Download SOLUTION EXAM 06/07/04

SOLUTION EXAM 06/07/04
INTRODUCTION TO ECONOMIC ANALYSIS
1. a) Disagree. If an increase in the price of butter leads, by demand law, to an
increase in the quantity demanded of margarine that means that a fall in the
demand of butter will provoke an increase in the demand of margarine, then
margarine and butter are substitutes
b) Agree. The marginal cost curve crosses the average total cost (ATC) curve at
the minimum of ATC, and it is the efficiente scale.
c) Agree. Fixed costs are not considered, then covering variable costs is enough
to supply.
2. a) X is a normal good. The sign of income in the demand function is positive.
b) X and Y are substitutes. The sign of Py is positive, that means that changes in
the price of good Y will provoke changes in the opposite direction in the demand
of good X, therefore they must be substitutes.
c) For Py = € 1.00, M = € 500 and Px = 1.00, substituting these values in the the
demand function, we have:
X = 100 -1.5 + 0.2 – 0.5 x 500, then X = 348.70
d) Arch-elasticity method
X 2  X1
X 2  X1
100 , where, X2 = final demand of good X,
P2  P1
P2  P
X1 = initial demand
P2 , final price of good X, P1 initial price.
We work out the quantity demanded when price goes down from € 1.00 to €
0.90:
X = 100 -1.5 x 0.90 + 0.2 – 0.5 x 500, then X = 348.85, then we will have
348.85  348.70
348.85  348.70 100  0.4%
1.00  0.90
1.00  0.90
3. Taxes reduce the quantity sold and bought in a market. This is the main sourde
of inefficiency. Taxes increase the price paid by buyers and decrease the price
received by sellers. It does make no difference so far on the economics effects if
the tax is imposed on buyers or sellers, what matters are the elasticities of
demand and supply.
4. a) Disagree. GDP is the market values of goods and services produced within a
country by national and foreigners.
b) Agree. In a closed economy: Y = C + I + G [1]
Each unit of output is consumed, invested or bought by the government. From
[1], we can we can rewrite the equation:
Y – C – G = I [2]
Total income in the economy that remains after paying for consumption and
government purchses, that is, national saving, calling it S, [2] can be written as:
S = I, this equation states that saving equals investment.
c) Disagree. Money supply depends on the reserve ratio, but
also on others factors such as the liquidity preferences of individuals
5. i) GDP deflator = ( Nominal GDP/ Real GDP ) 100
First, we calculate nominal GDP:
1995 Nominal GDP = 1 x 100 + 1 x 100 + 1 x 100 = 300
2000 Nominal GDP = 1 x 120 + 1.4 x 150 + 0.8 x 110 = 418
Second, we calculate real GDP:
Real GDP 1995 is the same a nominal GDP 1995, the base year (1995), both
nominal and real are the same.
Real GDP 2000: 1995 prices x 2000 quantities:
1 x 120 + 1 x 150 + 1 x 110 = 380,
Then GDP deflator will be: (418/300) 100 = 110
Increase over the period = [(110 – 100) / 100] 100 = 10%
ii) CPI in 1995 (base year) = 100
CPI in 2000 (base 19959 = 2000 prices x shares A B C,
1 x 40 + 1.4 x 30 + 0.8 x 30 = 106
CPI growth = [(106 – 100)/ 100] 100 = 6%
iii) None is better than the other. The two are good depending on the purpose for
which they are to be used.
The GDP deflator is the adequate index to correct nominal figures of output, in
order to isolate real growth of this output. The CPI is good to identify the evolution
of the prices of the goods and services we consume.
The main differences between the two indices are:
a) The GDP deflator is an index of prices with variable weights (the extent of
production of each year), the CPI, on the other hand, is an index with fixed
weights (the consumption shares of the base year) and it is a Laspeyres index.
b) CPI includes the price of imports and excludes the prices of exports. GDP
deflator, on the other hand, includes the price of exports and excludes the price
of imports.
6. The equation of the quantity theory of money is:
MxV=PxY
Where:
M = quantity of money
V = velocity of money
P = prive level
Y = quantity of output (real GDP)
This equation states that the quantity of money (M) time the velocity of money (V)
equals the price of output (P) times the amount of output. It relates the quantity of
money (M) to the nominal value of output (P x Y).
According to this theory inflation is exclusively caused by the growth of money supply.
The assumptions needed to fulfill that statement are:
1. The velocity of money is relatively stable over time.
2. When the Central bank changes the quantity of money (M ), that causes
proporcionate changes in the nominal value of output (P x Y ).
3. Money does not affect output, given that money is neutral.
4. given that output is determined by factor supplies and technology, when the
Central Bank alters the money supply and induces parallel changes in nominal
output (P x Y), these changes are reflected in the price level (P).
5. therefore, when the Central Bank increases the money supply, the result is a high
rate of inflation.