Download Economics 201

Economics 102
Homework #1
Due: January 25th at the beginning of class
Complete all of the problems. Please do not write your answers on this sheet. Show all
of your work.
1. Assume that a country produces only two goods, skis and surfboards. The table
below shows the prices and quantities produced by the country for each of three
years.
Year
Price of
Quantity of
Price of
Quantity of
Skis
Skis
Surfboards
Surfboards
Year 1
$5
100
$12
200
Year 2
8
140
18
300
Year 3
12
150
17
325
a. Calculate nominal GDP in each of the three years.
Nominal GDP is calculated using current prices and current quantities. So,
Year1: ($5*100) + ($12*200) = 500 + 2,400 = 2,900.
Year2: ($8*140) + ($18*300) = 1,120 + 5,400 = 6,520.
Year3: ($12*150) + ($17*325) = 1,800 + 5,525 = 7,325.
(Note: For nominal GDP both prices and quantities change)
b. Calculate Real GDP in each of the three years, using Year 1 as the base
year.
Real GDP is calculated using base year prices and current quantities. So,
Year1: ($5*100) + ($12*200) = 500 + 2,400 = 2,900.
Year2: ($5*140) + ($12*300) = 700 + 3,600 = 4,300.
Year3: ($5*150) + ($12*325) = 750 + 3,900 = 4,650.
(Note: For real GDP only quantities change.)
c. Calculate the growth rate of nominal GDP each year.
The growth rate formula is: ((Year2 – Year1)/Year1) *100.
Year 2 growth rate = ((6,520 – 2,900)/2,900)*100 = 124.8%.
Year 3 growth rate = ((7,325 – 6,520)/ 6,520)*100 = 12.3%.
d. Calculate the growth rate or real GDP each year.
The growth rate formula is: ((Year2 – Year1)/Year1) *100.
Year 2 growth rate = ((4,300 – 2,900)/2,900)*100 = 48.3%.
Year 3 growth rate = ((4,650 – 4,300)/ 4,300)*100 = 8.1%.
2. What component (or components) of GDP would each of the following
transactions affect? Also indicate whether that component would increase or
decrease, and whether GDP increases or not.
a. Consumption increases because a guitar is a good purchased by a household,
GDP also increases (C↑, Y~).
b. Investment increases because a house is considered a structure, GDP also
increases (I↑, Y↑).
(Note: consumption does not change.)
c. Investment increases, GDP also increases. Since the definition of GDP
contains the phrase ‘within the borders of a country’, even though Toyota is a
foreign company the factory is being built in the U.S. therefore U.S. GDP
increases. (I↑, Y↑)
d. Investment increases, GDP also increases. Even though the wood is an
intermediate good it is being put into inventory, and inventory is a part of
investment. Next year when the wood is turned into furniture and sold, I will
decrease and C will increase. (I↑, Y↑)
e. There is no change to any component or GDP. Welfare benefits are a transfer
payment, which do not affect GDP. An increase in consumption would be a
secondary effect. The paying of the benefits themselves have no effect on
GDP. (Y~)
f. Government spending increases, GDP increases. (G↑, Y↑)
g. Consumption increases because the car is purchased by a household,
Imports increase because the car was imported from another country, these
two changes offset so GDP does not change. (C↑, M↑, Y~)
h. Investment decreases, Consumption increases, and GDP does not change.
Even though this wine came from France it entered the country last year. So
last year imports increased and inventories increased. This year the wine is
simply being sold from inventory. (I↓, C↑, Y~)
i. Imports increases, Exports increases and GDP does not change. Since the
purchaser is not an American consumption does not change. We simply
imported a toy from China and then exported it to Canada. This is an example
of a transaction called re-exporting. (X↑, M↑, Y~)
j. Consumption increases because a household bought a computer
Investment decreases because Dell reduced its inventory, GDP does not
change. (C↑, I↓, Y~)
3. Using the GDP equation and the circular flow diagram, explain in detail the
assumptions that need to be made for you to reach the following conclusion I = S.
Start with Y = C + I + G + X - M, Y = C + Sp + T, Sg = T – G, and S = Sp + Sg,
then solve for either I or S. Then figure out any assumptions you would need to
make to make the other parts of the equation equal 0. Show your work!
First we need to use the two different formulas for GDP. Since they are both equal to Y,
we can set them equal to each other. This gives the following equation: C + Sp + T = C +
I + G + X – M. Solving for Sp and using a bit of algebra gives us the following: Sp = I +
G – T + X – M. Now add Sg to both sides of the equation. Sp + Sg = I + G – T + X – M +
Sg. Which simplifies to: S = I + G – T + X – M + T – G. The Ts and Gs cancel out
leaving us with S = I + (X – M). In order for S to equal I, we need the (X – M) term to
disappear. There are two possible assumptions that we can make to reduce this term to
zero. The first is that X is equal to M. However this would only be the case if there were
no international financial markets. The second option is to simply close the economy. In
a closed economy there are no imports and exports allowed so both X and M are equal to
zero.
So we have a choice of either assuming the economy is open, but there are no
international financial markets, or assuming the market is closed. The second seems to
be a more useful assumption (and one we are going to make frequently in this class). The
second would hold for example if we were thinking about the economy of the entire
world rather than an individual country.