1. A) Macroeconomics vs.

We live in a world of scarcity. There is a limited amount of money, resources, time, etc.
Economics is the study of how individuals and societies choose to use these scarce
resources. Most people tend to think of economics as something related to the stock
market, or inflation, or unemployment. In truth, it includes those subjects and a whole lot
more. Given the breath of the areas covered by economics, the discipline is divided into
two major subgroups which are : Microeconomics and Macroeconomics.
Economics is defined as the study of how individuals and society choose to use
scarce resources. In essence, economics is a study on how individuals make choices.
There are two branches of economics: Microeconomics and Macroeconomics
Microeconomics looks at the decision making behavior of individual decision
making units: Households, firms, industries, etc…
Macroeconomics looks at the entire (aggregate) economy. Table 1 illustrates the
difference between the type of questions addressed by microeconomics vs.
Table 1
Micro How many What is the price of What are the wages How many workers
hamburgers does In an In N’ Out of the workers at In are employed at In N’
N’ Out produce? hamburger? N’ Out? Out?
Macro How much goods and What is the price of What are the total What are the total
services does the all consumer goods wages and salaries number of workers in
United States produce in the economy? of workers in the an economy?
each year? economy?

B) Fiat Money and Commodity Money
Fiat Money: Fiat money is a currency that is declared as legal tender or means of economic
transaction by the government or law. In case of fiat money, value of currency comes from the

cocoa beans.  Fiat money has only face value while commodity money has both face value and token value. Commodity money has value and other use such as gold. silver. shells.  Risk of inflation and deflation is most associated with fiat money because its value as not intrinsic. Its value is unrelated to the value of any physical quantity. cigarettes.000 A. it has no sense in real terms. Commodity Money: Cmmodity money is a type of money whose value comes from a commodity or goods of which it is made.government or law. jewelry. etc. These often includes: precious metal like gold. In case of fiat money. fiat money is not backed by the precious metals such as gold or silver that has uses other than as a medium of exchange. the face value of money is greater than its token value. and pepper corns. Key Differences  Fiat money is a legal tender that is declared for mode of exchange by government while commodity money is not a legal tender. tea.  Fiat money has no value without the guarantee of government or law. However. While commodity has intrinsic value but risks large price fluctuations based on changing commodity prices. alcohol. silver. etc. It is made of those objects that have value in both in themselves and their usage as a money. Fiat Money Commodity Money .D. Unlike representative money. A piece of paper has value because it is guaranteed by the law. copper. Since then it has been used widely by carious countries concurrently with commodity currencies. Fiat money was first used in China in 1. precious stones. metal coins.

. This definition has three parts: Market value Produced within a country In a given time period Market Value GDP is a market value—goods and services are valued at their market prices To add apples and oranges. normally a year or a quarter of a year. GDP and the Circular Flow of Expenditure and Income GDP measures the value of production. computers and popcorn.2. Measuring GDP GDP or gross domestic product is the market value of all final goods and services produced in a country in a given time period. which also equals total expenditure on final goods and total income. we add the market values so we have a total value of output in dollars. Produced Within a Country GDP measures production within a country—domestic production. In a Given Time Period GDP measures production during a specific time period.

rent. investment.1 illustrates the equality of income and expenditure. and profit.The equality of income and value of production shows the link between productivity and living standards. and net exports. Aggregate income equals the total amount paid for the use of factors of production: wages. . GDP Equals Expenditure Equals Income Total expenditure on final goods and services equals GDP. Y=C+I+G+X–M The circular flow shows two ways of measuring GDP. The circular flow diagram in Figure 20. Measuring Somalian GDP The Bureau of Economic Analysis uses two approaches to measure GDP:  The expenditure approach  The income approach The Expenditure Approach The expenditure approach measures GDP as the sum of the red flowof the graph above: consumption expenditure. government expenditure on goods and services. Firms pay out all their receipts from the sale of final goods. so income equals expenditure. GDP = C + I + G + X – M. Y = C + I + G + (X – M). interest.

0. The implicit price deflator is a Paasche index because it is computed with a changing basket of . The CPI for 2005.000.000 Implicit Price Deflator2015 = Nominal GDP2015 / Real GDP2015 = 1.a Nominal GDP2005 = ( Pcars2005 * Qcars2005 ) + ( Pbread2005 * Qbread2005 ) = $10. 2.000 Real GDP2015 = ( Pcars2005 * Qcars2015) + ( Pbread2005 * Qbread2015 ) = $10.52 CPI2010 = ( Pcars2015 * Qcars2005 ) + ( Pbread2015 * Qbread2005 ) ( Pcars2005 * Qcars2005 ) + ( Pbread2005 * Qbread2005 ) = 1.000. equals 1.200.6 b) This calculation shows that the price of goods purchased in 2015 increased by 60 percent compared to the prices these goods would have sold for in 2000.GDP = C + I + G + (X  M) The Income Approach The income approach measures GDP by summing the incomes that firms pay households for the factors of production they hire.000 Nominal GDP2015 = ( Pcars2015 * Qcars2015 ) + ( Pbread2015 * Qbread2015 ) = $15. the base year.

Yet. so the CPI places a higher weight on bread. the change in the price level depends on how the goods˛a´r prices are weighted. one wants a measure of the price level that accurately captures the cost of living. Since the price of bread increased relatively more than the price of cars. such as the CPI. 50 percent. the implicit price deflator for the year 2015 is 1. The price of cars rose by 20 percent. which indicates that prices rose by 60 percent from what they were in the year 2005 If prices of all goods rose by. so they are not part of our GDP – . in our example. say. The implicit price deflator weights the price of goods by the quantities purchased in the year 2015. then one could say unambiguously that the price level rose by 50 percent. The quantity of bread consumed was higher in 2005 than in 2015. The CPI weights the price of goods by the quantities purchased in the year 2005. In this example. people buy less of it a----nd more of other goods. An index with fixed weights. overestimates the change in the cost of living because it does not take into account that people can substitute less expensive goods for the ones that become more expensive. As the discrepancy between the CPI and the implicit price deflator illustrates. The prices of capital goods are included in the GDP deflator but not in the CPI index (people don’t buy capital goods for consumption purposes).52. the CPI for the year 2015 is 1. relative prices have changed. an index with changing weights. the price of bread rose by 100 percent.a.). consumers bought less bread and more cars. which indicates that prices rose by 52 percent from what they were in the year 2005. As a good becomes relatively more expensive. On the other hand. The prices of imported goods are included in the CPI index but not in the GDP deflator (we don’t produce imported goods. c) There is no clear-cut answer to this question. Ideally.goods. From (6.iv. making bread relatively more expensive. the CPI shows a larger increase in the price level. the CPI is a Laspeyres index because it is computed with a fixed basket of goods.6.

4. . when MC=MB. The basket of goods are fixed in the CPI index (Laspeyres index). One reason for this is. This is especially true if by measurement one means simply counting heads and neglecting differences among workers in levels of skill and intensity of work. the relatively large share of labour costs in the value of most products.they are however a part of our consumption baskets). profits are unchanged – and are at a maximum because of either increasing MC and/or decreasing MB due to diminishing returns). it increases profit. The amount of real output an economy can produce is determined by the quantities of the factor inputs (labor. statistics of employment and labour-hours are often readily available. Labour is by far the most common of the factors used in measuring productivity. capital. energy…) and the state or level of technology (knowledge) about the use (productivity) of those inputs. profit-maximizing firm weighs the costs and benefits of employing an additional unit (at the margin). it decreases profit. In addition. Although ratios of output to persons engaged in production or to labour-hours are referred to as labour productivity. the basket of goods changes every year in the GDP deflator (Paasche index). A competitive. such as capital. A second reason is that labour inputs are measured more easily than certain others. If the marginal cost (MC) is less than the marginal benefit (MB). of course. the term does not imply that labour is solely responsible for changes in the ratio. others – land. while information on other productive factors may be difficult to obtain. if the MC is greater than the MB.

it is a basis for quoting and bargaining prices. For capital. such as the dependence on the occurrence of a coincidence of wants. To be widely acceptable. As a result. Thus. Money functions as: 1. Therefore. It avoids the inefficiencies of a barter system. a medium of exchange should have stable purchasing power. A unit of account 3. the MC is the real wage and the MB is the marginal product of the worker. it would be demanded and used up to the point where the real rental price equals the marginal product of capital. Functions of Money Money acts as a standard measure and common denomination of trade. A medium of exchange 2. It is necessary for developing efficient accounting systems. 5. but its most important use is that it provides a method to compare the values of dissimilar objects. it is performing the function of a medium of exchange. it should possess the following characteristics:  Valuation of common assets  Constant utility  Low cost of preservation . in the case of labor. the firm employs workers up to the point where the real wage equals the marginal product of labor. A store of value A Medium of Exchange When money is used to intermediate the exchange of goods and services.

and retrieved. it must be predictably usable as a medium of exchange when it is retrieved. whatever is being used as money must meet these characteristics:  It must be divisible into smaller units without a loss of value. Some have . precious metals can be coined from bars or melted down into bars again. coins are often milled with a reeded edge. The value of the money must also remain stable over time. and other transactions. Transportability  Divisibility  High market value in relation to volume and weight. This is why diamonds. money must be able to be reliably saved. To function as a unit of account. Moreover. services. A Store of Value To act as a store of value. money acting as a store of value allows its owner to transfer real purchasing power from the present to the future. In other words.  It must have a specific weight. one unit or piece must be perceived as equivalent to any other. Put simply. For example. a unit of account is a necessary prerequisite for the formulation of commercial agreements.  It must be fungible. Also known as a "measure" or "standard" of relative worth and deferred payment. or size in order to be verifiably countable. A Unit of Account A unit of account is a standard numerical unit of measurement of the market value of goods. stored. measure. For instance. so that any removal of material from the coin (lowering its commodity value) will be easy to detect. or real estate are not suitable as money. works of art.

The central banks tend to control the quantity of money in circulation to achieve economic objectives and effect the monetary policy." which means that its status as a legal tender allows it to function for the discharge of debts.edu 14. visit: http://ocw.mit.  Macroeconomis.argued that inflation. 2015  GOOGLE AND WIKIPEDIA . diminishes its ability to function as a store of value. Spring 2015 March 12. we take a look at some of the common ways that central banks control the quantity of money in circulation REFFERENCES  MIT OpenCourseWare http://ocw.mit. Through this article.01SC Principles of Macroeconomics Fall 2011  For information about citing these materials or our Terms of Use. Money can also function as a "standard of deferred payment. by reducing the value of money.edu/terms.