ECO102 Principles of MacroeconomicsProblem Session-1 by Research Assistant Serkan Değirmenci 02.03.2012
Today • Mankiw (2008), Principles of Economics: - Chapter 23: Measuring A Nation’s Income: • Questions for Review (QfR): 1-8 (page: 525) • Problems and Applications (P&A): 1-11 (page: 525-527) - Chapter 24: Measuring the Cost of Living: • Questions for Review (QfR): 1-5 (page: 543) • Problems and Applications (P&A): 1-10 (page: 543-545) - Chapter 25: Production and Growth: • Questions for Review (QfR): 1-8 (page: 573) • Problems and Applications (P&A): 1-10 (page: 574) - Chapter 26: Saving, Investment, and the Financial System: • Questions for Review(QfR):1-6 (page: 594) • Problems and Applications(P&A): 1-11 (page: 595-596)
Chapter 23: QfR-1 (page: 525) • Explain why an economy’s income must equal its expenditure. income = expenditure (why?) ANSWER: (page: 508) => please see Figure 1 (page: 509) An economy's income must equal its expenditure, because every transaction has a buyer and a seller. Thus, expenditure by buyers must equal income by sellers.
Chapter 23: QfR-2 (page: 525) • Which contributes more to GDP—the production of aneconomy car or the production of a luxury car? Why? GDP: the market value of all officially recognized final goods and services produced within a country in a given period. ANSWER: (page: 510-512) The production of a luxury car contributes more to GDP than the production of an economy car because the luxury car has a higher market value. because market pricesmeasuretheamountpeoplearewillingto pay fordifferentgoods, theyreflectthevalue of thosegoods. (page 510)
Chapter 23: QfR-3 (page: 525) • A farmer sells wheat to a baker for $2. The baker usesthe wheat to make bread, which is sold for $3. What isthe total contribution of these transactions to GDP? ANSWER: (page: 511) The contribution to GDP is $3, the market value of the bread, which is the final good that is sold.
Chapter 23: QfR-4 (page: 525) • Many years ago, Peggy paid $500 to put together arecord collection. • Today, she sold her albums at a garagesale for $100. • How does this sale affect current GDP? ANSWER: (page: 511) The sale of used records does not affect GDP at all because it involves no current production.
Chapter 23: QfR-5 (page: 525) • List the four components of GDP. Give an example ofeach. ANSWER: (page: 512-513-514) The four components of GDP are consumption, such as the purchase of a music CD; investment, such as the purchase of a computer by a business; government purchases, such as an order for military aircraft; and net exports, such as the sale of American wheat to Russia. (Many other examples are possible.)
Chapter 23: QfR-6 (page: 525) • Why do economists use real GDP rather than nominalGDP to gauge economic well-being? ANSWER: (page: 515-516-517) Economists use real GDP rather than nominal GDP to gauge economic well-being because real GDP is not affected by changes in prices, so it reflects only changes in the amounts being produced. You cannot determine if a rise in nominal GDP has been caused by increased production or higher prices.
Chapter 23: QfR-7 (page: 525) • In the year 2010, the economy produces 100 loaves ofbread that sell for $2 each. In the year 2011, the economyproduces 200 loaves of bread that sell for $3 each. Calculate nominal GDP, real GDP, and the GDP deflatorfor each year. (Use 2010 as the base year.) By whatpercentage does each of these three statistics rise fromone year to the next? • ANSWER: (page: 516-518) The percentage change in nominal GDP is (600 − 200)/200 x 100 = 200%. The percentage change in real GDP is (400 − 200)/200 x 100 = 100%. The percentage change in the deflator is (150 − 100)/100 x 100 = 50%.
Chapter 23: QfR-8 (page: 525) • Why is it desirable for a country to have a large GDP? Give an example of something that would raise GDP and yet be undesirable. ANSWER: (page: 519-522) It is desirable for a country to have a large GDP because people could enjoy more goods and services. But GDP is not the only important measure of well-being. For example, laws that restrict pollution cause GDP to be lower. If laws against pollution were eliminated, GDP would be higher but the pollution might make us worse off. Or, for example, an earthquake would raise GDP, as expenditures on cleanup, repair, and rebuilding increase. But an earthquake is an undesirable event that lowers our welfare.
Chapter 23: P&A-1 (page: 525) • The “government purchases” component of GDP doesnot include spending on transfer payments such asSocial Security. Thinking about the definition of GDP,explain why transfer payments are excluded. ANSWER: (page: 514) With transfer payments, nothing is produced, so there is no contribution to GDP.
Chapter 23: P&A-2 (page: 525) • 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? ANSWER: (page: 511) If GDP included goods that are resold, it would be counting output of that particular year, plus sales of goods produced in a previous year. It would double-count goods that were sold more than once and would count goods in GDP for several years if they were produced in one year and resold in another.
Chapter 23: P&A-3 (page: 525) • What components of GDP (if any) would each of the following transactions affect? Explain. a. A family buys a new refrigerator. b. Aunt Jane buys a new house. c. Ford sells a Thunderbird from its inventory. d. You buy a pizza. e. California repaves Highway 101. f. Your parents buy a bottle of French wine. g. Honda expands its factory in Marysville, Ohio. ANSWER: (page: 512-514) a.Consumption increases because a refrigerator is a good purchased by a household. b.Investment increases because a house is an investment good. c.Consumption increases because a car is a good purchased by a household, but investment decreases because the car in Ford’s inventory had been counted as an investment good until it was sold. d.Consumption increases because pizza is a good purchased by a household. e.Government purchases increase because the government spent money to provide a good to the public. f. Consumption increases because the bottle is a good purchased by a household, but net exports decrease because the bottle was imported. g.Investment increases because new structures and equipment were built.
Chapter 23: P&A-5 (page: 526) Below are some data from the land of milk and honey. a. Compute nominal GDP, real GDP, and the GDP deflator for each year, using 2008 as the base year. b. Compute the percentage change in nominal GDP, real GDP, and the GDP deflator in 2009 and 2010 from the preceding year. For each year, identify the variable that does not change. Explain in words why your answer makes sense. c. Did economic well-being rise more in 2009 or 2010? Explain. 2008 2009 2010
Chapter 23: P&A-5 (page: 526)-cont. 100% 100% ANSWER: a. Calculating nominal GDP: • 2008: ($1 per qt. of milk 100 qts. milk) + ($2 per qt. of honey 50 qts. honey) = $200 • 2009: ($1 per qt. of milk 200 qts. milk) + ($2 per qt. of honey 100 qts. honey) = $400 • 2010: ($2 per qt. of milk 200 qts. milk) + ($4 per qt. of honey 100 qts. honey) = $800 Calculating real GDP (base year 2008): • 2008: ($1per qt. of milk 100 qts. milk) + ($2 per qt. of honey 50 qts. honey) = $200 • 2009: ($1 per qt. of milk 200 qts. milk) + ($2 per qt. of honey 100 qts. honey) = $400 • 2010: ($1 per qt. of milk 200 qts. milk) + ($2 per qt. of honey 100 qts. honey) = $400 Calculating the GDP deflator: • 2008: ($200/$200) 100 = 100 • 2009: ($400/$400) 100 = 100 • 2010: ($800/$400) 100 = 200 b. Calculating the percentage change in nominal GDP: • Percentage change in nominal GDP in 2009 = [($400 − $200)/$200] 100 = 100%. • Percentage change in nominal GDP in 2010 = [($800 − $400)/$400] 100 = 100%. • Calculating the percentage change in real GDP: • Percentage change in real GDP in 2009 = [($400 − $200)/$200] 100 = 100%. • Percentage change in real GDP in 2010 = [($400 − $400)/$400] 100 = 0%. • Calculating the percentage change in GDP deflator: • Percentage change in the GDP deflator in 2009 = [(100 − 100)/100] 100 = 0%. • Percentage change in the GDP deflator in 2010 = [(200 − 100)/100] 100 = 100%. • Prices did not change from 2008 to 2009.Thus, the percentage change in the GDP deflator is zero. Likewise, output levels did not change from 2009 to 2010.This means that the percentage change in real GDP is zero. • c. Economic well-being rose more in 2009 than in 2010, since real GDP rose in 2009 but not in 2010. • In 2009, real GDP rose but prices did not. In 2010, real GDP did not rise but prices did. 100% 0% 0% 100%
Chapter 23: P&A-6 (page: 526) Consider the following data on U.S. GDP: a. What was the growth rate of nominal GDP between1999 and 2000? (Note: The growth rate is thepercentage change from one period to the next.) b. What was the growth rate of the GDP deflatorbetween 1999 and 2000? c. What was real GDP in 1999 measured in 1996 prices? d. What was real GDP in 2000 measured in 1996 prices? e. What was the growth rate of real GDP between 1999 and 2000? f. Was the growth rate of nominal GDP higher orlower than the growth rate of real GDP? Explain. 1996 2000 1999 9873 9269 118 113
Chapter 23: P&A-6 (page: 526)-cont. ANSWER: a. The growth rate of nominal GDP is ($9,873 − $9,269)/$9,269 100% = 6.5%. b. The growth rate of the deflator is (118 − 113)/113 100% = 4.4%. c. Real GDP in 1999 (in 1996 dollars) is $9,269/(113/100) = $8,203. d. Real GDP in 2000 (in 1996 dollars) is $9,873/(118/100) = $8,367. e. The growth rate of real GDP is ($8,367 − $8,203)/$8,203 100% = 2.0%. f. The growth rate of nominal GDP is higher than the growth rate of real GDP because of inflation.
Chapter 23: P&A-11 (page: 527) • 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 Barry’s 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 23: P&A-11 (page: 526)-cont. ANSWER: a.GDP equals the dollar amount Barry collects, which is $400. b.NNP = GDP – depreciation = $400 − $50 = $350. c.National income = NNP − sales taxes = $350 − $30 = $320. d.Personal income = national income − retained earnings = $320 − $100 = $220. e.Disposable personal income = personal income − personal income tax = $220 − $70 = $150.
Chapter 24: QfR-1 (page: 543) • Which do you think has a greater effect on the consumerprice index: a 10 percent increase in the price of chickenor a 10 percent increase in the price of caviar? Why? • ANSWER: A 10% increase in the price of chicken has a greater effect on the consumer price index than a 10% increase in the price of caviar because chicken is a bigger part of the average consumer's market basket.
Chapter 24: QfR-2 (page: 543) • Describe the three problems that make the consumerprice index an imperfect measure of the cost of living. ANSWER: The three problems in the consumer price index as a measure of the cost of living are: (1) substitution bias, which arises because people substitute toward goods that have become relatively less expensive; (2) the introduction of new goods, which are not reflected quickly in the CPI; and (3) unmeasured quality change.
Chapter 24: QfR-3 (page: 543) • If the price of a Navy submarine rises, is the consumerprice index or the GDP deflator affected more? Why? ANSWER: If the price of a Navy submarine rises, there is no effect on the consumer price index, because Navy submarines are not consumer goods. But the GDP price index is affected, because Navy submarines are included in GDP as a part of government purchases.
Chapter 24: QfR-4 (page: 543) • Over a long period of time, the price of a candy bar rosefrom $0.10 to $0.60. Over the same period, the consumerprice index rose from 150 to 300. Adjusted for overallinflation, how much did the price of the candy barchange? ANSWER: Because the overall price level doubled, but the price of the candy bar rose sixfold, the real price (the price adjusted for inflation) of the candy bar tripled.
Chapter 24: QfR-5 (page: 543) • Explain the meaning of nominal interest rate and realinterest rate. How are they related? ANSWER: The nominal interest rate is the rate of interest paid on a loan in dollar terms. The real interest rate is the rate of interest corrected for inflation. The real interest rate is the nominal interest rate minus the rate of inflation. r = i - ∏
Chapter 24: P&A-2 (page: 543-544) Suppose that people consume only three goods, asshown in thistable: Golf Balls 2009 price 2009 quantity 2010 price 2010 quantity $4 100 $6 100 What is the percentage change in the price of each of three goods? Using the method similar to the consumer price index, compute the percentage change in the overall price level. If you were to learn that a bottle of Gatorade increased in size from 2009 to 2010, should that information affect your calculation of the inflation rate? If so, how? If you were to learn that Gatorade introduced new flavors in 2010, should that information affect your calculation of the inflation rate? If so, how?
Chapter 24: P&A-2 (page: 543-544)-cont. ANSWER: a.The percentage change in the price of tennis balls is (2 – 2)/2 × 100% = 0%. The percentage change in the price of golf balls is (6 – 4)/4 × 100% = 50%. The percentage change in the price of Gatorade is (2 – 1)/1 × 100% = 100%. b.The cost of the market basket in 2009 is ($2 × 100) + ($4 × 100) + ($1 × 200) = $200 + $400 + $200 = $800. The cost of the market basket in 2010 is ($2 × 100) + ($6 × 100) + ($2 × 200) = $200 + $600 + $400 = $1,200. The percentage change in the cost of the market basket from 2009 to 2010 is (1,200 – 800)/800 × 100% = 50%. c.This would lower my estimation of the inflation rate because the value of a bottle of Gatorade is now greater than before. The comparison should be made on a per-ounce basis. d.More flavors enhance consumers’ well-being. Thus, this would be considered a change in quality and would also lower my estimate of the inflation rate.
Chapter 24: P&A-3 (page: 544) Suppose that the residents of Vegopia spend all of their income on cauliflower, broccoli, and carrots. In 2008, they buy 100 heads of cauliflower for $200, 50 bunches of broccoli for $75, and 500 carrots for $50. In 2009, they buy 75 heads of cauliflower for $225, 80 bunches of broccoli for $120, and 500 carrots for $100. Calculate the price of each vegetable in each year. Using 2008 as the base year, calculate the CPI for each year. What is the inflation rate in 2009? ANSWER: a.Find the price of each good in each year: b.If 2008 is the base year, the market basket used to compute the CPI is 100 heads of cauliflower, 50 bunches of broccoli, and 500 carrots. We must now calculate the cost of the market basket in each year: 2008: (100 x $2) + (50 x $1.50) + (500 x $.10) = $325 2009: (100 x $3) + (50 x $1.50) + (500 x $.20) = $475 Then, using 2008 as the base year, we can compute the CPI in each year: 2008: $325/$325 x 100 = 100 2009: $475/$325 x 100 = 146 c.We can use the CPI to compute the inflation rate for 2009: (146 − 100)/100 x 100% = 46%
Chapter 24: P&A-7 (page: 544) The New York Times cost $0.15 in 1970 and $0.75 in 2000.The average wage in manufacturing was $3.23 per hourin 1970 and $14.32 in 2000. a. By what percentage did the price of a newspaperrise? b. By what percentage did the wage rise? c. In each year, how many minutes does a worker have to work to earn enough to buy a newspaper? d. Did workers’ purchasing power in terms of newspapersriseorfall? ANSWER: a.($0.75 − $0.15)/$0.15 x 100% = 400%. b.($14.32 − $3.23)/$3.23 x 100% = 343%. c.In 1970: $0.15/($3.23/60) = 2.8 minutes. In 2000: $0.75/($14.32/60) = 3.1 minutes. d.Workers' purchasing power fell in terms of newspapers.
Chapter 25: QfR-1 (page: 573) • What does the level of a nation’s GDP measure? Whatdoes the growth rate of GDP measure? Would yourather live in a nation with a high level of GDP and alow growth rate, or in a nation with a low level and ahighgrowth rate? • ANSWER: The level of a nation’s GDP measures both the total income earned in the economy and the total expenditure on the economy’s output of goods and services. The level of real GDP is a good gauge of economic prosperity, and the growth of real GDP is a good gauge of economic progress. You would rather live in a nation with a high level of GDP, even though it had a low growth rate, than in a nation with a low level of GDP and a high growth rate, because the level of GDP is a measure of prosperity.
Chapter 25: QfR-2 (page: 573) • List and describe four determinants of productivity. • ANSWER: The four determinants of productivity are: (1) physical capital, which is the stock of equipment and structures that are used to produce goods and services; (2) human capital, which consists of the knowledge and skills that workers acquire through education, training, and experience; (3) natural resources, which are inputs into production that are provided by nature; and (4)technological knowledge, which is society’s understanding of the best ways to produce goods and services.
Chapter 25: QfR-3 (page: 573) • In what way is a college degree a form of capital? • ANSWER: A college degree is a form of human capital. The skills learned in earning a college degree increase a worker's productivity.
Chapter 25: QfR-4 (page: 573) • Explain how higher saving leads to a higher standard ofliving. What might deter a policymaker from trying toraise the rate of saving? • ANSWER: Higher saving means fewer resources are devoted to consumption and more to producing capital goods. The rise in the capital stock leads to rising productivity and more rapid growth in GDP for a while. In the long run, the higher saving rate leads to a higher standard of living. A policymaker might be deterred from trying to raise the rate of saving because doing so requires that people reduce their consumption today and it can take a long time to get to a higher standard of living.
Chapter 25: QfR-5 (page: 573) • Does a higher rate of saving lead to higher growthtemporarilyorindefinitely? • ANSWER: A higher rate of saving leads to a higher growth rate temporarily, not permanently. In the short run, increased saving leads to a larger capital stock and faster growth. But as growth continues, diminishing returns to capital mean growth slows down and eventually settles down to its initial rate, though this may take several decades.
Chapter 25: QfR-6 (page: 573) • Why would removing a trade restriction, such as a tariff,lead to more rapid economic growth? • ANSWER: Removing a trade restriction, such as a tariff, would lead to more rapid economic growth because the removal of the trade restriction acts like an improvement in technology. Free trade allows all countries to consume more goods and services.
Chapter 25: QfR-7 (page: 573) • How does the rate of population growth influence thelevel of GDP per person? • ANSWER: The higher the rate of population growth, the lower is the level of GDP per person because there's less capital per person, hence lower productivity.
Chapter 25: QfR-8 (page: 573) • Describe two ways in which the U.S. government triesto encourage advances in technological knowledge. • ANSWER: The U.S. government tries to encourage advances in technological knowledge by providing research grants through the National Science Foundation and the National Institute of Health, with tax breaks for firms engaging in research and development, and through the patent system.
Chapter 25: P&A-1 (page: 574) • Suppose that society decided to reduce consumptionandincreaseinvestment. a. How would this change affect economic growth? b. What groups in society would benefit from thischange? What groups might be hurt? • ANSWER: a.More investment would lead to faster economic growth in the short run. b.The change would benefit many people in society who would have higher incomes as the result of faster economic growth. However, there might be a transition period in which workers and owners in consumption-good industries would get lower incomes, and workers and owners in investment-good industries would get higher incomes. In addition, some group would have to reduce their spending for some time so that investment could rise.
Chapter 25: P&A-2 (page: 574) • Societies choose what share of their resources to devoteto consumption and what share to devote to investment.Some of these decisions involve private spending;othersinvolvegovernmentspending. a. Describe some forms of private spending thatrepresent consumption, and some forms thatrepresentinvestment. b. Describe some forms of government spending thatrepresent consumption, and some forms thatrepresentinvestment. • ANSWER: a.Private consumption spending includes buying food and buying clothes; private investment spending includes people buying houses and firms buying computers. Many other examples are possible. Education can be considered as both consumption and investment. b.Government consumption spending includes paying workers to administer government programs; government investment spending includes buying military equipment and building roads. Many other examples are possible. Government spending on health programs is an investment in human capital. This is truer for spending on health programs for the young rather than those for the elderly.
Chapter 25: P&A-3 (page: 574) • Most countries, including the United States, importsubstantial amounts of goods and services from othercountries. Yet the chapter says that a nation can enjoy ahigh standard of living only if it can produce a largequantity of goods and services itself. Can you reconcilethesetwofacts? • ANSWER: The facts that countries import many goods and services yet must produce a large quantity of goods and services themselves to enjoy a high standard of living are reconciled by noting that there are substantial gains from trade.In order to be able to afford to purchase goods from other countries, an economy must generate income. By producing many goods and services, then trading them for goods and services produced in other countries, a nation maximizes its standard of living.
Chapter 25: P&A-4 (page: 574) • What is the opportunity cost of investing in capital? Doyou think a country can “over-invest” in capital? Whatis the opportunity cost of investing in human capital? Do you think a country can “over-invest” in humancapital? Explain. • ANSWER: The opportunity cost of investing in capital is the loss of consumption that results from redirecting resources toward investment. Over-investment in capital is possible because of diminishing marginal returns. A country can "over-invest" in capital if people would prefer to have higher consumption spending and less future growth. The opportunity cost of investing in human capital is also the loss of consumption that is needed to provide the resources for investment. A country could "over-invest" in human capital if people were too highly educated for the jobs they could getfor example, if the best job a Ph.D. in philosophy could find is managing a restaurant.
Chapter 25: P&A-5 (page: 574) • Suppose that an auto company owned entirely byGerman citizens opens a new factory in South Carolina. a. What sort of foreign investment would thisrepresent? b. What would be the effect of this investment on U.S.GDP? Would the effect on U.S. GNP be larger orsmaller? ANSWER: a.When a German firm opens a factory in South Carolina, it represents foreign direct investment. b.The investment increases U.S. GDP because it increases production in the United States. The effect on U.S. GNP would be smaller because the owners would get paid a return on their investment that would be part of German GNP rather than U.S. GNP.
Chapter 25: P&A-6 (page: 574) • In the 1990sandthefirstdecade of the 2000s, investorsfromtheAsianeconomies of JapanandChina made significant directand portfolio investments in the United States. At thetime, many Americans were unhappy that thisinvestmentwasoccurring. a. In what way was it better for the United States toreceive this Japanese investment than not to receive it? b. In what way would it have been better still forAmericans to have done this investment? ANSWER: a.The United States benefited from the Chinese and Japanese investment because it made our capital stock larger, increasing our economic growth. b.It would have been better for the United States to make the investments itself because then it would have received the returns on the investment itself, instead of the returns going to China and Japan.
Chapter 25: P&A-7 (page: 574) • 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. ANSWER: Greater educational opportunities for women could lead to faster economic growth in these developing countries because increased human capital would increase productivity and there would be external effects from greater knowledge in the country. Second, increased educational opportunities for young women may lower the population growth ratebecause such opportunities raise the opportunity cost of having a child.
Chapter 25: P&A-8 (page: 574) • International data show a positive correlation between income per person and the health of the population. • Explain how higher income might cause better health outcomes. • Explain how better health outcomes might cause higher income. • How might the relative importance of your two hypotheses be relevant for public policy? • ANSWER: • Individuals with higher incomes have better access to clean water, medical care, and good nutrition. • b. Healthier individuals are likely to be more productive. • c. Understanding the direction of causation will help policymakers place proper emphasis on the programs that will achieve both greater health and higher incomes.
Chapter 25: P&A-9 (page: 574) • International data show a positive correlation betweenpolitical stability and economic growth. a. Through what mechanism could political stabilitylead to strong economic growth? b. Through what mechanism could strong economicgrowth lead to political stability? ANSWER: a.Political stability could lead to strong economic growth by making the country attractive to investors.The increased investment would raise economic growth. b.Strong economic growth could lead to political stability because when people have high incomes they tend to be satisfied with the political system and are less likely to overthrow or change the government.
Chapter 25: P&A-10 (page: 574) • From 1950 to 2000, manufacturing employment as a percentage of total employment in the U.S. economy fell from 28 percent to 13 percent. At the same time, manufacturing output experienced slightly more rapid growth than the overall economy. • What do these facts say about growth in labor productivity (defined as output per worker) in manufacturing? • In your opinion, should policymakers be concerned about the decline in the share of manufacturing employment? Explain. • ANSWER: • a. If output is rising and the number of workers is declining, then output per worker must be rising. • b. Policymakers should not be concerned as long as output in the manufacturing sector is not declining. The reduction in manufacturing jobs will allow labor resources to move to other industries, increasing total output in the economy. An increase in productivity of workers (as measured by output per worker) is beneficial to the economy.