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Why does inflation make nominal GDP a poor measure of the increase in total production from one year to the next?

Written Assessment ECO10004 Economic Principles
Part B – Macroeconomics
Due Beginning of Study Week – Tuesday 31st May; 5 pm
Task 7: GDP, economic growth and unemployment
Pass Questions
1. What is the gross domestic product of a country? What is meant by ‘intermediate goods’ and are they included in the measure of GDP? Suppose that the following table represents the goods and services produced in a very simple closed economy in 2016. Assume that steel is used as an input in the production of cars. Using that information, calculate the GDP for the year 2016?.
$25 000
Legal Services
2. Why does inflation make nominal GDP a poor measure of the increase in total production from one year to the next? When measuring real GDP, what does the term ‘chain volume measures’ refer to? Give reasons why measured GDP does not reflect total production in an economy.
3. What factors determine labour productivity? Outline the various actions the government sector should take to promote growth.
4. For each of the following, indicate if the person would be classified as employed, unemployed, or not in the labour force and why: (i) a 65-year-old man who left his job and is now working as a volunteer for 10 hours a week; (ii) a university graduate who has not been able to find a position using her skills and is working as a wait-person for 30 hours a week; and (iii) a manufacturing worker who is out of a job and has given up searching for a job.
5. Suppose 180 000 people are employed, 20 000 people are unemployed, and an additional 50 000 people are not in the labour force but are of working age. Calculate the labour force participation rate.
Credit Questions
6. Suppose that a very simple economy produces three goods: pizzas, haircuts and backpacks. Suppose the quantities produced and their corresponding prices for 2009 and 2013 are as shown in the table:
Use the information in the table to compute real GDP in the years 2011 and 2015. Calculate real GDP in 2015 assuming the base year is 2011. Real GDP is found by valuing GDP in a particular year using base year prices. When 2011 is the base year, real GDP for 2015 is found by multiplying 2011 prices by 2015 quantities and then adding the values up. Does the same calculation assume the base year is 2013? Compare and explain the two results.
7. Use production functions from the economic growth model to explain why the United States of America grew at a much faster rate than the Soviet Union in the latter half of the 20th century.
8. Read the following excerpt and answer the following questions
Macroeconomics and Economic Development: Informal Work and Dead Capital
“Dead capital” is Hernando de Soto’s term for an asset that cannot easily be bought, sold, valued or used as an investment. Despite obvious poverty in the informal sector in Peru, de Soto’s work shows that even those who live in slums possess far more capital than anyone realizes. In fact, the informal economy is so large in Peru that almost 70 percent of the working population work in informal arrangements. … Possessions … are not represented in such a way as to make them fungible (i.e. easily exchangeable) assets. Dead capital cannot, therefore, create value for the poor. What you’re really leaving behind is the world of legally enforceable transactions and property rights. The developed world has devised a formal property system of titles, title registries, and inclusive property law that includes real estate used for homes or businesses. De Soto shows that this is in a large part why some nations are rich while others remain in poverty. He says:
With titles, shares and property laws, people could suddenly go beyond looking at their assets as they are — houses used for shelter — to thinking about what they could be—things like security for credit to start or expand a business.
The moment Westerners were able to focus on the title of a house and not just the house itself, they achieved a huge advantage over the rest of humanity. When purchasing a home, an open records system enables buyers and sellers not only to gauge the value of homes in nearby areas, but to set reasonable prices based on comparative values. Clear titles and title insurance give buyers the confidence they need to complete a purchase. No clear title? No sale. The system also gives banks the assurance they need to offer a mortgage. It represents a real house (house, land, a factory, a car, etc.)
Source: Excerpts from : “Informal Work and Dead Capital” .
1. Explain how “Dead Capital” is related to the informal economy? Define these terms and explain what they mean in the context of DeSoto’s ‘dead capital’.
2. Many of the owners of houses in ‘shanti towns’ in the outskirts of Peru’s capital Lima, are happy that they do not have to pay land taxes, or municipal rates, as we do in Australia. Is this an advantageous situation to be in for the poor in Peru? Explain your answer.
3. “… Possessions … are not represented in such a way as to make them fungible (easily exchangeable) assets” … and … “the informal economy is so large in Peru that almost 70 percent of the working population work in informal arrangements”. How would this impact on the measurement of Peru’s GDP? Explain your answers in terms of the components of GDP, i.e. GDP = C+I+G+NX. Which components would be most affected? How would this affect transfer payments?
4. Would the informal economy hinder or promote economic growth in Peru? Explain your answer. Hint: look at “New Growth Theory” and the case study on Botswana on p. 380-381 to answer this question.
Task 8: Inflation, aggregate demand & supply
Pass Questions
1. Suppose an economy has only three goods, and the typical family purchases the amounts given in the following table. If 2005 is the base year, then, what is the CPI for 2012? Show all working out.
Quantity (2005)
Price (2005)
Expenditures (2005)
Price (2012)
Expenditures (on base year quantities) (2012)
2. Explain how the CPI is constructed, and discuss any weaknesses with this measurement technique.
3. What type of consumer good is most affected by the business cycle—durable goods or non-durable goods? Why?
4. Explain what happens to inflation and unemployment during the business cycle.
5. Explain the three reasons the aggregate demand curve slopes downward.
Credit Questions
6. Read the following excerpt and explain, using economic concepts, how the impact of Cyclone Larry would cause an increase in CPI.
Yasi tipped to send banana prices soaring
“The figures the Australian Bureau of Statistics used back then showed in the June quarter of 2006 there was a 250 per cent rise in the price of bananas due to Cyclone Larry, and what they also said at the time was that [higher] fruit prices overall contributed 0.6 percentage points to inflation – and bananas were most of that,” Mr Blythe said.

Author: Eli Greenblat; Sydney Morning Herald – February 3, 2011.
7. Suppose you are an advisor to the federal government. You are asked to look at macroeconomic data to evaluate whether the economy has entered an economic contraction this year. Which data do you look at? How does the economy behave at the onset of an economic contraction?
8. Watch the following video clip (A big lift in consumer confidence but how much is showing through on the shop floor) and answer the following questions.
link to video
8a. What has been some of the microeconomic impacts on Harvey Norman. Use economic analysis to describe how this impacts on profits (Hint: what type of market structure does Harvey Norman operate in?).
8b. If consumer confidence is rising, then use economic analysis to describe how this impacts on the economy. Given the level and growth of sales of Harvey Norman what is the more likely scenario.
8c. Thinking about the zero level of investment in new Harvey Norman stores and the lower/patchy sales growth. In what stage of the cycle would this happen. Why should we be careful using Harvey Normans sales growth as the only source of information to determine if Australia is in a period of slow growth? What information would be useful to verify this?
Task 9: Money and Monetary Policy – Exchange Rate
Pass Questions
1. What is the main monetary policy tool used by the Reserve Bank of Australia (RBA) and why?
2. Briefly discuss the effect of a fall in the cash rate on consumption.
3. Suppose the following table illustrates the values of real and potential GDP and the price level, if the Reserve Bank of Australia (RBA) does not change its current policy to be more contractionary or expansionary. Suppose that the RBA uses an appropriate policy and is successful in keeping real GDP at its potential level in 2014.
Potential GDP
Real GDP
Price level
$1.44 trillion
$1.44 trillion
$1.47 trillion
$1.45 trillion
State whether each of the following will be higher or lower than if the RBA had taken no action:
3a. Real GDP
3b. Potential GDP
3c. The price level
3d. The unemployment rate
4. How does monetary policy affect the share market?
5. Suppose that Australia’s price level is 125, the British price level is 100, and the nominal exchange rate of pounds to the dollar is £0.60 = $1. Calculate the real exchange rate of pounds to the dollar. Show all workings.
Credit Questions
6. Suppose that the average price of goods imported from Great Britain increased. Is it likely that the value of the Australian dollar would appreciate or depreciate versus the British pound, ceteris paribus? Is it likely that the average price in British pounds of goods exported from Australia to Great Britain would rise or fall?
7. Watch the following video clip (CPI: A surprise jump in inflation to a 2-year-high appears to have reduced the chances of further official interest rate cuts in Australia.) and answer the following questions.
link to video
7a. What were the underlying causes of the stronger than expected inflation rate? Did the article provide much evidence of why it increased? How does the lower Australian dollar contribute to inflation? What is the concern that this was unexpected rise?
7b. Explain how the underlying inflation rate influences the RBA’s position on changing interest rates.
8. Read the following excerpt and answer the following questions
Interest rates: RBA pressured to flag more cuts
The Reserve Bank will come under pressure this week to flag further interest rate cuts to bolster Australia’s sluggish economy in the wake of sharp falls in global equity markets and a deteriorating outlook for world growth. The RBA board will meet for the first time this year tomorrow against a backdrop of mounting deflationary fears as the global oil price wallows at 13-year lows, and weakening growth prospects in the US, Japan and China, Australia’s biggest three trade partners…….
The ABS last week said Australia’s underlying inflation rate was 2 per cent in 2015, a little stronger than economists had expected but still affording the RBA plenty of scope to cut further.
Author: Adam Creighton; Economics correspondent, The Australian – February 1, 2016.
8a. Based on the article what is the key concern of the RBA which may result in it decreasing interest rates?
8b. What are the factors that determine whether such a policy will be successful?
8c. Can you explain why there seems to be a difference in opinion between the article in this question and the previous question (video) regarding the prospect of a rate reduction?
Task 10: Fiscal Policy
Pass Questions
1. How could the existence of unemployment benefits or other transfer programs reduce the severity of an economic contraction?
2. Refer to the figure below and answer the following questions.
2a. Given that the economy has moved from A to B what would be the appropriate fiscal policy to achieve potential GDP and why?
2b. If fiscal policy is successful at moving the economy from point B to equilibrium at potential GDP, which of the following will occur and why?
3. Identify each of the following as (i) part of an expansionary fiscal policy, (ii) part of a contractionary fiscal policy, or (iii) not part of fiscal policy.
3a. The personal income tax rate is lowered.
3b. The government increases spending on defence due to a change in spending priorities.
3c. The company income tax rate is lowered.
3d. The State of New South Wales builds a new tollway in an attempt to expand employment and ease traffic congestion.
4. Using the following table, answer the following questions. The numbers in the table are in billions of dollars.
Real GDP
Planned Investment
Government Purchases
Net Exports
4a. What is the equilibrium level of real GDP?
4b. What is the MPC?
4c. If investment spending declines by 50, what will happen to equilibrium GDP?
5. Suppose the current equilibrium GDP for a country is $14.5 trillion and potential GDP is $14.3 trillion. Will decreasing government purchases by $200 billion or raising taxes by $200 billion restore the economy to potential GDP? Briefly explain why.
Credit Questions
6. During an economic contraction, why is it likely that the federal government budget will move into deficit?
7. Watch the following video clip (Jacking up the GST is no longer just a thought bubble for the Federal Government) and answer the following questions.
link to video
7a. How would changing the proportion of tax collected from Income tax to consumption tax (GST) impact savings/investment and hours worked; and in turn GDP and economic growth.
7b. What would be the benefit of broadening the GST and then lowering income tax?
7c. Extra question for those interested: Why is it claimed that the GST hurts low income families? Why would it be claimed that this effect is overestimated?
8. Read the following excerpt and answer the following questions
Fiscal stimulus did not save us
The second, more important, question is whether fiscal stimulus did actually stave off recession on the basis of the narrow and somewhat arbitrary definition favoured by the media: two successive quarters of negative real GDP growth as conventionally measured.
And contrary to common lore, what the data shows is that when the GFC (global financial crisis) most affected real economic activity around the world, it was a dramatic turnaround in Australia’s trade balance that mainly offset falling private investment, including inventory rundowns, not extra government spending, or household consumption assisted by federal cash handouts at the time. Private consumption did increase minimally in the December 2008 and March 2009 quarters, no doubt due in part to cash handouts. But the minor improvement in household consumption is dwarfed by an unusual rise in net exports, and is less than the private investment turnaround in the March quarter. In turn, the private investment improvement was due to a significant reversal of inventory rundown, in part due to increases in farm stocks arising from a breaking of drought.
Fiscal stimulus also involved direct federal government spending initiatives, yet the data shows there was no net contribution from federal spending in the December 2008 and March 2009 quarters, though there was a nugatory contribution from state and local consumption spending. Aggregate public spending has risen in subsequent quarters, but due to administrative delays in implementing new programs, the extra spending arrived after the worst of the GFC had passed.
As modelled more formally in a paper of mine forthcoming in Economic Papers, it was a dramatic loosening of monetary policy and an exchange rate depreciation of nearly 30 per cent on a sustained basis throughout the crisis interval that best explains how Australia avoided a narrowly defined recession. Paul Keating, Bob Hawke, Peter Costello and John Howard can all claim some credit, the first pair for the float of the dollar, and the second for making the Reserve Bank more independent.
Author: Tony Makin (Professor of Economics Griffith University); Opinion piece in The Australian – July 28, 2010.
8a. With the aid of an AD/AS graph describe how the fiscal spending could have led to the avoidance of a recession.
8b. With the aid of an AD/AS graph describe the alternative situation where the floating exchange rate and monetary easing could have led to the avoidance of a recession.
8c. what are the key differences between the two?


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