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Short Answer Questions: Chapter 10
Q1. Explain the difference between GDP at market prices and GNP at market prices.
Q2. Explain the difference between demand pull and cost push inflation.
Q3. Discuss the concept of inflation illusion
Q4. Explain why deflation represents a transfer of wealth from the borrower to the lender.
Q5. Explain the four different categories of unemployment typically considered by
economists.
Essay questions
E1. Explain what is inflation targeting and what are its advantages and disadvantages.
E2. Discuss what are risks of a structural balance of payment deficit.
ANSWERS:
Short Answer Questions
Q1. Explain the difference between GDP at market prices and GNP at market prices.
A: GDP at market prices is the sum of private consumption, public spending,
investment, and net exports. GNP is equal to GDP plus net property income from
abroad.
Q2. Explain the difference between demand pull and cost push inflation.
A. Demand pull inflation occurs when a rise in aggregate demand leads to an
increase in overall prices. Cost push inflation occurs when a reduction in supply
leads to an increase in overall prices..
Q3. Discuss the concept of inflation illusion
A. People suffer inflation illusion if they confuse nominal and real changes. For
example, people may perceive a 5% increase in the price of a basket of goods as
inflation despite an equal increase in nominal wages. In such a case, real wages
would remain unchanged and goods will not be more expensive than they were
before.
Q4. Explain why deflation represents a transfer of wealth from the borrower to the lender.
A. Consider a mortgages with a fixed rate. If you borrowed £100,000 last year and
deflation results in a 5% loss in earnings, then your mortgage increases in real
terms to £105,000. From the lender’s perspective, the real rate of interest received is
now increased.
Q5. Explain the four different categories of unemployment typically considered by
economists.
A. The four categories are: frictional, cyclical, structural and classical
unemployment. Frictional unemployment refers to individuals who have quit one job
and are currently searching for another job. As such, frictional unemployment is
temporary. Cyclical unemployment is related to the business cycle and is
sometimes also referred to as demand deficient unemployment. Cyclical
unemployment reflects workers who have lost jobs due to the adversities of the
business cycle. Structural unemployment occurs when an industry moves into
decline. The structurally unemployed find it difficult to gain employment in new
industries because of what is known as a mismatch of skills. Classical
unemployment refers to workers who have priced themselves out of a job.
Essay questions
E1. Explain what is inflation targeting and what are its advantages and disadvantages.
Answer guidelines. You need to start by the definition of inflation target. Inflation
targeting means that the central bank publicizes a target goal for the inflation rate. It
then steers monetary policy to try to hit the target inflation rate, raising rates to curb
inflation and lowering rates to juice up growth and raise inflation. Advantages:
under inflation targeting there will be more price transparency, small and infrequent
changes of the interest rate, less uncertainty and stable inflation expectations.
Disadvantages: problems with cost push inflation.
E2. Discuss what are risks of a structural balance of payment deficit.
Answer guidelines. What you should highlight here is that in the short run, a oneoff deficit is unlikely to be a problem. A country may expect to run a deficit this year
and a surplus next year. What really matters is why there is a deficit. It may be that a
country is running an external deficit with its overseas partners because it is
purchasing high-productivity capital items, which will improve the country’s
productivity in the future. In the long run, however, the real concern arises when the
deficit represents a structural, as opposed to a temporary, problem. If a country
produces low-quality output but demands high-quality and expensive products from
overseas, then it will run a deficit. The way for you to solve the debt problems is for
a country to improve the type, quality and cost of
the products that it sells to the
rest of the world. In essence, by becoming more internationally competitive a
country may be able to generate the finances that it requires to fund its expenditure
on expensive imports.