Name:

Principles of Economics Davidson CollegeFall 2002 Mark C. Foley

Review # 3

Due Friday December 6th by 5 p.m. in Chambers 202SUGGESTED SOLUTIONS

Directions: This review is closed-book, closed-notes, but you may take as long as you want in one sitting. You may use a calculator if you wish.

There are 150 points on the exam. Each multiple-choice question is worth 2 points. Each short answer is worth 5 points. The problems in Sections III and IV are worth 25 points each.

You must show all your work to receive full credit. Any assumptions you make and intermediate steps should be clearly indicated. Do not simply write down a final answer to the problems without an explanation.

Think clearly and work efficiently. Carpe diem.

Honor Pledge

Section 1: Multiple Choice Indicate your answer in the space provided to the right of each question.

1. The goal of macroeconomics is B

(a) to explain the economic changes that affect a particular household, firm, or market.(b) to explain the economic changes that affect many households, firms, and markets at once.(c) to devise policies to deal with market failures such as monopoly, externalities,

common resources, and public goods.(d) all of the above

2. In a simple circular-flow diagram, total income and total expenditure in D

an economy(a) are seldom equal because of the dynamic changes which occur in an economy.(b) are equal only when all goods and services produced are sold.(c) are always equal because of accounting rules.(d) are always equal because every transaction has both a buyer and a seller..

3. In the CPI, goods and services are weighted according to D

(a) whether the goods and services are necessities or luxuries.(b) the levels of production of the goods and services in the domestic economy.(c) a random weighting scheme.(d) how much consumers buy of each item.

4. If Honda, a Japanese-owned company, opens a factory in Ohio D

(a) U.S. GNP rises more than U.S. GDP.(b) Japanese GDP rises more than Japanese GNP.(c) Both (a) and (b) are correct.(d) None of the above are correct.

5. The demand for loanable funds D

(a) slopes upward because an increase in the interest rate induces people to save more.(b) slopes upward because an increase in the interest rate induces people to invest more.(c) slopes downward because an increase in the interest rate induces people to save less.(d) slopes downward because an increase in the interest rate induces people to invest less.Savers provide loanable funds, Investors (in the macroeconomic sense of the word) use (i.e., demand them.

6. Which list contains only actions that decrease the money supply? B

(a) raise the discount rate, make open market purchases, decrease reserve requirements(b) raise the discount rate, make open market sales, increase reserve requirements

(c) lower the discount rate, make open market purchases, increase reserve requirements(d) lower the discount rate, make open market sales, decrease reserve requirements

7. When the Fed wants to change the money supply, it most frequently A

(a) conducts open market operations.(b) changes the discount rate.(c) changes the reserve requirement.(d) issues Federal Reserve notes.

8. John Keynes explained that recessions and depressions occur because of D

(a) excess aggregate demand.(b) inadequate aggregate supply.(c) excess aggregate supply.(d) inadequate aggregate demand.

9. The natural rate of unemployment is C

(a) zero percent.(b) the rate associated with the highest possible level of GDP.(c) the amount of unemployment that the economy normally experiences.(d) the difference between the long-run and the short-run unemployment rates.

10. Part of the argument against deficits is that they C

(a) increase interest rates and investment.(b) decrease interest rates and investment.(c) increase interest rates and decrease investment(d) decrease interest rates and increase investment.

Section II: Short Answer Answer all these questions (No choice )

On these pages, respond to the following.

1. Define productivity. List the determinants of productivity and then provide one example of each for a furniture factory. Productivity is the amount of goods and services produced from each hour of a worker’s time.Y/L = Af(K/L,H/L,N/L,1)Physical capital (K/L) – more lathes per worker enables more chairs to be built per hour worked.Human capital (H/L) – manager’s greater understanding of how the factory works enables more chairs per hour to be built.Natural resources (N/L) – more wood per worker enables more rocking chairs to be builtTechnological knowledge (A) – knowledge about the best way to make furniture enables more chairs per hour to be built.

2. Precisely define gross domestic product and explain each of the seven (7) important phrases or words. Then define each of the components of GDP when it is written as the identity: Y = C + I + G+ NX. Rank the four components by size (% of Y).

GDP is the market value of all final goods and services produced within a country in a given period of time.

“Market value” implies that many different goods and services are added together to calculate GDP and the common unit of measurement is the market price, which reflects the value of the good or service.

“of all” indicates that GDP tries to be exhaustive, including all goods and services produced and sold legally, including the market value of housing services (i.e., rent or imputed rental value if you own your home). Excluded from GDP are illegal items and anything produced and consumed at home, so that it never enters a market, e.g., vegetables grown in your backyard garden.

“final” indicates that intermediate goods are not included, unless they are added to a firm’s inventory (and then when they leave that firm’s inventory, GDP falls!). The value of intermediate goods is included in the price paid for a final good.

“goods and services” indicates that things we buy and consume are included in GDP, tangible (apples, laptops, bottles of water, etc.) and intangible (haircut, amusement park visits, etc.).

“produced” indicates that only goods produced in the given time period are included. Goods and services produced in the past but which change ownership in the current time period are not included in current GDP, e.g., used cars.

“within a country” indicates that GDP measures the value of all production taking place on that country’s land, no matter which country the producer is a citizen of. This is in contrast to GNP, which measures the market

value of all production taking place by a given country’s citizens (regardless of where they’re living).

“in a given period of time” indicates that GDP figures are for a given time frame, typically a quarter, i.e., 3 months, or a year.1998 U.S. GDP (Y) = $31,522 per person.

1. C = $21,511 (68%) 2. G = $5,507 (18%)3. I = $5,063 (16%)4. NX = -$559 (-2%)

3. What’s the definition of a recession?

The old definition was two consecutive quarters of falling GDP; however, today the National Bureau of Economic Research (NBER) employs a variety of factors and indicators to assess the beginnings and endings of economic cycles. The following is taken from http://www.nber.org/cycles/recessions.html.

A recession is a significant decline in activity spread across the economy, lasting more than a few months, visible in industrial production, employment, real income, and wholesale-retail sales. A recession begins just after the economy reaches a peak of activity and ends as the economy reaches its trough. Between trough and peak, the economy is in an expansion. Expansion is the normal state of the economy; most recessions are brief and they have been rare in recent decades.

Because a recession influences the economy broadly and is not confined to one sector, the committee emphasizes economy-wide measures of economic activity. The traditional role of the committee is to maintain a monthly chronology, so the committee refers almost exclusively to monthly indicators. The committee gives relatively little weight to real GDP because it is only measured quarterly and it is subject to continuing, large revisions.

The broadest monthly indicator is employment in the entire economy. The committee generally also studies another monthly indicator of economy-wide activity, personal income less transfer payments, in real terms, adjusted for price changes. In addition, the committee refers to two indicators with coverage of manufacturing and goods: (1) the volume of sales of the manufacturing and wholesale-retail sectors adjusted for price changes and (2) industrial production. The Bureau of Economic Analysis of the Commerce Department compiles the first and the Federal Reserve Board the second. Because manufacturing is a relatively small part of the economy, the movements of these indicators often differ from those reflecting other sectors.

Although the four indicators described above are the most important measures considered by the NBER in developing its business cycle chronology, there is no fixed rule about which other measures contribute information to the process.

4. Mankiw’s Principle #8 says “a country’s standard of living depends on its ability to produce goods & services.” List three ways in which a government can help raise productivity and explain how they would facilitate higher productivity.

Invest in production of capitalInvest in capital by foreignersInvest in human capitalProtect property rightsPromote free tradeGeography (create a port!)Limit population growthPromote research & developmentAll these will change one of these 4 determinants of productivity A f(1, K/L, H/L, N/L). See text for details on how.

5. Using a simple example, explain how banks create money under a system of fractional reserve banking.

See text pages 617-619.

Section III: Problems Do 2 of these 3 questions . (Your choice )If you start more than two, be sure to indicate (by circling the question #) which you want graded.

1. Suppose that firms become very optimistic about future business conditions and invest heavily in new capital equipment.

(a) Using an aggregate-demand/aggregate-supply diagram, show the short-run effect of this optimism on the economy. Assume the economy begins in long-run equilibrium. Label the original equilibrium levels of prices and real output, P1 and Q1. Label the new short-run levels of price and real output, P2 and Q2.Explain why the aggregate quantity of output supplied changes (3 reasons).

Let’s assume the economy begins in long-run equilibrium at point “a”, with price level P1 and output level Q1 at the intersection of AD1 and short-run AS1. If firms become optimistic about future business conditions, they will tend to invest more, so the AD curve shifts to the right to AD2. Now the economy is at point “b”, with price level P2 and output level Q2. The aggregate quantity of output supplied rises because the price level has risen and people have misperceptions about the price level, and/or wages are sticky, and/or prices are sticky, all of which cause output supplied to increase.

(b) Now use the diagram from part (a) to show the new long-run equilibrium of the economy. For now, assume there is no change in the long-run aggregate-supply curve.) Explain why the aggregate quantity of output demanded changes between the short-run and the long-run (3 reasons).

Over time, as the misperceptions of the price level disappear, and/or wages adjust, and/or prices adjust, the short-run AS curve shifts up to AS2 and the economy reaches equilibrium at point “c”, with price level P3 and output level back at Q1. The quantity of output demanded declines as the price level rises because of the wealth effect, the interest rate effect, and the exchange rate effect, all of which lead to lower AD at higher prices.

Price Level

Quantity of Output

LR AS

AS1

AD1

P1

Q1

a

AD2

AS2

b

c

Q2

P2

P3

(c) How might the investment boom affect the long-run aggregate-supply curve. Explain. The investment boom might affect the long-run AS curve because higher investment today means a larger capital stock in the future, thus leading to higher productivity and higher output.

2. Assume the economy is in a recession. Explain how each of the following policies would affect consumption and investment. In each case, indicate any direct effects, any effects resulting from changes in total output, any effects resulting from changes in the interest rate, and the overall effect. If there are conflicting effects making the answer ambiguous, say so.

(a) an increase in government spendingAn increase in government spending would shift the AD curve to the

right (to AD2), increasing output. The rise in output would raise consumption spending, since people would have higher incomes (“the multiplier effect”, AD2 to AD3), and raise investment spending through the accelerator (AD3 to AD4).

But money demand would also increase (due to the higher G and higher C), raising the interest rate through the market for money. This would tend to reduce consumption (C), since people would save more, and also reduce investment (I), since the cost of investing would be higher.

Overall, the changes in both consumption and investment are ambiguous.

The rise in AD will be more or less than the G, depending on whether the multiplier effect (plus investment accelerator) or the crowding-out effect is larger. As drawn above, the multiplier effect (plus investment accelerator) is larger, so the increase is AD (ADinitial to ADfinal) is bigger than the simple shock of G.

(b) a reduction in taxesA reduction in taxes would directly increase consumption spending

(C), since people would have higher after-tax incomes. Also, since the reduction in taxes increases consumption spending, AD increases, so total output goes up. The rise in output would raise consumption spending further, since people would have higher incomes (“the multiplier effect”), and raise investment spending through the accelerator. But money demand would also increase, raising the interest rate. This would tend to reduce consumption, since people would save more, and reduce investment, since the cost of investing would be higher.

Overall, consumption must increase (otherwise AD wouldn’t have increased at all) while the change in investment is ambiguous.

Price Level

Quantity of Output

ADinitial

AD2

G

AD3

multiplier effect

AD4

investment accelerator

ADfinal

Crowding-out

The shift in AD will be more or less than the tax change that caused it depending on the size of the multiplier effect (plus investment accelerator) compared to the size of crowding-out investment. (c) Suppose this tax reduction in part (b) equals $20 billion, that there is no crowding out, and the marginal propensity to consume is 0.75. What is the total effect of the tax cut on aggregate demand (calculate a number)?

The initial effect of the tax reduction of $20b is to increase AD by $20b * 0.75 since that’s how much of the money consumers spend, the Marginal Propensity to consume, MPC) = $15b. The total effect is determined by recognizing the multiplier effect, the fact that additional effects follow the initial effect as the added incomes get spent. The second round leads to increased consumption spending of $15b*0.75 = $11.25b. The third round would lead to $11.25*0.75 = $8.44b. These effects continue indefinitely, diminishing with time. Adding them up gives the total effect of the tax reduction.

With a MPC = 0.75, the sum of the infinite series is 1/(1-MPC), called the multiplier.The multiplier = 1/(1-.75) = 4, so the total effect is $15b *4 = $60 billion.

(d) How does the total effect of this $20 billion tax cut compare to the total effect of a $20 billion increase in government purchases? Explain the difference.

Government purchases have an initial effect of the full $20b, since they increase AD directly by that amount. The total effect of an increase in government expenditures is therefore $20b*4 = $80 billion. So government purchases lead to a bigger effect on output than a tax cut does. The difference arises because government purchases affect AD by the full amount, but a tax cut is partly saved by consumers, and so it doesn’t lead to as much of an increase in AD.

3. From 1947 to 1997, the consumer price index (CPI) in the United States rose 637 percent. Use this fact to adjust each of the following 1947 prices for the effects of inflation and fill in the last column of the table.

Item 1947 Price 1997 Price Does it cost more in 1997 in real

terms?University of NC tuition $130 $2,470 YesGallon of gasoline $0.23 $1.22 No3 minute phone call from NYC to LA

$2.50 $0.45 No

1 day hospital stay $35 $2,300 YesMcDonald’s hamburger $0.15 $0.59 No

Since the CPI rose 637%, that means [(CPI1997 – CPI1947)/CPI1947 ] * 100% = 637%.So [(CPI1997 – CPI1947)/CPI1947 ] = 6.37 CPI1997 / CPI1947 – 1 = 6.37 CPI1997 / CPI1947 = 7.37.So if an item costs under 7.37 times as much in 1997 as it did in 1947, then it’s relatively less expensive. An easy way to see this is to take the 1947 nominal price, multiply it by 7.37 and compare to the 1997 nominal price.

University of NC tuition: 130*7.37 = $958 < $2,470, so 1997 cost is higher.Gasoline: 0.23*7.37 = $1.70 > $1.22, so 1997 cost is lower.Phone call: 2.50*7.37 = $18.42 > $0.45, so 1997 cost is lower.Hospital stay: 35*7.37 = $258 > $2,300, so 1997 cost is higher.Hamburger: 0.15*7.37 = $1.11 > $0.59, so 1997 cost is lower.

(b) Using specific examples, explain four problems in using the CPI as a measure of changes in the cost of living.

The examples will depend upon your choice, but the three major problems are substitution bias (not taking into account consumer’s ability to substitute to relatively cheaper goods over time when a fixed basket is used to compute the CPI), the introduction of new goods (the purchasing power of the dollar rises when new goods are introduced), and unmeasured quality change (the CPI is distorted to the extent the Bureau of Labor Statistics does not perfectly account for changes in the quality of goods, which change over time). In addition, over time individuals have purchased more products at discount stores (where the same product is cheaper) and if the CPI baskets contains the higher-priced products, it will overstate the cost-of-living.

Section IV: Problems Do 2 of the following 4 problems. (Your choice )If you start more than one, be sure to indicate (by circling the question #) which you want graded.

4. (a) Suppose that Congress were to institute an investment tax credit. Label the axes below and show what would happen to the equilibrium values in the market for loanable funds. Explain the transition process in moving from the original equilibrium to the final equilibrium.

An investment tax credit would encourage firms to invest more and thus shift the demand curve for loanable funds to the right. It would not affect the amount that households save at any given interest rate, so the supply curve of loanable funds would not change. At the initial equilibrium interest rate, r1, there would be an excess demand for loanable funds (distance Q3 – Q1). This shortage of loanable funds would encourage lenders to raise the interest rate they charge (moving up along the Supply curve). As the interest rate rises, the demand for loanable funds would decline since it’s more expensive to borrow at higher interest rates (this would be a movement upward along the D2 curve). Through this process, the market would reach equilibrium at real interest rate r2 and quantity of loanable funds Q2.

(b) What would happen to the equilibrium values if the government went from a deficit to a surplus? Show the effects on the right-hand graph above.

Recall that the supply of loanable funds is public saving plus private saving. The effects of a government surplus would be to increase public saving, thus shifting the supply to the right. This would decrease the equilibrium interest rate and increase the quantity supplied of loanable funds in equilibrium.

(a) Market for Loanable Funds

Real Interest Rate

Qty Loanable Funds

(b) Market for Loanable Funds

Qty Loanable Funds

D1

D2

S

Excess demand

r1

r2

Q1 Q2 Q3

Real Interest Rate S1

D

S2

5. Choose one of the following debates and discuss both the pro and con viewpoints.

Should monetary and fiscal policymakers try to stabilize the economy? Should a country’s central bank aim for zero inflation? Should fiscal policymakers reduce the government debt?

See text Ch. 34.

6. (a) What are the three functions of money? How does inflation affect the ability of money to serve each of these functions?

(b) List 4 of the costs of inflation, and explain why they impose real costs. Which of all costs of inflation do you think is most important in the U.S. and why?

7. Mankiw’s Principle #8 says “a country’s standard of living depends on its ability to produce goods & services.” List three ways in which a government can help raise productivity and explain how they would facilitate higher productivity.

Invest in production of capitalInvest in capital by foreignersInvest in human capitalProtect property rightsPromote free tradeGeography (create a port!)Limit population growthPromote research & developmentAll these will change one of these 4 determinants of productivity A f(1, K/L, H/L, N/L). See text for details on how.

8. Explain how each of the following would affect the supply of money, the demand for money, and the interest rate. Illustrate your answer with properly-labeled diagrams.

(a) The Fed’s bond traders buy bonds in open-market operations.When the Fed’s bond traders buy bonds in the open-market operations, the money supply curve shifts to the right, causing a lower interest rate.

(b) Households decide to hold more money to use for holiday shopping.When households decide to hold more money to use for holiday shopping, the money demand curve shifts to the right, causing an increase in the interest rate.

(c) An increase in oil prices shifts the short-run aggregate supply curve to the left.

When an increase in oil prices shifts the short-run AS curve upward, the higher price level increases money demand. The money demand curve shifts to the right causing a higher interest rate.

Section V: Extra Credit

List the 10 Principles of Economics in Chapter 1 of Mankiw’s text.

1.

2.

3.

4.

5.

6.

7.

8.

9.

10.