TABLE OF CONTENTS

Question 1 of 3

Work It Out
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You must read each slide, and complete any questions on the slide, in sequence.

An economy has the following money demand function: (M/P)d = (1/3)Y/i.

If, in the aftermath of the announcement, both the economy’s output and the current money supply are unchanged, what happens to the price level?
3

Larry is the sole owner of Larry’s Moving Company, Incorporated (LMC). In one year, LMC collects $2,000,000 from customers to help them move. LMC’s equipment depreciates in value by $200,000. LMC pays $1,400,000 to its workers, who pay $500,000 in taxes on this income. LMC pays $175,000 in corporate income taxes and pays Larry a dividend of 100,000. Larry pays taxes of $50,000 on this dividend income. LMC retains $125,000 of earnings in the business to finance future expansion. How much does this economic activity contribute to each of the following?

Compensation of Employees =

Proprietors’ Income =

Corporate Profits =

3
Review text pages 21-22, and 29-32 for a discussion of the various measures of economic activity provided in the national income accounts.
3
Review text pages 21-22, and 29-32 for a discussion of the various measures of economic activity provided in the national income accounts.

By what percentage did prices rise between 2010 and 2015? Give the answer for each good and also for the two measures of the overall price level. Compare the answers given by the Laspeyres and Paasche price indexes. Explain the difference.
The CPI shows a larger percentage increase in the price level compared to the GDP deflator. Because it uses fixed quantities of goods as weights, Laspeyres indexes like the CPI do not allow for substitution away from products whose price rises relative to other products. Paasche indexes like the GDP deflator, on the other hand, allow the quantity weights to change and account for substitution away from products whose price rises relative to other products. The CPI rises by more than the GDP deflator in this example because it doesn’t account for substitution away from bread and toward automobiles as the price of bread rises relative to the price of autos.
The CPI shows a larger percentage increase in the price level compared to the GDP deflator. Because it uses fixed quantities of goods as weights, Laspeyres indexes like the CPI do not allow for substitution away from products whose price rises relative to other products. Paasche indexes like the GDP deflator, on the other hand, allow the quantity weights to change and account for substitution away from products whose price rises relative to other products. The CPI rises by more than the GDP deflator in this example because it doesn’t account for substitution away from bread and toward automobiles as the price of bread rises relative to the price of autos.

By what percentage did prices rise between 2010 and 2015? Give the answer for each good and also for the two measures of the overall price level. Compare the answers given by the Laspeyres and Paasche price indexes. Explain the difference.

2010 2015 %Change
Autos $50,000 $60,000
Bread $10 $20
GDP Deflator 1.0 1.52
CPI 1.0 1.60
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Review text pages 35-36 for details of how Paasche indexes, such as the GDP deflator, differ from Laspeyres indexes, such as the CPI.
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