Answer to Question 3:

Consider an economy in which each unit of capital stock produces 0.1 units of output. Every scrap of output is being consumed and the capital stock is depreciating by 10 billion per year. If the capital stock is now 200 billion, what will be the level of income next year?


The correct answer is 9 billion. Since consumption equals output, the capital stock must be declining by the amount of depreciation---i.e., by 10 units per year. This means that the capital stock next year will be 190. Output will be 10 percent of 190, or 19 units. Of these 19 units, 10 would have to be plowed back into the capital stock to keep it from declining. This leaves an income of 9 units.

You had to keep three things in mind here. First, if the entire output is being consumed, no allowance is being made to cover depreciation. Second, the capital stock will therefore decline by the amount of depreciation, leaving a capital stock of 190 at the beginning of next year. Third, while the level of output next year is 19 units, next year's income is only 9 units because 10 units have to be deducted to allow for depreciation. Remember, income is the amount that could be consumed if the capital stock and next year's output and income are to be maintained at the current year's level.

Also notice that output and income here refer to Gross and Net Domestic Product because they refer to what is produced by capital employed in the economy and not necessarily capital owned by the residents of that economy. That capital may or may not be entirely owned by domestic residents and domestic residents may also own capital employed abroad.

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