114.02 Principles of Macroeconomics Problem Set 1 Spring 2003 Posted Wednesday, February 19. Due Wednesday February 26 in class. PLEASE FILL IN THE BLANKS BELOW AND ATTACH THIS COVER SHEET TO THE FRONT OF YOUR COMPLETED PROBLEM SET. YOU WILL BE AUTOMATICALLY REGISTERED IN THE SECTION/RECITATION YOU INDICATE BELOW. THEREAFTER, YOU CAN CHANGE RECITATIONS/SECTIONS ONLY WITH FACULTY APPROVAL. NAME: MIT ID NUMBER: TA: CLASS TIME:2Question 1: Short answer Answer true or false to each of the following statements, and briefly (one paragraph) explain your reasoning: (a) A standard goods market model (eg. Chapter 3) predicts that, if the government cuts taxes but also cuts government spending by the same amount, the equilibrium level of GDP will fall. (b) Since rich people generally live in large houses, eat expensive meals etc., it is logical to conclude that they generally have a higher marginal propensity to consume than poorer people. (c) When measuring GDP, you must include the salary the government pays to a currently employed Navy officer. (d) When measuring GDP, you must include the pension the government pays to a retired Navy officer. (e) If the central bank buys government bonds from the general public in an open market operation, interest rates should fall. (f) Imports can be larger than GDP. (g) The growth rate of nominal GDP per capita is the best summary measure of changes in material living standards in a country over time.3Question 2: Understanding Economic Data (based on the material in Chapter 2 of Blanchard) I. NATIONAL ACCOUNTS Consider a very simple economy where there are only three firms, and only one good is produced – baseball bats. Nomar Inc. is a lumber company, and cuts the trees used to provide wood for the bats. Over the past year, Nomar Inc. cut down and sold $120 of lumber, and paid its timbercutters $70 in wages. Nomar Inc. sold its lumber to Manny Inc., which used the wood to manufacture the baseball bats. As well as paying for the raw lumber, Manny Inc. paid its manufacturing workers $80 over the year. Manny Inc. used all the wood it purchased, and sold all the bats it produced to the retailer Pedro Inc. for $300. Pedro Inc. on-sold the bats to the general public for $500. Out of this $500, Pedro Inc also paid its salespersons $70 in wages, and paid indirect taxes (eg. sales tax) of $40 to the government. (a) Calculate the revenues, expenses and profits for each of the three firms. (b) What is the GDP of this economy? Calculate your answer in at least two different ways, and check that the answers are the same! (c) Calculate the shares of GDP attributable to labor income, capital income and indirect taxes. Are these income shares similar to the income shares of labor income, capital income and indirect taxes in the US economy? II: UNEMPLOYMENT Consider the following labor force statistics for an economy. Total population (000s): 1 000 Number of adults employed (000s): 600 Number of adults unemployed and looking for work (000s): 50 Number of adults unemployed and not looking for work (000s): 100 Number of elderly and children [none of whom 250 work or look for work] (000s):4(d) Calculate the unemployment rate for this economy. There is an economic boom, and 20 000 new jobs are created, all of which are filled by adults who were previously unemployed but looking for work. (e) Calculate the new unemployment rate. Now the stock market crashes, and the boom turns into a deep recession. Total employment falls to 520 000. All the laid off workers give up hope of finding another job, and decide to retire and move to Florida. So the number of people unemployed but looking for work remains at 30 000 as in Part (e). (f) What is the new unemployment rate? Compare your answer to the answers you found in parts (d) and (e). Thinking about this comparison, comment on the strengths and weaknesses of the unemployment rate as a measure of the strength of the labor market. III: NOMINAL AND REAL DATA Consider the following data on nominal GDP and prices. Nominal GDP Price level 1996 260 100 1997 279 103 1998 299 107 1999 342 115 2000 379 122 2001 388 125 (g) Calculate the inflation rate between each of the years in the above table. (h) Calculate real GDP in each year in terms of 1996 dollars. (i) Calculate the growth rate in nominal GDP between each of the years. Calculate the growth rate in real GDP between each of the years. Which growth rate is generally higher? Why? Which growth rate is a more informative measure of economic performance? (j) Suppose you found out that the unemployment rate increased sharply in 2001 to a 20 year high. Would this fact surprise you, given the inflation rates you calculated in part (g)? [HINT: Think of the Phillips curve relation]. Is it consistent with the growth rates for GDP you calculated in part (i)? [HINT: Think of the Okun’s law relation].5Question 3: The Goods Market (based on the material in Chapter 3 of Blanchard) Consider the following simplified model of an economy: C = 3 + 0.9(Y T)I6G11 YT0.1YZC+I+GY=Z−==−=≡001. This is similar to the models you have seen in class, except that government spending, instead of being constant, is `counter-cyclical’, that is, it is a negative function of output Y, and tax is `pro-cyclical’, that is, it is a positive function of Y. (a) Why in the real world, might you expect taxation revenues to decrease when Y is decreasing, and government spending to increase when Y is increasing? Give a couple of specific examples if you can. (b) Solve for the equilibrium level of income, Y, in this economy. Calculate the government’s budget balance (T-G). [HINT: You should get nice round numbers for both these answers. If you don’t, then you should recheck your algebra]. The rest of this question considers the effects of a decline in investment (I) from 6 to 4. (c) Calculate how much Y decreases following the decline in I. Calculate the new budget balance (T-G). (d) Does Y fall by more or less than I? Give an intuitive (non-mathematical) explanation why. Now show graphically what happens when I falls, using a goods market diagram like the ones in Chapter 3 of the textbook. (e) Since T = 0.1Y, the income tax rate is therefore 10%. Calculate how much the government would have to lower the income tax rate in order to return Y to its original level (the level you calculated in part (a)) following the
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