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Economics 302 Answers to First Midterm June 7, 2007 Name ________________________________ Student ID Number _____________________ Version 2 This midterm consists of 28 multiple choice questions (some with just two answers and some with up to five answers) worth 2 points each for a total of 56 points and 3 problems worth 10 points each for a total of 44 points. Please answer all multiple choice questions on the scantron provided. Pleases show all your work on the exam booklet: if any questions arise as to the integrity of your exam, we will NOT give full credit unless suitable work is shown in the exam booklet. For all questions please pick the BEST answer. SCANTRON DIRECTIONS Please fill out your scantron sheet carefully. You need to use a number 2 pencil and you need to bubble in your Name Student Identification Number (and NOT your social security number) Your exam version number in special codes column “A” PROBLEM DIRECTIONS: Please answer these questions on your test booklet. Please write legibly and please take some time to organize your answer before your write it. If you have questions about any question on the exam please make a note of that question on your exam booklet and then draw the proctor’s attention to this question at the end of the exam. Please do not ask the proctor any questions during the exam: no questions will be answered during the exam period. You have 75 minutes to complete the exam. Please use your exam booklet margins for any calculations you need to do. Calculators are fine to use. Problem #1 (12 points) _____________________ Problem #2 (12 Points) ______________________ Problem #3 (20 Points) ______________________ TOTAL _______________________ 1 Multiple Choice Questions: 1. Real GDP in year 3 is calculated by a. Summing together the product of the base year’s prices times the year 3 quantities of production. b. Summing together the product of year 3’s prices times the year 3 quantities of production. c. Summing together the product of year 3’s prices times the base year quantities of production. Answer: A. 2. In the classical model, an increase in the level of the money supply I. Has no effect on nominal variables II. Has no effect on real variables III. Will result in an increase in the price level, holding everything else constant a. b. c. d. e. Statements I, II and III are true. Statements I and III are true. Statements II and III are true. Statement I is true. Statement III is true. Answer: C. 3. Economists build models and then use these models to test hypotheses. Variables explained by the models are called a. Endogenous variables. b. Exogenous variables. Answer: A 4. Depreciation is an example of a a. Stock. b. Flow. Answer: B. 5. Positive increases in inventories cause a. GDP for that period to increase. b. No change in the level of GDP computed for that period. Answer: A. 2 6. Income is an example of a a. Stock. b. Flow. Answer: B. 7. Computing GDP using the value added approach can also be referred to as double counting. a. True b. False Answer: B. 8. Reductions in inventories from the beginning level of inventories to the final level of inventories during the period under consideration cause a. GDP for that period to decrease. b. No change in the level of GDP computed for that period. Answer: B. 9. Sue, a U.S. resident, purchases Italian wine twice a month at her local grocery store. Holding everything else constant, this purchase 1. Increases the level of U.S. consumption spending. 2. Decreases the level of net exports. a. b. c. d. Statements (1) and (2) are correct. Statement (1) is correct. Statement (2) is correct. Neither statement (1) nor (2) is correct. Answer: A. 10. Real GDP is measured using a. Constant dollars. b. Current dollars. Answer: A. 11. Suppose an economy’s production is described by a Cobb-Douglas production function. If the amount of labor used increases, holding everything else constant, this will I. Increase the value of the MPL for this economy II. Decrease the value of the MPL for this economy III. Decrease the value of the MPK for this economy IV. Cause labor productivity to decrease 3 a. b. c. d. e. Statements I, III and IV are correct. Statements II, III and IV are correct. Statements I and III are correct. Statements II and III are correct. Statements II and IV are correct. Answer: E. An increase in the amount of labor used, holding everything else constant, will cause labor productivity to fall as the additional labor has less capital per unit of labor to work with. An increase in the amount of labor used, holding everything else constant, will cause the MPK to increase since the capital can now be used more intensively. 12. An increase in the GDP deflator may be due to 1. An increase in nominal GDP holding everything else constant. 2. An increase in real GDP holding everything else constant. 3. A decrease in real GDP holding everything else constant. a. b. c. d. e. Statements (1) and (2) are true. Statements (1) and (3) are true. Statement (1) is true. Statement (2) is true. Statement (3) is true. Answer: B. 13. The CPI holds constant prices in its calculation, using prices defined at the level they are at during the base year, while allowing quantities to vary from year to year. a. True b. False Answer: B. The CPI holds quantities constant at a predetermined level (this is the idea of a fixed “market basket”) while utilizing the price level for each particular year. Hence, prices vary from year to year in the calculation of the CPI while quantities are fixed in its calculation. 14. An increase in the number of discouraged workers in an economy will, holding everything else constant, I. cause the unemployment rate to fall II. cause the unemployment rate to rise III. cause the labor force participation rate to rise a. b. c. d. Statements I and III are correct. Statements I and II are correct. Statement I is correct. Statement II is correct. 4 e. Statement III is correct. Answer: C. An increase in the number of discouraged workers will reduce the unemployment rate since the unemployment rate is defined as the (number of unemployed divided by the number in the labor force)*100: when discouraged workers increase this causes both the denominator and the numerator to change, but the decrease in the numerator has a larger impact than the decrease in the denominator resulting in the overall ratio falling. The labor force participation rate decreases when the number of discouraged workers increases because the measure of the labor force is smaller (recall that the measure of the labor force is the sum of the employed plus the unemployed) while the total adult civilian population is unchanged. Hence, the labor force participation rate = (labor force/total adult civilian population)*100 is now smaller. 15. Suppose that the MPL for the next additional unit of labor is $35 while the prevailing wage rate is $30. If you are a profit maximizing firm, you will a. Hire more labor since the value of the production of another unit of labor exceeds the cost of that unit of labor. b. Hire less labor since you already have the profit maximizing amount of labor employed at your factory. c. Make no changes in the amount of labor you hire since more labor will only reduce your level of labor productivity at your factory. Answer: A. 16. Joe, a U.S. resident, purchased a brand-new Ford in 2002 for $22,000. This year he sold the Ford for $8000. U. S. GDP for this year a. Decreased by $14,000. b. Increased by $8,000. c. Was unaffected by this transaction. d. Was affected by this transaction, but insufficient information is provided to measure the effect of the transaction on U.S. GDP for this year. Answer: C. 17. The number of employed people in an economy is an example of a a. Stock. b. Flow. Answer: A. 18. When the central bank purchases treasury bills on the open market this a. Increases the money supply and therefore raises the market interest rate. 5 b. Decreases the money supply and therefore raises the market interest rate. c. Increases the money supply and therefore lowers the market interest rate. d. Decreases the money supply and therefore lowers the market interest rate. Answer: C. 19. When k, the constant that tells us how much money people want to hold for every dollar of income, has a relatively large value then a. Money in this economy changes hands infrequently. b. Money in this economy changes hands frequently. Answer: A. Since v = 1/k, then when k is relatively large then v is relatively small and that implies that the velocity of money is low and therefore money changes hands infrequently. 20. Use the following table to answer this question. Year Money Supply Velocity Real GDP 2006 10,000 2.5 125 2007 11,000 3.0 132 Using the arithmetic tricks for estimating percentage changes in a variable and the above information, estimate the percentage change in the price level from 2006 to 2007. The percentage change in the price level is approximately a. 24.70% b. 20.46% c. 23.84% d. 24.40% Answer: D. 21. Joe lends $1000 to Sue for the year. Sue promises to repay Joe the $1000 plus 8% interest on the loan at the end of the year. Joe figures that the inflation rate for the year will be 4%. The actual inflation rate for the year is 5%. Which of the following statements is true? I. The ex ante real interest rate for Joe is 4%. II. The ex post real interest rate for Joe is 5%. III. Joe ends up worse off than he expected when he agreed to make the loan. a. b. c. d. e. Statements I, II and III are true. Statements I and II are true. Statements I and III are true. Statements II and III are true. Statement III is true. Answer: C. The ex post real interest rate is 3%. 6 22. Suppose that the money supply increases by 1 percent in one year and then remains constant at this higher level thereafter. According to the quantity theory of money, the inflation rate a. Is 1 percent in the first year and thereafter. b. Increases by 1 percent in the first year and remains constant at the higher level thereafter. c. Increases by 1 percent in the first year and returns to its former value thereafter. d. Is unaffected. Answer: C. The key thing here is to remember that the question is asking about what is happening to the inflation rate and not the aggregate price level. 23. When the government spends more than it receives in tax revenue, holding everything else constant, we know that I. Public Saving is positive II. The government is running a deficit III. The government is running a surplus a. b. c. d. e. Statements I and II are correct. Statements I and III are correct. Statement I is correct. Statement II is correct. Statement III is correct. Answer: D. When G is greater than T, then G – T > 0 and this implies that the government is running a deficit. When the government runs a deficit, holding everything else constant, it must be a situation where public saving (the saving the government does) is negative. 24. Suppose nominal GDP is $150 in 2002 and $300 in 2003. Furthermore, you know real GDP in 2002 was $200 and that real GDP increased by 50% in 2003. With certainty you know a. The GDP deflator decreased between 2002 and 2003. b. The GDP deflator increased between 2002 and 2003. Answer: B. 25. During periods of unexpected inflation, lenders are hurt while borrowers gain because the a. Ex post real interest rate exceeds the ex ante real interest rate. b. Ex post real interest rate is lower than the ex ante real interest rate. c. Real interest rate rises. d. Nominal interest rate falls. Answer: B. 7 26. The GDP deflator is calculated using a pre-determined “market basket” of goods and services that includes particular amounts of all goods and services produced in an economy. a. True b. False Answer: B. The GDP deflator is calculated using each year’s level of production of all goods and services produced in an economy rather than specific amounts of all goods and services (this would be similar to how the CPI is calculated). 27. Constant returns to scale occurs when a. Output doubles when the amounts of all factor inputs double. b. Output remains constant over time. c. The marginal productivity of labor equals the marginal productivity of capital. d. The marginal products of capital and labor do not change. Answer: A. 28. Suppose, k, the constant that tells us how much money people want to hold for every dollar of income, has a value of .2. If the money supply is equal to $1000, then what is the value of nominal GDP? a. $5000 b. $500 c. $50,000 d. The value of nominal GDP cannot be determined without information about the aggregate price level. Answer: A. Short Essays/Problems: 1. (12 points total) Use the following information about an economy that produces three goods – books, socks, and pizzas – to answer this set of questions. Books Pairs of Socks Pizzas Prices in Year 1 Quantities in Year 1 10 100 2 50 4 200 Prices in Year 2 Quantities in Year 2 12 120 1 200 3 250 8 a. (2 points) Using year 1 as the base year, what is the value of real GDP in year 1? Show your work and provide the base formula you are using. (An answer without any indication of how you got the answer will not receive full credit.) Answer: Real GDP in Year 1 = (10)(100) + (2)(50) + (4)(200) = $1900 b. (2 points) Using year 1 as the base year, what is the value of nominal GDP in year 2? Answer: Nominal GDP in Year 2 = (12)(120) + (1)(200) + (3)(250) = $2390 c. (2 points) Using Year 1 as the base year, what is the value of the GDP deflator for this economy in year 2? Assume the GDP deflator is being measured on a 1 point scale. Answer: GDP deflator for Year 2 = (Nominal GDP for Year 2)/(Real GDP for Year 2) = ($2390)/($2600) = .919 = .92 d. (2 points) Using Year 1 as the base year and defining the consumer market basket as 50 books, 20 pairs of socks, and 100 pizzas, calculate the CPI for Year 2. What is the value of the CPI for year 2? Assume the CPI is being measured on a 100 point scale. Answer: CPI = [(Cost of market basket in year 2)/(Cost of market basket in base year) ]* 100 = [(920)/(940)]*100 = 97.87 e. (2 points) Given the market basket defined in part (d) and this economy’s CPI figures, what is the rate of inflation between Year 1 and Year 2? Answer: Inflation Rate = [(97.87 – 100)/(100)]*100 = -2.13% f. (2 points) Suppose a particular good in this economy cost $1200 in year 1 and its price precisely adjusts to the rate of inflation in this economy. What will its price be in year 2? Answer: $1174.44. This just requires you to utilize the calculation you made in part (e). 2. (12 points total) The economy of your country can be described using a CobbDouglas production function where A is a measure of the available technology, L is the amount of labor available, K is the amount of capital available, and Y is the level of aggregate real output. Capital’s share of output is 50%. You also know that this country has 625 units of labor available this year and 900 units of capital. Its level of available technology has a value of 2. 9 a. (2 points) What is the level of aggregate real output in this country for this year? Show your work. Y = AK.5L.5 = 2(30)(25) = 1500 b. (2 points) What is labor’s income in this economy during the current year? Show your work. Labor receives 50% of income or .5(1500) = 750. c. (2 points) What is the value of labor productivity for this year? Show your work. Labor productivity equals Y/L = 1500 units of output/625 units of labor = 2.4 units of output per unit of labor d. (2 points) What is the ratio of labor income to capital income equal to in this economy? Ratio of labor income to capital income equals (labor’s share of income)/(capital’s share of income) = 750/750 = 1. e. (2 points) Suppose that the unemployment rate in this economy during this year is 4% (resulting in 625 units of labor being utilized in this economy). This economy has no discouraged workers. What is the size of the labor force in this economy during this year? (Hint: round to the nearest whole number.) Answer: to find the labor force recall that the unemployment rate is equal to (the number of unemployed/labor force )* 100 and therefore the employment rate is equal to (the number of employed/labor force)*100. In this case we have (625/LF) *100 = 96 or LF = 651. f. (2 points) Suppose there is no change in the labor force in this economy and no change in the level of employment, but that productivity changes in the economy are such that Okun’s Law holds. If Okun’s Law holds, what is your prediction as to the level of real output in the next year for this economy? (Assume that labor and capital are unchanged, but that productivity does change in such a way that Okun’s Law precisely captures the predicted change in real GDP.) Okun’s Law states that the percentage change in real GDP = 3% - 2(the change in the unemployment rate). In this example there is no change in the unemployment rate so the second term on the right hand side of the equation has a value of zero. Thus, the percentage change in real GDP = 3%. So, if real GDP equals 1500 initially, then it will equal 1500(1.03) = 1545. 10 3. (20 points) For this problem carry all calculations out to two places past the decimal. Use the following information to answer this question. A closed economy can be described by the standard Cobb-Douglas production function. Furthermore, all firms in this economy are competitive firms with constant returns to scale and they all are profit maximizing firms. Technology in this economy can be measured as having a value of 15, while capital’s share of aggregate income is 70%. There are initially 100 units of capital and 100 units of labor. Furthermore, this economy can be described using the Classical Model where Y = C + SP + T Y = C + I + G in equilibrium C = a + b(Y – T) = 10 + .6(Y – T) I = I(r) G is a constant and is equal to 100 T is a constant and is equal to 200 Where Y is real GDP C is consumption spending SP is private saving T is net taxes I is investment G is government spending r is the real interest rate SG is government saving a. (2 points) What is the initial value of private saving, SP , in this economy? Show your work. Answers without supporting work cannot receive full credit. First, you need to find Y: Y = AK.7L.3 Y = (15)(100).7(100).3 Y = (15)(25.12)(3.98) Y = 1499.66 Then, you need to find C: C = a + b(Y – T) = 10 + .6(Y – T) = 10 + .6(1499.66 – 200) C = 10 + .6(1299.66) C = 789.80 Then, use the equation Y = C + SP + T to find SP: 1499.66 = 789.80 + SP + 200 SP = 1499.66 – 989.80 SP = 509.86 11 b. (2 points) What is the initial value of government saving, SG , in this economy? Show your work. Answers without supporting work cannot receive full credit. Government saving = SG = T – G = 200 – 100 = 100 c. (2 points) Describe the government’s initial budget situation. In your answer be sure to relate the budget situation to the level of government saving. Since net taxes are greater than government expenditure on goods and services, the government is running a budget surplus and therefore has positive government saving. d. (2 points) In this economy, what is the initial equilibrium value for investment? Show your work. Answers without supporting work cannot receive full credit. To find the level of investment use the equation Y = C + I + G: 1499.66 = 789.8 + I + 100 I = 609.86 Now, suppose net taxes are reduced by 100. Use this information to compute the answers for the rest of the questions in this problem. e. (2 points) What is the new value of private saving, SP , in this economy? Show your work. Answers without supporting work cannot receive full credit. First, you need to find Y. But, since nothing has changed in the variables determining Y, you already know that Y’s value is the same as it was initially, or Y = 1499.66. Then, you need to find C: C = a + b(Y – T) = 10 + .6(Y – T) = 10 + .6(1499.66 – 100) C = 10 + .6(1399.66) C = 849.80 Then, use the equation Y = C + SP + T to find SP: 1499.66 = 849.80 + SP + 100 SP = 1499.66 – 949.80 SP = 549.86 f. (2 points) What is the value of government saving, SG , in this economy? Show your work. Answers without supporting work cannot receive full credit. Government saving = SG = T – G = 100 – 100 = 0 12 g. (2 points) Describe the government’s budget situation now that the level of net taxes has changed. Since net taxes are equal to government expenditure on goods and services, the government is running a balanced budget and therefore government saving equals zero. h. (2 points) In this economy, what is the new equilibrium level of investment? Show your work. Answers without supporting work cannot receive full credit. To find the level of investment use the equation Y = C + I + G: 1499.66 = 849.80 + I + 100 I = 549.86 i. (2 points) What is the effect on the real interest rate of this change in fiscal policy? Explain your answer, making note of any shifts of curves or movements along curves. The effect of this change in fiscal policy on the real interest rate is to raise the real interest rate. The change in fiscal policy causes the national savings curve to shift to the left and this causes a movement along the investment demand schedule. This movement along the investment demand curve is due to the increase in the level of the real interest rate. j. (2 points) Now, draw a well-labeled graph of the loanable funds market to illustrate your answer. 13 14