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Below is a set of sample answers. Obviously the numerical questions are correct and complete; however, the review and analytical problems are just a guide. In some cases you will need a more complete answer or elaborate on points to get a complete answer. This applies not only to this key but all future keys.

9. Classicals see wage and price adjustment occurring rapidly, while Keynesians think that wages and prices adjust only slowly when the economy is out of equilibrium. The classical theory implies that unemployment will not persist because wages and prices adjust to bring the economy rapidly back to equilibrium. But if Keynesian theory is correct, then the slow response of wages and prices means that unemployment may persist for long periods of time unless the government intervenes.

1. (a) Average labor productivity is output divided by employment:

2005: 12,000 tons of potatoes divided by 1000 workers  12 tons of potatoes per worker

2006: 14,300 tons of potatoes divided by 1100 workers  13 tons of potatoes per worker

(b) The growth rate of average labor productivity is [(13/12) – 1] ´ 100%  8.33%.

2005: (100 unemployed/1100 workers) ´ 100%  9.1%

2006: (50 unemployed/1150 workers) ´ 100%  4.3%

(d) The inflation rate is [(2.5/2) – 1] ´ 100%  25%.

5. Given data: I  40, G  30, GNP  200, CA  –20  NX  NFP, T  60, TR  25, INT  15, NFP  7 –9  –2.

Since GDP  GNP – NFP, GDP  200 – (–2)  202  Y.
Since NX  NFP  CA, NX  CA – NFP  –20 – (–2)  –18.
Since Y  C  I  G  NX, C  Y – (I  G  NX)  202 – (40  30  (–18))  150.
S_pvt  (Y  NFP – T  TR  INT) – C  (202  (–2) – 60  25  15) –150  30.
S_govt  (T – TR – INT) – G  (60 – 25 – 15) – 30  –10.
S  S_pvt  S_govt  30  (–10)  20.

(a) Consumption  150

(b) Net exports  –18

(d) Net factor payments from abroad  –2

(e) Private saving  30

(f) Government saving  –10

(g) National saving  20

Base-year quantities at current-year prices		at base-year prices
Apples	3000 ´ $3  $ 9,000	3000 ´ $2  $ 6,000
Bananas	6000 ´ $2  $12,000	6000 ´ $3  $18,000
Oranges	8000 ´ $5  $40,000	8000 ´ $4  $32,000
Total	$61,000	$56,000

Current-year quantities at current-year prices		at base-year prices
Apples	4,000 ´ $3  $ 12,000	4,000 ´ $2  $ 8,000
Bananas	14,000 ´ $2  $ 28,000	14,000 ´ $3  $ 42,000
Oranges	32,000 ´ $5  $160,000	32,000 ´ $4  $128,000
Total	$200,000	$178,000

(a) Nominal GDP is just the dollar value of production in a year at prices in that year. Nominal GDP is $56 thousand in the base year and $200 thousand in the current year. Nominal GDP grew 257% between the base year and the current year: [($200,000/$56,000) – 1] ´ 100%  257%.

(b) Real GDP is calculated by finding the value of production in each year at base-year prices.
Thus, from the table above, real GDP is $56,000 in the base year and $178,000 in the current year. In percentage terms, real GDP increases from the base year to the current year by

[($178,000/$56,000) – 1] ´ 100%  218%.

(c) The GDP deflator is the ratio of nominal GDP to real GDP. In the base year, nominal GDP equals real GDP, so the GDP deflator is 1. In the current year, the GDP deflator is $200,000/$178,000  1.124. Thus the GDP deflator changes by [(1.124/1) – 1] ´ 100%  12.4% from the base year to the current year.

(d) Nominal GDP rose 257%, prices rose 12.4%, and real GDP rose 218%, so most of the increase in nominal GDP is because of the increase in real output, not prices. Notice that the quantity of oranges quadrupled and the quantity of bananas more than doubled.

1. The key to this question is that real GDP is not the same thing as well-being. People may be better off even if real GDP is lower; for example, this may occur because the improvement in the health of workers is more valuable to society than the loss of GDP due to the regulation. Ideally, we would like to be able to compare the costs and benefits of such regulations; they should be put in place if the overall costs (the reduced GDP in this case) are valued less than the overall benefits (the workers’ health).

3. (a) The problem in a planned economy is that prices do not measure market value. When the price of an item is too low, then goods are really more expensive than their listed price suggests—we should include in their market value the value of time spent by consumers waiting to make purchases. Because the item’s value exceeds its cost, measured GDP is too low.

When the price of an item is too high, goods stocked on the shelves may be valued too highly. This results in an overvaluation of firms’ inventories, so that measured GDP is too high.

A possible strategy for dealing with this problem is to have GDP analysts estimate what the market price should be (perhaps by looking at prices of the same goods in market economies) and use this "shadow" price in the GDP calculations.

(b) The goods and services that people produce at home are not counted in the GDP figures because they are not sold on the market, making their value difficult to measure. One way to do it might be to look at the standard of living relative to a market economy, and estimate what income it would take in a market economy to support that standard of living.