1.

For each transaction, explain why it would or would not be counted in the
GDP of the United States.
A) American auto producer Ford builds a factory in Alberta, Canada.
B) You buy a blueberry muffin at your local coffee shop.
C) A Ford dealership in Ohio has 15 unsold new 2011 model cars at the end of
2011.

Correct Answer:
A) No. This is investment spending but not in the United States, so it does not
count in U.S. GDP.
B) Yes. This is consumer spending.
C) Yes. These unsold cars would be counted as unsold inventory in investment
spending.

2. Why do economists bother to compute real GDP? Why can't we just compare
nominal GDP from one year to the next?

Correct Answer:
Nominal GDP shows the value of a nation's output of goods and services in a given
year, but part of that value is determined by the prices of those goods and services.
If those prices increase, nominal GDP will increase, even if output levels stay the
same. Real GDP computes the value of goods and services produced during a
year using prices from a reference year, or base year. This way we can see
whether the nation's output changed, holding prices constant.

3. You have agreed to borrow $2000 from the bank for one year. The nominal
rate of interest is 8.5 percent and the real interest rate is 6 percent. At
the end of the year, inflation was 3.5 percent. How does this affect the
borrower (you) and the lender (the bank)? Who is better off?

Correct Answer:
The terms of the loan included an inflation expectation of 2.5 percent (8.5 percent
% – 6 percent). Since actual inflation was 3.5 percent, more than expected, the
bank is worse off and you are better off. The real rate of interest, with actual
inflation of 3.5 percent, was 8.5 percent – 3.5 percent, or 5 percent, which is lower
than the original terms of the loan. Because of the unexpectedly high rate of
inflation, in real terms you are actually undercompensating the bank for lending
you the money.

4. The market for loanable funds is in equilibrium. All else equal, the federal
government has eliminated all taxes on interest that is earned from savings.
Describe how this will affect the market for loanable funds, the equilibrium
interest rate, and the equilibrium quantity of loanable funds.

Correct Answer:
If households are no longer taxed on income earned from interest on savings,
savings will increase and the supply of loanable funds will shift to the right. The
equilibrium interest rate decreases and the equilibrium quantity of loanable funds
increases.

5. How does rising consumer optimism affect the aggregate demand curve? Explain
your response.

Correct Answer:
When consumers are more optimistic about future income, they often increase
spending now. As spending increases at all price levels, the aggregate demand
curve shifts to the right.

6. Suppose the economy is initially in long-run equilibrium and there is a

negative demand shock to the economy. Describe the short-run effects of this
demand shock and how the economy will adjust in the long run.

Correct Answer:
If the economy is initially at potential real GDP and the AD curve shifts to the left,
it will decrease real GDP and the price level along the SRAS curve. This is a
recessionary gap. Because of the high level of unemployment, nominal wages
eventually fall, which gradually shifts the SRAS to the right. As the SRAS
increases, real GDP increases and the price level decreases along the new AD
curve. The adjustment process concludes when real GDP again reaches the level
of potential real GDP, but at a lower price level.
7. Suppose that real GDP is $500 and potential GDP is $1000, while the marginal
propensity to consume is 0.9. If the government is going to engage in
government spending and does not impose taxes, what specific fiscal policy
action should policy makers take?

Correct Answer:
The MPC = 0.9, so the multiplier is 1 / (1 – 0.9) = 10. Because real GDP needs to
increase by $500, government spending must increase by $50.

8. Donald owns several hotels in New York, Las Vegas, and other centers of
tourist activity. Much of Donald's hotel revenue comes from European tourists.
Suppose the U.S. dollar depreciates against the euro. Explain how this will
affect Donald's hotel business.

Correct Answer:
When the dollar depreciates against the euro, the dollar becomes less expensive
to purchase with those euros. Because Donald's hotel rates are quoted in dollars,
those prices just fell for European tourists. Donald's hotel business should expect
increased revenue from Europeans, who now find it less expensive to travel to the
United States.

9. Explain why a recession would, all else equal, decrease the demand for
money.

Correct Answer:
Households hold money to make purchases. A recession is going to decrease real
GDP and the number of purchases made by most households, thus shifting the
money demand curve to the left.

10. Suppose that on January 1 the exchange rate was ¥120 per U.S. dollar. On
December 31 of that year, a person needed ¥125 to buy $1. Over the course of
that year, did the dollar appreciate or depreciate against the yen? Did the
change in the exchange rate make American goods and services more or less
attractive to Japanese consumers? Explain.
Correct Answer:
At the end of the year, it took more yen to buy a dollar. In other words, the price of
a dollar has increased, or appreciated. Because it takes more yen to buy a dollar,
the price of American goods to Japanese consumers will increase. As a result,
American goods will be less attractive to Japanese consumers.