inflation and economic growth

1. Can gross domestic product be used as a measure of welfare, well being? Discuss.
Gross domestic product (GDP) is a vital concept in national income accounting. It may be defined as “the total market value of all final goods and services produced within a given period by the factors of production located within a country” (Case, Fair & Oster, 2008, p.105.). Essentially, GDP is a measure of production of an economy; that is, it measures its economic performance. Despite this, economists often use GDP statistics as an indication of social welfare. According to Case, Fair and Oster (2008) however, this may cause serious problems to arise. These problems are put forwards in the following limitations.
Firstly, GDP tends to misrepresent or exaggerate social welfare in periods of natural disasters. During hurricane Gilbert in 1988 for example, Jamaica was massively destroyed by heavy rainfall and destructive winds. Lives and valuable possessions were lost and homes and businesses were left with millions of dollars worth of damages. Subsequently, consumer, business and government expenditure increased in order to effect repairs, replace possessions and relieve the suffering. This extensive expenditure caused Jamaica’s GDP to increase. However, Jamaicans did not enjoy a higher standard of living. On the contrary, they were made worse off. This illustrates that GDP is not an accurate measure of the welfare of an economy.
Secondly, GDP does not reflect transactions that take place in the underground economy1. These transactions, however, involve actual output and generate income that may have a tremendous effect on the society’s welfare. According to Adir (2013), the underground economy is not only important in developing countries but also in many developed ones, particularly in Southern Europe. These economies provide employment for the relatively unskilled as well as resources for the formal economy and pump large amounts of income into the circular flow. This acquisition of employment, resources and income makes firms and households better off in many respects. However, since such transactions are not documented by GDP, it is not a true measure of social well-being.
Another limitation of GDP as a measure of welfare is that it excludes non-market activities which may make people better or worse off in important ways. Such activities include volunteer and household work. Volunteer work done at hospitals, schools, community centers, children homes and other organizations greatly benefit society and contributes to the improvement of one’s general standard of living (Adir, 2013). Similarly, household work and the production of goods and services (such as cooking and childcare) within the home involve actual output and benefit those who live there (Case, Fair &Oster, 2008). However, because such work is not for the market, it is not captured by GDP and therefore does not show these welfare gains.
Because GDP is computed at market prices, it ignores production externalities (Adir, 2013). Such externalities include noise, pollution and traffic congestion which may have tremendous effects on people’s (and the environment’s) well-being. However, according to Case, Fair and Oster (2008), GDP accounting rules do not adjust for production that confers externalities, regardless of how much of these externalities are ‘split over’ during production. This can be applied to the issue of using fossil fuels for energy. Even though increased energy consumption usually corresponds with growth thus boosting a country’s GDP, it may mean more pollution and adverse and harmful effects to our environment (Adir, 2013). GDP’s exclusion of these negative effects makes it an inappropriate and inaccurate measure of welfare.
Wealth distribution; an important attributing factor to welfare and standards of living, is not expressed by GDP (Case, Fair & Oster, 2008) and therefore cannot be used as a welfare measure. In other words, GDP does not describe whether or not the people of an economy are truly benefitting from economic growth. This can be seen in countries such as Qatar that has significant wealth due to oil trade but where only an insignificant percentage of the population hold all the wealth of the country (Adir, 2013). Due to the manners in which GDP is calculated it does not show whether or not growth is actually improving the welfare of the general population.

Leisure time is of utmost importance to the well-being of all individuals. An increase in leisure time means an increase in social welfare. This, however, is not reflected in GDP. In fact, according to Case, Fair and Oster (2008), some increases in leisure time (such as in a period of full employment) leads to a decrease in GDP even though social welfare have increased. It is therefore obviously, the GDP cannot be used as a measure of welfare and well-being.

2. What are some of the problems with the interpretation of unemployment statistics that can cause unemployment statistics to underestimate or overestimate the true rate of unemployment?
Unemployment is a macroeconomic concept which refers to the situation in which people are without work and are making active efforts to gain employment (Investopedia, 2014). According to Case, Fair and Oster (2008), unemployment statistics is a key indicator of an economy’s performance. As such, the Statistical Institute of Jamaica (STATIN) conducts Labour Force Surveys and publishes various measure of unemployment on a quarterly basis. One such measure is the unemployment rate. The unemployment rate, as defined by Investopedia (2014), is a measure of the prevalence of unemployment and is calculated as a percentage by dividing the number of unemployed individuals by all individuals currently in the labor force. Like other unemployment data, the unemployment rate has various limitations. These may cause either an underestimation or an overestimation of the true rate of unemployment and are presented below.
Firstly, the unemployment rate does not account for underemployment. The Merriam Webster Dictionary (2014) defines underemployment as the condition in which people in a labor force are employed at less than full-time or regular jobs or at jobs inadequate with respect to their training or economic needs. In Jamaica for example, there are formally trained and highly skilled nurses who are working at fast food joints because they find it difficult to get jobs within the health sector. Similarly, there are persons with master’s degrees in education who are working as part-time or substitute teachers. Despite the fact that these persons represent unused labour efforts, they are counted as employed and are therefore not accounted for in the country’s unemployment rate. As such, the unemployment rate underestimates the actual amount of unemployment in the economy.
Another limitation of the unemployment rate which causes an underestimation of the true amount of unemployment in an economy is the exclusion of discouraged workers. Discouraged workers refer to people who are without a job and who have stopped looking for employment (Buck, 2008). Such workers may have stopped looking because of a lack of skills, previous unsuccessful searches or a lack of available jobs in the field. Because they are no longer looking for jobs, discouraged workers are classified as “not in the labour force” and no longer counted as unemployed (Case, Fair & Oster, 2008). Therefore, an increase in the number of discouraged workers reduces the unemployment rate. During the recession of 1972 to 1980, for example, Jamaica’s unemployment rate reduced by approximately 0.23 between 1976 and 1977. According to Chung (2012), this was due to the fact that thousands of workers became discouraged and stopped looking for work, thus falling out of the ranks of the unemployed and the labour force. If these workers had continued their search for jobs, the unemployment rates for these three years would have increased. Consequently, workers becoming discouraged may reduce the reported unemployment rate and underestimate the true amount of unemployment in the economy.
The unemployment rate may also be understated if persons who have been unemployed for prolonged periods are not included in the calculations (Buck, 2008). In carrying out its Labour Force Surveys, STATIN excludes persons who have been unemployed for over 12 months from the unemployment figures. This will cause the true rate of unemployment to appear lower than it really is.
Other limitations of the unemployment rate will cause an overestimation of the real amount of unemployment in an economy. One such limitation has to do with the misrepresentation of facts with the aim of receiving unemployment benefits. In many developed countries such as the United States of America and England, the government provides monetary compensation for unemployed citizens. According to Buck (2008), this provides an incentive for persons to provide misleading information to surveyors. With the increase in reported unemployment, the unemployment rate of such countries will be overestimated. Even though the Jamaican government does not provide a benefit that is specifically for the unemployed, citizens may misrepresent themselves to STATIN officials with the hope that some benefit is received. Many people have been found to respond untruthfully to questions about employment, welfare and standard of living because they believe that they will get sum benefit. This contributes to the overestimation of Jamaica’s unemployment rate.
3. How might an economy experience an increase in nominal GDP but experience negative growth at the same time?
According to the Library of Economics and Liberty (2010), economic values (such as gross domestic product [GDP]) may be expressed in one of two ways; as a nominal value or as a real value. Simply put, a nominal value is an economic value that is measured at current market prices. In other words, it is an unadjusted value which reflects current situations. Consequently, nominal GDP is GDP measured in current dollars; that is, all components of GDP measured at their current prices (Case, Fair & Oster, 2008). Since nominal GDP is a measure of output at current prices, if the general price levels in an economy increase (due to inflation) then the figure for nominal GDP will also increase. This increase in nominal GDP may cause one to believe that there has been actual growth in the economy. However, this is not so if the quantity of output itself did not change since actual economic growth is characterized by an increase in total output (Case, Fair & Oster, 2008). Take the example of a simplified economy that produces only one good: pencils. In each year (2012 and 2013), twenty (20) pencils were produced. If the price of a pencil was $3 in 2012, then the nominal GDP for that year would have been $60 (i.e. $20 *$3). If, however, the price of a pencil rose by $2 in 2013 due to inflation, then the nominal GDP would be $100 (i.e. $20*$5). Evidently, nominal GDP increased by $40 even though the quantity produced remained the same. In summation, inflation may cause an economy to experience an increase in nominal GDP but at the same time experience negative growth. A measure of real GDP makes adjustments for inflation and is therefore a more accurate measure of actual economic growth.

4. Inflation exerts significant costs on the economy. Specifically, explain how inflations:
i. causes a misallocation of resources ii. discourages savings iii. redistributes wealth from lenders to borrowers.
Inflation, in economics, refers to the sustained increase in the general price levels of goods and services in an economy over a given period of time (Investopedia, 2014). Price stability is one of the four main objectives of macroeconomic policy and this is because of the adverse economic effects associated with increasing price levels (inflation). These include the misallocation of resources, the discouragement of savings and the redistribution of wealth from lenders to borrowers.
When inflation occurs, the prices of commodities rise at different rates. Firms, unions, banks and other economic institution will influence costs, rents, wages and interest rates to different extents and this causes price distortions. According to Beggs (2013), these distortions negatively affect the efficiency of the price mechanism in the allocation of resources towards different goods and services. When inflation is volatile, firms and households are unlikely to have sufficient information on relative price levels in order to make informed decisions about which products to supply and purchase. As a result, resources may be misallocated. Firms may ignorantly inject capital and allocate extra labour to goods that are more costly and relatively unprofitable. Similarly, households, not having sufficient information on price relations, may allocate their financial resources to more expensive goods. The distortions caused by inflation may cause resources to be misallocated in different ways. Suppose, for example, manufacturing workers get fast wage increases while public sector employees do not. This will cause resources (labour) to be reallocated (ultimately misallocated) due to the relative market power of the different workers and various socio-economic and political issues may arise.
According to Rennie (2014), inflation is seen as highly undesirable for the simple reason that it reduces the purchasing power of money. As a result, inflationary periods tend to encourage quick spending and discourage saving. As the general price levels in an economy increase, ceteris paribus, the value of money will fall. This means that people will not be able to buy as many goods and services as before. Because of this, they will not want to save. Instead, they will spend their incomes as quickly as possible (before its value falls any further) in order to acquire goods and services at current prices; that is, before they become more expensive and less affordable (Economic Revision, 2014). This problem becomes even more severe during periods of hyperinflation2, such as that which was experienced in Bolivia in 1984 and 1985. During this period, the price of an egg rose from 3,000 pesos to $10,000 pesos in one week. In 1985, three bottles of aspirin were sold for the same price a luxury car had been sold for in 1982 (Case, Fair & Oster, 2008). Evidently, money held in savings accounts would not be able to acquire the same amount of goods and services as before since the real value of such savings would have been eroded. A man saving to buy a luxury car would only be able to buy a mere three bottles of aspirin. Of course, this effect occurs when the rates of interests paid on savings are below the actual rate of inflation. According to Rennie (2014), if interest rates are higher than the inflation rate, then savers would still be able to acquire the goods and services they desire and be left with real returns.
Inflation also redistributes wealth from lenders to borrowers. As Beggs (2013) proposed, when the price levels in an economy rise, the value of debt repayments diminish. This benefit borrowers at the expense of lenders since the repayments will be made with less valuable dollars. For example, suppose I borrow $10 to buy a pencil with the intent to pay back next week. However, at the point of my repayment, the price of pencils increased by 50% now costing $15. The $10 dollars that I repaid would have been less valuable in real terms since it would not be able to a buy a pencil. Obviously, I would have benefitted at the lender’s expense. In order to get real returns on loans, lending agencies charge interest rates which often take into account the rate of anticipated inflation; the higher the expected rate of inflation, the higher the interest charged. However, the problem of redistribution remains if the rate of inflation is higher than the interest charged. According to Beggs (2013), this causes the value of debt to be lower in real terms and therefore reduces the real returns on loans. Again, this makes borrowers better off at the expense of lenders. Consider the example proposed by Case, Fair and Oster (2008). Suppose you borrow $100 from me to be paid back in a year. We both anticipate that the inflation rate during the year would be 10% and therefore agree on an interest rate of 15%; 10% to account for inflation and a 5% real interest rate for me (I would receive $115). Suppose however, the actual rate of inflation during the year turned out to be 20%, I as the lender will be hurt. Because inflation was higher than expected, you have paid back less than you have borrowed in real terms and I received a negative real interest rate of 5%3. Evidently, inflation, especially when it is higher than expected, redistributes wealth from lenders to borrowers.

5. Consider the following basket
ITEMS
PPU ($) 1999
QPU (1999)
T ($)
PPU ($) 2000
T ($)
PPU ($) 2001
T ($)
PPU ($) 2002
T ($)
Clothing
1200
2
2400
2000
4000
2500
5000
3500
7000
Food
3500
5
17500
5700
28800
6000
30000
6500
32500
Drink
3000
3
9000
4000
12000
4200
12600
4400
13200
Textbook
1300
10
13000
2000
20000
3550
35500
4000
40000
Medication
800
3
2400
2000
6000
3000
9000
3500
10500
Necessities
600
9
5400
1500
13500
1800
16200
2800
25200
TOTAL

49700 84000 108300 128400

b) Using the data in the table, compute the CPI for 2000, 2001 and 2002; assume 1999 to be the base year.
CPI = Price of basket in 2000 × 100 = 84000 × 100 = 169 Price of the basket in 1999 49700

CPI = Price of basket in 2001 × 100 = 108000 × 100 = 218 Price of the basket in 1999 49700

CPI = Price of basket in 2002 × 100 = 1284000 × 100 = 258 Price of the basket in 1999 49700

c) Calculate the rates of inflation for 2001 and 2002.
Inflation rate of 2001 = CPI2001 - CPI2000 × 100 CPI2000 = 218 - 169 × 100 169 = 49 × 100 = 29% 169

Inflation rate of 2001 = CPI2002 - CPI2001 × 100 CPI2001 = 258 - 218 × 100 218 = 40 × 100 = 18% 218
REFERENCES
Adir, A. (2013). GDP: An Indicator of Economic Welfare? Retrieved on March 4, 2014, from Friedman’s Economy, from http://friedmanseconomy.wordpress.com/2013/03/04/gd panindicatorofwelfare/
Beggs, J. (2013). The Costs of Inflation. Retrieved on March6, 2014, from About.com, from http://economics.about.com/od/inflation-category/a/The-Costs-Of-Inflation.htm
Buck, J. (2008). Limitations of Unemployment Data. Retrieved on March2, 2014, from Economic Perspective, from http://econperspectives.blogspot.com/2008/09/limitatio ns-of-unemployment-data.html
Case, K. E., Fair, R. C., & Oster, S. M. (2008). Principles of Macroeconomics. (9th ed.). NJ: Prentice Hall.
Chung, D. (2012). Why Jamaica is back in Recession? Retrieved on March 7, 2014, from the Jamaica Observer, from http://www.jamaicaobserver.com/business/Why-is-Jamaica-back-in-recession-
Economic Revision. (2014). Types, Causes, Consequences and Effects of Inflation. Retrieve on March 5, 2014, from http://economicsrevision.co.uk/type-causes-consequences-and-effects-of-inflation/
Investopedia. (2014). Inflation. Retrieved on March 2, 2014, from http://www.investopedia.c om/terms/i/inflation.asp
Investopedia. (2014). Unemployment. Retrieved March 6, 2014, from http://www.investoped ia.com/terms/u/unemployment.asp
Investopedia. (2014). Unemployment Rate. Retrieved March 6, 2014, from http://www.investo pedia.com/terms/u/unemploymentrate.asp
Library of Economics and Liberty. (2010). Real vs. Nominal. Retrieved on March 5, 2014, from http://www.econlib.org/library/Topics/HighSchool/RealvsNominal.html.
Merriam Webster Dictionary. (2014). Underemployment. Retrieved on March 7, 2014, from http://www.merriam-webster.com/dictionary/underemployment
Rennie, W. (2014). Costs of Inflation. Retrieve on March 3, 2014, from Economics Help from http://www.economicshelp.org/macroeconomics/inflation/costs-inflation/

References: Adir, A. (2013). GDP: An Indicator of Economic Welfare? Retrieved on March 4, 2014, from Friedman’s Economy, from http://friedmanseconomy.wordpress.com/2013/03/04/gd panindicatorofwelfare/ Beggs, J Buck, J. (2008). Limitations of Unemployment Data. Retrieved on March2, 2014, from Economic Perspective, from http://econperspectives.blogspot.com/2008/09/limitatio ns-of-unemployment-data.html Case, K Chung, D. (2012). Why Jamaica is back in Recession? Retrieved on March 7, 2014, from the Jamaica Observer, from http://www.jamaicaobserver.com/business/Why-is-Jamaica-back-in-recession- Economic Revision Investopedia. (2014). Inflation. Retrieved on March 2, 2014, from http://www.investopedia.c om/terms/i/inflation.asp Investopedia Investopedia. (2014). Unemployment Rate. Retrieved March 6, 2014, from http://www.investo pedia.com/terms/u/unemploymentrate.asp Library of Economics and Liberty Merriam Webster Dictionary. (2014). Underemployment. Retrieved on March 7, 2014, from http://www.merriam-webster.com/dictionary/underemployment Rennie, W