Questions: GDP definition, components, measurement

Question 1

GDP definition:

A. What is the formal definition of GDP?

B. What is meant by market value and why do we use market value to measure
GDP?

Question 2

• What is an intermediate good and why are these goods excluded from GDP?
Explain how under different circumstances flour might be considered either a
final good or an intermediate good.

Question 3

Which of the following transactions should be included in GDP for 2015:

A) Glass currently produced and used by GM as an automobile side-window.

B) Glass currently produced and sold directly to households.

C) The purchase of newly produced imported cars.

D) The sales commission paid to the domestic seller of an imported car.

E) Salaries paid to US Naval officers.

F) The purchase of a 15th-century painting (exclusive of sales commission).

G) Newly produced, but unsold, wheat.

H) Purchase of Apple stock (exclusive of brokerage fees).

Question 4
• What are some of the shortcomings of GDP (as currently measured) as a
measure of total production.

Question 5

• Suppose a new environmental law forces some steel firms to close their plants
and therefore causes a reduction in steel production. Explain how this might
simultaneously lead to a drop in GDP as currently measured and a rise in the
actual level of total production (which includes the quantity clean air as good).

Question 6

Explain how a how sharp increase in income tax rates might cause a drop in
measured GDP while the actual level of production also falls, but by a smaller
amount.

Question 7

What is the economic definition of investment? What are the different kinds of
investment?

Question 8

Why are transfer payments excluded from government expenditures?

Question 9

Explain why total production is necessarily equal to total expenditure.

Question 10

Suppose per-capita GDP is currently $1,000. If it grows at an average annual rate

of 1%, then what will per-capita GDP be at the end of 100 years? What if the
average annual growth rate was 2%?
Answers: GDP definition, components, measurement
Answer 1

(A) GDP is the market value of all newly produced final goods and services within
a nation during some period of time.

(B) Market value means that we measure goods and services at their market
prices, so GDP = p1q1 + p2q2 + p3q3 ...... pnqn where pi = market price of
good i and qi is the quantity of good i produced. This allows us to put all goods
and services into a common unit (the dollar unit in the case of the US), but
means we have to make sure we do not confuse price changes for quantity
changes when measuring GDP.

Answer 2

• Intermediate good is a good used up in the production of another good during

the same period that it itself was produced. We exclude these goods to avoid
double counting. If flour, for example, is currently produced, but not sold (i.e.,
not used up in the production of bread), then it is considered a final good. If it is
sold in used to make bread, then it is an intermediate good and therefore not
counted in GDP.

Answer 3

A) Not counted. Intermediate good since the value of the glass is already included
in the value of the car.

B) Counted. It is newly produced and it is a final good.

C) Not counted. Was not domestically produced.

D) Counted. This is a currently produced service.

E) Counted. Newly produced service.

F) Not counted. Not newly produced.

G) Counted. Newly produced and final good.

H) Not counted. Financial transactions (exclusive of brokerage fees) are not
counted in GDP.

Answer 4

A) GDP excludes household production because it is difficult to measure this non-

market production. But since household production represents current
production we would like to count this in GDP.

B) Illegal production. Again, it is difficult to measure these types of non-market

transactions. Some current production may not be reported (to avoid paying
taxes) and some current production may be illegal (bootleg DVDs).

C) Environmental goods such as clean air or clean water are difficult to measure
because there is no formal market transaction. People value these goods just as
they value cars, food, shelter, etc., so we would ideally like to include this in
GDP.

D) Government production is measured at cost of production instead of at market

value since many government provided goods and services are not formally
sold at some price p. There is no guarantee that the value of some govt. goods
(measure by p*q) will exceed their cost.

E) Quality changes, new products.

Answer 5

If the value of the increased clean air exceeds the value of the lost steel, then total
production increased. But since steel production is included in GDP measures, but
clean air is not (because it is difficult to measure) , this would show up as a
reduction in measured GDP.

Answer 6

If this causes a drop in reported production (income) then measured GDP would
fall. The actual drop is much smaller since many people are still producing goods
and services, they are just not reporting it.
Answer 7

Investment = fixed investment (purchase of newly produced capital goods) +

inventory investment (changes in the level of inventories). Notice that this
definition of investment does NOT include financial transactions.

Answer 8

Transfer payments do not represent payments to individuals in exchange for goods

and services currently produced.

Answer 9

We assume that goods not sold to consumers are "purchased" by the firm from
itself. Thus, if 100 widgets are newly produced with 90 sold to consumers, the
other 10 “unsold” units are said to be purchased by the firm from itself (it is
referred to as inventory investment and shows up in the I component of GDP).

Answer 10
100
For 1% growth: 1000*(1.01) = $2,710

100
For 2% growth: 1000*(1.02) = $7,250.
Questions: Price Level and Inflation Rate

Question 11

What is wrong with the following statement: "Inflation causes a continuous rise in
the price level.”

Question 12

What is the price level and how do we measure it?

Question 13

Use the following information to answer the questions below. The table shows:
year, GDP (in $millions), and Price index normalized to 100.00 at 2009

A) Calculate the annual inflation rate for 2013 and also for 2014.

B) Find real GDP for 2006, 2007, 2008 and 2009. In which year(s) did real GDP
decline from the previous year?

C) Find the annual growth rates of real GDP for 2009 - 2013.
Question 14

A) Using the table below, compare the real price of gasoline in 1994 and 2014.
Can you offer a possible reason for this change? (It does not have to correct,
just see if you can give a good guess as to why it changed this way).

B) Calculate the change in the real price of gasoline in 2009 and 2010. Based on
your answer to question 13b, can you provide a possible explanation for drop
in the price for these two years relative to 2008?
Answers: Price Level and Inflation Rate

Answer 11

Inflation does not cause a continuous rise in the price level because inflation is a
continuous rise in the price level.

Answer 12

The price level is a measure of the average money price of final goods and
services. It is measured by a price index.

Answer 13

A) The inflation was 1.5% in 2013 and 1.4% in 2014.

B) Real GDP is calculated (using 2006 as an example) by: (13,855.90) /

(94.814/100) = $14,613.77)

• Thus, Real GDP is 2006 ($14,613.77M), 2007 ($14,873.69), 2008

($14,830.42), and 2009 ($14,418.70). Real GDP declined in both 2008 and
2009 from the previous year. This period is know as the “Great Recession”.

C) The growth of real GDP is given by:

• = [(real GDP in year N) - (real GDP in year N-1) ] / (real GDP in year N-1). Thus for
2009, real GDP growth = [14,418.70 - 14,830.42] / (14,830.42) = - 2.77%

• 2009: - 2.8%

• 2010: +2.5%

• 2011: +1.6%

• 2012: +2.3%

• 2013: +2.2%
Answer 14

A) Convert the prices to real terms. In 1994: (1.08 / 1.482) = $0.73 (in real terms)
vs. 2014: (3.36 / 2.367) = $1.42 (in real terms). So the price of gas nearly
doubled in real terms. A possible reason is that several large countries (China
and India for example) experienced substantial growth over this period. This
has in turn led to a significant in increase in demand and price for crude oil (an
input for gasoline).

B) The real price of gasoline fell in 2009 and 2010 compared to 2008. There was a
recession during this period, and less demand for gasoline.

• 2008: $1.51

• 2009: $1.10

• 2010: $1.27
Questions: Present Value, Future Value

Question 15

A) A dollar invested in stocks on the average,over all stocks of the NY stock

exchange, yielded more than 10% per year over the interval 1915 to
approximately 1990. If you had purchased $1000 of stock (and received the
average return) then how much would you have had at the end of 10
years?...how much would you have had at the end of 10 years if you deposited
$1,000 into savings account at 5% per year?

B) A painting is purchased from a young, unknown artist for $2,000 today. Twenty
years later it is expected to sell for $14,000. What is the average annual rate of
return on this purchase?

Question 16

A) A firm plans to build a new factory once the funds in a special building account
reaches $100 million. The most the firm can afford to place in the fund each year is
$15.46 million (first deposit is one year from now). There is currently zero dollars
in the fund. At an interest rate of 3%, how long will it take to accumulate the $100
million?

B) How would your answer change if you currently had $5 million in the account?
Just set up the problem, no need to find the exact value for n.

Question 17

A) Suppose you are ten years from retirement. You currently have $50,000 in your
savings account, but desire to have $150,000 in your account when you retire.
What would your annual deposit have to be to end up with a balance of $150,000
when you retire? Assume i = 6%.

B) Suppose your retirement goal is to have enough in your account to be able to

withdraw $30,000 per year for 10 years, once you retire. Answer question (A)
under this new assumption.
Question 18

A) You have the option of $100 today OR $112 dollars received one year later. The
interest rate is 12% (this is the rate at which people can borrow and lend at).
Explain why a person who has a utility function such that this person only cares
about today’s consumption would be indifferent between these projects. Do so by
showing that the options available are exactly the same under either option (budget
line is the same) and writing an equation that shows this, and by showing giving
examples of the pattern of borrowing and lending that leads to this conclusion.

Question 19

A timber company must decide between the following available options: (a) cutting
down its stock of trees today, which could then be sold for $50,000 today, or (b)
letting the trees grow another 5 years, cutting them down then, and selling the
stock for $75,000. Assume that i = 8%. Ignoring other factors, assuming the firm to
maximize the present value of its revenue, it should cut the trees down when?

Question 20

Suppose your parents, having reached the age of 70 with savings of $300,000, plan
to retire on that fund. They want to know the maximum amount they can withdraw
each year over the next 15 years. Assume an interest rate of 6%, and that the
withdrawal is 1 year from today. Find the amount they will be able to withdraw
each year for exactly 15 years.

Question 21

A new machine costs $250,000, but would increase net cash inflow by $22,000 per
year for 20 years. If the prevailing rate of interest equals 8%, is this investment
profitable. Answer this question by calculating the rate of return on the investment
and comparing that return to the prevailing rate of interest.

Question 22

Two printing presses are available for purchase. One costs more to buy but less to
operate:
Printing Press A

Current purchase price $4,000

Operating cost per yr. in each of 10 years $1,000 per year

Printing Press B

Current purchase price $3,000

Operating cost per yr. in each of 10 years $1,200 per year

At an interest rate of 12%, which printing press is cheaper over a ten-year period?
At what interest rate would the buyer be indifferent between buying A or B?

Question 23

Mary has just won the $40 million lottery. She has been informed that she will
receive payment in 40 equal annual installments (the first payment one year from
today). She offers to sell you the rights to her lottery earnings for $10 million
payable today. At i = 12%, is Mary making a smart move? Would your answer be
the same at 8%?

Question 24

Suppose it costs $600 million to build a new stadium. It is expected to take 4 years
to build, with the construction cost being evenly distributed over these four years
(all costs incurred at the end of the year, so the first in the series is one year from
now). Upon completion, the stadium will yield benefits of $40 million per year for
100 years (with the first in the series being FIVE years from now). At an interest
rate of 6%, is this project worth it?

Question 25

You currently have $200,000 in your account. The interest rate is 6%. How much
could you withdraw each year (first withdrawal one year from today) if you desire
to have $50,000 in your account at the end of ten years?
Question 26

Assume that you face the following options: (a) You can buy a car fro $11,500
payable today, or (b) you can lease a car for $1,000 per year for 17 years. (In either
case, assume the car lasts exactly 17 years and has no resale value at the end on
this period).The interest rate is 8%. Which option is cheaper?

Question 27

A share of stock in Company A is expected to have a dividend payment of $10/

share one year from today. Dividend payments are expected to grow at a 2%
annual rate. The going rate of interest is 7%. What is the price of the stock?
Answers: Present Value, Future Value

Answer 15

A) Use formula 1, the formula to find the future value of a single current dollar
n 10
amount. V0 (1+i) = Vn and table A1. $1,000*(1.10) = $2,594. Then at a 5%
10
rate, we get $1,000*(1.05) = $1,629.

n 20
B) Use V0 (1+i) = Vn. 2,000(1+i) = V20 = 14,000. First, since we are trying to
20.
solve for i, we must isolate the term (1+i) . This is done by dividing both
20
sides by 2,000 so that we have 7= (1+i) . Now, using Table A.1, we find the
row corresponding to n =20, then read across that row until find number
closest to 7. This gives us the answer that i is approximately equal to 10%
(actually, just a bit above 10%).

Answer 16

n n
A) UseFAV=V[(1+i) –1 /i] and table A2. 100M=15.46M*[(1.03) –1/0.03].
n
Isolating the term that contains n we get (100/15.46) = 6.468 = [(1.03) – 1/
0.03]. Referring to table A2, we find the 3% column and read down to the
number 6.468 or the number closest to it. If occurs at n = 6 years.

B) This question involves a combination of formulas. The future value of current

balance plus the future accumulated value of the annual deposits needs to add
n n
up to $100M. Therefore, V0 (1+i) +V[(1+i) –1 /i] =$100M.
n n
5M*(1.03) + 15.46M[(1.03) – 1/ 0.03] = 100M. Solving for n in this case
without a good financial calculator is hard! So you can just leave this way.

Answer 17

A) For this problem, you have to use two formulas: formula #1 and formula #2.
 10 10
$50,000*(1.06) + V*[{(1.06) - 1} / 0.06] = $150,000. Thus, we solve $89,542
+ V[13.18] = $150,000 for V, where we have used Table 2. This gives us V =
$4,587.

B) First, determine the present value of the $30,000 series as of the day of
10 10
retirement: V0 = $30,000*[(1.06) - 1 ] / [ (0.06)(1.06) ] = $220,800, where we
10
use Table 4. Next, set up the problem as in part (A): $50,000*(1.06) +
10
V*[(1.06) - 1] / 0.06] = $220,800. Using Table 2, this gives us: $89,542 +
V[13.18] = $220,800. Now solve for V=$9,958.

Answer 18

Both have a PV of $100, so any combination of consumption today (C0) and

consumption tomorrow (C1) that comes out to a PV of $100 is feasible (is on the
budget line). Thus, the budget line can be written as $100 = C0 + C1/(1.12) in either
case. If I choose the second option I can borrow up to $100 for spending today. By
borrowing $100 today for consumption I will have to pay back in one year
100(1.12) = $112 which I can do with the funds that come to me under this option.
So under either option I have the ability to consume up to $100 today. Likewise, if
choose the first option, I can always lend out the entire $100 today and get back
100(1.12) = $112 next year, same as if I had selected option 2. Another example,
suppose I desire to consume $50 today and C1 = ___ (fill in blank) next year. C1 =
$50(1.12) = $56. Under option one, I would save 50 of my 100 income. The $50
saved would accumulate to 56 at 12%. If I choose option two, I would borrow $50
today. This would run up a debt of 50(1.12) =56. With $112 income coming to me
under this option, this would leave me with 112-debt-112-56= $56 to spend on
consumption in the future period. So under either option I can get to the same
consumption bundles.

Answer 19
Compare the PV of each option. Since option (A) is already in present value terms,
we need only to compare this number ($50,000) with the PV of $75,000.
5
V0 = $75,000/(1.08) = $51,075. Thus, option (B) is better since it has a larger PV.

Answer 20

Using formula #4 (and Table 4), the PV of an annuity formula. $300,000 = V

[9.712] and solve for V = $30,889.

Answer 21

To find the rate of return, use formula #4:

20 20
$250,000 = $22,000 [(1+i) -1 divided by (i)(1+i) ] and solve for i. Do this by
isolating the term in the brackets. That is, divide both sides by $22,000. You
20 20
should get 11.36 = [ (1+i) -1 ] / [ (i)(1+i) ] . From table A.4, find the row
corresponding n= 20 years, and then read across this row until to find the number
closest to 11.36. See what interest rate this corresponds to. The answer is the rate
of return is approximately 6%. Because this is less than the prevailing rate of
interest of 8%, this is not a good investment.

Answer 22

A) Use formula #4. PV of machine A = $4,000 + $1,000*[5.65] = $9,650. The PV

of machine B = $3,000 + $1,200*[5.65] = $9,780. Thus, printing press A is
cheaper.

B) Again use formula #4. To find this interest rate, set the PV of each printing press
10 10
equal to each other: $4,000 + $1,000*[(1+i) -1 ] / [ (i)(1+i) ] =
10 10
$3,000 + $1,200*[(1+i) -1 ] / [ (i)(1+ i) ].
Next, isolate the term in brackets by first subtracting $3,000 from both sides and then
subtracting $1,000*[…] from both sides. You should now have: $1,000 =
10 10
$200*[(1+i) -1 ] / [ (i)(1+i) ]. Now divide both sides by $200 to get: 5 = […].
Finally, refer to table A.4. and find the row where n = 10. Read across this row until
you find the number nearest to 5. You should get interest rate = 15% (approx.)
Answer 23

Mary is to receive $1 million per year for 40 years. Find the PV of this series and
compare it to $10 million. V0 = $1 million [ 8.244] = $8.24 million when i = 12%.
Since this is less than $10 million, it is a smart move to sell the rights to the lottery
payments. At 8%, the present value equals $11.93 million. It is better not sell the
rights for $10 million.

Answer 24

First, find the PV of the construction costs: V0 = $150 million [3.465] = $519.8
million. We must compare this figure with the PV of the benefit stream. Note that
the benefit stream starts FIVE years from now, so we cannot directly use formula
#4. We must first calculate the PV of the benefit stream as if it is started one year
from today and then subtract off the PV of a four-year series starting one year from
4 4
today: ($40 mill./0.06) MINUS $40 million [(1.06) -1 ] / [ (0.06)(1.06) ] = $528
million. Notice the use of the perpetuity formula in the first term, this is fine
because it involves a large number of years.

Answer 25

The PV of the current balance = PV of withdrawals + PV of balance at end of 10

n n n 10
years. Thus, 200,000 = V [(1+i) -1] / [(i)(1+i) ] + V10 / [1+i) ] = V [(1.06) -1]
10 10
/ [(.06)(1.06) ] + 50,000/[(1.06) ] . Thus, we have

(200,000 - 27,900) = V*[7.36], or V = 172,100 / 7.36 = $23,383.

Answer 26

The PV of option A is $11,500. The PV of option b is = 1,000[9.122]=$9,122. So

option B is cheaper.

Answer 27

V0 = V1 / (i - g) = $10/(.07-.02) = $10/(.05)= $200.

Questions: Bond prices

Zero coupon bonds

Question 28

A risk-free, zero-coupon bond with a $5000 face value has ten years to maturity.
The bond currently trades at $3650. What is the yield to maturity of this bond?

Question 29

What is the yield to maturity of a one-year, risk-free, zero-coupon bond with a

$10,000 face value and a price of $9600 when released?

Coupon bonds

Question 30

(i) How much will the coupon payments be of a 20-year $500 bond with a 8%
coupon rate and quarterly payments?

(ii) How much will the coupon payments be of a 30-year $10,000 bond with a
4.5% coupon rate and semiannual payments?

(iii) A university issues a bond with a face value of $10,000 and a coupon rate of
5.65% that matures on 08/15/2020.
08/15/2030. The holder of such a bond receives coupon
payments of $282.50. How frequently are coupon payments made in this case?

Question 31

(i) What is the yield to maturity of a five-year, $5000 bond with a 4.5% coupon
rate and semiannual coupons if this bond is currently trading for a price of
$4,876?

(ii) What must be the price of a $10,000 bond with a 6.5% coupon rate, semiannual
coupons, and two years to maturity if it has a yield to maturity of 8% APR?
Bonds and default risk, Bond market vs. loanable funds market
Question 32

XYZ Industries needs to raise $10 million to fund a branch. The

company plans on issuing five-year bonds with a face value of $1000
and a coupon rate of 8.0% (annual payments). The following table
summarizes the YTM for similar five-year corporate bonds of various
credit ratings:

(i) If company receives an AA rating, the price of bonds would be

expected to be equal to what amount?
(ii) Suppose that when these bonds were issued, XYZ received a price of
$982.42 for each bond. What is the likely rating that XYZ's bonds
received?
Answers: Bond price questions

Zero coupon bonds

Answer 28

10
3650 = 5000/(1+YTM)
10
(1+YTM) = 5000/3650 = 1.369
(1/10)
(1+YTM) = 1.3690 = 1.03197 or YTM = 3.197%

Answer 29

2. 9600 = 10,000/(1+YTM)
YTM = 0.041667 or 4.167%.

Coupon bonds

Answer 30

(i) Periods 20*4 = 80; 0.08/4 = 0.02; coupon payments = .02*500 = 10.

(ii) CPN = 10,000* (0.045/2) = 225

(iii) if annual, then (10,000)*(0.0565) = $565. Because we received 282.50, this

implies semi-annual.

Answer 31

th
(i) CPN = 5000*(0.045/2) = $112.5 for each 6 month
monthperiod.
period.
The number of Periods (semiannual) = 5*2 = 10.
2 10
$4,876 = 112.5/(1+0.5YTM) + 112.5/(1+0.5YTM) + …+ (112.5+5000) /(1+0.5YTM)
Then, solving for 0.5YTM = 0.02534 so YTM = 0.0507 = about 5.1%.

(ii) CPN = 10000*(0.065/2) = 325 per semiannual period. There are four periods.
2 4
P = 325/(1.04) + 325/(1.04) +....+ (325 +10000) / (1.04) = 9727.76.
Bonds and default risk, Bond market vs. loanable funds marke
Answer 32

a) If company receives an AA rating, the price of bonds would be expected to be:

2 5 5
P = 80/(1.068) + 80/(1.068) + ....+ 80/(1.068) +1000/(1+0.068) = $1,049.47

2 5
b) 982.42 = 80/(1+YTM) + 80/(1+YTM) + ....+ (80+1000)/(1+YTM)
This lower
This lower present
YTM implied by the by
value implied droptheindrop
price
in would implyimply
price would a YTM greater
a YTM than than
greater
6.8%,
6.8%, thus
thus the bond
bond rating
rating would
would fallfall below
below AAAA rating.
rating.