Cosumnes River College Principles of Macroeconomics Problem Set 3 Due September 17, 2015

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1 Cosumnes River College Principles of Macroeconomics Problem Set 3 Due September 17, 2015 Name: Solutions Fall 2015 Prof. Dowell Instructions: Write the answers clearly and concisely on these sheets in the spaces provided. Do not attach extra sheets. 1. You are given the following data for a hypothetical economy: Spending Component Value (billions of dollars) Personal Consumption Expenditure $600 Exports 75 Government Purchases of Goods and Services 200 Construction of New Homes and Apartments 100 Sale of Existing Homes and Apartments 200 Imports 50 Beginning of Year Inventory 100 End of Year Inventory 125 Business Fixed Investment 100 Government Payments to Retirees 100 Beginning of Year Capital Stock 3,000 End of Year Capital Stock 3,175 Showing your work, complete the following: a. Calculate for this economy. Also explain what you are doing and why. Using the expenditure approach, add up personal consumption, investment, government spending and net exports. To get investment, add new home construction, business fixed investment and the change in inventory. Sale of existing homes is not included because they were not produced in the current year. Government payments to retirees are excluded because it is a transfer payment. Beginning and ending capital stocks are not included because they are stock variables. They tell us how much capital we own, not what we ve produced in the current year. Note that with respect to inventories, we include only the change, not the level. Adding up, you get b. Calculate net investment. Y = (75 50) = 1,050 Net investment is just the change in the capital stock or 3,175 3,000 = 175 c. Calculate Net Domestic Product (NDP). First, calculate depreciation. Use the relation, Net Investment = Gross Investment Depreciation. We know the values of Gross and Net Investment. Substitute these and solve. 175 = 225 Depreciation => Depreciation = 50. Use this to find NDP: NDP = 1, = 1,000 Principles of Macroeconomics: Problem Set 3 Solutions Page 1

2 d. Is NDP less than? If yes, why? Explain. Yes, NDP is less than because of depreciation. Some of the gross investment in went to replace capital that is worn out or obsolete. 2. Suppose the data below represents the economic activity of a country in 2010: Spending (or income) Component Value (billions of dollars) Consumption $140 Business Fixed and Residential Construction $27 Inventory Stock at the end of 2009 $10 Inventory Stock at the end of 2010 $5 Depreciation $12 Government Spending $80 Government Purchases $65 Exports $21 Imports $17 Labor Income $126 Capital Income $70 Net Income of Foreigners $5 Taxes, Subsidies and Transfers $28 Showing your work, complete the following: a. Calculate inventory investment. Inventory Investment = Inventory 2010 Inventory 2011 = $5-10 = -5 b. Calculate net exports. NX=X M = = 4 c. Calculate gross domestic product. First calculate total Investment: Investment = Business Fixed Investment + New Residential Construction + Change in Inventory = 27 5 = 22 Then, Y = C + I + G + NX = = 231 d. Calculate the statistical discrepancy. The statistical discrepancy is the difference between calculated using the income approach and calculated using the income approach. First, calculate using the income approach: = income (where income = capital income + labor income) + depreciation + sales tax, indirect business tax and subsidies + net income of foreigners = $70 + $126 +$12 + $28 + $5 = $241. The statistical discrepancy thin is $231 - $241 = $-10 e. Calculate national saving. National Saving is defined as less consumption and government spending. S = Y C G = $231 - $140 - $65 = $8 Principles of Macroeconomics: Problem Set 3 Solutions Page 2

3 3. You are given the following data on a hypothetical economy: Good Quantity in 2013 Price in 2013 Quantity in 2014 Price in 2014 Ice Cream Cones 1,000 $ $3.50 Hot Dogs 500 $ $2.25 Surf Boards 10 $ $ a. Showing your work, calculate the following: i. nominal in 2013 Y 2013 = (1,000 x $2.50) + (500 x $1.25) + (10 x $100) = $4,125 ii. nominal in 2014 Y 2014 = (800 x $3.50) + (400 x $2.25) + (14 x $100) = $5,100 iii. real in 2013 using 2013 as the base year Y 2013 = (1,000 x $2.50) + (500 x $1.25) + (10 x $100) = $4,125 iv. real in 2014 using 2013 as the base year Y 2014 = (800 x $2.50) + (400 x $1.25) + (14 x $100) = $3,900 v. real growth from 2013 to 2014 using your results from parts iii and iv $3,900 $4,125 % x % $4,125 vi. real in 2013 using 2014 as the base year Y 2013 = (1,000 x $3.50) + (500 x $2.25) + (10 x $100) = $5,625 vii. real in 2014 using 2014 as the base year Y 2014 = (800 x $3.50) + (400 x $2.25) + (14 x $100) = $5,100 viii real growth from 2013 to 2014 using your results from parts vi and vii $5,100 $5,625 % x % $5,625 b. If your answers to parts v and viii above are different, why? Explain. The answers are different because the starting points are different. Think of it this way: Suppose you buy a share of stock for $100 and that its value falls by 50%. If from this point the value rises by 50%, do you recover all your losses? No! Now it is worth $75, not the original $100. After the 50% drop the value must increase by 100% for you to recover all your losses. This happens because your starting points are different, $11 vs. $50. Principles of Macroeconomics: Problem Set 3 Solutions Page 3

4 4. Given the information in the table below for three consecutive years in a hypothetical economy, calculate the missing data: Real Nominal Inflation Real (percent (in billions Deflator per Year (in billions change in of 2002 (2002 = capita of 2002 dollars) 100) (in 2002 dollars) deflator) dollars) Population (in millions) , , , , , , , , % 25, Why has nominal increased faster than Real in the U.S. over time? What would it mean if an economy had real increasing faster than nominal? Nominal has increased faster because prices have been increasing, or in other words, because of inflation. If Real were increasing faster than nominal, this would indicate that prices were falling or that there was deflation. 6. If a surf board is produced this year but not sold until next year, how is it counted in this year s and not next year s? This year, since it isn t sold it will go into inventory. The resulting increase in inventory is a component of investment which is included in. Next year when it is sold, it will be counted as consumption, but will also be a decrease in inventory. The net result is that there is no effect on next year. 7. Explain why imports are subtracted in the expenditure approach to calculating. Consumption, investment, and government spending (C, I, and G) include expenditures on goods produced both domestically and by foreigners, and so C + I + G overstates domestic production. Imports have to be subtracted to obtain the correct figure 8. During 2002, real in Japan rose almost 1.3%. During the same period, retail sales to consumers fell almost 1.8% in real terms. What are some possible explanations for this? Consumption as measured by retail sales is just part of. Using the expenditure approach, real is made up of consumption plus investment plus net exports plus government purchases. If the sum of I, G, and (X M) grows more rapidly than C, real will rise more rapidly than retail sales. Principles of Macroeconomics: Problem Set 3 Solutions Page 4

5 9. For each of the following transactions, state the effect both on U.S. and on the individual components of aggregate expenditure: a. You buy a new car from a U.S. producer. Consumption and both increase. b. You buy a new car imported from Germany Consumption and imports both increase. There is no change in. c. Your family s rental car business buys a new car from an American producer. Investment and both increase. d. Your family s rental car business buys a new car imported from Korea. Investment and imports both increase. There is no change in 10. Explain what double counting is and discuss why is not equal to total sales. Double counting occurs when intermediate goods are counted directly in calculating. This means these intermediate goods will be counted more than once because they are also counted as part of the value of the final product. Total sales includes sales of intermediate goods that firms sell to each other. includes only the sales of final goods and services. 11. Larson has started a home wine making business and he buys all his ingredients from his neighborhood farmers market and a local bottle manufacturer. Last year he purchased $4,000 worth of ingredients and bottles and produced 2,000 bottles of wine. He then sold all 2,000 bottles of wine to a restaurant for $10 each. The restaurant sold all the bottles of wine to customers for $45 each. a. For the total wine production, calculate the value added by Larson. Value added = sales price less costs = ($10 x 2,000) - $4,000 = $20,000 - $4,000 = $16,000 b. For the total wine production, calculate the value added by the restaurant. ($45 x2,000) - $20,000 = $90,000 - $20,000 = $70,000 Principles of Macroeconomics: Problem Set 3 Solutions Page 5