The Production Choices to Achieve Trend Growth - Assignment Example

Q a) Use the production possibilities curve to show the production choices available to an economy to achieve trend growth and explain what the points inside, outside and on the curve mean. b) Identify whether the following policy statements are positive or normative. Give reasons for your answer. ." Balancing the federal budget would be good for the economy " (Hint: Define what " good " means in this context) . " The Asian crisis was caused by Jewish financiers". This comment paraphrases the former Malaysian leader Dr. Mahathir. (Hint: is this statement, whether true or false, purely about facts? or is it a normative statement that is primarily about approval or disapproval? . "IN my opinion, interest rates will rise next month" Ans. 1 a) The production possibility represents alternative combinations of different commodities which can be produced by the economy with the total available resources. In other words, production possibility curve is the locus of all those points that represent different production combinations that an economy can attain by employing its total available resources to the fullest. For simplicity, let us assume that only two commodities (x and y) are being produced using the total available resources in an economy. In the following diagram we plot units of x on the horizontal axis and units of y on the vertical axis. The curve AF represents the production possibility curve of the economy. If all the resources are devoted to the production of x then the country can get OF amount of x and no amount of y. On the other hand if the total resources are devoted to produce y then the country can OF amount of y and no amount of x. since the resources are assumed to be fixed in quantity and since they are assumed to be fully employed with utmost efficiency, if though production of one commodity is increase then that of the other will definitely decrease. For this reason this curve is assumed to be downward sloping. The coordinates of any point of AF curve shows the different product mix that are available to the economy to produce with the given amount of resources. Sot he country can produce on any point of the curve and achieve trend growth. If the supply of resources increase or a technological improvement takes place then the production possibility curve or production possibility frontier (PPF) will shift to the right from AF to A’F’. Any point on the curve (e.g. Point ‘d’) implies a full and efficient employment of the resources, that is, the maximum amount of output that an economy can produce in the most effective manner using the given amount of resources. Any point inside the curve (e.g. Point ‘g’) implies that production in the economy is taking place without using all the resources to the optimum level. It is an inefficient point to produce on because the nation can produce more by employing its resources to the maximum. Any point outside the curve (e.g. point ‘i’) cannot be considered as a point of production because the resources of an economy will fall short so that the country can reach this point. Ans. 1 b) The first statement is a positive one. Positive statements are objective statements dealing with matters of fact or the question about how things actually are. Positive statements are made with obvious value judgments and emotions. They may suggest economic relationships that may be tested by recourse to the available evidence. The statement complies with the definition of positive statement. ‘Balancing the federal budget would be good for the economy’ is backed by economic theory and can be tested through historical data and empirical investigation. The statement actually followed from a logic that balancing the budget will result in optimum employment of the resources without being drawn into any indebtedness. That may put severe interest burden on the nation in the long run. The second statement ‘the Asian crisis was caused by Jewish financiers though sounds like a normative one (as it expresses opinion of a particular individual) but it is actually a positive statement. The logic is that there is plenty of empirical evidence of the fact that Jewish financiers actually had a role to play in Asian crisis. The third statement “In my opinion interest rates will rise next month” is a normative one because it cannot be tested empirically at present times nor is it backed by economic theory. It is actually a personal opinion. Q2. 1) Determine whether each of the following would be included in Gross Domestic Product (GDP). Explain why and why not. You buy a used CD from a friend. You buy a new CD at a music shop. You steal a CD from a shop. 2) Distinguish between real and nominal GDP. Explain the importance and limitations of real GDP measures. Gross Domestic Product (GDP) is a measure of all currently produced final goods and services produced within the country and evaluated at market prices. In the first case, when I buy an used CD from a friend, the price or market value of the used good will not be added to the GDP of the economy. The logic is that the good (the CD I buy) need not have been produced in the current year and even if it is produced in the same year when I buy the CD, inclusion of the value will lead to double counting in the GDP as it has been already taken into account when first produced as a final good or when my friend purchased that from the market. There may be another possibility that the price I purchase the CD at, is not actually the market price. In the second case, when I buy a new CD from the market, the price value will be taken into account in the GDP, as the price will measure the value of the final good that has already been estimated within the measure of GDP. However one thing that needs to be taken into consideration is that whether the production was within the nation. When I steal a CD from the shop, it will not be added to the GDP measure because there is no question of paying a price for it. Though I believe some additional points have to be taken care of while commenting on the first two. Firstly the CD I am purchasing, if imported, will not be added to the GDP, as it has not been produced within the nation. Secondly, if the CD I am purchasing is actually produced by some foreign country but within my native nation, then it will be added in the GDP. Nominal GDP is the output of currently produced goods and services evaluated at current market prices. GDP is the value of currently produced goods and services measured at market prices. So it will change when the overall price level changes as well as the actual volume of production changes. For many purposes we want a measure of output that varies only with the quantity of goods produced. Such a measure would for example be most closely related to the level of employment; more workers are not needed to produce a given volume of output simply because it is sold at a higher price. The GDP measure that changes only when quantities, not prices, change is termed ‘real GDP’. Thus real GDP is basically nominal GDP adjusted for inflation rate. Real GDP = nominal GDP valued in the prices of the base year. This essentially means that one needs to take into account the gross output (goods and services) produced within a nation) and multiply them with the prices of the base year. The importance of real GDP lies in the fact that the value would not be affected by the volatility of prices in an economy. Hence when we compare the GDP over time periods, the results would not be biased. Again, we can say a country is rowing only considering its growth of real GDP and not the nominal GDP. This follows from the fact that if the nominal GDP if growing but the price level is growing at a faster rate than that, then the country is actually experiencing recession rather than growth. There are however some limitations of real GDP: 1. Firstly, like the nominal GDP the problem of not counting domestic services (goods produced at home and not formally sold, e.g., the services of housewives) or the goods sold in the over the counter markets or underground economy remains. 2. The GDP does not account for the aspects like personal security, environmental cleanliness or even democracy. 3. When internationally compared, the results yielded may be inaccurate or biased because the prices of similar goods in different nations may differ to a large extent. 4. Transfer payments and capital gains are not considered in the GDP measure. 5. Further, there is severe controversy over valuation of inventories. The two methods followed to evaluate inventories are market price method and cost price method. Market price method includes imputed profit that may not be realized in the same year. The cost price method does not include the imputed profit. So the GDP value will differ depending upon these two methods. Q 3. Draw a diagram for the Malthusian equilibrium and explain the mechanism by which the economy gets to the equilibrium point. Suppose the subsistence level increase because a disease forces workers to eat more to stay alive. Show this situation in the diagram. What happens to Malthusian equilibrium quantity of labor input? Identify each of the following as a capital saving or a labor saving technological change. A petrol station installs fuel pumps that can be activated by a customer with credit card. A university upgrades its telephone system to include voice mail A university reorganizes its departments to cut back on administrative costs. Ans. 3. 1) Around two centuries ago, reverend Thomas Malthus opined in his Essay on the Principle of Population (1798) that the population of a country, unless checked by dwindling food supplies, grows at a geometric rate doubling every thirty to forty years. On the other hand, owing to the diminishing returns to the fixed factor, land, food supplies could expand only at an arithmetic rate. As each member of the population would have less land to work, his or her marginal contribution to food production would actually start to decline. Because the growth in food supplies could not keep pace with the increase in population, per capita income would have a tendency to fall and will lead to a stable population existing barely at a subsistence level (in terms of wage rate). Mathus defined per capita income in an agrarian society simply as per capita food production. It has been observed that to sustain life a population needs a minimum level of production. If the production is actually higher than the subsistence level, population will grow and if production falls below that level, population will decline. In the above diagram, SL represents the minimum level of output that is required for a population to keep on (sustain) living. At a very low level of production the rate of growth of population is almost zero. So initially the growth of output is more than the growth rate of population. For some period, output remains above the subsistence level. Hence, the population rises. After a certain period, due to diminishing marginal returns the rate of growth of output declines. However, population still increases, as till then, the declining rate of growth of output is higher than the increasing rate for growth of population. In the process, where the production frontier crosses the SL line (the line along which the output level is the subsistence output), rate of growth of population equals that of output. Implication is that at this point, the output produced is equal to the subsistence level of output for the given population. This point ‘E’ is known as the Malthusian equilibrium point. This point is dynamically stable, as any point above SL will lead to increase in population and so over the time it will reach LME (Malthusian level of equilibrium labor heads). Any point below the SL will lead to decrease in population and in a similar way LME will be reached once again. YME (Malthusian equilibrium level of output) is the Malthusian equilibrium output any LME is the Malthusian equilibrium labor input. Ans. 3.2) When the subsistence level increases because of a disease, the SL line will shift upward resulting in lower level of labor input and lower level of output. The implication is that due to subsistence level being higher than what it was before, therefore the falling rate of growth of output will equal the rising population growth rate much earlier than before. This situation is explained in the above diagram. Ans. 3.3) When a petrol station installs fuel pumps that can be activated by a customer with a credit card, then it is a labor saving technological change. As the person who was previously assigned this job will no longer be required. When a university upgraded its telephone system to include voice mail then it will not require any operator anymore. So it is a labor saving technological change. When a university reorganizes its departments to cut back all administrative costs, then it may be capital saving or labor saving technological change. The implication is that if reorganization involves retrenchment of labor, then it is labor saving but if it involves actions like replacing means of transport by a cheaper one, then it is capital saving. Ans. 4) The following table shows the demand for and supply of skilled labor at different hourly wages. Demand for labor Supply of labor Wage/Hour Quantity Wage/Hour Quantity 12 75 12 47 14 68 14 54 16 61 16 61 18 54 18 68 20 47 20 75 22 40 22 82 Draw the supply and demand curve for labor. What are the wage and quantity levels of labor at equilibrium? Suppose a law is passed forbidding employers to pay wages less than $20 per hour. What will be the new quantity of labor in the market? Who gains and who loses from this law? What would be the effect of a payroll tax or employment? b) Distinguish between structural, frictional and cyclical unemployment and identify what constitutes the natural rate of unemployment. Wage/Hour In the above diagram DD’ is the labor demand curve and SS’ is the labor supply curve. At equilibrium, the level of hourly wage and quantity of labor are 16 and 61 respectively. The logic is that at this hourly wage level labor supply = labor demand. At $20 hourly wage rate, labor supply is 75 and labor demand is 47. So 47 people will be employed and the remaining 28 people will be unemployed. At this situation those 47 people who got employed will definitely be gainer, as now they will get a higher wage. Previous equilibrium employment was 61 and hence 14 people will lose their job and will be loser. Again at $20 hourly wage rate, total people willing to work are 75 but only 47 are getting jobs. So altogether 28 people (those 14 people who lost their job already and those 14 people who are now willing to work due to higher wage rate) who lost their job would be loser. A Payroll tax shifts the labor demand curve inward. So, it reduces the level of employment and real wage rate as well as the output. In the above diagram, DD’ is the initial labor demand curve and SL is the labor supply curve. Equilibrium occurs at the point of intersection (E) of DD’ and SL. Now, after the imposition of a payroll tax the labor demand curve shifts inward from DD’ to D1D1’. The new equilibrium point occurs at the point of intersection (E’) of D1D1’ and SL. In the process equilibrium level of employment falls from L0 to L1 and the real wage rate falls from W0 to W1. Ans. b) Cyclical unemployment exists due to inadequate effective aggregate demand. It gets its name because it varies with the business cycle, though it can also be continuous. During the Great Depression of the 1930s we could find such kind of unemployment prevailing. Gross domestic product is not as high as potential output due to failure in demand, perhaps due to pessimistic business expectations which discourages private fixed investment spending. Low government expenditure or high levels of taxes, underconsumption, or low net exports may also lead to this result. This type of unemployment can be considered as some kind of frictional unemployment in which factors causing the friction are partly a result of some cyclical variables. Frictional unemployment involves people moving temporarily between jobs, searching for new ones. It often complements the full employment status. It is also called search unemployment and is often seen as largely voluntary. It arises because either employers fire workers or workers quit jobs. This quiting occurs usually because the individual characteristics of the workers do not fit the individual characteristics of the job. These issues may include elements of the personal taste of the employer or the inadequate work effort of employee. New entrants and re-entrants suffer from such phases of frictional unemployment. Structural unemployment involves a mismatch between the workers searching for jobs and the vacancies that are available. Despite the number of vacancies available being equal to the number of the unemployed, the unemployed workers may lack the skill needed for the jobs or are may be in the wrong part of the world to take the jobs offered. It is a discordant match of skills and opportunities due to the structure of the economy altering. Natural unemployment = structural unemployment + frictional unemployment. The natural rate of unemployment represents the unemployment rate consistent with aggregate production at the "long-run" level. This is the level where the economy reaches in the absence of different temporary frictions like incomplete price adjustment in labor and goods markets. Ans. 5 a) Before proceeding to classify the four elements as money and non money, it will be better to know what money is. The definition of money follows from its functions. The three universally accepted functions of money are a means of exchange, a store of value and an unit of account. Means of exchange- money acts as a medium for transactions. One can buy goods or services with money and one receives money in exchange of what he says. This unique function of money is at the root of the economic efficiency of our system. If there were no money, goods had to be exchanged for goods. This was known as a barter system. Though barter till exists in some manner, but barter as a predomnant means of exchange is inefficient. Actually barter ‘for its functioning requires double coincidence of wants, that is, wants of two people must compliment each other for the barter to take place. Store of value- Money is a type of financial asset. It functions as a store of wealth, that is, we use money as a way of saving for future spending. The other forms of financial assets that are used as a means of store of value, like corporate or government bonds, cannot be classified as money since they are bereft of the other two functions that money performs, namely, unit of account and means of exchange. Unit of account- Prices are measured in terms of money. Money provides great convenience as a unit of account. The importance of this function of money can be realised by the fact that due to the existence of money a merchant simply quote a price in terms of money rather than in terms of different commodities. A dollar coin can perform all the three aforesaid functions of money. So it can be classified as money. It falls under the M1 definition of money. Once a cheque is been issued it remains valid for a stipulated period. Within this period it serves the three functions of money. So in this period a cheque can be considered as money. However once a period gets over, a cheque fails to perform any of the functions and in that period it cannot be considered as money. Funds in current deposits can perform all the three functions of money and hence can be classified as money. A credit card can also be classified as money because it can perform all the three functions of money. Ans b) Role of Reserve Bank of Australia and how it manipulates the interest rate In broad sense the role of the Reserve bank of Australia (RBA) comprises of three functions Maintaining the stability of the Australian Currency. Maintaining full employment Ensuring the economic prosperity of Australian people RBA issues note, provides banking servces to the other bnks, and to the government. It also provides prudential supervision and formes and implements foreign exchange policies. It also conducts monetary policy i,e through interest rate manipulation it regulates the monetary environmennt. The RBA manipulates interest rates through changing official cash rate and open market operation. Open Market Operations: it refers to purchase and sale of government bonds. RBA buys bonds from the public and the dollar it releases in that manner increases the money supply in the economy. With this increased money supply people purchase bonds (interest bearing asset). Demand for bond increases and so does its price. Due to the inverse relationship between bond price and interest rate, interest rate decreases. In order to increase the market rate of interest, RBA purchases government bonds from the public. It dries up the excess supply of money in the economy (arising from the unsatisfied transaction demand for money). To meet the excess demand for money people sell bonds. Supply of bonds rises and so their price falls. Due to the inverse relation between bond price and rate of interest, market interest rate rises. Cash rate is the rate that RBA charges when making any loan to a bank. The lower the discount rate, the cheaper are the borrowed reserves and the more banks borrow at RBA’s discount window. So, a reduction in discout rate increases the money supply in the economy. With that increased supply of money bankss purchase bonds. So demand for bond rises and so does its price. Again due to inverse relation between bond price and market rate of interest, interest rate falls as well. Ans. 6 a) Aggregate expenditure (E) is the summation of total consumption ( C), investment (I), government expenditure (G) and net exports (X). E = C + I + G + X. Now, we may draw the aggregate expenditure line by assuming that the only component of income (Y) on which spending is dependent is on Consumption. Thus it is dependent essentially on consumption expenditure needs. Hence, the marginal propensity (the increase in consumption per unit change in production or output) to consume is taken as the slope of the E-curve. The slope essentially shows how sensitive aggregate expenditure is to change in income. If we want to illustrate an income-spending identity, we would need to draw a 45 degree line along which the economy is at equilibrium, that is, Y=E. The point where the AE line cuts or intersects the 45-degree line is known as the point of spending balance. Thus the spending balance equilibrium occurs on the 45-degree line and economic forces bring the real GDP at this point of equilibrium in the long run. While explaining an economic phenomenon we must consider short and long run incidents separately. Potential GDP of an economy refers to the maximum amount of output that can be produced by using all its resources in the most efficient manner. On the other hand real GDP stands for the actual level of production. Equilibrium in product market occurs at the point of intersection between the aggregate expenditure and the 45-degree line. If aggregate expenditure is denoted as AE and output as Y, then at equilibrium AE=Y. however, this is a long run phenomenon. In short run due to asymmetric information about the market, that is actual demand, a firm may tend to over produce or under produce, and there may be inventory accumulation. Sometimes firms also maintain a certain level of inventory to use as a buffer against any unexpected market shock. Due to all these the actual production may be more or less than the equilibrium output. This phenomenon tends towards equilibrium in the long run as the firm soon realizes the actual level of demand and then if it has surplus inventory, it reduces its level of production and if it has negative inventory it increases its level of production. In this manner, through inventory adjustment in the long run, the level of production tends to reach the equilibrium point. When we talk of potential GDP lying to the right of the equilibrium income level, there is excess capacity in production or unused resources. The firms might adjust by cutting down its resources in the long run, in order to reach equilibrium. Again, if it lies to the left of the equilibrium income level, a firm needs to improve upon its technology or increase resources in order to increase its production capacity. Import increases with the rise in income because as income level rises, demand rises in the economy. Now, that part of the aggregate demand, which cannot be satisfied by the domestic production, is usually satisfied through purchase of foreign goods. Hence we have a positive sloping curve representing the relationship between imports and income. The slope of this curve is equal to the marginal propensity to import. The second diagram reflects the relation between net exports and income. Net exports = Export –Import. As income rises, import rises and hence net exports fall as total export is given. Here net exports become a falling function of income or are inversely related to income. Thus the demand for foreign goods increases. At the GDP level of $360 billion there is a trade deficit of $6 billion. The government might undertake expansionary fiscal policy through increased government expenditure and/or discounting the tax rate and increasing the subsidies. The multiplier = 1/(1-c); c= 0.6 (given). Therefore, the multiplier’s size = 1/ (1-0.6) = 1/0.4 = 2.5 References: 1. Ackley, G. 1961, Macroeconomic Theory. New York: Macmillan. 2. Ackley G. 1978, Macroeconomics: Theory and Policy. New York: Macmillan. 3. Bailey, M.J. 1971, National Income and the price level. New York: McGraw-Hill Book Company 4. Bailey RE, Chambers MJ 1994 Long-term Demographic Interactions in Pre-Census England. Journal of the Royal Statistical Society (Series A), Part 1 5. Chambers MJ, Hastie TJ, 1992 Statistical Models in S. Wadsworth & Brooks, Pace’s. Grove, CA 6. Dixit, Avinash K, 1989. "Entry and Exit Decisions under Uncertainty," Journal of Political Economy, University of Chicago Press, vol. 97(3) 7. Dorn, Bush and Fischer, 1990, Macroeconomic. New York: McGraw-Hill 8. Froyen R.T., 1999. Macroeconomics: Theories and policies. 6th ed. Singapore: Addison Wesley Longman. 9. Mankiw G. N., 1988. "The Optimal Collection of Seigniorage: Theory and Evidence," National Bureau of Economic Research, Inc. 10. Philip L., 1995. "The Link Between the Cash Rate and Market Interest Rates," Reserve Bank of Australia. 11. Todaro M.P, Smith S.C. 2003. Economic development, 8th Ed. Singapore: Pearson Education Private Limited 12. Tore E. & Ulf S., "undated". "Why are Long Rates Sensitive to Monetary Policy," IGIER (Innocenzo Gasparini Institute for Economic Research), Bocconi University. Read More