ECON 201 Exam 3 review solutions PDF

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ECON 201 Exam 3 Review Sheet This covers topics of CPI, inflation, Money and GDP. Good luck! True-False Questions (Provide Reasoning) 1. Mark True or False for the following and explain why. a. Money is neutral if if affects real output and prices. False. Money is neutral only if does not affect real output, increase in money supply purely translates into increase in prices, given velocity is constant in short run. b. As prices go up, purchasing power declines. True. Purchasing power = real wealth = Money/Prices hence, as prices go up, purchasing power declines because there is an inverse relationship between the two as specified above. c. Real interest rates are not corrected for inflation. False. Any real variable is corrected for inflation. (Real interest rate = Nominal interest – inflation rate) d. If you take $100 out of your piggy bank and deposit in your checking account, M1 changes. False. M1 consists of both cash (bills and quarters) as well as checking account => only the components change not the money supply M1. e. GDP does not get affected by value of imported goods, however, it does include value of used goods. False. GDP is not affected both by imported as well as used goods because the value of used goods is already incorporated in the value of final goods and this avoids problem of double counting. Recall the egg and omelet example discussed in lab. f. More human capital per worker helps us increase productivity in an economy. (Hint: Remember the definition of productivity from our slides posted on canvas). True. Productivity = Y/L; We learned that through the production function, increase in input H “human capital” increases Y (output per worker). So, in per capita terms, increase in H/L (human capital per worker) will increase Y/L (output per worker) or productivity. Multiple-Choice 2. Which of the following best explains why the consumer price index (CPI) may not accurately measure changes in the cost of living? Choose 1 answer: a. b. c. d. e.

It only includes goods purchased every day When prices of some goods go up, consumers buy less of those and more of goods that are cheaper It doesn't include all prices, such as input costs to firms When real GDP increases, the CPI doesn't change It does not account for changes in consumers' incomes

A problem with the CPI as a measure of cost of living is that there might be “substitution bias.” The CPI assumes that consumers always buy the same quantity of every good. But, in reality, if the price of one

good increases, people might buy more of a substitute for that instead. This can cause CPI to overstate an increase in cost of living. 3. Which of the following best describes the relationship between a worker's real wage and nominal wage when there is no inflation? Choose 1 answer: a. b. c. d. e.

Real wage is higher than nominal wage Real wage is lower than nominal wage Both real and nominal wage increase, but in different amounts Real wage and nominal wage are the same Both real and nominal wage decrease, but in different amounts

Real variables are nominal variables adjusted for inflation. If there is no inflation, then the real and nominal variables are the same.

4. Which of the following best describes what is necessary for consumers to maintain the same standard of living over time if there is inflation? Choose 1 answer: a. b. c. d. e.

Nominal incomes are the same over time Business investment must increase at a faster rate than the official rate of inflation Consumer incomes must increase at at least the same rate as the official rate of inflation Consumer incomes must increase at a faster rate than the official rate of inflation Government spending must increase at the same rate as the rate of inflation

The official inflation rat is calculated using the CPI. The CPI measures the change in income a consumer would need to maintain the same standard of living over time. 5. Which of the following is NOT a function of money? a. b. c. d.

It facilitates the barter system. It serves as a store of wealth. It serves as a unit of value. It serves as a medium of exchange.

Barter was the transaction system used before the introduction of money.

6. The Required Reserve Ratio (RR) is a percentage set by the Federal Reserve System that requires banks to: a. Lend the RR percent of the bank’s customer Demand Deposits (DD) to the public. b. Hold the RR percent of the bank’s customer DD in the form of cash in their vault or in accounts at the Federal Reserve. c. Pay RR percent of the bank’s customer DD to the Federal Reserve as an annual membership fee. d. Hold the RR percent of the bank’s customer DD in the forms of cash in their vault. The bank always has an account with the Fed that facilitates its daily operations. Moreover, the funds that the bank holds as their required reserves is the portion of money that the bank CANNOT lend out to its customers. 7. An open market operation (OMO) refers to: a. b. c. d.

The purchase of goods and services by the Fed. An announcement about the level of the money supply in the economy. The process of printing more money and distributing it to the public. The purchase or sale of bonds to influence the level of the money supply in the economy.

By definition. 8.

Which of the following actions by the government is most likely to increase the money supply in an economy? (Hint: it is probably better to first answer Q7 of the problems) a. b. c. d.

Decreasing the RR while selling bonds in the market. Increasing the RR while selling bonds in the market. Buying bonds in the market. None of the above would have any effect on the money supply.

By observations from Q7 in the problems. Problems

9. Suppose that you lend your flat mate $100 for one year at 9 per cent nominal interest. a. How many dollars of interest will your flat mate pay you at the end of the year? $9 b. Suppose at the time you both agreed to the terms of the loan, you both expected the inflation rate to be 5 per cent during the year of the loan. What do you both expect the real interest rate to be on the loan? 9 per cent – 5 per cent = 4 per cent

c. Suppose at the end of the year, you are surprised to discover that the actual inflation rate over the year was 8 per cent. What was the actual real interest rate generated by this loan? 9 per cent – 8 per cent = 1 per cent d. In the case described above, actual inflation turned out to be higher than expected. Which of the two of you had the unexpected gain or loss? Your flat mate (the borrower), or you (the lender)? Why? Your flat mate (the borrower) gained; you lost because the borrower repaid the loan with dollars of surprisingly little value. e. What would the real interest rate on the loan have been if the actual inflation rate had turned out to be 11 per cent? 9 per cent – 11 per cent = –2 per cent f. Explain what it means to have a negative real interest rate. If there is a negative real interest rate, it means that the inflation rate is greater than the nominal interest rate. The Federal funds rate is 9% and the inflation rate is 11%, then the borrower would gain about 2% of every dollar borrowed per year and the saver would lose money if he puts it in the bank.

10. The GDP deflator in each of the past five years is given below: Year GDP deflator 2018

200

2017

210

2016

200

2015

190

2014

180

The rate of inflation was highest between which two years? Choose 1 answer: a. b. c. d. e.

The rate of inflation is the same every year Between 2017 and 2018 Between 2016 and 2017 Between 2015 and 2016 Between 2014 and 2015 Just use the formula to calculate for each year. Highest in 2014-15 = 5.5%

11. Suppose a country has the following monetary asset information as of April 2004: Cash in hands of the public = $300b (where ‘b’ represents billion) Demand Deposits (DD) = $400b Other Checkable Deposits = $150b Traveler’s checks = $50b Savings Type accounts = $2000b

Money Market Mutual Funds (MMMF) = $1000b Small Time Deposits = $500b Large Time Deposits = $450b a. Calculate M1. M1 = Cash in hands of public + Demand Deposits + Other Checkable Deposits + Traveler’s Check = 300b + 400b + 150b + 50b = $900 billion b. Calculate M2. M2 = M1 + Savings type accounts + MMMF + Small Time Deposits = 900b + 2000b + 1000b + 500b = $4400 billion c. Which item is not included in the calculations of M1 and M2? Large Time Deposits 12. Suppose John deposits $100,000 in Bank 1 and Ming borrows $80,000 from Bank 1 to buy a 2017 Dodge Viper. The required reserve ratio for all banks (set by the Fed) is 20%. The company Dodge deposits the money from Ming’s Viper purchase in Bank 2. Assume that there are no currency drains. a. Fill in the following balance sheets, for Bank 1 and Bank 2, respectively:

Bank 1’s Balance Sheet Assets Reserves: $20,000

Liabilities Demand Deposits: $100,000

Loans: $80,000 Bank 2’s Balance Sheet Assets Reserves: $80,000

Liabilities Demand Deposits: $80,000

Loans: $0

b. What is the level of required reserves Bank 1 must hold after John’s deposit? RR = $100,000 x 0.2 = $20,000 c. What is the level of required reserves Bank 2 must hold after Dodge’s deposit? RR = $80,000 x 0.2 = $16,000 d. Are these two Required Reserves the same? If so, why? If not, why not? They’re not the same since only part of John’s demand deposits (namely the part that exceeds the RR) is lent out. Hence only part of the initial deposit of $100,000 goes into Bank 2’s balance sheet (and remember that balance sheets always balances!). 13. You are given the following information:

Year 3

Nominal GDP $5,000

GDP Deflator 125

Population 11

Year 4

$6,600

150

12

a. What is the real GDP in Year 3? (5,000/125) x 100 = $4,000 b. What is the real GDP in Year 4? (6,600/150) x 100 = $4,400## c. What is the real GDP per capita in Year 3? (4,000/11) = $364 d. What is the real GDP per capita in Year 4? (4,400/12) = $367 e. What is the rate of real output growth between Years 3 and 4? [(4,400—4,000)/4,000] x 100 = 10%## f. What is the rate of real output growth per capita between Years 3 and 4? (Hint: Use per capita data in the output growth rate formula.) [(367—364)/364] x 100 = .82% 14. An economy produces three goods: Widgets, Gizmos, and Thingamajigs. The accompanying table shows the output and prices for years 2006 and 2007. (Hint: GDP, in its most basic form, is P x Q. You take the quantity of output and multiply by the price of output.)

a. Calculate the nominal GDP for: I. 2006 ($100 x 1) + ($10 x 8) + ($5 x 4) = $200

II.

2007 ($110 x 1) + ($12 x 10) + ($4 x 5) = $250

b. Compute the percentage of growth in nominal GDP from 2006 to 2007. [(250 - 200)/200] x100 = 25%

c. Using 2006 as the base year, calculate the real GDP for 2007. ($100 x 1) + ($10 x 10) + ($5 x 5) = $225

d. What is the GDP deflator for 2007? What was the inflation rate between 2006 and 2007? GDP Deflator: (250/225) x100 = 111; Inflation rate: 11% (111-100)/100 * 100

15. You are given the following information:

a. What was the value of real GDP in each year? Year 1: $1400; Year 2: $2000 (Use same formula used in question above; base year is year 1) ð Year 1: 3000*0.2 + 2000*0.4 = $1400 ð Year 2: 4000*0.2 + 3000*0.4 = $2000

b. What is the GDP Deflator for Year 2? Nominal GDP in Year 2: 4000*0.3 +3000*0.5 = $2700 Real GDP in Year 2: $2000 Deflator = 2700/2000 * 100 = 135...