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Review Questions: The Classical Model 1. Write down the Quantity Equation and provide an explanation of all the variables included in it. 2. Use the Quantity Equation to explain the Quantity Theory of Money. Also explain why this theory implies that money is neutral to real GDP and the level of employment in the economy. 3. On a graph draw the demand and supply curves for labor. Explain why these curves are shaped the way they are. Also provide an explanation of the forces that push the wage rate to the equilibrium level. 4. At this equilibrium wage rate there is no unemployment in the labor market in the Classical Model. Is this statement accurate? 5. Provide an explanation of what is meant by the term “full employment” in the context of the Classical Model. 6. Using the Quantity Equation, derive the Aggregate Demand curve. Then use the Aggregate Demand – Aggregate Supply framework to depict the equilibrium level of output in the Classical Model? Is this equilibrium level of output equal to the full employment level? 7. Why are expansionary monetary and fiscal policy ineffective to combat recession in the world of the Classical Model? Review Questions – GDP, Circular Flow and Keynes’ Model 1. Consider an economy with three goods – wheat, flour and bread. Wheat and flour are intermediate goods (non-durable capital goods) whereas bread is the only consumer good and no inventory of any good is maintained. i. Assuming wages and profits are the only forms of income, construct an example showing the payments of the producers of the three goods (including interproducer payments) ii. Calculate the GDP of this imaginary economy using the product, income and expenditure methods. Explain how these methods deal with the problem of double counting in the calculation of GDP. 2. Draw, label and explain the circular flow of income and expenditure. 3. Explain Keynes’ theory of consumption expenditure (use a schedule or table if required). What implications does the value of the marginal propensity to consume have for the relationship between the amount of savings and the level of income? 4. Explain the concept of the equilibrium level of output or real GDP. Why, according to Keynes, does its emergence require an equality between the amount of savings (income not devoted to consumption expenditure) and the amount of investment expenditure? 5. Explain the concept of the full employment level of output. How is this concept different from that of the equilibrium level of output? 6. Assume an economy where the equilibrium level of output coincides with the full employment level. Now assume that there is a decline in the level of investment expenditure. Analyze the effects of this decline on the equilibrium level of output. In the process, also provide an explanation of the workings of the Keynesian multiplier. 7. Use the Aggregate Demand – Aggregate Supply framework to compare the Keynesian and the Classical Models of output and employment. 8. Explain the concept of the marginal efficiency of capital (use a numerical example if required). 9. Using the concept of the MEC, explain why the level of investment expenditure shares a negative relationship with the prevailing rate of interest in the Keynesian system. 10. Investment expenditure, for Keynes, is driven by animal spirits. Explain. What implications does this have for the attainment of full employment equilibrium? 11. Distinguish between necessary and idle cash balances. Why, according to Keynes, do individuals hold idle cash balances? 12. Derive the negative relationship between the amount of money held to satisfy the speculative demand for money and the rate of interest. What implications does the existence of this speculative demand for money have for attaining full employment? 13. Why, in the Keynesian system, do monetary and fiscal stimulus help in attaining full employment? What role does the multiplier play in this process? Depreciation, GDP and NDP Table 1 (Year 1) Payments of wheat producers: $150 as wages, $50 as interest. Revenue earned from sale of wheat: $300. Total profits earned = $100. Payments of flour producers: $300 on wheat (to wheat producers), $100 as wages, $50 as interest. Revenue earned from sale of flour: $600. Total profits earned = $150. Payments of bread producers: $600 on flour (to flour producers), $100 (on ovens currently used), $100 as wages, $50 as interest. Revenue earned from sale of bread: $1000. Total profits earned = $150. Payments of oven producers (on the part of ovens unused in production of bread): $150 as wages, $50 as interest. Revenue earned from sale of ovens: $300. Total Profits = $100. Depreciation, GDP and NDP • We concluded that the GDP of this economy was $1200 by the income and expenditure methods. • The income method was straightforward. We just added the value added in the oven industry to that generated in the other three. Each industry contributed $300 worth of value added. • The figure of consumption expenditure is only $1000. Thus, investment expenditure was broadened to maintain the identity of the GDP figures yielded by the two methods. • Its magnitude was $200 ($300 - $100), which represents the value of the net addition to oven capacity added in year 1. $100 is the value of the ovens used up in bread production in year 1. Depreciation, GDP and NDP • The $100 expended on ovens used up in year 1 is termed depreciation. • Depreciation is the value of durable capital goods used up in the production of consumer goods in any period. • If depreciation is included in investment expenditure, the value of GDP would be $1300. • We would, in effect, be double counting the value of the ovens used up in year 1 in the production of bread. • This is similar to the double counting of the value of intermediate goods used in the production of bread. Depreciation, GDP and NDP • If depreciation is included in the calculations made, then the figure that results is called GDP. If depreciation is excluded we obtain NDP (Net Domestic Product). • For theoretical purposes, when national income is used in establishing cause and effect relationships, NDP is what matters. • In practice, however, depreciation is hard to measure and deduct from gross investment expenditure. It is hard to estimate the value of durable capital goods used up. GDP in a Simple Economy • In our simple, imaginary economy production takes place during the course of a year. • In that year producers (firms) produce only one consumer good – bread. • Two capital goods (intermediate goods) are produced – wheat and flour. Both are inputs in the production of bread. • Bread is produced utilizing labor and flour, flour is produced with labor and wheat, and wheat is produced utilizing only labor. GDP in a Simple Economy • Labor Wheat (+ labor) Flour (+ labor) Bread • Our imaginary economy is extremely underdeveloped. No tools or machinery utilized in the production of any good. • Tools and machinery are examples of durable capital goods (fixed capital). • All the capital goods utilized are non-durable (working capital). • Only one original factor utilized – labor. Simplifies (but does not affect) the analysis. GDP in a Simple Economy • Each producer/entrepreneur pays wages to the laborers and makes payments to other producers from whom he purchases previously produced inputs (capital goods) • He pays interest to creditors from whom he borrows money to invest. (Interest may be imputed, i.e., paid to himself if he invests his own past earnings). • The entrepreneur earns a profit when he sells his product to either another entrepreneur (a capital good) or to consumers (a consumer good). GDP in a Simple Economy • Consider the wheat producers. They pay wages to the laborers hired, interest to creditors and obtain a profit upon selling their wheat (a capital good) to the flour producer. • The flour producers pay money to the wheat producers, hire laborers in exchange for wage payments and earns a profit when they sell their flour to the bakers. • The bakers, in turn, incur expenditure on flour, labor and earns a profit when they sell their bread to the consumers. • Next slide shows assumed figures for these payments. GDP in a Simple Economy Table 2 Payments of wheat producers: $150 as wages (to labor), $50 as interest (to creditors/imputed). Revenue earned by selling wheat (to flour producers): $300. Total profits earned = $100. Payments of flour producers: $300 on wheat (to wheat producers), $100 as wages (to labor), $50 as interest (to creditors). Revenue earned by selling flour (to bread producers): $600. Total profits earned = $150. Payments of bread producers: $600 on flour (to flour producers), $150 as wages (to labor), $50 as interest (to creditors). Revenue earned through sale of bread (to consumers): $1000. Total profits earned = $200. GDP in a Simple Economy • Out of the three goods being produced, only bread qualifies as a “Final Product/Good” since flour and wheat are intermediate goods and are used up in the production of bread. • The product that can be used to satisfy wants in this simple economy during the course of a year is bread, not bread plus flour plus wheat. • It is important to note that Final Goods are a sub-set of all the goods produced in a year. In this simple scenario, only consumer goods are included; intermediate goods/working capital are excluded. GDP in a Simple Economy • The total monetary value of all final goods produced in an economy during a given period of time is defined to be the economy’s Value of National Output or Gross National Product (GDP). • In our example, given that the only final good is bread, the GDP is equivalent to Total Consumer Expenditure (both being $1000). This constitutes the expenditure method of calculating GDP. • Including the value of intermediate goods in our estimate of GDP would involve counting the value of these goods more than once. The value of these goods (wheat and flour) is included in the price of the bread sold. GDP in a Simple Economy Table 2 Payments of wheat producers: $150 as wages (to labor), $50 as interest (to creditors/imputed). Revenue earned by selling wheat (to flour producers): $300. Total profits earned = $100. Payments of flour producers: $300 on wheat (to wheat producers), $100 as wages (to labor), $50 as interest (to creditors). Revenue earned by selling flour (to bread producers): $600. Total profits earned = $150. Payments of bread producers: $600 on flour (to flour producers), $150 as wages (to labor), $50 as interest (to creditors). Revenue earned through sale of bread (to consumers): $1000. Total profits earned = $200. GDP in a Simple Economy • What figure would we get if we simply added up the money value of all the goods produced (intermediate and consumer goods)? • If we estimated GDP this way we would obtain an estimate of $1900 ($1000 for the bread + $600 for the flour + $300 for the wheat). • But if you study the figures in the table closely, you will see that the $1000 worth of bread sold already includes or incorporates the value of the flour and the wheat used in producing it. Similarly, the value of the flour already includes the value of the wheat used in producing it. • This method of estimating GDP involves double counting the value of flour and triple counting the value of wheat. GDP in a Simple Economy • GDP can also be estimated using the income method. This involves adding up the incomes earned in every production process. • GDP = wages + interest + profit earned in production of wheat, flour and bread. • GDP = $600 (bread) + $300 (flour) + $300 (wheat) = $1000. • Total income generated in a production process also called “value added.” Value added = Value of product – value of inputs purchased from other producers. • The product or output method of calculating GDP involves summing up the value added in all production processes. Inventories • Let us now drop the assumption that the entire money value of all the goods produced in a year are used up in the production of bread. • Instead, let us assume that firms maintain inventories of unused goods with the intention of utilizing them the following year. • In order to obtain an accurate picture of GDP (by all the three methods) in this more complicated world we introduce and analyze the concept of investment expenditure. Inventories Table 1 (Year 1) Payments of wheat producers (on unsold wheat held as inventory): $150 as wages (to labor), $50 as interest (to creditors). Market value of unsold wheat: $300. Implicit profit earned: $100 Payments of wheat producers: $150 as wages (to labor), $50 as interest (to creditors). Revenue earned by selling wheat (to flour producers): $300. Total profits earned = $100. Payments of flour producers: $300 to wheat producers, $100 as wages (to labor), $50 as interest (to creditors). Revenue earned by selling flour (to bread producers): $600. Total profits earned = $150. Payments of bread producers: $600 to flour producers, $150 as wages (to labor), $50 as interest (to creditors). Revenue earned through sale of bread (to consumers): $1000. Total profits earned = $200. Inventories • Table 1 presents our simple economy but with the inclusion of unsold wheat held as inventory. • The total value of wheat produced is $600. Only half of this is sold ($300) is sold to the flour producers. The other half remains unsold and is held and carried over to the following year by the wheat producers. • What implications does the introduction of this unsold wheat have for the calculation of this economy’s GDP? Inventories • Consider the income method first. Given that this method sums up all incomes earned, the introduction of inventories does not introduce substantial complications. • All the incomes paid by all producers are still summed up, regardless of whether these incomes were generated on goods actually sold or on unsold goods. • The only complication arises with the calculation of profits on the unsold wheat, this profit being unearned and therefore implicit. • GDP by this method = $1300 (extra $300 net incomes on wheat held as inventory). Inventories • Consider now the expenditure method. If we continue to include only consumption expenditure, then GDP remains $1000. • A mismatch between this figure and that calculated by the income method. • To obtain equality, final goods broadened to include unsold goods carried over into following year/period. • Final goods now includes bread produced and sold and the unsold wheat. • A new category of expenditure – investment expenditure is therefore introduced. Inventories • The entire amount of unsold wheat held as inventory is valued at the prevailing market price. The market value of the unsold stock is $300. • By holding this unsold stock, the wheat producers have implicitly expended money on it (not selling something and holding it instead is equivalent to buying at the prevailing price). • Thus, the value of unsold wheat is counted as investment expenditure. • GDP = $1300 = $1000 (consumption expenditure) and $300 (investment expenditure). Inventories • Treatment would be identical regardless of which good remains unsold. • If flour producers hold some amount of flour as inventory, then net incomes earned on it included in income method, market value of unsold flour counted as part of investment expenditure, unsold flour included in final goods. • Likewise if the consumer good – bread – remains unsold at the end of the year. Market value of unsold consumer goods counted as part of investment expenditure. Inventories • While additions to inventories are included in the GDP of that year, the money value of inventories brought forward from the previous year and used up in production this year is deducted from current GDP. • As an illustration of this, assume that Table 1 was a depiction of production in year 1. But Table 2 (next slide) depicts production in year 2. • In year 2 there are no unsold stocks and no additions to inventories. But assume that the $300 worth of wheat used this year is actually the unsold wheat from year 1. Inventories Table 2 (Year 2) Payments of wheat producers: $150 as wages (to labor), $50 as interest (to creditors/imputed). Revenue earned by selling wheat (to flour producers): $300. Total profits earned = $100. Payments of flour producers: $300 to wheat producers, $100 as wages (to labor), $50 as interest (to creditors). Revenue earned by selling flour (to bread producer): $600. Total profits earned = $150. Payments of bread producers: $600 to flour producers, $150 as wages (to labor), $50 as interest (to creditors). Revenue earned through sale of bread (to consumers): $1000. Total profits earned = $200. Inventories • Thus, in year 2 no wheat was actually produced. All the wheat utilized consisted of the running down of the inventory carried over from year 1. • So, the $300 worth of incomes earned in wheat production were really not generated this year, but in the previous year. • Similarly, investment expenditure for this year is actually -$300 (since inventories were exhausted) and $300 worth of the final good (bread) were in essence produced in the previous year. • Thus, by both methods, GDP for year 2 = $700 ...
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