueplacedonlargerhousesandyardsascomparedtotheconcentration
andsizeofhomesinmanyEuropeancountries.
Land Mines1. Atanintuitivelevel,theequalitybetweenincomeandexpenditureisnota
difficult concept to get across. It makes sense to students that whatever
someonespends
must
ultimately
end
up
as
income
to
someone
else.
The
problemcomeswhenweput this intopractice.Thereasonhastodowith
the fact that thereare twononincomechargesagainstGDP (depreciation
andindirecttaxeslesssubsidies).Iftheyareignored,thenwhenusingthe
incomeapproach the figureobtainedwillbe less than the figureobtained
usingtheexpenditureapproach.
Asalwayswearefacedwithatradeoff.Youcanproceedimmediatelyto
introducedepreciationand indirect taxes lesssubsidiesanddoacompre
hensivejob.Itwillbeaccurate,butyoursimpleandpowerfulpointthatin
comeequalsexpenditurewillbelost.Thesecondalternativeistowaitand
lettheintuitiveequalitysinkin.Thisprocedurehasthebenefitofpreserv
ingthe
expenditure/income
equality
without
prematurely
exhausting
your
students.Thedownside is thatyoudelay the inevitable.Youwilleventu
allyhavetoexplainthediscrepancysometime.
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Chapter 20 . GDP and the Standard of Living 509
2. StudentsoftengetcaughtupinthemathwhencalculatingtheGDPdeflator
and forgetwhat thepoint is to thesecalculations.Youmightwant touse
theEyeontheEconomy,DeflatingtheGDPBalloon,beforepresentingany
formulas.EmphasizetheintuitionthatrealGDPgivesameasureoftheac
tualoutputproduced.Pointout thatnominalGDPcan increasedue toan
increaseinthegoodsandservicesproducedorduetoanincreaseinprices.
When wemeasuregrowth, however,we want toknow how much more
stuff isproduced.Thus, to focusjustonoutputchanges,wehave to take
outthepricechanges.ThisisexactlywhatthecalculationofrealGDPdoes.
3. GDPisprobablyoneofthemostwidelyreportedeconomicstatisticsinthe
world.Itispartofnewsstoriesontelevision,radio,andnewspapers.Busi
nesses,consumers,investors,andgovernmentofficialshaveallcometode
pendonitasayardstickofeconomicprogress.However,aswithjustabout
anyeconomicstatistic ithas itsflaws.Themostprominentshortcoming is
thatitisnotaperfectmeasureofsocialwelfare.Thetextdoesaverygood
joboutliningsomeoftheseproblems.However,itisanareathatstilltrips
up
a
good
many
students.
So
if
wouldnt
be
a
bad
idea
to
spend
extra
time
withsomeofthecentralissues.
Lets take the environment. Suppose the
economyisoperatingatfullemploymenton
theproductionpossibilitiesfrontier.Assume
furthermore that GDP increases along the
frontier, as depicted in the figure by the
movementfrompointAtopointB.Askyour
students if this movement necessarily
involves an improvement in this countrys
standard of living. Granted, output has
expanded,
but
it
has
come
at
the
expense
of
a dirtier environment. Most students will
respondby saying that it is difficult to say
because it depends onjust howbadly the
environmenthasdeteriorated.Thatistosay,
if the increase in GDP more than
compensatesforthereductioninthequality
of the environment, then perhaps it is a
welfareenhancingmoveandthestandardof
livinghas indeedgoneup.Pointoutthatthis issue isthecruxof thecon
troversymeasuringsomethingaselusiveasacleanenvironment.
Youmight considerasking students if there isanywayoutof thisdi
lemma.One
possible
answer
is
that
the
standard
of
living
could
actually
improve ifthereweredevelopmentsthatpushedtheproductionpossibili
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510 Part 7 . MONITORING THE MACROECONOMY
tiesfrontieroutward.Inthiscase,wewouldbeintheenviablepositionof
beingabletoenjoyahigherGDPcoupledwithgreaterenvironmentalqual
ity.
Towrapup thediscussionyoumightwant tomakeaconnectionwith
thislectureandthematerialcoveredinChapter4onDemandandSupply.
First,
ask
students
what
kind
of
a
good
they
think
the
environment
is.
That
is,ask them if it isanormalgoodoran inferiorgood.Theymightbalkat
firstattheideabyquestioningwhetheritisagoodinthefirstplace.Dont
let this problem derail you from your task. Explain that there are many
things thatwe enjoy thatarenotnecessarilyboughtand sold inmarkets
thatqualifyasgoods.Acleanenvironment is something that is injustas
much demand as national defense, fire protection, or a safe workplace.
With this discussion, someone isbound to say that the environment is a
normalgood.Refreshtheirmemorybyrestatingwhatittakesforagoodto
beanormalgood.Nowyoucanpointoutthatwehaveananswerforour
dilemma in the production possibilities frontier. That is, as a nation ex
pandsitsnationaloutputthereis,foratime,damagedonetotheenviron
ment.However,
as
anation
prospers
it
has
agreater
demand
and
prefer
enceforacleanerenvironment.And,youcanpointoutthatthisoutcomeis
exactlywhathappenedinEurope.WhenthericherWestGermanyreunited
withthepoorerEastGermanyinthelate1980s,observerswerestunnedby
how environmentally dirty East Germany was, especially compared to
WestGermany!
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Chapter 20 . GDP and the Standard of Living 511
ANSWERS TO CHECKPOINT EXERCISES
CHECKPOINT 20.1: GDP, Income, and Expenditure1a. Thefertilizerisanintermediategoodbecauseitwillbeusedtogrowtoma
toes.
1b.
Theringtone
is
a
final
good
because
you
are
the
final
user.
It
is
part
of
con
sumptionexpenditure.
1c. Thecomputersareafinalgood.BecausetheyarepurchasedbyPepsi,they
areinvestment.
1d. TheaircraftboughtbySouthwestAirlinesisafinalgood.Becausetheyare
purchasedbySouthwestAirlines,theyareinvestment.
2a. Totalexpenditureequalsthesumofconsumptionexpenditure,investment,
governmentexpenditure,andnetexports.SoGDPequals$60million+$25
million+$15million+$0=$100million.
2b. Totalincomeequalstotalexpenditure,sototalincomeequals$100million.
2c. To calculate net taxes, subtract from households total income their con
sumptionexpenditure
and
their
saving.
Total
income
equals
total
expendi
ture,sototalincomeequals$100million.Consumptionexpenditurewas$60
millionandsavingwas$20million,sonettaxesequals$20million.
CHECKPOINT 20.2: Measuring U.S. GDP1a. Using theexpenditureapproach,GDP=C+ I+G+NX=$7,376billion+
$1,579billion+$1,957billion$425billion=$10,487billion.
1b. Usingtheincomeapproach,netdomesticproductatfactorcost=Wages+
Interest,rent,andprofit=$6,075billion+$2,399billion=$8,474billion.
1c. The statistical discrepancy equals the GDP expenditure total minus the
GDP income total. GDP calculated using the expenditure approach is
$10,487billion.
To
calculate
GDP
using
the
income
approach,
to
net
domes
ticproductatfactorcostwemustaddindirecttaxeslesssubsidiesandthen
adddepreciation.SoGDPusingtheincomeapproachequals$8,474billion
+ $724 billion + $1,304 = $10,502. So the statistical discrepancy equals
$10,487$10,502=$15billion.
1d. GNPequalsGDPplusnetfactorincomefromabroad,sothedifferencebe
tween the two isnet factor income from abroad.Net factor income from
abroad=GNPGDP,sousingthedata intheproblem,netfactor income
fromabroad=$10,514billion$10,487billion=$27billion.
1e. U.S. national income = GNP depreciation statistical discrepancy =
$10,514billion$1,304billion($15billion)=$9,225billion.
1f.
Disposablepersonal
income
=national
income
retained
profits
plus
trans
ferpaymentspersonalincometaxes=$9,225billon$347billion$1,051
billion=$7,827billion.
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512 Part 7 . MONITORING THE MACROECONOMY
1g. AsapercentageofU.S.national income,disposable income is ($7,827bil
lion$9,225billion)100=84.8percent.
1h. Asapercentageofdisposablepersonalincome,consumptionis($7,376bil
lion$7,827billion)100=94,2percent.
CHECKPOINT 20.3: Nominal GDP Versus Real GDP
1a. NominalGDPin2004=($1590)+($2020)=$1,350+$400=$1,750.
1b. NominalGDPin2005=($20100)+($2525)=$2,000+$625=$2,625.
1c. Thevalueof 2005production in2004prices is ($15 100) + ($20 25) =
$1,500+$500=$2,000.
1d. In2004prices,thevalueofproduction increasedfrom$1,750to$2,000,an
increase of $250. The percentage increase is ($250 $1,750) 100, which
is14.29percent.
1e. Thevalueof2004productionin2005pricesis($2090)+($2520)=$1,800
+$500=$2,300.
1f. In2005prices,thevalueofproduction increasedfrom$2,300to$2,625,an
increaseof
$325.
The
percentage
increase
is
($325
$2,300)
100,
which
is
14.13percent.
1g. RealGDP in2004=$1,750.It isequaltothenominalGDPbecause2004is
thebaseyear.TocalculaterealGDPin2005computethegrowthrateofreal
GDPbetween2004and2005.Thatgrowthrateistheaverageofthegrowth
ratesbetween2004and2005usingpricesfrom2004andusingpricesfrom
2005.Theanswerstoparts(d)and(f)giveusthesegrowthrates.Theaver
agepercentage increase is14.21percent.SorealGDP in2005 is14.21per
centgreater than realGDP in2004.RealGDP in2004was$1,750, soreal
GDPin2005equals($1,750)(1.1421)=$1,999.
1h. TheGDPdeflator=(NominalGDPRealGDP)100=($2,625$1,999)
100
=
131.
CHECKPOINT 20.4: Real GDP and the Standard of Living1. The relativelyhigh lifeexpectancyandpolitical freedommeansCanadas
and theUnitedStates relative rankings rise.The low lifeexpectancyand
politicalfreedomdecreaseChinasandRussiasrankings.
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Chapter 20 . GDP and the Standard of Living 513
ANSWERS TO CHAPTER CHECKPOINT EXERCISES
1. FlowQisincome.FlowRisnettaxes.FlowUisgovernmentexpenditures
ongoodsandservices.FlowVissaving.FlowWisconsumptionexpendi
ture.FlowX is firmsborrowing for investment.FlowZ isnetexportsof
goodsandservices.
2a. GDPequalsC+I+G+NX.Rearranging,NX=GDPCIG.SoIberiasnetexportsequal$100billion$67billion$21billion$20billion,which
is$8billion.
2b. Netexportsequalexports imports,so importsequalexportsminusnet
exports.Iberias importsequal$30billion($8billion),whichis$38bil
lion.
2b. Frompart(a),Iberiasnetexportsare$8billion.
2c. FlowQequals$100billion.FlowRisnettaxesandequals$18billion.Flow
U isgovernmentexpendituresongoodsandservicesandequals$20bil
lion.FlowV issavingandequals$15billion.FlowW isconsumptionex
penditure and equals $67billion.Flow X is firmsborrowing for invest
mentand
equals
$21
billion.
Flow
Z
is
net
exports
of
goods
and
services
andequals$8billion.
3a. FlowQisincome,Y.RecallthatYequalsC+I+G+NX.FlowUisgovernmentexpendituresongoodsand services,G; flowW isconsumptionex
penditure, C; flow X is investment, I; and flow Z isnet exports, NX.So
flowQ=$7,376billion+$1,579billion+$1,957billion$424billion,which
is$10,488billion.
3b. FlowR isnet taxespaid to thegovernmentand flowV issaving.House
holdsdividetheirincome,flowQof$10,488billion,intoconsumptionex
penditure, flowW(equal to$7,376billion),net taxes, flowR,andsaving,
flowV
.
So
the
sum
of
net
taxes
plus
saving
(flowR
+
flowV
)
equals
income
(flow Q)minusconsumptionexpenditure (flowW),which is$10,488bil
lion$7,376billion=$3,112billion.
3c. GDPequalsincome,flowQ.SoGDPequals$10,488billion.
4a. FlowQ is income,Y.FlowX is investment.YequalsC+I+G+NX.Rearranging,I=YCGNX.FlowUisgovernmentexpendituresongoodsandservices,G;flowWisconsumptionexpenditure,C;and,flowZisnet
exports,NX.So flowX=$1,092billion$621billion$231billion$56
billion,whichis$184billion.
4b. GDPequalsincome,flowQ.SoGDPequals$1,092billion.
5a. For the expenditure approach, GDP equals the sum of consumption ex
penditure,investment,
government
expenditures
on
goods
and
services,
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514 Part 7 . MONITORING THE MACROECONOMY
andnetexports.Fortunately, thesedatawere saved from the fire.Hence
GDP=C+I+G+NX=$2,000+$800+$400$200=$3,000.5b. From the incomeapproach,GDPequals the sumofwagesplus interest,
rent, and profit plus indirect taxes less subsidies plus depreciation. The
value of the income approach GDP survived the fire and is $2,900. The
sum
of
wages
plus
interest,
rent,
and
profit
plus
indirect
taxes
less
subsi
diesequals$2,000+$500+$100=$2,600.Sodepreciationequals$2,900
$2,600=$300.
5c. Netdomesticproductatfactorcostequalsthesumofwages,interest,rent,
andprofit.Onceagain,allthesedatawerefortunatelysavedfromthefire,
sonetdomesticproductatfactorcost=$2,000+$500=$2,500.
5d. The statistical discrepancy equals GDP from the expenditure approach,
$3,000frompart(a),minusGDPfromtheincomeapproach,$2,900.Sothe
statisticaldiscrepancyis$100.
5e. GNPequalsGDPplusnetfactorincomefromabroad.Formpart(a),GDP
is$3,000.Netfactorincomefromabroadis$50.SoGNPequals$3,000+$50
=$3,050.
6a. TheGDPdeflatorequals(nominalGDPrealGDP)100.SotheGDPde
flator in2004equals ($11,734.4billion$10,755.7billion)100,which is
109.1.
6b. TheGDPdeflator in thebaseyearequals100.0because in thebaseyear
nominalGDPequalsrealGDP.
6c. Thepricelevelroseby9.1percent.
6d. RealGDProseby($10,755.7billion$9,817billion)$9,817billion100,
whichis9.6percent.
6e. NominalGDProseby($11,734.3billion$9,817billion)$9,817billion
100,whichis19.5percent.
7a.
NominalGDP
equals
(real
GDP
GDP
deflator)
100.
So
nominal
GDP
in
1990equals($7,112.5billion81.6)100,whichis$5,803.8billion.
7b. NominalGDPequals(realGDPGDPdeflator)100.SonominalGDPin
2004equals($10,755.7billion109.1)100,whichis$11,734.5billion.
7c. NominalGDProseby($11,734.5billion$5,803.8billion)$5,803.8billion
100,whichis102.2percent.
7d. Thepercentage increase inproduction ismeasuredby thepercentage in
creaseinrealGDP.RealGDProseby($10,755.7$7,112.5)$7,112.5100,
whichis51.2percent.
7e. Thepercentageincreaseinthecostoflivingismeasuredbythepercentage
increaseinthepricelevel.Thepricelevelroseby(109.181.6)81.6100,
whichis
33.7
percent.
8a. NominalGDPin2005is(40)($2)+(60)($3)=$80+$180,whichis$260.
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Chapter 20 . GDP and the Standard of Living 515
8b. NominalGDP in2006 is (44) ($3)+ (72) ($2)=$132+$144,which is
$276.
8c. RealGDP in2006usingthetraditionalmethodvaluesproduction in2006
using2005prices.So the traditionalmeasureofrealGDP is (44) ($2)+
(72)($3)=$88+$216,whichis$304.
8d.
The
chained
dollar
method
multiplies
real
GDP
in
the
previous
year
by
the
averagegrowthrateofGDPovertheyear,wheretheaveragegrowthrate
istheaverageofthegrowthratewhenpreviousyearpricesareusedand
whencurrentyearpricesareused.
RealGDPinthebaseyearisthesameasnominalGDP,sorealGDPin2005
is$260.GDP in2006using2005prices is (44) ($2)+ (72) ($3)=$88+
$216,whichis$304.GDP in2005using2005pricesis$260.SoGDPusing
2005pricesgrewby($304$260)$260100=16.9percent.
GDP in 2005using 2006prices is (40) ($3) + (60) ($2)= $120 + $120,
which is$240.GDP in2006using2006prices is$276.SoGDPusing2006
pricesgrewby($276$240)$240100=15.0percent.
The
average
growth
rate
is
16.0
percent.
So,
real
GDP
in
2006
using
the
chaineddollarmethodis($260)1.160,whichis$302.
8e. TheGDPdeflatorequals(nominalGDPrealGDP)100.SotheGDPde
flatorin2006equals($276$302)100,whichis91.4.
8f. ProductionismeasuredbyrealGDPandrealGDPgrewby16percent.
9a. NominalGDPin2003is(50)($3)+(72)($3)=$150+$216,whichis$366.
9b. NominalGDPin2008is(51)($4)+(80)($6)=$204+$480,whichis$684.
9c. RealGDP in2007usingthetraditionalmethodvaluesproduction in2007
using2005prices.So the traditionalmeasureofrealGDP is (50) ($2)+
(72)($3)=$100+$216,whichis$316.
9d. RealGDP in2008usingthetraditionalmethodvaluesproduction in2008
using2005
prices.
So
the
traditional
measure
of
real
GDP
is
(51)
($2)
+
(80)($3)=$102+$240,whichis$342.
9e. ThechaineddollarmethodmultipliesrealGDPinthepreviousyearbythe
averagegrowthrateofGDPovertheyear,wheretheaveragegrowthrate
istheaverageofthegrowthratewhenpreviousyearpricesareusedand
whencurrentyearpricesareused.
Frompart (d)of thepreviousexercise,realGDP in2006 is$302.GDP in
2007using2006prices is (50) ($3)+ (72) ($2)=$150+$144,which is
$294. GDP in 2006 using 2006 prices is $276. So GDP using 2006 prices
grewby($294$276)$276100=6.5percent.
GDP in2007using2007prices is$366.GDP in2006using2007prices is
(44)
($3)
+(72)
($3)
=$132
+$216,
which
is
$348.
So
GDP
using
2007
pricesgrewby($366$348)$348100=5.2percent.
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516 Part 7 . MONITORING THE MACROECONOMY
The average growth rate is 5.9 percent. So, real GDP in 2007 using the
chaineddollarmethodis($302)1.059,whichis$320.
9f. ThechaineddollarmethodmultipliesrealGDPinthepreviousyearbythe
averagegrowthrateofGDPovertheyear,wheretheaveragegrowthrate
istheaverageofthegrowthratewhenpreviousyearpricesareusedand
when
current
year
prices
are
used.
Frompart(e),realGDP in2007 is$320.GDP in2008using2007prices is
(51)($3)+(80)($3)=$153+$240,whichis$393.GDPin2007using2007
pricesis$366.SoGDPusing2007pricesgrewby($393$366)$266100
=7.4percent.
GDP in2008using2008prices is$684.GDP in2007using2008prices is
(50) ($4)+ (72) ($6)=$200+$432,which is$652.SoGDPusing2008
pricesgrewby($684$652)$652100=4.9percent.
The average growth rate is 6.2 percent. So, real GDP in 2008 using the
chaineddollarmethodis($320)1.062,whichis$340.
9g. TheGDPdeflatorequals(nominalGDPrealGDP)100.SotheGDPde
flator
in
2007
equals
($366
$320)
100,
which
is
114.4.
And
the
GDP
de
flatorin2008equals($684$340)100,whichis201.2.
9h. ProductionismeasuredusingrealGDP.Between2006and2008,realGDP
increasedfrom$302to$340,whichisa12.6percentincrease.
9i. The cost of living is measured using the price level. Between 2006 and
2008,thepricelevelrosefrom91.4to201.2,whichisanincreaseof120per
cent.
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Chapter 20 . GDP and the Standard of Living 517
Critical Thinking10a.Goods and services produced within the United States are part of U.S.
GDP.Boeingsdecisiontoproduceitsnew787airlinerinJapanmeansthat
thisproduction isnotproducedwithin theUnitedStatesand so it isnot
partofU.S.GDP.Goodsandservicesproducedanywhereintheworldus
ingfactors
of
production
supplied
by
residents
of
the
United
States
are
partofU.S.GNP.Boeingsdecision toproduce airliners inJapanmeans
that Boeing will supplyU.S. owned factors production toJapan. For in
stance,U.S.engineersemployedbyBoeingandworkinginJapanareaU.S.
factorofproductionproducingagoodinanothercountry.Sopaymentsto
U.S.engineersandotherU.S.citizensaswellaspaymentstootherU.S.fac
torsofproduction,suchasBoeingsprofit,willbeincludedinU.S.GNP.
10b.Goods and services produced within the United States are part of U.S.
GDP. So Toyotas decision to outsource its manufacture of cars to Ken
tuckymeansthatthisproductionwillbeincludedaspartofU.S.GDPbe
causeittakesplacewithintheUnitedStates.Goodsandservicesproduced
anywherein
the
world
using
factors
of
production
supplied
by
residents
of
theUnitedStatesarepartofU.S.GNP.Someof thefactorsofproduction
making theToyota carsareJapanese factorsofproduction,For instance,
Japanese engineersworking inKentuckyareJapanese notU.S. factorsof
production.ThepaymentstoalltheJapanesefactorsofproductionwork
inginKentuckyarenotpartofU.S.GNP
11. Undergroundeconomicactivitiesundermine (!) theusefulnessof thena
tional income accounts. For example, there is abias in the comparison
when comparing GDP in an Eastern European country, where under
groundactivitiesareextensive,withGDPinaWesternEuropeancountry,
whereundergroundactivitiesarelessextensive.ComparedtotheWestern
Europeancountry,
the
Eastern
European
countrys
standard
of
living
looks
much lower than itactually is.Undergroundeconomicactivities include
jobsdoneforcashtoavoidpayingtaxes,aswellasproductionandsaleof
illegalgoodsandservices.Someof theseactivitiescontribute to thestan
dardof living.Inparticular,thejobsoffthebooksdoneforcashtoavoid
taxescontributethesameamounttothestandardoflivingasiftheywere
doneonthebooks.IntheUnitedStates,undergroundeconomicactivities
are probably not extensive enough to warrant spending a large sum of
moneyto try tomeasure them.Inothercountries, though,theamountof
underground economic activities may be substantial enough to make
measuringthemaworthwhileendeavor.
12.
Ifthe
United
Nations
is
trying
to
measure
the
standard
of
living,
pollution
andpolitical freedom shouldbe included.Thedifficulty comes indeter
mining theirvalues.For instance,howmuch ispolitical freedomvalued?
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518 Part 7 . MONITORING THE MACROECONOMY
Doweadd50timesthemeasureofpoliticalfreedomtoGDPordoweadd
100 timespolitical freedom toGDP?Another important factor thatcould
be included isthevalueofleisuretime.Thisvalueisabiteasiertocalcu
late.Leisuretimemustbeatleastasvaluableastimespentatwork(orelse
more time wouldbe spent at work) so the wage rate provides a good
measureofthevalueofleisuretime.Thedistributionofincomemightalso
beusedintheUnitedNationsmeasureiftheU.N.isinterestedinmeasur
ingthestandardoflivingofatypicalpersonwithinanation.
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Chapter 20 . GDP and the Standard of Living 519
Web Exercises13a.Yourstudentsanswerswillvaryaccordingtowhenyouassigntheprob
lem.Bywayofexample,inJuly2005,themostrecentlyreleaseddatawere
forthe1stquarterof2005.FromtheBEAsWebsite,thenominaldataare:
Consumptionexpenditure (calledpersonalconsumptionexpenditures),
$8,538.5billion;
Investment
(called
gross
private
domestic
investment),
$2,084.5billion;Governmentexpenditures(calledgovernmentconsump
tionexpendituresandgrossinvestment),$2,259.4;andNetexports,$690.7
billion.(Therealdataforthesamequarterare:Consumptionexpenditure,
$7,815.8 billion; Investment, $1,962.9 billion; Government expenditure,
$1,954.8;andNetexports,$637.5billion.)
13b.Thesumofthesefournominalexpenditurecategories is$12,191.7billion,
whichispreciselythesameasthereportednominalGDP.(Thesumofthe
fourrealexpenditurecategoriesis$11,096.0billion,abitdifferentfromthe
reported real GDP of $9,096.2billion. Though the students will notbe
aware of it, the larger difference for the real numbers compared to the
nominalnumbers
is
that
each
of
the
four
real
components
and
real
GDP
is
calculatedseparatelyusingitsownchainofgrowthrates.Sotherealcom
ponentswillnotnecessarilysumtoequalrealGDP.)
13c. Theimplicitpricedeflatorwasreportedas109.873.
13d.NominalGDPwas$12,191.7billion, so realGDP, calculatedbydividing
nominal GDPby the GDP deflator and then multiplyingby 100, equals
($12,191.7billion109.873)100,whichis$11,096.2billion.
13e.The cost of living definitely was higherbecause the GDP deflator was
higher.In2000,thebaseyear,theGDPdeflatorwas100andintherecent
quarteritwas109.873.Pricesincreasedbetween2000andthe1stquarterof
2005,sothecostoflivingincreased.
14a.Your
students
answers
will
vary
according
to
your
state.
14b.Yourstudentsanswerswillvaryaccordingtoyourstate.
15a.Yourstudentsanswerswillvaryaccordingtowhenyouassigntheprob
lem.Foranexampleofananswer,using thedataavailable in2005,U.S.
realGDPperpersoninconstantdollarsin1980was$22,676.53andin2005
was $37,867.28. So in the United States, real GDP per person grewby
[($37,867.28$22,676.53)$22,676.53]100=67.0percent.InJapan,Japa
nese realGDPperperson in constantyen in1980was2,590,421and in
2005was4,202,027.InJapanovertheseyearsrealGDPperpersongrewby
[(4,202,027 2,590,421) 2,590,421] 100 = 62.2 percent. (Source:
http://www.imf.org/external/pubs/ft/weo/2005/01/data/dbginim.cfm).
15b.Yourstudentsanswerswillvaryaccordingtowhenyouassigntheprob
lem.Foranexample, inJuly2005,theU.S.GDPwas20.9percentofworld
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520 Part 7 . MONITORING THE MACROECONOMY
GDP and the Japanese GDP was 6.9 percent of world GDP. (Source:
http://www.imf.org/external/pubs/ft/weo/2005/01/pdf/statappx.pdf) Or, us
ingpurchasingpowerparityGDP, theU.S.GDPwas20.7percentof the
worldGDPandtheJapaneseGDPwas6.7percentoftheworldGDP.(the
sourceofthesedataisthesameasinpart(a)).
15c.
Your
students
answers
will
vary
according
to
when
you
assign
the
prob
lem.ProbablythemajorissueisthattocalculatethelevelofrealGDPper
personinJapanasapercentageofthatintheUnitedStates,estimatesmust
be in thesamecurrency.Foranexampleofananswer,dataongrossdo
mestic product per personbased on purchasingpowerparity prices are
available.(Thesedatacannotbeusedtocalculatethegrowth inrealGDP
perperson inpart(a)becausetheGDPsarenominalGDP.)In2005,Japa
neseGDPperpersonwas$31,384andU.S.GDPperpersonwas$41,557.
SorealGDPperpersoninJapanwas75.5percentthatintheUnitedStates.
15d.Your students answers might vary according to when you assign the
problem.Ingeneral,however,part(a)showsthatU.S.realGDPperperson
grewmorerapidlythatJapaneserealGDPperperson,sothestandardof
livinggrew
more
rapidly
in
the
United
States.
Part
(c)
shows
that
the
stan
dardof living is lower inJapanbecauseJapansGDPperperson isonly
about75percentofGDPperpersonintheUnitedStates.
ADDITIONAL EXERCISES FOR ASSIGNMENT
Questions CHECKPOINT 20.1: GDP, Income, and Expenditure1. Identifyeachof the followingaseither includedornot included inGDP.
Makesuretogiveanexplanationforthosethatyoujudgeasnotincluded.
Inaddition,
state
whether
each
included
item
is
consumption,
investment,
governmentexpenditure,ornetexports.
1a. The purchase of copy paperby PepsiCo, which is usedby the company
staff.
1b. The purchase of an electronic handheld organizerby a sales manager to
keeptrackofclients.
1c. ThepurchaseofanewaircraftcarrierbytheNavy.
1d. AnincreaseinDellsinventoryofunsoldpersonalcomputers.
1e. AfamilyeatingdinneratTacoBell.
1f. ThesalaryofthePresidentoftheUnitedStates.
1g. AMombakingabirthdaycakeforher8yearolddaughter.
1h.The
sale
of
aused
computer.
1i. Yourdonationofausedcomputertoalocalelementaryschool.
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Chapter 20 . GDP and the Standard of Living 521
2006 2007
Item Quantity Price Quantity Price
Lobsters 100 $20 each 110 $25 each
Crabs 25 $25 each 30 $30 each
1j. ThepurchasebyaGermanresidentinGermanyofanAmericanmadeceil
ingfanproducedintheUnitedStates.
CHECKPOINT 20.2: Measuring U.S. GDPItem Dollars
Consumption expenditure 800
Investment 400Government expenditures 200Exports 50Imports 75Depreciation 100
2. Usingtheinformationinthetableabove,calculateGDP.
Item
Amount
(trillions of dollars)
Consumption expenditure 4.97Investment 1.14Government expenditures 1.37Net exports 0.08Wages 4.20Interest, rent, and profit 1.68Depreciation 0.89
3. The tableabovegives someof the items in theU.S.National Incomeand
ProductAccountsin1995.
3a. UsetheexpenditureapproachtocalculateU.S.GDPin1995.
3b. Use the incomeapproach to calculateU.S.netdomesticproductat factor
costin1995.
3c. CalculateGDPminusnetdomesticproductatfactorcostin1995.
3d. Calculateindirecttaxeslesssubsidiesin1995.
CHECKPOINT 20.3: Nominal GDP Versus Real GDP
4. An island economy
produces only lobsters
and crabs. The table
gives the quantities
produced and the
prices in 2006, and the
quantitiesproducedandthepricesin2007.Thebaseyearis2006.Calculate:
4a. NominalGDPin2006.
4b. NominalGDPin2007.
4c. Thevalueof2007productionin2006prices.
4d.
Percentage
increase
in
production
when
valued
at
2006
prices.
4e. Thevalueof2006productionin2007prices.
4f. Percentageincreaseinproductionwhenvaluedat2007prices.
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522 Part 7 . MONITORING THE MACROECONOMY
4g. RealGDPin2006and2007.
4h. TheGDPdeflatorin2007.
5. IfnominalGDP in1998was$8,759.9billionandrealGDPwas$8,165bil
lion,calculatetheGDPdeflatorin1998.
Answers CHECKPOINT 20.1: GDP, Income, and Expenditure1a. Notincludedbecauseitisanintermediategood.
1b. Includedaspartofinvestment.
1c. Includedaspartofgovernmentexpenditures.
1d. Includedaspartofinvestment.
1e. Includedaspartofconsumptionexpenditure.
1f. Includedaspartofgovernmentpurchases.
1g. Notincludedbecauseitishouseholdproduction.
1h. NotincludedbecauseitwasincludedinGDPintheyearitwasproduced.
1i. NotincludedbecauseitwasincludedinGDPintheyearitwasproduced.
1j. Includedaspartofnetexports.
CHECKPOINT 20.2: Measuring U.S. GDP2. GDPequalsthesumofconsumptionexpenditure,investment,government
expenditureongoodsandservices,andnetexports.SoGDP=$800+$400+
$200+($50$75),whichis$1,375.Theamountofdepreciationisnotused.
3a. Using theexpenditureapproach,GDP =C+ I+G+NX=$4.97 trillion+$1.14trillion+$1.37trillion$0.08trillion=$7.40trillion.
3b. Usingtheincomeapproach,netdomesticproductatfactorcost=Wages+
Interest,rent,andprofit=$4.20trillion+$1.68trillion=$5.88trillion.
3c. GDPminusnetdomesticproductat factorcost=$7.40 trillion$5.88tril
lion=$1.52
trillion.
3d. ThedifferencebetweenGDPandnetdomesticproductatfactorcost,$1.52
trillion,isequaltodepreciationplus(indirecttaxesminussubsidies).From
the table, depreciation, $0.89 trillion. So indirect taxes minus subsidies =
$1.52trillion$0.89trillion=$0.63trillion.
CHECKPOINT 20.3: Nominal GDP Versus Real GDP4a. NominalGDPin2006=($20100)+($2525)=$2,000+$625=$2,625.
4b. NominalGDPin2007=($25110)+($3030)=$2,750+$900=$3,650.
4c. Using2006prices,thevalueof2007productionis($20110)+($2530)=
$2,200+$750=$2,950.
4d.In
2006
prices,
the
value
of
production
increased
from
$2,625
to
$2,950,
an
increaseof$325.Thepercentage increase isequal to($325$2,625)100,
whichis12.38percent.
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Chapter 20 . GDP and the Standard of Living 523
4e. Thevalueof 2006production in 2007prices is ($25 100) + ($30 25) =
$2,500+$750=$3,250.
4f. In2007prices,thevalueofproductionincreasedfrom$3,250 to$3,650,an
increaseof$400.Thepercentage increase is($400$3,250)100,which is
12.31percent.
4g.
Real
GDP
in
2006
=
$2,625.
It
is
equal
to
nominal
GDP
because
2006
is
the
baseyear.
TocalculaterealGDPin2007computethegrowthrateofrealGDPbetween
2006and2007.Thatgrowthrateistheaverageofthegrowthratesbetween
2006and2007usingprices from2006andusingprices from2007.Taking
theaverageoftheanswerstoparts(d)and(f)givesusanaveragepercent
ageincreaseof12.35percent.
RealGDPin2007is12.35percentgreaterthanrealGDPin2006.RealGDP
in2006was$2,625,sorealGDPin2007equals($2,625)(1.1235),whichis
$2,949.
4h. TheGDPdeflator=(NominalGDPRealGDP)100=($3,650$2,949)
100
=
124.
5. The GDP deflator equals (Nominal GDP Real GDP) 100, which is
($8,759.9$8,165)100=107.3.
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524 Part 7 . MONITORING THE MACROECONOMY
USING EYE ON THE U.S. ECONOMY
Is a Computer Program an Intermediate Good or a Final Good?Thisarticlepresentsaperfectopportunity todemonstrate to students thateco
nomicstatisticsarenotperfect.After reading it, theymightget the impression
thateconomists
are
being
arbitrary
about
the
classification
of
software
in
the
na
tional incomeaccounts.Remind them that the reason for the reclassificationof
softwarefromanintermediategoodtoinvestmentreflectsthefactthatsoftware
hasmanyofthesamecharacteristicsasothertypesofinvestment.Forinstance,it
hasalifespanjustlikecapitalandithelpsimproveproductivity.Inaddition,it
alsodepreciatesjust likecapital.Studentswontneed toomuchconvincing for
themtoagree.Butjustincase,itwouldnthurttomentionthatsoftwareeventu
allybecomesobsoleteasnewsoftwareisdevelopedtomeetthechangingneeds
ofindustry.Pointoutthatthemeaningofdepreciationherecomeswithabitofa
twistbecausethesoftwaredoesntactuallygetusedupthewayphysicalmachin
erytoolsorfactorieswouldbutinsteadgetsusedupasitbecomesobsolete.
Deflating the GDP BalloonThissegmentmightbebestusedifyouintroduceitbeforeyouactuallypresent
the formula for theGDP deflator.The GDP deflator is one of these topics for
which the formula itselfdoesnoteffectively communicate theunderlyingeco
nomicforcesatwork.Theballoonmetaphorisanexcellentwaytoappealtostu
dentsintuitions.
USING EYE ON THE GLOBAL ECONOMY
The Human Development IndexExplain
to
students
that
economists
have
long
wrestled
with
the
inadequacies
of
using GDP to measure the standard of living. In fact, economists have never
thoughtofitasasingularmeasureofsocialwelfareforthereasonsthataremen
tionedattheendofthechapter.TheeffortbytheUnitedNationsisastepinthe
direction toamelioratesomeof these shortcomings.However, the troublewith
theHumanDevelopmentIndexisthatitcombinesvariablesthataredifficultto
aggregatebecause theyaremeasured inmarkedlydifferentunits.For instance,
there isnoobviousway tocombinerealGDPperpersonwith lifeexpectancy.
Perhapsyoucouldaskstudentshowtheythinkitwouldbeappropriatetotreat
thesedissimilarvariablesintherankingofstandardofliving.Forexample,you
mightask them toprovideaweighting foreachcategoryandprovidejustifica
tionfor
the
weightings.