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14.02 Ricardo Caballero

PROBLEM SET I

(Due date: Friday, September 22 in recitation)

1. Answer true or false (explain your answer in 50 words or less) – 10 Points Total

i. (Outsourcing) If a firm decides to hire an agency to clean all their offices, GDP and true output will increase (previously, personnel within the firm performed those duties).

ii. (Trade) Exports can be larger than GDP.

iii. (Vertical Integration) If McDonald's buys all the farms from which it used to purchase meat, GDP and true output will decrease.

2. Inflation – 5 Points Each

Assume a country produces only two goods: bread and beer. Prices in year 1 are 10 dollars for a loaf of bread and 2 dollars for a can of beer. Under this scenario an average person consumes 2 loaves and 10 cans a day.

In year 2, prices change to 5 dollars a loaf and 5 dollars a can, as a result of which an average person decides to consume 5 loaves and 5 cans daily.

i. Use year 1 to create a price index. With this index, measure the inflation rate from the first to the second year.

ii. Use year 2 to create a price index. With this index, measure the inflation rate from the first to the second year.

iii. Using your results in part i. and ii. Discuss one of the problems in measuring inflation. How can it be solved? What assumption on relative prices do you need to solve this problem?

iv. Comment on at least one other problem regarding inflation measurement.

3. Goods Market – 4 Points Each

A country’s government spending is 100 dollars, citizens consume 60% of every extra dollar they receive as disposable income (If disposable income were zero, then they would still consume 50 dollars). The government keeps a balanced budget (i.e. taxes = government spending) and investment is equal to 30 dollars.

Assuming the country is a closed economy, answer the following questions.

1. Write the consumption function. What is the propensity to consume?
2. Write the country’s demand for goods and services.
3. Write the equilibrium condition for the goods market
4. What is the autonomous spending in this country? What’s the value for the multiplier?
5. How much are GDP and consumption in equilibrium?
6. For the remaining parts, start each from the initial assumptions (i.e. the changes are not cumulative).

7. If investment increases by 10 dollars, what happens to output?
8. If government spending increases by 10 dollars, what happens to output? (no change in taxes)
9. If government spending increases by 10 dollars, what happens to output? (Taxes adjust in order to maintain a balanced budget). Explain in words why output increases in this case.
10. If government spending increases by 10 dollars, what happens to output? Assume taxes are always equal to one third of total income.
11. How do savings change when the economy undergoes each of the changes mentioned above? (parts vi to ix)