ECONOMICS 161

FALL 2003
E. McDEVITT STUDY QUESTIONS-SET #2

GDP, PRICE INDEX

1. What is the formal definition of GDP? Why do we use the market value of goods and services to measure
GDP?
2. What is an intermediate good and why are these goods excluded from GDP? Explain how under different
circumstances flour might be considered either a final good or an intermediate good.
3. Which of the following transactions should be included in GDP for 2003:
a. Glass currently produced and used by GM as an automobile side-window.
b. Glass currently produced and sold directly to households.
c. The purchase of newly produced imported cars.
d. The sales commission paid to the domestic seller of an imported car.
e. Salaries paid to US Naval officers.
f. The purchase of a 15th-century painting (exclusive of sales commission).
g. Newly produced, but unsold, wheat.
h. Purchase of IBM stock (exclusive of brokerage fees).
4. What are some of the shortcomings of GDP (as currently measured) as a measure of total production.
5. Suppose a new environmental law forces some steel firms to close their plants and therefore causes a
reduction in steel production. Explain how this might simultaneously lead to a drop in GDP as currently
measured and a rise in the actual level of total production (which includes clean air as good).
6. Suppose that an uneconomic private rail service is taken over and operated by the government. When
operated privately, the rail service had a market value of $100 million. The cost to the government of
providing identical rail service is $120 million. What is the impact on GDP as a result of the switch to
government ownership?
7. Explain how a how sharp increase in income tax rates might cause a sharp drop in measured GDP while the
actual level of production also falls, but by a much smaller amount.
8. What is the economic definition of investment? What are the different kinds of investment?
9. Why are transfer payments excluded from government expenditures?
10. Explain why total production is necessarily equal to total expenditure.
11. What is wrong with the following statement: "Inflation causes a continuous rise in the price level."
12. What is the price level and how do we measure it?
13. Use the following information to answer the questions below:
2001 2002 2003
Good Price Quantity P Q P Q
X $1 100 X $1 200 X $2 200
Y $2 50 Y $2 100 Y $4 100
a. Calculate nominal GDP for each year.
b. Assume that 2001 is the base year. Calculate the GDP deflator for each year.
c. Calculate real GDP for each year.
d. Calculate the annual percentage change for nominal GDP, real GDP for 2002 and 2003.
e. Calculate the annual inflation rate for 2002 and 2003.
14. Use the following information to answer the questions below:
YEAR NOMINAL GDP (in billions) PRICE LEVEL (1996=100)
1929 $103.7 12.6
1933 $56.4 9.4
1989 $5,489.1 83.3
1990 $5,803.2 86.5
1991 $5,986.2 89.7
2000 $9,872.9 107.0
2001 $10,208.1 109.4
a. Find the inflation rate for 1991 and 2001.
b. Find real GDP for each year.
15. The money (nominal) price of oil was approximately $5/barrel in 1972, $39 in 1981, and $25 in 2000.
Find the real price of oil for each year. The price level for these years was 31.8, 62.4, and 107.0, respectively.
 ANSWERS
1. GDP--the market value of all final goods and services newly produced within a nation during some period
of time. So that the we can put each good and service into the same unit-the dollar unit in the case of the US.
2. Intermediate good- a good used up in the production of another good during the same period that it itself
was produced. We exclude these goods to avoid double counting. If flour is currently produced, but not sold
(i.e., not used up in the production of bread), then it is considered a final good. If it is sold in used to make
bread, then it is an intermediate good and therefore not counted in GDP.
3. a. Not counted. Intermediate good.
b. Counted. It is newly produced and it is a final good.
c. Not counted. Was not domestically produced.
d. Counted. This is a currently produced service.
e. Counted. Newly produced service.
f. Not counted. Not newly produced.
g. Counted. Newly produced and final good.
4. a. It excludes household production because it is difficult to measure this non-market production. But since
household production represents current production we would like to count this in GDP.
b. Underground economy. Again, it is difficult to measure non-market transactions. Some current production
may not be reported (to avoid paying taxes) and some current production may be illegal (bootleg liquor).
c. Environmental goods such as clean air or clean water are difficult to measure because there is no formal
market transaction. People value these goods just as they value cars, food, shelter, etc., so we would ideally
like to include this in GDP.
d. Government production is measured at cost of production instead of at market value. There is no guarantee
that the value of some govt. goods will exceed their cost.
e. Quality changes, new products.
5. If the value of the increased clean air exceeds the value of the lost steel, then total production increased. But
since steel production is included in GDP measures, but clean air is not, this would show up as a reduction in
measured GDP.
6. Since government production is measured at cost, it would show up as an increase in GDP. This is
misleading since the market value has not changed.
7. If this causes a drop in reported production (income) then measured GDP would fall. The actual drop is
much smaller since many people are still producing goods and services, they are just not reporting it.
8. Investment=fixed investment (purchase of newly produced capital goods) + inventory investment (changes
in the level of inventories). Notice that this definition of investment does NOT include financial transactions.
9. Transfer payments do not represent payments to individuals in exchange for goods and services currently
produced.
10. We assume that goods not sold to consumers are "purchased" by the firm from itself.
11. Inflation does not cause a continuous rise in the price level because inflation is a continuous rise in the
price level.
12. The price level is a measure of the average money price of final goods and services. It is measured by a
price index.
13. a. Nominal GDP for each year 2001: $1*100+$2*50=$200, 2002: $1*200+$2*100= $400,
2003: $2*200+$4*100= $800. b. 2001: GDP deflator = 100.
2002: GDP deflator = [(1*200 + 2*100)/(1*200 + 2*100) ] * 100 = 100.
2003: GDP deflator = [(2*200 + 4*100)/(1*200+2*100)] * 100 = 200.
c. Real GDP for 2001 = Nominal GDP for 2001/[Price level for 2001/100]= $200/1 = $200.
Real GDP for 2002 = Nominal GDP for 2002/[Price level for 2002/100]= $400/1 = $400.
Real GDP for 2003 = Nominal GDP for 2003/[Price level for 2003/100]= $800/2 = $400.
d. 2002: Nominal GDP percentage change= [(400-200)/200 ] * 100% = 100%.
2003 : Nominal GDP percentage change = [(800-400)/400] * 100% = 100%.
2002: Real GDP percentage change = [(400-200)/(200)] *100% = 100%.
2003 Real GDP percentage change = [(400-400)/400] *100% = 0%.
e. For 2002: Inflation rate = [(100-100)/100] *100% = 0%.
For 2003: Inflation rate = [(200-100)/100]*100% = 100%.
14. a.3.7% in 1991 and 2.2% in 2001. 14 b. $823.0, $600, $6,589.6, $6,708.9,6,$6,673.6,$9,227 and
$9,330.9, respectively.
15. $15.72,$62.5, and $23.36, respectively.