Spring 2010

Eco 302: Macroeconomics

Institute of Management Sciences

Assignment 1
Maximum Marks: 40
Instructor: Muhammad Imran Student ID: 093306

Question.1

• What are the three approaches to measure economic activity?

What do they give the same answer?

Answer:

Three Approaches to Measuring GDP

The national income accounts are based on the idea that the amount of economic activity
that occurs during a period of time can be measured in terms of:

1. The amount of output produced, excluding output used up in intermediate stages of

production (the product approach);

2. The incomes received by the producers of output (the income approach); and

3. The amount of spending by the ultimate purchasers of output (the expenditure

approach).

Each approach gives a different perspective on the economy. However, the fundamental
principle underlying national income accounting is that, except for problems such as
incomplete or misreported data, all three approaches give identical measurements of the
amount of current economic activity.

We can illustrate why these three approaches are equivalent by an example. Imagine an
economy with only two businesses, called Orange Inc and Juice Inc. Orange Inc owns
and operates orange groves. It sells some of its oranges directly to the public. It sells the
rest of its oranges to Juice Inc, which produces and sells orange juice. The following
table shows the transactions of each business during a year.

What is the total value, measured in dollars, of the economic activity generated by these
two businesses? The product approach, income approach, and expenditure approach are
three different ways of arriving at the answer to this question; all yield the same answer.

The product approach measures economic activity by adding the market values of
goods and services produced, excluding any goods and services used up in intermediate
stages of production. This approach makes use of the value‐added concept. The value
added of any producer is the value of its output minus the value of the inputs it purchases
from other producers. The product approach computes economic activity by summing the
values added by all producers.
In our example, Orange Inc produces output worth $35,000 and Juice Inc produces output
worth $40,000. However, measuring overall economic activity by simply adding $35,000
and $40,000 would “double count” the $25,000 of oranges that Juice Inc purchased from
Orange Inc and processed into juice. To avoid this double counting, we sum value added
rather than output: Because Juice Inc processed oranges worth $25,000 into a product
worth $40,000; Juice Inc’s value added is $15,000 ($40,000 – $25,000). Orange Inc
doesn’t use any inputs purchased from other businesses, sot its value added equals its
revenue of $35,000. Thus total value added in the economy is $35,000 + $15,000 =
$50,000.

2. The income approach measures economic activity by adding all income received by
producers of output, including wages received by workers and profits received by owners
of firms. As you have seen, the (before‐tax) profits of Orange Inc equal its revenues of
$35,000 minus its wage costs of $15,000, or $20,000. The profits of Juice Inc equal its
revenues of $40,000 minus the $25,000 the company paid to buy oranges and the $10,000
in wages to its employees, or $5,000. Adding the $20,000 profit of Orange Inc, the
$5,000 profit of Juice Inc, and the $25,000 in wage income received by the employees of
the two companies, we get a total of $50,000, the same amount determined by the product
approach.

3. Finally, the expenditure approach measures activity by adding the amount spent by
all ultimate users of output. In this example, households are ultimate users of oranges.
Juice Inc is not an ultimate user of oranges because it sells the oranges (in processed,
liquid form) to households. Thus ultimate users purchase $10,000 of oranges from
Orange Inc and $40,000 of orange juice from Juice Inc for a total of $50,000, the same
amount computed in both the product and income approaches.

• Why are goods and services counted in GDP at market value? Are
there any advantages or problems in using market value to measure production?

Answer:

Market Value:

To measure total production we must add together the production of all final goods
and services produced in a country.
Since we cannot add tons to units to meters to gallons, it is necessary to convert all
output to the same unit of measurement. Conversion is to calculate the market value
(market price) of each good and service and then add them together. Thus, market
value means valuing production according to market price.

Market value of a good = (Price of the good) (Quantity of the good) = P*Q

Example:
Suppose a country produces only three final goods. Quantities and prices of these
goods for two different years are given in the table below:
 Using market value allows us to add goods and services produced together, and to
compare the GDP of one year to that of another. We can see here that GDP increases
in 2004. This means the economy has grown from 2003 to 2004.

A problem with using market values to measure GDP is that some useful goods and
services are not sold in formal markets. Ideally, GDP should be adjusted upward to
reflect the existence of these goods and services. However, because of the difficulty
of obtaining reliable measures, some non-market goods and services simply are
ignored in the calculation of GDP. Some nonmarket goods and services are partially
incorporated in official GDP measures. An example is activities that take palace in
the so called underground economy. The underground economy are both legal
activities hidden from government record keepers (to avoid payment of taxes or
compliance with regulations, for example) and illegal activities such as drug dealing,
prostitution and gambling. Some might argue that activities such as drug dealing are
“bads” rather than “goods” and should not be included in GDP anyway although a
consistent application of this argument might rule out many goods and services
currently included in GDP.

• Look at the news paper for past few days. What new economic
statistics have been released? How do you interpret these statistics?

Answer:

Realistic assessment of economic issues, policies and performance

The report has emphasized the importance of strengthening the capability of the Federal
Board of Revenue, increase in documentation, reduction of exemptions, equal treatment
of incomes from different sources and the levy of comprehensive Value Added Tax

By Aftab Ahmad Khan

The First Quarterly Report for the year 2009-10 released by the State Bank of Pakistan on
12th January, 2010 presents a perceptive and realistic picture of current trends in the
economy and recommends appropriate policies and measures for putting it on a path of
sustained growth in a stable and equitable milieu.

Aggregate demand in the economy in the first five months of FY2009-2010 showed some
signs of recovery due to higher sales of selected industrial and agriculture raw materials
as wells as consumer goods. As a result the commodity producing sector and service
sector are likely to witness a modest recovery in FY10.

The overall growth of the economy in FY10 according to SBP may be around the target
of 3.3 per cent, higher that 2.0 per in FY09. The report quite appropriately has
highlighted the fact that the pace of economic recovery in the country has so far remained
weak due to uncertain domestic political and security situation which caused weakening
in investment demand. The commercial banks in this uncertain security milieu were also
reluctant to finance private sector credit, which was another factor obstructing quick
recovery of the economy.

Services growth in FY10 according to SBP is expected to maintain and slightly surpass
the FY09 growth mainly on account of recovery in finance and insurance sub-sectors,
which are likely to benefit from favorable supervisory measures announced during the
first quarter of FY10. These measures include: (a) ease in regulations regarding the
benefit of forced sale values of collateral while computing the provisioning requirements,
and (b) relaxation in loan classification and resultant lower provisioning requirements. In
addition, higher banking spread in QI-FY10 is expected to further boost banks net
earnings during the year.

The report has very correctly highlighted the importance of increasing the tax-to-GDP
ratio which in FY09 was already low at 9.8 per cent and may decline from this
unimpressive level in FY10. In view of our growing development needs and large
expenditure on debt servicing, it is crucial to increase our tax revenues. For this purpose
the report has quite correctly emphasized the importance of strengthening the capability
of Federal Board of Revenue, for equal treatment of incomes from different sources and
the levy of comprehensive Value Added Tax. Unfortunately tax morality has not become
a part of our national culture. Generally we look for the ways and means to evade taxes
and simultaneously expect that the government should provide us with all sorts of
benefits and facilities.

In the monetary field, the Year on Year (y-o-y) growth in broad money (M2) after
witnessing the lowest level of 8.0 per cent in April 2009 reached 13.4 percent by Dec. 5,
2009. The rise resulted entirely from y-o-y increase in net foreign assets (NFA) of the
banking system as growth in net domestic assets (NDA) of the banking system slowed to
8.4 percent y-o-y by December 5, 2009.

The contraction in corporate demand for bank credit which began in the second half of
FY09 further intensified in the initial months of FY10. The private sector witnessed the
worst performance in twenty years with y-o-y growth recording net retirement of 2.7 per
cent by December 05, 2009.

Inflationary pressures in the economy eased during the first five months of FY10 relative
to the corresponding period in FY09. The CPI index in Oct. 2009 dropped to 8.9 percent
but it bounced back 10.5 percent y-o-y during November 2009. Inflation as measured by
WPI rose to 12.5 per cent in November 2009 and is expected to remain strong in coming
months.
SPI inflation showed an increase during November 2009 to reach 10 per cent. As far as
the external sector is concerned, Pakistanis overall balance of payments recorded a
surplus of $0.9 billion during July-November FY10 compared to a deficit $5.6 billion in
the same period last year. During July-Nov FY10 current account deficit declined to $1.4
billion compared with $7.3 billion in the corresponding period of last year. This is the
lowest current account deficit for the July-Nov period during the last five years. The trade
deficit contracted by 33.4 per cent during July-Nov. FY10.

Workers’ remittances showed a notable growth (29.2per cent) during July-November

FY10. According to SBP projection during FY10 these would amount to $8.8 billion.

Pakistan’s foreign exchange reserves position during July-Nov. FY10 benefited from an
increase in financial inflows as well as a decline in current account deficit. Pakistan’s
total foreign exchange reserves increased to $13.7 billion by end-November 2009. SBP’s
reserves increased by $1.0 billion during July-Nov FY10, while scheduled banks’
reserves increased marginally by $300 million compared to $293 million in the
corresponding period of last year.

A careful study of the report reveals that the major challenges confronting economic
managers in Pakistan are these:

(1) Enhancing the rate of growth of the economy in FY2010-11 particularly by

concentrating on programs designed to raise agricultural incomes.

(2) Making necessary investments for removing constraints in the manufacturing

sector.

(3) Increasing investment in the transport and communications sector.

(4) Accelerating growth in the construction sector by facilitating release of new landing
urban areas and setting up a system to ensure clear land titles.

(5) Establishing training and vocational institutes on a priority basis to ensure that
new skills become available for effectively implementing development programs and
projects.

(6) Ensuring high employment intensity of the growth process.

(7) Enhancing tax-GDP ratio.

TABLE-1.1: Selected Economic Indicators

Growth rate (percent) FY08 FY09 FY10

LSM Jul-Oct 7.7 -5.0 0.7

Exports (fob) Jul-Nov 6.5 12.0 -7.4

Imports (cif) July-Nov 18.4 16.4 -23.0

Tax revenue (FBR) Jul-Sep 11.6 27.7 0.6

CPI (12 month ma) Nov 7.6 19.1 14.6

Private sector credit Jul-5th Dec 5.7 4.4 0.9

Money supply (M2) Jul-5th Dec 4.8 0.6 4.2

Billion US dollars

Total liquid reserves end-Nov 15.7 9.1 13.7

Home remittances Jul-Nov 2.6 2.9 3.8

Net foreign investment Jul-Nov 2.1 1.4 1.1

Percent of GDP

Fiscal deficit Jul-Sep 1.5 1.1 1.5

Trade deficit Jul-Nov 4.4 5.3 3.1

Current a/c deficit Jul-Nov 2.9 4.4 0.8

1. With SBP & commercial banks.

2. Based on full-year GDP in the denominator. For FY10, estimated full-year GDP has
been used.

Table 1.2: Projection of Major Macroeconomic Indicators

FY10

Annual Plan SBP

FY09 Targets Projections

Growth rates in percent

GDP 2.0 3.3 2.5-3.5

Average CPI inflation 20.8 9.0 10.0 - 12.0

Monetary assets (MD) 0.6 -120 - 13.0

Billion US dollars

Workers remittances 7.8 7.0 7.8 - 8.8

Exports (fob-Bop data) 19.2 19.9 18.5 - 19.0

Imports (fob-Bop data) 31.7 28.7 30.5 - 31.0

Percent of GDP

Fiscal deficit 5.2 4.9 4.7 - 5.2

Current account deficit 5.3 5.3 3.7 - 4.7

Note: Targets of fiscal and current account deficit to GP ratios are based on nominal GDP
in the budget document for FY10, while their projections are based on projected (higher)
nominal GDP for the year.

• List two things that GDP measures.

Answer:

GDP stands for gross domestic product. It is one of the measures of national income and
input for a given country's economy. It measures:

Expenditure
• Income

• How can GDP measures two things at once?

GDP or Gross Domestic Product is the total value of the money economy of a country,
usually in a year. It adds up all the profits made by all companies and all wages earned y
all people. It is a measure for the size of an economy, and its per capita variant is a
measure of wealth. A series of GDP values gives an idea of economic growth.

Moreover So I would say that a GDP doesn't 'measure' anything. It is by definition the
sum of all money transaction, (which is not measuring) and serves as a proxy to say
something about an economy, such as economic growth etc. It would be a mistake to say
that you can determine facts about an economy by looking at GDP, except for size of the
money-economy, which already is its definition.

As a measure for national or personal wealth it is criticized for not including non-
monetary items, such as unpaid services, or non-market, non-excludable goods (such as
clean air, or public safety).