COR2100 Economics and Society

Homework 3 – chapters 4, 5, 6
Due: Friday 10/04/2020, 11.30pm, online in your own section’s assignment section.
Note: As much as possible, please submit your work in one file (pdf programs allow you to join jpegs
together quite easily), so that they are easier for our TAs to handle and keep track of.

1. Assume there are only two goods in the economy, french fries and onion rings. In 2011, 1,000,000
servings of french fries were sold at $0.40 each and 800,000 servings of onion rings at $0.60 each. From
2011 to 2012, the price of french fries rose by 25% and the servings sold fell by 10%; the price of onion
rings fell by 15% and the servings sold rose by 5%.
a. Calculate nominal GDP in 2011 and 2012. Calculate real GDP in 2012 using 2011 prices.
b. Why would an assessment of growth using nominal GDP be misguided?

2. Which of the problems in the construction of the CPI might be illustrated by each of the following
situations? Explain.
a. the invention of the iPod
b. the introduction of air bags in cars
c. increased personal computer purchases in response to a decline in their price
d. more scoops of raisins in each package of Raisin Bran
e. greater use of fuel-efficient cars after gasoline prices increase

3. A small nation of ten people idolizes the TV show American Idol. All they produce and consume are
karaoke machines and CDs, in the following amounts:

a. Using a method similar to the consumer price index, compute the percentage change in the overall
price level. Use 2011 as the base year, and fix the basket at 1 karaoke machine and 3 CDs.
b. Using a method similar to the GDP deflator, compute the percentage change of the overall price level.
Also use 2011 as the base year.
c. Is the inflation rate in 2012 the same using the two methods? Explain why or why not.

4. Explain the difference between saving and investment as defined by a macroeconomist. Which of the
following situations represent investment? Saving? Explain.
a. Your family takes out a mortgage and buys a new house.
b. You use your $200 paycheck to buy Singtel shares.
c. Your roommate earns $100 and deposits it in her account at a bank.
d. You borrow $1,000 from a bank to buy a car to use in your pizza delivery business.

5. Let’s assume that Singapore wants to achieve zero inflation. Given that Singapore’s output (income)
grows every year and that the amount of money we need to hold also depends on our income, how do
you think this will require Singapore to adjust its money supply to achieve its objective? Draw a diagram
to illustrate this situation.
6. Suppose that the economy is currently at full-employment output. Also suppose that you are an
economic policy maker and that a college economics student asks you to rank, if possible, your most
preferred to least preferred type of shock: positive demand shock, negative demand shock, positive
supply shock, negative supply shock. How would you rank them and why?

7. Suppose firms become very optimistic about future business conditions and invest heavily in new
capital equipment.
a. Draw an AD-AS diagram to show the short-run effect of this optimism on the economy (starting from
full-employment). Label the new levels of prices and output. Explain in words why the aggregate
quantity of output supplied changes.
b. Now use the diagram from part (a) to show and explain how the new long-run equilibrium of the
economy is reached.
c. Make a reasoned guess whether this event will increase or decrease the full-employment level of
output in the long run. Explain your answer.
Further practice (not for submission)

1. Below are some data from the land of milk and honey

a. Compute nominal GDP, real GDP, and the GDP deflator for each year, using 2010 as the base year.
b. Compute the percentage change in nominal GDP, real GDP, and the GDP deflator in 2011 and 2012
from the preceding year. For each year, identify the variable that does not change. Explain in words
why your answer makes sense.
c. Did economic well-being rise more in 2011 or 2012? Explain.

2. Eastland College is concerned about the rising price of textbooks that students must purchase. To
better identify the increase in the price of textbooks, the dean asks you, the Economics Department’s
star student, to create an index of textbook prices. The average student purchases three English, two
math, and four economics textbooks per year. The prices of these books are given in the accompanying
table.

a. What is the percent change in the price of an English textbook from 2010 to 2012?
b. What is the percent change in the price of a math textbook from 2010 to 2012?
c. What is the percent change in the price of an economics textbook from 2010 to 2012?
d. Using 2010 as a base year, create a price index for these books for all years.
e. What is the percent change in the price index from 2010 to 2012?

3. Suppose you deposit $1,000 in a bank account that pays an annual interest rate of 10 percent. A year
later, after you have $100 in interest. Are you $100 richer now? What if over this one year, prices have
increased by 20%?

4. Economists in Funlandia, a closed economy, have collected the following information about the
economy for a particular year:
Y = 10,000 C = 6,000 T = 1,500 G = 1,700
The economists also estimate that the investment function is:
I = 3,300 – 100 r,
where r is the country’s real interest rate, expressed as a percentage. Calculate private saving, public
saving, national saving, investment, and the equilibrium real interest rate.

5. Use the market for loanable funds to explain what happens to private savings, private investment
spending, and the interest rate if each of the following events occurs. Assume that there are no capital
inflows or outflows.
a. The government reduces the size of its deficit.
b. At any given interest rate, consumers decide to save more. Assume the budget balance is zero.
c. At any given interest rate, businesses become very optimistic about the future profitability of
investment spending. Assume the budget balance is zero.

6. Explain whether the following statements are true, false, or uncertain.

7. Let’s consider the effects of inflation in an economy composed of only two people: Bob, a bean
farmer, and Rita, a rice farmer. Bob and Rita both always consume equal amounts of rice and beans. In
2010, the price of beans was $1, and the price of rice was $3.
a. Suppose that in 2011 the price of beans was $2 and the price of rice was $6. What was inflation? Was
Bob better off, worse off, or unaffected by the changes in prices? What about Rita?
b. Now suppose that in 2011 the price of beans was $2 and the price of rice was $4. What was inflation?
Was Bob better off, worse off, or unaffected by the changes in prices? What about Rita?
c. Finally, suppose that in 2011 the price of beans was $2 and the price of rice was $1.50. What was
inflation? Was Bob better off, worse off, or unaffected by the changes in prices? What about Rita?
d. What matters more to Bob and Rita—the overall inflation rate or the relative price of rice and beans?

8. Suppose that changes in bank regulations expand the availability of credit cards so that people need
to hold less cash.
a. How does this event affect the demand for money?
b. If the central bank does not respond to this event, what will happen to the price level?
c. If the central bank wants to keep the price level stable, what should it do?

9. Using the AD-AS model to explain the process by which each of the following economic events will
affect the economy, starting with the economy in full employment. Describe also how the economy will
restore itself to full employment. Illustrate with diagrams and give sufficient explanation.
a. There is a decrease in households’ wealth due to a decline in the stock market.
b. The government lowers taxes, leaving households with more disposable income, with no
corresponding reduction in government purchases.
c. A positive supply shock raises firms’ profits and thus induce firms to increase production at all price
level.

10. In the accompanying diagram, the economy is at full-employment when an oil shock shifts the short-
run aggregate supply curve to SRAS2. Based on the diagram, answer the following questions.

a. How do the aggregate price level and aggregate output change in the short run as a result of the oil
shock? What is this phenomenon known as?
b. If left to itself, how will the economy adjust in the long run?
c. What fiscal or monetary policies can the government use to address the effects of the supply shock?
Use a diagram to show the effect of policy chosen to address the change in real GDP. Use another
diagram to show the effect of policy chosen to address the change in the aggregate price level.
d. Why do supply shocks present a dilemma for government policy makers?
11. An economy is in macroeconomic equilibrium when each of the following aggregate demand shocks
occurs. What kind of gap—inflationary or recessionary—will the economy face after the shock, and
what type of fiscal policies would help move the economy back to full-employment output? How would
your recommended fiscal policy shift the aggregate demand curve?
a. A stock market boom increases the value of stocks held by households.
b. Firms come to believe that a recession in the near future is likely.
c. Anticipating the possibility of war, the government increases its purchases of military equipment.
d. The quantity of money in the economy declines and interest rates increase.

12. Suppose the Central bank expands the money supply, but because the public (people and firms)
expects this action, it simultaneously raises its expectation of the price level. What will happen to output
and the price level in the short run? Compare this result to the outcome if the Central Bank expanded
the money supply but the public didn’t change its expectation of the price level.