Assignment #1 Principal of Macroeconomics
Due Nov 29 in class
Please hand in a printed hardcopy of your work as a group.
1. Suppose that in 2012 the CPI was 113 and the GDP deflator is 120 (both using a
base year of 2005). The difference in these measures can be attributed to the price
of imports increasing more than the price of domestically produced goods. Is this
True, False or Uncertain. Please explain (less than 100 words).
False.
Explanation:
CPI = the price of basket of goods in 2012 / that in 2005
GDP deflator = nominal GDP / real GDP
Imports affect price of goods but not nominal GDP
Therefore, the price of imports increasing more than the price of domestically
produced goods will lead to the fact that CPI > GDP deflator, which is not the case.
2. In a particular economy, the following relationships holds:
C=5+0.7Yd
T=5+0.1Y
I=15
G=20
X=10
M=0.23Y
Note: All amounts are in $billions.
a) What is the equilibrium level of national income? Show your calculation
C = 5 + 0.7(Y – T)
Y = (X – M) + G + I + C
Therefore, Y = 77.5 billion dollars
b) The government increases transfer payments (pensions to retired worker) by
$5 billion. Will the equilibrium level of national income increase? Why? (less
than 100 words). What is the new outcome of the equilibrium level?
1) Yes.
2) Yd' = Yd + 5
The new outcome of the equilibrium level is $83.3 billion.
3) Reasons: the disposable income increase, so the consumption willingness
increases, which result in increase in GDP.
c) If the import function were M=0.33Y, would the multiplier increase or
decrease. Explain (no need to calculate the new value of the multiplier).
Increase. Because when Y changes delta Y, delta X, G, I do not change, delta M
increases, so delta C increases. Thus, multiplier (delta Y / delta C) would decrease.
3. In a particular economy, the Aggregate Supply and Aggregate Demand Schedules
are as follows:
a) Why is the Aggregate Demand curve downward sloping?
1) Higher price level implies lower real wealth and therefore lower
consumption spending, giving a lower quantity of goods demanded in the
aggregate. ( Pigou's wealth effect)
2) A higher price level implies a lower real money supply and therefore higher
interest rates resulting from financial market equilibrium, in turn resulting in
lower investment spending on new physical capital and hence a lower quantity
of goods being demanded in the aggregate. (Keynes' interest rate effect)
3) A lower real interest rate (nominal interest rate minus expected inflation)
leads to higher consumption spending. (Mundell–Fleming exchange-rate
effect)
b) In an appropriate diagram, show the equilibrium price level and Real GDP.
Does the economy have a recessionary or an inflationary gap? Explain your
answer and illustrate the gap on the diagram.
The main cause of the gap is considered to be expansionary monetary policies carried
out by the government. An inflationary gap is a signal that the economy is in the boom
part of the trade cycle, resources are being used over their capacity, factories are
operating with increasing average costs; wage rates increase because labor is used
beyond normal hours at overtime pay rates.
