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The Weekend Quiz – October 15-16, 2022 – answers and discussion – Bill Mitchell – Modern Monetary Theory

Here are the answers with discussion for this Weekend’s Quiz. The information provided should help you work out why you missed a question or three! If you haven’t already done the Quiz from yesterday then have a go at it before you read the answers. I hope this helps you develop an understanding of Modern Monetary Theory (MMT) and its application to macroeconomic thinking. Comments as usual welcome, especially if I have made an error.

These were the Quiz questions for the first week of my edx MOOC – Modern Monetary Theory: Economics for the 21st Century – that finished up this week.

I promised students that I would provide answers and analysis for them after the course finished. So over the next 4 weeks that is what I will do as the ‘Weekend Quiz’.

Question 1:

Which of the following would add to GDP in any on period?

  1. (a) The purchase of some strawberries from the supermarket.
  2. (b) The payment by the national government for public servants in the tax department.
  3. (c) The payment by the national government to an aged pension recipient.
  4. (d) The purchase of an old model car from a car dealer.
  5. (e) The purchase of some house paint by an owner occupier as part of a refurbishment project.
  6. (f) The purchase of some house paint by a professional painting tradesperson as part of a refurbishment project.
  7. (g) The sale of some military equipment to another country.
  8. (h) The purchase of some shares in an airline company.

The answer is a, b, e, g

GDP is the market value of all final goods and services produced in a given period.

So it must be a market value and a final rather than an intermediate good or service.

It must also be something that is produced in the relevant period.

It cannot be an intermediate good.

It cannot be a transfer of income.

It cannot be a financial asset, which is not produced.

So GDP in the current period would not count:

Option (c) – which is just a redistribution of income generated not new income.

Option (d) the second hand car, which would have been counted in the GDP for the period it was produced but not this period.

Option (f) which would be considered an intermediate good. The final value of the painting by the tradesperson would be counted though.

Option (h) is a financial market transaction – there is no production.

Question 2:

Suppose an economy produces two products: Product A and Product B. The National Accounts data is presented in the following table.

Using that data, how much has the economy grown between Year 1 and Year 2?

(a) 5 per cent
(b) 15 per cent
(c) 20 per cent
(d) 100 per cent
(e) Cannot tell from the information given

Dataset – National Accounts

Sectoral Balance Year 1 Price Per Unit ($) Year 1 Output (units) Year 2 Price Per Unit ($) Year 2 Output (units)
Product A 1.00 20 2.50 10
Product B 2.00 15 3.00 25

The answer is c – 20 per cent

The System of National Income and Product Accounts (NIPA) is the framework assembled by national statisticians for measuring economic activity. The most important measure of production is Gross Domestic Product or GDP, which is the measure of all final goods and services evaluated at market prices which are produced per period of time, say a quarter or a year.

We call this the nominal GDP measure because it relates to current prices.

In the example provided, nominal GDP would be:

Year 1: (20 x $1.00) + (15 x $2.00) = $50

Year 2: (10 x $2.50) + (25 x $3.00) = $100

Change in nominal GDP = 100 per cent.

But when we talk about economic growth, we are referring to another concept – real GDP.

We need to understand that growth in GDP over time can be influenced by changes in market prices as well as output changes.

If we find that nominal GDP today is 100 times greater than it was a hundred years ago, does that mean that we enjoy 100 times more physical output?

Clearly not if prices have also risen.

Economists have devised ways of separating out the price change component of GDP increase from the actual output change.

The techniques used by the statistician in this regard go beyond our focus here.

The important point to understand is that ‘real’ GDP corrects the nominal GDP measure for changes in prices.

Thus, when we speak of economic growth, we are using the real GDP measure which has purged any price change impacts over time.

In the video accompanying the course in this section, I had some apples and oranges and we conducted the above experiment.

To isolate the output effects from the price effects, we would ask if prices were unchanged, what would the GDP measure be in Year 2.

If we do that calculation we are effectively computing a ‘constant price’ or ‘fixed price’ measure of GDP – which we call real GDP.

So to answer the question we need to do that calculation:

Year 1: (20 x $1.00) + (15 x $2.00) = $50 (so real and nominal GDP are identical at this point)

Year 2: (10 x $1.00) + (25 x $2.00) = $60 (this is real GDP in Year 2)

Change in real GDP = $10 or 20 per cent.

Question 3:

If the output an economy can achieve when all resources are productively employed is $120 billion and in the current year actual real GDP is on $114 billion, the output gap would be:

(a) 2 per cent
(b) 4 per cent
(c) 5 per cent
(d) 6 per cent

The answer is c – 5 per cent

If all the productive resources – labour, land, capital – are being fully utilised in production then we say that the economy is operating at full capacity or at its potential.

The difference between actual real GDP level in any period and Potential GDP level is the output gap, which is the percentage deviation of actual output from potential.

1. Potential GDP = $120 billion.

2. Actual GDP = $114 billion.

3. Output gap = Difference between actual and potential expressed as a percentage of potential.

4. So, 100 times (120 – 114)/120 = 5 per cent.

Question 4:

The reason that economy-wide wage cuts will not reduce unemployment relates to the observation that:

(a) Wages are both an income to workers and a cost to firms.
(b) Workers will go on strike if their wages are cut.
(c) Cutting wages will reduce import expenditure.
(d) Firms know that if they cut wages, they will damage their reputation.

The answer is Option (a)

Prior to the 1930s, there was no separate field of study called macroeconomics.

The dominant neoclassical school of thought in economics at the time considered that to make statements about the economy as a whole (the domain of macroeconomics) one could just infer from reasoning conducted at the individual unit or atomistic level.

This reasoning was rejected in the 1930s, and macroeconomics became a separate discipline precisely because the dominant way of thinking at the time, blithely transposing microeconomic truisms to the macro scale, was riddled with errors of logic that led to spurious analytical reasoning and poor policy advice.

Microeconomics develops theories about individual behavioural units in the economy – at the level of the person, household, or firm. For example, it might seek to explain the employment decisions of a firm or the saving decisions of an individual income recipient. However, microeconomic theory ignores knock-on effects on others when examining these firm- or household-level decisions. That is clearly inappropriate if we look at the macroeconomy, where we must consider these wider impacts.

During the Great Depression, British economist John Maynard Keynes and others considered that by ignoring these interdependencies (knock-on effects), economists were creating a compositional fallacy.

Compositional fallacies are errors in logic that arise when we infer that something which is true at the individual level, is also true at the aggregate level.

The fallacy of composition arises here when actions that are logical, correct and/or rational at the individual level are found to have no logic (and may be wrong and/or irrational) at the aggregate level.

In the video that was relevant to this question, we discussed the paradox of thrift and another fallacy concerning the use of economy-wide wage cuts to improve employment prospects.

In the latter case, the superintendency that creates the logical flaw is that wages are not only a cost of production but also a major source of income, which determines consumption expenditure.

The dominant view was that the mass unemployment that had skyrocketed in the early 1930s could only be solved by wage cuts.

Their reasoning was based on their analysis of single firm decision-making. They believed we could generalise from firm-specific analysis.

Say we start with a single firm employing a few workers.

If the firm can persuade its workers to accept lower wages, then its labour costs will fall.

The loss of income of its workers as a result of the wage cuts, will, in the overall scheme of things, be inconsequential for the total sales of the firm.

Accordingly, with lower labour costs and no loss of sales, the firm will increase its profits, Neoclassical economists then asserted that the firm would then employ more workers.

Thus, the neoclassical solution to unemployment was to always engineer a wage cut.

This view was disputed by Keynes and others during the Great Depression, when the British Treasury engineered a wage cut for all workers and unemployment became worse.

Keynes asked the question: what would happen if we extended the individual logic to the economy as a whole?

What would happen if all the firms cut the wages for all workers in an effort to reduce unemployment?

Keynes opposed this solution during the Great Depression of the 1930s as neoclassical economists pressured governments to cut wages.

But this is no idle historical exercise.

The strategy remains a solution advocated by mainstream economists today.

The fallacy relates to the observation by Keynes that wages are both a cost item (supply-side), AND, a source of income (demand-side).

The neoclassical reasoning failed to account for the second characteristic.

Let’s see what this means.

If all firms cut their wages, then labour costs throughout the economy will decline.

Neoclassical reasoning was that this would boost profits and businesses would start hiring the unemployed to produce more output and generate even greater profits.

But the dual nature of wages, meant that all workers now had less income, which meant that they could consume less. Consumption expenditure is the largest component of total spending in the economy (around 60 per cent of total).

As workers cut their spending, sales would fall, and, profits would start to decline.

Firms would note the unsold goods on their shelves and would cut back production and lay off workers. Firms only hire workers if they can sell the extra output produced.

So, the laid off workers would then lose their incomes and the problem would get worse.

Consequently, unemployment starts to rise, and, unless there is a spending stimulus from government, the economy will quickly enter recession.

The point is that the individual logic, even if true, cannot be applied at the aggregate level.

Mass unemployment is always the result of insufficient total spending and can be resolved by governments increasing spending if the non-government sector spending falls. Wages cuts are not a macroeconomic solution.

Question 5:

Which nations will be considered to have the highest GDP over the year?

  1. (a) A military-inclined nation that produces $130 billion worth of new tanks and jet fighters in addition to $100 billion worth of all other final goods and services.
  2. (b) A nation that produces no military equipment, but instead, creates a new renewable industry that produces $200 billion worth of new solar panels, pays $20 billion out to old aged pensioners, and produces and additional $30 billion worth of all other final goods and services.
  3. (c) A social democratic nation that produces $10 billion worth of new military equipment, builds $50 billion worth of new schools and universities, and produces an addition $170 billion worth of all other final goods and services.
  4. (d) A nation where the government spends $40 billion in environmental restoration projects, businesses purchase new machinery and equipment worth $30 billion, export sales to the rest of the world equal $60 billion and consumers purchase $100 billion worth of final goods and services.
  5. (e) They all have the same level of production.

The answer is Option (e) They all have the same level of production

To answer the question, we have to calculate the real GDP in each case.

Nation A: GDP = $230 billion.

Nation B: GDP = $230 billion (we exclude the $20 billion transfer to old age pensioners).

Nation C: GDP = $230 billion.

Nation D: GDP = $230 billion.

The composition and quality of the production is very different across the 4 nations and that allowed us to have a discussion about the deficiencies of the GDP measure.

But the fact is they all record the same GDP in the year.

That is enough for today!

(c) Copyright 2022 William Mitchell. All Rights Reserved.

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