ECON 151

Prepare: Chapter 8
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In order to get full credit, answer all questions in either bold font or red font.
Read Chapter 8 in the Hubbard/O’Brien text.

1. Define gross domestic product (GDP). Why is market value used instead of quantities? Is the value of
intermediate goods and services included in GDP?
GDP is the market value of all final goods and services produced in a country during a period,
typically one year. The word value is important in the definition of GDP. In microeconomics, we
measure production in quantity terms: the number of cars Ford produces, the tons of wheat U.S.
farmers grow, or the number of turkey sandwiches Panera Bread sells. When we measure total
production in the economy, we can’t just add together the quantities of every good and service
because the result would be a meaningless jumble. Numbers of cars would be added to tons of wheat,
gallons of milk, numbers of sandwiches, and so on. Instead, we measure production by taking the
value, in dollar terms, of all the goods and services produced. The value of intermediate goods and
services are not included in GDP rather, the final goods and services are included in calculating GDP.

2. Why does the value of total production in the economy equal the value of total income? Explain
simply and use the example in the text of the New Balance running shoes.
When we measure the value of total production in the economy by calculating GDP, we are at the
same time measuring the value of total income. To see why the value of total production is equal to
the value of total income, consider what happens to the money you spend on a single product.
Suppose you buy a pair of New Balance running shoes for $149 at a Foot Locker store. All of that
$149 must end up as someone’s income. New Balance and Foot Locker will receive some of the $149
as profits, workers at New Balance will receive some as wages, the salesperson who sold you the
shoes will receive some as salary, the firms that sell components to New Balance will receive some as
profits, the workers for those firms will receive some as wages, and so on. So, the amount that you
spend on the shoes equals the amount of income received by the people who make and sell the shoes.
Therefore, if we add up the values of every good and service sold in the economy, we must get a total
that is exactly equal to the value of all the income in the economy.

3. List and define the four components of GDP.

Consumption
Spending by households on goods and services, not including spending on new houses.
Investment
Spending by firms on new factories, office buildings, machinery, and additions to inventories, plus
spending by households and firms on new houses.
Government purchases are spending by federal, state, and local governments on goods and services,
such as teachers’ salaries, highways, and aircraft carriers. Again, government spending on transfer
payments is not included in government purchases because the spending does not result in the
production of new goods and services.
Net exports are equal to exports minus imports. Exports are goods and services produced in the
United States and purchased by foreign firms, households, and governments.

4. What are the two types of production not included in GDP? Give two examples of each type of
production.
 Household Production
If a person has been caring for children, cleaning the house, and preparing the family meals, the
value of such services is not included in GDP. If the person then decides to work outside the
home, enrolls the children in day care, hires a cleaning service, and begins buying the family’s
meals in restaurants, the value of GDP will rise by the amount paid for day care, cleaning
services, and restaurant meals, even though production of these services has not actually
increased.
The Underground Economy
Illegal drugs and prostitution.

5. What are the reasons why GDP is not a perfect measure of well-being?

GDP is a useful indicator of a nation's economic performance, and it is the most commonly used
measure of well-being. However, it has some important limitations, including: The exclusion of non-
market transactions. The failure to account for or represent the degree of income inequality in society.

6. Distinguish between real GDP & nominal GDP. Which would be a better measure of the output of
an economy over time? Why?
The BEA separates price changes from quantity changes by calculating a measure of production
called real GDP. Nominal GDP is calculated by summing the current values of final goods and
services. Real GDP is calculated by designating a particular year as the base year and then using the
prices of goods and services in the base year to calculate the value of goods and services in all other
years. Real GDP is often favored over nominal GDP as it accounts for the effects of inflation. Thus, if
nominal GDP grew at 4% each year, but the inflation rate was 5%, it shrunk by 1% in real (constant-
dollar) terms.

7. What do economists mean by the price level?

The price level measures the average prices of goods and services in the economy. One of the
goals of economic policy is to maintain a stable price level.

8. What does the GDP deflator have to do with the price level?
To see why the GDP deflator is a measure of the price level, think about what would happen if
prices of goods and services rose while production remained the same. In that case, nominal GDP
would increase, but real GDP would remain constant, so the GDP deflator would increase. Both
prices and production usually increase each year, but the more prices increase relative to the
increase in production, the more nominal GDP increases relative to real GDP, and the higher the
value for the GDP deflator. Increases in the GDP deflator allow economists and policymakers to
track increases in the price level over time.

9. Briefly describe the 4 alternative ways to measure total production and total income:
Gross National Product
We have seen that GDP is the value of final goods and services produced within the United
States. Gross national product (GNP) is the value of final goods and services produced by
residents of the United States, even if the production takes place outside the United States.
National Income
In the production of goods and services, some machinery, equipment, and buildings wear out and
must be replaced. The value of this worn-out machinery, equipment, and buildings is called
depreciation. In the NIPA tables, depreciation is called the consumption of fixed capital. If we
subtract this value from GDP, we are left with national income.
Personal Income
Personal income is income received by households. To calculate personal income, we subtract the
earnings that corporations retain rather than pay to shareholders in the form of dividends. We also
add the payments households receive from the government in the form of transfer payments or
interest on government bonds.
Disposable Personal Income
Disposable personal income is equal to personal income minus personal tax payments, such as the
federal personal income tax. It is the best measure of the income households actually have
available to spend.