Test 2 Study Guide Key
ECO 221
Practice Problems:
Chapter 7
1.) Real GDP in the U.S. in 1987 was $6,475 billion and was $6,742 billion in 1988. The
population of the U.S. was 242.8 million in 1987 and 245 million in 1988. Calculate:
a. The economic growth rate between 1987 and 1988
% change in Real GDP
(6742-6475)/6475 x 100 = +4.12%
b. The population growth rate
(245-242.8)/242.8 = +0.91%
c. The levels of RDGP per capita in 1987 and 1988
RGDP per capita 1987 = $6475 billion/242.8 million = $26,668.04
RGDP per capita 1988 = $6,742 billion/245 million = $27,518.37
d. The growth rate of Real GDP per capita between 1987 and 1988
1. (27518.37-26668.04)/26668.04 = 3.2%
2. RGDP per capita growth = Economic growth rate – population
growth rate
4.12 – 0.91 = 3.2%
2.) What is labor productivity? What factors influence the pace of productivity growth?
Labor productivity = Output/labor, the quantity of GDP produced by 1 unit of
labor.
Productivity growth is influenced by increases in physical capital, human
capital, and technology
3.) What are the types of institutions within an economy that can help to promote
economic growth?
Institutions include: private property rights, legal system, financial system,
educational system, and free/democratic government with competitive markets.
4.) What are the Supply factors which contribute to growth? Which factor is the most
important in influencing long-run economic growth?
Physical capital, Human capital, Labor, Natural Resources, Entrepreneurship,
Technology
Changes in technology have driven productivity gains
5.) How does the rate of population growth affect the level of Real GDP per capita?
If population growth > total economic growth, then Real GDP per capita will fall
6.) What are some of the ways that an economy can promote faster economic growth?
Increases in the rate of saving lead to capital growth
Increase in R&D leads to technological growth
Increases in education lead to human capital growth
encouragement of trade leads to an expansion of available markets
7.) According to the different economic growth theories, what do they say is the most
important source of long-term growth?
Neo-Classical growth = productivity is driven by technological change
New Growth theory = productivity is driven by technological change and human
capital growth.
8.) The nation of Tarabon produces two types of goods (silk clothing
and fish). Production in Tarabon is represented by the Production
Possibilities Frontier (PPF) found below. On the PPF you must
indicate:
a. A point of production that represents Production Efficiency.
Any point of production on the PPF curve achieves
Productive Efficiency
b. A point of production that is possible for the economy to
produce but is inefficient.
Any point inside/under the PPF curve is possible, but
inefficient due to unemployed/underemployed resources.
c. The opportunity cost of moving from point B to point C.
Opportunity Cost = Loss/gain = -3000 silks/+20,000 fish =
0.15 silks given up per fish caught (must shift resources
from silk production, loss, into fish production, gain. Opp.
Cost represents equivalent values of the goods
d. A movement representing short-run economic growth. From
inside the PPF moving toward the PPF
e. A movement representing long-run economic growth. The PPF
shifts to the right
Silks
A
25,000
B
23,000
20,000 C
9.) The production function is given as Y = AK½, where Y = Real GDP, K = quantity of
physical capital, and A = productivity measure.
a. Currently, A = 4. What level of output is produced when K = 225?
Y = 4(225½) = 4 x 15 = 60 units of output created
b. The saving rate in the economy is 10% (0.1). Investment = 0.1Y, where Y = your
answer from part a. What is the level of total Investment?
I = 0.1(60) = 6 new units of capital created
c. Every year 5% of the capital stock depreciates and must be replaced.
Depreciation = 0.05K, where K = 225. How much capital must new investments
replace?
Depreciation = 0.05(225) = 11.25 units of capital to replace
d. Using your answers from parts b and c, what is the net change (Investment –
depreciation) in the capital stock? Does this economy have a positive or negative
growth rate?
Net Investment = 6 – (11.25) = -5.25 reduction in the capital stock
10.) A steady-state of zero growth can be reached when the level of -
__Investment_________ is equal to the amount of _____Depreciation_________.
Investment > Depreciation = positive economic growth (capital stock K inc.)
Investment < Depreciation = negative economic growth (capital stock K shrinks)
11.) What change is necessary for an economy to avoid a steady-state of zero growth?
Temporary: increase saving and investment
Long-run: increase resource productivity (NeoClassical Growth)
Technological change and Human capital growth (New Growth Theory)
Chapter 11:
1.) Briefly explain why the long-run aggregate supply curve is vertical at the level of
Potential GDP. How is full employment in the economy achieved? What factors will
cause the level of Potential GDP to change?
LRAS represents the full employment level of production, Potential GDP. Potential
GDP depends on only the quantities of the factors of production available within the
economy and the productivity of those same factors. Potential GDP is not influenced
by price since if the factors of production cost more, then the price level will rise to
compensate.
2.) Explain two reasons why the short-run aggregate supply curve is upward sloping?
Sticky-Wage Theory – wages and other input prices are slow to adjust to price level
changes. In the short run, if the price rises, firms can increase production without a
proportional increase in costs. This increases profitability in the short run and
provides an incentive for increased production.
Sticky-Price Theory – some prices in the economy are slow to adjust to economic
shocks due to high menu costs (the costs of changing prices). If the price level
increases but an individual firm has not raised their price, then their Relative Price
(Price of good/Price Level) has fallen signaling to consumers that this product is
relatively cheaper compared to other available alternatives. Demand increases for
goods whose relative prices fall thereby increasing production of these goods and
RGDP.
3.) What happens to the short-run aggregate supply curve and the long-run aggregate supply
curve if firms face an increase in the money wage rate?
An increase in wages paid to labor will reduce Short-run Aggregate Supply due to
the higher total cost of production. Long-run Aggregate Supply is unaffected.
Ultimately, the higher costs of production will lead to inflation in prices (Cost-push
inflation).
4.) What are the four components of Aggregate Demand? What are the three reasons that
explain why the Aggregate Demand curve is downward sloping?
AD: RGDP = C + I + G + NX
Real Balances Effect (Pigou Wealth Effect) – a higher price level reduces the
purchasing power of money and reduces consumer spending.
Interest Rate Effect (Keynes Effect) – An increase in the price level will lead to
higher interest rates. Higher interest rates will reduce Investment.
Exchange Rate Effect (Mundell-Fleming Effect) – higher price level strengthens the
dollar against foreign currencies. Imports rise while U.S. exports fall causing NX to
fall.
5.) What are the factors that determine the spending plans in the economy (cause AD to
shift)? What happens when each of the factors increase? Decrease?
Any change which causes a change to Consumption, Investment, Government
spending, of Net Exports will cause AD curve to shift. Changes which lead to an
increase in spending will shift AD to the right and any change which reduces
spending will cause AD to shift left.
6.) What will happen to the level of U.S. exports, imports, and Real GDP if the exchange
rate between the Euro and the dollar falls (depreciates)?
A depreciation of the $ to Euro exchange rate will mean that European goods are
more expensive to US consumers (each $ trades for fewer Euros). As a result,
imports from Europe will fall. At the same time, US goods seem relatively cheaper
to European consumers. US exports to Europe rise. As a result, net exports and
RGDP both rise.
7.) This variable will adjust to achieve the level of Potential GDP in the long run. Price
level/inflation rate
8.) The economy is currently in long-run macroeconomic equilibrium (RGDP = PGDP).
What happens to the level of Real GDP, the price level, and the unemployment rate in the
short-run if a tax hike causes a decrease in Aggregate Demand?
An increase in taxes will reduce AD (shift left). RGDP falls and the unemployment
rate rises.
9.) The economy is currently in long-run macroeconomic equilibrium (RGDP = PGDP).
What happens to the level of Real GDP, the price level, and the unemployment rate in the
short-run if government stimulus checks causes an increase in Aggregate Demand?
Government stimulus checks will increase AD (shift right). RGDP increases and the
unemployment rate falls.
10.) The economy is currently in long-run macroeconomic equilibrium. A decrease in the
price of oil has lowered the costs of production and increased short-run Aggregate
Supply. What is happening to Real GDP and the Price level in the short run?
The lower price of oil lowers the cost of production for many firms in the economy.
Lower costs allow for expanded production. SRAS curve shifts to the right. GDP
increases and the unemployment rate falls.
11.) What are the three short-run equilibriums that the economy moves among in the business
cycle? When does the economy experience an inflationary gap? When does the
economy experience a recessionary gap?
1. Above full employment (expansion)
a. Real GDP > potential GDP
b. Unemployment rate < Natural Rate of Unemployment
c. Output gap > 0 = Inflationary Gap (pressure for prices to rise)
2. At full employment
a. Real GDP = Potential GDP
b. Unemployment rate = Natural Rate of Unemployment
c. Output Gap = 0
d. Transition point between expansions and recessions
3. Below full employment (recession)
a. Real GDP < Potential GDP
b. Unemployment rate > Natural Rate of Unemployment
c. Output gap < 0 = Recessionary Gap
12.) Explain whether each factor will increase, decrease, or have no effect on Long-run
Aggregate Supply:
a. The United States experiences new wave of immigration.
LRAS and SRAS both increase
b. Congress raises the minimum wage to $15.00 per hour.
SRAS decreases, no effect on LRAS
c. Intel invents a new, more powerful computer chip.
LRAS and SRAS both increase
d. A severe hurricane damages factories along the East Coast.
LRAS and SRAS both decrease
13.) Explain how each event might shift the Aggregate Supply Curve, the Aggregate Demand
Curve, both, or neither. Identify in which direction the curve(s) will shift?
a. Households decide to save a larger share of their income.
Consumption will begin to fall as people begin to save more. The AD curve
will shift left at first. The increased amount of saving eventually leads to
lower interest rates. Lower interest rates lead to an increase in Investment,
causing AD to shift to the right. As the new investment spending is
transformed into new factories, stores, and equipment, SRAS will then begin
to increase (shift right)
b. Florida orange growers suffer a prolonged period of below-freezing weather.
This weather event will reduce the orange crop leading to higher orange
prices, reducing the quantities of goods produced with oranges. Slight shift of
SRAS to the left.
c. Increased job opportunities overseas cause many people to leave the country.
A drain of the labor force will reduce SRAS (left). Fewer people in the
country means a lower level of consumption, so AD shifts left.
d. China decides to reduce the exchange rate between the Yuan and the Dollar.
Chinese goods are now even cheaper for US consumers. Imports from China
increase at the same time that exports to China decrease. Net Exports fall
causing AD to shift to the left (short-run effect). Overtime, this trade policy
will shrink the US export sector causing SRAS to shift left (medium-run
effect)
14.) Briefly explain how the recessions of 1973-1975 and 1980 behaved differently than all
other economic recessions in the last 40 years. What were the main causes of the 1973-
1975 and 1980 recessions? What were some of the main causes of the 2001 recession?
What steps did the government take which made the 2001 recession the mildest in recent
history?
Unlike most recessions, which are caused by a negative demand shock, the
recessions of 1973-75 and 1980 were primarily caused by a negative supply shock.
This supply shock was due to the rapidly rising price of oil which made production
of many goods and services much more expensive. The higher costs caused SRAS to
shift to the left. Unemployment rose as production (RGDP) fell. However, unlike
other recessions where the economy experiences disinflation, inflation rates were
rising due to higher production costs (Cost-push inflation). These are two periods of
Stagflation.
The 2001 recession was the result of the collapse of DotCom bubble of the late 1990s
and the terrorist attacks of 9/11. As many internet-based companies began to fail,
stock values for all similar companies began to decline leading to a significant
reduction in investment in the sector. The 9/11 attacks forced to closure of the New
York Stock exchange. After markets were reopened, the Dow Jones lost 14% of it’s
value with more losses to come due to investor fears and general uncertaintiy about
the economic future. The Federal Reserve worked to lower its key interest rate in
order to boost investment spending. The Federal government passed a tax cut
earlier in the year and significantly increased their direct spending, leading to an
increase in Aggregate Demand and an eventual end to the recession.