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Difficulty: Very hardUses and Limitations of National Income Estimates

The national income data for an economy over two consecutive years is shown in the table below:

Economic IndicatorYear 1Year 2
Nominal GDP50 billion50\text{ billion}75 billion75\text{ billion}
GDP Deflator100100150150
Population20 million20\text{ million}25 million25\text{ million}
Estimated Non-Monetized Output15 billion15\text{ billion}8 billion8\text{ billion}

Based on these national income estimates and the standard limitations of national income accounting, which of the following accurately assesses the change in the average citizen's economic welfare from Year 1 to Year 2?

  1. Economic welfare declined because real per capita GDP fell from 2,500to2,500 to 2,000, compounded by a reduction in non-monetized output.Answer
  2. B
    Economic welfare improved by 50% because nominal GDP increased from 50billionto50 billion to 75 billion.
  3. C
    Economic welfare remained unchanged because real GDP stayed constant at $50 billion in both years.
  4. D
    Economic welfare increased because population growth from 20 million to 25 million expanded the nation's total labor force.

Answer

Economic welfare declined because real per capita GDP fell from 2,500to2,500 to 2,000, compounded by a reduction in non-monetized output.
To evaluate economic welfare, nominal figures must be deflated to real terms and divided by population. Year 1 real per capita GDP was 2,500(2,500 ( 50 billion / 20 million), while Year 2 real per capita GDP fell to 2,000(2,000 ( 50 billion / 25 million). Furthermore, non-monetized subsistence production fell from 15billionto15 billion to 8 billion, meaning total real output available to households decreased overall.

Step-by-Step Solution

1
Calculate Real GDP for Year 1 and Year 2 using the GDP Deflator formula: Real GDP=(Nominal GDPGDP Deflator)×100\text{Real GDP} = \left(\frac{\text{Nominal GDP}}{\text{GDP Deflator}}\right) \times 100
Year 1 Real GDP = (50100)×100=50 billion\left(\frac{50}{100}\right) \times 100 = 50\text{ billion}. Year 2 Real GDP = (75150)×100=50 billion\left(\frac{75}{150}\right) \times 100 = 50\text{ billion}. Total real national product remained unchanged.
Nominal GDP figures must be adjusted for price level changes to evaluate physical volume of goods and services produced.
2
Calculate Real Per Capita GDP for Year 1 and Year 2: Real Per Capita GDP=Real GDPPopulation\text{Real Per Capita GDP} = \frac{\text{Real GDP}}{\text{Population}}
Year 1 Real Per Capita GDP = $50,000,000,00020,000,000=$2,500\frac{\$50,000,000,000}{20,000,000} = \$2,500. Year 2 Real Per Capita GDP = $50,000,000,00025,000,000=$2,000\frac{\$50,000,000,000}{25,000,000} = \$2,000.
Living standard evaluation requires adjusting national output for population size changes.
3
Evaluate the non-monetized sector change and determine overall economic welfare
Non-monetized production decreased from 15billionto15 billion to 8 billion, indicating that unrecorded subsistence goods and household services also shrank. Coupled with the drop in real per capita income, economic welfare unambiguously declined.
National income statistics understate total welfare when non-monetized activities decrease or are omitted.

Key Concept

Uses and Limitations of National Income Estimates in Measuring Economic Welfare
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Uses and Limitations of National Income Estimates

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