Macroeconomics Examination Questions

1. A first look at Macroeconomics

2. Real GDP—real gross domestic product

3. GDP and the Circular Flow of Expenditure and Income

The circular flow illustrates the equality of income, expenditure, and the value of production. The circular flow diagram shows the transactions among four economic agents—households, firms, governments, and the rest of the world—in two aggregate markets—goods markets and factor markets.

In the goods market, households, firms, governments, and foreigners buy goods and services. For analytical purposes, we can categorize spending by these four agents in the calculation of GDP:

• The total payment for goods and services by households in the goods markets is consumption expenditure, C.

• The purchases of new plants, equipment, and buildings and the additions to inventories are investment, I.

• Governments buy goods and services, called government expenditure or G, from firms.

• Firms sell goods and services to the rest of the world, exports or X, and buy goods and services from the rest of the world, imports or M. Exports minus imports are called net exports, X  M.

In factor markets households receive income from selling the services of resources to firms. The total income received is aggregate income. It includes wages paid to workers, interest for the use of capital, rent for the use of land and natural resources, and profits paid to entrepreneurs; retained profits can be viewed as part of household income, lent back to firms.

GDP Equals Expenditure Equals Income

Aggregate expenditure equals C + I + G + (X  M). Aggregate expenditure equals GDP because all the goods and services that are produced are sold to households, firms, governments, or foreigners. (Goods and services not sold are included in investment as inventories and hence are “sold” to the producing firm.)

• Because firms pay out as income everything they receive as revenue from selling goods and services, aggregate income equals aggregate expenditure equals GDP.

The “Gross” in gross domestic product reflects the fact that the investment in GDP is gross investment and so part of it goes to replace depreciating capital. Net domestic product subtracts depreciation from GDP.

4. The Expenditure Approach

5. The Income Approach

The income approach measures GDP as the sum of compensation of employees, net interest, rental income, corporate profits, and proprietors’ income. This sum equals net domestic income at factor costs. To obtain GDP, indirect taxes (which are taxes paid by consumers when they buy goods and services) minus subsidies plus depreciation are included. Finally any discrepancy between the expenditure approach and income approach is included in the income approach as “statistical discrepancy.”

6. Nominal GDP and real GDP

The market value of production and hence GDP can increase either because the production of goods and services are higher or because the prices of goods and services are higher.

Real GDP allows the quantities of production to be compared across time. Real GDP is the value of final goods and services produced in a given year when valued at the prices of a reference base year.

Nominal GDP is the value of the final goods and services produced in a given year valued at the prices that prevailed in that same year.

Calculating Real GDP

Traditionally, real GDP is calculated using prices of the reference base year (the year in which real GDP=nominal GDP).