# GDP and the Standard of Living

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1 GDP and the Standard of Living Chapter 20 CHAPTER IN PERSPECTIVE Chapter 20 explains GDP and how it is measured. It shows why GDP is the same whether measured as income, as expenditure, or as the value of production. It explains the difference between real and nominal GDP, and the limitations of GDP as a measure of the standard of living. Define GDP and explain why the value of production, income, and expenditure are the same for an economy. Gross Domestic Product, GDP, is the market value of all the final goods and services produced within a country in a given time period. Only final goods and services are included in GDP; intermediate goods and services are not included. Expenditures are consumption expenditure (C), investment (I), government purchases of goods and services (G), and net exports (NX). Total expenditure equals C + I + G + NX. Firms pay out everything they receive as incomes to the factors of production. We call total income Y. The circular flow shows that total expenditure equals total income so that Y = C + I + G + NX. Describe how economic statisticians measure GDP in the United States. GDP is measured using the expenditure approach and the income approach. The expenditure approach adds the four sources of expenditure: consumption expenditure, investment, government purchases of goods and services, and net exports. The income approach adds the National Income and Products Accounts five categories of income (compensation of employees, net interest, rental income of persons, corporate profits, and proprietors income). This sum is net domestic product at factor cost. To get GDP, indirect taxes are added, subsidies are subtracted, and depreciation is added to net domestic product at factor cost. Value added is the value of a firm s production minus the value of the intermediate goods it uses. Distinguish between nominal GDP and real GDP and define the GDP deflator. GDP changes when prices or production change. Real GDP is the value of final goods and services produced in a given year valued at constant prices; nominal GDP is the value of final goods and services produced in a given year using prices that prevailed in that year. The GDP deflator is an average of current prices expressed as a percentage of base-year prices and equals (nominal GDP real GDP) 100. Explain and describe the limitations of real GDP as a measure of the standard of living. GDP measures the value of goods and services that are bought in markets. It does not measure household production, underground production, the value of leisure time, the environmental quality, health and life expectancy, and political freedom and justice.

2 304 Part 7. MONITORING THE MACROECONOMY EXPANDED CHAPTER CHECKLIST When you have completed this chapter, you will be able to: 1 Define GDP and explain why the value of production, income, and expenditure are the same for an economy. Define GDP. Explain the difference between a final good or service and an intermediate good or service, and tell why only final goods and services are included in GDP. Discuss the four types of expenditure. State why the value of production equals income, which equals expenditure. 2 Describe how economic statisticians measure GDP in the United States. Explain the expenditure approach to measuring GDP. Discuss why used goods and financial assets are not included in GDP. Explain the income approach to measuring GDP and discuss each of the components. State what adjustments must be made to net domestic product at factor cost to convert it to GDP. Define value added and calculate it. 3 Distinguish between nominal GDP and real GDP and define the GDP deflator. Define nominal GDP and real GDP, and explain the difference between them. Calculate real GDP. Define the GDP deflator and calculate it. 4 Explain and describe the limitations of real GDP as a measure of the standard of living. List the goods and services omitted from GDP and explain why each of these goods and services are not measured in GDP. Discuss how these omitted factors affect the standard of living. KEY TERMS Gross domestic product (GDP) (page 494) Final good or service (page 494) Intermediate good or service (page 494) Consumption expenditure (page 495) Investment (page 495) Government purchases of goods and services (page 496) Net exports of goods and services (page 496) Exports of goods and services (page 496) Imports of goods and services (page 496) Net domestic product at factor cost (page 502) Depreciation (page 502) Value added (page 503) Real GDP (page 505) Nominal GDP (page 505) GDP deflator (page 507) CHECKPOINT 20.1 Define GDP and explain why the value of production, income, and expenditure are the same for an economy. Practice Problems Classify each of the following items as a final good or service or an intermediate good or service: a. Banking services bought by a student. b. New cars bought by Hertz, the car rental firm. c. Newsprint bought by USA Today from International Paper. d. Ice cream bought by a diner and used to produce sundaes. 2. During 2001 on Lotus Island, net taxes were \$10 billion; consumption expenditure was \$30 billion; government purchases of goods and

3 Chapter 20. GDP and the Standard of Living 305 services were \$12 billion; investment was \$15 billion; and net exports were \$3 billion. Calculate: a. Total expenditure. b. Total income. c. GDP. Solution to Practice Problems 20.1 For the first question, ask if the good is used to produce another good or service. If so, it is an intermediate good. For the second question, keep in mind the equality between total expenditure, total income, and GDP. Quick Review Total expenditure Total expenditure is the total amount received by producers of final goods and services and equals C + I + G + NX. Total income Total income is the income paid to all factors of production and equals total expenditure. 1a. Banking services bought by a student. Because the student uses the services and does not use them to produce or sell anything else, the banking services are a final service 1b. New cars bought by Hertz, the car rental firm. Hertz is the final buyer of the cars so they are a final good. The cars are additions to capital and are part of investment when they are bought. 1c. Newsprint bought by USA Today from International Paper. Because the newsprint was bought to be processed into newspapers that will be sold to others, this is an intermediate good. The newspapers are the final goods, not the newsprint itself. 1d. Ice cream bought by a diner and used to produce sundaes. The sundaes are the final goods. The ice cream that was bought by the diner to make the sundaes is an intermediate good. During 2001 on Lotus Island, net taxes were \$10 billion; consumption expenditure was \$30 billion; government purchases of goods and services were \$12 billion; investment was \$15 billion; and net exports were \$3 billion. Calculate: 2a. Total expenditure. Total expenditure is the sum of consumption expenditure, investment, government purchases of goods and services and net exports. Total expenditure = C + I + G + NX, or \$30 billion + \$15 billion + \$12 billion + \$3 billion = \$60 billion. 2b. Total income. Total income is always equal to total expenditure, so it also is \$60 billion. You don t have the information about wages, rents, interest, and profits that would allow a separate calculation of total income, but you don t need to make that calculation. 2c. GDP. GDP can be measured either as total income or as total expenditure. So GDP is \$60 billion. Additional Practice Problem 20.1a Last year consumption expenditure was \$70 billion, investment was \$16 billion, government purchases of goods and services were \$12 billion, exports were \$4 billion, and imports were \$3 billion. This year imports increased to \$5 billion. If all the other types of expenditure stay the same, what was GDP last year, GDP this year, and how did GDP change from last year? Solution to Additional Practice Problem 20.1a To solve this problem use the equality between GDP and expenditure, GDP = C + I + G + NX. Last year s GDP = \$70 billion + \$16 billion + \$12 billion + (\$4 billion \$3 billion) = \$99 billion. This year, imports increased from \$3 billion to \$5 billion, so replace the \$3 billion in the calculation with \$5 billion and GDP for this year is \$97 billion. The \$2 billion increase in imports results in a \$2 billion decrease in GDP.

4 306 Part 7. MONITORING THE MACROECONOMY Self Test 20.1 Fill in the blanks The market value of all the final goods and services produced within a country in a given time period is (GDP; investment). (Two; Three; Four) groups buy the final goods and services produced. Net exports equals the value of (imports; exports) minus the value of (imports; exports). C + I + G + NX equals and. True or false 1. The computer chip that Dell Corp. buys from Intel Corp. is a final good. 2. Expenditure on a bulldozer is consumption expenditure. 3. The value of net exports of goods and services can be negative. 4. The value of production equals income, which equals expenditure. Multiple choice 1. The abbreviation GDP stands for a. Gross Domestic Product. b. Gross Domestic Prices. c. General Domestic Prices. d. Great Domestic Prices. 2. GDP is equal to the value of all the final goods and services produced within a country in a given period of time. a. production b. market c. wholesale d. retail 3. The following are all final goods except a. flour used by the baker to make cup cakes. b. bread eaten by a family for lunch. c. pencils used by a 6th grader in class. d. Nike shoes used by a basketball player. 4. Investment is defined as a. the purchase of a stock or bond. b. financial capital. c. what consumers do with their savings. d. the purchase of new capital goods by firms. 5. In one year, a firm increases its production by \$9 million worth of computers and increases sales by \$8 million. All other things in the economy remaining the same, which of the following is true? a. GDP increases by \$8 million and inventory investment decreases by \$1 million. b. GDP increases by \$9 million and inventory investment increases by \$1 million. c. Inventory investment decreases by \$1 million. d. GDP increases by \$8 million and investment increases by \$1 million. 6. Total expenditure equals a. C + I + G + NX. b. C + I + G NX. c. C + I G + NX. d. C I + G + NX. Short answer and numeric questions 1. Why aren t intermediate goods or services counted in GDP? 2. Classify each of the following into the components of U.S. GDP: consumption expenditure, investment, government purchases of goods and services, exports, or imports. a. The purchase of a Sony DVD player made in Japan. b. A family s purchase of a birthday cake at the local Safeway grocery store. c. Microsoft s purchase of 1,000 Dell computers. d. The purchase of a new pizza oven by Pizza Hut. e. The government s purchase of 15 stealth fighters. 3. Why does total expenditure equal total income?

5 Chapter 20. GDP and the Standard of Living 307 CHECKPOINT 20.2 Describe how economic statisticians measure GDP in the United States. Practice Problem The table below gives some of the items in the U.S. National Income and Product Accounts in Amount (billions of Item dollars) Compensation of employees 5,875 Consumption expenditure 6,987 Indirect taxes less subsidies 630 Net interest 650 Corporate profits 732 Capital consumption 1,329 Rental income of persons 138 Investment 1,586 Net exports 349 Proprietors income 728 a. Calculate U.S. GDP in b. Did you use the expenditure approach or the income approach to make this calculation? c. How much did the U.S. government spend on goods and services in 2001? d. By how much did capital in the United States depreciate in 2001? Solution to Practice Problem 20.2 This question focuses on calculating GDP. To solve problems such as this, you need to know how to use the expenditure approach and the income approach. The expenditure approach adds four categories of expenditure while the income approach adds five income categories and then makes a few additional adjustments. Quick Review Expenditure approach GDP equals the sum of consumption expenditure, investment, government purchases, and net exports. Income approach GDP equals the sum of compensation of employees, net interest, rental income of persons, corporate profits and proprietors income, plus indirect taxes minus subsidies, and depreciation. The sum of the first five income categories is net domestic product at factor cost. a. Calculate U.S. GDP in To calculate GDP using the expenditure approach you need to know the values of consumption, investment, government purchases, and net exports. The table does not give the value of government purchases, so you cannot find GDP using the expenditure approach. To calculate GDP using the income approach you need to know the values of compensation of employees, net interest, rental income of persons, corporate profits, proprietors incomes, indirect taxes less subsidies, and depreciation, called capital consumption. All these items are listed in the table, so GDP can be calculated using the income approach. In this case, GDP = \$5,875 billion + \$650 billion + \$138 billion + \$732 billion + \$728 billion + \$630 billion + \$1,329 billion, which is \$10,082 billion. b. Did you use the expenditure approach or the income approach to make this calculation? The only way you could get GDP in (a) is by the income approach, which is the approach used. c. How much did the U.S. government spend on goods and services in 2001? You calculated GDP in (a) using the income approach. The expenditure approach notes that GDP = C + I + G + NX. Subtract C, I, and NX from both sides of the equation to show that G = GDP C I NX. Using the values of GDP, C, I, and NX yields G = \$10,082 billion \$6,987 billion \$1,586 billion + \$349 billion = \$1,858 billion. (The net exports were negative, so ( \$349 billion) equals + \$349 billion). d. By how much did capital in the United States depreciate in 2001? Depreciation is the loss of value of capital that results from use and obsolescence. Depreciation also is called capital consumption, so the amount of depreciation is the amount of capital consumption, listed in the table as \$1,329 billion.

8 310 Part 7. MONITORING THE MACROECONOMY Quick Review Nominal GDP The value of the final goods and services produced in a given year valued at the prices that prevailed in that year. a. Nominal GDP in Nominal GDP in 2001 equals the 2001 expenditure on bananas, (100 \$10), plus the expenditure on coconuts, (50 \$12), which is \$1,000 + \$600 = \$1,600. b. Nominal GDP in Similar to part (a), nominal GDP in 2002 = (110 \$15) + (60 \$10) = \$1,650 + \$600 = \$2,250. c. The value of 2002 production in 2001 prices. The value of 2002 production in 2001 prices equals the expenditure on bananas, (110 \$10), plus the expenditure on coconuts, (60 \$12), which is \$1,100 + \$720 = \$1,820. d. The percentage increase in production when valued at 2001 prices. In 2001 prices, the value of production increases from \$1,600, in part (a), to \$1,820, in part (c). The increase is \$220, so the percentage increase is equal to (\$220 \$1,600) 100, or percent. e. The value of 2001 production in 2002 prices. The value of 2001 production in 2002 prices equals the expenditure on bananas, (100 \$15), plus the expenditure on coconuts, (50 \$10), which is \$1,500 + \$500 = \$2,000. f. The percentage increase in production when valued at 2002 prices. In 2002 prices, the value of production increases from \$2,000, in part (e), to \$2,250, in part (b). The increase is \$250, so the percentage increase is equal to (\$250 \$2,000) 100, which is percent. g. Real GDP in 2001 and 2002 using the chain-linking method. Because 2001 is the base year, real GDP in 2001 equals nominal GDP in 2001, which is \$1,600. To calculate real GDP in 2002 it is necessary to compute the growth rate of real GDP between 2001 and That growth rate is the average of the growth rates between 2001 and 2002 using prices from 2001 and from Using the answers to parts (d) and (f), the average percentage increase is percent. Real GDP in 2002 is percent greater than real GDP in Real GDP in 2001 is \$1,600, so real GDP in 2002 equals (\$1,600) ( ), which is \$1,810. h. The GDP deflator in GDP deflator = (Nominal GDP Real GDP) 100 = (\$2,250 \$1,810) 100 = Additional Practice Problem 20.3a Answer the following questions. a. Nominal GDP = \$10 trillion, real GDP = \$9 trillion. What is the GDP deflator? b. Real GDP = \$8 trillion, GDP deflator = 120. What is nominal GDP? c. Nominal GDP = \$12 trillion, GDP deflator = 120. What is real GDP? Solution to Additional Practice Problem 20.3a a. Nominal GDP = \$10 trillion, real GDP = \$9 trillion. What is the GDP deflator? GDP deflator = (Nominal GDP Real GDP) 100 = (\$10 trillion \$9 trillion) 100 = b. Real GDP = \$8 trillion, GDP deflator = 120. What is nominal GDP? Rearranging the formula used in part (a) gives (GDP deflator Real GDP) 100 = Nominal GDP, so (120 \$8 trillion) 100 = \$9.6 trillion. c. Nominal GDP = \$12 trillion, GDP deflator = 120. What is real GDP? Once again rearranging the formula used in part (a) gives (Nominal GDP GDP deflator) 100 = Real GDP, so (\$12 trillion 120) 100 = \$10 trillion. Self Test 20.3 Fill in the blanks (Real; Nominal) GDP values production during the year using constant prices; (real; nominal) GDP values production using prices that prevailed during the year. If the

9 Chapter 20. GDP and the Standard of Living 311 GDP deflator rises, nominal GDP rises more (rapidly; slowly) than real GDP. The GDP deflator equals 100 times (real nominal) GDP divided by (real; nominal) GDP. True or false 1. Nominal GDP increases only if the production of final goods and services increases. 2. Real GDP is just a more precise name for GDP. 3. Real GDP equals nominal GDP in the base year. 4. If real GDP is \$600 billion and nominal GDP is \$750 billion, then the GDP deflator is 125. Multiple choice 1. Nominal GDP can change a. only if prices change. b. only if the quantities of goods and services change. c. only if prices increase. d. if either prices or the quantities of goods and services change. 2. The difference between nominal GDP and real GDP is a. the indirect taxes used in their calculations. b. the prices used in their calculations. c. that nominal GDP includes the depreciation of capital and real GDP does not. d. that nominal GDP includes net exports and real GDP includes net imports. 3. Real GDP measures the value of goods and services produced in a given year valued using a. constant prices. b. prices that prevail the same year. c. no prices. d. future prices. 4. If nominal GDP increases, then real GDP a. must decrease. b. must increase. c. must not change. d. could increase, decrease, or not change. 5. The GDP deflator is a measure of a. taxes and subsidies. b. changes in quantities. c. prices. d. depreciation. 6. The GDP deflator is calculated as a. (nominal GDP real GDP) 100. b. (real GDP nominal GDP) 100. c. (nominal GDP + real GDP) 100. d. (nominal GDP real GDP) 100. Short answer and numeric questions 1. An economy produces only pizza and soda. The table gives the quantities produced and prices in 2003 and The base year is Data for 2003 Data for 2004 Item Quantity Price Quantity Price Pizza 100 \$ \$20.00 Soda 50 \$ \$4.00 a. What is nominal GDP in 2003? b. What is real GDP in 2003? c. What is nominal GDP in 2004? d. What is real GDP in 2004? 2. If you want to measure the change in production, is it better to use nominal GDP or real GDP? Why? 3. How does the term chain linking apply to real GDP? CHECKPOINT 20.4 Explain and describe the limitations of real GDP as a measure of the standard of living. Practice Problem 20.4 The United Nations Human Development Report gives the following data for real GDP per person in 2000: China \$3,976; Russia, \$8,377; Canada, \$27,840; United States, \$34,142. Other information suggests that household production is similar in Canada and the United States and smaller in these two countries than in the other two. The underground economy is largest

10 312 Part 7. MONITORING THE MACROECONOMY in Russia and China and a similar proportion of the economy in these two cases. Canadians and Americans enjoy more leisure hours than do the Chinese and Russians. Canada and the United States spend significantly more to protect the environment, so that air, water, and land pollution is less in those countries than in China and Russia. Given this information and ignoring any other influences on the standard of living a. In which pair (or pairs) of these four countries is it easiest to compare the standard of living? Why? b. In which pair (or pairs) of these four countries is it most difficult to compare the standard of living? Why? c. What more detailed information would we need to be able to make an accurate assessment of the relative standard of living in these four countries? d. Do you think that real-gdp-per-person differences correctly rank the standard of living in these four countries? Solution to Practice Problem 20.4 Comparing GDP per person is perhaps the most common method of comparing the standard of living among different countries. This question reminds us that other factors also matter when it comes to determining the standard of living. Quick Review Goods and services omitted from GDP Household production, underground production, leisure time, and environmental quality are omitted from GDP. a. In which pair (or pairs) of these four countries is it easiest to compare the standard of living? Why? The factors that affect the standard of living, but which are not measured by real GDP per person, are similar in Canada and the United States. Comparing these two countries living standards based on real GDP per person likely would give a proper ranking. Similarly, Russia and China are stated to be similar in the areas not measured by real GDP per person, so a comparison between these two countries based on measurement of real GDP per person is likely to rank their standard of living correctly. b. In which pair (or pairs) of these countries is it most difficult to compare the standard of living? Why? Comparing either the United States or Canada to Russia or China would be the most difficult. Take the comparison between the United States and Russia for an example. The fact that household production in Russia is a larger proportion of the economy than in the United States means that a comparison based on real GDP per person looks less favorable to Russia than the actual differences in living standards warrant. On the other hand, Russia does less to protect the environment than does the United States, so Russians would suffer more of the consequences of pollution. That would make the comparison based on real GDP per person more favorable to Russia than it really should be. Similarly, less leisure in Russia makes the comparison too favorable to Russia. Because some of the problems make Russia look better and some make it look worse, it is hard to tell what a proper comparison would be. A similar conclusion is true for the United States to China, Canada to Russia, and Canada to China comparisons. c. What more detailed information would we need to be able to make an accurate assessment of the relative standard of living in these four countries? If we knew the actual value of the underground economy in each country (the value of household production, the value of leisure, and the value of environmental quality), we could adjust real GDP per person in each country to make a more accurate assessment of the relative standard of living. d. Do you think that real-gdp-per-person differences correctly rank the standard of living in these four countries? The areas where real GDP per person fails to measure living standards are similar in the United States and Canada, so the comparison between the United States and Canada based

12 314 Part 7. MONITORING THE MACROECONOMY make to the doctor to complain of breathing difficulties. Which of the following is true? a. GDP will decrease as a result of fewer doctor services being provided. b. GDP is not affected. c. GDP will increase to reflect the improvement in the health of the population. d. GDP will increase to reflect the improvement in the health of the population, and the likely increase in the cost of the car. 5. The calculation of GDP using the income approach excludes a. rental income. b. proprietors income. c. environmental quality. d. compensation of employees. 6. Good health and life expectancy are a. included in GDP but not in our standard of living. b. included in both GDP and in our standard of living. c. included in our standard of living but not in GDP. d. not included in either our standard of living or in GDP. Short answer and numeric questions 1. What general categories of goods and services are omitted from GDP? Why is each omitted? 2. If you cook a hamburger at home, what happens to GDP? If you go to Burger King and purchase a hamburger, what happens to GDP?

13 Chapter 20. GDP and the Standard of Living 315 SELF TEST ANSWERS CHECKPOINT 20.1 Fill in the blanks The market value of all the final goods and services produced within a country in a given time period is GDP. Four groups buy the final goods and services produced. Net exports equals the value of exports minus the value of imports. C + I + G + NX equals total expenditure and total income. True or false 1. False; page False; page True; page True; page 497 Multiple choice 1. a; page b; page a; page d; page b; page a; page 496 Short answer and numeric questions 1. Intermediate goods or services are not counted in GDP because if they were, they would be double counted. A computer produced by Dell Corp. is included in GDP. But if the Intel chip that is part of the computer is also included in GDP, then that production is counted twice: once when it is produced by Intel, and again when it is included in the computer produced by Dell; page a. Import; page 496. b. Consumption expenditure; page 497. c. Investment; page 497. d. Investment; page 497. e. Government purchases of goods and services; Total expenditure is the amount received by producers of final goods and services. Because firms pay out everything they receive as incomes to the factors of production, total expenditure equals total income. From the viewpoint of firms, the value of production is the cost of production, which equals income. From the viewpoint of consumers of goods and services, the value of production is the cost of buying it, which equals expenditure; page 497. CHECKPOINT 20.2 Fill in the blanks The expenditure approach and the income approach are two methods used to calculate GDP. Expenditure on used goods is not included in GDP. Compensation of employees is part of the income approach to calculating GDP. To calculate GDP, depreciation is added to net domestic product at factor cost. The value of a firm s production minus the value of the intermediate goods it buys is called the firm s valued added. True or false 1. True; page False; page False; page False; page 503 Multiple choice 1. b; page d; page b; page a; page d; page b; page 502 Short answer and numeric questions 1. a. GDP = \$6,400, the sum of consumption expenditure, investment, government purchases of goods and services, and net exports; page 499. b. Net domestic product at factor cost equals \$5,300, the sum of compensation of employees, net interest, corporate

15 Chapter 20. GDP and the Standard of Living 317 CHECKPOINT 20.4 Fill in the blanks The value of household production is not included in GDP. The value of people s leisure time is not included in GDP. As it is calculated, GDP does not subtract the value of environmental degradation resulting from production. Real GDP does not take into account the extent of a country s political freedom. True or false 1. True; page False; page False; page True; page 511 Multiple choice 1. c; page b; page b; page a; page c; page c; page 510 Short answer and numeric questions 1. Goods and services omitted from GDP are household production, underground production, leisure time, and environmental quality. GDP measures the value of goods and services that are bought in markets. Because household production, leisure time, and environmental quality are not purchased in markets, they are excluded from GDP. Even though underground production frequently is bought in markets, the activity is unreported and is not included in GDP; pages If you cook a hamburger at home, the meat you purchased is included in GDP but the production of the hamburger is not included in GDP because it is household production. If you buy a hamburger at Burger King, the production of the hamburger is included in GDP; page 519.

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