Economics IB HL

Economics – Chapter 11 Practice Questions

1. Explain the differences between GDP and GNP/GNI as measures of economic activity.        

Gross Domestic Product (GDP) is defined as the total value of all economic production in a country in a given year. GDP measures production within the borders of a country, regardless of who owns the factors of production (FoP), i.e., Ireland’s GDP may include the production of English firms with factories/outlets in Ireland, and vice versa for Irish firms operating in England adding to English GDP.

Gross National Product (GNP) is defined as the market value of all the products and services produced in a time period by the labor and capital supplied by the residents of a country, which means the flow of income is measured based on actual ownership of the FoP. GNP is measured by subtracting payments to foreign FoP and adding payments from domestically owned FoP in other countries. This is called ‘net property income’. The summarized method of measuring GNP is: GNP = GDP + net property income from abroad.

2. Explain using diagrams the circular flow of income as a system with leakages and injections.      

photoThe circular flow of income model above is a graphic representation of the movement of resources and money through the economy. There are 2 basic concepts:

  • in the product market, households exchange money payments for the goods and services produced by firms
  • in turn, firms buy the FoP (land, labor, capital, entrepreneurship) from households, making factor payments in the form of rent, wages, interests and profits.                                                    

Additionally, in the model there are “leakages” which is money that exists the system, and “injections” which is money that enters the system. There are three sectors which make up the flow of income:

The government sector – taxes and government spending 

Even in the most free market economies, governments have strong impacts on the flow of income in an economy. Governments draw tax money from the population (leakage), but that money re-enters the model as government spending on different things such as salaries and infrastructure. Even with the assumption that some of the money is lost through corruption, it may eventually re-enter as consumer spending.

The foreign sector – imports and exports

Imports are leakages since it is assumed that some of the money spent in either the factor or product market is spent on imported goods/services, however, roughly the same amount of money enters in the form of exports, which is an injection.

The financial sector – savings and investment

Savings slow down the flow of expenditure and eventually income, so they are classified as a leakage. However, money that is saved in banks is made available to borrowers, who then inject the savings back into the economy in the form of investment (capital goods or the purchase of housing), and so the leakages of savings re-enter the system through loans.

3. Explain the process by which nominal GDP is calculated and distinguish it from real GDP.          

Nominal GDP can be calculated through 3 different approaches:

The expenditure approach

  • places spending into 4 categories: consumption (C), investment (I), government spending (G), net exports (X – M)
  • consumption includes durable goods (lasting more than a year, e.g. TVs, fridges), non-durable goods (not lasting a year, e.g. food, magazines) and services (actions performed by a firm, e.g. legal services, healthcare, education)
  • investment refers to spending by firms (capital goods) and households (housing and new construction)
  • government spending includes all government purchases but not transfer payments
  • net exports count export revenues – import payments                                                                      

Summary: GDP = C + I + G + (X – M) 

The income approach

This approach is based on the circular flow of income. If all spending on goods/services must be income to the firms and individuals receiving payment, it must be possible to arrive at a GDP number by counting the income received in a given year. The variables in the income approach approximate to the returns for factors of production – wages, interest, rent, profits for labor, capital, land, entrepreneurship. After finding the net national income, business taxes and fixed capital consumption are added, along with some minor statistical adjustments which becomes the equivalent to GDP.

The output approach

This approach identifies the value added at each stage of the production process, and add that to GDP to get an accurate total value of the production and avoid “double counting”.

*Nominal vs Real GDP*

Nominal GDP is defined as the value, in current prices, of all final goods and services produced in a country within a given time period. It is simply the value of goods/services produced in a country in a given year, expressed in the value of the prices charged for that year.

Real GDP  is defined as the value, in constant prices, of all final goods and services produced in a country within a given time period, usually measured against prices of predetermined base year. In other words, it is the measure of output that factor out price changes and shows a more accurate measure of the true output from one year to the next. The equation is: real GDP = (nominal GDP / GDP deflator ) x 100 

For example, a car that is manufactured and sold for $20000 in one year could be manufactured and sold for $25000 the next year (the same exact car). Although this mathematically shows a 25% increase in price, nothing about the car is actually 25% greater than the previous year. Nominal GDP counts this 25% price increase as a contribution to national income, which shows how inflation could cause GDP to be overestimated, and deflation to be underestimated.

4. Analyze the use of GDP per capita to compare living standards in different countries.    

GDP per capita is defined as the average based on the national income of the country divided by the country’s population. It gives us a better sense of the standard of living in a country than total GDP because it shows how productive a country is on a per person basis. However, in most countries, income is distributed unequally among citizens, and in many countries, a small group of elites are extremely wealth while the rest live on average or below average. So while GDP per capita provides information about a country’s economic performance and allows us to compare countries, it ignores income distribution, which is a great limitation.

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