5

Theory and measurement in the macroeconomy

Theory and measurement in

the macroeconomy
Supplement

Self-assessment task 5.7 (page 191)

Which of the following should be included in measuring GDP by the income method:
government subsidies to farmers
the pay of civil servants
the pay of nurses
supernormal prots
state pensions?
The pay of civil servants, the pay of nurses and supernormal prots should be included in measuring
GDP by the income method. These are all payments received in return for providing a good or service.
Government subsidies to farmers and state pensions are transfer payments.

Self-assessment task 5.8 (page 192)

In 2008 a countrys GDP is $1000 billion. In 2009 nominal GDP rises to $1092 billion and the price index
increases by 4%. Calculate:
a real GDP

real GDP = money GDP

So $1092 bn

price index in base year

price index in current year

100
= $1050 bn
104

b the percentage increase in real GDP.

The percentage increase in real GDP is $50 bn/$1000 bn = 5%.

Self-assessment task 5.9 (page 194)

1 Explain what is meant by sustainable economic growth.
Sustainable growth is growth which can be maintained year after year and generation after
generation. In the short term this means that both aggregate demand and aggregate supply increase
in line with each other so that an output gap does not develop. In the longer term it means that
growth is achieved in a way that will not endanger future generations ability to experience economic
growth. For example, a rapid depletion of oil reserves may harm the growth prospects of many
countries, unless sufcient progress is made in developing alternative sources of fuel.
2 What evidence is provided in the feature to suggest that Ghanas economic growth is not sustainable?
The extract indicates that Ghana is destroying its forests at too rapid a rate. Farmers, timber merchants
and loggers are cutting down trees and digging up forest areas at a such a rate that they cannot be
replaced. This means that they are threatening the future viability of two of the countries main
industries, logging and tourism.

Original material Cambridge University Press 2010

Theory and measurement in the macroeconomy

Self-assessment task 5.10 (page 199)

1 Explain what is meant by purchasing power parity.
Purchasing power parity involves adjusting exchange rates to reect price levels in different countries.
For example, the actual exchange rate between Bangladeshs taka and the US$ may be 70 taka = $1. If,
however, the same basket of goods costs 12 000 taka in Bangladesh and $200 in the US, the exchange
rate based on purchasing power parity would be 60 taka = $1.
2 Explain what effect using an undervalued exchange rate for the Polish zloty would have when comparing
the GDP of the Poland with that of the USA.
An undervalued exchange rate for the Polish zloty would result in Polands GDP seeming relatively low
when compared to the GDP of the USA. For instance, the true value of the zloty may be 3Zl per $1 but
the actual rate may be 5Zl per $1. This would mean that if Polands GDP is $1 200 billion, it would be
converted into $240 billion using the actual exchange rate whereas the true exchange rate would give
a value of $400 billion.
3 Explain how information on the purchasing power parity of wage rates can be used to draw conclusions about
the cost of living in different countries.
Information on the purchasing power parity of wage rates indicates how much the wages can
purchase. If the purchasing power is high, it would suggest relatively high living standards.

Self-assessment task 5.11 (page 201)

1 Use Figure 5.16 to compare the difference between HDI and HPI-1.

HDI

DIMENSION
INDICATOR

A long and
healthy life

Knowledge

A decent standard
of living

Life expectancy
at birth

Adult literacy rate Gross enrolment ratio

(GER)

GDP per capita

(PPP US$)

Adult literacy index

DIMENSION
INDEX

GER index

Education index

Life expectancy index

GDP index

Human development index (HDI)

HPI-1

DIMENSION

A long and
healthy life

INDICATOR

Probability at birth
of not surviving
to age 40

Knowledge
Adult illiteracy rate

A decent standard of living

Percentage of population
not using an improved
water source

Percentage of children
under weight-for-age

Deprivation in
a decent standard of living
Human poverty index
for developing countries (HPI-1)

Figure 5.16 Calculating the HDI and HPI-1

The HDI essentially concentrates on what people have whereas the HPI examines what they lack.
Whereas the HDI measures how long people live on average, the HPI considers what proportion of
people will not survive until aged 40. The HDI measures adult literacy. In contrast, the HPI calculates
adult illiteracy. The third component of the HDI is GDP per capita whereas the HPI measures the
deprivation of a decent standard of living but taking into account the proportion of the population
not using an improved water source and the proportion of children underweight for their age.

Original material Cambridge University Press 2010

Theory and measurement in the macroeconomy

2 Table 5.7 shows that Russia has a higher GDP per head than Malaysia, but a lower HDI value. How might
this be explained?

Rank

Country

Life
expectancy at
birth

Adult
literacy
rate

Combined primary,
secondary, tertiary
enrolment

GDP
per head,
PPPUS$

HDI
value

Very high
1

Norway

80.5

99.0

98.6

53 433

0.971

Ireland

79.7

99.0

97.6

44 613

0.965

13

USA

79.1

99.0

92.4

45 592

0.956

23

Singapore

80.2

94.4

n.a.

49 704

0.944

High
43

Hungary

73.3

98.9

90.2

18 755

0.879

66

Malaysia

74.1

91.9

71.5

13 518

0.829

71

Russia

66.2

99.5

81.9

14 690

0.817

81

Mauritius

72.1

87.4

76.9

11 296

0.804

Medium
92

China

72.9

93.3

68.7

5 383

0.772

95

Maldives

71.1

97.0

71.3

5 196

0.771

102

Sri Lanka

74.0

90.8

68.7

4 243

0.759

141

Pakistan

66.2

54.2

39.3

2 496

0.522

Low
176

DR Congo

47.6

67.2

48.2

298

0.389

179

CAR

46.7

48.6

28.6

713

0.369

180

S. Leone

47.3

38.1

44.6

679

0.365

182

Niger

50.8

28.7

27.2

627

0.340

Table 5.7

Human Development Index, 2007

Russia has a higher GDP per head but a lower HDI value because it has a lower life expectancy at birth,
a lower adult literacy rate and a lower school enrolment rate.
3 Make a few notes on how the information produced by the HDI and HPI-1 might be used by UN
policy makers.
The information produced by the HDI and the HPI-1 may be used by the UN to assess living
standards in different countries and to make recommendations on how countries can increase their
development.

Original material Cambridge University Press 2010

Theory and measurement in the macroeconomy

Self-assessment task 5.12 (page 203)

1 Explain why China has found it necessary to increase its budget decit in 2009.
China found it necessary to increase its budget decit in 2009 for a number of reasons. One was
the downturn in economic activity which reduced tax revenue and raised government spending
automatic stabilisers. Other reasons included the Chinese governments attempt to stimulate economic
activity (discretionary scal policy), to cope with a drought and to improve medical care.
2 What are the consequences of successive budget decits for an economy?
Successive budget decits for an economy would increase government borrowing and build up
national debt.

Self-assessment task 5.13 (page 208)

1 How and why is Singapore an open economy?
Singapore is an open economy in the sense that it engages in international trade. Indeed, it is very
heavily involved in international trade with its net exports generating a high proportion of its
aggregate demand, usually around 40%.
2 Explain how Singapores real growth rate is susceptible to external events in the global economy.
As Singapore is such an open economy, its real growth rate is susceptible to external events in the
global economy. If other countries experience a recession, demand for Singapores exports will decline
as Singapore relies on export-led growth.
3 Discuss two factors which could increase another component of Singapores aggregate expenditure.
A cut in income tax and a cut in the rate of interest would both be likely to cause an increase in
consumption. A lower rate of income tax would increase consumers disposable income, enabling
them to spend more. A lower interest rate would tend to encourage spending as it would be cheaper to
borrow and less rewarding to save.

Self-assessment task 5.14 (page 212)

In an economy, mps is 0.1, mrt is 0.1 and mpm is 0.2. GDP is $300 billion. The government raises its spending
by $6 billion in a bid to close a deationary gap of $20 billion. Calculate:
a the value of the multiplier
The multiplier is:
1
1
=
0.1 + 0.1 + 0.2 0.4
= 2.5

b the increase in GDP

GDP will increase by $6 billion 2 = $15 billion.
c whether the injection of extra government spending is sufcient, too high or too low to close the
deationary gap.
The injection is not sufcient. It is too low, by $5 billion, to close the deationary gap.

Original material Cambridge University Press 2010

Theory and measurement in the macroeconomy

Self-assessment task 5.15 (page 212)

1 Calculate the value of the tourism multiplier for the Caribbean, Thailand and India.
The value of the tourism multiplier for the Caribbean is 1/0.8 = 1.25, for Thailand it is 1/0.7 = 1.43
and for India it is 1/0.4 = 2.5.
2 Explain the likely reasons for the differences in the values you have calculated.
The values are different because different proportions of the money spent by tourists leak out of the
economy. For instance, tourists may stay in foreign hotels and eat food brought in from outside the country.
3 Discuss how governments in developing economies might introduce policies to make international tourism
more benecial than seems to be the case.
There is a range of policies developing economies might introduce to make tourism more benecial.
These include setting up their own airlines, subsidising the building of holiday resorts in their
countries and running courses on travel and tourism in state run schools and universities.

Self-assessment task 5.16 (page 216)

A bank keeps a liquidity ratio of 5%. It receives additional cash deposits of $20 000. Calculate:
a the credit multiplier
The credit multiplier is 100/5 = 20.
b the potential increase in total liabilities (deposits)
The potential increase in total liabilities is 20 $20 000 = $400 000.
c the potential increase in bank lending.
The potential increase in bank lending is $400 000 $20 000 = $380 000.

Self-assessment task 5.17 (page 219)

1 Dene liquidity.
Liquidity is the ability to turn an asset into cash quickly without loss. The most liquid asset is
obviously cash.
2 Explain why ooding the markets with liquidity would be expected to keep interest rates low.
Increasing the money supply will raise the money balances households and rms hold. They will use
some of these extra balances to buy government bonds. The extra demand for government bonds will
raise their price and so push down the rate of interest.
3 Discuss the possible effect that the rise in Japanese corporate lending rates may have on investment.
The rise in Japanese corporate lending rates would be expected to reduce investment. Higher interest
rates will increase the opportunity cost of using retained prots to buy capital goods and would reduce
rms expectations of high consumer demand.
4 Explain why cutting interest rates can be as useless as pushing on a string .
Cutting interest rates can be as useless as pushing on a string as if entrepreneurs are
pessimistic about the future lowering interest rates will not encourage them to invest.

Original material Cambridge University Press 2010

Theory and measurement in the macroeconomy

Specimen exam questions (page 220)

1 a

Road building is often undertaken by the government rather than the private sector for a
number of reasons. These include the public nature of some roads, the large capital outlay often
needed, the signicant externalities that can be involved and the impact that road building can
have on a countrys macroeconomic objectives.
Roads which have many entry and exit points and which are relatively empty may be both
non-excludable and non-rival. An inability to exclude free riders may discourage private sector rms
from building and maintaining roads. In practice, however, some roads are operating privately using
tolls. It is also becoming easier to charge for the use of roads with advances in technology such as
smart cards which can be tted into cars to record when and where they are driven.
A more signicant reason in many countries for the involvement of the government in road
building is the high capital expenditure needed. Road building can be very expensive and the
private sector may lack the funds. A government may have larger funds and if it does not it may
be able to borrow from international organisations such as the World Bank.
Private sector rms also base their decisions just on private costs and benets. The
construction and use of roads can generate signicant externalities. Air, noise and visual pollution
may be created, there may be environmental damage and there may be an adverse effect on the
income of railways if they follow a similar route. On the other hand, roads can link communities
and can increase economic activity. A government can undertake a costbenet analysis to nd out
if the social benets arising from constructing the road exceed the social costs.
By building roads to productive rural areas, a government will make it easier and cheaper to
transport agricultural products from rural areas to the cities and capital equipment and other products
from the cities to the rural areas. As a result, incomes should rise in both the rural and urban areas.
A road development programme can have a major impact on an economy. The spending on
the programme will be an injection into the circular ow of income. National income will
increase by a multiple amount. The diagram below shows real GDP rising from Y to Y1.
LRAS

AD1

Price level

AD

P1
P
AD1
AD

Y1

Real GDP

Original material Cambridge University Press 2010

Theory and measurement in the macroeconomy

If, for example, the government spends $10 billion on a road development programme and the
multiplier is 3, real GDP will rise by $30 billion.
People will be employed in the road building programme and the extra income generated will
create jobs for workers in other industries.
The lower transport costs which should arise from the road building programme should
increase the international competitiveness of the countrys products. This, in turn, should increase
the countrys exports. Higher exports will further increase aggregate demand and will reduce any
current account decit.
Lower transport costs will reduce prices or reduce the increase in prices of a wide range of
products. This will reduce inationary pressure.
Improved transport links may also encourage multinational companies to set up in the country.
These companies may create more jobs and contribute to the countrys employment, real GDP and
exports.
Of course, the impact of a road development programme will depend on a number of factors
including the size of the scheme, whether it is built in the most productive areas and how it is
nanced. A larger programme which links previously remote but highly productive rural areas to
urban areas, airports and docks will obviously have more of an impact than a small programme
which builds roads to places which already have reasonable transport links. If the money for the
programme is diverted from educational and health care programmes, the effect on the country
will be less benecial than if the money is extra spending. If the government has borrowed the
money from, for instance, the World Bank it may experience difculties repaying it unless it uses
wisely the extra tax revenue which the scheme should generate through raising real GDP.
2 a An increase in taxation may cause a multiple fall in national income. A rise in income tax, for
instance, would reduce disposable income and so peoples ability to spend. A rise in sales tax may also
reduce consumer expenditure. Lower spending would result in a multiple fall in aggregate demand.
The diagram below shows aggregate demand moving to the left from AD to AD1, causing real
GDP to fall from Y to Y1.
AS

AD

Price level

AD1

P
P1
AD
AD1

Y1

Real GDP

Original material Cambridge University Press 2010

Theory and measurement in the macroeconomy

If corporation tax is raised, investment may decline which may reduce aggregate demand and
aggregate supply, which in turn would reduce real GDP as shown in the diagram below.

AS1

AD

AS

Price level

AD1

AD
AD1
0

Y1

Real GDP

A rise in tax rates, however, increase the marginal rate of tax which would reduce the size of the
multiplier. As a result, the fall in aggregate demand would be reduced.
Whilst a rise in taxes would be expected to reduce national income, this may not necessarily be
the case. If aggregate demand is rising beyond full employment, higher taxes may have more of an
impact on ination than on real national income.
The effect of higher taxes on national income also depends on how much taxes are increased
by, which taxes are increased, how consumers respond and what happens to the other components
of aggregate demand. A large rise in taxes will obviously have more of an impact than a small rise.
A rise in regressive taxes would be expected to have more of an impact on aggregate demand and
so on national income than a rise in progressive taxes. This is because the poor spend a higher
proportion of their disposable income. A relatively high proportion of the tax taken from the rich,
in contrast, may have been saved rather than spent. The impact of increasing indirect taxes on a
range of products will be inuenced by the price elasticity of demand for the products. Indeed, it is
possible that consumers may avoid paying extra tax by switching their purchases to other products
which have not experienced a rise in taxes. Higher taxes matched by an increase in government
spending may lead to a rise in national income. This will occur if the extra government spending
raises the disposable income of those who have a higher marginal propensity to consume than
those who pay the higher taxes.
b A fall in the level of national income might be expected to result in a decline in the standard of
living in the country as it indicates that there is a reduction in goods and services available, This,
however, may not be the case. If population has fallen by more than national income, there may
be more products available per person. It is also important to consider real national income. If the
general price level has fallen, national output of products may have increased despite a fall in
money national income. So it is important to assess real national income per head when assessing
living standards.

Original material Cambridge University Press 2010

Theory and measurement in the macroeconomy

Even if real national income per head falls, it does not necessarily mean that living standards
have fallen. Income may have become more evenly distributed. This may mean that whilst a
number of people may have experienced a fall in living standards, the majority of the population
may have enjoyed more goods and services. It is also possible that whilst the quantity of products
produced may have fallen, the quality of products may have improved or the composition of output
may have changed. For instance, if a country produces fewer weapons but more consumer products,
people may feel better off.
Ofcial real national income gures may also not accurately represent the total amount
produced in a country. Real national income may fall but if the size of the informal economy has
increased, the country may actually be producing more goods and services.
The standard of living in a country is also inuenced not only by the quantity of products
but also by a range of other factors. For example, living standards may rise if working conditions
improve and the number of hours worked decline. People may prefer to have safe working
conditions and more leisure time rather than more products. Improvements in environmental
conditions can also improve the quality of peoples lives. For example, the closure of chemical
plants may reduce real national income, but improve may the quality of peoples lives.
A number of composite measures of living standards recognise that living standards are
inuenced not only by national income but also by other factors. The Human Development Index
takes into account education, as measured by the adult literacy rate and school enrolment ratios,
and health care, as indicated by life expectancy as well as GDP per head. Cuba, for example, has
a lower GDP per head than Saudi Arabia but a higher HDI value. Cuba has a very high tertiary
enrolment rate with the country spending a high proportion of its GDP on education and its
people, on average, live longer than people in Saudi Arabia.
The Index of Sustainable Economic Welfare starts with GDP per head and then adjusts it to take
account of other factors that affect peoples quality of life. It considers that, for instance, inequality,
pollution and depletion of resources reduce welfare and so are given negative gures in the index.
In contrast, the value of domestically produced services such as childcare are thought to add to
welfare and so are given positive gures.
A fall in the level of national income may indicate a decline in the standard of living in the
country. This, however, is not always the case and to assess what is happening to living standards
in a country, other measures, which take into account more than income, may be examined.

Original material Cambridge University Press 2010

Theory and measurement in the macroeconomy

KEY TERMS

Denitions of key terms can be found in the glossary.

accelerator
active balances
aggregate demand
aggregate expenditure
aggregate supply
autonomous investment
average propensity to consume/
save
balanced budget
broad money
capital-output ratio
circular ow of income
closed economy
credit multiplier
deationary gap
dissaving
Gross Domestic Product (GDP)
GDP deator
Gross National Product (GNP)
idle balances
induced investment
inationary gap
injections
Keynesian approach
leakages

Original material Cambridge University Press 2010

liquidity preference
liquidity trap
loanable funds theory
marginal propensity to consume/
save
Monetarist approach
money supply
multiplier
narrow money (supply)
national income
Net Domestic Product (NDP)
Net National Product (NNP)
net property income from abroad
open economy
paradox of thrift
precautionary motive/demand for
money
saving
speculative motive/demand for
money
total currency ow
transactions motive/demand for
money
withdrawals

10