Chapter 24

Review Questions

1. What is the difference between real GDP and nominal GDP?

Real GDP is adjusted for inflation and the nominal is not. Real GDP is measured in units of base year dollars (for some base year). For example, real GDP in the year 2000, in base-year 1990 prices, calculates how much the goods and services produced in 2000 would have been worth using prices from 1990 (base-year-prices), instead of prices in 2000. In contrast, nominal GDP for any year (1990, 2000) is measured using the prices of that same year (1990, 2000).

2. Roughly how large is the U.S. GDP? Roughly how large is world GDP? How big is GDP per person in the United States? GDP per person in the world?

In Fall, 2000, the U.S. GDP was roughly $10,000 billion or $10 trillion per year. With population of about 277 million, the U.S. GDP per person was roughly $36, 000 per year.

World GDP in Fall, 2000 was roughly $41 trillion. With world population of about 6.1 billion people, this amounted to about $6500 per person each year.

Thinking Exercises

3. Use the numbers in Table 2 to calculate real GDP in 2010 measured in 1998 dollars.

Price of Videos in 1998	Price of Pillows in 1998	Videos in 2010	Pillows in 2010	Real GDP of year 2010 in 1998 Dollars
6	8	9	16	69+816=182

4. A nation of elves produces only one good: cookies. In 1990, cookies sold for 2 cents each; in 1998, they cost 3 cent each; in 2000, they cost 4 cents each. How is this nation’s real GDP related to the number of cookies it produces? How does your answer depend on your choice of the base year for measuring real GDP?

The nation's real GDP equals the number of cookies produced in the given year times the price of cookies in the base year. For example, choose 1990 to be the base year. In that case to calculate real GDP in cents for any year simply double the number of produced cookies. To express the GDP in dollars, divide the result by 100.

Review Questions

5. Consumption is (roughly) what fraction of GDP?

Consumption accounts roughly for two-thirds of U.S. GDP.

6. How is the unemployment rate measured in the United States?

The unemployment rate is the percentage of unemployed people in the labor force. The labor force is the sum of employed and unemployed people. Notice that people that are not in the labor force (not employed and not looking for jobs) are not included for calculation of the unemployment rate.

7. What is a recession? What happens to unemployment during a recession?

A recession occurs when real GDP is unusually low relative to its trend value. Some economists define a recession as a period when real GDP falls for two consecutive quarters (3-month periods), although official recession dates set by the National Bureau of Economic Research are based on more sophisticated criteria.

The unemployment increases during recessions.

8. List three main problems in measurement (or interpretation) of GDP.

First, GDP figures omit production of goods and services that are not sold on markets. This component includes housework, meals cooked at home, and child care provided by parents, as well as services volunteered for charities and other groups. For example, when parents care for their own children, the value of their care does not appear in GDP. However, when parents pay for child care, those services appear in GDP (for more examples see the book).

Second, GDP includes only a very imperfect estimate of production of goods and services sold on the underground economy (or black market). This activity includes production of illegal goods and services (such as drugs and prostitution). It also includes production of legal goods that goes unreported to avoid taxes. Many estimates suggest that the underground economy in the United States amounts to between 5 and 10 percent of GDP; this figure is even larger in many other countries.

Third, special measurement problems result when GDP includes certain goods that are not sold on markets. When you rent a house or apartment, your expenses appear in GDP as payments for housing services. However, if you own the house or apartment where you live, GDP includes the government’s estimate of the rent that you would pay if you were renting.

9. List three main problems in measurement (or interpretation) of unemployment.

First, unemployment tends to be understated by official numbers, which ignore discouraged workers, who do not have jobs but have given up hope of finding them and stopped looking. The government classifies these people as not in the labor force.

Second, unemployment tends to be understated, because it counts underemployed workers (mathematicians driving cabs, and so on) as fully employed people. Similarly, official statistics count people who work part-time as employed, although they may want full-time jobs.

Third, official statistics overstate unemployment to the extent that people are not truthful or not serious about looking for work (some of them, although they are not really interested in getting a job may declare themselves as unemployed to receive the unemployment benefits).

Thinking Exercise

10. Explain how you could try to estimate a broader concept of GDP that would include final goods and services that are currently omitted or measured at their costs of production (instead of their equilibrium prices).

Review Questions

11. Explain three problems with measurements of the average price level.

The three main problems are substitution bias, new-good bias, and quality-change bias.

Substitution bias: When a price of one good goes up, people tend to spend less on it and buy more of some substitutes. However, the CPI measures the increase in the cost of buying the same amounts of all goods. As a result, the change in the CPI overstates the increase in the cost of living.

New-good bias: As new goods appear in the market, they need to be included into the CPI, otherwise the CPI would reflect cost of purchasing a combination of goods that are not accurate for the cost of living of current consumers. But including them to the CPI index makes the comparisons across years not 100% clear.

Quality-change bias - the goods that we buy often change in quality over time but keep the same names. For example, a high-end laptop computer is much more powerful than it was even a year ago. This is true not only for electronics products but also for most other categories of goods. One can try to measure the improvements in order to say what fraction of the change of the price is due to changes of quality and what due to changes of cost of living. This process is quite difficult though and is always made with some errors. (Think about examples of products for which such quality adjustments are relatively easy and for which they are relatively difficult).

12. How is the consumer price index calculated?

The consumer price index measures the average nominal prices of goods and services that a typical family living in an urban area buys. The CPI is a weighted average; goods such as salt and shoelaces (on which people spend small fractions of their incomes) receive less weight in the average than goods like cars and televisions, on which people spend more money.

Questions and Problems

12. Which issue of macroeconomics listed in the introduction to this chapter involves normative judgment?

The last question: What (government) policies are best? To answer it we would need to decide what norms we use to rank policies.

14. About what fractions of U.S. GDP are spent on consumption, investment, and government purchases of goods and services?

Consumption constitutes about 2/3 of the GDP, Investment about 15% and Government purchases about 20%.

15. Why doesn’t GDP cover all government spending, including transfer payments (such as social security)?

The transfer payments are not included in GDP because it would lead to double accounting. These money are not directly connected to buying any product. They are either spent by their recipients on consumption or saved and then being lent by banks, spent on investment, or some other combination. If we added the transfers to the GDP, value of the same products would appear twice and this would create a bias.

16. How is GDP affected when (a) you buy a used textbook? (b) You buy a video? (c) You rent a video? (d) A town cleans up after a tornado? (e) Microsoft introduces a new computer operating system? (f) Someone buys cocaine from Colombia? (g) The government raises taxes? (h) A town builds a new school?

a) It is not affected. (Unless you buy it in a store and then the value of the service provided by the store is added to GDP. In this case the difference between the prices at which the store bought the book and at which it sold it is added to the GDP).

b) The price you paid for the video adds to the GDP: you bought a new good.

c) The price that you paid adds to the GDP - new service have been provided.

d) The cost of cleaning adds to the GDP - new services have been provided.

e) Every copy they sell adds to the GDP.

f) This is not added to the GDP as an illegal, unreported transaction. Even if it was a legal transaction - say somebody buys a car in Germany, it would not be added to the GDP as GDP measures goods produced in the given country. In that case the value of the car would be first added as consumption and then subtracted as an import.

g) It does not by itself imply producing more or less of any goods so the increase of taxes has no immediate effect on GDP (though, it can influence it indirectly by affecting behavior of firms or consumers).

h) The cost of the school is added to the GDP as government purchases.

17. Purchases of cars and stereo systems are part of consumption spending. Why might someone sensibly decide to count them as investment instead of consumption?

Unlike typical consumer goods, say food or movie tickets, you can use a car or a stereo system more than once and over quite long time. Buying a car you pay for its benefits that you enjoy over the whole period of time that you use it. And as you do, the value of the car decreases.

In this sense they are similar to investment goods that are being used repeatedly in the production process over extended periods of time. And as time passes, they depreciate.

18. Do the three main problems in measuring price indexes also create problems in measuring real GDP? Explain whether and how each problem applies to real GDP.

Real GDP depends on the prices in the base year. So from the technical point of view, the calculated numbers are not affected, but because of these problems, the calculated number is more difficult to interpret. We calculate real GDP to get a measure of the value of production adjusted for inflation. However these problems can affect it:

Substitution bias: As consumers' tastes change and as new technological improvements are introduced, the relative prices of goods change. Such changes are independent of inflation so optimally we would like the real GDP measure to take them into consideration. For example, as more people started using cellular phones, the cost of supplying this service went down and so has price. In the real GDP the value of these services is measured using old, higher prices, overstating the increase in the value of production.

New-good bias: it is very difficult to include new goods into the real GDP: In the base year they did not exist and hence their price was infinite.

Quality-change bias: if you simply take the number of TV sets produced and multiply it by the price of a typical TV set in the base year, the value of production is going to be underestimated, as this measure does not take into account the improvements in quality.

19. Why should we adjust a price index, like the CPI, for changes in the quality of goods? What is wrong with simply measuring price changes and ignoring changes in quality?

The price of a high-end personal computer stayed more or less constant (say, around $3000) over the last couple of years. Would you agree to a statement that the computers haven't got any cheaper over this period of time?

In order to obtain a meaningful measure of the change of costs of living, we have to take into account the change of quality of goods. As times goes on, in many markets producers improve the quality of goods and introduce new features that consumers are willing to pay for.

By simply measuring price changes and ignoring changes in quality we overstate the change in the cost of living. Not surprisingly a car with a stronger engine costs more than a car with weaker one. If the producer changes the engine in the car and subsequently increases the price, we should not treat it as an increase in the cost of living.

20. Why does substitution bias always lead the CPI to overstate inflation? Why doesn’t it lead the CPI to understate inflation?

Substitution bias in measuring CPI is implied by the fact, that as one good gets relatively more expensive, people ten to buy LESS of it and more of some substitute goods that get relatively cheaper. By this substitution consumers partly avoid the increase of the goods.

For example, suppose that the price of oranges goes up by 10% and the price all other fruits stays constant. Clearly, we should expect the consumption of oranges to fall relative to consumption of other fruits. By substituting away from oranges, consumers partly avoid the increase of price of oranges. However, the CPI would measure the cost of living as if no substitution took place. Clearly this would result in overstatement and not understatement.