Answer both questions:
1. Explain what GDP is. What are the problems associated with the use of GDP as a measure of economic well being? Briefly discuss each. [40%] 2. Explain with the help of a numerical example how the quantity theory..
1. Explain what GDP is. What are the problems associated with the use of GDP as a measure of economic well being? Briefly discuss each.
Gross Domestic Product or GDP is defined as the market value of all final goods and services produced within a country in a given period of time. It is used for measuring the economic well being of a country. Gross Domestic Product is identical to the Gross National Product but they are entirely different because GDP is about the region’s income which was generated inside the region while Gross National Product (GNP) is a measure of the accumulation income to a region.
The most commonly used approach to measure the Gross National Product of the region is the expenditure method or the aggregate demand using the equation: (tutor2u, 2007)
Gross National Product = consumption (C) + investment (I) = (government expenditures) (G) + (exports –imports) (X-M)
Consumption is referred to as the total consumption expenditures which include the purchase of currently produced goods and services out of the income or from the savings or from the borrowed funds. Investment is referred to as the production per unit time of all the goods which are not consumed but are to be used by the region for future purposes. Examples of the investment goods are the tangibles like buildings and non-tangibles like the on-the-job-training. Government expenditure is referred to as the government purchases which can be generated from seigniorage an taxes. Seigniorage is the money created for government funding when devastating consequences occur in a country (typhoons, high inflation rate etc.). Export is referred to as the any good or commodity shipped to another country legitimately which is used in trade. Import is referred to as any good or commodity brought into one country from another country which is legitimately done. Goods or services that were imported are provided by the foreign producers.
Other approaches in measuring the Gross National Product of the region are by using the other two methods. The Income Method or the Sum of all Factor Income is another method to measure the GDP of the region. Another method for GDP measurement is the Output Method. Output method is used to measure the worth of the all the product produced by the productive areas in the economy. The value of the products is measured by using the value added approach. Value added approach is being used as a measurement because it prevents the scenario of double counting. Value added is the increment of the worth of the produced product in each of the successful stage in the process of production in the region (tutor2u, 2007).
There are problems that involving the use of the Gross National Product as a measurement for the economic well being of the country or the region. One of the obvious problem of the GDP as a measurement of the economic status is that every expenditure by the country is considered as a good expenditure. One very evident example of this is that the establishment of more police offices in the country and deploying more of the police officers to take care of the peace and order of a particular area. This set up will strengthen the economy of the country since it will show a growth in the GDP of the country. In contrast of the strengthened economy because of the concerns of the peace and order is the reason behind the deployment of more police officers in the streets and in some of the areas that crime had been prevalent. Crimes are increasing so the strategy of the country is to increase the police force and this is not in accordance with the growth of the economy (Edens, 2007).
Another evident problem of GDP as a measure of the economic growth is that GDP only measures the goods and services that are passing through the market. The problem with this is that the products that are not sold will not be measured. Statistics that will show the per capita Gross Domestic Product of the country may deceive the public because many of the production that is done inside the country is not included because it unsold products are not included in the measurement of GDP. One good example of this problem is when a country has small groups of people that are agriculturally nomadic, there products are not entering the market so this is not considered to be measured with the Gross Domestic Product of the country. This means that all production will not be measured, so the declaration of statistics of the Gross Domestic Product of the country is not that much that indicates the economic status of the country (Schenk, 2007).
Another problem of the Gross National Product as a measurement of the country’s economy is the term “underground economy”. Underground economy involves economic activities being done by the people that are not reported to the government. The reason of unreported economic activities of the some people is they refuse to pay taxes. One good example of the underground economy is that when waitresses in a restaurant receive tips from costumers and not reporting to the manager of the restaurant (Schenk, 2007).
2. Explain with the help of a numerical example how the quantity theory of the demand for money can be empirically applied to form an estimate of the hidden economy. Make sure to state the assumptions behind your analysis.
It is defined in economics that the quantity theory of money is highlighted by the positive relationship of the general prices towards the quantity of money. It was developed by Simon Newcomb and Irving Fisher. Irving Fisher has been able to derive an original equation of the quantity theory of money that is the amount of money in circulation is equals to the money that is considered the national income. The equation is:
MV = PT
where: M- money stock, V- velocity of circulation, P- mean price level, T- number of transactions
Several approaches to measure the hidden economy are presented by the paper done by Maurin et al (2003). Hidden economy is also referred and related to the black economy and underground economy which involves economic activities that are not included to the measurement of the Gross Domestic Product of a country. The quantity theory of money which was stated earlier can be used to estimate the hidden economy of the country. However, the theory of quantity theory of money can’t be used alone; it must go along with some approaches that will go hand in hand to be able to estimate the hidden economy of the country (Maurin et al, 2003).
One of the approaches that could be used to estimate the hidden economy together with the quantity theory of money is the use of the voluntary survey approach. The approach is an obvious way to determine the hidden economy of the country. The voluntary survey approach uses the method wherein people are individually asked if they have been participating in the hidden economy activities. When the chosen sample is not a participant of the hidden economy activities, they are separated from the group of those who are actively participating in the activities which concerns hidden economy. The use of the voluntary survey method is very useful to the determination of the hidden economy. To make it in a way that it would be done more empirically, the combination of the quantity theory of money equation with the voluntary survey approach could be done. After doing the survey, the analysis of the survey will lead to a quantitative analysis wherein the quantity theory of money equation can be used.
The quantity theory of money equation stated above can be regarded as the equation to measure the hidden economy is based on the equation of exchange wherein: money * velocity = total spending. For example the economy of the country has US$4 and it was spent six times in month, then the total spending for the month is $24 dollars. Applying this on the equation of the quantity theory of money wherein the assumptions like number of transactions (T) and velocity of money (V) is constant. Applying the equation: MV = PT, for example, the number of transactions done by a farmer and a merchant in the hidden economy is 6/month and they have a velocity of money say, 2/month, money stock (M) used is $24 while the average price level (P) is $8 then, both sides of the equation is equal with each other. Since T and V are constant, M and P are the only variables that would determine the hidden economy using the quantity theory of money. Continuing from the example, when M is increased to $30 while P is also increased as $10, then, difference from the first set of data to the second set of data will be evident. This proves some of the assumptions of the quantity theory of money like the assumption that when there is a change in the money supply there is also a change in the price levels of the goods and services offered. This assumption is also followed by the measurement of the hidden economy. Another assumption is that the number of transactions (T) is measured using the indicators like labor, capital and some factors of production.
The different assumptions regarding the theory of money the amount of money is the one which will determine the value of money. That is, when the amount of money is increased, the value of money will decrease because an increase in money value causes a rise in the inflation rate of the economy. Therefore, high inflation will require more money to purchase goods and services (Haekal, 2005).
Edens, M. (2007). GDP: A true measure of economic welfare? Retrieved August 21,
2007 from www.angelfire.com/realm3/secret_garden/GDP.doc
Haekal, Reem (2005). What is the quantity theory of money?. Investopedia. A forbes Media Company. Retrieved August 21, 2007 from http://www.investopedia.com/articles/05/010705.asp
Maurin, A., Sookram, S. & Watson, P.K. (2003). Measuring the Size of the Hidden Economy in Trinidad and Tobago. Retrieved August 21, 2007 from http://ecomod.net/conferences/ecomod2003/ecomod2003_papers/Maurin.pdf
Olivier Vaury, “Is GDP a good measure of economic progress? “, post-autistic economics review, issue no. 20, 3 June 2003, article 3, http://www.paecon.net/PAEReview/issue20/Vaury20.htm
Schenk, Robert. (2007). Limitations of the GDP of the country. Retrieved August 21, 2007 from http://www.ingrimayne.com/econ/Measuring/GNP2.html
tutor2u. (2007). Measuring National Income. Retrieved August 21, 2007 from http://www.tutor2u.net/economics/content/topics/macroeconomy/national_income.htm