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Answer Key to the Midterm Exam, Macroeconomics (103) with by pharmphresh31


									              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

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
curves. If the price is
above the equilibrium
then there will be
excess supply (AB).                 P2
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
produced increases every year, increasing        (for
example, from 200 to 220 in the graph, in one
year), all else equal. This is the cause of long run

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

Question 9
The accelerator is the change in investment generated by a change in national income,
(or,      ). Some initial stimulus increases national income, and this causes the multiplier to
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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