EC202 Macroeconomics Koç University, Summer 2014 by Arhan Ertan

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1 EC202 Macroeconomics Koç University, Summer 2014 by Arhan Ertan Study Questions The production function for an economy can be expressed as Y = F(K, L), where Y is real GDP, K is the quantity of physical capital in the economy, and L is the quantity of labor in the economy. a. If F(K, L) = K + 9L, what is real GDP if the quantity of capital is 200 and the quantity of labor is 500? b. What is/are the endogenous variable(s) in this model? c. What is/are the exogenous variable(s) in this model? a. Y = (200) + 9(500) = 5,200 b. Y c. K, L 2. Exhibit: Quantity Consumed and Price of Good A & Good B. Base Year Later Year Price of good A Quantity of good A Price of good B Quantity of good B In the exhibit, the citizens of country XYZ come to desire more of good A. As a result, the quantity and price of the good both rise. a. Compute nominal GDP in the base year and later year. b. Compute real GDP in the base and later years (in base-year prices). c. Compute the GDP deflator in the later year, using your answers to parts a and b.- d. Compute a fixed-weight price index for the later year, using the baseyear quantities as weights (as consumer basket). a. Base-year nominal GDP = 20,000. Later-year nominal GDP = 50,000. b. Real GDP in base year = 20,000. Real GDP in later year = 30,000. c. GNP deflator in later year = d. Typical consumer s basket contains 100 good A and 100 good B. Fixed-weight index = cost of basket in later year / cost of basket in base year = / =

2 3. In $ billions: Nominal GDP $14,700 $15,200 Real GDP $12,100 $11,900 Based on the data in the table above, explain what happened to output and prices in the economy between 2009 and Real GDP decreased, indicating that the production of final goods and services was lower in 2010 than in Nominal GDP increased, which indicates that prices, on average, were higher in 2010 than in 2009, given that real GDP decreased. 4. Explain why the value of GDP in 2009 would or would not change as a result of each transaction described below: a. In 2009, the Smith family purchases a new house that was built in b. In 2009, the Jones family purchases a house that was built in c. In 2009, a construction company purchases windows to put in the Smith family home that was built in d. In 2009, Mr. Jones paints all of the rooms of the Jones family house purchased in e. In 2009, Mr. Smith uses an online brokerage service to purchase shares of stock in a construction company. a. GDP in 2009 increases by the purchase price of the house, which is a newly produced good. b. GDP in 2009 does not change because the house is not a newly produced good, since it was built in Transactions involving used goods are not included in GDP. c. GDP in 2009 does not change directly because the windows are intermediate goods, not final goods. The value of intermediate goods is not included in GDP to avoid double counting. The value of the windows is implicitly included in the price of the house. d. GDP in 2009 does not change because home production is not included in GDP. e. GDP in 2009 does not change because financial transactions do not represent the production of final goods and services and are not included in GDP. 5. Explain which expenditure category of GDP changes and the direction of the change that results for each transaction described. a. A domestic business purchases a domestically produced computer to use in a business office. b. A domestic business produces a computer that is sold to a foreign company. c. The federal government purchases a domestically produced computer to use in a court house. d. A domestic household purchases a domestically produced computer to use in a home. e. A domestic household purchases a computer produced in a foreign country to use in a home. 2

3 a. Investment spending increases by the price of the computer. b. Exports (and net exports) increase by the price of the computer. c. Government spending increases by the price of the computer. d. Consumption spending increases by the price of the computer. e. Consumption spending increases by the price of the computer, but imports also increase by the price of the computer, so that net exports decrease by the price of the computer and there will be no net change in GDP. 6. Into which of the three categories employed, unemployed, out of the labor force would an interviewer for the Current Population Survey place each of the following people? Explain. a. Jennifer Temple is working as a second-grade schoolteacher. b. Frank Peabody is attending college full-time to earn a degree in elementary education. c. Martin Hampton is working as a high school social science teacher, but is at home sick with the flu. d. Kyle Brown does not currently have a job. He wants to be an elementary schoolteacher. He has the appropriate degree. He has not looked for a position in the last month because he doesn't believe schools are currently hiring. e. Brenda Dewey does not currently have a job. She has sent her resume to several school districts in the past week in the hope of finding a teaching position. a. employed b. out of the labor force c. employed d. out of the labor force e. unemployed 7. Why does the GDP deflator give a different rate of inflation than does the CPI? The GDP deflator and the CPI differ in two important ways. The GDP deflator uses as a basket of goods all final goods and services produced in the domestic economy, while the CPI basket includes goods and services purchased by typical consumers. Therefore, changes in the price of imported goods affect the CPI, but not the GDP deflator. Also, changes in the price of domestically produced capital goods affect the GDP deflator, but not the CPI. Changes in the price of domestically produced consumer goods are likely to affect the CPI more than the GDP deflator because it is likely that those goods make up a larger part of consumer budgets than of GDP. 3

4 8. Using a graph representing the market for loanable funds, show and explain what happens to real interest rate and investment if a government goes from a deficit to a surplus. Assume that consumption depends on the interest rate. As shown in the graph below, the economy starts in equilibrium at point E 0 with interest rate r 0 and equilibrium quantity of saving and investment at q 0. If the government succeeds in obtaining a surplus, there will be more public saving in the economy and so more national saving at each interest rate, and the supply of loanable funds curve will shift from S 0 to S 1. The new equilibrium will be at E 1, with a lower interest rate, r 1 and a higher quantity of saving and investment, q 1. Hence, if the federal government succeeds in having a surplus, interest rates will fall and investment will increase. Market for Loanable Funds 9. Using data in the following table: a. Compute nominal GDP in each year. b. Compute real GDP in each year using 2006 as the base year. c. Compute the GDP deflator in each year. d. Use GDP deflator to compute the inflation rate from 2006 to 2007 and from 2007 to P Q P Q P Q good A $ $31 1,000 $36 1,050 good B $ $ $

5 a. nominal GDP: multiply Ps & Qs from same year 2006: $46,200 = $ $ : $51, : $58,300 b. real GDP: multiply each year s Qs by 2006 Ps 2006: $46, : $50, : $52,000 = $ $ c. GDP deflator: (nominal GDP / real GDP) x : : : d. Inflation: : 2.8% : 9.1% 10. An American farmer sells a truckload of sugar cane to an American sugar refinery for $200. The refinery extracts the sugar from the sugar cane and sells it to Coca- Cola for $350. Coca-Cola uses the sugar in its bottling plant in Toronto, Canada and the resulting Cola is sold in Canada for $575. How will this string of transactions affect U.S. GDP? How will it affect U.S. GNP? How will it affect Canadian GNP and GDP? U.S. GDP increases by $350 since it measures only production within the borders of the U.S. U.S. GNP increases by $575 because it included production owned by U.S. companies and citizens. Canadian GNP does not change since businesses involved are all American owned. Canadian GDP increases by $225 due to the value added of the Coca-Cola plant in Toronto. 11. Suppose an automobile manufacturer is choosing between two production options. It can produce 100 cars with 200 workers and 50 machines, or it can produce 166 cars with 300 workers and 75 machines. Would you describe the manufacturer s production function as exhibiting decreasing, constant, or increasing returns to scale? Explain. The capital stock and the labor force increase by 50% and the output increases by 66%. This is increasing returns to scale. 12. Consumer s basket contains 20 pizzas and 10 compact discs. For each year, compute the cost of the basket, the CPI (use 2002 as the base year), the inflation rate from the preceding year. Here are the prices: Year pizza CDs 2002 $10 $ $11 $ $12 $ $13 $15 5

6 Year Cost of basket CPI Inflation rate 2002 $ n.a % % % 13. Use the below data to calculate: a. the labor force, b. the number of people not in the labor force, c. the labor force participation rate, d. the unemployment rate. Adult Population by Group Number employed = million Number unemployed = 7.0 million Adult population = million According to data: E = 144.4, U = 7.0, POP = a. labor force: L = E +U = = b. not in labor force: NILF = POP L = = 77.4 c. unemployment rate: U/L x 100% = (7/151.4) x 100% = 4.6% d. labor force participation rate: L/POP x 100% = (151.4/228.8) x 100% = 66.2% 14. Suppose population increases by 1%, labor force increases by 3%, number of unemployed persons increases by 2%. Compute the percentage changes in a. the labor force participation rate, b. the unemployment rate. a. the labor force participation rate: 2% b. the unemployment rate: -1% 15. Suppose MPC = 0.8 and MPL = 20. For each of the following, compute S (change in national saving) in a closed economy. a. G = 100 b. T = 100 c. Y = 100 d. L = 10 S = Y - C - G = Y 0.8( Y - T) - G = 0.2 Y T - G a. S = -100 b. S = 0.8 x 100 = 80 c. S = 0.2 x 100 = 20 d. Y = MPL x L = 20 x 10 = 200 S = 0.2 x Y = 0.2 x 200 = Draw the diagram for the loanable funds model. Suppose the tax laws are altered to provide more incentives for private saving (assume that total tax revenue T does not change). What happens to the interest rate and investment? Private saving, therefore, national saving goes up. Supply shifts right, reducing interest rate and increasing investment. 6