Mid Term (II) : DE-102: Macroeconomics for Closed Economy

Time: 1hr Max. Marks: 15

Note: Attempt any three questions from the following five. Each question carries 5 marks.

1. Consider how each of the following events is likely to affect real GDP. Do you think the change in real GDP
reflects a similar change in economic well-being?
a) The discovery of a new, easy-to-grow strain of wheat increases farm harvests.
b) Increased hostility between unions and management sparks a rash of strikes.
c) Firms throughout the economy experience falling demand, causing them to lay off workers.
d) Govt. passes new environmental laws that prohibit firms from using production methods that emit large
quantities of pollution.
e) More high-school students drop out of school to take jobs mowing lawns.
2. Consider an economy described by the following equations: Y = C + I + G
Y = 5,000
G = 1,000
T = 1,000
C = 250 + 0.75(Y − T)
I = 1,000 − 50 r.

a) In this economy, compute private saving, public saving, and national saving.
b) Find the equilibrium interest rate.
c) Now suppose that G rises to 1,250. Compute private saving, public saving, and national saving.
d) Find the new equilibrium interest rate.
3. Consider an economy that produces only chocolate bars. In year 1, the quantity produced is 3 bars and the
price is $4. In year 2, the quantity produced is 4 bars and the price is $5. In year 3, the quantity produced is 5
bars and the price is $6. Year 1 is the base year.
a) What is nominal GDP for each of these three years?
b) What is real GDP for each of these years?
c) What is the GDP deflator for each of these years?
d) What is the percentage growth rate of real GDP from year 2 to year 3?
e) What is the inflation rate as measured by the GDP deflator from year 2 to year 3?
4. Explain the neoclassical theory of investment in detail and its policy relevance.
5. Describe the theory of life cycle hypothesis and explain how it is different from Keynes theory of
consumption function.

Solution

Answer
a) The discovery of a new, easy-to-grow strain of wheat increases farm harvests.
Effect on Real GDP:
Real GDP is likely to increase because agricultural output rises, leading to higher
production and income in the economy.
Effect on Economic Well-Being:
Economic well-being improves as food becomes more abundant and potentially
cheaper, benefiting consumers. However, the well-being of small farmers might
decline if prices drop significantly due to overproduction.

b) Increased hostility between unions and management sparks a rash of strikes.

Effect on Real GDP:
Real GDP is likely to decrease because strikes disrupt production, reducing output in
affected industries.
Effect on Economic Well-Being:
Economic well-being decreases due to lost wages for workers, reduced business
income, and potential ripple effects across other sectors. However, if strikes result in
long-term improvements in working conditions, well-being could improve in the
future.

c) Firms throughout the economy experience falling demand, causing them to lay off
workers.
Effect on Real GDP:
Real GDP will decrease due to reduced production and lower consumption spending
as unemployed workers cut back on their expenditures.
Effect on Economic Well-Being:
Economic well-being declines as unemployment rises, leading to financial stress and a
lower quality of life for laid-off workers.

d) Government passes new environmental laws that prohibit firms from using
production methods that emit large quantities of pollution.
Effect on Real GDP:
Real GDP might decrease in the short term as firms incur higher production costs to
comply with regulations, reducing output.
Effect on Economic Well-Being:
Economic well-being may improve in the long term due to reduced pollution, better
health outcomes, and environmental sustainability, despite the short-term adjustment
costs.

e) More high-school students drop out of school to take jobs mowing lawns.
Effect on Real GDP:
Real GDP may increase in the short term due to higher labor supply and immediate
income generation.
Effect on Economic Well-Being:
Economic well-being is likely to decrease in the long term, as students forgo
education, which limits their future earning potential and reduces the economy’s
overall human capital.
2. Given Equations and Data

1. Y=C+I+G
2. Y=5,000
3. G=1,000 (in part c, G=1,250)
4. T=1,000
5. C=250+0.75(Y−T)
6. I=1,000−50r

Part (a): Compute Private Saving, Public Saving, and National Saving
Step 1: Disposable Income and Consumption
• Disposable income Y−T=5,000−1,000 = 4,000
• Consumption C=250+0.75(4,000) = 250+3,000 = 3,250.
Step 2: Private Saving
• Private saving = Y−T−C
• =5,000−1,000−3,250=750.
Step 3: Public Saving
Public saving =T−G
=1,000−1,000=0
• Step 4: National Saving
• National saving S= private + public
S=750+0=750.

Part (b): Find the Equilibrium Interest Rate

At equilibrium, S=I:
750=1,000−50r.
Rearranging for r:
50r=1,000−750 = 250, r = 250/50 = 5.
Equilibrium Interest Rate: r=5.

Part (c): Compute Savings when G=1,250G = 1,250G=1,250

Step 1: Public Saving
• Public Saving = T−G
• =1,000−1,250=−250.

Step 2: Private Saving

• Disposable income remains Y−T = 4,000.
• Consumption C=250+0.75(4,000) = 3,250
• Private saving = Y−T−C:
=5,000−1,000−3,250=750.

Step 3: National Saving

• S= private + public
 Part (d): Find the New Equilibrium Interest Rate
At equilibrium, S=I:
500=1,000−50r.
Rearranging for r:
50r = 1,000−500 = 500,
r = 500/50 = 10.
New Equilibrium Interest Rate: r = 10.

Summary of Results
• (a) Private Saving = 750, Public Saving = 0, National Saving = 750.
• (b) Equilibrium Interest Rate = 5.
• (c) Private Saving = 750, Public Saving = -250, National Saving = 500.
• (d) New Equilibrium Interest Rate = 10.

Solution

Given Data
Quantity Produced Price Base Year (Year 1)
Year Price
(Q) (P)

1 3 $4 $4

2 4 $5 $4

3 5 $6 $4

Part (a): Nominal GDP

Nominal GDP is calculated using current prices and quantities for each year:
Nominal GDP=P×Q
Year Nominal GDP ($)

1 3×4=12

2 4×5=20

3 5×6=30

Nominal GDP:
• Year 1: $12
• Year 2: $20
• Year 3: $30

Part (b): Real GDP

Real GDP is calculated using base year prices (Year 1 prices) and current quantities:
 Real GDP=Base Year Price×Q
Year Real GDP ($)

1 3×4=12

2 4×4=16

3 5×4=20

Real GDP:
• Year 1: $12
• Year 2: $16
• Year 3: $20

Part (c): GDP Deflator

The GDP deflator is calculated as:
GDP Deflator= (Nominal GDP/Real GDP)×100
Year GDP Deflator

1 12/12×100=100

2 20/16×100=125

3 30/20×100=150

GDP Deflator:
• Year 1: 100
• Year 2: 125
• Year 3: 150

Part (d): Percentage Growth Rate of Real GDP from Year 2 to Year 3
The growth rate of real GDP is calculated as:
Growth Rate= (Real GDP in Year 3 - Real GDP in Year 3)/Real GDP in Year 2×100
Growth Rate = (20−16)/16×100 = 164×100 = 25%
Percentage Growth Rate of Real GDP: 25%

Part (e): Inflation Rate from Year 2 to Year 3 (GDP Deflator)

The inflation rate is calculated as:
Inflation Rate =
(GDP Deflator in Year 3−GDP Deflator in Year 2)/GDP Deflator in Year 2×100

Inflation Rate = (150−125)125×100 = 25/125×100 = 20%

Inflation Rate: 20%

Summary of Results
• Nominal GDP: Year 1 = $12, Year 2 = $20, Year 3 = $30
• Real GDP: Year 1 = $12, Year 2 = $16, Year 3 = $20
• GDP Deflator: Year 1 = 100, Year 2 = 125, Year 3 = 150
• Percentage Growth Rate of Real GDP (Year 2 to Year 3): 25%
• Inflation Rate (Year 2 to Year 3): 20%