ECON 20200: E LEMENTS OF E CONOMIC A NALYSIS -III

P ROBLEM S ET 1
D UE : J ANUARY 18, 2018, BEFORE THE LECTURE BEGINS

This problem set serves as the math refresher and Econ 200/201 review, as well as the discussion of the
difference equations. Questions may look long but they are mostly instructions. You may, and are strongly
encouraged to, work in group of no more than four people.

1. Calculating GDP – We would like to compare the methods in calculating the GDP using the product
and income approaches. Suppose there are three goods produced by three producers in a closed-
economy – Tomato, Cheese, and Margherita Pizza.
- The tomato farmer plants and harvest the tomatoes in his field.
- The cheesemonger produces cheese from the cows in his farm.
- The pizza producer reports that he makes the dough by himself using flour milled in his backyard, but each
pizza pie is made from 0.5 lbs of tomato and 0.25 lbs of cheese.
The following table shows the total quantity and price of each good produced in each year.
2016 2017
Price Quantity Price Quantity
Tomato $ 1 / lb 200 lbs $ 0.9 / lb 210 lbs
Cheese $ 2 / lb 100 lbs $ 2.2 / lb 110 lbs
Margherita Pizza $ 10 / pie 100 pies $ 9 / pie 120 pies

(a) Let 2016 be the base year, calculate nominal GDP and real GDP for each year using the traditional
method.
(b) Calculate the growth rates of nominal GDP and real GDP.
(c) Calculate the GDP deflator for each year. What is the inflation rate in 2017?

2. Difference Equations – Suppose the first-order linear difference equation is

Yt+1 = 0.5Yt + 3

with the initial condition Y0 = 1.

(a) What are the values of Y1 and Y2 ?

(b) Solve for the steady state (Yss = Yt+1 = Yt )
(c) Plot the phase diagram and determine the stability
(d) Plot the time path given the initial condition Y0 .
(e) Suppose instead that the difference equation is Yt+1 = 1.5Yt + 3, with the initial condition Y0 = 1.
What are the values of Y1 , Y2 and Y3 ? Do you predict that this system is stable?

3. The Cobweb Model – This is an economic application of the difference equation techniques you
studied in the discussion section. Suppose the market demand and market supply for an agricultural
product are

Qdt = a − bPt
Qst = cPt−1

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 where a > 0, b > 0, c > 0 are the parameters of the demand and supply functions. Here, the supply of
this good is “lagged” in price by one period. You may think of this as the production decision today
is made yesterday, i.e. how the agricultural product needs time to grow and harvest. The market
clearing condition requires Qdt = Qst , that is, demand equals supply.

(a) Use the market clearing condition to solve for the first-order linear difference equation explaining
the dynamics of price.
(b) What is the steady-state price, Pss ?
(c) Under what parametric conditions that the price of this good is stable?
(d) Optional: Plot the time path of the price given the initial price P0 > Pss .

4. The Rule of X – We want to find a convenient way to estimate the time it takes for a variable to double.
We will call this the “Rule of X,” where X is the “magic” number. Suppose a variable Y constantly
grows at g%, that is, it grows at the rate g/100 – meaning, 2% growth rate is 0.02. When this variable
Y doubles after T time periods, we have
 g T
Y 1+ = 2Y
100

(a) To derive the estimation for this time T, start by taking log (·) – the natural logarithmic – to the
expression above.
g

(b) You will notice that there is a log 1 + in the expression from part (a). A function F ( x ) can
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be approximated by the Taylor series expansion around any values a to the n-th order. That is,

∞
∂n F ( a) /∂x n F 00 ( a)
F (x) = ∑ n!
( x − a)n = F ( a) + F 0 ( a) ( x − a) +
2
( x − a )2 + . . .
n =0

Put simply, when a = 0, a function F ( x ) can be approximated to the 1st-order by

F (x) ≈ F (0) + xF 0 (0)

Provide a Taylor series expansion around a = 0 to the 1-st order of the function F ( x ) = log (1 + x ).
(c) You can now obtain the approximate for T as a round integer divided by g, that is, T = X/g.
What is this magic number, X?
(d) How long does it approximately take for a variable growing at 2% to double? Check your answer
to that of 1.02T , using the number T you found.

5. Growth Rate Approximation – We want to find a convenient way to estimate the growth rate of a
multiplicative variables. Suppose Xt and Yt are time-dependent variables. Let Zt be defined as

Zt = Xt Yt

That is, Zt is the multiplication of Xt and Yt .

(a) Argue that %∆Xt = ( Xt − Xt−1 ) /Xt−1 ≈ d log ( Xt ) /dt ≈ log ( Xt ) − log ( Xt−1 ). That is, one
can approximate the percentage of any time-dependent variable using the log-difference.

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 (b) Start by taking log (·) to Zt = Xt Yt , show that %∆Zt = %∆Xt + %∆Yt .
(c) Provide the growth rate expression for the variable Wt = A ( Xt )α (Yt ) β , where A, α and β are
constants.

6. The Microeconomic Problem of CPI – Here is one of the problems of using CPI in calculating the cost-
of-living adjustment. Suppose a household is maximizing the Cobb-Douglas utility by consuming
two goods, X and Y, subject to the budget constraint, that is

max X 0.5 Y 0.5

X,Y
subject to Px X + Py Y = I

where Px and Py are the prices of goods X and Y, and I is the income. Here, the preference parameter
in the Cobb-Douglas utility function is α = 0.5.

(a) Find the demand functions for goods X and Y, and the indirect utility function as functions of α,
Px , Py and I.
(b) Suppose the prices in period 1 are Px = 1 and Py = 1, and the income is I = 2. What is the
quantity demanded for each good? What is the total utility?
(c) Suppose the price of good X has increased to Px = 2 in period 2. Using the quantity demanded
for each good in part (b) as the “standard” consumption basket in the consumer price index,
what is the income required to afford the same quantity as in part (b)? (This is how the CPI is
traditionally calculated.)
(d) Let period 1 be the base year, what are the CPIs in period 1 and period 2? What is the inflation
rate in period 2?
(e) Suppose Px = 2, Py = 1 and I = 3. What is the quantity demanded for each good? What is the
total utility?
(f) To maintain the same level of utility as in part (b) when the price of good X is now Px = 2, what
is the required income? (Hint: Use the indirect utility function here.)
(g) Does the use of CPI as the cost-of-living adjustment over-, exactly- or under-compensate? That
is, does the cost-of-living adjustment using CPI make the consumer better off, worse off, or
indifferent? Why or why not?
(h) If you are to construct the optimal price index with the knowledge of the household’s utility
maximization problem, what are the price indices in period 1 and period 2?

7. Crusoe’s Island – Consider a variation to the Crusoe’s consumption-labor problem. With the utility
function and the production function specified in class, we find that the labor supply is insensitive to
the productivity/technology parameter, that is L is constant. Suppose instead that the utility function
is given by

C 1− σ L 1+ η
U (C, L) = −
1−σ 1+η

where σ > 0 is the coefficient of relative risk aversion, and η > 0 is the elasticity of labor supply. This
class of utility function is called the “constant relative risk aversion” (CRRA) utility function, widely

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adopted in modern macroeconomic literature.
For algebraic simplification, assume that Crusoe’s production function is linear, that is

Y = AL

where A > 0 is the factor (labor) productivity parameter.

(a) Write down the market clearing condition and define the equilibrium.
(b) Write down the Crusoe’s Lagrangian function.
(c) Solve for Crusoe’s optimal labor supply.
(d) Suppose the factor productivity (A) increases, what would happen to his labor supply? Specifi-
cally, find dL/dA.
(e) To fit the model with the data from non-U.S. OECD countries, at least, we need the negative sign
of dL/dA, that is dL/dA < 0. Macroeconomists tend to agree that the parameters are σ = 1.5
and η = 0.1, as inferred from the data. Does this variation of Crusoe’s model fit the data from
non-U.S. OECD countries?