Macroeconomics 2301 - Test 2
7.6) List and explain some limitations of the GDP measure.
GDP is a reasonably accurate and very useful indicator of a nation's economic performance, but it has its limitations. It fails to account for non market and illegal transactions, changes in leisure and in product quality, the composition and distribution of output, the environmental effects of pollution, and economic activity at earlier stages of production and distribution. GDP should not be interpreted as a complete measure of well-being.
7.5) Discuss the nature and function of a GDP price index and describe the difference between nominal GDP and real GDP.
Price indexes are computed by dividing the price of a specific collection or market basket of output in a particular period by the price of the same market basket in a base period and multiplying the result (the quotient) by 100. The GDP price index is used to adjust nominal GDP for inflation or deflation and thereby obtain real GDP. - Nominal (current-dollar) GDP measures each year's output valued in terms of the prices prevailing in that year. Real (constantdollar) GDP measures each year's output in terms of the prices that prevailed in a selected base year. Because real GDP is adjusted for price-level changes, differences in real GDP are due only to differences in production activity.
9.5) Discuss how inflation may affect the economy's level of real output.
Cost-push inflation reduces real output and employment. Proponents of zero inflation argue that even mild demand-pull inflation (1 to 3 percent) reduces the economy's real output. Other economists say that mild inflation may be a necessary by-product of the high and growing spending that produces high levels of output, full employment, and economic growth. - Hyperinflation, caused by highly imprudent expansions of the money supply, may undermine the monetary system and cause severe declines in real output.
7.1) Explain how gross domestic product (GDP) is defined and measured.
Gross domestic product (GDP), a basic measure of an economy's economic performance, is the market value of all final goods and services produced within the borders of a nation in a year. - Final goods are those purchased by end users, whereas intermediate goods are those purchased for resale or for further processing or manufacturing. Intermediate goods, non production transactions, and secondhand sales are purposely excluded in calculating GDP.
8.4) Describe "growth accounting" and the specific factors accounting for economic growth in the United States.
Growth accounting attributes increases in real GDP either to increases in the amount of labor being employed or to increases in the productivity of the labor being employed. Increases in U.S. real GDP are mostly the result of increases in labor productivity. The increases in labor productivity can be attributed to technological progress, increases in the quantity of capital per worker, improvements in the education and training of workers, the exploitation of economies of scale, and improvements in the allocation of labor across different industries.
7.3) Explain how GDP can be determined by summing up all of the incomes that were derived from producing the economy's output of goods and services.
By the income or allocations approach, GDP is calculated as the sum of compensation to employees, rents, interest, proprietors' income, corporate profits, taxes on production and imports minus net foreign factor income, plus consumption of fixed capital and a statistical discrepancy.
7.4) Describe the relationships among GDP, net domestic product, national income, personal income, and disposable income.
Other national accounts are derived from GDP. Net domestic product (NDP) is GDP less the consumption of fixed capital. National income (NI) is total income earned by a nation's resource suppliers plus taxes on production and imports; it is found by subtracting a statistical discrepancy from NDP and adding net foreign factor income to NDP. Personal income (PI) is the total income paid to households prior to any allowance for personal taxes. Disposable income (DI) is personal income after personal taxes have been paid. DI measures the amount of income available to households to consume or save.
10.1) Describe how changes in income affect consumption (and saving).
Other things equal, a direct (positive) relationship exists between income and consumption and income and saving. The consumption and saving schedules show the various amounts that households intend to consume and save at the various income and output levels, assuming a fixed price level. - The average propensities to consume and save show the fractions of any total income that are consumed and saved; APC + APS = 1. The marginal propensities to consume and save show the fractions of any change in total income that are consumed and saved; MPC + MPS = 1.
8.5) Explain how the average rate of U.S. productivity growth has fluctuated since 1973.
Over long time periods, the growth of labor productivity underlies an economy's growth of real wages and its standard of living. U.S. productivity rose by 1.5 percent annually between 1973 and 1995, 2.6 percent annually between 1995 and 2010, and just 0.4 percent annually from 2010 to 2015. - The 1995 to 2010 increase in the average rate of productivity growth was based on (a) rapid technological change in the form of the microchip and information technology, (b) increasing returns and lower per-unit costs, and (c) heightened global competition that holds down prices. - The main sources of increasing returns are (a) the use of more specialized inputs as firms grow, (b) the spreading of development costs, (c) simultaneous consumption by consumers, (d) network effects, and (e) learning by doing. Increasing returns mean higher productivity and lower per-unit production costs. - Possible explanations for the slow productivity growth rate after the Great Recession of 2007-2008 include high debt levels, overcapacity, the rise of "free" Internet products, and a slowdown in technological innovation.
8.1) List two ways that economic growth is measured.
A nation's economic growth can be measured either as an increase in real GDP over time or as an increase in real GDP per capita over time. Real GDP in the United States has grown at an average annual rate of about 3.2 percent since 1950; real GDP per capita has grown at roughly a 2 percent annual rate over that same period.
6.2) Discuss why sustained increases in living standards are a historically recent phenomenon.
Before the Industrial Revolution, living standards did not show any sustained increases over time. Economies grew, but any increase in output tended to be offset by an equally large increase in the population, so that the amount of output per person did not rise. By contrast, since the Industrial Revolution began in the late 1700s, many nations have experienced modern economic growth in which output grows faster than population—so that standards of living rise over time.
9.2) Illustrate how unemployment is measured and explain the different types of unemployment.
Economists distinguish between frictional, structural, and cyclical unemployment. The full employment or natural rate of unemployment, which is made up of frictional and structural unemployment, is currently between 5 and 6 percent. The presence of part-time and discouraged workers makes it difficult to measure unemployment accurately. - The GDP gap, which can be either a positive or a negative value, is found by subtracting potential GDP from actual GDP. The economic cost of unemployment, as measured by the GDP gap, consists of the goods and services forgone by society when its resources are involuntarily idle. Okun's law suggests that every 1 percentage point increase in unemployment above the natural rate causes an additional 2 percent negative GDP gap.
6.4) Describe why economists believe that "shocks" and "sticky prices" are responsible for short-run fluctuations in output and employment.
Expectations have an important effect on the economy for two reasons. First, if people and businesses are more positive about the future, they will save and invest more. Second, individuals and firms must make adjustments to shocks—situations in which expectations are unmet and the future does not turn out the way people were expecting. In particular, shocks often imply situations where the quantity supplied of a given good or service does not equal the quantity demanded of that good or service. - If prices were always flexible and capable of rapid adjustment, then dealing with situations in which quantities demanded did not equal quantities supplied would always be easy since prices could simply adjust to the market equilibrium price at which quantities demanded equal quantities supplied. Unfortunately, real-world prices are often inflexible (or "sticky") in the short run so that the only way for the economy to adjust to such situations is through changes in output levels. - Sticky prices combine with shocks to drive short-run fluctuations in output and employment. Consider a negative demand shock in which demand is unexpectedly low. Because prices are fixed, the lower-than-expected demand will result in unexpectedly slow sales. This will cause inventories to increase. If demand remains low for an extended period of time, inventory levels will become too high and firms will have to cut output and lay off workers. Thus, when prices are inflexible, the economy adjusts to unexpectedly low demand through changes in output and employment rather than through changes in prices (which are not possible when prices are inflexible).
7.2) Describe how expenditures on goods and services can be summed to determine GDP.
GDP may be calculated by summing total expenditures on all final output or by summing the income derived from the production of that output. - By the expenditures approach, GDP is determined by adding consumer purchases of goods and services, gross investment spending by businesses, government purchases, and net exports: GDP = C + Ig, + G + Xn. - Personal consumption expenditures consist of expenditures on goods (durable goods and non durable goods) and services. About 60 percent of consumer expenditures in the United States are on services, leading economists to refer to the U.S. economy as a service economy. - Gross investment is divided into (a) replacement investment (required to maintain the nation's stock of capital at its existing level) and (b) net investment (the net increase in the stock of capital). In most years, net investment is positive and therefore the economy's stock of capital and production capacity increase.
6.1) Explain why economists focus on GDP, inflation, and unemployment when assessing the health of an entire economy.
Macroeconomics studies long-run economic growth and short-run economic fluctuations. - Macroeconomists focus their attention on three key economic statistics: real GDP, unemployment, and inflation. Real GDP measures the value of all final goods and services produced in a country during a specific period of time. The unemployment rate measures the percentage of all workers who are not able to find paid employment despite being willing and able to work at currently available wages. The inflation rate measures the extent to which the overall level of prices is rising in the economy.
9.3) Explain how inflation is measured and distinguish between cost-push inflation and demand pull inflation.
Inflation is a rise in the general price level and is measured in the United States by the Consumer Price Index (CPI). When inflation occurs, each dollar of income will buy fewer goods and services than before. That is, inflation reduces the purchasing power of money. Deflation is a decline in the general price level. - Unemployment rates and inflation rates vary widely globally. Unemployment rates differ because nations have different natural rates of unemployment and often are in different phases of their business cycles. Inflation and unemployment rates in the United States recently have been in the middle to low range compared with rates in other industrial nations. - Economists discern both demand-pull and cost-push (supplyside) inflation. Demand-pull inflation results from an excess of total spending relative to the economy's capacity to produce. The main source of cost-push inflation is abrupt and rapid increases in the prices of key resources. These supply shocks push up per-unit production costs and ultimately raise the prices of consumer goods.
6.3) Identify why saving and investment are key factors in promoting rising living standards.
Macroeconomists believe that one of the keys to modern economic growth is the promotion of saving and investment (for economists, the purchase of capital goods). Investment activities increase the economy's future potential output level. But investment must be funded by saving, which is only possible if people are willing to reduce current consumption. Consequently, individuals and society face a trade-off between current consumption and future consumption since the only way to fund the investment necessary to increase future consumption is by reducing current consumption in order to gather the savings necessary to fund that investment. Banks and other financial institutions help to convert saving into investment by taking the savings generated by households and lending it to businesses that wish to make investments.
6.6) Explain why the greater flexibility of prices as time passes causes economists to utilize different macroeconomic models for different time horizons
Price stickiness moderates over time. As a result, economists have found it sensible to build separate economic models for different time horizons. For instance, some models are designed to reflect the high degree of price inflexibility that occurs in the immediate short run, while other models reflect the high degree of price flexibility that occurs in the long run. The different models allow economists to have a better sense for how various government policies will affect the economy in the short run when prices are inflexible versus the long run when prices are flexible.
6.5) Characterize the degree to which various prices in the economy are sticky.
Prices are inflexible in the short run for various reasons, two of which are discussed in this chapter. First, firms often attempt to set and maintain stable prices to please customers who like predictable prices because they make for easy planning (and who might become upset if prices were volatile). Second, a firm with just a few competitors may be reluctant to cut its price due to the fear of starting a price war, a situation in which its competitors retaliate by cutting their prices as well-thereby leaving the firm worse off than it was to begin with.
8.6) Discuss differing perspectives as to whether growth is desirable and sustainable.
Skeptics wonder if the recent rise in the average rate of productivity growth is permanent, and suggest a wait-and-see approach. They point out that surges in productivity and real GDP growth have previously occurred but do not necessarily represent long lived trends. - Critics of rapid growth say that it adds to environmental degradation, increases human stress, and exhausts the earth's finite supply of natural resources. Defenders of rapid growth say that it is the primary path to the rising living standards nearly universally desired by people, that it need not debase the environment, and that there are no indications that we are running out of resources. Growth is based on the expansion and application of human knowledge, which is limited only by human imagination.
8.2) Define "modern economic growth" and explain the institutional structures needed for an economy to experience it.
Sustained increases in real GDP per capita did not happen until the past two centuries, when England and then other countries began to experience modern economic growth, which is characterized by institutional structures that encourage savings, investment, and the development of new technologies. Institutional structures that promote growth include strong property rights, patents, efficient financial institutions, education, and a competitive market system. - Because some nations have experienced nearly two centuries of modern economic growth while others have only recently begun to experience modern economic growth, some countries today are much richer than other countries. - It is possible, however, for countries that are currently poor to grow faster than countries that are currently rich because the growth of real GDP per capita for rich countries is limited to about 2 percent per year. To continue growing, rich countries must invent and apply new technologies. By contrast, poor countries can grow much faster because they can simply adopt the institutions and cutting-edge technologies already developed by the rich countries.
9.1) Describe the business cycle and its primary phases.
The United States and other industrial economies have gone through periods of fluctuations in real GDP, employment, and the price level. Although they have certain phases in common—peak, recession, trough, expansion—business cycles vary greatly in duration and intensity. - Although economists explain the business cycle in terms of underlying causal factors such as major innovations, productivity shocks, money creation, and financial crises, they generally agree that changes in the level of total spending are the immediate causes of fluctuating real output and employment. - The business cycle affects all sectors of the economy, though in varying ways and degrees. The cycle has greater effects on output and employment in the capital goods and durable consumer goods industries than in the services and non durable goods industries.
8.3) Identify the general supply, demand, and efficiency forces that give rise to economic growth.
The determinants of economic growth to which we can attribute changes in growth rates include four supply factors (changes in the quantity and quality of natural resources, changes in the quantity and quality of human resources, changes in the stock of capital goods, and improvements in technology), one demand factor (changes in total spending), and one efficiency factor (changes in how well an economy achieves allocative and productive efficiency). - The growth of a nation's capacity to produce output can be illustrated graphically by an outward shift of its production possibilities curve.
10.4) Identify and explain factors other than the real interest rate that can affect investment.
The durability of capital goods, the irregular occurrence of major innovations, profit volatility, and the variability of expectations all contribute to the instability of investment spending.
10.3) Explain how changes in real interest rates affect investment.
The immediate determinants of investment are (a) the expected rate of return and (b) the real rate of interest. The economy's investment demand curve is found by cumulating investment projects, arraying them in descending order according to their expected rates of return, graphing the result, and applying the rule that investment should be undertaken up to the point at which the real interest rate, i, equals the expected rate of return, r. The investment demand curve reveals an inverse (negative) relationship between the interest rate and the level of aggregate investment. - Shifts of the investment demand curve can occur as the result of changes in (a) the acquisition, maintenance, and operating costs of capital goods; (b) business taxes; (c) technology; (d) the stocks of capital goods on hand; and (e) expectations. - Either changes in interest rates or shifts of the investment demand curve can change the level of investment.
10.2) List and explain factors other than income that can affect consumption.
The locations of the consumption and saving schedules (as they relate to real GDP) are determined by (a) the amount of wealth owned by households, (b) expectations of future prices and incomes, (c) real interest rates, (d) household debt, and (e) tax levels. The consumption and saving schedules are relatively stable.
10.5) Illustrate how changes in investment (or one of the other components of total spending) can increase or decrease real GDP by a multiple amount.
Through the multiplier effect, an increase in investment spending (or consumption spending, government purchases, or net export spending) ripples through the economy, ultimately creating a magnified increase in real GDP. The multiplier is the ultimate change in GDP divided by the initiating change in investment or some other component of spending. - The multiplier is equal to the reciprocal of the marginal propensity to save: The greater is the marginal propensity to save, the smaller is the multiplier. Also, the greater is the marginal propensity to consume, the larger is the multiplier. - Economists disagree on the size of the actual multiplier in the United States, with estimates ranging all the way from 2.5 to 0. But all estimates of actual economy multipliers are less than the multiplier in our purposefully simple text illustrations.
9.4) Relate how unanticipated inflation can redistribute real income.
Unanticipated inflation arbitrarily redistributes real income at the expense of fixed-income receivers, creditors, and savers. If inflation is anticipated, individuals and businesses may be able to take steps to lessen or eliminate adverse redistribution effects. - When inflation is anticipated, lenders add an inflation premium to the interest rate charged on loans. The nominal interest rate thus reflects the real interest rate plus the inflation premium (the expected rate of inflation).