Macroeconomic Questions And Answers

Why real GDP might be an unreliable indicator of the standard of living

1. Explain why real GDP might be an unreliable indicator of the standard of living.

2. Why does unemployment arise and what makes some unemployment unavoidable?

3. Consider the following statement: ‘When the average level of prices of goods and services rises, inflation rises’? Do you agree or disagree? Explain.

4. What is the aggregate demand (AD) curve and why does it slope downwards? Explain.

5. What is the long run aggregate supply (LRAS) curve and why is it vertical? Why does the short run aggregate supply curve slope upwards?

1. Gross Domestic Product (GDP) is the summation of all the services and goods produced within the domestic territory of a country calculated for a year. Mathematically, GDP is written as the sum of consumption (C), investment (I), government expenditure (G) and Net export (NX).

The equation is: GDP = C+I+G+NX

GDP can help us in interpreting the economic growth of the nation. But there are some serious drawbacks of this measurement (Blanchard and Leigh 2013). The reason can be summed up as follows:

• GDP misses out the depth and distribution of the economy’s output amongst its people. A country having very high level of GDP may also at the same time show high level of poverty as the amount of production is not distributed proportionately amongst its population.
• GDP misses out on the psychological aspect of the people. Some people may remain happy working for less hours and making them work for long hours to raise GDP may affect their productivity.
• The increase in GDP may also come at the cost of depletion of the environment. It can be said that if many industries are established in a country it will enhance the economic output and influence the GDP but it does all these at the cost of creating pollution.
• The basic elements of economic well-being are left out in the GDP. People’s health condition, their level of education, their lifestyles is beyond the GDP’s capacity of measurement. These factors are very important as it ensures that the country is walking in the path of development (Fleurbaey and Blanchet 2013).

2. The situation where a person who is willing to work does not get suitable jobs and thereby remains idle is known as unemployment. It occurs in the economy due to several reasons (Hobson 2013). They are:

Lack of information: Often it has been observed that there are jobs in the market but still people remain unemployed. It is because people are not well informed about the existing jobs. Lack in the information system creates this fuss.

Lack of resource utilization and inefficient allocation: There are several instances where the inefficiency in allocating the resource in the production process has led to unemployment. Even if they are properly allocated resources are not utilized up-to their full productive capacity due to inefficiency of the workers.  

Technological advancement: Modern technology requires less of manpower and produces high quality goods at a faster rate. Use of these technologies requires shirking off the excess manpower thereby creating unemployment.

Full employment is a utopian situation. The reasons behind the existence of this unemployment in the economy are as follows (Gordon 2013):

• In any particular phrase of time the number of people searching for jobs fluctuates as some people gets jobs while others enters the market for job hunt.
• People may not get the job that they find suitable and hence continues with their job search and remain unemployed.
• Unemployment is inversely related to the phenomenon of inflation. Any economy that has high level of unemployment faces low level of inflation and vice-versa.

Hence, it is feasible for an economy to have some amount of positive of natural rate of unemployment at low level of inflation called the NAIRU. 

3. No, I do not agree with the quoted statement in the question. The basic notion of inflation states that it is the situation where there has been a constant rise in the overall level of prices. There are two types of inflation, namely the cost push inflation and the demand pull inflation (Hansen 2016). The former one occurs due to an increase in the prices of the components especially raw material required to produce the goods. Demand pull inflation occurs as a result of excess demand in the economy which cannot be met up by the supply of that period. The very definition itself suggests that for an inflation to occur there are two different criteria that needs to be matched. They are:

1. Increase in the overall level of prices in the economy.
2. The increase is measured through some consecutive period of time.

Why unemployment arises and what makes some unemployment unavoidable

This statement has been disagreed because there may be situations where the price in goods has suddenly increased due to some market distortions (Blanchflower et al. 2014). There may be some warfare in other country due to which the price of goods has increased. Also some natural calamities like drought or flood may have resulted in the rise of the average prices. At the same time this increase in the price did not persists for long. Then it cannot be termed as inflation.  

4. The curve which shows us the total production of the economy’s goods and services is known as as aggregate demand curve. Just like the normal demand curve this Aggregate demand curve also slopes downwards (Caes et al. 2012). It is also known as domestic final demand curve. The diagram below highlights the same.  

Figure 1: AGGREGATE DEMAND CURVE

Source: Created by the Author

The downward slope of the curve indicates the fact that with the increase in the prices of the services and goods, there will be a decrease in the quantity demand of those goods. The reasons behind this aggregate demand curve to be downward sloping can be viewed from three perspectives. They are: Mundell-Fleming effect, Pigou effect and effect on the interest rate as suggested by Keynes (Gali 2013).

According to the Mundell-Fleming a decrease in the price-level within the economy is associated with the decrease in the interest rate of the country. This leads to the depreciation of domestic currency and thereby increases the net export of the economy. Net export being a component of AD increases the same.

The wealth theory of Pigou suggests that due to a fall in the price level people feel that they have become wealthier as the same amount of money now can fetch them a bigger basket of goods. Thus they demand more goods and thereby this inverse relationship occurs making the curve downward sloping.

Keynes’ theory suggests that a decrease in price level is associated with excessive supply of loanable funds thereby reducing the interest rate and inducing currency depreciation. Again through the systematic method the net export increases increasing AD. Hence the inverse relationship results in the downward curvature.

5. The long run is a situation where none of the factors of production are assumed to be fixed. All of them are variable. The graphical representation of the relationship established between such long run prices and the level of output is known as Long Run Aggregate Supply (LRAS).

This curve is vertical in nature. This is because in the long run the potential output of the economy is shown through this curve (Varian 2014). It is assumed that the economy is in its full employment stage and it cannot produce any more output by any other combination of the factors of production. The figure below shows the vertical LRAS. 

Figure 2: LRAS

Source: Created by the Author

The figure above denotes the generally accepted LRAS. But analysis from Keynesian and Classical viewpoint fetches a different scenario. Under them the LRAS looks like the following:

Figure 3: LRAS II

Source: Created by the Author

The SRAS curve is upward sloping because in the short run all the factors that are needed for production are not variable (Canto. Joines and Laffer 2014). The producers have a scope to increase their production with the increase in the price level as that increases their level of profit. The theory of Sticky-price and Sticky wages model can help in the understanding of this scenario.

References:

Blanchard, O.J. and Leigh, D., 2013. Growth forecast errors and fiscal multipliers. The American Economic Review, 103(3), pp.117-120.

Blanchflower, D.G., Bell, D.N., Montagnoli, A. and Moro, M., 2014. The Happiness Trade?Off between Unemployment and Inflation. Journal of Money, Credit and Banking, 46(S2), pp.117-141.

Canto, V.A., Joines, D.H. and Laffer, A.B., 2014. Foundations of supply-side economics: Theory and evidence. Academic Press.

Case, K.E., Fair, R.C. and Oster, S.M., 2012. Principles of economics. Prentice Hall,.

Fleurbaey, M. and Blanchet, D., 2013. Beyond GDP: Measuring welfare and assessing sustainability. Oxford University Press.

Galí, J., 2013. Notes for a new guide to Keynes (I): wages, aggregate demand, and employment. Journal of the European Economic Association, 11(5), pp.973-1003.

Gordon, R.J., 2013. The Phillips curve is alive and well: Inflation and the NAIRU during the slow recovery (No. w19390). National Bureau of Economic Research.

Hansen, B., 2016. A Study in the Theory of Inflation. Routledge.

Hobson, J.A., 2013. The Economics of Unemployment (Routledge Revivals). Routledge.

Varian, H.R., 2014. Intermediate Microeconomics: A Modern Approach: Ninth International Student Edition. WW Norton & Company.