C h a p t e r

4 MEASURING GDP
AND ECONOMIC
GROWTH**

Answers to the Review Quizzes

Page 88 (page 490 in Economics)
1. Define GDP and distinguish between a final good and an intermediate good. Provide
examples.
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

*
* This is Chapter 21 in Economics.
64 CHAPTER 4

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 time.
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 production.
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 GDP?
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
MEASURING GDP AND ECONOMIC GROWTH 65

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 Quantities 2008 2009
produces only bananas and Bananas 1,000 bunches 1,100 bunches
coconuts. Calculate Tropical Coconuts 500 bunches 525 bunches
Republic’s nominal GDP in 2008
and 2009 and its chained-dollar Prices
real GDP in 2009 expressed in Bananas $2 a bunch $3 a bunch
2008 dollars. Coconuts $10 a bunch $8 a bunch
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.
66 CHAPTER 4

Answers to the Problems and Applications

1. Figure 4.1 above shows the flows of expenditure and income in the United States. During the
second quarter of 2007, B was $9,658 billion, C was $2,147 billion, D was $2,656 billion, and
E was −$723 billion. Name the flows and the calculate
Flow A is aggregate income; Flow B is consumption expenditure; Flow C is government expenditure; Flow
D is investment; Flow E is net exports.
a. Aggregate expenditure.
Aggregate expenditure is $13,738 billion. Aggregate expenditure is the sum of consumption expenditure
(Flow B), investment (Flow D), government expenditure (Flow C), and net exports (Flow E). Therefore
aggregate expenditure equals $9,658 billion plus $2,656 billion plus $2,147 billion plus −$723 billion,
which is $13,738 billion.
b. Aggregate income.
Aggregate income is $13,738 billion. Aggregate income equals aggregate expenditure, which from part a is
$13,738 billion.
c. GDP.
GDP is $13,738 billion. GDP equals aggregate expenditure, which from part a is $13,738 billion.
2. In Figure 4.1, during the second quarter of 2008, B was $10,144 billion, C was $1,980 billion,
D was $2,869 billion, and E was −$737 billion. Calculate the quantities in problem 1 during
the second quarter of 2008.
Aggregate expenditure is $14,256 billion. Aggregate expenditure is the sum of consumption expenditure
(Flow B), investment (Flow D), government expenditure (Flow C), and net exports (Flow E). Therefore
aggregate expenditure equals $10,144 billion plus $2,869 billion plus $1,980 billion plus −$737 billion,
which is $14,256 billion.
Aggregate income is $14,256 billion. Aggregate income equals aggregate expenditure, which is $14,256
billion.
GDP is $14,256 billion. GDP equals aggregate expenditure, which is $14,256 billion.
MEASURING GDP AND ECONOMIC GROWTH 67

3. In Figure 4.1, during the second quarter of 2006, A was $13,134 billion, B was $9,162 billion,
D was $3,340 billion, and E was −$777 billion. Calculate
a. Aggregate expenditure.
Aggregate expenditure is $13,134 billion. Flow A is aggregate income and aggregate income equals
aggregate expenditure.
b. Aggregate income.
Aggregate income is $13,134 billion.
c. GDP.
GDP is $13,134 billion. GDP equals aggregate expenditure, which from part a is $13,134 billion.
d. Government expenditure.
Government expenditure is $1,409 billion. Aggregate expenditure is the sum of consumption expenditure
(Flow B), investment (Flow D), government expenditure (Flow C), and net exports (Flow E). Therefore
government expenditure equals aggregate expenditure minus consumption expenditure minus investment
minus net exports, Government expenditure equals $13,134 billion minus $9,162 billion minus $3,340
billion minus −$777 billion, which is $1,409 billion.
4. The firm that printed this textbook bought the paper from XYZ Paper Mills. Was this
purchase of paper part of GDP? If not, how does the value of the paper get counted in GDP?
The printing firm’s purchase of paper is the purchase of an intermediate good and so the value of the paper
is not (directly) included in GDP. The value of the paper is included in GDP as part of the value of the
textbooks that the company produces.
5. The table shows data from the United Item Billions of pounds
Kingdom in 2005.
Wages paid to labor 685
a. Calculate GDP in the United Kingdom. Consumption expenditure 791
GDP in the United Kingdom was £1,223 Taxes 394
billion.
Transfer payments 267
b. Explain the approach (expenditure or Profits 273
income) that you used to calculate Investment 209
GDP. Government expenditure 267
The expenditure approach was used; that Exports 322
is, GDP was calculated by adding
Saving 38
consumption expenditure, investment,
Imports 366
government expenditure, and exports,
and subtracting imports.
6. Tropical Republic produces only Quantities 2008 2009
bananas and coconuts. The base year
Bananas 800 bunches 900 bunches
is 2008, and the tables give the
Coconuts 400 bunches 500 bunches
quantities produced and the prices.
a. Calculate Tropical Republic’s Prices
nominal GDP in 2008 and 2009. Bananas $2 a bunch $4 a bunch
In 2008, nominal GDP is $5,600.
Coconuts $10 a bunch $5 a bunch
In 2009, nominal GDP is $6,100.
Nominal GDP in 2008 is equal to total expenditure on the goods and services produced by Tropical
Republic in 2008. Expenditure on Tropical Republic on bananas is 800 bunches of bananas at $2 a
bunch, which is $1,600. Expenditure on coconuts is 400 bunches at $10 a bunch, which is $4,000. Total
expenditure is $5,600, so nominal GDP in 2008 is $5,600.
68 CHAPTER 4

Nominal GDP in 2009 is equal to total expenditure on the goods and services produced by Tropical
Republic in 2009. Expenditure on Tropical Republic on bananas is 900 bunches of bananas at $4 a
bunch, which is $3,600. Expenditure on coconuts is 500 bunches at $5 a bunch, which is $2,500. Total
expenditure is $6,100, so nominal GDP in 2009 is $6,100.
b. Calculate real GDP in 2009 in terms of the base-year prices.
Real GDP in 2009 using base-year prices is $6,800. The base-year prices method calculates the market
value of the 2009 quantities at the base-year prices of 2008. To value the 2009 output at 2008 prices, real
expenditure on Tropical Republic on bananas is 900 bunches at $2 a bunch, which is $1,800, and real
expenditure on coconuts is 500 bunches at $10 a bunch, which is $5,000. Adding these two expenditures
shows that real GDP in 2009 using the base-year prices method is $6,800.
7. Use the Data Grapher in MyEconLab to answer the following questions. In which country, in
2007 was
a. The growth rate of real GDP highest: Canada, Japan, or the United States?
Canada’s growth rate was the highest.
b. The growth rate of real GDP lowest: France, China, or the United States?
France’s growth rate was the lowest.
8. Toyota to Shift U.S. Manufacturing Efforts
Toyota Motor Corp. will start producing the hybrid Prius in the U.S. for the first time as the
Japanese automaker adjusts its U.S. manufacturing operations to meet customer demands for
smaller, more fuel-efficient vehicles. The company said Thursday it will start producing the
Prius in 2010 at a plant it is building in Blue Springs, Mississippi. … this will be the first time
the Prius, which has been on sale for more than a decade, will be built outside of Asia. …
CNN, July 10, 2008
a. Explain how this change by Toyota will influence U.S. GDP and the components of
aggregate expenditure.
Toyota’s change will increase U.S. GDP. Presuming the number of Priuses purchased in the United States
does not change as a result of Toyota’s action, the production of Priuses in the United States increases the
net exports of goods and services because fewer Priuses will be imported.
b. Explain how this change by Toyota will influence the factor incomes that make up U.S. GDP.
Toyota likely will need to hire more factors of production to produce the Priuses. So compensation of
employees will rise because more workers are hired. If Toyota uses more land or other rented inputs, then
rental income will increase.
9. Toting Katrina’s Severe Distortions
Hurricane Katrina could wind up being the most devastating storm to hit the U.S. Early
forecasts of insured losses run as much as $26 billion. ... As far as damage to the economy, the
storm is likely to drop third-quarter gross domestic product (GDP) growth by 50 basis points,
figures Beth Ann Bovino, senior economist at Standard & Poor’s. She also expects consumer
sentiment and production to be hurt. … However, likely repairs from hurricane-related
damage should boost GDP in the following three quarters. This is largely because of rebuilding. ...
Business Week, August 31, 2005
a. Explain how a devastating storm can initially decrease GDP.
A devastating storm, such as Katrina, can initially decrease because it destroys capital equipment, such as
plants, shops, and factories, which reduces production.
b. How can a devastating storm then contribute to an increase in GDP?
GDP increases as a result of the increased production to rebuild the capital that was destroyed.
MEASURING GDP AND ECONOMIC GROWTH 69

Government expenditure increases to rebuild infrastructure such as roads and bridges and private
investment increases to replace buildings, equipment, and other capital. Investment also increases to
replace homes.
c. Does the increase in GDP indicate a rise in the standard of living is a result of the storm?
The increase in GDP represents a rise in the standard of living compared to the situation immediately after
the storm. However the increase in production is returning the standard of living to its initial level before
the storm. So the increase in GDP does not indicate a rise in the standard of living but instead represents a
return to the initial standard of living.
10. Poor India Makes Millionaires at Fastest Pace
India, with the world’s largest population of poor people living on less than a dollar a day, also
paradoxically created millionaires at the fastest pace in the world in 2007. … Growing them at
a blistering pace of 22.7 per cent, India added another 23,000 more millionaires in 2007 to its
2006 tally of 100,000 millionaires measured in dollars. … In contrast, developmental agencies
put the number of subsistence level Indians living on less than a dollar a day at 350 million
and those living on less than $2 a day at 700 million. In other words, for every millionaire,
India has about 7,000 impoverished people. ...
The Times of India, June 25, 2008
a. Why might a measurement of real GDP per person misrepresent the standard of living of the
average Indian?
There are a few reasons why this measurement of real GDP per person misrepresents the standard of living
of the average Indian. First GDP includes only goods and services bought and sold in markets. In India
many goods and services are produced by the household itself and this home production, while boosting
the household’s standard of living, is not included in GDP. Second the prices used to value Indian
production and thereby calculate Indian GDP are likely quite different than the prices used to value U.S.
production and calculate U.S. GDP. When looking at prices of identical or near-identical goods, it is
likely that more of these prices are lower in India than in the United States. So, even if the actual
quantities produced are the same, India’s production would be valued less than U.S. production and
India’s GDP would be less than U.S. GDP. If similar prices, such as purchasing power parity prices, were
used to value India’s GDP and U.S. GDP, India’s GDP per person would be closer to U.S. GDP per person.
b. Why might $1 a day and $2 a day under estimate the standard of living of the poorest Indians?
One important reason why the $1 and $2 a day estimates undervalue the standard of living of the poorest
Indians is because much of these people’s transactions do not occur in markets. GDP is calculated using
only goods and services bought and sold in markets. So if a poor, self-sufficient farmer grows only enough
food for his or her family and does not buy or sell food in the market, the farmer will be estimated to have
a very low income. But this low income vastly understates the farmer’s standard of living because it omits
all the food the person produced on his or her land. Another reason why the standard of living of the
poorest Indians is under estimated is because the estimate is made using prices that prevail in India and
then compared to the standard of living in the United States. Prices in India are often much lower than in
the United States, so comparing what the income can purchase in the United States understates the
standard of living.
11. Canada Agency Says 2nd Quarter GDP Dip Won’t Prove Recession
Statistics Canada may not conclude the economy is in a recession even if gross domestic
product contracts for a second straight quarter, according to one of the agency’s top
economists. ... Defining a recession as two consecutive quarterly drops in GDP “is a silly,
simplistic, simplification,” Cross said by telephone. ... The National Bureau of Economic
Research, which chronicles business cycles in the U.S., defines a recession as “a significant
70 CHAPTER 4

decline in economic activity spread across the economy, lasting more than a few months,
normally visible in real GDP, real income, employment, industrial production, and wholesale-
retail sales.”
Bloomberg, June 18, 2008
a. Why might defining a recession as “two consecutive quarterly drops in GDP” be too
“simplistic”?
GDP is just one indicator of the overall economy. It’s a good indicator but it is still just one. Looking at a
broader range of economic indicators can give a more complete picture of how the economy is fairing. So
looking at only GDP and defining a recession only in terms of two consecutive quarterly drops in GDP
might miss a recession that is apparent when looking at other data.
b. Why might people still be feeling the pain of recession after an expansion begins?
When GDP first enters an expansion after a trough, employment does not immediately rise. Firms tend to
hesitate in increasing employment until they are certain the expansion will last. So on this count people
still feel the pain of recession after an expansion begins. In addition people may have increased their debt
during the recession. It will take a while after the economy is growing for people to pay back their debt, so
on this count people also fell the pain of recession after an expansion begins. Finally some job losers might
need retaining before they are qualified for new jobs, which also increases pain’s time span.
12. GDP Expands 11.4 Percent, Fastest in 13 Years
China’s economy expanded at its fastest pace in 13 years in 2007. … The country’s Gross
Domestic Product (GDP) grew 11.4 percent last year from 2006, to 24.66 trillion yuan ($3.42
trillion). … That marked a fifth year of double-digit growth for the world’s fourth largest
economy after the U.S., Japan, and Germany. The increase was especially remarkable given the
fact that the United States is experiencing a slowdown due to the sub-prime crisis and housing
slump. … According to Citigroup estimates, each one percent drop in the U.S. economy will
shave 1.3 percent off China’s growth, as Americans are heavy users of Chinese products. In
spite of the uncertainties, the country’s economy is widely expected to post its sixth year of
double-digit growth in 2008 on investment and exports.
The China Daily, January 24, 2008
a. Use the expenditure approach for calculating China’s GDP to explain why “each one percent
drop in the U.S. economy will shave 1.3 percent off China’s growth.”
China’s GDP growth will drop because U.S. demand for China’s exports will decrease. China’s GDP
equals its aggregate expenditure and the fall in China’s exports decreases China’s aggregate expenditure.
b. Why might China’s recent double-digit GDP growth rates overstate the actual increase in the
level of production taking place in China?
China’s GDP, similar to all nations’ GDPs, omits the value of home production. As more of China’s
economy moves to being traded in markets, China’s GDP and therefore the growth rate of China’s GDP
increases even though the actual production is not changing.
c. Explain the complications involved with attempting to compare the economic welfare in
China and the U.S. by using the GDP for each country.
China’s GDP is calculated using prices in China while U.S. GDP is calculated using prices in the United
States. But relative prices in China and the United States are quite different. When looking at prices of
identical or near-identical goods, more of these prices are lower in China than in the United States. So
even if China and the United States produced the exact same quantities of these goods and services,
China’s GDP, using China’s lower prices, would value China’s production at a smaller value than would
U.S. GDP, using U.S. higher prices. To have a valid comparison of Chinese and U.S. GDP, purchasing
power parity (PPP) prices must be used to value Chinese and U.S. production because then prices are the
same for China and the United States.
MEASURING GDP AND ECONOMIC GROWTH 71

13. Consumers Can’t Save the Economy

Consumers are too tapped out to lead the economy out of its troubles, according to a report on
household credit released Wednesday. And even after things turn around, consumers weighed
down by debt won’t be able to spend as they did in the past. Americans have little money on
hand and banks aren’t eager to lend anymore, said Scott Hoyt, senior director of consumer
economics at Moody’s Economy.com. … Sluggish consumer spending power means that the
recovery may be a little slower and less vigorous, leaving it to corporations to spur the
economy. It will also take years for consumers to straighten out their household budgets since
their debt burdens are near record highs. Americans put 14.3 percent of their disposable
income toward debt in the first quarter, near the record 14.5 percent reached at the end of
2006. By comparison, the rate was 12.3 percent in 2000... Before the 1980s, consumer
spending made up about 63 percent of the nation’s gross domestic product, a key measure of
the economy. Since then, it has grown to about 70 percent as Americans took on more debt to
fuel their buying habits. Going forward, consumer spending will likely drift back to about 67
percent of GDP, Hoyt said. Americans simply can’t sustain a near-zero savings rate and an
ever-growing debt load.
CNN, May 22, 2008
a. How has the influence of consumer spending on GDP changed over the past three decades in
the United States? What has allowed this change to take place?
The influence of consumer spending on GDP has increased over the past 3 decades. Before the 1980s
consumer spending was about 63 percent of GDP while in recent years it has risen to about 70 percent of
GDP. Consumers’ willingness to increasingly borrow and increasingly take on debt has allowed this
change to occur.
b. Why does Hoyt predict that consumer spending will shrink as a percentage of GDP?
Mr. Hoyt believes that consumers will need to spend more of their income paying down their debt, so
they will have less to spend on consumption. According to Mr. Hoyt this change will lower the percentage
of GDP attributed to consumption expenditure.
14. Consumer Spending a Big Factor: NBS
When the [Chinese] National Bureau of Statistics (NBS) in October released its consumption
figures for the first three quarters, people were surprised to discover that consumers are
playing an ever-important role in the growth of the economy. … Consumption contributed 37
percent of gross domestic product growth while foreign demand, or net exports, accounted for
21.4 percent. … The remaining 41.6 percent was made by investment. … While exports are
growing, imports are increasing at a faster pace, narrowing the gap and leading to shrinking
net exports… But challenges lie ahead. Consumption will continue to grow, but only slowly,
analysts said, because the public are still bothered by spending pressures like Social Security,
health, education and housing. With those uncertainties, they prefer to save rather than spend.
China remains a developing country with a relatively low level of income, which cannot
provide a strong back-up for consumption. … The government has yet to provide adequate
public services, such as education and health, and people prefer to save more in anticipation of
rising future expenditure. ... In 2006, rural residents earned about one-third of the income
earned by urban residents.
The China Daily, December 11, 2007
a. Compare the relative magnitudes of consumption expenditure, net exports, and investment in
China compare to those of the United States.
The relative magnitude of Chinese consumption expenditure is much lower than that for the United
72 CHAPTER 4

States. The relative magnitudes of Chinese net exports and investment is much higher than those in the
United States.
b. Why is consumption expenditure in China so low?
China’s consumption expenditure is so low because Chinese consumers are concerned about their future
expenditures on Social Security, health, education, and government public services. Because they are
concerned Chinese consumers spend less and save more than similar consumers in other nations.
15. Totally Gross
… Over the years, GNP and GDP have proved spectacularly useful in tracking economic
change—both short-term fluctuations and long-run growth. Which isn’t to say GDP doesn’t
miss some things. [Amartya] Sen, a development economist at Harvard, has long argued that
health is a big part of living standards—and in 1990 he helped create the United Nations’
Human Development Index, which combines health and education data with per capita GDP
to give a more complete view of the wealth of nations (the United States currently comes in
12th, while on per capita GDP alone, it ranks second). [Joseph] Stiglitz, a Columbia professor
and former World Bank chief economist, advocates a “green net national product” that takes
into account the depletion of natural resources. Also sure to come up… is the currently
fashionable idea of trying to include happiness in the equation. The issue with these alternative
benchmarks is not whether they have merit (most do) but whether they can be measured with
anything like the frequency, reliability and impartiality of GDP. …
Time, April 21, 2008
a. Explain the factors identified here that limit the usefulness of using GDP to measure
economic welfare.
GDP focuses on the amount of goods and services produced. While goods and services lead to improving
people’s welfare, there are other factors that also come into play. The Human Development Index includes
people’s education and health, which are obvious factors that affect people’s wellbeing. Mr. Stiglitz is
suggesting that sustainability issues should be included. Others have recommended that people’s overall
happiness be a factor in measuring economic welfare.
b. What are the challenges involved in trying to incorporate measurements of those factors in an
effort to better measure economic welfare?
There are two major difficulties. First, measuring some of these variables, especially “happiness”, would be
very difficult. Second, even if the variables could be accurately measured determining the weighting
scheme to be used is very difficult. For instance, how much should depletion of copper be weighted
relative to GDP per person?
c. What does the ranking of the U.S. in the Human Development Index (12th) imply about the
levels of health and education relative to other nations?
Because the U.S. ranking in the Human Development Index is well below its ranking of per person real
GDP, the levels of health and education in the United States must be lower than those in many other
advanced countries.
16. Boeing Bets the House
Boeing plans to produce some components of its new 787 Dreamliner in Japan. The aircraft
will be assembled in the United States, and much of the first year’s production will be sold to
ANA (All Nippon Airways), a Japanese airline.
The New York Times, May 7, 2006
a. Explain how Boeing’s activities and its transactions affect U.S. and Japanese GDP.
Goods and services produced within the United States are part of U.S. GDP. Boeing’s decision to produce
part of its new 787 airliner in Japan means that this production is not produced within the United States
MEASURING GDP AND ECONOMIC GROWTH 73

and so it is not part of U.S. GDP. This production is, however, part of Japan’s GDP. The parts of the
Dreamliner that are assembled in Japan and sent to the United States for final assembly add to Japan’s
GDP as exports and subtract from U.S. GDP as imports. Then the Dreamliners that Boeing sells to All
Nippon Airways in Japan are counted as U.S. exports and Japanese imports so they add to U.S. GDP and
subtract from Japan’s GDP.
b. Explain how ANA’s activities and its transactions affect U.S. and Japanese GDP.
ANA’s purchase of Dreamliners is counted in U.S. GDP as exports and is counted in Japan’s GDP as
imports.
c. Use a circular flow diagram to illustrate your answers to parts (a) and (b).

Figure 4.2 shows these transactions. For part a, Boeing buys some parts of the Dreamliner from firms in
Japan. This flow is Flow A, an import into the United States. This flow travels through the goods market
and goes to Boeing as Flow B. Boeing then assembles the Dreamliners. For part b, Boeing sells some
Dreamliners to ANA. The airliners travel from Boeing through the goods market and are exported to ANA
in Japan. These are the reverse of flow B and then of flow A. Flows C and D indicate that Boeing is paying
households (through the factor market) for the factors of production the households supply to Boeing.
17. The United Nations’ Human Development Index (HDI) is based on real GDP per person, life
expectancy at birth, and indicators of the quality and quantity of education.
a. Explain why the HDI might be better than real GDP as a measure of economic welfare.
The HDI might be a better measure of economic welfare because it includes some important factors that
affect welfare and which are omitted from GDP. In particular, life expectancy is included in the HDI but
not in GDP and on this count the HDI is superior. The HDI also includes direct measures of the quality
and quantity of education. These are indirectly included in GDP because they affect GDP per person, but
it might be the case that the direct inclusion in the HDI is better.
74 CHAPTER 4

b. Which items in the HDI are part of real GDP and which items are not in real GDP?
The HDI is based on real GDP per person and so directly includes GDP. In addition, the quality and
quantity of education affect people’s productivity, which is closely related to GDP per person. So real
GDP indirectly includes some of the education effects explicitly included in the HDI.
c. Do you think the HDI should be expanded to include items such as pollution, resource
depletion, and political freedom? Explain why.
Ideally factors such as pollution, political freedom, and so forth should be included in a broad measure of
welfare. Two difficulties, however, occur. One difficulty comes when trying to measure these variables. For
instance, how can political freedom be measured in a way that is accepted by all? A second difficulty is
weighting these factors. For instance, how much should political freedom be weighted relative to GDP per
person?
d. What other influences on economic welfare should be included in a comprehensive measure?
Aside from the factors listed above, potentially some measure of culture might be included. Another set of
factors might attempt to take into account sustainability. But otherwise the list above is fairly
comprehensive.
18. Study Reading Between the Lines on pp. 500–501(98-99 in Macroeconomics) and then answer
the following questions:
a. Which components of aggregate expenditure increased at the fastest rate in the second
quarter of 2008?
The two components that increased the most were net exports and government expenditure on goods and
services.
b. Which components of aggregate expenditure increased at the slowest rate (or decreased at the
fastest rate) in the second quarter of 2008?
The two components that increased the slowest was consumption expenditure and investment, which
actually fell. (Imports also decreased, but this fact served to increase U.S. aggregate expenditure.
c. For how long has the U.S. economy been expanding since the last business cycle trough?
After the business cycle trough in 2001 the U.S. economy expanded until 2007, an expansion of 6 years.
As this answer is written, the United States is still in a recession and so the time the economy has been
expanding since the last business cycle trough depends on when the trough occurs and when the students
are answering the question.
d. Argue the case that the economy was in recession in 2007 and 2008.
Real GDP contracted in the last quarter of 2007. Growth in the first quarter was a tiny 0.9 percent and in
the second quarter was only 1.9 percent. Moreover growth in the second quarter was boosted by $100
billion of tax rebates, which would not recur in future quarters. Absent those tax rebates and the resulting
increase in consumption expenditure growth in the second quarter would have been much lower.
Essentially the economy was in a recession and that recession was concealed by the one-time effects of the
tax rebates.
e. Argue the case that the economy was not in recession in 2007 and 2008.
The conventional definition of a recession is six or more consecutive months of contraction in real GDP.
Quite simply that has not occurred. U.S. GDP decreased for three months in the last quarter but since
then real GDP growth has been positive and even increasing.
MEASURING GDP AND ECONOMIC GROWTH 75

19. Use the link on MyEconLab (Chapter Resources, Chapter 21, Web links) to find the available
data from the BEA on GDP and the components of aggregate expenditure and aggregate
income. The data are in current prices (nominal GDP) and constant prices (real GDP).
a. What are the levels of nominal GDP and real (chained-dollar) GDP in the current quarter?
These answers will change from one quarter to the next. For an example, on September 1, 2008 the most
recent quarter was 2008 Q2. Nominal GDP in that quarter was $14,312.5 trillion and real (chained
dollar) GDP was $11,740.3 trillion.
b. What was the level of real GDP in the same quarter of the previous year?
These answers will change from one quarter to the next. For an example, on September 1, 2008 the year-
ago quarter was 2007 Q2. Real GDP in that quarter was $11,491.4 trillion.
c. By what percentage has real GDP changed over the past year?
These answers will change from one quarter to the next. For an example, on September 1, 2008 real GDP
had grown from $11,491.4 billion to $14,740.3 billion, a growth rate of [($14,740.3 − $11,491.4 billion)
/ $14,491.4 billion] × 100, or 1.71 percent.
76 CHAPTER 4

Additional Problems

1. The figure above shows the flows of expenditure and income for a small nation. During 2009,
A was –$15 million, B was $40 million, C was $90 million, and D was $45 million. Calculate
a. Aggregate expenditure.
b. Aggregate income.
c. GDP.
2. The transactions in Jupiter last year
Item Dollars
are in the table to the right.
GDP 1.400,000
a. Calculate Jupiter’s aggregate
Consumption expenditure 700,000
expenditure.
Taxes 350,000
b. Calculate Jupiter’s net exports. Transfer payments 150,000
c. Calculate Jupiter’s government Profits 300,000
expenditure. Investment 350,000
Exports 400,000
Saving 400,000
Imports 350,000
MEASURING GDP AND ECONOMIC GROWTH 77

3. Desert Kingdom produces only

Quantities 2008 2009
dates and camel rides. The base
Dates 1,000 pounds 1,100 pounds
year is 2008, and the tables
Camel rides 50 rides 60 rides
give the quantities produced
and the prices in 2008 and
Prices
2009. Calculate Desert
Kingdom’s Dates $1 per pound $2 per pound
Camel rides $100 per ride $120 per ride
a. Nominal GDP and real GDP
in 2008 and 2009.
b. Real GDP in 2009 in terms of the base-year prices.
4. Desert Kingdom (described in problem 3) decides to use the chain-weighted output index
method of calculating real GDP. Using this method, calculate
a. The growth rate of real GDP in 2009.
b. Compare and comment on the differences in real GDP in terms of the base-year prices and
real GDP calculated using the chain-weighted output index method.
78 CHAPTER 4

Solutions to Additional Problems

1. a. Aggregate expenditure is $160 million. Aggregate expenditure is the sum of consumption expenditure,
investment, government expenditure, and net exports. In the figure, C is consumption expenditure, D is
investment, B is government expenditure, and A is net exports. So aggregate expenditure equals $90 million
plus $45 million plus $40 million minus $15 million, which is $160 million.
b. Aggregate income is $160 million. Aggregate income equals aggregate expenditure, which from part a is
$160 million.
c. GDP is $160 million. GDP equals aggregate expenditure, which from part a is $160 million.
2. a. Jupiter’s aggregate expenditure is $1,400,000. Aggregate expenditure equals GDP and Jupiter’s GDP is
$1,400,000.
b. Jupiter’s net exports equals $50,000. Net exports equal exports, $400,000, minus imports, $350,000.
c. Jupiter’s government expenditure was $300,000. Aggregate expenditure equals the sum of consumption
expenditure, investment, government expenditure, and exports minus imports. That is, $1,400,000 equals
$700,000 plus $350,000 plus government expenditure plus $400,000 minus $350,000. Solving this
equation for government expenditure gives $300,000.
3. a. In 2008, nominal GDP is $6,000. In 2009, nominal GDP is $9,400.
Nominal GDP in 2008 is equal to total expenditure on the goods and services produced by Desert Kingdom
in 2008. Expenditure on dates is 1,000 pounds at $1 a pound, which is $1,000. Expenditure on camel rides
is 50 rides at $100 a ride, which is $5,000. Total expenditure is $6,000, so nominal GDP in 2008 is $6,000.
Nominal GDP in 2009 is equal to total expenditure on the goods and services produced by Desert Kingdom
in 2009. Expenditure on dates is 1,100 pounds at $2 a pound, which is $2,200. Expenditure on camel rides
is 60 rides at $120 a ride, which is $7,200. Total expenditure is $9,400, so nominal GDP in 2009 is $9,400.
b. Real GDP in 2009 is terms of base-year prices is $7,100.
To calculate real GDP in 2009 in terms of base-year prices, we calculate market value of the 2009 quantities
at the base-year prices of 2008. To value the 2009 output at 2008 prices, expenditure on dates is 1,100
pounds at $1 a pound (which is $1,100), and expenditure on camel rides is 60 rides at $100 a ride (which is
$6,000). So real GDP in 2009 in terms of base-year prices is $7,100.
4. a. The growth rate of real GDP in 2009 is 17.9 percent.
The chain-weighted output index 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 $6,000. The value of the 2009 quantities at 2008 prices is
$7,100. We now compare these values. The increase in the value is $1,100. The percentage increase is
($1,100 ÷ $6,000) × 100, which is 18.33 percent.
The value of the 2008 quantities at 2009 prices is $8,000. The value of the 2009 quantities at 2009 prices is
$9,400. We now compare these values. The increase in the value is $1,400. The percentage increase is
($1,400 ÷ 8,000) × 100, which is 17.5 percent.
The chain-weighted output index calculates the growth rate as the average of these two percentage growth
rates. That is, the growth rate in 2009 is 17.9 percent
b. Real GDP in 2009 in terms of base-year prices is $7,100. Real GDP in 2009 using the chain-weighted
output index method is $7,074. Real GDP growth is fastest when real GDP is measured in terms of base-
year prices.