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24 PRINCIPLES OF ECONOMICS
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come on this commodity. Even if the price of salt were to rise substantially, households would reduce their purchases of salt little. b. The demand for stereos is elastic because stereos are expensive and, as a luxury rather than a necessity, their purchase can be postponed or avoided when their price rises. One could also use the radio as a partial substitute for a stereo. Solved Problem 2.5 a. Should the price of a subway ride or bus ride be increased or decreased if total revenue needs to be increased b. What about the price of a taxi ride Solution: a. To the extent that there are no inexpensive good substitutes for public transportation in metropolitan areas, the demand for subway and bus rides is inelastic. Their prices should, therefore, be increased to increase total revenue. However, this can be self-defeating. Sharply increasing the price of public transportation will encourage people to use their cars and increase congestion and pollution. b. For taxi rides, the case is likely to be different. Taxi rides are relatively expensive; an increase in their price may encourage people to rely much more on their cars and public transportation. To the extent that this makes the demand for taxi rides elastic, total revenue will fall when the price of taxi rides is increased.
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Unemployment, In ation, and National Income
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Gross Domestic Output Aggregate Demand, Aggregate Supply, and Equilibrium Output Changes in Aggregate Output Business Cycles Unemployment and the Labor Force In ation True or False Questions Solved Problems Gross Domestic Output
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Gross domestic product (GDP) measures total output in the domestic economy. Nominal GDP, real GDP, and potential GDP are three different measures of aggregate output. Nominal GDP is the market value of all nal goods and services produced in the domestic economy in a one-year pe-
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riod at current prices. By this de nition, (1) only output exchanged in a market is included (do-it-yourself services such as cleaning your own house are not included); (2) output is valued in its nal form (output is in its nal form when no further alteration is made to the good which would change its market value); and (3) output is measured using current-year prices. Because nominal GDP values are in ated by prices that increase over time, aggregate output is also measured holding the prices of all goods and services constant over time. This valuation of GDP at constant prices is called real GDP. The third measure of aggregate output is potential GDP, the maximum production that can take place in the domestic economy without putting upward pressure on the general level of prices. Conceptually, potential GDP represents a point on a given production-possibility frontier. The U.S. economy s potential output increases at a fairly steady rate each year while actual real GDP uctuates around potential GDP. These uctuations of real GDP are identi ed as business cycles. The GDP gap is the difference between potential GDP and real GDP; it is positive when potential GDP exceeds real GDP and negative when real GDP exceeds potential GDP. A positive gap indicates that there are unemployed resources and the economy is operating inef ciently within its productionpossibility frontier. It therefore follows that an economy s rate of unemployment rises as its GDP gap increases, and falls when the gap declines. An economy is operating above its normal productive capacity when there is a negative gap.
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Aggregate Demand, Aggregate Supply, and Equilibrium Output
The economy s equilibrium level of output occurs at the point of intersection of aggregate supply and aggregate demand. In microeconomics, equilibrium price exists where quantity demanded equals quantity supplied. The supply and demand schedules in macroeconomics differ in that they relate the aggregate quantity supplied and the aggregate quantity demanded to the price level.
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