Economics 102

Spring (yes, sure… that’s why there’s all that snow…) 2003

Exam 1—L. Stone

 

1. For each of the following, indicate which category of GDP this good or service is counted under, or if it is not counted, briefly state why. (2 points each)

 

a.  You purchase a house built in 1965.

 

Not counted—used good

 

b.  Kodak buys some chemicals to use in photo-finishing.

 

Not counted—intermediate good

 

c.  The U.S. government sells some Patriot missiles to Saudi Arabia

 

Exports (or net exports)

 

d.  Honda, a Japanese company, builds a plant in Ohio.

 

Investment

 

e.  The State of NY pays the salary of professors at Geneseo.

 

Government spending

 

f.   You buy some U.S. Treasury bonds.

 

Not counted—paper transaction or used good or no production

 

g.  You buy a Sony Walkman, manufactured in Japan.

 

Imports or not counted because it’s an import or counted as consumption but subtracted as imports

 

h.  The state government sends a welfare check to a poor person.

 

Not counted—transfer payment

 

2.  What are the two factors that suggest that unemployment statistics may understate the true amount of unemployment?  Briefly explain.   (6 points)

 

1.  Discouraged workers way drop out of the labor force.  These workers are not counted toward unemployment, even though they would like a job.

 

2.  Underemployment.  If workers are working part time but would like full time jobs, or if they are working below their skill level, the unemployment rate is misleading (because output is lower than it would be if the workers were fully employed).

 

 

 

 

 

3.  a.  What the major differences in the way that the CPI and the GDP deflator are calculated?  (4 points)

 

1.  The CPI is based on a fixed market basket of goods, as opposed to the GDP deflator, which is based on whatever goods are produced that year.

 

2.  The GDP deflator includes only new goods that are produced in the US, while the CPI includes used goods and imports (and excludes things that consumers don’t buy).

 

There may be other acceptable answers to this.

 

b. Why is it possible that the rate of inflation, as measured by the CPI, may be too large? Why is it important that the rate of inflation as measured by the CPI may be too large? (8 points)

 

The CPI uses a fixed basket of goods, and thus it does not allow for substitution/introduction of new goods/changes in the quality of goods.  Thus, since consumers change consumption bundles, the CPI may be overstated.  It matters because the rate of increase of Social Security payments is tied to the CPI, and thus if the CPI increases too fast, it will aggravate the future deficit problems of the Social Security system.

 

4.  Refer to the table below:

                                                  1995     1996

Real GDP                                2000     2400

GDP deflator                          165         175

 

a. Calculate the growth rate of real GDP and the inflation rate (as based on the GDP deflator). (5 points)

 

(2400 –2000/2000)* 100 = 20%  (GDP growth rate)

(175-165/165)*100 = 6%

 

b.  A job paid $10,000 in 1968.  The CPI in 1968 was approximately 70, as compared to 164 in 1999.  In 1999, a comparable job paid  22, 000.  Has the real wage increased, decreased, or stayed the same?  (Show some evidence supporting your answer.)  (5 points)

 

10000/.7 = 14,285

22,000/1.64 = $13,414

 

The real wage has decreased.

 

5.  a.  Supply-side economists believe that cutting payroll taxes will increase output.  Show graphs and explain why this is true.  (10 points)

 

Cutting payroll taxes increases the demand for labor, which increases employment and thus output.  Must be supported by graphs.

 

b.  Why is there reason to believe that this is not correct, at least in the short run?  Carefully explain. 

 (5 points)

 

Empirical evidence shows that the elasticity of supply of labor is close to perfectly inelastic.  Thus increasing the demand for labor would increase real wages but have no effect on employment, and thus there would be no effect on output.

 

c.  Explain why decreasing the capital gains tax is expected to increase output.  (10 points)

 

Cutting the capital gains tax encourages people to sell stock.  If they sell stock in less productive industries and move funds to more productive (higher growth) industries, then output will grow more quickly.  (WRONG:  sell stock, spend more money….)

6.  a.  Explain exactly why crowding occurs if the government spends more in a closed economy.  (5 points)

 

Output is fixed.

Y = C + I + G

With fixed Y, if G increases, something else has to go down, and thus either investment or consumption or both must fall.

 

b.  Carefully explain why the government budget deficit and the trade deficit are often called the “twin deficits.”  (5 points)

 

In an open economy, Y = C + I + G + NX, but Y is still fixed in the long run.  If G increases (and taxes don’t rise), the government budget deficit rises.  If C or I doesn’t fall, then NX must fall (either because exports fall or imports rise or both), and the trade deficit increases (or trade surplus decreases).

 

7. a.  Suppose that a war in Iraq causes sufficient long-run damage to oilfields, such that the price of oil rises very sharply, and producers are forced to switch to alternative (and less productive) technology.   Show the effect on the economy in long run equilibrium, on the graphs below.  (10 points)

 

The production function shifts down.  The demand for labor shifts down.

 

b. State the effect on each of the following: (5 points)  (Note:  you don’t have to explain; just indicate whether it increases, decreases, or stays the same)

 

national income (output)  falls

employment falls

per capita income  falls

real wages fall

 

 

8.  What is Say’s Law, and why does it matter?  (In other words, what point is Say’s Law trying to explain?)  (6 points)

 

 Say’s Law states that supply creates its own demand.  In other words, when firms produce, they hire workers, and thus they pay them, and thus the workers have income, and can buy the stuff that is produced.  The point is that (unless potential demand does not become effective demand), there will not be persistent gluts/excess supply, and thus the economy will produce (and consume) at maximum output.

BONUS QUESTION!  POSSIBLE EXTRA CREDIT!

 

In Kuwait, almost all industry is oil production, and thus almost all of GDP essentially consists of oil.  However, people in the country obviously don’t consume nothing but oil.  Lately, the price of oil has been rising sharply.   Carefully explain how exactly this would affect the CPI and the GDP deflator. In Kuwait.  What is each one of them telling you about prices?  (Be as precise as possible.)

 

The GDP deflator would increase sharply due to the increase in the price of oil, but the CPI would not increase nearly as much.  The GDP deflator is telling you about overall prices of the nation’s consumption, while the CPI is telling you about the prices of things that consumers buy.  (To get any credit, you have to say something more than “both will rise”.)