Economics 101b: Fall 2001: Problem Set 1

J. Bradford DeLong

1. Explain whether or not and why the following items are included in the calculation of GDP:

A. Declines in business inventories
B. The fees earned by real estate agents on selling existing homes
C. Social Security checks written by the government
D. Purchase of a new aircraft carrier by the Department of Defense
E. Rent that you pay to your landlord
F. Purchases of American-made trucks by foreign residents

A. Yes. Decreases in business inventories are counted as negative investment; they are part of investment spending.

B. Yes. They are providing a useful (and paid for) service: helping you sell your house.

C. No. Social Security checks are neither consumption spending, investment spending, government purchases (the government hasn't bought anything from you), or net exports. They are not a component of GDP. Social Security checks do show up in the calculation of disposable income, however: they are counted as negative taxes--as transfer payments from the government to households that boost household disposable income.

D. Yes. The purchase of an aircraft carrier is definitely a government purchase.

E. Yes. Rent that you pay is part of your consumption spending: you are purchasing "housing services" from your landlord. F. Yes. These are exports, and are definitely part of GDP.

2. Do you calculate real GDP by dividing nominal GDP by the price level or by subtracting the price level from nominal GDP?

By dividing nominal GDP by the price level (more precisely, dividing by the GDP implicit price deflator.

3. Do you calculate the real interest rate by dividing the nominal interest rate by the price level or by subtracting the inflation rate from the nominal interest rate?

By subtracting the inflation rate from the nominal interest rate.

4. Are your answers to 2 and 3 the same? Since both sets of calculation aim to transform a real into a nominal quantity, shouldn't they be calculated in a parallel fashion?

No, they are not the same. The reason for the different treatment is that the first calculation is concerned with levels, and the second with rates of change. As you will remember from our mathematical rules of thumb, division turns into subtraction when we move from levels to rates of change.

5. In 1979 the (short-term) nominal interest rate on three-month Treasury bills averaged 10.0%, and the GDP deflator rose from 50.88 to 55.22. What was the annual rate of inflation in 1979? What was the real interest rate in 1979?

a. Were real interest rates higher in 1979, or in 1998 (when the (short-term) nominal interest rate on three-month Treasury bills was 4.8%, and the inflation rate was 2.6%?
b. Which interest rate concept--the nominal interest rate or the real interest rate--do lenders and borrowers care more about? Why?

The rate of inflation--the proportional rate of change of the price level--was about 8.5% per year in 1979, and the real interest rate was 1.5% per year. a. In 1998, the real interest rate was 2.2% per year, so the real interest rate was higher in 1998 than it had been in 1979.

b. It is the real interest rate that lenders and borrowers care more about. In the end it is not the number of dollar bills you can spend that determines your welfare, but how many goods and services those dollar bills can buy. Thus the real interest rate--the interest rate adjusted for inflation, the interest rate in terms of goods and services--is ultimately more important than the nominal interest rate.

6. Suppose that the appliance store buys a refrigerator from the manufacturer on December 15, 2003 for $600, and that you then buy that refrigerator on January 15, 2004 for $750. a. What is the contribution to GDP in 2003? b. How is the refrigerator accounted for in the NIPA in 2003? c. What is the contribution to GDP in 2004? d. How is the refrigerator accounted for in the NIPA in 2004?

a. $600 of inventory investment are credited to 1993.

b. The refrigerator counts as inventory investment in 1993.

c. In 1994 $750 of consumption demand are credited to GDP, and -$600 of inventory disinvestment are debited from GDP, so the total contribution in 1994 is $150.

d. The refrigerator shows up both as a positive in consumption and a negative in inventory investment.

7. What do economists mean when they say that it is time to "build a model" of a situation or a problem?

To strip down a situation to its simplified essentials, and then to use quantitative methods to analyze the implications of those simplified essentials that you have focused on.

8. Write down four metaphors that you have heard people use in talking about the economy that are now--or were at the time--obscure to you.

This is an open-ended question--one that has many answers. Moreover, this is a question that it is genuinely hard for me to answer because it is genuinely hard for me to remember when these metaphors were ever obscure or concusing. It has been too long, and now economic metaphors are too ingrained into my thought. The idea that a process of rising inflation and falling unemployment is "pushing the economy up the Phillips curve" still strikes me as strange. The idea that money has a "velocity"; the circular flow metaphor itself; and the idea that you can speak of a single "labor market" are also candidates.

9. In what sense can a line on a graph "be" an equation?

In the sense of Rene Descartes's analytic geometry. Plot one variable on the vertical axis, a second on the horizontal axis. And the set of points whose coordinates satisfy an equation makes up a curve that we can identify with the equation.

10. What are the principal flaws in using GDP per worker as a measure of material welfare? Given these flaws, why do we use it anyway?

It does a lousy job of taking account of within-the-household non-marketed production. It measures goods at their market prices, rather than at the level of user satisfaction they produce. It has no place for "bads"--pollution, resource depletion, crime. In fact, it counts expenditures necessary to try to limit the damage done by "bads" as positive accomplishments.