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Answers to Pop quizzes and other questions

Section 2.3– macro objectives (Chapters 48 – 55)

Note that the answers below are my own and have no links to ‘official’ IB exam questions. I have not included the questions for the simple reason that one might reasonably assume that you have a copy of the book – and I am simply not interested in providing free-riders with material. I have left these answers ‘unlocked’ in that you may print them out and re-vamp them to your needs. Again, feel free to write me with comments and/or questions at

S2.3Ch49 Economic growth

Page 323HL extension: Calculating growth from data

Table 1

  1. The rate of growth is given by a simple formula; ((GDP1 – GDP0) / GDP0)* 100.
  2. In the first time period, 2005 to 2006, we get ((2,447.7 – 2,282.9) / 2,282.9) * 100 = 7.2%.
  3. The second period, 2005 to 2006, gives us ((2,812 – 2,447.7) / 2447.7) * 100 = 14.8%.
  4. ….etc…
  1. Real GDP is calculated using the GDP deflator to adjust for inflation. The formula for calculating is GDPr = (GDPnom at tn / GDP deflator at tn) * 100. Now, the problem here is that we need to re-do the GDP deflator for a new base year, namely 2005. For the two years calculated above, we get:
  • New base year for GDP deflator: 2005 = 100
  • GDP deflator for 2006: the GDP deflator has increased by 3.45%, calculated by

((90 – 87) / 87) * 100. Thus our GDP deflator in 2006 is 103.45

  • GDP deflator for 2006: ((92 – 87) / 87) * 100 gives us a 5.7% increase in the price level since the base year 2005. Thus, the GDP deflator for 2005 is 105.7

Now, having a new series of the GDP deflator using 2005 as a base year, we can deflate the nominal values of GDP by the formula GDPr = (GDPnom at tn / GDP deflator at tn) * 100:

  • Since 2005 is the base year, nominal and real GDP are the same: GDPr = 2282.9.
  • We calculate real GDP for 2006 by (2447.7 / 103.45) * 100. GDPr = 2366.
  • GDP real….for 2007 is calculated by (2812 / 105.7) * 100. GDPr = 2660
  1. Again, using the first two years as an example, we would do the same calculation as in question 1. above – but with real rather than nominal values.
  • The first time period, 2005 to 2006, gives us ((2366 – 2282.9) / 2282.9)* 100 = 3.64%
  • Growth during 2006 – 2007; ((2660 – 2366) / 2366) * 100 = 12.8%
  • …and so on…

Page 323…continued

Table 2

  1. (Note: the question reads “…higher than the US…” which of course should read “…higher than the UK…”.)Well, there are quite a few more than two ‘howevers’, yet what immediately stands out is that the nominal values are not adjusted for inflation and that we know nothing about population or population growth rates. Adjusting for China’s 1.3 billion people and the UK’s 60 million people will give an entirely different outcome. Then there is the issue of GDP per capita being an average – nothing is said about the distribution of income. One might also mention that it is easier to have high growth rates at lower levels of GDP than at higher levels – for example, an increase from 10 to 11 is a 10% growth rate while an increase from 100 to 105 is a 5% growth rate.
  1. Adjusting for purchasing power is a method to show that “…USD10 in the UK most certainly does not mean the same as having USD10 in China!”

S2.3Ch50 Unemployment

Page 329Calculating unemployment from data

a)The total labour force is: 80,000 + 100,000 + 90,000 + 70,000 + 50,000 = 390,000

b)High school students (50,000), disabled (20,000), military (10,000), university students (10,000) are removed from the labour force.

c)Total labour force is thus 300,000 individuals

d)The unemployment rate is 24,000 / 300,000; 8%

S2.3Ch52 Inflation

Page 344Pop Quiz 52.1

  1. Trick question! We really cannot say since we do not have the year-upon-year CPI data. It is impossible to say what has been happening to the rate of inflation.
  1. The nominal price of a Guinness has gone from €1.5 in 1995 (€30/20 pints) to €1.65 (€33/20) in 2001. The CPI has gone from 100 in 1995 to 119 in 2001. Thus, the real price of a pint of Guinness in 2001 is €1.38, calculated by ((€1.65/119))*100). A pint is now cheaper in real terms.
  1. The nominal price of potatoes has fallen from €0.2 per kg to €0.18 per kg. The real price has fallen from €0.2 per kg to €0.15 per kg, calculated by ((€0.18/119)*100).

Page 349Pop Quiz 52.2

  1. Simple, they don’t! They set the price in USD, £ or € - depending on which is/are the most important tourist group(-s). You can still pay using the Turkish lira but the amount you pay will vary on the daily exchange rate.
  1. Assuming that you are not paying a commission (which is a fixed or flat-rate fee for exchanging any amount of currency) you should exchange as little as possible every day! As the Turkish lira depreciates against hard currencies such as the USD, € and £, you will get more lira.
  1. Credit card. Hopefully it will take a while for the money to be taken from your account – during which time the Turkish lira depreciates further…and you pay less to buy the 2.5 billion lira for the carpet.
  1. The Temple of Artemis in Ephesus and the Mausoleum of Halicarnassus. Worth a visit!

S2.3Ch53 Causes/consequences of inflation and deflation

Page 357Pop Quiz 53.1

  1. High inflation means that the value of real debt is falling – as the principal (= original loan) is ‘hollowed-out’ by inflation. This was how Robert Mugabe for many years managed to, in effect, steal from his own people; he would borrow money, allow high inflation, print more money – that was ever more deflated, i.e. worthless – to ‘pay back’…etc.
  1. This would become a ‘classic’ cost-push spiral. Higher prices of imported factors would decrease both AD (due to increased import expenditure – HL; note we are assuming rather low PED for these imports!) and AS (as production costs for domestic firms rise). Higher wage demands (possibly to counter the ‘first round’ of imported inflation) will further drive up costs for firms…
  1. (Apologies here for the unforgivable stupidity in losing the source for these figures! I did not make these up but compiled them from real data…the source of which I neglected to note. Here’s a real-life lesson for all our extended essay students.) Recall that the monetarist/new-classical view is that LRAS does not show correlation between real output and the price level. The increase in the supply of money (Sm), via the ‘transmission mechanism’ of lower interest (r) and increased consumption (C) and investment (I) will lead to an increase in AD. This can be seen during the first three time periods, where increased money supply causes ever-increasing inflation – and also real growth. However, since real growth rates are falling throughout, a monetarist/new-classical view would be that long run aggregate supply (LRAS) has not increased at the same rate as AD. This would lead, according to the monetarist/new-classical view, to wage and factor prices being bid-up (as households and firms to not suffer from ‘money illusion’) and a subsequent decrease in short run aggregate supply (SRAS). Ultimately, it appears, SRAS has decreased more than AD has increased – leading to de facto falling growth rates.

Page 358Pop Quiz 53.2

  1. Well, this is actually not so much a textbook answer as it is an interesting case study – in light of the “Deflation – the ten year sunset in Japan” story on the same page. The Japanese government in fact did precisely this in 2010; the cigarette tax in Japan was increased by 40% on October 1st 2010. Now, the answer I had in mind for this question was “This is actually a one-off increase in the price level and thus does not meet the technical requirement for ‘general and sustained’ increase in the price level – so, not technically inflation.”

Now, what in fact frequently happens when additional expenditure taxes are announced in advance, is that expectations kick in. People seeing a rise in expenditure taxes bring forward their purchases of goods to avoid paying more after the tax hike. This indeed becomes inflationary if/when the boost to overall consumption is such that it does not ‘crowd out’ other consumption but in fact adds to consumption; AD increases and we see demand-pull inflation.

This is exactly what happened in the autumn of 2010 in Japan. Japanese started hoarding cigarettes the months before the tax hike. So much in fact that it was estimated at the time that the increase in consumption of cigarettes during the 3rd quarter added 1.3 percentage points to estimated yearly growth! This had the immediate effect of slowing down the rate of deflation (e.g. falling price levels) in Japan during the last months of 2010.

  1. The function of money is to act as a medium of exchange (rather than bartering, which is very inefficient); a store of value (negating inflation, €1 today equals two Snicker bars today…and two snicker bars next week); unit of account (€1 is two Snicker bars or one Coke); and a way to defer (= put off, postpone) payments (which is hard to do if you are going to pay with a horse or bag of strawberries…they don’t age with style!). Inflation erodes all of these functions: high inflation reduces our confidence in money and simply not accept it; inflation means that the value of ‘stored money’, e.g. savings, decreases; inflation makes it difficult for people to compare prices and thus arrive at ‘fair’ exchanges; and of course inflation makes it harder to defer payments as those we owe money (creditors) will be receiving less real money in the future.
  1. Most students will have income on the form of an allowance from parents and/or government. These funds will be set for given time periods and you will not be able to ‘bid-up’ your allowance at the same speed that prices are rising. In other words, inflation will have a negative effect on the real spending power of people on fixed incomes.
  1. Assume the home currency to be the Japanese Yen (¥). Rising domestic inflation – ceteris paribus! – will cause the relative price of export goods to increase and the relative price of import goods to fall. Disregarding any issues of the PED for exports and imports, one would see exports fall and imports rise. Foreigners would thus need less ¥ (the demand for a currency is derived to a great extent from the demand for a country’s goods and services) and the Japanese would need more foreign currencies to buy imports. We would see a decrease in demand for the ¥ and an increase in supply. The ¥ would depreciate.
  1. Well, it’s relatively uncommon, but one speaks of ‘benign deflation’ – an increase in AS that reduces the price level in an economy. The increase in AS increases GDP and also makes the economy more competitive internationally.
  1. We would have a completely inelastic investment schedule (demand for investment) – thus, no correlation between the rate of interest and firms’ investment plans. Monetary policy would be ineffective in changing national income.

S2.3Ch54 HL extension on SR and LR Phillips Curve

Page 369Pop Quiz 54.1

  1. To show the relative importance of goods households consume. Milk and gasoline are more important than paper clips and rubber bands. We assign gasoline (petrol) with greater (relative) weights than paper clips to show that a 5% increase in the price of gasoline will have a greater effect on households than the same percentage increase in the price of paper clips.
  1. The CPI is the most commonly used measure of inflation – yet there are inherent (= built-in) weaknesses in all such indexes. Perhaps the main criticism is that any price index is an average and thus there might be huge differences in the price changes of individual goods. The CPI ‘basket of goods’ does not show increases in quality or choice
  1. ‘Money illusion’ is the concept that households believe that ‘more money is more real money’ – i.e. they do not understand that inflation hollows out the real value of their wages. People think in nominal rather than real prices. Thus, if people do NOT suffer from money illusion, they will realise that inflation has eaten-away at their purchasing power and thus act to bid-up wages. It is this bidding-up process that increases costs for firms and decreases aggregate supply, returning the economy to YNRU in the monetarist/new-classical model.
  1. (See pages 367 and 368 for illustration.) Higher inflationary expectations shift the short run Phillips curve to the right. Posit that households have negotiated (themselves or via unions) for 4% wage increase during the next year on an assumption of 2% inflation. In other words, they have negotiated for a real wage increase of 2%. A rise in inflation to 4% means that real wages over the coming year are effectively the same. Now households have higher inflation expectations and bid up wages which causes a decrease in aggregate supply; inflation increases and unemployment returns to the natural rate of unemployment. The economy is operating along a new short run Phillips curve.
  1. Demand-side policies stimulate the (derived) demand for labour, which in turn decreases unemployment. However, another effect of rising aggregate demand is inflation – which means a rise in inflationary expectations…and thus a bidding-up of wages that decreases aggregate supply. The economy returns to the NRU. Figure 54.5 (page 368) illustrates this.
  1. Supply-side policies aim to increase LRAS by a) removing labour market impediments such as minimum wage; b) increasing the incentives for firms to produce and workers to work by lowering taxes on labour and income, and; c) increasing competition in the economy. By increasing both the quantity, quality and availability of factors, government can lower the NRU in the LR. Recall that the NRU consists of structural/frictional/seasonal unemployment – any government policies that decrease the time between jobs for workers will in fact decrease the NRU.