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Chapter 5

Measuring a Nation’s Income

SOLUTIONS TO TEXTBOOK PROBLEMS

Quick Quizzes

1. What two things does gross domestic product measure? How can it measure two things at once?

Gross domestic product measures two things: (1) the total income of everyone in the economy; and (2) the total expenditure on the economy’s output of goods and services. It can measure both of these things at once because income must equal expenditure for the economy as a whole.

2. Which contributes more to GDP—the production of a kilogram of hamburger or the production of a kilogram of caviar? Why?

The production of a kilogram of caviar contributes more to GDP than the production of a kilogram of hamburger because the contribution to GDP is measured by market value and the price of a kilogram of caviar is much higher than the price of a kilogram of hamburger.

3. List the four components of expenditure. • What does it mean when net exports have a negative value?

The four components of expenditure are: (1) consumption; (2) investment; (3) government purchases; and (4) net exports. Net exports are equal to the difference between the value of exports and the value of imports. When our country imports more than it exports, net exports are negative.

4. Define real and nominal GDP. Which is a better measure of economic well-being? Why?

Nominal GDP is the production of goods and services valued at current prices. Real GDP is the production of goods and services valued at constant prices. Real GDP is a better measure of economic well-being because it reflects the economy’s ability to satisfy people’s needs and desires. Thus, a rise in real GDP means people have produced more goods and services, but a rise in nominal GDP could occur either because of increased production and/or because of higher prices.

5. Why should policymakers care about GDP?

Although GDP is not a perfect measure of economic well-being, policymakers should care about it because a larger GDP means that a nation can afford better health care, better educational systems, and more of the material necessities of life.

1. Explain why an economy’s income must equal its expenditure.

An economy’s income must equal its expenditure since every transaction has a buyer and a seller. Thus, expenditure by buyers must equal income of sellers.

2. Which contributes more to GDP—the production of an economy car or the production of a luxury car? Why?

The production of a luxury car contributes more to GDP than the production of an economy car because the luxury car has a higher market value.

3. A farmer sells wheat to a baker for $2. The baker uses the wheat to make bread, which is sold for $3. What is the total contribution of these transactions to GDP?

The contribution to GDP is $3, the market value of the bread, which is the final good that is sold.

4. Many years ago Peggy paid $500 to put together a record collection. Today she sold her albums at a garage sale for $100. How does this sale affect current GDP?

The sale of used records does not affect GDP at all because it involves no current production.

5. List the four components of GDP. Give an example of each.

The four components of GDP are consumption, such as the purchase of a music CD; investment, such as the purchase of a computer by a business; government purchases, such as an order for military aircraft; and net exports, such as the sale of Canadian wheat to Russia.

6. Why do economists use real GDP rather than nominal GDP to gauge economic well-being?

Economists use real GDP rather than nominal GDP to gauge economic well-being because real GDP is not affected by changes in prices, so it reflects only changes in the amounts being produced. If nominal GDP rises, you do not know if that is because of increased production and/or higher prices.

7. In the year 2014, the economy produces 100 loaves of bread that sell for $2 each. In the year 2015, the economy produces 200 loaves of bread that sell for $3 each. Calculate nominal GDP, real GDP, and the GDP deflator for each year. (Use 2014 as the base year.) By what percentage does each of these three statistics rise from one year to the next?

The percentage change in nominal GDP is (600 – 200)/200 × 100 = 200%. The percentage change in real GDP is (400 – 200)/200 × 100 = 100%. The percentage change in the deflator is (150 – 100)/100 × 100 = 50%.

8. Why is it desirable for a country to have a large GDP? Give an example of something that would raise GDP and yet be undesirable.

It is desirable for a country to have a large GDP because people could enjoy more goods and services. But GDP is not the only important measure of economic well-being. For example, laws that restrict pollution cause GDP to be lower. If laws against pollution were eliminated, GDP would be higher, but the pollution might make us worse off. Or, for example, an earthquake would raise GDP, as expenditures on cleanup, repair, and rebuilding increase. But an earthquake is an undesirable event that lowers our welfare.

Quick Check Multiple Choice

1. If the price of a hot dog is $2 and the price of a hamburger is $4, then 30 hot dogs contribute as much to GDP as what number of hamburgers?

a. 5

b. 15

c. 30

d. 60

2. Angus the sheep farmer sells wool to Barnaby the knitter for $20. Barnaby makes two sweaters, each of which has a market price of $40. Collette buys one of them, while the other remains on the shelf of Barnaby’s store to be sold later. What is GDP here?

a. $40

b. $60

c. $80

d. $100

3. Which of the following does NOT add to Canada’s GDP?

a. Air France buys a plane from Bombardier, the Canadian aircraft manufacturer.

b. PotashCorp develops a new mine in Saskatchewan.

c. The city of Toronto pays a salary to a police officer.

d. The federal government sends a Canada Pension Plan cheque to your grandmother.

4. A Canadian buys a pair of shoes manufactured in Italy. How is the transaction treated in Canada’s national income accounts?

a. net exports and GDP both rise

b. net exports and GDP both fall

c. net exports fall, while GDP is unchanged

d. net exports are unchanged, while GDP rises

5. What is the largest component of GDP?

a. consumption

b. investment

c. government purchases

d. net exports

6. If all quantities produced rise by 10 percent and all prices fall by 10 percent, which of the following occurs?

a. Real GDP rises by 10 percent, while nominal GDP falls by 10 percent.

b. Real GDP rises by 10 percent, while nominal GDP is unchanged.

c. Real GDP is unchanged, while nominal GDP rises by 10 percent.

d. Real GDP is unchanged, while nominal GDP falls by 10 percent.

1. b

2. c

3. d

4. c

5. a

6. b

Problems and Applications

1. What components of GDP (if any) would each of the following transactions affect? Explain.

a. A family buys a new refrigerator.

b. Aunt Jane buys a new house.

c. Ford sells a Thunderbird from its inventory.

d. You buy a pizza.

e. Quebec repaves Highway 50.

f. Your parents buy a bottle of French wine.

g. Honda expands its factory in Alliston, Ontario.

a. Consumption increases because a refrigerator is a good purchased by a household.

1. Investment increases because a house is an investment good.

2. Consumption increases because a car is a good purchased by a household, but investment decreases because the car in Ford’s inventory had been counted as an investment good until it was sold.

3. Consumption increases because pizza is a good purchased by a household.

4. Government purchases increase because the government spent money to provide a good to the public.

5. Consumption increases because the bottle is a good purchased by a household, but net exports decrease because the bottle was imported.

6. Investment increases because new structures and equipment were built.

2. The “government purchases” component of GDP does not include spending on transfer payments such as Employment Insurance. Thinking about the definition of GDP, explain why transfer payments are excluded.

With transfer payments, nothing is produced, so there is no contribution to GDP.

3. Why do you think households’ purchases of new housing are included in the investment component of GDP rather than the consumption component? Can you think of a reason why households’ purchases of new cars should also be included in investment rather than in consumption? To what other consumption goods might this logic apply?

Purchases of new housing are included in the investment portion of GDP because housing provides services for a long time. For the same reason, purchases of new cars could be thought of as investment, but by convention they are not. The logic could apply to any durable good, such as household appliances.

4. As the chapter states, GDP does not include the value of used goods that are resold. Why would including such transactions make GDP a less informative measure of economic well-being?

If GDP included goods that are resold, it would be counting output of that particular year, plus sales of goods produced in a previous year. It would double-count goods that were sold more than once and would count goods in GDP for several years if they were produced in one year and resold in another.

5. Below are some data from the land of milk and honey.

a. Compute nominal GDP, real GDP, and the GDP deflator for each year, using 2013 as the base year.

b. Compute the percentage change in nominal GDP, real GDP, and the GDP deflator in 2014 and 2015 from the preceding year. For each year, identify the variable that does not change. Explain in words why your answer makes sense.

c. Did economic well-being rise more in 2014 or 2015? Explain.

a. Calculating nominal GDP:

2013: ($1 per L of milk  100 L milk) + ($2 per L of honey  50 L honey) = $200

2014: ($1 per L of milk  200 L milk) + ($2 per L of honey  100 L honey) = $400

2015: ($2 per L of milk  200 L milk) + ($4 per L of honey  100 L honey) = $800

Calculating real GDP (base year 2008):

2013: ($1 per L of milk  100 L milk) + ($2 per L of honey  50 L honey) = $200

2014: ($1 per L of milk  200 L milk) + ($2 per L of honey  100 L honey) = $400

2015: ($1 per L of milk  200 L milk) + ($2 per L of honey  100 L honey) = $400

Calculating the GDP deflator:

2013: ($200/$200)  100 = 100

2014: ($400/$400)  100 = 100

2015: ($800/$400)  100 = 200

b. Calculating the percentage change in nominal GDP:

Percentage change in nominal GDP in 2014 = [($400 – $200)/$200]  100 = 100%.

Percentage change in nominal GDP in 2015 = [($800 – $400)/$400]  100 = 100%.

Calculating the percentage change in real GDP:

Percentage change in real GDP in 2014 = [($400 – $200)/$200]  100 = 100%.

Percentage change in real GDP in 2015 = [($400 – $400)/$400]  100 = 0%.

Calculating the percentage change in GDP deflator:

Percentage change in the GDP deflator in 2014 = [(100 – 100)/100]  100 = 0%.

Percentage change in the GDP deflator in 2015 = [(200 – 100)/100]  100 = 100%.

Prices did not change from 2013 to 2014. Thus, the percentage change in the GDP deflator is zero. Likewise, output levels did not change from 2014 to 2015. This means that the percentage change in real GDP is zero.

c. Economic well-being rose more in 2014 than in 2015, since real GDP rose in 2014 but not in 2015. In 2014, real GDP rose and prices didn’t. In 2015, real GDP didn’t rise and prices did.

6. Consider an economy that produces only chocolate bars. In year 1, the quantity produced is 3 bars and the price is $4. In year 2, the quantity produced is 4 bars and the price is $5. In year 3, the quantity produced is 5 bars and the price is $6. Year 1 is the base year.

a. What is nominal GDP for each of these three years?

b. What is real GDP for each of these years?

c. What is the GDP deflator for each of these years?

d. What is the percentage growth rate of real GDP from year 2 to year 3?

e. What is the inflation rate as measured by the GDP deflator from year 2 to year 3?

f. In this one-good economy, how might you have answered parts (d) and (e) without first answering parts (b) and (c)?

a. Calculating Nominal GDP:

Year 1: (3 bars  $4) = $12

Year 2: (4 bars  $5) = $20

Year 3: (5 bars  $6) = $30

b. Calculating Real GDP:

Year 1: (3 bars  $4) = $12

Year 2: (4 bars  $4) = $16

Year 3: (5 bars  $4) = $20

c. Calculating the GDP deflator:

Year 1: $12/$12  100 = 100

Year 2: $20/$16  100 = 125

Year 3: $30/$20  100 = 150

d. The growth rate of real GDP from Year 2 to Year 3 = (20 – 16)/16  100 = 25%

e. The inflation rate from Year 2 to Year 3 = (150 – 125)/125  100 = 20%

f. To calculate the growth rate of real GDP, we could simply calculate the percentage change in the quantity of bars. To calculate the inflation rate, we could measure the percentage change in the price of bars.

7. Consider the following data on Canadian GDP:

a. What was the growth rate of nominal GDP between 2013 and 2014? (Note: The growth rate is the percentage change from one period to the next.)

b. What was the growth rate of the GDP deflator between 2013 and 2014?

c. What was real GDP in 2013 measured in 2007 prices?

d. What was real GDP in 2014 measured in 2007 prices?

e. What was the growth rate of real GDP between 2013 and 2014?

f. Was the growth rate of nominal GDP higher or lower than the growth rate of real GDP? Explain.

a. The growth rate of nominal GDP between 2013 and 2014 is ($1975 – $1893)/$1893  100% = 4.3%.

b. The growth rate of the deflator is (113 – 111)/111  100% = 1.8%.

c. Real GDP in 2013 (in 2007 dollars) is $1893/(111/100) = $1,705.

d. Real GDP in 2014 (in 2007 dollars) is $1975/(113/100) = $1,748.

e. The growth rate of real GDP is ($1748 – $1705)/$1705  100% = 2.5%.

f. The growth rate of nominal GDP is greater than the growth rate of real GDP because the inflation rate was positive.

8. If prices rise, people’s income from selling goods increases. The growth of real GDP ignores this gain, however. Why, then, do economists prefer real GDP as a measure of economic well-being?

Economists ignore the rise in people’s incomes that is caused by higher prices because although incomes are higher, the prices of the goods and services that people buy are also higher. Therefore, they will not necessarily be able to purchase more goods and services. For this reason, economists prefer to look at real GDP instead of nominal GDP.

9. Revised estimates of Canadian GDP are usually released by Statistics Canada near the end of each month. Find a newspaper article that reports on the most recent release, or read the news release yourself at www.statcan.gc.ca, the website of Statistics Canada. Discuss the recent changes in real and nominal GDP and in the components of GDP.

Many answers are possible.

10. Goods and services that are not sold in markets, such as food produced and consumed at home, are generally not included in GDP. Can you think of how this might cause the numbers in the second column of Table 5.4 to be misleading in a comparison of the economic well-being of Canada and India? Explain.

In countries like India, people produce and consume a fair amount of food at home that is not included in GDP. So GDP per person in India and Canada will differ by more than their comparative economic well-being.

11. The participation of women in the Canadian labour force has risen dramatically since 1970.

a. How do you think this rise affected GDP?

b. Now imagine a measure of well-being that includes time spent working in the home and taking leisure time. How would the change in this measure of well-being compare to the change in GDP?

c. Can you think of other aspects of well-being that are associated with the rise in women’s labour-force participation? Would it be practical to construct a measure of well-being that includes these aspects?

a. The increased labour-force participation of women has increased GDP in Canada, since it means more people are working and production has increased.

b. If our measure of well-being included time spent working in the home and taking leisure, it wouldn’t rise as much as GDP, since the rise in women’s labour-force participation has reduced time spent working in the home and taking leisure.

c. Other aspects of well-being that are associated with the rise in women’s increased labour-force participation include increased self-esteem and prestige for women in the workforce, especially at managerial levels, but decreased quality time spent with children, whose parents have less time to spend with them. Such aspects would be quite difficult to measure.

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