Question

1. Describe the limitations of using Gross Domestic Product (GDP) as a measure of economic activity.

2. How does classical economics explain its confidence in the ability of natural forces to return the economy to its potential level of real GDP?

3. What were the reasons for establishing the Federal Reserve System as 12 Reserve banks rather than a single central bank in Washington?

4. What is meant by the "independence" of the Fed? Is the Federal Reserve independent? Explain why or why not.

Answer 1

1) GDP has various limitations as a measure of economic activity. The major ones are as follows-

GDP does not take into account the value of goods and services generated in the black market or in an informal sector.The activities of this market are hidden from the government especially in less developed economies where a large unstructured market exist and where transactions are done through barter and other such medium and so these transactions are not counted while computing the GDP and the share of this market is relatively huge which ranges from 8%- 20% of a country's GDP so if they are not being taken into consideration then, the GDP is mainly showing a understated economy.

GDP only provides data for domestic output whereas, the true measure of an economy and its inhabitants can be found by using GNP which reflects the output of a country's nationals only after making adjustments for factor incomes and transfer payments. Thus, not GDP but GNP is a true measure of the output of a country, if it wants to see how it is performing and how productive it's nationals truly are.

GDP also does not measure the welfare of the country. It only provides the final value of goods and services produced in a country and does not state whether those goods were actually used to increase the welfare of the economy. It also does not cover the inequality of income distribution.A country can have a very large GDP but it is not distributing those resources equally among it's inhabitants then it is not doing so well as it will only result in umemployment, huge costs in providing subsidies and welfare payments to a large number of its population,increase debt and widen the income gap.

GDP also does not show if the goods and services produced have had any negative impact on the environment or due to exploitation of its natural resources and the pollution it generated as measured by carbon emittion. It also does not show if the goods produced were actually beneficial for the society or harmful such as tobacco which will have a negative impact on its environment and only going to cost the economy in the long-run.