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PRACTICE PROBLEM ANSWERS
Use the following table to answer question 1.
Q Marginal Benefit Total Cost
0
-30.00
1
40.00
50.00
2
25.00
70.00
3
15.00
90.00
4
10.00
110.00
5
5.00
130.00
The table above represents the marginal benefits and total costs associated with a government
program (in millions).
a.) What is the optimal quantity of this program?
MB>MC for only the 1st and 2nd units, so Q*=2
b.) Suppose the total costs at Q=0 are $50.00 instead of $30.00, but everything else remains the
same. What is the optimal quantity of this program?
Sunk costs don’t matter, so it remains Q =2.
c.) If marginal costs increased from $20.00 to $26.00 per unit, what is the new optimal quantity?
Q=1.
2. Suppose the government invests in a policy which results in $45 million in net benefits. They
faced two alternatives, one which would have resulted in $20 million in net benefits and another
which would have resulted in $30 million. What is the opportunity cost of the chosen policy?
$30 million (the value of the next best alternative).
3. What would the following changes cause to the equilibrium price and the equilibrium quantity
in a market?
a.) An increase in demand. P* increases; Q* increases
b.) A decrease in demand. P* decreases; Q* decreases
c.) An increase in supply. P* decreases; Q* increases
d.) A decrease in supply. P* increases; Q* decreases
4.
What is the definition of GDP?
The market value of all final goods and services produced in a nation during a year.
5. Bob owns a lawn mowing company. On Monday he mows 6 customers lawns and
chargers them each $30. He also mows his own lawn and his neighbor’s lawn for free
later in the day. How much was contributed to GDP?
Only consider goods and services that are traded in the market place, so $180.
6. What is the expenditure formula for GDP?
GDP = Consumption + Investment+ Government Expenditures + (Exports – Imports).
= C + I + G + (X – M)
7. Which of the expenditure components of GDP can be negative?
Net exports.
8. Which of the following is excluded from GDP calculations?
A. capital goods
B. services
C. leisure
D. new home sales
E. used good sales
F. government interest payments
G. government expenditures on goods and services
H. exports
I. nonmarket transactions
C., E., F., and I. would be excluded.
9. Suppose nominal GDP increases by 3% in a year and inflation equals 4%. What happens to
real GDP?
It decreases by 1%
10. Suppose an economy is made up of two goods: books and pretzels.
pretzels
books
Price 2000
Quantity 2000
Price 2007
Quantity 2007
$2.00
5
$4.00
5
$50.00
2
$75.00
3
11. Assuming a base year of 2000, what is real GDP in 2007? What is the percent
change in real GDP from 2000 – 2007?
Real GDP in 2007 is calculated by multiplying 2007 quantities by 2000 prices. This
equals $2.00*5 + $50.00*3 = $160. Real GDP in 2000 was $2.00*5 + $50.00*2 = $110
so the percentage change in real GDP equals $50/$110*100=45.45%.
12. What is not included in real GDP that affects overall well-being in society?
Lots of things, but some of the major ones include environmental quality, the value of leisure,
income inequality, health, and education.
13. What is real GDP per capita in the U.S.? How has it changed over the last 200 years? What
is the historical rate of growth? What is the average real GDP per capita in the world?
Real GDP per capita in the U.S. is approximately $48,000. Real GDP per capita was
approximately $2,000 200 years ago. The historical rate of growth is 2%. Average real GDP per
capita in the world is approximately $10,000.
14. Suppose that in 1998 you deposited $1000 in a savings account that gives 5% interest
compounding annually. How much would your savings be worth in 2008?
It would be worth $1000*(1.05) in 1999, $1000*(1.05)*(1.05) in 2000, and
$1000*(1.05)10 = $1628.90 in 2008.
15. Real GDP per person in the United States was $11,484 in 1950 and $34,875 in 2003.
Suppose the United States had grown at a rate of 3.0% from 1950 to 2003 instead 2.1%. How
much larger would real GDP per person have been in 2003?
If the growth rate was 3.0%, real GDP per person would have been $11,484*(1.03)53=
$55,013.10, which is $20,138.10 more than $34,875.
16. Suppose U.S. real GDP per person grows at a rate of approximately 4% per year. About how
long will it take for real GDP to double from $48,000 per person to $96,000 per person?
You could use the rule of 70 to approximate for how long it takes to double, which is 72/growth
rate = 70/4 = 17.5 years.
17. Suppose one knows the average labor productivity in an economy. What else would one need
to measure real GDP per capita?
Real GDP per capita = Average Labor Productivity * Share of Population Employed
So one would need to know the share of the population employed.
18. Suppose average productivity growth is zero. As the baby boom generation begins to retire,
what will happen to real GDP per person in the United States?
The retirement of the baby boom generation would reduce the portion of the population
that is employed, and if productivity is not increasing, real GDP per person will have to
decrease.
19. What are the primary reasons for the increase in real GDP per person in the U.S over
the past 100 years?
The main reasons are that there have been substantial increases in labor productivity and
a significant increase in the share of the population employed over the past 100 years.
20. Suppose real GDP per person is $20,000 when the average productivity of labor is $50,000
and the share of the population in the workforce equals 0.40. Suppose average productivity of
labor remains constant and the share of the population in the workforce increases to 0.50. What
happens to real GDP per person?
It increases to $50,000 * 0.50 = $25,000.
21. How is economic growth shown on a production possibilities curve? How is a
recession show on a production possibilities curve?
Economic growth is shown by the PPC shifting out. A recession is when the economy is
operating within the PPC (the PPC does not shift in during a recession, we’re just not
producing at our potential level of output).
22. What are the major determinants of productivity?
Education/Human Capital, Physical Capital, Technological Advances, Entrepreneurship,
Improved allocation of resources
G
F
Real
GDP
C
D
E
B
A
0
Year
23. Given the diagram above, what are the periods of:
Expansion:
A to C and E to G
Peak:
C and G
Recession:
C to E
Trough:
A and E
24. What is the definition of a recession?
The definition is a period in which the economy is growing at a rate significantly below normal.
The general rule of thumb that the NBER uses is two consecutive quarters of negative GDP
growth.
25. Suppose the population of Employtown is 1000. Of those 1000, 600 people have
jobs, 100 people do not have jobs but are looking for jobs, and 300 people are not in the
labor force. What is the unemployment rate in Employtown?
The employment rate is the #unemployed/labor force = 100/(600+100)=14.29%
32. In the U.S. there are approximately 150 million employed, 8 million unemployed,
and 80 million not in the labor force.
26. In the U.S. there are approximately 150 million employed, 8 million unemployed,
and 80 million not in the labor force. What is the participation rate for the United States?
Participation Rate = Labor Force/Working-Age Population = (150+8)/(150+8+80) =
66.4%
27. Suppose a country has a population of 80 million, of which 25% are not working age. The
number of working age adults currently not looking for jobs is 11 million. The number of
employed people equals 40 million. Use this information to calculate the following:
Unemployment rate = __# unemployed/labor force *100 = (49 – 40)/49 *100 = 18.4%
Labor force participation rate = _ Labor force/working age pop*100=(80 – 20 – 11)/60 *100=
81.7%
28. Suppose 1 million unemployed workers become discouraged and drop out of the labor force
(so the number of adults not looking for jobs is 12 million). Everything else is the same.
Calculate the:
Unemployment rate = (48 – 40)/48 *100 = 16.7%
Labor force participation rate =(80 – 20 – 12)/60 *100= 80%
29. How does the ‘underemployment rate’ differ from the ‘unemployment rate’?
The underemployment rate would include discouraged workers in addition to the unemployed,
whereas the unemployment only includes the unemployed. The underemployment rate can be
calculated as: [(#unemployed+ #discouraged) / (civilian labor force + #discouraged)]*100
30. Bob worked as an IT specialist for a large investment bank, but he lost his job due to
the slumping economy. What type of unemployed would he be considered?
Cyclically unemployed. Cyclical unemployment is the extra unemployment that occurs
during periods of recession.
31. What are the three types of unemployment and what is the natural unemployment
rate?
Frictional, Structural and Cyclical. The natural unemployment rate is unemployment when there
is zero cyclical unemployment, which equals frictional + structural unemployment.
32. According to Okun’s Law, if there is a recessionary output gap of 4%, and the natural rate of
unemployment is 5%, what is cyclical unemployment and what is the actual unemployment rate?
According to Okun’s Law, % output gap = 2* cyclical unemployment rate. Plugging numbers in
and solving for cyclical unemployment rate, one gets cyclical unemployment rate = 4%/2=2%.
The actual unemployment rate equals the natural rate of unemployment + cyclical
unemployement = 5% + 2% = 7%.
33. Suppose that the actual unemployment rate is 5.5% and assume that the natural rate of
unemployment is 5.0%. According to Okun’s Law, by what percentage did actual GDP differ
from potential GDP?
There is a recessionary gap of 1%. According to Okun’s Law, % output gap = 2* cyclical
unemployment rate. The cyclical unemployment rate = 0.5%. Therefore, the output gap =
2*0.5%=1%.
34. What will happen to equilibrium wages and equilibrium employment levels if demand for
labor decreases, other things constant?
Wages will decrease and equilibrium employment levels will decrease (unemployment will
increase).
35. What happens to quantity supplied and quantity demanded of labor when real wages
increase, other things constant? What happens to supply and demand for labor?
Quantity supplied increases and quantity demanded decreases. Nothing happens to supply or
demand when prices (wages) change.
36. The Columbian American Free Trade Agreement had been a subject of considerable
debate. If we assume that Columbia specializes in low-skilled production and the U.S.
specializes in high-skilled production, explain what will happen to employment and real
wages in the U.S. for high-skilled and low-skilled workers respectively if it is passed.
The free trade agreement will increase labor demand for high-skilled workers and
decrease labor demand for low-skilled workers. The net result is an increase in
employment and real wages for high-skilled workers, and a decrease in employment and
real wages for low-skilled workers.
37. Suppose the CPI in year one equaled 1.45. The CPI in year two equaled 1.51. The
rate of inflation between years one and two was _____ percent.
.06/1.45*100 = 4.1 percent
38. Here are values of the CPI for each year from 1990 to 1994.
Year
1990
CPI
1.307
Inflation Rate (%)
x
1991
1.362
4.2%
1992
1.403
3.0%
1993
1.445
3.0%
1994
1.482
2.6%
a. For each year beginning with 1991, calculate the rate of inflation from the previous year.
b. If the nominal interest rate was 6.4% in 1992, what was the real interest rate?
Real = nominal – inflation; 6.4% – 3.0% = 3.4%
c. Suppose you learn your grandfather earned $3,000 in 1933 when the CPI was 0.130. Your
father earned $50,000 in 1993. Who earned more in real terms?
Grandpa’s real salary = 3,000/0.130=23,076.92
Father’s real salary = 50,000/1.445=34,602.08
Your father earned more!
39. Suppose the CPI equaled 1.00 in 1995 and 1.65 in 2005 and a typical household's
income equaled $35,000 in 1995 and $40,000 in 2005. What happened to real
household income between 1995 and 2005?
The price level increased 65%, while nominal income increased by 14.3%. Therefore
real household income decreased. Or 1995 income in 2005 dollars is (1.65/1.00)*$35,000
= $57,750 (higher than $40,000, so real income declined)
40. Suppose workers expect inflation to be 3% next year and create a contract to
increase real wages by 4%. Actual inflation turns out to be 5%. What happens to
the real wages of workers?
Under their contract, workers will be receiving a 7% (3%+4%) increase in nominal
wages. With inflation at 5% instead of 3%, workers will actually be receiving a 2%
increase in real wages (7%-5%).
41. If a bank wants to earn a 4% real interest rate and inflation is 6%, what nominal
interest rate would the bank have to charge?
Real interest rate = nominal interest rate – inflation rate. 4% = nominal interest rate - 6%.
Solving for the nominal interest rate, you get 10% = (6%+4%).
42. Why is deflation generally considered to be worse as far as its impact to the economy than
inflation?
Because it reduces consumer spending (by encouraging consumers to save more) and
destroys credit markets (because banks don’t want to lend).
The answer to the first extra credit question is Tom Sargent.