Chapter 21 Study Questions

Problem 1 1. For each of the following transactions, determine if it takes place in the market for outputs or the market for inputs. Then, determine the direction of the flow of goods and services and the flow of money between households and businesses. Finally, determine how GDP as measured by the market value of output, spending on output, income received, or wages and profits changes. a. Labanya purchases a robotic vacuum cleaner on Amazon for $375. b. Matt gets paid $3,000 to teach a creative writing class at his local community college. c. Dollar General hires 10 new workers at the federal minimum wage to staff a new store. d. 96 million people purchased a monthly Spotify premium subscription for $10 last month.

Solution 1 a. Market for outputs. Flow of goods (vacuum cleaner) from businesses (Amazon and vacuum manufacturer) to household (Labanya). Flow of money ($375) from household (Labanya) to businesses (Amazon and vacuum manufacturer). GDP increases as measured by spending on output. b. Market for inputs. Flow of services (teaching) from household (Matt) to businesses (the community college). Flow of money ($3,000) from business (the community college) to household (Matt). GDP increases as measured by income received. c. Market for inputs. Flow of services (staffing of store) from new workers (Dollar General cashiers and other personnel) to the business (Dollar General). Flow of money (federal minimum wage) from business to workers. GDP increases as measured by wages and profits. d. Market for outputs. Flow of goods and services (Spotify app and music streaming) from business (Spotify) to households (subscription purchasers). Flow of money ($960 million) from households (Spotify users) to business (Spotify). GDP increases as measured by market value of output.

Question 10 10. You read two articles online. The first says GDP grew by 5% last quarter, but the second states that the economy grew by 3.4% over the same time period. What do you think explains the difference in the two measures?

Solution 10 10. The authors of the articles may be referencing two different calculations of last quarter's GDP. The first article referenced nominal GDP growth, and the second article referenced real GDP growth. Real GDP growth would be smaller than nominal GDP growth because the calculation of real GDP removes the impact of rising prices.

Problem 10 10. If nominal GDP rose, does that mean that production had to increase as well? Why or why not? What about if real GDP increased? Why is it important to use real GDP when comparing changes over time?

Solution 10 If nominal GDP rose, it does not necessarily mean that production increased. It could mean that production (quantity of output) increased, or it could mean that prices increased. It could also mean that both quantity and price increased by some combination. If real GDP increased, it means that production increased, because prices are held constant. When comparing changes over time, using real GDP is important because, by excluding the effect of price changes, real GDP isolates economic growth.

Question 11 11. In 2018, U.S. President Donald Trump proposed a 33% cut in the United States Agency for International Development (USAID) budget for the upcoming fiscal year, which would have reduced USAID spending in 2019 to $16.8 billion. His total proposed 2019 budget for the U.S. federal government was $4.4 trillion. How could you explain the magnitude of foreign aid spending by developing a sense of scale?

Solution 11 People often struggle to correctly comprehend extremely large numbers, because most people don't work with large numbers on a regular basis. The money spent on foreign aid is only a small fraction of total expenditures. To help people develop a sense of scale, you could express the USAID budget as a percentage of total expenditures. You could also divide the USAID budget by the population to express the spending in dollars per person.

Problem 13 13. In 2018, India was the world's seventh largest economy, with a $2.69 trillion GDP (as measured in U.S. dollars). India was also one of the world's fastest-growing economies, with an annual growth rate of real GDP of 7.3%. a. If the country maintains the same growth rate, how many years will it take for India's GDP to double? b. Bangladesh's GDP was $286.27 billion, but its growth rate was equal to India's. How many years will it take for Bangladesh's economy to double? c. Although Bangladesh and India have the same annual growth rate, their economies are much different in size. How can you explain the size difference to someone who is unfamiliar with scaling large numbers? Which strategies would you use?

Solution 13 13. a. years. b. years. c. Bangladesh is much smaller than India, both in physical size and population. Bangladesh's economy is much smaller as well: $286.27 billion versus $2.69 trillion. You could also calculate Bangladesh's GDP as a percentage of India's GDP, or evaluate the GDP of both countries in per person terms.

Question 2 2. You bought an old car a couple years ago for $1,000 and put about $5,000 of parts and labor into improving it. You sold it yesterday for $3,000. How does this sale affect GDP? Explain.

Solution 2 2. The sale itself does not affect GDP. GDP does not include the sale of second-hand goods. When you sold the car, you simply changed the ownership of a car that had already been counted in GDP the year it was produced. However, part or all of the $5,000 you spent on parts and labor may contribute to this year's GDP. If you bought the car parts new, your spending on the parts contributed to GDP as a sale of a final good. If you worked on the car yourself, your labor did not count toward GDP. However, if you paid a mechanic to work on the car, you contributed to GDP as spending on a service.

Problem 2 2. In 2017, GDP in Switzerland was $680 billion and GDP in the United States was $19.5 trillion. Does this indicate that the standard of living in Switzerland must be well below that of the United States? Switzerland has a population of 8 million people, while the United States has a population of 326 million people. How could you better scale the numbers to compare their standards of living?

Solution 2 The 2017 measures of GDP do not indicate that the standard of living in Switzerland must be well below that of the United States. Looking at GDP alone often results in a misleading interpretation of living standards. Although U.S. GDP greatly exceeds that of Switzerland, the U.S. population is also much larger. To accurately compare standards of living, you must use GDP per person. GDP per person in the United States was $19.5 trillion ÷ 326 million people = $59,816 per person. GDP per person in Switzerland was $680 billion ÷ 8 million people = $85,000 per person. Controlling for differences in population reveals that Switzerland's GDP per person is higher than that of the United States.

Question 3 3. After reading a report that says that around 70% of U.S. GDP is consumption, your friend Alex states, "Spending 70% of GDP on consumption is a lot. All people care about is buying stuff, consuming stuff, and accumulating stuff. We would be much better off if we spent our money on services or experiences." Identify Alex's misunderstanding of GDP.

Solution 3 3. Figure 4 divides GDP per person as total spending into its four components. Consumption accounts for 69% of total GDP, so Alex heard the statistic right. However, Figure 5 illustrates GDP as total output by sector. Although Americans do consume "stuff," output comprises much more. Alex misunderstood that GDP includes not only the purchase of goods, but also the purchase of services which includes experiences. In fact, services account for 82% of output (so 82% of GDP).

Problem$3,000) from business (the community college) to household (Matt). GDP increases as measured by income received. c. Market for inputs. Flow of services (staffing of store) from new workers (Dollar General cashiers and other personnel) to the business (Dollar General). Flow of money (federal minimum wage) from business to workers. GDP increases as measured by wages and profits. d. Market for outputs. Flow of goods and services (Spotify app and music streaming) from business (Spotify) to households (subscription purchasers). Flow of money ($960 million) from households (Spotify users) to business (Spotify). GDP increases as measured by market value of output. 3 3. Determine whether each of the following transactions contributes to the calculation of GDP as total spending, then, identify the relevant component of GDP (C, I, G, or NX). a. Michelin sells tires to Nissan to install on their 2019 Sentras that are produced and sold in the United States. b. Molly Maid company provides house cleaning services across the United States. c. American consumers import $3.5 billion of woven apparel from Bangladesh. d. The U.S. government spent $523.1 billion on national defense. 3. Entrepreneur and Shark Tank investor Barbara Corcoran purchasing 15% of Cousins Maine Lobster food truck company for $55,000.

Solution 3 a. Not in GDP. The tires count as intermediate goods. However, the sale of the vehicles would belong in GDP as consumption. b. Contributes to GDP as consumption. Molly Maid provides house cleaning as a service for a fee. However, someone cleaning their own house would not contribute to GDP. c. Contributes to GDP calculation in NX. d. Contributes to GDP as government purchases. e. Not in GDP. Not part of investment because Cousins Maine was already an existing company.

Question 4 4. Think of a good or service you've purchased in the last month. Explain how your purchase changed GDP by using each of the three ways to measure GDP: adding up every dollar spent, adding up every dollar's worth of output produced by detailing the value added at every stage of production, and adding up every dollar of income earned. How should GDP differ based on the way it is measured?

Solution 4 4. Student answers for individual purchases will vary. Students can trace the good from its origination as raw materials through each stage of production, documenting the value added and incomes earned along the way. The purchase increased GDP, as measured by total spending, by the market value of the good or service, which is also equal to the sum of the value added and the sum of income earned at each production stage. All three perspectives of GDP result in the same measure. In practice, differences in measure result from differences in sources of imperfect data.

Question 5 5. Explain how total spending and total income for an economy must be equal.

Solution 5 5. When you work, you earn income in exchange for your labor. You then spend your earned money on goods and services. Every dollar that you spend on goods and services is a dollar of income for someone else, and so total spending must be equal to total income.

Question 6 6. From your own experiences, provide an example of each: consumption, investment, government purchases, and net exports.

Solution 6 6. Student experience will vary. Consumption includes spending on goods and services, which include most everyday transactions. Students may mention examples of business investment, such as new inventory or equipment. Government purchases are when the government spends money, such as paying teachers or expanding infrastructure. Exports and imports make up net exports. Students may mention items they purchase that are manufactured in another country, such as clothes made in India or gadgets made in China. Example of exports from the United States could include crops or pharmaceuticals.

Problem 6 6. Explain why total spending on T-shirts in the previous problem is also equal to the total incomes earned in the economy. Hint: there are two sides to every transaction.

Solution 6 There are two sides to every transaction—a buyer and a seller—so that every dollar that a buyer spends also registers as a dollar of income to a seller. With the income, a seller pays wages to its employees and keeps the remainder as profit. As a result, GDP equals total spending and total income, which is the sum of total wages and total profits.

Problem 7 7. Vinny and Sandra have just had their first baby, and need to make a decision about how to handle work and child-care responsibilities. Explain how each of the options below will affect measured GDP, relative to when they both worked full time and had no child-care responsibilities. a. Both Vinny and Sandra will return to work, and pay a child-care provider $600 per week to care for their child. b. Both Vinny and Sandra will return to work, while Sandra's mother takes care of their child without financial compensation. c. Both Vinny and Sandra will return to work, While Vinny's brother takes care of their baby. They'll pay him $600 a week to care for their child, but neither they nor Vinny's brother will report those payments to the IRS or on any government surveys. d. Vinny and Sandra will each return to work part time, and split child-care responsibilities. e. Vinny will stay home to care for the baby, while Sandra returns to work full time.

Solution 7 7. a. Increase in GDP b. No change in GDP c. No change in GDP d. Decrease in GDP e. Decrease in GDP

Question 7 7. Jeremiah expressed his disdain for the economic reports he heard on the news. "All economists care about is increasing GDP," he said. "I wish economists cared about living conditions and well-being instead of just some economic indicator." How could you acknowledge the shortcomings of GDP to Jeremiah, while also showing him how GDP functions as both an economic indicator and a measure of well-being?

Solution 7 7. In general, GDP fails to consider the following: prices are not values, household production, the underground economy, environmental degradation, and leisure. Although GDP per person ignores distribution of income, it provides an idea of how much the average person earns. Higher income enables people to move beyond subsistence living. Higher GDP per person is associated with greater life satisfaction, higher education levels, longer life expectancy, and lower infant mortality rates. Economists care about the growth rate of GDP because overall, higher GDP means there are more resources available for people to improve their well-being.

Question 8 8. In 2010, 4.9 million barrels of oil spilled into the Gulf of Mexico due to an explosion on an oil rig. Describe both the negative and positive impact this disaster had on GDP. Explain how this example highlights the limitations of GDP.

Solution 8 Positive impacts on GDP could include the expenditures on clean-up. Negative impacts on GDP could include the lost tourism and fishing in the impacted areas. One important limitation of GDP is that environmental degradation isn't counted. As a result, the loss of marine life and gulf water habitats do not impact GDP.

Problem 9 9. Identify the limitation of GDP relevant to each scenario. a. The U.S. Department of Commerce reports that a "dead zone" of low oxygen that can kill fish and marine life in the Gulf of Mexico has grown as large as the state of New Jersey. It is the result of agricultural and developed land runoff in the Mississippi River watershed. b. The World Bank reports that in 2015 the income share held by the lowest 10% of the U.S. population was 1.7%. The income share held by highest 10% of the population was 30.6%. c. Data from the Pew Research Center shows that one-in-five U.S. parents are stay-at-home moms or dads. d. U.S. GDP per person is around 15% higher than Netherlands GDP per person. However, in the United States, people work about 26% more hours than people in the Netherlands. e. Most internet searches (86.5%) occur via Google, Google Maps, or Google Images, all of which provide search results for free.

Solution 9 9. a. Environmental degradation isn't counted. b. GDP ignores distribution. c. Nonmarket activities are excluded. d. Leisure doesn't count. e. Prices are not values.

Question 9 9. Between 2000 and 2017, real GDP per person grew, on average, 1% per year in the United States. Did this GDP growth benefit all Americans? What does this tell us about the limitations of GDP as a measure of living standards?

Solution 9 9. On average, Americans are better off because after controlling for inflation, average income (and output and spending) increased. Higher average GDP per person is closely related to many indicators of quality of life. However, the GDP growth from 2000 to 2017 did not necessarily benefit all Americans. Real GDP per person tells us how much the average person's income changes, but it does not tell us anything about how people in the lower end (or any part) of the distribution fared. As a result, the growth may have benefitted some but not others.

Problem 12 12. The growth rate of nominal GDP was 9.4%, and the growth rate of real GDP was 7.4% for Iceland in 2016. Approximately what was the percentage change in prices?

Solution12 12. % change in prices = % change in nominal GDP - % change in real GDP % change in prices = 9.4% − 7.4% = 2%