ECON 20A: INTRODUCTION TO MACROECONOMICS MIDTERM I
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ECON 20A: INTRODUCTION TO MACROECONOMICS
MIDTERM I
1. Suppose that the following information is known about a given economy:
Real GDP2021 = 5,000 |
GDP Deflator2021 = 95 |
CPI2021 = 105 |
Base Year: 2019
a) (4 points) The consumer price index for this economy is higher than the GDP price deflator. What reasons may explain this difference?
The consumer price index measures the average price change of a selected basket of consumption goods, either produced domestically or imported. The GDP deflator measures the average price change of all goods and services produced domestically, many of which are not consumed by local households (capital goods, government spending, exports). Hence, if imported consumption goods see their price increase more than domestic goods, this will only be captured by the CPI, pushing its value above the GDP deflator. The same conclusion applies when domestic consumption goods see their price increase more than other domestic goods. The GDP deflator measures all these price changes, but the CPI only captures the former.
b) (5 points) Use the GDP Deflator to determine the nominal value of GDP in 2021. Which one is higher, nominal or real GDP? What is the explanation for this difference?
Real GDP is obtained as
Real GDP = (Nominal GDP / GDP Deflator) × 100.
Hence,
Nominal GDP = (Real GDP × GDP Deflator) / 100
Nominal GDP = 5,000 × 95 / 100 = 4,750.
Real GDP is higher than nominal GDP. The average price for all commodities actually decreased between the base year and 2021, that is, deflation is observed (that is why the GDP deflator is less than 100). Accordingly, output valued at current prices is less than that same output valued at older prices (from the base
2. Suppose that a given economy has only one final good (MP3 players) produced by firm X. In 2021, this firm produced $5 million worth of players, all sold in the domestic market. Firm X incurred in the following costs during 2021 (values in millions):
CEO compensation 0.5
Wages 1
Rent 0.8
Inputs 1.5
The rent refers to a building owned by a household and the inputs are hard drives produced by firm Y. Assume that firm Y has no costs.
a) (4 points) Calculate the profits (that is, revenues minus costs) earned by firms X and Y in this economy. Are they included in the economy’s disposable personal income? Explain.
Profits are (in million dollars):
πX = 5 – 1 – 0.5 – 0.8 – 1.5 = $1.2
πZ = 1.5 – 0 = $1.5.
Households own all inputs and they have a claim on profits, either directly or indirectly (through stocks). Hence, profits become part of disposable personal income, unless firms choose to retain these gains (not paying them in the form of dividends).
b) (4 points) Calculate the gross domestic product of this economy using an income approach.
The income approach yields in this simple example
GDP = wages + profits + rents.
Wages (and labor compensations, such as the one paid to the CEO) amount to $1.5 million. Profits for all firms (calculated in the previous question) are $1.2 + $1.5 = $2.7 million. Rents amount to $0.8 million. Hence, gross domestic product becomes $1.5 + $2.7 + $0.8 = $5 million. Notice that this matches the value of all final goods produced in the economy (which we would obtain following an expenditure approach).
c) (5 points) Suppose now that firm X replaces its CEO, without changing his compensation. The new CEO is a non-resident temporarily working in this economy. What will be the effect of this on gross domestic product? What about national income? Explain.
There is no effect on gross domestic product (that is, it says the same). The value of income generated within the country remains the same. Residency or nationality issues are not relevant for calculating gross domestic product. However, national income for this economy will decline by $0.5 millions. This value is counted negatively on net factor income from abroad, representing income paid to non- residents temporarily located in the domestic economy.
3. The following information is known about a given economy:
Working Age Population 1,000,000
Participation Rate 70%
Unemployment Rate 10%
a) (4 points) Suppose that the natural unemployment rate equals 6%. What can you say about the output gap and cyclical unemployment in this economy? Explain.
There is a negative output gap, that is, actual GDP is below potential GDP. The difference between the observed unemployment rate and the natural rate reflects cyclical unemployment. In this case, the economy is undergoing a downturn. Under the estimate that a 1% gap in unemployment matches a 2% gap in output, the latter would currently be 8% below its potential level.
b) (5 points) Suppose now that this economy receives a wave of 100,000 legal immigrants of working age looking for employment. Out of them 74,000 find a job. Determine the new unemployment rate.
Recall that
Participation Rate = (Labor Force / Working Age Population) × 100. Given the initial values, before the arrival of immigrants,
0.7 = Labor Force / 1,000,000 ó Labor Force = 700,000.
The unemployment rate of 10% implies that the number of unemployed workers was 70,000. After the arrival of immigrants, the labor force increases to 700,000 + 100,000 = 800,000. The number of unemployed workers increases to 70,000 + 26,000 = 96,000. Hence, the new unemployment rate is
(Unemployed / Labor Force) × 100 = (96,000 / 800,000) × 100 = 12%.
4. The following functions represent the aggregate behavior of demand in a given economy:
C = 50 + 0.8YD
G = 25
T = 10 + 0.15Y
I = 15 + Animal Spirits
The tax function (T) includes lump sum and proportional components. There are no transfers. Currently, Animal Spirits equal the baseline value ofzero.
a) (5 points) Determine the equilibrium output and represent it on a graph.
In equilibrium, Y = AE:
Y = 50 + 0.8 (Y – 10 – 0.15Y) + 25 + 15 ó 0.32Y = 82 ó Ye = 256.25 Graphically:
Aggregate
Expenditures
82
42
25
15
AE = Y
AE = 82 + 0.68Y C = 42 + 0.68Y
G = 25
I = 15
256.25 |
Income (Y) |
b) (5 points) Determine the public budget deficit (or surplus) as a percentage of gross domestic production. Without further calculations, what does this say about private savings? Explain.
The budget deficit equals in this case
G – T = 25 – 10 – 0.15 × 256.25 = – 23.4375.
This value means that the government displays a surplus, where tax revenues are
In equilibrium,
I = SAggregate = SPrivate + SPublic .
Investment assumes a constant value (15) that is more than covered by public saving (23.4375). This enables private saving to be negative in this case. Households display a high level of autonomous consumption, requiring them to borrow to sustain consumption at this level.
c) (4 points) Suppose that Animal Spirits become unfavorable, that is, negative. Explain what happens to equilibrium output and why. What is the multiplying effect equal to?
Animal Spirits will now take a negative value. Firms become less optimistic and reduce their investment levels. This decreases aggregate demand, leading to an unplanned increase in inventories. Production is reduced, along with income, prompting a new round of decrease in aggregate demand, now through lower consumption. In equilibrium,
Y = 50 + 0.8 (Y – 10 – 0.15Y) + 25 + 15 + Animal Spirits
ó Ye = 256.25 + Animal Spirits / 0.32.
Hence, the multiplier equals
m = DYe / D(Animal Spirits) = 1 / 0.32 = 3.125.
d) (5 points) The government decides to adjust its fiscal policy to stimulate the economy. What is more effective: a change in the lump sum component of taxes or on the proportional tax rate? Explain.
A decrease of one monetary unit in either lump sum taxes or proportional taxes generates the same initial effect on consumption (and aggregate demand). However, a lower proportional tax rate also means that as production and income increase, disposable income will be allowed to grow by more, pushing demand further up. In other words, a lower tax rate reinforces the multiplying effect associated to the initial fiscal stimulus, making this the preferred solution.
2022-03-31