PS1 2021 Solutions - PS1 RESOLUTION - MACRO I PDF

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PS1 RESOLUTION - MACRO I...

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Universitat Pompeu Fabra

Macroeconom Macroeconomics ics I (2020-21)

Instructor: Priit Jeenas Teaching Assistant: Andrea Sy

Proble Problem m set 1

You can find in your Aula global the readings needed. 1. Using the highlighted paragraphs from The Economist´s article about GDP (Article 1), answer the following: a) Mention three cases showing that the GDP is a limited measure of standard of living, think also about situations where an increase in GDP does not make a country better off (it does not improve wellbeing), or where a decrease in GDP does not necessarily make a country worse off. 1. GDP measurements can miss the additional value of innovation and new types of services provided at no price at all (e.g. Facebook, YouTube, etc.) 2. GDP treats the plunder of the planet as something that adds to income, rather than as a cost. This means that, for example, the coal mined from a country’s ground is counted as value added, but the fact that this reduces resources available in the future is not taken into account. 3. As Robert Kennedy emphasized: GDP measures advertising and jails but does not capture “the beauty of our poetry or the strength of our marriages”. Thus, if we build more jails because crime is rampant, GDP increases while the country is certainly not better off. 4. “Home production”, such as housework or caring for an elderly relative is not captured in GDP although it is valuable for society. b) In the article, we can read that nowadays GDP does not capture an important proportion of production, innovation or improvements in quality. Explain Many products and services are significantly different from the one GDP was designed to measure in the interwar period (i.e. manufacturing and agricultural output). For example, GDP struggles to measure properly digital innovations that replace traditional services: like in the case of AirBnB and hotels or private cars and Uber taxis. Services that are ¨free¨ to consumers (at least in monetary terms) but provide daily entertainment to millions like Youtube and Facebook are outside of the traditional scope of GDP statistics. Some services that used to be paid for, are now given away free, such as long-distance phone calls. Some physical products have become digital services, the value of which is harder to track. Consumers once bought newspapers and maps. They paid middlemen to book them holidays. Now they do much more themselves, an effort which doesn’t show up in GDP. Also, it is difficult to measure the additional value coming from changes in the quality of technology. This year’s smartphone might cost more than last year’s, but if so it will also do more. If statisticians focus only on changes in price, they will overstate the true inflation rate by missing improvements in performance. It is not the case that the old smartphone has simply become more expensive. Instead, the new smartphone model provides better services. c) In that article we can read: …” Paul Samuelson joked that GDP falls when a man marries his maid”. Explain.

Where there are market prices, it is straightforward to put a value on output. This convention means that so-called “home production”, such as housework or caring for an elderly relative, is excluded from GDP, even though such unpaid services have considerable value. When a man buys household services from a maid, the price he pays enters GDP. When the man marries his maid, she will probably continue doing at least some of the cleaning, cooking, etc. at home, but without explicit monetary payment. Hence, GDP would decrease. d) In the same reading they talk about hedoni hedonicc prices, explain the concept and how we could the use of those prices improve the measurement of GDP? Hedonic estimation is a proposed way to the problem outlined in question 1.b, that is on how to incorporate innovation and improving quality into GDP. Hedonic estimation is a technique capturing the implicit value of each particular attribute of a product by measuring how variation in those traits affects the product’s price: for example, how much more do people pay for a better smartphone? How much is it worth that you can make cooler pictures for Instagram, play videos faster, or have a longer life for the battery? It is possible to estimate how much those features are worth to consumers in monetary terms. Once an implicit price for each attribute is established – processor speed, camera quality or memory, say, for a phone – prices are tweaked accordingly.

2. The Economist’s article in exercise 1 mentions that some prominent economists and politicians have called for using a “dashboard” of measures to capture human welfare instead of only focusing on GDP. Using the help of the UK Office of National Statistics “Measures of National Well-being Dashboard” (Link 1), list some measures from the dashboard that you find most important for measuring human welfare in addition to GDP, explaining why. “Because GDP is only one measure of the health of the economy, the ONS also collects data on broader measures of personal and societal well-being. These include things like health, relationships, education and skills, what we do, where we live, our fina finances nces and the environment environment.” For example, more specifically: • Healthy life expectancy at birth is defined as the average number of a new-born is expected to continue to live in a healthy conditions. Healthy life expectancy reflects both the overall mortality level of a population and the proportion of the population without disability, and is another indicator for the general health of a country. Unemployment rate measures the fraction of people in the labour force who currently • do not have a job but are looking for one. A high unemployment rate can lead more people to experience lower life satisfaction. Also people can become discouraged and potentially stop looking for a job, thus dropping out of the labour force and decreasing the economy’s capabilities to produce. • Crime (crimes against the person, per 1000 adults) reflects the frequency that a person might suffer from a crime against them. A lower crime level ensures a safer, more enjoyable living environment • Trust in government reflects the fraction of surveyed people who report that they tend to trust their government. If trust in the government is low, it might lead to lack of order and a worse functioning of society • Greenhouse gas emissions measure the amount of greenhouse gases released into the atmosphere. Low emissions provide for cleaner air, a healthier life environment, and

reduce global warming which can have adverse effects on the nature and agricultural productivity.

3. The following statements are false. Explain why. a) If a country had an inflation rate of 3% between 2018 and 2019, and its inflation rate was 2% between 2019 and 2020, then we say that the country experienced deflation in 2020. Deflation is a sustained decline in the price level. It corresponds to a negative inflation rate, and not to a decrease in the inflation rate. A slowing of the pace of inflation rate is called disinflation. b) If an economy experiences a price level decrease (calculated using the CPI), then we know with certainty that the CPI inflation rate has decreased, but we do not know whether the CPI inflation rate is positive or negative. The inflation rate is defined as the rate at which the price level increases. So if the price level decreases, it means by definition, that the inflation rate is negative. In addition, simply knowing that the price level decreased between two periods is not enough to say whether inflation is higher or lower than previously. For example, if inflation was previously positive, then a decrease in the price level also necessarily means a decrease in the inflation rate. But if the price level was falling at a fast rate already previously, meaning that the inflation rate was very negative already before, then the current (negative) inflation rate might actually be higher than the previous “very negative” inflation rate. c) If nominal economic (GDP) growth in an economy was 10% between 2014 and 2015, and the nominal growth decreased to 4% between 2015 and 2016, we can necessarily say that this is bad news since it implies a severe fall in production growth and a fall in expected net creation of jobs. Give an example, of one economy producing one good, illustrating why this may be wrong. (Don’t worry about the growth rates being off by a few decimals when you are giving an example based on numbers.) Nominal GDP can grow either because of the production of goods and services increasing or because of prices increasing over time. This means that the observed fall in nominal GDP growth can actually be explained by the slowing down of price growth (a fall in GDP deflator inflation), and not necessarily a slowing down of growth in actual production (real GDP). This can be seen in the following example.

2014 2015 2016

Quantity of Oil 100.0 102.0 104.1

Price per barrel $10.0 $10.8 $11.0

Or an even simpler example: Quantity Price of Oil per barrel 2014 100 $10 2015 100 $11 2016 104 $11

Nom. GDP $1000.0 $1101.6 $1145.1

Real GDP (2014 price) $1000 $1020 $1041

Nom. GDP growth

Real. GDP growth

10.16% 3.95%

2.00% 2.06%

Nom. GDP $1000 $1100 $1144

Real GDP (2014 price) $1000 $1000 $1040

Nom. GDP growth

Real. GDP growth

10% 4%

0% 4%

d) A lower Inflation derived from CPI compared to the GDP deflator inflation could be explained by a decrease in the price of goods that are bought by firms but not by consumers. Indeed, the prices of goods and services bought by firms but not by consumers are included in the GDP deflator calculation, but not in the CPI calculation. However, a decrease in the price of such goods contributes to a relatively lower GDP deflator inflation relative to HICP inflation. This would thus justify a lower inflation derived from the GDP deflator against the HICP. Or rephrasing, this would justify a higher inflation from HICP against the GDP deflator.

4. Go to the Spanish Economic Outlook, March 2021 (Link 2), download the Report and answer: a) Unemployment. By how much and in which direction did the number of registered unemployed people change in February 2021? If the labor force in Spain was approximately 23 million people at the end of February 2021, use the approximate number for unemployment in the Report (4 million) to calculate an implied unemployment rate for Spain at the end of February 2021. According to the Report, registered unemployment increased by 20,000 people in February 2021, bringing the number of unemployed people to over 4 million people. If the labor force in Spain was approximately 23 million at the end of February 2021, this implies an approximate unemployment rate of 4/23  17.4%. b) Inflation. What is the difference in the definitions of the headline and core CPI inflation rates? (Hint: one of them excludes certain, volatile components of the consumption basket.) Following the CPI growth figure, comment on headline and core CPI inflation during 2020. Based on their definitions, what could we say about the reasons behind the differences? Headline inflation is a measure of the total CPI inflation within an economy, including commodities such as energy and unprocessed food. Core CPI inflation is calculated by excluding changes in unprocessed food and energy prices from headline inflation. Further explanation: Commodities such as unprocessed food and energy prices tend to have very volatile prices. So including their price fluctuations may cause large changes in headline CPI inflation. And this can make it difficult to assess the development of the overall price level in the economy. Because of this, economists also study the development of core CPI inflation that excludes these volatile components of the consumption basket. In 2020, headline CPI inflation was negative throughout, indicating a decrease of the price level (deflation) based on headline CPI. At the same time, core CPI inflation was slightly positive, fluctuating between 0% and 1% during the year. Because the difference between the headline and core CPI definitions is that headline CPI includes energy and unprocessed food prices, the fact that headline CPI inflation was lower than core CPI inflation must be explained by the fact that energy and unprocessed food prices increased less than other consumption good prices. More specifically, because headline CPI inflation was negative while core CPI inflation was positive, this suggests that energy and/or unprocessed food prices must have been decreasing considerably, while other consumption good prices in the core CPI were increasing, on average.

5. An economy produces three goods: bikes, computers and chairs. Quantities and prices per unit for the years 2016 and 2017 are as follows: 2016 Quantity Bikes Computers Chairs

2017 Price

20 10 100

€500 €1000 €100

Quantity

Price 22 13 120

€700 €500 €120

a) What is nominal GDP in 2016 and in 2017? By what percentage does nominal GDP change from 2016 to 2017? Nominal GDP levels: €Y2016 = 20*€500 + 10*€1000 + 100*€100 = €30000 €Y2017 = 22*€700 + 13*€500 + 120*€120 = €36300 Nominal GDP growth = (€Y 2017/€Y2016 – 1)*100 = (€36300/€30000 – 1)*100 = 21% b) Using the prices for 2016 as the set of common prices, what is real GDP in 2016 and 2017? By what percentage does real GDP change from 2016 to 2017? Let us denote real GDP in year t measured at year k prices as Yt,k. Real GDP levels (at 2016 prices): Y2016,2016 = €Y2016 = €30000 Y2017,2016 = 22*€500 + 13*€1000 + 120*€100 = €36000 Real GDP growth = (Y2017,2016/Y2016,2016 – 1)*100 = (€36000/€30000 – 1)*100 = 20% c) Using the prices for 2017 as the set of common prices, what is real GDP in 2016 and in 2017? By what percentage does real GDP change from 2016 to 2017? Real GDP levels (at 2017 prices): Y2016,2017 = 20*€700 + 10*€500 + 100*€120 = €31000 Y2017,2017 = €Y2017 = €36300 Real GDP growth = (Y2017,2017/Y2016,2017 – 1)*100 = (€36300/€31000 – 1)*100 = 17.1% d) Why are the two output growth rates constructed in b) and c) different? Which one is correct? Explain your answer. Because we cannot simply sum up quantities of cars, computers, and oranges to measure their aggregate economic value, we must use prices in euros to make the value of the produced quantities comparable. However, by changing the year at which common prices are measured, we might change the relative weight we attribute to the quantities of each good, and thus change the resulting growth of real GDP. Both the real GDP growth rates in b) and c) are correct. They are simply calculated based on different base years. Further explanation: A way to see how changing the base year for prices affects the resulting growth rate of real GDP mathematically, let us go through the following general derivation. For simplicity, consider an economy with two goods A and B. Let QtA denote the quantity of good A produced in year t and let PtA denote the price of good A in year t, etc. Real GDP growth between t and t-1, using t-1 as the base year can be written as follows:

𝑌𝑡,𝑡−1

𝑌𝑡−1,𝑡−1

𝐴 𝑄 𝐴 + 𝑃 𝐵 𝑄𝐵 𝑡−1 𝑡 𝑡 𝑃 𝑡−1 𝐴 𝐴 𝐵 𝐵 𝑃 𝑄 + 𝑃 = 𝑡−1 𝑡−1 𝑡−1 𝑄𝑡−1 𝐴 𝑄𝐴 𝐵 𝑄𝐵 𝑃𝑡−1 𝑄𝑡𝐴 𝑃𝑡−1 𝑄𝑡𝐵 𝑡−1 𝑡−1 =( 𝐴 𝐴 )( 𝐴 ) + ( 𝐴 𝐴 )( 𝐵 ) 𝐵 𝐵 𝐵 𝐵 𝑃𝑡−1 𝑄𝑡−1 + 𝑃𝑡−1 𝑄𝑡−1 𝑄𝑡−1 𝑃𝑡−1 𝑄𝑡−1 + 𝑃𝑡−1 𝑄𝑡−1 𝑄𝑡−1

Notice that gross real GDP growth between t and t-1, using t-1 as the base year, can be thought of as a wei weighted ghted average of the gross growth rates of the qua quantities ntities of the various goods, (QtA/ A B B Qt-1 and Qt / Qt-1 ). The weights are the fractions each good “contributes” (Pt-1AQt-1A and Pt-1BQtB pricess. Notice that the weights sum up to 1, so it is really a 1 ) to GDP in t-1 calculated at t-1 price weighted average. Similarly, real GDP growth between t and t-1, using t as the base year can be written as: 𝐴 𝐵 𝑃𝑡𝐴 𝑄 𝐴 + 𝑃𝑡𝐵 𝑄𝑡𝐵 𝑃𝑡𝐴 𝑄𝑡−1 𝑄𝑡𝐴 𝑃𝑡𝐵 𝑄𝑡−1 𝑄𝑡𝐵 𝑌𝑡,𝑡 = 𝐴 𝐴𝑡 = ( ) ( ) + ( ) ( ) 𝐵 𝐴 + 𝑃𝐵 𝐵 𝐴 𝐵 𝑌𝑡−1,𝑡 𝑃𝑡 𝑄𝑡−1 + 𝑃𝑡𝐵 𝑄𝑡−1 𝑃𝑡𝐴 𝑄𝑡−1 𝑄𝑡−1 𝑃𝑡𝐴 𝑄𝐴𝑡−1 + 𝑃𝑡𝐵 𝑄𝑡−1 𝑄𝐵𝑡−1 𝑡 𝑄𝑡−1

Notice that again, gross real GDP growth between t and t-1, using t as the base year, is a weighted average of the gross growth rates of the quantities across goods. But now, the weights are the fractions each good “contributes” to GDP in t-1 calculated at t prices . In the two formulas, therefore, the only thing that changes, are the prices which in turn influence the weights. And by changing the weights we change the importance of the different goods’ quantities in calculating GDP growth. For example, if good A was very expensive in year t-1 and cheap in t (compared to good B), then the real GDP growth rate measured at t-1 prices is “tilted more towards” QtA/ Qt-1A than the real GDP growth rate measured at t prices. e) Using the prices for 2016 as the set of common prices, compute the GDP deflator for 2016 and 2017 and compute the rate of inflation from 2016 to 2017. Let us denote the GDP deflator in year t using k as the year for common prices as Pt,k. GDP deflators (using 2016 prices): P2016,2016 = (€Y2016/Y2016,2016)*100 = (€Y 2016/€Y2016)*100 = 100 P2017,2016 = (€Y2017/Y2017,2016)*100 = (€36300/€36000)*100= 100.83 Rate of inflation: (P2017,2016/ P2016,2016 – 1)*100 = (100.83/100 – 1)*100 = 0.83% f) Using the prices for 2017 as the set of common prices, compute the GDP deflator for 2016 and 2017 and compute the rate of inflation from 2016 to 2017. GDP deflators (using 2017 prices): P2016,2016 = (€Y2016/Y2016,2017)*100 = (€30000/€31000)*100= 96.77 P2017,2016 = (€Y2017/Y2017,2017)*100 = (€Y 2017/€Y2017)*100 = 100 Rate of inflation: (P2017,2017/ P2016,2017 – 1)*100 = (100/96.77 – 1)*100 = 3.34% g) Why are the rates of inflation in e) and f) different? Which one is correct? Explain your answer. Both are correct. Again, depending on the choice of the base year for prices, the relevance of the different goods’ prices when computing changes in the price level. Analogously as gross real

GDP growth can be written as a weighted average of goods’ quantities’ gross growth rates, one can show that the GDP deflator can be written as a wei weight ght ghted ed average of goods’ prices’ gross growth rates relative to their price pricess in the base year year. By changing the base year, the weights change, and therefore, also the implied growth rate of the price level (inflation) changes.

6. Suppose the nominal GDP of an economy in 2014 is 200 billion €, and the same variable in 2015 becomes 210 billion €. If in this period prices increased by 2%, what is the real GDP growth rate? Nominal terms: €Y2014 = P2014Y2014 = €200 B €Y2015 = P2015Y2015 = €210 B Because prices increased by 2%, we also know that (P2015 - P2014) / P2014 = 0.02, or equivalently, P2015 / P2014 = 1.02 To calculate the real GDP growth rate, we need to find: Y2015 / Y2014. Using the relation between nominal and real GDP from above, we can write: Y2015 / Y2014 = (€Y2015 / P2015) / (€Y2014 / P2014) = (€Y2015 / €Y2014) / (P2015 / P2014) = = (210 / 200) / 1.02 = 1.0294. That is, the real GDP growth rate is: (Y 2015 / Y2014 – 1)*100 = 2.94 percent. Note also, that when growth rates are relatively small, the following approximate relation gives you a reasonable estimate of the relation between real and nominal GDP growth and inflation: Real GDP growth rate = Nominal GDP growth rate – Inflation = 5% - 2% = 3%

7. The Excel file (Data 1) provided in Aula Global includes annual data for Spanish real GDP (at 2017 prices) for 1960-2019. … See Excel solution file....