ECON 352x Problem Set 1

Spring 2022

Professor F. Ibrahimi-Nazarian

Table 1-2

Hours Total Revenue

Open (dollars)
1 $40
2 65
3 80
4 90
5 95
6 98

Julius runs a small tailor shop in the city of Bloomfield. He is debating whether he should extend his hours of operation.
Julius figures that his sales revenue will depend on the number of additional hours the tailor shop is open as shown in the
table above. He would have to hire a worker for those hours at a wage rate of $18 per hour.

1) Refer to Table 1-2. What is Julius's marginal benefit if he decides to stay open for three hours instead of two
hours?
A) $15 B) $25 C) $65 D) $80

2) Refer to Table 1-2. What is Julius's marginal cost if he decides to stay open for three hours instead of two
hours?
A) $0 B) $18 C) $54 D) $65

3) What is the difference between economic efficiency and equity?

4) What is a market economy?

5) Define allocative efficiency. Explain the significance of this concept in economics?

6) The economic analysis of minimum wage involves both normative and positive analysis. Consider the
following consequences of a minimum wage:
a. The minimum wage law causes unemployment.
b. Unemployment would be lower without a minimum wage law.
c. Minimum wage laws benefit some workers and harm others.
d. The minimum wage should be more than $7.25 per hour.

Which of the consequences above are positive statements and which are normative statements?
A) a, b, and c are positive statements and d is a normative statement.
B) a and b are positive statements, c and d are normative statement.
C) Only a is a positive statement, b, c, and d are normative statements.
D) a and c are positive statements, b and d are normative statements.

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 7) Which of the following is a normative economic statement?
A) Falling global demand for pesticides has led to decreases in the price of pesticides.
B) With falling mortgage rates and falling unemployment rates, the number of new homes being built has
increased.
C) The state of Florida's unemployment rate dropped when several large companies relocated to the Miami
area.
D) Global warming should be at the top of every economic agenda.

8) Which of the following are positive economic statements and which are normative economic statements?

a. An increase in the minimum wage causes unemployment.

b. The government should raise the minimum wage above $7.25 per hour.
c. The prolonged recession has caused the unemployment rate to reach a 30-year high.
d. Interest rates need to be lower for the economy to emerge from the recession.
e. Inflation has decreased since the onset of the recession.
f. Once the recession has ended, interest rates should increase to assure that inflation does not go up.

9) Which of the following would be directly counted in GDP in 2020?

A) kitchen cabinets purchased from Home Depot in 2020 to be installed in a house built in 1997
B) kitchen cabinets built in 1887, extracted from the 1887 home, and installed in a brand new country-style
home
C) kitchen cabinets built in 1887, extracted from the 1887 home, and installed in a farm house built in 1950
D) none of the above

Table 8-5

Stage of Production Seller Buyer Price

1 Steel mill Auto manufacturer $10,000
2 Auto manufacturer Auto dealer 18,000
3 Auto dealer Consumer 25,000

Consider the table above showing three stages of production of an automobile.

10) Refer to Table 8-5. The value added by the automobile dealer equals
A) $7,000. B) $15,000. C) $18,000. D) $25,000.

11) Emily is a writer, and uses her tablet computer to write a 500-page novel that she sells to a publishing company
for $500,000. If the publisher prints 1 million copies that sell for $25 each, what is the contribution to GDP of
Emily's novel?
A) $25 million B) $20 million C) $500,000 D) $50,000

12) The Bureau of Economic Analysis divides it's statistics on GDP into four major categories. List the categories of
expenditures and define each.

13) Why do we subtract import spending from total expenditures?

14) Describe briefly how the final value of an iPhone which costs $900 must be equal to the sum of incomes
generated by the production of the iPhone.

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Table 8-8

Product Quantity Price

Sweaters 50 $50.00
CDs 150 10.00
Sugar 600 1.00
Soft drinks 800 0.75

15) Refer to Table 8-8. Suppose that a simple economy produces only four goods and services: sweaters, CDs,
sugar, and soft drinks. Assume one half of the sugar is used in making the soft drinks and the other half of the
sugar is purchased by households. Calculate nominal GDP for this simple economy.

Table 8-9

Product Quantity Price per Unit

Steel 1,000 $100
iPods 5,000 200
Autos 500 25,000
Legal services 100 2,000

16) Refer to Table 8-9. Suppose that the above table represents the goods and services produced in a very simple
economy in 2020. Assume that steel is used as an input in the production of autos. Using that information,
calculate GDP for the year 2020.

17) The table below describes the value added in the production of a gallon of gasoline by each stage of production.
(The values are hypothetical.)
Table 8-10

Stage of Production Value of Sales Value Added

Oil drilling 0.75
Refining 1.25
Shipping 1.85
Retail sales 3.65

a. What is the value added by each stage of production?

b. What is the total value added?
For simplicity, you can ignore the cost of the inputs for oil drilling.

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 Article Summary
While gross domestic product (GDP) measures the size of a nation's economy and is widely used as an indicator of
living standards, it does have limitations in that it does not fully take into account quality of life. GDP does measure
the value of goods and services produced in an economy, but it does not take into account any positive or negative
effects resulting from the production process, including such things as environmental damage or health issues. GDP
also focuses on production, whereas today's society is increasingly driven by the growing service sector. In attempting
to more accurately represent modern economies, some countries have developed alternative measurements of
well-being to complement the data measured by GDP. India is one of these countries, and its Ministry of Housing and
Urban Affairs has developed the Ease of Living Index which is designed to measure quality of life as well as
economic ability and sustainability. These new measurements are expected to provide more accurate insights into
development, living standards, income distribution, and overall well-being within societies.
Source: Amit Kapoor and Bibek Debroy, "GDP Is Not a Measure of Human Well-Being," Harvard Business Review,
October 4, 2019.

18) Refer to the Article Summary. India's Ease of Living Index is designed to measure quality of life as well as
economic ability and sustainability, which can all be considered as contributing to a person's well being. As it is
currently measured,
A) none of the factors used in measuring well-being is included in calculating GDP.
B) many factors of well-being are not considered in calculating GDP.
C) GDP calculations include all factors of well-being.
D) GDP calculations include factors of human well-being but not corporate well-being.

19) Refer to the Article Summary. Today's society is increasingly driven by the growing service sector, and this
includes an increasing amount of information and entertainment delivered free-of-charge via social media. All
else equal, these free services being provided by social media will result in GDP being ________ what it would
be if consumers had to pay for these services.
A) higher than B) lower than
C) equal to D) negative compared to

20) Even though it is generally true that the more goods and services people have, the better off they are, GDP
provides only a rough measure of well-being. Assuming language is not an issue, what other factors besides
GDP might you consider when deciding where to live and work?

21) What is the underground economy and how could it hurt an economy? How does it hurt developing
economies?

22) China's current rate of GDP growth is quite rapid. Its current growth rate is probably three times that of the
United States. However, the levels of pollution are much higher in China. Would you consider China to be
better off than the United States given this information? Why or why not?

Table 8-19

2019 2020
Nominal GDP $10,000 $12,000
Real GDP 9,500 10,500

23) Refer to Table 8-19. Given the information above, calculate the GDP deflator in 2020.
A) 114 B) 105 C) 95 D) 87

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 24) Refer to Table 8-19. Given the information above, calculate the GDP deflator in 2019.
A) 87 B) 95 C) 105 D) 114

25) Refer to Table 8-19. Given the information above, calculate the rate of increase in the price level from 2019 to
2020.
A) 8.6% B) 7.9% C) -7.9% D) -8.6%

Table 8-24

2019 2020
Nominal GDP $10,000 $15,000
Real GDP 9,500 10,500

26) Refer to Table 8-24. Given the following information, calculate the rate of increase in the price level from 2019
to 2020. Use the percent change in the GDP deflator.

Table 8-30

Billions of
Dollars
National income $7,400
Retained earnings 480
Depreciation 660
Interest on government bonds 450
Transfer payments 1,000
Personal taxes 1,100

27) Refer to Table 8-30. The table above represents hypothetical data from the National Income Accounts for 2020.
Use the data to calculate personal income and disposable personal income.

28) Suppose 180,000 people are employed, 20,000 people are unemployed, the working-age population is 250,000,
and 50,000 people are not in the labor force. Calculate the unemployment rate.

29) Suppose 180,000 people are employed, 20,000 people are unemployed, and 50,000 people are not in the labor
force. Calculate the labor force participation rate.

30) Describe the three types of unemployment.

31) Explain what economists mean by full employment and why this rate of unemployment is not zero.

32) To understand why someone cannot get a job, it helps to know the three types of unemployment. List the three
types of unemployment and explain what causes each type. What advice for finding a job would be
appropriate for someone in each type of unemployment?

33) A central concept in macroeconomics is the idea of the natural rate of unemployment. Why does it make sense
to define full employment to occur when the unemployment rate equals the natural rate of unemployment,
instead of when the unemployment rate equals zero? Elaborate and explain carefully.

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34) Which of the following explains why many European countries have unemployment rates that are higher than
in the United States?
A) Technological change occurs at a faster rate in Europe, so structural unemployment is higher in Europe.
B) European countries offer higher unemployment benefits than the United States.
C) Firms in European countries offer employees higher wages and higher benefits than do firms in the
United States.
D) The minimum wage in Europe is lower than it is in the United States.

35) Discuss the likely impact of each of the following on the unemployment rate:
a. The length of time workers are eligible to receive unemployment insurance payments is cut in half.
b. The government passes a law making labor unions illegal.
c. The minimum wage is raised by 50 percent.
d. The government funds an Internet site where companies can post job openings at no charge.

36) What are some reasons why the unemployment rate is typically lower in the United States as compared to
Canada and some Western European countries?

37) List three different price indices and explain how they differ in terms of the market basket on which they are
based.

38) What is the difference between the nominal interest rate and the real interest rate?

39) What is labor productivity? How does a country's standard of living relate to labor productivity?

40) What factors increase potential GDP? Include a definition of potential GDP in your answer.

41) When potential GDP increases, is it necessarily the case that real GDP increases as well? Explain.

42) Explain why a centrally planned economy might not grow as rapidly as a market economy.

43) Suppose you are a famous international economic advisor. You have been asked to asses the possibilities for
growth in an African country. It is a country abundant in labor and some natural resources. The
capital-to-labor ratio is low. It has a free market economy. You have found that this country does not have a
very strong and healthy banking system, however the political system is stable and the government does a
good job protecting property rights. Assess this country's prospects for growth. Recommend two things that
would enhance the country's growth.

44) Outline the various actions the government sector could take to promote growth.

45) Define the two categories of saving in the economy.

46) Explain, in detail, how the adjustment to macroeconomic equilibrium occurs when spending is less than
production. Be sure to discuss how inventories play a crucial role in the adjustment process. State what
happens to GDP and employment during the adjustment process.

47) What are inventories? What usually happens to inventories at the beginning of a recession, and what usually
happens to inventories at the beginning of an expansion?

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48) Why do economists care about aggregate expenditures?

49) What is the main reason for changes in GDP in the short run?

50) Ceteris paribus, how does a recession in the United States affect U.S. net exports?

51) Explain how a stock market crash has the potential to lead to a recession in an economy.

52) Suppose the United States experiences a long period of high inflation relative to other countries. How will this
affect U.S. net exports?

53) What are the four categories of aggregate expenditure?

54) Ceteris paribus, how does an expansion in the United States affect U.S. net exports?

55) What are the five main determinants of consumption spending? Which of these is the most important?

56) What impact does a higher price level have on interest rates, wealth, and investment spending?

57) C = 2,800 + 0.9Y

I = 750
G = 1,200
NX = 150

Given the equations for C, I, G, and NX above, what is the equilibrium level of GDP (Y)?

58) C = 3,600 + (MPC)Y

I = 1,200
G = 1,400
NX = -200

If the equilibrium level of GDP is $30,000, using the equations for C, I, G, and NX shown above, find the value
of the marginal propensity to consume.

59) What are the major factors affecting the long-term growth of the economy's output?

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60) Determine whether each of the following is a positive or normative statement.
(a) The Fed should lower interest rates to increase economic growth, because we're in a recession.

(b) Higher government budget deficits cause higher interest rates.

(c) The trade deficit should decline because of the fall in the value of the dollar.

(d) Because of our high inflation rate, we must reduce the rate of money growth.

(e) A generous unemployment insurance system is a primary cause of high unemployment in Europe.

(f) Increased average labor productivity in a country should lead to faster growth.

(g) Government budget deficits are too high in the United States and should be reduced.

61) Compare and contrast the classical and Keynesian schools of thought for the following economic issues.
(a) The flexibility of wages and prices.

(b) The importance of macroeconomic policies.

62) In 1993, the debate heated up in the United States about the North American Free Trade Agreement (NAFTA),
which proposed to reduce barriers to trade (such as taxes on or limits to imports) among Canada, the United
States, and Mexico. Some people opposed strongly the agreement, arguing that an influx of foreign goods
under NAFTA would disrupt the U.S. economy, harm domestic industries, and throw American workers out of
work. How might a classical economist respond to these concerns? Would you expect a Keynesian economist to
be more or less sympathetic to these concerns than the classical economist? Why?

63) Describe the three different approaches to measuring the amount of economic activity that occurs during a
period of time and explain why they all give identical measurements.

64) What is the main conceptual difference between GDP and GNP? How different are GDP and GNP for the
United States? For countries with many citizens who work abroad?

65) How are net exports, net factor payments from abroad, and the current account balance related?

66) In a given year, a country's GDP = $3843, net factor payments from abroad = $191, taxes = $893, transfers
received from the government = $422, interest payments on the government's debt = $366, consumption =
$3661, and government purchases = $338. Calculate the values of private saving, government saving, and
national saving.

67) What is the difference between nominal and real economic variables? Why do economists tend to concentrate
on changes in real magnitudes?

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68) The country of Myrule has produced the following quantity of gauges and potatoes, with the price of each
listed in dollar terms.

Year
1 2
Quantity Price Quantity Price
Gauges 8000 $4 10,000 $3
Potatoes 6000 $8 5000 $14

(a) Using Year 1 as the base year, what is the growth rate of real GDP from Year 1 to Year 2?

(b) Based on the GDP deflator, what is the inflation rate from Year 1 to Year 2?

69) By how much does the CPI overstate true increases in the cost of living, according to the Boskin Commission?
What are the main reasons for this bias in the CPI? What are the economic implications of the bias?

70) The nominal interest rate is 7%, today's price level is 150, and you expect the price level to be 156 one year from
now. What is the expected inflation rate? What is the expected real interest rate?

71) Suppose the economy's production function is Y = AK0.3 N0.7 . Suppose K = 200, N = 2000, and A = 1.
Calculate the marginal products of labor and capital.

72) Suppose a firm's hourly marginal product of labor is given by MPN = A (200 - N).
(a) If A = 0.2 and the real wage rate is $10 per hour, how much labor will the firm want to hire?

(b) Suppose the real wage rate rises to $20 per hour. How much labor will the firm want to hire?

(c) With the real wage rate at $10 per hour, how much labor will the firm want to hire if A rises to 0.5?

73) The marginal product of labor (measured in units of output) of a firm is given by
MPN = A(2000 - N)
where A measures productivity and N is the number of labor hours used in production. Suppose the price of
output is $6 per unit and A = 0.002.
(a) What will be the demand for labor if the nominal wage is $18?

(b) What will be the demand for labor if the nominal wage rises to $21?

74) Over the past 100 years, what has happened to the average workweek in the U.S. manufacturing industry?
Why has this occurred? What are the implications for the size of the income and substitution effects?

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75) In each of the following scenarios, state whether the labor supply curve would shift to the left, to the right, not
shift at all, or if the shift is ambiguous because there is more than one effect and they would move the curve in
opposite directions.
(a) The stock market rises sharply.

(b) Fewer teenagers work while in school than before.

(c) A large fraction of the population flees the country because of a bird flu epidemic.

(d) The expected future wage declines and the stock market crashes.

(e) The current real wage rate rises.

76) Suppose oil prices fall temporarily, as oil becomes more plentiful. What impact is this likely to have on the
production function, the marginal products of labor and capital, labor demand, employment, and the real
wage?

77) Suppose the marginal product of labor in the economy is given by MPN = 200 - 0.5 N, while the supply of labor
is 100 + 4w.
(a) Find the market-clearing real wage rate.

(b) What happens if the government imposes a minimum wage of 40? Is there involuntary unemployment?

(c) What happens if the government imposes a minimum wage of 60? Is there involuntary unemployment?

78) How would each of the following events affect the level of employment and the real wage rate? Explain which
curves in the labor market diagram would be affected and show your work.
(a) The stock market falls sharply.

(b) A war destroys a substantial amount of a country's physical capital.

(c) A new law reduces immigration of workers into the country.

79) How would each of the following events affect the level of employment and the real wage rate?
(a) A tremendous boom occurs in the stock market, increasing people's wealth by $100 billion overnight.

(b) A major government loan-guarantee program goes bust, losing $500 billion. To pay off the loss, the
government announces that tax rates will rise 30% in the future.

(c) A nuclear mishap contaminates all auto plants in the Detroit area, destroying their capital.

(d) Medical science cures the common cold, causing fewer work days lost due to illness, thus greatly increasing
labor productivity.

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80) In April 2000, the United States had a labor force of 141,230,000, employment of 135,706,000, and there were
67,986,000 people not in the labor force (all numbers rounded to the nearest 1000).
(a) Calculate the unemployment rate.

(b) Calculate the participation rate.

(c) Calculate the employment ratio.

81) What is the marginal propensity to consume, and why is it always less than one?

82) How would the expected real after-tax rate of return be affected by each of the following events?
(1) the tax rate on interest income increases
(2) expected inflation declines

83) The nominal interest rate on taxable bonds is 8%, while on municipal bonds (which aren't taxable) it is 5%. The
expected inflation rate is 3% and the tax rate on interest income is 40%. Calculate the expected real after-tax
interest rate on both bonds. Which would be the better investment? Now suppose the actual inflation rate
turned out to be 6%. Which bond was the better investment? Would your answer change if inflation had turned
out to be 0%?

84) What is the q theory of investment? Who developed it? What is q, and what do different values of q imply?
How is q related to the stock market value of a firm and its capital stock?

85) Identify two variables that shift the desired investment curve. Is desired investment negatively related or
positively related to each of these variables?

86) What are the economic consequences of reductions in defense spending by the government? What happens to
national saving, the interest rate, and investment?

87) Use a saving-investment diagram to explain what happens to saving, investment, and the real interest rate in
each of the following scenarios in a closed economy.
(a) Current output rises due to a temporary productivity increase.
(b) The tax code changes so that business firms face higher tax rates on their revenue (offset by other
lump-sum tax changes so there's no overall change in tax revenue).
(c) The government increases spending temporarily for a one-year project to turn mercury into gold.
(d) The average educational level rises, inducing an increase in the future marginal productivity of capital.

88) Use a saving-investment diagram to explain what happens to saving, investment, and the real interest rate in
each of the following scenarios in a closed economy.
(a) In an agricultural economy, great weather this year promises a bumper crop next year, leading citizens to
expect higher income next year.
(b) Government regulations going into effect next year will reduce the marginal product of capital.
(c) The government increases lump-sum taxes on citizens.

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89) An economy has full-employment output of 5000. Government purchases are 1000. Desired consumption and
desired investment are given by
C d = 3000 - 2000r + 0.10Y
Id = 1000 - 4000r
where Y is output and r is the expected real interest rate.
(a) Find the real interest rate that clears the goods market. Assume that output equals full-employment output.
(b) Calculate the amount of saving, investment, and consumption in equilibrium.
(c) If a shock to wealth causes desired consumption to decline by 200 (so that the new equation for desired
consumption is C d = 2800 - 2000r + 0.10Y), find the equilibrium real interest rate, saving, investment, and
consumption.

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Answer Key
Testname: ECON 352X PROBLEM SET 1

1) A
2) B
3) Economic efficiency is concerned with maximizing the value of output that can be generated by a given resource
base while equity deals with the distribution of society's total output among the sectors and individuals of society.
4) A market economy is an economy in which the decisions of households and firms interacting in markets allocate
economic resources.
5) Allocative efficiency is an efficiency criterion that describes a situation where the marginal benefit (or marginal
valuation) of the last unit purchased is equal to the marginal cost of producing that unit. In other words, allocative
efficiency occurs when production reflects consumer preferences. This is a significant concept in that all societies
face scarcity which necessitates that societies make choices about what goods and services to produce. To maximize
society's wealth, resources must flow to their highest valued use. This value is determined by consumers.
6) A
7) D
8) Statements a, c, and e are positive economic statements. Statements b, d, and f are normative economic statements.
9) A
10) A
11) A
12) The largest category of expenditures is consumption expenditures. These are purchases by households of final
goods and services. They can be divided into purchases of services, nondurable goods (goods that last less than 3
years) and durable goods (goods that last for longer than 3 years). Consumption spending does not include
purchases of housing. Spending by firms on new factories, office buildings, machinery and inventories and
spending by households on new houses is the second category of spending called investment spending.
Government consumption and gross investment make up the third category of spending called government
purchases. Government purchases include purchases by state, federal, and local governments. Finally, net export
spending makes up the last category of expenditures. This is exports minus imports. Imports are purchases of
foreign goods and services by the domestic economy, and exports are purchases of domestic goods and services by
foreigners.
13) Import spending is defined as spending on goods and services that are produced in foreign countries. When we
total up consumption expenditures, investment spending, and government spending, this total includes spending
on goods and services, regardless of where they are produced. That is, it includes some import spending. We must
then subtract the value of import spending from total expenditures because we would be including spending on
goods and services that is not the result of production of newly produced goods and services in the United States.
We want total expenditures to reflect expenditures on final goods and services produced in the domestic economy.
14) Consider the value of an iPhone which costs $900. Part of the $900 goes to Apple in the form of profit. Part of the
$900 goes to the firms that sold Apple the parts that made up the iPhone. Part of the $900 goes to the workers that
built the iPhone. A portion of the $900 goes to pay the sales clerk who sells the iPhone. Part of the $900 goes to the
trucking company that shipped the iPhone. In fact, all of the value of the $900 ends up as income for someone in the
economy. If we extend this idea to the entire economy and add up the value of all goods and services, then the total
will equal the total amount of income in the economy.
15) Nominal GDP equals (50 × $50) + (150 × $10) + ((600 × .5) × $1)) + (800 × 0.75) = $4,900.
16) First, we must decide which goods to include in the calculation of GDP. GDP is defined as the money value of final
goods and services produced. Since steel is included in the production of autos, it is an intermediate good, not a
final good. So steel should be excluded from the calculation. Final goods and services are goods and services
consumed by the ultimate user of the good or service. All the other goods and services in the table are considered
final goods.
Next, the money value of these final goods and services must be calculated. The money value is found by
multiplying the price of the good or service times the quantity produced of that good or service. The total money
value is found by summing up the individual money values. Thus GDP for 2020 = ($200 × 5,000) + ($25,000 × 500) +
($2,000 × 100) = $1,000,000 + $12,500,000 + 200,000 = $13,700,000.
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Answer Key
Testname: ECON 352X PROBLEM SET 1

17) Stage of Production Value of Sales Value Added

Oil drilling 0.75 $0.75
Refining 1.25 0.50
Shipping 1.85 0.60
Retail sales 3.65 1.80
$3.65

a. The value added is the difference between the price the firm sells a good for and the price it paid other firms for
the intermediate good. The firm that does the oil drilling sells the gallon of oil to the refinery for $0.75. Since we are
assuming no other input costs for simplicity, the value added by the drilling firm is $0.75. The refinery processes
the oil and then sells it to the transport company for $1.25. The refinery's value added is $0.50. The transport
company sells the oil to the retail company for $1.85. The transport company's value added is $1.85 - $1.25 = $0.60.
Finally, the retail gas station sells the gallon of gas for $3.65. The value added by the retail station is $1.80.
b. The total value added is found by summing the value added by each firm involved the production of the gallon
of gas. The retail price is the same at this total of value added.
18) B
19) B
20) Factors not included in GDP which you might consider include the value of leisure, levels of pollution, crime levels,
and other social problems. All of these factors are not included in GDP measurements, yet may be very important in
making a decision concerning your well-being.
21) The underground economy is that part of the economy involved in buying and selling of goods and services that
are concealed from government to avoid taxes or regulations or because the goods and services are illegal. This
sector of the economy can serve as a drag on the economy. Firms that participate in the underground economy face
the possibility of the government finding out about their operations and shutting them down because they are
acting illegally. They tend to be smaller, and invest less in capital. Since workers in this sector have less capital to
work with, they are less productive, and produce fewer goods and services. The firm also incurs costs to avoid
discovery by the government by paying bribes and hiring lookouts. These are resources that could be used in other
productive activities. Because of these reasons, this sector of the economy is not as productive as it might be if it
were legal. Less goods and services are produced. This is not an insignificant problem as the underground sector
can be large in developing countries as high tax rates drive many firms to the underground sector to seek ways to
avoid taxes.
22) China is not better off because of higher rates of growth of GDP. GDP is not a perfect measure of well-being. GDP is
not adjusted for pollution or other negative effects of production. Certainly the rapid growth of GDP raises the
standards of living of many in China. However, this comes at a cost of dirty air and water. According to the World
Health Organization, seven of the ten most polluted cities in the world are in China. This pollution can result in
negative health effects. The improvement in standards of living affect well-being in a positive manner, but the
increased pollution has a negative effect on well-being. In addition, GDP per capita may be a better measure of
standard of living rather than growth in GDP.
23) A
24) C
25) A

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Answer Key
Testname: ECON 352X PROBLEM SET 1

26) To calculate the rate of change of prices, the GDP deflator for 2019 and 2020 must be determined.

10,000
The GDP deflator for 2019 = × 100 = 105.3
9,500

15,000
The GDP deflator for 2020 = × 100 = 142.9
10,500

142.9 - 105.3
= 35.7%
105.3
27) Personal income = National income - Retained earnings + Transfer payments + Interest on government bonds.
Substituting the table values:
Personal income = $7,400 - 480 + 1,000 + 450
= $8,370 billion.

Disposable personal income = Personal income - Personal taxes

= $8,370 - 1,100 = $7,270 billion.
28) The unemployment rate is calculated as:

Number of unemployed × 100

Labor force
The labor force is the sum of those employed plus the unemployed. This is 180,000 plus 20,000 which equals
200,000 people. Substituting this information into our equation, we get:

20,000 × 100
200,000
which equals 10%.
29) The labor force participation rate is calculated as:

Labor force × 100

Working-age population

The labor force is the sum of those employed plus the unemployed. This is 180,000 plus 20,000 which equals 200,000
people. The working-age population is the sum of those in the labor force and those out of the labor force. This is
200,000 plus 50,000 which equals 250,000. Substituting this information into our equation, we get:

200,000 × 100
250,000
which equals 80%.
30) Frictional unemployment is short-term unemployment that arises from the process of matching workers with jobs.
Structural unemployment arises from a persistent mismatch between the skills and attributes of workers and the
requirements of jobs. Cyclical unemployment is caused by a business cycle recession.

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31) Full employment occurs in the macro economy when cyclical unemployment is zero. The full-employment rate of
unemployment is then made up of the frictional rate of unemployment and the structural rate of unemployment.
Because it will always take time to find a job, frictional unemployment will never be zero. Also because demand
and technology are constantly changing in an economy, structural unemployment will never be zero. That is, some
workers will always lose their jobs as the demands for the products they make fall or disappear entirely.
32) Frictional unemployment is the unemployment that arises from the process of matching workers with jobs. These
workers are qualified; they just need to search for a job. The advice for finding a job would be to keep searching,
because there are jobs available for which they are qualified.
Structural unemployment is unemployment arising from a persistent mismatch between the skills and
characteristics of workers and the requirements of the jobs. The advice for finding a job would be to retrain so that
they can match up with the requirements of current jobs.
Cyclical unemployment is unemployment caused by a business cycle recession. The advice for finding a job
would be to hang in there and continue searching, but realize that there are less jobs available than the number of
applicants. The cyclically unemployed person could perhaps get a temporary job until the economy picks up, or
perhaps consider continuing his or her education while the business cycle slowdown lasts.
33) With a growing, dynamic economy where businesses expand and contract, technological change regularly occurs,
and people enter and leave the labor market on a continual basis, zero percent unemployment is not possible nor
desirable. Frictional unemployment and structural unemployment are normal parts of a healthy, growing economy.
With frictional unemployment, people and firms have to search for one another and that takes time. With structural
unemployment, technology changes and international competition cause people to have to retrain to match up with
the evolving job requirements. Economists, consequently, consider full employment to occur when the only
unemployment is frictional unemployment and structural unemployment.
34) B
35) a. The unemployment rate will likely decrease, since decreasing the time people are eligible to receive
unemployment benefits will increase the opportunity cost of searching for a job.
b. The unemployment rate will likely decrease, since companies will no longer have to pay above-market union
wages and will be able to afford to hire more workers.
c. The unemployment rate will likely increase since an increase in minimum wage will raise the wage above the
market wage for some workers.
d. The unemployment rate will likely decrease, since making information on job openings more available lowers
the search involved in frictional unemployment.
36) Workers in Western Europe and Canada are eligible for unemployment insurance benefits for about twice as long
as in the United States. In addition, some of the social insurance programs in these countries are more generous as
compared to the United States. This makes the opportunity cost of job search lower in Canada and Western Europe,
so unemployed workers in those regions will search longer for jobs. This increase in the duration of unemployment
raises the unemployment rate in these countries, relative to the United States.
37) Three examples of price indices are the GDP deflator, the consumer price index, and the producer price index. All
three differ by the kinds of goods that are contained in the market basket that is used to calculate the average level
of prices. The GDP deflator is based on the average price of all final goods and services produced. The consumer
price index is based on the average price of 211 goods/services purchased by the typical urban family of four. The
producer price index is based on the prices received by producers of goods and services at all stages of the
production process.
38) The nominal interest rate is the stated interest rate on a loan, while the real interest rate is the nominal interest rate
minus the inflation rate.
39) Labor productivity refers to the amount of goods and services produced per worker. Per capita real GDP increases
only if labor productivity increases, so, increases in a country's standard of living are tied to increases in labor
productivity.

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40) Potential GDP is the level of GDP attained when all firms are producing at capacity. Growth in potential GDP is
determined by growth in the labor force and the capital stock and by technological change. Capital investments
accompany growth in the labor force, encouraging technological progress and increasing potential GDP.
41) An increase in potential GDP is a result of an expanding labor force, growth in the capital stock, and technological
change. The actual level of real GDP may be higher or lower than potential GDP. If firms are all producing at
capacity, we would expect potential GDP and real GDP to be equal. If firms are producing below capacity, we
would expect real GDP to be below potential GDP. And if firms are temporarily producing above capacity, real GDP
will be above potential GDP.
42) Technological change is very important for growth. Simply accumulating inputs will not ensure growth unless
technological change occurs. This is essentially what happened in the Soviet Union. The Soviet Union failed to
enhance growth when it simply increased its capital to labor ratio because it did not foster technological change at
the same time. In a market economy, entrepreneurs make decisions about employing technology and seeking
innovations. If the entrepreneur makes a correct decision, then he or she stands to make a large profit. In a centrally
planned economy, these decisions are made by managers employed by the government. If the innovation works
out, the manager may not reap any sort of benefit from it. Likewise, if the innovation fails, the manager's financial
position is unaffected. Because of this, managers employed by the central government may be slower to adopt new
technologies as compared to entrepreneurs in a market economy. The profit incentive spurs entrepreneurs in
market economies to move more quickly.
43) The prospects for this country's growth are fairly good. It has a lot of labor and natural resources. Having abundant
factors of production can contribute to strong growth. The free market system is also another characteristic that
should help enhance economic growth. Entrepreneurs can respond quickly and adopt technological innovations.
We know that technological change can increase labor productivity. Also the fact that the government enforces
property rights can help the free market to flourish. The political stability of the government is also a good sign.
Investors won't be afraid to risk investing in the country. Two things the country could do to increase growth
would be to raise the capital-to-labor ratio and develop the financial sector. The country could increase the
capital-to-labor ratio by attracting foreign investment, or perhaps giving tax breaks to firms that increase the
amount they invest. This is probably one of the most effective ways to increase growth.
44) The government should secure private property rights. Private property rights are crucial for a smoothly
functioning market system. The government should create a court system that will enforce contracts. It should also
assist in the development of the country's financial system. Additional endeavors include strengthening the
education, communication, and transportation systems.
45) There are two categories of saving in the economy: private saving by households and public saving by the
government. Private saving is what is left of income after consumption expenditures and income taxes. Public
saving is the amount of tax revenue that the government collects minus government expenditures and transfer
payments.
46) If spending is less than production, then firms will not be selling as many goods and services as they had expected.
Inventories of goods will start to build up. This sends a signal to those managing the retail firms to cut back on
orders of goods from their distributors. Distributors cut back purchases from manufacturers. Manufacturers of the
goods will cut back on production of the goods, and reduce purchases from their suppliers and lay off workers. The
reduction in production will continue until inventories equal their desired levels, or until spending equals
production. If this happens across many different industries, GDP and total employment will decline.
47) Inventories are goods that have been produced but not yet sold. Inventories rise at the beginning of a recession and
fall at the beginning of an expansion.
48) Increases and decreases in aggregate expenditures cause the year-to-year fluctuations in GDP. Economists devote
considerable time and energy to forecasting what will happen to each component of aggregate expenditure. If they
forecast aggregate expenditures will decline in the future, this is equivalent to saying that GDP will decline and the
economy will enter into a recession. This means fewer job opportunities, lower wages, and lower profits.
49) The main reason for changes in GDP in the short run is changes in the level of aggregate expenditure.

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50) As GDP decreases in the United States due to the recession, the incomes of households fall. Households respond by
lowering their purchases of goods and services. Some of the decline in purchases includes domestic goods and
services; some of the decline includes foreign produced goods and services. This essentially lowers imports.
Assuming that exports do not change, net exports will rise.
51) A stock market crash is essentially a substantial decrease in the average price of stocks. Stocks are a part of real
wealth. A stock market crash decreases the value of stocks which decreases real wealth. Real wealth is an important
determinant of consumption spending. If real wealth declines, so does consumption spending. Therefore, a stock
market crash will result in a decline in consumption expenditures. This will result in a decline in GDP. If the
decrease in GDP is substantial enough, this can lead to a recession.
52) If inflation in the United States is higher than inflation in other countries, then prices of products and services
produced in the United States increase more rapidly than the prices of products and services of other countries.
This difference in the price levels decreases the demand for U.S. goods relative to foreign goods. U.S. exports
decrease, imports increase, and U.S. net exports decline.
53) The four categories are consumption spending, planned investment spending, government purchases, and net
exports.
54) As GDP increases in the United States due to the expansion, the incomes of households rise. Households respond
by increasing their purchases of goods and services. Some of the increase in purchases includes domestic goods and
services; some of the increase includes foreign produced goods and services. This essentially raises imports.
Assuming that exports do not change, net exports will fall.
55) The five main determinants of consumption spending are current disposable income, household wealth, expected
future income, the price level, and the interest rate. The most important determinant is current disposable income.
56) A higher price level reduces the purchasing power of wealth, increases interest rates, and reduces investment
spending.
57) Y = C + I + G + NX.
Y = 2,800 + 0.9Y + 750 + 1,200 + 150.
Y = 4,900 + 0.9Y.
0.1Y = 4,900.
Y = 49,000.
58) Y = C + I + G + NX.
30,000 = 3,600 + (MPC)30,000 + 1,200 + 1,400 - 200.
30,000 = 6,000 + (MPC)30,000.
24,000 = (MPC)30,000.
0.8 = MPC.
59) The major factors are population growth and average labor productivity.
60) (a) Normative
(b) Positive
(c) Positive
(d) Normative
(e) Positive
(f) Positive
(g) Normative

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Testname: ECON 352X PROBLEM SET 1

61) (a) The flexibility of wages and prices is a principal point of disagreement between classical economists and
Keynesians. Classical economists believe that wages and prices are quite flexible; in response to a change in market
conditions, wages and prices adjust quickly to their new market-clearing levels. Keynesians believe that wages and
prices are rigid or sticky; in response to changes in the economy, wages and prices adjust slowly to their new
market-clearing levels.
(b) Classicals and Keynesians also disagree about the use of macroeconomic policies. Given wage-price flexibility,
classical economists believe that the market economy normally provides for full employment. They believe that
government intervention in the form of macroeconomic fiscal and monetary policies is not needed to prevent
recessions. Given slow adjustments in wages and prices, Keynesians believe that recessions could plague the
economy for several years. They believe that efficient use of macroeconomic policies could return the economy to
equilibrium more quickly.
62) A classical economist might argue that the economy would work more efficiently with NAFTA because it reduces
trade barriers, making the invisible hand work even better. Workers could specialize even more than before so that
total output produced by all three countries would be more. Though the industrial mix might change in each
country, wages and prices across industries would adjust quickly, and people in industries that closed down in a
particular country would quickly find new jobs.
A Keynesian economist might be more sympathetic to concerns about NAFTA because of the belief that adjustment
to the changes will not occur quickly. As a result, people in particular industries in a country may become
unemployed. Wages won't adjust quickly to restore full employment, so some government action (like retraining
programs to give displaced workers new skills) may be desirable.
63) The approaches are the product approach, which measures the amount of output produced; the income approach,
which measures the incomes received by producers of output; and the expenditure approach, which measures the
amount of spending by the ultimate purchasers of output. They give identical measurements because everything
that is produced is purchased by someone, so the expenditure and product approaches must be equal, and because
anything that is purchased means that someone is earning income in the same amount, so the expenditure and
income approaches must be equal.
64) GDP represents output produced within a country, while GNP represents output produced by a country's factors of
production; the difference is net factor payments from abroad. For the United States there's little difference, but for
countries that have many citizens working abroad, there may be a big difference.
65) NX + NFP = CA.
66) Private saving = Y + NFP - T + TR + INT - C = $3843 + $191 - $893 + $422 + $366 - $3661 = $268. Government saving
= T -TR - INT - G = $893 - $422 - $366 - $338 = -$233. National saving = Y + NFP - C - G = $3843 + $191 - $3661 -
$338 = $35.
67) Nominal variables are in units of money, while real variables are in physical quantities of output. We measure
nominal variables using current market prices and real variables using market prices in a given base year. Nominal
variables may increase, but you don't know if the increase is due to higher prices and the same quantity, or a higher
quantity with unchanged prices; real variables reflect just quantity changes. For the most part, real variables
(consumption, investment, and the capital stock) affect each other in the economy, with lesser roles played by
nominal variables (money supply, and price level).
68) (a) Real GDP for Year 1 = Year 1 quantities at Year 1 prices = (8000 × $4) + (6000 × $8) = $80,000.
Real GDP for Year 2 = Year 2 quantities at Year 1 prices = (10,000 × $4) + (5000 × $8) = $80,000.
Growth rate of real GDP = 0%
(b) Nominal GDP for Year 1 = Year 1 quantities at Year 1 prices = (8000 × $4) + (6000 × $8) = $80,000.
Nominal GDP for Year 2 = Year 2 quantities at Year 2 prices = (10,000 × $3) + (5000 × $14) = $100,000.
GDP deflator = nominal GDP/real GDP
GDP deflator in Year 1 = $80,000/$80,000 = 1.
GDP deflator in Year 2 = $100,000/$80,000 = 1.25.
Inflation rate = [(1.25/1) - 1] × 100% = 25%.

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Testname: ECON 352X PROBLEM SET 1

69) The Boskin Commission reported that the CPI overstates inflation by 1 to 2 percentage points per year. The bias
arises because of difficulty in measuring quality change (especially for services) and because the CPI doesn't
account for the substitution that people make between goods when relative prices change. The bias implies that our
measures of real income growth are understated and that Social Security benefits are being adjusted more than they
should be to account for inflation.
70) Expected inflation rate = 156/150 - 1 = 0.04 = 4%; expected real interest rate = 7% - 4% = 3%.
71) Using calculus, the marginal product of capital is dY/dK = 0.3A(N/K)0.7 and dY/dN = 0.7A(K/N)0.3 .
Plugging in the values for N and K gives: MPK = 0.3 (2000/200)0.7 = 1.5; MPN = 0.7 (200/2000)0.3 = 0.35. If you do
not use calculus, you can arrive at the same answer (rounded) by plugging the values of for A, N and K into the
production function to find Y = 1002.37. Increase K by 1 and recalculate Y; it is now 1003.88. The difference is the
MPK = 1003.88 - 1002.37 = 1.51. Increase N by 1 and recalculate Y; it is 1002.73. The difference is the MPN = 1002.73
- 1002.37 = 0.36.
72) (a) The firm will hire labor such that w = MPN, or 10 = 0.2(200 - N), so N = 150.
(b) Now 20 = 0.2(200 - N), so N = 100. The firm's labor demand falls when the wage rate rises.
(c) Now 10 = 0.5(200 - N), so N = 180. The increase in productivity increases labor demand.
73) (a) The real wage = $18/$6 = 3. Setting the real wage equal to the marginal product of labor gives 3 = 0.002(2000 -
N), so 0.002N = 1, so N = 500.
(b) The real wage = $21/$6 = 3.5. Setting the real wage equal to the marginal product of labor gives 3.5 = 0.002(2000
- N), so 0.002N = 0.5, so N = 250.
74) The average workweek in manufacturing has declined from about 56 hours a week a century ago to just over 40
hours a week more recently. The primary reason for the decline in the workweek is the higher real wage. This
suggests that the income effect of a permanently higher real wage dominates the substitution effect, as workers
choose to have more leisure and to work fewer hours per week.
75) (a) Higher wealth shifts the labor supply curve left.
(b) Lower participation rate shifts the labor supply curve left.
(c) Smaller working-age population shifts the labor supply curve left.
(d) The lower future wage shifts the labor supply curve to the right and the stock market crash reduces wealth,
also causing the labor supply curve to shift to the right.
(e) No effect; just a movement along the curve.
76) More output can now be produced by the same amounts of capital and labor, since oil is more abundant and
cheaper. The production function shifts upward, with the marginal products of labor and capital rising. Since the
marginal product of labor is higher, so is labor demand. As a result of the shift to the right in the labor demand
curve, employment rises, as does the real wage.
77) (a) The market-clearing real wage rate equates the demand and supply of labor. Setting w = MPN = 200 - 0.5 N
and solving for N gives N = 400 - 2w, which represents labor demand. Equating labor demand to labor supply
gives 400 - 2w = 100 + 4w, or 300 = 6w, or w = 50.
(b) A minimum wage of 40 has no effect, as it is below the market wage, so involuntary unemployment is 0.
(c) A minimum wage of 60 is binding, as it is above the market wage. At w = 60, labor demand is 400 - (2 × 60) =
280, while labor supply is 100 + (4 × 60) = 340. So unemployment is 60 workers.
78) (a) Lower wealth shifts the labor supply curve to the right; the new equilibrium has higher employment and a
lower real wage.
(b) The loss of capital lowers the marginal product of labor, reducing labor demand; the shift of the labor demand
curve to the left lowers the real wage and employment.
(c) Reduced labor supply causes a rise in the real wage rate in equilibrium and a decline in equilibrium
employment.

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Testname: ECON 352X PROBLEM SET 1

79) (a) Increased wealth reduces labor supply; the shift of the labor supply curve to the left brings a new equilibrium
with lower employment and a higher real wage.
(b) The loss of wealth increases labor supply, leading to higher employment and a lower real wage.
(c) The loss of capital lowers the marginal product of labor, reducing labor demand; the shift of the labor demand
curve to the left lowers the real wage and employment.
(d) Increased productivity increases the demand for labor; in equilibrium the real wage and employment increase.
80) (a) Unemployment = labor force - employment = 141,230,000 - 135,706,000 = 5,524,000, so the unemployment rate
is 5,524,000/141,230,000 = 3.9%.
(b) The participation rate is the fraction of the adult population in the labor force. The adult population is the labor
force + the number not in the labor force = 141,230,000 + 67,986,000 = 209,216,000. The participation rate is then
141,230,000/209,216,000 = 67.5%.
(c) The employment ratio is the employed fraction of the adult population, which is 135,706,000/209,216,000 =
64.9%.
81) The marginal propensity to consume (MPC) is the amount by which desired consumption rises when current
income rises by one unit. The marginal propensity to consume is less than one because a part of any increase in
current income is saved.
82) The expected real after-tax rate of return is
ra-t = (1 - t) i - expected inflation rate.
(1) Clearly ra-t would decline if the tax rate on interest income increases.
(2) From the formula, ra-t would increase if expected inflation declines.
83) ra-t (taxable bond) = (1 - 0.40)8% - 3% = 1.8%; ra-t (municipal bond) = 5% - 3% = 2%; municipal bond is the best
buy; note that the same expected inflation rate is subtracted from both, so it doesn't matter what the actual inflation
rate turns out to be the municipal bond is always the best.
84) The q theory of investment captures the relationship between stock prices and firms' investment in physical capital.
The theory was developed by James Tobin. Tobin's q equals capital's market value divided by its cost. When Tobin's
q exceeds one, more investment should take place. When q is less than one, there should be no investment. Tobin's q
is related to the stock market value of the firm via the formula q = V/(pK K), where V is the stock market value of the
firm, pK is the price of capital, and K is the quantity of capital.
85) Variables that shift the desired investment curve are the real interest rate, the expected future marginal product of
capital, and the effective tax rate. Desired investment is positively related to the future marginal product of capital,
but negatively related to the real interest rate and the effective tax rate.
86) The reduction in defense spending increases national saving, so that the desired saving curve shifts to the right. As
a result, the real interest rate declines, and investment increases.
87) (a) The rise in output raises desired saving, shifting the S d curve to the right; in equilibrium, this reduces the real
interest rate, increasing investment as well.
(b) The rise in taxes reduces desired investment, shifting the Id curve to the left; in equilibrium, this reduces the
real interest rate, reducing saving as well as investment.
(c) The rise in government purchases reduces desired saving, shifting the S d curve to the left; in equilibrium, this
raises the real interest rate, reducing investment as well as saving.
(d) The rise in future marginal productivity of capital raises desired investment, shifting the Id curve to the right;
in equilibrium, this raises the real interest rate, increasing saving as well as investment.

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Testname: ECON 352X PROBLEM SET 1

88) (a) The rise in future income reduces desired saving, shifting the S d curve to the left; in equilibrium, this raises the
real interest rate, reducing investment and saving in equilibrium.
(b) The lower future marginal product of capital reduces desired investment, shifting the Id curve to the left; in
equilibrium, this reduces the real interest rate, reducing saving as well as investment.
(c) If Ricardian Equivalence holds, this has no effect on desired national saving and thus no effect in equilibrium
on the real interest rate, saving, or investment. If Ricardian Equivalence does not hold, then people may reduce
consumption spending somewhat, leading to increased desired national saving, shifting the S d curve to the right; in
equilibrium, this reduces the real interest rate, increasing investment as well as saving.
89) (a) S d = Y - C d - G = 5000 - [3000 - 2000r + 0.10Y] - 1000 = 500 + 2000r.
Setting S d = Id gives 500 + 2000r = 1000 - 4000r, which can be solved to get r = 0.0833.
(b) Plugging this value of r into the equations for consumption and investment gives
C = 3333, I = 667, and S = 667.
(c) Follow the same steps as above with the new equation for desired consumption to get:
r = 0.05, C = 3200, I = 800, S = 800.

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