Notes

Measuring a Nation’s Income:

Note:

1. Also included in GDP is the rental price for a house, but if you own the house yourself it is more
difficult. The government then estimates a rental price and assumes you are renting the house
from yourself. GDP also excludes some goods such as illegal drugs or goods that never enter the
market place. If you buy vegetables at a supermarket, then it is included in GDP, but if you grow
it at home, then it is not included.
2. The term “final” refers to the fact that GDP only includes final goods. When International Paper
makes paper, which Hallmark then uses to make a greeting card, the paper is called an
intermediate good, and the card is called a final good. GDP only includes final goods, because
the value of intermediate goods is already included in the prices of final goods. Adding the
market value of the paper to the market value of the card would double the counting.
3. Produced” refers to all goods and services currently produced. If Volvo is selling new cars, then
that is included in GDP. But if someone sells his used Volvo car, then that is not included in GDP.
4. “Within a country” means that all goods and services included in GDP must be produced within
the geographic confines of a country. The wage of a Canadian worker in the US is included in the
GDP of the US, whereas a US company operating in Haiti is not included in GDP of the US but in
the GDP of Haiti.
5. The Real GDP = Nominal GDP – Inflation. And The GDP Deflator measures the amount of
deflation in a country.
6. Nominal GDP uses current prices to place a value on the economy’s production of goods and
services. Real GDP uses constant base-year prices to place a value on the economy’s production
of goods and services. Hence, the value of real GDP is not affected by a change in price.
7. We can now define the GDP deflator:
 GDP deflator = (Nominal GDP)/ (Real GDP) *
 The GDP deflator measures the current level of prices relative to the prices in the base
year. This is true because if only production would change and not the prices, then
nominal and real GDP would rise by the same amount and hence the GDP deflator
would be constant. If instead the prices would change too, then the GDP deflator will
also change. For example, if we calculate the GDP deflator for the year 2012 we find
that it is 240. We can use the GDP deflator also as a measure of inflation. Inflation is a
situation in which the economy’s overall price level is rising. We can define the
inflation rate as:
 Inflation rate year 2 = (GDP deflator year 2 – GDP deflator year 1)/ (GDP deflator year
1) *100
for example, the inflation rate in 2012 = 100*(240-171)/171 = 40%.
8. GDP is not a perfect measure of economic well-being, for example it does not incorporate
leisure as a contribution to life. Neither does it incorporate products that never enter the
market place nor does GDP only measure averages. Despite these problems, GDP comes the
closest to measuring economic-well-being.
 9. If the GDP Deflator or inflation is 0% then it means that the PRICES did not increase at all from
the previous year to this year. If the Real GDP did not increase and show 0%, so OUTPUT remain
the same from previous year.
10. We can analyze the economic well-being of two years in this manner. Compare both year’s Real
GDP and GDP Deflator. Suppose Year 1 have 0% (less change) in GDP Deflator so the prices did
not increase that year and have 100% change in Real GDP so Output increased that year so
overall economic well-being increased. Now, We’ll do the same and analyze for the Year 2. At
the end compare economic well-being of each year.
1
𝑋 𝐹𝑖𝑛𝑎𝑙
11. 100 × {(𝑋 𝐼𝑛𝑖𝑡𝑖𝑎𝑙𝑁 ) − 1} used to find the growth rate between a large gap e.g. we won’t use

power if between 2004 to 2005.

12. Y is GDP = C (Consumption) + I (Investment) + G (Government Spending) + NX (Net Export=
Export – Import)

Questions:

1. What components of GDP (if any) would each of the following transactions affect? Explain?
a. Ford sells a Mustang from its inventory: Consumption increases because a car is a good
purchased by a household, but investment decreases because the car in Ford’s inventory
had been counted as an investment good until it was sold.
b. California repaves Highway 101: Government purchases increase because the government
spent money to provide a good to the public.
c. Your parents buy a bottle of French wine: Consumption increases because the bottle is a
good purchased by a household, but net exports decrease because the bottle was imported.
2. The government purchases component of GDP does not include spending on transfer
payments such as Social Security. Think about the definition of GDP, explain why transfer
payments are excluded. With transfer payments, nothing is produced, so there is no
contribution to GDP.
3. As the chapter states, GDP does not include the value of used goods that are resold. Why
would including such transactions make GDP a less informative measure of economic well-
being? If GDP included goods that are resold, it would be counting output of that particular
year, plus sales of goods produced in a previous year. It would be double-count goods that were
sold more than once and would count goods in GDP for several years if they were produced in
one year and resold in another.

Measuring the Cost of living:

Note:

1. The consumer price index is an imperfect measure of the cost of living for three reasons. First, it
does not take into account consumers’ ability to substitute toward goods that become relatively
cheaper over time. Second, it does not take into account increases in the purchasing power of the
dollar due to the introduction of new goods. Third, it is distorted by unmeasured changes in the
quality of goods and services. Because of these measurement problems, the CPI overstates true
inflation.
2. The GDP deflator differs from the CPI because it includes goods and services produced rather than
goods and services consumed. As a result, imported goods affect the consumer price index but not
the GDP deflator.
3. The consumer price index is a measure of the overall cost of goods and services bought by a typical
consumer. It consists of a fixed basket and economists study the price changes of the goods in this
basket. The producer price index is used to measure inflation in an economy. There are some
problems attached to the producer price index such as the substitution bias and the introduction of
new goods. The consumer price index does not take products into accountant which have just been
produced or products that are changed in quality.
4. The nominal interest rate = normal interest rate
5. real interest rate = nominal interest rate – inflation. When Nominal value/monetary is value is
corrected for inflation, we say it has been indexed for inflation.
6. We can use price-indexes to compute what someone’s salary is worth now compared to years ago.
Babe Ruth (a famous base-ball player) earned $80.000 per year in 1930. Nowadays, the average
New York Yankee player earns $4 million per year. Government statistics show that the price index
in 1931 was 15.2 and the price index in 2009 was 214.5. Hence Ruth’s salary nowadays would be
$80.000*(214.5/15.2) = $1.128.947. This is still 4 times less than the average base-ball player, but
this has other causes such as increased standards of living and more spectators.
7. REMEMBER IN ORDER TO CALCULATE THE CPI ADD ALL (PRICES 1 X QUANTITY 1) + (PRICES 2 +
QUANTITY 2)
8. Percentage change is {(new-old)/old x 100}
9. NOTE THAT IT IS NOT MENTIONED IN THE BOOK BUT NOTES!!!!!
Real Value of some year (variable) = (Nominal Value of that year)/CPI value of that year.
10. More recent dollars in terms of past dollars = Dollar Amount × Beginning-period CPI ÷ Ending-period
CPI.
AND
Past dollars in terms of recent dollars = Dollar amount × Ending-period CPI ÷ Beginning-period CPI.

QUESTIONS:

1. If you were to learn that a bottle of Gatorade increased in size from 2011 to 2012, should that
information affect your calculation of the inflation rate? If so, how? This would lower the
estimation of the inflation rate because the value of a bottle of Gatorade is now greater than before.
The comparison should be made on a per-ounce basis.
2. If you were to learn that Gatorade introduced new flavors in 2012, should that information affect
your calculation of the inflation rate? If so, how? More flavors enhance consumers’ well-being.
Thus, this would be considered a change in quality and would also lower the estimate of the
inflation rate.
3. See the Question 5 from Makiew Book. Answer is in photo gallery.
4. Which of the problems in the construction of the CPI might be illustrated by each of the following
situations? Explain.
a. the invention of the iPod. introduction of new goods. It can drastically alter the typical basket.
b. the introduction of air bags in cars. unmeasured quality change. The quality of the good might
have improved or decreased.
 c. increased personal computer purchases in response to a decline in their price. substitution
bias. Consumer buy other type of products.
d. more scoops of raisins in each package of Raisin Bran. unmeasured quality change.
e. greater use of fuel-efficient cars after gasoline prices increase. Substitution bias.

Production and Growth

Note:

1. Productivity is Output produced per unit worker. Determinants of Productivity are Physical
capital (stocks that produces goods and services e.g. machines), Human capital (knowledge,
education, and skills a worker have), Natural resources, technological knowledge.
2. Capital accumulation obeys the law of diminishing marginal return. This is why richer countries
experience less economic growth over time, whereas poor countries can experience high growth
rates, this is known as the catch-up effect.
3. As the stock of capital rises, the extra output produced from an additional unit of capital falls.
4. Productivity is equal to Y (GDP)/L (labor)
5. Convergence theory states that poorer countries tend to grow at a faster rate when invested in
them as compare to developed countries because of diminishing marginal return.
6. SEE CLASS NOTES AS THINGS ARE NOT MENTIONED IN BOOK
7. Physical capital, human capital, natural resources cause a shift in the growth of GDP per capita/
time graph. While technological knowledge cause steepness increase or decrease in the graph.
8.