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(ECON 102) REVIEW SESSION BY (GUANG YOW LOW)

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TABLE OF CONTENT

I. Chapter 19: What Macroeconomics is

About

II. Chapter 20: The Measurement of

National Income

III. Chapter 21: A Simple Macro Model

IV. Chapter 22: A Simple Macro Model

(Continued)

V. Chapter 23: Short Run Equilibrium

VI. Chapter 24: Long Run Equilibrium

VII. Chapter 26: Long Run Economic

Growth

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Chapter 19

1) Which of the following macroeconomic issues are normally not associated

with the causes of economic growth?

a) Increases in living standards over a decade.

b) A temporary tax cut

c) Sustained increases in output per person

d) An increased stock of resources for future production

e) The role of increases in investments in generating a higher capital stock

for a nation.

2) Actual GDP may exceed potential GDP for a short period of time when

a) The unemployment rate is high

b) Factors of production are employed at levels that are above normal

utilization levels

c) Nominal GDP is less than real GDP

d) There is a recessionary gap

3) Full employment in Canada

a) Implies that the measured unemployment rate is zero

b) Occurs when the natural rate of unemployment is zero

c) Occurs when the output gap is positive

d) Has not been achieved in the past 50 years

e) Occurs when the only existing unemployment is structural and

frictional

4) Stats Canada reported that CPI increased from 104.2 to 105.9 from 1995 to

1996. Calculate he rate of inflation during that one year period.

[(105.9-104.2)/104.2] * 100% = 1.63%

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5) Mix of Chapter 19 & 20. For the following questions, suppose an economy produces only food and clothing, and that price and quantity data are given in the table below.

Calculate

a) Year 1 nominal GDP

20*$6 + 10*$8 = $200

b) Year 2 nominal GDP

25*$10 + 20*$7 = $390

c) Suppose year 1 is base year. What is year 2 real GDP?

25*$6 + 20*$8 = $310

d) Suppose year 2 is base year. What is year 1 real GDP?

20*$10 + 10*$7 = $270

e) Suppose year 1 is base year. What is the growth rate of GDP?

$310/$200=1.55, grows by 55%

f) Suppose year 2 is base year. What is the growth rate of GDP?

$390/$270=1.44, grows by 44%

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g) Suppose year 1 is base year. What is CPI for year 2?

($270/$200)*100 = 135

h) Suppose year 2 is base year. What is CPI for year 1?

($310/$390)*100 = 80

Chapter 20

1) Suppose that a firm sells its output for $40,000 that it pays $22,000 in wages,

$10,000 for materials purchased from other firms, and $3,000 to bankers,

and it declares profits of $5,000. Calculate the firm’s value added.

$22,000 + $3,000 + $5,000 = $30,000

2) If an economy’s annual income GDP increases by 11% and prices increase on

an annual basis by 9%, then real GDP increases by how much?

1 + real GDP = (1 + nominal GDP)/(1 + inflation) = 1.8%

3) The value of a product in its final form is the sum of the value added by each

of the various firms throughout the production process. Using the info

provided here, calculate the value of one loaf of bread that is ultimately sold

to a household. In doing so, calculate the value added at each stage of

production.

Stage of production Selling Price Value added

Farmer $0.30 $0.30

Milling $0.55 $0.25

Bakery $0.90 $0.35

Retailer $1.00 $0.10

Total $2.75 $1.00

So the sum of the value added at each stage equals the value of the final

product.

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4) This exercise focuses on other measures of national income. You are given

the following national income measures for an economy in a particular year.

Gross domestic product at market prices $285

Capital consumption allowances (depreciation) $32

Retained earnings $12

Government transfers to households $30

Personal income taxes $42

Indirect taxes less subsidies $30

Consumer expenditure $168

Business taxes $12

Net foreign investment income received $5

a) Calculate the value for disposable personal income.

Disposable personal income = GDP + net foreign investment income

– capital consumption allowance – indirect taxes less subsidies –

retained earnings – business taxes + government transfers –

personal income taxes

285 + 5 - 32 – 30 – 12 – 12 + 30 – 42 = 192

b) Define personal savings as disposable personal income minus

consumption expenditure. What is its magnitude?

Personal saving = disposable personal income minus consumption

expenditure, S = 192 – 168 = 24

5) Which of the following transactions will be recorded in the GDP accounts in

that year? Explain.

a) Jim normally earn $20 per hour, volunteers 100 hours of his time to assist

a local politician in the 1999 Ontario provincial election.

This is a nonmarketed activity so it would not be included in GDP

accounts. If the politician paid Jim $2,000, then only it will be

included in GDP accounts.

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b) The federal government increases the defense budget in order to send ten

jet aircraft to Italy during the Yugoslavia-Kosovo crisis in spring 1999.

Increase in government purchases, included in GDP accounts

c) Drug smugglers, using funds from the drug trade purchase a new hotel in

Vancouver.

Even though the funds use to purchase the hotel are from illegal

activities, the actual purchase would be recorded in the investment

component of the GDP accounts.

d) A self-employed carpenter buys $1,000 worth of nails and lumber to build

a fence for his customers. He charges the customer $1,800 but doesn’t

report the $800 of wages or profits to the tax authorities.

The $1,000 purchase will be included in GDP account, but the $800

will not be included because he didn’t report his income.

e) Pollution in Toronto beach forces the city of Toronto to lay off three

lifeguards.

Pollution cost are not included in GDP accounts, but the effect of

pollution on market activity can appear in the GDP accounts. In this

case, 3 lifeguards lost their jobs hence the income approach will

indicate a decline in overall income.

Chapter 21

1) If aggregate real disposable income rose from $20,000 to $30,000 and

desired consumption expenditure rose from $19,000 to $26,000, it can be

concluded that the

a) APC fell as disposable income increase

b) MPS is 0.3

c) MPC is 0.7

d) Desired saving increased from $1,000 to $4,000

e) All of the above are correct

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2) At a level of national income where aggregate desired expenditure falls short

of actual national income, there will be a tendency for

a) National income to rise

b) National income to fall

c) Inventories to unexpectedly decrease

d) Price to rise

3) On a graph showing equilibrium national income (desired AE = desired

national income) consider a level of actual national income where the vertical

distance from the horizontal axis to the AE function is less than the vertical

distance to the 45 degree line. At such an income level unintended

inventories are ( ), and so actual national income will tend to ( ).

a) Accumulate, rise

b) Equal to planned inventory accumulation, stay at that level

c) Being depleted, rise

d) Accumulating, fall

e) Being depleted, fall

4) The simple multiplier, which applies to short run situations in which prices

are given, describe changes in

a) Investment induced by changes in equilibrium income

b) Saving caused by changes in investment

c) The equilibrium level of income caused by changes in autonomous

expenditure.

d) The rate of interest caused by increased demand for credit

5) Assuming constant prices and MPS of 0.75, an increase in autonomous

investment of $1M will increase equilibrium real national income by

a) $1M

b) $4M

c) $250,000

d) $750,000

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6) This exercise involves an algebraic determination of equilibrium national

income. You are given the following information about behavior in an

economy:

Equation 1: C = 100+0.75Y

Equation 2: YD = Y

Equation 3: I = 50

a) What does equation 2 imply?

Disposable income equals total income. So no net taxes.

b) Derive the algebraic expression for AE.

AE = C + I, 100 + 0.75Y + 50. So AE = 150 + 0.75Y

c) What is the MPC and MPS?

From the AE function, we can see that the slope is 0.75 which is the

MPC. MPS is 1 – MPC = 0.25

d) What is the equilibrium function when AE intersects the 45 degree line?

AE = Y

e) From (d), solve for equilibrium Y.

Y = 150 + 0.75Y, Y = 600

f) What is the simple multiplier?

K = 1/(1-z), z = MPC, 1/(1-0.75) = 4

g) If I increase from 50 to 55, what is the new equilibrium Y?

(5*4=20) An increase in real national income of 20. So new

equilibrium level will be 620 (600+20)

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Chapter 22

1) Potential Y = 300

C = 30 + 0.9YD , MPC(b) = 0.9

YD = 0.8Y, T = 0.2Y

I = 40, G = 20

X – IM = 20 – 0.12Y, MPIM(m) = 0.12

AE = C + I + G + (X-IM)

Public saving (B) = T – G

AE = Y

Solve for equilibrium Y using the AE approach

a) What is the MPC?

Since AE is a relationship between desired expenditures and Y, it is

necessary to express consumption as a function of Y. Substitute YD =

0.8Y into C = 30 + 0.9YD, you will get C = 30 + 0.72Y. The MPC is 0.72.

b) Derive the AE function

AE = 30 + 0.72Y + 40 + 20 + 20 – 0.12Y = 110 + 0.6Y

c) Prove that slope of AE (z) , z = b – bt – m equals to the coefficient of Y in

(b)

Z = b (=0.9) – bt (=0.9*0.2) – m (=0.12) = 0.6

d) Solve for equilibrium Y. what is the simple multiplier? Output gap?

AE = Y, 110 + 0.6Y = Y, Y = 275. Value of simple multiplier is K =

1/(1–z) = 2.5. Output gap is 275 – 300 = -25, a recessionary gap.

e) What is the public saving (budget surplus) at equilibrium GDP?

B = 0.2*275 – 20 = 35

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f) What is the value for net exports at equilibrium GDP?

(X - IM) = 20 - 0.12(275) = -13

Solve for equilibrium Y using the savings - investment approach

a) Prove private savings = -30 + 0.08Y

YD – C or Y – 0.2Y – [30 + 0.9(Y – 0.2Y)]

b) Prove public savings = 0.2Y -20

T – G or 0.2Y – 20

c) Prove national savings = -50 + 0.28Y

S (Private Savings) + T – G or 0.28Y – 50

d) Prove national asset formation function = 60 – 0.12Y

I + NX or 60 – 0.12Y

e) From c) and d), prove that equilibrium national income is 275

Equate both c) and d) will get Y = 275

2) For each events, indicate if AE curve shift up, down or not at all and if the

slope of AE increase/decrease/not affected.

a) Income tax reduced

Disposable income will increase. Marginal propensity to consume

will increase. The AE curve will pivot up and its slope will increase.

b) Sales of Toronto produced software increase to Australia

Export sales increase, AE curve will shift up. Since exports are

autonomous, slope of AE will be unaffected.

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c) Actual national income increase

Movement along AE curve, not a shift.

d) Real interest rate increase

Investment decrease. Since investment are autonomous, AE curve

will shift down.

Chapter 23

1) Within an AD-SRAS model, the simple multiplier can be measured by

a) The extent of the horizontal shift of the AD curve in response to a

change in autonomous expenditure.

b) The extent of the vertical shift of the AD curve in response to a change in

autonomous expenditure.

c) The distance between initial equilibrium and the new intersection of AD

and SRAS in response to a change in autonomous expenditure.

d) The ratio of the change in price to the change in autonomous expenditure.

2) If autonomous investments increased, the multiplier would be zero if

a) Price increases reduced consumption and net exports by the same

amount as the increase in autonomous investment.

b) The demand shock occurred in the vertical range of the SRAS curve.

c) If the upward shift in the AE curve associated with the increase in

investment was completely counteracted by the reduction in net exports

and real wealth.

d) All of the above.

e) None of the above.

3) Assuming the SRAS curve is positively sloped, which of the following events

would lead to a fall in both the equilibrium levels of real GDP and the price

level?

a) An increase in productivity.

b) A decrease in government purchases.

c) An increase in exports.

d) A depreciation of the external value of the domestic currency.

e) A decrease in the marginal propensity to save.

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4) The AD function is given by P = 40 – 2Y, SRAS function is given by P = 10 + Y,

where Y refers to real national income and P is the price level.

a) Graph the AD curve and show both intercept values

b) Plot the SRAS curve and show its intercept values

c) What is the macroeconomic equilibrium?

P = 20, Y = 10. Solve 40 – 2Y=10 + Y.

d) Suppose that the expression for AD curve became P = 70 – 2Y. Plot this

expression in the graph, and discuss the changes that occurred to the

levels of P and Y. Comment on the size of the horizontal shift in the AD

curve in relation to the value of the change in output.

New equilibrium is P = 30 and Y = 20. Demand shock cause real

income to increase by 10, but the horizontal shift in AD curve is 15. A

greater AD results in higher prices rather than output because the

expansion in output causes unit cause to increase too.

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5) AD function: P = 60/(0.2Y – 25)

SRAS function: P = 0.02Y

AE function: 0.8Y – 25 + 0.1(W/P), marginal propensity to spend=0.8,

W(nominal wealth)=600

a) What are the equilibrium values of P and Y?

Solve AD and SRAS and get Y=200, P=4

b) Using equilibrium condition Y = AE, prove that your answer for the

equilibrium value of Y in b) is confirmed.

Substitute W=600 and P=4 into AE equation, you will get AE = 40 +

0.8Y. when Y=200, AE = Y

c) What is the value of the simple multiplier?

Since marginal propensity to spend is 0.8, multiplier is 5.

d) Suppose that the AE function becomes AE = 0.8Y + 10 + 0.1(W/P), AD

function becomes P = 60/ (0.2Y-10). What is the new equilibrium level of

Y according to the new AE function at P = 4?

Y = 0.8Y + 10 + 15, Y = 125

e) What is the quantity of output and demand supplied at P = 3 according to

the SRAS and new AD function?

Y = 150

f) A fall in autonomous expenditure of 15 triggered a decline in the

equilibrium level of Y of 50. What is the value of the new simple

multiplier? Explain how this value compares to the old simple multiplier.

The value of the multiplier is 50/15 = 3.33. This is smaller than the

value of the simple multiplier, which is 5.0. this is because the fall in

price level (from 4 to 3) increases the real value of wealth, thereby

stimulating more consumption, and the domestic price level falls

relative to foreign prices, thereby stimulating more exports and

fewer imports.

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Chapter 24

1) Starting from a position in which potential national income is constant and

equal to actual income, an expansionary demand shock will result in

a) Short run increases in both price level and real GDP

b) A recessionary gap, which creates pressure for factor price increases.

c) Pressure for an upward shift of the SRAS curve in the long run.

d) All of the above.

e) Both a) and c)

2) The LRAS curve is likely to shift rightward if

a) Tax changes reduce incentives for investments.

b) The nation’s supplies of all factors of production increases.

c) Tax decreases cause higher levels of AD

d) Factor prices increase.

e) National saving increase.

3) The paradox of thrift suggest that

a) Increased saving directly generates economic growth in the short run.

b) Increased saving reduces AD and increases unemployment in the short

run.

c) By providing larger funding sources for investment expenditure,

increased domestic saving fosters economic growth in the long run.

d) Both b) and c)

4) Which of the following are potential limitations of discretionary fiscal policy?

a) There may be long decision lags.

b) The change in fiscal policy may overshoot its target because factor prices

may be working simultaneously to eliminate the gap problem.

c) Private sector decision makers may view the policy to be shirt lived and

hence they do not change their expenditure plans.

d) All of the above.

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5)

a) The initial equilibrium reflects what sort of output gap?

It reflects a recessionary gap, since output of 480 is less than

potential output as shown by the LRAS curve.

b) If the government chose to wait for factor price changes to eliminate the

current gap, what predictions for future values of Y and P, assuming the

appropriate factor price changes do occur, would you make?

The SRAS curve would shift down along the AD curve until potential

income is reached (Y* = 500)

c) The government is concerned that the policy stance associated with part

b) will take too long. Thus, the government considers eliminating the gap

by increasing its expenditures by 8. It has arrived at this number by

knowing that the value of the simple multiplier is 2.5. Show this policy

stance in the diagram above. Will this policy change eliminate the output

gap? Explain.

Increase in government expenditure of 8 will shift the AD curve to

the right by 20 (2.5*8=20). The new AD curve intersects the LRAS

curve at P = 1 and Y = 500, but it intersects the SRAS curve at a level

of output less than potential output. Although the size of the

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recessionary gap has been reduced, a recessionary gap still remains.

It is possible that the remaining gap will be eliminated if factor

prices decreases thereby shifting the SRAS curve to the right.

d) Demonstrate the consequences of a fiscal policy that expands government

expenditures by 18. Explain whether you would expect this equilibrium

to change in the long run.

If the government expands its purchases by 18, the new AD curve

will shift to the right and pass through the point P = 1 and Y = 525. If

the new AD curve has the same slope as the initial one, it will also

pass through the point P = 125 and Y = 500. There will be no need

for factor prices to adjust in the long run since the recessionary gap

has been eliminated.

Chapter 26

1) Which of the following would normally not be considered a beneficial result

of economic growth?

a) Higher living standards.

b) More wealth concentrated in the hands of a few citizens.

c) Ease in achieving some types of income redistribution.

d) Technological changes that produce substitutes for dwindling resource

stocks.

2) For the economy as a whole, the primary opportunity cost of economic

growth is

a) The reduction in GDP per capita in future time periods.

b) The widespread environmental deterioration that inevitably results from

economic growth.

c) The loss of current consumption opportunities.

d) Increased unemployment in the short run.

e) A greater inequality of income within a country that inevitably results

from economic growth.

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3) In neoclassical assumption of constant returns to scale means that

a) Economic growth occurs with increased GDP per capita.

b) GDP per capita increases with economic growth.

c) Living standards must decrease with economic growth.

d) Living standards must decrease if technological change is labor

augmenting.

4) Which of the following is not a feature of the increasing returns theory of

economic growth?

a) Firms that first develop new investment opportunities receive low initial

rates of return because of high fixed cost.

b) Investors who follow “pioneer” investors face higher investment

cost s and therefore decreasing rates of return.

c) Once a technological breakthrough has been made, new investors earn

high rates of return since this technology is usually available to them.

d) The acceptability of new products takes a learning by using process by

consumers.

5) Consider the following aggregate production function, Y = T * (KL)1/2, where

Y is real GDP

T is state of technology

K is capital stock

L is the amount of labor

For parts a) to c), labor changes but the rest remain constant.

a) Fill in the missing values

Labor Capital Technology Real GDP 10 20 3 42.4 15 20 3 52.0 20 20 3 60.0 25 20 3 67.2

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b) Marginal productivity of labor is defined as the change in real GDP

divided by the change in labor use. What is the marginal productivity

when labor use increases from 10-15, 15-20, and 20-25?

When labor increase from 10-15, output increase by 9.6. MPL = 1.9

When labor increase from 15-20, output increase by 8.0. MPL = 1.6

When labor increase from 20-25, output increase by 8.0. MPL = 1.4

c) As labor increase, what happens to the living standard as measured by

the value of real output per worker?

Real per worker output continually falls, average output per worker

= 4.2, 3.5, 3.0, 2.7

Parts d) to e), labor and capital changes but technology remain the same.

d) Fill in the missing values

Labor Capital Technology Real GDP 10 20 3 42.4 15 30 3 63.6 20 40 3 84.9 25 50 3 106.1

What do you observe happens to changes in Y for successive,

proportional increases in labor and capital?

Output increased by 50% which is the same proportionate increase

as occurred to labor and capital. 10 to 15 labor increased by 50%, 20

to 30 capital increased by 50%, 42.4 to 63.6 real GDP increased by

50%. (15 to 20 labor increased by 33%, 40 to 30 capital increased by

33%, 63.6 to 84.9 real GDP increased by 33%)

e) What happens to the standard of living as measured by real output per

worker?

GDP per worker remains constant at 4.2. Standard of living has not

changed

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Part f) assumes labor, capital and technology changes,

f) Calculate the value for real GDP. Compare this value with the value in row

3 for part a). What do you conclude?

Labor Capital Technology Real GDP 20 20 4 80

Technology increased output by 20 units without any increased usage

of labor or capital.