Suggested answers EC111 Macroeconomics mid-semester test second semester 2010

Question 1:
( a) Nominal GDP: 2008 (2 x 400) + (20 x 100) = $2800
2009 (2 x 440) + (22 x 100) = $3080
(2 marks)
(1 marks for GDP of each year)
(b) It is not possible to come to a conclusion in regard to economic growth with nominal
GDP figures as they are influenced by both the price and quantity effects. Therefore Real
GDP figures have to be worked out to determine economic growth. (1 mark)
Real GDP 2008: (2 x 400) + 20 x 100) = $2800
2009 (2 x 440) + (20 x 100) = $2880
(1 mark)
This shows that economic growth is 2880 2800/2800 x 100 = 2.85%.
Therefore it is clear that the economy has grown only by 2.85%
(2 marks)
(c) GDP deflator for 2008: 2800/2800 x 1000 = 1000
2009: 3080/2880 X 1000 = 1069.4
(If students multiply by 100 full marks awarded.)

(2 marks)

(d) No. Per capita real GDP is only the average income per person obtained by simply
dividing the real GDP by the population. This figure fails to give any indication about the
distribution of income amongst the people of the country. In no country do we find
complete equality of income distribution among all the people and normally subject to
and therefore large disparities. The standard of living of people in a country is determined
by the income they receive and therefore the per capita real GDP been an average cannot
be an accurate picture of this.
(4 marks)
(e) No. The per capita real GDP in New Zealand could be 5 times greater than that of
India because the GDP of India is likely to be understated as its economy will have many
non-market activities not captured by the GDP statistic If the value of the black economy
can be captured the real GDP, the per capita figure for India will be much greater, and
New Zealanders will not be 5 times better off than the people who live in India.(6 marks)

Question 2:
(a)

2007 (10 x 50) + (1 x 100) = (5 x 100) = $1100

2008 (10 x 50) + 1 x 100) + (10 x 100) = $1600
2009 (10 x 60) + (1.50 x 100) + 20 x 100) = $2750
CPI: 2007 = 1100/1100 x 100 = 100
2008 = 1600/1100 x 100 = 145.5
2009 = 2750/1100 x 100 = 250
( 3 marks)
(1 mark for each year)

(b) Inflation rate: 2008 (1600 1100)/ 1100 x 100 = 45.5%

2009 (2750 1600)/1600 x 100 = 71.8% (4 marks)
(2 marks for each year)
(c) Substitution bias. Because the price of pens increased and the quantity consumed
declined significantly.
(3 marks)
(d) Over the period of 2007 to 2009 the inflation rate has increased first by 45.5% and
then by 71.8% as a result of which the wages also would be increased by similar
percentages. However, the CPI normally overstates the cost of living as a result of the
substitution effect, the introduction of new goods and improved quality of goods.
Therefore the increase in wages would lead to a higher standard of living of people
(4 marks)
(e) If a person only consumes pens his standard of living will decrease because the price
of pens had increased by a greater percentage than shown in the CPI figure and the
COLA clause will increase this persons wage to compensate for the change in CPI only.
(3 marks)
(f) Yes. The GDP deflator is the ratio of nominal GDP to real GDP because nominal
GDP is current output valued at current prices while real GDP is current output valued at
base year prices. The GDP deflator reflects the current level of prices relative to the level
of prices in the base year. Therefore the GDP deflator shows the proportion of the
increase in nominal GDP attributable to price increases and hence indicates the amount of
inflation in the economy just like the CPI.
However, there are dissimilarities between the two statistics as GDP deflator reflects the
prices of all goods and services produced domestically, whereas the CPI reflects the
prices of all goods and services consumed by the typical consumer. For example if the
price of a Boeing 747 aircraft produced in USA increases in price it will show up in the
GDP deflator but not in the CPI of USA as such aircraft will not be in the typical
consumer basket of goods. On the other hand when the price of Toyota cars
manufactured in Japan increase, it will show up in the GDP deflator of Japan and not in
the GDP deflator of New Zealand, but will be shown in the CPI of NZ as it is an item in
the typical consumer basket in NZ.
When oil price increases in the world the GDP deflator will show this increase, but the
CPI in the USA will show a higher increase as Americans consume more oil than they

produce by importing large quantities from the middle East. In this case the increase in
the CPI will be much greater than the GDP deflator.
(4 marks)
Question 3:
(a) Debt finance is when a firm borrows money by selling bonds in the bond market
or obtaining a loan from a financial intermediary like the bank. On the other hand
equity finance is when a firm sells stock to savers in the financial market who will
then own a share of that company in proportion to the equity bought. Both these
instruments are extremely important as the funds required for investment in an
economy is raised in this manner and such investment is vital to bring about
economic growth.
(3 marks)
(b) Investment which is vital for economic growth has to come through savings in an
economy. Therefore it is important to reward the savers and not penalise them as
in New Zealand for performing this important function. The ideal incentive would
be to remove tax taken from interest earnings which would as shown in the
diagram shift the supply curve to the right showing an increase in savings.

A
B

The result in this increased supply of loanable funds is a decrease in the rate of
interest and borrowers increasing the amount borrowed as shown in the
movement along the demand curve from point A to B. The result of this
increase in investment on the economy would be growth in GDP output, increased

employment and incomes that would lead to a higher standard of living.

(12 marks)
(c) When government runs a budget deficit (G>T) savings by the government will be
negative, and as a result the supply of loanable funds would be reduced. This will
shift the supply curve to the left as shown in the diagram leading to a rise in the
rate of interest.

B
A

This will result in borrowers been discouraged, and they will move along the
demand curve from point A to point B borrowing and investing less in the
economy. This is called crowding out as the government would borrow some of
the loanable funds available in the market thereby pushing out private sector
businesses especially in the light of higher rates of interest.
(8 marks)

Question 4:
(a) The Green party members and Environmentalists have set off alarm bells in a
similar fashion as Thomas Malthus did in the 19th century about limits to
economic growth to satisfy the increasing population on the grounds that the
supply of natural resources will run out. It is difficult to agree with this as on the
one hand such a theory ignores human ingenuity, and on the other the ability to
provide more people through conservation of resources. Greens try to say that the
world has reached peak oil whereas the world continues to find more and more
oil in different parts of the world as evidenced by oil sands in Alberta and oil
found in Ghana just two months back. So far the human race has never run short
of anything such as coal, steel etc. Scientific research and human ingenuity has
enabled us to produce more output with fewer inputs in addition to the discovery
of new resources. Recently it was reported that Bolivia has found large deposits
of Lithium which scientists say is the new oil. Another example could be farming
where more than 90% of the population of countries such as USA worked in
farms 100 years ago, but now less than 10% of the population work in farms and
yet produce food for the entire population and export the balance to other
countries.
(10 marks)
(b) Savings are necessary in an economy to create investment and bring about
economic growth. However, in NZ savings are inadequate to meet the investment
required to grow the economy. Therefore more than other countries in the world
NZ badly needs foreign investment as a strategy to create economic growth. In
order to attract foreign investment it is vital to remove restrictions imposed by the
government on foreign ownership of domestic assets. At the same time incentives
should be offered to attract foreign capital into the country, especially because
there are several countries in the world that are competing to attract such capital.
In the light of these arguments the rejection of the offer by the Canadian Pension
Fund to purchase 40% of the Auckland international airport in 2007 by the then
government of NZ would send out the wrong signals specially because the
government allowed the process to go through, and at the last minute rejected the
offer on the basis that the airport was a strategic asset and cannot be sold to
overseas investors. If it was so that should have been stated right at the outset.
The current government too is showing reluctance to allow Chinese companies to
purchase NZ farms and thereby is sending a message to the world that the country
is not supportive of foreign investment. Such an attitude could discourage FDI in
NZ which is vital for economic growth .
(10 marks)

Question 5:
(a) Efficiency wages is an above-market equilibrium wage paid by employers
voluntarily to their employees to achieve increased worker productivity. Such a
wage will reduce worker turnover, improve quality of workers as well as the
effort put in by workers at the work place.
A high worker turnover is likely to disrupt the production process of a firm, and
therefore paying them an attractive above-market wage could prevent this.
When an above-market wage is paid an employer is able to attract the best quality
workers who can be more productive.
Such a wage will also improve the worker effort as they would not like to lose
such a job when the market wage is much lower.
(6 marks)

(b) Any government intervention in the labour market by way of imposing a

minimum wage above the market equilibrium wage or a trade union negotiating
such a wage through the process of collective bargaining would result in
unemployment. A certain amount of unemployment is also attributable to the
reluctance of employers to hire low- skill people and new migrants as they are
sceptical about the ability and the quality of such workers, together with the
difficulty of making them redundant when such workers are found to be
unsuitable. Therefore the types of workers referred to above would remain
unemployed. The new 90-day rule which the current government is introducing
would remove this problem as employers are more likely to offer jobs to the
above category of workers as they have the option of sending them away if found
to be unsuitable. Although this law is criticised in some quarters on grounds that
firms will take on employees and just send them away after 90 days simply
because the law permits them to do so is unlikely to happen as no employer will
ever send away a good productive worker even though the law may allow him to
do so.
(6 marks)
(c) The labour force participation rate is the percentage of the adult population that is
in the labour force. In New Zealand they include every person above 15 years of
age who are either employed or unemployed.
Since 1950 the labour participation of women has increased due to three reasons.
First new and improved technology has enabled housewives to complete their
household chores in a couple of hours which leaves them plenty of free time to
get employment. Secondly birth control has enabled women to have only the
number of children they want, which again gives them free time to join the
workforce. Thirdly the change in social attitudes where both men and women are
considered to be equal as opposed to the earlier concept that the womans place
was in the home.
The above three reasons have increased the labour force participation rate of
women systematically after 1950.
On the other hand the participation rate of men has declined considerably over the
last 60 years, firstly because men continue to study longer than earlier and will

not be looking for employment. Secondly men retire early and live much longer
than 60 years ago and therefore the numbers of adults not participating in the
labour force has increased. Thirdly there are house husbands who may prefer to
stay at home when the wife is employed in a lucrative job and brings a large
income home. The above reasons have led to the participation rates of men to
decline over this period.
(6 marks)