What Is Meant by GDP and How Is it Measured - Assignment Example

1. What is meant by GDP and how is it measured In your answer make clear any difficulties associated with this measurement A country's Gross Domestic Product (GDP) is an important indicator of its performance. The most common measure of GDP is called expenditure method which aggregates the country's consumption, investment, government spending, and net exports. Consumption denotes household expenditure for goods and services while investment refers to business spending on capital. Government spending is comprised of public expenses to finance projects to the benefit of the whole economy. Examples are bridges, schools and other public infrastructures. Net export, on the other hand refers to the inflow and outflow of goods and services in the economy. It is computed as the difference between exports and imports. GDP is flawed for the following reasons: "it does not include the value of non-market production and leisure; it contains intermediate and regrettable expenditures that do not contribute to economic welfare; government expenditure on health, education, social services and environmental protection does not necessarily reflect outcomes in these areas; it does not account for resources required for sustainable development; and it does not directly measure investment in social capital." 2. Let consumption be C, investment I, government expenditure G, the marginal rate of taxation t, income Y, and disposable income Yd. Assuming a closed economy and given the following: C = 230 + 0.8Yd 1=400 G = 770 t = 0.3 Yd=Y-tY (i) Write out an expression for Aggregate Demand (AD) in terms of Y. Y = 230 + 0.8Yd + 440 +770 or Y = 230 + 0.08 (Y - 0.3Y) + 440 + 770 (ii) Calculate the value of Y at equilibrium. Y = 230 + 0.8 (Y - 0.3Y) + 440 + 770 Y = 230 + 0.8 Y - 0.24Y + 440 +770 Y - 0.8Y + 0.24Y = 230 + 440 + 770 0.44 Y = 1440 Y = 1272 (iii) Derive an expression for the multiplier and work out its value. Marginal propensity to consume (mpc) is 0.8. Let mul = multiplier mul = 1 / (1 - mpc) mul = 1/ (1-0.8) mul = 5 (iv) If Y was at potential output what implications would this have for the multiplier If Y is at potential output, then multiplier is equal to zero. 3. What is fiscal policy Using the income expenditure model, explain the effect of an increase in government spending on real output. What factors or possible problems should a government bear in mind when devising an expansionary fiscal policy Fiscal policy aims to correct the economy by increasing or decreasing tax levels and public spending. For example, if the economy is down and the government wishes to fuel the economy, it will reduce tax levels. This will give consumers more disposable income and encourage spending. With the increase in demand, businesses will then turn to higher production. It can be seen that in fiscal policy, the sensitivity of interest rate is not significant for the policy to be effective. In this type of macroeconomic tool, the economy is corrected without influencing the level of interest rate in the economy. The policy directly targets consumer spending and business production. However, economists should also take into account that any increase in government spending (a fiscal policy) will have a tendency in raising interest rates, causing private investment and net exports to fall. This is known as the crowding out effect. 4. Give short definitions of both the IS and LM curves and briefly explain how this model can help economists understand the interaction between the goods and money markets. Show how the IS and LM curves can be derived and explain how equilibrium is reached. The IS curve shows the combinations of interest rates and the aggregate output for which the goods market is in equilibrium, while the LM curve gives out combinations for which the money market is in equilibrium. The IS curve is the downward sloping schedule which shows the equilibrium in the goods market. The slope of the IS curve denotes the interest elasticity of investment demand and the marginal propensity to save. The LM schedule is an upward sloping curve representing the role of finance and money and is denoted as "the equilibrium of the demand to hold money as an asset and the supply of money by banks and the central bank" (IS-LM 2006). The slope of the LM curve shows the change in interest rate in response to the change in output. Increases in government spending, consumer expenditure, investment, and net exports will shift the IS curve rightward. An increase in money supply will shift the LM curve rightward. An increase in money demanded will shift the LM curve leftward. Since the IS-LM represents the different equilibrium in the money and goods market, the IS-LM curves intersect at a point wherein both of these markets are in equilibrium determining the equilibrium value of real GDP and interest rate. For example, an increase in government spending will cause the IS curve to shift to the right, which will cause interest rate to rise also causing an increase in GDP within the same LM curve. 5. Distinguish between monetary base and broad money. Explain what role commercial banks have in the creation of broad money. What implications does this have for monetary control Monetary base or narrow money are composed of cash outside Bank of England and Bank's operational deposits with Bank of England. On the other hand, broad money or simply money supply includes cash outside banks (i.e. in circulation with the public and non-bank firms), private sector retail bank and building society deposits, and private sector deposit wholesale bank and building society and certificate of deposits accounts. Commercial can create broad money by offering more attractive interest rates which attracts depositors to invest their money. Thus, the Central Bank should always monitor the interest rates as well as the discount rate which are offered to commercial banks in order to have a tight control of the money supply. 6. Distinguish between different kinds of unemployment. What kind of unemployment can be reduced by supply side policies and what specifically could those policies be Use a diagram to help explain these policies. Frictional unemployment is transitional unemployment due to people moving between jobs. An example of frictional unemployment is search unemployment which occurs when workers do not take the first job they are offered and thus are "needlessly unemployed." Real wage unemployment occurs as "cyclical unemployment" wherein the general case exists due to the excess labour supply in the economy brought about by the real wage rate set above the market clearing level. Factors such as set minimum wage, high benefit levels and poverty trap existence are the most common contributors of real wage unemployment. Demand deficient unemployment (refined by Keynes) in the general case occurs due to a deflationary gap that exists in the economy and thus aggregate supply outnumbers demand. It is an involuntary unemployment caused by the lack of aggregate demand for goods and services. Frictional and real wage unemployment can be reduced by supply side policies. As for the supply-side labour market economic policies, these are designed to enhance the quality and quantity of the supply of labour available to the economy. They seek to make the labour market in a country more flexible so that it is better able to match the labour force to the demands placed upon it by employers in expanding sectors thereby reducing the risk of structural unemployment. An expansion in the country's total labour supply is then seen to raise the productive potential of an economy. For instance, frictional unemployment can be avoided by making information about jobs more available especially to those who are searching for jobs. The government can also provide trainings in order to enhance the skills of job-seekers which will give them a higher chance in finding an appropriate job. Investment and spending in education and training have the potential to raise the skills within the work force and improve the employment prospects of unemployed workers. Government spending on education and training improves workers' human capital. Improved training should improve the occupational mobility of workers in the economy. This should help reduce the problem of frictional unemployment. A well-educated workforce also acts as an attraction for foreign investment in the economy. Monitoring the level of wages and making sure that they are in the equilibrium are supply side policies which can clear up real wage unemployment. 7. What is the Phillips Curve Explain why for policy makers this relation appeared to offer a menu of choices Explain why many policy makers no longer believe in such a menu of choices. The Phillips curve depicts the relationship between the state of the economy relative to its productive capacity and changes in inflation. Once unemployment rate surpasses the non-accelerating inflation rate of unemployment (NAIRU) with output above the potential, inflation will start to decrease. But if it is below NAIRU with potential output, then inflation will start to rise. The Phillips curve shows a trade-off between inflation rate and levels of unemployment. This model states that if economies want higher levels of employment, this can be achieved by allowing higher levels of inflation and vice-versa. Thus, policymakers are left with the choice of either lowering inflation rate or higher employment. Into the 1970s, however, many countries experienced high levels of both inflation and unemployment also known as stagflation. Theories based on the Phillips curve suggested that this could not happen, and the curve came under concerted attack from a group of economists headed by Milton Friedman-arguing that the demonstrable failure of the relationship demanded a return to non-interventionist, free market policies. The idea that there was a simple, predictable, and persistent relationship between inflation and unemployment was abandoned by most if not all macroeconomists. 8. Explain what is meant by a fixed exchange rate regime and a flexible exchange rate regime. What are the perceived advantages and disadvantages of each kind of regime A fixed exchange rate regime requires the intervention of the government to maintain a fixed target for the value of the domestic currency relative to foreign currency. On the other hand, the determination of exchange rate in a flexible exchange rate regime is through the demand and supply of foreign exchange in the market with little or no intervention from the state. Advantages of fixed exchange rate Fixed rates provide greater certainty for exporters and importers and under normally circumstances thereis less speculative activity - although this depends on whether the dealers in the foreign exchange markets regard a given fixed exchange rate as appropriate and credible. Fixed exchange rates can exert a strong discipline on domestic firms and employees to keep their costs under control in order to remain competitive in international markets. This helps the government maintain low inflation - which in the long run should bring interest rates down and stimulate increased trade and investment. Advantages of floating exchange rate Fluctuations in the exchange rate can provide an automatic adjustment for countries with a large balance of payments deficit. If an economy has a large deficit, there is anet outflow of currency from the country. This puts downward pressure on the exchange rate and if a depreciation occurs, the relative price of exports in overseas markets falls (making exports more competitive) whilst the relative price of imports in the home markets goes up (making imports appear more expensive). This should help reduce the overall deficit in the balance of trade provided that the price elasticity of demand for exports and the price elasticity of demand for imports is sufficiently high. A second key advantage of floating exchange rates is that it gives the government / monetary authorities flexibility in determining interest rates. This is because interest rates do not have to be set to keep the value of the exchange rate within pre-determined bands. 1. Using the Keynesian model of injections and withdrawals in the goods market, explain what happens if people decide to save more at any level of income. Make sure you express the process of adjustment and assess what implications the results may have for policy. In the Keynesian model, household's decision to save more at any level of income will lessen the overall consumption in the economy. It should be noted that more savings will consequently lower the households' marginal propensity to consume. In this situation, we see a contraction in the total output in the economy as the multiplier shrink. It should be noted that the change in marginal propensity to save causes a downward shift in the Y curve. In this type of economy, policymakers can benefit from instituting policies in order to enhance and curb output. It can be noted that as the economy has not yet reached its potential output, it can still be enhanced through policies which can boost consumption, investment, and government spending. 2. In a closed economy let C= 500 + 0.8Yd I=500 G=1800 t=0.1 Yd= Y-tY Where C is consumption, I is investment, G is government spending, t is the proportional rate of direct taxation, Y is income and Yd is disposable income. i) Write out the expression for AD in terms of Y. Y = 500 + 0.8Yd + 500 + 1800 or Y = 500 + 0.8 (Y - 0.1Y) + 500 +1800 ii) What will the value of Y be at equilibrium Y = 500 + 0.8 (Y - 0.1Y) + 500 + 1800 Y = 500 + 0.8Y - 0.08Y + 500 + 1800 Y - 0.8Y + 0.08Y = 500 + 500 + 1800 0.28Y = 2800 Y = 10, 000 iii)What is the value of the multiplier mul = 1 / (1- mpc), where mpc = 0.08 and mul= multiplier mul = 1/ (1-0.8) = 5 iv) What difference in the multiplier would there be if the economy were at full employment If the economy is in full employment, then multiplier will be equal to zero. 3. What factors should a government take into account in deciding whether to use fiscal policy to achieve a certain level of output Fiscal policy aims to correct the economy by increasing or decreasing tax levels and public spending. For example, if the economy is down and the government wishes to fuel the economy, it will reduce tax levels. This will give consumers more disposable income and encourage spending. With the increase in demand, businesses will then turn to higher production. It can be seen that in fiscal policy, the sensitivity of interest rate is not significant for the policy to be effective. In this type of macroeconomic tool, the economy is corrected without influencing the level of interest rate in the economy. The policy directly targets consumer spending and business production. However, economists should also take into account that any increase in government spending (a fiscal policy) will have a tendency in raising interest rates, causing private investment and net exports to fall. This is known as the crowding out effect. 4. What is the difference between the monetary base and the broad money supply Explain the role of banks in creating the latter. Monetary base or narrow money are composed of cash outside Bank of England and Bank's operational deposits with Bank of England. On the other hand, broad money or simply money supply includes cash outside banks (i.e. in circulation with the public and non-bank firms), private sector retail bank and building society deposits, and private sector deposit wholesale bank and building society and certificate of deposits accounts. The monetary policy tools refer to the policy tools of the central bank used to affect the money supply and interest rates. First are the open market operations which affect the quantity of reserves and monetary base. Second are changes in the discount rates which influence the quantity of discount loans. Third are the changes in the reserve requirements which affect the money multiplier. 5. In what ways can the central bank set out to control the money supply How successful can central banks be in achieving direct monetary control and what alternatives could they have Central banks can use either expansionary or contractionary fiscal policy according to which is suited for the economy. Under an expansionary policy, the central bank must increase the money supply and lower the short- term interest rates. The central bank can engage in the following: a. open market purchase which expands reserves and monetary base; b. lower the discount rate which encourages borrowing by banks; or c. lower the reserve requirements among banks. All options lead to higher money supply and lower federal funds rate. Under a contractionary policy, the central bank needs to lower the money supply level and raise short- term interest rates. To do so, the central bank can: a. raise the discount rates which discourages bank borrowings; b. open market sale which tightens reserves and monetary base; c. raise the reserve requirement among banks which shrinks the available funds for banks to grant as loans to borrowers. It should be noted that the effectiveness of all these policies rests on the relationship between money supply and interest rate. Accordingly, an increase in the money supply tends to bring a reduction in the interest rate while a decrease in money supply brings about a rise in interest rates. It is notable that without affecting the interest rate, monetary policy renders no effect on the economy. For example, a government wishing to eliminate unemployment pursues an expansionary monetary policy lowering the reserve ratio. This in effect will lead to excess reserve rates and encourages bank lending while increasing the money supply. Since interest rate is inversely related with money supply, interest rate falls which encourages investment. Aggregate demand increases and unemployment is reduced or eliminated through the creation of jobs in the economy. In this example, it can be seen that without the reaction of interest rate in the increase in money supply, the monetary policy is useless and the economy will remain in its current position. It should be noted that the decrease in interest rate encourage investors to borrow funds in order to finance their projects. Without this, job creation will not be facilitated. 6. What is the importance of the IS-LM diagram for the Keynesian macroeconomic model Show carefully in diagrams and explain how both the IS and LM curves are derived. The IS curve shows the combinations of interest rates and the aggregate output for which the goods market is in equilibrium, while the LM curve gives out combinations for which the money market is in equilibrium. The IS curve is the downward sloping schedule which shows the equilibrium in the goods market. The slope of the IS curve denotes the interest elasticity of investment demand and the marginal propensity to save. The LM schedule is an upward sloping curve representing the role of finance and money and is denoted as "the equilibrium of the demand to hold money as an asset and the supply of money by banks and the central bank" (IS-LM 2006). The slope of the LM curve shows the change in interest rate in response to the change in output. Increases in government spending, consumer expenditure, investment, and net exports will shift the IS curve rightward. An increase in money supply will shift the LM curve rightward. An increase in money demanded will shift the LM curve leftward. Since the IS-LM represents the different equilibrium in the money and goods market, the IS-LM curves intersect at a point wherein both of these markets are in equilibrium determining the equilibrium value of real GDP and interest rate. For example, an increase in government spending will cause the IS curve to shift to the right, which will cause interest rate to rise also causing an increase in GDP within the same LM curve. 7. What is the Phillips Curve What part does it play in the breakdown of demand side policy The Phillips curve depicts the relationship between the state of the economy relative to its productive capacity and changes in inflation. Once unemployment rate surpasses the non-accelerating inflation rate of unemployment (NAIRU) with output above the potential, inflation will start to decrease. But if it is below NAIRU with potential output, then inflation will start to rise. The Phillips curve shows a trade-off between inflation rate and levels of unemployment. This model states that if economies want higher levels of employment, this can be achieved by allowing higher levels of inflation and vice-versa. Thus, policymakers are left with the choice of either lowering inflation rate or higher employment. In this regard, demand side policies are utilized in order to achieve the desired economic outcome. Into the 1970s, however, many countries experienced high levels of both inflation and unemployment also known as stagflation. Theories based on the Phillips curve suggested that this could not happen, and the curve came under concerted attack from a group of economists headed by Milton Friedman-arguing that the demonstrable failure of the relationship demanded a return to non-interventionist, free market policies. The idea that there was a simple, predictable, and persistent relationship between inflation and unemployment was abandoned by most if not all macroeconomists. This paved the way for the preference for supply side policies in solving the problem of unemployment. Supply-side economic policies are mainly micro-economic policies designed to improve the supply-side potential of an economy, make markets and industries operate more efficiently and thereby contribute to a faster rate of growth of real national output. Most governments now accept that an improved supply-side performance is the key to achieving sustained economic growth without a rise in inflation. 8. Use a labour market diagram to illustrate how different supply side policies could affect the 'Natural Rate of Unemployment'. Can government spending be argued to have a role in a supply side policy The natural rate of unemployment is the equilibrium rate of unemployment. At the real wage rate W1 in the diagram above, E1 workers are employed. But the total labour force remains higher than the employed labour force. Thus the natural rate of unemployment = AB and consists of frictional + structural unemployment. The government might cut the natural rate of unemployment by reducing the horizontal distance between the supply of labour curve and the labour force curve. Any supply-side labour market policy that can increase the number of people willing and able to find employment in the labour market will shift SL to the right, this narrowing the gap. Read More