Macroeconomics and Public Policy, 252H

Problem Set 1

Most of the problems will be given from the textbook.

N and A stand for numerical and analytical correspondingly.

N2.4. For each of the following transactions, determine the contribution to the current
year’s GDP. Explain the effects on the product, income, and expenditure accounts.

a. On January 1, you purchase 10 gallons of gasoline at $2.80 per gallon. The gas
station purchased the gasoline the previous week at a wholesale price
(transportation included) of $2.60 per gallon.
Effect on Product: Gas station's value added ($0.20 x 10 gallons) = $2.

Effect on Income: Gas stations profit = $.20 x 10 gallons = $2.

Effect on expenditure: Expenditure on final good by consumers ($28) + Investment

(Inventory change of -$20) = $2.

b. Colonel Hogwash purchases a Civil War–era mansion for $1,000,000. The

broker’s fee is 6%.
Effect on Product: $60,000 broker's fee for providing brokerage services.

Effect on Income: $60,000 income to the broker for wages, profits, and so on.

Effect on expenditure: $60,000 counts as residential investment made by the homebuyer.

c. A homemaker enters the workforce, taking a job that will pay $40,000 over the
year. The homemaker must pay $16,000 over the year for professional childcare
services.
Effect on Product: $40,000 salary plus $16,000 childcare equals $56,000.

Effect on Income: $56,000 ($40,000 compensation of homemaker plus $16,000

income to the factors producing the childcare: employees' wages, interest, taxes,
and profits).

Effect on expenditure: $56,000 ($16,000 consumption spending on childcare

services plus $40,000 in categories that depend on what the homemaker spends
his or her income).
 d. A Japanese company builds an auto plant in Tennessee for $100,000,000, using
only local labor and materials. (Hint: The auto plant is a capital good produced by
Americans and purchased by the Japanese.)

Effect on Product: $100 million of a capital good. Since it is produced with local
labor and materials, and assuming no payments go to Japanese factors of
production, this is all added to U.S. GDP.

Effect on Income: $100 million paid to U.S. factors of production.

Effect on expenditure: $100 million net exports, since the plant is owned by the
Japanese.

e. You are informed that you have won $3,000,000 in the New Jersey State Lottery,
to be paid to you, in total, immediately.
Effect on Product: $0 because nothing is produced.

Effect on Income: $0, because this is not a payment to a factor of production, just a
transfer.
Effect on expenditure: $0 because this is a transfer, not a government purchase of goods
or services.

f. The New Jersey state government pays you an additional $5000 fee to appear in a
TV commercial publicizing the state lottery.

Effect on Product: $5,000 worth of advertising services.

Effect on Income: $5,000 of government purchases.

Effect on expenditure: $5,000 compensation of employees.

g. Hertz Rent-a-Car replaces its rental fleet by buying $100,000,000 worth of new
cars from General Motors. It sells its old fleet to a consortium of used-car dealers
 for $40,000,000. The consortium resells the used cars to the public for a total of
$60,000,000.

Effect on Product: $120 million composed of $100 million of new cars produced
plus $20 million of sales services provided by the consortium

Effect on Income: 100 million to the factors of production of GM plus $20

million in payments to the factors of production and profits for the consortium.

Effect on expenditure: $100 million by Hertz as investment plus $60 million by

the public for consumption of the used cars minus $40 million of investment
goods sold by Hertz, for a total of $120 million.

N2.5. You are given the following information about an economy:

Gross private domestic investment =40

Government purchases of goods and services =30

Gross national product (GNP) =200

Current account balance =−20

Taxes =60

Government transfer payments to the domestic private sector =25

Interest payments from the government to the domestic private sector =15 (Assume all
interest payments by the government go to domestic households.)

Factor income received from rest of world =7

Factor payments made to rest of world =9

Find the following, assuming that government investment is zero:

a. Consumption
 C = Y - (I + G + NX)
C = 202 - (40 + 30 - 18) = 150

b. Net exports

-20

c. GDP

Y = GNP - NFP

Y = 200 - (-2) = 202

d. Net factor payments from abroad

Net factor payment= 7-9= -2

e. Private saving

Private saving= Y + TR + NFP + Interest Payment - C - T

= 202 + 25 + (-2) + 15 - 150 - 60

= 30

f. Government saving

Government Saving = T - G - TR - Interest Payment

= 60 - 30 - 25 - 15

= -10

g. National saving

Private saving + Public saving = 30 -10 = 20

N3.5. Consider an economy in which the marginal product of labor MPN is MPN = 309 -
2N, where N is the amount of labor used. The amount of labor supplied, NS, is given by
NS = 22 + 12w + 2T, where w is the real wage and T is a lump-sum tax levied on
individuals.

a. Use the concepts of income effect and substitution effect to explain why
an increase in lump-sum taxes will increase the amount of labor supplied.

The substitution effect is the tendency for workers to increase labor supply when the
incentive to work increases. The income effect is the tendency for workers to decrease
labor supply when wealth or income increases. This can equivalently be stated as the
tendency for workers to increase labor supply when wealth or income increases.

If there is an increase in lump-sum taxes, this will cause an increase in workers’ costs,
decreasing their income. The income effect then says that workers will tend to increase
the amount of labor supplied because their income is decreasing.

b. Suppose that T = 35. What are the equilibrium values of employment and
the real wage?

NS = 22 + 12w + 2T
= 92+12w
W= MPN- 2N (solve for N)
= 154.5- 0.5w= N
92+12w= 154.5- 0.5w
W= 5 which is the equilibrium values of real wage
Now substitute W in the 1st equation of N= 92+12w to get N= 152 equilibrium values of
employment

c. With T remaining equal to 35, the government passes minimum wage

legislation that requires firms to pay a real wage greater than or equal to 7. What are the
resulting values of employment and the real wage?

Plug in W=7 in the second equation of N= 154.5- 0.5w

To get the resulting value of real wage as N=151.

N3.8. Use the data from the table 3.12 in the Lecture Notes 2 to calculate how many
people become unemployed during a typical month. How many become employed? How
many leave the labor force?

Unemployed: 2,859,000 become unemployed

Employed: 6,613,000 become employed
Leave the labor force: 4,509,000 leave
A3.6. Can the unemployment rate and the employment ratio rise during the same month?
Can the participation rate fall at the same time that the employment ratio rises? Explain.

Yes, it is possible for the unemployment rate and the employment ratio to rise during the
same month. For example, suppose the population falls, the labor force is constant, the
number of unemployed rises, and the number of employed falls (but by less than the
decline in population). Then the unemployment rate rises, since there are more
unemployed but the same labor force, but the employment ratio rises, since population
declines more than employment does.

        Yes, it is possible for the participation rate to fall at the same time that the
employment ratio is rising. For example, suppose that population is constant, the labor
force declines, employment rises, and unemployment falls. The participation rate falls,
since there are fewer people in the labor force from the same population. The
employment ratio is rising, since employment rises while population is constant.