Brief answers to problems and questions for review
1.
Not every market transaction is included in GDP. The items excluded from the
calculation of GDP include all of the intermediate goods produced in the country for
use as inputs into the production of final goods and services. In addition, nonmarket
transactions and illegal transactions are excluded.
2.
Although GDP uses current prices as a measure of market value, current prices can
distort our measure of real output. A rise in GDP does not mean there is an increase in
the quantity of goods and services that the economy produces. To distinguish
increases in the quantity of goods and services from increases in their prices, countries
construct real GDP. Nominal GDP is the value of final output measured in current
prices and real GDP is the value of final output measured in constant prices. When
calculating real GDP the market value of goods and services produced in a year is
adjusted to account for changing prices.
3.
GDP is composed of four components: (1) consumption by the public (C); (2) gross
private domestic investment (I); (3) government spending on goods and services (G);
and (4) net exports [exports (X) minus imports (M)].
4.
In a closed economy, firms must use any final good or service that individuals do not
consume or the government does not purchase to produce new plant and equipment.
The easiest way to express this for a closed economy is:
Y=C+I+G
Y or GDP equals the sum of consumption, investment, and government spending.
This equation holds in a closed economy because we have assumed that the public,
the government, or the business sector consumed or invested all output.
The equation for an open economy is:
Y = C + I + G + (X – M)
This equation shows that GDP in an open economy is equal to the sum of
consumption, investment, government spending, and the trade balance. Since the trade
balance is equal to the sum of exports and imports there are three possibilities. It is
possible that exports and imports would exactly match and GDP would equal
domestic spending. When a country’s exports are greater than its imports, the country
has a trade surplus and GDP is greater than domestic spending. When a country’s
imports are greater than its exports, the country has a trade deficit and GDP is less
than domestic spending.
5.
To illustrate this, we can rearrange the open-economy equation to yield:
X-M=Y–C–I–G
The equation shows that exports minus imports are equal to GDP minus consumption,
investment, and government spending. This equation illustrates that a country’s trade
deficit or surplus is essentially a residual of what is produced and consumed in the
© 2015 W. Charles Sawyer and Richard L. Sprinkle
domestic economy. This shows that with GDP of $10 trillion and the sum of C, I, and
G of $9 trillion, then by definition the trade balance must have a surplus of $1 trillion.
6.
Although a country’s total income equals GDP, not all income flows are immediately
spent on goods and services. Some income is temporarily withdrawn from this
circular flow. This income is referred to as leakages of income. There are three
sources of leakage: savings, taxes, and imports. However, these outflows of income
do not disappear from the economy. Businesses, government, and foreigners engage
in activities that inject money back into the circular flow. There are three sources of
injections: investment, government spending, and exports. For any economy the sum
of the outflows of income must equal the sum of the injections of spending so that:
S+T+M=G+I+X
7.
The relationship between a country’s trade balance and the other leakages and
injections of income can be shown with the following equation:
X–M=S–I+T–G
This illustrates that the trade balance becomes the mismatch between private saving
(S), government saving (T – G), and investment (I). When the leakages (S + T) are
greater than the injections (G + I), then the trade balance (X – M) will be positive.
When the sum of saving and taxes is less than the sum of government spending and
investment; the trade balance (X – M) will be negative. Examining trade imbalances
(X – M) in this manner gives us another way of looking at what causes them. For
example, consider a country with a trade deficit. A trade deficit indicates that the
country’s economy has an excess of domestic spending compared to domestic
production.
8.
The relationship between a country’s trade balance and the other outflows and
injections of income can be shown with the following equation:
X–M=S–I+T–G
Assuming that S, I, G, and T were equal to 10, 20, 30, and 40, respectively, then the
value of X – M would be 0.
9.
If S + T is 150 and G + I is 100, then given the following equation:
X – M = S +T – (I + G)
the country would have a trade balance of 50 or a trade surplus.
10.
Recall that the trade balance, X – M, is equal to S+T – G – I. If savings (S) were equal
to almost half of GDP, then it would be quite likely that X – M would be a positive
number.
11.
If a country is running a trade deficit then it is currently consuming more than it is
producing or in other words Y < C + I + G. However, in order to do this it must
borrow from the rest of the world. Presumably at some point this borrowing will have
© 2015 W. Charles Sawyer and Richard L. Sprinkle
to be paid back. In order to do this, at some point in the future domestic production
must be larger than consumption. A trade deficit today equals a trade surplus in the
future. It is in this sense that a country running a trade deficit is trading present
consumption for future consumption.
12.
The balance of payments is a summary of all the international transactions of a
country’s residents with the rest of the world during a given period of time, usually
one year.
13.
Purchases of goods, services, and financial and real assets by foreigners create an
inflow of dollars as they buy US goods, services and assets. Purchases of goods,
services, and financial and real assets by US citizens create an outflow of dollars as
US residents buy foreign goods, services and assets.
14.
A merchandise trade deficit means that imports of goods by a country are greater than
its exports of goods. A balance on services deficit means that imports of services by a
country are greater than its exports of services. A balance on goods and services
deficit means that imports of goods and services by a country are greater than its
exports of goods and services. A balance on investment income deficit means that
domestic income paid to foreigners is greater that foreign income received from
abroad. A balance on goods, services and income deficit means that imports of goods,
services and income paid to foreigners by a country are greater than its exports of
goods, services and income received from foreigners. A balance on current account
deficit means that imports of goods, services, income paid to foreigners, and unilateral
transfers by a country are greater than its exports of goods, services and income
received from foreigners. A balance on financial account deficit means that imports of
financial and real assets by a country are greater than its exports of financial and real
assets.
15.
Suppose that a country had a balance on current account equal to a positive $100
million and a merchandise trade deficit of $90 million. This means that the country
had a surplus of $190 million in services, income earned abroad, and unilateral
transfers.
16.
a.
b.
c.
d.
e.
f.
g.
h.
i.
17.
merchandise trade balance $100
balance on services $50
balance on goods and services $150
balance on investment income –$50
balance on goods, services and income $100
unilateral transfers –$10
balance on current account $90
balance on capital and financial account –$100
statistical discrepancy $10.
If we examine the different stages of the balance of payments that follows a
country’s development from poor to rich, we find that a poor country usually has
abundant labor and scarce capital. To raise its GDP per capita, the country must
increase the amount of capital per worker. A solution is to import foreign capital
in the form of foreign direct investment. This creates a capital account surplus and
© 2015 W. Charles Sawyer and Richard L. Sprinkle
a current account deficit. Over time, the foreign direct investment may lead to an
increase in exports that creates a trade surplus. However, investment income may
be negative, as the return to the foreign investors must be paid. As the debt is paid,
the country shifts to a current account surplus and a capital account deficit. This
capital account deficit may eventually lead to a surplus in investment income. If
the investment income surplus becomes large enough, then the trade balance may
shift into a deficit that is offset by a positive investment income.
© 2015 W. Charles Sawyer and Richard L. Sprinkle