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Nathaniel KanEcon 116 - Problem Set 5

TA: Akiko, Tuesday 5PM

I. Shorties. Answer the following questions briefly.

a. Why is nominal GDP not a reliable measure of true economicwelfare? Give two reasons why an increase in nominal GDP

that does not increase economic welfare.

Nominal GDP is not a reliable measure of trueeconomic welfare because it is not corrected forinflation, and therefore not useful in comparing realproduction of one year with another year. Anincrease in nominal GDP that does not coincide withan increase in economic welfare could be pricesincreasing while production stays constant.

b. Define capital deepening. Give an example from your own

observation where capital deepening occurred and increasedoutput per worker.

Capital deepening is the process by which thequantity of capital per worker increases over time.An example of capital deepening could be anaccounting firm where accountants began by doingcalculations by hand, and as the firm ages it addscomputers which allow accounts to do calculationsmuch more quickly, increasing output per worker.

c. What is globalization? Give two ways that globalizationaffects the growth of living standards.

Globalization is the overall trend for internationaltrade to increase. This increases living standards byone, allowing countries to produce more goods inwhich they have a comparative advantage, and thusallows more goods to be produced overall, and two,globalization promotes the spread of technology,which has a capital deepening effect, allowing moregoods to be produced per worker.

II. Economic arguments without facts are seldom persuasive. To helpyou become economically persuasive, the following gives you somepractice at understanding and using economic data.

a. The following table shows indexes of the capital stock and thelabor force. These index numbers take the values of the

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variables in 1960 as 100. For this problem, assume that laborand capital inputs are proportional to the labor force and thecapital stock.

http://www.bea.gov/bea/dn/nipaweb/TableViewFixed.asp

b.In billions of 1996 dollars:

1960 GDP = 2,376.71970 GDP = 3,578.01980 GDP = 4,900.91990 GDP = 6,707.92000 GDP = 9,191.4

Divide all these by 2376.7 and multiply by 100

Year Q K L

1960 100.0 100.0 100.01970 150.5 145.8 119.7

1980 206.2 204.4 153.4

1990 282.2 254.2 180.42000 386.7 330.5 210.1

c. Calculate the average growth rate of each of the variables forthe periods 1960-70, 1970-80, 1980-90, and 1990-2000. (Thiswill be very easy if you use a spreadsheet.)

[Hint: To calculate average growth rates, use the followingformula:

where t1 is starting year, t2 is ending year, g is the averageannual growth rate, and yrs is the number of years between t1and t2.]

g = [GDP(t2)/GDP(t1)]1/yrs 1

growth rate table

Period

%Qgrowth

%Kgrowth

%Lgrowt

h

1960-1970 4.17 3.84 1.81

( ) ,112 t

yrs

t GDPgGDP +=

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1970-1980 3.20 3.43 2.51

1980-1990 3.19 2.20 1.63

1990-2000 3.20 2.65 1.53

d. Using your results from (c), use the growth accountingequation to calculate T.C. assuming that labor compensationis 75 percent of total income. Calculate an index of output perworker. Calculate the growth of output per worker. What isthe relationship between the growth of output per worker andT.C. (Do these for all four subperiods.)

%Q growth = %L growth + %K growth +T.C.

T.C. = %Q growth - %L growth - %Kgrowth

Period

%growthduetoTC

1960-1970 1.85

1970-1980 0.46

1980-1990 1.41

1990-2000 1.39

Index of output / worker = Q/L

Year Q L(Q/L)*100

1960 100.0 100.0 100.01970 150.5 119.7 125.7

1980 206.2 153.4 134.41990 282.2 180.4 156.42000 386.7 210.1 184.1

g = [(Q2/L2)/(Q1/L1)]1/yrs 1

Period % Yearly growth of

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output / worker

1960-1970 2.31

1970-1980 0.641980-1990 1.53

1990-2000 1.84

The percentage yearly growth of output per worker should and does

mirror the growth due to technological change, because any growth in

output per worker is due to increasing technology which causes a

capital deepening effect.

III. Terror, War, and Growth

Many people perceive the world as a more dangerous place since9/11/01. As a result, both the private sector and the government aredevoting a larger fraction of their resources to homeland security,military spending, and, possibly, war in Iraq. The result might be lowerprivate investment, lower public investment, and higher taxes.

a. For this problem, assume that the economy is maintainedat full employment by monetary policy. That is, monetary policyadjusts to ensure that actual output always equals potential output.Explain briefly what would happen in this situation if consumersdecided to raise their savings rate.

If consumers decide to raise their savings rate,consumption and investment would decrease, causing GDPto decrease.

b. Next assume that government military spending (G-M) risessharply. Furthermore, the Republican administration is reluctant toincrease taxes. What is the implication of an increase in G-M forinterest rates, investment, and consumption under the assumptionabout monetary policy in (a)?

The government sells war bonds to fund an increase in

G-M. This takes money out of the market and thus increasesinterest rates. This increase in interest rates causes adecrease in investment and a decrease in consumption, asless the opportunity cost of spending money increases, i.e.the interest rate increases.

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c. Given your answer to (b), what is the impact of the policymix of higher G-M and responsive monetary policy on the growth ofthe capital stock and of potential output?

Investment decreased, so growth of capital stock andpotential output both decrease.

d. What difference would it make to your answer in (c) if the

increase in G-M were paid for by taxes on consumption that exactlyoffset the effect of G-M on aggregate demand?

Investment would stay the same, because interestrates stay constant, because gov't does not need to sellbonds for money. Thus, growth of capital stock andpotential output both stay the same.