AP Macroeconomics: Economic Indicators and the Business Cycle Quiz (Part II)

In AP Macroeconomics, nominal GDP can be calculated using both the expenditure approach and the income approach. Theoretically, both methods should yield the same result, as total spending in an economy must equal total income.

Expenditure Approach

The expenditure approach calculates GDP by summing up all spending on final goods and services in an economy over a period. It is represented by the formula: ext{GDP} = C + I + G + (X - M)

• C (Consumption): Spending by households on goods and services (e.g., food, housing, education, healthcare).

• I (Investment): Spending by businesses on capital goods (e.g., machinery, factories), new housing construction, and changes in inventories.

• G (Government Spending): Spending by all levels of government on goods and services (e.g., infrastructure, military, public employee salaries). This excludes transfer payments like social security.

• (X - M) Net Exports: The value of exports (X) minus the value of imports (M$). (X) represents goods and services produced domestically and sold abroad, while (M) represents goods and services produced abroad and purchased domestically.

Income Approach

The income approach calculates GDP by summing up all the incomes earned by the factors of production in the economy. It includes:

• Wages: Payments to workers for their labor.

• Rent: Income earned from land and property.

• Interest: Income earned from capital (e.g., loans, investments).

• Profit: Income earned by businesses (owners' income).

• Indirect Business Taxes: Taxes like sales tax, excise tax, and property taxes, which are included in the price of goods and services.

• Depreciation (Consumption of Fixed Capital): The wear and tear on capital goods, which represents a cost of production.

Key Differences

• What they measure: The expenditure approach measures the total spending on final goods and services, reflecting demand in the economy. The income approach measures the total income generated from producing those goods and services, reflecting the supply side.

• Components: Their components are distinct. Expenditure focuses on the categories of buyers (households, firms, government, foreign sector), while income focuses on the types of earnings (wages, rent, interest, profit, plus adjustments).

In essence, the expenditure approach looks at "who buys what," while the income approach looks at "who earns what" from producing goods and services.

To calculate nominal GDP using the expenditure approach with the components you've listed, you would sum consumption spending, investment spending, and net exports. The formula is: {GDP}=C+I+G+(X-M)

• Consumption spending (C): This is the spending by households on goods and services.

• Investment spending (I): This is the spending by businesses on capital goods, new housing, and changes in inventories.

• Net Exports (X - M): This is the value of exports minus the value of imports.

Savings are not directly included in the GDP calculation through the expenditure approach, as GDP measures aggregate spending. You would also typically need Government Spending (G), which represents spending by all levels of government on goods and services, to complete the calculation using the full expenditure approach formula. If government spending is not provided, you can only calculate a partial GDP from the given components.

Example Problem: Calculating Nominal GDP using Expenditure and Income Approaches

Scenario:
An economy has the following economic activities in a given year:

Question:

1. Calculate the Nominal GDP using the Expenditure Approach.

2. Calculate the Nominal GDP using the Income Approach.

3. Identify which items from the table are not included in the GDP calculation and explain why.

Solution:

1. Expenditure Approach:
   The formula for the expenditure approach is: \text{GDP} = C + I + G + (X - M)

   • C (Consumption): 10,000 ext{ billion}

   • I (Investment): 2,500 ext{ billion}

   • G (Government Spending): 3,000 ext{ billion}

   • (X - M) Net Exports: 2,000 - 1,500 = 500 ext{ billion}

   \text{GDP} = 10,000 + 2,500 + 3,000 + 500
   \text{GDP} = 16,000 ext{ billion}

2. Income Approach:
   The income approach sums all incomes earned by factors of production, plus indirect business taxes and depreciation.

   • Wages and Salaries: 8,000billion

   • Rental Income: 1,200 ext{ billion}

   • Corporate Profits: 2,800 ext{ billion}

   • Net Interest Income: 900 ext{ billion}

   • Indirect Business Taxes: 1,600 ext{ billion}

   • Depreciation (Consumption of Fixed Capital): 1,500 ext{ billion}

   \text{GDP} = 8,000 + 1,200 + 2,800 + 900 + 1,600 + 1,500
   \text{GDP} = 16,000 ext{ billion}

3. Items Not Included in GDP Calculation:

   • Social Security Payments (700 ext{ billion}): These are transfer payments from the government to individuals. They do not represent production of new goods or services, but rather a transfer of existing income.

   • Purchase of Used Cars (500 ext{ billion}): GDP measures only the value of newly produced goods and services. Buying used goods is merely a transfer of existing assets and does not represent new production.

   • Government Unemployment Benefits (400 ext{ billion}): Similar to social security, these are transfer payments. They are provided by the government without any corresponding production of goods or services by the recipient.

In this scenario, the contribution to nominal GDP is the value of the final good sold to the end consumer. The wheat and the bread sold to the bakery are considered intermediate goods, meaning they are used in the production of another good. To avoid double-counting, only the value of the final good is included in GDP. Therefore, the nominal GDP contribution from this chain of production is the 30 \text{ trillion} that the baker sells the bread for to the final consumers.