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Introduction to GDP, Growth, and Instability Purchases of new houses are considered to be investment rather than consumption because the houses could be used as income generating assets. 12-4 Why are changes in inventories included as part of investment spending? Suppose inventories declined by $1 billion during 2004. How would this affect the size of gross private domestic investment and gross domestic product in 2004? Explain. Anything produced by business that has not been sold during the accounting period is something in which business has investedeven if the investment is involuntary, as often is the case with inventories. But all inventories in the hands of business are expected eventually to be used by businessfor instance, a pile of bricks for extending a factory buildingor to be soldfor instance, a can of beans on the supermarket shelf. In the hands of business both the bricks and the beans are equally assets to the business, something in which business has invested. If inventories declined by $1 billion in 2004, $1 billion would be subtracted from both gross private domestic investment and gross domestic product. A decline in inventories indicates that goods produced in a previous year have been used up in this years production. If $1 billion is not subtracted as stated, then $1 billion of goods produced in a previous year would be counted as having been produced in 2004, leading to an overstatement of 2004s production. 12-5 Suppose foreigners spend $7 billion on American exports in a specific year and Americans spend $5 billion on imports from abroad in the same year. What is the amount of United States net exports? Explain how net exports might be a negative amount. If American exports are $7 billion and imports are $5 billion, then American net exports are +$2 billion. If the figures are reversed, so that Americans export $5 billion and import $7 billion, then net exports are -$2 billiona negative amount. 12-6 Which of the following are included in this years GDP? Explain your answer in each case. a. The services of a commercial painter in painting the family home. b. An auto dealers sale of a new car to a nonbusiness customer. c. The money received by Smith when she sells her biology textbook to a used-book buyer. d. The publication and sale of a new economics textbook. e. A $2 billion increase in business inventories. f. Government purchases of newly produced aircraft. (a) Included. Payment for a final service received by a household. (b) Included. Purchase of a final good by a household. (c) Excluded. Secondhand sales are not counted; the textbook is counted only when sold for the first time. (d) Included. Purchase of a final good by a household. (e) Included. Represents production that occurred during the year. (f) Included. Purchases of final goods by government are included. 12-7 Using the following NIPA data, compute GDP. All figures are in billions.
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Introduction to GDP, Growth, and Instability Personal consumption expenditures Wages and salaries Imports Corporate profits Consumption of fixed capital (depreciation) Gross private domestic investment Government purchases Exports $245 223 18 42 28 86 82 9
GDP = $404 = [$245 + 86 + 82 + (9-18)] 12-8 Suppose that in 1984 the total output in a single-good economy was 7,000 buckets of chicken. Also suppose that in 1984 each bucket of chicken was priced at $10. Finally, assume that in 2004 the price per bucket of chicken was $16 and that 22,000 buckets were purchased. Determine real GDP for 1984 and 1996, in 1984 prices. Real GDP for 1984 = 7,000 x $10 = $70,000. Real GDP for 1996 (in 1984 prices) = 22,000 x $10 = $220,000. 12-9 Suppose an economys real GDP is $30,000 in year 1 and $31,200 in year 2. What is the growth rate of its real GDP? Assume that population was 100 in year 1 and 102 in year 2. What is the growth rate of GDP per capita? Growth rate of real GDP = 4 percent (= $31,200 - $30,000)/$30,000). GDP per capita in year 1 = $300 (= $30,000/100). GDP per capita in year 2 = $305.88 (= $31,200/102). Growth rate of GDP per capita is 1.96 percent = ($305.88 - $300)/300). 12-10 Use the following data to calculate (a) the size of the labor force and (b) the official unemployment rate: total population, 500; population under 16 years of age or institutionalized, 120; not in labor force, 150; unemployed, 23; part-time workers looking for full-time jobs, 10. Labor force = 500 120 150 = 230. Official unemployment rate = (23/230) x 100 = 10%. 12-11 Since the U.S. has an unemployment compensation program which provides income for those out of work, why should we worry about unemployment? The unemployment compensation program merely gives the unemployed enough funds for basic needs, and it is only temporary. Furthermore, many of the unemployed do not qualify for unemployment benefits. The programs apply only to those workers who were covered by the insurance, and this may be as few as one-third of those without jobs. Most of the unemployed get no sense of self-worth or accomplishment out of drawing this compensation. Moreover, from the economic point of view, unemployment is a waste of resources and potential output is lost; when the unemployed go back to work, nothing is forgone except undesired leisure. Finally, unemployment could be inflationary and costly to taxpayers: The unemployed are producing nothingtheir supply is zero but the compensation helps keep demand in the economy high 12-12 What is the Consumer Price Index (CPI) and how is it determined each month? What effect does inflation have on the purchasing power of a dollar? How does it explain differences between nominal and real interest rates? How does deflation differ from inflation?
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Introduction to GDP, Growth, and Instability The CPI is constructed from a market basket sampling of goods that consumers typically purchase. Prices for goods in the market basket are collected each month, weighted by the importance of the good in the basket (cars are more expensive than bread, but we buy a lot more bread), and averaged to form the price level. Inflation reduces the purchasing power of the dollar. Facing higher prices with a given number of dollars means that each dollar buys less than it did before. The rate of inflation in the CPI approximates the difference between the nominal and real interest rates. A nominal interest rate of 10% with a 6% inflation rate will mean that real interest rates are approximately 4%. Deflation means that the price level is falling, whereas with inflation overall prices are rising. Deflation is undesirable because the falling prices mean that incomes are also falling, which reduces spending, output, employment, and, in turn, the price level (a downward spiral). Inflation in modest amounts (<3%) is tolerable, although there is not universal agreement on this point. 12-13 If the CPI was 110 last year and is 121 this year, what is this years rate of inflation? What is the rule of 70? How long would it take for the price level to double if inflation persisted at (a) 2, (b) 5, and (c) 10 percent per year? This years rate of inflation is 10% or [(121 110)/110] x 100. Dividing 70 by the annual percentage rate of increase of any variable (for instance, the rate of inflation or population growth) will give the approximate number of years for doubling of the variable. (a) 35 years ( = 70/2); (b) 14 years ( = 70/5); (c) 7 years ( = 70/10). 12-14 Briefly distinguish between demand-pull inflation and cost-push inflation. Demand-pull inflation occurs when prices rise because of an increase in aggregate spending not fully matched by an increase in aggregate output. It is sometimes expressed as too much spending (or money) chasing too few goods. Cost-push inflation describes prices rising because of increases in per unit costs of production. Demand-pull inflation is more likely to occur with rising GDP; cost-push inflation will generally coincide with falling GDP. 12.15 How does unanticipated inflation hurt creditors and help borrowers? Inflation causes the dollars repaid by the borrower to be worth less than the dollars initially borrowed from the creditor (lender); the lender receives back dollars with eroded purchasing power. If the rate of inflation exceeds the nominal interest rate, the creditor will lose (in absolute real terms) from the loan transaction. If the inflation is unanticipated, the initial nominal interest rate will be set too low. If it is a fixed nominal rate, the creditor will lose more than if the rate is variable and can be adjusted as inflation rises. Even with variable rates, lenders are still better off if they can anticipate the inflation and adjust the rates as or before the inflation is occurring.
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