Macroeconomics Homework 1 Essay

Principles of Macroeconomics Homework 1 Please write down your answers as clearly as possible. 1. Below are some data from the land of milk and honey. Year 2008 2009 2010 Price of Milk $1 $1 $2 Quantity of Milk 100 quarts 200 200 Price of Honey $2 $2 $4 Quantity of Honey 50 quarts 100 100 a. Compute the nominal GDP, real GDP, and the GDP deflator for each year, using 2008 as the base year. Calculating nominal GDP: 2008: ($1 per qt. of milk ï‚ ´ 100 qts. milk) + ($2 per qt. of honey ï‚ ´ 50 qts. honey) = $200 2009: ($1 per qt. of milk ï‚ ´ 200 qts. milk) + ($2 per qt. of honey ï‚ ´ 100 qts. honey) = $400 2010: ($2 per qt. of milk ï‚ ´ 200 qts. milk) + ($4 per qt. of honey ï‚ ´ 100 qts. honey) = $800 Calculating real GDP (base year 2008): 2008: ($1 per qt. of milk ï‚ ´ 100 qts. milk) + ($2 per qt. of honey ï‚ ´ 50 qts. honey) = $200 2009: ($1 per qt. of milk ï‚ ´ 200 qts. milk) + ($2 per qt. of honey ï‚ ´ 100 qts. honey) = $400 2010: ($1 per qt. of milk ï‚ ´ 200 qts. milk) + ($2 per qt. of honey ï‚ ´ 100 qts. honey) = $400 Calculating the GDP deflator: 2008: ($200/$200) ï‚ ´ 100 = 100 2009: ($400/$400) ï‚ ´ 100 = 100 2010: ($800/$400) ï‚ ´ 100 = 200 1 b. Compute the percentage change in nominal GDP, real GDP, and the GDP deflator in 2009 and 2010 from the preceding year. For each year, identify the variable that does not change. Explain in words why your answer makes sense. Calculating the percentage change in nominal GDP: Percentage change in nominal GDP in 2009 = *($400 − $200)/$200+ ï‚ ´ 100 = 100%. Percentage change in nominal GDP in 2010 = *($800 − $400)/$400+ ï‚ ´ 100 = 100%. Calculating the percentage change in real GDP: Percentage change in real GDP in 2009 = *($400 − $200)/$200+ ï‚ ´ 100 = 100%. Percentage change in real GDP in 2010 = *($400 − $400)/$400] ï‚ ´ 100 = 0%. Calculating the percentage change in GDP deflator: Percentage change in the GDP deflator in 2009 = *(100 − 100)/100+ ï‚ ´ 100 = 0%. Percentage change in the GDP deflator in 2010 = *(200 − 100)/100+ ï‚ ´ 100 = 100%. Prices did not change from 2008 to 2009. Thus, the percentage change in the GDP deflator is zero. Likewise, output levels did not change from 2009 to 2010. This means that the percentage change in real GDP is zero. c. Did economic well-being rise more in 2009 or 2010? Explain. Economic well-being rose more in 2009 than in 2010, since real GDP rose in 2009 but not in 2010. In 2009, real GDP rose but prices did not. In 2010, real GDP did not rise but prices did. 2. What components of GDP in this year (if any) would each of the following transactions affects? How about total GDP in this year? Explain. a. A family buys a new refrigerator Consumption increases because a refrigerator is a good purchased by a household. Total GDP increases by the same amount. b. Aunt Jane buys a new house Investment increases because a new house is an investment good. Total GDP increases by the same amount. c. Ford sells a Mustang from its inventory 2 Consumption increases because a car is a good purchased by a household, but investment decreases because the car in Ford’s inventory had been counted as an investment good until it was sold. The increase in consumption cancels the decrease in investment, so there is no change to the total GDP (recall that GDP does not include the value from sale of used good) d. You buy a pizza from a local Pizza place. Consumption increases because pizza is a good purchased by a household. Total GDP increases by the same amount. e. California repaves Highway 101 Government purchases increase because the government spent money to provide a good to the public. Total GDP increases by the same amount. f. Your parents buy a bottle of French wine Consumption increases because the bottle is a good purchased by a household, but net exports decrease because the bottle was imported. The increase in consumption cancels the decrease in net exports, so there is no change to the total GDP (recall that GDP does not include the value of foreign produced goods) g. Honda downsizes its factory in Marysville, Ohio Investment decreases because some structures and equipment were put away. Total GDP decreases by the same amount. h. A senior lady in Cleveland receives social security from the government. Neither any of the components nor the total GDP is affected. Because social security is a kind of transfer payment, which is not included in GDP. 3. Explain a. Why a closed economy’s income must equal its expenditure? A closed economy’s income must equal its expenditure, because every transaction has a buyer and a seller. Thus, expenditure by buyers must equal income by sellers. b. Why do economists use real GDP rather than nominal GDP to gauge economic wellbeing? Economists use real GDP rather than nominal GDP to gauge economic well-being because real GDP is not affected by changes in prices, so it reflects only changes in the amounts being produced. Because it measures the economy’s production of goods and services, it reflects the economy’s ability to satisfy people’s needs and desires. But nominal GDP is affected both by quantity and price. You cannot determine if a rise in nominal GDP has been caused by increased production or higher prices. Thus real GDP is a better gauge of economic well-being than is nominal GDP.