Washington University in St. Louis Spring Economics 402 Homework # 1 Suggested Solution

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1 Washington University in St. Louis Spring 8 Department of Economics Prof. James Morley Economics 2 Homework # 1 Suggested Solution Note: This is a suggested solution in the sense that it outlines one of the many possible answers to the questions in the homework. 1. Measuring Economic Activity Real GDP per capita is, perhaps, the most common measure of standard of living. It provides a way to understand the level of comfort in terms of material goods- that a particular group of people have. Nonetheless, basing standards of living on a measure of economic performance only has some limitations: Efficiency: It focuses on the aggregate level of production and thus, aggregate income. It abstracts from matters relating to how this income is distributed among the population. For instance, in 1, the richest 1% of people in the U.S. held 32% of aggregate wealth, whereas the poorest half of the US held only 3% of aggregate wealth (Aiyagari, 1994; De Nardi and Cagetti, 5). Lack of accounting for other sources of well-being: Working is usually seen as a bad in Economics. Working translates into wage income and higher production, which increases real GDP. However, the opportunity cost of working is leisure, which is valued by people and not taken into account in GDP. Furthermore, it ignores the non-market economy of households and communities. Benhabib et al. (1) estimate that labor hours in the household sector are almost as great as in the market sector. Economic performance arising from bads : Because GDP records every monetary transaction as positive, the costs associated with natural disasters, pollution and social failures are tallied as economic improvements. Reconstruction efforts after Hurricane Katrina account for more than $1 billion, treatment of toxic wastes costs millions of dollars each year, and so do activities associated with crime prevention or property damage (Lawn, 3). Despite these criticisms, real GDP per capita is still used as a measure of standard of living due to its frequency and consistency of estimation. But, most importantly, it is still widely used because standard of living and real GDP per capita are positively correlated (see Easterlin, 1974, 5; Hagerty and Veenhoven, 3, 6; Pritchett and Summers, 1993; among others). Nonetheless, it is more useful for comparing standards of living across time than across countries. Crosscountry comparisons of GDP may be inaccurate, even after adjusting for PPP, due to the heterogeneous quality of goods and informal sectors and due to price level adjustments among countries (Rogoff, 1996). In addition to being positively correlated with other measures of standards of living, real GDP per capita correlates with political freedom in a positive way (Persson and Tabellini, 6). The idea that democracy influences economic performance through investment decisions and expectations creates a virtuous circle and makes expectations about democratic stability a key determinant of 1

2 economic prosperity. In general, political and economic structures, as well as institutions and property rights play a key role in determining the dynamics that allow a society to adapt and evolve over time (North, 1981). Independently of whether it is used as a measure of production or standard of livings, real GDP is not confined to those purposes. It has been essential for policymakers and individuals who determine their economic choices based on current or future economic performance. Stabilization or growth-oriented policies can help improve welfare based on the analysis of real GDP. Moreover, because it provides a measure of future economic conditions, high real GDP positively influences expectations of stability and economic prosperity that reinforces virtuous circles, as in Persson and Tabellini (6), or attracts other sources of wealth, such as Foreign Direct Investment (FDI). 2. Shares 2.1. Expenditure components Figure and table 1 show the relative importance of expenditure components of GDP as share of total expenditures for the period. Figure 1 Table 1 Components of GDP as a share of total expenditure: Components of GDP as a share of total expenditure: selected years 1 8 Cons. Invest. Gov. Sp. Net Exp CONS INV GOV XN The share of consumption was higher-than-average before WWII and dwindled as a consequence of the latter. In the aftermath, it stabilized around 7%, a lower level than before WWII, reflecting a reduction in savings. Indirectly, this backs up the assumption that the marginal propensity to consume is constant, as stated in the Neoclassical model seen in class. The share of investment fluctuates a lot more than that of consumption, even though it is much smaller. As consumption, it fell dramatically during WWII and recuperated after that. By contrast, the share of Government expenditure notably increased during this period, and stabilized to a higher level than the one prevailing before the war. Moreover, note that investment and Government expenditure are negatively correlated, which indicates the existence of a crowding-out effect. 2

3 Finally, net exports remained close to zero until the early nineties. As a consequence of globalization and the rapid reduction of relative prices around the world, the U.S. economy opened up and increased its trade deficit notoriously Output components Figure and table 2 show the relative importance of goods, services and structures as a share of total production for the period. 5 3 Figure 2 Table 2 Good, services and structures as a share of total production: Good, services and structures as a share of total production: selected years Goods Services Structures GOODS SERVICES STRUCTURES Over time, the share of structures has not changed drastically during the last 65 years. On the other hand, the relative importance of goods in the economy has gradually declined in the last 5 years whereas that of services has risen. This shift has been more pronounced in the last few decades because it has become economically advantageous for the U.S. economy to import such goods. Because the economic structures of other countries allow them to produce those goods at a cheaper cost, U.S. producers find it more profitable to move their operations overseas or simply stop producing. As a consequence, the bulk of economic activities in the U.S. economy has shifted toward the service sector Income components Figure and table 3 below show the relative importance of labor income and corporate profits as a share of total income for the period. The share of labor income and that of capital income are both relatively stable over the last 75 years. In a more detailed view, corporate profits have been more stable with the exception of the first years of the 193s, where they even became slightly negative as a consequence of the stock market crash in On the other hand, labor income share rose during these years and the subsequent recessions. One of the reasons behind this fact is that, during recessions, national income feel sharply and the Federal Government instituted higher wage standards. But, most importantly, labor was better compensated due, in part, to rising union memberships, which 3

4 allowed workers to bargain for higher wages. In the past 3 years, however, labor income share then leveled off at around 65%. Note that these relative stable shares are consistent with the assumption of the Cobb-Douglass function as an aggregate production function of the economy Figure 3 Table 3 Labor and corporate profits as a share of total income: Labor and corporate profits as a share of total income: selected years Labor share Corporate Profits LABOR CORPORATE 3. Adbusters The article states that GDP will increase as a result of a person falling sick. Implicitly, it is assuming that the additional medical expenses of the sick person will result in a higher GDP level. Nonetheless, the article fails to recognize GDP as an aggregate index and it is in this sense that the fallacy of composition makes the statement incorrect. When the person increases his medical expenses, he will likely reduce his expenses in other goods or services, say clothing. Therefore, the increase in the medical care share of GDP will likely be offset by a reduction in the apparel share of GDP. Furthermore, a long illness of the man will likely result in the loss of his job, which will reduce labor and, thus, GDP (as stated by the production function studied in class). In short, to determine the effect on an aggregate measure such as GDP, it is necessary to understand the effects of a particular action over all components of that aggregate measure, since they likely interact with each other. 4

5 References Aiyagari, Rao (1994). Uninsured Idiosyncratic Risk and Aggregate Saving. The Quarterly Journal of Economics 19(3), pp Benhabib, Jess, Richard Rogerson and Randall Wright (1). Homework in Macroeconomics: Household Production and Aggregate Fluctuations. Journal of Political Economy 99(6), pp De Nardi, Mariacristina and Marco Cagetti (5). Wealth Inequality: Data and Models. Wokring Paper Series WP51. Chicago: Federal Reserve Bank. Easterlin, Richard A. (1974). Does Economic Growth Improve the Human a lot? Some Empirical Evidence in: David, Paul A. and Melvin W. Reder (Eds.), Nations Households and Economic Growth: Essays in Honor of Moses Abramovitz. New York: Academic Press Inc. Easterlin, Richard (5). Feeding the Illusion of Growth and Happiness: A Reply to Hagerty and Veenhoven. Social Indicators Research 74, pp Hagerty, Michael and Ruut Veenhoven (3). Wealth and Happiness Revisited: Growing National Income does Go with Greater Happiness. Social Indicators Research 64, pp Hagerty, Michael and Ruut Veenhoven (6). Rising Happiness in Nations : A Reply to Easterlin. Social Indicators Research 79, pp Lawn, P.A. (3). A Theoretical Foundation to Support the Index of Sustainable Economic Welfare, Genuine Progress Indicator, and Other Related Indeces. Ecological Economics 44, pp North, Douglass C. (1981). Structure and Change in Economic History. New York: W.W. Norton. Pritchett, Lant and Lawrence H. Summers (1993). Wealthier is healthier. Policy Research Working Paper Series 115. Washington, D.C.: The World Bank. Persson, Torsten and Guido Tabellini (6). Democratic Capital: The Nexus of Political and Economic Change. Working Paper Series 38. Innocenzo Gasparini Institute for Economic Research, Bocconi University. Rogoff, Kenneth (1996). The Purchasing Power Parity Puzzle. Journal of Economic Literature 34(2), pp