Professor Novarro

Pomona College
Economics 51

Homework #3

1. Use aggregate supply and demand diagrams to explain what would happen to GDP and
inflation in the following circumstances. Put P for price level on the vertical axis and
GDP as a measure of aggregate output on the horizontal axis.
a. Consumers decide to cut back their savings, and buy more household appliances.

b. Tornadoes destroy many factories in the country, while a severe drought ruins
many crops.

c. Miraculous new technological developments raise productivity in manufacturing.

d. Because of a loss of business confidence in the US, firms cut back on buying new
capital goods like plants, machinery, and equipment.
2. Suppose that the US economy can be described by the model of aggregate demand (AD)
and aggregate supply (AS).
a. Intuitively, what does a relatively flat AS curve tell you about how sensitive
producers are to price changes? What does a steep AS curve tell you? Explain
using a diagram. Put P on the vertical axis and Y (standing for real GDP) on the
horizontal axis.

b. Suppose that the AS curve for the US economy is relatively flat and given by
Y=300+10P where Y denotes real GDP and P is the price level. The AD curve is
given by Y=450-5P. Compute the equilibrium real GDP and price level for the
US economy.
c. Ben Bernanke, chair of the Federal Reserve (Americas central bank) is seriously
worried that the US economy might be slipping into a recession. He decides to
encourage consumer spending and aggregate demand by cutting interest rates.
The new AD curve is given by Y=480-5P. The AS curve is unchanged. Compute
the new equilibrium real output and price level.
d. Illustrate your results from parts b. and c. in an AD/AS diagram. Make sure you
put P on the vertical axis. Denote the initial equilibrium point by A and the new
equilibrium point by B.
e. In percentage terms, by how much does real GDP change? What is the inflation
rate (the percentage change in the price level)?

Now suppose that the AS curve is relatively steep and given by Y = 380+2P.

f. Redo parts b through e. Re-use the diagram you drew in part d. Denote the initial
equilibrium point there by C and the new equilibrium point by D.
g. Compare your results in part e and in part f. In particular, how much difference
does the slope of the AS curve make for the percentage change in real GDP and
for the inflation rate? If you were Ben Bernanke and were concerned with
preventing a recession, would you be happier with a steep or flat AS curve?
(Steep and flat here are defined in terms of a picture that has read GDP on
the horizontal axis.)
3. How do the following events influence GDP?
a. Each of five mothers living in a neighborhood takes care of her pre-school child
in her own home.
b. The mothers share the childcare work, each one taking all five children one day a
week.
c. Four of the mothers pay the fifth to take care of their children five days a week
(taking care, of course, to pay the required Social Security taxes!).
d. Mary buys a new car from a dealer for $20,000.
e. Dave sells Mary a used car for $7,000.
f. Dave sells his old car to a dealer for $6,000. The dealer washes it, lists it in the
classified ads and on the dealers web page and then sells it to Mary for $8,000.
g. A Japanese company builds a factory in Tennessee. (If this affects GDP, is it the
Japanese or the American GDP?)
h. A Japanese company buys stock in a Tennessee company.
i. An earthquake destroys many structures in Santa Cruz, California. The structures
are not rebuilt this year.
j. An earthquake destroys much of Santa Cruz, and within a short time the city is
rebuilt as it was before.

4. Fraternia is a small utopian community which produces and consumes only 2 goods:
Beer and chips. Fraternia does not trade with anybody else.
In 2006, Fraternia produced 600 bottles of beer and 600 bags of chips. The market price
of beer was $1 a bottle and the market price of a bag of chips was $2.

In 2007, Fraternia produced 650 bottles of beer and 700 bags of chips. The 2007 prices
of beer and chips were $1.15 and $2.10 respectively.

a. Compute Fraternias nominal GDP in 2006 and 2007.

b. Taking 2006 as the base year, compute real GDP for 2006 and 2007. What is the
rate of growth of real GDP between the two years?
c. Compute the ratio of nominal to real GDP for 2007. Provide an intuitive
interpretation for this numberwhat does it measure?
5.

RGDP

Labor

The above graph shows the relationship between a fully employed labor force and output
(real GDP) holding all other inputs constant.

a. On the graph above, show the effect on output of an increase in the fully
employed labor force. What is the effect on output?
b. List three factors that would increase potential GDP for a given amount of labor.
c. Describe and show on the graph above the effect of an increase in one of the
factors listed in part b) for a given amount of labor.
d. For the factor you chose in part c) list two government policies that would
encourage economic growth.