1.

Classical Approach
All markets must function smoothly without impediments such as minimum wages and interest rate
ceilings. Wages and prices must adjust rapidly to equate quantities demand and supplied.The classical
economy automatically and quickly adjusts during a recession. Prices and wages fall during a recession.
That affects profits positively. Production increases and more people are hired. The economy bounces back
out of a recession. No government spending or tax reduction (fiscal policy) is necessary to bring economy
out of recession. The price mechanism (the invisible hand) works like magic in the classical market
economy to rectify economic ills.

Keynesian Approach
Keynes argues persistent unemployment occurs because wages and prices adjust slowly, so markets
remain out of equilibrium for long periods. Thus, wages and price are not flexible. Keynes proposed
solution to high employment was to have the government increase its purchases of goods and services,
thus raising the demand for output. In Keynesian economy, prices and wages are sticky downwards. They
do not fall during a recession. Economy doesn’t automatically adjust. The result is prolonged
unemployment. Government spending and tax reductions (or more generally, fiscal policy) is necessary to
stimulate the economy to bring it out of a recession.

2. Stagflation refers to an economy that is experiencing a simultaneous increase in inflation and stagnation
of economic output.Stagflation can also be alternatively defined as a period of inflation combined with a
decline in gross domestic product (GDP).In 1970s, US suffered from both high unemployment and high
inflation-called stagflflation, or stagnation plus inflation. This reduce confindence on Keynes approach.
Development in economic theory made classical macroeconomics look more interesting and attractive to
many economist. From 1970s, a modernized classical approach enjoyed a major resurgence.

3. a. Nonmarket Activitie
Certain productive activities do not take place in any market-the services of homemakers, for example, and
the labor of carpenters who repair their own homes. GDP only get data on economic transactions involving
market activities
b. Leisure
An increase in leisure time has clearly had a positive effect on overall well-being. But our system of national
income accounting understates well-being by ignoring leisure’s value.
c. Improved Product Quality
Because GDP is a quantitative measure rather than a qualitative measure, it fails to capture the full value of
improvements in product quality. Obviously quality improvement has a great effect on economic well-
being, as does the quantity of goods produced.
d. The Underground (Shadow) Economy
Some of the people who conduct business there are gamblers, smugglers, prostitutes, "fences" of stolen
goods, drug growers, and drug dealers. They have good reason to conceal their incomes.

4. In the case that output is measured at producers’ prices (not basic price as Malaysia production
approach), import duties need to be added to gross value added at producer prices to derive GDP.
Gross value added at producers’ prices
+Import duties less subsidies on imports
=Gross Domestic Product (GDP)
This is not a preferred solution as changes in taxes may change value added/output ratios
which are assumed to be constant in many analyses. For Malaysia, the output is measured
at producers’ price.
5. a) Price controls are set by the government to help either the producers and consumers. The prices are
set either below or above the equilibrium point in order to curb excess demand or supply in the market.
However, these controls in effect introduce a lot of inefficiencies in the market. They create a supply-
demand gap by curbing the price rise or fall .For example, price ceiling set on rent prices for apartments
creates an excess demand of apartments and lower supply. As a result of this, some apartment owners
start demanding rents even higher than the equilibrium prices and those who are I dire need of
apartments have no option other than paying such high rents. This inefficient allocation of resources
distorts the correct calculation of GDP. In order to avoid this problem ,the government can adopt other
measures like rationing using coupons, adopting monetary policies to control the supply or demand of
goods in the long run.

b)