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Practice Problems 129

PRACTICE PROBLEMS
1. Which of the following statements is the most appropriate description of gross
domestic product (GDP)?
A. The total income earned by all households, firms, and the government
whose value can be verified

B. The total amount spent on all final goods and services produced within the
economy during a given period

C. The total market value of resalable and final goods and services produced
within the economy during a given period

2. The component least likely to be included in a measurement of gross domestic

product (GDP) is:
A. the value of owner occupied rent.

B. the annual salary of a local police officer.

C. environmental damage caused by production.

3. Which of the following would be included in Canadian GDP for a given year? The
market value of:
A. wine grown in Canada by US citizens.

B. electronics made in Japan and sold in Canada.

C. movies produced outside Canada by Canadian filmmakers.

4. Suppose a painting is produced and sold in 2018 for £5,000. The expens-
es involved in producing the painting amounted to £2,000. According to the
sum-of-value-added method of calculating GDP, the value added by the final step
of creating the painting was:
A. £2,000.

B. £3,000.

C. £5,000.

5. Which of the following conditions is least likely to increase a country’s GDP?

A. An increase in net exports

B. Increased investment in capital goods

C. Increased government transfer payments

6. The most accurate description of nominal GDP is:

A. a measure of total expenditures at current prices.

B. the value of goods and services at constant prices.

C. a measure to compare one nation's economy to another.

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130 Learning Module 3 Aggregate Output, Prices, and Economic Growth

7. From the beginning to the ending years of a decade, the annual value of final
goods and services for country X increased from €100 billion to €300 billion.
During that period, the GDP deflator increased from 111 to 200. Over the de-
cade, real GDP for country X increased by approximately:
A. 50%.

B. 67%.

C. 200%.

8. If the GDP deflator values for Year 1 and Year 3 were 190 and 212.8, respectively,
which of the following best describes the annual growth rate of the overall price
level?
A. 5.8%

B. 6%

C. 12%

9. The numerator of the GDP price deflator reflects:

A. the value of base year output at current prices.

B. the value of current year output at current prices.

C. the value of current year output at base year prices.

10. Consider the following data for a hypothetical country:

Account name Amount ($ trillions)

Consumption 15.0
Capital consumption allowance 1.5
Government spending 3.8
Imports 1.7
Gross private domestic investment 4.0
Exports 1.5

Based only on the data given, the gross domestic product and national income
are respectively closest to:
A. 21.1 and 20.6.

B. 22.6 and 21.1.

C. 22.8 and 20.8.

11. In calculating personal income for a given year, which of the following would not
be subtracted from national income?
A. Indirect business taxes

B. Undistributed corporate profits

C. Unincorporated business net income

12. Equality between aggregate expenditure and aggregate output implies that the
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Practice Problems 131

government’s fiscal deficit must equal:

A. Private saving – Investment – Net exports.

B. Private saving – Investment + Net exports.

C. Investment – Private saving + Net exports.

13. Because of a sharp decline in real estate values, the household sector has in-
creased the fraction of disposable income that it saves. If output and investment
spending remain unchanged, which of the following is most likely?
A. A decrease in the government deficit

B. A decrease in net exports and increased capital inflow

C. An increase in net exports and increased capital outflow

14. A GDP deflator less than 1 indicates that an economy has experienced:
A. inflation.

B. deflation.

C. stagflation.

15. In explaining the downward slope of the aggregate demand curve, the interest
rate effect suggests that a higher price level will:
A. lead to lower interest rates, which will lead to higher levels of consumption
and investment.

B. lead to higher interest rates, which will lead to lower levels of consumption
and investment.

C. not affect interest rates and therefore will lead to a higher level of aggregate
demand.

16. One of the reasons the aggregate demand curve is downward sloping is because a
lower price level means that the real exchange rate:
A. depreciates, making domestic goods cheaper in other countries and imports
less competitive, resulting in a higher level of net exports.

B. appreciates, making domestic goods more expensive in other countries and

imports more competitive, resulting in a higher level of net exports.

C. appreciates, making the country’s exports and imports less competitive and
leading to lower net exports.

17. The full employment, or natural, level of output is best described as:
A. the maximum level obtainable with existing resources.

B. the level at which all available workers have jobs consistent with their skills.

C. a level with a modest, stable pool of unemployed workers transitioning to

new jobs.

18. Which of the following best describes the aggregate supply curve in the short run
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134 Learning Module 3 Aggregate Output, Prices, and Economic Growth

SOLUTIONS
1. B is correct. GDP is the total amount spent on all final goods and services pro-
duced within the economy during a specific period.

2. C is correct. Byproducts of production processes that have no explicit market

value are not included in GDP.

3. A is correct. Canadian GDP is the total market value of all final goods and ser-
vices produced during a given period within Canada. The wine was produced in
Canada and counts toward Canadian GDP.

4. B is correct. The value added by the artist is £5,000 – £2,000 = £3,000.

5. C is correct. Government transfer payments, such as unemployment compensa-

tion or welfare benefits, are excluded from GDP.

6. A is correct. Nominal GDP is defined as the value of goods and services mea-
sured at current prices. Expenditure is used synonymously with the value of
goods and services because aggregate expenditures must equal aggregate output
of an economy.

7. B is correct. Real GDP in the first year was €100 billion/1.11 = €90 billion, and
in the last year it was €300 billion/2.00 = €150 billion. Thus, (€150 – €90)/€90 =
0.67, or 67%.

8. A is correct: (212.8/190)1/2 – 1 = 0.0583, or 5.8%.

9. B is correct.
Value of current year output at current year prices
​GDP deflator = ___________________________________
​ Value
    
     of current year output at base year prices ​× 100​

10. B is correct. GDP = Consumption + Gross private domestic investment +

Government spending + (Exports – Imports) = 15 + 4 + 3.8 + (1.5 – 1.7) = 22.6.
National income = GDP – CCA = 22.6 – 1.5 = 21.1.

11. C is correct. Unincorporated business net income, also known as proprietor’s

income, is included in personal income.

12. A is correct. The fundamental relationship among saving, investment, the fiscal
balance, and the trade balance is S = I + (G – T) + (X – M). This form of the
relationship shows that private saving must fund investment expenditures, the
government fiscal balance, and net exports (= net capital outflows). Rearrang-
ing gives G – T = (S – I) – (X – M). The government’s fiscal deficit (G – T) must
equal the private sector’s saving/investment balance (S – I) minus net exports.

13. C is correct. The fundamental relationship among saving, investment, the fiscal
balance, and the trade balance is S = I + (G – T) + (X – M). Given the levels of
output and investment spending, an increase in saving (reduction in consump-
tion) must be offset by either an increase in the fiscal deficit or an increase in
net exports. Increasing the fiscal deficit is not one of the choices, so an increase
in net exports and a corresponding increase in net capital outflows (increased
lending internationally and/or increased international purchases of assets) are
the correct response.

14. B is correct. The GDP deflator = Nominal GDP/Real GDP. To obtain a ratio less
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Solutions 135

than 1, real GDP must exceed nominal GDP, which indicates that prices have
decreased and, accordingly, deflation has occurred.

15. B is correct. Assuming a fixed supply of money, a higher price level will lead to
a higher price of money. Because the price of money is the interest rate, as the
price level increases, the interest rate increases. Higher interest rates will lead to
lower consumption and investment.

16. A is correct. A lower price level results in a weaker real exchange rate, making
domestic goods cheaper to people in other countries and imports less competi-
tive, resulting in a higher level of net exports.

17. C is correct. At the full employment, or natural, level of output, the economy is
operating at an efficient and unconstrained level of production. Companies have
enough spare capacity to avoid bottlenecks, and there is a modest, stable pool of
unemployed workers (job seekers equal job vacancies) looking for and transition-
ing into new jobs.

18. C is correct. Because of long-term contracts and other rigidities, wages and other
input costs do not fully adjust to changes in the price level in the short run. Given
input prices, firms respond to output price changes by expanding or contracting
output to maximize profit. Hence, the SRAS is upward sloping.

19. B is correct. The slope of the short-run aggregate supply curve reflects the extent
to which wages and other input costs adjust to the overall price level. Automatic
adjustment of wages would mitigate the impact of price changes on profitability.
Hence, firms would not adjust output as much in response to changing output
prices—the SRAS curve would be steeper.

20. B is correct. A weak domestic currency will result in an increase in aggregate

demand at each price level—a rightward shift in the AD curve. A weaker cur-
rency will cause a country’s exports to be cheaper in global markets. Conversely,
imports will be more expensive for domestic buyers. Hence, the net exports
component of aggregate demand will increase.

21. B is correct. Productivity measures the efficiency of labor and is the amount of
output produced by workers during a given period. A decline in productivity
implies decreased efficiency. A decline in productivity increases labor costs,
decreases profitability, and results in lower output at each output price level—a
leftward shift in both the short-run and long-run aggregate supply curves.

22. C is correct. The wealth effect explains the impact of increases or decreases in
household wealth on economic activity. Household wealth includes financial and
real assets. As asset values increase, consumers save less and spend more out of
current income because they will still be able to meet their wealth accumulation
goals. Therefore, an increase in household wealth results in a rightward shift in
the aggregate demand curve.

23. B is correct. Higher aggregate demand and higher aggregate supply raise real
GDP and lower unemployment, meaning employment levels increase.

24. A is correct. Stagflation occurs when output is declining and prices are rising.
This dynamic most likely results from a decline in aggregate supply—a leftward
shift of the SRAS curve. Depending on the source of the shift, the LRAS may shift
too.

25. B is correct. An increase in energy prices will shift the short-run aggregate supply
curve (SRAS) to the left, reducing output and increasing prices. If the aggregate