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) Gross domestic product (GDP) is the market value of the final goods and services produced in a country during a given period and can be calculated using three different approaches. 1. Production approach: GDP is determined by calculating the total market value of all final goods and services produced. 2. Expenditure approach: GDP is calculated by adding the four components of expenditure. Y = C + I + G + NX Let, Y = Gross domestic product (GDP) C = Consumption expenditure I = Investment G = Government purchases NX = Net exports 3. Income approach: GDP is determined by calculating the total income received by producers in the country. Does GDP provide a good measure of a countrys economic welfare? Discuss. (4 marks) GDP provides us with a basic measure of an economys economic performance and is used because it can tell how the economy is doing in general. It also shows whether the economy is in expansion or recession. However, GDP captures only those goods and services that are priced and sold in markets and many other factors that contribute to peoples economic wellbeing are largely or entirely omitted from GDP. It does not include in any nonmarket economic activities that bring in an increase of wellbeing, health and education, environmental quality, economic inequality and many more. For example, GDP does not account for household domestic or volunteer work as they are deemed valueless under the GDP regime. Any unpaid volunteer work is seen as not benefiting the economy. Despite the limitations of GDP, it is widely used as an indicator of economic health and wellness of a nation and its society. 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 consumer price index (CPI) is an index of the cost of all goods and services to a typical customer. It measures changes in the prices of goods and services purchased by households such as food and clothing that are directly purchased in the marketplace. The CPI can also be used to measure the rate of inflation i.e. a measure of how fast prices a rising. It is calculated as the percentage increase in the level of prices between two time periods. Explain why the CPI may give a biased measure of the true rate of inflation or cost of living? (3 marks) The CPI is an accurate measure of the selected goods that make up the typical bundle, but it is not a perfect measure of the cost of living or rate of inflation. The first problem with the CPI is the substitution bias. When the price of a product in the consumer basket increases substantially, consumers tend to substitute lower-priced alternatives. However, since the CPI is a fixed-weight price index it would not accurately predict the impact of price increase on the consumers budget and can cause inflation to be overestimated.

Secondly, the CPI is slow to respond to the change in quality of goods or services. Over time, technological advances increase the life and usefulness of products. Ignoring these changes will result in a quality bias. For example, if a good significantly increase in quality but the price remained the same, then the cost of living would remain the same while the standard of living would increase. This change would not be reflected in the CPI and can cause an overestimation of the rate of inflation. Lastly, new products are not introduced into the index until they become common. New products result in greater variety, which in turn makes each dollar more valuable, so the dramatic price decreases often associated with new technology products are not reflected in the index. Identify and briefly explain the various economic costs associated with inflation. (5 marks) Inflation is a rise in the general level of prices of goods and services in an economy over a period of time and as a result the economy experiences a number of economic costs. 1. Inflation initiates global competitiveness in the worldwide markets. If a country, such as the UK, has a higher inflation than the rest of the world, then this will make British goods less competitive and lead to a fall in the world share of UK exports. Ultimately this will lead to a fall in the rate of economic growth and level of employment. 2. A high inflationary growth is unsustainable and will usually be followed by a collapse (recession). Consequently this will lead to a high level of unemployment, a decrease in business productivity and will negatively impact the stability of families and the health and well-being of individuals. 3. Another consequence of inflation is that it imposes a shoe-leather cost on society. This refers to the cost of time and effort that people spend trying to counteract the effects of inflation such as having to make more frequent trips to the bank due to lack of cash. 4. Not only does inflation impose many economic costs on society but there is also a cost in reducing inflation. As high inflation is considered unacceptable the governments will reduce inflation by imposing higher interest rates in order to reduce spending and investment. This reduction in aggregate demand will lead to a decline in economic growth and unemployment. 5. Lastly, inflation will also lead to menu costs which are the extra costs imposed on firms when changing price information. When inflation is high, prices need to be changed frequently as it is important for companies who rely on bulky catalogues to send price information to customers. 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) Nominal interest rate refers to the rate of interest before adjustment for inflation whereas real interest rate is the growth of purchasing power or nominal interest rate minus the inflation rate r = i Real interest rates reflect the real return to a lender and the real cost to a borrower and are thus more relevant than nominal rates for economic decisions. 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)

Real interest rate and price of the capital goods will influence a firms decision to purchase a new piece of capital equipment. Value of marginal product of capital must be equal or greater than the cost of capital for a firms decision to invest in the new capital. 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 labour demand curve shows the number of workers firms are willing and able to hire at different wages. It is downward sloping because firms have fixed capital so each additional worker produces less and less additional output, and revenue, to the firm.

Anything that changes either the amount of output workers can produce or the price of that output will cause a shift in the labour demand curve. A higher demand for the product, which means a higher relative price for the firms output, will cause the labour demand curve to shift to the right. Similarly, an increase in marginal productivity of labour, which arises from factors such as improvements in technology, will also cause the labour demand curve to shift to 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 motivated by a desire to smooth consumption over an individuals lifetime and to meet special needs that arise in various times of life such as saving for retirement.

Precautionary saving is saving for protection against unexpected setbacks, such as the loss of a job or a medical emergency. Bequest saving is saving done for the purpose of leaving an inheritance. What factors might cause households to under-save relative to some rationally optimal level? (2 marks)
Factors that tend to reduce saving Availability of consumer credit, e.g. home equity loans Demonstration effects. High consumption levels of our neighbors may influence us to consume more and save less Government provision of retirement benefits may lead to less private saving for retirement. Reducing ones own saving in response to government retirement benefits may be rational behavior

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) To find equilibrium, solve for w: Let Ls = Ld 48 + 0.5w = 80 1.5w 40 = 2w w = 20 Now solve for E: At w = 20, L = 58

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) A minimum wage is the lowest wage that an employer is allowed to pay can is determined by contract or by law. The labour supply and demand curve can be used to show the effects of a minimum wage law on the level of employment in an economy. If the wage is set above the minimum wage then supply exceeds demand and unemployment is created.

Raising the minimum wage benefits workers whose wages are raised and harms people who are not hired, or even lose their jobs, because companies cut back on employment. 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 unemployment which exists in any economy due to people being in the process of moving from one job to another. Having zero frictional unemployment may appear to be desirable on the surface. However this would mean that people were all stuck in the same jobs and not changing jobs (e.g. no promotions). Therefore having some level of frictional unemployment would be favourable in any economy as frictional unemployment allows the temporarily unemployed to pursue their dream job and find a career that best matches their skills and capabilities. 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)

Using the labour demand and supply model, provide one explanation for increasing wage inequality. (4 marks)
Increasing Wage Inequality: Technological Change Technological change increases worker productivity and is the basic source of rising living standards However a given technological innovation can affect different workers in different ways. Skill-biased technical change: Raises the marginal product of high-skill workers Reduces the marginal product of low-skill workers