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1.  In a simple economy, people consume only 2 goods, food and clothing. The market basket of goods used to compute the CPI has 50 units of food and 10 units of clothing.


  food clothing
2002 price $4 $10
2003 price $6 $20


  1. What are the percentage increases in the price of food and in the price of clothing?




= {(6-2)/4} * 100%

= 50%



= {(20-10)/10} * 100

= 100%


  1. What is the percentage increase in the CPI? (hint: Calculate % change in total market basket for the goods from 2002 to 2003)


Food & Clothing

In 2002 (50*$4) + (10*10) = 300

In 2003 (6*50) + (20*10) = 600



= (600/300)*100%

= 200




2. List and explain in your own words the three major problems in using the CPI as a measure of the cost of living.



1. Substitution Bias – this is the fact that different goods and services have different amount of change each year. This simply implies that the CPI does not have a true reflection of consumer’s preference for changes in items that increase by small amounts as consumers will likely purchase less of items with big changes and more of items with fewer changes.

2. Quality Changes – changes in the quality of goods and services from the base year to the current year are not reflected. When the quality of any goods or services increases or decreases, this is not reflected as the value of desirability of the item also changes

3. Introduction of New Items – CPI only uses fixed items and if a country starts purchasing a different set of goods, this is not reflected in the cost of estimate to the typical consumer.







3. Henry Ford paid his workers $5 a day in 1914 when the CPI was 10. Today with the price index at 177 the $5 a day is worth how much?




= $88.5



4. Both the standard of living and the growth of real GDP per person vary widely across countries. (TRUE/FALSE)






5. What is a production function? Write an equation for a typical production function, and explain what each of the six terms represent.


A production function is defined as a function that relates the output of a firm to the amount of inputs and usually capital and labor


Production function is defined as a mathematical representation of the relationship between the quantity of inputs used in production and the quantity of output produced using the inputs.

A typical production function could be written as

Y = A F (L, K, H, N),


Y denotes the quantity of output,

L the quantity of labor,

K the quantity of physical capital,

H the quantity of human capital the quantity of natural resources, and

A is a variable that reflects the available production technology.







6. Which of the following is an example of the “brain drain”?

a.  A country’s most highly educated workers emigrate to rich countries.

b.  A country has such a poor educational system that human capital falls over time.

c.  The population of a country grows so fast that the educational system can’t keep up.

d.  A country steals patented technology from another country.





7.  In the first segment from the video, “Commanding Heights,” the famed Latin American economist Hernando de Soto tells the story of  a coffee bean farmer from Tanzania, who when asked whether he can produce proof that he owns the land, asserted that he had no official deed but that he had purchased the land from someone years ago and the fact that he lives there today is proof enough that he owns it.  In your own words, explain what De Soto’s main argument is about property rights and how it relates to a country’s standard of living?



De Soto’s main argument about property rights in third world countries like Tanzania is that they lack a national formal system of law and information; hence, property relations in such countries are governed by webs of informal norms that are based on trust which however does not extend past narrow local circles. As a result, most assists in such countries are not documented and therefore cannot ‘cannot readily be turned into capital, cannot be traded outside of narrow local circles where people know and trust each other, cannot be used as collateral for a loan and cannot be used as a share against an investment’.



8 Below is a graph showing the market for loanable funds.


Market for Loanable Funds



Assume that this economy is currently running a major deficit.  Show on the graph above what would happen to the interest rate and investment (as marked by the quantity of loanable funds available to firms) if the government pursues policies that would go from a deficit to a surplus.  EXPLAIN in your own words what policy options might the government pursue to achieve a surplus




9.  Using a graph representing the market for loanable funds, show and explain what happens to interest rates and investment if the government budget goes from a deficit to a surplus.




Market for Loanable Funds


As shown in the graph above, the economy starts in equilibrium at point E0 with interest rate r0interest rate r0 and equilibrium quantity of saving and investment at q0. If the government succeeds in obtaining a surplus, there will be more public saving in the economy at each interest rate, and the supply of loanable funds curve will shift from S0 to S1. The new equilibrium will be at E1, with a lower interest rate, r1 and a higher quantity of saving and investment, q1. Hence, if the federal government succeeds in having a surplus, interest rates will fall and investment will increase.




10. The model of the market for loanable funds shows that an investment tax credit will cause interest rates to rise and investment to rise. Yet we also suppose that higher interest rates lead to lower investment. How can these two conclusions be reconciled?     


The claim that an increase in the interest rate decreases investment supposes that only the interest rate changes and everything else is constant. The investment tax credit causes investment to rise at each interest rate. As firms want to borrow more, the interest rate will also rise. The rise in interest rates does make investment less than it would otherwise be, but unless the supply of loanable funds is vertical, the increase in investment demand from the tax credit is larger than the decrease in investment demand from the rising interest rate.






11. You are Secretary of the Treasury Jack Lew.  It’s six months into Obama’s second term as president and you receive some estimates of national accounts numbers you plan to report to the President in a cabinet meeting.  Under one set of expectations, government expenditures will be $30 billion, transfer payments will be $10 billion, and taxes will be $45 billion. Under another set of expectations, GDP will be $200 billion, taxes will be $50 billion, transfer payments will be $20 billion, consumption will be $120 billion, and investment will be $40 billion.


a. Based on these numbers in the first case there should be a surplus or deficit of how much?


Taxes – (Government expenditure + transfer payments)

= $45 – ($30 + $10)

= +$5

ð  There is a surplus of $5 billion





b. Under the second scenario, there should be a surplus or deficit of how much?


GDP + Taxes – (Transfer payments + consumption + Investments)

= $200 + $50 – ($20 + $120 + $40)

= $250 – $180

= $70


ð  There is a surplus of $70 billion






12.  The table below uses data for the year 2003 provided by the BLS and adjusted to be comparable to U.S. data. All values are in thousands. Fill in the blank entries in the table. Show your work!




















Japan 109,474 66,010 62,510 3,500 5.30 60.30
France 46,804 26,870 25,293 2,577 9.59 57.41
Germany 70,159 39,591 35,755 3,836 9.69 56.43




Labor force = (62510+3500)

= 66,010


Unemployment rate

Unemployment rate = (# of unemployed / labor force) x 100%

= (3,500/66,010) * 100%

= 5.30%



Labor-Force Participation Rate

Labor force participation rate = (labor force / adult population) x 100%

= (66,010/109.474) * 100%

                                                     = 60.30%




Adult population

From the equation; Labor force participation rate = (labor force / adult population) x 100%


57.41= (26,870/AP)*100

AP = (26870/57.41)*100

= 46,804




Adult population –unemployed

= 46,804 – (2,577 + 25,293)

= 25,293


Unemployed Rate


Unemployment rate = (# of unemployed / labor force) x 100%

= (25,293/26,870) * 100%

= 9.59






Labor Force –unemployed

= 39,591- 3,836

= 35,755




Unemployment rate = (# of unemployed / labor force) x 100%

9.69 = (x/39,591) * 100%

X = 39,591 * 9.69

= 383636.79/100

= 3,836



Labor-Force Participation Rate


= (labor force / adult population) x 100%

= (39,591/70,159) * 100%

= 56.43



13. Suppose the Bureau of Labor Statistics announced that in August, 2012, of all Massbaylians, 156,024,000 were employed, 4,765,000 were unemployed, and 84,420,000 were not in the labor force.  Please calculate


a. The Adult population of Massbaylia


Employed                   156,024,000

Unemployed                   4,765,000

Not in labor Force        84,420,000


The adult population will consist of all the above groups of people;


Employed + unemployed + Not in labor force

= 156,024,000 + 4,765,000 + 84,420,000


= 245,209,000




b. the labor force of Massbaylia


Labor force = Employed + Unemployed

= 156,024,000 + 4,765,000

= 160,789,000



  1.  the labor-force participation rate of Massbaylia


Labor force participation rate = (labor force / adult population) x 100%


= (160,789,000/245,209,000) * 100%

= 65.57%



d. The Unemployment Rate of Massbaylia


Unemployment rate = (# of unemployed / labor force) x 100%

= (4,765,000/160,789,000) * 100%

= 2.96%