1st Mid Term Exam - Answers

Short Answers:

Q1.which of the following questions involves microeconomics, and which involve macroeconomics?Give one-line justification for your answera. Why did consumers switch to smaller cars in 2008?b.Why did overall consumer spending slow down in 2008?c.Why did the standard of living rise more rapidly in the first generation after World War II?d.Why have starting salaries for business graduate risen sharply?e.Why has chicken gotten cheaper as compare to fish over past 20 years?f.Why did inflation fall in the 1990s?

Answer.a. Microeconomics it addresses decisions made by consumers about a particular productb. Macroeconomics it addresses consumer spending in the overall economyc. Macroeconomics it addresses changes in the overall economyd. Microeconomics it addresses changes in a particular market i.e. market for business graduatese. Microeconomics microeconomics it addresses choices made by consumers about which type ofmeat to eatf. Macroeconomics it addresses changes in a measure of economys overall price level

Q2. How Great Depression (1929) and Keynes seminal work (1936) affect ideologies like invisiblehand and self-regulation of the economy?

Answer.If you believe in self-regulation and invisible hand, then you would advocate doing nothing in response tothe slump/recession. This was the policy followed during Great Depression. The failure of market forcesto regulate and correct things during depression is followed by seminal work of Keynes (general theory ofemployment, interest and money) - a book that transformed the macroeconomics. Leading role to beplayed by government in the management of economy of one of the key argument of Keynesianeconomics.

Q3. What is the greatest pain of recession?

Answer.Recessions cause a great deal of pain across the entire society. They cause large number of workers tolose their jobs and make it hard to find new jobs. Recessions hurt the standard of living of many familiesand are usually associated with a rise in the number of people living under poverty line. Firms profits arealso declined. People also lose their houses due to non-repayment of mortgages.

Q4. List down main participants among various sectors in the macroeconomy?

Answer.i. Households (private sector)ii. Firms (private sector)iii. Government (public sector)iv. Rest of the world (international sector)

Q5. Differentiate between GDP and GDP per capita by giving example of two nations which have sameGDP but different GDP per capita?

Answer.In order to compare GDP across countries while eliminating the effect of difference in population size (itis assumed that country with larger population will have higher GDP), GDP Per Capita is more accuratemeasure GDP divided by the size of the population, equivalent to the average GDP per person. Forexample, if two countries have same GDP, say, $500,000 during 2005 with country A having populationof 10,000 inhabitants and country B having population of 7,000 inhabitants. GDP per capita of country Awill be (500,000/10,000 = $50) whereas GDP per capita of country B will be (500,000/7,000 = $ 71.42).per capital GDP enables us to conclude that incomes and living standard of country Bs people is likely tobe better as compare of country Bs people.

Q6. Clarify the difference between GDP and GNP? If many citizens of your country are working abroad,which of these two measures is more relevant/appropriate for your country? Why?

Answer.Difference between GDP and GNP lies in the treatment of output produced by capital and labor (factorsof production) working outside its home (domestic) country.GNP is the market value of final goods and services newly produced by domestic factors of production(within as well as outside host country) during the current period whereas GDP is the market value offinal goods and services newly produced within a countryNet Factor Payments from abroad (NFP): Income paid to domestic factors of production by the rest of theworld minus income paid to foreign factors of production by the domestic economy. NFP is thedistinguishing component between GDP and GNP (GDP = GNP NFP)Distinction between GDP and GNP is more important for countries that have many citizens workingabroad income earned by workers abroad is part of a countrys GNP but not its GDP

Q7. Recall measurement of GDP using Expenditure approach, why do we add exports and subtractimports?

Answer.We add export in the measurement of GDP because Export means foreigners spend on goods that areproduced in our country. We subtract import in the measurement of GDP because Imports are subtractedfrom total spending because C, I, and G are defined to include imported goods & services. If we do notsubtract it, then it means we are including products in the calculation of GDP that are not produced in thecountry.

Q8. What are the two biases through which Consumer Price Index (CPI) might overstate inflation andcost of living?

Answer.i. Quality adjustment biasii. Substitution bias

Q9. Fill in the blanks with appropriate type of unemployment(i)Actual unemployment = Natural unemployment (plus) -------------------(ii)Natural unemployment = --------------- (plus) structural unemployment(iii)Cyclical unemployment = Actual unemployment (minus) ----------------

Answer.(i) Actual unemployment = natural unemployment + cyclical unemployment(ii) Natural Unemployment = Frictional unemployment + structural unemployment(iii) Cyclical unemployment = Actual unemployment (-) natural unemployment

Q10. Write down goods market equilibrium condition and income-expenditure identity. How are theydifferent from one another?

Answer.- Income-expenditure identity: Y = C + I + G + NXIt states that total income (output/production) Y equals total expenditure C+I+G+NXGoods market equilibrium condition: Y = Cd + Id + GIt differs from income-expenditure identity, as goods market equilibrium condition need not always hold;undesired goods may be produced, so goods market won't be in equilibrium. Goods market is atequilibrium only when desired production equals desired demand.

Q11. Unemployment rate can understate the true level of unemployment. Give your answer by namingkey reasons?

Answer.Due to three categories of frustrated workers who are not counted as unemployed, unemployment rate islikely to be understated. Discouraged workers, Marginally attached workers and part-time workers commonly known as measures of labor underutilization are not counted as unemployed. Thus,Unemployment rate would be much higher if these 3 categories of frustrated workers are also counted.

Q12. Value addition is the key concept in GDP measurement. Can you name some goods and services towhich this concept cannot be applied?

Answer.(i)Some goods and services are not sold in markets so they are left from inclusion in GDP. For example,homemaking, child care by family, clean air and water. (ii) Similarly, value of services provided by thegovernment e.g. defense, education, construction and maintenance of roads and bridges etc. so suchservices are calculated at their cost of production (iii) Illegal activities like gambling, drug dealing as wellas legal activities to evade taxes like black marketing, stocking etc. are also left from inclusion in GDP

Multiple Choice Questions (MCQs)Q13. How do following changes affect frictional unemployment:

i.Government increased unemployment allowance from $ 400 per month to $600 per month. Frictionalunemployment will

(a) increase(b) decrease(c) remain unchanged(d) ambiguousAnswer. A

ii. New Union Act is introduced which enhanced collective bargaining power of unions. Frictionalunemployment will

(a) increase(b) decrease(c) remain unchanged(d) ambiguousAnswer. C

iii. Due to greater access to internet for job listings as well as the growth of employment agencies,frictional unemployment will(a) increase(b) decrease(c) remain unchanged(d) ambiguousAnswer. B

Q14. when actual wage rate is above the equilibrium wage rate, structural unemployment will(a) increase(b) decrease(c) remain unchanged(d) ambiguousAnswer. A

Q15.Desired national saving equals(a) Y Cd G.(b) Cd Id G.(c) Id G.(d) Y Id G.Answer. A

Q16. With no inflation and a nominal interest rate (i) of 3%, a person can trade off one unit of currentconsumption for _____ units of future consumption.(a) 0.97(b) 1.03(c) .03(d) .03Answer. B

Q17. The fraction of additional current income that a person consumes in the current period is known asthe(a) consumption-smoothing motive.(b) consumption surplus(c) saving rate(d) marginal propensity to consume.Answer. D

Q18. In her will, Aunt Agatha left her nephew $5000. The most likely response is for her nephew to(a) increase current consumption, but not future consumption.(b) decrease current consumption, but increase future consumption.(c) increase future consumption, but not current consumption.(d) increase both current consumption and future consumption.Answer. D

Q19. When desired national saving equals desired national investment, what market is in equilibrium?(a) The goods market(b) The labor market(c) The money market(d) The stock marketAnswer. A

Q20. If the government cuts taxes today, issuing debt today and repaying the debt plus interest next year,a rational and forward-looking taxpayer will(a) spend the full amount of the tax cut today and reduce consumption next year.(b) increase consumption today, before taxes go up next year.(c) leave consumption unchanged, and increase saving with increase in income due to tax cut(d) leave a smaller gross bequest to her or his heirs.Answer. C

Q21 (i).The saving-investment diagram shows that a higher real interest rate due to a leftward shift of thesaving curve(a) raises the profitability of investment for firms.(b) causes the amount of firms investment to increase.(c) increases the total amount of saving because of the increase in the real interest rate.(d) causes the total amounts of saving and investment to fall.Answer. D

Q21 (ii). Support your answer by drawing this shift on diagram

Q22 (i). An invention that raises the future marginal product of capital would cause an increase in desiredinvestment, which would cause the investment curve to shift to the ________ and would cause thereal interest rate to ________.(a) right; increase(b) right; decrease(c) left; increase(d) left; decreaseAnswer. A

Q22 (ii). Support your answer by drawing this shift in investment and change in real interest rate ondiagram

Q23. The component least likely to be included in a measurement of GDP is(a) the value of owner occupied rent(b) the annual salary of a local police officer(c) environmental damage caused by productionAnswer. C

Q24. Which of the following conditions is least likely to increase a countrys GDP?(a) an increase in net exports(b) increased investment in capital goods(c) increased government transfer paymentsAnswer. C

Problems:Q25. Recalling that Real GDP= Nominal GDP/(GDP Deflator/100), please solve following problem:From the beginning to the ending years of a decade, the annual value of the final goods and services for acountry increased from $ 100 billion to $ 300 billion. Over that time period, the GDP deflator increasedfrom 111 to 200. Over the decade, calculate the percentage by which this countrys real GDP isincreased?

Answer.Real GDP (yr 1)=100/(111/100) = 90.090; Real GDP (yr2) = 300/(200/100) = 150Percentage change = [(150 90.090)/90.090] * 100 = 66.5%

Q26. A country has a working age population of 70 million, a total population of 100 million,unemployment of 5 million and employment of 45 million.

a. what is its labor force?b. what is its unemployment rate?

Answer.Labor force = employed + unemployed = 45 + 5 = 50 millionUnemployment rate = 5/50 * 100 = 10%

Q27. The nominal interest rate is 10%, the expected inflation rate is 5%, and federal tax rate is 35%.Calculate the expected after-tax real interest rate.

Answer.(1 t)i - e = [(1 0.35)*0.10] 0.05 = 0.065 0.05 = 0.15 = 1.5%

Q28. Machine A costs $15,000 and depreciates at a rate of 25%; machine B costs $10,000 and depreciatesat a rate of 20%; machine C costs $20,000 and depreciates at a rate of 10%; and machine D costs $17,000and depreciates at a rate of 11%. The expected real interest rate is 5%. Calculate User cost of eachmachine in order to determine that which machines has the lowest user cost?

Answer. (r + d)pKUser cost of Machine A = (0.05 + 0.25)*15,000 = 0.30 * 15,000 = 4,500User cost of machine B = (0.05 + 0.20) * 10,000 = 0.25 * 10,000 = 2,500User cost of machine C = (0.05 + 0.10)*20,000 = 0.15 * 20,000 = 3,000User cost of machine D = (0.05 + 0.11)*17,000 = 0.16 * 17,000 = 2,720

User cost of machine B is the LOWEST.

Q29. Calculate the user cost of capital of a machine that costs $100,000 and depreciates at a rate of 25%,when the nominal interest rate is 4% and the expected inflation rate is 1%.

Answer. Real Interest rate = nominal real = 4% - 1% = 3%Cost of capital = 100,000 * 0.25 + 100,000 * 0.03 = 25,000 + 3,000 = 28,000

Q30.Calculate the tax-adjusted user cost of capital of a machine that costs $10,000 and depreciates at arate of 10%, when the real interest rate is 3% and the tax rate on revenue is 5%.

Answer. UC/1-t = (10,000*0.10)+(10,000*0.03)]/1-0.05 = (1,000 + 300)/0.95 = 1300/0.95 = 1368

Q31. Recall CPI and market basket: Market basket of a retired person is allocated in the following way:10% on housing, 15% on food, 5% on transportation, 60% on medical care, 0% on education, and 10% onrecreation. Market basket of a college student is allocated in the following way: 5% on housing, 15% onfood, 20% on transportation, 0% on medical care, 40% on education, and 20% on recreation.The accompanying table shows the November 2012 CPI for each of the relevant categories.

Market basket CPI Nov 2012Housing 221Food 225.4Transportation 210Health care 390.5Education 208.8Leisure/Recreation 112.3

a. Calculate the overall CPI for the retired person and for the college student by multiplying the CPI foreach of the categories by the relative importance of that category to the individual and then summing eachof the categories.b.The CPI for an average consumer is 225.9. How is the average CPI tends to overstate and/or understatethe CPI calculations for the retired person and the college student?

Answer.CPI for retired person

Market basket Weights (%) CPIHousing 10 22.1Food 15 33.81Transportation 5 10.5Health care 60 234.3Education 0 0Leisure/Recreation 10 11.23Total 311.94

CPI for studentMarket basket Weights (%) CPIHousing 5 11.05Food 15 33.81Transportation 20 42Health care 0 0Education 40 83.52Leisure/Recreation 20 22.46Total 192.84

b. The CPI for the retired person is 311.94 and for the college student is 192.84. Since the CPI for theaverage consumer was 225.9, the CPI will overstate the increase in the cost of living for the collegestudent and understates it for the retired person.

Q32. The CPI in the US was 214.537 in 2009 and 218.056 in 2010. Calculate the inflation rate from 2009to 2010.Answer. [(CPI 2010 CPI 2009)/CPI 2009] * 100 = [(218.056 214.537)/214.537]*100 = 1.6%