Luiggi Donayre Summer 2009 Department of Economics Economics 104 Washington University Session 2. Exam 1

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1 Luiggi Donayre Summer 2009 Department of Economics Economics 104 Washington University Session 2 Exam 1 Name (Print Clearly!) This is a 105 point exam. There are 30 multiple choice questions worth 2 points each and 4 short answer questions worth a total of 40 points. At the end, there is a bonus question worth 5 points. Make sure you read every alternative for the multiple choice questions carefully before writing the letter of the alternative you think is best in the blank. Take your time with the multiple choice questions; they require careful thought. Write legibly in the space provided for the short answer questions. Your score may be lower if your answer cannot be easily read. Be concise and use sound economic reasoning, not just common sense. Make a special effort to be clear in your writing; the grade you receive on the questions depends in part on how well you communicate. Important Note: You may use your calculator for growth rate and compounding questions on this exam. You may not refer, however, to any saved information in your calculator. Accessing any inappropriate information, in your calculator or from any other source, is a serious breech of academic integrity and will be treated as such. GOOD LUCK! Multiple Choice Short Answer #1 Short Answer #2 Short Answer #3 Short Answer #4 Bonus Question /60 /12 /12 /12 /4 /5 Total Score /100 1

2 MULTIPLE CHOICE (2 points each): Write the letter of the alternative that best answers the question in the blank. Make sure you read all four alternatives before making your choice. D 1. Which of the following statements best represents the principle represented by the adage, "There is no such thing as a free lunch"? a. Ezekiel can attend the concert only if he takes his brother with him. b. Jeff is hungry and homeless. c. Drew must repair the tire on his bike before he can ride it to class. d. Luiggi must decide between going to Japan or China for the summer break. C 2. Molly decides to spend three hours working overtime rather than watching a video with her friends. She earns $8 an hour. Her opportunity cost of working is a. the $24 she earns working. b. the $24 minus the enjoyment she would have received from watching the video. c. the enjoyment she would have received had she watched the video. d. nothing, since she would have received less than $24 of enjoyment from the video. B 3. The business cycle is the a. relationship between unemployment and inflation. b. irregular fluctuations in economic activity. c. positive relationship between the quantity of money in an economy and inflation. d. predictable changes in economic activity due to changes in government spending and taxes. C 4. The basic principles of economics suggest that a. markets are seldom, if ever, a good way to organize economic activity. b. government should become involved in markets when trade between countries is involved. c. government should become involved in markets when those markets fail to produce efficient or fair outcomes. d. All of the above are correct. A 5. Just like models constructed in other areas of science, economic models a. incorporate assumptions that contradict reality. b. incorporate all details of the real world. c. complicate reality. d. avoid the use of diagrams and equations. B 6. In the circular-flow diagram, in the markets for a. goods and services, households and firms are both sellers. b. goods and services, households are buyers and firms are sellers. c. the factors of production, households are buyers and firms are sellers. d. the factors of production, households and firms are both buyers. 2

3 Figure 1 batteries B A bagels B 7. Refer to Figure 1. Which of the following events would explain the shift of the production possibilities frontier from A to B? a. The economy s citizens developed an enhanced taste for batteries. b. The economy experienced a technological advance in the production of batteries. c. More capital became available in the economy. d. More labor became available in the economy. A 8. Which of the following is an example of a normative, as opposed to positive, statement? a. Universal health care would be good for U.S. citizens. b. An increase in the cigarette tax would cause a decrease in the number of smokers. c. A decrease in the minimum wage would decrease unemployment. d. A law requiring the federal government to balance its budget would increase economic growth. D 9. Which of the following statistic is usually regarded as the best single measure of a society s economic well-being? a. the unemployment rate b. the inflation rate c. the trade deficit d. gross domestic product D 10. Maggie owns two houses. She rents one house to Qing for $10,000 per year. She lives in the other house. If she were to rent the house in which she lives, she could earn $12,000 per year in rent by doing so. How much do the housing services provided by the two houses contribute to GDP? a. $0 b. $10,000 c. $12,000 d. $22,000 3

4 C 11. GDP is not a perfect measure of well-being; for example, a. GDP incorporates a large number of non-market goods and services that are of little value to society. b. GDP places too much emphasis on the value of leisure. c. GDP fails to account for the quality of the environment. d. All of the above are correct. B 12. Real GDP is the yearly production of final goods and services valued at a. current prices. b. constant prices. c. expected future prices. d. the ratio of current prices to constant prices. C 13. Paul, an American wine connoisseur, purchases a bottle of Italian wine for $100. Then, a. U.S. consumption does not change, U.S. net exports decrease by $100, and U.S. GDP decreases by $100. b. U.S. consumption does not change, U.S. net exports increase by $100, and U.S. GDP increases by $100. c. U.S. consumption increases by $100, U.S. net exports decrease by $100, and U.S. GDP does not change. d. U.S. consumption increases by $100, U.S. net exports do not change, and U.S. GDP increases by $100. C 14. Suppose a basket of goods and services has been selected to calculate the CPI and 2002 has been selected as the base year. In 2002, the basket s cost was $50; in 2004, the basket s cost was $52; and in 2006, the basket s cost was $ The value of the CPI in 2004 was a b c d A 15. By far the largest category of goods and services in the CPI basket is a. housing. b. transportation. c. education & communication. d. food & beverages. A 16. If the price of domestically produced power tools increases, then a. the consumer price index and the GDP deflator will both increase. b. the consumer price index will increase, and the GDP deflator will be unaffected. c. the consumer price index will be unaffected, and the GDP deflator will increase. d. the consumer price index and the GDP deflator will both be unaffected. D 17. Sarah S. earned a salary of $50,000 in 2001 and $70,000 in The consumer price index was 177 in 2001 and in Sarah's 2001 salary in 2006 dollars is a. $25, b. $33, c. $44, d. $75,

5 C 18. Chai deposits $1,000 in a savings account that pays an annual interest rate of 4 percent. Over the course of a year, the inflation rate is 1 percent. At the end of the year, Chai has a. $30 more in his account, and his purchasing power has increased by $10. b. $30 more in his account, and his purchasing power has increased by $40. c. $40 more in his account, and his purchasing power has increased by $30. d. $50 more in his account and his purchasing power has increased by $40. B 19. Yu bought word-processing software in 2005 for $50. Yu's twin sister, Nidhi, bought an upgrade of the same software in 2006 for $50. To which problem in the construction of the CPI is this situation most relevant? a. substitution bias b. unmeasured quality change c. introduction of new goods d. income bias D 20. The deviation of unemployment from its natural rate is called a. the unnatural rate of unemployment. b. structural unemployment. c. frictional unemployment. d. cyclical unemployment. A 21. Julie is searching for a job that suits her tastes about where to live and coworkers. Saranya is looking for a job that makes best use of her skills. a. Julie and Saranya are both frictionally unemployed. b. Julie and Saranya are both structurally crazy. c. Julie is frictionally unemployed, and Saranya is structurally unemployed. d. Julie is structurally unemployed, and Saranya is frictionally unemployed. A 22. Frictional unemployment is inevitable because a. sectoral shifts are always happening. b. there is a federal minimum-wage law in the U.S. c. some people do not want to be employed. d. unions are very popular in the U.S. D 23. Which of the following statements describes best how the unemployment rate is an imperfect measure of joblessness in the economy? a. discouraged workers are correctly counted as unemployed. b. people have incentives to correctly report their status in the BLS survey. c. the unemployment rate distinguishes between full-time and part-time workers. d. working at Jack in the Box is as good as working at the World Bank. B 24. According to the Shapiro-Stiglitz model of efficiency wages a. in equilibrium, some workers can find it optimal to shirk. b. if firms pay the market-clearing wage, all workers will shirk. c. the higher the probability of being caught while shirking, the higher the efficiency wage. d. firms pay efficiency wages to increase the turnover rate. 5

6 C 25. If the natural rate of unemployment is NOT constant, then a. most of the variation in the unemployment rate is due to cyclical unemployment. b. transitory shocks to the economy are the main source of fluctuations in the unemployment rate. c. business cycles reflect market-clearing adjustments to exogenously changing conditions. d. all of the above are correct. C 26. Which of the following statements is correct about Okun s Law? a. it is a theoretical model. b. it shows that there is no clear relationship between unemployment and the growth rate of output. c. If the unemployment rate does not change, the growth rate of output is about 3.5%. d. it states that for each percentage point the unemployment rate increases, the growth rate of output will increase in two percentage points. C 27. Which of the following statements is true about annualized growth rates? a. annualized growth rates are slightly larger than 4 times the quarterly growth rate. b. the compounding effect of annualized growth rates becomes smaller for longer periods. c. it makes all data more easily comparable d. all of the above are correct. B 28. During the current economic crisis a. less developed economies have not been affected. b. sub-prime mortgage-backed securities collapsed at the beginning of the downturn c. prices have increased steadily. d. lack of credit is blamed as a cause of the crisis. D 29. Laurie buys a 1966 Mustang for $2,000, planning to restore and sell the car. She goes on to spend $8,000 restoring the car. At this point she can sell the car for $9,000. As an alternative, she can spend an additional $3,000 replacing the engine. With a new engine the car would sell for $12,000. Laurie should a. complete the repairs and sell the car for $12,000. b. sell the car now for $9, 000. c. never try such an expensive project again. d. be indifferent between (i) selling the car now and (ii) replacing the engine and then selling it. C 30. Joyce spends an hour studying instead of playing tennis. The opportunity cost to her of studying is a. the improvement in her grades from studying for the hour. b. the improvement in her grades from studying minus the enjoyment of playing tennis. c. the enjoyment and exercise she would have received had she played tennis. d. zero. Since Joyce chose to study rather than to play tennis, the value of studying must have been greater than the value of playing tennis. 6

7 SHORT ANSWER QUESTIONS. Read all parts of each question carefully and answer in the space provided. Use clear economic reasoning and make sure you write legibly. 1. (12 points) Favazza Inc., an Italian auto company has been producing cars in the U.S., just like traditional U.S. auto companies, such as Ford. a) (3 points) Suppose Favazza Inc. produces a car in the U.S., sells it in the same year to Ben, an American citizen, for $20,000, and earns a profit of $3,000. The car contains parts worth $10,000 imported from Italy. How much will U.S. GDP change due to these activities alone? Which components of GDP change and by how much? Consumption increases in $ 20,000. Profits are not counted in GDP. Even though the parts are intermediate goods, they were not produced in the U.S. Since the $20,000 includes these parts, we need to subtract them from GDP. Hence, imports increase by $10,000. The net effect, then, is that GDP increases in $10,000. b) (4 points) Suppose that Favazza Inc. produced a car in 2007 that was worth $20,000, which contained parts worth $10,000 imported from Italy and earned a profit of $3,000. However, assume that Favazza Inc. was not able to sell the car in How did this change U.S. GDP in 2007? If Favazza Inc. decided this year that no one was going to buy a car produced in 2007 and got rid of the car, how would this affect U.S. GDP in 2009? Which components of GDP would change and by how much? This situation is similar, except for the fact that the car is not sold in Hence, inventories (and, hence, investment) increases in $ 20,000. Profits are not counted in GDP. Imports increase in $10,000. The net effect, then, is that GDP for 2007 increases in $10,000. In 2009, Favazza got rid of the car. Hence, inventories decrease in $20,000 and GDP decrease in the same amount. c) (5 points) Now, assume that Favazza Inc. is owned entirely by Italian citizens and Ford is owned entirely by American citizens. Suppose also that Favazza Inc. sells a car produced in the U.S. to Katie, an American citizen, for $20,000, with imported parts worth $10,000 and earns a profit of $3,000. Likewise, Ford sells a car produced in the U.S. to Saranya, another American citizen, for $20,000, with imported parts worth $10,000 and earns a profit of $3,000. Explain the difference between the effects of these activities on U.S. national income. How much does U.S. National Income change in each case? This question is the one that caused more problems/confusion. We are considering National Income in this question, not GDP. Many people analyzed this question as if GDP and National Income were the same. Recall that National Income is a measure of income that is based on GNP (total income earned by a nation s permanent residents): GNP = GDP + income of nationals earned abroad income of foreigners earned locally Hence, National Income excludes profits earned by foreign citizens in the U.S. Since GDP increases in $10,000 in each of those transactions (this is the net effect, exactly the same as part (a)), then National Income increases 7

8 in $10,000 in the case of Ford. However, it only increases in $7,000 in the case of Favazza (the $3,000 are deducted from the $10,000). 2. (12 points) As a result of a coup d etat, President Obama is overthrown by revolutionary leader Julie Mannarino, who has now taken political power in the U.S. Suppose that, because she does such a good job as a president, she also wins the 2012 presidential elections. The table below provides hypothetical economic data for , the years over which her policies are likely to be judged. Year Real GDP Real GDP CPI Infl. (Trillions of 2000 $) Growth % % % % % % % % % % % % % % % % a) (3 pts.) Sarah L., a conscious voter, wants to compare the macroeconomic performance (i.e. GDP s performance) of Julie Mannarino s government to that of earlier presidencies. Which single number should she use? Write down the equation to compute this number and calculate it, using the information provided in the table. (Hint: think about the broadest measure of macroeconomic activity and how it is best to present the performance of this measure over a number of years.) The broadest measure of macroeconomic activity and most used variable to measure macroeconomic performance is the real GDP. Because this administration covers 8 years, Sarah L. needs to find a way to make her calculations comparable to other presidencies. Hence, she should use the annualized real GDP growth rate for the 8 year period (note that it is 8 years, and not 9, because growth rates are the change in GDP between two years): / % b) (9 pts.) Calculate the inflation rate for 2010 and Next, suppose that CPI in 2004 and 2008 are 87.9 and 110.4, respectively. Calculate the overall inflation for the Julie Mannarino administration and the Bush Administration ( ). Then, find a way to compare inflation in both terms. Did inflation grow faster during the Julie Mannarino administration or during the Bush administration? Explain. The inflation rates for 2010 and 2016 are given by: 8

9 x 3.83% and x 2.48% The overall inflation for both administrations are given by: Bush 100x % and Mannarino 100x % To compare the inflation rates in both terms, we need to annualize the growth rates of the price level. Hence, annualized inflation is given by: ( ) 1/ 4 A 1/ % and ( ) % A Bush Mannarino These two numbers are comparable now. Therefore, based on these calculations, inflation grew faster during the Bush administration. 3. (12 points) The following figure shows the world income distribution for 1960 and Specifically, it plots the GDP per worker relative to the U.S. of 121 countries. Think of it as the number of countries on the y- axis and the measure of income in the x-axis. Answer the following questions: a) (4 pts.) You learned in class that GDP per capita would be a good definition of income when comparing welfare among countries. However, the figure above uses GDP per worker as a measure of income. Why do you think the latter is used instead of the former? (Hint: think about what GDP measures and what it omits) 9

10 Even though GDP is the most used and best indicator of living standards, it is not exempt from problems. One of these problems is that it only takes into account transactions that take place in a market. GDP per capita seems like a natural definition of income if one is interested in average welfare. However, in many developing countries, non-market production is quite a big percentage of their GDP (see page 276 of the book for some statistics about the underground economy in certain countries. It is as high as 68% of GDP in Bolivia), leading GDP per capita to understate true income in these countries. A coarse correction to this problem is to focus on GDP per worker instead. Both the numerator and denominator then correspond to the market sector. To the extent that wages are equalized at the margin between the market and non-market sectors, this is a natural measure of income and it is broadly used in Economics. b) (4 pts.) Describe, in terms of equity, the shift in the world distribution of income from being single-peaked in 1960 to double-peaked in In which of those two years was the distribution of income in the world more equitable? Why? The 1960 distribution is single-peaked and looks roughly normal. In contrast, the distribution in 1988 exhibits twin-peaks. This change reflects a shift in the mass of the distribution away from the middle and towards the ends. That is, over time, rich countries have become richer and poor countries have become poorer. As a consequence, we can conclude that the distribution of income was less equitable in In 1960, the mass of countries with similar incomes was much higher than in c) (4 pts.) What can be inferred from the figure in terms of efficiency? Is the world income higher in 1988 than it was in 1960? I did not expect people to actually measure the area under the surfaces to determine in which year income was higher (not feasible with the given information anyway). However, you should have been able to infer that, indeed, total income in 1988 was higher than total income in Because there is a trade-off between efficiency and equality, the reduction in equality from 1960 to 1988 should imply an increase in efficiency and, thus, world income. Moreover, you know this from the fact that GDP exhibits and upward trend over time. Furthermore, from the graph, you can observe that the distribution in 1988 has fat tails. That is, the distribution is wider in both ends (especially at the richest end). Therefore, we can conclude that efficiency is higher in 1988 than in (4 points) If the economy were at a steady-state unemployment rate with a separation rate of 0.03 per month and a job-finding rate of 0.12 per month, and the labor force was 200 million, how many individuals would lose their jobs each month? Show your work. According to the job-search model seen in class, the natural rate of unemployment is then given by: U L s s f

11 With this information, we can calculate the stock of unemployed people in the economy, U (expressed in millions): U 0.2xL 0.2(200) 40 This means that the number of unemployed people is 40 million. This is a stock. The question asked for the number of individuals that would lose their jobs each month. That is, it is asking for the flow from those employed towards those unemployed. This is given by: Individuals losing their jobs each month se 0.03(200 40) 4. 8 Thus, each month, 4.8 million individuals would lose their jobs. 5. (5 points) Bonus Question Explain what core CPI/core inflation is. How is it different than CPI/inflation? Why is it calculated? This is a question I asked in one of the blog posts. The question of the correct measure of inflation is an important one. Price stability in the long-run, together with sustainable economic output and unemployment, are the Fed s primariy goals (not so much other central banks). One common way economists use inflation data is by looking at core inflation, which is generally defined as a chosen measure of inflation (e.g., CPI-based or GDP deflator-based inflation rates) that excludes the more volatile categories of food and energy prices. If economists were to look only at measures of inflation that include expenditures on food and energy, which would include the more sensitive price fluctuations, they may be fooled into believing that general prices are rising or falling more rapidly than they really are. An additional argument for excluding changes in food and energy prices from measures of inflation is that, although these prices have substantial effects on the overall index, they often are quickly reversed and so do not require a monetary policy response. To understand why the categories of food and energy are more sensitive to price changes, consider environmental factors that can ravage a year s crops, or fluctuations in the oil supply from the OPEC cartel. Each is an example of a supply shock that may affect the prices for that product. However, although the prices of those goods may frequently increase or decrease at rapid rates, the price disturbances may not be related to a trend change in the economy s overall price level. Instead, changes in food and energy prices often are more likely related to temporary factors that may reverse themselves later. 11

Luiggi Donayre Summer 2009 Department of Economics Economics 104 Washington University Session 2. Exam 3

Luiggi Donayre Summer 2009 Department of Economics Economics 104 Washington University Session 2 Exam 3 Name (Print Clearly!) This is a 115 point exam. There are 25 multiple choice questions worth 2 points