There are four major components of GDP. Describe each of these components, including a discussion of the way in which each contributes to GDP.

University Degree Business and Administrative studies

Question 1

There are four major components of GDP. Describe each of these components, including a discussion of the way in which each contributes to GDP.

The four major components of GDP(Y) are household consumption (C), investment (I), government spending (G) and net exports (NX). Their relationship can be express as an identity:

Y=C+I+G+NX

Household consumption (C), calculated in the Australian National Accounts as private final consumption expenditure, is the expenditure on goods and services by households, such as the Rose’s dinner at Garden Hotel. It is made up of spending on durable goods (cars, appliances and furniture), non-durable goods (food, clothing, soap and petrol) and services (education, medical). Consumption can be influences by 4 main factors, they are disposable income (income-net taxes), expected future income, wealth, and interest rates.

Consumption is a function of GDP because disposable income relies on GDP and net taxes are a proportion of GDP. Figure (a) shows positive the relationship between real consumption expenditure and real GDP. The bold line is an estimate of the consumption function for real GDP.

Generally, the biggest portion of GDP is consumption, which averages around 60 percent. Consumption is regarded as the most stable component of GDP and investment the most volatile. Since disposable income can only be consumed or saved, and saving is equal to investment, the more consumption is, the less investment is.

Gross investment (I) is the spending on new buildings (residential, commercial, and public), new inventory and new. For example, Jack purchases a new house. It is measured in the Australian National Accounts as private gross fixed capital expenditure. Gross investment is the sum of replacement investment (for worn-out or depreciated capital) and Net investment (for additional capital), excluding public or government investment. The main influences on firms’ investment decisions are: real interest rates and profit expectations, and stock of existing capital. Real GDP isn’t a significant influence. That is to say, investment is an autonomous expenditure as it is independent of real GDP.

Government spending and gross public fixed investment expenditures (G) contains expenditure on goods and services for our national security, international representation (embassies and delegations in other countries), and domestic programs such as transportation, health care and education, such as the Airforce’s purchase of a fighter-bomber. It measures spending on current goods (salaries and the inputs consumed in govt. depts.) and investment goods (highways and buildings). Government spending on is determined mainly by the political process. In this light, we will presume it is independent of real GDP and is an autonomous expenditure like investment.

Net export (NX) equal the expenditure by foreigners on domestically produced goods (exports) minus the expenditure by domestic resident on foreign-made goods and services (imports). For example, a foreigner’s purchase of a woollen coat made in Australia increases net exports and GDP. But an Australian’s purchase of a mobile phone from abroad decreases net export and increases consumption, because mobile phone purchase is part of household consumption. As a result, this transaction does not affect GDP.

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Net export is the smallest portion of GDP. Along investment, fluctuations in net exports significantly contribute to fluctuations in real GDP.

Why can we conclude that in a simplified economy, GDP=Income(Y) =Expenditure?

Assume that in a simplified economy that has only households and firms. Everything that a firm receives from the sale of its output is paid out as income to the owners of the factors of production. Similarly, the revenue a household earns from the production factors market is spent on goods and services produced by firms. Thus, expenditure equals income. GDP also equals ...

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Net export is the smallest portion of GDP. Along investment, fluctuations in net exports significantly contribute to fluctuations in real GDP.

Why can we conclude that in a simplified economy, GDP=Income(Y) =Expenditure?

Which components of GDP, if any, would each of the following transactions effect? (explain briefly)

Firms have a build up of inventory
Investment will be increased. Though inventory is intermediate good, its value should be added to GDP as inventory investment when it was produced and reduced GDP when it is used or sold later.

A resident of country X, buys products from country Y

Net export will be decreased. The domestic purchase of foreign goods adds to imports which will minus the net export.

You build a new factory

It will be added to investment because it is the purchase of new capital (factories are land resources).

iv. Vegetables grown in your garden at home

No component will be affected. It was not final good which was sold to ultimate consumers. Furthermore, GDP excludes the value of all activity that takes place outside of markets.

v. Purchase of a television set made in your own country

Consumption will rise. Such purchase is spending by household on goods and services.

Question 2

Draw and fully label a diagram to illustrate the market for loadable funds for each of the following events, making sure you clearly explain what happens to the equilibrium level of Savings and Investment, the level of private savings, public saving and national savings.

the effects of a government surplus

A government surplus means the public saving rises, as a result, the national saving grows though the level of private would not be affected. Therefore, the supply of the loanable funds will increase. Because the government surplus will not directly affect the amount that borrowers want to borrow at any given interest rate, the demand for loanable funds would be unchanged.

Because the government revenue (T) now exceeds the government spending (G), government then has more income to save. Government may place extra money in banks or buy additional bonds or shares. Thererfore, the supply of loanable funds would increase, and the supply curve would shift to the right from S1 to S2.

As figure 1.1 shows, the shift of the supply curve drops the interest rate from Ir1 to Ir2 and higher the quantity of loanable funds from Q1 to Q2. That is, the shift in the supply curve moves the market equilibrium along the demand curve. It means investment would rise according to the interest rate drops. The quantity demanded rise and supply grows until the equilibrium goes down to E2.

a drastic loss of business confidence in future prospects

A loss of business confidence in future prospects would decrease the incentive of firms to borrow and invest in new capital. As a result, the level of investment decreases. The demand for loanable funds would change. Whereas it would not affect the amount that households save at any given interest rate directly, it would not affect the supply of loanable funds.

Thus, the demand curve shifts to left because firms would have an incentive to lower investment at any interest rate, the quantity of loanable funds demanded would be dropped at any given interest rate. Figure 1.2 reveals this decrease of demand as a shift in the demand curve from D1 to D2. National saving decreases.

Figure 1.2 depicts that the shift in the demand curve bring the interest rate down from Ir1 to Ir2, and the lower interest rate in turn drops the quantity of loanable funds supplied from Q1 to Q2, as households respond by declining the amount they save. That is, the level of private saving goes down, but the public saving would not be affected. This change in household behaviour is shown in the figure 1.2 as a movement along the supply curve from S1 to S2. Thus, the equilibrium level drops to E2.

A rise in real interest rate

Investors focus the real interest rate rather than the nominal interest rate. The rise in real interest rate means that investors now should pay more to borrow for purchasing new capital. It alters the incentive of investment. Meanwhile, the real interest rate rise the return of saving, so it would affect the amount that household save at any given interest rate, That is to say, it would influences the supply of loanable funds.

Because the incentive of investment decreased, firms would diminish the amount they wanted to invest, the quantity of loanable funds demanded would be lower at any given interest rate. This change is shown in the figure 1.3 as a movement along the demand curve from D1 to D2. The level of investment decreases.

The quantity of demand decreased raise the interest rate from Ir1 to Ir2, and the higher level of interest rate in turn inspire the amount of private saving. The level of private saving therefore rises. As figure 1.3 shows, the quantity of loanable funds supplied increased from Q1 to Q2, which is represented by a movement along the supply curve. It results in a surplus (Q3 – Q2) at the Ir2 level. That is, the quantity of supply would exceed the quantity demanded as a result of the rise in real interest rate. National saving rises while public saving remains the same. The equilibrium level grows to D2, I2.

The government announces new incentives to encourage business to undertake a range of investment projects.

The new incentives of investment would affect the investment level; it would increase the demand of loanable funds. In contrast, because it would not affect the amount that household save (private saving) at any given interest rate directly; thus, the supply curve for loanable funds would not be affected.

Because firms would have an incentive to increase investment at any interest rate, the quantity of loanable funds demand would be higher at any given interest rate. Thus, the demand curve for loanable funds would shift to the right from D1 to D2, as revealed in the figure 1.4. The investment level rises.

The increased demand for loanable funds raises the interest rate from Ir1 to Ir2 and the quantity of loanable funds supplied from S1 to S2, which is contributed by the private saving according to the higher interest rate incentive. This change is depicted as a movement along the supply curve in figure 1.4. The overall level of national saving increases as a result. But the public saving would be unchanged because there is no incentive for it to increase.

Question 3

a) Clearly explain why unemployment is considered a key policy target for government.

The most obvious cost of unemployment is the loss of output and income that the unemployed would have created if they had had been employed.

The second cost of unemployment is the permanent loss of human capital. For example, Kate got a bachelor of management when unemployment is high and she can’t find a job as a manager. After several years, she found herself couldn’t compete with the new management graduates. Her human capital has been depreciated by high unemployment.

Unemployment could cause society crime. People may turn to illegal work if they cannot earn from legal work. Furthermore, low incomes and increased frustration make family life suffer and domestic violence and juvenile crime increase.

Unemployment imposes pressures on individuals and families both financially and psychologically. Increased stress raises physical and mental sickness and may even lead rising suicide rates.

The final cost that is the loss of self-esteem, and which also affects their families.

To sum up, unemployment can directly reduce the standard of living people are able to achieve, so it was usually ranked as the most important problem facing a government.

b) Use a diagram to illustrate and explains the concept of a natural rate of unemployment.

A society’s natural rate of unemployment is the unemployment rate that the economy experience as normal. In other words, the natural rate of unemployment is the unemployment rate at full employment. This reveals by the figure 2.1 as a straight line. We can see that the natural rate of unemployment is always exists through the whole period of time form the figure. Stated differently, the economy always has some unemployment.

The major reason why the natural rate of unemployment is greater than zero is job search and employer search. Even though the quantity of job vacancies equalled the quantity of unemployed people, there would still be unemployed because the unemployed couldn’t find the matching jobs.

Job search and employer search is caused by some structural factors which are minimum-wage laws, unions, efficiency wages and job search, etc. However, the word “natural” doesn’t suggest that this rate of unemployment is required or inevitable. It only means that this unemployment does not go away itself, even in the long run.

In figure 2.1, we can see that actual unemployment rate fluctuate around the natural rate of unemployment from year to year. It represents the equilibrium of labour force changes due to flexible wages which cause both the labour demand and supply fluctuates. It is called cyclical unemployment.

c) It can be argued that the payment of efficiency wages increases the level of unemployment. Clearly explain this concept, including a discussion of how relevant you think each of the reasons for paying ‘efficiency wages’ is.

Efficiency wages refer to the amount of wage that pay to stimulate workers to stay in the job, put in a high level of productivity, or simply to attract productive workers. This wage higher than the equilibrium level would attract more labour supply than the actual amount of labour demand. That is, it would cause a surplus at that wage level and some workers are unemployed. It meets the general lesson which states that if the wage is kept above the equilibrium level for any reason, the result is unemployment.

If such jobs are widespread, the result would be a lot of unemployment. However, unlike other reasons that keep wages above the equilibrium level, the efficiency wage itself depends on the level of unemployment. There are four reasons can explain why this is true.

Workers’ health

This theory pinpoint that there is a positive relation between the salary and workers’ health. The workers with higher salaries would be more healthy and productive than the workers received lower salaries. Though this may not match the developed countries, it may be true for some developing countries. In such countries, firms worry about the negative influences of lowering wage on health and productivity. However, the cost of a firm is limited. Firms can only afford to pay such efficiency wage for a part of workers. To pay these wages, a firm would not manage to pay for new workers. The people not concerned by such firms will lose the opportunity to work for these firms.

Workers’ liquidity ratio

If the workers’ liquidity ratio is higher, a firm’s production cost is usually larger. Because the training of labour cost. The frequency of dimission depends on the whole set of incentive they faced. Usually, the higher the wages are the fewer workers would choose to leave. But the required payment for preventing the premium employers leaving is also dependent on a worker’s prospects for finding a new job. If these prospects are high, (it means unemployment is low), such payment would also be high.

Workers’ productivity

Higher wage make workers desire to stay in the job. Then motivate workers to do their best. Unemployment menace people with higher wage to work hard. If the wage is equal to the equilibrium level, there is no reason for workers to work hard, because they would find a job of same wage quickly. So, firms made wage higher, cause unemployment, and motivate workers do not shirk.

Workers’ quality

Firms can attract higher quality worker by paying an efficiency wage. For example, Susan is a skilled worker and she would work for any wages above $10 per hour. Alice is a worker with lower skill level and she would work for any wages above $3 per hour. If a firm pay the wage of $11 per hour, both Susan and Alice would apply for the job and the firm can choose the proper one from the two. As a result, one would be unemployed.

However, firms that pay efficiency wage could not afford to employ a very large amount at that wage. So the low unemployment would not be sustainable. The rate of unemployment would rise and, correspondingly, wages would fall until equilibrium was reached. Therefore, though paying efficiency wage would cause a short-term low unemployment. While this unemployment grows, the wages would be forced to fall until the unemployment is cleared at the equilibrium level.

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