PRINCIPLES OF MACROECONOMICS ASSIGNMENT

(UMS Class:95935 / CMS Class:40455)

Mehreen Ahmed 27852

Haniya Aamir 27841
Mitra Faisal 27920
Mohammad Talha Chohan 28437

Chapter 2 - Questions for Review

Q1. List the two things that GDP measures. How can GDP measure two things at once?

The Gross Domestic Product measures the total income of everyone in the economy as well as
the total expenditure on an economy’s output of goods and services. The two things are
measured at once as income equals expenditure in the economy. Each transaction has a buyer
and seller, so any amount spent represents an amount that another person earns.

Q2. What does the consumer price index measure?

The Consumer Price Index measures the overall level of prices in the economy by comparing
the prices of a typical consumer’s fixed basket of goods and services over time. The price index
is an indicator of inflation in the economy.

Q3. List the three categories used by the Bureau of Labor Statistics to classify everyone in the
economy. How does the Bureau compute the unemployment rate?

The Bureau of Labor Statistics classifies everyone into three different categories; employed,
those who are working and have a job position, unemployed, those without a job but actively
searching for one, and as not part of the workforce, those who are not employed and are not
seeking a job. The labor force is thus made up of the sum of the amount of employed and
unemployed people. To calculate the employment rate, a formula is used. As it is a percentage
of the labor force not employed , the number of unemployed people is divided by the total labor
force and then multiplied by 100.
Unemployment Rate= Number of unemployed individuals / Labor force * 100

Q4. Describe the two ways the Bureau of Labor Statistics measures total employment.

The Bureau of Labor Statistics measures total employment in two ways, the Household Survey
and the Establishment Survey.
The household survey makes use of the Current Population survey of about 60,000 households.
This data is used to categorize people according to their status of employment. This tells us the
amount of people employed and unemployed. However, the establishment survey conducts a
survey on about 160,000 business establishments with over 40 million workers about the
workers on each business’ payroll. The numbers on both these surveys are not identical as both
surveys measure different things. For example, self-employed people are not counted in the
establishment survey whereas the Household survey may count people who are employed at
two jobs as one.
Chapter 2 Problems and Applications

Q#1: Look at any of the latest information you had. What new economic statistics have been
released? How do you interpret these statistics?

Here are a couple of examples of recent economic statistics and interpretations based on
publicly available information as of February 27, 2024:

U.S. Gross Domestic Product (GDP): The Bureau of Economic Analysis (BEA) reported that the
U.S. economy grew at an annual rate of 3.3% in the fourth quarter of 2023, following a growth
rate of 4.9% in the third quarter. This indicates that the pace of economic growth has slowed
down, but the economy is still expanding.

U.S. Trade Deficit: The BEA also reported that the U.S. trade deficit decreased from $951.2
billion in 2022 to $773.4 billion in 2023. This is a positive development, suggesting that the gap
between U.S. exports and imports is narrowing.

Q#2: A farmer grows a bushel of wheat and sells it to a miller for $1.00. The miller turns the
wheat into flour and then sells the flour to a baker for $3.00. The baker uses the flour to make
bread and sells the bread to an engineer for $6.00. The engineer eats the bread. What is the
value added by each person? What is GDP

Value Added:

Farmer: $1.00 (selling price of wheat)

Miller: $3.00 (selling price of flour) - $1.00 (cost of wheat) = $2.00

Baker: $6.00 (selling price of bread) - $3.00 (cost of flour) = $3.00

Engineer: $0.00 (consumes the bread and doesn't add any value through production or sales)

GDP (Gross Domestic Product):

GDP represents the total market value of all final goods and services produced in a country
during a specific period. In this simplified example, we can consider it the total value added
across all stages.
Therefore, GDP = $1.00 (farmer) + $2.00 (miller) + $3.00 (baker) = $6.00

Q#3: Suppose a woman marries her butler. After they are married, her husband continues to
wait on her as before, and she continues to support him as before (but as a husband rather than
as an employee). How does the marriage affect GDP? How should it affect GDP?

In this specific scenario, the marriage itself wouldn't directly affect GDP. Here's why:

No Change in Production or Market Transactions:

The marriage doesn't change the underlying economic activity. The woman still provides
financial support, and the man still performs the same butler duties. No new goods or services
are being produced or exchanged in the market, which is what primarily drives GDP.

Potential Indirect Impacts:

However, there could be some indirect impacts on GDP, depending on the specific
circumstances:

Change in Spending Patterns: If the couple chooses to combine their finances and adjust their
spending habits, it could slightly alter the demand for certain goods and services, impacting
GDP indirectly.

Taxation Changes: Depending on the tax laws, the marriage could lead to changes in their
combined tax filing status, potentially affecting government revenue (which is a component of
GDP). These indirect effects might be minimal and difficult to isolate in this specific example.

How Should Marriage Affect GDP?

There isn't a single definitive answer to how marriage should affect GDP. It's primarily a social
construct, not an economic activity in itself. However, some argue that: Marriage could indirectly
contribute to GDP by promoting social stability, fostering child-rearing, and potentially leading to
increased economic productivity.
Others argue that focusing solely on market transactions for GDP calculation might
underestimate the value of non-market activities like caring for family members, which marriage
can support.
Q#4: Place each of the following transactions in one of the four components of expenditure:
consumption, investment, government purchases, net exports. a. Boeing sells an airplane to the
Air Force. b. Boeing sells an airplane to American Airlines. c. Boeing sells an airplane to Air
France. d. Boeing sells an airplane to Amelia Earhart. e. Boeing builds an airplane to be sold
next year

a. Boeing sells an airplane to the Air Force: Government purchases (The Air Force is a
government agency, and their purchase is considered government spending.)

b. Boeing sells an airplane to American Airlines: Investment (American Airlines, a private

company, is purchasing the airplane to use for generating future income through passenger
transportation.)

c. Boeing sells an airplane to Air France: Net exports (Air France is a foreign company, and this
transaction represents an export of goods from the US.)

d. Boeing sells an airplane to Amelia Earhart: Consumption (Amelia Earhart is likely purchasing
the plane for personal use, not for generating income.)

e. Boeing builds an airplane to be sold next year: Investment (Boeing is investing in its
production capacity by building the airplane in anticipation of future sales. This increases the
company's stock of capital goods.)

Q#5: Find data on GDP and its components, and compute the percentage of GDP for the
following components for 1950, 1980, and the most recent year available to you. a. Personal
consumption expenditures b. Gross private domestic investment c. Government purchases d.
Net exports e. National defense purchases f. State and local purchases g. Imports Do you see
any stable relationships in the data? Do you see any trends? (Hint: A good place to look for data
is the statistical appendices of the Economic Report of the President, which is written each year
by the Council of Economic Advisers.

Here are some observations about the data:

Stable Relationships:

Personal consumption expenditures: This component has remained the largest share of GDP
throughout the years, ranging from 62.7% to 68.2%. This suggests that consumer spending has
consistently been a major driver of the US economy.
Net exports: Net exports have consistently been a negative value, indicating that the US has
consistently imported more goods and services than it has exported.

Trends:

Personal consumption expenditures: The share of GDP has shown a slight upward trend over
time, potentially indicating a growing emphasis on consumer spending in the economy.

Gross private domestic investment: The share of GDP has remained relatively stable, with a
slight increase in 2022.

Government purchases: The share of GDP has decreased slightly over time, from 22.1% in
1950 to 17.5% in 2022. This could be due to various factors, such as changes in government
priorities or spending policies.

Imports: The share of GDP has significantly increased over time, from 4.4% in 1950 to 15.5% in
2022. This reflects the growing importance of international trade and the US's reliance on
imported goods and services.

Q#6: Consider an economy that produces and consumes bread and automobiles. In the
following table are data for two different years.

Good Quantity Price

Automobiles (2000): 100 $50,000

Automobiles (2010): 120 $60,000

Bread (2000): 500,000 $10

Bread (2010): 400,000 $20

a. Using the year 2000 as the base year, compute the following statistics for each year: nominal
GDP, real GDP, the implicit price deflator for GDP, and a fixed-weight price index such as the
CPI.
b. How much have prices risen between 2000 and 2010? Compare the answers given by the
Laspeyres and Paasche price indexes. Explain the difference.

c. Suppose you are a senator writing a bill to index Social Security and federal pensions. That
is, your bill will adjust these benefits to offset changes in the cost of living. Will you use the GDP
deflator or the CPI? Why?

a. Using the year 2000 as the base year:

1. Nominal GDP:

2000: 100 * $50,000 + 500,000 * $10 = $10,000,000

2010: 120 * $60,000 + 400,000 * $20 = $14,400,000

2. Real GDP (using 2000 prices):

2000: 100 * $50,000 + 500,000 * $10 = $10,000,000

2010: 120 * $50,000 + 400,000 * $10 = $9,600,000 (calculated using year 2000 prices for both
years)

3. Implicit Price Deflator for GDP:

2000: (Nominal GDP / Real GDP) * 100 = ($10,000,000 / $10,000,000) * 100 = 100

2010: ($14,400,000 / $9,600,000) * 100 = 150 (This indicates a 50% increase in the overall price
level between 2000 and 2010)

4. Laspeyres Price Index (fixed basket of 2000 goods):

2000: (2010 quantity * 2000 price) / (2000 quantity * 2000 price) * 100 = (100 * $50,000 +
500,000 * $10) / (100 * $50,000 + 500,000 * $10) * 100 = 100

2010: (120 * $50,000 + 400,000 * $10) / (100 * $50,000 + 500,000 * $10) * 100 = 112

5. Paasche Price Index (fixed basket of 2010 goods):

2000: (100 * $60,000 + 400,000 * $20) / (100 * $50,000 + 500,000 * $10) * 100 = 124

2010: (120 * $60,000 + 400,000 * $20) / (120 * $60,000 + 400,000 * $20) * 100 = 100

b. Price increase between 2000 and 2010:

Implicit Price Deflator: 50% increase

Laspeyres Price Index: 12% increase

Paasche Price Index: 24% increase

b. Explanation of the difference:

The Laspeyres Price Index gives more weight to goods whose prices have not increased as
much (bread in this case), whereas the Paasche Price Index puts more weight on goods whose
prices have increased (automobiles in this case). This is because they use different base year
quantities to calculate the price changes. As a result, the Laspeyres index underestimates the
true inflation rate, while the Paasche index can overestimate it.

c. Choosing an index for Social Security and pensions:

As a senator, you would likely choose the Consumer Price Index (CPI) to index Social Security
and federal pensions. This is because the CPI:

Measures the change in the price of a fixed basket of goods and services that are typically
purchased by consumers, which better reflects the actual living costs of the beneficiaries.

Takes into account substitution effects, meaning consumers may switch to cheaper alternatives
if prices of certain goods rise significantly.

Is widely used and publicly available

Q7. Abby consumes only apples. In year 1, red apples cost $1 each, green apples cost $2 each,
and Abby buys 10 red apples. In year 2, red apples cost $2, green apples cost $1, and Abby
buys 10 green apples.

a. Compute a consumer price index for apples for each year. Assume that year 1 is the base
year in which the consumer basket is fixed. How does your index change from year 1 to year 2?

a.CPI= cost of basket / base year cost * 100

Basket :
year 1: 10 red apples
year 2: 10 green apples
 Year Price of Green Price of Red Cost of basket CPI (base year
Apple Apple 1)

1 2 1 10*1= 10 10/10*100= 100

2 1 2 10*1= 10 10/10*100= 100

There is no change in CPI from year 1 to year 2.

b. Compute Abby’s nominal spending on apples in each year. How does it change from year 1
to year 2?

b.Nominal spending for year 1= 10 * $1= $10

Nominal spending for year 2 = 10 * $1= $10
There is no change in nominal spending from year 1 to year 2.

c. Using year 1 as the base year, compute Abby’s real spending on apples in each year. How
does it change from year 1 to year 2?

Year Price of Price of Red Quantity of Quantity of Real GDP

Green Apple Apple Green Apples Red Apples (base yr 1)

1 2 1 0 10 10*1= 10

2 1 2 10 0 10*2= 20

The real GDP increases by $10 from year 1 to year 2.

d. Defining the implicit price deflator as nominal spending divided by real spending, compute the
deflator for each year. How does the deflator change from year 1 to year 2?

d.Year 1: Nominal Spending / Real spending = 10 / 10 = 1 * 100 = 100

Year 2: 10 / 20 = 0.5 * 100 = 50
Deflator decreases from 100 to 50, indicating that the average prices have decreased by 50%.

e. Suppose that Abby is equally happy eating red or green apples. How much has the true cost
of living increased for Abby? Compare this answer to your answers to parts (a) and (d). What
does this example tell you about Laspeyres and Paasche price indexes?

e.If the color of the apple does not matter for Abby, nothing has changed in both years since as
it still costs $10 for 10 apples. However, it is observed that the cost of living has decreased as
shown by gdp deflator whereas CPI states them to be the same, despite the fact that the cost of
one type of apple has risen and the price of another type of apple has fallen. CPI only takes into
account one type, causing inaccuracies. This implies that the Index such as Laspyers, that uses
the costs of base year, overestimates living cost while Paasche underestimates it.

Q8. Consider how each of the following events is likely to affect real GDP. Do you think the
change in real GDP reflects a similar change in economic well-being?

a. A hurricane in Florida forces Disney World to shut down for a month.

a. Real GDP falls as Disney World stops making revenue.This shut down affects economic
well-being adversely as the income of the company and shareholders causes the income of the
workers to fall.

b. The discovery of a new, easy-to-grow strain of wheat increases farm harvests.

b. Real GDP increases as this discovery causes farm harvests to increase, adding to the total
output of the economy. The economic wellbeing of people also rises as the increase in output
causes a decrease in the price of wheat, allowing people to spend less.

c. Increased hostility between unions and management sparks a rash of strikes.

c.A decline in real GDP is observed as the strikes cause production to slow down, causing a
decline in output of goods and services. This can negatively affect the economic wellbeing as
the income of the workers that are protesting may be stopped.

d. Firms throughout the economy experience falling demand, causing them to lay off workers.
d. Real GDP will decrease as a lower amount of workers will cause a decrease in the amount of
production of goods and services. The economic wellbeing is also negatively affected due to
workers being laid off, who will then have no income, causing them to have less money to spend
on goods and services for consumption.

e. Congress passes new environmental laws that prohibit firms from using production methods
that emit large quantities of pollution.
e. Real GDP is most likely to decrease as there is an increase in the average cost of production
causing the productivity of the firm to fall. The wellbeing of people, however, will rise as the laws
lead to a reduction in the level of pollution.
f. More high-school students drop out of school to take jobs mowing lawns.
f. The real GDP will rise as mowing lawns will generate income in the economy, however
economic wellbeing declines as dropping out means that the students lose the possibility of
getting higher paying jobs after graduating.

g. Fathers around the country reduce their workweeks to spend more time with their children.
g. The real GDP will decrease as fathers will spend less time working, causing a decrease in
productivity. Economic well being will rise as families will be more satisfied with fathers spending
more time with their children.
Q9. In a speech that Senator Robert Kennedy gave when he was running for president in 1968,
he said the following about GDP:

[It] does not allow for the health of our children, the quality of their education, or the joy of their
play. It does not include the beauty of our poetry or the strength of our marriages, the
intelligence of our public debate or the integrity of our public officials. It measures neither our
courage, nor our wisdom, nor our devotion to our country. It measures everything, in short,
except that which makes life worthwhile, and it can tell us everything about America except why
we are proud that we are Americans.
Was Robert Kennedy right? If so, why do we care about GDP?

Ans. GDP is an imperfect measure of growth because it fails to take into account the hidden
economies or the development and well-being in a country. There are underground economies
such as the drugs market that fail to add to the gdp, there are the household activities such as
cleaning that are not recorded or there is the rent earned that is not recorded. Other than this,
GDP fails to record development such as the literacy rate in a country or the life expectancy or
poverty index which are crucial to understand if the economy is developing. GDP in itself is
useful in measuring growth in the case of goods and services although with limitations, but GDP
along with the development measures can make an overall good measure of growth and
development within an economy.
Chapter 3 - Questions for Review

Q1: What determines the amount of output an economy produces

An economy’s output is determined by the factors of production it hires and the production
technology. Factors of production are the inputs which produce goods and services and the two
most important ones are Labour And Capital. We use the production function to see how a
change in either of these factors of production causes a change in the output.
Y=F(K,L) is the production function that says that output is a function of capital and labour. This
function can help us understand that If an economy has a constant returns to scale it will mean
that by doubling the capital and labour, the output to can be doubled.

The production technology in this case helps in turning capital and labour into output quickly
and determines how much output can be produced at any given level of input. This is why
innovation and advancement of technology is important in increasing output.
If an economy has a constant returns to scale it will mean that by doubling the capital and
labour, the output to can be doubled.

Q2. Explain how a competitive, profit-maximizing firm decides how much of each factor of
production to demand.

Once a firm acknowledges the need to hire factors of production to produce goods and services,
the need to know how many to hire so they can profit maximize. These firms look at the
marginal of each cost and revenue to decide whether they earn profits or go into loss. To decide
how much labour to hire for example, the firms look at the Marginal Product of Labour(MPL)
which is the additional unit of output that is produced when each new labour is hired. The
multiply MPL with the Price(P) of every unit of output to calculate the additional revenue.
MPLxP. From this the Wage(W) which is the additional cost of hiring labour, is subtracted to
calculate the additional profit that is earned by hiring labour.
This gives us the equation Profit= (MPLxP)-W
This means that a company will hire until profit is equal to 0 and therefore gives the equation
MPL=W/P which means a company hires till the additional output is equal to the addtional cost
of hiring.
A profit maximizing firm hires till the additional output is equal to the real wage. This theory can
also be applied to the case of hiring capital as a firm will hire until the output produced from
additional capital will be equal to the additional rent of hiring capital.
Q5. What determines consumption and investment?

Consumption is determined by the amount of disposable income an individual earns.

Disposable income the income that received after income tax reductions. It is believed that if an
individual has a higher disposable income they will be likely to spend more and therefore the
consumption function is
C=C(Y-T)
This means that consumption is a function of disposable income(Y-T). Marginal Propensity to
Consume(MPC) is the additional consumption done for each dollar earned. Whatever is not
spent is is saved therefore MPC+MPS=1

Investment is determined by the real interest rate(r). The investment decision is made looking at
the return on investment. If the interest rate is higher than the return on investment, then a
business would choose to keep their money in a bank rather than investing in the business
however if the return on investment is higher than the interest rate the company would choose
borrow and invest. This reaches the investment function:
I=I(r)

Q6.Explain the difference between government purchases and transfer payments. Give two
examples of each.

Government Purchases and Transfer Payments are part of the Government spending.
Government Purchases are when the Government spends on goods and services. These
transactions are made in exchange of the economy’s output. Examples include the buying of
weapons or building roads. Transfer payment on the other hand are those against which no
output is generated. These include welfare payment for example unemployment benefits or
social security payments for the elderly.

Q7. What makes the demand for the economy’s output of goods and services equal the supply?

The demand for goods and services comes from consumption, investment and government
purchases. Consumption depends on disposable income, investment depends on real interest
rate and government purchases and taxes are set by the fiscal policy makers who either aim for
a surplus or deficit in the budget. They make up Y=C+I+G
The factors of production and production function are the supply of goods and service with the
production function Y- = F(K – , L – ).
The demand and supply must reach an equilibrium now where the output is fixed due to fixed
capital and labour
Y – = C(Y – − T – ) + I(r) + G – .
All elements are fixed except for the interest rate since it plays a role in adjusting the equation
and making sure the equilibrium is always reached.
 Chapter 3 problems and applications

1) Use the neoclassical theory of distribution to predict the impact on the real wage and the
real rental price of capital of each of the following events:

a. wave of immigration increases the labor force.

An increase in the labor force means the labor supply will increase and firms will
have a larger pool of workers to hire from. Marginal product of labor is the amount
increased of a unit when there is an increase of an additional unit of labor. According
to the theory of diminishing marginal product, marginal product of labor decreases as
the amount of labor increases. Firms may hire more than they need for tasks that
require a few workers, hence, confusion occurs which slows down the production
process and MPL falls. As a result, the demand for labor remains relatively constant
while the supply increases, leading to a decrease in the real wage.

b. An earthquake destroys some of the capital stock.

This means there is a reduction in the capital stock hence a leftward shift in the
supply curve. A demand for capital will increase but met with scarce resources.
Marginal product of capital is the increase in output produced when firms employ an
additional unit of capital. The theory of diminishing marginal product applies here as
well, too many units of capital to execute one task may hinder the production
process. As a result, the real rental price of capital would rise as firms compete for
the limited available capital, leading to higher returns for capital owners.

c. A technological advance improves the production function

An increase in technological advancement increases MPK as more advanced

equipment will produce more capital goods. Firm owners can keep a higher profit
margin and get a greater return on investment.therefore the rent rental price will rise.
There will alongside be an increase in MPL as the demand for skilled and tech-savvy
employees will rise. This means that more output will be produced when there is one
extra labor employed. Consequently leading to a rise in real wages.

2) If a 10-percent increase in both capital and labor causes output to increase by less than
10 percent, the production function is said to exhibit decreasing returns to scale. If it causes
output to increase by more than 10 percent, the production function is said to exhibit increasing
returns to scale. Why might a production function exhibit decreasing or increasing returns to
scale?
When a firm varies all its factors of production, changing the scale of production, it may face a
more than proportional return in terms of output and leading to long run average costs, known
as increasing returns to scale. Less than proportionate returns in terms of output lead to
average costs rising which defines decreasing returns to scale.

A production function may show an increase in output by 10 percent due to economies of scale.
Here the firm enjoys a decrease in its average costs as the output increases resulted by sharing
of resurces between firms in the same industry as the supplier may be in the same vicinity.
There could be an improvement in infrastructure and facilities which makes the mobility of
goods and services easier. Moreover, an advancement in techonology can lead to an increasing
returns to scale. For example, in industries like software development or online platforms, larger
user bases can lead to more valuable networks, resulting in increasing returns.

A production function may show a decrease in output by 10 percent essentially due to

diseconomies of scale. A rapid increase in the size of industry could lead to managerial
problems where managers have difficult y delegating tasks and instilling employee morale which
leads to them being unproductive. Specialization and division of tasks becomes more inefficient.
Disproportionate demands of raw materials may also increase the cost of production.

4) Figure 3-5 shows that in U.S. data, labor’s share of total income is approximately a
constant over time. Table 3-1 shows that the trend in the real wage closely tracks the trend in
labor productivity. How are these facts related? Could the first fact be true without the second
also being true?

We can assume that the share of total income is constant over time then labor productivity has
also remained constant over time, however, inaccuracies can be made because if total income
does not account for inflation. An increase in revenue from additional units of labor depends on
the marginal product of labor and price output (Px MPL)-W. figure 3-5 shows that firms
continued to employ a specific number of employees which would not exceed total wages.
Hence, the total income is constant.

5) According to the neoclassical theory of distribution, the real wage earned by any worker
equals that worker’s marginal productivity. Let’s use this insight to examine the incomes of two
groups of workers: farmers and barbers.

a) Over the past century, the productivity of farmers has risen substantially
because of technological progress. According to the neoclassical theory, what should
have happened to their real wage?

The theory states that demand for the factor of production depends on its marginal
productivity. Since the farmer invested in such technology that produced more crops,
this lead to an increase in their productivity and a rise in MPL. Therefore, leading to a
rise in their real wage.

b) In what units is the real wage discussed in part (a) measured?

In units of crops produced

c) Over the same period, the productivity of barbers has remained constant.
What should have happened to their real wage?

The relation between labor productivity and their real wage is directly proportionate.
Therefore, the real wage will also remain constant, there will be no increase or
decrease unless their productivity changes.

d) In what units is the real wage in part (c) measured?

In units of haircuts done.

e) Suppose workers can move freely between being farmers and being barbers.
What does this mobility imply for the wages of farmers and barbers?

This could imply that the difference in wages aren’t significant and either barbers or
farmers can choose their profession due to other non-wage related reasons.

f) What do your previous answers imply for the price of haircuts relative to the
price of food?

Since food is a basic need and most agricultural goods are staple foods, they have
relatively low prices. However, haircuts are tailored to personal needs and can be
customized and so may be priced relatively higher. Demand for both are high and in
need.

g) Who benefits from technological progress in farming—farmers or barbers?

Farmers because the harvesting and sowing season becomes quicker and efficient.
Less manual labor would be needed to execute day to day tasks.