Eco exam

Midterm 1 (Practice) Solutions

ECON 3 − Principles of Macroeconomics University of California San Diego

Christopher Gibson

Monday, April 27th

Multiple choice

1 2 3 4 5 6 7 8 9 10

B A E F E B D B B D

For the following questions, choose the best answer. Choose only one. Multiple choice questions are worth 3 points each.

1. If real GDP increases, we know for certain that

(a) the price of some goods in the economy decreased.

(b) the production of some goods in the economy increased.

(c) the price of some goods in the economy increased.

(d) the production of some goods in the economy decreased.

2. If CPI decreases, we know for certain that

(a) the price of some goods in the economy decreased.

(b) the production of some goods in the economy increased.

(c) the price of some goods in the economy increased.

(d) the production of some goods in the economy decreased.

3. Unemployment may suffer from underestimation as a result of

(a) retired workers.

(b) unreliable workers.

(c) voluntary part-time workers.

(d) disabled workers

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(e) discouraged workers.

(f) temporary workers.

4. The labor force participation rate is

(a) the fraction of the population that is of working-age.

(b) the fraction of the working-age population that is actively seeking employment.

(c) the fraction of the population that is employed.

(d) the fraction of the population that is employed or actively seeking employment.

(e) the fraction of the working-age population that is not a student, retired, or disabled.

(f) the fraction of the working-age population that is employed or actively seeking em- ployment.

5. The Fisher effect predicts that

(a) nominal interest rates and real interest rates move together.

(b) real interest rates and GDP move together.

(c) real interest rates and inflation move together.

(d) GDP and inflation move together.

(e) nominal interest rates and inflation move together.

(f) nominal interest rates and GDP move together.

6. Which of the following contributes to GDP?

(a) You buy a bond from the Federal Reserve.

(b) You buy stock in Facebook from a broker who charges commission.

(c) Your sister-in-law sells you a house that she has lived in for 3 years before it is on the market to the public.

(d) You pay your hairdresser to watch your dog, knowing full well that she will not report the income on her taxes.

7. If nominal interest is 8% and inflation is 2%, the exact real interest rate (not the approx- imate rate) would be

(a) 8%

(b) 6%

(c) Between 6% and 8%

(d) Less than 6%

8. One reason the CPI might not measure the true price level is

(a) the income effect.

(b) the substitution effect.

(c) the output effect.

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(d) the conglomeration effect.

9. If CPI rises more than GDP deflator, there is

(a) unemployment in the economy.

(b) inflation in the economy.

(c) deflation in the economy.

(d) a looming recession.

10. Workers who would like a job but have not looked recently enough to be counted as unemployed are referred to as

(a) abandoned workers.

(b) berated workers.

(c) condemned workers.

(d) discouraged workers.

(e) excluded workers.

(f) frustrated workers.

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Short answer

1. (25 points total)

(a) (5 points) Name three “costs of inflation” and provide an example for each

i. Price as a signal of scarcity

• For example: Have prices of rice increased because rice is becoming harder to grow or is it just inflation?

ii. Distortions caused by taxes

• For example: Not all taxes are indexed to inflation, such as the deduction from capital depreciation.

iii. Increases in the cost of cash

• For example: The cost of having to reprint menus to reflect higher prices iv. Unexpected redistribution of wealth

• For example: Inflation decreases the real interest rate, hurting lenders but benefiting borrowers.

v. Interference with long-term planning

• For example: Inability to predict prices will limit your ability to know how much to save.

(b) (15 points total) Suppose an economy produces the following three goods

Year Groceries Clothing Industrial equipment

Quantity Price Quantity Price Quantity Price

2029 15 $1.00 20 $3.00 3 $10.50 2030 16 $1.50 25 $2.00 3 $9.50 2031 17 $2.00 19 $2.50 2 $9.00

i. (5 points) Which of the three does not belong in consumer price index and why?

Industrial equipment since it is not a consumer good.

ii. (10 points) Calculate CPI with the two most appropriate consumer goods, using 2029 as the base year.

CPI2029 = 100

CPI2030 = 83.33

CPI2031 = 106

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(c) (5 points) From 2030 to 2031 is the real interest rate higher or lower than the nominal interest rate?

Since there is inflation between 2030 and 2031 the real interest rate is lower than the nominal rate, given that

r ≈ i − π

Note that it does not matter if you use the exact formula or the approximation. The direction will be the same, as (1 + π) > 0.

2. (25 points total)

(a) (5 points) Name three sources of growth and provide an example for each

i. Increase of physical capital

• For example: More machines per worker. ii. Increase of human capital

• For example: Training in Microsoft Office. iii. Land and other natural resources

• For example: Finding new places to drill for oil. iv. Technological advances

• For example: Inventing a new way to extract previously unattainable shale oil (fracking)

v. Entrepreneurship and management

• For example: Allocating employees to the tasks where they would be most productive. Incentivizing small business ownership through low-interest loans.

vi. Legal systems

• For example: A system that protects property rights.

(b) (10 points) If after three years, RUC has only grown at an annual rate of 1% per year while RES has enjoyed a steady annual growth of 5% per year, one dollar would have grown as shown in the table below.

Time passed RUC RES 3 years 1.03 1.16

By investing in RES, after three years your savings would be higher by( 1.16 − 1.03

1.03

) · 100% ≈ 12.36%

(c) (10 points) If over the next three years RUC grew by 10% per year while RES maintained a 5% growth rate, one dollar would have grown as shown in the table below.

Time passed RUC RES 3 years 1.03 1.16 6 years 1.37 1.34

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Thus you would not have preferred to invest in RES, as your total return over 6 years with RUC would be 37% whereas your return with RES would be 34%.

3. (20 points total) Suppose that in 2023, you have entered the labor force and, as a successful UCSD student, you secure a job with a starting salary of $100,000 per year. With your new salary, you rent an amazing apartment for $2,000 per month.

(a) (10 points total) In one year you are given a 5% raise. You are confused, however, because after paying your new rent of $2,200, you find that you are able to afford fewer goods and services than you were the year before.

i. (4 points) Given this information alone, what explains your reduced purchasing power?

With this information alone, it seems that prices have increased by 10%, since the change in rent is (

2200 − 2000 2000

) · 100% = 10%

Thus, a 5% increase in nominal income results in a decrease in real income and hence purchasing power.

ii. (6 points) If all prices in the economy move identically, what is the percentage change in your real income?

If inflation is 10% and nominal income increases by 5%, the approximation tells us that real income is approximately 5% − 10% = −5%. Thus, a 5% increase in nominal income results in a decrease in real income and hence purchasing power.

Using the exact formula, purchasing power changes from 100, 000/P to 105, 000/(1.1)P , so that the change in real income is(

105000 (1.1)P

− 100000 P

100000 P

) · 100% = −

( 0.05

1.1

) · 100% ≈ −4.55%

(b) (10 points) Suppose instead that inflation is 6% per year. What must be your income in 2024 in order to assure a 5% increase in real income?

In order to guarantee a 5% increase in real income, a income of $100,000 must be increased not only by 5%, but by an additional 6% to compensate for inflation, giving income

$100, 000 · (1.05) · (1.06) = $111, 300

Income in 2024 must then be $111,300.

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