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ECON 102 Tutorial 2 TA: Iain Snoddy 18 May 2015 Vancouver School of Economics Questions What is Gross Domestic Product? Gross Domestic Product The value of all final goods and services produced within a country in a given year. There are three ways to calculate GDP. By summing either total expenditure, income or production. Typically we think of GDP=C+I+G+NX, ie, the Expenditure approach. 3/53 Question 1 In calculating GDP, economists use the value of final goods and services because (a) by using final goods and services, they avoid double counting. (b) final goods can be exported to other countries. (c) intermediate goods are imported from other countries. (d) GDP is underestimated if intermediate goods are used instead. (e) none of the above. 4/53 Question 1 In calculating GDP, economists use the value of final goods and services because (a) by using final goods and services, they avoid double counting. (b) final goods can be exported to other countries. (c) intermediate goods are imported from other countries. (d) GDP is underestimated if intermediate goods are used instead. (e) none of the above. 5/53 Double Counting The problem of Double Counting Essentially the problem of double counting arises because goods used in the production of another good add value to that new good. Intermediate goods add value to final goods. 6/53 An example Perhaps the easiest example to think of is car tires. A car manufacturer buys tires from a tire manufacturer, which increases the value of the car produced. If both the car and the tires were included in the calculation of GDP, it would overstate total production. 7/53 Another example Let’s think of a numerical example. Consider a basic computer made up of Component Price CPU RAM Heatsink Cables Software Battery $125 $75 $25 $7 $85 $65 The Computer costs $490. $382 on components and an extra $108 for construction etc. Clearly the Computer derives its value to some degree from its components. If we included intermediate goods the contribution to GDP here would be $872 (490+382). But clearly some of the computers value ($382 here) is made up of the value of the intermediate goods. 8/53 Question 2 Of the following items, which one would be considered as investment in the National Income and Expenditure Accounts? (a) The purchase of a new van by a potter who packs it with his wares and travels to art shows on weekends. (b) The purchase of 100 shares of Bell Canada stock on the Toronto Stock Exchange. (c) The purchase of a 100-year-old house that was put on the protected historic sites list. (d) The purchase of a Canadian government bond. (e) All of the above. 9/53 Question 2 Of the following items, which one would be considered as investment in the National Income and Expenditure Accounts? (a) The purchase of a new van by a potter who packs it with his wares and travels to art shows on weekends. (b) The purchase of 100 shares of Bell Canada stock on the Toronto Stock Exchange. (c) The purchase of a 100-year-old house that was put on the protected historic sites list. (d) The purchase of a Canadian government bond. (e) All of the above. 10/53 Investment Investment Economists think of investments as expenditure on physical capital, basically on machines, equipment and buildings. Inventories are also included. Financial transactions are not considered to be investment. 11/53 Question 3 Which of the following would be an example of a consumption expenditure? (a) More spending by the government on children’s programs. (b) An increase in welfare payments to single mothers. (c) The purchase of a new car by the IPSCO steel company. (d) The purchase of a new car by the Singh household. (e) All of the above. 12/53 Question 3 Which of the following would be an example of a consumption expenditure? (a) More spending by the government on children’s programs. ◦ This is government expenditure (b) An increase in welfare payments to single mothers. ◦ This is a government transfer (c) The purchase of a new car by the IPSCO steel company. ◦ This is investment (d) The purchase of a new car by the Singh household. ◦ This is consumption expenditure (e) All of the above. 13/53 Consumption Expenditure Consumption Expenditure This is private spending on final goods and services by households. The selling of used/second-hand goods are not included in this measure. 14/53 Question 4-7: Circular Flow ◦ A=$100 ◦ B=$50 ◦ C=$30 ◦ D=$10 15/53 Question 4 How much is GDP? (a) $75 (b) $50 (c) $90 (d) $100 (e) None of the above 16/53 Question 4 How much is GDP? (a) $75 (b) $50 (c) $90 (d) $100 (e) None of the above 17/53 Arriving at the Answer To calculate GDP we use the income approach. GDP is equal to the income paid to households in the factor market. This is $100 here. 18/53 Question 5 How much is Net Exports? (a) $10 (b) $25 (c) $30 (d) $50 (e) None of the above 19/53 Question 5 How much is Net Exports? (a) $10 (b) $25 (c) $30 (d) $50 (e) None of the above 20/53 Arriving at the Answer Remember that Yi nc = Yp rod = Ye xp. We already know that GDP is $100 using the income approach. From the expenditure approach we know that 100=C+G+I+NX. We know the value of investment, consumption and government expenditure. C=50, I=10, G=30. So NX=10. Meaning exports are greater than imports. 21/53 Question: Openness to Trade Is Net exports useful in telling us how open an economy is to trade? 22/53 Question 6 How much is Aggregate Expenditure? (a) $50 (b) $75 (c) $90 (d) $100 (e) None of the above 23/53 Question 6 How much is Aggregate Expenditure? (a) $50 (b) $75 (c) $90 (d) $100 (e) None of the above 24/53 Question 7 How much is Aggregate Income? (a) $25 (b) $50 (c) $75 (d) $90 (e) $100 25/53 Question 7 How much is Aggregate Income? (a) $25 (b) $50 (c) $75 (d) $90 (e) $100 26/53 Question 8 In the Canadian economy, market prices and factor costs would be the same except for (a) Depreciation (b) Exports (c) Personal Taxes (d) Indirect Taxes and Subsidies (e) Capital Consumption 27/53 Question 8 In the Canadian economy, market prices and factor costs would be the same except for (a) Depreciation (b) Exports (c) Personal Taxes (d) Indirect Taxes and Subsidies (e) Capital Consumption 28/53 Factor Costs Factor Cost Factor Cost is the revenue received by producers from the sale of a good. It includes the cost of factors of production plus a mark-up. The market price paid by consumers is equal to this amount plus sales taxes. 29/53 Question 9 Given that pollution is a by-product of some production processes, (a) GDP accountants adjust GDP downward. (b) GDP accountants adjust GDP upward. (c) GDP accountants do not adjust GDP unless pollution is a serious problem. (d) GDP tends to overstate economic well-being (e) GDP tends to understate economic well-being. 30/53 Question 9 Given that pollution is a by-product of some production processes, (a) GDP accountants adjust GDP downward. (b) GDP accountants adjust GDP upward. (c) GDP accountants do not adjust GDP unless pollution is a serious problem. (d) GDP tends to overstate economic well-being (e) GDP tends to understate economic well-being. 31/53 Other problems with GDP Beyond the exclusion of externalities that are many limitations of GDP. Here are just a few: ◦ It does not account for the Distribution of Income ◦ Does not account for hours worked ◦ It does not provide information on the structure of the economy ◦ Home Production is not included ◦ Underground economy is not included 32/53 Questions 10-12 Disposable Income (dollars) Consumption Expenditure (dollars) 325 400 475 550 625 325 375 425 475 525 33/53 Question 10 When saving is zero, what is the level of disposable income? (a) $325 (b) $400 (c) $475 (d) $550 (e) $625 34/53 Question 10 When saving is zero, what is the level of disposable income? (a) $325 (b) $400 (c) $475 (d) $550 (e) $625 35/53 The Answer Put simply, saving is zero when all income that is consumed is spent. Here’s a tricky question: If total consumption expenditure equals total disposable income in the economy does that mean that nobody has saved any money? 36/53 The Answer The answer is no! Some people could have saved. But it means that others also borrowed to finance consumption. Typically when we talk about savings at the macro level we are thinking about net savings. Or the amount of savings available for investment. 37/53 Question 11 What is the value of the marginal propensity to consume? (a) 0.75 (b) 0.25 (c) 1.33 (d) 0.34 (e) 0.67 38/53 Question 11 What is the value of the marginal propensity to consume? (a) 0.75 (b) 0.25 (c) 1.33 (d) 0.34 (e) 0.67 39/53 The Marginal Propensity to Consume The MPC The MPC is the proportion of the increase in income that an individual consumes. 40/53 Calculating the MPC To calculate the MPC you calculate the fraction of the increase in income that is spent on consumption. In this case income is increasing by $75 dollars between each row. Expenditure is increasing by $50. The MPC is therefore 50/75=0.67. 41/53 Autonomous Versus Induced Expenditure The MPC captures induced consumption, the level of consumption that depends upon the amount of income you are earning. Autonomous consumption is the amount of consumption you would have if you had an income of zero. 42/53 Calculating Autonomous Consumption In this example we can actually calculate autonomous consumption. We are assuming that the MPC here is linear at all points and takes the form C = a + M P C × Income where the MPC is 0.67. We know that at an income level of $325, spending is $325, and so 325 = a + 0.67 × 325. Autonomous spending is $107.25 43/53 Plotting the Marginal Propensity to consume 500 400 Consumption 300 200 100 0 0 100 200 300 400 Income 500 600 44/53 A side note You will always work with linear Consumption functions. Meaning that the marginal propensity to consume is constant. As income increase you will always consume the same fraction of income. But of course this is unlikely to be true! A person earning $100,000 and a person earning $1,000 are likely to act very differently to an increase in income of $100. 45/53 MPC possibility It could be that the MPC looks like this Consumption Income 46/53 MPC possibility Or maybe this: Consumption Income 47/53 Question 12 What is the value of the marginal propensity to save? (a) 0.27 (b) 0.25 (c) 0.67 (d) 0.33 (e) 1.33 48/53 Question 12 What is the value of the marginal propensity to save? (a) 0.27 (b) 0.25 (c) 0.67 (d) 0.33 (e) 1.33 49/53 The Answer The Marginal Propensity to save is 1-MPC. Or it is the proportion ∆S of additional income that is saved: ∆Y . Here it is given by 25 75 = 0.33 50/53 What the hell is the AE model anyway? Let’s try to put some context on the AE model. The AE model is a short run model used to explain fluctuations in the economy. The basic intuition of the model is this: Desired Expenditure drives production. Or put another way, demand is key. Demand actually drives supply here. AE = a + bY d AE can then be written as: AE = a + bY d where Y d = Y − T . 51/53 What the hell is the AE model anyway? AE = a + bY d From this equation we know the desired level of expenditure for all output. If output is Y , how much is purchased. If output exceeds expenditure then firms are producing too much. If expenditure exceeds output then firms will run down inventories and increase production. In both cases desired expenditure drives actual output. 52/53 What the hell is the AE model anyway? This is the central tenet of the AE model. Actual output is driven by expenditure choices. In fact the model implies that expenditure is quite powerful in driving economic activity. There is a multiplier effect. The multiplier effect states that if autonomous consumption increases, output increases by a greater amount. The reasoning behind this is that output becomes income. A change in expenditure in the model yields to a large change in actual output. 53/53