Answer Key for Test 2

ANSWER KEY FOR TEST 2
DECEMBER 2011
ECON 0110: MACROECONOMICS
DR. KENKEL

25 questions worth 10 points each. Total Points = 250

1. Assume the following data apply to a certain country using 1996 as the base year: Year Consumer Nominal Price GDP Index (Trillions) 2005 144.9 12.2 2006 155.6 14.8 2007 169.5 17.5

The growth rate of real GDP between 2005 and 2006 is
a. Less than 5.0%
b. 5.0% to less than 6.0%
c. 6.0% to less than 7.0%
d. 7.0% to less than 8.0%
*e. 8.0% or higher
ANSWER: Real GDP in 2005 = (12.2/144.9) x 100 = 8.4196
Real GDP in 2006 = (14.8/155.6) x 100 = 9.5116
Growth rate = (9.5116 – 8.4196)/8.4196 x 100% = 12.97%

2. When Bill’s disposable income is $55,000, his consumption spending is $47,000. Suppose his disposable income increases to $75,000. Suppose his marginal propensity to consume is .70. His new consumption spending will be:
a. Less than $52,000
b. from $52,000 to $54,999
c. from $55,000 to $59,999
*d. from $60,000 to $63,999
e. $64,000 or higher
ANSWER: Change in income = $75,000 - $55,000 =$20,000
Change in spending = .70 x ($20,000) = $14,000
New consumption = $47,000 + $14,000 = $61,000

3. Which of the following is true?
a. Value added equals total sales revenue of a firm minus its depreciation.
b. Cash payments made by the government to people who do not supply goods, services, or labor in exchange for these payments are called fringe benefits.
c. The three main categories of consumption spending are durable goods, nondurable goods, and stock purchases.
d. An inflation that results from an initial increase in business costs is called wage pull inflation.
*e. A major cost of highly variable inflation is that it causes extreme uncertainty which discourages long term investment.
ANSWER: Value added equals value of sales minus cost of purchases from suppliers. Government payments when no goods or services are received are called TRANSFER payments. Consumption spending consists of spending on durable goods, nondurable goods, and services. Inflation resulting from an increase in business costs is called COST-PUSH inflation. Highly variable inflation makes long term investing extremely risky.
4. Assume the following data apply to a certain country: Total Population 280.4 million Civilian Noninstitutional Population 210.0 million Employed 112.4 million Unemployed 5.8 million Not in Labor Force 91.8 million

The unemployment rate is
a. Less than 3.0%
*b. 3.0% to less than 5.0%
c. 5.0% to less than 6.2%
d. 6.3% to less than 7.4%
e. 7.4% of higher
ANSWER: Labor force = 112.4 + 5.8 = 118.2. Unemployment Rate = (5.8/118.2) x 100% = 4.91%

5. Last year Joe earned $53,275 in disposable income and his consumption spending was $48,900. This year his disposable income increased by $20,000 and his new consumption spending amounted to $61,500. What is Joe's marginal propensity to consume?
a. less than 60%
*b. 60% to less than 65%
c. 65% to less than 70%
d. 70% to less than 75%
e. 75% or higher
ANSWER:
Change in C = 61,500 – 48,900 = 12,600
Change in disposable income = 20,000 mpc = change in C/ change in Y = 12,600 / 20,000 = .63 or 63%

6. A person was injured in a car accident. The person will need three different medical treatments one, two, and three years from today. The cost of the first treatments will be $40,000 in one year; the cost of the second treatment will be $32,000 in two years; the cost of the third treatment will be $26,000 in three years. The insurance company has offered to give the injured person a payment today to pay for the three future medical treatments. Assume that at the present time investors can invest money at 4% annual interest elsewhere in the economy. What is the appropriate amount for the insurance company to give to the injured person today. That is, what is the present value of the future cost of the three medical treatments?
*a. Less than $92,000
b. $92,000 to less than $93,999
c. $94,000 to less than $95,999
d. $96,000 to less than $97,999
e. $98,000 or higher
ANSWER: $40,000/(1.04) + $32,000/(1.04)2 + $26,000/(1.04)3 = $38,461.54 + $29,585.80 + $23,113.91 = $91,161.25

7. When Mary had taxable income amounting to $38,000, her income taxes amounted to $12,000. When her taxable income increased to $64,000, her income taxes increased to $16,000. This is an example of
a. A progressive tax
b. A proportional tax
*c. A regressive tax
d. None of the above
ANSWER: Mary’s original average tax rate is 12,000/38,000 = 31.58%
Her new average tax rate is 16,000/64,000 = 25.0%
As income increased, the percentage of income paid in taxes has DECREASED. THIS IS A REGRESSIVE TAX SYSTEM.

8. Use the following data to calculate the value of GDP. Some of the data may be unnecessary for the correct calculation. Consumption = $20,000; Change in inventories = $3,000; New residential construction = $2,000; Gross private domestic investment = $5,600; Net exports = $1,400; Government transfer payments = $3,800, Depreciation = $2,000, Spending on consumer durable goods = $4,000; Government purchases of final goods and services = $4,500; Individual income taxes = $7,000; Corporate income taxes = $2,000; Social security benefits = $1,500; Medicare payments = $1,000; New stock offerings = $1,200 The value of GDP is
*a. less than 33,000
b. 33,000 to 35,499
c. 35,500 to 40,499
d. 40,500 to 44,499
e. 44,500 or higher
ANSWER: Y = C + I + G + NX = 20,000 + 5,600 + 4,500 + 1,400 = 31,500
ALL THE OTHER ITEMS ARE EITHER SUBSETS OF THE ABOVE ITEMS, OR THEY ARE NOT INCLUDED IN GDP.

9. Suppose an economy is characterized by the following equations: Consumption = 15,000 + .64 Yd, where Yd denotes disposable income Gross Private Domestic Investment = 2,600 Government spending on final goods and services = 3,900 Net exports = -2,400 There are no taxes. In this model, equilibrium output will be:
*a. less than 56,000
b. between 56,000 and 59,999
c. between 60,000 and 64,999
d. between 65,000 and 69,999
e. 70,000 or higher
ANSWER:
TOTAL AUTONOMOUS SPENDING = C0+I0+G0+NX0 = 15,000 + 2,600 + 3,900 - 2,400 = 19,100
Ye = EQUILIBRIUM =[1/(1-MPC)] x (C0+I0+G0+NX0)
= 19,100/(1 - .64) = 19,100/ .36 = 53,055.56

10. A farmer grows corn and sells it to the Kelloggs Cereal Corporation for $90. Kelloggs refines the corn into Corn Flakes, which it packages and sells to a trucking company for $320. The trucking company transports the Corn Flakes to a supermarket and sells the Corn Flakes to the supermarket for $380. The supermarket sells the Corn Flakes to customers for $450. Which of the following is true?
a. The value added by the supermarket is between $320 and $460.
*b. The value added by the trucking company is between $40 and $65.
c. The value added by the farmer is $450 because the corn is necessary for each of the remaining stages of production.
d. The trucking company contributed more, in value added, than the farmer.
e. None of the above
ANSWER: Value added by supermarket = 450 – 380 = 70. Value added by farmer = 90 – 0 = 90. Value added by trucking company = 380 – 320 = 60.

11. The Phillips Curve is a graph showing that
a. when tax rates decrease, equilibrium income tends to increase
*b. when the unemployment rate decreases, the inflation rate tends to increase
c. when the unemployment rate decreases, GDP tends to increase
d. when tax rates decrease, government revenue tends to increase
e. when interest rates increase, borrowing tends to decreases

12. The term full employment refers to a situation when
a. the unemployment rate is zero
*b. there is no cyclical unemployment
c. there is no frictional unemployment
d. there is no seasonal unemployment
e. all of the above

13. Assume the following data apply to a certain country: Total Population 374.0 million Children, military, etc. 83.0 million Employed 145.6 million Unemployed 9.4 million Not in Labor Force 136.0 million

Calculate the labor force participation rate.
a. Less than 44%
b. 44% to less than 48%
*c. 48% to less than 55%
d. 55% to less than 64%
e. 64% or higher
ANSWER: Labor Force = 145.6 + 9.4 = 155 million
Civilian Noninstitutional Population = 145.6 + 9.4 + 136.0 = 291 million
Labor force Participation Rate = 155 million/291 million = 148/279 = .5326

14. Which of the following is true?
a. If a corporation goes bankrupt, the owners of the corporation’s bonds are responsible for paying off the corporation's debts.
b. According to John Maynard Keynes, recessions were self correcting.
c. In macroeconomics, we classify the economy into four sectors: households, business firms, governments and the banking sector.
d. Dividends are the portion of a corporation's profits that are distributed to the corporation’s bond holders.
*e. None of the above. They are all false.
ANSWER: Bondholders loaned money to a corporation. When a corporation goes bankrupt, the company’s assets are sold in an effort to pay back the owners of the bonds.
Keynes argued that, during a recession or depression, if the economy does not improve, then the government should try to stimulate the economy by using fiscal or monetary policy. The four sectors of the economy are households, businesses, government and foreigners. Dividends are paid to STOCKHOLDERS, not bond holders.

15. Which of the following is true?
a. The definition of full employment means that everyone who wants to work can find a job.
b. The only way for an individual to end a spell of unemployment is to get a job.
*c. The level of unemployment, both in the US and in different countries, is influenced by the amount of unemployment benefits received by the unemployed.
d. During the 1970s and 1980s, the Phillips curve relating to the US economy showed an inverse relationship between the unemployment rate and Federal government tax revenues.
e. The major determinant of household consumption expenditures is the wealth of the household.
ANSWER: Full employment is defined as a situation when there is no cyclical unemployment, so there still will be frictional unemployment, some structural unemployment, etc.. A person can end a spell of unemployment by getting a job, by dropping out of the labor force, by retiring, by dying, etc. The Phillips curve shows the relationship between the unemployment rate and the inflation rate, not the level of tax revenues. Income is the major determinant of consumption spending. Most families have accumulated very little wealth. Their annual consumption spending depends on their annual income.

16. Which of the following is true?
a. The value of consumption when disposable income is zero is called automatic consumption.
b. The marginal propensity to consume shows the proportion of total disposable income that will be consumed.
*c. If GDP is lower than the equilibrium level, then planned expenditures exceed GDP. Inventories will decrease and fall below the desired level. This leads producers to increase output.
d. If GDP is higher than the equilibrium level, then planned expenditures exceed GDP. Inventories will tend to be above the desired level. This leads producers to increase output.
e. The larger is the MPC, the smaller is the multiplier.
ANSWER: The value of consumption when income is zero is AUTONOMOUS consumption. The mpc shows the proportion of a CHANGE in income that will be spent. If GDP is HIGHER than the equilibrium level, then MORE has been produced than everyone wishes to purchase. This means that UNDESIRED inventories will pile up. This tells producers to DECREASE output. The multiplier = 1/(1 – MPC). A larger MPC yields a larger multiplier.

17. Which of the following is true?
a. Disposable income minus consumption equals taxes.
b. Autonomous consumption is the value of consumption where the consumption function crosses the 45 degree line.
c. Suppose that a company's unplanned increase in inventory was $10 million. This indicates that sales for the company exceeded expectations by $10 million.
*d. Firms react to unplanned inventory increases by reducing output.
e. A decrease in disposable income causes the multiplier to decrease.
ANSWER: Disposable income minus consumption equals savings. Autonomous consumption is the value of consumption spending when income is zero. If there was an UNPLANNED increase in inventory of $10 million, then the company produced $10 million too much in output, i.e., sales were $10 million less than expected, so the remaining output piled up on the store shelves. The multiplier shows the ratio: change in equilibrium income / change in autonomous spending. The multiplier depends on the marginal propensity to consume, not the LEVEL of disposable income.

18. Which of the following is true? Assume a closed economy with no government and no foreign trade. Thus, G = T = X = M = 0 Suppose at various levels of output we have the following data showing the plans or desires of consumers and business (all figures in billions). Desired Desired or
Aggregate Aggregate Planned
Output Consumption Investment 200 300 50 400 450 50 600 600 50 800 750 50
1000 900 50
_____________________________________________________________________

*a. If aggregate output is $200 billion, there will be an unplanned decrease in inventory of $150 billion.
b. If aggregate output is $600 billion, there will be an unplanned increase in inventory of $50 billion.
c. The equilibrium level of output exceeds $900 billion.
d. If aggregate output exceeds $800 billion, the unplanned change in inventories will be negative.
e. If aggregate output is $400 billion, there will be an unplanned inventory increase of $50 billion.
ANSWER: When output = 200, desired spending = 350. Thus, people want to buy 150 more than was produced this year. Thus, inventories will decrease by 150.
When output = 600, desired spending = 650. Inventories will decrease by 50.
When output = 800, desired spending = 800. This is the equilibrium level of output.
When output = 400, desired spending = 500. Inventories will decrease by 100.

19. Suppose an economy is characterized by the following equations: Consumption = 9,800 + .75 Y Investm ent = 3,150 G = 4,250 NX = -1,000 There are no taxes. In this model, equilibrium output will be:
*a. less than 65,000
b. from 65,000 to 69,999
c. from 70,000 to 74,999
d. from 75,000 to 79,999
e. 80,000 or higher
ANSWER: Y = [1/(1 – .75)] x (9,800 +3,150 + 4,250 – 1,000) = 4 x 16,200 = 64,800

20. Refer to the data in the previous problem. Suppose that full employment will occur when equilibrium output = $88,800. If the government wishes to achieve full employment by providing an increase in autonomous government spending, by how much must G increase?
a. less than $3,500
b. from $3,500 to $4,499
c. from $4,500 to $5,499
*d. from $5,500 to $6,499
e. $6,500 or higher
ANSWER: Multiplier = 1/(1 – mpc) = 1/(1 - .75) = 4
Change in equilibrium output = 88,800 – 64,800 = 24,000
Multiplier = change in equilibrium output/change in autonomous spending
Thus, change in autonomous spending = change in equilibrium output/multiplier = 24,000/4 = 6,000

21. Suppose the consumption function is C = 12,700 + .72 Y, where Y is disposable income. Suppose disposable income = $66,500. What is the average propensity to consume out of disposable income?
a. less than .70
b. between .70 and .79
c. between .80 and .89
*d. between .90 and .99
e. 1.00 or higher
ANSWER: C = 12,700 + .72 x (66,500) = 60,580
Average Propensity to Consume = 60,580/66,500 = .911

22. If the Consumer Price Index is 200 in one year and 206 the next year, then the annual rate of inflation between the two years is
a. 103 percent
b. 206 percent
c. 6 percent
*d. 3 percent
e. none of the above
ANSWER: Inflation rate = (New – Old)/Old x 100% = (206 – 200)/200 x 100% = 3%

23. In periods of rapid inflation,
a. people tend to postpone purchases for as long as possible
b. people want to hold as much cash as possible
c. the purchasing power of money is increasing
d. low nominal interest rates are likely to occur
*e. None of the above is true.
ANSWER: Assume you had $20,000 in your piggy bank and you wanted to buy a used car that was selling for $20,000. With rapid inflation, tomorrow the car might cost $23,000, but you would still have only $20,000 in your piggy bank. The rational buyer would buy the car immediately before the inflation kicked in. Thus, it would be irrational to hold on to the dollars in your piggy bank because their value (or purchasing power) would be decreasing every day. It would be rational to buy things as rapidly as possible before their prices increased.

24. Which of the following is true?
a. Unanticipated inflation benefits bondholders.
*b. The real interest rate can be negative.
c. If the expected inflation rate is high, then the nominal interest rate will tend to be low.
d. Unanticipated inflation generally hurts people who have borrowed money and benefits people who have loaned money.
e. None of the above is true.
ANSWER: Assume I have $20,000 in my piggy bank. Assume I could buy a used car for $20,000 today, or lend the money to a corporation or the government for one year, get an agreed upon amount of interest, and then hope to buy the car when they give me my money back on the maturity date. If there is rapid inflation, when they give me my money back (even with interest), I cannot buy the car. When there is unanticipated inflation, the person who LOANED the money gets paid back with dollars that have less purchasing power than expected when the deal was consummated. Bondholders are LENDERS. They LOSE when there is unanticipated inflation.
The REAL rate of interest shows if LENDERS made a profit after taking inflation into account. If I get 3% interest when prices increased 5%, I lost 2% of purchasing power. The real rate of interest = nominal interest rate – rate of inflation.
Suppose you loaned $100,000 to the US government and got 3% interest for one year. At the date of maturity you would receive $103,000. Now suppose there had been 10% inflation. What originally cost $100,000 would now cost $110,000. The LENDER could no longer purchase what he/she could have purchased BEFORE LENDING money to the government. The BONDHOLDER was a loser in the transaction.

25. What is the effect on the consumption function of a decrease in disposable income?
a. The consumption function becomes steeper.
b. The consumption function SHIFTS downward.
*c. There is movement DOWNWARD ALONG the consumption function.
d. The consumption function becomes flatter.
e. None of the above is true.
ANSWER: The consumption function would become steeper (or flatter) if and only if the marginal propensity to consume (the slope) increased (or decreased). A SHIFT in the consumption function (i.e. a parallel movement upward or downward in the entire line) requires a CHANGE in the Intercept (i.e. a change in autonomous consumption) while the slope remains constant.
For example:
Assume a given consumption function, such as C = 60 + .75Yd
Graph this line with intercept = 60 and slope = .75. Now assume disposable income be 800. Then, C = 60 + .75(800) = 660. This is one point on the consumption function. Now assume disposable income be 400. Then C = 60 + .75(400) = 360. Now we have another point on the SAME consumption function. The point has moved DOWNWARD TO THE LEFT on the SAME consumption function. There is a difference between a SHIFT in the function and a MOVEMENT along the function.