Questions - Johan Lindén, Mälardalens högskola



Chapter 6Aggregate IncomesQuestions1.Suppose you are comparing per capita income in Germany and Hungary. According to the International Monetary Fund’s World Economic Outlook Database (April 2017), the per capita GDP of Hungary in 2015, using exchange rates and current prices, was Intl$ 12,344, whereas the purchasing-power-parity (PPP) based per capita GDP was Intl$ 26,536. For Germany, the exchange rate based per capita GDP was Intl$ 41,197 whereas the PPP-based per capita was Intl$ 47,254. Which GDP calculation will be more accurate at showing the differences in living standards between the two countries? Explain your answer. [Note: An international dollar has the same purchasing power as the U.S. dollar had in the United States in that given year. It is mainly used for comparison purposes.] Answer: The exchange rate-based calculation of the Hungarian GDP is dependent on the annual fluctuations between the US dollar and the Hungarian forint. Thus, in theory Hungarian per capita GDP figures can increase by the US dollar weakening vis-à-vis the Hungarian forint, whereas it might not be represented in actual changes in terms of production. The PPP-based per capita GDP is estimated by calculating how much a representative bundle of commodities costs in various countries. Thus, the purchasing power parity-adjusted exchange rate will show how much it will cost residents of Hungary and Germany to purchase the same bundle of goods. Therefore, while the difference between Germany and Hungary was 3.33 using exchange rate per capita GDP, based on the PPP approximation of per capita GDP the difference was 1.78. 2.What are the disadvantages of using Big Macs to measure purchasing power parity? Answer: The price of a Big Mac is used as an alternative measure of the exchange rate between two countries. One of the problems with using Big Macs to measure purchasing power parity is that, instead of a bundle of diverse goods, this index simply compares a bundle consisting of just one good. Also, Big Macs are only a very small fraction of people’s consumption, so their prices will not reflect true cost-of-living differences across countries. 3.Suppose that country A has higher income per capita than country B. Explain why this does not imply that most citizens of country A have higher income than most citizens of country B. Try to construct an example in which both countries have 10 citizens to demonstrate this point.Answer: Although income per capita does correlate strongly with various measures of the quality of life, it does not give a complete picture of the standard of living of all of a country’s citizens. Income inequality can make income per capita a deceptive measure of economic well-being. Individual incomes can vary widely within a country and may not be reflected in a simple measure of income per capita. PersonCountry A IncomeCountry B Income 1 $ 1,000 $ 5,000 2 $ 1,500 $ 6,000 3 $ 2,000 $ 7,000 4 $ 2,500 $ 9,000 5 $ 3,000 $ 9,500 6 $ 3,500 $10,000 7 $ 4,000 $11,000 8 $15,000 $12,000 9 $30,000 $14,000 10 $45,000 $15,000Imagine that countries A and B each have ten people (or ten equally large groups of people) with incomesdistributed as follows:Country A’s GDP per capita is $10,750, while country B’s is only $9,850. But notice that GDP appears to be much more equally distributed in country B than in country A. The median income in country A is $3,250, whereas the median in country B is $9,750. Hence, most of the citizens in country B have a higher income than most citizens in country A have. 4.Is GDP per capita more relevant in understanding differences in international living standards than GDP per worker?Answer: Yes, GDP per capita is likely to be a better measure of differences in living standards. GDP per capita is estimated by dividing the country’s aggregate output by the total population, while GDP per worker divides aggregate output by the number of people in employment. GDP per worker is a good measure of how productive an economy is as it considers the average output produced by the workforce. GDP per capita, however, might be a better measure of welfare as it considers the conditions of the whole population, including children and the elderly. 5.What is the correlation between GDP per capita and welfare measures like absolute poverty and life expectancy? What does this suggest about GDP per capita as a measure of welfare? Answer: GDP per capita shows a strong correlation with measures like absolute poverty and life expectancy. However, GDP per capita might hide inequalities between countries and within countries. Also, it doesn’t take into account factors like the quality of health care, the environment, and public safety. Although GDP per capita is by itself not a perfect measure of welfare, it does give us a lot of information about the living standards in a country. Therefore, it makes sense to first focus on GDP per capita and then look more deeply into data on health, education, poverty, and inequality within and across countries. 6.What does the Human Development Index measure? What is the correlation between this index and GDP per capita in a country?Answer: The Human Development Index was developed by the United Nations to measure living standards across various countries. It combines GDP per capita, life expectancy, and measures of education (the mean of years of schooling for adults aged 25 years and expected years of schooling for children of school-entering age). Data on GDP per capita and HDI of various countries show a strong positive correlation between HDI and income per capita.7.What is productivity? Why does it vary across countries?Answer: Productivity refers to the value of goods and services that a worker generates for each hour of labor. There are three main reasons why productivity differs across countries:i.Human capital: Workers differ in terms of human capital, which is their stock of skills to produce output or economic value. Differences in human capital across countries result in differences in productivity.ii.Physical capital: Physical capital is any good, including machines (equipment) and buildings (structures) used for production. Workers will be more productive when the economy has a bigger physical capital stock, enabling each worker to work with more (or better) equipment and structures.iii.Technology: An economy with better technology uses its labor and capital more efficiently and thus achieves higher productivity8.What are the two components of technology? Answer: Technology has two very distinct components: the first is knowledge that society has acquired and applied to its production process. This knowledge is embedded partly in the capital stock of firms. The second component has to do with the efficiency of production. The efficiency of production refers to the ability of society to produce the maximal amount of output at a given cost or for given levels of factors of production.9.What are factors of production? What does the aggregate production function describe? Answer: A factor of production is an input used in producing output in an economy. An aggregate production function describes the relationship between a nation’s GDP (Y) and its factors of production, such as physical capital (K) and total efficiency units of labor (H). It is written as follows: A is an index of technology. A higher level of A implies that the economy produces more GDP with the same level of physical capital stock and total efficiency units of labor.10.What are the total efficiency units of labor? What is the relationship between this concept and human capital?Answer: Because the workers in an economy have different levels of human capital, we would not be able to gauge how much the economy can produce only by looking at the number of workers it has. Total efficiency units of labor accounts for the number of workers as well as the level of human capital. Denoting total efficiency units by H, the total number of workers in the economy by L, and the average efficiency or human capital of workers by h, total efficiency units of labor is calculated using the formula: 11.Use the following diagram to explain the relationship between a country’s physical capital stock and GDP, holding all else constant. Answer: The diagram shows the aggregate production function, holding total efficiency units of labor constant. This graph shows both the positive relationship between capital and output as well as the law of diminishing marginal product. Holding labor constant, if capital stock increases, the level of output produced also increases. However, the marginal contribution of an additional unit of capital to output—how much output increases as a result of a unit increase in the capital stock—eventually decreases. This can be seen by comparing a unit increase in output at two different points on the aggregate production function. At a point closer to the origin, when there is less capital in the economy, an increase in capital stock will lead to a relatively large increase in output. When we have the same unit increase starting with a larger capital stock—farther to the right on the horizontal axis—the corresponding increase in output is smaller. 12.Explain the difference between the terms “physical capital” and “human capital.”Answer: Physical capital is any good, including machines (equipment) and buildings (structures), used for production. Human capital, on the other hand, refers to workers’ skills that enable them to produce output or economic value.13.Explain what distinguishes physical capital from natural resources.Answer: Physical capital is not given to a country by nature; it must be produced. In fact, it is sometimes called “produced means of production.” This is what the authors mean when they say that capital is not given to us as an “endowment,” as are natural resources.14.How do increases in technology affect the aggregate production function?Answer: An increase in technology means that the economy can generate more output from the same set of inputs. Exhibit 6.9 shows the implications of better technology for the aggregate production function: Again holding the efficiency units of labor, H, constant, the relationship between GDP and the physical capital stock shifts upward. Therefore, for every level of K, the physical capital stock, a better technology implies that the economy will be able to produce more GDP.15. What does Moore’s law state? Is Moore’s law borne out by historical data?Answer: Moore’s Law, named after Intel cofounder Gordon Moore, predicts that the number of transistors on a chip will double approximately every two years. The number of transistors is a key determinant of how fast a computer processor is. So Moore’s Law implies that computer processor power should double approximately every two years. Gordon Moore made this prediction in 1965. Moore’s law has turned out to be fairly accurate, with the number of transistors packed in a computer chip doubling approximately every two years. Several other measures of technological advances in computing have also behaved according to Moore’s Law. 16.Why is the average American so much richer than the average Indian?Answer: The difference between the average income of an American and an Indian can be explained by differences in physical capital stock per worker, total efficiency units of labor, and technology in the United States and in India. Compared to the United States, India’s aggregate production function shows that India has significantly lower levels of capital stock per worker, human capital, and technology. If an Indian had access to the same level of technology as an American does, the average income level in India would more than double. 17.What policies can be used to raise GDP in a country?Answer: Four types of policies can be used to raise a country’s GDP: i.Increasing physical capital: Countries can increase their capital stock by increasing their savings rate. ii.Raising efficiency units of labor: Increasing the levels of schooling and education would help countries increase their levels of human capital thus their efficiency units of labor. iii.Improving efficiency in the allocation of resources to improve the efficiency of production: By increasing the competitiveness of markets, countries can make resource allocation more efficient. iv.Improving technology: Investing in research and development as well as using technology transfers can improve the technology that is used in the production process.Problems1.You read a newspaper report that compares wages paid to employees at Starbucks in India and in the United Kingdom. At the time, 1 pound was equal to 87 rupees. The report says that Starbucks baristas in India are paid a mere 56 pence an hour, which is lower than the cheapest coffee that Starbucks sells in the United Kingdom. A friend of yours who read the report is appalled by this information and thinks that Starbucks ought to raise its salaries substantially in India. Is your friend necessarily correct? Explain your answer. Answer: No, your friend is not necessarily correct. The flaw in the report is that it converts the wages paid in India to pounds using the current exchange rate but does not account for the cost of living (or the prices of goods) in India. So, while the wages paid to Starbucks employees in India may seem extremely low or exploitative, it is entirely possible that the cost of living in India is lower than the cost of living in the United Kingdom. If the cost of living in India is substantially lower than that in the United Kingdom, then the Starbucks employee in India is not necessarily worse off than a Starbucks employee in the United Kingdom. Based on: & following table lists 2012 GDP per capita for four countries. The data are given in the national currencies of the countries. It also lists the price of a Big Mac burger in local currency in each country in 2012.The price of a Big Mac in the United States in 2012 was $4.20. Using the Big Mac burger as a representative commodity common to the countries, calculate the purchasing power parity (PPP)-adjustment factor for each country, and then the PPP level of per capita GDP in each country.Answer: Following the procedure given in the text, we first calculate the ratio of the U.S. Big Mac price and the Big Mac price in the country in question. For example, for Norway, the calculation would be $4.20/41 krone = 0.102. This is the PPP adjustment factor, which we then multiply by per capita GDP stated in the local currency. For Norway, the calculation is 0.102 × 579,162 = $59,328.79. Here is the table showing the results for all the countries:Country (currency)2012 GDP per Capita2012 Big Mac PricePPP Adjustment Factor (rounded)PPPGDP/CapitaNorway (krone)579,162410.10259,328.79Poland (zloty)41,3989.10.46219,106.77Turkey (Turkish lira)19,5806.60.63612,460.00United Kingdom (British pound)24,7402.491.68741,730.123. Let us use what we have learned in the first part of the chapter to compare living standards in the United States and Germany in 2015.a.The U.S. GDP in 2015 was approximately $18,120 billion, and the U.S. population was approximately 321.08 million. What was the per capita GDP in U.S. in 2015? b.Suppose that Germany’s GDP in 2015 was €3,082 billion, and Germany’s population was approximately 81.7 million. What was Germany’s per capita GDP in euros? What problems do you foresee in comparing this number to the United States’ GDP per capita in U.S. dollars computed in part (a)? c.On January 3, 2015, the €/$ exchange rate was 1.2 (meaning that €1 was worth $1.2), and on March 15, 2015, the exchange rate changed to 1.05. Calculate an exchange-rate-based measure of GDP per capita in Germany, in U.S. dollars, on these two dates. Do you think the change in Germany’s exchange-rate-based measure of GDP per capita between these two dates reflects a true change in living standards? d.McDonald’s has a thriving business in Germany. It sold a Big Mac for €3.65 in 2015, while at the same time, a Big Mac sold for $5 in the United States. Using this information, provide an alternative estimate of GDP per capita in Germany. Would you trust this estimate better than the one based on exchange rates? Why or why not?Answer: a. b.The U.S. per capita GDP, which is in dollars, cannot be compared to the per capita GDP in Germany, which is in euros. To facilitate comparison, we would have to convert both values into a common unit of measurement. Either the German GDP into dollars or the American GDP into euros. c.January 3, 2015: Germany’s per capita GDP in U.S. dollars = 37,121 × 1.2 = $44,545March 15, 2015: Germany’s per capita GDP in U.S. dollars = 37,121 × 1.05 = $38,977No. The change in Germany’s exchange-rate-based measure of per capita GDP is unlikely to reflect a change in living standards. However, if Germans decide to import more goods from the United States in the long run, they would have to pay more for those goods, and even though they are producing the same amount of goods, they shall slightly have to adjust their consumption habits. d.This information can be used to arrive at a PPP-adjusted exchange rate between the United States and Germany. If a Big Mac costs €3.65 in Germany and $5.00 in the United States, then €1 = $1.37. It follows that the per capita GDP in Germany in U.S. dollars = 37,121 × 1.37 = $50,850. Yes. The Big Mac index is commonly used as an alternative measure of exchange rates. It is a very simple example of purchasing-power-parity adjustment. PPP-adjustments account for the relative differences in the cost of living in various countries. Because it involves the prices of actual goods in the two countries, it is more reliable than the estimate based on exchange rates. Of course, in reality the Big Mac index is not an accurate approximate of purchasing-power-parity, because people consume additional products as well in a given year.4.Suppose you are given the following information for the country, Lusitania:?2011Population; total in Lusitania190 millionEmployment80 millionGross Domestic Product (GDP)2,476 billion U.S. dollarsa.What is the GDP per capita in Lusitania?b.What is the GDP per worker in Lusitania? The following table gives you the same information for the country, Arctica.?2011Population; total?in?Arctica80 millionEmployment40 millionGross Domestic Product (GDP)3,600 billion U.S. dollarsc.What is the GDP per capita in Arctica? d.What is the GDP per worker in Arctica? e.Based on the given information, would Arctica be considered more productive than Lusitania? Explain your answer.f.How would you use the information given in both these tables to compare living standards in Lusitania and Arctica? Answer:a. = = = $13,032 (approx.)b. = = $30,950c. = = $45,000d. = = $90,000e.GDP per worker in Arctica is much higher than Lusitania. Therefore, it can be concluded that workers in Arctica are more productive than workers in Lusitania.f.GDP per capita takes into account the whole population, including children and the elderly, and so can be used to understand differences in living standards. The GDP per capita in Arctica is higher than that in Lusitania. This implies that the standard of living in Arctica is higher than that in Lusitania. 5.Suppose that the GDP in current dollars for Polonia is higher than Ruritania’s GDP. However, using purchasing-power-parity-adjusted dollars, Ruritania’s GDP is higher than Polonia’s GDP. Based on this information, what would you conclude about living standards in Polonia and Ruritania?Answer: The purchasing-power-parity adjustment constructs the cost of a representative bundle of commodities in each country and uses these relative costs for comparing income across countries. This means that purchasing-power-parity measures adjust nominal GDP for the cost of living in a country. So, if Ruritania’s PPP-adjusted GDP is higher, this means that the standard of living in Ruritania is likely to be better than Polonia’s standard of living. 6.In 2011, China revised its poverty line upward to 2,300 yuan per year, or 6.3 yuan per day. At the prevailing exchange rate, this was equal to a little less than a single U.S. dollar. Some commentators felt that China’s poverty line fell short of the World Bank’s poverty line of $1.25 per day, in 2005 purchasing-power-parity (PPP) U.S. dollars. Would you agree? What other information would you need to evaluate this claim?Answer: The World Bank’s poverty line is based on PPP-adjusted U.S. dollars. This means that people whose purchasing power is so low that they cannot afford to buy the same goods and services that could be bought in the United States in 2005 for $1.25 are considered to be below the poverty line. To check whether China’s poverty line falls below the World Bank’s poverty line, we need to use the PPP-adjusted exchange rate for Chinese yuan and the U.S. dollar. Based on . Assume that the country Lusitania has two industries, clothing production and computer chip production. At first, both industries have identical aggregate production functions: the following table shows how the output of each industry is affected by a change in efficiency units of labor. GDP (in millions of dollars)Stock of physical capital (units)Efficiency units of labor10015,00016,00015015,00020,00018015,00024,00020015,00028,00021015,00032,000a. Using the data in the table, draw a graph showing how output (on the y axis) changes with efficiency units of labor (on the x axis). What explains the shape of the graph? Why is it valid in this case to plot output against the efficiency units of labor and leave the stock of physical capital in the background?b. A Lusitanian inventor has produced a new technology that doubles output of computer chips for any combination of Capital and Labor. Explain, using an equation, how this invention affects the production of computer chips. Write a new table for computer chip production and compare it to the (unchanged) table for clothing production. c.If you were a central planner, would you make any changes to the allocation of labor, holding capital fixed? If so, what factors might prevent you from implementing your policy? Answer: The graph should look approximately like the figure below: GDP increases with an increase in the efficiency units of labor. However, the rate of increase in GDP gradually decreases as the efficiency units of labor increase. The student should explain that this shape is due to the decreasing marginal product: holding the stock of physical capital constant, the relationship between aggregate product and efficiency units of labor becomes less and less steep as the total efficiency units of labor increases.Here, in effect, we’re multiplying A by 2. So now, any combination of labor and capital produces double the output it did before. We show this in the table below:GDP (in millions of dollars)Stock of physical capital (units)Efficiency units of labor20015,00016,00030015,00020,00036015,00024,00040015,00028,00042015,00032,000c. A central planner would re-allocate workers to computer chips—because now marginal product of labor has increased at each level. We’ll be able to get more bang for our buck with workers in computer chip industry. However, it may be that higher training is required for workers to produce computer chip, so it might not be possible to simply re-allocate employees. 9.The old Soviet Union devoted enormous resources exclusively to increasing its physical capital stock, and yet eventually the increase in the country’s GDP came to an end. Based on the discussion in the chapter, explain why this was inevitable. Answer: The Soviet Union had many problems that would have slowed economic growth: corruption, lack of incentives, etc. Even without these issues, however, the emphasis on capital accumulation could not have spurred robust economic growth indefinitely.Recall from the chapter that capital is subject to the law of diminishing marginal product. This means that each additional unit of capital produces less and less additional output. In the absence of technological innovation, the increase in GDP per hour worked as capital accumulates gets smaller and smaller until it is virtually constant. Thus, economic growth in the Soviet Union was doomed to slow and eventually to stagnate. 10.According to U.S. census projections, the percentage of U.S. citizens over the age of 65 will increase from 14.9% in 2015 to 22.1% in 2050, due, in part, to both prolonged life expectancy and declining fertility rates. How would you expect such a demographic shift to affect productivity? What about GDP per capita? Answer: Productivity will likely decrease--as the workforce ages, its members will become less productive (alternatively, students could argue that there are ambiguous effects, since an older workforce may be more qualified overall, for some industries; for others, which perhaps involve manual labor, they will indeed decrease in productivity). Here, the effects are ambiguous—so multiple, well-reasoned answers are acceptable. Likely it will go down slightly, all else equal, due to a decline in the workforce and decreased productivity; in addition, the increase in life expectancy may lead to higher populations. This could, of course, be offset entirely be declining fertility; another acceptable answer, then, could be that both GDP and population will be lower, all else equal, so the overall effect depends on what dominates. 11.In “Dead Aid,” economist Dambisa Moyo argues that humanitarian aid—provision of food or medicine to poor families, for example—is an ineffective tool for promoting growth in the developing world.? Instead, she argues in favor of foreign aid policies that encourage/subsidize?foreign investment in the businesses of developing countries. Using the concepts in this chapter, evaluate her approach. Your answer should?consider the short-term and long-term effects of such policies on both poverty rates and aggregate growth. If you were trying to?improve macroeconomic growth andlower poverty rates in the developing world, what kind of programs would you encourage the U.S. government to fund?? What trade offs would you weigh in making your recommendation? Answer: In the short term, any infusion of capital will boost GDP mechanically—we should see, then, an increase in GDP and GDP per capita, all else equal. Perhaps more importantly, if these investments enhance productivity, then they will, as we’ve seen in this chapter, boost GDP in the long run (and GDP per capita, all else equal). However, it’s not clear how these increases will affect the poorest segments of the population—while GDP will increase, poverty rates may stay the same (or even potentially increase, if the investments come at the expense of aid). This persistence of poverty will be particularly likely in countries without mechanisms for redistribution (like any kind of government-run welfare programs). In the long run, high poverty rates may actually hamper the growth of GDP—a starving, sick population may be unable to work or innovate. The second part of this answer may vary—multiple well-reasoned arguments are acceptable. For example: In developing programs, then, we may, based on funding constraints, face a short-term trade-off between alleviating poverty and increasing GDP. Ideally, a mix of well-targeted programs would bolster productivity—perhaps partially through training programs and improved technology, and partially through aid to poor segments of the population. 12.Give an algebraic and an intuitive explanation of the concept of “efficiency of production.” Why is efficiency of production so important to GDP? Answer: Given the aggregate production, function Y=A×F(K,H), higher productive efficiency implies that A is higher. Therefore, for a given level of K and H, a higher level of A implies a higher level of Y, or GDP.“Efficiency of production” is defined as the ability of an economy to produce the maximal amount of output at a given cost or from a given amount of factors of production. This is important for GDP because the greater productive efficiency in an economy, the more goods and services that can be produced from a given input, or combination of inputs. For example, with a given labor force, a country with greater efficiency will be able to produce more goods and services than a country with lower efficiency and, therefore, will have a larger GDP than a country where such efficiency remains low.When a nation’s workers are more productive, real GDP (Y) is larger, and therefore incomes are higher than they would otherwise have been. Higher incomes mean higher living standards. So, when the efficiency of production grows rapidly, so do living standards. ................
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