ECON1001 Study Guide - Final Guide: Economic Equilibrium, Economic Surplus, Externality

Suppose you win a small lottery and have the choice of two ways to be paid: You can accept the money in a lump sum or in a series of payments over time. If you pick the lump sum, you get $2,800 today. If you pick payments over time, you get three payments: $1,000 today, $1,000 1 year from today, and $1,000 2 years from today.

At an interest rate of 6% per year, the winner would be better off accepting the 1)________ (LUMP SUM or PAYMENTS OVERTIME), since it has the greater present value.

At an interest rate of 9% per year, the winner would be better off accepting 2) ________ (LUMP SUM or PAYMENTS OVERTIME), since it has the greater present value.

3) Years after you win the lottery, a friend in another country calls to ask your advice. By wild coincidence, she has just won another lottery with the same payout schemes. She must make a quick decision about whether to collect her money under the lump sum or the payments over time. What is the best advice to give your friend?

A) The lump sum is always better.

B) The payments over time are always better.

C) It will depend on the interest rate; advise her to get a calculator.

D) None of these answers is good advice.

1. ABC software, a small producer, decides to renovate its premises. Instead of hiring an outside contractor and tradespeople, the firm decides to use its employees---secretaries, programmers, sales staff, and others--to do most of the work. The firm makes all its employees try painting and carpentry and other tasks needed for the renovation and selects the people with the strongest skills in those areas to take time off their regular tasks and work on the renovation. Is the strategy a good one? Why or why not?

2. Suppose that one Euro can be exchanged for 1.3 U.S. dollars and that one U.S. dollar can be exchanged for 80 Japanese yen. If these currencies can be traded freely with low transaction costs, what exchange rate would you expect between the Euro and Japanese yen? Describe the transactions that would occur if the Euto-yen exchange rate is higher than this amount?

3. A government is considering a quota and a tariff, both of which will reduce imports by the same amount. Why might the government prefer one of these policies over the other?

Suppose that the are two goods in the economy, Xylophones (X) and Yams (Y). In year t, consumers in the economy purchase 20 Xylophones at a price of $20 each and 100 Yams at a price of $2 each. In year t + 1, consumers in the economy purchase 18 Xylophones at a price of $30 each and 150 Yams at a price of $2.50 each.

1. Calculate the GDP deflator in years t and t + 1 with base year t. What is inflation according to this deflator? Show each step. (Hint: it will be helpful for you to first calculate nominal and real GDP in years t and t + 1. When you calculate real GDP, make sure that you use the appropriate base year).

2. Calculate the GDP deflator in years t and t + 1 with base year t + 1. What is inflation according to this deflator? Show each step. (Hint: you will need to calculate real GDP in years t and t + 1 using a different base year than you used in part 1. Once you calculate real GDP with the appropriate base year, you will follow the same steps that you did in part 1.)

3. Compare your answers to a and b above. Are they the same? If not, why not? How does chain-weighting address any potential difference?

4. Calculate the CPI in years t and t + 1, using year t as the base year.

5. Describe two ways in which the CPI differs from the GDP deflator.

6. There are several problems with using the CPI to calculate real GDP and measure growth. One of these problems is that the CPI does not account for changes in the quality of goods sold over time. A computer today is significantly more efficient than it was even just ten years ago, so even if the price of computers rise with inflation, you are getting significantly more computing power per dollar. How would this bias estimates of GDP growth and inflation?