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ECON 122 Principles of Macroeconomics Sections A, B Fall 2017

Problem Set 1
Chapter 23.
Quick Check Multiple Choice : 1-6 (see the textbook)
Problems and Applications

Problem 2:
The government purchases component of GDP does not include spending on transfer payments such
as Social Security. Thinking about the definition of GDP, explain why transfer payments are
excluded
Problem 3:
As the chapter states, GDP does not include the value of used goods that are resold. Why would
including such transactions make GDP a less informative measure of economic well-being?
Problem 4:
Below are some data from the land of milk and honey.

Year Price of Milk Quantity of Milk Price of Honey Quantity of Honey


2013 $1 100 quarts $2 50 quarts
2014 $1 200 $2 100
2015 $2 200 $4 100

a. Compute nominal GDP, real GDP, and the GDP deflator for each year, using 2013 as the base year.
b. Compute the percentage change in nominal GDP, real GDP, and the GDP deflator in 2014 and 2015 from
the preceding year. For each year, identify the variable that does not change. Explain why your answer makes
sense.
c. Did economic well-being rise more in 2014 or 2015? Explain

Problem 5:
Consider an economy that produces only chocolate bars. In year 1, the quantity produced is 3 bars
and the price is $4. In year 2, the quantity produced is 4 bars and the price is $5. In year 3, the
quantity produced is 5 bars and the price is $6. Year 1 is the base year.
a. What is nominal GDP for each of these three years?
b. What is real GDP for each of these years?
c. What is the GDP deflator for each of these years?
d. What is the percentage growth rate of real GDP from year 2 to year 3?

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ECON 122 Principles of Macroeconomics Sections A, B Fall 2017

e. What is the inflation rate as measured by the GDP deflator from year 2 to year 3?
f. In this one-good economy, how might you have answered parts (d) and (e) without first answering
parts (b) and (c)?
Problem 6:
Consider the following data on U.S. GDP:
Year Nominal GDP (in billions of dollars) GDP Deflator (base year 2005)
2012 15,676 115.4
2002 10,642 92.2

a. What was the growth rate of nominal GDP between 2002 and 2012? (Hint: The growth rate of a
variable X over an N-year period is calculated as 100 [(Xfinal/Xinitial) 1/N 1].)
b. What was the growth rate of the GDP deflator between 2002 and 2012?
c. What was real GDP in 2002 measured in 2005 prices?
d. What was real GDP in 2012 measured in 2005 prices?
e. What was the growth rate of real GDP between 2002 and 2012?
f. Was the growth rate of nominal GDP higher or lower than the growth rate of real GDP? Explain
Problem 8:
A farmer grows wheat, which she sells to a miller for $100. The miller turns the wheat into flour,
which she sells to a baker for $150. The baker turns the wheat into bread, which she sells to
consumers for $180. Consumers eat the bread.
a. What is GDP in this economy? Explain.
b. Value added is defined as the value of a producers output minus the value of the intermediate
goods that the producer buys to make the output. Assuming there are no intermediate goods beyond
those described above, calculate the value added of each of the three producers.
c. What is total value added of the three producers in this economy? How does it compare to the
economys GDP? Does this example suggest another way of calculating GDP?

Problem 10:
The participation of women in the U.S. labor force has risen dramatically since 1970.
a. How do you think this rise affected GDP?
b. Now imagine a measure of well-being that includes time spent working in the home and taking
leisure. How would the change in this measure of wellbeing compare to the change in GDP?

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ECON 122 Principles of Macroeconomics Sections A, B Fall 2017

c. Can you think of other aspects of well-being that are associated with the rise in womens labor-
force participation? Would it be practical to construct a measure of well-being that includes these
aspects?

Problem 11:
One day, Barry the Barber, Inc., collects $400 for haircuts. Over this day, his equipment depreciates
in value by $50. Of the remaining $350, Barry sends $30 to the government in sales taxes, takes
home $220 in wages, and retains $100 in his business to add new equipment in the future. From the
$220 that Barry takes home, he pays $70 in income taxes. Based on this information, compute
Barrys contribution to the following measures of income.
a. gross domestic product
b. net national product
c. national income
d. personal income
e. disposable personal income

Chapter 24
Quick Check Multiple Choice : 1-6 (see the textbook)
Problems and Applications

Problem 3:
Suppose that people consume only three goods, as shown in this table:
Tennis Balls Golf Balls Bottles of Gatorade
2014 price $2 $4 $1
2014 quantity 100 100 200
2015 price $2 $6 $2
2015 quantity 100 100 200

a. What is the percentage change in the price of each of the three goods?
b. Using a method similar to the consumer price index, compute the percentage change in the overall
price level.
c. If you were to learn that a bottle of Gatorade increased in size from 2014 to 2015, should that
information affect your calculation of the inflation rate? If so, how?
d. If you were to learn that Gatorade introduced new flavors in 2015, should that information affect
your calculation of the inflation rate? If so, how?
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ECON 122 Principles of Macroeconomics Sections A, B Fall 2017

Problem 5:
A small nation of ten people idolizes the TV show American Idol. All they produce and consume
are karaoke machines and CDs, in the following amounts:

Karaoke Machines CDs


Quantity Price Quantity Price
2014 10 $40 30 $10
2015 12 $60 50 $12

a. Using a method similar to the consumer price index, compute the percentage change in the overall
price level. Use 2014 as the base year and fix the basket at 1 karaoke machine and 3 CDs.
b. Using a method similar to the GDP deflator, compute the percentage change in the overall price
level. Also use 2014 as the base year.
c. Is the inflation rate in 2015 the same using the two methods? Explain why or why not.

Problem 6:
Which of the problems in the construction of the CPI might be illustrated by each of the following
situations? Explain.
a. the invention of the cell phone
b. the introduction of air bags in cars
c. increased personal computer purchases in response to a decline in their price
d. more scoops of raisins in each package of Raisin Bran
e. greater use of fuel-efficient cars after gasoline prices increase

Problem 7:
The New York Times cost $0.15 in 1970 and $2.00 in 2011. The average wage in manufacturing
was $3.36 per hour in 1970 and $23.09 in 2011.
a. By what percentage did the price of a newspaper rise?
b. By what percentage did the wage rise?
c. In each year, how many minutes did a worker have to work to earn enough to buy a newspaper?
d. Did workers purchasing power in terms of newspapers rise or fall?
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ECON 122 Principles of Macroeconomics Sections A, B Fall 2017

Problem 8:
The chapter explains that Social Security benefits are increased each year in proportion to the
increase in the CPI, even though most economists believe that the CPI overstates actual inflation.
a. If the elderly consume the same market basket as other people, does Social Security provide the
elderly with an improvement in their standard of living each year? Explain.
b. In fact, the elderly consume more healthcare compared to younger people, and healthcare costs
have risen faster than overall inflation. What would you do to determine whether the elderly are
actually better off from year to year?

Problem 9:
Suppose that a borrower and a lender agree on the nominal interest rate to be paid on a loan. Then
inflation turns out to be higher than they both expected.
a. Is the real interest rate on this loan higher or lower than expected?
b. Does the lender gain or lose from this unexpectedly high inflation? Does the borrower gain or
lose?
c. Inflation during the 1970s was much higher than most people had expected when the decade
began. How did this affect homeowners who obtained fixed-rate mortgages during the 1960s? How
did it affect the banks that lent the money?

Chapter 25.
Quick Check Multiple Choice : 1-6 (see the textbook)

Problems and Applications

Problem 2:
Suppose that society decided to reduce consumption and increase investment.
a. How would this change affect economic growth?
b. What groups in society would benefit from this change? What groups might be hurt?

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ECON 122 Principles of Macroeconomics Sections A, B Fall 2017

Problem 4:
What is the opportunity cost of investing in capital? Do you think a country can overinvest in
capital? What is the opportunity cost of investing in human capital? Do you think a country can
overinvest in human capital? Explain.

Problem 5:
In the 1990s and the first decade of the 2000s, investors from the Asian economies of Japan and
China made significant direct and portfolio investments in the United States. At the time, many
Americans were unhappy that this investment was occurring.
a. In what way was it better for the United States to receive this foreign investment than not to
receive it?
b. In what way would it have been better still for Americans to have made this investment?

Problem 6:
In many developing nations, young women have lower enrollment rates in secondary school than do
young men. Describe several ways in which greater educational opportunities for young women
could lead to faster economic growth in these countries.

Problem 7:
International data show a positive correlation between income per person and the health of the
population.
a. Explain how higher income might cause better health outcomes.
b. Explain how better health outcomes might cause higher income.
c. How might the relative importance of your two hypotheses be relevant for public policy?

Chapter 26.
Quick Check Multiple Choice : 1-6 (see the textbook)
Problems and Applications

Problem 1:
For each of the following pairs, which bond would you expect to pay a higher interest rate? Explain.

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ECON 122 Principles of Macroeconomics Sections A, B Fall 2017

a. a bond of the U.S. government or a bond of an Eastern European government


b. a bond that repays the principal in year 2020 or a bond that repays the principal in year 2040
c. a bond from Coca-Cola or a bond from a software company you run in your garage

Problem 2:
Many workers hold large amounts of stock issued by the firms at which they work. Why do you
suppose companies encourage this behavior? Why might a person not want to hold stock in the
company where he works?

Problem 3:
Explain the difference between saving and investment as defined by a macroeconomist. Which of
the following situations represent investment? Saving?
Explain.
a. Your family takes out a mortgage and buys a new house.
b. You use your $200 paycheck to buy stock in AT&T.
c. Your roommate earns $100 and deposits it in his account at a bank.
d. You borrow $1,000 from a bank to buy a car to use in your pizza delivery business.

Problem 4:
Suppose GDP is $8 trillion, taxes are $1.5 trillion, private saving is $0.5 trillion, and public saving is
$0.2 trillion. Assuming this economy is closed, calculate consumption, government purchases,
national saving, and investment
Problem 5:
Economists in Funlandia, a closed economy, have collected the following information about the
economy for a particular year:
Y = 10,000
C = 6,000
T = 1,500
G = 1,700
The economists also estimate that the investment function is:
I = 3,300 - 100r,
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ECON 122 Principles of Macroeconomics Sections A, B Fall 2017

where r is the countrys real interest rate, expressed as a percentage. Calculate private saving, public
saving, national saving, investment, and the equilibrium real interest rate.

Problem 6:
Suppose that Intel is considering building a new chipmaking factory.
a. Assuming that Intel needs to borrow money in the bond market, why would an increase in interest
rates affect Intels decision about whether to build the factory?
b. If Intel has enough of its own funds to finance the new factory without borrowing, would an
increase in interest rates still affect Intels decision about whether to build the factory? Explain.

Problem 7:
Three students have each saved $1,000. Each has an investment opportunity in which he or she can
invest up to $2,000. Here are the rates of return on the students investment projects:
Harry 5 percent
Ron 8 percent
Hermione 20 percent
a. If borrowing and lending is prohibited, so each student uses only personal saving to finance his or
her own investment project, how much will each student have a year later when the project pays its
return?
b. Now suppose their school opens up a market for loanable funds in which students can borrow and
lend among themselves at an interest rate r. What would determine whether a student would choose
to be a borrower or lender in this market?
c. Among these three students, what would be the quantity of loanable funds supplied and quantity
demanded at an interest rate of 7 percent? At 10 percent?
d. At what interest rate would the loanable funds market among these three students be in
equilibrium? At this interest rate, which student(s) would borrow and which student(s) would lend?
e. At the equilibrium interest rate, how much does each student have a year later after the investment
projects pay their return and loans have been repaid? Compare your answers to those you gave in
part (a). Who benefits from the existence of the loanable funds marketthe borrowers or the
lenders? Is anyone worse off?