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Give two reasons why the official figures for National Income (GDP) may understate the true level of economic activity.

Why is GDP calculated in both real and nominal terms?

What does Real GDP per capita show?

Explain two limitations of Real GDP per capita as a measure of a country’s economic well-being.

Consumer Price Index (CPI)

Consumer price index (CPI) measures the weighted mean of prices of a bundle of consumer products like food and medical care. Through considering price changes for every product and averaging them, this CPI is measured (Powell et al., 2018). In New Zealand, this index measures the changing rate of price of products brought by households. Formula for calculating this CPI in New Zealand is as follows:

Consumer Price Index (CPI) = (Cost of market basket at present year/ Cost of market at base year) *100

The CPI index in year1 is 1080 and in year 2, this index is 1119. Hence, the rate of inflation is as follows:

            Inflation rate of year 2 = (CPI of year 2 – CPI of year 1)/ CPI of year 1 * 100

                                     = (1119- 1080)/ 1080 * 100

                                     = 39/ 1080 * 100

                                     = 0.036 * 100

                                                 = 3.6

To determine gross domestic product (GDP), two methods can be used , viz., expenditure method and income method (Konchitchki & Patatoukas, 2014).

To calculate GDP ($m) by expenditure method, following components will be considered:

 Final government consumption expenditure =  6200

 Final household consumption expenditure = 23100

 Changes in inventories = 1300

 Gross fixed capital formation = 9500

 (Exports – Imports) = (13300 – 15100) = -1800

 GDP (expenditure method) = 6200 + 23100 + 1300 + 9500 – 1800

 GDP (expenditure method) = 38300

To calculate this GDP ($m) by income method, following components will be considered:

 Compensation of employees = 18900

 Gross operating surplus = 15700

 Taxes on production and imports = 4500

 Subsidies = 600

GDP (income method) = 18900 + 15700 + 4500 – 600

GDP (income method) = 38500

Difference between GDP (income method) and GDP (expenditure method) calls statistical discrepancy, which is given as 200 and is proved from the difference between two values of GDP.

38500 – 38300 = 200

Situation

Included or Excluded

(in the calculation of GDP)

(i)     The voluntary work of a group in cleaning up a local reserve.

Excluded

(ii)    Activities of the underground economy.

Excluded

(iii)   The purchase of alcohol for a party.

Included

(iv)   The money spent on cleaning up the mess resulting from a road accident and hospital care for injured passengers.

Including

(v)    The proceeds from illegal activities that do not go through a market.

Excluded

(vi)    Spending by the government on new motorways out of all the main centers.

Including

(vii)   A student renting a video for the weekend.

Including

(viii)  Non-market activity such as growing your own vegetables or paving your own driveway.

Excluding

(ix)    A business upgrading its computer network.

Excluding

(x)     An electrician does the wiring for his neighbor (a plumber) in exchange for unblocking his drain, i.e. payments in kind.

Excluding

(xi)    A builder build a block of flats.

Including

(xii)   Paying for electricity.

Including

Two reasons, where GDP understates the true level of economic activity can be described as follows:

  1. i) This indicator represents standard of living of a society however, this rough measurement does not consider the direct account of environmental quality and leisure, standard of education and health and changing inequality of income and so on (Feldstein, 2017).
  2. ii) The GDP of any country does not consider non-market products as the economy produces those goods but these are not exchanged in market.

The chief difference between real GDP and nominal GDP is that the first type of GDP indicator is inflation adjusted while the second one does not consider the value of inflation. Real GDP can measure the changes in price level and gives proper figure of economic growth (Pan, Wang, Wang & Yang, 2018). Nominal GDP, on the other side, represents the value of national income for a particular year considering inflation.

Real GDP per capita measures total output of a country, which considers the gross domestic product (GDP) divided by the number of population of that country (Feldstein, 2017). This measurement is useful as it can compare relative performance of different countries.

Thus, Real per capita GDP = Real GDP / total population

Two limitations of Real GDP per capita related to well-being:

Firstly, this real GDP per capita is an average concept and ignores the pattern of income distribution of a country (Feldstein, 2017). Hence, a country with higher income inequality may have higher GDP compare to other countries where GDP is low but income is equally distributed.

Gross Domestic Product (GDP) Calculation Method

Secondly, this per capita measure does not represent spending power of consumers. This is because price level varies country wise.

Hence, from above two limitations it can be said that real GDP per capita cannot measure well-being of a country.

Situation

Direction that AD shifts inward or outward

AD curve does not shift place a cross (X)

(i)

Income tax rates decrease

Shifts outward

(ii)

A rise in business confidence

Shifts outward

(iii)

A larger than expected budget surplus

Shifts outward

(iv)

Interest rates rise as the OCR is raised

Shifts inward

(v)

The government announces that GST will increase in six months time

X

(vi)

New technology

X

(vii)

Costs of production fall

X

(viii)

A fall in business confidence

Shifts inward

(ix)

Transfer payments are increased

Shifts inward

(x)

Next exports $1 912m surplus

Shifts outward

(xi)

The Reserve Bank Governor lowers the OCR and interest rates fall

Shifts outward

(xii)

Contractionary fiscal policy

Shifts inward

(xiii)

A net migration loss

Shifts outward

(xiv)

A budget surplus

Shifts outward

(xv)

A large increase in households starting to save for their retirement

Shifts inward

(xvi)

Consumers go on a spending spree fearing price rises in the future

Shifts outward

Situation

Direction that AS curve will shift inward or outward

AD curve does not shift place a cross (X)

(i)

New technology is developed

Shifts outward

(ii)

Workers’ productivity falls as machinery wears out and depreciates

Shifts inward

(iii)

Workers’ wages rise

Shifts inward

(iv)

New Zealand dollar appreciates resulting in a fall in the price of imported raw materials

Shifts outward

(v)

The government runs a budget surplus

Shifts outward

(vi)

Rising oil prices

Change inward

(vii)

An increase in investment spending by firms

X

(viii)

Household incomes fall

X

(ix)

An increase in GST

Shifts inward

Net immigration can increase aggregate demand of a country and this in turn can shift the AD curve outwards. This is because total expenditure of this economy may increase due to increasing demand of people. Moreover, net immigration increases as most of the people come for searching a job or for obtaining higher education (Mankiw & Reis, 2018). This in turn increases labor force and. As a result, aggregate supply curve increases as well. Figure 1 represents this where AD curve shifts from AD0 to AD1. On the other side, aggregate supply curve also increases from AS0 to AS1.  

Event

AD-AS Model

Effect on real GDP, inflation (CPI). And unemployment level

A fall in business confidence

· Real GDP falls

· Negative inflation

· Unemployment rate increases

A large increase in households starting to save for their retirement

· Real GDP falls

· Negative inflation

· Unemployment rate increases

A rise in business confidence

· Real GDP increases

· Inflation

· Unemployment rate increases

Increase in transfer payment leads the aggregate demand curve outwards, which in turn increases real GDP. According to business cycle, real GDP increases during expansionary phase when the economy experiences economic growth along with inflation (Mankiw & Reis, 2018).  In figure 3, real GDP increases from Y0 Y1 showing economic growth while price increase in price level from P0 to P0 indicates inflation.  

Advantages:

 Due to fastest economic growth in property market, consumers can receive more products, which in turn can develop their standard of living. Moreover, poverty level will be reduced as well.

Disadvantages:

  1. i) Fastest growth of an economy increases the aggregate demand by large extend compare to aggregate supply and consequently price level can increase further. This may cause inflation within the economy.
  2. ii) Economic growth in property market can generate environmental problems and consequently negative externalities generate within the economy. Due to infrastructural development, pollution can be generated as well.

Due to inflation, macroeconomic objective related to price stability and sustainable economic growth cannot be achieved (Csereklyei, Thurner, Bauer & Küchenhoff, 2016). In addition to this, negative externalities can also affect sustainable economic growth adversely

Source: (created by author)

Reduction in OCR tends the aggregate demand curve of New Zealand outward implying increase in demand from AD0 to AD1.  

Monetary policy includes some actions that central bank of any country takes to control monetary and financial situations for obtaining sustainable economic growth and low level of inflation (Dosi et al., 2015).

Official Cash Rate (OCR) means the interest rate, which the central bank of New Zealand set to meet the targeted inflation, specified in the policy targets Agreements (PTA). The OCR affects the price related to borrowing money and helps the central bank of this country to influence the inflation and economic activity.

In this given scenario, expansionary monetary policy has been conducted by decreasing the interest rate. As a result, the economy of NZ can experience increase in domestic national income, increasing demand for imports and decrease in domestic currency exchange rate.

Tax cut increases consumption of households and this further increases aggregate demand of New Zealand. As a result, the demand curve shifts from AD0 to AD1.

In this context, the government of NZ has adopted expansionary fiscal policy to stimulate economic growth and to control inflationary prices.

Through taking this form of fiscal policy, the government can increase aggregate output of the country (Dosi et al., 2015). This happens because of increasing demand as people can purchase more products now compare to before.

OUTPUT PER WORKER PER ANNUM

WOOL

FISH

NZ

60/90 = 0.67

90/60= 1.5

AUSTRALIA

50/30= 1.67

30/50= 0.6

Limitations of Using Real GDP Per Capita

According to the table, calculation of comparative advantage for New Zealand

60 wools cost 90 fish

  • 1 wools cost 60/90 = 0.67 fishes

On the other side,

            90 fishes cost 60 wools

  • 1 fish costs 90/60 = 1.5 wools

For Australia,

50 wools cost 30 fish

  • 1 wool cost  50/30 = 1.67 fishes

30 fish cost 50 wools

  • 1 fish costs 30/50 = 0.6 wools

  According to this calculation, New Zealand has comparative advantage to produce wools.

Australia has comparative advantage to produce fish.

It is a good idea for both NZ and Australia to trade fish and wools. Through this trade process, a country can specialize on a particular product and consequently it can produce this product by large number with limited resources. This further can help this country to export excess product on other countries (Levchenko & Zhang, 2016). This is also true for NZ and Australia. With limited labor, capital and other resources, it will be difficult for both countries to produce two products by large amount. However, these two countries can increase their consumption level for both goods by doing trade.

Exporting chilled meats of New Zealand in China may bring some negative impacts on consumers of exporting country and producers of importing country. One possible disadvantage is reduction of consumer surplus in New Zealand due to higher prices of chilled meat in market. As producers will export this product in other country, supply of it will reduce in domestic market. However, demand will be at same level or may increase further. Due to this excess demand but limited supply of chilled meat, price will be increased and NZ consumers will face disadvantage. On the other side, producer surplus in China will be reduced as well. Due to excess supply of chilled meat with higher quality from NZ, competition will be increased in chilled meat market of China (Levchenko & Zhang, 2016). As a result, domestic producers will reduce prices for this product and this in turn will decrease the amount of revenue for them.

  • Export of goods= Current account (credit)
  • Import of good= Current account (Debit)
  • Import of service= Current account ( Debit)
  • Export of service= Current account ( Credit)
  • Investment income receipt= Capital account (credit)
  • Investment income payment= Capital account ( Debit)
  • Balance of current transfers= Current account (Credit)

Transactions

Category

(i)

Foreign tourist using domestic airline.

Export of service

(ii)

Premium paid to an overseas insurance company.

Investment income receipt

(iii)

Interest paid by domestic companies for foreign bank loans.

Export of Service

(iv)

Aluminium hub caps sold in Detroit by a New Zealand firm.

Export of goods

(v)

Foreign aid to a tsunami ravaged Pacific neighbor.

Balance of current transfer

(vi)

Dividends received by domestic shareholders from overseas.

Investment income receipt

(vii)

A New Zealand firm buys cars from Japan.

Import of goods

(viii)

A New Zealand flies on a plane operated by Singapore Airlines.

Import of service

(ix)

An Australian firm uses a New Zealand firm to ship its produce to an Asian destination.

Import of service

The current account of New Zealand can be affected positively after hosting the 2021 America’s cup. Through this event, the country can export its service to other countries and this can increase the credit side of export service (Febrero, Uxó & Bermejo, 2018). Moreover, foreign visitors will buy products along with match tickets in New Zealand and this will increase the credit side of export of goods as well.

Situation

Demand for $NZ or supply of $NZ?

Direction of shift

Appreciation or depreciation of $NZ?

(i)

New Zealand tourist traveling overseas

Supply of $NZ

Supply curve will shift rightward

Depreciation of $NZ

(ii)

New Zealand importers paying for raw materials

Supply of $NZ

Supply curve will shift rightward

Depreciation of $NZ

(iii)

New Zealand firm setting up in Fiji

Supply of $NZ

Supply curve will shift rightward

Depreciation of $NZ

(iv)

The Fijian government buying New Zealand goods and services

Demand for $NZ

Demand curve shifts outward

Appreciation of $NZ

(v)

Loss of overseas markets for New Zealand

Demand for $NZ

Demand curve shifts inward

Depreciation of $NZ

NZ dollar depreciates compare to the U.S dollar. Hence, export of NZ will be increased with the U.S while imports will be reduced. On the contrary, NZ dollar appreciates with respect to the AUD. Hence, exports of NZ with Australia will be decreased but imports will be increased.  

Strong NZ dollar means exchange rate of this country is high compare to other countries. As a result, going to NZ for higher education can be costly for students of other countries. As a result, the number of international students in this country will be decreased and international education industry will suffer from a huge loss.

The expansionary monetary policy can reduce the exchange rate through lowering interest rates and increasing money supply. Huge supply of money can depreciate the currency value and consequently exchange rate can be decreased (Febrero, Uxó & Bermejo, 2018). On the contrary, contractionary monetary policy reduces the money supply in market and this in turn causes currency appreciation and exchange rate to increase further.

Recession in the U.S.A depreciates the value of U.S dollar. As a result, exchange rate between New Zealand and US.A increases. Thus, exports of NZ product will be decreased in U.S.A and other countries and consequently aggregate demand of NZ will also be decreased. This further decreases the price level of this country.

Due to increase in interest rate, value of NZ dollar appreciates and this in turn can influence foreign investors to invest more money in this country. Hence, demand for NZ will be increases as shown in above figure. In this figure, demand curve for NZ dollar shifts from D0 to D1 for representing this outcome.

Due to increase in export, exchange rate of New Zealand can be decreased, which implies currency depreciation. As a result, the country will earn higher revenue because of its developing terms of trade. Thus, the demand for NZ dollar will be increased further as shown in above figure.

References:

Csereklyei, Z., Thurner, P. W., Bauer, A., & Küchenhoff, H. (2016). The effect of economic growth, oil prices, and the benefits of reactor standardization: Duration of nuclear power plant construction revisited. Energy Policy, 91, 49-59.

Dosi, G., Fagiolo, G., Napoletano, M., Roventini, A., & Treibich, T. (2015). Fiscal and monetary policies in complex evolving economies. Journal of Economic Dynamics and Control, 52, 166-189.

Febrero, E., Uxó, J., & Bermejo, F. (2018). The financial crisis in the eurozone: a balance-of-payments crisis with a single currency?. Review of Keynesian Economics, 6(2), 221-239.

Feldstein, M. (2017). Underestimating the real growth of GDP, personal income, and productivity. Journal of Economic Perspectives, 31(2), 145-64.

Konchitchki, Y., & Patatoukas, P. N. (2014). Accounting earnings and gross domestic product. Journal of Accounting and Economics, 57(1), 76-88.

Levchenko, A. A., & Zhang, J. (2016). The evolution of comparative advantage: Measurement and welfare implications. Journal of Monetary Economics, 78, 96-111.

Mankiw, N. G., & Reis, R. (2018). Friedman's presidential address in the evolution of macroeconomic thought. Journal of Economic Perspectives, 32(1), 81-96.

Pan, Z., Wang, Q., Wang, Y., & Yang, L. (2018). Forecasting US real GDP using oil prices: A time-varying parameter MIDAS model. Energy Economics, 72, 177-187.

Powell, B., Nason, G., Elliott, D., Mayhew, M., Davies, J., & Winton, J. (2018). Tracking and modelling prices using web?scraped price microdata: towards automated daily consumer price index forecasting. Journal of the Royal Statistical Society: Series A (Statistics in Society), 181(3), 737-756.

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