Assignment 1: Intermediate Macroeconomics

Fall 2019
Deadline: 2 October 2019, 11 am.
Total Marks: 100

1. Consider a macroeconomy that produces smartphones, automobiles and haircuts. Use

Products Quantity (in millions) Price (in USD)

(a) (10 points) Calculate nominal and real GDP for 2018 and 2019 using 2018 as the
base year. What are the growth rates of nominal and real GDP over this period?
Answer:
Nominal GDP2018 = (50 X $4) + (8 X $40) + (60 X $20) = $200 + $320 +$1200
= $1720
Nominal GDP2019 = (60 X $3.5) + (10 X $35) + (50 X $25) = $210 + $350 +
$1250 = $1810
Real GDP2018 = Nominal GDP2018 = $1720
Real GDP2019 = (60 X $4) + (10 X $40) + (50 X$20) = $240 + $400 + $1000 =
$1640
Nominal GDP growth rate = 100 X $1810−$1720
$1720
= 5.23%
$1640−$1720
Real GDP growth rate = 100 X $1720 = −4.65%

(b) (10 points) Assuming that the 2018 quantities in the table also represent the typical
consumer’s basket of goods, calculate the GDP deflator and CPI for 2018 and 2019
using 2018 as the base year.
Answer:
GDP Def lator2018 = 100
GDP Def lator2019 = N ominal GDP2018
Real GDP2018
X100 = $1810
$1640
X100 ≈ 110.
CP I2018 = 100
CP I2019 = (50X$3.5)+(8X$35)+(60X$25)
$1720
X100 = $1955
$1720
X100 ≈ 113.
 (c) (6 points) What is CPI inflation rate between 2018 and 2019? Explain how the
substitution bias may cause the CPI to overstate inflation and give an example
using one of the three goods or services.
Answer: The CPI inflation rate between 2018 and 2019 is approximately 13%.
The CPI inflation rate is biased because consumers substitute away from more
expensive items, but the CPI uses a fixed basket of goods that does not recognize
this substitution. For example, increase in milk price leads some consumers to
substitute away from milk. This substitution is not reflected in the CPI because
the quantity of milk in the representative “basket” is fixed.

2. Consider whether each of the following events is likely to increase or decrease real GDP.
In each case, do you think the well-being of the average person in society most likely
changes in the same direction as real GDP? Why or why not?
(a) (2 points) A hurricane in Florida forces Disney World to shut down for a month.
Answer: Real GDP falls because Disney does not produce any services while
it is closed. This corresponds to a decrease in economic well-being because the
income of workers and shareholders of Disney falls (the income side of the national
accounts), and people’s consumption of Disney falls (the expenditure side of the
national accounts).
(b) (2 points) Firms throughout the economy experience falling demand, causing them
to lay off workers.
Answer: Real GDP falls because the firms that lay off workers produce less. This
decreases economic well-being because workers’ incomes fall (the income side), and
there are fewer goods for people to buy (the expenditure side).
(c) (2 points) Congress passes new environmental laws that prohibit firms from using
production methods that emit large quantities of pollution.
Answer: Real GDP is likely to fall, as firms shift toward production methods that
produce fewer goods but emit less pollution. Economic well-being, however, may
rise. The economy now produces less measured output but more clean air; clean
air is not traded in markets and, thus, does not show up in measured GDP, but is
nevertheless a good that people value.
(d) (2 points) Fathers around the country reduce their workweeks to spend more time
with their children.
Answer: Measured real GDP falls because fathers spend less time producing mar-
ket goods and services. The actual production of goods and services need not have
fallen, however. Measured production (what the fathers are paid to do) falls, but
unmeasured production of child-rearing services rises.
(e) (2 points) Increased hostility between unions and management sparks a rash of
strikes.
Answer: Real GDP falls because with fewer workers on the job, firms produce less.
This accurately reflects a fall in economic well-being.

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3. Assume the currency is 500 billion USD and bank reserves are 2 trillion USD. The
minimum allowable reserve requirement set by the Fed is 10% of deposits. Show all your
calculations.
(a) (5 points) What is the money supply if banks lend the maximum allowable and
households do not hold any cash?
1+cr 1+0.0 1
Answer: The money multiplier is: m = cr+rr = 0.0+0.1 = 0.1 = 10.
The money supply is: M = m X B = m X (C + R) = 10 X 2.5 = $25 trillion.
(b) (5 points) What is the money supply if households decide to hold 20% of deposits
in the form of cash?
1+cr 1+0.2
Answer: The money multiplier is: m = cr+rr = 0.2+0.1 = 1.2
0.3
= 4.
The money supply is: M = m X B = m X (C + R) = 4 X 2.5 = $10 trillion.
(c) (5 points) What is the money supply if banks become cautious about lending, and
even though the minimum reserve requirement by law remains at 10%, banks decide
to hold back 20% of deposits in reserves? Assume households still hold 20% of
deposits as cash.
1+cr 1+0.2
Answer: The money multiplier is: m = cr+rr = 0.2+0.2 = 1.2
0.4
= 3.
The money supply is: M = m X B = m X (C + R) = 3 X 2.5 = $7.5 trillion.
(d) (5 points) The Fed wishes to increase the money supply by 10%. Carefully describe
two methods for doing this using the multiplier in part (a).
1
Answer: The Fed could change the reserve requirement to rr = 11 = 9.1$, so the
new money supply would be M = m X B = 11 X 2.5 = $27.5 trillion.
Alternatively, the Fed could increase bank reserves to $2.25 trillion by purchasing
$250 billion of government securities on the open market.

4. When the government subsidizes investment, such as with an investment tax credit,
the subsidy often applies to only some types of investment. This question asks you to
consider the effect of such a change. Suppose there are two types of investment in the
economy: business investment and residential investment. The interest rate adjusts to
equilibrate national saving and total investment, which is the sum of business investment
and residential investment. Now suppose that the government institutes an investment
tax credit only for business investment.
(a) (4 points) How does this policy affect the demand curve for business investment?
The demand curve for residential investment?
Answer: The demand curve for business investment shifts out because the subsidy
increases the number of profitable investment opportunities for any given interest
rate.
The demand curve for residential investment remains unchanged.
(b) (6 points) Draw the economy’s supply and demand curves for loanable funds. How
does this policy affect the supply and demand for loanable funds? What happens
to the equilibrium interest rate?
Answer: The total demand curve for investment in the economy shifts out since it
represents the sum of business investment, which shifts out, and residential invest-

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 ment, which is unchanged. As a result the real interest rate rises as in the Figure
(4b).

(c) (6 points) How does this policy affect the total quantity of investment? The quan-
tity of business investment? The quantity of residential investment?
Answer: The total quantity of investment does not change because it is con-
strained by the inelastic supply of savings. The investment tax credit leads to a
rise in business investment, but an offsetting fall in residential investment. That
is, the higher interest rate means that residential investment falls (a shift along the
curve), whereas the outward shift of the business investment curve leads business
investment to rise by an equal amount. The following Figure (4c) shows this change.

5. Consider a Cobb–Douglas production function with three inputs. K is capital (the num-
ber of machines), L is labor (the number of workers), and H is human capital (the number
of college degrees among the workers).
The production function is Y = K 2/5 L1/5 H 2/5 .

(a) (3 points) Derive an expression for the marginal product of labor. How does an
increase in the amount of human capital affect the marginal product of labor?
Answer: The production function: Y = K 2/5 L1/5 H 2/5 .
The marginal product of labor is: M P L = δY
δL
= 15 K 2/5 L−4/5 H 2/5 = 15 YL .

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 An increase in H will increase MPL.
(b) (3 points) Derive an expression for the marginal product of human capital. How
does an increase in the amount of human capital affect the marginal product of
human capital?
Answer: The marginal product of human capital is: M P H = δHδY
= 25 K 2/5 L1/5 H −3/5 =
2Y
5H
.
An increase in H will decrease MPH.
(c) (3 points) What is the income share paid to labor? What is the income share paid
to human capital?
Answer: The labor share of output is the proportion of output that goes to labor.
The total amount of output that goes to labor is the real wage (which, under perfect
competition, equals the marginal product of labor) times the quantity of labor. This
quantity is divided by the total amount of output to compute the labor share. Thus,
the income share paid to labor (L) is M PYLXL = 15 .
Similarly, the income share paid to human capital (H) is M P HXH
Y
= 52 .
Since both labor payment and human capital payment goes to the worker, they will
receive 3/5 of the total income.
(d) (5 points) An unskilled worker earns the marginal product of labor, whereas a
skilled worker earns the marginal product of labor plus the marginal product of
human capital. Using your answers to parts (a) and (b), find the ratio of the skilled
wage to the unskilled wage. How does an increase in the amount of human capital
affect this ratio? Explain.
Answer: The ratio of skilled wage to the unskilled wage is: M P ML+M P H
PL
= 1 + 2LH
.
The ratio is always greater than 1 because skilled workers get paid more than
unskilled workers. Also, when H increases this ratio falls because the diminishing
returns to human capital lower its return, while at the same time increasing the
marginal product of unskilled workers.
(e) (4 points) Some people advocate government funding of college scholarships as a
way of creating a more egalitarian society. Others argue that scholarships help only
those who are able to go to college. Do your answers to the preceding questions
shed light on this debate?
Answer: If more college scholarships increase H, then it does lead to a more egali-
tarian society. As more and more people get higher education, the amount of human
capital H in the economy increases, which actually reduces the wage difference be-
tween educated workers and uneducated workers. This will help to create a more
egalitarian society. The policy lowers the returns to education, decreasing the gap
between the wages of more and less educated workers. More importantly, the policy
even raises the absolute wage of unskilled workers because their marginal product
rises when the number of skilled workers rises.
0.2Y
6. An economy has the following money demand function: (M/P )d = i1/2
.
(a) (3 points) Derive an expression for the velocity of money. What does velocity
depend on? Explain why this dependency may occur.

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 Answer: As we know, (M/P )d = kY = 0.2Y i1/2
and from both versions of quantity
theory of money we know that k=1/v.
i1/2
Now, k = i0.2
1/2 , then velocity of money, v = 0.2 .

Hence, velocity of money depends on the nominal interest rates level since nominal
interest rate represents the opprtunity cost associated with holding money.
(b) (2 points) Calculate velocity if the nominal interest rate i is 4 percent.
Answer: Nominal interest rate = 4 percent = 0.04.
1/2 1/2
Substituting the value of i in velocity of money: v = i0.2 = 0.040.2
= 0.2
0.2
= 1.
(c) (2 points) If output Y is 1,000 units and the money supply M is 1,200 USD, what
is the price level P ?
Answer: Y = 1000, M = 1200, V = 1 from part (c). From quantity theory of
money: MV = PY. Then, price level, P = MYV = 1200X1
1000
= 1.2.
(d) (3 points) Suppose the announcement of a new head of the central bank, with a
reputation of being soft on inflation, increases expected inflation by 5 percentage
points. According to the Fisher effect, what is the new nominal interest rate?
Answer: Fisher equation: r = i − Eπ. or, i = r + Eπ
Then, a 5 percent increase in expected inflation rate leads to a 5 percent rise in
nominal interest rate hence the new nominal interest rate becomes (4 + 5) = 9
percent.

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