Created: 2000-08-30
Last Modified: 2000-09-21
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Economics 101b: Fall 2000: Problem Set 1 Answers

J. Bradford DeLong

Pawel Dyczewski

1. Explain whether or not and why the following items are included in the calculation of GDP:

A. Increases in business inventories

Yes. Increases in business inventories are part of investment

B. Sales of existing homes

No. It's a transfer of an existing asset--not an element of current production.

C. The fees earned by real estate agents on selling existing homes

Yes. They are providing a useful (and paid for) service: helping you sell your house.

D. Income earned by Americans living and working abroad

No. This is part of GNP, but not of GDP.

E. Purchases of IBM stock by your brother

No. Once again this is a transfer of an already-existing asset from one person to another, not part of current production.

F. Purchase of a new tank by the Department of Defense

Yes. Government purchases are part of GDP.

G. Rent that you pay to your landlord

Yes. You are purchasing housing services from your landlord.

2. Why do you calculate real GDP by dividing nominal GDP by the price level, but calculate the real interest rate by subtracting the inflation rate from the nominal interest rate. Since both sets of calculation aim to transform a real into a nominal quantity, shouldn't they be calculated in a parallel fashion? So why divide in one case, and subtract in the other?

Because real GDP is nominal GDP divided by the price level, the growth rate of real GDP is the growth rate of nominal GDP minus the price level. Quotients turn into subtraction when you move from levels to growth rates.

3. In 1979 the (short-term) nominal interest rate on three-month Treasury bills averaged 10.0%, and the GDP deflator rose from 50.88 to 55.22. What was the annual rate of inflation in 1979? What was the real interest rate in 1979?

The rate of inflaiton was about 8.5% per year. The short-term real interest rate was about 1.5% per year.

a. Were real interest rates higher in 1979, or in 1998 (when the (short-term) nominal interest rate on three-month Treasury bills was 4.8%, and the inflation rate was 2.6%?

In 1998. The real interest rate was then 2.2% per year.

b. Which interest rate concept--the nominal interest rate or the real interest rate--do lenders and borrowers care more about? Why?

The real interest rate. In the end it is not the number of dollar bills you can spend that determines your welfare, but how many goods and services those dollar bills can buy. Thus the real interest rate--the interest rate adjusted for inflation, the interest rate in terms of goods and services--is ultimately more important than the nominal interest rate.

4. Suppose that the appliance store buys a refrigerator from the manufacturer on December 15, 2003 for $600, and that you then buy that refrigerator on January 15, 2004 for $750. a. What is the contribution to GDP in 2003? b. How is the refrigerator accounted for in the NIPA in 2003? c. What is the contribution to GDP in 2004? d. How is the refrigerator accounted for in the NIPA in 2004?

a. $600 of inventory investment are credited to 1993. b. The refrigerator counts as inventory investment in 1993. c. In 1994 $750 of consumption demand are credited to GDP, and -$600 of inventory disinvestment are debited from GDP, so the total contribution in 1994 is $150. d. The refrigerator shows up both as a positive in consumption and a negative in inventory investment.

5. In 1997 nominal GDP was equal to $8.1109 trillion; consumption spending was $5.4937 trillion; gross investment spending was $1.256 trillion; and government purchases were $1.4546 trillion. What was the level of net exports?

Because consumption plus investment plus government spending plus net exports equals GDP, we can solve for net exports. They are -$94.8 billion.

6. What do you think a "science" is? Write down five characteristics that you think that a science must have. Which of these does economics satisfy?

The answer to this is a matter of opinion. I would say that a science's five most important properties are:

  • The experimental method
  • The use of a standard body of analytic assumptions to motivate research
  • Research directed toward solving puzzles that arise given that standard body of analytic assumptions
  • Rewarding scientists for pointing out anomalies in the standard body of assumptions, or in the puzzle solutions that standard body generates
  • Rewarding scientists for resolving such anomalies...

Which of these does economics satisfy? The first not, the second sort of, the third yes, the fourth yes, and the fifth sort of.

7. What do economists mean when they say that it is time to "build a model" of a situation or a problem?

To strip down a situation to its simplified essentials, and then to use quantitative methods to analyze the implications of those simplified essentials that you have focused on.

8. Write down four metaphors that you have heard people use in talking about the economy that are now--or were at the time--obscure to you.

This is genuinely hard for me to remember--it has been too long, and now economic metaphors are too ingrained into my thought. The idea that a process of rising inflation and falling unemployment is "pushing the economy up the Phillips curve" still strikes me as strange. The idea that money has a "velocity"; the circular flow metaphor itself; and the idea that you can speak of a single "labor market" are also candidates.

9. In what sense can a line on a graph "be" an equation?

In the sense of Rene Descartes's analytic geometry. Plot one variable on the vertical axis, a second on the horizontal axis. And the set of points whose coordinates satisfy an equation makes up a curve that we can identify with the equation.

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