Practice Questions

Chapter 21 Measuring National Output and National Income

Q1. Define GDP in broad terms.

A1. GDP stands for Gross Domestic Product. It represents the total market value of a

country's output. It is the market value of all final goods and services produced within a

given period of time by factors of production located within a country.

Q2. Explain carefully the difference between GDP and GNP.

A2. Gross Domestic Product is the market value of all final goods and services produced

within the confines of a country regardless of the national origin of the inputs that were

used to produce the goods. Gross National Product by contrast measures the market value

of all final goods and services produced within a given period by factors of production

owned by the country's citizens, regardless of where the output is produced.

Q3. Suppose that your economics professor spent a week in Moscow delivering a series of

lectures sponsored by the Russian government and a Russian professor spent a week in the

Turkish delivering a series of lectures sponsored by your university. How would each of these

events be reconciled in the Turkish and Russian GDP and GNP accounts?

A3. The Turkish economics professor's lecture would count as part of the Turkish GNP

because it is output produced by a Turkish input. It would also count as part of Russia's

GDP since the lecture was delivered on Russian soil. Remember that GDP is prejudiced as

to where the output is produced but is blind as to the national origin of the input. Just the

reverse is true of the Russian professor's lecture in the Turkey. His lecture would count as

Russia's GNP and as Turkish GDP.

Q4. Based on the expenditure approach, discuss and explain each of the components of GDP.

A4. Personal consumption expenditures represent the purchase of final goods and services

by the household sector. Gross Private Domestic investment represents spending by firms

and households on new capital, changes in business inventories, and new residential

structures. Government consumption is the purchase of goods and services by the

government at the state and local levels. And finally, net exports (exports - imports)

represent the net sale of final goods and services to the rest of the world.

Q5. Explain how the term investment in economics is different from the way it is used in

everyday life.

A5. In economics, investment refers to the purchase of new capital such as housing, plants,

equipment and inventory. In everyday use the term often means the purchase of common

stocks, bonds or mutual funds.

Q6. Using the below data calculate National income using the income approach and identify

which two items on the list are superfluous in your calculation.

A6. Using the income approach the GDP is $7750 billion. Consumption and government

spending are not needed in the calculation, as they are expenditure components.

In the first step, please review National Income accounting table in your textbook, that is

National Income= Compensation of Employees + Proprietors' income +Rental Income +

Corporate Profits + Net Interest + Indirect Taxes minus subsidies + Net business transfers

+ Surplus of government enterprises.

In above question sum all corresponding items up regarding our formula of National

Income.

National Income=4500+500+800+400+100+500=6800
Q7. Refer to Table below.

a. What is current year’s nominal GDP?

b. What is current year’s real GDP in terms of base-year prices?

A7. Current year’s nominal GDP:

𝒄𝒖𝒓𝒓𝒆𝒏𝒕 𝒚𝒆𝒂𝒓 𝒄𝒖𝒓𝒓𝒆𝒏𝒕 𝒚𝒆𝒂𝒓 𝒄𝒖𝒓𝒓𝒆𝒏𝒕 𝒚𝒆𝒂𝒓 𝒄𝒖𝒓𝒓𝒆𝒏𝒕 𝒚𝒆𝒂𝒓

𝑮𝑫𝑷𝒄𝒖𝒓𝒓𝒆𝒏𝒕 𝒚𝒆𝒂𝒓 = (𝑷𝒃𝒓𝒆𝒂𝒅 × 𝑸𝒃𝒓𝒆𝒂𝒅 ) + (𝑷𝒄𝒐𝒎𝒑𝒖𝒕𝒆𝒓 𝒅𝒊𝒔𝒌𝒔 × 𝑸𝒄𝒐𝒎𝒑𝒖𝒕𝒆𝒓 𝒅𝒊𝒔𝒌𝒔 )

𝑮𝑫𝑷𝒄𝒖𝒓𝒓𝒆𝒏𝒕 𝒚𝒆𝒂𝒓 = (𝟐. 𝟏𝟎 × 𝟕𝟓. 𝟎𝟎𝟎) + (𝟏. 𝟖𝟎 × 𝟏𝟖. 𝟎𝟎𝟎) = 𝟏𝟖𝟗. 𝟗𝟎𝟎

Current year’s real GDP in terms of base-year prices:

𝒃𝒂𝒔𝒆 𝒚𝒆𝒂𝒓 𝒄𝒖𝒓𝒓𝒆𝒏𝒕 𝒚𝒆𝒂𝒓 𝒃𝒂𝒔𝒆 𝒚𝒆𝒂𝒓 𝒄𝒖𝒓𝒓𝒆𝒏𝒕 𝒚𝒆𝒂𝒓

𝑮𝑫𝑷 𝒄𝒖𝒓𝒓𝒆𝒏𝒕 𝒚𝒆𝒂𝒓 = (𝑷𝒃𝒓𝒆𝒂𝒅 × 𝑸𝒃𝒓𝒆𝒂𝒅 ) + (𝑷𝒄𝒐𝒎𝒑𝒖𝒕𝒆𝒓 𝒅𝒊𝒔𝒌𝒔 × 𝑸𝒄𝒐𝒎𝒑𝒖𝒕𝒆𝒓 𝒅𝒊𝒔𝒌𝒔 )
𝒘𝒊𝒕𝒉 𝒃𝒂𝒔𝒆 𝒚𝒆𝒂𝒓 𝒑𝒓𝒊𝒄𝒆𝒔

𝑮𝑫𝑷𝒄𝒖𝒓𝒓𝒆𝒏𝒕 𝒚𝒆𝒂𝒓 𝒘𝒊𝒕𝒉 𝒃𝒂𝒔𝒆 𝒚𝒆𝒂𝒓 𝒑𝒓𝒊𝒄𝒆𝒔 = (𝟏. 𝟎𝟎 × 𝟕𝟓. 𝟎𝟎𝟎) + (𝟏. 𝟎𝟎 × 𝟏𝟖. 𝟎𝟎𝟎) = 𝟗𝟑. 𝟎𝟎𝟎
 Practice Questions

Chapter 22 Unemployment, Inflation and Lon-Run Growth

Q1. Using the Table below, calculate the labor force participation rate and unemployment rate.

A1. Labor-force participation rate = Labor force/Population = (45,000 + 5000)/70000 x 100% =

71.4%

Unemployment rate = Unemployed / (Employed + Unemployed) = 5000/(45000 + 5000) x 100%

= 10%

Q2. Classify the following people as either employed, unemployed, discouraged worker or not
in the labor force:

a. A retired person
b. A full-time student who is not working
c. An individual who looked for work for six months and stopped looking five weeks
ago
d. A law student who finishes law school, quits his job as a law clerk and has been actively
seeking work as a lawyer.

A2.

a. This person is not in the labor force out of personal choice.

b. This person is not in the labor force because he is devoting his time as a student.

c. This person is not in the labor force because she or he is a discouraged worker and
would not qualify as unemployed because he is no longer looking for work.

d. This person is classified as unemployed because he is actively seeking employment.

Q3. Define frictional unemployment and structural unemployment. Give some examples.

A3. Frictional unemployment is the portion of unemployment that is due to the normal
working of the labor market; used to denote short-run job/skill matching problems.
Examples might include a person who leaves the workforce for personal reasons such as
retirement, pregnancy, or sickness. This person drops out of the labor force. When
he/she returns and starts looking again, he/she is counted as part of frictional
unemployment. Graduating students are a good illustration of frictional unemployment.
They join the labor force and are unemployed until they find work. Mothers who rejoin
the workforce after they've raised their children are another example. Seasonal workers ,
becoming unemployed because the work is done for the season.
Structural unemployment arises when skills of workers become obsolete and generally
refers to longer-run adjustment problems that tend to last for years. Examples might include
a welder who is put out of work because of the introduction of robotics on the assembly
line or a receptionist who is displaced by a modern voice mail system.

Q4. What is the difference between a recession and a depression?

A4. A recession is a period of at least two consecutive quarters of real GDP decline while a
depression is a prolonged and deep recession.

Q5. Assume that the CPI for year 3 is 120 and the CPI for year 4 is 130. Compute the inflation
rate for year 4.

A5. The inflation rate = (130 - 120)/120 * 100 = 8.33 (8.33%)

Q6. Suppose you want to earn a 7% rate of return on a one-year loan you are about to make
and the expected inflation rate for the duration of the loan is 5%. How much interest should
be charged? Secondly, suppose that your forecasts are 2% below the actual level. What would
happen to your real rate of return? What if you overestimated inflation by 2%?

A6. In this question, 7 % is real interest rate. The formula of real interest rate: real interest
rate=nominal interest rate –expected inflation rate. Thus, to earn 7 % real return, you need
to offer 12 % (7% +5%) to borrower. 12 % is the nominal interest rate. Simply, you would
need to assess an interest rate of 12% to earn 7%. The 5% is basically an inflation premium.
However, if you underestimate) inflation by 2% (if you expect a lower rate of inflation by 2
%), your real rate of return will only be 5% not 7%, that is (12%-(5%+2%)).

Q7: What is the relationship between inflation and cost of living?

A7. A significant concern for many households is the expense they incur to buy the goods
and services that are necessary to maintain a certain standard of living – that is, their ‘cost
of living’. The prices of many of these items tend to rise over time, which places upward
pressure on the cost of living. The CPI, which measures inflation in prices, is often used to
assess changes in the cost of living. However, there challenging points in this issue. For
example, suppose that the inflation rate measured by changes in the consumer price index
is 5%. Does this mean that every individual's cost of living has increased by 5%? No.
Everyone will not experience a 5% increase in the cost of living. It depends on the
combination of goods and services consumers buy. If consumers spend a high percentage
of their income on goods and services that have increased in price, then their cost of living
may have risen by 5% or more. If consumers are able to substitute toward less-expensive
goods or if they don't purchase goods whose prices increased, then their cost of living would
increase by less than 5%.
 Practice Questions

Chapter 23 Aggregate Expenditure and Equilibrium Output

Q1. What is the relationship between consumption and the following economic variables:
household income, wealth, household's expectations about the future, and interest rates?

A1. Consumption is positively related to household income and wealth and household's
expectations about the future, but negatively related to interest rates.

Q2. Assume a consumption function that takes on the following algebraic form: C = 100 +
0.8Y. Assume that Y = $1000 what is the level of consumption at this income level.

A2. C = $100 + 0.8($1000) = $100 + $800 = $900.

Here, Y is current income which is given as 1000. 100 is autonomous consumption, 0.8 is
marginal propensity to consume. Total consumption can be find through substituting all
of the given data to the consumption function. This a typical consumption function that
shows the positive relationship between aggregate consumption and income level.

Q3. What is marginal propensity to consume (MPC)?

A3. It is the fraction of an increase in income that is consumed.

Q4. Assume a consumption function of the form C = 200 + 0.8Y. Derive the saving function
and write out the algebraic representation.

A4. S = Y - C. Therefore, S = Y - (200 + 0.8Y) = - 200 + 0.2Y

Q5. Draw a consumption table where autonomous consumption is $200 and the marginal
propensity to consume is 0.8. Make sure to start with an income level of $0 and increase by
$100 each time up to an income level of $400. Without completing the table any further
determine the level of income where consumption and income are equal. Prove this
algebraically.

e.g.

Income Consumption
0 ?
100 ?
A5.

Income Consumption
$0 $200
$100 280
$200 360
$300 440
$400 520

The consumption function is C = 200 + 0.8Y Therefore if C = Y we can write Y = 200 + 0.8Y.
After rearranging terms this yields 0.2Y = 200. Solving for Y gives us 1000.
Q6. Assume a two sector economy where C = $100 + 0.9Y and I = $50. Calculate the equilibrium
level of output for this hypothetical economy. What would the level of consumption be if the
economy were operating at 1400? What would be the amount of unplanned investment at this
level? In which direction would you expect the economy to move to at $1400 and why?

A6. Equilibrium in a two sector economy is where C + I = Y.

Thus, 100 + 0.9Y + 50 = Y.

Rearranging terms yields 150 = 0.1Y.

Solving for Y results in an equilibrium of $1500. (Y=1500). This is the equilibrium level of
income.

But, if the economy is operating at 1400, economy is in a disequilibrium and the level of
unplanned investment is -$10. Why?

Proof: First, calculate the consumption level at the given income of 1400. In that case,
consumption would be $1360, C= 100 + 0.9(1400).

Second, add investment spending to the consumption. With investment of 50 this means
aggregate spending is $1410. That is, 1360+50=1410

This level is $10 above the level of aggregate output which is 1400. With inventories being
drawn down the expectation would be that firms would step up production and the
economy would expand beyond $1400.

Q7. Assume consumption is represented by the following: C = 400 + 0.5Y. Also assume that
planned investment (I) equals 100.

(a) Given the information, calculate the equilibrium level of income.

(b) Given the information, calculate the level of consumption and saving that occurs at the
equilibrium level of income.

(c) Write out the saving function for this economy. What is the marginal propensity to save?

A7.

(a) Y = 1000

In equilibrium, Y=AE=C+I= (400 + 0.5Y) + 100

If 500+ 0.5Y=Y, rearrange the terms, 500=0.5Y and solve for Y, that is Y is 1000.

(b) C = 900 and S = 100

If Y=1000, substitute it in consumption function: C=400+0.5(1000) =900

(c) S = -400 + 0.5Y; the MPS =0.5

S=Y-C=Y-(400+0.5Y)=-400+0.5Y
S=1000-400-0.5(1000)

S=100

Saving is the remaining part of income that is not spent. If income is 1000 and the
consumption level is 900, the remaining part of 100 is simply saving.

Q8. Assume consumption is represented by the following: C = 200 + 0.9Y. Also assume that
planned investment (I) equals 300.

(a) Now, suppose the level of income is equal to 4000. What is the level of planned aggregate
expenditures at this level of income? What is the value of any unplanned changes in
inventories?

(b) Given the information, calculate the equilibrium level of income.

(c) Given the information, calculate the level of consumption and saving that occurs at the
equilibrium level of income.

(d) Suppose planned investment falls by 100. Graphically illustrate using the AE - Y graph
(Keynesian-cross diagram) the effects of this reduction in planned investment on the economy.
Also, calculate the new level of equilibrium income.

A8.

(a) First, calculate the aggregate expenditures: AE=C+I (C is given as C = 200 + 0.9Y ad I is
given as 300)

AE = 200 + 0.9(4000) + 300 = 4100.

Second, compare your result with given income level. Given income level is 4000. But
aggregate expenditures are 4100. AE>Y. They are not equal to each other and thus, there
would be changes in inventories. Unplanned changes in inventories equal Y - AE = 4000 -
4100 = -100.

(b) In equilibrium: AE=Y

AE=200+0.9Y+300

Equate Y and AE

Y=200+0.9Y+300

Rearrange items

0.1Y=500

Solve for Y

Y=5000 (This is the equilibrium level of income)

(c) Substitute equilibrium income level of 5000 in consumption and saving function

C=200+0.9(5000)
C = 4700

S = Y-C=Y-(200+0.9Y)

S=-200+0.1Y (algebraic form of saving function)

S= 300

Or if C=4700 and Y=5000, savings is simply Y-C=5000-4700=300

(d) Here, investment falls by 100. Which means it drops to 200 from 300. Recalculate the
equilibrium income by following the steps above.

AE=Y=C+I

Y=200+0.9Y+200

0.1Y=400

Y=4000

Graphical representation:

How to draw?

First, draw AE0 line, it represents AE in part a. AE0=200+0.9Y+300

This AE0 line intersects with 45 degree line at 5000 since we find our equilibrium level of
income as 5000 by equating AE and Y, that is the result of AE=Y.

Second, please draw your AE1 line that represents AE in part c. In part c, investment drops
to 200 and this fall causes to decrease in aggregate expenditures. It means our initial AE line
shifts downwards. (From AE0 line to AE1 line). Then, find the intersection of this line with
45 degree line. It is 4000 level of income. This means that after the fall of investment to 200,
equilibrium income also drops to 4000.

Q9. Assume an economy with the following consumption and investment function:

C = 100 + 0.75Y
I = 25

Based on this information fill in the following table:

 Aggregate Aggregate Planned Planned Unplanned
Output Consumption Investment Aggregate Inventory
(Income) Expenditure Change
$100
200
400
500
600
800

A9.

Aggregate Aggregate Planned Planned Unplanned

Investment Inventory
Output Consumption Aggregate
Change
(Income) Expenditure

$100 175 25 200 -100

200 250 25 275 -75

400 400 25 425 -25

500 * 475 25 500 0

600 550 25 575 +25

800 700 25 725 +75

Asterisk (*) shows the equilibrium level of income.

Q10. Define the multiplier and algebraically derive the value of the multiplier assuming the
basic form of the consumption function as C = a + bY where "a" is autonomous consumption
and "b" is the marginal propensity to consume. You may assume a two-sector private economy
(e.g. There are only households and firms)

A10. The multiplier is the ratio of the change in the equilibrium level of output to a change
in some autonomous variable.

Since Y = C + I we can write Y = a + bY + I.

This equation can be rearranged to yield

Y - bY = a + I

Y(1-b) = a + I

We can then solve for Y in terms of I by dividing through by (1 - b):

Y = (a + I) (1/1 - b)
Now we can see that an increase in I will increase Y by

Y = I x (1/1 - b)

Since b  MPC, the expression becomes

Y = I x 1/(1 - MPC)

Therefore, the multiplier is 1/1 - MPC or 1/MPS.