Revision 2 - Module 1, Part 2: Measurement

Question 1 False. Gross Domestic Product is defined as the market value of all final goods and services produced in an economy during a given period of time. It is important to include only final production. Question 2 Real capital: tools, machinery, buildings, productive equipment. Capital: investment goods (physical/human capital) Money/financial capital: stocks, shares, and bonds. False. The purchase of stocks/shares is an addition to money/fin capital and has no effect on the level of real capital within the economy. Question 3 As money or nominal GDP is effectively a price-times-quantity figure, it is important that students appreciate the limitations of using such a figure for comparative purposes either between countries, or within a single country for the aim of measuring real physical output. Money GDP could increase over time because of (a) increased output or (b) increased prices or both. We are interested in GDP to the extent that it measures the quantity of output produced. Thus must separate these two effects. Question 4 While we assume there should be a strong positive correlation between GDP and social welfare (we would think that increased production would also increase the well being of society), GDP itself is not an accurate indication of a nations social well being because it excludes: non-market transactions; housework, voluntary work does not measure an increase in leisure or work satisfaction. does not measure changes in a products quality. does not take into account changes in the composition/distribution of output that might affect the economic well-being of society. Unless adjusted for population, it does not necessarily reflect living standards per se. Does not accurately reflect changes in environment, ie; spillover costs are not deducted from GDP, therefore GDP overstates national economic welfare. excludes transactions in the black market.

Question 5 Unlike the CPI, the GDP deflator measures the cost of a changing basket of goods. It overcomes some of the disadvantages of CPI. (1) Based on obsolete patterns of expenditure. The CPI is computed using a fixed basket of goods, whereas the GDP deflator allows the basket of goods to change over time as the composition of GDP changes. When a new good is introduced, consumers are better off, because they have products from which to choose (more variety). In effect, the introduction of new goods increases the purchasing power of a dollar. Yet this increase in purchasing power is not reflected in the CPI. (2) Since consumers tend to buy less of goods whose prices have risen, the CPI will tend to overstate true inflation. Consider the case of a major flood which destroys the nations apple crop, where the quantity of apples produced falls to zero, and the price of the few apples that remain on fruit shop shelves are driven up. Because apples are no longer part of GDP, the increase in the price of apples does not show up in the GDP deflator. But because the CPI is computed with a fixed basket of goods that includes apples, the increase in their price causes a substantial rise in the CPI. Because the CPI measures the price of a fixed basket of goods, it does not reflect the ability of consumers to substitute towards goods whose relative prices have fallen. The fixed basket assumes that consumers continue to buy the now expensive apples in the same quantity as before. For this reason, the CPI will measure a much larger increase in the cost of living than consumers actually perceive. (3) Does not include producer goods. The GDP deflator measures the prices of all goods and services produced, whereas the CPI measures the prices of only the goods and services bought by consumers. Thus, an increase in the price of goods bought by firms or the government will show up in the GDP deflator but no in the CPI. (4) However, the GDP deflator includes only those goods produced domestically. Imported goods are not part of GDP and do not show up in the GDP deflator. Hence, an increase in the price of a Toyota made in Japan and sold in Australia affects the CPI, because the Toyota is bought by consumers, but it does not affect the GDP deflator. (5) Both the GDP deflator and CPI may overstate a true rise in prices by ignoring quality improvements. For example, cars, computers and CD players improve from year to year. Part of the increase in price of these items reflects the improvement in the quality of the product. Yet the CPI and GDP deflator will regard such a price change as inflation.

Question 6 When cyclical unemployment is zero, there is full employment. Full employment is therefore achieved when real GDP is equal to potential GDP. However, full employment does not mean zero unemployment. At full employment, there will inevitably be some structural and frictional unemployment. The unemployment rate at full employment is termed the natural rate of unemployment. The natural rate of unemployment is the unemployment rate that is sustainable into the future given the structural and institutional characteristics of the economy. Frictional and structural unemployment is inevitable in a changing, dynamic economy. Where the types of goods that firms and households demand varies over time, and where some industries expand and others decline, there will always be movement of individuals from one job to another. Questions for Review Chapter 7 1 3 4 5 An economys income must equal its expenditure since every transaction has a buyer and a seller. Expenditure by buyers equals income by sellers. The contribution to GDP is $3, the market value of the bread, which is the final good that is sold. The sale of used records doesnt affect GDP at all because it involves no current production. The four components of GDP are consumption (such as the purchase of a music CD), investment (such as the purchase of a computer by a business), government purchases (such as the purchase of military aircraft), and net exports (such as the sale of domestic wine to Britain less the import of French champagne to Hong Kong). The percentage change in nominal GDP is (600 200)/200 x 100 = 200%. The percentage change in real GDP is (400 200)/200 x 100 = 100%. The percentage change in the deflator is (150 100)/100 x 100 = 50%. It is desirable for a country to have a large GDP because people could enjoy higher expenditures. But GDP isnt the only important measure of wellbeing. For example, laws that restrict pollution cause GDP to be lower. If laws against pollution were eliminated, GDP would be higher but the pollution might make us worse off. Or, for example, an earthquake would raise GDP, as expenditures on clean-up, repair and rebuilding increase. But an earthquake is an undesirable event that lowers our welfare.

Chapter 8 1 A 10% increase in the price of chicken has a greater effect on the consumer price index than a 10% increase in the price of caviar because chicken is a bigger part of the average consumers market basket. The 3 problems in the consumer price index as a measure of the cost of living are: (1) substitution bias, which arises because people substitute toward goods that have become relatively less expensive; (2) the introduction of new goods, which are not reflected quickly in the CPI; and (3) unmeasured quality change. If the price of a Navy submarine rises, there is no effect on the consumer price index, since Navy

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submarines arent consumer goods. But the GDP price index is affected, since Navy submarines are included in GDP. Since the overall price level doubled, but the price of the Mars bar rose sixfold, the real price (the price adjusted for inflation) of the Mars bar tripled. The nominal interest rate is the rate of interest paid on a loan in dollar terms. The real interest rate is the rate of interest corrected for inflation. The real interest rate is the nominal interest rate minus the rate of inflation.

Chapter 11 1 The Australian Bureau of Statistics categorises each adult (15 years of age and older) as either employed, unemployed, or not in the labour force. The labour force consists of the sum of the employed plus the unemployed. The unemployment rate is the percentage of the labour force that is unemployed. The labour-force participation rate is the percentage of the total adult population that is in the labour force.

Problems and Applications Chapter 7 a consumption increases b investment increases c consumption increases, investment decreases d consumption increases e government purchases increase f consumption increases, net exports decrease g investment increases. 2 With transfer payments, nothing is produced, so there is no contribution to GDP. 3 Purchases of new housing are included in the investment portion of GDP because housing lasts for a long time. For the same reason, purchases of new cars could be thought of as investment, but by convention, they are not. The logic could apply to any durable good, such as household appliances. 6 a The growth rate of nominal income is ($629 $591)/$591 x 100% = 6.43%. b The growth rate of the deflator is (101.4 98)/98 x 100% = 3.47%. c Real income in 200304 measured in 200304 prices is $591. d Real income in 200405 measured in 200304 prices is $629/(101.4/98) = $607.9 e The growth rate of real income is ($607.9 $591)/$591 x 100% = 2.86%. f The growth rate of nominal income is higher than the growth rate of real income because of inflation. 9 To tell if the farmer is better off, you'd need to know if the prices of the goods she buys have increased by more or by less than the prices of the goods she sells. 10 Knowing that the GDP of China is three times that of Sweden doesnt tell you which country is better off economically. Most importantly, the populations of the two countries are quite different. A better measure of economic wellbeing would be GDP per person. 11 In countries like India, people produce and consume a fair amount of food at home that is not included in GDP. So GDP per person in India and the Australia will differ by more than their comparative economic wellbeing. 13 a The increased labour-force participation of women has increased GDP in Australia, since it means more people are producing goods and services. 1

b If our measure of wellbeing included time spent working in the home and taking leisure, it wouldnt rise as much as GDP, since the rise in womens labour-force participation has reduced time spent working in the home and taking leisure. c Other aspects of wellbeing that are associated with the rise in womens increased labour-force participation include increased self-esteem and prestige for women in the workforce, especially at managerial levels, but decreased quality time spent with children, whose parents have less time to spend with them. Such aspects would be quite difficult to measure. Chapter 8 1 a The price of tennis balls increases 0%; the price of tennis racquets increases 50% [=($60-$40)/$40 x 100%]; the price of Gatorade increases 100% [= ($2 $1)/$1 x 100%]. To find the percentage change in the overall price level, follow these steps: i Determine the fixed basket of goods: 100 balls, 10 racquets, 200 Gatorades ii Find the price of each good in each year:

iii Compute the cost of the basket of goods in each year: 2006: (100 x $2) + (10 x $40) + (200 x $1) = $800 2007: (100 x $2) + (10 x $60) + (200 x $2) = $1,200 iv Choose one year as a base year (2006) and compute the CPI in each year: 2006: $800/$800 x 100 = 100 2007: $1,000/$800 x 100 = 150 v Use the CPI to compute the inflation rate from the previous year: 2007: (150 100)/100 x 100% = 50% b Tennis racquets are less expensive relative to Gatorade, since their price rose 50% while the price of Gatorade rose 100%. The wellbeing of some people changes relative to the wellbeing of others. Those who purchase a lot of Gatorade become worse off relative to those who purchase a lot of tennis racquets or tennis balls. To find the percentage change in the overall price level, follow these steps: i Determine the fixed basket of goods: 100 heads of cauliflower, 50 bunches of broccoli, 500 carrots ii Find the price of each good in each year:

iii Compute the cost of the basket of goods in each year: 2006: (100 x $2) + (50 x $1.50) + (500 x $.10) = $325 2007: (100 x $3) + (50 x $1.50) + (500 x $.20) = $475 iv Choose one year as a base year (2006) and compute the CPI in each year: 2006: $325/$325 x 100 = 100 2007: $475/$325 x 100 = 146 v Use the CPI to compute the inflation rate from the previous year: 2007: (146-100)/100 x 100% = 46%

Since the CPI rose 1900%, that means [CPI(2002)-CPI(1950)]/CPI(1950) x 100% = 1900%, so CPI(2002)/CPI(1950) 1 = 19.0, so CPI(2002)/CPI(1950) = 20.0. So if an item costs under 20.0 times as much in 2002 than it did in 1950, then its relatively less expensive. The easiest way to see this is to take the 1950 price, multiply it by 20.0 and compare it to the 2002 price. A day at the cricket: $0.25 x 20.0 = $5 < $25, so the 2002 cost is higher. Womans Day magazine: $0.05 x 20.0 = $1.00, so the 2002 cost is higher. Orange marmalade: $0.12 x 20.0 = $2.40, so the 2002 cost is higher. A Holden sedan: $700 x 20.0 = $14,000, so the 2002 cost is higher. Sending a package by air from Sydney to the UK: $1.28 x 20.0 = $25.60, so the 2002 cost is lower. a Since the increase in cost was considered a quality improvement, there was no increase registered in the CPI. b The argument in favour of this is that consumers are getting a better good than before, so the price increase equals the improvement in quality. The problem is that the increased cost might exceed the value of the improvement in air quality, so consumers are worse off. In this case, it would be better for the CPI to at least partially reflect the higher cost. a introduction of new goods b unmeasured quality change c substitution bias d unmeasured quality change e substitution bias a ($0.50 $0.05)/$0.05 x 100 = 900%. b ($10.82 $3.35)/$3.35 x 100 = 223%. c In 1970: $0.05/($3.35/60) = 0.9 minutes. In 1990: $0.50/($10.82/60) = 2.8 minutes. d Workers purchasing power fell in terms of newspapers. Note the wage estimates set out in the text are incorrect and reflect the wage rates that applied in the U.S. a If the elderly consume the same market basket as other people, Social Security would provide the elderly with an improvement in their standard of living each year because the CPI overstates inflation and Social Security payments are tied to the CPI. b Since the elderly consume more health care than younger people, and since health care costs have risen faster than overall inflation, its possible that the elderly are worse off. To investigate this, youd need to put together a market basket for the elderly, which would have a higher weight on health care. Youd then compare the rise in the cost of the elderly basket with that of the general basket for CPI. Adjustments would need to be made for the proportion of health care costs covered by Medicare benefits as compared with private health insurance benefits and out of pocket expenses. a When inflation is higher than was expected, the real interest rate is lower than expected. For example, suppose the market equilibrium has an expected real interest rate of 3% and people expect inflation to be 4%, so the nominal interest rate is 7%. If inflation turns out to be 5%, the real interest rate is 7% minus 5% equals 2%. b Since the real interest rate is lower than was expected, the lender loses and the borrower gains. c Homeowners in the 1970s who had fixed-rate mortgages from the 1960s benefited from the unexpected inflation, while the banks who made the mortgage loans lost a lot of money. a With a nominal interest rate of 3% and inflation of 0%, the real interest rate is 3% 0% = 3%. The after-tax real interest rate is [3% (3% x .33)] 0% = 2%. The effective tax rate on real interest income is (3% 2%)/3% x 100% = 33%. b With a nominal interest rate of 6% and inflation of 3%, the real interest rate is 6% 3% = 3%. The after-tax real interest rate is [6% (6% x .33)] 3% = 1%. The effective tax rate on real interest income is (3% 1%)/3% x 100% = 67%. c Inflation discourages saving by interacting with the tax system to increase the tax rate on interest income.

10 Bracket creep occurs when inflation increases peoples nominal incomes, pushing them into higher tax brackets, so they have to pay a higher proportion of their incomes in taxes, even though they arent getting higher real incomes. As a result, real tax revenue rises. Chapter 11 1 The labour force consists of the number of employed (9,770,700) plus the number of unemployed (548,600), which equals 10,319,300. To find the labour-force participation rate, we need to know the size of the adult population. Adding the labour force (10,319,300) to the number of people not in the labour force (5,880,543) gives the adult population of 16,199,843. The labour-force participation rate is the labour force (10,319,300) divided by the adult population (16,199,843) times 100%, which equals 63.70%. The unemployment rate is the number of unemployed (548,600) divided by the labour force (10,319,300) times 100%, which equals 5.32%. All age groups of men experienced a decline in their labour-force participation rate in the period 1978 to 2004. The decline was largest for men aged 55 and over. The decline in the labour-force participation rate for young men reflects increases in school and higher education participation rates over the last 15 years or so. The participation rate for men aged 25-54 only decreased marginally. The participation for men aged 55 and over declined, which could reflect an increased propensity to take early retirement. a A construction worker who is laid off because of bad weather is likely to experience short-term unemployment, since the worker will be back to work as soon as the weather clears up. b A manufacturing worker who loses her job at a plant in an isolated area is likely to experience long-term unemployment, since there are probably few other employment opportunities in the area. She may need to move somewhere else to find a suitable job, which means shell be out of work for some time. c A blacksmith laid off because of the introduction of cars is likely to be unemployed for a long time. The blacksmith would have a lot of trouble finding another job when his entire industry is shrinking. Hell probably need to gain additional training or skills to get a job in a different industry. d A cook in a fast food outlet who loses his job when a new restaurant opens is likely to find another job fairly quickly, perhaps even at the new restaurant, so will probably have only a short spell of unemployment. e An expert welder with little education who loses her job when the company installs automatic welding machinery is likely to be without a job for a long time, since she lacks the technological skills to keep up with the latest equipment. To remain in the welding industry, she may need to retool by going back to TAFE and learning the newest techniques.