1. Macroeconomic information for the economy of Anchovy is given below.

2003 2004 Output (pizzas) 8000 9000

Employment (workers) 700 800

Unemployed (worker) 70 100

Labor force (workers) 770 900

Price per pizza $8.00 $9.00

(a) What was the growth rate of average labor productivity in Anchovy between
2003 and 2004?

(b) What was the inflation rate in Anchovy between 2003 and 2004?

(c) What was the unemployment rate in 2003? In 2004?

procductivity year 2
a. growth rate of average labor productivity¿ productivity year 1 -1=
(9000/800)/(8000/700)-1= -1.6%

b. inflation rate=price year 2/price year -1=9/8-1=12.5%

c. unemployment rate= unemployment/labor force

2003: 70/770=1/11=9.1%

2004: 100/900=1/9=11.1%

2. Using the CPI measure of the price level, which is 100 in the base year of 2001,
calculate the annual inflation rates for

(a) 2002, when the index is 103.7.

(b) 2003, when the index is 105.5.

(c) 2004, when the index is 107.7.

a. inflation rate 2002=103.7/100-1=3.7%

b. inflation rate 2003=(105.5-103.7)/100=1.8%

c. inflation rate 2004=(107.7-105.5)/100=2.2%

3. Last year, Linus earned a salary of $25,000 and he spent $24,000, thus saving
$1000. At the end of the year, he received a bonus of $1000 and he spent $500 of
it, saving the other $500. What was his marginal propensity to consume?

MPC=dental C/dental Y=500/1000=0.5

4. With a nominal interest rate(i) of 4%, an expected inflation rate(pi(e)) of 1%,

and interest income taxed at a rate(T ) of 25%, what is the expected after-tax real
interest rate?

rafter tax =(1-T)i-pi(e)=(1-0.25)0.04-0.01=0.02=2%

The nominal interest rate(i) is 10%, the expected inflation rate(pi(e)) is 5%, and the
combined state-federal tax (T ) rate is 35%. The expected after-tax real interest rate

rafter tax =(1-T)i-pi(e)=(1-0.35)0.1-0.05=0.015=1.5%

5. Calculate the user cost of capital of a machine that costs $5,000 and depreciates
at a rate of 25%, when the expected real interest rate is 5%.

Uc=(r+d)pK=(0.25+0.05)5000=$1500

Calculate the user cost of capital of a machine that costs $5,000 and depreciates at
a rate of 25%, when the nominal interest rate(i) is 10% and the expected inflation
rate is 5%.

Uc=(r+d)pK=(0.25+0.05)5000=$1500

Calculate the user cost of capital of a machine that costs $100,000 and depreciates
at a rate of 25%, when the nominal interest rate is 4% and the expected inflation
rate is 1%.

r=i-pi(e)=4-1=3%

=(0.25+0.03)100000=$28000

6. You have just purchased a home that cost $250,000(pK). The nominal mortgage
(money you borrow fore a bank in order to buy a house and you pay back) interest
rate is 8% per annum, mortgage interest payments are tax deductible, and you are
in a 30% tax bracket. The expected inflation rate is 4%. Maintenance and other
expenses are 8% (d) of the initial value of the house. What is the real user cost of
your house?

r=(1-0.3)0.08-0.04=0.016

uc=(0.016+0.08)250000=24000

7. An economy has full-employment output of 5000. Government purchases are

1000. Desired consumption and desired investment are given by

Cd = 3000 – 2000r + 0.10Y

Id = 1000 – 4000r

where Y is output and r is the real interest rate. The real interest rate that clears the
goods market is equal to

Y=C+I+G=>5000=5000-6000r+0.1Y=>r=0.1Y/6000=500/6000=8.3%

8. An economy has government purchases of 1000. Desired national saving and

desired investment are given by

Sd = 200 + 5000r + 0.10Y – 0.20G

Id = 1000 – 4000r

When the full-employment level of output equals 5000, then the real interest rate
that clears the goods market will be

Goods market when Sd=Id=>200+5000r+0.1Y-0.2G=1000-4000r

=>500+5000r=1000-4000r =>9000r= 500=> r=0.556=5.56%

9. Suppose the one-year T-bill rate was 5% on 1/1/2001, 4% on 1/1/2002, and 6%

on 1/1/2003. The GDP deflator (1996 = 100) was 110 on 1/1/2001, 112 on
1/1/2002, 114 on 1/1/2003, and 120 on 1/1/2004. The tax rate on interest income is
30%.

(a) Calculate the after-tax nominal rate of return for 2001, 2002, and 2003.
(b) If you began with $1000 on 1/1/2001 and invested in T-bills each year (paying
taxes at the end of each year), how much would you have in nominal terms on
1/1/2004? How much would you have in real terms (1996 dollars)?

(c) How much was your nominal after-tax interest earned in part (b) over the three
years? How much did you earn in real (1996) after-tax dollars?

a. after tax nominal rate =(1-t)i

2001: i= (1-0.3)0.05=0.035=3.5%

2002: i= (1-0.3)0.04=0.028=2.8%

2003: i= (1-0.3)0.06=0.042=4.2%

(b) Nominal: $1108.67 = $1000 × 1.035 × 1.028 × 1.042; Real: $923.89 =

$1108.67/(120/100)

(c) Nominal: $108.67 = $1108.67 – $1000; Real: $14.80 = $923.89 –

$1000/(110/100) = $923.89 –

$909.09

10. The nominal interest rate on taxable bonds is 8%, while on municipal bonds
(which aren’t taxable) it is 5%. The expected inflation rate is 3% and the tax rate
on interest income is 40%. Calculate the expected after-tax real interest rate on
both bonds. Which would be the better investment? Now suppose the actual
inflation rate turned out to be 6%. Which bond was the better investment? Would
your answer change if inflation had turned out to be 0%?

Expected after tax on taxable bonds=(1-0.4)0.08-0.03=0.018

Expected after tax on municipal bonds=0.05-0.03=0.02

Municipal bond better to investment

11. Suppose you divide your life into two periods—working age and retirement
age. When you work, you earn labor income Y; when retired, you earn no labor
income, but must live off your savings and the interest it earns. You save the
amount S while working, earning interest at rate r, so you have (1 + r)S to live on
when retired. Because you don’t need to consume as much when retired, you want
to set consumption when working twice as high as consumption when retired.

(a) Suppose you earn $1 million over your working life, and the real interest rate
for retirement saving is 50%. How much will you save and how much will you
consume in each part of your life?

(b) Suppose your current income went up to $2 million when working. Now what
will you save and how much will you consume each period?

(c) Suppose a social security system will pay you 25% of your working income
when you are retired. Now (with Y = $1 million, as in part (a) how much will you
save and how much will you consume each period?

(d) Suppose the interest rate rises (starting from the situation in part (a). Will you
save more or less?

a. Consumption= money receive after saving=>aY=2(Y-aY)x(1+r)=> a = (2-2a)1.5

 4a =3 =>a=0.75
Consumption 0.75 and saving 0.25 milion

b. 2a=2(2-2a)1.5 =>a=0.75

consumption 1.5, saving 0.5 million

d. interest rate rises, I will saving less

(c) Now cR = (1 + r)S + pY, where p = .25. So Y – S = 2(1 + r)S + 2pY, or (3 +

2r)S = (1 – 2p)Y.

With r = 0.5 and p = .25, we get 4S = 0.5 Y, and with Y = $1 million, this gives S
= $125,000,

cW = $875,000, and cR = $437,500. The social security system reduces saving and
increases consumption in both periods.

12. A firm has current and future marginal productivity of capital given by MPK =
10,000 – 2K + N, and marginal productivity of labor given by MPN = 50 – 2N +
K. The price of capital is $5,000, the real interest rate is 10%, and capital
depreciates at a 15% rate. The real wage rate is $15.
(a) Calculate the user cost of capital.

(b) Find the firm’s optimal amount of employment and the size of the capital stock.

a. uc=(r+d)pK=(0.1+0.15)5000=1250

b. MPK=uc

=> 2K-N=8750(1)

MPN=real wage

=>K-2N=-35 or 2K-4N=-70(2)

(1)-(2)=3N=8820

N= 2940 and K= 5845

13. Use a saving-investment diagram to explain what happens to saving,

investment, and the real interest rate in each of the following scenarios.

(a) Current output rises due to a temporary productivity increase.

(b) The tax code changes so that business firms face higher tax rates on their
revenue (offset by other lump-sum tax changes so there’s no overall change in tax
revenue).

(c) The government increases spending temporarily for a one-year project to turn
mercury into gold.

(d) The average educational level rises, inducing an increase in the future marginal
productivity of capital.

a. saving increase shift saving curve to the right, and reduce interest rate and
increase investment

b. investment shift to the left and interest rate reduce, at equilibrium, saving reduce
too

c. government increease make governmet saving reduce and national saving

reduce, the saving curve shift to the left, increase interest rate and reduce
investment
MPFf increase make investment curve shift to the right and increase interest rate,
thus increase saving

14. How would each of the following affect Cheryl Shirker’s current consumption
and saving? Cheryl is a forward-looking consumer with no borrowing constraints.

(a) Cheryl’s firm announces a reorganization plan, increasing Cheryl’s future

income dramatically.

(b) Cheryl’s father, who had planned to leave her a large bequest, must spend all
his wealth on medical bills after a prolonged illness.

(c) The real interest rate rises from its original level. Cheryl originally planned to
have no assets for the future; that is, she planned to spend all her original assets
and all her income when she was young, and planned to consume an amount equal
to her future income when she was old.

a. increase future income=> increase current consumption, saving less

b. current consumption reduce and increase saving

c. rise real interest rate, saving more and reduce consumption

15. For each outcome below, tell what type of shift must have taken place in either
the aggregate demand curve or the long-run aggregate supply curve.

(a) In the short run, the price level is unchanged and output rises.

(b) In the long run, the price level declines and output is unchanged.

(c) In the long run, the price level rises and output declines.

a. AD shift right

b. AD shift left

c. LRAS shift left

16. In the expectations-augmented Phillips curve, π = πe – 3(u – u ). If π = 0.03

when πe = 0.06 and u = 0.06, then u =

0.03=0.06-3(u-u)=> u-u=0.01=>u=0.05
17. Which of the following machines has the lowest user cost? Machine A costs
$15,000 and depreciates at a rate of 25%; machine B costs $10,000 and depreciates
at a rate of 20%; machine C costs $20,000 and depreciates at a rate of 10%; and
machine D costs $17,000 and depreciates at a rate of 11%. The expected real
interest rate is 5%.

A :uc=15000(0.25+0.11) =5400 B:uc=(0.2+0.11)10000=3100

C: uc=(0.1+0.11)20000=4200 D: uc=(0.1+0.11)17000=3570

 Machine B have less user cost

18. Three-wheel cars made in North Edsel are sold for 5000 pound. Four-wheel
cars made in South Edsel are sold for 10,000 mark. The real exchange rate between
North and South Edsel is four three-wheel cars for three four-wheel cars. The
nominal exchange rate between the two countries is

1.50 mark/pound

19. If the real exchange rate rises by 2%, domestic inflation is 3%, and foreign
inflation is 1%, what is the percent change in the nominal exchange rate?

0%

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Suppose purchasing power parity holds. If the price level in the United States is
100 dollar per good and the price level in Japan is 250 yen per good, then the
nominal exchange rate is _____ yen per dollar.

2.5

An increase in domestic output would cause a _____ in net exports and a _____ in
the exchange rate.

fall; fall

A rise in the domestic real interest rate would cause a _____ in net exports and a
_____ in the exchange rate.
fall; rise

Which of the following changes would cause American net exports to increase?

An increase in foreign income

The U.S. real interest rate rises relative to the British real interest rate. British net
exports _____ and the British exchange rate _____.

increase; falls

In an open economy, a decrease in net exports because of reduced demand for

domestic products by foreigners should cause the domestic real interest rate to
_____ and should cause desired saving minus desired investment to _____.

fall; fall

A decrease in foreign output would cause the domestic country’s net exports to
_____ and cause the domestic country’s IS curve to _____.

fall; shift down

A decrease in the foreign real interest rate would cause the domestic country’s net
exports to _____ and cause the domestic country’s IS curve to _____.

fall; shift down

A shift in demand toward the home country’s goods would _____ the domestic real
interest rate and _____ net desired saving (desired saving less desired investment)
in the economy.

raise; increase

A temporary decrease in government purchases would _____ the domestic real

interest rate and _____ net desired saving (desired saving less desired investment)
in the economy.

lower; increase

In a Keynesian model, a temporary increase in government purchases would cause

output to _____ and the domestic real interest rate to _____, in the short run.
increase; increase

In the short run in the Keynesian model, an increase in the domestic money supply
would cause domestic output to _____ and the domestic real interest rate to _____.

rise; fall

An increase in the American money supply would cause the value of the dollar to
_____ and net American exports to _____ in the short run using a Keynesian
model.

fall; fall

The Federal Reserve has just purchased bonds in the market, carrying out open
market operations. In the short run in the Keynesian model, this would cause the
foreign real interest rate to _____ and foreign output to _____.

increase; increase

According to the classical model, an increase in the American nominal money

supply would cause the nominal exchange rate to _____ and the real exchange rate
to _____.

depreciate; remain unchanged

Suppose Japan is currently running a current account surplus. The most effective
way of eliminating this current account surplus would be to temporarily _____
government purchases and _____ the domestic money supply.

increase; increase

To encourage more investment, Mexico has lowered its tax rates to reduce the user
cost of capital. Argentina is unable to pay back its foreign debts, causing its
expected future marginal product of capital to fall. Mexico’s real exchange rate
will _____ and its net exports will _____.

appreciate; fall

-------------------------
20. The nominal exchange rate is 15 crowns per florin, the domestic price level is 6
florins/bottle, and the foreign price level is 2 crowns/bushel.

(a) What is the real exchange rate?

(b) What is the real exchange rate in the foreign country?

(c) If the domestic price level rises to 8 florins/bottle, what must the nominal
exchange rate become if the real exchange rate remains unchanged?

a. 15 crowns equal 1 florin=> 1 bottle=90 crown, 1 bushel=2 crown=> 1bushel=45

bottle

b. forgine: 1bottle=1/45 bushel

c. if real exchang rate remains unchanged, the nominal exchange rate will decrease

21. Suppose the real exchange rate is 10, the domestic price level is 8, and the
foreign price level is 4.

(a) What is the nominal exchange rate?

(b) Suppose the real exchange rate rises by 10%, the inflation rate in the domestic
country is 6%, and the inflation rate in the foreign country is 4%. By what
percentage does the nominal exchange rate change?

(c) Suppose the nominal exchange rate rises by 5%, the real exchange rate rises by
8%, and domestic inflation is 3%. What is the foreign inflation rate?

a. nominal exchange rate=4x10/8=5

b. dental (nominal exchange rate)=0.04+0.1-0.06=0.08

c. dental (foreign inflation rate)= dental enom-real echange rate +domestic iflation
rate = 0.05-0.08+0.03=0

22. What happens to the exchange rate and net exports in each of the following
cases?

(a) The foreign real interest rate falls.

(b) Foreign output rises.

(c) Foreign demand for domestic goods rises.

(d) Domestic output rises.

(e) The domestic real interest rate falls.

a. foreign real interest rate fall, foreign assets less attactive, money supply reduce
and increase money demand, exchange rate increase, net export reduce

b. foreign output rise=>foreign consumption increase, import more, domestic

increase net export

foreign output rise, money demand for domestic currency increase, exchange rate
increase

c. foreign demand for domestic goods rise=> reduce net export and increase
exchange rate

d. domestic out put rise=> consumption increase, import increase, net export
reduce, supply for money increase, exchange rate will reduce

e. domestic real interesr rate fall, domestic asset less attractive, demand currency
reduce, exchange rate reduce, net export rise

23. Describe the effects of contractionary fiscal policy by the domestic government
on output, the real interest rate, and net exports in both the domestic and foreign
country, using a Keynesian model.

Domestic country: output falls, real interest rate falls, and net exports rise.

Foreign country: output falls, real interest rate falls, and net exports fall.

24. Describe the effects of contractionary monetary policy by the domestic central
bank on output, the real interest rate, and net exports in both the domestic and
foreign country, using a Keynesian model in the short run. What happens in the
long run?

Domestic country: output falls, real interest rate rises, and net exports rise.

Foreign country: output falls, real interest rate falls, and net exports fall.

There are no real effects in the long run.

25. A classical economy is described by the equations

AD: Y = 1000 + 100M/P

AS: Y = 1500

M/P=5

The real exchange rate is 3 bushels/bottle, the domestic nominal money supply is
30 florins, and the foreign price level is 8 crowns/bushel.

(a) What is the nominal exchange rate?

(b) If the government wants to maintain an official nominal exchange rate of 6

crowns/florin, what must the nominal money supply be?

a. real exchange rate=(nominal exchange rate x domestic price)/foreign price

=> nominal exchange rate=(real exchange rate x foreign price)/domestic price

=(3x8)/(30/real money supply)=24/(30/5)=4 crowns/florin

b. 6=24/(M/5)=>M/5=4=>M=20