Econ 116

Problem Set 1 Solutions

I True/False:
1. True: The expenditure approach and the income approach to measuring GDP yield the same
result. When money is spent for a good or service, this is also income which is received by the
firm. This, in turn, goes towards paying wages or other expenses such as interest or taxes, and
what remains is corporate profit.
2. True: GDP is the total value of all goods produced and services provided in a given year. The
child provided a service worth $20 and, assuming this is reported, is thus counted in GDP.
3. True: Inventories are finished goods which are produced by a firm, but not yet sold. Holding
all else constant, an increase in inventories means that more goods were produced than sold in a
given year. However, GDP measures the production, not sales, of goods and services, and
therefore an increase in inventories, assuming everything else is unchanged, amounts to an
increase in GDP.
4. False: The measure of unemployment includes all individuals who are actively looking for a
job, but do not have a job. Cyclical unemployment, caused by fluctuations in economic activity,
is not the only reason for unemployment. The measure of unemployment also includes frictional
unemployment and structural unemployment. Frictional unemployment is the unemployment
that results from short run matching problems. It takes time and effort for workers to search for a
job and employers to search for workers, and this friction in the labor market results in short run
unemployment. Structural unemployment refers to the long run adjustment problems resulting
from changes in the structure of the economy, but is not related to economic fluctuations. For
example, increases in international trade have caused structural unemployment domestically
when firms, and therefore jobs, have moved overseas.
5. False: A discouraged worker is someone who was once looking for a job, but has given up.
Since the worker is no longer actively searching for a job, he or she is no longer counted as being
in the labor force, and therefore is no longer included in the measure of unemployment. Many
complain that since the unemployment measure does not include discouraged workers, the true
unemployment rate is underestimated.

II
1. 2008 I to 2008 II:
Quarterly Rate:

11,727.4 11,646.0
0.0070 0.7%
11,646.0

Annual Rate:
(1.007 ) 4 1 0.028 2.8%

2008 II to 2008 III

Quarterly Rate:

11,712.4 11,727.4
.0013 0.13%
11,727.4

Annual Rate:
(1 0.0013) 4 1 0.0052 0.52%

Residential Investment:
353.7 596.5
0.4070 40.7%
596.5

Note that this increase is over 2 years, or 10 quarters, whereas an annual rate is over 4
quarters. Therefore, the exponent you want to use is 4/10.
(1 0.4070)

4
10

1 0.1886 18.86%

2. The increase in savings was due to the tax rebate checks that were sent out by the federal
government.

III
1. On January 16, the BLS announced that the change in the CPI over the month of December
was -0.7%. This is not given at an annual rate, but instead as a monthly rate. The market
expected a change of -0.9%, so the difference between the actual rate and the expected rate was
not large enough to create a significant reaction from the financial market.
IV
1. To find the price level in a given year using 2005 quantity weights, multiply the price of each
good in that year times the quantity purchased in 2005, and sum across goods.
2005 Price Level = (5 x 100) + (4 x 80) + (10 x 200) + (13 x 50) + (20 x 20) = 3870
2006 Price Level = (7 x 100) + (4 x 80) + (15 x 200) + (15 x 50) + (22 x 20) = 5210
Percent Change:

5210 3870
0.346 34.6%
3870

To find the price level in a given year using 2006 quantity weights, multiply the price of each
good in that year times the quantity purchased in 2006, and sum across goods
2005 Price Level = (5 x 75) + (4 x 100) + (10 x 200) + (13 x 50) + (20 x 25) = 3925
2006 Price Level = (7 x 75) + (4 x 100) + (15 x 200) + (15 x 50) + (22 x 25) = 5225
Percent Change:

5225 3925
0.3312 33.12%
3925

Since the price change of each good is weighted differently, the inflation rates will be different
depending on the base year used.

To find nominal GDP for a given year, multiply the price of each good times the quantity
produced, and sum across goods:
2005 GDP = (5 x 100) + (4 x 80) + (10 x 200) + (13 x 50) + (20 x 20) = 3870
2006 GDP = (7 x 75) + (4 x 100) + (15 x 200) + (15 x 50) + (22 x 25) = 5225