Week 2 - Prices & Growth

Question 1

Inflation

Answer 1

a general increase in the prices of goods and services in an economy

Question 2

Inflation rate

Answer 2

the rate of increase in prices over a given period of time

Question 3

Consumer Price Index (CPI)

Answer 3

measures the average change in prices paid by consumers over a period of time for a basket of goods and services.

Question 4

How to calculate the CPI

Answer 4

1. Fix the basket
2. Find the prices (the goods are weighted according to how much income is spent on each of them)
3. Compute the baskets cost (inflation rate)
   i. Same basket of goods
   ii. Isolate the effects of price changes

Question 5

Producer Price Index (PPI)

Answer 5

measures the average change over time in the prices domestic producers receive for their output (basket of goods)

Question 6

What are the problems with CPI?

Answer 6

1. Substitution bias
   i. Prices do not change proportionately (some prices rise/fall more than others) and as a result consumers substitute toward a good that has become relatively less expensive. However, the index assumes a fixed basket of goods and overstates inflation
2. Introduction to new goods
   i. Greater variety of goods makes the pound more valuable, therefore the cost of living declines, however the basket of goods in the index is updated only at a lag.
3. Unmeasured quality change
   i. The index doesn’t adjust prices to reflect quality changes when a good becomes better, therefore its price has effectively fallen and the pound stretches further
4. Peoples spending patterns are not typical and may differ
   i. This means that one person’s inflation rate may be higher/lower than the published, average CPI rate

Question 7

Retail Price Index (RPI)

Answer 7

tracks changes in the cost of a fixed basket of goods over time, but includes council tax and mortgage interest payments which the CPI excludes

Question 8

GDP deflator

Answer 8

a price index that shows how, on average, prices for all goods and services produced domestically in an economy change over time

Question 9

GDP deflator formula

Answer 9

GDP deflator = ratio of nominal GDP to real GDP

Question 10

GDP deflator vs CPI

Answer 10

1. GDP deflator is a measure of all products and services of the country (including non-consumer goods and services), while the CPI uses only consumer goods.
2. GDP deflator includes only domestic goods, while CPI includes anything bought by consumers, which includes non-domestic products (imported or foreign made).
3. GDP deflator has a changing set of commodities (compares the price of currently produced goods/services to the price of the same goods/services in the base year) while the CPI compares a fixed basket of goods to the price of the basket in the base year, therefore unlike the deflator the basket of goods us not updated automatically over time

Question 11

Economic growth

Answer 11

an increase in the production of goods/services in an economy

Question 12

Long run/trend growth

Answer 12

the long term, sustainable and non-inflationary increase in the economy’s productive capacity due to an increase in the long-run aggregate supply

Question 13

Short run/cyclical movements in the business cycle

Answer 13

when the economy uses spare capacity to increase the real output

Question 14

Endogenous growth theory

Answer 14

investment in human capital is the key driver of growth

Question 15

Productivity

Answer 15

measures how much output can be produced with a given set of inputs (measures the efficiency of the combination of labour and capital)

Question 16

Determinants of productivity

Answer 16

1. Physical capital
   i. Stock of equipment and structures used to produce goods and services. Capital is a produced factor of production
2. Human capital
   i. Knowledge and skills that workers acquire through education, training, and experience. It is less tangible than physical capital but is a produced factor of production as education is an investment.
3. Natural resources
   i. Inputs into the production of goods/services provided by nature, such as land, rivers, and mineral deposits. There is a distinguish between renewable resources (trees, wind, solar energy) and non-renewable resources (coal, gas, and oil)
4. Technological knowledge
   i. When there is an innovation in the economy, the production becomes easier since labour is used less, and the innovated technology is used more. This has been acknowledged as society’s understanding of the best ways to produce goods/services

Question 17

Production function

Answer 17

a function that represents the quantity of output a firm can produce given a certain quantity of input combination

Y = A F (L, K, H, N)

Y = output
A = available production technology
F() = a function that shows how inputs are combined to produce output
L = quantity of labour
K = quantity of physical labour
H = quantity of human capital
N = quantity of natural resources

Question 18

What are the causes of increase in producutivity input?

Answer 18

Capital (K) investment
Law of diminishing marginal returns
Human capital investments
Health and nutrition
Research and development (the ‘A’ in the production function)
Population growth