ECON EXAM #3 - 15, 16, 20

CHAPTER 15

MICROeconomics:

• Looks at the individual parts of an economy

• ex: a household deciding what to buy

MACROeconomics:

• Looks at the economy as a whole

• inflation, unemployment

GDP =

The market value of final goods and services produced within a country in a given period

GDP uses market prices to determine the value of different goods and services.

For example:

• Apple = $1

• Orange = $2

If you produce 10 apples:

10 × $1 = $10

If you produce 10 oranges:

10 × $2 = $20

-is this included in the GDP?

No, because they aren’t measured in the same units. You cannot simply add 10 apples + 10 oranges + 3 cars + 5 haircuts

Important things not included in the GDP:

-illegal production

-household production

-volunteer work

-leisure

Illegal production - selling drugs

Household production - things you do yourself, like mowing your own lawn instead of paying someone else to do it

Volunteer work - volunteering is free

Leisure - done on your own time; does not count either

final good vs intermediate good:

• final good - a good purchased by its final user

• intermediate good - a good used to produce another good

Final Good Example:

Suppose:

A farmer sells wheat to a baker for $2.

The baker uses the wheat to make bread.

The consumer buys the bread for $3.

What goes into GDP?

$3, not $5.

Why?

Because the $2 wheat is already incorporated into the $3 price of the bread.

If we counted both:

$2 wheat + $3 bread = $5

Important Exception of GDP:

Suppose a company produces a computer worth $1,000 but doesn't sell it.

Instead, it puts it into inventory.

The $1,000 can still count toward GDP because the computer was produced during that period.

The national accounts treat the increase in inventory as investment.

Produced but not sold =

inventory investment

• A company produces a new car for 30,000

• You sell your old car to another person for 15,000

Determine if it counts toward GDP.

1. counts toward GDP

2. does not count toward GDP

• A Canadian works temporarily in the United States.

  The production occurs in the U.S.

• An American owns a factory in Haiti.

  The factory produces goods in Haiti.

Determine if it counts toward GDP.

1. Counts toward GDP

2. Does not count toward GDP

GDP can be viewed as total _______ OR total ________

income, expenditure

Income = Expenditure Example:

You pay a barber $30.

You:

Spend $30

The barber:

Earns $30

Therefore:

Expenditure = Income

The Four Components of GDP:

Y = C + I + G + NX

Where:

Symbol	Meaning
Y	GDP
C	Consumption
I	Investment
G	Government purchases
NX	Net exports

The Four Components of GDP:

CONSUMPTION (C)

Household spending on goods and services, NOT including new housing

Ex: food, clothes, cars, furniture

The Four Components of GDP:

INVESTMENT (I)

Purchases of capital goods used for future production

Ex: machines, (new housing is considered an investment)

Investment Example:

A company buys a new $500,000 machine.

→ Investment

A person buys $500,000 of stocks.

→ Not GDP investment

The Four Components of GDP:

GOVERNMENT PURCHASES (G)

Include government spending on currently produced goods and services

Ex: government employee salaries

-TRANSFER PAYMENTS ARE NOT GOVERNMENT PURCHASES!!! (Social Security, unemployment benefits)

The Four Components of GDP:

NET EXPORTS (NX)

NX = Exports - Imports

Exports:

Goods/services produced domestically and sold to foreigners.

→ Increase GDP (we make it here and EXPORT it to another country)

Imports:

Goods/services produced abroad and bought domestically.

→ Subtract from NX (another country makes it and we buy it from them, decreasing GDP)

U.S. company sells an airplane to France for $10 million.

Exports = +$10 million

-What happens to NX?

increases

Now suppose an American buys a $40,000 car made in Sweden.

Consumption rises by $40,000.

But because the car was produced abroad:

Imports = +$40,000

-What happens to NX?

decreases

The government sends an unemployment check to someone who lost their job.

C, I, G, or NX?

NONE

No transfer payments count towards GDP

Nominal GDP vs. Real GDP:

Suppose an economy produces:

• 100 pizzas in Year 1

• 100 pizzas in Year 2

But the price increases from:

$10 → $15

Nominal GDP increases (current price), but the economy did not produce more pizzas

Nominal GDP vs. Real GDP:

uses BASE year prices to measure production

Nominal GDP vs. Real GDP EXAMPLE:

Suppose the economy produces only pizza.

Year 2025

100 pizzas × $10 = $1,000

Year 2026

120 pizzas × $15 = $1,800

 _______________________________

Nominal GDP in 2026

Use 2026 prices:

___

 

Real GDP in 2026

Suppose 2025 is the base year.

Use the 2025 price:

___

So:

So:

• Nominal GDP = (current price and quantity in 2026) $1,800

• Real GDP = (2025 price and 2026 quantity) $1,200

The difference comes from the higher price.

3 Big GDP Formulas:

1. Calculating nominal GDP and real GDP

2. (Nominal GDP / real GDP) x 100

3. (New deflator - old deflator) / (old deflator) x 100

GDP EXAMPLE:

• 2020 base-year price = $10

• 2021 current price = $12

• 2021 quantity = 100 shoes

Nominal GDP:

$1,200

Real GDP:

$1,000

Step 2. Calculate the GDP deflator.

120

Step 3. Calculate the percentage change in the deflator.

Old deflator = 100.

= 20%

Economists generally use _____ to measure economic growth

Real GDP

Because if nominal GDP increases, we don't know whether:

• production increased,

• prices increased,

• or both.

Real GDP removes the price effect.

GDP / population

It gives us an idea of the average amount of income/expenditure per person.

GDP is useful because higher income generally allows people to obtain more goods and services.

Higher GDP can make it easier for a society to afford:

• Healthcare

• Education

• Housing

• Food

• Infrastructure

• Other material necessities

Is GDP a perfect measure of well-being?

NO!

Name if the following things are counted in GDP?

-Leisure

-Cooking at home

-Buying a meal at a restaurant

-volunteer work

-no

-no

-yes

-no

GDP

Production _______

GNP

Income earned by a country's _________

The major distinction:

GDP = ?

GNP = ?

GDP

Production within a country's borders.

GNP

Income earned by a country's permanent residents/nationals.

The major distinction:

GDP = location

GNP = nationality/residency

National Income

Income earned by a nation's residents from producing goods and services.

Personal Income

Income received by households and noncorporate businesses.

Disposable Personal Income

Personal income left after personal taxes and certain nontax payments.

CHAPTER 16

Cost of living:

Imagine that you spend:

• $50 on groceries

• $30 on gas

• $20 on entertainment

Total = $100

Now imagine that a year later, those same things cost:

• $60 on groceries

• $40 for gas

• $25 entertainment

Total = $125

Your cost of living has increased.

CPI:

Consumer Price Index measures the cost of a fixed basket of goods and services relative to the cost of that same basket in a base year

The Market Basket:

For example, suppose our imaginary consumer buys:

• 4 hot dogs

• 2 hamburgers

That's our basket.

Why does the quantity matter?

Because if consumers buy a lot of something, changes in its price have a bigger effect on their cost of living.

If someone spends $500 a month on housing and only $20 on coffee, a 10% increase in housing prices has a much bigger effect on their cost of living than a 10% increase in coffee prices.

Your cost of living will not increase if the coffee prices go up because it is not a necessity to live

HOW CPI IS CALCULATED:

Step 1: Fix the basket

Determine what goods and services the typical consumer buys.

Our example:

-4 hot dogs

-2 hamburgers

HOW CPI IS CALCULATED:

Step 2: Find the Prices

Find the price of each item in different years.

Example:

Year	Hot Dog	Hamburger
2025	$1	$2
2026	$2	$3
2027	$2.50	$4

HOW CPI IS CALCULATED:

Step 3: Calculate the basket's cost

Multiply:

Quantity × Price

and add everything together.

2025

4 hot dogs × $1 = $4

2 hamburgers × $2 = $4

Total basket:

$8

2026

4 × $2 = $8

2 × $3 = $6

Total:

$14

2027

4 × $2.50 = $10

2 × $4 = $8

Total:

$18

Notice something important:

The quantities stay the same.

Only prices change.

HOW CPI IS CALCULATED:

Step 4: Choose a Base Year

The base year is the benchmark year.

The CPI formula is: (cost of basket in current year)/(cost of basket in base year) x 100

HOW CPI IS CALCULATED:

Step 5: Let's Calculate the CPI

Suppose 2025 is our base year.

We already calculated:

2025 basket = $8

2026 basket = $14

Therefore: 175

-What does CPI = 175 mean?

It means the basket costs 175% of what it cost in the base year.

Inflation Rate Formula:

(CPI new - CPI old / CPI old) x 100

CPI VS. INFLATION:

CPI

Measures the level of prices.

Inflation

Measures the rate at which the price level is changing

Why Does CPI Use a Fixed Basket?

The goal is to measure how much the cost of purchasing the same collection of goods changes.

The Three CPI Problems

1. Substitution bias

Consumers switch toward relatively cheaper goods.

2. New goods

New products increase consumer choice and purchasing power, but a fixed basket doesn't immediately capture the benefit.

3. Unmeasured quality changes

Products can become better or worse, and measuring the value of those changes is difficult.

How Large Is the CPI Bias?

0.5% to 1.0% per year

Producer Price Index (PPI)

 

While CPI focuses on prices faced by consumers, PPI measures prices received by producers.

Think:

CPI → consumers

PPI → producers

CPI vs. GDP Deflator:

CPI

Measures prices of goods and services bought by consumers.

GDP Deflator

Measures prices of goods and services produced domestically.

Do CPI and the GDP deflator include imports?

-CPI includes imports

-GDP does NOT include imports

CPI vs. GDP example:

The price of imported French wine increases.

Which index is affected?

CPI → YES

U.S. GDP deflator → NO

Suppose the price of a fighter jet increases.

The government buys the fighter jet.

-Which index is affected?

The jet is part of GDP because it is domestically produced.

Therefore:

GDP deflator → affected

But consumers aren't buying fighter jets as part of the CPI basket.

Therefore:

CPI → not affected

CPI vs. GDP Deflator Chart:

Measures:	CPI Consumer prices	GDP Deflator Domestic production prices
Imports:	✅ Included	❌ Not included
Consumer goods:	✅Included	If domestically produced
Investment goods:	Generally ❌	✅
Government purchases:	❌	✅
Basket:	Relatively fixed	Changes with GDP
Main perspective:	Consumer	Domestic producer/economy

Nominal vs. Real Interest Rates

Suppose you put:

$1,000

into a savings account.

After one year you have:

$1,050

Your account increased by:

5%

That's the nominal interest rate.

Now suppose prices also increased by 4% and your money increased by 5%, but prices increased by 4%. Your purchasing power increased by only 1%. What is this?

real interest rate

Nominal Interest Rate:

The nominal interest rate measures how quickly the number of dollars in your account increases.

Real Interest Rate:

The real interest rate measures how quickly the purchasing power of your money changes.

Real interest rate = Nominal interest rate − Inflation rate