Macroeconomics: Real GDP, Unemployment, Inflation, AD And AS Curves

Limitations of Real GDP as a Measure of 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. Williams (2013) pointed out that GDP’s reflection on the nation’s true health is inadequate, and, he proposed replacement by more comprehensive measures. He argued that it doesn’t include the happiness of citizens in its measurement of which is a good indicator of well-being.

It does not include household production in its measure which makes it underestimate the total production (McTaggart, Parkin and Findlay, 2012). So the increment in GDP is from a decrease in household production.  The underground economic activities have a significant contribution in the economy and is not included in the GDP measure. The standard of living is overstated by the real GDP since new problems of health and life expectancy are faced each year and are not included in its measurement.

There is a problem arising when comparing the standard of living between countries since there is a condition that the real GDP have to be converted into a similar currency units. On the other hand, goods and services for different countries are priced differently; real GDP comparison requires that they be priced the same which is not possible. Real GDP does not take into consideration the value of leisure and clean environment. Most importantly, it doesn’t take into consideration the distribution of income; the real GDP could be very high but some people are living in the poverty trap. Therefore using real GDP to conclude that the economy has a high standard of living is not practical as it have ignored many factors.

2. Unemployment arise because there are new entrants into the job market freshly from schools. This group is not willing to enter in some jobs even if they have no income. They opt to wait for the job that match their skills to arise. During the search period, they are considered unemployed; this is frictional unemployment. This is unavoidable in an economy since matching of the student’s skill with the employee in need of the skills held may take some significant amount of time (Jee, 2016). The other group is the reentrants into the labour market; some people get discouraged from getting a job and exit the labour market. After some time, these people may decide to get back and find some job.

Causes of Unemployment

There is another group of the job leavers; they are not satisfied with the returns they get from their current job. They therefore leave their job and begin the search for a new job. They are also said to be frictionally unemployed. This is also unavoidable since some employees offer little returns and some employees engage in such jobs before they get a better job.

Technology is growing every day and new firms are emerging posing competition to the old ones (Blobbert, 2016). This creates a need for advanced skills. This explains why structural unemployment is unavoidable. The unavoidability is present since both people and businesses are making transitions in life stages.

3. I agree.

The definition of inflation by Harvey (2011) affirms my agreement.  I’ll base my argument on Harvey’s argument that money growth is not responsible for causing inflation. He argued that on the real world, the assumption in which the basis for money growth causing inflation is founded does not hold. The existence of money occurs when it’s added to a portfolio of assets. This may be by borrowing money or by selling securities to the central bank. This two scenarios do not allow the money supplied by the central bank to exceed the demand for money. Harvey’s argument was that it is inflation that happens first and is accompanied by money growth. How? When the average price level of goods and services rise, inflation rises; the initial income level for the households become insufficient to buy the original consumer bundle. They therefore borrow more from banks and sell the securities they held to the fed causing money growth.

Money growth is part of the demand-pull argument for causing inflation. There is also the cost-push argument where rising cost of production pushes up the price for the final products. Such cost increments may result from; when wages and salaries in an economy rise, cost of production is high and therefore price for products go up causing inflation (Dr. Econ, 2002). Other factors include; increase in the price of imported intermediate goods and capital, natural disaster and increased profit margin.

4. Aggregate demand is the model used by economists in the determination of national income. It is a representation of the combination of goods and services demanded by all individuals. This demand is given at different price levels in the economy. Accordingly, AD curve is a curve derived when the all output levels in an economy are plotted against the different price levels.

Inflation and Relationship to Average Price Levels

Just like any other demand curve for individual goods, the AD obeys the demand laws; it is thus downward sloping. This is an indicator of inverse relationship. Since it’s not possible to hold income and price of other goods constant in the economy as for individual demand curves, there are three different explanations for this. One the wealth effect where money supply is assumed to be constant. As price rise, wealth reduces, purchasing power reduced, people become poorer and cut their demand; the opposite is true (Kalpana, 2009). The second is the interest rate effect where more money is needed by households as price go up to enable them service their transactions. Since money supply is held constant, an expansion in money demand results in high interest rate, subsequently spending is reduced (Pettinger, 2014). The last reason is net export effect where rising domestic prices makes imports cheaper and exports expensive; imports demand goes up and exports demand falls. This results in a reduced net exports (Morton and Goodman, 2003).

5. The long run aggregate supply (AS) curve is a vertical curve indicating the output level firms produce in the long run to the price level. It is obtained when the general price level is plotted against the real GDP.

In the long run, the factors of production are allowed to change (they are not fixed). The supply by firms is independent and varies as per the expected economic profits. In the long run, the AS curve is only affected by labour, capital and technology since other factors are assumed to be optimally used. The vertical curve is explained by the fact that nominal wages and price of products change by the same percentage (Tucker, 2010).

The short run AS curve slopes upward because of two major reasons. One is that of sticky-wage model where wages are set in contracts and cannot change immediately with the expansion of the economy. So in the short run it doesn’t and to the cost of production. Therefore, the series of a price rise causing growth of output is as follows. Price rises, nominal wage remain fixed, real wage falls, labour become cheap, firms hire more, output expands. Second is worker-misperception model where wages are allowed to vary. In this case, firms raise the nominal wage of workers as price rises. Since workers assume real wages have gone up, they are induced to supply more labour and output expands (Mankiw, 2007). The factors of production are fixed in the short run.

References

Blobbert, (2016). Why does unemployment arise and what makes some unemployment unavoidable. [Online] Answers.com. Available at: https://www.answers.com/Q/Why_does_unemployment_arise_and_what_makes_some_unemployment_unavoidable [Accessed 18 Dec. 2016].

Dr. Econ, W. (2002). What are some of the factors that contribute to a rise in inflation? [Online] Federal Reserve Bank of San Francisco. Available at: https://www.frbsf.org/education/publications/doctor-econ/2002/october/inflation-factors-rise/ [Accessed 20 Dec. 2016].

Harvey, J. (2011). What Actually Causes Inflation (and who gains from it). [Online] Forbes.com. Available at: https://www.forbes.com/sites/johntharvey/2011/05/30/what-actually-causes-inflation/#683a50a54ad2 [Accessed 20 Dec. 2016].

Jee, S. (2016). Unemployment in Developing Countries. [Online] Economics Discussion. Available at: https://www.economicsdiscussion.net/essays/unemployment-essays/unemployment-in-developing-countries/10389 [Accessed 18 Dec. 2016].

Kalpana, S. (2009). Textbook on economics for law students. [Place of publication not identified], Universal Law Publishing.

Mankiw, N. (2007). Principles of macroeconomics. Mason, OH, Thomson South-Western.

McTaggart, D., Parkin, M. and Findlay, C. (2012). Microeconomics. 1st ed. French Forest, N.S.W.: Pearson Education Australia.

Morton, J. and Goodman, R. (2003). Advanced placement economics. 1st Ed. New York, N.Y.: National Council on Economic Education.

Pettinger, T. (2014). Why is the Aggregate demand (AD) curve downward sloping? | Economics Help. [Online] Economicshelp.org. Available at: https://www.economicshelp.org/blog/11437/economics/why-is-the-aggregate-demand-ad-curve-downward-sloping/ [Accessed 20 Dec. 2016].

Williams, R. (2013). Why the GDP is not a good Measure of a Nation’s Well Being. [Online] Psychology Today. Available at: https://www.psychologytoday.com/blog/wired-success/201309/why-the-gdp-is-not-good-measure-nations-well-being [Accessed 18 Dec. 2016].

Tucker, I. (2010). Macroeconomics for today. Mason, OH, South-Western Cengage Learning.