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                         Solution to Discussion #2

Question 1
Use Table 2 (exercise 5.2, p. 124) to answer the following questions.
  a. Use expenditure approach to calculate Canada’s GDP in 1999.
  b. Use income approach to calculate Canada’s net domestic product at factor
     cost in 1999.
  c. Calculate GDP – net domestic product at factor cost in 1999.
  d. Calculate indirect taxes less subsidies in 1999.

 a. Using the expenditure approach,
    GDP = C + I + G + NX
          = $559 + $170 + $200 + $28 = $957 billion.
 b. Using the income approach,
    Net domestic product at factor cost
     = Wages, salaries, and supplementary labor income + Interest
     and investment income + Profits of corporations and govt.
    enterprises + Income from farms and unincorporated
    businesses = $499 + $48 + $113 + $62 = $722 billion.
 c. GDP minus net domestic product at factor cost
                    = $957 − $722 = $235 billion.
 d. Net domestic product (market price) = GDP – depreciation.
          = 957 – 120 = $837 billion
      So, indirect taxes minus subsidies
             = NDP (market price) – NDP (factor cost)
             = $837 − $722 = $115 billion.

Question 2
The survey of Household spending in the city of Firestrom shows that people
consume only firecrackers and bandages. In 2002, the year of the survey and
also the base period, the average household spent $ 100 on firecrackers and $ 10
on bandages. The price of a firecracker in 2002 was $2 and the price of
bandages was $ 1 a pack. In the current year, 2003, the price of a firecracker is
$ 3 and the price of bandages is $ 1.25 a pack. Calculate
   a. The CPI basket.
   b. The percentage of average household’s budget spent on firecrackers in the
      base period.
   c. The CPI in 2003.
   d. The inflation rate in 2003.

 a. The CPI basket is the quantities bought during the Survey year,
    2002. The average household spent $100 on firecrackers at $2 a
    firecracker so the quantity of firecrackers bought was 50. The
    average household spent $10 on bandages at $1 a pack so the
    quantity of bandages bought was 10 packs. The CPI basket is
    50 firecrackers and 10 packs of bandages.
 b. In the base period, expenditure on firecrackers was $100 and
    expenditure on bandages was $10, so the household budget was
    $110. Therefore percentage expenditure on firecrackers
       = ($100/$110) × 100
       = 90.9 % of the average household’s budget.
 c. To calculate the CPI in 2003, find the cost of the CPI basket in
    2003 and 2002. In 2002, the cost of CPI basket
         = $110 ($100 for firecrackers and $10 for bandages).
    In 2003, the cost of CPI basket = $150 (50 firecrackers at $3
    each) + $12.50 (10 bandages at $1.25 a pack)
       = $162.50.
    The CPI in 2003 = ($162.50/$110) × 100 = 147.7.
 d. The inflation rate in 2003 = [(147.7 − 100.0)/100.0] × 100
                                 = 47.7 %.

Question 3
Explain the effect of Japan’s AD in the short run of each of the following events,
one at a time.
   a. The price level in Japan is constant, and the price level in its trading
       partners increase.
   b. The real interest rate in Japan is negative in the short run.
   c. The rest of the Asia goes to recession.
   d. The Asian economy experiences very strong growth.
   e. The yen strengthens against world currencies.
   f. Japan adopts an expansionary fiscal policy and cuts taxes.
   a. The increase in the price level in Japan’s trading partners makes Japanese-
      made goods relatively less expensive. Japan’s exports increase and
      Japan’s imports decrease, which shifts Japan’s AD curve to the right.
   b. Faced with a negative real interest rate, businesses and people in Japan
      buy new capital and consumer durable goods and increase spending. The
      quantity of Japanese real GDP demanded increases and there is a
      movement down along the AD curve.
   c. As the rest of Asia goes into recession, the demand for Japanese exports
      decreases. Japan’s AD decreases and the AD curve shifts leftward.
   d. As Asian economies experience very strong growth their demand for
      Japanese-produced goods increases. Japanese exports increase, which
      increases AD, and shifts the AD curve rightward.
   e. A stronger Yen makes Japan’s exports relatively more expensive and
      imports from other countries relatively less expensive. Japanese exports
      decrease and imports increase, which decreases Japanese AD and shifts
      the AD curve leftward.
   f. When Japan adopts an expansionary fiscal policy and cuts taxes, AD
      increases and the AD curve shifts rightward.

Question 4
For several years Japanese economy has experienced deflation,
   a. How might have caused this deflation?
   b. How might consumers and business react to deflation in ways that might
      worsen it?

   a. The most likely cause of the Japanese deflation is a shift in AD to the left
      caused by expectations such as (1) a decrease in expected future income
      which lower the amount of consumption goods that people plan to buy
      now (2) a decrease in expected future inflation, which delay people’ plan
      to buy and (3) a decrease in expected future profit, which decreases
      investment that firms plan to undertake (draw a diagram).

   b. When consumers expect the deflation to continue, they expect prices to
      continue to fall. They will decide to buy goods and services in the future
      when they are cheaper and AD today shift to the left. When people are
      buying fewer goods and services today, businesses are unsure of when
      their profits will increase. Businesses decrease investment, which shift
      AD to the left, further worsening the deflation (draw a diagram).