COR2100 Economics and Society

Homework 3 – chapters 4 and 5

1. a. Nominal GDP in 2011: 1000000 × 0.40 + 800000 × 0.60 = $880000

Nominal GDP in 2012: 900000 × 0.50 + 840000 × 0.51 = $878400

Using 2011 prices: real GDP in 2012 = 900000 × 0.40 + 840000 × 0.60 = $864000

b. Actual output has fallen by more than the nominal GDP values from 2011 to 2012 indicate.

2. a. Introduction of new goods. This is the standard problem of keeping the consumption basket fixed
for a period of time.
b. Unmeasured quality change. Airbags make cars a better product by making them safer.
c. Substitution bias
d. Unmeasured quality change
e. Substitution bias

3. a. The cost of the market basket in 2011 is (1 × $40) + (3 × $10) = $40 + $30 = $70.
The cost of the market basket in 2012 is (1 × $60) + (3 × $12) = $60 + $36 = $96.
Using 2011 as the base year, we can compute the CPI in each year: 2011: $70/$70 × 100 = 100
2012: $96/$70 × 100 = 137.14
We can use the CPI to compute the inflation rate for 2012: (137.14 – 100)/100 × 100% = 37.14%

b. Nominal GDP for 2011 = (10 × $40) + (30 × $10) = $400 + $300 = $700. Nominal GDP for 2012 =
(12 × $60) + (50 × $12) = $720 + $600 = $1,320. Real GDP for 2011 = (10 × $40) + (30 × $10) = $400
+ $300 = $700.
Real GDP for 2012 = (12 × $40) + (50 × $10) = $480 + $500 = $980.
The GDP deflator for 2011 = (700/700) × 100 = 100.
The GDP deflator for 2012 = (1,320/980) × 100 = 134.69.
The rate of inflation for 2012 = (134.69 – 100)/100 × 100% = 34.69%.

c. No, it is not the same. The rate of inflation calculated by the CPI holds the basket of goods and
services constant, while the GDP deflator allows it to change.

4. a. When your family takes out a mortgage and buys a new house, that is investment because it is a
purchase of new capital.
b. When you use your $200 paycheck to buy stock in Singtel, that is saving because your income of
$200 is not being spent on consumption goods.
c. When your roommate earns $100 and deposits it in her account at a bank, that is saving because the
money is not spent on consumption goods.
d. When you borrow $1,000 from a bank to buy a car to use in your pizza-delivery business, that is
investment because the car is a capital good.

5. Since the amount of money we need to hold also depends on our income, as Singapore’s output
grows, demand for money in Singapore also grows, meaning the money demand curve will keep shifting
to the right.

If Singapore’s money supply remains constant, this will cause the value of money in Singapore to
increase, meaning the price level in Singapore will decrease over time (deflation). To keep prices stable,
Singapore needs to grow its money supply to keep up with money demand. Refer to the diagram below.
 MS MS’
Value of
money

MD’
MD

6. The most preferred shock should be a positive supply shock. The economy would have higher output
without the danger of inflation (on diagram: SRAS shifts to the right; price level decreases). The
government would not need to respond with a change in policy.

The least preferred shock would be a negative supply shock. The economy would experience
stagflation. There would be lower aggregate output and higher inflation (on diagram: SRAS shifts to
the left; output decreases while price level increases). There is no good policy remedy for a negative
supply shock: policies to counteract the slump in aggregate output would worsen inflation, and policies
to counteract inflation would further depress aggregate output.

It is unclear how economic policy makers would rank positive and negative demand shocks. A positive
demand shock brings a higher level of aggregate output but at a higher aggregate price level. A negative
demand shock brings a lower level of aggregate output but at a lower aggregate price level. With either
a positive or negative demand shock, policy makers could try to use either monetary or fiscal policy to
lessen the effects of the shock.

7. a. If firms become optimistic about future business conditions and increase investment, the result is
shown in figure below. The economy begins at point A (full-employment) with aggregate-demand
curve AD1 and short-run aggregate-supply curve AS1. Increased optimism leads to greater
investment, so the aggregate-demand curve shifts to AD2. Now the economy is at point B, with price
level P2 and output level Y2. The aggregate quantity of output supplied rises because with higher
prices, firms get more profits by expanding production.

b. In the long run, due to the inflationary gap, prices will increases, the expected price level rises,
shifting SRAS up (AS2) to restore output to full employment (LRAS).
c. This should have the effect of increasing the full-employment level of output in the long run, as this
increases the level of physical capital in the economy, contributing to economic growth.
Further practice (not for submission)

1.a. Nominal GDP:

2010: 1x100 + 2x50 = 200
2011: 1x200 + 2x100 = 400
2012: 2x200 + 4x100 = 800

Taking 2010 as the base year, real GDP and GDP deflator:
2010: real GDP = 200 GDP deflator = (200/200) x 100 = 100
2011: real GDP = 1x200 + 2x100 = 400 GDP deflator = (400/400) x 100 = 100
2012: real GDP = 1x200 + 2x100 = 400 GDP deflator = (800/400) x 100 = 200
b. Percentage change in nominal GDP
From 2010 to 2011: (400 – 200)/200 x 100 = 100%
From 2011 to 2012: (800 – 400)/400 x 100 = 100%

Percentage change in real GDP

From 2010 to 2011: (400 – 200)/200 x 100 = 100%
From 2011 to 2012: (400 – 400)/400 x 100 = 0%

Percentage change in GDP deflator

From 2010 to 2011: (100 – 100)/100 x 100 = 0%
From 2011 to 2012: (200 – 100)/100 x 100 = 100%

Between 2010 and 2011, prices did not change, thus there’s no change in the GDP deflator (0%), and
so the entire change in the nominal GDP (100%) is due to the change in the real GDP (100%).

Between 2011 and 2012, quantities did not change, thus there’s no change in the real GDP (0%), and
so the entire change in the nominal GDP (100%) is due to the change in the GDP deflator (100%).

c. Economic well-being rose more in 2011 than in 2012, since real GDP rose in 2011 but not in 2012.
In 2011, real GDP rose but prices did not. In 2012, real GDP did not rise but prices did.

2.a. The percent change in the price of an English textbook from 2010 to 2012 is 14.0% (equal to ($57
− $50)/$50 × 100).
b. The percent change in the price of a math textbook from 2010 to 2012 is 5.7% (equal to ($74 −
$70)/$70 × 100).
c. The percent change in the price of an economics textbook from 2010 to 2012 is 25% (equal to ($100
− $80)/$80 × 100).
d. To create an index of textbook prices, we first calculate the cost of the market basket (three English,
two math, and four economics textbooks) in each of the three years; then normalize it by dividing the
cost of the market basket in a given year by the cost of the market basket in the base period; and then
multiply by 100 to get an index value (base period of 2010 = 100).
Cost of textbooks in 2010 = 3 × $50 + 2 × $70 + 4 × $80 = $610
Cost of textbooks in 2011 = 3 × $55 + 2 × $72 + 4 × $90 = $669
Cost of textbooks in 2012 = 3 × $57 + 2 × $74 + 4 × $100 = $719

Index value for 2010 = $610/$610 × 100 = 100

Index value for 2011 = $669/$610 × 100 = 109.7
Index value for 2012 = $719/$610 × 100 = 117.9

e. The percent change in the market index for textbooks from 2010 to 2012 is (117.9 − 100)/100 × 100)
= 17.9%.
3. $100 richer in nominal (monetary terms), yes. The amount now is $1100. But prices have increased
by 20%, meaning that in actually purchasing power, the money put in the bank has not grown. So in
fact, the person putting in the money in the bank is 10% poorer (with the $1100 he/she has).

4. Private saving is equal to (Y – C – T) = 10,000 – 6,000 – 1,500 = 2,500.

Public saving is equal to (T – G) = 1,500 – 1,700 = -200.
National saving is equal to (Y – C – G) = 10,000 – 6,000 – 1,700 = 2,300.
Investment is equal to saving = 2,300.
The equilibrium interest rate is found by setting investment equal to 2,300 and solving for r:
3,300 – 100r = 2,300
100r = 1,000
r = 10 percent.

5.a. The government can reduce its deficit by reducing spending (decreasing G) and/or raising taxes
(which will decrease private consumption C). Either way, national saving increases, the supply curve
shifts right, increasing the quantity of funds and lowering interest rate.

b. If consumers decide to save more, there will be an increase in the supply of loanable funds. In the
accompanying figure, this is represented by the rightward shift of the supply curve from S1 to S2. The
increase in the supply of loanable funds reduces the equilibrium interest rate from r1 to r2. In response
to the lower interest rate, private investment spending will rise from Q1 to Q2.

c. Higher investment spending at any given interest rate leads to an increase in the demand for loanable
funds. In the accompanying figure, the increase in the demand for loanable funds shifts the demand
curve from D1 to D2 and raises the equilibrium interest rate from r1 to r2. In response to the higher
interest rate, private savings will rise from Q1 to Q2.
6.a. The statement that "Inflation hurts borrowers and helps lenders, because borrowers must pay a
higher rate of interest," is false. Higher expected inflation means borrowers pay a higher nominal rate
of interest, but it is the same real rate of interest, so borrowers are not worse off and lenders are not
better off. Higher unexpected inflation, on the other hand, makes borrowers better off and lenders worse
off.
b. The statement, "If prices change in a way that leaves the overall price level unchanged, then no one
is made better or worse off," is false. Changes in relative prices can make some people better off and
others worse off, even though the overall price level does not change.
c. The statement, "Inflation does not reduce the purchasing power of most workers," is true. Most
workers' incomes keep up with inflation reasonably well.

7.a. When the price of both goods doubles in a year, inflation is 100%. Let’s set the market basket equal
to one unit of each good. The cost of the market basket is initially $4 and becomes $8 in the second
year. Thus, the rate of inflation is ($8 – $4)/$4 × 100% = 100%. Because the prices of all goods rise by
100%, the farmers get a 100% increase in their incomes to go along with the 100% increase in prices,
so neither is affected by the
change in prices.
b. If the price of beans rises to $2 and the price of rice rises to $4, then the cost of the market basket in
the second year is $6. This means that the inflation rate is ($6 – $4) / $4 × 100% = 50%. Bob is better
off because his dollar revenues doubled (increased 100%) while inflation was only 50%. Rita is worse
off because inflation was 50% percent, so the prices of the goods she buys rose faster than the price of
the goods (rice) she sells, which rose only 33%.
c. If the price of beans rises to $2 and the price of rice falls to $1.50, then the cost of the market basket
in the second year is $3.50. This means that the inflation rate is ($3.5 – $4) / $4 × 100% = -12.5%. Bob
is better off because his dollar revenues doubled (increased 100%) while prices overall fell 12.5%. Rita
is worse off because inflation was -12.5%, so the prices of the goods she buys didn't fall as fast as the
price of the goods (rice) she sells, which fell 50%.
d. The relative price of rice and beans matters more to Bob and Rita than the overall inflation rate. If
the price of the good that a person produces rises more than inflation, he or she will be better off. If the
price of the good a person produces rises less than inflation, he or she will be worse off.

8.a. If people need to hold less cash, the demand for money shifts to the left, because there will be less
money demanded at any price level.
b. If the Fed does not respond to this event, the shift to the left of the demand for money combined with
no change in the supply of money leads to a decline in the value of money (1/P), which means the price
level rises, as shown in Figure 1.

c. If the Fed wants to keep the price level stable, it should reduce the money supply from S1 to S2. This
would cause the supply of money to shift to the left by the same amount that the demand for money
shifted, resulting in no change in the value of money and the price level.
9. The diagrams are straightforward to draw so these answers are only giving a description of the effects.
Be sure to draw out the diagrams carefully.
a. This would cause a decline in consumption spending, directly affecting AD. AD shifts left, causing
output and prices to decrease.
In the long run, due to the recessionary gap, prices will fall, the expected price level falls, shifting SRAS
down to restore output to full employment (SRAS shifts down until AD, SRAS meet on LRAS).
b. This is the opposite of (a). This would cause a rise in consumption spending, shifting AD right.
causing output and prices to increase.
In the long run, due to the inflationary gap, prices will increases, the expected price level rises, shifting
SRAS up to restore output to full employment (LRAS).
c. This would cause an increase in aggregate supply, shifting SRAS down, causing output to increase
and prices to decrease.
In the long run, due to the inflationary gap, prices will increase, the expected price level rises, shifting
SRAS up to restore output to full employment (LRAS).

10. a. This is a negative supply shock: output decreases, prices increase. The result is called a stagflation.
b. In the long run, the recessionary gap will causes prices to decrease; expected price level therefore
falls, causing SRAS to shift back down until output is back at full employment (𝑌").
c. Using expansionary policy (fiscal or monetary) to restore output:

Using contractionary policy to restore prices:

d. This type of shocks represents a trade-off in terms of policy response: responding to restore output
will cause prices to rise even higher, while stabilizing prices will cause the recession to get worse.

11. a. This would cause a rise in consumption spending, shifting AD right, causing output and prices to
increase. An inflationary gap will result.

To restore output back to full employment, the government can pursue a contractionary FP (either by
raising taxes or cutting government spending). This will provide a counter reduction in AD, shifting
AD back left.

b. This would cause a drop in investment spending, shifting AD left, causing output and prices to
decrease. A recessionary gap will result.

To restore output back to full employment, the government can pursue an expansionary FP (either by
reducing taxes or raising government spending). This will provide a counter increase in AD, shifting
AD back to the right.

c. This would cause a rise in AD, shifting AD right, causing output and prices to increase. An
inflationary gap will result.

To restore output back to full employment, the government can pursue a contractionary FP (either by
raising taxes or cutting other government spending). This causes a counter reduction in AD, shifting
AD back left.

d. This would cause a drop in consumption spending and investment spending, shifting AD left, causing
output and prices to decrease. A recessionary gap will result.

To restore output back to full employment, the government can pursue an expansionary FP (either by
reducing taxes or raising government spending). This will provide a counter increase in AD, shifting
AD back to the right.

12. Expanding the money supply is an expansionary monetary policy that causes AD to increase.
Normally this would cause output to expand and result in an inflationary gap. Over time, prices go up
and expected price level increases, to bring SRAS up and restore output to full employment.

However, if the public knows in advance what the CB will be doing, they will be adjusting their price
expectations almost straight-away. So, as AD shifts out due to the expansionary MP, SRAS will also
shift up in tandem due to a rise in the expected price level. Thus, compared to the case in which the
public doesn’t adjust their expectations straightaway, there is no short-run expansion in output, just a
rise in the price level.