Answer Key to the Midterm Exam, Macroeconomics (103) with Gottheil, Spring 2008 Question 1 Economic growth occurs when more resources are available or when more productive technology is used. This is because more goods and services can be produced with more resources. Technology, on the other hand, makes the production process more efficient, so more goods and services can be produced without increasing the amount of available resources. An economy can also choose to allocate some of its resources in the production of capital goods, which can be used to produce more goods and services, thus furthering economic growth. The economic growth can be seen as an outward shift of the PPC as seen in the graph. Question 2 If S>Ii, then there are unwanted inventories as consumption goods accumulate and actual investment is above intended investment. In response, business order fewer consumption goods produced, which decreases production and worker layoffs occur, and national income falls. This process continues until intended investment equals actual investment (equals savings) and the economy is at equilibrium. Question 3 A recessionary gap is the amount by which aggregate expenditure (AE) falls short of the level needed to generate equilibrium nation income (Y) at full employment without inflation. To close the recessionary gap by increasing AE the government can increase spending, lower taxes, or both. Question 4 Part (a) The income multiplier is 1/(1-MPC), and the Tax multiplier is –MPC/(1-MPC), where MPC is the marginal propensity to consume, ΔC/ ΔY. More taxes mean less money in consumers’ pockets, so an increase in taxes has a negative effect on Y, while government spending increases Y (though more production, income, etc). Taxes pass through consumption fc’n first, so some Δ T is saved, making the effect smaller in absolute value than the spending/inc multiplier. Part (b) A balanced budget implies G=T (in a given year), while a deficit budget happens when G>T (in a given year). In a deficit budget, the government spends more than it takes in as tax revenue. These things are identical in a balanced budget. Question 5 The shoe market is at equilibrium when quantity supplied equals A B quantity demanded i.e. P1 Supply at the intersection of demand and supply Equilibrium curves. If the price is above the equilibrium then there will be excess supply (AB). P2 Demand Since the suppliers C D cannot sell all the goods they produced, they will Quantity cut back on the price and bring it back to the equilibrium price. If the price is below the equilibrium, then there will be excess demand (CD), in which case the competition among demanders will force the price up to the equilibrium price. Question 6 Four things can shift the AD curve positively: (1) increases in government spending (2) increases in income abroad (3) tax cuts, and (4) changes in expectations of future income Part (b) Demand-pull inflation is inflation caused primarily by an increase in AD, illustrated as a shift from AD1 to AD3 in the graph to the right. Question 7 Part (a) Nominal GDP is Gross Domestic Product measured in terms of current market prices- that is, the price level at the time of measurement (i.e., it is not adjusted for inflation). Real GDP is GDP adjusted for changes in the price level. Part (b) Real GDP = Nominal GDP *100 / GDP deflator. Question 8 Long run growth occurs because of continued capital accumulation. Specifically, as the amount K rGDP of capital per laborer increases, the productivity per worker increases. As rises, L L (“labor productivity”) rises, and in the capital deepening model, the increase in productivity is the definition of growth. This concept is illustrated in the graph. There is capital accumulation because given productivity, some fraction is consumed, and some is saved. Since S=Ia and firms investment in capital, as Y (rGDP) grows every year, savings grows every year, and so the amount of capital K produced increases every year, increasing (for L example, from 200 to 220 in the graph, in one year), all else equal. This is the cause of long run growth. Note: an increase in technology, shifting the curve from Q to QT, increases production, but this jump is “instantaneous” – any further growth over time (i.e., LONG RUN growth) happens because of capital. “Technology” does not cause long run growth. Question 9 ΔI The accelerator is the change in investment generated by a change in national income, ΔY ΔAE (or, ). Some initial stimulus increases national income, and this causes the multiplier to ΔY kick in and increase income and consumption further. Firms observe the growth, expect consumption growth to continue, and via the accelerator, increase investment (in future production). This further stimulates the economy, increasing Y, C, etc. As growth speeds up, demand for consumption goods eventually is not able to rise as fast as production capacity grows. But when firms see this, they expect income to grow more slowly, and cut down investment. Investment falls, Y falls, C, falls, etc. The same happens on the way down; productive capacity falls faster than expectations of consumption, and I will increase again. This interaction between consumption, expectations of growth, and the resultant changes in investment, allow the accelerator and multiplier to internally generate business cycles. Question 10 Absolute income hypothesis: MPC falls as national income rises. As production rises, there is less value to consuming more and more, and so increasing amounts of the “additional dollar” are put into savings. Relative income hypothesis: MPC stays constant as national income rises. Spending is driven by relative differences (like status, competition, etc) within a country, and these relative differences do not (necessarily) change as total production rises. Structural unemployment: Unemployment arising from changes in the “productive composition” of the US economy. Over time, some goods will become more or less popular, we will become more or less efficient at producing them relative to other countries, etc. As some markets are destroyed and others created, some people will be unemployed. This is “healthy” (or not necessarily “unhealthy”) and part of natural unemployment. Underemployment: an individual holds a job that does not utilize all his/her human capital. This represents unused resources in the economy, but is not technically unemployment (since they have a job and are in the LF) Unwanted inventories: A buildup of production, when firms expected HHs to consume more than actually occurred: Ia>Ii. Happens when Y>Y*, and causes Y to fall as firms do not need as many workers put into production in the next period.
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