Download Exam #1

Department of Economics
College of Saint Benedict | Saint John's University
Fall Semester 2015
Louis Johnston
Economics 111
Exam #1
Model answers
Part I. True, False, Uncertain Questions. (8 total points; 10 minutes)
1. (4 points) The “rule of 70” states that, on average, it takes 70 years for a country’s per capita GDP to
double.
False. The “rule of 70” states that the number of years it takes for a country’s per capita GDP to double is
equal to 70 divided by the growth rate of per capita income (expressed as a percent.)
2. (4 points) The difference between the unemployment rate and the natural rate of unemployment is that the
latter excludes frictional unemployment.
False. The difference between the unemployment rate and the natural rate of unemployment is that the
latter excludes cyclical unemployment. In particular, the natural rate of unemployment equals the sum of
frictional plus structural unemployment divided by the labor force.
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Part II. Short answer questions (32 total points; 45 minutes)
1. (8 total points) The table below provides data for the U.S. economy for the past few years:
Year
Nominal GDP
(trillions of
dollars)
GDP deflator
(2009 = 100)
2012
2013
2014
16.1
16.7
17.4
105
107
108
Nominal
interest rate
(percent per
year)
1.7
2.9
2.2
a. (4 points) In which year was real GDP higher: 2013 or 2014? Show your work.
2014 is higher. The relationship among real GDP, nominal GDP, and the GDP deflator is
𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃
∙ 100 = 𝑟𝑒𝑎𝑙 𝐺𝐷𝑃
𝐺𝐷𝑃 𝑑𝑒𝑓𝑙𝑎𝑡𝑜𝑟
Using the information above, we have
2013:
16.7
∙ 100 = 15.6
107
2014:
17.4
= 16.1
108
b. (4 points) In which year was the real interest rate higher: 2013 or 2014? Show your work.
2014 is higher. The relationship among the nominal interest rate (i), the real interest rate (r), and the
inflation rate (π) is
𝑟=𝑖− 𝜋
We therefore need to calculate the inflation rates for 2013 and 2014 and then use that information in
the formula above.
The inflation rate is the percentage change in the GDP deflator; thus
2013: 𝜋 =
107 − 105
= 1.9%
105
2014: 𝜋 =
108 − 107
= 0.9%
107
Using the information above, we have
2013: 𝑟 = 2.9 − 1.9 = 1.0 and 2014: 𝑟 = 2.2 − 0.9 = 1.3
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2. (12 total points) Suppose that a country produces two goods: computer chips and potato chips. The
production possibilities frontier (PPF) for this country looks like this:
Potato
Chips
·A
Computer
Chips
a. (4 points) Does this production possibilities frontier exhibit the law of increasing relative cost? If so,
explain why. If not, explain why not.
Yes. Start at the point on the vertical axis where this economy is producing only potato chips; then, if
we decrease production of potato chips by a given amount the amount of computer ships produced in
response to that change gets smaller and smaller. This is increasing relative cost.
(PROBLEM CONTINUED ON NEXT PAGE)
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b. (4 points) Suppose that this economy is currently operating at point A in the graph above. If this
economy wants to produce more potato chips, what is the opportunity cost in terms of computer chips?
You may use the graph above to illustrate your answer or draw a new graph below.
The opportunity cost of producing more potato chips in terms of computer chips is zero at point A.
Since the economy is operating inside its PPF, we can increase production of one good without
sacrificing production of the other good.
c.
(4 points) Forget about part (b) and now assume that this economy is operating on the PPF. Suppose
that technological progress is such that the productivity of workers in the computer industry steadily
increases while the productivity of workers in the potato chip industry remains constant. Would it now
be possible to produce more computer chips and more potato chips, or only more computer chips?
Explain your reasoning. (You may use the graph above to illustrate your answer or draw a new graph
below.)
It can now produce more of both goods except for the case in which this economy only produces potato
chips. The PPF rotates outward, keeping its place on the vertical axis; this means that there are now
combinations of both goods that are outside the original PPF.
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(12 points) An economy has two workers, Chris and Jenna. For every day that they work, Chris can
produce 4 cell phones or 16 shirts and Jenna can produce 12 cell phones or 24 shirts.
a. (4 points) Does the same person who has absolute advantage in the production of shirts also have
comparative advantage in the production of shirts? Explain your reasoning.
No. Chris has an opportunity cost for shirts of ¼ phone, while Jenna has an opportunity cost of
shirts of ½ phone. Jenna has absolute advantage in shirts since she can produce more shirts per
day.
b. (4 points) How much of each good is produced in a single day if each worker fully specializes
according to his or her comparative advantage? Explain your reasoning.
Chris: specialize in shirts, produce 16 shirts per day
Jenna: specialize in phones, produce 12 phones per day
c. (4 points) Suppose that this economy can trade with the rest of the world. Specifically, suppose
that Chris and Jenna can sell any amount of shirts that they can produce at $20 per shirt and they
can sell any number of cell phones that they can produce at $60 per phone. Would this
economy’s consumption possibilities exceed its production possibilities if it engages in trade?
Explain your reasoning.
Yes. For example, suppose they each specialize and produce 16 shirts and 12 phones. Now,
suppose they don’t want any phones; they can then sell 12 phones and earn $720 and then use
this to purchase an additional 36 shirts. They can now have more shirts (52) than they could
produce if they both make only shirts (40).
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