Macro Test Prep

8/4/2019 Macro Test Prep

1/10

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 onvarious 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 produceddomestically, or

2. Adding up the total amount spent by each of the four groups on final goods and services andsubtracting spending on imported goods and services.

3. Y=C+I+G+NX, where Y=GDP, C=consumption expenditure, I=investment, G=governmentpurchases, 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 theenvironment such as air and water (China). Increased pollution certainly detracts from thequality 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 andopen 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 andservices 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 moreand better goods and services. On average, high-GDP countries enjoy larger, betterconstructed 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 infantand 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)


2/10

Consider the following National Accounts data for the calendar year 2010.

Private Consumption

$Bill

1200

Imports 700

Public Expenditure 600

Gross Taxation Receipts 800Exports 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 figurefor 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


3/10

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 transmittedthrough the price system become more difficult to interpret. Inflation creates static, ornoise, 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 bevulnerable 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. High-

inflation 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 toplan 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 timethe restaurateur wishes to change the price of a meal she would need to have new menusprinted. 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 marginalproduct, shifting the labour curve to the right.

An increase in productivity raises workers marginal product and assuming no change inthe 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.


4/10

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 interestrate) 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 theCPI 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.


5/10

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 theyhave 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 thecurve 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 marginalproduct, shifting the labour curve to the right.

An increase in productivity raises workers marginal product and assuming no change inthe 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 cyclicalunemployment. 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 non-

cyclical 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 andemployment, while

b) Demand for workers in the exporting industry (software) increases, raising real wage andemployment in that industry.


6/10

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 lessefficient 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.


7/10

The country ofUtopia 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)


8/10

Consider the following model for supply and demand of workers in the aggregate labour market,

where wis 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)


9/10

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)


10/10

Consider the following quantity and price data for the country of Laputa.

2005 2006

Cars

Qty 20 30

Price 1000 1000

BreadQty 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)

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Macro Test Prep