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ECON 2400
Wai Ming Ho

ECON 2400D: Intermediate Macroeconomic Theory I Fall 2012 Midterm Test Solutions Professor Ahmet Akyol Start: 4:00pm. Finish: 6:00pm. The test has ▯ve questions. Please show all your work. Good Luck! 1. {35 points{ The economy consists of a coconut producer, a restaurant, consumers, and a government. The coconut producer produces 10 million coconuts which are sold for $2 each. It pays $5 million in wages, $0.5 million in interest on a loan to some consumers, and $1.5 million in taxes to the government. Of the 10 million coconuts produced, 6 million are used by the restaurant which sells $30 million in meals to consumers. The restaurant pays its workers $4 million in wages, and the government $3 million in taxes. The government provides national security by paying the Armed Forces $5.5 million dollars in wages. (a) Calculate the GDP of this country using the Value Added, Expenditure, and Income Approach. This is identical to the example on page 34 in the textbook. (b) Suppose now that the government is more generous to its Armed Forces even though the threat by foreign invaders did not change at all. In particular, the government pays $6.5m instead of $5.5m to its soldiers. In order to balance its budget, the government taxes the coconut producers by $2m (instead of $1.5m), and taxes the restaurant by $3.5m (instead of $3m). Calculate the GDP using the product, expenditure, and income approach. Compare these values to those in part (1a). Do you see a problem with the GDP calculation? Explain. ▯ Value Added Approach The value added by the government increases exactly by $1m as G = $6:5m instead of G = $5:5m. The value added by the coconut producer and restaurant stay the same. Thus, GDP increases by $1m. ▯ Expenditure Approach 1 The income-expenditure identity is simply: Y = C + I + G + NX (1) Here, we still have I = NX = 0. Government spending increases by $1m. The consumption by the private sector stays the same. Thus, GDP increases by $1m. ▯ Income Approach Here, the income by the government goes up by $1m as additional taxes on pro▯ts of the coconut producer and restaurant are imposed. This also implies that after-tax pro▯t income, distributed to consumers, decrease exactly by $1m, o▯setting the increase in the government’s income. There is also an increase of $1m in labour income as consumers, working for the government, earn $1m extra. Thus, GDP increases exactly by $1m. The main problem here has to do with the valuation of economic activity by the government. The value of government services in the economy with a more generous government is $1m higher than the one with the \stingy" government yet the services provided by the Army are not di▯erent (the outside threat did not change). The calculation of the value of the government services is performed by looking at the cost of providing those services. Thus, higher costs of running the government implies a higher GDP. In reality, some of these costs are related to how well certain groups are organized (such as labour unions), and should be considered as transfer payments as these organized groups lobby for higher pay, more perks, etc. As we know, transfer payments, unlike government spending on goods and services, are not part of GDP. (c) Suppose now the government establishes the Price-Control Board which can set prices of goods and services as it wishes. Suppose that the Price-Control Board sets the price of coconuts at $1 each. Assume that the quantities of coconuts and restaurant meals do not change as a response to this. Calculate the GDP using the product, expenditure, and income approach. Compare these values to those in part (1a). Do you see a problem with the GDP calculation? Ex
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