Explain the three different approaches that can be used to calculate GDP.

Briefly indicate why all three approaches should give the same figure for GDP. (3 marks) Assuming that all the final goods and services that are produced in a country in a given year will be purchased and used by members of one or more of the 4 groups (households, firms, governments, foreign sector foreign purchasers of domestic products). The amounts that purchasers spend on various goods and services should be equal to the market value of those goods and services. Therefore, GDP can be measured with equal accuracy by either of 2 methods: 1. Adding up the market values of all the final goods and services that are produced domestically, or 2. Adding up the total amount spent by each of the four groups on final goods and services and subtracting spending on imported goods and services. 3. Y=C+I+G+NX, where Y=GDP, C=consumption expenditure, I=investment, G=government purchases, NX=net exports. National income accounting identity: a mathematical relation that shows how GDP is equal to the sum of expenditure, investment, government purchases and net exports.

Does GDP provide a good measure of a countrys economic welfare? Discuss. (4 marks) At best, GDP is an imperfect measure of economic wellbeing because it captures only those goods and services that are priced and sold in markets. Whereas factors that contribute to peoples welfare are not priced and sold in markets. Leisure time increased leisure time allows workers to pursue many worthwhile activities, being with family and friends, sports and hobbies, cultural and educational activities, is a major benefit of living in a wealthy society. Environmental quality and resource depletion growth in GDP can affect the quality of the environment such as air and water (China). Increased pollution certainly detracts from the quality of life, but because air and water quality are not bought and sold in markets, the Chinese GDP does not reflect this downside of their economic growth. Quality of life Low crime rates, minimal traffic congestions, active civic organisations and open space are not reflect in the GDP which are the social aspects of the welfare of people. Poverty and economic inequality GDP does not reflect who gets to enjoy the goods and services sold. Two countries may have identical GDPs but differ radically in the distribution of economic welfare across the population. Economic satisfaction depends on what people have compared to others and not so much on the quality and quantity. GDP does relate to economic welfare: Availability of goods and services countries with a high GDP are likely to possess more and better goods and services. On average, high-GDP countries enjoy larger, better constructed and more comfortable homes, higher quality food and clothing, greater variety of entertainment and cultural opportunities, better access to transportations and travel, better communications and sanitation. Health and education high GDP countries have higher life expectancies, lower infant and child mortality rates and more doctors, higher nutrition levels and more education opportunities. Identify two factors that might affect the economic welfare of the residents of Australia but are not included in its GDP. Does the existence of such factors mean that GDP is not a useful economic concept? Briefly explain. (2 marks)

Consider the following National Accounts data for the calendar year 2010. $Bill Private Consumption 1200 Imports 700 Public Expenditure 600 Gross Taxation Receipts 800 Exports 500 Government Transfer Payments 300 Beginning-of-year Inventories 150 Net Interest Payments on Government Debt 40 End-of-year Inventories 100 Sales of existing houses and flats 600 Business Fixed Investment 400 (a) Use the above data to calculate GDP for 2010. Explain how you arrive at your figure for GDP (1 mark) (b) Use the above data to calculate National saving in 2010. Explain how you arrive at your figure for National Saving. (1 mark) (c) Use the above data to calculate private saving in 2010. Explain how you arrive at your figure for private saving. (1 mark) a) Y=C+I+G+NX = (1200) + (400) + (800) + (500-700) + (100-150) = 2150 b) S=Y-C-G = 2150-400-800 = 950 c) S (private)=Y-T-C = 2150-800-1200 = 150

Explain how the consumer price index (CPI) can be used for both of the following purposes: As a measure of the cost of living As a measure of the inflation rate (2 marks) The CPI for any period measures the cost in that period of a standard set or basket of goods and services relative to the cost of the same basket of goods and services in a fixed year (base year).

CPI =
The inflation rate is simply the percentage change in the CPI over the specified time period.

E.g.

x 100

Identify and briefly explain the various economic costs associated with inflation. (5 marks) Shoe-leather cost inflation erodes the real purchasing power of any given amount of cash. The longer cash is held during a period of inflation the larger is this reduction in purchasing power. Therefore, by leaving as much money as possible in banks accounts where the

interest paid on deposits acts to insulate moneys purchasing power from the effects of inflation. However, it is more likely that individuals will have to visit their banks more frequently in order to withdraw cash needed to complete transaction. The inconvenience associated with the increased frequency of bank visits is a real cost of inflation (traditionally known as shoe-leather cost as frequent visits will wear out shoe leather). Noise in the price system when inflation is high, the subtle signals that are transmitted through the price system become more difficult to interpret. Inflation creates static, or noise, in the price system, obscuring the information transmitted by prices and reducing the efficiency of the market system. This reduction in efficiency imposes real economic costs. Distortion of the tax system in countries like Australia where our tax system is not indexed, inflation can cause problems. People with higher incomes pay a higher percentage of their income in taxes. Without indexing, an inflation that raises peoples nominal incomes would force them to pay an increasing percentage of their income in taxes as they move into higher tax brackets, even though their real income many not have increase. Unexpected redistribution of wealth if wages are not indexed to inflation, workers will be vulnerable to upsurges in the price level. If inflation is much higher than expected, the buying power of the workers wages their real wage - will be less than anticipated. However, if inflation is lower than expected the workers would enjoy greater purchasing power than anticipated and the employer would be the loser. The effect of inflation is not to destroy purchasing power but to redistribute it. Redistribution caused by inflation are bad for incentive based economies as it will affect workers in ways that they will think why bother working hard and save money when inflation can take away savings overnight. Highinflation economy encourages people to use up resources in trying to anticipate inflation and protect themselves against it. Interference with long-run planning with high and erratic inflation rates it would be hard to plan for the future as households and businesses cannot accurately predict the cost of living. Menu costs the act of changing prices itself can impose significant costs, e.g. every time the restaurateur wishes to change the price of a meal she would need to have new menus printed. Any firm that publicly list its prices in some form will incur costs when prices change.

Explain the difference between the nominal interest rate and the real interest rate. Which rate is most relevant to decisions to borrow and lend. Briefly explain. (2 marks)/ (3 marks) Real interest rate is the percentage increase in the real purchasing power of a financial asset. Whereas nominal interest rate is the percentage increase in the nominal or dollar value of a financial asset. In terms of borrowing and lending, the real interest rate would be most relevant as the purchasing power will affect how much one can borrow or lend.

Explain why the labour demand curve for an individual firm is downward sloping and indicate the main factors that cause the curve to shift. (3 marks) The demand curve for labour is downward sloping because the higher the wage, the fewer workers employers will hire. An increase in the relative price of workers output increases the value of their marginal product, shifting the labour curve to the right. An increase in productivity raises workers marginal product and assuming no change in the price of output the value of their marginal product. Since a productivity increase raises the value of marginal product, employers will hire more workers at any given real wage, shifting the labour demand curse to the right.

Briefly explain the following three motives for saving: Life-cycle Precautionary Bequest Indicate what effect the widespread availability of home equity loans might have on each form of saving. {Note: A home equity loan allows households to borrow (usually at a relatively low interest rate) against the equity they have in their home. (Equity refers to the difference between the market value of the home and any mortgage debt.)} (5 marks) Life-cycle saving is to meet long-term objectives, such as retirement, university attendance, or the purchase of a home. Precautionary saving is for protection against unexpected setbacks, such as the loss of a job or a medical emergency. Bequest saving is done for the purpose of leaving an inheritance.

What factors might cause households to under-save relative to some rationally optimal level? (2 marks) The lack of self-control can be a factor for households to under-save. An implication is that consumer credit arrangement that make borrowing and spending easier may reduce the amount that people save. A person who is not saving enough might arrange to use a payroll saving plan, through which a predetermined amount is deducted from each pay and set aside in a special account from which withdrawals are not permitted until retirement. Another factor may be that when additional spending by some consumers stimulates additional spending by other. Such demonstration effects arise when people use the spending of others as a yardstick by which to measure the adequacy of their own living standards.

Explain what is meant by frictional unemployment. Is it likely to be desirable for an economy to have zero frictional unemployment? Explain. (2 marks) Frictional unemployment is the short-term unemployment associated with the process of workers searching for the right job. It is not desirable for an economy to have zero frictional unemployment because the search process leads to a better fit between worker and job, which can promote productivity, in the sense that it leads to higher output over the long run.

Explain what is meant by substitution bias in the CPI and indicate whether it is likely to cause the CPI to overstate or understate changes in the cost of living. (3 marks) Substitution bias is the bias causes measured inflation to overstate changes in the cost of living caused by the failure to take into account peoples substitution towards relatively less expensive goods and services. The rise in the CPI, which ignores the fact that people can substitute tea for coffee without being significantly worse off, exaggerates the true increase in the cost of living. This procedure does not allow for the possibility that consumers can switch from products whose prices are rising to those whose prices are stable or falling. Ignoring that fact that consumers can switch from more expensive to less expensive goods leads statisticians to over-estimate the true increase in the cost of living.

Explain the precautionary motive for saving by a household. Briefly discuss how widespread availability of credit cards might affect precautionary saving. (2 marks) Precautionary saving is for protection against unexpected setbacks, such as the loss of a job or a medical emergency. The wide spread of availability of credit cards may affect precautionary saving as consumers will think of the credit card as a security blanket when it comes to emergencies as they have the benefit of purchasing now and pay back later.

Explain the role of the real interest rate in influencing the level of saving and investment in the economy. (3 marks) The real interest rate is the percentage increase in the real purchasing power of a financial asset.

Draw a clearly labelled diagram showing the labour demand curve for a firm. Explain why the firms labour demand curve is downward sloping and indicate the main factors that cause the curve to shift. (4 marks) The demand curve for labour is downward sloping because the higher the wage, the fewer workers employers will hire. An increase in the relative price of workers output increases the value of their marginal product, shifting the labour curve to the right. An increase in productivity raises workers marginal product and assuming no change in the price of output the value of their marginal product. Since a productivity increase raises the value of marginal product, employers will hire more workers at any given real wage, shifting the labour demand curse to the right.

Explain the concept of full employment. If an economy is at full employment does this imply that no one is looking for work? Explain. (2 marks) Full employment is a condition of the national economy, where all or nearly all persons willing and able to work at the prevailing wages and working conditions are able to do so. It is defined either as absolutely 0% rate of unemployment, as by James Tobin, or as the level of employment rates when there is no cyclical unemployment. It is defined by the majority of mainstream economists as being an acceptable level of natural unemployment above 0%, the discrepancy from 0% being due to noncyclical types of unemployment. It does not imply that no one is looking for work as some may be considering a career change while they still have a job.

Using the labour demand and supply model, provide one explanation for increasing wage inequality. (4 marks) Globalisation effects demand for workers in two industries: Initially, real wage in the two industries are equal at W. After an increase in trade: a) Demand for workers in the import industry (textiles) declines, lowering real wage and employment, while b) Demand for workers in the exporting industry (software) increases, raising real wage and employment in that industry.

Initially, there is little or no international trade in these two goods. Without trade, the demand for workers in each industry is indicated by the curves D (textiles) and D (software). Wages and employment in each industry are determined by the intersection of the demand curves and the labour supply curves in each industry. Initially the real wage is the same for both industries. Under free trade agreement, countries will begin to produce for export those goods and services at which they are relatively more efficient, and to import goods or services that they are relatively less efficient at producing. With the opening of trade, the country gains new foreign markets for its software and begins to produce to exports and domestic use. While textiles being less production efficient, consumers begins to purchase cheaper or of higher quality foreign made textiles. The greater majority of worlds workers, particularly those in developing countries, have relatively low skill levels. Thus, when industrialised countries open up trade with developing countries, the domestic industries that are likely to face the toughest international competition are those that use mostly low skilled labour. Conversely, industries that are likely to do the best in international competition are those that employ mostly skilled workers. Thus, increased trade may lower wages of those workers who are already poorly paid and increase the wage of those who are will paid.

The country of Utopia is considering the introduction of a compulsory retirement saving scheme. Under this scheme all workers are required to save ten percent of their annual wages and salaries until they retire. Use the supply and demand model for saving and investment to explain the likely effects of this scheme on national saving, investment and the real interest rate in Utopia. (You can assume that Utopia is a closed economy). (4 marks)

Consider the following model for supply and demand of workers in the aggregate labour market, where w is the real wage. Supply curve Ls = 48 + 0.5w Demand curve Ld = 80 1.5w Calculate the equilibrium real wage and level of employment and illustrate your answer on a diagram. (2 marks)

Use a model to show the possible effect of a minimum wage law on the level of employment in an economy. Briefly explain which workers benefit and which workers lose from a minimum wage law. (3 marks)

Explain the various factors that will influence a firms decision to purchase a new piece of capital equipment. What condition would need to be satisfied for the firm to be willing to invest in the new capital? (3 marks)

Explain why the CPI may give a biased measure of the true rate of inflation or cost of living? (3 marks)

Consider the following quantity and price data for the country of Laputa. 2005 2006 Cars Qty 20 30 Price 1000 1000 Bread Qty 100 40 Price 2 5 Cheese Qty 50 100 Price 5 6 (a) Explain how to calculate nominal GDP for Laputa in 2005 and indicate what it measures. (1 mark) (b) Calculate the growth rate of real GDP for Laputa between 2006 and 2005 using three approaches. Briefly explain each approach. (3 marks)