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Unformatted text preview: © Prep101 Student Last Name: ________________ Student First Name: ________________ Student Number: __________________ Economics 100 (Pesando) Practice Test 3 Students Must Answer All Questions in the Space Provided. No Aids Allowed. I. (25 points) Suppose the following accurately summarizes the macroeconomic activity in the country Snowland (millions of dollars, with constant dollar): Y C I G T M = = = = = = 1000 200 + 0.5(Yd) 150 200 0.2(Y) 0.0625(Yd) 1. In words, explain the difference between the marginal propensity to consume out of disposable income and marginal propensity to consume out of national income? Using the given information, find the numerical values of these multipliers for Snowland. MPC ~ the proportion of an additional dollar in income spent on consumption. The difference between these two terms stems from differences in the definition of “income”. MPC out of disposable income ~ the proportion of an additional dollar of after tax income spent on consumption. MPC out of national income ~ the proportion of an additional dollar of gross income spent on consumption. MPC(Yd) = 0.5 (taken from C=200 + 0.5[Yd]) C = 200 + 0.5(Yd) = 200 + 0.5(Y – .2Y) = 200 + 0.5(0.8Y) = 200 + 0.4Y MPC(Y) = 0.4 (taken from C=200 + 0.4Y) by factoring out the Y (as opposed to Yd), we can isolate the multiplier for gross income Page 1 of 11 © Prep101 2. If the given measure of GDP (Y = 1,000) is this economy’s equilibrium level, what is the value of Snowland’s exports? Y =C+I+G+X–M = 200 + 0.5(Yd) + 150 + 200 + X - 0.0625(Yd) = 200 + 0.5(Y – 0.2Y) + 150 +200 + X – 0.0625(Y – 0.2Y) = 200 + 0.5(0.8Y) + 150 +200 + X – 0.0625(0.8Y) = 550 + 0.4Y + X – 0.05Y = 550 + 0.35Y + X 1,000 = 550 + 0.35(1,000) + X 100 = X 3. If the level of investment fell to 100: a. Calculate the new national income Multiplier = 1/(1 - slope of the AE schedule) = 1/{1 – [MPC(1 – t) – m]} = 1/{1 – [0.5(1 – 0.2) – 0.0625]} = 1/{1 – [0.3375]} = 1.509434 The multiplier shows how much equilibrium expenditure will change in response to a unit change in autonomous spending. Y = [1/(1 - slope of the AE schedule)] A A is total autonomous expenditure Y = 1.509434(-50) = -75.4717 ~ -75 Y’ = 1,000 + (- 75) = 925 b. Why is the change in national income not the same as the change in investment? There is a multiplied increase in national income due to the fall in investment spending. The drop in investment immediately decreases the level of national income. This drop then inspires a drop in consumption, which further inspires a change in disposable income and national income. This cycle continues until the “ripple’s” effect is negligible. Thus the change in real GDP (- 150) is larger than the change in investment (- 100). Page 2 of 11 © Prep101 4. When is actual aggregate expenditure different from planned aggregate expenditure? What happens to bring the two back to equality? Consider the example of real GDP and aggregate expenditure exceeding equilibrium expenditure. In this predicament there is an unplanned rise in inventories (production is too high for current consumption levels). In response to this deviation (the increase in inventories), firms will slow their production, and in doing so bring the actual economy back towards equilibrium. The same logic applies when real GDP and aggregate expenditure are below equilibrium expenditure (15 points) 1. What is the difference between an inflationary and a recessionary gap? Ensure your explanation includes diagram(s) to illustrate this difference. An inflationary gap occurs when real/actual GDP exceeds potential GDP. Conversely, a recessionary gap occurs where real GDP is below potential GDP. Potential GDP occurs where the economy is operating at full employment. LRAS 120 Recessionary Gap SRAS 100 80 Price level Price level LRAS Inflationary Gap 120 900 1,000 Real GDP SRAS 100 80 AD AD 1,000 1,200 Real GDP 2. Suppose the economy experiences an inflationary gap, and that the government does not adjust expenditure to correct this deviation. How does the economy move back to equilibrium in the long-run? Price level II. In response to the inflationary pressures, nominal (or money) wage rates will increase. This creates an increase in the costs of production. Higher wages for employees means a higher SRAS1 wage bill for employers. The increase in LRAS production costs causes firms to decrease SRAS0 120 their production levels (they can’t afford 100 production at the SRAS0 level), which manifests itself as a leftward shift of the 80 AD SRAS curve. This process continues until the economy returns to potential GDP. 1,000 1,100 Real GDP Page 3 of 11 © Prep101 III. (15 points) Consider the following table, which summarizes the opportunity cost of real GDP in terms of leisure time foregone for the island of Trinbago. The people of this island have 200 hours/day to allocate between leisure and work. Work-Leisure Option A B C D E F Leisure Opportunity cost of leisure (hrs./day) (dollars of real GDP per hour) 0 40 80 120 160 200 0 10 20 30 40 50 a) Develop a table that summarizes Trinbago’s PPF for leisure and real GDP. Using this table, draw a PPF for Trinbago. (Hint: start from the bottom of the table, and note that the the opportunity cost of leisure = ( real GDP)/( leisure hours). (hrs./day) 0 40 80 120 160 200 Real GDP (dollars / day) 6,000 {[( real GDP)/(40)] = 10 real GDP = 400 + existing GDP = 6,000} real GDP = 800 + existing GDP = 5,600} 5,600 {[( real GDP)/(40)] = 20 4,800 {[( real GDP)/(40)] = 30 real GDP = 1200 + existing GDP = 4,800} 3,600 {[( real GDP)/(40)] = 40 real GDP = 1600 + existing GDP = 3,600} real GDP = 2000} 2,000 {[( real GDP)/(200-160)] = 50 0 (real GDP with no working hours = 0) 6,000 Real GDP (dollars/day) Leisure 4,800 3,600 2,000 40 80 120 160 Page 4 of 11 200 Leisure (hrs/day) © Prep101 b) Develop a table and corresponding graph that summarizes Trinbago’s production function. Real GDP (dollars/day) 0 2,000 3,600 4,800 5,600 6,000 PPF 6,000 Real GDP/day Labour (hrs/day) 0 40 80 120 160 200 2,000 40 200 Labour hours /day c) Find Trinbago’s marginal product of labour for each of the quantities of labour. MPL = ( real GDP)/( labour hours) Labour increases from __ to __ 0 to 40 40 to 80 80 to 120 120 to 160 160 to 200 Real GDP 2,000 3,600 4,800 5,600 6,000 ( real GDP)_ = MPL ( labour hours) . 50 = (2000 – 0) / (40 – 0) 40 = (3,600 – 2,000) / (80 – 40) 30 = (4,800 – 3,600) / (120 – 80) 20 = (5,600 – 4,800) / (160 – 120) 10 = (6,000 – 5,600) / (200 – 160) Page 5 of 11 © Prep101 (35 points) 1. The wages of certified plumbers is considerably higher than that of general laborers. This can be explained by the differences in their productivity. Suppose the government takes strides towards equalizing their wages by pushing the wages of plumbers down, and the wages of general laborers up. What would happen to the level of employment in these fields? a) General laborers will increase, and plumbers will fall b) General laborers will fall, and plumbers will increase c) Both will fall d) Both will rise e) Both will remain unchanged Solution: Fewer plumbers will want to work at the new low rate, and fewer employers will want to hire general labourers at the increased wage rate. The change comes from the deviation in compensation and productivity. 2. Which will cause an increase in the labour supply? a) An increase in the capital/worker ratio b) A substantial influx of migrant workers c) The advent of new technology that improves worker productivity d) An increase in human capital e) None of the above. Solution: Increase in population Increase in the working age population increase in labour supply rightward shift of the labour supply curve. The other options (except e) drive an increase in labour productivity, which makes hiring people more profitable, thus causing a rightward shift of labour demand. 3. If a monopoly took over a healthy and perfectly competitive industry, the monopoly would ________ production, and sell at ________ price a) Decrease; the same price b) Decrease; a lower price c) Decrease; a higher price d) Not change; the same price e) Not change; a higher price Solution: In perfect competition, equilibrium occurs where supply equals demand. A monopolist produces where MC=MR. In terms of quantity, MR is lower than demand, and at this lower production level customers are forced to pay higher prices for an increasingly scarce product. Page 6 of 11 © Prep101 4. All of the following are plausible examples of market failure due to externalities EXCEPT: a) Long traffic jams every day on the Don Valley Parkway in Toronto. b) The despoiling of Canadian lakes and forests by acid rain produced by North American industry. c) The high salaries enjoyed by professional sports stars. d) The low revenues, despite acclaimed programming, of a public television station in the U.S. funded by voluntary donations, but whose programs can be seen by anyone with a TV. e) A beekeeper that benefits from locating next to an apple orchard. Solution: Market failure is the failure of unregulated markets to achieve allocative efficiency. In the case of externalities, market failure occurs when the absence of property rights fails to facilitate the exchange of social benefits. Since there is no exchange, the equilibrium where marginal social benefit equals marginal social cost, is not feasible. Option c) does not exemplify a disparity between marginal social benefit and cost. 5. Besides the expenditure approach, there is the income approach to measure GDP. What does the income approach include in its tabulation of GDP? a) Wages, salaries, and supplemental labour income + corporate profits + interest and miscellaneous investment income + farmers´ income and income from non-farm unincorporated businesses + indirect taxes less subsidies + depreciation. b) Consumption + Investment + Government expenditures + Exports + Imports c) Wages, salaries, and supplemental labour income + corporate profits + interest and miscellaneous investment income + farmers´ income and income from non-farm unincorporated businesses. d) Consumption + Investment + Government expenditures + Exports Imports e) Income + Profits - Taxes Page 7 of 11 © Prep101 6. You sell a car bought for $11,000 in the year 2000 for $2,000 in 2006. How does this transaction affect 2006’s GDP? a) The GDP (2006) will increase by $9,000. b) The GDP (2006) will increase by $2,000. c) The GDP (2006) will increase by $11,000 d) The old GDP (2000) will be adjusted downwards, in order to facilitate an $11,000 increase in the current GDP (2006) e) GDP (2006) is unaffected. Solution: The GDP is the value of all final goods and services produced in a country during a year, and since the car was not produced in 2006, it would not be counted towards the 2006 GDP. 7. Consider the following 2 statements: i. In equilibrium, the natural rate of unemployment is above actual unemployment when the economy is producing at its potential ii. If the natural rate of unemployment is above actual unemployment, the LRAS curve will shift rightward until LRAS=SRAS=AD a) b) c) d) e) (i) and (ii) are true (i) is true, and (ii) is false (i) is false, and (ii) is true (i) and (ii) are false none of the above Solution: The natural rate of unemployment is the actual level of unemployment when the economy is producing at its potential. To bring the economy back to equilibrium, it is the SRAS that shifts to the left. The actual unemployment rate is below the natural rate meaning employment is above the potential level. Thus, SRAS intersects the demand curve somewhere to the right of the LRAS. So, SRAS needs to shift left to bring the economy back to equilibrium. NOT the LRAS. 8. If Jim’s disposable income rose from $200 to $300 dollars/week and he increased his consumption from $190 to $280, which of the following is true? a) Jim’s marginal propensity to consume is 0.9 b) Jim’s marginal propensity to save is 0.2 c) Jim’s marginal propensity to consume is 2 d) Jim’s average propensity to consume is 0.9 e) Jim’s average propensity to save is 0.2 Page 8 of 11 © Prep101 Solution: One’s marginal propensity to consume measures what portion of each additional dollar in income goes towards consumption expenditure (i.e. versus savings). MPC = ( consumption) / ( income) = (280-190)/ (300-200) = 0.9 Page 9 of 11 © Prep101 9. All other things being equal, if the stock of physical capital increases, what happens to potential GDP and the marginal product of labour? a) Potential GDP and MPL do not change b) Potential GDP increases and MPL falls c) Potential GDP falls and MPL increases d) Potential GDP and MPL falls e) Potential GDP and MPL increase Solution: An increase in the economy’s stock of capital drives an increase in the amount of capital per worker. With more capital, each worker becomes more productive (MPL increases), which in turn causes potential GDP to increase. 10. Suppose Neverland’s labour market is in equilibrium. Which of the following events will cause an increase in the employment level and a decrease in real wages? a) b) c) d) e) Labour supply decreases Labour supply increases Labour demand decreases Labour demand increases None of the above Solution: An increase in labour supply (i.e. caused by an increase in the working age population [i.e. migration]) causes real wages to fall. Labour becomes more abundant, so employers have no need to pay such high wages - there are people willing to take the job at the decreased wage. Then at the decreased real wage, employers are willing to hire more people. Page 10 of 11 © Prep101 IV. (10 points) Consider the adjacent schedule of the costs and benefits of steel smelting, which pollutes the air of the city. Marginal Marginal Smelter’s external benefit MC cost of steel (dollars per tonne) 0 0 600 50 7.5 550 100 12.5 500 150 25 450 200 50 400 250 100 350 300 150 300 350 200 250 400 250 200 Qty. of Steel (tones/day) 0 5 10 15 20 25 30 35 40 1. With no ownership/title on the city’s air and no pollution regulation, how much steel is produced/day? What is the marginal cost of the consequent pollution? Production occurs until the point that the Smelter’s MC is equivalent to the marginal benefit of steel. This occurs at the production of 30 tonnes of steel a day. At this production level, citizens bear a marginal cost of $150, without remuneration. 2. Suppose the city issues two marketable pollution permits: one for the city government, and one for the privately owned smelter. The total permissible pollution is the efficient amount, shared equally between the city and the smelter. i. How much steel is produced? In this case, production occurs where total marginal cost (that facing firms AND citizens) equals the marginal benefit of production. This occurs at the production of 25 tonnes of steel/day (MCS) + (MCC) = MB 250 + 100 = 350 25 tonnes ii. What is the market price of the permit? All values taken from the aforementioned level of production: [(Marginal external cost)/tonne] x (# of tones) = 100*25 = 2,500 The price of the permit would be $2,500 Page 11 of 11 ...
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