Why Do Economists Use Real GDP Essay

Custom Student Mr. Teacher ENG 1001-04 17 September 2016

Why Do Economists Use Real GDP

1. Why do economists use real GDP rather than nominal GDP to gauge economic well-being? Real GDP is the production of goods and services valued at constant prices. Nominal GDP is the production of goods and services valued at current prices. Real GDP rather than nominal GDP to gauge economic well-being because real GDP is not affected by changes in prices, so it reflects only changes in the amounts being produced. If nominal GDP rises, you do not know if that is because of increased production or higher prices.

2. Economists and policymakers monitor both the GDP deflator and the consumer price index to gauge how quickly prices are rising. However, these two statistics may not always tell the same story. Discuss two important differences that can cause them to diverge. The first difference :

the GDP deflator reflects the prices of all goods and services produced domestically the consumer price index reflects the prices of all goods and services bought by consumers. For example : suppose that the price of an airplane produced by Boeing and sold to the Air Force rises. Even though the plane is part of GDP, it is not part of the basket of goods and services bought by a typical consumer. Thus, the price increase shows up in the GDP deflator but not in the consumer price index The second difference:

( concerns how various prices are weighted to yield a single number for the overall level of prices) The consumer price index compares the price of a fixed basket of goods and services to the price of the basket in the base year the GDP deflator compares the price of currently produced goods and services to the price of the same goods and services in the base year (This difference is not important when all prices are changing proportionately. But if the prices of different goods and services are changing by varying amounts, the way we weight the various prices matters for the overall inflation rate.) 3. Describe the three problems that make the consumer price index an imperfect measure of the cost of living. substitution bias

Over time, some prices rise faster than others

This is consumer substitution toward goods that have become relatively less expensive. But CPI is computed assuming fixed basket of goods so it ignores the possiblity of consumer substitution. It overstates the cost of living For example : In 2000, mangos are cheaper than oranges, consumer buy more mangos. The Department of Statistics include more mangos than oranges in the basket. In 2002, oranges are cheaper than mangos so consumer choose to buy more oranges. Howeverthe CPI is computed by fixed basket in 2000 so the change in quantities of oranges and mangos aren’t reflected. Introduction of new goods:

When new goods become available, variety increases, allowing consumers to find products that more closely meet their needs.
This has the effect of making each dollar more valuable.
For example: 4 years ago, with $399 you can buy an Iphone 3G (8GB). Now, with $399, you can buy an Iphone 4GS (16 GB)
When there is introduction of new goods, consumer will have more choices => makes each dollar more valuable. In other way, with same given of dollars, people are better off => cost of living deacreases. However, this is not reflected in CPI.

For example : the appear of Iphone 4S is not included in the basket. a. Unmeasured quality change:
More flavors to choose

If the quality of a good rises from one year to the next, the value of a dollar rises, even if the price of the good stays the same. If the quality of a good falls from one year to the next, the value of a dollar falls, even if the price of the good stays the same. The Department of Statistics tries to adjust the price for constant quality, but such differences are hard to measure. For example, when a car model has more horsepower or gets better gas mileage from one year to the next—the Bureau adjusts the price of the good to account for the quality change. It is, in essence, trying to compute the price of a basket of goods of constant quality. Despite these efforts, changes in quality remain a problem because quality is so hard to measure

3. Why is frictional unemployment inevitable? How might the government reduce the amount of frictional unemployment? ANSWER:
Frictional unemployment is inevitable because the economy is always changing. Some firms are shrinking while others are expanding. Some regions are experiencing faster growth than other regions. Transitions of workers between firms and between regions are accompanied by temporary unemployment.

The government could help to reduce the amount of frictional unemployment through public policies that provide information about job vacancies in order to match workers and jobs more quickly, and through public training programs that help ease the transition of workers from declining to expanding industries and help disadvantaged groups escape poverty.

4. What claims do advocates of unions make to argue that unions are good for the economy? ANSWER:
Advocates of unions claim that unions are good for the economy because they are an antidote to the market power of the firms that hire workers and they are important for helping firms respond efficiently to workers’ concerns.

5. Explain four ways in which a firm might increase its profits by raising the wages it pays. ANSWER:
Four reasons why a firm’s profits might increase when it raises wages are:
(1) Better paid workers are healthier and more productive;
(2) Worker turnover is reduced;
(3) The firm can attract higher quality workers; and
(4) Worker effort is increased.
6. Using a diagram of the labor market, show the effect of an increase in the minimum wage on the wage paid to workers, the number of workers supplied, the number of workers demanded, and the amount of unemployment. ANSWER:

Figure 2 shows a diagram of the labor market with a binding minimum wage. At the initial minimum wage (m1), the quantity of labor supplied L1S is greater than the quantity of labor demanded L1D, and unemployment is equal to L1S − L1D. An increase in the minimum wage to m2 leads to an increase in the quantity of labor supplied to L2S and a decrease in the quantity of labor demanded to L2D. As a result, unemployment increases as the minimum wage rises.

7. Why don’t banks hold 100 percent reserves? How is the amount of reserves banks hold related to the amount of money the banking system creates? ANSWER: (PAGE: 650-651-653-653)
Banks do not hold 100% reserves because it is more profitable to use the reserves to make loans, which earn interest, instead of leaving the money as reserves, which earn no interest.
The amount of reserves banks hold is related to the amount of money the banking system creates through the money multiplier. The smaller the fraction of reserves banks hold, the larger the money multiplier, because each dollar of reserves is used to create more money.

8. Explain the difference between nominal and real variables, and give two examples of each. According to the principle of monetary neutrality, which variables are affected by changes in the quantity of money? ANSWER:

Nominal variables are those measured in monetary units, while real variables are those measured in physical units. Examples of nominal variables include the prices of goods, wages, and nominal GDP.

Examples of real variables include relative prices (the price of one good in terms of another), real wages, and real GDP.
According to the principle of monetary neutrality, only nominal variables are affected by changes in the quantity of money.

9. In what sense is inflation like a tax? How does thinking about inflation as a tax help explain hyperinflation? ANSWER:
Inflation is like a tax because everyone who holds money loses purchasing power.
In a hyperinflation, the government increases the money supply rapidly, which leads to a high rate of inflation.
Thus the government uses the inflation tax, instead of taxes, to finance its spending.

10. According to the Fischer effect, how does an increase in the inflation rate affect the real interest rate and the nominal interest rate? ANSWER:
According to the Fisher effect, an increase in the inflation rate raises the nominal interest rate by the same amount that the inflation rate increases, with no effect on the real interest rate.

11. Suppose that this year’s money supply is $500 billion, nominal GDP is $10 trillion, and real GDP is $5 trillion.
a. What is the price level? What is the velocity of money?
b. Suppose that velocity is constant and the economy’s output of goods and services rises by 5 percent each year. What will happen to nominal GDP and the price level next year if the Fed keeps the money supply constant?

c. What money supply should the Fed set next year if it wants to keep the price level stable?
d. What money supply should the Fed set next year if it wants inflation of 10 percent? ANSWER:
In this problem, all amounts are shown in billions.
a.Nominal GDP = P x Y = $10,000 and Y = real GDP = $5,000, so P = (P x Y )/Y = $10,000/$5,000 = 2.
Because M x V = P x Y, then V = (P x Y )/M = $10,000/$500 = 20.
b.If M and V are unchanged and Y rises by 5%, then because M x V = P x Y, P must fall by 5%. As a result, nominal GDP is unchanged.
c.To keep the price level stable, the Fed must increase the money supply by 5%, matching the increase in real GDP. Then, because velocity is unchanged, the price level will be stable.
d.If the Fed wants inflation to be 10%, it will need to increase the money supply 15%. Thus M x V will rise 15%, causing P x Y to rise 15%, with a 10% increase in prices and a 5% rise in real GDP.

11. List and explain the three reasons why the aggregate demand curve is downward sloping. ANSWER: (SEE PAGES: 746-749)-see FIGURE-3
The aggregate-demand curve is downward sloping because:
(1) a decrease in the price level makes consumers feel wealthier, which in turn encourages them to spend more, so there is a larger quantity of goods and services demanded;
(2) a lower price level reduces the interest rate, encouraging greater spending on investment, so there is a larger quantity of goods and services demanded;
(3) a fall in the U.S. price level causes U.S. interest rates to fall, so the real exchange rate depreciates, stimulating U.S. net exports, so there is a larger quantity of goods and services demanded.

12. Explain why the long-run aggregate-supply curve is vertical.
ANSWER: (SEE PAGES: 752-753)-see FIGURE-4
The long-run aggregate supply curve is vertical
because in the long run, an economy’s supply of goods and services (its real GDP) depends on its supplies of capital, labor, and natural resources and on the available production technology used to turn these resources into goods and services.

The price level does not affect these long-run determinants of real GDP. 13. List and explain the three theories for why the short-run aggregate-supply curve is upward sloping.
ANSWER: (SEE PAGES: 755-760)-see FIGURE-6
Three theories explain why the short-run aggregate-supply curve is upward sloping: (1) the sticky-wage theory, in which a lower price level makes employment and production less profitable because wages do not adjust immediately to the price level, so firms reduce the quantity of goods and services supplied; (2) the sticky-price theory, in which an unexpected fall in the price level leaves some firms with higher-than-desired prices because not all prices adjust instantly to changing conditions, which depresses sales and induces firms to reduce the quantity of goods and services they produce (3) the misperceptions theory, in which a lower price level causes misperceptions about relative prices, and these misperceptions induce suppliers to respond to the lower price level by decreasing the quantity of goods and services supplied.

14. Suppose that the reserve requirement for checking deposits is 10 percent and that banks do not hold any excess reserves.
a. If the Fed sells $1 million of government bonds, what is the effect on the economy’s reserves and money supply?
b. Now suppose the Fed lowers the reserve requirement to 5 percent, but banks choose to hold another 5 percent of deposits as excess reserves. Why might banks do so? What is the overall change in the money multiplier and the money supply as a result of these actions?

ANSWER:
a. With a required reserve ratio of 10% and no excess reserves, the money multiplier is 1/.10 = 10. If the Fed sells $1 million of bonds, reserves will decline by $1 million and the money supply will contract by 10 x $1 million = $10 million.

b. Banks might wish to hold excess reserves if they need to hold the reserves for their day-to-day operations, such as paying other banks for customers’ transactions, making change, cashing paychecks, and so on.

If banks increase excess reserves such that there is no overall change in the total reserve ratio, then the money multiplier does not change and there is no effect on the money supply.

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