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Question 1.
When we calculate GDP we do not include intermediate goods. We also leave out things like securities (stocks and bonds) and we leave out used goods. Would it be more or less accurate for economists to include some or all of these? Explain what issues arise in each of these three cases if they were to be included in our measure of GDP.
Answer:
The Gross Domestic product GDP for any country is given by sum total of value of all the finished goods produced by the given country in the given period. Thus GDP indicates the size of the economy. GDP calculation happens in 2 main ways, incremental value generation or the value of the total finished goods. In both the cases only the final output is calculated.
We exclude the following while calculating the GDP.
Intermediate Goods:
An intermediate good is a good or service that is used in the eventual production of a final good or finished product. Intermediate goods are not fully counted but the incremental value generated at each level for intermediate good is calculated.
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For Example:
A bread worth of 100 Dollar is made up of only wheat floor. The farmer grows the Wheat and sells to the milling company at 30 dollar thus $30 is calculated for GDP. The milling company sells the flour at 60 dollars to the bakery, hence adds $30 value which is calculated. The bakery sells the finished bread at $100 to the seller, thus adds $ 40 of value which is added to GDP. The total of value generated is 30 + 30 + 40 = 100 which is equal to the cost of the finished good. Instead of that if total value of intermediate goods is taken the GDP would be 30 + 60 + 100 = 190, which is not exactly the worth of the final good produced by the process.
To avoid multiple counting of the same item, only Finished Goods are calculated in GDP.
Stocks and Bonds:
The value of the Stocks and Bonds are notional, as it is derived by the demand and supply forces acting on it. The Stocks and Bonds do not indicate the real value of the company. The real items like plant and machinery, employment produced, goods produced are counted for GDP.
If a company is doing well then there will be rise in the stock price, which is not calculated. But when the company does well it produces more at higher efficiency thus leading to higher value of finished product which increases the GDP value. Thus Stocks and Bonds are also not calculated in GDP calculation.
Question 2.
Economists use the market value of aggregate output to facilitate comparisons across years rather than just the amount of output itself. Why is that? This is not a perfect solution. What issues arise when we try to compare market values of aggregate output across time periods? How do macroeconomists attempt to address this issue?
Answer:
The real value of any good in the past is never same as the value of the good at present. Thus to compare the aggregated output, the economists convert the output to current market value because of 2 reasons.
Inflation:
A sustained increase in price levels of all the goods over a period of time. This is caused due to increased level of money supply in economy.
Time Value Of money:
Due to the above inflationary effect the quantity of any good that can be bought today for x amount of money is always more than the quantity of the same good that can be bought later with x amount of money.
In order to account for the effects of above 2 things, the aggregate output of past is discounted by multiplying with a multiplication factor that accounts for inflation and time value of money. Thus aggregated output is first converted into today’s market value. Now they can be compared as all are now on a same base of inflationary and Time value of money factors.
Question 3.
Suppose you take cash from your piggy-bank (or sofa cushions) and deposit it into a bank thereby removing this currency from circulation. Does this have the effect of reducing the money supply? Explain your reasoning.
Answer:
Money Supply includes entire stock of currency that a country’s economy at any particular time holds in bank. This currency can be in the form of any liquefiable asset. But when any person keeps this money as savings with himself then it is not a part of money supply. Money supply needs to be in rotation and hence have to be open for transaction.
When any person removes the money from his personal savings in M1 money (cash) – here Piggy bank and converts into bank savings, he brings back the money into rotation. The money in the saving account of the person can now be lent to some borrower, who in turn through money multiplier process pass this money down into the economy creating a manifold increase in money supply from a small increase in money supply.
Thus, when a person transfers the personal savings in M1 money from his premise to a bank account, the money supply in the economy increases.
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Place Your OrderQuestion 4.
Describe the monetary multiplier and the relationship between it and the reserve ratio. An individual bank only makes loans up to the amount of its excess reserves. Suppose it receives a deposit of $1000, if it's required to hold 10% it cannot lend out more than $900. If it does otherwise, it runs the risk of over-extending itself. But we know that we use the multiplier to calculate the loans possible from the entire financial system of banks. Explain the reasoning behind this difference and why the system is able to create so much money.
Answer:
Monetary Multiplier:
Money multiplier is the ratio of the commercial bank money to the central bank money. With every dollar of money injected by the central bank there is manifold increase in the money supply in actual. This is due to the money multiplier effect.
Reserve Ratio:
In a fractional banking system where in a commercial bank is required to keep a certain fraction of the gross deposit with the bank as the Reserve, the money multiplier is equal to the inverse of the Reserve ratio. Thus Reserve ratio is given by:
R.R. = 1/M.M.
Where R.R. is money multiplier and R.R. is reserve ratio is fraction banking system.
In the Example given:
With injection of $1000 with a bank, after fulfilling the Reserve requirement the bank can lend $900 dollar further. When the borrower gets $900, he deposits into another bank. After reserve requirement of 10% fulfillment the bank can lend 810 further to borrower 2. Borrower 2 in turn deposits this money in bank, out of this 810$ the bank can in turn lend $729 further. This cycle continues infinitely causing a multiplier effect.
Empirically M.M. = 1/R.R.
Thus with a 10% of Reserve ratio the effective money supply created is 10 times the money actually injected.
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