1. An economy's income must equal its expenditure, because every transaction has a buyer and a seller. Thus, expenditure by buyers must equal income by sellers.

5. The four components of GDP are consumption, such as the purchase of a music CD; investment, such as the purchase of a computer by a business; government purchases, such as an order for military aircraft; and net exports, such as the sale of American wheat to Russia. (Many other examples are possible.)

6. Economists use real GDP rather than nominal GDP to gauge economic well-being because real GDP is not affected by changes in prices, so it reflects only changes in the amounts being produced. You cannot determine if a rise in nominal GDP has been caused by increased production or higher prices.

8. It is desirable for a country to have a large GDP because people could enjoy more goods and services. But GDP is not the only important measure of well-being. For example, laws that restrict pollution cause GDP to be lower. If laws against pollution were eliminated, GDP would be higher but the pollution might make us worse off. Or, for example, an earthquake would raise GDP, as expenditures on cleanup, repair, and rebuilding increase. But an earthquake is an undesirable event that lowers our welfare.

1. a. Consumption increases because a refrigerator is a good purchased by a household.

b. Investment increases because a house is an investment good.

c. Consumption increases because a car is a good purchased by a household, but investment decreases because the car in Ford’s inventory had been counted as an investment good until it was sold.

d. Consumption increases because pizza is a good purchased by a household.

e. Government purchases increase because the government spent money to provide a good to the public.

f. Net exports decrease because the bottle was imported.

g. Investment increases because new structures and equipment were built.

5. a. Calculating nominal GDP:

2008: ($1 per qt. of milk ´ 100 qts. milk) + ($2 per qt. of honey ´ 50 qts. honey) = $200

2009: ($1 per qt. of milk ´ 200 qts. milk) + ($2 per qt. of honey ´ 100 qts. honey) = $400

2010: ($2 per qt. of milk ´ 200 qts. milk) + ($4 per qt. of honey ´ 100 qts. honey) = $800

2008: ($1 per qt. of milk ´ 100 qts. milk) + ($2 per qt. of honey ´ 50 qts. honey) = $200

2009: ($1 per qt. of milk ´ 200 qts. milk) + ($2 per qt. of honey ´ 100 qts. honey) = $400

2010: ($1 per qt. of milk ´ 200 qts. milk) + ($2 per qt. of honey ´ 100 qts. honey) = $400

2008: ($200/$200) ´ 100 = 100

2009: ($400/$400) ´ 100 = 100

2010: ($800/$400) ´ 100 = 200

b. Calculating the percentage change in nominal GDP:

Percentage change in nominal GDP in 2009 = [($400 − $200)/$200] ´ 100 = 100%.

Percentage change in nominal GDP in 2010 = [($800 − $400)/$400] ´ 100 = 100%.

Percentage change in the GDP deflator in 2010 = [(200 − 100)/100] ´ 100 = 100%.

Prices did not change from 2008 to 2009. Thus, the percentage change in the GDP deflator is zero. Likewise, output levels did not change from 2009 to 2010. This means that the percentage change in real GDP is zero.

c. Economic well-being rose more in 2008 than in 2009, since real GDP rose in 2009 but not in 2010. In 2009, real GDP rose but prices did not. In 2010, real GDP did not rise but prices did.

2. The three problems in the consumer price index as a measure of the cost of living are: (1) substitution bias, which arises because people substitute toward goods that have become relatively less expensive; (2) the introduction of new goods, which are not reflected quickly in the CPI; and (3) unmeasured quality change.