macroeconomics notes semester 4 Delhi university economics hons PDF

Preview

Summary

PMG Economics ClassesExtra Qs. of UNIT- 1Q1. Is GDP a true indicator of economic welfare?GDP is a strong indicator of economic well being of the society because countries with a large GDP tend to have better educational systems, better health case, better housing, better diet and longer file expecta...

Description

PMG Economics Classes

Extra Qs. of UNIT-1 Q1.

Is GDP a true indicator of economic welfare ?

GDP is a strong indicator of economic well being of the society because countries with a large GDP tend to have better educational systems, better health case, better housing, better diet and longer file expectancy and so on but GDP is not a perfect measure of material well being due to following reasons. 1.

Under-reported Income : Business people often under state their reported incomes, teachers do not report their earnings from tuition classes. All these individuals understate their incomes as not to pay taxes and work with an accounting system that leaves no paper trails. So that the government finds it difficult to track their real incomes.

2.

Underground and illegal incomes: In addition there are all sorts of underground activities that people are involved in such as drug dealing and gambling where they do not report their incomes. Similarly, income from illegal activities also do not form a part of GDP but due to income it increases welfare but are not known in GDP.

3.

Non marked activities: There are many activities that are not marketed through formal markets. These non-market activities do not get included in aggregate income thus although it increases the welfare but still not counted in GDP for example subsistence farming done by some formers.

4.

Production for Self Consumption: There are certain goods and services which are provided to our self instead of contracting out such as housewives Services, Cooking your own meals etc. These also affect our welfare but are not included in GDP.

Q2.

Compare Real GDP and Nominal GDP.

Nominal GDP is the sum total of the value of goods and services measured at current prices. Nominal GDP is also known as GDP at current prices. Nominal GDP is not an ideal measure of economic well being because it does not indicate precisely the ability of an economy to satisfy the demand of households, firms and the government. Real GDP is the sum total of the value of goods and services measured by using a constant set of prices i.e. prices of base year. It shows the changes in expenditure of a result of changes in the quantities of goods of services produced, keeping price constant. If we observe that nominal GDP has risen from one year to next, we are unable to determine whether the quantity of goods and services have increased. However, if we observe that real GDP has risen, we are certain that the quantity of goods are services have risen because the output from each year is valued in terms of same base year prices. Thus Real GDP is the better measure of production in the economy.

PMG Economics Classes Whatsapp ONLY - 9899312641

Page | 1

PMG Economics Classes Q3.

What are the ways of measuring cost of living ?

These are two ways in which the price level can be measured. 1.

CPI i.e. Consumer price index: The CPI is the most commonly used measure of the price of the price level. The CPI is a measured of the price of one basket of goods and services relative to the price of the some basket in some particular base year. It is calculated by the Bureau of Labour Statistics. These are five steps to calculating a CPI. 1.

Fix the basket: Estimate the quantity of the products purchased by the typical consumer (i.e. the basket of goods and services)

2.

Find the prices: Locate the price of each item in the basket for each point in time (each year for an annual CPI).

3.

Compute the basket cost: Use the prices and quantities to calculate the cost of the basket for each year.

4.

Choose a base year and compute the index: Choose a year as the benchmark against which other years can be compared. The choice of the base year is arbitrary. Make a ratio of the cost of the basket for each year to the cost in the base year. Multiply each ratio times 100. Each resulting number is the value of index for that year.

5.

Computing Inflation: Inflation is the percentage change in the price index from the previous year for example

Inflation rate in 2011 =

CPI in year 2011  CPI in ear 2010 100 CPI in year 2010

The major categories in the CPI basket are housing, transportation, good and beverages, medical case, recreation, education and communication and other goods and services. 2.

GDP deflator: The GDP deflator in calculated from the nominal GDP and the real GDP. It is also called implicit price deflator. It is defined or the ratio of the nominal GDP to the real GDP Symbolically GDP deflator 

Nominal GDP Real GDP

From, the above relationship, it is seen that GDP deflator is a price index too, however it differ from CPI in two ways. 1.

First the basket of goods and services is different. The GDP deflator utilizes the prices of all goods and services produced domestically. The CPI utilizes the prices of goods and services bought by consumers only, regardless of where the goods were

PMG Economics Classes Whatsapp ONLY - 9899312641

Page | 2

PMG Economics Classes produced. Therefore, a change in the price of foreign crude oil raises the price of gasoline, is captured by CPI but not by GDP deflator, while a change in the price of a domestically produced nuclear missile is captured by the GDP deflator and not by the CPI. 2.

Q4.

Second the GDP deflator utilizes the quantities of goods and services in current output, so the basket changes each year. The CPI utilizes the quantities in a fixed basket, so the basket changes only when the bureau of Labour statistics chooses.

What are the problems with choosing CPI as a measure of cost of living ?

The cost of living is the amount by which incomes must rise in order to maintain a constant standard of living. These are however three problems with using the CPI to measure changes in the cost of living 1.

Substitution bias: Over time, some prices rise more than others. Consumers will substitute for goods that are relatively less expensive. The CPI however, is based on fixed basket of purchases, because the CPI falls to acknowledge the consumers/ Substitution of less expensive product for more expensive products, the CPI overstates the increase in the cost of living.

2.

Introduction of New goods: When new goods are introduced a dollar has increased in value because it can now by a greater variety of predicts, because the CPI is based on a fixed consumed basket. It does not reflect this increase in the purchasing power of the dollar. Thus again the CPI overstates the increase in the cost of living.

3.

Unmeasured quality change: If the quality of a good rises from year to year, then the value of dollars is rising even it actual prices are constant. This is equal to a reduction in price, but this increase in quality is not measured by CPI than again it over states the increase in the cost of living. The opposite is also true for deterioration in quality

Q5.

What is the main conceptual difference between GDP and GNP? How different are GDP and GNP for the United States? For countries with many citizens who work abroad? Answers: GDP represents output produced within a country, while GNP represents output produced by a country’s factors of production; the difference is net factor payments from abroad. For the United States there’s little difference, but for countries that have many citizens working abroad, there may be a big difference.

Q6.

In the country of Kwaki, people produce canoes, fish for salmon, and grow corn. In 1993 they produced 5000 canoes using labor and natural materials only, but sold only 4000, as the economy entered a recession. The cost of producing each canoe was $1000, but the ones that sold were priced at $1250. They fished $30 million worth of salmon. They used

PMG Economics Classes Whatsapp ONLY - 9899312641

Page | 3

PMG Economics Classes $3 million of the salmon as fertilizer for corn. They grew and ate $55 million of corn. What was Kwaki’s GDP in 1993? Answer: Inventories are valued at the cost of production, so the 1000 canoes in inventory were valued at $1000 each, for a total of $1 million. Four thousand canoes at $1250 each totaled $5 million. Salmon as a final good were worth $27 million (the other $3 million were used up as an intermediate good), and corn worth $55 million was grown. So total GDP (in millions) was $1 + $5 + $27 + $55 = $88 million. Q7.

How does chain weighting lead to a different measurement of real GDP than the methods used by the BEA prior to 1996? What are the advantages of chain weighting? What are the disadvantages? Answers: Prior to 1996, the growth rate of real CDP depended on which year was chosen as the base year. Now, however, the current year and preceding year are used as base years, averaging results using each as base year. The advantages of this method are that there’s no longer a need to recompute historical data or to change base years. However, a disadvantage is that real GDP is no longer the sum of its components.

Q8,

Explain how it was possible for U.S. national wealth to have risen substantially from 1990 to. 1999, yet national saving declined as a percentage of GDP?. Answer: An increase in wealth doesn’t require additional saving, if the value of existing assets increases. In the l990s, gains in the stock market caused U.S. national wealth to rise.

Q9.

What is the difference between nominal and real economic variables? Why do economists tend to concentrate on changes in real magnitudes? Answers: Nominal variables are in units of money, while real variables are in physical quantities of output. We measure nominal variables using current market prices and real variables using market prices in a given base year. Nominal variables may increase, but you don’t know if the increase is due to higher prices and the same quantity, or a higher quantity with unchanged prices; real variables reflect just quantity changes. For the most part, real variables (consumption, investment, and the capital stock) affect each other in the economy, with lesser roles played by nominal variables (money supply, and price level).

Q10.

The country of Myrule has produced the following quantity of gauges and potatoes, with the price of each listed in dollar terms. Year 1999

(a)

2000

Quantity

Price

Quantity

Price

Gauges

8,000

$4

10,000

$3

Potatoes

6,000

$8

5,000

$14

Using 1999 as the base year, what is the growth rate of real GDP from 1999 to 2000?

PMG Economics Classes Whatsapp ONLY - 9899312641

Page | 4

PMG Economics Classes (b)

Based on the GDP deflator, what is the inflation rate from 1999 to 2000?

Answers: (a)

Real GDP for 1999

= 1999 quantities at 999 prices = (8000  $4) + (6000  $8) $80,000.

Real GDP for 2000

= 2000 quantities at 1999 prices = (10,000  $4) + (5000  $8) = $80,000.

Growth rate of real GDP = 0% (b)

Nominal GDP for 1999 = 1999 quantities at 1999 prices = (8000  $4) + (6000  $8) = $80,000. Nominal GDP for 2000 = 2000 quantities at 2000 prices = (10,000  $3) + (5000  $14) = $100,000. GDP deflator = nominal GDP/real GDP GDP deflator in 1999 = $80,000/$80,000 = 1. GDP deflator in 2000 = $100,000/$80,000 = 1.25. Inflation rate = [(1.25/1) – 1]  100% = 25%

Q11.

By how much does the CPI overstate true increases in the cost of living, according to the Boskin Commission? What are the main reasons for this bias in the CPI? What are the economic implications of the bias? Answers: The Boskin Commission reported that the CPI overstates inflation by I to 2 percentage points per year. The bias arises because of difficulty in measuring quality change - (especially for services) and because the CPI doesn’t account for the substitution that people make between goods when relative prices change. The bias implies that our measures of real income growth are understated and that Social Security benefits are being adjusted more than they should be to account for inflation.

Q12.

The nominal interest rate is 7%, today’s price level is 150, and you expect the price level to be 156 one year from now What is the expected inflation rate? What is the expected real interest rate? Answers: Expected inflation = 156/150 – 1 = 0.04 = 4%; Expected real interest rate

Q13.

= 7% – 4% = 3%.

Loretta agrees to lend Ted $500,000 to buy computers for his consulting firm. They agree to a nominal interest rate of 8%. Both expect the inflation rate to be 2%. -

PMG Economics Classes Whatsapp ONLY - 9899312641

Page | 5

PMG Economics Classes (a)

Calculate the expected real interest rate.

(b)

If inflation turns out to be 3% over the life of the loan, what is the real interest rate? Who gains from unexpectedly high inflation, Loretta or Ted?

(c)

If inflation turns out to be 1% over the life of the loan, what is the real interest rate? Who gains from unexpectedly high inflation, Loretta or Ted?

Answers: (a)

8% – 2% = 6%.

(b)

8% – 3% = 5%. Ted gains from unexpectedly high inflation, because he repays the loan with dollars that aren’t worth as much as was expected.

(c)

8% – 1% = 7%.

Loretta gains from unexpectedly low inflation, because she gets repaid with dollars that are Worth more than was expected

Examination questions Q1.

What is net factor payment to the rest of the world? Explain why this item is added when using the income approach to calculate GDP.

Net factor payment to the rest of the world = Factor payments made to the rest of the world – Factor Payment received from the rest of the world. The positive item is value added by foreign-owned factor working within the country while the negative item is the value added by domestically owned factors working outside the country. Since the +ve item is part of GDP but not of national income and the –ve item is not a part of GDP but of national income, the net difference is added to calculate GDP under income approach. Q2.

Neha borrowed Rs.10, 00,000 front a bank in 2005, to be paid back in 2006. During this course of the year, inflation was more than anticipated. Who gained and who lost?

Neha, the debtor, gained. Bank, the creditor or the lender, lost. The money repaid by Neha had lower purchasing power than the money she borrowed.

PMG Economics Classes Whatsapp ONLY - 9899312641

Page | 6

PMG Economics Classes Q3.

Calculate the national income and personal disposable income from the following information: GDP

6,000

Receipts of factor income from the rest of the world

150

Payments of factor income to the rest of the world

225

Depreciation

800

Indirect taxes minus subsidies

700

Corporate Profits

1,200

Dividends

600

Transfer payments to persons

1,300

Personal Taxes

1,500

National Income = GDP – Dep. – Net Indirect Taxes + Net factor payments from rest of the world National Income = 6000 – 800 – 700 + (150 - 225) = 6000 – 1575 = 4425 Personal Disposable Income = 3625

Q4.

You are given the following for an economy: Consumption function

C = 80 + 0.8 Yd

Investment function

I = 80

Govt. spending

G = 60

Net taxes

T = 60

Exports

X = 20

Imports

M = 0.2 Yd

(i) (i)

What is the current account balance for this economy?

Y

= C + I + G + NX

Y

= 80 + 0.8Yd + 80 + 60 + (20 – 0.2Yd)

Y

= 240 + 0.6 Yd.

Y

= 240 + 0.6(Y – 60)

Y

= 240 + 0.6Y – 36

(1 – 0.6)Y

= 204

Y

=



M

= 0.2Yd = 0.2(510 – 60) = 90



Current Account Balance

204  510 0.4

= Trade Balance = (20 – 90) = –70

PMG Economics Classes Whatsapp ONLY - 9899312641

Page | 7

PMG Economics Classes I.e. Deficit in Current A/c Q5.

(i)

(i)

Describe the various government policies used to address macroeconomic concerns of an economy.

(ii)

Real GDP and not the nominal GDP is the correct measure of production of an economy. Discuss.

(iii)

What are the limitations of GDP concepts?

Major macroeconomic concerns are growth (of GDP), employment level, exchange rate, rate of inflation, interest rate, investment, infrastructure and most importantly fiscal and financial sector stability. To address these concerns the government uses, (i) fiscal policy, (ii) Taxation policy, (iii) Subsidies and transfer payments policy, (iv) Foreign Trade policy, (v) Management and finance of public debt, (vi) Investment Promotion policies etc. (ii) Try yourself. (iii) Try yourself.

Q.6

out of all adult population of a city, 1, 20,000 is employed, 5,000 are unemployed and 25,000 are not in the labour force. Calculate: ( i) the sized of labour force; (ii) The unemployment rate; and (iii) The labour force participation rate.

(i)

The size of labour force = 1, 20,000 + 5,000 = 1,25,000

(ii)

The unemployment rate = (5,000/1, 25,000) = 0.04 = 4%

(iii)

The labour force participation rate = (1, 25,000 /(1,25,000 + 25,000)) = (1,25,000/1,50,000) = 5/6 = 83.33%

Q7.

if the balance on capital account of a country is positive the change in the country’s assets abroad must be greater than the change in foreign assets in the country. Do you agree? Explain. What happens to the net wealth position of the country?

No. A positive balance on capital account means that the country had more sources of foreign exchange through sale of its assets abroad or through foreigners purchase of assets in that country. Such sources exceeds use of foreign exchange through purchase of assets abroad or purchase of foreign held assets in that country. It is not possible to determine whether changes in assets abroad exceeded or not the changes in foreign assets in the country. Yet, one thing is for certain that the net wealth position of the country decreases if we do not consider the liquid foreign exchange as part of net wealth.

PMG Economics Classes Whatsapp ONLY - 9899312641

Page | 8

PMG Economics Classes Otherwise, the net wealth position remains unchanged. Q8.

U.S. employment date for African Americans for April 2005 shows Employed = 15.184 million Unemployed = 1.736 million Not in the labour force = 9.473 million Find the labour force, unemployment rate and labour force participation rate for African Americans. Employed

= 15.184 Million

Unemployed = 1.756 Million Not in labour force

= 9.473 Million

Labour Force = Employed...