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									AEB 2014: Economic Issues, Food and You                   Answers to Problem Set # 4
Professor: Carlos Pitta                                                   Page  1

Here are the suggested answers to your problem set # 4. Of course, your working
and mine would differ, but as long as you recognized in your answers the basic
economic principles involved, you answer is as valid as mine.
Carlos Pitta

Chapter 23/Measuring a Nation’s Income

1.     a.     Consumption increases because a refrigerator is a good purchased by
              a household.
       b.     Investment increases because a house is an investment good.
       c.     Consumption increases because a car is a good purchased by a
              household, but investment decreases because the car in Ford’s
              inventory had been counted as an investment good until it was sold.
       d.     Consumption increases because pizza is a good purchased by a
       e.     Government purchases increase because the government spent money
              to provide a good to the public.
       f.     Consumption increases because the bottle is a good purchased by a
              household, but net exports decrease because the bottle was imported.
       g.     Investment increases because new structures and equipment were

3.     If GDP included goods that are resold, it would be counting   output of that
       particular year, plus sales of goods produced in a previous   year. It would
       double-count goods that were sold more than once and would    count goods in
       GDP for several years if they were produced in one year        and resold in

                   Year           Nominal      GDP     Deflator
                                  GDP          (base     year:
                                  (billions)   1996)
                   2000           $9,873       118
                   1999           $9,269       113

       a.     The growth rate of nominal GDP is ($9,873 − $9,269)/$9,269  100%
              = 6.5%.

       b.     The growth rate of the deflator is (118 − 113)/113  100% = 4.4%.

       c.     Real GDP in 1999 (in 1996 dollars) is $9,269/(113/100) = $8,203.

       d.     Real GDP in 2000 (in 1996 dollars) is $9,873/(118/100) = $8,367.

       e.     The growth rate of real GDP is ($8,367 − $8,203)/$8,203  100% =

       f.     The growth rate of nominal GDP is higher than the growth rate of real
              GDP because of inflation.

7. Many answers possible.
AEB 2014: Economic Issues, Food and You                    Answers to Problem Set # 4
Professor: Carlos Pitta                                                    Page  2

9.     a.     GDP is the market value of the final good sold, $180.

       b.     Value added for the farmer: $100.
              Value added for the miller: $150 – $100 = $50.
              Value added for the baker: $180 – $150 = $30.

       c.     Together, the value added for the three producers is $100 + $50 +
              $30 = $180. This is the value of GDP.

11.    If the government cares about the total income of Americans, it will
       emphasize GNP, because that measure includes the incomes of Americans
       that is earned abroad and excludes the incomes of foreigners living in the
       United States. If the government cares about the total amount of economic
       activity occurring in the United States, it will emphasize GDP, which measures
       the level of production in the country, whether produced by domestic citizens
       or foreigners.

Chapter 24/ Measuring the Cost of Living

1.     a.     Find the price of each good in each year:

                Year          Cauliflower   Broccoli      Carrots
                2006          $2            $1.50         $0.10
                2007          $3            $1.50         $0.20

       b.     If 2006 is the base year, the market basket used to compute the CPI is
              100 heads of cauliflower, 50 bunches of broccoli, and 500 carrots. We
              must now calculate the cost of the market basket in each year:
                     2006: (100 x $2) + (50 x $1.50) + (500 x $.10) = $325
                     2007: (100 x $3) + (50 x $1.50) + (500 x $.20) = $475

                     Then, using 2006 as the base year, we can compute the CPI in
              each year:
                     2006: $325/$325 x 100 = 100
                     2007: $475/$325 x 100 = 146

       c.     We can use the CPI to compute the inflation rate for 2007:
              (146 − 100)/100 x 100% = 46%

3.     a.     The percentage change in the price of tennis balls is (2 – 2)/2 × 100%
              = 0%.
              The percentage change in the price of golf balls is (6 – 4)/4 × 100% =
              The percentage change in the price of Gatorade is (2 – 1)/1 × 100% =

       b.     The cost of the market basket in 2006 is ($2 × 100) + ($4 × 100) +
              ($1 × 200) = $200 + $400 + $200 = $800.
AEB 2014: Economic Issues, Food and You                    Answers to Problem Set # 4
Professor: Carlos Pitta                                                    Page  3

              The cost of the market basket in 2007 is ($2 × 100) + ($6 × 100) +
              ($2 × 200) = $200 + $600 + $400 = $1,200.

              The percentage change in the cost of the market basket from 2006 to
              2007 is (1,200 – 800)/800 × 100% = 50%.

       c.     This would lower my estimation of the inflation rate because the value
              of a bottle of Gatorade is now greater than before. The comparison
              should be made on a per-ounce basis.

       d.     More flavors enhance consumers’ well-being. Thus, this would be
              considered a change in quality and would also lower my estimate of
              the inflation rate.

5.     a. introduction of new goods;

       b. unmeasured quality change;

       c. substitution bias;

       d. unmeasured quality change;

       e. substitution bias

7.     a.     If the elderly consume the same market basket as other people, Social
              Security would provide the elderly with an improvement in their
              standard of living each year because the CPI overstates inflation and
              Social Security payments are tied to the CPI.

       b.     Because the elderly consume more health care than younger people
              do, and because health care costs have risen faster than overall
              inflation, it is possible that the elderly are worse off. To investigate
              this, you would need to put together a market basket for the elderly,
              which would have a higher weight on health care. You would then
              compare the rise in the cost of the "elderly" basket with that of the
              general basket for CPI.

9.     In deciding how much income to save for retirement, workers should consider
       the real interest rate, because they care about their purchasing power in the
       future, not the number of dollars they will have.
AEB 2014: Economic Issues, Food and You                     Answers to Problem Set # 4
Professor: Carlos Pitta                                                     Page  4

Chapter 25/ Production and Growth

1.     The facts that countries import many goods and services yet must produce a
       large quantity of goods and services themselves to enjoy a high standard of
       living are reconciled by noting that there are substantial gains from trade. In
       order to be able to afford to purchase goods from other countries, an
       economy must generate income. By producing many goods and services, then
       trading them for goods and services produced in other countries, a nation
       maximizes its standard of living.

3.     a.     Private consumption spending includes buying food and buying
              clothes; private investment spending includes people buying houses
              and firms buying computers. Many other examples are possible.
              Education can be considered as both consumption and investment.

       b.     Government consumption spending includes paying workers to
              administer government programs; government investment spending
              includes buying military equipment and building roads. Many other
              examples are possible. Government spending on health programs is an
              investment in human capital. This is truer for spending on health
              programs for the young rather than those for the elderly.

5.     a.     When a German firm opens a factory in South Carolina, it represents
              foreign direct investment.

       b.     The investment increases U.S. GDP because it increases production in
              the United States. The effect on U.S. GNP would be smaller because
              the owners would get paid a return on their investment that would be
              part of German GNP rather than U.S. GNP.

7.     Greater educational opportunities for women could lead to faster economic
       growth in the countries of South Asia because increased human capital would
       increase productivity and there would be external effects from greater
       knowledge in the country. Second, increased educational opportunities for
       young women may lower the population growth rate because such
       opportunities raise the opportunity cost of having a child.

9.     a.     Political stability could lead to strong economic growth by making the
              country attractive to investors. The increased investment would raise
              economic growth.

       b.     Strong economic growth could lead to political stability because when
              people have high incomes they tend to be satisfied with the political
              system and are less likely to overthrow or change the government.

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