Individuals Economics Limitations

Question: 1. Explain why real GDP might not be an unreliable indicator of the standards of living. 2. Why does unemployment arise and what makes some unemployment unavoidable? 3. Consider the following statement: When the average level of prices of goods and services rise, inflation rises' Do you agree or disagree? Explain. 4. What is the aggregate demand (AD) curve and why does it slope downwards? Explain. 5. What is the long-run aggregate supply (LRAS) curve and why is it vertical? Why does the short-run aggregate supply curve slope upwards? Answer: 1. Using real GDP to measure the wellbeing of individuals in a given economy presents various limitations which make the technique unreliable when it comes to the measuring of the standards of living. One of the reasons why GDP cannot be used to measure the country's living standard is the fact that it does not factor in leisure time. According to Thoma (2016, par. 3), leisure time is an important product which contributes a lot to the economic well-being of an individual. Therefore, keeping other factors constant, the more leisure time we have, the better off we are. GDP does not factor in environmental elements such as air and water pollution. Two economies might be having identical real GDP, but one contains polluted water and air while the other economy doesn't have any pollution. The standard of living between these economies will be different, but this will not be captured in the real GDP. Again, GDP focuses on goods and service which goes through clearly defined markets and ignores those products and services which are usually produced for subsistence purposes and barter trade activities. Barter trade and subsistence farming are among the major economic activities which take place in developing economies and lack of inclusion will mean that the GDP and the living standards are low which is not the case. Additionally, there are other factors which are not directly or completed omitted in the composition of real GDP which makes the method unreliable. They include security, social justice and political freedom, and household production. Structural unemployment occurs due to the long-term decrease in the demand in a particular industry leading to fewer opportunities as demand for human labor declines. (Janoski, Luke, Oliver, 2014, p.78-100). Recent replacement of robots with human labor in various manufacturing industries such as assembly industry is an example of structural unemployment. Apart from the replacement of robots with human labor, structural unemployment might also be as a result of foreign competition brought by globalization and shift in comparative advantage. Voluntary unemployment is also another type of unemployment which arises when individuals decide to stay unemployed instead of taking the jobs opportunities available. 2. Cyclical unemployment also known as demand deficient or Keynesian is caused by lack of demand for the available products and services. It arises when the economy of a given country is below the full capacity. A perfect example is when an economy experiences the recess period whereby the aggregate demand will reduce translating to a decrease in the level of output and adverse economic growth. During this economic period, organizations produce less units of output and may be forced to lay off some of its employees to cut-off some of its fixed costs and reduce redundancies. Frictional unemployment is also another kind of unemployment which occurs during the time people move from one job to another. Some unemployment such as cyclical and structural are unavoidable because firms, economy, and people are always making shifts through the phases of life. 3. I concur with the statement that an increase in the average price of goods and services leads to increase in inflation. According to McMahon (2010, par. 1), inflation is defined as the general increase in prices or a situation where too much money is chasing few goods. Based on the definition, we can infer that there is a connection between inflation and the pricing of average products and services. When there is too much money in circulation, it implies that consumers have more disposable income to spend. Disposable income is defined as the amount which remains with the consumer after the deduction of direct taxes such as PAYE and income taxes. The individual has the choice of whether to consume or save the amount. But due to low-interest income which the consumer is likely to receive as a result of low-interest rates, most consumers will prefer to spend the money instead of saving. The increase in disposable income leads to increase in the level of consumption of consumer goods and services, and this creates demand. According to the law of demand, an increase in demand leads to rising in the prices of the demanded goods and services. Therefore, with the increase in consumer demand and too much in money in circulation, we anticipate the producers to increase the prices which will lead to consumers spending more money than before in buying a particular set of products. Thus, there exist the direct connection between the level of prices and the rate of inflation. 4. Aggregate demand curve refers to the overall demand for final products and services in a given economy at a particular period. The curve presents the quantity of commodities and services which will be purchased by the consumers at various levels of price. (Mankiw, 2011, p.500-521). The inverse relationship between price and real GDP is caused by different reasons. One of the reasons why the curve slopes downward is wealth effect. The AD is based on the assumption that federal government maintains a constant supply of money. An increase in the level of prices leads to a decrease in value of wealth. The value of wealth is calculated based on the money supply. The rise in the prices also leads to decline in the purchasing power of money, and this makes consumers reduce the purchases. On the other hand, a decrease in the rates increases the consumers' purchasing power hence consumers can buy more goods and services. The second reason for the decline in AD curve is interest rates whereby as the interest rates rise, consumers are likely to reduce the transactions which are directly affected by the interest rates. The third reason is the net export effect. When there is an increase in the prices of locally-made products, buyers will consider buying foreign goods since they are slightly cheaper. This will lead to the decline in demand for local goods and increase in demand for foreign products. Exports will also decline, and since net export is a component of GDP, its demand (real GDP) will reduce with a decrease in net exports. 5. The long-run aggregate supply curve refers to a graphical representation of the relationship between the output and price level in the long run. It is an economic period which is sufficient for firms to adjust their factors of production to cater for anticipated economic gains or losses. (Boundless, 2016, par 1-5). The curve is vertical because, in the long run, the amount of products and services produced relies on the labor, natural resources, technology, and capital available in an economy and not the price. Wages and prices are highly flexible, and this implies that when the level of prices changes as a result of either deflation or inflation, salaries and other factors of production adjust fully. For instance, if the prices are doubled or cut by half and the wages adjusted respectively, there will be no effect and the economy will remain at full-employment. The short-run aggregate supply curve is upward sloping since the average supply curve is drawn based on a nominal variable such as salary rate. During the short-run, the rate of wages is fixed, and any increase in prices leads to high level of profits as a result of the increase in output. References Boundless. 2016. The Slope of the Long-Run Aggregate Supply Curve. Boundless Economics. [Online]. Available from: https://www.boundless.com/economics/textbooks/boundless-economics-textbook/aggregate-demand-and-supply-24/aggregate-supply-109/the-slope-of-the-long-run-aggregate-supply-curve-418-12515/ [Accessed 2 January 2017]. Janoski, T., Luke, D., Oliver, C. 2014. The causes of structural unemployment: Four factors that keep people from the jobs they deserve. Cambridge, UK: Polity Press. Mankiw, N. G. 2011. Essentials of economics. Cincinnati, Ohio: South-Western. McMahon T. 2010. What is the Real Definition of Inflation. [Online]. Available from: https://inflationdata.com/articles/2010/07/21/real-definition-inflation/ [Accessed on 2 January 2017]. Thoma M. 2016. Why GDP fails as a measure of well-being. [Online]. Available from: https://www.cbsnews.com/news/why-gdp-fails-as-a-measure-of-well-being/. [Accessed on 1 January 2017].