Multiple Choice Questions Solutions are provided directly when you do the online tests.

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1 SOLUTIONS Multiple Choice Questions Solutions are provided directly when you do the online tests. Numerical Questions 1. Nominal and Real GDP Suppose than an economy consists of only types of products: computers and automobiles. Sales and price data for these two products for two different years are as follows: Table 1 (1) () (3) () (5) No. of Computers Sold Price per Computer No. of Automobiles Sold Price per Automobile 1975, $1, 1,, $, ,5, $, 1,5, $1, Nominal GDP in any year is calculated by multiplying the quantity of each final product sold by its price and summing over all final goods and services. Algebraically, this can be written as i P i Q i where P i and Q i represent the price and the quantity sold of the i th final good or service. Assuming that all computers and automobiles are final goods, calculate nominal GDP in 1975 and in Solution: Nominal GDP in 1975 = $ 8 billion; Nominal GDP in 1995 = $ 18 billion. 1. Using 1975 as the base year, real GDP in 1975 is equal to nominal GDP in Calculate real GDP in 1995 using 1975 as the base year. Solution: $ billion.. Calculate the percentage change in real GDP between 1975 and 1995 using 1975 as the base year. Solution: % 3. Calculate real GDP in 1975 using 1995 as the base year. Solution: Real GDP in 1975 using 1995 as a base = $ 1. billion. 1

2 . Calculate the percentage change in real GDP between 1975 and 1995 using 1995 as the base year. Solution: 73.1% 5. Explain why your answers to () and () are different. Solution: In 1975 computers were expensive relative to automobiles. Consequently, when 1975 is used as a base year, the dramatic increase in the quantity of computers produced between 1975 and 1995 is multiplied by a big price ($1,) resulting in a large increase in real GDP. In 1995 however, computers were cheap relative to automobiles. Consequently, when 1995 is used as the base year, the large change in the quantity of computers produced in the period is multiplied by a relatively low price ($,) resulting in a much smaller increase in GDP.

3 . The GDP Deflator and the Consumer Price Index 1. Let 1975 be the base year for the CPI (i.e. CPI 1975 = 1). If the fixed market basket is the total amounts of computers and automobiles purchased in 1975, use the data in Table 1 to calculate the CPI in 1995, using 1975 as the base year. Solution: 13.. Calculate the GDP deflator in 1995 using 1975 as the base year (i.e = 1). Solution: Calculate the percentage changes in CPI and the GDP deflator between 1975 and Solution: %CPI (1975 = 1) = 3%; % Deflator (1975 = 1) = -5%.. Explain why you answers in 3 are so different from each other and relate your explanation to the difference between the Laspeyres and Paasche indices. Solution: In 1975 computers comprised a small portion of the consumer market basket. Therefore, in a Laspeyres index like the CPI, the dramatic reduction in the price of computers will be outweighed by the increase in the price of automobiles. For a Paasche index like the GDP deflator, however, the weight given to computers is much greater because they comprise a much large portion of the GDP in 1995 than in Consequently, in this index, the reduction in computer prices will outweigh the increase in automobile prices. 3

4 Computer Questions 1. a. Solution: Series are generated in the EXCEL file Q1.xls b. Solution: CPI inflation and PCE inflation Percent CPI PCE c. Solution: The figure above shows that the inflation rate measured using CPI tends to be slightly higher than the inflation rate measured using PCE (which is closer to GDP deflator in nature) most of the time. Despite of the slight difference, these two measures of prices usually tell the same story about the inflation rate in the past years. According to the NBER business cycle reference dates, there are 7 peaks and troughs since 19 s (April 19-February 191, December 199-November 197, November 1973-March 1975, January 198-July 198, July 1981-November 198, July 199-March 1991, March 1-November 1). During each recession period (Recession starts at the peak of a business cycle and ends at the trough), the inflation rate tended to rise. Especially in the 197 s and early 198 s, when the U.S economy was attacked by the two oil crises (the 1973 oil crisis and the 1979 oil crisis), inflation rate was substantially higher than at any other time in recent history. This result confirms that price is counter-cyclical during this period.

5 d. Solution: CPI inflation (All items v.s Less food and energy) 7 5 Percent change CPI all iterms CPI less food and energy PCE inflation (All items v.s Less food and energy) 5 Percent change PCE all items PCE less food and energy Comments: Both graphs show that when food and energy are excluded from the price index, the price changes become less volatile. This shows that the market fears of rising inflation are justified. 5

6 . a. Solution: Series are generated in the EXCEL file Okun.xls. b. Solution: Series are generated in the EXCEL file Okun.xls. c. Solution: Okun's Law perncent change in real GDP change in unemployment rate y = -1.91x R =.771 d. Solution: The figure above shows clearly that there is a negative relationship between the year-toyear change in unemployment and the annual percent change in real GDP i.e. increases in unemployment tend to be associated with lower growth in real GDP. To be precise, the regression equation tells us that percentage change in real GDP = *change in unemployment rate, which means that if the unemployment rate remains the same, real GDP grows by 3.98 percent. What s more, for every percentage point the unemployment rate rises, real GDP growth typically falls by 1.91 percent. This result is quite consistent with what Okun s Law has predicted.