(ECON2123)[2018](f)quiz~=2ba4g^_82784.pdf downloaded by cykim from http://petergao.net/ustpastpaper/down.php?course=ECON2123&id=5 at 2019-10-15 07:26:48. Academic use within HKUST only.

Econ 2123, Fall 2018, Problem Set 1

Instructor: Prof Wenwen Zhang

SOLUTION

Problem 1
Suppose that an economy shows only the following activities in a specific year:
i. It costs an automobile manufacturing company €10 million to assemble 5,000 cars. The cars
are then sold to stores for €12 million.
ii. The stores pay their workers an annual wage of €1 million and then sell the cars directly to
the consumers for €15 million.
a. Calculate the GDP in this economy using the production-of-final-goods approach.
The value of final goods = €15 million the value of the cars

b. Calculate the GDP using the value-added approach. Show the value added at each stage of
production.
1st Stage: €12 million.
2nd Stage: €15 million − €12 million = €3 million.
GDP: €12 million + €3 million = €15 million.

c. Calculate the GDP using the income approach. Show the costs incurred and profits earned.
Costs: €10 million + €1 million = €11 million.
Profit: (€12 million − €10 million) + (€15 million − €12 million − €1 million) = €2 million +
€2 million = €4 million.
GDP: €11 million + €4 million = €15 million.

Problem 2
An economy produces three goods: cars, computers, and oranges. Quantities and prices per unit for
years 2009 and 2010 are as follows:

2009 2010
Quantity Price ($) Quantity Price ($)
Cars 10 2000 12 3000
Computers 4 1000 6 500
Oranges 1000 1 1000 10

a. What is nominal GDP in 2009 and in 2010? By what percentage does nominal GDP change from
2009 to 2010?
2009 nominal GDP: 10($2,000) + 4($1,000) + 1000($1) = $25,000

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2010 nominal GDP: 12($3,000) + 6($500) + 1000($10) = $49,000

Nominal GDP has increased by (49,000 – 25,000)/ 25,000 x 100% = 96%.

b. Using the prices for 2009 as the set of common prices, what is real GDP in 2009 and in 2010? By
what percentage does real GDP change from 2009 to 2010?
2009 real ($2009) GDP: $25,000
2010 real ($2009) GDP: 12($2,000) + 6($1,000) + 1000($1) = $31,000
Real GDP ($2009) has increased by (31,000-25,000)/25,000 x 100% = 24%.

c. Using the prices for 2010 as the set of common prices, what is real GDP in 2009 and in 2010? By
what percentage does real GDP change from 2009 to 2010? Why are the two rates different from the
answers in (b)? Which one is correct? Explain briefly.
2009 real ($2010) GDP: 10($3,000) + 4($500) + 1,000($10) = $42,000
2010 real ($2010) GDP: $49,000.
Real GDP ($2010) has increased by (49,000 – 42,000)/ 42,000 = 16.67%.
The answers measure real GDP growth in different units. Neither answer is incorrect, just as
measurement in inches is not more or less correct than measurement in centimeters.

d. Use the prices for 2009 as the set of common prices. Compute the GDP deflator for 2009 and for
2010, and compute the rate of inflation from 2009 to 2010.
2009 base year:
Deflator in 2009 = 1; Deflator in 2010 = $49,000/$31,000 = 1.5806
Inflation = (1.5806-1)/1= 58.06%

e. Use the prices for 2010 as the set of common prices. Compute the GDP deflator for 2009 and for
2010, and compute the rate of inflation from 2009 to 2010. Why are the two rates different from the
answer in (d)? Which one is correct? Explain briefly.
2010 base year:
Deflator in 2009 = $25,000/$42,000 = 0.5952; Deflator in 2010 = 1
Inflation = (1 − 0.5952)/ 0.5952= 0.31999 = 68.01%

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Problem 3
The following equations refer to the goods market of an economy in billions of euros:
C = 480 + 0.5YD
I = 110; T = 70; G = 250
a. Solve for the goods market equilibrium.
Goods market equilibrium: Y = Z = C + I + G and YD = Y-T
Y = [480 + (0.5) (Y – 70)] + 110 + 250 = (0.5) Y + 805 = €1610 billion
b. Find equilibrium disposable income (YD).
YD = 1610 – 70 = €1540 billion
c. Find equilibrium consumption (C).
C = 480 + (0.5) (1540) = €1250 billion
d. Calculate the private savings, public savings, and investment spending.
Private Saving S = YD – C = Y - T - C = 1610 – 70 – 1250 = €290 billion
Public Saving (T – G) = (70 – 250) = − €180 billion (Budget Deficit)
Investment I = S + (T – G) = sum of private and public saving
I = 290 – 180 = €110 billion

e. Calculate the multiplier and explain how it affects equilibrium output.

MPC = 0.5
Multiplier = 1/(1 – 0.5) = 2
The multiplier tells us how much equilibrium output will change for a given change in
autonomous spending. As government spending increases by €50 billion, the equilibrium
output will rise by €50 billion x 2, or €100 billion. When government spending increases
by €50 billion, total demand also increases. As a result, production also rises to maintain
equilibrium. When output increases, disposable income increases, raising consumption.

f. Suppose that the government decides to increase its spending from €250 billion to €300 billion.
Find the equilibrium output, consumption, and disposable income. Why would the government decide
to expand fiscal spending?
When government spending increases by €50 billion, autonomous spending increases by €50
billion. Since the multiplier is 2, the equilibrium output will increase by €100 billion.
Therefore, disposable income will rise by €50 billion and consumption will rise by €50 billion
since MPC is 0.5. The government would decide to increase fiscal spending in order to
increase equilibrium demand and equilibrium output as a means of boosting economic
growth.

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Problem 4
Automatic stabilizers
In this chapter we have assumed that the fiscal policy variables G and T are independent of the level
of income. In the real world, however, this is not the case. Taxes typically depend on the level of
income and so tend to be higher when income is higher. In this problem, we examine how this
automatic response of taxes can help reduce the impact of changes in autonomous spending on output.
Consider the following behavioral equations:
C = c0 + c1YD
T = t 0 + t1 Y
YD = Y - T
G and I are both constant. Assume that t1 is between 0 and 1.
a. Solve for equilibrium output.
Y = c0 + c1YD + I + G => Y = [1/(1 − c1 + c1t1)][c0 − c1t0 + I + G]

b. What is the multiplier? Does the economy respond more to changes in autonomous spending when
t1 is 0 or when t1 is positive? Explain.
The multiplier = 1/(1 − c1 + c1t1) < 1/(1 − c1), so the economy responds less to changes in
autonomous spending when t1 is positive. After a positive change in autonomous spending,
the increase in total taxes (because of the increase in income) tends to lessen the increase in
output. After a negative change in autonomous spending, the fall in total taxes tends to lessen
the decrease in output.

c. Why is fiscal policy in this case called an automatic stabilizer?

Because of the automatic effect of taxes on the economy, the economy responds less to
changes in autonomous spending than in the case where taxes are independent of income.
Since output tends to vary less (to be more stable), fiscal policy is called an automatic
stabilizer.

Balanced budget versus automatic stabilizers

It is often argued that a balanced budget amendment would actually be destabilizing.
d. Solve for taxes in equilibrium.
T = t0 + t1Y = t0 + t1[1/(1 − c1 + c1t1)][c0 − c1t0 + I + G]

Suppose that the government starts with a balanced budget and that there is a drop in c0.
e. What happens to Y? What happens to taxes?
Both Y and T decrease.

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(ECON2123)[2018](f)quiz~=2ba4g^_82784.pdf downloaded by cykim from http://petergao.net/ustpastpaper/down.php?course=ECON2123&id=5 at 2019-10-15 07:26:48. Academic use within HKUST only.

f. Suppose that the government cuts spending in order to keep the budget balanced. What will be the
effect on Y? Does the cut in spending required to balance the budget counteract or reinforce the effect
of the drop in c0 on output?
If G is cut, Y decreases even more. A balanced budget requirement amplifies the effect of the
decline in c0. Therefore, such a requirement is destabilizing.

Problem 5
Suppose that the household nominal income for an economy is £50,000 billion and the demand for
money in this economy is given by
Md = £Y(0.2 - 0.8i)
a. What is the demand for money when the interest rate is 1% and 5%?
i = 0.01: money demand = (50,000)(0.2 - 0.8*0.01) = £9,600
i = 0.05: money demand = (50,000)(0.2 - 0.8*0.05) = £8,000

b. What will be the impact on the demand for money if the nominal income declines by 20%?
New nominal income = 50,000(1-20%) = £40,000
When i = 0.01, Md = £7,680. The demand for money falls by 20%.
When i = 0.05, Md = £6,400. The demand for money falls by 20%.

c. What is the relationship between the demand for money and income? Money demand and the
interest rate?
Independent of the interest rate, an increase (decrease) in income leads to the same percentage
increase (decrease) in money demand. This effect is independent of the interest rate.
As the interest rate rises, the demand for money declines. This is because households’ demand
for bonds would increase when financial instruments such as bonds pay lower interest, hence
making demand for money more attractive.

d. Explain what the central bank should do to interest rates if it needs to increase the demand for
money.
The central bank should lower the interest rate to increase the demand for money.

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(ECON2123)[2018](f)quiz~=2ba4g^_82784.pdf downloaded by cykim from http://petergao.net/ustpastpaper/down.php?course=ECON2123&id=5 at 2019-10-15 07:26:48. Academic use within HKUST only.

Problem 6
Suppose that a person’s wealth is $50,000 and that her yearly income is $60,000. Also suppose that
her money demand function is given by
Md = $Y(0.35 – i)
a. Derive the demand for bonds. Suppose the interest rate increases by 10 percentage points. What is
the effect on her demand for bonds?
Demand for bond = 50,000 – 60,000 (0.35 – i)
= 50,000 – 21,000 + 60,000i
= 29,000 + 60,000i
If the interest rate increases by 10 percentage points, bond demand increases by $6,000.

b. What are the effects of an increase in wealth on her demand for money and her demand for bonds?
Explain in words.
An increase in wealth increases bond demand, but has no effect on money demand, which
depends on income (a proxy for transactions demand).

c. What are the effects of an increase in income on her demand for money and her demand for bonds?
Explain in words.
An increase in income increases money demand, but decreases bond demand, since we
implicitly hold wealth constant.