Module 1: National Income Accounting. Practice problems and illustrative test questions for the final exam

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1 Module 1: National Income Accounting Practice problems and illustrative test questions for the final exam (The attached PDF file has better formatting.) This posting gives sam ple final exam problem s. Other topics from the textbook are asked as well; these problems are just examples. All final exam problems are multiple choice; some practice problems are not m ultiple choice so that the solutions methods can be explained with no distraction of wrong choices. ** Question 1.1: GDP and GNP U.S. GDP in 20X2 is 400,000.! Jacob, a U.S. citizen, works in Paris and earns 30,000.! Jacques, a French citizen, works in Boston and earns 40,000.! Rachel, a U.S. citizen, owns a condominium in Berlin which she rents to a German family for 20,000.! Angela, a German citizen, owns a warehouse in California which she rents to a U.S. firm for 70,000. W hat is U.S. GNP in 20X2? A. 340,000 B. 350,000 C. 390,000 D. 410,000 E. 460,000 Answer 1.1: A 400, ,000 40, ,000 70,000 = 340,000 GDP (Gross Dom estic Product) is the wealth produced in the country, regardless who owns the wealth. GNP is the wealth produced by citizens of the country, regardless where the wealth is produced. Jacob: W hich is the better measure, GDP or GNP? Rachel: Each m easure has advantages. GDP is the better measure of the wealth produced in the country. W e don t care about the citizenship of the people producing the wealth. If Jacob and Jacque work as actuaries and each produces 50,000 of wealth, GDP increases the same amount from each worker, even if Jacob is a citizen and Jacques is a foreigner. GDP is the better measure of the wealth produced by the citizens. W e don t care where the people work. If Jacob and Rachel are oil engineers earning 50,000 apiece, GNP increases the sam e am ount from each worker, even if Jacob works in Texas and Rachel works in Libya. See Barro Macroeconomics Chapter 2 National Incom e Accounting, page 20

2 ** Question 1.2: GDP vs Income W hich of the following is true regarding the national income accounts? A. GDP > GNP B. NNP > GNP C. Personal income > national income D. National income > NNP E. Personal income > disposable personal incom e Answer 1.2: E Statement A: GDP may be more or less than GNP. For the world as a whole (combining the national income accounts for all countris), GDP = GNP. Statement B: NNP = GNP depreciation, so NNP < GNP. Statement C: National income is more than personal income in the United States, though the relation depends on the size of personal transfer paym ents and corporate taxes. Statement D: National incom e = NNP (net national product), except for statistical discrepancies. Statement E: Personal incom e personal taxes = disposable personal incom e See Barro Macroeconomics Chapter 2 National Incom e Accounting, page 21

3 ** Question 1.3: National incom e National incom e has the following pieces:! Net factor income from abroad = 10! Income from private domestic industries = 780! Incom e from governm ental industries = 100 The national accounts also show! Personal consum ption expenditures = 500! Governm ent purchases = 250! Exports = 40! Imports = 60! Depreciation = 30 W hat is gross private domestic investment? A. 150 B. 180 C. 220 D. 230 E. 240 Answer 1.3: B Measuring by the production approach gives National income = NNP = = 890. Subtract factor income from abroad to get NDP = = 880. Add depreciation to get GDP = = 910. Use expenditure approach: GDP = (40 60) + investment investment = 910 ( ) = 180 See Barro Macroeconomics Chapter 2 National Incom e Accounting, page 22

4 ** Exercise 1.4: GDP and social welfare France has proposed a GDP yardstick that better m easures social welfare. A. W hy might real GDP not be a good measure of social welfare? B. W hy are the criticisms of real GDP too subjective for scientific use? C. W hy might traditional real GDP be a good measure of social welfare? Part A: The problems of real GDP as a measure of social welfare are shown by the Soviet satellites before the collapse of the Soviet Union, such as East Germany. Industrial production was forced on communities with no concern for environm ental hazards. The social welfare costs of pollution often exceeded the welfare benefits of higher real GDP. Part B: Social welfare costs like global warm ing and degradation of the environm ent depend on the observer. Carbon dioxide em issions m ight expose the world to natural catastrophes and a less healthy environm ent many years in the future, but these costs are unknown. Part C: Economic progress is often the best way to solve other problems. W ealthier countries can afford better education and health care for their citizens; programs to reduce air and water pollution; and welfare paym ents to reduce incom e inequality. During the transition phase, developing countries m ay neglect non-econom ic goals, and they may have high growth rates of real GDP but poor results on other objectives. In the steady state phase, the wealthier countries have the best grades on other indices of social welfare. The textbook lists items that are not in GDP but affect social welfare. See Barro Macroeconomics Chapter 2 National Incom e Accounting, page 15, colum n 2.

5 ** Exercise 1.5: Inflation indices An economy produces only two goods: bread and muffins. Consumers buy bread vs muffins by their relative prices. From 2000 to 2010, the price of a loaf of bread increases from $1 to $2 and the price of a muffin increases from $2 to $3.! Index Y m easures inflation based on quantities in year 2000.! Index Z m easures inflation based on quantities in year A. W hich good has a greater increase in its relative price? B. W hich good has an increase in its equilibrium quantity? C. W hich inflation index is higher, Y or Z? Part A: In 2000, one loaf of bread can buy ½ a muffin; in 2010, one loaf of bread can buy b of a muffin. The relative price of bread have increased b / ½ 1 = 33.33%. In 2000, one m uffin can buy two loaves of bread; in 2010, one m uffin can buy 1.5 loaves of bread. The relative price of bread has decreased 1.5 / 2 1 = 25.00%. Alternatively, the absolute price of bread increased 100%, and the absolute price of m uffins increased 66.7%, so the relative price of bread increased and the relative price of muffins decreased. Part B: The demand curves for bread and muffin remain the same in real terms.! The relative price of bread increases, so its equilibrium quantity decreases.! The relative price of muffins decreases, so its equilibrium quantity increases. Part C: The relative quantity of bread decreases from 2000 to Its relative price increases com pared to muffins, so the inflation index that puts more weight on bread shows the higher inflation rate. Index Y uses the 2000 relative quantities, so it puts more weight on bread. Jacob: W hat does this illustration show? Rachel: An inflation index that uses quantities based on a market basket of goods at the beginning of the period overstates inflation (as the CPI does).