Krug2e Macro PS CH07

Solution

S-95

chapter:

Tracking the Macroeconomy1. Below is a simplified circular-flow diagram for the economy of Micronia.

a. What is the value of GDP in Micronia?

b. What is the value of net exports?

c. What is the value of disposable income?

d. Does the total flow of money out of households—the sum of taxes paid and con-sumer spending—equal the total flow of money into households?

e. How does the government of Micronia finance its purchases of goods and services?

1. a. We can measure GDP in Micronia as the sum of all spending on domestically produced final goods and services. Spending consists of consumer spending, government purchases of goods and services, and exports less imports, or $750($650 + $100 + $20 − $20).

b. Net exports are exports less imports. In Micronia, net exports equal zero ($20 − $20).

c. Disposable income is income received by households less taxes plus governmenttransfers. In Micronia, disposable income equals $650 ($750 − $100).

d. Yes. Consumer spending plus taxes equals $750—the same as the wages, profit,interest, and rent received by households.

e. The government finances its purchases of goods and services with tax revenue.

Government purchases of goods and services = $100

Consumer spending = $650

Imports = $20

Exports = $20

Wages, profit, interest,

rent = $750

Gross domestic product

Wages, profit,

interest, rent = $750

Government

Households

Taxes = $100

Markets for goods and services

Factor markets

Firms

Rest of world

723 ECO

NO

MIC

S

MA

CRO

ECO

NO

MIC

S

S95-S106_Krug2e_Macro_PS_Ch07.qxp 2/25/09 8:00 PM Page S-95

Solution

S-96 M A C R O E C O N O M I C S , C H A P T E R 7

E C O N O M I C S , C H A P T E R 2 3

2. A more complex circular-flow diagram for the economy of Macronia is shown below.

a. What is the value of GDP in Macronia?

b. What is the value of net exports?

c. What is the value of disposable income?

d. Does the total flow of money out of households—the sum of taxes paid, consumerspending, and private savings—equal the total flow of money into households?

e. How does the government finance its spending?

2. a. We can measure GDP in Macronia as the sum of all spending on domestically pro-duced final goods and services. Spending consists of consumer spending, invest-ment spending, government purchases of goods and services, and exports lessimports, or $800 ($510 + $110 + $150 + $50 − $20).

b. Net exports are exports less imports. In Macronia, net exports equal $30 ($50 − $20).

c. Disposable income is income received by households less taxes plus governmenttransfers. In Macronia, disposable income equals $710 ($800 − $100 + $10).

d. Yes. Consumer spending plus taxes plus private savings equals $810—the same asthe wages, profit, interest, rent, and government transfers received by households.

e. In Macronia, the government needs to finance $160 in spending ($150 on pur-chases of goods and services and $10 in government transfers). The governmentfinances $100 of its spending with tax revenue and the other $60 through borrow-ing in financial markets.

Government purchases of goods and services = $150 Government borrowing = $60

Consumer spending = $510

Imports = $20

Exports = $50


rent = $800

Gross domestic product

Investment spending = $110


rent = $800

Borrowing and stock issues by firms = $110

Foreign borrowing and sales of stock = $130

Foreign lending and purchases of stock = $100

Government

Households

Taxes = $100 Government transfers = $10 Private savings = $200

Markets for goods and services

Financial markets

Factor markets

Firms

Rest of world


Solution

3. The components of GDP in the accompanying table were produced by the Bureau ofEconomic Analysis.

a. Calculate consumer spending.

b. Calculate private investment spending.

c. Calculate net exports.

d. Calculate government purchases of goods and services and investment spending.

e. Calculate gross domestic product.

f. Calculate consumer spending on services as a percentage of total consumer spending.

g. Calculate exports as a percentage of imports.

h. Calculate government purchases on national defense as a percentage of federalgovernment purchases of goods and services.

3. All figures below are in billions of dollars.

a. Consumer spending is $1,082.8 + $2,833.0 + $5,794.4 = $9,710.2.

b. Private investment spending is $2,134.0 − $3.6 = $2,130.4.

c. Net exports are $1,662.4 − $2,370.2 = −$707.8.

d. Government purchases of goods and services and investment spending are$1,695.5 + $979.3 = $2,674.8.

e. Gross domestic product is $9,710.2 + $2,130.4 + $2,674.8 − $707.8 = $13,807.6.

f. Consumer spending on services as a percentage of total consumer spending is($5,794.4/$9,710.2) × 100 = 59.7%.

g. Exports as a percentage of imports is ($1,662.4/$2,370.2) × 100 = 70.1%.

h. Government purchases of goods and services on national defense as a percentageof federal purchases of goods and services is ($662.2/$979.3) × 100 = 67.6%.

T R A C K I N G T H E M A C R O E C O N O M Y S-97

Components of GDP in 2007Category (billions of dollars)

Consumer spending

Durable goods $1,082.8

Nondurable goods 2,833.0

Services 5,794.4

Private investment spending

Fixed investment spending 2,134.0

Nonresidential 1,503.8

Structures 480.3

Equipment and software 1,023.5

Residential 630.2

Change in private inventories –3.6

Net exports

Exports 1,662.4

Imports 2,370.2

Government purchases of goods and services and investment spending

Federal 979.3

National defense 662.2

Nondefense 317.1

State and local 1,695.5


Solution

4. The small economy of Pizzania produces three goods (bread, cheese, and pizza), eachproduced by a separate company. The bread and cheese companies produce all theinputs they need to make bread and cheese, respectively. The pizza company uses thebread and cheese from the other companies to make its pizzas. All three companiesemploy labor to help produce their goods, and the difference between the value ofgoods sold and the sum of labor and input costs is the firm’s profit. The accompany-ing table summarizes the activities of the three companies when all the bread andcheese produced are sold to the pizza company as inputs in the production of pizzas.

a. Calculate GDP as the value added in production.

b. Calculate GDP as spending on final goods and services.

c. Calculate GDP as factor income.

4. a. To calculate GDP as the value added in production, we need to sum all value added(value of output less input costs) for each company. Value added in the bread com-pany is $50; in the cheese company, $35; and in the pizza company, $115 ($200 − $50 − $35). The total value added in production is $200 ($50 + $35 + $115).

b. To calculate GDP as spending on final goods and services, we only need to estimatethe value of pizzas because all bread and cheese produced are intermediate goodsused in the production of pizzas. Spending on final goods and services is $200.

c. To calculate GDP as factor income, we need to sum factor income (wages and prof-its) for each firm. For the bread company, factor income is $50: labor earns $15and profit is $35. For the cheese company, factor income is $35: labor earns $20and profit is $15. For the pizza company, factor income is $115: labor earns $75and profit is $40 ($200 − $75 − $50 − $35). Factor income is $200 ($50 + $35 +$115).

5. In the economy of Pizzania (from Problem 4), bread and cheese produced are sold both to the pizza company for inputs in the production of pizzas and to con-sumers as final goods. The accompanying table summarizes the activities of thethree companies.

a. Calculate GDP as the value added in production.

b. Calculate GDP as spending on final goods and services.

c. Calculate GDP as factor income.



Bread Cheese Pizzacompany company company

Cost of inputs $0 $0 $50 (Bread)35 (Cheese)

Wages 15 20 75

Value of output 50 35 200

Bread Cheese Pizzacompany company company

Cost of inputs $0 $0 $50 (Bread)35 (Cheese)

Wages 25 30 75

Value of output 100 60 200


Solution

Solution5. a. To calculate GDP as the value added in production, we need to sum all value added(value of output less input costs) for each company. Value added in the bread com-pany is $100; in the cheese company, $60; and in the pizza company, $115 ($200 −$50 − $35). The total value added in production is $275.

b. To calculate GDP as spending on final goods and services, we need to sum thevalue of bread, cheese, and pizzas sold as final goods. GDP equals $275 because thebread company sells $50 worth as final goods, the cheese company sells $25 worthas final goods, and all $200 worth of pizzas are final goods.

c. To calculate GDP as factor income, we need to sum factor income (labor and prof-its) for each firm. For the bread company, factor income is $100: labor earns $25and profit is $75. For the cheese company, factor income is $60: labor earns $30and profit is $30. For the pizza company, factor income is $115: labor earns $75and profit is $40 ($200 − $75 − $50 − $35). As factor income, GDP equals $275($100 + $60 + $115).

6. Which of the following transactions will be included in GDP for the United States?

a. Coca-Cola builds a new bottling plant in the United States.

b. Delta sells one of its existing airplanes to Korean Air.

c. Ms. Moneybags buys an existing share of Disney stock.

d. A California winery produces a bottle of Chardonnay and sells it to a customer inMontreal, Canada.

e. An American buys a bottle of French perfume in Tulsa.

f. A book publisher produces too many copies of a new book; the books don’t sell thisyear, so the publisher adds the surplus books to inventories.

6. a. When Coca-Cola builds a new bottling plant, it is investment spending andincluded in GDP.

b. If Delta sells one of its airplanes to Korean Air, this transaction is not included inGDP because it does not represent production during the current time period. Theairplane would have been included in GDP when it was produced; now it is just asale of a used item.

c. When an individual buys an existing share of stock, the transaction is not includedin GDP because there is no production.

d. If a California winery sells a bottle of Chardonnay to a customer in Montreal, it isa U.S. export and is entered as such in U.S. GDP.

e. When an American buys a bottle of French perfume, it is a consumption expendi-ture as measured by GDP. But since it does not represent production in the UnitedStates, it is also deducted from GDP as an import. The net effect of the transactiondoes not change GDP in the United States.

f. If a book publisher produces too many copies of a new book and the books don’tsell in the year they are produced, the publisher adds the surplus books to invento-ries. These books are considered investment spending and added to GDP. It is as ifthe publisher bought the books itself.



Solution

7. The economy of Britannica produces three goods: computers, DVDs, and pizza. Theaccompanying table shows the prices and output of the three goods for the years2005, 2006, and 2007.

a. What is the percent change in production of each of the goods from 2005 to 2006and from 2006 to 2007?

b. What is the percent change in prices of each of the goods from 2005 to 2006 andfrom 2006 to 2007?

c. Calculate nominal GDP in Britannica for each of the three years. What is the per-cent change in nominal GDP from 2005 to 2006 and from 2006 to 2007?

d. Calculate real GDP in Britannica using 2005 prices for each of the three years. Whatis the percent change in real GDP from 2005 to 2006 and from 2006 to 2007?

7. a. From 2005 to 2006, the percent change in the production of computers is 5.0%(equal to ((10.5 − 10)/10) × 100); of DVDs, 5.0% (equal to ((105 − 100)/100) ×100); and of pizza, 0% (equal to ((2 − 2)/2) × 100). From 2006 to 2007, the per-cent change in the production of computers is 14.3% (equal to ((12 − 10.5)/10.5)× 100); of DVDs, 4.8% (equal to ((110 − 105)/105) × 100); and of pizza, 50.0%(equal to ((3 − 2)/2) × 100).

b. From 2005 to 2006, the percent change in the price of computers is 11.1% (equalto (($1,000 − $900)/$900) × 100); of DVDs, 20.0% (equal to (($12 − $10)/$10)× 100); and of pizza, 6.7% (equal to (($16 − $15)/$15) × 100). From 2006 to2007, the percent change in the price of computers is 5.0% (equal to (($1,050 −$1,000)/$1,000) × 100); of DVDs, 16.7% (equal to (($14 − $12)/$12) × 100);and of pizza, 6.25% (equal to (($17 − $16)/$16) × 100).

c. Nominal GDP for each year is calculated by summing up the value of the threegoods produced in that year:

d. Real GDP in 2005 prices is calculated by summing up the value of the three goodsproduced each year using 2005 prices:



Computers DVDs PizzaYear Price Quantity Price Quantity Price Quantity

2005 $900 10 $10 100 $15 2

2006 1,000 10.5 12 105 16 2

2007 1,050 12 14 110 17 3

Year Nominal GDP Percent change in nominal GDP

2005 $10,030

2006 11,792 17.6%

2007 14,191 20.3%

Real GDP Year (2005 dollars) Percent change in real GDP

2005 $10,030

2006 10,530 5.0%

2007 11,945 13.4%


Solution

8. The accompanying table shows data on nominal GDP (in billions of dollars), realGDP (in billions of 2000 dollars), and population (in thousands) of the United Statesin 1960, 1970, 1980, 1990, 2000, and 2007, years in which the U.S. price level consis-tently rose.

a. Why is real GDP greater than nominal GDP for all years before 2000 and lower for2007? Does nominal GDP have to equal real GDP in 2000?

b. Calculate the percent change in real GDP from 1960 to 1970, 1970 to 1980, 1980to 1990, and 1990 to 2000. Which period had the highest growth rate?

c. Calculate real GDP per capita for each of the years in the table.

d. Calculate the percent change in real GDP per capita from 1960 to 1970, 1970 to1980, 1980 to 1990, and 1990 to 2000. Which period had the highest growth rate?

e. How do the percent change in real GDP and the percent change in real GDP percapita compare? Which is larger? Do we expect them to have this relationship?

8. a. Real GDP is greater than nominal GDP for all years before 2000 because from1960 to 2000 prices rose. So to calculate real GDP for the years 1960, 1970, 1980,and 1990, we would multiply output in those years by the higher prices that existedin 2000. To calculate nominal GDP, we would multiply output by the lower pricesthat existed in those particular years. Since prices rose from 2000 to 2007, valuingthe output in 2007 using 2000 prices (real GDP) will result in a lower numberthan valuing the output in 2007 using 2007 prices. Real GDP equals nominal GDPin 2000 because the year 2000 is the base year and we use the same set of prices tovalue both real and nominal GDP in that year.

b. The accompanying table shows the percent change in real GDP from 1960 to 1970,1970 to 1980, 1980 to 1990, and 1990 to 2000. The percent change in real GDPwas the highest during the 1960s.


Nominal GDP Real GDP (billions of (billions of Population

Year dollars) 2000 dollars) (thousands)

1960 $526.4 $2,501.8 180,671

1970 1,038.5 3,771.9 205,052

1980 2,789.5 5,161.7 227,726

1990 5,803.1 7,112.5 250,132

2000 9,817.0 9,817.0 282,388

2007 13,841.3 11,566.8 301,140

Real GDP Year (billions of 2000 dollars) Percent change in real GDP

1960 $2,501.8

1970 3,771.9 50.8%

1980 5,161.7 36.8%

1990 7,112.5 37.8%

2000 9,817.0 38.0%


c. We can calculate real GDP per capita by dividing real GDP by population. Theaccompanying table shows real GDP per capita for each of the years in the table.Remember that real GDP is measured in billions and population is measured inthousands. Real GDP per capita in 1960 was $13,847.27 (equal to$2,501,800,000,000/180,671,000).

d. The accompanying table shows the percent change in real GDP per capita from1960 to 1970, 1970 to 1980, 1980 to 1990, and 1990 to 2000. The percent changein real GDP per capita was the highest during the 1960s.

e. In this example, the percent change in real GDP is larger than the percent changein real GDP per capita. As long as the population is growing, the two will alwayshave this relationship.

9. Eastland College is concerned about the rising price of textbooks that students mustpurchase. To better identify the increase in the price of textbooks, the dean asks you,the Economics Department’s star student, to create an index of textbook prices. Theaverage student purchases three English, two math, and four economics textbooks.The prices of these books are given in the accompanying table.

a. What is the percent change in the price of an English textbook from 2005 to 2007?

b. What is the percent change in the price of a math textbook from 2005 to 2007?

c. What is the percent change in the price of an economics textbook from 2005 to 2007?

d. Using 2005 as a base year, create a price index for these books for all years.

e. What is the percent change in the price index from 2005 to 2007?



Real GDP Population Year (billions of 2000 dollars) (thousands) Real GDP per capita

1960 $2,501.8 180,671 $13,847.27

1970 3,771.9 205,052 18,394.85

1980 5,161.7 227,726 22,666.27

1990 7,112.5 250,132 28,434.99

2000 9,817.0 282,388 34,764.23

2007 11,566.8 301,140 38,410.04

Real GDP(billions of Population Percent change in real

Year 2000 dollars) (thousands) Real GDP per capita GDP per capita

1960 $2,501.8 180,671 $13,847.27

1970 3,771.9 205,052 18,394.85 32.8%

1980 5,161.7 227,726 22,666.27 23.2%

1990 7,112.5 250,132 28,434.99 25.5%

2000 9,817.0 282,388 34,764.23 22.3%

2005 2006 2007

English textbook $50 $55 $57

Math textbook 70 72 74

Economics textbook 80 90 100


Solution9. a. The percent change in the price of an English textbook from 2005 to 2007 is 14.0%(equal to (($57 − $50)/$50) × 100).

b. The percent change in the price of a math textbook from 2005 to 2007 is 5.7%(equal to (($74 − $70)/$70) × 100).

c. The percent change in the price of an economics textbook from 2005 to 2007 is25% (equal to (($100 − $80)/$80) × 100).

d. To create an index of textbook prices, you must first calculate the cost of the mar-ket basket (three English, two math, and four economics textbooks) in each of thethree years; then normalize it by dividing the cost of the market basket in a givenyear by the cost of the market basket in the base period; and then multiply by 100to get an index value (base period of 2005 = 100).

Cost of textbooks in 2005 = (3 × $50) + (2 × $70) + (4 × $80) = $610



Index value for 2005 = ($610/$610) × 100 = 100

Index value for 2006 = ($669/$610) × 100 = 109.7

Index value for 2007 = ($719/$610) × 100 = 117.9

e. The percent change in the price index for textbooks from 2005 to 2007 is 17.9%(equal to ((117.9 − 100)/100) × 100).

10. The consumer price index, or CPI, measures the cost of living for a typical urbanhousehold by multiplying the price for each category of expenditure (housing, food,and so on) times a measure of the importance of that expenditure in the average con-sumer’s market basket and summing over all categories. However, using data from theconsumer price index, we can see that changes in the cost of living for different typesof consumers can vary a great deal. Let’s compare the cost of living for a hypotheticalretired person and a hypothetical college student. Let’s assume that the market basketof a retired person is allocated in the following way: 10% on housing, 15% on food,5% on transportation, 60% on medical care, 0% on education, and 10% on recre-ation. The college student’s market basket is allocated as follows: 5% on housing, 15%on food, 20% on transportation, 0% on medical care, 40% on education, and 20% onrecreation. The accompanying table shows the November 2007 CPI for each of the rel-evant categories.

Calculate the overall CPI for the retired person and for the college student by multi-plying the CPI for each of the categories by the relative importance of that category tothe individual and then summing each of the categories. The CPI for all items inNovember 2007 was 210.2. How do your calculations for a CPI for the retired personand the college student compare to the overall CPI?


CPINovember 2007

Housing 210.7

Food 206.3

Transportation 190.7

Medical care 357.0

Education 121.4

Recreation 118.8


Solution

Solution10. To calculate the CPI for the retired person and for the college student, we need toweight the CPI for each component with the importance of that component in his orher market basket. The CPI for the retired person is 286.93 and for the college stu-dent is 150.54. Since the CPI for the average consumer was 210.2, the CPI overstatesthe increase in the cost of living for the college student and understates it for theretired person.

For the retired person:

For the college student:

11. Each month the Bureau of Labor Statistics releases the Consumer Price IndexSummary for the previous month. Go to www.bls.gov and find the latest report.(On the Bureau of Labor Statistics home page, click on “News Release” under“Latest Numbers—Consumer Price Index” and then choose “Consumer Price Index Summary.”) What was the CPI for the previous month? How did it changefrom the previous month? How does the CPI compare to the same month one year ago?

11. Answers will vary with the latest data. For November 2007, the CPI was 210.2; it rose0.6% from October 2007. The CPI was 4.3% higher than in November 2006.



CPI CPIWeight November 2007 Contribution

Housing 0.1 210.7 21.07

Food 0.15 206.3 30.945

Transportation 0.05 190.7 9.535

Medical care 0.6 357.0 214.2

Education 0 121.4 0

Recreation 0.1 111.8 11.18

Overall CPI 286.93

CPI CPIWeight November 2007 Contribution

Housing 0.05 210.7 10.535

Food 0.15 206.3 30.945

Transportation 0.2 190.7 38.14

Medical care 0 357.0 0

Education 0.4 121.4 48.56

Recreation 0.2 118.8 23.76

Overall CPI 151.94


Solution

Solution

12. The accompanying table provides the annual real GDP (in billions of 2000 dollars)and nominal GDP (in billions of dollars) for the United States.

a. Calculate the GDP deflator for each year.

b. Use the GDP deflator to calculate the inflation rate for all years except 2002.

12. a. The GDP deflator in a given year is 100 times the ratio of nominal GDP to realGDP, yielding the figures in the accompanying table.

b. The inflation rate obtained by using the GDP deflator is calculated using the for-mula ((current GDP deflator − GDP deflator in the previous year)/(GDP deflatorin the previous year)) × 100, yielding the figures in the accompanying table.

13. The accompanying table contains two price indexes for the years 2004, 2005, and2006: the GDP deflator and the CPI. For each price index, calculate the inflation ratefrom 2004 to 2005 and from 2005 to 2006.

13. The accompanying table calculates the inflation rates based on the GDP deflator andon the CPI.

Inflation rateGDP (based on Inflation rate

Year deflator GDP deflator) CPI (based on CPI)

2004 109.5 188.9

2005 113.0 3.2% 195.3 3.4%

2006 116.6 3.2% 201.6 3.2%

GDPYear deflator CPI

2004 109.5 188.9

2005 113.0 195.3

2006 116.6 201.6

2002 2003 2004 2005 2006

GDP deflator 104.19 106.41 109.46 113.00 116.57

Inflation 2.13% 2.87% 3.23% 3.16%

2002 2003 2004 2005 2006

Real GDP (billions of 2000 dollars) 10,048.80 10,301.00 10,675.80 11,003.40 11,319.40

Nominal GDP(billions of dollars) 10,469.60 10,960.80 11,685.90 12,433.90 13,194.70

GDP deflator 104.19 106.41 109.46 113.00 116.57

2002 2003 2004 2005 2006

Real GDP(billions of2000 dollars) 10,048.8 10,301.0 10,675.8 11,003.4 11,319.4

Nominal GDP(billions ofdollars) 10,469.6 10,960.8 11,685.9 12,433.9 13,194.7



Solution

14. The cost of a college education in the United States is rising at a rate faster than infla-tion. The table below shows the average cost of a college education in the UnitedStates in 2006 and 2007 for public and private colleges. Assume the costs listed in thetable are the only costs experienced by the various college students in a single year.

a. Calculate the cost of living for an average college student in each category for 2006and 2007.

b. Assume the quantity of goods purchased in each category, i.e., the market basket, isidentical for 2006 and 2007. Calculate an inflation rate for each type of collegestudent between 2006 and 2007.

14. a. To calculate the cost of living, we add all the costs in each category. The cost of liv-ing for each type of student is calculated in the accompanying table.

b. The inflation rate for each type of student is calculated as follows: ((price index in2007)/(price index in 2006)) × 100. Because the market basket stays the same foreach type of student, the cost of living can be used as a price index. Using the for-mula, the inflation rates are calculated in the following table.

Inflation rate

Two-year public college: commuter 6.8%

Four-year public college: resident 7.8%

Four-year public college: commuter 6.2%

Four-year public college: out of state 5.7%

Four-year private college: resident 6.2%

Four-year private college: commuter 5.8%

Average cost of attendance in dollars2006 2007

Two-year public college: commuter $12,294 $13,126

Four-year public college: resident 16,087 17,336

Four-year public college: commuter 16,967 18,014

Four-year public college: out-of-state 26,304 27,791

Four-year private college: resident 33,301 35,374

Four-year private college: commuter 33,085 35,001



Cost of college education (averages in 2006 dollars)Tuition and fees Books and supplies Room and board Transportation Other expenses

Two-year public college: commuter $ 2,272 $850 $6,299 $1,197 $1,676

Four-year public college: resident 5,836 942 6,690 880 1,739

Four-year public college: commuter 5,836 942 6,917 1,224 2,048

Four-year public college: out-of-state 15,783 942 6,960 880 1,739

Four-year private college: resident 22,218 935 8,149 722 1,277

Four-year private college: commuter 22,218 935 7,211 1,091 1,630

Cost of college education (averages in 2007 dollars)Tuition and fees Books and supplies Room and board Transportation Other expenses

Two-year public college: commuter $ 2,361 $921 $6,875 $1,270 $1,699

Four-year public college: resident 6,185 988 7,404 911 1,848

Four-year public college: commuter 6,185 988 7,419 1,284 2,138

Four-year public college: out-of-state 16,640 988 7,404 911 1,848

Four-year private college: resident 23,712 988 8,595 768 1,311

Four-year private college: commuter 23,712 988 7,499 1,138 1,664


Documents

Krug2e Macro PS CH07