Unit I – Intro and Measurement

Chapter 1 Introduction

n Solutions to End-of-Chapter Problems

1. Calculating percentage growth rates, and log approximations to percentage growth rates, we
obtain:

Year Percentage Growth Rate Log Approximation

2011 0.828625 0.825211

2012 1.448554 1.438162

2013 0.742574 0.739831

2014 1.632587 1.619403

In this case, calculating the change in the natural logarithm from one year to the next gives a good
approximation to the percentage growth rate, as the growth rates are small. But if we do the same
thing for growth rates over ten-year periods, as below, the approximation is poor, as the growth
rates are relatively large.

Ten-year percentage growth rate Log Approximation

196
0 20.11502 18.32796

197
0 34.04096 29.29752

198
0 22.534 20.32183

199
0 26.45757 23.47367

200
0 23.60228 21.18988

201
0 6.711907 6.496256

Copyright ©2018 Pearson Education, Inc.

2 Williamson • Macroeconomics, Sixth Edition

2. Some obvious possibilities include Federal Reserve open market purchases to keep the money
supply from shrinking, instituting bank reforms before the Depression started, avoiding high tariff
rates, etc.

3. Newton’s model of falling bodies.

Ignores air resistance.

Works well for most dense objects, doesn’t work well for feathers.

Diagrams of plays in football and basketball.

Ignores the characteristics of individual players, and opponent reactions.

Works well for evenly matched teams.

Scale models of new aircraft designs.

Ignores working engines and interior contents.

Wind tunnel testing approximates aerodynamics of actual aircraft.

4. The time series for unemployment exhibits an asymmetry. The unemployment rate typically
increases at a much higher rate than the rate at which it decreases. Thus, it seems that the process
by which employment falls – through layoffs and quits – works much faster than the process by
which employment increases – through workers returning from layoff and new hires.

5. Both. During the recession, taxes fell and spending rose. Some of this occurred automatically, as
transfer payments such as unemployment insurance (which contributes to spending) rose as
unemployment rose, and taxes fell because income and private sector spending were lower, given
tax rates. As well, the federal government expanded discretionary transfers and expenditures on
goods and services.

6. In Figure 1.10, the inflation rate is more variable before 1985 than after. This can be attributed to a
change in how monetary policy was conducted in the post-1985 era.

7. In Figure 1.12, there have been some sharp movements in the real interest rate. Before late 2008,
those movements in the real interest rate were due both to variability in inflation, and to variability
in the nominal interest rate. The latter movements in the nominal interest rate were driven
primarily by the Federal Reserve System. However, in late 2008, the Fed adopted a policy of
essentially zero nominal interest rates, which continued until December 2015. Over the 2008-2015
period, movements in the real interest rate were due solely to movements in the inflation rate.

8. The recent recession, in 2008-09, in figure 1.13, was more severe than the previous two
recessions, but slightly less severe than the 1981-82 recession, and about as severe as the 1974-
75 recession. An issue here is how we determine the deviation from trend, and what the trend is.
Given the way the trend is calculated here, there is a sense in which the recent recession does

Copyright ©2018 Pearson Education, Inc.

 Chapter 1 Introduction 3

not look so bad, but that may be because of a long-term deterioration in the US economy, i.e.
there was a downward level adjustment to the trend.

9. When there are spikes in the interest rate spread, those tend to occur during recessions, i.e.
periods when real GDP is below trend. Further, large (small) spikes in the interest rate spread
tend to be associated with large (small) negative deviations from trend in real GDP. However, in
the 1990-91 recession, there is only a small spike in the interest rate spread, which looks like
other random spikes in the spread that have occurred which are not associated with recessions.

10. The two previous declines in housing prices occurred in the early 1980s and early 1990s. The two
early housing price declines were mild, relative to the 2006-12 decline. Also, these early episodes
seem to have been driven by recessions, whereas the 2006-12 decline seems to have in part driven
the 2008-2009 recession.

Copyright ©2018 Pearson Education, Inc.

4 Williamson • Macroeconomics, Sixth Edition

Chapter 2 Measurement

n Solutions to End-of-Chapter Problems

1. Product accounting adds up value added by all producers. The wheat producer has no intermediate
inputs and produces 30 million bushels at $3/bu. for $90 million. The bread producer produces
100 million loaves at $3.50/loaf for $350 million. The bread producer uses $75 million worth of
wheat as an input. Therefore, the bread producer’s value added is $275 million. Total GDP is
therefore $90 million + $275 million = $365 million.

Expenditure accounting adds up the value of expenditures on final output. Consumers buy
100 million loaves at $3.50/loaf for $350 million. The wheat producer adds 5 million bushels of
wheat to inventory. Therefore, investment spending is equal to 5 million bushels of wheat valued
at $3/bu., which costs $15 million. Total GDP is therefore $350 million + $15 million = $365
million.

2. Coal producer, steel producer, and consumers.

(a) (i) Product approach: Coal producer produces 15 million tons of coal at $5/ton, which adds
$75 million to GDP. The steel producer produces 10 million tons of steel at $20/ton,
which is worth $200 million. The steel producer pays $125 million for 25 million tons of
coal at $5/ton. The steel producer’s value added is therefore $75 million. GDP is equal to
$75 million + $75 million = $150 million.

(ii) Expenditure approach: Consumers buy 8 million tons of steel at $20/ton, so consumption
is $160 million. There is no investment and no government spending. Exports are 2
million tons of steel at $20/ton, which is worth $40 million. Imports are 10 million tons of
coal at $5/ton, which is worth $50 million. Net exports are therefore equal to $40 million
$50 million = $10 million. GDP is therefore equal to $160 million + ($10 million) =
$150 million.

(iii) Income approach: The coal producer pays $50 million in wages and the steel producer
pays $40 million in wages, so total wages in the economy equal $90 million. The coal
producer receives $75 million in revenue for selling 15 million tons at $15/ton. The coal
producer pays $50 million in wages, so the coal producer’s profits are $25 million. The
steel producer receives $200 million in revenue for selling 10 million tons of steel at
$20/ton. The steel producer pays $40 million in wages and pays $125 million for the 25
million tons of coal that it needs to produce steel. The steel producer’s profits are
therefore equal to $200 million  $40 million  $125 million = $35 million. Total profit
income in the economy is therefore $25 million + $35 million = $60 million. GDP
therefore is equal to wage income ($90 million) plus profit income ($60 million). GDP is
therefore $150 million.

Copyright ©2018 Pearson Education, Inc.

 Chapter 1 Introduction 5

(b) There are no net factor payments from abroad in this example. Therefore, the current
account surplus is equal to net exports, which is equal to ($10 million).

(c) As originally formulated, GNP is equal to GDP, which is equal to $150 million.
Alternatively, if foreigners receive $25 million in coal industry profits as income, then net
factor payments from abroad are ($25 million), so GNP is equal to $125 million.

3. Wheat and Bread

(a) Product approach: Firm A produces 50,000 bushels of wheat, with no intermediate goods
inputs. At $3/bu., the value of Firm A’s production is equal to $150,000. Firm B
produces 50,000 loaves of bread at $2/loaf, which is valued at $100,000. Firm B pays
$60,000 to firm A for 20,000 bushels of wheat, which is an intermediate input. Firm
B’s value added is therefore $40,000. GDP is therefore equal to $190,000.

(b) Expenditure approach: Consumers buy 50,000 loaves of domestically produced bread at
$2/loaf and 15,000 loaves of imported bread at $1/loaf. Consumption spending is
therefore equal to $100,000 + $15,000 = $115,000. Firm A adds 5,000 bushels of wheat to
inventory. Wheat is worth $3/bu., so investment is equal to $15,000. Firm A
exports 25,000 bushels of wheat for $3/bu. Exports are $75,000. Consumers import
15,000 loaves of bread at $1/loaf. Imports are $15,000. Net exports are equal to $75,000 
$15,000 = $60,000. There is no government spending. GDP is equal to consumption
($115,000) plus investment ($15,000) plus net exports ($60,000). GDP is therefore equal
to $190,000.

(c) Income approach: Firm A pays $50,000 in wages. Firm B pays $20,000 in wages. Total
wages are therefore $70,000. Firm A produces $150,000 worth of wheat and pays $50,000
in wages. Firm A’s profits are $100,000. Firm B produces $100,000 worth of bread. Firm
B pays $20,000 in wages and pays $60,000 to Firm A for wheat. Firm B’s profits are
$100,000  $20,000  $60,000 = $20,000. Total profit income in the economy equals
$100,000 + $20, 000 = $120,000. Total wage income ($70,000) plus profit income
($120,000) equals $190,000. GDP is therefore $190,000.

4. Price and quantity data are given as the following.

Year 1

Good Quantity Price

Computers 20 $1,000

Bread 10,000 $1.00

Copyright ©2018 Pearson Education, Inc.

6 Williamson • Macroeconomics, Sixth Edition

Year 2

Good Quantity Price

Computers 25 $1,500

Bread 12,000 $1.10

(a) Year 1 nominal GDP .

Year 2 nominal GDP .

With year 1 as the base year, we need to value both years’ production at year 1 prices. In the base
year, year 1, real GDP equals nominal GDP equals $30,000. In year 2, we need to value year 2’s
output at year 1 prices. Year 2 real GDP .

The percentage change in real GDP equals ($37,000  $30,000)/$30,000  23.33%.

We next calculate chain-weighted real GDP. At year 1 prices, the ratio of year 2 real GDP to year
1 real GDP equals g1 = ($37,000/$30,000) = 1.2333. We must next compute real GDP using year 2
prices. Year 2 GDP valued at year 2 prices equals year 2 nominal GDP = $50,700. Year 1 GDP
valued at year 2 prices equals (20  $1,500 + 10,000  $1.10) = $41,000. The ratio of year 2
GDP at year 2 prices to year 1 GDP at year 2 prices equals g2 = ($50,700/$41,000) = 1.2367. The chain-

weighted ratio of real GDP in the two years therefore is equal to . The
percentage change chain-weighted real GDP from year 1 to year 2 is therefore approximately
23.5%.

If we (arbitrarily) designate year 1 as the base year, then year 1 chain-weighted GDP equals
nominal GDP equals $30,000. Year 2 chain-weighted real GDP is equal to (1.23496  $30,000) =
$37,048.75.

(b) To calculate the implicit GDP deflator, we divide nominal GDP by real GDP, and then
multiply by 100 to express as an index number. With year 1 as the base year, base year
nominal GDP equals base year real GDP, so the base year implicit GDP deflator is 100.
For the year 2, the implicit GDP deflator is ($50,700/$37,000)  100 = 137.0. The
percentage change in the deflator is equal to 37.0%.

With chain weighting, and the base year set at year 1, the year 1 GDP deflator equals
($30,000/$30,000)  100 = 100. The chain-weighted deflator for year 2 is now equal to
($50,700/$37,048.75)  100 = 136.85. The percentage change in the chain-weighted deflator
equals 36.85%.

(c) We next consider the possibility that year 2 computers are twice as productive as year
1 computers. As one possibility, let us define a “computer” as a year 1 computer. In this

Copyright ©2018 Pearson Education, Inc.

 Chapter 1 Introduction 7

case, the 25 computers produced in year 2 are the equivalent of 50 year 1 computers. Each
year 1 computer now sells for $750 in year 2. We now revise the original data as:

Year 1

Good Quantity Price

Year 1 Computers 20 $1,000

Bread 10,000 $1.00

Year 2

Good Quantity Price

Year 1 Computers 50 $750

Bread 12,000 $1.10

First, note that the change in the definition of a “computer” does not affect the calculations of
nominal GDP. We next compute real GDP with year 1 as the base year. Year 2 real GDP in year 1
prices is now The percentage change in real GDP is
equal to ($62,000  $30,000)/$30,000= 106.7%.

We next revise the calculation of chain-weighted real GDP. From above, g 1 equals
($62,000/$30,000) = 206.67. The value of year 1 GDP at year 2 prices equals $26,000. Therefore,
g2 equals ($50,700/$26,000) = 1.95. The percentage change chain-weighted real GDP from year 1
to year 2 is therefore 100.75%.

If we (arbitrarily) designate year 1 as the base year, then year 1 chain-weighted GDP equals
nominal GDP equals $30,000. Year 2 chain-weighted real GDP is equal to (2.0075  $30,000) =
$60,225. The chain-weighted deflator for year 1 is automatically 100. The chain-weighted deflator
for year 2 equals ($50,700/$60,225)  100 = 84.18. The percentage rate of change of the chain-
weighted deflator equals 15.8%.

When there is no quality change, the difference between using year 1 as the base year and using
chain weighting is relatively small. Factoring in the increased performance of year 2 computers,
the production of computers rises dramatically while its relative price falls. Compared with earlier
practices, chain weighting provides a smaller estimate of the increase in production and a smaller
estimate of the reduction in prices. This difference is due to the fact that the relative price of the
good that increases most in quantity (computers) is much higher in year 1. Therefore, the use of
historical prices puts more weight on the increase in quality-adjusted computer output.

Copyright ©2018 Pearson Education, Inc.

8 Williamson • Macroeconomics, Sixth Edition

5. Price and quantity data are given as the following:

Year 1

Quantity Price
Good (million lbs.) (per lb.)

Broccoli 1,500 $0.50

Cauliflower 300 $0.80

Year 2

Quantity Price
Good (million lbs.) (per lb.)

Broccoli 2,400 $0.60

Cauliflower 350 $0.85

(a) Year 1 nominal GDP = Year 1 real GDP

Year 2 nominal GDP

Year 2 real GDP

Year 1 GDP deflator equals 100.

Year 2 GDP deflator equals ($1,730.5/$1,450)  100 = 119.3.

The percentage change in the deflator equals 19.3%.

(b) Year 1 production (market basket) at year 1 prices equals year 1 nominal GDP  $990
million. The value of the market basket at year 2 prices is equal to
=$1,050 million.

Year 1 CPI equals 100.

Year 2 CPI equals ($1,050/$990)  100  106.1.

The percentage change in the CPI equals 6.1%.

The relative price of broccoli has gone up. The relative quantity of broccoli has also gone up. The
CPI attaches a smaller weight to the price of broccoli, and so the CPI shows less inflation.

Copyright ©2018 Pearson Education, Inc.

 Chapter 1 Introduction 9

6. Corn producer, consumers, and government.

(a) (i) Product approach: There are no intermediate goods inputs. The corn producer grows
30 million bushels of corn. Each bushel of corn is worth $5. Therefore, GDP equals
$150 million.

(ii) Expenditure approach: Consumers buy 20 million bushels of corn, so consumption equals
$100 million. The corn producer adds 5 million bushels to inventory, so investment equals
$25 million. The government buys 5 million bushels of corn, so government spending
equals $25 million. GDP equals $150 million.

(iii) Income approach: Wage income is $60 million, paid by the corn producer. The corn
producer’s revenue equals $150 million, including the value of its addition to inventory.
Additions to inventory are treated as purchasing one’s own output. The corn producer’s
costs include wages of $60 million and taxes of $20 million. Therefore, profit income
equals $150 million  $60 million  $20 million = $70 million. Government income
equals taxes paid by the corn producer, which equals $20 million. Therefore, GDP by
income equals $60 million +$70 million + $20 million = $150 million.

(b) Private disposable income equals GDP ($150 million) plus net factor payments (0) plus
government transfers ($5 million is Social Security benefits) plus interest on the
government debt ($10 million) minus total taxes ($30 million), which equals $135 million.
Private saving equals private disposable income ($135 million) minus consumption ($100
million), which equals $35 million. Government saving equals government tax income
($30 million) minus transfer payments ($5 million) minus interest on the government debt
($10 million) minus government spending ($5 million), which equals $10 million.
National saving equals private saving ($35 million) plus government saving ($10 million),
which equals $45 million. The government budget surplus equals government saving
($10 million). Since the budget surplus is positive, the government budget is in surplus.
The government deficit is therefore equal to ($10 million).

7. Price controls.

Nominal GDP is calculated by measuring output at market prices. In the event of binding
price controls, measured prices equal the controlled prices. However, controlled prices
reflect an inaccurate measure of scarcity values. Nominal GDP is therefore distorted. In
addition to distortions in nominal GDP measures, price controls also inject an inaccuracy
into attempts to decompose changes in nominal GDP into movements in real GDP and
movements in prices. With price controls, there is typically little or no change in white
market prices over time. Alternatively, black market or scarcity value prices typically
increase, perhaps dramatically. Measures of prices (in terms of scarcity values) understate
inflation. Whenever inflation measures are too low, changes in real GDP overstate the
extent of increases in actual production.

8. Underground economy.

Copyright ©2018 Pearson Education, Inc.

10 Williamson • Macroeconomics, Sixth Edition

Transactions in underground economy are performed with cash exclusively, to exploit the
anonymous nature of currency. The Fed always knows how much currency in total is outstanding,
so if we can measure the amount of currency held abroad, we know how much is held
domestically. If we then obtain a measure of how much currency is needed to support regular
transactions, we can infer how much currency is supporting underground transactions, and
therefore determine a measure of underground economic activity.

9. “Questionable financial activity” is essentially theft. If someone steals, there is no contribution to

GDP as something is simply transferred from one individual to another. Possibly worse, the time
and effort of the thief is pure waste for society, as that time and effort could be used in producing
goods and services. Some financial activity could be wasteful in the same way. If workers in
financial firms spend their time and effort in designing financial products for the purpose of hiding
malfeasance, or to convince ill-informed consumers that such products are something they are not,
that time and effort is counted as contributing to GDP, when it should not be.

10. The dollar value of a transaction need not all be a contribution to GDP. Indeed, typically only a
fraction of any given transaction in the economy actually represents something we should add to
GDP. For example, the production of a given good could involve many stages, with each stage of
production done in a different firm. At each stage of production, the intermediate good gets passed
on to the next firm in the production process, and a transaction takes place. From this chapter, we
know that we only count the value-added at each stage of production toward GDP. Similarly, the
financial sector contributes to GDP, but the dollar value of every financial transaction is not
counted toward GDP, and rightly so. If the Bank of America makes a payment of $10 million to
J.P. Morgan Chase, that payment represents the settlement of a debt between the two institutions.
What is actually provided, in terms of financial goods and services, could be very small when
measured correctly.

11. Sp – 1 = CA + D

(a) By definition:

Next, recall that Substitute into the equation above and subtract I to obtain:

Sp – I = C + I + G + NX + NFP + TR + INT – T – C – I

= (NX + NFP) + (G + INT + TR – T)

= CA + D

(b) Private saving, which is not used to finance domestic investment, is either lent to the
domestic government to finance its deficit (D), or is lent to foreigners (CA).

Copyright ©2018 Pearson Education, Inc.

 Chapter 1 Introduction 11

12. The answers to parts (a) and (b) are in the table.

Yea Capital when initial capital = 80 Capital when initial capital = 100
r

0 80 100

1 82.0 100

2 83.8 100

3 85.4 100

4 86.9 100

5 88.2 100

6 89.4 100

7 90.4 100

8 91.4 100

9 92.3 100

10 93.0 100

In the first case, where the initial quantity of capital was 80, with a constant quantity of investment
each period, the quantity of capital increases over time, but at a decreasing rate (note that the
increment to the capital stock gets smaller each period). This happens because, as the capital stock
grows, the total amount of capital that depreciates each period increases. The quantity of capital
appears to be converging to some quantity, but what is this quantity? When the quantity of capital
is initially 100, then the capital stock stays at 100 indefinitely, as long as investment is 10 each
period. This is because, when the capital stock is 100, the total quantity of depreciation each
period when the depreciation rate is 10% is 10, so new investment just replaces the capital that
depreciates each period. Here 100 is what we would call the “steady state” quantity of capital.
Steady states are useful when we study economic growth in Chapters 7 and 8.

13. Assume the following:

Copyright ©2018 Pearson Education, Inc.

12 Williamson • Macroeconomics, Sixth Edition

(a)

(b)

(c)

(d)

(e)

(f)

(g)

14. As the unemployment rate is 5% and there are 2.5 million unemployed, it must be that the labor
force is 50 million (2.5/0.05). Thus, the participation rate is 50% (50/100), the labor force 50
million, the number of employed workers 47.5 million (50 – 2.5), and the employment/population
ratio is 47.5% (47.5/100).

Copyright ©2018 Pearson Education, Inc.

 Chapter 1 Introduction 13

Chapter 3 Measurement

n Solutions to End-of-Chapter Problems

1. In Figure 3.12, during the 1970s it appears that the inflation rate was countercyclical – a
reverse Phillips curve. That is, the inflation rate and the deviation from trend in real GDP
appear to be negatively correlated. This was perhaps due to the nature of shocks hitting
the economy during this period.

2. In Figure 3.16, what we tend to see during the last three recessions is a quick recovery of
average labor productivity prior to real GDP recovering to the point where it is above
trend. This is part of the jobless recovery phenomenon. Employment has been very slow
to recover during the last three recessions, which makes for higher growth in average
labor productivity coming out of the recession. We get this, as average labor productivity
is the ratio of real GDP to employment, so if employment is not recovering and real GDP
is, then the ratio shows a spurt of growth.

3. Both consumption and investment are procyclical and coincident. The key difference is
that investment is much more volatile than consumption. Consumer durables provide
services over a horizon greater than one year. Some consumer nondurable products, like
apparel, provide services well beyond the date of purchase. Services, by definition, are
fully utilized at the point of sale. The same kinds of timing considerations that affect
business investment are likely to come into play with consumer durables, and to a lesser
extent, consumer nondurables. Therefore, it is logical that consumer durable purchases
should be more volatile than consumer nondurable purchases and that consumer
nondurable purchases should be more volatile than consumption of services.

4. After the 1981-82 recession, the cyclical behavior of the price level varies. From 1980-
2000, the price level appears to be countercyclical, but after 2000 it appears to be
procyclical. This is important, as alternative types of macroeconomic shocks will move
the price level in different directions. As a result, the cyclicality of the price level may be
useful in uncovering what shocks are driving aggregate fluctuations at particular dates.

5. In Figure 3.12, the inflation rate is less variable during the Great Moderation (after the
1981-82 recession) period than it was before that time. This was perhaps the result of
policy, or it could just have been a relatively tranquil time, in terms of the shocks that
were hitting the economy during that period.

Copyright ©2018 Pearson Education, Inc.