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Economics 101 (SSII 2011)
Midterm 1
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Problem 1: Nominal v. Real GDP, GDP Deflator & CPI (Total 12 points)
Consider an economy that only produces bread, steel (to be used in missile production) and
patriot missiles. This economy imports Italian wines and exports missiles. Use the data below:
2010
Price
Bread
Cement
Patriot missile
Italian wine
2011
Quantity
6
12
20
10
40
4
2
8
Price
Quantity
8
16
40
20
60
4
2
4
Using 2010 as the base year, compute the following statistics for 2011:
a) nominal GDP = 8*60+40*2 =560
b) real GDP = 6*60+20*2= 400
c) GDP deflator = 560/400 = 1.4
d) CPI = (8*40+20*8)/(6*40+10*8)=480/320 =1.5
Problem 2: National Income Accounting (Total 8 points, 2 points each)
a) Name the three approaches for measuring GDP
Spending approach, Income approach and the Value Added approach
b) What is difference between GDP and GNP
GDP measure value of good and services produced domestically regardless of
the nationality of owners of those who have produced them while GNP is a
measure of goods and services produced by factors of production owned by
citizens of the country in question regardless of their whereabouts.
c) What is considered to be investment in national Accounts? Are the stocks you buy
in the stock market considered to be investment? What about inventories?
Investment in purchases made for investment purposes. Stocks are not
investment but a form of savings. Inventories are defined as Investment.
d) In the following national income identity: Y = C + I + G + EX – IM
Does an increase in IM decrease Y? Explain your answer.
No. C, I and G all have import component and hence with an increase in IM
they increase too and the two cancel out.
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Problem 3: Neoclassical Model (18 points, 2 pts each part)
Suppose the U.S. economy could be described by the following equations:
Production:
Y = 40K1/2L1/2
Factors of Production:
L = 100
K = 400
Government Behavior:
G = 1100
T = 200
Consumer Behavior:
C = 200 + 0.8(Y-T)
Investment Behavior:
I = 500 – 1000r
a) Compute the real wage
W/P = MPL = 20K1/2L-1/2 = 20(400)1/2(100)-1/2 = 40
b) What is the total factor payment to labor?
Total Factor Payment to Labor = MPL x L = 40 x 100 = 4000
a) Compute GDP
Y = 40(400)1/2(100)1/2 = 8000
c) Compute the equilibrium levels of the following variables:
i) Consumption
C = 200 + 0.8(8000-200) = 6440
ii) Interest Rate
Use the fact that Y = C + I + G
8000 = 6440 + 500 – 1000r + 1100
8000 = 8040 – 1000r => r = 0.04
iii) Investment
I = 500 – 1000(0.04) = 460
d)
Compute the following variables:
i) Public Savings
T – G = 200 – 1100 = -900
ii) Private Savings
Y – C – T = 8000 – 6440 – 200 = 1360
iii) National Savings
Y – C – G = 8000 – 6440 – 1100 = 460
Public Savings + Private Savings = -900 + 1360 = 460
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Problem 4: Circle the correct answer (10 pts, 2 pts each)
Suppose that the U.S. Congress lowers taxes. What effect will this have on the variables below?
(Assume everything else is held constant)
a) Interest Rate
rise
b) Consumption
rise
c) Investment
fall
d) Public Savings
fall
e) National Savings
fall
Problem 5: Circle the correct answer (10 point) No explanation is needed.
Suppose that a country promotes a one-child policy which has the effect of drastically lowering
the population growth rate. What will happen to the steady-state values of the following
variables:
Capital per worker
rise
fall
no change
Output per worker
rise
fall
no change
Consumption per worker
rise
fall
no change
Growth rate of output per worker
rise
fall
no change
Growth rate of total output
rise
fall
no change
Problem 6: Growth Accounting (7 points, 4 and 3)
The table below shows the growth rate of real output Y, Labor force L and real capital stock K in
U.S. over two periods of 1948-2007.
Percentage Change
Year
1948-2007
Y
L
K
3.6
1.7
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Suppose the following Cobb Douglas production function: Y= ALa Kb, where a=.07 (output
elasticity of labor) and b=0.3 (output elasticity of capital).
a) Calculate the contribution of capital accumulation and labor to the US economic growth
over 1948-2007.
b) Calculate the Solow residual over this period. What does this measure?
Percentage change
Year
1948-2007
aL/L
.7*1.7=1.19
A/A
3.6-1.2-1.2=1.21
bK/K
.3*4=1.2
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Problem 7: Convergence (15 points total, 3 points each)
Use the growth theories studied in class (use Solow growth model unless stated) to answer the
following questions. Discuss your reasoning briefly. Unless stated otherwise, assume that the
underlying features of the two economies are the same: the same saving rate, depreciation rate,
the production function, population growth rate, the level economic efficiency, and the same
technological growth rate (for simplicity you can assume technological growth rates are zero in
both countries, unless stated otherwise). Obviously their starting income per capita is not the same.
a) State whether the level of income per person in China in the long run will be higher than in
the U.S., lower, or the same, or if it is impossible to tell.
Income per person in China will increase and converge to that of U.S. in the long run
Now re-answer the question in part (a) if you know that ceteris paribus (meaning all else equal)
b) China has a lower population growth rate
Income per person in China will be higher than U.S. in the long run
c) China has a higher rate of technological progress (as defined in class).
Income per person in China will increase and surpass that of U.S. in the long run
d) China and US have the production function Y=AK and zero technological growth rate.
Income per person in China will remain lower. With equal saving rates, output per person
in both countries will grow at the same rate but they will not converge (because US have a
head start)
e) China has a higher saving rate (in answering this question, consider Solow growth model and
the AK model separately, assume zero technological growth rate).
Income per person in China will increase and surpass that of US under both the Solow and
the “AK” model.
Problem 8: Unemployment (6 points total)
(a) Assume that for Belize the natural rate of unemployment is 0.125 and the rate of job finding
is 0.56. What is the fraction of employed workers who lose their jobs each month (the rate of job
separation)?
s = 0.08
(b) Explain what is meant by wage-rigidity. What are three examples of wage-rigidity?
Wage rigidity is the idea that there is something preventing the labor market to adjust to where
labor supply equals labor demand.
1. Minimum wage
2. Unions
3. Efficiency Wages
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Problem 9: Quantity Theory of Money (12 points total, each part 6 points)
Suppose that in Canada the velocity of money is constant, real GDP grows by 0% per year each
year, the money stock grows by 1% per year, and the nominal interest rate is 3%.
a) Using the quantity theory of money and the Fisher relation, what should be the inflation rate
and the real interest rate in Canada?
M V P Y
P
P



 1 0 
0
 1   Inflation rate should be 1%
M
V
P
Y
P
P
i  r    3  r  1  r  2 The real interest rate is 2%
b) Suppose the central bank of Canada decides to increase inflation by increasing the money
supply growth rate to 4% (all else constant). Now what would be the equilibrium values of
inflation and the nominal interest rate? (Assume the Classical Dichotomy holds here.)
M V P Y
P
P



 40 
0
4
M
V
P
Y
P
P
The inflation rate has increased to 4%
i  r   i  2  4  6
The nominal interest rate would need to increase to 6% in order to keep the real
interest rate at 2%.
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