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Economics 104B, Section 41 Instructor: Tara Sinclair ANSWERS TO QUIZ NO. 1 Please review the answers to this quiz even if you got full points for a question. There may be a similar question on the midterm and the comments in this answer key may help you. 1. According to the neoclassical synthesis, Keynesian analysis should be used to study: the short run. 2. (modified from question 2, page 121 of textbook) The country of Freedonia uses the same method to calculate the unemployment rate as the U.S. Bureau of Labor Statistics uses. From the data below, compute Freedonia’s a. unemployment rate b. labor force participation rate Population Under 16 Over 16 In military Service In hospitals In prison Worked one hour or more in previous week Searched for work during the previous four weeks 10,000,000 3,000,000 500,000 200,000 100,000 4,000,000 1,000,000 Please show your work here: Unemployment rate = Unemployed/Labor Force = Unemployed/ (Unemployed + Employed) = 1,000,000/(1,000,000 + 4,000,000) = 1/5 = 20% Labor force participation rate = Unemployed + Employed / Over 16 not military or institutionalized (called the civilian noninstitutional population) = 5,000,000/6,200,000 = 81% (Over 16 not military or institutionalized = total population – under 16 – military – in hospitals –in prison = 10,000,000 = 3,000,000 – 500,000 – 200,000 – 100,000 = 6,200,000) 3. Which of the following activities are reflected in GDP? How much does each activity change GDP? Give a brief (few word) explanation. a. Smith pays a carpenter $8,000 to build a garage. GDP rises by $8,000 because the garage is a final good. b. Smith purchases $2,000 worth of materials and builds a garage herself, which adds $8,000 to the value of her house. GDP rises by only $2,000, the value of the goods bought in the market. The value of the labor does not count towards GDP because it does not go through the market. c. Smith goes to the woods, cuts down trees, and builds a garage from logs that is worth $8,000. None of these activities go through the market, so Smith’s work for herself does not affect GDP. d. The Jones family sells its old house to the Reynolds family for $125,000. The Joneses then buy a newly constructed home for $180,000. GDP rises by the value of the newly constructed home $180,000. The sale of the existing Jones home is the exchange of a previously produced asset and therefore has no effect on GDP. e. Your grandmother wins $10,000 in the state lottery. Lottery winnings do not represent the sale or production of final goods and services. Therefore, they are not included in GDP. f. Your grandmother uses her $10,000 winnings to finance a trip around the US. The expenditure on a vacation represents the consumption of final goods and services. GDP rises by $10,000 regardless of the source of the money. 4. Which of the following people is considered unemployed by the Bureau of Labor Statistics? a. A housewife or househusband. A housewife or househusband is probably not actively engaging in searching for a job, so they would not be counted as part of the labor force and would not be counted as unemployed. b. An inmate in the state prison. Because an inmate is not actively looking for a job, he or she is not counted as unemployed. c. A college student who is not looking for work. This college student in not unemployed because he or she is not looking for a job. d. A college student who has just graduated and is looking for a job. A recent graduate who is looking for a job but has not found one will be counted as unemployed. e. A person who was fired 3 months ago and has been looking for a job ever since. A person who was fired and is looking for a job would be counted as unemployed. f. A person who was fired 3 months ago and unsuccessfully looked for a job for 1 month, but has not looked for a job recently. If jobless people stop actively seeking work they will not be counted as unemployed—even if they once held a job and would like to have one again. 5. Suppose you agree to lend money to your friend on the day you both enter college, at a zero real rate of interest (r = 0). Payment is to be made at graduation, with interest at a fixed nominal rate i. If inflation (π) proves to be lower during your four years in college than what you both had expected, who will gain and who will lose? Explain. You will gain and your friend will lose. Because you set the real interest rate on your loan (r) equal to 0, you must have set the nominal interest rate (i) equal to the inflation rate (π). If inflation turns out to be lower that what you expected, the actual real interest rate (r) will be positive over the term of the loan. When your friend repays the loan, the total amount repaid will buy more "stuff" than what you could have bought with the amount of money you lent at the time you made the loan. (formula r = i - π) 6. In terms of the business cycle, when in the cycle do we call it a recession? Officially, a recession is from the peak to the trough of the business cycle. You might also have talked about negative GDP growth for two quarters or when NBER calls it a recession. All of these answers got you full credit. 7. In 1974, the yield (interest rate) on 10-year U.S. Treasury securities averaged 7.56 percent. The inflation rate (measured by the GDP deflator) was 8.7 percent. What was the real interest rate on these securities? Do you think the level of inflation in 1974 was fully anticipated by individuals who bought these Treasury bonds at the time of their purchase? Why or why not? The real interest rate was the nominal rate (7.56 percent) less the inflation rate (8.7 percent) or negative 1.14 percent. Because the real interest rate is negative, we can deduce that the individuals who bought these bonds did not expect inflation to be so high. They probably would not have chosen to lend money to the government at an interest rate that did not even compensate them for the loss in purchasing power due to inflation. 8. Year Suppose that a mythical economy produces just one kind of output that is called "stuff." The table below gives the economy's output of stuff and the corresponding prices for 1997, 1998, and 1999. Use these data to answer the questions below. For parts (b) and (c), express your answers in percentage terms to two decimal places. Price of Stuff $20 Nominal GDP GDP Deflator Real GDP 1997 Units of Stuff Produced 500 $10,000 (500*20)/(500*21) =95.24 500*21=10,500 (or 10,000/95.24*100) 1998 520 $21 $10,920 100 (base year) 10,920 (base year) 1999 560 $24 $13,440 (560*24/(560*21) =114.29 560*21=11,760 (or 13,440/114.29*100) a) Calculate nominal GDP for each year. Because the structure of this economy is so simple, it is easy to calculate the GDP deflator. Calculate the price deflator for each year using 1998 as the base year, with a value of 100. Then, calculate real GDP for each year. (Show your work below and fill in your final answers in the chart above.) b) What is the growth rate in nominal GDP between 1998 and 1999? (show your work below) Growth rate = (GDP1999-GDP1998)/GDP1998 = ($13,440 - $10,920)/$10,920 = 23.08% c) What is the inflation rate between 1997 and 1998? (show your work below) Inflation Rate = (Deflator1998 – Deflator1997)/Deflator1997 = (100 – 95.24)/95.24 = 5.00% 9. List three of society’s resources. Labor, Capital, and Land 10. The supply of Sumatra coffee is given by the function QS = 2P. The demand for Sumatra coffee is given by QD = 120 – P. What is the equilibrium quantity of Sumatra coffee transacted? Equilibrium means where supply = demand so set QS = QD or 2P = 120 – P. Solving for P we have: 3P = 120 or P = 40. This implies that the equilibrium Q = 80. 11. Assume you are lending money to a friend for a year and want to earn real interest of 5 percent on the loan. If you believe the inflation rate for the next year will be 3 percent, what nominal interest rate should you charge? i = r + expected inflation so nominal interest rate = 5% + 3% = 8% 12. Assume that the U.S. population is 260 million. If 100 million individuals are legally classified as unable to work (or are less than 16 years of age), 60 million are classified as unwilling to work, and 7 million are unemployed, a. What is the unemployment rate? Labor force = population – unable – unwilling = 260 – 100 – 60 = 100 million Unemployment rate = unemployed/labor force = 7/100 = 7% b. What is the labor force participation rate? Labor force participation rate = labor force/(population – unable) = 100/(260-100) = 100/160 = 62.50%