ECON 300 MIDTERM (homework)

(ch 1-5)

(CH1+2) What’s the difference between microeconomics and macroeconomics?

Macroeconomics is the study of the economy as a whole, including growth in incomes, changes in prices, and the rate of unemployment. Microeconomics is the study of how firms and individuals make decisions and how these decision-makers interact.

(CH1+2) In macroeconomics, what’s the difference between short-run and long-run?

Short-run and long-run have nothing to do with time. If prices are flexible (i.e. prices are free to change) then it is long-run; if prices are sticky/fixed (i.e. prices can’t be changed) then it is short-run. In the long-run markets clear because prices are flexible; in the short-run markets may not clear (i.e. surplus or shortage/disequilibrium) because prices are sticky.

(CH1+2) Consider a model of demand for and supply of apples. Determine if the following variables are exogenous or endogenous.

• a. The price of oranges.

  b. Household Income.

  c. The price of fertilizers/pesticides.

  d. Weather.

  e. The quantity sold of apples.

a. The price of oranges. (Exo) 

b. Household Income. (Exo) 

c. The price of fertilizers/pesticides. (Exo) 

d. Weather. (Exo) 

e. The quantity sold of apples. (Endo) 

(CH1+2) What's the definition of GDP? Why can it be measured by income, output and expenditure?

GDP (Gross Domestic Product) is the market value of all (new) final goods and services produced in a country (in a year). At the macroeconomic level, total income should be equal to total output because output is distributed as income; total income should also be equal to total expenditure because one’s expenditure must become someone else’s income.

(CH1+2) Using expenditure to measure GDP, it can be written as Y=C+I+G+NX. Explain each component. In particular, explain whether C includes imports and how that is adjusted in calculating GDP.

C is consumption (private). I is investment (private). G is government expenditure (i.e. consumption and investment). NX is net exports (i.e. Exports-Imports). Equation calls for net exports (rather than just exports) which can be calculated by subtracting imports from exports. So while the imports are initially included in (C) consumption, it is balanced by being subtracted in the net exports.

(CH1+2) Compare the two price indexes: GDP deflator vs. CPI. Use a two-good two-year example to show how GDP deflator and CPI are calculated, respectively. You can use the common notation P_1,0 to denote the price of good #1 in the base year, Q_2,1 the quantity of good #2 in the current period (i.e. period 1), etc.

GDP DEFLATOR: (Current year production at current prices / Current year production at base prices) × 100
- Year 1 = [(P1,1 x Q1,1 + P2,1 x Q2,1) / (P1,0 x Q1,1 + P2,0 x Q2,1)] x 100

CPI: (Base year basket at current prices / Base year basket at base prices) × 100
- Year 1 = [(P1,1 x Q1,0 + P2,1 x Q2,0) / (P1,0 x Q1,0 + P2,0 x Q2,0)] x 100

(CH1+2) Suppose the adult population is 10 million, the employed is 6 million, and the unemployed is 0.5 million, calculate (1). Labor force participation rate; (2). Unemployment rate.

1) Labor force participation rate = Labor force/Population x 100%
- Labor force = Employed + Unemployed
L = (6 million + 0.5 million) / 10 million
= 0.65 x 100
= 65%



2) Unemployment rate = Unemployed/Labor force x 100%
U = 0.5 million / 6.5 million
= Approx. 0.077 x 100
= 7.7%

(CH3) GDP is assumed to be produced by a production function such as Y=F(K,L). Explain this production function. In particular, explain what factors affect the national output, what assumption do we make about these factors, and what other factors should also affect the national output but are omitted from this production function.

This production function has three main components: capital (K), labor (L), and technology (implicit in F). We assume all three components are constant. Besides these factors, one might also include the skill of labor into the production function. Land is another possibility. 

(CH3) According to the neo-classical theory of distribution, factors of production earn their respective marginal products. Using labor as an example, explain why this makes sense. 

Marginal product of labor should be equal to real wage (to maximize profit). Real wage is the real cost of hiring one more labor; marginal product is the extra output this one more labor can bring in. Therefore, firms will hire until marginal product equals real wage. If marginal product is more than real wage, firms should continue to hire more. When they do so the marginal product declines (i.e. diminishing marginal product). If marginal product is less than real wage, hiring one more labor will decrease profit, therefore firms should hire less.

(CH3) What is diminishing marginal product of labor? And what is diminishing marginal product of capital? Compare these two concepts with returns to scale.

Diminishing marginal product is when holding everything else constant, increasing labor will cause the marginal product of labor to decrease. Diminishing marginal product of capital is when capital increases as marginal product of capital is decreasing. Returns to scale is what happens when all factors of production are increased proportionally and simultaneously rather than changing one factor while all others are fixed.

• This can lead to constant, increasing, or decreasing returns to scale depending on if doubling K and L equals the same, less, or more, than exactly double the output

(CH3) The demand side of GDP comprises three parts: consumption C, investment I, and government spending G. We assume C=MPC(Y-T), I=I(r), and G is an exogenous constant. In this simple closed-economy model, which factor equates the supply with the demand, and how?

The real interest rate (r) is the factor that equates aggregate supply (y) with aggregate demand (C + I + G). This rate adjusts to ensure equilibrium; if demand exceeds supply, r rises, reducing investment and bringing demand down. If supply exceeds demand it creates excess supply in goods, causing firms to reduce production and prices; r falls which encouraging investment and increasing demand until it matches supply.

• Other answer: The real interest rate, r, equates the supply of and demand for loanable funds. Market equilibrium in a closed-economy requires S=I. S=Y-C-G=Y-MPC(Y-T)-G is constant. I depends on r. So, r must adjust so that I is equal to S. If r is too small, I will be too large

(CH3) Use the loanable funds model to explain why the interest rate tends to be higher during war times. In particular, what happens to private saving, public saving, total national saving, and investment?

Real interest rate depends on the interaction of demand for loanable funds, i.e. I(r), and supply of loanable funds, i.e. S=Y-C-G. National saving S is the sum of two components: private saving Y-T-C and public saving T-G. During war time, government needs to spend a lot of money to fight the war, therefore G is much higher. Although T can be raised, most of the G is funded by issuing bonds, i.e. borrowing. As a result, T-G is usually large and negative. This will cause S to decrease, in the graph it causes the S line (vertical) to shift to the left. Assuming the I(r) doesn’t change, real interest rate will rise, total saving and investment will both be lower. (Change in private saving is uncertain.)

(CH3) Consider the Cobb-Douglas production function Y=AKαL1-α. Suppose both a developed country (e.g. the United States) and a developing country (e.g. China) adopt this production function but certainly with different values of A, K, L, and α. Explain which country is more likely to have higher values of A, K, L, and α, respectively, and why.

Technology parameter “A” is also called the “total factor productivity”. It is certainly higher in more developed countries. Moreover, developed countries tend to have more capital (K), relative to labor (L), mainly due to many years of accumulation. But also because of the more abundance of K, the rental price of capital is also lower in developed countries (relative to real wage for labor). Since α measures the capital share, which depends on both rental price and the amount of capital, it is ambiguous which type of countries has larger α.

(CH4) List the three functions of money.

1. Medium of exchange (using it to purchase things)

2. Store of value (transfer purchasing power from present to future)

3. Unit of account (common unit which everyone uses to measure prices and values)

(CH4) Compare and contrast commodity money and fiat money.

They both serve the three functions of money, but fiat money has no intrinsic value (paper money) whereas commodity money does have intrinsic value. For example gold as currency is valuable for the material, the weight and purity of it, this is commodity money.

(CH4) Explain M1 and M2 respectively

M1 and M2 are measurements in money supply. M1 consists of currency and demand deposits (traveler’s checks, etc.). M2 includes M1 and saving deposits, small time deposits (or CDs), and money market deposit accounts, and retail money market mutual fund balances.

(CH4) Suppose the monetary base is $100. If the currency-deposit ratio is 0.20 and the reserve-deposit ratio is 0.10, calculate the money multiplier and total money supply.

Money multiplier is (cr+1)/(cr+rr)

m = (0.20 + 1) / (0.20 + 0.10) = 4

total money supply = monetary base x money multiplier
$100 x 4 = $400

(CH4) During the 1929-1933 Great Depression, money supply plummeted. Is this because of a decrease in monetary base, or a decrease in the money multiplier? or both? If there was a decrease in the money multiplier, is it mostly because of an increase in the currency-deposit ratio, or the reserve-deposit ratio?

The money decrease during this time was mostly due to the money multiplier. This was because banks failed in mass and the public lost a lot of confidence in their financial systems. People tried to convert their deposits into physical currency to remove their money from the banking system which increased the currency-deposit ratio. However the reserve-deposit ratio also increased substantially (although not as much as the currency-deposit). This is because after the depression, any existing banks became more careful about the way they lended money and instead increased their excess reserves instead of making loans.

(CH4) What is Open Market Operations? How to increase (or decrease) money supply by Open Market Operations? Use the U.S. Fed as an example.

U.S. Fed Open Market Operation is the buying and selling of government bonds. Selling bonds amounts to decreasing money supply (therefore interest rate rises) while buying bonds amounts to increasing money supply (therefore interest rate falls).

(CH5) What is the Quantity Equation? Explain each component of the Quantify Equation. From the Quantity Equation, derive the price determination function and inflation determination function.

M (money) x V (velocity) = P (price) x Y (output)

• M is the quantity of money, V is the number of times a dollar bill enters someone's income in a given period of time, P is the price of a typical transaction (dollars exchanged), and Y is total income.

The derived price determination function after isolating P would be:
P = (MV) / Y

INFLATION DETERMINATION FUNCTION:
ΔM/M + ΔV/V = ΔP/P + ΔY/Y

• growth rate of m + growth rate of v = growth rate of p + growth rate of y

ΔV/V = 0
-> ΔM/M = ΔP/P + ΔY/Y
π denotes the inflation rate = ΔP/P
-> ΔM/M = π + ΔY/Y
-> π = ΔM/M - ΔY/Y

(CH5) What is the Fisher Equation? What is ex ante real interest rate and ex post real interest rate?

i = r + π
The Fisher equation shows that the nominal interest rate can change for two reasons: because the real interest rate changes or because the inflation rate changes. Hence, an increase in π causes an equal increase in i.

There are two real interest rates:

• ex ante real interest rate (i - Eπ) or the real interest rate people expect at the time they buy a bond or take out a loan

• ex post real interest rate (i - π) or the real interest rate actually realized

(CH5) Why should real money demand depend on nominal interest rate?

The nominal interest rate is the opportunity cost of holding money or in other words it is what you give up by holding money rather than bonds. We can compare the real returns on different assets. While assets such as government bonds earn a real return r, money typically earns no interest. Therefore, holding money effectively costs you the nominal interest rate that you could have earned elsewhere.

People want to hold money for two main reasons: to make transactions and to earn returns. When income goes up, people need more money to buy things, so they want to hold more cash (demand increase for real money balances). But when nominal interest rates rise, people want to reduce their money holdings in favor of interest-bearing assets. This creates a trade-off where income and interest rates pull the demand for money in opposite directions.

(CH5) Besides the costs of expected inflation, what additional costs do unexpected inflation have? Explain why.

Unexpected inflation can arbitrarily redistribute income between creditors (lenders) and debtors (borrowers). For example, if inflation turns out to be higher than expected, debtors gain because in real terms they paid less. If inflation turns out lower, then creditors gain because in real terms they received more.

(CH5) Assume the velocity of money is constant. Real GDP grows by 3 percent per year, the money stock grows by 5 percent per year, and the nominal interest rate is 5 percent. What is the real interest rate? Show all formulas used and steps taken

Using the INFLATION DETERMINATION FUNCTION:
ΔM/M + ΔV/V = π + ΔY/Y
where
ΔV/V = 0
ΔM/M = 5%
ΔY/Y = 3%

π = 5% - 3%
π = 2%

Plug that into the Fisher equation i = r + π where we are solving for r (real interest rate) rearranged

-> r = i (nominal interest rate) - π (inflation rate)

r = 5% - 2%

r = 3% or 0.03

(CH6) If a country starts a contractionary fiscal policies, real exchange rate __________ and NX _________.

real exchange rate DECREASES and NX INCREASES

(CH6) If a country starts to adopt protectionist trade policies real exchange rate _________ and NX _________.

real exchange rate INCREASES and NX STAY THE SAME

(CH6) In 1997 a Big Mac cost $2.42 in the U.S., while it cost 294 Japanese Yen in Japan. The actual exchange rate between these two currencies is $1 equal to 126 Japanese Yen. Calculate the real exchange rate between these two currencies.

1.04

(CH6) In a small open economy, if the government decides to increase spending and tax by the same amount, in the short run, NX ________ and real exchange rate ________.

NX DECREASES and real exchange rate INCREASES

(CH6) Explain why in an open economy NX = S-I.

In an open economy Y (output) = C + I + G + NX, we can rearrange the equation to get NX = Y - C - G - I. For savings we also know that S = Y - C - G. Combining these equations we get NX = S - I

(CH6) Consider an economy described by the following equations:

Y=C+I+G+NX

Y=6000

G=1000

T=1000

C=0.8(Y-T)

I=1000-50r

NX=500-500ê

r=r*=10

What is the equilibrium ê? (You must show steps!)

C = 0.8(Y-T)
C = 0.8(6000-1000)
C = 0.8(5000)
C = 4000

I = 1000-50r
I = 1000-50(10)
I = 1000-500
I = 500

Y = C + I + G + NX
NX = Y - C - I - G
NX = 6000 - 4000 - 500 - 1000
NX = 500

NX = 500-500ê
500 = 500-500ê
500ê = 0
ê = 0

(CH7) Let’s use the following notation: Pop: Total adult civilian population; L: Labor force; E: Employed; U: Unemployed. Answer the following questions:

a. What is the labor force participation rate?

b. Is E+U=L correct?

c. What is the formula of unemployment rate?

d. Who are the people in Pop but not in L?

a. Labor force participation rate = L/Pop
b. yes, E+U=L is correct
c. Unemployment rate = U/L
d. Individuals who are not working or seeking employment are not included in the labor force but are still included in the Pop. (Retirees, students, etc.)

(CH7) Assume E=10 million, U=0.5 million, job separation rate s=0.05 and job finding rate f=0.10. Is this labor market in steady-state? Why? What are the steady-state E and U given the s and f?

If the labor market is in steady-state, sE=fU. However, sE=0.05x10=0.5mil while fU=0.10x0.5=0.05mil. Therefore, the labor market is not in steady-state. The steady-state unemployment rate should be s/(s+f)=0.05/0.15=1/3.

So the steady-state

U=(1/3)L=3.5mil

E=L-U=7 mil.

(CH7) Describe the pros and cons of Unemployment Insurance.

Insurance can help temporarily unemployed to afford basic standard of living until they find new employment. However, if the unemployment insurance is too generous, it might discourage the unemployed from find new jobs.

(CH7) Describe the pros and cons of Minimum Wage Laws.

Minimum wage can guarantee unskilled workers a decent wage rate. However, it also creates more unemployment at this category.

(CH7) What is efficiency wage? Why is it used and what are the consequences?

A wage that is higher than the market wage so that workers will show more effort. Once we realize that employers are actually paying for effort instead of just a physical individual, paying efficiency wage is profit-enhancing.

(CH7) What are the income effect and substitution effect of a wage rate change, respectively?

Substitution effect: When wage increases each hour of leisure becomes more expensive (in terms of loss income) which causes individuals to substitute work for leisure since there is more reward for working. When wages decrease, leisure becomes relatively cheaper, which causes individuals to substitute leisure for work and thus work fewer hours.

Income effect: When wages increase workers can maintain the same standard of living while working fewer hours. This additional income may lead them to "purchase" more leisure time aka work less. When wages decrease the workers need to work more hours to maintain their previous standard of living, so they may reduce leisure time (work more).