ECON 202 Quiz 2 (Section 50193 Evening Time) Total Marks: 15

Quiz 2 Solution

ECON 202 Intermediate Macroeconomics (Spring 2021)

Instructor: Sonan Memon

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ECON 202 Quiz 2 (Section 50193 Evening Time) Total Marks: 15

Total Marks: 15. Time: 40 minutes for physical takers, 50 minutes in-
cluding submission of scanned file for online quiz takers.

Note: Some of my solutions may be slightly more involved than what I

expect from a typical student in the class.

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ECON 202 Quiz 2 (Section 50193 Evening Time) Total Marks: 15

Question 1: 3 Marks
Discuss only one major difference between the CPI and the GDP Deflator
approaches for calculating macroeconomic inflation.
Answer
The consumer price index based inflation is based on the growth rate in
consumer price index PtCP I , which is calculated by using a fixed basket of
Costt
commodities over time. More precisely, PtCP I = Costb , where Costt means
the cost of purchasing a fixed basket in period t, Costb is the cost of purchas-
ing the same fixed basket in period b, t is current period and b is the base
year. Meanwhile, the GDP deflator approach looks at the growth rate in the
implicit price index, which is the nominal GDP relative to the real GDP in
current year. Base year prices are used for calculating Real GDP and current
prices are used for calculating Nominal GDP, but current quantities of all the
goods are used for both nominal and real GDP calculations.
Thus, one major difference is that the CPI index is calculated by always
using a fixed basket of goods over time, whereas the GDP Deflator uses
current quantities of goods and services.
Note: You could also discuss the difference that CPI focuses on consumer
goods, including imported goods but the GDP Deflator looks at all the do-
mestically produced goods and services.

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ECON 202 Quiz 2 (Section 50193 Evening Time) Total Marks: 15

Question 2: 2 Marks
Suppose an economy produces rubber, cotton and and oil. The rubber
industry produces $100,000 in revenue, spends $4,000 on cotton, $10,000 on
oil, pays workers $80,000. The cotton industry produces $150,000 in revenue,
spends $20,000 on rubber, $10,000 on oil, and pays workers $90,000. The oil
industry produces $200,000 in revenue, spends $40,000 on rubber, $30,000 on
cotton, and pays workers $100,000. There is no government in this economy.
There are neither exports nor imports, and none of the industries accumulate
or decumulate any inventories. Calculate GDP using the production and
income methods separately and show that they are equal to each other.
Answer
Pn
Production Method: GDPt = i=1 pit yit , where yi are the real quan-
tities of final goods. Total Revenue = 100, 000 + 150, 000 + 200, 000 =
$450, 000. We just added the revenues in the three respective industries.
The total expenditure on intermediate goods across all three industries must
be subtracted from this total revenue to avoid double counting, which is
4, 000 + 10, 000 + 20, 000 + 10, 000 + 40, 000 + 30, 000 = 114, 000 so that
GDPt = 450, 000 − 114, 000 = 336, 000.
When using the Income Method for calculation of GDP, we need to add
all the incomes for all the factors of production. The total wage incomes
are 80, 000 + 90, 000 + 100, 000 = 270, 000. Since we know that GDP, when
measured by each of the three methods is equivalent to the other two, it must
be that the total income of other factors of production apart from labor is
66, 000 so that 270, 000 + 66, 000 = 336, 000 can be true. This income is
not given in the question but it must be %66, 000 for the GDP values from
income and production approaches to be equal to each other.
I am sorry for saying “show that they are equal to each other” in the
question. I should have said “use that the two approaches give the same

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ECON 202 Quiz 2 (Section 50193 Evening Time) Total Marks: 15

answer to calculate the value of GDP from the two approaches”. I will keep
this in mind when checking. You get full marks if you have calculated the
GDP correctly using the production approach and realized that 270 + 66 =
336 must be true since the total wage income of 270 is not equal to 336,
implying that the difference must be composed of returns to other factors of
production.

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ECON 202 Quiz 2 (Section 50193 Evening Time) Total Marks: 15

Question 3: 3 Marks
We often take logarithms of various time series in economics. Describe one
major reason for performing this transformation.
xt+1 −xt
Mathematically prove that ∆ln(xt+1 ) = ln(xt+1 ) − ln(xt ) ≈ gt+1 = xt .
Make sure that you explain every step very carefully.
For what values of gt+1 is this approximation that you proved above more
accurate and for which unique value of gt+1 is the approximation exactly
correct?
Answer
(a) We take logarithms of time series ln(xt ) for of re-scaling purposes
since logarithms scale down the original values xt to more readable/digestible
ranges and by applying a positive, monotonic transformation, they preserve
all rankings of original values.
A more important reason for taking logarithms is that the change in log-
arithm of any time series is approximately equal to the growth rate in the
original time series xt , which means that we can conveniently interpret the
change in the time series graph with log of time series on y axis per unit of
time on the x axis as approximately equal to the growth rate in the original
time series. In other words, the slope of the time series plot for small intervals
approximates the growth rate of the original series.
(b)
xt+1 −xt
Claim: ∆ ln(xt+1 ) = ln(xt+1 ) − ln(xt ) ≈ gt+1 = xt .
Proof:
xt+1 −xt
gt+1 = xt =⇒ 1 + gt+1 = 1 + xt+x1t−xt = xt +xt+1 −xt
xt = xt + 1
xt
=⇒ gt+1 = xxt+t 1 − 1.
We know that the first order Taylor expansion of the function y = ln(1 + )
around  = 0 is  so that ln(1 + ) ≈  for  ≈ 0 =⇒ ln(1 + gt+1 ) ≈ gt+1 for

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ECON 202 Quiz 2 (Section 50193 Evening Time) Total Marks: 15

 
xt + 1 xt + 1
gt+1 ≈ 0 and hence gt+1 ≈ ln(1 + xt − 1) = ln xt = ln(xt+1 ) − ln(xt ).
xt+1 −xt
Thus, we have proved that ∆ln(xt+1 ) = ln(xt+1 ) − ln(xt ) ≈ gt+1 = xt
for small growth rates.
(c) Due to the use of ln(1 + ) ≈ , which comes from a first order Taylor
expansion, the approximation is more accurate for smaller values of growth
rates gt+1 ≈ 0 in some neighborhood of 0. When gt+1 = 0, then ln(1 + gt+1 ) =
gt+1 since ln(1 + 0) = ln(1) = 0. The Taylor expansion is exactly correct
xt+1 −xt
only at  = 0 so that ∆ln(xt+1 ) = ln(xt+1 ) − ln(xt ) = gt+1 = xt when
gt+1 = 0.

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ECON 202 Quiz 2 (Section 50193 Evening Time) Total Marks: 15

Question 4: 2 Marks
Briefly explain the substitution bias in the measurement of inflation based
on the Consumer Price Index (CPI).
Answer
The substitution bias arises from the use of fixed quantities of various goods
over time in the fixed basket of consumption items, used in the calculation of
CPI. In reality, when relative prices change over time, consumers substitute
away from the relatively expensive items and toward the relatively cheaper
items, so the basket consumed by median household also changes over time.
By using a fixed basket rather than the current basket, which accounts for
substitution effects of price changes, we bias the CPI, creating a substitution
bias.
The explanation below is not required in your answer but is pro-
vided just for understanding:
One consequence of this substitution bias is that it makes the CPI based
PtCP I −Pt−1
CP I
inflation πtCP I = CP
Pt−1 I higher on average because PtCP I , which is the cost
of fixed basket in current year, relative to base year is overstated whenever
there exists inflation by the fact that we did not account for the substitution
away from the now more expensive goods and services relative to base year
and toward the now more relatively cheaper goods.

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ECON 202 Quiz 2 (Section 50193 Evening Time) Total Marks: 15

Question 5: 3 Marks
Suppose the unemployment rate (u) in Pakistan is 5% during 2019, the to-
tal working-age population is 130 million (L), and the number of unemployed
people is 5 million in 2019. Suppose that the total population of country was
210 million.
In 2020, 5 million new workers became unemployed from their previously
employed positions in 2019, due to the global pandemic. Out of these 5 mil-
lion, 2 million enrolled in PhD Mathematics programs at various universities
in Pakistan. These individuals have become full time students and are no
longer looking for any job. The remaining 3 million remain unemployed and
are still actively looking for jobs. The rest of the previously employed work-
ers remained employed and previously unemployed people in 2019 remained
unemployed in 2020.
Moreover, 1 million new children were born during 2020 in Pakistan and
0.1 million people died. 0.5 million 15 year olds passed the age of 16 (assume
16 is the working age) in 2020, whereas 0.3 million passed the age of 62
(assume 62 is official retirement age) and turned 63.
There were no other relevant changes in the economy in 2020.
Calculate u, total working age population L, number of unemployed people
U , employment to population (total population) ratio and size of labor force
(LF) for year 2020 in Pakistan.
Answer
E
Define LF = U + E and n = P, where U refers to number of unemployed
people, LF is labor force, E is the total employment level, P is total popu-
lation and n is total employment divided by total population. Let u be the
unemployment rate and let L be the working age population.
The question asks you to calculate u2020 , L2020 , n, U2020 and LF2020 .

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ECON 202 Quiz 2 (Section 50193 Evening Time) Total Marks: 15

U2019
First note that u2019 = = 5+E52019 = 0.05
U2019 +E2019
=⇒ 5 ∗ 0.05 + 0.05 ∗ E = 5 =⇒ E2019 = 95 million since u2019 = 5% is
given to you.
We can also calculate that E2020 = 95 − 5 = 90 million since 5 million of
previously employed workers in 2019 are not longer working. 3 million of
these are still unemployed, while 2 million students are neither employed,
nor unemployed but all 5 million are no longer employed. Given that no
other changes in employment occurred, E2020 = 90 million.
U2020 5+(5−2) 8
We can now calculate: u2020 = U2020 +E2020 = 8+90 = 98 = 8.16%.
Note that U2020 = 5 + 5 − 2 = 8 million since 5 million new unemployed
were created, out of which 2 million went out of the labor force and are
neither employed, nor unemployed. These 2 million are now part of working
age population only but no longer part of LF .
L2020 = L2019 + ∆L2020 = 130 + 0.5 − 0.3 = 130.2 million after accounting
for net increase in working age population.
P2020 = P2019 + ∆P2020 = 210 + 1 − 0.1 = 210.9 million after accounting for
net new births in 2020.
E2020 90
n2020 = P2020 = 210.9 = 42.7%.
U2020 = 5 + (3) = 8 million.
LF2020 = U2020 + E2020 = 8 + 90 = 98 million.

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ECON 202 Quiz 2 (Section 50193 Evening Time) Total Marks: 15

Question 6: 2 Marks

ICSGR and GDPGR

1.0

0.5
Cross correlations

0.0

-0.5

-1.0
-20 -10 0 10 20
lag

Figure 1: Cross Correlation between growth rate of Quarterly ICS (Index of Consumer
Sentiment) and Growth Rate of GDP (GDPGR) for 1978-2020, US data.

I have included a plot of cross-correlation function between two series for

US data above, a plot which we also generated in the R sessions for some
other series. The correlations have form Cor (ICSGRt+h , GDP GRt ) for h ∈
{., ., −2, −1, 0, 1, 2, ., , }.
(a) How to identify whether the correlations are statistically significant in
such a plot?
(b) Provide an interpretation of the positive values of cross-correlations
when h (lag) is negative and roughly greater than -5. Do the same for negative
values of cross-correlations when h > 0 and h < 6 is roughly true.

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ECON 202 Quiz 2 (Section 50193 Evening Time) Total Marks: 15

Answer
(a) The two horizontal, dark, black lines in the figure define a confidence
interval. By default, the interval reported is usually a 95% confidence interval.
If the value of any correlation in the plot of the cross-correlation function
lies outside this interval, whether above or below, then we can say that the
correlation is statistically significant. Whether the correlation is economically
significant is another matter.
(b) If Cor (ICSGRt+h , GDP GRt ) > 0 for h < 0, as is the case when
h ∈ (−5, 0), it means that the growth rate in the index of consumer senti-
ment is a leading and positively correlated indicator for the business cycle.
In other words, a higher growth rate in index of consumer sentiment to-
day is correlated with higher growth rates in GDP tomorrow. Similarly, If
Cor (ICSGRt+h , GDP GRt ) < 0 for h > 0, as is the case when h ∈ (0, 6)
means that a higher growth rate in GDP today is correlated with a lower
growth rate in the index of consumer sentiment tomorrow.

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