NEW

Universidad Carlos III de Madrid – Department of Economics

Principles of Economics - Problem Set 8

Conceptual Questions

Write down a short and concise answer. When you are asked to solve the question in class,
explain the concept clearly and give examples or pieces of evidence.

1. What is Gross Domestic Product? Give at least three examples of goods that are
bought or sold but that are not included in the GDP.
GDP measures the value of final goods and services produced within an economy
during a certain period. Examples of purchases not included: Selling a used car,
buying illegal drugs and selling a self knitted jumper to a friend.
2. What is the difference between Real GDP and Nominal GDP? What is the GDP
deflator?
Nominal GDP is computed using the prices of the current year while real GDP is
computed using the prices of a base year. The GDP deflator is defined as the ratio
of nominal GDP to real GDP and it measures the change is prices of the goods and
services in GDP occurred between this year and the base year. relative to the base
year.
3. Why is the total income equal to total expenditure for an economy as a whole?
Gross domestic product measures two things at once: (1) the total net income of
every household in the economy and (2) the total expenditure on the economy’s
output of final goods and services. It can measure both of these things at once
because all expenditure in the economy ends up as someone’s incomes. The sum of
the aggregated values of the economy is the GDP and at the same time the
aggregate value of each production stage is someone’s income as it is distributed as
salaries, returns to land, returns to capital and profits of the firms.
4. In which component(s) of the Spanish GDP is recorded: a car produced in
Germany and bought by a consumer in Santander? And a machine produced in
Almería and sold to a Japanese firm?
The German car bought in Spain enters as an import and also enters Spanish
consumption. The machine produced in Spain and sold to Japan enters as an
export.
5. In which component(s) of the GDP is recorded the production and sale of a new
house? And the transaction of a used house? And the rent paid by renters?
The selling of a new house is an investment, the transaction of a used house does
not enter GDP (it is not built in the current period) and the rent paid by renters is
counted as consumption.
6. The government purchases component of GDP does not include spending on
transfer payments such as Social Security. Thinking about the definition of GDP,
explain why transfer payments are excluded.

1
 Public transfers are payments that have nothing (goods or services) in exchange.
Transfers simply redistribute income.

Problems

1. In an economy, only three goods are produced: ham, bread and sandwiches.

GOODS QUANTITY PRICE

Ham 100 (kg) 20
Bread 200 (kg) 4
Sandwiches 300 (units) 3

Ham and bread do not require any intermediate good and 10 kg. of ham 50 kg. of bread
are used to produce sandwiches; the rest of the goods are all final products.
a) Calculate the value added in each of the three sectors
Ham: 100*20=2000
Bread: 200*4=800
Sandwiches: 300*3-10*20-50*4=500
TOTAL:2000+800+500=3300
b) Calculate the value of the final products in each of the three sectors
Ham: (100-10)*20=1800
Bread: (200-50)*4=600
Sandwiches: 300*3=900
TOTAL:1800+600+900=3300
c) Compare the answers in question a and b and comment.
The sum of value added is the same as the sum of the total vale of the final
products. Overall the measure the same things, but some enter in different
categories.

2. Consider an economy in which investment is 15%, government expenditure is 18%,

transfers 10 % of the GDP and the consumption is 70% of the GDP. What is the value of
the net exports (NX) in terms of GDP percentage?
Y=C+I+G+NX: 100%=70%+15%+18%+NX. Hence net exports are -3% of GDP.
Transfers do not enter the GDP.

Other questions

1. Below are some data from the land of milk and honey.
Year Price of Milk Quantity of Price of Quantity of
Milk Honey Honey
2010 $2 100 $6 50

2
 2011 $2 200 $6 100
2012 $4 200 $12 100

a. Compute nominal GDP, real GDP, and the GDP deflator for each year, using 2010
as the base year.
Nominal GDP: 2010: 100*2+50*6=500,
2011: 200*2+100*6=1000,
2012: 200*4+100*12=2000
Real GDP: 2010:500,
2011: 200*2+100*6=1000,
2012: 200*2+100*6=1000
GDP deflator: 2010: (500/500)*100=100,
2011: (1000/1000)*100=100,
2012: (2000/1000)*100=200
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.
Percentage change in nominal GDP:2011:100%,
2012:100%
Percentage change in real GDP: 2011:100% (same as nominal GDP, because
prices did not change), 2012:0% (amount of goods produced did not
change)
Percentage change in GDP deflator: 2011:0% (prices did not change),
2012:100% (prices doubled)
c. Did economic well-being rise more in 2011 or 2012? Explain.
Economic well-being rose more in 2011, since more goods were produced than in
the previous year. In 2012 prices changed but the level of production remained the
same.

3. Consider an economy with GDP=1000 in 2002, with private consumption C=500, and
net exports of 0. If we know that in 2003 private consumption increased by 5% and that
investment, public expenses and exports did not change:
a) The GDP increased by 5%
b) The GDP increased by 2.5%
c) The change in GDP cannot be computed.
d) The GDP did not increase
The only component of GDP that changed is consumption. The GDP hence went up
to 1000+500*0.05=1025. Hence GDP increased by 2.5%.

4. What components of GDP (if any) would each of the following transactions affect?
Explain.
a) A family buys a new refrigerator.
Consumption
b) Aunt Pilar buys a new house.
Investment

3
 c) Seat sells an Ibiza from its inventory.
None. Its production was already counted in the past.
d) You buy a pizza.
Consumption
e) Madrid repaves the A-4.
Government spending
f) Your parents buy a bottle of French wine.
Consumption and imports.
g) Coca Cola expands its factory in Madrid.
Investment increases because new structures and equipment were built.
5. Between 1970 and 1990 the Spanish nominal GDP has always increased, this means
that:
a) Every year between 1970 and 1990 more goods were produced;
b) Every year between 1970 and 1990 the prices increased;
c) The increase in prices between 1970 and 1990 is higher than the increase in GDP
d) Either prices or the quantity of goods has increased every year
The correct answer is d). We don't know whether it was an increase in prices or an
increase in the production that led to the increase in nominal GDP.

4
 NEW
Universidad Carlos III de Madrid – Department of Economics
Principles of Economics - Problem Set 9

Conceptual Questions

Write down a short and concise answer. When you are asked to solve the question in class,
explain the concept clearly and give examples or pieces of evidence.
1. Why we say that national savings are equal to investment? What assumption is
crucial for the statement being true?
The crucial assumption is that of a closed economy (Nx=0). National Savings equal
private savings plus public savings . The first one equals Y-T-C and the second is T-
G. Therefore, national savings are S=Y-C-G. This equation combined with the
identity Y=C+I+G of a closed economy, implies that S=I
2. Why the supply of loanable funds has a positive slope and the demand for loanable
funds has a negative slope?
It is more attractive to save when the interest rate is high, the supply of funds is
higher. It is more costly to borrow when interest rates are high, investment is the
demand of funds.
3. What is the difference between the natural rate of unemployment and the rate of
unemployment during a recession?
The additional unemployment due to jobs being lost in the recession.
4. Is true that if a person losses her/his job, unemployment rate always increases?
No, if the person finds another job within four weeks or the person does not look for
a job, or if the job is given to an unemployed person, the unemployment rate does
not change.
5. Explain why can be the case that some prices increase but the CPI does not increase.
The good may not be included in the basket of representative goods or the prices of
some other goods may have decreased so that the cost of the basket is constant.
6. Why an increase of 10% in the price of bread will have a larger impact in the CPI
than an increase of 10% in the price of salt.
Bread has more weight in the basket of goods considered in CPI than salt

Problems

1. In an economy, two goods are produced in: orange juice and sandwiches with the
following prices

GOODS Orange juice Sandwiches

(per liter)
2012 3 2
2013 6 2
2014 6 4

1
 a) Calculate the price index for this economy if the basket is 1 liters of orange juice and
1 sandwich and the base year is 2012.
Cost of basket in 2012: 3*1+2*1=5
Cost of basket in 2013: 6*1+2*1=8
Cost of basket in 2014: 6*1+4*1=10

CPI in 2012= 100

CPI in 2013=100*8/5=160
CPI in 2014 =100*10/5=200

b) Calculate the price index for this economy if the basket is 1 liter of orange juice and
15 sandwiches and the base year is 2012.
Cost of basket 2012: 3*1+2*15=33
Cost of basket 2013: 6*1+2*15=36
Cost of basket 2014: 6*1+4*15=66

CPI in 2012 =100

CPI in 2013 =100*36/33=109
CPI in 2014 =100*66/33=200

c) Compare the evolution of the price indexes and explain why they behave differently.
Basket a: Inflation 2013 = 60%
Basket a: Inflation 2014 =100*(200-160)/160 = 25%
Basket b: Inflation 2013 = 9%
Basket a: Inflation 2014 =100*(200-109)/109 = 84%

In the basket a, although the quantity is the same, juice has more weight because its
relative value is higher. Therefore, the biggest change in the CPI comes in 2013 when
the price of juice increases.
Sandwiches matter more in the second basket and, thus, when their price changes,
the CPI in this case changes a lot. Contrarily, when the prices of the juice double
(2013) the CPI changes little.

2. Explain what happens to savings, investments and interest rate if

a) The government decides to reduce public expenditure (G) but it does not change tax
revenues (T)
Total savings increase (public savings go up and private savings stays constant
because T is constant), then the supply of funds curve shifts to the right. The new
equilibrium exhibits a lower interest rate and then the investment rises (funds are
higher).
b) What would be the impact of such a measure in the prospective for economic growth
in the long run?

2
 Since investment is higher, there will be larger capital accumulation in the long run
and thus on the long run the economic growth will be bigger.

3. According to the EPA (Encuesta de Población Activa) in the second quarter of 2018 in
Spain there were 22,834.2 thousand active people, 19,344.1 thousand occupied and
3,490.1 thousand unemployed. Activity rate was 58.80%.
a) Calculate unemployment rate and population older than 16
Unemployment rate: 15.28%
Adult population: 22,834.2/0.5880=38,833.33
b) Recalculate unemployment rate if 1,000 thousand individuals lose their job and
become immediately non-active.
The active population decreases in 1,000 thousand, while the amount of unemployed
does not change. Thus, the unemployment rate will be: 3,490.1/(22,834.2-1,000) =
3,490.1/(21,834.2) =15.98%

Other questions

1. Suppose that in a closed economy GDP is 10,500, consumption is 7,500, and taxes are
500. What value of government purchases would make national savings equal to 2,000
and at that value would the government have a deficit or surplus?
a. 1,500, deficit
b. 1,500, surplus
c. 1,000, deficit (CORRECT)
d. 1,000, surplus

2. If the government currently has a budget deficit, then

a. the current level of public debt must be above zero.
b. its debt is increasing. (CORRECT)
c. government expenditures are lower than taxes.
d. All of the above are incorrect.

3. If there is a sudden increase in the oil price (not produced in Spain). What will be the
behavior of the GDP deflator in relation to the CPI?
The CPI would rise, but there would be no effect in the deflator since this is a good that
is imported and consumed.

4. The inflation rate is defined as the

a. price level in an economy.
b. change in the price level from one period to the next.

3
 c. percentage change in the price level from the previous period. (CORRECT)
d. price level minus the price level from the previous period.

5. Suppose that the adult population in the town of Springfield is 225 million. If 40 million
are unemployed and 100 million are employed, then the unemployment rate is
approximately
a. 29%. (CORRECT)
b. 18%.
c. 24%.
d. 6%.

6. Which of the following helps to reduce frictional unemployment?

a. government-run employment agencies
b. public training programs
c. the Internet
d. All of the above are correct. (CORRECT)

7. Assume an economy experienced a positive rate of inflation between 2003 and 2004 and
again between 2004 and 2005. However, the inflation rate was lower between 2004 and
2005 than it was between 2003 and 2004. Which of the following scenarios is consistent
with this assumption?
a. The CPI was 100 in 2003, 110 in 2004, and 105 in 2005.
b. The CPI was 100 in 2003, 120 in 2004, and 135 in 2005. ( CORRECT)
c. The CPI was 100 in 2003, 105 in 2004, and 130 in 2005.
d. The CPI was 100 in 2003, 90 in 2004, and 88 in 2005.

4
 NEW
Universidad Carlos III de Madrid – Department of Economics
Principles of Economics - Problem Set 10

These answers and solutions are only a general guide because they are preliminary.

Conceptual Questions

Write down a short and concise answer. When you are asked to solve the question in class,
explain the concept clearly and give examples or pieces of evidence.

1. What does liquidity mean and why it is important for defining what money is?
How easy it is to convert an asset into the economy’s medium of exchange. It is
important for the definition of money because, given that money is the a medium of
exchange, it has infinite liquidity.
2. What is the mechanism that allows banks to multiply money?
Banks make loans. They keep only a fraction of deposits (reserve).
3. What is the money multiplier?
The money multiplier indicates the amount of money generated for each euro
(dollar in the US) the banks have in reserve.
4. Why the quantity demanded of money is positively related to the price level?
The higher the price level is, the more money people need to buy the same amount
of goods and services. Hence, ceteris paribus, they want to keep more cash.
5. What does the Quantity Theory say about the causes of inflation?
If the money supply grows more than the value of the production, the value of
money will tend to decrease and the price level will tend to increase. If there is no
growth in the production of goods, inflation rate will be (more or less) proportional
to the growth rate in the money supply.
6. How the central banks can influence the money supply?
Changing the discount rate, through open market operations, or changing the
required reserve-deposit ratio.

Problems

1. A central bank conducts a $10 million open-market purchase of government bonds.

a. If the required minimum reserve ratio is 20%, what is the largest possible
increase in the money supply that could result?
10 million * (1/0.2) = 10*5 millions = 50 millions

b. Explain. What is the smallest possible increase? Explain.

Even if the required minimum reserve ratio is 20%, banks can decide to
keep a higher percentage and it can even reach the 100% level. If banks
keep 100% reserves, the increment will only be 10 millions * (1/1) = 10
millions, despite the lower reserve ratio.

1
2. Suppose that this year’s money supply is $4,000 billion, the nominal GDP is
$20,000 billion, and real GDP is $5,000 billion. NOTA: EN LA VERSIÓN EN
ESPAÑOL LAS UNIDADES SON DISTINTAS PORQUE UTILIZAMOS
BILLONES (1 MILLÓN DE MILLONES) Y EN LA INGLÉS BILLIONS (1000
MILLONES).
a. What is the price level? What is the velocity of money?
Price level: 20,000 / 5,000 = 4
Velocity: P*Y/M= 4*5,000/4,000= 5
b. Suppose that velocity is constant and the economy’s output of goods and
services rises by 5% this year. What will happen to nominal GDP and the
price level next year if the Central Bank keeps the money supply constant?
Y is the real GDP and, given that next year it will hold that MV=PY;
4,000*5=P*1.05*5,000, so the price level will be P = 3.809. Therefore, the
nominal GDP = 3.809*(1.05*5,000) =20,000 billion
c. What money supply should the Central Bank set next year if it wants to
keep the price level stable?
Given the equation M=PY/V, if P=4, then M=4*(5,000*1.05)/5 = 4,200.
The money supply should increase to accommodate the growth in the real
GDP.
d. What money supply should the central banks set next year if it wants
inflation of 10 percent?
When P=4.4, and M=PY/V, M=4.4*(5,000*1.05)/5 = 4,620. The money
supply should increase more than the price level because there exists a real
GDP growth.

3. 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?
If people need to hold less cash, the demand for money shifts to the left,
because there will be less money demanded at any price level.
b. If the Fed does not respond to this event, what will happen to the price
level?
If the Fed does not respond to this event, the shift to the left of the demand
for money combined with no change in the supply of money leads to a
decline in the value of money (1/P), which means the price level rises, as
shown in the next Figure.

2
 c. If the Fed wants to keep the price level stable, what should it do?

If the Fed wants to keep the price level stable, it should reduce the money
supply from S1 to S2 in the next Figure. This would cause the supply of
money to shift to the left by the same amount that the demand for money
shifted, resulting in no change in the value of money and the price level.

Other questions

1. You take $100 you had kept under your mattress and you decide to deposit them in
your bank account. If this $100 stays in the banking system as reserves and if banks
hold reserves equal to 10 percent of deposits, by how much does the total amount of
deposits in the banking system increase? By how much does the money supply
increase?
Initially, deposits rise in 100, which increases the reserves in the same quantity, 100.
Then, the bank loans out 90 (10% reserve ratio) and 10 are kept as reserves. The 90 are
deposited in other banks that keep 9 as reserves and loan out 81 that are deposited in
other banks and so on… In the limit, there will be a money supply of
100*(1+0.9+0.9^2+0.9^3+…)=100/(1-0.9). Summarizing, since the multiplier is

3
 1/0.1=10, money supply increases in 100*1/0.1=1000. This is the final increase in
deposits. Nevertheless, in this case we are supposing that individuals deposit every
loan that they receive in the bank and do not keep any cash; hence, the increase in
deposits is equal to the increase in the money supply.

2. Which list ranks assets from least to most liquid?

a. currency, demand deposits, money market mutual funds
b. currency, money market mutual funds, demand deposits
c. money market mutual funds, demand deposits, currency (CORRECT)
d. demand deposits, money market mutual funds, currency

3. When conducting an open-market operation, if a Central Bank

a. buys government bonds, it increases the money supply. (CORRECT)
b. buys government bonds, it decreases the money supply.
c. sells government bonds, it increases the money supply.
d. All of them are false.

4. Under a fractional-reserve banking system, banks

a. hold more reserves than deposits.
b. generally lend out a majority of the funds deposited. (CORRECT)
c. cause the money supply to fall by lending out reserves.
d. All of the above are correct.

5. When the Central Bank decreases the discount rate, commercial banks will
a. borrow more from the Central Bank and lend more to the public. The money
supply increases. (CORRECT)
b. borrow more from the Central Bank and lend less to the public. The money
supply decreases.
c. borrow less from the Central Bank and lend more to the public. The money
supply increases.
d. borrow less from the Central Bank and lend less to the public. The money
supply decreases.

6. The economy of Mainland uses gold as its money. If the government discovers a large
reserve of gold on their land
a. the supply of money decreases and the value of money rises.
b. the supply of money increases and the value of money falls. (CORRECT)
c. the demand for money increases and the value of money rises.

4
 d. the demand for money decreases and the value of money falls.

7. Suppose the money supply tripled, but at the same time velocity doubled and real GDP
was unchanged. According to the quantity equation the price level
a. is 1.5 times its old value.
b. is 3 times its old value.
c. is 6 times its old value. (CORRECT)
d. is the same as its old value.

8. The classical dichotomy argues that changes in the money supply

a. affect both nominal and real variables.
b. affect neither nominal nor real variables.
c. affect nominal variables, but not real variables. (CORRECT)
d. do not affect nominal variables, but do affect real variables.

5
 NEW
Universidad Carlos III de Madrid – Department of Economics
Principles of Economics

Problem Set 11

These answers and solutions are only a general guide because they are
preliminary.

Conceptual Questions
Write down a short and concise answer. When you are asked to solve the question in
class, explain the concept clearly and give examples or pieces of evidence.

1. Define net exports and net foreign investment.

Explain how and why they are related. The net exports of a country are the value of its
exports minus the value of its imports. Net capital outflow refers to the purchase of
foreign assets by domestic residents minus the purchase of domestic assets by
foreigners. Net exports are equal to net capital outflow by an accounting identity,
because exports from one country to another are matched by payments of some asset
from the second country to the first.

2. Explain the relationship among saving, investment, and net foreign investment.
Saving equals domestic investment plus net capital outflow, because any dollar saved
can be used to finance accumulation of domestic capital or it can be used to finance
the purchase of capital abroad.

3. Describe the difference between foreign direct investment and foreign portfolio
investment. Who is more likely to engage in foreign direct investment—a corporation
or an individual investor? Who is more likely to engage in foreign portfolio
investment?
Foreign direct investment requires actively managing an investment, for example, by
opening a retail store in a foreign country. Foreign portfolio investment is passive, for
example, buying corporate stock in a retail chain in a foreign country. As a result, a
corporation is more likely to engage in foreign direct investment, while an individual
investor is more likely to engage in foreign portfolio investment.

4. Keeping the national savings constant, does an increase in the net capital
outflows increase, decrease or has no effect on the capital accumulation of a
country?
It decreases it, because there is a lower amount of resources disposable to
internally accumulate them as capital.

5. Define nominal and real exchange rate and write a mathematical expression that
relates them.
The nominal exchange rate is the relative price of the currency of two countries, and
the real exchange rate is the relative price of the goods and services of two countries.
When the nominal exchange rate changes so that each dollar buys more foreign
currency, the dollar is said to appreciate or strengthen. When the nominal exchange
rate changes so that each dollar buys less foreign currency, the dollar is said to
depreciate or weaken. The real exchange rate and the nominal exchange rate relate
through the following expression:
𝑇𝐶𝑁𝑈,𝐽 × 𝑃𝑈
𝑇𝐶𝑅𝑈,𝐽 = ,
𝑃𝐽
Where 𝑇𝐶𝑅𝑈,𝐽 is the real exchange rate (amount of US goods in terms of Japanese
goods), 𝑇𝐶𝑁𝑈,𝐽 is the nominal exchange rate (amount of yens per US dollar), 𝑃𝑈 is the
price level in the USA and 𝑃𝐽 the price level in Japan.

6. Describe the economic logic behind the theory of purchasing-power parity.

The economic logic behind the theory of purchasing-power parity is that a good must
sell for the same price in all locations. Otherwise, people would profit by engaging in
arbitrage.

Problems

1. How would the following transactions affect U.S. exports, imports, and net
exports?
a. A retail seller from the USA buys a shipment of phones produced at Korea.
b. Students in Paris flock to see the latest Arnold Schwarzenegger movie.
c. An American resident buys a new Volvo.
d. The student bookstore at Oxford University buys a shipment of Levi’s 501 jeans.
e. A Canadian citizen shops at a store in northern Vermont to avoid Canadian sales
taxes.
a. The U.S. imports rise, and since exports are not affected by this transaction,
the net exports decrease.
b. When students in Paris flock to see the latest movie from Hollywood,
foreigners are buying a U.S. good, so U.S. exports rise, imports are
unchanged, and net exports increase.

c. When your uncle buys a new Volvo, an American is buying a foreign good, so
U.S. exports are unchanged, imports rise, and net exports decline.

d. When the student bookstore at Oxford University buys a shipment of Levi’s

501 jeans, it is buying U.S. goods, so U.S. exports increase, imports are
unchanged, and net exports increase.

e. When a Canadian citizen shops in northern Vermont to avoid Canadian sales

taxes, a foreigner is buying U.S. goods, so U.S. exports increase, imports are
unchanged, and net exports increase.

2. What is happening to the U.S. real exchange rate in each of the following
situations? Explain.
a. The U.S. nominal exchange rate is unchanged, but prices rise faster in the United
States than abroad. If the U.S. nominal exchange rate is unchanged, but prices rise
faster in the United States than abroad, the real exchange rate rises.
b. The U.S. nominal exchange rate is unchanged, but prices rise faster abroad than in
the United States. If the U.S. nominal exchange rate is unchanged, but prices rise
faster abroad than in the United States, the real exchange rate declines
c. The U.S. nominal exchange rate rises, and prices are unchanged in the United
States and abroad. If the U.S. nominal exchange rate rises and prices are
unchanged in the United States and abroad, the real exchange rate increases.
d. The U.S. nominal exchange rate declines, and prices rise faster abroad than in the
United States. If the U.S. nominal exchange rate declines and prices rise faster
abroad than in the United States, the real exchange rate declines.

3. A case study in the chapter analyzed purchasing-power parity for several countries
using the price of a Big Mac.
Here are data for a few more countries:

Country……Big Mac Price……Predicted exchange rate…Actual Exchange rate

Chile 1750 pesos …………________pesos/$ 549 pesos/$
Hungary 720 Forint _______ Forint/$ 199 Forint/$
Czech Republic 67,9 Koruna _______Koruna/$ 18.7 Koruna/$
Brazil 8.03 Real _______Reales/$ 2.0 Reales/$
Canada 3.89 $Cad. _______ $ cad/$ 1.16$Cad./$

a. For each country, compute the predicted exchange rate (this is, the exchange
rate under the assumption that the Purchasing Power Parity theory holds) of
the local currency per U.S. dollar. (The U.S. price of a Big Mac is 3.57$)
b. According to purchasing-power parity, what is the predicted exchange rate
between the Brazilian real and the Canadian dollar? What is the actual
exchange rate?
c. How well does the theory of purchasing power parity explain exchange rates?
Answer: a) If you take X units of foreign currency per Big Mac divided by 3.57 dollars
per Big Mac, you get X/3.57 units of the foreign currency per dollar; that is the predicted
exchange rate.

a. Chile: 1750 pesos/$3.57 = 490.2 pesos/$

Hungary: 720 forints/$3.57 = 201.7 forints/$
Czech Republic: 67.9 korunas/$3.57 = 19 korunas/$
Brazil: 8.03 reales/$3.57 = 2.25 reales/$
Canada: 3.89C$/$3.57 = 1.09 C$/$

b. Under purchasing-power parity, the exchange rate of the Brazilian real to the
Canadian dollar is 8.03 reales forints per Big Mac divided by 3.89 Canadian dollars
per Big Mac equals 2.06 reales per Canadian dollar. The actual exchange rate is 2.0
 reales per dollar divided by 1.16 Canadian dollars per dollar equals 1.72 reales per
Canadian dollar. According to the purchasing power parity theory of the exchanges
rates, the Brazilian real is overvalued with respect to the Canadian dollar (the theory
predicts that a Canadian dollar would buy 2.06 reales, when actually it only buys
1.72. This is, according to the theory one real should buy 1/2.06=0.48 Canadian
dollars but it buys 1/1.72=0.58 dollars).

c. The exchange rates predicted by the Big Mac index are somewhat close to
the actual exchange rates with the exception of the Chilean peso which is
undervalued (actual 549 peso/ US $> Big Mac index 490 peso/ US $).

Other questions

1. The country of Elbia has a GDP of $2,000, consumption of $1,300, and

government purchases of $400. Which of the following is equal to $300?
a. domestic investment
b. domestic investment plus net capital outflow
c. domestic investment minus net capital outflow
d. None of the above is correct.
2. In an open economy, gross domestic product equals $1,650 billion,
government expenditure equals $250 billion, and savings equals $550 billion.
What is consumption expenditure?
a. $250 billion
b. $300 billion
c. $550 billion
d. $850 billion
3. From 1980 to 1987
a. foreigners were buying more assets from the United States than
Americans were buying abroad. The United States was going into debt.
b. Americans were buying more assets abroad than foreigners were buying
from the United States. The United States was going into debt.
c. foreigners were buying more assets from the United States than
Americans were buying abroad. The United States was moving into
surplus.
d. Americans were buying more assets abroad than foreigners were buying
from the United States. The United States was moving into surplus.

4. The nominal exchange rate is .80 euros per dollar and the real exchange rate
is 4/3 between the USA and Italy. Which of the following prices for a
particular good are consistent with these exchange rates?
a. $4 in the U.S. and 3 euros in Italy.
b. $4 in the U.S. and 3.75 euros in Italy.
c. $5 in the U.S. and 3 euros in Italy.
d. $6 in the U.S. and 2.50 euros in Italy.

5. Other things the same, which of the following could be a consequence of an

appreciation of the U.S. real exchange rate?
a. John, a French citizen, decides that Iowa pork is now relatively less expensive and
orders more for his restaurant.
b. Nick, a U.S. citizen, decides that the trip to Nepal he’s been thinking about is now
affordable.
c. Roberta, a U.S. citizen, decides to import fewer windshield wipers for her auto
parts company.
d. All of the above are correct

6. If over the next few years inflation is higher in Mexico than in the U.S., then
according to purchasing-power parity which of the following should rise?
a. the U.S. real exchange rate but not the U.S. nominal exchange rate
b. the U.S. nominal exchange rate but not the U.S. real exchange rate
c. the Mexican real exchange rate but not the Mexican nominal exchange rate
d. neither the U.S. real nor the U.S. nominal exchange rate.
 Universidad Carlos III de Madrid – Department of Economics
Principles of Economics - Problem Set 12

These answers and solutions are only a general guide because they are preliminary.

Conceptual Questions

Write down a short and concise answer. When you are asked to solve the question in class, explain
the concept clearly and give examples or pieces of evidence.

1. List and explain the three reasons why the aggregate demand curve is downward sloping.
Wealth effect (at higher prices can afford fewer goods with the same income, consumption
falls) , interest rate effect (at higher prices interest rates go up, investment falls) , exchange
rate effect ( if prices are higher, less demand for local good from foreigners, net exports
fall) .
2. Explain why the long-run aggregate-supply curve is vertical. Explain one of the theories for
why the short-run aggregate-supply curve is upward sloping.
Long run supply is determined by the economy’s stocks of labor, capital, and natural
resources, and on the level of technology. In the short run, the sticky-wage theory, in
which a lower price level makes employment and production less profitable because wages
do not adjust immediately to the price level, so firms reduce the quantity of goods and
services supplied.
3. What might shift the aggregate-demand curve to the left? Use the model of aggregate
demand and aggregate supply to trace through the effects of such a shift.
The aggregate-demand curve might shift to the left when something (other than a rise in
the price level) causes a reduction in consumption spending (such as a desire for increased
saving), a reduction in investment spending (such as increased taxes on the returns to
investment), decreased government spending (such as a cutback in defense spending), or
reduced net exports (such as when foreign economies go into recession. Use a graph of the
AD-AS model to explain the effects

4. What might shift the short-run aggregate-supply curve to the left? Use the model of
aggregate demand and aggregate supply to trace through the effects of such a shift.
The aggregate-supply curve might shift to the left because of a decline in the economy's
capital stock, labor supply, or productivity, or an increase in the natural rate of
unemployment, all of which shift both the long-run and short-run aggregate-supply curves
to the left. An increase in the expected price level shifts just the short-run aggregate-supply
curve (not the long-run aggregate-supply curve) to the left. Use a graph of the AD-AS
model to explain the effects

Problems

1. Suppose the economy is in a long-run equilibrium.

a. Draw a diagram to illustrate the state of the economy. Be sure to show aggregate demand,
short-run aggregate supply, and long-run aggregate supply.

1
b. Now suppose that a stock-market crash causes aggregate demand to fall. Use your
diagram to show what happens to output and the price level in the short run. What
happens to the unemployment rate? The equilibrium level of output and the
price level will fall. Because the quantity of output is less than the natural
level of output, the unemployment rate will rise above the natural rate of
unemployment.

Price Long-Run Aggregate

Level Supply
AS1

AS2

AD1

AD2

Output

Figure 6

2
 a. The current state of the economy is shown in Figure 6. The aggregate-
demand curve (AD1) and short-run aggregate-supply curve (AS1) intersect
at the same point on the long-run aggregate-supply curve.

b. A stock market crash leads to a leftward shift of aggregate demand (to

AD2). The equilibrium level of output and the price level will fall. Because
the quantity of output is less than the natural level of output, the
unemployment rate will rise above the natural rate of unemployment.

2. Suppose that the economy is in a recession with high unemployment and low output
caused by a decrease in aggregate demand. Use the sticky-wage theory of aggregate supply
to explain what will happen to output and the price level in the transition to the long run
equilibrium (assuming there is no change in policy). What role does the expected price
level play in this adjustment? Be sure to illustrate your analysis in a graph.
If nominal wages are unchanged as the price level falls, firms will be forced to cut back on
employment and production. Over time as expectations adjust, the short-run aggregate-
supply curve will shift to the right (to AS2), moving the economy back to the natural level
of output. (see graph above)

3. Explain whether each of the following events shifts the short-run aggregate-supply curve, the
aggregate-demand curve, both, or neither. For each event that does shift a curve, draw a diagram to
illustrate the effect on the economy.
a. Households decide to save a larger share of their income.
Aggregate demand shifts down.
b. Valencia orange groves suffer a prolonged period of below-freezing temperatures.
If Valencia orange groves suffer a prolonged period of below-freezing
temperatures, the orange harvest will be reduced. This decline in the
natural level of output is represented in Figure 11 by a shift to the left in
both the short-run and long-run aggregate-supply curves. The equilibrium
changes from point A to point B, so the price level rises and output
declines.

c.

3
 I
c. Increased job opportunities overseas cause many people to leave the country.

If increased job opportunities cause people to leave the country, the long-run and short-
run aggregate-supply curves will shift to the left because there are fewer people
producing output. The aggregate-demand curve will also shift to the left because there
are fewer people consuming goods and services. The result is a decline in the quantity
of output, as Figure 12 shows. Whether the price level rises or declines depends on the
relative sizes of the shifts in the aggregate-demand curve and the aggregate-supply
curves.

Other questions
1. The economy begins in long-run equilibrium. Then one day, the president of the US appoints a

4
new chairman of the Federal Reserve. This new chairman is well-known for his view that inflation
is not a major problem for an economy.
a. How would this news affect the price level that people would expect to prevail?
People expect the inflation to be higher in the long-run.
b. How would this change in the expected price level affect the nominal wage that workers
and firms agree to in their new labor contracts?
The nominal wages will be higher.
c. How would this change in the nominal wage affect the profitability of producing
goods and services at any given price level?
The profitability at a given price level goes down. Producing the good is more costly,
because workers are paid higher real wages (price level P same and Pe has increased).
d. How does this change in profitability affect the short-run aggregate-supply curve?
The short-run aggregate supply curve shifts left.
e. If aggregate demand is held constant, how does this shift in the aggregate-supply curve
affect the price level and the quantity of output produced?
The price level goes up and the output produced decreases.
f. Do you think this Fed chairman was a good appointment?
No. Although the effects are driven by his reputation, rather than his actions.

2. Which of the following is correct?

a. Real GDP is the variable most commonly used to measure short-run economic fluctuations.
These fluctuations can be predicted with some accuracy.
b. Real GDP is the variable most commonly used to measure short-run economic fluctuations. It
is almost impossible to predict these fluctuations with much accuracy.(Correct)
c. Nominal GDP is the variable most commonly used to measure short-run economic
fluctuations. These fluctuations can be predicted with some accuracy.
d. Nominal GDP is the variable most commonly used to measure short-run economic
fluctuations. It is almost impossible to predict these fluctuations with much accuracy.

3 Classical economist David Hume observed that as the money supply expanded after gold
discoveries it took some time for prices to rise and in the meantime the economy enjoyed
higher employment and production. This is inconsistent with monetary neutrality because
a. monetary neutrality would mean that neither prices nor production should have risen.
b. monetary neutrality would mean that production should have risen, but prices should
not have.
c. monetary neutrality would mean the prices should have risen, but production should
not have changed. (Correct)
d. monetary neutrality would mean that prices and production should both have fallen.

4. Other things the same, if technology increases, then in the long run
e. both output and prices are higher.
f. output is higher and prices are lower. (Correct)
g. output is lower and prices are higher.
h. both output and prices are lower.

5
4. The sticky-wage theory of the short-run aggregate supply curve says that when the price
level is lower than expected,
a. relative to prices wages are higher and employment rise.
b. relative to prices wages are higher and employment falls. (Correct)
c. relative to prices wages are lower and employment rises.
d. relative to prices wages are lower and employment falls.

6
 NEW
Universidad Carlos III de Madrid – Department of Economics
Principles of Economics - Problem Set 13

These answers and solutions are only a general guide because they are preliminary.

Conceptual Questions

Write down a short and concise answer. When you are asked to solve the question in class,
explain the concept clearly and give examples or pieces of evidence.

1.Use the theory of liquidity preference to explain how a decrease in the money supply
affects the aggregate-demand curve. According to the theory of liquidity preference, the
interest rate adjusts to balance the supply and demand for money. Therefore, a
decrease in the money supply will increase the equilibrium interest rate. This
decrease in the money supply reduces aggregate demand because the higher interest
rate causes households to buy fewer houses, reducing the demand for residential
investment, and causes firms to spend less on new factories and new equipment,
reducing business investment.

2. Give an example of a government policy that acts as an automatic stabilizer. Explain

why the policy has this effect. Government policies that act as automatic stabilizers
include the tax system and government spending through the unemployment-
benefit system. The tax system acts as an automatic stabilizer because when
incomes are high, people pay more in taxes, so they cannot spend as much. When
incomes are low, so are taxes; thus, people can spend more. The result is that
spending is partly stabilized. Government spending through the unemployment-
benefit system acts as an automatic stabilizer because in recessions the
government transfers money to the unemployed so their incomes do not fall as
much and thus their spending will not fall as much.

3. The government spends $3 billion to buy police cars. Explain why aggregate demand
might increase by more than $3 billion. Explain why aggregate demand might increase by
less than $3 billion. If the government spends $3 billion to buy police cars, aggregate
demand might increase by more than $3 billion because of the multiplier effect on
aggregate demand. Aggregate demand might increase by less than $3 billion because
of the crowding-out effect on aggregate demand.

4. Suppose government spending increases. Would the effect on aggregate demand be

larger if the Federal Reserve held the money supply constant in response or if the Fed were
committed to maintaining a fixed interest rate? Explain. If government spending increases,
aggregate demand rises, so money demand rises. The increase in money demand leads to a rise in

1
the interest rate and thus a decline in aggregate demand if the Fed keeps the money supply
constant. But if the Fed maintains a fixed interest rate, it will increase money supply, so aggregate
demand will not decline. Thus, the effect on aggregate demand from an increase in government
spending will be larger if the Fed maintains a fixed interest rate.

Problems

1.Explain how each of the following developments would affect the supply of money, the
demand for money, and the interest rate. Illustrate your answers with diagrams.
a. The Fed’s bond traders sell bonds in open market operations.
b. An increase in credit-card availability reduces the cash people hold.
c. The Federal Reserve increases banks’ reserve requirements.
d. Households decide to hold more money to use for holiday shopping.
e. A wave of optimism boosts business investment and expands aggregate demand.

a. When the Fed’s bond traders sell bonds in open-market operations, the money-
supply curve shifts to the left from MS 1 to MS 2, as shown in the following figure.
The money-demand stays the same. The result is a rise in the interest rate.

b. When an increase in credit card availability reduces the cash people hold, the
money-demand curve shifts to the left from MD 1 to MD 2, as shown in the
following figure. The result is a decline in the interest rate.

2
 c. When the Federal Reserve increases reserve requirements, the money supply
decreases. Thus, the money-supply curve shifts to the LEFT, as shown in the
figure of section a. The result is an increase in the interest rate.

d. When households decide to hold more money to use for holiday shopping, the
money-demand curve shifts to the right from MD 1 to MD 2, as shown in the
following figure. The result is a rise in the interest rate.

e. When a wave of optimism boosts business investment and expands aggregate

demand, money demand increases from MD 1 to MD 2 in the figure from part a.
The increase in money demand increases the interest rate.

2. The Federal Reserve reduces the money supply by 5 percent.

a. Use the theory of liquidity preference to illustrate in a graph the impact of this policy on
the interest rate.
b. Use the model of aggregate demand and aggregate supply to illustrate the impact of this
change in the interest rate on output and the price level in the short run.
c. When the economy makes the transition from its short-run equilibrium to its long-run
equilibrium, what will happen to the price level?
d. How will this change in the price level affect the demand for money and the equilibrium
interest rate?

3
e. Is this analysis consistent with the proposition that money has real effects in the short
run but is neutral in the long run?

a. The reduction in the money supply will cause the equilibrium interest rate to rise,
as it was shown in the figure in the section a of the previous exercise. Households will
reduce their spending and will invest less in new housing. Firms too will reduce their
investment spending. This will cause the aggregate demand curve to shift to the left as
it is shown in the following figure.

b. As shown in the figure above, the reduction in aggregate demand will cause a
decrease in both output and the price level in the short run (point B).

c. When the economy makes the transition from its short-run equilibrium to its
long-run equilibrium, short-run aggregate supply will increase, causing the price level
to fall even further (point C).

d. The decrease in the price level will cause a decrease in the demand for money,
reducing the equilibrium interest rate.

e. Yes. While output initially falls because of the decrease in aggregate demand, it
will rise once short-run aggregate supply increases. Thus, there is no long-run effect
of the increase in the money supply on real output.

4
3. Suppose the government reduces taxes by $20 billion, that there is no crowding out, and
that the marginal propensity to consume is 4/5
a. What is the initial effect of the tax reduction on aggregate demand?
b. What additional effects follow this initial effect? What is the total effect of the tax cut on
aggregate demand?
c. How does the total effect of this $20 billion tax cut compare to the total effect of a $20
billion increase in government purchases? Why?
d. Based on your answer to part (c), can you think of a way in which the government can
increase aggregate demand without changing the government’s budget deficit?

a. The initial effect of the tax reduction of $20 billion is to increase aggregate
demand by $20 billion × 4/5 (the MPC ) = $16 billion.

b. Additional effects follow this initial effect as the added incomes are spent. The
second round leads to increased consumption spending of $16 billion × 4/5 =
$12.8 billion. The third round gives an increase in consumption of $12.8 billion ×
4/5 = $10.24 billion. The effects continue indefinitely. Adding them all up gives a
total effect that depends on the multiplier. With an MPC of 4/5, the multiplier is
1/(1 – 4/5) = 5. So the total effect is $16 billion × 5 = $80 billion.

c. Government purchases have an initial effect of the full $20 billion, because they
increase aggregate demand directly by that amount. The total effect of an increase
in government purchases is thus $20 billion × 5 = $100 billion. So government
purchases lead to a bigger effect on output than a tax cut does. The difference
arises because government purchases affect aggregate demand by the full
amount, but a tax cut is partly saved by consumers, and therefore does not lead to
as much of an increase in aggregate demand.

d. The government could increase taxes by the same amount it increases its
purchases. If not all the increase in taxes (and the implied reduction of disposable
income) is transformed in a reduction in consumption, the aggregate demand
would increase.

Other questions
1.According to the theory of liquidity preference,
a. if the interest rate is below the equilibrium level, then the quantity of money people
want to hold is less than the quantity of money the Fed has created.
b. if the interest rate is above the equilibrium level, then the quantity of money people
want to hold is greater than the quantity of money the Fed has created.
c. the demand for money is represented by a downward-sloping line on a supply-and-
demand graph.

5
 d. All of the above are correct.
2. In a certain economy, when income is $100, consumer spending is $60. The value of the
multiplier for this economy is 4. It follows that, when income is $101, consumer
spending is
a. $60.25.
b. $60.75.
c. $61.33.
d. $64.00.

3.Which of the following correctly explains the crowding-out effect?

a. An increase in government expenditures decreases the interest rate and so increases
investment spending.
b. An increase in government expenditures increases the interest rate and so reduces
investment spending.
c. A decrease in government expenditures increases the interest rate and so increases
investment spending.
d. A decrease in government expenditures decreases the interest rate and so reduces
investment spending.

4. Economists who are skeptical about the relevance of “liquidity traps” argue that
a. a central bank continues to have tools to stimulate the economy, even after its
interest rate target hits its lower bound of zero.
b. a central bank continues to have the option of committing itself to future monetary
contraction, even after its interest rate target hits its lower bound of zero.
c. a central bank can greatly reduce the likelihood of a liquidity trap by setting the
target rate of inflation at zero.
d. while the concept of a liquidity trap is theoretically possible, nothing resembling a
liquidity trap ever has been observed in the real world.