Question

Suppose that the only thing you know about Gondor is that its economy can be described as a Cobb-Douglas production function of labor and capital with constant returns to scale. After some Internet surfing, you find out from the United Nations website that Gondor has a GDP of 16. Then you discover on the World Bank website that capital's share of total income in Gondor is 40%. The final piece of the puzzle comes from the CIA Factbook, where you learn that Gondor's real rent is 1.1. Show all work.

1. (3 points) Discuss the difference betwen GDP Deflator and CPI in terms of basket content, what they measure, and how they're used.
2. (2 points) Explain why GDP has three definitions in the circular flow diagram.

Answer 1

a. In terms of basket content, GDP Deflator includes only the domestic good and not any imported good. Whereas, CPI includes all the products that consumer buys including foreign goods. The CPI uses fixed basket of goods & services whereas GDP Deflator uses changing basket of goods & services as the composition of GDP changes.

In terms of measure, GDP Deflator measure the general price level of all the final goods & services produced within the domestic territory of the country. Whereas, CPI measure the general price level based on the goods & services bought by the consumers. That means, any increase in the price of the goods & services purchased by the firm or the government would be reflected in GDP Deflator.

In terms of usage, GDP Deflator is used to arrive at real GDP and hence, real GDP growth numbers from the nominal GDP numbers and is used to facilitate the comparison of the economic growth over time. Whereas, CPI is used to estimate the inflation rate of the economy and cost of living.

b.

The GDP is the measure of the market value of the final goods and services produced within the domestic territory of the economy in the given year.

The two things that the GDP measures includes:

1. The total income of everyone within the domestic territory of the economy
2. The total expenditure on the economy’s outputs of goods & services
3. The value addition that takes place in course of production of goods & services

The GDP could measure the income of everyone in the economy in a given year and the total expenditure on the economy’s outputs of goods & services in a year simultaneously because of the rule of accounting that states that every dollar spent by the buyer is the dollar income earned by the seller. Every transaction that affects income must affect expenditure and vice-versa. There is a circular flow of money and income. For the economy as a whole, the income generated from the sale of economy’s output of goods and services produced in a given year must equal expenditure on the economy’s outputs of goods & services produced in that given year which in turn is equal to the value added in course of production of goods and services in the given year.

Hence, GDP has three definition - (1) Production definition of GDP (2) Income definition of GDP and (3) Expenditure definition of GDP

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