Study Guide 2 Practice Problem Answers:
- How is the CPI calculated?
It’s calculated as the cost of a market basket of goods and services in one year divided by the cost of that same market basket of goods and services in a base year.
- Here are values of the CPI for each year from 1990 to 1994.
Year / CPI / Inflation Rate (%)
1990 / 1.307 / x
1991 / 1.362 / 4.2%
1992 / 1.403 / 3.0%
1993 / 1.445 / 3.0%
1994 / 1.482 / 2.6%
- For each year beginning with 1991, calculate the rate of inflation from the previous year.
- If the nominal interest rate was 6.4% in 1992, what was the real interest rate?
Real = nominal – inflation; 6.4% – 3.0% = 3.4%
- Suppose you learn your grandfather earned $3,000 in 1933 when the CPI was 0.130. Your father earned $50,000 in 1993. Who earned more in real terms?
Grandpa’s real salary = 3,000/0.130=23,076.92
Father’s real salary = 50,000/1.445=34,602.08
Your father earned more!
- Suppose the CPI equaled 1.00 in 1995 and 1.65 in 2005 and a typical household's income equaled $35,000 in 1995 and $40,000 in 2005. What happened to real household income between 1995 and 2005?
The price level increased 65%, while nominal income increased by 14.3%. Therefore real household income decreased. Or 1995 income in 2005 dollars is (1.65/1.00)*$35,000 = $57,750 (higher than $40,000, so real income declined)
- Who does higher than expected inflation help and who does it hurt?
It helps borrowers and employers, and it hurts savers, lenders, and employees.
- Suppose workers expect inflation to be 3% next year and create a contract to increase real wages by 4%. Actual inflation turns out to be 5%. What happens to the real wages of workers?
Under their contract, workers will be receiving a 7% (3%+4%) increase in nominal wages. With inflation at 5% instead of 3%, workers will actually be receiving a 2% increase in real wages (7%-5%).
- If a bank wants to earn a 4% real interest rate and inflation is 6%, what nominal interest rate would the bank have to charge?
Real interest rate = nominal interest rate – inflation rate. 4% = nominal interest rate - 6%. Solving for the nominal interest rate, you get 10% = (6%+4%).
- Why is deflation generally considered to be worse as far as its impact to the economy than inflation?
Because it reduces consumer spending (by encouraging consumers to save more) and destroys credit markets (because banks don’t want to lend).
10. What is the current economic situation in the U.S.? How bad was the Great Recession compared to the Great Depression and previous recessions? What economic indicators have rebounded since the Great Recession ended? What are projections for GDP, unemployment, and inflation in the next few years?
Review the presentation titled “Today’s Economic Situation” which we went through in class (and which is posted on the class website).
11. What is total factor productivity? What does it tell us? Why is it important?
It’s a measure of output changes not caused by observable inputs. It tells how GDP changes as a result of changes in technology. It is important because it is the most closely aligned with Median income levels.
12. The larger the mpc, the larger the multiplier and the larger the effect of a change in initial spending on short-run equilibrium output.
13. Suppose the marginal propensity to consume is 0.67, and the change in initial spending is $50 million. What is the estimated change to GDP?
If the MPC is 0.67, the multiplier is 3, so the change to GDP would be $50 million*3=$150 million.
14. If aggregate expenditure in an economy equals 1,000 + .9Y, initial spending equals 1000, the MPC equals 0.9, and the multiplier equals 10.
15. If aggregate expenditure in an economy equals 1,000 + .9Y and potential output (Y*) equals 9,000, then this economy has a(n) expansionary output gap equal to 1,000.
16. short-run equilibrium output equals 9,000, the MPC equals .8, and potential output (Y*) equals 10,000, then spending must be increased by $200 to eliminate any output gap.
17. Suppose the potential output in an economy is $8 trillion, actual output is $7 trillion, and the multiplier is 4. To remove this output gap, what must the change in initial expenditures equal?
There must be an increase in output equal to $1 trillion. With a multiplier of 4, the change in initial expenditures must equal $250 billion.
18.Refer to the figure above. Based on the figure and starting from an initial short-run equilibrium where output equals 20,000, if initial spending decreases by 1,000, then the new short-run equilibrium is at an output equal 16,000.
19. Based on the figure, if the economy is in short-run equilibrium with output equal to 16,000, then there is a(n) recessionary gap and a $1,000 increase in government spending would return the economy to potential output (Y*).
20.Based on the figure, suppose output is currently at 16,000. According to Okun’s Law, what is the level of cyclical unemployment?
According to Okun’s Law, the level of cyclical unemployment equals ½ the output gap in percentage terms. If output is 16,000, the output gap equal (4,000/20,000)*100=20%, so cyclical unemployment is equal to 10%.
21.Based on the figure above, if the economy is in short-run equilibrium with output equal to 24,000, then there is a(n) expansionary gap and a $1,000 decrease in government spending would return the economy to potential output (Y*).
22. Based on the figure above, the multiplier in the economy equals 4.
23. Suppose there is an expansionary output gap. What steps could the government take to eliminate the gap?
Decreasing government spending or increasing taxes would lead to a downward shift of the aggregate expenditure line and would thus decrease short-run equilibrium output.
24. An increase in inflation causes a(n) decrease in aggregate quantity demanded and a(n) increase in aggregate quantity supplied, other things constant.
25. Suppose there is a boom in the stock market that increases wealth in the economy. How would this affect the AD and/or AS curve? How would this affect inflation in the short-run
An increase in wealth will increase aggregate demand (shift the AD curve to the right).
It will not affect the AS curve.
This will increase inflation and output in the short run.
26. Consider a situation where the economy is initially in a long-run equilibrium and a decrease in housing prices induces a large decrease in consumer spending. How would this affect inflation and output in the short-run?
The decrease in consumer spending causes a leftward shift of the AD curve and causes a recessionary gap. Inflation will be lower and output will be below potential.
Consider the following graph:
27. At point A there is a recessionary gap equal to (Y*-Y1).
28. Suppose the economy starts at point A. What is the appropriate fiscal policy to bring the economy back to potential?
Because there is a recessionary gap the appropriate fiscal policy is to increase government spending and/or decrease taxes in order to increase aggregate demand.
29. As the U.S. dollar appreciates in value compared to foreign currencies, what will happen to the prices of U.S. exports and foreign imports, as well as net exports?
U.S. exports become more expensive and foreign imports become cheaper, causing net exports to fall.
30. Suppose the invention of a new computer system permanently increases worker productivity. What will happen to output and inflation in the long-run?
Increasing productivity will shift the LRAS curve to the right. We would see output increase and inflation decrease.
31. What is stagflation and what is it associated with in the AD/AS model?
Stagflation occurs when inflation is increasing at the same time output is falling below potential (so there is high inflation and high unemployment).
It is associated with a decrease in AS.
32. Fill in the first two blanks with high or low. Then explain what was true of AD or AS to explain that situation (AD was higher, AD was lower, AS was higher, AS was lower).
a. For most of the 1960s there was high inflation and low unemployment. This is because AD was higher than normal.
b. For most of the 1970s there was high inflation and high unemployment. This is because AS was lower than normal.
c. For most of the 1990s there was low inflation and low unemployment. This is because AS was higher than normal.
d. Today there is low inflation and high unemployment. This is because AD is lower than normal.
33. What are automatic stabilizers?
Automatic stabilizers are anything that creates automatic increases in government spending or decreases in taxes when output declines and vice versa.
34. The U.S. income tax system is progressive, which means that as GDP rises, average tax rates rise.
The following table shows U.S. income tax brackets in the U.S. in 2011
Tax Bracket / Taxable Income10% / $0–$8,350
15% / $8,351– $33,950
25% / $33,951–$82,250
28% / $82,251–$171,550
33% / $171,551–$372,950
35% / $372,951 and above
35. a. What’s the average tax rate for someone who earns $25,000?
Amount paid in taxes = 0.10 * $8350 + 0.15 ($25,000 - $8,351) = $3332.25
Average tax rate = 3332.25/25,000 = 13.3%
b. What’s the average tax rate for someone who earns $50,000?
Amount paid in taxes = 0.10 * $8,350 + 0.15 ($33,950 - $8,351) + 0.25 ($50,000 - $33,951) = $835 + $3839.85 + $4012.25 = $8687.10
Average tax rate = 8687.10/50,000 = 17.4%
36. Someone who earns $50,000 falls into a tax bracket of 25% in the U.S. The percent of their income paid in federal taxes will be less than 25% (as shown by 35 b. they only pay 17.4%).
37. The U.S. deficit currently equals approximately $1.3 trillion, and the national debt currently equals approximately $15 trillion.
38. What is the difference between gross and net public debt?
Gross public debt includes the total amount owed to all holders of government securities. Net public debt is equal to gross public debt minus intragovernmental debt (the amount owed to holders of public securities outside of the government).
39. What are the major problems associated with a large amount of government debt?
The opportunity cost of interest payments, the transfer of wealth to foreign governments, the increase in income inequality, the reduction in national savings (and investment), and it limits the government’s ability to respond to adverse events.
40. What are the future projections regarding the U.S. debt situation?
Future projections suggest it’s likely to get a lot worse before it gets better. The main reason is Social Security, Medicare/Medicaid, and Interest Payments are expected to increase dramatically.
41. Currently, approximately 34% of the federal U.S. budget is ‘discretionary’. If fiscal policy is not changed, it is projected that 0% of the federal U.S. budget will be discretionary by 2030.
42. Increase tax revenue (by increasing payroll tax rates (employer/employee rates are currently equal to 6.2%) and/or increasing the current ceiling of $106,800).
AND/OR:
Decrease expenditures (by increasing the age of eligibility, decreasing benefits for all retirees, and/or disqualifying wealthy individuals)
43. Since 2000, what has happened to average tax rates in the U.S. and the top marginal income tax rate?
Since 2000, both average tax rates and the top marginal income tax rate have fallen. The top marginal tax rate fell from 39.6 to 35%, and average tax rates have fallen from 18.5 to 16.3%
44. Laffer curve shows the relationship between tax rates and tax revenue.
45. Empirical studies suggest that the peak of the Laffer curve is equal to approximately 80%.
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