Macro Economics 1

                Question 1: (1 point for the diagram, 2 points for the explanation)

                Using this outline (see Graph 1), insert arrows and complete the circular-flow diagram representing the interactions between households and firms in a simple economy. Explain briefly the various parts of the diagram.

Answer:

[pic 1]

Explanation:

This model depicts the interaction of households and firms in the product and the factors of production market. The exchange of products between households and firms occurs in the product market and the exchange of capital, land, and labour occurs in the factors of production market. Households earn money by supplying labour to the factor market and receive payment from the firms in return for their input into the firm’s production. From the labour supplied by the households, the firms provide goods and services that are sold in the product market to households (or consumers). This household consumption of goods and services generates revenue for the firms.

Question 2: (2 points)

                What is the process used to separate the change in GDP due to an increased output of goods and services, from the change due to increased prices? Why do we make this distinction? Limit your answer to 100 words.

Answer:

This process is calculating nominal and real GDP to separate them.

The increases in prices and production of goods and services altogether cause increases of GDP from a year to another. GDP is a measure of production, so a method of differentiating the volume changes and price changes is required. Therefore, calculating real GDP, which measures the number of goods and services without the prices’ fluctuation, is necessary.

Nominal GDP = Current Quantity x Current Price

Real GDP = Current Quantity x Base Price

This distinction helps distinguish inflation, which is viewed as undesirable, from desirable growth in real output.

Question 3: (2 points)

                Suppose people consume only two goods, apple pies and meat pies:

Question 4: (3 points)

                                Table 4-1 shows the following amounts for the years 2010 to 2012.

Question 5: (2 points)

Identify and discuss two biases of the CPI. Limit your answer to a maximum of 150 words.

Answer:

A bias of the CPI is the change in quality bias. As time goes by, factors like; education, science, etc. will improve the quality of goods and services in the market basket; for instance, workers become more skilled or more versatile technology is developed. These price increases include not just pure inflation but also reflect the improvement of quality. Adjustments are made to make CPI contain only the pure inflation, but it is hard to eliminate completely the quality increases. Consequently, CPI may not reflect correctly the pure inflation.

Another bias of the CPI is the new product bias. It takes about five or six years before another survey is conducted to determine the contents of the market basket. In that gap, new goods and services might be introduced with various prices. Consequently, the CPI cannot reflect any changes to purchases consumers may make in between surveys conducted .

Question 6: (1 mark for the diagram, 1 mark for each of the explanations, 3 marks total)

                Suppose that a firm is faced with an excess supply of workers. What would the firm do? Illustrate and explain in no more than 100 words with standard economic theory and with efficiency wage theory.  

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