Short Answer Practice Questions-Econ201-Sp2010.doc

Short Answer Practice Questions?Econ 201 Answers are found under the ?Answers? title below (page 12). For optimal learning experience, it is important that you address these questions without looking up the answers. After you have written your own answers, you can check them by looking up the answers given in this file. 1. a) Explain what the term ?productivity of a factor of production? means and b) list two distinct factors that contribute to a higher productivity of labor. 2. Which of the following types of expenditures contribute to long term economic growth and can be described as an investment expenditure: i) government expenditures on a new bridge, ii) government social security payments, iii) a company's salary payment to its worker iv) a manufacturing firm's expenditures on a new assembly line. 3. Robinson Crusoe spends 10 hours working in a day. It takes him 2 hours to make a fishing net, 1/2 hour to catch a fish and 3 hours to build a fence. Write down his production possibility frontier equation. 4. An economy produces cars and robots (which help assemble cars; a robot is an investment good). A worker can either produce 10 cars in a year or 4 robots. Each of the 100 workers in this economy earns $40,000 a year in wages. Cars sell for $ 5000 each and robots sell for $12,500 each. Currently, the economy produces 900 cars per year and all workers are employed. a. What is the opportunity cost of a robot (in terms of forgone cars)? Briefly explain. b. Calculate the level of savings in this economy. Show your work. c. Calculate the level of national income in this economy. Also calculate the total profits of firms. Show your work. 5. Which of the following plays a larger role in the long term economic prosperity in the U.S.: i) increased government expenditures, ii) increased investment, iii) increased consumption, iv) decreased government expenditures. List the most important category and briefly explain your answer. 6. Robinson Crusoe can produce 1 fishing net, or, build 2 fences, or, catch 4 fish in each hour of his 16-hour work per day. Write down his daily production possibility frontier. 7. In an economy with only household and firm sectors, the level of household savings is $4 billion and the undistributed profits of the firm are $2 billion. Calculate the level of investment in this economy. Briefly explain your answer. 8. An economy produces two goods: pizza and pizza ovens (pizza oven is considered a capital good to produce pizza). There are 200 workers in this economy. Each worker can produce either 200 pizzas or 10 ovens a year. Price of a pizza is $10 and that of an oven is $200. Currently, 140 workers work in the pizza factory and the rest produce ovens. a. Calculate the value of consumption and investment in this economy in a year. Also calculate the level of national product. Show your work. b. Every worker earns $1700 a year in wages. Calculate the level of profits of all firms. Show your work. c. Calculate i) the level of firms' savings (firms' profits are not distributed to households as dividends and, ii) the level of household savings. Are the total of these savings equal to the level of investment in the economy? Verify and show your work. 9. The Bureau of Labor Statistics reports that productivity in the business sector for the second quarter of 2001 increased at a rate of 2.2% while output in the same sector fell by 0.8% in the same quarter. How is this possible? Briefly explain. 10. It takes Tina 1 hour to design a card and 1/2 hour to type a letter. She currently has 8 hours available to her to devote to these tasks. Write down, i) her production possibility frontier, and ii) the opportunity cost of typing a letter. 11. An economy produces only apples which are considered a consumption good. There are 200 workers in this economy each of whom produces 100 pounds of apples a year, priced at $1 per pound. Write down i) the level of national product, ii) the level of national income and iii) the level of savings in this economy. 12. The economy of Choco has 10 workers who produce two goods: cocoa, which is considered a consumption good, and, cocoa pressing machine (CPM) which is an investment good. Each worker can produce either 1000 pounds of cocoa or 1 CPM a year. The price of cocoa is $5 a pound and the price of a CPM is $5000. Each worker receives $3000 in wages annually. Currently, 9 workers are producing cocoa and 1 worker produces CPM. a. What is the opportunity cost of a cocoa pressing machine (CPM)? b. Calculate the levels of i) national product, ii) savings in this economy. Show your work. c. The cocoa producing firm purchases the 1 CPM produced. The rest of the profits of this firm are distributed to workers in this firm as dividends. Calculate the amount of dividend received by all workers in this firm. Show your work. 13. An economy with consumers, businesses, government, and a foreign sector generates national income of $ 2.8 billion (net of depreciation). Consumption in this economy is $1.5 billion and government expenditures are $ .8 billion. The net exports is valued at $.5 billion. Calculate the level of net investment. Show your work. 14. The economy of Yemen produces two goods: Coffee and Coffee Roasting Machines (CRM-this is an investment good). There are 100 workers/consumers. It takes one worker to produce one ton of coffee and 4 workers to produce 1 CRM in one year. Coffee is priced at $ 700 a ton and a CRM is priced at $ 2800. Of the 100 workers, 80 produce coffee and 20 produce CRMs! The government of Yemen buys half of the coffee and the rest is available for consumption. The coffee firm buys all the CRMs. There is no foreign sector, nor is there any depreciation of capital stock. a. Calculate the level of national income in Yemen. Show your work. b. Suppose all revenues from production of all goods are distributed to households and that government taxes household income at 20%. Calculate i) the level of government revenues and ii) the level of government budget deficit or surplus. Show your work. c. Calculate the level of household savings in this economy. Show your work. 15. List the 4 major functions of commercial banks and other financial institutions, acting as intermediaries between savers and real investors (which are firms). 16. i) Which of the three assets, cash, bonds, and stocks promises a fixed return? ii) Which has a fixed maturity date? iii) Which is guaranteed to maintain its value when there is no inflation? Briefly explain each. Also explain what a Mortgage Backed Security is. 17. In an economy, the level of consumption, and disposable income of consumers are $150 billion and $180 billion respectively. The government tax revenues and expenditures are $25 billion and $35 billion. The firms' level of undistributed profits (after depreciation) is $10 billion. This economy runs a trade surplus of $12 billion. Calculate the level of net investment in this economy. Show your work. 18. List the 3 characteristics of a bond and contrast each characteristic with that of a stock. 19. As financial intermediaries, what are the main differences between commercial banks, mutual funds, and insurance companies? Also explain what a hedge fund is. 20. An economy produces $100 million worth of consumption goods, $50 million worth of investment goods, and $70 million worth of government goods in a year. Government tax revenues and the undistributed profits of businesses run at $75 million and $38 million respectively. There is no foreign sector in this economy. There is also no depreciation. Calculate the level of household savings in this economy. Show your work. 21. The open economy of Success produces the following values of consumption, investment and government goods in a year: $150 million, $100 million, and $ 98 million respectively. The level of household disposable income is $200 million and that of firms' undistributed profits is $20 million. The government tax revenues amount to $120 million a year. Calculate the trade balance for this economy (show your work) and explain if this country has a trade surplus of deficit. Show your work. 22. Use the following two concepts: a) risk and, b) return to compare your financial investment in i) a savings account, ii) corporate bonds. 23. What is the price of a one-year bond with a coupon of 5% when the market interest rate is 5.5%? Show your work. 24. On Jan. 1, 2007 you buy a 5-year bond for $104. The par value of this bond is $100 and it pays a coupon of 6% a year. What was the market rate of interest on the day this long-term bond was issued? Briefly explain your answer. 25. Do you expect the yields for two one-year bonds to be the same? Why or why not? 26. Write down the three characteristics of a bond, and, briefly explain the difference between the coupon rate and the yield of a bond. 27. The interest rate on a one-year bond is 3% today. What would you have to pay for an 8-year Treasury Note that was issued 7 years ago? The coupon rate on this Note is 5%. Show your work. 28. Looking at the table of Government Treasuries, would you expect to see the coupon rate on two one-year bonds to be the same? Why or why not? 29. Your salary in 2005 is $ 40,000. You get a raise in 2008 and your salary rises to $ 42,000. The CPI for 2008 (base year = 2005) is 110. Has your real salary -also called purchasing power- i) increased, ii) stayed the same, or, iii) decreased between 2005 and 2008? Briefly explain or, show your work. 30. Your real income has increased by 0.9% over the last year (considered the base year), while you were given a 3.2% nominal raise at work. Calculate i) the inflation rate in the consumer price index and ii) the consumer price index this year. Show your work. 31. Inflation rates in the mid 1980s were lower than expected. Which of the following groups are considered winners: i) union workers on fixed contracts, ii) bond holders, iii) homeowners who bought their homes with mortgage loans in late 1970s or early 1980s. Briefly explain. 32. By how much does a 1% increase in the expected inflation rate affects i) the real interest rate, ii) the nominal interest rate? Briefly explain. 33. In 1999, Steve received a salary of $30,000. Then in year 2000 he got an increase of $3000 to his salary. If the CPI for years 1999 and 2000 are 170 and 174 respectively, calculate the growth rate in Steve's real income in year 2000. 34. In 1999, when the CPI was 150, your nominal income was $45,000. In year 2000, CPI is 155 and your nominal income is $ 46,000. Calculate i) the rate of inflation in the CPI for year 2000, ii) the percentage increase in your real income. Show your work. 35. Is the inflation rate in the CPI a leading, or a lagging economic indicator? List two reasons for your answer and briefly explain. 36. Use the Fisher Hypothesis to explain why nominal interest rates are higher in Eastern Europe than in Western European countries. Also, according to your explanation above, with nominal rates of interest higher in Eastern Europe, would you expect to see a major flow of savings from Western to Eastern Europe? 37. Inflation rates in the U.S. rose unexpectedly in the late 1970s. Which of the following groups were adversely affected: i) Homeowners who had bought their houses with long term mortgage loans in early 1970s, ii) Employers who had agreed to a fixed wage contract in early 1970s, iii) Banks that had loaned out long term mortgage loans in early 1970s? Briefly explain your answer. 38. How do the following events affect the real interest rate (in the market for loanable funds), i) a decrease in the amount of foreign savings, ii) a decrease in Federal government borrowing (deficit spending)? Mention in each case whether the supply or demand schedule for loanable funds shifts and in which direction. 39. The economy of Solo has an NGDP of $240 billion in year 2000. The GDP deflator for this economy in year 2000 (base year 1996) in 120. The natural rate of unemployment in this economy is estimated at 5%. a. Calculate the RGDP of this economy in year 2000. Show your work. b. The RGDP for the same economy in the base year (1996) is $180 billion. Calculate the NGDP for this economy in year 1996. Show your work. c. The actual rate of unemployment in this economy stands at 4% in year 2000. Is this economy experiencing a recessionary or an overheating (inflationary) phase? Why? 40. The RGDP of an economy grew by -1.5% in year 2008. If the nominal GDP has grown by 2% during the same period, what is the inflation rate (in the GDP deflator) for the year 2008? Show your work. 41. An economy?s natural rate of unemployment is estimated to be 5.6%. For the past year, the Real GDP of this economy has been declining. Would you expect the actual rate of unemployment in the economy to be lower or higher than 5.6%? Also explain if unemployment is a pro cyclical or a counter cyclical variable. 42. In a recession, which of the following is (are) expected to fall: i) real GDP, ii) nominal GDP, iii) the unemployment rate, iv) the inflation rate. Briefly explain. 43. Of the following variables which are i) pro-cyclical, and, ii) lagging economic indicators: a) the inflation rate in the CPI, b) the index of stock prices. Briefly explain. 44. An economy?s NGDP, RGDP, and GDP deflator data are given as follows (in billions of $): 2002 NGDP 12 12.5 RGDP ---- 10.4 GDP Deflator (base yr. 1996) 118 ----- a. Fill in the blanks and show your work. b. Calculate the annual rate of growth of RGDP for 2002. Show your work. c. This economy?s natural rate of unemployment is estimated at a range of 4%-4.5%. Currently, 95% of the workforce is working and the rest are unemployed. Would you say this economy is operating at full employment RGDP, below full employment RGDP (a recessionary economic condition) or above full employment RGDP (an overheating economy)? Briefly explain. d. The economy in this question is slowly recovering from a recession, started last year. Would you say that the inflation rate in this economy is expected to rise or fall? Would you say that the inflation rate in this economy leads or lags the movement of the RGDP? Briefly list and explain reasons for your argument. (8 points) 45. Write down two major differences between commodity and fiat money. Which type of money does the U.S. use today? 46. Which of the following are considered to be part of M1? Which are considered money but are not part of M1? Which are not part of any definition of money (narrow or broad) and why? i) Money market mutual fund accounts, ii) Savings account, iii) Bonds, iv) credit cards. 47. A modern bank has $180 million in loans. At the required reserve ratio of 10%, calculate i) the value of demand deposits, ii) the value of required reserves of this bank (there are no excess reserves). 48. A bank?s balance sheet shows loans of $ 270 million. If the required reserve ratio is 10%, and the banks do not keep any excess reserves, how much demand deposits does this bank have? Show your work. 49. On February 2, 2000, the Fed conducted "contractionary" open market operations, intending to reduce the money supply by $200 billion. a. Did the Fed buy or sell government securities? If the required reserve ratio is 10%, and all banks are fully loaned up (no excess reserves), calculate the amount of transactions in Treasury securities that Fed has to undertake in order to reduce the money supply by $200 billion. Show your work. (Assume there are no cash transactions). b. What is the effect of the contractionary open market transactions by the Fed on i) bond prices and ii) interest rates? Briefly explain. 50. A Goldsmith, practicing an early form of fractional reserve banking in England, keeps 1/5 of his issued notes in reserves. He has made loans of 2000 pounds to his customers. a. What is his total liability, and, what are his reserves? Show your work. (6 points) b. Draw the asset balance sheet of the Goldsmith. Write down the amounts of reserves, loans and notes issued, and, label each entry. (6 points) c. Now suppose we replace the goldsmith with a modern fractional reserve bank in the U.S. Draw the balance sheet for the bank (use the same amounts of loans, reserves, and total liabilities for the commercial bank- in $-as you found for the goldsmith above) and explain the differences between the commercial bank and the goldsmith in each entry of the balance sheets of these two institutions. (9 points) 51. The money multiplier for the U.S. is about 1.7, while the required reserve ratio is 10%. Explain two reasons why despite a 10% required reserve ratio, the value of the money multiplier in the U.S. is so low. 52. Dividing up the total amount of currency by the population of U.S. implies that every man, woman, and child carries over $1500 daily! Explain where you are likely to find this cash. Also explain if the cash in the vault of the bank is money or not and why? 53. The Fed sells a $ 10,000 Treasury bond to an individual who draws a check on her bank (Bank A) to pay for the bond. a. Is this part of an ?expansionary? or ?contractionary? monetary policy? Draw the simplified balance sheet of bank A and show the changes in various entries (and their direction of change) on this balance sheet. The required reserve ratio is 10%. b. Suppose that all banks in the system are fully loaned up and there are no cash transactions. Calculate the total change (and the direction of change) in the economy?s money supply (rr = .1). Show your work. c. Now suppose that banks do keep an extra 10% of their deposits as excess reserves and do not loan them out. What would be the total effect of the $10,000 selling of the bond by the Fed on the total supply of money in the economy? Show your work. 54. As the interest rate falls, would you expect to see a shift in the demand for money, or, a movement along the demand for money curve? Briefly explain (also mention in which direction the change would occur). 55. At the 4% rate of interest, you keep $2000 of your wealth in bonds and $1000 in your checking account at the bank plus $50 in your purse. Answer the following: i) what is your quantity of money demanded at 4% interest rate and ii) would you keep more or less of your wealth in money form if interest rate falls to 3%? Briefly explain. 56. At 3% rate of interest, Tran keeps $800 in her checking account, $2000 in a bond fund, and $5500 in a stock mutual fund. What is her quantity of money demanded? How will the quantity of money she holds change if interest rates rise to 4%? Briefly explain. 57. How does a recession in Britain affect the equilibrium interest rates in that country? Suppose the supply of money is held constant in Britain. Briefly explain. 58. In an economy, the supply of money is $60 million. The RGDP and the GDP deflator for this economy are $400 million and 150 respectively. Calculate the K(i) and interpret your answer. Show your work. 59. In an economy in a long run steady state, the rate of interest is 6.5%. The money supply growth rate is 7% annually and the economy grows at a rate of 3% a year. What is the rate of inflation? Show your work. 60. In 2001, the inflation rate in the U.S. was 1.8%, while the growth rate of M1 was 1%. The velocity of money had been constant since 2000. Calculate the growth rate of real GDP of the U.S. in 2001 by using the quantity of money equation. Show your work 61. The levels of M1 in an economy were respectively $1.1 trillion and $1 trillion in 2006 and in 2007 respectively. NGDP had stayed at the same level of $8 trillion between 2006 and 2007. Calculate the K(i) in each year, and interpret the change in K(i) between 2006 and 2007. Would you expect the interest rate to rise, or to fall between 2006 and 2007? Briefly explain. 62. A photocopy service retailer, Copies, etc., intends to buy a new copy machine priced at $18,000. The owner estimates that the copy machine will increase its business by $10,000 during the year. The resale value of this machine at the end of the year is $10,000. This firm has $20,000 in a bond fund that pays 7.5% interest. Should this firm use the funds it has to buy the copy machine? Use the concept of ROI to answer the question. Show your work. 63. A bookseller is interested in purchasing a new computer for his/her business. The price of the computer is $3000 and its resale value at the end of the year is $1600. The firm estimates the new computer can increase its sales orders by $2000 a year. This firm has $3000 in a mutual fund paying 5%. Should it use the funds to buy the computer? Use the concept of ROI to answer this question and show your work. 64. Do the increases in the overall labor productivity in an economy affect the aggregate demand (AD), or, the aggregate supply (AS) schedule? Briefly explain. Also briefly explain the direction of shift of the relevant curve. 65. How does i) an increase in government expenditures and ii) a decrease in exports affect the AD curve (explain if the changes will lead to movement along the AD, or, shifts of the AD curve and in which direction). 66. The economy of Canada is facing a possible recession. The Central Bank of Canada (CBC) is charged with the task of conducting monetary policy in order to keep the economy at full employment equilibrium. a. Use graphs of money supply and demand, and, the investment demand graph to trace and show the effects CBC?s monetary policy to prevent a recession. Use the concept of ROI in deriving the investment demand. Also fully label your graphs. b. Use the AD/AS graphical analysis to show the effects of CBC?s policy on the level of economic activity, given that its analysis of economic trends in Canada are correct. Fully label your graph. c. Now suppose the CBC is mistaken about the economic trends in output and employment in Canada. In this case, what is the effect of an expansionary monetary policy on the RGDP and the GDP deflator in Canada? Use a graph to accompany your brief explanation. Fully label your graph. 67. i) For some 20 years (1988-2008), the growth rate of money supply in an economy is 5%. The RGDP in this economy grows at 2.5% a year over the long run. The rate of interest is stable at 4%. Calculate the rate of inflation. ii) In the same economy in 2009, with the real GDP growing at 2.5% per year but with forecasts of an economic slowdown in the near future, the central bank increases the money supply by 10%. The rate of inflation does not change over the short term (sticky prices). What is the effect of this money supply increase on the resting time for money and also on the rate of interest? Use the quantity equation of money in growth form to accompany your written answer. Show your work. 68. The Western Washington Lumber Co. is thinking about buying a new truck for its business. The cost of a new truck is $40,000 and it will increase business by $15,000 a year. The truck can be sold for $27,000 at the end of the year. The firm has $40,000 of funds in a bank paying a 4% rate of interest. a. Use the concept of ROI to explain if the firm should use its funds in the bank to purchase the truck. Show your work. b. Now suppose the Fed raises the interest rate to 5.5%. Explain how the aggregate level of investment will change in this economy. Use a graph to accompany your brief explanation. c. What is the effect of an increase in the interest rate by the Fed on the level of RGDP and the aggregate price level in the economy in the short run? Use a graph to accompany your answer in this part (assume that currently, there is a correctly perceived threat of an inflationary and overheating rate of economic activity). Fully label your graph. 69. List 2 factors/forces that shift the aggregate supply curve of an economy. Also explain in which direction the AS shifts as these forces increase. 70. How does i) a decrease in imports, and ii) an increase in investment affect the AD curve (mention if the changes will lead to movement along the AD, or, shifts of the AD curve and in which direction). 71. Due to fears of a possible recession in the near future, the Central Bank of Tunisia (CBT) has been charged with the task of averting the recession in that country. a. Should the CBT buy or sell government Treasury securities? Draw two graphs, i) money market and ii) investment demand to trace the effects of CBT?s open market operations on interest rates and the quantity of investment goods demanded in Tunisia. Fully label your graphs. b. Use the AD/AS graphical analysis to show the short run effects of CBT?s policy, given that its analysis of economic trends in Tunisia are correct. Fully label your graph. c. Now suppose the CBT is mistaken about the economic trends in output and employment in Tunisia. In this case, what is the short run effect of the monetary policy by CBT on the RGDP and the GDP deflator in Tunisia? What is the long run impact of a continuously easy monetary policy on PRGDP, the inflation rate and the nominal interest rate? Use a graph to accompany your brief explanation. Fully label your graph. 72. The Central Bank (CB) of Argentina fears an impending rise in the inflation rate in that country. The CB takes early action with the intent of eliminating the possibility of a rising inflation rate in that country. a. Does the CB buy or sell government bonds? Use a graph of the money market to show the effect of CB's action on the rate of interest. Fully label your graph. b. How does the change in the rate of interest influence the demand for investment goods in this economy? Use the concept of ROI to explain, and, draw a graph of investment demand to show the effect of CB's action on demand for investment goods. Fully label your graph. c. Considering that the CB is incorrect in its evaluation of the impending inflation, use a graph of aggregate demand and aggregate supply curves to show the effect of the CB's policy on the RGDP and the aggregate price level in Argentina. Fully label your graph. 73. The economy of Chile faces a possible recession. The central bank of Chile (CBC) is charged with the task of preventing recession in that country. Does the CBC buy or sell government bonds? If the forecast by the CBC about the upcoming recession is correct, draw a graph of AD and AS forces and illustrate the effect of CBC?s policy on RGDP and the GDP deflator in Chile. Fully label your graph. Now suppose the CBC is incorrect in its forecast. Use a graph of AD and AS to show i) the short run and ii) the long run effects of the CBC?s policy on the RGDP and the GDP deflator in Chile. Briefly explain. Once the full effects of Fed?s policy have been realized, do you think that interest rates in Chile will be higher under scenario a. or b. above? Briefly explain. 74. Consider an economy in the midst of a deep recession. a. The task of boosting economic activity is given to the central bank of this country. What should the central bank do to boost RGDP of this economy? Briefly explain the mechanism though which the Central Bank can increase economic activity. b. There is a famous Keynesian economist in this country that argues that monetary policy to boost activity in deep recession is ineffective. How would this economist articulate his reasons for the ineffectiveness of monetary policy? What does he propose the government do instead? List two government policies a Keynesian economist would propose to eliminate a recession. c. According to the Keynesian theory, if the economy is in "recessionary gap" of $200 billion, does the government need to spend more, or, less than $200 billion in order to eliminate the recession? Why? 75. Consider the economy of Peru in a recessionary state. Now, suppose the government is taking fiscal policy measures to combat the recession. a. It is estimated that Peru is experiencing a $100 billion recessionary gap. The MPC in Peru is 0.75 (MPC = 0.75). Calculate the amount of government expenditure increase necessary to eliminate the recessionary gap. Show your work. b. Now suppose that instead of an increase in government expenditures, the government decides to enact a tax cut to close the same $100 billion recessionary gap. Calculate the size of the tax cut and show your work (MPC = 0.75). c. Of your answers for the amount of government increases in G or tax cuts in parts a. and b., which is the larger amount and why? 76. The economy of Peru is facing a possible recession. The Central Bank of Peru (CBP) conducts monetary policy to prevent a recession in that country. a. The CBP intends to increase money supply by $50 billion. Calculate the volume of transactions in the Open Market Operations that would increase Ms by $50 billion (rr =0.12). Consider no cash transactions and no excess reserves held by banks. Show your work. b. Suppose the CBP is correct in its forecast of the upcoming recession. Use a graph of AS and AD, to show the short run effect of CBP?s policy on RGDP and the GDP deflator. Fully label your graph. c. Now suppose the CBP to be incorrect in forecasting an upcoming recession. Use an AS/AD graph to show the short run effects of CBP?s expansionary monetary policy in Peru. Fully label your graph. 77. Consider again the economy of Peru in a recessionary state. Now, suppose the government is taking fiscal policy measures to combat the recession. a. It is estimated that Peru is experiencing a $200 billion recessionary gap. The MPC in Peru is 0.8 (MPC = 0.8). Calculate the amount of government expenditure increase necessary to eliminate the recessionary gap. Show your work. b. Now suppose that instead of an increase in government expenditures, the government decides to enact a tax cut to close the same $200 billion recessionary gap. Calculate the size of the tax cut and show your work (MPC = 0.8). Answers 1. a) It is the amount of output produced by a factor of production (e.g., labor) per hour (or day or week?.). b) - investments in skills training for labor - investment in new technology (for capital) - improvements in the working environment in companies, etc. 2. i) and iv) are both investment items (by government and by firms). i) and iv) are both correct. 3. Fishing net * 2 + Fish * 1/2 + Fence * 3 = 10 4. a. 1 robot costs 2.5 cars. To produce one more robot, 10/4 cars have to be sacrificed! b. As S = I, we can calculate I = the value of robots = 40* $12,500 = $500,000 S = I = $ 500,000 c. NI = NP = Agg. Exp. NI = Value of cars + value of robots = 900*$5000 + $500,000 = $5 million As wages are $40,000 per worker, W = $40,000* 100 = $4,000,000 = $4 million Hence profits are = NI - wages = $5 million - $4 million = $ 1 million. 5. Number ii) is correct. Increased investment expenditure leads to productivity improvements in all factors of production, allowing us to produce more or better goods with every hour of work. This in turn increases our standard of living. 6. The PPF is: 1 (hours per net) * NETS + 1/4 (hours per fish) * FISH + 1/2 (hour per fence)* FENCE= 16 hours 7. Total savings = investment HH savings + firms' savings (the undistributed profits) = Investment Therefore investment = 2 + 4 = $6 billion 8. a. C = 140* 200* $10 = $280,000 I = 60*10*$200 = $120,000 GNP = C + I = $400,000 b. Total wage bill = $200 * $1700 = $340,000 Total NI = National Product = $400,000, as profits = NI - wages, hence profits of firms are $400,000 - $340,000 = $60,000 c. i) Firms' savings = Undistributed profits = $60,000 HH income - HH consumption = HH savings = $340,000 - $280,000 = $60,000 ii) Total Savings = $60,000 + $60,000 = $120,000. Since the level of investment in pizza ovens is also $120,000, it is clearly the case that S = I! 9. Since productivity is output per person, it implies that the number of employees must have fallen too! Moreover, the number of employees must have fallen more than the fall in the output {Since %change in Productivity = %change in output- % change in employment, 2.2% = - .8% - (-3.0%)}, so the number of employed workers has fallen by about 3%. 10. Cards * 1 + Letters * 1/2 = 8 The opportunity cost of a letter is 1/2 of a card! 11. i) NP = 200 * 100 * $1 = $20,000 ii) NI = NP = $20,000 iii) Savings are zero, there is only consumption! 12. a. The opportunity cost of a CPM is 1000 pounds of cocoa. b. NP = C + I C = 9000* $5 = $45,000 I = 1*$5000 = $5,000 So NP = $50,000 ii) Savings are equal to investment, S = $5000 c. - Total revenue of the firm = 9000*$5 = $45,000 Wages paid to workers = $3000* 9 = $27,000 - Profits = 45000 - 27000 = $18000 - Profits - profits held to buy one CPM = 18000 - 5000 = $13000 13. NNP = NI = C + net I + G + X -M 2.8 = 1.5 + net I + .8 + .5 Net I = $0 14. a. Value of coffee = 80* $700 = $56,000 Value of CRM = 5*$2800 = $14,000 NI = NNP = $56,000 + $14,000 = $70,000 b. As NI is paid to HHs: Tax revenues are = .2 * $70,000 = $14,000 G = $28,000, so the government runs a deficit of $14,000 or, T - G = -$14,000 c. HH sav + Firm Sav + Gov. Sav = net Investment HH sav + 0 + (-14,000) = $14,000 HH sav = $ 28,000 15. i) Lowering transaction costs for borrowers ii) Lowering information costs for lenders iii) Liquidity: Banks help turn illiquid loans in to liquid deposits. iv) Diversification: A large pool of many financial investors and many borrowers helps lower the risks involved for all parties?. 16. i) Bonds promise a fixed return. ii) Bonds have a fixed maturity. iii) Cash maintains its value in the absence of inflation. The Mortgage Backed Security (MBS) is a bond that derives its value from home mortgage loans. In the last two decades, banks and non-bank ?mortgage brokers? devised this financial instrument. They would bundle individual mortgage loans in to bonds called MBS. They would sell them to investment banks, hedge funds, insurance companies, other commercial banks, etc. For banks that originated the mortgage loans, the sale of MBS to various institutional investors would allow them to receive funds for those securities and they could loan again to more homebuyers and increase their earnings. The subprime crisis refers to the large drops in the value of MBS as some homeowners (subprime borrowers) started to default on their mortgages, 2006-present. 17. (DI - C) + (T-G) + UP + Foreign Sav = net Investment (180-150) + (25 - 35)+ 10 + (-12)= net Investment Net Investment = $18 billion 18. a. Fixed maturity- the period after which the bond ceases to exist. Stocks do not have a maturity date. b. Fixed coupon-stocks do not yield a fixed payment (in the form of an interest rate) c. Fixed par value (principal to be paid back on bonds). Stocks do not promise such a payment. 19. Commercial banks loan out your money in relatively "safe" types of investments. They provide easy liquidity for your funds. Also your funds are insured by the FDIC. Mutual funds may invest in "riskier" type investments, and your funds there are not insured (thought the return is higher than your commercial bank account). Insurance companies can loan out long term for big commercial projects as your payments to them are not really liquid. A hedge fund uses the funds invested by a number of small wealthy financial investors to win (and earn profits) by ?betting? against movements in stock prices. ?Hedging? is essentially a kind of ?betting?. So for example, the hedge fund would sell a stock today and agree to buy it back in some future date, betting that between now and that future date, the price of stock will fall. This is also called ?short selling?. If the price does actually fall, the hedge fund earns a profit. Moreover, hedge funds did not just use their own funds to ?short sell? they actually would borrow the stocks they would ?short sell?. Engaging in hedging activities with borrowed funds is called leverage. 20. HH sav + (T-G) + UP + Foreign Sav = Investment HH Sav + (75-70) + 38 + 0 = 50 HH Sav = $50 - 43 = $7 million 21. (DI - C) + Firms' sav + (T-G) + (IM-EX) = I (200 -150) + 20 + (120 - 98) + (IM-EX) = 100 70 + 22 + (IM - EX) = 100 IM - EX = 100 -92 = $ 8 million This economy runs a trade deficit of $8 million. 22. a) Savings accounts are not risky! They are insured by the FDIC (up to $100,000 per depositor). Corporate bonds carry some risk (the corporation could default). b) Corporate bonds pay a higher rate of interest than that of the savings accounts. 23. P = (100 + coup) / (1 + yield/100) = 105/1.055 = $ 99.53 24. The market rate of interest on the day the bond was issues is 6%- the coupon rate! 25. Yes. If one has a higher yield than the other, everyone wants the higher yield bond. Therefore, many will bid for that bond. As a result, its price will rise and hence its yield will fall to equalize the yield on two bonds! 26. Fixed coupon rate, 2. Fixed maturity, 3. Par value or face value in denominations of $100. The coupon rate is the fixed rate the borrower pays per $100 of the principal. The yield is the "effective" interest rate on the bond given the bond's price on a given day after it is issued. 27. This Note is now a one-year bond! P = (100 + coup)/(1 + yield/100) P = (100 + 5)/(1 + .03) = $101.94 28. No, not necessarily! These bonds, though one year is left of their maturity, may have been issued at different years in the past. As the coupon rate reflects the interest rate on the day the bond is issued and these bonds were issued at different times, their coupon rates are rarely the same! 29. iii) decreased! Your salary has gone up only 5% while the inflation rate between 2005 and 2008 is 10%! 30. Using the formula: % change in nominal income = % change in real income + inflation rate, the inflation rate is: 3.2-.9 = 2.3%. Since last year was the base year, CPI = 100 for last year. Hence CPI for this year is 102.3! 31. Both i) and ii) are correct. In i) Workers got large inflation premiums in their wage negotiations in early 1980s. In ii) the price of bonds in mid 1980s must have increased as inflation rates and with it yields on these bonds fell. 32. It only affects the nominal interest rate by 1%. According to the analysis in Ch. 4, the ex-ante real interest rate (determined in the market for loanable funds) is not affected by inflation expectations. Nominal rate of interest = real rate of interest + expected inflation rate. Therefore an increase of 1% in inflation expectation increases the nominal rate by 1%. 33. His real income in 1999 = (30,000/170)*100 = $ 17,647.05 His real income in 20000 = (33000/174)*100 = $18,965.5 The percentage change in real income is = {(18965.5 - 17647.05)/17647.05}*100 = 7.47% 34. i) The inflation rate = {(CPI 2000 - CPI 1999)/CPI 1999}*100 = {(155-150)/150}*100 = 3.3% ii) Percentage change in nominal income = {(46000-45000)/45000}*100 = 2.22% Percentage change in nominal income = %change in real income + inflation rate Hence, %change in real income = 2.2% - 3.3% = - 1.1% 35. It is a lagging indicator. The reasons are: 1) Contracts for wage (and possibly other determinants of costs) are usually set for more than a year, up to 3 years. With wage costs being fixed, firms tend to fix their prices for a while and do not desire to change them too quickly. So the price change lags the quantity change. 2) Menu costs: firms prefer not to publish new prices (new menus) too frequently. This is especially true for non-standard type of goods. 36. Fisher Hypothesis: Nominal interest rates = 2% + expected inflation rate It must be that inflation in Eastern Europe is higher than that of Western Europe. No! The incentive to invest their savings depends on the REAL rate of interest they will earn. As long as the real rates are about the same (2%) in both West and East, there is no desire on the part of Western Europeans to take their savings to the East. 37. Inflation rates were unexpectedly high in the late 1970s, so the borrowers gained while lenders lost. The only group in the question that was adversely effected is iii) banks! Banks had given low interest rate mortgage loans (with a small inflation premium) in the early 1970s. As the inflation rate increased, the "real" interest rate (ex-post) earned by the banks declined. 38. i) A decrease in foreign savings shifts the S curve (of loanable funds) to the left and increases the real interest rate. ii) A decrease in government borrowing reduces the demand for loanable funds (D curve shifts to the left) and reduces the real interest rate. 39. a. GDP deflator for 2000 = (NGDP/RGDP)* 100, Hence: RGDP for 2000 = (NGDP/GDP deflator)*100 = (240/120)*100 = $200 billion b. As GDP deflator for base year is 100, then RGDP for base year = NGDP for base year. Hence, NGDP for 1996 is also $180 billion. c. Since the actual rate of unemployment is less than the natural rate, then too many people are working! The economy is facing a "labor shortage", wages and hence prices are expected to rise. This is an inflationary (overheating) phase for the economy. 40. Since GDP deflator = (NGDP/RGDP) * 100, or NGDP = RGDP * GDP deflator/100 We can, for small changes, write this relationship in terms of growth rates: NGDP % = RGDP% + GDP deflator% Inflation rate = NGDP% - RGDP% Inflation rate = 2% + 1.5% = 3.5% 41. It is very likely that the actual rate of unemployment is higher than the natural rate since RGDP has been falling for a year. The unemployment rate is counter cyclical: as the RGDP falls, it rises. 42. i) real GDP falls. In fact, recessions are defined by a drop in RGDP for two or more quarters. iv) Inflation rate also tends to drop in a recession, although with some lag (it starts to fall after RGDP drops). As demand for goods and services drops, producers can not raise prices on their goods as before so inflation rate tends to fall a bit. 43. The inflation rate in the CPI is lagging and pro-cyclical and the index of stock prices is leading and it is also a pro-cyclical variable. 44. RGDP for 2001 = [NGDP/GDP deflator]* 100 = [12/118]*100 = 10.17 GDP deflator for 2002 = (NGDP/RGDP)*100 = (12.5/10.4)*100 = 120.19 b. Annual inflation rate = [(RGDP 2002 ? RGDP 2001)/RGDP2001]*100 = [(10.4 ? 10.17)/10.17]*100 = 2.26% c. Currently as the actual rate of unemployment is 5%, this economy is operating below the full employment RGDP. There is a 0.5% rate of unemployment that is considered ?cyclical? (due to recession). Therefore, the little extra ?involuntary? unemployment signals a recessionary state for the economy. d. As the RGDP is rising, the inflation rate will also rise (pro-cyclical). The inflation rate lags the movements in RGDP-RGDP changes first and then inflation rate will change! The reasons are: a) Producers tend to first change the quantity of their production and then change their prices (in a recession, they cut production first then lower prices if they have to). b) Fixed wages (cost of production) for the period of wage contracts between workers and employers. c) ?Menu? costs! 45. a. Commodity money has ?intrinsic? value and other uses-gold can be worn and various instruments can be made out of it. Cattle can be milked, fur can be used in clothing, etc. Fiat money has no other use except as a means of payment. b. It is hard to determine the quality of commodity money-cheating was common with gold coins and cattle used in payments could be sick. ?Bad money drives out good money!? Fiat money does not have such a problem. We use fiat money in the U.S. 46. i) MMMF is part of M2, not M1 ii) Savings accounts are part of M2 not M1 iii) Bonds are not money- they fail to perform the function of an accepted medium of exchange. iv) Credit cards are not money as they are not a store of value. 47. Since all excess reserves are loaned out, loans = 90% of all deposits. i) DD = 180/.9 = $200 m, and RR = 200*.1 = $20 m 48. Since rr = .1 and banks have loaned out 270 million dollars, it implies that this amount is in fact 90% of total deposits. Therefore, the demand deposits of this bank are 270/.9 or $ 300 million. 49. a. The Fed sold government securities thereby withdrawing reserves from banks. Using the money multiplier formula, change in money supply = change in reserves* 1/rr Therefore the initial sale of bonds = 200*.1 = $20 b b. As the Fed increases the supply of bonds to the public, i) bond prices fall and ii) interest rates rise. [Interest rates move in the opposite direction to bond prices] 50. a. His loans are, therefore, 4/5 of his total liability (notes)! X * 4/5 = 2000 X = 2500 His total liability is 2500 pounds. His reserves are 2500* 1/5 = 500 pounds b. Goldsmith Assets Liabilities ------------------------------------------------------------------------- Reserves: 500 pounds of gold Notes: 2500 pounds Loans: 2000 pounds c. Modern Commercial Bank Assets Liabilities ------------------------------------------------------------------------------------------ Req. Reserves at the Fed: Demand Deposits: $2500 $500 Loans: $2000 Reserves of the goldsmith are gold, reserves of the bank are just computer entry at the Fed Notes of the goldsmith are actual pieces of paper (notes), the demand deposits of a bank is just a computer entry. Banks do not print their own notes! Loans are notes issued by the goldsmith, loans by a bank are in the form of a check to the borrower. 51. The simple money multiplier formula, 1/rr, is derived with 2 assumptions: 1. No one uses cash. 2. Banks do not hold excess reserves. In reality none of these assumptions hold. This implies that the actual money multiplier is different (and smaller) than 1/rr. 52. Some of the cash is in foreign countries. Somme is in the hands of illegal dealers (drugs, smuggled goods) and some is in the cash registers of retailers. Cash in the vault of the bank is in the form of reserves. Of what the bank holds only our deposits (checking and saving) are part of money supply (savings accounts are part of M2). Counting cash in the bank as money would amount to double counting of money. 53. a. This is a contractionary monetary policy. The Fed sells a bond and withdraws that person?s money balances out of circulation. Bank A Change in Res. Change in Liab. ------------------------------------------- -$1000 req. res. | -$10000 DD - $9000 loan | Bank is short of reserves by $ 9000 and has to call in loans. b. Total change in the money supply = change in reserves (1/rr) Therefore, change in M = -10,000 * (1/.1) = $ -100,0000 c. In this case, 10% is added to their rr so ; Total change in Money = -10,000 *[1/(rr+.1)] or, Total change in M= -10,000*(1/.2) Total change in M = -$ 50,000 The change is less here than in part b. above since banks have prudently kept some extra (excess) reserves at hand. 54. Since the demand for money curve is made up of the relationship between quantity of money and the rate of interest, the fall in the interest rate would mean a movement along the demand for money curve. As interest rate falls, the quantity of money demanded increases! 55. i) The quantity of money demanded = 1000 + 50 = $1050 ii) As the interest rate falls, I would likely keep more of my wealth in the form of money. The opportunity cost of holding money has fallen as interest rates on bonds are lower now. 56. Her quantity of money demanded is $800. If the interest rate rises to 4%, she will hold less money (i.e., her quantity of money demanded falls)! 57. A recession in Britain leads to a fall in equilibrium interest rate since due to the recession the ?transaction? demand for money falls. Hence the demand for money shifts to the left and given the supply of money is unchanged, interest rates fall. 58. M = K(i)* NGDP or M = K(i)*RGDP * GDP deflator/100 60 = K(i) * 400 *150/100 Therefore, K(i) is = .1 This means that a dollar of money rests in a checking account for .1 of a year or for 1.2 months. 59. M% = K(i)% + Q% + P% Since i = 6.5% implying that it is stable, then K(i) does not change, that is K(i)% = 0 in steady state. Therefore, 7% = 0 + 3% + P% or inflation rate is = 4%. 60. Since the velocity of money is constant, so is the K(i)! Therefore, K(i)% = 0. M% = K(i)% + RGDP% + P%. As M% = 1% and P% = 1.8%, then RGDP% = -.8%. K(i) in 2006 = 1.1/8 = .14, A dollar rested in checking account of purse for .14 of a year in 2006. K(i) in 2007 = 1/8 = .125, A dollar rested in checking account of purse for .125 of a year in 2007. Since the K(i) fell from 2006 to 2007, it implies that interest rates rose between 2006 and 2007. 62. ROI = (cost savings + resale value ? price)/price * 100% or {(10,000 + 10,000 ? 18,000)/18,000}*100 = 11.11% Since the next best alternative (the nominal interest rate) is less than the ROI (11.11 %> 7.5%), the firm should use its funds to buy the new copy machine. 63. ROI = (net revenues + resale value ? price)/price * 100 or ROI = [(2000 + 1600 ? 3000)/3000]* 100 = 20% Since ROI for this project is higher than 5%--the rate the business earns in the mutual fund?this business should use its funds to buy the computer. 64. The increase in the overall labor productivity affects the AS curve. The increase in productivity shifts aggregate supply down (and pictorially, to the right). 65. i) As G increases, the AD curve shifts to the right. ii) As exports decrease the AD curve shifts to the left. 66. a. SHAPE \* MERGEFORMAT Given the ROI for various investment projects, if the rate of interest falls, the quantity of viable investment projects will increase. So the quantity of investment goods demanded will go up. (Graph below). SHAPE \* MERGEFORMAT b. The AD1 shifts to the right (to AD2), RGDP increases in the short run and so does the GDP deflator. SHAPE \* MERGEFORMAT c. If the Central bank is mistaken, then AD will move beyond the potential RGDP and in the short run, the RGDP moves beyond its full employment level and the inflation rate rises. SHAPE \* MERGEFORMAT 67. i) M% = K(i)% + Q% + P% Since interest rate is stable at 4% over the long run, then K(i) does not change, that is K(i)% = 0 in steady state. Therefore, 5% = 0 + 2.5% + P% or inflation rate is 2.5%. P% = 2.5% ii) Again, M% = K(i)% + Q% + P%. Here, keeping Q% and P% unchanged, the increase in M%, will increase K(i)%, therefore the resting time for money increases. This means that interest rates have dropped. [You can also verify this from a graph of money supply and money demand. Keeping the demand for money constant (when RGDP and GDP deflator are constant), an increase in the money supply reduces interest rate.] 68. a. ROI = (cost savings + resale value ? price)/price * 100% or (15,000 + 27,000 ? 40,000)/40,000 = 5% Since the ROI at 5% > the interest rate at 4%, the firm should use its funds to buy the new truck. b. Given the ROI for various investment projects, if the rate of interest is raised to 5.5%, the quantity of viable investment projects will decrease. So the quantity of investment goods demanded will fall. (Graph below). SHAPE \* MERGEFORMAT c. The Fed?s contractionary monetary policy lowers AD; this leads to a fall in RGDP (back to Potential RGDP) and also a fall in the aggregate price level. SHAPE \* MERGEFORMAT 69. The increase in productivity shifts aggregate supply to the right. The increase in wages will shift the AS to the left. 70. AD = C + I + G + X - M i) Since imports are subtracted from exports and appear with a negative sign, a decrease in imports increases AD and shifts it to the right. ii) An increase in investment will increase AD and shift it to the right. 71. a. The CBT should buy Treasury securities. SHAPE \* MERGEFORMAT SHAPE \* MERGEFORMAT b. The CBT policy restores the economy to full employment equilibrium. (Graph below). SHAPE \* MERGEFORMAT SHAPE \* MERGEFORMAT c. If CBT is incorrect in its forecast, then RGDP will increase beyond PRGDP and prices will start to rise after some time lag. This is the short run equilibrium. SHAPE \* MERGEFORMAT If the CBT keeps the easy monetary policy going, higher inflation rate will be a fact of life and the public will adjust its expectations of inflation to higher rates. In time, the workers will demand higher wages in order to keep up their standard of living (real wage). As wages rise, AS curve shifts to the left and inflation rates rise further while the RGDP goes back toward PRGDP. The result is a higher long run inflation rate while the level of economic activity is restored at the long run level on the graph above (or considering growth rates rather than levels, the rate of growth of RGDP goes back to its long run equilibrium). According to the Fisher Hypothesis, due to higher inflation rates in the long run, the nominal interest rates will be higher too. 72. a. The CB sells government bonds. The variable immediately affected is the interest rate, which rises. b. Given the ROI on various investment projects, the higher the rate of interest, the fewer of these projects will be viable. Hence the quantity of investment goods demanded will fall. c. The action of the Central Bank brings down the demand (from AD0 to AD1). If the Central Bank is incorrect in its forecast, then a recession will result. 73. a. CBC needs to buy government bonds. SHAPE \* MERGEFORMAT i) In the short run, RGDP goes up and the GDP deflator follows with some time lag. In the long run, as the central bank maintains an expansionary monetary policy the AS graph shifts. In the graph of AD/AS below, the AS shifts back due to higher wages (demanded by workers to offset their falling purchasing power as inflation rate rises) and the RGDP falls back to its long run Potential RGDP and prices rise even higher. In growth rate terms, the growth rate of RGDP falls back to its long run steady state and the inflation rate settles at a high inflation steady state. The long run effect of Fed?s mistake is just higher inflation rates. SHAPE \* MERGEFORMAT Clearly, due to the Fisher hypothesis, the nominal interest rates in Chile will be higher under scenario b! This happens due to the inflation creating policy by the Central Bank of Chile. The Fisher hypothesis operates in the long run when the CBC?s policy of preventing a recession turns out to be a mistake! 74. a. The general procedure for monetary policy: The central bank increases the money supply. - interest rates fall - investment activity is encouraged - AD increases and so does the RGDP b. In a deep recession, interest rates are already quite low as demand for loans dries up. The central bank is able to only lower rates slightly, failing to bring about a large effect on investment and AD. Also, banks may not want to lend to many businesses in a recessionary time, as borrowers look less creditworthy in bad times. Furthermore, many businesses may postpone their expansion plans or other investment plans in a recession and so demand for loans by businesses also dries up. Therefore, the monetary policy is ineffective in eliminating the recession. The Keynesian economist would like to see fiscal measures employed for eliminating the recession: 1. Increasing the government expenditures, 2. Tax cuts. c. Due to the "expenditure Multiplier" effect, the government needs to spend only a fraction of $200 billion to close a recessionary gap of $200 billion. 75. a. Change in RGDP = Change in G * [1/(1-MPC)]. Change in G = 100*.25 = $25 billion b. Change in RGDP = Change in Tax * [MPC/(1-MPC)]. Therefore, change in taxes (tax cut) necessary to increase RGDP is: Change in Tax = 100 *.25/.75 = $33.3 billion c. The amount of tax cut needed is higher than that of G increase, since the public that receives the tax cut, they will save .25 of every dollar and not spend it. The government does not save so the initial effect with government expenditures is higher and therefore the amount of G increase to achieve $100 billion increase in income and expenditures is lower than the needed tax cut for the same desired effect on RGDP. 76. a. Change in Money supply = Change in Reserves * 1/rr Change in Res = 50*.12 = $6 billion b. SHAPE \* MERGEFORMAT SHAPE \* MERGEFORMAT If the Central Bank is correct in its forecast, then it will put the demand forward to AD2 so the AD and AS intersect at potential RGDP and the threat of recession is over. c. SHAPE \* MERGEFORMAT If the Central Bank is incorrect, the, AD moves from AD1 to AD2. The RGDP increases beyond its potential level and after some time lag price rise as well. 77. a. Change in RGDP = Change in G * [1/(1-MPC)]. Change in G = 200*.20 = $40 billion b. Change in RGDP = Change in Tax * [MPC/(1-MPC)]. Therefore, change in taxes (tax cut) necessary to increase RGDP is: Change in Tax = 200 *.20/.08 = $ 50 billion PAGE PAGE 1