GDP and How It Is Measured - Essay Example

Macro Economics What is meant by GDP and how is it measured GDP is an acronym for Gross Domestic Product. It was designed to measure the valueof the goods and the services produced during a time period. In spite of its limitations, real GDP is a reasonably precise measure the rate of output and the year-to-year changes in that output. In short, GDP is the measure of economic performance. It is measured in the country's currency both in current and constant prices. There are two basic ways to measure GDP. The first is to measure total spending on goods and services. This is the expenditures approach. The second method is to measure total income, this is the incomes approach. However, the factor income and output measures of GDP differ by a very small statistical discrepancy, because of problems of measurement. Beyond these, there are other issues faced while measuring like distinguishing consumption from investment and accounting for changes in quality when estimating price changes. 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; I = 400; t = 0.3; Yd = Y - tY and G = 770 i) Write out an expression for Aggregate Demand (AD) in terms of Y. Y = C(Y - T) + I(r) + G + NX(e). 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 is an effort by the government to stimulate the economy by adjusting and monitoring the level of spending. It refers to government purchases, transfer payments, taxes, and borrowing as they affect macroeconomic variables such as real GDP, employment, the price level, and economic growth. Using the income expenditure model, we will focus on the demand side to consider the effect of changes in government purchases, transfer payments and taxes on real GDP demanded. The short story is that at any given price level, an increase in government purchases or in transfer payments increases real GDP demanded, and an increase in net taxes decreases real GDP demanded, other things remain constant. 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 describes the combination of interest rates and output that clear the goods and services market in the short run. The goods and services market is said to clear when spending by consumers, firms, the government (and foreigners if an open economy) on goods and services equals the production of goods and services. The basic equation for the IS curve in a closed economy is closely related to the national income accounting identity Y = C+I+G, where Y is GDP The LM curve summarizes all the combinations of income and interest rates that equate money demand and money supply. The LM curve in conjunction with the IS curve will help pin down the interest rate in the economy. It is well known that establishing the elasticity of the IS and LM curves provides basic information about the predicted outcome of fiscal and monetary policies in a given model, with a combination of inelastic LM and elastic IS implying fiscal crowding out and potent monetary policy, whereas elastic LM and inelastic IS lead to potent fiscal and weak monetary effects. Estimation of these locuses 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 The monetary base consists of the liabilities of central bank of a country which supports the expansion of credit and broad money. It is a measure of the funding base which underlies the monetary aggregates and promotes money expansion due to the money multiplier effect. Broad money is the sum of liabilities of the financial system which corresponds to all the features of the "money". The analytical distinction between monetary base and broad money us grounded on the liquidity effect: monetary base is composed of all those instruments that when their supply increases the interest rate declines. 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 explain these policies The three broad categories under which unemployment could be classified are: Frictional Unemployment: this occurs when an individual moves from one job to another, it refers to the temporary time period during which the individual is not employed. Structural Unemployment: this occurs due to geographical boundaries - i.e. when an individual job-seeker is not willing to change geography or skills. Cyclical Unemployment: this occurs when there is no aggregate demand for the labor. Besides these, we also have technological, seasonal, classical and Marxian types of unemployment. Structural unemployment could be reduced by supply side policies. Supply side policies seek to generate jobs by encouraging private investment through reduced taxes and also they aim at increasing the availability of labor resources. 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, which has played an important role in macroeconomic theory since the early 1960s, can be viewed as an intermediate form of supply function, in which process are partially, but not fully, flexible, so that both the level of output and the price level share in the adjustment to the various shocks impinging on the economy. It is assumed that, for purposes of policy analysis, the Phillips curve represents the menu of choices open to the policy makers, i.e. policy makers could opt for low unemployment and high inflation or for high unemployment coupled with low inflation - the so-called trade-off relationship between inflation and unemployment - under given circumstances, but also a constraint that might be made less binding by improvements in the efficiency of the labor-market (which would tend to equalize demand pressure disparities between individual sectors of that market) or altered or eliminated by an incomes policy. Many policy makers no longer believe in such a menu of choices, because it was seen that if fluctuations in economic activity emanate from the supply side, higher rates of inflation will be associated with higher rates of unemployment, and lower rates of inflation will be associates with lower rates of unemployment. Thus for those, picking the combinations of inflation and unemployment are simply unsustainable. 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 The exchange rate regime is the process by which a country manages its currency in regards to foreign exchange markets and foreign currencies. A fixed exchange rate is defined as an exchange rate that is set at a determined amount by government policy. In a flexible exchange rate arrangement, the monetary policy is not constrained by a pre- determined level of the exchange rate. Thus, monetary policy sets interest rates in order to achieve domestic equilibrium (i.e. price stability) while the normal exchange rates adjusts to balance the external accounts. The advantages and disadvantages of fixed and flexible exchange rate regimes are as follows: Advantages Disadvantages Fixed - exchange rate regimes -> Maintains investors confidence in the -> Does not allow the implementation currency, thus encouraging domestic of independent monetary policy; savings and investment and discouraging domestic interest rates should follow capital outflows. those of the dollar in case of dollar peg. -> Reduces inflationary pressures associated -> Exchange rates cannot be used to with devaluation and provides a credible adjust for external shocks or anchor for non-inflationary policy, restrict imbalances. -ting monetary expansion or arbitrary print- -> A fixed peg is also a fixed target -ing of the currency. for speculators. Flexible- exchange rate regimes -> Allows pursuit of an independent monetary -> Reduces investors faith in the curre- policy, when an economy suffers a downturn, -ncy, thus discouraging capital inflo- monetary expansion can soften the impact. -ws to avoid exchange risks. -> Allows the country to adjust to external -> Floating rates can overshoot and shocks through exchange rates; that is lower become highly unstable, leading to export prices and higher import prices would speculation, volatility and high inter- help the country regain external equilibrium. -est rates. 1) Using the Keynesian model of injections and withdrawals in the goods market, explain what happens if people decides 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. 3) What factors should a government take into account in deciding whether to use fiscal policy to achieve a certain level of output Fiscal authorities in different countries remain free to tailor policies to their countries preferences. These policies will influence the size of government, the allocation between public and private consumption and investment, and the level of taxation and redistribution. All of these choices will affect the composition of output and some of them the level of potential output. Thus, the government needs to take into account these factors to use fiscal policy to achieve a certain level of output. 4) What is the difference between the monetary base and the broad money supply Explain the role of banks in creating the latter. The difference between broad money and monetary base money is the liability of the banking system, not of the currency board. The currency's board obligations are limited to the redemption of base money only. As long as there is sufficient condition in place to ensure that broad money can be completely "unwound" (at least in the accounting sense) to fully-backed base money, the currency board will never run out of reserves, even if the public tries to convert their holdings of brad domestic money en masse. Of course, such a complete implosion of the domestic money supply is neither desirable nor probable, but the point is that if the currency board operates by the rules, the promised conversion of the official parity is always technically feasible. By creating money, banks affect the total money supply in an economy and as a result indirectly affect the growth of the economy. 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 The central bank controls in the real world is not the inflation rate directly, but a nominal variable such as the exchange rate or the money stock. In the long run the central bank can control only one of these variables. In the short run, it may be able to control both, if financial integration is imperfect. In principle, the central bank faces several choices in announcing its policy strategy. The central bank would stand ready to alter the exchange rate and/or the money supply as necessary to achieve a certain price level outcome, changing the economy's nominal anchor from time depending on circumstances. Read More