ECON 2123: Macroeconomics Problem Set 1 Instructor: Fei DING

ECON2123 Macroeconomics
Problem Set 1 *Solution*
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100 marks total

Part I: True/False/Uncertain Please justify your answer with a short argument. (12 marks, 3 marks
each)
1. When disposable income equals zero, consumption equals zero.

False.

When disposable income equals zero, consumption is still positive due to autonomous consumption/consumer

confidence/c0.

2. The multiplier is greater than 1 if T = 0 and G = 0.

True.

If the marginal propensity to consume is less than 1, it means that people consume less than 100% of

their disposable income. It also implies that the multiplier is greater 1 (you can also write down the

formula of the multiplier and indicate c1 is less than 1). The fact that T = 0 and G = 0 is irrelevant.

3. Paradox of saving occurs when the attempts by people to save more lead to a decline in output and an
increase in saving in the short run.
False.
… leads to a decline in output and unchanged saving. (you should understand the mechanism behind).

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ECON 2123: Macroeconomics Problem Set 1 Instructor: Fei DING

4. When MPC (marginal propensity to consume) increases and investment decreases, goods market
equilibrium output increases.
Uncertain.

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ECON 2123: Macroeconomics Problem Set 1 Instructor: Fei DING

Part II: Multiple Choice Questions: choose the best answer (8 marks, 2 marks each)
( a ) 1. Suppose the marginal propensity to consume equals 0.8 (i.e., c1 = 0.8). Given this
information, which of the following events will cause the largest increase in output?
a. G increases by 200
b. T decreases by 200
c. I increases by 150
d. both a and b

( a ) 2. Based on our understanding of the model presented in Chapter 3, we know with

certainty that an equal and simultaneous increase in G and T will cause:
a. an increase in output
b. no change in output
c. a reduction in output
d. an increase in investment

( a ) 3. If C = 2000 + .9YD, what increase in government spending must occur for equilibrium
output to increase by 1000?
a. 100.
b. 200.
c. 250.
d. 500.
e. 1000.

( d ) 4. Which of the following is an exogenous variable in our model of the goods market in
Chapter 3?
a. consumption (C)
b. saving (S)
c. disposable income (YD)
d. government spending (G)
e. none of the above.

Part III: NATIONAL ACCOUNTS (25 marks)

For Part III, consider an artificial economy and assume the following:
(1) HKUST is an autonomous economy.
(2) The only good/service produced at HKUST is undergrad (freshmen) education.

1. Fill in the following table:

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ECON 2123: Macroeconomics Problem Set 1 Instructor: Fei DING

Year # of HKUST freshmen Price Nominal GDP Real GDP Real GDP
(tuition: HK$) (in 1990 $) (in 2000 $)
1990 300 2,000 600,000 600,000 6,000,000
2000 900 20,000 18,000,000 1,800,000 18,000,000
2001 1,000 21,000 21,000,000 2,000,000 20,000,000
2002 1,100 23,000 25,300,000 2,200,000 22,000,000

2. Find the growth rate of real GDP (using 2000$ as common price) for 2001 and 2002. (Express as
percentage change and round to the nearest tenth).

Growth rate of real GDP for 2001 (at 2000 price): (20,000,000-18,000,000)/18,000,000 = 11.1%
Growth rate of real GDP for 2002 (at 2000 price): (22,000,000-20,000,000)/20,000,000 = 10.0%

3. Find the growth rate of real GDP (using 1990$ as common price) for 2001 and 2002. (Express as

percentage change and round to the nearest tenth).

Growth rate of real GDP for 2001 (at 1990 price): (2,000,000-1,800,000)/1,800,000 = 11.1%
Growth rate of real GDP for 2002 (at 1990 price): (2,200,000-2,000,000)/2,000,000 = 10.0%

4. Given GDP deflator in 2000 is 100, compute inflation rate using GDP deflator (using 2000$) for 2001

and 2002.

GDP deflator = (nominal GDP in year t) / (real GDP in year t) = Pt

In year 2000: GDP deflator = 100

In year 2001: GDP deflator = 105, inflation rate = 5%

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ECON 2123: Macroeconomics Problem Set 1 Instructor: Fei DING

In year 2002: GDP deflator = 115, inflation rate = 9.5%

5. Use the approximation proposition: if z=x/y, the growth rate of z is approximately equal to the growth

rate of x – the growth rate of y.

Write down the GDP deflator = nominal GDP/real GDP, the growth rate of GDP deflator = inflation rate

= the growth rate of nominal GDP – the growth rate of real GDP = 10%-4% = 6%.

Part IV: The Goods Market (55 marks)

1. Suppose that the economy is characterized by the following behavioral equations: (16 marks)
C = 160 + 0.6 YD
I = 150
G = 150
T = 100
Solve for the following variables:
(1) Equilibrium GDP (Y)
(2) Disposable income (YD)
(3) Consumption spending (C)
(4) What is the value of marginal propensity to consume (MPC)?
(5) What is the value of marginal propensity to save (MPS)?
(6) Find the multiplier and autonomous spending.
(7) Solve for private saving and public saving.

Ans: (1) equilibrium GDP (Y) = 160+0.6(Y‐100)+150+150

Y=1000

(2) YD=Y-T=1000-100=900

(3) C=160+0.6(900)=700

(4) What is the value of marginal propensity to consume (MPC)? c1=0.6

(5) What is the value of marginal propensity to save (MPS)? 1-0.6=0.4

(6) Find the multiplier and autonomous spending.

Multiplier = 1/(1-c1) = 1/(1-0.6)=1/0.4= 2.5

Autonomous spending = c0 + I + G -c1 T = 160+150+150 - 0.6*100=400

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ECON 2123: Macroeconomics Problem Set 1 Instructor: Fei DING

(7) Solve for private saving and public saving.

Private saving: S = YD - C = 900 - (160+0.6*900) = 200

PUBLIC saving: T-G = 100-150= -50

2. Use the economy described in problem 1 in Part IV. (9 marks)

(1) Solve for equilibrium output. Compute total demand. Is it equal to production?
(2) Assume that G is now equal to 110. Solve for equilibrium output. Compute total demand. Is it equal to
production?
(3) Assume that G is now equal to 110, so output is given by your answer to (2). Compute private plus public
saving. Is the sum of private and public saving equal to investment? Briefly explain.
Ans:
(1) Equilibrium output is 1000. Total demand=C+I+G=700+150+150=1000. Total demand
equals production. We used this equilibrium condition to solve for output.

(2) Output falls by (40 times the multiplier) = 40/(1‐.6)=100. So, equilibrium output is now
900. Total demand=C+I+G=160+0.6(800)+150+110=900. Again, total demand equals
production.

(3) Private saving=Y‐C‐T=900‐160‐0.6(800)‐100=160. Public saving =T‐G= ‐10. National

saving equals private plus public saving, or 150. National saving equals investment.
This statement is mathematically equivalent to the equilibrium condition, total demand
equals production. In other words, there is an alternative (and equivalent) equilibrium
condition: national saving equals investment.

3. [This is a separate question. Do not use data from Part IV, Q1] Consider the following behavioral equations:
(18 marks)
C = c0 + c1 YD
T = t0 + t1 Y
YD = Y – T
G and I are both constant. Assume that t1 is between 0 and 1.
(1) Solve for equilibrium output and equilibrium taxes.
(2) What is the multiplier? Does the economy respond more to changes in autonomous spending when t1
is 0 or when t1 is positive? Explain.
(3) Why is fiscal policy in this case called an automatic stabilizer?
Now suppose that the government starts with a balanced budget and that there is a drop in c0.
(4) What happens to Y? What happens to taxes?
(5) Suppose that the government cuts spending in order to keep the budget balanced. What will be the
effect on Y (compared with your answer in (4))? Does the cut in spending required to balance the
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ECON 2123: Macroeconomics Problem Set 1 Instructor: Fei DING

budget counteract or reinforce the effect of the drop in c0 on output? (Give the answer in words briefly
and no need to do the algebra.)
(6) Based on your answer in (5), would a balanced budget requirement actually be stabilizing or
destabilizing?
Ans:
(1) Y=c0+c1YD+I+G implies Y=[1/(1‐c1+c1t1)][c0‐c1t0+I+G]
Y=[1/(1‐c1+c1t1)][c0‐c1t0+I+G]
(2) The multiplier=1/(1‐c1+c1t1)<1/(1‐c1), so the economy responds less to changes in
autonomous spending when t1 is positive. After a positive change in autonomous spending,
the increase in total taxes (because of the increase in income) tends to lessen the increase in
output. After a negative change in autonomous spending, the fall in total taxes tends to
lessen the decrease in output.
(3) Because of the automatic effect of taxes on the economy, the economy responds less to
changes in autonomous spending than in the case where taxes are independent of income.
Since output tends to vary less (to be more stable), fiscal policy is called an automatic
stabilizer.
(4) Both Y and T decrease.
(5) If G is cut, Y decreases even more. A balanced budget requirement amplifies the effect of
the decline in c0.
(6) Therefore, such a requirement is destabilizing.

4. [This is a separate question. Do not use data from Part IV, Q1] Suppose the economy is characterized
by the following behavioral equations: (12 marks)
C = c0 + c1 YD
YD = Y – T
I = b0 + b1 Y
Government spending and taxes are constant. Note that investment now increases with output.
(1) Solve for equilibrium output.
(2) What is the value of the multiplier? How does the relation between investment and output affect the
value of the multiplier? For the multiplier to be positive, what condition must (c1 + b1) satisfy?
(3) Suppose that the parameter b0, sometimes called business confidence, increases. How will
equilibrium output be affected? Will investment change by more or less than the change in b0? Why?
What will happen to national saving?
Ans:
(1) Y=C+I+G
Y=[1/(1‐c1‐b1)]*[c0‐c1T+b0+G]

(2) Including the b1Y term in the investment equation increases the multiplier. Increases in
autonomous spending now creates a multiplier effect through two channels:
consumption and investment. For the multiplier to be positive, the condition
c1+b1<1 is required.

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ECON 2123: Macroeconomics Problem Set 1 Instructor: Fei DING

(3) Output increases by b0 times the multiplier. Investment increases by the change in b0
plus b1 times the change in output. The change in business confidence leads to an
increase in output, which induces an additional increase in investment. Since
investment increases, and saving equals investment, saving must also increase. The
increase in output leads to an increase in saving.