# 4. Measuring the Macroeconomy - Sample Problems

Contents

1. GDP versus GNP

1. Which of the following would increase Gross Domestic Product (GDP)?
1. Ford Motor Company starts to build and sell cars in Japan.
2. Honda Motor Company starts to build and sell cars in Tennessee.
3. A New York resident travels to Germany to buy a new Mercedes Benz produced in Germany to ship back to the U.S.
4. A Canadian resident travels to Detroit to buy a new Chevrolet produced in Michigan to drive back to Canada.
5. A U.S. college buys paper produced at a Canadian paper mill
6. A U.S. college buys paper produced at a Maine paper mill
7. A U.S. college buys paper produced at a Maine paper mill owned by a Canadian company
8. A New York resident buys dinner on a visit to Germany

Answer: B, D, F, G, and I. The answers to this question focus on the differences between gross domestic product (GDP) and gross national product (GNP). First, it doesn't matter who makes the purchase. The buyer could be a New York resident or a Canadian resident, a U.S. citizen or not. Second, it doesn't matter where the purchase was made. The only important issues in this question are (1) who produced the good or service and (2) where was it produced. We can summarize the distinction in the following table:

 GDP GNP Who produced the good? domestic resident  (anyone living in the U.S.) U.S. citizen or firm  (living anywhere in the world) Where was the good produced? in the U.S. anywhere in the world

Answers A, D, F, and I would result in an increase in GNP. Note that (D), (F), and (I) increase both GDP and GNP since these are goods and services produced in the U.S. by U.S. firms. Answer (A) increases GNP only because it is production by in a foreign country by a U.S. firm. Answers (B) and (G) increase GDP only because these are goods produced in the U.S. by foreign companies. Finally, answers (C), (E) and (H) have no net effect on GDP or GNP because these are goods produced in other countries by foreign firms.

2. GDP as a Measure of Social Welfare

1. The 1997 GDP per capita in Northern Ireland was \$17,653 per person and the average Northern Ireland laborer worked 35 hours per week. In the United States the 1998 GDP per capita was \$29,326 and an average work week of 39.3 hours. Who was better off?

2. Answer: There is no correct answer. It depends on your preferences. If you prefer to work to accumulate more toys then you might say the U.S. If you're willing to give up some luxuries for more leisure then you might prefer Northern Ireland. In markets with free (frictionless) labor movement, people should be able to migrate to those cities/states/countries that maximize their personal welfare. If that were the case then the residents of Northern Ireland should be happiest with their current situation and the same for those in the U.S. While conditions in both countries are comparatively different, each may still maximize the social welfare of its own residents.

The bottom line is that GDP may not be a good measure of social welfare. GDP not only fails to account for the value of leisure, but also pollution, traffic, the underground economy, volunteer work, home production (e.g., doing your own housecleaning, home repairs, etc.), and more.

3. What Is Included in GDP

1. Which of the following activities are not included in GDP (note - all activities occurred during the period in which GDP is being measured):

1. The \$20,000 profit I made by selling my home.
2. The purchase of a Boeing 767 jet by Southwest Airlines.
3. Government payment of unemployment insurance benefits to those who have lost their jobs.
4. Government payment of wages to maintenance workers who clean the White House.
5. The purchase of 100 shares of America-On-Line stock.
6. The cost of a room at the bed-and-breakfast I stayed at on the Isle of Mull in Scotland.
7. The price I paid for a used car I purchased directly from a friend.
8. My friend is a plumber and I gave him \$20 for fixing my leaking pipe after he got off work one day.
9. The 504 million barrels of crude oil produced in Texas in 1998 and sold to U.S. refineries.
10. The bushel of tomatoes I grew in my yard last summer.

Answer: A, C, E, G, H, I, J. The answers to this question relate to what is omitted and what is excluded from GDP accounting. First, we do not include transactions for which noting was produced or a service performed. Even though the payment of unemployment benefits (C) is a government expense it is not included as government expenditures in GDP. Similarly, the purchase of stocks and bonds (E) or other financial investments are also excluded.

Productive activities that are omitted are those that can't be measured directly because they are not reported to the government. If the government isn't told then it's hard to include in the GDP accounts. We do not count underground activities. If my plumber friend did not report the \$20 I gave him (H) to the IRS as income then that activity is not counted in GDP. We also do not include home production like housekeeping or growing your own vegetables (J).

Productive activities that are excluded are those that would result in double counting. The sale of the house (A) and used car (G) aren't included in GDP. The sale of used equipment is not counted because it was included in GDP in some previous year. If some value was added or a paid service performed (e.g., the used car dealer's commission) during the current year then that would be included in current year GDP. We do not include intermediate products like crude oil (I). Intermediate goods and services are excluded since their value would be counted more than once in the several stages of production. The value of the crude oil is counted when the gasoline, heating oil, and other products produced from the oil are sold to final consumers.

Included in GDP are the Boeing airplane (investment) and the White House maintenance (government spending). My vacation at the Scottish bed and breakfast should be counted as an import (a reduction to GDP) even though I was in another country. Remember that GDP is equivalent to national Income (with some corrections). Not counting my vacation would leave some of my income missing on the GDP side. And if my Scottish relatives visit the U.S. their expenses while here are included as GDP as an export.

2. The next series of questions approach GDP accounting in terms of changes in market practices.

1. American society has become more urbanized since 1930. Would you expect this to have a positive or negative influence on the size of GDP and national income?

2. Answer: GDP does not measure productive efforts that do not lead to market transactions such do-it-yourself activities. GDP is probably larger since there are more transactions occurring in the urban marketplace than in a rural setting. Commodities that you may produce for yourself in a rural setting are now traded in a market and measured. Similarly national income should be larger. This consideration is also relevant to cross-national comparisons of developed and less-developed countries. Less-developed countries likely have more home production and the difference between GDPs may be larger than the actual difference in total productive efforts.

3. What would happen to national income and GDP if government hired unemployed workers, who had been receiving unemployment benefits, as government employees and now paid them to do nothing?

4. Answer: Government transfer payments do not arise out of any production activity and thus are not counted in the value of GDP although they are included in national income. If the people currently receiving transfer payments were hired by the government, their wages would be counted as part of government purchases, G, which is counted in GDP (no judgement is made as to whether government employees are productive or not). Thus national income would be unchanged but GDP would rise.

5. You divorce your spouse because he is a neatness freak. But you like how clean he keeps the house so you hire him as your maid. What happens to GDP?

6. Answer: The service that a homemaker provides (no matter how valuable) are not counted in GDP. However, once a wage (and income tax) is paid to perform household duties, the service will be counted in GDP. GDP increases. During the last 20 years the number of women joining the labor force has increased dramatically and GDP has grown not only from the higher labor force participation rate but also the increase in home and child care services.

7. What effect do you think the fall of Communism has had on the GDP of Russia?

8. Answer: This is a tough question relating to underground economic activity, which is not counted in GDP. During the Communist regime production and prices were controlled by the government. Prices on many necessities were held at prices below what they would be in a free market. Price ceilings lead to shortages and shortages lead to black markets. Transactions in black markets are not included in GDP. After the fall of Communism some prices were decontrolled. Although price decontrol should lead to the elimination of the black markets and a likely increase in GDP another type of underground economy has probably risen. Privatization requires the collection of taxes and tax cheating is likely a serious problem in Russia since government institutions are still developing.

4. GDP Expenditure Accounting

1. This question has three parts relating to how different transactions are reported in the GDP expenditure accounts (consumption, investment, government spending, imports, and exports):

1. In January 2000 I purchased a new Maytag refrigerator from Best Buy for \$800. How will this transaction be reported in the GDP expenditure accounts?

2. Answer: GDP for the year 2000 should include an \$800 entry under Consumption expenditures.

3. Best Buy purchases a refrigerator (which was built in the U.S.) in December 1999 for \$600 from Maytag, and the refrigerator remained unsold as of December 31, 1999. How is this transaction reported in the GDP expenditure accounts?

4. Answer: GDP for the year 1999 should include a \$600 entry under Investment for inventory accumulation.

5. Now let's put the transactions in the previous two questions together. Best Buy purchases a refrigerator (which was built in the U.S.) in December 1999 for \$600 from Maytag, and the refrigerator remained unsold as of December 31, 1999. In January 2000 I purchased a new Maytag refrigerator from Best Buy for \$800. How are these transactions reported in GDP?

 Transaction 1999 GDP 2000 GDP Explanation Best Buy purchases a refrigerator in Dec. 1999 \$ 0 \$ 0 Intermediate goods not counted in GDP Best Buy has a refrigerator in inventory on 12/31/1999 \$ 600 (Investment) \$ 0 Inventory accumulation I purchase the refrigerator from Best Buy in Jan. 2000 - \$ 600 (Investment) Inventory decline \$ 800 (Consumption) Sale to final consumer Total GDP \$ 600 \$ 200 Production of the refrigerator included in 1999 GDP and retail services provided by Best Buy counted in 2000 GDP Note: On the income side, national income would include \$600 in 1999 and \$200 in 2000 since expenditures must equal income in the National Income and Product Accounts (NIPA). The income could appear as wages, dividends, or corporate retained earnings. If the refrigerator had been manufactured overseas the 1999 GDP expenditure entry would be \$600 investment and -\$600 net exports (i.e., an import), for total 1999 GDP of \$0 (the refrigerator was not produced in the U.S.). Also there would be no contribution to national income in 1999 since the proceeds of the sale went outside the U.S.

5. Real GDP

1. In the text we calculated the change in real GDP in the hypothetical economy of Table 4-5, using the prices of 1992. Calculate the change in real GDP between 1992 and 1994 using the same data but the prices of 1994. Your answer should reveal that the prices that are used to calculate real GDP do affect the calculated growth rate.

2.  Calculating Real GDP    (Base Year = 1994) Average Prices Quantity Sold 1992NominalGDP 1992RealGDP 1994NominalGDP 1994RealGDP 1992 1994 % change 1992 1994 Food \$ 12 \$ 14 17 % 4 5 \$ 48 \$ 70 Housing 9 10 11 % 3 3 27 30 Fun 4 5 25% 3 4 12 20 Machines 20 20 0 % 2 2 40 40 \$127 ? \$160 ?

Answer: Assuming 1994 is base year:

1992 Real GDP = (4 * \$14) + (3 * \$10) + (3 * \$5) + (2 * \$20) = \$141
1994 Real GDP = (5 * \$14) + (3 * \$10) + (4 * \$5) + (2 * \$20) = \$160 (same as 1994 Nominal GDP)

Change in real GDP (assuming base year is 1994) = 100 * (160 - 141) / 141 = 13.5 %
Change in real GDP (assuming base year is 1992 as in text) = 12.6 %