Solution Key: Homework 1

Solution Key: Homework 1 Economics 101

Chapters 1 & 2

1) a) G and GDP rise.

b) I and GDP rise.

c) No effect on GDP or any sub-category. This is an intermediate good.

d) NX and GDP rise.

e) I rises, NX falls an equal amount, so there is no change in GDP.

f) C and GDP rise.

g) I (inventory investment, to be precise) and GDP rise.

2) 2005 nominal GDP = (30 x 150) + (6 x 300) + (500 x 0) = 6300 $ (2005)

2005 real GDP (in 2004 $) = (20 x 150) + (5 x 300) + (100 x 0) = 4500 $ (2004)

GDP deflator = nominal GDP / real GDP = 6300 / 4500 = 1.4

CPI = [(30 x 100) + (6 x 200) + (500 x 30)]/ [(20 x 100) + (5 x 200) + (100 x 30)] = 3.2

The CPI here suggests prices have risen more, because it gives greater weight to flights to Cancun, even though none was bought in 2005. This illustrates how the CPI can overstate inflation because of substitution bias. The GDP deflator may be a better measure here of cost of living, since trips to Cancun is not part of the consumption bundle, and rises in its price do not affect the consumer. However, it potentially could be argued that the GDP deflator underestimates the impact of the rise in living costs. People might have wanted to buy trips to

Cancun, but the dramatic rise in price forced them to forfeit this, and thereby lowered their welfare.

3) a) GDP falls. The services of the butler are no longer counted in the official statistics. This

shows one weakness of GDP as a measure of production: it excludes services that are not

sold in a market.

b) The butler is not counted as unemployed; he has just left the labor force. So the

denominator of the unemployment ratio falls with no change in the numerator, and this

means the unemployment rate rises (a small amount).

4) P95Q95 = $14,000, P05Q95 = $21,000, P06Q06 = $20,000, P95Q05 = $15,000,

Laspeyres index (as of CPI index) = 21,000/14,000 = 1.50,

Paasche index (as of GDP deflator) = Nominal/Real = 20,000/15,000 = 1.33,

5) Unemployment rate = 9.4/(117.6+9.4)=7.4,

6) a) True. GDP can be calculated as sum of value of final goods and services, or as sum of value added generated in the economy or finally as sum of income to productive factor.

b) False. A firm’s value added in a year is the value of its revenue minus the cost of intermediates.