Midterm

Exam
Economics 601 Answer Key

Dustin Chambers

Fall 2014

Student ID # _______________________

Name ____________________________________

This exam consists of two sections. There are 100 points possible. Section I consists of 15 True/False
questions, each worth 1 point, for a total of 15 points. Section II consists of 6 analytical questions, worth 85
points. Any answer that is otherwise correct, but does not materially address the question at hand will
receive no credit.

Section I: True/False Questions [15 points] Questions 1 to 15

1.

2.

3.

4.

5.

6.

7.

Write True or False in the blank lines provided.

Investment (I) is the largest component of gross domestic product (GDP). __________
False
The U.S. national debt is an example of a stock variable (because it can be measured
at a given moment in time) whereas the governments budget deficit is a flow
variable (because it is measured per unit of time). __________ True

According to the lecture slides, government entitlement spending (e.g. Social
Security, Medicare) have been steadily declining over the past 10 years, while
government discretionary spending (e.g. national defense) have been steadily rising
over the same period. __________ False
Substitution bias, which refers to the fact that the consumer price index (CPI) uses
fixed basket weights, and thus fails to reflect consumers ability to substitute away
from expensive goods toward relatively cheaper goods, is one reason the CPI may
overstate inflation. __________ True

Using the Rule of 70, if Indias GDP continues to grow at the rate of 7% per year,
their economy will double in size in just over 14 years. __________ False
According to Okuns Law, for every one percentage point increase in economic
growth beyond the potential growth threshold, unemployment will fall by 0.4
percentage points over the next year. __________ True

The nonaccelerating inflation rate of unemployment (NAIRU) is approximately 3%.
__________ False


8.

9.

10.

11.

12.

13.

14.

15.

According to the Phillips Curve, there is a positive correlation between

unemployment and inflation. __________ False
Supply shocks are caused by a sharp increase in the price of a fundamental input or
commodity (typically energy/oil). __________ True
Alan Greenspan and Timothy Geithner and well-known proponents of the Taylor
Rule. __________ False
An increase in inflation expectations will likely cause a rally in the bond market (i.e.
higher bond prices). __________ False
Higher interest rates and better asset returns increase foreign investors demand for
dollars, causing an appreciation of the dollar. __________ True
The ADP National Employment Report has a poor track-record predicting new job
creation. __________ False
The Federal Reserves preferred measure of inflation is the CPI. __________ False
A value of the ISMs Purchasing Managers Index above 50 signals an economic
expansion. __________ True

Section II: Analytical Questions [85 points] Questions 16 to 21

16.

There are a total of six (6) questions in this section. Keep your answers succinct.
Please write all relevant formulas and show your work, and underline key words
and concepts in your answer. If your answer is illegible, you will receive no credit.

[15 points] Suppose that you are given the responsibility of constructing a consumer
price index (CPI). You send surveys and discover that the typical American
purchases two things: 5 gallons of milk and 3 loaves of bread.

You collect price information on milk and bread for three years, which is provided
below:
Year
Milk ($ per gallon) Bread ($ per loaf)
2005
$2.50
$1.00
2006
$3.00
$1.25
2007
$3.25
$1.75

Assume that 2005 is the base year.
2

a. [5 points] Calculate the basket cost for 2005, 2006, and 2007.
2005: (5 ga. Milk)($2.50 per ga.) + (3 loaves)($1.00 per loaf) = $15.50
2006: (5 ga. Milk)($3.00 per ga.) + (3 loaves)($1.25 per loaf) = $18.75
2007: (5 ga. Milk)($3.25 per ga.) + (3 loaves)($1.75 per loaf) = $21.50

b. [5 points] Calculate the CPI for each year.

2005: 100 (base year)

2006: 100 18.75 15.50 121
2007: 100 21.50 15.50 139

c. [5 points] Calculate the rate of inflation between 2005-2006, and 2006-2007.

2005-2006: Prices increased from 100 to 121, so inflation is approximately 21%
2006-2007: Prices increased from 121 to 139, so inflation is approximately 15%


17.

[20 points] An economy has two firms. Households own all of the labor services and
all of the capital, which they rent out to the firms. Firm A produces lumber using
capital services worth $8,000 and labor services worth $2,000. It sells $3,000
worth of lumber to households and $7,000 of lumber to firm B; a furniture maker.
The furniture maker produces furniture worth $14,000 that it sells directly to
households. Households earn $5,000 in wages from firm A and B combined.

a.
[5 points] What is the value of GDP in this economy?

GDP = value of all final goods and services = $3,000 (wood) + $14,000
(furniture) = $17,000.

b.

[5 points] What is the value added by firm A and B?

Firm A: $0 intermediate goods $10,000 lumber, so VAA = $10,000
Firm B: $7,000 lumber $14,000 furniture, so VAB = $7,000
(note: to double-check our answer, we confirm that VAA + VAB = GDP)

c.

[5 points] How much does the household earn in profit from firms A and B
combined?

Profits refer to payments to capital owners. We also know that
Total VA = Wages + Rents + Profits. In this problem, Rents = $0, and we are
told that Wages = $5,000. Therefore, Profits = $12,000.





18.

19.

d.

[5 points] What is the total value of intermediate goods produced in this

economy?

The $7,000 in lumber sold to the furniture manufacturer.

[10 points] Suppose that the potential growth threshold for the U.S. is 2.5% per
year, and that the current rate of unemployment is 6.3%. If economists are
forecasting a 3% rate of economic growth, what does Okuns Law predict the
unemployment rate will be in one years time?
According to Okuns Law:
0.4% !"#$%&'( !"#$%#&'( =
0.4% 3% 2.5% = 0.2%
!"#$%&'( = 6.1%

[10 points] Match each of the following pieces of legislation with its corresponding
Federal Reserve policy mandate:

The Employment Act (1946)
Full Employment and Balanced Growth
Act (1978)
The DoddFrank Wall Street Reform and
Consumer Protection Act (2010)

20.

Financial Stability
Price Stability

Full Employment

[15 points] Fill-in the missing growth values in the table below.
Purchase Information
Date
1-Oct-14
17-Feb-13

Price

Sale Information
Date

10,000.00 2-Oct-14
100.00

24-Feb-13

Price

Elapsed

Gross

Annualized

Time

Return

Return

0.0213%

8.08%

10,002.13 1 day
100.50

1 week

0.50%

29.61%

1 month

2.00%

26.82%

1-Jun-11

50.00

1-Jul-11

51.00

1-Apr-13

1,000.00

1-Jul-13

1,025.00

1 quarter

2.50%

10.38%

3-Apr-12

85.00

90.95

6 months

7.00%

14.49%

5 years

10.00%

1.92%

15-Nov-06

165,000

3-Oct-12
15-Nov-11

181,500


21.

[15 points] For the economic indicators in the following table, state whether you
expect declining (-) or increasing values (+) during a recession and during a period
of economic expansion.
Indicator

Nonfarm Employment
Weekly Claims for Unemployment Insurance
Personal Consumption Expenditures
Retail Sales
Durable Goods Orders
Housing Starts
International Trade Balance (NX)
Inflation (growth rate of CPI)

Recession
(+/-)
-
+
-
-
-
-
+
-

Expansion
(+/-)
+
-
+
+
+
+
-
+